CORPORATIONS Prof.

James Feinerman (Powerpoint Fall 2011) o Agency Principal and Agent Master and Servant; Independent Contractors o o o o o o o o o Agents As Fiduciaries Creation Of Authority -- General Rule Apparent Authority How Agencies Are Created Express agency Implied agency Ostensible agencies Agency by estoppel Agency by ratification Dual agency

of trust incident to that employment, even though those engaged in the practice of accountancy would regard as unusual the collecting and disbursing of a client's funds by an accounting firm. Reversed and remanded. Agent can impose liability upon his principal even where there is no actual or apparent authority or estoppel, as the agent may have an inherent agency power to bind his principal. General agent for disclosed or partially disclosed principal subjects his principal to liability for acts done on his account which usually accompany or are incidental to transactions which the agent is authorized to conduct if, although they are forbidden by the principal, the other party reasonably believes that the agent is authorized to do them and has no notice that he is not so authorized. If third person reasonably believes that service he has requested of member of an accounting partnership is undertaken as part of the partnership business, the partnership should be bound for breach of trust incident to that employment even though those engaged in the practice of accountancy would regard as unusual the performance of such service by an accounting firm. Reasonableness of third person's belief in assuming that partner is acting within scope of partnership should not be tested by profession's own description of the function of its members, but question must be answered upon basis of facts in particular case. In view of fact that it was reasonable for accounting firm client, who dealt exclusively with one partner of the firm, to assume that the added assignment she delegated to the partner of collecting and disbursing her funds delegated to the partner was an integral part of the proper functions of the partner who kept the accounts reflecting the income and disbursement of those funds, the accounting partnership was liable for the partner's breach of trust incident to that employment, even though those engaged in the practice of accountancy would regard as unusual the collecting and disbursing of a client's funds by an accounting firm. Accounting partnership client whose affairs were handled exclusively by one of the partners did not act unreasonably in trusting the partner further after learning of his unauthorized payment of the client's funds to the client's husband, and accordingly, client was not estopped from asserting against the partnership her claim for subsequent breaches of duty by the partner in paying out money to himself and to his client's husband.

Proof of Agency Authority of Agents Express authority Implied authority Delegation of agents authority Duties of an Agent Fiduciary duties Full disclosure Due care Loyalty Honesty Integrity Obedience Agents duty Fiduciary Duties Obedience Loyalty Disclosure Confidentiality Duty to Account Reasonable Care CROISANT V. WATRUD Suit in equity for an accounting brought against copartners in firm of certified public accountants and against executrix of a deceased partner. The Circuit Court rendered judgment in favor of defendants, and plaintiff appealed. The Oregon Supreme Court held that, in view of fact that it was reasonable for an accounting firm client, who dealt exclusively with one partner of the firm, to assume that the added assignment she delegated to the partner of collecting and disbursing her funds was an integral part of the proper functions of the partner who kept the accounts reflecting the income and disbursement of those funds, the accounting partnership was liable for the partner's breach

TARNOWSKI V. RESOP Action by principal against agent for damages which resulted when principal had been compelled, by agent's breach of duties, to sue third parties for rescission of sale on ground of fraud. The District Court entered judgment for plaintiff, and defendant appealed. The Minnesota Supreme Court held that election by principal to sue third parties for rescission did not bar action against agent to recover expenses and losses resulting from agent's wrongful conduct. Affirmed. All profits made by an agent in course of an agency belong to principal, whether they are fruits of performance or of violation of agent's duty, and it is immaterial that principal has suffered no damage, or even that transaction concerned was profitable to him. Where agent of buyer received secret commission from seller of business, election by buyer, upon discovery of fraud in transaction, to rescind contract of sale and recover from seller that with which he had parted, did not preclude subsequent action by buyer against his agent to recover secret commission obtained in violation of duties of agency. If agent has received benefit as result of violating his duty of loyalty, principal is entitled to recover from agent what he has so received, its value, or its proceeds, and also the amount of damage thereby caused, except that if violation consisted of wrongful disposal of principal's property, principal cannot recover its value and also what agent received in exchange therefor. A tort-feasor is answerable for all injurious consequences of his tortious act which, according to usual course of events and general experience, were likely to ensue and which, when the act was committed, might reasonably be supposed to have been foreseen and anticipated. Where violation by agent of buyer of fiduciary duties necessitated suit by buyer against sellers of business to recover amount with which buyer had parted as result of fraud, buyer was entitled to recover in separate suit against his agent, amount expended for attorney's fees and expenses of suit against seller, as well as such other expenses and losses which were direct consequence of agent's wrongful conduct. Dismissal of action by buyer against sellers for rescission of sale upon cash payment by sellers did not bar subsequent action by buyer against his agent to recover elements of damage in relation to sale transaction which were recoverable against agent and which were not involved in action for rescission. Directors and officers have a fiduciary duty to the corporation and its stockholders

Directors and officers have a fiduciary duty to the corporation and its stockholders. A mere employee of a corporation does not ordinarily occupy a position of trust or confidence, unless he is also its agent. Fiduciary duties result from the nature of the employment, and without any stipulation to that effect. No act of the directors, in violation of their own duties, and in fraud of the stockholders, will justify an officer in violating his fiduciary duties. The fiduciary duty extends to existing stockholders, but not to prospective stockholders, although, it has been held that the confidential relation extends not only to existing stockholders, but also to persons invited to purchase stock, and subscribers. The duty extends to pledgees of stock. It has been held both that directors and officers do and do not owe a fiduciary duty to individual shareholders, as distinct from the shareholders collectively. Where there is only one shareholder, a decision in the interest of that shareholder which does not harm any creditor is not a breach of the duty to the corporation. A shareholder may not complain of acts of corporate mismanagement if he acquired his shares from those who participated or acquiesced in the allegedly wrongful transactions. DUTIES -- LOYALTY In discharging their function of managing the business and affairs of the corporation, directors owe fiduciary duties of care and loyalty to the corporation. The duty of loyalty is a broad encompassing duty, that in appropriate circumstances, is capable of impressing a special obligation upon a director in any of his or her relationships with the corporation. The duty of loyalty mandates that the best interest of the corporation and its shareholders take precedence over any interest possessed by a director, officer or controlling shareholder and not shared by the shareholders generally. The duty of loyalty is fiduciary in nature, by reason of which the officer is held to something stricter than the morals of the market place. The duty obtains most directly when the officer is interested personally in a matter affecting the corporation. The concept of interest is broadly defined and includes cases where the officer has a relationship with a party to the transaction that may reasonably be expected to affect the officer's judgment or is subject to the influence and domination of such a party. Yet, the duty goes beyond this and is coextensive with the legitimate, enduring interests of the corporation. DUTIES - CARE In addition to their duty of loyalty, discussed in the previous slide, directors and officers of a corporation are required by law to perform their obligations in accordance with a minimum standard of care. Courts apply the duty of care in cases involving alleged 2

negligence, mismanagement, or intentional decisions to commit unlawful acts. Cases involving fraud, self-dealing, and conflicts of interest are covered under the duty of loyalty. The standard of care for directors and officers of business corporations is derived from common law and state business corporations codes. This standard is tempered by the business judgment rule (BJR), a common-law doctrine under which courts generally refuse to second-guess a business decision, so long as management made a reasonable effort to make an informed decision. We will examine many cases adumbrating the BJR, especially in the courts of Delaware. PARTNERSHIP Partnerships are governed both by common law and by statutory laws. Agency Concepts and Partnership Law: Each partner is deemed to be an agent of the other. There may be imputation of liability. Each partner is a fiduciary of the other. Law Governing Partnerships Partners are agents and fiduciaries of one another, but differ from agents in that they are also co-owners and share in profits and losses. Sources of Law: State common law. Uniform Partnership Act (UPA), adopted by all states in some form. Revised Uniform Partnership Act (RUPA): adopted by some states. Definition of Partnership Partnership is created when two or more persons agree to carry on business for profit as co-owners with equal right to manage and share profits (UPA). Disadvantages Partners are personally liable for all torts/contracts Dissolved upon death Difficult to raise financing

The Nature of Partnerships At common law, the partnership was not a separate legal entity from its owners. Today, partnership law in many states recognizes a partnership as an independent entity for some purposes. Partnership as an Entity Today, many states recognize the partnership as a separate legal entity for the following purposes: To sue and be sued (for federal questions, yes; for state questions, differs). To have judgments collected against its assets, and individual partners assets. Partnerships are recognized as separate legal entities (contd): To own partnership property. To convey partnership property. At common law -- property owned in tenancy in partnership, all partners had to be named and sign the conveyance. Under UPA partnership property can be held and sold in firm name. Partnership as an Entity [3] Partnerships are recognized as separate legal entities (contd): For marshaling of assets. Federal Bankruptcy changes marshaling of assets. To keep its own books. File its own federal/state tax returns. Aggregate Theory of Partnership. Partnership pays no federal income tax. MARTIN V. PEYTON Partnership results from contract, express or implied. Where contract as a whole contemplates association of two or more persons to carry on business for profit as co-owners, there is partnership, notwithstanding statement that no partnership is intended, in view of Partnership Law. A contract which, taken as a whole, contemplates anything less than an association of two or more persons to carry on as co-owners a business for profit does not create a partnership. In determining whether contract between parties creates partnership, arrangement for sharing profits should be considered and given due weight, but it is not decisive, since it may be merely method adopted to pay debt or wages, interest on loan, or for other reasons. Agreement expressed in three documents, whereby securities were loaned to partnership and lenders acquired supervisory powers with option to enter firm and to accept resignation of any member, held not to create partnership. Where written contract between parties is complete and expresses in good faith full understanding and obligation of parties, it is for court to say whether partnership exists. 3

Advantages Easy to create and maintain Flexible, informal Partners share profits and losses equally

Definition of Partnership If a commercial enterprise shares profits and losses a partnership will be inferred. Exceptions: Partnership not inferred if profits received as payment in the following situations: Debt by installments of interest on a loan. Wages of an employee. Rent to a landlord. Annuity to a widow or representative of a deceased partner. Sale of good will.

NATIONAL BISCUIT CO., INC. V. STROUD Proceeding by seller of bread against former partners who had operated food store for value of goods sold and delivered. The Superior Court rendered judgment for seller, and partner appealed. The Supreme Court majority held that purchase of bread by food store operated as going concern by two partners was an ordinary matter connected with partnership business within statute to effect that any difference arising as to ordinary matter connected with partnership business may be decided by majority of partners, and although partner told bread seller he would not be personally responsible for additional bread sold to store, partner and partnership were liable for such purchase by copartner. Affirmed. Rodman, J., dissented. At the close of business on 25 February 1956 Stroud and Freeman by agreement dissolved the partnership. By their dissolution agreement all of the partnership assets, including cash on hand, bank deposits and all accounts receivable, with a few exceptions, were assigned to Stroud, who bound himself by such written dissolution agreement to liquidate the firm's assets and discharge its liabilities. It would seem a fair inference from the agreed statement of facts that the partnership got the benefit of the bread sold and delivered by plaintiff to Stroud's Food Center, at Freeman's request, from 6 February 1956 to 25 February 1956. But whether it did or not, Freeman's acts bound the partnership and Stroud. MEINHARD V. SALMON A joint venture with terms embodied in a writing. Meinhard was to pay to Salmon half of the money requisite to reconstruct, alter, manage, and operate the property. Salmon was to pay to Meinhard 40 per cent of the net profits for the first five years of the lease and 50 per cent for the years thereafter. If there were losses, each party was to bear them equally. Salmon, however, was to have sole power to 'manage, lease, underlet and operate' the building. There were to be certain pre-emptive rights for each in the contingency of death. They were coadventurers, subject to fiduciary duties akin to those of partners. Questions What was Meinhards theory of liability? What was the basis of Salmons defense? (Hint: difference between partnership and joint venture); Why did Cardozo side with Meinhard? In particular, where did Salmon go wrong? Hypotheticals Suppose Salmon disclosed Gerrys proposal to Meinhard, but then competed vigorously with Meinhard for the contract and won. Result? Suppose the new lease was for different plot of land

and hadnt come from Gerry. Result? What if Salmon could prove that Gerry hated Meinhard, and wouldnt have dealt with him? What if the opportunity came to Meinhard (the silent partner)? What if they both managed? Rationale for the Outcome? Does this holding make sense from a property rights perspective? Does outcome support both parties investment backed expectations of their property rights? What about from a contractarian perspective? How long do you think Meinhard & Salmon envisioned their relationship lasting? Suppose M & S anticipated this potential contingency in April of 1902. Would they have favored a rule mandating disclosure by Salmon? Fiduciary Duty Judge Cardozos words Many forms of conduct permissible in a workaday world for those acting at arms length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is thenthe standard of behavior. How did Salmon breach his fiduciary duty to Meinhard? Elf Atochem North America, Inc. v. Jaffari and Malek Member of limited liability company (LLC) brought purported derivative suit against LLC and its manager, alleging, inter alia, breach of fiduciary duty. The Court of Chancery dismissed suit for lack of subject matter jurisdiction. Member appealed. The Delaware Supreme Court held that: (1) limited liability company was bound by agreement defining its governance and operation, even though company did not itself execute agreement, and (2) contractual provisions directing that all disputes be resolved exclusively by arbitration or court proceedings in California were valid under Limited Liability Company Act. A limited liability company agreement will only be invalidated when it is inconsistent with mandatory statutory provisions Limited liability company was bound by agreement defining its governance and operation, and derivative claims brought on its behalf were therefore subject to arbitration and forum selection clauses of the agreement, even though the agreement was only signed by the members and not by the company, itself. In the corporate context, the derivative form of action permits an individual shareholder to bring suit to enforce a corporate cause of action against officers, 4

directors and third parties. The derivative suit is a corporate concept grafted onto the limited liability company form. Members of a limited liability company may contract to avoid the applicability of statutory provisions giving Court of Chancery subject matter jurisdiction over certain claims. While Limited Liability Company Act allowed members of limited liability company to bring actions involving removal of managers and interpretation of limited liability company agreements in the Court of Chancery, it did not afford Court of Chancery special jurisdiction to adjudicate member's breach of fiduciary duty and removal claims despite a clear contractual agreement to the contrary. DUTIES AND LIABILITIES OF AGENT TO PRINCIPAL

District Court certified a question to the Supreme Court. The Supreme Court held that the equitable remedy of piercing the veil is an available remedy under the Limited Liability Company Act. N.B. Advisory Opinion (Certified question answered). Available in STATE court!

