Corporations Dibadj Fall 2009

Corporations Outline

I. Introduction to Corporations - Developed from contract law, property law, wills and trusts and agency law. - There are three forms of business organization: agency, partnership and corporations - Goal of corporate law: create wealth and facilitate transactions. 1. Measuring Efficiency How do we know if a transaction is efficient or has created wealth?Pareto efficiency (Pareto-Optimal): system is efficient when resources are distributed in such a way (within a given group or territory) that no reallocation of resources can make at least one person better off without making at least one other person worse off. Problem: there is no way to judge the effect the transaction has had on the rest of society. Kaldor and Hicks: As long as there is a way in society to potentially compensate the people who are worse off, then it is ok, and it is efficient.Problem: the compensation is hypothetical and doesn’t say that the person needs to be made whole.

2. ConcernsWe are concerned with keeping down costs. The most important transaction cost is agency costs (ex: CEOs and CFOs who have tastes in very fine wine). Notion is that the agent (actor) will be doing something to benefit himself to the detriment of the principle. Struggle here: We want the agent to be productive and work to make money for the principle, and we therefore want to give them incentives to work hard. At the same time, we don’t want them to go crazy with their spending.

3. Debt, Equity and Economic Value Capital Structure: made up of debt and equity There are two ways that a company can raise money: 1. Debt: have people lend you money: essentially a contract that allocates the relationship between debtors and creditors with the company to get payments over the course of a certain number of years, and then get it all back, plus interest. Look at solvency: is the company going to make it or not? All you need is for the company to make back their investment, how successful does not matter. 2. Equity: issue shares there is no contractual relationship, since it is buying part of the company. Once the debtors have been paid, shareholders get the rest. It is therefore riskier then debt, but the risk of return can be much better. how do we value these assets? Use the Discounted Cash FlowWhen you buy the share you are hopefully getting a return in some way: a cash flow. We then use a “discount rate” to determine the return an investor would expect over time. This is not an accurate reflection, since you are assuming a future cash flow, and choosing an arbitrary discount rate. Risk and Return: the riskier the project, the greater the return, and therefore the higher discount rate. Diversification can eliminate some of the risk, but some projects are so risky that they cannot be diversified.

CorporationsDibadj, Fall 2009 Page 1

II. Agency 1. Introduction Agency problems have come up before in contracts and tort liability. Agency is the simplest form of business organization: you are hiring someone to represent you.This is not a contract: agency law imposes a fiduciary duty (higher duty) on the agent then that which is imposed in contract law. Agent, formally in restatement 3rd: “Agency is a fiduciary relationship that arises when one person (a principal) manifests assent to another person (an agent) that the agent shall act on the principal’s behalf and subject to the principal’s control and the agent manifests assent or otherwise consents so to act”. the agent has authority to effect a legal relationship.

2. Vocabulary Special agent: deals with one transaction (go by this house for me)General agent: multiple transactions (here is someDisclosed Principal: 3rd party knows that there is a principalUndisclosed Principal: don’t know that there is a principal, think that the agent could be the principal… might want to do this because knowing who they are may drive up the price (eg: a University wants to buy land next to the University. If the land owner knows that it is the University, then they might want to drive up the price). Partially disclosed Principal: 3rd party knows that there is a principal, but doesn’t know exactly who it is.

3. FormationAn agency relationship can be expressly created, or implied. 1. Express: the fiduciary duty that arises when:

- one person (the principal) manifests assent to another person (the agent) that- the agent will act on the principal’s behalf and subject to the principal’s control and- the agent manifests assent as well.

2. Implied: don’t need an explicit contract to be an agent for an agency relationship to form, just need the court to infer an agreement. Must find:

- principal assent- agency assent- principal control.

Jenson Farms Co. v. Cargill Inc. : An agency was implied when one party directed the other implement its recommendations (principal assent), control through paternal guidance in financing, etc, agent’s consent through getting products for the principal as part of normal operation.

4. TerminationEither party can terminate at any time, but if the contract is for term then they other party can collect damages. Otherwise, it can be terminated after a reasonable amount of time.

5. Principal’s liabilitya. Liability in ContractA principal can be held liable for the actions of the agent to a third party based on three theories: Actual authority: that which the agent could reasonably assume from the principal: key thing is


the relationship between the principal and the agent. Would the reasonable person standing in the agent’s shoes assume from the principal’s action that they had authority. There can be express or implied authority. Apparent authority: the relationship between the principal and the third party. What a reasonable third party would infer from the behavior of the principal. Designed to protect the third party… look to the manifestations of the principal.Inherent authority: relationship between the agent and the third party… looking for any action from the agent to the third party to signal authority.White v. Thomas: White hires Simpson to go and bid on a certain amount of land for him. She over spends and then tries to sell part of it to the Thomas’. Court said that there was no reason for Thomas’ to believe from her actions that she had authority to make a side deal. Gallant Insurance Co. v. Isaac: Car insurance case. An agent had inherent authority because the third party reasonably believed that it had authority to orally bind coverage, and the past dealings went through and agent, and the agent filled out the paperwork.

b. Liability in TortIf there is a master/servant relationship, then the master is liable for the tort of the servant. Look at how much control the principal has control over the agent: the more control the principal has over the agent, the more likely we are to find the principal liable for the actions of the agent. Humble Oil and Refining Co. v. Martin: Man who ran the gas station for a large company was an agent because the company had financial control, agent had so discretion. Principal was found liable. Hoover v. Sun Oil Co.: Guy who ran a gas station for a large company was not an agent because he was under no obligation to follow the principal’s recommendations. Principal was not liable for injuries that occurred at the station.

6. Agent’s DutiesThe agent is a fiduciary: they are a category of legal actors upon whom we impose a higher duty.

We are trying to create legal rules that can advance the goals of the relationship: to help the principal. Three important duties: 1. Duty of Care: the agent must behave in the way that a reasonable person would behave under the circumstances… This is similar to torts, except that it is more defendant friendly. 2. Duty of Loyalty: agent must advance the purposes of the principal’s and can’t “line their pockets at the expense of the principal”. Tarnowski v. Resop: Agent made a secret commission while selling juke boxes on behalf of the principal; the court said he had to return those profits because he had a duty to advance the interest of the principal over his own. InRe Gleeson: agent running trust for the principal leased the principal’s land to himself; court saud he could not deal with himself even though he was trying to keep the land in good shape. 3. Duty of Obedience: not as important.


III. Partnership1. Introduction - Partnerships are a way to pool capital. - There are two major problems with partnerships:

1. Liability: partners are personally liable, if you go into a general partnership, then creditors can go after your personal assets.

2. Inadvertently get into a partnership, and if no control is specified both partners have equal control, and it only takes one person to spoil the partnership.

2. Duty owed among partnersPartners owe to one another a duty of loyalty, and are held to a higher standard than one who merely contracts. Meinhard v. Salmon: Third party asked Salmon alone to re-lease a building. Salmon did not mention this to his partner Meinhard. Court said that Salmon breached his duty of loyalty to Meinhard by excluding him from the opportunity he had as a partner.

3. Problem of Joint OwnershipPartners are jointly and severally liable for the debts of the business this is why people should not go into partnerships.

4. Formation of PartnershipsA partnership can be formed expressly, or impliedly. 1. A partnership can be implied:

1. A voluntary contract of association for the purpose of sharing profits and losses. 2. Intent on the part of the individuals to share profits and losses

Factors to establish intent: a. receipts showing share of profits and lossesb. furnishing skill instead of money: relevantc. lack of involvement is not necessarily relevant.

If you are share of the sales, the argument is that you are an employee but if you are getting a share of the profits, then you are most likely a partner and have some control over the business. Vohland v. Sweet: Sweet worked at Vohland’s nursery. He was paid a 20% commission that came out of the profits, not the sales. The court found that had partnership could be implied.

5. Third Party Claimsa. Claims against departing partnersPolicy concern: should we release departing partners from debt? If you release them from debt, then they can bail when things get bad. If you hold them accountable, then creditors can go after then years later for faults of their partners. Rule comes from UPA Section 36(2) releases the departing partner of partnership debts if the courts can infer an agreement between the continuing partner and the creditor to release the withdrawing partner. (3) releases the departing partner from personal liability when a creditor renegotiates his debt with the continuing partners after receiving notice of the departing partner’s exit.b. Claims against partnership propertyThe partnership has a segregated pool of assets available for creditors.


c. Claims against partner’s individual propertyWhen a creditor’s claim is not fully satisfied by the partnership property, the creditor can make a claim to the assets of the individual partner’s assets as well. When the UPA is state law, and it is not a §723 bankruptcy case: Jingle Rule applies: Creditors of the partnership get assets of the partnership first, creditors of the individual get assets of the individual firstWhen RUPA is state law or it is a §723 bankruptcy case: Parity Rule applies: creditors of the partnership get first claim on both the assets of the partnership and the assets of the individual. Creditors of the individual get first claim on the assets of the individual, and then second claim on the assets of the partnership. → If you are giving benefits to the creditors then you are encouraging the formation of partnerships.

6. Partnership Governance

One partner’s action within the scope of ordinary partnership business is binding on the other partner.

The majority of the partnership has the ability to make the business decision, but 50% is not the majority when choosing between these rules, chose the rule that will encourage business: policy.

National Biscuit Co. v. Stroud: Two partners in a baker business. One partner tells Nabisco that they will not accept anymore bread, the other partner tells them to send it. Court ruled that the acceptance was binding on the partnership, even though it was 50%, since it was in the ordinary course of business.

7. Termination a. Partnership at will: a partnership with no time limit (at will), can be dissolved by either partner as long as it is in good faith. b. Partnership at term: a partnership at term cannot be dissolved until the term is up

1. Explicit: the term of the partnership is explicit in the contract. If there is a contract in place regarding the terms of dissolution, the terms in the contract trumps any state law to the contrary. policy: we want parties to be able to negotiate, and we want to encourage the formation of contracts. Adams v. Jarvis: one partner withdrew from the partnership, under UPA that would result in dissolution except there was a contract in place saying that such an occurrence would not result in dissolution. Court said that the contract agreement trumped the UPA.

2. Implicit: the term of the partnership can be implied in some casesA term can be implied when the partnership is for particular undertakings such as:

i. a certain sum of money is earnedii. one or more partners recoup their investmentsiii. certain debts are paidiv. certain property can be disposed of on favorable terms.

Page v. Page: One partner wanted to terminate the partnership and cut the other partner out of the business. Court found that the partnership was at will and therefore could be terminated since there was no evidence of bad faith.


c. Sale of Assets in Parternship Dissolution: There must be an actual sale of assets, not court-determined fair market value estimation and sale (in kind)Exceptions: 1. The partners have contracted for an in-kind distribution 2. An in-kind distribution can be ordered when

i. No credotrs would be paid off from the proceeds, orii. Ordering a sale would be senseless because only the partners would bid or,iii. An in kind distribution is fair to all partners.

Dreifuerst v. Driefuerst: partnership was dissolved without any written agreement, parties could not agree how the assets would be distributed. Court ordered an actual sale since the parties did not agree otherwise, and none of the exceptions applied.

8. Modifications to the Partnership Forma. Limited Partnership:

- the general partner has unlimited liability- limited partners share in the profits without incurring personal liability for debts- the limited partner is only liable for the money he put into the partnership- the limited partner cannot participate in management or control

b. Limited Liability Partnership- intended to protect professionals- same as a normal partnership, except partners have limited liability for tort of colleagues

c. Limited Liability Company- All members have liability limited to their contributions even when they exercise control as a general partner would- Can choose to be taxed as a partnership or corporation.

