wachter corporations 2006

UrkevichWachter—Corporations

Fall 2006

I. Introduction

A. History1. Big Change in corporations began in the 1900s when we began to see separation of

ownership and control.

B. Overarching themes1. Why has the corporate form been so successful?2. Most people put all of their savings in the common stock of corporations or their bonds.

No guaranteed return on C/S. Why do we do it?3. Interplay between state corporation law and the interplay between federal securities law;

in both cases there are statutes and case law4. Very few corporate cases ever go to trial on the merits-- most settle. When you read a

case pay attention to the stage where the case is at (most are on a motion to dismiss on the merits).

5. To get the system to work is to get the directors to be faithful fiduciaries (developing a set of incentives to get there)

II. Agency—Liability of P to 3rd Parties

A. Intro1. Definition: Agency is the fiduciary relationship that arises when one person (a

“principal”) manifests assent to another person (an “agent”) that the agent shall act on the principal’s behalf and subject to the principal’s control, and the agent manifests assent or otherwise consents so to act. (Restatement 3rd of Agency §1.01).

2. General agent : authorized to conduct a series of transactions involving continuity of service.

3. Special agent : agent who is authorized to conduct on a single transaction, or only a series of transactions not involving continuity of service.

B. Actual Authority1. Definition: An agent acts with actual authority when, at the time of taking action that has

legal consequences for the principal, the agent reasonably believes, in accordance with the principal’s manifestations to the agent, that the principal wishes the agent so to act. (Restatement 3rd, §2.01).

a. Example: believe you have actual authority to close the windows in the classroom--- you have been instructed to do so)

2. §3.01- Creation of Actual Authority:a. Actual authority, as defined in § 2.01, is created by a principal’s manifestation to an agent

that, as reasonably understood by the agent, expresses the principal’s assent that the agent take action on the principal’s behalf.

3. Express authority—I tell you to close the windows.4. §2.02- Scope of Actual Authority—Implied Authority (bulk of problems arise here—you

think you have the authority to do it)a. An agent has actual authority to take action designated or implied in the principal’s

manifestations to the agent and acts necessary or incidental to achieving the principal’s objectives, as the agent reasonably understands the principal’s manifestations and objectives when the agent determines how to act.

b. Agent’s interpretation is reasonable, if it reflects any meaning known by the agent to be ascribed to the principal, and in this absence, if a reasonable person in the agent’s

1


Fall 2006

position would interpret the manifestations in light of the context… including the agent’s fiduciary duty to the principal.

c. Incidental authority : (implied authority) authority to do incidental acts that are reasonably necessary to accomplish an actually authorized transaction, or that usually accompany it.

5. Liability—if A is acting with actual authority then P is always liable. A principal becomes liable to a third person as a result of an act or transaction by another, A, on the principal’s behalf if A had actual, apparent, or (traditionally) inherent authority to act on the principal’s behalf in the way that he did, or was an agent by estoppel, or if the principal ratified the act or transaction.

C. Apparent Authority1. Definition : Apparent authority is the power held by an agent or other actor to affect a

principal’s legal relations with third parties when a third party reasonably believes that the actor has authority to act on behalf of the principal and that belief is traceable to the principal’s manifestations. (Restatement 3rd, §2.03).

D. Agency By Estoppel1. Definition: A person who has not made a manifestation that an actor has authority as

an agent and who is not otherwise liable as a party to a transaction purportedly done by the actor on that person’s account is subject to liability to a third party who justifiably is induced to make a detrimental change in position because the transaction is believed to be on the person’s account, if

(1) the person intentionally or carelessly caused such belief, or(2) having notice of such belief that it might induce others to change their positions, the

person did not take reasonable steps to notify them of the facts.

E. Inherent Authority1. Gap filler for where there seems to be authority. Disappears from the third restatement.

Has been incorporated into a broader definition of apparent authority.2. May bind a principal in certain cases even where he agent had neither actual nor

apparent authority.3. Example: if one appoints an agent to conduct a series of transactions over a period of

time, it is fait that he should bear losses which are incurred when such an agent, although without authority to do so, does something which is usually done in connection with the transactions he is employed to conduct.

4. foreseeable that an agent acting in good faith is likely to deviate occasionally from instructions; better that a loss that results from a foreseeable deviation be placed on the principal.

F. Ratification1. Definition: Ratification is the affirmance of a prior act done by another, whereby the act is

given effect as if done by an agent acting with actual authority.2. A person ratifies an act by

(a) manifesting assent that the act shall affect the person’s legal relations, or(b) conduct that justifies a reasonable assumption that the person so consents.

3. Ratification does not occur unless(a) the act is ratifiable as stated in § 4.03,(b) the person ratifying has capacity as stated in § 4.04(c) the ratification is timely as stated in § 4.05, and(d) the ratification encompasses the act in its entirety as stated in § 4.07.

G. Liability of Undisclosed Principal- Morris Oil1. Principal is disclosed when a third party has notice that the agent is acting for a principal

and has notice of the principal’s identity.

2


Fall 2006

2. Paritally disclosed or unidentified when a third party has notice that the agent is acting for a principal, but does not have notice of the principal’s identity.

3. Undisclosed if third party has no notice that the agent is acting for a principal.4. Morris Oil v. Rainbow Oilfield Trucking, Inc.

Dawn owns oilfield trucking business; has contract with Rainbow-- Rainbow is allowed to use the trucking business.

Rainbow is the agent and Dawn is the principal. Rainbow entered into a contract with Morris (3rd party) and accumulated

approximately $25K in debt. Case of agency by ratification. Agreement between Dawn and Rainbow that might or might not give rise to actual or

apparent authority. Section that says Rainbow is not entitled to incur debt other than "in the ordinary course of business."

Apparent authority?---no apparent authority because Morris didn't know of Dawn's existence.

5. Court: Agreement specifically states that Rainbow may create liabilities of Dawn in the ordinary course of business of operating the terminal. Second, recitation of the parties’ contractual documents need not bind third parties who deal with one of them in ignorance of those instructions.

6. Secret instructions or limitations placed upon the authority of an agent must be known to the party dealing with the agent.

7. A principal may be held liable for the unauthorized acts of his agent if the principal ratifies the transaction after acquiring knowledge of the material facts concerning the transaction.

8. Where the principal retains the benefits or proceeds of its business relations with an agent with knowledge of the material facts, the principal is deemed to have ratified the methods employed by the agent in generating the proceeds.

H. Agent’s Duty of Loyalty1. Tarnowski v. Respo (Minn. Sup. Ct. 1952)

П hired D to purchase and negotiate for a business of juke boxes. He purchased the business after he was told about the number and profit making potential of the juke boxes. After the purchase, the buyer realized that the agent had not fully investigated the purpose and the agent had received $2000 from the sell of the business to the principal.

Held: П has a right to recovery of the fee ($2000) and attorney’s fees. Can also recover damages to his business because they are a direct result of the agent’s actions. If the damages had occurred and the agent had not acted wrongfully then the agent would not be liable for damages; however, once you break the duty of loyalty then liability is wide open.

2. § 8.01—General Fiduciary Principle: An agent has a fiduciary duty to act loyally for the principal’s benefit in all matters connected with the agency relationship.

3. § 8.02—Material Benefit Arising Out of Position: An agent has a duty not to acquire a material benefit from a third party in connection with transactions conducted or other actions taken on behalf of the principal or otherwise throught the agent’s use of the agent’s position.

4. § 8.02 Comment Comes down to why willing to put money in common stock. Can rely on reasonable

enforcement of the duty of loyalty. Expectation to receive benefits may stem from the fact that when an agent acts with actual

or apparent authority, the principal risks being bound by transactions that may turn out to be disadvantageous to the principal in some respect.

Another risk is that the agent may believe that no harm will befall the principal, but the agent is not in a position to disinterestedly assess whether harm may occur or whether the principal’s interests would be better served if the agent did not pursue or acquire the benefit from the third party.

5. Reading v. Attorney General (pg. 23)

3


Fall 2006

When A used his position in working for P to obtain money which he received→ the P is entitled to this money

III. Partnership

“Partnership results from contarct, express or implied. If denied it may be proved by the production of some written instrument; by testimony as to some conversation; by circumstantial evidence. If nothing else appear the receipt by the defendant of a share of the profits of a business is enough.” Martin v. Peyton

A. Introduction: Arguments that partnership exists: share in profits; you can be in a partnership if you act

like you’re in a partnership it’s a legal conclusion. If you act as a partner, you can be held to be a partner even if there was no conscious intention to be a partner. Banks get into this problem all of the time. Creditors having difficulty repaying the loan, bank wants to step in and get its money back key question becomes “how much can the bank do to recover its money in terms of participating in its business, involvement in its operations…etc.?”

A business relationship is a partnership when there are two people doing business for profit.

2. RUPA v. UPA(a) UPA § 6(1)—does not define a partnership as an entity(b) A partnership is an association of two or more persons to carry on as co-

owners a business for profit.(c) RUPA § 202—defines a partnership as an entity(d) RUPA § 101(6) “Partnership” means an association of two or more persons to

carry on as co-owners a business for profit formed under Section 202, predecessor law, or comparable law of another jurisdiction.

3. RUPA § 202—defines a partnership as an entity4. UPA § 7(3) Rules for determining existence of partnership

(3) The sharing of gross returns does not of itself establish a partnership, whether or not the persons sharing them have a joint or common right or interest in any property from which the returns are derived.(4) The receipt by a person of a share of the profits of a business is prima facie evidence that he is a partner in the business, but no such inference shall be drawn if such profits were received in payment:

(a) As a debt by installments or otherwise(b) As wages of an employee or rent to a landlord(c) As an annuity to a wide or representative of a deceased partner(d) As interest on a loan, though the amount of pmt vary with the profits of the business(e) As the consideration for the sale of a good-will of a business or other property

by installments or otherwise.- RUPA § 202—says essentially the same thing. No substantive change in law.

B. Partnership Liability- Partnership liability is UNLIMITED.(A) UPA § 15. All partners are liable joint and severally for everything chargeable to the partnership under sections 13 and 14. (B)And jointly for all other debts and obligations of the partnership; but any partner may

enter into a separate obligation to perform a partnership contract.(C) UPA § 40(b) ranks liabilities in terms of priority.Martin v. Peyton KN&K found itself in financial difficulties; Hall was one of the partners and his friend was Mr.

Peyton. Hall obtained a loan of $500k (of liberty bonds) from Peyton. Loan was not sufficient and entered into negotiations w/ Peyton and others, who were eager to

help. Decided that they would not become partners, but an agreement was reached. Were going to loan $2500000 of liquid securities.

4


Fall 2006

For compensation of the loan the respondents were to receive 40% of the profits of the firm until the return was made.

Issue: did they in truth associate the respondents with the firm so that they and it together thereafter carried on as co-owners a business for profit?

Later, a closer connection w/ the firm appears—the management of the firm is to be in the hands of Hall until the securities are returned.

Arrangement for sharing of profits should be considered minus absence of other factors, thought it is not decisive.

Court: Partnership does NOT exist. All the factors taken together are not enough to induce the finding of a partnership.

Control was mere supervisory they couldn’t initiate anything on their own. They had no right to participate in management, or bind the partnership. “Mere words will not bind us…statements that no partnership is intended are not conclusive. If

as a whole a contract contemplates an association of two or more persons to carry on as co-owners a business for profit a partnership there is.”

6. Lupien v. Malsbenden Banker Malsbenden gave bank loan to York Motor Mart. Cragin entered into contract w/ Mals

for construction of a Bradley. Malsbenden never delivered the Bradley he had contracted to sell.

Mals asserted his interest in the Bradley op of York Motor Mart was only that of a banker. Cragin had disappears months earlier and Mals had physical control of the premises of York Motor and continued to dispose of the assets up until the tail.

T.C. concluded that even though Mals was “only a banker” his total involvement in the Bradley operation was that of a partner.

Court: Malsbenden was a partner.- “Loan” carried no interest; loan was made in the form of day to day purchases of

Bradley kits and equipment. Moreover, the loan was not to be repaid in fixed amounts at fixed times. Unlike a banker, Mals had the right to participate in the control of the business and in fact did so on a day-to-day basis.

- The joint control over the business and the intent to share the fruits of the enterprise amounted to a partnership under 31 MRSA § 286.

7. Four element test:Sometimes said that where there is no express partnership agreement, a relationship will be considered a partnership only if four elements are present:

1. an agreement to share profits2. agreement to share losses3. mutual right of control or management of the business4. community of interest I the venture

This test departs from the statutory test of UPA § 6(a) and RUPA § 202 which say nothing about control or loss-sharing.

C. Legal Nature of a Partnership(i) UPA § 6(ii) RUPA §§ 101(6), 201

Entity vs. Aggregate: 1. Aggregate Theory (UPA § 6, CL)

a. Partnership is aggregation of individuals and can’t own property

2. Entity Theory (RUPA §201)a. RUPA §201(a) – “A partnership is an entity distinct from its partners”

i. So means partnership can sue in its own nameii. Ability of partnership to continue business if one of

partners drop outb. BUT , RUPA allows certain areas for aggregate theory (liability for debts, duty of

loyalty, etc.)

D. Ongoing Operation of Partnerships(iii) Management

UPA §§ 18(a), (e), (h), 19, 20 (section 18 are default rules in the absence of an explicit partnership agreement).

5


Fall 2006

RUPA §§ 401 (f), (i), (j), 403 (§ 401 is different in that it tries to be more specific in areas where things are likely to be litigated—on the cusp of what is an “ordinary matter” and an “extraordinary matter.”

In a partnership, ALL of the partners are boss. Not very hierarchal.1. Statutes are default statutes can K out of them, w\ few EXCEPTIONS: UPA § 18, RUPA § 103(b)2. Making Decisions Regarding Ordinary Course of Business AND becoming a partner

a. In partnership→ all partners are counted EQUALLY (subject to partnership agreement), UNLIKE corporation i. UPA

UPA § 18—Rights and Duties of Partners [KEY these are default rule→ SUBJECT TO ANY AGREEMENT BTW THEM]o (e) All partners have equal rights in the management and conduct of the businesso (g) No person can become a member of a partnership without the consent of all the

partnerso (h) Any difference arising as to ordinary matters connected w\ the partnership business

may be decided by a majority of the partners BUT no act in contravention of any agreement btw the partners may be done

rightfully w\o the consent of all the partnersii. RUPA

RUPA § 401—Partner’s Rights and Duties (f) Each partner has equal rights in the management and conduct of the business (i) A person may become a partner only with the consent of all of the partners. (j) A difference arising as to a matter in the ordinary course of business of a

partnership may be decided by a majority of the partners BUT there must be consent of all parties for

an act outside the ordinary course of business of a partnership,AND an amendment to the partnership agreement

[KEY these are default rule → Comment says still SUBJECT TO ANY AGREEMENT BTW THEM, which is supported by §103 which says partner agreement trumps ]

RUPA §403- Partner's Rights and Duties with Respect to Information (b) A partnership shall provide

o partners and their agents & attorneys access to its books and records o former partners and their agents & attorneys access to books and records

pertaining to the period during which they were partners The right of access provides the opportunity to inspect and copy books and records during ordinary business hours.

(c) Each partner and the partnership shall furnish to a partner:o (1) without demand, any infor concerning the partnership's business and affairs

reasonably required for the proper exercise of the partner's rights and duties under the partnership agreement or this [Act]; and

o (2) on demand, any other info concerning the partnership's business and affairs, o EXCEPT to the extent the demand or the info demanded is unreasonable or

otherwise improper under the circumstances.a. Ordinary v. Extraordinary extraordinary changes the form of the business entity, or

substantially alters the rights of the parties. (iv) Summers v. Dooley

Summers and Dooley were partners who started a trash collection agency. There rule was that they could hire someone out of the own pocket to help. Summers hired a person notwithstanding Doley’s objection. Dooley sued to try to recover the expenses for the third person.

Dooley made it clear that he was “voting no” to hiring “Any difference arising as to ordinary matters connected with the partnership

business may be decided by a majority of the partners…” Concept of equality b/t partners w/ respect to management of business affairs is a

central theme and recurs throughout the Uniform Partnership Law. Does this make sense? Says “majority on ordinary matters” is this an ordinary

matter?(v) Sanchez v. Saylor

6

UPA has 2 categories: Ordinary and in Contravention.RUPA has 3 categories: Ordinary, not ordinary and amendment.


Fall 2006

Sanchez and Saylor were partners. Third party was considering lending them money for restructuring, but the potential lender required that Sanchez provide his personal finaicial statements as a condition granting the loan. Sanchez refused and Saylor brought suit against him claiming that he violated his fiduciary obligations.

The court reversed the decision of the lower court, holding that “all partners have equal rights in the management and conduct of the business of the partnership… neither partner had the right to impose his will or decision concerning the operation of the partnership on the other.”

The fact that a proposal benefited the partnership did not require High to agree.

The Covalt decision states that absent an enforceable agreement covering circumstances of disagreement, it is dissolution, not an action for breach of fiduciary duty, that is appropriate avenue of relief.

E. Partnership AgreementsDistributions, Remuneration, and Capital ContributionsA. Distributions—UPA § 18(a), RUPA § 401(a),(b)B. In partnership→ all partners share EQUALLY (subject to partnership agreement), UNLIKE

corporation b. UPA

UPA § 18→ SUBJECT TO ANY AGREEMENT BTW THEM] (a) Each partner shall be

repaid his contributions (capital or property) and share equally in the profits and surplus remaining after all liabilities,

including those to partners, are satisfied; and must contribute towards the losses sustained by the partnership according to

his share in the profits.c. RUPA

RUPA § 401 (a) Each partner is deemed to have an account that is:

o (1) credited with an amount equal to the money the partner contributes PLUS the value of any other property (NET of the amount of any

liabilities) the partner contributes to the partnership PLUS the partner's share of the partnership profits;

AND o (2) charged with an amount equal to the

money distributed by the partnership to the partner PLUS the value of any other property (NET of the amount of any

liabilities) distributed by the partnership to the partner PLUS the partner's share of the partnership losses.

(b) Each partner is entitled to an equal share of the partnership profits and is chargeable with a share of the partnership losses in proportion to the partner's share of the profits.

F. Authority of a Partner Apparent authority is often key in partnerships—power of position is important. If someone has the

position and title generally have that apparent authority to do what a person in that position would do.

Example: Hamm & Williams are partners. Williams had been buying goods on credit. Credit is regularly paid off. Hamm decides no longer wants to buy on credit b/c it is more expensive. Williams continues buying on credit from Agassi. Can Agassi recover any loss of interest?

Two scenarios: 1) Agassi Ø know partners are deadlocked and Ø try to find out. 2) Agassi is notified that they are deadlocked. Turn to UPA and RUPA.

7


Fall 2006

- UPA § 9(1) Every partner is an agent of the partnership for the purpose of its business, and the act over partner… for apparently carrying on in the usual way the business of the partnership of which he is a member binds the partnership, unless the partner so acting has in fact no authority to act for the partnership in the particular matter, and the person with whom he is dealing has knowledge that he has no such authority.- RUPA § 301(1) Each partner is an agent…unless the partner had no authority to act for the partnership in the particular matter and the person with whom the partner was dealing knew or had received a notification that the partner lacked authority.

(vi) DIFFERENCE: RUPA requires constructive knowledge. If that person should have known then the court attributes knowledge.

(vii) First question: carrying on the partnership business in the usual way? If yes, ends inquiry unless:

(viii) Second question: was it shown that the person w/ whom the partner is dealing actually knew or received notification that the partner lacked authority? (RUPA protects partners by making notification of lack of authority to third persons effective upon receipt.

RNR Investments A partner at RNR entered into a construction loan agreement with People’s bank. RNR

defaulted on the loan—RNR asserted that the bank has negligently failed to investigate and to realize that the general partner had no authority to execute notes. RNR claimed that the agreement approved a financing amount of $665K, not $990K. As a result, they argue that the partner did not have authority to enter into the loan.

Bank can rely unless it has actual knowledge of restrictions of that authority. RNR adds that RUPA provides greater protection to third persons dealing w/ partners b/c RUPA

is confined to actual knowledge, i.e. cognitive awareness. Northman Investment Company Within the partnership, the fact that one partner has apparent authority does not change one

partner’s obligation to another….”does not affect the right of partners as b/t themselves to prevent contemplated transactions w/ third parties, or otherwise to assert their ‘equal rights in the management and conduct of the partnership business.’”

G. Liability for Partnership Obligations Joint liability: just liable for your share of damages Joint & several: higher degree of liability for partners… one partner could be held liable

for all the damages. Important issue for entity status. Exhaustion Rule: under joint and several liability you would exhaust all the partnership

assets before you can go after an individual’s assets. The partner who has now been sued jointly and severally Ø have to seek indemnification or contribution b/c the exhaustion rule would have that affect.

UPA § 15: partners are jointly and severally liable for everything chargeable to the partnership under sections 13 and 14 and jointly for all other debts and obligations of the partnership but any partner may enter into a separate obligation to perform a partnership contract.

RUPA § 306, 307 307: (a) a partnership may sue and be sued in the name of the partnership. (b) an action may be

brought against the partnership and, to the extent not inconsistent with section 306, any or all of the partners in the same or separate actions. (c) judgment against a partnership is not by itself a judgment against a partner. A judgment against a partnership may not be satisfied from a partner’s assets unless there is also a judgment against the partner. (d) restrictions on judgment creditor of a partner.

RUPA: Under RUPA you are liable for the capital contribution you put in, but beyond that you are not personally liable.

RUPA: would have to name all of the partners that you would have the right to collect against.

8


Fall 2006

H. Partnership Interests and Partnership Property Income Partner—person gets the title, but does not share in the equity of the firm—not unlimitedly

liable for any of the problems, but probably will not have a vote in the partnership affairs. More like a complimentary title.

Rapoport v. 55 Perry Co.—assignability of interests 2 families in partnership—each owned 50% interest. R wanted to name their children as partners.

D (the other family) objected. Court held that P may assign partnership interests, but not management rights, b/c partnership

agreement does not say otherwise. UPA § 18 (g): No person can become a member of a partnership without the consent of all

partners. RUPA § 502: The only transferable interest of a partner in the partnership is the partner’s share of

the profits and losses of the partnership and the partner’s right to receive distributions. The interest is personal property.

Cannot assign your liability for losses (Can’t assign to your children who have no money the obligations to make up for losses)

Can assign your interest away in the partnership agreement—“when my kids become adults they become partners.” Can write it into the agreement b/c it means that you have unanimous consent when you adopt the agreement so they carry forward as effectively your commitment to them. However, still cannot contract away your unlimited liability through the agreement.

Assign does not have right to inspect partnership books. UPA § 27: assignment of a partner’s interest does not dissolve the partnership, nor does it entitle

the assignee, during the continuance of the partnership to interfere in the management or administration of the partnership business or affairs, or to require any information or account of partnership transactions.

Dissolution: UPA 31 § (c): By the express will of all the partners who have not assigned their interests or suffered them to be charged…

RUPA, § 601 (4)(ii): can dissolve by the partner’s expulsion by the unanimous vote of the other partners if: there has been a transfer of all or substantially all of that partner’s transferable interest in the partnership, other than a transfer for security purposes, or a court order…

CREDITORS: Under UPA § 28, if a partner’s separate creditor (extended credit to the partner as an individual, rather than to the partnership) obtains a judgment under UPA § 28 he can get a charging order on the partner’s partnership interests. This order will effectively give the creditor the right to be paid the partnership distributions to which the debtor partner would otherwise be entitled. The creditor can foreclose on the partnership interest under UPA § 28, and thereby cause its sale. In that case, the buyer of the interst has the tirght to compel dissolution if i) the term of the partnership phas expired or ii) the partnership is at will. Alternatively, the creditor may put the individual partner in bankrupty, which will result in dissolution of the partnership under UPA § 31(5).

I. Partner’s Duty of Loyalty Partners have a fiduciary duty to share business opportunities Meinhard v. Salmon (NY 1928) (Wachter loves this case). Meinhart was the money man Meinhart was the money man and

Salmon was doing all the work/operating the business. They were co-adventurers…(joint-venture). Been in a long term relationship. Now, another deal comes in with the adjacent property next door—Salmon things that he should have a right to it ,doesn’t give Meinhard a chance and he isn’t included in the deal.

Cause of action: duty of loyalty judge held that Salmon was approached in the realm of being a partner in a partnership and they had an opportunity to make more money.

Classic language by Cardozo: “Joint adventures, like copartners, owe to one another, while the enterprise continues,

the duty of finest loyalty. Many forms of conduct permissible in a workaday world for those action at an arm’s length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.

RUPA § 103: The partnership agreement may not: (cannot contract out of duty of loyalty, but may make specific exceptions in the partnership agreement). (3) eliminate the duty of loyalty under Section 404(b) or 603(b)(3) but:

9


Fall 2006

(i) the partnership agreement may identify specific types or categories of activities that do not violate the duty of loyalty, if not manifestly unreasonable; or

(ii) all of the partners or a number or percentage specified in the partnership agreement may authorize or ratify, after full disclosure of all material facts, a specific act or transaction that otherwise would violate the duty of loyalty.

RUPA § 404: partners owe a duty of care and a duty of loyalty to the partnership and one another. (generally narrower or limiting language rather than expansive language on loyalty, but covers duty of care and good faith and fair dealing). Prohibits (a)(3) to refrain from competing with the partnership in the conduct of the partnership

business before the dissolution of the partnership (e) a partner does not violate a duty or obligation under this Act or under the partnership

agreement merely because the partner’s conduct furthers the partner’s own interest.UPA § 21

1. Every partner must account to the partnership for any benefit, and hold as trustee for it any profits derived by him without the consent of the other partners from any transaction connected with the formation, conduct, or liquidation of the partnership or from any use by him of its property.

2. This section applies to the representation of a deceased partner engaged in the liquidation of the affairs of the partnership as the personal representatives of the last surviving partner.

J. Dissolution

Partnerships are really easy to dissolve—just have to say that you don’t want to be a partner.

Dissolution starts the winding up process; winding up process gives the partners a way to end the business in a way that is least advantageous to them.

1. Dissolution by Rightful ElectionUPA § 29 Dissolution DefinedThe dissolution of a partnership is the change in the relation of the partners caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business.

UPA § 30On dissolution the partnership is not terminated, but continues until the winding up of partnership affairs is completed.

UPA §31 Causes of Dissolution [p. 109]: Dissolution is caused(1) without violation of the agreement between the parties; (a) by termination of the definite term or particular undertaking specified in the agreement, (b) by the express will of any partner when there is no definite term, (c) by the expulsion of any partner from the business(2) in contravention of the agreement between the partners, where the circumstances do not permit a dissolution under any other provisions of this section, by the express will of any partner at any time

2. Three stages of Dissolution:(i) Dissolution—the event that triggers notification by one of the partners(ii) Winding up—settling accounts, finishing unfinished projects, etc.(iii) Termination—the sale or distribution of assets.Girard Bank v. Haley Stands for the right of a partner to terminate an at-will partnership without stating a cause for

seeking the dissolution. If partnership is at will you can dissolve for almost any reason. Alternative to at will is a

partnership for a term. If results in a breach of contract can sue for damages. Partnership at term has specific requirements for dissolution—if you Ø have the right to

dissolve there is generally some loss to you or the partnership if you wrongfully dissolve. UPA § 38—when a partnership is being dissolved the partnership’s assets are pretty much

dissolved into cash. UPA § 40—rules for distribution; who gets paid first: 1. pay off creditors 2. pay off partners if they have contributed or loaned anything to business

10


Fall 2006

3. partners in respect to capital 4. partners in respect to profit.Creel v. Lilly—dissolution must occur in good faithMr. Creel, a previous partner with Lilly and Altizer, died. Mrs. Creel argues that she has the right to liquidate the business and cause it to cease operations. Mrs. Creel is going to get “cashed out.” П asserts that instead of winding up the affairs of Joe’s Racing in accordance with her demand, Lilly and Alitzer continued the partnership business under a new name, using the assets of the partnership. Case tells us that dissolution must occur in good faith.Page v. Page—Partners can’t dissolve partnerships in bad faith- Π and ∆ entered into an oral partnership agreement in regards to a linen business; it was

losing money for a while, and once it started to make a bit, Π sought to dissolve it; Π is also a creditor of the partnership

- ∆ asserts that Π just wants to dissolve the partnership so he can take up the business himself and profit from it the court here deems this an at-will partnership, as there was no evidence that the

partnership was meant to continue for a specified term but Traynor here asserts that if Π is seeking to dissolve this partnership for his own profit,

then the dissolution is in bad faith a violation of loyalty, such that Π was at fault in the dissolution

partners can’t use pressure to freeze out a co-partner Partnerships are intended to be easy to get out of, greatly due to the fact that there is no

specific enforcement of personal service contracts hence RUPA §602(b)(1) overrules Traynor here, stating that a partner-at-will can dissolve the partnership for any reason

- Excessive use of this idea of “bad faith” in court rooms will discourage business activityDisotell v. Stiltner Held that relevant statute did not require liquidation of business assets, but rather Stitlner was

permitted to buy out Disotell’s partnership interest. Statute did not absolutely compel liquidation and did not forbid buyout.

McCormick v. Brevig Court held that when a partnership’s dissolution is court ordered pursuant to § 35-10-624(5)

the partnership assets necessarily must be reduced to cash in order to satisfy the obligations of the partnership and distribute any net surplus in cash to the remaining partners in accordance with their respective interests.

