Corporate Law Class Notes

8/7/2019 Corporate Law Class Notes

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Updated 04/28/11 10:11:00 PM Page 1 of 58

Class 1 (August 18)

1 Exam Information

Exam will be take-home. Response of about 1,200 words is expected. 2 Overview of Corporations

When we talk about corporations, we generally mean publicly tradedcorporations. Publicly traded corporations are distinguished from other types ofcorporations, such as limited liability corporations (LLCs).

3 What is a corporation?

Prof. Goshen: A corporation is a make-believe game for adults. A corporation isa legal person whose existence is specified in a paper document. A manager isthen appointed to make the corporation do things.

4 The First Corporations Case

In Solomon v. Solomon Inc., Adam Solomon owned a business in which producedletter products. Adam wanted to organize his business as a corporation. At thattime, the law required that at least seven people participate in the formation of acorporation. The corporation had 1,000 shares, of which 994 were owned byAdam. The remaining six shares were owned by his wife and children. Adam thensold the letter-making business to his corporation. Of course, the seller was Adamin his personal capacity whereas the buyer was the corporation. Because Adamasked for a price that was higher than what the corporations assets allowed, Adamdecided to give a loan to his corporation. The sale created a situation in which thecorporation owed Adam some amount (lets say 1,000). Adam thereby became asecured creditor.

As it turned out, the business ultimately failed. Adam claimed that he, as asecured creditor, meant that he had first dibs to the corporations remainingassets. Adam prevailed on appeal, where the court said that the corporation wasnot an alter-ego of Adam. Rather, it was to be treated as an entirely separatelegal entity. The court said that the other creditors should have realized thatcorporation was a distinct entity even though Adam had made the loan tohimself.

5 A Second Corporations CaseIn Lee v. Lees, Lee created a corporation that owned one small aircraft used foragricultural purposes. Lee owned the vast majority of the shares and piloted theairplane. One day, the aircraft crashed, with Lee dying in the accident. Thecorporation, however, continued to live. The shares that formerly belonged toLee passed via inheritance to his wife. His wife proceeded to sue the corporationfor compensation for Lees death. Because the wife was acting as a manager ofthe corporation, she was effectively on the receiving end of the suit. The point ofthe exercise was to extract compensation from the British social-security system,


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which provided compensation for deaths in workplace accidents. The social-security system made the argument that Lee was not an employee of thecorporation. The court said nothing prevents a person from being an employee ofa corporation while also serving in other capacities (such as a manager). Pointingto the fact that Lee had signed an employment contract with the corporation, thecourt found that Lee was indeed an employee of the corporation. Note that oneparty to the contract was Lee in his individual capacity and the other was Lee in hiscapacity as an agent of the corporation.

6 A Hypothetical

Suppose that Lee planned to smuggle drugs using his airplane and that the policehad enough probable cause to arrest Lee. Could Lee be convicted of conspiringwith his corporation to smuggle drugs? (From the standpoint of criminal law, thistheory does not fly because there is no actus reus.) Courts have declined toimpose liability for this sort of self-conspiracy.

Alternatively, suppose that there were two managers of the corporation whoconspired to smuggle drugs. In this case, criminal liability could attach becausethere are three parties: the two managers and the corporation.

7 In Summary

A corporation is a fiction, but a fiction that can sign contracts, commit torts, andeven commit crimes under the right circumstances.

8 The Business Perspective

Consider the individuals and entities with which a corporation has relationships:

shareholders, managers, creditors, suppliers, employees, consumers, othercorporations, the government, and so forth. Each type of contact falls under somelegal regime. Employees, for example, fall under the protection of employmentregulations. Consumers fall under the law of products liability and contracts.Suppliers are likely to have security interests in certain goods. The general publicis likely to fall under the protection of environmental laws. The government islikely to impose taxes and regulations. Other corporations fall under the protectionof antitrust laws.

When we speak of corporate law, we usually refer to the laws that govern acorporations relationships with shareholders, managers, and creditors. Withregard to creditors, corporate law addresses only those obligations that

corporations have when they are alive. (If a corporation is going bankrupt, itsobligations are governed by bankruptcy law.)

This view of corporations essentially holds that corporate law addresses the nexusof contracts that sustains its relationships to other parties.

9 A Story

Mrs. Fields got a cookie recipe from her grandmother, which is well-received byfriends. Mrs. Fields decided to open a store to sell her cookies, which becomes a


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success. Eventually, Mrs. Fields decides to open a second store and hires John torun it. At this point, she faces the problem of how to make sure that John does anacceptable job of running the store.

This is the classic agency problem. The agency problem has two elements: (1) an

information gap and (2) a conflict of interest. Here, the information gap consists ofMrs. Fieldss not knowing what John is up to at the second store. The conflict ofinterest is that John wants to shirk whereas Mrs. Fields would prefer that he work ashard as possible. Both ingredients must be present for the agency problem toexist.

Mrs. Fields might try to solve the agency problem by entering into a contract withJohn for the purpose of imposing certain minimum requirements on hisperformance. Alternatively, she might install a camera in the second store in orderto monitor John. She might ask for regular accounting reports. She might sharesome of the profits with John, so that he has an incentive to do well.

In practice, the solution is likely involve a mix of these approaches. Of course,implementing these measures will impose costs, known as agency costs, on thebusiness.

Still, this does not solve the problem entirely. Suppose that John is intent onleaving the store at 5pm to play tennis with this girlfriend and that he valuestennis-playing at $50. On the other hand, the store stands to make $200 if it staysopen for the rest of the evening. If Johns share of the profits amounts to less than$50, he will close the store and leave. Of course, Mrs. Fields would prefer to walkin and offer him a $100 share of the profits, but this is impractical in mostcircumstances. These kinds of losses are known as residual losses.

Of course, it makes sense to hire an agent only if the profits from the second storeexceed the agency costs. A business owner, such as Mrs. Fields, therefore wantsto minimize agency costs. Many businesses have solved this problem on a largescale. (Consider that McDonalds manages thousands of stores worldwide.)

Suppose that Mrs. Fields has solved the agency problem for the second store andwants to turn her two-store operations into a chain. Mrs. Fields approaches Dianeexpressing a desire for a $2M investment. In exchange, Mrs. Fields offers Diane a40% share in the profits.

Now Diane is starting to worry. Perhaps Mrs. Fields will underreport profits. Mrs.Fields might start paying herself a much higher salary, which would reduce

reportable profits and thereby lower the amount to be paid to Diane.Suppose that Mrs. Fields decides to start a chocolate factory to manufacturechocolate chips for her cookie factories. As long as Mrs. Fields has 100%ownership of both the chocolate factory and the cookie factory, it doesnt matterwhat price at which the chocolate is sold to the cookie factory. The only party thatcares is the IRS, which collects taxes on such transactions.

This, however, creates a problem for Diane. Because Dianes interest comes solelyfrom the profit from the cookie factory, Mrs. Fields has an incentive to lower the


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cookie factorys profits by raising the price of the chocolate. This issue known asthe conflicted-transactions problem.

Diane might respond by demanding veto rights over potentially conflictedtransactions. Alternatively, Diane could establish a benchmark price above which

the sale of chocolate would be suspect.Note that Diane is now the principal and Mrs. Fields is the agent. As with theFields/John relationship, Diane will invest only if the gains exceed the agency costs.

Now suppose that Mrs. Fields wants to get a $2M loan from a bank. The loanofficer is now worried. Perhaps Mrs. Fields will take the money and flee. Perhapsshe will take on additional creditors who might take precedence in claims to thebusinesss assets.

Suppose Mrs. Fields wants to upgrade the ovens in the store. Option 1 is astandalone oven, which takes up store space and isnt very efficient. Option 2 isan oven built into the wall, which takes up no store space and is quite efficient.

Mrs. Fields would obviously prefer the built-in oven. The bank, however, wouldprefer the standalone oven since it could be sold in the case of bankruptcy. Thebank might respond by writing restrictions into how the business might operate.

We now have three agency relationships: Diane/Fields, Creditors/Fields, andFields/Jones. Corporate law is all about these relationships. In a typical business,

Diane Shareholders

Minority Shareholders Mrs. Fields

Management John

The point of corporate law is to provide solutions to these agency problems.Rather than having Mrs. Fields enter into tailor-made contracts for each agencyrelationship, corporate law provides default solutions to these problems.

