Corporations

INTRODUCTION

Pareto Efficiency: At least one party experiences a net gain and no one experiences a loss Policy: Too difficult to achieve; too impractical to apply (everything makes someone worse off) Kaldor-Hicks Efficiency: Move that creates gains for some players that are larger than the costs on other players Then, parties could split the gains and have everyone be the same or better off Agency Problem: When one person puts his interests in the hands of another party Agency cost develops to the extent that the incentives of the agent differ from those of the principal o Ex: salaries, benefits, and non-obvious costs Organizational Law Helps Efficiency Controls Agency Problems Establishes standard form terms for contracting with and through business organizations Establishes internal governance structures of business organizations Alters property right to accommodate the partitioning of assets into separate pools o Separates corporate assets from personal assets of shareholders o Allows parent company to separate its assets into subsidiary corporations for different purposes o Impossible to do under contract law b/c involves different property entitlements Business creditors would have to contract with personal creditors and agree on who has first dibs over assets to satisfy claims

AGENCY LAW

Agency Relationship: Consensual relationship such that Agent can bind Principal to a Third Party and vice versa Agency rules should be structured to minimize the costs of transacting b/w Ps and Xs Special Agent: Limited to a single act or transaction General Agent: Agent for a series of transactions or acts Agency relationship may be implied, even if not explicit (Jensen Farms) Is it a creditor-debtor relationship or an agency relationship? (Jensen Farms) Is there an intent to make money on the loan? Or to receive a source of business?
Jenson Farms v. Cargill (Minn. 1981) Plaintiffs (farmers) bring suit against Cargill and Warren to recover losses when Warren defaulted on the contracts made for the sale of grain to the plaintiffs. Plaintiffs claim that Warren was acting as an agent for Cagill. o There was an implied agency relationship b/c of the degree of control asserted by Cargill over Warren o In directing Warren to implement its recommendations, Cargill showed its consent that Warren serve as its agent

Disclosure to X Disclosed Principal: X is aware that the Agent is acting on behalf of a particular principal (ex: President of corporation) Undisclosed Principal: Third parties are unaware of the Principals existence; think Agent is Principal Partially Disclosed: Third parties is aware of A Principal, but does not know the identity of the Principal Termination Either party may terminate an agency If agency term is set by contract, termination may give rise to claim for damages (but NO specific performance) o Policy: Cant sell a position as a form of property: no specific performance Authority Actual Authority: Reasonable person in As position would infer from Ps conduct (either express or implied) o P actually gave A power o Explicit Authority o Incidental Authority: Authority to do steps reasonably calculated to discharge Ps explicit instructions Apparent Authority: Authority that a reasonable third party would infer from Ps actions or statements o P did not actually give A this power 2

o Protects 3rd parties relying on Ps conduct with A even if P told A he was limited in this fashion o Principal can still sue Agent for violating Ps instructions, but X has a valid claim against P Inherent Authority: Gives general agent power to bind a principal (disclosed or undisclosed) to an unauthorized contract as long as a general agent would ordinarily have the power to enter into such a contract and the 3rd party doesnt know that matters are different in this case (Restatement 161) o Where theres ambiguity, the burden should fall on the Principal and not 3rd Party o Necessary b/c of undisclosed principals: If A has all trappings of being a P and uses them to lure people into doing deals, and P didnt authorize the deals, then P perhaps did a soft misrepresentation Otherwise, 3rd parties wouldnt be able to rely on contracts b/c principal would not be bound o Symmetry: If P can enforce the contract that A entered into, X should be able to enforce this one

LIABILITY IN CONTRACT Agent must reasonably understand from the action or speech of the principal that she has been authorised to act on the principals behalf. This is actual authority: what A could reasonably infer from the conduct of P Actual authority also includes incidental authority: the authority to take those implementary steps that are necessary to complete the authorized act. Apparent authority is the authority that a reasonable third party would infer from the actions or statements of P (designed to prevent fraud or unfairness to third parties who reasonably rely on Ps actions or statements in dealing with A even where P has explicitly limited As authority but the third party is unaware of that). Inherent power: gives a general agent the power to bind a principal, whether disclosed or undisclosed to an unauthorised contract as long as a general agent would ordinarily have the power to enter suich a contract and the third party does not know that matter stands differently in this case. There are three types of situations in which this type of power exists: (1) an agent does something similar to what he is authorized to do, but in violation of orders (2) an agent acts purely for his own purposes in entering into a transaction which would be authorized if he were actuated by a proper motive (3) an agent is authorised to dispose of goods and departs from the authorized method of disposal it is fairer that the risk of loss caused by disobedience of agents should fall upon the P rather than upon the third person.
Nogales Service Center v. Atlantic Richfield Co (Ariz. App. 1980) Agent offered a 1 discount on gas to keep Nogales competitive, but then did not honor the discount o Jury should have been told about inherent authority

Even where no agency, P may still be bound through estoppel or ratification.

LIABILITY IN TORT Principals are liable for torts committed w/in scope of employment by servants (EEs) but not 3

independent contractors Servant independent contractor: depends on whether the principal has the power to control the details of the way in which the agent goes about her task or only has limited control.

Restatement (Second) Agency 2 Master, Servant, Independent Contractor (1) A master is a principal who employs an agent to perform service in his affairs and who controls or has the right to control the physical conduct of the other in the performance of the service (2) A servant is an agent employed by a master to perform service in his affairs whose physical conduct in the performance of the service is controlled or is subject to the right to control by the master (3) An independent contractor is a person who contracts with another to do smth for him but who is not controlled by the other nor subject to the others right to control wiuth respect to his physical conduct in the performance of the undertaking. He may or may not be an agent. Considerations for Determining if EE or IC (RST 220(2)(a-j)) Extent of control that the master exercises Whether or not the EE is engaged in a distinct occupation

Kind of occupation usually done under ERs direction or a specialist w/o supervision? Skill required for the occupation (more skill required; less control possible) Who supplies the instrumentalities, tools, and place of work (who has title to the products? Sunoco) Length of time of employment Method of payment (by time or by job) (if by time, probably more control to ensure efficiency EE) Whether or not work is part of regular business of ER Intention of the parties (ignored in Humble) Who pays bills? Net or Gross to encourage efficiency? (Humble and Sunoco) Is termination of the agreement unilateral or bilateral? (Humble & Sunoco) Who controls the day-to-day operations? (Humble & Sunoco) Could the person sell independent products? (Sunoco)

Right of control is key to distinguishing btw servants and independent contractors Franchises are Quasi-Independent Businesses Encourage proprietor to work harder b/c they get percentage of profits (Incentive) Not wholly independent b/c economic concerns of establishing a brand name o E.g., bundling service w/ products to make it more than a fungible commodity Who is in the Best Position to Prevent Loss? One With Responsibility Net Profits: Leeway under contract gives opportunity to prevent accidents, and responsibility for loss provides incentive to do so Proprietors: Theyre on site and can prevent accidents most easily o Anything else would make them lazy and not careful Parent Company: They have access to R&D about safety, can gather most info o Parent company can spread costs of liability o They are not judgment proof like proprietors, so they have an incentive to take precautions Barone is less likely judgment proof, b/c with all of Sunocos investment, he probably had to put much out up front

Gas station cases:

Humble Oil v. Martin (Tex. 1949) Car hits a man. Humble leases to Schneider, who hired Attendant, who didnt set emergency brake. o Humble is liable for operation of gas station; Schneider is EE/Agent o Humble owns station and principal products, Schneider must make reports an perform duties requested by Humble, Humble pays net utility bills, Humble kept title to products, Humble determined hours of operation, Humble only could terminate the agreement o Not as persuasive that intent of the parties was not EE/ER, EEs were paid directly by Schneider Contrast with: Hoover v. Sun Oil Co Del. 1965) Smoking EEs negligence at service station caused a fire o Sunoco is NOT liable; Barone is an IC o Sun had no control over day-to-day operations, Barone could sell competitive products, Barone assumed responsibility for overall risk of profit or loss in business, lease subject to termination by either party, Barone had title to products sold Restatement (Second) Agency 215 Conduct authorised but unintended by principal A master or other principal who unintentionally authorises conduct of a servant or other agent which constitutes a tort to a third person is subject to liability to such person. 216 Unauthorized tortious conduct A master or other principal may be liable to another whose interests have been invaded by the tortious conduct of a servant or other agent, although the principal does not personally violate a duty to such other or authorise the conduct of the agent causing the invasion 219 When master is liable for torts of his servants (1) A master is subject to liability for the torts of his servants committed while acting in the scope of their employment (2) A master is not subject to liability for the torts of his servant acting outside the scope of their employment, unless: (a) the master intended the conduct or consequences (b) the master was negligent or reckless (c) the conduct violates a non-delegable duty of the master (d) the servant purported to act or to speak on behalf of the principal and there was reliance upon apparent authority, or he was aided in accomplishing the tort by the existence of the agency relation 228 General statement as to scope of employment (1) Conduct of a servant is within the scope of employment if: (a) it is of the kind he is employed to perform (b) it occurs substantially within the authorized time and space limits (c) it is undertaken by a purpose to serve the master 230 Forbidden Acts An act although forbidden or done in a forbidden manner, may be within the scope of employment 231 Criminal or tortious acts An act may be within the scope of employment although consciously criminal or tortious 232 Failure to act The failure of a servant to act may be conduct within the scope of employment.

AGENTS DUTIES: FIDUCIARY RELATIONSHIP AND LOYALTY

Duty of Loyalty 390: Agent owes the principal the obligation to: o Deal fairly with the principal (and give impartial advice) o Fully disclose to him all facts that reasonably affect the principals judgment o Comment: Payment of less than reasonable market price is evidence that bargain was unfair Agent has an obligation to disclose any and all profits obtained in the course of an agency (Resop)
Tarnowski v. Resop (Minn. 1952) Resop was employed to find a business for buyer but took a $2000 secret commission from seller. Resop assured buyer about the juke box business, but did not investigate it and lied about business value. o Not disclosing the secret commission (or any profits obtained in the course of agency) is a violation of agents fiduciary duty o Even though Tarnowski is better off than had he not been betrayed, damages may be punitive for violating fiduciary duty Restatement (Second) Agency 387 General Principle Unless otherwise agreed, an agent is subject to a duty to his principal to act solely for the benefit of the principal in all matters connected with his agency 388 Duty to account for profits arising out of employment Unless otherwise agreed, an agent who makes a profit in connection wioth transactions conducted by him on behalf of the principal is under a duty to give such profit to the principal Comment: Use of confidential information An agent who acquires confidential information in the course of his employment or in violatuion of his duties has a duty not to use it to the disadvantage of the principal. He also has a duty to account for any profits made by the use of such information, although this does not harm the principal. Thus, where a corporation has decided to operate an enterprise at a place where land values will be increased because of such operation, a corporate officer who takes advantage of his special knowledge to buy land in the vicinity is accountabel for the profits he makes, even though such purchases have no adverse effect upon the enterprise. 389 Acting as adverse party withotu principals consent Unless otherwise agreed an agent is subject to a duty not to deal with the principal as an adverse party in a transaction connected with his agency without the principals knowledge. 390 Acting as adverse party with principals consent An agent who, to the knowledge of the principal, acts on his own account in a transaction in which he is employed has a duty to deal fairly with the principal and to disclose to him all facts which the agent knows or should know would reasonably affect the principals judgement, unless the principal has manifested that he knows such facts or that he does not care to know therm. Comment: Facts to be disclosed: duty of loyalty not violated if the A makes full disclosure and takes no unfair advantage of P when acting for his own benefit Fairness: A must not misuse his position to persuade P to make an unfair or improvident bargain; the fact that A acts as an adverse party does not relieve him from giving the principal impartial advice.

FIDUCIARY DUTY IN TRUSTS Trustee: Nominal ownership over some pool of assets; manages the assets in the interests of the 6

beneficiary Beneficiary: Owns the benefit of the assets Per se rule for trusts: Trustee cannot have an individual role w/ trust property (violates Fiduciary Duty)
In re Gleeson (1954) Colbrooke leased land belonging to Mary Gleeson, upon her death he is named trustee of her estate which is to be allocated to her children. A few days after her death the lease runs out and defendant decides to renew it and increases the rent he has to pay. o Colbrook violated his fiduciary duty b/c of peer se rule that trustee cant have an individual role with trust property o Colbrook must turn over the proceeds of the trust property back to the trust

Fiduciary Rules Interpreted Strictly in Trusts: Dealing with less sophisticated people; not business people
Restatement (Second) of Trusts 203 Accountability for profits in the absence of a breach of trust The trustee is accountable for any profit made by him through or arising out of the administration of the trust, although the profit does not result from a breach of trust 205 Liability in case of breach of trust If the trustee commits a breach of trust, he is chargeable with (a) any loss or depreciation in value of the estate resulting from any breach of trust; or (b) any profits made by him through the breach of trust; or (c) any profit which would have accrued to the trust estate if there had been no breach of trust

PARTNERSHIPS
PARTNERSHIPS AND JOINT VENTURES All jointly and severally liable as principles Can all bind the partnership (like general agents) All share equally in control unless otherwise agreed Joint Venturers owe one another the highest duty of loyalty: Fiduciary duty is courts ability to impose a rule when parties couldnt plan in advance b/c too far in the future
Meinhard v. Salmon (NY 1928) Meinhard and Salmon are joint venturers: Meinhard put up 1/2 the capital and is passive investor, Salmon runs the leased hotel. Agreed to split profits and losses. Before the lease ended, Gerry offered a lease to develop the rest of the block to Salmon and he took it w/o Meinhard. o (Cardozo) Meinhard should get 49% of new venture b/c Salmon owed a fiduciary duty to Meinhard as joint venturers o Salmon violated the punctilio of honor by failing to relay the opportunity to Meinhard o Salmon gets to keep control of the new piece b/c he was controlling the previous one and know the hotel extends current contract o Considerations The new property includes the current property geographically Salmon chosen only b/c of previous deal, & Gerry went to Salmon only b/c he didnt know about the passive investor o BUT: Parties wouldnt have chosen this result if they had considered it when negotiating the contract (20 yrs earlier) different project, different status, different management options. What other options could the parties have chosen & the court imply: (1) same term option: M participates in any new opportunity on the same terms as the original joint venture (close to Cardozos remedy) (2) competition/renegotiation: S must inform M of the new opportunity, who is free to compete for or negotiate over any new opportunity (Cardozo suggests this is what Ss fiduciary duty required). (3) Ss option: S can keep the new opportunity or offer a piece to M, as he likes (maybe Ms gets first right of refusal on outside financing). PROBLEMS with options Ad (1) S may not be motived to get a new deal if he must share Ad (3) S may over invest in the first 20 yr period with Ms money, to pick up the sole returns in the second 20 yr period. o Andrews (dissent): this is no offshoot of the original lease; there was no general partnership, just a joint venture for a particular project; the new lease was not merely a renewal of the old one, with which previous precedents are concerned.

FORMATION OF PARTNERSHIPS Partnerships: Two or more people carrying on a business for profit (Uniform Partnership Act, Art 6) Can own property Are not required to be legally registered Partnership agreement can be explicit or assumed from the facts o Receipt of a share of profits is prima facie evidence of partnership (PA 7(4)) 8

Net profits are more persuasive for partnership than gross profits (is EE insulated against loss?) But is it a commission or a salary? o How much control does the person exercise in the business? o Is there an agreement? Intent of the parties? (Cant have a partner that other partners dont know about) Partnership by Estoppel? o Is EE putting money back into the business (increase inventory, purchase new products) o Any bad faith involved? E.g, X deliberately kept the situation ambiguous, parties unsophisticated o If no partnership, is there some other relationship? Respondiat superior? Agent-Principal? Can be dissolved at will by any partner
Vohland v. Sweet (Ind. App. 1982) Vohland (the elder) gives Sweet, the nursery man, 20% of net returns (no explicit agreement) of nursery business. Sweets income tax stated he was a self-employed salesman at the nursery; money paid Sweet was listed as commissions in Vs income tax return. V handled all financial books and made most of the sales. V alone took up loans. S managed the physical aspects of the nursery. When V dies, Vohland (the younger) takes over. Sweet tries to dissolve partnership and get his share of business (wind-up, sell assets and distribute proceeds). o Court finds a partnership b/c he is getting a percentage of the NET profits; receipt of a share of the profits prima facie evidence that person is partner (UPA 7(4)); a partnership may be formed by contributing labour and skill by others o Sweet is only getting a cut after the expenses (costs for inventory to purchase new products) had been paid; thus his commission is partly being invested into new inventoryonly makes sense for a partner to do that o Policy: Court decided paternalistically b/c Vohland kept it deliberately ambiguous and Sweet was unsophisticated PROBLEMS: o Suppose the nursery went under and the assets did not cover the debts; could the bank have succeeded in getting Ss assets? Probably not, would argue: not really manaing affairs of the business o Thus, this case has stretched the definition of partnership; reason: Sweet has been led on by V, theres an element of duplicitness; thus court searches for equitable outcome.

PARTNERSHIP RELATIONS WITH THIRD PARTIES Partners are jointly and severally liable for the TORTS of the business (UPA 15) UPA: Partners are jointly liable for CONTRACTS of the business (must join everyone in the suit) o RUPA 306: Partners are jointly and severably liable for contracts of the business Partnership by Estoppel (UPA 16) If youre held out as a partner and receive the liabilities of a partner, then you may be a partner even if the parties never intended to make you one Issues of concern: (1) Who is a partner for the purposes of personal liability to business creditors? (see above UPA 6 and 7; decision will come done to role in business Sweet v. Vohland) (2) When can an exiting or retiring partner escape liability for a partnership obligation? (3) Since a partnerships liability on a partnership debt can be settled from a partners nonpartnership property; how are such claims to an individual partners personal assets to be balanced against the claims of other (nonpartnership personal) creditors of that person? 9

Ad (1) Problem on p. 50
Is Ars a partner? Arguments for: sweat equity, name of entity (held out to be partner), tax return, profit sharing. Arguments against: wages as employee (UPA 7(4)(b), does contribute completely to losses (gets $5,000 no matter what). Is Mayer a partner? Arguments against: no one knows of profit sharing but Artis (UPA 18(g)); intent to form partnership (UPA 6) could argue money is a loan; has no control over the business. Arguments for: suppose Mayer had put up all the $; there may be a subpartnership between Artis and Mayer. Is Low liable to the bank or any other creditors?

Ad (2) Splitting Partnerships: In general, withdrawing partners are personally liable for debts of partnership UPA 36(a)(1) o Otherwise, they could always run when something goes wrong BUT, where creditors are aware of the withdrawal and consent to a material alteration in the nature of time of payment of such obligations, the withdrawing partner is not liable (Munn) (36(3)) Advanatages of 36(a)(3): o Renegotiating makes it easier to pay, which benefits only remaining partners o Have an OUT-clause so withdrawing partners dont wander w/ a cloud of liability hanging over his head w/o the control to see that the partnership proceeds safely (no monitoring ability) o Otherwise, withdrawing partner would always DISSOLVE the partnership huge transaction costs Easier to let the withdrawing partner withdraw and contract out of liability o Promote partnership initially; no one would join if they could never get out of liability o Insulating withdrawing partner from liability encourages the partners to renegotiate the terms to benefit all parties including creditors pro-workout measure Disadvanatges (costs) of 36(a)(3): o Creditors cannot rely on withdrawing partners assets o Creditors will prefer that business goes belly up, so that he can approach the retired partners.
Munn v. Scalera (1980) Munna hire Pete and Bob Scalera Partnership to build house. Partnership splits up and Munns choose Bob. Munns get stuck with materials costs and try to sue Pete b/c Bob is judgment proof. o Pete is NOT liable b/c terms were changed to pre-pay and over-pay Bob; Munns had knowledge of this material change and consented to it; this action is against Peter and hes no longer liable o Case differs from the normal 36(3) case, because M was not an outstanding creditor entitled to payment for past performance but a party to a largely executory contract with the dissolved partnership.

Ad (3) Partnership Creditors Claims to Partners Individual Property UPA 25: Partners cant exercise individual discretion over the fate of partnership property once it is given to the partnership Pool of assets belongs to the business as a business Partners cant remove their contribution to pay off personal creditors (but can assign their interest in profits elsewhere UPA 26 and 27; RUPA 502 and 503) 10

Limited Partnerships: half-way stations b/w the partnership form and the corporate form Limited partners are passive and are liable only to the extent of their investment General partners are personally liable on partnership debts, just like general partners in ordinary partnerships Because general partners personal assets may be used to repay partnership debts, creditors who cannot seize partnership assets (e.g., b/c of bankruptcy) cant seize personal assets either (Comark)
In re Comark (1985) Bell & Owens are general Comark partners, which is a limited partnership. Creditor sues the partnership (which is bankrupt) and Bell & Owens (who are not bankrupt) personally for payment. But bankruptcy court issues a stay to prevent creditors from seizing partnerships assets, so creditor focuses on Bell & Owens personal assets. If creditor could get away with this he could circumvent the bankruptcy order to the detriment of other creditors. The courts decides: o If creditors cannot seize partnership assets, then they cannot seize personal assets of general partners either b/c theyre all part of the partnership o As general partners personal assets may be used to satisfy debts of the partnership, one creditor cant take them early, before they are apportioned according to the reorganization plan in bankruptcy

When creditors need to be paid by partnership, conflicts will arise concerning priority of claims btw partners personal creditors and creditors of the partnership. Two solutions: (1) UPA 40(h) and (i): Jingle Rule: Which Creditors Get Dibs on What Partnership creditors get first dibs on partnership assets Individual creditors get first dibs on individual assets (2) 1978 Bankruptcy Act 723(c) & RUPA 807(a): Which Creditors Get Dibs on What Partnership creditors get first dibs on partnership assets Neither partnership nor individual creditors get first dibs on individual assets on equal footing More efficient: requires less research by creditors prior to lending b/c they no longer have to investigate the credit of each general partner in his/her individual capacity (too high monitoring costs) o Much easier for individual creditors to find out if individuals are in a partnership and research that Partnership creditors are more likely to recover individual assets under post-78 rule b/c individual creditors wont eat up all individual assets before they get there o They should have some claim to individual assets b/c of partnership as an unlimited liability mechanism (differentiate partnerships from LLCs) Jingle rule amounts to de facto limited liability, since ultimately the individual partner will remain liable only to individual creditors.

