Historical Introduction - Washington University in St. …law.wustl.edu/sba/upperlevel/Corporations/Seligman/... · Web viewCorporation – not cheap or simple, must file docs with

CORPORATIONS Seligman

HISTORICAL INTRODUCTION

I. 1790-1830 Instrument of Economic Development- monopoly privileges and special charters were used to encourage the development of public utilities such as

railroads, banks, turnpikes, etc.- limited liability was used to encourage investment- after War of 1812 manufacturing firms encouraged- Dartmouth College recognized the distinction between public and private firms.

II. 1830-1865 Jacksonian Reaction- Jackson vetoed the Second Bank of the U.S. in 1832 which led to a general attack on corporate privileges.- General corporation laws were developed which required

1. limits on capital2. limits on lines of business (most corporate laws were enforced through the doctrine of ultra vires)3. limits on length of charter

III. 1865-1890 The Age of Trust- emergence of a strong national economy led to efforts to evade size limits and monopolies were initiated

(1871 Standard Oil Trust)- by 1880s many trusts were declared ultra vires- Jacksonian period restrictions were effectively ended by the emergence of modern corporation laws without

size limits, or business and merger restrictions.

IV. 1890-1913 New Jersey- New Jersey Act first modern state corporate law

1. holding company permitted, size and line of business limitations repealed2. adopted a popularized proxy system of shareholder voting3. facilitated mergers by giving directors the power to value firms for which they traded shares4. to be incorporated in NJ you were not required to do business in the state

- NJ law was eventually struck down by W. Wilson for being too lenient, this led to many companies moving to DE, another favorable state

V. 1913-1934 Delaware- DE became “happy-hunting ground for the corporate promoter”

1. eliminated concept of “par value”, and allowed “low par” and “no par” value which allowed larger dividend returns

2. eliminated the pre-emptive right favoring early investors, now investors get proportionate returns

VI. 1933-1940 Federal Securities Law- Securities Act of 1933 (full disclosure act) requires a seller to disclose all relevant information- Securities Act of 1934

1. Established a mandatory disclosure system of material information for when new securities are sold to the public and for all large businesses on an annual, quarterly, or monthly basis.

2. Prohibits insider trading3. ended the allowance of blank proxies4. amended by Congress in 1968 and 1970 to require full disclosure in tender offers

VII. Policy Debate- Berle & Means: Modern Corporate Reformers – basic view is that the scheme for large companies if

separating ownership from control has led to corporate managers that pursue their own interests instead of those of the company1. this view represents a conflict of interests gone bad2. for many years this was dominant until an alternative approach was developed

- Agency Costs/Law and Economics View – acknowledges the fundamental conflict between managers and owners but argues the marketplace responds to these conflicts and corrects them

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1. acknowledges that certain agency losses are inevitable, and efforts to correct them do more harm than good

2. this view works better in the long term which is not always a reasonable time allowance

AGENCY & AUTHORITYI. Agency

a. Generally – the manifestation of consent of one person that another shall act on his/her behalf and subject to his/her control

i. Hierarchical relationship – principal/agentii. Volitional relationship, can only be created by mutual consent

iii. No contract required, can be proven by circumstantial evidenceiv. Pivotal concept is control

b. Principal/Agent relationship is determined by 9 factors (Gay Jenson Farms v. Cargill1):i. P’s constant recommendations to A by telephone

ii. P’s first right of refusal on product (grain)iii. A’s inability to enter into mortgages, purchase stock, or pay dividends without P’s approval *** indicates

very high level of controliv. P’s right of entry onto A’s premises to carry on periodic checks and auditsv. P’s correspondence and criticism regarding A’s finances, officers salaries, and inventory

vi. P’s determination that A needed, “strong paternal guidance”vii. Provision of drafts and forms to A upon which P’s name was printed ***gives impression of apparent

authorityviii. Financing all of A’s purchases of grain and operating expenses

ix. P’s power to discontinue financing of A’s operations ***ultimate level of control b/c Cargill was lending the money to a party who probably could not get a loan elsewhere and had no other choices

c. Sole proprietorship – Single individual is directly liable for all the debts of the proprietorship and reports gains/losses on his own individual tax return. Single individual who owns a business can employ “agents”, no filings required unless they choose to do business under another name then a DBA form must be filed so people know who is liable for the company.

II. Authority

a. Traditional view – corporation is managed by Bd. of Dir., not officers, thus even when an officer purports to act on behalf of the corporation may not be binding. Since the officer is an agent of the corporation the agency principle of authority is used to determine if the officer had the authority to act at the time.

b. Actual Authorityi. Express Actual Authority – typically written in a statute, certificate of incorporation, bylaws or

established by a Bd. of Dir. resolution. Can also be established orally, but it must be expressly communicated

ii. Implied Actual Authority – a “fuzzier” doctrine, it usually created as:1. incidental to express authority, someone may be hired to do X, but Y and Z are necessary for the

accomplishment of X.2. is established though past dealings3. evaluated against the custom of the trade or industry, or what is common practice in the company

1 Warren ran a grain elevator. Cargill financed Warren’s operations and kept raising Warren’s credit limit even though Warren was not showing a profit. Cargill then began purchasing wheat from Warren. Issue in case was whether Cargill, by its course of dealing, was now liable for outstanding contracts of Warren. In addition to 9 factors listed above Cargill should not have been both financing Warren AND purchasing wheat from Warren (could have invoked a 3d pty.)

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4. can be established through emergency circumstances, ex.) ill bus driver asks passenger to drive to hospital, but then passenger should not finish the routea. two common ways implied authority comes into existence is that it is either inherent in a

person’s post in the company, or the Bd. of Dir., by action or inaction, has implicitly granted

c. Apparent Authority – although this is not good authority under Del. Gen. Corp. L. §124(2) it will bind a corporation to a third party.

i. With actual authority the third party can recover and the agent has insulations from litigation; With apparent authority the third party can recover but the agent can then be sued by the corporation for their recovery.

ii. Two requirements for apparent authority:1. Manifestation by principal – Principal must act in a way that would induce someone to believe that

they had the authority to make the offer; ex.) jewel thief in hotel blazer2. Reasonable reliance on a third party – third party is aware of those manifestations and relies on them

(to their detriment)iii. Lee v. Jenkins Bros. - brought suit against corporation alleging that Yardley, a former president

(now deceased) made him an offer for lifetime pension. Ct. held it was error for the trial ct. to dismiss this case as a matter of law, and whether or not there was apparent authority was for the jury to decide1. General rule is that the president ahs the apparent authority to make usual and ordinary contracts, but

not extraordinary contracts on behalf of his company2. lifetime employment contracts are generally agreed to be extraordinary and thus apparent authority

does not apply, however this was a contract for lifetime pension, not quite as extraordinary, thus is for a jury to decide.

d. Ratification – If an officer acts on behalf of the corporation, and has no actual or apparent authority, the corporation may still be bound by his actions if a person with actual authority to enter into the transaction either expressly affirms it or fails to disavow it.

CHOOSING A FORM OF ORGANIZATION

I. Partnership

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

i. Three basic policies of a partnership1. generation of capital2. protection of creditors3. fairness among partners

b. Formation – no written agreement required (although preferred) a partnership can be established ex antei. See UPA § 7 Rule for Determining the Existence of a Partnership; receipt by a person of the share of

profits of a business is prima facie evidence that he is a partner in the business. This is a rebuttable presumption.

ii. Martin v. Peyton – a broker-dealer firm KN&K received a bailout loan from PP&F. PP&F were to receive 40% of KN&K profits until the loan was repaid, had the right to inspect the books and any other info they though important, and had the right to veto any business they though highly speculative or injurious. 1. while the fact that PP&F were receiving profits creates a presumption of a partnership under the

UPA that presumption is rebutted by the fact that PP&F expressly declined an offer to enter into a partnership, also, PP&F was in the business of making loans and the measures were undertaken to ensure they got repaid. Unlike Cargill PP&F was no also a customer of KN&K.

c. Creation by estoppel – UPA § 16, “ a person …[who] represents himself, or consents to another representing him to anyone, as a partner in an existing partnership…is liable to any such person to whom such representation has been made, who has, on the faith of such representation, given credit to the actual or apparent partnership”.

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d. Partnership Finances:

i. No minimum capital is requiredii. Each partner has two types of interest:

1. partnership property (UPA § 25) can be used only for partnership purposes and is not subject to individual property attachment

2. partnership interest (UPA § 26) are freely transferable and assignable. However transferee does not become a partner unless all other partners unanimously agree.

3. UPA § 18 is key providing: all profits/losses are shared equally, partners receive no salary but are entitled to reimbursement of expenses. All of § 17 can be modified by written agreement.

e. Governance – all partners have equal management rights these rights are accompanied by fiduciary duties to one another.

i. When one partner goes into business with another individual, regardless of what entity you create, you agree to be bound by a higher standard of loyalty and duty of care, than average, to your fellow member. This higher standard creates trust which will engender more capital and thus stimulate the creation of business and investments. Meinhard v. Salmon.

f. Liability – inherent in partnership is a collective responsibility. i. UPA § 9, a partner may usually bind a partnership and ultimately create personal liability for other

partnersii. UPA § 13, in the ordinary course of business partners may bind the partnership for torts.

iii. UPA § 14, partners may bind the partnership with breaches of trust

g. Limited partnership – limits liability to “general” partners only, who are liable for all of the debts of the partnership; “limited” partners are not liable beyond the amount of their initial investment but they cannot actively participate in management of the partnership. RULPA § 303.

i. Requires a written agreement filed with a state official, RULPA § 201ii. General partner can be a corporation with few assets to further limit liability. (LLC)

h. Modern Types of Partnership: LLP, LLC

II. Partnership vs. Corporationa. Corporate form is superior when:

i. Owners find it important to limit their liabilityii. Free transferability of interest is important

iii. Centralized management is importantiv. There is a large number of owners and they cannot all be active in the businessv. Continuity of existence, in the face of withdrawal or death of an owner is significant

b. Partnership is superior when:i. Simplicity and inexpensiveness of creation are very important

ii. There are either losses or large profits making taxation at the individual level significant

III. Factors to Consider

a. Limited Liabilityi. Corporation – shareholders’ liability is limited to the amount of initial investment

ii. Partnership – with the exception of a limited partnership, all partners are personally liable

b. Managementi. Corporation – centralized, corporation is managed under the supervision of the Bd. of Dir., with day-

to-day control resting with the officers ii. Partnership – all partners have equal right to management unless modified by a written agreement, or

if a limited partnership

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c. Continuity of Existencei. Corporation – perpetual existence, the fact that ownership changes hands does not effect the

corporation’s continuing existenceii. Partnership – dissolved by the death or withdrawal of any partner, unless modified by written

agreement, but death of limited partner has no effect

d. Transferability of Interesti. Corporation – interest is embodied in shares of stock which are freely transferable, especially

important where business wants to attract investments, or where business is large and owned by many different people

ii. Partnership – a partner may assign his interest but that gives the transferee limited rights, transferee cannot become a partner unless all other partners unanimously agree

e. Complexity of Formation and Operationi. Corporation – not cheap or simple, must file docs with Sec. of State, comply with regulatory

requirements, and fulfill minimum annual tax requirements even if not profitableii. Partnership – easier and cheaper, no formal documents (unless a limited partnership) and fewer

regulatory requirements

f. Federal Income Tax – probably the most significant considerationi. Corporation – is taxed as a separate entity and is subject to double taxation (corporation pays income

tax on its profits and then shareholders are taxed on their dividends)ii. Partnership – not separately taxable, each partner pay taxes for their portion on their own individual

income tax return

THE CORPORATE FORM

I. Where and How to Incorporate

a. Where to Incorporatei. Principal place of business – pay fee and register with the state, easier for smaller

companies, only one set of filings requiredii. Delaware – advantage is extremely well-formed body of corporate law, thus the law

is more predictable; must also pay taxes within your state of operation

b. Mechanics of Incorporating

i. Certificate of Incorporation – required to contain:

1. the corporation’s name and addressa. DGCL §102(a)(1)-(2) is required to contain certain words such as assoc.,

foundation, fund, society, limited, etc.; must be distinguishable from other names, and cannot contain the word “bank”.

