CORPORATIONS OUTLINE

Squires
Spring 11
Professor Lin

Organization and Structure of a Corporation

 Corporation: characterized by limited liability, centralized decision making, perpetual

existence, free transferability of ownership
o Can do all of this with LLC; however, everyone is more comfortable with corporations
because there is case law
o “legal person”: has assets, liabilities, contractual rights, credit rating, right to sue, right
to be sued, due process rights, etc.
 Treated as a person when constitutional rights/provisions can be seen as
protecting commercial interests
o Mostly a malleable set of default rules that specifies the terms of the parties’ relationship
unless they agree otherwise
o For the most part, corporate law is state law
 Roles:
o Officers: are in charge of the day-to-day operations of the corporation (e.g., CEO,
President, CFO, etc.); not very regulated by corporate law
 Can bind corporation:
 When officer had preexisting authority to do so (whether express, implied,
inherent or apparent); and
 When the corporation ratified the transaction (or was otherwise estopped
from denying it), even though the officer lacked authority to bind the
corporation
 Ratification: kicks in when a corporation (through its board of
directors) somehow OKs a transaction that an officer had no
preexisting authority to enter into on the corporation’s behalf

 Officers have actual authority whether express or implied

 Express authority – given through articles, bylaws or resolutions of the
board
 Implied authority – can be either inherent in the officer’s particular position
or a pattern of conduct exists (officer has done this and directors or SHs
have accepted)
 Inherent authority – stems from officer’s particular office; 2 most
important:
 President: only officer who has the power to bind the corporation to
anything within the ordinary course of business
 Secretary: can certify that others have the authority to bind the
corporation
o Directors: elected by shareholders to supervise the officers (SH’s representatives); no
authority to act as individuals only through board; most corporate law ISSUEs between
directors and SHs; part time job; set major Corp. policy and hire officers

 Directors set policy; officers execute

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  “All corporate powers shall be exercised by or under the authority of, and the
business and affairs of the corporation managed under the direction of, its board
of directors.”
o Shareholders (SHs): “owners” of the corporation; possess important control rights; not
personally liable for the obligations of the corporation – limited liability; Residual
claimants; elect directors
 Only have a limited governance role: can vote to elect directors, approve
fundamental corporate changes and initiate limited reforms
 No power to act on behalf of the corporation
 Rights protected through: voting rights, litigation rights and liquidity rights
 Structure:
o Public corporation: shares owned by large number of investors and traded in public
securities markets
o Closely-held corporations: shares owned by small number of SHs without access to
public securities markets
 Operate functionally the same as partnerships in terms of decision-making
o Structure determines roles; in public corp. usually three distinct groups of people
whereas in closely held it is norm to have overlap
o Structure determines mechanisms of control; in public – directors exercise formal
mechanisms but SHs control directors, if at all, through elections and voting on
proposals (SH oversight is weak); in closely held – SHs exercise formal mechanisms of
control
o Public corps subject to disclosure requirements under federal securities law changes
decisions of directors and SHs
o Rules governing relations between officers, directors and SHs taken from state of
incorporation (based on “internal affairs doctrine”)
 Return on Investment?
o Creditors (including bank lenders, bondholders, trade creditors and employees) are first
in line and receive a return based on contracts
o SHs are last in line and receive dividends as declared at the discretion of the board

 Incorporation
o Most statutes require only one person to form a corporation
o Corporation comes into existence when articles of incorporation are filed with the state,
unless a later effective date is specified
o Articles of Incorporation/Charter: the organizing document used to incorporate a
company
 incorporator signs and files articles of incorporation; after formation, call first
meeting of SHs/directors to elect officers/directors, adopt by-laws; then usually
exits
 Incorporator usually elects directors, who complete organization
 Adopt by-laws
 Appoint officers
 ISSUE stock
 Required to include certain provisions, including name, number of authorized
shares of stock, name and address of registered agent
 Requirements for articles of incorp also include:
 Initial directors (permitted under
 requires if incorporator power terminates at filing
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  Corporate purposes
 must also include the purpose of the corporation which can be
general as “to engage in any lawful purpose for which a corporation
may be organized”
 Limitations expressed in charter; three means of enforcing: 1) SH
suit against Corporation 2) suit by Corp against directors or officers
for actions beyond purpose 3) involuntary judicial dissolution
proceeding by attorney general
 Management Provisions
 Usually placed in bylaws; but placed in Charter to insulate from
change by SHs; only directors may propose changes to the charter
(which must be approved by SHs to become effective) 
 Bylaw Provisions
 Anything required or permitted to be in bylaws
 Director Liability
 Exculpatory provisions
 Indemnification
 NOT REQUIRED:
 Duration
 MBCA § 3.02 presumes corporation is perpetual unless charter
provides otherwise
 Initial capital
 MBCA eliminates minimum capital requirements
o By-laws: document adopted after incorporation; deals with internal governance
 CHARTER ALWAYS TRUMPS BY-LAWS because harder to change
 Inlcudes:
 Date, time, place of annual SHs meeting
 Regular meeting of board of directors
 Voting rules, existence of quorum
 Express authority of officers
 Restrictions on transfer of stock
 Existence and duties of various committees (e.g., audit committee,
executive compensation committee = two most important, generally)
 Audit committee: makes sure compliance with the rules; ensures
internal controls are working
o Delaware is most popular state of incorporation for Public
 Home to about half of Fortune 500
 Friendly to corporations
o Closely Held Corps usually in home state (law not as important because important
ISSUEs are contracted)
 Internal Affairs Doctrine: choice of law rule which permits parties through the incorporation
process to fix the law that applies to their corporate relationship, wherever litigation is brought
(law of state of incorporation)
o Internal affairs are those that relate to the legal relationships between the traditionally
regarded corporate participants

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 Formalities
o Corporation is liable for breach of pre-incorporation contract only if and when it either:
1) adopts (aka ratifies) the contract expressly or impliedly or 2) accepts a desired
benefit under circumstances making it inequitable to retain the benefit without paying for
it
o “All persons purporting to act as or on behalf of a corporation, knowing there was no
incorporation under this Act, are jointly and severally liable for all liabilities created while
so acting” (MBCA § 2.04) (abolishes de facto and doesn’t recognize corporation by
estoppel but result essentially the same – exonerates anyone acting as a corporation
believing in good faith that corporation exists)

 Basics of Finance
o Charter authorizes stock and lists classes and series
o Common stock: 1) unlimited voting rights (including especially the right to vote for
directors) 2) the right to the residual assets of the corporation (after payment of all the
corporate liabilities)
 Corporation must at all times have at least one share having each of the rights of
common stock
o “ISSUEd” – shares are ISSUEd when they are sold
o “Outstanding” – shares are outstanding as long as SHs hold them
o “Treasury Shares” – if the corporation repurchases the shares, the corporation may
continue to hold them as treasury shares which are ISSUEd but not outstanding
 Not voted by the corporation and may be resold for any price determined by the
board, even if price is below par value
o Preferred Stock: shares that have some preference or priority in payment over common
shares
 “divided preference” – more like to get dividend (first in line)
 “liquidation preference” – preference in Ch. 11 bankruptcy (get paid back first);
protects against risk
 Terms of preferred stock set out in articles or in a separate document called
“certificate of designations”
o Debt is not described in the articles of incorporation
 “bonds” not considered an ownership interest – promise to pay a specific sum of
money at a definite time
o “options” – financial instruments that convey the right, but not the obligation to engage
in a future transaction on some underlying security
 Holder does not have to exercise this right
 “call option” – gamble that price will go up
 “put option” – gamble that price will fall
o Debt or preferred stock may be converted into common stock
 Debt securities may be convertible into capital stock of the corporation at a price
and at times specified in the indenture
o Conflict between debt and equity
 Debt has priority over equity // equity has a residual interest
 Debt wants to be repaid
 Equity wants the company to be successful
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


 Directors and Shareholders
o Shareholders elect directors – directors appoint officers – officers run day-to-day
operations
o Board of Directors: Each corporations must have one
 Shareholder agreement may “eliminate the board of directors or restrict the
discretion or powers of the board”
 Key advantage: centralized management
 Insider Directors: employees
 Outsider Directors: non-employees
 Independent Directors: non-employees without substantial ties to the corporation
(not also officers)
 Disinterested Directors: directors without a financial interest in the relevant
transaction
 Board size: one director is enough, (number (or range) is usually fixed by the
charter or a bylaw

o Independent Directors in DE:

 Delaware courts review deferentially corporate transactions in which
management has a conflicting interest if a majority of the board is composed of
directors who are disinterested (no conflicting financial interest in the transaction)
and independent (neither beholden to interested party because of financial or
business relationships, nor dominated by interested party through family or social
relationships).
 Oracle: court concluded professor’s and executives’ close and overlapping ties
to Stanford—as large donors, fellow professors, and members of a university
policy institute—suggested an institutional context in which motives of friendship
and collegiality could not be ignored.
 Stewart: DE Supreme Court has stopped short of saying that social and
business relationships alone undermine independence (finding directors
sufficiently “independent” in demand-futility case, despite longstanding personal
friendships and close business relationships to CEO who held 94 percent of
company’s voting power).
o Election of Directors:
 Directors elected at annual meeting of shareholders
 Directors hold office until successors are elected and qualified
o Meetings of the Board:
 Directors act at regular or special meetings of the board
 Directors may act without meeting, but unanimous written consent
 Board of Directors acts by majority vote, unless the charter or bylaws require a
supermajority
o Board Committees:
 The Board of directors may act through committees compromised of fewer than
the total number of directors Committees may be authorized to act on behalf of
the whole board
 Two most important are audit committee and executive compensation committee
o Removal of Directors
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  Directors may be removed by shareholders with or without cause
 Unless articles of incorporation say that it has to be for cause
 If a director is elected by a specific class of shares, only those shares may
remove the directors
 Directors may be removed in a judicial proceeding for bad behavior, if the
court finds that removal is in the best interest of the corporation
 When a director is to be removed, SHs must be given specific notice that
the removal will be considered

Directors in a Publicly Held Firm

 Unlike close corporations, SHs in large publicly held Corp don’t have large incentive to monitor
their agents (directors and officers)
 Potential Problems
o Shirking – agents can become complacent, lazy, and unmotivated (See Van Gorkom)
o Stealing—agents are less likely to get caught diverting Corp resources, opportunities to
themselves (See Enron; Tyco)
o Entrenchment – agents protecting perks of corner office
 Outside monitoring from rating agencies
 Duties and Protections of Directors/Officers
o Duty of Care
 Negligence, gross negligence, recklessness, egregious misconduct
 Shirking
o Duty of Loyalty
 Conflict of interest (self-dealing)
 Stealing
o Business Judgment Rule
 Use as affirmative defense for errors in judgment
 Judicial standard for reviewing decisions by Corp officers/directors
 Not applicable if: fraud, illegality, conflict of interest, negligence (degree?)

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 o Shareholder Voting
 Each share of common stock carries one vote
 Shareholders vote on the election of directors and on certain fundamental
transactions:
 Amending the corporation’s charter
 Amending the by-laws
 Approving a merger
 Approving the sale of assets not in the ordinary course of business (i.e.,
selling all or substantially all of the assets of the company)
 Approving the dissolution of the company
 Shareholders may vote to ratify conflict-of-interest transactions
 To approve indemnification of directors or officers on claims brought
because of relationship to corporation
 Shareholders may vote at a shareholder’s meeting either in person or by proxy
 Majority vote wins except in director elections, when only a plurality is required
o Shareholder Meetings
 Annual meetings required
 If failure to hold as required, shareholders have power to seek judicial order
setting a date
 Special meetings to vote on particular ISSUEs that may arise between annual
meetings

o Adlerstein v. Wertheimer (DE Chancery Ct. 2002)

 Right to advance notice derives from “a basic requirement of corporation law
boards of directors conduct their affairs in a manner that satisfies minimum
standards of fairness”
 No law that permits or requires directors of an insolvent company to conduct
affairs in a manner inconsistent with principles of fairness or breach of fiduciary
duty
 But the absence (or presence) of notice is not a critical factor.
 Nevertheless, when a director either is the controlling SH or represents
the controlling SH, our law takes a different view of the matter where the
decision to withhold advance notice is done for the purpose of preventing
the controlling SH/director from exercising his or her contractual right to
put a halt to other directors’ schemes.
Dividends and Distributions
 Dividend: simply in payment, usually in cash, from a corporation to its SHs
o Timing and amount determined by Board
 Redemption of shares, reduces number of outstanding shares; however, does not reduce fact
that outstanding shareholders own 100% residual interests of corporation
 When a corporation redeems its shares it cancels them (only possible if articles or bylaws
provide for it)

 Shareholder Voting
o Generally:
 Each outstanding share is entitled to one vote on each matter voted on at a SH’s
meeting
 Charter can deviate from one-share/one-vote standard and create, for example,
super-voting shares or voting caps on any SH who holds a specified percentage
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 of shares (permitting special, conditional, or limited voting rights, or no right to
vote))
 Corporate statutes prohibit a majority-owned subsidiary from voting shares of the
parent corporation.
 Subject matter:
 Electing directors (MBCA § 8.03 (d))
 Removal of directors (MBCA § 8.08)
 Amending the charter (MBCA § 10.03)
 Amending the bylaws (MBCA § 10.20)
 Approving a merger
 Approving sale of all the company’s assets
 Approving dissolution
 Ratifying conflict-of-interest transactions
 Under DGCL, absolute majority (majority of votable shares) required for merger,
charter amendment, sale of assets, and dissolution
 Under MBCA, simple majority only (majority of shares present)
o Rules:
 Director elections
 MBCA § 7.25 (c) -- plurality wins (more votes than other candidates)
o § 7.28 (a) unless otherwise provided in articles of incorporation,
directors are elected by a plurality of the votes cast by the shares
entitled to vote in the election at a meeting at which a quorum is
present
 DGCL § 216 (2) affirmative vote of majority of shares present
o (3) for election of directors – plurality
 Ex: 1000 shares, 800 present (directly or proxy), 399 in favor, 398
opposed, 3 abstain
o DE: not enough to be majority (need 401)
o MBCA: plurality
 SHs can act without a meeting by giving their written consent (DGCL §211 (b) –
annual meeting)
 MBCA §7.04 (a) allows written consent but it has to be unanimous
o Extraordinary events require higher vote than default statutory minimum
 MBCA § 10.03 – amendments to articles by majority of votes entitled to vote (so
501 in hypo—out of 1000)
 MBCA § 11.04 merger
 MBCA § 12.02 sale of all or substantially all corporate assets
 DE law similar
 Shareholder Meetings
o Typically, votes take place at annual meeting (MBCA § 7.01); however, special
meetings can be called by boards or SHs
 MBCA § 7.02 (a)(1) – empowers Board of Directors to call
 MBCA § 7.02 (a)(2) – 10% of voting shares to call special meetings
 Articles may alter
 DGCL § 2.11 (d) – special meetings only if Board of Directors or if others allowed
by articles of incorporation
o Modern statutes also allow for written consent:

