This outline is based on the Corporations Class taught by John Armour, visiting professor from Oxford University, during the Fall of 2009. The textbook used was Commentaries and Cases on the Law of Business Organizations, 3rd ediction, by Allen, Kraakman, and Subramian.

Table of ContentsI. Policy Perspectives on the Corporate Form 3

II. Agency and Partnership 6

A. Agency.............................................................................................................................................................................6

B. Partnerships....................................................................................................................................................................11

1. Formation and Obligations to Each Other.................................................................................................................11

2. Partnership Relations with 3rd Parties........................................................................................................................13

3. Termination of Partnerships......................................................................................................................................15

4. General vs. Limited Partnerships...............................................................................................................................18

III. Corporate Form20

A. Overview........................................................................................................................................................................20

B. Corporate Finance..........................................................................................................................................................24

1. Basic Capital Claims on a Corporation.....................................................................................................................24

2. Valuation....................................................................................................................................................................25

C. Creditor Protection.........................................................................................................................................................26

1. Overview....................................................................................................................................................................26

2. Fraudulent Conveyance.............................................................................................................................................27

3. Equitable Subordination............................................................................................................................................28

4. Piercing the Corporate Vail.......................................................................................................................................29

5. Successor Liability.....................................................................................................................................................31

IV. Shareholder Voting 32

A. Overview........................................................................................................................................................................32

B. Proxy Solicitations.........................................................................................................................................................34

C. Shareholder Access to Books, Records, and Shareholder List......................................................................................35

D. Circular Voting and Other Schemes to Entrench the Board..........................................................................................36

E. Collective Action Problem.............................................................................................................................................40

F. Proxy Rules....................................................................................................................................................................41

V. Director Duties 45

A. Overview........................................................................................................................................................................45

B. Duty of Care...................................................................................................................................................................46

1. General.......................................................................................................................................................................46

2. Breach of Duty of Care Due to Inaction....................................................................................................................52

C. Duty of Loyalty – Conflicted Transactions....................................................................................................................59

1. Overview....................................................................................................................................................................59

2. Self-Dealing Transactions with Directors/ Officers..................................................................................................61

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3. Transactions with a Controlling Shareholder............................................................................................................64

4. Executive Compensation...........................................................................................................................................67

5. When may a fiduciary take a corporate opportunity.................................................................................................71

6. Duty of Loyalty in a Close Corporation....................................................................................................................73

VI. Shareholder Lawsuits 76

A. Overview........................................................................................................................................................................76

B. Derivative Suits..............................................................................................................................................................78

VII. Controlled Transactions 85

A. Sale of Control...............................................................................................................................................................85

B. Tender Offers.................................................................................................................................................................90

1. Overview....................................................................................................................................................................90

2. What is a beneficial owner........................................................................................................................................92

3. What is a tender offer................................................................................................................................................94

VIII. Mergers and Acquisitions97

A. Overview........................................................................................................................................................................97

1. Statutory Mergers......................................................................................................................................................98

2. Asset Acquisition.......................................................................................................................................................99

3. Triangular Mergers..................................................................................................................................................101

B. Appraisal Right............................................................................................................................................................102

C. Duty of Loyalty in Controlled Mergers – i.e. duty of fairness.....................................................................................104

IX. Contested Control Transactions 111

A. Introduction..................................................................................................................................................................111

B. Defending Against Hostile Tender Offers...................................................................................................................112

C. Revlon Duties...............................................................................................................................................................120

D. State Anti-Takeover Statutes.......................................................................................................................................126

E. Proxy Fights.................................................................................................................................................................128

F. Shareholder Efforts to Limit the Pill............................................................................................................................131

X. Trading in the Corporation’s Securities 132

A. Overview......................................................................................................................................................................132

B. Common Law Fraud....................................................................................................................................................134

C. Short Swing Profits......................................................................................................................................................136

D. Rule 10b-5....................................................................................................................................................................137

E. Rule 14e-3....................................................................................................................................................................147

F. Regulation FD..............................................................................................................................................................148

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I. POLICY PERSPECTIVES ON THE CORPORATE FORM

Efficiency & Fairness Note : Although courts look at efficiency and fairness, courts ultimately often focus on fairness because morality is

easier to explain. However, often efficiency and fairness produce the same result. Pareto Efficiency – resources are distributed so that no reallocation can make at least one person better off without

leaving someone else worse off.o Does NOT take into account moral issueso Does NOT take into account the initial allocation of the partieso Very difficult to apply in the real world because this theory assumes no transaction costs and there are

transaction costs in the real world. Kaldor-Hicks Efficiency – efficient if the transaction produces total gains greater than the externality costs. Does

NOT mean that actual payments must be made. o What is the base of efficiency? From what point do you start in order to measure the positive externalities

and benefits versus the negative externalities and costs?

Economics of the Firm Coase theorem: Firm reduces transaction costs, but increases agency costs. Where ΔT > ΔA, corp. should be formed

o Transaction Costs – the use of the firm reduces transaction costs – allows complex repetitive transactions to be accomplished more cheaply.

o Agency Costs – the firm creates agency costs because of the misalignment of the interests of owners (shareholders) and managers (officers and directors)

Agency Costs Monitoring costs – costs that owners expend to assure agent loyalty Bonding costs – costs that agents expend to assure owners of their reliability Residual costs – any inefficiency arising from misaligned incentives

Efficiency of the Corporate Form Artificial Entity Status – reduces transaction costs by creating a corporate entity don’t have to re-contract every

time you want to raise capital AND creditors/employees don’t have to individually contract Centralized Management – reduces costs for larger firms because:

o A centralized body can gather information and process it more cheaply o People can be more specialized in handling a problemo Encourages employees to make firm specific commitments thereby increasing the cost to them if they get

fired, thereby encouraging them to act in interests of firm. Limited Liability – greatly reduces the risk and cost of investing – less investigation necessary. Makes it easier to

transfer shares – do not need to look at financial status of co-owners and creates a workable market price.o ALSO, reduces monitoring costs because creditors will monitor activity more carefully.

Freely Transferable Shares – much easier to raise capital – more flexibility and liquidity – speedy access and more stable than a partnership.

o ALSO, allows for diversification by shareholder in the market – allows shareholders to hedge their investments and thus take on more risky ventures.

Stakeholders in the corporate form: Shareholders - greater need for law to protect shareholders than other stakeholders because:

o It’s their capital – they have the most to lose.o They provide the capital, which is very important.o Most difficult for shareholders to protect themselves by K – transaction costs too high – so the law protects them.

Managers o Note : Ostensibly it would seem directors are agents of shareholders BUT notice that while shareholders can

vote for managers, they can NOT dictate the actions of managers (as per DGCL §141(a)). (See VANDEVOORT Article)

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o ALSO, even though shareholders can elect managers, who controls the voting machinery? Creditors Employees

Collective Action Problem When the corporation is large enough and ownership is heavily divided, no one’s stock ownership gives them

sufficient inventive to monitor management. As a result, waste and inefficiency (and possibly malfeasance) will go undetected.

Note : The total amount of monitoring will go up with more owners, but the benefits of the monitoring do not. Two Forms of Collective Action Problems:

o Rational Apathy – In a large corporation where the ownership interest is divided up among many individuals, the ownership by any one investor may be so small that the costs of individual monitoring outweigh his personal benefits so he has no incentive to monitor.

o Free-Rider Problem – invest nothing in monitoring because the benefit the costs of monitoring are large compared to your stake, whereas every other shareholder benefits for free if you spend on monitoring.

Ways to Ameliorate Collective Action Problem Fiduciary Duties – help to ameliorate collective action problems of investors – managers and directors make an

implied promise that the extremely broad and flexible legal powers they are given over the corporate process and property will be used only in an honest, good faith effort to advance the interests of the corporation.

o Duty of Loyalty – the power of managers must be used for the good of the corporation – NO self-dealing transactions.

Note : Subject to entire fairness test (see below)o Duty of Care – manager must:

Act with no conflicting self-interest (manager must NOT be interested) Make himself reasonably informed; AND the decision must be rational as of the moment it was made (manager must rationally believe

that the judgment he’s making is in the best interests of the corporation). Note : Subject to Business Judgment review (see below)

Derivative lawsuits – technically two claims - shareholders are bringing suit on behalf of the corporation to: Have the corporation enforce a claim which they believe should have been pressed by the board

of directors but was not; AND Enforce a claim against the directors for breaching a fiduciary duty in failing to bring an

enforceable claim. Note : Recovery in a derivative suit goes to the corporation itself, NOT to the

shareholders.

Shareholder Rights Right to sell – market for corporate control – if there’s mismanagement, the value of the stock sells ot the point

where the corporation is taken over and management is replaced Right to vote – elect directors and proxy contests Right to sue – derivative suits and suits for breach of fiduciary duties

Protection of Shareholder Voting Rights Statutory protections – Statutes give shareholders the right to vote on fundamental corporate transactions, like

mergers, sales of all (or essentially all) assets, changes of the corporate charter, and/or dissolution of the enterprise.

o ALSO, the right to elect directors at annual meetings. Fiduciary protections – Duty of loyalty creates a duty to disclose so that the shareholder can make a legitimate

decision on a vote. Also, there are limitations on the directors’ ability to affect the outcome of the vote … need legitimate and compelling justification.

Federal statutory protections o The 1934 Securities Exchange Act regulates what a corporation cannot contain in solicitation of proxies

(Rule 14-a) and it regulates false or misleading statements in proxy solicitation materials (Rule 14-a(9)).o Williams Act governing tender offers.

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o Sarbanes Oxley Act covers corporate governance issues on a federal level.

Hostile Takeovers Hostile Takeover Theory – Achieves efficiency b/c poor and improper management (or inefficient use of assets) will

reduce stock price, which will lead to increased incentives to acquire control and replace management.o Note : Shareholders can receive a premium on the current share price because of total expected gain from

replacing management.o Note : Defense against a hostile takeover must satisfy an intermediate form of judicial review – like

enhanced Business Judgment – because of the conflict of interest of directors.

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II. AGENCY AND PARTNERSHIP

A. Agency

Rule and Regulations

Agency Defined§ 1 Restatement of Agency – Agency is the fiduciary relation which 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.

Note : A secured lender does NOT create an agency relationship – the creditor does NOT become the agent of the lendero BUT, if the lending K essentially has the lender controlling the creditor’s business, the court MAY infer an

agency relationship (See JENSON v. CARGILL)

TerminationIf no term is stated in a general agency K, the authority terminates after a reasonable term.If no term is stated in a specific agency K, the authority terminates after specific act is performed or after a reasonable time.Agency relationship is terminable at will (R2d Agency § 118 – p. S8)

Note : Agency relationship is terminated EVEN IF there is a contractual provision stating it is NOT terminable – provision is enforceable ONLY to the extent that breaching party may be liable for damages.

Breach of Agency (such as if a party terminates a fixed term agency contract early) Note : A breach of an agency K only brings damages, NOT specific performance (specific performance, among

other things, would violate the 13th Amendment)o Problems: how to value the damages, duty to mitigateo Reason to not enforce specific performance it’s too much of a burden on the courts to enforce

performance of contracts for personal services Outcome of ‘no specific performance’ and ‘difficult valuation’ it’s advisable to include a liquidated damages

clause at the outset.

Authority Derived from Agency Relationship Actual Authority – that which a reasonable person in A’s position would infer from P’s conduct.

o Express if communication was explicito Implied (or incidental) if A’s actions are reasonably calculated to discharge P’s explicit instructions

Apparent Authority – that which a reasonable 3rd party would infer from the actions or statements of Po Principal signals the third party that the agent has the authority to acto Even if the Principal has expressly limited the Agent’s actions, the Principal MAY be bound by

transactions that the Agent has ordinarily done for him in the past within the scope of his agency relationship (See NOGALIS SERVICE CENTER v. ATLANTIC RICHFIELD)

Inherent Power – in the 2nd restatement, but not the 3rd restatemento A general agent can bind P (whether disclosed or undisclosed) to an unauthorized contract if A would

ordinarily have the power to enter such a contract and T does not know that matters stand differently. R2d Agency §161, §194

o The Agent has the authority to bind the Principal even against the Principal’s wishes as long as a third party could reasonably assume authority in the Agent and rely upon it (court looks at what is normal in general, outside of the specific context)

o If the third party knows that the agent does NOT have the authority to take such actions, then, of course, the principal is NOT bound by the transaction. (R2d Agency §8A)

o R3d Agency provides for similar overall result if the principal is undisclosed (R3d Agency §2.06) and provides for agency by estoppel (§2.05)

Agency by Estoppel / Ratificationo Where P has knowledge and an opportunity to act to show lack of agency relationship, and T makes a

reasonable change in position based on the apparent agency relationship, P is estopped from denying the agency relationship. (R3d §2.05)

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o Where P accepts benefits from an unauthorized agency K, this constitutes ratification of the agency K’s obligations and benefits. (R3d §4.01, 4.07)

Liability in Tort P is directly liable for unintentionally authorized torts of A (R2d Agency §215), or negligent selection of an agent (§7.07) P is liable for the torts of his servants committed while acting in the scope of their employment. R2d Agency §219

o Applicable to employee-agent only (not independent contractor) R2d Agency §220 At the core of determining whether someone is an employee vs. an independent contractor is the extent of

control exercised or exercisable by P. Compare Humble Oil ](substantial control = agency) to Hoover ( limited control rights do not equal agency)

o This is because, with control, P can mandate reductions in risk, etc

Factors for determining control R2d Agency §220 The extent of control which, by the agreement, the master may exercise over the detail of the work; Whether or not the one employed is engaged in a distinct occupation OR business; The kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of

the employer or by a specialist without supervision; The skill required in the particular occupation; Whether the employer or the workman supplies the instrumentalities, tools, and the place of work for the person

doing the work; The length of time for which the person is employed; The method of payment, whether by time or by the job; Whether or not the work is part of the regular business of the employer; Whether or not the parties believe they are creating the relationship of master and servant (but not entirely determinate). whether the principal is or is not in business.

Duties of an Agent Duty of obedience – agent must obey principal’s demands (this is like how an officer must obey the Board) Duty of loyalty – Agent must exercise power he believes in good faith to best advance the interest or purposes of the

P, and must refrain from exercising power for a personal benefit (unless you get a waiver from the P) Duty of Care – Duty to act in good faith, as one believes a reasonable person would act in becoming informed and

exercising any agency or fiduciary power

Remedies for Breach Termination (R2d Agency § 118) Liability for losses caused (R2d Agency § 401) Liability for Things Received in violation of Duty of Loyalty (R2d Agency § 403)

o A must disgorge benefits he received in violation of §403, irrespective of compensation received from third parties (i.e. P can collect from A even if P collected from the 3rd party already (See Tarnowski)

Liability for Principal’s Use of Assets (R2d Agency § 404) Principal gets to choose the remedy if A breaches (R2d Agency § 407):

Damages against an agent for a violation of the duty of loyalty may be higher than the harm suffered. Tarnowski v. Resop (Resop got a kickback from a 3rd party for binding Tarnowski; Tarnowski collects the kickback from Resop + cost of recovering the down payment from the 3rd party)

A trustee cannot deal with the trust, because he is not allowed to negotiate with the beneficiaries to obtain a waiver from them such as would satisfy the duty of loyalty (In Re Gleeson – Colbrook is executor of estate for Gleeson, who died

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Humble Oil & Refining Co. v. Martin (Tex. 1949): Humble responsible for torts of service station because station was its servant. Humble had power to control details of station work, paid operational expenses, furnished equipment, controlled hours of operation.

Hoover v. Sun Oil Co. (Del. 1965): Sun not liable for torts of service station because station was independent contractor. Areas of close contact came from fact that they had mutual interest in sale of Sun products; Sun had no control over day-to-day operations of station even though it chose to do things in way that was good for Sun.

2 wks before his tenant farmer’s lease expired; Colbrook leases it for the next year at a 67% higher rental rate (since 2 wks wasn’t enough time to find a new tenant) but gets a new 3rd party tenant for Y2. Beneficiaries object after learning of the lease. Court holds that Colbrook must return any profits he made from the farm to the trust).

Case Summaries

Jensen Farms v. Cargill Facts – Warren Seed and Grain runs a grain elevator. They buy grain from farmers and then sell it to distributors.

They enter into a financing agreement with Cargill, in which Cargill provides Warren with loans to buy farmers’ grain. Cargill gets a right of 1st refusal, and ends up buying 90% of Warren’s grain. Remainder is sold on grain exchange market. Cargill also has some control over Warren’s actions. Warren finances deteriorate. Warren has contracts with local farmers to buy their grain, and defaults. The farmers sue Cargill, on theory that Warren was Cargill’s agent.

Issue – Whether Warren was Cargill’s agent Reasoning

o In addition to the loan relationship, Cargill’s purpose in the relationship was to secure access to grain for its own business downstream.

o If Cargill had pulled out earlier (which a normal lender would have done once the financial problems were apparent), Warren would have stopped signing contracts and the farmers would not be in the wind.

Holdingo Warren was Cargill’s agent. By directing Warren to implement its recommendations, Cargill manifested its

consent to be bound by its actions

White v. Thomas Facts – White gives his employee Simpson the authority to bid on a lot for him up to $250,000. She bid $327,500 and

won. She then agreed to sell to Thomas 45 acres to offset this over-expenditure. White learns of the excessive price, agrees to honor it. Then, Simpson tells him about Thomas’s wanting to buy the 45 acres. White refuses to sell.

Reasoningo Not actual authority because nothing White did / said with respect to Simpson would make a reasonable

person think he had the authority to sell land.o Maybe apparent authority because Simpson signed a paper saying she has POA for White. However,

Thomas didn’t confirm this POA or inquire as to its extent. Also, the blank check indicates only that she had power to buy, not sell.

i. Certainly, on the buy side, the blank check indicates that there is some POAii. On the sell side, however, Thomas’s should have inquired. (Also, a simple statement by A that A

has agency shouldn’t be sufficient because then anyone could bind anyone else)o No inherent power, because someone with the power to buy a specific property up to a designated price

does not ‘usually’ have the ability to sell off part of that land after acquiring it

Gallant Insurance v. Isaac Facts – Gallant (P) sells a policy to Isaac (T) through a broker Thompson-Harris (A). Agreement says any changes

must be authorized by P. Right before it expires, T buys a new car (Dec 2). T tries to add it to the policy through A on Dec 2, and A agrees to insure it effective immediately. T and A agree to fill out paperwork on the following Monday. On Dec. 4, T gets in an accident. On the 5th, T and A fill out paperwork. P denies coverage because A wasn’t authorized to renew T’s policy without authorization from P.

Rule – Inherent agency power is derived from the power of the position of the agent (i.e. from the nature of the agency)

Holdingo Neither actual nor apparent authority applies here. Analyzes inherent authority sua sponte.o Due to A’s direct and indirect manifestations over time and its direct verbal communication that there was a

binding K in place, T could have reasonably believed that A had authority to orally bind P Comments

o Here, there was a pattern of transactions between P and A that indicated that P was ok with A’s behavior in binding P without P’s authorization. Thus, maybe the court dismissed the idea of actual authority too quickly. (pattern of dealing can contradict express terms)

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Policy rationale for different outcomes on White, Gallanto Thomas is in a better position to discover the defect in the agency than is Whiteo Gallant is in a better position to discover the defect in the agency than is Isaaco This properly incentivizes the least-cost avoider to avoid the defect

Humble Oil and Refining v. Martin (1949) Facts – Martin is struck by a car that Love dropped off at Humble Oil Station operated by ‘indep. contractor’

Scheider. The car rolls off the lot and hits Love and her 2 daughters. Issue – Whether Humble is liable (i.e. whether Schneider was Humble’s agent) Reasoning

o Fact that Humble, Scheider, other employees all considered Schneider to be the boss at the station and that agreement repudiated any agency relationship is not determinative

i. Here, franchise agreement required reports and duties from Schneider. ii. Although Schneider paid the operating costs, Humble paid a ‘commission’ back to Schneider

equal to 75% of the utilitiesiii. Hours of operations were controlled by Humbleiv. All merchandise on-site was owned by Humble, v. ‘rent’ paid by Schneider to Humble was proportionate to sales.

vi. Lease was terminable at willvii. Schneider was to ‘perform such other duties’ as required by Huble.

Holding - Humble is liable, because Scheider is an employee not an independent contractor

Hoover v. Sun Oil Co Facts – Hoover’s car catches fire due to negligence of an employee of Barone. Station and equipment are owned by

Sun. Rental fee partly linked to sales, but there is a minimum and maximum. Barone requested and took advice of Sun on some things, but wasn’t bound to do so.

o Barone made no written reportso Barone undertook overall risk of profit/ losso Barone sets the operating hourso Lease contract and pattern of behavior indicate lessor-lessee relationship, not master-servanto Barone could sell-non Sunoco goodso Barone took title to goodso Lease was terminable once annually

Holdingo Barone is not an agent

Tarnowski v. Resop (1952) A (Resop) takes a $2,000 secret commission, from 3rd party on jukebox deal on behalf of P (Tarnowski)

o P’s remedy from seller – deal is void, 9,500 of down payment is returned (out of 11,000)o P’s remedy from agent –

i. Gets the $2,000 commissionii. Gets the cost of collecting from sellers as damages

1. Thus, a total of $5,200 is collected from Aiii. The total remedy from A is greater than the harm suffered reason is deterrence

1. A has more info than the P, so risk of being sued is lower. Adding to potential penalty rebalances the playing field to discourage A’s breach

In Re Gleeson Gleeson leaves a will, under which Colbrook is the executor, and trustee of the will and residuary estate. 160 acres

of farm is to be held in trust by Colbrook for the benefit of Gleeson’s children. Gleeson dies with 2 weeks left under the old lease on the land. (Colbrook was the tenant) Colbrook talks to the 2

competent beneficiaries, and leases the land to himself at a 67% raise in rent, then finds another tenant for the next year. Colbrook files the 1st semi-annual report, beneficiaries object, lower court approves it, appeals court reverses it.

Court holds that Colbrook violated duty, and must return all profits he generated as tenant during that year.

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Rationale is that, although there’s no evidence of bad faith, the self-dealing is inherently problematic, so the court is concerned about setting precedent for the future

o Even though Colbrook negotiated with beneficiaries, the P was dead, so there’s no way to negotiate with the Po Trusts are not quite like agents, because A can’t negotiate with beneficiaries. A would have to choose

between being trustee and being a tenant.

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B. Partnerships

1. Formation and Obligations to Each Other

Rules and Regulations

DefinitionUPA § 6(1) “A partnership is an association of two or more persons to carry on as co-owners a business for profit.”

UPA § 7 : Rules of inferenceWe will not find a partnership, without more, from:

Joint ownership of property Sharing gross returns

Prima facie evidence of partnership: UPA §7(4) Sharing [net] profits: but not if by way of (a) repaying a debt; (b) wages; … (d) paying interest, (e) payments for

sale of the goodwill or other property of a business in installments Note: Reason that profit sharing is prima facie evidence is because each person receiving profits will likely want to

participate in control. People who participate in control and share in profits are the owners.Default rule is that no person can become partner UNLESS ALL other partners consent . (§18(g))

Partners are both principals and agents of the partnership. § 9 UPA / §301 RUPA They each have authority to bind each other through actions that apparently carry out the business of the partnership,

unless the partner so acting does not have such authority and the 3rd party is aware of this. UPA §9(1)o i.e. authority is limited to the scope of the partnership. Scope may be informal, or set out explicitly.

They each have contractual and tortious liability for actions of the other under the scope of the partnership Partners have equal right to management and control. (§18(e)) Decisions on ordinary matters decided by majority of the partners. (§18(h))

o BUT, if the decision is in contravention of an existing agreement between the partners then the decision MUST be unanimous (so, any one partner has veto power).

Partners CANNOT act for specific unusual, non-operational activities (e.g., selling off major assets) UNLESS he has consent of ALL partners. (See UPA §9(3)) UNLESS a partner has abandoned the business – then you do NOT need his consent.

Duty of Loyalty Duty of the managing partner is to disclose any new business opportunity he learns about by virtue of his position in

the partnership. Meinhard v. Salmon ( ‘Not honesty alone but the punctilio of an honor the most sensitive is then the standard of behavior’)

o I.E. there’s a heightened duty placed on the managing partner because courts want to mitigate the effects of information dissymmetry in order to build trust among partners

Every partner is a fiduciary of the partnership and MUST account to the partnership for ANY benefit, and hold as trustee for it ANY profits derived by him without the consent of the other partners from ANY transaction connected with the formation, conduct, or liquidation of the partnership or from any use by him of its property. (See UPA §21; Meinhard)

Partnership by EstoppelIf 1) a person represents itself as being a partner in an enterprise (or consents to others making the representation) and 2) a third party reasonably relies on the representation (actual reliance required) and does business with the enterprise* Then the person who was represented as a partner is personally liable on the transaction, even though that person is not in fact a partner…. *

While UPA § 16(1) refers only to those who “give credit”, RUPA § 308 expands this to all transactions and case law has made this clear even in the UPA context.

Profit-sharing. Default rule is pro rata division of profit, regardless of initial capital contribution differences. UPA 18(a)

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Remember: UPA provides default rules only. Express partnership agreements can vary the obligations and duties.

Policy Implications

Reasons to enter into a partnership Pamela wants to buy a grocery store for 200,000. She has 20,000, and is offered 150,000 is senior debt by Walter at

10% interest. Should she borrow 30,000 in junior debt from Abe/Bill at 20%?o No. The debt servicing requirements will eat all of the cash flows.

Alternatives to junior debto Zero coupon debt relieves the debt load a bit (no interest payments until end- capitalized annually)

But this is risky for A/B, who will then increase interest even more.o Give Abe/Bill a residual claim (i.e. some share of profits and losses) a partnership

3 Possible Remedies if a partner takes a partnership opportunity for himself Same Terms as existing partnership. Meinhard would have the option to participate in any new opportunity on the

same terms as in the 20 year joint venture. (Close to Cardozo’s remedy) Disclose and Compete/ Renegotiate. Salmon must inform Meinhard who is then free to compete for, or

renegotiate over, any new opportunity. (Cardozo suggests that this is what fiduciary duty requires) Salmon’s Option. Salmon can keep a new opportunity or offer a piece to Meinhard, as he prefers. (this argument is

shot down) Not a good default option. Tough to cobble together a majority of parties interested in this if there are more than 2 partners. Could have this by contract.

Case Summaries

Vohland v. Sweet (1982) Facts – Sweet does apprenticeship with Vohland the Elder; Elder dies, Vohland Junior (Paul) takes over and

renames it “Vohland’s Nursery.” Beginning in 1963, Sweet is paid 20% of net profits of Vohland’s Nursery. No explicit agreement. Sweet’s 20% share is (erroneously) called “commission.” In 1979, Sweet sues to dissolve “partnership” (i.e., wind-up, sell assets, and distribute proceeds)

Issue – was there a partnership Rule - Under UPA 7(4), receipt of a share of the profits is prima facie evidence of a partnership. Reasoning

o Sweet argues that he contributed nursery stock to the partnership because the stock was built up using annual profits (which thus reduced Sweet’s piece of the pie)

o Vohland argues that it’s just a commissiono ‘Not putting in capital’ is not dispositive, because labor can be an equal contribution in a partnership

Holdingo It was a partnership b/c lower court could reasonably have found there was an intent to form a partnership

Meinhard v. Salmon (1928) Salmon is a developer. Meinhard has money. Salmon is approached to develop land in Manhattan, but needs equity.

Meinhard agrees to provide $, but on the basis of a joint venture.o JV is like a partnership, but is limited to a specific project.

Salmon holds lease in his name, and operates the developed hotel. Salmon gets 60% of profits for first 5 years, then they split it 50/50.

When lease is about to run out, owner of the land (Gerry) presents Salmon with a new opportunity (to develop the entire block)

o Salmon accepts without consulting Meinhard; Meinhard wants a piece of the action. Holding

o Meinhard gets 49% of the stock in the realty corporation that Salmon set up to develop the new spaceo Would have been 50/50, but Cardozo awards Salmon with 51% so he can maintain operational control

i. Differs from the lower court’s 25% award. (Which was 50% share x 50% Bristol hotel as a share of the new lot)

o Duty of the managing partner (Salmon) was to disclose any new business opportunity he learns about by virtue of his position in the partnership.

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Better for Salmon

Better for Meinhard

i. I.E. there’s a heightened duty placed on the managing partner because courts want to mitigate the effects of information dissymmetry in order to build trust among partners

o ‘Not honesty alone but the punctilio of an honor the most sensitive is then the standard of behavior’i. This incentivizes disclosures in the future

2. Partnership Relations with 3rd Parties

Rights of Partnership Creditors UPA §15: Partners jointly and severally liable on partnership torts; jointly liable on P’ship contracts. RUPA

o RUPA §306: Partners jointly and severally liable on partnership torts and contracts. BUT:o RUPA §307(d): Must exhaust business assets before pursuing personal assets

Property ownership = Tenancy in partnership Can’t alienate property except within the course of partnership business Creditors of the partnership have priority over partnership assets relative to the creditors of the individual partners

An ex-partner is on the hook for debts incurred while he was a partner In practice, outgoing partners agree with remaining partners and the creditor to release the outgoing guy and then the

remaining partners and creditor renegotiate the debt

Creditor Priority – Jingle Rule vs. 1978 Act (1978 act is applicable today)

If the state still has the UPA and it’s not Chap. 7 bankruptcy, then the Jingle rule applies. (in which case the partnership creditors have priority on partnership assets and individual creditors have priority on individual assets).

Under 1978 Act and RUPA, partnership creditors have priority on partnership assets, and are treated equally to individual creditors with respect to individual assets

Impact of this rule is that partnership creditors don’t have to be as concerned with a partner’s individual creditors. (because the partnership creditor knows that it will get priority in collecting against partnership assets)

If both the partnership and the partner go bankrupt, the partnership creditors have priority on the partnership assets, and are treated equally to individual creditors with respect to individual assets. (if either the partnership is going through Chapter 7 bankruptcy or the RUPA applies)

The ‘property law’ aspect here makes a big difference in parties ability to secure credit (it would be almost impossible to contractually create a structure like this, especially because any partner could just go out and sign a new K with a non-party creditor, who would not be subject to the original K and agreement on priority)

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Salient Examples

Hypo: Consumer is injured by a product that Artis knows is dangerous.

Ars and Gratia are liable.o Rule: §13 attributes knowledge of any partner to all the partnerso Both are partners. Therefore, both liable.

If Ars received the lesser of $5,000 or 1/3 the profits, he probably wouldn’t be a partnero However, Ars could be found to be liable by estoppel if the consumer thought he was a partner (under

contract law, because on the tort side, the customer didn’t rely on Ars being a partner). (For instance, based on the name of the firm Argrar). Since Ars permits this representation to be made.

Mayer – can be held as a partner only in facto Can’t be said to be a partner by estoppel because no one knows about it.o In fact, he’s not a partner anyway, because the other partners couldn’t have consented to Mayer being a

partner if they don’t know about him. o Prima facie is a partner with Artis because they ‘consented’ to share their profits.o If the agreement said it was a loan and that Mayer would be repaid at a variable level based on a share of

the profits, then he wouldn’t be a partnero Right to demand repayment at any point is a really strong point of control

If a loan has an early-call-in provision and no option to repay early, it gives the lender a lot of control, and thus would function to make Mayer a partner despite the fact that it’s called a loan

Inference from §7 does not depend on control, but it does bear on whether a “loan” creates a partnership

Policy Reason for Default Equal Voting RightsIn a 3-person partnership, unless the partnership agreement specifies some other form of voting rights, each partner has equal voting rights.

The reason for not defaulting to ‘capital contributed’ is that many partnerships require at least 1 partner to contribute something that isn’t capital (i.e. skill, labor, knowledge etc)

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3. Termination of Partnerships

Dissolution means different things under UPA vs. RUPAUnder UPA:

Dissolution (§29): any change of partnership relations, e.g., the exit of a partner. Winding up (§37): Orderly liquidation and settlement of partnership affairs. Termination (§30): partnership ceases entirely at the end of winding up.

Under RUPA: Dissociation (§ 601): a partner leaves the partnership. Dissolution: (§ 801): the onset of liquidating of partnership assets and winding up its affairs.

UPA Dissolution§38(1): When dissolution is caused in any way, except in contravention of the partnership agreement, each partner, as against his copartners and all persons claiming through 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 the respective partners.

While the withdrawal of a partner works a dissolution under the statute as to the withdrawing partner, it does not follow that the rights and duties of remaining partners are similarly affected if there is a K providing for continuation therefore, the partnership as to the others does not auto-terminate by the withdrawal of the partner. Adams v.Jarvis

If the dissolution is in contravention , the breacher is liable for previous debts and any damages caused by his wrongful withdrawal. Remaining partners may either continue to operate or wind up the business.

In any lawful dissolution (or any dissolution not caused in contravention to the partnership agreement), each partner has the right to have the business liquidated and his share of the surplus paid in cash. Dreifurst v. Dreifurst

UNLESS:o all partners agree to like-kind distribution, OR o like-kind distribution is part of the partnership agreement. (See DRIERFURST (pp. 67-69))

Note : If the assets are non-marketable (i.e., nobody is interested in buying them, including creditors) then a like-kind distribution MAY be okay. (See DRIERFURST – but the court in this case does NOT think UPA §38 permits like-kind distribution UNLESS all partners agree.)

A partnership may be dissolved ‘by the express will of any partner when no definite term or particular undertaking is specified.’ UPA §31(1)b, but this power must be exercised in good faith. Page v. Page

Although an intention to make enough money to cover investments and debts using the profits can imply a term, this is only possible with corroborating evidence. This is not a fixed term. Page v. Page

A partner can’t sell/ attach his rights to participate in management, but can sell/ attach his right to the financial returns of the partnership Reason: don’t want to force remaining partners to take on a new partner who can bind them

RUPA Dissolution/ Dissociation Under the RUPA (§§601-800 the leaving of a partner can be either a dissolution OR a dissociation. With a dissociation, the partnership continues; with a dissolution it prompts liquidation and wind up. Wrongful dissolution in contravention of a partnership agreement does NOT necessarily lead to a winding up of

business the partnership CAN continue by paying the withdrawing partner. (See RUPA § 701 (p. 171)

Creditor Rights Withdrawing partner retains liability for obligations incurred prior to his departure BUT has NO control over the business. The withdrawing partner is NOT liable for new liabilities AFTER he withdraws AND gives notice. A retiring partner CAN be let off the hook if the creditors AND remaining partners agree to do so.

o Note : An agreement to let the retiring partner off the hook CAN be inferred by the court from the course of dealing if the creditor:

has knowledge of the dissolution AND continues to do business with the existing person or partnership. (See UPA §36(2)

If a creditor consents to a material alteration of a debt or performance K (MUNN v. SCALERA)or partnership agreement (UPA § 36(3)), and one person agrees to assume the existing obligations of a dissolved partnership, the

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partner whose obligations have been assumed is released from liability to the creditor. (See UPA §36(3)(p. 112 of supplement); MUNN v. SCALERA)

Three Issues1. Ability of partners to design own formula for exit (Adams v. Jarvis)2. Operation of statutory default rules for exit (Dreifuerst v. Dreifuerst)3. Equitable limitations on ability to use exit rights (Page v. Page)

Policy Implications

Advantage of liquidation auction is that it establishes a market price (and it’s hard for a court to value the firm in the absence of this market action)

o Creditors have an interest in the auction, because they don’t want partners liquidating at lower than market prices and zeroing out the debts at a fraction of the cost.

In-kind distribution might be better if it is a thinly traded market, or if partners lack liquidity

Salient Examples

Ex: Artis (partner) leaves and business is worth 700,000 as a going concern, 400,000 liquidated, 500,000 in sold to a related business with no need to alter facilities. Best way to let Artis fairly leave:

Issue – buying out Artis’s share of partnership assetso Remaining partners buy out Artis’s share of existing assets, and then sell it to incoming person

Issue – Artis’s liability for existing debtso Incoming partner can assume this debt as part of renegotiation of debt with creditors upon Artis’s

departure. An indemnity clause would accomplish this alsoo If not, new guy is on the hook only to the level of his capital investment (i.e. addition to the partnership

assets), but old liabilities can’t reach his personal assets

Case Summaries

Adams v. Jarvis (Wis. 1964) Facts –

o Dr. Adams withdraws from the three-doctor “Tomahawk Clinic” partnership; contends that his withdrawal constitutes a “dissolution” that gives him right to require a winding-up.

o Partnership Agreement: “The incapacity, withdrawal, or death of a partner shall not terminate this partnership” (¶15). ¶16 deals with “withdrawal” – “situation in which a partner leaves the partnership at a time when [it] is not dissolving”; provides Adams should get 5/12 (prorated according to months worked) * 1/3 (partnership share) = 5/36 of profits in year of his withdrawal.

o Accounts receivable to remain the sole possession and property of the remaining partner(s) History – trial court says he’s entitled to force a wind-up so as to gain 1/3 of the accounts receivable, because para

16 says that withdrawal is when a partner leaves but partnership is not dissolving... however, a partner leaving necessarily means that the partnership is dissolving. (very semantic interpretation)

Issue – whether withdrawal constitutes a dissolution that gives the dissociating partner a right to require a wind-up, notwithstanding a partnership agreement to the contrary.

Ruleso UPA § 38(1): “When dissolution is caused in any way, except in contravention of the partnership

agreement, each partner, as against his co-partners . . . , 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 the respective partners.”

Reasoningo Partnership agreement specifically provides that the partnership shall not terminate by the withdrawal of a

partner, so the parties clearly intended that even if a partner withdrew the partnership and business would continue for the purposes for which it was organized

o While the withdrawal of a partner works a dissolution under the statute as to the withdrawing partner, it does not follow that the rights and duties of remaining partners are similarly affected

Holding

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o If the partnership agreement provides for continuation, sets forth a method of paying the withdrawing partner his agreed share, does not jeopardize the rights of creditors, then the agreement is enforceable.

o When P withdrew, the partnership was not wholly dissolved so as to require complete winding up. Notes:

o The controversy here is because P gives up his rights to the accounts receivable upon withdrawing. This is the largest asset of professional firms. So, remaining partners could just tell clients to wait to pay for a year, and then shut out P from what should have been his share of profits.

o Solutions: allocate % of future profits from cases you worked on, provided client pays out (whenever it occurs); reserve a % of existing accounts receivable whenever it’s paid; reserve % of profits from all cases for a fixed time into the future.

i. Tradeoff on insuring each other against non-payment is that it lowers incentive for each partner to take on only paying customers

Dreifuerst v. Dreifuerst (Wis 1979) Facts - Winding-up of at-will partnership among three brothers to run two feed mills. No partnership agreement. P

wants to be paid in cash. History - Trial court declines one brother’s request for a sale of the assets; instead, gives one mill (St. Cloud) to the

one brother and other mill (Elkhart Lake) to the other two brothers. Issue – whether a trial court has the authority to order in-kind distribution. Rules

o UPA §38(1): “When dissolution is caused in any way, except in contravention of the partnership agreement, each partner, as against his co-partners . . , 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 the respective partners.”

Holdingo UPA can’t be read to allow for in-kind distribution unless the partners agree to ito In any lawful dissolution (or any dissolution not caused in contravention to the partnership agreement),

each partner has the right to have the business liquidated and his share of the surplus paid in cash. Dicta

o Any potential hardship from a market liquidation can be prevented by ex ante contracting in the partnership agreement

Noteo Advantage of liquidation auction is that it establishes a market price (and it’s hard for a court to value the

firm in the absence of this market action)o Creditors have an interest in the auction, because they don’t want partners liquidating at lower than market

prices and zeroing out the debts at a fraction of the cost.o In-kind distribution might be better if it is a thinly traded market, or if partners lack liquidity

Page v. Page (Cal 1961) Facts - Oral partnership agreement to run a laundry (linen supply company). Both partners contribute $43K in

original equity capital, and “Big Page” (a.k.a., the brains, like Salmon) loans the partnership another $47K through his wholly-owned corporation. Just when business seems to turn a corner in 1958-59, Big Page seeks to dissolve the partnership. Little Page claims that Big Page is trying to take an opportunity for himself stemming from the new Vandenberg Air Force Base

History – trial court found that the partnership was ‘for a term’ rather than ‘at will’ (‘such reasonable time as is necessary to enable said partnership to repay from partnership profits, indebtedness incurred for the purchase of land, buildings, laundry, and delivery equipment and linen for the operation of such business.)

o Thus, the dissolution would be wrongful, and Big Page wouldn’t have the right to force a winding up and he’s liable for damages to Little Page.

Ruleso A partnership may be dissolved ‘by the express will of any partner when no definite term or particular

undertaking is specified.’ UPA 31(1)b Reasoning

o Although an intention to make enough money to cover investments and debts using the profits can imply a term, this is only possible with corroborating evidence. This is not a fixed term.

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i. Here, there is no evidence that the partners had that intentionii. These 2 had formed partnerships with an explicit fixed term in the past, and this agreement is

substantially different from that agreement. Holding – Since D failed to prove any facts from which an agreement to continue the partnership for a term may be

implied, a definite term cannot be found. Dicta

o Little Page is still protected from strategic dealing by Big Page by BP’s fiduciary duty to the partnership. No evidence of bad faith dealing here, but if found on remand, then BP is liable for damages for breach.

Notes:o In Meinhard v. Salmon, Meinhard got more protection because he was given a piece of Salmon’s new

business (regardless of whether Salmon’s action was good/ bad faith). Here, Little Page does not automatically get a piece of the new business.

i. This is probably because nothing in this case is hidden (each partner had the knowledge to act on the new opportunity presented by the Air Force base)

ii. Little Page is still protected to some extent because he will get his share of the surplus in a liquidation of the partnership.

1. Although there isn’t much surplus in existing assets vs. debts, he likely could find a buyer to pay a decent amount because of the positive cash flow and opportunity for growth presented by the air force base.

o 2 styles of protection from strategic dealing i. Meinhard v. Salmon style (strong protection)

ii. Page ‘no bad faith’ protection (weaker)

4. General vs. Limited Partnerships

Limited partnership form creates limited liability for limited partners (i.e. partnership creditors can’t reach their personal assets) because limited partners don’t have control over management

In a Limited PartnershipGeneral partners – same as partners in a general partnership Limited Partners

Limited liability – liability limited to contribution Enjoy a share of the profits CANNOT participate in management EXCEPT voting on special events, such as dissolution. Control Test –

o If limited partners participate too much, they might be considered general partners and lose limited liability. (See RULPA §303 ( (pp. 237-238 of supplement); DELANEY v. FIDELITY LEASE LIMITED (overruled) (pp. 74-75))

o But: ULPA §303 of 2001 eliminates the Control Test and creates an absolute shield for limited partners, limiting their liability to their contribution EVEN IF they partake in management.

Although Limited Partners CANNOT take part in management, they are protected by fiduciary duties owed to them by general partners.

LPs, LLPs, and LLCs have pass-through tax treatment (profits NOT taxed, only taxed as income for individual partners) UNLESS their equity is publicly traded.

Limited partners CAN use corporate veil as a limit on liability (DELANEY overruled), UNLESS they hold themselves out to be general partners AND third party reasonably relies on representation

LPs are almost always for ‘a term’, and are frequently used by PE / VC firms the firm will be the general partner, and will open up for investment by LPs.

Advantage in pass-through taxation (avoiding double taxation regime on corporate profits and dividends) Also very advantageous when your investors are tax-exempt VCs get something like 2% of assets under management as a management fee, and 20% of the profits annually.

o The 20% is to ensure that the fund doesn’t just sit on the money and take the 2%o However, Wharton study shows that the funds generally make more money from the 2% than the 20%.

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Nonetheless, people still invest with these funds because the returns are high (or people think they will be high), and there is enough of a reputational incentive for the funds to perform well such that they can increase assets under management when the initial fund expires and they look to recapitalize/ rollover current investors.

Limited Liability Partnership (LLP) – allowed by statute in majority of states. Designed to protect professional partnerships

o E.g., lawyers and accountants Most statues only limit liability from tort claims against partners not involved in the transaction, NOT K claims.

o SOME states allow protection from K claims as well. SOME states have minimum capitalization or insurance requirements. There is less judicial scrutiny of self-dealing transactions.

Limited Liability Corporation (LLC) Limited liability, BUT control also allowed, unlike in a limited partnership. Members (investors) can control the firm OR elect managers to do so. Resignation of a member does NOT lead to dissolution though decision to continue may affect tax treatment Members may transfer ownership freely by default

o BUT, control interest is transferrable only by unanimous consent or provision in the LLC agreement GENERALLY qualifies for pass-through tax treatment UNLESS it has 3 of the following 4:

o Limited liability;o Centralized management;o Free transfer of ownership; ANDo Continuity of life.