As a general rule, a corporation is a separate entity distinct from the individuals comprising it. Piercing the corporate veil is an equitable doctrine. The concept of piercing the corporate veil is a judicially-created remedy for situations where corporations have not been operated as separate entities as contemplated by statute and, therefore, are not entitled to be treated as such. COMMON BUSINESS ENTITIES

376. General Rule The existence and extent of the duties of the agent to the principal are determined by the terms of the agreement between the parties 377. Contractual Duties A person who makes a contract with another to perform services as an agent for him is subject to a duty to act in accordance with his promise 379. Duty Of Care And Skill Unless otherwise agreed, a paid agent is subject to a duty to the principal to act with standard care and with the skill which is standard. 381. Duty To Give Information 382. Duty To Keep And Render Accounts 383. Duty To Act Only As Authorized 385. Duty To Obey 386. Duties After Termination Of Authority Duties Of Loyalty 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 389 390 Acting As Adverse Party Without (With) Principal's Consent 391 392 Acting For Adverse Party Without (With) Principal's Consent 393 396 Competition, Conflicts of Interest, Uses of Confidential Information during and after Agency

Sole Proprietorship Partnership S Corporation C Corporation Limited Liability Company Single Member Limited Liability Company Factors to Consider in Selecting an Appropriate Business Entity Liability - Limited Liability v. Personal Liability Tax Implications Complexity of Formation and Management Capital - effect on ability to raise capital through angel investment, venture capital, or initial public offering (IPO) Credibility in the business world Sole Proprietorship An individual (or husband and wife team) carrying on a business for profit Unlimited personal liability Single level of income tax - all income and expense items reported on Schedule C of the owners 1040 Relatively simple to start If business conducted other than under the name of the sole proprietor, assumed name publication needed Managed by the sole proprietor Any transfer of the business would be of the underlying assets as opposed to a transfer of shares in the business Capital needs - addressed through loan to sole proprietor General Partnership Association of two or more co-owners carrying on business for profit Partners have unlimited personal liability for partnership debts 5

KAYCEE LAND AND LIVESTOCK v. FLAHIVE Landowner brought action for damages against limited liability company (LLC) and its managing member, alleging that the LLC had caused environmental damage to the land when exercising its contractual right to use the surface of the land. The

 Pass through tax treatment (partnership files form 1065 but all income and expense items pass through to individual partners on schedule K-1) Relatively easy to start - partnership agreement is typically entered into but is not legally required Managed by the partners or as described in the partnership agreement; Problem: any partner can bind the partnership Ability to raise capital limited since most investors would prefer to invest in an entity offering limited liability LLC is almost always the better choice if partnership tax treatment is the goal S Corporation Limited liability for shareholders even if they participate in management Pass-through tax treatment under most circumstances but not as complete as for the LLC Formation steps include filing Articles of Incorporation with the Secretary of State, filing sub S election with the IRS, adoption of bylaws, and, usually, adoption of a shareholder (buy-sell) agreement Limitations on the number of shareholders and the type of shareholders limits ability to raise capital Limit of 75 shareholders Only one class of stock is allowed so ability to give priority return of capital to investors compromised Differences in voting rights is allowed Partnerships and corporations cannot be shareholders Only citizens or residents of USA can be shareholders Is easier to convert S corp to C corp than it is LLC to C corp in event venture capital is sought C Corporation Limited liability for shareholders even if they participate in mgmt Tax at both corporate and shareholder level. This double level tax can be avoided to some extent by payment of reasonable salaries to shareholders in exchange for services actually rendered Formation similar to S corporation except sub S election not filed with IRS Typically required for publicly traded corporations, businesses that require venture capital, or if a broad based stock option program is utilized No limits on type or numbers of shareholders Different classes of stock allowed thus enabling different priority for return of capital Common Stock Preferred Stock Limited Liability Company Combines limited liability provided by a corporation with pass-through partnership tax treatment LLC files a partnership tax return with all income and expenses being passed through to individual owners of the

LLC Formation steps include filing articles of organization with the Secretary of State, contributing an appropriate amount of capital, and adopting an operating agreement Can be managed by the members or, more often, by managers selected by the members. Can also elect officers Self-employment tax treatment less favorable than for S corporation Offers several advantages over the S corporation: 1. No limitation on the number of members 2. No limitation on who may invest (corporations, partnerships, and non US residents can invest) 3. Treatment of gain on distribution of appreciated property more favorable 4. Different classes of ownership are allowed so there is the flexibility to provide for a priority return of capital to investors Single-Member Limited Liability Company Limited liability for owners makes it a better choice than a sole proprietorship unless cost of formation or maintenance is a controlling factor Disregarded entity from an income tax perspective All income and expenses are reported on the sole members tax return and no income tax return need be filed by the LLC Formation process similar to multiple-member LLC, except that the operating agreement will likely be less complex In addition to circumstances where a sole proprietorship would be considered, a single-member LLC is often used by a corporation or LLC to insulate the liability associated with a particular line of business DODGE v. FORD MOTOR CO. A business corporation is organized primarily for the profit of the stockholders, and the discretion of the directors is to be exercised in the choice of means to attain that end, and does not extend to the reduction of profits or the non-distribution of profits among stockholders in order to benefit the public, making the profits of the stockholders incidental thereto. Where a corporation had on hand about $54,000,000 cash with a constant income of over $60,000,000 per year profits, and proposed improvements and extensions would not exceed $24,000,000, the court did not err in requiring that directors declare an extra dividend of $19,000,000, in an action by minority stockholders. Where a corporation had a surplus of $112,000,000, about $54,000,000 cash on hand, and had made profits of $59,000,000 in the past year with expectations of $60,000,000 the coming year, refusal of directors to declare a dividend of more than $1,200,000 was, in the absence of some 6

justifiable reason, an arbitrary exercise of authority which would give a court of equity the right to interfere. BUT It is a well-recognized principle of law that the directors of a corporation, and they alone, have the power to declare a dividend of the earnings of the corporation, and to determine its amount. Courts of equity will not interfere in the management of the directors unless it is clearly made to appear that they are guilty of fraud or misappropriation of the corporate funds, or refuse to declare a dividend when the corporation has a surplus of net profits which it can, without detriment to its business, divide among its stockholders, and when a refusal to do so would amount to such an abuse of discretion as would constitute a fraud, or breach of that good faith which they are bound to exercise towards the stockholders.'

More than half a million business entities have their legal home in Delaware including more than 50% of all U.S. publicly-traded companies and 58% of the Fortune 500 Corporate Chartering in US Federalism Federal Government Regulates Stock Offerings, Protects Investors, and Sets Standards for Financial Disclosures State Governments Regulate Corporation Actions Under Civil and Common Law Regimes State of Incorporation Very Important Why Delaware? First mover advantage History lesson on Incorporations Primary Corporate Market has been in New York as Commercial Capital of US th In late 19 Century States Began to Experiment with Corporate Law to become more flexible in regulating incorporations and rules governing the separation of ownership and management New Jersey was the first successful state to move into corporate charter business Delaware entered into the market after New Jersey enacted a series of anti-trust laws Delaware Law Features Allows flexibility of drafting corporate charters Law sets basic structure Respecting the right to free contract Shareholder franchise Board initiation Basic Principles duty of due care to shareholders duty of loyalty duty of good faith Delaware Who decides? Delaware Court of Chancery Delaware's court of original and exclusive equity jurisdiction, and adjudicates a wide variety of cases involving trusts, real property, guardianships, civil rights, and commercial litigation Delaware Supreme Court Delaware's court of final appeal to which appeals from the Delaware Court of Chancery immediately proceed Institutions are Important! Courts and regulators have played an important role to ensure that corporate governances mechanisms are effective and efficient Management, General Directors, CEOs, Individual directors and the board as a whole need to be held to their duties of care and loyalty to the firm and to apply business judgment in their decisions 7

A. P. SMITH MFG. CO. v. BARLOW Action brought by corporation for judgment declaring its contribution to a privately supported educational institution to be within its powers, where defendants asked for judgment declaring the contribution to be a misappropriation of corporate funds and an ultra vires act in violation of property and contract rights of defendants and of other stockholders of the plaintiff corporation. The Superior Court, Chancery Division, held the donation to be intra vires. An appeal taken to the Appellate Division was certified directly to the Supreme Court which held that the corporate power to make reasonable charitable contributions exists under modern conditions even apart from express statutory provisions. Where justified by advancement of public interest, reserved power of State to alter corporate charter may be invoked to sustain later charter alterations even though they affect contractual rights between corporations and its stockholders and between stockholders Charitable contribution statutes were within powers reserved by State in granting corporate charter, and therefore such statutes did not unconstitutionally impair obligations of charter of pre-existing corporations or operate as a deprivation of property without due process of law Corporate power to make reasonable charitable contributions exists, under modern conditions, even apart from express statutory provision. Thus, a business corporation's contribution of funds for general maintenance of privately supported educational institution was not an ultra vires act. Delaware Corporate Governance Influence Why is Delaware Important? State based incorporation statues of the US Delaware Corporate Law tradition Delawares Corporate Registry

The strength of a joint stock company in a market system is the underlying principles of rule of law and fairness to the interest of all stockholders Delaware Code General Corporation Law Subchapter IV. Directors and Officers 141. Board of directors; powers; number, qualifications, terms and quorum; committees; classes of directors; nonprofit corporations; reliance upon books; action without meeting; removal (a) The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation. If any such provision is made in the certificate of incorporation, the powers and duties conferred or imposed upon the board of directors by this chapter shall be exercised or performed to such extent and by such person or persons as shall be provided in the certificate of incorporation.

CAMPBELL V. LOEW'S, INC. Action by a stockholder against a corporation, where stockholder requested a preliminary injunction restraining the holding of a stockholders' meeting, or alternatively, restraining the meeting from considering certain matters, or voting certain proxies. The Court of Chancery held, inter alia, that in view of fact bylaws of corporation authorized president to call special meetings of the stockholders for any purpose or purposes, president of the corporation was authorized to call a stockholders' meeting to fill director vacancies, amend the bylaws to increase the number of the board of directors, and to remove certain directors and fill such vacancies, even though such purposes were not in furtherance of routine business of corporation, and notwithstanding fact that such matters might have involved policy matters not defined by the board of directors, and therefore, court would not issue a preliminary injunction enjoining the holding of such meeting. A corporate bylaw giving corporate president the power to submit matters for stockholder action, could be presumed to only embrace matters which were appropriate for stockholder action, and so construed, such bylaw would not be deemed to impinge upon statutory right and duty of a corporate board of directors to manage the business of the corporation. Call of a stockholders' meeting, by corporate president, to fill director vacancies, to amend the bylaws to increase the number of the board, and remove certain directors and fill such vacancies, was not action of a character which impinged upon power of management given board of directors by statute.

Where corporate bylaws authorized president to call a stockholders' meeting for any purpose, mere fact that another section of the bylaws provided that stockholders might, on their initiative, call a meeting for the purpose of filling vacancies on board of directors, did not mean that president was deprived of power to call a stockholders' meeting for such purpose. Statute providing that not only vacancies, but newly created directorships of a corporation may be filled by majority of directors in office, unless it is otherwise provided in the certificate of incorporation, or by-laws, is not exclusive and does not prevent stockholders from filling new directorships between annual meetings. The board of directors of a corporation, acting as a board, must be recognized as the only group authorized to speak for "management" in the sense that by statute, they are responsible for the management of the corporation. Where a certain corporate faction was in charge of a corporation's facilities, and symbolized existing policy, it had sufficient status to justify reasonable use of corporate funds to present its position to the stockholders, and to expend reasonable sums of corporate funds in solicitation of proxies, although, to assure equal treatment between such faction and opposing faction in event of a proxy contest, such faction would be enjoined from using corporate facilities and employees in connection with its proxy solicitation. PIERCING THE CORPORATE VEIL

In General - Personal Liability for Corporate Debt Non-functioning of other officers and directors Siphoning of funds Absence of corporate records Corporation acts as faade for owners/shareholders Elements of injustice or fundamental unfairness General rule: The rule is the court may disregard the corporate entity if 1. there is Fraud or 2. Alter Ego Doctrine Unity of Interest: there is such a unity of interest and ownership such that the separate personalities of the corporation and the individual no longer exist the company is "a mere instrumentality or alter ego of its owner, and Injustice: Allowing shareholder to avoid liability would promote an injustice

Perception v. Reality Perception It is nearly impossible to pierce the corporate veil. Because limited liability holds such an esteemed place in our law, courts frequently opine that their power to pierce the veil should be exercised reluctantly, cautiously, or only in exceptional circumstances. 8

A Colorado Example: Insulation from individual liability is an inherent purpose of incorporation; only extraordinary circumstances justify disregarding the corporate entity to impose personal liability. Leonard v. McMorris, 63 P.3d 323 (Colo. 2003). Reality Courts will pay homage to the exceptional circumstances tradition, but do what they believe is right. An analysis of nearly 1,600 reported decisions revealed that courts pierced the corporate veil more than 40% of the time. Thompson, Piercing the Corporate Veil: An Empirical Study, 76 Cornell L.Rev. 1036 (1991). Development of the Piercing Doctrine When a plaintiff has a valid cause of action against an insolvent corporation, the Court must weigh two competing values. The first is societys desire to uphold the principle of limited liability, and the second is the desire to achieve an equitable outcome. Early decisions relied on equitable principles, and typically involved allegations of fraud. See, Booth v. Bunce, 33 N.Y. 139 (1865) General Rule If any general rule can be laid down, in the present state of authority, it is that a corporation will be looked upon as a legal entity as a general rule, and until sufficient reason to the contrary appears; but, when the notion of legal entity is used to defeat public convenience, justify wrong, protect fraud, or defend crime, the law will regard the corporation as an association of persons. A Remedy Not a Cause of Action Most Courts hold that piercing the corporate veil is an equitable remedy not a cause of action. Piercing the corporate veil is an equitable remedy, requiring balancing of the equities in each particular case. Great Neck Plaza, L.P. v. Le Peep Restaurants, LLC, 37 P.3d 485 (Colo. App. 2001); See also, Equinox Enterprises, Inc. v. Associated Media Inc., 730 SW2d 872 (Tex. App. 1987) BERKEY v. THIRD AVE. RY. CO.

required to be complete, in order for the parent company to be treated as liable for the debts of the subsidiary. It was needed that the subsidiary be merely the alter ego of the parent, or that the subsidiary be thinly capitalized, so as to perpetrate a fraud on the creditors. BARTLE v. HOME OWNERS COOPERATIVE Action to compel corporation to meet obligations of its subsidiary. The Supreme Court, Appellate Division, affirmed judgment of Supreme Court, Equity Term, dismissing complaint, and plaintiffs appealed. The Court of Appeals held that trustee of bankrupt subsidiary corporation could not maintain action to compel parent corporation to meet obligations of its subsidiary, where there had been neither fraud, misrepresentation nor illegality involved in incorporation of such subsidiary or its subsequent operation. Judgment affirmed. Doctrine of piercing corporate veil is invoked to prevent fraud or to achieve equity. The law permits incorporation of a business for very purpose of escaping personal liability. Trustee of bankrupt subsidiary corporation could not maintain action to compel parent corporation to meet obligations of such subsidiary, where there had been neither fraud, misrepresentation nor illegality involved in incorporation of such subsidiary or its subsequent operation. WALKOVSZKY v. CARLTON Action against corporation in name of which a taxicab was registered, driver of the taxicab, nine other corporations in whose names other taxicabs were registered, two additional corporations, and three individuals for injuries sustained by plaintiff when struck by the taxicab. The Supreme Court granted motion of an individual defendant who was claimed to be a stockholder of ten corporations, including corporation in name of which taxicab was registered, to dismiss the complaint as to him for failure to state a cause of action, and plaintiff appealed. The Supreme Court, Appellate Division reversed and denied the motion and individual defendant appealed by leave of the Appellate Division on a certified question. The Court of Appeals held that complaint containing allegations that individual defendant organized, managed, dominated and controlled a fragmented corporate entity and that fleet ownership of taxicabs had been deliberately split among many corporations was insufficient to state a cause of action against individual defendant as a stockholder in such corporations, where there was no allegation that individual defendant was conducting such business in his individual capacity. Order of Appellate Division reversed, certified queston answered in the negative, order of the Supreme Court, Richmond County, reinstated with 9

Actions by Minnie Best Berkey and Charles P. Berkey against the Third Avenue Railway Company, from an order of the Appellate Division reversing a judgment of the Trial Term, which dismissed complaints, and granting new trial, defendant appealed. Order reversed, and judgment of the Trial Term affirmed. The New York Court of Appeals held that the Third Avenue Railway Co was not liable for the debts of the subsidiary. It was necessary that the domination of the parent company over the subsidiary was

leave to serve an amended complaint. Courts will disregard the corporate form or pierce the corporate veil whenever necessary to prevent fraud or to achieve equity. Incorporation of a business is permitted for the purpose of enabling its proprietors to escape personal liability, although the privilege is not without limits. In determining whether liability should be extended to reach assets beyond those belonging to the corporation, courts will be guided by general rules of agency. Whenever anyone uses control of a corporation to further his own rather than the corporation's business, he will be responsible for the corporation's acts upon principle of respondeat superior applicable even where the agent is a natural person, and such liability extends not only to the corporation's commercial dealings, but to its negligent acts. Although either the circumstance that a corporation is a fragment of a larger corporate combine which actually conducts a business, or that a corporation is a dummy for its individual stockholders who in reality are carrying on a business in their own personal capacities for purely personal rather than corporate ends would justify treating the corporation as an agent and piercing the corporate veil to reach the principal, in the first circumstance only a larger corporate entity could be held financially responsible, while in the other circumstance the stockholders would be personally liable. In ascertaining whether a complaint states a cause of action, the entire pleading must be considered. Complaint containing allegations that an individual defendant organized, managed, dominated and controlled a fragmented corporate entity and that fleet ownership of taxicabs had been deliberately split among many corporations was insufficient to state a cause of action in tort against individual defendant as a stockholder in such corporations, where there was no allegation that individual defendant was conducting business in his individual capacity. The corporation form could not be disregarded merely because the assets of corporate owner of a taxicab together with mandatory insurance coverage on the taxicab which struck plaintiff were insufficient to assure plaintiff recovery sought.

MORRIS V. NEW YORK STATE DEPT. OF TAXATION AND FINANCE Board member of corporation brought action for judicial review of determination of Tax Appeals Tribunal regarding compensating use tax assessment. The Supreme Court, Appellate Division confirmed. Board member appealed. The Court of Appeals held that corporate veil could not be pierced so as to hold board member personally liable for compensating use taxes allegedly incurred by corporation.