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  MBCA § 7.04 (a) – evidenced by one or more written consents bearing date and
description, signed by all SHs entitled to vote on the action
 DGCL § 228 has to be signed by enough people as number of votes would be
required in meeting
o Calling a SH meeting
 Annual meetings
 MBCA § 7.01 (a) in accord with bylaws (if silent, presumably by board)
 DGCL § 211 (a) in accord with charter or bylaws; if silent, by board
 Required and SHs can apply to a court to compel a meeting if one not
held within a specified period
o MBCA §7.03 (a)(1) – within 6 months of end of fiscal year or 15
months of last annual meeting
o DGCL § 211 (c) – within 30 days after designated date or 14
months after annual meeting
 Special meetings
 MBCA § 7.02: called by board or other person authorized by charter or
bylaws; 10% SHS (or different percentage less than 25%) may demand
 DGCL § 211 (d): called by board or other person authorized by charter or
bylaws (note that no default provision for SH action)
 Setting annual meeting date:
 MBCA § 7.01 (a) in accord with bylaws
o Court may order if meeting is not held within 6 months of the end of
the fiscal year or 15 months after its last annual meeting (§ 7.03 (a)
(1))
 DGCL § 211 (b) in accord with bylaws
o If not held within 30 days after the designated date, the court may
order a meeting (§ 211 (c))
o If no date is designated and 13 months have passed since the last
annual meeting (or written consent in lieu thereof), the court may
order a meeting (§ 211 (c)).
 Setting a Special Meeting Date:
 MBCA
o § 7.05 (a): board must give notice no fewer than 10 nor more than
60 days before the meeting date
o § 7.03 (a)(2): court may order if notice not given within 30 days of
SH demand or the meeting was not held
o Board has 90 days after SH demand to hold the meeting
 DGCL
o § 222 (b): Board must give notice no fewer than 10 nor more than
60 days before the meeting date
o BUT § 211 (d) does not provide for SH right to call special
meetings; therefore, date regulations are less critical here
 Fiduciary Limits on Setting Meeting Date
 Generally: directors must act in the interests of SHs, not for the purpose
of entrenchment
 Two situations:
o Setting date: board given broad discretion
o Changing the date: courts want specific evidence of SH benefit
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  Fiduciary duties fill gaps left by the statute and organizational documents
(charter and bylaws)
 Notice: SHs entitled to vote must be given timely written notice of annual and
special meetings
 For annual meetings that are ordinary, notice need only state date, time
and place of meeting (MBCA §7.05, DGCL §222)\
 Notice for special meetings must specify the purpose of the meeting, as
well (MBCA §7.05 (c) and DGCL §222(a)).
 Attendance at the meeting (except to object to improper notice) constitutes
a waiver of notice (MBCA §7.06(b) and DGCL §229).
 If notice is defective and not waived, meeting is invalid and any action
taken at the meeting is void.
 Record Dates
 Record date: date on which the right to vote is determined; only SHs ‘of
record’ are entitled to notice and to vote
 MBCA § 7.07 (a) in accord in bylaws; absent bylaw provision, the board
sets a “future date”
o Not be more than 70 days before the meeting (§ 7.07 (b))
o If no date is set, day before notice of the meeting
 DGCL § 213 (a) board fixes record date
o Cannot preceded the date of the board resolution
o Not more than 60 days nor less than 10 days before meeting
o If not date is set, it is the day before notice of the meeting
 Quorum: for action at a SHs’ meeting to be valid, must be a quorum which is
typically majority of shares entitled to vote (MBCA §7.25(a) and DGCL §216(a)).
 Can be reduced in articles or bylaws (DGCL §216(a) – one third; MBCA
§7.25(a) – no limitation)
o Shareholders may vote in person or by proxy (MBCA § 7.22(a))
o SHs’ meeting is largely a formality, votes have already been “cast” in proxy cards

o Unisuper Ltd. Et al v. News Corporation (DE Ct. of Chancery 2005)

 ISSUES: (1) does the board of directors of a DE corporation have the ability to
revoke a Board policy—like the one embodied in the Press Release and Letter to
SHs—at will? (2) If a contract is found to exist between the Board and SHS
requiring the Board to uphold the Board Policy, is such a contract unenforceable
under § 141 (a) of DGCL?
 HOLDINGs: (1) generally yes; board has power to adopt and rescind resolutions
(or board policies) at will. However, if the board enters into a contract to adopt
and keep in place a resolution (or policy) that others justifiably rely upon to their
detriment, that contract may be enforceable without regard to whether its typically
revocable at will and (2) § 141 (a) merely vests power to manage the corporation
in the Board, and precludes the board from ceding that power to outside groups
or individuals// SHs do not qualify as outside groups or individuals since they are
the owners of the company

 FN 39:
o (Court finds problematic that) Plaintiffs are sophisticated investors
capable of negotiating enforceable agreements to protect their

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 interests . . . of the five key issues that the parties negotiated over,
three were dealt with through amendments to the certificate and
another was made binding absent SH vote – so why buy a “board
policy” for this one?
 Facts:
 Board policy instead of proposing change by amendment to the charter
saying that poison pill, if adopted without SH approval, would expire after
one year
 Poison pill in response to threat of hostile takeover; one year later
extended poison pill in contravention of Board Policy
 Board Policy < Bylaws < Charter
 If the board has the power to adopt board policies, then the power to rescind
those policies must also reside with the board. If the board enters into a binding
contract to not rescind a board policy, that contract may be enforceable, in which
case the board may not rescind such a policy at will
 DGCL § 141 was not intended to prevent the board from entering into contracts;
rather, meant to prevent board from ceding power to outside groups, unless
memorialized in charter
 “Nonetheless, when SHs exercise their right to vote in order to assert control
over the business and affairs of the corporation the board must give way. This is
because the board’s power – which is that of an agent’s with regard to its
principal – derives from the SHs, who are the ultimate holders of power under DE
law.”

o Poison Pill: mechanism to make hostile offer difficult; target company ISSUEs rights to
existing SHs to acquire large number of new securities, usually common or preferred
stock; the new rights typically allow holders (other than a bidder) to convert the right into
a large number of common shares if anyone acquires more than a set amount of the
target’s stock (typically 20-30%). This dilutes the percentage of the target owned by the
bidder, and makes it more expensive to acquire control of the target. This form of
poison pill is sometimes called a SH rights plan because it provides SHs (other than the
bidders) with rights to buy more stock in the event of a control acquisition.
o DGCL § 141 (a): the business and affairs of every corporation organized under this
chapter shall be managed by or under the direction of a board of directors, except as
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.
 Makes clear that any SH-initiated limitation on the board’s authority must be
included in the articles
 On its face, nothing in the statute compels a conclusion that the board cannot
create self-imposed limitations on its authority

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Limited Liability, Piercing the Corporate Veil and Related Doctrines
 Unless otherwise provided in the articles, SH of a Corporation is not personally liable for the
acts or debts of the corporation except that he may become personally liable due to his own
acts or conduct
o Thus, SH losses are limited to the amount he/she invested in the firm—the amount
initially paid for stock
o This last part encompasses “piercing the corporate veil”
 Very fact specific
 Piercing is usually limited to closely held corporations (most cases involve 3 or fewer SHs)
 The Doctrine of Piercing the Veil is an attempt to balance the costs and benefits of limited
liability; based mainly on fairness
 Some examples of when pierced: commingling of funds and other assets, treatment by
individual of corporate assets as his own, HOLDING out that personally liable for debts of
corporation, sole ownership of all of the stock in a corporation by one individual or members of
a family, etc.
 This is a widely divergent area of corporate law
 Comparisons for piercing:
o Corporate Parent v. Individual SH (Identity of SH)
 Piercing to reach a corporate parent does not diminish the value of limited liability
to an individual
 Corporations may be tempted to place risky activities in a separate subsidiary
 No evidence that Courts more willing to pierce if corporation
 Sokol’s theory: perhaps courts are looking for something approaching “fraud”
and individuals are easier to demonize
o Torts v. Contracts
 No evidence that courts more willing in tort context
 Seems like more frequent in contracts (easier to prove fraud)
 Undercapitalization: assets < liabilities? (If yes, then limited liability is meaningless) difficult to
define so limited role
 Analyzing a Piercing Claim
o Check first for direct liability
o Failure to maintain corporate formalities is often cited by courts, but usually not
sufficient to justify piercing
 Ex: meetings of SHs and directors, up-to-date corporate records (e.g., minutes
of meetings), separate bank accounts, public identification as corporation
 Is capitalization a formality? Some courts treat it this way.
 Absence of formality may lead to third-party confusion
 If corporation treated like separate entity, courts rarely pierce
 If corporation not treated like separate entity (alter ego), courts will sometimes
pierce
o Courts usually requiring a showing of inequity (here is where Courts act arbitrarily and
infuse morality)
 Must be something beyond the fact that a third party will not be paid
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  Injustice!
 Need not rise to level of “fraud” (but courts almost always pierce when there is
misrepresentation)
 Best cases for Plaintiff suggest “unjust enrichment” of defendant if no piercing
 Some courts require Plaintiff (in K cases) to show that it should not have
anticipated the harm (assumption of risk)

 Soerries v. Dancause (App. Ct. GA 2001)

o ISSUE: whether under GA law courts may pierce the corporate veil of a corporation,
when its sole proprietor systematically commingles the corporation’s financial liabilities
with his personal expenses
o HOLDING: there is sufficient evidence to justify piercing the corporate veil
o Important to never commingle funds – looks like alter ego
o LESSON: If the line between the corporate entity and a controlling personal entity of
that corporation becomes blurred, then courts are apt to pierce the corporate veil

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Fiduciary Duties – Overview
 Officers with no actual authority have traditional duties of care and loyalty as agents of the
corporation
 Corporate officers and employees have duty of candor
 To Whom are Fiduciary Duties Owed?
o Ultimate goal of shareholder wealth maximization
o When corporation on the verge of insolvency, the question arises whether directors
should be allowed to take risks to return assets (for benefit of creditors).
o Some cases suggest directors can take stakeholders into account only if rationally
related to promoting SH interests (Revlon)
o Other cases suggest that directors have significant latitude to consider “corporate
culture” not just immediate SH returns, when responding to takeover threats.
(Paramount)
 Duty of Care – addresses attentiveness and prudence of managers in performing decision-
making and oversight functions
 Duty of Loyalty – addresses fiduciaries’ conflicts of interest and requires fiduciaries to put the
corporation’s interests ahead of their own – cannot serve 2 masters
o Flagrant Diversion – stealing tangible corporate assets
o Self-Dealing
o Executive Compensation
o Usurping Corporate Opportunity
o Disclosure to SHs
o Insider-Trading
o Selling Out (bribe to sell corporate office)
o Entrenchment – a manager uses the corporate governance machinery to protect his
incumbency and diverts SH control to self
 Fiduciary breaches usually are challenged by SHs in derivative litigation brought on behalf of
the corporation

Duty of Care

o party challenging a business decision must show the directors failed to act (1) in good
faith, (2) in the honest belief that the action taken was in the best interest of the
company, or (3) on an informed basis.
 In general, applies to Officers as well
 Duty of Care: act with the care of an ordinarily prudent person; defer to actions by directors
taken in good faith
 Facets of Duty of Care:
o “reasonable belief” standard involves the substance
 Embodies “waste standard”, under which board action is invalid if it lacks any
rational business purpose
 Presumption of BJR can be overcome if the action of the directors lacked
a “rational” business purpose
o Reasonable care – “informed basis” and “ordinary care” standards relate to the process
 Officers with discretionary authority are subject to similar standards (MBCA §8.42 (a))
 Anytime control is material to a corporate transaction, the controlling SH has the burden of
proving the transaction in question is fair. (Sinclair Oil Corp. v. Levien)
Page 14 of 56
Director’s Duty of Care and the Business Judgment Rule

 Business Judgment Rule

o Rebuttable presumption that directors in performing their functions are honest and well-
meaning, and that their decisions are informed and rationally undertaken
o Holds that directors’ judgments can’t be challenged unless they are tainted by fraud, a
conflict of interest or illegality, or are uninformed or wholly irrational. The real thrust of
the BJR is that it insulates directors from liability for honest mistakes and mere good-
faith errors in judgment
o Substantive standard of review to which director and board action should be submitted
and procedural burden of proof that requires the challenging party to rebut the
presumption
o Justifications: encourages risk-taking, avoids judicial meddling, and encourages
directors to serve
o Two competing conceptions of the BJR in case law:
 Standard of liability under which courts undertake some objective review of the
merits of board decisions
 A principle of abstention, pursuant to which courts decline to review board
decisions so long as certain preconditions are satisfied
 Directors can be stupid (if “informed”) but not selfish
o Implications:
 Various preconditions courts have identified that must be satisfied for BJR:
 An exercise of judgment (Aronson v. Lewis and Rosenblatt v. Getty Oil
Co.)
 Disinterested and independent decision makers (Seminaris v. Landa)
 Absence of fraud or illegality (Cottle v. Storer Communication)
 Rationality (Sinclair Oil Corp. v. Levien)
o In that case, Court held that so long as the board’s decision could
be attributed to any rational business purpose the BJR precluded
the court from substituting its judgment as to the merits of the
decision for those of the board
o BJR + Duty of Care = directors’ judgments can’t be attacked, unless those judgments
were arrived at negligently or were tainted by fraud, conflict of interest, or illegality
o Reliance Corollary (MBCA §8.30 (c) – (e)): directors can claim reliance on others to
whom the board has delegated decision-making or oversight functions if they have
become familiar with the information or advice, and must reasonably have believed that
it merited confidence

 The Decision Making Context

o Smith v. Van Gorkom (DE Sup. Ct. 1985)

 Most important case in Corporate law!
 ISSUE: whether the board of directors of Trans Union reached an informed
decision to “sell” the company at the September 20 meeting
 HOLDING: using a standard of “gross negligence,” the DE Sup. Ct. held that the
board of directors (1) did not adequately inform themselves as to Van Gorkom’s