IF it has at least 3 of the 4, then it is taxed like a corporation

Limited Liability Companies & IRS Four-Factor Test

4 Factors

If you’re thinking you may go public at some point, you would want to set up as an S corp (as it avoids taxation when you public), but if the firm expects to remain private, then the more exotic LLC, LLP forms are more advantageous with their pass-through taxation

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III. CORPORATE FORM

A. Overview

Basic Characteristics of the Corporate Form Legal personality (separate entity), with divisible ownership Assets separated from SH (they can’t reclaim their pro rata share of assets; SH creditors can seize shares, but not assets) Indefinite duration Limited liability for investors Free transferability of share interests Centralized control (Board) appointed by equity investors (separation of ownership and control)

Benefits of Limited Liability:1. Reduces need to monitor agents (managers)2. Reduces need to monitor other shareholders3. Makes shares fungible (which also facilitates takeovers, see below) 4. Facilitates diversification (without LL, minimize exposure by holding only one company) 5. Enlists creditors in monitoring managers (because creditors bear some downside risk)

Benefits of Transferable Shares:1. Permits takeovers => disciplines management2. Allows shareholders to exit without disrupting business3. And because of limited liability, shares are fungible => facilitates active stock markets, increasing liquidity

Corporate charter By §102(a), charter must include (1) name of company, (2) address of registered office/ agent in-state, (3) nature

of business to be conducted, (4) # of issuable shares and their characteristics (two tier, different voting rights, different seniority, etc), (5) names of the incorporators, and if incorporators’ power terminates upon filing then the names of the temporary directors to serve until first annual shareholder meeting.

By §102(b), charter may include (1)anything that is includable in the bylaws, (2) not important), (3) grant of ‘first refusal’ power to existing shareholders’ by which they can preemptively subscribe to new issues of stock or convertibles. (4) provisions requiring super-majority votes on specified corporate actions, (5) limits on the lifespan of the corporation, (6) provision providing personal liability on corporate debts for shareholders, (7) waiver of directors’ duty of care (but not loyalty waiver)

Corporation’s legal life begins after the charter is filed. DGCL §106 (in other states, the legal life begins after the Secretary of State issues a charter – i.e. after he accepts the filed charter)

Amending a charter. o Need board to submit the amendment to shareholders, then also need a majority of all shares AND a

majority of each class of shares entitled to a class vote to approve the amendment. §242(b) Note : Directors MUST initiate the charter amendment. Note : Change in the number of authorized shares MUST be made through charter amendment.

Bylaws set operating rules for the company. They must be in compliance with the state incorporation statute and the charter. DGCL §109(b) In Delaware, shareholders have an inalienable right to amend the bylaws. DGCL §109(a) The board may also be granted the power to amend the bylaws DGCL §109(a) in practice, almost all corporate

charters grant this power to the board. Bylaws contain control issues not mentioned in the charter: exact number of board directors, method of voting (i.e.,

cumulative), the offices of the corporation, empowerment for calling a shareholders meeting, board quorum requirements, etc.

Constituencies: Shareholders Officers Board of directors Third parties (creditors, workers, customers, etc)

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Tension between shareholders’ §109(a) immutable right to amend the bylaws and directors’ §141 exclusive rights to manage the business and affairs of the corporation

Shareholders Shareholders act principally through three mechanisms: 1) the right to sell, 2) the right to vote, 3) the right to sue Shareholders do not have the right to conduct business directly on behalf of the corporation (the power to

manage the business and affairs is reserved to the board by §141); therefore, shareholders cannot bind the corporation by their own direct actions. Automatic Self-Cleansing Filter Co.

Board of Directors DGCL § 141 – board has primary power to direct or manage the business and affairs of the corporation, This generally includes:

o appoint/remove officers, direct enterprise activity, issue stock, issue dividends, initiate M&A and dissolutions, and call shareholder meetings.

Directors are NOT agents of the shareholders – they are entitled to good faith business judgment. They are NOT required by duty to follow the judgment or wishes of the majority of shareholders. Automatic Self-Cleaning Filter Syndicate v. Cunningham (the board is an agent of the corporation as a whole and it would be a disservice to the corporation to say that a majority always has to be followed.)

o If a majority of shareholders disagrees with the board, they can vote to remove them. Directors are subject to duty of loyalty and duty of care Board powers are ONLY exercised at meetings UNLESS ALL directors consent in writing to act without a

meeting. Without formality, board resolutions have NO power.o MUST have a quorum (majority of directors) to do business. IF quorum is present, passing a resolution

ONLY requires a majority vote of those present UNLESS the charter provides for a supermajority vote on an issue – each director has ONE vote.

Board CAN delegate to an independent committee, BUT matters that require board action by statute CANNOT be delegated to a committee for final action. (See DGCL §141(c))

o If non-directors are in a committee, the committee can ONLY be advisory. Fundamental transactions

o ONLY the full board, NOT shareholders, can initiate fundamental transaction (except: Short-form mergers) Calpers Global Principles of Accountable Corporate Governance. §5.1 duties of the board

o i. Reviewing, approving and guiding corporate strategyo ii. Monitoring the effectiveness of the company’s governance practices o iii. Selecting, compensating, monitoring and, when necessary, replacing key executives o iv. Aligning key executive and board remuneration with the longer term interests of the company and its SHs.o v. Ensuring a formal and transparent board nomination and election process.o vi. Monitoring and managing potential conflicts of interest of management, board memberso vii. Ensuring the integrity of the corporation’s accounting and financial reporting systems,o viii. Overseeing the process of disclosure and communications

Structure of the board Board can be of any size – usually stated in certificate of incorporation as a range and the actual amount is fixed

in the bylaws. An annual meeting of stockholders to elect directors is required UNLESS directors are elected by written

consent. (See DGCL § 211(b) (pp. 579-589 of supplement))o Default rule is that board members are elected annually to one-year terms. But charters can restructure, create

staggered boards in which directors are divided into classes that stand for election in consecutive years. Staggered board:

o Option to have as low as 1/3 of the board elected each year (1/4 for NY). (DGCL §141(c)(3)(D) Thus, board can’t be fully replaced for 3 years

o Directors of a staggered board can ONLY be removed before their election date for cause. (DGCL §141(k) o MUST be included in the charter.o Important in takeovers – institutional investors do NOT like them and will usually NOT allow them after

an IPO – only found normally in small, new corporations. Removing Directors

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o Shareholders can remove directors without cause in MOST states (DGCL §141(k)o If corporation has a classified board, shareholders may ONLY remove for cause unless certificate of

incorporation or bylaws otherwise provide otherwise If the corporation has cumulative voting, if less than the entire board is to be removed, then NO

director may be removed without cause if the votes cast against his removal would be sufficient to elect the director if cumulatively voted at an election of the entire board of directors, or if there are classes of directors, at an election of the class of directors of which such director is part.

o Director removal can only happen at a meeting called for the purpose of removing him, and the meeting notice must state that the purpose, or one of the purposes, of the meeting is removal of the director

o Note : In NY, shareholders CANNOT remove without cause UNLESS granted in the charter – MUST wait until annual meeting.

Directors CANNOT remove each other – directors can ONLY be removed by shareholders or judicial injunction (b/c crooked, insane, or inept) through equitable fiduciary laws.

o BUT, board CAN maneuver around a director through use of committees.

Vacancies on the board — DGCL 8.10(a) Unless the articles of incorporation provide otherwise, if a vacancy occurs on a board of directors, including a

vacancy resulting from an increase in the number of directors:o (1) the shareholders may fill the vacancy; (at a SH meeting called by directors, or at annual meeting)o (2) the board of directors may fill the vacancy; oro (3) if the directors remaining in office constitute fewer than a quorum of the board, they may fill the

vacancy by the affirmative vote of a majority of all the directors remaining in office.

Corporate Officers Officers are agents of the corporation Corporation is bound by actions of officers who have authority to act on its behalf Sources of authority to act for corporation:

o Actual authority – An explicit grant of authority to the officer to act on behalf of the corporationo Apparent authority – Actions of a principal that give the appearance to reasonable persons that the agent is

authorized to act as he is acting.o Inherent power – Authority inherent in the office; measured by common understanding of business peopleo Ratification – A corporation is bound by subsequent actions, if a person with actual authority to enter into

the transaction learns of the transaction and either expressly affirms it or fails to disavow it. Apparent Authority. In order for a reasonable inference of the existence of apparent authority to be drawn from prior

dealings, these dealings must have o 1) a measure of similarity to the act for which the principal is sought to be bound, ando 2) a degree of repetitiveness

Corporation not bound by officer’s actions where the officer had no apparent authority to engage in those actions. Jennings v. Pittsburgh Mercantile Co (An agent by his own words cannot invest himself with apparent authority. The office of treasurer/ comptroller and vice president does not provide a basis for a reasonable inference of apparent authority to bind on an extraordinary transaction, and neither does any action that was taken in the past)

Inherent authority. President has the inherent authority to enter into contracts with a 3rd party. Menard, inc. v. Dage-Miti, inc. – (Corporation was bound by the fact that president entered into contract with third party, even though he was not actually authorized to do this – he had inherent authority and therefore risk falls on the corporation)

Case Summaries

Automatic Self-Cleansing Filter Co Facts

o McDiarmid and friends own 55% of Automatic Self-Cleansing Filter (ASCF).o ASCF articles vest “management of the business and control of the company” in the board, subject to

“extraordinary resolution” of 75% of shareholders.o McDiarmid (shareholder) and friends try to pass resolution mandating sale of company’s assets; only gets

55% of votes.

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o McDiarmid then asks the court to order the board to sell the assets. Reasoning - Directors are not agents of the shareholders, but rather are agents of the corporation itself. Holding - Court refuses to order the sale

Jennings v. Pittsburgh Mercantile Co. Facts

o Mercantile is a publicly-held corporation with 400 shareholders, nine directors, and a three-member executive committee of directors.

o Egmore (Mercantile’s VP and Treasurer-Controller, corporate officer, and director), along with Stern (“financial consultant”), instructs Jennings to solicit offers for a sale and leaseback of its real property in order to raise money for modernization.

o Egmore tells Jennings that the executive committee has the power to accept an offer, and eventually does so through Stern.

o But the board rejects, and Jennings sues for his commission. o Mercantile argues that Egmore did not have authority to do the deal, and therefore Mercantile is not bound.

Jennings argues that Mercantile is bound through apparent authority of Egmore Issue

o Whether there was sufficient evidence from which the jury could conclude that Mercantile clothed its agent with the 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, admittedly, no actual authority to do so

Ruleso In order for a reasonable inference of the existence of apparent authority to be drawn from prior dealings,

these dealings must have i. 1) a measure of similarity to the act for which the principal is sought to be bound, and

ii. 2) a degree of repetitiveness Reasoning

o The proposed sale and leaseback was not in the ‘ordinary course of business’, therefore the apparent authority that Jennings must establish is the authority to bind the firm in a matter of an extraordinary transaction

o This transaction was not similar to previous transactions, and was not repetitive Holding

o An agent by his own words cannot invest himself with apparent authority. The office of treasurer/ comptroller and vice president does not provide a basis for a reasonable inference of apparent authority to bind on an extraordinary transaction, and neither does any action that was taken in the past

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B. Corporate Finance

1. Basic Capital Claims on a Corporation

Debt Less risky for investors – legally guaranteed repayment of principal and interest Limited upside risk – can only recover principal and interest Has a fixed maturity date Normally NO fiduciary duty owed to secured creditors UNLESS there is a pending insolvency If the bond is publicly traded, there is usually a trustee appointed to interact with the issuer on behalf of the

bondholders to solve collective action problems. Typical elements of debt contract:

o Basic obligation of borrower (issuer of debt securities) (Repayment of principal, payment of interest at specified rate and intervals)

○ Additional obligations stated in “convenants”: agreements of obligations of issuer Limits on dividend payments Limits on claim dilution (restricts firm’s ability to take on new debt unless it’s subordinated to the

current debt) Prohibition on asset substitution (no mergers or changes in control without creditor waiver) Assurances against under-investment (capital requirements, requirement to maintain line of business)

Preferred Stock Preferred stock is any deviation from normal liquidation or dividend rights. Generally, has enhanced dividend rights and priority claim on assets upon liquidation – less risky than common

stock Note : DGCL §151 gives corporation right to issue different types of stocks.

o Corporate Charter lays out the different kinds of stock a particular company can issue. Issuance MUST be made commensurate with the authority given to the board in the certificate of incorporation. (See DGCL §151 (pp. 558-562 in supplement))

Normally does NOT have voting rights UNLESS dividends are in arrearso EXCEPTION : major events like mergers

Convertible preferred stock has advantage of creating a fixed obligation (i.e. 10% dividend) while still letting the investor capture additional residual value at some point in the future by converting into common stock.

Common Stock Unlimited upside risk and limited downside risk b/c of limited liability, so can only lose what you put in. RESIDUAL RIGHTS – have residual rights to corporate assets and income, so can reap huge reward if company is

successful Common stock has voting rights – giving shareholders voting rights makes management less risk averse than they

oterhwise would be.o The reason we give control rights to common stock is that they have the highest incentive to maximize returns

Note : There is NO right to dividends – dividends are within the business judgment of the board. Exit rights – shareholders can sell, whereas debtholders can’t get out so easily.

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2. Valuation

Risk

For volatile investments, people tend to be unwilling to pay the full expected value of the opportunity Ex: Coin toss: heads gets $10, tails gets $0 people tend to be willing to pay less than $5

o However, if you package 10 coin flips together (or invest 1/10 as much in 10 different occurrences of the flip), the risk is mitigated (likelihood of 10 tails or heads is very, very low) leads people to be willing to pay a bit closer to the expected value.

i. Helps to avoid market failure

3 stories about risk aversion1. Declining marginal utility of wealth.

o Additional $$ are worth less to you than the $$ you have. o When we’re talking about v. large sums of money, losing will impact a larger amount of utility than

gaining the same amount (i.e. if you have 2 billion, losing 1.5 billion will affect your utility much more than gaining 1.5 billion)

2. Transaction costso Greater variance in outcomes incurs greater transaction costs.

3. “Endowment effect” o We regret losing what we have more than not gaining what we don’t have. (psychological/ behavioral

economics)

Valuing RiskTwo step method: First, find the certainty equivalent (CE), thereby incorporating risk as a smaller numerator. Then, discount the CE by the risk-free discount rate, i.e., the market interest rate on 1 year T-bill.

If someone is willing to pay 4.5 for the EV $5 coin flip, the $4.5 is the CE. Then, discount the 4.5 by the risk-free discount rate.

Single step method: Increase the discount rate, thereby incorporating risk as a larger denominator. Specifically, discount by (rf + risk premium)

Theoretically, the 1st method is the best because it doesn’t exponentialize the risk However, method 2 is typically used because it’s easier to determine empirically. take a look at a similarly

situated investment and ID the total interest rate, then subtract the risk free interest rate this yields the risk premium rate

Valuing a Company Get the EV of future cash flows, then discount all future cash flows into the present according to the risk-adjusted

interest rate. Or….. given a well-functioning market, the market should already be the best available estimate of this calculation

(Efficient Capital Markets Hypothesis As long as some section of the market is engaging in the basic valuation, they should bid up/ down the price to reflect their best estimate of its value)

o Criticism: the market isn’t fully rational (Lots of bubbles/ bursts)… Even if you know that stocks are under/overvalued, if there are enough irrational people, you won’t be able to move the market.

Home prices rose way above the EV of rental income (which is a good proxy for home value) Tech stocks rose waaay above the EV of future earnings Bank stocks Info that subprime was crappy really came out in Feb. 2007, but bank stocks didn’t

collapse until April 2007. It’s generally true that the market capitalization is higher than the ‘shareholder’s equity’ on the balance sheet

o This is because property, plant, and equipment are valued at historical costs (and likely have appreciated)o Also because market cap (if shares are publically traded) take into account the PV of future earnings

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C. Creditor Protection

1. Overview

Basic agency problem: shareholders can walk away from failing corporations. Not only do they have no interest in protecting creditors, but have interest in misrepresenting things to them.

Private Protections Security Interests – property rights to specific property that becomes possessory upon default Warranties – promise by borrowers that certain facts are true or will be at the time of the closing transaction.

Violation of warranty brings breach of K damages in addition to possible fraud. Covenants – promises that the corporation makes to the lender

o Creditors control activities that will hurt them – limited dividend or stock repurchase amountso Financial covenants – early warning systems on business performance – default upon missing ration and

must correct soon or payment is accelerated Minimum Capital Restrictions - as a condition of non-default Restrictions on other debt – MUST be subordinate or junior to this debt

Public Law Protections Minimum Capitalization requirements – NOT in US, but in other countries. Dividend restrictions – distributions CANNOT be made if they would make the corporation insolvent. Also,

traditionally could not distribute beyond par value, BUT not true today.o Two tests for insolvency:

Inability to meet cash flows; OR Balance sheet w/ assets measured at FMV.

Fiduciary Duties to Creditorso If the firm is insolvent, directors owe a duty of loyalty to creditors. Directors CANNOT take equity

opportunism and take excessive risks with the creditor’s money. Directors become trustees in bankruptcy.

Rules generally forbid firms from paying stated capital out to their shareholders But, today, most states don’t require a par value. (see §154 DGCL) Therefore, directors have discretion as to

whether to put money into stated capital vs. capital surplus, so it’s not really relevant

Minimum Capital Requirements Advantages – should help to protect creditors Disadvantages

o This capital can be depleted after the company starts operatingo This minimum capital isn’t really effective in protecting creditorso Functionally, minimum capital requirements just serve to screen out small companies

Also, note that regulatory competition in the EU (created by recent decision that company registrations in other EU territories must be honored in each EU country) is pushing minimum capital requirements downward

Constraints on Distributions DGCL § 170(a) (“nimble dividend” test): may pay dividends out of capital surplus + retained earnings, or net

profits in current or preceding fiscal year (whichever is greater). AND: DGCL § 244(a)(4) allows board to transfer out of stated capital into surplus for no par stock. (Defines ‘surplus’ as capital surplus + retained earnings)

New York Bus Corp. Law § 510 (capital surplus test): may only pay distributions out of surplus (§510(b)), and distributions cannot render the company insolvent (§510(a)). AND: NYBCL § 516(a)(4) allows board to transfer out of stated capital into surplus if authorized by shareholders.

EU Second Company Law Directive, Art 15(1): can only pay dividends out of retained earnings, as long as net assets >= capital.

Cal. Corp. Code § 500 (“modified retained earnings test”): may pay dividends either out of its retained earnings (§ 500(a)) or out of its assets (§500(b)(1)), as long as ratio of assets to liabilities remains at least 1.25, and CA>=CL (§500(b)(2)).

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K protectionsPublic law (min. capital, dividend restrictions, fiduciary duty to

creditors in ltd. circumstances)Anti-fraud laws p. 27Equitable subordination of debt held by SH where motivation of

loan was to avoid exposure to creditors p. 28Piercing the corporate veil to collect on individual assets of SH p. 29Successor liability p.31

RMBCA § 6.40(c): may not pay dividends if you can’t pay debts as they come due (§ 6.40(c)(1)); or assets would be less than liabilities plus the preferential claims of preferred shareholders (§ 6.40(c)(2)). BUT: board may meet the asset test using a “fair valuation or other method that is reasonable in the circumstances” (§ 6.40(d))

Divergence in Stakeholders’ Interests

2. Fraudulent Conveyance

Corporate assets that are fraudulently conveyed are subject to clawback.

Present or future creditors may void transfer made with actual intent to delay, hinder or defraud any creditory (See Uniform Fraudulent Transfer Act §4(a)(1))

Creditors can void transfers by establishing that they were either actual or constructive frauds on creditors (UFTA §4(a)(2)) Covers transfers made without receiving a reasonably equivalent value in exchange for the transfer. . . when the

debtor:o (i) was engaged or about to engage in a business transaction for which the remaining assets of the debtor

were unreasonably small. . . oro (ii) intended to incur. . . or reasonably should have believed that he [or she] would incur debts beyond his

[or her] ability to pay as they came due. . . or For this 4(a)2, the court does NOT look to the intent of the conveyance it looks for the person’s knowledge of

pending insolvency proceeding and fairness of consideration There is no good faith defense to §4(a)2. For purposes of determining whether equivalent value was received, courts will usually consider the transfer OK as

long as it is reasonably fair and on an arms-length basis

Transfers where … the debtor was insolvent at the time … or … became so as a result of the transaction are also voidable. UFTA §5(a)

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If you’re dealing with a debtor that is or may be in financial difficulty, and seem to be getting a really good deal, you should look into that firm’s finances, or risk facing actions under UFTA

3. Equitable Subordination

PartnershipsAny loans from the partners are subordinated to claims of non-partner creditors

CorporationsLoans from shareholders are not subordinated

Applicable test for equitable subordination- Whether the transaction between affiliated creditors and corporation can be justified within the bounds of fairness. Costello v. Fazio

Costello v. Fazio (9th Circ. 1958) –loans from shareholders that are used to purchase a partnership owned by those shareholders are subordinated to third party debts where the motivation seems to have been avoiding exposure to creditors.

Basically, Leonard and Fazio ‘withdraw’ their capital, but don’t actually take it rather they ‘lend’ this money to the corporation in exchange for a note.

Then, they incorporate.o The new corporation takes on all assets and liabilities of the old partnership

i. Basically, they have converted part of their status as equity partners into status as creditorso This looks like an attempt to reduce their exposure to the company in the event of bankruptcy

i. If the firm had gone under as a partnership, they would have got nothingii. If the firm goes under as a corporation, they get a pro rata recovery alongside the unsecured

creditors after the claims of secured creditors are satisfied.o Alternate explanation

i. Tax implications. Payments of interest on the notes to fazio and ambrose are deductible from corporate income. (dividends would not have been deductible). Reduces burden of corporation tax.

o Note:i. Partnership creditors would still be able to collect directly from partners after it becomes a

corporation1. However, the 1952 creditors are not the same as those in 1954 the trade creditors of

1952 almost certainly have been paid off, and trade credit revolves frequently (i.e. paying off accounts payable at the end of each month)

o Secured debtor is finei. Can collect on the secured asset

ii. Also negotiated for personal guarantees from leonard, ambrose, fazio and their wives 1. Note: creditors can negotiate for personal guarantees that corporate law otherwise

wouldn’t extend on shareholders Holding: Circuit court reverses trial court and subordinates the debt held by Leonard, Ambrose, and Fazio

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4. Piercing the Corporate Vail

Piercing: creditors of subsidiary go after the assets of a parent corporation (or shareholder)Reverse piercing: creditors of a parent (or shareholder) go after the assets of a subsidiary corporation

There is probably no piercing of any kind against public corporation; against passive shareholders; minority shareholders; if all formalities are observed and nothing “funny” is going on with the accounts

Policy Issue: If creditors bargain on basis of assets in corporate pool, does veil-piercing upset ex ante risk allocation?

Veil-piercing threshold tests Tests go under various names: “agency test;” “instrumentality of the individual”; “alter ego of the individual;” etc. Generally consist of two components:

o Evidence of “lack of separateness,” e.g., shareholder domination, thin capitalization, no formalities/co-mingling of assets (“Tinkerbell test” – to be protected, shareholder must believe in the separation)

o “Unfair or inequitable conduct” – hard to specify with precision: wildcard in veil-piercing cases.

Lowendahl test (NY)Veil-piercing requires (1) complete shareholder domination of the corporation (including failure to treat formalities seriously); and (2) use of control to perpetrate fraud or “wrong” that proximately causes creditor injury

Van Dorn test (7th Circuit – applied in Sea Land):Veil piercing requires (1) such unity of interest and ownership that the separate personalities of the corporation and the individual [or other corporation] 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.

Mixing of corporate and personal assets weighs toward finding first condition satisfied. Sea-Land Services v. Pepper Source To find the 2nd condition satisfied:

o Evading shareholders pre-existing legal obligations iii. Undermining rules of adverse possessioniv. Former partners skirting monetary obligations

o Actual fraud o Shell game

A party unjustly enriched (e.g. siphoning off corporate assets) Parent company causing subsidiary’s liabilities and the inability to pay (e.g. siphoning off

corporate assets) Intentional scheme to channel assets to one corporate entity and liabilities to another (e.g.

siphoning off corporate assets)

Laya test (applied in Kinney Shoe)Veil piercing requires (1) unity of interest and ownership such that the separate personalities of the corporation and the individual shareholder no longer exist; and (2)that an inequitable result occur if the acts were treated as those of the corporation alone. BUT: (3) if both prongs satisfied, there is still a potential “third prong” D might still prevail by showing assumption of risk.

On the issue of the 3rd prong, most creditors can’t be expected to investigate the other party to see if it has sufficient assets against which it can collect (only banks and other financial institutions should be doing this). Kinney Shoe

o “When, under the circumstances, it would be reasonable for that particular type of a party [those contract creditors capable of protecting themselves] entering into a contract with the corporation, for example, a bank or other lending institution, to conduct an investigation of the credit of the corporation prior to entering into the contract, such party will be charged with the knowledge that a reasonable credit investigation would disclose. If such an investigation would disclose that the corporation is grossly undercapitalized, based upon the nature and the magnitude of the corporate undertaking, such party will be deemed to have assumed the risk of the gross undercapitalization and will not be permitted to pierce the corporate veil”

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If the corporation being sued is keeping up with the formalities required to be a corporation, then it the first prong of any of these tests probably won’t be met. See Walkovsky v. Carlton.

Case Summaries

Sea-Land Services Inc v. The Pepper Source (7th Circ 1991)- Piercing (unity of interest, actual fraud/ inequity)

Reasoningo Marchese doesn’t have his own bank account (he pays alimony, child support, photos with politicians,

veterinarian bills out of corporate checking accounts) so, there’s mingling of assetso Can’t have a 2nd prong that says ‘someone must have not been paid’, because that’s useless (as all these

cases involve someone not being paid)o So, you need mingling and either actual fraud or injustice

v. Here, the Court references the actual fraud Marchese committed in avoiding taxes However, that’s a poor reference

Holding – Veil is pierced to reach Marchese, and reverse-pierced to reach the assets in his other subsidiaries

Kinney Shoe Corp. v. Polan – piercing (unity of interest, shell game)

Factso Kinney subleases a building it’s not using (but has to pay

rent on). Polan has gone bankrupt before. Polan sets up a no-assets shell corporation to sub-lease from Kinney. Polan then arranges for Industrial to sub-lease 50% of the space to Polan Industries. Polan doesn’t pay (as Industrial fails). Kinney sues Polan individually to collect.

Issue – Can Kinney pierce the veil and collect against Polan? Rule

o To pierce the veili. (1) unity of interest and ownership such that the separate personalities of the corporation and the

individual shareholder no longer exist; ii. (2) would an inequitable result occur if the acts were treated as those of the corporation alone.

iii. (3) if both prongs satisfied, there is still a potential “third prong” D might still prevail by showing assumption of risk.

1. When, under the circumstances, it would be reasonable for that particular type of a party [those contract creditors capable of protecting themselves] entering into a contract with the corporation, for example, a bank or other lending institution, to conduct an investigation of the credit of the corporation prior to entering into the contract, such party will be charged with the knowledge that a reasonable credit investigation would disclose. If such an investigation would disclose that the corporation is grossly undercapitalized, based upon the nature and the magnitude of the corporate undertaking, such party will be deemed to have assumed the risk of the gross undercapitalization and will not be permitted to pierce the corporate veil.

Reasoningo There is a unity of interest and ownershipo Even if an inequitable result might occur if the sub-leases were treated as acts of the corporation alone,

Polan set up Industrial to limit his liability and the liability of Polan Industries, Inc. in their dealings with Kinney.

o A stockholder's liability is limited to the amount he has invested in the corporation, but Polan invested nothing in Industrial.

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o This corporation was no more than a shell--a transparent shell. When nothing is invested in the corporation, the corporation provides no protection to its owner; nothing in, nothing out, no protection. If Polan wishes the protection of a corporation to limit his liability, he must follow the simple formalities of maintaining the corporation.

Holdingo Polan is personally liable for the debt of Industrialo Without deciding whether the third prong should be extended beyond the context of the financial institution

lender mentioned in Laya, even if it applies to creditors such as Kinney, it does not prevent Kinney from piercing the corporate veil in this case. The third prong is permissive and not mandatory.

Noteso Note: Unlike in the Sea Land case, there hasn’t been any movement of assets here (Industrial was a no-

asset company right from the outset)o The court’s point here is that most creditors can’t be expected to investigate the other party to see if it has

assets (only banks and other financial institutions should be doing this)

Walkovszky v. Carlton – no piercing

Factso Carlton is majority shareholder of a lot of small

corporations, each of which own 1 taxi (which is mortgaged) and holds minimum insurance. Walkovszky gets hit by a cab owned by the Seon corporation (1 of the small corporations).

Issueo Can W pierce the veil?

Ruleo In order to prevail, P would need to show that Seon corporation is carrying on the business of Carlton

Reasoningo There’s nothing wrong with setting up a thinly capitalized corporation. o Each of the corporations is keeping up with the formalities required to be a corporationo Cabs say ‘Seon’ on the side. Cab is owned by Seon

Holdingo The veil cannot be pierced

Dictao Court notes that it is willing to consider all of the small taxi corps as a single business because they’re

engaged in the same business, but this isn’t important because they all suffer the same problem as Seon (no assets)

5. Successor Liability

DGCL § 278 & § 282: shareholders remain liable pro rata on their liquidating dividend for three years.

RMBCA § 14.07: same as Delaware, provided that corporation publishes notice of its dissolution. (if no publication, then there’s no 3 year SOL)

Successor Corporation Liability: Product line test in some jurisdictions may hold acquiror liable if it buys the dissolved corporation’s business intact, and continues to manufacture the same line of products any sophisticated buyer who buys the business as a going concern will contract for indemnification for tort liability, or pay less.

So only way for shareholder to escape long-term liability through dissolution is to sacrifice the going-concern value of the business and keep only the piecemeal liquidation value

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IV. SHAREHOLDER VOTING

A. Overview

Shareholders only have a right to vote on three kinds of matters: 1. election of directors; 2. “fundamental” changes, (merger, sale of all assets, dissolution, charter amend.)3. shareholder resolutions

Election of Directors Must have board of directors. DGCL § 141(a). Election must occur every year DGCL §211, but not every director must be up for reelection. DGCL §141(a)

o Quorum requirements for annual meeting. DGCL §216, RMBCA §7.25, 7.27, but court can waive DGCL 211(c)o Annual election cannot be delayed (Hilton Hotels v. ITT) if the purpose is to entrench the board (probably

also can’t be moved up for the same purpose… analogize to Schnell v. Chris-Craft which struck down early meeting designed to preclude submission of a proxy statement)

o By default, shareholders don’t vote to fill board vacancies arising during the year; have to wait until the annual meeting DGCL § 223 (default is that existing directors get to vote on appointing people to fill these vacancies)

Fundamental Changes Corporate charter amendments must be proposed by the board, and approved by shareholders DGCL §242 Dissolution of the company must be approved by shareholders. DGCL §275 Sale/lease/exchange of substantially all property/assets of corporation must be approved by shareholders DGCL §271 Mergers must be proposed by board and approved by SH, DGCL §251. But approval of SH of surviving corporation

isn’t required unless acquirer issues more than 20% new shares. §251(f). See p. 100 of outline for more detailShareholder resolutions.

Shareholders have an inalienable right to amend bylaws. DGCL §109(a) Can only be voted on at meeting or by written consent Special meetings of the stockholders may be called by the Board OR by such persons who are authorized by the

charter. At SH meeting (annual or special), you need majority of shares voting to pass resolution. DGCL § 211(d) If trying to pass through written consent, you need a majority of all outstanding shares to pass DGCL §228(a) RMBCA §7.02 – shareholders can call special meeting if at least 10 percent of the authorized voting shareholders

on the issue proposed want to have one (pp. 711-712 of supplement)

Types of VotingStraight voting (default) – each director seat is voted on separately leads to biggest shareholder group selecting every directorCumulative voting – election is aggregated, with each shareholder getting #of votes equivalent to his shares x number of seats up for election helps to allow minority groups get some representation on the board

DGCL § 214 permits opt-in via charter ; mandatory in California for close corps Ex: Family Corp. has 300 shares outstanding; A owns 199 shares and B owns 101 shares. Family Corp. has a three-

person board elected to annual terms.o Straight Voting: A would win each seat 199 to 101. Cumulative Voting: B casts all 303 shares for one,

guaranteeing 1 seat, as A’s 597 votes can’t be divided 3 ways so that all 3 get more than 303 votes.

Counting RulesPlurality Voting

This is the default in Delaware for election of directors. DGCL §216) Directors elected who receive largest # votes in favor Votes withheld are irrelevant; votes against impossible if uncontested If uncontested, elected if votes for > 0

‘Majority of shares at meeting’ This is the default in Delaware for everything else. DGCL §216 Resolution passed by majority of shares present (or in proxy) at meeting and entitled to vote High hurdle: elected if votes for > votes (withheld + against)

‘Majority of shares voting’ Is the default rule in the UK. Can be opted into in the corporate charter. Resolution passed by majority of shares voting (in person or by proxy)

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Withheld votes don’t count as anything Elected if votes for > votes against. (In recent years (since 2005), a huge share of companies can moved to

‘majority-voting’, making it hard for unopposed directors to get elected)

Salient Examples

The Unfireable CEO

CEO owns 25% of Village’s single class of stock. Balance is widely held. Stock takes a nosedive; CEO puts in charter amendments to allow board to amend bylaws, and to provide for

cumulative voting. Directors then amend bylaws to provide for a staggered board of nine directors (3classes of 3). At next annual meeting, nine CEO-supporters are elected to the new staggered board. Best case scenario for an opposition group (or a new majority shareholder) is to elect 2 directors each year

o However, if voting is cumulative, it’s likely that CEO can elect 1 director of each time Potential strategies of attack for the opposition group:

1. Amend certificate of incorporationa. DGCL §242(b)1 says that shareholders vote on amending the charter; however, only the board can

propose amendments to the charter2. Amend by-laws through a shareholder proposal

a. Increase the size of the boardb. Remove one or more directors

o But, default is that only the Board can call a meeting to amend the bylaws, certificate, etc. (so this may have to wait until the annual meeting)

3. Dissolve the company and distribute the assets Why can’t opposition group fire the entire board under DGCL §141(k)?

o Because the board is classified (staggered elections), you can only remove a board member for causeo However, if they can change the bylaws to remove the classification provision, the board is no longer

classified, and the entire Board of Directors can be fired via §141(k) (because under cumulative voting system, either all directors are fired or none)

Default rule in Delaware is that a director can be removed without cause This is modified if there is a classified board (no termination without cause) This is modified if there is cumulative voting (termination of all or none)

Note: Under the old Illinois statute, Kagan couldn’t take over quickly (would need to wait) If the staggered board was in the charter, Kagan couldn’t take over quickly (would need to get the board to

recommend the amendment, which it wouldn’t do if controlled by Revesz)

Rule for dissolution in Delaware is similar to modifying the charter Needs to be approved by the board of directors

Outcome: Effective Staggered Boards (i.e. can’t be dismantled by a bylaw amendment) are very effective in deterring takeovers

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B. Proxy Solicitations

Proxy solicitations are used to allow quorum requirements at annual meeting to be met (it’s impossible to get thousands of dispersed shareholders to show up at a meeting)

The full cost of distributing proxy materials is conditionally reimbursed for insurgents (i.e. they must win in order to later vote to reimburse themselves)

Unconditional reimbursement for management / incumbent directors (as long as the views in the incumbent’s statement are focused on policy rather than persons)

i.e. Board gets reimbursed for ‘vote for us, we have the best knowledge of the business’ i.e. board doesn’t get reimbursed for ‘vote for me because I have a divine right to manage the company’

You can’t have a bylaw mandating reimbursement, because it would remove the board’s ability to fulfill its fiduciary duty to act in the best interests of the corporation. CA Inc v. AFSCME

Board’s costs in sending out a proxy statement are reimbursed. Challenger’s costs are reimbursed only if he wins (because at that point, he can vote to reimburse himself).

Policy Implications

Froessel Rule Decision Tree Analysis

Assumptions:Dissident owns 20% of sharesG = gain to the corporation from the contest50% likelihood of winning if insurgent spends $2M; no chance of winning if insurgent spends less; and corporation will spend $2M opposingOutcome –

If you win the proxy challenge, you get paid 20% of the net effect (net effect = G – 2 million (insurgent costs) – 2 million (director costs)

If you lose the proxy challenge, you lose 20% of the board’s costs and the full amount of the insurgent costs

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Policy Reasons Against the Super Froessel Rule If you reimburse everyone, they aren’t going to put much effort into researching their proposal (and thus more

proposals will lose and cost the company money) If you have this rule, people will propose things that lose money for the corporation but earn them personal benefit

o However, if we have effective rules for preventing majority shareholders from hurting the interests of minority shareholders, this is less of a concern

Policy Reasons For the Froessel Rule Discourages frivolous proposals

Rosenfeld v. Fairchild Engine & Airplane Facts – Classic derivative suit. Brought by attorney who owns 25 shares, attempting to force both sides in proxy

contest to reimburse corporation for their proxy expenses. o Incumbents spent $106K, for which they reimbursed themselves from the corporate treasury, and another

$28K for which they were never able to reimburse themselves.o Insurgents generously reimburse incumbents for the additional $28K. o Insurgents spent $127K, for which they reimbursed themselves after shareholder resolution authorizing

reimbursement. (Shareholders apparently never asked to ratify insurgent generosity to the old board.) Holding

o Illustrates majority rule: o The full cost of distributing proxy materials is conditionally reimbursed for insurgents (i.e. they must win

in order to later vote to reimburse themselves)o Unconditional reimbursement for management / incumbent directors (as long as the views in the

incumbent’s statement are focused on policy rather than persons)i. i.e. Board gets reimbursed for ‘vote for us, we have the best knowledge of the business’

ii. i.e. board doesn’t get reimbursed for ‘vote for me because I have a divine right to manage the company’ Notes - Practical reason underlying reimbursement of the Board is that given the low attendance at annual meetings,

you could never meet the quorum requirements unless the Directors sent out proxy statements.

C. Shareholder Access to Books, Records, and Shareholder List

Delaware approach: (DGCL § 220(c)) for books & records, burden is on shareholder to show proper purpose; for shareholder list, burden is on corporation to show improper purpose.

Specifically enumerated documents (RMBCA): shareholder list, excerpts from board minutes, shareholder meeting minutes, and accounting records if shareholder

shows “proper purpose” (RMBCA § 16.02, § 16.01(e))Hybrid approach (New York):

statutory right to inspect key financial statements, stock list, and shareholder meeting minutes if proper purpose (§ 624(a)-(e)); and

“catch-all” under § 624(f) for books & records

The point of allowing access to books and records is to enable the opposition to find information to support the claim that something needs to change

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D. Circular Voting and Other Schemes to Entrench the Board

DGCL §160(c)The corporation can’t vote any shares

of its own capital stock or of another corporation if a majority of shares entitled to vote in the election of directors of such other corporation is

held, directly or indirectly, by the corporation and neither shall these shares be counted for quorum purposes.

But, nothing in this section shall be construed as limiting the right of any corporation to vote stock, including but not limited to its own stock, held by it in a fiduciary capacity.(not important)

Corporate law isn’t tax law. The Court will read the statute broadly to prohibit a wider range of behavior the basic prohibition in §160 is that shares won’t be allowed to vote if they are held by the corporation itself.

o Convertible stock scheme disallowed. Speiser v. Baker (Del.)

Vote BuyingVote buying is ok where there is no intent to defraud or disenfranchise the other shareholders and the payment is voidable and thus subject to shareholder approval and is subsequently ratified by a fully informed majority of the independent stockholders. Schreiber v. Carney

This is not to say, however, that vote-buying accomplished for some laudable purpose is automatically free from challenge. Because vote-buying is so easily susceptible of abuse it must be viewed as a voidable transaction subject to a

test for intrinsic fairness." Separation of voting rights and economic concerns is problematic because the voting partner doesn’t have any

incentive to benefit the shareholders

Separation of Economic Rights from Voting Rights Perry / Mylan Perry buys 10% of shares, along with put options, and its broker shorts 10% and gets call options

from Perry. Result is that Perry owns the shares but will not share in any gain or loss on the shares. Reason for doing so was that Perry wanted to pressure Mylan to go through with acquisition of a Perry-owned company.

Minority Control Structures Dual-classification system in which one class has more voting rights than the other Pyramiding (Controller owns 50.1% of A, which owns 50.1% of B, which owns 50.1% of C. What is Controller’s

economic stake in C? About 12.5%, but it has control of C (separates control rights from voting rights) Cross ownership (pictured below) Less problematic, because if the directors at A are taking private benefits, this

reduces the benefits going to B, C, D (and the general public) creates a strong interest among leadership at B, C, D to hold A accountable

Pyramiding and cross ownership are not common in the US because of taxation (money gets taxed each time it’s distributed up the pyramid, or each time it goes around the circle)

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Dual Class Voting The old days: NYSE required one-share, one-vote (no dual class structures). Mid 1980s: companies start to demand dual class structures as a takeover defense, and NASDAQ allowed it, so

NYSE forced to allow as well. Late 1980s: SEC becomes alarmed and passes Rule 19c-4, which prohibited dual class recapitalizations but allows

low-vote new issues. 1990: ‘Empire Strikes Back’ – Business Roundtable gets 19c-4 overturned in D.C. Circuit, on grounds that SEC

lacked statutory power. Dual class recaps come back, but no one cared – takeovers were down, and other defensive measures (e.g., poison pill) were just as good.

1995: NYSE, Amex, and NASDAQ adopt a uniform voluntary rule that basically re-adopts 19c-4, prohibiting dual class recaps but allowing low/no-vote new issue (see e.g. NYSE Listed Company Manual §313.00)

o Premise of allowing new issues of low/no-vote stock is that the market will price these shares efficiently incorporating the lack of a vote into the price

Whereas with a recapitalization, the old shareholders may not have a strong voice Why would old shareholders vote for a process that will drive the value of their investment down?

Maybe some have access to the new recap round A rational shareholder knows his share has very little voting value, so he will be willing

to sell his ability to vote for any non-zero price; so, if management offers a small premium (like a dividend), the old shareholders will sell off their ability to vote.

Cases and Examples

If a corporation owns its own stock, management could be permanently entrenched. So, we need to prohibit the corporation from voting on stock it holds directly or indirectly Some countries used to say (UK) that when a company purchased its own stock, this ‘retired’ the shares. Today,

most countries (US and UK included) allow the company to hold its own shares in the company Treasury

If the corporation owns a subsidiary, which owns stock in the parent company, 160(c) catches this because the subsidiary is majority-controlled, so it can’t vote the shares

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DGCL §160(c) doesn’t come into play, because ExploitCorp “only” owns 30% of Follow, and Follow only owns 45% of ExploitCorp

Despite the fact that MBP is a director at Follow, Inc, if Follow shareholders don’t like the way MBP is managing ExploitCorp, the 70% of shareholders could kick him out of his position at Follow.

Speiser v. Baker (Del. Ch. 1987)

Facts – o Speiser seeks to compel ASM of Health Med under DGCL § 211(c) (because Baker has frustrated quorum

requirements by not attending)o Baker states that at the ASM Speiser will remove Baker as a director of Health Med by voting the shares of

Medallion (that Speiser controls), in violation of Speiser’s fiduciary duty to Health Med’s shareholders. o Baker counterclaims that Chem’s shares held by Health Med should not be votable under § 160(c).

Reasoningo If Medallion doesn’t convert the stock in Health Med, it can’t appoint directors, but if they do convert, they

can appoint the whole board. o The convertible stock scheme was deliberately set up to avoid 160(c)o Corporate law isn’t tax law. The Court will read the statute broadly to prohibit a wider range of

behavior the basic prohibition in 160 is that shares won’t be allowed to vote if they are held by the corporation itself.

i. If Health Med were to liquidate, 95% of the money would go to Medallion (because it’s a preferred shareholder) so even though Speiser and Baker nominally ‘control’ Health Med, they used the capital from Health Chem to set it up.

Holding – Chancellor Allen grants Speiser’s § 211(c) claim requiring Health Med to holds its ASM, but treats Baker’s § 160(c) counterclaim as a separate issue

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Schreiber v. Carney (Del. Ch. 1982)

Factso Jet Capital Corporation owned 35% of Texas International Airlines, Inc. and had veto power over a

proposed merger between Texas International and another company. o Jet claimed that it would veto the proposed merger unless it could exercise warrants it held in Texas

International. i. However, Jet need cash to finance the exercising of the warrants and suggested that Texas

International provide the necessary funds. o Texas International and Jet proposed the financing and the board approved. o As a condition to the approval and based on an awareness of impropriety, the company's required a

majority of shares voted by stockholders other than Jet and Texas International. o Special TI committee of three independent directors hires independent counsel and bankers and concludes

that the loan makes sense.o TI board and independent shareholders approve the deal.o The plaintiff brought suit alleging that Texas International's loan constituted vote buying, as Texas

International's loan removed Jet's opposition to the proposed merger. Reasoning

o (1) the intent was not to defraud or disenfranchise the other shareholders and (2) that the the loan agreement was voidable and thus subject to shareholder approval and was subsequently ratified by a fully informed majority of the independent stockholders,

Holdingo [A]n agreement relating to voting must be considered and voting agreements in whatever form, therefore,

should not be considered to be illegal per se unless the object or purpose is to defraud or in some way disenfranchise the other stockholders.

i. This is not to say, however, that vote-buying accomplished for some laudible purpose is automatically free from challenge.

o Because vote-buying is so easily susceptible of abuse it must be viewed as a voidable transaction subject to a test for intrinsic fairness."

o Because there was no intent to defraud or disenfranchise the other shareholders and that the loan agreement was voidable and thus subject to shareholder approval and was subsequently ratified by a fully informed majority of the independent stockholders, the transaction was valid

Commentso Critical points are the full disclosure, approval of disinterested shareholders, the independent study, the

lending agreement was fair.o Separation of voting rights and economic concerns is problematic because the voting partner doesn’t have

any incentive to benefit the shareholders

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E. Collective Action Problem

b = benefit from decisionα = proportion of shares held by investor (0% < α < 100%)c = cost of becoming informed and voting

It’s only rational to become informed if: c < αb

Small average α => free riders, rational apathyLarger average α => more informed, activist shrs

Objective of SEC proxy disclosure regulations is to lower c, so small retail shareholders may become informed Interestingly, the nature of share ownership has changed the retail investor is much less prevalent

o the outcome is that we have more institutional owners with large αi. However, most of these institutions get paid based on a % of assets under management (for mutual

funds, if they underperform their peers, they will lose AUM, so they aren’t looking to maximize gain, just outperform others)

ii. hedge funds get paid based on AUM, plus some % of gainsiii. For most funds, the assets-under management fee is the bigger source of income

o Perversely, these rules actually get in the way of these large investors’ communications with each other

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F. Proxy Rules

Set by federal government rather than states, so compliance is reviewed by federal courts

Securities Act of 1933 (“33 Act”): deals with disclosure procedures that companies must follow when selling securities on the public markets.

