CORPS OUTLINE

I. INTRODUCTIONA. EFFICIENCY AND SOCIAL SIGNFICANCE OF ENTERPRISE ORG

i. Corporate law addresses creation of economic wealth through facilitation of voluntary, ongoing collective action

1. Does NOT focus on what to do with that wealth ii. Wealth creation and corporate form of organization:

1. Creation and governance of private legal entities that are principal economic actors in modern world

a. Control over vast aggregations of wealth and poweri. How corporate enterprises are

created/capitalizedii. How power over internal affairs is distributed

iii. How economic performance is monitorediv. What mechanisms exist to improve

performance 2. Idea that an organization’s internal governance affects its performance 3. Dominance of corporate form throughout the world

a. Legal form of large-scale firms is remarkably similar in almost all economies

4. Corporate form dominates in all instances where technology creates economies of scale

iii. Efficiency—what is it?1. Economic efficiency = principal standard by which corporation law

should be evaluated2. Pareto Efficiency:

a. Most basic definitionb. Given distribution of resources is efficient when, and

only when, resources are distributed in such a way that no reallocation of resources can make at least one person better off w/out making at least one other person worse off

i. Pareto-optimalii. BUT utility as subjective state of well-being that

can’t be accurately assessed by outside observers

1. THUS only through voluntary exchange in which individuals reveal their own preference for one outcome over

another that we can be sure that any transfer or redistribution yields utility gain for both sides of transaction

a. Only when all parties affected by transfer experience net utility gain that we can be certain that there is a net utility gain from transaction overall

i. Pareto-efficient c. Drawbacks:

i. Pareto-efficient transfers are those that are certain to increase social welfare starting from a fixed starting point—original distribution of resources BUT

1. In real-life legitimacy of existing distribution is contested

ii. Virtually impossible for courts/legis to make decisions that don’t make someone worse off

1. Thus almost all public polices/many private arrangements fail test for Pareto-efficiency b/c of the fact no matter how much good is conferred at least one person will be made worse off

d. Pareto-efficiency as poorly suited to evaluating or criticizing law of enterprise organization

3. Kaldor-Hicks Efficiencya. Definition: act/rule is efficient (leads to overall

improvement in social welfare) if at least one party would gain from it after all those who suffered a loss as a result of the transaction/policy were fully compensated

i. ACTUAL payment not stipulated merely potential improvement

b. Rule of wealth maximization i. Total wealth of affected parties increases

1. Efficient if aggregate monetary gains to winners exceed aggregate monetary losses to losers

c. Drawbacksi. Ignores actual distributional consequences of

polices/difficulty of accurately measuring all

negative/positive effects of third parties that follow given action

d. BUT—still more workable than Pareto efficiency as yardstick for policy makers

B. Law from Inside and Out:i. Fairness and Efficiency

1. NOTE: courts rarely use efficiency concept to justify their decisionsa. Courts avoid using “exterior” concepts like efficiency to

justify their choices—even if these concepts are central to evaluating wisdom of outcome reached

i. Efficiency as controversial judicial standard1. WHY?

a. Determining what counts as costs and what counts as benefit in a world incomplete markets, strategic behavior and informational asymmetry inevitably involves guesswork

2. Courts speak in terms of fairness as opposed to efficiency a. Fairness to shareholders

C. Development of Modern Theory of the Firmi. Adam Smith:

1. Firms facilitate specialization2. Require hired managers who be posited would work less diligently

than would the owners themselvesa. b/c so he reasoned corporate form would remain little

used 3. Early history: caused on the market not the market that went on

inside the firma. Ignored the inner firm and what went on

4. Reality: much of what happens in markets is accomplished not by individuals effecting simple buy/sell transactions but by firms entering into complex Ks

ii. Ronald Coase’s 1937 Insight1. Hypothesized that in reality costs associated w/ transactions b/w

market participants were substantiala. Suggested firms exist b/c in a world of positive

transaction costs, it’s sometimes more efficient to organize complex tasks w/in hierarchal org than on market

iii. Transactions Cost Theory:1. Theory of the firm:

2. Firm as set of transactions cot-reducing relationshipsa. Owners of various resources are seen as committing

some “contractual” governance agreement such as the firm in order to reduce transactions costs and share resulting efficiency gains

iv. Agency Cost theory 1. Addresses how the actions of one actor (agent) affect the interest of

another (principal) with whom she is tied by K or otherwisea. Agents typically act w/ respect to property that

principals own2. Agents as maximizers of their OWN interests rather than the interests

of their principalsa. Transaction may be motivated in part at least to serve

an interest of a controlling agent rather than the interest of her principal

3. Basic insight: to the extent that the incentives of the agent differ from the incentives of the principal herself, a potential cost will arise agency cost

a. Any cost – explicit or implicit—associated with the exercise of discretion over the principal’s property by an agent

i. Includes salaries/benefits; loss of job; ii. Risks and rewards of managers may be out of

alignment with the interests of shareholders 4. Three general sources of agency costs

a. Monitoring costsi. Costs that owners expend to ensure agent

loyaltyb. Bonding costs

i. Costs that agents expend to ensure owners of their reliability

c. Residual costsi. Costs that arise from differences of interest that

remain after monitoring and bonding costs are incurred

d. Jensen/Meckling—principal bears all of these costs 5. Corporation and agency problems

a. Conflict b/w managers and investors/ownersb. Ability of majority owners to control returns in a way

that discriminates against minority ownersc. Problem existing b/w firm and all other parties w/

whom it transacts such as creditors of the firm

II. ACTING THROUGH OTHERS: THE LAW OF AGENCY A. INTRODUCTION TO AGENCY

i. Simplest form of joint economic undertaking occurs when one person extends the range of her own activity by engaging another to act for her and be subject to her control

1. Paradigm of principal-agent relationship ii. Problems of agency can arise in corporation context

1. Putative principal of widely held public corp—class of dispersed shareholders may be entirely unable to monitor its agent—corporation’s management

2. NOTE: Principal typically an individual capable of actively monitoring her agent’s activities to some extent

B. AGENCY FORMATION, AGENCY TERMINATION, AND PRINCIPAL’S LIABILITY i. Formation

1. Restatement (third): agency is the fiduciary relationship that arises when one person (principal) manifests assent to another person (agent) that the agent shall act on the principal’s behalf and subject to the principal’s control and the agent manifests assent or otherwise consents so to act

2. Agency: consensual relationship b/w principal who grants authority to another to bind her in certain respects and agent who accepts that responsibility

a. Agent is holder of a power to affect the legal relations of the principal w/in the scope of the agent’s agreed-on appointment (employment) and beyond this scope in some circumstances, subject to agent’s consents, the principal can define or delimit the granted authority in any way she pleases

3. Types of agentsa. Special agents

i. Agency limited to single act or transaction b. General agent

i. Agency contemplates series of acts/transactions4. Types of principals

a. Disclosed: third parties transacting w/ the agent understand that the agent is acting on behalf of particular principal

b. Undisclosed: third parties are unaware of a principal and believe the agent herself is a principal

c. Partially disclosed: when third parties understand that they’re dealing with an agent bud don’t know the identity

5. Right to control: a. Principal’s right—essential aspect b. Can vary under agreement

i. EE v. IC (agent)ii. Termination

1. Either the principal or agent can terminate an agency at any timea. Think at-will employment

2. If K sets fixed set term of agency—Principal’s decision to revoke OR the agent’s decision to renounce gives rise to claim for breach of K

a. Agency can’t continue over objection of one of the parties

b. No specific enforcement iii. Parties’ Conception Does NOT Control

1. Agency relations may be implied even when the parties haven’t agreed to an agency relationship

a. AGAIN think back to employment law2. Jenson Farms Co. v. Cargill, Inc. (Minn 1981)

a. FACTS: Ps were partnerships of corporate farmers who claimed that Cargill was jointly liable for Warren Grain’s indebtedness to the farmers b/c Cargill had acted as principal for the grain elevator

i. Cargill provided extended credit lines and used Warren as its agent to seek growers for new wheat

b. ISSUE: whether Cargill by its course of dealing with Warren became liable as principal on contracts made by Warren w/ Ps

c. RULE: agency is fiduciary relationship that results from the manifestation of consent by one person to another that the other shall act on his behalf and subject to his control and consent by the other so to act

i. In order to create agency – must be agreement but not necessarily K b/w parties

ii. May be proved through circumstantial evidence iii. HERE: Cargill manifested consent that Warren

would be agent; Warren acted on behalf of Cargill in procuring grain; Cargill had control over Warren through:

1. Constant recommendations2. Right of first refusal3. Warren needed Cargill’s approval for

certain deals

4. Cargill had right of entry onto Warren’s premises

5. Cargill’s correspondence/criticism regarding warren’s financials

6. Determination that Warren needed strong paternal guidance

7. Drafts and forms to Warren w/ Cargill’s name imprinted

8. Financing of Warren’s purchases and operating expenses

9. Cargill’s power to discontinue financing iv. ACTIVE PARTICIPANT paternalistic

relationship iv. Liability in Contract

1. Actual and Apparent Authority a. Agency = arrangement that confers legal power on

agent AND gives rise to duties by both the principal and the agent

i. Both most manifest their intention to enter into an agency relationship

1. Need not be in writing or even verbal a. Necessary that agent

reasonably understand from the action or speech of the principal that she’s been authorized to act on principal’s behalf

b. Scope of actual authority is that which a reasonable person in the position of agent would infer from conduct of principal

2. Actual authority includes incidental authority authority to do those implementary steps that are ordinarily done in connection w/ facilitating the authorized act

3. Apparent authority: authority that a reasonable 3d party would infer from actions/statements of PRINCIPAL

a. Equitable remedy designed to prevent fraud or unfairness to 3d parties who reasonably rely

on P’s actions or statements in dealing with A

b. Did P permit A to take such conduct OR hold A out has having such authority?

i. OR are the two types of actions (the one authorized and the one in question) so similar that a third party could reasonably believe that the authority to do one carried w/ it authority to do the other

ii. White v. Thomasb. White v. Thomas (Ark 1991): found that P was not

bound under a K conveying real estate to Psi. FACTS: A instructed to attend an auction and

bid on behalf of Principal up to $250K farm; A bought off the acreage from Plaintiffs and when realized it exceeded her authorized bid she agreed to sell 45 acres; Principal didn’t want to sell that portion; Plaintiffs began action seeking specific performance of K and release of the land embraced in the K from White’s mortgage

ii. COURT: Agent not expressly authorized to sell Principal’s property—only purchase; she didn’t have implied authority to contract to sell Plaintiffs a portion of the property that she had purchased as that act WAS NOT necessary to accomplish her assigned task of purchasing the entire tract

1. in order for Principal to be liable for Agent’s actions in entering into the offer and acceptance w/ Plaintiffs, her actions must have fallen w/in the scope of apparent authority

2. Plaintiffs knew Agent was acting on behalf of Principal but there is no evidence that Principal knowingly allowed agent to enter into a K to sell

OR ever held her out as having such authority

a. Can’t conclude that two types of transactions—purchasing and selling—are so closely related that 3d person could reasonably believe that authority to do one carried w/ it authority to do the other

i. Plaintiffs made no attempt to contact Principal

3. While the declarations of an agent may be used to corroborate other evidence of the scope of agency, neither agency nor the extent of the agent’s authority can be shown SOLEY by his own declarations or actions in the absence of the party affected

2. Inherent Authority a. Definition: inherent power that is not conferred on

agents by principals but represents consequences on principals by law

i. Ex: Undisclosed principal transactionb. Traditional approach: the doctrine of inherent power

gives a general agent the power to bind a principal, whether disclosed or undisclosed, to an unauthorized K AS LONG AS a general agent would ordinarily have the power to enter such a K and the third party does not know that matters stand differently in this case

c. Gallant Ins. Co. v. Isaac (Ind 2000): i. FACTS: Gallant became bound to provide

insurance coverage as soon as independent insurance agent faxed or called required information to Gallant’s production agent and premiums were paid Gallant insisted that ind. Ins. Agent didn’t have authority to renew insurance policy or orally K in a manner contrary to what policy states w/out approval of Gallant’s producing agent (COURT DISAGREES)

ii. COURT: inherent agency power indicates the power of an agent that is derived not from authority, apparent or estoppel, but from agency relation itself exists for protection of persons harmed from dealing w/ principal’s servant/agent

1. Here: Ind. Ins. Agent could bind Gallant on new policies and interim endorsements

a. ALSO: the common practice of binding coverage verbally, in violation of Gallant’s orders, is similar agent’s authorized conduct, given expressly by Gallant to bind coverage by fax/phone

i. Agent acted w/in usual and ordinary scope of its authority

2. Court next looks to Agent’s direct/indirect manifestations and determines whether 3d party could have reasonably believed the agent had authority to conduct the act in question

a. Found that direct and indirect manifestations by A over time and its direct verbal communication that coverage was bound lead the third party to the reasonable conclusion that A had authority to renew its insurance policy

b. Furthermore—3d party lacked notice that A didn’t have authority to verbally bind coverage

3. Agency by Estoppel and Ratification: a. Even where an agent’s act isn’t authorized the by the

principal or isn’t w/in any inherent agency power of the agent principal may still be bound by agent’s acts by estoppel or by ratification

b. Estoppel

i. Failure to act when knowledge and an opportunity to act arise PLUS reasonable change in position on the part of the third person

c. Ratification i. Accepting benefits under an unauthorized K will

constitute acceptance (affirmance in the Restatement) of its obligations as well as its benefits

v. Liability in Tort1. Most circumstances principals liable for torts committed by class of

agents known as “Employees” as distinguished from “Independent Contractors”

a. Only a particular kind of agency relationship – employer-employee relationship—ordinarily triggers vicarious liability for all torts committed w/in agent’s scope of employment

2. Humble Oil & Refining Co. v. Martin (1949)a. FACTS: Love family (one of Ds) left car at gas station for

servicing, before any station employee touched it, the car rolled by gravity off the premises into the street striking Martin and his kids from behind as they were walking into their yard

i. Humble Oil claims it wasn’t liable to either Love or Martin b/c the station was operated by IC and Humble isn’t responsible for IC’s negligence or the IC’s employee on duty at this time

b. COURT: Humble responsible for operation of the station, which it owned—as well as the principal products sold there under “Commission Agency Agreement”

i. The fact that no one saw Humble as “ER,” the employees were paid by the IC, and the agreement bw/ IC and Humble expressly repudiates any authority of Humble over EEs—not conclusive against ER-EE relationship

1. Humble controlled details of station work, expressly contemplated the EEs the IC would hire

2. IC made reports and performed other duties that were required of him by Humble in the agreement

3. IC gets a commission on public utility bills paid which requires Humble to pay ¾ of important operational expense

4. Strict system of financial control and supervision by Humble, with little or no business discretion by IC except as to hiring/discharge/payment and supervision of EES

5. Humble provided the location/equipment/advertising/ products/majority of operating costs

6. Agency Agreement terminable at the will of Humble

ii. Little difference b/w IC’s situation and a store clerk

3. Hoover v. Sun Oil Co (Del 1965)a. FACTS: fire started at rear of P’s car where it was being

filled w/ gas and was allegedly caused by negligence of an EE of service station operated by Barone and owned by Sun Oil

i. The station/equipment (with a few exceptions) were owned by Sun; lease subject to termination by either party upon 30 days’ notice; min and max monthly rental; agreement that Barone was to purchase petroleum products from Sun and Sun was to loan necessary equipment and materials; Barone allowed to sell competitive products if he wanted but had to sell Sun products under Sunoco label

ii. Sun representative conducted weekly visits and was in contact w/ Barone on other occasions BUT Barone didn’t have to follow the rep’s advice

iii. No written reports made by Barone to Sun; Barone alone assumed overall risk of profit/loss in business operation; determined his own hours of business, identity/pay scale and working condition of his EEs; named as proprietor

b. COURT: Barone was an IC

i. Lease K and dealer’s agreement fail to establish any relationship other than Landlord-Tenant and IC

ii. The areas of close contact b/w Sun and Barone don’t necessarily indicate ER-EE BUT that they both have a mutual interest in the sale of Sun products and in success of Barone’s business

iii. Sun had no control over the details of Barone’s day-to day operation THUS no liability can be imputed to sun from allegedly negligent acts of Barone’s EE

4. Franchisor-Franchisee Relationshipsa. Core Question: Whether the franchisor sufficiently

controls the franchisee to establish an agency relationship

i. If so—franchisor is vicariously liable for claims against franchisees acting w/in the scope of their employment

1. CONTROL TESTii. Hoffnagle v. McDonald’s Corp (Iowa 1994):

applying control test to find that McDonald’s wasn’t liable for injuries suffered by a franchisee’s EE from an assault by a third party

iii. Miller v. McDonald’s Corp (Or 1997): applying control test to find that McDonald’s could be liable for injuries to a customer of a franchisee who bit into a Big mac sandwich w/ a stone in it

C. GOVERNANCE OF AGENCY: THE AGENT’S DUTIESi. Nature of the Agent’s Fiduciary Relationship

1. C/L: agent is fiduciary of principal a. Legal power over property (Including information) held

by the fiduciary is held for the SOLE purpose of advancing the aim of a relationship pursuant to which she came to control that property

b. Agencies— fiduciary duty is to advance the purposes of the principal

i. Corporations—directors to advance the purposes of the corporation

c. Fiduciary bound to exercise Good-Faith Judgment in an effort to Pursue, under Future Circumstances, the Purposes Established at the Time of Creation of the Relationship

2. Three Categories of Fiduciary Dutiesa. Duty of Obedience

i. To the documents creating the relationship ii. Duty to obey principal’s command

b. Duty of loyaltyi. Pervasive obligation ALWAYS to exercise legal

power over the subject of the relationship in a manner that the holder of the power believes in good faith is best to advance the interests or purposes of the principal or beneficiary and NOT to exercise such power for personal benefit

c. Duty of Care:i. Duty to act in good faith, as one believes a

reasonable person would act, in becoming INFORMED and exercising ANY agency or fiduciary power

ii. Agent’s Duty of Loyalty and The Principal 1. Restatement 8.01-8.03, 8.062. Benefit by A of Breach of Duty of Loyalty:

a. Res. 407(1): if an A has received a benefit as a result of violating his duty of loyalty, the P is entitled to recover from him what he has so received, its value or its proceeds AND also the amount of damage thereby caused, EXCEPT that if the violation consists of the wrongful disposal of P’s property, the P can’t recover its value AND also what the agent received in exchange

b. Comment: whether or not P elects to get back the thing improperly dealt w/ or to recover from the agent its value/amount of benefit improperly received—P is entitled to, in addition, be indemnified by A for ANY loss which has been caused to his interests by improper transaction

1. Attorney’s Fees—these were directly traceable to the harm caused by A’s wrongful act and are recoverable

2. Tarnowski (P entitled to secret commission PLUS losses suffered caused by the improper transaction, including attorney fees)

3. Tarnowski v. Resop (Minn 1952):

a. FACTS: Principal engaged D as agent to investigate/negotiate for the purchase of a route of jukeboxes P relied upon A’s advice and investigation he’d made and purchased a business from Loechler and Mayer (sellers); A made representations of a thorough investigation w/ 75 locations w/ one or more machines in operation w/ new equipment and gross income to more than $3K/month

i. In reality—A only made superficial investigation of 5 locations and adopted false representations by sellers and passed them to P as his own

ii. P had already paid $11k down when he discovered false reps rescinded the sale; offered to return what he’d received and demanded return of his $

1. After jury verdict sellers paid himiii. HERE P alleges that A while acting as agent

collected secret commission from sellers consummating the sale and seeks to recover that PLUS losses suffered in operating the route prior to recession; loss of time; expenses connected w/ rescission/investigation; nontaxable attorney/litigation expenses

b. COURT: Firmly established that ALL profits made by an A in the course of an agency belong to the P—whether they “are fruits of performance or the violation of an agent’s duty”

i. Doesn’t matter if the Principal has suffered no damage OR even transaction was profitable to him

ii. Right to recover profits made by A in course of agency- NOT affected by fact the P rescinded K upon discovering fraud AND recovered that w/ which he parted

1. THUS P has absolute right to secret commission

2. Whether a principal may recover of an agent who has breached his trust the items of damage mentioned after a successful prosecution of an action for

rescission against the 3rd parties w/ whom A dealt for his P

a. Res. 407(1): if an A has received a benefit as a result of violating his duty of loyalty, the P is entitled to recover from him what he has so received, its value or its proceeds AND also the amount of damage thereby caused, EXCEPT that if the violation consists of the wrongful disposal of P’s property, the P can’t recover its value AND also what the agent received in exchange

b. Comment: whether or not P elects to get back the thing improperly dealt w/ or to recover from the agent its value/amount of benefit improperly received—P is entitled to, in addition, be indemnified by A for ANY loss which has been caused to his interests by improper transaction

3. Attorney’s Fees—these were directly traceable to the harm caused by A’s wrongful act and are recoverable

III. THE PROBLEM OF JOINT OWNERSHIP: THE LAW OF PARTNERSHIPA. INTRODUCTION TO PARTNERSHIP

i. General partnership = earliest/simplest form of jointly owned/managed business1. Each partner binds the partnership when acting in the USUAL COURSE

OF BUSINESS 2. Uniform Partnership Act (UPA) and RUPA (Revised UPA)

a. UPA—default partnership agreement that can be superseded by an express agreement among the partners

ii. Property held by partnership “Tenancy in Partnership”1. Partnership qua firm (rather than individual partners) exercises true

ownership rights over partnership property

a. In even of partnership bankruptcy or liquidation gives creditors of the partnership FIRST priority over the claims of creditors of individual partners

i. Fundamental step in creation of freestanding legal entity

ii. Without partnership laws—creditors could enforce judgments only against property owned by any of the individual partners and would share priority w/ other creditors of that individual

b. Partnership owns assets partnership acting through partner can K on its own behalf

iii. Why have joint ownership?1. Capital partners go into business together b/c they can’t afford to

finance the business on their own OR even if they can , don’t want to risk the funds

2. After a certain point—selling an ownership stake may simply be a cheaper way to raise capital than attempting to borrow more funds

a. Whatever the cost of co-ownership after a certain point they may be lower than the agency costs of debt K

b. Cost of borrowing can include fixed obligations that are payable w/out regard to the success of the business

i. If instead the investor shares in the risk of the business—no fixed obligation but investor gets share of current earning/ share of proceeds of its sale investors would share “residual” or “equity” w/ the “investee” i.e, interest in the business

1. So instead of getting fixed interest as a part of loan repayment get interest in the business

2. Also share in control – what amount not dependent on contribution BUT on relative bargaining positions

c. Partnership (and corporate form) assigns ownership rights – control and residual profits—to the parties who provide capital

i. Other possible assignments—ownership might go to workers/customers/suppliers

iv. Agency Conflict Among Co-Owners1. Two fundamental agency problems in law of business organizations:

(1) conflict b/w agents/principals; (2) conflict b/w principals and third

parties such as creditors NOW partnership law provides conflict b/w controlling and “minority” co-owners

2. Scope of the Duty of Loyalty owed by managing co-venturer to passive co-venturer

a. KEY: one partner may NOT appropriate to his OWN use a renewal of a lease though its term is to begin at the expiration of the partnership includes Purchase as well as lease

b. Meinhard v. Salmon (NY 1928)i. FACTS: Salmon obtained a lease for 20 years

and undertook to change hotel into shops and offices; arranged the funds through Meinhard joint venture w/ terms in writing

1. Meinhard to pay Salmon half of $$ requisite to reconstruct/alter/manage/operate the property; Salmon to pay Meinhard 40% of net profits for first 5 years and 50% for years thereafter

a. If losses—each party bore them equally

b. Salmon had sole power to manage the lease and operate the building

2. When lease was near its end—Gerry became owner of the reversion and was going to lease it to someone who would destroy the building and put others in its place approached Salmon with less than 4 months on the lease left; new lease obtained to business owned/controlled by Salmon for 20 years BUT w/ successive covenants for renewal that extended to a maximum of 80 years at will of either party

a. Buildings to be unchanged for 7 years; then torn down

b. Salmon told nothing about this to Meinhard who only found out AFTER lease was accomplished wanted lease to be held in trust as an asset of

the venture making offer upon the trial to share the personal obligations incidental to guaranty

c. COURT: joint venturers like co-partners owe to each other, while the enterprise continues, the duty of “finest loyalty” trustee held to stricter standard than morals of market place

i. Salmon held the lease as a fiduciary—for himself AND Meinhard

ii. Salmon excluded his coadventurer from any chance to compete, from any chance to enjoy the opportunity for benefit that had come to him alone by virtue of his agency under a duty to concede

iii. KEY: one partner may NOT appropriate to his OWN use a renewal of a lease though its term is to begin at the expiration of the partnership includes Purchase as well as lease

iv. Salmon had an even greater duty b/c he was “managing coadventurer” relentless and supreme duty of loyalty upon him

v. Number of shares allotted to Meinhard ought to be reduced to such an extent as may be necessary to preserve to Salmon the expected measure of domain – extra share added to his half share (Salmon was to have power/control under partnership agreement)

B. PARTNERSHIP FORMATIONi. To form partnership, must be:

1. voluntary K of association for purpose of sharing profits/losses which may arise from use of capital/labor/skill in a common enterprise and

2. intention on part of principals to form a partnership for that purpose a. If intent is there—doesn’t matter if they proposed to

avoid the liability attaching to partners or expressly stipulated they weren’t partners

b. Vohland v. Sweet 3. UPA Sec. 7(4): receipt by a person of a share of the profits is prima

facie evidence that he is partner in the business

a. Lack of daily involvement for one partner is not per se indicative of absence of a partnership

b. Partnership may be formed by furnishing of skill and labor by others

i. Contribution of labor/skill by one of partners may be as great as property or money

ii. Vohland v. Sweet (In 1982)1. FACTS: action for a dissolution of alleged partnership; when he was

young, Sweet worked for Vohland’s father; father retired and Vohland began another nursery and Sweet was to receive 20% share of net profit of the enterprise AFTER all of the expense were paid;

a. Money paid to Sweet as listed as business expense on tax returns; Sweet’s tax returns listed him as self-employed salesman

b. Vohland handled all of the finances/books; borrowed money solely in his name including the interest of his brothers/sisters in their father’s business—Sweet NOT involved in any of the loans

i. Sweet managed physical aspect of nurseryii. BUT the acquisition and enlargement of the

inventory of nursery stock was paid with earning and therefore financed partly with Sweet’s money

c. Sweet contended that he intended to enter into partnership but Vohland contends no partnership was intended and Sweet was merely an EE working on commission

i. No contribution to capital on Sweet’s part OR claim of any interest in real estate/machinery/motor vehicles

2. COURT: Under UPA Sec. 7(4): receipt by a person of a share of the profits is prima facie evidence that he is partner in the business

a. Lack of daily involvement for one partner is not per se indicative of absence of a partnership

b. Partnership may be formed by furnishing of skill and labor by others

i. Contribution of labor/skill by one of partners may be as great as property or money

c. Partnership can commence only by voluntary K of parties—interest w/ another in profits of a business

i. Voluntary K to carry on business w/ intention of parties to share profits as common owners

d. Must be: (1) voluntary K of association for purpose of sharing profits/losses which may arise from use of capital/labor/skill in a common enterprise and (2) intention on part of principals to form a partnership for that purpose

i. If intent is there—doesn’t matter if they proposed to avoid the liability attaching to partners or expressly stipulated they weren’t partners

e. HERE: commission used to refer to Sweet’s share of the profits and receipt of the share of the profits is prima facie evidence of partnership

i. Parties intended a community of interest in any increment in the value of capital/profit

ii. Correct in finding existence of partnership

C. RELATIONS W/ THIRD PARTIESi. General partnership form—unlimited personal liability for partners

1. A lot of partnership law has to do w/ creditors’ rights a. Issues arise as to (1) who is a partner for purposes of

personal liability to business creditors (2)when can an existing or retiring partner escape liability for partnership obligation (3) since a partner’s liability on partnership debt can be satisfied from partner’s nonpartnership property, how are such claims to an individual partner’s personal assets to be balanced against claims of other nonpartnership creditors of that person?

ii. Who is a partner?1. § 6 UPA

a. Partnership is association of 2 or more persons to carry on as co-owners a business for profit

2. § 7 UPAa. Joint tenancy; tenancy in common; tenancy by

entireties; joint property; common property; part ownership does not of itself establish a partnership whether such co-owners do or don’t share any profits made by use of property

b. Sharing of gross returns doesn’t alone establish a partnership, whether or not the persons sharing them have a joint or common right or interest in any property from which the returns are derived

c. Receipt by a person of a share of the profits of a business is prima facie evidence that he is partner in the business but no such inference shall be drawn if such profits were received in payment:

i. As a debt by installments or otherwise;ii. As wages of an EE or rent to landlord

iii. As an annuity to a widow/representative of deceased partner;

iv. As interest on a loan, though the amount of payment vary w/ profits

v. As consideration for sale of a good-will of business or other property by installments or otherwise

3. § 12 UPA: Partnership Charged w/ Knowledge or Notice of Partner a. Notice to any partner of any matter relating to

partnership affairs and the knowledge of the partner acting in the particular matter, acquired while a partner or then present to his mind, and the knowledge of any other partner who reasonably could and should have communicated it to the acting partner operate as notice to or knowledge of the partnership, except in case of fraud

4. § 13 UPA: Partnership Bound by Partner’s Wrongful Actsa. Where, by any wrongful act or omission of any partner

acting in the ordinary course of the business of the partnership OR with the authority of his co-partners, loss or injury is caused to any person, not being a partner in the partnership, or any penalty is incurred, the partnership is liable therefor to the same extent as the partner so acting/omitting to act

5. Sec. 14 UPA: Partnership Bound by Partner’s Breach of Trusta. Partnership bound to make good the loss:

i. Where one partner acting w/in the scope of his apparent authority receives money or property of a third person and misapplies it; and

ii. Where the partnership in the course of its business receives money or property of 3d person and the money or property so received is misapplied by any partner while it’s in the custody of the partnership

6. Sec 15 UPA: Nature of Partner’s Liability a. All partners are liable

i. Jointly and severally for everything chargeable to the partnership under sections 13 and 14

ii. Jointly for all other debts and obligations of the partnership BUT any partner may enter into separate obligation to perform partnership K

7. Sec 16 UPA: Partner by Estoppel a. When a person, by words spoken/written or by

conduct, represents himself OR consents to another representing him to any one, as a partner in an existing partnership OR with one or more persons not actual partners, he is liable to any such person to whom such representation has been made, who has, on the faith of such representation given credit to the actual or apparent partnership, and if he’s made such representation or consented to its being made in a public manner he’s liable to such person whether the representation has or hasn’t been communicated to such person so giving credit by or with the knowledge of the apparent partner making the representation or consenting to its being made

i. When a partnership liability results, he’s liable as though he were an actual member of partnership

ii. When no partnership liability results, he’s liable jointly w/ other persons, if any, so consenting to the K or representation as to incur liability , otherwise separately

b. When a person has been thus represented to be a partner in an existing partnership, or w/ one or more persons not actual partners, he’s an agent of the persons consenting to such representation to bind them to the same extent/manner as though he were a partner in fact, w/ respect to persons who rely on representation. Where all members of the existing partnership consent to the representation, a partnership act or obligation results; but in all other cases, it’s the joint act/obligation of the person acting and persons consenting to representation

8. Sec. 18 UPA: Rules Determining Rights and Duties of Partnersa. Each partner shall be repaid his contributions, whether

by way of capital or advances to partnership property and share equally in the profits and surplus remaining

after all liabilities, including those to partners, are satisfied; and must contribute towards losses, whether of capital or otherwise, sustained by the partnership according to his share in the profits

b. Partnership must indemnify every partner in respect of payments made and personal liabilities reasonably incurred by him in the ordinary and proper conduct of its business, or by the preservation of its business/property

c. A partner, who in aid of partnership makes any payment or advance beyond the amount of capital which he agreed to contribute, shall be paid interest from the date of the payment/advance

d. A partner shall receive interest on the capital contributed by him only from the date when repayment should have been made

e. All partners have equal rights in the management and conduct of partnership business

f. No partner is entitled to remuneration for acting in the partnership business, except that a surviving partner is entitled to reasonable compensation for his services in winding up partnership affairs

g. No person can become a member of a partnership w/out consent of ALL partners

h. Any difference arising as to ordinary matters connected w/ partnership business may be decided by a majority of partners; but no act in contravention of any agreement b/w partners may be done rightfully w/out consent of ALL the partners

iii. Third-Party Claims Against Departing Partners1. NOTE: Dissolution of a partnership doesn’t itself affect partner’s

individual liability on partnership debtsa. When a partner w/draws from partnership but other

partners continue the business continuing liability for existing obligations remain

i. Exiting partner liable for partnership obligations incurred prior to her departure but no longer exercises control over the capacity of the continuing business to satisfy those obligations