10 Solutions to the Agency Problem

A Legal Solutions

Legal rules, such as the fiduciary duty, try to establish basic rules that

management must follow.

B Structural Solutions

Structural solutions include devices such as the board of directors, whichsupervises the management. The board of directors supervises the managers onbehalf of shareholders. (Of course, this raises the question of who monitors theboard of directors.)


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C Market Solutions

If management runs a corporation too poorly, share values might become lowenough to allow for a takeover. This in itself provides an incentive for themanagement not to abuse the agency relationship. In addition, securities

regulations ensure that corporations disclose enough information for the market tofunction effectively.

11 Creating a Corporation

The charter, certificate of incorporation, or articles of incorporation is thedocument that creates the legal fiction known as a corporation. Corporate law isstate law; each state sets forth its own technical requirements for incorporations aswell as default solutions to the agency problems. By far, Delaware is the mostpopular state for incorporation. As a practical matter, this class will be concernedmainly with Delaware law, though the differences between Delaware corporate lawand analogous laws in other states are not great.

The charter mustcontain certain provisions. First, the charter must state the nameof the corporation. Usually, the name cannot be something that could createconfusion as to the identity of the business. Second, the charter must specify thenumber of shares that can be issued by the corporation. The number of sharescontrols the amount of discretion to be exercised by the board of directors.Suppose that Fields Inc. issues 100 shares to Diane and 200 shares to John. Thisinitial allocation would make John the controlling shareholder. If the board issues500 shares to Mrs. Fields, however, Mrs. Fields then becomes the controllingshareholder.

The charter may additionally designated different classes of shares or delegate

that responsibility to the board. This is also a large source of control, and it laysthe foundation for the poison pill defense to hostile takeovers.

In sum, the board of directors may exercise control through (1) allocation of thenumbers of shares and (2) setting the rights associated with each class of shares.

Additionally, the charter must specify agents to receive service in the event of alawsuit as well as the personal liability of the directors.

The charter may contain additional provisions to govern the corporation.

12 Treaties

A corporate charter may be changed after filing, but the board of directors mustrecommend the change. Shareholders may notrecommend any changes. Once achange has been recommended, however, shareholders must approve the change.Changes must be filed with the Secretary of State.

The particular requirements for passing an alteration to the charter depend on thejurisdictions. In particular, DGCL 242(b)(1) says that abstentions count for thequorum but not as yes votes.


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13 Adopting Bylaws

Bylaws specify rules regarding the internal operations of the corporation. Thebylaws are not a public document. The charter can be considered theconstitution of the corporation, and the bylaws can be considered subsidiary

statutes. In practice, this means that bylaws cannot contradict the charter.According to DGCL 109(a), shareholders can always change the bylaws; theboard of directors may also do so ifthey are permitted to do so in the charter.Jurisdictions operating under MBCA 10.20(b) say the same with regard toshareholders but say that the board is allowed to change the bylaws by default,unless expressly restricted from doing so.

Suppose that the charter itself empowers the board to change the bylaws. (This istrue for most corporations.) Suppose that the board makes some change thatdoesnt sit well with the shareholders. The shareholders change the bylaws back.Can the board then reinstate their change? The MBCA says that shareholders have

the last word in such cases of competing modifications. The DGCL does not giveshareholders this power, but it authorizes courts to adjudicate such disputes.

There is a division of view between the U.S. and the rest of world as to where thecenter of the corporation lies. In non-U.S. countries, shareholders are the center;as such, shareholders may dictate the bylaws. The U.S. view is that the center isthe board of directors. Just as the board may take out loans or hire employees, it isthe board of directors that hires shareholders. (The notion of hiringshareholders is admittedly a bit odd.)

14 Sources of Regulation

Corporations must comply with regulations from state and federal regulations.Usually, federal regulations set forth only disclosure requirements, but Congressmay impose requirements beyond mere disclosure.

A third source of regulation is the stock exchange. Each stock exchange has itsown rules, some of which might affect the operation of the corporation.

Fourth, private arrangements might modify the default rules supplied bycorporate law.

15 Why Delaware?

Initially, the leading state for incorporation was New Jersey. In the early 20th

century, New Jersey had a versatile corporate law as well as good courts with agreat deal of experience in administering that law. In 1909, governor WoodrowWilson of New Jersey introduced seven changes to the law (known as the sevensisters), which were unacceptable to the business community. Delaware, whichhad the same advantages of the old New Jersey laws, announced that it wouldrecognize all New Jersey precedent. As a result, all the corporations moved toDelaware. Currently, fees from incorporation make up about 20% of the Delawarebudget.

At least one professor has argued that Delaware is leading a race to the bottom


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in the sense of allowing directors to exploit shareholders. Another professor,however, has argued that shareholders can simply respond by selling shares inDelaware corporations and buy shares in some other corporations. Empirically,one study has found that shareholders of Delaware corporations tend to makemore money than those for other corporations.

Class 2 (August 19)Recall that corporate law is intended to solve the agency problems that arise invarious contexts. In the shareholders/management problem, the shareholderswould like the management to work as hard as possible while the managementwould prefer otherwise. The information gap makes it difficult for shareholders tomaintain control over the management. Another agency problem may arisebetween a controlling shareholder and minority (public) shareholders. Typically,the controlling shareholder has access to more information about the corporationthan the minority shareholders and may have the incentive to take certain actionsat the expense of minority shareholders. Creditors may also have interests thatare at odds with those of shareholders.

16 Dispersed Ownership versus Controlling Owner

The difference between dispersed ownership and a controlling owner reflects thechoice of where to place the most serious agency problem. In a dispersed-ownership model, most of the discretion is vested in the management. Therefore,there is a serious agency problem between the shareholders and the management.If there is a controlling owner, the controlling owner will minimize any agencyproblem between shareholders (including himself) and the management. On the

other hand, there will be a greater agency between himself and the minorityshareholders. Neither model is necessarily better; which to choose depends onthe circumstances.

The board of directors, which sits between the shareholders and the management,is one way to minimize the shareholers/management agency problem.

17 Limited Liability and Separate Legal Entity

Recall that the corporation is considered a separate legal entity. If a corporation isconfronted with a judgment against it, the individual shareholders are liable for thecorporations acts only to the extent that they own shares. Even if the corporationdoes not have enough assets to satisfy the judgment, the shareholders cannot bemade to add more of their own money. Contrast corporations with partnerships, inwhich the partners are not so insulated from liability.

The separate entity status of corporations means that personal creditors of ashareholder cannot go after the corporations assets. In general, the corporationscreditors must be paid back first; only then can personal creditors of shareholdersbe paid.


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18 Limited Liability as an Invention

Limited liability is an invention, albeit one as important as electricity (according toProf. Goshen). To understand why, we need to take a detour into corporatefinance.

A Expected Return

In real-world situations, the probabilities and returns that determine the expectedreturn on any investment is not known with great certainty. As a result, eachperson will have a different estimate of what the expected return will be.

B Risk

When we speak of risk in everyday life, we usually mean the chance thatsomething bad will happen. In finance, risk is a completely neutral term thatrefers only to the degree of variation among possible outcomes. In general, risk is

measured in terms of the variance. In corporate finance, the expected return andthe standard deviation are sufficient to characterize any investment. (This onlyworks for returns that have a normal distribution.) In finance, there is a generalassumption that people will prefer sure bets to riskier investments (i.e., thatpeople are risk-averse).

C Decreasing Marginal Utility

There is a difference between the moneyoutcome of a game and the utilityoutcome of a game. In particular terms, the pain of losing $5 is greater than thepleasure of making an additional $5. (This is a direct result of decreasing marginal

utility of money.) If there is a 50/50 chance of winning $5 and losing $5, a rationalperson would not play the game. In order to balance the two utility outcomes, it isnecessary to make the good outcome more than $5the additional amount isknown as the risk premium.

In practice, investments are black box games whose internal workings cannot bechanged. Investors can express their preferences only by changing theirwillingness to pay for the shares. When investors are risk-averse, they will demandlarger risk premiums and ask for lower share prices.

D What do investors do?

Typically, an investor will diversify his investments, so as to avoid putting all theeggs in one basket. Fundamentally, there are two kinds of risks: (1) systematicrisks, which affect large chunks of the market, and (2) specific risks, which affectonly specific corporations. The idea is that a diversified portfolio will make thespecific risk go away. The question is how many different investments one shouldmake so as to lower the specific risk to the level of the systematic risk. Thegeneral assumption is that the requisite number of investments will no be so highas to impose prohibitive logistical burdens.