Securities Exchange Act of 1934 (“34 Act”): establishes (among other things) disclosure requirements for corporations after they have gone public. All public companies are subject to proxy regulation under § 14(a) of the Act.

Regulation 14A (Rules 14a-1 through 14a-12): substantive regulation of the process of soliciting proxies and communication among shareholders.

Deals with regulating solicitation of proxies and communications between shareholdersSchedule 14A: what you need to disclose in a “full dress” registration statement: name of SH, name of proxy solicitor,

Prohibition on solicitations unless either a proxy statement is filed or the solicitation is exemptRule 14a-3(a): one may not solicit a proxy unless you provide a proxy statement “containing the information provided in Schedule 14A,” unless the communication is exempt:

What is a solicitationAny communication to security holders … reasonably calculated to result in [a decision regarding a proxy]. Rule 14a-1(L)(1)(iii))

What is a “Proxy” Rule 14a-1(f)- “Every proxy, consent, or authorization … [including] failure to object or dissent”- ‘Withholding consent’ or ‘not doing anything’ is a proxy

Exemptions from proxy statement requirements:Rule 14a-2(b)(1): a solicitation that “does not . . . seek directly or indirectly . . . the power to act as proxy” Rule 14a-2(b)(2): solicitation to ten or fewer other shareholders

But, if soliciting shareholder owns more than $5 million worth of stock, it must still file the communication itself and a “Notice of Exempt Solicitation” after sending it out. Rule 14a-6(g)

o This is much easier than filing the full proxy statement, but still some work

Possibility for proxy-solicitor to delay submission of proxy statement for non-exempt solicitationsRule 14a-12. A solicitation may be made before furnishing security holders with a full proxy statement provided that any written communication:

gives details of the identity and interests of the participants in the solicitation; tells security holders to read the proxy statement when it is available…; Is filed with the SEC no later than the day it is sent to security holders, AND

A full proxy statement … is sent to security holders … no later than forms of proxy, consent or authorization are furnished to or requested from them.

Essentially, you don’t have to file a full proxy statement until you actually provide forms for the proxy/ consent/ authorization as long as you included the above requirements on the initial memo / attachment

Note: If you fall within the 14a-2(b)1 exception, you have 3 days to file the memo and notice of exemption with the SEC, while if the solicitation does seek a proxy and is relying on 14a-12, it must file the solicitation with the SEC on the same day

Short Slate ProblemNew Rule 14a-4(d)(4): permits challenges to solicit proxies for its own nominees plus the six management nominees that it believes to be the most qualifiedPre-1992 Rule 14a-4(d) (“bona fide nominee rule”): prevents challengers from listing management nominees on its slate.

The old problem: Assume 10 shares, 9 seats on the board, and straight (non-cumulative) voting. Management holds 4 shares; Challenger supporters hold 6 shares. Challenger proposes a short slate of 3 directors; management nominates a full slate. If challenger supporters vote for the short slate plus six management nominees at random, management’s nominees will each receive 8 votes, while the 3 challenger directors will receive 6 votes each.

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Shareholder wants to make a communication Is it a solicitation? Is it exempt? Does proxy statement meet requirements? Can the proxy statement be delayed? Can it be placed on the board proxy? Is it excludable by board?

o If excluded, board should seek an SEC no action letter

Placing a Proxy on the Corporate FormRule 14a-8 . Must hold $2,000 or 1% of the corporation’s stock for a year ((b)(1)); must file with management 120 days before management plans to release its proxy statement ((e)(2)); proposal may not exceed 500 words (d); and proposal must not run afoul of subject matter restrictions . . .

If the shareholder proposal wins, the person proposing it doesn’t have to solicit voters’ proxies for himself the corporation’s proxy will have to act to fulfill the proposal thus, the person making the proposition would not have to make the disclosures required of people who directly or indirectly solicit proxies (the corporation would)

Board can possibly exclude 14a-8 shareholder proposals. P. 441 in supplementThirteen grounds for excluding proposals from the company’s solicitation materials (14a-8(i)): including

(1) improper under state law (2) violation of state law or (3) proxy rules (4) personal grievance (7) relates to a matter of ordinary business ((i)(7)), (5) relates to a matter < 5% of business ((i)(5)), (8) relates to an election of directors or a procedure for such election ((i)(8)), (9) conflicts with company’s proposal ((i)(9).

Burden is on the company to demonstrate grounds for exclusion 14a-8(g).

Company has to file its reasons with SEC under Rule 14a-8(j) and seek SEC approval for the exclusion (no action letter)

Ordinary Business Exclusion Requires case by case analysis. Certain tasks (mgmt of workforce, hiring/firing/promotion, decisions on production

quality and quantity, supplier selection) are so fundamental to management’s ability to run a company that they cannot be subject to shareholder oversight, while others (proposals related to those things but focused on social policy) are not excludable. Micromanagement (intricate detail, imposition of specific time-frames/ methods for implementing complex policy) is also excludable.

Proposals on procedure are not ‘matters of ordinary business’ so they may be considered (Requiring expenditure of corporate funds does not automatically deprive a proposal of its procedural character)

However, if the proposed bylaw contains no language or provision that would reserve to the Board its full power to exercise its fiduciary duty to decide whether or not it would be appropriate in a specific case to award reimbursement at all, it would violate Delaware law if enacted, and is thus excludable. CA v. AFSCME

Shareholder Remedy for False or Misleading Proxy Materials Rule 14a-9 prohibits false or misleading proxy solicitations. Key elements roughly follow pattern of common law

fraud—materiality, culpability, and causation and review.o If Board proxy includes statements of reasons, opinions, or beliefs that were made with full knowledge that

Board members did not hold these opinions/ beliefs, it could be actionable…However, proof of mere disbelief or belief undisclosed is not sufficient for liability under §14(a). Virginia Bankshares

o If minority votes are necessary to authorize a transaction, then a misleading proxy can satisfy causation (Mills v. Electric Auto-Lite Co),

I.E. if a false/ misleading proxy preserves a state claim that would make the proposed action void (such as if it required minority approval and the false statement voided minority approval) then there is no valid action by the corporation and thus no harm (and no federal remedy) Virginia Bankshares

Policy Implications

Why do we need these rules Agency problems (if left to their own devices, managers would under report bad information) Competitive externalities (companies wouldn’t want to disclose information that might help their competitors)

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Common framework for understanding the disclosures (if the information from all companies is the same/ very similar, it’s easier to build up expertise in interpreting the data)

Proposed Proxy Access Rule 14a-11Would require companies to allow access to their proxy statement (at their own cost) to allow certain shareholders to place nominees for directors on it.

The reason that shareholders can’t achieve this result already through a shareholder proposal is that 14a-8(i) allows corporations to exclude proposals that relate to the selection of directors or the process by which directors are elected.

Directors should be more accountable because the financial crisis tells us that directors were not accountable to shareholders

o But, that’s wrong because UK had same crisis and had much stronger shareholder rights laws.

CA vs. AFSCME Facts

o AFSCME (pension fund) submits a 14a-8 proposal to CA (formerly Computer Associates) to amend the bylaws so that the board must reimburse a shareholder for “reasonable expenses” incurred in the successful election of its candidates to less than 50% to the board.

o CA seeks a no-action letter from the SEC to exclude the proposal, and the SEC certifies two questions to the Delaware Supreme Court:

Issueso Is the AFSCME Proposal a proper subject for action by shareholders as a matter of Delaware law?o Would the AFSCME Proposal, if adopted, cause CA to violate any Delaware law to which it is subject?

(i.e. by directing CA to reimburse the nominating stockholder, does this violate DGCL 141(a) reservation of business decisions to the board)

Ruleso §109(a) vests in shareholders a power to adopt, amend, or repeal bylaws that is sacrosanct, o §109(b): “The bylaws may contain any provision, not inconsistent with law or with the certificate of

incorporation, relating to the business of the corporation, the conduct of its affairs, and its right or powers of its stockholders, directors, officers, or employees.”

o DGCL §141(a) ‘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 in its certificate of incorporation

o DGCL §102(b)1 requires any provision that limits the board statutory power of the directors must be contained in the certificate of incorporation.

Reasoningo The proposal would prevent directors from exercising their full managerial power in circumstances where

their fiduciary duties would otherwise require them to deny reimbursement to a dissident slate.i. i.e. it would require reimbursement even when the proxy contest is “motivated by personal or

petty concerns, or to promote interests that do not further, or are adverse to, those of the corporation” which would normally compel denial of reimbursement due to the fiduciary duty

Holdingo The AFSCME proposal is a proper subject for action by shareholders because it is procedural (the fact that

it requires expenditures of corporate funds does not automatically deprive it of its procedural character)o Because the proposed bylaw contains no language or provision that would reserve to CA’s directors their

full power to exercise their fiduciary duty to decide whether or not it would be appropriate, in a specific case to award reimbursement at all, it would violate Delaware law if enacted, and is thus excludable.

Commento This proposal would have been ok if it had provided a fiduciary out – i.e. the Board must reimburse unless

doing so would violate their fiduciary duty.

Virginia Bankshares Inc v. Sandberg (1990)

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FABI begins a freeze-out in which FABI would merge into Virginia Bankshares (VBI), a wholly owned subsidiary of FABI. VBI owns 85% of FABI, remaining 15% is in hands of 2000 minority shareholders. Corporation sends out a proxy saying that the $42 bid is a “high” and “fair” price.

Issue 1o Whether statements of reasons, opinions, or belief are actionable per se

Reasoningo If I make a statement about my belief, it can be factual in 2 senses whether I actually hold that belief,

and whether that belief is true.i. Because the directors’ belief that something is true is material in that it would affect a

shareholder’s decision on how to vote, it can be material Holding

o Because the directors statements of reasons, opinions, or beliefs were made with full knowledge that they did not hold these opinions/ beliefs, it could be actionable.

i. However, Proof of mere disbelief or belief undisclosed is not sufficient for liability under §14(a) Issue 2

o Whether causation of damages can be demonstrated by a member of a class of minority shareholders whose votes are not required by law or corporate bylaw to authorize the transaction giving rise to the claim

i. Claim 1 by P – yes, because company wouldn’t have gone ahead with the merger without securing the minority votes

ii. Claim 2 by P – yes because the merger would foreclose state action by the shareholders Rule

o Causation of damages by a material proxy misstatement could be established by showing the minority proxies are necessary and sufficient to authorize the corporate acts had been given in accordance with the tenor of the solicitation, and the Court described such a causal relationship by calling the proxy solicitation an ‘essential link in the accomplishment of the transaction’

o Under VA law, the statute bars a shareholder from seeking to avoid a transaction tainted by a director’s conflict if the minority shareholders ratified the transaction following disclosure of the material facts of the transaction and the conflict.

Reasoningo Reasoning that the company needed the minority votes to avoid bad press is too speculative (no one can

prove that bad PR would occur, nor what the company would have done in its face)o There is no loss of remedy under state law here

Holdingo Causation of damages can be demonstrated by a member of a minority shareholder group whose votes

weren’t necessary to authorize the transaction

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V. DIRECTOR DUTIES

A. Overview

Duty of obedience - A fiduciary must act consistently with the legal document that creates his authority. A director CANNOT violate the corporate charter and MUST perform obligations imposed upon him by the charter (e.g., annual meeting requirements). Whether or not the violation is in good faith is irrelevant for these purposes – this duty is quite clear and there is little legal dispute over it.

Duty of loyalty – Agent must exercise power he believes in good faith to best advance the interest or purposes of the P, and must refrain from exercising power for a personal benefit (unless you get a waiver from the P)

Duty of Care – Duty to act in good faith, as one believes a reasonable person would act in becoming informed and exercising any agency or fiduciary power

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B. Duty of Care

1. General

ALI Principles of Corporate Governance §4.01(a) A director or officer has a duty to the corporation to perform the director’s or officer’s functions:

(1) in good faith, (bad faith = violation of duty of care and duty of loyalty) (2) in a manner that he or she reasonably believes to be in the best interests of the corporation, and (3) with the care that an ordinarily prudent person would reasonably be expected to exercise in a like position

and under similar circumstances. This is subject to the provisions of the business judgment rule 4.01(c) where applicable Includes obligation to make, or cause to be made, an inquiry when circumstances would alert a reasonable director

or officer to the need for one. Extent of inquiry is such as the director or officer reasonably believes to be necessary.

DGCL §102(b)7 Waiver of Liability. Allows for provision in corporate charter waiving the D/O duty of care (not loyalty) Consequently, shareholders cannot bring direct or derivative suits alleging violations of the duty of care Duty of care claims should be dismissed at the pleading state if there is a §102(b)7 waiver. Malpiede v. Townson.

(complaint must allege a breach of duty of loyalty to survive a motion to dismiss).o Alleging that an officer agreed to the transaction so he could keep his job after a merger is not a sufficient

claim for breach of loyalty such generic allegations are too easy to make. Unless the particularized facts supporting duty of loyalty claims are alleged, the claim can’t go to trial. Malpiede v. Townson

However, suits seeking to enjoin the challenged action may proceed regardless of the waiver.

Proving breach of duty of care Plaintiff bears the burden of proving that BSJR and presumptive ability to rely on committees, officers, and

employees are inapplicable. Business Judgment Rule. Directors/ officers are required to

o Be informed with respect to the subject of the business judgment to the extent that the director/ officer reasonably believes is appropriate under the circumstances;

o Rationally believe that the business judgment is in the best interests of the corporation Directors are entitled to exercise their honest BSJ on the information before them, and to act within their corporate

powers. As long as it appears that the directors have been acting in good faith to advance the corporation’s interest, there is no violation of the duty of care. There is a presumption that this is the case. Kamin v. American Express

o In Delaware, there is no need to show injury to show a violation of the duty of care. Cede v. Technicolor II. It becomes relevant after the ‘entire fairness’ inquiry is resolved. See Emerald Partners.

o But, for damage actions outside of Delaware (not those seeking injunctions), plaintiffs need to prove that the breach was the legal cause of damage suffered by the corporation before the burden shifts ALI §4.01(d)

Gross negligence is sufficient to rebut the presumption of the BSJR. Van Gorkum

Entire FairnessIf the plaintiff rebuts the presumption of the BSJR (by showing either a breach of the duty of care or the duty of loyalty), the directors may defend their action by proving that the transaction was entirely fair. Cede v. Technicolor II

Entire fairness is a combination of ‘fairness of process’ and ‘fairness of price’ Ch. Allen pushes emphasis toward price If breach of entire fairness is due only to breach of DoC, and there’s a 102(b)7 waiver, then it’s dismissed. If the action is not ‘entirely fair’, then the case must go to trial unless the only reason for lack of fairness is shown to

be breach of duty of care. If there’s any doubt as to whether there is a DoL breach, then it must go to trial.

Liability Shields Business Judgment Rule (shields directors from liability when neither loyalty nor care were violated) doesn’t

bar suits in equity seeking to enjoin poor business decisions. Indemnification: corporation may indemnify against 3 rd parties for D&O actions in good faith (DGCL §145(a));

bylaws may provide for mandatory indemnification provided action was taken in good faith. §145(f). o Corporation must indemnify when the D/O is sued but “succeeds” regardless of what the suit alleged

(unless corp. can prove that bad faith actually did occur). §145(c)

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Is there a 102(b)7 waiver? If no,Can P prove breach of DoC? If yes,Can directors prove entire fairness? If no,What are the damages?Is indemnification possible/ required? If no,Is there D&O insurance?

If there’s no breach of DoC, act is subject to BSJRIf no BSJ is made, see ‘inaction’ section

D&O Insurance: corporation may buy D&O insurance “whether or not the corporation would have the power to indemnify such person against such liability.” (DGCL §145(g)).

o Alternative to waiver and indemnification. Won’t cover violation of duty of loyalty for market reasons.

Indemnification -Possible for breaches of the duty of care, but not loyalty or where director is liable to the corporation itself. DGCL §145(a) – Corporation can indemnify its directors and agents if they ‘acted in good faith and in a manner

reasonably believed to be in or not opposed to the best interest of the corporation’o Judgment, settlement, conviction, plea of nolo contendre does not create any presumption that the D/O did

not act in good faith and in accordance with the BSJR. DGCL §145(b) – corporation cannot indemnify D/O where he has been found liable to the corporation itself, unless

the Court determines that he is fairly entitled to indemnification of some expenses notwithstanding his liability DGCL §145(c) requires corporations to indemnify officers/ directors for the ‘successful’ defense of certain claims

o (successful = either win on the merits or settlement without director paying damages) (where D settles for $0 in civil damages and no criminal liability due to corporation’s separate settlement that pays P money, D is still “successful” so he must be indemnified for his legal expenses. Waltuch v. Conticommodity

o Covers cases in which director/ officer is sued for his actions taken as a D/O provided the person acted in good faith, fulfilled BSJR, and had no reason to believe the conduct was unlawful if corp. can show that bad faith did occur, a carefully worded settlement will not save him

“A breach of the duty of care, without any requirement of proof of injury, is sufficient to rebut the business judgment rule … A breach of either the duty of loyalty of the duty of care rebuts the presumption that the directors have acted in the best interests of the shareholders, and requires the directors to prove that the transaction was entirely fair. Cede.v. Technicolor II

Gross negligence is a violation of the duty of care that is not protected by the BSJR. Van Gorkum. Gross negligence with respect to process is sufficient to put burden on directors to show entire fairness (Cede II). BUT: gross negligence doesn’t necessarily mean that the substance was unfair – you can have gross negligence and

still the transaction can be entirely fair (Cede III).

Technicolor Outcome1. Duty of care does not require P to show injury (Cede II).2. Gross negligence with respect to process is sufficient to put burden on directors to show entire fairness (Cede II). BUT: gross negligence doesn’t necessarily mean that the substance was unfair – you can have gross negligence and

still the transaction can be entirely fair (Cede III).

Policy Implications

The point of the BSJR is to allow directors to take risks. Without the BSJR, directors would choose blue project.Risk taking by directors is good, because diversification is best undertaken at the investor level.

According to Chancellor Allen, the duty of care serves to give directors some guidance on what to do, without compromising their ability to take risks basically, it encourages them to ‘do the right thing’ but excuses them from liability in most cases (except when it’s taken in bad faith)

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Corp. can’t indemnify against derivative suits or loyalty claims, unless director succeeds (in which case indemnification is mandatory.

Case Summaries

Waltuch v. Conticommodity Services (2d Circuit 1996) - indemnification Facts –

o Waltuch is Vice President and Chief Metals Trader for Conticommodity Services (“Conti”).o When silver prices crash, he becomes the target of lawsuits by angry silver speculators and an enforcement

proceeding brought by the Commodity Futures Trading Commission (CFTC), for fraud and market manipulation.

o In the private actions, Conti settles for >$35 million; Waltuch is dismissed with no settlement contribution, but incurs $1.2 million in unreimbursed legal fees.

o In the CFTC action, Waltuch agrees to a penalty that includes a $100,000 fine and a six-month ban on buying or selling futures contracts from any exchange floor, and spends another $1 million in unreimbursed legal fees.

o Corporate indemnification clause says: corporation shall indemnify and hold harmless … against expenses actually and necessarily incurred by him in connection with the defense of any action… in which he is made a party, by reason of his serving in or having held such position, except in relation to matters as which he shall be adjudged in such action to be liable for negligence or misconduct in the performance of duty.

History - Waltuch brings suits against Conti for indemnification of his $2.2 million, under charter and under §145 (c) Rules

o DGCL §145(a) – expressly grants a corporation the power to indemnify its directors and agents if they ‘acted in good faith and in a manner reasonably believed to be in or not opposed to the best interest of the corporation’

i. Judgment, settlement, conviction, plea of nolo contendre does not create any presumption that the D/O did not act in good faith and in accordance with the BSJR.

o DGCL §145(c) requires corporations to indemnify officers and directors for the ‘successful’ defense of certain claims

i. (successful = either win on the merits or settlement)ii. Covers cases in which director/ officer is sued for his actions taken as a D/O provided the person

acted in good faith, fulfilled BSJR, and had no reason to believe the conduct was unlawful Reasoning

o Although §145(f) permits the corporation to grant other rights, this merely acknowledges that one seeking indemnification may be entitled to other rights it does not talk about additional corporate powers, so it can’t be read to free a corporation from the ‘good faith’ requirement of 145(a)

o §145(g) gives corporations the power to purchase insurance against any liability for its directors, agents incurred by them in such capacity whether or not the corporation would have the power to indemnify him against such liability under this section i.e. corporation can buy insurance against non-indemnifiable actions (which implies there is such a thing) means 145(f) can’t be read to expand indemnification to cover everything upholds requirement for good faith

o Once Waltuch settled the claims against him in the civil suit for $0 in damages, he obtained ‘success on the merits or otherwise’

o Once Waltuch settled the criminal case without being convicted, he obtained success ‘on the merits or otherwise’ Holding - Waltuch is entitled to indemnification under §145(c) for his expenses pertaining to private lawsuits Comments

o This rule (indemnification for any result other than conviction/ personal loss in civil suit) creates incentives for directors/ officers to settle the suit, and to try to ensure that any payments to the plaintiff come from the corporation rather than through personal accounts

o Also places importance on trying to keep a judgment of ‘bad faith’ out of the settlementi. For directors/ officers, lack of ‘bad faith’ means their costs must be reimbursed by the corporation

ii. For plaintiff, lack of bad faith increases the likelihood of collecting, because the corporation has deeper pockets

o §145(g) has no restrictions against buying insurance to protect against ‘bad faith’ actions by officers/ directors However, it’s not in the interest of insurance companies to insure against bad faith acts, because there is

such a large moral hazard (no one wants to insure you against you acting criminally, in bad faith, etc)

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Even if settlement occurs that obligates the corporation to indemnify the D/O, an insurance company can still argue that bad faith existed that would preclude payment under an insurance policy

Kamin v. American Express Co. (NJ 1976) – dividend distribution is protected by BSJR Facts –

o In 1972 Amex acquired 2.0 million shares of DLJ common stock for $29.9 million; by 1976 the stake was worth approximately $4.0 million.

o Amex declares a special dividend to all shareholders distributing the DLJ shares in kind.o Two shareholders file suit to enjoin the distribution, or for monetary damages, claiming waste of corporate

assets because Amex could sell the DLJ shares and use the capital loss to offset capital gains, which allegedly would have resulted in a net tax savings of $8 million.

o Defendant directors claim that this possibility was considered but rejected due to negative impact on accounting profits; move for summary judgment (i.e. if they recognized the loss, net profits would have been reduced, which would negatively affect the stock price)

Ruleso Mere errors of judgment are not sufficient as grounds for equity interference, for the powers of those

entrusted with corporate management are largely discretionary Holding

o The question of whether a dividend is to be declared or a distribution of some kind should be made is exclusively a matter of business judgment for the Board of Directors

o More than mere imprudence must be showno The only things not covered by business judgment rule are fraud or breach of duty of loyalty

i. The hint of self-interest alleged simply by officers’ membership in the Executive Compensation Plan (through which compensation would rise due to misstated earnings) is not sufficient to support an inference of self-dealing

o The directors are entitled to exercise their honest business judgment on the information before them, and to act within their corporate powers. That they may be mistaken, that other courses of action might have differing consequences, or that their action might benefit some shareholders more than others presents no basis for the super-imposition of judicial judgment, so long as it appears that the directors have been acting in good faith.

Commentso Seems strange, because the Board is throwing away $8 million (and Board clearly has a motive to protect

short term share prices compensation)o If you make a distribution, it comes out of the surplus (from the balance sheet) at the original purchase

price of $29.9 million, but it doesn’t affect the income statementi. If they had sold the stocks, the loss of ~$26 million would have to come out of earnings.

o Under Efficient Capital Markets theory, the choice of what to do shouldn’t make a difference (because investors would see through the accounting scheme)

1. Investors would have forecast that the firm would have taken the loss to benefit from the $8 million in tax savings if the firm doesn’t, stock price should drop

ii. However, ECM isn’t accurate because:1. Investors have bounded rationality2. Investors use heuristic shortcuts like P/E ratios, hitting/ missing earnings targets

o Kamin’s argument relies on the ECM being true; AEX says ECM doesn’t work all the time. This judgment is protected by the business judgment rule.

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Smith v. Van Gorkom (1985) – gross negligence violates duty of care Facts –

o Trans Union Corp. is a publicly held company with unused NOL’s (net operating losses) and a CEO (Jerome Van Gorkom) looking to retire. Stock is selling for $35 per share.

o Acting mainly on his own, Van Gorkom arranges a sale to Jay Pritzker’s company for $55 per share cash.o Van Gorkom calls a special meeting of the board but does not give them an agenda beforehand; board

approves the merger, and deal protection features, after two hour meeting. History

o Trans Union shareholder sues, claiming breach of the duty of care. No allegation of conflict of interest, but claim that the board did not act in an informed manner in agreeing to the deal.

o Chancery Court approves the transaction, finding that board approval fell within protection of the BJR. Holding - Delaware Supreme Court reverses, 3-2, finding that the directors had been “grossly negligent.”

o On remand, Chancery Court determines that the FMV of the shares exceeded $55 per share. The case is settled for $23.5 million ($1.87 per share)

i. The Trans Union D&O policy covers the first $10 million, and the remaining $13.5 million is covered by the Pritzker family (apparently motivated by the sentiment that Van Gorkum and the board had done nothing wrong)

Commentso Because the board did not take the reasonable steps to become informed that a reasonable person would

take, it was grossly negligent. encourages directors to take more outside adviceo Results of this case:

i. Rise in D&O insurance premiaii. Passage of DGCL 102(b)7, which says that corporations can adopt a provision in its charter

exculpating directors from liability provided they act in good faith1. i.e. charter can say “a corporate director has no liability for losses caused by transactions

in which the director had no conflicting financial interest or otherwise was alleged to violate a duty of loyalty”

iii. Note: even with 102(b)7, a shareholder can still seek injunctive relief if there is a procedural violation of the duty of good faith. (the directors just aren’t going to be held personally liable)

Cede v. Technicolor – duty of care doesn’t require proof of damage, and shifts burden to D to prove entire fairness Facts

o Technicolor CEO Kamerman negotiates with takeover artist Perelman to sell Technicolor to Perelman for $23 per share, representing a 100% premium over pre-bid share price.

o Disinterested board is rather casual (similar to Van Gorkom) in approving the transaction: it gets no credible valuation, company is not “shopped” to other potential buyers, etc.

o In appraisal proceeding, Chancellor Allen finds that the value of the Technicolor stock at the date of the merger was $21.60 per share.

o Dissenting shareholders nevertheless bring suit against the Technicolor directors claiming breach of DOC History –

o Chancery Court notes possible lapses of care, but holds that P failed to prove any injury because they had received full value for their stock.

o Delaware SC reverses: “breach of the duty of care, without any requirement of proof of injury, is sufficient to rebut the business judgment rule … A breach of either the duty of loyalty of the duty of care rebuts the presumption that the directors have acted in the best interests of the shareholders, and requires the directors to prove that the transaction was entirely fair.

Holdingo On remand, Chancery Court finds that Technicolor had carried the burden of showing “entire fairness” to

the plaintiffs, and Del. SC affirms. Comments

o Entire fairness is a combination of ‘fairness of process’ and ‘fairness of price’ Chancellor Allen pushes emphasis toward price

o Results in a complicated interplay between §102(b)7, which seeks to insulate directors from liability, and the Technicolor line of cases, which has the effect of increasing director liability exposure.

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o The way to remedy Van Gorkum with this is that the Court in Van Gorkum there found that directors were grossly negligent because there was such bad process, so they remanded it to assess damages

Malpiede v. Townson. Basically, a complaint must allege a breach of the duty of loyalty in order to survive a motion to dismiss when the

company has a §102(b)7 provision in its charter. Alleging that an officer agreed to the transaction so he could keep his job after a merger is not sufficient such

generic allegations are too easy to make. Unless the particularized facts supporting duty of loyalty claims are alleged, the claim can’t go to trial.

Emerald Partners v. Berlin (Del 2001) Facts - Craig Hall is Chairman, CEO, and 52% owner of May’s common stock. Hall proposes a “roll-up”

transaction in which May would acquire thirteen corporations controlled by Hall.o Transaction is negotiated and approved by May’s independent directors. Emerald Partners, a minority

shareholder in May, brings suit alleging that the transactions were unfair to May.o Hall declares bankruptcy and is out of the picture;

History – Chancery Court dismisses the complaint against the remaining directors without conducting an “entire fairness” analysis because all that is left are duty of care claims, which May had waived under §102(b)(7).

Holdingo Supreme Court reverses: “[W]hen entire fairness is the applicable standard of judicial review, . . . injury or

damages becomes a proper focus only after a transaction is determined not to be entirely fair [citing Cede II]. . . . §102(b)(7) only becomes a proper focus of judicial scrutiny after the directors’ potential personal liability for the payment of monetary damages has been established.”

o “director defendants can avoid personal liability for paying monetary damages only if they have established that their failure to withstand an entire fairness analysis is exclusively attributable to a violation of the duty of care”

Commentso Where there’s a mixed allegation of duty of loyalty and duty of care, the Court wants to send the duty of

loyalty to trial, so as not to undermine the Bus Judgment rule

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2. Breach of Duty of Care Due to Inaction

Positive Duties to Act Duty of care imposes continuing obligation to keep informed of the financial status of the company and to

monitor company affairs (attend board meetings regularly, maintain/ gain knowledge necessary to do job, and inform other directors about finances - Francis). ALSO, she’s not entitled to BSJR b/c she didn’t make a BSJ

o Generally, boards of public companies have a particular obligation to monitor their firm’s financial performance, the integrity of its financial reporting, its compliance with the law, its management compensation, and its succession planning

G ood faith REQUIRES that reasonable control systems be put in place to ensure compliance with law, EVEN where the board has no prior reason to suspect that wrongdoing is occurring. (See CAREMARK)

o This duty is founded on the requirement to act in good faith, so it is part of both the duty of care and the duty of loyalty. Its position inside the duty of loyalty means it is not waivable.

If a director is aware of a material misstatement in a security filing, he must resign and inform the SEC to avoid personal liability.

Upon discovery of an illegal course of action, a director has a duty to object and, if the corporation does not correct the conduct, to resign… Francis v. United Jersey Bank

o Because any director who is present at a board meeting is presumed to concur in corporate action taken at the meeting unless his dissent is entered in the minutes or filed promptly after adjournment. Francis v. United Jersey Bank, and a director who votes for or concurs in certain actions may be “liable to the corporation for the benefit of its creditors or shareholders to the extent of any injuries suffered by such persons as a result of any such action. Francis

SOX §§ 302: requires CEO & CFO signature on financial documents SOX §404: Requires annual reports to SEC to include evaluation of firm’s internal controls.

Relying on Officers, Employees, etc DGCL §141(e). A director or member of any committee designated by the board is entitled to rely in good faith

upon the records of the corporation and upon [info provided by/ statements of]:o officers, employees, committees of the board, oro any other person on matters reasonably believed to be within such other person's professional or expert

competence and who has been selected with reasonable care by or on behalf of the corporation Stone v. Ritter (Del. 2006). Absent any red flags, in order for directors to be held liable for lack of oversight of

officers and employees there must be a finding that directors either:o “utterly failed to implement any reporting or information system or controls,” (citing Caremark) or o having implemented such system or controls, “consciously failed to monitor or oversee its operations thus

disabling themselves from being informed of risks or problems requiring their attention.” Basically, in order to hold directors liable for failing to monitor, there must be a showing of bad faith . This is shown where there is no monitoring system or where directors consciously failed to monitor/ act on that system.

Reports on deteriorating markets aren’t red flags for business risk. In Re: Citigroup Shareholder Derivative Lit.(2009)

Caremark ClaimsWhere a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating activities within the corporation, … only a sustained or systematic failure of the board to exercise oversight… will establish the lack of good faith that is a necessary condition to liability. Caremark

Basically says that a monitoring system will shield directors from DoC liability for inaction caused by ignorance By rooting the liability in good faith, Caremark requires P to prove that failure to establish a monitoring system was

the causation for damage

Liability for inaction that is a knowing violations of the law. Where the director has taken an action (or inaction – here failing to collect fees from that is in violation of a criminal statute, the director will lose the benefit of the BSJR, EVEN IF he was pursuing the best interests of the corporation. (See MILLER v. AT&T)

No defense for lack of knowledge needed to exercise care. If one ‘feels he has not had sufficient business experience to qualify him to perform the duties of a director, he should either acquire the knowledge by inquiry, or refuse to act. Francis v.

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United Jersey Bank (where cursory reading of financial statements would reveal corporate pillage by officers, directors have a positive obligation to protest and resign if defect is not corrected)

Policy Implications

Criminal Fine Enforcement Act of 1984 & Criminal Fines Improvement Act of 1987: introduced very high potential fines for corporate defendants.

U.S. Sentencing Guidelines for Organizations (last revised Nov. 2004): An effective compliance and ethics program (ECEP) can provide the basis for a downward adjustment in the punishment for corporate wrong-doing (although recent U.S. Supreme Court decisions make the Guidelines advisory rather than mandatory).

Basically, if a firm has a monitoring system and an employee gets caught breaking the law, the sanction on the corporation is adjusted downward.

o This is supposed to offset the increased likelihood of enforcement that is caused by having an internal monitoring system and thus creates an incentive for firms to have these programs

What is the content of the obligation to act in good faith? Does it vary by the director’s expertise?

o Directors with special expertise are not held to a higher standard of care in the oversight context simply because of their status as an expert. In Re Citigroup Shareholder Derivative Litigation (Del . Ch. 2009) N. 63

o It doesn’t raise your obligation (because the requirement is ‘do you believe what you’re doing is the right thing to do), but the more experience you have, the more likely you are to understand the situation and the more difficult it makes it to escape liability by reason of lack of knowledge.

Does it vary by the severity of the penalty for a violation?o Yes – since the Federal Sentencing Guidelines create severe penalties for violations, it’s hard to argue that

an increase in sanctions isn’t relevant to the success/ failure of the corporations business model Thus, good faith is very context specific.

o Depends on particular circumstances of the business and the individual.o That said, it’s still very difficult evidence-wise to establish that someone was not in good faith

Best Practices for Boards in the New Era of Corporate Monitoring1. Establish an appropriate supervisory and compliance structure.2. Create a sophisticated inventory of regulatory and reputational risks faced by the firm’s businesses.3. Establish an “early warning” system to identify emerging areas of regulatory focus.4. Communicate the board’s and senior management’s compliance message throughout the organization.5. Conduct specialized training for supervisors.6. Ensure that information concerning regulatory and reputational risks and issues is promptly surfaced to senior

management and compliance personnel.7. Use internal discipline effectively to reinforce the compliance message when appropriate.

Case Summaries

Francis v. United Jersey Bank Facts –

o Pritchard & Baird is a closely-held reinsurance firm with four directors: Charles Pritchard Sr. (founder), Mrs. Pritchard, and two sons Charles Jr. and William

o Charles Sr. starts the practice of co-mingling accounts and making “shareholder loans” which he pays back; i. after he dies, Charles Jr. and William run the business, continue the practice of “shareholder

loans,” but don’t pay the money back.o Firm goes bankrupt; trustees in bankruptcy bring suit against Mrs. Pritchard (and eventually her estate) for

negligence in the conduct of her duties as a director of the corporation History

o Trial court finds that the reason Mrs Pritchard never knew what her sons were doing was “because she never made the slightest effort to discharge any of her responsibilities as a director of Pritchard & Baird.

Rules

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o Determination of the liability of the director requires finding that she had a duty to the clients of Pritchard & Baird, that she breached that duty, and that her breach was a proximate cause of their losses

o Because directors are bound to exercise ordinary care, they cannot set up as a defense ‘lack of knowledge needed to exercise the requisite degree of care’

i. If one ‘feels he has not had sufficient business experience to qualify him to perform the duties of a director, he should either acquire the knowledge by inquiry, or refuse to act

o Generally directors are 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 corporation and prepared by an independent public accountant or certified

DGCL 141(e) - A member of the board of directors, or a member of any committee designated by the board of directors, shall, in the performance of such member's duties, be fully protected in relying in good faith upon the records of the corporation and upon such information, opinions, reports or statements presented to the corporation by any of the corporation's officers or employees, or committees of the board of directors, or by any other person as to matters the member reasonably believes are within such other person's professional or expert competence and who has been selected with reasonable care by or on behalf of the corporation

o Upon discovery of an illegal course of action, a director has a duty to object and, if the corporation does not correct the conduct, to resign…

o A director who votes for or concurs in certain actions may be “liable to the corporation for the benefit of its creditors or shareholders to the extent of any injuries suffered by such persons as a result of any such action.

o A director who is present at a board meeting is presumed to concur in corporate action taken at the meeting unless his dissent is entered in the minutes or filed promptly after adjournment.

Reasoningo Mrs. Pritchard should have realized that her sons were withdrawing substantial trust funds under the guise

of shareholders loans. Detecting a misappropriation of funds would not have required special expertise of extraordinary diligence; a cursory reading of the financial statements would have revealed the pillage.

Holdingo Even if Mrs. Pritchard’s mere objection had not stopped her sons, her consultation with an attorney and

threat of suit would have deterred them. Whether in other situations a director has a duty to do more than protest and resign is best left to case by case determinations. In this case we are satisfied there was a duty to do more than object and resign. Consequently, we find that Mrs Pritchard’s negligence was a proximate cause of the misappropriations.

Commentso If a director is aware of a material misstatement in a security filing, he is personally liable unless he resigns

and informs the SEC.o Generally, boards of public companies have a particular obligation to monitor their firm’s financial

performance, the integrity of its financial reporting, its compliance with the law, its management compensation, and its succession planning

Graham v. Allis-Chalmers Manufacturing Co. (Del 1963) – no requirement to monitor employees unless red flags exist Facts –

o Allis-Chalmers is a very large, decentralized public corporation that makes electrical equipment.o In 1937, it entered into a consent degree with the FTC to stop fixing prices on condensers and turbine

generators.o In late 1950s, Allis-Chalmers and four mid-level managers plead guilty to price-fixing charges, pay big fines.o Shareholder brings derivative suit against directors and top officers to recover on behalf of corporation.o Since defendant directors had no knowledge of anti-trust violations, the theory is they breached their duty

of care Rules

o There is no general duty to monitor your employees for compliance with the lawi. Directors are entitled to rely on the honesty and integrity of their subordinates until

something occurs to put them on suspicion that something is wrong.

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o If a director has recklessly reposed confidence in an obviously untrustworthy employee, has refused or neglected cavalierly to perform his duty as a director, or has ignored either willfully or through inattention obvious danger signs of employee wrongdoing, the law will cast the burden of liability upon him.

Reasoningo Business judgment rule doesn’t apply because there’s no need to insulate directors from the consequences

of inactioni. Note: the reliance on information provided by others is only applicable if the directors actually

look at the information Holding

o Knowledge by 3 of the directors that in 1937 the company had consented to the entry of decrees enjoining it from doing something they had satisfied themselves it had never done does not put the Board on notice of the possibility of future price fixing.

o Directors are not required to assume, with no justification whatsoever, that all corporate employees are incipient law violators

o Company is not liable Comments

o The red flag structure is designed to reduce monitoring costs in the general sense, while imposing a duty to monitor when there is notice something bad might be going on

In re: Michael Marchese – Reckless signature of Form 10-KSB leads to liability Facts

o Chancellor Corp. acquires MRB in 1999 but CEO and other officers forge documents showing the transaction taking place in August 1998 in order to consolidate MRB earnings a year earlier.

o Marchese receives a report from outside auditor challenging 1998 acquisition date but doesn’t follow up. o CEO fires auditors; new auditors sign off on 1998 acquisition date; Marchese does not ask any questions.o Marchese certifies 1998 10-KSB, but resigns from the board in 1999 and expresses concerns to the SEC.o Marchese agreed to undisclosed settlement for “recklessly ignor[ing] signs pointing to improper accounting

treatment.” Rules

o Relevant mens rea requirement is scienteri. But a court can infer scienter from recklessness or gross negligence

Reasoningo Marchese was reckless in not knowing that 10-KSB contained materially misleading statements because he

knew it reflected a 1998 MSRB acquisition date, that the old auditor had been fired at least in part due to a dispute over whether this date was correct.

Holdingo Marchese violated and caused Chancellor’s violation of §10(b) of the Exchange Act and Rule 10(b)5 when

he signed the 1998 Form 10-KSB

In Re: Caremark International Inc Derivative Litigation – positive obligation to implement system to uncover red flags Facts

o Caremark is a publicly traded health care provider -- provides a lot of specialized patient care, treatment for conditions ranging from AIDS to hemophilia.

o Caremark is subject to the complex provisions of Anti-Referral Payments Law: basically, you’re not supposed to pay MDs to refer patients whose treatment is paid for by Medicare or Medicaid.

o Caremark had always had an ethics guidebook, an internal audit plan, and a toll-free confidential ethics hotline. Price Waterhouse gave control system a clean bill of health. But despite it all, lower-level officers apparently engaged in enough misconduct to lead to plea bargain payment of $250 million.

History – o Shareholders file derivative suit seeking recovery from the board of directors, claiming breach of the duty

of care. Issue

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o Whether the Chancellor should approve a settlement in which the Caremark directors promised only to implement relatively insignificant additional safeguards to increase Caremark’s ability to comply with the ARPL in the future.

Reasoningo There are 2 sources of director liability for breach of duty to exercise appropriate attention

i. Negligenceii. Failure to act

o Relevant and timely information is an essential predicate for satisfaction of the board’s supervisory and monitoring role under DGCL 141

i. It would be a mistake to conclude that Boards may satisfy their obligation to be reasonably informed without assuring themselves that information and reporting systems exist in the corporation that are reasonably designed to provide to senior management and the board itself timely, accurate information sufficient to allow management and the board to reach informed judgments concerning both the corporation’s compliance with law and its business performance.

