Corporations Outline: Professor Gentile CHAPTER 1: INTRODUCTION TO THE LAW OF ENTERPRISE ORGANIZATION 3 Basic Principles of Organizational Law o (1)

) Efficiency o (2) Theories of the Firm o (3) The role of Law and Lawyers (1) Efficiency Q1: Is this rule efficient? o Corporation Law succeeds when it facilitates the increase of individual utility it is efficient. o Intuitive: Maximum output with minimal waste. o Formal (Economic): Pareto Efficiency & Kaldor Hicks Efficiency (1) Pareto Efficiency Definition: a solution, transaction, or a rule, will be efficient if no reallocation of resources can make at least one person better off without making at least one other person worse off. Pareto-optimal: when this distribution of resources is achieved. Cons: o (1) No objective definition of better off. Measured by utility, not necessarily wealth. o (2) Ignores the initial distribution of wealth. o (3) Someone is always going to be worse off almost impossible to implement. (2) Kaldor Hicks Efficiency Definition (Wealth Maximization Model): a solution, transaction or rule will be efficient if, once it is complete, if the people who benefited from the transaction have benefited more than people who were harmed by the same transaction were harmed. Looks at the aggregate. Winners win more than the losers lose. Theoretically calculates efficiency after those who were harmed by the transaction are fully compensated but does not require their actual compensation. Winner could compensate the loser and still come out on top but they dont have to for a transaction to be efficient. One goal is to reduce agency and transactional costs Cons: o (1) Ignores the initial distribution of wealth. If aggregate gain for Bill Gates is greater than the aggregate loss to societys poorest members it is still efficient under this model. I.e. is it ok for the poor people to lose everything as long as the rich get more than the poor lose? o (2) Ignores the impact of that distributional consequence does not consider the consequences if societys poorest members on the aggregate loss side of the transaction are forced to withdraw from societys economic transactions. Rationale: other areas of the law can compensate for these flaws (Labor Law/Minimum Wage) and it is currently the best standard we have. o Courts use the term fairness to stand in for economic efficiency in their decisions.

(2) Theories of the Firm o Definition & Model of Agency Costs (Profs. Jensen & Meckling): Agency Cost: any cost, explicit or implicit, associated with the exercise of discretion over the principals property by the agent. Monitoring Costs: costs that the owner expends to ensure agent loyalty (ex. auditor costs). Bonding Costs: costs the agent expends to ensure owners of their reliability (ex. entering into a commission agreement). Basically where you are paying someone more so that their interests are aligned with the company. Residual Loss: costs that remain after monitoring and bonding costs are incurred (constant). There will always be residual loss. o Specialization (Adam Smith, 18th C): firms facilitate specialization. Theorized thats it great to hire people to work for you because then you can specialize to be more productive. The problem is that whenever you hire someone to work for you that person does not work as hard as you do. Pros: greater individual productivity, wealth maximization to satisfy greed. Cons: increase agency costs people wont work as hard if they are not owners. o Transaction Cost Theory (Ronald Coase, 1937): Firms permit reduction in transaction costs when compared to conducting the same transactions on the market. Therefore, firms are efficient, despite agency costs. o Transacting Costs (Oliver Williamson,): Identified 3 forms of transaction costs and their import. A way to reduce transactions costs are governing structures. For example, the role of the board of directors in figuring out what the managers are doing and where the costs are and how to eliminate them. (1) Asset Specificity (most important): how specific the Asset is. Assets value depends on its context. Vertical Integration reduces transaction costs. Ex: Aluminum processing requires processing Boxite. Factory for processing Boxite is located next to Aluminum factory. Once the factory for processing Boxite is located and built next to the Aluminum processing plant, it has a higher value. The assets value is specific to its location. (2) Uncertainty: how much is there within the transaction (3) Repetition: how often the transactions take place. Repetition reduces the transaction costs. (3) The Role of Lawyers o (1) Regulatory Arbitrage: making sure people comply with the regulations as closely as possible for the least amount of money. Efficient compliance. o (2) Private Ordering: assist parties in organizing their business so that transaction costs are reduced and trade is facilitated.