2. a purposes clause which was traditionally required to be narrow but today usually written as broad as possible

a. DGCL § 102(a)(3), requires to state nature of business but shall also be sufficient to state “any lawful act or activity”

3. list the number and type of shares of stock the corporation is authorized to issue

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a. DGCL § 102(a)(4) in only class 1 stock must list total number of shares and par value of each, if more than 1 class of stock must list total number of shares of all classes and specify for each class which shares are with/without par value

ii. Certificate of Incorporation – optional provisions1. limits on directors or shareholders

a. DGCL §102(b)(1) – allowance for any provision “creating, defining, limiting, and regulating the powers of the corporation, the directors, the stockholders, or a class of stockholders”

b. DGCL §141(a), general provision defining the duties of the Bd., except as provided in the certificate of incorporation

2. supermajority vote or quorumsa. DGCL § 102(b)(4), “provisions requiring for any corporate action the vote

of a larger portion of the stock or of any class series thereof”3. limits on duration

a. DGCL § 102(b)(5), “provision limiting the duration of the corporation’s existence…otherwise the corporation shall have perpetual existence”

4. provisions imposing personal liabilitya. DGCL §102(b)(6) “provision imposing personal liability for the debts of

the corporation, otherwise stockholders/members of corporation shall be exempt from personal liability”

5. preemptive rightsa. DGCL §102(b)(3), a useful protection device for smaller corporations,

grants stockholders preemptive right to subscribe any or all additional issues of stock. This is only allowed if it is expressly granted in the certificate of incorporation

6. stock transfer restrictionsa. Close corporation requirement that stock, when sold, must be sold to those

within the company or at least initially offered to them7. “opt-out” provision for monetary damages arising out from duty of care

a. DGCL §102(b)(7), limits personal liability of a director for monetary damages arising out of a breach of fiduciary duty as a director

iii. Amending Article of Incorporation – can be amended at any time but must be done by a majority vote, either the BD. of Dir., or shareholders

c. Bylaws – govern the internal affairs of the corporation, easily amended by the Bd. of Dir., usually include:i. Date, time , place of annual shareholders meeting

ii. Number of directorsiii. Describes voting rights of directorsiv. Listing of officers with a description of each of their dutiesv. Quorum requirements for a meeting of directors, etc.

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d. Registered office and agent – main purpose is to provide address for notice and service of process as well as other official communications within the state of incorporation

e. Initial Bd. of Directors – most states allow for the incorporators to elect the initial directors, or for the initial directors to be named in the articles of incorporation.

f. Other Practical Considerations:

i. One corporation or many ?1. This is essentially a liability issue b/c there are no longer tax advantages to

multiple incorporations. You can limit asset attachability by having several corporations, but it is also a lot more work and you may be subject to “piercing”. If you operate a risky business the benefits may outweigh the costs.

ii. Where to incorporate? (see above)iii. Can the promoter (incorporator) enter contracts before the corporation is formed?

1. Usually the answer is yes, however he/she is liable unless the contract expressly disclaims liability. After the corporation is formed the promoter is liable until novation, but is later entitled to reimbursement from the company

2. The corporation may adopt a contract formally, by novation, or absent novation, by a course of conduct. Both corporation and promoter will be liable. If contract expressly disclaims promoter liability then no contract exists, it just remains an offer until the corporation adopts the contract. (EXPLAIN)

II. Defective Incorporation & its Consequences

a. Generally – this occurs when a promoter attempts to incorporate but fails to do so b/c of some technical defect. The issue then becomes whether the promoter and/or passive investors are liable.

b. Common law “de facto” doctrine - as long as there was a colorable attempt to incorporate the ct. will hold there is a “de facto” corporation, this shields shareholders from liability. Elements include:i. Existence of law authorizing incorporation

ii. Good-faith effort by promoter to incorporate under the lawiii. Actual use and exercise of corporate powersiv. The other party must have though a corporation existed

c. Modern View – de facto doctrine is used less frequently todayi. It is easier to incorporate thus a good-faith attempt to do so is more likely to be

successfulii. RMBCA § 2.04, “All persons purporting to act as or on behalf of a corporation,

knowing there was no incorporation…are jointly and severally liable” Those without knowledge will be shielded from personal liability. (most states have a provision such as this) Cts. are also less likely to shield active investors.

iii. In many states if you have your receipt of incorporation it establishes a rebuttable presumption that you are incorporated

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d. Corporations by Estoppel – also shields promoter/investor(s) from liability, elements include:i. Creditor dealt with the business as a corporation

ii. Promoter/Investor must not have known the incorporation was defective, thus the doctrine is most likely used when the party asserting the doctrine has relied in good faith on a third party (ex. a lawyer) to incorporate.

iii. Cranson v. Int’l Business Machines Corp. - was an investor in a new business, was advised by the corporate lawyer that incorporation is complete. ordered typewriters from IBM under the corporate name. Unbeknownst to incorporation does not take place until after the order. Ct. held is not personally liable b/c is estopped from denying the corporation’s existence. dealt with the business as a corporation and relied on its credit.

1. de facto doctrine was not available in this case b/c agency theory applies. The lawyer was the ’s agent and thus is liable for the lack of due care of his attorney.

2. doctrine applies only to contract cases – cannot be applied to shield a defective incorporator from tort liability b/c the injured contracting party chose to deal with the and had the opportunity to protect themselves, but the injured tort party had no such choice

3. often estoppel doctrine is easier to apply than de facto doctrine as long as creditor dealt with company as a corporation and the promoter has behaved with good faith

4. underlying policy of leniency is to promote investment

III. Piercing the Corporate Veil

a. Generally – corporate shareholders are shielded from personal liability, however there are some instances where cts. will “pierce the corporate veil” and hold the shareholders personally liable. Overall this is accomplished rarely, and determined based on facts of each case. Generally tendency not to allow as want to promote investment in limited liability scheme.. There are 3 ways the veil can be pierced:i. Individual Owner – Corporation

ii. Parent Corporation – Subsidiaryiii. Enterprise Liability

b. “Piercing” can be accomplished under 3 different theories:i. Alter Ego/ Instrumentality Doctrine – if person controlling firm does not treat it as

separate but rather as personal property, can be pierced.1. Walkovsky v. Carlton - owns stock in 10 corporations each of which owns 2

cabs. is severely injured by one of ’s cabs and sues to hold personally liable. Ct. dismissed the pleading holding the corporate form may not be disregarded simply b/c the assets of the company exceed the ’s damages.

2. Most cts. require that there be some affirmative fraud/wrongdoing by the shareholder, or that the shareholder failed to follow the formalities of corporate existence before they will allow the veil to be pierced.

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ii. Undercapitalization 1. Minton v. Cavney - brought wrongful deaths suit against director of company

after her daughter drowned in a pool owned by ’s corporation. The Ct. held that , an involuntary creditor could pierce the corporate veil where the corporation had grossly inadequate capital even in the absence of fraud or wrongdoing.

2. Radaswekski v. Telecom. Corp. (8th Cir.) - was on a motorcycle and struck by one of ’s trucks. Ct. here refused to allow argument of undercapitalization. The Ct. noted that the theory of allowing piercing for undercapitalization is b/c the corporation has not been financially responsible. However here met (an exceeded) the minimum liability coverage required under MO law. This is enough for the company to satisfy the federal financial-responsibility requirements.

a. MO has a tripartite test to pierce the corporate veil, (1) at the time of the transaction there must have been complete control by the corporation, (2) the control must have been used by the to have committed a fraud or wrong, and (3) the breach of duty must have been proximate cause of ’s injury.

iii. Fraud – Cts. will also allow the veil to be pierced where there has been grievous fraud or wrongdoing by the corporation’s shareholders

1. Ex. shareholders fraudulently siphon away a corporation’s assets so there is nothing left to satisfy the needs of creditors.

IV. Ultra Vires and Corporate Power

a. Ultra Vires Doctrine – while once very important is of little significance today

b. Historical Interpretation – early statutes narrowly restricted a corporation’s business activities, if a corporation acted beyond the scope of what is was authorized to do by statute the transaction was held to be void as unenforceable. These transactions were referred to as ultra vires, “beyond the power”i. Exceptions – in order to prevent injustices several exceptions were created:

1. if one party fully performed the other was estopped from relying on the doctrine, thus they had to perform as well

2. in some instances shareholders were held to have implicitly ratified the ultra vires act by either participating in the act, or accepting benefits stemming from the act without complaint.

c. Modern Abolition – corporate statutes have virtually eliminated this doctrinei. Broad “powers” clauses – in most statutes, unless otherwise stated in the certificate

of incorporation, corporations are allowed to engage in any lawful business activityii. Formal abolition of doctrine – most states have explicitly abolished the doctrine to

prevent 3d parties from bringing lawsuits under it. See RMBCA §3.04(a) “validity of

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a corporate action may not be challenged on the grounds the corporation lacked the power to act”

iii. DGCL §124 almost totally eradicates the common law doctrine of ultra vires stating, “No act of a corporation and no conveyance or transfer of real or personal property to or by a corporation shall be invalid by reason of the fact that the corporation was without capacity to do such act…” except for three limited cases. Thus the doctrine is dormant, not totally dead.

d. Corporate Powers today – a shareholder may still sue to enjoin a corporation from acting beyond its powers if, the corporation has a charter that expressly limits its powers, or if the charter is silent as to the corporations powers and the state does not provide for “any lawful business purpose” in its statutes.i. Charitable Donations – corporations have the implied power to make charitable

donations reasonable in size and type, and not so extreme as to excite the opposition of the shareholders whose property is being used.

1. Dodge v. Ford Motor Co. - sued when Ford terminated special dividend they were to receive and instead donated the money to constructing a large factory. The Ct. held the main purpose of a corporation is to carry on its business for the benefit of its stockholders, thus even though the construction of the factory was “charitable” in that it benefited the public a better way would have been to donate the money over time to construct the plant while at the same time paying shareholders their dividends.

2. A.P. Smith Mfg. Co. v. Barlow – AP Smith mfg. Indus. valves and fire hydrants, they made a cash donation to Princeton U., the Ct. upheld it as valid b/c it did not violate the rule…A corporation may make a charitable contribution as long as the amount does not exceed 1% of capital and surplus, unless the excess amount is authorized by stockholders at a special meeting.

ii. Pensions, Bonuses and other fringe benefits – 1. If the employee is currently employed it will be allowed unless it is clearly

excessive or based on self-dealing. If the employee is retired, it will be allowed under the same circumstances and is justified by the rationale that the current labor force will be pleased.

2. RMBCA §3.02(12) explicitly gives corporations the right to institute pension plans, share option plans, and other incentive for its current and former employees.

THE CORPORATE STRUCTURE

I. General Allocation of Power

a. Traditional Statutory Scheme – historically power has been allocated in a particular way which has been followed by most states and led to the development of a common statutory scheme. Most of these statutes allow a corporation to modify this scheme.

b. Powers of Shareholders – influence business indirectlyi. Elect and remove directors

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ii. Articles of Incorporation and Bylaws – can approve/disapprove changes and thus influence the scheme of power in the corporation

iii. Fundamental Changes – approve/disapprove changes not in the ordinary course of business such as mergers, sales of assets, amendments to bylaws, etc., share exchanges and dissolution

iv. Void/Voidable transactions – some transactions by officers/Bd. are void or voidable unless ratified by a shareholder vote, ex. self-dealing transactions

v. Do not have to power to conduct business on behalf of the corporation and thus cannot bind the corporation

c. Powers of Directorsi. Shareholders cannot order the Bd. to do anything b/c it is the Bd. not shareholders

that formulate the companies policies.ii. Bd. supervises the activities of the corporate officers and sets policy

d. Powers of Officers - run the day to day business operations of the company acting as agents of the corporation and thus have the power to bind the corporation

II. The Board of Directorsa. Generally – mechanics include how the Bd. is elected, how it holds its meetings, and

what formalities it must observe in order to take action.b. Election of Board Members – Bd. is always elected by stockholder

i. Proper notice of the time and place of the meeting must be given to all shareholdersii. A quorum must be present, more than 50% of the shares eligible to vote must be

present either in person or via a valid proxy.c. Number of Directors – traditionally statutes have required at least 3 directors but now

many states will allow less as long as the number of directors is not less than the number of shareholders

d. Filling of Vacancies – can be filled by shareholder vote or by action of the Bd., unless otherwise specified in the articles of incorporation

e. Removal of Directors – can be removed byi. Shareholder vote – accomplished by a majority vote of shareholders and can be done

with or without causeii. Court order – can only be ordered for cause

f. Procedures for a Directors’ Meetingi. Frequency of meeting – regular meetings are dictated by the bylaws, usually quarterly

or annually; special meetings are all othersii. Notice – not necessary for regular meetings but all Bd. members must receive notice

of a special meeting iii. Quorum – if the Bd. has a fixed size a quorum is a majority of that number, this holds

true even if there are vacancies on the Bd. If permitted by statute bylaws can require a super-majority, this is a useful control device in smaller corporations.