Holdingo There is a very low probability that it would be determined that the directors of Caremark breached any

duty to appropriately monitor and supervise the enterprise, so the settlement is approvedo Where a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating

activities within the corporation, … only a sustained or systematic failure of the board to exercise oversight… will establish the lack of good faith that is a necessary condition to liability

i. Here, the corporation’s information systems appear to be a good faith attempt to be informed or relevant facts, so it’s unlikely the Board would be liable

Commentso Caremark establishes a positive duty on corporations to establish a monitoring system to turn up the

‘red flags’ in Allis-Chalmero It’s kind of weird that Chancellor Allen uses a settlement review to change the substantive duty to monitoro Caremark adds to the minimum baseline requirement

i. It’s not enough to rely on reports from others: there must also be a monitoring system to oversee how this information is being produced and to identify any criminal activity

o The reason it’s framed as part of the ‘good faith’ requirement is that we don’t want to impose negligence liability on directors for bad business decisions through the back door

i. Also, charter provisions under §102(b)7 can provide for indemnification of negligence, but not bad faith thus a failure to establish a monitoring system cannot be indemnified by the corporation

ii. Also, Caremark came out at about the same time as Cede (in which the Delaware SC said that Ps alleging negligence of duty of care do not have to prove causation)

1. So, by rooting the liability in good faith, Caremark requires the P to prove that the failure to establish a monitoring system was the causation for damage

o Also, a ‘good faith’ requirement sounds like the old time business judgment rule (which was ‘a good faith belief that the action was in the interests of the corporation’)

Stone v. Ritter (Del. 2006) – In the absence of red flags, the presence of a monitoring system satisfies duty of care unless directors consciously ignore it

Facts: o AmSouth shareholders brought suit against their directors for failing to detect a scheme among certain

employees which led to a $40 million fine against the company. Holding (endorsing Caremark):

o Absent any red flags, in order for directors to be held liable for lack of oversight of officers and employees there must be a finding that directors either:

i. “utterly failed to implement any reporting or information system or controls,” or ii. having implemented such system or controls, “consciously failed to monitor or oversee its

operations thus disabling themselves from being informed of risks or problems requiring their attention.”

o And: “imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations

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In Re: Citigroup Inc. Shareholder Derivative Litigation (2009) Facts

o Citigroup is deep into so-called “toxic assets,” which leads to massive losses by late 2007.o Citigroup has a 102(b)(7) waiver in its chartero Some CDOs sold by Citigroup included liquidity puts (which allowed the buyer to sell back the CDO at

face value to Citigroup)o Citi had risk management systems and a committee in place to manage risk

Issueo Whether the Board should be liable under Caremark for failing to “make a good faith attempt to follow the

procedures put in place or fail[ing] to assure that adequate and proper corporate information and reporting systems existed that would enable them to be fully informed regarding Citigroup’s risk to the subprime mortgage market.”

i. Whether public reports on deterioration of subprime mortgage market should have served as “red flags.” Rules

o BSJ Rule is a presumption that in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Burden is on plaintiffs to rebut this presumption.

o Absent an allegation of interestedness or disloyalty to the corporation, the BSJ rule prevents a judge or jury from second guessing director decisions if they were the product of a rational process and the directors availed themselves of all material and reasonably available information.

o A P can show bad faith conduct by properly alleging particularized facts that show athat a director consciously disregarded an obligation to be reasonably informed about the business and its risks or consciously disregarded the duty to monitor and oversee the business.

o Directors have a responsibility to implement and monitor a system of oversight (Stone) Reasoning

o Because Citi has a 102(b)7, the only possible liability is on pleading of non-exculpated claimso The duty to implement and monitor an oversight system does not eviscerate the core protections of the

business judgment rule. i. burden to rebut the presumption by showing gross negligence is difficult, and showing bad

faith is even hardero P don’t contest that Citi had procedures and controls in place designed to monitor risko To impose oversight liability on directors for failing to monitor ‘excessive’ risk would involve courts in

conducting hindsight evaluations of decisions at the heart of the BSJ of directors.o Oversight duties under Delaware law are not designed to subject directors, or even expert directors, to

personal liability for failure to predict the future and properly evaluate risk. Holding

o P fails to plead ‘particularized facts suggesting that the Board was presented with ‘red flags’ alerting it to potential misconduct at the Company.

o That the director-defendants knew of signs of deterioration in the subprime mortgage market, or even signs suggesting that conditions could decline further, is not sufficient to show that the directors were or should have been aware of any wrongdoing at the Company or were consciously disregarding a duty somehow to prevent Citi from suffering losses

Footnoteso N. 63 – Directors with special expertise are not held to a higher standard of care in the oversight context

simply because of their status as an expert. Comments

o Citi is a bank, and is thus subject to banking laws Caremark monitoring duty would require Citi to establish monitoring systems to identify / prevent violations of banking laws

o The baseline duty for risk management is less than Caremark monitoring of employee misconduct i. In order to find Citi liable, the Court would have had to rule that the directors could not have

actually believed this risk taking was in the interests of the company.o Note: Citi’s risk taking could be diversified against by buying other financials who were not involved with

CDOs

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Miller v. AT&T (3d Circ. 1974) Facts

o Shareholder suit against AT&T’s board, alleging that AT&T is refusing to collect on a $1.5 million loan made to the Democratic National Committee during the 1968 election.

o Shareholders bring a derivative action claiming that this is an intentional failure to collect, amounting to an illegal campaign contribution in violation of federal law prohibiting corporate campaign contributions.

o AT&T is incorporated in NY History

o District Court dismisses the suit for failure to state a claim. Rules

o Even though committed to benefit the corporation, illegal acts may amount to a breach of fiduciary duty in NY (Roth v. Robertson)

Reasoningo Failure to collect is ok, but if this constitutes a crime, then BSJ rule doesn’t shieldo Since political contributions by corporations can be checked and shareholder control over the political use

of general corporate funds is effectuated only if directors are restrained from causing the corporation to violate the statute, such violation seems a particularly appropriate basis for finding breach of the defendant directors’ fiduciary duty to the corporation

Holdingo Under these circumstances, directors cannot be insulated from liability on the ground that the contribution

was made in the exercise of sound business judgment.o Since Ps have alleged actual damage in the form of $1.5 million, the complaint does state a claim

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C. Duty of Loyalty – Conflicted Transactions

1. Overview

Directors’ duty of loyalty is normally to the corporation as a whole, but the shareholder interest should have priority over the interests of other constituencies.

Other constituencies’ interests can be taken into account insofar as they affect the value of the company in either the ST or the LT. Unocal (i.e. some protection for ‘business strategy’ of directors even in opposition to shareholders)

If a situation arising in which it is clear that the corporation will no longer exist (sale of assets or control), then the duty becomes explicitly one toward shareholders exclusively (i.e. maximize price). Revlon

Managers can’t disburse corporate funds for philanthropic or other causes (interests of non-SH constituencies) unless the expenditure would benefit the corporation. Dodge v. Ford Motor Co.

In the US, we bar corporate contributions that we think are particularly problematic (political donations)

4 General Categories of Duty of Loyalty Issues Self-dealing transactions – transactions that primarily benefit the directors/officers rather than the corporation.

o Includes dealings with directors/ officers AND controlling shareholders Executive compensation – Decisions about a senior executive’s salary, bonuses, stock options or pensions MAY

be overturned if they are clearly “excessive,” taking into account the nature of the executive’s services. Corporate Opportunity doctrine – Before a director or senior executive may take for himself an opportunity that

is likely to be of interest to the corporation (e.g., purchase of some property adjacent to the corporation’s property), he MUST first offer that opportunity to the corporation. If he doesn’t, he may be required to surrender the opportunity to the corporation after the fact, and/or pay damages.

Sale of Control – The owner of a controlling block of stock is generally allowed to sell his shares for an above-market “premium,” without sharing that premium with other shareholders. HOWEVER, there are several exceptions.

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Policy Implications

PA ‘Other Constituency’ Statute (PCBL §1715(a)) General Rule. -- In discharging the duties of their respective positions, the board of directors, committees of the

board and individual directors of a business corporation may, in considering the best interests of the corporation, consider to the extent they deem appropriate:

o (1) The effects of any action upon any or all groups affected by such action, including shareholders, employees, suppliers, customers and creditors of the corporation, and upon communities in which offices or other establishments of the corporation are located.

o (2) The short-term and long-term interests of the corporation, including benefits that may accrue to the corporation from its long-term plans and the possibility that these interests may be best served by the continued independence of the corporation.

o (3) The resources, intent and conduct (past, stated and potential) of any person seeking to acquire control of the corporation.

o (4) All other pertinent factors.

Delaware does not have a constituency statute. However, Del. SC has stated that in takeover defense, the board may consider other corporate constituencies, as long as these have some relationship to the long-term shareholder value.

One problem of taking a pluralist view of the corporation is that even if the directors are supposed to take everyone’s interest under consideration, it’s only the shareholders who can remove them (so the shareholder voice will have the most influence)

Case Summaries

AP Barlow v. Smith (NJ 1953) Facts

o Corporation makes a “modest” donation to Princeton University; shareholder challenges the donation on the grounds that the corporation does not have the power to make it.

o Plaintiff shareholder claims that the statutes are not applicable to Smith Mfg. Co. because the company was created before the statutes were passed

Ruleso Managers can’t disburse corporate funds for philanthropic or other causes unless the expenditure would

benefit the corporation. Dodge v. Ford Motor Co.o 1930 New Jersey statute allows corporations to create and maintain charities and philanthropic ventures, as

the directors “deem expedient and as in their judgment will contribute to the protection of the corporate interest.”

o 1950 New Jersey statute allows charitable contributions up to 1% of total capital unless authorized by shareholders

Reasoningo Modern conditions require that corporations acknowledge and discharge social as well as private

responsibilities; thus, donations to academic institutions are incidental to the object of the corporation Holding

o The donation is valid because it was not indiscriminate or to a pet charity in furtherance of personal rather than corporate ends.

o The duty of the board is to act in the interest of the shareholders, but it may consider the long-term interest.o 1930 statute applies because a law pre-existing the charter set out that all corporate charters are subject to

alteration, suspension, and repeal by the Legislature. Comments

o Instrumental justification – donations benefit the company in the long runo In the US, where we think certain donations are problematic, we regulate them directly rather than through

corporate law (i.e. campaign donations, etc) compares to in UK, where donations are presumptively invalid unless shareholders approve them.

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2. Self-Dealing Transactions with Directors/ Officers

Rules and Regulations

P must prove that D is a fiduciary (director, or officer, or controlling shareholder) and that there was a conflict of interest. If either fails, BSJR applies. If P proves these 2, burden shifts to D to prove DGCL §144 safe harbor, either by:

o Showing entire fairness of the transaction (price + procedure)o Showing that §144 disclosure + approval requirement was satisfied,

Disjunctive Requirement. If either §144 safe harbor is met, then the action is only reviewable under the BSJRo Note: BSJR rule applies (not fairness review) if the interested party is not a majority shareholder and

informed truly disinterested directors/ shareholders approve the transaction. Cooke v. Oolie (Del. 2000) If the transaction fails to satisfy entire fairness or safe harbor, then court may order:

o Rescission of the transactiono Give P what they would have gotten in absence of the self-dealing transactiono Force interested breacher to disgorge profits to corporation (STATE EX REL HAYES OYSTER)

DGCL General Substantive Rule §144(a)A self-dealing transaction with a director (or corporation in which a director is interested), is not void(able) solely for this reason (or for the director’s participation in voting or quorum at decision to authorize) if

(1) disclosure to + good faith authorization by majority of disinterested members of board; or (2) disclosure to + good faith authorization by vote of shareholders; or (3) transaction is fair to the corporation at the time approved Basically, self-dealing transaction is subject to disjunctive reading if conflicted party isn’t a majority shareholder

o Note: A fiduciary is not required to state his reservation price. Kahn v. Tremont Corp (Del. 1997)

General Substantive Rule elsewhere (Hayes)Self-dealing is okay if done with

full disclosure of any conflict by the Key Player; AND independent director OR shareholder approval (but no deference to approval if there is waste); and it is a Fair transaction (entire fairness test)

o Procedural fairness (was the procedure itself fair?)o Substantive fairness (is the price fair?)

RemediesIf there IS a breach of the duty of loyalty (e.g., transaction NOT fair), the courts can:

Void the transaction (or enjoin it) Award damages

o Give P what they would have gotteno Force interested breacher to disgorge profits to corporation (STATE EX REL HAYES OYSTER)

Total Prohibitions – SOX §402 – prohibits any loans from being made to executives (although states may allow it – see DGCL §143)

if there’s a loan being made, can sue corp. for failure to monitor if it didn’t have a monitoring system Any transaction that constitutes waste is prohibited. Lewis v. Vogelstein.

Policy Implications

Actual injury is not the foundation here: fidelity in the agent is what is aimed at. To secure this, the law does not permit the agent to place himself in a situation in which he may be tempted by his own private interest to disregard that of his principal.

Three main areas of concern: the Key Player and the corporation are on opposite sides; the Key Player has exerted influence the corporation’s decision to enter the transaction; the Key Player’s personal financial interests are at least potentially in conflict with the financial interests of the

corporation, to such a degree that there is reason to doubt whether the Key Player is necessarily motivated to act in the corporation’s best interests.

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CoastOyster Co.(Verne CEO)

KeypointOyster Co.

VerneHayes

23%

SamHayes

25%75%

Engman

50%

HayesOyster

50%

twooysterbeds

$250K

Case Summaries

State ex rel. Hayes Oyster Co v. Keypoint Oyster Co. (Wash. 1964) Facts

o Verne Hayes is director, 23% shareholder, and CEO of Coast Oyster, a public corporation. Coast faces cash flow problems and Verne convinces the board to sell two oyster beds.

o Verne then suggests to Engman, a Coast employee, that Engman form a new corporation (Keypoint) to buy the oyster beds. Verne arranges for his own family corporation, Hayes Oyster, to help Keypoint with financing, in exchange for which Hayes Oyster receives 50% of the equity in Keypoint.

o The agreement whereby Hayes Oyster gets 50% equity in Keypoint happens after Coast board votes to sell, but before Coast shareholders approve sale

Historyo Coast’s new management discovers what Verne has done and brings suit to recover Verne’s and Hayes

Oyster’s “secret profits.”o Trial court rules for Verne.

Issueo Whether Verne was in violation of his duty to Coast and should disgorge his secret profit

Ruleso Directors and other officers cannot directly or indirectly acquire a profit for themselves or acquire any other

personal advantage in dealings with others on behalf of the corporation.o Even if a transaction was self-interested, it is not voidable if the director can show that such transaction was

fair. Reasoning

o Nondisclosure by an interested director or officer is in itself unfairo Even though the negotiations between Hayes and Engman up to Sept. 1 resulted in no binding agreement,

Hayes knew he might have some interest in the sale.o Coast shareholders and directors had the right to know of Hayes’ interest in Keypoint in order to

intelligently determine the advisability of retaining Hayes as manager and president under the circumstances

o Actual injury is not the foundation here: fidelity in the agent is what is aimed at. To secure this, the law does not permit the agent to place himself in a situation in which he may be tempted by his own private interest to disregard that of his principal.

Holdingo Hayes was required to divulge his interest in Keypoint. His obligation arose from the possibility, even

probability, that some controversy might arise between coast and Keypoint relative to the numerous provisions of the executory contract.

o It is not necessary that an officer/ director have an intent to defraud or that any injury result to the corporation for an officer or director to violate his fiduciary obligation in secretly acquiring an interest in corporate profits.

o Remedy: Coast gets Hayes’ shares in Keypoint Comment

o The remedy looks punitive, because Coast gets not only the profit, but also Hayes’ investment in Keypointi. Court stacks remedies for the corporation to force directors to disclose in the future

o Courts are much more willing to wade into the weeds to analyze self-interest than to look at business judgments

o Directors and other officers cannot directly or indirectly acquire a profit for themselves or acquire any other personal advantage in dealings with others on behalf of the corporation.

Cookies Food Products v. Lakes Warehouse (IA’88): Director who engaged in self-dealing to benefit of the corporation still had the burden of proving that the transactions were entirely fair to the corporation

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Cooke v. Oolie (Del. 2000) Facts –

o The Nostalgia Network (“TNN”) has a board with four directors, including Oolie and Salkind.o Board votes unanimously to pursue the USA acquisition proposal.o Minority shareholders bring suit, claiming that Oolie and Salkind breached their fiduciary duty by “electing

to pursue a particular acquisition proposal that . . . best protected their personal interests as TNN creditors, rather than pursue other proposals that . . . offered superior value to TNN’s shareholders

Issueso Whether D breached fiduciary duty of loyalty by electing to pursue a particular acquisition proposal that

allegedly best protected their personal interests as TNN creditors, rather than pursue other proposals that offer superior value to TNN shareholders.

Ruleso P bears burden to rebut the presumption that BSJ rule applies to Oolie and Salkind.o Even though DGCL doesn’t explicitly apply (because Oolie and Salkind aren’t on both sides of the

transaction, and because no transaction occurred), the policy rationale appliesi. Court will apply the BSJ rule to the actions of an interested director, who is not a majority

shareholder, if the interested director fully discloses his interest and a majority of the disinterested directors ratify the interested transaction.

Reasoningo Ratification by disinterested directors cleanses the taint of interest, because they have no incentive to act

disloyally.o Disinterested vote to pursue the same proposal that Oolie and Salkind voted to pursue provides strong

evidence to the Court that they acted in good faith and with the interests of TNN and its shareholders in mind.

Holdingo The BSJ rule applies (not fairness review) where the interested party is not a majority shareholder and the

disinterested directors approve the transactiono i.e. if Defendant can show that he is not a majority shareholder, that he made full disclosure, and that

disinterested directors approved the transaction, he can take advantage of the safe harbor

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3. Transactions with a Controlling Shareholder

Rules and Regulations

P must prove that D is a controlling shareholder and that there was a conflict of interest. If either fails, BSJR applies. If P proves these 2, burden shifts to D to prove entire fairness based on DGCL §144, either by:

o Showing entire fairness of the transaction (price + procedure)o Showing that §144 disclosure + approval requirement were satisfied

To show §144, majority shareholder cannot dictate the terms, and special committee must have true bargaining power to deal with majority SH at arms-length, in which case fairness is presumed. Kahn

If §144 is satisfied, burden shifts back to the P to prove that the transaction fails the entire fairness test (price + procedure) Kahn v. Lynch Communication Systems(Del. 1994). It will fail if either:

Board failed to retain its own financial advisor in a merger/ acquisition/ sale. McMullin v. Beran The transaction constitutes waste. Lewis v. Vogelstein.

If the transaction is shown to satisfy ‘entire fairness’, then it is reviewable under the BSJR If the transaction fails entire fairness, then court may order

o 1) Rescission; or 2) Expectation damages; or 3) Disgorgement of profits by the controlling shareholder

Is there a conflictSelf-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. Sinclair Oil (Del. 1971)

So if the parent does not receive something to the exclusion of minority shareholders , there’s probably no self- dealing and thus no fairness review pro rata dividends are ok unless it’s corporate waste.

DGCL General Substantive Rule §144 read 1/2 + 3 conjunctively due to KahnA self-dealing transaction with a director (or corporation in which a director is interested), is not void(able) solely for this reason (or for the director’s participation in voting or quorum at decision to authorize) if

(1) disclosure of material facts to + good faith authorization by majority of disinterested members of board; or (2) disclosure of material facts to + good faith authorization by vote of shareholders; or (3) transaction is fair to the corporation at the time approved

Proving Fairness Fair price. In M&A situations, fair price is not a definitive price it CAN be a price in a range of fairness. See

WEINBERGER v. UOP; Cannot be waste. Lewis. Procedural fairness. Look to DGCL §144 (1) and (2) safe harbors, whether SC retained its own advisors . McMullin

Disclosure and good faith authorization by disinterested members of the board If there’s a controlling shareholder, it may be hard to say that any member of the board is truly independent Approval by disinterested directors merely shifts the burden of proving fairness in a controlled transaction to the

plaintiff challenging the deal (Kahn v. Lynch Communication Systems)

Disclosure and good faith authorization by a vote of the shareholders If the majority is obtained through the votes of the controlling shareholder, entire fairness still needs to be proven If a majority of the minority approve the transaction, then the burden of proof shifts to the P to prove that it’s not

entirely fair. Kahn v. Lynch; In Re Wheelabrator

Absolute prohibitions The Board cannot delegate control of the sale process to a majority shareholder by relying on a valuation done by

the majority shareholder’s financial advisor. McMullin v. Beran (Del. 2000) (board must retain own fin. advisor. Shareholders cannot validly approve WASTE unless vote is unanimous—defined as “exchange or corporate

assets for consideration so disproportionately small as to lie beyond the range at which any reasonable person might be willing to trade.” (Lewis v. Volgelstein)

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Is there a conflict of interest?, if yesIs D a controlling SH? If no (go to p.63), if yesDid D disclose and get approval- If no, P must show that action satisfies entire fairness

o Emphasis on price w/in range of fairness- If yes, burden shifts to P to prove that action fails

entire fairness:o Price w/in range of fairnesso Did Board retain own advisors?o Is the transaction waste?

Policy Implications

Kahn interpretation of DGCL §144 – transaction with a controlling shareholder must satisfy both procedural requirements and entire fairness not a safe harbor, just burden shifting (conjunctive test)

MBCA §8.61 – transaction with a self-interested director is subject to a disjunctive reading (i.e. no fairness review if approval received by disinterested directors or entire fairness) strong safe harbor, disjunctive reading

ALI 5.02(a) – if you have authorization, no remedy unless the board doesn’t have a reasonable basis to believe that the transaction is fair medium-strength safe harbor, closer to conjunctive reading

Compare to UK Regime (very strong shareholder rights on this)Authorization must be given following disclosure to board AND disinterested shareholders by both if transaction is “significant” ( >5% asset value). Companies Act 2006 §§177, 190; Listing Rule 11)

If there authorization, then something like BSJR applies (limited by restriction on waste) If there’s no authorization, the transaction is voidable.

No fairness review in either circumstance.

Case Summaries

Sinclair Oil Corp. v. Levien (Del. 1971) Facts

o Sinclair Oil Company owns 97% of Sinven’s stock and dominates Sinven’s board. Sinven is involved in oil exploration and production in Venezuela.

o Sinven pays out $108 million in dividends from 1960-66 during a time in which Sinclair had a need for cash (although they were compliant with 8 Del. C. §170

o Sinven minority shareholders bring suit against Sinclair Oil for paying excessive dividends, allegedly impeding Sinven’s industrial development.

o Sinclair responds that dividends and other decisions should be judged under business judgment rule. History –

o Chancellor finds that Sinclair owed Sinven a fiduciary duty and applies the intrinsic fairness test; finds that Sinclair did not sustain its burden of proving that the dividends were intrinsically fair to the minority shareholders. Sinclair Oil appeals

Issueo Whether the dividend payments were intrinsically fair

Ruleso When the situation involves a parent and subsidiary, with the parent controlling the transaction and fixing

the terms, the test of intrinsic fairness (and its burden-shifting to the controlling shareholder) is appliedo 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

o If a plaintiff can meet his burden of proving that a dividend cannot be grounded on any reasonable business objective, then the courts can and will interfere with the board’s decision to pay the dividend.

Reasoningo Compliance with applicable statues may not, under all circumstances, justify all dividend paymentso Dividends can be self-dealing (if for instance, they’re only issued to class A stockholders or something,

which are held by the majority shareholdero Sinclair received nothing to the exclusion of minority shareholders, so they’re not self-dealing (Sinclair did

not take any business opportunities that came to Sinven or to Sinclair by virtue of its position in Sinven) Holding

o Fairness review is required only if the parent receives something from the subsidiary to the exclusion of, and detriment to, minority shareholders of the subsidiary

o Dividend payments complied with the business judgement standard

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o Motives for declaring dividends are immaterial unless the plaintiff can show that they resulted from improper motives and amounted to waste.

o Sinclair usurped no business opportunity belonging to Sinven, and dividends went to all shareholders pro rata therefore, no self-dealing

McMullin v. Beran (Del. 2000) Facts

o ARCO owns 80.1% of Chemical; Lyondell negotiates with ARCO to buy its Chemical shares. ARCO agrees to a deal at $57.75 in cash and Lyondell submits a proposal to Chemical’s board.

o Chemical’s board (controlled by ARCO) unanimously approves the deal, solely on the basis of information given to them by ARCO’s financial advisor.

o Minority shareholder of Chemical brings suit claiming that “Chemical’s directors violated their fiduciary duties to manage the sale of Chemical by delegating control of the sale process to ARCO.”

History – o Chancery Court grants Chemical’s motion to dismiss.

Holdingo Delaware Supreme Court reverses and requires fairness review: “Given ARCO’s majority shareholder 80%

voting power . . . The Chemical Directors did not have the ability to act on an informed basis to secure the best value reasonably available in any alternative to the third-party transaction with Lyondell that ARCO had negotiated. The Chemical Directors did, however, have the duty to act on an informed basis to independently ascertain how the merger consideration being offered in the third party transaction with Lyondell compared to Chemical’s value as a going concern.”

Commento If there is an application of fairness review, what should the board have done to satisfy their duty of

loyalty? should have had independent advisors for the minority shareholders Although it looks like a pro rata benefit to everyone, the harm to the minority shareholders was

that they didn’t get an independent valuation Without this independent valuation, the personal problems of the majority shareholder may cause

everyone to accept a lower price (for instance if ARCO had liquidity problems and was desperate to sell) under the belief that the transaction accurately reflected the going-concern value without discounting for any problems of the majority shareholder

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4. Executive Compensation

Rules and Regulations

Stock OptionsWhat is necessary to validate a stock option grant is a finding that a reasonable board could conclude from the circumstances that the corporation may reasonably expect to receive a proportionate benefit (Beard v. Elster)

DGCL§143 authorizes loans to directors/ officers and guarantees of loans to these people provided by 3rd party lenders if the loan/ guarantee benefits the corporation.

BUT, SOX §402 prohibits any corporation whose shares trade on a national exchange or NASDAQ or a subsidiary of such corporation from directly or indirectly extending any credit to any director/ officer

For an example of a ridiculously high compensation package, look to the Disney case, where it’s upheld because CEO was acting in good faith to benefit the corporation when he signed Ovitz and when he fired him, and the board had no duty to act to become informed about the consequences of the firing because Eisner fired Ovitz unilaterally (which was within his power as CEO)

Generally speaking, if a shareholder disagrees with a compensation plan, the proper remedy is to either sell the stock or seek to replace the board.

SOX §304 – if a company must restate its financials as a result of misconduct, the CEO and CFO must pay back to the company any bonuses or incentive or equity-based pay and/or trading profits realized in the 12 months after the incorrect financial information was publically disclosed.

Emergency Economic Stabilization Act (2008) – imposes a $500,000 cap on deductibility for pay to the top 5 employees, with no exception for performance-based pay

American Recovery and Reinvestment Act (2009) – TARP recipients may not pay any bonus, retention award, or incentive compensation to top executives (with the scope of ‘top’ expanding as firms take on more TARP funds) (although this does not apply to restricted stock grants that do not fully vest while government assistance is outstanding and have a value of less than 1/3 of the executive’s annual compensation)

Disincentivizes risk-taking among firms on TARP assistance

Under ARRA (2009) – TARP recipients must consult with the Pay Czar before setting executive pay levels. WSJ article from Oct. 15ish says that he will slash pay of top 25 officers at big financial institutions to about 50% of what they are right now

Pro – this is standard practice for a creditor/ debtor relationship, it just happens to be that the govt. is the creditor and the restriction on the debtor’s action is legislative rather than in a covenant

Con – don’t want to push high-performing people out of these companies because then they will have a harder time paying back the government; when creditor is the govt, the parties do not have equal bargaining power and we usually grant higher levels of protection in that case

Lewis v. Vogelstein (Del Ch. 1997) Facts

o Directors of Mattel are given a then-unusually generous one-time grant of options (not part of a more general compensation scheme), conservatively worth $85,000 on date they are granted.

o However, vest over several years, and directors lose these should they leave the board.o Grant is approved by shareholder vote.o Lewis, a shareholder who voted against the grant, brings a derivative action challenging it as “waste”.

Issueo Whether in practice the waste standard for when informed shareholders ratify a grants of options

recommended by a self-interested board is i. the classic waste test (total lack of consideration, one which no reasonable person could imagine

was in the interests of the firm0

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ii. or a species of intermediate review in which the court assesses reasonableness in relationship to perceived benefits

Ruleso For stock options grants to be valid, a 2 part test must be satisfied: there must be sufficient consideration

(Kerbs) and there must be conditions/ circumstances which may be expected to insure that the contemplated consideration will in fact pass to the corporation

o What is necessary to validate a stock option grant is a finding that a reasonable board could conclude from the circumstances that the corporation may reasonably expect to receive a proportionate benefit (Beard v. Elster)

Reasoningo These one-time options seems strange because the directors have already agreed to a compensation

structure, and are now awarding something in addition despite the fact that no extra work is being contemplated

Holdingo It cannot be said that no set of facts could be shown that would permit the court to conclude that the grant

of the options is not an exchange to which a reasonable person could agree to in good faithi. So summary judgment isn’t granted… but

1. “I do not mean to suggest… that these grants are suspect, only that [they] seem at this point sufficiently unusual to require the court to refer to evidence before making an adjudication of their validity and consistency with fiduciary duty…”

In Re: Walt Disney Co. Facts –

o September 1995: To help solve succession problems, Ovitz is persuaded to leave his $20-million-per-year job at CAA to join Disney as President. Eisner (CEO), Litvack (GC), Russell (Chairman of Comp. Committee), and Bollenbach (CFO) are heavily involved in negotiations, but other board members are only partially informed and approve the employment agreement after cursory review and discussion. Disney market capitalization goes up by $1 billion on announcement.

o December 1996: Disney board votes to terminate Ovitz’s employment agreement without cause, due to Ovitz’s poor performance. Litvack investigates possibility of termination for cause but does not keep any notes or seek outside legal advice on this point. Despite Ovitz’s poor performance, the board awards him a $7.5 million bonus for his services during 1996.

o January 1997: Ovitz receives $140m severance package under the terms of his employment agreement. Plaintiff shareholders bring derivative suit alleging that the payment breached the Disney directors’ duty of care and constituted waste.

o October 1998: Chancellor Chandler dismisses plaintiffs’ complaint in three paragraphs, because it was solely a duty of care issue and Disney had installed in its charter a DGCL § 102(b)(7) waiver. "Just as the 85,000-ton cruise ships Disney Magic and Disney Wonder are forced by science to obey the same laws of buoyancy as Disneyland's significantly smaller Jungle Cruise ships, so is a corporate board's extraordinary decision to award a $140 million severance package governed by the same corporate law principles as its everyday decision to authorize a loan."

o February 2000: Delaware Supreme Court reverses in part, allowing plaintiffs to replead duty of care claim (as 102(b)7 does not exclude ‘bad faith’)

o May 2003: Chancellor Chandler denies defendants’ motion to dismiss. “[T]he facts alleged . . . suggest that the defendant directors consciously and intentionally disregarded their responsibilities, adopting a ‘we don’t care about the risks’ attitude concerning a material corporate decision. . . .[T]he alleged facts, if true, imply that the defendant directors knew that they were making material decisions without adequate information and without adequate deliberation, and that they simply did not care if the decisions caused the corporation and its stockholders to suffer injury to loss.”

o So, in 2005, the case goes to full trial at the Delaware Chancery court Issue

o Whether Directors violated fiduciary duties and/or committed waste in signing the original employment agreement, and in terminating Ovitz

Rules

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o P must prove by a preponderance of evidence that the presumption of the BJR does not apply either because the directors breached their fiduciary duties, acted in bad faith, or made an ‘unintelligent or unadvised judgment’ by failing to inform themselves of all material information reasonably available to them before making a business decision

o If the plaintiffs succeed in rebutting the presumption of the BJR, then the burden shifts to the defendants to prove by a preponderance of evidence that the challenged transactions were entirely fair to the corporation

Reasoningo Eisner was acting in good faith, because he believed that it was in the company’s best interest to hire Ovitz

and to do it quicklyo The Board was entitled to rely on Eisner as he wasn’t conflicted in the transactiono Although the board has exclusive authority to hire the President, termination was not an exclusive power,

so it could permissibly delegate this decision to Eisnero Because Eisner unilaterally terminated Ovitz, the board had no duty to act to become informed about the

consequences Holding

o Directors did not act in bad faith in hiring Ovitz with the original employment agreement, and were at most ordinarily negligent; since BJR applies (since no bad faith, etc), ordinary negligence is not a violation of the fiduciary duty of care

o The Board was not under a duty to act, because its right to Issue

o Whether the board was under an obligation to act in connection with Ovitz’s Comments

o Note: Ovitz is not named, because when he signed the contract, he was not a fiduciaryi. However, the court’s reasoning would apply equally in a Cooke v. Ooley situation where there is

approval by disinterested directors of a self-interested transaction with another director/ executiveo Plaintiffs can’t just rely on proof of gross negligence because Disney has a 102(b)7 waiver in its chartero This case leaves a question hanging

i. Whether there is a separate duty of good faith Stone v. Ritter said that good faith is doctrinally part of the duty of loyalty (it’s a positive obligation within the duty of loyalty)

1. Thus, to make someone liable if there’s a 102(b)7 waiver, you need to show a violation of the duty of loyalty, and one way to prove that is to show bad faith

o There is no separate duty of good faith, it is just part of the duty of loyalty and the duty of carei. While ‘duty of care’ can be waived in a 102(b)3 provision in the charter, the fact that good faith is

also part of the non-waivable duty of loyalty means that ‘good faith’ cannot be waived.

Jones v. Harris Associates Facts –

o Harris is an investment advisor to Oakmark mutual funds, gets paid based on assets under managemento P is a shareholder in Oakmark, challenges D’s compensation package as not being a real ‘arms-length’

bargain because where D is working for large institutional clients, it charges a lot lesso Harris argues that its fee schedule is standard industry practice

Historyo District court awards SJ to Harris

Reasoningo Disclosure of executive compensation is to inform shareholder choice in buying/ sellingo If a shareholder disagrees with the compensation plan, the proper remedy is to sell the stocko The fact that mutual fund investors may not all be sophisticated is irrelevant, because sophisticated

investors will exert price pressure on the funds anyway (and even unsophisticated investors can recognize price trends)

Holdingo The fee is not a breach of loyaltyo Capital markets will ensure that payments to investment advisors are not excessive

Commentso P appeals for an en banc hearing, which is denied.

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Dissento In dissent on the en banc denial, Posner writes that capital markets can’t restrain executive compensation in

the context of mutual funds (or other firms generally) because of weak incentives for boards of directors to police executive compensation.

i. Also says that mutual funds and investment advisors do not operate at arms-length because mutual funds have been ‘captured’ by their advisors

o Also, because of disclosure requirements, everyone knows what everyone else is paying executives, so it encourages firms to converge on a particular norm, which disadvantages investors by reducing choice and competition among investment advisor price levels

Note: price of a mutual fund is largely determined by the underlying value of the portfolioo When a shareholder sells, it doesn’t reduce the price of shares, because the shares of the other investors are

still valued equal to the underlying securitieso However, when a mutual fund shareholder sells, it reduces AOM for the investment manager, which should

convince the manager to charge a competitive fee in order to maintain/ increase AOM

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5. When may a fiduciary take a corporate opportunity

Rules and Regulations

Line of Business Test. Gulf v. Loft (Del. 1939) – Anything a corporation could reasonably be expected to do is a corporate opportunity. Factors affecting this include: (1) how this matter came to the attention of the director, officer, or employee; (2) how far removed from the ‘core economic activities’ of the corporation the opportunity lies; and (3) whether corporate information is used in recognizing or exploiting the opportunity

Ex: Where Sinven was organized to operate in Venezuala, Sinclair was not usurping corporate opportunity by operating other companies in other countries. Other opportunities were not discovered b/c of Sinclair’s stake in Sinven, nor were they part of the ‘core economic activity’ of Sinven (which was w/in Venezuala), nor was corporate info used to recognize/ exploit the opportunity (Sinclair had the technology by virtue of its own R&D)

Fiduciary can only take a corporate opportunity when the corporation is not in a position to do so. See Miller v. Miller (Minn. 1974)

Incapacity is related to disinterest, and implies that a corporation’s board has determined not to accept the opportunity. In either event, a fiduciary should be allowed to accept the opportunity

Presentation of the opportunity to the board is not necessary. Broz v. Cellular Information Systems (Del. 1996) However, presenting the opportunity to the board provides a kind of ‘safe harbor’ for the director, which

removes the specter of a post hoc judicial determination that the director or officer has improperly usurped a corporate opportunity (provided the board is independent and fully informed). Broz v. Cellular Information Systems (Del. 1996)

o Most courts accept a 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 his own account.

DGCL §122(17) (passed in 2000) – explicitly authorizes waiver in the charter of the corporate opportunity constraints on directors, officers, and shareholders

Poses agency problems, but does allow collaborative efforts between people who have their own side businesses in the same line of business (Dreamworks Animation is the most prominent example – Spielberg, Katzenberg, and Geffen collaborate, but each can do his own thing outside the company)

Policy Implications

Other Possibilities Expectancy Interest Test. Lagarde v. Anniston Lime and Sonte Inc (Ala. 1900) – the expectancy or interest must

grow out of existing legal interest, and the appropriation of the opportunity will in some degree ‘balk the corporation in effecting the purpose of its creation’

o Narrow interpretation , but not very useful when the purpose of every modern corporation is to engage in any legal business authorized by the corporations statute.

Fairness Test. Looks at factors such as (1) how a manager learned of the disputed opportunity, (2) whether he used corporate assets in exploiting the opportunity, (3) and other fact-specific indicia of good faith and loyalty to the corporation, in addition to a (4) company’s line of business

ALI Principles of Corporate Governance §5.05 (requires presentation to board, and includes business line test extending corp. opp. even to opportunities director/ officer IDs unrelated his role as a director/officer)

ALI Principles of Corporate Governance §5.05 (a) General Rule. A director or senior executive may not take advantage of a corporate opportunity unless:

o (1) he first offers the opportunity to the corporation and makes disclosure concerning the conflict of interest and the corporate opportunity

o (2) the corporate opportunity is rejected by the corporation; ando (3) either

(A) the rejection is fair to the corporation, or (B) the opportunity is rejected in advance, following such disclosure, by disinterested directors,

or, for a senior executive, a disinterested superior, in a manner that satisfies the BSJ rule, or

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(C) The rejection is authorized in advance or ratified, following such disclosure, by disinterested shareholders, and the rejection is not a waste of corporate assets

(b) Definition. For purposes of this section, a corporate opportunity means:o (1) Any opportunity to engage in a business activity of which a director/ senior executive becomes aware,

either:i. (A) in connection with the performance of function as a director or senior executive, or under

circumstances that should reasonably lead the director or senior executive to believe that the person offering the opportunity expects it to be offered to the corporation; or

ii. (B) through the use of corporate information or property, if the resulting opportunity is one that the director or senior executive should reasonably be expected to believe would be of interest to the corporation; or

o (2) Any opportunity to engage in a business activity of which a senior executive becomes aware and knows is closely related to a business in which the corporation is engaged or expects to be engaged

(c) Burden of Proof. A party who challenges the taking of a corporate opportunity has the burden of proof, except that if such party shows that the requirements of §5.05(a)3(B) or (C) are not met, the director/ senior executive has the burden of proving that the rejection and the taking of the opportunity were fair to the corporation

(d) Ratification of Defective Disclosure. A good faith but defective disclosure of the facts concerning the corporate opportunity may be cured if at any time (but no later than a reasonable time after suit is filed challenging the taking of the opportunity) the original rejection of the corporate opportunity is ratified, following the required disclosure, by the board, the shareholders, or the corporate decision-maker who initially approved the rejection of the corporate opportunity, or such decision-maker’s successor

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6. Duty of Loyalty in a Close Corporation

Rules and Regulations

Definition of Close Corporation. DGCL §342-356 / Donahue v. Rodd Electrotype Co.

o Corporation having less than 30 shareholderso With a lack of any ready market for the corporation’s stock; AND

Note : Under DGCL §342, a close corporation CANNOT make a public offering under SA of 1933o Substantial participation by the majority stockholder in the management, direction and operations of

the corporation.

Majority shareholders in close corporations owe a strict good faith standard to the minority shareholders, because minority shareholders in a close corporation are particularly vulnerable. (See DONOHUE)

When a corporation reacquiring its own stock is a close corporation, the purchase is subject to the additional requirement that the stockholders who caused the corporation to enter into the stock purchase agreement must have acted with the utmost faith and loyalty to other shareholders. Donahoe

To meet this test, the controlling shareholders must cause the corporation to offer each stockholder an equal opportunity to sell a ratable number of shares to the corporation at an identical price.See Donohue

o If NOT, this would be tantamount to a usurpation of corporate assets by the majority stockholder, because he would be redirecting corporate assets solely towards himself.

A SH in a close corporation has the duty to exercise his voting rights in compliance with the strict standard of good faith Close corporation shareholders may not act out of avarice, expediency, or self-interest in derogation of their duty of

loyalty to other shareholders and to the corporation. See Smith v. Atlantic Properties (Mass. App. 1981)o E.g., close corporation divided by four shareholders, each with 25 shares of stock. Need 80% majority for

board to act, so each shareholder has an effective veto over all board actions. 3 shareholders wanted declaration of dividends, but fourth shareholder wanted to funnel accumulated retained earnings back into company. Because money was not spent, company was assessed tax penalty. Even after repeated penalties, fourth shareholder persisted. This was unreasonable risk by the fourth shareholder, in violation of his duty, and he was forced to personally recompense company for tax penalty assessed

Policy Implications

Potential conflicts of interest that are particularly troubling in the context of a close corporation Majority shareholder group employing itself and paying itself salaries Entering into contracts with itself Repurchasing shares from majority shareholders (because part of the minority’s interest is coopted into paying out to

the majority shareholders in exchange for the majority’s shares)

The ‘maximum protection’ here is valuable only to the minority shareholder, and reduces the value of the corporation. According to Easterbrook and Fischel, the rule should approximate the ex ante deal that the parties would have agreed on, i.e. one that maximizes firm value while adequately protecting the minority shareholder.

Criticism is that Easterbrook and Fischel are treating the fiduciary duty as a contractual agreement rather than the ‘safety net’

o However, in the close corporation, you don’t have the same collective action problem as in a public corporation, so maybe the contractual viewpoint is accurate because the shareholders have a greater interest in the firm.

Massachusetts qualified the duty of ‘utmost good faith and loyalty’ with a balancing test that recognized the controlling shareholder’s right of ‘selfish ownership’ (Wilkes v. Springside Nursing Home Inc)

If the controlling shareholder can demonstrate a ‘legitimate business purpose’ for its actions, then there is no breach of fiduciary duty unless the minority shareholder can demonstrate ‘that the same legitimate purpose could have been achieved through an alternative course of action less harmful to the minority’s interest.

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Case Summaries

Donahue v. Rodd Electrotype Co (Mass 1975) Facts

o P seeks to rescind D’s purchase of Harry Rodd’s shares in D and to compel repayment of the purchase price by Harry Rodd.

o Harry Rodd and Donahue were co-owners of the company, with 200 shares (80%) and 50 shares (20%) respectively

o In 1970, Harry Rodd is 77, and is thinking of retirement. He already distributed 117 of his 200 shareso Company’s board approves the corporation repurchasing 45 of Harry’s shares at $800/ share reflecting

book and liquidation valueo In the meantime, Donahue dies, and when Donahues learn of the repurchase, they offer to sell his shares to

the corporation at the same priceo Between 1965-1969, company offers to purchase the Donahue shares for $40 to $200 per share

Issueso Whether distribution constitutes a breach of fiduciary duty owed by the Rodds as controlling shareholders

because they failed to accord an equal opportunity to the minority shareholder Reasoning

o Close corporation looks a lot like a partnership, so the relationship must be one of trust, confidence, and absolute loyalty

o In a close corporation, the minority is vulnerable to ‘freeze-outs’ (refusals to declare dividends, payouts to majority shareholders in the form of salaries, high rent for corporate property paid to majority shareholders – i.e. self-dealing contracts)

i. While self serving conduct is proscribed, in practice P will have difficulty challenging these policies

ii. True plight of minority shareholder is that he cannot easily reclaim his capital1. Whereas a partner can dissolve the partnership, and a shareholder in a publically traded

firm can sell his shares thereby disincentivizing freezeouts by majority through threat of reduced stock price

o Because a repurchase distributes corporate assets to the stockholder whose shares were purchased, it operates as a preferential distribution of assets unless an equal opportunity is given to all shareholders (because it gives the selling shareholder an opportunity to turn corporate funds to personal use)

Holdingo A close corporation is typified by

i. A small number of shareholdersii. No ready market for the corporate stock

iii. Substantial majority stockholder participation in the mgmt, direction, and operations of the corpo Duty owed by stockholders in a close corporation to each other is the same as in a partnership: one of

‘utmost good faith and loyalty’o When a corporation reacquiring its own stock is a close corporation, the purchase is subject to the

additional requirement that the stockholders who caused the corporation to enter into the stock purchase agreement must have acted with the utmost faith and loyalty to other shareholders

i. To meet this test, the controlling shareholders must cause the corporation to offer each stockholder an equal opportunity to sell a ratable number of shares to the corporation at an identical price.

o Here, Rodds are treated as a single controlling group because they have a strong community of interest on its face, the purchase of Harry’s shares is a breach of the duty which the controlling shareholders owed to the minority shareholders, so Donahue is entitled to relief

Commentso Potential conflicts of interest that are particularly troubling in the context of a close corporation

i. Majority shareholder group employing itself and paying itself salariesii. Entering into contracts with itself

iii. Repurchasing shares from majority shareholders (because part of the minority’s interest is coopted into paying out to the majority shareholders in exchange for the majority’s shares)

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o Note: the $800 per share price that Rodd sold at was a good deal for the company, because book value and liquidation value is almost always less than the value of the company as a going-concern

Smith v. Atlantic Properties Inc (Mass App. 1981) Facts

o Wolfson purchases land for $50,000, then sets up Atlantic Properties, Inc., with equal shares for Smith, Zimble, and Burke who each contribute $12,500.

o Wolfson puts in a charter provision requiring an 80% shareholder vote to approve any action, effectively giving each of the four shareholders veto power. Wolfson testifies that he included the provision to prevent the others from “ganging up” on him.

o Atlantic Properties does well, but Wolfson continually vetoes the payment of any dividends (preferring to allocate toward repairs/ improvements of property) partially for tax reasons and partially due to personal animosity with the other shareholders.

o Wolfson is warned about the likelihood of penalty taxes being assessed, but still refuses to issue dividends. IRS assesses penalty taxes totaling approximately $40,000 for unreasonable accumulation of corporate earnings and profits, levying the fees in 1962, 1963, 1964, 1965, 1966, 1967, 1968

o Smith, Zimble, and Burke bring suit to remove Wolfson as a director and to have him reimburse Atlantic for the penalty taxes and related expenses.

o Trial court finds that Wolfson breached his fiduciary duty and holds him liable for the penalty taxes Issue

o What is the extent that the minority veto power may be exercised as its holder may wish without violating the fiduciary duty of Donahue

Ruleso Close corporation shareholders may not act out of avarice, expediency, or self-interest in derogation of their

duty of loyalty to other shareholders and to the corporation Reasoning

o The minority, by virtue of the 20% veto provision, becomes an ad hoc controlling interesto Wolfson refused to vote dividends in any amount adequate to minimize the danger and failed to bring forward a

convincing definitive program of appropriate improvements which would satisfy the IRS Holding

o Whatever may have been the reason for Wolfson’s refusal to declare dividends, he recklessly ran serious and unjustified risks of precisely the penalty taxes assessed

i. These risks were inconsistent with any reasonable interpretation of a duty of ‘utmost good faith and loyalty’

1. Maybe because there were less harmful ways to achieve his individual goals Comments – although the 3 could have dissolved the corporation, this would have destroyed wealth (no more going-

concern value) so it’s not a good solution

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VI. SHAREHOLDER LAWSUITS

A. Overview

Types of shareholder suits1. Derivative suits

An assertion of the corporate claim against an officer or director or 3rd party, charging them with a wrong to the corporation represents 2 suits in 1:

o Charging directors with improperly failing to sue on an existing corporate claimo Charging according to the underlying claim of the corporation itself

Damages go to the corporation (+ legal fees for lawyers if they win)2. Direct suits (class actions)

An assertion of an individual claim for damages suffered by individuals directly (or to prevent such individual damage) because they are a shareholder

Damages go to individual shareholders directly

Which type of suit is appropriate?Determining whether a claim is derivative or direct turns solely on

Who suffered the alleged harm (the corporation or the suing shareholders) Who would receive the benefit of any recovery or other remedy (the corporation or the stockholders individually)

o a ‘special injury’ is not necessary for a derivative action anymore

Ex: interference with voting rights affects the shareholders directly (i.e. as shareholders), so it’s a direct suit.