2. Sec. 36(2) UPA—releases the departing partner of partnership debts IF the court can infer an agreement b/w the continuing partners and creditors to release the w/drawing partner

a. Sec 36(3) UPA—usually applied to release the departing partner from personal liability when a creditor renegotiates his debt w/ the continuing partners after receiving notice of departing partner’s exit

iv. Third-Party Claims Against Partnership Property1. Segregated pool of assets available to secure business debts w/out

which all of business and personal assets of investors would be available to both business and personal creditors

2. UPA Sec 25(1): partnership property owned by the partners is owned as “tenants in partnership”

a. Affords to individual partners virtually no power to dispose of partnership property de facto business property

b. 25(2): partner can’t possess or assign rights in partnership property, a partner’s heirs can’t inherit it AND a partner’s creditors can’t attach or execute upon it

c. BUT NOTE RUPA i. 501: partner not a co-owner of partnership

property and has no interest in partnership property which can be transferred, either voluntarily or involuntarily

ii. 502: the only transferable interest of a partner in the partnership is the partner’s share of the profits/losses of the partnership and the partner’s right to receive distributions

iii. THUS: this is straightforward entity ownershipiv. If a partner doesn’t own her partnership’s

assets in any ordinary senseshe retains a transferable interest in the profits arising from the use of the partnership property and the right to receive partnership distributions

1. These rights to cash flow that a creditor can attach or heir may succeed to

v. Two-level ownership structure: contributors of equity capital don’t “own” the assets themselves BUT own the rights to the net financial returns that these assets generate, as well as certain governance/management rights

vi. RUPA 503: partnership’s transferable interest can be transferred in most circumstances

1. RUPA 504 and UPA 28: individual creditors of partners can obtain a charging order—lien on partner’s transferable interest that is subject to foreclosure unless it’s redeemed by repayment of debt

v. Claims of Partnership Creditors to Partner’s Individual Property1. Issue comes up when partners AND partnership are in bankruptcy 2. C/L rule evolved in Bankruptcy Act of 1898—“jingle rule”

a. Gave partnership creditors priority in all partnership assets and assigned first priority to the separate creditors of individual partners in individual assets of those partners

3. Parity Rulea. Bankruptcy Act of 1978, Sec 723 trustee in

bankruptcy first administers the estate of the partnership (partnership property) and then turning to assets of general partners to extent of any deficiency

b. 723(c): when there is deficiency in partnership assets—the trustee’s claim against the assets of any general partner is on a parity with the individual creditors of the partner

i. THUS: partnership creditors still have first priority in assets of partnership BUT they are also placed on parity w/ individual creditors in allocating assets of an individual partner when partnership is bankrupt under Chap 7

4. Insolvent partner—a. UPA: gives partner’s creditors priority over partnership

creditors b. RUPA: parity treatment of 723 in Bankruptcy Code

i. Bankruptcy assets of partner whose partnership is NOT in Chapter 7 will be distributed according to jingle rule is UPA applies and parity rule if RUPA applies

c. NOTE: UPA and RUPA gives partnership creditors first priority in assets when they belong to partnership and NOT to the partner

5. Breakdown: a. In all cases—partnership creditors get first priority in

the assets of partnership

b. Claims against individual assets of partner—partnership creditors are subordinated to the claims of partner’s creditors in allocation of partner’s assets IF

i. UPA is controlling state law ANDii. 723 doesn’t apply (partnership isn’t in Chapter 7

OR the individual partner is not in bankruptcy)c. Partnership creditors receive parity treatment IF EITHER

i. RUPA is controlling state law ORii. 723 applies (partnership is in Chapter 7 OR

individual partner is in bankruptcy)D. PARTNERSHIP GOVERNANCE AND ISSUES OF AUTHORITY

i. Majority Rule: half of 2 person partnership is NOT a majority for purposes of making firm decisions w/in the ordinary scope of business (Nat’l Biscuit Co v. Stroud)

1. UPA 18(h): can’t restrict power and authority of partner to make decisions for the partnership as a going concern if it was an “ordinary matter connected w/ the partnership business” for the purpose of its business and w/in its scope—without majority of partners

a. Stroud (infra)2. Nat’l Biscuit Co. v. Stroud (1959)

a. FACTS: general partnership to sell groceries; Stroud (a partner) told Nabisco he wouldn’t be responsible for any additional bread sold by P to Stroud’s food center; bread was sold by request of other partner

b. COURT: partnership is a power to bind the partnership in any manner LEGIT to the business

i. What either partner does w/ 3d person is binding on the partnership

ii. Freeman (other partner) as a general partner w/ Stroud had no restrictions on his authority to act w/in the scope of the partnership business and under UPA had “equal rights in the management and conduct of the partnership business”

iii. UPA 18(h): Stroud couldn’t restrict power and authority of Freeman to buy the bread for the partnership as a going concern b/c this purchase was an “ordinary matter connected w/ the partnership business” for the purpose of its business and w/in its scope; ALSO Stroud couldn’t be a majority of the partners

1. when there’s an even division of partners as to whether or not to act /win scope of businessno restriction can be placed on power to act

E. TERMINATION (DISSOLUTION AND DISSOCIATION)i. Accounting for Partnership’s Financial Status and Performance

1. Evaluation of financial status of partnership—begins w/ balance sheeta. Balance sheet: simple statement of the assets that it

holds; liabilities it owes; difference b/w the two—which is the equity that the partners have in the firm

i. Reported as of particular date—must bring it up to date

1. Historical costs2. Second fundamental accounting statement reflects the results of

transactions in which the firm has engaged over a set period (often a year)

a. Income statement (statement of profits and losses)i. Cash basis

ii. Accrual basis accounting: amounts paid are treated as expenses in the period to which they relate

1. Pay X to cover something for 12 months in Nov; Dec income statement would report only 2/12 of that as an expense (rest wouldn’t be reported here BUT would be reported on balance sheet as prepaid expense)

3. Accounting for Partner’s Capitala. Capital account will have a report that records the

effects on the partner’s capital of the operations of the business over the year

4. Adams v. Jarvis (Wis 1964): a. FACTS: P w/drew from partnership 7 years after it was

formed and the dispute concerns the extent of P’s right to share in partnership assets—specifically accounts receivable (represents amounts owed to a firm by customers who have purchased goods/services on credit—bills to patients who’ve been treated but haven’t paid)

i. Agreement stated that withdrawing partner shall be entitled to receive from the continuing partners—any balance standing to his credit on

the books, proportion of partnership profits to which he was entitled in the fiscal year of his withdrawal

ii. “further agreed that in the event of the w/drawal of any partner or partners, in and all accounts receivable for any current year and any and all years past shall remain sole possession and property of remaining member(s) of [partnership]

b. PROCEDURAL POSTURE: trial court found the withdrawal of the P worked a dissolution of the partnership under UPA 29, 30; the partnership assets should be liquidated and applied to the payment of the partnership interests; P’s interest was one third of net worth including accounts receivable

c. COURT: partnership agreement specifically provided that partnership shall not terminate by w/drawal of partner—parties clearly intended that even though partner w/drew, the partnership would continue

i. w/drawal of a partner woks a dissolution of the partnership as to the w/drawing partner BUT the rights/duties of remaining partners aren’t similarly affected

1. when P w/drew the partnership wasn’t wholly dissolved so as to require complete winding up of its affairs BUT continued to exist under terms of agreement

ii. Regarding accounts receivable—provision in the agreement is clear and unambiguous

1. Nothing suggest that P had such unequal bargaining power that it should be unenforceable as matter of PP

2. Thus P doesn’t receive accounts receivable pursuant to the partnership agreement

iii. B/c P’s eventual distributive share of profits is dependent upon management of business for the remainder of the fiscal yearcontinuing partners stand in a fiduciary relationship to the w/drawing partner and are obligated to conduct the business in a good-faith manner including

good-faith effort to liquidate the accounts receivable consistent w/ good faith practices

5. UPA 31(1)(b)a. Dissolution may occur by the express will of any partner

when no definite term or particular undertaking is specified

i. Term can be impliedly agreed upon (see Page)

6. UPA 38(1):a. When dissolution is caused in any way EXCEPT in

contravention of the partnership agreement, each partner as against his copartners and all person claiming thorough them in respect to their interests in the partnership UNLESS otherwise agreed may have the partnership property applied to discharge its liabilities and the surplus applied to pay in cash the net amount owing to each partner

b. Protection of partners AND creditors i. Dreifuerst

7. UPA 38(a)(2): if partner acted in bad faith/violated fiduciary duties by attempting to appropriate to his own use prosperity of the partnership w/out adequate compensation to co-partner dissolution wrongful and partner can be liable for violation of an agreement (implied or express) not to exclude co-partner wrongfully from partnership business opportunity

a. SEE Page (infra)8. Winding-Up the Partnership

a. Process of settling partnership affairs AFTER dissolutionb. Often called liquidation – involves reducing the assets to

cash to pay creditors and distribute to partners the value of respective interest

i. Lawful dissolution—gives each partner right to this and have his share of surplus paid in cash

ii. Dreifuerst (infra)c. Dreifuerst v. Dreifuerst (Wis 1979)

i. FACTS—Ps and Ds (all bros) formed partnership which operated 2 feed mills; no written Articles of Partnership governing; Ps served Ds w/ notice of dissolution/wind-up of partnership—no allegations of fault/expulsion/contravention of an alleged agreement but parties unable to agree to a winding-up of partnership

ii. COURT: partnership was a partnership at will w/ no written agreement

1. UPA 38(1) does not allow in-kind distribution unless the partners agree to in-kind distribution OR there is a partnership agreement calling for it

a. In-kind distribution—only in very limited circumstance no creditors to be paid form proceeds; sale would be senseless since no one else would be interested; in kind is fair to all AND all must agree

2. Partnership at will is a partnership which has no definite term/particular undertaking – can be rightfully dissolved by express will of any partner

3. Sale is the best means of determining the true market value of the assetsany partner who has not wrongfully dissolved the partnership has the right to wind it up, force liquidation and force a sale

4. SEE RUPA 402, 801, 802, 804 9. Page v. Page (Cal 1961)

a. FACTS: P and D partners in linen supply business; P wants to terminate the partnership

b. COURT: implied agreements for terms may be found such as to continue business until a certain sum of money is earned or one or more partners recoup their investments or until certain debts are paid or until certain property could be disposed of on favorable terms

i. HERE: no facts from which an agreement to continue the partnership for a term may be implied

1. Common hope for partnership earnings to pay for all necessary expenses is NOT implied agreement for term

ii. EVEN though UPA provides a partnership at will may be dissolved by the express will of any

partner (UPA 31(1)(b)) this power must be exercised in good faith

1. If P acted in bad faith and violated fiduciary duties by attempting to appropriate for his own use the new prosperity of the partnership w/out adequate compensation to co-partner, dissolution would be wrongful and P would be liable under UPA 38(2)(a) for violation of implied agreement not to exclude D wrongfully from partnership

F. Limited Liability Modifications of Partnership Form i. General Partnership Elements: (1) dedicated pool of business assets; (2) class of

beneficial owners (partners); and clearly delineated class of agents authorized to act for the entity (partners)

1. Fourth element may be added to separate partnership as legal entity from its investors even further Limited Liability

a. Ltd Liability—business creditors can’t proceed against personal assets of some/all of firm’s investors

i. Only rely on assets of partnershipii. Limited Partnership

1. Limited partners—share in profits w/out incurring personal liability for business debts

a. Must have at least one general partner w/ unlimited liability in addition to any limited partners

2. Uniform Limited Partnership Act (ULPA) or RULPAa. General partner is treated almost exactly like a member

of ordinary partnership—personally liable for partnership debts, may bind partnership w/ 3d parties

b. Limited partner: enjoys liability limited to his/her partnership contributions

i. May not participate in management or control beyond voting on major decisions such as dissolution

1. If do so—risk losing LL protection as de facto general partners

3. Pass-Through Tax Advantages of Partnership a. Two-tier tax treatment also

i. Entity income and investors are taxed again when income is distributed

1. Double taxation test: whether or not ownership interest of firm are traded

either on established securities market or secondary market

4. Control and Limited Liability Partnershipsa. Sec 7 of ULPA: hallmark of general partner in LLP—takes

part in control of business b. Sec 303 of RULPA: adopts control test but adds

qualification that limited partner who participates in control of business is liable only to persons who transact business w/ the limited partnership reasonably believing based on limited partner’s conduct that the ltd partner is general partner

c. Uniform Partnership Act: limited partner not personally liable for partnership liabilities even if ltd participates in management/control;

iii. Limited Liability Partnerships and Companies 1. Limited Liability Partnership

a. General partnership in which partners retain limited liability—for certain liabilities and ltd periods

b. Protect professionals such as lawyers/accountants c. Limit liability only w/ respect to partnership liabilities

arising from negligence/malpractice/wrongful act/misconduct of another partner or an agent of the partnership not under partner’s direct control

d. Some LLP statutes—establish minimum capitalization or insurance requirements

2. Limited Liability Companya. General contours: internal relations among investors in

the LLC (known as members) are to be governed more or less by general or ltd partnership law

i. Members can operate firm/serve as agents, elect managers to do so; resignation may/may not lead to dissolution

ii. Like LPs—must file copy of articles of organization w/ Secy of State

iii. Members enjoy ltd liability even when they exercise control over the business in much same way as general partner

b. Check the box regulations from IRSi. Allow all new unincorporated business

(including general and ltd partnerships, LLC, LLPs) to choose whether to be taxed as partnerships or corporations

ii. Can combine pass-through treatment for fed income tax purposes w/ ltd liability, participation in control by members (w/out loss of liability), free transferability of interests and continuity of life

c. Advantages of corps:i. Closely held corps seeking pass-through tax

treatment must comply w/ ownership limitations of S of the IRC—single class of stock; 75 or less noncorporate shareholders

1. LLCs/other unincorporated entities—can pass entity-level debt through to members for income tax purposes and ability to adjust inside basis of firm’s assets upon death of owner, transfer of ownership interest, distributions from the firm

ii. BUT—S corps (and not LLCs etc.) can participate in tax-free reorganizations w/ subchapter C Corps (all publicly held corps)

1. All new publicly held businesses taxed as corps anyway

iv. NOTE Delaware and LLCs/LPs/LLPs1. LLCs in DE can provide professional services, unlike other states2. DE Revised Uniform Ltd Partnership Act (LPs) and DE LLC Act (LLCs):

partners’ or members’ fiduciary duties may be expanded, restricted or eliminated by provisions in the agreement provided the agreement may not eliminate the implied contractual covenant of good faith and fair dealing

v. NOTE: growth of LLCs and LLPs has come at expense of LPs and GPs NOT corporations

IV. THE CORPORATE FORM A. INTRO TO CORPORATE FORM

i. Standard legal form adopted by large-scale private enterprises ii. Basic characteristics of corporate form

1. Legal personality w/ indefinite life2. Limited liability for investors3. Free transferability of share interests4. Centralized management 5. Appointed by equity investors

iii. Distinctions:1. Close Corporations

a. Closely held corps (few shareholders) often businesses that incorporate for tax/liability (vs. capital raising purposes) purposes rather than for capital-raising purposes

b. Often restrict transfer of shares; buy-sell agreements allowing any shareholder to name own shares; commitments to make further capital contributions to the business

c. Firms that incorporate b/c they foresee a need to raise capital in public capital markets tend to adopt all basic characteristics of corporate form

d. Corporate form = more default rules = less drafting = cheaper

2. Controlled Corporations a. Controlled corps: single shareholder or group of

shareholders exercises control through its power to appoint the board

b. “in the market”: no such person or group i. Anyone can purchase control of these

companies in the market by buying enough stock until then—no shareholder/group exercises control

1. Most large public corps in US 2. Control in market = practical control w/

existing mgmt of firm B. CREATION OF FICTIONAL LEGAL ENTITY

i. Corp = separate legal entity in eyes of law1. Acting through authorized agents—can sign binding Ks, close sales and

take title in its own name a. Principal investors don’t need to execute/agree to

transaction2. Own assets—including businesses—helps out creditors and reduces

costs of contracting for credit 3. Indefinite “life”—enhances stability

a. Death/departure of “principal” doesn’t need to disturb operation as it would in partnership

ii. History of Corporate Formation1. Internal Affairs Doctrine: law of the state of incorporation governs the

internal affairs of a corporation including matters such as who votes, on what and how often

2. Move from general statutes w/ mandatory governance terms to today’s statutes which are largely free of substantive regulation

3. Holding company structure as first created by NJ’s incorporation lawsa. Authorizing corps to own the stock of other corps –

made corporate joint ventures and networks of corporations related by ownership – corporate groups

4. Disappearance of Shareholder Preemptive Rightsa. Preemptive rights allow shareholder to buy stock in any

future corporate offering of new stock, up to such amount as required to permit a shareholder to maintain his/her proportionate interest in the corp

5. Typical corp statute today (such as DGCL)—non regulatory, “enabling” statute w/ few mandatory features

iii. Process of Incorporating Today1. Revised Model Business Corporation Act (RMBCA) Sec 2.01-2.04

a. Individual or entity (corps/partnerships) called “incorporator” signs requisite docs and pays necessary fees

i. Incorporator drafts and signs either Articles of Incorporation (RMBCA) or certificate of incorporation (DGCL)

1. Corporation’s “charter”2. State purpose and powers of

corporation3. Define all of its special features—great

flexibility afforded to designer of firm’s legal structure

4. Broad statements such as “to engage in any lawful act/activity for which corporations may be organized under this title”

5. Contain customized features of the new enterprise such as complex capital structure/customized voting rights

a. BUT usually generic doc w/ few special features

6. Filed w/ designated public official—Secy of State which also identifies corporation’s principal office w/in the state

ii. DE: fee calculated in part as function of how many shares new corp is authorized to issue

iii. DE: corp’s legal life begins when charter is filed

iv. Charter issued by Secy of State (often when corp begins in other states)

b. First acts of business electing directors (if initial ones aren’t named in charter); adopting bylaws; appointing officers

i. Take place at organizational meeting called by either incorporators who elect initial board of directors or when initial board is named in articles of incorporation by board members themselves

iv. Articles of Incorporation, or “Charter”1. May contain any provision not contrary to law 2. MUST provide for :

a. Voting stockb. Board of directorsc. Shareholder voting for certain transactions d. Original incorporators e. Corporation’s name / business (very broadly)f. Fix original capital structure

i. How many shares/classes of shares corp authorized to use and what characteristics of those shares will be

3. May establish size of board or other governance terms a. Whether directors have concurrent one year terms,

staggered three year terms and procedures for removing them

4. Overriding concept—contractual freedom 5. BUT if corp is to have special/limited purpose OR governance oddity

must be spelled out in charter v. Corporate Bylaws

1. Least fundamental of corp’s constitutional docs must conform to statute/charter

2. Fix the operating rules for the governance of the corporationa. Establish existence and responsibilities of corporate

officesb. Establish size of bd of directors or manner in which size

is to be established (if charter doesn’t)3. Under some statutes (DGCL 109(a))—shareholders have inalienable

right to amend bylawsa. BUT b/c directors owe a fiduciary duty of loyalty to the

corp and its shareholders, courts have sometimes

reviewed directors’ exercise of power to modify and invalidate bylaws as abuse of power

vi. Shareholders’ Agreement 1. Typically address such questions as restrictions on the disposition of

shares, buy/sell agreements, voting agreements and agreements w/ respect to the employment of officers or the payment of dividends

2. Courts will specifically enforce these agreements where all shareholders are parties (corp is party to these Ks)

3. Voting trust—arrangement in which shareholders publicly agree to place their shares w/ a trustee who then legally owns them and is to exercise voting power according to the terms of the agreement

a. Subject to special statutory restrictions C. LIMITED LIABILITY

i. Corporations have unlimited liability and shareholders by reason of shareholder status have no liability for the debts or obligations of the corp

ii. LL means – shareholders can’t lose more than the amount they invest unlike general partner who under traditional principles is legally a party to all partnership agreements and liable under them

1. NOTE: shareholder can undertake by K to be corporate guarantor 2. Main purpose in limited liability—encourages investment in equity

securities which makes capital more available for risky ventures3. Decreased need to monitor managers potentially reduces operating

costs of corporation4. Reduces monitoring costs of other shareholders5. Managers have incentives to act efficiently poorly run firms will

attract new investors who can assemble large blocs at a discount and install new managerial teams

a. Potential for displacement gives existing managers incentives to operate efficiently in order to keep share prices high

6. Allows more efficient diversification – investors can minimize risk by owning a diversified portfolio of assets

7. Facilitates optimal investment decisionsa. Each investor can hedge against the failure of one

project by holding stock in other firms b. Increased availability of funds for projects w/ positive

net valuesD. TRANFSFERABLE SHARES

i. Equity investors in the corporate legal entity legally own something distinct from any part of corporation’s property own a share interest

1. Legal property and generally such a share may be transferred together with all rights it confers

2. Allows the firm to conduct business uninterruptedly as the identities of its owners change which avoids the complications of dissolution and reformation – which can affect partnerships

ii. Ability of investors to freely trade stock encourages the development of an active stock market

1. Facilitates investment by providing liquidity and by facilitating the inexpensive diversification of the risk of any equity investment

iii. Free transferability is DEFAULT provision 1. Agreements can be made to restrict transfer 2. Complements centralized management in the corporate form by

serving as a potential constraint on self-serving behavior of the managers of widely held companies

a. Share price will fall along with trust and its managers are more likely to be replaced

E. CENTRALIZED MANAGEMENT i. Intro:

1. Can achieve economies of scale in knowledge of the firm, its technologies and markets

2. Shareholder designated bd. of directors NOT investors are accorded power to initiate corporate transactions and manage day to day affairs of corp

3. Default rule—management appointed by board of directors that is elected by the holders of common stock in the company

a. Corporate form makes centralization of management power in the board a strong default option for firms organized as corporations

b. Vests more power in the board than even large partnerships do

c. DGCL 141: the business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or certificate of incorporation

4. Board “acts” by adopting resolutions at duly called meetings that are recorded in minutes

a. Appoints firm officersi. Corporate officers are agents of company

ii. Board often treated as quasi-principal of company

5. Initiation and execution of business decisions are province of management—monitoring and approval are province of the board

6. Bd. usually elected by firm’s shareholders

a. Default rule—all stock votes at a ratio of one share per vote and bondholders are never accorded voting rights except by K when there is a default of interest payments

ii. Legal Construction of the Board1. Holder of Primary Mgmt Power

a. Board—ultimate locus of managerial powers i. Bd. members not required by duty to follow

wishes of majority shareholderrepublican form of gov’t

b. Automatic Self-Cleansing Filter Syndicate v. Cunninghame (England 1906)

i. COURT: corporate directors aren’t legal agents of the corp governance power resides in the BOARD of directors, not in the individual directors who constitute the board

ii. Concurrence—shareholders have by express K mutually stipulated that their common affairs should be managed by certain directors to be appointed by the shareholders in the manner described by other articles – such directors being liable to be removed only by special resolution

c. DGCL 141: bd. of directors has primary duty to direct/manage business affairs of the corporations BUT usually designates managers or CEO who in turn nominates other officers for board confirmation

i. Managerial powers of directors are broad power to appoint/compensate/remove officers; delegate authority to subcommittees, officers or others; declare/pay dividends; amend company bylaws; exclusive power to initiate and approve certain extraordinary corporate actions such as amendments to the articles of incorporation, mergers, sale of all assets and dissolutions; power to make major business decisions including deciding products to offer, prices to charge, wages to pay, financing agreements to enter

2. Structure of the board

a. Charter sets forth structure of board in very general terms default – board members elected annually to one year terms

i. Board seats may be elected by certain classes of stock

ii. Specially elected directors do not owe a particular duty to the class that elected them

b. While statutory default in almost all states = entire board elected for one year term—corporation statutes generally permit corporate charters to create staggered boards in which directors are divided into classes that stand for election in consecutive years

i. DGCL 141(d): may be up to 3 classes individual director may have 3-year term

3. Formality in Bd. Operationa. Directors act as a board only at a duly constituted board

meeting and by majority vote (unless corporate charter requires supermajority vote on an issue) that is formally recorded in the minutes of the meeting

i. Proper notice of meetings must be given and quorum must be present

ii. NOTE: board may act w/out a meeting IF members give unanimous written consent to the corporate act in question

b. Fogel v. US Energy Systems, Inc—three of the four members decided to oust the 4th member as CEO; held the meeting among the outside directors didn’t constitute valid meeting of the board mere fact that directors are gathered doesn’t make a meeting

4. Critique of Boardsa. Most corp statutes don’t even mention CEOsb. Most instances—bd. of directors of large corp meet

only for a single day b/w 4 and 8 times a yeariii. Corporate Officers: Agents of the Corporation

1. Bd. usually has power to delegate authority to corporate officers as it sees fit Pres; VP; Treasurer; Secretary (CEOs)

a. Corporate officers UNLIKE directors are agents of the corporation and subject to fiduciary duty of agents

2. Authority of the Corporate Officersa. Apparent authority: authority which, although not

actually granted, the principal (1) knowingly permits the agent to exercise OR (2) holds him out as possessing

i. Agent, by his own words, cannot invest himself w/ apparent authority authority comes from actions of the Principal NOT agent

b. In order for reasonable inference of the existence of apparent authority to be drawn from prior dealings, these dealings must have

i. Measure of similarity to the act for which the principal is sought to be bound; and grating this similarity

1. A degree of repetitiveness c. Corporate offices alone don’t provide basis for

reasonable inference that board held out the VP as having apparent authority

i. Jennings v. Pitt Mercantile 3. Jennings v. Pittsburgh Mercantile Co. (Pa 1964)

a. ISSUE: whether there was significant evidence upon which the jury could conclude that Mercantile clothed its agent w/ apparent authority to accept an offer for the sale and leaseback thereby binding it to the payment of the brokerage commission, the agent having had no actual authority to do so

b. FACTS: VP of Mercantile promised Jennings that acceptance of an offer would be automatic and promised him a commission if he brought in an offer on terms; Mercantile’s financial consultant told Jennings the exec committee agreed to the deal but then VP told him it was rejected and Mercantile refused to pay Jennings’ commission

c. COURT: the proposed sale was NOT a transaction in the ordinary court of business the apparent authority Jennings is seeking to establish is apparent authority to accept an offer for extraordinary transaction

i. Apparent authority: authority which, although not actually granted, the principal (1) knowingly permits the agent to exercise OR (2) holds him out as possessing

1. Agent, by his own words, cannot invest himself w/ apparent authority authority comes from actions of the Principal NOT agent

ii. In order for reasonable inference of the existence of apparent authority to be drawn from prior dealings, these dealings must have

1. Measure of similarity to the act for which the principal is sought to be bound; and grating this similarity

2. A degree of repetitiveness iii. Corporate offices of VP don’t provide basis for

reasonable inference that Mercantile held out the VP as having apparent authority to accept offers produced by Jennings

1. Holding otherwise would greatly undercut the proper role of the bd. of directors in corporate decision-making by thrusting upon them determinations on critical matters which they’ve never had opportunity to consider

iv. Extraordinary nature of transaction placed Jennings on notice as to inquire about the actual authority—particularly since he was a part of an experienced real estate broker and investment team

1. Had inquiry been made—discovered the board had never considered proposals or delegate authority to accept offers

4. Grimes v. Alteon Inc. (Del. 2002): CEO was held to lack the authority to enter an oral K to sell 10% of any new issue of stock to an existing shareholder who wished to maintain proportionate shareholdings

a. COURT: such a K constituted a “right” in the company’s securities and required board approval under DGCL 152, 157

i. Noted fundamental social policies of protecting the board’s power to regulate corporate capital structure and ensuring the certainty of property rights in corporate shares

V. DEBT, EQUITY AND ECONOMIC VALUEA. CAPITAL STRUCTURE

i. Business corp—raises capital to fund its operations selling legal claims to its assets and prospective cash flows

1. Two types of long-term claims that a corp may sell for this purpose

a. Like any market participant—may borrow money through issuance of debt instruments

i. Those who buy corporate debt have contractual right to receive periodic payment of interest and to be repaid their principal – money originally loaned—at stated maturity date

1. Corp fails—creditor has legal remedies ii. Typically gets contractual right to “accelerate”

payment of principal amount if debtor defaults in paying interest

iii. Debtor generally must pay its creditors what’s currently due before debtor can distribute funds or other things of value to equity owners

b. May sell ownership claims in the corporate entity by issuing equity securities

i. Most take form of common stockii. Holders have no right to any periodic payment

nor can they demand the return of their investment from the corp

iii. Can’t generally tell firm’s managers what to do merely have right to vote

iv. Can get dividends but only when bd. of directors declares them

2. Capital structure—mix of long-term debt and equity claims that corporation issues to finance operations

ii. Legal Character of Debt1. Debt securities = Ks

a. Loan agreement = debt Ki. Allocation of risks and responsibilities b/w

debtor and creditor 2. Maturity Date

a. Single most common characteristic of debtb. Obligation to repay at stated date in the future

i. Often to repay principal amount plus any outstanding interest not yet paid by maturity date

ii. Zero coupon bonds—no interest BUT debtor must repay at maturity an amount much larger than original loan

c. Default—interest or principal not paid when due

i. Creditor can accelerate payment of principal from its original maturity date to the current date

d. Investors choose b/w investing in debt as a creditor by lending the money to the debtor or by buying a bond of the debtor

i. Advantage of bonds—investor generally faces less risk as a creditor than as an equity holder b/c creditors have a legal right to periodic payment of a return (interest) and a priority claim over the company’s shareholders on corporate assets in the event the corp defaults

1. Can sue on their Ka. Equity owners can’t

3. Tax Treatment a. Interest paid by the borrower is tax deductible cost of

business when firm calculates taxable income i. Corp pays tax only on taxable income net

income after costsb. No deduction available for dividends or distributions

paid to the corp’s stockholdersi. Debt is less costly than equity here

iii. Legal Character of Equity 1. Common stock:

a. Owners of stock can vote to elect directors and that stock carries one vote per share

b. Right to vote on important matters—not the right to payment

c. Equity securities—generally possess control rights in the form of the power to elect bd. of directors

i. Deviation from one vote/share must be in charter

2. Residual Claims and Residual Controla. Common stock—control rights through power to

designate board AND residual claim on corp’s assets and income

i. After company pays expenses (met its payroll) and paid interest to creditors—whatever’s left “belongs” to stockholders in dividends

3. Preferred Stocka. Any equity security on which the corporate charter

confers a special right/privilege/limitation

i. Carry stated dividend that is payable only when declared by the board

b. All accumulated dividends must be paid to preferred stockholders before any dividend can be paid to common stockholders

i. Could get votes/designated board seats if preferred stock dividend has been skipped for long enough

c. Ordinarily less risky than common stock b/c it typically has preference over common stock in liquidation as well as dividends

i. If corp fails and plans to close—designated $ must be paid first to the preferred stockholders before the liquidating corp can distribute any property to holders of common stock

B. BASIC CONCEPTS OF VALUATIONi. Time Value of Money

1. Old adage—one dollar today is worth more than a promisea. You can use the money during the waiting period

2. How much more valuable a payment or sum of money is today rather than later depends on the value of the use you have for it or on the value you can get by finding someone who needs that dollar now for something valuable

a. Time value as rental charge $1 today worth whatever $1 is worth in ten years PLUS whatever you can get for renting out $1 for ten years

3. Present Value—value today of money to be paid at some future pointa. Discount rate—how to calculate present values

i. Rate that is earned from renting/lending money out for one year in the market for money

ii. Discount rate of 10 $1.00 + 10% of $1.00 = $1.10 (for year 1)