CHAPTER 2: ACTING THROUGH OTHERS: THE LAW OF AGENCY Agency Law Approach: Hunting for Authority o (1) Liability in Contract Issue Spotting: When a third party is trying to enforce a K against a principal. Q1: Was there actual authority? (May be either explicit or implicit). If YES principal bound. If NO go to Q2. Q2: Was there apparent authority? Apparent Authority: requires manifestation by the principal that the third party reasonably believed indicated principals consent for the agent to act on his behalf. **must look at the principles knowledge or the reasonableness of 3Ps belief that A had authority from PR o If YES principal bound. o If NO go to Q3. Q3: Was there inherent authority? Likely to be an issue where the principal is undisclosed. Inherent Authority: created by Courts to protect third party in his dealings with an agent. ***will always bind the undisclosed PR o If YES principal bound. o If NO go to Q4. Q4: Is there either estoppel or ratification sufficient to bind the principal? If YES principal bound. If NO no liability. o (2) Liability in Tort Issue Spotting: Look for control & scope (Restatement 219) & consider financial investment. Q1: Is there a master-servant relationship? (Ask: Who is the party best able to control the employees physical conduct?) If YES go to Q2. If NO no liability. Q2: Was the servants act within the scope of his employment? If YES liability. If NO no liability. Note: Actions of an independent contractor will not bind the principal. Restatement Second of Agency 1 (Definition): Agency is a fiduciary relationship which results from 1) the manifestation of consent by one person (principal) to another that the other (agent) shall act on his behalf and subject to his control, and 2) consent by the other to so act. o 5 Main Points about Agency (1) Contractual Relationship (2) Fiduciary Relationship (3) Formation: can be formed implicitly or explicitly, the parties views of the relationship do not control. Formation requires only a manifestation of consent and control. (4) Termination: Either party can terminate at any time. (5) Breach: Money damages only for breach, no specific performance. o Explicit v. Implicit Formation & Efficiency: It is efficient to ignore the parties stated intentions and imply and agency relationship b/c where there is control, there should be responsibility. Incentives people to take care.
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Jensen Farms v. Cargill, Inc. Facts: Cargill (lender) finances Warrens (Seed Co.) operations and retains certain rights. When Warren (A) defaults on debts to farmers (T), the farmers sue Cargill (P). Holding: Implied agency relationship exists based on the course of dealing between the two companies. Cargill was closely controlling the financing entered into an implicit agency relationship. Rationale: Efficient because Cargill cant just plead lender where they exercise control. Liability of Principles for the acts of their Agents: Liability in CONTRACT: Q: Is there binding authority for the agents actions? If YES principal liable. If NO principal not liable. *Remember that you only need 1 type of authority to bind the principal!! Types of Authority: (1) Actual Authority (agents pov) Restatement Definition 26: created by words or other conduct of principal which reasonably causes the agent to believe that the principal desires the agent to act on his account o (1) Express Authority: principal will only be liable for the actions that the agent takes in accordance with his express instructions. o (2) Implied Authority: the authority to do all things incidental to completing specific task authorized by express authority. When principal tells agent to do thing X, he is also authorizing the agent to have implied authority to do that which is necessary to accomplish X. o Rationale: Incentives principal to be clear on what is said to the agent to avoid being bound beyond the scope of his consent. (2) Apparent Authority (third partys pov) Restatement Definition 27: created by words or other conduct of the principal which reasonably causes the third party to believe that the principal consents to have the agent act on his behalf. Manifestation = the third partys pov. The third party views the actions that manifest the principals authority in the agent. o Manifestation is created by: (1) Principal (2) Another agent of the principal. (3) The agent. Requires: o (1) That the agent has valid actual authority. o (2) That the manifestation is reasonable. o Rationale: Efficient because it encourages all parties to do their jobs principal should be clear in his instructions and third party should investigate agents authority. o White v. Thomas Facts: White (P) instructs Simpson (A) to bid up to $250K for land surrounding farmhouse in an auction. A overbids and exceeds her authority by trying to sell land P repudiates sale, Court holds for P. Holding: A did not have apparent authority to sell the land.
