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Corporations – Fall 2013

Outline

Professor Clarke

TABLE OF CONTENTS

Introduction & Agency Issues.......................................................................................................... 1Economics & Legal Aspects of Business Associations.........................................................................1

Agency................................................................................................................................................................. 2

Partnerships.......................................................................................................................................... 2Introduction...................................................................................................................................................... 2

Fiduciary Duty.................................................................................................................................................. 4

Dissolution & Disassociation....................................................................................................................... 6

Statutory Framework.....................................................................................................................................................6

Wrongful Dissociation................................................................................................................................................... 7

Corporations.......................................................................................................................................... 8Introduction...................................................................................................................................................... 8

Corporate Roles................................................................................................................................................................ 8

Shares & Voting Rights..................................................................................................................................................9

Shareholder Action.......................................................................................................................................................11

Shareholder Investment & Governance (Publically Held Corporations)..............................................13

Directors’ Duties & The Business Judgment Rule..............................................................................14

Business Judgment Rule.............................................................................................................................................14

Fiduciary Duty of Loyalty...........................................................................................................................................15

Fiduciary Duty of Care.................................................................................................................................................19

Derivative Suits.............................................................................................................................................. 21

Overview........................................................................................................................................................................... 21

Demand Requirement.................................................................................................................................................22

Aronson Test – Prong 1.............................................................................................................................................. 23

Aronson Test – Prong 2.............................................................................................................................................. 24

Demand Requirement Analysis...............................................................................................................................25

Corporations Outlineii

Close Corporations............................................................................................................................ 25Contracting as a Device to Limit Majority Discretion.......................................................................25

Contracting Regarding Director Decisions.........................................................................................................25

Contracting Regarding Voting.................................................................................................................................26

Enhanced Fiduciary Duty and the Partnership Analogy..................................................................26

Share Repurchase Agreements (SRAs)..................................................................................................29

Limited Liability Corporations...................................................................................................... 30Overview.......................................................................................................................................................... 30

Planning for the LLC..................................................................................................................................... 31

Fiduciary and Contractual Duties............................................................................................................32

Overview........................................................................................................................................................................... 32

Conflicting Interest Transactions...........................................................................................................................32

Judicial Dissolution.......................................................................................................................................................33

Third Parties....................................................................................................................................... 34Introduction.................................................................................................................................................... 34

Piercing the Corporate Veil....................................................................................................................... 37

Introduction.....................................................................................................................................................................37

In Contract........................................................................................................................................................................ 38

In Tort.................................................................................................................................................................................39

Where the Shareholders are Corporations........................................................................................................40

De Facto Incorporation............................................................................................................................... 40

Veil Piercing Analysis.................................................................................................................................. 42

Acquisitions......................................................................................................................................... 42Introduction.................................................................................................................................................... 42

Statutory Mergers......................................................................................................................................... 42

Sale of Assets................................................................................................................................................... 44

Triangular Mergers...................................................................................................................................... 45

Compulsory Share Exchanges................................................................................................................... 45

Corporations Outlineiii

De Facto Mergers........................................................................................................................................... 46

Cash-Out Mergers.......................................................................................................................................... 47

Hostile Takeovers......................................................................................................................................... 49

Overview........................................................................................................................................................................... 49

Poison Pills....................................................................................................................................................................... 50

Hostile Takeover Analysis.........................................................................................................................................52

Federal Law & Insider Trading..................................................................................................... 52Federal Securities Law................................................................................................................................ 52

Overview........................................................................................................................................................................... 52

Rule 14a-9 (Proxy Statements)...............................................................................................................................53

Rule 10b-5 (Issuance of Securities).......................................................................................................................53

Insider Trading.............................................................................................................................................. 54

Insider Trading Analysis............................................................................................................................................56

Appendix – Flow Charts................................................................................................................... 57Partnerships – Fiduciary Duty..................................................................................................................57

Partnerships – Dissociation.......................................................................................................................58

Business Judgment Rule – General Application..................................................................................59

Corporate Opportunities Doctrine – ALI...............................................................................................60

Corporate Opportunities Doctrine – Guth Test...................................................................................61

Conflicting Interest Transactions............................................................................................................ 62

Duty of Care..................................................................................................................................................... 63

Duty of Good Faith........................................................................................................................................ 64

Corporations Outlineiv

INTRODUCTION & AGENCY ISSUES

ECONOMICS & LEGAL ASPECTS OF BUSINESS ASSOCIATIONS

- Classical firm : a business that is owned and managed by one person; also known as a sole proprietorship.

o Sole proprietor : the owner of a classical firm/sole proprietorship.o Entrepreneur : a person who organizes and operates a business; has two main tasks that it

must do: The entrepreneur directs the business and exercises ultimate business judgment ,

and The entrepreneur accepts full responsibility for his or her business decisions by

being the residual guarantor and claimant (i.e. has unlimited liability).o Firm : a set of relations that arise when the entrepreneur allocates resources via commands

to his employees.o Coasean firm : includes the entrepreneur and his employees, but excludes customers,

suppliers, and creditors with whom the entrepreneur does business via contract or market exchanges.

- Business association : a collection of firms that are jointly owned – ranging from two owners (closely held corporation) to thousands of owners (publically traded corporation).

o Modern corporation : characterized by a complete separation of ownership from control; shareholders own and managers control.

o Berle-Means Critique : the modern corporation destroyed the theoretical underpinnings of the free enterprise system; the main concern of this critique is the problem of power.

o The modern firm represents a consensual choice by shareholders (principals) and managers (agents) to cede authority and power over the corporation almost entirely to the managers.

Principals may be tempted to shirk responsibilities because they do not have to worry about managing the business.

There are ways to limit the cost of principals shirking their duties: Direct monitoring of the managers’ actions, Agreements by managers that will result in the imposition of penalties or

other costs if certain objectively verifiable events do or do not occur, Incentive schemes to align managers’ interests with those of the

shareholders. But there are costs of these cost-limiting devices as well. So the shareholders’ gain from owning the corporation must be reduced by the sum

of: the cost of the cost-limiting devices plus the residual loss from shirking.- A firm can be described using one of several theories:

o Nexus of contracts theory : a firm is a nexus of contracts between the various claimants to a share of the gross profits generated by the business.

o Nexus of patrons theory : everyone who transacts with the firm is a patron, and a select number of patrons are owners who control the business and have a right to profits and the residual.

Corporations Outline1

- The goal of business planning is to minimize the use of litigation as a governance tool while preserving the availability of litigation to deal with circumstances that cannot appropriately be governed by private ordering.

- The goal of informed rational choice between competing investment options is to determine the likely return from alternative investment choices and to choose based on the individual’s risk preference and portfolio diversification.

- In state provided governance structures, such as the employer-employee relationship, the corporation, the partnership, and the LLC, default rules govern the relationship unless the parties provide otherwise.

o Immutable rules cannot be contracted around.o Tailored rules are rules that the parties would have chosen had they been able to bargain

over the matter in dispute with zero transaction costs.o Majoritarian rules are rules that are designed to provide investors with the result that most

similarly-situated parties would prefer.o Penalty default rules are rules that are designed to motivate one or more of the contracting

parties to contract around the default rules.

AGENCY

- There are three types of authority that an agent may have to act on behalf of the principal:o Actual authority : where the principal manifests consent directly to the agent.o Apparent authority : where a third party reasonably believes that the agent is authorized to

act on behalf of the principal as a result of the principal’s manifestations.o Inherent authority : where the agent derives authority from the agency relation itself

This is designed to protect third parties where the doctrine of apparent authority fails.

But normally assurances of the purported agent are not enough to bind the principal.

- The principal has a duty to the agent with regard to discharge:o Foley : An employer may not discharge an employee for refusing to act in a way contrary to

public interest. The employee here has to show that there is a public interest in seeing firms operate efficiently and honestly, and that courts can make this policy judgment.

There is a presumption that employment is at-will. This presumption can be overcome by showing an express agreement to the contrary or by showing evidence of contrary intent (looking at the length of employment, the employer’s general policies and practices, and the employer’s actions with regard to this particular employee).

There is no tort remedy for actions done in bad faith. This is a contract remedy.

PARTNERSHIPS

INTRODUCTION

- General partnership : an association of two or more persons to carry on as co-owners a business for profit. UPA 202(a).

o This is the only business association that parties can enter into without a filing – no written agreement is needed.


o GPs are governed by a standard set of default form rules.o Defining characteristics of ownership:

The right to the residual claim, Management rights, Actual authority to bind the partnership, Share of the profits and a responsibility for the losses.

o The ideal firm for a GP structure is: Small and intimate, One in which each partner participates in all aspects of the business, and One in which there is trust among the partners.

o GPs are subject to the following default rules: Equal sharing of ownership and management, If the partnership wants to terminate its association with a partner, it may only do

so by dissolving the partnership and paying the partner his interest in cash, All partners are jointly and severally liable for all obligations of the partnership, Each partner owes a fiduciary duty to the others.

- Joint venture : a legal relationship between two or more persons who seek a profit jointly in some specific venture without the existence of any actual partnership.

o JVs are generally government by the same rules as GPs.o There are a few key differences:

Third parties may not assume that joint venturers have agency powers equal to those of general partners.

There is less fiduciary duty in a JV.- Limited partnership : a business association of one ore more general partners and one or more

limited partners.o An LP is formed by filing a certificate of limited partnership with the secretary of state in the

jurisdiction that the partners in control choose.o General partners : active participants in the firm, empowered to make and carry out the

firm’s business policies GPs are jointly and severally liable for the firm’s obligations. GPs may withdraw from the partnership at will, and this will not trigger dissolution.

o Limited partners : passive investors with no management power and no authority to act as agents.

LPs are not personally liable for the partnership’s obligations. They may not withdraw from the partnership at will.

- Byker v. Mannes : If partners associate themselves to carry on as co-owners a business for profit, they will be deemed to have formed a partnership relationship regardless of their subjective intent to form such a legal relationship.

- Hynasky v. Vietri : To prove the existence of a partnership, one must show intent to divide the profits of the venture. Evidence in the form of a partnership agreement is strong by not conclusive proof of intent. The court looks to the actions of the parties.

o The requirement to share losses is, in some jurisdictions, indispensible to the existence of a partnership, and sometimes a joint venture.

- Under the UPA, the default rule for profits is that they are divided equally among the partners.o The default rule for losses is that it must be the same as that for profits, whether it is the

default rule (split evenly) or another one agreed to by the parties.


- Under the UPA, the default rule for services is that a partner is not entitled to receive compensation for his services or interest on capital.

- Kovacic v. Reed : The general rule is that, in the absence of an agreement to the contrary, the law presumes that partners and joint venturers intended to share profits and losses equally, regardless of actual contribution.

o There is an exception however. Where one partner or joint venturer contributes money against the other’s services, neither party is liable to the other for contribution for any loss sustained.

- Each partner is an agent of the partnership for the purpose of its business (UPA 301), subject to the effect of a statement of partnership authority under UPA 303.

o UPA 306 : Generally, partners are jointly and severally liable for all obligations of the partnership.

o PAP v. Moss : The joint venture is liable for the obligation of its joint venturer, even if the action taken was not allowed and even if the joint venturer did not disclose the existence of the joint venture, where the action taken was for the benefit of the joint venture and where the action taken was within the scope of the joint venturer’s duties and powers.

o Haymond v. Lundy : The partnership agreement said that a partner could not dispose of a material asset worth more than $10,000 without the consent of the partnership. A $150,000 referral fee was a material asset, so the partnership was not liable.

- It is not reasonable to assume that joint venturers have granted each other the authority of a general manager because a joint venture is for a limited purpose only.

o The party seeking to bind the joint venture must establish the extent of the agent’s actual authority.

o Conversely, third parties without knowledge to the contrary can rely on the presumption that all general partners have the actual authority of a general manager.

o Matanuska Valley Bank v. Arnold : The power of one joint venturer to bind another must come from express authority to do what he did, or by implication from the nature of the agreement. Here, Davis had never been given authority to borrow money nor was authority implied, so the joint venture was not responsible for the borrowed money.

- A finding that the partnership is liable for the unauthorized actions of a partner in an LLP will normally not expose other partners to the risk of liability.

o Dow v. Jones : The partner had apparent authority and could therefore bind the LLP (though not its partners) even though the firm dissolved prior to the alleged malpractice.

Partnership by estoppel : a person who represents himself or is represented by others as a partner in an existing partnership is an agent of the persons consenting to such representation.

A partnership may be held liable for the malpractice of a partner committed after dissolve under two theories:

The malpractice concerned an open case that had to be wound up, or The third party never had proper notice of the dissolution, so the partner’s

agency powers continued after dissolution with respect to the third party.

FIDUCIARY DUTY

- Partners have a duty of loyalty to one another.o Under UPA 404(b), partners must:

Account to the partnership and hold its property, profit, or benefit as a trustee,


Refrain from dealing with the partnership as or on behalf of a party with an adverse interest, and

Refrain from competing with the partnership before its dissolution.o Meinhard v. Salmon : Partners, like trustees, owe to each other a strict standard of loyalty –

“not honesty alone, but the punctilio of an honor the most sensitive.”o UPA 405 recognizes a partner’s formal right to an accounting to enforce fiduciary duties or

contractual rights.o Fiduciaries carry the burden of proof by clear and convincing evidence that they have

fulfilled their fiduciary obligations.o Self-dealing : when a partner does not inform other partners of business opportunities that

should belong to the partnership; a violation of the duty of loyalty. Vigneau v. Storch Engineers : A partner who breaches his duty of loyalty is still

entitled to the value of his partnership interest. However, a partner that breaches his duty of loyalty by self dealing may have to pay

the following damages: Always any profits earned as a result of the breach, plus interest, Sometimes payment by the partnership for services rendered as a partner.

o Some courts say that the partner is not entitled to his compensation even if he performed the services properly.

o Most courts, however, hold that the discretion rests with the trial court and that this type of penalty should only be used if the services were performed improperly.

Always losses that the partnership sustained as a result of the breach. Sometimes punitive damages, and Sometimes reasonable attorney’s fees.

o In the absence of a mutual agreement, the remedy for an impasse between partners is dissolution of the partnership. The impasse itself is not a breach of fiduciary duty of loyalty.

Covalt v. High : The conflict of interest existed at the time of partnership formation, and both parties were complicit in it. Therefore it is not a breach of fiduciary duty. The fact that a business proposal may benefit the partnership does not mandate acceptance by all partners, and failure to accept the business proposal does not result in a breach of the duty of loyalty.

But the key here is that both Covalt and High knew about the conflict of interest before partnership formation and still went ahead.

UPA 401(f) : each partner has equal rights in the management and conduct of the partnership’s business.

UPA 401(j) : ordinary business decisions are decided by a majority vote.- Partners may sometimes attempt to contract for absolute discretion by way of a partnership

agreement.o UPA 103(b)(3) : A partnership agreement may not eliminate the duty of loyalty.o UPA 404 : A partner’s fiduciary duty is limited to a duty of loyalty and a duty of care.o Starr v. Fordham : Once it is shown that a partner has engaged in self-dealing, that partner

has the burden of proving the fairness of his actions and to prove that his actions did not result in harm to the partnership.

Business judgment rule : If the allegedly violating partner can demonstrate a legitimate business purpose for his action, there is no breach of the duty of loyalty.


The business judgment rule does not apply if the plaintiff can demonstrate self-dealing on the part of the allegedly violating partner.

An unfair determination of a partner’s respective share of a partnership’s earnings is a breach of both one’s fiduciary duty and the implied covenant of good faith and fair dealing.

Note: Not a UPA jurisdiction.o UPA 404(e) : A partner does not violate his fiduciary duty of loyalty merely because his

conduct furthers his own interest.- Partners all owe to each other a duty of care.

o UPA 404(c) : General partners owe to each other and to limited partners a duty of care, using a gross negligence standard.

o Limited partners in a limited partnership do not owe general partners a duty or care of loyalty.

o Ferguson v. Williams : A general partner does not owe other partners a duty of care under a negligence standard. The standard is gross negligence.

This decision is a bit contrary to the UPA.

DISSOLUTION & DISASSOCIATION

STATUTORY FRAMEWORK

- The general partnership is an at-will relationship that can continue only as long as every member assents.