1. For year 2: $1.10 + 10% of 1.10= $1.21 (at end of year 2)

iii. For a period of one year – PresentValue 1 + rate(PresentValue) = Future Value

iv. If you want to calculate the present value of an amount of money one year from now—divided the amount by the sume of 1 and the discount rate

1. Present Value = Future Value / 1+ rate

4. Rate of Return—percentage you would earn if you invested in a particular project

a. $1000 a year ago, receive $1,200 rate of return = 20%i. Does NOT mean the present value of $1200 one

year from now is $10005. Positive Net Value Projects

a. Projects for which the present value of the amount invested is less than the present value of the amount received in return

6. Interesta. Money you are promised when you lend out money or

the amount you have to pay if you borrow money ii. Risk and Return

1. Future returns on most investments are uncertain2. Expected return—used to attempt to calculate probability of success

or failure in an investment a. If a return a year from now on an investment will be

either $2K or zero—each w/ equal likelihood, expected return on the investment is $1000

i. Investor will discount $1000 to present value b. Weighted average of the value of the investment

i. Sume of what the returns would be if an investment succeeded multiplied by probability of success PLUS what the returns would be if the investment failed multiplied by probability of failure

1. If outcomes intermediate b/w success and failure are possible, they must be multiplied by probabilities and added in to calculate expected return

3. Financial Riska. Risk neutral—all investor is concerned about is the

expected return of an investment b. Risk averse—most investors

i. Volatile payouts are worth less to them; may prefer one option over the other if it’s more of a sure thing—even if expected future value is lower

ii. Risk premium --- additional amount that risk averse investors demand for accepting higher-risk investments in the capital markets

1. Does NOT compensate investor for possible out-of-pocket losses associate w/ probability an investment might fail

2. Compensation for the intrinsic unpleasantness of volatile returns to the risk averse investors who dominate market prices

iii. In order to calculate the present value of risky expected future cash flows—need to discount these cash flows at a rate that reflects both the time discount value of money and the market price of the risk involved

1. Risk adjusted rate2. Risk free rate—rate at which future

cash flows which are certain are discounted

3. Difference b/w risk-adjusted and risk-free rates risk premium

a. More risk in expected future cash flow yields a higher risk premium and a higher adjusted risk rate

iii. Diversification and Systematic Risk 1. Packaging of investments to reduce risk construction of mutual

funds, construction of diversified portfolio2. Risk aversion—investors are averse only to risks that they actually end

up bearinga. Risk investment held as part of portfolio that includes

other equally risk investments likely to be worth more to its owner than if it were held alone

b. Less total risk than its individual components c. Still risk premiums are present b/c not every risk is

diversifiable 3. Most projects involve combination of diversifiable and undiversifaible

risk a. Appropriate risk premium and risk-adjusted discount

rate depend only on undiversifiable portion of the risk i. The greater the undiversifiable risk is—greater

the risk premium and risk-adjusted discount rate are

C. VALUING ASSETSi. Discount Cash Flow (DCF) Approach

1. Highest level—requires a prediction of all future cash flows and a discount rate to bring those cash flows back to the present to yield a “net present value” (NPV)

2. Routinely used by investment bankers in valuing takeovers and small businesses; by courts in valuing shares in closely held corps; by bankruptcy courts in valuing plans for reorganizing businesses; by managers in valuing corporate projects

3. First Step in DCF valuation—a. Estimation of all future cash flows generated by the

assetb. NOTE: many assets typically have indefinite life while

cash flows can only be calculated for finite number of periods

c. Terminal Value all cash flows from a future year and going into perpetuity, into that future year

i. Large fraction of overall cash flows 4. Second Step—

a. Calculation of an appropriate discount rateb. Weighted-Average Cost of Capital (WACC)

i. Calculated as the weighted average of the cost of debt and the cost of equity

1. Weights are relative amounts of debt and equity in the capital structure

ii. Before tax cost of debt for a firm is the interest rate that the firm would pay if it were to seek new debt financing today

1. After-tax cost of debt—lower b/c companies deduct interest payments from taxable income

iii. Equity: investors must expect a return before they will make their funds available to the firm

1. Capital Asset Pricing Model (CAPM)a. Idea that risky ventures are

required to pay a higher price for their capital in order to compensate investors for their risk aversion

b. Links securities risk to the volatility of the security prices

2. Historical average equity risk premia data—less precise than CAPM

a. Requires calculation of the firm’s before-tax cost of debt

iv. Risk from future events can be said to be two types—

1. Systemwide/Systematic riska. Investors can’t get rid of it no

matter how they construct their portfolio

2. Company-specific/Unsystematic riska. Investors can get rid of

ii. Relevance of Prices in the Securities Market1. Stock market prices rapidly reflect all public information bearing on

the expected value of individual stocksa. Efficient Capital Market Hypothesis (ECMH)b. Prices in an informed market should be regarded as

prima facie evidence of the true value of traded sharesc. Accuracy of market prices depends entirely on the

quality of information that informs trading which in turn depends on the integrity of all major actors in the market including top corporate management, accounting firms, law firms, investment banks, security analysts, and even portfolio managers who invest on behalf of institutional investors

VI. PROTECTION OF CREDITORS A. INTRO:

i. Problems of corporate creditors can included debtors who misrepresent their income/assets before they borrow OR after borrowing dilution of assets that secure their debts; dilution of claims of unsecured creditors; increase riskiness of their debt

ii. Belief that core corporate feature of LL greatly exacerbates the traditional problems of debtor-creditor relationships

1. LL opens opportunities for both express/tacit misrepresentation in transactions w/ voluntary creditors

a. Bait and switch-- misrepresent assets w/in the corporation and simply walk away if business fails

2. LL makes it possible and sometimes attractive to shift assets out of the corporation after a creditor has extended credit to the corporation

3. LL—protection of shareholders’ personal assets from the consequences of contractual default on the part of the corporation

iii. Creditors can minimize costs of shareholder opportunism by exercising vigilance and negotiating for contractual protections

1. Covenants giving early warning of credit problems

2. Most effective creditor protection—contractually based protectionsa. BUT are costly

iv. Three basic strategies of corporate law in efforts to protect creditors1. Mandatory disclosure duty on corporate debtors2. Promulgate rules regulating amount and disposition of corporate

capital3. Impose duties to safeguard creditors on corporate participants

B. MANDATORY DISCLOSUREi. Federal securities law imposes extensive mandatory disclosure obligations on

public corps creditors are among its beneficiaries1. Public issues of debt occasions for extensive disclosure

ii. NO US state requires closely held corps to prepare audited financial statements or to file financial statements w/ a commercial register or atty general’s office

C. CAPITAL REGULATION i. Financial Statements

1. Generally Accepted Accounting Principles (GAAP)—set by Financial Accounting Standards Board (FASB) a self-regulatory body authorized by SEC to establish accounting standards

a. Balance sheet: financial picture as it stands on particular day

i. Limitation: reflect historical costs instead of current economic/market values

1. Each asset is listed at acquisition cost a. Book value may differ quite a

bit from current economic value of an asset

ii. Asset and liability portions of the balance sheet always in balance every element of the corporation’s value must be accounted for by an equivalent debt or equity claim

1. Stockholders’ equity category is what brings the assets and liabilities into balance

a. Amount of equity or ownership stake that shareholders have in the business (NOTE – doesn’t determine the market values of equity)

b. “plug figure”—difference b/w corporate assets and liabilities

c. Divided into 3 accounts--Stated/legal capital; Capital

surplus; Accumulated retained earnings

i. Stated Capital—capital stock; legal or nominal capital which represents all or a portion of the value that shareholders transferred to the corp at the time of the original sale of the company’s stock to its original shareholders; Par Value—stated amount in articles of incorporation—multiplied by number issued and outstanding shares

ii. Capital surplus—if the stock is sold for more than its par value—excess is accounted for here

iii. Accumulated retained earnings—merely the amounts that a profitable corporation earns but hasn’t distributed to its shareholders

iii. Current assets include: cash; marketable securities; accounts receivable; inventories; prepaid expenses

1. “working” assets2. Fixed

assets—property/plant/equipment; capital assets

a. Assets not intended for sale which are used for lengthy periods in order to manufacture, display,

warehouse and transport the product

b. Historical cost w/ adjustments downward to reflect depreciation

iv. Current Liabilities—due within the year; long-term liabilities—due over longer period

1. Comparison of current assets and current liabilities gives sense of liquidity (or capacity of noncash assets to be converted into cash) and the likelihood that it can pay its obligations or make new investments in the future

b. Income statement: results of the operation of the business over specified period

i. Limitation: account of profits/losses don’t reflect actual amount of cash a business throws off or makes available in the year

1. Net profit report may differ from cash available for distribution

c. Firms show these figures for 2+ years in order to show how situation of firm has changed

ii. Distribution Constraints 1. Stated capital—permanent capital that couldn’t be paid out to

shareholders and upon which creditors could rely in extending credit a. Most distribution restrictions look to legal capital

account in corporate balance sheeti. NY Business Corporation Law 510 bars

distribution that would render the corporation “insolvent” by which is meant insolvency in the equity sense of being unable to pay its immediate obligations as they come due

1. 510(b): dividends may only be paid out of surplus—not out of stated capital

a. NOTE: bd of directors able to restructure the capital account by shifting any portion of the stated capital account to the surplus account if it’s authorized to do so by shareholders

ii. DGCL 170—nimble dividend test

1. 170(a)—directors of a business corporation (not banking corp) may pay dividends either out of capital surplus OR if there is no capital surplus—out of net profits in the current or preceding fiscal year

2. Bds in DE may freely transfer stated capital associated w/ no par stock into the surplus account on its own decision

a. NOTE: no par stock—bd of directors must set aside some discretionary portion of the sale price as the company’s stated capital

b. Reducing stated capital associated w/ par stock requires charter amendment to reduce par stock value – shareholder vote

iii. RMBCA 6.40—traditional distribution test w/ a twist

1. Corps may not pay dividends IF as a result of doing so (a) they can’t pay their debts as they come due or (b) their assets are less than their liabilities plus the preferential claims of preferred shareholders

2. Can rely on GAAP or a fair valuation or other method that’s reasonable in the circumstances

a. More accurately reflect economic reality

iv. Economic Reality 1. If a corp’s assets are worth more in

economic value than amount at which they’re carried on the firm’s books—no law prevents the firm from adjusting its books to reflect higher value

a. GAAP allows it to account for assets on the basis as long as it’s disclosed and concurred to be fair estimate

b. Revaluation surplus—adjustment of capital surplus account

v. Only real protection under DGCL and RMBCA creditors have against dividend payments is under fraudulent transfer act (infra)

iii. Minimum Capital and Capital Maintenance Requirements 1. Distribution constraints could be avoided by placing trivial sums in

“trust fund” of legal capital reserved for creditors a. Statutory minimum capital requirements are minimal or

nonexistent (DGCL AND RMBCA)D. STANDARD-BASED DUTIES

i. Director Liability 1. Under certain circumstances—directors owe an obligation to creditors

not to render the firm unable to meet its obligations to creditors by making distributions to shareholders or to others w/out receiving fair value in return

a. Est. under Uniform Fraudulent Transfers Act by statutory restrictions on payment of dividends

b. DE Chancery Court opinions—when firm is insolvent but federal bankruptcy provisions haven’t been invoked, directors owe a duty to consider the interests of corporate creditors

i. One decision—when a corp is in vicinity of insolvency, directors, in making business decisions shouldn’t consider shareholders’ welfare alone but should consider the welfare of the community of interests that constitute the corp

2. North American Catholic Educational Programming Foundation, Inc. v. Gheewalla (Del 2007): creditors couldn’t assert direct claim alleging injury to their own interests as creditors BUT did have standing to assert a derivative claim alleging injury to the corp against an insolvent corporation

a. Recognizing that directors of insolvent corp owe direct fiduciary duties to creditors would create uncertainty for directors who have a fiduciary duty to exercise their business judgment in best interest of insolvent corp

ii. Creditor Protection: Fraudulent Transfers 1. Fraudulent conveyance laws (general creditor remedy) imposes an

effective obligation on parties contracting w/ an insolvent—or soon to be insolvent—debtor to give fair value for the cash or benefits they

receive, or risk being forced to return those benefits to the debtor’s estate

a. Designed to void transfers by a debtor that are made under circumstances unfair to creditors

i. Provides a means to void any transfer made for the purpose of delaying/hindering/defrauding creditors

2. Uniform Fraudulent Conveyance Act (UFCA) and updated Uniform Fraudulent Transfer Act

a. Creditors may attack a transfer on two grounds:i. Present or future creditors may void transfers

made w/ the ACTUAL INTENT to hinder/delay/defraud any creditor of the debtor (UFTA 4(a)(1); UFCA 7)

ii. Creditors may void transfers made w/out receiving a reasonably equivalent value if the debtor is left w/ remaining assets . . . unreasonably small in relation to its business OR the debtor “intended. . . believed. . . reasonably should have believed he would incur debts beyond his ability to pay as they became due” or debtor is insolvent after transfer (UFTA 4(a)(2), 5(a) &(b))

3. Fraudulent transfer doctrine allows creditors to void transfers by establishing that they were either actual or constructive frauds on creditors

a. Constructive fraud reasonable expectations of creditors when negotiating w/ debtors

i. Business debtors implicitly represent that their assets, as affected by normal business or diminished wear/tear/legal distributions will be available to creditors in event of default

ii. Kupetz v. Wolf (9th Cir 1988): future creditors who knew or could easily have found out about otherwise vulnerable transfers can’t void them

4. Fraudulent conveyance law has important corporate role in challenges to leveraged buyouts (LBOs)

a. Implicated in proposals that large tobacco companies insulate assets from potential tort liability by placing these assets in subsidiaries and then distributing the stock of these subsidiaries to their shareholders

i. “spin-off”

iii. Shareholder Liability 1. Intro: shareholders can be liable to corporate creditors or have any

“loans” they’ve made to the company subordinated to other creditors2. Equitable Subordination

a. Recharacterization of debt owed by the company to its controlling shareholders as equity

i. “Deep Rock doctrine”1. Section 510(c)(1) of US Bankruptcy

Code which permits the subordination of debt claim under the principles of equitable subordinationrarely invoked outside bankruptcy context

b. Means of protecting unaffiliated creditors by giving them rights to corporate assets superior to those of other creditors who happen to also be significant shareholders of the firm

i. First requirement—creditor must be an equity holder and typically an officer of the company

1. Insider-creditor must have in some fashion behaved unfairly or wrongly toward the corp and its outside creditors

c. Costello v. Fazio (9th Cir. 1958)i. FACTS: creditors’ claims against bankrupt estate

of Leonard Plumbing and Heating Supply, Inc. filed by Fazio (partner of business who made initial capital contribution) trustee in bankruptcy objected to these claims and moved for an order subordinating them to the claims of general unsecured creditors

1. The corporation assumed all liabilities of the previous partnership including promissory notes to Fazio

2. At the time of bankruptcy petition, the corp wasn’t indebted to any creditors whose obligations were incurred by the preexisting partnership except for Fazio’s promissory note which he subsequently filed a claim against the estate in that sum (save for set-offs and transfers)

3. Trustee claimed that the transfer of the sum in question from the partnership capital account to another account effectuated a scheme and plan to place copartners in the same class as unsecured creditors if Fazio is allowed to get the assets now, he’ll receive a portion of capital invested which should be used to satisfy creditors’ claims before any capital investment can be returned to the owners/stockholders of said bankrupt

ii. COURT: corporation was grossly undercapitalized claimants w/drew capital from partnership in contemplation of incorporation and in doing so acted for their own personal/private benefit; acted to detriment of corporation and creditors

1. Likelihood that business failure would result from such undercapitalization should have been apparent to anyone who knew the company’s financial and business history and who had access to its balance sheet and profit/loss statements

2. Where a claim in bankruptcy court is found to be inequitable, it may be set aside OR subordinated to the claims of other creditors

a. Question—whether w/in the bounds of reason and fairness such a plan can be justified

b. Test where claims are filed by persons standing in a fiduciary relationship to the corporation whether or not under all the circumstances the transaction carries the earmarks of an arm’s length bargain

3. HERE: claimants took advantage of their fiduciary position seeking to gain

equality of treatment w/ general creditors

4. Fraud and mismanagement need not always be present in subordination cases

3. Piercing the Corporate Veil a. Most frequently invoked form of shareholder liability in

the cause of creditor protection equitable power of the court to set aside the entity status of the corp (piercing the veil) to hold its shareholders liable directly on K or Tort Obligations

b. Lowendahl Test—P must show existence of a shareholder who completely dominates corporate policy and uses her control to commit a fraud or wrong that proximately causes P’s injury

i. “domination” – failure to treat corp formality seriously

c. Krivo Industrial Supp. Co—disregard of corporate form when recognition of it would extend the principle of incorporation beyond its legit purposes and would produce injustices or inequitable consequences

d. Some factors for veil-piercing decisionsi. Disregard of corporate formalities

ii. Thin capitalization iii. Small numbers of shareholdersiv. Active involvement by shareholders in

managemente. Two prong test:

i. Unity of interest and ownership such that separate personalities of corp and individual shareholder no longer exist

1. Factors for determining unity of interesta. Failure to maintain adequate

corporate records or to comply w/ corporate formalities;

b. Commingling of funds/assetsc. Undercapitalization d. One corp treating assets of

another corp as its owne. Sea-Land, infra

ii. Would an inequitable result occur IF the acts were treated as those of corp alone?

1. Kinney Shoe, infraf. Sea-Land Services v. Pepper Source (7th Cir 1991)

i. FACTS: Sea-Land shipped peppers on behalf of PS who then stiffed Sea-Land on the freight bill; judgment against PS entered but it had been dissolved and had no assets; THUS Sea-Land sought to pierce corporate veil and render owner personally liable and then “reverse pierce” owners other corps so they’d be on the hook too

1. Corps as “alter-egos” of each other and of the owner; also included another corp which PS owner owned half of the stock

ii. COURT: corporate entity will be disregarded and the veil of Ltd. Liability pierced when 2 requirements are met—(1) there must be such unity of interest and ownership that the separate personalities of the corp and individual (or other corp) no longer exist; and (2) circumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice

1. Factors for determining unity of interesta. Failure to maintain adequate

corporate records or to comply w/ corporate formalities;

b. Commingling of funds/assetsc. Undercapitalization d. One corp treating assets of

another corp as its own2. None of the corps had a corporate

meeting; all run out of the same office w/ same phone line, expense accounts etc.;

a. Owner borrows sums of $$ from the corps and corps borrow from each other

b. Used bank accounts of corps to pay personal expenses

c. HERE there was clearly shared control/unity of interest

3. Unity of interest not enough must also show that honoring the separate corporate existences of D would sanction fraud OR promote injustice

a. Once unity of interest is shown—EITHER sanctioning of fraud or promoting of injustice will suffice

b. Promoting injustice—some element of unfairness, something akin to fraud or deception or existence of compelling public interest must be present in order to disregard corporate fiction

c. Must be the case that not piercing the veil would allow some “wrong” other than creditor’s inability to pay will occur

i. Unjust enrichment; skirting legal rules concerning monetary obligations; escape liabilities; intentional scheme to squirrel assets in corp while heaping liabilities upon asset-free corp would be successful

g. Kinney Shoe Corp v. Polan (4th Cir 1991)i. FACTS: Kinney filed suit against Polan’s

company for unpaid rent and obtained judgment of $144K; filed this action against Polan individually to collect the amount

ii. COURT: corporation is an entity, separate and distinct from its officers/stockholders and the individual stockholders aren’t responsible for debts of corp BUT is fiction of law that should be disregarded when it’s urged w/ an intent not w/in its reason/purpose and in such a way that

its retention would produce injustices/inequitable consequences

1. Totality of the circumstances test used in determining whether to pierce the veil

a. Two prong test: i. Unity of interest and

ownership such that separate personalities of corp and individual shareholder no longer exist

ii. Would an inequitable result occur IF the acts were treated as those of corp alone?

2. Polan’s corp wasn’t adequately capitalized—had none individuals who wish to enjoy ltd personal liability for business activities under corporate umbrella should be expected to adhere to relatively simple formalities of creating/maintaining corporate entity

a. Grossly inadequate capitalization PLUS disregard of corporate formalities causing basic unfairness are sufficient to pierce the veil in order to hold shareholders actively participating in the operation of the business personally liable for breach of K to the party who entered into the K w/ the corp

b. No stock; no capital contribution; no minutes kept; no officers elected; corp was paper curtain set up b/w Polan’s other corp and Kinney to prevent Kinney from going against corp WITH assets

3. Third prong may apply in certain cases—when, under circumstances, it’d be

reasonable for party to conduct an investigation of the credit of the corp will be charged w/ the knowledge that reasonable credit investigation would disclose and if such investigation would disclose that corp is grossly undercapitalized based upon nature and magnitude of corporate undertaking—such party will be deemed to have assumed the risk of gross undercapitalization and won’t be permitted to pierce the veil

a. NOTE: permissive not mandatory 3rd prong

b. HERE: not a factual situation that calls for 3d prong if seeking equitable result

4. HELD: Polan personally liable for debt of corp

4. Veil Piercing on Behalf of Involuntary Creditorsa. Tort based creditors are different from contract based

creditorsi. Didn’t rely on creditworthiness of the corp in

placing themselves in a position to suffer a lossii. Generally can’t negotiate/ corporate tortfeasor

ex ante for contractual protections from risk iii. General rule for veil piercing: thin capitalization

alone is insufficient ground for piercing corporate veil

1. BUT sufficient proof can extend to K and torts

b. Walkovszky v .Carlton (NY 1966)i. FACTS: common practice in taxicab industry of

vesting ownership of taxi fleet in many corps each owning one or two cabs; P was injured by taxi driver; Carlton—stockholder of 10 corps including the corp that owned the cab, each of which has only 2 cabs registered in its name w/ minimum insurance carried on each cab

1. Cabs alleged to be “operated as a single entity, unit and enterprise” with regard

to financing supplies, repairs, EEs and garaging—all named as Ds

2. P claims entitled to hold stockholder personally liable for damages sought b/c multiple corporate structure constitutes an unlawful attempt to defraud members of the general public who might be injured by cabs

ii. COURT: disregarding public form or piercing the public veil to prevent fraud or to achieve equity – whenever anyone uses control of the corp to further his own rather than corp’s business

1. Can extend to commercial dealings and negligent acts

2. Corporate form may not be disregarded merely b/c the assets of the corporation, together w / the mandatory insurance coverage of the vehicle which struck P are insufficient to assure him the recover sought

3. No evidence that Ds were actually doing business in their individual capacities shuttling personal funds in and out of corps w/out regard to formality and to suit their immediate convenience

iii. DISSENT: corps intentionally undercapitalized for the purpose of avoiding responsibility for acts which were bound to arise as a result of the operation of large taxi fleet having cars out on the street 24 hours a day and engaged in public transportation

1. Would hold that a participating shareholder of a corporation vested w/ pubic interest organized w/ capital insufficient to meet liabilities which are certain to arise in ordinary course of corp’s business may be held personally responsible for such liabilities

5. Substantive Consolidationa. Equitable remedy in bankruptcy that consolidates assets

among corporate subsidiaries for the benefit of creditors of the various corporate subsidiaries

b. “horizontal” veil piercingi. Corporate holding company structure ignored

for purpose of distributing assets in bankruptcy ii. Federal law as undermining well-established

state corporate law doctrine on veil piercing? 6. Dissolution and Successor Liability

a. Although shareholders can eventually escape all liability through the simple act of dissolving the corp and abandoning assets, it may be more difficult to escape tort costs by selling corporation’s assets

b. Successor corporation liability : buyer of the liquidating firm’s product line picks up the tort liability of the seller, at least as that liability relates to the purchased product line

i. Anticipating the liability the purchasing firm will reduce the offering price by the amount of expected liability

1. Potential liquidator can’t escape liability through sale of damage causing product line and distribution of proceeds

VII. NORMAL GOVERNANCE: THE VOTING SYSTEMA. THE ROLE AND LIMITS OF SHAREHOLDER VOTING

i. Three default powers of shareholders1. Right to vote2. Right to sell 3. Right to sue

ii. Most important factor affecting shareholder voting--? Collective action problem faced by shareholder in large public companies

1. Costly—any one shareholder’s prospective share of the potential benefit that informed action MIGHT produce would probably not justify personal cost

a. AND any one shareholder’s vote is unlikely to affect outcome of the vote same share of benefit whether or not invest in becoming informed and voting intelligently

b. The larger a proportionate stake is—greater probability shareholder’s vote will affect the outcome and the less she suffers from “rational apathy”

2. 1934 Securities and Exchange Act sought to empower shareholders through forced disclosure of information

a. SEC under section 14 elaborate proxy rules designed to encourage informed shareholder voting

3. Growing institutional portfolios, cheaper costs of communication between institutions and evolution of new agent of shareholder organization have created ownership and coordination structures collective action costs may not be large enough from preventing shareholders from monitoring managerial performance

B. ELECTING AND REMOIVNG DIRECTORSi. Electing Directors

1. Foundational and mandatory voting righta. Every corp MUST have bd. of directors—even if only a

single member (DGCL 141(a))b. Almost all common stock carries voting rights (one

share, one vote)2. Annual election of directors—mandatory feature

a. Either elect the whole board when there’s single class of director s OR

b. Some fraction of the boardi. “staggered” or “classified” board

3. Framework for annual meeting of shareholdersa. Minimum and maximum notice period and b. Quorum requirement for general meetingc. Minimum and maximum period for board to fix “record

date”i. Shareholders who are registered as of record

date = legal shareholders entitled to vote at the meeting

4. Cumulative Votinga. Usual regime one vote for each share of voting stock

owned and MAY cast it for each directorship/board position that’s to be filled in the election

i. Holder of 51% of voting block could designate complete membership of board

b. Alternative technique cumulative voting i. Increases possibility for minority shareholder

representation on board of directorsii. Each shareholder may cast a total number of

votes equal to the number of directors for whom she’s entitled to vote X number of voting shares she owns w/ top overall vote getters getting seated on board

5. Staggered boards—harder for shareholders even with 51% to gain control of a board must win 2 elections which can be as long as 13-15 months a part in order to gain majority control (2/3)

ii. Removing Directors 1. C/L: directors could be removed by shareholders only “for cause”

a. Campbell v. Loew’s Inc. – director entitled to certain due process rights when removed for cause

b. Poor business judgment alone not enough “for cause”2. State law in all jx—bars directors from removing fellow directors for

cause or otherwise in the absence of EXPRESS shareholder authorization

a. If board uncovers cause for removal—can petition court of competent jx to remove director from office

i. Any court of equity supervising the performance of any fiduciary has inherent power to remove for cause

ii. State law of incorporation can do it so can federal courts where corp is publicly traded and registered under Sec. and Exchange Act of 1934

b. More difficult when board is classified—DGCL 141(k) provides when the board is classified directors can be removed only “for cause” unless charter provides otherwise

iii. Shareholder Meetings and Alternatives1. Shareholder may vote to adopt/amend/repeal by laws; remove

directors; adopt shareholder resolutions that may ratify board actions or request board to take certain actions

2. Special Meetingsa. Meetings of shareholders other than the annual

meeting called for special purposes i. Often called to permit shareholders to vote on

fundamental transactions ii. Many jx—only way shareholders can initiate

action b/w annual meetings b. Revised Model Business Corporation Act (RMBCA) sec

7.02i. Corporation must hold a special meeting of

stockholders if1. Such a meeting is called by board of

directors or a person authorized in the charter or bylaws to do so, or

2. The holders of at least 10% of all votes entitled to be cast demand such a meeting in writing

c. DE law: special meetings may be called by board or by such persons as are designated in charter or bylaws

i. Doesn’t contain mandatory 10% provision in many state statutes (DGCL 211(d))

3. Shareholder Consent Solicitationsa. Alternative to special meetings statutory provision

permitting them to act in lieu of a meeting by filing written consents

b. DE stockholder consent statute any action that may be taken at a meeting of shareholders (e.g., amendments of bylaws or removal of directors from office) may also be taken by the written concurrence of the holders of the number of voting shares required to approve that action at a meeting attended by shareholders

c. RMBCA: unanimous shareholder consent C. Proxy Voting and Its Costs

i. Intro: 1. shareholder meetings require a quorum to act BUT given the widely

dispersed share ownership of most publicly financed corps public shareholders are unlikely to actually attend shareholder meetings

2. To get quorum—board and its offices are permitted to collect voting authority from shareholders in the form of proxies

a. Management acts on behalf of and expense of corp3. Generally—proxies must record the designation of the proxy holder by

the shareholder and authenticate the grant of the proxy a. “proxy card”b. But electronic communications may also be used to

designate a proxy so long as sufficient evidence of authenticity is provided

c. Proxy holder—bound to exercise the proxy as directed i. Specific nominees and specific issues on which

proxy holder proposes to voteii. May exercise independent judgment on issues

arising at shareholder meeting for which they haven’t received specific instruction

d. Revocable agency UNLESS holder has contracted for the proxy as a means to protect a legal interest or property such as interest in themselves

4. NOTE: proxy is not solution to collective action problem of shareholders relies on one or more persons to incur initial expenses of soliciting proxies

5. Normal governance setting—mgmt. must be allowed to expend corporate funds to call annual meetings and solicit proxies

a. Reimbursementb. NOTE reimbursement not possible for insurgent

shareholders to solicit proxies unless insurgents are victorious in fight in which case they can vote to reimburse themselves

i. Proxy fights for control ii. Would give board control over others

6. eProxy Rules—SEC Rule 14(a)-16 a. all public companies must post their proxy materials on

a publicly available website and may simply mail a “Notice for Internet Availability of Proxy Materials” to shareholders no later than 40 calendar days before shareholder meeting

ii. Rosenfeld v. Fairchild Engine and Airplane Corp (NY 1955)1. FACTS: P owns 25% of company’s shares and sought to compel return

of $$ paid out of the corporate treasury to reimburse both sides in proxy contest for their expenses

2. COURT: mgmt. may look to corporate treasury for reasonable expenses of soliciting proxies to defend its position in a bona fide policy contests

a. If directors may not in good faith incur reasonable and proper expenses in soliciting proxies – corporate business might be seriously interfered w/ b/c of stockholder indifference and difficulty of procuring a quorum where there is no contest

b. TEST: when directors act in good faith in a contest over policy, they have the right to incur reasonable/proper expenses for solicitation of proxies and in defense of corporate polices

c. Members of the “new-group” could be reimbursed by the corp for their expenditures in this contest by affirmative vote of stockholders

d. Rule: in a contest over policy as compared to purely personal power contest, corporate directors have right to make reasonable and proper expenditures subject to court scrutiny when duly challenged from the corporate treasury for the purpose of persuading the stockholders of the correctness of their position and soliciting their support for policies which the directors believe in all good faith are in the BEST INTERESTS of the corp

i. But corporate directors can’t under all circumstances disport themselves in a proxy contest w/ corp’s $$ to unlimited extent

1. Where $$ spent for personal power; individual gain; private advantage courts can disallow reimbursement

iii. Doctrine: win or lose, incumbent mgrs. Are reimbursed for expenses that are reasonable in amount and can be attributed to deciding issues of principle or policy

1. Any disagreement tends to satisfy difference in policy requirement for reimbursement

2. Insurgents—stand good chance of being reimbursed only if they win a. Shareholders decided expenses were made in good-

faith effort to advance a corporate interest D. CLASS VOTING

i. Minority interests need structural protection against exploitation by the majority

1. Class voting requirements 2. Transaction subject to class voting simply means that a majority of the

votes in every class that is entitled to separate class vote must approve the transaction for its authorization

a. EX: class A common stock elects 4 directors and Class B common stock elects 2

E. SHAREHOLDER INFORMATION RIGHTSi. Function of informing shareholders (at least in US) left largely to the market

1. State law mandates neither annual report or other financial statement 2. Federal securities law and rules promulgated by SEC mandate

extensive disclosure for publicly traded securities ii. C/L—shareholders recognized to have a right to inspect the company’s books and

records for proper purposes 1. DGCL 220(b): any stockholder shall upon written demand under oath

stating the purpose thereof, have the right during the usual hours of business to inspect for any proper purpose, the corp’s stock ledger, a list of its stockholders and its other books/records and to make copies and extracts from there. Proper purpose—purpose reasonably related to such person’s interest as stockholder

a. DE recognizes 2 different types of requests—i. Request for stock list

ii. Request for inspection of “books and records” of the corp

iii. The Stock List1. Corporate stock list—discloses identity, ownership interest and

address of each registered owner of company stock

2. Doesn’t contain proprietary info and is easy to produce a. Readily available to registered owners of corp’s stock

3. Proper purpose of acquiring list—broadly construed and once shown court won’t consider whether shareholder has additional improper purposes