PARTNERSHIP GOVERNENCE AND AUTHORITY ISSUES When the partnership is a going concern, activities within the scope of the business cant be limited except by a majority AND by notifying the third party (other contracting party) 11

Partnerships can contract around this default rule, though This rule is the case even when one party puts up more capital (b/c all parties equally at risk personally); its bodies that count not contribution (why? b/c other partners are just as personally liable as the partner putting in the most capital). But partners can contract out of this rule. A creditor can decide which partner he wishes to appraoch to filfill his debts. Dont give any one partner that type of veto power by letting him opt out of liability from a creditor such that the creditor will not make deals with the other partner alone Any other rule would destabilize the business

Considerations Does the partner have actual authority? I.e., majority agreement? Apparent authority? Was it w/in the scope of the partnership business or a change in character of the business? If outside the ordinary scope of the partnership, may need ALL partners consent to bind partnership.
National Biscuit v. Stroud Stroud and Freeman are partners in Strouds Food Center. Stroud tells Nabisco hes not personally responsible for bread delivered after 2/6. Business delivers at Freemans request, and partnership dissolves on 2/25. o Stroud is personally liable as a general partner for the bread b/c Stroud is not a majority of the partners necessary to cancel the ordering o Freedman is able to bind the partnership on matters connected with the ordinary course of the partnership business (Stroud could not limit his authority UPA 18). o If there had been 3 partners, and two voted against it, theyd have to notify Nabisco in order to not be bound by the 3rd partners orders (half of a two person partnership is not a majority). UPA 9 Partner agent of partnership as to partnership business 12 Notice to a partner operates as notice to the partnership 13 Partnership bound by partners wrongful act 14 Partnership bound by partners breach of trust 15 Partners jointly and severably liable 16 Partner by estoppel 18 Rights and duties of partners

Accounting: It does not matter whether you call gains to the partnership salary or capital increase because it is all taxed to the personal taxes of the partner in the same way No double taxation like with corporations DISSOLUTION AND DISASSOCIATION Partnerships may be dissolved at any time by any partner Any partner can force a windup or judicial sale of the assets of the business One does not get wind-up rights if the partnership agreement specifies otherwise (Adams v. Jarvis) When parties dont specify, default rule is partnership at will; anyone can dissolve at any time (Page) o BUT: Fiduciary relationship tempers purely opportunistic dissolution (Page) When winding up, it is more fair to sell the business and payoff in cash rather than dividing the 12

assets (Dreifuerst) o Going concern is more valuable than dividing up the assets; theyd lose this value o Need to protect the creditors creditors can be paid off when business is liquidated; not if assets are split o Appraisal Alternative: Have an appraisal of the business and pay the withdrawing partner his pro rata share Avoids the need to actually sell the business Full sale is usually better than appraisal b/c it includes the market value (a real market test) BUT appraisal may not always be better: Sale of business has high transaction costs Tiny businesses may not have a liquid asset market Often, the only interested buyers are your ex-partners who wont pay a fair price RUPA 701(b): Disassociating partner who doesnt insist on wind-up rights gets the higher of the liquidation or growing concern rates If partner is kicked out of the partnership o Under UPA could not get going concern value or insist on wind-up rights o Under RUPA is entitled to a claim on going concern value, minus the damages you caused Going concern value: cash flows you expect the business to flow in the future, discounted by time value of money

Under UPA Dissolution 29: any change of partnership relations, e.g., the exit of a partner o After a formal dissolution, 2 things can happen Partners can continue the business Or the business may be wound up Winding up 37: Orderly liquidation and settlement of partnership affairs o Sometimes need to keep partnership alive (to pay creditors and earn money) until the business can be sold Termination 30: Partnership ceases entirely at the end of winding up Under RUPA Disassociation 601: A partner leaves but the partnership continues, e.g., pursuant to agreement Dissolution: the general term for winding up and terminating a partnership
Adams v. Jarvis (1964) Dr. Adams withdraws from 3 Doctor Tomahawk Clinic partnership. He says his withdrawal constitutes a dissolution that requires a winding up o UPA 38(1): When dissolution is caused, each partner, unless otherwise agreed, may have the partnership property applied to discharge its liabilities, and the surplus cash paid out to the individual partners. o The partnership agreement asserts that the withdrawal of a partner shall not terminate the partnership agreement; thus, he cant get a winding up. o Partnership agreement also states that a withdrawing partner is entitled to receive (1) balance standing to his credit and (2) partnership profits for the fiscal year of his withdrawal; it also states that any accounts receivable shall remain the sole possession of the partnership.

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o Dr. Adams wants % of Accounts Receivable instead of profits for that year so his partners dont deliberately
o delay collecting on bills until after the year is over (this is the partnerships greatest asset and the doctors have a discretion about when to collect). Because the partnership does not apply a double bookkeeping (accrual accounting) but a simple bookkeeping, the doctors are able to regards the accounts receivable as a profit only once they actually collect The court declares that since Dr. Adams share of the profits is dependant on the conduct of the other partners, these partners stand in a fiduciary relationship to him to conduct the business in a good faith manner in ensure the liquidation of the accounts receivable consistent with good business practices.

Dreifuerst v. Dreifuerst (1979) Three brothers in feed mill business, served notice of dissolution in 1975. Two brothers want to divide the assets and split it off from the 3rd; the 3rd wants a sale of the business and divide up the proceeds among the 3 parties. o No partnership agreement in writing. o Trail court declines one brothers request for sale of assets, instead gives one mill to one brother and the other mill to the other two brothers. o There must be a sale of the business (either piecemeal or as a whole business) under UPA 38(1): Payout in cash o Sale determines a more accurate market value of the business b/c it considers the value of the business as a whole, which may be worth more than the sale of individual assets o RUPA 402, 801, 802 and 804 codify the holding in this case. o ABA Committee on Partnerships and Unincorporated Associations recommends allowing majority of the partners in an at-will partnership to continue the business w/o a winding up, provided the majoirty purchase the disassociating partners interest at fair value. Page v. Page (1961) Active (Big Page) & Passive (Little Page) investor, parties have agreement to run a linen supply company. Big Page seeks to dissolve the partnership right before business is getting successful. Little Page says Big Page is trying to take the new Air Force base as an opportunity solely for himself; can claim on his promissory note and repurchase the business for himself. o Trail court: partnership is for term, namely, such reasonable time as is necessary to make partnership profitable to repay the indebtedness. This would prevent Big Page from dissolving in accordance with UPA 31(1)(b) o (Traynor) Partnership is not for term b/c default agreement is partnership at will; Big Page can dissolve o Partners had, in the past, used express agreements with partnership terms (they knew about this option and didnt use it here) o Lesson: Passive investors should always insist on a term, b/c they can be kicked out just as it gets successful o Notwithstanding power to dissolve, Traynor J reminds Big Page of fiduciary duty to Little Page as copartners (Meinhard v. Slamon), that if partnership is dissolved solely to capitalize on profits in bad faith, he can be held liable for breach of the partnership agreement (UPA 38(2)(a)). Little Page deserves a share of the Air Force profits thus, fiduciary relationship provides an indirect limit on strategic dissolution.

Newcomers to the partnership are only liable up to the contribution to the partnership for debta accrued before they were a general partner (UPA 17). o All other partners must agree to new partner. LIMITED LIABILITY MODIFICATIONS OF THE PARTNERSHIP FORM Limited Partners: Passive investors who are traditionally prohibited from exercising control All partnerships must have at least one general partner. Limited partners are: Liable only to the extent of their investment 14

Limited partners may be held liable if they are the ones exercising control (Fidelity Lease) overruled by TX legis. RULPA 303(a) If you clearly label yourself a limited partner, then youre not personally liable even if you exercise control Often receive their payout prior to general partners (at the end of the term) o Give an incentive to those exercising control to perform well so general partners dont take limited partners money and run Sometimes heavy penalties for limited partners withdrawals o So limited partners dont take their own money and run before the return of the general partners efforts has been realized

Limited partnerships are attractive because they combine the tax advantages of partnership with limited liability.But this has changed with the introduction of the LLC and the rule that any enterprise with public traded equity faces the same two-tier tax treatment as a corporation.
Delaney v. Fidelity Lease Limited (TX SC 1975) Overruled by TX legislature Fidelity Lease is limited partnership. A corporation is the sole general partner (thus complete limited liability b/c a no-liability entity is the only partner who can be held liable). Crombie, Sanders, and Kahn are corporate officers of corporation and also limited partners of Fidelity. o Creditors can go after the limited partners in personal capacity b/c the issue is control and these people were exercising control o They are organized as a partnership instead of a corporation (with limited liability) to get the pass-through taxation and not be taxed twice: once when the money comes in as profit and again when shareholders are paid their dividend returns. o RULPA 303(a) would lead to a different outcome today.

Limited Liability General Partnership (LLP) Under RUPA o Most state statutes limit liability only in respect of partnership liabilities arising out of negligence, malpractice, wrongful act or misconduct of another partner o A few statutes extend protection to contact debts as well as tort liabilities. Limited Liability Company Like limited partnership in that it must be registered Designed to fail IRS 4 attributes to be taxed as a corporation: o Had a limited term to fail continuity of life requirement Or required dissolution when a member leaves until remaining members consent o Required members consent to transfer interest (to fail transferability of interest requirement) IRS Check the Box rules scrap the 4 factor test and let new unincorporated businesses choose to be taxed as a partnership or as a corporation o Except publicly traded entities, which get two-tier C class corporation taxation

15

CORPORATE FORM

Core Characteristics Investor Ownership Legal Personality (this is the only thing you cant do by contract) Limited Liability Transferable shares Centralized (delegated) management under elected board

GP X X

LP X X X X

LLC X X X X

Corp X X X X X

Corporate Form Legal personality eliminates problems of personal liability creditors rely on business assets only Limited liability is necessary for transferable shares b/c share value would depend on personal liability Transferable shares lets investors easily enter and exit the firm by buying/selling shares o Necessary for delegated management so anyone can leave if theyre unhappy w/ management o Also necessary so people can leave where they have no control over payouts o Permits takeovers disciplinary measures Prevents minority investors from holding up the firm by threatening to dissolve it Delegated management makes it easy for 3rd parties contracting with the firm to know when they are dealing w/ an unauthorized agent o E.g., when there had been no board resolution (board is de facto principal) Primary Difference: Delegated management such that board is separate from shareholders Agency Problems Manager-SH Problems o Outrageous management compensation Controlling SH v. Minority SH o Corporate opportunities (mostly a small company problem) o Self Dealing, insider trading (big company problem) Shareholders v. Everyone Else (stakeholders) o Corporate law protects creditors b/c of the larger hazards of a fictional legal entity Articles of Incorporation (Charter) Name of company, address, purpose (any lawful act), capital structure (classes, number of common shares, rights of preferred shareholders) Requires a shareholder vote to change Bylaws (guts of the corporation) Information about stockholders, board of directors, committees, officers, stocks, indemnification Can be changed by Board of Directors w/o shareholder approval (in most but not all states) 16

In DE shareholders have mandatory right to amend bylaws.

Automatic Self-Cleansing Filter Syndicate v. Cunninghame (1906) Third party wants to buy company, 55% of shareholders want to sell it, but board is against sale. Charter says decision to sell company must be passed by special resolution requires 75% to overrule the Board and sell the company. Shareholders ask court to order the board to sell the company: o Shareholders cannot sell the board b/c they lack the 75% of approval as required by charter to override the Board o Board has expertise and information to make important decisions, and this ruling protects the minority In DE, a sale of all assets under DGCL 271 requires Board of Director approval AND vote of shareholders 141(a): Board of Directors manages the Corporation Even if theres 99% shareholder approval o Gives much authority to the Board of Directors as opposed to shareholders

THE BOARD OF DIRECTORS Statutory provisions of most states declare that entire board is elected for one year terms; Most corporate statutes permit the creation of staggered boards; directors are divided into classes that stand for election in consecutive years. DGCL 141(d) allows up to three classes; NYBCL 704 allows four classes. Staggered boards assist managements ability to resist hostile takeovers. Legally, directors act as board only at duly constituted board meetings and by majority vote where a quorum is present, which is formally recorded in the minutes of the meeting. In general boards only meet 4 to 8 times per year; thus cannot consider all types of complex corporate decisions; therefore corporate officers appointed to do the nitty gritty work of the corporation; board delegates power to the officers, can appoint, remove and decide on compesnation. CORPORATE OFFICERS The Board is the quasi-principal; the corporate officers are general agents of the corporation The board is not bound by agents (officers) acting without actual or apparent authority (Mercantile) o No apparent authority for an extraordinary transaction where one expects a higher level of approval o Otherwise, the boards authority will be compromised whenever agent makes a false representation o May be inherent authority if the deal-maker is the President (Menard) o Boards good faith may play a role (3 month delay in Menard)
Jennings v. Pittsburgh Mercantile Co (1964) Egmore, Mercantiles VP, officer, and director, tells Real Estate broker to solicit offers for Sale & Lease back of corporate headquarters. Jennings and Executive Committee accepts an offer, but board rejects the offer and Real Estate Broker sues for commission. Mercantile said Egmore lacked authority to do the deal with the broker. o Egmore lacked actual authority; this deal wasnt one which a general agent of the company is empowered to do. o Did Egmore have apparent authority? That is the case if the principal (the board) (1) knowingly permits the

17

agent to exercise or (2) holds him out as possessing. For apparent authority to be infered from prior dealings there needed to be (1) a similarity of transactions in the past (this is an extraordinary transaction, not a transaction in the ordinary course of business) and (2) a degree of repetetiveness . Requires a higher level of approval because of the unusualness of the transaction and the expertise of the third party (Jennings) See rules on Agency (chapter 2).

Menard v. Dage-MTI (2000) M offers to buy land from Dage. Dage board rejects offer and tells Sterling (President CEO) he needs approval to accept a land purchase. Sterling accepts one without approval, agreeing to the same conditions the Board previously rejected. Board orders Sterling to back out but doesnt tell Menard for 3 months. o Sterling had inherent authority and thus the deal is valid; land is sold o Why? o S is CEO, other directors are often away o S often did real estate transactions, but company not in the business of real estate o S was in effect a one-man-show and seemingly had authority o S told the other company he had authority o The board took too long to tell M that S was not authorized; the deal was not renounced immediately, but only 3 months later. o This case is the outer limit most cases go like Jennings w/ an extraordinary transaction Dissent (Shepard CJ): o The board authorizes a CEO to sell land but requires that the sale be submitted for approval o The CEO tells buyer he must submit and the buyer knows it must be approved o The agreement is disapproved o This court holds the sale is binding anyway.

18

DEBT, EQUITY, and ECONOMIC VALUE

CAPITAL STRUCTURE Ways to Raise Money for a Corporation (1) Debt (bonds): Corporation can borrow o Subordinated Debt: Paid before equity but after other classes of debt o Debt (Notes): Unsecured notes, against the company not against specific assets if debt not paid o Secured Debt: Have particular assets of the company as collateral (2) Equity: Investors can contribute equity investments & receive residual returns after the business pays off debt claims a. Stock DGCL gives flexibility on how to craft shareholders rights (151) i. Common Stock (junior claim) 1. Has voting rights, gets residual returns by way of dividends once everyone else is paid off 2. Can choose who sits on the Board of Directors a. B/c the companys success is most in their interest b/c they are paid off last b. Common stockholders rely completely on Board of Directors b/c they lack claims 3. Board of Director has no obligation whatsoever to pay dividends ii. Preferred Stock (senior claim) 1. Paid first, before junior claims are paid 2. Usually no voting rights unless they are not paid their dividends 3. Usually fixed set of dividend rights, but only payable when declared by the board 4. Dividends are cumulative (made up next year) and if not paid in 6 quarters, they can elect Board of Directors 5. They get 1st rights on proceeds of liquidation The mix of debt and equity a corporation issues to finance operations is termed its capital structure btw Debt and Equity: if debtholder is not paid he can get the sheriff to seize assets and sell at auction; w/ equity it is the board which decides whether dividends are paid and for how much, no obligation to do so. Debt can be had directly or can purchase tradable debt (bonds). All companies must have at least common stock with voting rights. If all have a stake in the company, why do only common stock holders have voting rights? o Common stock holders have most junior claim and get paid out of the risidual, thus have a stake in maximising the value of the business. 19

o Common stock carries the greatest risk and are the most vulnerable; everyone else has contractual claim. o Debt holders only care about bottom line (getting paid principal and interest on loan). BASIC CONCEPTS OF VALUATION Future Values: FV = PV (1 + r) n What you presently have is worth in the future Present Values: PV = FV / (1 + r) n What some future value is worth today Annual Interest Rate: r = (FV/PV) 1/n -1 r = discount rate (often interest rate), and n is number of years When the discount rate goes up, you have a lower present value Expected Value: The sum of all possible outcomes multiplied by their corresponding probabilities But risk aversion may decrease an investors valuation of a certain deal E.g., less risky if outcome is either $20 or $10 than if outcome is $5 or $25 even though EV is $15 in both Risk: Measured by the square of the distance each outcome has from the expected return Risk Premium: Difference b/w the EV and the amount the investor would pay for this deal When Calculating Value of a Deal that Pays Out in the Future 1st :determine the expected value (deal with the possibility of default) 2nd: deal with the risk by discounting the EV by the risk premium 3rd: deal with the time by discounting the certainty value by the discount rate using the PV equation Investment bankers combine these steps: use a higher R to incorporate both risk & time value Net Present Value: When there are payouts going in both directions A positive NPV is a good investment; a negative NPV is a poor investment Look at the returns on the investment, determine present value of returns, and balance them against the cost paid out Use the same operations mentioned above: Risk-Adjusted Discount Rate 1st: determine Expected payout to adjust for default risk that investment is bad 2nd: adjust for time value using PV and FV formulas. 3rd: factor in risk by adding the risk premium % to the risk free discount rate % in denominator 4th dont forget to subtract what you laid out for the investment Diversification Idiosyncratic risks can be diversified away by holding multiple investments with independent (unrelated) risks in the same portfolio (ex: get 1% 20

of 100 coin tosses instead of 100% of 1 coin toss) As such, consumer can demand risk premiums only for the systematic risks that affect all investments CEOs dont really value long-term rights to buy company stock b/c it is undiversified CEO has too much risk of the type that investors wont compensate (his whole investment is tied up in 1 company) CEO can use the options and sell the company stock in favor of more diverse stock Stock Value: A stock should be worth the discounted stream of dividends plus the amount of the residual value if the company is liquidated Efficient Capital Market Hypothesis: We should trust the market to value the assets of a corporation ESTIMATING THE FIRMS COST OF CAPITAL Cost of debt to finance the corporation is usually lower than the cost of equity because: Debt creates tax benefits b/c interest is paid out of pre-tax dollars (dividends are paid out in post-tax dollars) BUT: Dont finance wholly with debt b/c costs of bankruptcy are prohibitive Debt is also less risky than equity for the debtholder, so cost of debt is closer to risk-free rate Value firms cash flows by using the weighted average cost of capital: The weighted average of the cost of debt and the cost of equity Weights are the relative amount of debt and equity in the capital structure Optimal Leverage: Balances the benefits from the lower cost of debt against the cost of financial distress that arises from too much debt

21

PROTECTION OF CREDITORS

Corporate law has always protected creditors Creditors are viewed as in more danger than other unprotected constituencies, like EEs, b/c of limited liability Assets can be shifted out of the corporation, leaving debts in violation of an implicit representation to continue to operate a solvent business; Shareholders can undertake highly risky investments Creditors can minimize these risks by exercising vigilance and negotiating for contractual protection; they can take security interests in particular assets or negotiate covenants. Default rules of protection come in three forms: METHODS OF PROTECTION: 1. MANDATORY DISCLOSURE: Force corporations or officers to disclose info about assets of a corporation to creditors Not big in the US (in contrast to EU): US lacks mandatory corporate disclosure laws for closely-held, small corporations BUT we do, though, have broad disclosure requirements for public corporations to protect shareholders (federal securities law); creditors benefits from these rules. Policy Reasons for Not Having Mandatory Disclosure Requirements o It is more inefficient for small corporations to have to file these, than it is beneficial to creditors o Creditors contracting with a company can always demand a profit-loss and income statement o Creditors can get a companys credit report (more valuable than a balance sheet) 2. CAPITAL REGULATION: Ex ante restrictions on capital 1. Distribution constraints 2. Minimal capital requirements 3. Capital maintenance requirements Corporate Balance Sheet Assets and liabilities are always in balance Differs from partnership balance sheet b/c of the equity accounts Equity value is a plug figure, it is the difference between assets and liabilities so that they remain in balance. Includes Preferred stock (w/ listed aggregate par value) Includes Common stock (w/ listed aggregate par value) Par value: Each shares nominal legal value (only a small 22

fraction of what the stock is sold for) Legal (stated) capital: Aggregated par value of the shares If a company has no par stock, the legal value is a number that the Board of Directors contrived, which we really set aside for creditors they can rely on getting this Par value and legal capital often set low, b/c value was traditionally unavailable for distribution to shareholders

Capital surplus: if stock is sold for more than its par value, the excess thereof Accumulated retained earnings: amounts that a profitable company earns but has not distributed to its shareholders

Ad 1. Distribution Restraints General Concept: There ought to be some amount of assets that cannot be distributed out of corporation to shareholders (i.e., through dividends, etc) leave a positive cushion to creditors (above and beyond what company owes) Distribution restrictions dont assure there will be some stated amount of capital available Just means that shareholders cant leave w/ assets of the corporation (a) Capital Surplus Test (NY Bus. Corp Law 510): Must leave the stated capital unimpaired Pay dividends only out of surplus capital distributions cannot render the company insolvent BUT: Board may transfer out of stated capital & into surplus capital if SHs authorize it (NYBCL 516(a)(4) (b) Nimble Dividend Test: May pay dividends out of capital surplus + retained earnings or net profits in the current or preceding physical year (whichever is greater) (DGCL 170(a)) BUT Board may transfer out of stated capital into surplus for no par stock DGCL 244. Thus, even if company is under water, Board can still pay out of any profits made last year (c) Modified Retained Earnings Test: May pay dividends either out of retained earnings or out of its assets as long as the assets remain 1.25 times the retained earnings (Cal. Corp. Code 500) (d) RMBCA 6.40(c) may not pay dividends if company cant pay debts as they come due; or assets would be less than liabilities plus the preferential claims of preferred shareholders BUT: board may meet the asset test using a fair valuation or other method that is reasonable in the circumstances asset test is manipulable None of these tests have much bite Ad 2. Minimum Capital: Most jurisdictions require a real minimum to start up - $75,000. We require $500 But whats the right minimum, especially when business sizes vary? 23

Minimum capital requirements dont protect creditors b/c it immediately gets invested in the assets and projects of the company and is no longer available to creditors It is difficult to come up with a set of ex ante constraints on capital that dont stifle the company in how it can use its assets

Individual Constraints on Capital Banks who fund small businesses may force the sole shareholder to guarantee the loans of the company (contract out of limited liability)

Ad 3. STANDARD-BASED DUTIES: Ex post standards to judge fiduciary behavior of managers and directors

A. Director Liability Fiduciary Duties protect corporate creditors by imposing a fiduciary common law obligation on directors to protect creditors when the company is in the vicinity of insolvency These duties are important to force directors to consider creditors interests when making decisions Ex: Whether to go to trial to maximize possible benefit to SH or settle to ensure creditors are paid As company is closer to insolvency, shareholders incentives get skewed and creditors wont be represented fairly by shareholder decisions see Credit Lyonnaise Bank Nederland discussion [139] B. Creditor Liability: Fraudulent Transfers Law of Fraudulent Transfers (UFTA 4 and UFCA 4-6): A transfer made by the debtor is fraudulent as to a creditor, whether the creditors claim arose before or after the transfer was made, if the debtor made the transfer: (i) W/ actual intent to hinder, delay, or defraud any creditor of the debtor, or (ii) W/o receiving a reasonably equivalent value in exchange for the transfer, and the debtor o Was engaged or about to engage in a business transaction for which the remaining assets of the debtor were unreasonably small, or o Intended to incur or reasonably should have believed s/he would incur debts beyond his/her ability to pay as they came due In this situation, a creditor can void the transfer and recapture the payout to the debtors estate Law of Fraudulent Transfers is Used in a Variety of Circumstances a) Leveraged Buy-Outs: Companies took out debts to buy back company stock, and either companies overpaid to recover the stock or the equity left in the company was unreasonably small creditors got burned Although creditors couldnt recover the purchase price of shares bought from public shareholders, bankruptcy trustees went after investment banker fees on the deal Courts are less likely to use this when creditors claim arose before the transfer (use 24

equitable subordination) Harder to satisfy the intent standard for actual fraud Courts are more likely to use this than piercing the veil, b/c it does not require intent; just negligence BUT, fraudulent conveyance cases require more evidence of bookkeeping, which may not exist b) Spin Offs: for instance tabacco companies placing assets in subsidiaries & distributing stock to their shareholders in order to insultate itself from tort liabilities

C. Shareholder Liability Shareholders may find themselves liable to corporate creditors or have any loans they have granted subordinated to other creditors under at least two legal doctrines: equitable subordination and corporate veil piercing. (1) Equitable subordination Shareholder loans of controlling shareholders may be equitably subordinated (given a lower priority) than the loans made by third party creditors USUALLY, SH liabilities (loans) are treated as 3rd party liabilities b/c SH assets are separate from corporate assets This doctrine departs from this general rule We dont subordinate SH loans as a matter of course because: o This would further compromise limited liability, which we already do through piercing the corporate veil o Encourage controlling SH to lend money to the company o Controlling SH w/ actual control are in a better position to make rd party creditors a loan than 3 Undercapitalization is not enough for equitable subordination (Fazio) o Also need controlling shareholders to have committed some injustice, mistreatment of the business (not quite fraud) o Typically the SH will also be an officer of the corporation o Kraakman: These issues could be dealt with under UFTA 4, which is the background governing norm
Costello v. Fazio (1958) Partners have $51,000 invested in the partnership. When business gets bad, they withdraw their money, reorganize in corporate form, and recapitalize the company by giving a loan to the company (representing most of the contribution withdrawn). They leave $2,000 each in the business, Business fails and creditors arent paid. Ex-partners now seek to claim on these notes.

