I.

Economic and Legal Aspects of the Firm A. Themes i. Purposes of corporations 1. Profit-seeking 2. Driving economic growth 3. Limited Liability 4. Minimize contracting costs 5. Minimize agency costs ii. Sources of corporate law 1. Mostly state legislatures 2. Some common law 3. Federal governmentdisclosure obligations 4. Stock exchange rules iii. Purpose of corporate law 1. Structure of corporation a. Legal view. Shareholders elect Board, who delegate to managers, who keep shareholders informed. b. Real world View. Managers call the shots and keep shareholders out of the loop. i. Wall Street Rule. Dissatisfied shareholders can sell. 2. Responsibilities of board to shareholders 3. Corporate governance a. Incentive structures i. Johnson and Mecklin, Theory of the Firm. Agents will act in interests of corporation only up to ownership stake. Anything less than full ownership produces waste. b. Fiduciary Duty c. Pricing i. Easterbook and Fischel, The Corporate Contract. The price of a corporations stock reflects its governance structure. Corporate law should be default rules to contract around. d. Institutional investors have become majority of shareholders. i. Leads to more agency problems, but also more sophisticated oversight e. Sarbanes-Oxley i. 301. A publicly held company must have independent directors sitting on the auditing committee. ii. 302. The CEO and CFO must sign off on reports. iii. 304. CEO and CFO forfeit compensation if the signed-off reports are wrong. iv. 307. SEC issues rules of professional responsibility for lawyers. v. 404. Accounting firm has to audit financial reporting. B. Agency Law i. Possible structures of organization 1. Market relationship

2. Operation by contract 3. State Supplied Forms

a. Sole proprietorship b. General partnership c. Limited partnership d. LLC e. Corporation 4. Organized as a spectrum, determined by: a. Specialization of product and human capital b. Asset specificity. The next best use of the asset declines dramatically in value. COMMUNITY COUNSELING SERVICE, INC. V. REILLY (Fourth Circuit, 1963) 1. Holding During his period of employment, an agent must place the interests of his principal above his own. 2. Fiduciary duty. Elements: a. Substitute principals interest for agents b. Turn over anything that comes to agent that belongs to principal c. Honesty and full disclosure 3. To extend the companys protection, could have had him sign a noncompete clause. a. Robbins v. Finlay. Non-compete clause must come with compensation, such as through specialized training. Restatement of Agency Law 1. 387. General Principle. Unless otherwise agreed, an agent is subject to a duty to his principal to act solely for the benefit of the principal in all matters connected with his agency. 2. 385. Duty to Obey. 3. 388. Duty to Account for Profits Arising out of Employment. 4. 393. Duty not to compete with the principal as to subject matter of agency. 5. 394. Duty not to act for one with conflicting interests. 6. 395. Duty not to use or disclose confidential information to compete with or injure the principal. 7. Alternative conception of fiduciary duty (Easterbrook): the bargain the parties would have struck. More room for contractual opt-out. At will employment 1. HAMBURGER V. HAMBURGER (Massachusetts Superior Court, 1995) a. Holding An at-will employee has no obligation not to set up financing for and plan his next job while still employed. 2. Combination of fiduciary duty and at-will employment favors the employer a. Imbalance exists because the principal is a residual claimant 3. FOLEY V. INTERACTIVE DATA CORP. (California Supreme Court, 1988) a. Holding An employer, through course of dealings and the presence of mandatory company policy, can transform at will employment into a relationship that can only be terminated for cause. BLACKBURN V. WITTER (California District Court of Appeal, 1962)

ii.

iii.

iv.

v.

1. Holding The principal is bound by the acts of its agent in a relationship

with a third party. 2. Apparent Authority. If principal gives signals to the world that its agent has authority, and a third party reasonably interprets these signals, the principal is bound. Partnerships and Other Non-Corporate Enterprises A. General Partnership has been eroded somewhat by the development of LLPs and LLCs i. Norms best suited for a trusting, small group of participants with similar ideas as to how to run the firm B. Uniform Partnership Act i. Profit/Loss 1. 401(b). Each partner is entitled to an equal share of the partnership profits and chargeable with a share of the of the partnership losses in proportion to the partners share of the profits. 2. HYNANSKY V. VIETRI (Delaware Court of Chancery, 2003) a. Holding Determination of whether a partnership exists requires an inquiry into the intent of the parties to share profits. b. Intent to form a partnership or a partnership agreement is not dispositive. 3. New York law: must ask whether the parties are intended to share losses 4. When only one party contributes money and the other human capital, courts generally will not force an equal sharing of financial losses. a. Other partner has already lost his time and invested human capital. ii. Management 1. 401(f). Each partner has equal rights in the management and conduct of the partnership business. 2. COVALT V. HIGH (New Mexico Court of Appeals, 1983) a. Holding When a partnership is equally divided, the status quo governs. iii. Dispute Resolution 1. 401(j). A difference arising as to a matter in the ordinary course of business may be decided by a majority of the partners. An act outside the ordinary course may be undertaken only with the consent of all of the partners. iv. Partner Admission 1. 401(i). A person may become a partner only with the consent of all the parties. v. Relationship 1. Fiduciary relationship a. MEINHARD V. SALMON (New York Court of Appeals, 1928) i. Holding The fiduciary duty between partners requires one partner to inform the other of an investment opportunity made possible by the partnership. ii. Not honesty alone, but the punctilio of an honor the most sensitive. iii. UPA tries to bound the decision. 2. 404(a). The only fiduciary duties a partner owes to the partnership and the other partners are the duty of loyalty and the duty of care a. Both duties also framed in the negative

II.

i. 404(b). Duty of loyalty: accounting and

competition ii. 404(c). Duty of care: negligence, recklessness, misconduct, or illegal conduct 301(1). Each partner is an agent of the partnership for the purpose of its business. An act of a partner carrying on in the ordinary course of the partnership business binds the partnership.

3.
vi. Liability

1. 306. [A]ll partners are liable jointly and severally for all obligations
of the partnership. a. 305(a). A partnership is liable for loss or injury as a result of wrongful act or omission of a partner acting in the ordinary course of business of the partnership or with authority. b. Includes malpractice or criminal behavior P.A. PROPERTIES, INC. V. B.S. MOSS CRITERION CENTER CORP. (S.D.N.Y. 2004) a. Holding When one partner has inherent authority ad is trying to further the interests of the partnership, any agreements are binding. HAYMOND V. LUNDY (E.D. Pa. 2002) a. Holding A partner acting contrary to the Partnership Agreement is exceeding his authority and the partnership is not bound. b. Anomalous case and difficult to square with P.A.P.

2.

3.

vii. Exit

1. 601. A partner is dissociated from a partnership upon the

occurrence of any of the following events: (1) the partnerships having notice of the partners express will to withdraw. a. Also expulsion, (3) and (4), or a judicial finding of wrongful conduct (5), bankruptcy (6), or death (7) b. For bankruptcy or death, the partnership does not have to be wound up; can buy out the partners share i. All other times, must be wound up. MCCORMICK V. BREVIG (Montana Supreme Court, 2004) a. Holding Dissolution requires liquidation of the partnerships assets into cash before distribution.

2.

III.

The Corporate Form A. Choice of the corporate form i. Important variables: liability, taxes, and governance ii. S-Corp and C-Corp are tax distinctions. 1. Limited liability, but entity/double taxation 2. Partnerships: flow through taxes, but no limited liability 3. Limited partnerships: flow-through taxes; limited partners only have limited liability a. LLCs can choose taxes, but members have limited liability iii. Limited Liability. Liability is limited to the amount of the initial investment. 1. Partnerships can use insurance to limit liability 2. In publicly held corporations, transaction costs would go way up; have to investigate the wealth characteristics of other shareholders iv. Tax treatment. Corporation itself is a taxed entity; so are shareholders. Leads to double taxation problems.