- In an at-will general partnership, any partner may dissociate and thereby cause a dissolution of the partnership by simply expressing his will to cease association with the partnership.

- As soon as the partnership’s affairs are wound up, the partnership terminates.- Article 8 of the UPA says that any partner normally has the right to require that the partnership’s

assets be liquidated via a judicially supervised auction only if the partnership is at-will and has been dissolved by a partner’s express will to dissociate (unless there is an agreement to the contrary).

- Article 7 of the UPA says that the partnership interest of a deceased or otherwise dissociating partner will be purchased by the partnership for a buyout price based on the greater of the partnership’s liquidating or going-concern value. But courts are tempted to avoid the buyout rules of Article 7.

- UPA 103(b)(6) : A partnership agreement cannot vary the power to dissociate as a partner, except to require that notice be in writing.

- UPA 601 : There are ten events that cause a partner’s dissociation:o The partner expresses will to withdraw as a partner,o An event agreed upon in the partnership agreement occurs,o Expulsion pursuant to the partnership agreement,o Expulsion by unanimous vote (note: there are some statutory limitations to this),o Expulsion by judicial determination (note: there are some statutory limitations to this),o A partner’s bankruptcy, assignment to creditors, or appointment of trustee,o A partner’s death, appointment of guardian, or judicial determination of incapacity,o A partner’s distribution of its interest in the partnership (when the partner is a trust),o A partner’s distribution of its interest in the partnership (when the partner is an estate),o Termination of a partner, where the partner is not an individual, partnership, corporation,

trust, or estate.- UPA 603 : If a partner’s dissociation results in dissolution and winding up, Article 8 of the UPA

applies. Otherwise, Article 7 of the UPA applies.


- UPA 801 : A partner’s dissociation results in dissolution and winding up only if:o In a partnership at will:

A partnership receives notice of a partner’s intent to dissociate under UPA 601(1) (express will),

o In a partnership for a definite term or particular undertaking: After a partner’s dissociation under UPA 601(6)-(1) (including death, or wrongful

dissociation under UPA 602(b), the remaining partners decide by majority within 90 days of dissociation to wind up, or

All partners wish to wind up (note: no need for dissociation), or The expiration of the term or undertaking occurs.

o In any partnership: An event agreed to in the agreement results in a winding up; or An event that makes it illegal for substantially all of the partnership’s business to

continue (unless there is a cure of illegality within 90 days), or Various judicial determinations occur (UPA 801(5)-(6)).

- UPA 802 : The default rule is that the partnership continues after dissolution only for the purpose of winding up, but the partners can agree otherwise prior to dissolution, thereby preventing termination of the partnership.

- UPA 701 : If nothing under UPA 801 applies, then the partnership must buy the dissociated partner’s interest (the fair share, either agreed to or based on the partnership’s liquidation value or market test).

o Damages for wrongful dissociation offset the buyout amount.o In a partnership for a term, a wrongfully dissociated partner is not entitled to a buyout until

the end of the term unless he shows that payment will not result in undue hardship to the partnership.

- McCormick v. Brevig : The lower court erred by adopting a judicially created alternative to the statutorily mandated requirement of liquidation and distribution of asserts when a partnership is dissolved under UPA 801(5).

o But see Nicholes v. Hunt where the court refused to apply the UPA literally.

WRONGFUL DISSOCIATION

- UPA 602(a) : A partner can always dissociate, rightfully or wrongfully.- UPA 602(b) : A dissociation is wrongful only if:

o It is in breach of an express provision of the partnership agreement, oro It is before the end of the term or undertaking (with some limitations).

- UPA 602(c) : A wrongfully dissociating partner is liable to the partnership for damages caused by the dissociation.

- UPA 701(c) : The partner still gets the buyout price of his interest, offset by the amount of damages under UPA 602(c).

- UPA 801(2)(i) : The other partners in a partnership for a term have 90 days after a partner’s wrongful dissociation to decide by majority if they want to wind up.

- Drashner v. Sorenson :o First, the court decides that this was not a partnership at will because the partnership

agreement contemplated that the association would continue at least until the $7,500 that the defendants loaned to the plaintiff had been repaid from the gross earnings of the business.


o Second, this was a wrongful dissociation by the plaintiff because the insistent and continuing demands of the plaintiff for more money rendered it reasonable impracticable to carry on the business in partnership with him.

- McCormick v. Brevig : The defendant did not dissociate under UPA 601(1) because he continued to carry on the business after the alleged dissociation.

o Instigating criminal theft charges against the other partners is not dissociation.- Page v. Page : A partnership at-will may be dissolved under UPA 601(1) at any time, but this power to

dissociate must be exercised in good faith.o A partner may not dissolve a partnership to gain the benefits of the business for himself

unless he fully compensates his co-partners for his share of the prospective business opportunity.

o If he does dissolve the partnership without compensating the partners, it is a wrongful dissociation.

o Page has been criticized; fairness does not require the stronger partner to carry the weaker partner indefinitely.

o The case should incentivize partners to choose their co-partners carefully.- In a term partnership, if the majority ousts the deficient partner, this dissociation could be deemed

wrongful, exposing the ousting partners to liability.o Partners will often negotiate in advance for terms governing expulsion.o Bohatch v. Butler & Binion : The partnership did not violate its fiduciary duty when it

expelled a partner who reported suspected overbilling by another partner because the ousted had created an irreparable schism between partners.

Other acceptable reasons to expel partners include: Pure business reasons, To protect relationships within the firm and with clients, Policy disagreements

- It is common for one or more partners to dissociate, form a new firm that carries on a similar business, and then attract former clients to the new firm.

o Partners sometimes contract in advance concerning the rights and obligations of continuing and withdrawing partners.

o Meehan v. Shaughnessy : The secrecy and preemptive tactics that the leaving partners employed was a violation of their fiduciary duty because it effectively excluded the old PC (old firm) from presenting its services as an alternative to MBC (newly created firm).

The old PC, not the new PC, is entitled only the amounts that flow from the breach. Here, the damages that flow from the breach are the fees from the clients that MBC

took from old PC.

CORPORATIONS

INTRODUCTION

CORPORATE ROLES

- The corporation separates ownership and management functions into three roles:o Directors: make major policy decisionso Officers: provide day-to-day managemento Shareholders: provide capital and vote.


- The separate roles do not have to be with separate people.o In a closely held corporation for example, one person may be a director, officer, and

shareholder.- The board of directors is the center of all legal power and authority exercised by the corporation.

MBCA 8.01; Del. GCL 141.o Directors are entitled to compensation for their services but do not share in the firm’s

residual profits, except by virtue of any shares they may own in their personal capacity.o Management power must be exercised by majority rule.o Individual directors are not given general agency power to deal with outsiders.o Courts give great deference to the board’s decisions (see section on the business judgment

rule below).- Officers are the agents of the corporation.

o They are entitled to compensation, but not the residual except by virtue of any shares they may own in their personal capacity.

o Modern statutes allow corporations to have the officers specified in the bylaws or determined by the board. MBCA 8.40; Del. GCL 142.

- The shareholders are the passive investors who provide capital and vote.o Shares : fungible ownership units that typically entitle the holder to a pro rata share of the

firm’s profits and net assets when a corporation dissolves and winds up business; freely transferable.

o Shareholders are risk-bearers and residual claimants.o Shareholders have no liability for the obligations of the corporation.o They have a limited governance role:

Elect and remove directors, Vote on actions proposed by the board, Make recommendations to the board.

o Almost all codes provide that the business of a corporation be entrusted to the directors, except as otherwise provided by the articles of incorporation.

The default rule is that an amendment to the articles may only be initiated by the board of directors, and the board will rarely limit its own power. MBCA 8.01; Del. GCL 141(a).

Shareholders can amendment the bylaws, but not to make ordinary business decisions or to establish corporate policies.

- There are two main sources of corporate law: the MBCA and Delaware. But overall, there is substantial uniformity

- Minimum requirements for forming a corporation by filing the articles of incorporation are very minimal. MBCA 2.01.

SHARES & VOTING RIGHTS

- There must be two classes of shares: a voting class and a residual claiming class.o These two classes do not have to be separate.o Common stock : shares that combine voting rights and residual claimant status.o All shares of a given class are fungible (meaning they have identical rights, preferences, and

limitations). MBCA 6.01.o Preferred shares : Depending on what is set out in the articles of incorporation, these shares

usually grant a dividend or liquidation preference over common shares. Usually also deny voting rights.


Vary from corporation to corporation and form class to class. Research costs make this type of share a sophisticated investment option.

- The default rule for voting rights is straight voting.o This means that directors are elected annually by plurality vote.o Each share gets one vote per director.o The number of directors is usually specified in the articles of incorporation of the bylaws.o The practical result is that a shareholder with 51% of the shares can elect 100% of the

directors.- The articles of incorporation can get around the default rule of straight voting by calling for

cumulative voting.o In cumulative voting, a shareholder can cast a total number of votes equal to the number of

shares he owns multiplied by the number of positions to be filled.o These votes can be spread among as many or as few candidates as the shareholder wishes.o For example:

If there are 9 positions to be filled, and You own 100 shares, You get 900 votes (9 x 100).

o The purpose of cumulative voting is to give minority shareholders a place on the board.o How many shares must an investor have to gain a particular number of seats on the board

under cumulative voting?

N> SX(D+1)

N = Number of shares you have S = Number of voting shares in existence X = Number of directors you want to elect D = Number of directors in total that will be elected For example: There are 10,000 voting shares in total, 9 open positions, and you

want to elect 2 directors

N>(10,000 )(2)

(9+1)

N> 20,00010

N>2,000 You must have at least 2,000 to elect 2 directors.

- Class voting : a corporation may, in its articles, divide its shares into classes and permit each class to select a specified number of directors.

o Normally, power to elect directors rests with the voting shares as a whole (default rule)o Dual class voting : shareholders are separated into two classes, and one class is given

disproportionate voting power as compared to their capital contribution. For example:

Class A (sold to public): One share, one vote Class B (retained by founders): One share, ten votes.

This allows founders to protect their control of the corporation. This has been disfavored by the SEC and curtailed by stock exchange rules. But this is still permitted in Delaware.


- Statutes allow corporations to adopt longer and staggered terms for directors than the default rule specifies. MBCA 8.06.

o The default rule says that directors are elected annually.o MBCA allows classification of the board into two or three groups of as equal size as possible.

If you have two groups of directors, then you have two-year terms. If you have three groups of directors, then you have three-year terms. The term of only one group expires each year. This ensures that the corporation will have experienced directors in officer. Even a majority shareholder cannot easily change corporate policy by electing a new

board. This provision can be in either the articles or the bylaws.

To get this provision in the articles, the directors themselves must propose it and then the shareholders must vote on it.

To get this provision in the bylaws, the shareholders can propose it.

SHAREHOLDER ACTION

- There is an immutable rule in most corporation codes that there must be an annual meeting.o Directors have some discretion in that they can make or change the bylaws affecting the

timing and location of the annual meeting.- All corporation codes provide for special shareholder meetings:

o These meetings address issues expressly identified in the meeting notice.o In Delaware, only directors and those listed in the charter can call special shareholder

meetings.o In an MBCA jurisdiction, shareholders of 10% or more can call special shareholder meetings.o The board cannot ignore a validly demanded special meeting.

- Shareholders can act by written consent in lieu of a meeting.o In Delaware, written consent can be used by a majority vote unless the articles or bylaws

specify otherwise.o In an MBCA jurisdiction, written consent is permitted only by unanimity, which effectively

limits its use to small corporations with few shareholders.o However, these are default rules that can be altered.o Hoschett v. TSI : Delaware corporations have a legal obligation to hold an annual meeting to

elect directors (absent unanimous consent) under Del. GCL 211. Del GCL 228 allows written consent in lieu of a meeting. The written consent in this

case clearly just removed the current directors as holdovers and designated them again as replacement.

The directors only hold office until the annual meeting (which has to take place).- The record date determines which shareholders can vote.

o Shareholders entitled to vote are those owning shares on the record date specified by directors.

o It usually has to be 60 to 90 days before the meeting, but the timing is more complicated in Delaware.

- In addition to electing directors, shareholders can also remove directors.o Generally, default rules allow shareholders to remove directors before the expiration of their

term in office, with or without cause, by majority vote. But note that there are exceptional circumstances.

o MBCA 8.08 contains certain limitations on removal:


If the board is a regular board (not staggered, straight voting): Directors can be removed with cause by majority vote. Directors can be removed without cause by majority vote. These are default rules that can be altered.

If the board is a staggered board: Directs can be removed with cause by majority vote. Directs can be removed without cause by majority vote. These are default rules that can be altered.

If the board is elected with cumulative voting: Directors can be removed with cause by majority vote, and the number of

votes cast against removal must be less than what was required to elect the director.

Directors can be removed without cause by majority vote, and the number of votes cast against removal must be less than what was required to elect the director.

This is an immutable rule that cannot be altered. If the board is a classified board:

Directors can be removed with cause by a majority vote of the director’s class.

Directors can be removed without cause by a majority vote of the director’s class.

This is an immutable rule that cannot be altered.o Del. GCL 141(k) contains certain limitations on removal:

If the board is a regular board (not staggered, straight voting): Directors can be removed with cause by majority vote. Directors can be removed without cause by majority vote. These are default rules that can be altered.

If the board is a staggered board: Directs can be removed with cause by majority vote. Directs cannot be removed without cause. These are default rules that can be altered.

If the board is elected with cumulative voting: Directors can be removed with cause by majority vote. Directors can be removed without cause by majority vote, and the number

of votes cast against removal must be less than what was required to elect the director.

This is an immutable rule that cannot be altered. If the board is a classified board:

Directors can be removed with cause by a majority vote, regardless of class. Directors can be removed without cause by a majority vote of the director’s

class. This is an immutable rule that cannot be altered.

o Campbell v. Loew’s : The directors’ plan to take over the corporation is not a cause for removal. A planned scheme of harassment that constitutes a real burden to the shareholders is a cause for removal. (Delaware).

o In Delaware, there are procedural requirements to remove a director for cause that must be satisfied before proxies are solicited.

These requirements are:


Service of the specific charges, Adequate notice, Full opportunity of meeting the accusation.

Alderstein v. Wertheimer : While the meeting called was in fact a board meeting, removal was still improper because Alderstein, as a shareholder and director, was entitled to advance notice of the plan to issue more preferred stock, which would have made him a minority shareholder.

This was also a breach of fiduciary duty. The duty arises not from his status as either a director or a majority

shareholder, but from both together. Only when lack of notice is done for the purpose of preventing the majority

shareholder/director from stopping the scheme is it a breach of fiduciary duty.

- Once the shareholders and directors make changes to the default rules, those changes have to be protected from future changes.

o Centaur Partners v. National Intergroup : Where the articles and bylaws show an intent to ensure continuity in the board of directors and to avoid hostile takeovers, courts must give effect to that intent even if the proposed amendment has found a loophole.

The proposed amendment to the bylaws was also technically in conflict with the articles:

The articles said that the board sets the size of the board. The proposed bylaw said that the board size was set at 15 directors and

that this could not be changed by the board.

SHAREHOLDER INVESTMENT & GOVERNANCE (PUBLICALLY HELD CORPORATIONS)- Publically held corporations are different from closely held corporations because there is a market

for their shares.- Efficient Markets Hypothesis:

o Weak form : You cannot develop a trading strategy based on the use of past prices that will enable you to beat the market because current price already incorporates past prices.

o Semi-strong form : You cannot develop a trading strategy that will beat the market based on publically available information related to the value of traded sock because the current price already incorporates this information.

o Strong form : You cannot develop a trading strategy that will beat the market by using nonpublic information because the current price already incorporates this information.

- Federal regulations require disclosure in five situations:o Issuing securities,o Tender offers,o Insider trading,o Periodic reporting.

- Proxy : a legal relationship under which one party is given the power to vote the shares of another party.

- 1934 Exchange Act:o Prohibits any proxy solicitation unless the person solicited is first furnished a publically filed

preliminary or final proxy statement.o Regulates the form of the proxy statement.o Regulates the form of the proxy that shareholders are asked to execute.


o Prohibits the making of false or misleading statements or missions as to any material fact in connection with a proxy solicitation.