Page 15 of 56
 role in forcing the ‘sale’ of the Company and in establishing the per share
purchase price; (2) were uninformed as to the intrinsic value of the Company;
and (3) given these circumstances, at a minimum, were grossly negligent in
approving the ‘sale’ of the Company upon two hours’ consideration, without prior
notice, and without the exigency of a crisis or emergency.
 Pritzker wants “No Shop” provision; but if want to get the best value for SHs,
have to auction to multiple bidders
 Company should have behaved like auctioneers and bid up the price not limit it to
one bidder
 Agency law: for fundamental transaction, CEO of company cannot just say done
deal (board and SHs have to agree)
 Court points out that outside valuation is not necessary but if insiders are doing it,
need an actual study
 “We do not imply that an outside valuation study is essential to support an
informed business judgment; nor do we state that fairness opinions by
independent investment bankers are required as a matter of law. Often
insiders familiar with the business of a going concern are in a better
position than are outsiders to gather relevant information; and under
appropriate circumstances such directors may be fully protected in relying
on good faith upon the valuation reports of their management...”
 Defense by board of DGCL § 141 (e) which states “directors are fully protected in
relying in good faith on reports made by officers” did not work here because Van
Gorkom’s presentation was not a report because he, himself, was uninformed
 None of the usual BJR exceptions present in this case; court’s ISSUE was not
with the sale itself but the way the board went about it
o Consequences of Van Gorkom
 Legislative intitatives like DGCL § 102 (b)(7) which said a corporation’s charter
may include a provision eliminating or limiting the personal liability of a director
(not officers) to the corporation or its SHs for monetary damages (equitable
remedies still available) for breach of fiduciary duty as a director, provided that
such provision shall not eliminate or limit the liability of a director:
 (i) for any breach of duty of loyalty
 (ii) for acts/omissions not in good faith or which involve intentional
misconduct or knowing violation of the law
 (iii) under § 174 of this title (unlawful dividends)
 (iv) improper personal benefit

 The Oversight Context
o MBCA § 8.31 (oversight function merits a unique standard of liability)
 A director shall not be liable to the corporation or its SHs for any decision to take
or not to take action, or any failure to take any action, as a director, unless the
party asserting liability in a proceeding establishes that . . . the challenged
conduct consisted or was the result of . . . a sustained failure of the director to be
informed about the business and affairs of the corporation, or other material
failure of the director to discharge the oversight function
o Oversight cases often arise where employees of the corporation have engaged in illegal
activities, and the corporation ultimately is forced to pay large penalties to the
government or judgments or settlements to third parties arising from those illegal
activities.
Page 16 of 56
 o Often oversight cases arise because managers are “asleep at the wheel” while
corporation crashes

o In Re Caremark International Derivative Litigation (DE Ct. Chancery 1996)

 Caremark Board had functioning committee charged with overseeing corporate

compliance
 Board relied on reports that company’s practices were lawful so did not
 Affirmative Duty of Board? P. 530 (“Thus”)
 Need to have reporting/compliance system
 Needs to actually work
 “Loss eventuates not from a decision, but, from unconsidered inaction.”
 Standard of Conduct:
 It is important that the board exercise a good faith judgment that the
corporation’s information and reporting system is in concept and design
adequate to assure the board that appropriate information will come to its
attention in a timely manner as a matter of ordinary operations, so that it
may satisfy its responsibility.
 Standard of Liability:
 Only a sustained or systematic failure of the board to exercise oversight –
such as an utter failure to attempt to assure a reasonable information and
reporting system exists – will establish the lack of good faith that is a
necessary condition to liability

 The Role of Good Faith
o How to get past BJR? Try conflict of interest. If not, try good faith.
 If plaintiff successful in showing that board did not act in good faith, 2
consequences:
 Defendants lose protection of BJR
o Post Caremark
 Stone v. Ritter: Delaware Supreme Court transforms Caremark standard of
review into one arising under the obligation of good faith
 Court held that the directors involved here did not engage in a deliberate
failure to exercise oversight (or a conscious disregard of their
responsibilities).
 In turn, good faith subsumed into loyalty
 Disney explains how this transformation occurred

o In Re Walt Disney Derivative Litigation (DE Sup. Ct. 2006)

 ISSUEs: (1) Did Ovitz breach his fiduciary duties of due care and loyalty by
negotiating for the NFT (non-fault termination) provision, or by accepting full
payment of it, upon termination? (2) Were the actions of Disney in approving the
OEA, hiring Ovitz, and then terminating his employment “not for cause” made
without any violations of the fiduciary duties of due care and good faith, and
therefore protected under the BJR? (3) Did the payment of the NFT clause
constitute corporate waste?
 HOLDINGs: (1) No. Ovitz did not breach any fiduciary duties. (2) No. None of the
actions made by Disney at any stage of its relationship with Ovitz breach the
fiduciary duties of due care or good faith (3) No. Disney received some form of
Page 17 of 56
 compensation for negotiating the NFT clause; therefore it does not constitute
corporate waste.
 **Read in conjunction with Stone v. Ritter, the opinion seems less important
since the Court immediately retracts the view that good faith is an independent
fiduciary duty.
 P. 556 definition of bad faith; based on not having good faith
 Waste
 Standard: directors are liable when they authorize an exchange that is so
one sided that no business person of ordinary, sound judgment could
conclude that the corporation has received adequate consideration
(difficult to make waste claim)
 Hiring: Directors/Eisner – OEA did not provide improper incentives to
leave; everyone believed Ovitz would be good for Disney
 Firing: Eisner – Ovitz could not be fired for cause, so paying the NFT
payment was not wasteful
o High standard; if doing what contract said, then not waste
 Loyalty
 Standard: the best interest of the corporation and its SHs take
precedence over interest possessed by a director, officer or controlling SH
and not shared by the SHs generally
 Hiring: Ovitz – before hiring, he owed no duty
 Firing: Ovitz – before termination, did not engage in a transaction with the
corporation; after termination, he owed no duty
 Care
 Standards:
o Consider all material information reasonably available
o Gross negligence (reckless indifference to or a deliberate disregard
of the whole body of SHs or actions which are without the bounds
of reason
 Hiring: Eisner – kept himself informed throughout; compensation
committee – could have done better BUT they were as informed as
necessary; Other directors – informed before voting
o Still met BJR/Van Gorkom rule because it was an informed
decisions (even if not the best)
 Firing: Eisner – knew all of the material information reasonably available
when making the decision; directors – no duty to act (CEO had authority to
fire President)
o Eisner was constantly asking if the there was “cause” or legal
theory to get out of this agreement a different way
 Bad Faith
 Standard: intentional dereliction of duty, a conscious disregard for one’s
responsibilities or deliberate indifference and inaction in the face of a duty
to act
 Hiring: Eisner – failed to inform board, acted unilaterally, pressured board
BUT subjective belief was good; other directors – did not intentionally shirk
or ignore their duty
 Firing: Eisner – he did not neglect an affirmative duty to act . . . and he
acted in what he believed were the best interests of the Company

Page 18 of 56
 o Bizarre claim: Ovitz breached duty of loyalty by not calling a
meeting to discuss potential firing or find a reason for cause but
Ovitz didn’t know about to be fired

o
o
o
o Stone v. Ritter (DE Sup. Ct. 2006)
 Immediately after Disney
 Delaware Supreme Court quite specifically characterized the duty of good faith
as part of the duty of loyalty: “a director cannot act loyally towards the
corporation unless she acts in the good faith belief that her actions are in the
corporation’s best interest”
 Court characterizes Caremark, until then a pragmatic duty of care case, as a duty
of loyalty case: “it follows that because a showing of bad faith conduct, in the
sense described in Disney and Caremark, is essential to establish director
oversight liability, the fiduciary duty violated by that conduct is duty of loyalty.”
 Good faith is now part of loyalty – no longer a triad
 ISSUE: what must a plaintiff in a derivative suit necessarily please in order to
establish the lack of good faith that is a necessary component of HOLDING
directors personally liable for the activities of non-director employees (a director
oversight claim)?
 HOLDING: a plaintiff must plead either (a) facts indicating that the directors
utterly failed to implement any reporting or information system or controls or (b)
facts indicating that having implemented such a system or controls, the directors
consciously failed to monitor or oversee its operations thus disabling themselves
from being informed of risks or problems requiring their attention. The plaintiffs
failed to plead either therefore, the claim was properly dismissed
 Care/Loyalty seen in derivative class action and merger context
 “demanding test of liability in the oversight context is probably beneficial to
corporate SHs as a class . . . since it makes board service by qualified persons
more likely.”
o What happened to good faith?
 Not an independent duty
 Element of the duty of loyalty such that failure to act in good faith is a necessary
condition to establishing a breach of the duty of loyalty where there is not a
financial or otherwise cognizable conflict of interest
 Thus, a failure to act in good faith may result in liability, but only indirectly
 Boundaries among care, loyalty, and good faith have become intertwined

 The Current State of Good Faith

o Ryan v. Lyondell Chemical Co. (DE Sup. Ct. 2009)

 ISSUE: SH brought class action lawsuit against corporation and its directors,
challenging merger transaction and asserting that directors breached their
fiduciary duties
 HOLDING: directors did not fail to act in good faith and thus did not breach their
fiduciary duty of loyalty
 Heightened fiduciary duties in a merger context
Page 19 of 56
  Break-up fee: if deal doesn’t happen they pay him money for costs (has to be
high enough to show serious)
 Merger was approved by 99% of voted shares; despite the seemingly
outstanding deal, a plaintiff filed suit

o Revlon violations may come in three flavors: lack of care, bad faith or disloyalty
 If claim implicates only duty of care, the court will dismiss the claim (In re
Frederick’s of Hollywood)
 If claim raises the possibility of bad faith or disloyalty, however, the claim will
survive
o Disney and Stone now have defined “bad faith” in a manner that does not require
illegality or fraud (the traditional meanings of bad faith) – at least in the traditional sense
of self-dealing. “Bad faith” now has a more expansive meaning, that might include
actions by directors who are admittedly independent and disinterested

Duty of Loyalty

 Anytime a director or manager participates in a transaction involving a conflict of interest – duty

of loyalty is implicated
 Main points:
o Loyalty concerns can arise in a number of different factual contexts
o Directors do not initially get the benefit of the BJR in such cases
o There are procedural mechanisms that directors can use to reinstate the BJR; but that
when controlling SHs are involved the standard of review is not ever as deferential as
full BJR review
o Where there is a controlling SH, even with procedural “freshening” by a fully-informed
vote of disinterested, independent directors or SHs, the substantive standard by which
to judge a breach of fiduciary duty claim will remain entire fairness
o The burden will shift to plaintiffs to prove entire unfairness if there is an adequate
freshening, but the fairness of the transaction will be subject to judicial oversight. This
is because the controlling SH will be around after the transaction to exact revenge
o Self-dealing: occurs when the corporation and director are parties to the same
transaction

Statutory Safe Harbor Approaches

 Conflict-of-Interest Transactions, Generally

o Hollinger International, Inc. v. Black (DE Ct. of Chancery 2004)
 ISSUE: in what ways did Conrad Black breach his fiduciary duties of loyalty to
International?
 HOLDING: As a controlling SH, Black owes a fiduciary duty of loyalty to
International that is inconsistent with withholding information, lying to his fellow
directors, using confidential company information for his own purposes, and
usurping corporate opportunities (International’s right to sell itself or the Daily
Telegraph).

 Corporate Opportunities
o ALI on Corporate Opportunity

Page 20 of 56
  (1) Any opportunity to engage in a business activity of which a director or senior
executive becomes aware, either:
 (A) In connection with the performance of functions as a director or senior
executive, or under circumstances that should reasonably lead the director
or senior executive to believe that the person offering the opportunity
expects it to be offered to the corporation; or
 (B) Through the use of corporate information or property, if the resulting
opportunity is one that the director or senior executive should reasonably
be expected to believe would be of interest to the corporation; or
 (2) Any opportunity to engage in a business activity of which a senior executive
becomes aware and knows is closely related to a business in which the
corporation is engaged or expects to engage
o ALI on Mandatory Disclosure Regime
 (a) General Rule. A director or senior executive may not take advantage of a
corporate opportunity unless:
 (1) the director or senior executive first offers the corporate opportunity to
the corporation and makes disclosure concerning the conflict of interest
and the corporate opportunity
 (2) the corporate opportunity is rejected by the corporation; and
 (3) either:
o (A) the rejection of the opportunity is fair to the corporation
o (B) the opportunity is rejected in advance, following such
disclosure, by disinterested directors or, in the case of a senior
executive who is not a director, by a disinterested superior, in a
manner that satisfies the standards of BJR; or
o (C) the rejection is authorized in advance or ratified, following such
disclosure, by disinterested SHs and the rejection is not equivalent
to a waste of corporate assets
o Most states pursue on a case by case basis
o DGCL on Corporate Opportunities
 § 122 (17): Every corporation created under this chapter shall have power to . . .
 Renounce, in its certificate of incorporation or by action of its board of
directors, any interest or expectancy of the corporation in, or in being
offered an opportunity to participate in, specified business opportunities or
specified classes or categories of business opportunities that are
presented to the corporation or one or more of its officers, directors or SHs
o If opportunity came to manager in individual (not corporate) capacity, courts are more
likely to conclude the opportunity was not corporate.
o Many courts employ an expectancy test to measure corporation’s expansion potential:
if corporation has an existing expectancy in a business opportunity, the manager must
seek corporate consent before taking the opportunity (also a line-of-business test)
 ALI approached is combination

o Broz v. Cellular Information Systems, Inc. (DE Sup. Ct. 1996)

 ISSUEs: Did Broz’s failure to formally present this business opportunity to a
board of directors create liability for a violation of the fiduciary duty loyalty? Does
a director have a fiduciary duty to a potential purchaser of his company, including
the duty to submit business opportunities in which he/she have a potential
interest?
Page 21 of 56
  HOLDING: While it is good practice to present a corporate opportunity to the
board of directors, it is not required, although it is good practice that creates a
clear “safe harbor” for the director. If the corporation is a target or potential target
of an acquisition by another company which has an interest and ability to
entertain the opportunity, the director of the target company does not have a
fiduciary duty to present the opportunity to the potential acquirer
 (Test from Guth) Corporate officer or director may not take a business
opportunity for his own if:
 (1) corporation is financially able to exploit the opportunity;
 (2) the opportunity is within the corporation’s line of business;
 (3) the corporation has an interest or expectancy in the opportunity; and
 (4) by taking the opportunity for his own, the corporate fiduciary will
thereby be placed in a position inimicable to his duties to the corporation
 Corollary from Guth – when director or officer may take a corporate opportunity
 (1) the opportunity is presented to the director or officer in his individual
and not corporate capacity;
 (2) the opportunity is not essential to the corporation;
 (3) the corporation holds no interest or expectancy in the opportunity; and
 (4) the director or officer has not wrongfully employed the resources of the
corporation in pursuing or exploiting the opportunity
 DE law doesn’t require formal presentation to board; Broz is allowed to proceed
in own economic interest absent countervailing duty (none here)
 Fundamental question: how does presentation to full board protect director?
Why have safe harbor?
 Be safe. But, if not doing, thinking Corp will compete so looks like
usurping corporate opportunity.
o Takeaways: 1) higher standards for officers than outside directors; 2) reasonableness –
case by case analysis; 3) safe harbor (take to board in formal context – but not a
requirement)