Concept of "piercing the corporate veil" is limitation on accepted principles that corporation exists independently of its owners as separate legal entity, that owners are normally not liable for debts of corporation, and that it is perfectly legal to incorporate for express purpose of limiting liability of corporate owners. Attempt of third party to pierce the corporate veil does not constitute cause of action independent of that against corporation; rather it is assertion of facts and circumstances which will persuade court to impose corporate obligations on its owners. Although there are no definitive rules governing circumstances when corporate veil may be pierced, generally showing is required that: (1) owners exercised complete domination of corporation in respect to transaction attacked; and (2) such domination was used to commit fraud or wrong against plaintiff which resulted in plaintiff's injury. While complete domination of corporation is key to piercing corporate veil, especially when owners use corporation as mere device to further personal rather than corporate business, such domination, standing alone, is not enough; some showing of wrongful or unjust act toward plaintiff is required. Party seeking to pierce corporate veil must establish that owners, through their domination, abused privilege of doing business in corporate form to perpetrate wrong or injustice against that party such that court in equity will intervene. Even assuming that sole board member of closely held corporation owned by board member's brother and nephew dominated corporation, corporate veil could not be pierced so as to hold board member personally liable for compensating use taxes allegedly incurred by corporation; there was no evidence of intent to defraud and thus board member did not misuse corporate form for personal ends so as to commit wrong or injustice on taxing authorities, and there was no corporate obligation to be imposed on board member since corporation was entitled to nonresident exemption and thus owed nothing. Even if federal rule, recognizing that corporation may have separate taxable identity, were to be applied to question of whether corporate veil should be pierced so that sole board member of closely held corporation could be held personally liable for compensating use tax allegedly incurred by corporation, board member would not be liable since corporation had legitimate business purpose of owning and chartering boats, and there was no evidence that corporation was set up as sham or for purpose of tax avoidance.

UNITED STATES v. BESTFOODS Compensation and Liability Act (CERCLA) against parent corporations of chemical manufacturers for costs of cleaning up industrial waste generated by chemical plant. The United States District Court for the Western District of Michigan imposed operator 10

liability on parent corporations. On appeal, the Court of Appeals for the Sixth Circuit reversed in part. After grant of certiorari, the Supreme Court held that: (1) when the corporate veil may be pierced, a parent corporation may be charged with derivative CERCLA liability for its subsidiary's actions; (2) a participation-and-control test looking to the parent corporation's supervision over subsidiary cannot be used to identify operation of a facility resulting in direct parental liability under CERCLA; and (3) direct parental liability under CERCLA's operator provision is not limited to a corporate parent's sole or joint venture operation with subsidiary. Judgment of Court of Appeals vacated and case remanded with instructions. It is a general principle of corporate law deeply ingrained in our economic and legal systems that a "parent corporation," so-called because of control through ownership of another corporation's stock, is not liable for the acts of its subsidiaries. The exercise of the control which stock ownership gives to the stockholders will not create liability on the part of parent corporation for acts of subsidiary beyond the assets of the subsidiary, with "control" including the election of directors, the making of bylaws, and the doing of all other acts incident to the legal status of stockholders. Duplication of some or all of the directors or executive officers will not create liability on part of parent corporation for acts of subsidiary, beyond the assets of the subsidiary. Corporate veil may be pierced and the shareholder held liable for the corporation's conduct when, inter alia, the corporate form would otherwise be misused to accomplish certain wrongful purposes, most notably fraud, on the shareholder's behalf. CERCLA gives no indication that the entire corpus of state corporation law is to be replaced simply because a plaintiff's cause of action is based upon a federal statute, and the failure of the statute to speak to a matter as fundamental as the liability implications of corporate ownership demands application of the rule that in order to abrogate a common-law principle, the statute must speak directly to the question addressed by the common law. When, but only when, the corporate veil may be pierced, a parent corporation may be charged with derivative CERCLA liability for its subsidiary's actions. If a subsidiary that operates, but does not own, a facility is so pervasively controlled by its parent for a sufficiently improper purpose to warrant veil piercing, the parent may be held derivatively liable under

CERCLA for the subsidiary's acts as an operator. District court's focus on the relationship between parent corporation which disputed direct CERCLA operator liability and its subsidiary, rather than on the parent and the subsidiary's polluting facility, combined with the court's automatic attribution of the actions of dual officers and directors to the corporate parent, erroneously, even if unintentionally, treated CERCLA as though it displaced or fundamentally altered common law standards of limited liability. THE DUTY OF CARE

The duty of care requires that directors make decisions based upon reasonably adequate information and deliberation Discharge duties with the care that an ordinarily prudent person in a like position would exercise under similar circumstances; Discharge duties in a manner they reasonably believe is in the best interest of the corporation. Requires the directors to attend board meetings; obtain and review adequate information concerning actions taken by the board; and generally supervise the corporations business and its major policies THE BUSINESS JUDGMENT RULE The business judgment rule is a presumption of the courts that in making a business decision the directors fulfill their fiduciary duties of care and loyalty to the corporation by: Acting on an informed basis; In good faith; In the honest belief that the decision was in the best interest of the company. APPLICATION OF THE BUSINESS JUDGMENT RULE The business judgment rule protects only informed decisions To come under the rules of protection, directors must inform themselves of all information reasonably available to them and relevant to their decision; The proper standard for determining whether a business judgment was an informed one is gross negligence. The Business Judgment Rule does not protect the directors when they have either abdicated their functions or failed to act THE DUTY OF CARE The duty of care requires that directors make decisions based upon reasonably adequate information and deliberation Discharge duties with the care that an ordinarily prudent person in a like position would exercise 11

under similar circumstances; Discharge duties in a manner they reasonably believe is in the best interest of the corporation. Requires the directors to attend board meetings; obtain and review adequate information concerning actions taken by the board; and generally supervise the corporations business and its major policies THE BUSINESS JUDGMENT RULE The business judgment rule is a presumption of the courts that in making a business decision the directors fulfill their fiduciary duties of care and loyalty to the corporation by: Acting on an informed basis; In good faith; In the honest belief that the decision was in the best interest of the company. APPLICATION OF THE BUSINESS JUDGMENT RULE The business judgment rule protects only informed decisions To come under the rules of protection, directors must inform themselves of all information reasonably available to them and relevant to their decision; The proper standard for determining whether a business judgment was an informed one is gross negligence. The Business Judgment Rule does not protect the directors when they have either abdicated their functions or failed to act FRANCIS v. UNITED JERSEY BANK Action was brought by trustees in bankruptcy of corporation to recover funds paid by corporation to principal stockholder for benefit of his estate, and to members of his family. After judgment was entered in favor of plaintiffs, the Superior Court denied motion for new trial or alternatively for amendment to judgment, and appeal was taken. The Superior Court, Appellate Division affirmed and administrator and executrix of estate appealed. The Supreme Court held that decedent was negligent in not noticing and trying to prevent misappropriation of funds held by corporation in an implied trust and her negligence was proximate cause of trustees' losses. Affirmed. As a general rule, a corporate director should acquire at least a rudimentary understanding of business of corporation and accordingly, a director should become familiar with fundamentals of business in which corporation is engaged and because directors are bound to exercise ordinary care, they cannot set up as a defense lack of knowledge needed to exercise the requisite degree of care and if one feels that he has not had sufficient

business experience to qualify him to perform the duties of a director, he should either acquire the knowledge by inquiry, or refuse to act. Directors of corporations are under continuing obligation to keep informed about activities of corporation; otherwise, they may not be able to participate in overall management of corporate affairs. Shareholders have right to expect that directors will exercise reasonable supervision and control over policies and practices of a corporation Corporate directors may not shut their eyes to corporate misconduct and then claim that because they did not see the misconduct, they did not have a duty to look Directorial management of corporation does not require a detailed inspection of day-to-day activities but, rather, a general monitoring of corporate affairs and policies and accordingly, a director is well advised to attend board meetings regularly. While directors of corporations are not required to audit corporate books, they should maintain familiarity with financial status of corporation by regular review of financial statements and, in some circumstances, directors may be charged with assuring that bookkeeping methods conform to industry custom and usage. Corporate director was personally liable in negligence for failure to prevent misappropriation of trust funds by other directors who were also officers and shareholders of the corporation where negligence was proximate cause of loss. Usually a corporate director can absolve himself from liability by informing the other directors of impropriety and voting for proper course of action; conversely, a director who votes for or concurs in certain actions may be liable to the corporation for the benefit of its creditors or shareholders, to the extent of any injuries suffered by such persons, respectively, as a result of such action. In most instances an objecting director whose dissent is noted in accordance with applicable statute will be absolved after attempting to persuade fellow directors to follow different course of action. Director is not an ornament, but an essential component of corporate governance; consequently, a director cannot protect himself behind a paper shield bearing the motto, "dummy director." NURSING HOME BUILDING CORPORATION v. DeHART Action was brought by corporate nursing home against former sole shareholders of corporation for alleged fraudulent misappropriation of corporate funds. The Superior Court, King County entered judgment for plaintiff for $9,914.85, an obligation conceded by defendants, and plaintiff appealed. The Court of Appeals held that former shareholders were not liable to corporate nursing home for disbursements, which were ratified by all shareholders, of corporate assets to sellers of 12

corporate stock as installment payments for purchase of stock, that evidence supported finding that challenged expenditures by former sole shareholders were made by such shareholders within scope of proper exercise of their business judgment in running corporate nursing home, and that evidence supported finding that use of corporate funds by former sole shareholders for payment of expenses other than taxes constituted valid exercise of business judgment. Affirmed. Corporation's separate legal identity is not lost merely because all of its stock is held by members of single family or by one person and thus fact of sole ownership does not of itself immunize sole shareholder from liability to corporation, but corporate entity will be disregarded when justice so requires. Courts should be reluctant to interfere with internal management of corporations and should generally refuse to substitute their judgment for that of directors. "Business judgment rule (BJR) immunizes management from liability in corporate transaction undertaken within both power of corporation and authority of management where there is reasonable basis to indicate that transaction was made in good faith. Evidence, in action brought by corporate nursing home against former sole shareholders of corporation for alleged fraudulent misappropriation of corporate funds, supported finding that challenged expenditures by former sole shareholders, who were experienced in operation of various types of businesses including nursing homes and who were involved in day to day management of corporate nursing home on full time or greater basis, were made by such shareholders within scope of proper exercise of their business judgment. Evidence in action brought by corporate nursing home against former sole shareholders of corporation for alleged fraudulent misappropriation of corporate funds supported finding that use of corporate funds by former sole shareholders for payment of expenses other than taxes constituted valid exercise of business judgment as to which court would not interfere in absence of bad faith or fraud. Where disbursements of installment payments for purchase of stock were made with corporate assets by former sole shareholders of corporate nursing home and such disbursements were ratified by all shareholders, former sole shareholders were not liable to corporation for such installment payments. Where contract for sale of stock was executed by all parties, including corporate nursing home, contract provided that asset of corporation would be assigned to sellers of stock, corporation approved contract at time when sellers were sole shareholders and constituted majority of board of directors, and all parties consented to and ratified assignment of such

contract, ratification of such transaction by all parties in accordance with stock purchase contract was binding on corporation and thus former sole shareholders who purchased stock from sellers were not liable to corporation for their subsequent transfer of such asset. SMITH v. VAN GORKOM Class action was brought by shareholders of corporation, originally seeking rescission of cash-out merger of corporation into new corporation. Alternate relief in form of damages was sought against members of board of directors, new corporation, and owners of parent of new corporation. Following trial, the Court of Chancery, granted judgment for directors by unreported letter opinion, and shareholders appealed. The Supreme Court held that: (1) board's decision to approve proposed cash-out merger was not product of informed business judgment; (2) board acted in grossly negligent manner in approving amendments to merger proposal; and (3) board failed to disclose all material facts which they knew or should have known before securing stockholders' approval of merger. On motions for reargument, the Court held that one director's absence from meetings of directors at which merger agreement and amendments to merger agreement were approved did not relieve that director from personal liability. Reversed and Remanded. McNeilly and Christie, JJ., filed dissenting opinions and dissented in part from denial of motions for reargument In carrying out their managerial roles, directors of corporation are charged with underlying fiduciary duty to corporation and its shareholders. Business judgment rule exists to protect and promote full and free exercise of managerial power granted to directors of corporations. Party attacking board of directors' decision as uninformed must rebut presumption that board's business judgment was informed one. Determination of whether business judgment of board of directors is informed one turns on whether directors have informed themselves, prior to making business decision, of all material information reasonably available to them. Board of directors acted in grossly negligent manner when it voted to amend merger agreement, where directors approved oral presentation of substance of proposed amendments, terms of which were not reduced to writing until two days later, rather than waiting to review amendments, again approved them sight unseen and adjourned, and even though amendments allowed corporation to solicit competing offers, corporation was permitted to terminate merger agreement and abandon merger only if, prior to shareholders' meeting, corporation had either consummated merger or sale of assets to third party or had entered into definitive merger 13

agreement more favorable than original and for greater consideration, and market test period for determining fairness of purchase price was effectively reduced by amendments. Board of directors lacked valuation information adequate to reach informed business judgment as to fairness of $55 per share for sale of company, notwithstanding magnitude of premium or spread between offering price and company's current market price of $38 per share, where market had consistently undervalued worth of stock, publicly traded stock price represents only value of single share and not value of whole company, board made no evaluation of company that was designed to value entire enterprise, board accepted without scrutiny chairman's representation as to fairness of $55 price per share for sale of company and thereby failed to discover that chairman had suggested $55 price and had arrived at that figure based on calculations designed solely to determine feasibility of leveraged buy-out. Business Judgment Rule (1) Under Delaware law, the business judgment rule is the offspring of the fundamental principle, codified in 8 Del.C. 141(a), that the business and affairs of a Delaware corporation are managed by or under its board of directors. The business judgment rule exists to protect and promote the full & free exercise of the managerial power granted to Del. directors

(e.g., causation): Transaction was entirely fair to corporation Fully-informed S/hs voted to approve boards action (Van Gorkom) 3. Process challenges may have lower threshold (e.g., ordinary negligence) for banks or financial intermediaries

Class Actions and Their Abuse Class actions were conceived as an expeditious way for people with similar grievances to join in a common suit and get compensated for injuries. But class actions have evolved into a favored means for trial lawyers to launch predatory assaults on businesses and large institutions, often in the name of clients who dont even know they are being represented. Despite the absurdity of many of these suits, legitimate companies are hard-pressed to defend themselves because they face thousands or even millions of plaintiffs. As they watch their share prices sink with bad publicity, companies almost always have to settle rather than risk billions of dollars in punitive damages. Increasingly, the end result is huge fees for the lawsuit industry an average of over $1,000 per hour according to Class Action Reports but relatively tiny awards for individual plaintiffs. For example, in one Texas case, lawyers sued two auto insurers for overbilling because the insurers rounded up premium bills to the next dollar (a practice that was sanctioned by the state insurance department) and pocketed almost $11 million; policyholders got a paltry $5.50 each, a typical result in class action lawsuits. MARKET IN SECURITIES Within days of a drop in a companys stock price (usually a high-growth technology stock with a naturally high shareprice volatility), trial lawyers swoop in to file a claimoften lacking any real proof of corporate wrongdoing. Corporations faced with the inevitable, extremely onerous discovery process must defend themselves at great expense; little wonder that such cases typically settle, with one-third of the proceeds going to lawyers. These actions merely redistribute wealth from one class of shareholders to another and thus do nothing to curb management abuse The empirical evidence shows that securities class actions settlement values are unrelated to the merits of the underlying cases, so the argument that the securities class action system offers any meaningful deterrent to corporate misconduct is wholly unpersuasive. Despite the Private Securities Litigation Reform Act of 1995, the securities gravy train for trial lawyers rolls on: securities class action filings rose 31 percent in 2002, and one prominent plaintiffs firm negotiated three recent 14

Business Judgment Rule (2) Since a director is vested with the responsibility for the management of the affairs of the corporation, he must execute that duty with the recognition that he acts on behalf of others. Such obligation does not tolerate faithlessness or self-dealing. But fulfillment of the fiduciary function requires more than the mere absence of bad faith or fraud. Representation of the financial interests of others imposes on a director an affirmative duty to protect those interests and to proceed with a critical eye. Business Judgment Rule (3) To be protected by the BJR, managerial decisions must meet the following criteria: made in good faith made with loyalty to the company made with due diligence