IV. The CorporationA. The Corporate FormThe most common form is the publically traded corporation.


1. TerminologyClosely held corporations: usually a small corporation where the shareholders and the board are the same (usually family businesses) that incorporate for tax purposes rather than capital. Public Corporation: corporations that traded publicly on stock exchanges for the purpose of accumulating more capital. Either of the above can have a controlling shareholder or no controlling shareholder. Problem: minority shareholders lack power, and are liable for the controlling shareholder’s action and decisions. Public Policy: there is a tension between giving officers flexibility and power to make decisions to make us money, and holding them accountable for their self-interested actions.

2. Creation of a Fictional Legal EntityCorporations are legally treated as a person.

a. History of Corporate FormationIn past corporations were non-profits for the public good, their charters were from the state. To make a corporation for profit, you had to get a special act from the legislature. This meant that only the well connected were able to have corporations.

b. Process of Incorporating Today- Individual called an “incorporator” drafts and signed the articles of incorporation/certificate of incorporation (corporations “charter”). This includes the name of the company, the board of directors, the number of shares, and value (usually one cent)- The charter is filed with a designated public official, usually the secretary of the state (in Delaware the corporations life begins then). - Fee is due: calculated in part as a function of how many shares the new corporation is authorized to issue (price discrimination). - Secretary of state issues the corporation’s charter: copy of the articles + and a certificate of good standing (in other jdx the corporations life begins then). - Corporation elects directors, adopts bylaws, and appoints officers.

c. Articles of Incorporation or CharterThe articles can contain any provision that is not contrary to law. overriding concept: contractual freedom. The corporate charter will contain the most important customized feature of the corporation, should there be any. (Governance oddities will be covered in this). Charter must name: the original incorporators, state the corporation’s name and (broadly) it’s business, and fix its original capital structure. Charter can establish the size of the board or include other governance terms.

d. Corporate BylawsMust conform to both the corporation statute and the corporation’s charter. → Bylaws fix the operating rules for the governance of the corporation. Under some statutes, shareholders have the inalienable right to amend the bylaws, while others limit this power to the board of directors.

e. Shareholder’s AgreementsFormal agreements among shareholders play an important part in the legal governance structures of many close corporations and in some controlled public corporations. Corporation can be party to these contracts: specifically enforce these agreements where all shareholders are parties as well. Where some shareholders are not parties: will not always enforce it against everyone.


Voting Trust: shareholders publicly agree to place their shares with a trustee who then legally owns them and is to exercise voting powers according to the terms of the agreement. 3. Limited LiabilityCorporations have unlimited liability, and shareholders have no liability for the debt or obligations of the corporations. shareholders cannot lose more than the amount they invest, but a shareholder can undertake by contact to be a corporate guarantor. Public Policy: Financial reasons why Limited Liability is good: 1. vastly simplifies the job of evaluating an equity investment2. ability of the corporate form to segregate assets may encourage risk-adverse shareholders to invest in risky ventures3. may also increase the incentive for banks or other expert creditors to monitor their corporate debts more closely. chief purpose of limited liability is to encourage investments in equity securities and thus to make capital more available for risky ventures. Easterbrook and Fischel on Limited Liability and Corporations1. Limited liability decreases the need to monitor managers.2. It reduces the cost of monitoring other shareholders. 3. By promoting free transfer of shares, limited liability gives managers incentives to act efficiently. 4. Limited liability makes it possible for market prices to impound additional information about the value of firms. 5. limited liability allows more efficient diversification. 6. Limited liability facilitates optimal investment decisions4. Transferable sharesShareholders own a share interest, and their share may be transferred together with all rights that it confers. tied to limited liability: if shareholders were liable, then the creditability of the company could change every time. The ability of investors to freely trade stock encourages the development of an active stock market. Free transferability is a default provision: all jurisdictions can limit these agreements. Free transferability compliments centralized management in the corporate form by serving as a potential constraint on the self-serving behavior of the managers of widely help companies. 5. Centralized ManagementThe shareholders elect the board, and the board appoints officers and managers. - Corporate Struggle: we want to give the board leeway so that they will go out and make money for us, but at the same time we don’t want to give them so much room that act against shareholder interests. - The structure we have come up with to empower shareholders is that they can sell, sue and elect the board.

a. Board of Directors- We give immense amounts of power to the board. - Directors have a fiduciary duty


Rule: the board is not required by duty to follow this wishes of a majority shareholder. This is because the board must represent the interests of the majority and minority shareholders. If an individual does not like it, then can sell their shares (Wall Street Rule). Automatic Self-Cleansing Filter Syndicate v. Cunninghame: Controlling shareholder (55%) wanted to sell the company’s assets. The directors refused to sell. The court said the board has absolute power because the minority has to be taken into account.Public Policy: there is a tension between protecting minority shareholders and letting the controlling shareholder have control because he has the most invested. If the board does go against the majority shareholders, then they can vote out the board. Staggered Boards: A third of the board gets elected each year. If you are a majority shareholder, it could take a while to get the whole board replaced. This prevents the board from turning over every year. They are therefore good for stability. Formality of Board Operations: Corporate directors are not legal agents of the corporation and directors act as a board only at board meetings. A certain number of directors must attend the meeting for it to be valid (a quorum). Minutes must be recorded at the meeting. The formality of board meetings must be followed.Fogel v. US Energy Systems: board with 4 directors. Three meet before the meeting and informally decide to fire the CEO. Court held that it was not valid since they did not follow the meeting formalities.

b. Corporate Officers/ManagersThe manager and the officers are the agents of the corporation. Rule: Officers, unlike directors, are agents of the corporation and therefore a subject to the fiduciary duties of agents. Jennings vv. Pittsburg Mercantile Co.: Mercantile’s VP (officer) made a representation to a real estate broker that if the broker made any offers, the board would accept them. The court ignored inherent authority and said that the VP did not have apparent authority (3rd party would believe based on dealing with the principal that the agent had authority) because the prior dealings with the board were not the same and the fact that the company had an office for Egmore was insufficient. Grimes v. Altheon Inc.: CEO of a company enters into a verbal contract to sell 10% of the company. Court says that he did not have the authority to do this.

B. The Protection of CreditorsCreditors get some protection: we do not want the corporation to falsify accounting, income or assets for a loan, continue to operate while bankrupt, etc… We are worried that companies are going to falsify their documents, and that ultimately creditors are not going to want to lend anymore policy-wise we are pro-business. 1. Mandatory DisclosureUnder Federal Securities Law: the general rule is that we force corporate debtors to disclose information to creditors. State corporate law in the US does not use mandatory disclosure laws, it leaves it to federal securities law. 2. Capital Regulation talk to DabajIn the US we do not require corporations to have capital reserves (essentially a portion of money in a separate account that you can’t touch until something goes wrong).


Policy wise we don’t do this because it ties up capital and creates barriers for individuals who want to start a company. 3. Standard Based DutiesThere are duties on individual participants in the corporation that provide for protection for creditors. a. Director Liability Director liability is to the shareholders, and in the unusual case when a corporation is insolvent, they may have a duty to the creditors. Corporate law does not tell the directors where the first duty is owed. b. Fraudulent TransfersGenerally: If you are moving money around to avoid paying creditors, then those transfers are void. Under statutes and common law: we will void any transfers that were done to hinder and violate the rights of creditors. If you are going to design any kind of transfer to defraud creditors, then we will void it. You can show this under fraud: 1. Actual Fraud: must show the intent to defraud: future or present creditors can void transfers made with “actual intent” to defraud. this is very hardOR 2. Constructive Fraud: creditors can void transfers made without receiving a reasonably equivalent value if the debtor is left with remaining assets unreasonably small in relation to its business. c. Shareholder Liability

i. Equitable SubordinationThis is a doctrine where the court will use its equitable powers to subordinate the shareholder’s assets. You have a shareholder who has access to the workings of the company, and company is not doing very well, and is insolvency is down the line. If the company goes bankrupt, the directors is going to start paying off the creditors at the top (ie: the debt) and then work its way down to the equity. The shareholder wants to be higher up in the creditor chain so that they can get paid out, so they re-classify their equity as debt. Court will determine that they are not being fair to the other debt-holders, and they will move the debt back to equity: they subordinate the shareholder back to equity. (Like being at the grocery store, and someone cuts in front of you at line. The court is telling them to back it up, and get at the end). Costello v. Fazio: Plumbing company with three partners who have debt and equity. Right before the company declares bankruptcy the partners take the majority of their equity and move it to debt. The court stated that they could not do this, and subordinated the shares back to equity.

ii. Piercing the Corporate VeilUnder this doctrine you are piercing the veil of the corporation and going directly to the assets of the shareholders: This is an unusual doctrine at the margins of corporate law. We are essentially ignoring limited liability. There is two part test to determine when the creditor can hold shareholders liable for a corporation’s debts1. There is such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist. Consider the following factors:

- failure to comply with corporate formalities


- comingling of funds- undercapitalization

2. Some kind of injustice or inequity: this injustice must go beyond not getting paid as a creditor. Note: normally you must show both elements, but in some cases you only need to show one (eg: cases where the corporation is obeying formalities, but you can still pierce the veil.)Sea-Land Services v. The Pepper Source: Sea Land shipped peppers for Pepper Source, refused to pay, and Pepper Source filed for bankruptcy. Sea Land attempted to pierce the corporate veil to get to Marchese’s assets, the owner of Pepper Source. Court said the first prong was met because corporate formalities weren’t followed, funds were commingled, and the company was undercapitalized. The second prong was not met because there was no evidence that there were wrongs past not getting paid.Kinney Shoe Corp. v. Polan: Kinney leased a building to Polan’s company Polan Industries, Polan Industries didn’t pay then went into bankruptcy. Kinney attempted to pierce the corporate veil to get to Polan’s assets. Court said the first prong was met because the company as not adequately capitalized, did not observe any corporate formalities, and Polan attempted to protect his assets by moving them to a different company. The second prong was also met because not piercing would cause a basic unfairness. Court ignored evidence that Kinney knew that the Polan Industries was undercapitalized.4. Veil Piercing on Behalf of Involuntary CreditorsWalkovsky v. Carlton: Walkovsky got hit by a cab owned by the Seon Cab Corporation, owned by Carlton. Carlton also owns 9 other corporations, each of which has two cabs with minimum auto insurance. Walkovsky attempted to pierce the corporate veil to get to Carlton’s assets. Court said the first prong was not met because he wasn’t conducting the business in an individual capacity. Also is not enough that a plaintiff can’t receive full recovery because of the insurance limits.