Apartment for diversification, there is a linear relationship between risk and the


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homogeneous vis-a-vis each other. Under unlimited liability, the value of ashare depends not only the expected return but also on the net worth of theshareholder. Under an unlimited-liability regime, rich persons have greater riskexposure by virture of having greater net worth. A homeless person on the streetwould, by contrast, enjoys a sort of natural limited liability by virtue of beingjudgment-proof. These differences make it very difficult to trade shares since twoindividuals might value a share very differently owing to their financialcircumstances.

Ultimately, corporations are a device for dispersing risk. Each corporation inviteseach shareholder to take a small slice of the total risk. Each individual investorprotects himself by investing in multiple corporations. This is all possible becauseof limited liability.

20 Involuntary Creditors

Suppose that a corporation is constructing a building. A load of bricks lands on an

unfortunate pedestrian, who sues for $2M in damages. The corporation has only$50K in assets to satisfy the judgment. How is limited liability justifiable in thissituation? Here, there is a tradeoff between the individuals buying insurance andthe corporations buying insurance. In limited circumstances, courts will allowpiercing of the corporate veil to place liability directly on shareholders.Alternatively, courts have said that particular managers who can be identified astortfeasors can be made personally liable for the tort. If you personally commit atort, even in your capacity as a CEO or other manager, you are nonethelesspersonally liable.

21 Capital Structure of Corporations

When a business wants to raise money, it generally does so by issuing debt orequity. Debt consists of a very specific contract stating the amount of money to beloaned and the amounts and times at which interest has to be paid. Equity, on theother hand, gives the shareholder a residual claim to the assets of the corporation.Importantly, fixed claims (such as debts) must be paid before residual claims canbe paid. Equity, however, also gives shareholders the power to control who is onthe board of directors.

Equity affords shareholders three rights: (1) voting rights, (2) dividends, and (3)the residual claim to assets after liquidation. The residual claim is very importantbecause it gives shareholders a proportional claim to the profits of the corporation.

Suppose that a corporation initially has two shares at $100 each (for a total valueof $200). Suppose that the corporation makes $40. The share price wouldsubsequently go up to $120 ($20 profit for each share).

A Types of Shares

If a corporation has only one type of share, then each share has exactly the samerights under a one right, one vote system.

Of course, a corporation doesnt have to have only one kind of share. It might opt


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to create Class A shares, which grant only voting rights, and Class B shares, whichgrant only economic rights.

Even more elaborately, a corporation can customize the types even further. ClassA shares might be given 10 times the voting rights of Class B shares with all other

rights identical among all shares. Even more elaborately, a corporation can createa Golden share whose only associated right is the right to veto a sale to the thirdparty.

Note that a share without economic rights has value for the shareholder onlyinsofar as the shareholder can steal without breaking the law by exploitingvarious aspects of the corporation.

B Preferred Shares

Preferred shares go below fixed claims but above common shares when it comes toprecedence of claims. In a going concern, dividends are paid first to the preferred-

share holders before common shareholders are paid.

Cumulative Preferred Shares

A cumulative preferred share allows unpaid dividends to stack up in favor ofpreferred shareholders, so that all accumulated dividends must be paid before anycommon shareholders can receive dividends.

Non-Cumulative Preferred Shares

For a non-cumulative preferred share, dividend payments deferred at the boardsdiscretion (but not dividends missed due to lack of profits) may generally stackup.

22 Debt Instruments

All debts entail a loan to the corporation with specifications as to when interestshould be paid.

23 Options

A call option is a document giving the holder the right to buy something on a pre-specified date at a pre-specified price. Aput option is a document giving theholder the right to sell something on a pre-specified date at a pre-specified price.Furthermore, a European option gives you the right only on the specified day. An

American option gives you the right at anytime up to the specified day.Suppose the price of a stock is $100 currently and that Zohar wants a Europeancall option with a strike (option to buy) price of $120 on December 31, 2011. If,when that day comes, the price is $118, there is no point in exercising the option.On the other hand, if the price on that day is $140, then exercising the optionwould allow Zohar to buy a $140 stock at only $120 (yay!). Basically, price goesup = make money.

Notice that an option is ordinarily a bet between two third parties as to the


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performance of the corporation. Options have no effect on the corporation itself.

A warrant, on the other hand, is a call option issued by the corporation itself. Arightis a warrant that is already in the money when it is issued.

A Convertible BondsA convertible bond is a bond that comes with a call option. The call option givesthe holder the right to exchange the bond for some shares.

Class 3 (August 20)Recall that corporations raise money by issuing securities, which fundamentallyconsists of debt and equity. In the real world, securities can become very complexthrough the creation of derivatives and other financial instruments.

24 Some Basic Accounting

A corporation has assets and liabilities. Entitlement to assets is divided amongshareholders and creditors. Recall, however, that the shareholders ownership ofresidual claims means that shareholders are the last in line to profit from anygains and the first to suffer losses since fixed claims must be satisfied first.

Recall the risk-versus-expected-return line. Various securities fall at various pointson the line. When a corporation is created, the incorporator decides the classes ofsecurities to issue and where each class falls on the line.

25 Fiduciary Duties

There are two fiduciary duties: (1) the duty of care and (2) the duty of loyalty. But

first things first. A crucial is question is what it means to be a fiduciary.

Dodge v. Ford Motor Co.

At the time, Ford Motor Company was making money hand over fist. At the time,demand was so high that it seemed Ford could sell as many cars as it wantedwithout lowering the price. The Dodge court said that the fiduciary duty consists ofimmediate maximization of profits. The court is saying that the corporation is notan instrument of charity; the court would not allow Ford to burden the othershareholders with his own altruistic goals. Ford, however, would have been free towrite rebate checks drawing on his personal accounts. This doctrine serves as a

protection for minority shareholders.At the time, the Dodge brothers were building their competing car company, andmany of the actions questioned in the case were directed at stifling competitionfrom Dodge. Ford had to spin an altruistic tale to avoid getting sued underantitrust laws.

A.P. Smith Mfg. Co. v. Barlow

First, we should make clear the distinction between pure donations anddonations that are promotional in nature (e.g., 50% of proceeds go to some


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charity). Here, we are dealing with an apparently pure donation. Here, SmithManufacturing was probably trying to take advantage of a tax break. That said,why not allow the shareholders to make individual donations? The Smith courtrealized that corporations made up most of the entities capable of making sizabledonations and that it is much more efficient to solicit the CEO of a corporation for adonation than to solicit thousands of shareholders individually.

Credit Lyonnais and North American v. Gheewalla

In Gheewalla, the Delaware Supreme Court made it clear that fiduciary duties areowed only to shareholders. From a practical standpoint, it is necessary to specifyan unchanging group of individuals to which the fiduciary duty runs. Otherwise, itbecomes impossible to enforce the duty since a CEO could always point to somegroup that benefits from some decision.

A Duty of Care

Francis v. United Jersey Bank (The Reinsurance Case)

Consider where the interests lie. Insurance companies entrusted money toPritchard & Baird. The money was then stolen by the two younger Pritchardbrothes. Now creditors are suing to recover the stolen money. But didnt we saythat fiduciary duties run only to shareholders, not creditors?

Here, the court is treating Pritchard & Baird as a bank, which owes a fiduciary dutynot only to shareholders but also to depositors (here, the client insurancecompanies). Given the resemblance of Pritchard & Baird to a bank, it would nothave been enough for Mrs. Pritchard to resign in the face of persistent malfeasance

by the directors.In re Emerging Communications

Consider the problems of relying on expert opinions in running a corporation. Onthe one hand, we want directors to be informed. On the other hand, increasingliability for knowledgeable individuals could create an incentive to be ignorant.

Kamin v. American Express Co.

Basically, American Express had paid $30M for an asset. Subsequently, businesswent wrong and the asset ended up being worth only $4M. American Expresstherefore suffered a loss of $26M. Even though it was possible for Amex to arrange

its accounts in such a way as to make it seem the asset was still worth $30M, themarket already knew that the value had decreased to $4M.

One way to deal with the problem would be to sell the asset to a third party for$4M. The sale, of course, would result in a loss of $26M, but the $26M loss couldbe used as a tax deduction. As it turned out, the IRS gave a tax deduction of $8M.So in effect, the sale resulted in a gain to Amex of $12M ($4M from the sale and$8M in tax breaks).

