Corporations Outline - Fall 2008

Open Book Final Three Essay Questions Office Hours 2-4, Room 222

I. Introduction: Why have a corporation?

A. Efficiency and the social significance of enterprise organization: Most corporate relationships are contractual in the sense that they are voluntarily entered into and may be customized or fine tuned by express agreement. The agency is the simplest form of a business organization and may be terminated at any time by either the principal or the agent. B. Wealth Creation and the Corporate Form of Organization: facilitating individual efforts to create wealth is wise public policy. C. Efficiency Theory: i. Pareto Efficiency: a. Pareto Optimal distribution of resources is efficient when, and only when, resources are distributed in such a way that no allocation can make at least one person better off without making another person worse off. Through voluntary exchange, individuals reveal their own preference for one outcome over another. When all parties experience a net utility gain, then we can be certain that there is a net utility gain from the transaction overall. However, it is virtually impossible for courts to make important decisions that do not make someone worse off. ii. Kaldor Hicks Efficiency (Wealth Maximization): An act/rule is efficient when it leads to an overall improvement in social welfare, if at least one party would gain from it after all those who suffered a loss as a result of the transaction were fully compensated. It is efficient if gains won by A are sufficient to compensate losses to B and still have excess. iii. Courts try not to choose efficiency justifications because it is difficult to determine what a cost is and what a benefit is. D. Development and the Modern Theory of the Firm: i. Ronald Coase: While markets tend to move distribution towards efficiency, it is sometimes more efficient to organize complex tasks within a hierarchical organization with established authority and compensation structures on a market. ii. Transaction Cost Theory: When a company tries to determine whether to outsource or to produce goods or services on its own, market prices aren't the sole factor. There are also significant transaction costs, search costs, contracting costs and coordination costs. Those costs frequently determine whether a company uses internal or external resources for products or services. This is the essence of the make-vs.-buy decision. iii. Agency Cost Theory: a. Agency Cost: Any cost, explicit or implicit, associated with the exercise of discretion over principals property by an agent. Types: (i) Monitoring: costs owners expend to ensure agent loyalty (ii) Bonding: costs agents expend to ensure owners of their reliability (iii) Residual: Costs that arise from differences in interest remaining after monitoring and bonding costs are incurred. Essentially inefficiencies resulting from misaligned incentives. Types of relationships: (i) Manager and owner (ii) Majority shareholder and minority shareholder (iii) Firm and third party.

II. Agency: A. Definition:

i.

Restatement 2d Agency 1: Agency is the fiduciary relationship that results from the manifestation of consent by one person (the principal) to another (the agent) that the other shall act on his behalf and subject to his control, and consent by the other to so act. a. Essentially a voluntary contractual relationship where one party has the ability to affect the legal relations of another for the principals benefit. b. The agency relationship is terminable at will either side can revoke at any time. A breach of contract for agency results in damages, not specific performance. A secured lender relationship does not result in an agency because there is no protection of the interests of the principal. ii. Scope of Authority a. Types: Special Agents: Agents limited to a single transaction General Agents: Agency contemplates a series of transactions. Principals: (i) Fully disclosed: third parties transacting with agent understand that the agent is acting on behalf of a particular principal. (ii) Partially disclosed: third parties transacting with the agent recognize that they are acting with an agent, but do not know the identity of the principal. (iii) Undisclosed: third parties are unaware that there is a principal and believe that the agent is her own principal. b. Both parties have to manifest their intention that the Agency exists. However, an agency relationship may be implied by the courts even when the parties have not explicitly agreed to an agency relationship. It depends on the type of exercise controlled. Jenson Farms Co. v. Cargill, Inc. (Minn. 1981): Cargill lent extensive credit to Warren, a grain elevator, which was overextended. Cargill got excessively entangled in Warrens business decision making, reviewing the books and when Warren went under, other creditors went after Cargill as Warrens principal. (i) Rule: Court agreed and held that Cargill was entangled enough in Warrens business that it was acting as Warrens principal and therefore was liable for Warrens debts. A creditor who assumes control of his debtors business may become liable as a principal for acts of the debtor in connection with the business. 1. Squire thinks this is because the right of first refusal was tied to Cargill (ii) This is efficient because it mitigates risk of breach and creates assurance of performance and therefore more commerce. Policy preference to keep a disclosed principal liable because disclosure tends to induce reliance and in this case, Cargill was in a better position to prevent. (iii) Pro rata: Each of several partners "is liable for his own share or proportion only, they are said to be bound pro rata. An example ... may be found in the liability of partners; each is liable ... only pro rata in relation to between themselves." (iv) Debtor/creditor relationship; principal/agent relationship (principle, agent and third party) (v) Agency: A, B, C = one person assents to work for the benefit of another, under the control of another (though this doesnt cover the full scope) 1. Footnote 4: Warren ignored the orders, which seems to imply that there was no agency (vi) Villains/victims: farmers are victims, Cargill is the villain c. Actual Authority: from the perspective of a reasonable agent. The agent must reasonably understand from the action or speech of the principal that she has been authorized to act on the principals behalf. Express authority: authority was expressly given by principal to agent look to see if there is a contract etc. Implied/Incidental Authority: authority to perform implementing steps that are ordinarily done in connection with facilitating the main authorized act. d. Apparent Authority: from the perspective of a reasonable third person authority that a reasonable third party would infer from the actions or statements of the principal. Apparent Authority: reasonable, from contact with the principal, to conclude that the agent has authority. Essentially an equitable remedy provided to prevent unfairness to third parties who reasonably relied on the principals actions in dealing with an agent. It

holds even if the principal has expressly limited the agents actions. Also, if its an ordinary transaction that the agent has repeatedly done in the past, it may bind the principal. (i) This can be in the form of communication, representations made by the principal (such as through a business card), and former history of the principal (such as if the individual is well known for a producing a certain type of good, this can be relevant to apparent authority if he no longer produces this good and does not let buyers know). (ii) White v. Thomas (Ark. 1991): White authorized his agent, Simpson, to attend a land auction and bid on his behalf and Simpson, after realizing she over bid, made an agreement with Thomas to sell him 45 acres of land she had just purchased for White, indicating that she had power of attorney, when this did not exist. White contended that his agent, Simpson, did not have apparent authority to enter into a contract for the sale of land to Thomas (plaintiff) (he repudiated). 1. Rule: In the absence of a principal and any indicia that an agent has authority to engage in a specific action on the principals behalf, the agent does not have apparent authority to engage in any such action merely because the agent asserts that she has such authority. a. Here, Simpson had neither the express nor the implied authority to contract to sell Thomas a portion of the land. In order for White to be liable, Simpsons actions had to have fallen within the scope of her apparent authority. Here, the only indication that Simpson had limited authority was a possession of a check and Thomas chose to rely on Simpsons claims. 2. An agent cant declare his or her own agency or the extent of his authority. 3. How would you make an inherent authority argument? People that have authority to buy, normally have authority to sell. a. Why didnt the court go for this argument? Maybe the Court didnt want Thomas to win. i. Theres also a fact problem the lower court believed White Inherent Authority: consequences imposed upon principals by law. Agent has the power to bind the principal even against the principals wishes as long as it is reasonable for the third party to assume authority in the agent and rely upon it. Gives the general agent the power to bind a principal (disclosed or undisclosed) to an unauthorized contract as long as the agent would ordinarily have the power to enter into the contract and the third party is unaware of any changes in its situation. Are agents who can do X, also able to do Y? If yes, then the third party can rely on it unless the principal told them that the agent cant do Y. (i) This is efficient because if a customer had to investigate an agents authority, commerce would be slowed. The principal should bear the burden of communication. 1. Brooks Brothers Hypo: A Brooks Brothers salesman was only allowed to sell casual clothing and someone approached him to sell a suit and he sells her the suit. Brooks Brothers would be liable in this case because the salesman had inherent authority to sell the suit given his job at Brooks Brothers and it was the obligation of Brooks Brothers to provide notice to customers that there was limited authority. He had authority to do X (sell casual suits), presumably, if you can sell casual clothes, you can sell suits, Y. (ii) Gallant Insurance Co. v. Isaac (Ind. 2000): Gallant was an insurer with Thompson Harris as its agent. THs authority included the power to bind Gallant on new insurance policies as well as interim policy endorsements such as adding a new driver. Although it wasnt authorized to do so, TH bound coverage on Isaacs new car although the premium wasnt paid until 3 days later. In between this period, Isaac got into a car accident. Gallant claimed it was not liable for the losses because the policy was not in force since the premium was not paid as dictated in the policy and because TH did not have the authority to renew the insurance policy. 1. Rule: an agent has inherent authority to bind its principal where the agent acts within the usual and ordinary scope of its authority, a third party can reasonably believe that the agent has authority to conduct the act in question, and the third party is not on notice that the agent is not so authority. 2. Here, TH was acting within the scope of its normal authority and Isaac could reasonably believe that it was bound it was customary for TH to tell its customers that they were bound.

3. Actual authority? NO. Apparent authority? Look between the principle and the 3rd
party (Isaac). NO. Inherent authority? YES. (iii) Three situations: 1. Agent does something similar to which he is authorized to do, but in violation of orders (161, 194). The result is that the principal may become liable as a party to the transaction, even if undisclosed. a. 161: a general agent for a disclosed or partially disclosed principal subjects his principal to liability for acts done on his account which usually accompany transactions which the agent is authorized to conduct, although they are forbidden by the principal, if the third party reasonably believes that the agent is authorized to do them. 2. Agent acts purely for his own purposes in entering into a transaction which would be authorized if done for principals benefit. ( 165, 262). a. 165 releases the principal from liability to third parties for contracts made by agents when the third party knows that the agent is not acting for the benefit of the principal. 3. Agent is authorized to dispose of goods and departs from the authorized method of disposal ( 175, 201). If the agent lies about the scope of authority, liable for contractual damages and tort of deceit. e. Agency by Estoppel: 1) failure to act when 2) knowledge and opportunity to act arise 3) in addition to reasonable change in position on the part of the third person this may make the principal liable for the agents actions. f. Ratification: when an agent exceeds his authority, a principal can affirm the contract afterwards. However, he can be bound under apparent authority for actions by the agent, even if the agent cant repay the principal. This creates mutuality because any action by a principal, including knowing delay, can ratify the agents work. The principal must repudiate the agents conduct immediately upon knowledge. (i) Repudiation is a defense when agent has NO authority. 1. However, where the agent might have apparent authority then this defense would not be available. Tort Liability: a. Only the master servant relationship triggers respondeat superior and vicarious liability, not independent contractor. Definitions: (i) Master: principal who controls or has the right to control agent within his employ (ii) Servant: employed by principal who controls or has the right to control (Restatement 3d) (iii) Independent Contractor: Individual who has contracted with another, but it is not controlled or subject to control. May or may not be an agent. If the principal has the right to control the details of the way in which agent performs tasks, the agent is an employee or servant. If the principal has limited control rights, the agent is an independent contractor. (i) List of Factors taken into consideration Restatement 2d 220. 1. extent of control over detail of work provided in an agreement 2. required skill to perform 3. whether the person employed is engaged in a distinct occupation or business 4. who provides the tools and place of work (who owns goods or property involved) 5. length of time of the employment 6. method of payment by hour/by job 7. intent of the parties 8. whether or not regular business of employer 9. local common practice. Humble Oil & Refining Co. v. Martin (Texas 1949): Mrs. Love left her car at a service station, which was owned by Humble Oil Co. Prior to anyone touching the vehicle, the car rolled off the premises and struck the Martin family from behind while they were walking

iii.

into the yard of their home. Humble Oil Co. argued that it was not liable, because the service station was operated by an independent contractor. (i) Rule: Although there may be an agreement that the nature of a relationship is that of an independent contractor, the court will look at other factors (such as whether the employer / vendee had control) to determine whether the relationship is that of an independent contractor or that of master-servant. (ii) In this case, the court found that the relationship was more in line with a masterservant relationship because Humble paid important operating expenses, the occupancy of the premises was terminable at will, had strict supervision over finances, and gave little business discretion to the service station essentially the purpose of the gas station was to sell Humble products. Therefore, Humble was liable under respondeat superior. Hoover v. Sun Oil Co. (Delaware 1965): While fueling at defendant's gas station, a fire started at plaintiff's car. Plaintiff sued defendant, but defendant contended that the gas station was operated by an independent contractor, James Barone, and thus that the negligence of Barone's employee should not result in liability for defendant. Plaintiff argued that Barone was operating the station as defendant's agent. (i) Rule: There is no agency relationship between a supplier and retail outlet where the retail outlet is solely responsible for profits and losses and the supplier exercises no dominion or control over the retailer. (ii) In this case, the Court found no relationship between the supplier, Sun Oil, and the retailer other than a landlord-tenant relationship and that both had an interest in selling Sun products. Sun asserted no operational control and was not responsible for the profits and losses of the retail outlet, but Barone was and there was no requirement that Barone had to implement the suggestions that Sun made. 1. Liability in tort requires more control than liability in a contract claim. There was apparent authority since Sun put the people in Sunoco uniforms and there was inherent authority since customer expectation is that gas station attendants are authorized to pump gas. However, Barone was in the best position to prevent because while Sunoco made regular visits, Barone was under no obligation to listen to recommendations. iv. Agents Duties to Principal: a. Agents Duties: Obedience: duty to respect definition of the scope of authority Loyalty: good faith effort to advance the purpose of the agency while achieving no self benefit that is not: (i) Disclosed (ii) Consented to, or (iii) Fair Care negligence standard. b. Agents Duty of Loyalty to Principal An agent is subject to a duty to act solely for the benefit of the principal in all matters connected to the agency (Restatement 2d Agency 387) Unless otherwise agreed, an agent who profits from a transaction must pass profit to principals, an agent may not profit even if it does not harm the principal. (Restatement 2d Agency 388). (i) Tarnowski v. Resop (Minnesota 1952): Plaintiff engaged defendant to investigate a coin operated juke box business opportunity for plaintiff. Defendant misrepresented the business to plaintiff saying it was profitable. Plaintiff purchased the business and realized he had been duped. He sued the sellers for rescission of contract and recovered in a post-trial settlement. He then sued the defendant for an allegedly secret commission the defendant received from the sellers during the course of the investigation. In addition, the plaintiff sought to recover damages incurred during the transaction. 1. Rule: Profits of the agent must be passed to the principal whether they are for performance or violation of duties. Restatement, Agency, Section 407(1). "If an agent has received a benefit as a result of violating his duty of loyalty, the principal

is entitled to recover for him what he has so received, its value, or its proceeds, and also the amount of damage thereby caused. . . ." even if there was no damage. An agent cannot deal with the principal as an adverse party in a transaction connected with his agency without the principals consent and knowledge. (Restatement 2d Agency 389). If there is knowledge of adverse dealing, and the principal consents to self-dealing, then the agent is bound to deal fairly with the principal and disclose all material facts to him. (Restatement 2d Agency 390). c. Trustees Duty to Trust Beneficiaries: For trusts, ownership and benefits are split Trustee is accountable for any profit made by him through or arising out of the trust, even if the profits do not result from a breach of trust. If Trustee commits breach of trust, he is chargeable with (1) loss or depreciation in value of estate resulting from any breach of trust (2) any profits made through breach (3) any profit that would have accrued but for breach (i) In re Gleeson (Illinois 1954): Tenant becomes trustee when landowner dies, Increases rent applied to him and extends lease for next season. Claims too difficult to secure a new tenant. Trustee was honest with beneficiaries and beneficiaries would have benefited. 1. Rule: a trustee cannot deal in individual capacity with trust property regardless of any special circumstances or good faith intentions. The power of the trustee is too great to allow self interest. 2. Restatement 2d of Trusts 203: the trustee is accountable for any profit NO UNLESS OTHERWISE AGREED a. Compare with 387 of the Restatement of Agency: unless otherwise agreed, an agent that makes a profit is under a duty to give it to the principal b. Why this difference? The point of a trust is to split the ownership and benefit so if you can otherwise agree, it defeats the purpose of a trust i. Also, once you have a trust, you cant change it!!! c. In a corporation, the board is acting on behalf of the shareholders. Question of if act like agents or trusts. In dealing with a trust beneficiary, but not on the matter of the trust, the trustee must fully disclose and must deal fairly with the beneficiary.

III. Partnerships: A. Definition: UPA a partnership is an association of two or more persons to carry on as co-owners a
business for profit. Property held in partnership is called tenancy in partnership. B. Disadvantages of partnerships: i. Higher transaction costs, not good for financing ii. Partnership is less stable than a corporation, which has unlimited duration. iii. Investors are personally liable for partnership activities if partnership funds are insufficient. Partners are jointly and severally liable for contract and tort claims. iv. Very hard to transfer interest in partnership. C. Agency Conflicts Amongst Co-owners: i. Partnership introduces the dilemma between controlling and minority owners what duty of loyalty does an active partner owe a passive partner? a. Meinhard v. Salmon (NY 1928): Salmon and Meinhard entered into a joint venture that centered around a twenty-year lease for premises in NY. Meinhard would provide the investment capital, Salmon would manage the business, and the two of them would divide up the profits. Before the lease ended, a third party approached Salmon about a new lease. Salmon entered into the new lease with the third-party and did not tell Meinhard. Meinhard sued for breach of duty of loyalty. Rule: "Joint adventurers, like copartners, owe to one another, while the enterprise continues the duty of the finest loyalty." A partner has a duty to disclose an opportunity to his partner(s) if the opportunity arises out of the partnership. The Court held in this case

that the opportunity did arise out of the partnership and thus Salmon had a duty to disclose the opportunity to Meinhard. (i) This decision extended the duties of partnership far beyond duties under a contract. It determined that in such a relationship, loyalty must be undivided and unselfish, and that a breach of fiduciary duty can occur by something less than fraud or intentional bad faith. (ii) Dissent: the case should hinge on whether the transaction was unfair or inequitable. Any duty following from the partnership ended at the end of the twenty year period; because the partnership was created to manage the building for the twenty year term, the dissent felt that deals involving events to occur after the expiration of that term were of no matter to the partnership. Rule forces communication amongst partners. Efficiency: Majoritarian Rule: if we know parties would want a specific provision, then there isnt really a need to write it in there, BUT if you dont want it, then you need to contract around it (i) No Imagination Rule: The more efficient default rule is the one that most of the people want Its hard ahead of time to think of all the different ways people can take advantage of you Written by Cardozo (part of the reason why it is so famous) he calls the K a "treaty" to create a joint venture Uniform Partnership Act (see supp.) see p.42 of Supp (S7, #4) re. partnership Opportunity arises out of the partnership? Agency relationship the agent breached the duty of loyalty here. While the enterprise continues there is a duty of the finest loyalty equating agent to trustee here, held to something stricter than morals of the marketplace. SO, what exactly should (in Cardozo's view) Salmon have done? Reading term into a lease? Why should we help out people like Meinhard who didn't help themselves in the first place? D. Partnership Formation: i. What establishes a partnership: a. Co ownership is not indicative of a partnership b. Share of gross returns (revenue) does not establish a partnership c. Receipt of the shares of the profits is prima facie evidence of a partnership Vohland v. Sweet (Ind. 1982): Sweet originally worked as an hourly employee for Vohland Sr. and when Voland Jr. took over, he decided to change Sweets status so that he would receive 20% of the net profits. However, Sweet did not contribute in the capital or machineries, a partnership tax return wasnt filed, Vohland was the sole purchaser, and Sweet didnt participate in any of the losses. (i) In this case, the Court looked at the sharing of profits as prima facie evidence of a partnership. And because there was no controlling evidence that there was not a partnership, the court held that the sharing of profits was evidence of the intent of a partnership and therefore held that there was a partnership. (ii) Sweet wants to be a partner that's what is going on here. He wants something above and beyond the 20% he is receiving. He wants an accounting so he can specifically get a percentage of the money that was invested in these plants/this nursery (basically saying he wants a cut of the partnership property. (iii) Looking at profits rather than gross? Profits are riskier. From a practical perspective, why in this case should it matter that the costs were being taken out of his pay. The cost of the inventory matters you would have to say that Sweet has a property interest. (iv) What about the title of the truck issue (w/ Sweet wanting his name on it) sweet was worried about a particular interest! It shows that Sweet didn't expect that he be considered a partner. Why did the court protect him anyway. (v) Rule: In order to have a partnership, there needed to be a voluntary contract of association for the purpose of sharing profits and losses which may arise from the use of capital, labor or skill in a common enterprise. There must also be an intention on the part of the principals to form a partnership for that purpose. 1. A partnership can be formed by the furnishing of skill and labor by others. The contribution of labor and skill by one of the partners may be as a great a