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Ts belief not reasonable because all A showed them was a blank check inadequate investigation. Rationale: Encourages P to be very specific and T to check into As authority. CCA. (3) Inherent Authority (courts pov) Authority to do the acts incidental to the actual authority even if there is no manifestation to a third party. Restatement Definition 8a, 161: created by agency relationship when courts view a finding of authority as necessary to protect a third party in his dealing with an agent. Binds disclosed principals and undisclosed principals when neither actual authority nor apparent authority exists. Issue Spotting/Rule: Where a principal is undisclosed look for inherent authority. o Nogales Service Center v. Atlantic Richfield Co. Facts: ARCO forecloses on NSC, litigation revolves around disputed agreement regarding 1-cent discount on the wholesale price of the gas. Issue: inherent v. apparent authority jury instruction. Analysis: Distinction between inherent and apparent authority become more significant when the principal is undisclosed since there will be no apparent authority from the principal (because he is undisclosed) and none from the agent (because he is protecting the principal) inherent authority becomes more important. Efficiency: difficult to evaluate because inherent authority doctrine is so muddled. Actual Authority goes between the principal and the agent. Both Apparent Authority and Inherent Authority go between the principal and the third party. Note: in addition to the above types of authority, principal may also be bound by estoppel or ratification.

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Scope of Authority: Custom is used as a tool to define the scope of authority. Ex. Janitor typically has authority to not only clean the building but also to buy the supplies, make minor repairs, etc. Does not have the authority to knock down walls. Inherent authority: less applicable because the doctrine is so messy/unpredictable. Liability in TORT: Q1: Is there a master-servant relationship? (Ask: Who is the party best able to control the employees physical conduct?) YES Q2 No is it merely an independent K? no liability Q2: Was the servants act within the scope of his employment? Master/Servant Relationship: principal employs an agent and controls the agents physical conduct in the performance of the service (Restatement 2, 220). Scope of Employment: conduct is within the scope of employment if 1) agent is employed to perform that particular service, 2) conduct occurs substantially within the authorized time and space limits, 3) conduct is intended to serve master, 4) if intentional force is used against another, the use of such force was not unexpected by the master (Restatement 2, 228). Independent Contractor: person contracts with another to do something for him but is not subject to the persons control in the physical performance of the undertaking (Restatement 2, 2). Rule: Actions of an independent contractor cannot bind the principal. Rule: Where there is a significant financial investment look for indicia of control b/c control is often linked to financial structure. Gas Station Cases: Humble Oil Co. v. Martin & Hoover v. Sun Oil Co. While the proprietor is often in the best situation to control his employees, cases illustrate that control, in the courts view, is often linked to financial investment. Hanson v. Kynast (Lacrosse player injured) No master/servant relationship, not only because there is no financial incentive but also because it just too much of a stretch to put the university/student relationship into this mold. Duties of Agent (Fiduciary Duties): Methods of Governance: K rights, Exit rights & Fiduciary Duties. K rights are too specific, Exit rights are too general Fiduciary duties achieve a balance that allows the relationship to develop and grow. 3 Main Fiduciary Duties: (1) Duty of Obedience: agent must adhere to documents that create the relationship and do what the principal says. (2) Duty of Care: duty to avoid negligence and to act in good faith, as per the reasonable person standard, while acting on behalf of the principal. (3) Duty of Loyalty: duty not to be a thief. o Pervasive obligation to exercise fiduciary power in a manner that the holder of the power believes in good faith is best to advance the interest or purposes of the beneficiary and not to exercise such power for personal benefit. o Most important duty!! Rule: Secret Profits o Where agent secretly profits from his relationship with principal (ex. undisclosed commission) the profits rightfully belong to the principal b/c court views them as having been held in trust for principal.