III. Corporate Officersa. Generally – executives appointed by the Bd., that oversee day to day operations

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b. Right to Hire/Remove – only Bd. has power to appoint/remove officers either with or without cause

c. Authority to act for corporation – If an officer has the authority to act on behalf of the corporation as its agent then his actions will be binding (see agency section above)

IV. Formalities for Shareholder Actiona. Generally – mechanics of how shareholders exercise their right to vote b. Annual vs. Special Meeting – Corporations must hold annual shareholders’ meetings the

purpose of which is to elect new directors. Special meetings can be held for a variety of issues, the notice of the meeting must specify the issue(s) and no other issues can be raised besides those

c. Quorum – it is generally required that a quorum be present at the shareholders’ meeting which is equal to a majority of the corporation’s outstanding shares

d. Vote Required for Approval – once quorum is present shareholders will be held to have approved the action only if the majority of shares actually present vote for the proposed action

THE DUTY OF CARE

I. Generally – stated in its broadest form a director or officer’s duty of care is, “When handling the corporation’s affairs, to behave with the level of care that a reasonable person in similar circumstances would use”a. Narrowed by business judgment rule – generally the B-J rule says that courts will not

second guess the wisdom of directors and officers business decisions and will not impose liability for even bad decisions as long as they had (1) no conflict of interest when they made the decision, (2) gathered a reasonable amount of information before deciding, and (3) did not act wholly irrationally.

b. Effect of 2 rules combined – scheme examines process by which director/officer made their decision, but gives little scrutiny to the substantive wisdom of the decision itself.

c. Remedyi. Damages – director/officer who violates his duty of care is personally liable to pay

money damages to the corporation. This often comes about through a shareholders’ derivative suit where shareholders sue “on behalf” of the corporation against the negligent person

ii. Injunction – where the Bd. ahs approved but not consummated a transaction a shareholder can sue for an injunction to block the transaction. This is generally an easier decision for the ct. to make and thus required less of a showing of negligence than would be required for the imposition of personal liability

II. The Standard of Care

a. The Basic Standard – “A director shall discharge his duties as director (1) in good faith, (2) with the care and ordinarily prudent person in a like position would exercise under similar circumstances, and

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(3) in a manner he reasonably believes to be in the best interests of the corporation.” RMBCA §8.30

b. Triggers – a breach of this duty generally arises only where the director has failed to comply with reasonable procedures for making decisions. Even when procedures prove to be inadequate most cts. will find a violation only for gross negligence or recklessness. Typical examples include:

i. Total Failure to act as director – director fails to do the basic things that directors do such as attend meetings, learn about the company’s business, read reports/financial statements, fails to obtain help/advice when he knows things are going wrong, otherwise fails to act diligently

1. Francis v. United Jersey Bank – Mrs. Pritchard is a director whose sons embezzle 12 million from the company. Pritchard is an elderly alcoholic who never attends bd. meetings and knows nothing of the corporation’s affairs. The ct. held this breached her duty of care – had she so much as even glanced at a financial statement she would have seen the dire situation her company was in which would have put her on notice that her sons were embezzling.

ii. “No win” transactions – if a transaction could at best benefit the corporation slightly and at worst cause significant damage the ct. may find that the decision was so irrational to amount to gross negligence

iii. Disguised self-dealing – cases where the director may be liable for inaction where the ct. believes their failure to act was for their own benefit. In Francis the ct. may have been additionally swayed by the fact the embezzlers were the ’s sons, thus she may have been more willing to let her sons get rich at the corporation’s expense.

c. Objective standard applied – a “reasonable person” in the director’s position. This standard, as applied, may be affected by the following:

i. Director has special skills – if director has special skills such as training as an accountant or in real estate he must use those skills. Std. becomes what a reasonable person, with that training, would have done under the circumstances.

ii. Surrounding Circumstances should be considered – Ex., if corporation is small with simple operations the level of attention of the director is probably somewhat less than if they sit on the Bd. of a very large corporation. Also, if the business serves as a trustee, or a guardian of the funds of others then the standard is also higher often requiring a director to be on the lookout for misappropriation

iii. Reliance on Experts and Committees1. RMBCA § 8.30(b) a director is entitled to rely on information, opinion, reports,

etc. if prepared or presented by (1) officers/employees whom the director reasonably believes to be competent and reliable, (2) lawyers, accountants, or

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other professional experts, or (3) a committee of the Bd. if the director reasonable believes the committee to be capable.

2. DGCL §141(e): The Bd. is fully protected in relying in good faith upon the records of the corporation and upon such information, opinions, reports, etc., as presented to the Bd. by any corporate officer or employee, or by “any other person as to matters the Bd. member reasonably believes are within such persons professional or expert competence”

3. Reliance unreasonable if the director knows the third person is lying or otherwise misinformed

iv. Passive Negligence – where the Bd./director fails to detect wrongdoing

1. No duty to detect wrongdoinga. Graham v. Allis-Chalmers Mfg. Co. – 4 of mfg. co.’s employees plead

guilty for price-fixing and directors are sued alleging they violated their duty of care by not learning about and preventing these antitrust violations. The Ct. held that absent a cause for suspicion there is no duty of directors to “ferret out” wrongdoing.

2. Actual grounds for suspicion – if directors are on notice of facts that would make a reasonable person suspicious then they must act.

a. Bates v. Dresser - , a bank president believes that his bookkeeper is honest but there are a number of clues to the contrary that he ignores (huge discrepancies in accounts) the Ct. held the violated his duty b/c he was put on guard and should have at least investigated further. Key to this case is that the duty was “triggered”.

3. Duty to put controls into place – modern trend is that Bds. should put into place formal control systems, such as annual audits, etc. to prevent/discover wrongdoing. §13(b)(2) of Sec. Exch. Act requires companies to “devise and maintain a system of internal accounting controls”.

d. Causation – even if a director has violated his duty of care he will not be held liable unless his lack of due care is the proximate cause of damage to the corporation.i. Barnes v. Andrews – corporation was a start-up that ran out of money before it made

it to production. Ct. concluded that the delay/failure was mostly attributable to the incompetence of employees and that there was no way a more attentive set of directors would have made the business a success. Even though did breach their duty it is the ’s burden to show that had the ’s duties been carried out the loss would have been avoided. Violation of the duty must be the proximate cause of the injury.

ii. Francis changed the std. of Barnes, no longer must ’s conduct be the contributing cause, now it must simply be a “substantial factor” for the ’s non-action to make them liable.

e. Policy Debate re: the Bd.’s role:

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i. Mace, “Directors: Myth & Reality” concluded directors1. do not establish the policies of the firm2. rarely choose CEOs3. rubber-stamp compensation decisions4. rarely ask tough questions

ii. While this may have been the case years ago Seligman argues the system has since evolved into a system of checks and balances where the Bd. is only one of the “checks”, and acts as a “monitor” rather than a “manager”

1. in small firms active shareholders carefully review mgmt.2. in large firm institutional owners and lenders perform a monitoring role3. stock mkt. prices may trigger a more active Bd.4. Product mkt. competition may trigger a more active Bd.5. SEC disclosure and fraud rules

iii. Bd.’s monitoring roles have evolved over time, 1970s corporate bribery scandals and 1980s takeover prompted reforms such as disclosure and fraud rules place certain requirements upon the Bd.

1. audit committees2. more information available to directors3. more outside directors4. greater involvement in fundamental decisions such as evaluating tender offers

and CEO succession

III.The Business Judgment Rule

a. Generally – idea behind the rule is that business decisions based upon reasonable information and with some rationality do not dive rise to director liability even if they turn out badly

b. Statement of BJ Rule: A director or officer who makes a business judgment in good faith fulfills their duty of care if the director or officer:i. Is not interested in the subject of the business judgment

ii. Is informed with respect to the subject of the business judgment to the extent reasonably believed to be appropriate under the circumstances; and

iii. Rationally believes the business judgment to be in the best interests of the corporation

c. Interplay between BJ Rule and Duty of Care – Duty of care sets out procedural requirements that must be met, once fulfilled the BJ Rule sets out a much easier satisfiable standard with respect to the substance of the business decision.

d. Rationale behind the BJ Rule (Joy v. North)i. Corporate law encourages risk-taking, it is nature of competitive business

ii. Shareholders voluntarily invest; shareholders assume directors are involved in risk-taking

iii. Rational shareholders can diversify away firm-specific risk through their portfolio

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e. Requirements for application of BJ Rule :i. No Self-Dealing – protection of rule is lost if director has an interest (is a party to the

transaction) or has a financial stake in the transaction. Rationale is that if director is serving their own interest than they have not really engaged in good business judgment

ii. Informed Decision – prior to making a business decision director must inform themselves of all material information reasonable available to them

1. gross negligence standard – most cts. (incl. DE) would hold that a director only loses the benefit of the rule if they were grossly negligent in the amount of information they gathered

2. all circumstances considered – ex.) if decision had to be made in an extremely short time period cts. would require less info to be gathered than if decision had months or years to made in.

iii. Rational Decision – as long as decision is not totally beyond the bounds of reason it will be considered rational, also rationality is considered under what the director knew at the time of making decision, hindsight is not applied

f. Exceptions to BJ Rule: even if 3 requirements are met rule will not be applied wheni. Act taken or approved by director is in violation of a criminal statute or otherwise

illegalii. The act was in pursuit of broad social or political goals not related to the

corporation’s welfare1. this is rare/extreme b/c cts. tend to give wide latitude to director’s judgments

that charitable/social purposes mesh with the corporation’s financial interests.

g. Leading Case: Smith v. Van Gorkom i. Facts: ’s were directors of Trans Union Corp., Van Gorkom (“VG”) was CEO. VG

was nearing retirement and wanted to sell his shares thus had CFO compute price at which a leveraged buy-out could be done. CFO reported that at it could be easily accomplished at $50 per share but that the corporation’s cash flow might not support $60 per share or over. VG did not consult with any other management and offered the stock to his friend, a well-known corporate acquirer at $55/share. NYSE price had never exceeded $39.5/share. VG sought no other approval nor an outside study. VG sought Bd. approval for the $55 price and stated an answer must be made in 3 days. Bd. was presented with no other info., valuation docs, did not know that $55 price came from own CFO, yet approved buyout.

ii. Holding: Directors were grossly negligent in failing to inform themselves adequately about the transaction they were approving considering:

1. the Bd. never found out it was VG, not the buyer, that promoted the deal and named the eventual sale price

2. Bd. may no real attempts to ascertain “intrinsic value” of company3. Bd. relied completely on oral statements from VG and no written documents4. Bd. made decisions in 2 hrs., w/ no advance notice of subject of meeting, and in

circumstances when there was no crisis/emergency

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5. In merger agreements it is std. for an attorney (not a Bd. member) to attend the meeting to provide legal advice, and none didiii. Dissent: the stock price was 50% above the average premium price, thus it

is not as if the price was unfairiv. Significance: In this case there were several opportunities for the Bd. to

request more information, yet they did not. Any easy way for the Bd. to protect themselves would be to request more info or postpone the merger.

h. Aftermath of Van Gorkomi. Motion practice - ’s assert BJ rule, occasionally wins by showing the lack of a

reasonable investigation, or Bd. conflicts of interestii. At trial, ’s must prove:

1. that duty of care was violated (requires evidence similar to what is necessary to rebut the application of the BJ Rule)

2. causation3. damages

iii. Unlikelihood of a duty of care case succeeding:1. has burden of proof2. in DE gross negligent standard applies3. § 102(b)(7) “opt out” provision available for articles of incorporation, limits

personal liability of a director for monetary damages arising out of a breach of fiduciary duty as a director

4. BJ rule defenseiv. Securities Fraud case has greater likelihood of success

1. no BJ Rule defense2. mandatory disclosure system produces detailed public evidence3. possibility of a prior SEC investigation

THE DUTY OF LOYALTY – See also Weinberger case

I. Fiduciary Status of Corporate Membersa. Officers, directors, shareholders and in effect “trustees” of the corporation and thus have

a fiduciary obligation to it.b. Joint Venturers/parters owe one another an even higher standard of care, “the duty of the

finest loyalty” (Meinhard v. Salmon)c. Usually any full-time employee of the corporation is an agent and thus is subject to all of

the fiduciary duty obligations including a strict ban on self-dealing.