4. An order to produce a stock list will carry w/ it an obligation to update the list, to produce second list of stock brokerage firms who stock is registered in the name of company and to furnish daily trading info

a. Often require company to furnish “non-objecting beneficial owners” (NOBO) list if company has such

iv. Inspection of Books and Records1. P may allege need for very broad access to company’s records in order

to uncover suspected wrongdoinga. More expensive than producing stock list and may

jeopardize proprietary or competitively sensitive information

b. Ps have burden the burden of showing a proper purpose and by carefully screening P’s motives and the likely consequences of granting her request

F. FEDERAL PROXY RULESi. Originated w/ provisions of Securities Exchange Act of 1934 section 14(a)-(c)

which regulated virtually every aspect of proxy voting in PUBLIC companies1. Four major elements of federal proxy rules

a. Disclosure requirements and a mandatory vetting regime that permit the SEC to assure the disclosure of relevant info and to protect shareholders from misleading communications

b. Substantive regulation of the process of soliciting proxies from shareholders

c. Specialized “town meeting” provision (14a-8) that permits shareholders to gain access to the corp’s proxy materials and to thus gain a low-cost way to promote certain kinds of shareholder resolutions; and

d. General antifraud provision (14a-9) that allows courts to imply a private shareholder remedy for false/misleading proxy materials

ii. Rules 14a-1 Through 14a-7 : Disclosure and Shareholder Communication 1. No imposition of an affirmative obligation on corps to inform

shareholders of the state of the company’s business or even distribute a balance sheet/income statement

2. 14(a) made it unlawful for any person in contravention of any rule that the commission may adopt to solicit any proxy to vote any security registered under section 12 of the Act

a. State w/ great detail the types of info that any person must provide when seeking a proxy to vote a covered security

i. Force disclosure by corps to the shareholders from whom they sought proxies

1. Applies to issuing corp AND 3d party who might seek to oust incumbent mgmt. by proxy fight

2. Studebaker Corp v. Gittlin (2d Cir 1966): a request to 42 stockholders of a large public company to join in a request to inspect the shareholders’ list was held to constitute a “solicitation” of a “proxy” requiring the preparation, filing and distribution of a proxy statement

b. 1992 Amendments to 14A limited solicitation in 14(a)-1(l) and created new exemptions under rule 14(a)-2 which released institutional shareholders in limited circumstances from the requirement to file a disclosure form before they could communicate w/ other shareholders about a corp

c. Rule 14a-3 central regulatory requirement of the proxy rules

i. No one may be solicited for a proxy UNLESS they are or have been furnished w/ a proxy statement containing info specified in Schedule 14A

1. When solicitation is made on behalf of the company itself (registrant) and relates to an annual meeting for the election of directors must include considerable info about the company

a. Including related party transactions and detailed info about the compensation of top managers

2. When proxy statement is filed by anyone other than the mgmt—it

requires detailed disclosure of the identity of soliciting parties as well as their holdings and the financing of the campaign

d. 14a-1(l)(2)(iv): announcements by shareholders on how they intend to vote EVEN if such announcements include the shareholders’ reasoning aren’t subject to proxy rules

i. Don’t exempt investors from 14a-9 which prohibits false/misleading statements in connection w/ oral or written solicitations

e. 14a-4 and 14a-5 regulate the form of the proxy actual “vote” itself and proxy statement

f. 14a-6 lists formal filing requirements not only for preliminary and definitive proxy materials but also for solicitation materials and notices of exempt solicitations

g. 14a-12 contains special rules applicable to contested directors or solicitations opposing anyone else’s (usually mgmt’s) candidates for the board

i. (a) permits solicitations prior to the filing of a written proxy statement as long as dissidents disclose their identities and holdings and don’t provide a proxy card to security holders

ii. (b)deals w/ treatment and filing of proxy solicitations made prior to the delivery of a proxy statement

h. 14a-7: list-or-mail rule under which, upon request by a dissident shareholder, a company must either provide a shareholders’ list or undertake to mail the dissident’s proxy statement and solicitation materials to record holders in quantities sufficient to assure that all beneficial holders can receive copies

iii. Rule 14a-8: Shareholders Proposals1. Town Meeting Rule

a. Entitles shareholders to include certain proposals in the company’s proxy materials

i. Shareholder could advance a proposal for vote by fellow shareholders w/out filing with SEC or mailing her own materials out to shareholders

b. Not so good for corporate mgmt—mgmt. has legit interest in excluding some materials from proxy statement

i. Mgmt. prefers to control the content of communications made by corp to its shareholders

c. 14A provides number of specific grounds to permit corps to exclude shareholder-requested matter from corp’s proxy solicitation materials

i. Shareholder proposals must satisfy formal criteria:

1. Must state identity of the shareholder (14a-8b1)

2. Number of proposals (14a-8c)3. Length of supporting statement (14a-

8d)4. Subject matter of proposal (14a-8i)

ii. Lists 13 grounds that permit firms to exclude proposals from company’s solicitation materials

1. 14-8(i)(1): approval of proposal would be improper under state law

2. 14a-8(i)(7): proposal relates to a matter of ordinary business

a. Province of the board under the corporate form

d. Most rule 14a-8 shareholder proposals fall into 2 categories:

i. Corporate governance1. 72% submitted in 2 years dealt w/ this2. Executive compensation; internal

corporate governance such as separation of chairman and CEO roles

3. External corporate governance proposals such as dismantling poison pill or staggered board takeover defenses

4. Often brought by labor unions/institutional investors

ii. Corporate social responsibility (CSR)1. Environmental policies, personnel

practices 2. Rarely win more than 10% of

shareholder votee. Companies that wish to exclude a shareholder proposal

generally seek SEC approval

i. 14a-8(j)ii. SEC approval—no-action letter; won’t take

action if proposal is omitted 1. Shareholder proponent has opportunity

to respond to request for no-action letter

f. Corporate Governance Proposals—i. Important question extent of shareholders’

ability to enact bylaws that limit the range of options open to the board in managing the firm

1. SEC won’t mandate access to company’s proxy statement if the matter on which shareholder action is sought isn’t a proper subject of shareholder action under state law

ii. SEC encourages shareholders to frame corporate governance resolutions in precatory for recommendations to the board of directors for adoption

1. Sidestep questions concerning scope of shareholder authority under state law

iv. NOTE: Rule 14A-11 Shareholder Proxy Access Rule1. SEC proposed Rule 14A-11 would’ve allowed long-term

shareholders the power to place their own nominees in a public company’s proxy materials under certain ltd circumstances

a. Opposition: would likely shift a dangerous amount of power into hands of institutional shareholders and other institutions that didn’t necessarily have the best interests of corp at heart

b. Proponents: no shareholder directors could be elected w/out receiving a majority shareholder vote and that shareholder nominees would be willing to survive arduous triggering conditions, year-long wait and subsequent shareholder vote only if corporate performance were truly terrible and in strong need of shareholder intervention

2. Corporate Governance Proposal Questions:a. Is the proposal a proper subject for action by

shareholders?b. Would the proposal if adopted cause the corp to violate

law to which it’s subject? c. CA, Inc. v. AFSCME Employees Pension Plan (Del 2008)

i. FACTS: AFSCME submitted proposed stockholder bylaw for inclusion in the company’s proxy materials for its 2008 annual meeting of shareholders which would amend the bylaws to provide reimbursement of a stockholder for reasonable expenses incurred in connection w/ nominating one or more candidates in a contested election of directors to the corp’s board of directors under certain conditions (fewer than 50% of directors to be elected is contested; one or more candidates nominated are elected to corp’s board of directors; stockholders aren’t permitted to cumulate votes for directors and election occurred and expenses incurred after bylaw’s adoption)

ii. COURT: shareholders have power to adopt/amend/repeal bylaws which can’t be non-consensually eliminated or ltd by anyone other than legis itself BUT the business and affairs of every corp organized shall be managed by or under direction of bd of directors . . .

1. Shareholders don’t have such broad mgmt. powers and cannot directly manage the business and affairs of corp w/out specific authorization in either the statute or cert of incorporation

2. Power by shareholders to amend/adopt/repeal bylaws ltd by board’s mgmt. prerogatives under DGCL 141(a)

3. Proper function of bylaws is to define the process and procedures by which substantive business decisions are made don’t encroach on section 141(a) managerial authority

a. Substantive v. procedural 4. HERE: purpose of the Bylaw is to

promote integrity of the electoral process by facilitating the nomination of director candidates by stockholders or

group of stockholders thus is proper subject for action by shareholders

5. The Bylaw here would prevent the directors from exercising their full managerial power in circumstances where their fiduciary duties would otherwise require them to deny reimbursement to dissident slate that shareholders rather than directors impose this limitation doesn’t legally matter

6. Proper application of fiduciary principles here could preclude reimbursement

7. Thus the Bylaw would violate DE law if enacted

3. Corporate Social Responsibility Proposalsa. Reg. 14A allows mgmt. to exclude matters that fall w/in

ordinary business of the corp i. Following a no-action letter decision regarding

Cracker Barrel—SEC reversed and decided that employment-related proposals focusing on significant social policy issues couldn’t be automatically excluded under “ordinary business” exclusion

ii. Case-by-case approachiii. STILL—want to confine the resolution of

ordinary business problems to mgmt. and the board of directors since it’s impracticable for shareholders to decide how to solve such problems

b. Central considerations:i. Certain tasks are so fundamental to mgmt’s

ability to run a company on a day to day basis that they couldn’t as practical matter be subject to direct shareholder oversight

1. EX: mgmt. of workforce—hiring/firing/promotion; decisions on production quality/quantity; retention of suppliers

ii. Degree to which proposal seeks to micromanage the company by probing too

deeply into matters of a complex nature that shareholders as a group wouldn’t be qualified to make an informed judgment on due to their lack of business expertise and lack of intimate knowledge of company’s business

c. Must focus on “significant social policy issues” AND must not seek to micromanage the business in order to avoid running afoul of ordinary course of business

v. RULE 14a-9: Antifraud Rule 1. Only SEC expressly authorized to enforce securities acts and rules

fed courts have implied private rights of action under securities acts a. J.I. Case v. Borak (US 1964): private right of action exists

under 14a-9 b. Cort v. Ash (US 1975): more restrictive test established

for implying private remediesi. Implied right must satisfy 3 criteria (1) P one of

the class for whose especial benefit the statute was enacted; (2) indication of legislative intent, explicit or implicit either to create such a remedy or deny one; (3) cause of action can’t be one traditionally relegated to state law, in an area basically the concern of the states so that it’d be inappropriate to infer cause of action based solely on federal law

2. 14a-9: SEC’s general proscription against false/misleading proxy solicitations; ELEMENTS:

a. Materiality i. Misrep or omission in proxy solicitation can

trigger liability only if it’s MATERIAL substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote

1. TSC Indus, Inc. v. Northway (US 1976)b. Culpability

i. No standard set by SCii. 2d/3d Circuits Negligence

iii. 6th cirproof of scienter (intentionality or extreme recklessness)

c. Causation and Reliancei. Unlike trad. fraud P need not proof actual

reliance on the misrep/omission

ii. Causation of injury presumed if misrep is material and proxy solicitation was “essential link” in accomplishment of transaction

1. Mills v. Electric Auto-Lite Co (US 1970)d. Remedies

i. Courts might award injunctive relief; monetary damages; rescission

1. Mills, supra3. Virginia Bankshares, Inc. v. Sandberg (US 1990)

a. QUESTIONS: whether a statement couched in conclusory or qualitative terms purporting to explain directors’ reasons for recommending certain corporate action can be materially misleading w/in the meaning of Rule 14a-9 AND whether causation of damages compensable under 14(a) can be shown by member of a class of minority shareholders whose votes aren’t required by law or corporate bylaw to authorize the corporate action subject to proxy solicitation

b. HOLDING: knowingly false statements of reasons may be actionable even though conclusory in form BUT that Ps failed to demonstrate equitable basis required to extend the 14(a) private action to such shareholders when any indication of congressional intent to do so is lacking

c. FACTS: corp solicited proxies for voting on merger proposal and told minority shareholders that adopted plan to achieve high value for their stocks

i. P claimed that directors hadn’t believed price offered was high or terms were fair but recommended the merger b/c they believed it to be the only way to stay on the board

d. COURT:i. Statements of opinion/reasons/beliefs may be

materially significant if there is substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote

1. They are statements of fact and characteristically matters of corporate record subject to documentation to be supported or attached by evidence

2. BUT proof of mere disbelief or belief undisclosed should NOT suffice for

liability under 14(a) need some sort of objective evidence that statement also expressly/impliedly asserted something false/misleading about subject matter

ii. Under Mills causation of damages by a material proxy misstatement could be established by showing that minority proxies necessary and sufficient to authorize corporate acts had been given in accordance w/ the tenor of the solicitation proxy solicitation as essential link in accomplishment of transaction

1. Rejects theory that causal connection exists on desire to avoid bad shareholder/public relations and stems from party’s apprehension of ill will

G. STATE DISCLOSURE LAW: FIDUCIARY DUTY OF CANDORi. Part of duty of loyalty

1. Duty not to lie to one to whom the duty extends ii. Make full disclosure of all material facts

1. Malone v. Brincat (DE 1998): involved false filings w/ the SEC and distribution of false financial statements to shareholders; court asserted that whenever directors communicate publicly or directly w/ shareholders about the corp’s affairs, w/ or w/out request for shareholder actions directors have a fiduciary duty to exercise care; good faith and loyalty; sine qua non of director’s fiduciary duty is honesty

a. Restricted to Ps who still held these shares VIII. NORMAL GOVERNANCE: DUTY OF CARE

A. INTRO TO DUTY OF CAREi. Fiduciary duties still present

1. Duty of obedience—fiduciary must act consistently w/ legal documents that created her authority

a. Directors must do the tasks assigned under corporate charter

2. Duty of loyalty—corporate fiduciaries must exercise authority in a good-faith attempt to advance corporate purposes

a. Bars officers/directors from competing w/ corporationb. Bars from appropriating its property, info or business

opportunities c. Bars D&O from transacting business w/ it on unfair

terms

3. Duty of care—parties must act w/ the care of an ordinarily prudent person in same/similar circumstances

B. DUTY OF CARE AND NEED TO MITIGATE DIRECTOR RISK AVERSION i. Directors also have duty of “reasonable diligence”

1. ALI’s Principles of Corporate Governance—corporate D&O must perform his/her functions

a. In good faithb. In a manner that (s)he reasonably believes to be in the

best interest of the corpc. With the care that an ordinarily prudent person would

reasonably be expected to exercise in a like position and under similar circumstances

d. Negligence rule prudent personi. Difference from regular torts—D&Os bear full

costs of any personal liability but receive only small fraction of gains from risky decision

1. Liability from flat-out negligence standard would predictably discourage officers/directors from undertaking valuable but risky projects

2. Gagliardi v. Trifoods Int’l (Del. Ch. 1996)a. QUESTION: what must shareholder plead in order to

state a derivative claim to recover corporate losses allegedly sustained by reason of mismanagement unaffected by directly conflicting financial interests

b. COURT: in absence of facts showing self-dealing or improper motive—corporate officer/director not legally responsible to the corp for losses that may be suffered as a result of a decision that the D&O made in GOOD FAITH

i. But some decisions may be so “egregious” that liability for losses they cause may follow even in the absence of proof of conflict of interest or improper motivation

1. Does NOT result in awards of money judgments against corporate D&Os

ii. Shareholders shouldn’t want their D&Os to be risk averse

1. If corporate directors were to be found liable for corporate loss from risky projects on ground the investment

were too riskyD&O liability would be joint and several

a. Only small probability of director liability based on negligence/waste could induce a board to avoid authorizing risky investment projects to any extent

b. Shareholders’ best economic interest to offer sufficient protection to directors from liability for negligence to allow directors to conclude as practical matter there is no risk if they act in good faith and meet minimal proceduralist standards of attention they can face liability as a result of business loss

iii. First protection against a threat of sub-optimal risk acceptance BJR

1. Where director is independent and disinterested there can be no liability for corporate loss UNLESS the facts are such that no person could possibly authorize such a transaction if (s)he were attempting in good faith to meet their duty

3. Protections of corporate D&Osa. Statutory law authorizes corps to indemnify the

expenses incurred by D&Os who are sued by reason of their corporate activities

i. DGCL 145b. Statutory law authorizes corps to purchase liability

insurance for their D&Os which may cover some risks that aren’t subject to indemnification

c. Courts evolved BJRd. Legislatures have specifically authorized companies to

waive DIRECTOR liability for acts of NEGLIGENCE or GROSS NEGLIGENCE

i. DGCL 102(b)(7)C. STATUTORY TECHNIQUES FOR LIMITING DIRECTOR AND OFFICER RISK EXPOSURE

i. Intro—BJR is most fundamental protection against liability for simple mistakes of judgment BUT

1. Indemnification/insurance is most reliable ii. Indemnification

1. Generally—most corporate statutes authorize corps to commit to reimburse any Agent, EE, Officer OR Director for REASONABLE expenses for losses of any sort (atty fees; investigation fees; settlements; sometimes judgments) arising from any actual or threatened judicial proceeding/investigation

a. BUT losses MUST result from actions undertaken on behalf of the corp in GOOD FAITH and CANNOT arise from criminal conviction

i. DGCL 145(a), (b), (c)2. Waltuch v. Conticommodity Services, Inc. (2d Cir 1996)

a. FACTS: Waltuch spent $2.2mil in unreimbursed legal fees to defend himself against numerous civil lawsuits and an enforcement proceeding brought by CFTC; seeks indemnification of legal expenses from fmr ER; Corp’s article of incorp doesn’t contain good faith requirement in its indemnification clause

b. COURT: subsections (a) and (b) of DGCL 145 expressly grant a corp the power to indemnify directors, officer, and others if they “acted in good faith and in a manner reasonably believed to be in or not opposed to the BEST INTERESTS of the corp”

i. Subsection (f) allows corp to grant additional rights but merely acknowledges that one seeking indemnification may be entitled to “other rights” doesn’t speak in terms of corporate power and cannot be read to free a crop from “good faith” limit explicitly imposed in (a) and (b)

ii. The corp’s article which would require indemnification of D&Os even if acting in bad faith is inconsistent w/ DGCL 145(a) and P was NOT entitled to indemnification

iii. 145(c): requires corps to indemnify officers/directors for “successful” defense of certain claimssuccess = vindication

1. Escape from adverse judgment even if it’s b/c of settlement of other parties

2. Once P achieved his settlement gratis he achieved success on merits and is entitled to indemnification under 145(c)

iii. Directors and Officers Insurance1. Liability insurance—designed to insulate D&Os from liability through

authorization of corps to pay premia on D&Os (DGCL 145(f))2. Insurance vs. forcing D&Os to buy their own insurance

a. Might be cheaper if corp acts as central bargaining agent for all D&Os

b. Uniformity has value in that it standardizes directors’ individual risk profiles in decision making and avoids potentially negative signaling that would arise from Ds having different level of coverage

c. Tax law may favor firm-wide insurance coverage since it’s deductible

d. Ds may under-invest in D&O insurance if left to themselves

D. JUDICIAL PROTECTION: BJRi. Core of BJR: courts shouldn’t second guess good faith decisions made by

independent and disinterested directors1. Courts won’t decide or allow jury to decide whether decisions of

corporate boards are either substantively reasonable by reasonable prudent person test or sufficiently well informed by the same test

ii. Kamin v. American Express Co (NY 1976)1. FACTS: complaint brought derivatively by 2 minority stockholders

asking for a declaration that certain dividend in kind is a waste of corporate assets, directing Ds not to proceed w/ distribution OR for monetary damages

a. Corp bought shares of company for $29.9mil and now worth $4 mil; Ds want to distribute special dividend of these shares; Ps think that if corp were to sell they’d sustain capital loss which could be offset against taxable capital gains and would result in tax savings of $8mil

2. COURT: allegations go to question of exercise by Bd of Directors of business judgment

a. No claim of fraud/self-dealing; no claim of bad faith; oppressive conduct

b. Courts will NOT interfere unless powers of D&O have been illegally or unconscientiously execute OR unless it be made to appear that the acts were fraudulent or collusive and destructive of shareholders’ rights

i. Mere errors in judgment are NOT sufficient grounds for equity interference, for powers of those entrusted w/ corporate management are largely discretionary

1. Whether or not dividend to be distributed—exclusively a matter of BJ

c. Courts will only become involved if directors have acted or about to act in bad faith and for dishonest purpose

d. Not enough to allege that D&O made imprudent decision which didn’t capitalize on possibility of using potential capital loss to offset capital gains

e. Furthermore—all directors have an obligation using sound business judgment to maximize income for the benefit of all persons having a stake in the welfare of the corporate entity

i. That they may be mistaken or other courses of action may have differing consequences or that action might benefit some shareholders more than others presents no basis for judicial judgment SO LONG AS it appears directors have been acting in good faith

f. Court won’t interfere unless clear case is made out of fraud; oppression; arbitrary action; breach of trust

iii. Understanding BJR1. B/c it’s state law based no single canonical statement of BJR

a. ABA Corporate Director’s Guidebook decision constitutes a valid BJ and gives rise to no liability for ensuing loss when :

i. Made by financially disinterested directors or officers;

ii. Who have become duly informed before exercising judgment and

iii. Who exercise judgment in good faith effort to advance corporate interests

b. Disinterested directors who act deliberately and in good faith should never be liable for resulting loss no matter how stupid their decisions may seem ex post

2. Why have BJR?a. When courts invoke it converting what would be

question of fact (whether financially disinterested directors who authorized this money-losing transaction exercised same care as reasonable person would in

similar circumstances) into a question of law for court to decide

b. Convert the question “was the standard of care breached?” into related but different questions of whether the directors were truly disinterested/independent and whether their actions weren’t so extreme/unconsidered/inexplicable as NOT to be exercise of good-faith judgment

iv. Duty of Care in Takeover Cases Van Gorkom1. Smith v. Van Gorkom (DE S.Ct. 1985): arose from agreement b/w Trans

Union Corp and corp controlled by Pritzker familya. Trans Union had substantial net operating loss (NOL)

that could for a ltd number of years be used to reduce current taxable income

b. Van Gorkom—CEO—arranged merger agreement w/ Pritzker’s entity who offered $20/share MORE than selling price board approved transaction and certain deal protection features in merger agreement

c. COURT held that Trans Union directors had been grossly negligent in their decision making and couldn’t claim protection of BJR

d. First DE case to actually hold directors liable for breach of the duty of care in a case in which bd had made business decision

v. Additional Statutory Protection: Authorization for Charter Provisions Waiving Liability for Due Care Violations

1. Reaction to Van Gorkom enactment of section 102(b)(7) of DGCLa. Validated charter amendments that provide a corporate

director has NO liability for losses caused by transactions in which the director had NO conflicting financial interest or otherwise alleged to violate duty of loyalty

b. Viewed as screening out some or all shareholder suits based on duty of care allegations

E. DE’S UNIQUE APPROACH TO ADJUDICATING DUE CARE CLAISM AGAINST CORPORATE DIRECTORS: FROM TECHNICOLOR TO EMERALD PARTNERS

i. NOTE: section 102(b)(7) waivers are directed at DAMAGE claims directors’ duty of care can still be basis for an equitable order such as injunction

1. Shareholders able to seek to enjoin transaction as a result of a breach of care by disinterested directors and should they do so—DE adopted unique approach to adjudicating such claims

2. Cede & Co. v. Technicolor Inc (Cede II) (DE 1993): Ron Perelman acquired Technicolor in transaction characterized by arguable breaches of duty of care by Technicolor’s Bd; DE S.Ct. found that breach of the duty of care WITHOUT any requirement of proof of injury is sufficient to rebut BJR

a. Breach of loyalty/duty rebuts presumption that directors acted in best interests of shareholders and requires directors to prove transaction to be entirely fair

b. ENTIRE FAIRNESS DOCTRINE 3. Malpiede v. Towson (DE 2001): when a corp has a 102(b)(7) provision

in its charter and the P files a complaint that only contains a duty of care claim court should dismiss the complaint

a. MUST allege breach of the duty of loyalty in order to survive motion to dismiss when company has 102(b)(7) provision

i. BUT these must be PARTICULARIZED FACTS supporting duty of loyalty in order for claims to proceed to trial

4. Emerald Partners v. Berlin (DE 2000): once Ps have overcome presumptions of BJR—section 102b7 offers less protection to D directors

a. Correct standard of review for a transaction in which a controlling shareholder is interested is entire fairness

b. NOTE: court said that if D directors had not met their burden of demonstrating entire fairness that they could avoid personal liability for paying monetary damages only if they have established their failure to withstand an entire fairness analysis is exclusively attributable to a violation of duty of care

F. BD’S DUTY TO MONITOR: LOSSES “CAUSED” BY BOARD PASSIVITY i. Note: BJR protects boards that have made decisions liability on directors for

breach of duty of car usually are ones in which directors simply failed to do anything under circumstances in which it’s later determined that a reasonably alert person would’ve taken action

1. Actual liability is more likely to arise from a failure to supervise/detect fraud than from erroneous business decision

ii. Majority View: minimum objective standard of care for directors1. Cannot abandon their office but must make good faith attempt to do a

proper job iii. Francis v. United Jersey Bank (NJ 1981):

1. FACTS: principal claim was that wife of deceased director was negligent in conduct of her duties as succeeding director of the corp

2. COURT : generally directors accorded broad immunity and are not insurers of corporate activities determination of liability for nonfeasance by a director and the losses caused by acts of insiders requires finding director had a duty, breached that duty and duty was proximate cause of losses

a. B/c directors are bound to exercise ordinary care can’t set up as a defense lack of knowledge needed to exercise requisite degree of care

b. Directors under continuing obligation to keep informed about activities of the corp = general monitoring of corporate affairs/policies

i. Advised to regularly attend board meetings—if absent from bd meeting director presumed to concur in action taken in corporate matter unless files dissent w/in reasonable time of learning of such action

ii. Directors to maintain familiarity w/ financial status of the corp by regular review of financial statements

c. Generally—directors immune from liability if in good faith they rely upon the opinion of counsel for the corporation or upon written reports setting forth financial data concerning the corp and prepared by independent public accountant/CPA or upon financial statements/books of account/reports of corp represented to them to be correct by the president, officer of corp having charge of its books of account or person presiding at meeting

i. Upon discovery of an illegal course of action—director has duty to object and if corp doesn’t correct conduct duty to resign

d. Analysis in negligent omissions—to be liable—negligence must have been proximate cause of loss which calls for determination of the reasonable steps a director should’ve taken and whether that course of action would’ve averted the loss

e. Where it’s reasonable to conclude that the failure to act would produce a particular result and that result occurred causation may be inferred

iv. In general—board of public companies have particular obligation to monitor firm’s financial performance, integrity of financial reporting, compliance w/ law, its management compensation and succession planning

1. Monitor largely through reports 2. Board authorizes only most significant corporate acts/transactions—

other decisions made by officers/employees w/in interior of organization

3. Graham v. Allis-Chalmers Manuf. Co. (Del 1963):a. FACTS: derivative action against directors and 4 non-

director EEs based upon pleas of guilty to indictments by the corp on anti-trust violations

i. B/c there was no evidence that any director had actual knowledge of anti-trust activity or facts which should’ve put them on notice that anti-trust activity was being carried on, Ps argue that they’re liable b/c of failure to take action designed to learn of and prevent anti-trust activity on part of any EEs

b. COURT: directors entitled to rely on the honesty and integrity of their subordinates until something occurs to put them on suspicion that something is wrong

i. If such occurs and goes unheeded then liability for directors might follow

1. BUT absent cause for suspicion there is NO duty upon directors to install/operate a corporate system of espionage to ferret out wrongdoing in which they have no reason to suspect exists

ii. Liability for losses through neglect of duty determined by circumstances—if corporate director recklessly reposed confidence in untrustworthy EE, ignored willfully or was inattentive to danger sign of EE wrongdoing he’ll be liable

1. HERE: as soon as wrongdoing became evident—board acted promptly to end it

v. NOTE: Federal Organizational Sentencing Guidelines1. US Sentencing Commission adopted Organizational Sentencing

Guidelines in 1991—set forth uniform sentencing structure for

organizations convicted of federal criminal violations and provided for penalties that generally exceed those previously imposed on corps

a. Powerful incentives for firms to put compliance programs in place, report violations of law promptly and to make remediation efforts

i. Organization that satisfies conditions of compliance programs, etc. will receive much lower fine

vi. Only a sustained or systematic failure of the board to exercise oversight will establish lack of good faith necessary to condition liability

1. Caremark a. Caremark duty: reasonable steps to see the corp has in

place an information and control structure designed to offer reasonable assurance that the corp is in compliance w/ the law

2. BUT—courts won’t impose oversight liability on directors for failure to monitor “excessive” risk

a. Citigroup, infra3. Caremark Int’l Derivative Litigation (Del Ch 1996):

a. FACTS: claims that members of Caremark’s board of directors breached their fiduciary duty of care to Caremark in connection w/ alleged violations by Caremark EEs of federal/state laws and regulations

i. Caremark had an internal audit plan in place to assure compliance w/ business and ethics policies of which the Board knew about BUT complaint charges director Ds w/ breach of their duty of attention or care in connection w/ the on-going operation of the corp’s business

1. Claim the board allowed situation to develop and continue which exposed the corp to enormous legal liability and that in doing so they violated duty to be active monitors of corporate performance does NOT charge loyalty type problems

b. COURT: i. director liability for breach of the duty to

exercise appropriate attention may arise in 2 contexts:

1. From Bd decision that results in a loss b/c that decision was ill advised or negligent

2. Loss that arises from unconsidered inaction

ii. Board must exercise good faith judgment that the corp’s info and reporting system is in concept and design is adequate to assure the board that appropriate info will come to its attention in a timely manner as a matter of ordinary operations

iii. Generally where a claim of directorial liability for corporate loss is predicated on ignorance of liability creating activities w/in the corp—only a sustained or systematic failure of the board to exercise oversight will establish lack of good faith necessary to condition liability

4. Sarbanes-Oxley Act of 2002: a. Section 404 requires CEO and CFO of firms w/ securities

regulated under Sec. and Exchange Act of 1934 to periodically certify that they have disclosed to company’s independent auditor all deficiencies in design/operation

5. Stone v. Ritter (DE S.Ct. 2006): endorsed/clarified Caremarka. Necessary conditions predicate for director oversight

liability i. Directors utterly failed to implement any

reporting or information system/controls; ORii. Having implemented such a system or controls,

consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks/problems requiring their attention

b. Either case—liability requires showing that directors KNEW they weren’t discharging fiduciary obligations

6. In Re Citigroup Inc. Shareholders Derivative Lit (De. 2009): a. FACTS: Ps alleged that Ds breached fiduciary duties by

failing to properly monitor/manage the risks the company faced from problems in subprime lending market and for failing to properly disclose Citigroup’s exposure to subprime assets (subprime lenders and whatnot)

b. COURT: typical Caremark case – Ps argue that Ds are liable for damages that arise from a failure to properly monitor or oversee EE misconduct or violations of law

i. HERE: Caremark claims are based on Ds’ alleged failure to properly monitor the business risks-specifically exposure to subprime mortgage market

1. Ps point to so-called red flags that should’ve put Ds on notice of problems in subprime mortgage market

ii. Court finds that P shareholders are attempting to hold director Ds personally liable for making business decisions that in hindsight turned out poorly for corp

iii. BJR: presumption that in making a business decision the directors of a corp acted on an informed basis, in good faith and in honest belief that the action taken was in the best interest of the company

1. Burden on Ps to rebut this2. Absent an allegation of interestedness

or disloyalty to the corp—BJR prevents judge/jury from second guessing director decisions IF they were product of rational process AND directors availed themselves of all material and reasonably available info

3. NOTE: standard of director liability under BJR GROSS NEGLIGENCE

iv. ALSO—Corp adopted provision under 102b7 exculpating the directors from personal liability for violations of fiduciary duty except for breaches of duty of loyalty/actions/omissions not in good faith etc.