Shareholders do not escape liability to creditors (even though they reorganized in a corporation) because their debts are subordinated to the debts of other creditors This prevents them from keeping the corporation going long enough to pay off the debts of the partnership (for which they were personally liable) by incurring debts of the corporation (for which they would not be liable) and keeping their initial capital Mistreatment here: undercapitalizing to change the situation once the business was already failing Switching the form without telling anyone, after they set up the business, established a market

25

reputation

Parties knew their business was undercapitalized, and reorganized to get out of existing debts
The transaction was by no means an arms length bargain. Comment: if the business had been started as a corporation with $6,000 in stated capital and $50,000 in loans from its shareholders, it is unlikely that there would have been any mention of inequitable conduct.

(2) Veil Piercing Doctrines Sets aside corporate form and finds shareholders directly liable for contract or tort obligations. a) Agency Test: Is the corporation the agent of its principal? b) Instrumentality of the Individual c) Alter Ego of the Individual Two Components i) Evidence of lack of separateness (shareholder domination, thin capitalization, no formalities, co-mingling of assets) Tinkerbell Test: Does the shareholder believe in the separation? ii) Unfair or Inequitable Conduct: Wildcard In addition to the fact that a creditor was burned (Sea Land) which happens in every case Usually some form of implicit or explicit misrepresentation Must be a specific intent to burn this particular creditor (Sea Land) BUT SEE Kinney: Just undercapitalization, no transfer, and Kinney knew about it When the injustice is insufficient for piercing the veil, check fraudulent conveyance, which requires only negligent rather than intentional conduct (also use this standard as norm for actions just short of fraud) Court will not likely pierce against a public corporation, against passive shareholders, against minority shareholders if all formalities are observed and there was nothing funny with the accounts REMEDY: Shareholders pay and are subject to unlimited liability (unlike equitable subordination) Formulations of the Doctrine (1) Lowendahl Test: (NY) a. Complete shareholder domination of the corporation, and b. Control used to commit a wrong that proximately causes creditor injury c. Failure to treat corporation formality seriously. (2) Krivo Industrial Supply Test: Wherever recognition of corporate form would extend the principle of incorporation beyond its legitimate purposes and produce injustices or inequitable consequences. (3) Van Dorn Test (7th Circuit, Sea Land) a. Such unity of interests and ownership that the separate personalities of the corp and the individual no longer exist Important factors
i. ii. iii. failure to maintain adequate corporate records commingling of funds or assets undercapitalization

26

iv.

one corporation treating the assets of another corporation as its own.

b. Adherence to the fiction of separate corp existence would sanction a fraud or promote injustice What does promote injustice mean? Must be more than a creditors inability to collect For instance: party would be unjustly enriched; a parent company causing a subsidiaries liability would escape liability; intentional scheme to squirrel assets into a liability free corporation while heaping liabilities on an asset-free corporation. (4) Laya Test (Kinney Shoe) a. Unity of interest and ownership such that the separate personalities of the corporation and the individual shareholder no longer exist b. Would an equitable result occur if the acts were treated as those of the corporation alone c. BUT, if 1st and 2nd prongs satisfied, 3rd prong: Is there an assumption of risk (should bank have known?) of undercapitalization. If so, no veil piercing possible (this prong is permissive, not mandatory).. 3rd prong has been applied to financial institutions only (Kinney) This test is stacked against shareholders of corporate debts Reverse piercing: Lets courts go after other corporations owned by the shareholder in addition to shareholders personal assets Will have to allege that corporations are alter egos of each other hiding behind the veil of separate corporate existence for the purpose of defrauding creditors. May be unfair to creditors of these other corporations

Sea-Land Services (1991) Sea Land is stiffed by Pepper Industries, which has no assets. Pepper one of many 1-shareholder corporations is owned by Marchese. Trial court pierces to Marcheses personal assets and reverse pierces through to get assets of his other corporations. Appellate court reverses No piercing under Van Dorn test b/c while there is a lack of separateness, there is no fraud or injustice here Theres no allegation short of fraud that is necessary to make the case for piercing It is not enough to just shift assets; must be a specific intent to shift away from this particular creditor Kinney Shoe Corp v. Polan (1991) Kinney subleases its factory to Industrial, which exists only to lease Kinneys building. Industrial sub-subleases to Polan Industries, which is capitalized by Polans personal assets. Industrial owns no assets, and Polan is protected by TWO corporate veils Court pierces under the Laya test: Polan is personally liable

BUT: Kinney probably did know better, but needed to lease its building (beggars cant be choosers). District court
refuses to pierce on this ground, but appellate court stresses that this requirement is permissive not mandatory, even if it can be extended to others than banks and lending institutions.

The wrong here was just undercapitalization; no misrepresentation by Polan. Kraakman: These cases should have been decided differently: Should have pierced in Sea Land, not in Kinney 27

E. VEIL PIERCING ON BEHALF OF INVOLUNTARY (TORT) CREDITORS Surprisingly, courts are more likely to pierce on behalf of contract creditors than on behalf or tort creditors. Also, tort victims claims come after those of secured creditors (like banks with mortgages on cabs) Problem: (1) tort creditors cannot decide with whom they will deal, unlike contract creditors; (2) they also do not rely on the creditworthiness of the corporation in placing themselves in a position to suffer a loss.
Walkovsky v. Carlton (1996) Cab that hit plaintiff is owned by a 2-cab company that is wholly owned by Carltons parent company . This company owns ten other 2-cab companies. Court permits horizontal piercing to other cab companies but does not permit vertical piercing to Carltons personal assets Evidence that the cab companies took from one another to pay money sloshed between businesses (commingling of assets) o NO evidence that Carlton used his own funds with business funds (no commingling of Carltons personal assets) so no vertical piercing o NOTE: If Carlton had been more careful with the books, he would have gotten off free (no horizontal piercing) and clear w/ no compensation to

This is not a good result for plaintiffs b/c each cab company is capitalized only with the minimum insurance
amount proscribed by law, which applies only to the cabs of the individual companies (medallions are judgment proof, cabs are mortgaged, tort creditors are unsecured creditors that come behind secured creditors); court argues it is up to the legislature to increase the minimu insurance.

Dissent (Keaton): Theres a general policy to compensate tort victims, and the rule should be such that if
the corporation lacks reasonable capital, the veil should be pierced Criticisms: Insufficient capital not sufficient basis for piercing (but Carlton used this construction precisely to minimize liability); this would make sense for contract creditors, but not tort creditors that cannot choose those with whom they deal

IS THIS OUTCOME JUSTIFIED? KRAAKMAN: Doctrine is problematic, b/c uses the corporate veil as a low-cost substitute for liability insurance If ones personal assets were at risk, there would be an incentive to have more insurance As long as corporate veil insulates him from liability, Carlton has no incentive to run a safe business Problem is that corporate law is developed w/ contracting parties in mind: Shareholders are given the same protections against tort suits as against contract suits even though the contracting party was in a position to protect himself ex ante through contract negotiations Solution: Make shareholders liable for corporate torts if there is not enough in the corporate kitty to pay s Make Shareholders pay pro rata the costs that they impose on the world, just as theyd have to pay for steel by contract (would be reflected in the share price) This would change a companys incentive to act safely W/ an undercapitalized kitty, there is a great incentive to act unreasonably and impose external costs Companies know best by following the market how much insurance they need. 28

Easterbrook: small taxi cabs with minimal assets will undercut larger corporations; leads to a race to the bottom SUCCESSORS LIABILITY DGCL 278, 282: if assets pass to corporation, liabilities may as well. In particular for torts liability for faulty products Best strategy is to break up assets and lose going concern value of business to avoid liability.

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VOTING
A. REMOVING DIRECTORS Default powers of shareholders: (1) Right to vote (2) Rights to sell (3) Right to sue ROLE OF SHAREHOLDER VOTING, ELECTING AND

Voting is important b/c ordinary business decisions by the board are unregulated This is the primary benefit of the corporate form: the ability to delegate management to other people Without limited liability the shareholders would not entrust business decisions to a delegated management. Shareholders vote on 3 kinds of issues (1) Election of directors: all states except one require an annual meeting for electing directors (2) Organic or fundamental changes (mergers, dissolutions, sales of assets, charter amendments) (3) Shareholder resolutions Collective Action Problem: any one shareholders vote is unlikely to affect the outcome of a vote; economic incentives to remain passive. Registered Shares: Each share has a holder of record which facilitates getting in touch with the ultimate SH o BUT, the nominal shareholder registered w/ the corp may be irrelevant when the nominal shareholder is a large depository, which has accounts with investment houses, which has accounts with individual SHs Proxy System: SHs who cannot attend the annual shareholder meeting can still vote w/ a proxy (representative) who attends the meeting and votes on SHs behalf Quorum Requirement Default: must have 50% of outstanding shares to have an election (including proxies) o Anti-manipulation measure: prevents board from giving minimal notice, holding meeting in Africa, etc Special shareholder meetings: No special meetings in DE unless it is in the charter o Solidifies the power of the existing board ELECTING AND REMOVING DIRECTORS Mandatory voting right: Every company mujst have BoD (DGCL 141(a)). There must be an annual election of directors. Every corporation must have at least one class of voting stock Each share of has one vote (no more, no less) DGCL 212(a) 30

 It is possible to create non-voting stock in addition to voting stock (there must be at least one voting share). Voting Rights can be Separated from Cash Flow Rights (United Airlines, employees vote board, they are issued voting stock w/o cash flow rights, other stockholders given cash flow rights w/o voting rights. This right is indespensible to shareholders; their security has no maturity date and there is no legal right to periodic payments. Cumulative voting: Each shareholder gets votes equal to the number of shares owned times the number of open seats Allows minority vote holders to pool all of their votes together for one candidate and get representation. Example: Farm Co. has 300 shares Two shareholders (A has 199 shares; B has 101). Three directors Straight voting: A would win every seat (199 votes to 101) Cumulative voting: A has 597 votes; B has 303 (3x shares) B can cast all his 303 votes on one candidate, is sure to get at least one seat since A cannot divided his 597 votes three ways to surpass 303 votes). Increases likelihood of minority representation on board. Removing directors: Directors may not remove fellow directors, whether for cause or otherwise, unless there is express shareholder authorization. Shareholders may remove directors in accordance with the following rules DGCL 141(k):
Any director or the entire board can be removed with or without cause by the holders of a majority of the shares then entitled to vote at an election of the directors, except the following: (i) Unless the certification of incorporation otherwise provides, in the case of a corporation whose board is classified (staggered), shareholders may affect such removal only for cause; or (ii) In the case of a corporation having cumulative voting, if less than the entire board is to be removed, no director can be removed without cause if the votes cast against his removal would be sufficient to elect him.

Staggered Boards: Boards whose directors are elected at different times (1/3 elected at board meeting each year for three year cycles) Also called classified board Cannot remove a director from a classified board except for cause 141(k)(1) Implication: An outsider cant take control of a board at the annual meeting; must go through at least 2 GMs MA has mandatory classified boards (needs 2/3 to get out of classification. Staggered boards are vital in prevent hostile takeovers. How to circumvent is sh has over 51%? Boards cannot amend their charters unilaterally requires shareholder vote DE 242(b)(1) Shareholders cannot amend the charter w/o boards consent Shareholders CAN amend the bylaws under DGCL 109 even if the Board objects 31

Amend bylaws to Increase the size of the board BUT 223(a) says the Board of Directors can fill any

vacancies on the board Thus, amend bylaws to provide that the shareholders, rather than the Board of Directors fills the vacancies Amend bylaws to remove the classified board (can only remove with cause), then remove directors w/o cause If cumulative voting, whole board must be removed & new board voted in. BUT board can re-amend bylaws to reinstate classified board DGCL 141(d) classification system can only be in original bylaw, or adopted at a later stage nut only by a shareholder vote. Dissolve company and distribute assets o BoD has right of intiative; must propose any dissolution, thus SH needs control of board to effectuate this.

For best protection: Boards should put anti-takeover devices into Charter, which SHs cannot unilaterally change Limits: Board cannot act to entrench itself by disenfranchising the shareholders
Hilton Hotels v. ITT (1997) Hilton announces tender offer and proxy context to take over ITT. ITT delays annual meeting by 6 months, and splits its assets into 3 wholly owned subsidiaries including Destinations, which gets 93% of assets. ITT as sole shareholder structures charter with staggered board (but with same directors), a SH vote of 80% is necessary to remove w/o cause.

Plan is invalid as its primary purpose is to disenfranchise the shareholders from employing their voting rights by entrenching the board in light of a proxy contest (see Blasius) Should not be left to boards business judgment, because it undercuts the primary justification for the business judgment rule in the first place. The boards actions would have been unproblematic had it not been in response to a hostile takeover bid

Board Terms DE has a 3 year term for board members Longer terms prevent short-term thinking Longer terms mean it is harder to get them out of power, though (especially if classified) unless it were possible to hold special meeting remove board members w/o cause SHAREHOLDER MEETINGS AND ALTERNATIVES SH may vote on a number of issues: election and removal of board, adoption, repeal or amending of bylaws, adoption of SH resolutions ratifying board action or requestion the board take certain actions. Special meetings: meetings called for special purposes other than the general annual meeting. RMBCA 7.02 A corporation must hold a special meeting of SH if (1) such a meeting is called by the BoD or a person authorised in the charter or bylaws to do so, or (2) the holders of at least 10% of all votes entitled to be cast demand such a meeting in writing. DGCL 211(d): special meeting may be called by the BoD or such persons as a designated by charter or bylaws. 32

Shareholder consent sollicitations: in lieu of a meeting by filing written consents DGCL 228: any action that may be taken at a meeting of SH may also be taken by the written concurrence of the holders of the number of voting shares required to approve that action at a meeting attended by all shareholders. PROXY VOTING AND ITS COSTS DE proxy system set up in 212(b) and (c) Voters (principal) dont have to be at the meeting to vote; they can set up a proxy (agency) to exercise their vote Each side must send out their own proxy card, and the voter sends in only the proxy card of the side they prefer In DE, management and boards of directors are able to solicit proxies on their own behalf One contesting an election must send out ones statement (no universal ballot on which to place ones name) Reimbursing Opposing Candidates Under Proxy System: Waging a Proxy Contest It is expensive to wage a proxy contest Must comply with federal proxy rules (requires lawyers) Securities and Exchange Act 1934 14. Must pay to send out proxies Incumbents reimbursed unconditionally if acting in good faith (costs associated with normal governance of the corporation); Insurgents reimbursed only if successful & SH ratification
Rosenfeld v. Fairchild Engine & Airplane Co (NY 1955) During proxy context, incumbents spent $106,000 and reimbursed themselves from company treasury. Spent $28,000 for which they were not reimbursed b/c they were voted out. Insurgent reimbursed incumbents $28,000 and reimbursed themselves. SH ratified insurgents reimbursement

(Froessel rule) Management can get reimbursed from business treasury for any reasonable expenses made during the proxy contest (Because it is part of the business) BUT insurgents are reimbursed only if they are successful and have SH ratification (bias for incumbents) o Dont make too high a barrier for getting new officers, but require SH ratification to ensure insurgence was reasonable Under waste doctrine, reimbursement must be ratified universally if corporation isnt benefited (to prevent waste)

Kraakman: It would be more equal to reimburse both sides whether they win or lose, but this would lead to strategic insurgents (super Froessel rule) o Making sure losing insurgents pay their own ensures that only serious insurgents wage contests o Is it preferrable to reimburse both sides pro-rata depending on the amount of votes they receive? o Or to reimburse neither side?

Decision Tree for Proxy decisions: (1) If insurgent wins, he gets his percentage of ownership multiplied by (the GAIN minus (the cost of his expense to wage the proxy contest plus managements expense to wage the proxy contest)) 33

(2) If insurgent loses, he loses (his percentage of ownership multiplied by managements proxy expenses) minus the money he spent on the proxy that is not reimbursed Proposed Reform SEC Proxy Rule 14(a)(11)

Would give, under restrictive circumstances, big shareholders the right to nominate a few candidates for the Board and have their names listed on managements proxy statement A step toward the universal proxy system
CLASS VOTING There may be multiple classes of stock in a company, with different payouts and voting rights Classes may have different interests RMBCA 10.04 NY 804: There must be a Class Vote to authorize a class of shares with rights superior to the class o Would require a vote to issue a senior preferred stock class over the regular preferred class DE 242(b)(2): Alteration in the rights of security triggers a class vote, but NOT other securities that may be introduced with a priority over the security o Would NOT require a vote to issue a senior preferred stock class over the regular preferred class In Both NY and DE, cant reduce par value of shares or increase the number of authorized shares w/o a class vote o Usually there are more authorized shares than issued shares so managers can do this w/o class vote SHAREHOLDER INFORMATION RIGHTS State law lacks serious disclosure responsibilities to shareholders, but SEC has strict ones for public companies State Law Information Rights Right to examine the books and records o May need to sue to enforce that right o Burden is on seeker to justify why s/he needs that Right to demand a shareholder list (DGCL 220) o Burden is on management to say why it is reasonably contrary to SH interest not to provide it o Courts are lenient and often require list to be handed over o Lists are unhelpful b/c they dont include actual beneficial owner of shares just lists depository institution o NOBO (Non-objecting beneficial owner) List includes those who register as official owners this helps.

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SEPARATING CONTROL FROM CASH FLOW RIGHTS (1) Circular Control Structures: Provisions bar the company from voting its own shares (that it buys back) DGCL 160(c) Also bars them from counting the votes of their subsidiaries when those subsidiaries own shares in the company Prevents Boards of Directors from buying shares in their own company to finance their own entrenchment
Speiser v. Baker (1987) Health Chem is a public company. Health Med is a wholly owned Health Chem subsidiary that owns 42% of Health Chem shares. Speiser and Baker own 10% and 8% of Health Chem respectively (to constitute common stock) This structure violates 160 b/c when the shares are converted, real voting rights at 95% - too much like treasury shares Too much like Health Chem owns shares of itself b/c almost all of the money put in is from Health Chem Cant get around 160 like this, b/c Health Meds shares effectively belong to the corporation itself

Vote Buying In general a shareholder may not sell her vote separately from transferring the entire share. Why? If a stock investment is an economic decision with profit-maximisation as its purpose, why shouldnt investors be permitted to split up share rights in any way they deem profitable. Separating votes from shares introduces a disproportion between expenditure and reward. Imagine if 20% stockholder possessed all the votes; incentive to take steps to improve the firm is only 20% of the value of any decisions taken. Since no voter expects to influence the outcome of an election, he would sell his vote (which to him is unimportant) for less than the expected dilution of his equity interest. Vote-buying requests may be okay in DE if there is sufficient independent review and it is in the best interest of the SHs Independent Counsel, Independent Committee, Shareholder Vote of unaffiliated shareholders (Schreiber)
Schreiber v. Carney (1982) Investors want to do a share-for-share merger to create a holding company (Texas Air) for Texas Intl airline to get around airline regulatory requirements. Jet Capital owns many shares of TI as well as warrants and doesnt want the merger b/c exchange of warrants is taxable. JCC says it will sink the transaction unless TI gives a low-interest loan to let it exercise its warrants now (to not be taxed on the transaction) This is vote buying for economic consideration, but it is allowed because it is in the interests of TI stockholders. JCC otherwise has a veto right. This vote buying does not run afoul of common law DE proscription against vote buying b/c there is independent review and it is in the best interest of the shareholders TI created an independent committee, with independent counsel, and a shareholder vote of unaffiliated SHs ratified it Brady v. Bean: vote buying prohibited per se if true intention is to defraud stockholders. Not the means, but the ends of bote buying is important (is the conduct designed to harm shareholders?)