II. Self-Dealing Transactionsa. Three aspects of a self-dealing transaction:

i. Key player and the corporation are on opposite sides of the transactionii. Key player has influenced the corporation’s decision to enter into the transaction

iii. Key player’s personal financial interests are at least potentially in conflict with those of the corporation to the extent that there is doubt as to whether he will act in the best interests of the corporation.

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b. Historical treatment of self-dealingi. Prior to late 1800s self-dealing transactions were completely prohibited regardless of

whether or not they were fairii. By 1910 most cts. had adopted the rule that a self-dealing transaction would be

allowed to stand if it was approved by both a majority of disinterested directors and was “fair” to the corporation (as determined by the ct.)

iii. Modern view, as long as the transaction is fait it is likely to be upheld by the ct. regardless of whether or not it was approved by a disinterested Bd.

c. General Statement of the Rulei. 3 types of self-dealing transactions:

1. fair transactions – if fair, cts. will uphold regardless of whether or not it was approved by a disinterested majority

2. waste/fraud – if transaction amounts to waste/fraud cts. will usually void it if a stockholder complains

3. middle ground – if not clear cts. will look to whether there has been director approval and shareholder ratification. If approved by a majority of disinterested directors, or ratified by shareholders it will probably be upheld

ii. Procedure1. Burden of proof rests with the key player who must prove:

a. Transaction was either approved by a disinterested and knowledgeable majority of the Bd. without participation by the key player, or

b. It was approved by a majority of the shareholders after full disclosure of the relevant facts

d. Illustrationsi. The Basic Standard – Globe Woolen Co v. Utica Gas and Elec. Co. - owns and

operated two mills in NY, Maynard is chief stockholder of corporation. approached Maynard about using electric power in the mills, negotiated a contract which ultimately benefited himself and proved to be a losing contract for his company. asserted that b/c Maynard did not vote or comment at the Bd. meeting approving the transaction it should be valid. J. Cardozo held a “dominating influence may be asserted in other ways that by a vote”

1. Maynard could have escaped this situation by resigning from the Bd., then he would no longer be on both sides of the transaction

2. Maynard could have also fully disclosed his involvement in negotiating the contract

3. Lesson – if you want to avoid a conflict of interest the best way to do it is to resign; if that is not an option you must recuse yourself or otherwise be physically absent from the negotiations

ii. Gries Sports Enter., Inc. v. Cleveland Browns Football Co. – Berick (key player) was a stockholder for CSC and the Browns and had a personal financial interest in the transaction which conflicted with his role as general counsel. The transaction was that the Browns would buy CSC, a corporation of the that had a large debt. The

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concluded that the $6 million price was unfair and voided the transaction b/c Berick and others who were involved in the vote had dominating interests.

1. In this case could have carried their burden of proving the transaction was fair by hiring an independent appraiser to determine the validity of the $6 million price.

2. In these cases often the party that carries the burden of persuasion loses.

e. DGCL § 144 (1967) ameliorated the per se rule that interest transactions should be voided and established three approaches for treatment: “no transaction between a corporation and its director in which a director has a financial interest shall be void solely for this reason…if:i. The material facts as to the director’s relationship or interest as to the transaction are

disclosed and the board in good faith authorizes the transaction by a majority vote of disinterested directors; or

ii. The material facts as to the director’s interest as to the transaction are disclosed and the transaction is approved in good faith by a majority of the shareholders; or

iii. The transaction is fair as to the corporation at the time it is authorized, approved, or ratified, by the board, a committee or shareholders.

1. In each situation, after this requirement is met the burden or persuasion shifts back to the to prove that the transaction was unfair.

f. Safe Harbor Statutes : as outlined above in § 144 if a transaction is approved by a majority of disinterested Bd. members or shareholders after a full disclosure of material facts then the burden shifts back to the to prove that the transaction was unfair. i. Ex.) corporations regularly seek ratification of stock options and other compensation

arrangements by shareholders to re-allocate the burden in the event of any challengeii. Marciano v. Nakash – Ct. held transaction at issue was valid and enforceable b/c the

met the §144 which is the exclusive test to be applied. In this case b/c of a deadlock on the bd. the transaction could not be approved, in this case then the can still validate the contract as long as they can prove that the contract was fair to the corporation at the time it was entered into.

III.Executive Compensation

a. Forms of Compensation – 3 typesi. Current payments (deductible from the corporation’s taxable income)

1. salary, paid throughout the year2. cash bonus, paid annually at the end of the year

ii. Stock-based incentive plans1. stock options, most common, the right to buy shares of the company stock at

some time in the future for a price that has been previously set2. restricted stock, stock that is awarded to an employee under a variety of

limitations, such as a certain number of shares vesting each year as long as that employee remains employed

3. stock appreciation rights (SAR), the right to a future cash bonus based on any increase in the price of the company’s stock

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4. phantom stock, a deferred cash bonus that is often equal to the total value of a set number of shares of company stock some time in the future (different than SAR b/c SAR only pays the increase in value since the date it was granted)

iii. Pensions/Other deferred cash compensation plans, most common is a pension/retirement plan for regular cash payments

b. Issues raised by compensation schemes:

i. Self-Dealing – Cts. will generally treat this the same as under a duty of loyalty analysis, a compensation scheme is more likely to be upheld if it has been approved by a majority of disinterested shareholders/directors after disclosure of all material facts.

1. Key inquiry – Is the compensation scheme fair?2. If it has been approved the burden then shifts back to the to shoe the scheme

is unreasonable (as a practical matter this is hard to prove); often the decision of the Bd. is insulated by the BJ rule

3. Extra protection – the executive should not take part in the vote deciding his compensation scheme, in fact, he should not even be present at the meeting

ii. Consideration Requirement – Cts. require consideration for each component of a compensation plan

1. Deferred compensation – this fulfills the consideration requirement as long as the receipt of deferred compensation in a scheme is dependant upon that executive still being employed at the company

2. Unbargained for payments and past services – a corporation usually cannot make a large payment upon the death or retirement of a senior executive unless it had been included in a prior plan

iii. Excessive/Unreasonable compensation schemes – even if a compensation scheme has been approved by a majority of disinterested Bd. members/shareholders a ct. may still void the scheme if it determines the level of compensation to be excessive or unreasonable.

1. Rule: The amount of compensation must bear a reasonable relationship to the value of the services performed for the compensation

a. As a practical matter this is an easier standard to satisfy than the “fairness” rule b/c excessiveness is even harder to prove than fairness, many cts. do not feel they have the appropriate standards available by which to judge the reasonableness of executive compensation

2. When excessive to the amount of “waste” cts. will strike down the compensation scheme

a. Rogers v. Hill – in 1912 American Tobacco Co. agreed to pay its top execs a bonus of 10% of the amount by which the company’s earnings exceed $8 million. This is ratified by the Bd. year after year. In 1932 he president is receiving close to $1 million bonus (HUGE for 1932). The

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S.Ct. held that b/c of the huge increase in profits the once-reasonable bonus scheme now amounts to waste. “If a bonus payment has no relation to the value of services for which it is given, it is in reality a gift in part and the majority stockholders have no power to give away corporate property against the protest of the minority”

b. Brehm v. Eisner – In 1995 Walt Disney Co. CEO hired M. Ovitz to be the president of Disney (they were good friends) and gave Ovitz and EXTREMELY lucrative 5 yr. employment compensation scheme that, among other things, included a $10 million payment to Ovitz if Disney decided not to renew the contract after 5 yrs. The DE Ct. of Chancery struck down the contract on the ground the Bd. was not “reasonably informed” in that they were not aware of every material fact at the time of ratifying the contract. The DE S.Ct. upheld the contract, saying that this treatment was improper and the Bd.’s only requirement is to examine material facts that are reasonable availablei. The Ct. notes that if the compensation committee was interested in the

transaction the burden shifts to the committee to shoe the scheme is not excessive.

ii. In this case b/c the committee was not interested the analysis simply proceeds under the BJ rule. Thus, if the Bd. was informed then it is the burden of the to show the amount is excessive. This is a burden than is capable of being met only in the most unusual of circumstances – unconscionable cases.

IV. The Corporate Opportunity Doctrine

a. Competition by the Key Player with the Corporationi. Generally – a director or senior executive may not compete with the corporation

where the competition is likely to hurt the corporationii. However as with other types of self-dealing conduct which may otherwise be

characterized as disloyal can be validated if approved by a disinterested majority of the Bd./shareholders after a material disclosure by the Key Player

iii. An executive may not prepare for competition with their corporation while they are still employed by that corporation

iv. Absent any agreements not to compete an executive that leaves a corporation is not barred from later competing with that corporation

b. Personal use of corporate assets by the Key Playeri. Generally – a Key Player may not use corporate assets if this use harms the

corporation or provides the Key Player a personal financial benefitii. “corporate assets’ for this purpose include both tangible and intangible assets, such as

informationiii. similarly, an improper use of corporate assets can be immunized if later approved by

a disinterested majority of the Bd./shareholders after a material disclosure by the Key Player

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c. Wrongful appropriation of a business opportunity for the corporation by the Key Player for personal gain (“Corporate Opportunity Doctrine”)

i. Generally – if it is found that an executive has taken an opportunity that belongs to the corporation for himself it is per se illegal and the corporation may recover damages equal to the loss it has suffered including any profits it would have made had it been given the chance to pursue the opportunity.

ii. 4 Tests for determining whether an opportunity is a “corporate opportunity”

1. “Interest or Expectancy” Test – if the corporation had an interest or expectancy in the opportunity, or if the opportunity is essential to the corporation t is a corporate opportunity. This is the narrowest of the 4 tests.

a. Interest – ex.) if the corporation already had some contract right regarding the opportunity

b. Expectancy – if, w/ respect to the corporation’s existing business arrangements it could have reasonably anticipated being able to take advantage of the opportunity the test will be fulfilled. Ex.) corporation has bldg. Lease for 2 more years, it expects to be able to renew the lease for a new term

c. Essential – if the corporation will suffer serious harm if it is not allowed to take advantage of the opportunity

d. Johnston v. Greene – this case illustrates the difficulty in applying this test, shows that if opportunity is determined to be in the corporation’s interest then it does not matter whether the offer was made to the key player in their capacity as an individual vs. corporate officer

2. “Line of Business” Test – if the opportunity is closely related to the corporation’s existing or prospective opportunities it will be considered a corporate opportunity. (opp. will also probably fulfill interest/expectancy test)

3. “Fairness” test – ct. will measure “the unfairness on the particular facts of a fiduciary taking advantage of an opportunity when the interests of the corporation justly call for protection. (Durfee v. Durfee & Canning Co.) Factors that will be looked at under the fairness test include

a. whether the offer was received by the Key Player in their capacity as an individual or in their capacity as a corporate manager who would then relay the opportunity to the corporation

b. whether the officer used corporate resources/assets (such as company time) to take advantage of the opportunity

c. whether the opportunity is essential to the financial well-being of the corporation

d. whether the parties involved had a reasonable expectation the opportunity was a corporate one

e. whether the corporation had the ability to take advantage of the opportunity. This may include a legal inability (such as antirust laws), a

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refusal by the offeror to deal with the corporation, or financial inability on the part of the corporation (financial inability is very controversial, most cts. do not recognize it)

i. Strict Approach (ALI) – if the Key Player does not first offer the opportunity to the corporation, and make a full disclosure, his taking of the opportunity is flat-out wrongful even if the corporation would have been totally unable to take advantage of the opportunity (Maj. view)

ii. Lenient View (Guth v. Loft) – is a “corporate opportunity” only if the opportunity is one the corporation would have been financially able to undertake. (Min. view…outdated)

4. Combination of “Line of Business” + “Fairness” Test – under this test even if the opportunity comes within the corporation’s line of business the officer will not be liable for taking advantage of the opportunity if he can show his conduct was fair to the corporation. (Miller v. Miller)

iii. ALI §5.05 Taking of Corporate Opportunities by Directors or Senior Executives1. General rule. A director…may not take advantage of a corporate opportunity

unless;a. He/she first offers the opportunity to the corporation and makes disclosure

concerning the conflict of interest and the corporate opportunity;b. The corporate opportunity is rejected by the corporation, and;c. Either:

i. The rejection of the opportunity is fair to the corporation;ii. The opportunity is rejected in advance (following disclosure) by a

disinterested majority of directors…in a manner that satisfies the std. of the BJ rule; or

iii. The rejection is authorized in advance, or ratified following such disclosure, by disinterested shareholders, and rejection is not equivalent to a waste of corporate assets.