Farnsworth v. Deaver—settling of capital accounts If partnership’s debts exceed its assets, these capital losses must be satisfied by the partners

in direct proportion to their share of the profits. Assume that partners contributed $10000, 5000, and 2000 to partnership X and agreed to

share in the profits equally. Upon dissolution only $5000 remained after paying all creditors. Partnership X now has a loss of $17,000 (the $!7,000 representing the sum of the capital due each partner less the $5000 remaining after obligations.

Dividing the $12,000 equally among the three partners (b/c they have an equal share in the profits and losses) results in them each owing the partnership $4000. This would be offset against their initial contributions.

Partner who paid $10,000 would have a balance of $6000, $5000 would have a balance of $1000 and the one who paid $2000 would have a negative balance of $2000. The partner with the negative balance would be obligated to pay $2000 from the partnership to remove his capital account from its negative position.

UPA § 31 (1) –Dissolution w/o violation of the agreement between partners(a) Definite term or particular undertaking specified in the agreement(b) By express will of any partner when no definite term or particular undertaking is specified.(c) Express will of all the partners who have not assigned their interests or suffered them to be

charged for their separate debts, either before or after termination of any specified term or particular undertaking,

(d) Expulsion of any partner from the business bona fide (good faith) in accordance with such a power conferred by the agreement between the partners;

UPA § 31 (2)—Dissolution in contravention of the agreement(2) In contravention of the agreement b/t the partners, where the circumstances do not permit a dissolution under any other provision of this section, by the express will of any partner at any time;

11


Fall 2006

(3) By any event that makes it unlawful for the business of the partnership to be carried on or for the members to carry it on in partnership; (4) By the death of any partner(5) By the bankruptcy of any partner or the partnership(6) By decree of court under section 32.RUPA § 602 (page 181)

3. Dissolution by Judicial Decree and Wrongful DissolutionDrashner v. SorensonΠ and ∆ bought a pre-existing insurance company together; Π soon sought dissolution of the agreement ∆s agreed that it should be dissolved, but asserted that Π’s behavior (he had demanded more

money for himself, had been arrested for reckless driving, and was a drunk) made the dissolution wrongful instead of rightful

the court here found that Π willfully committed a breach of the agreement by demanding more than the agreed amount and caused the dissolution; therefore, a wrongful dissolution, and UPA §31(2) and §38(2) must be followed, and the value of the partnership’s assets in giving Π his portion will not include that of the goodwill

Consequences of wrongful dissolution:(1) damages(2) valuation of his interest that does not reflect the real value of the interest because goodwill is

not taken into account(3) continuation of the business without himExpulsion of a partnerThe expulsion of a partner prior to the end of a partnership without good cause is ordinarily a wrongful violation of the partnership agreement, and the wrongfully expelled partner ordinarily has a right to have the partnership dissolved and liquidated.Crutcher v. Smith—held that $500 bad check was insufficient to trigger dissolution…”it is not for every trivial departure from duty or violation of the articles of partnership, or for every trifling fault or misconduct that courts of equity will interfere and decree dissolution.”Consequences of Dissociation

Under UPA, if the partnership status of one or more partners is terminated, the partnership is dissolved but the remaining partners might continue the business, albeit as a new partnership. (Dissolution winding up termination)

Under RUPA, dissociation does not necessarily cause dissolution at all. Dissociation leads to two forks in the road:

(1) winding up under Article 8 (2) Mandatory buyout under Article 7 (Dissociation, Article 6Buyout, Article 7winding up, Article 8

Absolute right to end the partnership changes when you move to RUPA b/c you no longer have an absolute right to dissolution. Is this UPA/RUPA distinction further evidence for the proposition that RUPA confers more of an entity status on corporations? A corporation really is supposed to go on forever, RUPA makes this more possible. However, partnership will still always be “at will” or for a term.

IV. Limited Partnership

A. Formation of a Limited Partnership1. Key Features

Cross between a general partnership and a corporation Only way you can be a limited partnership is by filing paper to make it be a limited

partnership can’t fall into it like you can a general partnership Limited liability granted to limited partners Greater degree of centralized management; GP run the day to day affairs Transferability: allows partnership to attract equity through passive investors Continuity or rules governing dissolution

2. Creations of statute RULPA § 101 (7): “Limited Partnership” and “domestic limited partnership” mean a

partnership formed by two or more persons under the laws of this State and having one or more general partners and one or more limited partners.

12


Fall 2006

As such it is a partnership within meaning of UPA § 6 and RUPA § 202. Must execute a certificate of limited partnership, setting forth certain basic info about

partnership. LP statutes contemplate that the parties will enter into a written agreement specifying

terms. (See voting)3. Separation of ownership and management functions

§ 403 General Powers and Liabilities The norm in LPs in one general partner; can have as many as you want, but the form

makes sense if you have ONE general partner. RULPA §403 [p. 242] the general partner assumes management responsibilities and

full personal liability for the debts of the partnership – i.e., the general partner has the same rights and obligations of partners found under RUPA

the limited partner makes a contribution of cash, property, or services to the partnership and obtains an interest in the partnership in return – but is not active in the management and his liability is limited to the amount of his investment

RULPA §302 indicates that limited partners can be given voting rights4. Voting

GP get to vote; LP get to vote if agreement says so. Most Ø give this right. The GP is designated in the agreement.

§ 405 § 302

4. Assignment and Dissolution Does “assignable in whole or in part” mean that a GP can escape liability? § 702 As an LP, your interest is the income you would get from the LP. Assignee will not get

more than the income essentially a commodity you can exchange—very liquid. If GP assigns his/her interests the partnership would dissolve unless there is another GP.

GP assigns her interests it is effectively a withdrawal as we understand a partnership. Transferability is easy for the LP, but highly restrictive for the GP.

Can an unhappy LP dissolve the partnership? § 801. No limited partnerships have increased continuity b/c LP cannot force dissolution.

B. Liability of Limited Partners1. RULPA §303 [p. 238]: Old rule: (a) a limited partner is not usually liable to third parties unless the limited partner

also participates in control of the business; but even if the LP participates in control of the business, she is liable only to persons who transact business with the limited partnership reasonably believing based upon the LP’s conduct, that the LP is a GP

(b) limits the definition of what can constitute control safe harbor New rule: added to section (a) “However, if the limited partner’s participates in the control of

the business, he [or she] is liable only to persons who transact business with the limited partnership reasonably believing, based upon the limited partner’s conduct, that the limited partner is a general partner.”

Change was made because of the difficulty of determining when the control line has been overstepped. But also because of a determination that it is not sound public policy to keep limited partners out of influencing management decisions.

Gateway Potato Sales v. G.B. Investment Co. Limited partners who assert control are personally liable for partnership liabilities Π, creditor, sued a limited partner, ∆, to recover for the partnership debts; Π had financed

the deal because it was assured by the other partners that ∆ would provide the financing; Π believed it was a general partnership, not a limited one; ∆ claimed he wasn’t involved in managing the business

the court does not follow the new RULPA rule; where the LP was not liable to a third party if there was no direct contact with the third party ; AZ only required that the third party had “actual knowledge” of the LP’s participation in management

in the absence of actual knowledge of the LP’s participation in the control of the business, there must be evidence from which a trier of fact might find not only control, but control that is “substantially the same as the exercise of powers of the GP remanded

Liability to third parties of limited partners must be limited to make partnership interests tradeable2. Incentives created by this system

Creditor has incentive to find out all you can about the LP.

13


Fall 2006

How does the banking industry work? If you are going to be a lender, the incentives created by the system are quite clear and

quite strong-- says that the lender has to take care of its own interests. In fact, if you look at the way banks work. One of the key jobs in a bank that does commercial lending--- you try to figure out who the LP and GP is… and you determine the interest rate based on the risk of the borrower. Who is liable? How much do they have? Depending on the answers, will lend them at a high rate, or ask for a lot of collateral. Whether you are a good bank or bad bank turns on whether you can solve that problem.

f you are the president of Gateway, what do you ask Ellsworth for? Certificate of limited partnership, the partnership agreement, then ask for financial statements

C. Corporate General Partners and the duty of loyalty1. RULPA §§ 303(b)(1) and 402(9) explicitly recognize that a corporation can be a general partner in

a limited partnership agreement.2. RULPA §§ 303(b) provides that “[a] limited partner does not participate in the

control of the business … by … being an officer, director, or shareholder of a general partner that is a corporation.”

3. Although a director or officer of a corporate general partner is not liable for the debts of a limited partnership merely because he participates in the control of the partnership’s business in that capacity, he may become liable (a) if the corporate officers fail to maintain their corporate-officer identify in conducting partnership

affairs(b) of if corporate assets are intermingled with partnership assets, (c) or if the corporation is not sufficiently capitalized.

In re USACafes, L.P. Litigation A corporate general partner’s officers owe a fiduciary duty to limited partners The officers of the GP are accused here of having sold the shares of the limited

partnership back to the GP for a lesser value than they were worth; Πs assert a breach of loyalty by the GP’s Directors

Corporate directors are regarded as fiduciaries for corporate stockholders; they owe the partnership and its LPs a fiduciary duty of loyalty for dealings with the partnership First result says that 3rd parties cannot go after the officers, only the Corp GP. But this involves whether the officers of the GP are unlimitedly liable for debts and obligations.

Here, the LPs can go after the corporate officers, but only for breach of fiduciary duty of loyalty.

Difference, relationship between LPs and the corporate officers of the Corp GP is a fiduciary relationship

In 3rd party case, the relationship is contractual, between the corporate GP and the 3rd party.

Gotham Partners v. Hallwood Court held that the GP breached its duty of loyalty by failing to comply with the

contractually created entire fairness standard during the Odd Lot Resale, which resulted in the GP and its corporate parent solidifying control over the Partnership.

GP never informed the audit committee as required as required by § 7.10(a) to review the approve the odd Lot offer and Resale and

the GP failed to perform a market check or obtain any reliable financial analysis indicating that the Odd Lot Resale would be conducted on the same terms obtainable from a third-party.

A limited partnership may provide for fiduciary duties that are the same as those in

corporate law. After the decision in Gotham, the DE Legislature amended the DRUPA to make explicit

that in these three forms of organization the governing agreement—partnership agreement, limited partnership agreement, or limited liability company agreement—can eliminate, as well as expand or restrict, fiduciary or other duties. Amendments also made clear that the implied contractual covenant of good faith and fair dealing cannot be eliminated by agreement.

Is good faith and fair dealing redundant when you have the duty of loyalty?

14


Fall 2006

D. Benefits of alternative corporate formsCompare general partnerships, limited partnerships, and corporations against four features: limited liability, transferability, continuity, and centralized management. In doing so can consider both the manager and the investor.On limited liability both the investor and manager have shared interests. 1. The partnership gives no protection since all are liable. 2. The Limited Partnership provides protection for limited partners as long as they don’t trip into

being general partners. 3. The corporation provides limited liability to the investor and the manager is protected by

agency. On transferability and continuity:1. Only the corporate form provides ease of transfer. Same is true for continuity. 2. For corporations, the combined features allow the corporation to exist forever while investors

can exit and enter at will. 3. In general partners, only the interest in the profits and losses can be assigned, and the

partnership dissolves at will by the partners unless the partnership agreement specifies a term. 4. In limited partnerships, there is imperfect ability to transfer shares by the limited partners. In

continuity, GPs can exit and the other GPs can maintain continuity and the LPs can trigger dissolution only by majority vote.

Form: GP LP: LPs/GPs CorporationLimited liability No Yes/No YesTransferability No Yes/No YesContinuity No Somewhat better YesLegal Personality No/Yes (RUPA) Yes YesCentral management

No Mixed Yes

V. Corporate Form

PartnershipLimited

PartnershipCorporation

Centralized Management

GPs all have a right to participate – not

central

LPs have no control or risk liability; only the GP

Board of directors has

controlContinuity No – ease of

dissolutionThe LP cannot dissolve,

but the GP canVery

continuousLimited Liability

All liableOnly GP liable, not LPs Directors &

SHs are not liable

Free Transferability

No – assign only the interest

Partial; LPs can (only have an interest, so by assigning away, they

assign everything they have), but GPs cannot

(only interest)

Very transferable

Entity Status/Personality

Entity status under RUPA, but not UPA

GPs can be sued Corp itself can be sued

15


Fall 2006

A. Characteristics of the Corporation1. Limited liability2. Free transferability of ownership interests3. Continuity of existence4. Centralized Mangement5. Entity status

B. Selecting a State of Incorporation

May incorporate in any state you want; states can’t discriminate.

Internal affairs right—traditional choice-of-law rules; corporation is governed by the state in which it is incorporated, not where it does business. Commerce clause, which prevents one state from discriminating against residents of another state.

Two Theories: This debate assumes that managers’ and shareholders’ interests are not aligned; and, moreover, that managers make the decision as to where to incorporate

1. Race to the bottom:

Managers choose where to incorporate and they are going to incorporate in the state that has the most hands off policies for managers—states that best allow entrenchment to take place

2. Race to the top: (Wachter believes this theory is correct) Suggests stockholders should be willing to pay more in states that don’t allow that type of

managerial discretion—so markets should correct that in the long term. Also, product market will solve it b/c if you’re a poorly run corporation you’ll go bankrupt in the long-run.

Market for capital: involves the market for corporate control. The takeover market is central to make sure these problems are not as serious as they otherwise might be. How well does this market for corporate control actually work?

if management were to choose a state whose laws were adverse to shareholders, the value of the corporation’s stock would fall, making it an appealing takeover target, and thus threatening management’s jobs

C. Organizing a CorporationHow do you incorporate?Partnership: no need to file a partnership agreementLimited Partnerships: § 201 have to file a certificate of limited partnerships w/ Secretary of StateBasic steps for organizing a corporation:Step 1: DGCL § 101(a) Any person, partnership, association or corporation…without regard to such person or entity’s

residence, domicile or state of incorporation, may incorporate or organize a corporation under this chapter by filing with the Secretary of State a certificate of incorporation which shall be executed, acknowledge and filed in accordance with section 103 of this title.

(b) A corporation may be incorporated or organized under this chapter to conduct or promote any lawful business or purposes, except as may otherwise be provided bythe constitution or other law of this State.

Step 2: § 102Certificate: 102(a): mandatory terms you need to specify—include the name, address, nature of the business to be conducted (or simply that it will engage in lawful activity), the total number of shares of stock which the corporation will issue, and a statement concerning the powers, rights, and limitations of any classes of stock102(b): terms that can be put into the article of incorporation if you want to include them.

provisions for management of the business and affairs of the corporation, providing for a vote of a larger portion of stock than required by the DGCL for a corporate action; imposing personal liability on its shareholders;

16


Fall 2006

eliminating/limiting personal liability of a director to the corporation or its shareholders for damages of breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director for a breach of loyalty to the corporation, for acts in bad faith, or for transactions where an improper personal benefit was derived

Step 3: By-laws § 109Unlike the hardcore constitution that is the CoI, the by-laws may be fairly easily changed

if you want to give management the right to pass by-laws, it must be stated in the CoI; most every corporation allows such rights; but shareholders always have the right to change the by-laws

§109(b) indicates that the by-laws may contain any provision not inconsistent with the provisions of the CoI

Number of members of the board can be in the by-laws, unless it’s in the certificate; this is often used by hostile bidders to encourage a shareholder vote to increase the size of a hostile board.

May change the articles of incorporation by a vote of both the BOD and the shareholders. May change the by-laws by one or the other.

DGCL §242: Amendment of CoI After Stock has been Issued every amendment must be made in this manner; (1) the Board has to authorize

amendments and adopt a resolution setting forth the proposal, (2) if the majority of each class of shareholders authorized to vote must approve the proposal

DGCL §212 Voting Rights of Stockholders [p. 581] one vote for one share eligible to so vote

§ 141(a)—CRITICAL SECTION: The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors…

Classes of Stock; § 151 (a), § 151(b)

D. The Classical Ultra Vires DoctrineCorporations were created as fictitious entities, given capacities only as provided in their charters; transactions outside that sphere were characterized by courts as ultra vires (beyond the corporation’s explicit or implicit power) and therefore unenforceable – both against the corporation and by the corporation. this doctrine has eroded as corporate powers came to be deemed implied or incidental to

the main business purpose of the corporation, and as CoIs lost importance DGCL §101(b) indicates that a corporation can be created so long as it is engaging in any

“lawful business or purpose” DGCL §121: corporations have all powers listed in §122, in the CoI, “together with any

powers incidental thereto, so far as such powers and privileges are necessary and convenient” to business purposes

DGCL §122: Specific Powers: perpetual existence, the power to sue and be sued, acquire property, adopt and amend by-laws, make donations, make contracts, dissolve itself

DGCL §124: Lack of Corporate Capacity or Power: no corporate act shall be invalid by reason of the fact that the corporation was without capacity or power to do such act, but a shareholder can seek to enjoin such acts, and a corporation can seek damages against a Director’s improper acts

This doctrine is pretty much dead at this point; statutes indicate that corporations can engage in pretty much any kind of businessfor a shareholder can at best enjoin corporate acts if they haven’t already happened; they can’t rescind them

VantagePoint Venture Partners 1996 v. Examen, Inc. (DE 2005) California enacted a statute that required companies, who were not incorporated in Cali, but

met certain criteria (x number of business, transactions, etc) to file as quasi-California corporation which was then subject to certain Cali statutes.

The company, was in fact a Delaware corporation and there was a conflict of law b/t the Cali and the DE statutes.

The court reaffirmed the internal affairs doctrine recognizing that only one state should have the authority to regulate a corporation’s internal affairs—the state of incorporation.

17


Fall 2006

To prevent corporations from being subjected to inconsistent legal standards, the authority to regulate a corp’s internal affairs should not rest with multiple jurisdictions.

Cites 14th amendment due process as further justification for internal affairs doctrine… corporations and directors “have a significant right to know what law will be applied to their actions.”

E. The Legal Structure of ManagementThe traditional legal model had the Board manage the corporation’s business the Board was, and still is, conceived as an independent institution, not as an agent of the

shareholdersIn the modern corporation, the management function is ordinarily located in the corporate executives, with the central figure in the corporation being the CEO Directors are constrained from managing by the fact that they don’t usually meet often, that

information is filtered through management, and that they are often recruited by management

The Board of DirectorsDGCL §141 (a) The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as otherwise may be provided in this chapter or in its certificate of incorporation. (b) the by-laws can provide that a number less than the majority of directors can constitute a

quorum; but it can be no less than 1/3 the total number of directorso the number of directors is fixed by either the certificate of incorporation or by the by-lawso corporations can’t be Directors; must be a natural person

(c)(2) the Board may appoint committees which may act in the Board’s stead the board can delegate its powers to themo indicative of the fact that in practice the Board does not run the corporation

(d) the election of the Board may be staggered (e) the Board is allowed to rely on committees or presentations by Officers in decisionsDGCL §223 [p. 590] indicates that vacancies resulting from an increase in the number of directors can be filled by the majority of Directors then in office, though less than a quorum

The election of the Board occurs as per DGCL §211 Meetings of Stockholders: (a) annual meetings will be held (b) stockholders vote DGCL §212(a): one vote for each share of capital stock DGCL §151 [p. 558]: there can be different voting rights across different classes of stock

o within each class, the rights are pro rata: each have the same rights DGCL §151: voting powers and preferences have to be set in the CoI

Dividends DGCL §170 Dividends: though not defined by the statute, a dividend is a payment made by the

corporation to its shareholderso they are made on a pro rata basis, such that each share is entitled to the same amounto §170(a) indicates that Directors can decide to pay dividends

Dissolution DGCL §275 requires the action of both the stockholders and the Board to dissolve the corporation

o if a majority of the Board approves such a resolution to dissolve, it will happen only once a majority of the shareholders agree

o if all the shareholders approve dissolution, then it will happen but the corporation is not required to buy back any shares from a shareholder who wishes to get

out (as a partnership would be so required)

Shareholder VotingShareholders usually on get to decide fundamental changes in the corporation; a merger or sale of the corporation, or a sale of its assetsThey are not usually present at annual meetings; they usually use proxies to vote; proxy: either a person the shareholder has authorized to vote for them, or a piece of paper they’ve

indicated their vote on

18


Fall 2006

DGCL §242 indicates that they get to vote on amendments to the CoI; that they share power to pass by-laws with the Directors; and to vote on certain mergers, etc. DGCL §220: shareholders have the right to access books of the corporation if their purpose is

properDGCL §228 Consent of Stockholders in Lieu of Meeting: “ . . . any action required by this chapter to be taken at any annual or special meeting of

stockholders of a corporation . . . may be taken without a meeting, without prior notice and without a vote, if [consent(s)] in writing, setting forth the action so taken, shall be signed by the holders of the outstanding stock having not less than the minimum of votes that would be necessary to authorize or take such action at a meeting. . . .”

Who Actually Runs the Corporation?As indicated above by §141, the Board is in theory supposed to run the corporation; but these days, the Officers do §142: every corporation shall have officers management is then structured around the CEO, who is usually empowered to choose all the other

directorsEmerging in DE and now around the world is the idea of the monitoring Board the Board is established as primarily made up of outside Directors (those not under the thumb of

the CEO or management) they dominate the Audit and Compensation committees, and seek to ensure the CEO and other

officers are doing their job

F. The Objective and Conduct of the Corporation—to what extent may a corporation act in a manner not intended to maximize corporate profits?

Dodge v. Ford Motor Co.Players: Ford owned 58% of the stock and controlled the board. Dodge brothers owned 10%. Five other shareholders owned the balance. Closed corporation. Issue of corporate social responsibility?

At the close of July 31, 1916, Henry Ford, who controlled the board declared it to be the settled policy of the company not to pay in the future any special dividends, but to put back into the business for the future of all earnings of the company (other than the regular dividend of $1.2 million). Ford declared his new goal was to "employ… more men… to spread the benefits of the industry to as many people as possible (make cars cheaper) to help people build up their lives and homes."

Dodge brothers brought suit to try to compel a dividend equal to 75% of the accumulated cash surplus.

- Trial court ordered Ford to declare a dividend of $19.3 million- Michigan Sup Ct affirmed this portion of the trial courts ruling, holding that

"a refusal to declare and pay further dividends appears to be not an exercise of discretion on the part of the directors, but an arbitrary refusal to do what the circumstances required to be done."

Court held that the apparent immediate effect will be diminish the value of shares and the returns to shareholders.

"A business corporation is organized and carried on primarily for the profit of the stockholders."

Irony is that Ford was trying to prevent the Dodge Brothers from competing. In actuality, Ford just wanted to increase his market share. He can't say it in this case, because at the same time he has an antitrust case going on that is claiming Ford is trying to manipulate the market.

A.P. Smith Mfg. v. BarlowPlaintiff sought declaratory judgment action that corporate donation to Princeton University was intra vires . Looks like the director who had personally given money to Princeton in the past just got the corporation do it. President of the Company argued that they gained a benefit from the donation and that it was a sound investment and that it is not good business to disappoint the public expectations.- Defendants argued that it was outside of the company’s powers.- Court held for corporation: "modern conditions require that corporations acknowledge

and discharge social as well as private responsibilities as members of the communities in

19


Fall 2006

which they operate. Lawful exercise of corp's implied and incidental powers. Court uses a “reasonable limits” standard of review.

- DGCL § 122(9) was put in place after this case. Gives corporations the power to “Make donations for the public welfare or for charitable, scientific or educational purposes, and in time of war or other national emergency in aid thereof.”

- This case suggests that there needs to be some kind of benefit to the corporation.Another case like this Ø up until the Revlon case. Raises some important issue in corporate law. For example, are short or long term interests more important? Which gets priority in investment decisions? HYPO: Ron Perelman arrives at Revlon and says that he would like to buy the company and will pay more than the current price.

- Management rejects the offer and refuses to meet with Perelman.- Says managing in long-run interest of Revlon, its employees, and the community.- White knight is sought by Revlon. (White Knight is someone who in a hostile

takeover someone that the company being taken over will prefer.)- Does the company have to accept the offer?

- If a group of shareholders decides that they think Revlon is under priced and they want to cash out, who gets to decide?

- ALI § 2.01 (b)(3) suggests there can be other constituencies besides shareholders—(b) Even if corporate profit and shareholder gain are not thereby enhanced, the corporation, in the conduct of its business: (3) may devote a reasonable amount of resources to public welfare, humanitarian, education, and philanthropic purposes.

Race to the bottom/race to the top: Pennsylvania statute: winning the race to the bottom. § 1715 Exercise of

Powers Generally (a) General Rule: in discharging the duties of their respective positions, the

BoD…may, in considering the best interests of the corporation, consider to the extent they deem appropriate:

(1) the effects of any action upon any or all groups affected by such action, including shareholders, employees, suppliers, customers and creditors of the corporation, and upon communities in which offices or other establishments of the corporation are located.

Most companies opted out of this provision. Wachter says Pa won the race to the bottom, that the race for the top means doing everything for the shareholders.

Does Delaware have an “other-constituency” section? Unocal has two paragraphs that go in somewhat opposite directions “In [determining the board’s exercise of corporate power to forestall a takeover bid our analysis

begins with the basic principle that corporate directors have a fiduciary duty to act in the best interests of the corporation’s stockholders.

In introducing the Unocal standard, the Court refers to “danger to corporate policy.” 1st part of test: reasonable grounds for believing that a danger to corporate policy exists (this is

represented by the tender offer). Does “corporate policy” have a meaning independent of the “the best interests of the corporation’s

stockholders.”? In describing the impact on the “corporate enterprise” they mention the impact on the

‘constituencies’ other than shareholders.Revlon:

“[W]hile concern for various corporate constituencies is proper when addressing a takeover threat, that principle is limited by the requirement that there be some rationally related benefit accruing to the stockholders.

“However, such concern for non-stockholder interests is inappropriate when an auction among active bidders is in progress, and the object no longer is to protect or maintain the corporate enterprise but to sell it to the highest bidder.”

In Time v. Paramount: Two key predicates underpin our analysis. First, Delaware law imposes on a board of directors the

duty to manage the business and affairs of the corporation. 8 Del.C. § 141(a). This broad mandate includes a conferred authority to set a corporate course of action, including time frame, designed to enhance corporate profitability. Thus, the question of "long-term" versus "short-term" values is largely irrelevant because directors, generally, are obliged to chart a course for a corporation which is in its best interests without regard to a fixed investment horizon. Second, absent a limited set of circumstances as defined under Revlon, a board of directors, while always required to act in an informed manner, is not under any per se duty to maximize shareholder value in the short term, even in the context of a takeover. [FN12]”

20


Fall 2006

Delaware law confers the management of the corporate enterprise to the stockholders' duly elected board representatives. 8 Del.C. § 141(a). The fiduciary duty to manage a corporate enterprise includes the selection of a time frame for achievement of corporate goals. That duty may not be delegated to the stockholders. Van Gorkom, 488 A.2d at 873. Directors are not obliged to abandon a deliberately conceived corporate plan for a short-term shareholder profit unless there is clearly no basis to sustain the corporate strategy. See, e.g., Revlon, 506 A.2d 173.”

G. The Nature of Corporate LawSeparation of ownership and control.Problems that emerge when have separation:1. Managers may take less risk2. Diversion—managers may decide to increase their wealth instead of shareholder wealth.3. Entrenchment-shirking: may tell yourself you are better off if you take long vacations w/

CEOs of other companies.- When KKR takes over a company and gives the directors amazing stock options,

companies suddenly become uber productive and cut costs.4. Why don’t shareholders guard against this, assuming they are aware of the behavior?

- Shareholders are rationally apathetic; Ø have the power to take them on. Key example:

- Suppose I owe a 1000 shares and spent a 100 hours I could figure out there was a real problem that could save the company $1 million. Let's say my hourly rate is $400. Cost to me of doing that, is $40K. Problem--- how much of the stock do I owe. Own 1000 shares, 1 million shares outstanding. The benefit that I get is only $1000. As an actor, I am rationally apathetic with respect to those companies. Separation of ownership and control means you get all the costs and very little of the benefit.

5. Solution to this wedge?- Give them stock options…

6. Paradox of corporate law:- Managers and directors know more about the company than anyone else; however,

when they tell us what they know we don’t know if we can believe them because of diversion and entrenchment.

7. Key Question: why are we willing to put all of our money into corporate stock when we have no clue who runs the company? Problem of corporate law is to solve this problem.

VI. Corporate Structure

A. Shareholdership in Publicly Held CorporationsBoard of Directors “run” the corporation, but in fact shareholders “control” the corporation. Where do we get the idea that shareholders are owners?

- They get to vote with the directors.Why do we give shareholders the right to vote?

- Shareholders are particularly sensitive to stock price drop. Why?- The nature of their claim is residual ownership of the business—they get whatever is

left over. Because of this, their interests encompass the interests of all the other owners.

- If employees and a bank owned part of the company, their interests would not be aligned. The shareholders are the only group that has an interest in maximizing the value of the corporation—bankers would want the corporation to take every safe project possible and employees want more work and don’t care about profits—this is what makes shareholders “owners.” Kind of misleading though b/c shareholders don’t really have much power.

In the last 10 years there has been a rise of institutional investors—pension funds, mutual funds. The early view of corporate power allocation, that propagated by Burley and Means, was that the dispersed holding of shares results in rational apathy: because their holding are so diversified, shareholders, though intelligent people, would not find it worth their time to examine the structure or operations of a particular corporation in detail

the rise of Institutional Shareholders signaled that this interpretation no longer held true- pension plans, both public and private, and mutual funds hold such large quantities of

stock that they are necessarily interested in the operations of their holdings

21


Fall 2006

- the ERISA requirements that pension managers act to maximize the pension holdings, making them fiduciaries, inspired the activism of institutional shareholders

further, there has also been an increase in activist shareholders in general, who buy into corporations because they think they are undervalued due to the ineptitude of managers, and seek to change management’s personnel and/or methods

The ones who make big best are the private equity and hedge funds—large pools of money that are not rationally apathetic? may have better monitoring of managers and reduced agency costs.- Dark side? be there to maximize their own investment (which presumably is

everyone’s interests—possibility of legal side deals is an open question).What do shareholders get to decide?