Challenging Process: Lessons from Van Gorkom 1. While BJR creates a presumption that the boards decision was informed plaintiff can rebut presumption by showing that prior to making decision, board was grossly negligent (or reckless) in informing themselves about material information reasonably available to them. 2. Defendants found to have breached their Duty of Care procedurally can still defend on other grounds

settlements of $300 million or more. Magnet Courts Unlike traditional lawsuits, class actions tend to involve plaintiffs from multiple jurisdictions, if not from all over the nation. Thus, instead of filing suit at the place of residence or injury as is normally required in the typical single plaintiff lawsuit trial lawyers are able to shop class action suits in search of the most favorable forum. Quite predictably, the best forum winds up being a state magnet court well known for its hospitable treatment of class action lawsuits. For instance, Madison County, Illinois recently made famous by handing out a $10.1 billion verdict against Philip Morris for allegedly insinuating that its light cigarettes were safer has seen a tremendous upsurge in class action filings in recent years. From 1998 to 2000, class action filings in Madison County increased over 1,800%; over 80% of these suits were brought on behalf of proposed nation-wide classes. Oversight of Class Action Settlements Many judges, too, see the need to rein in the lawsuit industrys worst excesses. In its landmark Campbell v. State Farm decision, the Supreme Court put a constitutional limit on a jurys ability to set punitive damages at an extreme multiple of actual damages. And while courts have traditionally been reluctant to enforce state codes of ethics prohibiting excessive fees, judges may finally be cracking down in the wake of the outrageous tobacco settlements: New York State judge Nicholas Figueroa recently threw out as excessive a $1.3 billion claim by the Castano group for work allegedly done on the California tobacco settlement. Magnet Courts Unlike traditional lawsuits, class actions tend to involve plaintiffs from multiple jurisdictions, if not from all over the nation. Thus, instead of filing suit at the place of residence or injury as is normally required in the typical single plaintiff lawsuit trial lawyers are able to shop class action suits in search of the most favorable forum. Quite predictably, the best forum winds up being a state magnet court well known for its hospitable treatment of class action lawsuits. For instance, Madison County, Illinois recently made famous by handing out a $10.1 billion verdict against Philip Morris for allegedly insinuating that its light cigarettes were safer has seen a tremendous upsurge in class action filings in recent years. From 1998 to 2000, class action filings in Madison County increased over 1,800%; over 80% of these suits were brought on behalf of proposed nation-wide classes. Oversight of Class Action Settlements Many judges, too, see the need to rein in the lawsuit industrys worst excesses. In its landmark Campbell

v. State Farm decision, the Supreme Court put a constitutional limit on a jurys ability to set punitive damages at an extreme multiple of actual damages. And while courts have traditionally been reluctant to enforce state codes of ethics prohibiting excessive fees, judges may finally be cracking down in the wake of the outrageous tobacco settlements: New York State judge Nicholas Figueroa in recent years threw out as excessive a $1.3 billion claim by the Castano group for work allegedly done on the California tobacco settlement. Duties of Agent to Principal Duty of Loyalty -- An agent: must act for the benefit of the principal. may not receive outside benefits without approval of the principal. can neither disclose nor use for her own benefit any confidential information. is not allowed to compete with his principal within the scope of the agency business. may not act for two principals whose interests conflict. may not become a party to a transaction without the principals permission. may not engage in inappropriate behavior that reflects badly on the principal Principals Remedies When the Agent Breaches a Duty The principal can recover damages caused by the agents breach. The agent must refund any profits made from the agency, if he breaches his duty of loyalty. The principal may rescind a transaction with an disloyal agent. Fiduciary Duties of Directors - Duty of Loyalty Questions about board members duty of loyalty most often arise where: There is a conflict of interest; or Board member takes advantage of a corporate opportunity of the Company. Traditional Duty of Loyalty Analysis Is there a conflict of interest? Direct Transaction between corporation and fiduciary Indirect Transaction between corp and another corp in which fiduciary has [substantial?] financial interest Family transactions If yes, transaction is voidable by corporation Compare: DGCL 144 Merely a financial interest for a conflict of interest Three Alternative ways to cleanse: Disclosure to Board of Directors & approval No quorum requirement; but majority of minority requirement 15

 Disclosure to Shareholders & approval No apparent Quorum requirement Transaction fair at time of approval Burden of Proof? HOLDEN v. CONSTRUCTION MACHINERY COMPANY An action in equity was instituted, individually and derivatively, by the holder of 49.976% of the outstanding stock of a corporation, against the corporation, its officers and directors. The Black Hawk District Court held in part adverse to the defendants, and they appealed. The minority shareholder cross-appealed. The Supreme Court held that where the majority shareholder was found to be a constructive trustee of another company's stock, purchased with a check from the corporation, an award to the corporation of the shares including shares acquired by stock split and cash dividends appropriately stood as a judgment for restitution. The Court also held that where the majority shareholder, as president and general manager of the corporation, personally engineered every phase of the deal by which the stock in the other company was acquired by a check from the corporation, appropriated to his own use all dividends issued upon such stock, directed falsification of corporate records and other documents, and subsequently endeavored to impress upon the whole transaction a coloration of honesty and also did all in his power to isolate the minority holder from any rights or privileges pertaining to management, assessment of exemplary damages was compelled. Affirmed on defendants' appeal; reversed in part, affirmed in part, affirmed in part as modified on plaintiff's cross appeal, and remanded with instructions. Equity holds officers and directors of corporate entity, particularly management-controlling directors of closely held corporations, strictly accountable as trustees. Majority shareholder of corporation who was also president and general manager was strictly accountable to corporation for another company's stock purchased with check from corporation, or for fair market value of such stock, and for all increases, income, proceeds or dividends realized.

that some legally protected right has been invaded, such as by intentional act of fraud or other wrongful conduct. Security Requirement In around 1/3 of states (though not Delaware), a derivative claimant with low stakes must post security for corporations legal expenses. Why do you think this requirement exists? Effects on strategic or incentive problems among relevant parties (Shareholders, Managers, Attorneys)? Demand Requirement Most states require S/hs in derivative suits first to approach Board of Directors and demand that they pursue legal action unless the S/h can claim a valid excuse. When is demand requirement excused? If not excused, what recourse does S/h have if Board decides not to pursue? Does making the demand affect ones subsequent rights to bring a derivative action? EISENBERG v. The FLYING TIGER LINE, INC. Action by stockholder, on behalf of himself and all other stockholders of corporation similarly situated, to enjoin effectuation of plan of reorganization and merger. The United States District Court for the Eastern District of New York dismissed the action after stockholder failed to post security for corporation's costs and stockholder appealed. The Court of Appeals held that action seeking to overturn reorganization and merger the effects of which was that business operations were confined to a wholly owned subsidiary of holding company whose stockholders were the former stockholders of defendant corporation was a "personal action" and not "derivative" within meaning of New York statute requiring posting of security for corporation's costs. Reversed. Action by stockholder, suing on behalf of himself and all other stockholders of corporation similarly situated, seeking to overturn reorganization and merger the effect of which was that business operations were confined to a wholly owned subsidiary of holding company whose stockholders were the former stockholders of defendant corporation, was a "personal action" and not "derivative" within meaning of New York statute requiring posting of security for corporation's costs. If the gravamen of the complaint is injury to the corporation the suit is derivative, but "if the injury is one to the plaintiff as a stockholder and to him individually and not to the corporation," the suit is individual in nature and may take the form of a representative class action. 16

Where majority shareholder, as president and general manager of corporation, personally engineered every phase of deal by which stock in another company was acquired with check from corporation, appropriated to his own use all dividends issued upon such stock, directed falsification of corporate records and other documents, and subsequently endeavored to impress upon whole transaction a coloration of honesty and also did all in his power to isolate minority holder of 49.976% of outstanding stock from any rights or privileges pertaining to management, assessment of exemplary damages was compelled. In shareholder's derivative action, equity court may, in its discretion, award exemplary damages upon showing

Eisenbergs Complaint: Deprivation of voting rights to former Flying Tiger S/hs with respect to operating company. FTLs Counter-argument: Eisenbergs claim is derivative. Must post security under NY law. Trial court: Held that Eisenberg was required to post security (as per NYs law and FTLs pre-trial motion) Eisenberg refused to pay. Complaint dismissed. MARX V. AKERS Appeal, by permission of the Court of Appeals, from an order of the Appellate Division of the Supreme Court in the Second Judicial Department, entered May 15, 1995, which affirmed an order of the Supreme Court granting motions by defendants to dismiss the amended complaint. Affirmed. In a shareholders' derivative action, plaintiff failed to state a cause of action with respect to the allegations of the complaint that the board of directors wasted corporate assets by awarding excessive compensation to the corporation's outside directors, consisting of a retainer of $55,000 plus 100 shares of the corporation's stock over a five-year period which bore little relationship to duties performed or to the cost of living. An allegation that directors have voted themselves compensation does not give rise to a cause of action, as directors are statutorily entitled to set those levels. Moreover, a complaint challenging the excessiveness of director compensation must--to survive a dismissal motion--allege compensation rates excessive on their face or other facts which call into question whether the compensation was fair to the corporation when approved, the good faith of the directors setting those rates, or that the decision to set the compensation could not have been a product of valid business judgment. Here, there are no factually based allegations of wrongdoing or waste which would, if true, sustain a verdict in plaintiff's favor. Plaintiff's bare allegations that the compensation set lacked a relationship to duties performed or to the cost of living are insufficient as a matter of law to state a cause of action. In a shareholders' derivative action, a demand that the board of directors initiate a lawsuit, Business Corporation Law 626 [c], was excused as to the allegations of the complaint that a majority of the board was self-interested in setting the compensation of the corporation's outside directors because the outside directors comprised a majority of the board. Directors are self-interested in a challenged transaction where they will receive a direct financial benefit from the transaction which is different from the benefit to shareholders generally.

A director who votes for a raise in directors' compensation is always "interested" because that person will receive a personal financial benefit from the transaction not shared in by stockholders. Consequently, a demand was excused as to plaintiff's allegations that the compensation set for outside directors was excessive. ZAPATA CORP. V. MALDONADO Brief Fact Summary: Plaintiff brought a derivative action against officers and directors of Defendant, Zapata Corporation. Defendant appointed a special committee that decided not to pursue the litigation proposed by Plaintiff. Synopsis of Rule of Law: The court should first determine if a defendant corporation proves that the appointed committee is independent, and then determine, when applying their business judgment standard, whether the motion to dismiss the derivative suit should be granted. Facts: Maldonado brought the derivative suit against ten officers and directors of Defendant, asserting that they breached their fiduciary duties. Plaintiff did not demand that the Defendant officers bring the action because all the directors at the time were named in the suit. After the suit, Defendant corporation appointed an Independent Investigation Committee comprised of two directors who were not part of the initial suit. The Committee decided that the derivative suits would be harmful to the company and therefore moved to dismiss the litigation. Issue: The issue is whether the authorized committee should be permitted to dismiss pending derivative suit litigation. Held: The court applied a two-step test to determine if the Committee should be permitted to dismiss the litigation. First, Defendant corporation has the burden to prove that the Committee is independent and is exercising good faith and reasonable investigation. Second, the court should apply their independent business judgment. Discussion: The courts two-step test shifts the burden to the corporation to prove the independence, which limits the advantage to a company of appointing an independent group to determine the merits of a derivative suit. AUERBACH V. BENNETT NEW YORK rule Disposition of the case turns on the proper application of the business judgment doctrine, in particular to the decision of a specially appointed committee of disinterested directors acting on behalf of the board to terminate a shareholders derivative action.... [T]he determination of the special litigation 17

committee forecloses further judicial inquiry into this case. If SLC is not independent, its recommendations are meaningless: Independence Factors: Non-defendants; no nomination by named directors; full delegation of authority to SLC Note: Decision not clear about who bears burden here If SLC is independent: Procedures used by SLC scrutinized under gross negligence standard Substantive Decision of SLC gets protection of the Business Judgment Rule Criticism of Decision: Ignores problems of structural bias in board Analysis In Delaware, do SLCs have the power to cause dismissal of derivative actions? Does the court distinguish between demand excused and required cases? 2-part test for demand-excused cases in which an SLC has recommended dismissal: Did SLC act independently, in good faith, and with a reasonable investigation (with the burden of proof on defendants), and Does dismissal pass independent judicial inquiry into business judgment? Demand in Delaware Zapata Demand made -Demand Excused Excused Aronson Futility Standard

Demand Excused In Delaware

Demand Excused Aronson Standard Burden on Board Good Faith Reasonable investigatio n d Faith Faith If not If not Case not Dismissed not Dismissed If not Case Case not Dismisse d not Dismissed not Dismissed Dismissed Dismissed Independen t

good faith, independence and reasonable and reasonable investigation investigation

YES -----Court applies ITS Business ITS Business Judgment

Derivative Case not Dismi

Board or Committee Upheld Committee Upheld Upheld Unless Wrongful

Demand Rejected and the BJR not Dismissed The business judgment rule provides that absent evidence of bad faith, fraud or lack of due care, courts will defer to the business judgment of corporate directors.

Special Committee

The business judgment rule creates a presumption that in making a business decision, the directors of a corporation met their fiduciary duties to the corporation, that is that that they acted on an Committee informed basis (i.e., with due care), in good faith, and Independent in the honest belief that the action taken was in the best interest of the company In most circumstances, the business judgment rule Good Faith places the burden on the party challenging the board decision to introduce evidence that the board either lacked good faith, acted in self-interest, or acted Reasonable investigation without due care investigation Special Litigation Committees A board may act as a whole in reviewing a 18

shareholder's demand or it may choose to appoint a committee to investigate the facts underlying a demand and make a report and recommendation regarding the suit. Cases that have rejected the decisions of special litigation committees have largely focused on the independence or good faith of the committee members and the reasonableness of the investigations. A special litigation committee may also be appointed to review and make a binding determination with respect to a pending derivative action where a demand has been excused.

IN RE ORACLE DERIVATIVE LITIGATION Special litigation committee (SLC) bore the burden of persuasion on motion to dismiss shareholder derivative action and was required to convince superior court that there was no material issue of fact calling into doubt its independence The question of independence turns on whether a director is, for any substantial reason, incapable of making a decision with only the best interests of the corporation in mind In order to prevail on its motion to terminate the shareholder derivative action, the special litigation committee (SLC) was required to persuade superior court that: (1) committee members were independent; (2) that they acted in good faith; and (3) that they had reasonable bases for their recommendations Superior Court must deny special litigation committee's (SLC) motion to terminate shareholder derivative action, if there is a material factual question causing doubt about whether the SLC was independent, acted in good faith, and had a reasonable basis for its recommendation; to grant the motion, the court needs to be convinced on the basis of the undisputed factual record, that the SLC was independent, acted in good faith, and had a reasonable basis for its recommendation Members of corporation's special litigation committee (SLC) could lose independence without being essentially subservient to officers and directors under investigation for insider trading; whether the members were under the domination and control of the interested parties was not the central inquiry in the independence determination necessary for ruling on SLC's motion to terminate shareholder derivative action. A director may be compromised and lose independence, if he is beholden to an interested person; "beholden" does not mean just owing in the financial sense, and it can also flow out of personal or other relationships to the interested party

Ties among special litigation committee (SLC) members, university where they were tenured professors, and chief executive officer (CEO) were so substantial that they caused reasonable doubt about the members' independence and ability to impartially consider whether CEO should face suit for insider trading; CEO was very wealthy, was publicly considering extremely large contributions to university when members were being added to board, and headed a medical research foundation that was a source of nearly $10 million in funding to university, university's rejection of CEO's child for admission did not keep CEO from making public statements about consideration of huge donation, and although members claimed ignorance, an inquiry into CEO's connections with university should have been conducted before the SLC was finally formed and, at the very least, should have been undertaken in connection with its report. IN RE THE WALT DISNEY COMPANY DERIVATIVE LITIGATION This was the Delaware Supreme Courts decision in the long-running shareholder litigation over The Walt Disney Companys hiring and termination of Michael Ovitz. Ovitz was hired as Disneys President in October 1995, and shortly thereafter was appointed to its board of directors. The terms of Ovitzs employment were largely negotiated by CEO Michael Eisner and two members of the companys four-person compensation committee, who were in turn assisted by an executive compensation consultant. Terms were presented to the full compensation committee at a meeting that lasted approximately one hour, a substantial part of which was devoted to other matters. The committee reviewed only a term sheet, rather than a draft of Ovitzs contract, and did not receive any materials prepared by or a presentation from the compensation consultant. The members of the committee unanimously approved the terms of Ovitzs employment, and Disneys board subsequently unanimously approved Ovitzs hiring. Ovitz's contract compensated him handsomely. It also included a severance provision guaranteeing him significant amounts of cash and accelerated vesting of options if Disney terminated his employment without cause. Ovitz's tenure at Disney was rocky and short-lived, and by late 1996, Eisner had decided to fire Ovitz. Company counsel was certain that there were no grounds for terminating Ovitz for cause, and that Ovitz would sue if the company attempted to circumvent the no-fault termination provision in his contract. On December 12, 1996, Ovitz was terminated without cause. At no time prior to his firing did Disney's board meet to discuss or vote on his firing. His severance eventually totaled $140 million. 19