The second way to deal with the problem is to distribute shares of the asset


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directly to shareholders. The problem, however, is that the IRS gives no taxdeduction for this transaction.

In Kamin, the board of directors foolishly chose the direct distribution of dividendsand missed out on the tax break.

How does Kamin differ from Francis? In Kamin, the board used a valid processeven though the ultimate decision was stupid. Francis, by contrast, involved acomplete lack of process.

What is the business-judgment rule?

The business-judgment rule requires two things: (1) that a decision was made; (2)that it was made with information and in good faith; and (3) that there was noconflict of interest. Under the business-judgment rule, the standard of liability isirrationality.

If the requirements of the business-judgment rule are not met, then the standard

of review is reasonable care (i.e., the same standard as in negligence liability).

Furthermore, if there is a conflict of interest, then the business-judgment rule isreplaced by the entire fairness standard.

Smith v. Van Gorkom

A key point here is that a director can rely on a report only if that report wasgenerated by an individual who is competent to produce that document. Supposethat a company receives an offer to be purchased for $38 per share. The Smithcourt says that merely obtaining a premium over such a price does not supportapplying the business-judgment rule. The Smith court found that Van Gorkom

should have taken some effort to determine the amount at which Pritzker actuallyvalued the company.

In Smith, the $55 per share purchase price came from estimates of what wouldhappen in a leveraged buyout (LBO).

How a LBO works

In a LBO, the management of an existing corporation forms a new corporation.The new corporation takes on a lot of debt in order to buy out the existingcorporation from its shareholders. Immediately after the LBO, the managementcontrols the new corporation, which owns the old corporation.

In Smith, the LBO scenario was essentially irrelevant to the Pritzker negotiationsbecause the LBO calculations reflected nothing about what a third party would bewilling to pay for the corporation.

Pritzker also demanded a lock-up option, which gave him the right to buy 1Mshares of the corporation at $38 per share, to be exercisable upon the attempt ofany other party to buy Trans Union. So why would the board of Trans Union givePritzker such an option? Pritzker is afraid that other buyers will free-ride on thedue diligence he performed in estimating the value of Trans Union. The lock-upoption would compensate Pritzker for his research costs in the event he failed to


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acquire the company.

The problem in the Smith case is that Pritzker left Trans Union with no ability toseek an alternative buyer.

Prof. Goshen: Note that the level of research needed to reach a decision as towhether to sell the company is subject to the business-judgment rule.

B Effect of Smith v. Van Gorkom

Following Smith, Delaware inserted 102(b)(7) of its General Corporation Law,which exempted directors from liability for breaching the duty of care as long asthey do not act in bad faith. (Delaware was afraid that Smith would causecorporations to reincorporate in other states.) Soon thereafter, corporationsstarted inserting 102(b)(7) into their charters. Why should shareholders vote forsuch an addition? Wouldnt directors tend to be negligent?

The answer is that directors already have an incentive to avoid being negligent.

C Gantler v. Stephens

There was a conflict of interest between the directors of First Niles and theshareholders. In particular, the directors had business relationships with First Nilesthat might be damaged in the event of a sale. The Chancery Court (the lowercourt) correctly concluded that standing to lose ones position as a director doesnot usually amount to a conflict of interest by virtue of being inevitable. In thiscase, however, there were additional business interests beyond merely remainingon the board.

Here, the board sought to implement a reclassification that would remove the

voting rights for small shareholders. (As it turned out, the board fixed the standardat 300 shares.) Shareholders who held fewer than 300 would have their sharesconverted to preferred shares. The effect was to cancel the voting rightsassociated with the vast majority of shares, thereby preventing the possibility of atakeover.

Here, the question was the effect of shareholder ratification. The court said thatratification allows a decision to be subject to the business-judgment rule, even ifthat decsions would not ordinarily be reviewed under a standard of reasonablecare.

D Lyondell Chemical Co. v. RyanHow is this case different from Van Gorkom? The main difference is that Lyondelltook place after the enactment of DGCL 102(b)(7). The plaintiffs claimed badfaith because bad faith is the only hook by which liability could attach. The lowercourt characterized the boards wait and see decision as bad faith, but theDelaware Supreme Court disagreed on the ground that Lyondell had no obligationto act at the time the wait and see decision was taken.


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26 Summary of Duty of Care

A If the Board Has Taken an Action

First, as whether the action was informed. If the action was notinformed, then the

standard of review is gross negligence. If the action was informed, then we ask ifthe action was conflicted.

Class 4 (August 23)Recall that even though the duty of care imposes a standard of reasonable care, itis fairly easy to fulfill the requirements of this duty. Absent irrationality or grossnegligence, liabilty will not attach. Furthermore, DGCL 102(b)(7) providesadditional protection against claims alleging breach of the duty of care.

By and large, courts try to avoid dealing with claims that management is running a

corporation incompetently. Courts generally leave the market to deal with suchproblems.

27 The Duty of Loyalty

Unlike the duty of care, the duty of loyalty entails considerably more judicialenforcement. The duty of loyalty often involves conflicts of interest interfere withthe proper operation of market forces. The main issue of the duty of loyalty isconflict of interest.

A Direct Conflicts of Interest

Suppose that the sale of an asset is taking place between a corporation and anofficer of the corporation. Here, the officer might have an incentive to overchargethe corporation for something he is selling. Similarly, the officers might underpayfor an asset he is buying from the corporation.

A typical real-world example is the compensation package. Unlike a normaltransaction, the corporation has no choice but to negotiate compensationpackages with its directors. (This lack of choice results in a specialized standardfor reviewing compensation decisions.)

B Indirect Conflicts of Interest

Suppose suppose that Corporation A is entering into a transaction with Corporation

B. As it happens, someone is simultaneously a director, officer, or controllingowner of both corporations. The possibility of self-dealing thus arises; theindividual on both sides of the transaction might try to negotiate terms that are notfair to one of the parties.

This situation commonly arises in parent-subsidiary dealings. In such dealings, theparent company may try to profit at the expense of the subsidiarys shareholders.


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C What is an interest for the purposes of conflict ofinterest?

Aside from obvious financial interests, there is the problem of favoritism towardcertain individuals (e.g., friends). People choose their friends to choose on the

boards of corporations in the hopes that the friends will support their views.

D Mixed Motives

Suppose we have a public corporation C whose shares are trading for $100.Suppose that acquirer A wants to buy C. A can buy up to 5% of the shares of Cwithout any notification. Once A has exceeded the 5% threshold, A must disclosewithin ten days whether it intends (1) to hold its shares as a passive investor or (2)to initiate a takeover. Suppose that A increases its holdings to 10% and makes atender offer for the rest of the shares at $150. When Cs directors learn of thetakeover attempt, they approach A and offer to buy out As 10% holding for $160

per share, subject to the condition that A promise not to abandon the takeoverattempt. (This is known as greenmail.) Note that at his point the shareholdershave missed out on (1) the money they would have made upon accepting thetender offer. The shareholders are also forced (2) to share the cost of paying A togo away.

Now, the motives of the board for participating in such greenmail are not alwaysclear. First, the board may genuinely believe that A is bad for the corporationsfuture. Alternatively, the board may be afraid that A might fire them upon asuccessful takeover. When courts review decisions of boards in this context, theyapply a special standard to account for the mixed-motive nature of the question.

Lewis v. S.L. & E., Inc.

The directors of SLE owned only 35% of the corporation whereas the directors ofLGT (the same people) owned 100% of LGT. Therefore, the directors had anincentive to have SLE lease ladn to LGT at a discounted rate. (The directors wouldsuffer only 35% of the loss to SLE but enjoy 100% of the gain to LGT.) In this case,there were no independent directors to approve the transaction. The onlyalternative was to have the transaction approved through a shareholder vote. Butwhat do we do when the shareholders in SLE might also have a conflict of interestwith LGT?

The court found that the rent charged by SLE was not fair.

E Three requirements for a fair transaction

(1) Fair price, (2) fair dealing, (3) transaction is in the interest of the corporation

Cookies Food Products

Mr. Herrig had four transactions with Cookies Food Products: (1) an exclusivedistribution agreement, (2) royalties for the taco sauce, (3) compensation for doingconsulting work for the company, and (4) the arrangement to use his


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warehouses.