Should a Court Allow Vote Buying? Letting these deals go through based on SH ratification is not right b/c it fails to recognize SHs coercion o They need to ratify the deal 35

 Not clear if there should be a normative requirement not to use voting power except to protect against common stock holders doing something to diminish the value of the company It probably is not allowed to let companies trade proxies on a market which would allow voting control in the hands of those with absolutely no cash flow rights in the company o Intuition that separating cash flow rights from control rights leads to distorted decision-making Controlling Minority SH: Legal Means of Separating Cash Flow Rights from Control Rights: These structures permit SH to control a firm while only holding a fraction of the equity
(3)

(a) Dual Class Share Structure: single firm that issues two or more classes of stock with differential voting rights. o It is legal to have 2 classes of public stock (one w/ 10 votes and one with 1 vote) b/c shareholders know these differences ex ante (different from vote buying) o Most common controlling minority structure in the U.S., but not most common worldwide o Most effective for separating voting rights from cash flow rights and entrenching an individual as a controlling min shareholder o Rare among public companies Can be adopted mid-stream only by charter amendment requiring a shareholder vote NYSE Rule 313 (b) Corporate pyramid structure a controlling minority shareholder holds a controlling stake in a holding company that, in turn, holds a controlling stake in an operating company. o For any fraction, however small, there is a pyramid that permits a controller to completely control a companys assets without holding more than that fraction of cash flow rights\ o Ex.: 3-tier pyramid, minority SH holds 50% of shares at each level but only 12.5% of cash flow rights (controller owns 51% of A, which owns 51% of B, which owns 51% of C, what is controllers economic stake in C?) (c) Cross-ownership structure linked by horizontal cross-holdings of shares that reinforce and entrench the power of central controllers. o Voting rights are distributed over the entire group o Differs from pyramids b/c the voting rights used to control the corporate group are distributed over the entire group rather than concentrated in the hands of a single company or SH o Permits a controller to exercise complete control over a corp with a small claim on its cash flow rights

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B. COLLECTIVE ACTION PROBLEM Easterbrook Voting is expensive in means of time and money, only those shareholders with many shares will bother to invest in voting. Shareholders dont read annual report or proxy statements Perception that one vote does not make a difference Black Incentive to cast an informed vote increases exponentially as shareholdings grow Legal rules keep financial institutions smaller than they otherwise would be; in contrast rules that encourage shareholder oversight over corporate managers are few and weak. Disclosure is still necessary b/c there are more big players who have the stake and sophistication necessary to make sensible decision about voting and who have some interest C. FEDERAL PROXY RULES

Proxy solicitation: Any solicitation reasonably expected to result in the procurement of a proxy 14(a) (1)(L)(iii) Securities Act of 1933: Disclosure procedures that companies must follow when selling securities on the public market o Covers initial offering of securities, when you first go public Securities Act of 1934: Establishes (among other things) ongoing disclosure requirements for corporations after IPO All public companies are subject to proxy regulation under 14(a) of the Act Regulation 14A (Rules 14a-1 through 14a-12) Substantive regulation of the process of soliciting proxies and communicating among shareholders Schedule 14A: What you need to disclose in a full-dress registration statement 1992 Amendments: Changed rule that shareholders couldnt speak to one another about the company through proxies w/o approval from the SEC of their proxy statement Purpose of Proxy Rules Require disclosure about management compensation, who is running, companys performance Substantively regulate the process of soliciting proxies and getting SHs to vote General anti-fraud rule 14(a)(9) allowing courts to imply a private SH remedy for false or misleading proxy materials 37

Shareholder resolution 14(a)(8) town meeting rule that lets SHs piggyback on managements proxy statements instead of having to do them themselves

Questions (a) Is it a proxy that is governed by the rules? 14(a)(1) & (2) (b) Is it a regulated solicitation that requires filing of proxy statement? 14(a)(2) (c) Do they still have to file under 14(a)(6)(g) b/c they own 1% or $5 million? (d) If they must file, did they enclose critical information with the proxy materials? (e) Were they justified in waiting until they send out the cards to give it to SEC and SH under 14(a)(12)? Rules 14a-1 through 14a-7 Disclosure and Shareholder Communication Section 14(a) of 1934 Securities & Exchange Act makes it illegal, in contravention of any rule the commission may adopt, to solicit any proxy to vote any security under 12. Regulation 14A contains the implementing rules. The basic scheme of the Regulation is to state with great detail the types of information that any person must provide when seeking a proxy to vote a covered secutiry. These rules apply not only to an issuing corporation but also to a third party who might seek to oust incumbent management by proxy fight. Had the unintended consequence of actively discouraging proxy fights. 1992 Amendments released institutional shareholders, in some circumstances, from requirement to file a disclosure form before they could communicate with other shareholders about a corporation Rule 14a-1 Defines terms and expands definition of proxy and solicitation: proxy any solicitation or consent The heroic breadth of these terms (almost any statement of views could be considered a solicitation) protected management from shareholder attack (the expenses of elaborate filing under Regulation tended to chill communications between institutional investors for fear of it being labelled a sollicitation). 1992 Amendment provided exemption of some solicitations (those disinterested in voting, those who do not seek to act as a proxy) Rule 14a-2 Also broadly framed to ensure that most proxy solicitations will be subject to regulation. o Exempted solicitations include the traditional one of fewer than 10 shareholders and of ordinary shareholders who wish to communicate but dont seek proxies 14a-2(b)(1) the principle registration requirements do not apply to: o Any solicitation by any person who does not, at any time during such solicitation, seek directly or indirectly, the power to act as proxy for a security holder 38

and does not furnish or otherwise request, a form or revocation, abstention, consent or authorization o Indirect may apply to exploratory research for a future proxy contest o Provided that the exemption does not apply to any person affiliated with the registrant, etc. Rule 14a-3 Central regulatory requirement of the proxy rules No one may be solicited for a proxy unless they are furnished with a proxy statement When the solicitation is made on behalf of the company itself and relates to an annual meeting for the election of directors, it must include considerable info about the company When the proxy statement is filed by anyone other than mgmt, it requires detailed disclosure of the identity of the soliciting parties, including their holdings and financing of the campaign Rules 14a-4 and Rule 14a-5 Regulate the form of the proxy and the proxy statement E.g., proxy must instruct SHs that they can withhold support for a director by crossing through the name. Dissident can also solicit votes for some but not all of mgmts candidates for the board (short slate rule). Rule 14a-6 formal filing requirements (g): Still have to file (though not full proxy statement) if acted under 14(a)(2)(b) and own 1% or $5 million Rule 14a-7 Sets forth the list-or-mail rule under which a company must either o provide a shareholders list or o undertake to mail the dissidents proxy statement and solicitation materials (at dissidents cost) to record holders in quantities sufficient to assure that all beneficial holders can receive copies Rule 14a-8 (TOWN MEETING RULE) Lets SHs introduce certain proposals on managements proxy (has advantage of not having to file own proxy), subject to some regulations o SH must hold $2,000 of 1% of the corporations stock for 1 year o File w/ mgmt 120 days before the date management plans to release proxy statement o Proposal limited to 500 words o Proposal must not run afoul of subject matter restriction (13 grounds for excluding proposals) Proper subject of shareholder vote Cant relate to ordinary conduct of business or election of directors Relates to a matter less than 5% of business Cant be counter to a management proposal Inconsistent with state law 39

Retains its political role like in Cracker Barrel

Rule 14a-9: Anti-Fraud Rule under Federal Proxy Rules Broad-range rules that let SHs bring suits in federal courts attacking disclosures made to them by managers Proscribes false or misleading statements that are MATERIAL (likely to influence how reasonable SH votes) SC recognizes a private right of action under 14a-9 (JI Case v. Borak) o Now area is open to plaintiffs bar who will enforce the rule o Elements of Private Right of Action for Fraud under 14a-9 1. False or misleading statement thats material (it influenced the Reasonable SH to vote) 2. Level of culpability (negligence or scienter) 3. Causation Fraud must be an essential link to the challenged transaction (no reliance necessary) 4. Reliance NOT necessary in 14a-9 actions, though it is an element of fraud in common law SC reads the implied right of action under 14a-9 narrowly
Virginia Bankshares v. Sandberg (SC) No need to solicit proxies to vote for merger b/c VBI owns 85% of stock. BUT, VB did solicit proxies (fear of lawsuit) and there was a misleading statement. Proxy called $42 a high and fair value of shares, but Board had valuation of $60. Is there causation b/c no vote was necessary? SC says fact that it was the boards opinion of fairness doesnt make it not a misrepresentation SC says this was not an essential link so there is no fraud action b/c no vote was required Plaintiffs thought it was an essential link b/c if minority voters had voted it down, the board of independent directors wouldnt have proceeded with the transaction SC rejects it b/c it was speculative

DE common law began to regulate misrepresentation even when the Board isnt making a direct request of the SHs to do something (Mallone v. Brincat (Del. 1998)) DE is encroaching on federal territory

Proposed 14(a)(11): Shareholder Access Rule If trigger met at previous meeting, a 5% group of people who have held shares for two years can nominate a short slate of 1, 2, or 3 directors to run against specified management directors on the companys proxy Trigger: Either (a) 35% of shareholders withheld vote on board nominee during prior annual meeting, or (b) Successful resolution brought by 1% of SHs requesting nomination rights during prior meeting This provision is NOT radical o Requires a 2 year process (1st year to get the trigger, 2nd year for the vote to occur) ADDITIONAL TRIGGER (proposed by HLS and HBS): Nomination by 10% shareholder group during the current meeting w/o meeting conditions (a) or (b) 40

o o

and have more access REJECTED by Corporate Governance Task Force of Business Roundtable (John Olson) 2) Doesnt improve corp governance: Independent directors dont necessarily give better results Ex: GE, Intel, Coke, UPS all have boards with insiders heavily represented and run well They know the business better and can better monitor officers 3) Appointed persons can have no connection; theyre usually professors 4) Provisions dont work for mutual or hedge funds b/c they wont be locked into a stock for 2 yrs 5) Prime proponents are labor unions and pension funds, but they have ulterior motives besides corporate governance they want companies to change the labor relations Also benefits Institutional Shareholder Services (who advise unions for a fee) Bad guys: unions follow them blindly, but theyre influenced by commercial donations o Companies will continue to pay off ISS so their candidates arent removed 6) Rule is ineffective for small shareholders 7) Only increases the leverage of those who already have leverage

ALSO propose reducing the 35% withheld to 25% withheld to trigger (a) RATIONALE: It is for election only of 3 candidates at most! POLICY: Provision lets shareholders communicate with the board

Rule 14a-12 Special rules applicable to contested directors Permits dissident solicitations prior to filing of proxy statement as long as dissidents disclose identities and holdings and dont furnish a proxy card Short Slate Elections: Offering fewer candidates for the board than there are board seats Used to be that dissidents couldnt list managements candidates on their proxy o EFFECT: If you give 3, and there are 9 total, and you cant tell your supporters which 6 of managements 9 people to vote for, their votes will be spread out o You will need more than 50% to get your candidates on the board NOW: 14(a)(4)(d)(4): Can tell them not only which of yours to vote for but also which of theirs NOT to vote for

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DIRECTORS DUTY OF CARE

A. Fiduciary Duties and the Duty of Care

Duty of obedience: fiduciary must act consistently with the legal documents that create her authority Duty of loyalty: corporate fiduciaries must exercise their authority in a good-faith attempt to advance corporate purposes. Duty of care Duty of Care - ALI Principles of Corporate Governance 4.01 Director or officer has a duty to corporation to perform his or her functions (2) In good faith, and (3) In a manner that s/he reasonably believes to be in the best interest of the corporation, and (4) With the care that an ordinarily prudent person would reasonably be expected to exercise in a like position under similar circumstances A. MITIGATING DIRECTORS RISK AVERSION Rationale: We establish a reasonable directors standard and then insulate them from liability even when they fail to meet the standard. Why? Avoid risk aversion. a. Corporate directors and officers invest other peoples money; they would bear full costs under any other negligence based standard, but receive only a small fraction of the gains from a risky decision. b. SHs benefit if the project turns out well; THUS: Limit director liability so that directors will still take risky (but profitable) projects c. We cant make sure directors will do the right thing, so we make sure they dont have an incentive to do the wrong thing
Gagliardi v. Trifoods International, Inc (Del. Ch. 1996) If directors didnt have protection from liability, managers would always opt for the less risky project, which would hurt SHs High-risk projects have a higher expected return. Assuming risk is diversifiable, we want managers to take the highest expected return In the absence of facts showing self dealing or improper motive, a corporate director should not be legally responsible for any decision made in good faith.

How to avoid risk aversion protection from the corporate duty of care (1) Indemnity: a corporation may indemnify its directors or officers for D&O actions taken in good faith (DGCL 145(a)) and for those beyond those provided by statute but still in good faith (145(f)) which cause losses to the corporations and other interested parties. (2) D&O insurance: corporation may buy D&O Insurance whether or not the corporation would have the power to indemnify such person against such liability (DGCL 145(g)). (3) Business Judgment Rule: Where a director is independent and disinterested, there is no liability for corporate loss unless no person could possibly authorize such a transaction if s/he were attempting in good faith to meet the duty. RMBCA 8.31(a)(2) offers a presumption that the duty of care standard has been met by D&O. 42

(4) DGCL 102(b)(7): corporations may waive D&O liability for acts of negligence or gross negligence not falling under the business judgment rule. Ad (1) Indemnification Most corporate statutes prescribe mandatory indemnification rights for directors. These authorize corporations to commit to reimburse any agent, employee, officer or director for reasonable expenses for losses of any sort arising from any actual or threatened judicial proceeding or investigation. Limits (DGCL 145 (a), (b), (c)): (1) losses must result from actions undertaken on behalf of the corporation, (2) taken in good faith; and (3) they cannot arise from a criminal conviction.
Waltuch v. Conticommodity Services (1996) When silver prices crash, angry silver speculators sue Waltuch as director of Conticommodity. Corporation settles for $35 million, W incurs $1.2 million in legal fees. In separate CFTC action, he agrees to a penalty that includes a fine of $100,000 and a 6 month ban, spends another $1 million on legal fees. Tries to get indemnification for these expenses. (1) W claims that Article 9 of Corporate Charter requires Conti to indemnify him for his expenses. Conti argues that DGCL 145(a) allows for indemnification only where good faith is present, smth W has not established W argues that DGCL 145(f) allows a corporation to grant indemnity in cases outside the limits of subsection (a) & that Conti did so w/ article 9 that makes no mention of good faith. The Court decides that a corporations grant of idemnification cannot be inconsistent with the substantive statutory provisions of DGCL 145. Subsection (f) permits for additional rights (such as rights out of D&O insurance), but not more expansive indemnification than expressly permitted by statute (2) W argues that DGCL 145(c) requires Conti to indemnify him since he was successful on the merits or otherwise in private lawsuits. W argues that he was successful in the private lawsuits since they were dismissed w/o any payment or assumption of liability by him. Conti argues that these claims were only dismissed because it paid out a settlement which was contibuted in part on behalf of W. The Court decides that success in the context of DGCL 145(c) means escape from an adverse judgment, it is not the duty of the courts to investigate how this escape came about.

Ad (2) D&O Insurance DGCL 145(f); RMBCA 8.57: why do corporations purchase insurance rather than raising salaries and board fees and then allowing directors and officers to take the money and purchase insurance on their own accounts; probably because of transaction costs. Ad (3) Business Judgment Rule Judicial protection: the courts should not second guess good-fath decisions made by independent and disinterested directors. Courts will not decide whether a decision is reasonable. Business Judgment Rule ALI Principles of Corporate Governance 4.01(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 interested in the subject of the business judgment; (2) is informed with respect to the subject of the business judgment to the extent that the director or officer reasonably believes is appropriate under the circumstances; 43

(3) rationally believes that the business judgment is in the best interests of the corporation.
Kamin v. American Express (NY 1976) DOES NOT REFLECT VIEW OF DEL SC When DLJ stock dropped from $29.9 million to $4 million, Amex spins off the stock as a special dividend to all shareholders instead of taking a tax loss and selling the shares. Shareholders sue to enjoin distribution b/c of waste Amex could have offset capital gains and saved $8 million

No liability b/c no evidence of fraud, self dealing, illegal or unconscientious behaviour no bad faith or oppressive conduct (Court wont intervene) Directors had informed themselves sufficiently for acting as they did (accounting purposes, protecting companys image), this was not an arbitrary decision, and Court looks no further. Does not need to determine whether it was the best possible decision, let alone if it was a reasonable decision. Mere errors in judgment are not sufficient. Smith v. Van Gorkum (1985) Van Gorkum with little outside advice and little advice from senior staff decided to effectuate a merger agreement with a corporation owned by Pritzker. Pritzker offered Van Gorkum the share price he asked for. At a quickly called board meeting, the board approved the deal and certain deal protection features in two hour meeting. A TransUnion shareholder sued, alleging that the TransUnion Board had breached their duty of care in approving the Pritzker offer. He alleged that although the price represented a large premium over the market price, the board had not acted in an informed matter and considered the deal insufficiently esp. seeing as it was a merger. Directors breach their duty of care if they have been grossly negligent in making their decision and therefore cannot claim the protection of the business judgment rule This was a shocking result, possibly explanable on the basis that the transaction concerned a merger.

The Delaware legislature reacted by adopting DGCL 102(b)(7)

Ad(4) Waiver of Liability - DGCL 102(b)(7)

DGCL 102(b)(7) [The charter may include] a provision eliminating or limiting the personal liability of a director for monetary damages for breach of a fiduciary duty as a director, providing that such provision shall not eliminate or limit the liability of a director for (i) any breach of the directors duty of loyalty, (ii) for acts and omissions not in good faith or which involve intentional misconduct or a knowing violation of the law.

90% of DE companies in their charter eliminate D&O liability for duty of care violations (self insurance for gross negligence) through waiver of liability as permitted by DGCL 102(b)(7) McMillan v. Intercargo o Shareholders can still file for equitable relief, just no money damages for breach of duty Shareholders have no incentive to bring suit, but they still do under duty of loyalty principles. If corporations charter immunizes directors for duty of care liability, s must show duty of loyalty to prevail (MacMillan) o 102(b)(7) enacted after Smith v. Van Gorkom when whole Board of TransUnion was found liable for breach of duty even though they clearly acted in good faith (but poorly informed themselves) o Del. SC wishes its courts would take a harder view on directors negligence. Del Ch. Ct. is more willing to accept good faith.
MacMillan v. Intercargo Corp (2000) Directors sued for not having an auction for the best price when selling the company (Revlon duty) and directors failed to make adequate disclosure. They sold for $12 a share, even though the acquirer had offered $14 a share 6 months before the deal was announced. P alleges that CEO suppored the subpar deal because he was promised future employment.

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Charter immunizes directors under 102(b)(7) so no liability unless violation of duty of loyalty breach of duty of loyalty. The court was unwilling to examine whether either the process or the outcome was one that a reasonable director would engage in.

o Since there was no evidence of disloyalty, or intentional, bad faith, or self-interested conduct, no liability for
o

B. Matter of proof Duty of care and Technicolor A breach of either the duty of care or the duty of loyalty rebuts the presumption of the business judgment rule. Directors must then prove that the transaction was entirely fair. Technicolor rules (1) If P can establish breach of duty of care, need not establish causation and injury (2) If P can show gross negligence of board with respect to the process, burden of proof is placed upon directors to show entire fairness of the transaction (fair price AND fair process) (3) BUT: gross negligence doesnt necessarily mean that the substance was unfair you can have gross negligence and still the transaction can be entirely fair.
Cede v. Technicolor (DE SC) (1993)) Technicolor CEO negotiates with Perelman to sell Technicolor at a 100% premium. Disinterested board is casual in approving transaction gets no credible valuation, company isnt shopped to other buyers. Trial court found sale price was better than fair price: No damages no liability. o Applied Entire Fairness doctrine and burden on Board to prove fair price and fair transaction o The lack of harm to SH from the sale price does NOT insulate the directors o Ultimately, on remand, the transaction was found to have been entirely fair

Damages claims What type of damages? Recissory damages: cannot rescind transaction; so damages as if transaction could be rescinded as of the moment of judgment (in tort, damages look at time when deal was closed). ! Implication of Cede II for DGCL 102(b)(7) Can the court dismiss a case if it is obvious that the P will not be able to claim damages? most cases do not ever end up in court for decision on merits however, the question of whether a case is dismissed at the outset or permitted to proceed on determination of merits is important for questions of reaching a settlement and THUS whether a lawyer is paid his contingency fees. If a case is dismissed at the outset the defendant will not need to settled, if permitted to go through, settlement will end up being cheaper than hearing. McMillian v. Intercargo: no monetary liability possible under DGCL 102(b)(7) so dismissed at outset Emerald Partners v. Berlin (2001): notwithstanding DGCL 102(b)(7) , if a P can show gross negligence, board must show entire fairness. if the transaction is deemed entirely fair: 45

DGCL 102(b)(7) will have it dismissed if not entirely fair: business judgment rule does not apply and neither does DGCL 102(b)(7) BOARDS DUTY TO MONITOR Passive directors The business judgment rule protects boards that have made a decision
Francis v. United Jersey Bank (NJ 1981) Pritchard and Baird is a reinsurance firm. Charles Sr. starts co-mingling accounts & making shareholder loans that he pays back. His sons then run the business & continue this practice but dont pay the money back. Their mom is old, sick, alcoholic, uninformed and does nothing to prevent it. o Ms. Pritchard is liable for breach of duty of care b/c she failed to monitor the company or prevent sons theft o She violated duty of care by not knowing how corporation was being run, not attending meetings, not reading the books o Case differs from Barnes b/c she could have stopped an illegal loan, objected to the behavior, resigned, and threatened suit o By going after her estate, which presumably benefited from the stolen money, trustee wants to prevent sons from benefiting from their own wrongdoing

Boards are liable not only for the decisions they make but also for their failure to monitor (United Jersey Bank) Monitoring Duty: Director should look at the books and be aware of what is going on Response Duty Director may have an obligation to stop certain behavior, resign, and hire a lawyer to threaten suit (whistle blowing duty?) o Once a board or director is put on notice, s/he must take sufficient action to stop the conduct or be found equally liable. o By requiring her to threaten suit or take sufficient action, causation is satisfied b/c she would have been able to stop it o Case is extreme; rare that corporate law requires one to do more than protest or resign BUT Barnes v. Andrews: No liability for failing to stop general mismanagement, which is hard to do o No proof that one director, by being there, could have made a difference (no causation) o Even if he had paid attention he could not have prevented the loss, so no causation
Hoye v. Meek Semi-retired chairman of OK trust company delegates day-to-day operation to son and does not attend board meetings, did not preside over those he attended and was frequently out of state. Son makes big interest rate bets, interest rates go down, and negative exposure puts company in bankruptcy o Dad is liable for failure to avert the loss by not wielding control

Red Flag Rule: No duty to monitor for violations if nothing puts you on alert (Allis-Chalmers) Under ALI 4.01(a)(2), where known violation is more recent, board should consider itself warned So far there is no violation for having an incentive structure that almost encourages violation like in Allis-Chalmers
Graham v. Allis-Chalmers Mfg (1963) Allis-Chalmers agreed to stop price-fixing in 1937, but pleaded guilty to price-fixing charges in 1950s by mid-level

46

managers. Shareholder sues to recover money for the corporation. Defendant directors had no knowledge of the antitrust violations (several levels down in the organization) and the organization of the corporation was enormous, fragmented (decentralised structure) and complicated. o Since there was no reason to suspect anything, the directors did not breach any duty; they acted like ordinary prudent person o No obligation to monitor for violations if nothing puts you on alert red flag rule; may rely on honesty and integrity of subordinates until something puts them on suspicion o Would probably be decided differently today. Beam v. Martha Stewart (2003) Shareholder of Martha Stewart Living sues directors for not picking up on Martha Stewarts illegal insider trades. MS given a tip by broker and offloads shares, sent to jail. These events cause Martha Stewart Living to lose money.

Martha Stewarts dealings were personal trading activity. Although the blemish to her reputation may have hurt Martha Stewart Living and SHs of that company, it was not for the board of MSL to monitor Martha Stewarts personal trading activity in other corporations. In re Caremark International Inc Derivative Litigation (Del. Ch. 1996) - Accepted by SC It is unlawful to give Drs kickbacks for sending patients if Medicare is paying. Caremark has a compliance program, monitoring procedure, updated guide for what is appropriate, internal audit plan to insure compliance and ethics hotline. BUT, low-lever officers engaged in kickbacks A company can only escape liability for failure to monitor where it has adequate informational and reporting systems in place to prevent such conduct. The level of detail that is appropriate for such an information system is a matter of business judgment.

No liability here b/c company acted sufficiently to assure good faith by having a working monitoring system in place.

Organisational sentencing guidelines: offer powerful incentives for firms to put compliance programmes in place, to report violations of law promptly and to make voluntary remediation efforts. Boards have some minimal obligation to assure compliance w/ an adequate and effective reporting and accounting system Federal Organization Guidelines fines for violation are extraordinarily high o Having a compliance program making it more difficult for low-level managers to misbehave greatly reduces your fine under Guidelines (now it is in companys interest to have the compliance program) and prevents liability for lack of monitoring (Caremark) KNOWING VIOLATIONS OF LAW What if committing fraud or antitrust violation is in SH interests derivative suit possible or is this a defence for board No shareholder suits are to ensure director lawfulness (directors arent held personally liable in antitrust suits) o Risk of individual liability gives directors an added incentive to do the right thing Yes this should be treated like any other investment gone bad (they got caught) and evaluated under BJ rule
Miller v. AT&T Alleges AT&T knowingly refused to collect on loan to DNC, which would violate campaign contribution laws o Would have been business judgment rule if it had been any other debtor, but here there has been a violation of federal law on illegal campaign contributions.

47

o o o

There is a knowing violation of the law, so there can be a derivative suit Otherwise, judges would have to admit that violating the law might be in the best interest of the business and shareholders But why should this be the case, arent there criminal and administrative sanctiosn to apply to this conduct?

p. 284 Hypothetical Directors personally liable for use of low grade fuel Fine dwarfed by costs saved and profits made for using LGF

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DUTY OF LOYALTY: CONFLICT OF INTERESTS

Applies whenever a director, officer or controlling SH engage in a conflicted transaction: more stringent controls than duty of care. Definition: requires director, officer or controlling SH to exercise institutional power over corporate processes or property in a good faith effort to advance the interests of the company. Such a person who transacts with the corporation must (1) fully disclose all material facts to the corporations disinterested representatives and (2) deal with the corporation on terms which are intrinsically fair. A.