Page 22 of 56
Litigation to Enforce Director’s Duties

 Stockholder harm derives from harm to the corporation

o Two suits in one:
 Suit by the SHs against the corporation
 Suit by the corporation against the directors
o Should SH π get damages? Its company that gets damages.
 Free-Rider Problem
o Company receives damages:
 Plaintiff bears all of the costs of enforcement
 Plaintiff compensated for only a portion of damages
 Fixing the Free-Rider Problem
o Plaintiff’s attorneys receive fees for conveying a “substantial benefit”
o Attorneys replace SHs as parties in interest
o Big incentive for plaintiff’s attorneys
 MBCA §7.46 (1) “if ... the proceeding has resulted in substantial benefit to corporation” the
corporation pays successful π attorney’s fees
 Strike Suits
o Pursuit of attorneys’ fees encourages bad claims
o Procedural hurdles:
 Contemporaneous ownership and standing
 Demand requirement
 Court supervision
 Derivative v. Direct
o Direct: SHs sue in their own capacity to enforce their rights as SHs
o Derivative: SHs sue on behalf of the corporation to enforce corporate rights that affect
them only indirectly
o Old Rule, Haphazardly Applied: “Special Injury” Test
o New Test: Tooley
 Whether the complaint alleges a direct or derivative claim “must harm solely on
the following questions: (1) who suffered the alleged harm (the corporation or
the suing SHs, individually); and (2) who would receive the benefit of any
recovery or other remedy (the corporation or the SHs, individually)?
o Lewis v. Anderson (Del. 1984): erected various procedural obstacles –
 (1) plaintiffs must have been SHs at the time of the alleged breach of duty
(“contemporaneous ownership” rule)
 (2) plaintiffs must remain SHs throughout the litigation (“standing requirement”) –
comes from CL
 (3) SHs must “demand” that the board of directors take action before the SH
assumes control of the litigation (“demand requirement”)
 (4) once a derivative claim is filed, the court must approve any settlement
o If derivative, plaintiffs must comply with Court of Chancery Rule 23.1 that the SH:
 (a) retain ownership of the shares throughout the litigation;
 (b) make pre-suit demand on the board; and
 (c) obtain court approval of any settlement



Page 23 of 56
 
 The Demand Requirement
o In order to proceed with a derivative suit, the plaintiff shareholder must first satisfy what
is known as the “demand requirement.” In virtually all United States jurisdictions, before
a shareholder’s suit can be brought, the shareholder must first make a demand on the
corporation’s board of directors for it to remedy the situation that is the basis of the
shareholder’s complaint. If the directors take action to remedy the situation, either by
bringing suit against the third parties implicated in the shareholder’s derivative claim or
some other corrective act, then a shareholder suit will not be allowed to proceed.
o If the directors refuse to sue after a shareholder demand, then a number of ISSUEs
arise. If the suit is against a third party who is not involved in any way with the
management of the corporation, then the director-protective BJR most likely applies,
and the directors’ decision not to sue would stand, thereby barring the plaintiff’s suit.
o If, on the other hand, the claim involves corporate management or directors, then
shareholders may be able to proceed with the suit even after a director refusal to sue if
the plaintiff can show that the directors are “personally involved or interested in the
alleged wrongdoing in a way calculated to impair their exercise of business judgment on
behalf of the corporation, or that their refusal to sue reflects bad faith or breach of trust
in some other way.”
o Another option for shareholder plaintiffs in circumstances where management is
implicated in the allegations is to plead the futility of any demand. In instances when
the good faith of a director or a group of directors is called into question, the courts do
not expect that the defendant directors will give adequate consideration to the
shareholder demand for a lawsuit. Thus, in such instances, courts will generally excuse
the demand requirement.
o By making demand, SH “tacitly acknowledges” board’s independence
o See Rales v. Blasband (Del. 1993)
 Board must inform itself of relevant facts
 Then three options
 Accept demand and prosecute action
 Resolve without litigation (settlement)
 Refuse demand
o Upon demand, Board can agree to take action (terminates π suit), refuse to take action,
appoint a SLC

Aronson’s test: “Reasonable

doubt” that
directors are disinterested and
independent OR
transaction was a valid exercise of
business judgment
o Settlement of Derivative Claims
 Plaintiffs’ incentives to settle
Page 24 of 56
  Attorneys fees
Defendants’ incentives to settle
 Insurance
o Martha Stewart
 Plaintiff Beam alleged that Stewart breached her fiduciary duties of loyalty and
care to Martha Stewart Omnimedia by allegedly selling ImClone stock in
December of 2001 on the basis of inside information from Sam Waksal
 Plaintiff further alleged that demand was futile with respect to Steward (94% SH;
CEO and Chairman of the Board)
 Plaintiff challenged independence of 3 of the remaining 4 board members based
on friendships with Stewart and common Social circles
 ISSUE: Is the existence of very close social relationships and friendships among
outside board members and 94% SH sufficient to call into doubt those directors’
independence?
 HOLDING: No. As held originally in Aaronson, claims of structural bias, without
more, are insufficient to cast doubt on a director’s independence. While Stewart
and the one inside director are clearly interested (Stewart) and lack
independence (Patrick), no sufficient showing has been made with respect to the
other directors, and so the case was properly dismissed for failure to bring
demand.
 Discussion: “Our jurisprudence explicating the demand requirement is designed
to create a balanced environment which will: (1) on the one hand, deter costly,
baseless suits by creating a screening mechanism to eliminate claims where
there is only a suspicion expressed solely in conclusory terms; and (2) on the
other hand, permit suit by a SH who is able to articulate particularized facts
showing that there is a reasonable doubt either that (a) a majority of the board is
independent for purposes of responding to the demand, or (b) the underlying
transaction is protected by the BJR.”
 Friendship is not enough – must be accompanied by substantially more in the
nature of serious allegations that would lead to a reasonable doubt as to a
director’s independence
 Substantially more: should be a financial relationship that is material to the
particular director (a subjective standard of materiality, taking into account that
director’s economic circumstances), such that the particular director can be said
to be beholden to the director who is interested in the transaction (here Stewart).
 Court makes note about Oracle: “Unlike the demand-excusal context, where the
board is presumed to be independent, the SLC has the burden of establishing its
own independence by a yardstick that must be ‘like Caesar’s wife’ – above
reproach.”
 How can SHs get information about a corporation under state law?
o SHs in most states have a right under the common law as well as under statutes to
inspect the corporation’s books and records
 Common Law: SHs must show they have a “proper purpose” for inspection
(usually requires suit)
 MBCA § 16.02 provides an automatic right to inspect certain records, gives the
SH the right to obtain copies (at SH’s expense) and allow the SH to have
attorney or agent do it
 Board minutes, accounting records and SH lists – require proper purpose,
MBCA §16.02 (b), (c)

Page 25 of 56
  Note: MBCA §16.01 (e) makes the articles of incorporation, bylaws and
minutes of SHs’ meetings available as of right
 DGCL § 220 (b) any SH, in person or by attorney or other agent, shall, upon
written demand under oath stating the purpose thereof, have the right . . . to
inspect for any proper purpose, and to make copies and extracts from: (1) stock
ledger, list of SHs and books and records
 Note: DGCL §219(a) makes SH lists available as of right 10 days before
SH’s meeting
 Proper purpose? SH’s request for records relates to interest in investment

 Direct versus Derivative claims

o Tooley v. Donaldson, Lufkin, & Jenrette, Inc. (DE Sup. Ct. 2004)

 Most recent case on this issue

 ISSUE: was plaintiffs claim for lost interest direct or derivative?
 HOLDING: Plaintiffs have no cause of action, since they have no contractual
right to receive the merger consideration at any particular time. If they had a
cause of action, it would be a direct action, since it would be based on rights that
they enjoy as SHs per se, and not based on a claim of injury to the corporation.
 The same directorial malfeasance can give rise to both derivative and direct
actions: think of a merger arranged by controlling SHs at an unfair price (and so
a breach of fiduciary duty to the corporation, and thus a derivative action); in
which approval is elicited by lying to the plaintiffs and in which the price the SHs
receive is too low (a direct action). Plaintiff’s lawyers prefer direct actions.
 RULE: a court should look to the nature of the wrong and to whom the relief
should go. The SH’s claimed direct injury must be independent of any alleged
injury to the corporation. The SH must demonstrate that the duty breached was
owed to the SH and that he or she can prevail without showing an injury to the
corporation.
 Distinction must turn solely on the following questions:
 Who suffered the alleged harm (the corporation or the suing SHs,
individually)?
 Who would receive the benefit of any recovery or other remedy (the
corporation or the SHs, individually)?
o Examples of direct suits:
 enjoin ultra vires actions,
 compel payment of dividends declared but not distributed,
 compel inspection of SH’s lists, or corporate books and records,
 require the holding on a SH’s meeting, whether board has violated statutory or
fiduciary duties
 challenge fraud on SHs in connection w voting, sale or purchase of securities
 challenge the sale of the corporation in a merger where directors violated their
duties to become informed or structure a transaction that was entirely fair
 challenge corporate restrictions
 Special Litigation Committees
o In most cases where demand is properly excused, the company would still like to take
control of the litigation.

Page 26 of 56
  Done by appointing a SLC (which sometimes might require expanding the size of
the board and appointing new, disinterested directors) and delegating authority to
the SLC to determine if it is in the company’s best interest to proceed with the
litigation
 Rare for SLC to recommend proceeding with litigation
o Zapata v. Maldonado (Del. 1980): Delaware Supreme Court articulated principles that
DE courts use to evaluate a SLC’s decision to terminate litigation
o Demand Excused Cases (Demand? No. Futile? Yes.)
 DE requires demand in all cases except those excused on grounds of futility
 Begins at the pleading stage

o In Re Oracle Corp. Derivative Litigation (DE Ct. of Chancery 2003)

 Background:
 ISSUE: whether the SLC can independently determine whether the
Trading Defendants should face suit for insider trading-based allegations
of breach of fiduciary duty
 DE specifically rejects Auerbach’s (NY) conclusion that BJR applies to
SLC recommendations
o Zapata – BJR is not strong enough standard for SLCs because of
inherent conflict (“structural bias”)
 Structural bias – only 1 of 20 first SLC cases did the
committee determine the suit should proceed (turns out deck
stacked against you either way)
o Two prongs:
 Independence, good faith, and reasonable investigation
(burden on SLC)
 Court should apply its “own independent business judgment”
o Prong 1 – DE judges make sure not just that all papers are in the
file but read the papers to see if the results support the SLC’s
conclusions
o Prong 2 – catch cases that comply with the letter but not the spirit
of prong 1 but Zapata does not give standards by which judges
should apply their own business judgment in the second step
 In later case, Kaplan v. Wyatt, DE Sup. Ct. makes clear that chancellors
are not obliged to conduct second step inquiry and that refusal to do so
subject to review under abuse of discretion standard
 ISSUE: Does a SLC meet its burden of demonstrating the absence of a material
dispute of fact about its independence where its members are professors at a
university that has ties to the corporation and to the defendants that are the
subject of a derivative action that the committee is investigating?
 HOLDING: No. A SLC does not meet its burden of demonstrating the absence of
a material dispute of fact about its independence where its members are
professors at a university that has ties to the corporation and to the defendants
that are the subject of a derivative action that the committee is investigating.
 Evidence of Independence?
 No compensation other than as directors
 No implication in wrongdoing
 Willingness to return SLC compensation
 Absence of other material ties to Trading Defendants
Page 27 of 56
  Disinterested people are: directors not named in the suit, directors who weren’t
directors when wrongdoing occurred and outsiders.
 Thick Ties present here
 What is Independence in the SLC context?
 “Domination and control”? no
 “At bottom, 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. This is, the Supreme Court
cases ultimately focus on impartiality and objectivity.” (Parfi HOLDING v.
Mirror)
 Strine has moved the inquiry from bias in favor of the defendant to “impartiality
and objectivity”
 “To conclude that the Oracle SLC was not independent is not a conclusion that
the two accomplished professors who comprise it are not persons of good faith
and moral probity, it is solely to conclude that they were not situated to act with
the required degree of impartiality.”
 Sokol: the system is a sham; you want someone who will “rule the right way” but
with the façade of impartiality
 Statutory Exculpation from Liability
o MBCA’s liability provisions state that directors who breach their care duties are liable in
damages only if the violation proximately caused harm to the corporation or SHs (§8.31
(b)(1)).
DGCL §102 (b)(7) MBCA §2.02 (b)(4)
No personal liability for breaches of duty of care, No liability for money damages to corporation or
though director remains liable for: SHs, except liability for
Breaches of duty of loyalty Financial benefits he received to which he is not
entitled
Acts or omissions not in good faith or that involve Intentional infliction of harm on the corporation or
intentional misconduct or knowing illegality its SHs
Approval of illegal distributions and Approving illegal distributions, or
Obtaining a personal benefit (such as insider an intentional violation of criminal law
trading)

o Van Gorkom previewed § 102 (b)(7); also basics of entire fairness here which comes
from Weinberger

o Malpiede v. Townson (DE. Sup. Ct. 2001)

 ISSUE: whether the amended complaint may be dismissed upon a Rule 12 (b)
(6) motion by reason of the existence and the legal effect of the exculpatory
provision of Article TWELFTH of Frederick’s certificate of incorporation, adopted
pursuant to DGCL § 102 (b)(7)
 HOLDING: if the complaint contains only an unambiguous, residual due care
claim and nothing else – as a matter of law – then § 102 (b)(7) charter provision
would bar the claim
 §102 (b)(7) protects directors from liability for monetary damages for duty of care
claims
 Cannot eliminate/limit for:
o Breach of duty of loyalty to Corporation or SHs

Page 28 of 56
 o Acts/Omissions NOT in good faith or which involve intentional
misconduct
o Under § 174 (self-dealing)
o Improper personal benefit
 Facts:
 Frederick’s for sale and Knightsbridge interested; Veritas and
Knightsbridge start bidding
 Here only duty of care claim
 In the case of a Rule 12(b)(6) motion, as here, if the §102 (b)(7) charter provision
is raised for the first time in the motion or brief in support of the motion, it is a
matter outside the pleading. If not excluded by the court, the existence of such
matter means that the motion will be converted, by clear force of the pleading
rules, into a motion for summary judgment under Rule 56.