Dissolution Mergers (some) Extraordinary transactions

B. The Legal Structure of Management State of incorporation—race to the top, race to the bottom theories Delaware has won the race and holds a kind of monopoly position. Delaware has a

special incentive not to lead in the adoption of innovative suboptimal rules. Incentive is to avoid massive federal intervention into corporate law (a.k.a. Sarbanes-

Oxley).Statutory Structure.

Board of directors Managers Shareholders Employees, suppliers, customers, the community Rise of the institutional investor. Who are the most informed institutional investors? What

does this do the Berle-Means story?

C. Formalities Required For Action by the Board Two levels: First level is rules that set out the formalities for board action. The second

level is rules concerning the consequence of noncompliance with the first level rules.

D. Authority of Corporate Officers

E. Formalities Required for Shareholder Action

F. The Allocation of Legal Power

“Inequitable action does not become permissible simply because it is legally possible.”

Delaware Case Law: Complicated and fact intensive; std of review equally fact intensive. Rule: known ex ante—clearly known by everyone before the fact. Standard: known ex poste—known after the fact. Developed b/c of holding. SEC has a lot of bright line rules, Delaware does not. Chancery court in Delaware is the trial court—5 chancellors; do not sit on a panel. One

handles each case.

Four Basic Standards of Review:1) Business Judgment Rule

- Default rule for all business decisions made by the board. Presumption is that it applies. If it does, highly differential.

- As the court entertains the case it presumes that the corporation’s Directors have acted (a) on an informed basis(b) in good faith, and

22


Fall 2006

(c) in the honest belief that the action taken was in the best interests of the corporation.

- Absent an abuse of discretion, the Director’s business judgment will be respected; - Plaintiffs will have to rebut this presumption.

2) Entire Fairness- Highly intrusive; if you are outside counsel for a corporation you want to make sure

whatever steps the board takes for making a decision satisfies the BJR presumption. - CEOs do not want the standard of entire fairness. Requires intensive fact finding.

3) Unocal- Applies to contested control transactions. In a tender offer, a hostile bidder bypasses

the board of directors of the target company and attempts to gain control by having the target’s shareholders tender (sell) their stock to the bidder. (Often the takeover battle involves a vote of the shareholders, hence involving the Blasius standard of review.)

- Enhanced business judgment rule or intermediate standard of review (b/t BJR and duty of loyalty).

- Board must first show that:1. It has reasonable grounds for believing that the tender offer presented

a danger to corporate policy and effectiveness.a. met by showing good faith and reasonable investigation

2. Board must then satisfy a proportionality test: the defensive action must be reasonable in relation to the threat posed.

a. Under Unitrin, board must first determine whether the board’s defensive action was “draconian” because “either preclusive or coercive.”

b. If not “preclusive or coercive” must be “within a range of reasonable responses to the threat” posed by the tender offer.

4) Blasius- In cases involving interference with the shareholder franchise, there is an intrusive

standard:- Directors must demonstrate a compelling justification for their actions.- Standard applies to cases involving the exercise of the shareholder franchise where

the directors have taken unilateral action for the primary purpose of interfering with the franchise.

Charlestown Boot & Shoe Co. v. DunsmoreThe shareholders ordered the Directors to close up shop, and chose one Osgood to direct the closing. The Directors refused to work with him, and kept the business running, at a loss. Shareholders sue the Directors.

the Directors are found not liable; the business of the corporation is under their control; any limits on this power must be in the bylaws; any usurpation of this power contrary to the bylaws will be void

People Ex Rel., Manice v. PowellDirectors are not mere employees but executive agents of the corporation; the stockholders can’t act in relation to the ordinary business of the corporation, and can’t control the directors in the exercise of judgment vested in them by virtue of their office

Directors possess and act as if they own the property of the corporation, which is in fact shareholder property: the standard agency relationship is not in effect here

Schnell v. Chris-Craft Industries, Inc.Board moved to advance the date of the shareholder meeting by more than a month. After a factual analysis, it was determined that the board had motives of entrenchment.

Court held that “management ha[d] attempted to utilize the corporate machinery and the Delaware Law for the purpose of perpetuating itself in office.”

Though the board may legally be allowed to change the date of the shareholder meeting, it is not equitable just because it is legal per se.

Directors can’t use corporate machinery to entrench themselves. Berle and Means:

23


Fall 2006

“All powers granted to a corporation or to the management of a corporation, or to any group within the corporation, whether derived from statute or charter or both, are necessarily and at all times exercisable only for the ratable benefit of all the shareholders as their interest appears.

The USE of the power is subject to equitable limitation when the power has been exercised to the detriment of their interest, however absolute the grant of power may be in terms, and however correct the technical exercise of it may have been.”

Blasius Industries, Inc. v. Atlas Corp.Blasius, a 9% shareholder presented the board with a consent solicitation to increase Atlas’s board to 15, with 8 of the new directors nominated by Blasius. At a board meeting the board decided to add two new members to Atlas’s seven member board. The board’s reaction was in response to a notice by Blasius that with stockholder approval would have increased Atlas’s board to 15, with 8 of the new directors nominated by Blasius.

Deferential business judgment does not apply to board acts taken for the primary purpose of interfering with a stockholder’s vote, even if taken advisedly and in good faith.

Shareholder vote is too important—“whether the vote is seen functionally as an unimportant formalism, or as an important tool of discipline, it is clear that it is critical to the theory that legitimates the exercise of power by some over vast aggregations of property that they do not own.”

Focuses on obligations of an agent towards his principal; in this case, the board had time to inform the shareholders of its views on the merits of the proposal subject to stockholder vote.

No other justification for the board’s action can be offered except that the board knows better than do the shareholders what is in the corporation’s best interest. The court didn’t like the undue speed that the board took.

Even though the action was taken in good faith, it constituted an unintended violation of the duty of loyalty that the board owed to the shareholders.

Conduct that interferes with the shareholder voting is not reviewed under the BJR. Instead, a much more stringent standard—the standard of compelling justification—should be applied.

Intl Brotherhood of Teamsters v. FlemingShareholders may propose bylaws which restrict board implementation of shareholder rights plans, assuming the certificate of incorporation does not provide otherwise.- The shareholder plan in question was an anti-takeover mechanism which gives the

directors the power to adopt and execute discriminatory shareholder rights upon the occurrence of some triggering event, usually when a certain percentage of shares has been amassed by a single shareholder.

- The defensive plans usually result in entrenching management—making takeover less likely.

- Plans are usually called “poison pills.”- Poison pills can be good or bad: can often buy valuable time to implement a merger

strategy or secure more lucrative offers. On the other hand, it can make mergers more costly—possibly preventing it from occurring or decreasing the profits from it if it does occur.

- Court equate this with a stock option plan—which the court explains can be subject to shareholder approval.

MM Companies, Inc. v. Liquid Audio, Inc. (DE 2003)- M&M was part of a group that help 7% of Liquid Audio Stock. On two different

attempts, M&M had tried to takeover control of Liquid Audio. MM had also offered two different prices for the stock, both of which were rejected by Liquid. Liquid Audio’s bylaws provided for a staggered board of directors.

- MM announced its intention to nominate its own candidates for the two seats on Liquid Audio’s BoD.

- A month later MM sent notice of its intention to bring to the annual meeting a proposal increasing the size of the board to four members.

- By the middle of August it was clear that MM’s two directors would be elected.- On Aug 23 Liquid Audio announced it had decided to increase the size of the board

from five to seven members.- MM alleged that the expansion of the Liquid Audio board, its timing, and the Board’s

appointment of two new directors violated the principles of Blasius and Unocal.

24


Fall 2006

The court determined that the primary purpose of the board’s effort was to impede an effective vote of the shareholders and to minimize the impact of MM’s nominees to the board.The most fundamental principles of corporate governance are a function of the allocation of power within a corporation between its stockholders and its board of directors. The stockholder’s power is the right to vote on specific matters—especially an election of directors.

The proper balance is dependent upon the stockholders unimpeded right to vote effectively in an election of directors.

Compelling justification standard of Blasius must be applied within Unocal’s requirement that any defensive measure be proportionate and reasonable in relation to the threat posed.

Blasius is first applied because the primary purpose of the Board’s action was to interfere with or impede the effective exercise of the shareholder franchise in a contested election.

Then, once the court determined that the primary purpose of the Liquid Audio board’s defensive measure was to interfere with or impede an effective exercise of the shareholder’s franchise in a contested election of directors, the Board had the burden to show a compelling justification for that action.

This compelling justification for such action is a condition precedent to any judicial consideration of reasonableness and proportionately.

G. Limited Liability Limited liability essentially means “no liability.” Traditionally, shareholders are not liable

for corporate obligations because corporations are separate legal entities. Corporate managers are also not normally liable for corporate obligations. Shareholders

are not liable by statutes whereas managers are not liable on straightforward agency principles. it encourages risk-taking of an entrepreneurial type

and, so it is argued, if you desire free transferability in capital markets, limited liability is necessary; for otherwise, the richest shareholder would be pursued by all the creditors, and the richest would therefore get out of the market

it also makes it easy to partition corporate assets when necessary for creditors to recover

DGCL § 102 (b)(6): shareholders are not liable unless the CoI explicitly states otherwise.There are distinct problems with it, however:

shareholders do not bear the full risk of a project, though they can receive unlimited gains; they may choose projects that society would not choose; corporations may take excessive risks on projects that will only be valuable if they succeed, and will harm only the creditors if they fail

when close to bankruptcy or having inadequate capitalization, corporations will be particularly prone to taking actions that have a negative expected value; but they will not suffer the losses due to limited liability

Banks are often seen as resolving some of the issues with limited liability; they protect the involuntary creditors by investigating the company prior to investment and

only financing certain projects or insisting on other protections for risky endeavors moreover, corporate managers will often be risk averse in ways that shareholders will not

be, as their interest in keeping their position will diverge from that of the shareholdersWhen Directors are held personally liable, it is known as Piercing the Corporate Veil

on these rare occasions, when it is deemed that one has used the control of the corporation to further his own business, the corporate veil will be pierced to prevent fraud

How big is the "dark side" of limited liability?o Excessive risk taking in that zone of insolvency given that no other courts have started to

enforce the zone.o What are controls that could be used?

Investigatory powers of the credit worthiness of the borrower. Amount of leverage the firm has Managers may be risk averse in that zone of insolvency

Limited Liability and directors:

25


Fall 2006

Risk aversion on the part of individuals or management. Directors want to entrench themselves—good side is that they don’t want the company to go bankrupt. If the company goes bankrupt the creditor committee takes over and executives are pushed out.

Hypo 1: Risk aversion on the part of owner/managers.1. Kim’s wealth is $10 million, all invested in Kim, Inc. 1. Kim Inc. has two possible investments, projects A and B. All $10 million of Kim’s money

will be invested in either Project A or B.1. If Kim does A, the payoff is $100 million 50% of the time, but the project is worthless ($0),

50% of the time. 1. Expected Value = Payoff – Project Cost.1. Project A: Expected Value = EV = ($100-$10)*.5 + ($10-$10)*.5 = $45 million1. Project B: EV = ($30-$10)*5 + ($20-$10)*.5 = $15 million1. Society prefers that investors maximize wealth. Society has lots of individuals with lots of

projects. Society can diversify and expect to earn the sum of the expected values of the different projects.

1. Kim may choose B because he is risk averse and does not want to lose all of his money.

Credit Lyonnais—zone of insolvencyWhen a company is in the zone of insolvency the fiduciary duty shifts not only to the shareholders, but to the creditors as well.

- corporation should be maximizing the value of the corp as a whole, thereby taking into account the interest of the creditors.

- When a company is in the “zone of insolvency” is unclear.- No case where the directors have been liable for violating the zone of insolvency.

Implications of limited liability in bankruptcy or zone of insolvency: If only see the upside and not the downside the project may look profitable—if company is

close ot bankruptcy then the creditors would take the loss, not the shareholders. Board might decide to make an investment when the downside is huge and upside small. When a limited liability company is close to bankruptcy you don’t see the downside, only

the upside.

PIERCING THE CORPORATE VEIL

Fletcher v. Atex (2nd Cir 1995)Plaintiff filed suit against Atex and its parent company, Eastman Kodak. Atex was a wholly-owned subsidiary of Kodak. Atex ended up being sold and lost most of its assets. Plaintiffs are trying to place liability on Eastman Kodak.

P’s are trying to pierce the corporate veil by arguing that Atex was Kodak’s alter ego; Atex was Kodak’s agent in the manufacture and marketing of keyboards; that Kodak was the “apparent manufacturer” of the Atex keyboards and that Kodak acted in tortuous concert with Atex in manufacturing and marketing the allegedly defective keyboards.

Court held that Kodak and Atex observed all corporate formalities and maintained separate corporate existences.

Delaware law permits a court to pierce the corporate veil of a company “where there is fraud or where it is in fact a mere instrumentality or alter ego of its owner.”To prevail on an alter ego claim under Delaware law, a plaintiff must show:

1. That the parent and subsidiary “operated as a single economic entity.” And2. That an “overall element of injustice or unfairness is present.”3. Under an alter ego theory there is no requirement of a showing of fraud.

Factors to be considered for a “single economic entity:”1. whether the corporation was adequately capitalized2. whether corporation was solvent3. whether dividends were paid4. whether corporate records were kept5. whether other corporate formalities were performed and6. whether, in general the corporation simply functioned as a facade for the dominate

shareholderCourt found that the two were separate entities even though:

Atex participated in Kodak’s cash management system Kodak required Atex to see approval for real estate leases, major capital expenditures—

normal in parent subsidiary relationship

26


Fall 2006

Presence of Kodak employees at periodic meetings with Atex’s chief financial officer and comptroller was found to be “entirely appropriate”

Presence of Kodak’s logo in Atex’s promotional literature Overlapping boards of directors

The law observes its own formalities. If a corporation acts as an independent agent the law will treat it as such.

Walkovsky v. CarltonΠ is run down by a cab. The cab is owned by a corporation owned by ∆; ∆ owns numerous corporations which operate single cabs, maintained with the minimal level of insurance on each.

the court finds that the veil should likely be pierced, as the cabs were undercapitalized; but that Π here didn’t assert the right argument

it tells him that he should amend his argument to assert that corporate boundaries weren’t being followed; that ∆ was operating the corporations for his personal benefit; that there were no formalities observed by the corporation Π must show that the corporation had no other purpose than to limit liability

A corporation is an entity that is supposed to flourish; moving funds freely between corporations demonstrates no regard for the corporation as an entity

Court says to look for: lack of meetings, shuttling money in and out of the company, taking all the money out of the corp as soon as it had any profit, not treating the corporation as an entity that was economically viable.

The corporate veil will be pierced where the corp. is a dummy for its shareholders.

Minton v. CavaneyPlaintiff is the sole stockholder of a company- Seminole- that rented a public swimming pool. The "business" was undercapitalized and the court still did not pierce the corporate veil. To what extent is this case followed?

The case that everyone follows. Wachter knows of no public corporations where there has been a piercing of the corporate veil.

Only time the piercing has taken place has been in private or closely held corporations. However, court did Ø pierce veil b/c D’s needed an opportunity to relitigate the issues of

Seminole’s negligence and the amount of damages sustained by plaintiffs.

Sea-Land Services, Inc. v. Pepper Source(7th Cir. 1993)Sea-Land shipped peppers on behalf of PS. PS Ø pay its bills. Sea-Land went after PS and found that the company had been dissolved.

Corporate entity will be disregarded and the veil of limited liability pierced when 2 requirements are met:1. must be such unity of interest and ownership that the separate personalities of the

corporation and the individual (or other corporation) no longer exist;a. failure to maintain adequate records or to comply with corporate formalitiesb. the commingling of funds or assetsc. undercapitalizationd. one corporation treating the assets of another corporation as its own. Van Dorn

2. circumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice.

PS was one of a handful of companies owned by defendant Marchese. The court held that PS was but one of Marchese’s playthings and pierced the corporate veil:

Ø had a single corporate meeting, Ø passed by-laws, etc. Runs all four companies out of the same single office, same phone lines,

same expense accounts His corps borrow money from each other Marchese did Ø even have a personal bank account Second prong is met b/c Marchese intentionally manipulated and diverted

corporate funds away from creditors.

Kinney Shoe Corp. v. PolanKinney subleased a portion of a building to Industrial corp., owned entirely by Polan; Industrial had no assets, no income, and observed no corporate formalities, having no stock, and keeping no minutes. Kinney filed suit against ∆ when Industrial didn’t pay the rent.

27


Fall 2006

the court adopted the standard two-prong test, and examined the viability of the third prong for contract creditors: they will be expected to have investigated the assets of the corporation and assumed the risk when they contract with them

o the court here finds this third prong permissive; asserts that here, ∆ established the corporation entirely as a shell, and that he is therefore liable

Wachter reminds us that you can legally establish a corporation as a shell, so long as you don’t start borrowing money for a corporation that exists only on paper

Summary of Piercing the Corporate Veil Requirements mere undercapitalization is not sufficient to establish that the veil should be pierced; it is only

one of several indicia if the corporation was completely dominated, such that it had no existence of its own, it is a

likely case for piercing; this will be shown byo (1) absence of formalities of corporate existenceo (2) personal use of corporate funds through commingling of funds or assetso (3) one corporation treating the assets of another as its owno (4) inadequate capitalization

FRAUDULENT TRANSFERS

Uniform Fraudulent Transfer Act§ 4. Transfers Fraudulent as to Present and Future Creditors(a) A transfer made or obligation incurred by a debtor is fraudulent as to a creditor, whether the

creditor’s claim arose before or after the transfer was made or the obligation was incurred, if the debtor made the transfer or incurred the obligation:

(1) with actual intent to hinder, delay, or defraud any creditor of the debtor; or(2) without receiving a reasonably equivalent value in exchange for the transfer or

obligation, and the debtor:(ix) was engaged or was about to engage in a business or a transaction for

which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or

(ii) intended to incur, or believed or reasonably should have believed that he or she would incur, debts beyond his ability to pay as they became due.

NOTE ON MONITORING BOARDS Burley & Dodd-- question: if the insiders, have an interest in diverting resources to their own use and

shareholders are dispersed and a "rationally apathetic" how can the managers be controlled?What we have so far:

o The Board manages and directs the business and affairs of the corporationo The Directors appoint the executive officers who run the corporation on a day-to-day basis;

they “own” the firm in terms of controlling its assetso The Shareholders can:

- elect Directors and amend bylaws- vote on certain extraordinary decisions- mount derivative suits on behalf of the corporation

The reality of things, however, does not always fit with this picture—the board does not control the corporation.

Having full-time professionals doesn’t help much either b/c they will be under the CEO’s thumb—or else will be rivals to the CEO.

Instead, the Monitoring Board has developed: The Board will no longer be a mere figurehead, but will have real power, yet power

separate and distinct from that of the CEO. The board will necessarily be made up significantly of outside directors It will have an oversight function

ALI has supported this movement. o Came up with idea of "independent director"o § 3.02 (b) [p. 1351] gives the Board the option to initiate corporate plans, adopt changes in

accounting principles, make recommendations to shareholders, and to create committeeso It supports the creation of (1) an independent nominating committee, (2) an audit committee and (3)

a compensation committee

28


Fall 2006

o § 3.04-- establishes independent directors who are not themselves experts can independently hire their own outside counsel and outside experts.

o Even if there is a CEO on the board, an independent director can hire outside counsel and outside expertise.

Has become effectively the way corporate governance works in the US today-- even though they are not technically law (though NYSE now requires some independent directors)

Audit committee 38.04 Important to understand that many corporate practices are not mandated, but accepted as good form of

corporate governance. Inside counsel, managers, are working for the corporation, have stock options, want the company to be well received on Wall Street. Good corporate governance is important to the multiples that Wall Street will attach to the corporation. Important to follow "best corporate practices." (Though some of it became law as part of Sarbanes-Oxley). The ALI are principles, not law.

SOX took the ALI model and moved it much further:- SEC now requires a corporation to have independent directors if it seeks to be listed

on a national stock exchange- The audit committee must be made up of independent directors; at least one of them

has to be an expert in finances; and the outside auditor now reports directly to the Committee, and not to the CEO.

H. Equitable Subordination of Shareholder Claims Under the doctrine of equitable subordination, when a corporation is in bankruptcy, debt

claims that a controlling shareholder has against the corporation may be subordinated to the claims of other persons, including the claims of preferred shareholders, on various equitable grounds.

VII. Information Rights and Voting Statutes

A. Shareholder Information Rights Under State LawHow do shareholders get the tools they need to wield the power they wield?How do shareholders get the information they need to launch a shareholder derivative suit?

1) Inspection of Books and Records DGCL § 219 [p. 616] gives you the right to see the stockholder list. You can get it

10 days before a stockholder meeting and it has to be for the purpose of that meeting.

The list of stockholders really just comes out to about four stockholders—the depositories; today, most stock is held in “street name” which means the bank’s name or the broker’s name.

Voting mechanism is complex b/c of the question of who actually owns the stock. If you get the stockholders list—it’s the NOBO list—non-objecting beneficial

owners. DGCL §220 [p. 617] is much more helpful—gives the shareholders the right to get

books and records. Cannot get any records—must establish a proper purpose. 220 suits are really key to derivative suits by shareholders. Initiate a 220 suit in

order to get the actual information that can be used as the basis of the derivative suit itself.

Pillsbury CasePillsbury is a rich man who spends his time suing corporations. He opposes the Vietnam War and Ø like the fact that Honeywell makes ammunitions. He wants the shareholder list to communicate w/ the other shareholders.

Court holds that this is an inappropriate purpose so he can’t use 220: Not related to his interest as a shareholder since it’s not about the corporation making

money. Delaware will later repudiate this (Delaware law says that Pillsbury can get the

shareholder list, but cannot get any books and records).

29


Fall 2006

What is a proper purpose? Mismanagement Anything related to the value of your stock

Improper purpose? Can’t just “find out what’s going on”—NO fishing expeditions Instituting annoying or harassing litigation Scheme to bring pressure on a third corporation Intention of selling the stockholder list.

Once you establish a proper purpose, what can you actually get?

Saito v. McKesson HBOC, Inc. Saito is a shareholder of McKesson. It wants records regarding the McKesson and HBOC

merger. For a suit, Saito first has to show credible evidence of wrongdoing, thus he files a 220 suit.

The court determined that the could get information prior to the period when he was a stockholder if it was related to the purpose.

To bring a shareholder derivative suit, you have to be a stockholder during the period of wrongdoing, however you do not have to be a stockholder during the period you’re seeking information from if the information is relevant to the suit.

Was an issue about financial advisor’s documents—court held that he couldn’t get anything the advisors created (Ø go to them and get their working papers).

Parent-subsidiary relationship—if you’re suing a parent, can you get information from the subsidiary and vice versa?

Parallel to piercing the corporate veil If there’s information in the subsidiary and you’re not certain it relates to the wrongdoing

and the parent company which you’re suing doesn’t have the information, you still can’t necessarily get the information if they’re independent entities.

Exception is if there’s a showing of fraud or that the sub is the alter ego, as with piercing the veil cases.

Steps of 220 Analysis:1. Filing—purely technical.2. Whether there is a proper purpose.3. Whether the plaintiff can show, by a preponderance of the evidence, that the claim (such

as mismanagement) indeed might be true—Ø have to prove it, just raise by a preponderance.

4. Plaintiff bears the burden of proving that each category of books and records is essential to the accomplishment of the stockholder’s articulated purpose of inspection.

“A Section 220 proceeding should result in an order circumscribed with rifled precision.”—Norm Veasey

Section 220 proceeding is not only protective of management, but also protective of shareholders. Shareholders Ø want the company spending countless hours on needless litigation, nor do shareholders want confidential, private information made public for no good reason. May place the company at a comparative disadvantage.

B. Shareholders Informational Rights Under Federal Law and Stock Exchange Rules

1) An Overview of the Stock Markets Primary markets: original sale of securities by governments and corporations.

30


Fall 2006

- Corporations engage in two types of primary market transaction—public offerings and private placements.

- Public offerings of debt and equity must be registered w/ the SEC.- Private placements do not have to be registered.

Secondary markets: those in which these securities are bought and sold after the original sale.- investors are much more willing to purchase securities in a primary market when they

know they can be resold if desired.- Two kinds of secondary markets—dealer and auction markets. Dealers buy for

themselves at their own risk. Auction markets have a physical location—primary purpose is to match those who wish to sell w/ those who wish to buy.

2) Overview of the SEC and Securities Exchange Act’34 Act—created the SEC and the rules promulgated there under.- Identifies and prohibits certain types of conduct in the markets and provides the

Commission with disciplinary powers over regulated entities and persons associated with them.

- Empowers the SEC to require periodic reporting of information by companies with publicly traded securities.

’33 Act—deals more with selling of securities.- Both passed after the 1929 stock market crash.- ’34 § 12(a), (b), (g); rule 12g-1 [p. 1848]- § 13(a) [p. 1854]—reports by issuer of security- § 13(d)—reports by persons acquiring more than five percent of certain classes of

securities.

3) Periodic Disclosure Under the Securities Exchange ActPeriodic reporting: 10-K annually, 10-Q quarterly, 8-K within four business days after the occurrence of certain events:

o change in control of the corporation, o acquisition or disposition of a significant amount of assets, o a change in accountants, o termination of a material definitive agreement, o departure of a director or principal officer, o amendments to by-laws or articles or code of ethics.

C. The Proxy Rules (I): An Introduction1. One purpose of the Proxy Rules is to require full disclosure in connection with transactions that shareholders are being asked to approve, such as mergers certificate amendments, or election of directors. [NOTE: Different from rule 10(b)5 which governs general non-proxy statements and where you need to show scienter.]2. Rule 14a-3 provides that no solicitation of proxies that is subject to the Proxy Rules shall be made unless the person being solicited “is concurrently furnished or has previously been furnished with a written proxy statement containing the information specified in Schedule 14A.

- Schedule 14A lists in detail the info that must be furnished when specified types of transactions are to be acted upon by the shareholders.3. Rule 14a-9 backs up Rule 14a-3 and Schedule 14A by providing that no solicitation subject to the Proxy Rules shall contain any statement that is false or misleading with respect to any material fact or omits a material fact. (gives an implied private right of action for breach of §14(a)).

- Broad in scope- Covers more than just proxy solicitations—even ads in the paper.

4. § 14(a) Solicitation of proxies in violation of rules and regulations It shall be unlawful for any person…in contravention of such rules and regulations as the

Commission may prescribe as necessary…to solicit or to permit the use of his name to solicit any proxy or consent or authorization in respect of any security…. Registered pursuant to section 12 of this title…

§ 14(e) Untrue statement of material fact or omission of fact with respect to tender offer It shall be unlawful for any person to make any untrue statement of a material fact or omit to

state any material fact necessary in order to make the statements made… not misleading…in

31


Fall 2006

connection with any tender offer or request or invitation for tenders or any solicitation of any security holders in opposition to or in favor of any such offer, request, or invitation. The commission shall… define and prescribe means reasonably designed to prevent, such acts and practices as are fraudulent, deceptive, or manipulative.

Definition: § 14a-1(f) The term “proxy” includes every proxy, consent or authorization within the meaning of section 14(a) of the act. The consent or authorization may take the form of failure to object or to dissent.

Coverage: § 14a-2 provides that Proxy Rules “apply to every solicitation of a proxy with respect to securities registered pursuant to section 12 of the Act.”

What constitutes a “solicitation of a proxy?” § 14a-1(l)1 the term “solicitation” includes (i) any request for a proxy…(ii) any request to

execute or not to execute or to revoke a proxy. In Studebaker Corp. v. Gittlin the court held that a letter which did not request the giving of any

authorization was subject to the Proxy Rules if it was part of “a continuous plan” intended to end in solicitation and to prepare the way for success.

Required to File: Rule 14a-3, Information to Be Furnished to Security Holders

- Persons solicited have to contemporaneously provide them with a proxy containing the information provided in Schedule 14A. HUGE filing requirements.

D. The Proxy Rules (II): Private Actions Under the Proxy Rules

We know we have a private action here, but what kind of right is this? Fraud? Negligence? Strict liability? Some sort of implied contract? What theory does the court use?

- After Wyandotte, the court decides that it’s under tort law. - For a tort claim we have to show if there is a duty to disclose he breached that duty

which caused a harm when the defendant relied on that to her detriment. However, causation issues.

J.I. Case v. BorakA shareholder sued for rescission or damages when a merger was consummated as authorized by proxies solicited by a proxy statement that Π claimed to have contained false statements the USSC here ruled that a shareholder has a private right of action against a ∆

corporation for issuing a materially false proxy statement and that this right is implied under the ’34 Acto there’s a congressional purpose, the right to enforce it is not there, so we’re going

to create it.o although merger rules are traditionally state rules, the regulation of proxy statements has

historically fallen to the SECo therefore, shareholders may bring a direct or derivative action for violation of proxy rules

To have such a suit under a 14a-9 violation, it clear that there must be;o (1) misrepresentation of a material facto (2) relianceo (3) evidence that the reliance caused harm

Mills v. Electric Auto-Lite Co.Mills is a minority shareholder of EAL which is merging with ML. He claims the proxy statement from EAL included a misleading statement—specifically, that it neglected to mention that the board of directors at EAL were also board members at ML. The district court held that the omission was material. Court of Appeals upheld the material omission but Ø award п’s damages b/c held that the

merger was fair (which the court claimed was an essential part of the analysis). Supreme Court says that fairness is not relevant. If the statement or omission is material, that is enough for a cause of action (so much as

the proxy was a necessary link in the merger). Don’t have to show that the shareholders relied upon it or wouldn’t have approved the

merger without it, merely that it was a necessary link. Shareholder can still collect attorney’s fees even if there aren’t damages court is saying that

shareholders have a right to an informed vote.