C. Normal Governance: The Voting System1. The Roles and Limits of Shareholder VotingVoting is the shareholder’s most basic right: however there is still a collective action problem: shareholders don’t vote. 2. Electing and Removing Directors

a. Electing Directors- Basic shareholder voting right: they elect the board of directors. - Annual election of directors: each year voting stockholder elect either the whole board, or some fraction of the board (staggered board). Corporations notice period, quorum requirement, record date are established by the charter and the bylaws.

b. Removing Directors- A director can be removed anytime for good cause (fraud, unfair self-dealing) at common law. Limitations on the common law rule: based on due process that director is entitled to the job, bad business judgment is not good cause. - Directors cannot be removed by other directors without express shareholder authorization. - 141 (k) confers broad removal power on the shareholders. - Staggered board: the idea is that it limits a controlling shareholder’s power to appoint the whole board. 3. Shareholder Meetings and Alternatives


i. Annual MeetingsIn addition to electing directors, shareholders can vote to adopt, amend and repeal bylaws, to remove directors and to adopt shareholder resolutions. The meeting is mandatory, if the board fails to convene an annual meeting within 13 months of previous meeting, courts will entertain shareholder petition and require that a meeting be held. ii. Special Meetings-These are meetings other then the annual meeting. They are often to allow shareholders to vote on fundamental transactions. - This is the only way that a shareholder can intitate action between annual meetings. - Revised Model Business Corporate Act section 7.02 allowed for special meetings when it is called by the board of directors, or when the holder of at least 10% of the stock demands a meeting in writing. - Delaware 221(d): it can be called by the board, or by people designated in the charter. Policy: should shareholders be able to call a special meeting over the board’s objection?- Must balance the need to manage with the costs of calling a special meetingPro special meetings: monitor corporate management, lower wasteful agency costs. Con special meetings: shareholder meetings are costly, both money and time of the senior executives. iii. Shareholder Consent SolicitationsThis is an alternative to special meetings: statutory provisions allow them to act in lieu of a meeting by filing written consents. - This is through of as primarily than a cost-reducing measure for small corporations. - This can also assist in hostile takeovers. Delaware 228: any action that may be taken at a meeting of shareholders may also be taken by the written concurrence of the holders of the number of voting shares required to approve that action at a meeting attended by all shareholders.RMBCA: requires unanimous shareholder consent. 4. Proxy Voting and Its Costsi. PurposeShareholder meetings require a quorum to act (there must be a certain number of people present). This involves a lot of time and expense, therefore the board and its officers are permitted to collect voting authority from shareholders in the form of proxies. ii. CostsSoliciting proxies requires someone to incur the initial expenses. For annual meetings, costs of soliciting proxies are a matter of normal governance, since subsidizing costs is essential to holding annual meetings as required. Froessel Rule: when there is a proxy contest the incumbent directors are reimbursed by the corporation for the costs of defending a win or loss; the insurgent directors are reimbursed for costs of attacking only if they win, unless they act in bad faith or the proxy battle is not over policy as opposed to being over pure power. Rosenfeld v. Fairchild Engine & Airplane Company: corporation paid 28k to incumbent directors for their defense in a proxy battle. The corporation also paid 127k to the insurgents in their bid for the seats. Shareholder wanted the money returned to the corporation. Court said no, because the insurgent won, and therefore could be reimbursed for this costs in the proxy war. 5. Class Voting


Companies have different classes of shares. Generally you need a majority of each class of the shares to approve or void a transaction. Transactions that are subject to class voting: - RMBCA Section 10.04: a class vote is required only if the transaction alters legal or economic rights. (example???)- Delaware Section 272(b)(2): a class vote is needed if a transaction would alter legal rights. 6. Shareholder Information RightsShareholders have the right to inspect: - The company’s books and records: plaintiff has a high burden to show proper purpose. - The company’s stock list: plaintiff has minimal burden to show proper purpose. The corporation has the burden of showing improper purpose. 7. Techniques for Separating Control From Cash Flow RightsBaseline Rule: control and cash flow go hand in hand. When you buy a share, you get the right to vote. In these cases we are talking about situations where people are violating this baseline rule by trying to get control of the company (ie: the vote) without investing their money fully.

a. Circular Control StructuresIdea is that directors will want to “vote the company’s shares” on transactions within the company itself without actually paying for them. Since they cannot do this directly, it is possible for them to set up a second company which then buys stock in the original company. - Essentially a way the director can control the company. - Delaware 160(c) is meant to enforce this baseline: DGCL § 160 (c): Shares of its own capital stock belonging to the corporation or to another corporation, if a majority of the shares entitled to vote in the election of directors of such other corporation is held, directly or indirectly, by the corporation, shall neither be entitled to vote nor be counted for quorum purposes.Speiser v. Baker: HealthChem owns 100% of the shares of Medallion. Medallion has 9% voting right in HealthMed, which turns into 95% voting right. HealthMed owned 42% of HealthChem, with Speiser and Baker owning the rest. Court said that because the stock could be converted to a majority, HealthChem could not vote its share in HealthMed.

b. Vote BuyingBaseline rule is still that you cannot separate control from cash flow. - Blatant way around this: allow people to sell their shares to unmotivated shareholders. Policy for why we do not want this: this would allow for people to take very high risks since they do not have a lot invested in the company. This is would be unfair to the other shareholders. We do not allow for blatant vote buying. Vote buying is not illegal per se, unless the purpose was to deceive or disenfranchise the shareholders. Look at the intrinsic fairness to see if the process was fair or if there is a reason to see it as unfair. Policy: Easterbrook & Fischel (Re-Read)(a) Vote buying is not a good public policy.(i) Selling votes will not protect the other shareholder’s equity.(ii) Want individuals to have a stake in what voting for.(b) Why not create a market for votes?(i) Will never be able to get back what the vote is actually worth.(ii) Person selling the vote attaches almost no value so will not charge what it is actually worth. (Anything is better than nothing mentality).(c) Efficiency: Valuing stocks not hard science, valuing right to vote even more complicated.


Schreiber v. Carney: Jet owns 35% of TIA. There is a plan for a merger between TIA and Texas Air, but in order for it to go through TIA needs Jets votes. Jets also owns warrants in TIA that they want to exercise since the stock price will go up. They need a loan to do so. TIA loans Jet the money so that they will vote for the merger. The court found that this was not illegal per se, unless the purpose was to deceive or disenfranchise the shareholders. Cryo-Cell: Angry shareholder had 6% stake in the company and threatened a proxy fight for control. Company they would add him to the management slate in order for him to back down. Court said this is not traditional vote-buying, but is more subtle, and that intrinsic fairness test should not be used.

c. Controlling Minority Structures- Controlling minority structures are ways to separate control from cash flow. - Since this is, in effect, doing away with some of the rights to vote, it places a lot of pressure on the right to sue and sell. - Idea is to allow a shareholder to control a firm while only holding a small part of its stock. - Three kinds of structures: i. Dual Class Shares: situations where you have one class of shares that have a disproportionate amount of voting rights (eg: Martha Stuart has 10 votes per share in her company). This is not common outside of the US. ii. Stock Pyramid: if you want majority control of the company, the best way to do this is to buy 51% of the company without buying all it. You stack this power by buying 51% of the company that owns the original company. This is used outside of the US. iii. Cross Ownership: this is when subsidiaries of a holding company own shares in one another: it is the horizontal version of the stock pyramid. This leaves the public shareholders with very little control. 8. Collective Action ProblemThe Problem: When many are entitled to vote, none of the voters expect his/her vote to decide the contest. None of the voters has appropriate incentive to study firm’s affairs and vote intelligently.9. Federal Proxy RulesThe federal government had moved to regulate the way that voting is done through the federal proxy rules under 14(a). These SEC rules apply only to publicly traded companies.

a. Disclosure and Shareholder Communication§ 14(a): Unlawful for any person, in contravention of any rule that the commission may adopt, to solicit any proxy to vote any security registered under §12 of the Act.i. Central Regulatory Requirement§14(a)(3): No one may be solicited for a proxy unless they are, or have been, furnished w/ a proxy statement containing the information specified in Schedule 14A.→ This is the general rule. ii. Limits and Exemptions→ If you don’t want to comply with the general rule (14(a)(3)), then look for limits and exemptions so that you don’t have to go through the steps. §14(a)(1): definitions of critical terms. These definitions are very broad. Proxy: any solicitation or consent whatsoeverSolicitation: Any request for a proxy. §14(a)(2): Two exemptions from the general rule.


1. Newer Exemption: solicitations by persons who are ordinary shareholders who wish to communicate with other shareholders but do not intend to seek proxies.

exception to this exemption: if you want to oppose a merger, then you have to follow the general rule even if you are not soliciting a proxy. 2. Traditional exemption: solicitation of 10 shareholders. iii. Mechanics §14(a)(4): regulates the form of the proxy. § 14(a)(5): regulates the presentation of the proxy.§14(a)(6): must file the solicitation with the SEC§14(a)(7): iv. Special Rules for Elections

b. Shareholder Proposals§14(a)(8): Townhall Meeting Provision: Shareholders can include certain proposals in the company’s proxy materials, however they must be excluded if: - approval of the proposal would be improper under state law OR- the proposal is about ordinary business as opposed to social policyHewlett Packard Case Study: Carpenter’s pension fund want to include a statement to move the board to use a plurality vote. SEC denies the request to have it excluded, and HP places the proposal on the ballot. Shareholders vote down the proposal. 14(a)(11)CA Inc. v. AFSCME Employees Pension Plan

c. The Anti-Fraud Rule: §14(a)(9)Definition of Fraud: - Material misstatement or omission: easier to get defendant for misstatement then omission. Test for materiality: would a reasonable shareholder consider it important when deciding whether or not to vote?- Made with the intent to deceive (scienter)- Upon which there is reliance-Causing-InjuryYou must meet all of these elements. Virginia Bankshares v. Sandberg: In a proxy solicitation regarding a merger, VBI stated that a 42 buyout price for the shareholders, who were against the merger, was a high value. Court said that the proxy solicitation was fraudulent because: it was material in that the statement made by a director will be relied upon, however there was no causation because the merger could have gone forward without these minority shareholders. 10. State Disclosure Law: Fiduciary Duty of CandorObligation of corporate insiders to be candid when talking with their shareholders. use this if you can not bring a 14(a)(9) anti-fraud case. Rule: Whenever directors communicate publicly with shareholders about shares with or without request for shareholder action, directors have a fiduciary duty to exercise care, good faith, and honesty. - This seems limited to the facts of Malone v. Brincat.

D. Normal Governance: The Duty of Care1. Duty of Care and the Need to Mitigate Director Risk Aversion


ALI’s principle of Corporation Governance: Duty of Care: a corporate director and officer is required to perform his or her functions…in good faith, in a manner reasonably believed to be in the corporations best interest, with the care of an ordinarily prudent person acting in similar circumstances. - The duty of care standard is not actually a negligence standard, since the doctrine is more defendant friendly. - Policy behind the rule: we don’t want to discourage directors and officers from taking risky decisions, we want to create a system that will allow for directors and officers to take risks this is why the negligence standard is relaxing into being defendant friendly. - Directors’ and Officers’ personal assets are protected through a set of the barriers that a plaintiff would have to overcome: indemnification, director and officer insurance, the business judgment rule, and 102(b)(7). Gagliardi c. TriFoods International Inc. “In absence of motive, D and Os are not legally responsible for losses incurred in good faith.”2. Statutory Techniques for Limiting Director and Officer Risk Exposure

a. Indemnification- Indemnification statutes authorize corporations to reimburse any agent/employee/O or D for reasonable expenses for losses (attorney’s fees, investigation fees, settlement amounts, judgments) arising from actual or threatened judicial proceeding or investigation. DGCL §145: (a) Limits to indemnification: this has to be in good faith and it cannot involve criminal activities. (c): if the officer has been successful on the merits or otherwise, he can be indemnified. Successful on the merits is escape from an adverse judgment or other detriment. (f): allows for other indemnification but doesn’t set aside good faith requirement. Waltuch v. Conticommodity Service Inc.: Waltuch was VP of Conticommodity where he traded silver. The silver market crashed, and speculators sued him. He had legal expenses from multiple suits that he settled. Court said the company had to indemnify him because the settlement showed that he acted in good faith. If he had been found guilty, it would have shown bad faith and therefore no indemnification.

b. Director’s and Officer’s InsuranceCorporations can pay the premiums for D and O liability insurance. The only difference from indemnification is the pot where the money is coming from (in this case it is coming from the insurance company rather than the corporation itself). Policy: Why do we allow corporations to buy D and O insurance?- If the company is a central purchaser: it is cheaper- Will provide uniform coverage across the company- When the company buys it, it can use it as a deduction. - More cynical view: it is a disguised bump in the D and O’s salaries (if the corporation did not buy it, it would come out of D and O’s pay check). Enron and WorldCom: company was going down, and the indemnification was wobbly. The extent of the fraud was so great that it exceeded the D and O insurance, individual D and Os were forced to pay out of their own pockets. this is the exception. 3. Judicial Protection: The Business Judgment Rule

a. The Business Judgment Rule


Courts should not second guess good faith decisions made by independent and disinterested (no loyalty claim) directors. The boardroom not the court room is the place to resolve purely business questions. Directors are entitled to exercise honest business judgment based on information before them as long as they act in good faith. Courts will not interfere unless there is fraud, oppression, arbitrary action, or breach of trust.Policy reasons why the BJR is good: encourages risk taking, avoid judicial meddling, encourages smart directors to serve, and makes director conduct a matter of law so it can be dealt with quickly in court. Kamin v. American Express: Am Ex bought out of BLJ for a loss. The Am Ex shareholders wanted Am Ex to take the loss and deduct from their taxes. Am Ex instead passed out the shares to the shareholders. Court said that this decision fell under Am Ex’s business judgment and should be decided in the board room.