Almost immediately after the separation when information about the size of the severance package became public Disney shareholders sued the members of the board to recover this amount. The plaintiffs filed an initial complaint with the Delaware Chancery Court in 1997; the defendants filed a motion to dismiss. The Chancellor, though required to assume all factual disputes in the plaintiffs favor when considering the motion, dismissed the complaint with prejudice. The plaintiffs appealed to the Delaware Supreme Court, which reversed the Chancellors dismissal with prejudice of certain of plaintiffs claims, thereby allowing the plaintiffs to file an amended complaint. The plaintiffs did so, and in 2003, the Chancellor denied the defendants motion to dismiss and allowed the case to proceed to trial. In the Disney case, the plaintiffs alleged that Ovitz had breached the duty of loyalty and that Disneys remaining directors breached their duty of good faith. The Disney court explained that a duty of loyalty claim is implicated when a fiduciary either appears on both sides of a transaction or receives a personal benefit not shared by all shareholders. Plaintiffs alleged that Ovitz had violated his duty of loyalty because he had used his office as a director improperly to obtain a no-fault termination, thereby benefiting himself at shareholders expense. A duty of loyalty claim is not protected by the business judgment rule. The court rejected this claim, finding that Ovitz played no role in the Company's decision to terminate him without cause. The plaintiffs case rested on whether Disneys directors had breached their duty of good faith. Previous Delaware rulings had left it unclear whether fiduciaries have an independent duty of good faith. Moreover, when such claims had arisen previously, the director-defendants typically prevailed on motions to dismiss based on the business judgment rule. Yet, here, based on allegations that the defendants had failed to exercise any business judgment or make any good faith attempt to fulfill their fiduciary duties, the court was willing to permit the case to go to trial. By allowing the trial to proceed, the court appeared to have created a new opportunity for future plaintiffs. Following a full trial on the merits and an evaluation of the extent to which each defendant fulfilled his fiduciary duties, the Disney court emphasized the importance of the business judgment rule and found that all of the defendants were on the facts entitled to the benefit of the presumption contained in that rule. The court set the threshold for a finding of bad faith very high, stating, A failure to act in good faith [may be found] . . . where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the company, where the fiduciary acts

with the intent to violate applicable positive law, or where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties. While repeatedly admonishing Disneys directors for failing to live up to the ideals of corporate governance (writing, e.g., that many lessons of what not to do can be learned from defendants conduct here), the court repeatedly noted that meeting an ever-evolving ideal is not what Delaware law requires of corporate fiduciaries. Although the court agreed that the defendants had been relatively inactive in the Ovitz matter and, from an aspirational perspective, should have been more diligent in carrying out their responsibilities, the court found that the boards failure to meet these standards did not demonstrate legally actionable bad faith. Duties of Controlling Shareholder A controlling shareholder has duties similar an officer or director, similar to the duties of due care and loyalty. The duty arises when the controlling shareholder: Exercises control over the corporation Engages in self-dealing transactions Sells control Intrinsic Fairness Test

Example: Sinclair Oil Corporation v. Levien (contd) But, Sinclair did engage in self-dealing because Sinclairs other subsidiaries paid their bills late and Sinclair caused Sinven not to enforce the contract? SINCLAIR OIL V. LEVIEN: Parent-Sub Transactions Controlling s/h (Sinclair) in a fiduciary relationship vis-a-vis Sinven Board of Directors (Sinclair directors) also have a fiduciary duty to Sinven Sinven pays $108 MM dividend, of which $104 MM goes to Sinclair (97% s/h) Conflict of Interest + Self-Dealing

A parent does indeed owe a fiduciary duty to its subsidiary when there are parent-subsidiary dealings. However, this alone does not evoke the intrinsic fairness standard. This standard will be applied only when the fiduciary duty is accompanied by self-dealingthe situation when a parent is on both sides of a transaction with its subsidiary. Self-dealing occurs when the parent . . . causes the subsidiary to act in such a way that the parent receives something from the subsidiary to the exclusion of, and detriment to, the minority 20

stockholders of the subsidiary. Can you attack a transaction if there is no self-dealing? Waste: The motives for causing the declaration of dividends are immaterial unless the plaintiff can show that the dividend payments resulted from improper motives and amounted to waste. Definition of waste: 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. Does Waste = Fraud? If so, then shareholders cannot approve the transaction and it is not protected by the Business Judgment Rule Burden of Proof

T-A Learns Private Information About Value of AFs Inventories 60-Day Call Notice ZAHN et al. (Class A S/hs) squeezed out

Was Transamerica a dominant shareholder? (If so, then they also owe fiduciary duties) But to whom? Who were residual claimants? I.e., under a property-rights theory of the firm, who was the beneficiary of fiduciary duties? Could Transamerica have been sued by class B shareholders for not calling the class A shares when it discovered A-Fs inventory value? If so, then what rights do Class A shareholders have under fiduciary duty law? Dominant Shareholders Duties

Once the plaintiff raises the issue of fairness, the burden is on the defendant to prove fairness The defendant can shift the burden to plaintiff if the transaction was Fully Disclosed Approved by independent, disinterested special committee Exercise of Control

Example: Zahn v. Transamerica Corporation (the tobacco leaf case) Transamerica cashed out the preferred shareholders of Axton-Fisher Tobacco Company and then liquidated the company. Court held the company had the power to cash out the preferred shareholders, but in doing so, they had duty to inform the shareholder of the value of the tobacco. ZAHN V. TRANSAMERICA

A S/h can be dominant with <50% of shares Courts usually presume dominance at 25%. Virtually all successful suits against dominant S/hs are for duty-of-loyalty: i.e., causing board to effect a non-prorata distribution of corporate assets. Duty of Care/BJR tends to protect otherwise As with interested directors, once plaintiff makes this showing, burden shifts to the defendant S/h to cleanse It is often harder for a dominant shareholder to demonstrate cleansing, however. Some questions What could T-A have done to shield itself from liability? Why do you think the redemption provision was in the charter? Given the ability to redeem at $60 + accrued dividends, were Class As 2-for-1 liquidation rights worth anything? Consider the information about A-Fs inventory; Why was this private information? Effect of holding on a dominant S/hs incentives to gather such information about the firm? Self Dealing Transactions When the exercise of control involves engaging in a selfdealing transaction with the corporation, the controlling shareholder has the duty to prove that the transaction is intrinsically fair to the minority shareholders. Intrinsic Fairness Test Consider two factors: Fair Dealing: Procedural aspects: How was the transaction was timed, initiated, structured, 21

AXTON FISHER CLASS B SHRS ANNUAL DIVIDEND: $1.60 VOTING RIGHTS LIQUIDATION RIGHTS -- 1:2CLASS CLASS A SHRS ANNUAL (Cum.) DIVIDEND: $3.20 CONVERTIBLE to B; 1:1 CONTINGENT VOTING RIGHTS LIQUIDATION RIGHTS -- 2:1 CALLABLE: $60 + Acc. Div. PREF. SHARES PAR VALUE: $100 ANNUAL (Cum.) DIVIDEND: $6 LIQUIDATION VALUE: $105+Cum. Div. NO VOTING RIGHTS DEBT

negotiated, disclosed and approved? Was it rushed by the controlling shareholder? Fair Price: Considering all relevant factors, was the price fair?

intrinsic fairness of the transaction to the first corporation. In re WHEELABRATOR TECHNOLOGIES, INC. SHAREHOLDERS LITIGATION Delaware law imposes upon board of directors fiduciary duty to disclose fully and fairly all material facts within its control that would have significant effect upon stockholder vote. Defendant directors of target corporation who were sued for breach of duty of loyalty in connection with merger with acquiring corporation, would not be granted summary judgment on breach of loyalty claim, where shareholder vote approved merger, and parties had not been heard on necessary question of how business judgment standard would apply to facts of case Target corporation shareholders could not prevail on claim that directors breached their duty of due care by recommending to stockholders that merger with acquiring corporation be executed, where merger was approved by informed shareholder vote. "Interested" transactions, between corporation and its directors, or between corporation and entity in which corporation's directors are also directors or have financial interest, will not be voidable if transaction is approved in good faith by majority of disinterested stockholders; approval by fully informed, disinterested shareholders pursuant to statute invokes business judgment rule and limits judicial review to issues of gift or waste with burden of proof upon party attacking transaction. In a parent-subsidiary merger, standard of review is ordinarily entire fairness, with directors having burden of proving that merger was entirely fair; but where merger is conditioned upon approval by "majority of the minority" stockholder vote, and such approval is granted, standard of review remains entire fairness, but burden of demonstrating that merger was unfair shifts to plaintiff. Self-interested Transactions Intrinsic Fairness

FLIEGLER V. LAWRENCE Shareholder brought derivative action on behalf of corporation against its officers and directors and against a second corporation which had been acquired by the first corporation. The Chancery Court entered judgment in favor of defendants and plaintiff appealed. The Supreme Court held that where defendant officers, directors, and shareholders of the first corporation had held a significant interest in the second corporation which was acquired by the first corporation, burden was on those defendants to show the intrinsic fairness of the transaction, and that defendants met that burden. Affirmed. Where certain individuals stood on both sides of transaction between two corporations in implementing and fixing terms of option agreement by which one corporation acquired the other, the burden was on those defendants to demonstrate its intrinsic fairness to the acquiring corporation and its shareholders. Since a majority of the shares of corporation voted in favor of exercising option to purchase a second corporation were cast by persons who were alleged to have acted detrimentally to the first corporation for their own gain, ratification of the option by the shareholders did not affect the burden of showing that the transaction was intrinsically fair. In determining intrinsic fairness of one corporation's option to acquire a second corporation in light of the fact that a number of persons owned stock and held positions in both corporations, court would examine the transaction as of the date on which shareholder approval, a requirement for exchange approval, was given. In view of evidence that corporation was not in a position, either financially or legally, to accept corporate opportunity at the time that it was offered to it by the president of the corporation, president and other persons associated with the corporation were entitled to acquire the opportunity for themselves after it was rejected by the corporation. Evidence sustained finding that there was no misuse by one corporation of either personnel or warrants of second corporation in developing a mining resource which had initially been offered to the second corporation by its president and which was then offered to the first corporation, which had been formed for that purpose by the president of the second corporation and others. Shareholders and officers of one corporation, which exercised option to acquire a second corporation in which the shareholders of the first corporation held a significant interest, met their burden of showing the

22

23

Intrinsic Fairness Fair Dealing

IN RE WALT DISNEY CO. DERIVATIVE LITIGATION After $130 million severance package was paid to president upon his termination, shareholders brought derivative action alleging breach of fiduciary duty and waste claims against directors and officers, and breach of contract fiduciary duties claims against president. Directors and president moved to dismiss. The Court of Chancery granted motion. Shareholders appealed. The Supreme Court affirmed in part, reversed in part, and remanded. On remand, the Court of Chancery denied defendants' motion to dismiss, granted in part and denied in part president's motion for summary judgment, and after a bench trial entered judgment for defendants. Shareholders appealed. The Supreme Court, held that: (1) president did not breach any fiduciary duties when he negotiated employment agreement with corporation; (2) president did not breach any fiduciary duties by accepting $130 million severance payout, pursuant to his employment agreement, when he was terminated; (3) evidence was sufficient to establish that corporation's compensation committee did not violate its fiduciary duties when it approved president's employment agreement; (4) neither board of directors nor compensation committee was required to act and vote on termination of president when chief executive officer (CEO) and corporate general counsel decided to terminate president; (5) evidence was sufficient to establish that CEO and corporate general counsel did not breach fiduciary duties when they concluded that president could not be terminated for cause, and thus that president was entitled to severance package; and (6) payment of severance package did not constitute waste. Affirmed. In appeal in breach of fiduciary duty and waste action arising out of severance package paid to corporation's former president, claim by shareholders, that corporation's officers who were involved in negotiating and approving severance payout were not protected by the business judgment rule or exculpatory provisions of corporation's charter, was procedurally barred, where claim was not fairly presented to the Court of Chancery. When a shareholder in a derivative action against the corporation's directors fails to rebut the presumption of 24

Intrinsic Fairness Fair Price

Entire Fairness

Entire Fairness Fair Dealing

Entire Fairness Fair Price

the business judgment rule, she is not entitled to any remedy, be it legal or equitable, unless the transaction constitutes waste. On appeal from a decision granting summary judgment, Supreme Court reviews the entire record to determine whether the trial court's findings are clearly supported by the record and whether the conclusions drawn from those findings are the product of an orderly and logical reasoning process. Supreme Court does not draw its own conclusions with respect to the facts found by the trial court unless the record shows that the trial court's findings are clearly wrong and justice so requires. For purposes of determining whether the presumptions of the business judgment rule were rebutted, there was no substantial difference between trial court's pretrial definition of bad faith, which was a conscious and intentional disregard of responsibilities, adopting a we don't care about the risks' attitude, and trial court's post-trial definition of bad faith, which was an intentional dereliction of duty, a conscious disregard for one's responsibilities, in breach of fiduciary duty and waste action brought by shareholders against corporation's directors, president and other officers as a result of large severance package paid to president upon his termination, as both formulations expressed the same concept, although in slightly different language. Trial court's articulated standard for bad faith corporate fiduciary conduct, intentional dereliction of duty, a conscious disregard for one's responsibilities, was legally appropriate, in breach of fiduciary duty and waste action brought by shareholders against directors, president and other officers as a result of large severance package paid to president upon his termination, though such definition was not the exclusive definition of fiduciary bad faith. Gross negligence, including a failure to inform one's self of available material facts, without more, does not constitute bad faith or a breach of the fiduciary duty to act in good faith that can rebut the presumptions of the business judgment rule, in a derivative action brought by shareholders challenging actions taken by the corporation's board of directors or officers.

(4) directors' lack of substantive due care is foreign to the business judgment rule; (5) waste by the directors was not shown; and (6) the president did not engage in gross negligence or malfeasance. Affirmed in part, reversed in part, and remanded. The blunderbuss complaint was properly dismissed, but leave to amend should have been granted. Famous quote: Courts do not measure, weigh or quantify directors judgments. We do not even decide if they are reasonable in this context. Due care in the decisionmaking context is process due care only. Irrationality is the outer limit of the business judgment rule (emphasis added). Definition of a security The term equity security is hereby defined to include any stock or similar security, certificate of interest or participation in any profit sharing agreement, preorganization certificate or subscription, transferable share, voting trust certificate or certificate of deposit for an equity security, limited partnership interest, interest in a joint venture, or certificate of interest in a business trust; any security future on any such security; or any security convertible, with or without consideration into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any put, call, straddle, or other option or privilege of buying such a security from or selling such a security to another without being bound to do so Basic Securities Laws Securities Act of 1933 (15 USC 77a et seq.) General rules and regulations promulgated under the Securities Act of 1933 (17 CFR Part 230) The Securities Exchange Act of 1934 (15 USC 78a et seq.) General rules and regulations promulgated under the Securities Exchange Act of 1934 (17 CFR Part 240) The Investment Company Act of 1940 (15 USC 80a-1 et seq.) Rules and regulations promulgated under the Investment Company Act of 1940 (17 CFR Part 270) The Investment Advisers Act of 1940 (15 USC 80b-1 et seq.) Rules and regulations promulgated under the Investment Advisers Act of 1940 (17 CFR Part 275)

BREHM V. EISNER After board of directors approved large severance package for former president, shareholders brought derivative action alleging breach of fiduciary duty and nondisclosure claims against directors and breach of contract claim against president. Directors and president moved to dismiss. The Court of Chancery granted motion. Shareholders appealed. The Supreme Court held that: (1) review was de novo, overruling Aronson; (2) pre-suit demand could not be excused on the ground that the directors lacked disinterestedness and independence or that the business judgment rule did not protect them; (3) directors relied in good faith on financial expert who advised the board on employment agreement;