- 1934 Exchange Act Rule 14a-8 permits a qualifying shareholder to insert a proposal in a company’s proxy for the annual meeting.

o Shareholder proposal : recommendation or requirement that the company and/or its board take action that you intend to present at the shareholder meeting.

o Qualifying shareholder : Must own a minimum stake of the shares for a minimum holding period at the time the proposal is submitting and continuously own such stock through the date of the meeting.

o A shareholder may only make one proposal per meeting.o A shareholder proposal may be excluded if it is:

Not a proper subject for shareholder action under state law. But this exception doesn’t apply where the proposal is just a

recommendation or request that the board do something. Not economically relevant.

A proposal is not economically relevant if it relates to operations accounting for less than 5% of total assets, gross sales, and net sales if the proposal is not otherwise significantly related to the company’s business.

Lovenheim v. Iroquois : Proposals cannot be excluded under the economical irrelevance exception for failure to reach the specified economic threshold if a significant relationship to the issuer’s business is demonstrated.

o “Significantly related” is not limited to economic significance, but can also include ethical or social significance.

o Directors can ignore a shareholder proposal even if it gains a majority vote.o However, directors are likely to implement winning proposals because of the fear of

removal.- Shareholders and directors have concurrent authority to make and amend bylaws.

o The following statutes are relevant in Delaware: Del. GCL 141(a): business and affairs f a corporation shall be managed by the board

of directors. Del. GCL 109(a): voting shareholders have the authority to make, amend, or repeal

bylaws. Del GCL 109(b): bylaws may contain any provision relating to the business of a

corporation.o CA v. AFSCME : A bylaw that effectively mandates that the board reimburse shareholders for

nomination expenses should their candidate be elected to the board falls within the scope of the shareholder’s power because it is more procedural than substantive in nature.

However, the bylaw as written may conflict with the directors’ fiduciary duties.

DIRECTORS’ DUTIES & THE BUSINESS JUDGMENT RULE

BUSINESS JUDGMENT RULE

GENERAL APPLICATION

- The business judgment rule is a judicial presumption that the directors have acted in accordance with their fiduciary duties of care, loyalty, and good faith.


- It applies to the directors’’ actions taken as managers, such as major business decisions on determining the corporation’s long-term goals and strategies.

- If the action at issue is protected, then there is a presumption of legality that may be overcome by a showing of:

o Fraud,o Illegality, oro Conflict of interest.

- If the rule does not apply, however, then the court will look at the fairness of the decision to the corporation and its shareholders.

- The business judgment rule only applies where the corporation is sued by shareholders as shareholders, not in tort.

- Shlensky v. Wrigley : The business judgment rule applies to the directors’ decision not to install lights at the baseball field. The directors’ concern for the surrounding community did not amount to fraud, illegality, or conflict of interest.

o The court also says that the plaintiff failed to allege damage to the corporation because he didn’t alleged that adding lights would result in a net benefit to the corporation, but it is unclear whether this is needed.

- The business judgment rule only applies when directors act in the best interest of the corporation.o The conventional (Delaware) view is that directors may consider the interests of other

constituents if there is some rationally related benefit accruing to the stockholders or if doing so bears some reasonable relation to general shareholder interests.

o Most states have “other constituency” statutes that allow corporations to consider other groups when determining the best interests of the corporation.

o Dodge v. Ford : While directors have discretion to decide how to increase profits in the long term (even if the result is short term loss), they do not have the discretion to make the goal of a given decision to be to decrease profits.

While Ford’s statement about expansion indicated that its purpose was to benefit employees and not shareholders, the conduct of the business did not menace the shareholders.

However, there was no justification for failing to issue a dividend give that, even after deducting the cost of expansion, there was a surplus of over $30 million.

o Shareholders are the corporate constituents who most need the protection of fiduciary duty because other constituencies are able to enforce their rights via contract.

o MBCA 8.30 does not mention constituencies, so it follows the Delaware rule.- Directors claiming protections of the business judgment rule must be disinterested.

o They cannot appear on both sides of the transaction,o They cannot derive personal benefit from the transaction, ando If a director is not disinterested and the transaction is not approved by a majority of

disinterested directors, the business judgment rule doesn’t protect the transaction.

FIDUCIARY DUTY OF LOYALTY

- The fiduciary duty of loyalty operates to constrain directors and officers in their pursuit of self-interest.

- It is an actionable wrong for an officer or director to compete with his corporation or to divert to him assets or opportunities belonging to the corporation.

- A breach of fiduciary duty of loyalty usually occurs in two scenarios:


o Corporate opportunities: a director personally takes an opportunity that the corporation later asserts rightfully belongs to it.

o Conflict of interest transactions: transactions between the corporation and the director.- Generally speaking, courts look at the following when analyzing fiduciary duty issues:

o Whether the director has unfairly favored her person interest in a transaction, ando Whether the director was completely candid with the corporation and shareholders.

CORPORATE OPPORTUNITY DOCTRINE

- The ALI approach to the corporate opportunity doctrine is outline in Principles of Corporate Governance 5.05:

o Is this a corporate opportunity? There are three definitions: A director or officer becomes aware of the opportunity in connection with his

performance as director or officer or under circumstances that should reasonably lead the director or officer to believe that the person offering the opportunity expects it to be offered to the corporation.

A director or officer becomes aware of the opportunity through the use of corporate information or property, if the resulting opportunity is one that the director or officer should reasonably expect to be of interest to the corporation.

An officer (not director) becomes aware of the opportunity, no mater how, and knows that it is closely related to a business in which the corporation is engaged or expects to engage.

o If this is a corporate opportunity, it is OK for the director or officer to take advantage of it? This is a three-part test:

The director or officer must disclose existence of the opportunity to the corporation and offer the opportunity to the corporation,

The corporation must reject the opportunity, and One of the following must be true:

The rejection must be fair to the corporation, The opportunity must be rejected by disinterested directors, following

disclosure, in a manner that satisfies the business judgment rule, or Following disclosure, the rejection is authorized in advance or ratified by

disinterested shareholders, and rejection doesn’t amount to waste.o If there is defective disclosure/first offer, can that be cured?

Relief that is based solely on failure to first offer to the corporation is not available if:

The failure to first offer resulted from a good faith belief that this was not a corporate opportunity (but it’s not clear what good faith this entails), and

Reasonably soon, the opportunity is offered, to the extent possible, to the corporation and properly rejected.

A good faith but defective disclosure can be cured if proper disclosure is made followed by a ratification of the original rejection by disinterested decision makers (usually directors or shareholders).

o If there was a proper disclosure/first offer, but no rejection, can this be cured? The corporation must ratify a defective rejection.


The director or officer may defend the taking of the corporate opportunity on the basis that taking the opportunity was fair to the corporation.

o Northwest Harbor Golf Club v. Harris : The court adopts the ALI approach. On remand, once the Club shows that Harris’ purchases were corporate opportunities, it must show either that she did not disclose/first offer the opportunities to the club or that the club never rejected it properly.

If the issue is lack of disclosure/first offer, then Harris cannot argue fairness. If the issue is lack of proper rejection, Harris can argue that taking the opportunity

was fair to the corporation.o Rejection of a corporate opportunity can be waste only if the opportunity was of such

obvious importance and value to the corporation that no person of ordinary business judgment would have rejected it.

Waste is treated as a void, not voidable act. If the rejection is waste, it cannot be fair. Shareholders may not ratify waste except by a unanimous vote.

- The Delaware approach is outlined in the Guth case. o This is a two-part test, and in both parts, all factors must be considered – no one factor is

dispositive. An officer or director may not take a business opportunity for his own if:

The corporation is financial able to exploit the opportunity, The opportunity is within the corporation’s line of business, The corporation has an interest or expects to have an interest in the

opportunity, and Taking the opportunity will put the director or officer in a position that

results in a conflict of interest. If the opportunity passes the first part of the test, the director or officer may take

the corporate opportunity if: The opportunity is presented to the director or officer in his individual, no

corporate, capacity, The opportunity is not essential to the corporation, The corporation has not interest, nor expects to have an interest, in the

opportunity, and The director or officer has not wrongfully employed the resources of the

corporation in pursuing or exploiting the opportunity.o Under the Guth test, formal presentation of the opportunity is not required, but it is

preferred, as lack of presentation can be evidence of bad faith.o Broz v. CIS : The defendant was not required to consider the potential interest of a

corporation that has contingent and uncertain plans to purchase the corporation to which the defendant owed a duty of loyalty when pursuing a corporate opportunity.

Rule: A director’s right to appropriate an opportunity depends on the circumstances existing at the time the opportunity is presented to him, without regard for subsequent events.

o The law doesn’t say who bears the burden. However, usually corporate fiduciaries must prove that they have not breached their fiduciary duty.

CONFLICTING INTEREST TRANSACTIONS


- Note that proof of a conflicting interest transaction takes the decision at issue outside of the business judgment rule.

- The common law rule for conflicting interest transactions is that they are voidable only if the transaction or the conduct of the conflicted transaction was unfair to the corporation.

o The transaction is void if: The substantive terms of the transaction are found to be unfair, or Even if the terms are fair, if the benefiting directors had in any way breached their

obligation to disclose fully all of the relevant facts to the corporation, including the conflict of interest.

- Globe Wooten v. Utica Gas & Electric : A director who orchestrated a one-sided deal to the detriment of the corporation did not rid himself of his duty to warn the corporation of the potential effects of the deal. He exerted too much influence and the end result was too unfair.

- Self-dealing : where a controlling party causes the corporation to do something that benefits the controlling party to the detriment of the minority shareholders of the corporation.

o Transactions between the corporation and the controlling party are subject to heightened judicial scrutiny.

o Intrinsic fairness standard : the defendant/controlling party has the burden of proving that the challenged transaction was objectively fair to the corporation.

This standard is applied (instead of the business judgment rule) in cases where there is self-dealing by a controlling party (i.e. in a party-subsidiary situation) who owned the corporation a fiduciary duty.

o Sinclair Oil v. Levien : Here it is clear that Sinclair (parent) owes Sinven (subsidiary) a fiduciary duty because it is a parent-subsidiary relationship. Therefore, if the contested transactions are self-dealing, they do not get the protection of the business judgment rule:

Parent’s causing subsidiary to issue a dividend: not self-dealing because the parent didn’t benefit to the exclusion of the subsidiary’s minority shareholders. All shareholders received the same amount. Here, the business judgment rule applies, and the subsidiary must prove that issuance of the dividend was waste or improperly motivated.

Parent’s expansion policies that left out subsidiary: not self-dealing because the parent did not usurp any expansion opportunity at the expense of the subsidiary’s minority shareholders. The business judgment rule applies, and the subsidiary must show fraud, illegality, or conflict of interest.

Parent’s failure to pursue a breach of contract claim on behalf of the subsidiary against another of the parent’s subsidiaries: this is self-dealing because the parent benefited (when its other subsidiary did not pay damages for breach) and the subsidiary’s minority shareholders suffered by losing those damages. The intrinsic fairness standard applies, and the parent has the burden of proving that the challenged transaction was objectively fair to the subsidiary.

- Most jurisdictions have conflicting interest statutes.o Del. GCL 144:

No conflicting interest transaction shall be void or voidable solely by reason of the conflict if the transaction is:

Authorized by a majority of the disinterested directors, Approved in good faith by the shareholders, or Fair to the corporation at the time it is authorized.


Director or shareholder approval is effective only if the interested director has disclosed all material facts.

This statute leaves some gaps: Burden of proof, Interests that constitute a conflicting interest, Standard of judicial review, Definition of “disinterested.”

There is also a good faith requirement – disinterested director ratification is valid, assuming the following three criteria are met:

The approving directors were aware of the conflict, The approving directors were aware of all of the material facts (due care

requirement), and The approving directors acted in good faith (in the interests of the

corporation).- MBCA 8.60-8.63: Transactions falling outside of the statutory definition of “conflicting interest

transaction” do not expose an interested director to any special duty of candor or fair dealing.o A conflicting interest transaction may not be voided as a result of such a conflict if the

transaction was: Ratified by qualified directors, Ratified by a vote of qualified shareholders, or Fair to the corporation.

- Shapiro v. Greenfield : An interested director is a director who either: (1) has self-interest in the transaction at issue, or (2) has lost independence because he is a director with no direct interest in the transaction but is controlled by a self-interested director.

o This focuses on (1) a director’s ability to exercise independent judgment, and (2) the expected influence of a particular relationship on the director.

- This issue of director self-compensation is addressed under: Del. GCL 141(h); Del. GCL 157; MBCA 6.24; and MBCA 8.11.

o When directors set their own compensation without ratification by disinterested shareholders, the general rule is that the intrinsic fairness standard and not the business judgment rule applies.

o To bring the decision within the protections of the business judgment rule, one of the following must be true:

The decision was ratified by disinterested shareholders, or The decision was made by disinterested directors.

o Compensation by stock options is reasonable if it satisfies a two-prong test: The stock option plan must involve an identifiable benefit to the corporation, and The value of the option must bear a reasonable relationship to the value of the

benefit that the corporation receives.- In Delaware, the duty of good faith is considered to be a part of the duty of loyalty.

o This also means that it cannot be eliminated by way of an exculpation provision (see below for information on exculpation provisions).

FIDUCIARY DUTY OF CARE

- The fiduciary duty of care constrains directors’ official conduct in directing and managing the business and affairs of the corporation.

- Duty of care (MBCA): the care that an ordinarily prudent person in a like position would exercise under similar circumstances.


- Duty of care in Delaware is not defined by statute, but rather by judicial doctrine.- Liability for a breach of the fiduciary duty of care has been rare and is usually reserve for egregious

circumstances.- Joy v. North : The business judgment rule applies to claims of breach of fiduciary duty of care because:

o Shareholders have voluntarily undertaken the risk of bad business decisions,o After-the-fact evaluation isn’t necessarily fair, ando We do not want to create incentives for directors to avoid risk.

- However, in order to get the protection of the business judgment rule, the decision still has to satisfy the requirements (for example, it has to be a decision with a business purpose).

- Smith v. Van Gorkom : Under the business judgment rule, a plaintiff must prove gross negligence to prevail on a claim that the corporation violated its duty of care by making an uninformed business decision.

o Here, the directors’ decision was uninformed such that it amount to gross negligence because the directors failed to inform themselves of the intrinsic value of the corporation. The decision was therefore voidable.

o The uninformed decision can be sustained if it was ratified by informed shareholders, which was not the case here. (Note: This part of the case is no longer good law.)

- Law has changed post-Van Gorkom:o Directors can now rely on opinions by corporation’s officers, even if the opinion is not

technically in report form.o Shareholder ratification cannot extinguish a claim of breach of duty of care in Delaware.

- In Delaware, the plaintiff carries the burden of proving a violation of duty of care.The burden then shifts to the defendant to prove that the transaction was intrinsically or entirely fair to the corporation.

o To determine the entire fairness of a merger, the court must consider: Fair dealing (concerns the process by which the transaction was made), and Fair price of the merger.

- The Van Gorkom decision shows that directors can be found to be grossly negligent even when acting in good faith.

o About 40 states, including Delaware, have legislation allowing corporations to limit or eliminate liability for breach of fiduciary duty of care by way of an exculpation clause.

o Malpiede v. Townson : The exculpation provision in the certificate of incorporation does not shield directors from liability for breaches of duty of loyalty or good faith.

The exculpation clause does not apply when the only relief sought is injunction, not monetary.

Note: A claim based on duty of candor (failure to inform shareholders or directors of material facts) can be either under a duty of loyalty or duty of care claim.

- Because an exculpation clause only eliminates duty of care claims and not duty of loyalty or good faith claims, an emerging litigation strategy is to repackage duty of care claims as bad faith claims.

o Disney Derivative Litigation : There are at least three different categories of fiduciary behavior that amount to bad faith:

Subjective bad faith: Actual intent to do harm (breach of the duty of good faith – non-exculpable),

Lack of due care: Fiduciary action taken solely by reason of gross negligence (this, without more, is not a breach of the duty of good faith but rather a breach of the duty of care), and


Intentional dereliction of duty or conscious disregard for one’s responsibilities: Failure to act in the fact of a known duty to act (breach of the duty of good faith – non-exculpable).