b. Duty of Care in Takeover CasesYou can defeat the BJR if one can show that the D and O’s were grossly negligent: establish that the directors didn’t take proper process to become duly informed. If the plaintiffs can show duty of care and breach of the that duty of care, the burden shifts to the defendants to show that the transaction was entirely fair. Smith v. Van Gorkom: Merger between two companies. Shareholder sued, alleging that the directors breached their duty of care in approving the deal without being informed about it. The board essentially rubber stamped a personally negotiated deal between the two CEOs. Court said the directors were grossly negligent because they didn’t follow proper process to make sure they were informed, so there was a breach of the duty of care.

c. Charter Provisions Waiving Liability for Due Care Violations§102(b)(7): a waiver in the charter for monetary damages that says a director has no liability for losses cause by transactions in which the director had no conflicting financial interest or otherwise didn’t violate the duty of loyalty. This essentially eliminates the possibility of a duty of care claim. if you want monetary damages and there is a 102(b)(7), you have to try a duty of loyalty claim. If there is a 102(b)(7) provision and there is a claim for money, it will not be actionable, unless there is an equitable remedy, like an injunction. 4. Delaware’s Unique ApproachTechnicolor: Emerald Partner : 5. The Board’s Duty to Monitor: Losses “caused” by Board PassivityA duty to monitor is a subset of a duty of care. - A board may have breached its duty to monitor when there is a failure to act. Directors must acquire at least a rudimentary understanding of the business, particularly financial performance (as opposed to detailed knowledge). - You have a much better chance of getting an officer for inaction then for bad decision making. - These are chases where the board members are not directly stealing, but have an inability/lack of monitoring those who are.

Francis v. United Jersey Bank: Mrs. Pritchard was a director along with her sons, who were taking money from the small company. She was sued by someone claiming that she breached her duty of care for failure to monitor her son’s activity. Court said Mrs. Pritchard breached her


duty to monitor because she didn’t know anything about the company and should have known her sons were stealing.Graham v. Allis-Cahlmers Manufacturing: Allis-Chalmers was a large manufacturer of equipment. A particular department manager was fixing prices, and the directors were sued because they didn’t take action to learn of the price fixing. Court said they did not breach the duty to monitor because they were relying on their employees and they were not given any reason to be suspicious.You can be liable for failure to monitor under federal securities law. In the Matter of Michael Marchese: Marchese never reviewed any of the accounting procedures, or the controls of the company. He backdated an acquisition, and approved multi-million dollar consulting fees. Court found that you can be liable for failure to monitor under federal securities law. In Re Caremark: Caremark is a health care provider that had some employees who were paying doctors to prescribe drugs, which is illegal. Government sued Caremark’s directors for failure to monitor their employees. Court said they were not liable because they tried to exercise oversight by providing a guide to govern compliance with the law.Sarbanes-Oxly Act of 2002We do not hold financial experts to higher standards to monitor. In Re Citigroup: plaintiff is saying that the board did not monitor and failed to pay attention to red flags. Citigroup had a 102b7, the Court found that they were not liable for lack of monitoring since experts are not held to a higher standard.

E. Conflict Transactions: The Duty of LoyaltyCorporate directors and officers’ have to place the corporation’s interests above their own. 1. Duty to WhomShareholder Primacy Norm: The duty is primarily owed to shareholders, the court found that you can be liable for failure to monitor under federal securities law. However, if the corporation is insolvent then the duty can also be owed to creditors. Constituency statutes. Dodge v. Ford: Dodge wants a special dividend paid out the shareholders. Ford says that instead they are going to use the money to cut their costs of production for consumers. Court said that Ford cannot do this, they must put the needs of the shareholders before the needs of the public. Corporations can make donations by applying the shareholder profit maximization broadly: if the directors decide that a donation can maximize the corporation’s profits, then it’s ok. A.P. Smith Manufacturing v. Barlow: A.P. Smith made a donation to Princeton. Shareholder sued, claiming that the company’s donation did not advance the interests of the company and therefore breached the duty of loyalty. Court said the donation did benefit the corporation because corporations need learning institutions to have educated people as employees, aid public welfare, respect.2. Self-Dealing TransactionsThis is a transaction where the director and officer is on both sides of the deal. If you engaged in a self-dealing transaction, and you owe a fiduciary duty, you must: 1. disclose all information2. get approval by a disinterested board or shareholdersIf you do not do this, then the transaction is reviewed for fairness.

a. Early Regulation of Self-Dealing


- Historically a bright line prohibition of self-dealing transactions developed from trust law. - Now corporate law has softened the bright-line rule where the transaction is:

1. Disclosed for approval by disinterested directors or shareholders AND2. Intrinsically fair.

Policy: Self-dealing transactions can be beneficial to a corporation (eg: a corporation gives a talented CEO a loan to make sure that they stay with the company).

b. The Disclosure RequirementAn interest director must make full disclosure of all material facts of which she is aware at the time of authorization of the conflicted transaction. Disclosure is only a pre-requisite to trying to get disinterested director or shareholder approval. If they have not disclosed, then the approval is not meaningful. Hayes Oyster Co. v. Keypoint: Verne Hayes was a director of Coast as well as a director of Hayes Oyster. Coast needed cash, so they sold some beds to Keypoint, which was partially owned by Coast. Therefore Verne was on both sides of the dealing. He did not tell anyone about Hayes Oyster’s interest in Keypoint. The court held that Verne breached the duty of loyalty by not disclosing his interest in Keypoint.

c. Controlling Shareholders and the Fairness Standardi. Controlling shareholdersA shareholder has control if they essentially control corporate machinery: this is someone who has enough stock to be able to control the board. General problem: some controlling shareholders engage in self-dealing transactions that hurt minority shareholders. Policy: controlling shareholders will argue that they should be able to do what they want, since they are in control. Minority shareholders say that control does not mean you can disregard all other shareholders. Controlling shareholders still owe a fiduciary duty when engaged in self-dealing transactions. If you are a controlling shareholder and you prove that you have gone through the necessary procedures, then the burden shifts back to the plaintiff to show that the transaction was unfair. Sinclair Oil v. Levien: Sinclair owned Sinven and Sinven was paying out dividends while the company needed cash. Court said there was no self dealing at all because minority shareholders were also receiving a benefit from the dividends being paid, so Sinclair did not meet the threshold for a duty of loyalty violation. Court then applied business judgment rule, which Sinclair passed because no gross negligence or waste.ii. Fairness StandardIf you are an entity with a fiduciary duty, and you are engaged in self-dealing transaction, then the baseline standard to evaluate is fairness. Fairness = fair price and fair process. Sinclair Oil v. Levien3. The Effect of Approval by a Disinterested Party

a. Safe Harbor StatutesDGCL 144 (a): these statutes make self-dealing transaction OK if: 1. You get disinterested board approval or 2. Unaffiliated shareholder approval OR/AND 3. Fairness. Disclosure is a pre-requisite for prongs 1 and 2, although the second prong is hard to determine. The baseline is already fairness, so the third prong is not really there.


Cookies Food Products v. Lakes Wherehouse: Herrig owned Lake and Speed. Cookies sold barbeque sauce, and made an agreement with Herrig to sell their sauce through Lake, resulting in great sales. Herrig eventually purchased enough stock of Cookies to become a majority shareholder. In this position he extended the dealership agreement with Lake for the sauce. Court said there was self dealing, no safe harbor, but Herrig did not breach his duty of loyalty because there was full disclosure of the arrangement so it was fair.

b. Approval by Disinterested Members of the Board- Approval by a disinterested board reverts to the business judgment rule. - Approval by disinterested directors shifts the burden of proving fairness in a controlled transaction to the plaintiff challenging the deal. Is this because of BJR, which makes it necassaey to show gross negligence to prevail?Cooke v. Oolie: Oolie, a director, wanted to make an acquisition, which two other disinterested directors voted for as well. Court said there was self dealing, but because he had disinterested director approval, business judgment rule applies which was passed because no gross negligence or waste.

c. Approval by a Special CommitteeApproval by a special committee has the same effect has approval by a disinterested board.

d. Shareholder Ratification of Conflict TransactionsShareholders can ratify conflicted transactions under the theory that the shareholder is the principle, and the principle can always ratify the actions of the agent. Shareholder ratification must be informed, not-coerced, and disinterested. - Even if the transaction is wasteful, if you have unanimous shareholder vote, then the transaction can still be ratified. Policy: these requirements are necessary because of the collective action problem. Lewis v. Vogelstein: Board established their own compensation. Court said the compensation is subject to the business judgment rule.In Re Wheelabrator Technologies Inc.; Review: if you have a self-dealing transaction between a corporate officer or director: then the BJR applies. If it is a controlling shareholder, then you have the fairness standard with a burden shift. 4. Director and Management CompensationPerceived Excess Compensation- CEO’s now make 500x the average worker, BUT it is difficult to estimate the market price for unique talents that make a good executive.- Often directors will appoint a separate compensation committee. Will use benchmarking studies to show arms length transaction.Lewis v. Vogelstein5. Good Faith StandardA breach of good faith is established when there is an intentional dereliction of duty, which is a conscious disregard for responsibilities by a director. → this is an even more defendant-friendly standard, than business judgment rule. → if you can prove this, you can overcome a 102(b)(7)In Re Walt Disney: Eisner, CEO of Disney, made the decision to hire Ovitz with minimal board input. Ovitz was fired without cause and therefore received a large severance package. The dismissal was approved by the board without research. Disney had 102(b)(7) waiver so only option was a duty of good faith suit or a duty of loyalty suit which was not at issue because no self dealing. Court said Eisner did not breach the duty of good faith because had no obligation to


continuously inform the board of his actions, and his actions were of the belief that hiring Ovitz would be good for the company.6. Corporate Opportunity i. Is the opportunity corporate? Three tests to determine this: Expectancy or Interest Test: The opportunity is corporate if there is an existing legal right that the corporation could act on. Line of Business Test: Anything that falls into the line of business belongs to the corporation. Factors: 1. How this matter came to the attention of the D and O or employee2. how far removed from the “core economic activities” of the corporation the opportunity lies.3. Whether corporate information is used in recognizing or exploiting the opportunity. Fairness Test: More modern test. Factors: how the manager learned of the disputed opportunity, whether he or she used corporate assets in exploiting the opportunity, and other fact-specific indicia of good faith and loyalty to the corporation, in addition to a company’s line of business. ii. Even if the opportunity is corporate, could the fiduciary have still taken the opportunity?- Corporation does not have the financial resources to take the opportunity (hard to argue unless the corporation is insolvent). - Corporation did not want to take the opportunity. if this is the case then you want to disclose, but it is not required Broz v. Cellular Information Systems. iii. Waiver of Corporate OpportunityUnder DGCL 122(17): explicitly authorizes a waiver in charter of the corporate opportunity constraints of officers, directors or shareholders.

F. Shareholder Lawsuits 1. Direct v. DerivativeTest to determine if the suit is direct or derivative:

1. Who suffered the alleged harm2. Who would receive the benefit of any recovery or other remedy

Tooley: delay in closing a merger by 22 days. a. DirectSuit in which the shareholders allege that the corporation did something to directly harm them. The recovery goes to shareholder. It can be done individually or in a class action. b. DerivativeAlleging a harm to the corporation, so the recovery would go back into the corporation. - When you bring a derivative suit, it is bifurcated: it is divided into two parts.