Regulatory Structure INTRODUCTION TO SECURITIES REGULATION (Contd) Securities and Exchange Commission (SEC) 25

administers federal securities law and issue rules and regulations to provide protection for investors independent commission 5 members serve staggered five year terms no more than 3 members of the same party PURPOSE Registration is intended to provide adequate and accurate disclosure of material facts concerning the company and the securities it proposes to sell. Division of Corporate Finance (of the SEC) ensures disclosure requirements are met (executive role) interprets security laws (judicial role) drafts rules and regulations (legislative role) In administering the securities statutes, the Commission issues a large number of rules and pronouncements: Releases: a type of pronouncement in which the Commission interprets rules and statutes that have been brought to their attention; they do not have force of law but are given that effect as a practical matter No-action letter: is only binding upon the person to whom the letter is issued if acts recommended are taken, then the SEC will recommend to the Commission that no action be taken; however, this does not preclude the Commission from taking action if not followed exactly as outlined in letter Note: one reason for the 29 crash was that shares were overvalued because investors did not have a lot of info on the companies this is why the emphasis of the 33 Act is on disclosure Financial information is the biggest component of the disclosure requirement. The information is disclosed through a registration statement. The most prominent form is the S-1. The prospectus is contained in the registration statement. Ongoing financial information is required under the 34 Act, filed quarterly (10-Q), annually (10-K) and in case of extraordinary events (8-K) UNITED STATES V. OHAGAN Defendant was convicted in the United States District Court for the District of Minnesota of a total of 57 counts of mail fraud, securities fraud, and money laundering. Defendant appealed. The Eighth Circuit Court of Appeals reversed and remanded. Certiorari was granted. The Supreme Court held that: (1) criminal liability under 10(b) of Securities Exchange Act may be predicated on misappropriation theory; (2) defendant who purchased stock in target corporation prior to its being purchased in tender offer, based on inside information he acquired as member of law firm representing tender offeror, could be found guilty of securities fraud in violation of Rule 10b-5 under misappropriation theory; and (3) Securities and Exchange Commission (SEC) did not exceed its rulemaking authority

in promulgating rule proscribing transactions in securities on basis of material, nonpublic information in context of tender offers. Reversed and remanded. Justice Scalia concurred in part and dissented in part with separate opinion. Justice Thomas concurred in part and dissented in part with separate opinion in which Chief Justice Rehnquist joined. Under "traditional" or "classical theory" of insider trading liability, 10(b) of Securities Exchange Act and Rule 10b-5 are violated when corporate insider trades in securities of his corporation on basis of material, nonpublic information; trading on such information qualifies as "deceptive device" under 10(b) because relationship of trust and confidence exists between shareholders of corporation and those insiders who have obtained confidential information by reason of their position with that corporation. Relationship of trust and confidence between shareholders of corporation and those insiders who have obtained confidential information by reason of their position with that corporation gives rise to duty to disclose, or to abstain from trading, because of necessity of preventing corporate insider from taking unfair advantage of uninformed stockholders. Classical theory of insider trading liability under 10(b) of Securities Exchange Act and Rule 10b-5 applies not only to officers, directors, and other permanent insiders of corporation, but also to attorneys, accountants, consultants, and others who temporarily become fiduciaries of corporation. "Misappropriation theory" holds that person commits fraud "in connection with" securities transaction, and thereby violates 10(b) of Securities Exchange Act and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of duty owed to source of information. Under misappropriation theory of securities fraud liability, fiduciary's undisclosed, self-serving use of principal's information to purchase or sell securities, in breach of duty of loyalty and confidentiality, defrauds principal of exclusive use of that information. Misappropriation theory of liability under 10(b) of Securities Exchange Act and Rule 10b-5 is designed to protect integrity of securities markets against abuses by outsiders to corporation who have access to confidential information that will affect corporation's security price when revealed, but who owe no fiduciary or other duty to that corporation's shareholders. Company's confidential information qualifies as property to which company has right of exclusive use, and undisclosed misappropriation of such information, in violation of fiduciary duty, constitutes 26

fraud akin to embezzlement, or fraudulent appropriation to one's own use of money or goods entrusted to one's care by another. S E C v. TEXAS GULF SULPHUR CO. In the United States District Court for the Southern District of New York the Securities and Exchange Commission commenced its action alleging violations by the fourteen defendants of the provisions of Section 10(b) of the Securities Exchange Act of 1934 and its Rule 10b-5 promulgated pursuant to the authority granted to it in Section 10b. The court below found that two of the individual defendants, Clayton and Crawford, had violated Section 10(b), and Rule 10b-5, but otherwise the Commission's complaint was ordered dismissed. Appeals were taken by the Commission and by Clayton and Crawford. Eleven of the thirteen original individual defendants, and the corporation, were parties in the proceedings before the Court of Appeals. The appeals were argued before a division of the court consisting of Waterman, Moore, and Hays, Circuit Judges. When the opinions prepared by them were distributed to the other judges of the court it was ordered on May 2, 1968 that the case should, without further argument, be considered in banc upon the record and briefs the parties had filed and upon the opinions that had been prepared and distributed by the panel judges. After in banc consideration the opinions appearing hereafter were prepared. The results reached in Judge Waterman's opinion for the court are concurred in unanimously as to appellee Coates, and appellants Clayton and Crawford; as to the remaining contested issues that opinion represents results concurred in either generally or in separate statements by a majority of the judges. The Court of Appeals, Waterman, Circuit Judge, held that not only are directors or management officers of corporation 'insiders' within meaning of rule of Securities and Exchange Commission, so as to be precluded from dealing in stock of corporation, but rule is also applicable to one possessing information, though he may not be strictly termed an 'insider' within meaning of Securities Exchange Act, and thus anyone in possession of material inside information is an 'insider' and must either disclose it to investing public, or, if he is disabled from disclosing it in order to protect corporate confidence, or he chooses not to do so, must abstain from trading in or recommending securities concerned while such inside information remains undisclosed. Purpose of provision of Securities Exchange Act that it shall be unlawful for any person, directly or indirectly, by use of any means or instrumentality of interstate commerce, or of mails, or of any facility of any national securities exchange, to use in connection with purchase or sale of any security any manipulative or deceptive device in contravention of

rules of Securities and Exchange Commission was to prevent inequitable and unfair practices and to insure fairness in securities transactions generally, whether conducted face-to-face, over the counter or on exchanges. Securities Exchange Act of 1934, 10(b). Provision of Securities Exchange Act that it shall be unlawful for any person, directly or indirectly, by use of any means or instrumentality of interstate commerce, or of mails, or of any facility of any national securities exchange to use in connection with purchase or sale of any security any manipulative or deceptive device and rule promulgated thereunder by Securities and Exchange Commission applies to stock purchases consummated on exchanges. Securities Exchange Act of 1934, 10(b). Essence of rule of Securities and Exchange Commission providing that it is unlawful for any person, directly or indirectly, by use of any means or instrumentality of interstate commerce, or of mails, or of any facility of any national securities exchange, to engage in any act which operates as fraud or deceit is that anyone who, trading for his own account in securities of corporation, has access, directly or indirectly, to information intended to be available only for corporate purpose and not for personal benefit of anyone may not take advantage of such information knowing it is unavailable to investing public. Not only are directors or management officers of corporation "insiders" within rule of Securities and Exchange Commission, so as to be precluded from dealing in stock of corporation, but anyone in possession of material inside information is an "insider" and must either disclose it to investing public, or, if he is disabled from disclosing it in order to protect corporate confidence, or he chooses not to do so, must abstain from trading in or recommending securities concerned while such inside information remains undisclosed. Individuals, who were insiders within meaning of rule of Securities and Exchange Commission precluding insiders from dealing in stock of corporation without disclosing material inside information, were not justified in engaging in insider activity because disclosure of material inside information was forbidden by legitimate corporate activity of acquisition by corporation of options to purchase land surrounding mineral exploration site, and if information was material, individuals should have kept out of stock market until disclosure of inside information was accomplished. An insider, within meaning of rule of Securities and Exchange Commission, is not always foreclosed from investing in his own corporation merely because he may be more familiar with corporation's operations than are outside investors, and duty of insider to disclose information or duty to abstain from dealing in corporation's securities arises only in 27

those situations which are essentially extraordinary in nature and which are reasonably certain to have substantial effect on market price of security if extraordinary situation is disclosed. Insider is not obligated by rule of Securities and Exchange Commission to confer on outside investors benefit of his superior financial or other expert analysis of value of securities of corporation by disclosing his educated guesses or predictions, and only regulatory objective is that access to material information be enjoyed equally, and such objective requires nothing more than disclosure of basic facts so that outsiders may draw on their own evaluative expertise in reaching their own investment decisions with knowledge equal to that of insiders. Basic test in determining whether information of insider is "material inside information", so that insider must disclose information or refrain from dealing with stock or securities of corporation, is whether reasonable man would attach importance to information in determining his choice of action in transaction in question, and that encompasses any fact which in reasonable and objective contemplation might affect value of corporation's stock or securities. "Material inside information" which insider is required by rule of Securities and Exchange Commission to disclose before dealing in stock and securities of corporation includes not only information disclosing earnings and distributions of corporation but also those facts which affect probable future of corporation and those which may affect desire of investors to buy, sell, or hold corporation's securities. Whether facts in possession of insider are material inside information within rule of Securities and Exchange Commission, so that insider cannot deal in stock without disclosing information, when facts known to insider relate to particular event and are undisclosed will depend at any given time on balancing of both, indicated probability that event will occur and anticipated magnitude of event in light of totality of corporation's activity. Efficient Capital Markets Hypothesis (ECMH)

BASIC v. LEVINSON Fraud on the Market The Supreme Court granted certiorari to resolve a split among the courts of appeals as to the standard of materiality applicable to pre-merger discussions, and to determine whether the courts properly imposed a presumption of reliance in certifying class members in an action alleging violations of Section 10(b) of the Securities and Exchange Act and Rule 10b-5 The court held that an omitted fact is material if a reasonable shareholder would consider it important in making their vote, and this standard should be applied to all Section 10(b) and Rule 10b5 actions. The court also held that materiality requires a case by case review of the facts, and a rebuttable presumption exists that s/hs relied on available information when buying or selling securities. The judgment of the court of appeals was accordingly reversed and remanded. New Disclosure Rules after 2001 Consistent with President Bush's "Ten Point Plan" and guided by the core principles of providing better information to investors, making corporate officers more accountable, and developing a stronger, more independent audit system, Sarbanes-Oxley contained a requirement that corporations disclose rapidly and in plain English any information that materially affects the company's financial condition. Corporations also have to include in their annual and quarterly financial reports information on "off-balance-sheet" transactions (like those made famous by Enron). Features of Common Stock Voting Rights Proxy voting Proxy votes are similar to absentee ballots. Proxy fights occur when minority owners are trying to get enough votes to obtain seats on the Board or affect other important issues that are coming up for the vote. Classes of stock Other Rights Share proportionally in declared dividends Share proportionally in remaining assets during liquidation Preemptive right first shot at new stock issue to maintain proportional ownership if desired Takeover Defenses Dual class: voting rights (general or board) Poison pill: triggering threshold Supermajority levels To amend charter, bylaws, approve merger, call for special meeting, act by written consent, remove director with and without cause (if applicable). Comparison with state law (more/less 28

Basic Assumption: Prices of publicly traded assets match the value that asset pricing theory says they should have Efficient Capital Markets Hypothesis, expanded Strong ECMH - Market prices are an unbiased estimate of future cash flows fully reflecting all information Semi-strong ECMH Market prices are based on an unbiased forecast of future cash flows that fully reflects all publicly available information Weak ECMH - Market prices reflect all information contained in the record of past prices

restrictive) for special meeting and written consent rules Summary lists of charter and bylaw amendments Shareholder ability to fill board vacancies Note on state laws opt outs Corporate Governance Conflicts

Independence vs. competence of directors Owner/managers willingness to convey information vs. hostility of board Disclosure vs. discretion Disclosure cuts owner/managers discretion Extraction vs. incentives Increases costs of being listed Windfall gains for minority shareholders

Management Controlling shareholders Minority shareholders Other Corporate Governance Mechanisms

Hostile takeovers Proxy fights Board activity Executive compensation schemes Litigation through courts Bank monitoring Employee monitoring Public opinion and media Controlling shareholders vs. minority shareholders

Forces That Limit Excessive Agency Costs of Centralized Management Competitiveness of product markets Capital markets: access to additional capital Hostile takeover market Hostile tender offers (selling) Proxy fights to replace management (shareholder voting) Board of Directors Fiduciary duties Shareholder lawsuits Annual Meeting Proxy Card Election of Directors Vote on Proposals (for and against) Signature Also, information about how to vote (by mail, by phone and on the Internet) Rule 14a-9 -- False or Misleading Statements

Controlling shareholders incentives to monitor, but can also extract rents Controlling shareholders often critical for restructuring, but minority capital also important Separation of ownership and control (dual class shares and pyramiding) allows control when wealth limited, but undermines incentives Large blockholders vs. other mechanisms Ownership and control structure influences most other governance mechanisms Boards Executive compensation schemes Hostile takeovers and proxy fights Litigation, banks, employees, media? Contestability of control as an objective? Investor protection vs. market for corporate control Investor protection discourages bidders (both good and bad) Weakening insiders to promote takeovers affects both minority and controlling owners Takeovers can help corporate governance, but they also suffer from agency problems Friendly vs. Hostile Boards

No solicitation subject to this regulation shall be made by means of any proxy statement, form of proxy, notice of meeting or other communication, written or oral, containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact, or which omits to state any material fact necessary in order to make the statements therein not false or misleading or necessary to correct any statement in any earlier communication with respect to the solicitation of a proxy for the same meeting or subject matter which has become false or misleading.

The fact that a proxy statement, form of proxy or other soliciting material has been filed with or examined by the Commission shall not be deemed a 29

finding by the Commission that such material is accurate or complete or not false or misleading, or that the Commission has passed upon the merits of or approved any statement contained therein or any matter to be acted upon by security holders. No representation contrary to the foregoing shall be made. Rule 14a-9 (contd) Note: The following are some examples of what, depending upon particular facts and circumstances, may be misleading within the meaning of this section. Predictions as to specific future market values. Material which directly or indirectly impugns character, integrity or personal reputation, or directly or indirectly makes charges concerning improper, illegal or immoral conduct or associations, without factual foundation. Failure to so identify a proxy statement, form of proxy and other soliciting material as to clearly distinguish it from the soliciting material of any other person or persons soliciting for the same meeting or subject matter. Claims made prior to a meeting regarding the results of a solicitation.

pendency of litigation, even to time of ultimate disposition by appellate court. In applying unclean hands doctrine, courts act for their own protection and not as a matter of "defense" to defendant. Public policy not only makes it obligatory for courts to deny plaintiff relief once his unclean hands are established but to refuse to even hear case under such circumstances. Candidate-stockholder's unclean hands would require denial of equitable relief in connection with proxy contest even though other stockholderplaintiffs had not participated in his acts. J. I. CASE v. BORAK

Stockholder's civil action charging deprivation of preemptive rights by reason of a consummated merger. The United States District Court for the Eastern District of Wisconsin dismissed two counts of the complaint upon holding that it had no power to redress alleged violations of the Securities Exchange Act but was limited solely to granting declaratory relief, and that state statute requiring security was applicable except with respect to the count for declaratory relief. On an interlocutory appeal, the United States Court of Appeals for the Seventh Circuit reversed, holding that the District Court had power to grant remedial relief, and that the state statute was not applicable. Certiorari was granted. The Supreme Court, Mr. Justice Clark, held that the Securities Exchange Act authorizes a federal cause for rescission or damages to a corporate stockholder with respect to a consummated merger which was authorized pursuant to the use of a proxy statement alleged to contain false and misleading statements violating the Act. Affirmed. Certiorari was granted to consider whether Securities Exchange Act provision authorizes federal cause of action for rescission or damages to corporate stockholder with respect to consummated merger which was authorized pursuant to use of proxy statement alleged to contain false and misleading statements in violation of the Act. Private parties have right under Securities Exchange Act provision to bring suit for violation of Act making it unlawful to solicit any proxy or consent authorization in violation of regulations prescribed by the Securities and Exchange Commission. Causal relationship of proxy material and merger presented questions of fact to be resolved at trial of stockholder's civil action under Securities Exchange Act for rescission or damages with respect to consummated merger authorized pursuant to use of the proxy statement alleged to contain false and misleading statements violating the Act and were not 30

GAUDIOSI V. MELLON Actions arising out of proxy contest. The United States District Court for the Eastern District of Pennsylvania made the determinations challenged on appeal. The Court of Appeals, Kalodner, Circuit Judge, held that candidate-stockholder's unclean hands would require denial of equitable relief in connection with proxy contest even though other stockholderplaintiffs had not participated in his acts. Two appeals dismissed and orders in other appeals affirmed. In action for declaratory and injunctive relief relative to proxy contest, wherein plaintiffs pleaded a class action in one count of complaint and asserted a derivative claim that defendant directors were liable to corporation for improper expenditure of corporate funds to promote candidacies of management's nominees for director, district court did not abuse its discretion in (1) reserving class action claim for separate trial, (2) in fixing security for expenses at $3,000, or (3) in rejecting, for non-compliance with order, 'costs' bond which bore signature of surety company only. In action for equitable relief relative to proxy contest, evidence sustained finding that one of plaintiffs had "unclean hands" by reason of his attempts to intimidate stockholders. One who comes into equity must come with clean hands and keep those hands clean throughout

to be resolved by Supreme Court on certiorari before trial Private right of action under Securities Exchange Act provision for rescission or damages with respect to consummated merger authorized pursuant to use of proxy statement allegedly containing false and misleading statements in violation of Act exists both as to direct and derivative causes. The purpose of Securities Exchange Act provision making it unlawful to solicit proxy or consent authorization in violation of commission rule is to prevent management or others from obtaining authorization for corporate action by means of deceptive or inadequate disclosure of proxy solicitation, stemming from congressional belief that fair corporate suffrage is important right that should attach to every equity security bought on a public exchange. Securities Exchange Act provision making it illegal to solicit any proxy or consent authorization in violation of commission rules was intended to control conditions under which proxies may be solicited with view to preventing recurrence of abuses which frustrated free exercise of voting rights of stockholders. Among chief purposes of Securities Exchange Act provision making it unlawful to solicit proxy or consent authorization in violation of commission rules is protection of its investors. It is duty of court to be alert to provide such remedies as are necessary to make effective congressional purpose in Securities Exchange Act provision making it unlawful to solicit proxy or consent agreement in violation of commission rules. It is for federal courts to adjust their remedies so as to grant necessary relief where federally secured rights are invaded, and when federal statute provides for general right to sue for such invasion, federal courts may use any available remedy to make good wrong done. Private remedies under Securities Exchange Act provision making it unlawful to solicit any proxy or consent agreement in violation of commission rules are not limited to prospective relief. Overriding federal law would, where facts required, control appropriateness of relief sought by shareholder attacking consummated merger as allegedly achieved by proxy statement containing false and misleading statements in violation of Securities Exchange Act, despite provisions of state corporation law. Fact that questions of state law had to be decided in shareholder's suit seeking, inter alia, rescission or damages with respect to consummated merger authorized allegedly pursuant to proxy statements containing false and misleading statements in violation of Securities Exchange Act did not change