DUTY TO WHOM? In US, SHs are the most important (SH primacy), but other constituencies are important too o Dodge v. Ford Motor Co is the only case that says corporation has primary duty to shareholders. Dodge bros., 10% SH in Ford, sued Ford to force its board to declare a dividend. Fords controlling SH explained his decision to eliminate special dividends on the grounds that Ford had an obligation to share its success with the public through lower prices. Court affirmed that Fords directors had wrongfully subordinated SH interests to those of consumers. o Today courts finesse the issue about SH primacy by couching it in terms of a duty to promote long-term growth, immunizing it from such a SH attack.
A.P. Smith v. Barlow (1953) Shareholder challenges corporations modest donation to Princeton University because they did it before the 1950 statute was passed to allow charitable contributions up to 1% of the total capital unless authorized. How can directors ever justify giving away the corporations profits to worthy causes if their principle duty is owed to shareholders? o Making charitable contributions instead of issuing dividends to shareholders is fine b/c it promotes long-term growth, the survival of the corporation in a free enterprise system and advances the interests of the corporation as part of the community in which it operates. o Corporations may serve public as well as private interests, in this case promoting a sound economic and social environment which rests upon free and vigorous nongovernmental institutions of learning.

Shareholder Constituency Statutes Shareholders interests sometimes conflict with the interests of creditors and other constituencies (ex: LBOs) Directors have a duty of loyalty to other constituencies (creditors, SH, managers, EEs, suppliers) o States enacted statutes that provided that directors have the power (but not obligation) to balance the interests of non-shareholder constituencies against the interests of shareholders o DE does NOT have one Allowed managers to protest LBOs even though the company was giving SH large premia in exchange for takeover B. SELF-DEALING TRANSACTIONS Requirements, in dealing with Directors or controlling SH (4) Interested party is required to disclose all material 49

information relevant to the transaction.

(5)

Interested party must show that the transaction was fair (not always a requirement for directors, see statute)

Ad (1) General Disclosure Rule in WA: In duty of loyalty cases, nondisclosure is almost per se unfair (Hayes Oyster) Same rule in ALI 4.02 and RMBCA 80 Also SEC proxy materials establish requirement for related party transactions triggering disclosure requirements However, transaction may also need to be fair (ALI), or fairness may dispense with requirement of disclosure (DGCL)
Hayes Oyster Co v. Keypoint Oyster Co (Wash 1964) Coast Oyster, of which Hayes is 23% director and shareholder, has cash flow problems and Verne convinces them to sell 2 oyster beds. Verne suggests to Engman, Coast EE that they form Key Point to buy the beds, and Hayes has a 50% interest in it. Suit to return secret profits o Verne violated duty of loyalty by failing to disclose his role in Key Point; must disgorge secret profits and give them to Coast o Even though the board did not wish to void the transaction (it was fair), non-disclosure is per se unfair o Actual injury or intent to defraud is unnecessary in such cases.

Ad (2) Controlling Shareholders Obligations Controlling shareholders owe fiduciary obligations to the company, b/c of their power over composition of the board If minority shareholders are gaining pro rata benefit, BJ rule may apply (Sinclair), but maybe not (McMullin)
Sinclair Oil Co v. Levien Sinclair Oil owns 97% of Sinvens stock and dominates its board. Sinven minority SHs bring suit against Sinclair for paying excessive dividends that prevented industrial development, treating Sinven as a wasting asset, and essentially liquidating the company. o No self-dealing b/c identital pro-rata treatment of shareholders. o Business Judgment rule applied b/c both minority & majority SH received dividends at the same time in the same proportion o As long as minority shareholders arent excluded from some benefit to their detriment, they cant force an intrinsic fairness review of controlling shareholders decision (minority SH are getting their fair share) SH filed suit b/c they felt they were losing out on corporate opportunity, but minority SH dont have a claim on this McMullin v. Beran (Del SC 2000) Arco owns 80% of Chemical and negotiates to sell the whole company for $57.75/share (for majority and minority SHs). Minority shareholders sue alleging directors violated fiduciary duty by failing to conduct their own investigation, bargaining o Complaint is that board just goes along with the controlling SH commands; SH provided all inof and investigation on the deal. o Different from Sinven because of severity of transaction; dividend payout vs. sale of the company o SC applies Entire Fairness and holds with s o Even though board had to sell to Arcos buyer, they could have chosen not to sell it at all, especially if worth more as a going concern than the price they were getting o Kraakman: Minority shareholders are lucky Arco isnt taking a control premium and is paying them pro rata

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C. DISINTERESTED PARTY

EFFECT OF APPROVAL BY

Effect of Approval by a Disinterested Party Competing Approaches (Burden of proof) Neither board nor shareholders approve Disinterested directors authorize (ex-ante authorization) Disinterested directors ratify (ex-post ratification) Shareholders ratify RMBCA 8.61/DGCL 144 Entire fairness (D), but see Siliconix BJR (P): Cooke v. Oolie, RMBCA 8.61(b)(1) and Comment 2 BJR (P): 8.62(a) and Comment 1 Waste standard (P) shareholders can ratify anything short of waste ALI Principles of Corporate Governance Entire fairness (D) Reasonable belief in fairness (P): ALI 5.02(a)(2)(b) Entire Fairness (D): ALI 5.02(c), 5.02(a)(2)(A), 5.02(b) Waste standard (P) shareholders can ratify anything short of waste

Disinterested Approval by the BOARD 1. Safe Harbor Statutes, Common law allows disinterested approval (by disinterested directors) as a substitute for fairness review (or as evidence of fairness Cookies) o Either the transaction gets a hard look by court, or gets a hard look by the board and can avoid court review DE 144 is weak: Disinterested Board Approval wont get BJ review in every case (though most of the time) o DE 144 does not exclude Fairness Judicial Review RMBA 8.61 is strong: Disinterested review by board is a complete bar to entire fairness doctrine (only BJ review) ALI shifts the burden: While D will normally share the burden of defending the action, disinterested board approval shifts the burden to the P to show the transaction is unfair o Also applies a weaker fairness review: Rational Belief in Fairness: Could you have had a rational belief as a board member that this transaction was fair when you approved it o Also, Burden shifts back (subject to Entire Fairness doctrine) if disclosure comes after K is signed Because boards have a greater incentive to go along with the deal once K is signed Preserve reputation, not show the world there is inner turmoil in the company DE will always apply Entire Fairness when theres a conflict involving a controlling SH
Cookies Food Products v. Lakes Warehouse (1988) Cookies food products enters into distributorship w/ minority shareholder Herig. Distributorship so successful that Herrig bought out Cook and owns 53%. Herig takes control of the board and enters into several self-dealing contracts w/ Cookies, all of which are successful. Minority SH challenges that the self-dealing contracts grossly exceeded the

51

value of the services rendered and that Herig didnt disclose his own benefit (SHs angry because Cookies doesnt pay out dividends regularly/ Cookies would have violated loan with SBA if it had done so). o Entire Fairness: No breach of fiduciary duty by Herig b/c all contracts were approved by disinterested majority of the board o Not that board approval insulates transaction from fairness review; rather, disinterested board approval is evidence of fairness o Herigs services werent provided at market price, but hes getting underpaid for all that he does in various capacities o KRAAKMAN: Court says it uses Entire Fairness but seems to use BJ review Entire fairness would have looked at the price and asked for the services and compared it to FMV of services

2. Approval By Disinterested Directors DE Chancery Court will apply BJR to an interested transaction btw a company and a director (where no controlling SH is involved) as long as the remaining disinterested directors who approve the transaction cannot be shown to be misinformed, dominated or manipulated. Neither DE SC or DE Ch. Ct. say theyll never look into fairness of a transaction thats been authorized or ratified Del Ch. Ct is more likely to use BJ review than SC (who will resort to entire fairness), b/c Ch. Ct is the one that has to do the difficult valuation If only 1-2 directors are disinterested, the Board may appoint other disinterested directors to help make this decision Must be only financially disinterested; friendship is irrelevant
Cooke v. Oolie (2000) Nostalgia has 4 directors that vote unanimously to pursue USA acquisition proposal. Minority SHs claim Oolie and Salkind (directors) breached duty by choosing the proposal that best protects their personal interests as Nostalgia creditors rather than those that offered better deal to SHs o Not a transaction but a decision, but DE SC still applies 144 o Business Judgment rule applies if the interested director has fully disclosed his interest b/c the disinterested directors agreed (Directors vote is evidence of fairness)

DE uses Entire Fairness when theres a controlling shareholder involved, as in a parent-freeze-out o Both Del Ch. Ct. and SC say theres a distinction b/w controlling shareholders and interested directors Entire fairness doctrine will always be used when the controlling shareholder is the interested one o Though burden may shift to s if theres approval 3. Approval by Special Committee of Independent Directors Standard template for transactions b/w subsidiary and parent, which involve the greatest risk of overreaching o Parent corporations have obligation to treat subsidiaries fairly; judicial review is prevalent In DE law, Special Committee must be properly charged by the full board, comprised of independent members, and vested w/ resources to accomplish its task Committee often retains I-bankers and lawyers to advise it Hiring an independent committee to review the transaction wont disable entire fairness review (b/c no board approval) but will bolster s claim Independent committees are usually used w/ a Parent-Subsidiary squeeze-out transaction 52

4.

Shareholder Ratification of Conflict Transactions Interested transactions with directors, approval by disinterested SH, invokes BJR Interested transactions with controlling H, approval by majority of minority SHs, invokes entire fairness rule, burden of proof shifts to P.

Lewis v. Vogelstein (Del. Ch. 1997) Deals with compensation of directors w/ stock options. Self-dealing transaction from boards perspective, but SH authorize it and it is attacked as wasteful by minority shareholders o Corporate waste doctrine means plaintiffs can win even when there is a disinterested shareholder ratification o A 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. In re Wheelabrator Technologies (Del. Ch. 1995) Wheelabrator was bought by Waste Management in merger transaction. o In DE, everything can be ratified by disinterested shareholder vote except a wasteful decision o The transactions arent voidable; rather, subject to BJ review and burden shifts to Plaintiff to prove waste

D. DIRECTOR AND MANAGEMENT COMPENSATION DE law says compensation is a core matter of BJ for the Board o As long as decision is approved by disinterested directors, DE wont review compensation for fairness, BJR Problem: In US with diffuse ownership of corporations, compensation is exceptionally high for CEOs o Maybe incentive is necessary b/c no controlling shareholder is checking their work Option Grants Dramatic shift toward equity-based pay (stock options) for CEOs o Make compensation dependent on companys performance as an inventive o Make the salary numbers not so outrageous b/c primary compensation is in options Usually one cannot exercise options all at once; some proportion each year for a set # of years Most people buy the options and sell immediately to diversify their investment
Lewis v. Vogelstein (Del. Ch. 1997) One-time grant of $85,000 in options, which were already accepted as appropriate compensation method. Is one-time payment sufficient? o This case can go to trial o Validating an officer or director stock option grant requires finding that a reasonable board could conclude from the circumstances that the corporation may reasonably expect to receive a proportional benefit In re Walt Disney Derivative Litigation (2003) CEO Eisner picks old friend Orvitz as Disneys president.Things dont work out. Contract has no-fault termination provision, unless gross misconduct. O leaves with bulk of his options. Ch. Refuses to dismiss derivative suit. Rules that both old and new board may have acted in bad faith in approving termination award knowing indifference to the companys interests (old board rubber stamped Eisners decision). Because of bad faith, conduct could not fall under DGCL 102(b)(7) bad faith must be worse than gross negligence (standard which gave rise to provision via Smith v. Van Gorkum. Three tiers of board inattention: - negligence - gross negligence - bad faith (intentional disregard of duty)

53

In re Walt Disney Derivative Litigation (2005) No bad faith found, at most gross negligence, but that is covered by DGCL 102(b)(7). Change in approach because 2003 was at the height of the Enron scandal, whereas 2005 gave court chance to return to balanced approach. The case is different from Smith v. Van Gorkum: latter case deal with sale of the company, this deals only with compensation (not a huge effect on business).

Interested Loans Board may authorize interested loans when the loan or guarantee benefits the corporation -DGCL 143 402 of Sarbanes-Oxley prohibits any corporation with publicly-traded shares (or a subsidiary) from directly or indirectly extending credit to any director or officer of the corporation o People were getting huge loans from companies that were forgiven by the board Corporate Governance and SEC Regulatory Responses Relatively legal control over executive compensation SEC amended disclosure rules requiring corporations to make more detailed public disclosures about the compensation of their top 5 corporate officers E. CORPORATE OPPORTUNITY DOCTRINE A fiduciary cannot take a business opportunity that belongs to the corporation (and should have profited shareholders) Expectancy or Interest Test: Does the company have an existing interest or expectancy in the opportunities? (Lagarde v. Anniston Lime & Stone) o Narrowest test Line of Business Test: Any opportunity in the companys line of business is a corporate opportunity. (Guft v. Loft): o How did this matter come to the attention of the director, officer or employee? o How far removed from the corfe economic activities of the corporation the opportunity lies? o Whether corporate information is used in recognizing or exploting the opportunity Fairness test: (most diffuse): o How did the manager learn of the disputed opportunity o Did he use corporate assets in exploiting the opportunity o Other fact-specific indicata of good faith and loyalty to the corporation. ALI 5.05: Narrow conception of corporate opportunity o Directors: Opportunities offered to the company, discovered through information provided by the company, in which the company has an interest or expectancy Narrower definition of corporate opportunity b/c director may have another fulltime job Need to keep people sitting on company boards, so recognize their split loyalty o Managers: Expansive Line of business test Broader b/c corporate officer, who spends all his time w/ corporation and loyalty is greater Two Steps Was it a corporate opportunity? 54

o Tests satisfied from above? o Opportunity presented to director in his individual rather than corporate capacity? (Broz) If so, was there some reason why the corporation couldnt take the opportunity such that it could go to the fiduciary? o Corporations board decided not to accept the opportunity, or (if not presented to the board) o Corporation lacked financial ability to take advantage of it.
Broz v. Cellular Information Systems (Del. 1996) Broz didnt formally present to CIS an opportunity, which came to him from his sitting as president of a competing cellular company. Opportunity wasnt offered to CIS b/c of its financial troubles, and CIS had no interest in taking the opportunity. Broz checked with several of CIS board members individually who said CIS wasnt interested and then he purchased the opportunity. Broz outbid PriCellular for the opportunity, and PriCellular bought CIS 9 days later. o There was no corporate opportunity in this deal, so Broz failure to formally present it to the board was okay o Informal consultation is NOT formal notification, but it does show Broz was acting in good faith o Court employs a narrow view of corporate opportunity (Guth v. Loft): (1) if the corporation is financially able to exploit the opportunity; (2) the opportunity is w/i corporations line of business (3) corporation has an interest of expectancy in the opportunity, and (4) by taking the opportunity as his own, the corporate fiduciary will be placed in a position inimicable to his duties to the corporation. A director may take an opportunity: (1) if it is presented to him in his individual and not corporate capacity (2) if it is not essential to the corporation (3) the corp holds not interest or expectancy in the opportunity, and (4) the director has not wrongfully employed the resources of the corp in pursuing the opportunity. Telxon Corporation v. Myerson (2002): an opportunity presented solely to the CEO and rejected by him does not fall w/i the safe harbour of consideration by the entire BoD.

F. DUTY OF LOYALTY IN CLOSE CORPORATIONS Courts are more aggressive in enforcing the duty of loyalty in small corporations than in large corporations o Investors are more vulnerable b/c there is no ready market for corporate stock not liquid investment o Minority shareholders must take whatever the board gives them, yet majority shareholders can extract cash from the corporation easily o Minority SH, unlike partners, have no power to dissolve the corporation Ways for Controlling SH to Get Corporate Cash Out of Corporation Issue dividends Pay salaries Have interested transactions w/ the company (sell it services or goods) Have share repurchases (company can buy back some stock) o While shareholders of the same class participate pro rata in corporate dividends, shareholders do NOT necessarily participate pro rata in opportunity to sell back shares These tactics are controlled by BJR and cannot be easily challenged by minority SH 55

Close Corporation: Small # of stockholders, no ready market for corporate stock, substantial majority shareholder participation in the management, direction, and operations of corporation (Rodd) Shareholders in close corporations owe one another the duty of utmost good faith and loyalty (UGFAL) o Similar to duty of good faith required between partners in a partnership: the punctillio of an honor the most sensitive is the standard of behaviour. o Cannot act out of avarice, expediency, or self-interest or derogation of duty of loyalty o UGFAL requires corporation to offer an equal opportunity to other SH to sell a ratable number of shares to corporation at the same price DE has REJECTED UGFAL (Nixon)
Donahue v. Rodd Electrotype Co (Mass 1975) DELAWARE HAS REJECTED THIS OPINION (Nixon) Donahue was minority shareholder; Rodds own 80%. Board had company buy back 45 shares of majority stockholder but didnt offer the same deal to Donahues widow. The share price was fair. Company had previously offered to buy Donahues shares for 1/2 that price. o Shareholders in close corporations owe one another the duty of utmost good faith and loyalty (UGFAL) o UGFAL requires equal opportunity to sell of ratable # of shares to corporation at same price o Donahue is at the mercy of the majority has no way to get $ out of the company b/c theres no ready market for shares

Minority and Majority Shareholders are Still Unequal, Though Controlling shareholder can still liquidate the company at any time; minority lacks this power Controlling SH can still negotiate retirement settlement (instead of selling back shares), raise salaries, hire friends (these decision are controlled by BJR) Easterbrook: Case was wrongly decided o Because fiduciary obligations fill gaps to address the issues the parties didnt address o Equal opportunity is NOT what the parties would have agreed to had they thought about it UGFAL modified in Smith, fn 5 QUGFAL (qualified) Revised standard: Controlling shareholder must pick the route least harmful to minority shareholders Majority SHs selfish ownership of corp should be balanced against his fiduciary obligation to the corp o If majority SHs sometimes dont have corps interests at heart, then minority SH wont sometimes either they have less of a stake We draw the line of selfish ownership at the point where the company is injured apart from the personal wealth of the shareholders (e.g., by IRS penalty)
Smith v. Atlantic Properties (Mass App. 1981) Wolfson purchased land with 3 others (close corp) and each transaction required 80% approval (everyone had veto power). Wolfson vetoed dividends even though it incurred IRS penalties to avoid paying taxes (he was in higher bracket). o Wolfson breached fiduciary duties and is liable for the penalty taxes o Wolfsons refusal to vote for dividends was caused more by dislike for other SH and desire to avoid tax payments than a genuine desire to improve holdings and make repairs

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SHAREHOLDER SUITS

A. SUITS 1. Direct Actions Individual Actions and Class Actions Applies when SH are thought to be injured in their own right qua shareholders, as when corp is sold for too little Not subject to demand requirement (fewer hoops to jump through) Recovery goes to SH 2. Derivative Actions: Actions brought by a SH but in the name of company, against officers and directors Breach of directors fiduciary duty (care loyalty) is usually a derivative suit: directors are being sued for improperly failing to sue on the existing corporations claim. Applies when SH are injured as investors in a corporation that is itself injured Subject to the Demand Requirement (Rule 23.1 Federal Rules of Civil Procedure) Recoveries go to the corporation Suits brought by platintiffs bar Often the claim can be manipulated to find a cause of action in both areas B. ATTORNEYS FEES Both suits may get attorney fees awarded, which is why they are brought If percentage of the recovery, no relationship b/w attorneys fee and the cost of bringing suit Plaintiffs lawyers arent paid for loss Majority rule: Attorney fees are paid whenever there are substantial benefits conferred on the corporation o If conferring substantial benefits, SHs shouldnt mind paying Alternative: Include costs of litigation as part of the settlement o Attorney fees avoided isnt the kind of benefit for which you want to compensate s for saving corporation Ex post: it is a benefit Ex ante: The suit probably wouldnt have been brought if there were no fees altogether, so doesnt seem like a benefit to save fees It is bizarre to give attorney fees when the only colorable benefit to the corporation is the avoidance of attorney fees
Fletcher v. A.J. Industries (1968) Suit b/c of excessive salary to Malone and domination by Ver Halen. Settlement reduced Vers influence, removed Malone as director and treasurer, and referred all monetary claims to arbitration. The attorneys could get fees only if corp received monetary award in arbitration. o Majority Rule: Attorney fees are paid whenever there are substantial benefits conferred on the corporation (whether or not those benefits are monetary) o Court seems to have thought that attorneys fees avoided was an actual substantial benefit the corporation received

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Dissent: Hard to value substantial benefits when they are not monetary, and liquidity problem to pay the fees

C. STANDING REQUIREMENTS Plaintiff must be at least a beneficial SH at the time the suit is brought Plaintiff must be representative of the class Plaintiff must have contemporaneous ownership (a SH when the alleged wrongdoing occurred) o Ensures that you dont wait for something to happen and then go out and buy a share For closely held corps, this can be an importnat restraint not always easy to find someone to bring suit Kraakman: why not let someone buy into a lawsuit to make sure that directors and officers obey their duties? If thats the goal, then let someone do it on behalf of the corporation.
D.

DEMAND REQUIREMENT

DERIVATIVE SUITS Arose from common law rule that SH was first required to ask the director to take action before bringing suit o Board ought to have ultimate control over companys assets including law suits and whether to bring them o As derivative suit is brought in the name of the company, it is an asset

Usually the directors refuse the the ability to bring suit If makes demand and demand is refused, evaluate it under relaxed BJR rule (Levine, Speigel) Demand Futility: SH was not under obligation to make a demand on the board b/c the board was presumptively biased from the outset 1. Aronson Demand Futility Test: Court must decide that directors are either: (a) Interested and dominated & (current standard is OR see Levine) Directors might not be disinterested if they were appointed by controlling SH (b) The challenged action was not the product of a valid exercise of business judgment Prong addresses the merits of the case by getting at egregious misconduct: relaxed BJR do the facts create a reasonable doubt of the soundness of the challenged transaction Dont apply 2nd prong if boards are different (theres a new board - unless theyre substantially the same Rales) This prong is an evidentiary route to the 1st prong (use circumstantial evidence to get bias) Rales: just another way of getting at the 1st prongs inquiry Basically: Board may be extremely biased, but SH cant bring suit alleging demand was futile unless it wasnt a valid exercise of business judgment (someone must be harmed) Kraakman says (a) should be sufficient

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2.

Levine Test: Same test but disjunctive; can meet either prong to say

demand is futile If same board participates in both the demand inquiry and the wrongdoing, it is presumed biased In DE, if you make demand, you waive your right to challenge disinterestedness of the board (Grobo) Implication: No one will ever make demand on a board in DE Strange, b/c purpose of demand was to give board control; now they wont even know Chancery Court, not the board, will be the one deciding if suits go forward

ALI and RMBCA have a universal demand requirement (1) ALI Must make demand unless irreparable injury (7.03) If demand is refused and SH continues, court will review board motions to dismiss derivative suits using a graduated standard: BJR for alleged duty of care violations (7.10(a) (1)) and reasonable belief in fairness (fairness-lite) for alleged duty of loyalty violations (7.10(a)(2) except no dismissal if alleges undisclosed self-dealing (7.10(b)) (2) RMBCA Must make demand unless irreparable injury (7.42). If demand is refused, shareholder may continue by alleging w/ particularity that board isnt disinterested (7.44(d)) or did not act in good faith (7.44(a))
Smith v. Levine (Del 1991) Perot became GMs largest shareholder. He complained to the board about practices and took complaints public. GM bought him out at $742 million and board approved. Challenged by shareholders. Uses a DISJUNCTIVE (alternative requirements) version of Aronson test to say demand should have been made Evidence: affidavits from 2 directors that they were interested and not fully informed when they voted (only 2 of 14) were insufficient to show interestness: Could not show the buyback was the product of a valid exercise of BJ Rales v. Blasband (Del 1993) Rales do public debt offering for Easco of $100M in notes but they invest in Drexel junk bonds (now known to be bad). Rales brothers are friends with Milken and are returning Drexels past favors. SH bring suit for duty of loyalty. Rales merge Easco into Danaher so SH/ is no longer a SH of Easco. Rales brothers own 44% of Dunaher, but the now just sit on the board w/ 6 others. 2nd prong doesnt apply where the board isnt the board as when transaction occurred (Veasey CJ) Justifies 2nd prong as an indirect way to get at director bias theres really only one prong Demand is Futile here This is like a double derivative suit: is suing the parent to force the board of the subsidiary company to bring suit o The injury complained of was an injury against the company that became the subsidiary company Demand is futile even though board is different b/c there was enough of a link b/w the two boards o Court applies the 2nd prong anyway b/c the boards are so similar o Rales are sufficiently interested b/c litigation has progressed, and thus their coboard members are interested so under 1st prong demand is futile

59

This is like a 2nd prong analysis b/c it doesnt use direct evidence but rather evidence from underlying transaction to find bias

E.