1. b/c they’re exculpated for certain conduct serious threat of liability may only be found to exist IF Ps plead non-exculpated claim against them based on particularized facts

v. Difference in business risk and actual wrongdoings w/in the company

1. To impose oversight liability on directors for failure to monitor “excessive” risk would involve courts in conducting hindsight evaluations of decisions at the heart of BJR

IX. CONFLICT TRANSACTIONS: DUTY OF LOYALTYA. INTRO:

i. Duty of loyalty requires a corporate director/officer/controlling shareholder to exercise institutional power over corporate processes or property (including info) in a good-faith effort to advance the interests of the company

1. Requires that such a person who transacts w/ the corp to fully disclose all material facts to the corp’s disinterested reps and to deal w/ company on terms that are intrinsically fair in all respects

2. May NOT deal w/ corp in any way that benefits themselves at the corp’s expense

B. DUTY TO WHOM?i. Short answer—to corp as a legal entity

1. but corp has multiple constituencies w/ conflicting interests including stockholders, creditors, EEs suppliers and customers

ii. Shareholder Primacy Norm1. Loyalty to corp = loyalty to equity investors 2. Competing norm of shareholder primacy directors must act to

advance the interests of all constituencies in corp, NOT just shareholders

3. A.P. Smith Manufacturing Co v. Barlow (NJ 1953)a. FACTS: shareholders object to Board’s contribution to

Princeton b. COURT: C/L rule—those who managed the corp couldn’t

disburse any corporate funds for philanthropic or other worthy public cause UNLESS expenditure would benefit the corp

i. Good public policy to help out institutions of higher learning and is truly beneficial to corp

ii. No suggestion of indiscriminate giving or that it was pet charity in furtherance of personal rather than corporate ends

iii. Constituency Statutes1. Duty to the entire corp came out of the 1980s hostile takeover era

2. Directors have power to balance interest of nonshareholder constituencies against the interests of shareholders in setting corporate policy

a. B/c nonshareholders often adversely affected in hostile takeovers

C. SELF-DEALING TRANSACTIONSi. Directors/corporate officers may NOT benefit financially at expense of the corp in

self-dealing transactions ii. Early regulations

1. By 1900s-- courts would uphold a K b/w a director and the corp if it was (1) fair and (2) approved by a board comprised of majority of disinterested directors

a. K that didn’t meet both tests = voidable iii. The Disclosure Requirement

1. Valid authorization of a conflicted transaction b/w director and her company requires the interested director to make full disclosure of all material facts of which she’s aware at the time of authorization

2. State Ex Rel. Hayes Oyster Co v. Keypoint Oyster (Wash 1964)a. FACTS : Ps assert that Coast’s president, mgr, director

acquired a secret profit and personal advantage to himself in an acquisition of stock through a side deal and that such was in violation of his duty to the company

b. COURT: directors and other officers of a private corp cannot directly or indirectly acquire a profit for themselves or acquire any other personal advantage in dealings w/ others on behalf of the corp

i. A K that involving corporate property in which a director has an interest can’t be voidable if the director/officer can show that the transaction was fair to the corp

1. BUT nondisclosure by an interested director is in itself unfair

2. HERE: Cost shareholders/directors had the right to know of Hayes’ interest in other company in order to intelligently determine the advisability of retaining Hayes as pres/mgr under circumstances and whether it was wise to enter into K at all in view of his conduct entitled to know that their pres/director might

be placed in position where he must choose b/w interest of companies

ii. Not necessary for D&O to have intent to defraud or that an injury result to the corp for a D&O to violate fiduciary obligation in secretly acquiring an interest in corporate property

1. Law won’t let an agent put himself in a situation in which he may be tempted by his own private interest to disregard that of principal

3. NOTE on Disclosure of Conflicted Transactions a. DE’s legal standard for disclosure by a conflicted

fiduciary is that a director or controlling shareholder must disclose ALL material info RELEVANT to the transaction

b. DE courts encourage use of special committees of independent directors to simulate arm’s-length negotiations

iv. Controlling Shareholders and Fairness Standard1. Practical test of fiduciary duties

a. Shareholder w/ less than 50% of the outstanding voting power of the firm MAY have a fiduciary obligation by reason of the exercise of corporate control

b. Shareholder w/ 50% or more of the vote will probably owe such a duty despite evidence that it didn’t in fact exercise control

2. Consensus in US that controlling shareholders owe a duty of fairness to minority of shareholders in exercise of corporate powers

a. BUT controller is also a shareholder and is entitled to pursue her own investment interests

i. Dominant value—controlling shareholder’s power over the corp and the resulting power to affect other shareholders gives rise to a duty to consider their interests fairly whiner the corp enters into a K w/ controller or its affiliate

1. Governs when controlling shareholder engages in conflicted transaction w/ corp

ii. Subsidiary value is entitlement of all shareholders—even controlling shareholders—to vote in their own interests

3. Sinclair Oil Corp v. Levien (Del 1971)

a. FACTS: Sinclair operated as holding company and owned 97% of Sinven’s stocks which was its subsidiary whose board of directors were officers/directors/EEs of corps in Sinclair complex Ps sought action requiring Sinclair to account for damages sustained by Sinven

i. Sinven paid out dividends of over $38mil in excess of earnings in times when Sinclair need cash

b. COURT: when situation involves a parent and a subsidiary with the parent controlling the transaction/fixing the terms the test of intrinsic fairness under which burden is on corp to prove its transactions were objectively fair

i. Basic situation is one in which parent received benefit to exclusion/expense of subsidiary

1. Parent owes fiduciary duty to subsidiary but that alone isn’t enough to invoke intrinsic fairness

ii. Intrinsic fairness standard applied only when fiduciary duty is accompanied by self-dealing when parent is on both sides of a transaction w/ its subsidiary

1. Self-dealing occurs when the parent, by virtue of its domination of the subsidiary, causes the subsidiary to act in such a way that the parent receives something from the subsidiary to the exclusion of and detriment to the minority stockholders of the subsidiary

iii. Although dividends were excessive—proportionate share was received by minority stockholders and Sinclair received nothing from Sinven to the exclusion of minority stockholders NOT self-dealing and BJR should’ve applied

iv. Motives are immaterial UNLESS P can show that the dividend payments resulted from improper motives and amounted to waste

D. EFFECT OF APPROVAL BY DISINTERESTED PARTYi. Safe harbor statutes—

1. Initially sought to permit boards to authorize transactions in which a majority of directors had an interest

a. Director’s self-dealing transaction isn’t voidable SOLELY b/c it’s interested so long as it’s adequately disclosed AND approved by a majority of disinterested directors/shareholders OR it’s fair

i. DGCL 144 2. Cookies Food Products v. Lakes Warehouse (Iowa 1988)

a. FACTS: derivative suit brought by minority of shareholders of closely held Iowa corp specializing in barbeque sauce; Ps allege that majority shareholder by acquiring control of Cookies and executing self-dealing Ks breached his fiduciary duty to the company and fraudulently misappropriated and converted corporate funds—part of this was his compensation

b. COURT: directors who engage in self-dealing must show disclosure/authorization as well as good faith/honesty/fairness

3. Requiring fairness in addition to approval by disinterested board after full disclosure conforms w/ safe harbor statutes under DGCL 144(a); NY and CA statutes

a. Approval of an interested transaction by a fully informed board has the effect of only authorizing the transaction NOT of foreclosing judicial review of fairness

b. DE law—approval by disinterested directors merely shifts the burden of proving fairness in a controlled transaction to the P challenging the deal –does NOT transform standard into BJR

4. Cooke v. Oolie (DE 2000)a. FACTS: issue was whether 2 director Ds breached their

fiduciary duty of loyalty by electing to pursue a particular acquisition proposal that allegedly best protected their personal interests as company creditors rather than pursue other proposals that allegedly offered superior value to shareholders

b. COURT: begin w/ presumption BJ applies to decision to pursue acquisition Ps bear burden of rebutting presumption that BJR applies

i. (NOTE: DGCL 144 safe harbor doesn’t apply b/c directors Ds weren’t on both sides of transaction or didn’t have interest in acquiring company)

ii. Under DE law BJR will be applied to actions of an interested director who is NOT majority

shareholder if the interested director fully discloses his interest and a majority of disinterested directors ratify interested transaction ratification cleanses the taint of interest b/c they have no incentive to act disloyally and should be concerned only w/ company

iii. HERE: disinterested directors’ votes implicate BJR

ii. Approval by Special Committee of Independent Directors 1. Parent companies have clear obligation to treat subsidiaries fairly

a. Special committee of disinterested independent directors most common technique employed to assure appearance and reality of fair deal

2. To be given effect under DE law special committee must bea. Properly charged by the full board

i. Must understand mission is not only to negotiate a fair deal but also to obtain best available deal

b. Comprised of independent membersc. Vested w/ resources to accomplish its task

3. Courts likely to be skeptical of any deal forced on minority shareholders w/out committee’s approval

4. Committee process shifts burden of proving fairness from D to the Pin a controlled transaction

iii. Shareholder Ratification of Conflict Transactions 1. Agency law—principal can adopt an agent’s unauthorized acts through

ratification 2. Corporate law—shareholders may ratify acts of the board BUT issues

arise due to shareholders’ collectivity that don’t present in agency model

a. Law must limit the power of an interested majority of shareholders to bind a minority that is disinclined to ratify a submitted transaction

b. Power of shareholders to affirm self-dealing transactions is limited by the corporate “waste” doctrine which holds that even a majority vote CANNOT protect wildly unbalanced transactions that on their face irrationally dissipate corporate assets

3. Lewis v. Vogelstein (De 1997)

a. COURT: in case of shareholder ratification—no single individual acting as principal but a class/group of divergent individuals, shareholders

i. Some portion of body doing the ratifying may have conflicting interests in the transaction and some dissenting members may be able to assert more/less convincingly the “will” of principal is wrong/corrupt/shouldn’t be binding

ii. Shareholder ratification may be held to be ineffectual (1) b/c majority of those affirming had conflicting interest w/ respect to transaction or (2) b/c the transaction that is ratified constituted a corporate waste

1. Waste may not be ratified except by unanimous vote

iii. Informed/uncoerced/disinterested shareholder ratification of a transaction in which corporate directors have a material conflict of interest has effect of protecting transaction from judicial review except on basis of waste

1. Waste—exchange of corporate assets for consideration so disproportionately small as to lie beyond range at which any reasonable person might be willing to trade

a. Transfer of assets that serves no corporate purpose/no consideration received

4. In re Wheelbrator Tech (Del Ch 1995)a. FACTS: brought by shareholders of company bought in

merger claiming their directors breached duties of care and loyalty

b. COURT: in no case has S.Ct. of DE held that stockholder ratification automatically extinguishes a claim for breach of loyalty it either changes the standard of review to BJR w/ burden on P OR to leave entire fairness as standard w/ burden on p

i. 2 kinds of ratification decisions that involve duty of loyalty

1. Interested transaction cases b/w corp/directors

a. Won’t be voidable if it is approved in good faith by majority of disinterested stockholder

b. Invokes BJR and limits review to issues of gift/waste w/ burden on P

2. Interested transactions b/w corp and controlling shareholder

a. Primarily parent-subsidiary mergers that were conditioned upon receiving majority of minority stockholder approval

b. Ordinarily entire fairness in parent-sub merger w/ directors having burden of proving entire fairness

c. But where conditioned upon approval and such approval granted—remains entire fairness but w/ P having burden of proving unfairness

E. DIRECTOR AND MGMT COMPENSATIONi. Disney Decision

1. Disney recruited Michael Ovitz to become President; day he did—stock rose 4.4% increasing Disney’s market capitalization by more than $1bilion

2. He was then fired w/out cause trigger $38 mil severance payments under employment agreement plus accelerated vesting of options which resulted in a sum of $140 million in compensation for 15 mos. as pres

3. Ps brought suit on behalf of corp claiming that Disney directors breached their duty of care in approving Ovitz’s employment agreement and severance payment to Ovitz constituted waste

4. In re Walt Disney Co. Derivative Lit (Del 2005)a. COURT: to rebut presumption of BJR—Ps must prove by

PofE that the presumption of the BJR doesn’t apply either (1) b/c the directors breached their fiduciary duties, (2) acted in bad faith or (3) directors made unintelligent or unadvised judgment by failing to inform themselves of all material info reasonably available to them before making business decision

i. If p can’t rebut BJR-Ds prevailii. If Ps can rebut BJR—Ds have burden of proving

entire fairness iii. Ordinary negligence insufficient to constitute a

violation of the fiduciary duty of care (particularly under 102b7)

iv. Found directors each acted in good faith w/ the subjective belief that those actions were in best interests of company

v. B/c Eisner had authority to act alone in terminating Ovitz—the board didn’t breach fiduciary duties and didn’t act in bad faith in connection w/ his termination by not acting

1. Eisner too acted in good faith in terminating—tried to get him fired for-cause, contemplated best alternatives and determined best decision as termination

vi. NOTE: in dicta—actual intent to do harm is quintessential “bad faith” while grossly negligent conduct w/out malevolent intent can’t constitute it; also—left open question of whether duty of good faith is independent duty

1. Stone v. Ritter—it’s not a. Bad faith essential to establish

director oversight liability – which is violation of duty of loyalty

b. Only duty of care/loyalty may directly result in liability

5. Understanding Dutiesa. Most basic duty of every fiduciary duty to exercise

good faith in an effort to understand and to satisfy the obligations of the office

b. All fiduciary offices require fiduciary to avoid unfair self-dealing and to exercise power for the purpose of the institution And NOT for fiduciary’s personal benefit

i. All require attention to the roleii. Predicate duty of good faith—may be seen as

simply higher level of abstraction of fiduciary obligations of care/loyalty

c. Why even need good faith?

i. 102(b)(7) of DE statute1. Stemming from Van Gorkom2. Corporate charter may waive director

liability to the corp for damages except for among other things damages in connection w/ breach of loyalty (financial conflict sense) and for acts/omissions not in good faith (bad faith is not gross negligence)

a. Under most conceptions of loyalty though acts not in good faith would constitute a breach

3. Disney establishes there can be level of director neglect/inattention that might lead a court to find that directors weren’t seriously trying to meet their duty in which case 102b7 might not protect

d. Formal structure of director liability for inattentioni. Mere director negligence—lacking that degree

of attention that a reasonable person in the same/similar situation would be expected to pay to a decision—doesn’t give rise to liability

1. BJR forecloses liability and generally permits dismissal at motion to dismiss phase

2. Gagliardi; American Expressii. Facts that establish gross negligence (Van

Gorkom ) may be basis for breach of duty finding and result in liability for any losses in that result

1. BUT under 102b7—such liability for gross negligence alone can be waived through shareholder approved amendment to charter

iii. Waivers may NOT waive liability that rests in part upon breach of loyalty and is extended to acts/omissions not in good faith

1. Director’s inattention so profound that court concluded that directors lacked good faith

2. Neither BJR nor waiver will protect D from liability

F. CORPORATE OPPORTUNITY DOCTRINEi. When may a fiduciary pursue business opportunity on her own account if the

opportunity might arguably belong to the corp1. When is opportunity “corporate” rather than personal and hence off-

limits to corp’s mgrs.2. Contrast w/ self-dealing case where issue is whether self-dealing

transaction violates duty of loyalty rather than whether a given transaction is “interested” in the first instance

ii. Determining which opportunities belong to the corp1. 3 general lines of corporate opportunity doctrine

a. Cases that tend to give narrowest protection to the corp by applying an “expectancy or interest” test

i. Lagarde v. Anniston Lime & Stone—expectancy/interest must grow out of an existing legal interest and the appropriation of the opportunity will in some degree “balk the corp in effecting the purpose of its creation”

ii. Practical business expectancy b. “Line of Business” Test

i. Classifies any opportunity falling w/in company’s line of business as corporate opportunity

ii. Anything the corp could be reasonably expected to do = corporate opportunity

iii. Factors:1. How matter came to attention of

Director/officer/EE2. How far removed from “core economic

activities” of the corp the opportunity lies

3. Whether corporate info is used in recognizing or exploiting the opportunity

c. Fairness test—i. Look to factors such as how mgr learned of

disputed opportunity, whether he/she used corporate assets in exploiting the opportunity and other fact-specific indicia of good faith/loyalty to corp, in addition to corp’s line of business

iii. When may a Fiduciary Take a Corporate Opportunity?1. Some courts—may take IF corp isn’t in financial position to do so

a. Incapacity related to disinterest and implies corp’s board determined not to accept the opportunity

2. Most courts accept board’s good-faith decision not to pursue an opportunity as a complete defense to a suit challenging a fiduciary’s acceptance of a corporate opportunity on own account

a. As long as decision to to accept is genuine BJ of disinterested decision maker

b. Fiduciary bears this burden of proving defense 3. Presenting a business opportunity to the board isn’t required under DE

lawa. DE: presenting opportunity to bd simply provides a kind

of safe harbor for the director which removes specter of post hoc judicial determination that D or O improperly usurped corporate opportunity

b. 122(17) of DE corporate code explicitly authorizes waiver in charter of corporate opportunity constraints for officers, directors, shareholders

4. Dreamworks Charter, Casebook pg 350X. SHAREHOLDER LAWSUITS

A. INTRO: i. Two principal forms of shareholder suits

1. Derivative suitsa. Assertion of corporate claim against an

officer/director/third party which charges them with wrong to the corp

b. Only derivatively harms shareholdersc. 2 suits in one

i. Against directors charging them w/ improperly failing to sue on the existing corporate claim

ii. Underlying claim of the corp itself1. Typically allege that corp’s directors

have failed to vindicate its claims b/c they themselves are wrongdoers and would be Ds in resulting suit

2. Direct actions—normally brought as class actionsa. Many individual or direct claims that share common

aspectsb. Recover damages suffered by individuals directly (or to

prevent injury to these individuals) b/c they’re shareholders

ii. Distinguishing between direct and derivative claims1. Most often – breaches of corporate law obligations arise in context of

derivative suits2. BUT numerous suits arising out of federal securities law are direct

actions injury alleged to personal interest rather than corporate interest

a. NOTE: often same behavior that gives rise to a derivative suit can also support a class action alleging securities fraud

3. Derivative suit advances a corporate claim any recovery should go directly to the corp itself

a. Derivative suits have number of special procedural hurdles designed to protect bd of directors’ role as primary guardian of corporate interests

i. May be dismissed if it doesn’t satisfy rule 23.1 of FRCP

4. Derivative Suits AND Class Actiona. Require Ps to give notice to absent interested partiesb. Permit other parties to petition to join in the suit c. Provide for settlement and release only after notice,

opportunity to be heard and judicial determination of fairness of settlement

d. Successful Ps customarily compensated from fund that efforts produce

e. NOTE statistics page 3655. Tooley v. Donaldson, Lufkin and Jenrette (Del 2004):

a. FACTS: suit brought by minority shareholders as class/direct action alleging that the board had breached fiduciary duty to them by agreeing to a 22 day delay in closing proposed cash merger claimed extension of time to close deprived them of the time value of the merger proceeds for the period of the delay

b. COURT: dismissed the claim; i. Test for determining derivative or direct—

1. Who suffered the alleged harm? (corp or suing shareholders)

2. Who would receive the benefit of any recovery or other remedy? (corp or stockholders individually)

ii. No claim stated b/c shareholders had no individual right to have merger occur at all

B. SOLVING A COLLECTIVE ACTION PROBLEM: ATTORNEY’S FEES AND THE INCENTIVE TO SUE

i. Problem of collective action associated w/ dispersed share ownershipii. Where all investors hold small stakes in enterprise—no single investor has strong

incentive to invest time/money into monitoring management 1. Derivative/class suits won’t be practical if shareholders have no

individual economic incentive to expend the time/money necessary to prosecute

a. Solution—attorneys’ fees to Ps whose litigation created a common fund that benefited others as well as P

b. When derivative succeeds on the merits or settles (usual outcome) the corp is said to benefit from any monetary recovery or governance change resulting from the litigation

iii. Fletcher v. AJ Industries Inc (Cal 1968)1. FACTS: settlement came out of derivative suit w/ agreement that 4

directors to be replaced and stockholder’s voting power limited; reorganization of corp’s board of directors and mgmt.

a. Stipulation in agreement stated Ps’ atty could only be awarded fees in even corp received monetary award

2. COURT: under American rule—party prevailing in an action may not recover atty fees unless a statute expressly permits such

a. Exception—Common-Fund doctrinei. Where a common fund exists to which a

number of persons are entitled and in their interest successful litigation is maintained for its preservation and protection – an allowance of counsel fees may properly be made from such fund

ii. “Substantial benefit” rule—successful P in stockholder’s derivative action may be awarded atty fees against the corp IF the corp received substantial benefits from the litigation although the benefits weren’t “pecuniary” and the action hadn’t produced a fund from which they might be paid

b. Substantial benefits—i. Results of the action maintain the health of the

corp and raise the standards of fiduciary relationships and of other economic behavior OR prevent an abuse which would be prejudicial to the rights/interests of the corp or affect the enjoyment or protection of an essential right to stockholder’s interest

iv. Agency Costs in Shareholder Litigation 1. One problem w/ derivative suits

a. Ps’ lawyers may initiated so-called strike suits—or suits w/out merit simply to extract a settlement by exploiting the nuisance value of litigation and the personal fears of liability even if unfounded on D&Os

2. Another problem—a. Corporate D may be too eager to settle b/c they bear at

least some of the costs of litigation personally (pain of depos, risk of personal liability) but they don’t bear costs of settling which is borne by corp or its insurer

3. Lodestar formula—a. Pays atty a base hourly fee for reasonable time

expended on a cast inflated by a multiplier to compensate for unusual difficulty or risk

4. Auction—some courts have experimented w/ auctioning the rights to represent the corp to the law firm that makes the best bid

5. Federal Private Securities Litigation Reform Act (PSLRA) of 1995a. Embraces variety of devices to discourage

nonmeritorious suits such as particularized pleading requirements and changes in substantive law; most adequate P rule

b. Minor speed-bump for Ps lawyers on way to court house but stock market volatility and good corporate governance are more important drivers

C. STANDING REQUIREMENTSi. Screen who may bring a derivative suit—established by court and statute

1. RMBCA 7.41; FRCP 23.1ii. DE (and FRCP 23.1)

1. P must be a shareholder for the duration of the action2. P must have been a shareholder at the time of the alleged wrongful

act or omission3. P must be able to fairly and adequately represent the interests of the

shareholders no obvious conflicts of interests4. Complaint must specify what action the P has taken to obtain

satisfaction from company’s board or state w/ particularity the P’s reason for not doing so

D. BALANCING THE RIGHTS OF BOARDS TO MANAGE THE CORP AND SHAREHOLDERS’ RIGHTS TO OBTAIN JUDICIAL REVIEW

i. Questions Arising from Derivative Suits1. When a shareholder-P has made a presuit demand on the board

under 23.1 but board has refused to bring the suit court must

decide whether or not to defer to board’s BJ in electing not to prosecute the action

2. When shareholder-P does NOT make demand on the bard on the ground that the board couldn’t exercise disinterested BJ court must pass on the validity of the P’s excuse for not making a presuit demand

3. Another question of board deference when board seeks to terminate derivative suit at a later point in litigation after suit has survived motion to dismiss—may be capable of exercising its BJ over the action usually b/c new directors have joined the board and should, arguably, be able to reclaim its power to direct company’s litigation strategy

ii. Demand Requirement of Rule 231. Originates in traditional rule that derivative complaint must allege w/

particularity the efforts if any made by P to obtain the action he desires from directors or comparable authority or the grounds for not making the effort

2. Levine v. Smith (Del 1991): a. FACTS: shareholders of GM brought several derivative

suits involving transaction by which Ross Perot—director of GM and largest shareholder—and others sold back to GM their holdings in exchange for $743million resulted from a buy-back which was approved by full board which Perot didn’t attend, in exchange for covenant not to compete and not publicly criticize the company

b. COURT: requirements of demand futility and wrongful refusal of demand are predicated upon and inextricably bound to issues of BJ and the standards of that doctrine’s applicability

i. Claim of demand futility—whether the threshold presumptions of director disinterests or independence are rebutted by well-pleaded facts; and if not, whether the complaint pleads particularized facts sufficient to create a reasonable doubt that the challenged transaction was the product of a valid exercise of BJ

1. Premise of demand futility claim—majority of the board of directors either has financial interest in the challenged transaction or lacks independence or otherwise failed to exercise due care

a. On either showing—may be inferred that the Board is incapable of exercising its power/authority to pursue the derivative claims directly

b. When lack of independence is charged—P must show the board is either dominated by an officer/director who is the proponent of challenged transaction OR that the Board is so under his influence that discretion is sterilized

c. If can’t prove interest/incapability of exercising independent BJ particularized facts must be plead creating reasonable doubt as to soundness of challenged transaction sufficient to rebut the presumption that BJR attaches

ii. Ps’ claims of lack of independence rested on evidence that at most 2 of GM’s 14 outside directors may have been interested which left 12 impartial ones

1. Conclusory statements of compromised independence were unsupported by particularized facts and were inadequate to establish board domination/control

iii. GM had special review committee that had no allegations of dominance/control by mgmt.

1. Further adding to lack of particularized pleadings

3. Presuit Demanda. ALI rule of universal demand P would be required to

always make a demand and if, as likely would be the case, she’s unsatisfied w/ board’s response to demand—could institute suit

i. If Ds thereafter sought dismissal of the suit—court would review board’s exercise of business judgment in making response

1. If court concluded board was in position to exercise valid BJ on the question of whether suit would be brought—dismissal

2. Otherwise—continue to its meritsb. DE S.Ct.: universal nondemand

i. Whenever P does make presuit demand—automatically concedes board is independent and disinterested w/ respect to the question to be litigated

1. Only prong of Aronson-Levine test P is left to contest in event demand is denied—second prong: whether bad faith or gross negligence may be inferred from the decision itself

c. Rales v. Blasband (DE 1993)i. FACTS: alleged misuse by board of the proceeds

of a sale of that company’s senior subordinated notes due; alleged Ds didn’t invest as they said they would be invested in highly speculative junk bonds w/ the desire of 2 members of the board to help out junk bond offeror

ii. COURT: double derivative suit—stockholder of parent corp seeks recovery for a cause of action belonging to subsidiary corp

1. Right of stockholder to prosecute derivative suit limited to situations where stockholder has demanded directors pursue corporate claim and they’ve wrongfully refused to do so OR where demand is excused b/c directors are incapable of making an impartial decision regarding such litigation

2. Stockholder Ps must overcome powerful presumptions of BJR before they can pursue derivative claim

3. Aronson’s test

a. Whether under particularized facts alleged, a reasonable doubt is created that:

i. Directors are disinterested and independent OR

ii. Challenged transaction as otherwise the product of a valid exercise of BJ

4. HERE though—board didn’t approve the transaction which is being challenged; made no decision relating to the subject

a. Court shouldn’t apply Aronson test for demand futility where the board that would be considering the demand did not make a business decision which is being challenged in derivative suit

i. Would occur where—majority of board making decision have been replaced; where subject of suit is not a business decision of the board; where, as here; decision being challenged as made by board of different corp

5. Court must determine whether or not the particularized factual allegations of a derivative stockholder create reasonable doubt that as of the time the complaint is field, the board could’ve properly exercised independent and disinterested BJ in responding to demand

a. If so demand excused as futile

6. Double derivative suit—P must still satisfy Aronson test

7. Director considered interested where (s)he will receive personal financial benefit from a transaction that isn’t equally shared by stockholders

a. Also exists where a corporate decision will have a materially detrimental effect on director but not on corp and stockholder

i. Can’t be expected to exercise independent BJ w/out being influenced

b. Decision by the board to bring suit could have potentially significant financial consequences for some directors—disqualifying financial interest that disables them from impartially considering response to demand

8. To establish lack of independence—must show directors are beholden to the interested director(s) or so under their influence the discretion would be sterilized

a. Here: members of the board were beholden by virtue of their employment being under Rales’ control

iii. Conclusion: appropriate inquiry in double derivative suit is whether P’s complaint raises reasonable doubt regarding the ability of a majority of the board to exercise properly its BJ in a decision on a demand had one been made at the time action was filed

d. Board of Directors’ response to stockholder demand letter

i. First must determine best method to inform themselves of the facts relating to alleged wrongdoing and considerations—legal/financial—bearing on a response to the demand

1. If factual investigation needed—must be reasonable and in good faith

ii. Board must then weigh alternatives available to it, including advisability of implementing internal corrective action and commencing legal proceedings

1. Must be able to act free of personal financial interest and improper extraneous influences

2. Rales

iii. Special litigation committees1. Standard feature of derivative suit doctrine even though it’s not

triggered in every casea. Chief divide b/w jx are those that follow Zapata which

gives a role to the court itself to judge the appropriateness of special litigation committee’s decision to dismiss and those jx such as NY that apply a rule that if committee is independent/informed its action entitled to BJ deference

2. Procedure under Zapata (infra) (NOTE : this is when demand is excused)

a. After objective and thorough investigation of derivative suit—Independent Committee may cause its corp to file pretrial motion to dismiss

i. Must be based on the best interests of the corp as determined by the committee

ii. Similar to SJ proceedings—each side has opportunity to make record on the motion

iii. Moving party has burden under Rule 56 that there is no genuine issue of material fact

b. Court then applies 2 step test: i. Court should inquire into independence and

good faith of the committee and bases supporting this conclusion

1. Ltd discovery may be ordered to facilitate

2. Corp has burden of proving independence, good faith and reasonableness

3. If court not satisfied by this shall deny corp’s motion

a. If satisfied under SJ court may proceed in its discretion to step 2

ii. Court should determine applying its own independent BJ whether the motion should be granted

1. Intended to thwart instances where corporate actions meet criteria of step one but result doesn’t satisfy its spirit

2.3. Zapata Corp v. Maldonado (Del 1981)

a. FACTS: derivative action instituted against 10 D&Os of Zapata, alleging breaches of fiduciary duty; P didn’t first demand board bring this action stating demand futility b/c all directors were named as Ds and allegedly participated in acts specified ; by 1979—4 D-Directors weren’t on the board and the remaining directors appointed 2 new outside directors to the board; board created independent investigation committee of the new directors to investigate P’s actions; committee’s decision would be final decided action should be dismissed

b. COURT: board members, owing a well-established fiduciary duty to the corp won’t be allowed to cause a derivative suit to be dismissed when it would be a breach of their fiduciary duty

i. Stockholder may sue in derivative right w/out prior demand upon directors to sue when it’s apparent that a demand would be futile, that the officers are under an influence that sterilizes discretion and couldn’t be proper persons to conduct the litigation

1. A demand when required and refused (if not wrongful) terminates a

stockholder’s legal ability to initiate derivative action

ii. Board entity remains empowered under 141(a) to make decisions regarding corporate litigation even after demand excused

iii. Section 141(c) allows board to delegate all of its authority to a committee—would have power to move for SJ if board did

1. Committee can properly act for the corp to move to dismiss derivative litigation that is believed to be detrimental to corp’s best interest

iv. If a committee composed of independent and disinterested directors, conducted a proper review of the matters before it, considered a variety of factors and reached, in good faith, a BJ that the action was NOT in the best interest of the corporation—action must be dismissed

1. Issues: a. Independenceb. Good faithc. Reasonable investigation

2. Not subject to judicial review 3. BUT whether court will be persuaded by

the exercise of a committee power resulting in a summary motion for dismissal of a derivative action where a demand hasn’t been initially made should rest in the independent discretion of court

4. In re Oracle Corp Derivative Litigation (Del 2003)a. FACTS: motion of special litigation committee to

terminate this action which allege Oracle directors engaged in insider trading ; also allege Caremark violation in the sense that the board’s indifference to deviation b/w guidance and reality was so extreme as to constitute subjective bad faith

i. Formed SLC to investigate the action and whether should press claims raised by Ps/settle/terminate

ii. Members of SLC come from Stanford

b. COURT: SLC bears the burden of persuasion and must convince the court that there is no issue of material fact calling into doubt its independence; acted in good faith; and had reasonable bases for recommendations

i. Issue of independence turns on whether a directors is for any SUBSTANTIAL reason incapable of making a decision w/ only the best interests of the corp in mind impartiality/objectivity