- Sometimes it is hard to tell if something is a breach of the duty of care, of loyalty, or of good faith:o Breach of the duty to exercise appropriate attention arises in two context:

A board decision results in a loss because the decision was ill-advised or negligent (average duty of care claim), or

There was a failure of the board to act in circumstances in which due attention would arguable have prevented the loss (also called the duty of oversight or a Caremark claim).

Where breach of the duty of oversight is an affirmative decision, courts can only look at the decision-making process, not the content.

The process must be rational and done in good faith.o In Delaware, to prove a breach of the duty of care for failure to control employees (Caremark

claim), a plaintiff must show: The directors knew or should have known that the law was being violated, The directors took no steps in good faith efforts to prevent or remedy the situation,

and This failure is the proximate cause of the loss. (Note: lack of causation can also be

raised as an affirmative defense.) Note: If the director liability is based on ignorance of the activity in question

(first element – didn’t know but should have known), only a sustained or systematic failure of the board to exercise oversight will establish lack of good faith (second element) (such as an utter failure to attempt to assure that a reasonable information and reporting system exists).

This is a much higher standard than gross negligence.o Waste doctrine : Directors are liable, even where there is no direct proof of lack of due care

or loyalty, if the substantive decision seems explainable only as a product of the directors’ failure to carry out their fiduciary responsibilities.

The standard for waste is whether what the corporation has received is so inadequate in value that no person of ordinary, sound business judgment would deem it work what the corporation has paid.

This is a substantive due care issue, as opposed to the requirement that decisions be well informed, which is a procedural due care issue.

Can an exculpatory clause eliminate a waste claim? Brehm v. Eisner : Court says that the plaintiff must replead. The plaintiffs allege that

the “old board” violated substantive due care by approving a wasteful compensation agreement, and that the “new board” committed waste by failing to terminate the employee with the wasteful compensation agreement for cause. In both of these circumstances, the waste doctrine, not the business judgment rule, applies. The plaintiffs must show that the value of what the corporation received in each of those cases was so inadequate that no person of ordinary sound business judgment would deem it worth what the corporation had paid.

The plaintiffs also allege an ordinary duty of care claim against the old board, saying that the old board failed to inform itself of the potential consequences of the severance agreement. Here, the board is fully protected by the business judgment rule if it relied in good faith on a qualified expert.


DERIVATIVE SUITS

OVERVIEW

- A derivative action is where a shareholder commences and manages fiduciary litigation on behalf of the corporation.

- It technically involves two causes of action in one:o One action against the corporation for failing to bring the specified suit, ando One action on behalf of the corporation that the board failed to bring.

- In derivative litigation, the shareholder plaintiffs do not recover anything – just the corporation and the plaintiffs’ counsel.

- To determine if a suit is derivative or direct, focus on who suffered the alleged harm – the corporation or the stockholder individually – and who would receive the benefit of recovery.

- The pleading requirements in derivative suits are more stringent than those of direct suits.o The shareholder does not have to plead evidence, but he must plead particularized factual

statements essential to the claim.- Directors and officers may have a common law or statutory right to indemnification against liability

in shareholder-initiated litigation.o Del. GCL 145(c): A corporation is required to indemnify its officers and directors if they are

successful on the merits or otherwise in defense of any action, suit, or proceeding related in any way to their service as an officer or director.

o MBCA 8.52: Indemnification is not required where a defendant has only been partially successful as, for example, by avoiding conviction on one of four counts in a criminal case.

DEMAND REQUIREMENT

- Demand requirement : The plaintiff-shareholder must explain to the board the matters to be investigated and remedied:

- If the board decides not to sue, the shareholder may challenge this decision alone but cannot pursue the original claim unless the director decision not to sue is not protected by the business judgment rule.

o If demand is made and refused, the plaintiff cannot argue that demand is excused.o Because the business judgment rule applies to the board’s decision not to pursue the claim,

the plaintiff-shareholder must rebut the presumption with proof of fraud, illegality, or conflict of interest.

o A corporation cannot ignore demand.o After a board refusal, the shareholder has the right to obtain relevant corporate records to

help determine if demand was wrongfully refused.- Demand futility exception : A shareholder may be excused from making a pre-suit demand if the

demand would have been futile.o Note: This exception does not exist in the MBCA but it does exist in DE.o Instead, the MBCA has a universal demand requirement. Therefore, most of the litigation

focuses on judicial review of a motion to dismiss based on the fact that the derivative suit isn’t in the best interests of the corporation.

- Aronson v. Lewis : Where officers and directors are under an influence that taints their discretion, they cannot be a proper person to conduct litigation on behalf of the corporation, and demand is therefore futile.

o Basic Aronson Test : To determine that demand would be futile, the court must determine that a reasonable doubt has been created regarding:


The disinterestedness and independence of the directors, and The challenged transaction as a valid exercise of the business judgment rule.

o If the directors are not disinterested, demand futility has been shown and the inquiry ends.o Mere threat of personal liability for approving the challenged transaction is not by itself

enough to establish demand futility But perhaps a substantial likelihood of liability as opposed to a mere threat. And you must also show facts indicating a breach of fiduciary duty.

o Stock ownership alone does not establish control over the directors – there must be proof of a relationship.

- Reasonable doubt in the context of derivative suits means that there is a reasonable belief that the board lacks independence or that the transaction is not protected by the business judgment rule.

o This is an objective test.- Zapata v. Maldonado : Excusal of demand does not mean that the corporation has lost its corporate

power with regard to the litigation. Therefore, in a case in which demand is excused (not refused), an independent committee may cause its corporation to file a pretrial motion to dismiss after an objective and thorough investigation of the derivative suit.

o The court must apply a two-step test to the motion to dismiss: The committee must come to its conclusions independently and in good faith, and its

conclusions must have support. The corporation carries the burden of proof of independence, good faith,

and a reasonable investigation. If the court finds that the committee is not independent, has not shown

reasonable bases for its conclusions, or has not acted in good faith, the motion should be denied.

If the motion passes the first step, then the court should apply its own business judgment to determine whether the motion should be granted.

This test is just a “smell test” to allow the court to let plaintiff’s litigate meritorious claims that the corporation wants to bury.

ARONSON TEST – PRONG 1- The first prong of the Aronson test is that the directors be disinterested and independent.- There are three ways that the plaintiff-shareholder can satisfy this requirement:

o The defendant directors had a financial interest in the challenged transaction,o They were motivated by a desire to retain their positions on the board or within the

company, oro They were dominated or controlled by a person of interest in the transaction.

- Disinterestedness : occurs where no divided loyalties are present, or where a director neither has received nor is entitled to receive a personal financial benefit from the challenged transaction that is not equally shared by the stockholders.

- Independence : where a director’s decision is based on the corporate merits of the subject matter before the board rather than extraneous considerations or influences.

- In re Limited Derivative Litigation : At least six of the twelve directors are disinterested or not independent, so demand is excused.

o Mr. Wexner and Mrs. Wexner may be disinterested because they stood to personally benefit from the decision to rescind the agreement.


o Gilman and Trust may not be independent from Mr. Wexner (CEO) because their principal employment is as an officer of the corporation, and his salary ($1.8 million per year) is material to them.

o Schlesinger may not be independent from Mr. Wexner because, even though he has a job as a senior administrative officer of a university, he earns about $150,000 per year in consulting fees from the corporation. The court finds that $150,000 is material.

o Gee may not be independent from Mr. Wexner because Gee is the head of a charitable institution that Mr. Wexner donated $25 million too, and there is no evidence that Mr. Wexner’s donation stems from a relationship with Gee or the institution outside of Gee’s position as director. Gee may feel beholden to Mr. Wexner for past acts.

o Not proof of lack of independence: Compensation from a person’s role as director alone; Receipt of director’s fees from a subsidiary; A business relationship between the director’s employer and the company on whose

board the director sits where the money paid to the director or his firm is not material or where the director did not benefit personally from the money paid.

ARONSON TEST – PRONG 2- If the first prong of the Aronson test is not satisfied, demand can still be excused if it satisfies the

second prong.- The plaintiff must show that there is reasonable doubt as to whether the challenged transaction was

a valid exercise of the board’s business judgment.- However, if the decision in question was not made by the board on which the plaintiff seeks demand,

it is impossible to test whether the current directors acted in conformity with the business judgment rule, so the Rales test applies.

o Rales test: Where the challenged transaction was not a decision of the current board, the plaintiff must show that there is a reasonable doubt that, at the time the complaint is filed, the current board could not properly have exercised its independent and disinterested business judgment in responding to a demand.

o How is the Rales test different from Prong 1 of the Aronson test?o Ryan v. Gifford : The Aronson and not the Rales test applies because even though the

compensation committee made the decision in question, the compensation committee consisted of one half of the entire board of directors. Approval of the compensation committee can be imputed to the entire board.

Aronson analysis: The alleged transaction (backdating stock options) was a violation of the express terms of the stock option agreement. Intentional violations of the stock option agreement cannot be a valid exercise of business judgment. The plaintiff has empirical evidence that the stock options were actually backdated. Demand is excused as futile.

Rales analysis: Directors are not disinterested where they face a substantial risk of liability. Backdating options qualifies as one of those rare cases in which a transaction may be so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability therefore exists for a director who approves backdating. Here, three of the six directors allegedly approved backdating options and another allegedly accepted the backdated options. Therefore, four of the six directors are not disinterested. Demand is excused as futile.


o Stone v. Ritter : In applying the Rales test to demand futility in the context of a Caremark claim, demand may be excused if the plaintiffs can show that they are likely to with their breach of the duty of care (oversight duty) claim on the merits. This is because if they can show that they are likely to win their Caremark claim, the directors face a substantial likelihood of liability.

However, if there is an exculpation clause that extinguishes a breach of the duty of care for inadequate oversight, there is no threat to the directors’ personal liability, and they are therefore disinterested.

The plaintiffs frame their claim as a breach of the duty of good faith due to intentional dereliction of duty and conscious disregard for one’s responsibilities. This is non-exculpable.

To show a substantial likelihood that the directors will face personal liability, the plaintiffs must show a sustained or systematic failure of the board to exercise oversight.

DEMAND REQUIREMENT ANALYSIS

CLOSE CORPORATIONS- Closely held businesses are fundamentally different from those that are publically held.

o They are more intimate enterprises that lack the separation of ownership from management.o There is no market for the ownership interest.

- Corporate law norms do not fit the closely held firm.- The only corporate norm that protects minority shareholders is the free transferability of shares.

o This allows minority shareholders to adapt individually to changed circumstances and to protect themselves unilaterally from majority opportunism.

o If they are unhappy with majority decisions, they can sell their shares and move on.o But minority shareholders in close corporations cannot do this, so minority shareholders are

particularly vulnerable.

CONTRACTING AS A DEVICE TO LIMIT MAJORITY DISCRETION

CONTRACTING REGARDING DIRECTOR DECISIONS

- Most states have default rules that grant management power to directors and specifically permit shareholders to restrict or eliminate the directors’ discretion. Del. GCL 141(a); MBCA 8.01.

- Most state statutes also permit a corporation to provide in its articles of incorporation that an action taken by shareholders or directors requires more than a majority vote – even unanimity.

o MBCA 7.32: Corporations can vary norms not only in articles but also in bylaws and in separate shareholders’ agreements, but only unanimous shareholder agreements are allowed

o Del. GCL 350-354: Only corporations that meet the statutory definition of close corporations can modify norms by contractual agreement.

- MBCA 8.24(c):- Del. GCL 344: Any Delaware corporation can elect to become a close corporation by filing a certificate

of amendment.- Del. GCL 350: A shareholders’ agreement of a close corporation is not invalid on the ground that it

interferes with the discretion or powers of the board of directors. Shareholder agreements made by


the owners of at least a majority of the corporation’s stock are valid as between the parties of the agreement.

- Del. GCL 351: The articles of incorporation may have a provision that says that the stockholders and not the board of directors will manage the business of the corporation as long as all of the outstanding shareholders approve the provision.

- Del. GCL 352:- Del. GCL 353:- Del. GCL 354: A shareholders’ agreement of a close corporation is not invalid on the ground that it is

an attempt by the shareholders to treat the corporation as a partnership. Internal agreements and arrangements should be allowed as long as they are not affirmatively improper or injurious to third parties.

- Zion v. Kurtz :o Majority : In a corporation with two shareholders who executed a shareholder agreement,

the shareholder agreement is binding on the shareholders even though the corporation did not file an appropriate certificate of amendment to the bylaws that it was an electing close corporation. The appropriate remedy is to order that the articles of incorporation be reformed or to estop the defendant from relying on the absence of the relevant provision in the articles.

o Dissent : Delaware law requires a close corporation to give notice of the fact that it is a close corporation in its articles of incorporation in order to receive the benefits of the close corporation statutes. The corporation here did not do this. Shareholder agreements are only valid for close corporations, which this corporation is not.

- Blount v. Taft : (North Carolina law, but similar to Delaware) Where a shareholder agreement is made a part of the bylaws, it is subject to amendment just as any other bylaw is unless there is an internal provision within the shareholder agreement bylaw itself that governs amendments.

o Here there was no evidence that the parties intended this particular bylaw to be subject to different amendment procedures.

o The shareholders amended the bylaw in question properly, so the amended bylaw will be enforced unless enforcement would contravene some principle of equity or public policy.

CONTRACTING REGARDING VOTING

- Voting agreements are used to create and preserve a majority or to ensure participation of shareholders on boards of directors.

- MBCA 7.22:- MBCA 7.30:- MBCA 7.31:- Del. GCL 212:- Del. GCL 218(a):- Del. GCL 218(c):- Ramos v. Estrada : (California law) The corporate shareholders’ voting agreement is valid even

though the corporation is not technically a close corporation in that its articles of incorporation does not say as much. Comments accompanying the relevant statute specifically state that the purpose of the statute is to preserve shareholder agreements, even those of corporations other than close corporations.

o The agreement is not a proxy agreement because the shareholders did not give another person power to vote with respect to their shares but instead agreed to vote their shares a certain way.


o This case is different from Zion v. Kurtz because in that case the court determined that the corporation was in fact a close corporation and that the articles had to be reformed. Here, the court determined that the corporation was not a close corporation but that the shareholder agreement was valid because the state legislature intended the statute to apply to corporations other than close corporations as well.

o If this case arose in Delaware, the end result would basically be the same. The defendants would be estopped from alleging that the corporation was not a close corporation because of the absence of the requisite language in the articles. Or the court would order the articles reformed. Therefore, the agreement would be valid.

ENHANCED FIDUCIARY DUTY AND THE PARTNERSHIP ANALOGY

- There are two principal avenues for minority shareholders’ suits:o A petition for involuntary dissolution, ando A direct or derivative suit for breach of fiduciary duty.

- Courts may dissolve a corporation is such action would be equitable.- An alternative to an involuntary dissolution petition or derivative litigation is a suit to compel the

payment of dividends or to protect other rights belonging directly to shareholders.- However, the majority traditionally has substantial discretion because of the business judgment rule

and the premise that decisions be made by majority unless otherwise agreed to.o Zidell v. Zidell : (Oregon) If a plaintiff/minority shareholder wants to compel a close

corporation to declare a dividend, he must show that the directors’ failure to issue a dividend is not the product of a good faith and informed business decision.

It sounds like the plaintiff is alleging that the majority breached its fiduciary duty to the minority by failing to issue a divided or by issuing a very small dividend.

Issuing a divided is a business decision, so the business judgment rule applies. The minority shareholder must show either: fraud, illegality, or conflict of interest/bad faith. (Sinven dealt with whether the issuance of dividends was self-dealing.)

If there’s a plausible business reason for the decision, the court should not interfere. Existence of hostility does not prove bad faith. The hostility toward the minority

shareholder must be the motivating causes of the decision to overcome the business judgment rule.

o A critical factor in divided-related cases is the corporation’s accumulation of an unreasonably large case reserve (a reserve that is so large that it can only be explained by the controlling majority’s bad faith).

o Under traditional doctrine, complaining minority shareholders face the same difficulty in challenging a closely held corporation’s salary policies as do complaining shareholders in a publically held corporation.

o Under traditional analysis, complaining minority shareholders in a successful corporation often face an uphill fight even when the burden of proving fairness is placed on the controlling shareholders.