2. Northeast Harbor Golf Club, Inc. v. Harris – ME S.Ct. rejected line of business and fairness tests and applied the ALI test to hold that Harris should have first offered the opportunity to purchase the property to the club (of which she was president) rather than purchasing the property herself prior to disclosure. This case represents the modern trend, and also that the DE approach (interest/expectancy) can be incorporated into the ALI approach.

iv. Other – this doctrine can also arise in a parent-subsidiary corporation context. If a parent decides to take a business opportunity for itself rather than offer it to its subsidiary, and the opportunity is deemed be more closely related to the subsidiary’s present or contemplated business than the parent’s, the ct. will most likely find the parent has violated their fiduciary obligation to the subsidiary.

v. Remedies granted:

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1. Constructive Trust – the property is treated as if owned by the corporation that lost the opportunity

2. Lost Profits – corporation that lost opportunity is entitled to any profits it would have received had it been allowed to partake of the opportunity (most often ’s profits are awarded)

CAPITAL STRUCTURE AND PROJECTIONS – Textual Disclosure

- state law duty of care focuses on providing compensation for investors after they have been injured; federal law focuses on deterring misconduct through the enforcement of a mandatory disclosure system.

I. Item 303: Management’s Discussion & Analysis (“MD&A”)

a. Generally , Item 303(a) requires discussion of a registrant’s financial condition, changes in financial condition and results of operations w/ respect to liquidity, capital resources and results of operation. Registrant shall also provide any other such information deemed necessary to understand the company’s financial condition, changes in financial condition, etc.

b. Purpose is to avoid ugly surprises in that it requires corporate managers to give investors a “big picture” overview of their corporation. Only becomes an issue when company has been “less than candid”.

i. Item 303(a)(1) Liquidity: Identify any known trends or any known demands, commitments, events or uncertainties that will result in or are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way. If a material deficiency is identified, indicate the course of action the registrant has taken or proposes to take to remedy the deficiency. Also identify and separately describe internal and external sources of liquidity; and briefly discuss any material unused sources of liquid assets.

ii. Item 303(a)(2) Capital Reserves: Describe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations

iii. Instruction 7 to Item 303(a) distinguishes mandatory forward looking disclosures from the voluntary disclosure that are encouraged by Item 10(b)

1. Registrants are encouraged but not required to supply forward looking information. This is to be distinguished from presently known data that will impact future results…which may be required to be disclosed.

iv. Flynn v. Bass Bros. Enter. Inc. – brought suit alleging ’s failed to disclose material information in conjunction w/ a tender offer as required by SEC Rule 10(b)

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(5). Issue was whether or not certain projection valuation reports should have been disclosed, Ct. held that had not advanced evidence to show that they would have relied on the reports, had they been available.

1. Case for Mandatory Projections:a. If prepared by management for internal use are material facts for investorsb. Permissive system might result in only favorable projections being

disclosedc. Fact that a firm has trouble making a projection tells a lot about the quality

of its management2. Case for Permissive Projections:

a. Requires disclosure of competitively advantageous informationb. Preparation expenses may be greatc. Mandatory system would expose firms to increased risk of litigationd. In new firms or with firms entering new fields there might be insufficient

data to make projections

II. Reg. S-K Item 10(b): Projections, under this rule are encouraged but not required

a. Rule 175(c) provides a safe harbor for forward looking information about:i. Revenues, income(loss), earnings (loss) per share, capital expenditures, dividends,

capital structure or other financial itemsii. Management plans and objective for future operations

iii. A statement of future management economic performance contained in item 303 (MD&A)

iv. Underlying assumptions of any of the above

b. Rule does require that :i. management have a reasonable basis for their assessment of future performance

ii. that the choice of items projected are not susceptible to misleading inferencesiii. with respect to previously issued projections there is a responsibility to make full and

prompt disclosure of material facts both favorable and unfavorable, regarding the company’s financial condition.

iv. Rule 175 – Safe Harbor Provision provides: “A statement made within the coverage of paragraph (b)…which is made by or on behalf of an issuer…shall not be deemed to be a fraudulent statement, unless it is shown that such a statement was made or reaffirmed without a reasonable basis or was disclosed in other than good faith.”

1. Wieglos v. Commonwealth Edison Co. – CE prospectus grossly underestimated the cost/time of getting their new power plant up and running. The Ct. held that the has the burden of showing that the prospectus projections were not made on a reasonable basis, an that in this case CE’s misstatements were protected under the safe harbor provision. The ct. acknowledged that the nuclear power business itself is difficult to estimate and that most consumers knew this which kept the potential for damage small.

III.Securities Act § 27Aa. § 27A: applies to forward looking statements made by the corporation

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i. an issuer, at the time that the statement is made, is subject to the reporting requirements of section 13(a) or section 15(d) of the SEC Act of 1934

ii. a person acting on behalf of such issueriii. an outside reviewer retained by such issuer making a statement on behalf of such issueriv. an underwriter w/ respect to the information provided by such issuer or information

derived from information provided by the issuer.

b. § 27A(b) Exclusions:i. if w/ in 3 yrs. of when statement was made, no violation if

1. was convicted of felony misdemeanor2. statement has been subject of administrative/judicial decree, etc.

ii. statement was made in connection w/ offering of securities by blank check company,…iii. statement is made in connection w/ a private transaction (& many others…see

supplement)

c. § 27A(c) provides 3 safe harbor provisions:i. a deliberately false forward looking statement may be immunized if the ct. concludes

it was accompanied by meaningful cautionary statements. (codification of bespeaks caution doctrine)

ii. if cannot offer and prove sufficient meaningful cautionary statements b/c a is required to prove a higher culpability standard “actual knowledge” rather than the lower recklessness standard available today under § 10(b) and rule 14a-9

iii. there is a novel safe harbor for oral forward looking statements when appropriate reference is made to a readily available written document

SHAREHOLDER VOTING RIGHTS

a. Federal Corporate law has 3 primary techniques to deter dysfunction:i. Fiduciary duty litigation

ii. Mandatory system of disclosure and fraud litigationiii. Electoral rights (weakest)

b. State Corporate law operates on assumptions of nondemocratic restraints:i. By laws against fraud and unfairness

ii. Shareholder’s ability to sell their shares in a stock market, iii. By holding stock in a portfolio (diversification)

c. Four major theories of shareholder voting in corporate law:

i. Minority representation – attempts to ensure that even minority shareholders can elect some representatives the to corporate bd.

1. mandatory cumulative voting – voting occurs in “blocs”, only six states use this today

2. permissive cumulative voting – Bd. is broken up into several “classes” with only one class up for election each year. DE has a system like this (DGCL §214)

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ii. Consent of the governed – argues that shareholders are essentially “voiceless” under the traditional system and that all of those w/ sufficient intimacy w/ the corporation should be considered “members” (Ex., employees). Very popular abroad but problems include:

1. unenthusiasm of labor2. difficulty determining “who” the governed are

iii. Contractarianism – argues for the adoption of any vote pattern negotiated by shareholders and managers. Underlying this approach are:

1. corporate elections are difference then political elections due to the mandatory disclosure requirements

2. votes should be subordinated to financial decisions of the corporation3. perpetuation of main impetus behind contract theory…managers negotiating with

labor and capital suppliers

iv. Relational Investment – focus on institutional investors, institutions themselves should maintain control. In practice, especially w/ large corporations the ability of institutions to assert any kind of influence is doubtful.

d. Corporate formalities relating to shareholder voting:- DGCL §211(b) annual meeting to elect directors- DGCL §211(d) special meeting may be called by Bd.- DGCL §212(a) one common share = one vote; unless certificate of incorporation

provides otherwise- DGCL §216 majority quorum, majority quorum rules, unless certificate of

incorporation provides otherwise- DGCL §212(b) most votes are by proxy in large publicly traded corporations;

proxies in DE are valid for up to three years.

e. Proxy Contests – any competition between two competing factions to obtain shareholder votes for a proposal

i. Generally – most proxy contests involve the election of directorsii. Purpose – the insurgent faction hopes to end up in operating control of the target,

whether by owning a majority of the shares or by merely obtaining a majority of Bd. seats.

1. Wall Street Rule – explains most proxy contests fail b/c shareholders vote in favor of current management; and if they are dissatisfied with management then they will usually sell their shares.

2. If the insurgent group is unsuccessful they are left with nothing except a great expense, whereas an unsuccessful tender offeror has usually built up a sizable minority stake in the company that they cal sell back to the company or to a “white knight” acquirer

iii. Regulation of proxy contests1. Management has 3 advantages: (1) stockholders tend to vote for management;

(2) management can use corporate funds to pay for its side of the contest; and

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(3) management knows who the shareholders are whereas the insurgents will usually have to litigate to get access to the shareholder list

2. SEC rule 14a-7 requires management to provide to insurgents the # of stockholders, # of beneficial owners, and mailing costs but are under no obligation to disclose a list of names/addresses (although some state laws may require this)

iv. Costs – can reach into the millions1. Management’s expenses – corporation will pay “bare bones” of what is

necessary for both sides to comply with SEC regulations, however all other costs much be met by each side

2. Rosenfeld v. Fairchild Engine and Airplane Corp. – Insurgent won proxy contest and then sough reimbursement. The Ct. held that as long as the contest involves economic or policy issues, and not just issues of a desire to seize control a decision of a newly appointed Bd. to approve reimbursement of the insurgent’s expenses is allowable as long as

a. The contest involved policy and was not just a mere power struggle, andb. The stockholders approve the reimbursement

b. Disenfranchisement- the huge amount of tender offers in the 1980s led to the NYSE proposal to abandon

its policy of “one share, one vote”- In 1988 instead of adopting the NYSE proposal the SEC adopted rule 19c-4 which

prohibited a listed firm from adopting disparate voting rights through amendment of its certificate of incorporation or dividends, however it did not prohibit new firms or leveraged buyouts from creating two-tiered voting plans

- In 1990 rule 19c-4 was vacated in Business Roundtable v. SEC as exceeding SEC authority, but the substance of the rule continues to exist in Stock Exchange listing standards

c. SEC Rule 14a-8- this rule applies only to corporations covered under §12 and Rule 12g-1 of the

Securities Exchange Act, this includes listed securities, a national securities exchange, or securities traded in the OTC market with 500 or more holder of a class of stock and $10 million in total assets. (Roughly 13,000 exist today)

- Rule 14a-8 allows a shareholder to circulate a proposal for action on issues (other than director nominations) is the shareholder can satisfy the eligibility requirements of the rule, and it is not included in any of the exclusions.