Iowa required a fair transaction to feature

1. Disclosure of the deal to disinterested directors

2. Shareholders can ratify the transaction3. Fair terms

Although the relevant statute said that anyof the three features would sustain afinding of a fair transaction, the court found that (3) fair terms had to be present inany fair transaction.

In this case, the board of directors approved the transactions. Why did the courtfind the transactions to be fair? The court essentially held that Herrig was amanager of better quality than the corporation might have found on the openmarket. Considerations of quality, however, raise complex issues for review bythe courts. Basically, being a successful tends to bolster ones chances of

prevailing in this kind of case.

According to DGCL 144,

director or officer controlling owner (who may nothave an official position in thecorporation)

disclosure + approval ofdisinterested directors

business-judgment rule;rationality is the standard;

transaction reviewed as if withthird party

entire fairness test, butplaintiffhas the burden of showing that

the transaction is unfair; i.e.,shift of burden

disclosure + approval ofdisinterested shareholders

waste doctrine; essentiallythe same as business-judgmentrule (waste = irrationality)

entire fairness test with burdenshifted to plaintiff

nothing entire fairness standard (threerequirements of fairness);director or officer has burden ofshowing fairness

entire fairness standard; burdenof proof is on the controllingowner to show fairness oftransaction

In practice, the allocation of the burden of proof has a major practical impact on

who is likely to win; usually, the party with the burden is less likely to win. Forcontrolling-owner transactions, the fairness test + shifted burden createssomething similar to the business-judgment rule, but with the court reserving theability to inspect the transaction in detail.

Note that any defect in obtaining the approval of directors or shareholders causesthat approval to become to equivalent to nothing, whereupon the entire-fairnessstandard applies.


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28 Distinctions between directors, shareholders,and controlling parties

Do we trust directors more than shareholders or vice versa? On the one hand,

directors have more knowledge of the operation of a corporation. But directorstend to be less objective than shareholders. By contrast, shareholders are moreobjective, but they have much less ability to weigh the merits of a transaction.

A Distinction between directors and controlling owners

Note that the controlling owner has more power than a director. The controllingowner dictates who can serve on the board, so the directors are likely to defer tothe judgment of the controlling owner. In particular, it is difficult for directorsappointed by the controlling owner to act with disinterest. Furthermore, acontrolling owner may threaten future retaliation against minority shareholderswho fail to vote for its propositions. This is why courts have declined to apply the

business-judgment rule outright in conflicted transactions involving controllingowners.

29 Waste

How is the waste standard different from the fairness standard? Waste usuallyrefers to a transaction in which the price paid for an asset is outrageouslydisproportionate to the price. Query, however, what happens when shareholdersapprove of the wasteful transaction.

When a court states that a particularly transaction was wasteful, it is expressingthe view that the particular decision is outside the decision-making competence of

the shareholders. Waste doctrine is an ongoing attempt to figure out what sorts ofdecisions are simply outside the scope of the corporate function.

Tyson II

Under the Tyson Stock Incentive Plan, the directors could receive options withstrike prices equal to whatever the market prices were at the time the options wereissued (i.e., the Plan authorized the granting of at the money options). Thewhole point of spring-loaded stock options is to grant options immediately beforethe disclosure of favorable inside information. That way, the probable priceincrease following disclosure of the information will put the options in the money.

A related practice is backdating, in which options are granted with a strike priceequal to some earlier, lower market price.

The court ruled against Tyson because the directors were hiding behindformalities when making the disclosures regarding the spring-loaded options. Ineffect, the court is imposing a duty of complete disclosure upon the corporation.

A Approving a Transaction

The Walt Disneycase, which took place a few years ago, had to do with a CEO whoreceived a $140M severance package after doing a bad job for a year. The issue


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the conflicted party is a controlling shareholder or a conflicted director.)

31 Controlling Owners

A What is control?

There are two ways to achieve control of a corporation. First, becoming a majorityshareholder automatically means that one is a controlling owner. Alternatively, aminority shareholder can be a de facto controller of the corporation bysubstantially dictating the operations of the corporation. From the perspective ofcorporate law, the question is whether a particular shareholder owns enough stockin a corporation so as to influence decisions that may impact the othershareholders.

Zahn v. Transamerica Corp.

Dividend Structure of Axton-Fisher

Class A Class B

Dividends $32 cumulative $16.00

Corporate redemption rights(effectively a call option)

$60 + any unpaid cumulativedividends; notice of 60 daysbefore exercising option

Conversion rights 1-to-1 switch of Class A sharesfor Class B shares

$0.00

Distributions of assets uponliquidation

x 2 x 1

Voting rights No Yes

Essentially, Transamerica realized the value of the tobacco stockpiled by Axton-Fisher. Transamerica didnt want to pay the dividends to the Class A shareholders.Note that the exercise of the call option technically fell within the bounds of thecorporate charter.

The breach of fiduciary duty did not consist of the mere exercise of the option. Thebreach occurred because Transamerica did not disclose information (the rise intobacco prices) that would have allowed Class A shareholders to decide whetherthe convert their shares to Class B shares.

Here, the fiduciary duty runs to Class B shareholders because they own theresidual interest in the corporation.

Why did the price of tobacco spike in this case? The government had imposedregulations, but the regulations divided tobacco into two classes: high-qualitytobacco (which had a high price) and low-quality tobacco (which had a lowerprice). Axton-Fisher had low-quality tobacco, but Transamerica realized that itcould sell the low-quality tobacco to Philip-Morris for use as high-quality tobacco.

The Class A shares were designed to protect shareholders from the downside.


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Sinclair Oil Corp. v. Levien

Levien made three claims: (1) dividends that were too high, (2) taking of acorporate opportunity, and (3) breach of contract.

On point (1), the rule is that as long as everyone is getting pro rata dividends,those dividends will be evaluated under the business-judgment rule.

Notice that the distribution of dividends by Sinven did benefit Sinclair since Sinclaircould then use that money to go exploring for oil elsewhere.

The point ofSinclairis that as long as dividend distributions arepro rata, thebusiness-judgment rule applies. Even if the distribution of dividends leads to theloss of a business opportunity, that does not mean that any heightened standardwill apply.

On point (3), the court found that the breach of contract benefited Sinclair at theexpense of Sinven.

B Fiduciary Duty of Controlling Owners

Levco Alternative Fund v. Readers Digest Assn, Inc.

Existing structure of Readers Digest:

Class A shares (no voting)

Class B shares (voting)

Proposed recapitalization:

1. Create new Class C shares

2. Allow B 1.24 C conversion

3. Allow A 1 B conversion

In this case, several transactions were combined in an attempt to hidemaneuverings that benefited Readers Digest at others expense.

Suppose that a controlling shareholder owns 60% of a company and the publicowns 40%. Suppose that Zohar owns exactly 1 share of the company. What is thevalue of his voting right? Effectively nothing. Suppose that the company is 100%owned by the public. In this case, the vote has value because it can become partof a controlling block of shares. However, in the 60/40 controlling/public

relationship, the value of the vote is nothing because there is no way for the sharesin the 40% publicy held block to become part of the controlling majority. Soclearly, the voting value of the share depends on the structure of the corporation.

Suppose now that we have Class A shares with no voting rights and Class B shareswith voting rights. Would it be sensible to allocate the corporations assets 50% toClass A and 50% to Class A? The answer is no since the value of Bs voting rightsshould be reflected in the value of B shares. So the B shares should get someadditional slice of the assets. Suppose now that we gave voting rights to Class A.What we have effectively done is to take away Bs control premium and impose a


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50/50 split of assets; B shareholders will demand to be compensated for thereduction in their ability to control the company. The corporation can compensateB for giving up a portion of its voting control by issuing B more shares. Note,however, that the size of the control premium depends on whether its possible fornon-majority shares to become part of the controlling block.

So there are two questions here: Is $100M indeed the value of the control-premium slice? Is the B 1.24 C conversion a fair way compensate Bshareholders for their loss of control?

There are two issues: (1) the value of the voting right of a single share. Thisanswer depends on whether someone already owns a majority of shares. If so,then the voting right of the remaining shares will be low since there will be no wayof taking control of the corporation simply by buying those shares. By contrast, ifthe ownership of the corporation is dispersed, then every vote carries with it somecontrol premium. Readers Digest Inc. started with 50% ownership in the hands ofa controlling owner. In other words, the owner had guaranteed control of thecorporation.