1. Shareholder must compel must either the directors or officers to take action, or they must get it out of their hands.

2. Substantive claims: underlying claims and violations (ie: violate duty of loyalty or care). 2. Collective Action Problem- Problem of a small number of corporate insiders and a large number of dispersed shareholders, but who are too busy to monitor the actions of the insiders. - One of the main issues here is that plaintiffs don’t really care: it is more that plaintiff’s lawyers are making a lot of money off of a lot of disinterested shareholders. You don’t necessarily need a common fund or monetary damages to get your attorney’s fees, all you need is for the litigation to provide a “substantial benefit” to the corporation.


Fletcher v. A.J. Industries, Inc.: derivative suit, and they get a settlement. Settlement doesn’t involve monetary damages, it is mostly around equitable relief. Even though there is no monetary damages, the lawyers sue and the court awards them their attorney’s fees. Dissent said that the trouble the corporation would have to go through the pay these fees will outdo the substantial benefit. 3. Standing RequirementsUnder 23.1 there are four things that a plaintiff must show to bring a derivative suit: 1. They must be a shareholder for the duration of the action2. They must be a shareholder at the time of the alleged wrongful action or omission: “contemporaneous shareholder”. 3. “Fair and Adequate”: represents the interest of shareholders, meaning that there are no obvious conflicts of interest. 4. Demand Requirement: the complaint must specify the action the plaintiff has taken to obtain satisfaction from the company’s board, or state with particularity the plaintiff’s reason for not doing so.

i. The Demand RequirementIn order to show the demand requirements, and plaintiff has the burden of showing: 1. The board is not disinterested/independent

- This is mainly just counting for a majority. - You need to point particular directors when making this claim- This should be analyzed at the time the complaint is filed

2. OR that the underlying transaction is not within the business judgment rule- This should be analyzed at the time of the underlying transgression

→ It is almost impossible to prove the second prong, so you want to hang your hat on the first. Policy: Pro: this weeds out frivolous/strike suits.

Con: you are asking for particularized pleading before discovery. Levine v. Smith: Transaction in which a director of GM sold his stock back to GM at a premium; part of the consideration was that he wouldn’t criticize. Shareholders brought a derivative action, and claimed demand futility. Court said the suit could not be brought because the demand futility requirements were not met. Under the first prong, at least 12 of 21 directors were independent, and under the second prong, the fact that the directors acted quickly is not enough to show gross negligence.Rales v. Blasband: Adds timing aspects to demand futility requirements

ii. Pre-Suit DemandUniversal Non-Demand: In Delaware, if you make a demand on the board, you are conceding that they are disinterested (presumes the first prong is met). Universal Demand: ALI, you should always make a demand, and it is does not mean that they are disinterested.

iii. Special Litigation Committees This a way to stop a lawsuit once it is underway. The corporation can appoint a special litigation committee made up of disinterested directors that can decide if the litigation is with merit. - New York: as long as the committee is independent, then their decision is ok, and cases can be dismissed.


- Delaware: Zapata Two Step1. Committee is independent and exhibited Good Faith

- Corporation has the burden of showing this2. Court should use its business judgment to decide of it is fair. Courts tend to avoid using this test by saying 1. Their business judgment lets them decide the first prong without analysis. 2. They only have to use their business judgment at their own discretion, and therefore chose not to. Zapata Corp. v. Maldonado: Maldonado brought suit and satisfied all standing requirements. Zapata appointed four new directors as a special litigation committee, which found that the action should be dismissed. Court set forward the test above and remanded the case to see if the committee was sufficient.In Re Oracle Corp. Derivative Litigation: Oracle’s directors were sued for insider trading. After the plaintiffs filed suit successfully, Oracle formed a special litigation committee made of Stanford professors. The court found that the first prong of the test was failed because the new committee was not independent. Even though they had tenure and therefore had freedom to make decisions adverse to Stanford, Oracle made a lot of contributions to the school. This is exceedingly rare, and is the exception. Courts sometimes use a balancing test to determine what business judgment looks like (Second Prong of Zapata): look at the relative cost benefit of allowing the litigation to go forward, and based on that to decide whether or not to dismiss. Joy v. North. An alternative to Zapata might be a more rigorous effort to ensure the independence of the directors who sit on the SLC: Michigan has tried this.

iv. Settlement and IndemnificationDirectors and Officers have great incentives to settle. Since they have indemnification and insurance, their personal assets aren’t really at issues: it is more a concern of bad publicity. → It is a nuisance to be involved in litigation.Courts usually apply the Zapata test to decide if the settlement should proceed.Policy: should courts be policing settlements? To what extent do wants suits to proceed? Pro: these allow individuals to police the corporationCon: saying that these are rich plaintiff lawyer driven suits at the expense of the shareholders. Carlton Investment v. TLC Beatrice: Shareholder sued the directors based on a payout package they approved. The corporation put together a committee to decide what to do, and they decided to settle. Court applied the Zapata test and found that both prongs were met, and the settlement could be approved.


SELL

A. Transactions in Controli. Intro

Generally we do not care about when shareholder’s sell, but there are some situations where the selling of shares involves some kind of transactions that corporate law is concerned about. One of these areas is when the selling shares changes the control of the corporation: these called transactions in control. They are typically sold as a premium. There are two ways that you can get controlling stock: 1. Buy someone’s block of controlling stock2. Amass a large amount of smaller shares from lots of minority shareholders

ii. Seller’s Dutiesa. Control Premium

Market 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.” defendant friendly. →In the US, as a matter of state corporate law, minority shareholders do not have the right to sell their shares at a premium. Zetlin v. Hanson Holdings, Inc.: Hanson Holdings sold their interests in Gable to Flinkote for a premium price of $15 per share; the shares were trading at about $7 per share. Court said that the premium was valid because the market offered it and there was no evidence of looting, etc.Feldman Exception to the Market Rule: In a time of market shortage, where a corporation’s product commands unusually large premium, a fiduciary may not appropriate to himself the value of the premium, it must be spread to the shareholders. this is very much an exception.. plaintiffs will want to use this. Perlman v. Feldman: Newport was in the steel business. Wilport wanted to get a source of steel in a tight market. Newport was controlled by Feldman, who sold his shares to Wilport for $20 per share, when the market price was at $12. Along with the sale went Newport’s unique business plan. Court said the premium must be spread around because Feldman sold a valuable business plan (corporate machinery) along with control of the corporation.Equal Opportunity Alternative: minority shareholders can sell their shares at the same premium as the control shares. Policy in Support of the Market Rule:Easterbrook & Fischel: Proposed alternatives to the Market Rule would inhibit transfers of control to the detriment of minority shareholders. The market will adjudicate.If pay premium to corporation rather than the shareholder, controlling shareholder’s will not agree to the sale.If minority shareholders can sell on the same terms as controlling shareholders, potential buyers may not want to buy.

Digex p. 428: you had effectively a controller in a subsidiary. The controller decides to sell themselves, and only their control block. Plaintiff lawyer argued that in order to make the sale, they had to use the corporate machinery. By needing to abide by Delaware 203 and needing to get board approval, you had to have access to the corporate machinery, and you therefore owed a fiduciary duty. Problem: if you apply this broadly it can eviscerate the Zetlin/Market rule. Plaintiff’s are going to want to do this every time. This is the same transaction, just pleaded differently.


b. Sale of Corporate OfficeThe greater the percentage of shares sold and the lower the premium paid, the more likely to court is to say that the sale is ok. (Carter)The small the percentage of shares sold, and the greater the premium paid, the more likely the court is to think that there is a side deal going on and that it is not OK worried about selling offices. (Brecher)Carter v. Muscat p. 428: management who sells about 10% of their stock. The premium was slightly above marketBrecher v. Gregg p. 429: sale was for 4% of the shares, and the premium was over 35%The greater the percentage of shares and the lower the premium, the more likely to court is going to say that it is ok.

c. LootingIf a reasonably prudent person would think that they were selling to looters, then they have a duty to investigate the buyers’ acts. Harris v. Carter: Carter controlled Atlas with 52% of its stock. Carter sold this block of stock to Mascola, who diverted much of the value from Atlas to Mascola and his friends. Court said that the baseline argument that Carter could sell his stock as he wished was no good because he had a duty to investigate the buyer. Case was remanded to see if he met that duty.

ii. Buyer’s Dutiesa. Williams Act

Federal Statute passed: this was designed to slow down the process, and make it so that shareholders were able to look at the offer before they accepted. → has had the unintended effect of reducing transfers in control. Elements of Tender Offers1. Early Warning System 13(d): if you cross the 5% ownership status, you have to file a form with the SEC. Essentially declaring to the world that you are crossing a certain threshold. 2. Disclosure 14(d): if you are going to actually make an offer you must disclose identity, future plans, financing, etc…3. Anti-Fraud 14(e): Specific anti-fraud statute: prohibits misrepresentations, nondisclosures, and “any fraudulent, deceptive or misrepresentative practice”. This also prohibits insider trading. 4. Substantive terms: how long must the offer be held open: at least 20 business days 14e1, and under 14e10, you must offer the same price to all shareholders (you can put conditions on it, like I will only buy 20,000 shares).→ Although the Williams Act was intended to govern Tender Offers, it does not define what a tender offer is. There are two different tests to determine what a tender offer is: 1. Southern District Test: look at whether there was solicitation, whether it was contingent on a certain number of shares, and whether there was an offer at a fixed price. 2. Eight Factor SEC Test:

1. Active and Widespread solicitation of public shareholders2. The solicitation is made for a substantial percentage of the issuer’s stock3. A premium over the prevailing market price4. The terms of the offer are firm rather than negotiable


5. Whether the offer is contingent is contingent on the tender of a fixed minimum number of shares6. Whether the offer is open only for a limited period of time7. Whether the offerees are subjected to pressure to sell their stock8. Whether public announcement of a purchasing program . . . precede or accompany a rapid accumulation.

Brascan Ltd. v. Edper Equities Ltd.: Edper had a 4% stake in Brascan and wanted to increase his influence. Edper had its investor contact potential offerees, informing them that Edper would purchase 3 or 4 million shares at several dollars above the market price. By the end of the day, Edper had purchased 6.3 million shares at the price mentioned by the investor. Court said there was no tender offer because only 50 of 55,000 shareholders were contacted; only slightly above market price; terms were negotiable (just trying to “find the right level”); number of shares desired was not fixed; offer was open; no pressure because of time constraints; and only a few scattered announcements.

b. Hart-Scott-Rodino (HDR) ActImposes a waiting period before a bidder can commence to offer. HSR filings must be disclosed immediately to target companies and bidders may not close a deal until the relevant warning period has elapsed. Cash offer: 15 daysStock Offer: 30 days

B. Mergers and Acquisitions (M and A)1. Intro

M and A is a particular subculture of corporate law that has extreme intensity.Three ways to do this: 1. Merger: unites two existing corporations in to2. Asset Acquisition: you are essentially going and buying the assets of the corporation. 3. Share Acquisitions: you go out and buy all the stock of the company.

2. MotivesWhy do people do M and A?PROs: economy of scope: you can spread you costs across a variety of areas, by not increasing the scale of production but instead by spreading costs across a broader range or related business activities. economy of scale: when a fixed cost of production is spread over a larger output , thereby reducing the average fixed cost per unit of output. Diversification: allows the companies to be more competitive and manufacture a variety of products. Synergy: you can do a lot more if you are working togetherSuperior Competition, Tax Reasons, Agency Costs are lowered→ it is much easier to build up through M and A rather than organically. CON: risk of monopoly, Clash of cultures, Over-paying for the company, Ego/Empire-Building“Squeeze out”: controlling shareholder acquires all of the company’s assets at a low price, at the expense of its minority shareholders.