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Tarnowski v. Resop (Juke Box Case) Principal can recover the secret commission and damages from the agent, despite the fact that he already recovered on the K from the third party Principal is made more than whole. Efficient: Overcompensation of the principal is efficient because it creates strong disincentive for the agent to be loyal. Rule: trustee cannot deal in trust property. Rationale: Where there is no principal to oversee the agent (trustee) there must be a strict rule to regulate the relationship. Efficiency: Generally, rule is efficient b/c protects third party (beneficiary) from agents (trustee) overreaching. In re Gleeson (Trustee transaction w/beneficiarys land) Here, even though trustee acted fairly and in good faith, the court did not permit an exception. Here, the rule operates inefficiently b/c of the facts of the case.

CHAPTER 3: THE PROBLEM OF JOINT OWNERSHIP: THE LAW OF PARTNERSHIP Nature of Joint Ownership o Pros: (1) Lower Transaction Costs (2) Operational benefits specialization (3) Increased access to capital by selling shares of ownership o Cons: (1) Agency Costs/conflicts o Consequences: Share Net Profits All partners are liable as principals All partners are agents of the partnership All partners are liable for the debts of the partnership. All partners share equally in the control of the partnership. o Rule: With great power comes great responsibility if you have more control of partnership then you will be held to a higher standard. Heavier fiduciary duty for the managing partner. o Effect: requires the disclosure of new business opportunities that come to the partnership while the partnership is in existence. o Rationale: forces people to negotiate up front about what they want to have happen in the future. Meinhard v. Salmon (co-venturers, lease extension on bldg. near Grand Central) APPROACH: Is the opportunity/new deal close enough to the line of business or property in the current arrangement that it should be expected that the partnership would continue? o Managing like business in like areas is close enough for the duty to apply Opinion written by Justice Cardozo. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. Salmon failed to inform Meinhard of a business opportunity which was presented to him Court says joint venturers, like copartners, owe to one another, while the enterprise continues, the duty of the finest loyalty, not honesty alone but the punctilio of an honor the most sensitive is then the standard of behavior o Whenever the court discusses the punctilio the defendant has lost o Requires disclosure of opportunities to co-venturer so that your coventurer can make a decision to either compete against you or work with you o Important that is was presented while Salmon was in control as a business opportunity o This quote is always bad news for the defendant. Salmons failure to include Meinhard in business opportunity presented to him during partnership pertaining to property of partnership breach. Court tries to create a solution that reflects what the parties would have Kd for has they originally negotiated. Court takes pain to call them co-venturers bc Partnerships have specific rules governing them. o Partnership Formation:
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UPA 6 (definition): association of two or more persons to carry on as co-owners a business for profit. UPA 7(4): Sharing in profits creates a presumption of partnership. UPA 7(3): but the sharing of gross returns (all the money that the business takes in) does not of itself establish a partnership. Distinction between profits and gross returns is intended to distinguish between partners & employees. o Employees paid from gross returns pre-expenses. o Partners paid from profits post-expenses. Inferred Partnership: You can find yourself in a partnership relationship without knowing it. Rule: Partnership status does not require a financial contribution. You can put in anything of value (labor/skills) in and still be a partner. Volhand v. Sweet (Long-time nursery employee = partner) o Court infers partnership based on circumstances where parties never explicitly agreed to a partnership. Commission was paid off net profits, not gross sales. Looks at: (1) Intent (2) Contribution of labor/skills (3) Profit Sharing: prima facie evidence of a partnership. o Partnership exists even though Sweet never contributed money to the business b/c can put in anything at all of value and still be a contributing member of a partnership. Partnership in Fact v. Partnership by Estoppel: Q1: Is there a partnership? Q2: If YES who is in the partnership? *Remember: all partners are imputed with the knowledge of others. Types of Partners: (1) Partner in Fact (2) Partnership by Estoppel (UPA 16): if you represent yourself out as a partner and a third party relies on that you can be liable on the transaction even if you are not technically a partner. o Rule: Partner by estoppel & parenership will be held liable for the debts of a partner by estoppel. o Rationale: agency monitoring principles. o It is possible for A to be a partner in fact of B and not be either a partner in fact or by estoppel of the entire partnership. Then, A would be liable for Bs partnership interest in the full partnership. o Consider the amount of control exercised by the individual when determining partnership status. Retired Partners Rule in UPA 36(c): you can get out of the debts so long as there has been some material change in the agreement so that it is clear that all parties know that the partnership has been dissolved. Rule: Material change = notice no liability. Rationale: partners cant just drop off and escape liability but it is equally unreasonable to keep them bound forever. Munn v. Scalera (Bros. construction co. liability post dissolution) Retired bro. not liable to former clients for brothers faulty construction job.