The first step in the transaction was to pay the controlling owner $100M to reducehis holdings from 50% to 40% of the corporation. (Was $100M the right sum?)Once that was done, the second step was to pay B shareholderes to give up theirvoting rights. Note that when a corporation owns its own shares, those sharesbecome meaningless because a corporation does not need claims against itself. Ineffect, the effect of a corporations purchase of its own shares is to decrease thenumber of shares circulating on the marketplace.

The two ways that A shareholders can be hurt is (1) if the controlling shareholder ispaid too much to give up his control premium and (2) if B shareholders arecompensated too much for giving up a portion of their voting control.

Calculating Damages in Readers Digest

If the B shareholders received too many shares of C at the B 1.24 C rate, thenthe corporation could issue more C shares to A shareholders at a number thatwould bring the A:B ownership ratio to the appropriate value.

Kahn v. Lynch Communication Systems, Inc.

Alcatel was trying to merge with Lynch. A merger requires approval from (1) theshareholders of both corporations and (2) the directors of both corporations.

However, notice that Alcatel already controls 43% of Lynchs shares, so it wouldautomatically be able to account for that fraction of the shareholder votes.

In an ordinary merger, the transaction is consensual in the sense that thedirectors and shareholders of both corporations agree to the transaction. A secondway to go about the merger is for the acquiring corporation is to make a tenderoffer to individual shareholders for their shares.

Alcatel is provoking a collective-action problem. Lets say that the unfriendlytender offer is for $14, which represents some premium over the market price of


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the stock. Although the shareholders know that they could collectively hold out for$15.50, each individual shareholder has an incentive to immediately cash out atthe $14 price.

Now, what is the effect of the fact that Alcatel threatenedLynch? Nothing.

Suppose that Alcatel had simply walked away from the negotiations and made theunfriendly tender offer the next day. It seems that theres nothing legally wrongwith doing this.

A key point in this case is that theprocess of fair dealing is a proxy for determiningwhether the purchase price was fair. Fair dealing allows the parties to avoidlitigation.

32 Property Rights versus Liability Rights

Ordinarily, a majority shareholder can force a transaction upon the minorityshareholders.

Class 6 (August 25)The legal aspects of corporate law are generally quite simple. The real task is tofigure out what trick a corporation is trying to pull off in a questionabletransaction? (For example, is the corporation trying somehow to benefit itself atthe expense of someone else?)

33 The Voting System

In a typical corporation with dispersed shareholders, we have the followingstructure:

Shareholders

|

Board of directors

|

Management

Dispersed shareholders have no incentive to monitor the board of directors. The

investment of the typical shareholder is too small to make it worthwhile to keeptrack of what the corporation is doing. Even is a single shareholder went to thetrouble of keeping an eye on the corporation, other shareholders could free-ride onhis efforts. In most matters, shareholders will agree with the managers course ofaction. (This has been empirically demonstrated.)

Although the shareholders are technically supposed to appoint the board ofdirectors, in practice it is often the management that chooses the directors. Ofcourse, this creates a fox-guarding-chicken-coop scenario. Delaware law is making


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a push toward having independent directors on corporate boards. Additionally,federal regulations and the rules of stock exchanges are also pushing in thisdirection. In other words, we should really treat the board of directors and themanagement as having the same agency relationship (and agency problems) inrelation to the shareholders.

Consider the potential conflicts of interest between management and directors.First, the board meets infrequentlytypically once a month. Furthermore, theboard relies on information provided by the management in making decisions, sothe management has an obvious incentive to avoid disclosing unfavorable facts tothe board. Finally, managerial control of the board means that directors have anincentive to avoid conflicts with the management. (However, this difficulty is notconsidered a conflict for the purposes of corporate law.) Prof. Goshen: Thehardest part of functioning as an effective monitor is that the shareholders (whomthe directors are supposed to be watching vigilantly) is the social environment inwhich directors operate. Managers often have very chummy relationships with

directors (with lots of expensive dinners and such). This tends to createfriendships between managers and directors, and directors have a hard timeevaluating managements performance impartially. Note that even independentdirectors, who are not appointed by the management, are susceptible to the samesort of chummy relationships.

For shareholders, the board-management ties mean that the chances of using theboard to overthrow ineffective management are effectively zero.

But what about institutional investors, which may own large blocks of thecorporations stock? Can they be trusted to correct ineffective management?

Weve now established that (1) boards of directors dont rein in the management,that (2) independent directors dont help either. So what about (3) hostiletakeovers as a device for overthrowing ineffective management? The fundamentalproblem with a hostile takeover is that it is very expensive (owing to the need topay shareholders a premium in a tender offer.) This means that ineffectivemanagement can drive down share prices by quite a bit (often by 50% relative to acompetently managed level) without facing any danger that a hostile takeoverwill become a real possibility. The prevalence of such situations was the basis forthe Wall Street rule, which held that dissatisfied shareholders should just selltheir shares rather than trying to overthrow the management.

So what about (4) institutional investors as a check on management? Note that

institutional investors do not represent all shareholders of a corporation. Rather,they are looking out for the interests of their own investors. Sometimes, a decisionthat is good for the institutional investor is not good for the corporation.

One might imagine that (5) the market for products might check bad management.The problem is that large corporations can withstand huge losses from badproducts before facing any danger of bankruptcy. For example, between 1986 and1990, GM lost $20B but had accumulated so much equity that the loss didnt evenaffect its bond ratings. In fact, the CEO was paid a severance package $50M toleave.


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Currently, the focus has shifted to (6) gatekeepers, such as accountants,lawyers, and somesuch. But as with the previous five iterations, there is an agencyproblem. For example, accountants are hired and paid by the management; it isnot good for accountants to rock the boat with the management.

As of now, millions of people are entrusting corporate managers with their moneyby buying shares of corporations, and they are making money. Why is this, giventhat so many agency problems exist? The first view is that the regulations, takentogether, are effective in reining in agency-relationships abuses. Alternatively, itcould be the case that most people are honest, so that management is not asprone to abuse agency relationships as one might expect. Within managerialcircles, managers know each others reputations, good or bad. These sorts ofsocial relationships might check abuses.

A Private Corporations or Public Corporations?

Suppose there is corporation held by three shareholders, who simultaneously serveas managers. Here, there is no agency problem since shareholders andmanagement are the same people. Does this mean that private corporations arepreferable to public ones in terms of avoiding agency problems?

Note that no one is forcing corporations to be public or private. Investors haveincentives to take private companies public (or vice versa) if they think that doingso will improve the efficiency of those corporations. The fact that both types ofcorporations exist suggests that neither type of corporation is inherently better.

Charlestown Boot & Shoe Co. v. Dunsmore

The court is articulating the principle that shareholders cannot directly interfere

with the business decisions of directors. The directors are independent. Ifshareholders dont like what the directors have been doing, they can fire thedirectors. Independence of the board protects the minority shareholders from themajority. The board of directors have a fiduciary duty to serve all shareholdersalike, not just those who are in the minority.

B Firing a Director

The corporate laws of many states allow shareholders to remove directors for goodreason. Furthermore, Delaware law allows shareholders to fire directors for noreason.

Classified Boards

Suppose there is a board with 15 members. In a normal board, a majorityshareholder can fire all 15 directors for no reason. In a classified board, thedirectors are divided into three groups, such that only one group comes up forreelection each year. Someone who takes over such a corporation can onlyappoint 5 directors upon takeover; it will take two additional years to replace theremaining 10 directors. (The sole exception is if the buyer has good reason to fireone of the remaining 10 directors.) The point of classified boards is to serve as a


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defense against takeovers; most owners are hesitant to deal with such a delaysince the non-removable directors can cause trouble with their business decisions.

Because classified boards strongly disincentivize takeovers, Delaware law forbidscorporations from arranging their boards in such a way to require more than three

years to obtain a majority of the board.

Directors are not agents of shareholders

Directors are not legally recognizable agents of shareholders. This is the centralbasis for the independence of the board; shareholders are not allowed to giveinstructions to the board. Contrast this with the relationship between directors andmanagement, which is an agency relationship. [So what exactly is the point ofhaving shareholders appoint the board?]

In some other countries (e.g., Israel), the shareholders can take authority awayfrom the board of directors and directly make decisions for the company. Which

rule is implemented depends on whether one thinks that the board or theshareholders should be the center of the corporation.

Schnell v. Chris-Craft Industries, Inc.