CLOSE CORPORATIONS

I. Close Corporations

A. The MA Definition & Rule – Donahue v. Rodd

i. Facts: , a minority stockholder, found of majority holders were able to purchase the ’s 36,000 shares. She would have liked an opportunity to sell her shares at the same

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(generous) price. did not find out about ’s sale until afterwards at a stockholder’s meeting. She refused to ratify the action and then attempted to offer her shares to the company on the same terms the had. The company told her they would not purchase the shares and she brought suit.

ii. Definition: Ct’s definition of a close corporation:1. small number of stockholders2. no ready market for the corporate stock (stocks are not liquid in that they are

not sold on the open market thus there is no ready purchaser)3. Substantial majority stockholder participation in the mgmt., direction, and

operations of the company

iii. Holding: Ct held that in a close corporation, when an offer to buy stock is made, there must always be an “equal offer” made to all shareholders (majority & minority)

1. Std. in public corporations is a “fair price” offer, given the unequal situation between maj. and min. shareholders in a close corporation an “equal offer” is more appropriate

2. this bright line std. benefits min, shareholder by making it easier for them to bring suit all they need to prove is (1) offer was made to maj. shareholders, and (2) equal offer was not made to them

3. this requirement arises out of the heightened duty of loyalty that exists on the part of maj. holders to min. holders in a close corporation

a. Ct. noted min. holders in close corporations are especially vulnerable to freeze-outs (attempts to push them out by maj. holders)

B. Expansion of MA “Equal Offer” holding – Wilkes v. Springside Nursing Home

i. Facts/Issue: 4 men organized a nursing home together when bad blood developed between 2 of them. Q became a dominant shareholder and after a dispute over a property transaction he had the ’s salary cut off and he was not re-elected to the Bd., dramatically reducing the value of ’s stock. brought suit. B/c there was no offer/sale of stock involved the issue was how to apply the Donahue std. Ct. developed a 2 –part test:

ii. Holding: In determining liability Ct. must ask:1. Is there a legitimate business purpose for the action taken by the majority?2. If there is a legitimate purpose could that same objective have been carried

out via a less harmful means to the minority?a. could not meet burden of showing a legitimate interestb. in the case where a legitimate interest can be proven it is often the case the

less harmful means is repurchase of the minority holder’s shares.

C. The DE Definition & Rule – DGCL §341(a):

i. Under §341(a) the ptys. must elect to be a close corporation. §342 lists 3 eligibility requirements:

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1. Fewer than 30 shareholders2. Section 202 share restriction 3. No public offering

a. The share restriction is this is typical, a lengthy buy/sell restriction which allows for sale only at death or retirement and then is highly detailed in the manner in which the stock must be offered. Most difficult issue in dealing w/ a share restriction is determining how to value the shares now to be transferred at a future time. (original/book price, appraisal, etc.)

b. §202 (a) requires conspicuous notice of share restrictions, and §202(c) governs appropriate restrictive provisions:i. prior opp. to corporation, other holders or any other person to buy

ii. obligation to the corporation, other holders or other persons to buyiii. corporation/other holders must consent to transferiv. prohibition of transfer to designated persons is allowed if such

designation is not unreasonablec. Although MA contains no express requirement for share restrictions in

practice most close corporations will have them…it is how corporation is kept “close”

II. Mechanisms for Concentrating Voting Control

A. Voting Agreements

i. Stock-Pooling Agreements – generally enforceable through an irrevocable proxy couple w/ an interest (confidence of s/h), or sometime by specific performance if partial performance has occurred

1. Ringling, Lower Ct. decision – Ringling (315), Hayley (315) and North (370) held stock in Ringling Corp. and entered into an agreement to submit all “disagreements” to an arbitrator who would then decide how to vote and cast the votes for the ptys. Ringling and Hayley had a disagreement which they submitted to the arbitrator but then Hayley refused to follow the arbitrator’s direction. Ringling sued.

a. At issue was whether or not the agreement was enforceable the Ct. said yes, and ordered specific performance. The ’s argument that the arbitrator had no “beneficial interest” and thus cannot cast the vote fail b/c the fact that the arbitrator is designated by the ptys, gives him their confidence as an interest.

2. Ringling ,Upper Ct. Decision (RULE) – The DE S.Ct. reversed on the grounds that specific performance could not be ordered absent an indication on either party that the arbitrator’s decision should be enforced.

a. The Ct. determined the agreement to be valid, it was not a disguised voting trust and thus should not be held illegal for the failure to meet statutory requirements

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b. Since Haley breached the contract by refusing to follow the directions of the arbitrator he votes should not be counted. (This is phyrric victory for b/c she was still outvoted by North).

ii. Voting Trusts

1. DGCL §218 Voting Trusts an Other Voting Agreementsa. §218(a) the beneficial owner(s) vest voting power in a designated trustee.

Must be written, filed w/ Sec. of State, and open for inspectionb. §218(d) provides that §218 does not invalidate any other voting agreements

(it is not exclusive)

B. Deadlock Avoidance and Dissolution

i. Generally – a Ct. can order dissolution as a remedy for deadlock; powerful remedy as it allows minority shareholders to cash in on their investment, however it is not an automatic right, even if the statutory requirements are met it is still a matter of strict judicial discretion.

ii. Kemp v. Beatley – Retired ’s owned 20.33% of corporation’s stock were informed they would not receive their “extra compensation bonuses” which up until then had been std. company procedure. The policy was changed (purposefully to exclude ’s) to only apply to employees. brought suit under §1104(a) of N.Y. Bus. Corp. Act which is available to stockholders owning more than 20% of shares of a not publicly traded firm, and permits dissolution for “oppressive actions”

1. “oppressive conduct” – conduct that substantially defeats reasonable expectations of minority shareholders in committing their capital to a particular enterprise

2. “reasonable expectation” refers to shareholders who reasonably expected that ownership in the corporation would entitled him/her to a job, a share of corporate earnings, a place in corporate mgmt., or some other form of security, would be oppressed when others in the corporation seek to defeat those expectations and there exists no effective means to salvage their investment.

3. purpose underlying statute is to provide protection to the minority shareholder whose reasonable expectation has been frustrated and they have no adequate means of recovery. It should not be allowed as a “coercive tool” thus the minority shareholder whose own acts, made in bad faith and undertaken w/ the goal of involuntary dissolution.

MERGERS

I. Merger Law

A. 19th cent. – Jacksonian hostility towards big business, mergers had 2 requirements1. unanimous or supra-majority votes

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2. appraisal remedy available to all dissenters (could liquidate shares at fair value any time subsequent to merger)

B. Modern Law1. high vote requirements eliminated2. no business size constraints3. shareholders in public corps. protected by ability to sell on open market at any time4. availability of appraisal remedy has been greatly reduced

C. DE Merger Law

1. §251 General Rule for Merger of Equals:a. requires majority vote by shareholders in both firmsb. (b) if shareholder voted against transaction or gave notice of their disapproval

they have the right to seek an appraisal remedyc. (f) exception to voting requirement (unless required in cert. of incorp. No vote

of surviving firms shareholders needed if:i. cert. of incorp. Will not be amended

ii. stock will be identical after mergeriii. no more than 20% of common stock employeriv. §262(b)(1) in this case there is no appraisal right available to the surviving

firm’s shareholders

2. § 253 Rule for Parent/Subsidiary Mergers:a. no vote of surviving corporation’s shareholders (either parent or subsidiary)b. when parent company owns 90% or more of subsidiary there is no right to

appraisal (may still exist for subsidiary shareholders)

3. §262 Appraisal Rightsa. any stockholder that has not voted in favor of merger nor consented in writing

has the right to an appraisalb. no appraisal rights available for

i. shares listed on national security exchange (or other national market), or ii. if stock is held by record of more than 2,000 shareholders, or

iii. if merger did not require shareholder approval

4. §271 Sale/Lease/Exchange of Assetsa. Corp. can sell, lease, exchange at will substantially all of its corporate assets,

however it must be approved by maj. stockholder vote.b. If the sale/lease/exchange is later terminated or abandoned there is no right to

appraisal (or any other action) by stockholdersi. This is unique to DE, most other states allow an appraisal

ii. DE does not allow appraisal for de facto merger either (where company buys stock but not assets of another), this is rare

5. Tender offers – no appraisal right

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a. Right to appraisal only created by a merger of 2 firms

II. The Appraisal Remedy

A. Traditional DE “Block Approach”1. Objective is to give shareholders the value of the stock at the moment before the

merger, thus all factors which might reasonably enter into fixing that value must be taken into account. These include:

a. Market value – never given more than 50% wt., can be reconstructedb. Asset value – use generally accepted accounting principles, not based on book

value2 but rather a current appraisalc. Dividends – only significant when not paid, then “substantial negative

dividend recognition”d. Earnings value – involves averaging last 5 yrs. (or fewer if there were big

variances) and then using a multiplier meant equal the price to the earnings ratio in the relevant industry

e. Anything else that might indicate future prospects of the firm

2. Criticism of traditional approach:a. Highly subjective – trial ct. discretion in assigning wts. Is decisive but rarely

explainedb. Earnings value often unrealistically lowc. Approach reflects a hostility to market values but at the same time creates a

stock market exceptiond. No explicit requirement of revaluation of assets for appraisal e. Appraisal remedy is difficult to commence. Often mergers are structured so

there will be no shareholder vote, also §262 requires written demand of an appraisal prior to vote and a vote against the merger or an abstention

f. Costs of appraisal are uncertain, can be substantialg. Appraisal remedy ignores synergical value in an interested merger b/c §262

provides for “fair value exclusive of any element of value arising out of accomplishment of the merger”

B. Application DE Block Approach – Valuation of Common Stock of Libby, McNeill & Libby (ME S.Ct.) – note this in no longer law in DE, modified by Weinberger

1. Ct. refuses to rely simply on stock mkt. price is b/c given the nature of parent/subsidiary mergers the parent company might have information that will ultimately affect the stock price that is unknown2. Ct. assigned percentages to stock market value (40%), investment value (40%), and

asset value (20%). Ct. affirmed the assigned wts.3. Investment value is determine by valuing average earnings and also looking to

comparable firms and using a multiplier to discount the future to the present4. Asset valuations should be determined by an appraisal rather than relying on book

value, although people do b/c it is free

2 book value is based on original cost and may be more accurate than original price

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C. Modification of the DE Block Rule – Weinberger v. UOP

1. Facts: a. is a minority shareholder at UOP that sued b/c he was unhappy w/ the price

he received for his shares in a cash buy-out ($21). Mkt. price at time was $14.50. Merger was an interested transaction b/c there were directors who sat on the Bd. of both companies. Thus president of UOP (acquiree) has a conflict between his personal interest and his duty of loyalty to his shareholders to get a good price for them

b. Two UOP directors prepared a report for the benefit if the acquiror company, indicating a fair price would be $24, but did not show it to anyone at UOP

c. Outside investment bank was hired to prepare a report for fair price but it was prepared in a limited time period and only based on a limited number of documents. Also showed up at final meeting with a letter “the price of ___ is fair”.

d. Ct. noted that had UOP est. a committee of disinterested directors to oversee the merger and make a decision re: fair price then the duty of loyalty would not have been an issue

2. Court held fairness test involved analysis of both fair dealing & fair price:a. Fair dealing is determined by examining:

i. Looking at time constraints imposed on transactionii. Availability of information

iii. Structure of transactionb. Court changed the method for proving fair price:

i. Can still use DE block methodii. You can add other techniques as long as they are accepted by the financial

community as reliable: if you use a discounted cash flow model you do not need to use earnings value or investment value

c. Ct. rejected business purpose test as a means for determining if the merger was fair (overruled Singer v. Magnavox)

3. 5 Principal Holdings of Weinbergera. Reaffirms burden of persuasion rules for the duty of loyalty. has burden of

showing conflict of interest. Then has burden to prove fairness, unless transaction has been approved by a maj. of disinterested stockholders. Then has burden to prove unfairness

b. Fairness = fair dealing & fair pricec. Appraisal remedy (DE Block approach) is broadenedd. Business purpose test is dropped in DEe. Merger can now be enjoined on a series of grounds –duty of loyalty violations,

fraud, waste.i. Rabkin v. Hunt Chem Corp. – reaffirmed holding #5 where corporation was

merged subject to a condition to buy future shares at $25, but then later purchased those shares at $20. The Ct. enjoined the merger b/c one “cannot indirectly achieve what one is directly prohibited of doing”.