32


Fall 2006

- FEE is important: it creates private law enforcement. If the fee didn’t exist a shareholder would have no interest in bringing the suit (b/c of rational apathy you have to do something like this for the system to work).

TSC Industries v. NorthwayStandard for Materiality as applied to 14a-9:

An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.

Does not require proof of a substantial likelihood that disclosure of the omitted fact would have caused the reasonable investor to change his vote—just that it would have assumed actual significance in the deliberations of the reasonable shareholder.

Virginia Bankshares v. Sandberg—provides a brake to the implied coaFirst American Bank of VA, in a squeeze out merger, merges into VA Bankshares. Board hires a bank to give opinion about price—told that $42 is fair. Board told shareholders in a proxy that they believed it was a “high” price. In reality, the board took the option b/c it was the only one.

Plaintiff argues this was a misleading conclusory statement. Court holds that a corporation can still be liable for statements of opinion as long as they

show two things:1. statement has to misrepresent the true reasons of the directors (i.e. have to

show that the director said it was fair but did not actually believe it was fair)2. Have to show that the merger would not have happened anyway.

In this case, no recovery b/c no causation. Under Virginia law the board was not required to submit the proposal for minority’s vote.

the Court was very reluctant to extend a cause of action here; it asserts that the remedy should have been found on the state level; i.e. in the right to appraisal or in an action based on a defective vote

NOTE: Gerstle v. Gamble—case says that negligence is the claim under Rule 14a-9 and that scienter is not an element of liability under § 14(a). Sup Ct. has explicitly referenced this case noting that scienter is not an element of liability under 14(a).

E. The Proxy Rules (III): Shareholders ProposalsRegulation 14a provides two mechanisms for addressing effective shareholder access to the real shareholders’ meeting—the proxy solicitation process.

Rule 14a-7: Obligations…to Provide a List of…Security Holdersrequires a corporation that is itself soliciting shareholders in conjunction with an annual or special meeting to provide specified proxy solicitation assistance to requesting shareholders.

14a-7(a)(1)(ii): it must provide the number of shareholders of record, the number of beneficial shareholders, or any more limited group of such holders, an estimate of the solicitation cost, and copies of any proxy statement

the company is required to mail one copy of the shareholder’s proxy statement to security holders

i.e. the corporation, or a shareholder, can opt to contact less than the whole body of voting shareholders

this does not preempt laws such as DGCL §220, which have a “proper purpose” requirement for shareholders to gain access to certain informationo 14a-7(c)(2)(i) also indicates that the mailing list can only be used for purposes relevant to

that of the shareholder meeting further, the shareholder must be entitled to vote on the matter he must defray the costs of mailing the proxy solicitation out

14a-7 is a benefit for shareholders; but it is less generous than state law, which allows access to shareholders’ list on demand not only for use in connection with a proxy solicitation, but for other “proper purposes”

Rule 14a-8: Shareholder ProposalsA “qualifying shareholder” may require her corporation to include a “shareholder proposal” and an accompanying supporting statement.

33


Fall 2006

(b)(1) any beneficial owner of 1% or $2000 of stock who has the stock for at least a year can present a proposal for action in a proxy statement

(c) only one proposal per shareholder per meeting (d) can only be 500 words or less (f) company can exclude your proposal after notifying you if you have failed to follow the

procedural requirements (g) company has the burden of proving that the proposal can be excluded

1. Reasons company can EXCLUDE an otherwise eligible proposal from the proxy: (question 9)

a. improper under state law (i.e. would be binding on the corporation; most recommendations or requests are proper)

- A by-law would be binding, a resolution would not beb. violation of lawc. violation of proxy rules (including Rule14a-9)d. personal grievance; special interest; redress of personal grievance; benefit to one

shareholder and not shareholders at largee. relevance: if relates to operations which account for <5% of company’s total assets or net

earnings and gross sales and is not otherwise significantly related to the company’s businessf. absence of power/authority (Ø be able to implement it)g. management functions (deals w/ a matter relating to the company’s ordinary business

operations)- SEC staff bulletin (2002): traditionally equity compensation plans have been

considered “ordinary business ops” b/c related to general employee compensation- Exception to “ordinary business” matters that focus on “sufficiently significant social

policy issues that “transcend the day-to-day business matters.” - Presence of widespread public debate may be indication of significant social policy

issues.- SEC determined that in 2002 equity compensation plans for senior executive officers

(not other employees) was a social policy issue and that companies could not rely on 14a-8(i)(7) to omit these proposals

- Determined that “employment-related proposals that raise sufficiently significant social policy issues” will be a significant policy issue (Crackel Barrel case)

h. relates to election (election for membership on the company’s BoD)i. conflicts with company’s proposal (if conflicts in substance to one of the company’s own

proposals it is submitting at the same meeting)j. substantially implemented—company has already substantially implemented the proposalk. duplication—substantially duplicates another proposal previously submitted to the company

by another proponent that will be included in the company’s proxy materials for the same meeting

l. resubmissions—deals w/ substantially the same subject matter as another proposal that has been included in the company’s proxy material w/ in the preceeding 5 years, a company max exclude it from its proxy for any meeting held within 3 calendar years of the last time it was included if the proposal received certain vote percentages in time frames.

2. If company intends it exclude the proposal it must: (14a-8(j)(1))a) file its reasons w/ the SEC no later than 80 days

before it files its definitive proxy statement and form of proxyb) must provide a shareholder with a copy of its

submission c) company must (j)(2) file six paper copies of the

following:- the proposal- an explanation fo why the company believes it may exclude the proposal- supporting opinion of counsel when such reasons are based on matters of state or

foreign law

If the SEC agrees with management’s statement, it sends management a “no-action letter” stating that if the shareholder proposal is omitted, no action will be taken by the SEC.

If the SEC disagrees—it sends management a letter stating why the proposal should be included. If management decides not to include it, there is an implicit threat of legal action.

34


Fall 2006

AT&T (1994)At this administrative hearing, the SEC determined that though the shareholder proposal was, as per 14a-8(i)(5) related to less than 5% of the company’s assets, it was otherwise significantly related to the company’s business,

Roosevelt v. E.I. Du Pont de Nemours & Co. (1992: p. 306)Π wanted Du Pont to phase out its production of chlorofluorocarbons in a quicker manner than it was already doing. ∆ sought to exclude the proposal from the proxy, and the SEC issued a “no-action letter” as it judged the letter to relate to ordinary business operations. Π filed suit seeking to have it included anyways.

firstly, the USSC here determined that there is a private right of action under §14(a) to enforce a company’s obligation to include a shareholder’s proposal in proxy materials

secondly, the Court found that here, Π had no right to include her proposal in the materials; beyond the fact that Du Pont had already sped up the reduction of CFCs, it is a matter related to ordinary business operations

Shareholders can’t propose that the corp. implement policies in a specific manner

International Brotherhood of Teamsters v. Fleming (OK 1999) Directors of Teamsters-- proposed by laws requiring that any shareholders rights plan be subject to shareholder majority vote. Could they have gotten this through as a resolution? Yes, probably so… but a by-law amendment is different.

Directors of Fleming instituted an anti-takeover poison pill plan which could potentially harm shareholders’ interests. Πs, Teamsters, proposed a by-law requiring any such plan to be subject to a shareholder vote before implementation. ∆ refused to include this in its proxy statement, but Π won at trial; ∆ now asserts that shareholders can’t restrict Directors’ ability to pass such plans through bylaws.

the OK Supreme Court here determined that the right to pass such poison-pill/shareholder rights’ plans is not restricted only to Directors; but that shareholders may pass them

DE has not yet taken up a case of this type; but it seems likely that the DE courts would go against this decision; for DGCL §141(a) indicates that the business of the corporation shall be managed by the corporation. Very hot issue—probably come down to 141(a).

General Datacomm Industries, Inc. v. Wisconsin Investment Board Π, the corp., seeks declaratory relief from ∆’s, an institutional shareholder, attempt to include a proposal in the proxy statement about allowing shareholder control over stock-option repricing.

the Chancery court here refused to rule on this matter until a vote had been taken by the shareholders on it; it was not yet ripe for adjudication

F. Proxy ContestsDefinition: Any competition between two competing factions to obtain s/h votes on a proposal.

Built in Advantages For Management:o Shareholders tend to vote for managemento Management can use corporate funds to pay for its arguments.o Management knows who the shareholders are and how much each owns so

that they can plan a strategy accordingly. Insurgents have to litigate to get those lists.

Rosenfeld.o In proxy contests, corporate funds may be used to pay reasonable and

proper expenses incurred in proxy fight: By incumbent directors acting in good faith in soliciting proxies

and defending their corporate policies AND/OR By successful insurgent groups where, after gaining power, such

groups receive ratification by stockholders for reimbursement.o Corporate funds can’t be used for proxy fights over personal differences;

must be trying to take over the company for policy reasons.

35


Fall 2006

VIII. Duty of Care

A. Basic Standard of CareIntro:

Duty of care is a negligence standard. You DO NOT find the duty of care in DGCL. First time the duty of care analysis appears

is in Aronson v. Lewis. Wachter says the duty of care is a jurisdictional boundary—it is more than a standard of

review. It is a statement by the court that it will keep its hands off business judgments, unless those business judgments are procedurally problematic.

Much of the duty of care is not a substantive review that you would expect in a negligence standard. The analysis is almost entirely procedural.

Francis v. United Jersey BankHave a family held reinsurance brokerage firm. Pritchett senior had founded and ran the corporation. Two sons also "ran" the firm. The wife, Lillian Pritchard, became the "director" of the firm. Ms. Pritchard didn't do anything as director--- she didn't even look at the financial statements. Sons ultimately misappropriated trust funds.

Court decided that her "nonfeasance" was actionable and that the estate was liable for paying back money to shareholders. Held that she was personally liable for negligence in failing to prevent the misappropriation.

Court applied a standard of ordinary care. Insisted that directors should acquire at least a rudimentary understanding of the business of the corporation.

Have to show that she:a) had a duty to her clientsb) breached that dutyc) her breach was proximate cause of their losses

“if she would have read the financial statements she would have known that her sons were converting trust funds.”

Nonfeasance is more difficult for causation—determination of the reasonable steps a director should have taken and whether that course of action would have averted the loss.

Is this really a duty of care case? What's going on here? Why are they going after poor Mrs. Pritchard?

They are going after her estate--- really a fraudulent conveyance, piercing the corporate veil case parading around as a duty of care case.

As a director, you can't do nothing. Was there much of Learned Hand's standard in this case?

If she had done something, and the fraud had continued, would they have been able to go after her personal fortune? We don't know… don't learn this in this case.

Rev. Model Bus. Corp. Act § 8.30 Standards of Conduct for Directors(a) …members of board shall act 1) in good faith 2) in a manner the director reasonably

believes to be in the best interests of the corporation.(b) …shall discharge their duties with the care that a person in a like position would reasonably

believe appropriate under similar circumstances.(c) …director shall disclose to other directors... information not already known by them but known

by the director to be material to the discharge of their decision-making or oversight functions…unless would violate a legal duty

(d) Discharging duties may rely on the performance…to whom the board may have delegated..the authority or duty to perform (under (f)) one or more of the board’s functions that are delegable under applicable law.

(e) …discharging duties… a director…is entitled to rely on information, opinions, reports or statements…prepared by any persons specified in subsection (f).

(f) Director is entitled to rely, in accordance with (d) or (e) on:(1) one or more officers or employees… whom the director believes is reliable and

competent in the functions performed or… reports provided.(2) Legal counsel, public accountants…other persons retained containing skills or

expertise that the directors reasonably believe are matters (i) within the particular

36


Fall 2006

person’s professional or expert competence or (ii) as to which the particular person merits confidence; or

(3) A committee of the BoD of which the director is not a member if the director reasonably believes the committee merits confidence.

Rev. Model Bus. Corp. Act § 8.31 Standards of Liability for Directors(a) a director is not liable for any decision or non-action unless the party challenging proves that:

(1) The challenge conduct consisted of or was a result of:(i) action not in good faith; or(ii) a decision

A. which the director did not reasonably believe to be in the best interest of the corporation, or

B. the director was not informed to an extent reasonably appropriate

(iii) lack of objectivity due to familial, financial, or business relationship OR a lack of independence due to director’s domination or control by, another person having a material interest in the challenged conduct.

(iv) a sustained failure of the director to devote attention to ongoing oversight of the business affairs of the corporation…

(b) party seeking to hold the director liable:(1) for money damages, shall also have the burden of establishing that:

(i) harm to the corporation or its shareholders has been suffered, and (ii) the harm suffered was proximately caused by the director’s challenged conduct….

ALI § 4.01 Duty of Care of Directors and Officers; the Business Judgment RuleEssentially the same as Rev. Model Bus. Corp. Act 8.30.(c) A director or officer who makes a business judgment in good faith fulfills the duty under this

section if the director or officer:(1) is not interest [§ 1.23] in the subject of the business judgment(2) is informed with respect to the subject of the business judgment to the extent the

director or officer reasonably believes to be appropriate under the circumstances(3) rationally believes that the business judgment is in the best interests of the

corporation

Trans Union“…on the threshold duty of care issue, the standard should be ‘reasonable care under the circumstances’ as some argued all along.”

In Re Emerging Communications, Inc.In this case the director voted to approve the merger at $10.25 claiming that it was a fair price. He said he relied on the opinion of the expert. The director, however, because of his expert financial knowledge was not entitled to rely on this expert’s opinion when he believed the stock was worth more (up to $20)…”[the director’s] expertise in this industry was equivalent, if not superior to that of Houlihan… that expertise gave the director far less reason to defer to Houlihan’s valuation…”

B. The Business Judgment Rule

BJR:1. Make an affirmative business decision (is this the std?)2. Informed, due inquiry3. Good faith—very important; semantics whether or not it’s a separate duty4. honest belief that it is good for the corporation5. no financial interest- disinterested, Ø interest other than the interest of owning the stock

How is the presumption rebutted? You file a § 220 suit to get the facts to rebut the presumption; ask for books and records.

Remember: need 1) proper purpose with 2) preponderance of evidence of some elements of wrong doing

Where get info for the § 220 suit? From reports of the companies (10K, 10Q, 8K, proxy statements and other things [’34 Act gives us these]).

37


Fall 2006

If rebut presumption, what happens next? Standard of review is based on entire fairness and reasonability Burden on directors

If accept BJR: Lower standard of review:

Acted in good faith Decision must be rational or have a rational basis

(case is usually over)

Kamin v. American Express Co.Πs, minority shareholders of AmEx, moved to stop a dividend, or alternately for monetary damages. The company had bought another which had been worth $30 million and is now worth only $4 million; ∆s, Directors, now want to distribute the shares to its own shareholders. Πs insist that a sale of these shares would result in a loss of $25 million which could be a tax write-off. Another derivative suit.

the court finds for the Directors here due to the business judgment rule. More than imprudence or mistake judgment must be shown.

o The Board could make a dumb decision and not get sued for it because Πs’ objections and alternate plan was carefully considered and rejected; and ∆s have expressed good reason to go with their plan; the financials would look bad and the stock would have decreased. There was no bad faith.

Tells us that the duty of care as a standard of review is almost entirely procedural (with a slight exception in the ALI).

Cede v. Technicolor (1993)Where Π has established that there was a breach of the duty of care, the presumption of the BJR is overcome and there is a prima facie case of liability; the burden shifts to ∆s to show that the transaction was “entirely fair.”

Decision that fails to satisfy the rationality standard because it cannot be coherently explained:

SelheimerCorp's managers poured almost all of the corporation's funds into the development of a single plant even though they knew that the plant could not operate profitably for a number of reasons.

Court held that the managers were liable in that the decision "defied explanation." Only one other case where the court has held “what could they have been thinking?!”

Smith v. Van Gorkem (DE 1985)Πs, shareholders sue in a class action the Directors after a merger of their company into another. Van Gorkom, CEO, about to retire, decided to look into getting bought out. He shared the idea with senior management and a very small amount of research was done; CFO saw $50/share as a good price. He determined a price of $55/share while talking only with one officer and consulting with one outside advisor. What does the Delaware Supreme Court have against the transaction?

Board never looked at the actual value of the company—no study was done to determine what value the shares could reach

Didn't get an I banker to tell them what the company was worth. The board conducts the affairs of a Delaware corporation; can't let the Chairman and CEO

call all the shots. VG is about to retire, wants to cash out- does the deal himself and brings it to the board for ratification. Court doesn't like this.

Failed to fully incorporate the clause that they could solicit other agreements; didn't do a thorough market test. Instead, took it to Pritzker then they did a market test with conditions attached to the side deal.

Senior management opposed the deal Senior management entirely opposed the deal. A deal was signed on this basis, and no

other firm offers came up. The Board approved it after a two hour meeting, without seeing the specifics of the deal

and relying entirely on Van Gorkum’s oral presentation. No market test of the stock was done.

38


Fall 2006

Van Gorkum was a pal with Pritzker, the individual who was in charge of the purchasing company

The DE Sup Ct finds that there was no fraud or bad faith on the part of the Board, but that it was grossly negligent in failing to inform themselves as to the transaction they were approving

if Van Gorkum had done a market test and had presented sound evidence to the Board, his opinion as to the deal could be relied upon (to determine whether a business judgment reached by a BoD is an informed one, we determine whether the directors were grossly negligent—as used in Moran v. Household(

The uninformed state of the Directors means that the BJR does not apply here the problem here was not that the price was bad; it was that the decision-making

process was defective although there was a shareholder vote here, it does not operate as effective ratification

because it was itself defective on remand, the fair value of the company had to be assessed so as to determine

damagesThe point here is that the court will look at the process not the substance, of the deal

with this finding of the duty of care, Chancery on remand had to determine whether there were damages; it did this under entire fairness scrutiny

it found damages, and Pritzker, the buyer, ended up paying them

Aftermath of Smith v. VanGorkem:

1. DGCL § 251 (d). Fiduciary-out; put in the statute after Smith v. VG. 2. What is its import?

- If you have the fiduciary-out what does it say about the board's discretion if another bid occurs.

- 141(a) managed by the BOD—in this context, this means that having signed a deal, selling the company, does not abrogate the duties of the directors.

- This fiduciary out says that if they get a better offer, even if shareholders have already approved it, they can take the better offer.

- May incur penalties that have clauses which make it costly to take a higher offer. - Penalties cannot be draconian—can have lock up provisions, but can't be at a level to

prevent another deal from going forward. Can compensate the other buyer for costs in time in pursuing the original deal.

3. Today, do you have to have an investment banker by law? No. But you will have an investment banker. Not only that, is the deal done by Van Gorkom? Who in fact runs the deal if VG said he

was going to sell the company? Do you have the inside directors run it? - No, have the outside directors run the company. - Look at Harrah's entertainment-- the day the received the unsolicited offer, the

directors met, established a committee with the outside directors to conduct negotiations on behalf of the company.

Outside directors will hire an investment banker who will not only give them a fairness opinion, but will solicit other offers through a market test.

4. This decision threatened the very fabric of corporate law; Directors like to think that if they make a decision in good faith, the courts will not reverse it

- Directors began having trouble getting insurance to cover themselves- DE stepped in and enacted § 102 (b)(7), effectively overruling this decision.

DGCL §102(b)(7) noted that the certificate of incorporation could include: a provision eliminating or limiting the personal liability of a director to the corporation or its

stockholders for monetary damages for breach of fiduciary duty as a director except for the breach of loyalty, good faith, or for any improperly-derived personal benefit

this removes duty of care liabilityo a Π would now have to claim that the Director acted in bad faith or with an intent to

harm the corporation, and not just stupidly or sloppily and though shareholder approval is required to amend the certificate of incorporation,

virtually all corporations have done thisCan have a finding of fault without harm. Finding that the presumption of the BJR has been rebutted only means that you have acted to violate your duty of care.

39


Fall 2006

If Smith v. VG was raised today it would be dismissed as soon as directors raise the shield of 102(b)(7).

C. Duty to Ensure that Corporation Has Effective Internal Controls

In re Caremark Intl Inc. Derivative LitigationHere, the court is looking at the fairness of a settlement b/t Caremark and its shareholders. In doing so, the court evaluates the likelihood of success on the merits. The court determined that there is a very low probability that the directors of Caremark breached any duty to appropriately monitor and supervise the corporation.

- Caremark has offices all over the world. Some of Caremark’s employees had entered into “deals” with medical service providers. Caremark had an internal audit plan designed to assure compliance with business and ethics policies. The Audit and Ethics Committee of Caremark received and reviewed an outside auditors report by PWC which concluded that there were no material weaknesses in caremark’s control structure.

Complaint charges director w/ breach of their duty of attention or care in connection w/ the ongoing operations of the business, but the complaint does not charge either director self dealing or "more difficult loyalty-type problems."Two situations where plaintiff may hope to win:

1. Potential liability for directorial decision - Board decision was ill advised or "negligent."- Unconsidered failure of the board to act in circumstances in which due attention

would have likely prevented the loss.2. Liability for failure to monitor - Loss eventuates not from the decision, but from unconsidered action.

Court: "absent grounds to suspect deception, neither corporate boards nor senior officers can be charged with wrongdoing simply for assuming the integrity of employees and the honesty of their dealings on the company's behalf."

- A director's obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system exists, and that failure to do so, in some circumstances, may render a director liable for losses caused by non-compliance with applicable legal standards.

- Only a sustained or systematic failure of the board to exercise oversight will establish the lack of good faith.

Does not mandate a reporting system, but suggests if companies have one they will be able to have suits such as this one dismissed.

Suppose duty of loyalty and duty of care claim—the loyalty claim is NOT dismissed:

- The duty of care claim would REMAIN because the two are “inextricably linked”—a duty of loyalty claim encompasses a duty of care claim.

- This matters to directors because 102(b)(7) only gets rid of the duty of care liability. If duty of loyalty survives, Ø raise affirmative shield.

- This will increase settlement value because directors don’t like to be found grossly negligent. Raising a lot more issues might be embarrassing for the corporation.

What do directors do as soon as the suit is filed? File a motion to dismiss under a duty of care claim

Stone v. Ritter (NEW case… Del. Nov. 6, 2006)Bank gets in trouble for having inadequate mechanisms in place to file SARs. Issue before the court is the derivative case brought shareholders. Shareholders want to hold the directors personally liable for the bank’s failure to file the SAR.

Trying to say duty of care and duty of loyalty are the only two duties still actionable. That to violate the duty of loyalty you don’t always have to have self dealing. If you act in

bad faith, you can’t be acting loyally. Question is, what is the standard they will now apply? Elaborate on the Caremark std?

40


Fall 2006

“you will have violated the standard if you intentionally act not in the best interest of the corporation” pulling in the duty to act lawfully into the duty of loyalty, then puts in the Caremark systematic failure of the board to exercise oversight.

Clearly intended that the standard requires intent. Nothing like gross negligence—need the intent to do bad things by the directors. If you prove this, this proves violation of good faith, which in turn is a violation of the duty of loyalty.

D. Liability Shields (102(b)(7) as affirmative defense)Three elements that may serve to reduce or eliminate civil liability for breach of director’s duties: direct limits of liability, insurance, and indemnification.

DGCL § 102(b)(7) supra- Has to be in articles of incorporation, shareholders have to approve it- Has been approved in every case by an overwhelming majority of shareholder vote.

Emerald Partners v. BerlinBurden of demonstrating good faith is upon the party seeking the protection of the statute.

- Supreme Court says if duty of loyalty claim survives, so does the duty of care claim.- “A determination that a transaction must be subjected to an entire fairness analysis is

not an implication of liability. Therefore, when entire fairness is the applicable standard of judicial review, this Court has held that injury or damages becomes a proper focus only after a transaction is determined not to be entirely fair.”

-

Malpiede v. Townson (2001)Merger w/ Fredericks of Hollywood and Knightsbridge Capital. F agreed Ø to solicit other bidders, but more emerged. Ulitmately, Veritas had the highest bid at $9, but the board went with K at $7.75 claiming that K’s “no talk” provision would have allowed K to vote against 3rd party shares.

- P’s claim that board was grossly negligent and thus, breached its duty of care in failing to implement a routine defensive strategy to enable the board to negotiate for a higher price.

Issue is whether 102(b)(7) applies? Does the complaint only include a due care claim?- Court holds that the complaint fails to invoke loyalty and bad faith claims

Cash out sale:- when a company is being put for sale in a cash sale—outside directors have to hold

an auction and sell at the highest price they can get for the company. If cash, high price is cash price. If it is stock and bonds, BoD can use their judgment with what it believes to be the best offer.

Is Shareholder ratification an effective tool of liability?- Not usually when directors want it to be.- If shareholders don’t have all of the information available to make a proper vote then

ratification Ø insulate directors b/c their vote is defective.- IF shareholder ratification is effective it can sometimes be used to extinguish claims

or allow D’s to win on a motion to dismiss.

How important is the duty of care? Less important than duty of loyalty or good faith. In most cases it’s the BJR anyway. In duty of care, the directors themselves lose too if the corporation does badly, so their

interests are aligned. This is not the case in duty of loyalty.

E. Duty to Act in Good Faith

In re The Walt Disney Company Derivative Litigation[derivative claim—demand must be made on board or demand must be shown to be futile]Disney hired Ovitz as new CEO. He has a huge compensation package if he’s terminated. Plaintiffs sue claiming directors violated their fiduciary duties by agreeing to it.

41


Fall 2006

- The analysis in this case doesn’t focus on the substance of the agreement—it focuses on the process of reaching it. The Sup Ct doesn’t want to judge business decisions, but it is good at procedure.

- The board hires an outside executive compensation expert—this is key to management’s victory. Court is more comfortable with outside experts because they are less likely to be biased and less likely to be influenced by what the CEO wants.

Then, the court turns to the issue of good faith—even though they found that the BJR is not rebutted!

NO violation of care NO violation of loyalty How can there be a violation of good faith?

Three definitions of good faith:1. Bad faith is when a director consciously and intentionally disregards their responsibilities.2. Intermediate category: intentional dereliction of duty, a constant disregard for one’s duties.3. Lack of due care—legislature has said the std here is gross negligence, Ø the same as bad

faith.How different is good faith from due care? Kamin says more than imprudence or mistaken judgment must be shown.

- Disney implies that you have to allege fraud, dishonesty, or malfeasance. Close to duty of care standard.

Miller v. AT&TAT&T provided service to the democratic national convention; never collected for the millions due from the service.

Shareholders brought a derivative suit claiming that didn't follow duty of loyalty. Don't get BJR protection.

If AT&T decides not to collect from someone, AT&T get BJR protection, except when the decision not to collect is because they are interested, or if the decision violates the law.

Entire fairness?

No. If you act unlawfully, the directors can be sued by shareholders. Once the shareholders are able to prove, or show the violation of law, then the directors lose.

Duty of loyalty is really where the action is. Basic self dealing Executive compensation Diversion of corporate opportunity Special obligations and sale of control

The interested directors, in themselves could not approve a transaction in which they were interested. This, however, has changed. Interested directors can approve an interested transaction and escape any claim of breach of fiduciary duty if the transaction is found to be entirely fair to the corporation.

IX. Duty of Loyalty

Duty of loyalty is markedly different from duty of care. With a duty of care analysis, the underlying facts are slightly different—with duty of care the director’s and the corporations interests are still aligned; under a duty of loyalty claim the alignment of interests has become skewed. The directors are charged with walking away with the corporate treasury; they have found a way of exploiting the corporate form for their own benefit.

The concept of loyalty has changed over the years. In 1880, it would have been said that any contract between a director and his corporation was voidable by the corporation or the shareholders without regard to the fairness of the transaction; the concept of disinterested directors did not matter.

Thirty years later this principle changed to a policy that allowed such a contract with approval by a disinterested majority of the board if the contract was not found to be unfair or fraudulent by the court if challenged. A contract where the majority of the board was interested was voidable, even if the contract was fair.

Difficult to pinpoint the place where the change in legal philosophy occurred, but it did…

42


Fall 2006

“By 1960 it could be said with some assurance that the general rule was that no transaction of a corporation with any or al of its directors was automatically voidable at the suit of a shareholder, whether there was a disinterested majority of the board or not; but that the courts would review such a contract and subject it to rigid and careful scrutiny, and would invalidate the contract if it was found to be unfair to the corporation.”