contribution to the common enterprise as property or money. Therefore, there does not need to be capital contribution to be a partner, contribution of labor will suffice. 2. The intent is to do those things which constitute a partnership therefore, if this intent exists, the parties will be partners notwithstanding that they proposed to avoid the liability attaching to partners or have expressly stipulated in their agreement that they were not to become partners. UPA 7: Rules for Determining the Existence of a Partnership: (i) Owning property together does not of itself establish a partnership, whether such coowners do or do not share any profits made by the use of the property. (ii) Share of gross returns does not of itself establish a partnership, whether or not the persons sharing them have a joint or common right or interest in any property from which the returns are derived. (iii) Profits received as payments will not create a partnership if these payments are: 1. An installment payment on debt 2. Wages of an employee or rent to a landlord 3. An annuity 4. Interest on a loan though the amount of payment varies with profits of the business 5. Consideration for sale of goodwill or other property by installments. E. Relationships with Third Parties: i. When can an exiting or retiring partner escape liability for partnership obligations? a. Withdrawing partner still has liability for obligations incurred prior to his departure, but has no control over the business. b. The retiring partner is not liable for new liabilities after he withdraws and gives notice. A retiring partner can be let off the hook if creditors agree to do so and the remaining partners agree. Courts are liberal on creditor agreement to retiring partners. If creditor knows and extends credit, this is valid. c. Dissolution: dissolution does not relieve partners of liability. It causes the partnership relationship to cease as a going concern, but does not mean termination of liabilities. UPA 36(a): discharge from partnership liability the dissolution of a partnership does not in itself discharge the existing liability of a partner. When a partner agrees to assume the existing obligations of a dissolved partnership, the partners whose obligations have been assumed shall be discharged from any liability to any creditor of the partnership who, knowing of the agreement, consents to a material alteration in nature or time of payment of such obligations. ii. Claims of Partnership Creditors to Partners Individual Property a. Partnership has completely separate property and this property is owned by partners as tenants in partnership. UPA 25(1). Partner cannot possess or assign rights in partnership property, a partners heirs cannot inherit it, and a partners personal creditors cannot attach or execute upon it. UPA 25(2). Partners do not own the assets, but rather the rights to the net financial return that these assets generate profits, losses and distributions. Partners can assign and transfer profit interests to others. b. Partners can go into bankruptcy without individual partners being bankrupt. c. Priority of attaching personal assets: In bankruptcy, creditors of partnership have priority in partnership assets and equal rights in individual assets of partners. If not bankruptcy, jingle rule apples partnership creditors have first priority in partners personal property. iii. Brudney's UPA Problems (on p. 53 of text) a. Ars, Gratia, Artis involved in entity called Argrar. Ars is the manager (puts that into Argrar) and gets back either 5k/yr or 1/3 profits. Gratia puts in the land and he gets back 1/3 profits. Artis puts in $30k and gets back 1/3 profits. Mayer lends 15k to Artis (putting in the money) and Ars and Gratia know about it, but they don't know that Artis in turn is repaying Mayer with of the 1/3 going to Artis. Artis knows about some equipment that hurts a customer is Ars liable? Yes S 12 (see p. 44 in supp) partnership charged w/ knowledge to partners, impute that knowledge to Ars. BUT that presumes that Artis and Ars are partners yes because they are sharing the profits of a business (joint venture). S 13 also. Is Mayer liable? Probably no (arg both sides of him being a partner or not being a partner).Now, if a customer is injured bc Gratia commits a tort, is Artis liable? They are both copartners in Argrar (so yes bc copartners are on

the hook for each other's torts). Is Mayer liable? No if he is a partnership with anyone it is w/ Artis, Artis is in a partnership w/ Gratis, but that doesn't mean that Mayer and Gratia are in a partnership together (transitive property). The law doesn't want surprise partnerships sprung on people. b. Receipt of profits is prima facie evidence that you're a partner, but no such inference that you're a partner bc you received profits shall be drawn if profits received were in payment of an interest on a loan. F. Partnership Governance and Issues of Authority i. Nabisco Biscuit Co. v. Stroud (N.C. 1959): There was a two person partnership between Stroud and Freeman in a grocery store. Stroud let Nabisco know that hed no longer be liable for purchases made from Nabisco and Freeman would be liable for purchases. Freeman made purchases anyway, but Stroud wouldnt pay. Court found Stroud was liable because Freemans actions were within the scope of the partnership and Stroud, not being a majority of partners, couldnt prevent Freeman from acting. Rule: Partners are agents of the partnership entity and when there are two partners, neither is the majority so both have to agree to change the scope of the authority of either partner. Partnership is a hybrid in which the partnership is the principal and the partners are the agents. You cant revoke the agents power without telling the agent Efficiency: you should honor peoples expectation Nabisco wants to recover unpaid bills. Notion that when you have a partnership and 1 of the partners makes a K generally all of the partners are liable on that. When Stroud called up Nabisco and said he wasn't taking anymore bread orders that didn't dissolve the partnership bc we don't know (and don't think) that that was communicated to Freeman (the partner). If you want out of a partnership, you dissolve it, but you cant unilaterally change the partnership's powers/etc. At the beginning of all this, Freeman had actual authority. The principle manifests authority. Would have been reasonable to Nabisco if this was principle/agent that Freeman had authority. BUT whose expectations do we look to for actual authority the agent. Here the agent wasn't notified, Freeman thought he still had the authority. Same principles apply in principal/agent situation. ii. UPA 9: every partner is an agent of the partnership for the purpose of its business and the act of every partner, for carrying on in the usual way of business binds the partnership, unless the partner so acting has in fact no authority to act for the partnership in the particular matter and the person with whom he is dealing has no knowledge of the fact that he has no authority. a. Partners individually, unless they are authorized to or there is an abandonment of the business, cannot assign the partnership property in trust for creditors, dispose of the good will of the business, do any other act which would make it impossible to carry on the ordinary business, etc. G. Termination (Dissolution and Dissociation) i. Accounting for Partnerships Financial Status and Performance: a. Normally, when a partnership dissolves, the assets are split. b. UPA 29 dissolution is the change in relation of the partners caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business. Essentially when partners cease to carry on the business together. 30: On dissolution, the partnership is not terminated until the winding up of partnership affairs occurs. (i) Termination: point in time when all the partnership affairs are wound up (ii) Winding Up: the process of settling partnership affairs (with creditors) after dissolution (i.e. paying off debts, settling Ks) (UPA 37) 1. When one partner leaves, rights arise and one of the rights that comes about is winding up. During a winding up, statute contemplates a period where everyone winds up the business such as taking care of old creditors, paying off creditors, etc. during dissolution, a partner can demand a winding up. 38 contemplates an auction whereas creditors are paid off and rest are distributed among the partners.

c. Adams v. Jarvis (Wis. 1964): There was a dissolution of a medical partnership and plaintiff
wanted his share of accounts receivable (which was an asset because it was the legal right to make a patient pay). There was an agreement indicating that if there was a dissolution, there did not need to be a winding up. However, the statute called for a winding up. Rule: a partnership agreement which provides for the continuation of the firms business despite the withdrawal of one partner and which specifies the formula according to which partnership assets are to be distributed to the retiring partner is valid and enforceable. 38 of the agreement says unless otherwise agreed so the agreement is valid and statute is a default where there is no agreement. UPA are default arrangements and are the rules unless owners of a business agree otherwise you are allowed to contract around mechanisms in the UPA of how to pay out a departing partner. (i) A legal dissolution does not require a complete winding up of the business, but rather a legal separation with the withdrawing partner. (ii) There was a good faith duty for the remaining partners to ensure that Jarvis got his share of the profits and in this situation, partners could have not made a profit by delaying collecting on the accounts receivable so there would be no cash to pay out if it was a cash accounting business. Therefore, this is why Jarvis wanted to have share of accounts receivable so he could get paid. 1. The court held that the remaining partners were obligated to conduct the business in a good faith effort to liquidate the accounts receivable consistent with good business practices. (iii) The formula that they use is: 1/3 * 5/12 = 5/36 = but Dr. Adams doesnt like this because it creates an incentive to move all payments into January so he gets less than his due. (iv) 802: a partnership can occur after dissolution if you continue acting like a dissolution didnt happen = BUT THIS DIDNT EXIST AT THE TIME OF THIS CASE (v) Lets enforce the contract the way they intended it Dreifuerst v. Dreifuerst (Wis. 1979): 3 brothers own 3 mills in partnership, one wants dissolution and wind up and sale of assets. There was no partnership agreement and the lower court gave an in kind distribution of the assets and split the mills. Rule: The court found that the lower court did not have the authority to give an in kind distribution. Under UPA 38 absent an agreement (unless otherwise agreed), dissolution occurs through a fire sale auction. Here, although a MI lower court case held that an in kind distribution was justified in situations where there were no creditors to be paid from proceeds, a sale was senseless since no third party was interested in the assets and in kind distribution was fair to all partners, the WI supreme court said it would follow the UPA. Can only have in kind distribution when partners agree to this or when the partnership agreement calls for an in kind distribution. (i) Policy rationales: 1. In kind distribution affects creditors rights since the whole is more valuable than the sum of the parts. An asset sale provides a more accurate means of establishing the market value of the assets while in kind can only approximate. The partners have the power to avoid liquidation through the drafting of their partnership agreement. 2. An auction is a good value of what the asset is really worth Page v. Page (Cal. 1961): there was a partnership for a linen supply business and the business was not profitable for 8 years and when it starting to make a profit, the active partner calls for dissolution and the passive partner argues that the active partner wanted the opportunity all for himself. The lower court found that although there was no agreement specifying the terms, there was an implied partnership for term until all the debt was erased a reasonable term to make a profit. Rule: Normally, partners are not obligated to continue in the partnership until all of the initial losses have been recovered. Justice Traynor found that UPA 31 holds that dissolution is caused by the express will of any partners when no definite term or undertaking is specific. Therefore, while partners may agree to continue a business until a certain sum of money is earned or one or more partners recoup their investments etc, absent an agreement or evidence of an implied term the partnership can be dissolved at will. (i) There are protections for people such as passive partners there are fiduciary duties on the partners when they are dissolving. Dissolution by a partner must be done in

d.

e.

10

good faith. If it is done in bad faith, it is a wrongful dissolution and the breaching partner is liable under 38(2) (a). To terminate with intent to appropriate the assets for the partners own use would violate the fiduciary duty. (ii) Lower courts standard of reasonable time was not good H. Limited Partnerships: i. Limited liability limited to partnership contribution. Creditors can get to the business entity, but not beyond that to the personal assets of the partners. a. Can still be active and have limited liability ii. Enjoy share of profits iii. Cant participate in management except voting on events such as dissolution. If there is too much participation, they might be considered general partners and lose limited liability (control test - 303 of the ULPA). iv. LLCs limited liability, participation in management, transferability of interest, continuity of life if a member resigns. v. Whats a venture capital and private equity fund? a. What if venture capitalist cut is fixed? What beyond the growth provides incentive for these people to do well IV. The Corporate Form: A. Attributes of a corporation: i. Legal personality with indefinite life ii. Limited liability for investors a. Rationale: Simplifies job of evaluating an equity investment Encourages risk adverse individuals to invest in riskier ventures. Increased incentive for lenders to evaluate the business more closely. iii. Free transferability of share interest iv. Centralized management v. Appointed by equity investors B. Types of Corporations: i. Public Corporations: usually those with shares sold on the public market to raise large amounts of capital. ii. Close Corporations: corporations that incorporate for tax or liability reasons, not to raise large amounts of capital. iii. Controlled Corporations: usually a single shareholder or a group of shareholders exercises control through its power to appoint the board. iv. In the market: where there is no such person or group exercising control where anyone can purchase control of the company, but until they do so, no shareholder or group exercises control (how much large public corporation are owned). C. Formation of corporations i. Delaware is the hub of incorporation. a. DGCL 101: can file with the department of state a certification of incorporation, pay a fee and have an incorporated business. b. 106: upon the filing of a certificate of incorporation, the people that signed will be the body incorporate. What goes into a certificate of incorporation: Name: has to include certain terms such as inc., corp., etc so that people will know that they are dealing with an entity that has limited liability. Address of the office in the state The nature of the business (often very broad purposes). The classes of stock and the number of shares in each class The name and mailing address of the incorporator/s If the powers of the incorporator are to terminate up on the filing of the certificate or incorporation (optional) Whether power will terminate upon filing the charter. Optional items there can be provisions for the management of the business and the conduct of the corporations. c. Elect directors

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d. After filing, have to call a meeting of the board of directors at which you can draw up by-laws. 109: by laws can contain anything not inconsistent with the articles of incorporation. If the by laws are inconsistent with items in article of incorporation then the article wins. (i) Distinction exists because of who can amend and change the articles and the by laws. ii. The Articles of Incorporation, or Charter (see above) a. Can contain any provision not contrary to law b. Must have: Provide for a voting stock, a board of directors, shareholder voting for certain transactions If a special or limited purpose Name the original incorporators State the corporations name and very broadly its business Fix its original capital structure May establish the size of the board or include other governance terms and the procedures for removing directors from office iii. Corporate Bylaws a. The least fundamental of the corporations constitutional documents they must conform to both the corporation statute and the corporations charter b. Generally fix the operating rules for the governance of the corporation Ex. the existence and responsibilities of corporate offices, annual meeting date c. Sometimes can amend laws, sometimes cant d. Can be created by the shareholders or the directors (in DE for example) iv. Shareholders Agreements a. Important in close corporations and some controlled corporations. Often address restrictions on disposition of shares, buy/sell agreement, voting agreements and agreements with respect to employment of officers or payment of dividends. b. Contracts are specifically enforced where shareholders and corporations are parties but when some shareholders arent parties, then turns on whether it is fair to non-signatories. c. Voting trust: arrangement in which shareholders publicly agree to place their shares with a trustee who then legally owns them and is to exercise voting power according to the terms of the agreement. v. Easterbrook and Fischel Limited Liability and the Corporation: a. There are high agency costs in a corporation since managers are legally separate from the owners of the corporation b. Limited liability decreases the costs of monitoring other shareholders and increases the incentives for management to act efficiently since free transferability allows a decrease in share price to cause a displacement of management. c. Limited liability allows shares to be priced per market since there is better information about firm value. d. Facilitates more optimal investment decisions. e. Increases availability of funds for projects with positive net value. vi. Transferable shares a. Advantages: Allows the firm to conduct business uninterruptedly as the identities of its owners change. Avoids the dissolution/reformation problems that affects partnerships. Creates an active market for ownership through liquidity and diversification. Keeps management in check and creates incentive for good management. b. Disadvantages: Can undermine control arrangements. vii. Centralized Management: goal is to keep agency cost as low as possible without unduly impinging on managements ability to manage firm productively. a. Automatic Self Cleaning Filter Syndicate Co., Ltd. v. Cunninghame (England 1906): There was a shareholder resolution to sell the companys failing assets by 55% majority. The articles of the corporation called for a supermajority. The plaintiff sued alleging that the directors are agents of the shareholders (the principals) and should be bound by the majority. Rule: The majority opinion held that a majority of the shareholders is not the principal, but rather the corporation is. The directors do not owe a duty to individual shareholders but to the corporation itself and this means that the directors owe a duty to everyone who has invested in the corporation, not the majority. Therefore, once authorized, directors may act

12

according to their own view of what they see the best interests of the corporation to be, and are not subject to shareholder override except in accordance with procedures set out in the corporate constitution or by statute. Shareholders cant tell the directors directly what to do (though they do elect them). (i) 141(a) DGCL business shall be managed by board of directors as except as otherwise provided by the articles/charter. 1. But not by by-laws cant limit the board of directors this way (ii) 271 DGCL can only have a sale of assets if the majority of shareholders approve. But, notwithstanding authorization to sell, a board of directors or governing body can veto this. (iii) Metaphor to principal agent law Concurrence: metaphor to partnership and contracts b. Structure of the Board: Charter sets out the structure of the board broadly. The default term of service is one year. (i) Charter can specify that directors are elected by a certain class of stock. But, the fiduciary duty of each board member is always to the corporation as a whole and not the class that elected them. Committees: (i) Advisory committees can be comprised of anyone, but executive committees that exercise any power must include only directors. Matters that by statute that require board action may not be delegated to committee. Corporate directors are not legal agents of the corporation. Governance powers reside in the board of directors, not in the individual directors themselves. (i) Therefore, a director can not act unilaterally on behalf of the corporation. However, an officer can act on behalf of the corporation unilaterally. 1. For example, a director can not unilaterally fire an individual, but the CEO can. Directors act as a board only at constituted board meetings by majority vote (unless super majority is called for). (i) There must be quorum and notice. c. Corporate Officers: Agents of the Corporation: Jennings v. Pittsburgh Mercantile Co. (Pa. 1964): Egmore, an executive at Pittsburgh, solicited Jennings to explore a sale and leaseback deal of all company owned land. Egmore assured board approval and offered commissions. After Jennings solicited a deal, the board did not approve and did not pay Jennings his commission. (i) Rule: The court discussed the apparent authority of Egmore to allow the transaction. With apparent authority, look to the expectations of the third party through prior dealings if in the past, the principal has permitted the agent to act, people will eventually infer that the agent has the authority. By not taking actions to the contrary there is a presumption that the agent has actual authority, BUT an agent cant selfauthoritate. In a corporation, its the board of directors acting as a group. 1. Here, there was no apparent authority because there were no similar prior dealings. Since the transaction was so huge, Jennings was on notice to verify authority. There was no apparent authority by virtue of Egmores position. Egmore couldnt self authorize because directors are individually powerless, need a majority. a. The corporations agents are the directors and the directors agents are the officers. The group that has the authority to authorize extraordinary transactions is the directors. 2. Probably best reviewed under inherent authority scope want to show that an agent that can normally do X, can also do Y a. Here, X is that Egmore had the authority to hire brokers. Y is to authorize a commission. Court was more worried about selling the land of the corporation so also a Y here. NO INHERENT AUTHORITY HERE. P would argue that Y is authorized to issue a commission b. Ask if the court focused on the wrong Y c. Egmore was on the board why couldnt this authorize the sale? i. Need the whole board V. Debt, Equity, and Economic Value:

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A. Introduction why talk about this? i. How do you value a company? a. Ex. Merril Lynch being bought out by BofA Shareholders of Merril will get shares of BofA board of directors decide all this so there might be a lawsuit later saying that they didnt get a good deal Should the court defer to the Board? Who should have a say? B. Capital Structure: how corporations raise their money two types of investors in a corporation, creditor/debtor investors and equity investors (shareholders). i. Most corporations issue debt and the most common form are bonds. A bond is a contract to repay money at a certain interest rate at a certain time. Usually has a maturity date and interest rate (except for zero coupon bonds). a. Characteristics of bonds: Tradeable Standardized so can be easily traded Restrictions on what corporations can do with bonds Less risky than equity because of a legal right to periodic payment and a priority claim to the companys assets over shareholders in case of default. b. Tax treatment: Interest paid by the borrower (the corporation) is a deductible business expense. ii. Equity: Shareholder investment in a company a. Characteristics of equity: Receive dividends from the corporation Acquisition buyout can create value. Shareholders receive the residual claims upon liquidation. b. Tax treatment: Payment of dividends is not tax deductible but the board of directors does not have a fiduciary duty to pay dividends, so there is no obligation to ever pay. c. Might have preferred stock as malleable as bonds but typically have a stated dividend and preference in liquidation. d. What do stockholders have that bond holder dont? A vote for the board of directors C. Concepts of Valuation: i. Time value of money having a dollar today is better than receiving a dollar tomorrow because you can invest the dollar today and earn money. a. Present value of 1.10 one year from now if the discount rate is 5% PV = FV/(1+r): 1.10/1.05 = 1.0467. so 1.10 a year from now is worth 1.05 today. b. $100 one year from now will have a higher present value at a lower discount rate, therefore, the lower the discount rate, the higher the present value. c. If the present value of 120 in one year is 150, the discount factor is: PV + r(PV) = FV 120 + r(120)=150. so r = .25. d. NPV = PV (to be received) PV (to be invested). ii. Projects for which the present value of the amount invested is less than the present value of the amount received in return are called positive net present value D. Risk i. Idea of expected value ex. 50/50 coin toss a. How do you calculate this? Expected value = probability x amount ii. Risk Neutral individuals indifferent between investments if they have the same expected return. iii. Risk Averse Individuals when dealing with different options that have the same expected value, the risk averse individual will want the investment that has the lowest variance (lowest range of possible outcomes). a. So if option A has a $10 million dollar return with 100% certainty and option B has a 50% chance of $20 million dollar return - the expected value of both is 10 million, but a risk averse person would chose option A. b. Problem: National Hotel seeks to borrow 10,000,000 from Bank for 1 year. NHC offers to pay back 11,300,000 as principle and interest in one year. Bank believes there is a 95% chance of being repaid and a 5% chance of receiving nothing. The risk free rate is 6.5% and the premium on the risk free rate is 2%.