o Emerald Partners v. Berlin (DE Sup. Ct. 2001)

 ISSUE: when is it appropriate procedurally to consider the substantive effect of a
§ 102 (b)(7) provision, in a SH challenge to a transaction that requires a trial
pursuant to the entire fairness standard of judicial review?
 HOLDING: When entire fairness is the applicable standard of judicial review,
injury or damages becomes a proper focus of judicial scrutiny only after the
transaction is determined not to be entirely fair. Thus, the exculpatory effect of a
§ 102 (b)(7) provision becomes a proper focus after the director’s personal
liability for the payment of damages is established.
 § 102 (b)(7) provision is an affirmative defense which solely implicates a violation
of the duty of care
 If conflict of interest transaction – legal test is “entire fairness”
 Determination that transaction must be subjected to EF analysis is not implication
of liability

 Effect of “Entire Fairness”

 Burden shifts to defendants (affirmative defense)
o Defendant may shift the burden back to plaintiffs
 Approval by independent committee
 Approval by majority of the minority SHs
 Two aspects: (bottom of p. 711)
o Fair dealing (procedural about inputs)
o Fair price (about outputs)
o (Weinberger says not bifurcated but examined as a whole)
 When entire fairness is standard, only way to determine if exculpation is
after basis of liability is decided
o If only care claim – no go
o If only loyalty – may have to pay out

Page 29 of 56
Friendly Mergers and Acquisitions

 Economic Justification for Mergers: efficiency, undervaluation of shares, synergistic gains, tax
advantages, 3rd parties
 Things to look for in merger context:
o Form v. substance
o Financing
o Duties of board and controlling SHs
 Board has fiduciary duties and heightened standards of scrutiny may apply
 Transactions initiated by controlling shareholders may be subject to review for
“entire fairness” in Delaware (see, e.g., Sinclair Oil, Wheelabrator).
 In controlling shareholder transactions, procedural safeguards may be necessary
or appropriate to establish “fair price” and “fair dealing” for minority shareholders.
o SH voting rights
o Appraisal rights
o 3rd party effects
o Disclosure requirements
 Friendly mergers:
o Two or more corporations become one // consolidation – surviving corporation is new
o Process: DGCL § 251
 Board of both corporations recommend
 SHs vote
 Certificate of merger filed with state
o Process: MBCA
 Four Basic Steps:
 Merger plan must be drafted specifying deal’s terms and conditions (§
11.02 (c))
 Merger plan must be approved by board (§ 11.04 (a))
 Merger plan must be approved by SHs (§ 11.04 (b) – (d))
 File articles of merger with state
 Mergers require majority of outstanding shares; not just majority of shares
present and voting
 § 11.07 (a) When a merger becomes effective – lists 8 ways
o Short-form Mergers
 Allows for mergers of subsidiaries into parents with no vote by subsidiary SHs
 Parent must own at least 90% of subsidiary’s shares
 Sale of Assets
o Sale of “all or substantially all” of a corporation’s assets is roughly equivalent to merger
 No bright-line rule on what “substantially all” means
o Process (MBCA § 12.02 and DGCL § 271)
 Board approves
 SHs authorize
Page 30 of 56
 o Unlike a merger, debts do not transfer to the surviving corporation as a matter of law
 Often selected debts are assumed by the purchaser
 Choosing between Merger and Asset Sale
o Ease of transferring control
 Merger – separate existence of all but surviving corporation come to an end
 Asset sale – target remains—virtually nothing happens by operation of law
o Ease of transferring assets
 Merger – title to all property automatically vests in surviving corporation
 Asset sale – documents of transfer must be prepared for each and every asset
and docs filed with each applicable agency
o Ease of passing consideration
 Merger – consideration passes directly to non-dissenting SHs
 Asset sale – more complicated
 Distribute consideration as dividend
 If target is formally dissolved and liquidated after creditors paid off,
remaining assets distributed to SHs in final liquidating dividend
o Successor liability
 Merger – surviving corporation succeeds to all liability
 Asset sale – subject to some exceptions (like tort law), purchaser does not take
liabilities of selling corporation unless there has been a written assumption of
liabilities
o SH voting
 Merger – approval by both companies’ boards and SHs required
 Asset sale – purchasing corporation’s SHs not entitled to vote on transaction
 Corporate combination will require a SH vote when:
o The combination will have a significant impact on the SHs (will require approval of
majority of SHs)
 Sale of assets
 Target – SH vote required
 Acquiring – no SH vote
 Exchange of substantially all assets
 If not in regular course of business, both companies’ SHs vote
 Merger
 Target – SH vote required
 Acquiring – depends on size of companies involved
 From perspective of target company’s SHs – difference between a corporation selling
substantially all of its assets and merging?
o The consideration they receive
 Sale of assets – wind up with cash
 Merger – receive stock from acquiring corporation

Page 31 of 56
 
 Appraisal
o Appraisal Rights: right of shareholders in a merger to demand the payment of a fair
price for their shares, as determined independently.
o Ensures that minority SHs receive “fair value” for their shares (DGCL § 262)
o In DE, applies to mergers, not sale of assets
o Process
 Corporation notifies SHs of appraisal rights
 SH must demand appraisal before SH vote on the merger
 If the merger is approved, corporation notifies the SHs who have made demand
that appraisal rights are available
 SH makes a second demand for appraisal
 SH or surviving corporation may petition Court of Chancery for appraisal
o Not always – if do, put in charter (?)
o If vote for a merger, don’t get appraisal rights
o To perfect: ask for appraisal rights, have to vote against or abstain, after merger have
to ask again
o Official Comment to MBCA §13.02 says that appraisal is exclusive unless the
transaction is “unlawful or fraudulent” which includes violation of corporate law on voting
or of the articles, deception of SHs and fiduciary breach
 Thus, appraisal is exclusive remedy when only price is challenged, but not when
procedural fairness or the adequacy of disclosure is challenged.
 Cash-Out Mergers
o Merger in which majority SHs receive shares in the surviving corporation and minority
SHs receive cash
 Ensuring Exclusivity
o Due diligence is expensive so want to exclude others
o Intended to prevent or discourage competing bids
o Two types:
 Performance promises – target’s board agrees to engage (or not engage) in
certain types of conduct prior to SH vote
 Best efforts clauses
 No shop clauses – provision in letter of intent or documents that says
during due diligence, board will not pursue other bidders
 Cancellation fees if transaction dies (“Break-up fees”)
 Structuring an Acquisition
o Daimler-Chrysler Case Study
 Worst deal of all time
 December 1990
 Kerkorian buys 9.8% of stock
 Iacocca immediately reacts: calls a special meeting of the board to
reduce the trigger on GM’s poison pill from 20% - 10%
 November 1994
 Chrysler builds up cash reserves
 Kerkorian wants to use it for: returning more money to SHs, through a
stock split, share repurchase (is easier than dividends because it is a
onetime thing whereas dividends are continual), and/or increased
dividends
Page 32 of 56
  Board partially responds to Kerkorian
 April 1995
 Kerkorian launches a $55 per share tender offer (which was 40% over
market) to be funded in substantial part from Chrysler’s cash reserves
 Tender offer failed when Kerkorian was unable to obtain financing (due to
Chrysler pressure)
o Unusual, now, only 10 or so companies would have that much clout
with banks
 May 1995
 Kerkorian begins a proxy fight
 Hires Jerome York
 Eventually Chrysler agreed to increase its stock repurchase program to $2
billion
 Commissions a 90-day study of its corporate governance policies and
board membership
 Kerkorian signs stand-still agreement (no more buying stock for five years)
in exchange for:
o A seat on the board
o Higher dividends
o A higher amount of money dedicated to share repurchase ($3
billion)
o The two-for-one stock split that Kerkorian had been asking for
 End result – Kerkorian has essentially forced Chrysler to give back a large
amount of its cash to the SHs
 Pushes Chrysler to Daimler
 Because of co-determination (seats on board to labor representatives), resulting
company could not be American company
 The Deal
 Mechanic of an exchange offer
 No-shop deal protection device (fiduciary-out)
 Question 1:
 Due diligence
o Tension between:
 Seller’s preferences for extensive buyer due diligence
 Buyer’s preferences for extensive representations and
warranties by seller
 Question 2:
 Buyer will require representations and warranties from the seller that the
company’s financial statements have been prepared according to GAAP
and that they fairly present the financial condition of the company
 Representations will cover several years of audited financial statements,
as well as the most recent fiscal year and any unaudited periods up to and
including the close of the transaction
 Buyers may also, in some cases, engage accountants to examine the
financial statements of an entity as part of their due diligence
 Question 3:
 Concerns about the selling company’s law compliance are dealt with by a
combo of due diligence and the seller’s reps and warranties
Page 33 of 56
  Use disclosure schedules that lists all pending litigation in various
categories (sometimes with a defined materiality screen)
 Question 4
 “best efforts” may include:
o Regulatory approvals that are necessary
o Obligations on the buying party to arrange financing
o The selling party (and sometimes the buying party) to obtain the
approval of their SHs
 Fiduciary Duty “Red Flags” in merger context:
o No shop clauses – boards’ responsibility
o Provisions in agreement if strategic decisions
o Data presented to board – has to be adequate amount of information
o Money from bank (financing)
 Financing for merger
o ISSUE new shares
o Retained earnings
o Leverage based on target’s assets

Fiduciary Duties in Friendly Transactions
o In an arm’s length transaction between two unrelated companies (e.g., Van Gorkom)
courts normally apply the (usually) deferential business judgment rule
o Entire Fairness is more probing standard than BJR
o Established exclusivity of appraisal when price is only issue in cash out merger
o Entire Fairness Review
 Presumption of the BJR
 Plaintiffs rebut by showing conflict of interest
 Places burden of showing “entire fairness” on controlling SH
 Defendants shift burden back to plaintiffs
 Special committee was independent
 Fundamental to DE corporate law
 Applied to cases involving a conflict of interest, the entire fairness standard is
designed to be more probing than the BJR
o Freeze Out Mergers
 Essentially force corporation to sell low by proposing a low price for the merger
and picking a time when the market is low
 Minority SHs cannot block a freeze out but they have rights: entire fairness,
statutory appraisal rights and cash

o Weinberger v. UOP, Inc. (DE Sup. Ct. 1983)

 USE THIS FOR ENTIRE FAIRNESS
 “The concept of fairness has two basic aspects: fair dealing and fair price. The
former embraces questions of when the transaction was timed, how it was
initiated, structured, negotiated, disclosed to the directors, and how the approvals
of the directors and SHs were obtained. The latter aspect of fairness relates to
the economic and financial considerations of the proposed merger, including all
relevant factors: assets, market value, earnings, future prospects, and any other
elements that affect the intrinsic or inherent value of a company’s stock.
However, the test for fairness is not a bifurcated one as between fair dealing and
Page 34 of 56
 price. All aspects of the issue must be examined as a whole since the question
is one of entire fairness.”
 Fair Price: preponderant consideration but DE’s valuation methods in
context of a merger liberalized – valuation must take into account all
relevant factors
 Fair Dealing: relating to “when the transaction was timed, how it was
initiated, structured, negotiated, disclosed to the directors, and how the
approvals of the directors and the stockholders were obtained.” (Court
recommends independent committee)
 ISSUE: Did Signal (and particularly the Signal directors on UOP’s board) act
consistently with their duty of loyalty to UOP by failing to disclose to the UOP
board and SHs the analysis they had done for Signal, using UOP’s data?
 HOLDING: No. In such a conflict of interest situation, where some directors sit
on both boards, the directors bear the burden of showing they’d acted with entire
fairness under the circumstances. “Entire fairness” requires fair price to the SHs
and fair dealing by the conflicted board. Here fair dealing would have required,
as a minimum, that Arledge and Chitiea have acted consistently with their duty of
candor, which would have required disclosing the analysis they had done for
Signal showing that at a price up to $24/share the UOP transaction would have
been beneficial to Signal.
 FACTS:
 1975, Signal acquired a 50.5% majority interest in UOP
 Signal had the right to nominate and elect 6 of UOP’s 13 directors.
 Of these 6 UOP directors, 5 were also Signal directors or employees.
 Two years later Signal decided to purchase by a cash-out merger the
remaining UOP shares.
 Arledge/Chitea analysis concluded that a share price of up to $24 would
be a beneficial deal for Signal.
 Did not discuss analysis with other UOP directors
 Crawford told $20-21 a share
 Arledge/Chitea analysis not considered
 $21/share merger approved
 Weinberger is minority SH who objects to sale
st
 1 guiding principle about loyalty – Board of UOP from Signal still owe duty of
loyalty to UOP and SHs
 Important facts to include in analysis but not limited to:
 Which party initiated the merger;
 Which imposed time constraints, if any;
 If there were an independent committee established by the target to
consider the merger (very important in showing fair dealing);
 If the independent committee had independent legal and financial advice
 Independent Board Committees
o In a conflict of interest, courts prefer to see some effort on the part of managers to
locate a disinterested decision maker
o When the managers create special litigation committee, courts review committee’s work
o Courts do not automatically defer to the committee but continue to demand scrupulous
adherence to basic standards of fairness

Page 35 of 56
 o Kahn v. Lynch Communications Systems, Inc. (DE Sup. Ct. 1994)
 ISSUEs: Was Alcatel a controlling SH? Did the Chancery Court err in shifting the
burden of proof with regard to entire fairness to the plaintiffs?
 HOLDING: Alcatel was a controlling SH, notwithstanding owning less than 50%
of the shares, since it actually controlled Lynch’s business decisions. The
Chancery Court erred in shifting the burden of proof to plaintiff to disprove entire
fairness, since the Committee’s ability to effectively negotiate at arm’s length was
compromised by Alcatel’s threats to proceed with a hostile tender offer.
 Application of entire fairness standard in a context that is simpler than
Weinberger
 Alcatel owned 43.3% of Lynch’s outstanding stock and designated 5 of 11 board
members  this is enough to be deemed controlling SH
 Board unanimously established an Independent Committee of non-Alcatel
directors to evaluate and negotiate the transaction with Celwave.
 Two factors are required to shift the burden of proof to plaintiff on the issue of
entire fairness: (1) the majority SH must not dictate the terms of the merger; (2)
the special committee must have real bargaining power that it can exercise with
the majority SH on an arm’s length basis