Four basic types of self-dealing (The “FOUR BOXES”):1) basic self-dealing; where one party is on both sides of the transaction2) executive compensation: can become problematic when directors decide their own

compensation3) diversion of corporate opportunity; where the director has taken business that is rightfully

the corporation’s4) controlling shareholders; special obligations result where controlling shareholders are

selling stock

A. Self-Interested TransactionsLewis v. S.L.E., Inc.Directors making self-interested transactions will not have the good graces of the BJR(closed corporation) Father had six children; three of them owned stock in LGT; Richard, Allen, Leon. All of them, those three plus Donald and his daughters, owned stock in SLE. Π alleged that ∆s, the three who owned LGT, wasted the corporate assets of SLE by renting the property it owned to LGT at below-market value prices, and thereby treating it as existing purely for the benefit of SLE.

the 2nd Cir.: where the Directors have a conflict of interest in regard to transactions entered into by the corporation, the BJR is rebutted they therefore have the burden of proof to show that the transaction was entirely fair and reasonable to the corporation;

because the BJR is rebutted, the court examines the substance of the deal with great detail; and ∆s had to prove that the rental price was a fair one; they failed to carry that burden

On remand, the court must determine the fair rental price and then, as per the deal between the parties before, ∆s will buy the stock from Π at its fair market value

Note on RemediesThe traditional remedies for violations of the duty of loyalty are restitutionary, that attempt to put the corporation back where it was before the duty of loyalty was violated (accounting for the difference between the contract price and the fair price), or rescissionary

the remedies are much less severe than sanctions for duty of care, for in a breach of duty of care, the director must pay damages even if he has made no gain from the wrongful action- note that these remedies are not as effective as they could be: that is, if optimal

deterrence theory was followed, the fine would be the gain divided by the probability of detection, such that if detection of the breach happened only half the time, the fine would be double the gain

where fraud is present, courts have occasionally awarded punitive damages against directors or officers who have breached their duty of loyalty- DE does not allow this, as Chancery is a court of equity

Talbot v. JamesΠs, Talbots, agreed with ∆ to form a corporation to construct and operate an apartment complex; ∆ was on both sides of the transaction. Πs argue that ∆ diverted funds to himself, while ∆ asserts that he only received the funds that he was supposed for building the apartments.

the court here finds that ∆ breached his fiduciary duty by examining the process of the transaction; it sees ∆ as not having revealed to Πs that he was to be the builder; there was no evidence in the minutes of him having told them

where a party is interested, it is their burden to make a full disclosure of all relevant facts when entering into a contract with the corporation.

The dissent asserts that ∆ received only a fair price for his trouble, and that Πs knew very well that ∆ was the builder

43


Fall 2006

There is no strict rule against self-dealing because it can be valuable to a corporation and its shareholders; but there must be rules to govern both the process and substance of such self-interested transactions

NOTE: How would Delaware come out on this case? It seems like the Supreme Court of South Carolina says that disclosure is a necessary element to a legitimate transaction; however, they also say that the transaction was not entirely fair. In Delaware, if the transaction was fair the directors probably wouldn’t be liable as long as the transaction was entirely fair and reasonable.

NOTE: on associates of directors and senior executives What if a corporation deals not with a director or senior executive, but with an enterprise

or individual with whom a director or senior executive has a significant relationship?- Such an enterprise or individual may be referred to as an “associate” of the director or

senior executive. ALI Principles of Corp Governance § 1.03

B. Statutory Approaches

DGCL § 144. Interested Directors; Quorum(a) No contract or transaction between a corporation and one or more of its

directors…shall be void or voidable solely for this reason, or solely because the director is present at or participates in the meeting of the board or committee thereof which authorizes the contract or transaction, or solely because any such director’s votes are counted for such purpose, if:

(1) the material facts of the director’s relationship are disclosed or are known to the BoD, and the BoD in good faith authorizes the contract… by the affirmative votes of a majority of the disinterested directors even though the disinterested directors be less than a quorum; or

(2) material facts…are known to the shareholders…and the shareholders approve the transaction by a vote in good faith

(3) contract is fair to the corporation…(b) Common or interested directors may be counted in determining the

presence of a quorum at a meeting of the board of directors which authorizes the contract or transaction.

Note on §144: it was written to change the common law away from “void and voidable.” Historically, self dealing was automatically void or voidable even if entirely fair. The DGCL changed this in 1967. The statute provides guidance for making a conflicted transaction rightful. Case law provides the details on how the board can avoid entire fairness scrutiny.

ALI § 5.02 Transaction with the Corporation(a) A director (§ 1.13) or senior executive (§ 1.33) who enters into a transaction with the

corporation…fulfills the duty of fair dealing with respect to the transaction if:(1) disclosure concerning the conflict of interest (§1.14(a)) and the transaction (§ 1.14(b))

is made to the corporate decision maker (§ 1.11) who authorizes in advance or ratifies the transaction and

(2) either:(A) the transaction is fair to the corporation when entered into;(B) the transaction is authorized in advance, following disclosure concerning

the conflict of interest and the transaction, by disinterested directors (§ 1.15)…who could reasonably have concluded that the transaction was fair to the corporation at the time of such authorization;

(C) transaction is ratified, following such disclosure, by disinterested directors (§ 1.23) who could reasonably have concluded that the transaction was fair to the corporation at the time ti was entered into..

(D) the transaction is authorized in advance or ratified following such disclosure, by disinterested shareholders (§ 1.16) and does not constitute a waste of corporate assets (§ 1.42) at the time of the shareholder action.

(b) Party challenging transaction has the burden of proof unless that party can establish that none of subsections (a)(2)(B), (C), or (D) is satisfied.

Is this different from ALI § 5.02? (144 seems like a less demanding standard?)

44


Fall 2006

The ALI has a disclosure requirement which the DGCL does not; §5.02(a)(1) makes disclosure an absolutely mandatory part of any interested transaction disclosure as a threshold condition

note also the burden shifting of the ALI in §5.02(b)

Cookies Food Products v. Lakes WarehouseHerrig, ∆, had acquired a majority of Cookies shares (BBQ sauce company) when the founder sold out. ∆ had been one of the original investors, and had operated another corporation which served, under exclusive agreements to distribute, market, and transport the sauce. When he acquired the majority, the agreements with his corp. were extended, and he received higher salaries as increased sales required increased management.

The minority shareholders, Πs, accused ∆ of self-dealing, in that he had negotiated agreements with the corp. without disclosing his interest; their real complaint is that they have not yet received a dividend/any profit.

the Iowa SC here rules that the transaction is not automatically void just b/c he was self-dealing; that a director can contract with the corporation so long as it is with the strictest good faith, full disclosure, and consent of all concerned- the burden of proof is on the director to establish these factors- there are three circumstances under which a director can deal with the company and

not violate his fiduciary duty of loyalty; (1) where the interest is disclosed to the board, and the disinterested directors approve it, (2) where the interest is disclosed to the shareholders, and they approve it, or (3) if the transaction is fair and reasonable to the corporation

here, ∆ satisfied the burden of proof in that he established that the other directors were well-aware of his interest in the transactions before they approved them

the majority here also sees ∆ as having done wonders for the corporation the dissent asserts that the majority places too much faith in the appearance of a profit;

that just because the transactions resulted in profits doesn’t meant they were fair; ∆ should have been made to show that the FMV of his services were in fact what he was paid (where he was in reality overcompensated)

Question whether or not there is a controlling shareholder turns out to be an important fact

Test for “disinterested”:

1. ALI § 1.23 Interested(a) a director (§1.13) or officer (§ 1.27) is “interested” in a transaction or conduct if either:

1) the director or officer, or an associate (§1.03) of the director or officer, is a party to the transaction or conduct;

2) the director or officer has a business, financial, or familial relationship with a party…that relationship would reasonably be expected to affect the director’s or officer’s judgment…in a manner adverse to the corporation;

3) the director…or an associate of the officer…with a business, familial or financial relationship…has a material pecuniary interest in the transaction or conduct… and that interest would reasonably be expected to affect the director’s or… in a judgment adverse to the corporation.

2. ’34 Act: § 10A(m)(3)(A) Each member of audit committee shall be independent(B) In order to be considered independent… a member of the audit committee may not, other than in their capacity as a member of the audit committee

(i) accept any consulting, advisory, or other compensatory fee from the issuer; or(ii) be an affiliated person of the issuer or any subsidiary thereof.

(C) Commission may exempt the requirements of B if deemed appropriate.

TAKE AWAY: earlier case law appears to suggest that approval by disinterested directors reinstate BJR in the sense that the plaintiff Ø ask the court to decide whether the transaction was fair to the corporation.

In Marciano v. Nakash (1987) the Delaware Sup Ct stated that “approval by fully-informed disinterested directors under section 144(a)(1), or disinterested stockholders under section (2), permits invocation of the BJR and limits judicial review to issues of gift or waste with the burden of proof on the party attacking the transaction.”

45


Fall 2006

By going through a disinterested committee you have effectively made the approval process disinterested. Without case law we have no way of knowing what 144 means.

How do we know if dealing is at arm’s length?- Do a market test

Waste of Corporate AssetsStandard: waste entails an exchange of corporate assets for consideration so disproportionately small as to lie beyond the range at which any reasonable person might be willing to trade.

A board that commits waste would normally also violate the BJR. The issue of waste therefore overlaps with the effect of shareholder ratification of a conflict of interest transaction.

Four possible effects of shareholder ratification (Chancellor Allen):1. Complete defense to any charge of breach of duty2. Shift the substantive test on judicial review of the act from one of fairness that

would otherwise be obtained to one of waste3. Shifts the burden of proof of unfairness to plaintiff, but leaves that shareholder

protective test in place.4. No assurance of assent of a character that deserves judicial recognition.

Practical advice to a CEO in making an interested transaction (i.e. a management buyout): make full disclosure to the board create a committee of outside and disinterested directors to study your

proposal and to hire an outside investment bank and attorneys do not try to sell the deal to the board do not vote on the deal; only disinterested individuals should vote

(Copied from old outline—check for accuracy!!!):Analysis of the Shifting Burden of Proof in an Interested Transaction:(1) Whether there is a controlling shareholder or not, the initial burden on Π is always to rebut the presumption of the BJR, which is the presumption that the directors were informed (not grossly negligent), were disinterested and/or independent, and that they rationally believed that the transaction was in the best interests of the corporation (that they acted in good faith)

(2) If Πs overcome the BJR presumption by showing that the transaction was interested, then ∆s will bear the burden of showing that the transaction was entirely fair to the corporation

(3) ∆s can attempt to satisfy entire fairness scrutiny in the following ways: (a) they may do so by showing there was a truly independent, disinterested committee that negotiated at

arm’s length and approved the interested transaction: if they do so, and there is not a controlling shareholder, the BJR will reattach; Πs will then have the burden of rebutting this presumption of the BJR by showing that either;

o (i) the disinterested committee was not truly disinterestedo (ii) the disinterested committee was not informed, oro (iii) the disinterested committee could not have rationally believed that the transaction was in the

corporation’s best interests (b) ∆s may also satisfy entire fairness scrutiny by showing that there was a fully informed, uncoerced vote

of the disinterested shareholders; and, if there is no controlling shareholder, the burden will shift to Πs to either;

o (i) prove that the vote was in some way defective, oro (ii) prove that the transaction amounted to waste

(c) ∆s may further satisfy entire fairness scrutiny at any time by proving that the deal was actually fair; that is, by showing that fair dealing and a fair price were both had

Addendum for Controlling Shareholders: (I) entire fairness scrutiny may also be met in the case of a controlling shareholder and a disinterested

committee, but only insofar as the burden will shift to Πs to prove that the deal was not entirely fair, and not to rebut the BJR presumption

(II) entire fairness scrutiny may be met in the case of a controlling shareholder and a valid shareholder vote, and then the burden will shift to Πs to prove that the transaction was unfair

The steps of analyzing the Burden of Proof in interested transactions, in stupid chart form:

46


Fall 2006

Transaction Approved by the Full Board

Approved by a Disinterested committee

Non-Controlling Shareholder

Once Π has rebutted the BJR by showing that the transaction was interested, the standard becomes Entire fairness: ∆s must establish that the transaction was entirely fair no BJR presumption permissible

(1) Once Π has rebutted the BJR, the standard becomes entire fairness; (2) then ∆s can establish entire fairness by showing the transaction was approved by a disinterested committee; therefore the BJR reattaches; (3) Π can then attempt to rebut this by showing that the committee was not truly disinterested, informed, or that its decision lacked a rational basis

Controlling Shareholder

Entire fairness: ∆s must simply establish that the transaction was entirely fair no BJR presumption permissible; i.e. Cookies v. Lakes Warehouse

(1) Once Π has rebutted the BJR, the standard becomes entire fairness; (2) then ∆s can establish entire fairness by showing the transaction was approved by a disinterested committee; the BJR does NOT reattach b/c of the existence of the controlling shareholder; (3) Π can then establish that the transaction was not entirely fair

C. Compensation—one of the “boxes” in the Duty of LoyaltyStatutory Guidance:

1. DGCL § 141(h): Unless otherwise restricted by the certificate of

incorporation or by-laws, the BoD shall have the authority to fix the compensation of directors.2. DGCL § 157 Rights and Options Respecting Stock

(a) subject to any provision in the CoI, every corporation may create and issue, whether or not in connection with the issue and sale of any shares of stock or other securities of the corporation, rights or options entitling the holders thereof to acquire from the corporation any shares of its capital stock of any class or classes, such rights or options…as shall be approved by the board of directors.

The terms, including the time or times… and the consideration for which such shares may be acquired from the corp upon the exercise of any such right or option, shall be stated in the CoI or in a resolution…in the absence of actual fraud in the transaction, the judgment of the directors as to the consideration for the issuance of such rights or options and the sufficiency thereof shall be conclusive.

3. SEC Regulation S-K, Item 402 Executive Compensation Requires a lot of public disclosure; as soon as you have requirement of disclosure, inaccurate or

misleading disclosure are then in violation of the Securities act and can lead to civil or criminal penalties.

Persons covered: CEO, the registrant’s four most highly compensated executive officers other than the CEO who were serving as executive officers at the end of the last completed fiscal year; and; up to two additional individuals for whom disclosure would have been required except for they were not serving as an executive officer of the registrant at the end of the last completed fiscal year.

4. IRS Code § 162(m) Trade or Business Expenses (1) indicates that there is no deduction allowed for paying executives over $1 million hence

corporations will not tend to pay more than that in salary (4) indicates that you can them more if you do so through performance-based compensation; i.e.

stock options or bonuses; but in order to do so, you must have shareholder approval These IRS rules work in tandem with the SEC rules requiring disclosure of executive pay for proxy statements are usually required to include any changes in executive compensation

Executive compensation1. Theories:

Tournaments theory : all along the way you have to encourage workers to work hard or they will slack. As you get up the pyramid, there is only ONE CEO position. You need to make the CEO position as attractive as possible to keep people working hard.

Market: as long as the stock market is doing well do you really want to fix something that might not be broken?- Shareholders may really care about compensation affecting performance—they care

about if the CEO will work harder if they are paid for it.

47


Fall 2006

- Phenom of private equity supports this argument:1. Highly levered—if stock market does well, you do better than the stock

market2. Strategy invented by KKR and Blackstone—take managers who were

not highly incentivized and give them the possibility of making $30 million, not $5 million. They started making decisions and improved the performance of the company.

3. is there a point of diminishing returns? What is excessive?

Option driven nature of Executive Compensation: Section 162(m) of the IRS code limits what you can pay as

straight pay and still be able to deduct it as an expense. Leads to options compensation. Options help align the interests of the CEO and the

shareholders. Need shareholder approval:

- § 1.162-27 Material forms of performance goals must be disclosed and subsequently approved by the shareholders of the publicly held corporation (to get IRS tax incentive).

- Shareholders are then informed through Regulation SK. Options granted as part of executive compensation are treated differently

depending if they are in the money or not. In the money options have to be expensed, out of the money options do not have to be expensed.

Issues with back dating. The exercise price is the is when the stock options are initially fixed. Say it was fixed in November at $20. If you back date the option you say you really gave it in July when it was selling for $10. The problem is that under regulation S-K this all has to be voted on (and thus, disclosed) and it will then violate IRS rules. Absent rule SK there would be no disclosure problem, but if you disclose incorrectly and knowingly it is fraud.- backdating will almost always violate disclosure requirements (also, fraud if done

intentionally and not reported)- runs into problems with the IRS because can violate their income reporting if stock

options are in the money they have to be expensed immediately and they have a different value than if they are at FMV.

Executive compensation and closed corporations: Court deals w/ exec compensation in closed corporations very differently than it does with

publicly traded corps. In part, this is because of IRS rules. From a corporate law perspective, in closed corporations managers have two benefits if they pay themselves a lot:

1. Not much income that gets doubly taxed2. If there are minority shareholders who are not working for the corporation, they

are harmed if there is excess compensation taken out by those directors who do work for the corporation. Special need to protect minority shareholders.

3. Not approved by disinterested directors of shareholders

Delaware’s solutions to this “conflict:” Market solution —a corporation that pays too much in executive

compensation may have too high of costs and suffer in the product market. Market will adjust for abuse of compensation.

Fiduciary law remedies —doesn’t work well. Easy for plaintiffs to rebut presumption of BJR, but because executive compensation is invariably ratified by shareholders (and assuming it is effective) then the remedy that remains, is only the test of waste—which is hard to show on a case on the merits.

Federal securities law —Reg SK. As soon as you have requirement of disclosure, inaccurate or misleading disclosure are then violations of the Securities Act and can lead to civil or criminal penalties.

Tax laws —162(m) and the rules coming out of it (E(4)), requirements for a stock option plan or a performance based plan to be ratified by the shareholders to meet IRS requirements that it is performance based [IRS ceiling on how much you can have if not performance based]. Disclosure and required voting places two hurdles in the way of wrongdoing.

48


Fall 2006

- § 1.162-27 (e)(2)(vi)(A): compensation attributable to a stock option or a stock appreciation right is deemed to satisfy requirements of (e)(2) if…the amount of compensation the employee could receive is based solely on an increase in the value of the stock after the date of the grant or award.

- Conversely, if the amount of compensation the employee will receive under the grant or award is not based solely on an increase in the value of the stock after the date of grant or award (e.g., …in the case of an option that is granted with an exercise price that is less than the fair market value of the stock as of the date of grant), none of the compensation attributable to the grant or award is qualified performance-based compensation because it does not satisfy the requirement of this paragraph (e)(2(vi)(A).

- § 1.162-27(e)(4) Shareholder approval requirement—- The material terms of the performance goal under which the compensation is to be

paid must be disclosed to and subsequently approved by the shareholder of the publicly held corporation before the compensation is paid….the material terms include the employees eligible to receive compensation… business criteria (p. 1290) on which performance is based…

D. Use of Corporate Assets; Corporate Opportunity Doctrine

Hawaiian Intl Finance v. Pablo (Ha 1971)Pablo’s ran a realty brokerage and were also part of the directorship of Hawaiian Itnl. Arranged a land deal in California. As a result of the deal, Pablo got some commission. The problem is that he was approached as a director of Hawaiian Intl Finances. He did not disclose his interest in the deal until the board approached him about it.

Court held that Pablo breached his fiduciary duty to Hawaiian Intl. Corporate opportunity is governed by the punctilio of honor.

- Hawaiian Intl Finances would have been interested in getting the land at a price less the commission.

- The money belongs to the corporation, part of your fiduciary duty towards it.

ALI § 5.04 Use by a Director…of Corporate Property, Material Non-public Corporate Information, or Corporate Position(a) General rule. A director or senior executive may not use corporate property, material non-

public corporate information, or corporate position to secure a pecuniary benefit, unless either:(1) Value is given for the use and the transaction meets the standards of § 5.02(2) The use constitutes compensation and meets the standards of § 5.03(3) The use is solely of corporate information, and is not in connection with trading of the

corporation’s securities, is not a use of proprietary information of the corporation, and does not harm the corporation

(4) Use is subject neither to § 5.02 nor § 5.03 but is authorized in advance or ratified by disinterested directors or disinterested shareholders, and meets the requirements and standards of disclosure and review set forth in § 5.02 as if that section were applicable to the use; or

(5) The benefit is received as a shareholder and is made proportionately available to all other similarly situated shareholders, and the use is not otherwise unlawful.

(b) A party who challenges the conduct of a director or senior executive under subsection (a) has the burden of proof…except that if value was given for the benefit, the burden of proving whether value was fair should be allocated as provided in § 5.02 in the case of transactions w/ the corporation.

Restatement 2nd of Agency§ 388. Duty to Account for Profits Arising Out of EmploymentUnless otherwise agreed, an agent who makes a profit in connection with transactions conducted by him on behalf of the principal is under a duty to give such profit to the principal.

Northeast Harbor Golf Club, Inc. v. Harris (Maine 1995)Defendant was director and president of the golf club. The club had been struggling financially and had considered the possibility of building homes around the golf course but the idea had always been rejected. On two occasions, Nancy, the director had the opportunity to buy some of the land

49


Fall 2006

surrounding the course. After she buys the land, she tells the club that she bought it. She now wants to develop it and the board sues her for breach of fiduciary duty.In determining the corporate opportunity doctrine of Maine, the court evaluates existing doctrine:

1) Line of business test :- Opportunity which the corporation is financially able to undertake and is, from its

nature, in the line of the corporation’s business.- The “real issue” is whether the opportunity “was so closely associated with the

existing business activities…as to bring the transaction within that class of cases where the acquisition of the property would throw the corporate officer purchasing it into competition with his company.” Guth v. Loft (De 1939)

- Weaknesses: whether a particular activity is within a corporation’s line of business is conceptually difficult to answer. Also, the Guth test includes as an element the financial ability of the corporation to take advantage of the opportunity.

2) Fairness test: - Also known as the Durfee test (Mass. 1948). The “true basis of governing doctrine

rests on the unfairness in the particular circumstances of a director, whose relation to the corporation is fiduciary, taking advantage of an opportunity [for her personal profit] when the interest of the corporation justly calls for protection.”

- Weaknesses: lack of principled content. 3) Combination of the two:

- Court notes that this test just piles the uncertainty of the second on the first.The court decides to explicitly adopt the ALI test in § 5.05—Taking of Corporate Opportunities by Directors or Senior Executives(a) General rule. A director…may not take advantage of a corporate opportunity unless:

(1) the director of senior executive first offers the corporate opportunity to the corporation and makes disclosure concerning the conflict of interest and the corporate opportunity

(2) the corporate opportunity is rejected by the corporation and(3) either:

(A) the rejection of the opportunity is fair to the corporation;(B) The opportunity is rejected in advance, following such disclosure, by

disinterested directors…in a manner that satisfies the standards of the BJR.

(C) Rejection in advance… and the rejection is not equivalent to a waste of corporate assets.

(b) Definition of a Corporate Opportunity. (1) any opportunity to engage in a business activity of which a director or senior

executive becomes aware, either:(A) in connection with the performance of functions as a director…or under

circumstances that should reasonably lead the director or senior executive to believe that the person offering the opportunity expects it to be offered to the corporation; or

(B) through the use of corporate information or property, if the resulting opportunity is one that the director or senior executive should reasonably be expected to believe would be an interest of the corporation.

(2) any opportunity to engage in a business activity… that is closely related to a business in which the corporation is engaged or expects to engage.

The central feature of the ALI test is the strict requirement of full disclosure prior to taking advantage of any corporate opportunity.

ALI seems to define corporate opportunity more broadly than the disclosure in Broz.

NOTE: employees do not owe a fiduciary duty to the company, but for an employee to take advantage of a corporate opportunity they have to get permission from directors/supervisors.

Delaware takes a different approach than the ALI (though is similar to § 5.05(b))

Broz. V. Cellular Information Systems, Inc. (Del. 1996)Here, Broz is on the board of CIS and owns RFB. Provider goes to Broz to sell the Michigan 2 license. Doesn’t go to CIS b/c they don’t think they can afford it. Broz doesn’t talk to the board of CIS, but the board says that if he would have they would have told him to go ahead with the

50


Fall 2006

investment for RFB. Pricellular buys CIS and goes after Broz for exploiting a corporate opportunity for CIS.

Delaware finds for Broz and says that he did not need to present it the CIS board. Puts corporate opportunity first, not disclosure. First is there a corporate opportunity?:

o is the corporation financially capable to exploit it?o In line of business?o Interest or expectancy?o If takes interest for own, will fiduciary be placed in a position contrary to his duty

for the corporation?o Only matters what the board things is in their line of business, Ø matter what

Broz thinks. Court says Broz did not misappropriate a corp opportunity. CIS was not

financially capable, nor was it clear that CIS had an interest or expectancy. No one factor is dispositive. All the factors must be considered.

Note that just because ∆ here approached the directors of CIS doesn’t mean he has obtained “safe harbor” for the court will still examine the board’s approval of an arguably interested transaction to determine if the directors were interested

ALI § 5.06 Competition with the Corporation(a) directors and senior executives may not advance their pecuniary interests by engaging in

competition with the corporation unless either:(1) any reasonably foreseeable harm to the corporation from such competition is

outweighed by the benefit that the corporation may reasonably be expected to derive from allowing the competition to take place, or there is no reasonably foreseeable harm to the corporation from such competition;

(2) The competition is authorized in advance or ratified, following disclosure concerning the conflict of interest and the competition, by disinterested directors…in a matter that satisfies the standards of the BJR.

In Re: eBay, Inc. Shareholders Litigation (2004)EBay shareholders in this derivative suit allege that the directors took opportunities that rightfully belonged to the corporation. Goldman Sachs had done eBay’s IPO, and rewarded the directors with the opportunity to buy shares in other IPOs. ∆s argue that these were “collateral business opportunities” not within eBay’s line of business.

the motion to dismiss this derivative suit for failure to make a demand on the corporation is denied as Chancery here finds that the “independent” directors were not in fact so independent due to the vast amount of stock options they received working for eBay

they further would have been fired if they had complained of the stock options the insider directors received from Goldman Sachs

Examining whether this was in fact a corporate opportunity, the court determines it was; for not only was eBay able to exploit the opportunities in question, it frequently invested in securitiesFurther,

∆s here obtained the opportunity to invest due to their connections with the corporation motions to dismiss are therefore denied; the burden of proof will be on ∆s to show that the

transactions were entirely fair at trial, as they were interestedThe court here turns ALI on its head by addressing first whether it was a corporate opportunity

E. Duty of Controlling Shareholders

Statutory Sections

ALI § 5.10 Transactions by a Controlling Shareholder With the Corporation(a) A controlling shareholder who enters into a transaction with the

corporation fulfills the duty of fair dealing to the corporation with respect to the transaction if:(1) the transaction is fair to the corporation when entered into; OR(2) the transaction is authorized in advance or ratified by disinterested shareholders,

following disclosure concerning the conflict of interest and the transaction, and does not constitute a waste of corporate assets at the time of shareholders action.

(b) If the transaction was authorized in advance by disinterested directors… the party challenging the transaction has the burden of proof. Also, the party challenging

51


Fall 2006

has the burden of proof if the transaction was ratified by disinterested directors and the failure to obtain advance authorization did not adversely affect the interests of the corporation in a significant way. If the transaction was not so authorized…the controlling shareholder has the burden of proof.

(c) If the transaction… was in the ordinary course of business…the party challenging the transaction has the burden of coming forward with evidence the transaction was unfair… whether or not the transaction was authorized in advance or ratified…

ALI § 5.11 Use by a Controlling Shareholder of Corporate Property, Material Non-public Corporate Information, or Corporate Position(a) A controlling shareholder may not use corporate property, its controlling position, or (when

trading in the corporation’s securities) material non-public corporate information to secure a pecuniary benefit, unless:

(1) Value is given for the use and the transaction meets the standards of § 5.10, or(2) Any resulting benefit to the controlling shareholder either is made proportionally

available to the other similarly situated shareholders or is derived only from the use of controlling position and is not unfair to the other shareholders.

(b) The party challenging the conduct in (A) has the burden of proof—except that if value was given for benefit, the burden of proving whether the value was fair should be determined as provided in § 5.10 in the case of a transaction w/ the corp.

(c) A controlling shareholder is subject to liability under this section only to the extent of any improper benefit received and retained, except to the extent that any foreseeable harm caused by the shareholder’s conduct exceeds the value of the benefit received, and multiple liability based on receipt of the same benefit is not to be imposed.

ALI § 5.12. Taking of Corporate Opportunities by a Controlling Shareholder(a) A controlling shareholder may not take advantage of corporate opportunity unless:

(1) the taking…was fair to the corporation; or(2) the taking…was authorized in advance…following disclosure of the conflict of interest

and the taking is not equivalent to a waste of corporate assets.(b) A corporate opportunity means any opportunity to engage in a business activity that:

(1) is developed or received by the corporation, or comes to the controlling shareholder primarily by virtue of its relationship to the corporation; or

(2) held out to shareholders of the corp by the controlling shareholder…as being a type of business activity that will be within the scope of the business in which the corporation is engaged or expects to engage [and will not be within the scope of the controlling shareholders business.] why do we care about this?

(c) The person challenging has the burden of proof unless the taking was not authorized in advance or ratified by disinterested directors or shareholders—then the controlling shareholder has the burden of proving the taking was fair to the corporation

Zahn v. Transamerica Corporation (3rd Cir. 1947)Transamerica owned a majority of Axton-Fisher Tobacco Company (AF). Class A AF stock were callable at any time by the corporation for $60 and could be converted to class B. Class A stock received a liquidation preference; if the company was liquidated, then Class A shareholders would receive twice as much as Class B shareholders. Before the company was liquidated {for an extremely good price because the market value of tobacco was very high at this point}, the A shareholders are converted to B shareholders; the former A shareholders protest that they should have been able to participate in the liquidation of the company and not just the redemption.

the 3rd Cir. here determines that a majority shareholder may not use its control of the board to gain at the expense of the minority shareholders; it may vote according to its interests, but it has a fiduciary duty to the corporation and the minority shareholders just as directors doo the burden will be on the controlling shareholder to show that the transaction

was in good faith and was entirely fair here, the certificate of incorporation gave the directors of AF the power to change the

Class A shares into Class B shares at any time; therefore such an act could have been legally consummated by a disinterested board, but since the directors here were under the control of Transamerica, the action is voidable in equity

a controlling shareholder need not always subordinate his interests to the minority, but it must make full disclosure to the fellow shareholders when proposing a transaction

52


Fall 2006

Note that the fiduciary obligation of the Board to shareholders with no voting rights is not the same as to those with voting power; the duty to those with no voting rights is only that of maximizing shareholder value – not of full disclosure, as it is for those with voting rightsControlling shareholders owe a duty to the minority shareholders of complete disclosure

KEY NOTE: duty of complete candor only applies when SHs are being required or asked to vote on an issue where they have voting rights (e.g. fact that SHs may be selling their stock doesn’t impose obligation for directors to disclose.