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The interest rate formula: (total repayment amount principal)/principal = interest rate. 1. EV = (.95)(11.3 million) + (.05)(0) = 10.735 mil 2. PV = FV/1+r: (10.735/1.065) = 10.079 (lending someone money today will get you 10.079). (ii) Risk occurs when the future is uncertain and here, since there is more than one possible outcome, there is risk. If people are risk averse, an investment will be worth less to them and one way to compensate is to build in a higher discount rate since they will require a higher rate of return. 1. 10.735 mill/1.085 =9.894: basically lending someone 10 million today but only getting 9.894, so it is not a good deal. (iii) If you dont care about risk, this is a good investment. iv. Diversification: many investors invest in a portfolio of stocks to reduce their risk. a. Unsystematic risk: company specific risk that can be diversified away. b. Systematic risk: risk that cant be diversified away. (such as the world economy is going to enter a period of prolonged recession). The appropriate risk premium and risk adjusted interest rate depends on the undiversifiable risk. The greater the systematic risk, the greater the risk premium and the risk adjusted discount rate are. E. The Discount Cash Flow Approach to Valuation: i. First: have to estimate all future cash flows generated by the asset use of termination value, which brings all cash flows from a future year and going into perpetuity into that future year. ii. Second: have to calculate an appropriate discount rate. a. Weighted average cost of capital calculated as the weighted average cost of debt and the cost of equity Cost of debt before tax cost of debt is the interest rate that the firm would have to pay if it were seeking debt financing presently. Cost of equity capital asset pricing model (CAPM). Links securities risk to the volatility of the security prices. F. Relevance of Prices in the Securities Market: i. Efficient Capital Market Hypothesis (ECMH): stock prices rapidly reflect all public information bearing on the expected value of individual stocks. a. What do you assume? Younger people put a higher value on stock than older people Theres perfect information as much information as is public and more than you do

(i)

VI. Creditor Protection:

A. Fundamentals: i. Creditors are afforded less protection when they lend to corporations than to partnerships because corporations have limited liability. Therefore, creditors can only levy against a pool of assets that is defined by a fictional boundary. a. One way the law protects creditors is by requiring corporations to have audited financial statements (federal laws). Audited means that an allegedly independent auditor vouches that the financial statement is truly representative of the state of corporation. ii. Financial statements: a. Balance sheets: tries to measure equity (Assets Liabilities). The assets have to balance liabilities but can have negative equity if liabilities exceed assets. b. Equity: stated capital + surplus (capital surplus + retained earnings) c. Stockholder equity: Par value historically, when a corporation issued shares in an IPO, it had to assign a par value that would be considered the rough estimate by the corporation of the amount that would be paid in the market for the shares. Stockholder equity consists of: (i) Preferred stock (ii) Common stock: par value times shares (iii) Capital surplus - when shares are sold above the par value and excess capital is brought in. (iv) Accumulated retained earnings - the profits that are not distributed by the corporation (v) Capital surplus and accumulated net earnings sometimes called surplus.

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1. The capital account money brought in from shareholders at the time of the original sale of the companys stock. Corporations were not allowed to issue dividends if it would cause the capital account to fall in value. This capitalized the corporation and acted as a buffer for the creditors. a. If a company wanted to issue no par stock under DGCL 154 the board of directors must set aside some discretionary portion of the sale price as the companys stated capital. (vi) Retained earnings = assets minus liabilities minus stated capital minus capital surplus d. Current Assets and Liabilities v. Long Term Assets and Liabilities Current liabilities have to be paid within a year whereas long term liabilities can be paid in more than 1 year. Current assets are assets that can be immediately used to pay a current liability. Often cash and accounts receivable if you expect them to be paid within a year and inventory if you expect to sell within the year. Fixed assets are items such as property, plant and equipment and are sometimes referred to as capital assets. These are assets that are not for sale and used for a long period of time to manufacture, display, warehouse and transport. e. Example Project: Cost $100, 50% chance pay of $150, 50% chance of $0 (i) Firm One 1. Assets = $100 2. Liabilities = $0 3. Equity = assets minus liabilities = 100 4. 50% chance of $75, 50% chance of $0 = Expected value = 75 + 0 = 75 5. Cost = $100 6. Net = $-25 (75-100) so would not do it 7. Leverage ratio = 1 no ratio (ii) Firm Two 1. Assets = $100 2. Liabilities = $90 3. Equity = $10 4. Cost = $100 5. 50% chance of $150 = $30 = 150-90/2 6. 50% chance of $0 = 0 7. Expected value = $30 + $0 = $30 8. Cost = $10 9. Net = $30 $10 = $20 so would do it 10.Leverage ratio = 10 (iii) Delaware = need to take into consideration the shareholders iii. Income statement looks at corporation in a specific year to value revenues and costs. iv. Distribution constraints places restrictions on when corporations are allowed to pay dividends and differs by jurisdiction. a. New York: NYCL 510(a): The corporation must be solvent to pay dividends NYCL 510(b): this is a balance sheet test. Dividends have to be paid out of the capital surplus, not out of the stated capital. (i) However, this is not really that great of a protection to creditors because the board of directors can reallocate money from surplus into the capital account if the shareholders authorize it. b. Delaware: DGCL 170: Nimble dividend test: CHECK THIS: directors or a business corporation can pay dividends out of capital surplus, and if there is no capital surplus, can pay out of net profits in the current or preceding fiscal year. Therefore, companies with negative retained earnings that nevertheless show a profit may pay dividends. c. RMBCA 6.40: corporations may not pay dividends, if as a result of doing so, they can not pay their debts as they come due or their asses are less than their liabilities plus the preferential claims of preferred shareholders. v. Fiduciary Duties to creditors:

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a. Corporate law subjects directors to certain fiduciary duties to creditors under specific circumstances. Directors owe an obligation to creditors not to render the firm unable to meet its obligations to creditors by paying out to shareholders or to another entity without getting a fair value in return. (i) Most often, when a corporation is insolvent, or near insolvency, a corporations directors owe a duty to consider the interests of corporate creditors. 1. Have to consider the community of interests that constitute the corporation. a. During times of insolvency, shareholders become more risk-loving and the board is duty bound to limit its risk exposure for the protection of creditors who become more risk averse. Lets say tomorrow you have to pay $100 but thats all you have left. What do you do? (i) Pay it? Lottery tickets? (ii) Same type of thing can happen in a corporation directors have a duty to protect creditors and shareholders 1. Obviously its good for the creditors, but how is it good for the shareholders too??? Less risk so less interest a. After the fact (ex post), shareholders will see it as a bad thing b. Ex ante, think that if they incorporated in DE, creditors will know that they cant get harmed so it could be better b. Fraudulent Transfers conveyance law: Fraudulent conveyance law is designed to void transfers by a debtor that are made under circumstances unfair to creditors. (i) Under the UFCA and UFTA, present or future creditors may void transfers made with the actual intent to hinder, delay, or defraud any creditor. (ii) Creditors may also void transfers made without receiving a reasonably equivalent value if the debtor is left without remaining assets unreasonably small in relation to its business or the debtor intended, believed or reasonably should have believed he would incur debts beyond his ability to pay as they became due. c. Shareholder Liability: Equitable subordination: a means of protecting unaffiliated creditors by giving them rights to corporate assets superior to those of other creditors who happen to also be significant shareholders of the firm. The court can declare that debt to affiliated creditors should be treated as equity and subordinated to other debt (this protects unaffiliated creditors). This is usually done in a bankruptcy where the subordinated creditor is also an equity holder and/or officer of the corporation. (i) Costello v. Fazio (9th Cir. 1958): 1. Case involved a partnership between 3 partners where two partners made significant contributions. The company experienced significant losses and the two partners that made significant contributions changed the capital structure by withdrawing most of their capital, leaving less equity for the company and issuing a note to the company without interest with the rest of the balance. This made Fazio and Ambroise creditors of the company and all three partners had equal capital in the company. The partnership decided to incorporate and eventually declared bankruptcy. A trustee in bankruptcy brought an action stating that the creditors claims of F and A should be subordinated behind those of the unsecured creditors because they manipulated the situation so that they were ahead of the other creditors. 2. Rule: The court, in subordinating the loan, held that there are two tests to determine if subordination should occur: a. Test 1: whether within the bounds of reason and fairness, such a plan can be justified (the insider/creditor must have, in some fashion, behaved unfairly or wrongly towards the corporation and its outside creditors). b. Test 2: whether or not under all the circumstances the transaction carries the earmarks of an arms length transaction. 3. The court held that it did not seem that there was an arms length transaction because it happened in the anticipation of incorporation and there was no interest

17

being paid on the note and the original money that was invested as equity was translated into debt and no new money was given as capital. a. The corporation was grossly undercapitalized and this was to the detriment of the corporation and the creditors this is evidence though but not enough to show fraudulent intent. d. Piercing the Corporate Veil: An equitable doctrine, rarely used in practice. If the veil is pierced, the shareholder loses limited liability and creditors can go after the personal assets of the shareholder. Common formula is the Lowendahl test veil piercing requires that the plaintiff show the existence of a shareholder who completely dominates the corporate policy and uses her control to commit a fraud or wrong that proximately cases the plaintiffs injury. (i) Domination usually equates to failure to treat the corporate formality seriously. Sea-Land Services v. The Pepper Source (7th Cir. 1991): Sea-Land shipped goods on behalf of Pepper Source and then was stiffed on its freight bill. The owner of Pepper Source also owned four other business entities which conducted substantially the same work. SeaLand sought to hold both the owner (veil piercing) and his other companies (reverse veil piercing) liable. (i) Rule: Court found that a corporate entity will be disregarded when two requirements are met. 1. Part One: Such unity of interest and ownership that the separate personalities of corp. and owner no longer exist. a. Four factor test for determining unity of ownership: i. Failure to maintain adequate corporate records and formalities (in sea-land, Marchese did not hold corporate meetings, did not have articles of incorporation etc). ii. Commingling of funds or assets iii. Undercapitalization iv. One corporation treating the assets of another as its own (in sea-land, Marchese comingled funds). 2. Part Two: Adherence to fiction of separate corporate existence would sanction a fraud or promote injustice. Why did Sea-land want to reverse pierce? Other corporate entities that Marchese owned could have gone bankrupt as well and their creditors would get paid first and therefore, Sea-land did not want to become a shareholder because it would be last in line to get assets. By becoming a creditor through reverse veil piercing, you come in after secured creditors. Kinney Shoe Corp. v. Polan (4th Cir. 1991): Defendant created two corporations: first was an industrial company (Polan) and second held a lease to a building (Industrial), which it then subleased to the first. Industrial had no other assets except the sublease. Plaintiff was the landlord who had leased the building to Industrial. When Industrial did not pay its lease, the plaintiff wanted to go after Polan and its owner. The court applied the two part test of Sea Land and added a third permissive/optional prong: (i) Part One: Unity of interest and ownership such that the separate personalities of the corporation and the individual shareholder no longer exist. 1. Here there was undercapitalization essentially no assets (ii) Part Two: Would an equitable result occur if the acts were treated as those of the corporation alone? (iii) Part Three: Assumption of risk there are situations where the creditor assumes the risk of undercapitalization. When a creditor can conduct an investigation prior to entering into a contract, the creditor will be imputed with the actual knowledge that a reasonable credit investigation would disclose. a. The court found that Polan was trying to limit his liability and the liability of his corporation by creating a paper curtain constructed of Industrials certificate of incorporation. Therefore, the two prong test was satisfied. b. However, the court since the third prong is permissive, the district court erred in applying the third prong to the case at hand because applying it would not lead to an equitable result. Therefore, since Industrial was only a corporate shell and

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since Polan did not follow the formalities of maintaining a corporation, he couldnt complain that Kinney should have known better. Tort Creditors: tort plaintiffs often lose veil piercing cases because it is tough to prove fraud or misrepresentation. (i) Tort plaintiffs differ from credit plaintiffs because they do not rely on the creditworthiness of their defendants and cannot negotiate with the tortfeasor ex ante for contractual protections. (ii) Walkonszky v. Carlton (NY 1966): W was negligently hit by a car driver and sues the corporation through the theory of respondeat superior. The cab company only had minimum insurance on the car and the medallion. The only asset the injured person could go after was the insurance policy. Plaintiff wanted to pierce the corporate veil and reverse pierce to go after all the cab companys other cars. a. Rule: plaintiff could not pierce the corporation veil. In this case, while there was undercapitalization, this was not enough plaintiff needed to show some sort of fraudulent intent. Is unlimited liability for tort liability workable? (i) Tort creditors do not have the option to contract and cant assume the risk so limited liability seems unfair. However, if the rule was joint and severable liability, there could be no transferable shares since shareholder capitalization is material to the corporation. 1. According to Hansmann and Kraakman there would be pro rata share, unlimited liability but only have to pay the portion of what you own in the company

VII. Shareholder Voting A. The Role and Limits of Shareholder Voting: the corporate form delegates broad discretion to a
centralized management structure. This discretion is limited by corporate by-laws and charter, but very few corporations place substantive controls in these documents. i. Shareholders essentially have the right to vote, the right to sell and the right to sue. a. Shareholders want corporations to make a profits (some want in a socially responsible way) and directors want to do so in order to keep their job. B. Collective Action Problem: since there are millions of shareholders, no one shareholder is going to influence management anyway and therefore, investment is purely passive and there is rational apathy. To combat this rational apathy, the SEC has proxy rules that encourage shareholder activism. C. DGCL 211 shareholders must elect directors annually either the whole board or a staggered board (allowed under DGCL 141(d)) (most often 1/3). i. A staggered board makes it very difficult to take over the Board by an aggressive stockholder and lets the board entrench itself. a. In order to change to a triggered board, the charter has to be amended at a stockholders meeting. Under 242(b)(1): board of directors has to recommend the amendment to the charter and the shareholders have to vote to approve. Board cant self classify. Notice: if there is a staggered board, then this will be in the charter therefore, once stock is bought, cant surprise the shareholders and change to staggered. D. Proxy Voting: i. While there are annual meetings where shareholders can vote, most do not vote at these meetings because of rational apathy. However, there must be a quorum at the meeting to elect the board. a. Under 216 of the DGCL can reduce the quorum, but still need a third of the shares represented at the meeting. ii. Therefore, when a shareholder signs a proxy statement, it gives the board of directors the right to vote on their behalf. This can get expensive because of mailing and postage. Under 212(c)(2) proxies may be done electronically. iii. Rosenfeld v. Fairchild Airplane Corporation (NY 1955): Plaintiff brought a derivative suit against the new board of Fairfield after there was a proxy fight and the new board took money out of the treasury to pay their costs and the old board also got money to pay the costs of the proxy fight.

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a. If the incumbents would have won, then the cost of the proxy battle would have come from the treasury and the incumbents would have been reimbursed. Rule: the management may look to the corporate treasury for the reasonable expenses (subject to judicial scrutiny when challenged) of soliciting proxies to defend its position in a bona fide proxy contest. Members of new management can be reimbursed by the corporation for their expenditures in a contest by an affirmative vote of the shareholders. (i) Where it is established that such moneys have been spent for personal power, individual gain, or private advantage, and not in a good faith effort to advance the interests of the shareholders, the court may strike down the reimbursement. (ii) Essentially, incumbent managers are always reimbursed; insurgents are reimbursed only if they win. iv. Shareholder Information Rights: a. The 1934 Act mandates annual reports by public corporations. States tend to mandate a right to inspect the books and records of a corporation pursuant to a proper purpose. Stock list: discloses the identity, ownership interest, and address of each registered owner of the company. Since the stock list does not contain proprietary information and is easy to produce, the law makes this list readily available to registered owners. Books and Records: inspection of books and records run the risk of revealing proprietary information. Delaware courts allow inspection only with a proper purpose and plaintiffs carry the burden of proving a proper purpose and will informally screen plaintiffs motives and the likely consequences of granting her request. b. General Time Corp. v. Talley Industries (Del. 1968): Talley Industries, a stockholder in General Time, wanted to obtain a list of General Times stockholders. Under 220 of the DGCL, can obtain a stock list provided he has a proper purpose and the burden is on the corporation to prove that the purpose is improper. Talley Industries wanted the stockholder list to mail out proxies and General Time did not give Talley the list. General tried to take a deposition of Talley and tried to ask questions about whether shareholder was going to try and take over corp. Rule: as long as there was a proper purpose (a proxy fight is proper purpose), then you get the stock list. Even if there is an illegal purpose or an improper purpose, as long as there is one proper purpose, then stock holder gets the list. (i) It is harder to obtain the financial statement and the court applies a different standard because it is more sensitive information. v. Techniques for separating control from cash flow rights: it is efficient to give shareholders voting right since they have the strongest incentive in maximizing corporate value, but capital structures can be used to affect voting and ownership of shares. a. There is a statutory prohibition against managements ability to vote stock owned by the corporation. b. Circular Control Structures - Speiser v. Baker (Del. 1987): Speiser and Baker established a subsidiary of Health Chem (Chem), Medallion, which invested in Health Med (Med) and held 10% of the common shares and all of the convertible preferred shares, giving a 95% voting interest if converted. Speiser and Baker each held 45% of Med and Med received a 42% ownership interest in Chem. Speiser and Baker had a falling-out and Speiser sued to compel an annual meeting, which required Baker's presence, and Baker filed cross-claims and counterclaims, seeking declaratory judgment that Med not be permitted to vote its 42% stock interest in Chem. Under 160(c), shares of its own capital stock belonging to the corporation, or to another corporation, shall neither be entitled to vote or counted for quorum purposes. (i) Corporations can have treasury stock and 160(c) essentially says that no one can vote the treasury stock. If shares are owned by another corporation, they cant vote in the meeting, if the majority of the shares are held by that companys parent corp. Corporation A is not allowed to vote shares in a meeting if those shares are owned by a corporation which Corporation A has a majority stock in. Rule: 160(c) prohibits the voting of stock that belongs to the issuer and prohibits the voting of the issuers stock when owned by another corporation if the issuer holds, directly or indirectly, a majority of the shares entitled to vote at an election of directors of the second corporation.

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Since a broader purpose of the statute is to prevent entrenchment, while the majority stock of Medallion only owns 5%, it may be converted to 95%. c. Public shareholders own 90% of A and B owns 10% of A. Public shareholders own 49% of B and A owns 51% of B. B cant vote in A because directors of A own 51% of B. vi. Vote Buying: a shareholder may not sell her vote or separate her ownership interest from her voting right for consideration. Attaching the vote firmly to the residual equity interest ensures that an unnecessary agency cost will not come into being. vii. Collective Action problem: a. When voters habitually approve whatever management proposes, the collective action problem can lead to exploitation of shareholders best interests. Shareholders are going to be rationally apathetic and will most likely defer to the directors. However, if shareholders dont like the decision, they dont have to invest in the stock. viii. Federal Proxy Rules: a. 1933 Securities Act covers any sale by a corporation of its own securities b. 1934 Securities Exchange Act covers sales between parties on a public market, applies to publicly traded companies Rule 14-a: Commits the SEC to issue rules governing the solicitation of proxies. (i) 14-a(1): Solicitation includes any request to proxy, any rebuttal of a proxy, or any communication with a shareholder that may advance a proxy. 1. Exceptions: a. If the shareholder furnishes a proxy upon the unsolicited request of a shareholder. b. If the shareholder furnishes a proxy because he is required to under 14a-7. c. If the shareholder makes a public statement announcing how the shareholder is going to vote. (ii) 14-a(2): proxy fights must be registered with the SEC 1. 14-a(2)(b)(1): exempts from filing requirement anyone engaged in preliminary discussions who doesnt seek an initial proxy. a. Under 14-a(2)(b)(1) still have to file if: i. The person engaging in the discussion is the corporation or an affiliate or associate of the corporation. ii. The person is an officer or director of the corporation engaging in a solicitation financed by the corporation iii. An nominee for whose election proxies are solicited iv. Any person who is soliciting in opposition to a substantial transaction with an alternate suggestion in opposition to the board of directors. v. Any person who is required to report beneficial ownership of the corporations securities under 13-d (shareholders who own more than 5% interest in a corporation have to file a 13-d). b. However, do not have to file if the solicitation is made not on the behalf of the corporation and the total number of persons solicited is not more than 10. (iii) 14-a(3): cant do a solicitation unless you have provided a person with a definite proxy statement. 1. Ex. There is an initial communication between Tarpers and other investors and Tarpers long term interest is soliciting their proxy. Is this initial communication a regulated solicitation? a. 14-a(3): no solicitation will be made unless you have provided other party with a publicly filed definitive proxy statement. Is this a solicitation? Under 14-a(1), a solicitation is: i. A request for a proxy whether or not in the form of a proxy (here there is only an initial communication, not a request). ii. Any request to execute/not to execute or revoke a proxy. iii. Any communication to a security holder under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy. Look at the intent of the communication. This is present in this example. 2. Look to 14-a(2)(b) for exceptions:

(i)