- Analysis of closely held corporations based on the partnership analogy as opposed to traditional doctrine asserts that the expectations and internal governance needs of shareholders in typical close corporations are similar to those of partners in a typical partnership.

o Wilkes v. Springside Nursing Home : (Massachusetts) When minority stockholders in a close corporation bring suit against the majority alleging a breach of the strict good faith duty


owed to them by the majority, the court must first ask (1) whether the controlling group can demonstrate a legitimate business purpose for its actions. (2) Once an asserted business purpose for their action is advanced by the majority, the minority stockholders must then demonstrate that the same legitimate objective could have been achieved through an alternative course of action less harmful to the minority’s interest. (3) The court must then weigh the legitimate business purpose against the practicability of a less harmful alternative.

Here, the court concludes that the action taken was designed to freeze out the minority because the majority admitted that the stock price offered was unreasonably low. There is therefore no legitimate business purpose of the action, and the majority therefore breached its fiduciary duty to the minority.

If partnership law was strictly applied here, the minority stockholder would have to dissolve the partnership.

o Hetherington & Dooley : The current remedies that are specifically designed to deal with the problems of illiquidity and exploitation of minority shares in close corporations are ineffective. A better option is a statutory buyout right.

A minority or 50% shareholder would be entitled to demand that the corporation purchase all of his shares, but no less than all.

If the corporation or the remaining shareholders have not agreed to purchase all of the shares by the end of a 90 day period, the court is required to enter a decree dissolving the corporation.

The court can provide for installment payments. There is a two-year holding period during which time the shareholder may not

exercise the buyout right. There could be a voluntary waiver of the buyout right, but this may result in

boilerplate language appearing in all articles of incorporation. By the statute, waivers are permitted but for no longer than two years at a time.

o Easterbrook & Fischel : There are problems with pushing the partnership analogy too far onto close corporations.

The buyout right proposed by Hetherington and Dooley does not take into account that in partnership law, a withdrawing partner may be held liable for wrongful dissociation.

It is questionable whether shareholders in close corporations want to be governed by partnership law. They incorporated for a reason, instead of choosing a GP or LLP. It is unreasonable to assume that shareholders in close corporations are knowledgeable enough to know about incorporating to obtain the benefits of favorable tax treatment but ignorant of all of the other differences between partnership and corporate law.

The right inquiry is always what the parties would have contracted for had the transactions costs been zero.

- The modern approach is to broad the scope of equitable relief available via a minority shareholder’s petition for involuntary dissolution.

o Some states have enacted liberal involuntary dissolution provisions that instruct courts to take into account shareholders’ reasonable expectations or interests in fashioning relief.

o Dissolution is now seen as a viable remedy for truly egregious conduct, and courts are increasingly willing to order corporations to repurchase the complaining minority’s shares in order to protect shareholders’ reasonable expectations or to remedy oppression.

o MBCA 14.30:


o MBCA 14.34: The defendant close corporation has a right to avoid a court-ordered involuntary dissolution by electing to repurchase the complaining minority’s shares for fair value.

Similar to Hetherington & Dooley’s buyout right, except here the majority, not the minority, has the right to elect to do this.

o In re Kemp & Beatley : (New York, but similar to MBCA) First, the court must determine whether the conduct is “oppressive.”

Conduct is oppressive if it substantially defeats the reasonable expectations held by minority shareholders in committing their capital to the enterprise. Subjective hopes and desires are not relevant. Instead, the court must look to what the majority knew or should have known the minority’s to be in entering the enterprise.

Oppression occurs only when the majority conduct substantially defeats the minority’s expectations that, objectively viewed, were both:

o Reasonable under the circumstances, ando Central to the minority’s decision to join the enterprise.

If the conduct is oppressive, then the court must determine whether involuntary dissolution is appropriate as opposed to an alternative remedy.

The party opposing dissolution has the burden of proving that there is another adequate remedy.

Before ordering involuntary dissolution, a court must consider,o Whether liquidation of the corporation is the only feasible means

to protect the complaining shareholder’s expectation of a fair return on his investment, and

o Whether dissolution is reasonably necessary to protect the rights or interests of any substantial number of shareholders – not just the complaining shareholders.

Any minority shareholder who acts in bad faith and tries to force an involuntary dissolution, resulting in the complained-of oppressive conduct, is not protected by the statute.

o Gimpel v. Bolstein : There are two tests to determine whether conduct of the majority towards the minority in a close corporation is oppressive.

The tests are not mutually exclusive. Did the conduct violate the reasonable expectations of the minority (Kemp

& Beatley), and Was there: burdensome, harsh, and wrongful conduct; a lack of probity and

fair dealing in the affairs of the corporation to the prejudice of the minority; or a visible departure of the standards of fair dealing and a violation of fair play?

Here, the first test doesn’t work because the complaining minority inherited his shares – he didn’t buy them. That does not mean that in every case in which stocks are inherited that this test cannot be applied. Also, he embezzled from this corporation, so he can’t really have reasonable expectations of fair dealing.

Under the second test, it is not clearly wrong or unfair for a corporation to fire a suspected embezzler and then exclude him from corporate management. Therefore, the minority shareholder is not entitled to dissolution.


Although he is not entitled to dissolution, the court still orders the corporation to either pay him dividends or buy out his stock. It is unclear why.

o Courts determine the fair value of a corporation (to set the buyout price) based on expert testimony.

SHARE REPURCHASE AGREEMENTS (SRAS)- Courts generally enforce the terms of SRAs, even if events subsequent to execution make the

purchase price substantially less than the fair value of the to-be-acquired shares, unless there is some compelling equitable reason not to enforce the agreement.

o For example, if the majority breached its fiduciary duty to the minority.- A well-written SRA can prevent a deterioration in shareholder relationships and the need for costly

litigation.- But contracts are costly, human rationality is bounded, and a poorly conceived contract may present

possibilities for oppression.- Concord Auto Auction v. Rustin : The SRA required the stockholders to review the stock repurchase

price every year, but there was no requirement that the repurchase price be updated every year. It also required a buyback of shares upon death. Therefore, even though the repurchase price is much lower than the fair market value, the shareholder’s estate must sell back the shares at that price. It is not the court’s job to protect parties from bad bargains.

- Gallagher v. Lambert : The minority shareholder of the close corporation voluntarily bought stock subject to an SRA that listed one (lower) price if the shareholder’s employment ended before a given date and another (higher) price if employment was terminated after. The shareholder alleged that the corporation fired him before that date just to get the lower buyback price. The shareholder has no right to the buyback at the higher price. The corporation had no fiduciary duty not to fire him before the given date. The result might seem unfair, but that was the deal the parties bargained for.

- Pedro v. Pedro : Even though the parties intended the buyback price in the SRA to be the exclusive remedy in dissolution cases, the minority shareholder is not limited to the remedy in the SRA (buyback at a stated, low price) because the majority breached its fiduciary duty and acted in bad faith.

o The minority shareholder can recover both for lost wages and for the fair value of his stock (as opposed to the buyback price) because the first recovery is for damages based in breach of contract as an employee and the second is for damages based in breach of fiduciary duty as a shareholder.

- In cases where a minority shareholder is unhappy with the repurchase price in the SRA, courts do not like to interfere with the agreement.

o If the shareholder alleges a breach of fiduciary duty solely because the terms of the SRA are unfair, the courts will not interfere.

o If the shareholder alleges a breach of fiduciary duty based on the fact that the conduct of the majority shareholders caused him to have to sell back his stock at the repurchase price, courts are more likely to step in.

LIMITED LIABILITY CORPORATIONS

OVERVIEW

- A limited liability company (LLC) is formed by filing a chartering document with the state.


- An operating agreement specifies in detail the ownership rights, duties, and obligations of those who will own and manage the LLC.

- LLC members are the residual claimants.o They share ratably in the profits of the firm, but only after all other claimants and needs of

the firm have been satisfied.o Member management is the default rule, but LLCs can also be manager-managed.

- Members in a member-managed LLC function like general partners in a general partnership.o They are the firm’s residual claimants.o They collectively have authority to manage the LLCs business and affairs.o Each member owes the other fiduciary and contractual duties in carrying out the

management role.- Managers in a manager-managed LLC share the ownership functions and are responsible for

managing the business and affairs of the LLC.o They may be members of the LLC, but they do not have to be members.o Members have no management authority or fiduciary responsibilities.

- Neither members nor managers are personally liable for the LLC’s obligations.o There is no assigned risk bearer.o That risk will fall on those with whom the LLC deals.

- An LLC is a contractual entity.o There are statutory default rules that can be modified by contract.o There are also some mandatory rules, such as the fiduciary duty of loyalty.

- Del. LLCA 402:- Del. LLCA 503:- Del. LLCA 804:- ULLCA 404(a):- ULLCA 407:- Elf Atochem North America v. Jaffari : An LLC does not have to sign the LLC agreement in order to be

bound by it. The plaintiff cannot get around the arbitration clause of the LLC by suing as the LLC.o The parties can agree to make a state other than Delaware the exclusive venue for litigating

party disputes between LLC participants. (Note: This part is no longer good law. The Delaware legislature changed it.)

PLANNING FOR THE LLC- Del. LLCA 101:- Del. LLCA 304:- Del. LLCA 306:- Del. LLCA 401:- Del. LLCA 402:- Del. LLCA 503:- Del. LLCA 504:- Del. LLCA 505(c):- Del. LLCA 601:- Del. LLCA 602:


- Del. LLCA 603: A member may resign from a LLC only at the time or upon the happening of events specified in a LLC agreement and in accordance with the LLC agreement.

- Del. LLCA 604: Unless the LLC agreement otherwise provides, upon resignation any resigning member is entitled to receive the fair value of the member’s LLC interest.

- Del. LLCA 804: - ULLCA 110:- ULLCA 404:- ULLCA 407:- ULLCA 601:- The LLC is an attractive business form for sophisticated investors who both need and want to tailor

their own governance structures.- The operating agreement should specify the basic economic and management arrangements that will

govern the firm and should specify the rules or processes that will determine how major changes in the relationships between and among members and managers will take place (i.e. what rights exist to exit from the relationship and withdraw invested capital).

- If the operating agreement is silent on a key issue, then statutory default rules will govern.o They may produce very hard results.

- Olson v. Halvorsen : The withdrawing member of the LLC sued claiming that the remaining remembers failed to pay him his equity interested in the LLC. The remaining members proved that there was an oral agreement that a departing member would receive only his “capital and compensation,” not his equity in the LLC. The provision to pay a departing member his equity was never agreed to.

- If the operating agreement does not vary the LLC statutory default rule of allowing a member to dissociate at will but without dissolution, minority members may find the value of their membership interest locked in with no market.

FIDUCIARY AND CONTRACTUAL DUTIES

OVERVIEW

- Del. LLCA 1101:- ULLCA 110:- ULLCA 409: A member in a member-managed firm owes to the company and to the other members

the fiduciary duties of loyalty and care.- LLC statutes vary in the extent to which they allow contractual variation of the common law fiduciary

duties of care and loyalty.o Delaware permits elimination of all duties other than the contractual duty of good faith and

fair dealing.o Most other states do not allow elimination of the duty or loyalty.o RULLCA does not allow elimination of the duties of care and loyalty but does permit detailed

specifications of how those duties can be satisfied that allow a careful drafter to sharply curtail those duties.

- Many states follow a general partnership analogy with respect to member-managed firms – members have a fiduciary duty to one another. RULLCA 409(a).

- Bay Center Apartments Owner v. Emery Bay : The Del. LLCA gives parties the discretion to limit or eliminate fiduciary duties. But in the absence of a contrary provision in the LLC agreement, the manager of an LLC owes the traditional fiduciary duties of loyalty and care to the members of the LLC.


o The LLC agreement says that the members shall have the same duties and obligations to each other that members of a LLC formed under the Del. LLCA have to each other. It also says that except for any duties imposed by the agreement, each member owes no other duty to the other.

o The court interprets the first part to mean that the members owe each other the traditional fiduciary duties of care and loyalty. Therefore, the second section does not eliminate them. The duty does not have to be expressly stated in the agreement.


- Del. LLCA 1101:- ULLCA 110:- ULLCA 409:- Under most LLC statutes, the ability to limit or eliminate fiduciary duty does not extend to the duty of

loyalty.- There are core duties that cannot be contracted away.- Kahn v. Portnoy : The LLC agreement contains a provision that supposedly alters the pleading

standards in a claim of breach of fiduciary duties to create a presumption that the board of directors acted in accordance with their duties (clear and convincing evidence standard as opposed to the business judgment rule as it applies to breaches of fiduciary duty). However, the court determines that this clause is ambiguous and could be reasonably interpreted to apply only to board decisions that involve a conflict between a shareholder and the board or a shareholder and the company (conflicting interest transactions). The clause must be interpreted in the manor most favorable to the plaintiff.

o Even assuming that the defendants are correct in their interpretation of the provision, a heightened burden of proof does not translate to the pleading stage.

o The exculpatory provisions do not eliminate bad faith claims, which this is.

JUDICIAL DISSOLUTION

- Del. LLCA 802:- ULLCA 701:- In some states, in cases of impasse or perceived oppression, the only recourse for a disgruntled

member may be a petition for judicial dissolution.o About one fourth of states follow the close corporation structure of conditioning a member’s

right to dissolution on a finding of oppression or unfairly prejudicial conduct.o Delaware and most states ask whether it is reasonably practicable to carry on the business

in conformity with the operating agreement.- Fisk Ventures v. Segal : The complaining member is an investor in an LLC. As part of his investment,

he negotiated a “put right” that allowed him to force the LLC to buy back his interest. If the LLC could not buy back the member’s interest, then the member would get to replace one of the four board members (currently split 2/2 between the two investors). This would essentially give the complaining member control over the corporation because 3 votes are needed to make decisions. There is a disagreement between the two members, and they are deadlocked, causing financial harm to the corporation. Under the “reasonably practicable” standard in Delaware, the court finds that the LLC cannot carry on business and should be dissolved.

o The court rejects the argument that the complaining member should be forced to exercise his put option. Clarke disagrees with the court because the complaining member bargained


for this put option remedy. Dissolution should be the last resort for parties without any option.

- There have been relatively few cases on whether or not members should be able to completely waive their exit rights provided by judicial dissolution.

o Del. LLCA 802:o ULLCA 110(c)(7):o R&R Capital v. Buck & Doe Run : The LLC agreements specifically state that members have

waived the right to seek dissolution under Del. LLCA 802. The court first finds that the Del. LLCA does not prohibit waiver of the right to seek judicial dissolution. Public policy also permits waiver because it is the policy of Del. LLCA to permit freedom of control.

The R&R brothers still have a claim of the breach of duty of good faith against Merritt because that is never waivable.

ULLCA would not allow you to waive the right to judicial resolution.- VGS v. Castiel : While a majority vote of the LLC’s board of managers could properly effect a merger,

the merger here is void because two of the three board members acted in bad faith by failing to give the third board member notice of what they were planning to do. (That third board member was vested with the power to remove and replace two of the three members of the board, so he would have prevented this from occurring.)

THIRD PARTIES

INTRODUCTION

- The introduction of a corporation or other limited liability entity into a transaction shifts some or all of those risks away from the shareholders to those whom the corporation owes money.

- Creditors often require personal guaranties from individuals before extending credit to a no-asset corporation or protect their interests in some other way.

- Since shareholders or members are the residual claimants to the entity’s assets and come after creditors in priority of payment, the amount of shareholder contribution, if it remains in the corporation, provides creditors a cushion against possible dissipation.

- Statutes can require limited liability entities to retain an equity cushion to protect creditors from the risk of extending credit to corporations.

o Under the Uniform Fraudulent Transfer Act (UFTA) if a corporation owes money to creditors, it cannot transfer money out of the corporation if it knows that it is going to hurt the creditors. However, this isn’t really a corporate law concept.

o Del. 170 states that you can only issue dividends out of a surplus of capital.o MBCA 6.40(c) says that a corporation cannot make a distribution if it will make the

corporation unable to pay its debts when the debts come due. A distribution is a direct or indirect transfer of money or property in relation to

shares (such as a dividend or a share repurchase).- The concept of an equity cushion/minimum initial capitalization doesn’t really protect creditors very

well because most corporation codes allow shares to have no par value.o Par value of shares : the stated or face value of a share in the corporate charter below which

shares of that class cannot be sold on an initial offering; has no relation to the market value of the stock

o Permanent capital or capital : Par value per share multiplied by the number of shareso Del. GCL 153: shares with a par value must be sold for at least that amount.


o Del. GCL 154: A corporation’s permanent capital is simply termed capital. A corporation’s directors may specify by resolution what amount of the consideration paid for shares shall constitute capital.