1. If SLC meets its burden—court can grant the motion OR may undertake its own examination of whether the corp should terminate and permit the suit to proceed if court concludes in its judicial business judgment it’s in the best interest of corp

ii. SLCs are permitted as a last chance for a corporation to control a derivative claim in circumstances when a majority of its directors can’t impartially consider a demand

1. By vesting the power of the board to determine what to do w/ the suit in a committee of independent directors—a corp may retain control over whether the suit will proceed so long as the committee meets standard set forth in Zapata

iii. Court finds that SLC hasn’t met its burden to show absence of material factual question about its independence b/c the ties among the SLC, trading Ds and Stanford are so substantial they cause reasonable doubt about SLC’s ability to impartially consider whether the Trading Ds should face suit

1. Nothing led to bad faith but difference in good faith and independence

5. NOTE: difficulty in this since the power to elect SLC comes form 141© which means SLC must consist entirely of directors

6. Beam v. Martha Steward—a. Ps claimed demand was futile against the board b/c a

majority wasn’t independent of Martha

b. Court applied test for demand futility articulate in Rales; held demand was NOT excused even though there were relationships; friendships; inter-connections b/w Martha and other board members similar to Oracle

i. BUT unlike the demand-excusal context where the board is presumed to be independent, SLC has the burden of establishing its own independence “above reproach”

iv. Court’s Exercise of Business Judgment 1. Joy v. North (2d Cir 1982)

a. FACTS: in diversity case, the court predicted that Conn would adopt Zapata approach to derivative suits and, exercising its business judgment, rejected SLC’s motion to dismiss

b. COURT: wide discretion afforded directors under BJR doesn’t apply when a SLC recommends dismissal of a suit

i. In these cases—burden is on the moving part to demonstrate that the action is more likely than not to be against the interest of the corp

ii. Function of the court’s review is to determine the balance of probabilities as to likely future benefit to the corporation NOT to render a decision on the merits, fashion the appropriate legal principles or resolve issues of credibility weigh uncertainties, not resolve them

iii. Where the court determines the likely recoverable damages discounted by the probability of a finding of liability are less than the costs to the corp in continuing the action DISMISS

1. Costs include atty fees, other out-of-pocket expenses, time spent, indemnification mandatory under by-laws,

a. NOT insurance2. Where having completed the analysis

the court finds a likely net return to the corp which isn’t substantial in relation to shareholder equity—can take into account impact of distraction of key personnel and potential lost profits

iv. HOLDING: judicial scrutiny of SLC recommendations should thus be ltd to a comparison of the direct costs imposed upon the corp by the litigation w/ potential benefits

v. Michigan Compiled Laws 450.11071. Independent Director means director who meets ALL of the following

requirements:a. Is elected by the shareholdersb. Is designated as an independent director by the board

or the shareholdersc. Has at least 5 years of business/legal/financial

experience d. Isn’t and during the 3 years prior to being designated as

an independent director hasn’t been any of the following

i. An officer/EE of the corp or any affiliate of the corp

ii. Engaged in any business transaction for profit or series of transactions for profit

iii. An affiliate, exec officer, general partner or member of immediate family of any person that had the status or engaged in a transaction described in (i) or (ii)

e. Doesn’t have an aggregate of more than 3 years of service as director of corp, whether or not as independent director

2. SECTION 495a. Court shall dismiss a derivative proceeding if, on motion

by the corp, the court finds that one of the groups specified has made a determination in good faith after conducting a reasonable investigation that the maintenance of derivative proceeding is not in the best interests of the corp . . . if the determination is made by court-appointed panel or by independent directors the P shall have the burden of proving that the determination wasn’t made in good faith or that investigation wasn’t reasonable

E. SETTLEMENT AND INDEMNIFICATION i. Settlement by Class Representatives

1. Parties strongly driven to settle in the typical derivative/class action suit

a. Director-Ds likely to settle b/c they have right to indemnification of reasonable defense costs BUT if the action goes to trial there is risk personal liability that can be indemnified only w/ court approval

2. DGCL 145(b) accords a corp broad latitude to indemnify corporate officers directors and agents for costs in derivative and shareholder suits

a. Upon a favorable determination of disinterested board members or outside counsel/director/officer can be indemnified for any payment made to settle a derivative action as well as for all of her litigation expenses

b. If litigation isn’t settled corp can’t indemnify D&Os who are adjudged to be liable to it except to extent authorized by court

i. BUT can purchase liability insurance to cover claims arising out of their status w/ corp whether or not corp would have the power to indemnify them against such liability

1. DGCL 145(g)3. Insurance—pg 408

ii. Settlement by Special Committee 1. Although rare—special committees can be in control of derivative suits

in order to settle them 2. Carlton Investments v. TLC Beatrice Int’l Holdings Inc (DE 1997)

a. FACTS: motion for approval of SLC proposed settlement of derivative action that alleged certain past/present directors and officers engaged in conduct constituting breach of fiduciary duty, corporate waste, fraud and conspiracy breach of duties in connection w/ board’s approval of compensation package awarded to CEO

i. Board unanimously voted to add 2 new directors and constitute them as SLC to investigate allegations of misconduct/best course of action w/ regard to litigation

b. COURT: as a general rule—in evaluating a proposed settlement court doesn’t’ attempt to make substantive determinations concerning disputed facts or merits of the claims alleged BUT considers whether the proposed settlement is FAIR and REASONABLE in light of factual support for the alleged claims/defense

i. Since settlement negotiated by SLC analyzed under Zapata

1. Proceeded in good faith; were well-informed; reasonable solution

2. Independent judgment—not badly off mark

F. WHEN ARE DERIVATIVE SUITS IN SHAREHOLDERS’ INTERESTSi. Shareholder would prefer a suit to be brought only when it increases corporate

value benefits outweigh costs to the company1. Derivative suit can increase corporate value 2 ways

a. Suit may confer something of value on the corpi. Benefits if it recovers compensation for the past

harms inflictedii. Governance change could prevent more harm

2. Costs of derivative suit resolved 2 waysa. Ligation imposes direct costs

i. Defending and prosecuting successful derivative suits

ii. Shareholders bear their own costs if lose and culpable mgrs. May be charged w/ defense costs if they lose

b. Indirect costs on corps/shareholdersi. Advance payment of prospective costs of

managerial liability ii. Includes D&O insurance

XI. TRANSACTIONS IN CONTROLA. INTRO

i. Share for share, controlling blocks of stock inevitably sell in negotiated transactions at a premium over market price of non-control shares

1. Premium as a payment for “private benefits of control” range of possible sources of value from power to capture salary, perks, and self-dealing opportunities (?)to prestige value of being company’s indisputable boss

2. Also can be acquired by buyers who have/believe they have a superior business plan that will increase value of stock

3. Anyone attempting to accumulate control block of stock from many trades will drive up the price of the stock and will have to pay a premium over market price

ii. Investors can acquire control over a corporation in 2 ways1. Purchasing a controlling block of shares from an existing control

shareholder a. Incumbent controller will demand a premium over the

price of the publicly traded stock for her control block 2. Purchasing the shares of numerous smaller shareholders

B. SHARE CONTROL BLOCKS: SELLER’S DUTIESi. Control blocks in public companies—costly to aggregate and valuable to have

ii. Regulation of Control Premia1. US jx don’t afford minority shareholders the right to sell their own

stock alongside the controlling shareholder OR a right to sell their stock back to the company as they would in a merger

a. Market Rule: sale of control is a market transaction that creates rights/duties b/w parties but does NOT confer rights on other shareholders

b. Equal Opportunity Rule: minority shareholders would be entitled to sell their shares to a buyer of control on the same terms as seller of control

2. Baseline Rule:a. Zetlin v. Hanson Holdings Inc (NY 1979)

i. Recognizing that those who invest the capital necessary to acquire a dominant position in the ownership of a corp have the right of controlling the corp—long been settled that absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts of bad faith, a controlling stockholder is free to sell AND a purchaser is free to buy that controlling interest at a premium rate

1. While minority stockholders are entitled to protection against abuse by controlling shareholders NOT entitled to inhibit legit interests of other stockholders

a. Premium—added amount an investor is willing to pay for the privilege of directly influence corp’s affairs

ii. Equal opportunity rule would be nothing more than tender offer

b. Perlman v. Feldman (2d Cir 1955)i. FACTS : action for Director-Ds to account to

non-participating minority shareholders for that share of their profit which is attributable to the sale of a corporate power

ii. COURT: as a director and dominant stockholder—Feldman stood d in fiduciary relationship to the corp/minority shareholders

1. Directors must not in any degree allow their official conduct to be swayed by their private interest which must yield to official duty

2. Fiduciary duty extends to him as director AND majority shareholder fiduciary held to something stricter than morals of market place; honor and honesty

3. If there was a possibility of corporate gain shareholders entitled to recover

4. Fiduciaries always have the burden of proof in establishing the fairness of their dealings with trust property

5. When the sale of controlling stock results in sacrifice of corporate good will and consequent unusual profit to fiduciary who’s caused the sacrifice – should account for gains

6. Burden also on D to prove the stock sold was worth the premium value

iii. Market Rule in Practice1. All modern courts treat the simple sale of a controlling block of stock

—unconnected to any corporate activity—as free of any duty to minority shareholders BUT these sales are rare

a. Controller often requires corporate action of some sort to facilitate the sale of a control block

i. Could be said corp’s independent directors have a duty to bargain w/ controller to extract part of control premium for minority shareholders

2. In re Digex Shareholders Litigation (De 2000): acquirer first approached the board of partly held subsidiary of the controller w/ lucrative offer; controller arranged to sell itself to the acquirer in lieu of selling subsidiary—excluding minority shareholders from premium deal

a. Ruled that controller was entitled to use its voting power as a shareholder to block a deal b/w subsidiary and acquirer BUT the controller violated a duty of fairness to minority public shareholders when in the course of selling itself it pressured the subsidiary’s board to waive the applicability of 203 of DGCL (prevents party who purchases control of DE corp from

pursuing a cash-out merger to eliminate minority shareholders for period 3 years unless company’s board approves ex ante)

b. Rationale—Board may waive 203 constraint only for benefit of the corp and all of its shareholder—not just controlling shareholder

C. SALE OF CORPORATE OFFICEi. Carter v. Muscat (NY 1964): board of the Republic Corporation appointed a new

slate of directors as part of a transaction in which the company’s mgmt. sold 9.7 % block of its stock to a new “controlling” person at a price slightly above market; despite shareholder challenge—court upheld re-election of the new directors at the annual shareholders meetings

ii. Brecher v. Gregg (1975): CEO of public company received a 35% control premium on the sale of his 4% block of stock in exchange for his promise to secure the appointment of the buyer’s candidate as the company’s new CEO and the election of 2 of the buyer’s candidates to the board of directors

1. Company board rebelled and fired buyer’s handpicked CEO; buyer sued Gregg for refund of the premium it paid for stock;

2. Stockholder of company sued Gregg derivatively and forced him to disgorge his control premium to the company

3. Court—paying a premium for control while purchasing only 4% of a company’s outstanding shares is contrary to public policy/illegal

D. LOOTINGi. Harris v. Carter (Del 1990):

1. QUESTION: whether a controlling shareholder or group may under any circumstances owe a duty of care to the corp in connection w/ the sale of a control block of stock

2. FACTS: Claim against Ds is allegation that they had reason to suspect the integrity of buyers but failed to conduct even a cursory investigation into any of several suspicious aspects of the transactionunaudited financial statement, mention of subsidiary in negotiations but not in representations concerning the subsidiaries and ownership of subsidiaries themselves

3. COURT: when transferring control of a corp to another—a controlling shareholder may, in some circumstances, have a duty to investigate the bona fides of the purchaser to take such steps as a reasonable person would take to ascertain that the buyer doesn’t intend or is unlikely to plan any depredations of the corp

a. Facts that would give rise to reasonably prudent person b. When shareholder presumes to exercise control over a

corp, to direct its actions, that shareholder assumes a

fiduciary duty of the same kind as that owed by a director of a corp

i. Sale of controlling interest that is coupled w/ an agreement for the sellers to resign from the board of directors in such a way as to assure that the buyer’s designees assume that corporate offices does involve/implicate corporate mechanisms to call duty into operation

c. In some circumstances the seller of a control block of stock may/should reasonably foresee danger to the other shareholders duty of care present

d. While a person who transfer corporate control to another is not a surety for his buyer, when the circumstances would alert a reasonably prudent person to a risk that his buyer is dishonest or in some material respect not truthful, a duty devolves upon the seller to make such inquiry as a reasonably prudent person would make and generally to exercise care so that others who will be affected by his actions shouldn’t be injured by wrongful conduct

E. TENDER OFFER—BUYER’S DUTIESi. Large public companies in US generally don’t have controlling shareholder

investor who wishes to purchase control stake must do so by aggregating shares of many small shareholders

1. 2 waysa. Buyer might approach largest of small shareholders

singly orb. Tender offer—general offer open to all shareholders

2. Tender offer = offer of cash or securities to the shareholders of a public corporation in exchange for their shares at a premium over market price

a. Generally—tender offeror aims at acquiring a control block in a diffusely held corp that lacks a dominant shareholder/shareholder group

i. Premium paid by offeror—similar to control premium paid to controlling shareholders

3. Before 1967 Williams Act—cash offers unregulateda. Saturday Night Specials—left public shareholders only

24/48 hours to decide whether to tender their shares w/out providing any info about identity/plans of offeror

b. Williams Act—sought to provide shareholders sufficient time and info to make an informed decision about tendering their shares and to warn market about impending offer

4. Elements of Williams Acta. 13(d): early warning system which alerts the public and

the company’s mgrs. whenever anyone acquires more than 5% of the company’s voting stock

i. 13d-1a: requires investors to file a 13D report w/in 10 days of acquiring 5+ percent beneficial ownership

1. 13d-1b allows certain qualified institutional investors to file a shortened 13G report in lieu of 13D report w/in 45 days of year end

ii. 13d-1(c): permits passive but nonqualifying investors to file a 13G report in lieu of 13D report w/in 10 days of acquiring their holdings

iii. 13d-2 requires shareholders to amend their 13D and 13G reports annually OR upon acquiring 10+ percent of an issuer’s shares

iv. 13d-5 defines a 13d group subject to 13d rules as multiple shareholders who act together to buy, vote, sell stock

b. 14d(1) which mandates disclosure of the identity, financing, and future plans of a tender offeror, including plans for any subsequent going-private transaction

i. 14d-3: requires bidders to file and keep current 14D-1 reports for tender offers

ii. 14e-2 which requires the target’s board to comment on the tender offer

iii. 13e-4 which requires companies to make much the same disclosures as 3d party offerors when these companies tender for their own shares

iv. 13e-3: mandates particularly strict disclosure when insiders, including controlling shareholders, plan going-private transactions that would force public shareholders out of company

c. 14e—antifraud provisions that prohibits misreps, nondisclosures, and any fraudulent deceptive or

misrepresentative practices in connection w/ a tender offer

i. 14e-3 bars trading on insider info in connection with tender offer

d. 14d4-7 and 14e: dozen rules regulating substantive terms of tender offers, including matters such as how long tender offers must be left open, when shareholders can w/draw previously tendered shares and how bidder must treat shareholders who tender

1. 14e-1 mandates that tender offers be left open for minimum 20 business days

2. 14d-10 requires bidders to open their tender offers to ALL shareholders and pay all who tender same best price

F. HART-SOCTT RODINO ACT WAITING PERIODi. Another legal constraint on immediate acquisition of control of large US companies

implemented in 19761. Intended to give FRC and DOJ proactive ability to block deals violating

antitrust laws2. If no antitrust issues—HSR Act affects only timing of transactions

ii. Filing always required for transactions in excess of $260 million in value and often when they’re smaller

iii. Waiting periods imposed BEFORE bidder can commence her offer1. Like 13(d) of Williams act but HSR filings must be disclosed

immediately to target companies and bidders may not close a deal until relevant waiting period has elapsed

2. Cash tender offers—acquirers must wait 15 calendar days after filing before closing

3. Regulated open market purchases—acquirers must wait 30 days after filing

4. Mergers, asset deals and other negotiated acquisitions—both parties must wait 30 days after filing

iv. Auction Debate and Shareholder Collective Action Problem 1. Williams Act created de facto auction period of at least 4 weeks which

allowed target mgmt. to build its defenses and permitted other acquirers to look over the firm

XII. FUNDAMENTAL TRANSACTIONS: MERGERS & ACQUISITIONSA. INTRO:

i. Three legal forms of transactions:1. Merger

a. Legal event that unites 2 existing corps w/ a public filing of a certificate of merge, usually w/ shareholder approval

b. Usually one of the 2 companies absorbs the other and is termed “surviving corp”owns all property and assumes all obligations of BOTH parties to the merger

2. Purchase/sale of all assetsa. Acquisitions comprise a generic class of “nonmerger”

techniques for combining companies which generally involve the purchase of the assets or shares of one firm by another

b. Following acquisition – acquiring corp may or may not assume liability for the obligations of the acquired corp

3. In RMBCA jx—compulsory share exchangeB. ECONOMIC MOTIVES OFR MERGER

i. Integration as a source of value1. Gains from integrating corporate assets arise from economies of

“scale,” “scope,” and vertical integrationa. Economies of scale a fixed cost of production such as

investment in a factory is spread over a larger output thereby reducing the average fixed cost per unit of output

b. Economies of scopemergers reduce costs not by increasing scale of production BUT by spreading costs across a broader range of related business activities

i. Ex: same sales force or mgmt. team if extended to larger asset base

c. Vertical integration special form of economies of scope, arise by merging a company backward towards its suppliers OR forward towards its customers

i. Cheaper to merge w/ supplier than buy the product?

ii. Other sources of value in acquisitions: tax, agency costs and diversification1. M&As generate value from tax; agency; diversification

a. Tax: corps w/ tax losses (deductible expenses GREATER than income during tax year) may set those losses off against income in subsequent years for up to 20 years

i. Net Operating Loss (NOL) carried forward is valuable asset BUT only if owner has sufficient taxable income to absorb it

1. NOL – can’t be sold directly SO corp that lacks sufficient income might prefer to find wealthy merger partner rather than waste its NOL

b. Replacement of underperforming mgmt. team that has depressed company’s stock price

i. Outside buyer can profit by purchasing a controlling block of company whose stock prices are lower due to market’s anticipation of mismanagement in the future AND outside buyer will replace incumbent mismanagers

ii. Poor managers can be bought off as part of the premium rate a new investor must pay to acquire corp’s assets

1. Golden parachute K—provides senior managers w/ a generous payment upon certain triggering events, typically a change in ownership of a controlling interest in the corp or a change in membership of its board

2. Stock option plan—allows options that would otherwise vest over 4-6 years to become immediately exercisable upon change in control

c. Diversifying – smoothing corporate earnings over business cycle

iii. Suspect Motives for Mergers1. Squeeze-out merger in which controlling shareholder acquires all of a

company’s assets at a low price at expense of minority shareholders2. Creation of market power in particular product market charging

monopoly prices3. Mistaken mergers—occur b/c planners misjudge difficulties of

realizing merger economies C. EVOLUTION OF U.S. CORPORATE LAW OF MERGERS

i. Modern Era1. DE and many other states allow mergers to proceed w/ the approval

of only a bare majority of the outstanding shares of each class of stock that is entitled to vote on them

a. Shareholders have right to “dissent” from proposed merger and demand an appraisal or judicial determination of the cash value of her shares as an

alternative to continuing as shareholder in new, merged corp

2. Cash-out merger shareholders can be forced to exchange their shares for cash as long as the procedural requirements for valid merger are met

D. ALLOCATION OF POWER IN FUNDAMENTAL TRANSACTIONSi. Most prominent of decisions requiring shareholder approval

1. Get power to approve amendments b/c they get power to vote on everything that may amend the corp charter

ii. Mergers require a shareholder vote on the part of both the target and acquiring company EXCEPT the acquiring company’s shareholders do NOT vote when the acquiring company is much larger than the target (DGCL 251(b)

1. Sales of substantially all assets require a vote by the TARGET’S shareholders (DGCL 271) BUT purchases of assets do not require them to do so

iii. By and large00 M&A transactions that require shareholder approval are those that change the board’s relationship to its shareholders most dramatically, reducing the ability of shareholders to displace their managers after the transaction is completed

1. Purchase of assets for cash doesn’t alter the power of shareholders to displace their managers

E. OVERVIEW OF TRANSACTION FORMi. Acquisition can occur three ways

1. Acquirer can buy target company’s assets2. Acquirer can buy all of the target corporation’s stock3. Acquirer can merge itself or a subsidiary corp w/ the target on terms

that ensure its control of the surviving entity4. Acquirer can use

a. Cashb. Own stockc. Any other agreed upon form of consideration

ii. Asset Acquisition 1. Acquisition of business through purchase of its assets has relatively

high transaction cost but low liability costa. Problems w/ asset acquisition—

i. Identify assets to be acquiredii. Conduct due diligence w/ respect to these

assetsiii. Establish representations and warranties that

both parties must make respecting the assets or themselves

iv. Negotiate covenants to protect assets prior to closing

v. Fix the price/terms of payment vi. Establish conditions of closing

2. Sale of substantially all assets is fundamental transaction for the selling company which requires shareholder approval under al US corporate law statutes

3. Katz v. Bregman (Del 1981)a. FACTS: Ps allege that board of directors embarked on a

course of action which resulted in disposal of several unprofitable subsidiaries of the corporate defendant ; at first got rid of unprofitable assets then sought to get rid of profitable asset to raise needed cash and improve balance sheets; declined to negotiate w/ one company

b. COURT: DGCL 271—decision of DE corp to sell all or substantially all of its property and assets requires an approval of such corp’s board of directors AND a resolution adopted by a majority of the outstanding stockholders of the corporation entitled to vote thereon at a meeting duly called upon at least 20 days’ notice

i. b/c the proposed sale would, if consummated, constitute a sale of substantially all of the assets as presently constituted an injunction should be issued preventing the consummation of such sale at least until it has been approved by a majority of the outstanding shareholders of the corp entitled to vote at a meeting duly called on at least 20 days’ notice

ii. NOTE: court found that 51% of the assets producing 45% of the income to be substantially all

4. Thorpe v. CERBCO (DE 1996): a. CERBCO was holding company w/ three subsidiaries;

CERBCO’s stock in one of these constituted 68% of its assets and was CERBCO’s primary income-generating asset

b. At issue was whether the controlling shareholders had a right in their capacity as shareholders to veto any CERBCO sale of its subsidiary (they wanted to sell their controlling interest in CERBCO)

i. Basically—would sale of CERBCO’s subsidiary stock constitute a sale of substantially all assets

thereby assuring CERBCO’s controlling shareholders power to block such a sale

c. COURT: the need for shareholder approval is to be measured not by the size of the sale alone but also on the qualitative effect upon the corp. it’s relevant to ask whether a transaction is out of the ordinary course and substantially affects the existence and purpose of the corp

i. Sale of 68% of assets would’ve been subject to a shareholder vote under DGCL 271

5. Hollinger, Inc. v. Hollinger Int’l (DE 2004)a. QUESTION: whether the sale of the Telegraph group of

newspapers constituted substantially all of the assets of Hollinger Int’l which in addition to Telegraph, held Chicago group

b. COURT: Telegraph group accounted for 56-57% of Int’l’s value w/ the Chicago group accounting for the rest; held that sale of Telegraph group didn’t constitute “substantially all” of Int’l’s assets substantially all means essentially everything

6. Chief drawback of asset acquisition as a method of acquiring a company is that it’s costly and very time consuming to transfer all of the individual assets of a large business

a. But as long as the asset purchase is at arm’s length and doesn’t violate Fraudulent Conveyances Act, an acquirer accedes only to the assets and not the liabilities of the target

b. BUT when assets at issue constitute an integrated business, courts have identified circumstances in which a purchaser of assets may become responsible for liability associated w/ those assets

i. Successor Liability 1. Tort claims as a result of defective

products manufactured in plants now owned by different owners

2. Culpable previous owners of the assets—plants—have dissolved and paid out a liquidating distribution to their shareholders leaving no one else to sue but asset’s new owners

a. Courts less likely to invoke today

c. Liability for environmental cleanup expenses that are imposed under various federal statutes on owners or operators of acquired assets

i. Purchase of assets that constitute hazardous environmental conditions may make the new owner jointly liable for cleanup expenses

iii. Stock Acquisition1. Second transactional form for acquiring an incorporated business is

through purchase of all or a majority of the company’s stocka. Company that acquires a controlling block of stock in

another has “acquired” the controlled firmb. Does not alter the legal identity of the corporation

something more needed beyond the purchase of control to result in full-fledged acquisition

2. To acquire a corp in full sense of obtaining complete dominion over its assets, an acquirer must purchase 100% of its target’s stock not merely control block

a. Acquirers typically don’t want small minority of public shares outstanding

i. Easy to execute short-form merger statutes which allow a 90% shareholder to simply cash out a minority unilaterally

ii. Compulsory share exchange—tender offer negotiated with the target board of directors that after approval by the requisite majority of shareholders becomes compulsory for all shareholders

1. Acquiring company’s stock or other tender offer consideration is then distributed to the target’s shareholders pro rata while the acquirer becomes the sole owner of all the stock of the target

a. Tax treatment of real tender offer w/out holdup problems or residue of minority of public shareholders

2. DE does NOT have this a. BUT has 2-step merger—boards

of the target and the acquirer negotiate two linked transactions in a single package

i. First transaction is tender offer for most or all of the target’s shares at an agreed-upon price which the target board promises to recommend to its shareholders

ii. The second transaction is a merger b/w target and subsidiary of the acquirer which is to follow the tender offer and remove minority shareholders who failed to tender their shares

iii. Cash-out mergeriv. Mergers

1. Mergers legally collapse one corp into another corp that survives w/ legal identity intact is the surviving corporation

a. Acquiring company initiates negotiations over terms of merger

i. Requires approval of the board ii. Good practice—outside directors should be

involved earlier and more intensively when the merger transaction is significant relative to assets of the corp

iii. Prepare merger agreement for board approval ; after board formally authorizes execution of the agreement—board will most instances call a shareholders’ meeting to obtain shareholder approval of the merger

b. Most states—valid merger requires majority vote by the outstanding stock of each constituent corp that is entitled to vote

i. Default rule—all classes of stock vote on merger UNLESS certificate of incorporation expressly states otherwise

2. Voting common stock of the target or collapsed corporation ALWAYS have voting rights

a. Voting stock of surviving corp generally afforded statutory voting rights on merger EXCEPT when three conditions are met:

i. Surviving corporation’s charter is not modified;ii. Security held by the surviving corporation’s

shareholders won’t be exchanged or modified; and

iii. the surviving corp’s outstanding common stock won’t be increased by more than 20%

b. NOTE: higher or special voting requirements for mergers may also be established by corporate charter or by state takeover statutes

i. Stock exchange rules may differ—require simple majority as opposed to absolute majority

3. Following an affirmative shareholder vote—merger is effectuated by filing a certificate of merger w/ the appropriate state office

a. Governance structure of the surviving corp may be restructured in the merger through the adoption of an amended certificate of incorporation/bylaws which will have been approved by shareholders as a part of merger vote

b. Shareholders who disapprove of the terms of the merger must dissent from it in order to seek a judicial appraisal of the fair value of their shares

v. Triangular Mergers1. To preserve the liability shield that the target’s separate incorporation

confers merge target into a wholly owned subsidiary of the acquirer (Or Reverse Triangular Mergermerging the subsidiary into the target)

a. Preserving liability protection that separate incorporation provides to the acquirer—almost always a highly desirable business goal

2. Triangular merger form Acquirer (A) forms wholly owned subsidiary, NewCo; A transfers merger consideration to NewCo in exchange for all of NewCo’s stock; then Target will merge into NewCo (or vice versa); merger consideration will be distributed to Target shareholders and Target stock will be canceled

a. A will own all of the outstanding stock of NewCo which will own all of Target’s assets and liabilities

F. STRUCTURING M&A TRANSACTION i. Timing

1. Speed almost always desirable 2. All-cash, multistep acquisition is usually fastest way to lock up a target

and assure its complete acquisition a. All cash tender offer may be consummated 20 business

days after commencement BUTi. Merger will generally require a shareholder

vote of at least the target shareholders which will involve several months of clearance of proxy materials w/ SEC and solicitation of proxies under proxy rules

3. Most deals using 100% stock consideration are structured as one-step direct/triangular mergers

ii. Regulatory Approvals, Consents and Title Transfers1. Title transfers not a matter of concern in mergers since all assets

owned by either corp vest as a matter of law in surviving corp w/out further action

a. In sale of assetstitle transfers can impose substantial costs/delay

b. Reverse triangular mergers are the cheapest and easiest methods of transfer b/c they leave both preexisting operating corps intact

iii. Planning Around Voting and Appraisal Rights1. Shareholder votes and appraisal rights are costly and potentially risky 2. Planners particularly wary of structures that trigger class votes for

holders of preferred/nonvoting common stock since these votes may enable holders of such securities to extract a holdup payment in exchange for allowing the deal to proceed

iv. Due Diligence, Representations and Warranties, Covenants and Indemnification 1. In any deal—buyer will want to acquire reliable info about target

a. Easier by public SEC filings and availability of financial statements audited by independent public accountant

2. Covenants—offered by target company will provide that the business will be operated only in the normal course from the date of the signing of the agreement to the closing and may require target to confer w/ acquirer before undertaking material transaction

a. Target pledge to use best efforts to close agreement 3. Parties will customarily indemnify each other for any damages arising

from any misrep or breach of warrant a. Allocates burden of undiscovered noncompliance to the

party making the representation v. Accounting treatment of mergers—casebook pg 466

G. APPRAISAL REMEDY

i. Shareholder vote principal protection against unwise or disadvantageous mergers or other fundamental transactions against unwise or disadvantageous mergers or other fundamental transactions

1. Through the vote shareholders can replace an underperforming board or reject a fundamental transaction that requires their authorization

a. If shareholders are stupid and approve stupid transaction shareholder has the right to judicial appraisal of the fair value of one’s shares

i. Shareholders who dissent from qualifying corporate mergers; most states allow for those who dissent from a sale of substantially all of corp’s assets; half the states allow an amendment of corporate charter to give rise to appraisal

ii. DGCL 262—only in connection w/ corporate mergers in certain circumstances

ii. Appraisal Alternative in Interested Mergers1. Tends to be invoked either in nonpublicly traded firms or in

transactions in which shareholders have structural reasons to think that the merger consideration may not be “fair value”

a. Rarely invoked in arm’s length mergersi. w/out conflicts of interests—arm’s length

mergers tend to get close to market price 2. When controlling shareholder or some other reason to doubt

shareholder vote fairly reflects independent BJ minority shareholder ought not to be at the mercy of the shareholder vote that is either controlled or potentially manipulated by an interested party as in a parent-subsidiary merger or even mgmt.-sponsored buyout

a. Parent-subsidiary merger (or any merger involving a self-interested controlling shareholder) continues to provide a compelling justification for the appraisal remedy or something like it in case of public firms

3. REMEMBER: when there is controlling shareholder—law provides equitable remedy in form of fairness review when minority shareholders challenge self-interested transaction

a. Overlap of fairness review and appraisal action b. BUT fairness standard may be more favorable to Ps

under statutory standard a P in an appraisal proceeding is entitled to claim only a pro rata share on the fair value of the company WITHOUT regard to any gain caused by the merger or its expectation

i. In fairness action against controlling shareholder—D must prove self-dealing transaction was fair in ALL respects

iii. Market-Out Rule1. Section 262 of DGCL: grants right of judicial appraisal to all qualifying

shares of any class in a merger effectuated under general merger statute BUT deny this remedy when shares of target corps are traded on nat’l security exchange or held of record by 2K registered holders

a. Appraisal denied if shareholders weren’t required to vote on the merger

i. Restores appraisal remedy IF target shareholders receive as consideration anything OTHER THAN