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a. (b)(1): communication that is not seeking to elicit a proxy. Essentially, during

the time of the solicitation, is the person tying to elicit a proxy. If not, then dont have to file. i. There are situations where this does not apply to the registrant, or affiliant of the registrant (essentially the corporation) here there is a shareholder. Under b(1)(vi) any person who is required to report beneficial ownership of the registrants equity securities on a schedule 13-d. Under 13-d, shareholders who own more than 5% interest in a corporation have to file a 13-d and therefore 14-a(2)(b)(1) wont apply to you. If you are a smaller shareholder therefore, you are allowed to have initial communications without filing. ii. Since Tarpers owns 1% of the outstanding shares, can qualify for the 14-a(2) (b) exception. If Tarpers owned 6%, then would have to file under 14-a(2)(b) (1)(vi). iii. But under 14-a(b)(2)(b)(2), if you talk to fewer than 10 people, then can do an initial communication. Since here Tarpers is talking to 15 people, should talk to 10 or less. (iv) 14-a(4),(5): the details of what you have to put in a proxy statement; the form of a proxy (v) 14-a(6): Have to file a proxy statement with the SEC 10 calendar days before you solicit a proxy. (vi) 14-a(7): if a registrant intends to make a proxy solicitation in connection with a shareholder meeting, the shareholder can ask for a shareholder list. The corporation can either send you the list or can put the shareholders proxy in the registrants mailing. 1. However, under DGCL 220, corporation has to provide the shareholder list of shareholders. Therefore, DE law is more burdensome because under federal law, have options. (vii) 14-a(8): there are situations under which a corporation must provide to the shareholders, in its mailing when it is soliciting proxies, a shareholder proposal that shareholders want to be voted at the meeting. This is basically a way for the shareholder to get the corporation to solicit proxies for the shareholders including social interest type of proposals. 1. What is a proposal? A shareholder proposal is a shareholders recommendation or requirement that the company and/or its board of directors take action, which shareholder intends to present at a meeting of the companys shareholders. The proposal should state as clearly as possible the course of action that the shareholder believes the company should follow. 2. Who is eligible to submit a proposal? In order to be eligible to submit a proposal, a shareholder must have continuously held at least 2,000 in market value, or 1% of the companys securities entitled to be voted on the proposal at the meeting for at least one year by the date you submit the proposal. The shareholder must continue to hold those securities through the date of the meeting. 3. How many proposals may a shareholder submit? Each shareholder may submit no more than one proposal to a company for a particular shareholders meeting. 4. Who has the burden of persuading the Commission or its staff that a shareholders proposal can be excluded? The burden is on the company to demonstrate that it is entitled to exclude a proposal. 5. On what bases may a company rely to exclude a proposal? a. Improper under state law if the proposal is not a proper subject for action by shareholders under the laws of the state. b. Violation of the law it would cause the company to violate any state, federal, or foreign law. c. Violation of proxy rules if the proposal is contrary to any of the proxy rules, including 14a-9, which prohibits false of misleading statements. d. Personal grievance/special interest if the proposal relates to the redress of a personal claim or grievance against the company or any other person, or if it is

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designed to result in a benefit to you or to further a personal interest, which is not shared by the other shareholders at large. e. Relevance if the proposal relates to the operations which account for less than 5% of the companys total assets at the end of its most recent fiscal year, and for less than 5% of its net earnings and is not otherwise significantly related to the companys business f. Absence of power/authority if the company would lack the power or authority to implement the proposal. g. Management functions - if the proposal deals with a matter relating to the companys ordinary business operations. h. Conflicts with companys proposal i. Substantially implemented j. Duplication k. Resubmissions i. The SEC generally supports corporate governance proposals, but waffles on social responsibility proposals. the Cracker Barrel no action letter holds that companies may have to include proposals in their proxy materials that some shareholders believe are important to companies and fellow shareholders. so employment related proposals focusing on significant social policy issues can not be automatically excluded under the ordinary business exclusion. There is a case by case analysis but the general policy of exclusion is to confine resolution of ordinary business problems to management and the board of directors since it is impracticable for shareholders to decide how to solve such problems. ii. Look to the subject matter of the proposal some tasks are so fundamental to managements ability to run a company that can not be subject to direct shareholder oversight these include management of the work force such as hiring, promotion, and termination of employees, decisions on production quality and quantity and retention of suppliers. However, proposals relating to such matters but focusing on significant social policy issues generally would not be considered to be excludable. iii. Also look to the degree to which the proposal seeks to micromanage the company by probing too deeply into the matters of a complex nature that shareholders would not be able to make an informed judgment on due to their lack of business expertise and lack of intimate knowledge of the companys business. (viii) 14-a(9): false or misleading statements can not be made to solicit a proxy. 1. A misrepresentation or omission in a proxy solicitation can trigger liability only if it is material that is there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. Must also have culpability whether there is a negligence standard or scienter is required. Also have to have causation and reliance plaintiff doesnt have to prove actual reliance, instead, causation is presumed is a misrepresentation is material and the proxy solicitation was an essential link in the accomplishment of the transaction. 2. Virginia Bankshares v. Sandberg (1990): FABI began a "freeze-out" merger in which the First American Bank of Virginia (Bank) merged into Virginia Bankshares, Inc. (VBI), a wholly owned subsidiary of FABI. VBI already owned 85% of the Bank's shares, and would acquire the remaining 15% from the Bank's minority shareholders. The Bank's executive committee and full board approved the merger at $42 a share. The directors then solicited proxies for voting on the proposed merger at the next annual meeting even though they were not required to do so. In their solicitation, the directors stated that they approved the plan because the price allowed the minority shareholders to achieve a "high" value for their stock. Sandberg did not give her approval of the merger and brought suit, the federal ground for which was soliciting proxies in violation of SEC Rule 14a-9, which prohibits the solicitation of proxies by means of materially false or misleading statements. The trial court instructed the jury that it could find for Sandberg as long as the proxy solicitation involved material misstatements, and the proxy solicitation was an "essential link" in the merger process. The jury found for Sandberg,

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awarding her $18 a share, finding that she would have received that much more if the stock had been valued adequately. a. Directors used the notion of subjectivity as a defense. i. Rule: Court said that while people disagree about $42, have to look at the number objectively. Beliefs are actionable only if the underlying facts are false. Here, the evaluation of 42 dollars v. 62 dollars depended on provable facts assessed in recognized methods of valuation. Therefore, proof of mere disbelief or belief, absent proof of objective evidence, does not cause liability. Essentially, subjective belief is not enough to cause liability, need objective facts to back up the statement. b. Furthermore, the defense argued that fraud is a tort claim and Ps have to show duty and breach of duty, but also need to show damages and causation. i. In regard to causation, the Ps argued that there was a essential link between the proxy solicitation and the transaction because without getting a majority of the minority to approve, FABI and VBI wouldnt have gone through with the merger because of public relations issues, and the majority of minority would not have voted without the misleading statements. ii. Rule: The court ruled that this was not a valid claim and would not create causation because the claim was speculative. c. The Ps also claimed that the proxy statement was an essential link because it was used to satisfy a statutory requirement of minority shareholder approval to eliminate director self interest. i. Rule: However, the court held that the state in question barred a shareholder from seeking to avoid a transaction tainted by directors self interest if the minority of shareholders ratified the transaction following the disclosure of the material facts of the transaction and the conflict. If the material facts and the conflict were not disclosed, the minority votes were inadequate to ratify the merger under state law and therefore, there was no loss of state remedy to connect the proxy solicitation with harm to the minority shareholders irredressable under state law. Essentially, since the votes werent needed anyways and the merger would have gone through, the solicitation did not cause the harm. 3. State Disclosure Law: Fiduciary Duty of Candor a. Although state law has traditionally done little to regulate proxy solicitation by management, things have changed post SEA of 1934 i. Two themes: 1) the gradual disappearance of substantive regulation 2) the growing importance of fiduciary duties ii. Ex. DE SC court held that a controlling shareholder making a cash tender offer for stock held by minority shareholders had a fiduciary duty to make full disclosure of germane facts later extended to corporate directors, proxy solicitors, tender offers b. Until recently, DE cases minimized potential conflict between state corporate law and federal regulatory and judicial law governing corporate disclosure i. BUT in Malone v. Brincat, the SC abandoned its limitations: Whenever directors communicate publicly or directly with shareholders about the corporations affairs, with or without request for shareholder actions directors have a fiduciary dutyto exercise care, good faith and loyaltythe sine qua non of directors fiduciary duty is honesty court tried to minimize conflict between its holding and federal law

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VIII. General Duties on Fiduciaries A. Duty of Obedience: Fiduciary must act consistently with the legal document that created his authority. A director cannot violate the corporate charter and must perform obligations imposed upon him by the charter. Little legal dispute over this. B. Duty of Loyalty: fiduciary must exercise his authority over the corporate processes or property in a good faith attempt to advance the corporate interests and not simply advance his or her interests. i. Bars corporate officers and directors from competing with the corporation, from appropriating its property, information or business opportunities, and from transacting business with it on unfair terms. C. Duty of Care: requires corporate directors to act with the care of an ordinary prudent person in the same or similar circumstances. However, the law insulates officers and directors from negligence liability in order to avoid risk adverse management of the firm. i. ALI Principles Definition of Duty of Care: A corporate director or officer is required to perform his or her functions in good faith, in a manner that he or she reasonably believes to be in the best interests of the corporation, and with the care that an ordinarily prudent person would reasonably be expected to exercise in a like position under similar circumstances. ii. Gagliardi v. Trifoods International (DE 1996): a. Business Judgment Rule: where a director is independent and disinterested, there can be no liability for corporate loss, unless the facts are such that no person could possibly authorize such a transaction if he or she was attempting in good faith to meet their duty. iii. Since investors can diversify risks of corporate investments, it is in their economic interest to accept positive net prevent value investment projectors and do not want directors to be risk averse. However, since directors enjoy limited/to no upside (as a residual) and unlimited downside (through liability), directors would be extremely risk averse or not become directors at all. D. Business Judgment Rule: courts should not second guess good faith decisions made by independent, informed and disinterested directors (applies to dumb behavior). i. Kamin v. American Express Co. (NY 1976): Amex board decided to spin off stock as dividend rather than sell to reduce taxes, even though this would have resulted in a capital loss. Kamin sued alleging that the dividend in kind constituted waste of corporate assets and was a transaction that no reasonable person could authorize. a. Rule: whether or not a dividend is to be declared is exclusively a matter of business judgment for the board of directors. The court did not have to decide whether it was a good decision, as long as made in good faith. b. The board room is the best place for business decisions, not the court room. ii. A decision constitutes a valid exercise of business judgment when it is: a. Made by financially disinterested directors or officers b. Who have become duly informed before exercising the judgment c. Who exercise judgment in a good faith effort to advance corporate interests. iii. Exceptions to the Business Judgment Rule: a. Lack of Any Action: The Boards Duty to Monitor: Losses Caused by Board Passivity (Lazy Acts) Francis v. United Jersey Bank (NJ 1981): small, family business; sons steal $, company goes bankrupt; Mom is drunk and dies. The plaintiff alleged that Pritchard violated her duty of care because she had an affirmative obligation to supervise and she did nothing and did not know anything didnt understand the business and didnt read the financial statements. (i) Rule: Ms. Pritchard did not get the benefit of the business judgment rule because in order for this rule to be applied, there must be some kind of decision. A director cannot abandon his office there are minimum objective standards for performance going to meetings, going to the office, looking at financial statements, inquiring about the business, etc. In order to get the protections of the business judgment rule, have to inform yourself. A reasonable director would have tried to stop the bad actions and Ms. Pritchards failure to pay attention was a cause of the losses and therefore, she could be held liable.

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1. Ms. Pritchard could have attained immunity by consulting a lawyer or consultant, reporting the impropriety to other directors and voting for a proper course of action, or voicing dissent and having this document. b. Graham v. Allis Chalmers (DE 1963): Plaintiffs sought to recover damages from directors for violations of anti-trust price fixing done by certain divisions of the company where the company was prosecuted and found guilty. P said that b/c the directors learned of certain decrees that were given to the corporation in 1937, they should have been on the look out for such activity. Rule: the directors did not breach their fiduciary duty of care. Directors have a duty of reasonable care: the amount of care a reasonable person in a like position in a similar situation would exercise. At the time of the FTC decrees, the directors knew of them and checked into them and found nothing to be amiss. A duty of care does not require directors to implement plans to fish out illegal activities if you dont know of any. Directors entitled to rely upon subordinates until something puts them on active notice; no obligation to put in a system of watchfulness. Under 141(e) directors are protected by good faith reliance on corporate records. (i) Board does not have a duty to actively monitor for illegal activity but are instead entitled to rely on the honesty and integrity of their subordinates until something occurs to put them on suspicion that something is wrong. If such occurs and goes unheeded, then liability of the directors might well follow, but absent cause for suspicion there is no duty upon the directors to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists. c. In re Caremark International Inc., Derivative litigation (DE 1996): Caremark International, Inc. was indicted and pleaded guilty to violating a federal statute which made it a felony to pay kickbacks to persons for referring Medicare and Medicaid patients to it. The company was forced to pay approximately $250 million in criminal fines and civil reimbursement. The suit is a derivative action against the board, asserting negligence and a failure to monitor company activity. Rule: The court held that boards have an obligation to assure a system exists that is reasonably designed to assure that information respecting the corporations compliance with law plus its performance is reported up to responsible parties. The court found that in Caremark, there was an adequate good faith attempt to be informed of the facts, and absent other consideration, directors would not be liable. (i) New rules promulgated post-Enron and post-Worldcom by NYSE and SOX. SOX 404 codifies Caremark: CEO and CFO have to certify to auditor any weaknesses in the companys control system; also, have to certify financial statements in a certain way (ii) Also, under the new sentencing guideline, there is a huge increase in potential liability. 1. Therefore, since corporations are subject to greater liability under federal criminal law, shareholders want them to be more careful. The system does not have to be perfect and the standard is quite high to show lack of good faith by management for systematic failure to exercise reasonable oversight. d. Illegal Activity: Miller v. ATT (3rd 1974): ATT made a loan and the shareholders wanted the bill to be collected from Democratic convention because if it was not collected, ATT would potentially be in violation of campaign finance rules. The directors argued that the company did not have to collect under business judgment rule and while there was intentional violation, it was in the companys best interest. Plaintiffs argued that violation of a statute would indicate a breach of the duty of care. (i) Rule: where there is a violation of a law and there is illegal activity, these actions will not fall within the business judgment rule. This is because judges are a good at deciding whether activities are illegal or not as opposed to second guessing investment decisions.

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IX. Duty of Loyalty: A. Duty of loyalty requires a person who transacts with the corporation to fully disclose all material facts to the corporations disinterested representatives and to deal with the company on terms that are intrinsically fair in all respects. The duty is owed to the corporation (which is essentially a fictional person representing various constituencies). i. Dodge v. Ford Motor Co. (Michigan 1919): Dodge bros. owned 10% of the shares of Ford Motor Co. Ford earned substantial retained earnings and did not plan to release dividends in order to be able to provide lowered priced cars for society. Dodge alleged that Fords directors wrongfully subordinated shareholder interests to those of consumers by holding back dividends. a. Rule: while there was no obligation to pay dividends, a corporation has to hold shareholder interests as the primary interest, not financing price reductions. Boards of directors owe a duty of loyalty to shareholders. Ford could have argued that this would lead to consumer confidence and greater increase in sales, which would have led to benefits to shareholders eventually. ii. AP Smith Manufacturing v. Barlow (NJ 1953): The Smith Company made a reasonable (relative to earnings) donation to Princeton. NJ state law mandated that corporations could give charitable donations up to 1% relative to earnings, unless shareholders agreed on more. Shareholders argued that they did not have to abide by the statute because it was passed after formation of the corporation and the directors did not have the authority to make the contribution. a. Rule: statutory alterations in the law can be retroactive and therefore, the corporation had to abide by the laws. Furthermore, according to the court, even if the statute didnt apply, the corporation was still authorized to donate to Princeton because shareholders benefit from the long term benefits of charitable giving. Therefore, while directors have a duty to the shareholders this takes into account the long term interests of the shareholders and therefore, the court would not second guess the decision under the business judgment rule. Ford is still good law but such freedom, just need to say certain things to make it ok for the benefit of the shareholders B. Self Dealing Transactions: i. Occurs when officers and directors put their interest before the interest of shareholders. Originally, courts adopted the law of trusts regarding self dealing as a fiduciary a trustee can not engage in any activity with trust property and if the trustee did, this had to be disclosed to the beneficiaries and profits had to be disgorged, even though there was no harm to the trust. a. Corporate law changed in the early 20th century and self dealing was permitted if a safe harbor was met. Safe Harbor: 144 DGCL: No contract or transaction between a corporation and its directors/officers shall be void or voidable merely because of self dealing as long as: (i) The facts are disclosed to the board and approved in good faith by disinterested board members (ii) The facts are disclosed to the shareholders and approved in good faith by disinterested shareholders. (iii) The transaction is intrinsically fair (court reserves the right for fairness review). In terms of disclosure, dont have to disclose the reservation price in negotiations but do have to disclose anything that would be disclosed in an arms length negotiation and anything else that would lead the directors to think the transaction was objectionable. State Ex Rel. Hayes Oyster Co. v. Keypoint Oyster Co (Wash. 1964).: Vernon Hayes was made a director of Coast, and was not allowed to take part in any business that competed with Coast, except for his share in Hayes Oyster Co. which was a family run business. Coast had problems paying creditors and VH engaged in a transaction with Engman involving the sale of certain of Coasts oyster beds. Keypoint was formed with Hayes Oyster Co owning 50% and Engman owning 50%. Keypoint would pay yearly installments before title passed. Coast sued VH alleging that VH was on both sides of the transactions and had a fiduciary duty to Coast since he was a director. (i) Rule: although there was no evidence that in substance the transaction was unfair, VHs nondisclosure itself was inherently unfair self-dealing that is not disclosed is intrinsically unfair.

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(ii) Coasts shareholders, while they gave approval, were not aware that Keypoint was owned by Hayes Oyster Co. which was owned by VH. Therefore, Keypoint had to disgorge shares. b. Controlling Shareholders and the Fairness Standard: Controlling shareholders have a fiduciary duty to the company and its minority shareholders because the controlling shareholders power over the corporation, and therefore the ability to affect other shareholders, gives rise to the duty to consider their interest fairly whenever the corporation enters into a transaction. Sinclair Oil Corp. v. Levien (Del. 1971): Sinclair was in the business of exploring for oil and of producing and marketing oil and oil products. It owned about 97% of Sinvens stock and nominated Sinvens board of directors. Almost all of these directors were officers or directors of Sinclair (Sinclair controls Sinven). Plaintiff, Levien, owned a small amount of shares in Sinven. Levien accused Sinclair of breeching fiduciary duty by paying out such excessive dividends to get cash for the development of itself and other subsidiaries, that the development of Sinven was hampered. Levien also accused Sinclair of breeching fiduciary duty by forcing Sinven to not enforce a K between Sinven and Sinclairs other subsidiary, such that Sinven effectively gave away products to Sinclairs other subsidiaries. Since the issuance of dividends falls under the business judgment rule, the P alleged that there was self dealing so the situation needed to be evaluated under the intrinsic fairness test. (i) Rule: there was no self dealing in this situation while Sinclairs directors were on both sides of the transaction, the policy behind self dealing is preventing fiduciaries from getting a benefit to the detriment of the minority shareholders and here the minority shareholders also received dividend payments. Sinclair also did not steal business opportunities from Sinven. (ii) The burden of proof was on the shareholders to show that the opportunity was with Sinven and not Sinclair had to show that there was a benefit that Sinven would reasonably expect, and here, the only benefits would come from Venezuelan opportunities. 1. While dividend payments between a subsidiary and a controlling parent can be self dealing subject to entire fairness standard if improper motive is detected, here there was no improper motive. c. Approving Self Dealing transactions: 144 DGCL: A Self Interested transaction cannot be inherently void if there is: (i) Board approval (with disclosure) (ii) Shareholder approval (with disclosure) (iii) The contract is fair to the corporation (non-disclosure is inherently unfair). Cookies Food Products v. Lakes Warehouse (Iowa 1988): Cookies Food Products, Inc. was a barbecue sauce manufacturing and distributorship that was not very successful until Herrig began distributing the barbecue sauce to retail outlets. Over the years, Herrig's distributorship agreement spurred significant growth in barbecue sauce revenue. In 1981, Herrig acquired a majority stake in Cookies and in 1982, Herrig even developed his own taco sauce. Herrig received royalties for the taco sauce and his distribution agreement with Cookies increased subsequent to his acquisition of a majority interest. The plaintiff alleged that Herrig was involved in self-dealing. (i) Rule: self-dealing is allowed if the self dealing has been disclosed and approved by a majority of disinterested board members, there is disclosure and approval of disinterested shareholders and it is inherently fair. Here the court infers approval by a disinterested board (even though Herrig put the board in, most were not financially interested in the transaction). (ii) The court read the statute to require fairness, so have to satisfy either approval by board or shareholders, and have fairness to corporate interests. In this case, the court felt that the transactions were fair because the shareholders were not harmed, but actually benefited by increased profitability. 1. Dissent: felt that the court focused too much on the success of the company and didnt focus on Herrigs burden of proof wanted Herrig to provide some indication of a fair market value for his services or royalties. Trying to figure out if this was an arms length transaction. d. Approval by Disinterested Members of the Board:

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e.