Payment of Attorney’s Fees The successful plaintiff in a derivative suit may be awarded attorneys’ fees against the corporation if the corporation

received “substantial benefits” from the litigation, (benefits don’t have to be monetary, and there is no requirement for a ‘final judgment’ so settlements count). Fletcher v. AJ Industries

To find that benefits were sufficiently substantial, it is enough to find that the results of the action 1) “maintain the health of the corporation and 2) either raise the standards of ‘fiduciary relationships and of other economic behavior’” or ‘prevent an abuse which would be prejudicial to the rights and interests of the corporation or affect the enjoyment or protection of an essential right to the stockholder’s interest

o An award of attorneys’ fees to a successful plaintiff may be properly be measured by, and paid from, a common fund where his derivative action on behalf of a corporation has recovered or protected a fund in fact; but the existence of a fund is not a prerequisite of the award itself

Case Summaries

Fletcher v. AJ Industries (Cal App. 1968) Facts

o Shareholders of A. J. Industries bring a derivative suit against the company and its directors alleging domination by Ver Halen and excessive salary to Malone that resulted in damage to the corporation.

o Plaintiffs’ lawyers negotiate a settlement that (a) reduced Ver Halen’s influence over the board; (b) removed Malone as director and corporate treasurer; and (c) referred all monetary claims to arbitration.

o The settlement specified that plaintiffs’ attorneys could be awarded fees only if the corporation received a monetary award in the arbitration proceedings, but plaintiffs’ attorneys applied for fees anyway.

o Trial court granted plaintiffs’ attorneys’ fees & costs (totaling $67,000) because “substantial benefits had been conferred” upon the corporation by the settlement

Issueo Whether settlement confers enough of a benefit that it permits payment of the lawyers

Ruleso The successful plaintiff in a derivative suit may be awarded attorneys’ fees against the corporation if the

corporation received “substantial benefits” from the litigation, although the benefits were not pecuniary and the action had not produced a common fund from which they might be paid

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o To find that benefits were sufficiently substantial, it is enough to find that the results of the action “maintain the health of the corporation and raise the standards of ‘fiduciary relationships and of other economic behavior’” or ‘prevent an abuse which would be prejudicial to the rights and interests of the corporation or affect the enjoyment or protection of an essential right to the stockholder’s interest

Holdingo An award of attorneys’ fees to a successful plaintiff may be properly be measured by, and paid from, a

common fund where his derivative action on behalf of a corporation has recovered or protected a fund in fact; but

i. The existence of a fund is not a prerequisite of the award itselfo Settlement vs. final judgment distinction is not relevant for these purposeso Since trial court found the benefits to be substantial, and that the P’s action brought them about, the award

of attorney’s fees is upheld. Comments

o The substantial benefits test potentially introduces perverse incentives for lawyersi. The settlement may not confer benefits greater than the fees charged by the lawyers

o While including ‘saving litigation costs’ as a benefit makes sense ex post, it incentivizes lawyers to bring cases ex ante (thereby increasing overall litigation costs)

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B. Derivative Suits

Rules and Regulations*Note: settlement at any point requires court approval. See Carlton Investments for the test on adequacy

FRCP Rule 23.1 Standing Requirements

o Plaintiff must be a shareholder for the duration of the action (the main bite here is in the context of mergers and dissolutions, because P are no longer shareholders as the corporation no longer exists)

o Plaintiff must have been a shareholder at the time of the alleged wrongful act or omissiono Plaintiff must ‘fairly and adequately’ represent the interests of shareholders (i.e. there are no obvious

conflicts of interests) Judicial Screening of Suits

o The complaint shall also allege with particularity the efforts, if any, made by the P to obtain the action the P desires from the directors and, if necessary, from the shareholders/ members, and the reasons for the P’s failure to obtain the action or for not making the effort .

Settlement Requirements – action shall not be dismissed or compromised without court approval, Alternative standing requirements: RMBCA §7.41, ALI Principles of Corporate Governance §7.02

If Demand is Made (note: due to Spiegel, demand is almost never made in Delaware) In Delaware, making a demand on the board concedes the point that the board is independent and disinterested. Spiegel

o If demand is made and refused, the only option for the shareholder is to allege that this refusal itself constitutes a breach of the duty of loyalty or gross negligence such that it should be enjoined. Spiegel

This basically leads to universal non-demand in Delaware.

Whether Demand is Required – Aronson/ Levine Demand Futility Test Demand is excused if the Ch. Court believes there to be a reasonable doubt (based on particular facts alleged) that either:

(1) the directors are disinterested and independent, and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.

Hence, the Court of Chancery must make two inquiries, one into the independence and disinterestedness of the directors and the other into the substantive nature of the challenged transaction and the board’s approval thereof.”

o This is a disjunctive test: if there is reasonable doubt as to either, then demand is excused. Levine v. Smitho Allegation that board is not independent can’t just be conclusory. Levine v. Smith

But 2nd Prong doesn’t apply when the board considering the demand didn’t make the action being challenged. Rales v. Blasband Where there is no conscious decision by directors to act or refrain from acting, the business judgment rule has no

application. Aronson . Arises in 3 situations (Rales v. Blasband)1. Where the business decision was made by the board of a company, but a majority of the directors making

the decision have been replaced2. Where the subject of the derivative suit is not a business decision of the board3. Where the decision being challenged was made by the board of a different corporation (Ex: double

derivative suit - stockholder of parent corp. seeks recovery for action taken by subsidiary) In these situations, it is appropriate to examine:

o whether the Board that would be addressing the demand can impartially consider its merits without being influenced by improper consideration (basically, is this board disinterested and independent)

*Note: a good way to get around the demand requirement is to allege a Caremark claim against any independent directors, which kills their status as ‘disinterested’ (sustained or systematic failure of the board to exercise oversight… that establishes

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Delaware Derivative Suit Tree

the lack of good faith that is a necessary condition to liability… i.e. failure to implement a monitoring system) this is what P did in In Re Oracle

After Demand is Excused If there’s no SLC, suit proceeds If there is a (new) SLC and

o it recommends bringing the suit suit proceedso it settles the case court must approve settlement; if it does, it’s entered into judgment (for attorney’s fee

discussion, see the shareholder litigation overview section on page 79 of this outline.o It recommends dismissing the suit…. See below

If SLC recommends dismissal (Zapata 2-Step) Zapata Corp v. Maldonado (Del. 1981)The Court must

Step 1) inquire into the independence and good faith of the committee and the bases supporting its recommendation on whether to bring dismiss P’s claim. . .

Step 2) Apply its own independent business judgment as to whether the SLC’s motion should be granted.”o 2nd step is discretionary (Kaplan)

Note: SLC gets its power from board’s ability to delegate its authority under DGCL §141(c)

Zapata Step 1 – Inquiry into independence and good faith Burden of proof is on corporation to prove SLC’s independence, good faith, and reasonable investigation “by a

yardstick that must be above reproach” Beam v. Martha Stewart (Del Ch 2004) Substantive inquiry into impartiality

o Independence turns on whether a director is, for any substantial reason, incapable of making a decision with only the best interests of the corporation in mind (focuses on impartiality and objectivity) In Re Oracle (Del. 2003)

o If there is a reasonable doubt as to impartiality, the claim should proceed subject to Step 2.o Zapata requires independence to ensure that stockholders do not have to rely upon SLC members who must

put aside personal considerations that are ordinarily influential in daily behavior in making the already difficult decision to accuse fellow directors of serious wrongdoing. In Re Oracle (SLC can’t be vulnerable to social pressures not to prosecute)

Zapata Step 2 – Court’s Exercise of its own Business Judgment (varies depending on the court) Active Involvement. Joy v. North (2nd Circ. 1982)

o The wide discretion afforded directors under the BSJR doesn’t apply when SLC recommends dismissal o Burden is on the SLC to prove that letting the suit proceed is not in the corporation’s best interest.o Where the court determines that the likely recoverable damages discounted by the probability of a finding

of liability are less than the costs to the corporation in continuing the action , it should dismiss the caseo Costs properly considered are

Attorney’s fees and out-of-pocket expenses related to the litigation and time spent by corporate personnel preparing for and participating in the trial

Court should also weigh indemnification which is mandatory under the bylaws, private contract, or State Law, discounted by the probability of liability for such sums.

Court should not weigh cost of D&O insurance since premiums have already been paido If net return to corporation is substantial in relation to shareholder equity, suit must proceedo If net return to corporation is positive but insubstantial in relation to shareholder equity, Court may taken

into account 2 other items as costs: impact of distraction of key personnel by continued litigation, and potential lost profits which may result from the publicity of trial

o If net return to corporation is negative, suit should be dismissed Reluctance to Hazard a BSJ. Kaplan suggests that court performing independent BSJ under Step 2 is discretionary

Settlement Review. Carlton Investments v. TLC Beatrice International Holdings Inc

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Court does not attempt to make substantive determinations concerning disputed facts or the merits of the claims alleged… the court must consider whether the proposed settlement is fair and reasonable in light of the factual support for the alleged claims and defenses in the discovery record before it

As long as proposed settlement falls within a range of reasonable solutions to the problem presented, it will be approved

Policy Implications

ALI Principles of Corp Gov. §7.04 establishes a universal demand requirement. If board refuses, shareholder can still bring the suit if upon review a court finds that the board was not in a position

to make a valid business judgment (i.e. not indep)Advantage of the universal demand requirement is that it should reduce the burden on courts (since any claims that the board would bring are eliminated and those that are refused now have a bigger body of evidence)

Disadvantage is that it places the cost and time burden of dealing with these demands on the Board

MBCA §7.42 establishes universal demand requirement, doesn’t allow for shareholder to file until 90 days after demand is made, or after rejection (whichever is sooner) or anytime after demand is made on board if delay would result in irreparable harm to the corporation.

How can a corporation find truly independent people? It’s probably true that selecting SLC from among existing directors doesn’t work (as there is already a social

thickness with the rest of the Board) Seek out people from the opposite coast (who aren’t part of the social network with the defendants)

What is the purpose of derivative suits? In almost all cases, directors are indemnified or covered by D&O insurance, and if the case goes to trial, it’s unlikely

that D will have enough money to pay the damages. 1 study found that there were only 4 instances of directors actually having to dig into their own pockets The purpose is reputational cost. if a director is sued and a large settlement is entered, he loses reputation and will

serve on fewer boards of directors (and might even get voted out)

Case Summaries

Levine v. Smith (Del. 1991) Facts

o In 1984, GM buys EDS from Ross Perot’s in a stock transaction that makes Perot GM’s largest shareholder, with 0.8% of its stock, and puts Perot on GM’s board.

o As Perot discovers how GM is run, he causes trouble – first internally, then criticizing GM publicly for making “second rate cars.”

o GM pays Perot $742 million in exchange for: his GM stock, notes, and an agreement not to wage a proxy contest or to publicly criticize GM’s management.

i. Deal is approved by a three-person subcommittee of the board, and then by the full (22-person) board minus Perot.

Historyo Shareholders bring derivative action claiming breach of fiduciary duty; argue that demand is excused

because it would have been futile.o Chancery Court rejects the demand futility claim because (a) plaintiffs did not plead particularized facts

sufficient to create a reasonable doubt as to the independence of the GM board, and (b) did not rebut the presumption that the decision was an exercise of valid business judgment.

Issueo Whether there’s a breach of fiduciary duty by the Board in approving the payment to Perot

Ruleso Directors, not shareholders, manage the business and affairs of a corporation

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o In determining the sufficiency of a complaint to withstand dismissal under FRCP 23.1 based on a claim of demand futility, trial court must determine whether 1) threshold presumptions of director disinterest or independence are rebutted by well-pleaded facts; and if not, whether 2) the complaint pleads particularized facts sufficient to create a reasonable doubt that the challenged transactions is protected under the BSJR

Holdingo Plaintiffs’ conclusory claim that GM outside directors are so manipulated, misinformed, misled that they

were subject to management’s control and are unable to exercise independent judgment are unsupported by particularized facts (i.e. even if 2 of the 14 indep. directors were compromised, it’s not enough, because the other 12 were still independent)

o Allegations that directors were uninformed about the Perot buy-out because they were misled out the buyout and 2 of the 14 directors’ testimony suggested they had misimpressions are not sufficient to show that it wasn’t a valid exercise of business judgment.

Commentso If the Board is independent, we still care whether the challenged transaction is a valid exercise of business

judgment because even if the Board is now independent, there are reasons that suits should be brought i. Implicitly tells the Board to allow these claims

o Stated rationale of demand requirement is to protect the Board’s business decision not to bring suit on a claim

Rales v. Blasband (Del. 1993) Facts

o Shareholder/plaintiff Blasband owns stock in Easco Handtools, a company that is controlled and managed by the Rales brothers (well-known takeover artists).

o Rales Brothers do a public debt offering of $100 million in notes, officially to finance investments, but they instead invest the proceeds in Drexel junk bonds at a time when Drexel is on its last legs and the DOJ is hot on Milkin’s trail.

o The suit alleges breach of the duty of loyalty -- the investment is the quid pro quo for Drexel’s past favors for the Rales brothers personally, in helping them finance their earlier takeovers with junk bonds.

o Shortly after the deal but before the shareholder suit, the Rales brothers merge Easco into a subsidiary of Danaher, which they also control.

o So at the time the suit is brought, the shareholder/plaintiff is no longer a shareholder of Easco but is instead a shareholder of Danaher.

o The Rales brothers own 44% of Danaher, but all they do now is sit on the board, along with six others. Issue – whether demand is excused Rules

o Where there is no conscious decision by directors to act or refrain from acting, the business judgment rule has no application. Aronson

Reasoningo In a double derivative suit, a stockholder of a parent corporation seeks recovery for a cause of action

belonging to a subsidiary corporationo The Danaher board did not approve the transaction being challenged by Po The second prong of Aronson is trying to get at the situation where a Board is asked to review its own

previous business judgment; where the Board is deciding to bring a claim against something that was done by a different Board, the current Board doesn’t necessarily lack independence

Holdingo Court should not apply Aronson demand futility test where the board considering the demand did not make

a business decision which is being challenged in the derivative suit. Arises in 3 situations1. Where the business decision was made by the board of a company, but a majority of the

directors making the decision have been replaced2. Where the subject o the derivative suit is not a business decision of the board3. Where the decision being challenged was made by the board of a different corporation

o In these situations, it is appropriate to examine whether the Board that would be addressing the demand can impartially consider its merits without being influenced by improper consideration

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i. A plaintiff in a double derivative suit fits in #3, but must still meet the Aronson test to establish that demand is futile (it’s just that only the first prong applies)

Ruleso The task of a board in responding to a shareholder demand letter is a 2-step process

i. Must determine the best method to inform themselves of the facts relating to the alleged wrongdoing and considerations (legal and factual) bearing on a response to the demand

1. If a factual investigation is required, it must be conducted reasonably and in good faithii. Must weigh the alternatives available, including the advisability of implementing internal

corrective action and commencing legal proceedingsIn carrying out these tests, the board must be able to act free of personal financial interest and improper

extraneous influences Reasoning

o Here, the Rales brothers and Caplin are interested (because a decision by the Board to bring suit against the Easco directors could have potentially significant financial consequences for those directors)

o Complaint includes allegations of particularized facts that the remaining Easco directors are beholden to the Rales brothers

Holdingo Under the ‘substantive law’ of Del., the Aronson test doesn’t apply in the context of a double derivative suit

because the Board was not involved in the challenged transactiono The appropriate inquiry is whether the amended complaint raises a reasonable doubt regarding the ability of

a majority of the Board to exercise properly its business judgment in a decision on a demand had one been made at the time this action was filed.

Zapata Corp. v. Maldonado (Del. 1981) Facts

o Plaintiff files a derivative suit in Delaware; demand is excused, and four years into the litigation, the Zapata board appoints two new independent directors who serve as an SLC.

o The SLC investigates the action -- and like virtually all SLCs, it recommends that the court dismiss the suit.o Chancery Court rules that shareholders have an independent, individual right to continue a derivative suit

for breaches of fiduciary duty, even if the corporation does not want to. Rules

o A stockholder cannot be permitted to invade the discretionary field committed to the judgment of the directors and sue in the corporation’s behalf when the managing body refuses

o A board decision to cause a derivative suit to be dismissed as detrimental to the company after demand has been made and refused, will be respected unless it was wrongful. Absent a wrongful refusal, the stockholder in such a situation simply lacks legal managerial power.

o Board can delegate its authority to the committee §141(c) Reasoning

o The Board as a whole was not independent (which is why demand was excused), and the remaining independent directors were selected by the Board and they may be sympathetic to the Board

i. The interest taint is not a per se legal bar to delegation of Board powers to the Committee o You don’t want to make it too easy for corporations to fix problems with the Board ex posto At the demand stage, there was little information available that would enable the Court to review the

Committee’s decision, but here there’s already been discovery and the merits of the case of clearer (so the Court is in a better position to review the decision of the Special Committee supports more invasive scrutiny)

o Whether the Court of Chancery will be persuaded by the exercise of a committee power resulting in a summary motion for dismissal of a derivative action, where a demand was not initially made, should rest in the independent discretion of the Court of Chancery

Holdingo “First, the Court should inquire into the independence and good faith of the committee and the bases

supporting its conclusion. . . i. The corporation should have the burden of proving independence, good faith, and a reasonable

investigation.”

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o “[Second,] . . . the court should determine, applying its own independent business judgment, whether the motion should be granted.”

Commentso 2nd step is discretionary (Kaplan)

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In Re: Oracle Corp. Derivative Litigation (Del. Ch. 2003) Facts

o Derivative complaint alleges insider trading by four Oracle directors: Ellison, Henley, Lucas, & Boskin.o Oracle appoints Profs. Grundfest and Garcia-Molina from Stanford to the board as a two-person SLC with

complete authority to respond to the litigation.o SLC produces 1,110 report concluding that Oracle should not pursue the plaintiffs’ claims against the

defendant directors.o Plaintiffs challenge independence of the SLC in Delaware Chancery Court.

Ruleso SLC bears the burden of proving there is no material fact calling into doubt its independenceo Independence turns on whether a director is, for any substantial reason, incapable of making a decision

with only the best interests of the corporation in mind (focuses on impartiality and objectivity)o SLC must persuade the Court that

i. Its members were independentii. That SLC members acted in good faith

iii. That the SLC had reasonable bases for their recommendationsAt this point, Court can then use its own discretion to review whether terminating the suit is in the best interest of the company

Reasoningo Although Grundfest and Garcia-Molina may be impeccably disinterested, they have extensive ties to Oracle

via Stanford (because Oracle, Ellison, and Ellison’s foundations all donate lots of money to Stanford)i. Corporate directors are generally the sort of the people deeply enmeshed in social institutions;

social institutions have norms, and some things ‘just aren’t done’ii. The law cannot assume, absent proof, that corporate directors are generally persons of unusual

social bravery, who operate heedless to the inhibitions that social norms generateiii. Accusing someone of wrongdoing in this context creates social discomfort (and thus, Grudfest and

Garcia-Molina may be somewhat disinclined to incur the social costs of accusing Ellison)iv. In the SLC context, the weight of the moral judgment falls on less than the full board, and with an

SLC of 2 people, the moral gravity is magnified Holding

o SLC has not met its burden to show the absence of a material factual question about its independence because the ties among the SLC, the trading defendants, and Stanford are so substantial that they cause reasonable doubt about the SLC’s ability to impartially consider whether the Trading Defendants should face suit.

o Zapata requires independence to ensure that stockholders do not have to rely upon SLC members who must put aside personal considerations that are ordinarily influential in daily behavior in making the already difficult decision to accuse fellow directors of serious wrongdoing

Commentso How did the P get past the demand test? In addition to the insider trading allegation, P also alleged a

Caremark claim against the rest of the Board for failing to adequately monitor the actions of the primary 4 defendants

Carlton Investments v. TLC Beatrice International Holdings Inc (Del Ch. 1997) Facts

o Reginald Lewis does an LBO of Beatrice Foods with the help of some banks. Lewis ends up with 45% of Beatrice and banks get 20%.

o Beatrice pays Lewis $19.5 million in compensation payment just before he dies. o One of the big bank shareholders brings derivative suit alleging self-dealing and waste. o The company appoints an SLCo SLC negotiates a settlement for Lewis’s estate to pay Beatrice $14.9 million plus interest in installment

payments over seven years.o Plaintiff objects to the settlement and brings suit in the Delaware Chancery Court

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Ruleso Under Delaware law in reviewing proposal settlements generally, in evaluating a proposed settlement, this

court does not attempt to make substantive determinations concerning disputed facts or the merits of the claims alleged… the court must consider whether the proposed settlement is fair and reasonable in light of the factual support for the alleged claims and defenses in the discovery record before it

Holdingo SLC and its counsel proceeded in good faith throughout the investigation and negotiation of the proposed

settlemento Conclusions reached by SLC that were the basis of the settlement amount were well informed by the

existing record.o Proposed settlement falls within a range of reasonable solutions to the problem presentedo To the extent Judge is required to form an independent judgment concerning the merits of the settlement,

Judge finds its close to the mark and thus lets it stand

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VII. CONTROLLED TRANSACTIONS

A. Sale of Control

2 Ways to Acquire Control Acquire an existing controlling bloc of shares (subject to market rule Zeitlin, and DGCL §203 Digex) Acquire enough non-controlling shares to create a controlling bloc (tender offers are on p. 93)Note: Sales of corp. office are not allowed (Brecher), but sales of control leading to change in officers are ok (Carter v. Muscat)

Rules and Regulations

US Default (market rule) – seller of a control bloc has no duty to minority shareholders (Zeitlin v. Hanson Holdings, NY 1979) Absent a looting of corporate assets (Harris – if red flag, duty towards shareholders arises), conversion of a

corporate opportunity (Perlman), fraud, or other acts of bad faith (Brecher), a controlling stockholders is free to sell, and a purchaser is free to buy, that controlling interest at a premium price.

Minority stockholders are not entitled to an opportunity to share equally in any premium paid for a controlling interest in the corporation (i.e. there doesn’t have to be a tender offer)

In Delaware, actions of controlling shareholders are also constrained by DGCL §203, which requires a 3 year waiting period before a cash-out merger, unless there’s a supermajority or majority of minority vote. Point is that the controlling shareholder can’t waive this requirement unless he gets value for all shareholders in exchange (i.e. can’t capture the full benefit himself)

o Alternative equal opportunity rule (not adopted) – control premium must be shared with all shareholders if it is clear that it was a sale of a corporate opportunity (Perlman v. Feldman)

o Feldman is probably only a carve-out for strange situations in which the US government is fixing price ceilings. I.E. In a time of market shortage, fiduciary may not appropriate to himself the value of this premium

DGCL §203 – prevents a party purchasing control of a Delaware corporation from pursuing a cash-out merger to eliminate minority shareholders for 3 years, unless the seller’s board approves ex ante (or if i) controller has 85% of voting stock of the company whose minority shareholders are being cashed out, or ii) the cash out is approved by 2/3 of the minority shares outstanding) (note: shares held by directors who are also officers are excluded from the ‘shares outstanding’ denominator)

Controller is entitled to use its voting power as a shareholder to block a deal between the subsidiary and the acquirer. Digex Failure to extract something in exchange for a §203 waiver might violate the board’s burden to show entire fairness

o The extraction of a price for a §203 waiver must benefit Digex as a corporation, not just the controlling SH – i.e. the minority shareholders must share in the benefit) In Re Digex

Controller is not entitled to pressure the subsidiary board to waive DGCL §203 In Re Digex

Sale of Office is not ok, unless the sale of shares is enough to confer control In Carter v. Muscat, shareholder sells 9.7% block of stock at slightly above market price and arrange for current

directors to resign and appoint in their place purchasers of the 9.7% block. Court upholds this against challenge that this is a sale of office requiring premium to be shared.

In Brecher v. Gregg, same thing but it is a 4% shareholder (CEO) selling at a large premium and promising to secure the election of the buying shareholder’s directors and secure the presidency for the buyer. Court strikes down and forces the disgorgement of the control premium.

o How to distinguish these? The 9.7% is actually enough to be a controlling interest so in Carter all that happened was the buyer got their directors in early. The 4% block in Brecher by contrast was not enough to carry control over the board, so the premium was basically a bribe to the current CEO to resign and secure as his replacement somebody else—CEO was selling his power as an officer not as a shareholder

o The CEO violated his duty of loyalty to the corporation when he took a payment to put someone on the board. Problem here is that if you can acquire control with only a small economic stake in the company,

you have less reason not to extract private benefit (misalignment of interests)

Looting. A controlling shareholder can be liable for looting if he negligently sells his controlling share to a looter (even if he has harmed by the sale as well) Harris v. Carter (Harris sold to looter in exchange for worthless shares… can still be held liable to minority SH)

Controller is under a duty not to transfer control to outsiders if the circumstances surrounding the proposed transfer are such as to awaken suspicion and put a prudent man on his guard – unless a reasonably adequate investigation

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discloses such facts as would convince a reasonable person that no fraud is intended or likely to result. Harris v. Carter, quoting Insuranshares Corporation (E.D. PA 1940)

Policy Implications

What does control mean in the context of a corporation? The proportion of votes you need in order to dominate the Board, given the distribution of ownership in the market

o In a widely held company, a 15% share would likely do it (certainly 20%, and maybe 10%) In a very widely held company, the locus of control is in the management

Why do control blocs command a premium? Beneficial story

o The controller can implement synergies between their own activities and those of the firm (creating higher profits for both parties)

o The acquirer can fire management and replace them with better people (making the firm more profitable) Negative story

o Controller can take the private benefits of control (high salaries, corporate apartments and travel, loans to the controller, other perks)

o Controller can enter into self-dealing contracts (steering output to another firm owned by the controller at below-market prices)

Unclear Which Rule is Better Generally, but in the US, the Market Rule is Best Market Rule allows looters to acquire the firm, but also allows efficiency gains Equal Opportunity Rule prevents looters from gaining control, but also locks in inefficient management In the US, where other anti-looting rules exist, the Market Rule is probably best . As Easterbrook and Fischel

illustrated, even in the Feldman case, the premium was probably due to Westport’s ability to more efficiently manage Newport, as evidenced by the rise in Newport’s prices after the acquisition.

Alternative Restraints on Taking Private Benefit Derivative action Duty of Loyalty (Fairness review of transactions) Securities Laws Disclosure requirements

Reason that Controlling Premia are higher outside the US More synergies that can be had (easier to add value to existing companies) Quality of protection of minority shareholders varies (higher premia reflects higher ability to extract private benefits)

If the reason there is a control premium is mostly the private benefit explanation, we might want to put a duty on the seller to not sell to those purchasers likely to engage in looting, etc

Note: this is not a corporate transaction doctrinally, it’s a big step to impose fiduciary duties in the context of a private transaction

So, the better way to prevent the private benefit taking would be to prevent the looting directly

European Takeover Directive, Art 5 A person who acquires > [30%] of a publicly-traded corporation must make an offer to all shareholders at the

highest price paid for target shares over previous 6-12 months (This is the “Equal opportunity rule” that was rejected in Zetlin)

Inefficient Sale Efficient Sale

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Case Summaries

Zeitlin v. Hanson Holdings Inc. (NY 1979) – market rule for sale of control Facts

o Hanson Holdings and Sylvestri family together own 44.4% of Gable Industries, and sell their controlling block to Flintkote Co. for $15 per share at a time when the Gable stock is selling for $7.38 per share.

o Minority shareholder Zetlin brings suit challenging the transaction, claiming that minority shareholders should have an equal opportunity to share in any premium paid for a controlling interest.

o New York Court rejects equal opportunity rule: “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 price.”

Ruleso Absent a looting of corporate assets, conversion of a corporate opportunity, fraud, or other acts of

bad faith, a controlling stockholders is free to sell, and a purchaser is free to buy, that controlling interest at a premium price

Holdingo Minority stockholders are not entitled to an opportunity to share equally in any premium paid for a

controlling interest in the corporation (i.e. there doesn’t have to be a tender offer)

Perlman v. Feldman (1955) – equal opportunity rule for sale of control Facts

o Setting: Korean War, steel shortage, semi-official price freeze and rationing of steel supply.o Feldmann is director, CEO, and controller of 37% of Newport Steel shares. Sells his stake to Wilport

Syndicate for $20 per share when the stock is trading at $10-$12. Feldmann resigns with his directors to allow Wilport to take control of the board. (premium of 80-100%)

o Shareholders bring suit alleging that Feldmann sold a corporate opportunity (control over steel supply) for personal gain, which the company could have used for its advantage (e.g., through the “Feldmann Plan”), in violation of his fiduciary duty to the corporation.

o Feldmann plan was to require buyers to give Newport Steel interest-free loanso Trial court finds that $20 per share was a reasonable value for a controlling block and rules for Feldmann

Issueo Whether sellers must account to the non-participating minority stockholders for that share of their profit

attributable to the sale of the corporate power Rules

o Corporate opportunities of whose misappropriation the minority stockholders complain need not have been an absolute certainty; if there was a possibility of corporate gain, they are entitled to recovery

o Defendant has the burden of proof on the issue of whether their dealings were fair to the corporation Holding

o When the sale necessarily results in a sacrifice of this element of corporate good will and consequent unusual profit to the fiduciary who has caused the sacrifice, he should account for his gains

o In a time of market shortage, a fiduciary may not appropriate to himself the value of this premiumo Case is remanded to the District Court to determine the value of the controlling stock stripped of its ability

to direct output toward Wilport.o Plaintiffs are entitled to a direct recovery, because neither Wilport nor its successors should share in any

judgment against Feldmann Comments

o Some commentators say that this case stands for the ‘equal opportunity’ doctrineo The reason that Perlman didn’t sue Wilport is that it would be hard to argue that Wilport has deprived

Newport of a corporate opportunity (given that the interest-free loans may have been illegal)i. It’s easier to sue the seller for cashing out the benefits of control

o Can be remedied with Zeitlin in 2 waysi. Where there is a corporate opportunity that the purchaser can exploit better than the vendor, the

minority shareholders are entitled to recovery

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ii. Or, it’s just a weird doctrine that applies when the government fixes prices (i.e. carve-out from Zeitlin)

In Re: Digex Inc Shareholders Litigation (Del. Ch. 2000) – premium gained by waiving §203 must be shared with minority SH Facts

o Intermedia owns 52% of Digex’s outstanding stock, 94% of its voting power, and controls the Digex board.o Intermedia seeks to sell its Digex stake; Digex board appoints a Special Committee of independent

directors to review potential transactions. Worldcom is originally interested, but at the last minute changes its bid to acquire Intermedia instead of Digex.

o Because Worldcom would be an “interested stockholder” of Digex after acquiring Intermedia, Worldcom sought a waiver of DGCL §203, which prevents Worldcom from pursuing a freeze-out merger for three years.

o Digex board grants the waiver; Rules

o DGCL §203 – prevents a party purchasing control of a Delaware corporation from pursuing a cash-out merger to eliminate minority shareholders for 3 years unless the seller’s board approves ex ante (or if some other technical requirements are met)

Reasoningo Part of the premium being paid to Intermedia is to pay it to waive §203, and this is a breach of fiduciary duty.

Holdingo Controller is entitled to use its voting power as a shareholder to block a deal between the subsidiary and the buyer.o Failure to extract something in exchange for the waiver might violate the board’s burden to show entire

fairness (the extraction must benefit Digex – i.e. the minority shareholders)o Controller is not entitled to pressure the subsidiary board to waive DGCL §203

Harris v. Carter Facts

o Carter Group owns 52% of Atlas Energy; appoints an agent to find a buyer for its block. Agent introduces the sinister Mascolo Group, to whom Carter Group sell their stake in Atlas in return for shares in ISA owned by Mascolo. Pursuant to agreement, Carter directors resign from the Atlas board and Mascolo takes over.

o Minority shareholders bring suit against the Mascolo directors alleging that they looted all of Atlas’ assets: diluting minority interest in Atlas by issuing Atlas stock for worthless ISA stock; buying a worthless chemical company owned by Mascolo; and engaging in various other self-dealing transactions.

o Minority shareholders also bring suit against the Carter directors alleging that Carter should have been alerted by the suspicious financial statements that Mascolo offered for ISA, which plaintiffs allege that a “cursory investigation” would have revealed as worthless.

o Comes before the Chancery Court on a motion to dismiss Issue

o Is there a duty on the seller not to sell to suspicious buyers (or people with a history of looting) Rules

o Those who control a corporation (whether through majority ownership, or bloc ownership, or corporate officeholding, or management contracts, etc) owe some duty to the corporation in respect of the transfer of the control to outsiders. Insuranshares Corporation (E.D. PA 1940)

o Owners of control are under a duty not to transfer it to outsiders if the circumstances surrounding the proposed transfer are such as to awaken suspicion and put a prudent man on his guard – unless a reasonably adequate investigation discloses such facts as would convince a reasonable person that no fraud is intended or likely to result. Insuranshares Corporation (E.D. PA 1940)

o A shareholder has a right to sell his or her stock and in the ordinary case owes no duty in that connection to other shareholders when acting in good faith

o Unless privileged, each person owes a duty to those who may be foreseeably harmed by her action to take such steps as a reasonably prudent person would take in similar circumstances to avoid such harm to others (Tort Law)

Reasoning

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o That a shareholder may sell her stock is a right that is no different than the right a licensed driver has to operate a motor vehicle upon a highway. The right exists but it is not without conditions and limitations. (my note: bad analogy… it’s actually like giving your keys to someone else while there are passengers in the back seat)

Holdingo There is no universal privilege arising from the corporate form that exempts a controlling shareholder who

sells corporate control from the wholesome reach of this common-law dutyo While a person who transfers corporate control is not a surety for his buyer, but 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 should not be injured by wrongful conduct.

Commentso The liability imposed is a fiduciary duty,

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B. Tender Offers

1. Overview

Tender offer = offer of cash/securities to shareholders of public corp. in exchange for their shares at a premium over mkt. price Typically contingent in that the acquirer does not have to purchase any shares if less than the desired amount

(usually 51% or 85%) are tendered to the acquirer. May also be contingent on the management of the target not engaging in defensive tactics (ie redeeming a poison pill) If tender is oversubscribed, then shares are accepted on a pro rata basis: if 50% are desired and 100% are offered, each

offer of 2 will be accepted for 1.

Rules and Regulations

Early Warning System SEC §13(d), (alerts public and company’s mgmt when anyone acquires > 5% of firm’s voting stock. 13d-1(a) requires investors to file a 13D report within 10 days of acquiring 5+% beneficial ownership, EXCEPT:

o 13d-1(b) allows certain ‘qualified institutional investors’ to file a shortened 13G report in lieu of the 13D report within 45 days of year-end.

o 13d-1(c) permits passive but non-qualifying investors to file a 13G report in lieu of the 13D report within 10 days of acquiring their holdings

13d-2 requires shareholders to amend their 13D and 13G reports annually, or upon acquiring 10+%, or upon acquiring a material change (+/- 1%)

13d-5 defines a §13d group, subject to 13(d) rules as multiple shareholders who act together to buy, vote, or sell stock “beneficial owner” means power to vote or buy/sell stock (13d-3(a)); “group” is anyone acts together to buy, hold,

vote, or sell stock (13d-5(b)(1)). Each group member deemed beneficially to own each member’s stock.

Hart – Scott – Rodino Antitrust Improvements Act of 1976 Minimum waiting period before closing a transaction (§18a(b)(1)(B)):

o 30 days for open market transactions, mergers and negotiated deals;o 15 days for cash tender offers;o May be extended for another 30 days (10 days for cash tender offers) if DOJ or FTC makes a Second

Request (§18a(e)(2)) Who must file ((§18a(a)(2)):

o The acquirer in all deals > $212 million;o An acquirer with assets or sales > $106 million and a target with assets or sales > $11 million (or vice

versa), if the deal involves assets or securities > $53 million

Disclosure RequirementsSEC Rule 14d-1 and related provisions in §§13 and 14 of SEC Act mandate disclosure of the identity, financing, and future plans of a tender offeror, including plans for any subsequent ‘going-private’ transaction. (Covers freeze out)

Rule 14d-3 requires bidders to file and keep current 14D-1 reports for tender offers Rule 14e-2 requires the target’s board to comment on the tender offer Rule 13e-4 requires companies to make much the same disclosures as 3rd party offerors when these companies

tender for their own shares Rule 13e-3 mandates strict disclosure when insiders (including controlling shareholders) plan going-private

transactions that would force public shareholders out of the company

Anti-Fraud Provision – see ‘Trading in Corporation’s Securities for more detail on 14e-3 §14(e) prohibits misrepresentations, nondisclosures, and any fraudulent, deceptive, or misrepresentative practices in

connection with a tender offer Rule 14e-3 bars trading on insider information in connection with a tender offer

Regulations on substantive terms of tender offers (Rule 14(d)4-7 and 14(e) Withdrawal Rights: shareholder who tenders has right to withdraw any time while offer remains open. Rules 14d-4-7 Pro rata rule: Where shares tendered exceed scope of offer, acceptances must be pro-rated. Rule 14d-8 Bidder must open the tender offer to all shareholders and pay all who tender the same ‘best price’ (Rule 14d-10) Offer must be left open for at least 20 days. Rule 14e-1

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Policy Implications

Timing of 13D filing (see early warning system), and why does it matter? Price of target stock rises a lot between day -10 and day 0 (announcement day), because the bidder is buying up as

much as it can during this 10 day period.o Accelerates buyer’s acquisition of stock as soon as it obtains 5% (i.e. once the disclosure is triggered)o Outcome is that the buyer must pay more

Speculators see the potential for a future premium, (if they can buy after the filing but before a bid is announced, they can capture the premium)

Gives incumbent board time to seek out an alternative suitoro Hopefully eliminating the effects of coercive two-tier front-end-loaded offers

Outcome is that the buyer must pay more So, buyers don’t want to become beneficial owners until the very last minute

Equity Swaps Basic idea: a derivative transaction in which 1 party is put in the same economic position as if they had bought

shares. How it works: investment bank (IB) promises to pay hedge fund (HF) the returns HF would receive if HF had

bought (say) $100k worth of X Corp stock and held over a fixed period (equal to ‘difference in stock price + any dividends paid’). If returns are negative (i.e. if stock price falls), HF must pay IB.

HF promises to pay IB ‘interest’ which would accrue on $100k loan. Economic effect:

o Same as if HF borrows $100k from IB to buy the X Corp stock. Note: IB will buy $100k worth of X Corp stock to hedge its position.

o Because it doesn’t want to expose itself to the ‘upside risk’ of the underlying security (i.e. the rise in value + dividends)

o Basically, if IB buys the shares, it makes the transaction risk-free for the IB So, why do the parties do this?

o Might be cheaper than a loan (if IB can do something with the stock in the meantime to lower its carrying costs)o Might be tax, accounting, or regulatory benefits (Ex: may avoid beneficial ownership)

How do the substantive regulations level the playing field? 14e-1: Tender offers must be open for 20 business days

o Supposedly allows shareholders to think about whether they want to sell i. However, the presence of arbitrageurs allows shareholders to sell earlier

o Creates possibility for an auctiono Allows management to respond / defend the corporationNote: the timing requirement is less important since the advent of the poison pill

14d-10: Tender offers must be open to all holders; all purchases must be made at the best price o Can’t limit the tender to the first 50% of sellerso Can make an open offer for 50% of shares

i. 14d-8: Where shares tendered exceed scope of offer, acceptances must be pro-rated (i.e. if tender is for 100, and 200 shares are offered, then each offeror is allowed to sell 50% of his shares to the buyer)

14d-7: Shareholders who tender can withdraw while tender offer open o Supports the equal price rationale

14e-5: Bidder cannot buy “outside” tender offer

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2. What is a beneficial owner

What is a beneficial owner/ what constitutes a group? “Multiple shareholders who act together to buy, vote, or sell stock” 13d-5 Beneficial owner” means power to vote or buy/sell stock 13d-3(a) ‘Beneficial ownership’ extends beyond strict ‘legal right to purchase or sale’ to reasonable knowledge that someone

will buy or sell. CSX v. The Children’s Investment Fund LLP Where there is an existing relationship, patterns of interactions, preparations for a proxy fight, an informal

understanding regarding the voting , holding, or disposal of a stock is sufficient to find a group for the purposes of beneficial ownership. CSX v. The Children’s Investment Fund LLP

Case Summaries

CSX vs. TCI Facts

o Jan 2007: TCI enters into “total return swap” (TRS) contracts with a group of investment banks, referenced to a total of 14% of CSX common stock.

i. These replicate for TCI the economic returns associated with holding CSX stock without actually owning it. Counterparties invariably hedge by purchasing CSX stock.

ii. None has more than 5%. Contracts may be settled in cash or in kind (i.e. by transfer of underlying stock).

o Feb 2007: TCI tells CSX that it “owns” 14% of CSX; that there are “no limits” to what it will do to make CSX do what it wants.

o March 2007: TCI tells other hedge funds to “buy CSX”, but steps in to curb enthusiasm of 3G, fearing heavy buying will alert the market.

o Dec 2007: TCI and 3G file a Schedule 13D disclosing 8.3% ownership of CSX common stock between them; then launch a proxy fight.

o CSX argues that (i) TCI’s total return swaps made it “beneficial owner” of 14% in Jan 2007; (ii) TCI and 3G had formed a “group” in March 2007

Ruleso SEC defined ‘beneficial ownership’ in Rule 13d-3, which provides in relevant part:

i. (a) For the purposes of sections 13(d) and 13(g) of the Act a beneficial owner of a security includes any person who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or shares:

1. (1) Voting power which includes the power to vote, or to direct the voting of, such security; and/or,

2. (2) Investment power which includes the power to dispose, or to direct the disposition of, such security.

ii. (b) Any person who, directly or indirectly, creates or uses a trust, proxy, power of attorney, pooling arrangement or any other contract, arrangement, or device with the purpose of [ sic ] effect of divesting such person of beneficial ownership of a security or preventing the vesting of such beneficial ownership as part of a plan or scheme to evade the reporting requirements of section 13(d) or (g) of the Act shall be deemed for purposes of such sections to be the beneficial owner of such security.

o The beneficial ownership “inquiry focuses on any relationship that, as a factual matter, confers on a person a significant ability to affect how voting power or investment power will be exercised, because it is primarily designed to ensure timely disclosure of market-sensitive data about changes in the identity of those who are able, as a practicable matter, to influence the use of that power.” SEC v. Drexel Burnham Lambert Inc., 837 F.Supp. 587, 607 (S.D.N.Y.1993).

Reasoningo The SEC intended Rule 13d-3(a) to provide a “broad definition” of beneficial ownership so as to ensure

disclosure “from all those persons who have the ability to change or influence control.”o Purpose of 13d is to require disclosure and provide time for other parties/ the market to respond. If people

can get around this by engaging in complicated equity swaps, then 13d would have no purpose.

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o Rondeau does not foreclose the possibility relief such as sterilization for Section 13(d) violations, but it does make clear that a prerequisite to such relief is a showing of irreparable harm. Moreover, the determinative question is whether, absent an injunction, there would be irreparable harm to the interests which Section 13(d) seeks to protect-viz. “alert[ing] investors to potential changes in corporate control.” In consequence, private plaintiffs usually are unable to establish an irreparable harm once the relevant information has been made available to the public

Holdingo There doesn’t need to be a contractual obligation on the investment bank to go out and buy the shares; there

just needs to be knowledge by the HF that the IB will, as a practical matter, go out and buy the shareso Judge extends the concept of ‘beneficial ownership’ beyond a ‘legal right to purchase or sale’ to reasonable

knowledge that someone will buy or sello TGI and 3G constitute a group (as early as February 2007), because there was an existing relationship,

patterns of interactions, preparations for a proxy fight an informal understanding regarding the voting, holding, or disposal of a stock is sufficient to find a group for the purposes of beneficial ownership

i. Thus, TGI and 3G are each the beneficial owner of the stock that they own cumulatively Comments

o Purpose of this interpretation is to stop the use of equity swaps to get around 13D requirementso If the ‘informal understanding regarding the voting, holding, or disposal’ is enough to create a ‘group’, it

means that anytime an activist shareholder seeks out (and at least informally obtains) the support of other owners in a proxy fight, he would have to file a schedule 13D

Raises transaction costs, disincentivizes shareholder activism

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3. What is a tender offer

Eight factors to help determine whether an offer is a tender offer subject to the Williams Act (Wellman v. Dickinson)1. active and widespread solicitation2. for a substantial percentage of the target’s stock3. at a premium over the market price4. with firm rather than negotiable terms5. contingent on the tender of a fixed number of shares6. offer open for a limited time7. offerees subjected to pressure to sell8. buyer publicly announces an acquisition program

Each positive response weighs toward finding that it is a tender offer. Factors #7 and 8 are the most important. Brascan v. Edper Equities Ltd.