The only limit is that capital cannot be less than an amount equal to the aggregate par value of the issued shares having par value.

So if a corporation issues 100,000 shares having a par value of $0.01 per share, the directors may elect to treat as little as $1,000 as capital, even if the corporation actually receives total consideration in the amount of $10,000,000.

o MBCA 6.21: o There is no provision in the MBCA that prohibits issuance of shares at a price below par

value.o The MBCA also doesn’t have the concept of “permanent capital.”

- In order for the creditors of a corporation to assume that the aggregate par value of the issued shares is an equity cushion, they must be convinced that the consideration paid by the shareholders is worth the par value.

o Del. GCL 152:o Both the MBCA and Delaware leave to the discretion of the board of directors the

determination of what type of consideration is acceptable.o Directors must determine the appropriate issue price.o Shareholders are liable to pay the amount for which their shares were issued.o Directors will be liable for setting an unfairly low price or accepting insufficient

consideration only if their actions are a breach of fiduciary duty.- Statutes also protect creditors by limiting corporate distributions to shareholders – either using

insolvency tests or legal capital rules (or both).o MBCA 6.40:o Del. GCL 244:o The majority of states follow the MBCA and use two insolvency tests – both of which the

corporation must satisfy: Equity insolvency test: A corporation is permitted to distribute assets to

shareholders so long as after such distribution the corporation will be able to pay its debts in the ordinary course of business.

Bankruptcy insolvency test: A corporation is permitted to distribute assets to shareholders so long as after such distribution the corporation will still have assets equal to or in excess of its liabilities.

o Delaware follows the majority view that imposes greater restrictions on distributions. Distributions are allowed only out of a surplus. Surplus : the net assets of the corporation in excess of capital. Therefore, the corporation cannot touch the capital. The distinction between Delaware and the MBCA usually isn’t too great because

capital is usually very small. Some states, but not Delaware, distinguish between earned surplus and capital

surplus: Earned surplus : a corporation’s net undistributed profit (old MBCA). Capital surplus : the consideration paid for the shares that is not designated

as capital (Delaware). Nimble dividends : Dividends can come from current earnings even where

there is no surplus.


o Klang v Smith’s : Under Delaware law, no corporation may repurchase or redeem its own shares except out of a surplus. However, the balance sheet is not a conclusive indicator of a surplus. Directors have the discretion to depart from the balance sheet to calculate a surplus so long as they evaluate assets and liabilities in good faith. The surplus just cannot be so off the mark as to constitute fraud.

In addition, the plaintiff here is a shareholder, not a creditor. These regulations were not designed to protect shareholders.

o Balance sheets generally:


o Revaluing assets can increase the surplus. The value of the assets on the balance sheet is often lower than market value of the

assets. Both the MBCA and Delaware allow good faith revaluation of assets.

o Reducing stated capital can also create a surplus. If you reduce the stated capital, you have to increase the amount in the surplus

account. A corporation can amend the charter or bylaws to reduce the par value of the stock. The board can resolve to transfer money from stated capital to surplus.

- Modern statutes impose liability on directors who assented to an illegal transfer and acted in bad faith.

- Fraudulent transfers under the UFTA are voidable by the creditor.

PIERCING THE CORPORATE VEIL

INTRODUCTION

- The separateness of the corporate veil will normally be respected.


- The corporate veil can be pierced whenever corporate form is employed to evade an existing obligation, circumvent a statute, perpetrate fraud, commit a crime, or work an injustice.

- Today, the test is generally given as a three-part test:o Whether there is complete control and domination by the defendant over the corporation

with the obligation such that the two are basically one,o Whether the control was used by the defendant to commit unjust, fraudulent, or wrongful

conduct towards the plaintiff, ando Whether the plaintiff actually suffered harm as a result of the defendant’s conduct.

- There are certain factors that indicate whether or not a court will rule that the veil may be pierced:o Whether the plaintiff is suing to enforce a contract claim or a tort claim, as courts are more

reluctant to pierce the corporate veil in contract cases as opposed to tort cases, where the injured party has not consented to the tortious conduct.

o The identity of the person behind the veil, as a court might be more willing to pierce the corporate veil to reach other corporations as opposed to a real person.

o Whether the corporation is closely held or publicly held, because courts will not find it equitable to hold shareholders of large publicly held corporations liable for the corporation’s debts.

- Most LLC statutes explicitly state that the liability shield does not protect a person from liability for his or her own tortious acts.

IN CONTRACT

- Those who deal with the corporation can adjust their price and terms according to the degree of security that the corporation provides.

- Courts search for factors that show that the bargaining relationship cannot be trusted.- Fraud or conduct approaching fraud is clearly a reason to pierce.

o Inadequate initial capitalization can be evidence of fraud.o Failure to observe corporate formalities can be evidence of fraud.

- Consumer’s Co-op v. Olsen : The court rules against piercing the veil because, even though the corporation was initially capitalized with $7,000 and the defendant had $190,000 in debts after 8 years, the defendant separated personal and business expenditures (i.e. he didn’t use the corporation as a “piggy bank” or as a way to spend money with no obligation; and he followed corporate formalities that are intended to protect shareholders) and because he used his own personal money to invest in the business as well.

o Inadequate capitalization is a significant factor to veil piercing, but there is no requirement to maintain an adequate level of capitalization as the company grows.

Adequacy of capitalization is therefore measured at the time of formation. To be inadequate, there must be an obvious inadequacy of capital measured by the

nature and magnitude of the corporate undertaking.o Three factors:

Domination/control element is satisfied. The defendant clearly owned the corporation.

The plaintiff was actually harmed as a result of the defendant’s conduct. But the second element is not satisfied because there was no fraud.

o Lastly, the plaintiff is estopped from claiming inadequate capitalization because they continued to give the defendant credit even after he didn’t pay them back.

- K.C. Roofing v. On Top Roofing : Court applies the three-part test to see if the veil should be pierced and ultimate decides to pierce the veil.


o Control must be complete, not just majority, and there must be domination. It is clear that the defendant Russell is in control of the corporation and exercised control over the business activities and decisions. He and his wife were the sole shareholders.

o Actual fraud is not necessary. The veil may be pierced to prevent injustice or inequitable consequences. The evidence shows that Russell was operating a shell game – he had used over 5 corporate names in five years, and used the excuse that he just needed a fresh start. But he only paid his secured creditors and paid himself and his wife salaries of over $100,000. They also used the corporate account to pay their rent. Russell also led creditors to believe that his corporation was still in business after it had been dissolved.

o The plaintiffs were actually harmed by the fraudulent conduct. Russell is using a corporation to borrow money, give it to himself, and never pay it back. The plaintiffs are now out that money.

- Easterbrook & Fischel argue that the courts should pierce the corporate veil in contract cases principally to remedy fraud.

- Undercapitalization is usually not a dominant factor in piercing cases.

IN TORT

- Tort cases are different from contract cases in part because the corporate entity has never provided insulation for an individual committing a tortious act.

- Piercing the corporate veil is not necessary to reach the corporation when an agent/shareholder commits a tort. The person can be liable directly, and the corporation is liable under agency law.

o Under respondiat superior, the employer is liable for the torts of employees committed within the scope of their employment.

o This theory does not apply in parent-subsidiary situations- Piercing the veil of corporations in tort cases usually emphasizes the participation of those who act

as officers or directors, even though piercing is usually described as reaching shareholders.- West Rock v. Davis : The corporation at issue here has no assets but instead leases assets from one of

the three shareholders/directors – it is basically a shell corporation. Their blasting operations are causing damage, which they are aware of, but they continue blasting anyways. The court decides to allow veil piercing. Even if piercing was not allowed, the two directors would probably be held liable directly in tort.

o There is domination and control. There are only three shareholders, and all three are directors. Two of the three are sued here, and the third is the wife of one of the two. The money-man controlled every single financial and contractual aspect of the corporation. The operations-man controlled the day-to-day activities.

o They perpetrated wrong because they knew of the damage and the impending lawsuit but continued to conduct blasting.

o And the wrongful conduct of continuing to blast was the proximate cause of the damage.- Baatz v. Arrow Bar : The plaintiffs are victims of a car crash where the driver at fault was drunk and

was served alcohol at the defendant bar. The driver and the bar tender, who would both be directly liable in tort, are judgment proof. The corporation has no insurance. The corporation itself (liable under respondeat superior) is judgment proof. The plaintiffs want to pierce the corporate veil to get at the assets of the corporation’s directors, so they sue under the state’s dram shop laws.

o The court lists the following factors that tend to show injustice or inequitable consequences, thus allowing the court to pierce the veil:

Fraudulent representation, Undercapitalization,


Failure to observe corporate formalities, Absence of corporate records, Payment by the corporation of the individual’s obligations, Use of the corporation to promote fraud, injustice, or illegalities.

o Ultimately, the court finds that there should be no veil piercing. Personal guarantee of corporate contractual obligations does not automatically extend to tort. The owners did not transact personal business through the corporation. The business was not undercapitalized. Failure to advertise that you are a corporation does not justify disregard for the corporate entity.

- Most corporations have insurance if they engage in risky activities, and sometimes the legislature mandates insurance.

WHERE THE SHAREHOLDERS ARE CORPORATIONS

- Craig v. Lake Asbestos : The subsidiary at fault no longer exists, so the plaintiff wants to pierce the veil of the subsidiary to get to the parent corporation. The court assumes for the sake of argument that the parent’s “scheme” to avoid asbestos-injury liability is a fraud or injustice.

o 100% control of the subsidiary by the parent and appointment of officers of the parent to the board of the subsidiary is not enough. The subsidiary must be so dominated by the parent that the two were basically one. The parent must use the subsidiary to perpetrate fraud or injustice, or otherwise circumvent the law.

o There is no control here because, even though the parent is heavily involved in the subsidiary’s financial and managerial affairs, this doesn’t rise to the high standard. Perhaps if the two corporations maintained the same books or records or retained the same consultants and advisors.

o Just trying to avoid liability is bad, but it is not a reason to pierce.- U.S. v. Bestfoods : A parent can be liable for a subsidiary’s actions under both a veil piercing theory

and under a theory of direct liability of the parent as the owner and operator of the subsidiary where the statute that the subsidiary violated states that any person who operates a polluting facility is directly liable for the costs of cleaning up the pollution.

o Unlike under the veil piercing theory, under a theory of direct liability, the parent may be liable if it owns or operates the facility (here for dumping hazardous waste) – not if it owns or operates the subsidiary itself.

o If the manager of the facility works for the subsidiary, then it will likely be found that the subsidiary, not the parent, operates the facility. If the supervisor works for both companies, it is presumed that the supervisor is an employee of the subsidiary.

o If the plaintiff, on remand, can show that a person employed solely by the parent operated the facility, the parent might be held directly liable.

- It is not “injustice” for a parent to take advantage of the corporate form and dissolve its subsidiary to avoid liability once it becomes clear that it has incurred such liability.

- Subsidiaries have less incentive to insure because the parents can just dissolve them.- The corporate veil can also be pierced in an LLC:

o Kaycee Land v. Flahive : The defendant, through his LLC, leased property from the plaintiff and contaminated the property. The LLC Act does not preclude courts from piercing the veil of an LLC.

The factors that would justify piercing an LLC veil would not be identical to the corporate situation.

o Normally, courts apply traditional common law corporate veil-piercing principles to lLCs.


DE FACTO INCORPORATION

- A corporation is an artificial entity that continues to exist until dissolved whether by:o Voluntary action of directors and shareholders,o Involuntary dissolution by administrative decree, oro Involuntary dissolution by judicial decree.

- If the corporation does not exist, it cannot have any agents.- If the corporation does not exist, then actions taken by individuals to benefit the nonexistent

principal will not be protected by the general agency law rule.- Contracts to benefit a nonexistent corporation occur in two settings:

o Being incorporation occurs, ando During periods when a corporation has be dissolved by the state for failure to pay taxes,

make required annual reports, maintain a registered agent or office, etc.- Creditors may or may not have knowledge of the fact that the corporation is nonexistent.- If a creditor attempts to enforce a contract that was entered into with a corporation before it came

into existence, the corporation will argue that it was not a party to the contract and did not implicitly or expressly adopted the contract.

o And the corporate insiders probably do not expect to be held personally liable for the contract because it was for the corporation’s benefit.

o Novation : replacing the shareholder who signed the agreement on behalf of the nonexistent corporation with the corporation itself.

- RKO-Stanley v. Graziano : The corporation’s agent entered into an agreement prior to the formation of the corporation that stated that all liabilities would shift to the resultant corporation once it was formed.

o The general rule is that a person who is a promoter is assumed to have acted on behalf of the projected corporation and not for himself. However, he is still personally liable for contracts made by him for the benefit of the projected corporation, and this personal liability continues after the corporation is formed.

o The court holds that the agreement does not release the agent of personal liability. It just means that the corporation is also liable. However, the corporation cannot be bound by a contract to which it was not a party. Essentially, the agreement states that upon formation, the corporation can either accept or deny liability for the contract. The parties could not have intended the agreement to mean that the creditor would have no remedy.

o Had the parties intended the agent to be released of personal liability, they would have had to make a new agreement when the corporation was formed.

o The creditor may hold the agent personally liable.- Timberline Equipment v. Davenport : (Oregon law, similar to MBCA) A corporation entered into

equipment rental agreements, but the director did not realize that he had not complied with statutes. The corporation was therefore not a corporation by law because it was defectively organized.

o There are two theories under which a creditor may recover from a de facto corporation: Corporation by estoppel, which is decided on a case-by-case basis.

Applies against someone who operates a business as if it were a limited liability entity or corporation, irrespective of whether there was a good faith effort by the business to incorporate.

The person doing business with such an entity, as if it were a limited liability entity or corporation, may later be estopped from arguing that it is


not in fact a limited liability entity, in an attempt to reach the assets of the incorporators.

For the same reason, defendants who had acted as a corporation will be estopped from denying liability as a corporation when sued by a plaintiff who had relied on the defendant's corporate form when dealing with the defendant.

De facto corporation theory, which is not accepted in all jurisdictions. . If all of these requirements are met, then the business will be treated as a corporation for all purposes, except with respect to acts by the state itself. However, most states will not apply this doctrine to protect a person who was aware that the incorporation effort was defective at the time that they purported to act on behalf of the corporation.

There must be an incorporation statute that lays out the various requirements under which legal incorporation can be accomplished,

There must have been a good faith attempt to comply with the statute by the intended incorporators,

There must have been act made on the corporation's behalf by its purported officers or agents.

o De facto corporation theory no longer exists in Oregon.o The court declines to apply the corporation by estoppel theory. The plaintiffs are allowed to

reach the assets of the individuals. The evidence suggests that the plaintiffs were not aware that they were dealing with a corporation but instead thought that they were dealing with the three individuals.

VEIL PIERCING ANALYSIS

ACQUISITIONS

INTRODUCTION

- Mergers : friendly transactions whereby control over a corporation or its assets is transferred to another corporation or a new controlling shareholder.

- Friendly : transactions that are supported by the directors of the corporation experience the change in control.

o Account for almost all of the transactions referred to as mergers and acquisitions.- There are various types of mergers:

o Statutory merger : The target corporation is absorbed into the acquiring corporation. The target disappears. The acquirer issues shares or pays cash to the target shareholders.

o Asset acquisition : The acquirer buys all of the assets of the target. The acquirer issues shares or pays cash to the target shareholders. The target doesn’t disappear as a result of the sale. But normally, the target is dissolved. Any assets that the target has (usually what the acquirer paid the target) go to the shareholders pro rata.

o Stock acquisition : The acquirer buys a controlling block of stock of the target either from the target or form shareholders of the target. The target becomes a subsidiary of the acquirer. The target doesn’t disappear as a result of the sale.