Here, the directors disingenuously changed the date of the shareholder meeting tomake it harder for shareholders to reach a consensus on removing the directors.Here, we are again confronted with an action that is ordinarily permitted but whichhas been prohibited because of disingenuous underlying motives. The directorsare interfering with shareholders rights. The law does not allow directors tofrustrate the division of power between themselves and shareholders.

Blasius Industries, Inc. v. Atlas Corp.Atlas basically implemented a board-packing plan in order to entrench itsmajority on the board. The court held that a board must have a compellingreason for such an action before that action could be validated.

Lets accept the courts conclusion that the primary interest of the maneuver wasto make sure the directors remained in power. But lets also say that theunderlying motivation was to prevent an unfavorable transaction.

The court says that directors generally have a duty to fend off purchasers whomight want to hurt the corporation. At the same time, the court is also saying thatthe directors cannot serve that duty by messing with the separation of power

between directors and shareholders. The court is imposing a higher level ofscrutiny on protective manipulation of the board than on other protectiveactions.

Delaware observes the Unocal rule, which says that manipulations designedprincipally to interfere with the effectiveness of a vote involves a conflict betweenthe board and a shareholder majority. The rule says that directors must respondproportionally to a threat; they are not to take draconian measures. TheUnocal rule falls between the entire-fairness standard and the business-judgment


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rule in terms of strictness.

In practice, it is difficult to tell when the Unocal rule should apply and when theBlasius analysis should apply. In fact, its hard to tell if there is any appreciabledifference between the two cases. As a result, courts often apply both standards

to cases.Suppose that a board of directors in a proxy fight realizes that the vote is likely tobe close. The board approaches a shareholder and offers to buy his block of sharesfor some (presumably elevated) price. As a result, the board solidifies its ownposition. Which standard should apply? (Business-judgment rule orBlasius/Unocal?)

Prof. Goshen: We need to decide whether Blasius or Unocal applies only if there issome material distinction between the standards. This question will be discussedlater.

C Proxy VotingThe BorakCase

The Borakcase established that private parties may sue for violations of proxyrules. To the extent that allowing private enforcement increases the number ofparties that could potentially enforce the rules, why doesnt the government justask for more manpower?

Mills v. Electric Auto-Lite Co.

There are two views in this case. First: In order to obtain damages, you need toshow that shareholders would nothave approved the merger but for themisleading statement. Second: The plaintiff need only show that controlling thevote itself (i.e., the proxy process) was necessary for prevailing on the decision.The court took the second view.

As to damages, the court says that fairness determines damages (fairness = nodamages). [So there will be damages if the defendant cannot prove thetransaction was fair?]

Materiality of information disclosed within proxy statement

The test for materiality is based on substantial likelihood of reliance on the partof the shareholders. See TSC Industries v. Northway, Inc.

Virginia Bankshares, Inc. v. Sandberg

There were several factors pointing toward a materially misleading statement bythe directors: (1) the $42 per share price was recommended despite valuation ashigh as $60, (2) the valuation of real estate based on historical rather than presentvalues, and (3) directors who wanted to keep their positions by approving themerger.

Note, however, that Virginia Bankshares had 85% of the shares. In other words, it


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did not need to go through the proxy process in order to prevail on the decision.Virginia Bankshares solicited proxies because it needed to preserve its reputationwithin the community.

The court said that one need not show reliance on the part of any shareholders

because that would be practically intractable. The court also imposed liability onthe basis of negligence, though courts disagreed as to the exact standard.

Rosenfeld v. Fairchild Engine and Airplane Corp.

The court limited reimbursement of proxy costs to disputes as to policy. Theincumbent can be compensated whether it loses or wins. Insurgents, however, canbe compensated only if they win and if they receive shareholder approval for thecompensation.

Now suppose that the insurgents admitted that the contest were purely personal.Note that such a claim would seem to eliminate the incumbents ability to be

reimbursed for the costs spent defending against such a contest. One way aroundthe problem is to frame the personal issue as a policy issue. The incumbents canclaim, for example, that the insurgents are actually lying and that the insurgentsactually intend to overthrow the management.

Class 7 (August 26)The new SEC rules mark the first step in shifting power from directors toshareholders.

Short Selling

Suppose that an investor knows that a stocks price will rise from $200 to $400. Inthat case, he should take a long position by buying shares and waiting for theprice to rise. Now suppose that the investor knows that the price will drop from$200 from $100. Suppose also that he does own any of the stock. In this case, hewill borrow the shares from someone who has no intention of selling. He will sellthe borrowed shares at $200, wait for the price to drop to $100, and repurchasethe shares at $100. Then he returns the shares to the lender and walks away with$100 per share. This is known as a short position. One takes this position whenhe believes that the price of a stock will go down.

Consider, however, the risk of short selling. If the investor initiates a short sale at$200 but then the price goes up to $1,000, he will lose $800 per share. Notice thatthere is no limit to the losses that can result from short selling. By contrast, themaximum that one can lose from a long position is the purchase price of thestock.

34 Shareholder Voting

Ordinarily, there is an alignment of interest between shareholders voting andshareholders economic interests. Suppose that a shareholder owns 10% of thevotes but none of the economic interest. In this case, the shareholder cannot be


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trusted to vote in a manner that will maximize the corporations economicinterests.

Think of a share as follows:

Vote

Economic Rights

A Vote Buying

The problem of vote-buying results from the fact that individual shareholders tendnot to value their votes very much. Since the average shareholder owns only atiny fraction of the voting stock, he is unlikely to believe that exercising thosevotes will have any impact on the outcome of any corporate decisions. At this

point, an interested party can approach the investor and offer $2 in exchange forthe votes. Buy accumulating a large number of votes, the interested party canthen influence the decisions of the corporation. Because the interested party hasno economic interest in the corporation, he cannot be trusted to vote in the bestinterests of the corporation. For this reason, Delaware law prohibits vote-buying.

B Eliminating Economic Rights Through Short-Selling

Suppose that an investor first purchases 10% of a corporations stock (i.e., obtainsa long position in those shares) and thereby obtains 10% of the vote. Suppose thatthe investor then enters into a short-sell with an additional 10% of the stock. Aslong as the investor holds on to the borrowed shares, the gains and losses from the

long and short positions will cancel each other. In effect, the investor no longerhas any economic interest in the stock; all that remains is the voting rightsassociated with the shares. The investor may then have an incentive to vote insuch a way as to benefit third parties (perhaps another corporation in which he hasan interest) regardless of whether the particular decision is good for thecorporation. This is known as empty voting.

As it stands, the SEC has no rules regarding disclosure by investors who takeempty-voting positions.

C Sale of Control

The whole point of the control premium is to reflect the fact that control of acorporation can allow a controlling owner to take advantage ofprivate benefits ofcontrol while staying within the bounds of his fiduciary duty. The extent of theseprivate benefits depends on various factors, including government regulations,market conditions, and so forth. Empirical studies indicate that the controlpremium is 10%. By contrast, these studies indicate that the control premium inItaly is 70%.

The minority shareholders will earn money if the purchaser of the control is a


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better manager than the seller of control. On the other hand, they will lose moneyif the purchaser is a worse manager than the seller. But this is a risk that occurs inany transfer of control.

For the seller, the crucial point is the moment of sale. Before that moment, the

seller can be held liable for violations of the fiduciary duty. After the shares havepassed in the hands of the buyer, the seller no longer cares what the buyer doeswith the corporation.

From the perspective of the minority shareholders, the important question iswhether the new controlling shareholder is a better thief than the previous one.

Zetlin v. Hanson Holdings, Inc.

The plaintiffs are complaining that the former controlling owners of HansonHoldings should have allowed the plaintiffs to share in the control premiumresulting from the sale of their controlling shares. The court is saying that the

control premium is the private property of the controlling owner.

Gerdes v. Reynolds

Note that the shares were valued at 6 but sold at $2. This is a typical example ofselling a corporation to a looter. The idea is that the sellers are receiving apremium in exchange for allowing the buyer to do whatever he likes. The plaintiffsclaimed that the sellers should have known that the buyer was a looter.

The rule is that the controlling owner can keep the control premium, but he has aduty to perform due diligence. He cannot close his eyes when he sees that thebuyer is paying a huge premium for the shares in question. In general, themajority shareholders have a duty to ensure that the buyers are not looters.

The law is essentially forcing the sellers of control to police buyers to make surethat the buyers are not corporate looters.