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TENDER OFFERS

I. State Corporate Law

A. Evolution of the Basic Rule – Substantial Threat to Corp. Existence, Cheff v. Mathesi. , Holland’s CEO believed Meremont sought to take control of their company and

either liquidate it or eliminate their retail sales force based on the increased trading activity on the mkt. and his past behavior. Holland purchased its own stock in an attempt to stave off acquisition by Maremont and Holland’s shareholders brought suit alleging the Dirs. purchased their own stock for the purpose of perpetuating their own control.

ii. The Ct. held that when Dirs. make a reasonable investigation they can withdraw from shareholders the right to sell their stock to an unsolicited bidder at a premium price if they can show a “threat” to corporate existence.

1. “threat” refers to a threat to the existence of the company, or to the company in its present form

iii. When a target corporation receives an unsolicited tender offer and adopts a defense the burden will be on the Bd. to show there was some kind of threat, that they made a reasonable investigation to the threat, and they acted rationally

1. reasonable investigation means you need to at least hire an outside source or conduct a study to establish a reasonable basis for rejecting the offer.

B. Modification to the Rule, Can Examine effect on constitutents – Unocal Corp. v. Mesa Petroleumi. Mesa made Unocal a two-tier, front loaded offer for 37% at $54 w/ a securities

exchange for the remaining shares supposedly equal to $54 (although it later turned out to be junk bonds). Unocal investigated and determined this and the Bd. adopted a resolution for a defensive self-tender at $72 a share.

ii. The Ct. modified the Cheff rule that in addition to threat to corporate existence a Bd. can examine the impact of such a merger on its constituents

1. constituents are people other than shareholders, i.e. creditors, customers, employees and perhaps even the community generally.

iii. The Ct. also noted that the defensive measure adopted must also pass muster under the BJ Rule.

C. When break-up inevitable, rule changes, Revlon Inc. v. MacAndrewsi. PP made an initial bid of $47.50, Revlon encouraged stockholders to reject the bid,

bid was raised to $53. Revlon begins negotiation w/ “white knight” corporation, who offers to pay $57.25 if lock-up results w/ a no-shop agreement. Revlon accepts the other offer, PP raises offer to $58 and sues

ii. Ct. held that while initial rejection of offer was permissible as it too low once the Bd. of Dir. authorized Revlon to negotiate a leverage buyout w/ the white knight corp. it changed the Bd.’s duties from a defender to an auctioneer. Now the Bd. is required to act as a good-faith auctioneer and their duty to the shareholders is to get them the best price they can get.

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iii. Ct. narrows the Unocal holding that saying that it is ok to look to the effect on constituencies only when it is reasonably related to the benefit of the shareholders, but that it is not permissible to do so when there is an auction in progress (i.e. 2 bids)

D. Expansion of Revlon – Paramount Comm. v. QVC Network, Inc. - and Viacom negotiated a merger, QVC then made a better deal. Viacom matched the bid and re-entered negotiation w/ included a no-shop provision preventing from considering other offers. shareholders brought suit. Ct. held:i. Revlon is triggered when:

1. break-up of company becomes inevitable, or2. when there is a change in control – either power of decision-making is gone, or

there potential shift of control as a result of proposed transactionii. Target Bd. duty once Revlon is triggered is to maximize shareholder value and

actions will be judged under enhanced judicial scrutiny which is a higher standard than the BJ Rule. This is the more exacting std. that is associated with the duty of loyalty.

1. under enhanced scrutiny no-shop, termination, and stock option provisions were invalid and unenforceable to the extent they prevented/limited the Dirs. from carrying out their fiduciary duties.

iii. Lock-ups are allowed to the extent they have the potential to maximize shareholder value, but if they are made in an attempt to end the deal/offer then they are illegal.

FEDERAL PROXY FRAUD

I. §14(a) and Rule 14(a)-9

A. §14(a) gives the SEC the right to set proxy solicitation rules, it is a regulatory scheme designed to protect investors.i. It shall be unlawful for any person, by use of the mails…or any other instrumentality

of interstate commerce…to solicit or to permit the use of his name to solicit any proxy or consent or authorization in respect to any security registered under §12 of this title.

1. securities register under §12 include companies that are req. to file 10-K; that is the company’ stock is traded on a national securities exchange, or the company has at least 5 million in assets and the class of stock in question is held by at least 500 record owners

B. The regulatory pattern set out in §14 is governed by rule 14(a)-9i. No solicitation subject to this regulation shall be made by means of and proxy

statement (or form thereof)…which at the time and in light of the circumstances under which it is made, is false or misleading w/ respect to

1. any material fact, or which omits to state any material fact necessary in order to make the statement therein not false or

2. misleading or necessary to correct any statement in an earlier communicationii. The subsequent Note provides examples of what may be misleading:

1. predictions as to specific future market values

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2. material that directly/indirectly impugns personal reputation or makes charges concerning improper conduct, without factual foundation

3. failure to identify a proxy statement as to distinguish it from the material of any other person soliciting for the same subject matter

4. claims made prior to a meeting regarding the results of solicitation.

II. Implied Cause of Action – J.I. Case Co. v. BorakA. , minority shareholders in Case Co. sued to enjoin a proposed merger between Case and

ATC. claimed Case’s mgmt. Had engaged in self-dealing, the merger was unfair, and that the proxy materials were false and misleading in that they did not disclose the true facts about the merger and its value to shareholders.

B. Rule 14a-9 does not expressly provide a private cause of action, S.Ct. held that such a right should be implied for private stockholdersi. Purpose of §14a is to prevent mgmt. From obtaining authorization for corporate

action by means of deceptive/inadequate disclosure in a proxy solicitationii. SEC does not have time/resources to investigate every proxy statement field with it

thus implied cause of action is necessaryiii. Valuable deterrent based on fact that there are now 2 potential s, SEC and private

investorC. Ct. refused to limit a implied right to prospective relief b/c federal courts should be

capable of providing both declaratory and injunctive relief, and given the differences in state law schemes a victim may need to bring separate suits in order to get the relief they want.

III.Causation

A. ’s Burden of Proof - Mills v. Electric Auto-Lite Co.i. was shareholder in Electric Auto-Lite, Merganthaler already owned 50% of the

stock, and was in control of Auto’s day to day affairs. Auto sent out proxy materials asking for the approval of a merger w/ Merganthaler which stated that the directors approved the merger but did not disclose that these directors were all Merganthaler nominees.

ii. argued that b/c the price of the merger was fair should have to show that, had the omitted information been supplied enough minority shareholders would have changed their votes blocking the merger.

iii. S.Ct. instead held that all the needs to show is that the material omission/misrepresentation in the proxy solicitation itself, rather than the defect, was an essential link in the contemplation of the transaction then the causal relationship between the injury and the violation has been established

1. i.e., all needs to show is that merger could not have been carried out without the submission of proxy materials to the minority shareholders

2. This dramatically eases ’s burden of proving causation

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B. If Minority Shareholder’s votes not required for merger to go through, cannot recover for proxy misstatements – VA Bankshares Inc. v. Sandbergi. FABI held 85% of shares of Bank and wanted to get rid of 15% of the public

shareholders, thus the 2 Bds. entered into a merger agreement. FABI hired an investment bank that came up w/ $42 as a fair price, and Bank agreed to the merger. Even though proxy solicitation is not necessary under federal law FABI prepared one anyway, most likely to maintain goodwill of minority shareholders, solicitation described merger price as “high” and “fair”. Minority shareholder who abstained from voting brought suit asserting price were worth at least $60.

ii. Ct. held no private recovery for proxy misstatements available to minority shareholders when their vote was not required by law to authorize the transaction

1. otherwise could lead to lots of litigation based on “speculative claims and procedural intractability” – not the intent of Congress with 14a-9

2. Dissent argued that as long as proxy solicitation is an essential link in the transaction recovery should be allowed. Here b/c Bank chose to get minority approval it should be enough to make it an essential link.

iii. Ct. refused to address issue of whether a in such a situation, who votes to block a transaction, may recovery b/c the misstatement induced them to surrender a state-law right, such as a right to an appraisal.

IV. Materiality – same law of materiality applies to rule 14a-9 and 10b-5

A. The Basic Std. – TSC Indus. v. Northway Inc.i. National owned 34% of TSC, there were 10 National indiv. on the Bd. of TSC. Later

a merger transaction was confirmed between the 2 under which TSC would be liquidated and sold to National. A joint proxy statement was issues and then challenged for violating rule 14a-9, it did not disclose the titled of officers.

ii. Ct. of appeals used “easy” std. to determine materiality, material facts include all information which a reasonable shareholder might consider important.

1. Ct. rejected this std. b/c it is too suggestive of a mere possibility and could lead to burying the shareholder in an avalanche of trivial info in proxy statements

iii. Higher std. was material fact is one which would have changed the way a shareholder voted.

1. Ct. rejected this std. b/c it is too hard to satisfy, essentially equivalent to Mills, which Ct. would have had to overrule

iv. Ct. chose middle ground and defined a material fact as “when there is a substantial likelihood that a reasonable shareholder would consider the fact important in deciding how to vote”…i.e. there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of the information made available.

1. ultimately Ct. held omission of titles was not material but rather trivial, if had failed to disclose control of the company itself, or that the merger was interested, that would have been material

2. materiality is a mixed question of fact/law that often has to go to the jury (although here Ct. makes determination)

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v. Accountants are the people who decide whether or not a fact should be disclosed, they use the following rules of thumb:

1. if misstatement or omission that involved more than 10% of assets of a firm, gross income, or stock price it must be disclosed

2. if less than 5% it is presumptively immaterial3. Over time SEC has strengthened these guidelines

a. Uses 5% as materiality stdb. Facts may be material even if below quantative std., such as criminality or

breach of fiduciary duty…these must always be disclosed

B. Contingent Events, Forward Looking Statements – Basic Inc. v. Levinsoni. Combustion officers met with Dirs. of Basic to discuss merger negotiations on several

different occasions and three times denied that there were any discussion of merger negotiations going on. Subsequently, a merger was announced. brought suit based on misleading public statements issued by under rule 10b-5

ii. S.Ct. explicitly adopted TSC std. of materiality for rule 10b-5 cases.1. Agreement in Principle test is rejected

a. This stated that preliminary premerger negotiations do not become material until an “agreement in principle” as to the price and structure of the transaction is reached. 3 rationales

b. Investors need to be overwhelmed by excessively detailed infoc. Helps preserve confidentiality of merger discussionsd. Provides bright line rule for when disclosure must be made

2. Ct. rejects test reasoning:a. Investors are not nitwits and thus will be able to appreciate the fact that

mergers are risky businessb. Secrecy is secrecy to price, not secrecy that there are ongoing negotiationsc. Ease of application of a bright line rule is no excuse to ignore the purposes

of Congress in the Securities Actiii. S.Ct. has held that if a corporation wants not disclose merger negotiations and avoid

liability they can say “no comment” when asked.iv. Ct. noted in fn. this case does not address other kinds of contingent/speculative info

such as earnings forecasts or projections.

C. Reasons, Opinions, Beliefs – VA Bankshares Inc. v. Sandbergi. Ct. held statements of reasons can be material as long as they are used in conjunction

with an express or implied statement of fact.1. alleged “high”, “fair” price was misleading as it was not a high price, and that

the statement was only made so the Dirs. could maintain their positions2. S.Ct. held the statement of the Bd. was misleading in that it was recommending

the merger for a different reason that why they actually wanted it to go through. ii. Thus has to show (1) disbelief, undisclosed motivation and (2) proof of objective

evidence that statement also asserted something misleading (either expressly or impliedly) about its subject matter.

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1. satisfied that burden here (1) directors but forth a misleading reason as to why they though merger should go through, and (2) the price in fact was not high ($42) as there was evidence the stock was worth as much as $60.