SPECIAL LITIGATION COMMITTEES If court finds demand was futile, board may appoint Special Litigation Committee to again suggest the suit be dismissed
(1)

Two tests are followed: (1) DE and (2) NY Zapata Test for reviewing SLC decision 1st: Is SLC unbiased and adequately informed? 2nd: In Courts business judgment, should the action go forward or not o Look at interest of the corporation and public policy Idea that judges have special expertise about continuing litigation, unlike other things covered under BJ rule o Deciding whether to exercise its own BJ is optional for DE Chancery Court Kaplan v. Wyatt o It is mandatory in 2nd Cir (but more objective) Jay v. North see below o Tougher standard at SLC stage b/c this is boards 2nd bite of the apple Test is NOT as tough under ALI or RMBCA
Zapata Corp v. Maldonado (1981) Plaintiff files derivative suit in DE, demand is excused, board appoints 2 directors to be SLC, and they recommend dismissing the suit (i) Shareholders have an independent right to continue a derivative suit for breaches of fiduciary duty even if corp doesnt want to (ii) This is as pro-shareholder as DE SC ever is (iii) See test written above Jay v. North (2nd Cir.) (1982) (iv) Second step of Zapata is mandatory (v) More objective standard: Judge should look at NPV of litigation (cost of litigation, atty fees, impact of distraction of key personnel by continued litigation, potential lost profits from bad publicity) Carlton Investments v. TLC Beatrice International Holdings (Del. Ch. 1997) SH litigation in which SLC decided the suit SHOULD go forward; SLC takes over litigation and settles the case Oracle (Del 2003) Board consists of Stanford alum and Stanford professor. SLC appointed with Stanford proffers. Provides 1,000 page document stating that board should not go forward with suit. Ties substanial that reasonably cast doubt upon whether directors should face suit or not.

Kraakmans Reform Before attorney gets fees, must show either some penalty imposed on s (not necessarily monetary) OR that there was monetary recovery to the corporation in excess of litigation costs not funded by D&O insurance 1. Money from D&O insurance shouldnt be viewed as a benefit to corporation b/c it just comes from the insurance premia paid by the 60

corporation (ii) Otherwise, company didnt get anything and s attorney shouldnt get a fee Are SH suits useful? They may not have any deterrence benefits (b/c D&O premia are already paid) Reform Act 1995 lets big shareholders take over securities suits form small s and s bar (i) If they have big $ in the game, theyll take the suit more seriously and do right by the corporation

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TRANSACTIONS IN CONTROL
A. SALE OF CONTROL BLOCKS Sale happens outside the company, but law recognizes that these transactions have implications for investors in the corporation (especially minority shareholders) Control: Whatever it takes to dominate decision-making in the corporation (can be less than 51% is widely held corps) Two methods of acquiring control: (1) purchasing controlling block from already controlling SH, or (2) purchasing numerous minority SH blocks to obtain a controlling block. Controlling blocks sell at premium price: why? Private benefits of control: power to capture salary, perks, self-dealing opportunities, prestige value of being the boss. Premium represents the difference between the sale price and the market price for the shares. Minority SH are protected through (a)minimum tender offer requirements and (b) mandatory cash out rights. Freeze-Out and Freeze-In Transactions Freeze-Out Transaction: Majority SH cashes out all the minority SHs (policed by equitable rules) Freeze-In Transactions: Majority SH wants out so he can sell his control block (minorities are frozen in) ! Sale of control transactions are like freeze-in transactions (subject to much less policing) Treat freeze-ins differently from freeze-outs b/c sale of control blocks happen outside the corporation, but freeze-out utilize the machinery of the corporation

(1) REGULATING CONTROL PREMIA Common Law Market Rule: Control SHs are entitled to keep the control premium (BUT see Feldmann) Facilitate control transactions based on presumption that they increase efficient use of assets Jurisdictions outside the US have a different rule: Equal Opportunity Rule (if someone buys more than 30% of a companys share, he must offer to buy from minority SHs on same terms)
Zetlin v. Hanson Holdings (1979) Absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts of bad faith, a controlling SH can keep the control premium for him/herself Common law rejects claims for equal opportunity or equal payment for minority shareholders

BUT
Perlman v. Feldman (2nd Cir.) (1955) THE OPPOSITE RULE Steel shortage, price-freeze on steel. Feldmann (director, CEO, controller) of Newport Steel sells his stake to Wilport for a premium and lets them control board. Minority SH allege Feldmann sold a corporate opportunity (control over

62

steel supply) for personal gain, which company could have used to its economic advantage Feldmann violated his fiduciary duties to the minority SHs (must give up the control premium to SHs) The good will the company had because of the price freeze and shortage on the market fell solely to Feldman in the form of a premium paid by Wilport to obtain control of the corporation. Minority SH had derived no benefit from that good will (this case does have unique facts though). Corporate opportunity represented by the Feldmann plan, which let buyers/sellers contract around the freeze (buyer gives interest-free loan to seller in exchange for firm commitment) o Concern: Wilport would stop giving interest-free loans to Newport but would still have ready source of steel for itself o Court treats this like a direct action to give the premia to the minority SHs instead of to corporation as a whole (in which case Wilport would benefit) Court uses this to punish Wilport AND Feldmann

Problem With Market Rule When controller loots corp, he will definitely sell the company for less than it is worth because of his private benefit Would not happen under Equal Opportunity Rule b/c looter wouldnt be able to sell for less than the company is worth (i) Equal sharing rule prevents inefficient transactions but also prevents many good transactions (ii) If fiduciary law was better at curbing private benefits, then the market rule would always be the right rule QUALIFICATIONS ON MARKET RULE SELLERS DUTIES There are qualifications whenever: The corporate machinery comes into play (B) Theres a sale of corporate office (C) Theres a looter (D) B. FACILITATING SALE OF CONTROL A controller often requires corporate action of some sort to facilitate the sale of a control blokc (redeeming pills). Directors have an obligation to bargain with the controller to extract part of the the control premium for minority SH in return for giving smth up, like a waiver
In re Digex Worldcom acquires Intermedia, which controls Digex. Worldcom received a waiver of 203 to allow it to pursue a freeze-out merger w/in 3 years and Digex board grants the waiver. Failure to extract something in exchange for the waiver may hamper Boards ability to show entire fairness A board may waive 203 only for the benefit of all its SH, not just the controlling SH.

The fact that a board may exercise corporate power to facilitate a sale of control only when in the interests of the company and all its SH does not imply tha controlling SH must share her control premium with other SH to gain board assistance. The board must show that it negotiated for a substantial benefit to compensate for its selective assistance to the controlling SH. C. SALE OF CORPORATE OFFICE 63

 Not enough equity to treat these as a sale of control We treat them more strictly, b/c as the % of shares declines, more likely that were talking about private benefits as the source of gains in the transaction (i) When you control a company w/ 5% of its shares, our incentives go way down
Carter v. Muscat 9.7% Slightly above market (p. 407) Directors re-elected by SHs Upheld Brecher v. Gregg 4% 35% Buyers handpicked CEO fired by board Disgorgement of Control Premium (belonged to the corp because sale of office). Paying a premium for control when purchasing only 4% of control is contrary to public policy and illegal.

Size of Control Block Premium Recd By Seller Fate of Newcomer(s) Holding

D. LOOTING Courts can go after the controllers who sell to looters (rather than the looters) to prevent loss before it happens
Harris v. Carter (1990) Carter exchanges its 52% in Atlas for Mascolos stake in ISA. Carter directors resign and Mascolo takes over. Mascolo directors loot Atlas assets dilute minority interests by issuing Atlas stock for worthless ISA stock, buying worthless chemical company, self-dealing. Minority SHs bring suit against Carter directors b/c ISA is a bogus firm and Carter should have been alerted by suspicious financial statements from Mascolo Controlling SH has a duty of care to exercise reasonable judgment in examining the buyer, especially if theres a red flag

E.

(i)

TENDER OFFERS: BUYERS DUTIES Buyer has a duty merely not to loot the company BUT buyers duties come into play when there is no pre-existing control and acquirer makes a tender offer Tender Offer: Public offer to SHs to buy shares at a premium price (enough shares to get control) o Tender offer can be made for only 51% (other jurisdictions if tender for over 30% must buy all tendered o Consideration can be in cash or in securities (such as shares in acquirers company) o SEC rules: cannot buy first come, first served, must buy pro rata to shares tendered o Rule 14(d) must reveal plans for corporation o Can publicly say will give junk bonds to those who dont tender but fidicuary duty for CH entire fairness rule

Ways to Get Rid of Minority SH by Controller Merge them out (involves many fiduciary issues) 64

 Cash them out Make a tender offer -buy them out (lower fiduciary standard for tender offers) Checklist for tender offers Tender offer? Williams Act Hart-Scott-Rodino SH approval? Board approval Fiduciary duties Appraisal rights What is a Tender Offer? Williams Act provides no definition
Wellman v. Dickinson DE FACTO TENDER OFFERS Sun buys 34% of Becton w/ simultaneous phone calls to 30 large institutional SH and 9 wealthy individuals at fixed price, open for 1 hour This is an attempt to end-run the Williams Act b/c it doesnt really look like a tender offer Minority shareholders were upset w/ this b/c they didnt get a chance to sell their stock Eight Factor Test for Tender Offer 1. Active and widespread solicitation 2. The solicitation is made for a substantial percentage of the issuers stock 3. A premium over market price 4. Terms of the offer are firm rather than negotiated 5. Offer is contingent on tender of a fixed minimum number of shares 6. Offer is open only for a limited period of time 7. Offerees are subjected to pressure to sell their stock 8. Whether public announcements of a purchasing programprecede or accompany a rapid accumulation Brascan v. Edper Equities, Ltd (1979) Edper owns 5%; his offer for friendly acquisition of Brascan is rejected. Edper asks Connacher to buy up shares; he buys 10% from 30-65 institutional and individual investors. He says he wont buy more. The next day, he buys 14% more. Brascan sues under 14(e) for fraud This was NOT a de facto tender offer, (met only 1 factor) so 14(e) does not apply Court applied Wellman test and found only factor 2: solicitation of stock BUT the court could have found more factors met: 7 (implicit time period), 5 (contingent on # shares), 3 (premium) Edgar would not have gotten away with this if it were a US transaction subject to Hart-Scott-Rodino Act Waiting Period 1976

Williams Act Designed to level the playing field b/w acquirers and acquirors by preventing disaggregated SHs of target companies from being taken advantage of Ex: Saturday Night Special: Tender offer made w/ very little allowed response time (1) Early Warning System 13(d) Requires disclosure when anyone acquires more than 5% 65

(ii) Investor must file a 13D report w/in 10 days Partial exemption for (passive) qualified institutional investors (iii) Updating requirement (12d-2): must amend filing promptly on acquiring material change ( 1%) (iv) Beneficial owner: power to vote or dispose of stock (v) Group: Anyone who acts together to buy, vote, or sell stock Ex: SHs who get together to aggregate stock to oppose a proposed merger (vi) BENEFIT: Board is put on notice and can begin its defenses, minority SH know stock price will rise b/c someone is trying to buy up lots of shares (2) General Disclosure 14(d)(1) Requires tender offeror to disclose identity and future plans, including any subsequent going-private transactions (3) Anti-Fraud Provision 14(e) Bars misleading statements, omissions, fraudulent acts in connection w/ tender offer Requires an element of deception Implied right of Action for SHs, and even a bidder though bidders are limited to injunctive relief SHs need not have actually tendered their shares to have an action Can assert you didnt tender your shares and lost out on an offer due to misrepresentation? (4) Terms of the Offer (14e-1, 14d-10) (a) Offer must be open for 20 business days (b) Tender offers must be made to all holders (c) All purchases must be made at best price (d) SHs who tender can withdraw while tender offer is open (bidder cant buy outside the tender offer) HART SCOTT-RODINO WAITING PERIOD Hart-Scott-Rodino Act Waiting Period 1976 Takes away the element of surprise Minimum waiting period before closing a transaction 18a(b)(1)(B) (i) 30 days for open market transactions, mergers, and negotiated deals (ii) 15 days for cash tender offers (iii) May be extended for 30 extra days (10 days for cash tender offers) if DOJ or FTC makes a request 18a(e)(2) Who must file 18a(a)(2) (i) Acquirer in all deals greater than $200 million (ii) Acquirer w/ assets or sales greater than $100 million and a target with assets or sales greater than $10 million or vice versa, if the deal involves assets or securities greater than $50 million

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FUNDAMENTAL TRANSACTIONS: M&A

Economic Motives for Acquisitions Efficiency Motives: economies of scale/scope, vertical integration, replacing bad management, diversification Redistributive Motives: shifting value from government (NOLs), creditors (e.g., LBOs), or consumers (e.g., monopoly pricing) Bad Motives: hubris, overestimation of synergies, empire building (all possibly driven by poor economic incentives) Shareholders are Protected by Vote Appraisal Rights BASIC FORMS OF TRANSACTION (1) Statutory Merger (2) Stock/Asset Acquisition (3) Stock Exchange (1) Statutory Merger (DGCL 251) Steps: Acquirer & Target boards negotiate the merger Proxy materials are distributed to SHs as needed Ts SHs always vote (251(c)); As SH vote if As stock outstanding increases by > 20% ( 251(f)). o Dont have too much procedure weighing down the merger process. o A large acquirer eating up a small company ought not to require a SH vote o Right around 20% youve got a new controlling SH If majority of shares outstanding approves, Ts assets merge into A, Ts shareholders get back As stock. Certificate of merger is filed with the secretary of state Dissenting SHs who had a right to vote have appraisal rights. Particular assets of T dont need to be physically transferred to A. Very little transaction costs in this regard. Asset Acquisition (DGCL 271; RMBCA 12.02) Steps: Boards of the Target and Acquirer negotiate the deal Only Ts SHs get to vote (because only T is being bought) if substantially all assets sold o No appraisal rights Transaction costs are higher because title to the actual physical assets of the target must be transferred to the acquirer A buys Ts assets with either cash or stock o If stock, then Ts SHs stick around with shares in A. If cash, then there will not be 67

anymore T SHs After transfer, selling corporation usually liquidates; all thats left is a shell company sitting on a heap of cash or stock. So itll just liquidate and distribute the cash or stock received from the deal to its SHs. Alternatively, the shell company is left with liabilities, while the A takes the assets. This is possible as long as the asset purchase is at arms length and does not violate the Fraudulent Conveyances Act; successor liability in tort for ex. defective products or environmental cleanup may attach to the A because of the sale.

Issue: What is substantially all assets? Theres some critical threshold amount of assets thats so large that the company is basically sold the issue is when this trigger is met. See Katz v. Bregman (anything above 50% of assets) o When this threshold isnt met, Ts SHs do not get to vote
Katz v. Bregman (1981) Board sold several unprofitable subsidiaries of the corporation and then disposed of a subsidiary that constituted its entire business in Canada, and 51% of the companys remaining assets, 45% of revenues, 52% of its operating income o This was a sale of substantially all assets, so it requires a shareholder vote o Anything above 50% of a companys assets, measured either by book value or revenues, will likely require SH vote Thorpe v. CERBCO (1996) o If something isnt right, the % of assets required to trigger the requirement drops o The need for SH approval is measured not by size of the sale alone, but also on qualitative effect on the corporation o Relevant to ask whether a transaction is out of the ordinary course & substantially affects the existence and purpose of the corporation.

RMBCA Sale of Assets Transaction - 13.02 A sale of substantially all assets, DOES trigger appraisal rights of selling corporation, so long as the selling corporation survives for more than 1 year post-transaction & distributes something other than cash to its SHs Stock Acquisition Through tender offers and the purchase of a controlling block Cash out once A has controlling block (second step of two-step merger; in DE Alternatively use compulsory share exchange transaction (not in DE, see RMBCA); As stock distributed pro rata to Ts Shs, A becomes sole SH in T. Compulsory Share Exchange, RMBCA 11.03 Transaction form is NOT found in the DE statues SHs in T company can be compelled to exchange their shares for shares in the A company (negotiated with Ts BoD and accepted by majority of Ts SHs). After transaction, left with A SHs and T SHs with shares in A corp but T survives as a wholly owned subsidiary Advantage to A: doesnt pick up Ts liabilities. o Also, T might have some unassignable contracts, say, franchise agreements, etc. 68

Forward Triangular Mergers available in DE Gets at a structure something like the compulsory share exchange A spins off a subsidiary, A-Sub. A will then merge T corporation into A-Sub The resulting structure is not quite what you get under compulsory share exchange o Keeps a corporate veil between assets and liabilities of the T and A companies. Reverse Triangular Merger (conventional form used) Merge the subsidiary into the target, rather than the target into the subsidiary o Merger agreement states the consideration is shares of A for shares of T T survives, rather than A sub This gets us to the same result as under the compulsory share exchange Acquiring shareholders do NOT have a vote here (though exchange rules may require it) Short Form Merger DE 253 Follows tender offer for control Does NOT require a SH vote if acquiror owns more than 90% of companys stock o Less than 90% requires a vote, though vote will definitely go through if 51% o Must still offer appraisal rights TAXATION General Rule: A reorg that qualifies under IRC 368 is tax-free under IRC 354. No recognition of gain to the seller, except to the extent that they receive boot; A gets carry-over basis in stock or assets acquired, T gets carry-over basis in stock received. IRC 368(a)(1)(A) (A reorg, statutory merger): mergers & consolidations executed pursuant to state law, provided that As stock must constitute a substantial and meaningful portion of the total consideration. Up to 50% boot allowable. A. APPRAISAL RIGHTS Appraisal Rights: Put option: shareholders in selling company (target) who maintain that the price is too low, can put their shares back to the company for a fair price (1) When do Shareholders get Appraisal Rights? In US, usually when they have a vote on a transaction they get appraisal rights too o BUT In 253 DGCL (short form merger), SHs get appraisal rights even w/o voting rights o BUT In 271 DGCL sale of assets transaction, shareholders get vote but no appraisal rights BUT RMBCA 13.02 does give appraisal rights with sale of substantially all assets (2) Procedure for Appraisal Rights DE 262 Shareholders get notice of appraisal right at least 20 days before shareholder meeting (262(d)(1)) SH submits written demand for appraisal before SH vote, and then votes against it (or doesnt vote 69

for) it 262(d)(1) If merger is approved, shareholder files petition in Chancery Court w/in 120 days after the merger becomes effective demanding appraisal 262(e) Court holds valuation proceeding to determine the shares fair value exclusive of any element of value arising from the accomplishment or expectation of the merger 262(h) No class action device available, but Chancery Court can apportion fees among s as equity may require 262(j) o The judge can decide ex post who pays the bills based on fairness o No guarantee

1320 et, sec of RMBA In these jurisdictions, the company must pay what it determines to be a fair price for the dissenters shares up front Dissenters can challenge this price and appraisal proceeding can move on from that point Important b/c dissenters get some money up front; they can litigate at their leisure o Different from DE where dissenters get no $ until litigation is resolved Small SH arent Likely to use Appraisal rights Especially in an arms-length transaction It is too much trouble for them, and the return is too little (w/o class action) Especially since they may be forced to pay the fees Appraisal rights work to the advantage of large shareholders; not minority shareholders the process needs a lawyer (3) Limitations on Appraisal Rights Not effective for small investors not worth the trouble No appraisal in sale of assets 262(b)(1&2): Stock Market Exception: (b)(1): No appraisal right if stock of the acquired company is listed on an exchange or if it has more than 2000 SHs (b)(2): Notwithstanding this, you can still get appraisal rights if you get anything other than (market out rule): stock in the surviving company shares traded on a national security exchange cash in lieu of fractional share o Basically, you dont get appraisal rights in a publicly traded company as long as you get shares in another publicly traded company (which can be the surviving company in the merger but it doesnt have to be) Rationale for this Provision: This is about liquidity, not about preserving a fair price for dissenting shareholder o If you get liquid shares, you dont get appraisal rights o If you dont get liquid shares, and youre stuck, then you do get appraisal rights a way out This is a little hard to reconcile w/ fact that if you get cash, you still get appraisal 70

rights (4) What Does Appraisal Right Give DE 262(n): Value of shares w/o recognition of value from the transaction o Makes sense b/c you dissented from the transaction o Fair value can be expressed as either (1) the share value that a minority SH has in the company or can say that it is a (2) pro rata sliver of the going concern value of the Corp DE sided w/ the more generous pro rata asset norm for what fair value is Measuring this: Traditional DE theory of what value was: DE Block Method o Market value of shares (share price, if shares are traded) o Earnings Value: last 3 years of earnings, capitalized using a price-to-earnings ratio o Asset value: net assets, valued at liquidation value o It is now fine to use whatever techniques modern financial economists use to value the company Weinberger (saying discounted cash flow analysis is the main valuation technique)
Weinberger v. UOP o It is permissible to use whatever techniques modern financial economists and I-bankers use to value the company o Principally, use discounted cash flow analysis to value the company and therefore what the appraisal value of shares is going to be In re Vision Hardware Group Vision has $125M in debt & $90M in assets. TCW buys debt at deep discount and cashes out minority SHs, who seek appraisal. SHs value corp at $39M b/c $90M minus the market value of the debt of $56M (price TCW paid for debt); Company values it at $0 uses face value of the debt o Court uses face value of the debt o B/c so obvious the company will go belly up w/o merger that minority SHs shouldnt benefit from this value o SH might have a greater claim if there were a lesser chance of company going belly-up

(5) Defacto merger doctrine DE has no de facto merger doctrine to give appraisal rights, though PA does
Hariton v. Arco Electronics (1963) DE FACTO MERGER Loral buys Arco and SHs approve. Arco transfers all of its assets to Loral, Loral transfers its stock to Arco, Arco dissolves and distributes Loral stock to its SHs. Looks like a merger, though accomplished through 271 techniques. Arco SH claims appraisal right b/c de facto merger o It is not a merger, so there are no appraisal rights; no de facto merger doctrine

T Voting Rights

Summary: Statutory Merger (DGCL 251, RMBCA 11.02) Yes need majority of shares outstanding

Shareholder Voting & Appraisal Asset Acquisition (DGCL Share Exchange 271, RMBCA 12.01-.02) (RMBCA 11.03) Not possible in DE Yes if all or substantially all Yes need majority of assets are being sold (DGCL shares voted (RMBCA 71

A Voting Rights

Appraisal Rights

(DGCL 251(c) or majority of shares voted (RMBCA 11.04(e)) Yes, unless < 20% shares being issued (DGCL 251(f) RMBCA 11.04(g) Yes if T shareholders vote, unless stock market exception (DGCL 262, RMBCA 13.02)

271(a) or no significant continuing business activity (RMBCA 12.02(a) No though stock exchange rules might require vote to issue new shares No in DE, unless provided in charter DGCL 262 (no defacto merger doctrine); Yes under RMBCA if T shareholders vote, unless stock market exception (RMBCA 13.02(a)(3).