Defending Against Hostile Takeovers

 Defensive techniques – also referred to as “shark repellents” – can be adopted prior to any
identified threat
o Adoption of staggered board
o Adoption of supermajority SH voting requirement for fundamental transactions
o Poison Pills (make it virtually impossible to buy control in a tender offer because it is
prohibitively expensive unless the target board approves the acquisition
 Board of directors knows that any defensive measures taken will be tested in litigation since
litigation is inevitable part of hostile acquisitions and attempted hostile acquisitions
o Thus, fiduciary duty litigation has an important role to play in providing a forum in which
the courts evaluate the central question: is board acting in corporation’s best interests
by adopting defensive measures, given the increased likelihood the takeover will fail
and there will be no premium, or is the board simply acting to entrench themselves and
maintain position?
 Legal procedures that permit: tender offers and proxy contests
o Tender offer – bidder offers to buy enough shares in the target company directly from
existing SHs to exert voting control and uses that control to elect its own directors
 Rule that must buy shares pro rata from SHs rather than buying on first-come
basis and rule that must pay every SH who tenders the highest price
o Proxy contest – suitor seeks proxy voting authority from enough SHs to put its slate of
directors in power on the board
 Entrenchment
o Incumbent managers are typically replaced following a hostile takeover
o Actions that deter or prevent hostile takeovers protect incumbent managers
o Incumbent managers are trying to protect themselves first and company second
 Hostile takeover defense:
o Directors have inherent self-interest
o BJR-style deference is inappropriate

Page 36 of 56
 o But courts are reluctant to apply “fairness”
o Courts apply “intermediate standard”
 Cheff case (DE Sup. Ct. 1964): What the Court really wants to know: “[I]f the actions of the
board were motivated by a sincere belief that the buying out of the dissident stockholder was
necessary to maintain what the board believed to be proper business practices, the board will
not be held liable for such decision, even though hindsight indicates the decision was not the
wisest course.”
o What this means:
 Court does not give directors immediate benefit of BJR’s presumption of good
faith
 Instead, directors have initial burden of showing they had reasonable grounds to
believe a danger to corp policy existed and did not act to save their own skins
 Only if they make this showing does board get BJR
o “It is important to remember that the directors satisfy their burden by showing good faith
and reasonable investigation; the directors will not be penalized for an honest mistake
of judgment….”

 Delaware’s “Intermediate Scrutiny” of Defensive Measures

o Unocal v. Mesa Petroleum Co. (DE Sup. Ct. 1985)

 Evaluates defensive measures that boards take to determine if those measures
are consistent with the board’s duties of care and loyalty to the corporation and
its SHs
 ISSUE: Did the Unocal board act consistently with its fiduciary duties by adopting
the discriminatory exchange offer?
 HOLDING: Yes. A corporation may, to repel an attempted takeover, adopt a
stock repurchase plan making the corporation an undesirable target.
 “Valid corporate purpose”: give SHs largest amount of money
 FACTS/ANALYSIS:
 Key action: decision to “self tender” in a way that excludes the hostile
bidder
 Two-tier, front-loaded, cash tender offer
o Two tiers: first is cash and second is “junk bonds”
o “Front loaded”: the first tier is more attractive than the second
 Board of directors has majority of outside directors
o Outside directors considered the ISSUE separately with financial
advisors and attorneys (good process!)
 Terms of the self-tender
o Original bid was $54 per share and the self-tender was priced at
$72 per share
o Mesa Purchase Condition: the self-tender would be triggered only if
Mesa’s bid were successful
o Mesa Exclusion: Mesa would not be allowed to participate in the
self-tender
 Problem: the Unocal offer was so attractive that everyone wanted to wait,
but waiting would ensure that the offer was unavailable!

Page 37 of 56
 o Unocal changed the Mesa Purchase Condition
 “The board has a large reservoir of authority upon which to draw. Its duties and
responsibilities proceed from the inherent powers conferred by DGCL. § 141(a),
respecting management of the corporation's ‘business and affairs.’”
 But director power is not unlimited:
 “[T]heir duty of care extends to protecting the corporation and its owners
from perceived harm whether a threat originates from third parties or other
shareholders. But such powers are not absolute. A corporation does not
have unbridled discretion to defeat any perceived threat by any Draconian
means available.”
 Business judgment rule applies, but …
 “Because of the omnipresent specter that a board may be acting primarily
in its own interests, rather than those of the corporation and its
shareholders, there is an enhanced duty which calls for judicial
examination at the threshold before the protections of the business
judgment rule may be conferred.”
 Two pronged test:
 Threat: Did the directors reasonably perceive a threat, or did they act
“solely or primarily out of a desire to perpetuate themselves in office“?
Court cites Cheff v. Mathes.
 Proportionality: “A further aspect is the element of balance. If a defensive
measure is to come within the ambit of the business judgment rule, it must
be reasonable in relation to the threat posed.”
o What is “proportionality review”?
 “This entails an analysis by the directors of the nature of the
takeover bid and its effect on the corporate enterprise.
Examples of such concerns may include: inadequacy of the
price offered, nature and timing of the offer, questions of
illegality, the impact on ‘constituencies’ other than
shareholders (i.e., creditors, customers, employees, and
perhaps even the community generally), the risk of non-
consummation, and the quality of securities being offered in
the exchange.”
 REVLON duty to maximize shareholder wealth/Change of Control Transactions
o If hostile transaction – address whether or not there is a Revlon Duty (Duty to maximize
SH wealth)
o Revlon duty cases rarely succeed – properly invoked in 1) cash-out mergers and 2)
exchange offers

o Revlon, Inc. v. MacAndrews (DE Sup. Ct. 2003)

 ISSUE: Were the board’s defensive measures consistent with its fiduciary duties
to its SHs
 HOLDING: Initially yes. Adopting a poison pill, the first self-tender and the Note
exchange were all proportional responses to the threat of an inadequate price, a
threat the board investigated in good faith and on an informed basis. Once it
became clear that the company could not be defended, though, and that it was
for sale (its break-up was inevitable), the duties of the directors shifted to
maximizing SHs’ per share value in the sale.

Page 38 of 56
  Where control is fluid (traditional public corporation) and control is same type of
unaffiliated group is not change of control
 Unocal standard applies to defensive measures
 Poison Pill: initially adopted in response to threat, but reasonableness
was “moot” when company decided to auction
 Self Tender: approved in response to threat and reasonable
 Change from Unocal to Revlon – not about defensive measures but inevitable
sale
 When break up inevitable duties shift to maximizing value per share in sale
 Problem with stopping bidding too early? If care about equity holders need to let
market set the value to obtain the biggest payout
 The Revlon Innovation:
 “When Pantry Pride increased its offer to $50 per share, and then to $53,
it became apparent to all that the break-up of the company was inevitable.
The Revlon board’s authorization permitting management to negotiate a
merger or buyout with a third party was a recognition that the company
was for sale. The duty of the board had thus changed from the
preservation of Revlon as a corporate entity to the maximization of the
company’s value at a sale for the stockholder’s benefit.”
 In the end – care about the money: “ITS ALL ABOUT THE BENJAMINS”
 Big questions: (1) When does Revlon apply? Must have change of control
transaction (taking place) (2) What are Revlon duties? Maximize SH wealth.
 Once in Revlon, BJR on steroids
o Post-Revlon
 In re Netsmart Technologies, Inc. Shareholders Litigation, attempts to distinguish
the Revlon standard from the BJR:
 What is important and different about the Revlon standard is the intensity
of judicial review that is applied to the directors’ conduct. Unlike the bare
rationality standard applicable to garden-variety decisions subject to the
BJR, the Revlon standard contemplates a judicial examination of the
reasonableness of the board’s decision-making process. Although
linguistically not obvious, this reasonableness review is more searching
than rationality review, and there is less tolerance for stack by the
directors. Although the directors have a choice of means, they do not
comply with their Revlon duties unless they undertake reasonable steps to
get the best deal.
 Sinclair Oil: Board of Director enjoys a presumption of sound business judgment
and decisions not disturbed if rational business purpose (substance)
 But Revlon – process

o Paramount Communications Inc. v. QVC Network Inc. (DE Sup. Ct. 1993)
 Clarified the types of transactions that trigger Revlon duties
 FACTS:

 This case involved a proposed merger between Viacom and Paramount

Productions; as part of the merger agreement, Paramount agreed to an
array of defensive measures, including a no-shop provision, $100 million
dollar termination fee and a lock-up option on approximately 20% of
Paramount’s common-stock. However, QVC intervened with its own,
Page 39 of 56
 facially more generous merger proposal, conditioned on cancellation of
the defensive measures. The Paramount Board refused to conduct a
formal bidding process with QVC on the grounds that it would be
inconsistent with its contractual obligations to Viacom.
 HOLDING:
 Revlon Triggers
When a corporation undertakes a transaction which will cause (a) a
change in corporate control, or (b) a break-up of the corporate entity, the
director’s obligation is to seek the best value reasonably available to the
stockholders
 Burden of Proof
The “directors have the burden of proving that they were adequately
informed and acted reasonably”.
 Key Features of the Enhanced Scrutiny Test
The courts will look into the adequacy of the directors’ decisionmaking
process, including what information they used in coming to their decision.
In addition, the court will consider the reasonableness of the directors’
action in light of the circumstances then existing.

Regulation of Disclosure, Fraud and Insider Trading

 Section 10(b) and Rule 10(b)-5

o Section 10 “It shall be unlawful for any person, directly or indirectly, by the use of any
means or instrumentality of interstate commerce or of the mails, or of any facility of any
national securities exchange ... (b) To use or employ, in connection with the purchase
or sale of any security . . . any manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the Commission may prescribe as
necessary or appropriate in the public interest or for the protection of investors
o Rule 10b-5: “It shall be unlawful for any person, directly or indirectly, by the use of any
means or instrumentality of interstate commerce, or of the mails or of any facility of any
nation securities exchange,
 (a) to employ any device, scheme, or artifice to defraud
 (b) to make any untrue statement of a material fact or to omit to state a material
fact necessary in order to make the statements made, in the light of the
circumstances under which they were made, not misleading, or
 (c) to engage in any act, practice, or course of business which operates or would
operate as a fraud or deceit upon any person, in connection with the purchase or
sale of any security
o Implied private cause of action:
 Kardon (1946) held that the right of action should be assumed absent express
intent to limit (Supreme Court recognized in 1971)
 Elements:
 (1) misstatement or omission
 (2) material fact (materiality)
 (3) on which plaintiff relied (reliance)
 (4) in connection with
 (5) purchase or sale of securities
 (6) causing
 (7) damages (will not deal with in this class)
Page 40 of 56
 Misstatements and Omissions
o Misstatements: Santa Fe says that someone must have been misled into entering the
transaction
o Omissions: is there a duty to disclose?
o Affirmative duty to disclose material information?
 New area
 No cause of action for omission unless you have a duty to disclose in the first
place (FN 17 of Levinson)

o Gallagher v. Abbott Laboratories (7th Cir. 2001)

 ISSUE: Did plaintiffs set out a cause of action under Section 10(b) and Rule
10b-5 based on Abbott’s having omitted to state material facts that they had a
duty to state?
 HOLDING: No. Firms do not have an absolute duty to disclose material
information as soon as news comes into their possession. Rather, there is some
discretion with respect to the timing of disclosure.
 Security laws do not impose a system of continuous disclosure—only disclose
when positive law creates a duty to disclose
 No class members purchased stock in any manner that would have triggered this
disclosure duty during the period at issue
 Didn’t meet requirements for fraud
 Possession of material, non-public information is not enough (in and of self) to
give rise to affirmative duty to disclose; but if voluntary statement (i.e., press
release) which gives rise to a duty to speak completely and avoid half-truths
 Keep silent, fully
 Or run risk of liability for not saying enough
 Under the regulations, Abbott did not have a duty to correct its 10-k report,
because the statements made in that report, which issued before the FDA issued
its letter, were accurate when made.
 Duty to update required only that Abbott issue accurate disclosure statements in
its next periodic report
 Under Sarbanes (SOX), if significant event, can only remain silent for 4 days
 Materiality and Reliance
o Materiality: Substantial likelihood that a reasonable investor would attach importance in
making a decision because the fact would significantly alter the "total mix" of available
information
o Reliance: presumption of reliance where the duty to disclose has been breached
(Affiliated Ute Citizens)

o Basic, Inc. v. Levinson (Supreme Court 1988)

 Important for three reasons:
 1) probability of magnitude process of analysis in determining materiality
 2) recognition of FN 17 that “silence” absent duty to disclose is not
misleading
 3) adoption of fraud on the market theory for proving reliance
 ISSUES: As a matter of law, when will preliminary merger discussions become
“material facts?” Should the Court adopt the fraud-on-the-market presumption of
reliance for shares traded in efficient markets?

Page 41 of 56
  HOLDING: The materiality of contingent or speculative information “will depend
at any given time upon a balancing of both the indicated probability that the event
will occur and the anticipated magnitude of the event in light of the totality of the
company activity.” Given impersonal trading markets, the Court should adopt the
presumption that investors rely on the integrity of the market price, which reflects
available information and hence, any material misrepresentations.
 Fraud on the Market: rests on the notion that stock prices “incorporate” all public
information about a company (Efficient Capital Markets Hypothesis); rebuttable
presumption of reliance on the market price
 Connection: material misstatements or omissions affect the stock price,
thus harming those who trade
 If every misstatement is material, too low a threshold
 Not enough that statement is false or incomplete, if misrepresented fact is
otherwise insignificant
 Material when actually have an agreement (something to talk about)
 Affirmative Duty to disclose information? When Regulation tells us to (i.e., annual and quarterly
filing); When company buying/selling own stock
o Fiduciary duties to disclose: if volunteering information (i.e., press conference) – have
to be very specific about language used
o Proof that markets are efficient?