DE courts have been very rigorous in requiring full disclosure by controlling shareholders when they deal with the minority

in Lynch v. Vickers Energy Corp. (1977), the court asserted that the controlling shareholders owed “complete candor” in disclosing fully “all the facts and circumstances surrounding” the tender offer they made for the 46% publicly-owned stock

Rosenblatt v. Getty (1985): all the “material” facts must be disclosedtaking a page from TSC Industries v. Northway (where the USSC said the test of materiality was whether a reasonable man would attach importance to the fact misrepresented or omitted in determining his course of action)

DE in Shell Petroleum (1992) found that Π must show that an omission or distortion of a fact must have been relevant to the investor for it to have been material

Sinclair Oil Corp. v. Levien (Del. 1971)∆, Sinclair Oil, owned 97% of Sinven (an oil corp. it had started in Venezuela). All Sinven’s directors were nominated by ∆. Π alleges Sinven paid out excess dividends for ∆’s cash needs, and therefore neglected a corporate opportunity to expand in Venezuela; and further that there was a breach of contract because ∆ had agreed to buy oil from Sinven which it did not do. ∆ argues that the BJR should apply to all transactions between it and Sinven.

the DE SC first states that the “intrinsic fairness” standard will be used to examine transactions between a parent and subsidiary corporation when there is self-dealing such that the parent corp. benefits and the minority shareholders lose

o in regards to dividends; DGCL §170 gives the board the power to declare dividends; and since the minority shareholders received their pro rata share, there was no self-dealing; therefore the BJR was the proper standard as to the dividend complaint

o as to the corporate opportunity claim, Π could not prove that there were any opportunities which Sinclair usurped from Sinven – therefore no self-dealing, therefore the BJR applied

o the breach of contract claim was, however, a case of basic self-dealing, as ∆ was on both sides of the transaction; therefore, (following the standard drill) the entire fairness standard applies; ∆ had to prove that causing Sinven not to honor the contract was entirely fair to the minority Sinven shareholders; ∆ couldn’t do that

Parent corporation engaging in self-dealing with its subsidiary has the burden of proof.

Greene v. Dunhill International (1968): ∆, Dunhill, owned 80% of Spalding which made baseballs and toys. The minority shareholders of Spalding protested when Dunhill, not itself making any toys, bought Child Guidance Toys for itself;

Πs argued for a lost corporate opportunity. controlling shareholders have a duty not to divert corporate opportunities, and the court

found that there was a showing that a corporate opportunity did exists here

VERY IMPORTANT CASE:Kahn v. Lynch Communications, Inc. (1994)Π had sought to stop the acquisition of Lynch by Alcatel. Alcatel owned 44% of Lynch, and was effectively its controlling shareholder as it dominated the board. Lynch had sought to a buy a fiber-optics company, TelCo; but Alcatel instead wanted it to purchase Celwave (owned by Alcatel’s own parent, CGE). The independent committee created by Lynch to examine the Celwave deal did not approve the purchase. Alcatel then moved to buy the other 56% of Lynch at $14 a share, and the independent committee was ordered to look into such a deal. It approved the deal, but only because it knew Alcatel would instead move in with a hostile takeover if this wasn’t approved. As the deal couldn’t be stopped, Π argues for damages in that Alcatel dictated the terms of the deal.

53


Fall 2006

DE SC here first determines that Alcatel dominated the Board here and was therefore a controlling shareholder, even though they only owned 44% of Lynch.

it then asserts that the controlling shareholder standing on both sides of a transaction must prove its entire fairness (burden of proof becomes entire fairness)- a demonstration of the transaction being at arm’s length is evidence of fairness; and

an independent committee can help support that; and will shift the burden to Π so long as the committee has some real bargaining power

- here, the burden of proof did not shift to Π to show that transaction was not entirely fair because the independent committee so quickly capitulated to the terms of Alcatelnot truly independent.

o the independent committee here are the running dogs of capitalism; they do not get into the pantheon of heroes

Great condemnatory language used in the case for the members of the independent committee who really were conflicted and did the master’s bidding.

(a) It is clear that Boushka and Stafford abdicated their responsibility as committee members . . . [p. 721 last paragraph]

(b) Stafford’s absence from all meetings . . . rendered him ill suited as a defender of the interests of minority shareholders.

(c) From its inception, the Special Committee failed to operate in a manner which would create the appearance of objectivity in Tremont’s decision to purchase NL stock. [P. 722 2nd full paragraph]

(d) The record is replete with examples of how the lack of the Special Committee’s independence fostered an atmosphere in which the directors were permitted to default on their obligation to remain fully informed. [P. 722 last paragraph.]

Note that courts do not like doing entire fairness scrutiny that much; they will therefore often take evidence of an arm’s length transaction as an equivalent demonstration of a fair price having been achieved

that is, if the corporation nominated an independent committee, did a market test (to see if the price offered was adequate), had independent counsel and financial advisors, and negotiated hard then the court is likely to find that it was an arm’s length transaction

Note also that if the price and the process stink badly enough, though DE is an equity court and does not award punitive damages, it may well award rescissory damages (above the actual proper market price; are very similar to punitive damages) because the deal was so bad

What do we mean by arm’s length? Does Alcatel have to tell shareholders their bottom line price? “Defendant need not disclose information which might be adverse to its interest because the normal standards of arms-length bargaining do not mandate a disclosure of weakness.”

Levco Alternative Fund v. The Reader’s Digest Ass’n (2002): the RDA had two classes of stock, A which voted, and B which didn’t. There was (as in Zahn) a recapitalization plan proposed that would make it so that there was only one class of stock. Πs allege that the independent committee which approved the deal did not in fact adequately consider their interests, in that they would gain voting rights but lose stock value.

the initial burden lies on the interested party to prove the fairness of the transaction; and here the independent committee did not in fact operate independently and therefore the burden never shifted to Π; the committee did not consider the harm this deal did to the shareholders, only the benefits to the corporation

this case is different from Zahn in that the corp. here did not have a contractual right to repurchase the stock; it was trying to change those rights; and if you are going to change contractual rights, you have an obligation to each and every shareholder to maximize their interests

Traynor’s broad notion of good faith:Jones v. H.F. Ahmanson & Co. (1969)

54


Fall 2006

Minority shareholder of a savings and loan brought an action against ∆s, 87% shareholders of the company. ∆s had transferred their shares in the S&L into a holding company, and created a public market for the shares of the holding company. ∆s shares were selling above book value, while Πs could not access that market and Πs’ dividends were declining.

this crazy CA court ruled here that Πs have a cause of action for breach of fiduciary duty by ∆s; as the minority should have gotten a chance to participate in the deal

o majority shareholders have a fiduciary duty to minority shareholders and can’t use their power to benefit themselves at the expense of the minority

o the majority denied the minority any market for their stockTraynor here seems to think that the minority shareholders should get an equal opportunity with that of the majority shareholders; Wachter is certain he is crazy, and even more certain that the law doesn’t work that way

he tries to assert a broad duty of fair dealing in states other than DE, employment and corporate law are combined in

an uneasy way; employees with shares have more rights than they would otherwiseo DE does not do this because it does not want to create a separate set of law for

big and small corporations;o it does have a separate section of the DGCL for close corporations; if parties

wish to, they can incorporate under that, and write in extra protections for employees who are also shareholders

F. Sale of Control

Minority shareholders are entitled to protection against abuse by controlling shareholders but are not entitled to inhibit the legitimate interests of other shareholders [that’s why controlling shareholders can get a premium price].

EXCEPTIONS:1. You can’t sell control for premium when you have reason to

believe premium is being paid to you in order to steal corporate assets (Gerdes)2. You can sell for a premium except when premium is in

consideration for sale of a corporate opportunity (Feldmann)3. you can’t use assets from one corporation to help second

corporation b/c you still have fiduciary duty to the first (Omundson?).

Zetlin v. Hanson Holdings Defendants sold their shares of Gable Industries to Flinkote Co. for a premium price of $15/share. Market price was $7.38/share. The amount sold by defendants was enough stock to give Flinkote effective control of Gable.

Absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts of bad faith, a controlling stockholder is free to sell, and a purchaser is free to buy, that controlling interest at a premium price.

Minority shareholders are not entitled to share equally in the premium.

Gerdes v. Reynolds∆s, the board of Reynolds Company, were selling off the company, a closed-down mutual fund which owned only stocks in publicly-listed companies. The buyers they found were willing to pay more than the fair price – but only because they were planning on stealing the company’s assets. ∆s immediately resigned upon the sale, and the buyers shredded Reynolds to pieces; Π is the trustee in bankruptcy.

While controlling shareholders may normally sell their shares without any fiduciary duty to the corporation or minority shareholders, it is in fact a breach of fiduciary duty to do so where the officers and directors decide to sell to person they should have known would loot the company, and then immediately resign after the sale- Liability for such an act would not even have to be predicated on a breach of fiduciary

duty because it would amount to a willful and malicious injury to property, tortious in its very nature…

Director’s right to resign, although sometimes stated with seeming absoluteness, is qualified by their fiduciary obligations to others.

55


Fall 2006

the sale would not have gone through without the resignations, and ∆s should have known of the potential fraudulent intent of the buyers, as the price was so high, particularly for a company whose only assets were other shares- directors must be reasonably vigilant in assessing the circumstances of the sale.

Duty to reasonably perceive risk, fully investigate, disclose resignation plans in connection with sale to shareholders.

Price paid here is egregious… in concluding that these officers and directors violated their fiduciary duty, they must account to the corporation… for the sum of $1,318,750, and for all damages naturally resulting from their official misconduct.

Perlman v. Feldmann (2nd Cir. 1955)In this derivative action by minority shareholders, Πs sue Feldman, the former President and Chairman of the Board of Newport Steel, and dominant shareholder. They assert ∆ violated his fiduciary duty to the corporation and the shareholders by selling control along with a corporate asset. That asset was the “Feldman Plan,” a method of obtaining high returns on steel sales when the prices were controlled by the government. For ∆ sold to Newport’s customers who immediately did away with the plan.

the Feldman plan was deemed to be a corporate asset here; and because ∆ received a premium for the sale of his shares and control, he violated his fiduciary duties, not only as a director and President, but as a controlling shareholder

there was no fraud or the like – just profit to which ∆ was not entitled; therefore, Πs in the end received their percentage of the premium which ∆ received for his shares; they received the extent to which ∆ profited from his sale of the asset (you can’t sell at a premium when premium is due to the sale of the corporate opportunity).

Suggest that fiduciary duties take into account a variety of things, one of which is in the sale of the company in a particular environment whereby you are losing out on a large source of revenue for the company through the sale.

Brecher v. GreggTransaction between defendant Gregg, largest beneficial owner of LIN and a member of the board of directors and the Saturday Evening Post Company (SEPCO) in which SEPCO bought Gregg’s 82,000 shares and paid an amount $1260000 more than the market price on the sale date. Plaintiffs argue that SEPCO paid Gregg a premium for his promise to resign immediately as CEO and president of LIN… in order to bring about the election of a majority of SEPCO’s nominees.

The agreement insofar as it provided for a premium in exchange for a promise of control with only 4% of the outstanding shares actually being transferred, was contrary to public policy and illegal.

It is illegal to sell corporate office or management control by itself (accompanied by no stock or insufficient stock to carry voting control).

Illegal profit belongs ot the corporation (any amount over and above that which would be realized in an arm’s length transaction, over the counter.

Essex Universal Corp v. Yates (2d Cir. 1962) p. 739A corp sued a controlling s/h from whom it had agreed to purchase a 28% share and immediate control of the board.

Held: General rule is that a bargain for the sale of a majority of stock isn’t made illegal by a plan for immediate transfer of management control. It is legal to give/receive payment for the immediate transfer of control to someone who has received majority control.

In this case, P contracted for 28.3% of the corp’s shares. It must be determined whether 28.3% gave P majority stock control.

NOTE:Shareholders have an interest as residual claimants. If not going to get elected, and are going to get appointed by outgoing directors. Needs to be a big enough chunk of stock so the new directors will have the same incentives as the outgoing directors. This issue has become very hot lately. In the last couple years hedge funds have bought stock to influence an election, sold options on that stock, essentially hedging that position (so they don't have real risk/ownership in performance), then vote their shares in a way that may protect some other investment that they have. Hedge fund has stock in A. A & B merge. Hedge fund thinks merger will be bad for A. Try to influence an election w/o having any ownership interest in one of the companies by buy stock and

56


Fall 2006

hedging position with options. Remember: Rule F 14(1) 2056, filing requirements when change of control.

SEC Rule 14(f)(1) Change in Majority of DirectorsIf pursuant to any arrangement or understanding with a person… acquiring securities in a transaction subject to 13(d) or 14(d) of the Act, any persons are to be elected or designated as directors of the issuer, otherwise than at a meeting of security holders… and the persons elected will constitute a majority of the directors of the issuer…then not less than ten days prior to the date such person take office as director….the issuer shall file with the Comission and submit to all shareholders…information which would be required by items 6(a)(d)(e), 7,8, of schedule and regulation 14A…

ALI § 5.16 Disposition of Voting Equity Securities by a Controlling Shareholder to Third PartiesA controlling shareholder has the same right to dispose of voting equity securities as any other shareholder, including the right to dispose of those securities for a price that is not made proportionally available to other shareholders, but the controlling shareholder does not satisfy the duty of fair dealing to the other shareholders if:

(a) the controlling shareholder does not make disclosure concerning the transaction to other shareholders with whom the controlling shareholder deals in connection with the transaction; or

(b) it is apparent from the circumstances that the purchaser is likely to violate the duty of fair dealing under Part V in such a way as to obtain a significant financial benefit for the purchaser or an associate.

X. Insider Trading

A. Securities Exchange Act § 10(b) and Rule § 10(b)-5

§ 10(b) Manipulative and Deceptive DevicesIt shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange—(b) to 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 or contrivance in contravention of such rules and regulations as the commission may prescribe as necessary or appropriate in the public interest or for the protection of investors…

Rule 10b-5 Employment of Manipulative and Deceptive DevicesIt shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,(a) to employ any device, scheme, or artifice to defraud,(b) to make any untrue statement of a material fact or to omit to state a material fact necessary in

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

(c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.

B. IntroIn some ways, this chapter is a continuation of the duty of loyalty—a lot of the analysis hinges on the duty of loyalty on the part of corporate executives, insiders, or other who have inside information. Two views:

1. Continuation of fiduciary duties. In some respects, it should be handled under state law in terms of the use of corporate property—viewed this way it’s an extension of what we already did.

2. Arises from need to protect market. Another view is that as ’34 Act trumps state law, for a free enterprise system to work with the separation of ownership and control necessary for a modern corporation, there is a need for well-functioning securities

57


Fall 2006

markets leads to the idea that the securities market itself has to be protected for the corporate form to succeed.

Remember, we are so willing to invest our money in stocks because the duty of loyalty can be controlled at the state level directors are not going to walk off with the treasury and the residual claimants get a return. An essential part of this is the ability to buy and sell those shares, which requires a well-functioning securities market.

Why don’t you want insiders trading stock? in essence, they are stealing from the corporation the corporation doesn’t want to disclose because they want to get the best position out of

the situation as possible…might prevent company from buying the additional land they might want at a cheap price b/c insider trading is clearly moving the market.

On the other hand—could argue that insider trading serves a good purpose because it gets the price right and that anything that gets the price right (by getting information into the market) has merit to it—but the problem is the duty of loyalty problem and that it can hurt the company.

C. Two very different claims under §10(b) and Rule 10b-5:1. Traditional “insider trading” insider trading by individuals who have material non-public

information when they have a duty to disclose; cases on this basis are brought by the SEC itself

2. Corporations/individuals who put out misleading statements. Defective disclosure by the corporation in the context of §13; for, whereas proxy statement disclosure is regulated by Rule 14a-9, all other disclosures are regulated by §10(b)- shareholders in these cases will be Πs, corps. ∆s- note that Rule 14a-9 is based on negligence, whereas a Π in a §10(b) case will have

to prove fraud

A. Elements of a Claim for 1) individuals who have material non-public info with a duty to disclose

1. the “in connection with” requirement2. inside information: material, non-public3. duty to “disclose or abstain”4. SEC will usually bring claim does Ø have to show causation/damages.

B. Elements of a Claim for 2) corporations/individuals who put out misleading statements1. defendant made material misrepresentation or omission (i.e. the “manipulative

or deceptive device”)2. with the intent to misrepresent or omit=scienter3. made in connection with the purchase or sale of a security4. upon which there was reliance5. which caused (economic loss)6. damage (loss causation)

1) The “In Connection With” Requirement

a) Requirement limits standing to those who purchased or sold stockb) Very expansive definition of sale (Zandford)c) Includes options or other rights to purchase or sell securities (Blue Chip)d) Includes oral contracts to purchase or sell securities (Wharf)

The Wharf (Holdings) Limited v. United International Holdings (2001)Wharf, a Hong Kong company, sought United’s help in assembling their proposal for a cable contract in Hong Kong. United bargained for an option for 10% of Wharf’s securities. After agreeing to it, Wharf refused to hand over the 10%.

this seems like a contract dispute; but the USSC here expanded the ’34 Act, allowing a private suit to be brought under §10(b); oral agreements to buy or sell stock options fall under the SEA umbrella

the “security” at issue is not the cable system stock, but the option to purchase that stock.

58


Fall 2006

for this agreement did relate to the value of the security; the option was in fact worthless

SEC v. Zandford (US 2002)—shows breadth of ’34 ActStockbroker would sell his customer’s securities and use the proceeds for his own benefit w/o the customer’s knowledge or consent. The court determined that this was “in connection with the purchase or sale of any security” within the meaning of the statute and the rule.

D’s argue that the sale of the securities was incidental to fraud and was more akin to stealing rather than “manipulation of a particular security.”

SC reiterates that “[the ’34 Act] should be ‘construed not technically and restrictively, but flexibly to effectuate its remedial purposes.’”

“Neither the SEC nor this Court has ever held that there must be a misrepresentation about the value of a particular security in order to run afoul of the Act.”

Court analyzed these events as a “scheme to defraud” noting that it is not “a case in which a thief simply invested the proceeds of a routine conversion in the stock market. Rather, respondent’s fraud coincided with the sales themselves.”

His clients were injured by these deceptions and each sale made further the respondent’s fraudulent scheme.

Merrill Lynch v. Dabit (US 2006)Sup Ct. took a very expansive reading of the phrase “in connection with the purchase or sale.”

Court held that it is enough that the fraud alleged “coincide” with a securities transaction—whether by the plaintiff or by someone else.

Requisite showing is “deception ‘in connection with the purchase or sale of any security” not deception of an identifiable purchaser or seller.

Blue Chip Stamps v. Manor Drugs Stores (1975: p. 819): to bring a private action under Rule 10b-5, you need to not only prove the elements of fraud and the like, it must be proven that the harm you suffered was “in connection with” the buying or selling of stock

continuing investors who neither bought nor sold shares around the time of misrepresentation with only a state law remedy this halted the federalization of corporate law by placing limits on Rule 10b-5 suits

to broadly expand the class of plaintiffs who may sue under rule 10b-5 would appear to encourage the least appealing aspect of the use of the discovery rules.

2) Manipulative/Deceptive Device Requirement

a) Misstatementb) Omission, if (and only if) you have a duty to disclosec) There has been some actual deception—claim is about fraud not enough that

it is unfair.d) The fact that you need a “material representation” keeps many traditional state-

law claims out of federal court (see Meridor)

Organ v. LaidlawFirst insider trading case, arising during the War of 1812. Organ and Laidlaw both sold tobacco. One day Organ bought a lot of tobacco—Laidlaw inquired as to why by Organ equivocated. Transaction occurs. In fact, the war is already over and Organ knew it—also knew that tobacco prices would take off as soon as the embargo was lifted.

- Justice Marshall says there is no duty to disclose, but the parties can’t say anything to mislead. Took a while for the SEC to get what Marshall got.

Santa Fe Industries, Inc. v. Green (1977)10b-5 actions on the basis of a breach of fiduciary duty due to corporate mismanagement are improper where there’s a state remedySanta Fe had aquired 95% of Kirby Lumber and sought to use the DE short-form merger to acquire the other 5%. Πs, minority shareholders, objected to the merger terms (they got $25 over the book value, but think with a calculation of assets their shares are worth $600 more than that) and are trying to take this §10b-5 action on the basis that ∆ had used a “fraudulent appraisal” of the value of the shares, therefore being an artifice to defraud.

the USSC denies this 10b-5 action thoroughly and completely, on three grounds;

59


Fall 2006

o (1) there was no intent to deceive; for Santa Fe here had actually given Πs here the ammunition by disclosing their rationale for the price

o (2) Πs here could have used the state law remedy of appraisal federal law does not provide a remedy for breach of fiduciary duty of officers in connection

with the sale of the corporationo (3) unnecessary litigation can be vexatious and a waste of money

a Π must have evidence of some sort of nondisclosure or a misleading representation; not just evidence of internal corporate mismanagement

This case, in conjunction with Blue Chip Stamps, marked the turning away from federalization of US Securities law

Goldberg v. Meridor (2nd Cir. 1977)Plaintiff alleges that ∆, a large shareholder in Banff, caused Banff to sell him shares with inadequate compensation. The 2nd Cir. allowed this to be a 10b-5 violation.

it allowed a derivative action to be brought under 10b-5 on the basis of an unfair transaction between a corporation and a controlling shareholder if

(1) the transaction involved stock and (2) material facts concerning the transaction had not been disclosed to shareholders

Π needs to show that this state act would likely have succeeded the 7th Cir. has rejected Goldberg as too much an extension of federal securities law which

would allow every complaint about corporations to come under the ’34 Act This case has been widely followed; generally, to succeed under the principles of

this case, the plaintiff must show:1. a misrepresentation or nondisclosure that caused a loss to the

shareholders2. if the controlling shareholder did not need approval by the minority

shareholders to effectuate the relevant transaction, then to show causation the plaintiff must normally establish that the result of the lack of full disclosure, a state remedy, was foregone.- most commonly, the plaintiff attempts to satisfy this by arguing that if full disclosure

had been made, the shareholders could have sought injunctive relief against the proposed transaction under state law.

Wachter points out that “non-disclosure” raised in such cases is just a hook to try to get this under the ’34 Act

really, at bottom these are state law cases; for they are about the duty of loyalty the ’34 Act does not have the rules on burden shifting and the like which DE does Under DE law, there is a duty of complete candor when shareholder action is required

3) Duty to disclose? “Any Person” unraveled

a) “Any Person”

Obvious insiders: officers, directors, controlling stockholders Obligation to “disclose or abstain” Cady Roberts Narrowed (or mooted?) by Chiarella

In the Matter of Cady, Roberts & Co (1961)—definition of “any person”Rule 10b-5 applies to securities transactions by “any person.” “Any person” includes those who we traditionally think of as corporate insiders—officers, directors and controlling stockholders. However, these three groups do not exhaust the classes of persons whom owe such obligations. The obligation rests upon two elements:1. the existence of a relationship giving access, directly or indirectly to information intended to

be available only for a corporate purpose and not for the personal benefit of anyone, (“regularly available”) and

2. the inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing.

Rule 10b-5(2)(b) [p. 1924]: Duties of Trust or Confidence in Misappropriation Insider Trading Cases: a duty of trust or confidence exists where;

60


Fall 2006

(1) you agree to maintain the information in confidence (2) where you and the person who gave you the information have a history of sharing such

information in confidence (3) whenever you receive such information from a spouse, parent, child or sibling (unless

you demonstrate their was explicit recognition there was no duty of confidence)

e) Other theories for assigning 10(b) duties

1. Fiduciary relationship Duty to disclose comes out of your fiduciary relationship

(Chiarella) You can inherit the fiduciary duty of another if you knew

or should have known of the other’s duty (Dirks)

Chiarella v. United States (1980)Chiarella was a mark-up man at a printing company. They were priting disclosure statements of “ABC company” and Chiarella decoded the actual name of the company. Once he figured it out he bought stock and made $30,000.This case surrounds the “any person” part of 10b. This guy is not trading in his own company’s stock, he is not a fiduciary of ABC nor his company. Did he employ a “manipulative or deceptive device?”

Didn’t say anything, just traded stock. SC says he does not owe a fiduciary duty to any shareholders. The standard is not “any person.” It is any person who has a duty to disclose but

doesn’t disclose. The case is about silence. Chiarella didn’t have a duty so his silence was lawful: “First, not every instance of financial unfairness constitutes fraudulent activity under §

10(b). Second, the element required to make silence fraudulent—a duty to disclose—is absent in

this case.” “Application of the duty to disclose prior to trading guarantees that corporate insiders,

who have an obligation to place the shareholder’s welfare before their own, will not benefit personally through fraudulent use of material, nonpublic information.”

Elements of a 10b-5 violation: (i) the existence of a relationship affording access to insider information intended to be

available only for a corporate purpose, and(ii) the unfairness of allowing a corporate insider to take advantage of that information by

trading without disclosure.“Such a duty to disclose under § 10(b) does not arise from the mere possession of nonpublic market information. Such a duty arises rather from the existence of a fiduciary relationship.”(the point here is that Cady Roberts is no longer good law: the “disclose or abstain” rule is compromised by Chiarella.

The SEC is not a good loser; after this case it passed Rule 14e-3.

2. Misappropriation Theory

Test is whether the insider benefited, either directly or indirectly, from the disclosure (Dirks)

Theory is used to fill the gap when fiduciary link breaks

Liability b/c of fiduciary turned trader’s deception of those who entrusted him with confidential info

Dirks v. SEC (1983)Dirks was an officer at a New York based broker-dealer firm. He gets tipped off by Secrest that Equity Funding of America has been engaging in fraudulent corporate practices, overstating their profits. Dirks flies to LA and conducts his own investigation. He talk to a lot of people and he

61


Fall 2006

thinks he’s onto something. Tries to get the WSJ to publish something, but they won’t do it. He starts telling people about it—none of his immediate clients and he doesn’t trade on it himself.

The SEC brings suit against him, but originally just to censure him. Is this like Chiarella? No, b/c he’s not doing the inside trading himself.

Tipper/tippee case; Dirks isn’t making money off of it so the question becomes who can he tell? The SEC censured, the Court of Appeals affirmed, but then it goes to the SC.

SC has two theories:1. if Secrest has a fiduciary duty, and he tells Dirks, then Dirks inherits

the fiduciary duty (if Dirks knows or should know). Is there a fiduciary?2. Test is whether the insider himself will benefit, either directly or

indirectly, from the disclosure. Did he benefit? The initial inquiry is whether there has been a breach of duty by the

insider. Requires court to focus on objective criteria:- whether the insider receives a direct or indirect personal benefit from the disclosure- pecuniary gain or a reputational benefit that will translate into future earnings.- Existence of a quid pro quo relationship will satisfy this

Here, the SEC wants to encourage collection of information, it does not want all investors thrown in jail for disclosing fraudulent practices!

United States v. O’Hagan (1997)∆ worked for a MN law firm which was helping to negotiate a tender offer for a corp. He bought stock in the target company and sold it at a profit when the merger was announced.

the USSC here finds (1) that a person who trades in securities for personal profit, using confidential information he misappropriated in breach of a fiduciary duty owed to the source is guilty of violating 10b-5, and (2) the SEC did not exceed its power by adopting 14e-3(a) (proscribing trading in the tender offer setting, even absent a duty to disclose)

the Court here approves the SEC’s misappropriation theory under 10b-5; that person commits fraud in connection with a securities transaction when he misappropriates confidential information for securities trading purposes in breach of a duty owed to the source of the informationo this theory satisfies §10(b)’s requirement that chargeable conduct include a

“deceptive device” used “in connection with” trading in securitieso the SEC has authority to promulgate this rule under 10(b) which says the SEC may

prohibit fraudulent acts. Rule 14e-3 is proper because the SEC may prohibit acts that aren’t themselves fraudulent if

that prohibition is reasonably designed to prevent acts that are fraudulentThe misappropriation theory here filled in a gap; ∆ wasn’t even dealing in the stock of the company which hired his law firm and which he therefore owed a fiduciary duty to

f) Rule 14e-3(a)—Tender Offers

SEC has said that with respect to tender offers, there is a per se prohibition on using material, non-public information for trading purposes.