1. Stock in surviving corp2. Any other shares traded on nat’l

security exchange3. Cash in lieu of fractional shares4. Combination of those items

2. Shareholders in privately traded firm w/ fewer than 2k shareholders will always have appraisal rights in a merger if they’re required to vote on it

3. Publicly traded company NO appraisal rights in stock-for-stock merger

iv. Nature of “Fair Value”1. Appraisal right as put option—opportunity to sell shares back to the

firm at a price equal to their fair value immediately prior to the transaction prior to the right

a. 2 dimensions to appraisali. Definition of the shareholder’s claim

ii. Technique for determining value 2. DE – dissenting shareholder claim defined as pro rata claim on the

value of the firm as a going concern a. Seeks to measure fair value of dissenting shares FREE of

any element of value that might be attributable to the merger

b. BUT includes all elements of future value that were present at the time of the merger, excluding only speculative elements of value

3. Most common valuation technique in appraisal cases – Discounted Cash Flow (DCF) (coming from Weinberger case)

a. Each side presents through an expert a detailed evaluation of the firm w/ a projection of future cash

flows and an estimate of appropriate costs of capital for discounting those expected cash flows to present value

H. DE FACTO MERGER DOCTRINEi. Some US courts accord shareholder voting and appraisal rights to all corporate

combinations that resemble mergers in effect ii. BUT DE takes formalist approach w/ regards to statutory protections self-

identified sale of assets that results in exactly same economic consequences as a merger will nonetheless be governed by the lesser shareholder protections associated w/ a sale of assets

I. DUTY OF LOYALTY IN CONTROLLED MERGERSi. Tension b/w controlling shareholders’ voting rights which can arguably reflect her

own selfish self-interest and her exercise of “control” over the corp or its property which cannot due to her fiduciary duties to the corp

1. Exercise of control that gives rise to an obligation of fairness de facto power to do what other shareholders can’t such as controller’s power to access nonpublic corporate info or influence the board to approve a transaction w/ another company in which the controller is financially interested

2. Controlled mergers—including parent-subsidiary mergers—expose minority shareholders to an acute risk of exploitation

ii. Cash Mergers or Freeze-outs1. SEC adopted rule 13e-3 under Williams Act specifically to require

uniquely extensive disclosure in going-private transactions 2. Weinberger v. UOP, Inc. (Del 1983)

a. FACTS: P, former shareholder of UOP, challenged elimination of UOP’s minority shareholders by a cash-out merger b/w UOP and its majority owner, Signal Co.

i. Signal had previously acquired 50.5% of UOP at $21/share when it had traded at $14/share

ii. Signal officers decided it would be good investment to acquire remaining 49.5% of UOP shares at any price up to $24/share

1. NOTE: as majority shareholder, Signal owed fiduciary duties to its own stockholders AND to UOP’s minority

iii. Signal’s board unanimously adopted a resolution authorizing Signal to propose to UOP a cash merger of $21/share required 2/3 approval (minority shares + Signal’s 50.5%) by UOP; resolution to accept offer proposed and adopted; in proxy statement—UOP mgmt./board urged approval of the board

1. 51.9% of minority voters (only 56% of the minority voted – so 51% of 56%) voted for merger; merger became effective and each share of UOP’s stock held by the minority was automatically converted into a right to receive $21 cash

b. COURT: report prepared by Signal outlining effect of merger on Signal, solely for the use of Signal—and was not given to directors at UOP doesn’t meet fiduciary standards applicable to transaction (report indicated range of $21-$24 would be good investment for Signal)

i. Matter of material significance since $21-$22 was discussed w/ UOP Directors;

ii. Problem occurs b/c there were common Signal-UOP directors participating at least to some extent in the UOP board’s decision-making processes w/out full disclosure of conflicts they faced

iii. When directors of a DE corp are on both sides of a transaction they’re required to demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain

1. No dilution of this obligation where one holds dual or multiple directorships as in parent-subsidiary context

iv. Concept of fairness has 2 aspects fair dealing AND fair price

1. Fair dealing = when transaction was time; how it was initiated/structured/ negotiated/disclosed to directors; how approvals of the directors and stockholders were obtained

a. Part of this is duty of candorb. One possessing superior

knowledge may not mislead any stockholder by use of corporate knowledge to which latter isn’t privy

2. Fair price = economic and financial considerations of the proposed merger,

including all relevant factors—assets/market value/earnings/future prospects/other elements affecting intrinsic or inherent value of company’s stock

a. More liberal approach at valuation must include proof of value by any techniques/methods which are generally considered acceptable in the financial community and otherwise admissible in court subject only to DGCL 262(h)

b. Stockholder entitled to be paid for that which has been taken from him proportionate interest in a going concern

c. Above elements and facts that could be ascertained at date of merger and throw light on future prospects of merged corp MUST be considered by agency fixing the value

i. Must exclude only speculative elements of value that may arise from accomplishment/execution of merger

ii. Standard applicable to appraisal

3. BUT b/c issue is ENTIRE FAIRNESS looked at as a whole

3. Rabkin v. Phillip A. Hunt Chemical Corp (Del 1985): even though under Weinberger, appraisal was to be exclusive remedy for shareholder complaints about merger consideration—the court permitted a nonappraisal attack on a cash-out merger action to proceed

a. Found cases could continue to be litigated where the claim was that a fiduciary duty b/w parties had been breached

b. Thus—entire fairness actions rather than appraisals have been principal means of attacking the fairness of price in a self-dealing merger

4. Today—discounted cash flow analysis is the most common technique for estimating asset values

a. Weinberger—“new” appraisal actions where the fair value to which a dissenter is entitled includes fair share of synergy gains that are available in the merger

b. BUT DE 262(H) states such gains are NOT to be included in the fair value which is said to be exclusive of any element of value arising from accomplishment or expectation of the merger

5. Cede v. Technicolor, Inc. (DE 1996)(supra)a. Two-step, arm’s length cash merger b. TRIAL Court found that although Perlman in acquiring

Technicolor may have owed a fiduciary duty to pay a fair price to public minority shareholders of Technicolor in the first step, following the closing of step one (tender offer)—the fact that the merger price had been fixed in arm’s length negotiations w/ an independent board and no important new info bearing on value since the date of the merger agreement had emerged meant negotiated price would be deemed fair

i. SUPREME COURT of DE—Perelman as controlling shareholder following tender offer had a burden to establish that the price paid to minority stockholders was fair and couldn’t be satisfied by looking to results of negotiations since Perelman had begun to implement his new business plan by the time of cash-out merger

ii. P could pursue appraisal action AND breach of fiduciary duty claim

1. Where there is a claim that the defendant owes fiduciary duties to public shareholders—as in parent-subsidiary merger or even two-tier cash-out merger by a third party—

appraisal is not exclusive remedy for complaints concerning price

a. BUT where there is straight one-step cash or stock merger b/w firms w/ NO shared ownership interest (arm’s length) complaints about price alone may be relegated to appraisal

6. Benefits of breach of fiduciary duty claim over appraisal a. Can be brought before effectuation of merger—greater

leverageb. Class action and means of counsel getting paid

iii. What Constitutes Control and Exercise Control1. REMEMBER: safe harbor statutes self-dealing fiduciaries have 2

principal devices for easing burden of proving entire fairness—shareholder ratification and independent director approval

a. Also available in controlled mergers 2. Kahn v. Lynch Communication Systems, Inc. (Del 1994)

a. COURT: controlling/dominating shareholder standing on both sides of a transaction as in a parent-subsidiary context bears the burden of proving its entire fairness

i. Even where there is no coercion intended, minority shareholders voting on a parent subsidiary merger might perceive that their disapproval could risk retaliation of some kind by controlling shareholder

ii. EXCLUSIVE standard of review in examining the propriety of an INTERESTED cash-out merger transaction by controlling OR dominating shareholder is entire fairness

1. Initial burden of establishing is on party who stands on both sides BUT

a. An approval of the transaction by an independent committee of directors or an informed majority of minority shareholders shifts the burden of proof on issues of fairness to challenging shareholder/P

b. BUT mere existence of independent special committee

doesn’t shift the burden alone; also need

i. Majority shareholder NOT dictating terms of merger AND

ii. Special committee must have real bargaining power that it can exercise w/ majority shareholder on an arm’s length basis

iv. Special Committees of Independent Directors in Controlled Mergers1. Effect given by courts of properly constituted/diligent/well-advised

special committee’s decision to approve interested transaction a. Treat special committee’s decision as that of

disinterested and independent board which merits review under deferential BJR

b. Continue to apply the entire fairness test even if the committee appears to have acted w/ integrity

v. Controlling Shareholder Fiduciary Duty on the First Step of a Two-Step Tender Offer1. Controlling shareholder who sets the terms of transaction and

effectuates it through his control of the board has a duty of fairness to pay a fair price

a. Kahn—controlling shareholder must still pay fair price even if he merely offers the transaction to the board BUT the burden lies w/ objecting shareholder to prove its price unfair

2. Duty of controlling shareholder who skips the board altogether and “offers” transaction directly to the public shareholders in the form of a tender offer

a. Shareholder has a duty under both corporate law and federal securities law (14(e) of 1934 act) to disclose all material info respecting the offer BUT there’s no duty under federal law to pay “fair price”

b. DE court—as long as such an offer is not coercive—as for example it would be if controller threatened to discontinue paying dividends – entering such a transaction is voluntary on part of minority shareholders

i. If they don’t like price—remain shareholders in the company and force the controller to cash

them out in which case they’ll have protection of appraisal action

XIII. PUBLIC CONTESTS FOR CORPORATE CONTROL A. INTRO

i. Stock prices fall when companies fail to perform well and cheap stock presents an opportunity to those who believe they could do better than incumbent managers driven by any of several motivations for acquisitions

ii. Threat of takeover can encourage mgrs. to deliver to their shareholder value iii. Traditionally – 2 avenues for initiating hostile change in control

1. Proxy contest—running an insurgent slate of candidates for election to the board

2. Tender offer—simpler expedient of purchasing enough stock for oneself to obtain voting control

a. Costlier than proxy contest but captures stockholders’ attention w/ promise of cash up front rather than promise of future performance

b. Proxy contest and tender offer have often merged into single hybrid form of hostile takeover

iv. DE’s attempt set framework for analysis of directors’ fiduciary duties in M&A transactions

1. Smith v. Van Gorkom—arose out of friendly 2-step acquisition consisting of cash tender offer followed by cash-out merger

a. An entire board was held liable for “gross negligence” under circumstances most experts would have said the standard of care had been met

2. Unocal Corp v. Mesa Petroleum (1985)a. Efforts by Unocal to defend against hostile tender offerb. Standard of judicial review intermediate b/w BJR and

entire fairness to address board efforts to defend against threatened change in control transaction

3. Revlon v. MacAndrews and Forbes Holdings (DE 1986)a. Addressed efforts by incumbent board to resist an

unwelcome takeover by pursuing an alternative transaction

b. Court adopted a form of heightened review short of intrinsic fairness

B. DEFENDING AGAINST HOSTILE TENDER OFFERSi. Unocal Corp v. Mesa Petroleum (Del 1985)

1. FACTS: Mesa owned 13% of Unocal’s stock; began a two-tier frontloaded cash tender offer for 37% of Unocal’s outstanding stock

a. “Back-end’ designed to eliminate the remaining publicly held shares by an exchange of securities worth $54/share but were junk bonds

b. After hearing presentations 8 members of the 13 members present at directors’ meeting unanimously agreed to advise the board that it should reject tender offer as inadequate and Unocal should pursue self-tender to provide stockholders w/ fairly priced alternative

2. COURT: under DE law—in the acquisition of its shares , a DE corp may deal selectively w/ its stockholder provided the directors haven’t acted out of sole/primary purpose to entrench themselves in office

a. When a board addresses a pending takeover bid- it has an obligation to determine whether the offer is in the best interest of the corp and it shareholders

i. Should be afforded same respect as any BJ BUT1. Enhanced duty exists which calls for

judicial examination at the threshold before BJR can be conferred due to the idea a board may be acting primarily in its own interests

ii. Directors must show they had reasonable grounds for believing a danger to corporate policy and effectiveness existed BECAUSE of another person’s stock ownership

1. Directors to protect shareholders from perceived harm whether it’s from 3d parties or other shareholder

a. But can’t have unbridled discretion to defeat any perceived threat by any means possible

iii. Restriction placed on selective stock repurchase is that the directors may NOT have acted solely or primarily out of a desire to perpetuate themselves in office

iv. If defensive measure is to come w/in ambit of BJR—must be reasonable in relation to the threat posed analysis by directors of the nature of takeover bid and its effect (inadequacy of price; nature/timing of the offer;

illegality; risk; securities’ quality offered in exchange); consider basic stockholder interest

v. Front-loaded two-tier offers are classic coercive measure designed to stampede shareholders into tendering at first tier out of fear they’ll receive backend of the offer

vi. The selective offer was reasonable related to threats posed

1. If board is disinterested; acted in good faith and with due care—will be upheld as proper exercise of BJ in the absence of abuse of discretion

2. Unless shown that directors’ decisions were primarily based on perpetuating themselves in officer or some other breach of fiduciary duty – court won’t substitute its judgment for that of the board

ii. Enhanced business judgment review of Unocal 1. To earn protection of BJR—board must show that its defensive tactic

was reasonable in relation to the threat posed iii. Unitrin v. American General Corp (DE 1995):

1. Threat of “substantive coercion” board believed shareholders might be “coerced” b/c they wouldn’t fully understand the value of their stock or the inadequacy of the consideration offered

2. Court found that if board of directors’ defensive response is not draconian (preclusive or coercive) and is w/in range of reasonableness court must not substitute its judgment for the board’s

a. If board established action was proportionate and w/in range of reasonableness—burden will shift back to Ps to prove defensive action was nevertheless breach of the duty motivated to maintain board in office

iv. Under Unocal/Unitrin1. Target’s directors NOT the Ps bear burden of going forward w/

evidence to show that the defensive action was proportionate to a threat

2. Substantively, action that is preclusive or coercive will fail to satisfy Unocal test

3. Assuming defensive measure passes preclusive/coercive test—satisfy Unocal so long as it’s w/in range of reasonable action

a. Similar to BJR in which an action will be sustained if it is attributable to any reasonable judgment

C. PRIVATE LAW INNOVATION: THE POISON PILL i. Poison Pill—

1. Rights to buy the company’s stock at a discounted price are distributed to all shareholders;

a. Rights are triggered—become exercisable to actually buy discounted stock—only if someone acquires more than a certain percentage of the company’s outstanding (1o or 15%)—without first receiving the target board’s blessing

i. The person whose stock acquisition triggers the exercise of the rights is excluded from buying discounted stock

1. Holdings severely diluted2. Practical power to veto a tender offer

2. Flip-in pill: each outstanding right would “flip-into” a right to acquire some number of shares of the target’s common stock at one half the market price for the stock

a. The right’s holder would be able to buy stock from the company at half price

b. Aggregate effect is to increase the proportionate holdings of all shareholders except the triggering person whose right would be canceled upon the occurrence of the triggering event and who, as a result, would only own a much smaller interest in the company than that for which she originally paid

3. Flip-Over Pilla. Purported when triggered to create a right to buy some

number of shares of stock in the corporation whose acquisition of target stock had triggered the right

b. Triggering event when followed by a merger or sale of more than 50% of the target’s assets to the triggering shareholder results in rights being exercisable

c. Purport to compel the target’s board to put terms in any merger agreement w/ the acquirer that will force the acquirer to recognize flip=over rights

4. Moran v. Household Int’l (DE 1985)a. FACTS: board of directors voted to adopt Rights Plan

which provides that stockholders are entitled to the issuance of one Right per common share under triggering conditions (announcement of tender offer for 30% of shares OR acquisition of 20% of shares by single entity or group)

i. Tender offer announcement triggers rights that are issued and immediately exercisable and redeemable; acquisition triggers aren’t redeemable; if right is not exercised for preferred and a merger or consolidation occurs, the Rights holder can exercise each right to purchase $200 of the common stock of the tender offeror for $100

ii. The rights plan was adopted as a preventative measure to ward off future advances

b. COURT – at issue is the applicability of BJR but b/c BJR can only sustain corporate decisions that are w/in the power or authority of Board, it must first be determined whether the Directors were authorized to adopt the Rights plan

i. w/ regards to flip-over provisions anti-destruction clauses generally ensure holders of certain securities of the protection of their right of conversion in the event of a merger by giving them the right to convert their securities into whatever securities are to replace stock of their company

ii. authority for the Rights Plan exists in DCGL 157 and 141(a) concerning the mgmt. of corp’s business and affairs

iii. Board can’t arbitrarily reject tender offer and request to redeem the rightsheld to same fiduciary standards any other board of directors would be held to in deciding to adopt a defensive mechanism

1. Restriction upon individuals/groups from first acquiring 20% of shares before waging a proxy contest doesn’t fundamentally restrict stockholders’ rights to conduct proxy contest

iv. Under Unocal directors must show that they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed through establishing good faith and reasonable investigation

1. AND that the defensive mechanism was reasonable in relation to the threat posed

2. THEN BJR applies 5. All that’s required to adopt poison pill board meeting NOT

shareholder vote 6. DE S.Ct—boards have an ongoing fiduciary duty to redeem the pill if

it’s no longer reasonable in relationship to the threat of an acquisition offer

7. “chewable” pilldisappear if certain fair price criteria are met—fully financed 100% offer for a 50% or more premium over current market price

D. CHOOSING A MERGER OR BUYOUT PARTNER i. Smith v. Van Gorkom (DE 1985)

1. FACTS: shareholders sought rescission of cash-out merger which was decided upon by an uninformed board approving it based primarily on Van Gorkom’s representations

2. COURT: substantial premium may provide one reason to recommend a merger BUT in the absence of other sound valuable info—the fact of a premium alone does NOT provide an adequate basis upon which to assess fairness of offering price

a. Vote approving the merger did not have the legal effect of curing any failure of the board to reach an informed business judgment in its approval of the merger stockholders weren’t fully informed of all facts material to their vote and the board acted in a grossly negligent manner; Van Gorkom’s representations on which the Board based its actions don’t constitute “reports” under 14e on which directors could’ve easily relied

b. NOTE: courts generally refuse to examine the reasonableness of decisions made by disinterested directors in the board’s regular decision-making process

i. Perhaps to be understood as the first of several important cases in which the court struggled to construct a new standard of judicial review for change in control transactions

ii. Introducing REVLON1. Revlon, Inc. v. MacAndrews and Forbes Holdings, Inc. (Del 1986)

a. FACTS: original threat posed by Perelman and Pantry Pride, the break-up of the company became a reality which directors embraced selective dealing to fend

off a hostile but determined bidder was no longer a proper objective

i. Obtaining the highest price for the benefit of the stockholders should’ve been the central theme guiding director action

ii. When Revlon entered into auction ending-up lock-up agreement w/ their White Knight Forstmann on the basis of impermissible considerations at the expense of their shareholders—breached primary duty of loyalty

iii. A board may have regard for various constituencies in discharging its responsibilities provided there are rationally related benefits accruing to stockholders BUT such concern for NON-stockholders’ interests is inappropriate when an auction among active bidders is in progress and the object no longer is to protect or maintain the corporate enterprise but to sell to highest bidder

1. Lockups which end an active auction and foreclose further bidding operate to shareholders’ detriment

2. Result of lock-up here wasn’t to foster bidding but to destroy it

iv. When a board ends an intense bidding contest on an insubstantial basis and where a significant by-product of that action is to protect directors against a perceived threat of personal liability for consequences stemming from adoption of previous defensive measures action cannot w/stand enhanced security which Unocal requires of director conduct

1. No-shop provisions are impermissible under Unocal when board’s primary duty becomes that of auctioneer responsible for selling the company to the highest bidder

2. When bids are similar—board can’t fulfill enhanced Unocal duties by playing favorites w/ contending factions—can’t favor white knight if other corp offer is adverse to interests

3. Market prices must be allowed to operate freely to bring target’s shareholder the best price available

2. Barkin v. Amsted Industries (Del 1989)a. Directors may not use defensive tactics that destroy the

auction process. Fairness forbids directors from using defensive mechanisms to thwart an auction or to favor one bidder over another

i. If only single bidder at the table—before singing up the deal, the board must engage in market check to see if higher bid is available unless directors possess body of reliable evidence w/ which to evaluate fairness of transaction

3. In re Pennaco Energy—board negotiated exclusively w/ Marathon Oil E. DIRECTOR AND MANAGEMENT COMPENSATION

i. Different type of self-dealing transaction payment of compensation to D&Os1. But is a necessary form of self-interested transaction2. Traditionally—EE compensation is core matter of business judgment

for the board 3. Substantial part of mgr compensation should take the form of fixed,

short-term claims salary commitments a. BUT fixed salary unlikely to do enough to induce a mgr

to accept risky projects that nevertheless are valuable from long-term shareholder perspective

b. Section 162(m) of Internal Revenue Code prevents public companies from taking a tax deduction for annual compensation to the CEO or four other top employees in excess of $1mil unless compensation is performance-based

4. Alternative to fixed salaries is high-powered incentive compensation based on the performance of individual managers OR on performance of company as a whole

ii. Perceived Excessive Compensation 1. Difficult to determine whether any particular CEO receives excessive

pay partly b/c it’s difficult to estimate the market price for unique executive talent

iii. Option Grants and the Law of Director and Officer Compensation 1. Lewis v. Vogelstein (Del 1997)

a. QUESTION: whether the waste standard that is utilized where informed shareholders ratify a grant of options that is recommended by a self-interested board is the classical waste test (no consideration; gift; no person of

ordinary prudence could possibly agree) OR whether it’s a species of intermediate review in which the court assesses reasonableness in relationship to perceived benefits

b. COURT: shareholder assent is a more rational means to monitor compensation than judicial determinations of fairness or sufficiency of consideration

i. Classic waste standard does afford some protection against egregious cases of constructive fraud

ii. Classic waste doctrine invoked to reject Ds’ motion to dismiss

2. Corporate loans to officersa. Section 402 of Sarbanes-Oxley Act of 2002

i. Prohibits any corporation whose shares trade on national exchange or NASDAQ or the subsidiary of such a corp from directly or indirectly extending any credit to any director or executive officer of the corp

iv. Regulatory Responses to Executive Compensation 1. Compensation committee of the board of directors generally sets the

compensation of the CEO/top officers in public corps2. SEC enhanced disclosure rules regarding compensation available to

institutional investorsa. Companies had to disclose in a standardized summary

compensation table the annual compensation long-term compensation and all other compensation for the top 5 EEs in the company

b. Narrative description of all employment contracts w/ top execs and disclosure of a compensation committee report explaining committee’s compensation decisions

c. Graph showing the company’s cumulative shareholder returns for the previous five years along with a broad-based market index and peer-group index for the same period

v. The rest is in the casebook 334-338

F. PULLING TOGETHER UNOCAL AND REVLON i. Paramount Communications Inc. v. Time, Inc. (Del 1989)

1. FACTS: Paramount launched bid after Time had already initiated a friendly merger transaction w/ Warner communications; Time thwarted Paramount by transforming original merger deal into a

tender offer by Time for Warner making itself too large/debt-ridden to be an attractive target; Time’s board rejected Paramount’s tender offer of $175/share as grossly inadequate and concluded that Warner was better deal; decided to do the tender offer by Warner after which a merger would be effectuated; shareholders asserted first a Revlon claim in that merger agreement put Time up for sale triggering Revlon duties and that directors structured merger to be takeover proof triggering Revlon duties by foreclosing their shareholder from any prospect of control premium; Paramount assets Unocal claim in that there was no cognizable threat to shareholders and no reasonable investigation of offer to be informed before rejecting AND that Time’s response wasn’t reasonable

2. COURT: board of directors’ duty to manage business/affairs is to do so in the best interest of corp w/out regard to fixed investment horizon

a. W/ regards to Revlon claims—no substantial evidence existed to conclude that Time’s board in negotiating w/ Warner made the dissolution or breakup of the corporate entity inevitable as was the case in Revlon

i. 2 circumstances under DE law which may implicate Revlon duties

1. When corp initiates an active bidding process seeking to sell itself or to effect a business reorganization involving a clear break-up of the company

2. Where in response to bidder’s offer a target abandons its long-term strategy and seeks an alternative transaction also involving the breakup of the company

a. “bust-up” sale of assets in leveraged acquisition must maximize immediate shareholder value and fulfill obligation to auction company fairly

ii. IF board’s reaction to hostile tender offer is found to constitute only a defensive response and NOT an abandonment of the corporation’s continued existence Revlon duties not triggered and Unocal duties attach

iii. Time’s recasting of its merger agreement doesn’t form conclusion that Time had either

abandoned its strategic plan or made sale of Time inevitable Unocal alone attaches

iv. Unocal Analysis 1. Time board’s decision to expand the

business of the company through the original merger w/ Warner was entitled to BJR

2. The later transaction was found to be defense-motivated thereby invoking Unocal—applied to all director actions taken that were reasonably determined to be defensive

3. Unocal standard not to lead to a simple math exercise of comparing discounted value w/ another’s offer and determining what’s higher

4. Time’s decision that Paramount’s offer posed a threat to corporate policy and effectiveness wasn’t motivated by self-dealing or bad faith

a. Time’s board reasonably perceived Paramount’s offer to be significant threat and Time’s response wasn’t overly broad and was reasonably related to the threat

ii. Paramount Communications v. QVC Network, Inc. (Del 1994)1. FACTS: Paramount unanimously approved Original Merger Agreement

whereby Paramount would merge w/ and into Viacom; Paramount agreed to amend its poison pill Rights Agreement to exempt proposed merger w/ Viacom; Also had a No-Shop Provision; Termination fee and Stock Option Agreement

a. No shop agreement—agreed Paramount wouldn’t solicit/encourage/discuss/negotiate/endorse any competing transaction unless: third party makes unsolicited proposal and board determines discussions necessary to comply w/ fiduciary duties

b. Termination fee—Viacom would receive $100mil fee if Paramount terminated agreement b/c of competing transaction, Paramount’s shareholders didn’t approve the merger or board recommended competing transaction

c. Stock option agreement granted to Viacom an option to purchase approximately 19.9% of P’s outstanding common stock if any of the triggering events for Termination fee occurred PLUS Viacom permitted to pay for the shares w/ senior subordinated note of questionable marketability instead of cash and Viacom could elect to require Paramount to pay Viacom in cash a sum equal to difference b/w purchase price and market price of stock

d. QVC filed action and publicly announced $80 cash tender offer for 51% of P’s outstanding shares and each remaining share of common stock would be converted into shares of QVC common stock in second-step merger led to amended merger agreement b/w P and V—V upped tender offer price to which QVC upped But P board determined that this offer wasn’t in best interests

2. COURT: case implicates 2 circumstances in which enhanced scrutiny will be subjected by the court approval of a transaction resulting in sale of control and adoption of defensive measures in response to threat to corporate control

a. In sale of control context—directors must focus on one primary objective – to secure the transaction offering the best value reasonably available for the stockholders—and they must exercise their fiduciary duties to further that end

i. Include conducting auction, canvassing market, etc. no single blueprint

ii. Enhanced scrutiny here is mandated by : threatened diminution of current stockholder’s voting power; fact that an asset belong to public stockholders (control premium)is being sold and may never be available again; and traditional concern of DE courts for actions impairing/impeding stockholder voting rights

iii. Features of enhanced scrutiny test1. Judicial determination regarding

adequacy of decision making process employed by directors including info on which the directors based their decision

2. Judicial examination of the reasonableness of the directors’ action

in light of the circumstances then existing

a. Directors—burden of proving that they were adequately informed and acted reasonably

iv. Court is NOT substituting its BJ BUT determining if directors’ decision was on balance w/in range of reasonableness

v. Revlon implicated b/c Paramount Board initiated an active bidding process seeking to sell itself by agreeing to sell control of the corp to Viacom in circumstances where another potential acquirer was equally interested in being a bidder

1. Both a change of control and a breakup are NOT required to implicate Revlon duties

2. When corp undertakes a transaction which will a change in corporate control OR break-up of the corporate entity the directors’ obligation is to seek the best value reasonably available to stockholders

vi. Paramount directors had the obligation 1. To be diligent and vigilant in examining

critically the Paramount-Viacom transaction AND the QVC tender offers

2. To act in good faith3. To obtain and act w/ due care on all

material info reasonably available including info necessary to compare the 2 offers to determine which of these transactions or an alternative course of action would provide the best value reasonably available to the stockholders; and

4. To negotiate actively and in good faith w/ both V and QVC to that end

5. THIS INCLUDES the defensive tactics, i.e. no shop/termination fee/stock option

a. Board to consider whether these adversely affect values to stockholders; inhibited/encouraged alternative bids; enforceable contractual obligations in light of fiduciary duties; would advance or retard directors’ obligation to secure stockholders’ best value reasonably available under circumstances

vii. Adopts change in corporate control trigger to distinguish b/w Revlon and non-Revlon duties

1. NOTE: stock-for-stock merger b/w 2 public companies w/ no controlling shareholders shouldn’t trigger Revlon but be reviewed under BJR

2. NOTE: Cash merger generally triggers Revlon duties unless there is ALREADY a majority shareholder in target company

3. NOTE: Paramount v. QVC imposes Revlon duties on target’s board when a merger shifts control to controlling shareholder but Time-Warner refuse to impose duties when control remains in dispersed body of shareholders

4. Spectrum of Revlona. Where as in Revlon the merger consideration is cash—

courts won’t defer to board’s judgment i. Where as in Santa Fe the consideration is stock

of a company approximately equal in size deal protections will receive greatest deference

ii. Where the merger represents mixed consideration or target is vastly smaller than survivor—courts will inevitably assess deal protective terms by evaluating the good faith of the corporate directors who approve these terms

5. Lyondell Chemical v. Ryan (Del 2009)a. FACTS: claim that directors failed to act in good faith in

conducting the sale of their company –inaction; merger price as grossly insufficient; directors motivated to approve merger for own self-interest; process by which

merger was negotiated was flawed; directors agreed to unreasonable deal protection provisions; prelim proxy statement omitted numerous material facts

b. COURT: Revlon did not create any new fiduciary duties but simply held that the board must perform its fiduciary duties in the service of specific objective—maximizing sale price of the enterprise; b/c charter had 102b7 provision duty of care breach exculpated and case must implicate duty of loyalty in order for directors to be liable – bad faith as breach of loyalty?

i. Bad faith can be intent to harm but also intentional dereliction of duty

ii. No court can tell directors exactly how to accomplish the Revlon duty of getting the best price for stockholders at a sale of the company

1. Must be reasonable decisions—not perfect decisions

2. Extreme set of facts is required to sustain a disloyalty claim premised on the notion that disinterested directors were intentionally disregarding their duties

a. If directors failed to do all they should’ve done under the circumstances—they breached duty of care

b. Only if they knowingly and completely failed to undertake their responsibilities would they breach their duty of loyalty

c. Did not breach duty of loyalty by failing to act in good faith

G. PROTECTING THE DEAL i. Revlon duties generally arise in context of negotiating or enforcing deal protection

provisions which could include lockups and termination payments1. Lock-up—any K, collateral to an M&A transaction, that is designed to

increase the likelihood that the parties will be able to close the deala. Two major categories—options to target’s assets and its

stocki. Asset lock-ups create rights to acquire specific

corporate assets that become exercisable after a triggering even such as target shareholder

vote disapproving merger OR target board’s decision to sign alternative merger agreement

1. target company will lose some of its attractive assets

2. Almost non-existent since Revlon which struck down an asset lockup granted to Forstmann Little

ii. Stock lock-ups are options to buy a block of securities of the target company’s stock (often 19.9% of current outstanding shares) at a stated price

1. Virtually non-existent 2. Termination fees or breakup fees are left now cash payments in the

event that the seller elects to terminate the merger or otherwise fails to close

a. Courts approve such fees as payment for time/money/energy even when target was in auction mode and subject to Revlon duties