 Scienter
o Hockfelder defines “scienter” as “intent to deceive, manipulate, or defraud”
 An auditing firm allegedly “aided and abetted” fraud by failing to uncover it –
Court later foreclosed aiding and abetting liability under Rule 10b-5 (Central
Bank)
o Court said negligence is not enough
 Language of the statute: “manipulative or deceptive device or contrivance”
suggests knowing or intentional misconduct
 Legislative history: “catch-all clause to prevent manipulative devices”
 Structure of the 1934 Act: the Commission cannot adopt rules that are broader
than the statute
o Blackmun (dissent): “an investor can be victimized just as much by negligent conduct as
by positive deception.”
o What if threshold is too low? If set at negligence?
o Private Securities Litigation Reform Act of 1995 (PSLRA)
 The PSLRA provides that “[i]n any private action arising under this chapter in
which the plaintiff may recover money damages only on proof that the defendant
acted with a particular state of mind, the complaint shall, with respect to each act
or omission alleged to violate this chapter, state with particularity facts giving rise
to a strong inference that the defendant acted with the required state of mind.”
 The purpose of this rule is clear: Congress sought to deter “frivolous, lawyer-
driven” securities class action litigation by requiring the plaintiff to demonstrate at
the outset that the action is likely to be meritorious and not a mere device for
extracting unwarranted settlements.
 The PSLRA’s scienter pleading rules are in tension with the pleading standards
otherwise applied in federal courts.

o Tellabs, Inc. v. Makor Issues & Rights, Ltd. (Sup. Ct. 2007)
Page 42 of 56
  ISSUE: Under the PSLRA, when will the courts be satisfied that the plaintiff had
pleaded sufficient facts to invoke a “strong inference” of scienter?
 HOLDING: In determining whether the standard of a “strong inference” of
scienter is met, “the reviewing court must ask: When the allegations are accepted
as true and taken collectively, would a reasonable person deem the inference of
scienter at least as strong as any opposing inference?” The majority felt that the
strength of an inference is inherently comparative, and the court must therefore
weigh the plaintiff’s allegations against other plausible explanations for the
defendant’s behavior to determine whether the facts invoke a “strong inference”
of scienter. The inference need not be irrefutable, or even the most plausible, yet
it must be “cogent and compelling, and thus strong in light of
other explanations.”
 PSLRA set a uniform pleading standard for S. 10(b) actions, requiring that a
plaintiff:
 (1) specify each statement alleged to have been misleading and the
reason or reasons why the statement is misleading; and
 (2) state with particularity facts giving rise to a ‘strong inference’ that the
defendant acted with the required state of mind.
 Specificity and Particularity
 Through the ‘strong inference’ standard, Congress raised the bar for pleading
scienter, but left the standard undefined and provided little guidance regarding
how or when the standard would be satisfied.
 In sum, the court must ask: when the allegations are accepted as true and taken
collectively, would a reasonable person (unclear who/what this is; not necessarily
from an unsophisticated one) deem the inference of scienter “at least as strong
as any opposing inference?”
 Justice Ginsburg sets forth the roadmap: 
 First, as with any motion to dismiss, the court must accept all factual
allegations in the complaint as true. 
 Second, the court must consider the complaint in its entirety, as well as
other sources courts ordinarily consider when ruling on motions to dismiss
-- documents incorporated by reference and other matters of which the
court may take judicial notice.  The inquiry is whether all of the alleged
facts, taken collectively, give rise to a strong inference of scienter. 
 Third, in determining whether the pleaded facts give rise to a "strong"
inference of scienter, the court must take into account plausible opposing
inferences.  The inference of scienter must be cogent and compelling,
thus strong in light of other explanations. 
 “In Connection With”
o Standard:
 Early: “deceptive practices touching [the] sale of securities”
 Later: Courts seem to require substantial contact

o SEC v. Zandford (Sup. Ct. 2002)

 ISSUE: Where a stockbroker engages in a fraudulent scheme in which he sells
his customer’s securities and then embezzles the proceeds, is such fraudulent
conduct “in connection with the purchase or sale of any security” within the
meaning of § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5?

Page 43 of 56
  HOLDING: Yes. Where a stockbroker engages in a fraudulent scheme in which
sales of his customer’s securities are necessary to advance the scheme, such
fraudulent conduct is “in connection with the purchase or sale of any security”
within the meaning of § 10(b) of the Securities Exchange Act of 1934 and Rule
10b-5.
 Zandford = “villain of the year”
 Facts:
 Zandford persuaded Wood to open a joint investment account for himself
and his mentally retarded daughter
 Woods gave Zandford discretion to manage account and POA
 When Wood died all of the money in the account was gone
 Zandford subsequently indicted on 13 federal wire fraud charges
 SEC then filed a civil complaint in the same District Court, alleging that
Zandford had violated § 10 of the Securities Exchange Act of 1934 (Act),
and Rule 10b-5
 In favor of SEC
 The court of appeals reversed, HOLDING that a wire fraud conviction did
not necessarily establish that his fraud was “in connection with” the sale of
securities
 It reasoned that Zandford's sales of securities were incidental to his
scheme to defraud
 Supreme Court granted review.
 Supreme Court says: “The securities sales and respondent's fraudulent
practices were not independent events. This is not a case in which, after a lawful
transaction had been consummated, a broker decided to steal the proceeds and
did so. Nor is it a case in which a thief simply invested the proceeds of a routine
conversion in the stock market. Rather, respondent's fraud coincided with the
sales themselves. . . [I]t is enough that the scheme to defraud and the sale of
securities coincide.”
 The securities sales and Zandford’s practices were not independent events.
Taking the complaint’s allegations as true, each sale was made to further his
fraudulent scheme; and each was deceptive because it was neither authorized
by, nor disclosed to, the Woods.
 In the aggregate, the sales are properly viewed as a course of business that
operated as a fraud or deceit on a stockbroker’s customer.
 Grippo v. Perazzo 357 F.3d 1218 (11th Cir. 2004).
 In Grippo, the plaintiff turned over funds to the defendants, who were to
invest them in securities having a high rate of return, but no specific
securities were ever identified. Grippo's “investment” didn’t work out and
he sued.
 District court dismissed Grippo's suit on lack of “in connection with” of the
fraud to any identifiable security.
 11th Cir reversed, relying on Zandford for the proposition that “a plaintiff
does not need to identify a specific security, or demonstrate that his
money was actually invested in securities” for the alleged fraud to be in
connection with the purchase or sale of securities.
 Causation

o Dura Pharmaceuticals, Inc. v. Broudo (Supreme Court 2005)

Page 44 of 56
 ISSUE: What is the requirement for the plaintiff to adequately allege loss
causation? Namely, does an inflated purchase price satisfy the requirement of
loss causation (as the Ninth Circuit would suggest), or must the plaintiff explicitly
allege and prove proximate causation and economic loss?
 HOLDING: In order to satisfy the requirement of loss causation, the plaintiff must
explicitly allege and prove both proximate causation and economic loss. An
“artificially inflated purchase price” is not a relevant economic loss. The plaintiff’s
claim failed to include a statement indicating that Dura’s share price fell
significantly after the truth became known, therefore loss causation has not been
alleged and the claim is insufficient.
 FACTS:
 SH’s complaint says the following (and nothing significantly more than the
following) about economic losses attributable to the spray device
misstatement: “In reliance on the integrity of the market, [the plaintiffs] . . .
paid artificially inflated prices for Dura securities and the Plaintiffs suffered
damage[s] thereby.”
 District Court dismisses: failure to allege loss causation
 9th circuit (most overruled circuit) overrules
 ANALYSIS:
 Supreme Court recognizes that payment of an artificially inflated purchase
price does not invariably lead to, or proximately cause, an economic loss
o “For one thing, as a matter of pure logic, at the moment the
transaction takes place, the plaintiff has suffered no loss; the
inflated purchase payment is offset by ownership of a share that at
that instant possesses equivalent value.”
 Many factors can affect, or combine to affect, the price of a company’s
securities.
 “Given the tangle of factors affecting price, the most logic alone permits us
to say is that the higher purchase price will sometimes play a role in
bringing about a future loss. It may prove to be a necessary condition of
any such loss, and in that sense one might say that the inflated purchase
price suggests that the misrepresentation (using language the Ninth
Circuit used) ‘touches upon’ a later economic loss. Ibid. But, even if that is
so, it is insufficient. To ‘touch upon’ a loss is not to cause a loss, and it is
the latter that the law requires.”
 Court also notes that from a policy perspective, 9th Circuit’s ‘inflated price’
approach essentially provides investors with a downside insurance policy
against market losses. This is inconsistent with the objectives of securities
law.
 Plaintiff’s claim must contain facts, which if found to be true, prove
proximate causation and economic loss. When this is sufficiently done, the
requirement of loss causation will be satisfied.
 If 9th circuit were to be adopted, would function as insurance policy against
market losses (the touched upon test) – inconsistent with securities laws
 Further Questions:
 Still don’t know:
o What types of disclosure count as corrected disclosure?
 When you have corrected disclosure that changes stock
price – what does that do to these claims?

Page 45 of 56
 o Distinction between class period and damages period
o Collateral damage from corrective disclosure?
o No clear sense of forward casting estimates of damages?
 How does this relate to Basic?
o Rebuttable Presumption – p. 926
 Reliance on the integrity of the price set by the market
o Why don’t we have a presumption for causation like we do for
materiality and reliance? What is different about these elements?
 Causation and loss are more quantifiable

Page 46 of 56
Control of the Closely Held Firm

 Agency costs are mitigated in closely held corporation because of the alignment of interests in
ownership and control but raises new set of problems:
o Apportioning control?
o Dividend/compensation issues
o Key: some or all of the owners also manage the company on a day-to-day basis
 Problems occur when benefits of owning a corporation are spread unevenly in
terms of owners and effort
 Cf. to Public Corporation: SHs get dividends on investment or can sell stock; Directors and
Officers both getting paid salaries (presumably at fair market value)
o For Close Corporation: benefits to owners not necessarily in dividends or appreciation
in value; also, no ready market; many don’t pay dividends
 Transfer Restrictions
o Under DE, usual rule is that shares of stock freely transferable. Implicit in statutory
provisions which regulate restrictions on share transfer.
o Restrictions must comply with the formal requirements relating to adoption of the
restriction and must be conspicuously noted on the share certificates (MBCA §6.27(a)
and (b) and DGCL §202(a)).
 Restrictions must be for a proper purpose – general test is “reasonableness”
o Types of Restrictions (from MBCA §6.27 (d) and DGCL §202(c))
 SH must offer the corporation or other SHs the option to purchase the shares,
either at a price specified by prior agreement or at the price offered by the
prospective third-party purchaser (an “option”)
 The corporation or other SHs are obligated to purchase the shares (a “buy-sell”
agreement)
 The corporation or other SHs must approve the transfer of the shares (a “prior
approval” or “consent” requirement)
 The SH is simply prohibited from transferring to certain persons or classes of
persons
o Flat prohibitions on transfer are viewed very skeptically by courts and usually would be
struck down as unreasonable
o All transfer restrictions may not affect shares issued before the restriction is adopted
unless the holders vote in favor of the restriction (MBCA §6.27(a) and DGCL §202(b)).
o Most common transfer restriction is: buy-sell agreement
o Buy-sell agreements: provide liquidity for SH who wish to withdraw, determine the price
of the shares at a time when none of the parties to the agreement knows which of them
will be the sellers and which will be the purchasers (incentive to all for “fair” price) and
allows the principals of the corporation to plan with some certainty.
 Prices take one of these four forms:
 Fixed price – updated constantly to reflect current value of the shares
 Book value – most popular measure because of ease of determination,
based on historical costs and may not reflect true underlying values
 Appraisal – potential to be good, but basis should be decided on
beforehand
 Formula – can be very complicated

o Capital Group Companies, Inc. v. Armour (DE Ct. of Chancery 2005)

Page 47 of 56
 ISSUE: whether a stock restriction agreement is reasonable when it prevents the
transfer of stock through divorce
 HOLDING: the restrictions on the transfer of stock are reasonable
 Appropriate question for reasonableness is whether the restrictions are
reasonable on their face, not in how applied to particular plaintiffs
 Proper inquiry is whether the actual restrictions are reasonable to achieve a
legitimate corporate purpose

Page 48 of 56
Oppression of Minority Shareholders

 The Plight of the Minority Shareholder

o In general, statutory law that governs the creation and governance of corporations
assumes that they will be large with principals (SHs/owners) taking a passive role,
merely collecting dividends and the agents (directors and officers) taking an active role
in the company, making strategic decisions on hiring and investment as Directors or
managing the day-to-day affairs of the company as officers
o But, in Close Corporation, SH/owners may invest only if they are certain they will also
be a director/officer. Certainty? Voting trusts, voting agreements, SH agreements
o Widespread recognition of an independent doctrine of minority oppression was part of a
wide movement toward dealing with the problems faced by minority SHs in closely held
corporation
o Basic takeaway: conventional corporate law norms of majority rule and centralized
control can lead to serious problems for the close corporation minority SH
o Combine principle of majority rule and lack of market exit = vulnerability to abuse for
minority SHs
o Squeeze Out: the use by some of the owners or participants in a business enterprise of
strategic position, inside information, or powers of control, or the utilization of some
legal device or technique, to eliminate from the enterprise one or more its owners or
participants
o Criticism of oppression doctrine: at odds with business judgment rule and typical
deference given to majority
o Following lead of Donahue court, several courts outside of Massachusetts have
imposed a fiduciary duty running from SH to SH in a close corporation but DE does not
o Minority SH in Close Corp has no legal entitlement to either dividends or employment
(can be secured through SH agreement or employment contract)
 In contrast, controlling SH can force himself to be elected an officer, also can
force generous (but not excessive) salary
 Value of minority bloc of stock is worth less than if Corp sold as a going concern
and minority SH received pro rata share
o Control Premium: Majority SH’s percentage is worth MORE than share if sold as going
concern if sold alone
o Minority Discount: Minority SH’s percentage is worth LESS than share if sold as going
concern if sold alone

o Elmaleh v. Barlow (Superior Ct. of Mass. 2005)

 ISSUE: whether Molecular is a close corporation and defendants owe plaintiffs a
heightened fiduciary duty of utmost good faith and loyalty
 HOLDING: Under the Donahue factors, Molecular is not a close corporation and
defendants did not owe a heightened fiduciary duty nor would they have
breached such a duty had it applied
 Facts: board authorized re-pricing plan – created new agreements with preferred
stock investors and issued additional shares of common stock to investors who
had participated in a prior offering
 Re-pricing plan ultimately diluted the equity ownership of the plaintiffs and
other minority SHs
 Donahue tests established three factors to consider to find a close corporation:
Page 49 of 56
  (1) small number of SHs
 (2) no ready market for corporate stock
 (3) substantial majority SH participation in the management, direction and
operations of the corporation
 If not a closed corporation, SH has NO fiduciary duty to other SHs
 Yet, here Court says there is no heightened duty but generalized fiduciary
duty (Mass. Common law a little unclear)

o Leslie v. Boston Software Collaborative, Inc. (Superior Ct. of Mass. 2002)