11.04(e)

Yes, unless <20% shares being issued (RMBCA 11.04(g) Yes, unless stock market exception (RMBCA 13.02(a)

D. FREEZE-OUT MERGERS DE 251 & 253 Cash out merger like VA Bankshares o In US, you can cash out if you own 51% of the shares; some other places (like Germany) say you cant do a cash out unless you own 90% of shares; o If 51%-89% cash out, must have approval of board, approval of a majoirty of the minority SHs flips the burden of proof; dissenting SHs get appraisal rights, entire fairness test if interested transaction. o If 90% or more cash out, no entire fairness test, no vote, only appraisal right (Glassman). Reverse Stock Split: When the corp redefines the shares so large number of shares is reclassified as a single share o Done so that the only SH left with one + shares is the controller; everyone else has a fractional share and will receive money in lieu of fractions. We permit cash-out mergers b/c o Sometimes, as w/ parent-subsidiary, it makes sense to consolidate assets under one roof o May encourage efficiency to let one with a better business strategy take control of the whole company to give him the benefit of his strategy (w/o having to share with the minority shareholders) o If controller wants to go private just to do so, it is harder to justify. DUTY OF LOYALTY IN CONTROLLED MERGERS Singer v. Magnavox (DE SC 1977) decided in response to SEC threatening to make regulation law federal as a result of going private transactions that were not always kosher: Lets SH bring class actions (in addition to appraisal proceedings) to challenge freeze-out mergers on grounds that controlling SH breached fiduciary duty of entire fairness to minority SHs (in all DGCL 251 mergers, not DGCL 253 short form mergers) Per se rule: A freeze-out w/o a colorable business purpose breaches Entire Fairness o getting rid of minority shareholders is NOT a colorable business interest 72

o Business purpose is business purpose of Controlling SH, CSH has to establish CSH has a business purpose for this transaction (per se rule weakened seriously) Minority SHs remedy is recissory damages monetary equivalent of rescission

When Can Minority SHs file for breach of Fiduciary Duty? (Weinberger) Minority SHs arent precluded by appraisal right can use both class action and appraisal right at same time (Rabkin) No need to file anything to be part of class action; all minority SHs are swept into the class (better than appraisal) Benefit of Entire Fairness class action in addition to appraisal remedy Ps attorney can come in and solve collective action problem, sues on behalf on everyone; appraisal rights are persued individually. Recissory damages as opposed to statutory remedy. Even if youve voted for cash-out, can still claim from class action, but waived appraisal rights.
Weinberger v. UOP (Del. SC) Signal owns 55% of UOP, wants to purchase the rest. Directors on both UOP and Signal value UOP share price at $24, but they dont share info with UOP board, and they use their knowledge of UOP to pitch Signals deal to UOP. Signal offered $21/share, SHs accept, UOP approves w/o negotiation and w/ a hastily drafted fairness opinion from Lehman (price is left out and filled in at last minute). UOP CEO hardly negotitates with Signal, ties to Signal. Shareholders challenge fiduciary duty of UOP directors. o Breach of duty of loyalty b/c controlling SH did not disclose info o Directors were UOP fiduciaries but they acted as Signal agents controlling SH was working on both sides of the deal, which makes disclosure necessary

Under Weinberger, Avoid Liability for Breach of Fiduciary Duty by: Using a Special Committee of Independent directors to negotiate the deal with controlling SH (BUT See Lynch Communications) Give more time to allow a more thorough fairness opinion by I-bankers Use a majority of the minority provision so Controlling SH cant dominate SH vote (shifts burden of proof) Class Action for breach of fiduciary duty is available in all DGCL 251 Merger freeze-out transactions (not DGCL 253)
Rabkin v. Phillip A. Hunt Chemical (Del 1985) Olin buys control block in Hunt and contracts that if it cashes out the minority w/in 12 months, it will pay minority SHs the same as it paid for its control block. Olin waits 12 months and then cashes them out for lower. They claim breach of fiduciary duty and deliberate waiting o Appraisal is not a stockholders sole remedy b/c it is inadequate in cases where fraud, misrepresentation, selfdealing, deliberate waste of corporate assets, or gross and palpable overreaching are involved o Now, class action is an available remedy in almost every freeze-out merger (not short form 253 merger) Cede v. Technicolor DE SC Perelman bought Technicolor through tender offer followed by statutory merger, which is at the same price as the tender offer price. He started implementing a plan for the company (selling off assets & reorganizing) before he completed 2nd step of merger. o Because Perelman began to implement his plan before 2nd step freezeout, the initial price negotiated at

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arms length isnt presumptively fair On remand, Ch. Ct finds that board carried its burden of showing entire fairness to SHs.

Even if an IC agrees with controlling SH about the cash-out price, may still violate fiduciary duty if SH asserts power too much
Kahn v. Lynch Communications (Del 1994) Lynchs board wants to buy Telco, Alcatel wants it to buy Celwave, Alcatel subsidiary. Alcatel can veto any decisions Lynchs board makes. IC set up, opposes Celwave deal. Alcatel makes an offer to acquire remaining 56% of Lynch at $14/share to bypass Lynch board. Lynchs Independent Committee rejects $15 as inadequate, but finally recommends $15.50 per share offer on threat of hostile bid from Alcatel (tender offer at lower price). Disinterested directors then approve the freezeout merger. Minority SHs sue: o Breach of entire fairness even though Alcatel consulted and negotiated with Lynchs independent committee o Alcatel violated its duty by being too pushy as a controlling shareholder towards the IC o This is high water mark for protecting minority shareholders

Entire Fairness doctrine does not apply to 253 Short Form Merger (in which controlling SH has 90% of shares so no SH vote needed but appraisal rights are still available) - Glassman v. Unical Exploration DE SC says there is still room for appraisal preclusion, as in a 253 freeze-out merger. Entire Fairness doctrine further limited b/c it does NOT apply to two-step tender offers + shortform 253 merger (In re Pure Resources): checklist Tender off must not be coercive Set up non-waivable majorty of the minority tender conditon Use same price in 253 merger as tender offer Ts board must have free rein to investigate deal; hire advisors, provide minority with information and suggestions. Details of the fairness opinion must be disclosed to the minority SHs
In re Siliconix Controlling SH with 80% launches a tender offer for minority shares in order to get 90% so as to avoid the entire fairness obligation o Vishay was under no duty to offer any particular price or a fair price to minority SHs b/c they had free choice to reject the tender offer o Entire Fairness does NOT apply unless there was actual coercion or disclosure violations

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PUBLIC CONTESTS FOR CONTROL

Hostile takeovers exercise disciplinary functions on bad managers Can be mounted either by proxy contest or tender offer; or a combination of both Defensive tactics are deeply problematic (BoD often interested, will lose jobs) A. INCUMBENT TRYING TO DEFEND AGAINST HOSTILE TAKEOVER Unocal Rule is somewhere between entire fairness and business judgment (1) Is there a reasonable threat? (the threat can also harm long term SH interests Unitrin) (2) Is the companys response proportional to the threat posed? (3) The response may not be preclusive? (Unitrin)
Unocal Corp v. Mesa Petroleum Co (DE SC 1985) Pickens buys 13% of Unocal on open market and makes contingent tender offer for 37% at $54/share in cash. Discloses intent to cash out remaining shareholders for high-risk debt (junk bonds probably worh $45/share, since financing is based on loans). Stock is trading at $33 before the deal announced. Unocal board makes a self-tender for $72 (to buy own shares) excluding Pickens, if Pickens succeeds in getting 50%; amends to apply to 30% even if Pickens offer fails (amended to differ from a dividend such that Pickens can be excluded). Ultimately, Pickens doesnt want the company, and the company is worth less after it overpays for 30% of the shares

(Moore) Pickens offer is a two tier front-end loaded COERCIVE offer (there is a reasonable threat), so Court upholds Unocals counteroffer i. Because the deal will probably go through, SHs must take the 1st tier price, even if inadequate, to avoid the low 2nd tier price ii. If you dont tender and Pickens loses deal, then price goes back to $33; if he wins, it is better to get $54 than $45 iii. This is the THREAT

Note: Unocals $72 offer is even more coercive, b/c if use company $ to buy shares at that inflated value, the rest of them will necessarily be worth less (value of the company is being front end loaded). ISSUE: What constitutes a threat justifying preclusive defense, other than a structurally coercive offer?

Unocal is strange b/c it endorses non-pro-rata treatment (this is a mega dividend to all SHs other than Pickens) SEC passes Rule 13(e)(4) and 14(e)(10) to require that tender offer be made to everyone on the same terms Thus, defence of the selected tender offer is gone Reasonable threats: (1) Structural coercion: the risk that disparate treatment of non-tendering SHs might distort SHs tender decisions (2) Opportunity loss: a hostile offer might deprive target SHs of the opportunity to select a superior alternative offered by management (3) Substantive coercion: the risk that Shs will mistakenly accept an underpriced offer because they disbelieve managements representations of intrinsic value. 75

B. POISON PILLS - PRE-EMPTIVE DEFENCES 1. Flip-In Pills: Dilute the interest of an acquirer of some control block of stock to make it unfeasible to proceed w/ acquisition Pill is preclusive, and does NOT require a SH vote to implement Pills always have a Board-Out clause, to let the Board authorize a purchase without triggering the pill (remdemption clause). Implementing a Flip In Poison Pill Step one: Rights plan adopted by board vote (BJR) o SH vote unnecessary if there is provision in charter allowing board to issue blank check preferred stock Step two: Rights are distributed by dividend and remain embedded in the shares o You can do this b/c most companies always have in their charter the ability to issue more shares Step three: Triggering event occurs (it never does) when prospective acquirer buys >10% of outstanding shares. Rights are no longer redeemable by the company and soon become exercisable (Unocal) Step four: Rights are exercised. All rights holders are entitled to buy stock at half price except the acquirer, whose right is cancelled. o The SHs thereby dilute controllers stake (it is worth much less b/c there are now so many shares out there but the company is worth the same); everyones share increased proportionately but controllers Moran legitimizes adoption of the pill; adoption is subjected to BJR; but Directors use of the pill is still subject to Unocal test
Moran v. Household International (DE SC 1985) - ACCEPTS THE PILL Flip-over pill adopted that is triggered on announcement of a 30% tender offer and acquisition of 20% of the shares. Moran, largest shareholder, brings suit to enjoin the pill as outside boards authority o Use of the pill is a legitimate anti-takeover device o Directors still have fiduciary duties to the corporation at the time it is asked to redeem the pill; cant arbitrarily reject the offer o ISSUE: When will a court force pill redemption b/c board arbitrarily rejected the offer?

Chancery Court is in the position of deciding which offers are good/bad and whether company must pull the pill on that basis Grand Metropolitan Pub v. Pillsbury (Del. Ch. 1988): Pull pill when Grand Mets hostile all-cash offer is better than Pillsburys own restructuring proposal Benefits of the Pill Board is able to avoid SEC tender offer rules b/c the rights are nominally already out there o No SH vote necessary either; Board can just adopt it More efficient: No need to deal w/ restructuring, no worry that board will throw away value to protect the incumbents Pill does not force any underlying business plan or restructure the company 76

C. DUTIES WHEN TARGET BOARD WANTS TO SELL THE COMPANY Revlon Duty: o When board is considering competiting offers (often hostile bidder), board has a duty to get the highest price for SHs and may not adopt defensive tactics that destroy the bidding process o When the board is considering a single offer and has no reliable grounds to judge its adequacy, fairness demands a canvas of the marketplace to determine if higher bids may be elicited, unless they have a body of reliable evidence that tells them the transaction is fair. Revlon Triggers (change creation of control) o When a corporation initiates an active bidding process seeking to sell itself or to effect a business reorganization involving a clear break-up of the company (Revlon) o Shift in control in target company from no controller to controller (Paramount v. QVC) Where a company is widely held there is less chance of a Revlon duty, than when it is has a controlling SH, why? Controlling SH may wilt away synergies by conduct Managers cannot say with any certainty that controller will realize synergies, since managers no longer have future control of the company in their hands if control changes to a new controlling SH; controlling Shs conduct will determine whether or not they get this. o May also be triggered when acquiring company is much larger than the target Mom and Pop grocery store lacks expertise in valuing the stock of the large acquiring company same institutional competence theory Also, Target SH will have little say in the new company Whatever synergies there are, SHs in small target will only get tiny pro rata fraction of gains from the transaction Only marginal synergies BoD in small T has no special insight to trump market value of the deal o All cash merger as opposed to all stock merger as consideration (T participates in synergies) Stock transactions not subject to Revlon but cash ones are, why?: w/ cash BoD can evalite the merits of the deal in a way the market does not if SHs get stoch they participate in the synergies of the deal decision of board is better than market to value stock (they have inside information), therefore its decision should be respected where case everyone can evaluate the different prices, does not take synergies into consideration o Stock-for-Stock Merger of Equals is NOT a sale (Paramount v. Time) Ultimately the question is what directors know, if they have high informational advantage there is more likelihood they will have a Revlon duty.
Smith v. Van Gorkom (1985) o TransUnion Corporation board is found to violate duty b/c it doesnt spend much time trying to get a

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good deal Revlon v. Mac-Andrews and Forbes Holdings (1986) Perelman makes hostile all-cash tender offer. Revlon adopts flip-in pill and tenders for 20% of its own shares with notes (intended to buy up public shares but also tie up Revlons assets in debt so that Perelman cannot finance the deal by selling off Revlons assets). Perelman raises offer to $56.25 and SHs want to accept it. Board finds a White Knight (Frostmann Little) to finance a management buyout as a competing offer. Frostman Little agrees to pay $57.25, gets an assets lockup, a no shop provision, and a termination fee in exchange for supporting the par value of the notes. o Once Board decides the corp should be sold, the Board becomes an auctioneer and has obligation to get the highest price for SHs Selective dealing at this stage is no longer a proper objective primary objective is getting high price for SHs Frostmann was already in the contest on a preferred basis, and lockup wasnt to foster bidding but to end it o This is straightforward short-term shareholder primacy o By locking up the assets to Frostmann if the deal didnt go through, the directors lost the collateral for the debt and the bottom of the debt fell out. They made the deal with Frostman to support the debt in order to avoid suit by the debtholders. B/c they put the threat of personal litigation (and noteholders) ahead of their duty to shareholders, they violated duty May consider other constituencies, but not during an action among active bidders o ISSUE: What is a sale sufficient to trigger Revlon duty? (see above Revlon Triggers)

Deal Protections (a) Types: Asset Lockup: Right to purchase Targets assets if someone else wins the bidding war No Shop Rule: Target is not allowed to negotiate with any other company Termination Fee: If company is outbid, Target must pay a price for ending negotiations (b) Rules: Lockup Options are still permissible after Revlon as long as the cost of the lockup option to shareholders is justified by the value obtained for shareholders o Lockup may be used to construct a bidding structure that is used to get the highest price BUT deal protections may need to be renegotiated during the bidding war (Paramount v. QVC) Court will likely reject deal protection measures if theyre too large (like Paramount v. QVC) Friendly deals must give the Target Board a fiduciary out such that they can abandon the deal protection if theyre advised by counsel that theyre going to violate fiduciary duties; if agreement lacks such a provision, it is invalid (Omnicare) Strange that we trust Board to do the deal, but we constrain them using Revlon in their contracting ability

D. UNOCAL AND REVLON COMBINED

Paramount v. Time (1989) Time & Warner want to merge with a stock-for-stock merger of equals. Paramount makes an all-cash hostile bid for 100% of Time shares, which Time board rejects as too low. Time SHs want this deal ($100 cash is better than $100 stock from deal w/ Warner). Time restructures deal w/ Warner: It borrows $10 billion and uses it to make a cash

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tender offer for Warner (Paramount will not buy heavily indebted Time-Warner conglomerate, and Time doesnt need SH vote to borrow huge amount of money) o UNOCAL: Times anti-takeover tactic to buy Warner for cash is NOT unreasonable in response to the threat posed Threat posed is that the hostile bid disrupts the long-term plan of the merger (business policy of the company) and creates confusion among SHs about what is the better deal With this justification, anything counts as a threat; anything can disrupt the long-term business plan Makes the Unocal test almost into BJ rule o REVLON: Duties not triggered b/c this is not a sale (no change of control no controlling SH)

This is not a sale even though 62% of stock moves; it is a merger of equals

One cannot contract deal protections in the face of contrary fiduciary obligations
Paramount v. QVC Network (1994) Paramount agrees to be acquired by Viacom for $70/share and gives Viacom no shop agreement, termination fee, and 20% stock option lockup. QVC enters and offers Paramount $80 in cash and then stock and makes a tender offer for 51% with a planned back-end squeezeout at $80 in QVC stock. Viacom matches QVC at $80, then goes to $85 but leaves deal protection unchanged except for fiduciary out. QVC raises to $90, but Paramount doesnt negotiate with them; just rejects offer. QVC challenges that Paramount was in Revlon mode (it cant go ahead w/ deal protections in place) o REVLON: Revlon is triggered b/c theres a shift in control in the target company (there used to be no controlling shareholder at Paramount (control in market) and now Redstone as QVC controlling SH has a controlling interest in the new company (control in SH)) Also, stock option lockup becomes worth a half billion dollars (3% to 4% of deal value is allowed) DE SC tells Chancery court to do enhanced scrutiny test to evaluate reasonableness of substantive merit of boards actions It was not reasonable (in Ch. Cts BJ) to use stock lockup, no shop, termination fee to maximize SH value Once Revlon is triggered, board should have investigated the offers, negotiated w/ both sides, gotten Viacom to drop its deal protection plans, and redeemed the pill w/r/t both sides (level the field to give SH best price Paramount is not contractually bound to Viacom for deal protections theyre not vested rights b/c one cannot contract in the face of contrary fiduciary obligations (Omnicare)

Even though used initially to get Viacom to place a bid (acceptable under Revlon), they should have renegotiated them once QVC and Viacom are in a bidding war

Omnicare (Del 2003) NCS was an insolvent health care company considering a pre-packaged bankruptcy reorganization. In 2001 Omnicare offers to buy NCS for $270 million. In 2002 Genesis offers to buy NCS but demands fully locked up deal in order to prevent a higher bid from Omnicare. Genesis and NCS agree to an exclusive negotiating period. GenesisNCS announce stock for stock deal, with NCS chairman and president committed to vote their stock in favor (>50%). Omnicare launches competing bid for NCS at twice the value of Genesis offer, board recommends the Omnicare proposal. Genesis nevertheless forces the vote on its merger agreement as permitted under DGCL 251(c). Omnicare brings suit to invalidate the stockholder lockup agreement. No change of control so no Revlon duty; Unocal steps in. Unitrin: protection is preclusive and coercive, SH agreemen is struck down.

An exclusive merger agreement -- such as a no shop or best efforts clause -- must include a fiduciary out, at least where the agreement presents target shareholders with a fait accompli. The board was required to contract for an effective fiduciary out to exercise its continuing fiduciary responsibilities to the minority stockholders

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 The board has an on-going fiduciary duty to constantly reevaluate its decision Visey CJ (dissent): this is not a poison pill, how can a SHs agreement be stopped? First bidder would not have committed himself w/o lock up and now court says cannot do so even when that lockup is supported by the majoirty of SHs. E. STATE ANTI-TAKEOVER STATUTES Many states adopted takeover statutes in response to anti-takeover antics of the 80s (legal under CTS Corp) Anti-Takeover Statutes That Burden Acquisition of a Control Block Control Share Acquisition Statutes (27 states) o Prevent a bidder from voting its shares beyond a specific threshold (20-50%) unless a majority of disinterested shareholders vote to approve the stake Bidder makes an offer, contingent on the shareholder approval. o Purpose: Bidder must persuade other shareholders when he buys a control stake that theyll be better off. Other Constituency Statutes (31 states) o Allow the board to consider non-shareholder constituencies IN uses BJ rule; does not accept Revlon and Unocal IN Constituency statute says directors may consider SHs, suppliers, communities, creditors, other factors (Do SHs still own the company? Yes, b/c they elect the directors) Pill Validation Statutes (25 states) o Endorse the use of a poison pill against a hostile bidder Anti-Takeover Statutes That Burden Second-Step Freeze-Out Business Combination (freeze-out) statutes (33 states) o Prevent a bidder from merging w/ the target for either 3 or 5 years after gaining a controlling stake unless approved by Ts board Fair Price Statutes (27 states) o Sets procedural criteria to determine fair price of freeze-outs Extreme Anti-Takeover Statutes Disgorgement Statutes (PA and OH) require bidders to disgorge short-term profits from failedbid attempts prevents bidders from recouping bid costs through toe-holds o Ex: A launches hostile bid takeover, stock price goes up in bidding war, dont get the takeover, but can sell stocks later at the higher price to recoup losses Classified Board Statutes (MA and MD) provide classified boards for all companies incorporated in the state (with opt-out possible) o Classified board is a staggered board DGCL 203: Anti-Takeover Statute Bars business combinations b/w Acquiror and Target 3 years after the acquiror passes the 15% threshold unless: o 203(a)(1): Takeover approved by target board before the bid occurs (board out clause), or o 203(a)(2): Acquiror gains more than 85% of shares in a single offer (i.e., moves from 80

below 15% to above 85%) excluding inside directors shares, or o 203(a)(3): Acquiror gets board approval and 2/3 vote of approval from disinterested shareholders (i.e., minority who remain after takeover) Doesnt prevent acquisition of the control block, but does deter self-dealing w/ the target postacquisition Also hampers financing of the deal: Because Acquiror cannot use the targets assets for 3 years, Acquiror cant use Ts assets as collateral Effective as Anti-Takeover Device b/c Exceptions are Hard to Get o Difficult to get 85% of shares b/c company can get a white knight with a 10% share o The ones who wouldnt sell to give you 85% are likely opposed and wont vote for you under 203(a)(3) The fewer there are, the harder it is to get 2/3 of them o But if you can wait 3 years, the statute does not cramp ones style
CTS Corp v. Dynamics Corp of America (1987) Indiana has control share acquisition statute prohibiting a bidder from voting its shares beyond 20% ownership unless approved by disinterested shareholders (SHs other than bidder and insiders). Dynamics challenges this statute as preempted by Williams Act and Commerce Clause. o SC legitimated anti-takeover statutes o This statute is innocuous, but the case opened the door for states to adopt much tougher statutes

F. PROXY CONTESTS FOR CORPORATE CONTROL Given that no one can acquire a control block unless the Board redeems its pill, it has become necessary (to mount a hostile takeover) to replace directors with ones who will redeem the pill, often by combining a proxy contest with a tender offer. Tender offer is conditioned on winning the proxy contest and electing the acquirers nomiees to the board and the boards redemption of the poison pill ISSUE: How much can incumbent boards use their power to thwart a proxy contest by a would-be acquiror? Board cannot act for the sole purpose of entrenching itself (Schnell)
Schnell v. Chris-Craft Industries (1971) Incumbent board is negotiating with dissidents and strings them along. Shortly before annual meeting, incumbent board moves the meeting up a month and moves it to an obscure town in upstate NY, leaving too little time for dissidents to organize and solicit proxies o Violation: The power held by a fiduciary entity cant be used to treat the beneficiary unfairly o Board cannot act for the sole purpose of entrenching itself by making it difficult for someone else to come in