Partnerships, etc., are flow-through entities. Individual partners are taxed, but the entity is not. B. Basic characteristics i. Internal Affairs Doctrine. The law of the state of incorporation governs the relationships between shareholders, directors, and officers. 1. 35 states have adopted the MCA, and compete with Delaware for the franchise tax. 2. Delaware has the advantage of experienced judges and legislators and extensive case law a. Two-layered court system, Chancery and Supreme: i. Chancery Court is a corporate law court; explicitly a court of equity b. Corporate law amendments are proposed by the Corporate Law Section of the Bar, adopted by the General Assembly ii. Norms. 1. Separation of function a. Assumes a hierarchy between passive investors and active managers. Directors are generally independent or executives b. Same person can hold multiple roles, especially in closed corporations c. Leads to agency and monitoring costs 2. Adaptability a. Free transferability of shares i. But, DCL 202 allows restrictions on transferability b. Corporation lasts indefinitely c. Common stock. Comes with residual claimant status and voting rights, for election of directors. d. Preferred stock. Comes with liquidation rights, and a right to receive dividends before common stock 3. Judicial Deference, via the business judgment rule 4. Limited liability iii. Shareholder/Director/Manager relations 1. Effecting change a. DGCL 242(b). Amendments to the certificate of incorporation are to be proposed by the board of directors and submitted to shareholders for majority vote b. DGCL 109. Shareholders have the right to amend the bylaws; can be delegated but not divested. 2. DCGL 141(a). The business and affairs of every corporation shall be managed by or under the direction of a board of directors, except as may be otherwise provided. 3. DCGL 211. Directors must be elected at an annual meeting or by written consent. Can get a court order to force it. a. 211(d). Shareholders cant call a special meeting. b. MBCA 7.02(a)(2). If 10% of voting power submit demands for a meeting, a special hearing will be called. 4. Voting. a. Straight voting. Vote for all board members, winner takes all. Default under MBCA 7.28(e). b. Cumulative Voting. Multiply number of shares by board members. i. Formula: SX/(D+1)+1=necessary number of shares

1.

Directors usually nominated by high-level officers, shareholders vote up, down, or withhold. d. HOSCHETT V. TSI INTERNATIONAL SOFTWARE, LTD. (Delaware Court of Chancery, 1996) i. Holding The ability to elect directors by written consent does not substitute for the mandatory annual shareholders meeting. ii. Since overruled by 211. 5. Removal a. Default rule is that directors may be removed by simple majority of shareholders, with or without cause. 141(k), 8.08(a). i. For cumulative voting, cant be removed if enough votes to elect him oppose his removal. 8.08(a), with or without cause, 141(k), without cause, with cause still majority. ii. MBCA 8.09. Can get a judicial override to remove a director for fraud or other grounds. b. Campbell v. Loews, Inc. Intent to take over not a cause, but harassment is. i. Director to be removed must be allowed to present his case to stockholders c. Classified boards; removal only for cause. 141(k). d. Removal by written consent i. DCGL 228. As many votes as would be necessary at a meeting ii. MBCA 7.04. Unanimity. e. MURRAY V. CONSECO (Indiana Supreme Court, 2003) i. Holding A director may be removed by the board, under Indiana law, unless shareholders are divided into classes and he was elected by one of these classes. ii. No other MBCA jurisdiction allows for removal by the board. f. ADLERSTEIN V. WERTHEIMER (Delaware Court of Chancery, 2002) i. Holding A director must be given adequate notice of intentions to remove him so that he may invoke his lawful defenses. g. CENTAUR PARTNERS, IV V. NATIONAL INTERGROUP, INC. (Delaware Supreme Court, 1990) i. Holding A shareholder may not change a provision requiring 80% vote to enlarge a board without 80% of the votes. C. Public Companies i. Distinctive features 1. A market for their shares 2. The makeup of the shareholder population 3. Proxy voting ii. Background of public corporations law 1. Federal securities laws assume passive shareholders 2. Many laws reflect the takeover boom of the 1980s 3. Hedge fund. Lightly regulated pool of private capital.

c.

4.

Mutual funds are regulated by the 1940 Act; hedge funds are much more active shareholders Equity-based compensation came into vogue in the 1990s and was regulated beginning in 2003

a.

iii. Benefits 1. For company a. Get capital b. Cash out holdings, at least partially c. Public awareness/status 2. For investors a. Liquidation. The Wall Street Rule b. Valuation i. Efficient Markets Hypothesis. 1. Weak form: Cant predict future movement on the basis of past prices. Generally accepted. 2. Semi-strong form: Stock prices reflect all relevant publicly available information 3. Strong form: Stock prices reflect all relevant information, including inside information. Controversial; we regulate insider trading. ii. Crashes/Bubbles, despite EMH, can be traced to: 1. Traders interest in hyping irrational propositions 2. Noise traders. Cancel each other out mostly, but sometimes cloud the market. 3. Professional arbitrageurs, who ride the wave created by noise traders iii. Alternative explanation for efficient markets: Stock market does a good job of evaluating projects and allocating capital. iv. Cross-listing 1. Alternative Deposit Receipts allow foreign companies to list their shares in the U.S. a. Different levels of regulation and disclosure v. Independent directors 1. From 20% in 1950 to 80% today 2. Reasons: a. Institutional ownership b. Market premium, post-Enron c. Increased legal rules, legal incentives, and exchange regulation d. Shareholder wealth-maximization more accepted as a measure of value 3. Tradeoffs arising from directors not being involved: objectivity vs. information vi. Proxy voting. 1. Federal laws supplement state law a. 1934 Act, 14. Registered security must comply with proxy regulations. May not solicit proxies. 2. Governed closely by SEC Rules a. Rule 14a-2(b)(2). Allowed to solicit less than ten shareholders i. Rule 14a-1(l)(2)(iv). A statement of how one intends to vote is not a solicitation b. Rule 14a-9. Anti-fraud rule.

IV.

D. Shareholder Proposals and Access to Corporate Records i. Company must either give you a shareholder list upon request or put your proposal in their own communications. Usually the latter. ii. Rule 14a-8. 1. 14a-8(b). To submit a proposal, must have held $2000 or 1% worth of stock for at least a year. 2. Proposals can be excluded for the following reasons: a. 14a-8(i)(1). Improper under state law i. For example, must be phrased as suggestions; under DCL 141(a), board is responsible for operations. b. 14-18(i)(3). False or misleading statements. c. 14-18(i)(5). Less than 5% of assets and earnings, if not otherwise significantly related to the companys business d. 14-18(i)(7). Ordinary business operations. e. 14-18(i)(8). Election process f. 14-18(i)(13). Raising the dividend. iii. Social issues 1. LOVENHEIM V. IROQUOIS BRANDS, LTD. (D.D.C. 1985) a. Holding The significantly related exception to Rule 14a-8(i) (7) permits shareholder proposals on social issues to be included for a shareholder vote. 2. Cracker barrel discriminated against gay employees; SEC declined to take enforcement action on exclusion of shareholder proposal, as employment is within the realm of management 3. Tide has turned recently from social issues to corporate governance a. Often, objections to anti-takeover provisions or the nominating process iv. Access to books and records 1. CONSERVATIVE CAUCUS V. CHEVRON CORP. (Delaware Court of Chancery, 1987) a. Holding Shareholder communications related to business risks of doing business in unstable nations is a proper purpose for acquiring a shareholder list. b. If seeking common documents, burden is on company to show purpose is improper, if unusual documents, like board minutes, the burden is on the shareholder 2. Delaware Code is more permissive as to what documents can be acquired. a. 220(b). Allows shareholders the right to inspect for any proper purpose, the corporations stock ledger, a list of its stockholders, and its other books and records. b. 16.02(b). Shareholder only entitled to an exclusive list of records: minutes, accounting records, and shareholder list. Fiduciary duties and Shareholder Suits A. Fiduciary Duty of Loyalty i. Types 1. Duty of Loyalty a. Corporate opportunities b. Conflict of Interest Transactions 2. Duty of Care a. Waste doctrine: a combination of the duties of loyalty and care 3. Duty of good faith 4. The business judgment rule interfaces with these duties