 ISSUE: whether the directors have a legitimate business purpose for their
actions, and were those actions the “least harmful alternative” for the minority SH
 HOLDING: Khayter and Goulart did not act with the utmost good faith toward
Leslie
 K, G and L each contribute $200; K and G are techies and L is office guy; all
three get 1/3 of shares; L gets paid significantly less because K and G are
bringing in the bacon and he is doing mostly administrative stuff (billable hours
model); employees complain about Leslie; L terminated (director’s meeting –
removal as treasurer; SH’s meeting – removal as trustee and director)
 Utmost Good Faith Requirement: “with an ordinary employee, not entitled to
partner-like treatment, the termination of Leslie was justified. Given Leslie’s
enhanced status as an owner, however, K and G did not act in a manner
demonstrating the utmost good faith.”
 Less harmful alternatives available: “creative compensation techniques” could
have been explored; Court is saying BUY HIM OUT – but Court is only creating
basis of bargain for this to happen
 Closed corporation for sure heightened duties
 So, what is the justification for booting a SH out of a Close Corp?
 Purposefully trying to destroy company
 Commingling funds
 Moral of the story: 1) cannot lose ownership without compensation 2) Court
wants parties to bargain 3) Courts should not be doing valuation; if matters to the
parties, they should figure it out

 Remedies for Minority Oppression

o Oppression is not defined statutorily – Courts define it so its unclear
o Common definitions include:
 Burdensome, harsh, and wrongful conduct that is a visible departure from
standards of fair dealing
 A breach of the duty of fair dealing, which is enhanced in the close corporation
setting
 Frustration of the reasonable expectations of the minority SH
o Remedies Against Oppression
 Dissolution (MBCA § 14.30)
 Can be involuntary, typically where petitioning SH established either 1)
deadlock among directors or SHs 2) illegality, fraud or oppression 3)
waste or misapplication of corporate assets
 Generally, courts won’t dissolve if doing so would oppress minority SHs
 MBCA §14.32 allows the court to appoint a receiver or custodian
 Receiver: winds up and liquidates
Page 50 of 56
  Custodian: manages and stays the course
 Buy-outs (MBCA § 14.34)
 Equitable Relief (Leslie v. Boston Scientific) – can be method for Court to force
parties to bargain
 Cancelling or Altering the Charter
 Sale to a single purchaser

o Naito v. Naito (App. Ct. Oregon 2001)

 Note: empirically by third generation, family businesses sink
 ISSUE: Were Sam’s actions, which may individually be reasonable business
decisions, oppressive to the minority SHs
 HOLDING: the trial court found that the corporation and the controlling SH had
acted oppressively toward Plaintiffs. The Court of Appeals vacated the trial
court’s judgment and remanded for modification.
 RULE: Majority or other controlling SHs owe fiduciary duties of loyalty, good
faith, fair dealing, and full disclosure to the minority.
 ANALYSIS:
 Court rules offering price under the repurchase plan was on the low end –
not a good faith effort by the board to provide a reasonable portion of the
corp.’s earnings to the SH and it did not justify a failure to pay dividends to
the SHs
 Sam acted in his own self-interest and failed to act with a fiduciary attitude
 Corporation’s managers are in the best position in determining dividends
 The court of appeals noted that the essential aspect of the dividend policy
was that it contained a provision for a committee of non-SH directors to
recommend the amount of the dividend and for minority SHs to participate
in the decision
 Important that here none of these acts alone was enough to be oppression but
the cumulative effect was
 Court not dissolving – forcing them to stay together
 Key: want to trust management but heightened duty in closed corporation
 It depends! On contexts  facts and circumstances
 Get outside support for business decisions (committee of external directors =
cover)
 But if CEO makes decisions, always claim of self-dealing lurking
 Agency costs?
 Outside people don’t have same knowledge as insiders
 But mistrust insiders
 Both sides have agency costs

 Federal Proxy Regulation
o Proxy appointment must be in writing and signed, including electronic transmission
(MBCA §7.22 and DGCL §212 (b)).
o Proxy, which creates an agency relationship in which the SH (the principal) grants the
proxy holder (the agent) the power to vote her shares, can give the proxy holder full
discretion or be subject to specific instructions.
o Proxy can be revoked by principal at any time (1) by submitting written notice with the
corporation of an intent to revoke, (2) appointing another proxy holder in a subsequently
dates proxy, or (3) appearing in person to vote
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o Generally limited to 11 months (long enough for one annual meeting) (MBCA §7.22 (c))
 DGCL §212 (b) (three years)
o Securities Exchange Act of 1934 regulates proxy voting in public corporations
o SEC mandated disclosure: “proxy statement” – must contain information specified in
Schedule 14A
o § 14 (a)
 Federal proxy rules apply only to proxy solicitations
 Informational document accompanying the proxy card, any request for
proxy even if no card, any request to not sign or to revoke a proxy, and
any other communications
o Requires specific form of proxy card
o All proxy materials must be filed with the SEC
o No false or misleading statements (or omissions of material facts)
o Shareholder Proposals: Intro to Rule 14a-8
 SH proposals becoming increasingly important tool in activist SHs’ efforts
 “social activist proposals” or “corporate governance proposals”
 Target ISSUEs such as:
o Executive compensation
o Director nominations
o Separation of the CEO from the Chair, and
o Removing take-over defenses
 SEC does not directly regulate corporate action but SEC regulates disclosure
 Proxy statement must be provided to SHs
 Schedule 14A under authority of § 14(a) of the ’34 Act
 Proxy process generally happens around time of annual meeting
 Most SHs give voting rights to a proxy
 Key: SH and potential SHs are informed of risk and so they can regulate
companies – gives accountability not just about companies financial information
but also information about significant conflicts of interest of the officers, who
management and directors are, financial compensation
 The whole ISSUE revolves around whether SHs can force proposals to be
included in the Company’s proxy statement
 Proposal: a recommendation or requirement that the company and/or the board
take action
 SH proposals appear on the company’s proxy card
o This is the key to understanding Rule 14a-8
o The question is not primarily about the extent of SH power, but
rather about who will pay for the dissemination of information and
ballots
 Rule 14a-8 (i) (Question 9) identifies 13 reasons that companies can lawfully use
to exclude SH proposals
 Question 1: What is a proposal?
 Question 2: Who is eligible? (and how to demonstrate eligibility)
 Must have held $2,000 market value or 1% of company’s securities
entitled to vote on proposal for one year prior to submission
 Must continue to hold these securities through the date of the meeting
 HOLDING requirement designed to prevent people from cheaply buying
into a proposal
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 Question 3: How many proposals? Each SH may submit no more than one
proposal to a company for a particular SH’s meeting
 Question 4: Hong long can proposal be? May not exceed 500 words
 Question 5: deadline to submit? For annual meeting, not less than 120 days prior
to the release of the proxy statement for the previous year’s meeting date; for
other meetings – reasonable time in advance
 Time allows for companies to oppose the inclusion of a proposal and SEC
staff needs time to evaluate the objection
 Question 6: What if SH fails to meet procedural requirements? Company must
first notify SH; if SH does not correct within 14 days, company may omit the
proposal
 Question 7: Burden of persuading SEC on exclusion? Company must
demonstrate that it is entitled to exclude a proposal
 Question 8: Must proponent attend SH’s meeting? Either them or representative
 If fail to show without good cause, company permitted to exclude your
proposals for two years
 Question 9: if procedural requirements met, what other reasons for exclusion?
 **Improper under state law (i.e., if binding on company; preference for
recommendations and requests)
 Violation of state, federal or foreign law
 **Contrary to any of the Commission’s proxy rules (inc. 14a-9) which
prohibits materially false or misleading statements in proxy soliciting
materials
 Redress of a personal claim, benefit to you only (not SHs generally)
 **Relates to operations which account for less than 5% of company’s total
assets – not significantly related to the company’s business
 Company would lack power or authority to implement
 **Deals with matter relating to the company’s ordinary business operations
 Nomination or election for board of directors (or other governing board)
 Conflicts with one of the company’s own proposals
 Already been substantially implemented
 Resubmission (2 sections on this)
 Specific amounts of cash or stock dividends
 Question 10: How does company exclude?
 File with SEC no later than 80 days before filing proxy statement
 Company may or may not ask for a no-action letter
o If ISSUEd, no-action letter comes from SEC staff --- legal effect of
these letters is not fully resolved; usually not treated as binding but
given some deference
 Question 11: Response to Company’s arguments?
 Yes, but not required
 Question 12: What SH information included in proposal in proxy?
 Name, address, number of voting shares; but could just include statement
that will provide upon request
 Question 13: what can the proponent do about disagreements with the Company
(in its reasons to vote against)? Express view in statement or send letter to SEC
if false or misleading information

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  Apache Corporation v. Nycers (S.D. Tex. 2008)
 ISSUE: was the NYCERS SH proposal properly excluded? What is the
scope of Rule 14a-8(i)(7)? Specifically, what is the definition of the term
“ordinary business operations”?
 HOLDING: Apache properly excluded the NYCERS proposal pursuant to
Rule 14a-8(i)(7). The proposal related to matters of “ordinary business
operations.”
 Facts: NYC Comptroller included proposal for proxy statement requesting
implementation of equal employment opportunity policies – Apache
refused and request no-action letter from the SEC that proper under
ordinary business operations
 Ordinary business exclusion rests on two central considerations: 1)
subject matter (day-to-day management proposals should be excluded) 2)
the degree to which proposal attempts to micro-manage (highly
discretionary)
 In 1992, SEC issued no-action letter to Cracker Barrel ruling that all
employment-related SH proposals raising social policy issues would be
excludable under the ordinary business exception. Cracker Barrel, SEC
No-action Letter
 1998, SEC reversed its prior ruling – return to case-by-case approach
 Wal-mart court noted that all proposals could be viewed as effecting at
least some aspect of ordinary business operations – whether a policy
implicates significant social policy is the dispositive inquiry

o Shareholder Proposals: Bylaw Resolutions

 CA, Inc. v. AFSCME (Supreme Court of DE 2008)

 ISSUEs: 1) is the AFSCME proposal a proper subject for action by SHs as
a matter of DE law? 2) would the AFSCME proposal, if adopted, cause CA
to violate any DE law to which it is subject?
 Proposal was about reimbursement of election expenses
 As a matter of law, these ISSUEs implicated §§ 109 and 141 (a)
 Under both DGCL and MBCA, SH’s power to initiate change under the
bylaws cannot be taken away in articles of incorporation, but Board can
share this power (MBCA § 10.20 (b)(2) and DGCL § 109).
 § 109 by itself is clear: SHs have right to amend bylaws but taken in
conjunction with § 141, it changes
 Content of SH’s proposal cannot interfere with director’s management
rights (especially under DGCL § 141).
 “No such broad management power is statutorily allocated to the SHs.
Indeed, it is well-established that SHs of a corporation subject to the
DGCL may not directly manage the business and affairs of the
corporation, at least without specific authorization in either the statute or
the certificate of incorporation. Therefore, the SHs’ statutory power to
adopt, amend, or repeal bylaws is not coextensive with the board’s
concurrent power and is limited by the board’s management prerogatives
under § 141(a).”
 End result: director supremacy

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  HOLDINGs: 1) that implementation of proposed bylaw would require
expenditure of corporate funds did not, in and of itself, make bylaw an
improper subject matter for SH action, but 2) proposed bylaw mandated
reimbursement of election expenses in circumstances that the board’s
proper application of fiduciary principles could preclude

ENRON CASE STUDY

 Key players:
o Ken Lay: Created Enron in 1985 – CEO until 2001
 Culture comes from top-down; even the elevator had the stock price
o Jeff Skilling: President/CEO in 1997; Resigned August 2001
o Andy Fastow: CFO in 1998; Fired October 2001
 Accounting Voodoo:
o Special Purpose Vehicle/Entities (SPV/E): legally distinct entity with a limited life
created to carry out narrowly defined pre-specified activity for a “sponsor” company.
SPVs can serve legitimate business purposes by raising capital for their sponsors, by
isolating and homogenizing the cash flows and business risks of a specific asset class,
and by optimally allocating tax benefits to investor classes. In doing so, SPV sponsor
can be rewarded with increased liquidity and lower capital costs by catering to the
needs to investment and tax clienteles
o Key: if own less than 51% of a subsidiary, don’t have to include that company on a
consolidated financial statement
o Enron used and abused accounting rules
 Special Purpose Entities (SPEs)
 Allow companies to take risk off balance sheet by creating a separate,
independently controlled entity with separate ownership
 Enron violated both SPE rules:
o Conflict of Interest (Fastow controls SPEs)
o Enron guarantees that it make good any SPE losses from deals
with Enron
 Should have been disclosed! They weren’t and Enron hid transactions,
“met” its earning expectations and sustained stock price.
 Mark to Market Accounting
 Lets a company book all expected profits in the first year of a long term
deal (if later the deal does not produce expected profits, company require
to restate original profit figures)
 Enron misuses – 1) creates never before seen deals and makes up
projected profit figures (nobody could challenge) and 2) never restated
profits (intentional misrepresentation)
 Accounting firm did not want to whistle blow – they were getting paid and
didn’t want to lose client
 How did Enron debacle happen?
o Lots of people who should be asking questions but are not!
 Some key documents/revelations:
o “Smoking Gun” Memo from Sherron Watkins of August 15, 2001 constitutes actual
knowledge

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 o Memo to Ken Lay on August 17, 2001 says no more “spin” – have to deal with ISSUEs
directly
o Email to Ken Lay on August 29, 2001 from Margaret Ceconi
o September 26, 2001 Ken Lay tells employees to talk up the stock, talk positively about
Enron
 Collapse: October 2001 begins; file for Bankruptcy on December 2, 2001
 Diagnosis #1: The Gatekeepers Failed
o Gatekeepers:
 Accountants
 Securities Analysts
 Rating Agencies
 Lawyers
o Why did they fail?
 Insufficient deterrence
 Conflicts of interest
 Market irrationality
 Pressure from managers
 Insufficient competition
 Diagnosis #2: Managers Failed
o American system of corporate governance relies heavily on the board of directors
 State corporate law grants vast authority to the board of directors
o Enron had 14 directors; 2 were insiders (Lay and Skilling)
o Directors supervise officers
 Officers have incentive to cheat
 Board did not prevent cheating
 Approved conflict transactions
 Waived Enron’s code of conduct
o Why did managers fail?
 Inadequate disclosure by Enron’s officers
 Complex accounting ISSUEs
 Conflicts of interest (financial ties)
 Insufficient time and other resources
 Structural bias
 Insufficient deterrence
 Cognitive bias (e.g., commitment bias)
 Diagnosis # 3: Stockholders Failed
o SHs have little direct power: vote, sell and sue
o Price of stock remained high until Skilling’s resignation when it collapsed
o Why did SHs fail?
 Complacency with the bubble market
 Cognitive bias
 Insufficient information

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