character of right; it remained federal. THOMAS & BETTS CORP. v. LEVITON MFG CO., INC. Minority shareholder, which had purchased its interest in closely held corporation with the goal of ultimately acquiring the entire company, requested inspection of corporation's books and records. The Court of Chancery granted limited inspection so that shareholder could value its shares, and shareholder appealed. The Delaware Supreme Court, held that: (1) shareholder failed to satisfy appropriate standard for inspection of books and records with regard to claim of waste and mismanagement; (2) facilitating its own use of equity method of accounting for its investment was not proper purpose for shareholder's requested inspection; and (3) trial court did not abuse its discretion in limiting scope of inspection to those documents which were essential and sufficient to shareholder's purpose of valuing its shares. Affirmed. Investigation of waste and mismanagement is proper purpose for shareholder to seek inspection of corporation's books and records. Stockholder seeking inspection of corporation's books and records in order to investigate waste and mismanagement must demonstrate that his purpose is proper; in order to meet that burden of proof, stockholder must present some credible basis from which court can infer that waste or mismanagement may have occurred. While stockholder seeking inspection of corporation's books and records in order to investigate waste and mismanagement has burden of coming forward with specific and credible allegation sufficient to warrant suspicion of waste and mismanagement, stockholder does not bear "greater-than-normal evidentiary burden," but rather has a normal burden. Although substantial evidence supported finding that shareholder's primary motives for inspection of closely held corporation's books and records were improper, shareholder failed to adduce sufficient evidence of waste and mismanagement to be entitled to inspection. Where in-court witness testifies to substance of statements made by out-of-court declarant and testimony is offered to prove truth of matter asserted, hearsay problem arises. Shareholder's statements during negotiations for sale of his shares were hearsay when offered to prove that waste and mismanagement had occurred at the company. Shareholder's statements during negotiations for sale of his shares were not admissible under hearsay exception for testimony of agent or servant concerning matters within scope of his agency or 31

employment, where shareholder was acting in his capacity as shareholder and was actively engaged in process of defecting to his company's suitor. Shareholder's contention that it needed access to records of closely held corporation to facilitate its use of equity method of accounting for its investment in the company was not a proper purpose; shareholder's need to account for its investment by particular method stemmed from its relationship with its own stockholders and bore no relationship to its status as shareholder; even if shareholder's accounting purpose was proper, shareholder failed to meet its evidentiary burden, since it was questionable whether it could justify use of equity accounting, given its lack of control over the company. Trial court has wide latitude in prescribing any limitations or conditions on inspection of corporation's books and records. Having found that shareholder's primary purpose for inspecting books and records of closely held corporation was to further its plans for acquiring corporation, that this interest was antithetical to interests of corporation, but that unwillingness of corporation's principal to negotiate change-of-control transaction put shareholder in unenviable position of "locked-in" minority stockholder, trial court properly limited shareholder's inspection to those documents which were essential and sufficient to its purpose of valuing its shares. Even where no improper purpose has been attributed to inspecting shareholder, burden of proof is always on party seeking inspection of corporation's books and records to establish that each category requested is essential and it is sufficient to stockholder's stated purpose. Thomas & Betts v. Levition The Final Word As a result, when corporate financial records are made available and those records provide an adequate basis upon which to value the shareholder's stock, courts have justifiably denied shareholder requests for additional corporate information. Thomas & Betts Corp. v. Leviton Mfg. Co., 685 A.2d 702, 714-15 denied stockholder's demand to inspect corporate contracts, lease and real estate agreements, internal financial statements and "key man" life insurance policies when corporate financial statements were available for inspection), aff'd, 681 A.2d 1026 (Del. 1996) Ironically, Thomas & Betts Corp sold its 29.1 percent stake in Leviton Manufacturing Co back to the family that controls Leviton for $300 million in June of 2008. It recorded an aftertax gain of about $1.70 a share from the sale. (Thomas & Betts purchased the stake in Leviton, a private maker of electrical wiring devices and energy management and lighting control products, in 1994.) Under the terms of the deal, if Leviton sells itself to anyone over the next three years at a price per share higher than the sum paid to Thomas & Betts, Leviton will pay Thomas &

Betts its prorated share of the difference. Sarbanes-Oxley Overview Sarbanes-Oxley Act of 2002 (SOA) enacted July 30, 2002 Corporate scandals (Enron, WorldCom) provided impetus for Congress to act quickly SOA approved by near unanimous vote in Congress (vote of 99-0 in the Senate and 423-3 in the House) Fast pace of approval likely to result in need for numerous interpretations and explanations Potential for far reaching impact on Corporate Governance and Conduct, Financial Reporting and the Public Accounting Profession Also affects legal community and investment banking analysts Several provisions of the SOA require detailed regulations by the SEC and other regulatory bodies SOA aims to restore investor confidence in financial reporting and public capital markets Broadly speaking the Acts provisions seem to be built around the following principles: Integrity Independence Proper Oversight Accountability Strong Internal Controls Transparency Deterrence Intended to provide more reliable, timely and useful information to investors Requirements span the reporting supply chain, reinforce accountability Requirements affecting Senior Executives, Individual Directors Requirements affecting the Board of Directors and Board Committees Requirements affecting outside Auditors CEO/CFO Certifications to assure accuracy, completeness and timeliness (separate civil, criminal certifications) Establish and assess disclosure controls and procedures for collecting, processing and disclosing information required to be disclosed in periodic reports (10K, 10Q, 8-K) (previous requirement); internal control reports in annual reports (fiscal years post 9/15/03) 32

Accelerated reporting by Executive Officers and Directors (2 days) Code of Ethics, Senior Financial Officers (Disclose in 10K after 1/26/03) Clawbacks for CEO/CFO bonus, stock sales profits if companys financial statements are restated due to st misconduct (12 months from 1 disclosure) Additional disclosure issues Off-balance sheet transactions, contractual commitments, and contingent liabilities ( Q1 03) Pro forma (non-GAAP) informationquantitative reconciliation (Q1 03) Earnings releases; other material, nonpublic information about annual/quarterly fiscal periods on Form 8-K (Q1 03) Additional (and accelerated) Form 8-K events (SEC proposed 6/02) MD&A critical accounting policies (SEC proposed 5/02) SHS approve equity-based compensation plans (NYSE/NASD 10/02 filings with SEC) No improper influence of Auditors (SEC proposed 10/02; effective Q1 03) Trading restrictions for Executive Officers and Directors- benefit plan blackout periods Corporate Governance requirements affecting full Board of Directors Audit Committee oversight, composition/integrity, reporting mechanism, pre-approvals Audit Committee and independent Auditors seen as key to restoring faith in the process of financial reporting and oversight Audit Committee will have enhanced role in Corporate Governance Bans on loans to Executive Officers/Directors (Compensation Committee) Increased Audit Committee Oversight Responsibilities: Directly responsible for appointment, compensation and oversight of independent Auditors (SOA);) Have sole authority to appoint, compensate and oversee outside Auditor (NASDAQ) Approve, in advance, the provision by the Auditor of all permissible non-audit services Authority to engage and determine funding for independent counsel and other advisors; company must provide funding Have a written charter (NYSE)(NASDAQ- 6

months post SEC approval) Public Company Accounting Oversight Board established Oversight of audit of public companies, protect investor interests Responsibilities include: Register and inspect public accounting firms Set standards for outside Auditors Enforce compliance with SOA Not a government agency; First meeting held January, 2003 5 members (only 2 CPAs)

WELCH V. CARDINAL BANKSHARES Corporate executive, who was terminated for engaging in activities protected by Sarbanes-Oxley Act's whistleblower protection provision, filed petition seeking enforcement of an ALJ's order of reinstatement. Employer filed motion to dismiss. Holdings: The District Court, held that: (1) ALJ's order was a preliminary order, and (2) court did not have subject matter jurisdiction to enforce ALJ's preliminary order. Welch v. Cardinal Bankshares (contd) Administrative law judge's (ALJ) order calling for reinstatement of corporate executive terminated for engaging in activities protected by Sarbanes-Oxley Act's whistleblower protection provision was a preliminary order of reinstatement where Department of Labor's Administrative Review Board (ARB) had not issued an order adopting the decision. Court did not have subject matter jurisdiction to enforce ALJ's preliminary order calling for reinstatement of corporate executive terminated for engaging in activities protected by Sarbanes-Oxley Act's whistleblower protection provision. Although agency rules are generally entitled to some deference by the court, deference cannot apply in situations in which the statute is granting jurisdiction to the federal courts because it would be inappropriate to consult executive interpretations of the statute to resolve ambiguities surrounding the scope of the judicially enforceable remedy. Due to the jurisdiction-conferring nature of statute governing enforcement of Department of Labor rulings, inconsistent agency interpretations could not inform the court's interpretation of the statute. Filing of an enforcement action with the district court under Sarbanes-Oxley Act's whistleblower protection provision vests jurisdiction in the district court. Under our constitutional scheme and Supreme Court precedent, the district court is required to strictly interpret a statutory grant of subject matter jurisdiction rather than to overread a congressional enactment. It is not for the court to fashion a remedy, even in those circumstances in which 33

principles of fairness might counsel intervention, when Congress has chosen not to provide for the form of redress sought by the plaintiff. For the reasons stated, the defendants' motion to dismiss was granted and the plaintiffs' petition to enforce the order of reinstatement was denied. The court's opinion should not be read as expressing any view as to the merits of plaintiff's claim of retaliation.

Euphemia DONAHUE v. RODD ELECTROTYPE COMPANY OF NEW ENGLAND, INC. Action was brought by minority stockholder in close corporation against the directors, the former director, officer and controlling shareholder and against corporation seeking to rescind corporation's purchase of former controlling shareholder's shares. The Superior Court, Middlesex County dismissed the bill and the minority stockholder appealed. The Appeals Court affirmed and leave to obtain further appellate review was granted. The Supreme Judicial Court held that the stockholders in close corporation owed one another the same fiduciary duty as that owed by one partner to another in a partnership and that the action of controlling stockholders in authorizing purchase of former controlling stockholders' shares by corporation without granting an equal opportunity to minority shareholder to sell shares for same price constituted a breach of fiduciary duty. Final decree insofar as it dismissed bill as to specific defendants and awarded costs reversed and case remanded for entry of judgment. Just as in a partnership, relationship among stockholders of corporation must be one of trust, confidence and absolute loyalty if enterprise is to succeed Although corporate form provides advantages for stockholders such as limited liability, perpetuity, etc., the close corporation provides an opportunity for majority stockholders to oppress or disadvantage minority stockholders who are subject to a variety of oppressive devices termed "freeze-outs" which majority may employ. To secure dissolution of ordinary close corporation, stockholder in absence of corporate deadlock must own at least 50% of the shares or have advantage of favorable position in articles of organization. Stockholders in close corporation owe one another substantially the same fiduciary duty in operation of the enterprise that partners owe to one another, and such stockholders must discharge their management in stockholder responsibilities in conformity with strict good faith standard and may not act out of avarice, expediency or self-interest in derogation of their loyalty to other stockholders and to the corporation. Strict good faith standard which stockholders in close corporation must observe in discharging management and stockholder responsibilities is in

contrast to somewhat less stringent standard of fiduciary duty which directors and stockholders of all corporations must adhere in discharge of their corporate responsibilities. Corporate directors are held to good faith and inherent fairness standards of conduct and are not permitted to serve two masters whose interests are antagonistic, and since their paramount duty is to the corporation and their pecuniary interests are subordinate to that duty. Agreement to reacquire stock is enforceable subject at least to the limitation that the purchase must be made in good faith and without prejudice to creditors and stockholders. When corporation reacquiring its own stock is a close corporation, the purchase is subject to the additional requirement that stockholders who as directors or controlling stockholders cause corporation to enter into stock purchase agreement must act with utmost good faith and loyalty to other stockholders. If stockholder in close corporation whose shares were purchased was a member of controlling group, controlling stockholders must cause corporation to offer each stockholder an equal opportunity to sell a ratable number of his shares to corporation at an identical price. Close corporation may purchase shares from one stockholder without offering the others an equal opportunity if all other stockholders give advance consent to stock purchase arrangement through acceptance of appropriate provision in the articles of organization, the corporate bylaws, or a stockholder's agreement; similarly all other stockholders may ratify purchase.

GALLER V. GALLER Action for specific performance of shareholders' agreement and for accounting. The Cook County Superior Court entered a decree adverse to defendants, and they appealed. The Appellate Court for the First District reversed in part and affirmed in part and remanded. Further appeal was taken. The Illinois Supreme Court held that where the agreement was not a voting trust but a straight contractual voting control agreement which did not divorce voting rights from ownership of stock in a close corporation, the duration of the agreement, which was interpreted as continuing so long as one of the two majority stockholders lived, did not offend public policy and did not render the agreement unenforceable. Affirmed in part, reversed in part and remanded with directions. Unless agreement is part of corrupt scheme, agreements between stockholders dealing on equal terms should be invalidated on grounds of public policy only where corrupt or dangerous tendency clearly and unequivocally appears on face of agreement or is necessary inference from matters expressed. For purpose of determining whether public policy 34

requires invalidation of shareholders' agreement, a "close corporation" is one in which stock is held in a few hands, or in few families, and wherein it is not at all, or only rarely, dealt in by buying or selling. In view of purposes of stockholders' agreement, which was not expressed to be for definite term and was to be binding upon and was to inure to benefit of legal representatives, heirs and assigns of parties, intention, that agreement was to be operative only so long as either of two majority stockholders was living was ascertainable from agreement as a whole. Where corporation was close corporation, clause of stockholders' agreement providing for election of certain persons to specified offices for period of years did not require invalidation. Stated purpose of stockholders' agreement to provide income for support and maintenance of stockholders' immediate families did not invalidate agreement, nor did fact that subject property was corporate stock, where corporation was close corporation and there existed no detriment to minority stock interests, creditors or other public injury. Where agreement between stockholders of close corporation required minimum annual dividend of $50,000, but only if earned surplus of $500,000, was maintained, such contractual requirements as restricted were not invalid. Where agreement between shareholders and agreement for continuation of salary to widow of deceased shareholder was contingent on deductibility for corporate income tax purposes and no complaining minority interests appeared, such salary continuation agreement was not invalid. Where shareholders' agreement relating to directorships, salary continuation and dividends was not invalid, defendant director-shareholders were properly ordered, on petition seeking such relief, to account for all moneys received by them from corporation from time that such defendants took control. LLC Operating Agreements (note 1, p. 330) Take the place of both the bylaws and shareholder/buy-sell agreement used for a corporation Address issues such as type of membership interests, who owns the membership interests, rights and duties of members, whether the LLC is member managed or manager managed, rights and duties of any officers, capital accounts, allocation of profits, transferability, and indemnification of managers, employees and agents

BAKER V. COMMERCIAL BODY BUILDERS, INC. Owners of 49% Of stock in a 'close corporation' filed action against owners of remaining stock and directors of corporation to compel dissolution of corporation for alleged oppressive and fraudulent conduct of defendants. The Multnomah County Circuit Court

dismissed the complaint and the plaintiffs appealed. The Oregon Supreme Court held that though some of defendants' conduct, including preventing plaintiffs from examining corporate records and failing to notify plaintiffs of certain corporate meetings, was 'oppressive' conduct within statute authorizing liquidation of assets and business of a corporation when it is established that acts of directors are illegal, oppressive or fraudulent, trial judge was not in error in finding that such conduct was not so serious as to require dissolution of corporation or any other equitable relief in view of fact that most of conduct complained of occurred during one year and did not continue after that year. Affirmed. Conduct of corporate directors or others in control of corporation need not be fraudulent or illegal to be "oppressive" within statute authorizing circuit court to liquidate the assets and business of a corporation when it is established that acts of directors or those in control are illegal, oppressive or fraudulent. Nonetheless, in a suit pursuant to statute permitting liquidation of assets and business of a corporation when it is established that acts of directors or those in control are illegal, oppressive or fraudulent or that corporate assets are being misapplied or wasted, circuit court is not required to dissolve corporation upon proof of deadlock between its stockholders but may consider equities of individual case and the circuit court retains discretion to grant or refuse equitable relief. Though showing of "imminent disaster" is not required to authorize liquidation of assets and business of a corporation pursuant to statute authorizing liquidation when acts of directors or those in control are illegal, oppressive or fraudulent, or corporate assets are being misapplied or wasted, liquidation is not available upon showing of mere vague apprehensions of possible future mischief or injury or to extricate minority stockholders from an investment that turns out to be a bad bargain. A "close corporation" is not like a partnership and a minority stockholder does not have the right to demand dissolution of a corporation upon substantially the same showing as might be sufficient for dissolution of a partnership. While showing of "oppressive" conduct by directors or others in control of corporation may be sufficient to confer jurisdiction of minority stockholder's action to liquidate corporation under statute, such showing does not require circuit court to exercise power conferred upon it by statute and does not require either dissolution of corporation or any other alternative equitable remedy. In suit for "oppressive" conduct of directors or others in control consisting of a "squeeze out" or "freeze out" of minority stockholders in a "close corporation," courts are not limited to remedy of dissolution but may, as an alternative, consider other specified appropriate equitable relief. 35