Intrinsic fairness standard. If directors havent met their duties, this standard is the backstop defense. ii. Standard of conduct. 1. MBCA doesnt use the word fiduciary conduct. 2. 8.30(a): Each member of the board of directors shall act: (1) in good faith, and (2) in a manner the director reasonably believes to be in the best interests of the corporation. a. 8.30(b): The members of the board of directors shall discharge their duties with the care of a person in a like position would reasonably believe appropriate under similar circumstances. 3. 8.31 defines the standard of liability, which is higher and separate. 4. Independent directors are obligated to ask tough questions when they discover something suspicious. B. Business Judgment Rule i. A judicial presumption that directors have acted properly. 1. If applicable, courts wont reach the duties. 2. Institutional competence is the oft-cited reason ii. Gries Sports Enter., Inc. v. Cleveland Browns Football Co., Inc. The rule is a rebuttable presumption that directors are better equipped than the courts to make business judgments and that the directors acted without self-dealing or personal interest and exercised reasonable diligence and acted with good faith. 1. If directors arent entitled to the business judgment rule, intrinsic fairness. Basically a shift in presumption. iii. SHLENSKY V. WRIGLEY (Illinois Appellate Court, 1968) 1. Holding The court will not judge the controlling shareholder for an idiosyncratic decision without a concrete showing it cost shareholders money. 2. Unanimity principle: ordinarily, shareholders are unanimous in desire to maximize shareholder price 3. Minority shareholders bought into the Cubs knowing they were subject to Wrigleys whims. C. Other constituencies i. DODGE V. FORD MOTOR CO. (Michigan Supreme Court, 1919) 1. Holding A court will not disturb a decision that seems to not maximize shareholder wealth if it has the potential to maximize long-term wealth. ii. Maine BCA 756. [T]he directors and officers may consider the effects of any action upon employees, suppliers, and customers of the corporation, communities and all other pertinent factors. iii. Pennsylvania BCC 1715. Directors may consider shareholders, employers, suppliers, customers, and creditors of the corporation, and communities. 1. (b). No factor necessarily controlling. iv. Fiduciary duties usually run to shareholders because they are residual claimants D. Corporate Opportunity Doctrine i. ALI Guidelines 1. Corporate opportunity: made aware because of status as director, through the use of corporate information or property, or is closely related to the companys line of business 2. May take it only after full disclosure and rejection 3. NORTHEAST HARBOR GOLF CLUB, INC. V. HARRIS (Maine Supreme Court, 1995) a. Holding Under the ALI guidelines, a director must formally disclose any corporate opportunity to escape liability.

5.

ii. Delaware standard 1. Guth v. Loft. If a business opportunity which the corporation is financially able to undertake, is, from its nature, in the line of a corporations business and is of practical advantage to it, is one in which the corporation has an interest or a reasonable expectancy, and [the directors interest] will be brought into conflict with that of the corporation, the law will not permit him to seize the opportunity for himself. 2. BROZ V. CELLULAR INFORMATION SYSTEMS, INC. (Delaware Supreme Court, 1996) a. Holding A director has no obligation to disclose an opportunity the corporation had no financial ability to take on the basis of a speculative potential purchase by another company. b. Presentation to the Board is a safe harbor only, not a necessity. 3. Guth standard leaves an unwieldy eight-factor test: a. Director may not take opportunity if: (1) corporation is financially capable of exploiting it, (2) it is within the line of business, (3) the corporation has an interest or expectancy in the opportunity, and (4) the fiduciary will be placed in a position inimical to the corporation b. Director may take opportunity if: (1) it is presented to him in his individual, not directorial capacity, (2) it is not essential to the corporation, (3) the corporation has no interest or expectancy, and (4) the director didnt employ the corporations resources to pursue the opportunity. E. Conflicting Interest Transactions i. This is one way to rebut the business judgment rule. ii. Common law rule: the contract was voidable at the defendants option, if any conflict was present. 1. GLOBE WOOLEN CO. V. UTICA GAS & ELECTRIC CO. (New York Court of Appeals, 1918) a. Holding A director on both sides of a transaction is not protected merely by refraining to vote, but must protest a transaction he knows to be unfair. iii. DCL 144(a). 1. No conflicted transaction will be voidable solely on the basis of the conflict if: a. The director makes it known and disinterested directors vote in good faith, or b. The director makes it known and shareholders vote in good faith, or i. Courts read disinterested there too c. Contract is fair to the corporation. i. Two elements: fair dealing and fair price d. Good faith: the vote is for the benefit of the corporation, not to do a friend a favor. 2. SHAPIRO V. GREENFIELD (Maryland Court of Special Appeals, 2000) a. Holding The standard to be applied to conflict of interest transactions is intrinsic fairness. b. Maryland statute was modeled after Delaware, among other states

10

F.

Difference between corporate opportunity and conflicts of interest is that the corporation is taking the opportunity in the latter. iv. MBCA 8.61. Deals with an elaborate set of provisions, defining applicable terms with specificity. No states have adopted it. v. Shareholder ratification 1. A disinterested shareholder ratification doesnt make transaction automatically valid, only shifts burden of proof. Plaintiff can still prove that it is not in corporations best interests. This is judicial gloss. 2. Plaintiff can argue waste: that the transaction was so fundamentally bad that the directors are giving away corporate property for trivial consideration. a. Only unanimous shareholder ratification can validate a wasteful transaction. vi. Parent-Subsidiary Conflicts 1. SINCLAIR OIL CORP. V. LEVIEN (Delaware Supreme Court, 1971) a. Holding In a parent-subsidiary relationship, there must be self-dealing to overcome the intrinsic fairness test. b. Self-dealing. Receiving a benefit to the exclusion of minority shareholders, or imposing a burden not shared by a majority. c. An excessive dividend payment is not self-dealing; minority shareholders receive it too d. Because parent dominates subsidiary, the shareholder owes a fiduciary duty to the corporation. vii. Executive Compensation 1. BYRNE V. LORD (Delaware Court of Chancery, 1995) a. Holding Stock option compensation is unfair if the directors have no obligation to remain with the corporation to exercise them. b. Establishes a two-prong test: i. Must provide a tangible benefit to the corporation ii. Value of the options have to bear a reasonable relationship to the value of the benefit 1. 157(b): the consideration set by directors is conclusivewhich guts the value prong. Fiduciary Duty of Care and Good Faith i. JOY V. NORTH (Second Circuit, 1982) 1. Holding The business judgment rule benefits shareholders, who can diversify, by rewarding risk. ii. Directors Duties 1. SMITH V. VAN GORKUM (Delaware Supreme Court, 1985) a. Holding Directors duty of care includes a duty to inform themselves about major transactions. b. The standard under the business judgment rule is gross negligence. c. This case breathed life into the duty of care. d. Delaware legislature responded by adding 102(b)(7), allowing certificate of incorporation to immunize directors for the duty of care i. Not good faith or loyalty; MBCA allows you to immunize breach of duty of loyalty. 2. IN RE CAREMARK INTERNATIONAL, INC. DERIVATIVE LITIGATION (Delaware Court of Chancery, 1996)

c.

11

a. Holding Directors duty of care includes a duty to set up a

system of monitoring and compliance. b. Graham v. Allis-Chambers. 1963 case saying there was no duty to implement corporate espionage to catch wrongdoing they had no reason to suspect. c. Only a systematic failure to exercise oversight will establish the necessary lack of good faith 3. IN RE ABBOTT LABS (Seventh Circuit, 2001) a. Holding Failure to take action despite six years of FDA warnings is sufficient to establish a breach of the duty of good care. iii. Officers Duties 1. MILLER V. U.S. FOODSERVICE, INC. (D. Md. 2005) a. Holding Failure to address compliance failures, and misrepresenting the protections in place, is a breach of the duty of care. b. Business judgment rule widely assumed to apply to officers. iv. Good faith 1. Disney Cases a. BREHM V. EISNER (Delaware Supreme Court, 2000) i. Holding Boards have wide discretion to determine executive compensation. ii. Difficult to call a compensation contract waste, which requires no consideration going to the corporation. b. IN RE THE WALT DISNEY COMPANY DERIVATIVE LITIGATION (Delaware Court of Chancery, 2003) i. Holding If a board fails to evaluate an executive compensation contract, they are not protected by the business judgment rule. ii. Chancellor Chandler has recharacterized a Van Gorkum-style failure of oversight from duty of care to duty of good faith. 1. Shrinking duty of care c. IN RE THE WALT DISNEY COMPANY DERIVATIVE LITIGATION (Delaware Court of Chancery, 2005) i. Holding The directors of Disney did not commit waste, malfeasance, or negligence in approving the compensation contract of Michael Ovitz. 1. This is after case has been tried, under fairness standard. ii. Bad faith can be proven by intentional dereliction of duty, a conscious disregard for ones responsibilities. iii. Distinguished from Van Gorkum; executive compensation not as important as a merger. d. After Disney cases, bad faith includes (1) intentional wrongdoing and (2) dereliction of duty, but not gross negligence. 2. STONE V. RITTER (Delaware Supreme Court, 2006) a. Holding The duty of faith is not a separate duty but part of the duty of loyalty. b. Also officially endorses the Caremark standard.