STATUTORY MERGERS

- There are three types of statutory mergers:o Straight merger (Detailed above)o Triangular subsidiary merger:

Forward: The target mergers into the acquirer’s subsidiary. Reverse: The acquirer’s subsidiary mergers into the target.

o Parent-subsidiary merger- The board must initiate and approve the merger, which implicates their fiduciary duties.

o Both boards must agree to the merger.o A plan of merger must be adopted by the board and outlines the terms and conditions of the

merger and the consideration that the target shareholders will receive.o The plan may also amend the bylaws of the surviving corporation.o If the merger is with a controlling shareholder or parent corporation, or there is otherwise a

conflict of interest, the merger is subject to review as a self-dealing transaction.o Federal disclosure laws apply.o Target board approval is not needed in a parent-subsidiary merger.

- Mergers must be voted on by the shareholders:o Under the MBCA, a majority of a quorum of the shareholders must vote on the merger

(simple majority).o Under Delaware law, a majority of all shareholders must vote on the merger, not just a

quorum (absolute majority).o The MBCA requires separate approval by each voting class.o The MBCA gives nonvoting shares a right to vote on the merger if the shares are to be

converted in the merger or would be adversely affected by the merger. o Approval by the shareholders of the target is always required.o There are some exceptions where the shareholders do not get to vote on the merger:

Whale-minnow mergers: Where the acquirer issues new shares in the merger with voting power equal to less than 20% or more of the voting shares that existed prior


to the merger. The whale is the acquirer and the minnow is the target. Only the target shareholders get a vote in this instance.

Parent-subsidiary mergers: Where a parent owns at least 90% of its subsidiary. The target shareholders do not get to vote where the target will be merged into its own parent.

- Shareholders can opt out of the merger and retain their original investment, which is why statutes give them appraisal rights:

o The general rule is that a disappointed shareholder has the right to appraisal in a merger as long as he follows proper procedures.

o You have no appraisal rights if you were not allowed to vote in the merger because you were an acquirer’s shareholder in a whale-minnow merger.

A target shareholder in a parent-subsidiary merger still has appraisal rights.

SALE OF ASSETS

- After the target sells substantially all of its assets to the acquirer, it still exists.o The target doesn’t need to sell all of its assets.

- Unlike a merger, an asset acquisition does not automatically substitute the buying corporation for the selling corporation.

- Creditors, suppliers, lessors, employees, and others who deal with the selling corporation may have to consent to a substitution.

o But liabilities do not necessarily pass to the acquirer automatically.- For the shareholders of the target corporation, the same protections apply to a sale of assets as apply

to a merger: board approval, shareholder approval, and (in many instances) appraisal rights.o But target shareholders only have voting rights if there is a sale, not transfer or pledge, ando If there if a sale of substantially all assets.

- If the acquiring corporation issues, as part of the transaction, new shares that have voting power equal to 20 percent or more of the corporation's voting shares that existed prior to the purchase, the shareholders of the acquiring corporation have voting rights.

- If substantially all of the assets are sold in the regular course of business— such as a real estate holding company that regularly sells all of its inventory— the transaction is treated like any other business transaction, and only board approval is required.


o The MBCA test for “substantially all” is whether the corporation is left without a "significant continuing business activity."

o The MBCA quantitative safe harbor rule: no shareholder voting or appraisal rights arise if the corporation retains a business activity that represents at least 25 percent of total assets and either 25 percent of after-tax operating income or 25 percent of revenues (measured at the end of the most recently completed fiscal year, on a consolidated basis).

o The Delaware qualitative/quantitative safe harbor rule: shareholder approval is required if the sale involves assets that are either quantitatively vital to the company's operations or qualitatively substantial to its existence and purpose.

TRIANGULAR MERGERS

- Forward triangular merger:o The acquirer sets up a wholly owned subsidiary.o The acquirer capitalizes the subsidiary with shares or other assets.o The subsidiary issues all of its stock to the acquirer.o The subsidiary enters into a merger plan with the target where the subsidiary will be the

surviving corporation.o The target merges into the subsidiary.o The target’s shareholders receive as consideration whatever assets the acquirer used to

capitalize the subsidiary (probably shares).o The acquirer is now the sole shareholder of the new merged entity.

- Reverse triangular merger: where the same process happens above except the subsidiary merges into the target.

- A forward merger, compared to a reverse merger, has the disadvantage that the non-survival of the target corporation may potentially affect contracts or intellectual property that depend on the corporation's continuing existence.

COMPULSORY SHARE EXCHANGES

- Some statutes have adopted a more direct procedure for accomplishing the same result as a triangular merger.

- In a compulsory share exchange, the acquiring corporation can force the target's shareholders to exchange their shares for consideration offered by the acquirer.


- Shareholders of the acquired corporation enjoy the same protections as they would in a triangular merger:

o The target's board must first approve the exchange,o A majority of the target's shareholders must then approve it, and o Dissenters of the target have appraisal rights.

- If the exchange is approved, all the target's shareholders receive the consideration offered by the acquirer.

- The target corporation can remain in existence.

DE FACTO MERGERS

- Often, parties will elect to use one of the above transaction forms that denies shareholders voting and appraisal rights that would have been available in a statutory merger.

- Shareholders denied voting or appraisal rights may ask courts to intervene and re-characterize the transaction as a merger under the de facto merger doctrine.

- Under this doctrine, if the asset sale has the effect of a merger, shareholders receive merger-type voting and appraisal rights.

- Farris v. Glen Alden : (Pennsylvania law) Glen Alden acquired the assets of List in a stock-for-assets exchange approved by both companies' boards and the List shareholders, but not the Glen Alden shareholders. The Glen Alden shareholders became minority shareholders after the acquisition. The court found that the acquisition was in substance a merger even though not in form. The transaction was enjoined.

- This doctrine is not provided for in statute and is often criticized. Only a few jurisdictions have it.o Most courts have rejected the de facto merger doctrine and have refused to imply merger-

type protection for shareholders when the statute does not provide it.o In fact, in many states where courts have used a de facto merger analysis, the legislature has

later abolished the doctrine by statute. - In most jurisdictions, particularly Delaware, courts accept that corporate management can structure

a combination under any technique it chooses. - Applestein v. United Board & Carton Corp. : The target corporation sold to the acquirer all of its

shares. The target corporation received as consideration shares in the acquirer. When the target corporation was dissolved, the target director was in control of the acquirer. The acquirer’s shareholders were not given any voting or appraisal rights. The court applies the de facto merger doctrine and says that the transaction is invalid.

o This transaction has hallmarks of a merger: Transfer of all of the shares and assets of the target to the acquirer, Assumption by the acquirer of all liabilities of the target, Pooling of the interests of the two corporations, Dissolution of the target, Joinder of the officers and directors.

o The state legislature has provided for the appropriate form to merge two corporations and protects shareholders in a merger. Do not try to get around those.

- Hariton v. Arco Electronics : (Delaware law) The target and acquirer complete a merger by way of a sale of assets. In a sale of assets, the target’s shareholders do not get appraisal rights. The plaintiff is a target shareholder who did not vote at the meeting who is against the merger. He petitions the court for appraisal rights under the de facto merger doctrine. The court rejects the de facto merger doctrine.


o Equal dignity rule: Corporate management can structure a combination under any technique it chooses. To maximize flexibility, form trumps substance. Each combination technique, including its particular protections, has its own legal significance. If you can accomplish the same result using two of the forms, there is no problem.

- ALI 7.21 : Shareholders of a parent corporation that uses a subsidiary to effect a merger (triangular merger) would normally receive appraisal rights as if the parent corporation had been a direct participant in the merger.

o If a corporation uses its own stock to purchase a substantial portion of the assets of another corporation, its shareholders get appraisal rights, as do the shareholders of the selling corporation, if the transaction results in the acquiring corporation’s pre-transaction shareholders owning less than 60% of the stock outstanding immediately after the acquisition is effected.

CASH-OUT MERGERS

- A cash-out merger is a way for controlling shareholders to directly force out minority shareholders

via a merger.- Singer v. Magnavox : A statutory merger made for the sole purpose of freezing out minority

stockholders is an abuse of the corporate process; it is a breach of fiduciary duty to minority shareholders.

o Majority must show a valid business purpose for the merger.o Proof of a purpose other than to freeze-out the minority without more will not necessarily

discharge fiduciary duty.o The court will look at the entire fairness of the transaction.

- Tanzer v. International General : The controlling shareholder’s own interest can be a valid business purpose, but that interest cannot be a pretense for getting rid of minority shareholders. This is an odd case because a controlling shareholder wouldn’t want to get rid of minority shareholders if it wasn’t in the controlling shareholder’s economic interest.

- Coggins v. New England Patriots : The majority here who wishes to freeze out the minority must show that the elimination of public ownership of the Patriots is in furtherance of a business purpose. Then, the court must determine if the transaction was fair by examining the totality of the circumstances.

o The restructuring of the Patriots seems to be for the sole purpose of enabling the controlling shareholder to repay his personal debt.

o Therefore, there is no business purpose to the transaction. So there is no need to look at the fairness of it.


o Appraisal rights are not the only remedy in a freeze-out merger. Sometimes rescission is the appropriate remedy.

o Here, the court awards rescissory damages instead of rescission for multiple reasons. They are determined based on the present value of the stock plus interest.

- M&W v. Pacific Guardian : Controlling shareholder's purpose was stated to be to simplify US operations, increase efficiency (management less distracted by shareholder litigation), reduce expenses (legal fees, audit fees, stockholder administration fees, director and officer liability insurance premiums). This was not a valid business purpose.

- Law before Weinberger:o In a parent-subsidiary merger, appraisal is the exclusive remedy.o In a cash-out merger, Delaware follows the business purpose rule. However, appraisal is not

the only remedy for minority shareholders. Where the claim is for breach of fiduciary duty by a majority shareholder, the court

must take into account the post-merger gains accruing to the controlling shareholder.

A claim of breach of fiduciary duty justifies rescission, but where rescission is impractical, rescissory damages are appropriate.

Post-merger gains are not available in an appraisal remedy.o Exclusive method of valuation: weighted average of asset value, market value, earnings

value, where weighting is at court's discretion. Asset value: Market value of assets held by corporation (less liabilities) Market value: Stock price Earnings value: Discounted present value of projected future income stream

- Weinberger v. UOP : In a cash-out merger, the plaintiff has the burden of establishing the basis for the entire fairness standard. Once the entire fairness standard applies, the defendant has the burden of showing: (1) fair dealing, and (2) fair price. There is no requirement that the defendant have a legitimate business purpose.

o Fair dealing: the procedures of the deal: how and when it was initiated, where it was negotiated, and how it was approved.

The duty of loyalty, as manifested by a showing of good faith and candor, is inherent to fair dealing.

When directors or controlling shareholders are on both sides of the transaction (parent-subsidiary merger), it is difficult to show that the transaction is indeed one at arms-length.

Directors can try to meet their burden by setting up an independent negotiating committee of outside directors.

Even where there is an independent negotiating committee, negotiating on behalf of the subsidiary, intrinsic fairness and not the business judgment rule is still the standard. The plaintiff carries the burden of proving unfairness.

Where merger is approved by an informed vote of the majority of the minority, then burden is on plaintiff to show unfairness.

Otherwise burden is on defendants to show fairness. Burden is on defendant to show that the vote was informed.

o Fair price: the terms of the deal. To determine whether there was a fair price, all relevant factors that may affect a

company's stock value are considered.


But this does not include any element of value arising from the accomplishment or the expectation of the merger.

Use "any techniques or methods which are generally considered acceptable in the financial community.” Therefore, the exclusive valuation method is abolished.

Includes, when trial court deems it appropriate, "any damages, resulting from the taking, which the stockholders sustain as a class.”

o Given the strength of the exclusive appraisal remedy and the high standard of showing entire fairness, the business purpose test does not afford "any additional meaningful protection" to minority shareholders.

o Appraisal is the sole remedy, but the valuation procedures are more liberalized, using "any techniques or methods which are generally considered acceptable in the financial community.”

- Valuation and exclusivity of appraisal after Weinberger:o Under the MBCA, appraisal is usually the exclusive remedy, and courts will not distinguish

between short form (parent-subsidiary) and long form (straight) mergers.o In Delaware, appraisal is the exclusive remedy in a short form merger, absent fraud or

illegality. (Glassman). In a long form merger, if the plaintiff alleges a breach of the duty of entire fairness,

appraisal is not the exclusive remedy. (Rabkin, Lynch).o In some states, such as Oregon, there is a very strict rule that appraisal is the exclusive

remedy even in cases of clear bad faith. (Car Data)o In both the MBCA and in Delaware, it is not appropriate for fair value of minority stock to

reflect a discount because the appraised stock is minority interest or is not readily marketable.

o In the MBCA, fair value is the value of the share immediately before the effectuation of the corporate action to which the dissenter objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable. MBCA 13.01(3).

o In Delaware, the effects of the merger are accounted for in fair value unless the effects are purely speculative. Cede & Co. v. Technicolor; Del. GCL 262(h).

HOSTILE TAKEOVERS

OVERVIEW

- Mergers generally cannot take place without board consent, so the board acts as a gatekeeper.- Boards can use this gatekeeping function opportunistically.- Two ways that an acquirer can get control of a corporation without consent of the board:

o Tender offer, ando Proxy fight (asking the shareholders if you can vote their shares).o Note: the acquirer can also combine the two forms.

The suitor can solicit proxies to replace the board, on the promise that it will make a tender offer after the new board removes any takeover impediments installed by the old board (poison pills).

This two-step bid is more costly than a straight tender offer, but may be the only way to acquire control in the face of an entrenched board.

- Securities Exchange Act of 1934 : requires disclosure to shareholders when their proxies are solicited to approve a merger.

- Williams Act : Provides procedural protections to shareholders faced with a tender offer; also, a tender offeror must disclose its:


o Identity and background,o The source and amount of the funds to be used in making the purchase, ando The purpose of the purchase, including any plans to liquidate the target or change its

corporate structure.- Usually, a tender offeror is willing to pay a significant premium for the shares, often as high as 30%

above the market price. But why?o The Disciplinary Hypothesis : The bidder believes that the target’s assets have not been

optimally utilized and that under superior management, they would ear a higher return. The higher the premium, the greater the degree of mismanagement.

o The Synergy Hypothesis : The takeover premium is justified by the target company’s unique value to the bidder that is in excess of its value to the market generally.

o The Empire Building Hypothesis : The bidder might have simply overpay because firms tend to want to maximize size, not profits, for a variety of reasons.

o The Exploitation Hypothesis : The bidder exploits temporary depressions in the target’s stock price in order to seize control of the target in a bargain purchase.

o The Winner’s Curse : Even if the bidders estimate value accurately on average, they win the bidding primarily when they overestimate an asset’s true value, and thus tend to overpay on average.

o The Discount Hypothesis : Acquisition premiums reflect the existing value of target assets, a value that may be much higher than the pre-bid market value of the target shares, for two possible reasons:

The misinvestment hypothesis : Discrepancies between share prices and asset values are caused by a rational mistrust of manager’s future investment decisions.

The market hypothesis : Share prices may discount asset values because of (1) the valuation model used does not accurately reflect asset value, or (2) the behavior of uninformed traders.

POISON PILLS

- Geenmail : pejorative term for a target’s repurchase of its own shares from a raider when the target pays a premium for the shares to induce the unwanted suitor to go away.

- Cheff v. Mathes : Directors of a corporation may use greenmail cause the company to buy out a dissident shareholder if they sincerely believe that this is necessary to maintain proper business practices. But they may not do this if the true motive is primarily to remain in office.

o The burden of proof is on the directors because they have a conflict of interest. However, the burden falls somewhere in between the business judgment rule and the intrinsic fairness standard of self-dealing.

o The directors must show that they had reasonable grounds to believe that the dissident shareholder posed a danger to “corporate policy and effectiveness.”

o To meet this burden, they must show good faith and a reasonable investigation – not total fairness.

- Unocal v. Mesa : The corporation defended against a hostile takeover by issuing its own tender offer to its shareholders but excluding the raider. The dissident shareholder/potential raider argued that the corporation breached its fiduciary duty by excluding it from the tender offer.

o The poison pill test: Before the board gets the protections of the business judgment rule, it must show that it had reasonable grounds for believing that a danger to corporate policy and effectiveness existed because of another person's stock ownership. Also, the defensive measure must be reasonable in relation to the threat posed.