3. HistoryVoting: there has been a decrease in regulation. It has gone from requiring a unanimous vote by shareholders, to a super majority, to a majority. this is very pro M and A.


Appraisal Right: additional right to voting. You can say “I didn’t vote for the merger”, and go to a judge and have him appraise how much your shares are worth.

4. Allocation of PowerTo whom do we want to allocate the power to decide mergers and acquisitions?

Do we want shareholders to vote, or do we want the board to decide. There is a continuum of importance of shareholder vote: we do not need shareholders to vote on the placement of the flowers in the lobby, but we do want them to decide if the corporation is going to be dissolved. Rule of Thumb: look after the transaction and if the shareholders will still have power, or a say in running the company, then we tend not to give them a vote on the transaction. If you look after the transaction, and the shareholder will not longer have power: they will probably have a vote. Mergers require a shareholder vote on the part of both the target and the acquiring company, expect the acquiring company’s shareholders do not vote when the acquiring company is much larger than the target. Sale of assets: need a shareholder vote if you are going to be selling all, or substantially all of their assets. Purchases of assets do not require a vote. If you are issuing additional shares: under state corporate law does not get the right to vote.

5. Transactional Formsi. Asset Acquisitions

When you do an asset acquisition, you are not stuck with the company’s liability this is not the case with share acquisitions or mergers. Problem: there are very high transaction costs, it is very lengthy, and due diligence is required. Delaware 248 governs asset acquisition: if you are selling “all or substantial all” of your assets. Problem What does “substantial all” mean? Two ways to look at this:

a. Qualitative approach: You look at whether the transaction is out of the ordinary course and substantially effects the existence and purpose of the corporation. Katz v. Bregman: Plant sold several subsidiaries including one which was their only income producing facility to raise cash. Court said that 51% of assets was substantially all, so the sale required shareholder approval.Thorpe: Controlling shareholders were also the directors and CEOs. If you put it to shareholder vote, then the controlling shareholder is the insider who can veto the deal. Also looking at the qualitative effect on the corporation they still put it to shareholder vote: whether a transaction is out of the ordinary course and substantially affects the existence and purpose of the corporation.

b. Literal approach: substantially all would therefore be essentially everythingHollinger, Inc. v. Hollinger Intl.: Hollinger Intl. sold the Telegraph Group of its newspapers, which constituted 56% of the company. Court said this was not substantially all of its assets, so no shareholder vote was needed.→ now there is a movement away from qualitative approach towards share acquisitions.

ii. Share AcquisitionsThis is when you purchase all, or a majority of, the company’s stock. - To fully acquire a company, much purchase 100% of outstanding shares this is the only way to change the company’s legal status. this does not require shareholder approval.

There are ways to get stock even if some shareholders refuse to sell:


Short Form Merger: if the acquirer gets 90% of the stock, then the remainder can be cashed out. Compulsory “Share Exchange Transactions”: this is a tender offer negotiated with the board that, once it is approved by the majority of shareholder, becomes compulsory for all shareholders. Two Step Merger: 1. Make a tender offer for most or all of the target’s shares. 2. Merge the target and a subsidiary which squeezes out minority shareholders.

iii. Mergers-Mergers legally collapses one corporation into another.- The corporation that survives is the surviving corporation (still maintains its legal identity). This surviving corporation generally assumes the liabilities of both corporations.

Voting for mergers: Preferred Stock:

- In Delaware: DGCL § 25 Generally preferred stock holders to not have the legal right to vote. - DGCL § 242(B)(2): They do however, have the right to vote if their legal rights would be formally altered.

Common Stock: - Target Company: always have voting rights- Surviving Company: Generally get a vote unless 3 things are met:

1. Surviving corporations charter is not modified2. The security held by the surviving corporation’s shareholders will not be exchanged or modified and3. The surviving corporation’s outstanding common stock will not be increased by more than 20 percent.

→ these are actually proxies for determining how much power the shareholder is going to have after the transactions, and whether it is a “whale-minnow” situation.

Triangular Mergers- Triangular mergers are a way around liability: surviving corporations create a subsidiary with little money or assets that then acquires the target: only the assets of the subsidiary are exposed.

6. Structuring the Mergers and Acquisitions TransactionsM and A are actually commercial contracts, and the parties are trying to protect themselves through contracts.

a. TimingIt will always be desirable to close a deal as quickly as possible. → the quickest way to make sure that a sale is complete: all cash tender offer to the shareholders (under the Williams Act, the deal can be closed in 20 days). Stock acquisitions are slower since you should put it to a shareholder vote (since this will dramatically reduce your chances of getting sued.)

b. Due DiligenceYou want to investigate the potential merger to make sure that you are not being defrauded: look to acquire reliable information about the target company. → this is made easier by representations and warranties: the companies represent their assets and liabilities, and warrant that they are legitimate, and that you own them.


7. Taxation of Corporate CombinationsThis is rarely the driving motivation behind corporate control transaction, but always important.

a. Basic Concepts- Federal taxes levied on income (includes gains in the value of investments).- Gain: Excess of the net amount realized on sale over adjusted cost basis.- Cost Basis: Cost after reduction for the depreciation made against the asset’s cost in

calculating annual income taxes.- Gains or losses recognized as either capital gains/losses or ordinary income/loss.

b. Tax-Free Corporate Reorganizations- No taxable gain recognized for reorganization of ownership interests w/o changing

identity of owners.c. Internal Revenue Code § 368: Save Harbor for Tax-Free Reorganizations

- Exempts Stock-for-Stock Mergers in which consideration is voting stock. - Exempts transactions in which at least 80% of all shares of voting stock (and 80% of each class of nonvoting stock) acquired in exchange only for voting stock of acquirer. - Exempts reorganizations in which acquirer gets assets only in exchange for voting stock of the acquirer.If qualify for exemption, no recognition of gain by sellers for tax purposes.Policy: Tax law shouldn’t interfere w/ capital in the market any more than necessary.

8. Appraisal RemedyAn appraisal remedy is given a qualifying merger: a minority shareholder can go to a judge, and say that since they did not vote for the merger, they would like the fair going concern value for their shares. DGCL 262: governs appraisal rights Market Out Rule1. If you are a shareholder in a private firm with fewer then 2,000 shareholders, you always get an appraisal right proxy for liquidity2. If you are a shareholder in a public firm or with more than 2,000 shareholders, you do not get an appraisal right if you are getting stock. you do get an appraisal right if you are getting cash, unless you are getting cash for a fraction of your shares, in which case you do not get an appraisal right.

Fair Value: what you can get is your pro rata rate for the fair value of your shares. 1. You do not get the value of the merger. 2. Technique used is the discount cash flow model. with no appraisal rights there is more freedom for business arrangements. Hariton v. Arco Electronics, Inc.: Loral purchased all the assets of Arco. Dissenting shareholders in Arco wanted a judicial appraisal. Court said no because even though the purchase of assets had a similar effect to the merger, the DE statute says appraisal is only available for mergers specifically.

9. De Facto MergerFunctionalist: if it looks like a merger, and it feels like a merger, then we are going to treat it like a merger. Formalist: even if it looks like a merger, it is not one unless it is a merger in form most jdxs follow this, including Delware. corporate law is already very formal. Hariton v. Arco: the Court ultimately said that the shareholders should have known that section


271 does not give you appraisal rights, therefore there was no de facto merger, so no appraisal rights.

10. Duty of Loyalty in Controlled Mergers There is a tension with the controlling shareholder: they can vote their shares for their benefit, but they still owe a fiduciary duty. Baseline rule: a controlling shareholder on both sides of a transaction has the burden of proving entire fairness.

a. Freeze OutsBasic steps for a freeze-out: majority shareholder has control over board, they have the board or a committee come up with a price, they may ask the shareholders to vote on it (it would be the majority of the unaffiliated shareholders), they then give them the money for their shares. Generally, once the board and the majority of the shareholders have voted on it, it becomes mandatory for all shareholders. Standard: Entire Fairness (Fair Price and Fair Dealing) when directors of a DE corporation are on both sides of the transaction.

Fair Dealing: Obvious Duty of Candor (Kahn v. Lynch) and may not mislead SH’s.Initial BoP on ∆ to prove entire fairness. If valid independent committee approves transaction, BoP shifts to Π to show it was not fair.

What Remedies are Available for Breach of Duty of Loyalty in controlled merger?(i) Weinberger : Appears to say appraisal remedy is the only available

remedy b/c transaction cannot be undone.1. If there is no evidence of fraud, etc. – Monetary damages limited to

appraisal.2. If there is fraud etc. – Court can award other remedies.

(ii) Rabkin : Court found Fiduciary Duty Remedy available as well as appraisal remedy. Upheld in Cede v. Technicolor.

(iii) In Practice Today : You can Raise Both.1. If you ask for appraisal rights, don’t have to show breach of fiduciary

duty but you won’t get as much money as w/ a fiduciary claim.2. If seek an appraisal remedy, have to permanently opt out of merger.3. Entire fairness actions (not appraisals) are the principal means used

today for SH’s attacking the fairness of price in a self-dealing merger.

(vi) Weinberger was the first case that said that when determining the fair price of the shares, you look to the discounted cash flow.

Weinberger v. UOP, Inc.: Signal is the majority owner of UOP. Signal elected 6 of UOP’s 13 directors. Signal then merged with UOP, eliminating minority shareholders. Disclosed report was given that said that a fair price for the dissident shares would be up to $24. Signal settled on $21 per share. Action brought for a duty of loyalty claim. No safe harbor statutes met, so subject to fairness. Disclosure of the report was flawed, so still stuck in fairness. Court said no fair dealing because no negotiation, poor disclosure; also said price may or may not be fair depending on judicial appraisal on remand.

b. ControlBaseline rule is still: a controlling shareholder on both sides of a transaction has the burden of proving entire fairness.


BUT an approval of the 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/dominating shareholder (plaintiff). This is like duty of loyalty. If the shareholder is in control: Entire fairness If not in control: BJRKahn v. Lynch Communications Systems: Alcatael is a subsidiary of CGE. Alcatel bought 43.3% of Lynch. Lynch wanted to merge with Celwave, which Alcatel opposed. Lynch established an independent committee to negotiate with Celwave, who declined. Alcatel then offered to buy up the rest of Lynch at $15.50 per share. Court said this was a conflicted merger, so entire fairness is the standard when a controlling shareholder is involved. Alcatel was effectively a controlling shareholder even though it had only 43% of the shares because it had authority. Even though there was a disinterested committee, the burden did not shift because the majority shareholder, Alcatel, dictated the terms of the merger by threatening to proceed with a hostile offer if the original offer was rejected. Court says they did not meet their burden of showing fairness.Western National: In another merger setting, court said Western was not a controlling shareholder because they were only allowed to have 2 of 8 directors, therefore they had business judgment standard which they met.

c. Special Committees of Independent Directors in Controlled MergersCourt’s Possible Approaches if Independent Committee Approves Transaction:

- Treat Special Committee’s decision as disinterested and independent Board (BJR)- Continue to Apply Entire Fairness Test b/c court can’t evaluate whether subtle pressure

unduly affect outcome of committee’s decision.Approaches in Delaware:

- Kahn v. Lynch : Entire Fairness should always be the standard but shifts burden of showing fairness → Π if independent committee approves.

Idea that committee of independent directors deserves some judicial recognition still seems to have some weight in Delaware. Apply BJR if looks like it approximates an arms-length transaction (Form over Function).

Again w/ the accordion analogy. Keep it broad so that it can open/close w/ facts.Another function: Accordion allows DE courts to avoid overruling each other.

d. Controlling Shareholder Fiduciary Duty on the First Step of a two step tender offerThe Duty: Controlling Shareholder who sets the terms of a transaction and effectuates it through his control of the board has a DUTY OF FAIRNESS to pay a fair price.