12

c. Affirms that a Van Gorkum-style standard is not due care and

cannot be insulated by a 102(b)(7) provision v. Executive Compensation 1. United States leads the world in absolute standards and in proportion of variable pay (63%). a. Variable pay had arisen out of attempt to align incentives. i. Problems with stock options: 1. Incentives for earnings management 2. No indexing; overstates managers contributions 3. Incentives to use insider information 4. No expensing, but they dilute the common stock pool when exercised a. This has changed; now they are expensed. ii. Also, has led to stock-option backdating 1. Not illegal, but companies do it fraudulently lying to shareholders 2. Debatable whether it is a problem. 3. Sarbanes-Oxley a. CEO and CFO must certify that all financial statements are accurate i. If there is a restatement of earnings, they must return their compensation for that period b. Attorneys must report information about fiduciary duties to general counsel or CEOthen must follow up. G. Derivative Litigation i. Mechanics 1. Brought by a shareholder on behalf of and in the name of the corporation a. A two-part suit, technically: i. Compel the corporation to take action against someone who has wronged it ii. The suit itself. b. The recovery goes to the corporation, not to shareholders directly. 2. 141(a). The decision to sue is a decision of the directors a. In a securities fraud case, shareholders can sue directly b. Must first make a written demand the directors take action. If refused, can sue for wrongful refusal i. In most jurisdictions, this is a requirement. MBCA 7.42 ii. In Delaware, it can be excused if demand would be futile ii. ARONSON V. LEWIS (Delaware Supreme Court, 1984) 1. Holding To excuse demand as futile, a shareholder plaintiff must prove improper influence on the board. 2. Two part test to excuse demand. Must establish a reasonable doubt: a. That the directors were disinterested and independent, or b. That the challenged transaction was otherwise the product of valid exercise of business judgment. 3. Essentially sets up a litigation-within-a-litigation iii. Brehm v. Eisner. Pleadings in derivative suits must be pled with particularized facts.

13

Difficult to do that before discovery, but shareholders have access to 220 records. 2. Also added wrinkles to both prongs: a. Were the judgments of the directors clouded? b. Was the informational component defective? iv. Grimes v. Donald. If demand is refused, the refusal gets the business judgment rule unless the shareholder can prove a reasonable doubt that the board acting interestedly or without due care. 1. Provides an incentive not to make demand. v. IN RE THE LIMITED, INC. SHAREHOLDERS LITIGATION (Delaware Chancery Court, 2002) 1. Holding A board of which half the directors, not a majority, are interested and not independent, excuses demand in a derivative suit. 2. Interestedness: a conflicted financial interest 3. Independence: not beholden to a controlling shareholder/CEO a. Independence turns on whether salaries are material, that they owe their primary job to the CEO, and a donation solicited by a college president. vi. Rales v. Blasband. Where the board considering the demand did not make the challenged decision, the Aronson test is inappropriate. Instead, examine whether there is a reasonable doubt that the board considering the demand could have exercised its independent and disinterested business judgment. vii. Special Litigation Committees 1. ZAPATA CORP. V. MALDANADO (Delaware Supreme Court, 1981) a. Holding Where the board appoints a special committee to evaluate a demand request, the committee will be evaluated for interestedness and good faith. b. Two-part test i. Was the Special Litigation Committee disinterested and act in good faith, and were there reasonable bases for the decision? ii. If plaintiff meets that requirement, court can use a smell test. Anything goes. 2. New York, in a related litigation to Zapata, had simply applied the business judgment rule 3. Iowa gives no deference to the SLC determination. 4. SLC disinterestedness turns on whether the director is, for any substantial reason, incapable of making a decision in the best interests of the corporation. viii. Directors can limit their liability through: 1. Exculpation a. 102(b)(7). Corporation, subject to certain limitations, can simply eliminate personal liability in the certificate of incorporation 2. Insurance. a. Permitted to purchase D&O insurance under the DCL 3. Indemnification. a. 145. A corporation can indemnify expenses, damages, or settlement amounts paid by directors if the director acted in good faith and reasonably believed the action to be in the best interests in the corporation.

1.

14

i. 145(b). Shareholder derivative suits do not allow

judgments and settlements to be indemnified. Corporation paying itself. b. 145(c). If the defense is successful, mandatory indemnification. c. 145(f). Can contract for more. i. OWENS CORNING V. NATIONAL UNION FIRE INSURANCE CO. (Sixth Circuit, 2001) 1. Holding A corporation cannot contract around the good faith requirement of indemnification in by-laws. Close Corporations and LLCs A. Basics i. Close corporations are analogous to partnerships, but perpetually existing 1. Majority rule presents problems in a close corporation context 2. Voting agreements are permitted ii. Major problem is lack of liquidity for shares. iii. Why, in light of problems for minority shareholders? 1. Limited liability, and limits transaction costs 2. Rational preference for corporate norms B. Ex Ante Contracting i. 141(a) can be contracted around. 1. 350. A written agreement among the stockholders of a close corporation holding a majority of the outstanding stock entitled to vote is not invalid on the ground that it so relates to the conduct of the business and affairs of the corporation as to restrict or interfere with the discretion or powers of the board of directors. ii. 343 and 342. Form a close corporation by putting it in the certificate 1. Cant have more than 30 shareholders 2. No public offering and subject to share transfer restrictions. 3. MBCA 7.32. A shareholder agreement stripping the board of discretion must be unanimous. Otherwise the same. iii. RAMOS V. ESTRADA (California Court of Appeal, 1992) 1. Holding An agreement to vote is valid and enforceable. 2. 7.22(d)(5). Could be prevented by issuing an irrevocable proxy to each party to the agreement. Self-enforcing. C. Ex Post Judicial Review i. ZIDELL V. ZIDELL (Oregon Supreme Court, 1977) 1. Holding A conservative dividend policy will only be overturned if not in good faith and for a legitimate business purpose. a. Courts will often look for large cash reserve in cases to compel dividends. 2. Minority shareholders have a large burden to overcome in the business judgment rule. ii. DONAHUE V. RODD ELECTROTYPE CO. (Massachusetts Supreme Court, 1975) 1. Holding If a close corporation buys back the shares of the controlling shareholder, it also must make an equal offer to all minority shareholders. 2. Imposes on majority shareholders a strict duty of good faith to minority shareholders. iii. WILKES V. SPRINGSIDE NURSING HOME, INC. (Massachusetts Supreme Court, 1976)

V.