This burden is satisfied by showing good faith and a reasonable investigation. Evidence of good faith and a reasonable investigation is enhanced when the board

has a majority of independent outside directors.o If they satisfy this burden, apply the business judgment rule to the decision to issue the

tender offer. To overcome the business judgment rule, the raider must show: that the directors'

decisions were primarily based on perpetuating themselves in office, or some other


breach of fiduciary duty such as fraud, overreaching, lack of good faith, or being uninformed

o Later refinements to this test under Revlon and Time-Warner: All-cash, all-shares offer (not just two-tier offer) can also constitute a "threat" to

which board may respond (i.e. institutional investors are dumb and need to be protected from themselves), and

The board has right and duty to select a time frame for achievement of corporate goals and "that duty may not be delegated" to stockholders.

- Moran v. Household : A corporation is allowed to issue securities in accordance with Delaware law even if the purpose of issuance of securities is to defend against hostile takeovers. The purpose of issuing the securities is irrelevant. However, courts will apply the same test as in Unocal v. Mesa:

o The creation of the poison pill is lawful. But its use must be exercised in good faith. That has to be reviewed when it is exercised.

- Air Products : If a board of directors has a good faith belief that an offer is inadequate, they can block it with a poison pill. If the court determines that the directors have satisfied their burden under the poison pill test and that the decision is protected by the business judgment rule, the court cannot force the directors to eliminate the poison pill. If the shareholders believe that the offer is adequate, their only remedy is to elect a new board to eliminate the poison pill.

- A dead hand poison pill is one that cannot be eliminated by future directors.o Carmody : A dead hand poison pill that prevents future directors from eliminating it is an

unlawful restriction on director discretion and is therefore illegal. It also removes the right from the shareholders to elect directors with the same powers as previous directors.

- The board of directors has an enhanced duty where the corporation is up for sale because instead of defending the corporation, they are charged with ensuring that the stockholders get the best price possible.

o Revlon : The board of the corporation up for sale gave preferential treatment in the auction to a bidder who was friendlier to management (the white knight bidder). The board wanted the white knight, not another bidder, so it allowed the white knight to acquire some of Revlon’s most valuable assets if another bidder bought Revlon.

Here, Revlon directors cannot assert that there was a threat to corporate policy and effectiveness because breakup was inevitable. Breakup is inevitable when a corporation is up for sale.

When Revlon duties are triggered, defensive measures such as this lock-up provision are OK as long as they enhance bidding. It is also OK to consider the interests of other constituencies as long as there is a rationally related benefit accruing to stockholders, to whom the primary duty of loyalty is owed.

o Revlon duties are triggered in the following circumstances: Where the corporation initiates active bidding process to sell itself or to effect

business reorganization involving clear break-up of company, Where, in response to bidder's offer, the target abandons long-term strategy and

seeks an alternative transaction involving break-up of the company, In general, where there is any change of corporate control even without a break-up

(because this is the last chance for stockholders to realize a control premium),o Revlon duties are not triggered where the board's reaction is a defensive response and not

an abandonment of the corporation's continued existence.- Paramount v. Time : Paramount wanted to acquire Time so it proposed an all-cash-for-all-shares

offer. Time was concerned that it would lose its “Time culture.” Time alleged that the offer was inadequate and that the market just didn’t see the value in the Time culture. To defend against the takeover, Time tries to purchase 51% of Paramount’s stock. Paramount responds by offering all cash – 59% premium over the market price of Time shares. Shareholders sue, claiming Revlon duties.

o The court finds that Revlon does not apply because Time will not break up after the proposed merger, even though Paramount’s shareholders ended up in control of the merged entity.

o This is therefore a Unocal claim, not a Revlon claim.


o The court says that the threat is coming from the Time shareholders who don’t understand the value of their shares. Confusing rationale.

- Paramount v. QVC : Paramount was looking for possible merger or acquisition targets in order to remain competitive in their field. Paramount and Viacom entered into an agreement QVC sought to enjoin the agreement between Paramount and Viacom because the agreement’s defensive measures prohibited QVC from competing for the merger. The court finds that Paramount’s Revlon duties were triggered.

o No shop provision : Board may not discuss competing transaction with anyone unless (a) third party makes bona fide bid not subject to material contingencies regarding financing, and (b) negotiations are required by board's fiduciary duties (i.e., only if we have to). There is a $100 million termination fee. A stock option agreement gave Viacom option to buy 23.67 million shares at $69, paid for by subordinated note (not cash). Viacom could also demand Paramount pay difference between market price and $69.

o The rule is the Revlon duties are triggered When a corporation undertakes a transaction which will cause (a) a change in corporate control, or (b) a break-up of the corporate entity, the directors' obligation is to seek the best value reasonably available to the stockholders

o Here this is a change in corporate control, so Revlon applies.o Because Revlon applies, only defensive measures that enhance bidding are acceptable. The

defensive measures here – except for the termination fee – do not enhance bidding.o The Paramount board’s failure to consider QVC’s offer was a breach of fiduciary duty to their

shareholders.HOSTILE TAKEOVER ANALYSIS

- Where the board is resisting a hostile takeover, there is a conflict of interest. But the standard to apply is an intermediate standard in between the business judgment rule and self-dealing. (Unocal)

o The Unocal test has two parts: First, the board must show that it had reasonable grounds for believing that a

danger to corporate policy and effectiveness existed. The board satisfies this prong by showing good faith and reasonable investigation.

Second, the board must show that the defensive measure was reasonable in relation to the threat posed. The board satisfies this prong by showing that the primary purpose was to defend corporate interest and not to remain in control of the corporation.

o If the board satisfies both prongs of the Unocal test, the business judgment rule applies.o If the board does not satisfy either prong of this test, the defensive measure is illegal.

- On the other hand, if it becomes plain that corporation will be sold or broken up, or that control will be transferred and shareholders will no longer be able to command control premium, the board’s Revlon duties to get the best value for the shareholders are triggered.

o Under Revlon, it is a breach of fiduciary duty for the board to fail to try to get the best value for the corporation.

o The board must hold an auction. Failure to do so is a breach of fiduciary duty.- Lastly, if during the process of a sale, the board enters into agreement with acquirer that has

provisions that are inconsistent with either Revlon or Unocal obligations, those provisions are unenforceable.

o However, reasonable lock-up provisions or termination fees are allowed.

FEDERAL LAW & INSIDER TRADING

FEDERAL SECURITIES LAW

OVERVIEW

- Federal securities law is generally about disclosure and applies to companies with large numbers of public shareholders (i.e. companies listed on the stock exchange).


- Securities Act of 1933 : concerns disclosure regarding initial public offerings (IPOs); places the burden of disclosure on the seller.

- Securities Exchange Act of 1934 : concerns continuing disclosure obligations- A company must make disclosures concerning the following:

o IPOso Quarterly reports,o Annual reports,o Tender offers,o Proxy solicitations,o Other material events

- Borak : There is a private right of action to enforce disclosure rules in proxy solicitations even where the statute doesn’t expressly provide for it. But the availability depends on the facts of the case.

o Alternatives: express federal cause of action by the SEC and a state cause of action under state (Blue Sky) laws.

RULE 14A-9 (PROXY STATEMENTS)- Rule 14a-9 makes it illegal for a proxy solicitation to contain a misrepresentation or omission of a

material fact.- Elements of a Rule 14a-9 claim: materiality, and reliance/causation

o Material : when there is a substantial likelihood that a reasonable investor would consider it important in deciding how to vote. (TSC test for proxy statements). The burden is on the plaintiffs to prove this.

The policy goal of 14a-9 is to make sure shareholders get enough information to allow them to make an informed decision, but to not give management an incentive to bury them with a flood of useless information.

o Reliance/Causation : If shareholder approval is needed for the merger, the plaintiffs just have to show

that the proxy solicitation was necessary and that the misrepresentation was material. This proves causation. Mills.

If shareholder approval is not needed for the merger, there is no causation because the merger would have occurred anyways.

But if the shareholders can show that the misrepresentation was material, they get appraisal rights (in Delaware, shareholders lose appraisal rights if they vote for the transaction).

This just puts the shareholders in the position they would have been in had they not voted for the transaction.

RULE 10B-5 (ISSUANCE OF SECURITIES)- Rule 10b-5 is a broad catch-all that covers fraud in connection with the purchase or sale of securities.- The question then becomes: what kind of fraud is closely enough connected to a securities

transaction to merit federal attention, either by the SEC or by courts in private rights of action?- Elements of a 10b-5 cause of action:

o Standing: “in connection with,” ando Reliance/causation

- Birnbaum v. Newport Steel : (2d Cir.) During the Korean War, there was a price ceiling on steel, but not on the stock price of steel. Steel users wanted to ensure they had an adequate supply of steel by bringing it “in-house” – buying controlling stock blocks. The defendant allegedly rejected a merger


offer and then sold his controlling stock block to a company that manufactured products that required steel as an input. Letters to the corporation’s stockholders stated that merger talks were suspended and later that the defendant sold his stock – but it didn’t disclose the price or that now the corporation was a subsidiary of the manufacturer. The court rules that the shareholders of the corporation do not have standing under Rule 10b-5 because Rule 10b-5 protects only a defrauded purchaser or seller.

- Superintendent of Insurance v. Banker’s Life : (S. Ct.) In a very far-reaching decision, the court holds that Rule 10b-5 is implicated in any fraudulent scheme if as part of that scheme a purchase or sale of securities occurs, even if the transaction is not fraudulent and there is no harm done to buyer, seller, or the integrity of the market.

o But what is the point of Rule 10b-5 being implicated if under Birnbaum there is no standing to enforce it? Must the plaintiff be a party to the securities transaction that brings Rule 10b-5 into play?

o It appears that this holding gives a securities seller a remedy under 10b-5 even if the seller sells to the buyer in a non-fraudulent transaction as long as the seller is somehow defrauded, even if not by the buyer but instead by some third party.

- Blue Chip v. Manor : (S. Ct.) Shareholder plaintiffs argue that they have standing under Rule 10b-5 because they would have purchased the corporation’s stock but for the misleading statements. The court rejects this argument. The court follows the Birnbaum rule – the plaintiff must either be an actual buyer or an actual seller of securities to have standing.

o This ruling excludes the following types of plaintiffs: Prospective stock buyers, Prospective stock sellers, Actual shareholders who argue that someone else’s fraudulent purchase or sale

caused the value of their stock to go down.o Dissent : The court is being too callous to the investing public and too nice to corporations.

- Santa Fe v. Green : The Supreme Court refuses to expand the reach of Rule 10b-5 to cover this situation. The shareholders received complete information and appraisal rights. It’s not fraud to offer the shareholders less money than they want to receive. Mere breach of fiduciary duty does not implicate Rule 10b-5 (that’s what breach of duty causes of action are for).

- Basic v. Levinson : If misrepresentation was material and public, then the Efficient Capital Markets Hypothesis tells us that it must have affected prevailing market price. Plaintiffs are price takers and are presumed to have relied on the assumption that the market price was not based on false information.

o However… Perhaps price-makers knew about the misrepresentation (experts might say that no

one believed Basic’s denials, so the market price is not reflective of the misrepresentation)

Perhaps plaintiff didn’t believe the misrepresentation and thought the market mispriced the stock (i.e., show that individual shareholders had different reasons for selling their shares).

INSIDER TRADING

- Even though Rule 10b-5 doesn’t mention anything about insider trading, it is used to regulate it.o §14(e) of the 1934 Act prohibits fraud,o Rule 14e-3 defines as fraud the use of inside information (defined by its source) in the

context of a tender offer.


o Thus, the SEC could essentially get rid of the fraud requirement in Rule 10b-5 by defining it away.

- §16(b) of the 1934 Act requires insiders to disgorge to corporation all profits made or losses avoided from short-swing (within 6 months) trades.

- Rule 10b-5 under §10(b) of the 1934 Act prohibits fraud in connection with the purchase or sale of securities but (unlike Rule 14e-3) does not define away the problem of finding it.

- Failure to disclose is only wrongful if there is a duty to disclose. Therefore, we need:o A duty to disclose,o A failure to disclose, ando Fraud.

- There is no prohibition on discovering unfairly acquired information – you just cannot use it to buy and sell securities.

- Fiduciary duty theory of insider trading : there is a special relationship between the insider and the person with whom they’re dealing (a shareholder), so there is a duty to disclose.

o But this theory really only applies when buyingo If you sell to someone who is not a stockholder, you don’t have a duty to disclose.o However, courts have chosen to ignore this discrepancy.

- Misappropriation Theory of Insider Trading : the wrongfulness of insider trading is the misappropriation of information for personal use, depriving the corporation from using the info on its own behalf.

- Cady Roberts Theory : “disclose or abstain” – you either have to disclose the insider information before you trade or you don’t trade.

o Texas Gulf Sulphur rule (2 Cir. 1968): Anyone in possession of material inside information must either disclose it to the investing public or . . . abstain from trading in or recommending the securities concerned while such inside information remains undisclosed.

- Chiarella : (Classical Theory) A low level employee of a legal printing firm bought stock in companies before his firm issued those companies tender offers. There was no insider trading.

o There must be a relationship of trust and confidence between person who trades on inside information and the person he deals with.

o Failure to disclose is fraudulent only when there is a duty to disclose. Here there was no duty.

o "[A] purchaser of stock who has no duty to a prospective seller because he is neither an insider nor a fiduciary has been held to have no obligation to reveal material facts."

- Dirks : A tippee is liable when the tipper would be liable; therefore when the tipper doesn't use information to gain directly or indirectly, the tippee is not liable. Whether the tippee violates 10b-5 depends on whether the tipper violated his fiduciary duty to firm’s sharholders in giving the tip, and whether the tippee knew or should have known of breach.

o Thus, if Dirks had bribed Secrist for information and then passed it on to clients (who don't know of bribe), Dirks would be liable if clients traded but clients would not be.

- In response to Chiarella, the SEC adopted Rule 14e-3: “it is unlawful for any person who obtains advance information about a tender offer to use that information in connection with a securities transaction.”

o This is the Misappropriation Theory.o O’Hagen : Upheld the misappropriation theory, even though the court acknowledged it might

capture some instances of insider trading not involving a breach of fiduciary duty.


Duty owed to: Why? Content Breach Fraud?Classic Theory (Chiarella)

Other side in the trade (special relationship)

Fiduciaryrelationship

Disclose or abstain – don’t mislead by failing to disclose

Trade without disclosing

Yes

Misappropriation (O’Hagan)

Source of info Relationshipof trust andconfidence

Don’t use info for personal purposes

Use info for own purposes & Don’t tell the other side

Yes

INSIDER TRADING ANALYSIS

1. What is the breach of duty that makes the transaction fraudulent?a. Classic: Failure to disclose before trading is the breach (disclose or abstain)b. Misappropriation: "Undisclosed [to principal], self-serving use of principal’s information to

purchase or sell securities, in breach of duty of loyalty and confidentiality, defrauds principal of exclusive use of information."

2. What do you have to fail to disclose to be liable?a. Classic: The inside information itself: the fact that the company is about to make a tender

offer, for exampleb. Misappropriation: Not the inside information. That would make no sense. The source of the

inside information already knows it. You have to disclose the fact that you’re using the info for your personal benefit, and failure to do so is the basis of 10b-5 liability.

3. Who has the duty of confidentiality?a. Classic: b. Misappropriation:

4. To whom is confidentiality owed?a. Classic: the duty is owed to the party with whom you deal.b. Misappropriation: Duty is owed to the source of the information, not to the person with

whom you trade the securities.


APPENDIX – FLOW CHARTS

PARTNERSHIPS – FIDUCIARY DUTY


PARTNERSHIPS – DISSOCIATION


BUSINESS JUDGMENT RULE – GENERAL APPLICATION


CORPORATE OPPORTUNITIES DOCTRINE – ALI


CORPORATE OPPORTUNITIES DOCTRINE – GUTH TEST


DUTY OF CARE


DUTY OF GOOD FAITH


DEMAND FUTILITY IN DELAWARE


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