(a) Two Possible Approaches : Kahn and Solomon(i) Kahn : Entire Fairness should always be the standard (w/ possible shifting).

1. Recognizes an “inherent coercion in controlling SH status. 2. Even majority of minority SH approval will not shift review all the

way to BJR.(ii) Solomon : Controlling shareholder owes no duty to pay a fair price. Only

use judicial review to ensure disclosure and prevent coercion.1. Coercion is defined as a “wrongful threat,” no inherent coercion. 2. Barring coercion → BJR.

(b) Rule : No fiduciary duty applies to non-coercive controlling stockholder tender offers. (i) Can avoid the Kahn line of cases by going to the SH’s directly.


(ii) Controlling Stockholder Tender Offer non-coercive only if . . . (Solomon Standard)1. Subject to a non-waivable majority of the minority condition2. Controlling stockholder promises to consummate §253 merger at same

price if obtains more than 90% of the shares3. Controlling stockholder makes no retributive threats

ii) Policy-ish: Reconciling Kahn and Solomon Line of Cases (1) Under Kahn cases: Where using the board and corporate machinery, Entire

Fairness.(a) In re Pure Resources limits Kahn standard, refuses to extend to SH tender

offer.(b) Policy : Recognize the inherent coercion structural bias that favors controlling

SH’s provides the basis for higher level of review.(2) Under Solomon cases: Unless there is coercion in the offer, no duty applies.

(a) Only remedy available is the appraisal remedy, and only if can show coercion.(b) Policy : Emphasize right of willingly buyers/sellers of stock to deal w/ each

other freely. Only permit judicial intervention to ensure fair disclosure & prevent structural coercion.

In re Pure Resources: Unocal owned 65% of pure and made an offer for the rest of Pure’s shares at a 27% premium. A special committee was appointed and decided not to recommend Unocal’s offer. Unocal launched its offer directly to minority shareholders. Court said the offer was not coercive because it did not threaten any retribution if it was turned down.

C. Public Contest for Corporate Control1. Intro The issue is who do we want to favor: the insurgents or the managers? Corporate law is torn. Political way to try and get control: mount a proxy contest. Economic way to try and get control: make a tender offer. Main issue: these cases are really about the standard of review to apply: should there be an intermediate standard in between fairness and business judgment. Examples: Cheff v. Mathes: as long as the board’s primary motive was to advance the interests of the shareholders and the company, then its defenses are fine. favoring the managersSchnell v. Chris-Craft: found 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. favoring the interests of the shareholders. Mini Attack Plan: 1. No threat, preventative: Business Judgment Rule (Moran)2. Threat, defensive measure: proportional, then draconian (Unocal/Unitrin)3. Company up for sale: must get the highest price (Revlon)

2. Defenses The defensive measures used by a corporation must be reasonable in relation to the threat posed. this standard is used when a defense has be adopted as a response to a threat. This has a proportionality principle to it. Unocal v. Mesa Petroleum Co.: Mesa owned 13% of Unocal’s stock. Mesa then made a cash tender offer for the rest of the shares. Unocal rejected the offer and decided to make a self tender


for its own stock at a much higher price, making it unappealing for Mesa to try to outbid it. Court said the defensive measure was legal. In this case, there was a threat and the defense was proportional because Mesa’s officer was coercive, and Mesa had a history of being a greenmailer.The defense adopted must not be draconian (coercive or preclusive), and within the range of reasonableness. Under this standard there is no proportionality as elaborated in Unocal, although you still must show that it was a threat to the corporation. Unitrin v. American General Corp.: AmGen owns part of Unitrin. AmGen does a hostile offer for more Unitrin shares, and Unitrin rejects the offer as inadequate, and adopt defensive measure: poison pill, advance notice bylaw. This also make a tender offer to repurchase shares, which will make the board of Unitrin the owners of 28%, effectively giving them the power to veto any deal, and vote against the AmGen deal. Court says that this was not draconian and was reasonable. Neither case has been overrules: general standard to go by is still draconian: look to see if it is coercive or preclusive, then see if it is within the range of reasonableness.

i. Poison Pill: Shareholder’s Rights Plan- Capital instruments including the right to buy a capital asset at a discounted price.- Purpose: Defense mechanism against hostile takeovers. Dilutes the stock market by triggering rights in shareholders that will be financially devastating to acquiring company.

i) How It Works :(1) Rights to buy company’s stock at a discounted price are “distributed to all

shareholders.(2) Rights are only triggered if someone acquires more than a certain percentage of

company’s outstanding stock w/o Board’s blessing.(3) Person whose acquisition is the triggering event is excluded from buying

discounted stock.(4) Result: Person whose acquisition triggered the event’s stock is severely diluted

when a lot of cheap stock floods the market (Other shareholders not adversely affected b/c have a lot more stock even though each individual stock is worth less).

Flip-In Plans: when triggered the poison pill creates a right to buy some number of shares of the stock in the corporation being acquired (the target). Flip-Over Plans: when triggered the poison pill creates a right to buy some number of shares in the corporate acquireror. Policy For Shareholders: PRO: protects shareholder from hostile takeovers and corporate raiders… long term best interest of the company since managers can focus primarily on the corporation. CONS: it is sometimes misused to protect the status quo, it insulates management, can be the source of scandals. Poison Pill is a proper defense, and if you adopt a poison pill before there is any kind of threat then you get business judgment rule deference. Moran v. Household International Inc.: Household adopted a poison pill before there was an actual threat because they were concerned about even the possibility of a takeover. Court said the poison pill plan was legal and because it was before the threat, the defense was accorded business judgment treatment which was passed.


Summary: If you adopt a poison pill with no threat: BJRIf you adopt a poison pill as a defense: Unocal/Unitrin

3. Choosing a merger or buyout partnerCourts elaborated a new standard for change in control transactions. Smith v. Van Gorkom: Van Gorkom, CEO of Trans Union, talked about selling to Pritzker. Pritzker made an offer at $55 per share, which Trans Union immediately accepted. Court said that because the company was for sale, the directors had a duty to get the highest price which they failed to do because they accepted the merger immediately based only on Van Gorkom’s presentation. Fact that the price was very high was good, but not enough.When there is an auction in progress, the board has the duty to try and get the highest bid for the shareholders… effectively, if your company is up for sale, you have a duty to get the highest price. Revlon Inc. v. MacAndrews and Forbes Holding Inc.: Pantry pride wanted to take over Revlon. Revlon opposed it with a poison pill, but Pantry just kept raising the bid price. Forstmann came in to try to outbid Perelman, but Perelman just kept outbidding him. Revlon decided to assure Forstmann’s victory by creating an option that would allow him to buy their most valuable assets if another bidder (i.e. Perelman) bought more than 40% of Revlon’s stock. Court said that the arrangement was invalid because the company was up for sale, and therefore Revlon had a duty to get the highest price which they couldn’t do with this plan because it ended the bidding war.

4. Pulling together Revlon and Unocal When a corporation undertakes a transaction which will cause (a) a change in corporate control, or (b) a break-up of the corporate entity, the director’s obligation is to seek the best value reasonably available to the stockholders. Differences from Revlon: “price” becomes “value”, and “break-up” is also “change in control”.When we are in Revlon Land: when there is a change in corporate control or a break-up of the corporate entity. Paramount v. Time: Time initiated a merger with Warner. Paramount launched its own bid. Time’s board rejected Paramount’s bid as inadequate and instituted a poison pill. Court said that the pill was reasonable and proportionate, and there was no change in control because Time had not abandoned their strategic plan or made a sale of Time inevitable so duty to get the highest value was not triggered.Paramount v. QVC: Paramount wanted to merge with Viacom, but QVC also wanted to merge with Paramount. Paramount adopted a poison pill to deter QVC. Paramount and Viacom announced their merger as a certainty, but QVC kept upping their bid. Court said there was a change in control so there was a duty to get maximum value. The defense mechanisms were blocking the best value, which was offered by QVC. The defensive measures were not proportionate to QVC’s threat because they limited Paramount’s directors’ fiduciary duties.Only Revlon duty is to get the best price: no Court can tell directors how to accomplish that goal , they just have to accomplish it reasonably essentially have to prove violation of a duty of loyalty. Unless you can’t show a loyalty claim, they must show that there was an utter failure to get the best price.


Lyondell Chemical Co. v. Ryan: Sale of Lyondell shares (owned by Smith) to a company called Basel, which was owned by Blavatnik. Blavatnik sends an initial letter to the board, saying that he is interested in the company, and would be willing to buy it for 26.50-28.50. Board says that they are not interested. In May 2007, Blavatnik files at 14d saying that they have the right to acquire a large portion of the shares. By filing this, the company is supposedly up for sale. Lyondell decides to wait and see… Blavatnik then starts raising the bid: goes up to $48/share. Board finally agrees to go with the Blavatnik price, and put it to shareholder vote. 99% of the shareholders approve the deal. The Court found that Revlon did not create new fiduciary duties, and that all that was left was to prove that they did not get the best price and there was a violation of the duty of loyalty. Neither claim was present in this case. Policy: Control is key in determining the level of protection.

→ if shareholders are losing significant control, greater fiduciary duties imposed→ if shareholders continue to have control, lesser protection.

Why have Revlon Duties? In most circumstances board are better able to able to value companies than shareholders are but then shareholder are or might be cashed out of post-merger enterprise, the board must maximize the short-term value because it is all shareholders are likely to receive.

5. Proxy Contest for Corporate ControlThere are two ways to change the management of the corporation: 1. Negotiate with the Incumbent Board

- might be able to convince them that change in management is a good thing- can entice them with lucrative offers.

2. Put out a tender offer (“sell”), but make it contingent on a proxy contest (“vote”). - this will certainly meet certain defensive tactics from the management.

Some theories say that anytime your defensive maneuver interferes with shareholder voting, then an alarm goes off, and you should be held to a higher standard. Obstructing the efforts of dissent insurgents to mount a proxy contest is not ok: legal powers held by a fiduciary may not be deployed in a way that is intended to treat a beneficiary of the duty unfairly. → There is a duty not to disenfranchise voters, especially if it just an effort to keep incumbents in office. Policy: Cannot use the corporate machinery to perpetuate yourself in office. Schnell v. Chris-Craft Industries, Inc.: Plaintiffs launched a proxy contest to remove incumbent directors. The board moved the annual stockholders meeting to defend against it. Court said the change in the meeting date was illegal because it was a blatant attempt to keep themselves in office. Unocal standard does not apply to the shareholder franchise: instead the board bears the heavy burden of demonstrating a compelling justification after the plaintiff has established that the board has acted for the primary purpose of thwarting the exercise of a shareholder vote. → If the defense is primary purpose is to interfere with the shareholder franchise, the board needs to have a compelling justification.