Do NOT need a fiduciary relationship or a misappropriation in the tender offer context

Rule 14e-3 Transactions in Securities on the Basis of Material, Nonpublic Information in the Context of Tender Offers(b) If any person has taken a substantial step or steps to commence, or has commenced, a tender

offer, it shall constitute a fraudulent, deceptive or manipulative act or practice within the meaning of section 14(e) of the Act for any other person who is in possession of material information relating to such tender offer which information he knows or has reason to know is nonpublic and which he knows or has reason to know has been acquired directly or indirectly from:

(1) The offering person,(2) The issuer of the securities sought or to be sought by such tender offer, or(3) Any officer, director, partner or employee or any other person acting on behalf of the

offering person or such issuer,

62


Fall 2006

to purchase or sell or cause to be purchased or sold any of such securities or any securities convertible into or exchangeable for any such securities or any option or right to obtain or to dispose of any of the foregoing securities, unless within a reasonable time prior to any purchase or sale such information and its source are publicly disclosed by press release or otherwise.

g) Rule 10b5-1 No defense to claim that you knew the information but didn’t use it when you

traded If you knew the information, you used the information The general rule under 10b5-1 is that the purchase or sale of a security

violates Rule 10b-5 if the purchaser or seller was aware of material nonpublic information about the security or issuer at the time of the purchase or sale.

an affirmative defense to this exists if you can prove that the contract of sale was already in place before any such inside information was known

4) Scienter

a) “manipulative and deceptive” devices require scienter rather than mere negligence (Ernst & Ernst)

b) Specific intent to misleadc) Recklessness is sufficient if you knew that you were being reckless. This kind of

recklessness is closer to intent than negligence.d) For allegedly fraudulent forward-looking statements you need actual knowledge,

recklessness is not enough (PSLRA)

5) Materiality

e) Omission is material if a reasonable investor would have attached importance in determining his choice of action (TSC)

f) When does an event, like a merger, become material enough to disclose? balancing of two factors:

3. Probability the event will occur4. Magnitude if it does occur

g) Once P’s have shown materiality, burden shifts to D to show P would have made the investment even if the disclosure had been made

h) You don’t have to disclose material information, but if you don’t disclose, you have to abstain (Casy, TGS)

i) If the SEC calls and asks if anything is going on in 1976 do you have to tell them? NO. Do not have a duty to disclose, but you DO have a duty not to misrepresent. Just say that “you have nothing to say, and that you don’t comment on market rumors.”

SEC v. Texas Gulf Supher Co. (TGS) (2nd Cir. 1968)Case grew out of an important discovery by TGS. The four person exploration team made a discovery of k-55-1; found an anomaly of copper, zinc, and silver. Sent it off for more tests in October. By November 8th, insiders start buying. Stories start circulating in the public about this new drill site, but the directors put out a press release saying they don’t know anything about it this is where the misrepresentation occurs. Ultimately, the company confirmed a 10 million ton ore strike and sent out a press release which was published on April 16th. Court held that all transaction in TGS stock or calls by individuals apprised of the drilling results of K-55-1 were made in violation of Rule 10b-5.Price history is important for this case.

11/63 before drilling: $17 when K-55-1 was completed12/63 after assay: $233/64 after drilling resumed $264/12 after 1st release $31 rumors spread

63


Fall 2006

4/16 after 2nd release $37 correct press release5/15 $57

Court goes through each element of 10(b):1. Materiality: the basic test of materiality is whether a reasonable man would attach

importance…in determining his choice of action in the transaction in question.- material facts include not only info disclosing the earnings and distributions of a

company but also those facts which affect the probable future of the company and those which may affect the desire of investors to buy, sell, or hold the company’s securities

- Whether a fact is material will depend upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.

2. When may insiders act?- Such information must have been effectively disclosed in a manner sufficient to insure

its availability to the investing public—all insider activity must await dissemination of the promised official announcement.

Basic Inc. v. Levinson (US 1988)This case looks at the materiality requirement of § 10(b) in the context of preliminary corporate merger discussions and whether a person who traded a corporation’s shares on a securities exchange after the issuance of a materially misleading statement by the corporation may invoke a rebuttable presumption that, in trading, he relied on the integrity of the price set by the market. Facts: CE began talking w/ options and directors of Basic in September of 1976. Trading was suspended in 1978 when the merger is going to be announced. In 1977 Basic made a public announcement denying that there were any talks of merger. Was this correct?

NO. There was scienter in this case—news release is clearly intentional misrepresentation the company was afraid it would create a problem in their negotiations.

Merger discussion: Whether merger discussions are material will depend on the facts. Generally, in order to

assess the probability that the event will occur, a factfinder will need to look to indicia of interest in the transaction at the highest corporate levels.

Fact finder will consider such facts as the size of the two corporate entities and of the potential premiums over market value.

Materiality depends on the significance the reasonable investor would place on the withheld or misrepresented information.

Rebuttable presumption reliance: Requiring proof of individualized reliance from each member of the proposed plaintiff class

effectively would have prevented respondents from proceeding with a class action. Reliance is an element of rule 10b-5, but there is more than one way to demonstrate the

causal connection. Fraud on the market theory:

- fraud on the market theory argues that persons who had traded Basic shares had done so in reliance on the integrity of the price set by the market, but because of petitioner’s material misrepresentation that the price had been fraudulently depressed.

- Because most publicly available info is reflected in market price, an investor’s reliance on any public material misrepresentations, therefore, may be presumed for purposes of a rule 10b-5 action.

- Any showing that severs the link between the alleged misrepresentation and either the price received by the plaintiff or his decision to trade at a fair market price will be sufficient to rebut the presumption of reliance.

64


Fall 2006

6) Transaction Causation/ Reliance

a) Transactional causality—news comes out, misinformation causes the lossh) Loss causality—difference between stock prices. Suppose stock selling

at $40, say “not in merger discussion” and it goes to $35. Do we have loss causation? YES. Company intentionally lies and market opens 5 points lower. We know exactly what the effect of the lie is on the market place.

i) Fraud-on-the-market theory—if the market for the security if efficient, there’s a presumption of reliance because the market incorporated the fraud into the price, and the investor then relied on the market price (Basic, Verifone)

j) Defendant can rebut the the presumption by showing that the investor did not rely on the market price

k) “Truth-on-the-market principle”—if the market knows about the misrepresentation and therefore isn’t affected by it, the fraud on the market theory can’t show reliance

l) Fraud on the market will only work when there is a well developed market for the security. If there isn’t, you’ll have to show reliance just as you would in traditional face-to-face transaction.

Lentel v. Merrill Lynch (2nd Cir. 2005)- relianceThis case takes into account Dura. People were buying stock based on Merrill Lynch reports. Merrill was pumping up their stock to get their clients to buy them. This was a problem.

Even if the clients didn’t read the reports, there was still reliance based on fraud on the market.

Loss causation?- Refers to the PSLRA and says there is proximate cause b/c the loss suffered was

foreseeable.- Have to isolate the impact of the misrepresentation of the stock.

In Re Verifone Securities Litigation (9th Cir. 1993)Fraud on the market theory shifts the inquiry from whether an individual investor was fooled to whether the market as a whole was fooled (if market already had the correct information from other sources could be no causation and no damages).

7) Loss Causation

j) Must how a causal nexus betweenthe misrepresentation and the actual loss suffered (Dura)

k) Have to isolate the period where the misrepresentation was in effect and see what part of the actual loss depended on it

l) 10b isn’t there to provide insurance against market losses that would have happened anyway

AUSA Life Ins. Co. v. Ernst & Young (2000)Πs, insurance companies, invested through bonds in a corp. JWP who had leveraged itself up shit’s creek. ∆s, here, Ersnt & Young, did JWP’s books, but, alas, the statements were not accurate or in accordance with accounting principles. JWP went under after acquiring Businessland, and ∆s sue the accountants for recovery of their bonds. The District Court found that Πs could not recover here because the causation requirement was not met, as JWP went under not because of misrepresentations in their financials but because of the business risk of their acquisition. 2nd Cir. remanded; it determined firstly that transaction causation was obviously established, as

Πs only bought the shares because of ∆’s accounting reports as to loss causation, it is a problem of proximate cause; for if there had been

misrepresentation but JWP was going to go under anyway, then Πs have no suit;

65


Fall 2006

o the idea here is that even if an investment is induced by a violation of Rule 10b-5, the investor’s loss may have been the result of an investment risk independent of the violation

the dissent asserts that loss causation was already proved, in that Πs would never have bought into JWP if ∆ had blown the whistle

It is clear from this case that courts will take the problem of loss causation seriously; you have to prove that you actually suffered damages from the misrepresentation there is protection being extended to these untruth-telling companies because we want to stem

the flow of unmeritorious lawsuits; people who lose money will seek to have someone to blame, but that is not how investing works

In regard to damages: you should be able to collect for the value of what the company was actually worth as opposed to what you paid for it if Π bought the stock at $50 when it was worth $45, and the market then drops the value down

to $2, he shouldn’t get $48 he should only get $5 the idea is that the wrong is redressed

Dura Pharmaceuticals v. Broudo (2005)—causation/lossDura makes asthmatic inhalers. Dura made false statements about the inhaler’s profits—they overstated them. Split on what you need to prove causation—circuit court said you just have to allege that the price was wrong when you bought it to establish loss causation. SC says NO.

can’t allege you paid an inflated price Have to allege actual causation between the material representation and the loss suffered

—must show a causal nexus running from the misrepresentation to the loss.Goes to what the purpose of the ’34 Act is:

Some say should come down hard against any potential misrepresentations. The SC says no, we want to prevent fraud, not provide insurance against market losses. In terms of Dura, it means that the stock price went down b/c the product didn’t catch on,

not because of the misrepresentation if there had been no misrepresentation the stock price would have been where it was with the misrepresentation.- To resuscitate this case, the plaintiff would have to argue that the misrepresentation

was somehow connected to the decline of the stock. - You would have to isolate the period where the misrepresentation was in effect, and

see what part of the actual loss depend on that (in other words to what extent did the misrepresentation buff up the price of the stock prior to the decline, which was not due to the misrepresentation?

Loss causation and JWP hypo:Damages depend critically on the treatment of lost causality. JWP is a company that is expanding rapidly. Not doing great, but expanding rapidly. Want to buy Business Land Computer. As part of that, in terms of the in connection with requirement—involves the private placement of notes that JWP sold to AUSA insurance to help fund the expansion of JWP's business. Evidence that JWP misstates its results. Evidence that Ernst & Ernst helped in the misstatement.

AUSA said relied on the Ernst certification of results, arguing that they were misled. If the stock price was originally $50 at the time they put out the news that was intentionally incorrect and then the stock goes to $0, is loss causality $50? Or is it less?

Did the misrepresentation cause the stock to go to zero? Can you show the nexus? Have to isolate the effect of misrepresentation on the stock price which in this case

essentially increased the value of the stock by giving better news than existed. But if the business model was bank, and the business was going bust anyway, the

misrepresentation did not result in all the losses. Compare to ENRON:

- Business didn’t go bankrupt b/c of a misrepresentation; most of the misrepresentations occurred after the business started to go bad.

- Enron lost causation; you do these event studies, figure out when the misrepresentation occurred, and figure out how much that shot up the stock price:

- Suppose the market itself went up during that period by 1%. In that case, the market, on its own probably would have dragged the stock up from $50 to $51. You would take that factor, subtract it from $55 and therefore the loss causation would be $4.

What helps is the assumption that markets are efficient and that all publicly held information gets quickly incorporated into stock prices.

66


Fall 2006

Efficient Markets:What do we learn from the efficient market theory? Price changes are completely independent of one another. The market, from one day to the

next, does not know what it is going to do. The market is not affected by how it did the day before. Three forms of market efficiency:1. Weak form. Can't predict future prices based on current prices. Also, prices reflect the

information contained in the record of past prices. It is impossible to make consistently superior profits by studying past returns.

1. Semi-strong form. All publicly available information is currently imbedded in market prices. If there is news overnight, when the market opens-- the news is in the stock price.

1. Strong form. Prices reflect all the information that can be acquired by painstaking analysis of the company. Includes all private and public knowledge. Strong form holds if enough illegal insider trading to move the stock price. This form implies that there are not any restriction to insider trading. The strong form does not hold.

1. What does this teach us?1. Trust market prices; in an efficient market one can trust these prices because

they contain all available information about the value of each security; there is no way for most investors to achieve consistently higher levels of return.

1. Markets have no memory; the sequence of past prices is irrelevant to future changes

1. Read the entrails-- security prices tell us a lot. 1. There are no financial illusions; investors are concerned strictly with cash flow

and profit.1. Do-it-yourself alternative: don't pay for others to do what you can do.2. Seen one stock, seen them all; investors don’t buy stock for its unique qualities,

but because it offers the prospect of a fair return for the risk.

8) Specific Requirements for Class Actions (Private Securities Litigation Act)

m) ’34 Act § 21D imposes specific requirements for class actionsn) § 21D(a)(2) has requirements about not accepting payment for being a named

plaintiff, not being a professional plaintiff, etc.o) § 21D(d) says the complaint must allege with particularity why the statement is

misleading and all the facts on which that belief is formedp) Greatly enhanced pleading requirement in securities fraud cases

9) Federal or State Court?

q) § 10b allows a lot of traditional state law claims into federal courtr) You do have to have a misrepresentation—that puts the brakes on it somewhats) Reasons you might not want to use the federal claim instead of the state claim:

1. Forward-looking statement protection (§ 21E)2. Heightened pleading requirement (§21D)

Malone v. Brincat (Del. 1998)2 directors sold stock (56,500 shares) before public news that would make stock price decrease was released. Complaint alleges that Directors breached fiduciary duty of disclosure. Also alleged that KPMG aided and abetted BoD to breach fiduciary duty. Said that BoD overstated financial condition throughout 4 year period in disclosures to shareholders; said that SEC filings were knowingly and materially false and as a direct result of the false disclosures, the company has lost virtually all of its value. Shareholders brought a direct suit claiming that the wrongdoings hurt the corporation. CoAs?

Federal: Could’ve sued under 14a-9 for a violation of the proxy rules; this is also like Basic where there was issuer misrepresentation

State: Breach of Fiduciary duty HOLDING: Suit was properly dismissed, but should’ve been dismissed w/o prejudice.

67


Fall 2006

Directors who knowingly disseminate false information that results in corporate injury or damage to an individual stockholder violate their fiduciary duty, and may be held accountable in a manner appropriate to the circumstances.

This case was properly dismissed because it should have been brought as a derivative not a direct suit since the injury happened to the corporation. If plaintiff’s plead properly they could allege injury to themselves if they want this to be a direct suit.

**This case was brought to avoid the requirements of the PSLRA **If you plead this properly you can avoid removal Federal passed law that said – SEA § 28(f) – no covered class action based on the statutory or common law of any state may be maintained in any federal court by any party alleging a misrepresentation of material fact in connection with the purchase or sale of a covered security; or that the defendant used or employed any manipulative or deceptive device or contrivance in connection with the purchase or sale of a covered security

10) Limits on Liability

a) § 21E (PSLRA) gives special protection for predictions about the futureb) No liability if they are meaningful and cautionary statementsc) Plaintiff has to prove actual knowledge that the statement was false or

misleading

Forward-Looking Statements and the “Bespeaks Caution” DoctrineCompanies will seek to legitimately inject information to the market through giving projections to financial analystsSEA §21E: Application of Safe Harbor for Forward-Looking Statements [p. 1755]; applies to forward-looking statements made by an issuer, except those included in a financial statement, or having to do with a tender offer or IPO (c)(1): a person shall not be liable for any forward-looking statement, whether written or oral, ifo (A) the forward-looking statement is identified as such an is accompanied by meaningful

cautionary statements identifying factors that could cause actual results to differ from those in the statement, or it is immaterial, or

o (B) if Π fails to prove that the statement was made with actual knowledge that it was false or misleading

(c)(2) an oral statement falls within the safe harbor if it is accompanied by a cautionary statement and points to documents that support it

(d) there is no duty to update (i) a “forward-looking statement” is (A) a statement containing a projection of

revenues, income, earnings, or other financial items, (B) a statement of plans and objectives of management for future operations, (C) a statement of future economic performance

This allows companies to make such statements without concerns of liability: Companies say “this is a forward looking statement” or “sales may not materialize” etc. If they put this cautionary language in, the plaintiff has the burden to prove that the

forward-looking statement was made with actual knowledge by the person that the statement was falsr or misleading.

68


Fall 2006

D. Liability for Short-Swing Trading Under § 16(b) of the Securities Exchange Act

a) Structure of § 161. §16a: Filing requirement at 10% trigger

- you can acquire in increments, once you cross the 10% line the six month counter starts

2. §16b: if you purchase and sell/sell and purchase within 6 months, you have to reimburse short-swing profits

- exercising an option is not a sale/purchase under 16(b). The purchase is dated from the date you bought the option, not the date you exercised it. (rule 16b-6)3. §16c: director/officer can’t short sell (interest Ø be aligned)

b) It’s the corporation that suesc) Unorthodox transaction exemption (Kern, Mesa Petroleum)

SEA §16 Directors, Officers, and Principal Stockholders [p. 1874](a) Disclosures required: if you are a director, officer, or owner of more than 10% of the stock, then you must file a statement with the SEC of the amount of all shares which you own, and any changes in the status of that ownership(b) Profits from purchase and sale within six months: any profit realized by one of the above folks from the purchase or sale and sale and purchase of any shares of such issuer within six months must be turned over to the corporation, regardless of the intent of the actor

suit to recover such profit may be instituted by the issuer or any holder of the stock if the issuer refuses to do so within 60 days

(c) Conditions for sale of security by beneficial owner, director, or officer: it shall be unlawful for any beneficial owner, director, or officer to sell any security if the person selling the security or his principal does not own the security sold you can’t sell what you don’t own (Ø short sell!)

Understand then, that if you acquire over 10% of a corporation and then decide you don’t want it, you can’t sell it again within six months

this prevents short-term trading on a stock want to make sure interests are aligned

Enforcement:§16(b) is enforced by shareholders or the corporation; plaintiff attorneys specialize in examining who has been doing such swing-trading and finding shareholders to reclaim the profits made§16(a), the filing requirement, is enforced by the SEC

Rule 16b-6, Derivative Securities:[p. 2069] (a) establishment or increase in a call equivalent position or liquidation of a decrease in a put equivalent position shall be deemed a purchase of the underlying security for purposes of § 16(b)…and the establishment of or increase in a put equivalent position or liquidation of or decrease in a call equivalent position shall be deemed a sale of the underlying securities.

(indicates that for options, the establishment of the call position (i.e. the date on which you are first given the option) determines the purchase date; a holder of options needs to hold the option for six months, but once that has passed, they can exercise the option and sell the stock immediately)

NOTE on § 16: § 16(a) is widely used by Wall Street to determine how well the company is doing and if

anyone inside the company is making a move. Under this section you have to report whether a big outside investor is buying or selling the stock. (even if Ø trade on inside info, seem to have a bias to selling and buying at the right time)

CANNOT trade on INSIDE INFO=bright line rule. CANNOT short swing trade. Why?- to remove temptation to cause fluctuations in the stock price in order to create

profitable trading opportunities- using inside info, should not be able to profit unfairly- no temptation to manipulate the market

69


Fall 2006

Arrow Distributing Corp. v. Baumgartner (2nd Cir. 1986)“Section 16(b) is a strict liability rule. Enacted precisely because of the difficulty of establishing whether an insider did indeed benefit from the information available to him in his strategic position. It adopts a purely objective test: if a sale and a purchase or a purchase and a sale result in a net gain, the gain is recoverable.”

Kern County Land Co. v. Occidental Petroleum Corp. (1973)After a failed attempt to merge with Old Kern, Occidental issued a tender offer for 500,000 Old Kern shares; it acquired more than 10% of the total. Old Kern’s directors sought to have Tenneco buy all the corp.’s assets, such that “New Kern” would be a subsidiary of Tenneco (it was also willing to pay $105, $20 more than Occidental). Occidental failed to stop the merger, so it initiated a deal with Tenneco where Tenneco would be able to buy all its Kern shares (giving Occidental a nice profit of $21/share) that couldn’t be used until six months and a day had passed. The merger went through before six months past, and the option became viable at that date. When six months passed, Occidental exercised its option (with $20 million profit), and New Kern filed a §16(b) suit.

the USSC here finds that the option was not a §16(b) sale; because (1) ∆ had no access to inside information on Old Kern and the potential merger, and (2) the exchange was essentially involuntary as the exchange of shares for stock in the

surviving company operated automatically as a matter of state lawThe Kern two-part test must be met before an unorthodox transaction will be exempt from §16(b) liability

in the usual situation, where a takeover target arranges a defensive merger, the failed bidder will normally not have §16(b) liability; unless it tries to unload its stocks in the open market

Colan v. Mesa Petroleum (1991): [from Unocal] Mesa acquired 13.6% of Unocal shares at an average of $45. It made its tender offer at $54 per share. Unocal initiates its exclusionary self-tender at $72. Eventually, a deal is struck allowing Mesa to participate in the self-tender. A Unocal shareholder brought this §16(b) action seeking to recover the short-swing profit Mesa made.

the 9th Cir. here held that this did not fall within the “unorthodox transaction” exception; ∆ here could have participated in the offer, or he could have held onto his stock; he opted to participate in the offer, and is therefore liable under §16(b)

o no state law forced ∆ to give up his Unocal shares, for it was merely a tender offer, not a statutory merger

o importance of the involuntariness factor

NOTE on definition of “officer” for 16(b): SEC’s definition of “officer” is more function based and more limited

than it’s old rule. The new rule, 16a-1(f) makes clear that a person’s functions and not simply title will determine the applicability of Section 16.

E. Regulation FD

The SEC promulgated rule FD in response to:

70


Fall 2006

t) concern over the “potential for corporate management to treat material information as a commodity to be sued to gain or maintain favor with particular analysts or investors…

u) in the absence of prohibition on selective disclosure, analysts may feel pressured to report favorably about a company or otherwise slant their analysis in order to have continued access to selectively disclosed information….concerned… with reports that analysts who publish negative views of an issuer are sometimes excluded by that issuer from calls and meetings to which other analysts are invited…

v) Finally, … technological developments have made it much easier for issuers to disseminate information broadly…regulation FD targets the practice by establishing new requirements for full and fair disclosure by public companies…” SEC Release No. 33-7881 (2000)

w) Regulation FD- rule 100Under this rule, whenever:

(1) an issuer, or person acting on its behalf,(2) discloses material nonpublic information,(3) to certain enumerated persons (in general, securities market professionals or

holders of the issuer’s securities who may well trade on the basis of the information)

(4) the issuer must make public disclosure of that same information:(a) simultaneously (for intentional disclosures) or(b) promptly (for non-intentional disclosures)

As a whole, the regulation requires that when an issuer makes an intentional disclosure of material nonpublic information to a person covered by the regulation, it must do so in a manner that provides general public disclosure, rather than through a selective disclosure. For a non-intentional selective disclosure, the issuer must publicly disclose the information promptly after it knows (or reckless in not knowing) that the information selectively disclosed was both material and nonpublic…

Note on Who can Bring a Derivative Action Shareholder Plaintiff must be a shareholder when the action begins and must remain a shareholder during the pendency of the action when a company merges with another, the suit drops out bc the plaintiff is no longer a shareholder of the constituent company EXCEPTION: (1) where merger is subject to claim that it was perpetrated merely to deprive stockholders of right to bring derivative action; (2) where merger is in reality a reorganization that doesn’t affect the plaintiff’s ownership of the biz enterprise Creditors – ordinarily has no right to bring a derivative action. Sometimes they can if they have debt that is convertible into stock. Directors – Occasionally statute gives officer or director right to bring derivative action. Ex. NY law.

71


Fall 2006

XI. Shareholder Suits

A. Derivative Suit

a) Characteristics The law permits shareholders to sue for breach of fiduciary duty

on the corporation’s behalf. Preconditions for claims (Ross v. Bernahard)

1. valid claim on which the corporation could have sued2. corporation itself had refused to proceed after suitable

demand (unless excused by extraordinary circumstances) Looked at the dual nature of the action: 1) the stockholder’s right

to sue and 2) the merits of the corporation’s claim itself A shareholder with a tiny investment can force an expenditure by

the corporation of a large amount of funds and executive time Corporation is an indispensable party and must be joined in the

suit Lawyer would prefer a direct suit b/c many procedural rules

apply to derivative suitsb) Direct or derivative?

The Test (Tooley):1. Nature of the injuryWho suffered the alleged harm (the corporation or

the suing stockholders, individually); and- a suit alleging breach of fiduciary duty will generally be considered to allege

an injury to the corporation2. Who recoversWho would receive the benefit of the remedy (the

corporation or the stockholders, individually)?3. Derivative suits are good in that they protect not only the shareholders,

but the creditors and the employees of the corporation.c) Who can bring a derivative suit?

Must have shareholder status at the time the action is begun, and must remain a shareholder during the pendency of the action.

Merger Implication: If shareholder’s company merges with another company, the S loses standing to continue prosecuting b/c no longer a shareholder in C.

Two exceptions to the merger rule:1. merger is perpetrated merely to deprive shareholders of

the right to bring a derivative action2. merger is really a reorganization that Ø affect plaintiff’s

ownership of business enterprised) When can a shareholder not bring a derivative suit?

Shareholder is barred from bringing a derivative action if either1) she participated in the alleged wrong2) consented to the wrong or explicitly ratified it3) guilty of laches?4) Acquiesced in the wrong or failed to object theory of these rules is that in such a

case the plaintiff lacks “clean hands.”e) Cases likely to be direct suit :

Issuance of stock for the wrongful purpose of perpetuating or shifting control Almost anything that turns on voting is going to be a direct case In Smith v. VG, shareholders were mad b/c Ø get highest price for their stock;

would be a direct harm (?)f) Nature of a derivative action

Tooley v. Donaldason, Lufkin & Jenrette (Del. 2004)

72


Fall 2006

Minority stockholders in DLJ brought a direct suit against the former directors of DLJ, arguing that when Credit Suisse had acquired DLJ, the directors allowed Credit Suisse to postpone the actual merger twice, thereby harming the minority shareholders due to the time value of money.

The Chancery Court had dismissed the suit, arguing that it was actually derivative under the “special injury” standard (i.e. the wrong was separate and distinct from that suffered by other shareholders, or involved a right that exists independent of a right of the corporation).

The DE Supreme Court rejected that test and substituted the two-prong analysis described above. In this case, the Court found that it would have been a direct claim, except that the plaintiffs didn’t actual have any of their rights violated.

Need to look at the nature of the wrong and who the relief should go to in order to determine direct or derivative.

Barth v. Barth—ALI permits direct suit in closed corpP is suing president of Barth Electric (who is his brother). Alleging that paid himself excessive salaries and diverted corporate funds to himself. P alleges that this is a direct suit b/c the nature of the corporation is closed; with a derivative suit, all the money would just go back to the offender—the corporation.

The SC of Indiana adopts the ALI rule 7.01(d) which allows a P to directly sue under a breach of fiduciary duty claim when the corporation is a close one.

Under this rule, a court, in its discretion, may treat an act raising derivative claims as a direct action if it finds it will NOT:

1. unfairly expose the corporation or Ds to a multiplicity of actions2. materially prejudice the creditors of the corporation3. interfere with a fair distribution of the recovery among all interested parties

DELAWARE does NOT follow the ALI rule!!!!!!!

g) Individual (Pro Rata Recovery in Derivative Actions)

Glenn v. Hoteltron Systems, Inc. (Ct. Appeals NY 1989)Π and ∆ were each 50% owners and officers in Ketek Corp. Π’s derivative suit was successful, and he argued that he, rather than the corporation, should get compensated, because it would allow ∆ to share in the benefit to the corporation when he caused the harm.

the NY Ct. here asserts that because a shareholder’s derivative suit seeks to vindicate a wrong done to the corporation, any recovery obtained is for the benefit of the injured corporation

This case states the black-letter law: corporations recover in derivative suits to protect the corporation and its creditors; and also the interests of the unaware shareholders and the desire to maintain the limited liability status of shareholders

Where there is individual recovery, the shareholder who sued recovers a percentage of the total damage that was done to the corporation corresponding to his percentage ownership in the corp.:

If Π owns 20% of the corporation, ∆ owns 80%, and the court determines that ∆ harmed the corporation to the extent of $1,000,000 then in pro rata recovery, Π would get $200,000, ∆ and the corporation would get nothing

Perlman v. Feldmann—(rehashed)This was the above case regarding the steel company whose controlling shareholder essentially sold the corporate asset (the unique business plan) to another company when he sold control to that company. Though it was a derivative suit, the court allowed individual recovery.

The key thing here is that the injured corporation was no longer in existence, and it wouldn’t be fair to allow the new corporation’s shareholders, many of whom weren’t owners of the injured corporation, to recover (the subsequent purchasers would otherwise share in the recovery)

When individual recovery is ordered it is often when the company has been taken over and new owner was involved and has done harm to the corporation

73


Fall 2006

h) Relief Unlike class actions, in which the relief is given to the plaintiff class members, any relief

recovered in a derivative action (net of expenses including attorneys’ fees) is returned to the corporation

B. Contemporaneous Ownership Rule—who has standing?

a) Policies in favor of the contemporaneous ownership rule- preventing unjust enrichment of shareholders who purchased w/ knowledge

of circumstances- discouraging litigation by individuals who purchase one share just to bring

suit no purchasing the cause of action

DGCL § 327 Stockholder’s Derivative Action; Allegation of Stock OwnershipIn any derivative suit instituted by a stockholder of a corporation, it shall be averred in the complaint that the plaintiff was a stockholder of the corporation at the time of the transaction of which such stockholder complains or that such stockholder’s stock thereafter devolved upon such stockholder by operation of the law.