3. In theory—when no change in control is involved in an M&A transaction the board acting in good faith is free to choose a facially lower-value merger over a higher value deal if it concludes it’s in the best interest of the corp to do so ‘

a. Same idea—court should review even a termination fee protecting such a transaction under traditional BJR

b. BUT courts will use Unocal version of BJ review since protective provision serves obvious defensive function

ii. No Shops/No Talks and Fiduciary Outs1. Buyers protect against risks in two ways

a. May seek large lockupb. May seek certain covenants from the seller that will

protect their deal i. Not to shop for alternative transactions or

supply confidential info to alternative buyersii. To submit the merger agreement and no other

agreement to shareholders for approvaliii. To recommend the shareholders approve this

agreement 2. When 3d party makes better offer before shareholders vote on

original offer Smith v. Van Gorkom found that a target’s board of directors had no fiduciary right (as opposed to power) to breach K

a. Even if the directors’ fiduciary duty required them to breach—corp wasn’t privileged to do and would be liable

b. Thus comes the Fiduciary Out clause specifies that if some triggering event occurs such as better offer or an opinion from outside counsel that the board has fiduciary duty to abandon the original deal—then target’s board can avoid K w/out breaching it

c. NOTE: if Revlon applies—no K term can protect a negotiated deal from an alternative buyer who’s willing to pay significantly more

d. Also note—DE S.Ct. seems to declare K unenforceable that violate fiduciary duty so K damages may not ever be available against corp that abandons a transaction subject to Revlon duties on grounds better deal is available

iii. Shareholder Lock-ups1. Omnicare, Inc. v. NCS Healthcare, Inc (DE 2003)

a. FACTS: Omnicare bid for NCS who rejected it; NCS contacted Genesis about possible transaction; Genesis had previously been outbid by Omnicare before so they were insistent about exclusivity agreements and lock-ups; upon hearing about this, Omnicare contacted NCS who didn’t return calls b/c of exclusivity agreement which prevented NCS from engaging or participating in any discussions/negotiations w/ respect to competing transaction

b. COURT: NCS directors’ decision to adopt defensive tactics to completely “lock up” the Genesis merger mandated special scrutiny under 2-part test of Unocal

i. BUT these were not reasonable devices to protect the Genesis merger or proportionate to the threat NCS perceived from potential loss of Genesis transaction

ii. Directors must first demonstrate they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed show they acted in good faith after conducting reasonable investigation

1. Next directors must show defensive response was reasonable in relation to threat posed

a. Establish merger deal protection devises weren’t coercive or preclusive

i. Preclusive—deprives stockholders of right to receive all tender offers or precludes bidder from seeking control by fundamentally restricting proxy contest

b. Actions were within range of reasonableness

iii. Fiduciary out the specifically enforceable irrevocable voting agreements; provision requiring board to submit transaction for stockholder vote AND the omission of fiduciary out clause completely prevent the board from discharging its fiduciary responsibilities to minority stockholders when Omnicare presented its superior transaction

1. Agreement requiring board to act or not act in such a way as to limit exercise fiduciary duties is invalid/unenforceable

c. DISSENT: pg 584-585H. PROXY CONTESTS FOR CORPORATE CONTROL

i. Alternatives for change in mgmt. negotiate w/ incumbent board OR1. Hostile option of running a proxy contest and tender offer

simultaneously a. Closing tender offer is conditioned on electing

acquirer’s nominees to the board and the board’s redemption of target’s poison pill

i. Board MAY engage in a wide variety of actions that are designed to impede an insurgent from gathering enough support to oust the current board through shareholder vote

ii. Schnell v. Chris-Craft Industries (Del 1971)1. FACTS: petition of dissident stockholders for injunctive relief to

prevent mgmt. from advancing the date of the annual stockholders’ meeting

2. COURT: when the by-laws of corp designate the day of the annual stockholder meeting—expected that those who intend to contest the

reelection of incumbent mgmt. will gear their campaign to the by-law date

a. Not expected that mgmt. will attempt to advance the date in order to obtain inequitable advantage in the contest

b. Even though a corp may comply w/ DE law—inequitable action doesn’t become permissible simply b/c it’s legally possible

3. Expression of most fundamental rule of fiduciary duty of loyaltylegal power held by a fiduciary may not be deployed in a way that is INTENDED to treat a beneficiary of that duty unfairly

iii. Blasius Industries v. Atlas (De 1988)1. FACTS: Blasius, owner of 9% of Atlas stock, proposed a restructuring of

Atlas’ mgmt. that would’ve resulted in major sale of Atlas assets, infusion of new debt financing and disbursement of a very large cash dividend to Atlas’ shareholder ; when mgmt. rejected—Blasius announced it would pursue campaign to obtain shareholder consents to increase Atlas’ board from 7 to 15 – max size allowed by charter—and to fill new seats w/ Blasius nominees; Atlas immediately amended by-laws to add two new board seats and filling them w/ own candidates

2. COURT: while addition of new seats/members would under other circumstances be clearly appropriate as an independent step, such a step was in fact taken to impede or preclude a majority of shareholders from effectively adopting the course proposed by Blasius

a. Found that board was acting in good faith to protect the company BUT even so—action designed principally to interfere with the effectiveness of a vote inevitably involves a conflict b/w the board and shareholder majority

i. Judicial review of such action involves determination of legal/equitable obligations of an agent towards his principal not a question that court may leave to the agent finally to decide so long as he does so honestly and competently

1. NOT left to agent’s BJ3. NOTE: court rejects per se rule, holding instead that the board bears

the heavy burden of demonstrating a COMPELLING JUSTIFICATION after the P has established that the board acted for PRIMARY PURPOSE of thwarting the exercise of shareholder VOTE

a. Unocal—reasonable in light of threat

i. Manipulations of voting process can be characterized as defensive so may apply Unocal test?

b. Blasius—compelling in light of threati. Under Blasius—corporate action to defeat a

proxy contest can’t be justified by parallel belief that voters simply don’t understand the foolishness of voting for insurgents

ii. Specifically attempts to impede shareholder vote

c. Liquid Audio—Blasius applied b/c the primary purpose of LA’s actions was to reduce insurgent directors’ ability to reduce MM directors’ ability to influence board decision

i. LA increased board size from 5-7d. Mercier v. Inter-Tel: IT delayed a merger vote by 25

days in order to provide more info to shareholders and b/c it became clear that shareholders weren’t going to approve the merger on original meeting date

i. Directors should bear burden of proving that their action

1. Serves and is motivated legit corporate objective; and

2. Is reasonable in relation to legit objective and is not preclusive or coercive

4. NOTE on Hilton v. ITT Corpa. Hilton Hotels v. ITT Corp (Nev. 1997): court required to

determine whether certain defensive actions by ITT board in response to Hilton takeover attempt constituted violation of fiduciary duty

i. ITT delayed calling its annual meeting and structured reorganization which didn’t require a shareholder vote

ii. Hilton sought injunction against effectuation of reorganization w/out shareholder approvalcontended that the action was motivated to protect incumbency of board and constituted breach of fiduciary duty

1. Was preclusive/coercive under Unitrin 2. Held that the defensive action was

directed toward affecting the outcome

of the pending proxy contest for control of ITT and holding that no sufficiently compelling justification had been put forward

I. TAKEOVER ARMS RACE CONTINUESi. Dead Hand Pills

1. A pill can’t be redeemed by the hostile board that is elected in a proxy fight for a stated period of time

a. Early attempts—could only be redeemed by the company’s continuing directors or those who’d been in office at the time of pill’s adoption

2. Allow board to limit the ability of shareholders to designate those w/ board power OR recognize a power in current boards to restrict authority of future boards

a. Bank of New York v. Irving Bank NY S.Ct. struck down an early version of dead hand pill which defined continuing director to be any person elected by 2/3 outstanding shares

b. GA federal district court upheld continuing director dead hand pill

3. Carmody v. Toll Brothers—DE ‘s first address of dead hand pills (DE 1998)

a. Held such a device invalid b/c it created 2 classes of directors w/out necessary authorization in company’s charter AND unduly conditioned the rights of shareholders to elect new directors

4. Mentor Graphics v. Quickturn (DE 1998): a. In this version of dead hand pill—no discrimination b/w

old and new directors but that board had redemption power but not for 6 months following election of new board (Or majority of new directors)

b. Delayed redemption provision struck down by Unitrin/Unocal analysis

i. No abstract threat made reasonable the imposition on the shareholders’ right to have fully functioning directors in place

ii. S.Ct—asserted that the present board didn’t have the authority to restrict the power of FACTS: plans to exercise managerial judgment

ii. Mandatory Pill Redemption By-laws

1. Shareholder by-law that requires the board to redeem an existing pill and refrain from adopting a pill w/out submitting it to shareholder approval

2. Most DE firms mandatory bylaw would constitute an invalid intrusion by shareholders into realm protected by 141(a) of DGCL

a. Rights and duties to make independent judgments respecting mgmt. of the firm

b. Policy of this – casebook pg 609iii. Unisuper v. News Corp (DE 2005)

1. COURT: section 141(a) doesn’t say board can’t enter into Ks—simply describes who will manage affairs of the corp and precludes a board from ceding that power to outside groups or individuals

a. Fact that the alleged contract regarding poison pills gives power to the shareholders saves it from invalidation under 141(a)

i. Ceded power over poison pills to the shareholders

ii. When shareholders exercise their right to vote in order to assert control over business and affairs of the corporation—board must give

1. Board’s power drives from shareholders b. Ks in Paramount and Quickturn were defensive

measures that took power out of the hands of shareholders

i. “omnipresent specter” that the board was using the K provisions to entrench itself prevent the shareholders from entering into a value-enhancing transaction w/ competing acquirer

1. HERE: power is directly in hands of shareholders – no risk of entrenchment

c. Unlike board in Omnicare—board entered into K that empowered shareholders giving them a voice in particular corporate governance matter—the poison pill

d. Fiduciary duties cannot be used to silence shareholders and prevent them from specifying what the corporate K is to say

e. Once corporate K is made explicit on particular issue directors must act in accordance w/ the amended corporate K

2. Restrictions on the board’s power imposed by shareholders (permissible) vs. restrictions on the board’s power imposed by the board itself (may not be permissible)

XIV. TRADING IN CORPORATION’S SECURITIES A. INTRO:

i. Publicly financed corps—primarily an area of federal law1. Securities Exchange Act of 1934 primary source

B. COMMON LAW OF DIRECTORS’ DUTIES WHEN TRADING IN THE CORPORATION’S STOCKi. C/L doctrine of fraud elements

1. False statement of material fact2. Made w/ the intention to deceive3. Upon which one reasonably relied and which 4. Caused injury

ii. Fraud remedy generally not available when buyer/seller failed to disclose w/out overt deception

1. Fraud unavailable to redress the losses of persons trading over impersonal markets—couldn’t have traded in reliance on statements by unknown counterparts

iii. Rules:1. Majority rule: director’s only duty was to corporation and he did not

owe a duty of disclosure to those w/ whom he traded shares2. Minority: director had a duty to disclose material information when he

traded opposite shareholders in company’s stock3. Special facts: director has obligation to disclose material, special facts

or refrain from buying corporate stock in face-to-face transaction iv. Goodwin v. Agassiz (Mass 1933):

1. FACTS: stockholder in corp seeks relief for losses suffered by him in selling shares of stock

a. Ds bought on the Boston stock exchange 700 shares of stock belonging to P; Pres/director, director/GM had certain knowledge material as to the value of the stock – which P didn’t have (possible existence of copper)

b. P sold his share of stock through brokers—didn’t know the purchase was made for Ds no communication b/w them

c. P wouldn’t have sold stock if he had known of copper possibility

2. COURT: directors of commercial corporation stand in a relation of trust to the corporation and are bound to exercise the strictest good faith in respect to its property and business

a. Directors aren’t trustees toward individual stockholders in the corporation

b. Directors’ knowledge as to condition of corp requires fair dealing when directly buying/selling its stock

i. Mere silence doesn’t equal breach of duty BUT parties may stand in relation that equitable responsibility exists to communicate

c. BUT—stock exchanges are different and impersonal i. Where a director personally seeks a stockholder

for the purpose of buying his share w/out making disclosure of material facts—transaction will be closely scrutinized

d. The copper theory was at most a hope requiring no disclosure and the company wasn’t harmed by nondisclosure

C. CORPORATE LAW OF FIDUCIARY DISCLOSURE TODAY i. Federal Court Remedies

1. Fed courts aggressively expanded federal investor remedies by implying private rights of action under Federal Securities Laws between 1946 and 1975

2. State fiduciary law plays role in 2 situationsa. Corporation can bring a claim against an

officer/director/EE for trading profits made by using information learned in connection w/ corporate duties

b. Shareholders can invoke state fiduciary duty to challenge the quality of the disclosure that their corporation makes to them

ii. Corporate Recovery of Profit from “Insider” trading 1. Idea that --Inside info as corporate assets and corp is entitled to any

profits made by its agents trading on ita. Agency law theory—agent may not use principal’s info

for personal profit b. Doesn’t matter principal isn’t injured leads to

constructive trust on profits from insider trading to discourage fiduciaries from violating duties

i. Under fiduciary or agency theory—corp or shareholders as a collectivity should be able to sue insiders derivatively to capture their profit on behalf of corporation

iii. Board Disclosure Obligations under State Law1. Although fed law is principal arbiter of disclosure obligations—

important C/L duty of disclosure arising out of Delaware 2. Director’s duty of candor under state law requires them to exercise

honest judgment to assure the disclosure of all material facts to shareholders

a. BUT failure to disclose a material fact is unlikely to give rise to liability unless failure represented INTENT TO MISLEAD

i. Otherwise—common charter waiver liability for damages, independent of a loyalty violation under 102(b)(7) will protect directors from good faith (when negligent) failure to adequately disclose

ii. NOTE: an injunction remains available if a P can show failure to disclose a material fact, regardless of the mental state of directors

D. EXCHANGE ACT SEC. 16(B) AND RULE 16i. 16(a) of Securities Exchange Act: designated persons must file public reports of any

transactions in corporation’s securities1. 403 of Sarbanes-Oxley Act of 2002: insiders have only 2 days in which

to file these reports ii. 16(b): strict liability rule intended to deter statutory insiders from profiting on

inside info1. Requires statutory insiders to disgorge to the corp any profits made on

short-term turnovers in the issuer’s shares (purchases and sales w/in 6 month periods)

2. How to calculate profits?a. Gratz v. Claughton – accepted rule that, in matching

sales w/ purchases for 16(b) purposes, a court must take into account all purchases and sales of the same class of securities occurring w/in 6 months of the reportable event (six months in future; six months in past)

i. Look back 6 months and match the number of shares sold (or purchased) w/ the same number of shares purchased (or sold); repeated looking forward 6 months; then deducts lower total purchase price from amount realized on the reportable sale to determine the profit, if any, that’s payable to corp

3. Who’s an “insider”?a. Statute explicitly covers:

i. 10% shareholdersii. Officers

iii. Directorsb. NOTE: titles alone are not dispositive

i. Relevant inquiry—whether the putative officer had recurring access to nonpublic information in the course of duties

4. What is a “Purchase or Sale”?a. All derivative combinations of purchase and sell that

track the financial characteristics of an issuer’s securities under 16(b)

b. All Ks or instruments that derive current value from the value of a covered security as a security for 16(b) purposes

5. Mergersa. Kern County Land Co. v. Occidental Petroleum Corp

(1973): w/in 6 month period: OPC acquired more than 20% of Kern; agreed to bow out and let Kern and Tenneco merge; Kern-Tenneco merger closed and OCP’ Kern shares converted by operation of law into Tenneco shares and OCP sold to Tenneco an option to repurchase its Tenneco shares for $9mil ; 6 months after OCP’s acquisition of Kern shares—bought out OCP which made $19mil profit

i. COURT: option grant wasn’t sale of stock but merely set up possibility of future sale; merger didn’t constitute a sale of Kern shares; D was in no position to profit from inside information—had no inside information and sale was corporate transaction authorized by others

1. Merger didn’t give rise to the risks that sect 16(b) ‘s remedy was designed to protect against and wasn’t covered by section 16

E. EXCHANGE ACT SECTION 10(B) AND RULE 10B-5i. Section 10 of 1934 Act [it shall be unlawful]

1. To use or employ in connection w/ the purchase or sale of any security registered on a nat’l securities exchange or any security not so registered, any deceptive or manipulative device or contrivance in contravention of such rules and regulations as the Commission may proscribe as necessary or appropriate in the public interest or for the protection of investors

ii. Evolution of Private Right of Action under Section 101. 10b-5: most important rule promulgated by SEC under 10(b)2. 10b-5 provides that it shall be unlawful:

a. To employ any device, scheme or artifice to defraud

b. To make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances in which they were made, not misleading

c. To engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person in connection w/ the purchase or sale of any security

3. Kardon v. Nat’l Gypsum Co – first recognized an implied private remedy for violation of 10b-5

a. “the disregard of the command of a statute is a wrongful act and a tort”

iii. Elements of 10b-5 Claim1. SEC has power to make rules that protect against ‘manipulative and

deceptive’ activity ‘in connection w/ the purchase or sale of covered securities’ or the making of untrue statements of material fact or the omission to state material fact in connection with the purchase or sale of a covered security

2. In addition to c/l fraud elements (false/misleading statement; of material fact that is; made w/ intent to deceive another; upon which that person; reasonably relies; and the reliance causes harm)—10b-5 seems to require that

a. the requisite reliance must be a buyer or seller of stock,b. the harm must be to trader in stock andc. the misleading statement must be made in connection

w/ purchase or sale of stock3. Duty Issue in Omission Cases

a. Rule addresses “omissions” i. Cady, Roberts (1961): SEC asserted that

possession of “inside” information itself gives rise to duty not to trade on it

ii. Chiarella (S.Ct. 1980): necessary that insider breach a fiduciary duty in trading on inside information in order to find 10b-5 liability

iii. US v. O’Hagan – adopted intermediate stance of augmenting the fiduciary duty theory w/ more far-reaching misappropriation theory

4. Elements of 10b-5 Claim: False or Misleading a. SEC v. Texas Gulf Sulphur Co (2d Cir 1968)

i. FACTS: action brought to enjoin certain conduct by TGS and the individual Ds said to violate Section 10b of the Act and to compel rescission

by the individual Ds of securities transactions assuredly conducted contrary to law; geological survey led Ds to believe is was desirable to acquire remainder of land Ds instructed to keep results of survey confidential/undisclosed

1. Certain individual Ds bought stocks of TGS; 26 officers/EEs were issued stock options

2. Word go out; issued statement by Ds that reports were exaggerated and w/out factual basis purported to be the drilling results

3. Only 3 people engaged in market activity b/w press release and the official announcement

ii. COURT: 10b-5 is based in policy on justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material info

1. Anyone trading for his own account in the securities of a corp has “access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone” may not take advantage of such info knowing it’s unavailable to those w/ whom he’s dealing investing public

2. Anyone in possession of material inside information must

a. Disclose it to investing public; or

b. If disabled from disclosing it in order to protect corporate confidence—must abstain from trading in or recommending the securities while such inside info remains undisclosed

3. Whether facts are material—depend at any given time upon balancing of both indicated probability the event will occur and the anticipated magnitude of

the event in light of the totality of company activity

a. Also relevant—importance attached to the info by those who knew about t it

i. Inference of influence can be compelled by the timing by those who knew of it of their stock purchases and purchases of short-term calls

5. Theories of Duty to Support Omission Casesa. Most courts (outside 2d circuit) require the need for an

act of fraud or manipulationb. Those who aren’t officers/directors but who know

nonpublic information?i. Those tipped by insiders (tippees)

ii. Those who get nonpublic info in connection w/ performing some service for corporation (lawyer/banker)

iii. Those who invest in info acquisition through legit means and in the process learn something material before the public generally appreciates it

c. Elements of 10b-5 Liability: d Theoryi. Holds that all traders owe a duty to the market

to disclose or refrain from trading on nonpublic info

1. Inherent unfairness of exploiting an unerodable informational advantage

ii. Cady, Roberts & Co. – first SEC decision to address insider trading on open market

1. 2 principal elements of 10b-5: (1)existence of relationship giving access, directly/indirectly, to the information intended to be available only for corporate purpose and not personal benefit of anyone; (2) inherent unfairness involved where a party takes advantage of such info knowing it’s

unavailable to those w/ whom he’s dealing

iii. Reaches all conduct that might be “insider trading”

iv. Possibility of chilling socially useful trading ALSO no call for misrepresentation or preexisting disclosure duty

d. Elements of 10b-5 Liability: Fiduciary Duty Theoryi. Chiarella decision: ruled that financial printer id

not breach a disclosure duty to other traders by trading on nonpublic information b/c he had gleaned info from docs of takeover bidders lacked relationship-based duty to shareholders of the target companies in whose securities he traded

ii. Dirks v. SEC : in tippee-tipper relationship, the tipper must first violate that duty to other traders in his own company’s stock by tipping improperly; tippee owes no duty

1. whether tipping is improper – turns on whether the insider tips to secure a personal benefit from the tippee

2. HERE: since EE didn’t benefit—there was no tipper violation of 10b-5 and there could be no violation by a tippee

iii. Chiarella v. US (1980): 1. QUESTION: whether a person who

learns from the confidential documents of one corporation that it’s planning an attempt to secure control of a second corporation violated 10b if he fails to disclose the impending takeover before trading in target company’s securities

2. COURT: Petioner’s use of the market info which concerned only the plans of the acquiring company was not a fraud under 10b unless he was subject to an affirmative duty to disclose it before trading

a. Not every instance of financial unfairness constitutes

fraudulent activity under 10b (Santa Fe v. Green)

b. Not duty here b/c he had no prior dealings w/ target company, not a fiduciary, not a person in whom sellers placed trust/confidence

c. Warehouseing: when corp gives advance notice of its intention to launch a tender off to institutional investors who then are able to purchase stock in target company before the tender offer is made public/price shares rise barred under Sec’s authority to regulate tender offers not under 10b

d. HOLD: duty to disclose under 10b does not arise from mere possession on nonpublic market info

iv. Dirks v. SEC (1983)1. FACTS: Dirks received material

nonpublic information from insiders of a corp w/ which he had no connection; disclosed info to investors who relied on it in trading in the shares of the corporation

a. Gained info of fraudulent corporate practices told people; urged Wall Street Journal to run the story

2. COURT: two elements of 10b-5 violation: (1) existence of a relationship affording access to inside information intended to be available only for corporate purpose; (2) unfairness of allowing a corporate insider to take advantage of that information by trading w/out disclosure

a. No general duty to disclose before trading on material nonpublic infoDuty to disclose doesn’t’ arise from mere possession of nonpublic market information

b. The fact that recipients of inside info do not acquire duty to disclose or abstain doesn’t mean that such tippees always are free to trade on information tippees assume insiders’ duty to shareholders b/c they obtain the info improperly

i. Improper only where it would violate Cady, Roberts Tippee assumes a fiduciary duty to the shareholders of a corp not to trade on material nonpublic information ONLY when the insider has breached his fiduciary duty to the shareholders by disclosing information to the tippee and the tippee KNOWS OR SHOULD KNOW that there has been a breach

c. First step w/ tippees—did insider’s tip constitute a breach of insider’s fiduciary duty

i. Depends in large part on purpose of disclosure – whether insider personally will benefit directly or indirectly from his disclosure (includes gift

of confidential info to trading relative/friend)

3. NOTE: Dirks was intended to create a safe harbor for security analysts

6. NOTES on Rule 14E-3 and Regulation FDa. SEC Rule 14E-3 imposes a duty on any person who

obtains inside information about a tender offer that originates w/ either the offeror or the target to disclose or abstain from trading

b. Regulation : Fair Disclosure i. Directed to the practice of issuers sometimes

publicly disseminating material business information through a process in which certain analysts/brokers/journalists were called to press conference in which a material piece of info would be released to public

1. Favored few could clearly derive a trading benefit from early access

ii. Section 243.100: General Rule Regarding Selective Disclosure

1. Whenever an issuer, or any person acting on its behalf, discloses any material nonpublic info regarding that issuer or its securities to any person described in b1 – issuer shall make public disclosure of that information

a. Simultaneously in case of intentional disclosure and

b. Promptly in case of non-intentional disclosure

c. Covers brokers/dealers/ investment advisors/investment analysts/managers/shareholders likely to sell

i. Doesn’t include persons who owe a duty of trust and confidence to issuer such as atty, investment banker, accountants

iii. Section 243.101: Definitions

1. Intentional: when person making the disclosure either knows, or is reckless in not knowing that the info he or she is communicating is both material and nonpublic

iv. Section 243.102: No Effect on Antifraud Liability 1. No failure to make a public disclosure

required solely by 243.100 shall be deemed to be a violation of Rule 10b-5 of Securities Exchange Act

7. Misappropriation Theorya. Response to Chiarella and Dirks deceitful

misappropriation of market-sensitive information is itself a fraud that may violate Rule 10b-5 when it occurs in connection w/ a securities transaction

i. Duty that a fiduciary owes to corporate ER/corporate client and predicates an action on the breach of that duty

ii. The relationship that triggers Rule 10b-5/resulting unfairness both refer to insider’s SOURCE of information

b. Almost endorsed by S.Ct. in 1987, US v. Carpenter WSJ article author who was subject to confidentiality to WSJ; provides info on recurring basis on what’s going to run in his column; nets a group around $700K b/c of the info released in the Journal

i. Court splits 4-4 on the issue; convictions upheld and ends up punting on this issue

ii. 10 years b/w Carpenter and O’Hagan – circuits split on misappropriation theory

8. US v. Chestman (2d Cir 1991)a. FACTS: client called Chestman, a stockbroker, telling

him he had familial info that publicly traded company owning a large supermarket chain was going to be sold at a substantially higher price than its market value tender offer at double the stock price

i. Chestman executed several purchases of the stock for his own account and clients’ discretionary accounts

ii. Tender offer publicly announced and stock rose over $20/share

iii. Grand jury returned indictment charging Chestman w/ 10 counts fraudulent trading in connection w/ a tender offer under Rule 14e-3(a); ten counts of securities fraud in violation of 10b-5; ten counts mail fraud; one count perjury; found guilty on all

b. COURT:i. Rule 14e-3(a) : violation occurs when trading on

the basis of material nonpublic information concerning a pending tender offer that he knows or has reason to known has been acquired “directly or indirectly” from an insider of the offeror or issuer or someone working on their behalf

1. Disclosure provision creating a duty in those traders who fall w/in its ambit to abstain or disclose w/out regard to whether the trader owes a pre-existing fiduciary duty to respect confidentiality of the info

2. Equal access theory don’t need a breach of duty under Dirks for tender offer

ii. 10b-5 convictions based on misappropriation theory which provides that one who misappropriates nonpublic information in breach of a fiduciary duty and trades on that information to his own advantage violated 10b; 10b-5 convicted as a tippee

1. Tipper must have breached a fiduciary duty or duty owed based on similar relationship of trust/confidence AND

2. Chestman knew about it iii. Kinship alone does not create the necessary

relationship under Rule 10b-5 (family as first step; relationship of spouse as second step)

1. Must be in inner circle; present in discussion of confidential business information

2. No duty of confidentiality shown b/w tipper and his wife who told him

a. “Don’t Tell” isn’t enough

iv. B/c there wasn’t a duty owed by the tipper, he didn’t defraud them by disclosing news of the pending tender offer to Chessman and absent a predicate act of fraud by tipper, Chestman couldn’t be derivatively liable as tippee

v. NOTE: Tippee liability always derivative liability vi. NOTE: Remote Tippee liability—remote tippee

not liable unless they knew or should’ve known first-tier tipper breached a duty

9. NOTE: Rule 10b5-2—nonexclusive definition of circumstances in which a person has a duty of trust or confidence for purposes of misappropriation theory

a. Duties of trust or confidence arisei. Whenever a person agrees to maintain info in

confidence Express Agreementii. Whenever two persons have a history, pattern

or practice of sharing confidence such that the recipient of the information reasonably should know that the speaker expects that the recipient will maintain its confidentiality

iii. Whenever a person receives or obtains material nonpublic information from his/her spouse, parent, child or sibling provided that the recipient may defend by demonstrating no duty of trust or confidence existed—neither knew or reasonably should’ve known speaker expected confidentiality based on agreement or parties’ history

1. Product of US v. Chestman a. TODAY: presumption that

nephew-in-law couldn’t trade on the info he learned from his wife

10. US v. O’Hagan (1997)a. FACTS: O’Hagan was partner at law firm retained by

Grand Met to help w/ potential tender offer of common stock of Pillsbury; while firm was still representing Grand Met, O’Hagan began purchasing call options of Pillsbury stock ended up owning more options than any other individual investor; also purchased common stock of Pillsbury—ended up making $4.3 million off of tender offer

i. 57 count indictment b. COURT: “Misappropriation theory” holds that person

commits fraud in connection w/ a securities transaction and thereby violated 10(b) and Rule 10b-5 when he misappropriates confidential information for securities trading purposes in breach of a duty owed to the source of the information

i. In lieu of the classical theory of premising liability on a fiduciary relationship b/w company insider and purchaser/seller of stock—misappropriation theory premises liability on a fiduciary-turned-trader’s deception of those who entrusted him w/ access to confidential info

1. Duty owed not to trading party but to source of information

ii. Misappropriation satisfies section 10(b)’s requirement that chargeable conduct involve a deceptive device or contrivance used in connection w/ the purchase or sale of securities

1. Theory consistent w/ Santa Fe v. Green all pertinent facts were disclosed by the persons charged w/ violating 10(b) and Rule 10b-5 therefore no deception through nondisclosure which liability could attach

2. If fiduciary discloses to the source that he plans to trade on the nonpublic info—no deceptive device and no 10b violation

a. NOTE: where person trading on basis of material, nonpublic info owes duty of loyalty/confidentiality to 2 entities/persons—but makes disclosures to only one, trader may still be liable

3. Fiduciary’s fraud consummated when w/out disclosure to principal he uses information to purchase or sell securities

11. Insider Trading/Securities Fraud Enforcement Act a. Sec. 78t-1: Liability to Contemporaneous Traders for

Insider Tradingi. Private rights of action based on

contemporaneous trading—any person who violates any provision of this chapter or the rules or regulations thereunder by purchasing or selling a security while in possession of material, nonpublic information shall be liable in an action in any court of competent jx to any person who, contemporaneously w/ the purchase or sale of securities that is the subject of such violation has purchased or sold securities of the same class

ii. Limitations on Liability1. Contemporaneous trading actions

limited to profit gained or loss avoided—total amount of damages imposed shall not exceed the profit gained or loss avoided in the transaction(s) that aren’t subject of the violation

2. Offsetting disgorgements against liability ---the total amount of damages imposed against any person under (a) shall be diminished by the amounts if any that such person may be required to disgorge pursuant to a court order obtained at the instance of the Commission in a proceeding brought under 78u(d) relating to same transaction(s)

3. Controlling person liability—no person shall be liable under this section solely by reason of employing another person who’s liable under this section, but the liability of a controlling person under this shall be subject to 78t(a)

iii. Joint and Several Liability – any person who violates any provision by communicating material, nonpublic info shall be jointly/severally liable under (a) w/ and to the

same extent as any person(s) liable under (a) to whom communication was directed

iv. Authority not to restrict other express or implied rights of action – nothing shall be construed to limit/condition the right of any person to bring an action to enforce a requirement of chapter or availability of any cause of action implied form provision of this chapter

b. 20A (78t-1) doesn’t define what constitutes insider trading or contemporaneously buying/selling

i. Assumes court will continue to employ standards of existing case law

ii. Only those who misappropriate the material nonpublic info should be liable

1. Could be possible under the language for a shareholder of the target to sue a person who misappropriates info from the bidder

a. Can’t be brought under 10b-5iv. Academic Debate

1. Insider trading—appropriation of information rights that permits informed insiders to earn systematically higher trading returns that can uniformed insiders

a. Can’t reach insiders’ informed decisions to refrain from trading

2. Insider Trading and Informed Prices a. Argument that insider trading ought to be tolerated in

interest of informationally efficient prices that ultimately lead to more efficient allocation of capital

b. Slow mechanism for releasing information to the market that can fail entirely to move prices if level of background “noise trading “ is sufficiently high

3. Insider Trading as Compensation devicea. Claim that insider trading might be an efficient device

for compensating insiders i. Assumption that insiders are likely to contract

for efficient compensation in a competitive market and the right to trade on this info might serve as component of compensation package