Not a tender: negotiated acquisition of existing control block Definitely a tender: open offer to acquire fixed amount of shares at a fixed price Gray areas:

o Creeping control acquisition on the open market (even if it’s just contacting 50 big institutional holders and 12 biggest individual holders) not a tender offer. Brascan

o Street sweep, calling up people who hold big chunks of shares in the name of individual investors (i.e. the brokerage houses) not a tender offer. Wellman v. Dickinson

Policy Implications

Creeping control is expensive & slow and leaves buyer holding shares even if they’re unsuccessful in gaining control, so it’s generally unattractive to buyers

If you make an offer that is contingent on acquiring control, you lower your risk

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Case Summaries

Wellman v. Dickinson (SDNY 1979, aff’d 2d Circ. 1982, cert. denied 1983) - street sweep is not a tender offer Facts

o Sun Company buys 34% of Becton, Dickinson in a “brilliantly designed lighting strike”: simultaneous phone calls to 30 large institutional shareholders and 9 wealthy individuals, at a fixed price substantially above market but left open only for one hour.

o “The lawyers indicated that the law regarding tender offers was still murky and that the concept of a tender offer had not been precisely defined. The lawyers wanted to structure a ‘privately negotiated’ transaction. Fogelson [of Wachtell, Lipton] and Charles Nathan of Cleary, Gottlieb felt this required that those solicited be limited in number. One felt that up to 60 solicitees was safe; the other argued for an upper limit of 40, but within those limits the lawyers felt there would be no problem.”

o “There was an extended discussion of strategy . . . considering (1) open market purchases, (2) a conventional tender offer, and (3) private purchases. In the face of a hostile target, a conventional tender offer was not considered attractive. It was felt that it would lead to competitive bidding which would make the desired acquisition more expensive.”

Holdingo Court crafts the Wellman 8 factor test to determine whether something is a tender offer

i. 1. “Active and widespread solicitation”ii. 2. “The solicitation is made for a substantial percentage of the issuer’s stock”

iii. 3. “A premium over the prevailing market price”iv. 4. “the terms of the offer are firm rather than negotiable”v. 5. “whether the offer is contingent on the tender of a fixed minimum number of shares”

vi. 6. “whether the offer is open only for a limited period of time”vii. 7. “whether the offerees are subjected to pressure to sell their stock”

viii. 8. “whether public announcements of a purchasing program . . . precede or accompany a rapid accumulation”

o Here, each of the factors is present except ‘widespread solicitation’, so it is a tender offer and is subject to the Williams Act.

Commentso Wellman test has been adopted in some states, but not otherso The 2 most important factors are #7 and #8 (Brascan)

Brascan v. Edper Equities Ltd (SDNY 1979) – creeping acquisition in the market does not equal tender offer (broker contacting 30-50 institutional holders + 12 largest individual shareholders does not equal tender offer)

Factso Edper owns 5% of Brascan (Canadian company) and is turned down when it proposes a friendly

acquisition. o Edper engages Connacher to buy shares; Connacher contacts 30-50 institutional investors and 10-15

individual investors and buys 10%, mostly from them, on April 30th. o In response to a demand from Canadian officials Edper announces that it has no plans to buy any more

shares at that time. o Nevertheless, without further announcement, Edper buys another 14% the next day, bringing total stake to

29% o Brascan brings suit claiming violation of ’34 Act §14(e) and Rule 10b-5 (general antifraud provision).o As a Canadian company, Brascan is not subject to §§13(d) and 14(d) of Williams Act, but if the action was

a tender offer, then §14(e) applies Issue

o Whether the failure to announce that it was making further purchases violated §14(e) of the Williams Act and Rule 10b-5 (general anti-fraud provision)

Reasoningo Very little of Edper’s conduct was similar to commonly understood ‘tender offer’

i. No solicitation

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ii. Not contingent on minimum acquisitioniii. No fixed priceiv. No depository

o Edper just acquired large amounts in open market transactions, bidding cautiously to avoid bidding up the price this is not a tender offer

o Even in Connacher were deemed to have been Edper’s agent, all it did was scout 30-50 institutional holders of Brascan stock, plus a dozen large individual holders to collect a large block for Edperto purchase at a price agreeable to both sides.

o Connacher acted through conventional methods of privately negotiated block tradeso Criteria assessment: ‘premium’ met only slightly, ‘firm terms’ not met, ‘contingent on tender of a fixed

minimum’ not met, ‘limited time’ not met, ‘pressure to sell’ not met, ‘public announcements’ not met basically only 1 criteria is met: solicitation for a substantial % of issuer’s stock.

Ruleso SEC lists 8 factors which authorities have considered

i. (same as Wellman) Holding

o No tender offer Comments

o This case is closer to the creeping acquisition of control than the private negotiation of purchaseo It’s not really clear how ‘open market’ these transactions were (they look like pre-negotiated trades that

happen to be done on open market)

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VIII. MERGERS AND ACQUISITIONS

A. Overview

Types of M&A Statutory (friendly) merger DGCL §251. Appraisal available if receive cash. Fiduciary action available Asset acquisition DGCL §271. No appraisal. Fiduciary action available, but tough to prove. Triangular Merger . Combines tender offer with freeze out statutory merger. No appraisal right unless cashed out in

2nd step. Fiduciary action available, some bite if there’s a controlling shareholder now. Short-form merger : (if controller has > 90%, it can force the minority shares to sell. No board or shareholder vote

required. DGCL §253. Appraisal available. No fiduciary actions available.

Structuring an Acquisition

Structure Transaction Costs Target LiabilitiesMerger. DGCL §251 Low AcquiredAcquisition of Assets. DGCL §271 High Not acquired (stay with old corp)Acquisition of Stock Low Not acquired (stay with old corp along with its assets)

Justification for Shareholder Approval Requirement of Fundamental Transactions Too big, too important.

o BUT: why don’t “bet the company” decisions in the normal course of business require a shareholder vote? Don’t require managerial expertise: e.g., dissolution, M&A look more like investment decisions than

management decisions.o Interestingly, only shareholders in the seller of the assets get to vote (not those in the buyer)o Shareholders of surviving company don’t always get to vote (only if 20% or more of shares are issued), but

shareholders in ‘dying’ company always get to vote. Pose special agency problems: final period for incumbent managers (so their actions are no longer constrained by

future votes of shareholders), or shareholders can be diluted such that their ability to remove the board is compromised

Motives for Acquisitions Value-Increasing (Efficient) Rationales: economies of scale/scope (e.g., manufacturing efficiencies, extending

management talent to a larger asset base), vertical integration, replacing bad management (agency costs), diversification. Ex:

o Scale – 2 factories operating at 50%, after merger shut 1 down and operate the other at 100%o Scope – good marketing/ distribution department, by acquiring new production lines, you can use those

skills on a broader basiso Vertical integration – reduce agency costs and risks of interruption in supply chaino Replacing management – generally leads to hostile takeover as inefficient incumbents don’t want to lose

their jobso Diversification – reduces risk-bearing cost, smoothes profit through the year if businesses are seasonal

(however, ‘conglomerates’ went out of style in the 1980s as people realized diversification is better done at the investor level)

Value-Transferring (Redistributive) Rationales: shifting value from government (NOLs), creditors (LBOs, asset stripping), minority shareholders (‘squeeze-out’), consumers (monopoly pricing), or employees (pay cut/ redundancy firing)

o NOLs – if a company has losses but can’t use them, another company can buy that firm to take advantage of the tax benefits (note: government prohibits transfers of NOLs if the transaction is solely tax-driven)

o Creditors – if the buyer acquires assets, the creditors can’t collect anymore/ if the companies merge, there are more creditors in the combined firm so there is a lot more debt in the corporation than before (so default risk has increased, but loan terms are already set so the firm gets value at the expense of the old creditors)

o Squeeze-out: offer minority shareholders less than what was offered to the controlling groupo Consumers: bigger market-share yields bigger price-setting power

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o Employees: can fire redundant workers to reduce overall operating costs to boost investor profits Value-Destructive Rationales: hubris, overestimation of synergies, empire building (all possibly driven by poor

economic incentives) Losses to the acquirer outweigh gains by the seller

History of Mergers (cyclical) 1900s was driven by monopolization (ended by anti-trust laws) 1920s was driven by rising stock market (increased $ to facilitate M&A) (ended by crash of 1929) 1960s was driven by diversification (ended by triumph of ‘investor diversification’ theory) 1980s was driven by break-up of conglomerates and cheap finance (junk bonds) 1990s was driven by globalization and international M&A and cheap finance from securitization

We can’t say ‘mergers are all good’ or ‘mergers are all bad’, because it’s highly contextual

1. Statutory Mergers

Classic Merger

1. A(cquiror) & T(arget) boards negotiate the merger2. Proxy materials are distributed to shareholders as needed,

giving 20 days at least.3. T shareholders always vote (DGCL §251(c)); 4. A shareholders vote if A stock outstanding increases by >

20% (DGCL §251(f)).5. If majority of shares outstanding approves, T assets merge

into A, T shareholders get back A stock. Certificate of merger is filed with the secretary of state

6. Dissenting shareholders have appraisal rights.

*Note: shares outstanding means ‘all shares’ regardless of whether they’re voted or not

Voting RightsT voting rights – Majority of shares outstanding must approve. DGCL §251(c)A voting rights – Approval of majority of shares outstanding not required, unless the A shares issued to T constitute more than 20% of the common stock of A. DGCL §251(f)

Policy Implications

Forcing shareholder to file for appraisal prior to the tender is problematic: He doesn’t know if the price is a good one (new bidders might come in, etc) He may not read the materials sent to him, so he might lose the appraisal right for no good reason

The lack of class action availability has a chilling effect, because you may or may not get your costs back, and the benefits of the procedure don’t just go to you.

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2. Asset Acquisition

Asset Acquisition

1. A and T boards negotiate terms of the sale2. T’s shareholders vote on approval DGCL§2713. T sells its assets to A for either cash or shares.4. T Corp liquidates, and distributes its cash/ shares in A to T

shareholders5. Difference from stat. merger A doesn’t hold T’s liabilities

o *BUT, if T corp is left with an unreasonably small capitalization relative to its obligations (to creditors or tort claimants), the transaction might be unwound due to ‘fraudulent conveyance’ doctrine

o Also, when the assets acquired constitute an integrated business, there are circumstances in which the buyer becomes responsible for the seller’s liabilities (successor liability) can’t erase liabilities unless you sacrifice the going concern value

Sale/lease/exchange of substantially all property/assets of corporation must be approved by shareholders at a meeting called with at least 20 days notice. DGCL §271

This includes assets of both the parent corporation and any of its subsidiaries, where subsidiary is defined 100% owned or controlled by the parent. DGCL §271(c)

But no approval is necessary for sale/lease/exchange of property/assets of a corporation to its subsidiary. §271(c) And the board can abandon the sale, etc. without seeking shareholder approval §271(b)

Sale of substantially all assets is not determined by formula A fair and succinct equivalent to the term ‘substantially all’ would therefore be ‘essentially everything’ Hollinger

Hypos Sale of 51% of assets that generate almost all profits requires shareholder approval under DGCL §271. Katz v.

Bregman (Outdated) Where 68% of a firm’s assets are shares in a subsidiary, the sale of that subsidiary is a sale of substantially all assets.

Thorpe v. Cerbco Today, courts generally require about 90% of assets to be sold before finding that it is ‘substantially all’.

Voting RightsT Voting Rights – yes if substantially all assets are being soldA Voting Rights – Not in the code, but some exchanges may require it if the compensation is shares in A, and new shares are being issued comprising > 20%

Case Summaries

Katz v. Bregman – sale of 51% of assets that generate almost all profits requires shareholder approval under DGCL §271 Facts

o As part of broader divestment strategy, Plant Industries decides to sell its Canadian operations (Plant National), which constitute 51% of its assets, 45% of its revenues, and 52% of its operating income.

o Idea is to take the proceeds and shift to a different line of business namely, making plastic drums instead of steel drums.

o Plant CEO Bregman agrees to sell Plant National to Vulcan, even though Universal offered a higher bid.o Plaintiff shareholders seek an injunction against the deal, alleging that shareholder vote is required because

the deal sells “all or substantially all of its property and assets.”

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Ruleso A sale of all or substantially all assets is a fundamental transaction for the selling company, which requires

shareholder approval by a majority of outstanding stockholders entitled to vote at a meeting called upon at least 20 days’ notice (DGCL 271)

Reasoningo Historically, the principal business of Plant Industries has not been to buy and sell industrial facilities, but

rather to manufacture steel drums for use in bulk shippingso The Canadian operations account for almost all profits of Plant Industries

Holdingo Where the assets to be sold are 51% of total assets, 45% of sales, and almost all profits, the proposed sale

of Plant National (Quebec) would be a sale of substantially all assets of Plant Industrieso An injunction is granted preventing the consummation of the sale until it has been approved by a majority

of the shareholders Comments

o The Chancellor uses this argument as a mask. His real concern is that Plant is not selling its assets to the highest bidder.

o This sort of behavior would be dealt with today under the law of directors’ duties

Thorpe v. Cerbco (Del. 1996) Facts

o Cerbco is a holding company with 3 subsidiaries including Insituform.o CERBCO stock in Insituform constitutes 68% of CERBCO’s assetso Public shareholders want CERBCO to sell its controlling interest in Insituform; controlling

shareholder wants to sell its controlling interest in CERBCO instead. Holding

o The sale of CERBCO’s stock in Insituform would constitute a sale of substantially all of CERBCO’s assets => requires a shareholder vote => controlling shareholder can veto the transaction.

o Test applied: “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 corporation. Thus, it is relevant to ask whether a transaction is out of the ordinary course and substantially affects the existence and purpose of the corporation.”

Hollinger Inc. v. Hollinger International (Del. Ch. 2004) Issue – Whether the sale of the Telegraph group of newspaper constituted substantially all of the assets of Holliger

International (which also holds the Chicago group of newspapers). Holding

o The sale of Telegraph did not constitute ‘substantially all’ of International’s assetso A fair and succinct equivalent to the term ‘substantially all’ would therefore be ‘essentially everything’

Commentso Doesn’t change Del. Law, just clarifies that ‘substantially all’ isn’t determined by formula

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3. Triangular Mergers

Triangular merger

Process

First transaction is a tender offer for most/ all of T’s shares at an agreed on price (which T board recommends to its shareholders)

Second transaction is a merger between the target and a subsidiary of the buyer, which follows the tender offer and “cashes out” minority shareholders who failed to tender their shares (with either cash or stock in A, §251 provides for broad power to adjust what shareholders get when they’re being ‘cashed out’).

Why do this Lowers costs (if there was a statutory merger, you would have

to file a proxy statement to get shareholder approval, and the value of the target might change during the mandatory 3-month waiting time if another party bids for the firm)

In the second step, A has already locked up control, so it doesn’t have to worry about a competing bid.

Outcome: Liabilities of T corp are contained within A subsidiary (or, in a reverse merger, ‘T Corp’ survives, and the A

subsidiary is folded after the merger) The directors of the surviving corporation will be those of the acquiring subsidiary The bylaws will be replaced by those of the acquiring subsidiary The charter is that of the surviving corporation The officers will be those of the target, until such time as they can be replaced

Policy Implications Ultimate self-dealing transaction

o In many European jurisdictions, this process isn’t available if there’s a controlling shareholdero Controller may have better info on the company’s future prospects that what is in the market (under-pricing

story) There are possible “good” explanations for the transaction

o A is more willing to invest in the company if it will reap the full benefitso Going private eliminates many regulatory costs associated with being a public companyo Reduces managerial agency costso If the market as a whole is down, the public tends to undervalue assets due to pessimism (which managers

may not share)

The freeze-out merger (looks like the second step of a triangular merger)

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B. Appraisal Right

For Statutory MergersDissenting T shareholders may seek appraisal if:

They hold the shares through the effective merger date they submit a written demand for appraisal before the shareholder vote and vote against the merger (or at least

abstain from voting) DGCL §262(d)1 then (if merger is approved) file a petition with the Chancery Court within 120 days after the merger becomes

effective demanding appraisal. §262(e) Court holds valuation proceeding to “determine [the shares’] fair value exclusive of any element of value arising

from the accomplishment or expectation of the merger.” (DGCL §262(h)) i.e. value prior to merger news.o No class action device available, but Chancery Court can apportion fees among parties (including pro rata

amongst plaintiffs) as equity may require ((§ 262(j)) Also always get appraisal remedy if your share class isn’t required to pass the merger. b/c §262(b)1 doesn’t apply

Market Out Rule §262(b)Appraisal right is restricted by the market out rule.

(1) No appraisal rights if your corporation’s shares are market-traded, or company has 2,000 shareholders; or shareholders not required to vote on the merger.

o (2) BUT appraisal right is restored if your merger consideration is anything other than shares in surviving corporation or shares in third company that is exchange-traded or has 2,000 shareholders (with de minimis exception for cash in lieu of fractional shares). (i.e. appraisal right is restored in cash out mergers)

Also, appraisal rights may be protected by a guarantee in the corporate charter. §262(c) Also, appraisal is always available in a §253 short form merger (for which no fiduciary duty action is available)

It is certainly possible to screw over a T’s shareholders by paying too few shares of stock in A, but in this case, we’re not too concerned because T’s shareholders can go after the directors of T for breaching the duty of loyalty (Revlon)

For Asset AcquisitionIn Delaware, no appraisal rights for T unless there’s a guarantee in the corporate charter. §262(c).

Any transaction following the formalities of an asset sale is a sale of assets, and is not entitled to an appraisal, even if the transaction was structured this way to avoid the appraisal remedy. Hariton v. Arco Electronics. (some states do, however, adopt the ‘de facto’ merger rule that Hariton rejected)

How to Calculate for Appraisal

3 options1. value as minority shares, that is, apply a minority discount; or2. value as pro rata claim on going concern value (no minority discount but no claim on the benefits of the deal); or 3. value as pro rata claim on going concern value, including any benefits from the deal that are not speculative (ruled

out by DGCL §262)

For transactions with a controlling shareholder

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Statutory Merger (DGCL §251, RMBCA

§11.02)

Asset Acquisition (DGCL §271, RMBCA

§12.01-.02)

Share Exchange (RMBCA §11.03)

T Voting Rights

Yes – need majority of shares outstanding (DGCL §251(c)), or majority of shares

voted (RMBCA §11.04(e))

Yes, if “all or substantially all” assets are being sold

(DGCL §271(a)) or no “significant continuing

business activity” (RMBCA §12.02(a))

Yes – need majority of shares voted

(RMBCA §11.04(e))

A Voting Rights

Yes, unless <20% shares being issued

(DGCL §251(f), RMBCA §11.04(g))

No (though stock exchange rules might

require vote to issue new shares)

Yes, unless <20% shares being issued (RMBCA §11.04(g))

Appraisal Rights

Yes if T shareholders vote, unless stock market exception

(DGCL §262, RMBCA §13.02)

Yes under RMBCA if T shareholders vote,

unless stock market exception (RMBCA §13.02(a)(3)); No in Delaware, unless provided in charter

(DGCL §262(c))

Yes, unless stock market exception

(RMBCA §13.02(a))

Pro rata value of the firm as a going concern, including benefits of the deal , but excluding speculative future benefits from the merger. Weinberger v. UOP (Del. 1983) (goes further than §262(h) b/c appraisal is to protect against self-dealing rather than to provide a liquidity event here)

The value added to the going concern by the “majority acquirer” during the transient period of a two-step merger accrues to the benefit of all shareholders. Cede v. Technicolor (Del. 1996)

Delaware Block Method (Old Method – no longer used) 3 mechanisms (all of which have flaws… so) Take average of

o Market values – price of shares before the merger is announced (this doesn’t include pro rata share of the firm … i.e. it’s subject to the minority discount because shares acquired on market are not controlling)

o Earnings value – last 3 years of earning, capitalized using a price-to-earnings ratio o Asset value – net assets valued at liquidation value (does give a pro rata value of the asset value, but

doesn’t take into account the control premium)

Case Summaries

Hariton v. Arco Electronics Inc (Del. Ch. 1962, aff’d Del. 1963) Facts

o Loral buys all of Arco in an arms-length asset acquisition after months of negotiating and two rejected offers.

o Shareholders approve the transaction, Arco transfers all of its assets to Loral, Loral transfers its stock to Arco, Arco dissolves and distributes the Loral stock to its shareholders (i.e., classic asset acquisition for stock).

o Arco shareholder brings suit claiming right to appraisal because the deal was a de facto merger. Issue

o Whether a de facto merger creates appraisal rights Reasoning

o Legislature has set up structures for various forms of corporate transactionso Shareholders know there’s a risk that they won’t get an appraisal right if the assets are sold rather than

corporations mergedo Appraisal is a right that compensate shareholders for no longer having a right to prevent a merger

Holdingo The transaction was not a de facto merger, as the corporation expressly has a right to sell all of its assets for

stock in another corporation under DGCL §271o Therefore, there is no appraisal right

Commentso Court here is being very formalist (rules-based), whereas in Katz v. Bregman the court was being

functionalist (standards-based)i. Katz was in the 1980s, when corporate raiders were breaking up companies to turn a quick profit,

so court was more willing to be functionalist.o This case is especially striking as an example of formalism because Loral was even acquiring all of Arco’s

liabilities

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C. Duty of Loyalty in Controlled Mergers – i.e. duty of fairness

Rules and Regulations

ProceduralShareholders can bring duty of loyalty claims the directors in a controlled merger. Rabkin v. Phillip A. Hunt Chemical Corp.

This allows for ex ante suits seeking injunction against the merger, and direct class action suits P can simultaneously pursue appraisal action and breach of fiduciary duty claim, and need not choose at any

point prior to judgment which remedy he would elect. Singer v. Magnavox Entire fairness review under duty of loyalty claim (instead of appraisal right) is appropriate for transaction where

buyer purposefully waited longer than 12-month buy-out period so as to avoid paying minority shareholders the front-end price. Rabkin

o Following Rabkin, an ‘entire fairness’ (breach of fiduciary duty) action rather than appraisal is the principal means of attacking the fairness of price in a self-dealing merger. (appraisal is still available)

Note: No Duty of Loyalty remedies for minority shareholders cashed out in §253 short-form. Glassman v. Unocal Tender offer contingent on obtaining a 90% interest does not support fairness review Siliconix Acquirer has no duty of loyalty in a 1-step cash out or stock merger. Cede. (although Revlon duties would attach to

existing board in a cash out)

Transaction must meet Entire Fairness StandardWhen directors of a Delaware corporation are on both sides of a transaction, they are required to demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain. Weinberger v. UOP (Del. 1983)

Basically, a controlling shareholder who sets the terms of a transaction and effectuates it through his control of the board has a duty to pay a fair price due to his duty of loyalty to minority shareholders.

This requires that the directors’ action satisfy the ‘entire fairness’ test (both price and procedure must be fair)

Entire Fairness Test RequirementsFair Price

Burden is on controlling shareholder to prove fairness. Cede v. Technicolor. (and it can’t be met by looking at negotiations in the 1st step of a 2-step cash-out merger if the new controller has started making improvements to the company before the cash out (as value is now different than prior to step 1 tender offer).

Fair Procedures Presenting to a Special Committee. If controlling shareholder does not ‘force’ the proposal through the use of his

directors, but rather presents it to a special committee of independent directors:o Approval of a transaction by an independent committee of directors is evidence of a fair process.

Weinberger fn.7o Approval shifts the burden of proof on the issue of fairness from the controlling or dominating shareholder

to the challenging shareholder-plaintiff. Kahn v. Lynch Communications Systemso SC must be truly independent. Controller must not dictate the terms of the merger. Kahn v. Lynch

The special committee must have real bargaining power that it can exercise with the majority shareholder on an arm’s length basis. Kahn v. Lynch (SC didn’t have independence because there was a pattern of obeisance on other issues);

Where controlling shareholder was limited by standstill agreement to 2 of 8 board seats, the independent committee was not corrupted. In Re Western National Corp Shareholders Litigation (Del. Ch. 2000)

Must have own advisors and access to information Majority of minority shareholder approval. (recommended not required). Approval shifts the burden of proof on

the issue of fairness from the controlling or dominating shareholder to the challenging shareholder-plaintiff. Kahn v. Lynch Communications Systems

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See option provided by avoiding the board and tendering to remaining minority shareholders on the next page.Tendering to the Minority on the 2nd Step this is not a controlled merger, so there’s no duty of fairnessController can (sort of) bypass the board on the 2nd step and issue a tender offer to minority shareholders to try to increase its share to above 90% to allow for a short form merger under §253

No duty to pay a fair price because as long as the offer is not coercive, because the transaction is voluntary on the part of the minority shareholders. In Re Pure Resources

As with any tender, the controlling shareholder must disclose all material information respecting such offer (SEC Act of 1934 §14(e); Lynch v. Vickers Energy Corp., Del 1977),

An acquisition tender offer by a controlling shareholder is non-coercive only when (In Re Pure Resources)o (1) it is subject to a non-waivable majority of minority tender condition,

The minority must be defined exclusive of stockholders whose independence from the controlling shareholder is compromised (including any stockholders affiliated with the controller, and any officers who have employment, severance, put option agreements) (In Re Pure Resources)

o (2) the controlling stockholder promises to consummate a prompt §253 short form merger if it obtains more than 90% of the shares, and

o (3) the controlling shareholder has made no retributive threats (withhold dividends, etc). Target Board Independent Directors must have a role.

o [T]he majority shareholder owes a duty to permit the independent directors on the target board free rein and adequate time to react to the tender offer, by (at the very least) hiring their own advisors, providing the minority with a recommendation as to the advisability of the offer, and disclosing adequate information for the minority to make an informed judgment.” In Re Pure Resources Inc Shareholders Litigation (2002)

Details of fairness opinion relied on by the independent directors must be disclosed: “Stockholders are entitled to a fair summary of the substantive work performed by the investment bankers…” In Re Pure Resources Inc Shareholders Litigation (2002)

Note: If minority shareholders don’t like the price on offer, they can always remain shareholders in the company and force the company to cash them out (such as in the short form merger), in which event they have the protection of an appraisal action. In Re Siliconix Incorporated Shareholder Litigation (Del. Ch. 2001)

Policy Implications

Why allow freeze out mergers at all? (1) it allows going private transaction which can reduce the cost of filling with the SEC. (2) it gets rid of fiduciary duty claims for self dealing which are a nuisance to a majority shareholder who may do

business with another company he owns.

SEC rule 13e3 antifraud provision disclosure rule for squeeze outs: requires disclosure of whether the company believes the price is fair or not and in detail. Must also say whether deal is conditioned on majority of minority and whether a special committee was formed to approve it and whether they obtained their own counsel.

Mergers lead to higher deal premiums because of the duty of fairness

Tenders reduce premiums because there’s no duty of fairness

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In Re Cox Communications reduced the lawyers’ fees on a settlement agreement on an ‘entire fairness’ action against a controlled merger. Judge doubted that the lawyers had much impact on the final price at all. Most of the work was done by the special committee’s investment advisor (Goldman Sachs), and it’s doubtful that the lawyers’ no-name financial advisor was really taken into consideration in the final price. Judge reduces lawyers’ fees to $1.26 million, or about $500 per hour. THIS CASE DISINCENTIVIZES FILING “ENTIRE FAIRNESS” ACTIONS IN DELAWARE.

Case Summaries

Singer v. Magnavox (Del. S. Ct. 1977) Permitted shareholders to bring class actions in addition to appraisal proceedings,

o challenging freezeout mergers on the grounds that the controlling shareholder breached its fiduciary duty of entire fairness to minority shareholders.

Established a per se rule: a freezeout without a colorable business purpose did breach entire fairness duty o (and “getting rid of minority shareholders” doesn’t count as a business purpose)

Established that minority shareholders’ remedy was so-called "rescissory damages" a.k.a. the monetary equivalent of rescission.

Weinberger v. UOP Inc (Del. 1983) Facts

o Signal owns 50.5% of UOP and holds six board UOP seats out of thirteen. Signal board decides to buy the remainder of UOP.

o Arledge and Chitiea (UOP and Signal directors) write report that any price up to $24 per share would be a “good investment” for Signal; study is shared with Signal board but not with UOP.

o Signal board offers $21 per share, a 55% premium over pre-bid market price, conditioned on approval by majority of the minority UOP shareholders. UOP CEO Crawford makes no effort to negotiate with Signal, and UOP board approves the offer with a hastily-drafted fairness opinion from Lehman Bros.

o Signal directors Walkup and Crawford withdraw from the UOP board meeting approving the transaction, but were involved in the negotiations up to that point (and persuade Crawford to sell the deal).

o 52% of total outstanding minority shares approve the merger. Plaintiff UOP shareholders bring a class action challenging the transaction as a breach of the UOP board’s fiduciary duty. Chancery Court rules for defendant directors

Rules

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o §262 – stockholder is entitled to be paid for that which has been taken from him Reasoning

o Arledge and Chitea wrote the feasibility report for the use of Signal, and didn’t share it with UOPo Report indicates that up to $24 was a good investment (15.5% return, relative to 15.7% return at $21)

Holding – 3 things going ono Conceptualization of appraisal remedy

i. Delaware block remedy is no longer appropriateii. Elements of future value, which are known or susceptible of proof as of the date of the merger and

not the product of speculation may be considered)iii. Court must appraise the pro rata value of the firm as a going concern, including the benefits

of the deal, but excluding speculative future benefits from the mergero Tells minority shareholders when they can bring a fiduciary duty claim vs. an appraisal claim (i.e. when

appraisal rights preclude the right to bring a fiduciary duty claim)i. Since the study was prepared by 2 UOP directors, using UOP information for the exclusive benefit

of Signal, and nothing was done to disclose it to outside UOP directors or minority shareholders, and the UOP directors did not totally abstain from the merger decision-making process, a question of breach of fiduciary duty arises. “When directors of a Delaware corporation are on both sides of a transaction, they are required to demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain.

ii. Newly fashioned appraisal remedy is the only remedy absent fraud, misrepresentation, self-dealing, waste, gross overreaching (overturned later)

o What are the obligations of the controlling shareholders with respect to ‘entire fairness’ and processo You don’t have to disclose your reservation price, but you do have to provide all the information you used

to arrive at it that was obtained from the target company through the acquiring company’s directors on the board of the target company.

Commentso The new appraisal valuation is similar to the ‘rescissory damages’ available from a fiduciary duty claim

i. Procedural differences remain 1. fiduciary duty claims allow for class action, can be brought prior to the closing of the

merger, can seek an injunction2. Appraisal requires lodging a protest before closing but cannot be brought in court until

after the merger, does not allow class actiono The court suggests that what should happen in a two-step cash-out merger is to use an independent

committee to negotiate with the controlling party for the 2nd step cash out price, and to provide the independent committee with the same information about the new ‘merged’ company that the controlling shareholder has; committee should also be given time to prepare its opinion in a careful way need an unhurried advisory opinion from investment bank and lawyers

o Footnote 7: “Although perfection is not possible, or expected, the result here could have been entirely different if UOP had appointed an independent negotiating committee of its outside directors to deal with Signal at arm’s length. . . . Since fairness in this context can be equated to conduct by a theoretical, wholly independent, board of directors acting upon the matter before them, it is unfortunate that this course apparently was neither considered nor pursued. . . . Particularly in a parent-subsidiary context, a showing that the action taken was as though each of the contending parties had in fact exerted its bargaining power against the other at arm’s length is strong evidence that the transaction meets the test of fairness. . . .

o Alternatively, a ‘majority of the minority’ vote in favor of the 2nd step cash-out, it helps to show fairness if these minority shareholders have been given access to all relevant information about the new company that the controlling shareholder has.

o Impact of ‘independent committee’ / ‘majority of minority’ vote: shifts the burden of proving ‘entire fairness’ to the plaintiff (Kahn v. Lynch, Del. 1994

Rabkin v. Phillip A. Hunt Chemical Corp. (Del. 1985) - Facts

o Olin Corp. buys a control block in Hunt Chemical, and contracts that if it cashes out the minority within twelve months it would pay the minority shareholders the same as it paid for its control block.

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o Olin waits twelve months and a bit and then cashes out the minority shareholders at less than the original transaction price.

o Minority shareholders bring suit claiming breach of fiduciary duty because Olin deliberately waited slightly longer than twelve months to avoid paying the minimum price.

Historyo Chancery Court dismisses on the ground that “absent deception,” Weinberger mandated appraisal as the

only remedy available to the minority shareholders. Holding

o Del. Supreme Court (Moore, J.) reverses: “Weinberger makes clear that appraisal is not necessarily a stockholder’s sole remedy. . . . ‘The appraisal remedy we approve may not be adequate in certain cases, particularly where fraud, misrepresentation, self-dealing, deliberate waste of corporate assets, or gross and palpable overreaching are involved.’” (citing Weinberger)

o Court holds that appraisal is not the only remedy for shareholders attacking a cash-out merger. Fiduciary duty claim can be brought alleging a duty between the parties has been breached.

Following Rabkin, an ‘entire fairness’ (breach of fiduciary duty) action rather than appraisal is the principal means of attacking the fairness of price in a self-dealing merger. (appraisal is still available)

Kahn v. Lynch Communication Systems Inc (Del. 1994) Facts

o Alcatel owns 43.3% of Lynch Communications; Lynch wants to buy Telco but supermajority provision gives Alcatel veto power and Alcatel proposes that Lynch acquire Celwave (owned by Alcatel) instead. Lynch board appoints a committee of independent directors to negotiate with Celwave.

o Dillon Read (Alcatel’s banker) recommends as 0.95 exchange ratio to the Lynch independent committee (IC); Thomson McKinnon (IC’s banker) concludes that 0.95 would overvalue Celwave. Based on this advice, the IC unanimously opposes a Celwave/Lynch combination.

o Alcatel withdraws the Celwave proposal but makes an offer to acquire the remaining 56.7% of Lynch at $14 per share cash. IC is reconstituted to negotiate with Alcatel, rejects $15.00 as inadequate, but finally recommends a $15.50 per share offer on threat of a hostile bid from Alcatel. Lynch disinterested directors then approve the freezeout merger.

o Minority shareholders bring suit against the Alcatel directors alleging breach of fiduciary duty as controlling shareholder.

o Chancery Court rules for defendants because the IC had “appropriately simulated a third-party transaction, where negotiations are conducted at arms-length and there is no compulsion to reach an agreement.”

Issueo Whether Alcatel is a controlling shareholdero Whether the practical context of a parent subsidiary merger offers reasons for the legal system to be more

suspicious of these procedural deviceso What a well-functioning special committee of independent directors entailso What effect does the use of a well-functioning special committee have in the controlled merger context

Ruleso A controlling or dominating shareholder standing on both sides of a transaction, as in a parent-subsidiary

context, bears the burden of proving its entire fairnesso A showing that the action taken was as though each of the contending parties had in fact exerted its

bargaining power against the other at arm’s length is strong evidence that the transaction meets the test of fairness (Weinberger)

Reasoningo Independent directors deferred to Alcatel because of its position as a significant shareholder and not

because of their own business judgment that Alcatel’s position was correcto Even where no coercion is intended, minority shareholders voting on a parent subsidiary merger might

perceive that their disapproval could risk retaliation of some kidn by the controlling stockholder (i.e. stopping dividend payments, subsequent cash out at a worse price)

Holding

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o Alcatel is a controlling shareholder, because it can i) veto any other proposed merger, ii) it has many directors on the board, a majority in the executive committee, and iii) the independent directors submitted to Alcatel on other issues (exec. compensation) creating a pattern of obeisance

o Approval of a transaction by an independent committee of directors or an informed majority-of-minority shareholders shifts the burden of proof on the issue of fairness from the controlling or dominating shareholder to the challenging shareholder-plaintiff

o Mere existence of an independent committee is not enough to shift the burden:i. Majority shareholder must not dictate the terms of the merger

ii. The special committee must have real bargaining power that it can exercise with the majority shareholder on an arm’s length basis.

o Here, the ability of the independent committee to negotiate at arm’s length was compromised by Alcatel’s threats to proceed with a hostile tender offer if the 15.50 price wasn’t approved

o There is no business purpose in a merger, so there is no BSJ rule protection on mergers that would allow an independent committee to choose not to bring litigation against the controlling shareholder (fear of retaliation by the controlling shareholder may make the committee not independent)

Commentso If a 40% shareholder is subject to a standstill agreement in which it has only 2 of 8 seats on the board, then

it’s not a controlling shareholder.

In Re Western National Corp Shareholders Litigation (Del. Ch. 2000)Court respects the judgment of an independent committee in approving a cash out merger at only slightly above pre-announcement market price where the controlling shareholder (46% of shares) was subject to a standstill agreement that limited it to 2 of 8 directors.

In Re Pure Resources Inc Shareholders Litigation (2002) Facts

o Unocal Corp. holds 65% of Pure Resources, Pure CEO Hightower holds 6%, and Pure managers hold another 11%.

o Pure board has eight members: 5 Unocal designees, 2 Hightower designees, and 1 joint designee.o Unocal makes a surprise exchange offer at a 27% premium to market price, contingent on getting to 90%

ownership of Pure.o Pure forms a Special Committee, consisting of two Pure directors who are plausibly independent of Unocal.o Special Committee negotiates with Unocal, fails to adopt a poison pill (that would give it veto power), and

finally recommends against the exchange offer to Pure’s minority shareholders.o Unocal nevertheless goes ahead, and Pure minority shareholders bring suit seeking an injunction to block

the offer Issue

o What equitable standard of fiduciary conduct applies when a controlling shareholder seeks to acquire the rest of the company’s shares

Ruleso 2 strands of Delaware law

i. Lynch line: deals with situations in which controlling shareholders buy out the minority, emphasizes protection of minority shareholders against unfairness

ii. Solomon line: deals with situations when a controlling stockholder seeks to acquire the rest of the company’s shares through a tender offer followed by a short-form merger under DGCL §253, emphasizes facilitation of free flow of capital between willing buyers and willing sellers so long as there’s no misleading information or coercion

Reasoningo When a tender offer is non-coercive in the sense below, and independent directors are permitted to make an

informed recommendation and provide fair disclosure, the law should be hesitant to superimpose the full fiduciary requirement of entire fairness on the statutory tender offer

o When a controlling shareholder makes a tender offer that is not coercive, the better rule is that there is no duty on its part to permit the target board to block the bid through the use of the pill, nor is there any duty on the part on the independent directors to seek blocking power

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Holdingo An acquisition tender offer by a controlling shareholder is non-coercive only when

i. (1) it is subject to a non-waivable majority of minority tender condition, ii. (2) the controlling stockholder promises to consummate a prompt §253 short form merger if it

obtains more than 90% of the shares, and iii. (3) the controlling shareholder has made no retributive threats.

o Here, the offer is coercive because it includes within the definition of the ‘minority’ those stockholders affiliated with Unocal as directors and officers, and the management of Pure (whose incentives are skewed by their employment, severance agreements, and Put option agreements)

o The minority must be defined exclusive of stockholders whose independence from the controlling shareholder is compromised

o There was no duty to execute the Poison Pill, because management already recommended against the offer to its shareholders and the independent committee had a free hand to recommend against the Offer.

o Stockholders are entitled to a fair summary of the substantive work performed by the investment bankers upon whose advice the recommendations of their board as to how to vote on a merger of tender rely

i. Here, only the banker’s negative opinion was given to the minority shareholderso Injunction is issued to allow for adequate disclosure to shareholders and to put in place a genuine ‘majority

of the unaffiliated minority condition’ Comments

o Dicta: To the extent that there is inconsistency between the lines, it would be better addressed in the Lynch line by affording greater liability-immunizing effect to protective devices such as majority of minority approval conditions and special committee negotiation and approval (indicates where the law might be heading instead of these measures shifting the burden, they might fully immunize the majority shareholder against entire fairness challenge, leaving only appraisal rights)

In Re Cox Communications Facts

o Cox family owns 74% of Cox Communications (‘CC’). o August 1, 2004, Coxes make offer to CC board to buy out minority at $32/share, conditional on Special

Committee (SC) approval. Makes clear won’t sell shares to third party.o August 2, 8.36am: Abbey Gardy files suit challenging fairness of merger. 5 further suits filed over the

course of the day.o October 18: extensive back-and-forth negotiations between SC and Coxes result in Coxes agreeing to offer

$34.75/share. Abbey and Coxes draft settlement MOU acknowledging “efforts of plaintiff counsel” in raising bid to $34.75/share. Coxes willing to pay up to $4.95m fees to Abbey.

o Strine, VC, is asked to approve the settlement. Reasoning

o “As the objectors point out and this court has often noted in settlement hearings regarding these kind of cases in the past, the ritualistic nature of a process almost invariably resulting in the simultaneous bliss of three parties-the plaintiffs' lawyers, the special committee, and the controlling stockholders-is a jurisprudential triumph of an odd form of tantra. I say invariably because the record contains a shocking omission-the inability of the plaintiffs, despite their production of expert affidavits, to point to one instance in the precise context of a case of this kind (i.e., cases started by attacks on negotiable going-private proposals) of the plaintiffs' lawyers refusing to settle once a special committee has agreed on price with a controller.” (Strine, VC).

i. Basically, Strine doubts that the lawyers had much impact on raising the price1. Much of the billable hours were spent fighting for ‘lead counsel’ status among the suing

law firmso Independent committee was the driving force behind the price negotiations the SC’s advisor (Goldman

Sachs) is much more credible than the tiny financial advisor used by the lawyers Holding

o Strine reduces the settlement to $1.26 million to better reflect the hours they actually worked (around $500 per hour worked)

Comments

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o What incentives does this create? Discourages lawyers from bringing these kinds of cases in Delaware Delaware law (Kahn v. Lynch) would be applied if you filed in the jurisdiction where the

company is headquartered, but you could get better fees in that jurisdiction as long as they don’t adopt the Cox skepticism (this has happened see chart)

Reduces the threat faced by the Board of being sued (so it might reduce their motivation to negotiate for a higher price)

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IX. CONTESTED CONTROL TRANSACTIONS

A. Introduction

Threat of a hostile takeover is a form of governance (i.e. last resort for shareholders to remove poor management teams)

De facto law that governs hostile takeovers is that of Delaware In 1980s, Delaware courts revamped the target board’s duties during a hostile takeover, building new responsibilities

out of their fiduciary duties

Greenmail. When a target board pays the raider to go away so they can keep their own jobs. It was alleged that in many cases, the ‘raiders’ were not reformers but rather blackmailers because they weren’t actually interested in improving corporate operations, just obtaining the greenmail.

Trilogy Smith v. Van Gorkum holds target’s board liable for gross negligence even though they met and discussed the offer Unocal v. Mesa Petroleum – says defensive measures must be proportional to the threat posed Revlon v. MacAndrews and Forbes Holdings – adopts a form of heightened review short of intrinsic fairness;

directors must maximize ST gains to SH once it is clear that the business strategy is being abandoned (i.e. cash merger, merger w/ change in control, sale of assets)

Precursors – Cheff. V. Mathes – as long as the board’s primary purpose was to advance business policies, a buyback of a

dissident shareholder’s stock at a premium price doesn’t violate a board’s fiduciary duty Schnell v. Chris-Craft Industries – there is a breach of fiduciary duty when a disinterested board advanced the

date of the company’s annual meeting solely in order to make a hostile proxy solicitation impossible to mount, (even though changing the date was permitted in the statute).

Types of Poison Pills Flip over Pill. Gives shareholders a right to buy stock in the acquiring company. (Remember, the tender offer is the

first stage of a 2 stage merger gives the shareholders a class right to not get merged out of existence unless they get this specified ratio of shares in the new company)

o Assumes that the 2nd step merger will occuro But, if the 2nd step isn’t done, then shareholders get screwed (acquirer leaves subsidiary in place, then

removes its board and redeems the rights plan) Flip in Pill . Confers on its shareholders a right to buy discount stock in the target company (Prevents the merger) Morning After Pill. If there’s no pill in place, the Board can create one without shareholder approval as long as it

had the power to issue new types of stock (because Board must be able to issue preferred shares under the untriggered rights plan)

Dead Hand Pill. Cannot be redeemed by the hostile board elected in a proxy fight for a stated period of time. (Dead hand pills are impermissible without a change in the corporate charter because it creates 2 classes of directors Toll Brothers)

Slow Hand Pill. Neither current nor hostile new board can redeem the pill for X months if this would facilitate a transaction with the buyer. Impermissible if there’s no other reason than ‘X months is reasonable’ Quickturn

Sample Pill LanguageIn the event that a Person becomes an Acquiring Person [has acquired beneficial ownership of 15% or more of the voting stock], each holder of a Right will thereafter have the right to receive, upon exercise, Common Stock … having a value equal to two times the exercise price of the Right. … [F]ollowing the occurrence of the event described in this paragraph, all Rights that are, or were, beneficially owned by any Acquiring Person will be null and void. At any time until ten business days following the Stock Acquisition Date, the Company may redeem the Rights … at a price of $0.001 per Right.

Company issues these rights as a dividend, and they’re way out of the money at issuance

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But, upon a triggering event, the right switches from ‘out of the money’ right to preferred stock into ‘in the money’ right to acquire common stock – except for the person who caused the triggering event

B. Defending Against Hostile Tender Offers

Rules and Regulations

If the board is disinterested, has acted in good faith and with due care, its decision in the absence of an abuse of discretion will be upheld as a proper exercise of business judgment.

Once it’s clear that company is being sold, good faith (DoL) requires Board to maximize SH value. Revlon, p. 125 of outline.