ALI §7.02: Standing to Commence and Maintain a Derivative Action (a) a holder of an equity security has standing to commence and maintain a derivative action if

the holder o (1) acquired the security (A) before the material facts relating to the alleged wrong were

publicly disclosed or known to the holder, or (B) by devolution of law from a prior holder who satisfies (A); [and]

o (2) continues to hold the security until the time of judgment, unless the failure to do so is the result of corp. action to which to holder did not acquiesce, and either (A) the derivative action was commenced prior to the corp. action terminating the holder’s status, or (B) the court finds the holder is better able to represent the interests of the shareholders than any other holder who has brought suit

NY law captures DE law; though DE doesn’t write out its law in its statute:NY Bus. Corp. Law. §626 Shareholder’s Derivative Action . . . (a) indicates that an action may be brought (b) Π must show that he is such a holder at the time of bringing the action and that he was

such a holder at the time of the transaction of which he complains, or that his shares or his interest therein devolved upon him by operation of law

(c) Π must set forth with particularity his efforts to secure the initiation of such action by the board or the reasons for not making such effort demand must be made

(d) such action shall not be discontinued, compromised, or settled without the approval of the court

(e) Π can receive attorney’s fees

Bangor Punta Operations v. Bangor & Aroostook (SC 1974) B&A sold 98% of the BAR stock to BP, BP held onto it then sold it to Amoskeag. Amoskeag, owning 99% of BAR caused it to bring suit alleging corporate waste when B&A and Punta owned BAR.

The SC rules for B&A wins. Price at which P bought it for was entirely fair---P’s were not contemporaneous owners. The sale price at which Amoskeag bought from BAR reflected the damage done to the corporation already they had negotiated a price and would be unjustly enriched if they received more money than they paid.

Though this is technically a derivative suit brought by BAR’s controlling shareholders, the court disregards the fiction and considers this a direct suit.

Rifkin v. Steele Platt (Co. Ct. App. 1991)Πs, the present principal shareholders, purchased a controlling interest in a restaurant from ∆. Πs, following the purchase, discovered that ∆s had misappropriated funds, made misrepresentations,

74


Fall 2006

and looted the corporation. Πs filed suit alleging breach of contract, breach of good faith, breach of fiduciary duty, and unjust enrichment.

the contemporaneous ownership rule can be rebutted if it is established that the share price at the time you bought it did not reflect the damage done to the corporation; as the parties here dispute whether the sale price reflected the wrongdoings, the case is remanded to the trial court for determining if it did or did not

m) Exceptions to the Contemporaneous Ownership Rule: A shareholder may not be barred from bringing a derivative action if he did not hold his

shares when the harm occurred, if one of the following things existed:

75


Fall 2006

1) Π received his shares by devolution of operation of law (i.e. a merger or inheritance) from one who was a shareholder at the time of the alleged wrong

2) the continuing wrong theory: a Π can bring an action to challenge a wrong that began before he acquired his shares but continues thereafter

3) SEA §16(b) claims: a non-contemporaneous shareholder can bring a derivative action for short-swing trading under §16(b); the statute states that an owner of securities may bring suit – with no qualification put upon it

4) potential Bangor Punta exception; in that case, no contemporaneous shareholders owned a significant amount of BAR stock; if there had been significant portions owned by a contemporaneous shareholder, a court could arguably impose liability on the wrongdoer but grant pro rata relief to the contemporaneous shareholders

C. Right to Trial By Jury In Derivative Actions

a) under 7th amendment a derivative action brought in federal court the parties have right to a jury where the action

b) would be triable to a jury if it had been brought by the corporation itself

D. Demand on the Board and Termination of the Derivative Actions on the Recommendation of the Board or a Committee

a) Shareholders have to bring the claim to the attention of the board and ask them to rectify it Otherwise, it will be dismissed for failure to make demand.

Attempts to balance the fact that shareholders are bringing suits on behalf of the corporation and 141(a)

More efficient to let corporation handle it before it gets to court If shareholder Ø hear back from company, has claim for

wrongful refusal.b) Demand excusable when it is futile.

1. directors were interested, or2. directors were uninformed or irrational (Aronson v.

Lewis)3. must plead with particularity the facts beyond a

reasonable doubt (NY is stricter, Ø use reasonable doubt)4. Pleading requirement for demand futility is basically the

pleading requirement for rebutting the BJR Delaware has collapsed the BJR inquiry into the demand requirement.

c) If you make demand and lose, your case is basically over because making demand means you didn’t have enough facts to rebut the BJR. Rarely, do groups make demand—the pleading time is the time to show the court what you have.

d) If demand is futile, board can either:1. settle2. go to trial on the merits3. Board can appoint its own Special Litigation Committee

a. Board can try to cleanse the transaction by appointing a committee to evaluate the claim and recommend settlement or dismissal

b. Ind. committee is made up of directors who are not even on the board at the time of the transaction. Power to delegate to them is § 141 (c).

c. NOT a safe harbor Board still has to prove the committee was independent and rationally informed.

d. Committee has to act rationally and has burden to show that it did.e. Two-part test for analysis of the decision:

76


Fall 2006

(1) Procedurally fair(2) Substantive evaluation of the

decision from the court’s perspective that considers even public policy concerns (rarely triggered)

4. Demand rule exists because whether or not to pursue litigation for the corporation is supposedly a business decision like any other—and directors will be in the best position to determine what’s in the best interests of the corporation. (Might not be the case when the action is against the directors themselves).

e) Most of the time a case dismissed for failure to make demand will also be dismissed for failure to state a claim. (Except: director compensation claim in Marx and a 102(b)(7) claim, where demand will be futile but there’s no claim b/c no remedy).

Marx v. Akers (NY Ct. of Appeals 1996)Π shareholders of IBM allege that the outside directors and certain senior executives were paid too much. Πs did not make a demand on the corporation, and the App. Div. dismissed the suit for failure to make demand.

the NY Ct. of Appeals here examines the DE approach and the universal demand approach:

o in DE, a Π can be excused from making demand if he casts a reasonable doubt on the idea that (1) the directors were disinterested, and (2) the transaction was a valid exercise of the BJR

o the universal demand approach expressed in ALI §7.03 establishes a bright-line rule that would always require demand to be made on the corporation (unless Π shows that irreparable damage would otherwise done to the corp.); if the corp. rejects the suit, then that decision would be closely examined

in refuting both these tests, the court determines that the NY law is that demand is futile if (1) a majority of the directors are interested or not independent, or (2) that that the directors didn’t fully inform themselves, or (3) the challenged transaction was so egregious on its face that it could not have been the product of sound BJ

o here, only three directors were alleged to have benefited from the executive compensation, and Π failed to allege that a majority of the board was interested and failed to establish that the Board didn’t make an informed business decision, failure to make a demand was fatal to the portion of the complain challenging that transaction

o as to the increased pay for outside directors, such business decisions are always interested: therefore, Π was not required to make a demand on the corp., and ∆s motion to dismiss for failure to make a demand is not granted

but Π’s claim here is dismissed nonetheless, for he has failed to make a showing of corporate waste that would be necessary to establish a cause of action (Ø allege particularized facts & 141(h) permits directors to set their compensation).

Auerbach v. Bennett (Ct. of App. NY 1979)Here company launches an internal investigation in response to rumors that it had bribed foreign officials. Audit committee finds that the wrong did occur. Derivative suit is filed. Board then creates an independent litigation committee (141(a) bd can allow a committee to act in its place). The members of this committee are people who weren’t even on the board at the time these wrongs took place—makes them truly independent. Independent committee decides it’s not in the corporation’s best interest to proceed.

Not a safe harbor: Plaintiff’s can now argue that the special litigation committee wasn’t truly disinterested.

The board has the burden of proving that the committee was in fact independent and rationally informed.

The independent committee’s decision is protected by the BJR and the court can only investigate the disinterestedness and the procedures of coming to its decision.

Zapata Corp. v. Maldonado (Del. 1981)

77


Fall 2006

Derivative suit against the board, plaintiffs Ø make demand b/c it would have been futile, but board decided to form a litigation committee to evaluate the claim. The court determined that even if the entire board had been implicated in the purported wrongful action, it still had authority under 141(a) to delegate its decision on whether to pursue the suit to a Special Litigation Committee of disinterested directors.

The standard of review for the committee’s decision will not be BJR—but the corporation has the burden of proving independence, good faith, and reasonable investigation (entire fairness) (step 1 procedure)—and the court can evaluate the decision using its own business judgment, including considerations of public policy (step 2 court BJR)

XII. Combinations

A. Terminology

a) Raider or bidder : person/corporation that makes a tender offerb) White Knight : when management knows it’s going to be taken over solicits

competing tender offers from other corporations. The more friendly corporations are “white knights.”

c) Lock-up : device used to protect one bidder (usually the white knight) against competition by other bidders. The favored bidder is given an option to acquire selected assets, or a given number of shares of the target at a favorable price under certain conditions—these conditions usually involve the defeat of the favored bidder’s attempt to acquire the company or the occurrence of events that would make such defeat likely.

d) Crown jewels : to defeat or discourage a takeover bid, a target may give the white knight a lock-up option that covers the target’s most desirable business or the business most coveted by the disfavored bidder.

e) Fair price provision : requires that a super-majority (usually 80%) of the voting power of a corporation must approve any merger or similar combination with an acquirer who owns a specified interest in the corporation—usually 20% of the voting power. This supermajority vote is not required in some conditions—most notably, if the transaction is approved by a majority of those directors who are not affiliated with the acquirer and who were directors at the time the acquirer reached the specified level of ownership of the company, or if certain minimum price criteria and procedural requirements are satisfied. Fair price provision discourages purchasers whose objective is to seek control of a corporation at a relatively cheap price and discourages accumulations of large blocks b/c it reduces the options that an acquirer has once it reaches specified level of shares.

f) Management buyout (MBO): acquisition in cash or securities by a newly organized corporation in which members of the former management of the public corporation will have a significant equity interest, pursuant to a merger or the like.

g) Leveraged buyout: an MBO that is highly levered, acquiring a huge amount of debt in relation to its equity.

h) Poison pill: plan under which the board of directors creates rights that are distributable to shareholders. Under the rights, upon the occurrence of certain events shareholders (other than a tender offer bidder or prospective bidder) have the right to purchase stock in the corporation (or maybe the acquirer) at a deep discount. Because the potential exercise of these rights would dramatically dilute the value of the target stock that the bidder proposes to acquire, the mere potential that the rights will be exercised may serve as a deterrent to making a bid in the first place.

i) the “flip-over” provision, triggered after the acquirer seeks to institute a merger, allows the target company’s shareholders to buy the acquirer’s stock at half price

B. Sale of Substantially all Assets

a) Asset sales

78


Fall 2006

Can sell assts for any type of consideration—cash, debt, stock, chocolate…

DGCL § 271—in a sale of ALL or SUBSTANTIALLY ALL of a corporation’s assets the corporation has to let the stockholders vote

First question: is there a vote? All or substantially all?o Gimble standard: whether a transaction involves the sale of:

1. assets quantitatively vita to the operation of the corporation2. is out of the ordinary and substantially affects the existence

and purpose of the corporation Second question: who gets to vote?

o Only the company that is selling all or substantially all Third question: is there an appraisal right?

Hollinger v. Hollinger (Del. Ch. 2004)The subsidiary is suing the parent company b/c the parent is trying to sell the Telegraph subsidiary without a 271 vote. Shareholders argue that is “substantially all” of the corporations assets. Strine uses the Gimbel standard and says it’s not substantially all.

Telegraph might be the “coolest” asset they have, but there’s still a lot of profitable company left after the asset is sold.

Strine says “substantially all” means “essentially everything.”

C. Appraisal

a) DGCL § 262 –gives stockholders the right to ask whether or not the received “fair value.” (fair value gets defined in case law)

b) When do you NOT have appraisal rights? If you are not a continuing shareholder § 262(d) tells us how to perfect appraisal

rights (hold shares continuously, non-consenting, obligation on company to inform you that you have appraisal rights)

If you voted “yes” have to be a dissenting shareholder Asset sales do not generate appraisal rights § 271 When the stock is traded on a public exchange (privately held corporations get

appraisal rights) (rationale seems to be that the public markets will price stock well) Exceptions:

o Cash out merger § 262 (b)(2) says that if it’s a cash-out merger you get appraisal rights. Why don’t you get this in a stock deal?

o CoI § 262(c) can put it in the CoI, but to Wachter’s knowledge this has never been done

o Possible EXAM question: do you expand appraisal rights or retract them and not

even give them to cash out mergers?c) How is appraisal calculated?

§ 262(h) is the substantive section, tells you that you get fair value exclusive of any value of appraisal arising from synergies of the company. Get going concern value. Calculated by a discounted cash flow analysis of the value of the free cash flows discounted to their present value.

d) When do you get appraisal? 3 cases: Closed corporations Cash mergers (§ 262(b)(2)) § 253, short form mergers (Ø get to vote, but get appraisal) If you don’t get appraisal, can argue for violation of fiduciary duty, unfair price/deal and

way to get into a kind of appraisal.

D. Statutory Mergers

79


Fall 2006

a) Often require shareholder approval (when new stock issued) In order for a company to issue new stock, which is often the consideration in a merger,

DGCL § 242(a)(3) requires that any changes to the number of issued shares by approved by a majority of shareholders.

Note: shareholder approval is not required to change the amount of authorized stock, just the amount of stock in existence at all (b/c will dilute current shareholders)

b) DGCL § 251 Merger or Consolidation of Domestic Corporations (b) board must adopt a resolution (c) agreement must be submitted to shareholders and a majority of the outstanding

stock must approve it before it will go into effect. (d) directors can decide to terminate the merger at any point (f) NO shareholder approval required when:

o The agreement in no way amends the certificate of incorporationo Each share of stock of the surviving corporation is to be identical to what it is

before the merger and:- no new shares are to be issued or- the authorized unissued shares will not amount to more than 20% of the

stock outstanding before the merger.c) Short form merger

Mergers b/t parents and their less than 100%-owned subsidiary, typically if a parent owns 90% or more of a company it can buy out the remaining minority shareholders without stockholder approval.

§ 253d) Trianagular mergers

Designed to give management the best of both types of “mergers”—the form of a merger, but without necessarily assuming the liabilities of the disappearing corporation and without voting or appraisal rights in the from of survivor’s shareholders.

Permitted under § 251(b)(5) How it works:

o S & T want to merge. S will be the survivor and T shareholders will end up with 100k shares of S.

o In a normal merger, this would happen by S issuing 100k of its own stock to T shareholders.

o In a triangular merger, S instead begins by creating a new subsidiary, S/sub. It then transfers 100k shares of its own stock to S/sub in exchange for all of S/sub’s stock.

o S/sub and T then engage in a statutory merger, but instead of issuing its own stock to T, S/sub issues 100k shares of S stock.

o T’s business is now owned by S’s wholly owned subsidiary and T’s shareholders now own 100k shares of S stock.

o S can now insulate itself from direct responsibility of T’s liabilities.o Traditionally, this may not have been permitted, however DGCL § 251(b)(4)

permits survivor corporation to issue shares or securities of any corporation.o Important problem caused by triangular mergers is that they may allow

subversion of shareholder voting and appraisal rights.e) Freezeouts

Corporate transaction whose principal purpose is to reconstitute the corporation’s ownership by involuntarily eliminating the equity interest of the minority shareholders.

Weinberger v. UOP, Inc (Del. 1983)Direct class action (value of shares and fact that it’s a takeover case make almost invariably makes it direct). Challenging value received for shares. Here, Signal has a lot of cash on hand and buys some of UOP. Eventually want to take it all. The board of UOP consists of five directors or employees of Signal. Signal and two of their directors at UOP do a “feasibility study” of the “fair

80


Fall 2006

price” for the remaining Signal stock and determine that anything up to $24 would be a good investment for Signal. They do NOT tell the shareholders about this study.

Market price is 14. However, reasons to believe that the $14 is not the accurate going concern price- under priced because there is a controlling shareholder. No market for corporate control. Decide to buy for $21.

the DE SC here affirms in part and reverses in part: it finds that even though the ultimate burden of proof to show a transaction is fair is on the majority shareholder, a Π must first show some basis for invoking the fairness testo where the corporate action is approved by an informed vote of the minority

shareholders, the burden of proof entirely shifts on Π to show the transaction was unfair to the minority; however, ∆s have the burden of establishing that the minority shareholders were informed in their voting

o if the vote was not an informed one, then the burden of proof remains with ∆s to show that the deal itself was entirely fair

Have to have arms length transactions—not the case here. Court holds that Signal also owed a fiduciary duty to UOP and breached it by

not disclosing the feasibility study. Ct says “entire fairness” here means fair dealing and fair price. Footnote 7: the result here could have been entirely different had UOP

appointed an independent negotiation committee of outside directors to deal with Signal at arm’s length.

NOTE: have fact pleading here—in b/t particularity and notice. Have a shareholder vote here, but NOT effective b/c the shareholders were

not fully informed b/c not told of report. Plaintiffs win and get appraisal.The Court here tried to say that appraisal following this case would be the “exclusive” remedy; but in fact, what it meant to say was what it said in Glassman v. Unocal Exploration: that that appraisal is the exclusive remedy only in §253 (short-form) and not in mergers pursuant to other statutes

from here on out, the fair price you receive in appraisal is equivalent to the fair price in a fiduciary duty suit

E. Tender Offers

a) Fundamentally different from other m&a’s in that the bidder goes directly to the shareholders.

b) Often a tender offer will be used to acquire 90% of the stock in order that the company can institute a short-form merger for the rest.

c) In a tender offer, you will normally have provisions that say this tender offer is effective only if you get X% of control. If they don’t get control then the tender offer fails.

d) Once the acquirer gains control, they will often want to put their people on the board. How is this done? EXAM. Where is the statutory authority for calling a meeting and getting the vote done?

- amend the by-laws?e) Target’s board now accepts a merger offer from the bidder which then cashes out the

minority shareholders (§ 251 cash-out merger). If it’s a cash out, minority shareholders WILL get appraisal.

f) Williams Act: § 13(d), any individual who has acquired more than 5% of a class of stock has to file a

Schedule 13D (includes purchaser’s background and identity, and the sources of funds the purpose of the purchase)

§ 13(e) indicates that corporations that tender for their own stock are subject to regulations similar to those imposed on outside bidders under Rule 14D and 14E.

§ 14(d) applies to tender offers for more than 5% of any class of security:o Rule 14e-1: minimum duration offer must be open for at least 20 dayso Rule 14d-8: proration: a bidder making a partial tender offer and more

securities are tendered thanit sought to buy will have to accept up to the percentage on a pro rata basis.

81


Fall 2006

o Rule 14d-10: all holder’s rule: the tender offer must be open to all shareholders (this overrules the Unocal holding which allowed a discriminatory merger)

o Rule 14d-10: also has the best price rule: the price paid to any security holder must equal the highest price the bidder paid to any security holder during the tender offer.

§ 14(e) are fraud provisions as applied to tender offers… no untrue statements or omissions of material fact in relation to tender offers. (Note: this is a scienter provision, requiring an intention to defraud, not merely negligent misstatement…)

Rule 14e-2 established an obligation of the target corp.’s management to respond to a hostile tender offer, to say whether they approve, disapprove, have no comment, or are unable to make comment.

Solomon v. Pathe (Del. 1996)Plaintiff argues that the tender offer was unfair to all shareholders. Complaint attempts to assert a breach of duty of fair dealing by the directors b/c they did not oppose the tender offer.

Court said tender offer is voluntary. You don’t have to sell your stock if you don’t want to. Plaintiff loses for failure to state a claim.

A tender offer is not voluntary when:- coercion is present or- there are “materially false or misleading disclosures made to shareholders in

connection with the offer.”

Pure Resources Inc. (Del. Ch. 2002)Two strands of cases:

1. controlling shareholders negotiate a merger agreement with a target board to buy out the minority gets entire fairness, appraisal rights

2. controlling stockholders seeks to acquire the rest of the company’s shares through a tender offer followed by a short-form mergerØ have to sell stock!

Prisoner’s dilemma: if you don’t tender your shares you may be stock with a lower price in a short form merger or you might lose liquidity b/c will be so few minority shares.

BL: To address prisoner’s dilemma in tender offer context and distort influence of tendering process on voluntary choice, will only consider tender offer by controlling shareholder non-coercive when:

(1) it is subject to the condition that a majority of the minority accept the tender; (2) The controlling shareholder promises to consummate a prompt short-form merger at the

same price if as a result of the tender it acquires ends up owning more than 90% of the controlled corporation’s shares; AND

(3) Controlling shareholder has made no threats of retribution if tender offer fails. **This provision goes a long way toward establishing entire fairness standard in tender offer context!

Unocal Corp. v. Mesa Petroleum (Del. 1985)Pickins, head of Mesa, made a two-tiered tender offer for Unocal: the front end was $54/share for Unocal stock with the back end $54/share, but comprised of junk bonds. The board rightly perceives this as a coercive offer and decided to initiate an exclusionary self-tender offer; buy back 49% of its stock at $74/share and hold it in its treasury. Mesa’s % of stock would then be worth very little.

SC of Delaware first decides that the board has power under § 141 (a) to defend itself from hostile takeovers (moreover, they have the duty to act) and under § 160(a) the corporation has the power to make a self-tender (authority to deal in its own stock)

Court developed a two-prong test to examine whether Unocal’s exclusionary self-tender and other general defensive measures were proper:1. The board has to have reasonable grounds for finding a threat to the corporation or

to corporate policya. satisfy this by showing good faith and b. reasonable investigation in their determination processc. will NOT satisfy it if they are trying to entrench themselves

2. Response has to be reasonable in relation to the threat posed

82


Fall 2006

IF directors meet both prongs of the test, BJR applies; established an intermediate standard of review. Don’t have presumption of BJR, but if they meet intermediate scrutiny they do. Both substantive and procedural.

Balancing comes from 1) if there is a threat triggers 141(a) duties to protect the corporation but then 2) the response has to be balanced because it is possible that the defensive measure, in some ways, is harmful to shareholder interest.

Unitrin, Inc. v. American General Corp (1995)—puts a “gloss” on Unocal1. Was there a threat to the company?2. Proporationality test (like Unocal)3. For it to be proportional, it cannot be draconian.

- Draconian means not coercive or preclusive.

Moran v. Household Intl, Inc. (Del. 1985)The court says that poison pill (or the “flip over” rights plan) is okay as a defensive measure. Doesn’t say that is per se legal or illegal. Bd has authority to issue such rights b/c it runs the corporation and § 157 can allow the creation of such rights.

Says that the ultimate response to an actual takeover bid must be judged by the directors response at the time, and nothing we say here relieves them of their basic fundamental duties to the corporation and its stockholders.

Directors have initial burden of demonstrating that their defensive plan was a reasonable one in response to a reasonably perceived threat to corporate policy then the burden will shift back to plaintiffs to demonstrate that the directors breached their fiduciary duties.

Court found that:1. the poison pill would not erode fundamental shareholder rights b/c the target board would

not have unfettered discretion arbitrarily to reject a hostile offer or to refuse to redeem the pill

2. even if the board refused to redeem the pill, that would not preclude the acquirer from gaining control of the target company, b/c the offeror could “form a group of up to 19.9% and solicit proxies for consents to remove the Board and redeem the Rights.

3. even if the hostile offer was precluded, the target company’s stockholders could always exercise their ultimate prerogative—wage a proxy contest to remove the board.

Carmody v. Toll Brothers, Inc. –invalidates “dead hand pill” (Del. Ch. 1998)Issue here was a “dead hand” poison pill—such a pill cannot be redeemed except by the incumbent directors who adopted the plan or their designated successors.

Dead hand pill is invalid because:1. It impermissibly creates voting-power distinctions among directors

without authorization in the certificate of incorporation, and by interfering with the directors’ statutory power to manage the business and affairs of the corporation.

2. unlawful under Blasius because it purposefully interferes with the shareholder voting franchise without any compelling justification

3. it is “disproportionate” defensive measure under Unocal/Unitrin because it either precludes or materially abridges the shareholder’s rights to receive tender offers and to wage a proxy contest to replace the board.

Quickturn Design Systems, Inc. v. Shapiro (Del. 1998)Quickturn’s BoD initiated two defensive measures:1. Amended shareholder’s rights plan by adopting a “no hand” feature of limited duration “delayed

redemption provision” court held invalid No newly elected board could redeem the Rights Plan for six months after taking

office, if the purpose or effect would be to facilitate a transaction with an “interested person”

2. Board amended the corporation’s by-laws to delay the holding of any special stockholders meeting requested by stockholders for 90 to 100 days after the validity of the request is determined.

Effect would be to delay shareholder’s meeting for at least three monthsThe combined effect of the two measures would be to delay any acquisition of Quickturn by Mentor for at least nine months.

The DRP would prevent a newly elected board from completely discharging its fundamental management duties to the corporation and its stockholders for six months.

83


Fall 2006

DRP is invalid under § 141(a).

REVLON (Del. 1985)What happened:1. Have the head of Revlon, Bergerac and the head of Pantry Pride, Perlman. P goes to B and

tells him he wants to buy his company. B thinks the price is too low and refuses to talk to him further b/c he didn’t like him.

2. Bergerac hires Lipton…does the steps the good Delaware law requires. They put together a couple of defensive measures to prevent PP from acquiring R. At this point, these measures were NOT in violation of B’s fiduciary duties.

3. PP keeps increasing its offer price. This is an early White Knight case B goes to Forstmann Little. B wants to get an MBO going as an alternative transaction; B would remain CEO after F would take it over.

4. The offer price from PP keeps increasing.5. The decision to hire Forstmann is a defensive measure employed by B. Would have to sell to

Forstmann at a lower rate, would have to pay a fee, and write out debentures from an earlier measure if Forstmann buys.

6. Here, the BoD are on the same side as Forstmann. B & F v. P.7. sdf

The decision to hire Forstmann is critical in this case at this point it becomes clear that the company is up for sale. Now, Revlon is going to sell itself on its own, “voluntarily.” At the point of the MBO they are intiating the sale of the company and there will be a cash out of Revlon shareholders.

B has an interest here, but he has to act neutrally b/c he is in “Revlon land.” He has agreed to sell the company and the only question is—what is the price going to be and who is going to be the buyer? Once you are in “Revlon land” the directors essentially have to run an auction to get the highest bidder.

B tries to argue that he is looking at other constituencies (P would fire a lot of people..) but the you cannot take into account other constituencies if it conflicts with the wealth creation of shareholders.

NOTE: ALI § 2.01 (b)(2) might give us a different answer: even if corporate profit and shareholder gain are not thereby enhanced, the corporation, in the conduct of business:…may take into account ethical considerations that are reasonably regarded as appropriate to the responsible conduct of business; and…(3) may devote a reasonable amount of resources to public welfare, humanitarian, educational, and philanthropic purposes.

Barkan v. Amsted Industries (Del. Supr. 1989)—Ø have to conduct “active market survey”Have to run the auction in a neutral manner, but “when directors possess a body of reliable evidence with which to evaluate the fairness of a transaction, they may approve that transaction without conducting an active survey of the market.”

Here, investment banker gave their approval Not a lot of different offers Moves away from this “neutral position” in that directors don’t have to run a full market test

if they are:1. fully informed2. investment banker said it’s a good deal3. not going to be cashing out all the shareholders

Still in Revlon land and still have to take best offer for shareholders, just don’t always have to run a formal auction. You can canvass the market, if no one else is out there and it’s a good deal, you can go for it.

Paramount v. Time Inc. (Del. 1989)Time and Warner decide they want to have a “merger of equals.” Paramount decides it wants in on the action. Paramount goes after Time. Time enacts defensive measures.

T also says P offer is inadequate and that their proposed deal with Warner creates more value for the company looking at synergies, firm cultures, etc; they make a very specific statement that they believe the Warner deal is better for the stockholders than the Paramount deal. they can say this b/c we are not dealing with a cash out merger, but a merger of equals…it’s not cash, but the value of companies when mergerd. TW creates more value than TP.

Definitely an informed board.

84


Fall 2006

Clearly the market thinks the P deal is better (price rises when market thinks it may go through)

Court says that Revlon does not apply. The board has fiduciary duties under Unocal. The company can chart a course for the company’s best interest, but not obliged to

abandon a deliberately conceived corporate plan for a short term corporate profit unless there is clearly no basis to sustain the corporate strategy.

The fact that the market thinks the paramount deal is better Ø matter; the SC of Delaware will not second guess the BoD.

This cases broadens what is included under the “threat.” This is when a threat to corporate policy becomes cognizable.

Stands for the proposition that a corporation can “just say no,” but to say no, they have to be informed. Have to hear them out, negotiate, bring in investment bankers.

Big picture: these cases are about the deal going through and whether or not a company has to take down its defensive shields. Once the Unocal stds are met, the BJR attaches and the deal can happen.

Paramount v. QVC NetworkParamount found its marriage partner in Viacom. QVC tries to make its own offer – and Paramount refuses to even chat with them. Defensive measures instituted. the DE SC here asserts that Revlon duties are instituted once a corporation initiates a

reorganization of itself or its break-up; or, when an active bidding process is initiated, such that in response to a bidder’s offer, the long-term plans of the company are abandonedo it emphasizes the importance of the change of control: “When a majority of a

corporation’s voting shares are acquired by a single person . . . there is a significant diminution in voting power of those who thereby become minority shareholders.”

o whereas, when a company is owned by a “fluid aggregation of shareholders” following the transaction, shareholder rights are preserved selling to a controlling party will send you to Revlon-land

the burden, therefore, is on the directors to prove the adequacy of the threat to the corporation and the reasonableness of their response; and their actions in this case cannot survive the higher level of scrutiny for the duty of care and loyalty; ∆s here violated their Revlon duties by favoring the Viacom deal over the QVC one for no sufficient reason

F. ConclusionWhy are corporations such fantastic things? Why do we all give them our money?

Wachter has given us answers:1. the market works: the management is properly controlled by the market2. the laws on the duty of loyalty are effective (State law works)3. securities regulation makes the stock market fair

85

wachter corporations 2006

Documents