Close Corporations Other factors to consider: Similar to partners carrying out a joint business for profit. The corporation may be their only source of income. Their investment in the business may also represent the majority of their personal assets. Allocation of Control Issues Courts allow shareholders in close corporations to modify the allocation of corporate control shareholder voting agreements voting trusts classified stock super-majority voting or quorum restrictions on share transfer Fiduciary Obligations in Close Corporation -- Shareholders in a close corporation have the following duties: a duty of reasonable care a duty to further the interests of each other within the scope of the relationship a duty not to withhold relevant information regarding the affairs of the relationship a duty not to use their positions to gain special advantage over the other people involved Public Policy Considerations Shareholders depend upon the corporation for their livelihood. Minority vulnerable to "freeze-outs" - controlling shareholder prevents minority from realizing the economic benefits of the corporation. Controlling shareholder can exercise economic coercion to get the minority shareholders to relinquish their shares at unfairly low prices Reasonable Expectations A shareholder in a close corporation may reasonably expect ownership will entitle him or her to a job, a place in management, a regular dividend, or some other form of security. The expectations of the shareholder must be: Reasonable under the circumstances Central to the decision to join the corporation Reasonable expectations may change over time Proper Purpose If acts defeat reasonable expectations, majority still has opportunity to show that they took action for a proper business purpose. The injured shareholder then has the right to show that there were alternative methods to achieve the business purposes that were less harmful to the minority. Public Policy Considerations Nature of the relationship in close corporation where

shareholders are similar to partners. Risk that majority shareholders are using economic duress to oppress, disadvantage or freeze-out a minority shareholder. Rule 14a-8 (contd) The SEC recently restructured this section in a question-and- answer format so that it is easier for the public to understand. The references to "you" in the new version of the Rule are to a shareholder seeking to submit the proposal. Altogether, there are 13 questions, some with rather longish answers, to illustrate how the Rule works. Rule 14a-8 (contd) Question 1: What is a proposal? Question 2: Who is eligible to submit a proposal, and how do I demonstrate to the company that I am eligible? Question 3: How many proposals may I submit? Question 4: How long can my proposal be? Question 5: What is the deadline for submitting a proposal? Question 7: Who has the burden of persuading the Commission or its staff that my proposal can be excluded? Rule 14a-8 (contd) Question 8: Must I appear personally at the shareholders' meeting to present the proposal? Question 9: If I have complied with the procedural requirements, on what other bases may a company rely to exclude my proposal? Question 10: What procedures must the company follow if it intends to exclude my proposal? Question 11: May I submit my own statement to the Commission responding to the company's arguments? Question 12: If the company includes my shareholder proposal in its proxy materials, what information about me must it include along with the proposal itself? Question 13: What can I do if the company includes in its proxy statement reasons why it believes shareholders should not vote in favor of my proposal, and I disagree with some of its statements? LOVENHEIM v. IROQUOIS BRANDS, LTD.

Shareholder filed suit seeking to bar corporation from excluding from proxy materials being sent to all shareholders in preparation for an upcoming shareholder meeting information concerning a proposed resolution he intended to offer at meeting. On shareholder's motion for preliminary injunction, the District Court held that shareholder demonstrated likelihood of prevailing on merits with regard to issue 36

of whether his proposed addition to proxy materials being sent to all shareholders in preparation for an upcoming shareholder meeting was "otherwise significantly related" to corporation's business within meaning of shareholder proposal rule, thus entitling shareholder to a preliminary injunction to bar corporation from excluding from proxy materials his proposed resolution related to procedure used to force-feed geese for production of pt de foie gras" in France, a type of pt imported by corporation, despite fact that none of corporation's net earnings and less than .05% of its assets were implicated by proposal; ethical and social significance of shareholder's proposal warranted inclusion in materials. Motion granted. Do you agree that the shareholder demonstrated likelihood of prevailing on merits with regard to issue of whether his proposed addition to proxy materials being sent to all shareholders in preparation for an upcoming shareholder meeting was "otherwise significantly related" to corporation's business within meaning of shareholder proposal rule, thus entitling shareholder to preliminary injunction to bar corporation from excluding from proxy materials his proposed resolution? How significant is the procedure used to force-feed geese for production of pt de foie gras in France, a type of pt imported by corporation, in the light of the fact that none of corporation's net earnings and less than .05% of its assets were implicated by proposal. Should ethical and social significance of shareholder's proposal warrant inclusion in materials? Where can a line be drawn?

STROH v. BLACKHAWK HOLDING CORP. Action by class A shareholders' protective association for decree cancelling class B stock certificates and restraining holders thereof from voting them at any shareholders' meeting. The Circuit Court entered final decree finding that issuance of such stock was invalid and ultra vires and defendants appealed. The Appellate Court reversed and remanded with directions. The Illinois Supreme Court held that corporation's class B stock, holders of which were entitled to vote, were valid shares of stock notwithstanding stock was not entitled to any dividends on voluntary or involuntary liquidation or otherwise, and right to vote which they possessed was not separation of voting rights from ownership of corporate shares. Judgment of Appellate Court affirmed and cause remanded to Circuit Court with directions. Schaefer, J., dissented and filed opinion in which Ward, J., concurred, noting that the public policy of Illinois condemns the separation of voting rights from beneficial stock ownership, and that, under Illinois law, the issuance of nonvoting stock was prohibited by section 3 of article XI of the state constitution of 1870. Corporation's class B stock, holders of which were entitled to vote, were valid shares of stock notwithstanding stock was not entitled to any dividends on voluntary or involuntary liquidation or otherwise, and right to vote which they possessed was not separation of voting rights from ownership of corporate shares. Count I of the plaintiffs' three-count complaint alleged that the Class B shares of stock issued by the defendant, Blackhawk Holding Corporation, were not valid shares of corporate capital stock in that their principal attribute consisted solely of the right to vote. The circuit court granted the plaintiffs' motion for summary judgment on count I and held that the Class B shares did not constitute shares of stock; that their issuance by the corporation was an invalid, ultra vires act; and was void ab initio. The only issue before this court is the validity of the 500,000 shares of Class B stock, which by the articles of incorporation of Blackhawk were limited in their rights by the provision none of the shares of Class B stock shall be entitled to dividends either upon voluntary or involuntary liquidation or otherwise. The plaintiffs contended that because of the limitation -- depriving the Class B shares of the economic incidents of shares of stock, or of the proportionate interest in the corporate assets the Class B shares do not in fact constitute shares of stock. The Illinois constitution requires only that the right to vote be proportionate to the number of shares 37

In addition to considering likelihood of prevailing on the merits, the courts consideration of plaintiff's motion for preliminary injunction requires a determination as to whether plaintiff will suffer irreparable injury without such relief and whether issuance of requested relief will substantially harm other parties, as well as consideration of public interest. Does this affect your view of the decision? The court holds that it should not matter that shareholder's resolution was likely to fail at the shareholder meeting in determining irreparable harm if corporation were permitted to exclude his resolution from proxy materials being prepared for meeting; without a preliminary injunction, the shareholder would lose an opportunity to communicate his concern with those shareholders not attending the meeting. Is this a proper concern? Is the holding consistent with public interest in view of "overriding" public interest embodied in the federal securities statute and shareholder proposal rule in assuring shareholders right to control important decisions which affect corporations, as the court maintains?

owned, not to the investment made in a corporation. It has long been the common practice in Illinois to classify shares of stock so that one may invest less than another in a corporation, and yet have control. In this case the parties went one step further than is customary. The stock which could be bought cheaper, and yet carry the same voting power per share, was not permitted to share at all in the dividends or assets of the corporation. However, this additional step did not invalidate the stock. Dissent criticizes the majority opinion for stating that In the area of public policy we must consider that all requirements of the securities division of the office of the Secretary of State have been met. The fact is, however, that the stated requirement that the Class B stock be less than 1/3 of the total number of shares outstanding after the public offering was not met in this case. After the public offering, which the record shows was closed on June 25, 1964, the number of shares of Class B stock substantially exceeded one-third of the total number of shares outstanding. The total number of shares outstanding was 1,087,868, of which 500,000 shares were Class B stock. More important in the long run than the factual error, however, is the implication that the public policy of Illinois can be fixed by regulations issued by a Secretary of State. That implication runs counter to what most commentators think is the correct view, stated elsewhere in the majority opinion, that the public policy of a State must be sought in its constitution, legislative enactments and judicial decisions. ZETLIN V. HANSON HOLDINGS, INC. Minority shareholder sued the owners of an effective controlling interest complaining of the sale of their interest for a premium price. The Supreme Court, Special Term, New York County, rendered partial summary judgment for defendants and denied plaintiff's motion to substitute a party and file further amended complaint and to compel depositions. The Supreme Court, Appellate Division, affirmed, and appeal was taken. The Court of Appeals held that: (1) absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts of bad faith, a controlling stockholder is free to sell and the purchaser is free to buy that controlling interest at a premium price, and (2) adoption of rule that a controlling interest may be transferred only by means of a tender offer would be contrary to existing law and so radical a change that it would be best effectuated by the legislature. Affirmed. Absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts of bad faith, a controlling stockholder is free to sell, and the purchaser is free to buy, that controlling interest at a

premium price. Although minority shareholders are entitled to protection against abuse by controlling shareholders, they are not entitled to inhibit the legitimate interests of the other stockholders. Any rule that a controlling interest in a corporation be transferred only by means of an offer to all stockholders, i. e., a tender offer, rather than by way of acquisition from controlling shareholders would be contrary to existing law and so radical a change that it would be best effectuated by the legislature. Plaintiff Zetlin owned approximately 2% Of the outstanding shares of Gable Industries, Inc., with defendants Hanson Holdings, Inc., and Sylvestri together with members of the Sylvestri family, owning 44.4% Of Gable's shares. The defendants sold their interests to Flintkote Co. for a premium price of $15 per share, at a time when Gable was selling on the open market for $7.38 per share. It is undisputed that the 44.4% acquired by Flintkote represented effective control of Gable. From the lone dissent by Judge Kupferman in the Appellate Division below: The plaintiff owned 2% and sues for himself alone and not derivatively or as a member of a class, challenging the arrangement on the sole basis that he should have had an opportunity also to sell his shares. Both companies are public, and their shares are traded on the New York Stock Exchange. The price received for the shares was approximately twice the market price at the time of the transaction, and so it is quite apparent that a premium was paid for the controlling interest. Although a point is made of the fact that certain principal officers of the company taken over were given lucrative long term employment contracts and fringe benefits as part of the transaction, this merely points up the fact that with the transfer of control, special arrangements had to be made for key personnel. It does not enter into my conclusion other than to emphasize the concession candidly (and I might say, commendably) made by counsel for the defendants that a transfer of control was purchased. We have here the simple question of whether a minority stockholder, an outsider to the controlling group, is entitled to an equal opportunity to sell holdings at the same premium that the controlling group received for the sale of its interest. The majority here holds that, absent looting, conversion or fraud, etc., there is no interdiction and no need to consider the position of a minority stockholder. I had thought that controlling stockholders in their relationship to other shareholders (citing Meinhard v. Salmon). PARAMOUNT COMMUNICATIONS V. TIME Paramount (Marvin Davis) Made Negotiable Tender offer ($175 increased to $200) for Time. As a Defensive Maneuver Time Recast Offer to Warner as Part Cash and Part Stock, still giving 38

Warner Shareholders a Premium (and Avoiding a Vote by Time Shareholders) and Maintained Other Defenses to the Warner Deal, thereby Thwarting Paramounts Tender Offer PARAMOUNT ASKS THE COURT TO INTERVENE Says that Time Had Put Company Up for Sale Because Time Shareholders Would own a Minority of Time-Warner The Character of Time Would Dramatically Change because of Debt and Combination with Warner Under Unocal Standard, there is No Threat to Shareholders and Reaction was not Proportional to any Perceived Threat THE COURT SUPPORTS TIMES BOARD Revlon Duties not Triggered by the Initial Merger Proposal or by Modified Transaction with Warner There is no Change of Control because the Stock of Time-Warner Would be Owned by a large Aggregation of Shareholders Time was not Put Up for Sale Under Unocal, there was a Perceived Threat to Shareholders (Because Board Properly Found Value in a Time-Warner Combination) and the Response was Proportional to the Threat Paramount could buy the Combined Time-Warner INTERPRETATIVE QUESTIONS Why Didnt the Time Board or the Court Allow the Time Shareholders to Decide What was best for Them? What do you Suppose were the Motivations of the Time Board? Would the Decision have been Different if the Time Board was Attempting to Retain Control? Do you Think that the Court is Correct in Saying that Revlon is not Triggered? Was this a Good Deal for the Time Shareholders? AFTERMATH OF DECISION Time acquires 51% of Warner @$70 per share cash, and completes squeeze-out merger for remainder using $10 Billion of junk bonds Time Shareholders get no vote, and Time Stock immediately drops Paramount withdraws its Tender Offer Time Stock drops to mid-50s & has to Refinance Debt Time-Warner and AOL are Merged (with AOL as nominal acquirer), Temporarily called AOL TimeWarner In 2002, Time-Warner takes a total Approximate $100 Billion Impairment Write Off

The Aftermath for Time In 2000, a new company called AOL Time Warner, with Steve Case as chairman, was created when AOL purchased Time Warner for US$164 billion. The deal, announced on January 10, 2000 and officially filed on February 11, 2000, employed a merger structure in which each original company merged into a newly created entity. The Federal Trade Commission cleared the deal on December 14, 2000, and gave final approval on January 11, 2001; the company completed the merger later that day. The deal was approved on the same day by [ the Federal Communications Commission, and had already been cleared by the European Commission on October 11, 2000. The shareholders of AOL owned 55% of the new company while Time Warner shareholders owned only 45%, thus the smaller AOL bought out the far larger Time Warner. 39

After the merger, the profitability of the ISP division (America Online) decreased. Meanwhile, the market valuation of similar independent internet companies drastically fell. As a result, the value of the America Online division dropped significantly. This forced a goodwill write-off, causing AOL Time Warner to report a loss of $99 billion in 2002 at the time, the largest loss ever reported by a company. In 2003, the company dropped the "AOL" from its name, and removed Steve Case as executive chairman in favor of Richard Parsons, with AOL remaining a part of the company. That same year, Time Warner spun off Time-Life's ownership under the legal name Direct Holdings Americas, Inc. Case resigned from the Time Warner board on October 31, 2005. The Revlon Test QVC-Paramount line of cases makes clear that while an auction is not necessary to satisfy the duty to seek best value, deal protection measures adopted without a market test must not unduly inhibit the ability of the board of a target company to negotiate with other potential bidders to obtain the highest possible value for the targets stock Directors should also not favor a bidder in which they have an interest The Entire Fairness Test, yet again If directors have economic interests that are in material conflict with those of the shareholders, the general business judgment test may not be applicable Directors may have to demonstrate that the transaction is entirely fair to the corporation and the shareholders (the entire fairness test) The importance of an active independent committee of directors: o Committee should select and retain its own advisors, including investment bankers and counsel o Committee should be fully informed, both regarding the terms of the transaction and in terms of diligence o To fulfill their duties, directors serving on a special committee must actively oversee the conduct of the transaction (usually done on its behalf by the Committees advisers coupled with numerous update meetings BUT WHEN PARAMOUNT WANTED TO CHOOSE VIACOM AS ITS BUYER Paramount (Marvin Davis) wanted to Merge with Viacom (Sumner Redstone) A number of Defensive Measures Protected the Deal QVC wanted to Purchase Paramount and Waged a Hostile Offer, While Filing Suit Against Paramount

Asking to Enjoin Defensive Maneuvers The Delaware Supreme Court Ruled that there was a Change of Control because Sumner Redstone controlled Viacom. Shareholders Should Get Control Premium Court relies on the Fact that there was a Competing (QVC) Offer Found that Defensive Tactics (No Shop, Break-Up Fee and Options) Were Unreasonable, and Therefore Void. WHO DECIDES? In the Context of Unocal and Paramount v. Time, the Board of Directors Decided If the Courts Determine that Defensive Measures are Inappropriate, then the Shareholders Decide (Revlon & QVC) Maybe the Courts are Taking Sides and Determining What is Best for the Shareholders? The Takeaway The importance of good process o The fairness of a corporate transaction has two components - substantive fairness (fair price); and - procedural fairness (fair dealing) o Courts do not generally like to decide whether a corporate transaction is substantively fair - For example, whether the terms of a merger are fair o The more defendants can show procedural fairness, the less likely it is that a court will overturn the directors determination as to the economic fairness of a transaction - For example, careful study by disinterested directors with access to relevant material information and with good and knowledgeable advisers

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