The approval of an interested transaction by a fully informed board has the effect of authorizing the transaction, not of foreclosing judicial review for fairness. Board might be influenced by management etc., so need a fairness test. However, where there is no controlling shareholder, then fairness is reviewed under the deferential business judgment rule. Cooke v. Oolie (Delaware 2000): involved a potential conflict where the defendants were shareholders who became creditors after issuing a loan to the corporation. Plaintiffs alleged that the deal would only have benefited the directors. (i) Rule: although the directors were also creditors, since there was a disinterested shareholder majority vote approval, this removed the taint of disinterest. 1. Eisenberg disinterested directors dont have a financial incentive to disagree, but they might have a social interest and board room isnt the atmosphere that produces the review. (ii) Chancery courts more likely to avoid valuation discussions while supreme court more likely to question intrinsic fairness of deal. Shareholder Ratification of Conflict Transactions: When there is a question of self dealing, there can be shareholder approval of the transaction. However, this ability to affirm self dealing transactions is limited by the corporate waste doctrine. (i) The corporate waste doctrine: holds that even a majority vote can not protect wildly unbalanced transactions that irrationally dissipate corporate assets. Waste occurs when there is no consideration and no reasonable person would approve the transaction. Therefore, even if there was majority shareholder approval, will still have judicial review. 1. If there is unanimous shareholder approval this is the only time there will not be judicial review of possible waste. Lewis v. Vogelstein (Delaware 1997): (i) Rule: Shareholder ratification may be held to be ineffectual because a majority of those affirming the transaction had a conflicting interest with respect to it or because the transaction that is ratified constituted corporate waste. Shareholders shall not ratify waste except by a unanimous vote. 1. A transaction that satisfies the high standard of waste essentially constitutes a gift of corporate property and no one against their will shall be forced to make a gift of their property. In re Wheelabrator Technologies, Inc. (Delaware 1995): Shareholder class action challenging a merger between Wheelabrator Technologies, Inc. (WTI) into a wholly-owned subsidiary of Waste. In 1988, Waste acquired a 22% equity interest in WTI and 4 of the 11 directors were from Waste. Waste sought to become a majority shareholder in WTI, by acquiring an additional 33% stake in the company. The board held a special meeting and voted unanimously to approve and recommend the transaction. The transaction was then approved at a special shareholders meeting by a majority of WTI shareholders other than Waste. The plaintiffs alleged that in negotiating and approving the transaction, the director defendants breached their fiduciary duties of loyalty and care. (i) Rule: ratification decisions that involve duty of loyalty claims are of two kinds: (a) "interested" transaction cases between a corporation and its directors (or between the corporation and an entity in which the corporation's directors are also directors or have a financial interest), and (b) cases involving a transaction between the corporation and its controlling shareholder. 1. Regarding the first category, the interested transaction will not be voidable if it is approved in good faith by a majority of disinterested stockholders. Approval by fully informed, disinterested shareholders invokes the business judgment rule and limits judicial review to issues of gift or waste with the burden of proof upon the plaintiff. 2. In cases involving a transaction between the corporation and its controlling shareholder, if the transaction is conditioned on receiving approval from a majority of the minority, and approval is given, then the standard of review remains entire fairness, but the burden of demonstrating that the merger was unfair shifts to the plaintiff.

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3. The court held that because Waste was not a controlling stockholder, the entire
fairness standard of review didn't apply and the correct standard was the business judgment rule. f. Director and Management Compensation: a necessary form of self interested transactions. Core matter of business judgment for the board but becomes problematic in the case of companys directors and officers. SEC has rules that require disclosure of the total compensation of the top five corporate officers, including options. Can give them stock options instead of stocks, pay = if the company goes down in value, then the stock options become worthless, whereas if they have stock, it just is worth less = net worth will drop if they have shares, but not much will happen with stock (i) They will be more risk averse with stocks, but to be more brave with stock options because they want it to go up in value (ii) Similar to: BUSINESS JUDGMENT RULE g. STEPS TO TAKE: Is the defendant a fiduciary of the corporation (director/officer or controlling shareholder)? If yes, was there a material conflict? (i) If No, Business judgment rule applies. 1. BJR will not apply if there is an illegal activity (this talks more about duty of care though). 2. BJR will not apply if there is a gift so large that nothing is coming back to the corporation. 3. BJR will not apply if there is a decision by a director that looks like corporate waste essentially looting the corporation. (See below). (ii) If yes, defendant can still prove transaction was valid by showing that 1. All the information was disclosed and there was approval by disinterested shareholders and/or board 2. The transaction was inherently fair (in terms of price, etc.). Judicial Review of Corporate Self Dealing Director Controlling Shareholders Entire Fairness (EF), D EF, D Business Judgment EF, D Business Judgment EF, P

ii.

Corporate Opportunity Doctrine: when may a fiduciary pursue a business opportunity on her own account if this opportunity might arguably belong to the corporation? a. See Sinclair Oil (parent subsidiary corporate opportunity), Meinhard v. Salmon (self-dealing by agent), and Juke box case (secret commission). Issues: (i) When is an opportunity a corporations opportunity? Three tests often applied by courts: 1. Expectancy of Interest: an opportunity belongs to the corporation if the expectancy grows out of an existing legal interest (narrow). a. Ex.: If the corporation is in negotiations to acquire a new business or an executive learns of a business offer directed to the corporation. 2. Line of Business Test: any business opportunity that falls within the line of business of the corporation belongs to the corporation as against any fiduciary (broad). a. Factors: i. How the opportunity came to the fiduciarys attention ii. How far removed the opportunity is from the core economic activities iii. Whether corporate information was used in recognizing or exploiting the opportunity. 3. Fairness Test: a. Factors: i. How a manager learned of the disputed opportunity ii. Whether he used corporate assets in exploiting the opportunity iii. Indicia of good faith and loyalty to the corporation

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iv. Companys line of business. (ii) Under what circumstances may a fiduciary take a corporate opportunity? 1. Some courts have held that a fiduciary may take an opportunity if the corporation is not in a financial position to do so. But the corporation must evaluate whether to take the opportunity in good faith. 2. Most courts accept a boards good faith decision not to pursue an opportunity as a complete defense to a suit challenging a fiduciarys acceptance of a corporate opportunity on her own account. 3. Under DE law, a director does not have to present a business opportunity to the board if, in good faith, he believed that it was not a corporate opportunity. BUT, presenting the opportunity to the board is seen as kind of safe harbor. (iii) What remedies are available when a fiduciary has taken a corporate opportunity illegitimately? 1. In re EBay, Inc. Shareholders Litigation (DE 2004): EBay hired Goldman Sachs as an underwriter of EBays IPOs. Goldman Sachs offered certain EBay directors shares in other companies at IPO prices, therefore allowing the directors to get in at the market at a lower price and sell to make a lucrative amount. Plaintiffs alleged that this was a loss of corporate opportunity because the IPO shares should have gone to the corporation, not the directors. If the corporation would have rejected the opportunity, then it could have gone to the directors. a. The court first had to determine whether this was a corporate opportunity and therefore whether it was within the scope of EBays busisness. Defendants argued that since EBay wasnt an investment bank, but an auction house, the IPO investments were not within the scope of EBays business. However, the court held that this was not true because EBay did actually invest in other stocks as part of its cash management plan. b. Furthermore, the directors argued that the investments were risky but the court found that EBay was never given the opportunity to decide whether the investments were risky. c. Therefore, the court held that the IPOS should have gone to EBay first. 2. DGCL 122(17): authorizes waiver in the charter of corporate opportunity constraints for officers, directors or shareholders. iii. Duty of Loyalty in Close Corporations: a. Donahue v. Rodd Electrotype Co (MA 1975): Plaintiff sought to rescind D's purchase of Harry Rodd's shares in Rodd Electrotype and to compel Harry Rodd to repay to the corporation the purchase price of said shares, together with interest from the date of purchase. The plaintiff alleged that the defendants caused the corporation to purchase the shares in violation of their fiduciary duty to her, a minority stockholder of Rodd Electrotype by not offering her the same deal as was offered to the Rodds. Plaintiff was left in a minority position with stock and was unable to get out. She said it was a breach of the fiduciary duty self dealing because the Rodds were on both sides of the transaction. Close corporations have three characteristics: (i) Small number of shareholders (ii) The majority of the shares are in few hands. (iii) No ready market for the corporate stock. Rule: there is a prejudice against minority shareholders because they can not sell their shares on the market and get out. Potential abuse could befall the minority including freeze outs, refusal of dividends, drain of resources in the form of exorbitant salaries, high rent to property owned by minority, etc. Therefore, the court found that the situation was similar to that of a partnership and held that: (i) In a close corporation, all shareholders have to act in good faith towards all shareholders they all have duties towards each other and therefore there can be no avarice, expediency or self interest to the detriment of the minority. Directors are bound to allow minority shareholders an equal opportunity to sell as accorded to the majority. (ii) Therefore, the Rodds had to pay back to the corporation the amount of the shares and get the shares back (rescind the contract) or the corporation had to pay the same amount for the Ps shares.

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b. According to Easterbrook corporate law with regard to close corporations should enforce what would be the likely intention of the parties at the formation of the relationship. In the Rodds case, it is unlikely that the Rodds would have given the Donahues equal rights at the inception. c. Smith v. Atlantic Properties (MA 1981): Corporations with 4 shareholders, each with 25% of the shares. Corporation does very well, but there is disagreement about whether to invest further, 3 wanted to issue dividends, and Dr. Wolfson wanted to invest in properties. The charter had a provision that any one shareholder had a veto because needed 80% approval. The 3 directors warned that IRS penalties would be imposed and eventually they were. Massachusetts had fiduciary duties amongst all shareholders. Rule: the common law dealt with the controlling shareholder not the majority shareholder and since Wolfson had a veto power, he was a controlling shareholder. The court found that Wolfson had to pay back the penalties because there was not a legitimate business purpose to his decision not to pay out dividends since it constituted an illegal activity. Are these plaintiffs different in any way? Yes, you could dissolve the corporation without a super majority Most troubling question is this a duty of loyalty case? (i) Classic duty of loyalty fact pattern is that someone would take a business opportunity for themselves or engages in self dealing (ii) Not like this here not a classic case they didnt even know the difference between the duty of care and duty of loyalty (iii) Any reason you can sue Wolfson and say that he should be liable under duty of care? 1. How can you argue not under business judgment rule? a. Not acting in good faith but in spite b. Dont know on the facts in the case that he didnt understand the tax penalties were coming c. If something is illegal it doesnt count a tax penalty d. Because any one particular shareholder is a controlling shareholder, than you apply the entire fairness standard not the business judgment rule

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X. Shareholder Lawsuits A. Types of Shareholder Lawsuits: i. Derivate suits: suit by a shareholder on behalf of the corporation. The corporation is the nominal defendant but the actual claim will be against the directors and officers since they represent the corporation. Recovery goes to the corporation itself. ii. Direct Actions (usually brought as class actions): wrong/injury to the shareholder. a. The practical implications surround the demand requirement and attorney fees. iii. Tooley v. Donaldson, Lufkin & Jenrette (two prong test to determine whether a stockholders claim is derivative or direct): a. Who suffered the alleged harm (the corporation or the suing shareholders) b. Who would receive the benefit of the recovery or other remedy (the corporation or the stockholders individually) B. Collective Action Problem Attorneys Fees and the Incentive to Sue: i. Strougo v. Bassini (2d circuit 2002) a. Facts: P is a shareholder of Brazilian Equity Fund, a non-diversified, publicly traded, closed end investment company incorporated in MD (Closed end means that the Fund has a fixed number of outstanding shares so that investors who wish to acquire shares in the Fund ordinarily must purchase them from a shareholder rather than from the Fund itself) The Fund then announced that it would issue a right (opportunity to purchase a new share) per shareholder and that three rights would enable the shareholder to purchase one new share in the Fund. price was 90% of the lesser stock for the last four days on the stock exchange and the per share net asset value at the close of business on August 16, 1996. P claim this is COERCIVE because it penalizes those that dont participate the introduction of new shares at a discount dilute the old shares because it couldnt be sold on the open market, the only way you could avoid a reduction in equity would be to purchase shares.August 16, they sold at 12.38 and the Funds per share net asset value was 17.24 subscription price of 11.09 (90%) THE COMPLAINT: Defendants breached their duties of loyalty and care: four kinds of injuries 1. 1) loss of share value resulting from the underwriting and other transaction costs 2. 2) downward pressure on share prices resulting from the supply of new shares 3. 3) downward pressure on share prices resulting from the offering of shares at a discount 4. 4) injury resulting from coercion in that shareholders were forced to either invest additional monies in the Fund of suffer a substantial dilution b. Rule: QUESTION TO ASK IS: IF THE SHARHOLDERS INJURY IS DISTINCT FROM THAT SUFFERED BY THE CORPORATION (i) Cannot flow from injuries to a corporations business 1. This would make possible multiplicity of suits, makes it possible to have recoveries that are inequitably distributed among those other than shareholders (ii) Reject the undifferentiated effect on shareholders standard that the district court used 1. Could lead to a situation in which shareholders are improperly left with an injury without legal recourse (iii) Incidental result in the diminish of a stock doesnt mean you can bring a direct action = not primarily or necessarily a damage to the stockholder (iv) Meaning of property or business: injury to the corporations business or property occurs when officers and directors waste funds on perquisites, salaries, and bonuses, or make imprudent investments 1. Court of Special Appeals: if officers and directors mismanage or misappropriate funds 2. Danielewicz: issues excessive number of shares in exchange for shares of another company 3. ***ILL ADVISED INVESTMENTS BY A CORPORATION, EVEN IF PAID FOR WITH THE CORPORATIONS SHARES, MAY CONSTITUTE AN IMPAIRMENT OR DESTRUCTION OF THE CORPORATIONS BUSINESS*** Plaintiffs Standing to Sue Directly (i) One harm is not supported by MD law, the other three are

33

1. 1) Loss in share value resulting from the substantial underwriting and other transactional costs associated with the Rights Offering a. Decreases share price, and is the type of suit that can only be a derivative action 2. 2) The others all resulted from coercion harm alleged depends on whether or not the shareholder participated in the rights offering a. Complaint specifies how non-participating shareholders were harmed b. Not as obvious with PARTICIPATING shareholders i. On the one hand, they received the redistributed Equity in the fund, but on the other hand, they could have suffered transaction costs in liquidating assets to pay for this ii. LEAVE THIS OPEN TO THE DISTRICT COURT TO RESOLVE (ii) DID NOT FAIL TO STATE A CLAIM 1. The alleged injuries didnt come from a reduction in the value of the Funds assets this actually INCREASED the Funds assets 2. For non-participating, harm didnt come from a reduction in the value of the Funds assets, but from A REALLOCATION OF EQUITY VALUE TO THOSE SHAREHOLDERS WHO DID NOT PARTICIPATE 3. NO INJURIES TO THE FUND AND THUS ARE DISTINCT ii. Fletcher v. A.J. Industries (CA 1968): D, a corporation on whose behalf the stockholders sued the corporations officers for misconduct, argued that it was not responsible for the stockholders' fees and costs because no statute authorized such an award, and no common fund existed from which the award could be taken. The stockholders argued that they were entitled to fees even without a common fund because their action had "substantially benefited" appellant by maintaining the corporations health and raising the standard of fiduciary relationships. a. Rule: The court agreed with the plaintiffs, holding that under the CA law, (1) an award of attorneys fees to successful Plaintiffs may properly be measured by, and paid from, a common fund where the derivative action on behalf of a corporation has recovered or protected a fund in fact; but (2) the existence of a fund is not a prerequisite of the award itself. b. Reasoning: General rule is that you can only recover if expressly permitted by statute. Exception is the common-fund doctrine, which provides for recovery of attorney fees if the fund exists and the litigation serves to enhance or protect the fund Substantial benefit test: may recover attorneys fees if the litigation substantially benefited the corporation even without a fund. (i) In this case, since there was no litigation, the action saved the corporation a lot of money (this is bad law this is not DE). Furthermore, there were structural changes that caused a benefit. For policy reasons, courts want to encourage derivative suits as a means of policing corporations C. Standing Requirements: determine who may bring a derivative suit. i. DE follows Rule 23.1 of Federal Rules of Civ. Pro.: a. The plaintiff must be a shareholder for the duration of the action This is because if you are no longer a shareholder, will most likely want damages and not structural changes must have an ongoing interest in the well being of the corporation. b. The plaintiff must have been a shareholder at the time of the alleged wrongful act or omission. c. The plaintiff has to fairly and adequately represent the interests of the shareholders. This takes into account the fear of claim preclusion because want to make sure that shareholders are adequately represented so there isnt a collusive settlement on the cheap. D. Balancing the Rights of Boards to Manage the Corporation and Shareholders Rights to obtain Judicial Review: i. Demand Requirement of Rule 23: originates from the rule that a derivative complaint must allege with particularity the efforts, if any, made by the plaintiff to obtain the action he desires from the directors or comparable authority, or the grounds for not making such efforts. a. Levine v. Smith (DE 1991): Shareholders brought a derivative suit against the board of directors challenging the repurchase from the corporation's largest shareholder - Ross Perot.

34

E.

The issue concerned what standard the court should apply when a demand for a suit has been refused. Before bringing a derivate suit, a plaintiff must go to the board and demand that they bring a suit. In the complaint, must describe the demand or explain why demand would be futile. (i) Have to show that the people entrusted with making the decision for litigation (the corporation) cant make the decision well. (ii) Aronson test: 1. Have to show that directors are conflicted (because there is a general presumption that directors are independent) through specific facts that overcome notion of director independence (i.e. majority of the board has a material interest in the transaction OR the majority of the board is dominated by the alleged wrongdoer). 2. If cant show this, then can show sufficient facts to present reasonable doubt that transaction was product of valid exercise of business judgment - bad faith or gross negligence may be inferred by the decision/transaction itself. a. Here, the plaintiffs alleged that the outside directors were deceived or misled but the court held that the shareholders did not meet their burden of showing that the directors were not independent because evidence indicating that the directors werent adequately informed by inside directors did not show a breach of the duty of loyalty. 3. Two prongs refer to two different point in time a. First prong refers to when the suit is brought b. Second prong refers to the board that made the underlying decision A shareholder plaintiff, by making demand upon a board before filing suit, "tacitly concedes the independence of a majority of the board to respond." Therefore, when a board refuses a demand, the only issues to be examined are the good faith and reasonableness of its investigation. (i) Thus, the court was only required to apply the business judgment rule to the Board's refusal of Levine's demand. ii. Delaware: if you bring a demand, and the directors say no, then you lose the ability to sue again. a. If you bring a demand, you concede that the directors are independent and disinterested you believe that they can make the decision objectively. b. Therefore, in DE, no one makes a demand and then the corporation brings a suit alleging that demand should have been make and shareholders allege that demand was futile. Special Litigation Committees: i. No basis in law for a procedure upon which a court, upon the motion of a special committee of disinterested directors, may dismiss a derivative suit that is already under way. But this is now a standard feature. Main divide is between courts that give a role to the court itself to judge the appropriateness of a special litigation committees decision to dismiss a derivative suit and those jurisdictions (such as NY) that apply a rule, that if the committee is independent and informed, its action is entitled to the business judgment rule without judicial second guessing. a. Zapata v. Maldonado (DE 1981): Maldonado instituted a derivative suit in which the requirement of demand was excused. Four of the defendants in the claim were no longer on the Board. The remaining directors appointed two new outside directors to the board and created an independent investigation committee composed solely of the two new directors. The independent committee investigated Maldonados claims and then asked that the derivative suits be dismissed on the grounds that continuing the suit would only hurt the corporation. Rule: The court held that after an objective and thorough investigation of a derivative suit, an independent committee may cause its corporation to file a pretrial motion to dismiss, which should include a thorough written record of the investigation and its findings. (Should be similar to a summary judgment review). When an independent committee files a motion to dismiss, the court must go through a two step process: (i) First step: inquiry into independence and good faith of committee and process. Essentially have to check duty of loyalty and duty of care (illegal recommendation or no action). 1. If committee can make a respected decision, case is dismissed (no 2nd step)

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(ii) Second step: court makes own business judgment on fairness of decision even if
lawsuit is meritorious, whether the actual harm to the corporation exceeds the benefits. THIS IS A DISCRETIONARY SECOND PRONG. 1. Consideration of law and public policy in addition to corporations best interests b. In re Oracle Corp. Derivative Litigation (DE 2003): a shareholder derivative suit was brought claiming that certain officers and directors of the corporation violated their fiduciary duties by participating in insider trading. The SLC was formed to investigate the validity of the insider trading allegations. Among the SLC members were two corporation directors, both whom were tenured professors at Stanford University. After an extensive investigation, the SLC concluded that the shareholders allegations were without merit. In regard to the SLCs independence, the SLCs report reasoned that it was independent based on the facts that the members received no compensation from the corporation other than as directors; both SLC members were not Oracle directors at the time of the alleged insider trading; and both members were willing to return their compensation as an SLC member if necessary in order to keep an independents status. A motion was made by the SLC, based on the results of the investigation and its independent status, to terminate the pending shareholder derivative action. Rule: In ruling, the court focused on whether the non-economic motivations of the SLC members could create a risk of bias. The court found that there were several significant relationships between the directors, the members of the SLC and Stanford Uni. The court rejected the SLCs argument that it was independent because its members were not under the domination and control of the defendant board members and the court in fact found that the SLCs members were not under the domination and control of the defendant directors. The court nevertheless found that the SLC had failed to prove its members independence because the relationship between and among the SLC members, Oracle, and Stanford University was found to be sufficiently substantial to defeat the SLCs motion. (i) Although the court found that the SLC was not under the domination and control of the defendants, the court rejected this as an indication of the SLCs independence. (ii) The court emphasized the entire fabric of social and institutional relationships among the SLC members and defendants in finding that the SLC had failed to meet its burden. c. Joy v. North (2d Cir. 1982): the corporation created a special litigation committee that makes a motion to dismiss. Rule: The CT court held that in evaluating a recommendation by a special litigation committee for dismissal of a derivative action, a court must use its own independent business judgment as to the corporations best interest. (i) Makes the second prong of Zapata mandatory. Essentially have to look at a cost/benefit analysis first and if the court finds a likely net return to corporation that is not substantial in relation to shareholder equity, it can take two other items into account as costs (distraction of personnel and lost profits because of publicity of trial). ii. Settlements by Special Committees: a. Carlton Investments v. TLC Beatrice International Holdings (DE 1997): Carlton Investment brings a derivative suit on behalf of TLC Beatrice alleging that the former CEO was excessively paid constituting waste. TLC added two new board members to an SLC which eventually entered into a proposed settlement with the estate of the former CEO. Rule: The court reviewed the decision under the Zapata prongs because it was a decision by a special litigation committee. (i) Under the first step, the court found that there was good faith and a well informed, reasonable decision. (ii) While uncomfortable with applying the 2nd prong, the court found that the settlement was not that bad off of the mark. The judge did not feel that that this was an egregious or irrational settlement. Statutory Techniques for Limiting Director and Officer Risk Exposure: i. Indemnification: Most corporate statutes prescribe mandatory indemnification rights for directors and officers. For permissive indemnification, the only limits on what can be reimbursed are that the losses must result from actions undertaken on behalf of the corporation in good faith and that they cannot arise from criminal conviction. DGCL 145(a)-(c).