Unocal/Unitrin TestDefensive measures taken by the board will be given the benefit of business judgment review if three conditions are met:

1. The board must act in good faith and upon reasonable investigation of the takeover attempt2. The board show some reasonable grounds for believing that the takeover attempt posed a threat to the

corporation’s welfare. (Requires analysis of the bid and its effect on the corporate enterprise). Covers:3. The defensive measures used must be reasonable in relation to the threat posed and must not be preclusive or coercive

1. Good faith and reasonable investigation A substantial premium over current market price may provide one reason to recommend a merger, but in the absence

of other sound valuation information, the fact of a premium alone does not provide an adequate basis upon which to assess the fairness of the price. Smith v. Van Gorkum

Adequacy of a premium is indeterminate unless it is assessed in terms of other competent and sound valuation information that reflects the value of the particular business. Smith v. Van Gorkum

o Board should generally: 1) Take some time; 2) Hire an investment bank to look at the proposal and assess it for fairness (advisory opinion); 3) Look for other suitors (market test)

2. Determining What is a Threat (Unocal) Inadequacy of price offered Timing and nature of offer (coercive/ preclusive) Questions of illegality (fraud, insider trading)

Impact on non-SH constituency (subject to Revlon) Risk of non-consummation Quality of securities offered in exchange (junk/risky?)

3. Is the defensive measure reasonable? (first, prove not draconian, then prove ‘reasonable’)“If the directors’ defensive response is not draconian (preclusive or coercive) and is within a ‘range of reasonableness,’ a court must not substitute its judgment for the board’s. Board bears the burden.” UnitrinPoison pills are generally reasonable when there is a threat because the acquirer still has the ability to run a proxy contest. Unitrin

However, when Board is faced with a tender offer and a request to redeem the Rights, the Board cannot arbitrarily reject the offer. The ultimate response to an actual takeover bid must be judged by the Directors’ actions at that time, and nothing relieves them of their fundamental duties to the corporation and its stockholders. Moran

Note: Courts can step in to force a Board to redeem its Pill (opening the way for the hostile bid) if Board’s refusal to do so is not reasonable/ there is no threat/ they’re acting to protect themselves rather than the corporate strategy/value. See Interco (Del. Ch. 1988); Pillsbury (Del. Ch. 1988)

Interfering with voting rights. Generally this is not ok as it’s preclusive. See proxy fight section on page 133 of outline. Can’t protect the existing board by adopting either dead hand (Toll Brothers) or slow hand (Quickturn) pills

Lock ups. Directors may not use defensive tactics that destroy the bidding process. Barkan Once it is clear that sale will occur, D must act to max sale price. Only def. measures that increase sale price are ok. Directors can’t use defensive mechanism to thwart an auction or to favor one bidder over another. Barkan No shop clause is not valid unless it contains a fiduciary out. QVC If only 1 bidder at the table, board must engage in a ‘market-check’ to see if a higher bid is available, unless the

directors possess a body of reliable evidence with which to evaluate the fairness of a transaction. Barkan Break up fees that are reasonably related to the costs borne by the initial bidder are ok. In Re Pennaco Energy Price-matching rights are reasonable, because other bidders can still enter by bidding higher. In Re Pennaco Energy DGCL §146 - Board can contract to put tender/merger to a shareholder vote (as long as Board is free to rec. against it) SH lockups are ok if 1) party binding self is acting as a SH not as a Dir. & 2) there’s no ‘force the vote’ provision. Orman

o Armour doesn’t like SH/ Dir. Distinction in Omnicare/ Orman. For better distinction, see next page

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The ‘shareholder vs. director’ distinction is bad because Omincare’s merger agreement specified that the directors were entering into the lockup as shareholders rather than in their board capacity

The real distinction between Orman and Omnicare is the temporary nature of the lockup (it’s more of a lock-out to 3rd parties than a lock-in for the acquirer)

In Orman, there is 1 foolproof way to get out of the lock-in: if a better offer comes along, the Cullmans can ‘buy out’ the agreement with Swedish Match if there is an economic surplus above the settlement cost

Source of power to defend/ issue pill (as detailed in Moran)DGCL §141(a) board has the power to manage the corporation’s business and affairs. DGCL §160(a) gives a corporation the power to deal in its own stockDGCL §157 –a corporation can issue and sell new stock/ securities/ options in the company with the approval of the board (unless charter strips this power)DGCL §151(g) if the shares are new, the company must file the number of shares issued with the state

Selective dealing with stockholdersA Delaware corporation may deal selectively with its stockholders provided the directors have not acted out of a sole or primary purpose to entrench themselves in office (Cheff. V. Mathes) (directors may not have acted solely or primarily out of a desire to perpetuate themselves in office or take inequitable action)

Selective dealing to exclude those making the coercive offer from benefitting is allowed. Unocal. Discriminatory self-tenders are now barred by SEC Rule 13e-4. greenmail and selective issues to board (as in

Unocal) are prohibited.

Embedded Defenses – Anti-takeover provisions embedded in customer Ks.These kinds of embedded protections are probably ok only insofar as they are related to the business plan (for PeopleSoft, that they are relatively proportional to the customers’ switching costs in the event of a buyout)

Oracle/ PeopleSoft – PeopleSoft initiates a customer assurance program basically, if there’s a change in control over PeopleSoft that causes a reduction in technical service to PeopleSoft products, the company will provide 2-5x the purchase price of the software as compensation

Oracle challenges the agreement in Ch. Court, but the parties settle before there’s a decision Court would have applied Unocal/ Unitrin to determine whether it was within the range of reasonableness

o PeopleSoft board would have argued that this program was necessary to get customers to continue buying their software in the face of a merger that would likely gut the new company of many ex-PeopleSoft people (PeopleSoft supporters alleged that the bid was really to accomplish just this result hope for failed bid that would still drive away current customers)

Policy Implications

Are pills good for efficiency? Returns to acquirers have dropped + Returns to targets have increased pills shift benefits toward targets Merger numbers have gone down (may indicate efficacy against bad actors, but also probably reflects the fact that

some mergers that once created efficiency gains large enough to prompt a takeover no longer do so because part of the gains must be shared with target shareholders.

Should investors be pro or anti-pill? If you were fully diversified and equally likely to be invested in acquirers and targets, you wouldn’t care whether

Pills are legal or not Since acquirers tend to not be publically traded companies, a diversified investor in the public market will be

overweight on ‘targets’, and so consequently prefer that the Pill be available.

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UK City Code on Takeovers and Mergers (equivalent doctrine is mandated for entire EU by Art. 9 of EC Takeovers Directive) General Principle 1. All holders of the securities of an offeree company of the same class must be afforded

equivalent treatment General Principle 3. The board of an offeree company must act in the interests of the company as a whole and must

not deny the holders of securities the opportunity to decide on the merits of the bid. Rule 21. During the course of an offer, or even before the date of the offer if the board of the offeree company has

reason to believe that a bona fide offer might be imminent, the board must not, without the approval of the shareholders in general meeting: (a) take any action which may result in any offer or bona fide possible offer being frustrated or in shareholders being denied the opportunity to decide on its merits.

If the Unocal case had arisen under the City Code, greenmail is prohibited Board can’t take defensive measures beyond recommending against the tender offer/ merger Coercive offers are prohibited (because they don’t treat shareholders equally)

3 types of threats that the Board can defend against under Unocal (Gilson and Kraakman) Structural coercion: “the risk that disparate treatment of non-tendering shareholders might distort shareholders’

tender decisions” T Boone Pickens offer in Unocal (coerces shareholders to take the front end for fear of receiving a less favorable back end)

Opportunity loss: “a hostile offer might deprive target shareholders of the opportunity to select a superior alternative offered by management” (incumbent management might be able to provide more value in the LT)

Substantive coercion: “the risk that shareholders will mistakenly accept an underpriced offer because they disbelieve management’s representations of intrinsic value.” (board tells shareholders that it provides the best LT value, but shareholders don’t believe management’s representations)

o Gilson and Kraakman don’t think this threat is very legitimate, because the board can always retain a 3rd party advisor to bring credibility to their position

How can we protect the old lady who doesn’t want to spend time reading management’s proxy statement? She can sell into the marketplace to arbitrageurs, who will then vote … if the market anticipates that the LT

proposition from management is positive, the stock price will go up. This should tell retail investors whether to sell or not

She can free ride by not voting

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Case Summaries

Unocal v. Mesa Petroleum (Del. 1985) – intermediate scrutiny of def. measures (higher than BSJR, lower than entire fairness)

Pickens Offer Unocal Defensive Offer

Factso Unocal stock trading at ~$33 per share. Mesa Petroleum (Pickens) quietly buys 13% of Unocal’s stock and

then makes a tender offer for another 37% at $54 per share in cash. Mesa discloses its plan to freeze out the remaining 50% for junk bonds with a face value of $54, if successful in the first-stage tender offer.

o Unocal board meets to review the offer; Goldman reports to the board that the minimum cash value in a liquidation would be $60 per share cash.

o Board decides on a “defensive recapitalization:” self-tender for 30% of the shares at $72 per share in debt securities, and tender for remaining 20%, also at $72 per share in debt securities, if Mesa gains 50% (and Mesa excluded from the offer).

o Mesa brings suit to enjoin the defensive measures, which would then allow the hostile tender offer proceed Issue

o Whether a corporation’s self-tender for its own shares is valid when the offer excludes from participation a stockholder making a hostile tender offer for the company’s stock

Ruleso A Delaware corporation may deal selectively with its stockholders provided the directors have not acted out

of a sole or primary purpose to entrench themselves in office (Cheff. V. Mathes)o DGCL 141(a) board has the power to manage the corporation’s business and affairso DGCL 160(a) gives a corporation the power to deal in its own stocko Board has a fundamental duty to protect the corporate enterprise, which includes stockholders, from harm

reasonably perceived, regardless of its sourceo Restriction placed upon a selective stock repurchase is that the directors may not have acted solely or

primarily out of a desire to perpetuate themselves in office or take inequitable action Reasoning

o The back-end securities will be junk-grade, so despite a $54 face value, they probably are worth something like $45 per share after discounting for the risk created by the much larger debt burden on the company

o When the board addresses a pending takeover bid, it has an obligation to determine whether the offer is in the best interest of the corporation and its stockholders. Because of the risk that a board acts in its own interests, there is an enhanced duty which calls for judicial examination at the threshold before the protections of the BSJ may be conferred so directors must show that they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed because of another person’s stock ownership

o The exclusionary tender to all Unocal shareholders except Mesa is necessary because

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1. If Mesa could tender its shares, Unocal would effectively be subsidizing the former’s continuing effort to buy Unocal stock at $54 per share

2. Mesa could not fit within the class of shareholders that needed protection from its own coercive and inadequate tender offer

Holdingo Board must shows some reasonable grounds that the hostile bidder poses some threat to the corporation

i. Requires analysis of the bid and its effect on the corporate enterprise1. Inadequacy of price offered2. Timing and nature of offer3. Questions of illegality4. Impact on non-shareholder constituency5. Risk of non-consummation6. Quality of securities offered in exchange

ii. Here, the hostile bid did pose a threat because the securities on the back end were worth less than the front end, making the initial bid coercive; also, the existing creditors will be harmed; also, the initial $54 was too low given the corporation’s liquidation value of $70

o If defensive measure is to come within the ambit of BSJ, it must be reasonable in relation to the threat posed

i. Here, the selective exchange is reasonably related to the threats posed because of #1,2 reasoning aboveo While the exchange offer is a form of selective treatment, given the nature of the threat, the response is

neither unlawful of unreasonable. If the board is disinterested, has acted in good faith and with due care, its decision in the absence of an abuse of discretion will be upheld as a proper exercise of business judgment.

Commentso SEC subsequently prohibits discriminatory self-tenders in Rule 13(e)4

Bars ‘greenmail’ and Unocal’s defensive measureo Unocal’s self-tender effectively changes the incentives so no one will tender (and Pickens will fail)o Because this upsets shareholders, the corporation gives an unconditional tender to shareholders for 30% of

shares at $72. Everyone subscribes, and essentially gives everyone a cash payout because pro rata share of stockholders remains the same

i. To pay for this, Unocal had to borrow lots of money 1. This prevents it from continuing with the drilling operations that Pickens purportedly

wanted to stop2. This also prevents Pickens from further levering the company’s assets (which would have

been the way he would have paid to acquire it)o Because the unconditional tender wasn’t open to Pickens, his shares drop in value

i. Court says this is ok because1. If Mesa could tender its shares, Unocal would effectively be subsidizing the former

continuing effort to buy Unocal stock at $54 per share2. Mesa could not fit within the class of shareholders that needed protection from its own

coercive and inadequate tender offer

Moran v. Household International (Del. 1985) Facts

o In August 1984, Household International board adopts a flip-over poison pill by a 14-2 vote, on the advice of Wachtell, Lipton and Goldman Sachs. Two triggers: announcement of a 30% tender offer, and acquisition of 20% of the shares.

o Directors Moran and Whitehead (co-Chairman of Goldman, Sachs) vote against; Moran, largest shareholder and potential acquiror, brings suit to enjoin the pill as outside the board’s authority and an invalid exercise of business judgment.

o Chancery Court upholds the poison pill as a legitimate exercise of business judgment; Moran appeals Issue –

o Whether the Board has the right to create this kind of Rights Plano whether the BSJ rules is the standard under which adoption of the Rights Plan should be reviewed

Rules

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o DGCL 157 – subject to any provision in the certificate of incorporation, every corporation may create and issue, whether or not in connection with the issue and sale of any shares of stock or other securities or the corporation, rights or options entitling the holders thereof to purchase from the corporation any shares of its capital stock … as shall be approved by the board of directors

o DGCL151(g) when any corporation desires to issue any shares of stock of any class … on which the voting powers, designations, preferences and relative, participating, optional, or other rights… shall not have been set forth in the certificate of incorporation … but shall be provided for in a resolution … adopted by the Board pursuant to authority expressly vested in it by the provisions of the certificate of incorporation… a certificate setting forth a copy of such resolution and the number of shares of stock of such class shall be executed, acknowledged, filed, recorded and shall become effective in accordance with §103

o To meet their burden, Board must show the defensive mechanism was ‘reasonable’ in relation to the threat posed

Reasoningo The rights plan isn’t a sham – it can and will be exercised upon the triggering evento The rights plan does not usurp shareholders’ right to receive bids, as a proxy contest can be launchedo The holder of a proxy is not the beneficial owner of the stock, so a proxy fight won’t trigger the rights plan

Holdingo Rights Plan was issued pursuant to DGCL 151(g) and 157, and it wasn’t a shamo The Rights Plan does not prevent stockholders from receiving tender offers, and the change in structure is

less than that from other defensive mechanismso “The Rights Plan [I.e., poison pill] is not absolute. When the Household Board of Directors is faced with a

tender offer and a request to redeem the Rights, they will not be able to arbitrarily reject the offer. . . . The ultimate response to an actual takeover bid must be judged by the Directors’ actions at that time, and nothing we say here relieves them of their fundamental duties to the corporation and its stockholders.”

o Here, the Rights Plan was legal and reasonable, so it’s upheld

City Capital Associates Ltd. Partnership v. Interco (Del. Ch. 1988): Chancery Court requires target board to redeem a stock rights plan that the company used to protect its recapitalization alternative to a hostile, all-cash, all-shares tender offer.

Grand Metropolitan Pub. Ltd. Co. v. Pillsbury (Del. Ch. 1988): Chancery Court required Pillsbury to redeem its poison pill after concluding that Pillsbury’s own restructuring proposal was not as good as a hostile all-cash offer from Grand Met.

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Unitrin v. American General Corp. Facts

o American General makes a hostile takeover bid; Unitrin’s board resists by installing a “morning after” pill and repurchasing 20% of its shares.

o Share repurchase increases the Unitrin directors’ stake from 23% to 28%, and gives the board a solid veto power over a freeze-out transaction (due to 75% vote requirement for transactions with a >15% shareholder).

o The Chancery court finds a threat of “substantive coercion” and upholds the pill as proportionate to the threat, but strikes down the repurchase as disproportionate under Unocal.

o Unitrin appeals to the Delaware Supreme Court. Rules

o Second step of Unocal is a two-part inquiry: 2a) was the defensive tactic “coercive” or “preclusive,” and, 2b) if not, does it fall within a “range of reasonableness.”

o Defendant directors have burden of showing proportionality (i.e. within “range of reasonableness”).o If D shows proportionality, burden shifts to P to show breach of fiduciary duty, e.g., entrenchment, lack of

good faith, or being uninformed.o If D fails to show proportionality, D gets a final opportunity to show entire fairness of the transaction.

Holdingo “[I]f the directors’ defensive response is not draconian (preclusive or coercive) and is within a ‘range of

reasonableness,’ a court must not substitute its judgment for the board’s”o Here, the repurchase is not coercive because AMG can still run a proxy contest to remove the existing

board o In a Unocal situation (defending the corporation), defenses aren’t coercive or preclusive as long as you

preserve the possibility of a proxy contest.

Omnicare Inc v. NCS Healthcare Inc (Del. 2003) Facts –

o With its stock in freefall NCS board begins exploring strategic alternatives in late 1999.o In 2001 Omnicare offers to buy NCS for $270 million but negotiations break down.o In June 2002 Genesis offers to buy NCS but demands a fully locked up deal in order to prevent a higher bid

from Omnicare. Genesis & NCS agree to a exclusive negotiating period. Omnicare renews its interest but conditions any offer on due diligence.

o Genesis-NCS announce stock-for-stock deal on July 29, 2002, with Outcalt (NCS Chairman) and Shaw (NCS President) committed to vote their shares (>50%) in favor.

o Omnicare launches competing cash offer for NCS at twice the value of the Genesis offer; on October 6th NCS board recommends the Omnicare offer as a “Superior Proposal.”

o Genesis nevertheless “forces the vote” on its merger agreement as permitted under DGCL 251(c).o Omnicare brings suit to invalidate the stockholder lockup agreement; Delaware Chancery Court upholds

the agreement under Unocal analysis Rules

o Unocal 2-Stage analysis:i. Directors must demonstrate they had reasonable grounds for believing that a danger to corporate

policy and effectiveness existedii. Directors must demonstrate that their response was within a ‘range of preclusiveness’ to the threat

perceived (i.e. not coercive or preclusive)o To the extent that a K purports to require a board to act/ not act in such a fashion as to limit the exercise of

fiduciary duties, it is invalid and unenforceable. Paramount Communications v. QVCo

Reasoningo An offer is coercive if the voter will vote for it regardless of whether he thinks it’s a bad idea o The fact that Genesis demanded strong deal lockup provisions means it anticipated new bids, so the NCS

Board should also have predicted additional bids and ensured that it could receive them

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Holdingo The shareholder lockup was coercive and preclusive so it’s invalido NCS Board did not have the authority to accede to the Genesis demand for an absolute lockupo NCS board was required to negotiate a fiduciary out clause

Commentso DGCL §146 now grants authority to the corporation to enter into K to put something to a shareholder vote

even if the Board thinks it’s a bad ideao There’s no controlling shareholder here, so there’s no duty of entire fairnesso The court may have gotten this wrong because if NCS hadn’t accepted the lock up, Genesis wouldn’t have

made any offer and then Omnicare’s offer wouldn’t have come along either

Orman v. Cullman (Del. Ch. 2004) Facts

o Through a dual class structure the Cullman family owns a controlling interest in General Cigar ever since its IPO in February 1997.

o In January 2000 Swedish Match agrees to buy out the minority shareholders of General Cigar at $15.25 per share cash, such that Swedish Match would own 64% and the Cullman family would own 36% of General Cigar (with Cullmans still retaining control).

o The merger agreement contained: (1) no breakup fee; (2) a fiduciary out that allowed General Cigar to consider an unsolicited superior proposal; (3) a class vote of the A and B shares separately; and (4) a majority-of-the-minority approval (effectively) from the Class A shareholders.

i. But -- the Cullman family agreed to vote their controlling interest for the Swedish Match transaction, and against any alternative acquisition proposal for 18 months after any termination of the merger.

Holdingo Shareholder lockup is upheld. “In [Omnicare] the challenged action was the directors’ entering into a

contract in their capacity as directors. The Cullmans entered into the voting agreement as shareholders. . . . [Unlike Omnicare,] the public shareholders were free to reject the proposed deal, even though, permissibly, their vote may have been influenced by the existence of the deal protection measures.”

o Shareholder lockups are ok if 1) the party entering into it is acting as a shareholder rather than as a board and 2) there’s no ‘force the vote’ provision

Commentso The ‘shareholder vs. director’ distinction is bad because Omincare’s merger agreement specified that the

directors were entering into the lockup as shareholders rather than in their board capacityo The real distinction between Orman and Omnicare is the temporary nature of the lockup (it’s more

of a lock-out to 3rd parties than a lock-in for the acquirer)o There is 1 foolproof way to get out of the lock-in: if a better offer comes along, the Cullmans can ‘buy

out’ the agreement with Swedish Match if there is an economic surplus above the settlement cost

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Revlon mode less likely Revlon mode more likely* TheoryConsideration All stock All Cash Institutional Competence Theory

(Revlon)Size of acquirer / target Merger of Equals Whale / minnowAcquirer Shareholders Widely held Controlling shareholder Sale of Control Theory (QVC)

*except where the target already has a controlling shareholder if target already has a controlling SH, then whale/minnow and controlling SH at the acquirer don’t matter as there’s no change in control.

C. Revlon Duties

Rules and Regulations

General Revlon Rule When it’s clear there is going to be a sale, the Board’s duty of loyalty compels it to maximize returns to

shareholders in the short term i.e. extract the highest possible sale price for the corporation. Revlon Board cannot end an active bidding contest on an insubstantial basis (i.e. only a small premium by A over last bid by

B) if a significant byproduct of the Board’s action is to protect it against possible personal liability from consequences of previously enacted defensive measures. Revlon

Revlon duties in at least 3 situations: Time Warner Whenever the board is pursuing a deal that involves the sale of control of the company Whenever the corporation initiates an active bidding process to sell itself or break up the company When the corporation abandons its LT strategy and seeks alternative transaction involving breakup of the company Directors must maximize value for SH when corp. will not exist after / when existing SH won’t be able to hold the

board accountable. Revlon duties are not triggered by a 13D filing. (Lyondell)

What is Sale of Control? (Point is to trigger Revlon if the transaction is SHs’ last chance to command a control premium) Any cash merger Any stock for stock merger where the acquirer has a controlling shareholder (who will remain a controlling

shareholder in the merged company) Also probably includes “whale minnow mergers—stock for stock mergers where the target shareholders get stock in

a much larger company (so that they only own a small minority of the new company and their control premium in a future deal will be diluted)

Does not include: stock for stock merger of equals where both are widely held companies

What is abandonment of LT strategy? (hard to say, but see below for info on what doesn’t qualify) 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 is not triggered, through Unocal duties attach. Time Warner If the target board doesn’t abandon its strategic plan, then Revlon duties don’t attach. Time Warner Where the board of Time was pursuing a merger with Warner, and Paramount made a hostile offer for Time, the

board of Time was entitled to change its strategy to buying Warner outright (and incurring debt to do so) even though this acted to prevent the Paramount tender by making Time heavily leveraged. Time Warner

Substantive Content of Revlon Duties As explained in Barkan v. Armstead Industries (Del. 1989)Directors have to obligation to: QVC

(a) be diligent and vigilant in critically examining the proposed merger and any competing offers/ tenders (b) to act in good faith; (c) to obtain and act with due care on all material reasonably available including information necessary to compare

which transaction or alternative would provide the best value reasonably available; (d) negotiate actively and in good faith with all bidders

Level Playing Field Among Bidders. Barkan (this is part of what ‘good faith’ negotiation with bidders requires) “When several suitors are actively bidding for control of a corporation, the directors may not use defensive tactics

that destroy the auction process. . . . When multiple bidders are competing for control . . . fairness forbids directors from using defensive mechanisms to thwart an auction or to favor one bidder over another.”

Market Check Required (but there is a very limited exception): Barkan (this is part of ‘negotiate actively’) “When the board is considering a single offer and has no reliable grounds upon which to judge its adequacy…

fairness demands a canvas of the marketplace to determine if higher bids may be elicited.” Exemption from Market Check Allowed in (Very) Limited Circumstances: “When ... the directors possess a body of

reliable evidence with which to evaluate the fairness of a transaction, they may approve the transaction without conducting an active survey of the marketplace.”

BUT: If there’s a 102(b)7 waiver, then instead of questioning whether disinterested independent directors did everything that they (arguably) should have done to obtain the best sale price, the inquiry should be whether those directors utterly failed to attempt to obtain the best sale price. (if they reasonably tried to obtain best price, they satisfy the non-waivable duty of loyalty)

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Revlon obligates target directors to look at all bids; but what should they look at?Target directors must determine if: Paramount Communications Inc v. QVC Network Inc (Del. 1994) [QVC].

(a) the tender offer of the new bidder (QVC) was, or would continue to be, conditional (b) the tender offer of the new bidder could be improved (c) the existing tender offer (of Viacom) or other aspects of that transaction could be improved (d) Each of the respective offers would be reasonably likely to come to closure and under what circumstances (e) other material information was reasonably available for consideration by the target directors (f) there were viable and realistic alternatives courses of action (g) the timing constraints could be managed so the directors could consider these matters carefully and deliberately

To the extent that a contract (merger agreement) purports to require a board to act/ not act in such a fashion as to limit the exercise of fiduciary duties, it is invalid and unenforceable. Paramount Communications v. QVC (fiduciary out is required)

Policy Implications

Hypo: When would Revlon duties apply? Both Viacom and Paramount are widely-held. Viacom agrees stock-for-stock merger with Paramount. no Revlon

duties As 1., but Viacom has Sumner Redstone as 80% controlling shareholder. Revlon duties (sale of control) As 1., but Viacom agrees an all-cash, all-shares offer for Paramount. Revlon duties (sale of control) As 1., but Viacom’s market capitalization is 10x Paramount’s. no Revlon duties because control is held before

and after by diffuse shareholders As 1., but Viacom agrees 51% cash-for-stock tender offer for Paramount followed by 49% stock-for-stock merger.

Revlon duties triggered (the 1st step results in Viacom having control over Paramount, so there’s a control transaction)

As 1., but Viacom agrees to sell its assets to Paramount in return for 45% of Paramount’s stock. Revlon duties on Paramount because there’s a de facto sale of control (Viacom board would control Paramount)

Viacom and Paramount both have controlling shareholders; agree stock-for-stock merger. no Revlon duties because the Paramount shareholders are subject to a controlling shareholder before and after (however, the transaction would be subject to fairness review because there’s a controlling shareholder selling off their control premium does the controlling shareholder get anything different than what the minority shareholders will get? (i.e. make sure paramount’s board isn’t violating its duty of loyalty) although this standard is less stringent than Revlon)

On fiduciary out, the Board doesn’t have a fiduciary right to breach a contract (Van Gorkum). So, if directors’ fiduciary duty requires them to breach a K, the corporation can be held liable to the other party to the K.

Solution: merger agreements have fiduciary out clauses that allow exit without breach Although, note that to the extent that a K purports to require a board to act/ not act in such a fashion as to limit the

exercise of fiduciary duties, it is invalid and unenforceable. Paramount Communications v. QVC

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Case Summaries

Revlon Inc v. MacAndrews and Forbes Holding Inc (Del. 1986) – clarifies what duty of loyalty means when selling, etc Facts –

o Perelman makes a hostile all-cash tender offer for Revlon at $47.50 per share when the stock is trading at $25 (a 90% premium).

o Revlon board adopts a poison pill and tenders for 20% of its own shares with notes. The recapitalization permits Revlon to subject itself to specialized debt covenants that restrict the sale of assets, which in turn makes an LBO more difficult.

o But Perelman is undeterred -- he raises his offer to $50, $53, and finally to $56.25 per share, with the promise of even more if Revlon redeems (i.e., gets rid of) its pill.

o Forstmann Little enters as a “white knight” and eventually agrees to pay $57.25; gets an “asset lockup,” a “no-shop” provision, and a breakup fee, in exchange for supporting the par value of the Notes which had faltered in the market.

i. Asset lockup bars sale of assets during the merger and gives Forstmann an option to buy crown jewels of Revlon at a steep discount if the Forstmann merger doesn’t occur

o Perelman increases his offer to $58, and brings suit to enjoin the defensive tactics and deal protection devices that Revlon used to preserve its deal with Forstmann.

o Chancery Court rules for Perelman and enjoins the asset lockup, no-shop provision, and breakup fee. Reasoning

o The original threat posed by Pantry Pride (break up of company) had already become a reality that directors embraced; selective dealing to fend off a hostile but determined bidder was no longer a proper objective highest price for the benefit of the stockholders should have been the primary goal of the directors’ action.

o The note-holders’ rights were already fixed by contracto Lockups that draw bidders into the process benefit shareholders, but those that end an active auction and

foreclose additional bidding operates to shareholders detrimenti. Forstemann option has a destructive effect because Forstmann was already in the bidding process

o Board’s stated reasons for approving Forstmann were:i. Better financing (But, in reality, financing differences were negligible and are inappropriate in a

cash offer)ii. Noteholder protection (Inappropriate during an auction)

iii. Higher price - While Forstmann’s offer is nominally higher, it is very very small when the time value of money is considered.

Holdingo Revlon board’s focus on the Forstmann agreement to shore up sagging market value of the Notes in the

face of threatened litigation … was inconsistent with… the directors responsibilities at this state of the developments.

i. Board could not make the requisite showing of good faith by preferring the noteholders and ignoring its duty of loyalty to the shareholders.

o A Board may have regard for various constituencies in discharging its responsibilities, provided there are rationally related benefits accruing to the stockholders; however, such concern for non-stockholder interests is inappropriate when an auction among active bidders is in progress: at that point, the object is not to protect or maintain the corporate enterprise, but to sell it to the highest bidder.

i. When an auction among active bidders is in progress, … the objective is no longer to maintain the corporate enterprise but to sell it to the highest bidder; (‘other constituency’ considerations allowable in Unocal no longer apply, because there is ‘no business left to save’ so protecting these constituencies won’t increase LT value of the corporation)

o When a board ends an intense bidding contest on an insubstantial basis, and where a significant by-product of that action is to protect the directors against a perceived threat of personal liability for consequences stemming from the adoption of previous defensive measures, the action cannot withstand the enhanced scrutiny which Unocal requires of director conduct.

Comments

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o Violation of Revlon Duties is a breach of the duty of care, but what the court is really trying to protect against is violations of the duty of loyalty (because board is trying to avoid a transaction in which it might be held liable to the original bidder) Both duties are implicated in this case

Paramount Communication Inc v. Time Inc (Del. 1989) [Time-Warner] – acquisition doesn’t trigger Revlon where it was part of LT strategic plan, even if the structure of the acquisition was set to ward off a sale

Factso Time and Warner agree to a stock-for-stock merger-of-equals in which Warner shareholders get 62% of the

surviving company. Various deal protection devices, including “cross-options” to deter third-party bidders.o Co-CEO’s for five years, then Warner’s CEO (Ross) retires and Time CEO (Nicholas) takes over. Ross

gets $200 million in cash and options by the time he retires, and $600 million total for Warner’s management team.

o Paramount makes an all-cash hostile bid for 100% of Time shares, first at $175, then upped to $200. Time’s board rejects the offer based on (revised) fairness opinion from Wasserstein Perella which values the Time shares for as much as $250.

o Time gets nervous about its shareholder vote, so the deal with Warner is restructured so that Time borrows $10 billion and uses it to make a cash tender offer for Warner.

o Paramount brings suit to enjoin Time’s defensive tactics under Unocal; Time shareholders join suit and also assert a Revlon claim.

Issueso Under what circumstances must a board of directors abandon an in-place plan of corporate development in

order to provide its shareholders with the option to elect and realize an immediate control premium?o Did Time, by entering into the proposed merger with Warner, put itself up for sale?

Ruleso Directors may consider, when evaluating the threat posed by a takeover bid, the inadequacy of the price

offered, nature and timing of the offer, questions of illegality, impact on non shareholder constituencies, risk of nonconsummation, quality of securities offered in the exchange

Reasoningo §141(a), which imposes on directors the duty to manage the business and affairs of the corporation,

includes a conferred authority to set a corporate course of action, including time frame, designed to enhance corporate profitability. thus, LT vs. ST value is irrelevant because directors are generally obliged to charter a course in the corporations best interest without regard to a fixed investment horizon.

i. Absent a limited set of circumstances as defined under Revlon, a board is not under any per se duty to maximize shareholder value in the ST, even in the context of a takeover

o Time’s board reasonably determined that Time shareholders might elect to tender into the Paramount cash offer in ignorance or mistaken belief of the strategic benefit which a business combination might produce

Holdingo At least 2 situations that trigger Revlon duties

i. When a corporation initiates an active bidding process to sell itself or effect a business reorganization involving a clear breakup of the company

ii. Where, in response to a bidder’s offer, a target abandons its LT strategy and seeks an alternative transaction also involving the breakup of the company

iii. Maybe others (see Paramount for actual formulation of others)o Here, there is no Revlon claim, because Time’s initial negotiation with Warner did not make the dissolution

or breakup of the corporate entity inevitable. (because Time is the surviving corporation)i. Here, Time’s recasting of its merger agreement with Warner from a share exchange to a share

purchase is not evidence that Time either abandoned its strategic plan or made a sale of Times inevitable

o If the Board’s reaction to a hostile tender offer is found to constitute only a defensive response and not an abandonment of the corporation’s continued existence, Revlon duties are not triggered, through Unocal duties attach

o Ample evidence in the record to support protection of Time’s board’s decision to expand the business through the merger with Warner with the BSJ rule

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o Directors are not obliged to abandon a deliberately conceived corporate plan for a ST shareholder profit unless there is clearly no basis to sustain the corporate strategy

o Times response was reasonably related to the threat posed by Paramount it did not preclude Paramount from making an offer for the combined Time-Warner or from changing its conditions so it wasn’t dependent on the Time Warner agreement

Paramount Communications Inc v. QVC Network Inc (Del. 1994) [QVC] – sale of control triggers Revlon Facts –

o Paramount agrees to be acquired by Viacom, controlled by Sumner Redstone, for Viacom stock and cash worth ~$70.

o The deal gives substantial deal protection measures to Viacom: “no shop” agreement; $100 million breakup fee; and 19.9% stock option lockup.

o QVC (Diller) “jumps” the deal with an offer to acquire Paramount for $80 in cash and then stock; when negotiations stall Diller makes a hostile $80 cash tender offer for 51% of Paramount, with a planned back-end squeeze-out for $80 in QVC stock.

o Viacom matches QVC at $80, and then raises its price to $85 in cash and stock, but leaves the deal protection unchanged except for a new “fiduciary out” to allow Paramount to not exempt Viacom from its poison pill provision if a better offer comes along

o QVC goes to $90; Paramount rejects as “excessively conditional” but makes no effort to explore the conditions or negotiate with QVC.

o QVC brings suit claiming that Paramount was in Revlon mode; Chancery Court agrees and strikes down all the impediments to the QVC offer

Reasoningo When a majority of a corporation’s voting shares are acquired by a single person or entity, there is a

significant diminution in the voting power of those who thereby become minority shareholderso Here, public shareholders own a majority of Paramount voting stock; after the proposed Viacom merger,

control would be held by Sumner Redstone in the combined company.o This is a stock-for-stock merger, but the two situations articulated in Revlon are not the only situations in

which Revlon duties are triggered (note the ‘without excluding other possibilities’ language there)o Scrutiny is mandated by

i. Threatened diminution of current stockholders’ voting powerii. An asset belonging to public SH (control premium) is being sold and may never be available again

iii. Concern of courts for actions that impair/ impede stockholder voting rights Holding

o Sale of control implicates enhanced judicial scrutiny under Unocal and Revloni. Whether directors made a reasonable decision (Court will not substitute its business judgment for

that of the board as long as the board’s action was, on balance, within the range of reasonableness) o Paramount SH are entitled to receive a control premium and/ or protective devices of considerable measureo Since there was no protective provision in the merger agreement, the Paramount directors had a duty to

take maximum advantage of the current opportunity to realize the best value reasonably availableo When Revlon duties are triggered – Where a corporation undertakes a transaction which will cause:

(a) a change in corporate control; or (b) a breakup of the corporate entity, the directors’ obligation is to seek the best value reasonably available to the stockholders

o Substantive duties – Paramount directors have to obligation to (a) be diligent and vigilant in critically examining the proposed merger and the QVC tender offer; (b) to act in good faith; (c) to obtain and act with due care on all material reasonably available including information necessary to compare which transaction or alternative would provide the best value reasonably available; (d) negotiate actively and in good faith with both Viacom and QVC

i. Revlon obligates the Paramount directors to determine if: 1. (a) the QVC tender offer was, or would continue to be, conditional2. (b) the QVC tender offer could be improved3. (c) the Viacom tender offer or other aspects of that transaction could be improved4. (d) Each of the respective offers would be reasonably likely to come to closure and under

what circumstances

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5. (e) other material information was reasonably available for consideration by the paramount directors

6. (f) there were viable and realistic alternatives courses of action7. (g) the timing constraints could be managed so the directors could consider these matters

carefully and deliberatelyo Revlon obligates the Paramount directors to look at both bidso Provisions in the merger agreement, whether or not presumptively valid in the abstract, may not

validly define or limit the directors’ fiduciary duty under Delaware law Comments

o If a control interest exists, minority shareholders don’t get a control premiumo If there is no control premium, and one would be created through the proposed merger, the minority

shareholders are entitled to a control premiumo Board basically has to go out and conduct a market test and negotiate to obtain merger terms that are within

a range of reasonableness, regardless of any provisions in a merger agreement barring a market check or negotiations with another party

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D. State Anti-Takeover Statutes

Rules and Regulations

States can require minority approval for vesting of voting rights in a shareholder whose acquisition of shares pushes its holding above certain designated thresholds. (CTS Corp. v. Dynamics Corp of America),

States cannot require a vote of disinterested shareholders before the buyer can actually acquire the shares (Edgar v. MITE Corp)

Delaware’s Anti-Takeover ProvisionDGCL § 203 bars business combinations between acquiror and target for 3 years after acquiror passes 15% threshold unless:

§ 203 (a)(1): takeover is approved by target board before the bid occurs; or § 203 (a)(2): acquiror gains more than 85% of shares in a single offer (i.e., moves from below

15% to above 85%), excluding inside directors’ shares; or § 203 (a)(3): acquiror gets board approval and 2/3 vote of approval from disinterested shareholders (i.e., minority

who remain after the takeover (a)1 Exempts friendly bids (a)2 Exempts short form mergers where buyer moved from 15 to 85% in a single step (a)3 Exempts where acquirer wins a proxy fight and gets a supermajority of the minority

Policy Implications

DGCL §203 deters junk-bond financed ‘bust up’ mergers by preventing acquirers from getting their hands on the assets of target firms

DGCL §203 incentivizes: Bids that are friendly (give directors big pay-outs/ say you’ll fire them if you win a hostile proxy fight)

o However, this may implicate the duty of loyalty as in Digex Proxy contests

Other States

In states with constituency statutes, there are no real Revlon duties because the board isn’t required to ever ‘just consider shareholder interests’ (i.e. sale of company is still a BSJ situation)

o However, if the acquirer engages in a proxy fight, then the shareholders are the only voters (not workers), so the buyer can bypass influence of other constituencies on the board.

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Bans greenmail

(but also deters legit.

bidders)

(basically requiring approval of independent directors)

Case Summaries

CTS Corp. v. Dynamics Corp of America (1987) Facts

o Dynamics makes a hostile tender offer for CTS Corp; brings suit challenging the Indiana antitakeover statute as preempted by the Williams Act and a violation of the (dormant) Commerce Clause.

o The Indiana control share acquisition statute prohibits a bidder from voting its shares beyond 20% ownership unless approved by “disinterested” shareholders (i.e., shareholders other than bidder and insiders).

o Court of Appeals strikes down the statute as preempted by the Williams Act. Holding

o U.S. Supreme Court upholds the Indiana statute; distinguishes the Illinois antitakeover statute struck down in Edgar v. MITE five years earlier

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E. Proxy Fights

Rules and Regulations

Legal power held by a fiduciary may not be deployed in a way that is intended to treat a beneficiary of the duty unfairly. Schnell v. Chris-Craft Industries

Moving the annual meeting up to prevent a proxy contest because there’s no longer enough time to submit & clear proxy materials is not allowed. Schnell v. Chris-Craft Industries

Inequitable action does not become permissible simply because it is legally possible, and trying to interfere with the proxy mechanism is inequitable. Schnell v. Chris-Craft Industries

Even if you’re acting in good faith, interfering with the voting process will be held invalid unless there is a compelling justification to do so (and maintaining control to ensure continuation of the business strategy is not compelling). Blasius

Basically, where challenger is running a proxy vote to seek shareholder support for expanding the board and filling it with challenger nominees, the incumbent board can’t expand the board and appoint its own nominees to stave off the possibility of losing its majority on the board.

Where the primary purpose of Board’s actions is to reduce the ability of others to influence board decision, the actions will be struck down. Liquid Audio

Shifting assets from a parent with an unclassified board to a subsidiary with a classified board (and charter provisions requiring a supermajority of 80% to remove directors without cause or remove the staggered board) is coercive and preclusive, as it precludes current shareholders from exercising a right they currently possess (appointing the board). Hilton v. ITT Corp

Can’t protect the existing board by adopting either dead hand (Toll Brothers) or slow hand (Quickturn) pills

Policy Implications

Today, to avoid a pill, you must capture the board (i.e. friendly deal w/ current board, or win proxy contest to replace it) Before the pill (1970s-1985): board control is an inevitable consequence of buying a majority of the shares: 1. Bidder makes a tender offer and gains a majority of the shares2. Board will almost certainly resign because independence is doomed.3. If directors stay they will be voted out over one (no Staggered Board) or two/three (staggered board) annual elections.

After the pill (1985-present): board control is a prerequisite to buying a majority of the shares: 1. Bidder launches a proxy contest to replace the target’s board over one (no SB) or two (SB) annual elections.2. Once in office, the new directors redeem the pill, thus clearing the way for the hostile bidder to proceed with its bid.3. Bidder makes tender offer and gains a majority of the shares*SB = staggered board

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Case Summaries

Schnell v. Chris-Craft Industries (Del. 1971) Facts

o Dissidents are negotiating with management up to the last possible moment, in hopes of avoiding a full-fledged proxy contest.

o Incumbent board strings the dissidents along in negotiations and then, when there are only a couple of months left before the annual meeting, the incumbent board amends the by-laws to advance the meeting date by one month to mid-December (and, for good measure, moves the meeting to an obscure town in upstate New York).

o All of this has the effect of leaving too little time for dissidents to organize and solicit proxies. o The excuse that the board gave was that it wanted to avoid the Christmas mail crush in sending out the

solicitation materials and getting back the proxy cards. History

o Dissidents bring suit seeking an injunction to postpone the meeting; o the Chancery Court reorganized this as a sleazy, hard-ball tactic, but refuses to grant the injunction.

Ruleso Board has the power to amend the bylaws and change the date/ time of the annual meeting

Reasoningo When the bylaws designate the date of the annual meeting, it is to be expected that those who intend to

contest the reelection of incumbent managers will gear their campaign to the bylaw dateo Inequitable action does not become permissible simply because it is legally possible.o Trying to interfere with the proxy mechanism is inequitable

Holdingo Legal power held by a fiduciary may not be deployed in a way that is intended to treat a beneficiary of the

duty unfairly. Schnell v. Chris-Craft Industries

Blasius Indus. v. Atlas Corp. (Del. Ch. 1988) Facts

o Blasius Industries, a 7% shareholder of Atlas, announces its intention to solicit shareholder consents to increase the size of the board from 7 to 15 members, and to fill the new board seats with Blasius nominees. Objective is to execute a restructuring plan for Atlas.

o Atlas preempts the campaign by immediately amending its bylaws to add two new board seats, and fills the board seats with its own candidates.

o Blasius brings suit to enjoin the “board packing” tactic. Reasoning

o In increasing the size of the board, the current directors knew they were precluding the holders of a majority of the board from placing a majority of new directors on the board should they want to do so, and the evidence shows this was the principal motivation

o Shareholders have 2 rights: to vote shares, and to sell shareso A board can take steps to defeat a change in corporate control if they are taken in good faith to benefit

corporation and are reasonable in relation to a threat to legitimate corporate interests posed by the proposed change in control. Unocal

Holdingo Even if you’re acting in good faith, interfering with the voting process will be held invalid unless

there is a compelling justification to do so (and maintaining control to ensure continuation of the business strategy is not compelling)

Commentso Blasius reverses the BSJ presumption on matters of voting

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Liquid Audio v. MM Companies Inc (Del. 2003) Facts

o Liquid Audio (LA) has $86 million of cash but a $52 million market capitalization. In October 2001, after a year of negotiations, MM offers ~ $3.00 per share to acquire LA, later reduced to $2.50.

o LA refuses the offer and in June 2002 announces a stock-for-stock merger with Alliance Entertainment.o MM forces LA to hold its annual meeting, at which MM plans to: (1) challenge the two incumbent

directors who are up for re-election; and (2) propose a bylaw amendment expanding the board from five to nine members.

o In August 2002, LA adds two directors, increasing board size from five to seven.o At the September 2002 annual meeting, shareholders elect the two MM candidates to replace the LA

incumbents, but reject the MM proposal to add four more board seats. History

o MM brings suit alleging violations of Blasius and Unocal; Chancery Court (Jacobs, V.C.) upholds LA’s defensive tactics under Unocal, and declines to apply Blasius “compelling justification” standard.