D. The “BeSpeaks Caution” Doctrine (addresses use of cautionary language as an attempt to render misstatements non-actionable)i. Under the doctrine a false statement is not material if it is accompanied by cautionary

language in the relevant corporate document. There are 2 limitations (Trump case):1. Limited only to forward looking statements, will not insulate from liability any

false/misrepresented historical fact2. use of vague/boilerplate language does not suffice to mitigate the effect of a

false statement to non-actionable3. Unaddressed by Trump is possible 3rd limitation: a cautionary statement found

in a risk factor or disclaimer should be given no weight if ’s were/should have been aware of a prospective material omission and chose not to disclose it. Doctrine should not be a means for to obscure/misrepresent bad news.

INSIDER TRADING

I. Policy Arguments

A. Arguments in Favor of Regulation1. Equity – all investors should have equal, or roughly equal, access to new material

information2. Allocative Efficiency (Incentives for research) – better achieved through a

mandatory disclosure system. To allow the opposite creates moral hazards: delays in publishing info., manipulation of info., subversion of duty of loyalty by creating the opportunity to profits from adverse corporate events, mgmt. May be more prone to adopt riskier business ventures than is wise

3. Property rights - confidential business information has been long recognized as property (Carpenter)

B. Arguments Against Regulation1. Compensation to Insiders – this fails b/c: there are other forms of compensation

available, it allows profit for unsuccessful corporate performance, trading cannot be limited to only entrepreneurs

2. Stock Price Smoothing – it is unclear that insider trading will have a significant impact on stock prices the way new info. About a firm would

3. Private ordering – firms themselves do not outlaw it b/c portfolio theory provides adequate protection to shareholders and collective action among businesses is difficult

II. §10(b) and Rule 10(b)-5

A. §10(b) Regulation of the Use of manipulative Devices

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1. It shall be unlawful for any person, directly or indirectly, by the means of any instrumentality of interstate commerce or the mails, or any facility of any national security exchange, to

2. use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device in contravention of such rules and regulations as the SEC may prescribe…

B. Rule 10(b)-5: It shall be unlawful for any person, directly or indirectly, any the use of any means or instrumentality of interstate commerce or the mails, or any facility of the national security exchange,1. to employ any device, scheme, or artifice to defraud2. to make any untrue statements of material fact or to omit to state a material fact

necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or

3. to engage in any act, practice, or course if business which operates, or which would operate as a fraud or deceit upon any person.

III.The “Disclosure or Abstain” Rule – an insider w/ material information must either disclose it to the public or abstain from trading in the stockA. SEC v. Texas Gulf Sulphur

1. TGS has been looking for minerals in NE Canada for years. In Nov. 1963 initial tests showed a higher concentration of minerals than ever before. From Nov. to Feb. 1964 TGS stopped drilling in order to keep its find confidential

a. During this period various employees bought shares and “calls” (options to buy),

b. TGS issued stock options to high-level employees who knew about the find.2. Drilling resumed in March w/ favorable results. On April 12 TGS issued a press

release dispelling rumors of a significant find saying they are “exaggerated”. Then on April 16 TGS made a final announcement disclosing the find

a. During this time employees brought stock.b. Overall stock price jumped from $17 to $36

3. SEC brought suit against employees who had traded w/ knowledge, and also against TGS for issuing false press release.

4. Ct. adopted “disclose or abstain” rule urged by the SEC that insiders w/ material non-public information must choose between disclosing it to the public or abstaining from trading in the stock.

a. Ct. adopted materiality std. from Basic, “information to which a reasonable man would attach importance in determining his choice of action in the transaction in question”

b. Information must be “material, non-public” this includes info covered by mandatory disclosure rules, there is a duty to correct prior material statements, and disclosure of important developments, while not required, is encouraged by the SEC.

c. Information must be widely disseminated in order to have the effect of a full disclosure

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d. Receipt of stock options is a form of insider tradinge. TGS itself violated 10(b)-5 in its failure to use due diligence is preparing its

new release. The mere fact that it was so general at the time when the company had much more info available to it is enough to make it “misleading”

5. Ct. required all ’s to disgorge their profits to be put in a fund to pay dmgs. to outside investors injured by the insider trading. They were also required to pay the profits any of their “tippees” (outsiders aware of drilling from insiders). Any sums not paid out over remaining 5 yrs. were to go back to company

IV. Requirements for a 10(b)-5 SuitA. Standing - must be a purchaser or seller of the company’s stock during the time of

non-disclosure. (Blue Chips)B. Scienter - must have acted w/ scienter, i.e. the intent to deceive, manipulate or defraud.

(Ernst)C. Reliance - must show he relied on ’s misstatement – in the case of omission this is

presumed…thus reliance only becomes an issue in a material misstatement case. (Basic)D. Duty - must be shown to have some come of relationship w/ the issuer of the

information, usually based on some kind of fiduciary duty, only an issue in material omission cases

E. Causation – fraud must be “in connection with” a securities trade.

V. Standing – purchaser or seller requirementA. Blue Chip Stamps v. Manor Drug Stores –

1. Blue Chip agreed to settle an antitrust claim by offering shares of its stock to certain retailers that had previously used the company’s stamp service. Stock offer was favorable, esp. b/c they were offered low but had the potential for high resale. Retailers who had not chosen to purchase shares brought suit alleging that Blue Chip made the prospectus misleadingly pessimistic to induce them not to buy.

2. S.Ct. interpreted language in rule 10b-5 “in connection with the purchase or sale of security” to mean that the must have been an actual purchaser or seller of shares. This affirmed the lower cts. Birnbaum rule. To allow otherwise would result in vexatious litigation b/c:

a. If anyone who declined to buy stock based on a misleadingly negative prospectus had standing to sue then a large number of suits could be brought that may stand no chance at trial but would still force the to settle to prevent the high costs of going to trial, also

b. proof that the relied on the stock would almost always depend on the ’s uncorroborated testimony, it would be difficult to distinguish those who are sincere from those who are not

3. Practical ruling of case is small, most ’s are buyers/sellers, the groups excluded would be:

a. Potential purchasers who don’t buy (as here) this is rare b/c usually the company make its shares out to be a more, not less, favorable investment

b. Non-sellers – similar to above, except based on a misleadingly optimistic prospectus

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c. Those who have suffered a loss of investment value due to insider trading – unfortunately these people are negatively affected, however they may have other remedies available.

d. “fire and brimstone” language is important b/c it put everyone on notice the S.Ct. was going to hold securities suits to higher stds., also supported Private Securities Reform Act of 1995 which enacted new procedural restrictions on securities litigation.

VI. ScienterA. Ernst & Ernst v. Hochfelder - will only be liable if he acted w/ intent to deceive,

manipulate or defraud.1. Ernst was an accounting firm that audited the books of First Sec., whose president

had been carrying out fraud for a number of years. Ernst failed to discover the fraud but there was no evidence of their intent to deceive, brought suit based on the fact they “aided and abetted” the president’s 10b-5 violation

a. “aiding and abetting” is no longer a cause of action in 10b-5 suit – Central Bank of Denver

2. Ct. held a showing of scienter is necessary in any 10b-5 action, and defined it as any intent to deceive, manipulate or defraud including:

a. Making a false statement knowing it to be falseb. Making a statement without any belief knowledge of whether it is true or notc. Making a statement that a fact is true regardless of whether or not you know it

to be trued. Recklessness has also been considered scienter (S.Ct. has not expressly stated so

but most lower cts. have helde. Negligence is not enough

3. Modern culpability stds.:a. Intent to defraud – always sufficesb. Negligence – never sufficesc. For historical statements recklessness will suffice

(bespeaks caution)d. Forward looking statements recklessness will not suffice

VII. Reliance – only an issue in material misrepresentations casesA. Basic Inc. v. Levsinson

1. Fraud on the Mkt. Theory – Most important way and can show that they relied on ’s misrepresentation. Under this theory the mtk. price of stock reflects all publicly known information, and when one relies on that fair price. When makes their misrepresentation they change that price, thus when buys/sells at that price they are affected by the ’s wrongdoing.

2. The S.Ct. accepted this theory holding that an affirmative misrepresentation by the creates a rebuttable presumption of reliance for the . The can only rebut that presumption if they can show that the mkt. was aware the was lying (hardly ever).

3. in cases of material omissions reliance is not an issue b/c all that is necessary to show is that a reasonable investor would have considered the withheld information material.

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VIII. Duty – only an issue in material omission casesA. Generally – w/ respect to rule 10b-5 there are several theories that can be advanced

1. Classical insiders – i.e. people w/ a duty to disclose, Chiarella, Cady2. Constructive insiders – defined by Dirks fn.143. Derivative Tippee Liability - Under some circumstances tippees and tippers can

be held liable when the tipper violates a fiduciary duty and the tippee trades knowing that person who gave them their information violated a fiduciary duty Dirks

4. Misappropriation Theory – O’Hagan

B. Chiarella v. U.S. – classical insiders (defined in Cady as officers, directors, controlling stockholders w/ access to material non-public info)

1. was a printer at a company that printed financial documents in connection with takeovers. While the names of the companies were kept blank was able to figure it out by reading the docs, and secretly used this information to buy shares in target corporations.

2. Ct. held was not liable for 10b-5 violation b/c he had no fiduciary duty (i.e. relationship of trust and confidence) with any of the target corporations, therefore he had no duty to disclose or abstain from trading.

a. An alternative theory the govt. tried to argue was that had a duty to his employer, the printing company, who in turn had a duty to its clients, not to disclose. The S.Ct. did not address this theory b/c it was not raised at trial for the jury’s consideration, thus it cannot be raised now.

b. J. Stevens noted duty to employer theory would not be applicable in private litigation b/c Chiarella would have no duty to a shareholder of a target corporation. This issue remained reserved though, for suits brought by the govt.

3. J. Burger advanced a “misappropriation theory”, that a target corporation could bring suit against a person that has misappropriated, but theory as articulated here is very broad, based on duty not to disclose to the world.

C. Dirks v. SEC – defines constructive insiders, derivative tippee liability1. Equity was an ins. company involved in a massive corruption scheme. Secrist

was an employee who was involved and then fired, b/c he was angry he disclosed the scheme to Dirks. Dirks was in a brokerage firm and passed along info to many clients. SEC brought suit claiming Dirks, as a “tippee”, had violated rule 10(b)-5.

2. S.Ct. held that only tippee’s who knowingly receives information in violation of the tipper’s duty can be liable. But here Secrist did not violate a duty in telling Dirks (b/c he was exposing fraud he received no personal benefit/gain).

a. SEC was arguing for the adoption of a broader rule which the Ct. rejected on the ground it would encompass people who stumble along info on a one time basis.

3. Fn. 14 creates “constructive insider theory”, “under certain circumstances, where corporate information is revealed legitimately to an underwriter, accountant, lawyer, or consultant working for the corporation, these outsiders

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have become fiduciaries to the shareholders”. BIG win for SEC as it creates a whole new category of constructive insiders.

a. Constructive insider theory is not unbounded, If information was received at arm’s length during negotiations then there is no duty imposed. Walton

D. U.S. v. O’Hagan – Misappropriation Theory1. GM was planning secret tender offer for Pillsbury and hired ’s law firm to

represent it. did not work on the deal, he just learned about it. While it was still a secret purchased thousands of shares and call options in target corp.’s stock, made 4.3 million in profit. SEC brought suit.

2. Ct. held 10b-5 liability can be based upon the misappropriation of confidential information from a source other than the issuer - breach of duty is to the source of the info (duty not to disclose) (Pillsbury)

a. Reading supp. by statutory construction of both §10b and 10b-5b. Public policy rationale is to encourage wide participation in securities mkt.

discouraging insider trading does this.3. Disclosure to source of information prior to trading can protect from 10b-5

liability4. by “misappropriating” there must be some kind of deception – simply stealing the

information would not give rise to 10b-5 liability.

IX. Causation – fraud must be “in connection w/ securities trade. A. Std. is proximate cause, must prove loss was a reasonably foreseeable consequence of

’s misconduct.

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Historical Introduction - Washington University in St. …law.wustl.edu/sba/upperlevel/Corporations/Seligman/... · Web viewCorporation – not cheap or simple, must file docs with