F.

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a. Waltuch v. Conticommodity Services, Inc. (2d. Cir. 1996): Waltuch brought

indemnification suit for $2.3 million. He tried to corner the silver market and was sued. All of the suits were settled out of court by Conti and not Waltuch himself. The CFTC enforcement action outcome was that Waltuch couldnt trade for 6 months and was fined. The case on behalf of his clients was paid out by the corporation. A committee said that Waltuch was not entitled to indemnification. Under 145 of DGCL, if Waltuch is successful on the merits, corporation has to pay his legal fees. Conti argued that the corporate article that would indemnify Waltuch violated 145 (must show that he acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corp.). Under 145(c) (i) Regulatory action: Waltuch could not get reimbursed because he was not found successful on the merits - paying a fine is not indicative of vindication. 1. Waltuch argued that Article Ninth of Contis Articles of Incorporation provided for indemnification except when a judge or jury decided that a person was negligent or there was misconduct. a. Conti argued that this was invalid because under 145(a), indemnification is limited to good faith actions and good faith was conceded in the lower courts. i. The court found that the statute controlled and a good faith requirement had to be read into the bylaws. So Waltuch was not indemnified for regulatory action. (ii) Civil Action: Conti argued that because it paid a settlement, Waltuch was not successful on the merits might have been successful on the merits but not normally. 1. However, the court found that this did not matter for 145(c) purposes a. Since Waltuch didnt have to pay a fine or go to jail, the court held that he was successful on the merits and therefore should be indemnified. ii. Directors and Officers Insurance: a. Under statute, can buy insurance for almost anything. However, read in limitations existing from contract law, including fraud, self dealing and criminal penalties. b. Under 145(a) and (b), can have maximum limitations on how much a person can be indemnified. c. Under 145(c), if you are successful on the merits, have to be indemnified. If there is self dealing, most likely will not get indemnified because it is a breach of a duty and probably will found not to have good faith and therefore, dont qualify under 145(a). G. Statutory Provisions Allowing Corporations to Opt Out of Damages: i. Smith v. Van Gorkam (DE 1985): Corporation underwent a merger where director executed price and merger by himself and board spent about 10 minutes approving it without informing itself. Delaware Supreme Court said there was a breach of the duty of care. This was the first time where the court assessed liability where the board made a business judgment and specifically acted. a. Rule: In response Delaware enacted 102(b)(7), which provided that corporations could have provisions in their charter that their officers would not be held liable for monetary damages for certain types of suits basically breach of fiduciary duty derivative actions with exceptions for: Duty of loyalty Acts or omissions not in good faith Intentional misconduct or knowing violations of the law (which is the normal exception to the BJ Rule). ii. In re the Walt Disney Company Derivative Litigation (DE 2005): Compensation for Ovitz was excessive, the employment agreement wasnt properly discussed by the Compensation Committee or the whole board and even the decision to fire Ovitz was not brought to the board. The Chancery Court first decided to dismiss the complaint because it alleged duty of care which, under 102(b)(7) the corporation is allowed to waive liability for breach of care actions for directors. The Del. Sup. Ct. allowed the complaint to be repleaded on good faith grounds. a. Rule: Chancery court held that there were essentially two duties and that good faith was more a component of both duties essentially the intentional dereliction of duty or conscious disregard of duty. Duty of care has two components:

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b.

Objective component acted as a reasonably prudent director would. 1. The court looks to see whether the directors thought the action was in the companys best interest. (ii) Subjective component look to intent too see if there is good faith. 1. 102(b)(7) protects against allegations that directors did not fulfill objective components, but carves out an exception for the subjective component. ALI 401(a): good faith (subjective requirement) and in a manner he or she reasonably believes is in the best interest of the corporation (objective requirement).

(i)

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XI. Transactions in Control: A. Sale of a control block (a portion large enough to give you control). i. Reasons for a Control Premium: a. Control is like an investment can replace current management, etc., to generate higher profits for the corporations. b. Control gives you a lot of power c. There might be an opportunity for looting (engaging in self interested transactions). d. Hobnobbing e. Pay a premium so that people will sell their shares. B. Sellers Duties: i. Zetlin v. Hanson Holdings, Inc (NY 1979): Z owned 2% of Gable Corporation and alleged that Hanson Holdings, Inc., a controlling shareholder, sold their interest for a premium. Z alleged that he was entitled to the premium because it is a corporate asset and so the value should be shared amongst all the shareholders instead of going to Hanson. a. Rule: The court held that shares can be sold at a premium, as long as done in good faith; doesnt have to share with the other shareholders. b. Sale of control is a market transaction that creates rights and duties among the parties, but does not confer rights on other shareholders. Therefore, if you are a corporate shareholder, can sell at whatever price and do not have to give any heed to shareholders. ii. Perlman v. Feldman (2d Cir. 1955): Feldman was the president, chairman of the board, and majority shareholder of Newport Steel. Newport had operated under the benefit of the Feldman Planwhich required purchasers of steel to advance the price of the steel before delivery (essentially an interest free loan). He sold his shares to Wilport, a syndicate of steel buyers, and procured the resignation of his own Board of Directors. a. Rule: The court held that the Feldman Plan was a corporate asset that belonged to all shareholders. In selling control, Feldman deprived the minority shareholders of the benefit of that asset and thus improperly appropriated it to himself. Burden of proving no breach of fiduciary duty is on the defendant. b. Since Wilport controlled Newport, it would not be paying above the regulated price and the interest free advances wouldnt occur. This is a very fact specific case. According to Easterbrook and Fischel, the value of the Feldman plan would already have been included in the share plan and people would have anticipated profits and the profits probably went up because Wilport put in better management, etc., not because there was looting. When youre selling control and receiving a premium for a corporate opportunity, it is wrong but the case is wrong here because the court assumed that because they were receiving a premium they were stealing a corporate opportunity (i) Loss of corporate opportunity only applies if you have a fiduciary duty to the company C. Sale of Corporate Office: i. In situations where controlling shareholders are on the board of directors and they sell their controlling block, there is often a provision in the sale that the controlling shareholder and his buddies will resign and so the buyer can come in and put his own friendly management in. Do fiduciary duties exist when selling corporate office? a. Normally it is a good thing that buyers of a control block are able to put in their directors because they will put in a new management scheme and this will be good for minority shareholders. If you are a controlling shareholder, then you can put this provision in absent any fiduciary duties, but if you are a director or officer/fiduciary it would be a breach of duty to sell some of your shares as well as resign. D. Looting: duty the law imposes to screen against selling control to a looter. i. Harris v. Carter (Del. 1990): Carter Group (controlling SH of Atlas) agreed to exchange Atlas stock for shares of stock held by Mascolo ISA and contemplated a later merger between ISA and Atlas. Carter group resigned from the board and Mascola loots the company. The P alleged that Carter group breached its fiduciary duty by not investigating ISA. a. Rule: The court held that a controlling shareholder has duty to a minority shareholder in situations where a reasonable person would suspect that buyer is not honest. If a controlling

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E.

shareholder has suspicions, he must do some reasonable investigation and if those suspicions are confirmed he cannot make the sale. To bring a duty a care claim here looting has to be foreseeable and there has to be some notice. (i) Easterbrook and Fischel: argue that should punish looters more because by putting duty on seller to investigate, this will discourage sale of control blocks and selling of control blocks are efficient. Tender Offers where an individual announces to the public generally that he is going to be acquiring shares for a certain price. Method to acquire control when control is in the market. i. Tender offers are regulated by the Securities Exchange Act. Before the Williams Act, there were Saturday Night Specials where the offeror would give 24 to 48 hours to sell and this pressured people into selling and small shareholders did not get to participate. ii. Williams act placed regulations on tender offers: a. If you own 5% or intend to acquire 5% of the shares, you have to announce what you intend to do with the corporation (file with the FCC). b. You have to keep the tender offer open for at least 20 days. R. 14e-1. c. Have to make tender offer open to everyone, cant say it is only open to certain people. d. There has to be a fixed price, no matter when the people accept e. Have to buy pro-rata shares (i.e. If you only want to buy 50%, but 75% want to tender, have to buy pro rata from everyone). Rule 14d-8. Under 14d-9: the target board of directors have a right to give an opinion (and should probably to fulfill their fiduciary duties) to shareholders about the tender offer. iii. Brascan Ltd. v. Edper Equities Ltd (NY 1979): a. Rule: Court applied 8 criteria provided by the SEC to determine whether there is a tender offer: 1) Active and widespread solicitation 2) The solicitation is made for a substantial percentage of issuer stock. 3) Premium over the prevailing market price 4) Terms of the offer are firm rather than negotiable. 5) Whether offer is contingent on the tender of a number of fixed shares 6) Whether the offer is open for a limited period of time 7) Whether offerees are subjected to pressure to sell the stock. 8) Whether public announcements of a purchasing program precede or accompany a rapid accumulation. iv. Hart Scott Rodino Act (WONT BE TESTED ON THIS): If there is a merger, there may be problems under antitrust law, so federal law requires that you file notice with antitrust authorities so they have the opportunity to block, but imposes a waiting period while they review the case.

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XII. Mergers and Acquisitions: A. Economic Motives for Mergers and Acquisitions:
i. Increase in efficiency potential decrease in production costs because lower fixed cost to produce goods. ii. M/As end competition and ensure that one group of shareholders is not duping another group of shareholders. iii. Net operating losses expire and if you dont have prospective future profits, wont get the benefit. Since net operating losses are not sellable, it provides an incentive to merge. iv. An opportunity to get rid of bad managers v. Decreases competition and increases market power which is good for shareholders but bad for society as a whole and therefore, might be blocked by antitrust laws. vi. Potential ego of the CEO (thinks he can master all trades) vii. Diversification protection against fluctuations a. This is a weak argument because shareholders can diversify their own portfolio. Types of Acquisitions: i. Asset Acquisitions: One company buys most or all of the assets of another corporation. a. A sale of substantially all the assets is a fundamental transaction for the selling company, which requires shareholder approval under all corporate law statutes. DGCL 271. b. Katz v. Bergman (Del 1981): P, a shareholder in Plant Industries, sued Bregman, CEO of Plant after Plant planned to sell off its Canadian subsidiary, which was its most profitable asset but only constituted 51% of the assets and less than half of the revenue. P wanted a shareholder vote before going through with the sale. Rule: Under 271 of the DGCL, if a corporation wants to sell all or substantially all of the assets, the corporation must go through a certain process: (i) Directors have to recommend the sale to the board, and the board has to agree. (ii) Shareholders have to then approve by a simple majority 1. Under 271(b), directors can still abandon sale after shareholder vote. The court held that 51% should constitute all or substantially all of the assets. (i) However, it seems like the court felt that it was unfair to the shareholders because there was another higher bid that the directors did not consider. c. Thorpe v. CERBCO (Del. 1996): the need for shareholder approval is to be measured not by the size of the sale alone, but also on the qualitative effect upon the corporation. Thus it is relevant to ask whether a transaction is out of the ordinary course and substantially affects the existence and purpose of the corporation. d. Hollinger Inc v. Hollinger International (Del. 2004): Substantially all does not equal approximately half. ii. Stock Acquisitions: Often, corporations will try and acquire 100% of the shares so that they can go private. a. Often through tender offer or acquisition of a block b. DGCL 253: In getting rid of a small minority of public shares outstanding, short form mergers allow a 90% stake holder to cash out a minority unilaterally. c. Minority shareholders still get an appraisal right (judicial review of the fairness of the price). iii. Mergers: legally collapses one corporation into another. In most states, a valid merger requires a majority vote by the outstanding stock. The default rule is that all classes of stock vote on a merger unless the certificate of incorporation states otherwise. a. A corporation considering a merger always has to get approval of the shareholders of the target corporation. Under DGCL 251, the voting stock of the surviving corporation is afforded voting rights on a merger except when: (i) The surviving corporations charter is not modified (no amendment to acquiring corporations charter). (ii) The security held by the surviving corporations shareholders will not be exchanged or modified (no change in the shares owned). (iii) The surviving corporations outstanding common stock will not be increased by more than 20% (wont be issuing more than 20% of total shares). DGCL 251(f).

B.

41

(i)

1. Mergers satisfying these requirements do not afford the surviving corp.s shareholders voting rights because there is too little impact on the shareholders to justify the delay and expense of a shareholder vote. When the acquiring corporation borrows a lot of money and then issues cash for a tender offer, shareholders do not need to vote because not implicate 251. Usually a sign that directors do not think that shareholders will vote for merger. b. Triangular Mergers: Acquiring parent company forms and owns 100% a subsidiary company that will be the acquirer. The acquiring subsidiary merges with the target corporation, which leaves the acquiring parent owning the surviving corporation. This preserves limited liability since the target is not the same corporation. Therefore, if the target defaults on its loans after the merger, creditors can not get to parent corporation. (i) If the target company is the surviving corporation, then this is a reverse triangular merger (ii) If the subsidiary is the surviving corporation, this is a forward triangular merger Reverse Triangular Merger The acquirer performs the subsidiary, subsidiary merges into target, can buy out remainder of the shareholders iv. Structuring the M & A Transaction: a. Timing: The fastest way to complete a transaction is an all cash tender offer. It can be consummated 20 days after commencement under the Williams Act. (i) In contrast, a merger requires shareholder voting of at least the target shareholders which involves the SEC in soliciting proxies. (ii) Furthermore, if there is any stock as part of the deal, then regardless of which transaction structure is used, the stock has to be registered with the SEC under rule 145. 1. Therefore, most deals using 100% stock consideration are structured as one step direct or triangular mergers. Representations and warranties facilitate due diligence by forcing the disclosure of the targets assets and liabilities. Deal protections and termination fees most important terms are often those that are designed to assure a prospective buyer that its investment in negotiating in good faith with a target will result in a closable transaction. b. Regulatory issues c. Contractual Promises and Warranties want to make sure that buyer is protected C. Appraisal Rights: i. What is it? a. A person goes to a court to have his shares valued so that he can get a fair price for them. ii. Why have it? a. Historically, shareholders of target corporations used to have to vote unanimously for the merger, but this made mergers difficult because of hold-outs. Eventually, the rule was switched to majority vote, but there was a concern that this might not protect minority shareholders. In order to address this concern, appraisal rights were created. Nowadays, appraisal rights are most often invoked either in nonpublicly traded firms or in transaction in which the shareholders have structural reasons to think that the merger consideration may not be fair value. However, where there is a controlling shareholder or some other reason to doubt that the shareholder vote fairly reflects the independent business judgment of a majority of disinterested public shareholders, then the remedy of appraisal rights are a way to assure that the minority shareholder is not at the mercy of a shareholder vote that is controlled. iii. If a shareholder dissents from a vote, he or she is afforded appraisal rights which afford the shareholder the right to go before a judge who reviews the merger to see if a fair price was given. iv. Delaware: appraisal rights can only be in a merger v. Shareholders are NOT afforded appraisal rights, notwithstanding the merger, if a. The target company is listed on a national stock exchange or there are more than 2000 shareholders. DGCL 262(b).

42

D.

These shareholders get appraisal rights unless the consideration is one of the following: (i) Stock of the surviving corporation (ii) Stock of another corporation that is publicly traded (iii) Or cash in lieu of fractional shares. 253 short form merger shareholders always get appraisal rights. b. Checklist: FIRST look at type of merger: long form v. short form, under a short form, you always get appraisal rights. SECOND look at quality of the target: public v. nonpublic. If the target is publicly traded, might not get an appraisal. THIRD look at consideration received: shares v. cash. With shares, you may not get an appraisal right. (i) Basically, if you are a shareholder of a publicly traded corporation, that is engaging in a long form merger that is giving shares as consideration, you WILL NOT get appraisal rights. vi. Corporations seeking to gain control via a tender offer shareholders that dont tender do not get appraisal rights. vii. Corporations seeking to gain control via asset acquisition while you might have voted in favor of this, you have just exchanged the underlying asset for cash, but the shares are still there so not vote. a. In order to avoid shareholder voting do either a tender offer, asset acquisition, or if you are a large public corporation, do a long form merger and give out shares. Duty of Loyalty in Controlled Mergers: i. What is the exercise of control that gives rise to a fiduciary duty of fairness on the controlling shareholders part? a. De facto power to do what other shareholders cannot do, such as the controlling shareholders power to access nonpublic information or influence the board to approve a transaction with another company in which the controller is financially interested. ii. Weinberger v. UOP, Inc. (Del. 1983): Signal purchased 51.5% of UOPs stock. Signal then decided to acquire the remaining outstanding stock of UOP stock through a cash-out merger. 2 conflicted board members (who were both on Signal and UOPs board) conducted a study using information they were privy to because of their position as directors and recommended a price up to which it would be worth it to conduct the merger. There werent really any negotiations and the merger was quickly approved. Plaintiff challenged the cashing-out of UOP's minority shareholders seeking appraisal rights and brought a duty of loyalty claim against UOP's directors. a. Rule: In regards to the appraisal rights, the court held that elements of future value known or susceptible of proof as of the date of the merger and not the product of speculation may be considered in the appraisal valuation The court expanded appraisal right before not allowed to look at value created by merger and but the court held that you must look at value created by merger b. The court held that where corporate action has been approved by an informed vote of a majority of minority shareholders, the burden entirely shifts to the plaintiff to show that the transaction was unfair to the minority. Where there is a controlling shareholder, the standard applied by the court is the ENTIRE FAIRNESS standard, which means that the merger must be fair in both price and process. c. The court held that the vote wasn't informed and that there were conflicting duties because of the similar directors in both target and acquiring companies. The court felt that since the two directors used UOP information to conduct a feasibility study, this information was acquired via a breach of fiduciary duty. d. Breached 1) Controlling directors used information from the target holders should have disclosed the feasibility study 2) Perception by the court that there was not an arm lengths transaction e. Court suggested that next time doing this, have an independent committee of targets it wont include directors that have an allegiance to the acquiring company

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f. Remedy: normally it would be a disgorgement of the profits BUT HERE the court used the appraisal remedy but its going to be a turbo charged one because there was a breach of the duty of loyalty How was it enhanced? (i) 262(h): when youre figuring out how much money a shareholder should get from an appraisal right, youre supposed to remove any extra wealth from the transaction 1. Dont want to give them value or it gets rid of the incentive of doing the deal in the first place iii. What Constitutes Control and Exercise of Control: a. Basically, a controlling shareholder who sets the terms of a transaction and effectuates it through his control of the board has a duty to pay a fair price. To see if a shareholder is controlling, have to determine his ability to control. b. Kahn v. Lynch (Del. 1994): Alactel owned 43% of Lynch and there was an agreement between the two companies that Alactel had an absolute right of veto in the company. Lynch wanted to buy a certain company, but Alactel vetoed this and wanted them to buy a company affiliated with Alactel. Lynchs independent committee rejected buying the corporation and Alactel decided it wanted to buy out Lynch. Lynchs independent committee felt that the price offered by Alactel was inadequate but eventually agreed to the agreement after Alactel offered a final price and threatened Lynch that if it did not accept, it would bring a hostile tender offer and offer a lower price. P brought a suit alleging breach of fiduciary duty. Rule: Court held that Alactel was a controlling shareholder because while it did not own 50%, Alactel negotiated the ability to veto decisions as well as had directors on the board. Since Alactel was a controlling shareholder, the standard was entire fairness and since Alactel was on both sides of the deal, the controlling shareholder has the burden of proof. (i) In order to shift the burden to the plaintiff, Alactel attempted to argue that the since Lynchs independent committee negotiated the deal the safe harbor applied since because the process was followed. 1. However, the court did not apply the safe harbor because the independent committee was ineffective since the controlling shareholder could dictate the terms of the agreement and the independent committee did not have an actual bargaining power because of Alactels threat. a. Lynchs independent committee could have said no to the transaction and let Alactel engage in the tender offer and in its obligation to inform shareholders, could have not recommended the tender offer. (ii) To see if the process was actually followed, make sure that controlling shareholder can not dictate the terms and the independent committee had actual bargaining power. 1. Basically, cannot make threats. (iii) Burden could have shifted to plaintiff if there would have been approval of minority shareholders. iv. Controlling Shareholder Fiduciary Duty on the First Step of a Two step Tender Offer: a. While a shareholder has a duty under both corporate law and federal securities law to disclose all material information respecting the offer, there is not duty to pay a fair price. As long as a tender offer is not coercive, entering into such a transaction is voluntary on the part of minority shareholders and if these shareholders do not like the price, they can remain shareholders and force the controller to cash them out, under which they will still have appraisal rights. b. In re Pure Resources (Del. 2002): Unocal owns 65% of Pure, directors some, public rest; Unocal springs a tender offer for the remaining shares. Pure did not put a poison pill in place but created an independent committee and hired an investment bank. Pure tried to negotiate for a higher price and the IC recommended not to tender the shares. Unocal went through with the tender offer and a preliminary injunction was sought. P alleged that the details of the investment bank report werent given and that the structure of the tender offer was coercive since the controlling shareholder was on both sides of the transaction. (i) Rule: The court found that the standard was NOT entire fairness because the transaction was between Unocal and the owners of the outstanding shares, so Unocal wasnt really on both sides. As long as shareholders have all the information, they should be able to make their own decision. (ii) As long as tender offer isnt structurally coercive then do not have to show entire fairness.