Compelling Justification: there must be a good reason for the maneuver as opposed to merely showing that what you did was not draconian. This is a higher level than Unocal/Unitrin. The more that you can argue that the maneuvers are for long term value, the further you might be able to get from Blasius.Classis Blasius example: moving the meeting date. Blasius Industries v. Atlas Corp.: Blasius owned 9% of Atlas. Blasius launched a proxy contest to increase Atlas’s board from 7 to 15 members, then fill those seats with Blasius nominees. Atlas responded by amending bylaws to add two new board seats and filling those seats with its own candidates. Court said this defense was legal because the board saw a real threat from Blasius’s policies and made a good faith effort to avoid it.Standard Summary: BJR Unitrin Unocal Revlon Blasius Fairness<-|----------|------------|------------|--------------|----------------|>

6. The Takeover Arms Race Continuesa. Dead Hand Pills

This is a pill that cannot be redeemed for a certain amount of time, or by only a certain board. → they permit a board to limit the ability of shareholders to designate those with board power, or stated differentially, they would recognize a power in the current board to restrict the authority of future boards. Delaware says that you cannot have dead-hand pills, but other Courts have come out differently. (redeem means remove when talking about pills).

b. Mandatory Pill Redemption BylawsThis is a shareholder bylaw that requires the board to redeem an existing Pill and refrain from adopting a pill without submitting it to shareholder approval. If bylaws give authority to the shareholders to redeem or refrain from redeeming a poison pill it cannot be taken away. Unisuper v. News Corp.: News Corp. implemented bylaws that said any poison pill adopted by the board would expire after one year, but said it may or may not stick to the one year limit. The board then refused to remove the pill after a year. Court said they had to stick to the agreement because it gave power to the shareholders; rejected the argument that boards have managerial authority because shareholders give boards their power. Policy: I’m a manager and I say WAAAAHHH!Two Controversial Issues . . .1. Is a bylaw that mandates Board to exercise judgment in a particular way a valid bylaw?2. Must managers include in co’s proxy solicitation materials respecting any such proposal?For Defense counsel arguing against Mandatory Pill Redemption Bylaw . . .1. DE § 141: Board manages, Board Knows Best, Board we Trust. Butt out SH’s!2. Can it be excluded under Rule 14(a)-8 (Town Meeting Rule for Proxy Voting)?

a. Request No Action letter from SEC so don’t have to include in proxy materials.

b. Argue to SEC that you don’t have to include b/c management allowed to exclude things that have to do w/ day to day governance of corporation.


D. Trading in the Corporation’s SecuritiesThis deals with the obligations of directors, officers and issuing corporations when dealing the corporation’s own securities. For publicly financed corporations this is primarily an area of federal law. Two Federal Acts that govern this area: The Securities Act of 1933 and the Securities Exchange Act of 1934. 1. Common Law of Director’s Duties When Trading in The Corporation’s StockThe 19th century was a time of caveat emptor: buyer’s beware. The remedy available was common law fraud. Elements: 1. A false statement

2. Of Material Fact 3. Made with the Intent to Deceive 4. Upon which one reasonably relied and which 5. Caused injury

Problems with this remedy for inside trading: - Fraud was not generally available for losses in person trading because it was difficult to prove reliance on statement made by an unknown counterparty. - Common law state duties are not well designed to prevent again insider trading: the real issue is often an omission, which is not one of the elements. - Causation and reliance are also problems. Director’s only duty is to the corporation, no duty of disclosure to those with whom director traded shares. Goodwin v. Agassiz: Where a director personally seeks a stockholder for the purpose of buying his shares w/o disclosing material facts, transaction will be closely scrutinized. NOT if on an open market.Strong v. Repide: Where special facts exist a director has an obligation to disclose these material facts or refrain from buying corporate stock in a face-to-face transaction.Insider Trading: Good or BadPROS: informs the market; investors monitor insiders; efficient CONS: perverse incentives to engage in insider trading; shareholders do not receive any benefits

2. The Corporate law of Fiduciary Disclosure Todaya. Corporate recovery of profit from insider trading

Freeman v. Deciob. Board disclosure obligations under state law

Recent Delaware cases creates a common law duty of disclosure. Director’s duty of candor: requires the director to exercise honest judgment to assure disclosure of all material facts to shareholders. historically the duty of candor has been very weak. Bottom line: state law is NOT going to provide a remedy for insider trading even though it is technically a violation of a fiduciary duty. 3. Exchange Act Section 16(b) and Rule 16Congress passed statutes to deal with insider trading: Section 16, and Section 10. SEC passed regulations to deal with the insider trading: Rule 16, and Rule 10b5

i. Section 16(a) and (b)16(a): requires “designated persons” to file petitions public reports of any transactions in the corporation’s securities.


1. Designated Persons: directors, officers, 10% shareholders2. Timing of Reports: you must report that you are doing the trade. 16(b): strict liability rule designated to deter statutory insiders from profiting on inside information. → requires statutory insiders to disgorge profits made on short-term turnovers to corporations. Mergers are not a purchase or a sale. Kern County Land Co. v. Occidental Petroleum1. Occidental purchases 20% of Kern shares2. Kern merges with Tenneco3. Kern shares convert to Tenneco shares4. Occident sells a repurchase option to Tenneco5. Tenneco exercises the plan. Kern is saying that either #3 or #4 was a sale. Court said that selling an option is not actually a sale, it is instead the option of having a sale. Court said you need to look at it in terms of the statutory provisions, have to look at it in the context: with that in mind, it was not a sale.

ii. Rule 164. Exchange Act Section 10(B) and Rule 10b-5Rule 10(b): [It is unlawful] to use or employ, in connection w/ purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may proscribe as necessary or appropriate in the public interest or for the protection of investors.→ This broadly empowers the SEC to create rules and regulate securities trading on national exchanges or through the means of interstate commerce.

a. Evolution of a Private Right of Action under Section 10Purpose of 10(b)-5: Intended to empower the SEC’s Enforcement Division to enjoin fraudulent/misleading conduct in federal court.

- Did NOT intend to create a private right of action.- Kardon v. National Gypsum Co. : First recognized private right of action for 10(b)-5.

b. Elements of a 10b-5 claim1. material misstatement or omission

Three theories for omission: equal access, fiduciary, misappropriation 2. in connection with the purchase or sale of securities2. with intention to deceive3. upon which there is reliance4. causation5. injury Courts have effectively read the elements of reliance and causation to be a fraud on the market theory. The Supreme Court has recently gone back to a stricter standard of reliance and causation.

i. False or Misleading statement or omissionThere are three theories for false or misleading statement or omission: equal access, fiduciary duty theory and misappropriation.

- Equal AccessIf you have material non-public information, you wither have to disclose it, or you have to abstain from trading. Disclose or Abstain.


Materiality: if a reasonable investor would find the information to be important, then it is material. More texture: probability and magnitude → very fact specific. SEC v. Texas Gulf Sulphur Co.: Company was doing mineral exploration. They were keeping it quiet while they were buying stock, and then would presumably sell it when the deposits are revealed. They instead issue a press release saying that the rumors are not true, etc…Shareholders sue, saying that the insiders knew that there was this big mineral deposit, and that they were trading on this information. Court said that there was a violation. Federalism: Plaintiffs cannot bring suits for corporate mismanagement under 10b5 if the causes of action are traditionally brought under state law. → the Supreme Court is trying to limit the number of corporate plaintiffs that are trying to get into federal court. Santa Fe Industries Inc. v. Green: Dissident shareholders who were cashed out in a short form merger brought a 10b-5 claim because they thought the shares were worth more. Court threw them out because the claim had nothing to do with manipulation or deception; case sent to state court.

- Fiduciary Duty TheoryThe Supreme Court has actively rejected the Equal Access theory. NO Duty to Disclose when person trading on info was not corporation’s agent, fiduciary, or a person in whom sellers of securities placed trust/confidence.→ No affirmative duty to disclose unless you have a special responsibility. Chiarella v. United States: Printer saw documents from the acquiring company regarding a trade that was going to happen and purchased stock in the target companies. Court said he did not have a fiduciary duty to the target company so not liable.There has been a breach when: Tippee: knows or should have known of a breach of fiduciary duty (+ someone trades on it)Tipper: breach of fiduciary duty and receives a personal benefit. Dirks v. SEC: Dirks received information about potential fraud from a former employee of Equity funding. Dirks then discussed the information he obtained with clients who then sold their stock. Court said the former employee did have a fiduciary duty as a former director of Equity, but did not receive a personal benefit from giving the information out. If this prong was met I think Dirks would have been liable.

- Misappropriation Theory → current lawMisappropriation theory: An insider may have a duty to disclose or abstain when - 1. Initial person with information (Tipper)2. Must have a fiduciary duty to the SOURCE of information; AND3. Personal benefit from giving out the informationLiability may extend to a person who learns of the information (Tippee) if:1. Must have known or should have known about the breach; AND2. Traded upon it


Policy: Good b/c doesn’t swing all the way to the TGS/Equal Access Standard (which the Supreme Court rejected as over-inclusive) but still allows you to get at people who are not technically ‘insiders’ (which is not possible under the fiduciary duty standard that the Supreme Court found to be under-inclusive).→ Reaches all forms of insider trading even if doesn’t involve ‘insiders.’(Better than Fiduciary Duty Theory)→ Based on actual fraud instead of a fictional relationship b/t insiders trading and uninformed market participants(Better than Equal Access Theory)Recognizes the Real Problem w/ Insider Trading: It is NOT wrong b/c of the informational disparities in the market (which ALWAYS exist) it is wrong b/c it involves the private appropriation of information rights belonging to someone else.U.S. v. Chestman: Loeb was the husband of the granddaughter of a director. Granddaughter learned of a coming merger and told him. He then told his stockbroker, Chestman, who bought stock in the target. Court said that Loeb had no duty to the source of the information, the director, as just a family member. Therefore liability can’t extend to Chestman.U.S. v. O’Hagan: O’Hagan was a partner at a firm that was representing a company who was doing a merger. At the time they were representing, O’Hagan purchased stock of the target company. Court said that O’Hagan had a duty to the source of information – the acquiring company because he represented them, met all other requirements, so he was liable.

ii. Of Material Fact A statement or omission is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. Look at the probability the event will occur and the possible magnitude of the event. Basic Inc. v. Levinson: Combustion and Basic were in talks of merging. Basic made three statements denying that there would be a merger. Defendants sold their stock after the first denial and before an announcement of merger. Court set forth this rule and remanded the case to find out if the denials were material.

iii. Scienter: intent to deceive anotherEvidence of IntentThe United States Supreme Court has gone back to requiring strict common law intent (specific intent). Recklessness has suggested as going towards the intent. Second Circuit: motive and opportunity are enough. Pleading RequirementHigher pleasing standard than the normal civil procedure short and plain statement: because it is hard to prove their intent. Policy: thought that higher standard has curbed litigation, but this is open to debate.

iv. StandingTo recover monetary damages, you must be an actual seller or purchaser of securities → speed bump to avoid strike suits. Circuits are split as to whether this is a requirement for injunctive relief.

v. RelianceFraud on the Market Theory: reliance is presumed even though the parties do not interact face and face.


→ This presumption is rebuttable: can argue that the person know about the fraud, and therefore could have relied. Basic Inc. v. Levinson

vi. CausationMust show that you loss was caused by the fraud, and not by another element. Two kinds of Causation: - Transactional Causation: a misstatement or omission must cause the plaintiff to enter into the transaction. - Loss Causation: a misstatement or omission must cause the plaintiff’s loss. Must show both of these. Dura Pharmaceuticals: Dura announces that the profits will be lower than anticipated, stock prices go down. Then the FDA does not approve their drug. Plaintiffs are individuals who purchased shares before the announcement that profits will be down. Under Levinson, this would be fraud on the market. Court effectively says that just because you bought at an inflated price does not necessarily mean that it caused the loss. Court said you have to show that your loss was caused by the fraud, and not by another element.Policy Rationale: when you buy stock on the market you take the risk that the stock will go up and then back down.

vii. RemediesTwo options:1. Out of pocket measure – difference between price paid and the value of the stock when bought. Calculation: price paid – the value had their been no fraud. Problems: value were there no fraud is hard to calculate, and plaintiffs may get a windfall. Note: preferred by defendants2. Disgorgement measure – can recover post purchase decline in market value of his shares up to a reasonable time after he learns of the information. → make the defense disgorge any profits they made. Note: preferred by plaintiffs, and used most regularly. Elkind v. Liggett and Meyers: shareholders initiated a class action against Liggett for insider trading Plaintiffs made their case, and the sole issue was how to calculate damages. Second circuit decides the disgorgement method is appropriate.


Documents

Corporations Dibadj Fall 2009