Perlman v. Feldmann

The central issue is the impact of the transaction on the Feldmann Plan. There wasa shortage of steel, so Newport Steel should have raised prices. However, this wasnot politically feasible because it would make the company look unpatriotic. TheFeldmann Plan got around this problem by allowing interest-free loans fromconsumers. This is effectively raising the price of the steel. The sale of NewportSteel upset the apple cart with regard to the Plan. The business opportunity

missed was the opportunity to make customers pay a bribe to get the scarce steel.The buyers (who were consumers of steel) wanted to avoid paying the bribe bybuying Newport Steel.

The court is not making a rule that the control premium always has to be sharedwith the minority. The court is saying that ifthe sale of a controlling block entailsthe sale of some asset belonging to the corporation, then the seller cannot keepthe premium all to himself.

Here are actual share prices for Newport Steel around the sale:


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Jul. $6.75

Aug. $8.50

Sep. $10.90

Oct. $12.50

Nov. $12.40

Dec. $12.00

Notice that share prices went up after the sale. However, we dont know two keyfacts: (1) what were the overall market conditions and (2) the value of thecompanys inventory.

D Possible Rules on Control Premiums

The U.S. rule: Seller gets to keep all of premium unless there is evidence that thebuyer is a corporate looter (i.e., transactions are subject to the fiduciary duty)

Equal premium: Premium must be shared with all shareholders on a pro rata basis

The goal of rules on control premiums is to make sure that all efficient transactions(i.e., which enhance the performance of the corporation) are allowed and all non-efficient transactions (i.e., those involving corporate looters and so forth) areprohibited. Which of these rules is better?

The U.S. rule allows all efficient transactions to go through. Suppose that a buyerpays $17 per share for a company whose stock is trading at $15. If the buyer is

indeed a good manager, then the minority should be very happy; the buyer isessentially betting that he can increase the value of the company to more than$18 per share. The problem is filtering out bad transactions. On the other hand, itis also possible that the buyer is a looter who seeks to recover his $2 premium byselling off assets of the corporation. The U.S. rule doesnt have any way todistinguish between these two scenarios.

In the same scenario, the equal-premium rule would require the buyer to buy outthe minoritys shares at $17 as well. In effect, the buyer would be required topurchase 100% of the corporation. Consequently, there is no incentive to loot thecorporation. So the equal-premium rule filters out all looting transactions. Theproblem, however, is that some good transactions will also be prohibited.

Basically, the requirement that the premium be paid to minority shareholdersincreases the expenses of the buyer, making some otherwise-efficient transactionsunprofitable.

Which rule is better depends largely on how good the courts are at using thefiduciary duty to rein in abuses that might take place under the U.S. rule. Perhapsthe U.S. rule would be better when corporations are being governed by Delawarecourts (which are very good at evaluating transactions for efficiency). By contrast,the equal-premium rule would be better with English courts, which are not asskilled with corporate law.


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Brecher v. Gregg

Importantly, the court is saying that there is a threshold size below which a blockof shares will, as a matter of law, not be considered a controlling block. When anextremely small block of shares is allowed to control a corporation, that

shareholder has no incentive to observe the fiduciary duty. Instead, theshareholder would be tempted to benefit himself at the expense of the othershareholders.

Butthe existing 4% owner can exploit the corporation just as much as the newone. So why are we afraid of new owner? The answer is that the new owner willhave even more incentive to steal from the corporation in order to compensate forthe control premium he paid to the original owner.

Essex v. Yates

Here, Yates received a control premium for a 28.3 percent block of shares. The

court said that the burden was on theplaintiffto show that 28.3 percent was toosmall to be a controlling block and that the payment of the control premium wastherefore inappropriate.

Note that the agreement concerning the appointment of new directors wasnecessary because the buyers were not sure that they would be able to gaincontrol of the board through the normal voting mechanisms. Judge Friendly andthe majority disagree as to whether these sorts of arrangements are a valid way tocircumvent an uncertain vote.

Inhibiting Changes to the Board

Delaware law prohibits corporate charters from saying outright that shareholdersmay not fire directors. Suppose, however, that we structure the shares in such away that the directors are guaranteed to have a majority of the voting shares. Thisapproach technically complies with the limitations of Delaware law. In fact, thecombination of a poison pill and a staggered board effectively prevents attemptsto fire the board, and this approach also falls within the limitations of Delaware law.

Suppose that a corporation initially has only A shares. It would be plainly illegal tolet the directors exchange their A shares for a new class of B shares, which as tentimes the voting rights of A shares. Now suppose that we try to avoid thisproblem. We redefine A shares to have ten times the voting rights of before.However, we write into the charter a condition saying that a buyer of an A share

will get only one vote with that share unless the buyer holds that share for at leastthree years. Because shares on the open market are traded frequently, it isbasically impossible for any buyer to get the ten votes. Delaware law says thatthis kind of scheme is nota conflicted transaction. Delaware law says that as longas a change to the corporate charter formallyaffects all shareholders equally, it isokay.


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Class 8 (August 27)

35 Mergers and Acquisitions

Corporations can grow (1) internally, by building more factories, etc., or (2)externally, by acquiring other corporations. Reasons for purchasing othercorporations include economies of scale, economies of scope, synergies, riskdiversification, gaining market presence, and so forth. Regardless of the motivesbehind the mergers, the key here is that the mergers discussed here are friendlymergers. From the standpoint of corporate law, the fear is that friendly mergersmay be designed to benefit the management of both corporations to the detrimentof the shareholders.

There are three ways to acquire a corporation: (1) asset acquisition, (2) stockacquisition, and (3) merger. The choice as to which method to use is influence bymany factors. Some of these considerations include tax issue and regulatory

issues. For our purposes, however, the important factors are shareholders rights,the speed of the merger, and several similar factors.

A Asset Acquisition

Suppose we have acquiring corporation A and target corporation T. Initially, both Aand T have their own assets. In an asset acquisition, A purchases Ts assets,paying in cash or by issuing shares of itself. This method, however, entails hugetransaction costs. A must spend time and money identifying Ts assets andperforming due diligence on them. Then there is the technicalities of transferringtitle of the assets. Furthermore, T may hold some assets that are not transferrable.At any rate, when the transaction is finished, all of Ts starting assets will belong toA, and Ts assets will consist only of A stock.

The advantage of this method is that A can pick and choose the assets it wants topurchase. A, for example, might buy only Ts factories without taking on theemployees working in those factories. In other words, A can avoid unfavorableliabilities that might arise against T. Suppose that T polluted a river some yearsbefore the merger. An asset purchase would insulate A from any judgmentrendered against T. In terms of shareholders, an asset purchase generally will nottrigger shareholder-approval requirements for either A or T. That said, the NYSEhas added its own requirement saying that some kinds of asset-for-stock purchasesmust be carried out with shareholder approval. In particular, if A pays out 20% or

more of its total shares in exchange for Ts assets, then A must have thattransaction approved by a simple majority of its shareholders.

Now, after Ts assets have been acquired, the next step is to liquidate T anddistribute the proceeds to Ts shareholders. If T was paid in cash, then Tsshareholders take that money and go home. If T was paid in A stock, Tsshareholders become A shareholders.

Normally, no liability against T will run to A. However, some courts will treat thissort of asset acquisition as a de facto merger and extend Ts liability to A.


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Usually, asset acquisitions are rare because they are so complex from a practicalstandpoint.

B Stock Acquisition

Here, our goal is to reach a situation where T is a subsidiary of A. One way to dothis is to buy shares of T from Ts shareholders. This is typically done through atender offer. The problem with this, of course, is that the shareholders may not bewilling to give up their shares. This is a particular problem when a few holdoutsprevent A from getting 100% ownership of T. But assuming that the purchase ofstock is successful, we again have a situation where A is insulated from Tsliabilities. Again, the main exception is when someone convinces a court to piercethe corporate veil. Because Ts shareholders are offered money for their sharesindividually, there is again no triggering of Ts shareholders rights.

A second way to do a stock acquisition is for T to issue enough new shares to A sothat A has control of T. In this case, T shareholders will have to approve thetransaction, but only under the simple-majority rule imposed by the NYSE. There isno appraisal on either side.

C Merger

In a merger agreement, the shareholders and directors of both corporations mustapprove. Furthermore, shareholders on both sides get appraisal rights. Norm

Documents

Corporate Law Class Notes