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1. for a parent tender-offer to not be coercive, the offer must be (1) subject to a
majority of minority tender condition (2) include a promise to engage in a prompt back-end merger at the same price as the tender offer and (3) not involve retributive threats (4) give time to board to review the price (full disclosure). a. If a majority of the minority shareholders tender, then the burden shifts to the Plaintiff. (iii) The court found that the offer was coercive because Unocals definition of minority included interested members of Pure and therefore would not be a correct majority of the minority vote. c. Should the independent committee be able to put a poison pill? If someone acquires a certain amount of the company without consent, then all the other shareholders get extra shares at a discount to dilute the guy thats trying to acquire the company (i) Triggered unless the board of directors votes to waive it

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XIII. Public Contests for Control:

A. Traditionally, contests for control were carried out in proxy fights and tender offers. However, contests for control began to rise with M & A transactions i. Cheff v. Mathes (Del. 1971): can deal selectively with your shareholders, as long as primary purpose isnt entrenchment purposes. ii. Defending against Hostile Tender Offers: a. Unocal Corp. v. Mesa Petroleum Co. (Del 1985): Mesa, the owner of approximately 13% of Unocal's stock, commenced a two-tiered hostile tender offer. The first tier was a cash offer of $54 per share for 64 million shares, which would give Mesa an additional 37% of the company's stock. The second tier, or "back-end," was designed to eliminate the remaining publicly held shares through the issuance of debt securities, which were essentially junk bonds. The Unocal board then met with investment bankers and counsel, who provided the board with the opinion that the Mesa offer was inadequate. As a defensive measure, it was suggested that Unocal pursue a self-tender, which excluded Mesa, to provide shareholders with a fairly priced alternative to the Mesa proposal, which would be triggered if Mesa acquired 50% of the shares. Mesa challenged the legality of its exclusion from Unocal's self-tender. Rule: When evaluating defensive measures a board has undertaken in response to a hostile takeover, the directors must satisfy a two-pronged threshold for their actions to fall within the ambit of the business judgment rule: (i) That they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed because of another person's stock ownership; and (ii) That the defensive measure was reasonable in relation to the threat posed. 1. Essentially, a court has to find that there is a real threat, and the defensive measure has to be a proportionate response. a. Threats do not include plant closings and layoffs because this does not affect shareholders. (iii) In this case, the court found that the Unocal board satisfied both elements. a. Mesa could have still shown that there was another breach of fiduciary duty, just not that the defensive tactic was a breach of fiduciary duty. As a specific matter, cant selectively tender anymore. SEC issues a rule 13e-4 that holds that a corporation cant make a tender offer unless it is offered to all shareholders. b. Private Law Innovation: the Poison Pill Two types: flip over (almost never used) and flip in (i) Problem with flip over: someone could get a controlling interest and hold onto it until the next election Moran v. Household International, Inc. (Del. 1985): Moran proposed to take over Household, a conglomerate, through a leveraged buy out and would subsequently pay back the debt by busting up Household, essentially selling out the different entities of Household. Households attorneys came up with a shareholders rights plan a poison pill. In this case, the type of pill was a flip over plan. (i) There were two triggering events when someone made a tender offer for 30% or any single entity acquired 20% of the company. In the event that one of them happened, the right to purchase shares of the acquiring corporation in a subsequent merger at half price (a call option deeply in the money) invested in the shareholders. Furthermore, the corporation triggering the pill would be unable to participate in the rights plan. 1. This discourages a hostile takeover because once a corporation acquires the target, shareholders are able to buy into the acquiring corporation and the other shareholders shares are diluted. 2. Rule: The court held that DGCL 157(a) allows a corporation to issue rights/options to buy shares of its own stock but doesnt say you cant do this for another corporations stock, and therefore, the shareholders rights plan is allowed. Furthermore, the options were not a sham because they could be exercised in their untriggered state, even though this was an anomaly. a. Lastly, the defensive measure was proportionate to the threat because it prevented a potential bust up and therefore harm to the shareholders.

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(ii) Flip in pill shareholders can buy shares of the target corporation before the merger
is effectuated if certain triggering events occur. c. Unitrin v. American General Corp. (Del. 1995): American General Corp tendered an offer for a controlling block of shares of Unitrin. The Board of Directors of Unitrin, who held 23% of the shares, did not think the price offered was adequate and so initiated a poison pill and offered a buyback to increase their holdings to 28% of the total shares. This was important because certain transactions require a super majority and this would not be acquired here and a change in control would be precluded Rule: The court held that while the poison pill was in proportion to the threat, the buy back was not because the threat was only mild. (i) A defensive measure is NOT proportionate if it is draconian preclusive or coercive. d. Defensive measures are allowed and will be analyzed under the business judgment rule if there is a threat and the response is proportional. A response will not be proportional if it is preclusive or coercive. (i) If the response is not proportional, then we move into entire fairness. However, if directors can show that the defensive tactic was within the range of reasonableness, the burden shifts to the plaintiff under the business judgment rule. Choosing a Merger or Buyout Partner: addressing the boards fiduciary duties in arranging for the sale of the corporation. a. Smith v. Van Gorkom (Del. 1985): VG was the CEO and a director of Trans Union and almost unilaterally negotiated a merger agreement with Pritzker. The board did not negotiate the merger agreement, but merely acquiesced to a draft version and did not see the final one that had changed. Conditions on the agreement Trans Union could not aid any other bidders and there had to be a signed merger agreement with another bidder before the deadline in order for Trans Union to opt out. Ps alleged that the directors werent fully informed and therefore could not go through the proper procedure to get the benefit of the business judgment rule. Rule: The Ds were found guilty of breaching the duty of care because were not fully informed. (i) While the Ds were found guilty of the duty of care, there is also a duty of loyalty issue because there might have been an entrenchment issue. Here, there was no entrenchment however so had to look at duty of care. b. Revlon, Inc v. Macandrews and Forbes Holdings, Inc. (Del. 1986): Pantry Pride made a hostile tender offer for Revlon at $45 per share, which the board considered grossly inadequate. In response to the tender offer, Revlon adopted a poison pill plan and made a selftender offer for over 33% of its outstanding shares by issuing notes that shareholders would exchange their shares for. Pantry Pride increased its offer for Revlon and Revlon responded by entering into a leveraged buyout with Forstmann Little. However, as part of the leveraged buyout, Revlon granted Forstmann a lock-up option to purchase the rest of Revlons assets at a deeply discounted price if anyone acquired more than 40% of the shares. The lock-up option prevented other firms from bidding on the company's assets. Rule: Under Unocal, there has to be a threat to the company. Here the court found that there was not a threat because PP was offering a higher price than Forstmann and while there was a threat of a bust up, it did not matter here because Revlon signed a deal with Forstmann that essentially made a bust up inevitable. Revlon argued that the Pantry Pride deal was inadequate because it did not preserve the rights of the note holders like the Forstmann deal. However, the court said that there was no practical difference between the two offers in terms of the note holders. (i) The court held that the directors could not have duties to the note holders where it would detriment the shareholders. Furthermore, since the threat was inevitable, had to get the best possible deal for the shareholders. (ii) A lock-up, or no-shop provision, while not per se illegal, is impermissible under the Unocal standards when a board's primary duty becomes that of an auctioneer responsible for selling the company to the highest bidder. (iii) The court held that "Favoritism for a white knight to the total exclusion of a hostile bidder might be justifiable when the latter's offer adversely affects shareholder interests, but when bidders make relatively similar offers, or dissolution of the company becomes inevitable, the directors cannot fulfill their enhanced Unocal duties

iii.

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c.

d.

e.

by playing favorites with the contending factions. Market forces must be allowed to operate freely to bring the target's shareholders the best price available for their equity." (iv) When a bust up is inevitable, the directors have a heightened duty (not just a Unocal analysis) the only legitimate purpose is to have an auction so the shareholders can have the highest possible price Bust-up: a leveraged buyout in which the acquirer sells some of the assets of the target company in order to repay the debt used to finance the takeover. Paramount Communications, Inc. v. Time, Inc (Del. 1989): strategic stock-for-stock merger between Time and Warner; Paramount comes in and offers $175/share for Time. Time rejected the deal because of the strategic goals between Time and Warner and get an investment bank who claims that Time is worth $250. Time and Warner decide that instead of a stock-for-stock deal that requires shareholder approval, theyll do a two-step tender offer by Time for Warner, then a merger. Under DGCL 251(c)(f) do not have to get a shareholder vote if more than 20% new shares are not issued and since here, there was no amendment to the articles, no stock being issued, by doing a cash offer dont have to get the approval of Times shareholders. Paramount increased its price and then sought to enjoin the merger. Plaintiffs argued that since the threat was going to be inevitable, Time had a duty to get the shareholders the highest price. Defendants argued that the threat in this situation was that the future value to the shareholders would be harmed because of the synergies arising out of a combined gain and given that shareholders do not have as much information as managers about what the company will be worth, shareholders do not know what is best for them. Paramount was attempting to confuse the shareholders. (i) Rule: The court held that Revlon duties werent triggered because there was no bust up contemplated by the company. Revlon duties are triggered if the initial deal is going to be a bust up/the company puts itself up for sale or as a defensive tactic management contemplates a bust up. 1. Court then proceeded to the Unocal duties: a. The court found that there was a threat because selling to Paramount would destroy the synergies. b. Is the response proportionate? The court found that the response was proportionate because Paramount could still go through and buy Time-Warner. Paramount v. QVC (Del. 1994): Paramount and Viacom were going to merge. In the agreement, Viacom demanded a no-shop provision, termination fee ($100 million), and a stock option agreement in which V could pay with notes or demand cash difference. After agreement was announced, QVC announced tender offer for 51% of Ps shares which was $10 higher than Vs offer. Even though P was in a much better bargaining position when V came to negotiate new terms, the board did nothing to get rid of the more noxious terms of the merger agreement with V. Ps board refused to negotiate with QVC, claiming the no-shop provision in its agreement with V prevented such talks. After another round of raises, the P board met to discuss QVCs offer. The only document circulated was one summarizing the conditions and uncertainties of the QVC offer which gave a very negative impression. The Paramount Board determined that the QVC offer was not in the best interests of its stockholders. QVC brought suit. Rule: The court held that Revlon was implicated because while there was not a bust up of the company contemplated, here Viacom had a controlling shareholder, whereas in Paramount, control was in the market. If the merger would go through, Paramount shareholders would lose any ability to exercise control because it would be in the controlling shareholder therefore, the synergies argument cant work because the controlling shareholder can defeat these synergies. (i) Furthermore, a control premium was going to be paid and this creates a heightened possibility that management isnt going to protect shareholders. Therefore, the board had the obligation to get the best possible deal for the shareholders under entire fairness analysis. Here, the court felt that it was not the best possible deal. Situations when Revlon duties would arise: Merger between a corporation where control is in the public that is going to be merged into a corporation with a controlling shareholder. (Paramount v. QVC).

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iv.

All cash offer on the front end and back end the board is no longer accountable to the shareholders that get cashed out and since shareholders will not get the benefit of the synergies then Revlon duties are triggered and board has to obtain best possible deal for shareholders. (i) It is more difficult to analyze where there is a deal for cash and shares have to determine which is more important the cash or the shares. 1. Therefore, in Time-Warner, while Time did not have a duty, Warner had a duty to get the best possible value for its shareholders since its shareholders were being cashed out. Sale of a company that has a controlling shareholder to another company that has a controlling shareholder. (i) If it is seen through the idea of synergies, then Revlon duties should be triggered because the controlling shareholder can still do whatever he wants. (ii) Control premium since the control premium was already paid to the minority shareholders to put the controlling shareholder in place, the minority shareholders have already been compensated. Whale/minnow transaction merger between a very small corporation and a very large one because The core problem is that the minnows shareholders will receive only a small fraction of any hidden value that arises from the minnows stand-alone value or minnowwhale synergy. Their share of that value will be diluted by the whales other shareholders. If the merger consideration is a mix of stock and cash the closer it gets to cash, the closer you get to cash, the closer you are to Revlon because its more like selling control since you have a diluted interest in the combined company. f. Under Revlon duties, directors may not use defensive tactics that destroy the auction process between two bidders. If there is only one bidder, board must engage in a market check to see if a higher bid is available, unless the directors possess a body of reliable evidence with which to evaluate the fairness of a transaction. Protecting the Deal: a. The standard way to lock up a deal nowadays is a termination fee. Also, exclusivity provisions, where during certain periods, target companys directors can not talk to someone else while negotiating with the primary suitor usually these provisions have fiduciary out clauses. Termination fees: (i) Reasons for: 1. Bad reason easy to facilitate entrenchment of the board 2. Reimburse the first bidder for incurring the transaction costs of initiating the merger such as research want to encourage this. This will justify a fee of around 3-4% of the deal. Can not do a preclusive termination fee under this justification. 3. Want to entice the first bidder to transact with you/trying to protect the deal for synergies but the question of how large a termination fee this will allow is questionable. (ii) Have to analyze lock up provisions such as termination fees in relation to Revlon and Unocal standards. If Revlon is implicated, then a termination fee above 3-4% will be disallowed because the synergies argument is not available. b. Omnicare v. NCS (Del. 2003): NCS was close to insolvency and was not receiving favorable terms from Omnicare and so sought to create a merger between itself and Genesis. Genesis demanded a no shop provision and began negotiating for favorable terms with NCS. Omnicare came in and made an offer. NCS felt that its no shop provision would not allow it to speak with Omnicare and Genesis eventually increased its bid, but with an ultimatum that NCS had to accept or the deal would fall through. Genesis also asked the two controlling shareholders (who were also two of the four directors) to commit their shares in advance. Also, NCS had to put the merger agreement to the shareholders even if they did not recommend the offer. NCS agreed to merge with Genesis and Omnicare sued and made a tender offer. NCS met with Omnicare and decides not to endorse the Genesis deal, but this was illusory because the shares were already committed. Rule: Court did not even get to Revlon duties, but held that the lock up provisions in the NCS Genesis deal were improper under Unocal/Unitrin review (framework for defensive measures) because the defensive measures were preclusive and coercive. The court felt that the fact that the 2 directors promised to vote their shares in favor was a fate complete

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B.

(fait accompli) because there was going to be a vote and the vote was going to be for the merger. Furthermore, there was no fiduciary out clause. (i) The dissent felt that there was no clear entrenchment purpose and enhanced scrutiny under Unocal is applied because of director self dealing and therefore there should not have been enhanced scrutiny here. The merger agreement was preclusive only to the extent that the shareholders said it was a good deal. Preclusiveness normally applies when directors are forcing an agreement upon shareholders but here, shareholders agreed themselves. Also, under DGCL 251 directors are permitted to submit a deal to the shareholders for a vote even when the directors do not recommend it. 1. Unocal has cases where the board is trying to entrench itself but that doesnt exist there no implication trying to save their jobs 2. Why duty of loyalty analysis when there is only a duty of care Why did the result come out the way it did? (i) The result may have come out like this because of the two-class structure of shares, where one class had all the voting rights while the other class had all the equity. Here, the two shareholders had more voting power than was proportionate to their share in the equity. (ii) DE courts do not like threats or ultimatums (Kahn v. Lynch). Here, since the company was close to insolvency, the ultimatum looked predatory to issue given that if NCS did not go through, it would be on the verge of bankruptcy the board may have been more susceptible to threats. (iii) Courts have required that there be a fiduciary out clause if there is a no shop provision. While NCS did negotiate a waiver this was an empty out because the directors/shareholders were already voting in favor of the merger and therefore, their hands were effectively tied. State Antitakeover Statues: i. 1st Generation Statutes: 60s were the first wave of hostile takeovers and the Williams Act was the first reaction to this. The states started to respond around the 70s. a. For example, in Illinois, management was afforded 20 days where it, and only it, could communicate to shareholders about the tender offer. Management could also delay a tender offer by holding a public meeting where the secretary of state would look at the fairness of the price etc. This statute was preempted by the Supreme Court through the Williams Act. ii. Second Generation Statutes: fair price statutes which required minority shareholders who were frozen out during the second tier of a takeover to receive the same price as individuals who tendered in the first tier. Also, control share statutes that required disinterested shareholder vote to approve the purchase of shares by any person crossing certain levels of share ownership. a. The Supreme Court in CTS Corp v. Dynamics Corp upheld a statute calling for giving the same consideration at the back end as with the front end if doing a cash out merger. iii. 3rd Generation Statutes DGCL 203: a. Prohibits a business combination (As defined in the statute) for at least 3 years with an interested shareholder unless certain exceptions are met. Who is an interested shareholder? (i) You become an interested shareholder if you acquire more than 15% of the shares without consent of the board. If directors approve initial transaction of 15%, then statute doesnt apply. (ii) Once you get 15%, then the statute applies and you are not allowed to merge or liquidate for 3 years. 1. This does not apply if you acquire 85% of the shares then can conduct business combinations. However, have to acquire 85% in one transaction (have to basically jump from less than 15% to 85%). a. If you hit 85%, can still merge if you get board of directors to approve or you get shareholders approval (however, this is 2/3 of ALL shareholders, so if 2/3 dont show up, this can create a hold up problem). i. Problem with this statute is that a small group of shareholders can hold up a corporation and directors are given another method to block a merger. (iii) However, this statute requires you to negotiate with management, which you would have to do anyways because there are poison pills put in place often triggered with 10% acquisition.

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(iv) Corporations can also opt out of the statute. 203(b)(1). Under 203(b)(3), can opt
out by a by law, but this by law cannot be amended unilaterally by the board of directors. (v) Exceptions: 1. Prior Board approval 2. If the Transaction results in ownership of that person by 85% of the statute, then it doesnt apply 3. Once you become an interested shareholder, you get board approval for a combination and 2/3 of other shareholders to vote in favor of it b. There is an Indiana statute that effectively overrules Revlon (which holds that you can only consider shareholders). This allows you to consider anyone you want. Proxy Contests for Corporate Control: one way to displace management is through the hostile option of running both a proxy contest and a tender offer simultaneously. Target board can engage in different defensive measures to prevent an insurgent from gathering enough supports to oust the current board. i. Schnell v. Chris Craft Industries, Inc. (Del. 1971): management tried to advance the date of the shareholders meeting, therefore making it difficult for a bidder to compile proxy statements. (Under DE law, a corporation under its charter can advance the meeting). a. Rule: The DE court held that while a corporation can move up a shareholder meeting, in this situation, the directors had the motive of entrenching themselves in office and directors can not move up shareholder meetings for improper purposes. ii. Courts generally find that defensive measures taken to prevent a vote are not allowed (as opposed to defensive measures taken to prevent a hostile takeover) because the foundational right that shareholders have is the right to vote and if they dont have this, they have nothing. a. This is often the argument even though shareholder votes are sometimes illusory. b. Courts give higher protection to non-economic rather than economic rights. iii. Blasius Industries v. Atlas Corp. (Del. 1988): Blasius, a 9% shareholder, tried to trigger a proxy fight with the future intention to bust up Atlas. Blasius wanted to increase the directors from 7 to 15 and then putting in 8 friendly directors. Atlas came in and increased the board to 9, putting in 2 directors friendly to them. Essentially, Atlas prevented Blasius from taking control of the board. a. Rule: The motive here could have been entrenchment and then there would be a duty of loyalty problem, but according to Chancellor Allen, the motive here might have been benign and pro shareholder because shareholders might have received less value for their shares because of the bust up. However, the board still lost because prevented the shareholders from voting for the directors. Allen analogized the shareholders and directors to principals and agents. Since principal has the last say, he can fire the agent and here directors could not dominate the shareholders. Dead Hand Pills: these pills entail that after a takeover, the new directors can not pull the poison pill unless the incumbent board decides to or a board appointed by the original board decides to. This was found to be excessive. i. Slow hand pills: hold that can not pull pill until 6 months after the takeover this has not yet found to be a reasonable defensive measure. Mandatory Pill Redemption Measures by Shareholders: i. Unisuper v. News Corp. (Del. 2005): There is a contract between directors and institutional shareholders that hold that a poison pill will be in place for a year, and if the board wants to extend it, shareholders have to approve of the extension. However, there was a hostile takeover and the directors extend the poison pill without shareholder approval. a. The directors tried to argue that the contract was unenforceable because under 141(a) board of directors have all the power except as granted in the charter, here the limitation wasnt in the charter, but in a contract. Rule: The court held that this was a principal agent relationship and the principal should be able to limit his agent by contract. According to Squire, this is a problematic argument because 141(a) contemplates that principals can limit the power of agents, but has to be in the charter. Here the board signed a contract with a few shareholders not all and this contract changes the relationship between the board and ALL the shareholders.