15

1. Holding When minority stockholders allege a breach of strict good

faith duties, the business decision itself must be analyzed. Two-part test: a. Was there a legitimate business purpose? b. If so, plaintiff can show a less harmful alternative 3. Cuts back on Donahue. iv. NIXON V. BLACKWELL (Delaware Supreme Court, 1993) 1. Holding Fiduciary duties to minority shareholders do not imply equal treatment. D. Involuntary Dissolution i. IN RE KEMP & BEATLEY, INC. (New York Court of Appeals, 1984) 1. Holding If a close corporation violates the reasonable expectations of minority shareholders, the conduct is oppressive enough to justify dissolution of the corporation. 2. New York law allows dissolution actions to be brought for illegal, fraudulent, or oppressive actions. ii. GIMPEL V. BOLSTEIN (New York Supreme Court, 1984) 1. Holding The reasonable expectations test should not be applied where the shareholders of a close corporation are not the initial investors. 2. Instead, conduct must be inherently oppressive; burdensome, harsh, and wrongful. iii. Often, courts will look to a less harsh remedy E. Share repurchase Agreements i. CONCORD AUTO AUCTION, INC. V. RUSTIN (D. Mass, 1986) 1. Holding A mandatory buyback of shares at a set price is valid in the absence of fraud and bad faith. ii. GALLAGHER V. LAMBERT (New York Court of Appeals, 1989) 1. Holding An at-will employee does not obtain fiduciary duty rights by virtue of receiving shares as a condition of employment. iii. Pedro v. Pedro. Where a minority shareholder is wrongfully forced out, he is entitled to fair value of his shares rather than the price in the buyback agreement. 1. An outlier case, but bad faith was key. F. Limited Liability Companies. i. Uniform Limited Liability Company Act 1. 301(a). Members actions bind the company. a. 301(b); if managers arent members, members dont bind the company. b. 302. LLC is liable for damages by a member or manager in the ordinary course. 2. 303. Debts incurred are only debts of the company, even if not abiding by the by-laws. 3. 404. Member-managed companies, have partnership-style management rights. Manager-managed companies have corporationstyle rights. 4. Broad contracting authority a. Elf Autochem North America, Inc. v. Jaffari. An LLC agreement to submit to arbitration will be upheld. ii. GOTTSACKER V. MONNIER (Wisconsin Supreme Court, 2005) 1. Holding Members of an LLC have to meet a standard of fairness when making a conflicted transaction. 2.

16

2. Also held: If two people hold stock in an LLC collectively, they each
hold half of the stock in question. iii. Fiduciary Duty 1. HARBISON V. STRICKLAND (Alabama Supreme Court, 2004) a. Holding Members of an LLC cannot contract out of their fiduciary duty. 2. VGS, INC. V. CASTIEL (Delaware Chancery Court, 2000) a. Holding It is a violation of fiduciary duty for minority shareholders in an LLC to act against the interests of the majority without notice. iv. Exit 1. Legislatures have passed tighter exit rules since the IRS liberalized its tax rules. a. McGee v. Best. The LLC agreement will be enforced, even if contrary to expectations of the founder as to exit. Creditors A. Dividends and Distributions i. Creditors are fixed claimantstheir obligations are fixed by contract. Risk of asset dissipation. 1. Law has protections in place a. Equity cushion. Shareholders are residual claimants. b. Par value. Shares were once a measure of capital the firm had measured by par value. No longer recognized in every jurisdiction ii. Directors determine the amount of capital of the firm 1. Must equal at least the par value of the shares a. All else goes to surplus. b. DCL 153. Shares of stock with par value may be issued for such consideration as determined from time to time by the board of directors. i. 152. Cant be an IOU. ii. MBCA 6.21(b). Any consideration, including promissory notes. iii. Dividends. 1. Delaware a. 170. Can only pay out of surplus, or a nimble dividend out of net profits from the fiscal year. b. 174. Directors personally liable for paying improper dividends. 2. Model Act a. 5.40. Can distribute dividends unless equitably or bankruptcy insolvent. b. Also provides for personal liability. c. 6.40(e). The insolvency tests have to be satisfied on the date that the debt is incurred, not when they are paid. B. Piercing the Corporate Veil i. A way for debtors to attack limited liability ii. Contract Context 1. Factors: a. Observance of corporate formalities b. Fraud or injustice c. Undercapitalization i. A controversial factor. Must be grossly inadequate ii. Judge it as of the time the firm is formed.

VI.

17

CONSUMER CO-OP V. OLSEN (Wisconsin Supreme Court, 1988) a. Holding When a creditor knows of its debtors financial situation but continues to loan, it waives its right to pierce the corporate veil. 3. KC ROOFING CENTER V. ON TOP ROOFING, INC. (Missouri Court of Appeals, 1991) a. Holding Where an individual uses a succession of corporations to contract and avoid debts, the corporate veil will be pierced. 4. Equitable Subordination a. When a shareholder transforms himself into a creditor, court can push him back to the end of the line i. Less drastic remedy than veil piercing. iii. Tort Context 1. Stronger case for piercing, because tort victims are not voluntary claimants a. Same three prong test. 2. WESTERN ROCK CO. V. DAVIS (Texas Court of Civil Appeals, 1968) a. Holding A director will be held liable for tort claims incurred when the director is in control, and the corporation is a shell with no assets. b. Factors: i. Reasonable foreseeability ii. Proximate causation (by the fraudulent use of the corporation) iii. Lack of insurance iv. Undercapitalization 1. Weighs heavier in tort cases; they cant investigate 3. BAATZ V. ARROW BAR (South Dakota Supreme Court, 1990) a. Holding No veil piercing will be found where the company observed corporate formalities and was not undercapitalized. 4. Walkovsky v. Carlton. Where taxicab companies had the legal minimum insurance, the veil is not pierced. This true even though the cab company was comprised of six different corporations. a. Enterprise Liability. Treating assets as a group that have been put into separate corporate boxes. Goes to the fraud or injustice prong. i. A solution where shareholders dont observe formal borders iv. Incorporated Shareholders 1. Theoretically, should be easier to pierce against corporate shareholders, but empirically litigation is less successful a. Moral hazard problem: corporations absorb upside but box in the risk; leads to riskier behavior b. Some of the positive justifications for individual shareholders dont hold for corporations 2. CRAIG V. LAKE ASBESTOS (Third Circuit, 1988) a. Holding The power to control a subsidiary does not allow for corporate piercing if that control is not exercised to a substantial extent. 3. UNITED STATES V. BESTFOODS (U.S. Supreme Court, 1998)

2.

18

a. Holding Control of a subsidiarys facility by a parent b.

corporation under CERCLA does not track corporate veilpiercing law. Court rules that CERCLA did not alter veil-piercing law. Veil piercing leads only to indirect liability, not direct liability. i. For direct liability, the parent must be in control of the facility, not just the subsidiary

VII.

KAYCEE LAND AND LIVESTOCK V. FLAHIVE (Wyoming Supreme Court, 2002( a. Holding The corporate veil piercing doctrine applies to LLCs. b. Most courts have found the same. C. Risk Allocation Devices i. Securitization 1. Pools of securitized assets transferred to a BRV, which is then marketed to private investors ii. Promoters Liability 1. RKO-STANLEY WARNER THEATRES, INC. V. GRAZIANO (Pennsylvania Supreme Court, 1976) a. Holding Promoters of a company are liable for the agreements they enter into before a corporation has formed, unless an express provision releases them. iii. Investors Liability 1. TIMBERLINE EQUIPMENT CO. V. DAVENPORT (Oregon Supreme Court, 1973) a. Holding Investors are strictly liable if they represent themselves as a corporation before it exists. 2. The strict liability rule is specific to Oregon a. Possible defenses: i. De facto corporation. 1. Operates against all creditors 2. Where the investor generally acts as a corporation, and a creditor reasonably would have believed that they were transacting with a corporation, not a person. ii. Corporation by estoppel. 1. Operates against a particular creditor 2. Creditor thought they were dealing with a corporation. It would be inequitable to find the investor liability. b. MBCA 2.04. 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. i. No strict liability; knowledge required iv. Ultra vires 1. Outdated doctrine; a corporation had no authority to act outside of its strict charter 2. Delaware law allows chartered powers to be to engage in any lawful activity. 3. MBCA 3.04 mostly disposes of it as well; limited opportunities under 3.04(b). Mergers

v. LLCs 1.