Board cannot interfere with a shareholder vote, or it will trigger Blasius review Very tough standard b/c it applies even when the board acted in good faith Cannot disenfrachise SHs from their voting rights
Blasius Industries v. Atlas Corp (1988) Blasius, a 7% SH of Atlas announces its intent to solicit SHs to increase board size from 7 to 15, to fill the new seats w/ Blasius nominees (to execute a restructuring plan for Atlas). Atlas preempts by amending bylaws to add 2 new seats and fills them with own candidates. o Board acted in good faith, but thwarted the shareholder vote and thereby did not pass the standard of review

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o Court uses a very tough standard of review to examine what the board did: the justification must be
compelling with regards to the threat posed (higher standard than Unocal)

Board can keep the pill where the board says it is substantively coercive, and it is fine to thwart a proxy contest by repurchasing shares as long as the proxy contest is not impossible to wage
Unitrin v. American General Corp (1995) Unitrin resists Am Gens hostile takeover bid by installing a morning after pill and repurchasing 20% of its shares. Repurchase gives directors 28% stake, which lets them veto a freeze-out deal. o Both the Repurchase and the Morning After Pill are fine b/c theyre neither preclusive nor coercive and they fall inside the range of reasonables (revises the Unocal Standard) o Transaction here isnt preclusive or coercive b/c the hostile takeover can still go through it is still possible to win the proxy contest o Also wasnt so burdensome to shareholder voting such that it triggered Blasius review o Cases reviewed under Unitrin usually lack staggered boards (or else extreme measures wouldnt be necessary)

Combination of staggered board + pill is powerful anti-takeover device b/c it takes a long time to replace the board, which is necessary in order to redeem the pill (much harder to wage proxy contest)
Hilton Hotels v. ITT (1997) Hilton announces $55/share tender offer for ITT; ITT responds by selling non-core assets and delaying annual meeting 6 months. Then announces comprehensive plan to split ITT; one subsidiary (Destinations) has 93% of assets and staggered board. Destinations charter requires 80% vote to remove member w/o cause or repeal the staggered board. o Court says this is a preclusive or coercive defensive tactic and is impermissible under Unitrin o It violates Blasius and Unitrin to spin off a bulk of assets to defeat a hostile takeover into a subsidiary with a staggered board o This is a disenfrachisment of SH voting rights

G. OTHER ANTITAKEOVER METHODS Structural Defenses Shark Repellents (least effective to most effective) Golden Parachutes: Large payments to mgmt team & sometimes EEs (silver parachutes) in event of takeover Anti-Greenmail Provision: Prohibits board from buying back a stake from a large blockholder at a premium price Supermajority Voting Provisions: Requires super-majority vote (e.g., 80%) to approve certain business combinations, e.g., sale of assets, liquidation, freeze-out, often with a fair price out Poison Pill: Dilutes the acquirers stake after hitting a certain trigger threshold of ownership (typically 10-25%) (50% have this in place, though they can make one whenever even morning after) Staggered board: Allows only a fraction of directors (typically 1/3 to stand for election each year) Dual class stock: two classes of stock with different voting rights, i.e., voting and non-voting stock Types of Poison Pills Flip over pill: Gives T shareholders other than the bidder the right to buy shares of the bidder at a substantially discounted price 82

Flip in pill: Might be illegal in CA: Gives target shareholders other than the bidder the right to buy shares of the T at a substantially discounted price Chewable Pill: Pill disappears if fair price criteria are met (e.g., fully-financed, 100% offer for a 50% or more premium over current market price) Slow Hand Pill: Illegal in DE, but legal in MD and GA: Pill that may not be redeemed for a specified period of time after a change in board composition Dead Hand Pill: Illegal in DE, but legal in MD and GA: Pill that may be redeemed by the continuing directors No Hand Pill: Illegal in DE, but legal in MD and GA: Pill that may not be redeemed by current or future boards for the life of the pill (usually 10 years)

De. SC precluded the use of some of these pills Power to manage the firm is in the hands of the director Dead hand or slow hand pill strips tomorrow board of the power to redeem the pill to manage the corporation o Cant hobble tomorrows directors Not clear if DE 109(b) (SHs inherent power to amend the bylaws of DE corp) extends far enough to let them amend the bylaws to compel the Board to redeem the pill

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INSIDER TRADING

COMMON LAW DIRECTORS DUTIES WHEN DEALING IN OWN STOCK Insider trading is principally federal law b/c state law doesnt bar this type of behavior WHO IS INJURED BY INSIDER TRADING? Inside information is a corporate asset and the corporation is therefore entitled to any profits made by its agents by trading on it. Equivalent of agency laws rule that an agent may not use her principals information for personal profit (Diamond v. Oreamuno (1969): this is the MINORITY opinion. It doesnt matter that the principal is not injured by this conduct Equity places a constructive trust on the profits in order to discourage fiduciaries from violating their duties. Under fidicuiary (agency) law the corporation or its shareholders derivatively should be able to sue the insiders in order to capture the profits made. BUT, since the corporation is seen as owning this information, it could allow its agents to trade on it if there were no other legal considerations (absent federal prohibitions). This fiduciary duty does NOT attempt to compensate the uninformed shareholders with whom the insider trades. Freeman v. Decio (1978): Company is not hurt by this and directors only duty is to his corporation; thus, no cause of action for company (no harm) or those with which he traded (no duty) (MAJORITY) Fear of making definition too broad to chill release of important info; too narrow and one will unjustly gain
Goodwin v. Aggassiz (1933) Aggassiz and MacNaughton begin anonymously buying shares of Cliff Mining Co (of which they are directors and officers) b/c of a non-public geologists report identifying copper deposits on the property. Goodwin (former shareholder) says he wouldnt have sold his shares to Aggassiz if he had this info. o Directors stand in a relationship of trust to the company and are bound to exercise the strictest good faith in respect to its property and business. Directors have no such relationship with individual stockholders. o Court rejects that they breached a duty to the corporation b/c this is property of the corporation which insiders used to make a profit (so as to violate principal/agent relationship) (holds with majority view) o Director cannot be expected to personally seek out individual stockholders and disclose material facts.

State fiduciary duty law continues to play a role 2) a corporation can bring a claim against a director for profits made by using information learned in connection with his corporate duties 3) shareholders can invoke state fiduciary duties to challenge the quality of the disclosure that their corporation makes to them. FEDERAL PROHIBITIONS ON INSIDER TRADING (1) 1934 Act: Express Statutory Proscription Against Insider Trading 16(a): Requires statutory insiders (directors, officers, 10% shareholders) to file public reports 84

of any transactions in the corporations securities within 2 days of the trade under Sarbanes-Oxley 403 o officer: Anyone with access to non-public information in the course of employment o File Form 3 saying one becomes a Statutory Insider o File form 4 when you trade in the companys stock 16(b): Statutory insiders must disgorge any profits on purchases and sales w/in any 6 month period (strict liability rule) o Exemption for unorthodox transactions, e.g., short swing profits in takeovers, no evidence of insider info, compensation plans (Kern County Land v. Occidental Petroleum Corp). o This is over- and under- inclusive and is not bright line as it was intended to be o To calculate Profits for 16(b), match any transactions that produce a profit (but no offset for those that result in loss) Purchases before becoming an insider do NOT count Purchases after leaving office DO count (because still has the knowledge) These provisions are enforced entirely by plaintiffs bar and derivative suits 2. Also Section 10(b) and Rule 10(b)-5 for Material Misrepresentation

10 [It shalle be unlawful] (b) To use or employ, in connection with the purchase or sale of any securit registered on a national securities exchange or any security no so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may proscribe as necessary or appropriate in the public interest or for the protection of investors. Rule 10b-5 It shall be unlawful: (a) To employ any device, scheme or artifice to defraud. (b) To make any untrue statements of a material fact or omit to state a material fact necessary in order to make the statements made, in the light of the circumstances in 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. Rule 10b-5 was recognised for its potential to create an implied private right of action in Kardon v. National Gypsum Co.

Elements of a 10b-5 claim: 1) False or misleading statement with respect to the sale of securities 2) Of a material fact (what would a reasonable SH consider important) 3) Made with intent to deceive another (specific intent to deceive, manipulate or defraud (Ernst & Ernst) though may be inferred from reckless or grossly negligent behaviour. 4) Upon which that person reasonably relies (presumption of reliance on integrity of market price (Basic)) 5) And that reliance causes the harm. (Injuries/damages: disgorgement rule (Liggett))

Reaches public AND private (closely-held) corporations The reliance must be by a buyer or seller in stock The harm must be to a trader in stock 85

The misleading statement must be made in connection with a purchase of stock. Standing: must be a purchase or sale of securities (Blue Chip Stamp) o The USSC manufactured this limitation o Different from 14e: people who dont tender can claim damages b/c of misrepresentation from a tender offer (I would/would not have tender if I have known)

Ad(1) Misleading statement or omission A. Duty to disclose: Two Elements for Obligation (Cady Roberts 1961) (i) Existence of a relationship giving access to info intended to be available only for a corporate purpose and not for the personal benefit of anyone Relationship of trust and confidence (RETAC) with those against whom youre trading Chiarella B/c failure to disclose doesnt count as fraud; only misrepresentation For an omission to count as fraud, requires a duty (which cant be made; must be found) Tipees not liable if no breach by insider, i.e., insider personally gained by disclosure) - Dirks Anytime someone who knows more makes a deal, someone gets hurt, but harm isnt legally cognizable in all situations If the rule is too expansive, analysts could be punished if theyre contacted by managers who reveal info (ii) Inherent unfairness involved where a party takes advantage of such info knowing it is unavailable to others with whom he is dealing B. Theories of 10b-5 Liability for omissions/duty to disclose Theory is buyer beware Equal Access Theory: All traders owe duty to the market to disclose or refrain from trading on non-public corporate information o No longer a good theory, but used in Texas Gulf Sulphur, Cady-Roberts Fiduciary Duty Theory: Must show a specific, pre-existing legal relationship of trust and confidence b/w the insider and the counterparty in order to establish that an insider violates 10b-5 by breaching a duty to disclose or abstain to an uninformed trader o Used in Chiarella, Dirks o Applies also to law firms, investment banks, consultants of the issuer who are temporary insiders Misappropriation Theory: A person who has misappropriated nonpublic info has an absolute duty to disclose that info or refrain from trading o Burger dissent in Chiarella C. Differences Between Fiduciary Duty and Misappropriation Theories Directors & Officers trading on insider info: Covered by Both: He breached fiduciary obligation to the SHs and also to the company Company itself engages in a share repurchase on basis of insider info (Covered Only by Fiduciary Duty) 86

o B/c not misappropriating their own info, but breaching fiduciary duty to SHs Giving info to Analysts to give a good spin (Covered only by Fiduciary Duty for the same reason) One just happens to hear the information Covered by Neither
SEC v. Texas Gulf Sulphur Co (2nd Cir.) Geologists find zinc/copper deposit and President enforces secrecy to let the company buy land. Then it issues options to top executives to buy, and everyone starts buying. To quiet speculation, TGS releases a misleading press lease and SEC brings a 10(b) action. o Directors not held liable solely on basis of issuing misleading press release. o Breached 10(b)-5 by virtue of the fact that they had access to info that no one else had a legal right to access o Directors have a duty either to disclose information or refrain from trading. o Decided under Equal Access Theory no longer persuasive for 10(b)-5 o Problem: No common law norm creating a duty to the marketplace as a whole to everyone in the market: Court didnt discuss DUTY

D. Limiting factor: Violations under 10b-5 require some form of misrepresentation, material omission, or fraud (Santa Fe)
Santa Fe Industries v. Green (US SC) Santa Fe tries to do short-form merger of Kirby Lumber. Morgan Stanley appraises FMV of Kirbys assets at $630/share, values stock at $125/share and offers $150/share in short form merger. Minority SHs allege 10b-5 violation for fraudulent appraisal o No insider trading here b/c no misrepresentation, material omission, fraud, manipulation or deception o It may be a fiduciary violation, but not the type protected in insider trading law under 10b-5; more likely corporate mismanagement by Kirbys board vis--vis minority shareholders to which they owed fiduciary duties. o Fiduciary duties are a matter of state, ot federal law, so rule 10b-5 does not cover this situation; court reluctant to federalise substantial part of corporate law but allowing such conduct to fall under the rule. o The shareholders should have either accepted the price or made use of their appraisal rights (shareholders wish to avoid this since it is costly, no class action possible).

E. Must be a Relationship of Trust and Confidence for there to be a duty to not trade on inside info (Chiarella) Incidental insiders
Chiarella v. United States Chiarella is EE in financial print shop and finds out the identity of a target from merger press release which is to be published the next day. Chiarella buys the Ts stock and immediately sells after the deal gains $30,000. o No violation of 10b-5 because there is no relationship of trust and confidence with those trading opposite (no duty to the market; no general duty to disclose trading on material non-public information; equal access theory rejected) o No duty to disclose; no relationship of trust and confidence (printer was not companys agent, fiduciary or person in whom sellers had placed their trust and confidence). The printer lacked a relationship-based duty to SHs of the target company in whose securities he traded (this is the fiduciary duty theory); he was an outsider with whom the sellers only dealt with on an impersonal contract basis. o Note: Garden variety insider trading (e.g., a director or officer doing it) is still protected Burger (dissent):a person how has misappropriated information has an absolute duty to disclose that information or refrain from trading. Possessing misappropriated non-public information constitutes an unfair trading advantage.

Tippers Tipping is a derivative violation of 10b-5: a tipper must first violate the duty by tipping 87

improperly; the tippee, who orginally owes no duty, then assumes the tippers duty by trading. The tipper can only violate his duty if he tips to secure a personal benefit from the tippee and trades indirectly on his own tip.
Dirks v. SEC (SC 1983) Dirks is investment advisor who receives info from Secrist (former officer of Equity) that Equitys assets are overstated due to fraud. Dirks does research on Equity and tells his clients, who sell their Equity stock. o No violation of 10b-5, b/c the insider is not the one who personally benefited o Secrist would incur liability if he traded on the info (hes the insider), but no liability for Dirks to use the info o If theres no underlying breach of duty by the insider, there is no secondary breach of duty by the tipee (aider and abettor) Underlying breach by insider comes when insider personally benefits from his confidential disclosure o Anytime someone who knows more makes a deal, someone gets hurt, but harm isnt legally cognizable in all situations o If the rule is too expansive, analysts could be punished if theyre contacted by managers who reveal info Blackmun (dissent): makes no difference whether insider gained or intended to gain personally from the transaction.

Solutions to problem of incidental insiders and tippers (1) Regulation Fair Disclosure (FD) 2001 (for provisions see p. 617) An issuer or officer/director of issuer cannot reveal information selectively when disclosing to market professionals (nonpublic information used to be disseminated to certain favoured analysts, brokers, journalists) o Does not apply to persons who owe a duty of trust and confidence to the issuer, like lawyers, I-bankers o But now theres a concern that less info will get out (2) Rule 14e: Equal Access Rule for Tender Offers 14e-3(a): It is a violation of 14(e) to purchase or sell securities on the basis of info that the possessor knows or has reason to know is non-public and originates w/ the tender offeror or the target or their officers o Creates duty in those traders who fall w/in its ambit to abstain or disclose, w/o regard to whether the trader owes a pre-existing fiduciary duty to respect the confidentiality of the information 14(e)(d): It is a violation for a possessor to communicate the info described in (a) under circumstances in what the tipee is reasonably likely to trade on that info This rule effectively reintroduces the Equal Access norm by regulatory fiat in limited domain ofcorporate takeovers (3) Courts adoption of Misappropriation Theory to Counteract Dirks and Chiarellas Limiting of Insider Trading The deceitful misappropriation of market sensitive information is itself a fraud that may violate Rule 10b-5 when it occurs in connection with a securities transaction. Outlaws trading on the basis of non-public information by a corporate outsider in breach of a duty owed not to a trading party but to the source of information, the corporate employer or client (OHagan) o Deception related to the SOURCE of information, rather than the relationship to other traders o Wrong b/c it uses info that rightfully belongs to someone else 88

o BUT doesnt offer any doctrinal basis for civil recovery by someone other than the entity who owns the information rights (such as an uniformed trader in stock).
US v. Chestman (2nd Cir. 1991) Ira Waldbaum plans to sell his control in Waldbaums to A&P for $50/share with simultaneous tender offer for public shares. Ira tells sister who tells daughter who tells husband Loeb. Despite warnings at each step not to reveal, husband tells Chestman (broker) about the sale. Loeb buys for himself, Chestman buys for himself, Loeb, and other clients. o Chestman loses under 14e-3 disclosure provision to regulate fraud with tender offers o Chestman wins under 10b-5:

Hes a tipee; he did not misappropriate the info himself. Loeb is not an EE/officer/director of Waldbaum In order to convict him, it must be shown that Loeb (1) breached a duty owed to the Walburn family or his wife based on a fiduciary or similar relationship of trust and confidence, and (2) Chestman knew that Loeb had done so TODAY, result would be different under 10b5-2

Misappropriation of nonpublic information by family members or non-business relations give rise to liability when a duty of trust and confidence is present. Such a duty is present (1) whenever a person agrees to maintain information in confidence; (2) whenever two persons have a history or pattern or practice of sharing confidences wush that the recipient of the information should know that the information should be kept in confidence; or (3) whenever a person receives material nonpublic information from a spouse, partner, child or sibling, provided that the recipient may defend by demonstrating that no duty of trust and confidence existed (she neither knew nor reasonably should have known that the speaker expected confidentiality based on agreement or parties history.

US v. OHagan (SC 1997) Grand Met hires D&W to represent it in its acquisition of Pillsbury. OHagan is D&W partner but doesnt work on the deal (no fiduciary duty as temporary insider). OHagan buys Pillsbury stock in his own name, D&W withdraws from Grand Met and Grand Met tenders for Pillsbury o US SC accepts misappropriation theory which outlaws trading on the basis of non-public information by a corporate outsider in breach of a duty owed not to a trading party but to the source of information o OHagan breached a duty of trust and confidence he owed to his law firm and its client. o The outlawed trader gains his advantageous market position through deception deceives the source of the info by feigning loyalty (O Hagan did not disclose to law firm that he would trade on non-public information) and simultaneously harms members of the investing public US v. Carpenter (1987) Winans writes for WSJ (and all news gleaned for employment is confidential). Winans gives financial info to stockbrokers at Killer Peabody through Carpenter, the messenger. o All convictions affirmed on mail/wire fraud, but split on whether 10b-5 applies o NOTE: If case were post-OHagan, convictions would have gone through b/c duty to WSJ, trading on the info cashes in on the fiduciary breach on the WSJ, and it is non-public info It is a breach of fiduciary duty only b/c WSJ had a policy about trading on insider info; if not, no misappropriation

(4) Insider Trading Act (ISTA) (1984) and Insider Trading in Securities Fraud Enforcement Act (ITSFEA) (1988) Amendments to 34 Act 89

 20A: Private right of action for any trader opposite an insider trader, damages limited to profit gained or losses avoidedthis isnt usually enough to support a s law firm in bringing a class action 21A(a)(2): Allows civil penalties up to 3X the profit gained or loss avoided o RATIONALE: Problem is that if disgorgement is the only remedy, you wont be deterred (need criminal sanctions or 3X damages) 21A(a)(1)(B): controlling person may be liable too, if the controlling person knew or recklessly disregarded the likelihood of insider trading and failed to take preventive steps 21A(e): bounty hunter provision which allows SEC to provide 10% recovery to those who inform on insider trading SEC Hierarchy 21(d): SEC can seek disgorgement of trading profits 20A(a): if SEC fails to act, of if any trading profits left over after SEC has acted, contemporaneous traders can seek disgorgement as well 21A(a)(2): SEC can seek civil penalties up to 3X profits gained or loss avoided, in addition to disgorgement Ad(2) Materiality
Basic v. Levinson (SC 1988) Basic Industries engaged in merger negotiations with Combustion for 2 years but denied rumors of pending deal 3x. Basic SH who sold after 1st public denial claimed 10b-5 violations by Basic directors o This information was material: a reasonable shareholder would regard it as important in deciding how to act; there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by a reasonable investor as having significantly altered the total mix of information made available. (Materiality depends on the significance the reasonable investor would place on the withheld or misrepresented information). o There is no affirmative obligation to disclose material info, but should not state lies or half-truths Basic should have said no comment o There was reliance b/c SH is entitled to rely on the market price, which should reflect the press releases o Standing to sue by anyone who sold during the entire period that the company lied about no M&A o Damages: SHs out-of-pocket losses, difference b/w companys real worth if info revealed and the share price

pay)

IRONY: The SHs that havent sold are the ones who end up paying the price (b/c the corp has to

Ad (3) Fraud Requires scienter or intention to deceive. Ernst & Ernst: liability under 10b-5 requires specific intent to deceive, manipulate or defraud. May be inferred from reckless or grossly negligent behaviour. Private Securities Litigation Reform Act (PSLRA) 105b-1(c)(1)(i): defendants may avoid liability if they can demonstrate that they had entered into an agreement to trade on securities on specified terms before becoming aware of the material nonpublic information and that the actual trading of securities was in compliance with the 90

terms of the agreement. Ad(4) Standing The plaintiff must have been a buyer or seller of stock in order to have standing to bring a complaint about an alleged infringement of Rule 10b-5. Must be a purchase or sale of securities (Blue Chip Stamp); i.c. company offered sale of its shares to a class of certain persons at a set price. Plaintiff declined offer to invest but later claimed that the offering document had been materially false and had it been true, they would have invested. Court denied claim, no sale or purchase. Different from 14e: people who dont tender can claim damages b/c of misrepresentation from a tender offer (I would/would not have tender if I have known) Ad(5) Reliance What if a false statement is made by an insider that affects the market price, but a shareholder never hears the false statement? Basic v. Levinson Fraud on the Market Theory: Presumption of reliance on integrity of market price, but because of misrepresentations that price had been fraudulently depressed. Market was deceived of material information so people who traded during this period of deception are due the difference b/w true value and what shares were trading at. Insider is taking a portion of the capitalized value of the corporate opportunity This doctrine reduces the risks/costs of trading on the market and the cost of equity capital White (part dissent): do not equate causation with reliance; recovery should not permitted by a plaintiff who merely claims that he was harmed by a material misrepresentation which altered a market price, notwithstanding proof that the plaintiff did not in any way rely on that price.Fraud on the Market Theory must be capable by rebuttal, if defendant can show that plaintiff did not rely on the market price. Ad(6) Causation Reliance must cause a loss to the party relying on a material misstatement. Transaction Causation: If truth were known, would the transaction have gone through? Loss Causation: Was the cause of the loss related to the information that was not disclosed? Defenses: SH would have sold anyway or SH didnt rely on the market price Ad(7) Damages
Elkind v. Liggett & Myers (1980) Shareholders bring a class action suit against L&M for wrongful tipping if inside information about an earnings decline to certain persons who then sold Liggett shares on the open market. Where buyer is induced to purchanse a companys stock by materially misleading statements or omissions the accepted measure of damages is the out-of-pocket measure: The difference between the price paid and the value of the stock received. On the open market which is characterised by impersonality, however, this measure is inadequate. Another measure is permitting recovery of damages caused by erosion of the market price of the security that is traceable to the tippees wrongful trading (the loss in market value as a result of tippees conduct). But this loss is not easily measurable. The prefferable alternative is to (1) allow any uninformed investor, where a reasonable investor would have either delayed his purchase or not purchased at all if he had the benefit of the tipped information , to recover any post-

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purchase decline in market value of his shares up to a reasonable time after he learned of the tipped information or after there is a public disclosure of it, but (2) limit his recovery to the amount gained by the tippee as a result of his selling at the earlier date rather than delaying his sale until the parties could trade on an equal information basis.

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