C.

D.

E.

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b. The directors also cite the Revlon line of cases to show that when there is a limitation of fiduciary duties, have to have a fiduciary out. However, the court said that those cases were about entrenchment and here, the contract was not about entrenchment, but rather it makes entrenchment more difficult.

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XIV. Insider Trading A. Introduction: i. With trusts, a trustee can deal with the beneficiary directly, but there has to be full disclosure and substantive fairness essentially have to disclose the material facts. ii. Common Law Fraud: requires 5 elements: a. False statement of b. Material fact c. Made with the Intent to deceive d. Upon which one reasonably relied and which e. Caused injury. B. Goodwin v. Agassiz (MA Supreme Court 1933): Ds are officers of a corporation and they buy shares of the corporation with knowledge that the company had found substantial copper deposits on land they owned and no one else had this information. When the information became public, the Ds sold their shares (at the time they bought the shares, the shares were undervalued because did not take these copper deposits into account). i. Rule: The court found that there was no duty to disclose to the public because directors are trustees to the corporation as a whole not to the individual shareholders and their shares and therefore, directors can trade on corporate information. When shareholder and director are interacting with respect to shares of the corporation, it is not really about the property in the trust. a. The court felt that it would be to the shareholders disadvantage anyways to have disclosed the information because it would have made securing the land more difficult. Furthermore the corporation was not harmed because it did not lose any of its profits. Essentially, insiders can trade, but only on an impersonal market, cant trade in face-to-face interactions. ii. However, if the shareholders and director interacted in a face to face interaction, the shareholder could show reliance and therefore there would need to be disclosure. However, with a stock market, there is no real reliance because the shareholder is dealing with a faceless opposite side. C. State fiduciary duty law continues to play an important role: i. A corporation can bring a claim against an officer, director, or employee for profits made by using information learned in connection with his corporate duties (see Freeman v. Decio (7th Cir. 1978)). ii. SH can invoke state fiduciary duty to challenge the quality of disclosure that their corporation makes to them. a. DE has gradually articulated a boards duty to provide candid and complete disclosure to shareholders in a serious of opinions. However, failure to disclose a material fact is unlikely to give rise to liability unless this failure represented intent to mislead. iii. Bring a state law insider trading claim when there is a corporation not on a public stock exchange. a. Ex.: In a closed corporation, one of the shareholders has information the other shareholder does not and goes to another shareholder to buy his stock and doesnt disclose the information. The shareholder who sold can sue under state law for insider trading. D. Freeman v. Decio (7th Cir. 1978): A derivative suit against an Indiana corporation, applying Indiana law. The company was doing great and then there was a precipitous drop in the stock and while the stock was dropping, the directors were selling shares because they knew that the companys shares were inflated. i. Rule: The court looked to NY Court of Appeals case in Diamond which holds that insider trading occurs if you have material nonpublic information and you trade on this have breached a fiduciary duty. The court also cited a DE case Brophy v. Cities that held that since the employee in question occupied a position of trust and confidence to his employer, and public policy would not permit him to abuse that relation for his own profit, a suit against the employer was permitted. a. However, the court felt that IN would not apply this law because in the Diamond case the court analogized inside information to a corporate asset and therefore the corporate opportunity doctrine applied. With the corporate opportunity doctrine, need an injury to the corporation and here, since there was no harm, there was no loss of corporate opportunity.

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Therefore, insider trading is only a breach if there is any potential loss to the corporation from the use of such information. b. The court recognized that while permitting this might be unfair, it is sometimes efficient to permit inside information because the information is reflected in the price of the shares and it will signal to outside investors. c. The court also did not want to extend federal law to overlap state law. ii. For our purposes, look to DE and NY law in which insider trading is ILLEGAL. E. Exchange Act Rule 16 and 16(b): i. Rule 16(a): insiders (officers, directors and owners of more than 10% of shares) have to file public reports with the SEC within 2 days, if they have traded in the corporations shares regardless of why the insider traded. ii. Rule 16(b): Short Swing Sale Rule: insiders have to disgorge any profit made from an actionable event. An actionable event includes buying and then selling, or selling and then buying within 6 months. a. An insider flipping the stock quickly is inherently suspicious. F. Exchange Rule 10: i. Rule 10b: cannot engage in fraud when buying or selling a share, and the SEC will define fraud. a. Rule 10b-5: Rule 10b-5(a): Can not employ any device, scheme, or artifice to defraud Rule 10b-5(b): Can not make an untrue statement or omit to state a material fact in order to make the statements made not misleading (i) This applies to omissions that occur when affirmative statements are actually made. Cant selectively make statements have to include all material facts. Rule 10b-5(c): cannot engage in any act, practice, etc which operates as a fraud or deceit in connection with a purchase. ii. Elements of a 10b-5 Claim: a. False of Misleading Statement or Omission: SEC v. Texas Gulf Sulphur (2d Cir. 1968): Certain directors had inside information about potentially lucrative ore findings. The insiders bought options and shares before the information was disclosed to the public. Under most state law and fiduciary duty causes of action, shareholders would win (Diamond), under Indiana, directors would win (Freeman). However, this is brought under 10b-5. (i) Rule: According to the 2d Cir., Rule 10b-5 is supposed to provide a cause of action for insider trading as all investors do not have access to all information. 1. Equal Access to Inside Information: all investors should have equal access to relevant information. a. According to the 2d Cir., since insiders inherently have more information, insiders can not trade on shares and if they wish to trade, have to disclose all the relevant information. This is done to equalize the information disparity. b. If do have this information, you need to DISCLOSE or REFRAIN/OBSTAIN from trading c. Squire Hypos: i. A director calls his friend and doesnt disclose any information, but tells him to buy a certain stock the buddy loses because he has more information than other shareholders. ii. A director leaves important information on the plane, a flight attendant sees it and buys the stock and is sued on 10b-5. According to the 2d Cir., she would lose because she has greater knowledge than other shareholders. (ii) In this case, the directors failed to state material facts that caused misleading statements the press release said that the discovery was speculative, and while it wasnt really certain, the tone of the press release was to dampen the excitement, while the mood of the directors was one of excitement. (iii) SECs Revenge: Rule 14e-3: if you know you have insider information, you cant trade on it!!! 1. Doesnt apply outside of the tender offer context (see below) Fiduciary Duty Theory:

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(i)

Chiarella v. US (1980): Chiarella was a worker in a financial printer and found out about a tender offer before it was going to happen and bought stocks of the target corporation and made 30,000 in 14 months. Under the equal access theory of liability of the 2d cir., Chiarella had unequal access and he did not come to the information honestly and was convicted. 1. Rule: The Supreme Court overturned his conviction. Under the fiduciary duties of common law, only have a duty to disclose when there is a fiduciary relationship (normally officers and directors). (This is the interpretation of fraud that the Supreme Court chose, can also see the interpretation where if you make an affirmative statement have to disclose all material facts). 2. Therefore, Chiarella could not be convicted because he was not a fiduciary and did not have a relationship with any of the other shareholders. a. The dissent noted that Chiarella did something wrong with respect to his employer/client. He misappropriated the information and this is like fraud because he deceived them. 3. The Supreme Court essentially rejected the equal access theory and adopted the fiduciary duty theory essentially the Diamond rule in NY that if you are an insider, cant trade. (ii) Dirks v. SEC (1983): Dirks was an investment advisor with expertise on stocks in insurance companies. Dirks received information from Seacrest who was a former insider in an insurance company that shares of the company, Equity, were overvalued because Equity was engaging in massive fraud. Dirks informed the WSJ and his clients, while he did not advise them to sell. People started selling, the price went down, trading was suspended and an investigation was conducted. The SEC argued that he violated 10b-5 and he was censured. 1. Rule: The Supreme Court recognizes tipper/tippee liability can exist. (Dirk's was not the ultimate tippee, but his clients who trade). 2. In order to be liable under tipper/tippee liability, the insider who tipped off the tippee has to breach his fiduciary duty and the tippee has to know or should have known that the insider was breaching a fiduciary duty. The tippee essentially has to disclose or abstain from trading because of his taint. a. The Court found that there was no tippee liability in this case because the Court looked to the actual intent of the tipper. To breach a fiduciary duty, the tipper has to benefit or intend to benefit somehow harm the shareholders and here he did not. i. This depends on how you view the harm to the shareholders can argue that shareholders were harmed because the share decreased tremendously or can argue that shareholders were going to get harmed anyways and shouldnt fault the individual that warned. Supreme Court equated benefit with intent therefore suggesting that if you get a benefit, there is a presumption that you had a bad intent and therefore presume a duty was breached. b. Since there was no passage of taint from the tipper to the tippee, no liability. 3. Blackmun Dissent: there can be doubt that Seacrest traded on this info, and he would have been breaching a fiduciary duty so why is it different if he gives it to Dirks who uses it? a. How is he breaching his fiduciary duty to CURRENT shareholders if hes selling to FUTURE shareholders? i. Squire thinks that when we think of insider trading, they theory we use is not fiduciary duty only to those trading you are breaching your duty to current shareholder because its a secret profit (iii) Tippees can create a chain of liability, if the breach of trust and confidence is passed down the line. SECs Response: (i) 14e-3: if any person has taken a substantial step, or steps to commence, a tender offer, it shall constitute a fraudulent, deceptive, or manipulative act or practice for any other person who is in possession of material information relating to such tender offer which information he knows or has reason to know is nonpublic and which he knows or has reason to know has been acquired directly or indirectly from

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1. the offering person, 2. the issuer of the securities sought or to be sought by the tender offer or 3. any officer, director, partner, or employee acting on behalf of the offering person or such issuer a. to buy or sell securities or options unless within a reasonable time prior to any purchase or sale such information and source are publicly disclosed. 4. Basically, if there are substantial steps towards completion of a tender offer, an individual finds out about this through an insider at the tender offeror, and trades on this without public disclosure have breached 14e-3. a. This was trying to make Chiarella irrelevant. (ii) Regulation Fair Disclosure (FD): if you are an insider and revealing insider information to certain analysts, have to make a public statement simultaneously. 1. One interpretation is that this overrules Dirks. a. 243(100): was Seacrest acting on its behalf? (iii) Is giving information to preferred analysts a breach of fiduciary duty? there is something suspect about giving this information to preferred individuals, but courts were finding it difficult to find a breach and this regulation gave a cause of action. The Misappropriation Theory: anyone who misappropriates information from a source, knowing that this information is not meant to be traded upon, and trades on that information, in any stock (not just the employers stock) is guilty of insider trading. (i) The theory behind misappropriation is that you are committing a fraud upon the individual from whom you got the information because there is a relationship of trust and confidence. 1. Ex.: If you get information from a friend at the patent office that a patent will be approved and you subsequently tell your board of directors in good faith, cant say that you misappropriated the information if you use this information in good faith because you break the chain of taint. (ii) To establish liability, have to show that the individual communicated material nonpublic information, with scienter, in violation of a fiduciary duty owed to the source of the information. Must also show that individual engaged in a manipulative or deceptive device, and that he or she did so in connection with the purchase or sale of any security. (iii) United States v. OHagan (1997): A law firm is hired by a company that is intending to engage in a tender offer. One of the partners, who wasnt working on the matter but had knowledge, bought shares of the target company and made a lot of money. 1. SEC was able to win on the 14e-3 claim. 2. Rule: The Supreme Court embraces the misappropriation theory and finds Hogan liable because the bidder did not want anyone to use the information and OHagan got this information and traded on it. a. A problem with this case is that you would have to find that OHagan had to disclose to the acquirer, because that is who he had the duty to. (iv) United States v. Chestman (2d Cir. 1991): Chestman is Keith Loeb's stockbroker. Keith is married to Susan, who is related to the Walbaum's. Ira Walbaum is the president and controlling shareholder, who tells his sister Shirley about a tender offer and tells her not to tell anyone, but she tells her daughter and she tells her daughter not to tell anyone but Keith. Susan tells Keith and says don't tell anyone, but Keith calls Chestman for advice. Chestman says he can't tell Keith what to do, but Chestman himself buys shares of Walbaums for himself and for Keith's discretionary fund. Keith is fined and disgorges his profit. Chestman is charged under 14e-3 and 10b-5. 1. Rule: The court found Chestman liable under 14e-3 since he found out about a tender offer essentially from a party to the tender offer and the 2d Cir. found that rule 14e-3 was a valid exercise of the SECs power. Therefore, equal access theory is still good but only within the context of tender offers. 2. Under 10b-5: a. Fiduciary Duty Theory since Chestman doesnt owe a fiduciary duty to the corporation, could only get tipper/tippee liability and there has to be a breach of

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fiduciary duty by the original tipper. Here, Ira did not breach a fiduciary duty since he did not gain a benefit from the transaction. i. What about his info to Shirley? Is she an outsider or an insider? ii. Is she an insider? Can argue its a family business. So shes an insider within the control group. Extends to Susan as well. b. Misappropriation Theory: Keith misappropriated the information from Susan because she told him not to tell anyone and he still called up Chestman. i. The misappropriation theory deals with how an individual gets the information here Keith did something Susan told him not to do. ii. There will only be a breach if there is a fiduciary duty and here, the court finds that even though there was a marital relationship, there is no fiduciary duty to your spouse. So although there was misappropriation, since there was no duty, there was no breach and no taint to Chestman. (v) 10b5-2: SEC enacts 10b5-2 in response to Chestman which clarifies when the misappropriation of material nonpublic information by providing a nonexclusive definition of circumstances in which a person has a duty of trust or confidence for purposes of the misappropriation theory: 1. The duties of trust and confidence arise a. Whenever a person agrees to maintain information in confidence b. Whenever two persons have a history, pattern, or practice of sharing confidences, such that the recipient of the information reasonably should know that the speaker expects that the recipient will maintain its confidentiality or c. Whenever a person receives or obtains material nonpublic information from his or her spouse, parent, child or sibling i. Provided that the recipient may defend by demonstrating that no duty of trust or confidence existed by established that he or she neither knew nor reasonably should have known that the speaker expected confidentiality based on agreement or the parties history. (vi) Scienter 10b5-1: the state of mind necessary have to intent to defraud, deceive or manipulate 1. According to 10b-5, person making the sale has to be aware of the material information when the purchaser makes the sale the rule does not say that the material information has to be the but for trading a bright line rule. If you possess material non public information, the presumption is that you relied upon it and traded. 2. Exceptions/affirmative defenses: a. Entered into a binding contract to purchase or sell the security, b. Instructed another person to purchase or sell the security for the instructing person's account, or c. Adopted a written plan for trading securities. 3. ***Government cant come after you if you decide NOT to trade*** (evidence issue) (vii) Martha Stewart Hypo page 673 q. 5: 1. Merrill Lynch stockbroker Peter Bacanovic, instructed his assistant to inform their client Martha Stewart that Sam Waksal, CEO of ImClone, and other members of the Waksal family were selling their shares in ImClone. That afternoon, Stewart sold 3,928 shares of ImClone at 58/share. The next day, ImClone announced that the FDA had rejected its application for the cancer drug Erbitux. Within the next 4 days, the stock price had dropped to 46.50/share. Under what theory would Martha be liable? a. Equal Access theory under the equal access theory, Martha would be liable because she possessed more information than other traders. However, given that this was not about a tender offer and the Supreme Court rejected the equal access theory Martha could not be liable under this theory. b. Fiduciary Duty Theory: Since Martha was not an insider she did not have a fiduciary duty to the corporation and therefore, would not be found liable. i. Tipper/tippee liability under the fiduciary duty theory: In order for Martha to be liable, have to show that the tipper breached his fiduciary duty by informing the tippee by gaining a benefit. Therefore, in this case, it would have to be shown that Waksal, in informing Bacanovic, intended for Martha to

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G. Private Actions i. Remedies for 10b-5 Violations - Damages: a. Elkind v. Liggett (2d Cir. 1980): there was insider trading and question was on how to measure the buyers damage. (Buyer was injured because his stock was worth a lot less than what he paid and when the disclosure was made, stock was dumped on him). The court discussed three different methods of valuation of damages Out of Pocket measures the difference between what the buyer paid and what the value of the stock was. (Essentially like compensatory damages- this is the measure under common law fraud). (i) Rule: The 2d Cir. rejected this because it was too hard to trace what the insiders did to the specific loss to each buyer. Furthermore, it was hard to figure out what the intrinsic value of the stock was when they actually bought. 1. Squire isnt this like appraisal rights? Difference is that usually it is state chancery court doing this evaluation, not federal judges. Erosion of the Market theory: incoherent according to Squire. (i) Might be able to get damages by: erosion in market shares after new shares maybe the buyer should get the difference between the original price and the price after erosion (ii) Problem: erosion could have happened before the erosion occurred, cant tell buyers are really being harmed Disgorgement theory this theory allows investors who were injured to recover the difference between what they paid and the price of the stock up to a reasonable time after disclosure (when they learn or when it is made public). This is limited by how much the insider profited. (i) If there are several claims have to share pro rata. ii. Insider Trading and Securities Fraud Enforcement Act of 1988 - 78t-1 of US Code: Liability to contemporaneous traders for insider trading. a. This gives anyone who was affected because they were trading at the same time as the insider a private right of action. Anyone who trades while in possession of material nonpublic information shall be liable to any person who, contemporaneously with the purchase or sale of securities, has purchased (where the violation is based on a sale) or sold (where the violation is based on a purchase) securities of the same class. b. There are two possibilities under insider trading either disclose or abstain from trading. If the status quo is disclosure, then by trading on the information, all stockholders are harmed because they all would have been better off by an increase in the price of the share. If the status quo is abstaining from trading, by trading on the information, some stockholders are benefited and some are harmed. (i) The stockholders who are harmed are those who see that the price is increasing (it is being bid up by the insider trading) and sells before the public information is made rather than holding on. 1. Buyers benefit here, because they receive the stocks on the cheap but cannot bring an action against them. (ii) The stockholders who are benefited are those we were going to sell anyways, and get the benefits of the increased price.

trade and gained a benefit from her trading and Martha was aware the Waksal was breaching his fiduciary duty in informing Bacanovic. ii. However, if Waksal did not benefit from telling Martha, than there is no taint to pass to Martha. c. Misappropriation theory: In order for Martha to be liable under the misappropriation theory, have to find that there was a relationship of trust and confidence between Waksal and Bacanovic and by informing Martha of the sale of stock, Bacanovic breached this relationship and misappropriated the information and Martha was aware that he was breaching this relationship of trust and confidence. i. However, if Waksal wanted the information to be shared with Martha, then there was no expectation of confidence and there can be no liability.

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1. However, all of these shareholders are allowed to sue.

H. Academic Debate: is insider trading a good or bad thing? i. Insider Trading and Informed Prices: insider trading is a good thing because it leads to more
informed prices that may actually increase investor confidence as well as the allocational efficiency of the market. a. Problems with this argument: Insider trading is a slow mechanism for releasing information to the market that can fail entirely to move prices if the level of background noise trading is sufficiently high. Illegal trading usually involves bombshell information that companies are forced to disclose publicly in the near term anyways. (i) Therefore, the total contribution of deregulation to informational efficiency is thus likely not to be large. Link between allocational efficiency and informational efficiency is really difficult to evaluate. Insider Trading as a Compensation Device: insider trading is another component of a managers total compensation. Proponents of this argument allege that expected gain from insider trading is said to have option-like properties that can motivate successful projects by allowing managers to benefit from prior knowledge of increases in share prices. Also, saves transactions costs of negotiating contracts and firms can recruit managers with the right risk preferences. a. Problems with this argument: Insiders are not likely to contract for efficient compensation, where insider trading is just another component of a managers total compensation, in a competitive market This only encourages selection of projects with volatile payouts, regardless of whether or not they have net positive or negative expected payouts. The fact that managers can increase their compensation through insider trading without negotiating with the firm merely permits then to unbundle the incentive features of their negotiated contracts and deprives the firm of control over the total levels of individual compensations. Deregulating insider trading would invite managers and similar insiders to extract large rents at shareholder expense without any real check by the corporation or the market.

ii.

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