19

A. Friendly Mergers i. Shareholders given more rights in merger context 1. Voting a. Condorets Jury Theorem: when facing a binary decision, if people are more than 50% likely to get the right answer, the more people voting, the more likely the group is to get it right. b. 251 governs both mergers (where one is absorbed) and consolidations (where they are combined into a new corporation) i. 251(c). Shareholders of both corporations get voting rights in a merger of equals ii. 251(f). De minimus exception for acquirer where the acquired firm is less than 20% of the acquirer. c. 253. No vote necessary for a short-form merger, where either corporation owns 95% of the other. d. Delaware doesnt contemplate a compulsory share exchange, a share for share transaction that makes one company a subsidiary of the other. i. MBCA 11.03 gives shareholders voting rights. 2. Appraisal. The right of a shareholder to have his or her shares valued and bought back by the corporation at fair value if he or she dissents from the merger. a. 262. Only dissenters receive these rights b. If no voting rights, no appraisal rights. i. Except non-parent owned shares in a short-form merger. c. 262(b)(1). Market exceptionno appraisal rights if held by at least 2000 holders or on a stock exchange. i. 262(b)(2). But, if receive anything but stock in exchange, get appraisal rights. Can receive cash for fractional shares. d. 13.02(a). Appraisal rights for compulsory share exchanges. e. Triangular Merger i. Acquirer creates a subsidiary, which acquires the acquired corporation. The ultimate acquirers shareholders do not get voting rights. ii. HEWLETT V. HEWLETT-PACKARD CO. (Delaware Chancery Court, 2002) 1. Holding Hewlett-Packard did not issue misleading information to shareholders or buy votes so as to render its merger with Compaq invalid. 2. A merger of equals. Shareholders of both constituent corporations must approve the merger agreement. 3. DCL 225 allows shareholders to challenge the vote in an expedited procedure iii. Sale of assets 1. 271. Only selling company gets voting rights and only if selling all or substantially all of assets a. No appraisal rights. b. HOLLINGER, INC. V. HOLLINGER INTERNATIONAL, INC. (Delaware Chancery Court, 2004)

20

i. Holding If the remaining assets are viable or

profitable, a corporation has not sold substantially all of its assets.

iv. De facto merger

Acquired sells assets for shares, dissolves, and distributes the shares to its own shareholders. 2. Ends up as a statutory merger, but have stripped away voting and appraisal rights, at least in Delaware. a. HARITON V. ARCO ELECTRONICS, INC. (Delaware Supreme Court, 1963) i. Holding Giving equal dignity to different statutes requires a finding that de facto mergers are distinct from statutory mergers. b. APPLESTEIN V. UNITED BOARD & CARTON CORP. (New Jersey Superior Court, 1960) i. Holding A de facto merger will be treated as statutory merger. ii. Most states follow this lead. v. Merger Accounting 1. Old system a. Purchase Accounting. Treats the companies as two separate corporations who have come together. Account for premium as a separate asset, goodwill. i. Goodwill, as an asset, must be depreciated. Reduces income when it amortizes. b. Pooling. Account for them as if they had always been together. Improved earnings. i. Eliminated in 2001. 2. Now, not necessary to amortize good will; evaluate it periodically until it becomes impaired; then depreciate. vi. Minority Squeeze outs 1. COGGINS V. NEW ENGLAND PATRIOTS FOOTBALL CLUB, INC. (Massachusetts Supreme Court, 1986) a. Holding A minority shareholder is entitled to rescissory damages when a merger is consummated by a conflicted controlling shareholder, for no legitimate business purpose. 2. WEINBERGER V. UOP, INC. (Delaware Supreme Court, 1983) a. Holding In appraisal actions, stocks must be valued according to modern financial measures. b. Reaffirms duties of loyalty and burden rules c. Says that the fairness test is not bifurcated between fair dealing and fair price. Its holistic. d. Ordinarily, appraisal is the favored remedy, with equitable exceptions for certain unsavory situations. e. Did away with Delaware Block valuation method. f. Overrules the business purpose protection. vii. Sale of control 1. Control premiums can be used for legitimate reasons (value of the ability to vote) and illegitimate ones (squeeze out minority shareholders, loot the company). Role of law is to sort out the good motives from the bad. 2. Generally, controlling block is allowed to be sold at a premium a. TRYON V. SMITH (Oregon Supreme Court, 1951) 1.

21

i. Holding There is no fiduciary duty to inform

minority shareholders of a controlling block sale as long as the sale is in good faith. b. Best price rule of the Williams Act regulates this somewhat. 3. Three exceptions a. ESSEX UNIVERSAL CORP. V. YATES (Second Circuit, 1962) i. Holding Mass, seriatim resignation of the board is acceptable as part of a sale of a control block of stock. ii. Naked sale of office is prohibited, but this is OKit allows control b. HARRIS V. CARTER (Delaware Chancery Court, 1990) i. Holding Controlling shareholders have a fiduciary duty to investigate whether the purchaser will loot the company. ii. Duty to investigate is triggered by circumstances that would awaken suspicion and put a reasonably prudent man on his guard. iii. New York: knowledge; Delaware: lowerperhaps gross negligence. c. PERLMAN V. FELDMANN (Second Circuit, 1955) i. Holding A control premium that reflects a sale of corporate opportunity must be distributed to shareholders. 4. IN RE DIGEX SHAREHOLDERS LITIGATION (Delaware Chancery Court, 2000) a. Holding A subsidiary must negotiate at arms length with its parent before surrendering control in a merger. b. Will lead to due diligence on subsidiaries as well as the targets B. Hostile Takeovers i. Target refuses to negotiate with the bidder. Tactics: 1. Bidder a. Makes a tender offer to shareholders i. Regulated by Williams Actcant play groups of shareholders against each other. ii. Obtains 51% and replaces board b. Proxy fightput in place your own slate of directors to control i. Regulated by proxy regulations ii. Own far less than half the shares 2. Target has legitimate and illegitimate reasons to resist takeover ii. Enhanced Scrutiny 1. CHEFF V. MATHES (Delaware Supreme Court, 1964) a. Holding When resisting a hostile takeover, a board must establish a danger to corporate effectiveness and policy by good faith and reasonable investigation. 2. UNOCAL CORP. V. MESA PETROLEUM CO. (Delaware Supreme Court, 1985) a. Holding When resisting a hostile takeover, directors must prove their response is in good faith. b. Unocal enhanced scrutiny test:

22

i. The burden is on the directors to show reasonable grounds of belief of danger to corporate policy or effective 1. Requires good faith and reasonable investigation 2. Materially enhanced by an independent majority of directors ii. Response to the danger must be appropriate. 1. Must not be draconian; that is, not preclusive or coercive iii. Once these are established, action must fall within a range of reasonableness; essentially business judgment rule 3. Unitrin, Inc. v. American General Corp. defines the draconian test. Has to be either preclusive or coercive to fail. a. Preclusive when it makes it mathematically impossible or reasonably unlikely that the insurgent can control a majority of the board. b. Coercive: Designed to force your own shareholders to vote for incumbent management or vote against the bid for reasons unrelated to the merits. iii. Poison Pills 1. Created in response to the outlawing of discriminatory share buybacks a. Trigger is usually the purchase of a threshold block of stock, often 20% b. Flip-in: Entitles the target shareholders to buy additional stock for half price. Discriminatory against bidder. c. Flip-over: Reserved for situations in which the target doesnt survive, or if shares are exchanged. i. Shareholders have the right of purchase shares in the bidder for half price. 2. MORAN V. HOUSEHOLD INTERNATIONAL, INC. (Delaware Supreme Court, 1985) a. Holding A pre-emptive poison pill defense can be a proportional response to a threat based on the firms overall vulnerability. b. Evaluated under Unocal. c. When a specific threat arises, must apply Unocal again to the invocation of the poison pill iv. Auction Context 1. REVLON, INC. V. MACANDREWS & FORBES HOLDINGS, INC. (Delaware Supreme Court, 1986) a. Holding Once a Board has committed to sale of the company, it must maximize shareholder price without regard to corporate policy. b. How to satisfy Revlon obligations? i. A closed auction ii. A market check, pre- or post-agreement c. Deal protection devices? Court says that no-shop provision is not per se illegal i. FN 16. Board is to be active, which includes enticements to land an initial bid. 2. PARAMOUNT COMMUNICATIONS, INC. V. TIME, INC. (Delaware Supreme Court, 1990)