Holdingo Delaware Supreme Court reverses, holding that Blasius applies because the “primary purpose” of LA’s

actions was to reduce the MM directors’ ability to influence board decisions. Court then applied Blasius to invalidate LA’s board expansion

Hilton v. ITT Corp (D. Nev. 1997) – applies Blasius Facts

o In January 1997, Hilton announces $55 per share tender offer for ITT, and announces plans for a proxy contest at ITT’s 1997 annual meeting to replace all of ITT’s directors.

o ITT takes defensive measures -- sells several non-core assets, files objections with gaming regulatory bodies, and delays its annual meeting by six months to November 1997.

o In July 1997, ITT announces Comprehensive Plan to split ITT into three entities, including ITT Destinations which will have 93% of the assets and a staggered board. ITT Destinations charter requires 80% vote for removal without cause and 80% vote to repeal the staggered board. (the subsidiary’s board is heavily entrenched by the staggered board, and it holds almost all the assets)

o Hilton brings suit to enjoin the Comprehensive Plan Holding

o Installation of a classified board is clearly preclusive and coercive under Unitrin, as it precludes current ITT shareholders from exercising a right they currently possess (to determine the membership of the board of ITT)

Toll Brothers - Dead hand pills are impermissible w/o a change in the corporate charter b/c it creates 2 classes of directors.

Mentor Graphics v. Quickturn Design (Del. 1998) Facts

o In the face of a hostile bid and proxy contest launched by Mentor, Quickturn board modifies its “dead hand” pill (of the sort invalidated in Toll Brothers) to become a “slow hand” pill: cannot be redeemed for 6 months if this would have the effect of facilitating a transaction with an Acquiring Person.

Historyo Court of Chancery (Jacobs, V.C.) concludes pill is disproportionate under Unocal/Unitrin: “Undoubtedly

a board is entitled to rely upon its experience when making a business decision, but when the decision is of a kind that is subject to enhanced judicial scrutiny, the board must articulate a reason more specific and nonconclusory than a statement such as ‘six months was reasonable.’”

Holdingo Supreme Court (Holland, J.): “slow hand” pill is an invalid encroachment on (future) board’s authority to

manage the business of the corporation under DGCL §141(a); in particular, by creating a potential conflict with the board’s fiduciary duties: “To the extent that a contract, or a provision thereof, purports to require a

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board to act or not act in such a fashion as to limit the exercise of fiduciary duties, it is invalid and unenforceable.”

Comments - Quickturn basically applies Omnicare to the situation

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F. Shareholder Efforts to Limit the Pill

Shareholder’s Proposal from Bebchuk In March 2006 Professor Lucian Bebchuk submitted a 14a-8 proposal to Computer Associates to amend its bylaws

so that CA could only adopt a pill through a unanimous board vote, and any pill so adopted would automatically expire after one year unless ratified by shareholders.

SEC refused to grant a “no-action” letter allowing the company to omit it from its proxy. In June 2006, Delaware Chancery Court refused to rule on the validity of the Bebchuk bylaw amendment, citing

ripeness problems. In September 2006, 41% of CA shareholders voted in favor of the proposal (so it failed)

The point of this amendment is to pull the teeth from a staggered board (since you only need 1 director’s support to pull the pill)

Tension between §109(b) and §141(a) §109(b): “The bylaws may contain any provision, not inconsistent with law or with the certificate of incorporation,

relating to the business of the corporation, the conduct of its affairs, and its right or powers of its stockholders, directors, officers, or employees.”

§141(a): “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 in its certificate of incorporation.”

Basically, a proposal like Bebchuk’s may be contrary to §141(a) because it limits the board’s ability to adopt a pill (requiring a unanimous vote), but since it doesn’t absolutely ban the pill, it may not affect §141(a)

If the provision limits the board’s ability to exercise its fiduciary duty, it is invalid Procedural limits are ok, but substantive limits are not (CA v. AFSCME)

Unisuper v. NewsCorp (Del. Ch. 2005) – Board refuses to adhere to agreement w/ certain investors not to extend a pill longer than 1 year. Board’s extension of pill violates the K

Factso In October 2004, as part of its reincorporation from Australia to Delaware, the News Corp. board agreed

with certain institutional investors to a “board policy” that any poison pill adopted by the News board would expire after one year, unless shareholders approved an extension.

o One month later, Liberty Media appeared as a potential hostile bidder, the News board promptly installed a pill, and announced that, going forward, it might or might not hold to its board policy.

o In November 2005, the News board extended its pill in contravention of its earlier stated board policy. History

o Shareholders filed suit in Delaware Chancery Court alleging breach of contract, among other claims. Reasoning

o §141(a) vests power to manage the corporation in the board, but since the agreement is with the shareholders, it’s ok

o Holding

o Where the principal wishes to make known to the agent exactly which actions the principal wishes to be taken, the agent cannot refuse to listen on the grounds that this is not in the best interests of the principal

o Where the principal makes knows to the agent exactly which actions the principal wishes to be taken, the agent must act in accordance with those instructions… so the agreement is upheld

Commentso This may violate the ASFCME case

Policy Implications:Tying the board’s hands over a period of time is problematic (deadhand pill cases), and Bebchuk-type provisions force reconsideration so it may be helpful

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X. TRADING IN THE CORPORATION’S SECURITIES

A. Overview

Definition: Person engages in insider trading if he buys/sells stock in a publicly traded company based on material non-public info

Ways to Combat Insider TradingState Common Law Fraud (covers all transactions)SEC Acts (covers publically traded companies only)

State Common Law Fraudp.140

Covers transactions where insider had a duty to counterparty (duty extends only to personal transactions with current shareholders; doesn’t cover ‘silent transactions’)Fraud = 1) a false statement of 2) material fact 3) made with the intention to deceive 4) upon which one reasonably relied and which 5) caused injury.

SEC §16(b)p.142

disgorgement of any short swing profits made while an insider

SEC Rule 10b-5p.143

prohibition on 1) fraudulent behavior, 2) untrue statements of material fact, or 3) omissions to state material facts where these omitted facts are necessary to make statements that are made not misleading, or 4) act in any fraudulent or deceitful way upon anyone

SEC Rule 14(e)3p.153

Covers tender offers only. imposes a duty on all parties who have insider info to disclose or abstain if they know or should know that the info is from an inside source (i.e. regardless of whether info comes from target or bidder, there’s a duty to disclose or abstain);

- also imposes liability on insiders who communicate the info under circumstances in which tippee is reasonably likely to trade on it

SEC Regulation FD p.154

imposes a duty on publically traded firms and anyone acting on their behalf to disclose any non-public information they either intentionally disclose or non-intentionally disclose to any outsider. (simultaneously in case of an intentional disclosure, and ‘promptly’ in case on a non-intentional disclosure) (duty is on the firm, not the tippee)

Policy Implications

What’s wrong with insider trading? (i.e. why we should have anti-insider trading rules) Fairness Incentivizes insiders to keep information private until they can profit on it (which disrupts ECM) Insiders are acting on corporate information, so the opportunity to profit really belongs to the corporation… if the

insider is trading on it, or selling it they are profiting off the company’s assets

What’s good about insider trading? (i.e. why we should get rid of anti-insider trading rules) Communication

o Insider trading provides a valuable and credible mechanism for communicating information to the marketplace (Fischel 1984)

i. They are adding information to the market more quickly than corporate disclosure requirements1. However, this information will reach the market pretty quickly anyway, so it’s not clear

how much of a benefit this really creates2. Also, analysts have less incentive to assess outside sources, which may be bad

Can compose part of executive compensation o Insider trading increases incentives to create valuable information (Fischel 1984) o Would function like an implied option on the company’s stock

i. BUT, this incentivizes maximizing ST value (might misalign with values of LT shareholders)ii. Creates implied call AND put options, so insiders profit from volatility not just growth

1. So they’ll be less focused on increasing the value of the firm and more focused on choosing volatile strategies

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iii. Pricing problem (because there’s no oversight by the board, the executive can make huge profits disproportionate to the value he adds to the firm)

Not unfairo Outsider will pay less for securities because of the possibility of insider trading, and so will still achieve the

expected rate of returni. However, this increases the cost of capital for firms

Enforcement. o Very difficult to enforce against it anyway

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B. Common Law Fraud

Rules and Regulations

Fraud = 1) a false statement of 2) material fact 3) made with the intention to deceive 4) upon which one reasonably relied and which 5) caused injury.

Directors don’t owe any fiduciary duty to individual shareholders, unless there’s a personal interaction and the other party knows that the director is a director. Goodwin v. Agassiz (Mass. 1933)

Where the insider remains silent and simply buys or sells based on inside information, the common law generally does not impose a duty to disclose the facts known to him (Goodwin v. Agassiz).

o BUT, where a director personally seeks a stockholder for the purpose of buying his shares without making disclosure of material facts, the transaction will be closely scrutinized and relief may be granted in appropriate instances. Goodwin v. Agassiz (Mass. 1933)

Directors never owe a duty to non-shareholders. I.E. No fraud claim for silent transaction (no misrepresentation) selling shares to someone who isn’t a current shareholder.

No Recovery by Corporation: You might think that under classic agency law the directors should have to disgorge all profits to the corporation from insider trading—trading on information belonging to the corporation. But only one court has held this way (Diamond v. Oreamuno).

This is because if the corporation doesn’t have an opportunity to act on the information, there is no injury (and thus no fraud), and in most cases, the corporation won’t be able to trade due to federal disclosure requirements Freeman v. Decio

Brophy case (Del.) held that the employee was in a position of trust and public policy prevented courts from allowing him to abuse the relationship for his own profit regardless of whether or not the employer suffered a loss

Director’s duty of candor under Del. Law requires directors to exercise honest judgment to assure the disclosure of all material facts to shareholders. Failure to disclose a material fact, however, is unlikely to give rise to liability unless this failure represented intent to mislead.

Case Summaries

Freeman v. Decio (7th Circ 1978) Facts

o Arthur Decio is the largest shareholder, chairman of the board, and president of Skyline Corp.o Resigns in Sept. 1972; in Nov. 1972, Skyline announces an unexpected 17% drop in earnings.o Freeman brings a shareholder derivative suit alleging that Skyline deliberately overstated its earnings for

the previous two quarters before Nov. 1972; and that Decio and others sold Skyline stock knowing that the earnings had been overstated.

History - District Court grants summary judgment for Decio; Freeman appeals to 7th Circuit Reasoning

o Distinguishes from Brophy because that case involved a secretary trading on information that the corporation was about to begin buying its own stock

o The information here is not a corporate asset because it couldn’t act on it itself without violating other federal and state securities laws

Holdingo If the corporation doesn’t have an opportunity to act on the information, there is no harm.o No need to rule based on common law because the federal SEC laws now constitute a more effective

deterrent to insider trading than they did when Diamond was decided Comments

o This is weird, b/c courts have never required a showing of a loss in cases claiming breach of fiduciary duty

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o The Brophy case (Del.) held that the employee was in a position of trust and public policy prevented courts from allowing him to abuse the relationship for his own profit regardless of whether or not the employer suffered a loss

Goodwin v. Agassiz (Mass. 1933) Facts

o Agassiz and MacNaughton are directors and officers of Cliff Mining Company and officers of another mining company.

o Based on surveys done by the other company, Cliff Mining starts exploring on its property in 1925 but ends without results in May 1926. On May 14th, 1926, a newspaper discloses that Cliff Mining has stopped exploration on its property.

o Meanwhile, in March 1926, a geologist writes a report identifying the possibility of copper deposits in Cliff Mining’s property.

o In May 1926, Agassiz and MacNaughton anonymously buy shares from Goodwin, on the Boston Stock Exchange, based on favorable non-public information contained in the geologist’s report.

o Goodwin claims that he would not have sold had he known the geologist’s information, and brings suit to rescind the transaction

Issue – whether non-disclosure of the private information was a wrong against Goodwin Rules

o Where a director personally seeks a stockholder for the purpose of buying his shares without making disclosure of material facts, the transaction will be closely scrutinized and relief may be granted in appropriate instances. Strong v. Repide

o Fraud = 1) a false statement of 2) material fact 3) made with the intention to deceive 4) upon which one reasonably relied and which 5) caused injury.

o When an agent trades with a principal (as in the fiduciary relationship), the agent must disclose everything relevant about the trade

Reasoningo Here, there was no personal interactiono Here, the shareholder was not principal the director is an agent of the corporationo The Cliff Mining Company was not harmed by the nondisclosure

Holdingo Directors don’t owe any fiduciary duty to individual shareholders, unless there’s a personal interaction and

the other party knows that the director is a directoro In the circumstances there was no duty on the part of the defendants to set forth to the stockholders at the

annual meeting their faith, aspirations, and plans for the future Comments

o If directors can’t be sued by shareholders directly, can they be sued in a derivative suit?

Brophy (Del.) finds there is a fiduciary duty to the corporation

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C. Short Swing Profits

Rules and Regulations

§16 of 1934 Act § 16(a): Statutory “insiders” (directors, officers, and 10% shareholders) must file public reports of any transactions

in the corporation’s securities,o The public reports must be filed within two days of the trade under Sarbanes-Oxley § 403. o “Officer” status depends on having a policy-making function within the corporation (Rule 16a-1(f)).

§ 16(b): statutory insiders must disgorge any profits on ‘matching’ purchases and sales within any six month period

*Note: For federal purposes, 10% shareholders are considered insiders because this is seen as the threshold for exercising influence on corporate policy. (differs from Del., where the test is more subjective)

There is exemption for unorthodox transactions Short swing profits from takeovers (Kern County) if

o (1) the transaction was essentially involuntary (ie if the exchange of shares for cash or stock in a surviving company was automatic under state law) and

o (2) the transaction was of a type in which the defendant probably did not have access to inside information. This exempts mergers, but won’t exempt a sale by an insider in a tender offer

Match any transactions that produce a profit looking forward and backward 6 months from each transaction (do any 2 transactions in a 6 month period create a profit or avoid a loss?) Gratz v. Claughton

Insider is not allowed to offset any notional losses within the period just determine if any 2 create profit or avoid loss Purchases you make before you become an insider are not included in the matching, unless the firm does an IPO

and you owned shares before the IPO. §16(a)2(A) Trades are included for the purposes of liability under 16(b) for 6 months after you’ve resigned §16(a)2(B)

Hypo: (p. 629)

Disclosure requirementso Must disclose 9/15 trade upon appointmento Must disclose 10/30-12/25 trades within 2 days of trade

Short swing profitso Match 10/30 and 12/15 to 3/20 yields profits of $1 + $1.20 = $2.20

Policy Implications

Criticism of §16: Underinclusive (doesn’t cover tip off profits, or profits made after the 6 month period, or profits based on stocks

purchased before becoming an insider) Overinclusive (covers profits made by insiders even if they’re not based on inside information)

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D. Rule 10b-5

Rules and Regulations

Rule 10b-5.It is unlawful for any person, directly or indirectly [in connection with the purchase or sale of any registered security]

(a) To employ any device, scheme, or artifice to defraud; (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to

make the statements made, in the light of the circumstances under which they were made, not misleading; (c) To engage in any act, practice, or course of business which operates … as a fraud or deceit upon any person,

in connection with the purchase or sale of any securityCreates implied right of private action for people who trade based on the prohibited behavior. Superintendent of Ins. v. Bankers Life

Rule 10b5-2 – broadens duty of trust or confidence with a rebuttable presumption to family members of insidersA duty of trust or confidence arises, in addition to other circumstances, whenever

(1) a person agrees to maintain information in confidence; (2) two people have a history, pattern, or practice of sharing confidences such that the recipient of material non-

public information knows or reasonably should know that the person communicating the information expects that the recipient will maintain its confidentiality; or

(3) a person receives or obtains material non-public information from a spouse, parent, child, or sibling, unless the recipient can demonstrate that, under the facts and circumstances of that family relationship, no duty of trust or confidence existed.

Elements of a 10b-5 claim1. Duty: if the claim is based on insider trading, the defendant must have either been an insider, a knowing tippee, or a

misappropriator. A person who is none of these has no duty to disclose or abstain … expanded by 10b5-2 above2. False or misleading statement or omission: Chiarella, Dirks, O’Hagan 3. Materiality: what a reasonable shareholder would consider important. Basic – probability x magnitude test.4. Scienter: specific intent to deceive, manipulate, or defraud (Ernst & Ernst), though may be inferred from reckless or

grossly negligent behavior.5. Standing: must be an actual purchase or sale of securities (Blue Chip Stamp – court reads this into 10b-5 from ‘in

connection with purchase or sale’ in the regulation).6. Reliance/Causation: presumption of reliance on the integrity of market price (Basic).7. Injury/Damages: disgorgement rule (Liggett)

1. DutyGenerally, there no duty to disclose or abstain if there is no relationship of trust and confidence between parties to a transaction. Chiarella

It’s up to the court to determine when these ‘relationships of trust and confidence’ are present, which gives courts flexibility to decide on a case-by-base basis

Insider (one who obtains info by virtue of his employment with company whose stock he trades in) has a duty to disclose or abstain (Texas Gulph Sulfur; Cady Roberts Rule) (10b5-2 creates rebuttable presumption for family members of insiders)

o D&O are subject to this relationshipo HOWEVER, even for D&O of the acquiring company, this rule doesn’t prevent them from trading in the

securities of the target company (because the acquirer doesn’t yet owe them any duty) Tippors and Tippees :

o (1) A tippee has derivative liability if the tipper breached a fiduciary duty to the company and the tippee knows or should know that there has been a breach.

o (2) The tipper in turn breaches his fiduciary duty to the corporation only if he personally will benefit directly or indirectly from his disclosure (including if the insider was intending to make a gift to the tippee).

o A tipper who acts not for private benefit but to expose a fraud does not violate a fiduciary duty, and thus the tippee who trades on it is not derivatively liable. Dirks v. SEC

No liability for tippees if they don’t owe the company a fiduciary duty. US v. Chestmano If an outsider acquires information purely by chance, he can trade on it without being liable (can’t have

prompted the disclosure; insider can’t have disclosed to tippee to benefit himself)

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RuleElements generallyElements in detailCivil remediesCalculating damages

2. False or misleading statement or omission10b doesn’t apply in the absence of a misstatement or omission. If the company provides information (such as asset value of a company) that would allow buyer/seller to draw his own conclusion about another representation (such as appraisal value), there is no 10b-5 violation. Santa Fe Industries v. Green

No false statement or omission where an ex-insider discloses to expose fraud. Dirks There is a deception if someone bound by a relationship of trust and confidence uses information obtained by an

insider and doesn’t tell the principal that he’s going to trade based on the information. O’Hagan

3. MaterialityGenerally, a statement/ omission is material if there is a substantial likelihood that a reasonable investor would view it as significantly affecting the mix of total information.

i.e. will it impact the investment decision of a reasonable investor Where it is uncertain whether the disclosure is material , look at the facts in detail to determine probability and

magnitude of the information. Basic Inc v. Levinsono Probability of event ‘known’ by insider x Magnitude takes an expected value approacho If the EV is large enough to be taken into account by a reasonable investor, then it’s material

Might be able to argue that investors ignore EV when the probability is very low Another factor for materiality: importance attached to fact by those that knew.  Timing of stock purchases by people

who’d never bought stock before.  Compels inference that they were influenced by the fact. Texas Gulf Sulphur

4. Scienter – requires ‘an intent to deceive, manipulate, or defraud’. Not really an issue in insider trading cases. Rule 10b5-1 provides a safe harbor if the insider adopted a written plan for trading securities that locked the insider

into making particular trades before the inside information become known to him. The scienter requirement is waived if D controlled X, an insider trader, and D knew or recklessly disregarded the

fact that X was likely to commit insider trading and failed to take proper steps to prevent it

5. Standing – nothing complicated here. Must be actual purchase or sale of securities. Note: this is stricter than for 14e-3

6. Reliance/ CausationReliance. Because the price in the market supposedly reflects the price of all information in the market, then anyone who buys/ sells in the market is implicitly relying on the accuracy of all the info in the market.

This is necessary because it’s almost impossible to prove reliance otherwise. It is possible to rebut the presumption:

Can show that market makers knew the truth such that the truth had been impounded into the price. Strong form of ECM holds that all info, public and private, is already in the price. Semi-strong form of ECM holds that only public info is impounded. Basic relies on the semi-strong form (that public misstatement was impounded, but not the privately known truth)

Can show that the seller needed liquidity, or needed to trigger gain/ loss. (As a practical matter, it’s impossible to show this when it’s a class action)

So, to rebut, you really need to argue that the truth was in the market already, or that the misstatement was not impounded (i.e. that the markets are weak-form ECM/ not informationally efficient)

Causation (of both transaction and loss) Presumed, but rebuttable if D can show change in price wasn’t caused by false info but rather some extraneous factor. If there is no decline in price, then there’s no causation. Dura Pharmaceuticals

Hypo: Transaction Causation vs. Loss Causation Facts

o ABC Corp. operates a commercial storage facility and makes a public representation that it is operating at full capacity, when, in fact, only 50% of its storage space is leased.

o ABC Corp. also discloses fully (and truthfully) that it has no fire insurance.o An investor buys common stock in the company in reliance on these representations.o One week after the investment, the facility burns to the ground and the stock becomes worthless.

Conclusionso Transaction causation is shown because, had the truth about the facility's capacity been disclosed, the

investor would have declined to make the investment.

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o BUT: the loss causation requirement is not satisfied because the proximate cause of the loss was the fire rather than the misrepresentation about capacity.

Civil Remedies SEC Act of 1934 § 21(d)(5): SEC can seek disgorgement of trading profits SEC Act of 1934 § 20A (AKS p.671): creates a private right of action for any trader opposite an insider trader,

with damages limited to profit gained or losses avoided (to the extent that profit/ loss avoided is not already disgorged to SEC: §20A(b)(2)).

SEC Act of 1934 § 21A(a)(2) (Statute book p.478): allows civil penalties up to three times the profit gained or loss avoided in addition to disgorgement;

SEC Act of 1934 § 21A(a)(1)(B): “controlling person” may be liable too, if the controlling person “knew or recklessly disregarded” the likelihood of insider trading and failed to take preventive steps.

SEC Act of 1934 § 21A(e): “bounty hunter” provision, which allows SEC to provide 10% of recovery to those who inform on insider traders

Possible Ways to Measure 10b-5 Losses of a Buyer. Court adopts disgorgement in Elkind v. Liggett and Myers (shows that the court takes the ‘abstain’ part of ‘disclose or abstain’ more seriously)

Disgorgement measure: Post-purchase decline due to disclosure, capped at gain (or loss avoided) by tippee. Here, same as out-of-pocket measure by assumption ($100,000), capped at gain by tippee ($50,000) = $50,000

Out-of-pocket measure: Price paid minus “true value” when bought. Here, P can recover ($50 - $40) * 10,000 shares = $100,000.

Causation-in-fact measure: Price decline caused by D’s wrongful trading. Here, P can recover ($50 - $48) * 10,000 shares = $20,000.

Calculating 10b-5 losses for a seller Value of the stock after disclosure – value of the stock without disclosure at the sale date

o It’s hard to work out what value of the stock without disclosure would be, because the insider trading in the market has raised the price already (thus, damages should be reduced by the amount that the seller earned due to the rise caused by insider trading)

Cady Roberts Rule – Disclose or Abstain (applies only to traditional insiders)10b5 requires that an insider not trade while in possession of material non public information.

There is no affirmative duty to disclose a material fact, they simply have to refrain from trading on it. Information is material if it would have been important to a reasonable investor trying to value the company’s stock

or the transaction in question Cady Roberts doesn’t prohibit investment in own company merely because insider is more familiar w/ corporate

operations than public.  Insider doesn’t have to disclose superior financial analysis.  Texas Gulf Sulphur

HYPO: Lawyer leaves a document at home, and his significant other (not a spouse) sees it and trades based on it

o Not liable unless 10b5-2(1) or (2)o Note: if the document was about a tender offer, Rule 14e-3 would establish liability irrespective of any

relationship provided the significant other knew it was from an inside source.

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Policy Implications

Incidence of the losses: Damages from insider trading fall on those who trade non-randomly

o If you’re not trading, you’re not affectedo If you trade randomly, you have an equal likelihood of being on the winning or losing side of the

transaction.Thus, sophisticated investors are the ones who will lose the most, forcing them to factor in these losses ex ante, thereby increasing the cost of capital to corporations.

Policy Arguments for Exempting Merger Discussion from Disclosure Requirements (rejected in Basic) Don’t want to flood the market with low-probability information

o Court says this is stupid because investors can screen out the unimportant info Don’t want potential suitor to be scared away by prospect of competing offers

o Court says this can be avoided by not saying anything at all. (Basic is about misstatements, not non-disclosure mgmt doesn’t have to disclose the negotiations, it just can’t deny them)

Also, (not addressed by court) defendants in Basic are not just the directors, but also the corporation itself. o Thus, the shareholders who bought/sold are compensated by those who did not buy/sell. Basically shifts

wealth from 1 group of owners to another, with lawyers taking a big cut.

Theories of Liability Equal Access Theory: all traders owe a duty to the market to disclose or refrain from trading on non-public

corporate information. (Cady Roberts, Texas Gulf Sulphur). Fiduciary Duty Theory: In order to establish that an insider violates 10b-5 by breaching a duty to disclose or

abstain to an uninformed trader, you have to show there was a specific, pre-existing legal relationship of trust and confidence (“RT&C”) between the insider and the counterparty. (Chiarella, Dirks)

Misappropriation Theory: “a person who has misappropriated nonpublic information has an absolute duty to disclose that information or refrain from trading.” (Burger dissent in Chiarella)

o If you take info that doesn’t belong to you, then you have a duty to disclose or abstain

3 Theories of 10b-5 liability for insider trading

TheoryTo whom is duty owed?

How is existence of duty established?

Which private plaintiffs have a remedy?

Equal access (rejected in Chiarella)

All trading counterparties Presumed Trading counterparties

Fiduciary Duty (Chiarella)

Shareholders of corporation

Prove fiduciary relation with shareholders

Trading counterparties if show fiduciary relation

Misappropriation(O’Hagan)

Principal in any fiduciary relation or confidentiality undertaking

Prove fiduciary relation or confidentiality agreement

Corporation, not counterparties(but SEC §20A extends liability to contemporaneous traders)

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Case Summaries

Texas Gulf Sulphur (2d Circ 1968) Facts

o In October 1963, Texas Gulf Sulphur geologists make a valuable discovery of an extremely rich zinc/copper deposit.

o TGS President Stephens instructs them to not tell anybody, including other TGS employees and directors, so that they can buy up the rest of the land needed.

o In February 1964, TGS issues stock options (= “calls”) to its top executives, all of whom knew at least something about the new discovery.

o And as information inevitably trickles through the organization, everybody starts trading.o In April, TGS issues a misleading press release (saying they haven’t discovered new deposits) to quiet

speculation. History

o SEC brings a 10(b) action against everybody; District Court finds Crawford, Clayton, and Coates liable but dismisses the suit against twelve other TGS insiders.

Reasoningo Despite the fact that the directors aren’t personally making any statements that are misleading, the

corporation has made a misleading statement Holding

o Policy of 10b-5: justifiable expectation of securities marketplace that all investors have relatively equal access to material info.

o Court finds an implied obligation to disclose under these circumstances due to Cady/ Roberts rule i. Must either disclose to investing public, or if unable, then abstain from trading while it remains

undisclosed.o This doesn’t prohibit investment in own company merely because more familiar w co operations than

public.  & don’t have to disclose superior financial analysis.  Just material info / basic facts so that outsiders may draw upon their own evaluative expertise.

o Materiality of facts depends on balance of indicated probability that event will occur & anticipated magnitude of event relative to total company activity.

i. Here: possibility = more than marginal.  & magnitude = vast.  Likely to affect stock price & important fact in reasonable investor’s decisions.

o Another factor: importance attached to fact by those that knew.  Timing of stock purchases by people who’d never bought stock before.  Compels inference that they were influenced by the fact.

Commentso The problem with the finding of an implied duty to disclose or abstain is that it’s not supported by the text

referring to ‘fraud’ in Rule 10(b)5o Thus, TGS looks at Rule 10(b)5 and broadens the concept of fraud from that at common lawo Impact depends on the baseline you’re viewing it against and whether the party is on the same side as the

insider or on the opposite side of the transaction as the insider

Santa Fe Industries v. Green Facts

o Santa Fe Industries gradually increases its stake in Kirby Lumber from 60% to 95% and then decides to do a short-form merger under DGCL § 253.

o Morgan Stanley appraises the FMV of Kirby’s assets at $640 per share, and values Kirby’s stock at $125 per share. (it had been trading between $60-90)

o Santa Fe offers $150 per share in the short-form merger.o Minority shareholders forego their appraisal remedy but bring suit alleging a 10b-5 violation by Santa Fe

for obtaining a “fraudulent appraisal,” appropriating value from the minority shareholders, and offering $25 above the Morgan Stanley stock valuation to lull minority shareholders into tendering.

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o District Court dismisses the claim because there was no “omission” or “misstatement” in the proxy information; Court of Appeals reverses; U.S. Supreme Court grants cert

Reasoningo No indication in 10(b) that congress meant to prohibit any conduct not involving manipulation or deceptiono Here, Santa Fe disclosed both the asset value (640) and the appraisal value (125).

Holdingo Congress doesn’t intend for 10(b) to apply in the absence of a misstatement or omission

Commentso If the court had held this to be a 10(b) violation, the court would have allowed a ‘unfair price’ claim into

federal securities regulation; impact would be that anytime a controlling shareholder entered into a share transaction P thought was unfair, the case could go to federal court.

i. This is problematic because it infringes on states’ right to regulate the content of fiduciary duty according to their own corporate law

ii. (any ‘fairness duty’ at the federal level would preempt the state laws, so the court doesn’t want to do this in the absence of explicit language in the legislation directing that action)

o Interestingly, this interpretation is contrary to that in TGS. The source of the ‘duty to disclose’ is implied in TGS based on the directors’ position in the company under federal law;

i. However, 10(b)5 doesn’t create this duty specifically, so it’s strange that the court there interpreted 10(b)5 broadly to create implied duties while Santa Fe takes the literalist approach for reasons of federalism.

o This is a squeeze-out mergeri. Note: Weinberger and its progeny create a fiduciary duty to minority shareholders in squeeze-out

mergers, and changes the formula for valuing price of minority shares (to DCF)o Court says that federal uniformity in merger rules may be necessary, but backs off. In response, Delaware

raises the duties on controlling shareholders

Chiarella v. US Facts

o Chiarella is employed in a financial print shop (Pandick Press) and is able to figure out the identity of a takeover target from code names in merger documents.

o Chiarella buys the target’s stock before the deal is announced and sells immediately afterwards; over 14 months he realizes a gain of $30,000.

o SEC begins investigating his activities and Chiarella eventually enters into a consent decree agreeing to return his profits to the sellers of the shares.

o Then the DOJ brings a criminal prosecution. Jury finds Chiarella guilty of violating §10(b) of the ‘34 Act and 10b-5. Second Circuit affirms, and the U.S. Supreme Court grants cert

Reasoningo Chiarella had no relationship whatsoever with the target companyo Distinguishable from TGS and Cady/Roberts because in those cases, the D was a corporate insider

i. (basically, anytime an insider deals in shares, he’s dealing with someone to whom he owes a fiduciary duty/ trust and confidence)

Holdingo SC find Chiarella not guilty because he’s not an insider and has no relationship with the companyo Theory of liability is premised on a relationship of trust and confidence with the shareholders who sell the

buyer their sharesi. If you’re in a fiduciary relationship with someone, you have to disclose fraud = failure to

disclose despite the relationship of trust and confidence with the counterparty1. Thus the breach is of a duty toward the counterparty

Commentso Requires a breach of trust and confidence between the D and person with whom they’re tradingo District court had used a broader rule in which you must disclose information you received from someone

with whom you share a relationship of trust and confidence, and breaching that trust is a fraud (i.e. doesn’t require a fraud on the counterparty)

o Court rejects the broad equal access theory from Cady/ Roberts

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i. Suggests the duty to disclose arises whenever you have a relationship of trust and confidence with the counterparty note: still expands corporate law, because at common law, directors had no direct fiduciary duty to shareholders, just the corporation

ii. It’s up to the court to determine when these ‘relationships of trust and confidence’ are present, which gives courts flexibility to decide on a case-by-base basis

1. D&O are subject to this relationship2. HOWEVER, even for D&O of the acquiring company, this rule doesn’t prevent them

from trading in the securities of the target company (because the acquirer doesn’t yet owe them any duty)

3. Lawyers, bankers have a relationship of trust and confidence with the company they represent; so, they can’t buy shares in that company.

o Chiarella would not be able to do this today due to §14(e)3o Court rejects the misappropriation theory because it hadn’t been put to the jury (inviting it to be re-

presented in a different case) Burger Dicta: Chiarella has used information that he obtained by virtue of his employment in a way that he was not

supposed to, for personal gain; Burger says that this ‘misappropriation’ from the employer satisfies the ‘fraudulent scheme’ requirement in 10b-5

US v. Chestman (2d Circ 1991 en banc) Facts

o Ira Waldbaum, president and controlling shareholder of Waldbaum’s, a supermarket chain, decides to sell out to A&P in a friendly deal. Plan is that Ira will sell his control block for $50 per share, and there will be a simultaneous tender offer for public shares in Waldbaum

o Ira tells his sister Shirley about the deal, who tells her daughter Susan, who tells her husband Keith Loeb. And despite warnings at each step in the chain to not tell anybody, Loeb calls his stockbroker, Chestman, to say that he has accurate information that Waldbaum is about to be sold.

o Loeb buys for himself; Chestman buys for himself, Loeb, and his other clients.o NASD begins an investigation; Loeb pays a fine and agrees to cooperate, and Chestman is indicted on 14e-

3, mail fraud, and 10b-5 violations.o Jury finds Chestman guilty on all counts, Chestman appeals, and Second Circuit panel reverses on all

counts. Second Circuit agrees to re-hear en banc Rules

o Rule 14e-3(a) It is a violation of the ’34 Act § 14(e) to purchase or sell securities on the basis of information that the possessor knows, or has reason to know, is non-public and originates with the tender offeror or the target or their officers.

o Rule 14e-3(d) It is a violation of ’34 Act § 14(e) for a possessor to communicate the information described in (a) under circumstances in which the tippee is reasonably likely to trade on that information

Reasoningo Chestman can only be held liable if Loeb had a duty not to disclose (i.e. if he had a fiduciary duty to his

wife or the Waldbaum family)o Kinship alone does not establish a fiduciary relationship. Based on Ira’s testimony, the insiders of

Walbaum were Ira and his childreni. Loeb had not been brought into the family’s inner circle

o The information was communicated to Leob gratuitously (wasn’t prompted)o Absent a pre-existing fiduciary relation or K duty of confidentiality, saying ‘don’t tell’ doesn’t establish

fiduciary statuso Fiduciary relationship is different that the marital relationship

Holdingo Convictions under Rule 14e-3 are affirmed, because the SEC does have authority to promulgate this rule

for tender offerso No 10b5 liability because Loeb did not owe the company a fiduciary duty.o In the absence of an explicit acceptance of a duty of confidentiality, the context of disclosure takes on

special import; here there was no evidence from which to draw an implied acceptance of confidentiality.

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because Loeb owed neither Susan nor the Waldbaum family a fiduciary duty, he did not defraud them by disclosing news of the pending tender offer to Chestman.

o Absent a predicate act of fraud by the tippor, the tippee cannot be held derivatively liable as an aider or abettor.

Commentso SEC responds with rule 10b-5(2) (covering family members)

Dirks v. SEC (1983) Facts

o Dirks is an investment advisor who receives information from Secrist, a former officer of Equity Funding, that Equity Funding has vastly overstated its assets.

o Dirks does research on Equity Funding, including interviewing employees, and discusses this information with his clients, many of whom then sell stock holdings in Equity Funding.

o Price of Equity Funding begins falling, and California insurance authorities discover evidence of fraud. NYSE halts trading in the stock.

o SEC censures Dirks for aiding and abetting in violations of 10b-5 by informing his clients of the alleged fraud at Equity Funding

Ruleso For a 10b-5 violation requires i) existence of a relationship affording access to inside information intended

to be available only for a corporate purpose, and ii) the unfairness of allowing a corporate insider to take advantage of that info by trading without disclosure

o No duty to disclose where the person who traded on inside info ‘was not the corporation’s agent, was not a fiduciary, or was not a person in whom the sellers had placed their trust and confidence

Reasoningo Dirks has no pre-existing relationship with the shareholders of Equity Funding

Holdingo In determining whether a tippee is under an obligation to disclose or abstain, it is . . . necessary to

determine whether the insider’s “tip” constitutes a breach of . . . fiduciary duty. All disclosures of confidential corporate information are not inconsistent with the [insider’s] duty . . . [T]he test is whether the insider personally will benefit . . .from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach [when a tippee trades].

o Here, there is no breach, because there was no benefit derived by Secrist A tipper who acts not for private benefit but to expose a fraud does not violate a fiduciary duty, and thus the tippee who trades on it is not derivatively liable.

Commentso The tipper is liable when he gains some personal gain, breaching his duty of loyalty to shareholderso The tippee cannot be liable if there was no breach by the tipper; the tippee must also be (reasonably) aware

that the conversation is a breacho Tippee’s liability is a form of secondary liability, punishing the tippee for abetting the tipper’s breach of

loyaltyUS v. O’Hagan (1997)

Facts o In July 1988, Grant Met hires the law firm Dorsey & Whitney (D&W) to represent it in its acquisition of

Pillsbury; O’Hagan is a partner of D&W but does no work on the deal.o In August, O’Hagan begins buying Pillsbury stock and call options on Pillsbury stock, in his own nameo In September, D&W withdraws from representing Grant Met; less than one month later, Grant Met

announces a tender offer for Pillsbury.o O’Hagan sells his call options and common stock for a profit of $4.3 million.o SEC brings criminal charges, trial court convicts, but Eighth Circuit reverses all of O’Hagan’s convictions. o U.S. Supreme Court grants cert to resolve a circuit split with respect to the misappropriation theory of

liability under 10b-5 Reasoning

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o A misappropriator deceives the source of the info and simultaneously harms the investing public.o Santa Fe requires deception; here the deception is not telling the principal that you’re going to trade based

on the information Holding

o §10(b) criminal liability may be predicated on the misappropriation theoryo A misappropriation occurs when the P misappropriates confidential information for securities trading

purposes, in breach of a duty owed to the source of the information Comments

o In Chiarella, the fraud is against the counterparty in the trade, so you have to show some fiduciary duty to themo Under misappropriation theory, the fraud is against the person who gave you the information

Basic Inc. v. Levinson Facts

o Basic Industries engages in merger negotiations with Combustion Engineering for almost two years about the possibility of being acquired at a premium price.

o Meanwhile, there are rumors of a pending deal, which Basic flatly denies (three times). (Afterwards, Basic says that it didn’t want to drive its suitor away by inviting competition.)

o Basic shareholders who sold after first public denial of the merger negotiations file suit claiming 10b-5 violations by the Basic directors.

o District court grants summary judgment to the defendant directors because the negotiations were not destined to lead to a merger “with reasonable certainty.”

o Sixth Circuit reverses, finding that otherwise immaterial merger discussions become material when Basic denied their existence. US SC grants cert.

Holdingo US SC says that merger discussions may be material, so a suit alleging that a misstatement was made with

respect to merger discussions cannot be dismissed without an inquiry into the factso Materiality test: whether the information is something that would have a substantial likelihood of a

reasonable investor viewing as significantly affecting the mix of total informationi. i.e. will it impact the investment decision of a reasonable investor

o Where it is uncertain whether the disclosure is material, look at the probability and magnitude of the transaction. requires looking at the facts in detail to gauge

i. Probability x Magnitude takes an expected value approacho If the EV is large enough to be taken into account by a reasonable investor, then it’s material

Commentso Policy arguments advanced against disclosure of merger info (rejected by court)

i. Don’t want to flood the market with low-probability information (court says this is stupid because investors can screen out the unimportant info)

ii. Don’t want potential suitor to be scared away by prospect of competing offers (court says this can be avoided by not saying anything at all) (Basic is about misstatements, not non-disclosure mgmt doesn’t have to disclose the negotiations, it just can’t deny them)

o Defendants in Basic are not just the directors, but also the corporation itself. o Thus, the shareholders who bought/sold are compensated by those who did not buy/sell. Basically shifts

wealth from 1 group of owners to another, with lawyers taking a big cut.

Dura Pharmaceuticals v. Broudo – misstatement doesn’t necessarily cause the loss in share price Facts

o Between February 1997 and February 1998 Dura makes allegedly false public statements about Dura’s drug profits and the likelihood of FDA approval for a new asthmatic spray device.

o In February 1998 Dura announces lower-than-expected profits, primarily from slow drug sales. Share price drops from $31 to $21.

o In November 1998 Dura announces that the FDA would not be approving the asthmatic spray device; share price drops temporarily but almost fully recovers.

o Plaintiffs bring a 10b-5 claim for Dura’s public statements between Feb. 1997 and Feb. 1998.

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o District Court dismisses the complaint – no scienter on drug profitability claim, and no loss causation on spray device claim.

o Ninth Circuit reverses on spray device claim. Holding

o U.S. Supreme Court unanimously reverses, rejecting “inflated purchase price” theory of loss causationo This misstatement has not caused a loss for plaintiffs, because the price decline has not shown to be tied to

the announcement about the spray device (i.e. spray device announcement didn’t cause a drop in share prices)

Elkind v. Liggett & Myers Facts

o On July 17, 1972, Liggett & Myers (L&M) tells certain analysts about a negative earnings announcement to be disclosed publicly the next day.

o Analysts’ clients sell 1,800 L&M shares at ~$55 per share; when negative earnings announcement is disclosed on July 18th, the L&M stock price drops to ~$46.

o District Court finds 10b-5 liability and calculates damages using the “out-of-pocket” method, i.e., the difference between the price that plaintiffs paid for the stock (~ $52-$55) and the actual “true value” of the stock when bought.

o Defendants appeal to Second Circuit Holding

o Court adopts the disgorgement measurement method. Damages are capped at the D’s profits/ losses avoided.

Commentso There are far more people who traded that the number of shares that D bought/ sold; thus, there will be far

more “losses” in the market than the actual gains reaped by D. Don’t want to establish this broad of liability, so cap the ‘losses’ at the ‘gains’. Shows that court takes the ‘abstain’ part of ‘disclose or abstain’ more seriously than the disclosure obligation. (if D had abstained, it wouldn’t have the profits, so the profits must be disgorged)

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E. Rule 14e-3

Rule 14(e)3 – covers tender offers; imposes a duty on all parties who have insider info to disclose or abstain (i.e. regardless of whether info comes from target or bidder, there’s a duty to disclose or abstain)

It is a violation of the ’34 Act § 14(e) to purchase or sell securities on the basis of information that the possessor knows, or has reason to know, is non-public and originates with the tender offeror or the target or their officers. Rule 14e-3(a)

It is a violation of ’34 Act § 14(e) for a possessor to communicate the information described in (a) under circumstances in which the tippee is reasonably likely to trade on that information. Rule 14e-3(d)

US v. Chestman (2d Circ 1991 en banc) – 14e-3 portion Facts

o Ira Waldbaum, president and controlling shareholder of Waldbaum’s, a supermarket chain, decides to sell out to A&P in a friendly deal. Plan is that Ira will sell his control block for $50 per share, and there will be a simultaneous tender offer for public shares in Waldbaum

o Ira tells his sister Shirley about the deal, who tells her daughter Susan, who tells her husband Keith Loeb. And despite warnings at each step in the chain to not tell anybody, Loeb calls his stockbroker, Chestman, to say that he has accurate information that Waldbaum is about to be sold.

o Loeb buys for himself; Chestman buys for himself, Loeb, and his other clients.o NASD begins an investigation; Loeb pays a fine and agrees to cooperate, and Chestman is indicted on 14e-

3, mail fraud, and 10b-5 violations.o Jury finds Chestman guilty on all counts, Chestman appeals, and Second Circuit panel reverses on all

counts. Second Circuit agrees to re-hear en banc Rules

o Rule 14e-3(a) It is a violation of the ’34 Act § 14(e) to purchase or sell securities on the basis of information that the possessor knows, or has reason to know, is non-public and originates with the tender offeror or the target or their officers.

o Rule 14e-3(d) It is a violation of ’34 Act § 14(e) for a possessor to communicate the information described in (a) under circumstances in which the tippee is reasonably likely to trade on that information

Holdingo Convictions under Rule 14e-3 are affirmed, because the SEC does have authority to promulgate this rule

for tender offerso No 10b5 liability because Loeb did not owe the company a fiduciary duty.

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F. Regulation FD

Rules and Regulations

Regulation FD If a publically traded firm or anyone acting on its behalf discloses non-public information to any non-insider, it must disclose the information publically

Simultaneously if the disclosure was intentional Promptly if the disclosure was non-intentional

There is no private right of action for violations of Regulation FD.

Policy Implications

Is designed to end the practice of giving favored analysts information in exchange for favorable ratings In a case like that, it might be hard to show as a matter of fact that the insider is receiving a benefit (the favorable

rating), but it’s definitely behavior that we want to prohibit. Would not apply to Dirks, because the tipper is not acting on behalf of the company (he’s no longer an employee,

and he’s acting against the company’s interest in exposing the fraud)

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