23

a. Holding Revlon duties are not triggered when the shareholders

of both corporations are the market, and therefore, there will be no change in control. b. Also a factor in not triggering Revlon was that the long-term planning was not abandoned, as it was in Revlon c. With Revlon not triggered, apply Unocal test. 3. PARAMOUNT COMMUNICATIONS, INC. V. QVC NETWORK, INC. (Delaware Supreme Court, 1994) a. Holding Revlon duties are triggered when defensive measures will result in a new controlling shareholder taking control. b. Market shareholders controlled Paramount, but the acquirer, had a controlling shareholder i. Market shareholders too are entitled to a control premium for their stock ii. Will be subject in the new company to the disadvantages of being minority shareholders c. Once the board has committed to a sale of control, they forfeit their right to say their long-term plan is better than the high bidders. d. Once Revlon is triggered, must look at substance of the deal. Process must be structured to maximize the deal. i. Cannot discriminate between favored and nonfavored bidders. ii. Standard is a range of reasonableness 4. Ultimately, Revlon triggered when: a. Board initiates a bidding process b. Board abandons long-term strategy in response to a third party bid c. Change of control. v. Shareholder franchise 1. Blasius line a. Schnell v. Chris-Craft Industries, Inc. Even legally permissible interferences with the shareholder franchise can be declared inequitable. b. Blasius Indus., Inc. v. Atlas Corp. The board must come up with a compelling justification for an action if the primary purpose is to interfere with or impede the shareholders right to vote for their directors. i. No one has ever survived the compelling justification test 2. MM COMPANIES, INC. V. LIQUID AUDIO, INC. (Delaware Supreme Court, 2003) a. Holding When the voting rights of shareholders are interfered with in the context of a battle for control, the Blasius test must be incorporated into Unocal. b. First, Unocal. When satisfied the measures arent draconian, have to ask if the primary purpose is to impede the franchise. i. If so, apply the compelling justification test ii. Do not get the benefit of the range of reasonableness. vi. Pre-planned defenses 1. CARMODY V. TOLL BROTHERS, INC. (Delaware Court of Chancery, 1998) a. Holding A dead-hand poison pill is an invalid defense.

24

b. Dead-hand Poison Pill. Only the directors who implemented

the poison pill or their designees can redeem it. Violates 141(d) by discriminating between directors. d. No compelling justification under Blasius. 2. Shareholder approval of defenses. a. Quickturn Design Systems v. Mentor Graphics suggests that when shareholders approve the defense, move to business judgment rule. i. Divided case with strong dissentsperhaps you have to check to make sure the shareholders were reasonably informed. vii. Deal protection Devices 1. Deal Protection Device. A defensive measure designed to protect a deal that was negotiated between two companies. a. Examples: i. Termination fee ii. Stock option lock-ups iii. No-shop closes iv. Matching rights v. Force-a-vote condition. b. Will encourage a higher initial bidless fear that the bidders deal will be jumped. 2. OMNICARE, INC. V. NCS HEALTHCARE, INC. (Delaware Supreme Court, 2003) a. Holding Where a deal is protected by an agreement that controlling shareholders will vote for the deal and an agreement to force a vote, and there is no fiduciary out, the devices are draconian. b. Preclusive because the minority shareholders cannot change the outcome. c. Disingenuous and limited to its facts. 3. IN RE TOYS R US, INC. SHAREHOLDER LITIGATION (Delaware Chancery Court, 2005) a. Holding There is no obligation under Revlon to negotiate a less restrictive deal protection device when doing so could jeopardize the highest bid. b. When the process looks good, the defendants will usually win. c. Dont want to promote endless incremental bidding; deal protection devices do not deter substantially higher bids Federal Law A. Proxy Regulations i. Disclosure regulations are broad and getting broader. 1. Regulation S-K is almost 100 pages long. ii. Generally, state law governs substantive law, and federal law governs procedure and disclosure 1. SROs have their own regulations, but 1934 Act gives SEC authority over SROs 2. State law governs the allocation of power with the corporation, the corporate governance 3. BUSINESS ROUNDTABLE V. SECURITIES AND EXCHANGE COMMISSION (D.C. Circuit, 1990) a. Holding The SEC is beyond its authority when it regulates the voting power of stock. b. The number of votes per share is a matter of state law. c.

VIII.

25

4. Sarbanes-Oxley establishes substantive laws in areas in which states

generally have not interferedboard structure, independent directors, executive compensation, etc. a. Attorney requirements i. Rule 205.3(b). Must report up the ladder to superior if you find a material violation of the securities laws. ii. Then must monitor the corporations response or go all the way to general counsel or CEO, or legal compliance committee iii. Can divulge confidential information to SEC, which conflicts with state law. iii. 14(a)

1. It shall be unlawful for any person, by use of the mails or by any

means of interstate commerce 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, to solicit or to permit the use of his name to solicit any proxy or consent or authorization in respect of any security registered pursuant to section 12 of this title. Rule 14a-9. (a) No solicitation shall be made by means of any proxy statement or other communication, written or oral, containing any statement, which.. is false or misleading with respect to any material fact, or which omits to state any material fact necessary in order to make the statements therein not false or misleading or necessary to correct any statement in any earlier communication with respect to the solicitation of a proxy for the same meeting or subject matter. a. Covers both affirmative misstatements and omissions or halftruths b. Creates an obligation to correct public statements to ensure they remain accurate. Elements for a private right of action a. Standing i. J.I. CASE CO. V. BORAK (U.S. Supreme Court, 1964) 1. Holding A private right of action exists under 14(a) of the Securities and Exchange Act. b. Statement or omission of a material fact i. TSC INDUSTRIES, INC. V. NORHTWAY, INC. (U.S. Supreme Court, 1976) 1. Holding A statement or omission is material if there is a substantial likelihood that a reasonable shareholder will find it important. a. Would significantly alter the total mix of available information. 2. Mixed question of law and fact. 3. Definition applies throughout the securities laws. ii. VIRGINIA BANKSHARES, INC. V. SANDBERG (U.S. Supreme Court, 1991) 1. Holding A statement of reasons, opinions, or beliefs are actionable only if they are

2.

3.

26

c.

d.

e.

materially misleading as to the underlying subject matter. 2. Have to look at the underlying value of the stock; doesnt matter if the directors thought it was different or the subjective motivation for giving the price Causation/Reliance i. MILLS V. ELECTRIC AUTO-LITE CO. (U.S. Supreme Court, 1970) 1. Holding If the proxy statement was an essential link in the transaction, causation is established. 2. Essential linkthe votes of the shareholders whose proxies were solicited were necessary to the transaction. a. Voting causation. Dont need to prove they even read the prospectus. ii. VIRGINIA BANKSHARES, cont 1. If votes arent necessary to approve the deal, the proxy statement is not an essential link. a. If the proxy statement is not an essential link, causation cannot be established. Mental state i. Not decided in Virginia Bankshares (FN 5). ii. Gerstle v. Gamble-Skogmo, Inc. Second Circuit: negligence is enough. 1. Other circuits require recklessness at least. Damages i. Intertwined with causation. ii. Transaction Causation. Misstatement caused shareholders to vote affirmatively for a transaction and therefore to forfeit appraisal rights. iii. Wilson v. Great American Industries, Inc. Loss causation. Would have gotten more value in appraisal than in the merger. iv. Supreme Court has not spoken.

B. Rule 10b-5. i. It shall be unlawful for any person (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 not misleading, or (c) to engage in any act, practice, or course of business which would operate as a fraud or deceit upon any person. 1. Applies to all securities, registered or unregistered. 2. Sweeping scopeany device, scheme, or artifice to defraud; applies to any type of communications ii. Elements 1. Materiality. TSC definition. a. BASIC INC. V. LEVINSON (U.S. Supreme Court, 1988) i. Holding To determine materiality of a statement or omission in a merger context, a court must weigh the probability of the merger against its magnitude.

27

2.

3.

Probability: Have to look at indicia of interest at highest corporate levels 2. Magnitude: Size of both corporate entities, size of premium, etc. ii. TSC test is not self-defining in the merger context because mergers are inherently speculative. iii. FN 17. Silence or no comments, absent a duty to disclose, are not misleading under 10b-5. Required mental state a. Ernst & Ernst v. Hochfelder. Requires scienter, but doesnt say what scienter. b. Private Securities Litigation Reform Act i. Enacted to combat fraud by hindsight. Plaintiffs sued everyone whose stock price declined, and would extract settlements by getting past motion to dismiss. ii. Contours 1. Imposes a lead plaintiff requirement; the plaintiff with the largest financial stake chooses the attorney. 2. Sanctions on attorneys for frivolous litigation 3. Stays discovery until motion to dismiss 4. Proportional liability on defendants 5. Plaintiffs must plead with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind. a. Required state of mind is punted to courts. iii. TELLABS, INC. V. MAKOR ISSUES & RIGHTS, LTD. (U.S. Supreme Court, 2007) 1. Holding A strong inference must be at least as strong as any other inference possible from the pleadings. Plaintiff must be a purchaser/seller. a. BIRNBAUM V. NEWPORT STEEL CORP. (Second Circuit, 1952) i. Holding An action under Rule 10b-5 can only be brought by purchasers or sellers of stock. ii. Primarily covers the type of fraud associated with the purchase or sale of securities 1. That is, fraud as to the value of the securities; not fiduciary duty, etc. b. SUPERINTENDENT OF INSURANCE V. BANKERS LIFE & CASUALTY CO. (U.S. Supreme Court, 1971) i. Holding As long as fraud touches on the sale of securities, there is a right of action. ii. Overturns Birnbaum on: 1. Does not only cover the type of fraud associated with the purchase/sale of securities 2. Does cover corporate mismanagement. iii. FN 9. Confirms that there is a private cause of action.

1.

28

4.

5.

BLUE CHIP STAMPS V. MANOR DRUG STORES (U.S. Supreme Court, 1975) i. Holding An action under Rule 10b-5 can only be brought by purchasers or sellers of stock. ii. Adopts Birnbaum on that point. iii. Shareholders who do not choose to sell have no claim d. SANTA FE INDUSTRIES, INC. V. GREEN (U.S. Supreme Court, 1977) i. Holding In an action under Rule 10b-5, it is required to prove manipulative or deceptive conduct. ii. Manipulative. Called a term of art: creating an artificial market for securities iii. Deceptive. Goes beyond a breach of fiduciary duty iv. Williams Act later required that a controlling shareholder state that a transaction is fairproviding the element of deception if it is not in fact fair. Reliance/Causation. a. Affiliated Ute Citizens v. United States. Materiality implies reliance and causation. b. BASIC, INC., cont. i. Holding Fraud on the market can be used to establish reliance in a 10b-5 action. ii. Fraud-on-the-Market. People who purchase securities do so in reliance on price as a measure of the stocks value. iii. Presumption that can be rebutted 1. Show that accurate information actually made it to the market 2. Show that plaintiffs sold or would have their stock for unconnected reasons iv. Only a four-justice majority. Damages a. DURA PHARMACEUTICALS, INC. V. BROUDO (U.S. Supreme Court, 2005) i. Holding To establish damages from a fraudulent misstatement, plaintiffs must plead and prove that when the truth came out, the inflated stock price dropped. ii. The inflated price itself is not enough. 1. Cant sell at an inflated price and recover. iii. Damages will be the difference between the inflated price paid by the plaintiff, and the price to which it declined at the time the news came out.

c.

C. Williams Act i. Construed as an attempt to protect shareholders during tender offers, while not affecting the relationship between the bidder and the target ii. Key facets 1. Disclosure element a. 13(d). If an investor owns more than 5% of a public company, must disclose percentage, identity, purposes, source of money i. 13D formtry to make it bland but truthful

29

 14(d). Must make a statement of 13(d) information plus an additional set from the SEC when you make a tender offer for 5% 2. 14(e). General anti-fraud provision a. Usually injunctive relief 3. Traffic rules a. 14e-1. Offer must remain open 20 days b. 14d-6. Shares must be bought pro rata c. 14d-5 and 14d-7. Shareholders can withdraw tendered securities d. 14d-9. Must offer same price to everyone. No premiums in a tender offer i. Trumps state law e. 14e-2. Target management must send statement recommending a course of action for shareholders, either in favor, against, or neutral. Is subject to anti-fraud provision. iii. FIELD V. TRUMP (Second Circuit, 1988) 1. Holding One cannot escape the best price rule by temporarily withdrawing a tender offer to give some shareholders a premium, then reinstating the offer. iv. What is a tender offer? 1. Teased out by case law. 2. Large number of shareholders in impersonal transactions is generally a tender offer a. Many factors can be taken into account v. State laws 1. CTS CORP. V. DYNAMICS CORP. OF AMERICA (U.S. Supreme Court, 1987) a. Holding A state law that limits the voting powers of acquiring companies, and is limited to corporations incorporated in and having a substantial connection to the state, is valid. b. Not preempted by the Williams Act, which is neutral as between bidder and target c. No commerce clause problem if limited to the state. States still allowed to regulate corporations. 2. AMANDA ACQUISITION CORP. V. UNIVERSAL FOODS CORP. (Seventh Circuit, 1989) a. Holding A state law freezing control after a hostile takeover is valid under the Williams Act and the commerce clause. D. Insider Trading i. Classical Theory 1. In re Cady, Roberts & Co. SEC case first linked 10b-5 to insider trading. 2. SECURITIES AND EXCHANGE COMMISSION V. TEXAS GULF SULPHUR CO. (Second Circuit, 1968) a. Holding A person with access to inside information has a duty to disclose it to the public or abstain from trading in the shares of the corporation. b. TSC definition of materiality not helpful; use a probabilitymagnitude test i. Materiality is rarely an issue in insider trading cases 3. CHIARELLA V. UNITED STATES (U.S. Supreme Court, 1980) a. Holding A person is not prevented from trading on inside information unless he or she has a fiduciary duty to the

b.

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shareholders of the corporation, or a similar relationship of trust and confidence. b. SEC follows this case with Rule 14e-3. In a tender offer, no one can trade on the information before it becomes public. 4. DIRKS V. SECURITIES AND EXCHANGE COMMISSION (U.S. Supreme Court, 1983) a. Holding A tippee will be found guilty of insider trading only when the disclosure by the tipper is a breach of fiduciary duty, and the tippee knew or should have known that it constituted such a breach. b. Since the tipper had an altruistic motiveexposing fraudno breach here, and no liability for Dirks. c. FN 14. Temporary/Constructive insiders. Outsiders, such as lawyers or accountants, can become fiduciaries if they are agents of the corporation. d. FN 22. In the context of a deal, a constructive insider does not have a duty to the other company. 5. Prevention for insiders a. Must wait until information reaches the market b. Set up a buying program in advance, with a set trading window; usually after the quarterly and annual reports have been released i. A 10b-5-1 plan is a contract that sets up that window ii. Regulation FD 1. Classical insider trading theory left a large loophole for analysts and market professionals; as long as disclosure was made for a valid corporate purpose, they could trade on it. 2. Regulation FD bans selective disclosure, specifically to Wall Street a. If an issuer discloses material information to someone on Wall Street, he or she must disclose it: i. Immediately if intentional ii. Promptly if inadvertent b. Companies complied with this by simultaneously streaming all press conferences c. Rule 102no private right of action for an FD violation, including under Rule 10b-5. 3. SECURITIES AND EXCHANGE COMMISSION V. SIEBEL SYSTEMS, INC. (S.D.N.Y. 2005) a. Holding General statements should not be parsed for borderline inconsistencies with public statements in order to find liability under Regulation FD. iii. Misappropriation Theory 1. Carpenter v. United States. Wall Street Journal reporter had no fiduciary duty to the shareholders of the corporations. His tipping couldnt be reached under Chiarella and Dirks. Court forced to affirm, 4-4 without opinion. 2. S.E.C. v. Cherif. Seventh Circuit upholds a theory of misappropriation in trading on stock information. 3. UNITED STATES V. OHAGAN (U.S. Supreme Court, 1997) a. Holding A trader will be found guilty under Rule 10b-5 for misappropriating financial information for securities trading purposes if the trader owes a fiduciary duty to the source of the information.

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4. S.E.C. v. Chestman. Pre-OHagan Second Circuit case.

Misappropriation theory can apply to family members based on discretionary authority and dependence. a. SEC promulgated 10b5-2, which created a rebuttable presumption of a duty of trust or confidence when a family member receives confidential information. 5. Unclear after OHagan if personal benefit to the tipper is still required when a misappropriating party tips another. a. If the tipper knows its misappropriated, that more likely to be found a violation. b. McDermott. Investment banker liable for misappropriation and for tipping mistress. c. United States v. Falcone. Attenuated circumstances still can provide tippee liability if the parties should have known that something was wrong. iv. Securities Exchange Act 16 1. An officer or director must report their holdings in their own corporation to the SEC. a. Sets up derivative liability in a short period of time; short swing liability. 2. No scienter necessary. A very blunt instrument.

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