For partners (including retired or withdrawn partners) to be released from agreements with third parties there must be a material change in the agreement that outs everyone on notice of one partners withdrawal. Partnership Property: UPA 25: Partnership property is viewed as being held in a tenancy in partnership. All partners jointly own partnership property so that partnership itself has property. Partnership Interest = interest in returns from partnership property, not property itself. Partners can transfer interest in returns (partnership interests) but, without the consent of all the partners, cant transfer your the full interest to the partnership property. o Can transfer cash flow but not anything else. Rationale: We dont want to bind unwilling partners to a random individual. Rationale: individual creditors only have access to the returns on the partnership property, not the partnership property itself. Note: Partnership interest is inheritable in the sense that you can inherit wind-up rights. Claims by Creditors against Partnership Property: Rules determine in what order the partnership & individual creditors are satisfied when a partnership and its partners go bankrupt simultaneously. Jingle Rule (40 of UPA (h) & (i)): partnership creditors have priority with respect to the partnership assets and the individual creditors have priority with respect to the individual assets. o People get what they expected based on their prior dealings. New (Parity) Rule: partnership creditors have priority with respect to the partnership assets and are on parity with the individual creditors with respect to the individual partners assets. o Application: If you are in Bankruptcy Court or a RUPA state. o Effect: When the individual partners assets are split up, the partnership creditors are considered at the same time as the individual creditors. o Rationale: Incentive use of partnership form, which is KH efficient. o Rationale: Individual creditors have stronger incentive to monitor individual partners if they know they will have to share the assets with the partnership creditors in the event of a bankruptcy. Bankruptcy court is more concerned about business creditors, so it protects them at the expense of personal creditors. Rule Application: o Jingle Rule: UPA state and there is no Bankruptcy Jingle Rule. (1) New York (continuing pressure to switch to New Rule b/c commercial center). (2) Dividing the assets of a partnership in a nonbankruptcy context (i.e. when one partner has passed away and you are dividing the estate). If partners are solvent Jingle. o New (Parity) Rule: Bankruptcy Court New Rule. RUPA State New Rule. In re Comark (Partnership bankrupt creditor seeks individual partners assets)
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Ct. issues injunction preventing partnership creditor from pursuing assets of individual partners while the partnership is in bankruptcy. o Efficient: injunction is necessary to avoid rush to courthouse to attach partners individual assets whenever a partnership declares bankruptcy. Efficient on a societal level b/c we prefer 1 bankruptcy proceeding to many individual proceedings. Governance of Partnerships: UPA 18(h): Ordinary matters in partnership business decided by majority of the partners. Voting Default Rule: we count bodies and not financial contribution. Rationale: in a partnership it is common for partners to contribute sweat equity we dont want to disadvantage those partners, who may know the most about the business, by voting pursuant to financial ownership. Costs: Rule biases against rich and poor becoming partners b/c those who invest financial capital typically want to retain proportional control. Can contract around the rule if desired. Majority Rule: 50% of a two-person partnership is not a majority for purposes of making firm decisions within the ordinary course of business. Rule: Activities within the scope of the partnerships ordinary business cannot be restricted unless by a majority of partners. National Biscuit Co. v. Stroud (grocery partners bound to bread K) o Stroud bound to bread K even though he rejected it because: (1) Affirmation of K by Freeman was within the scope of ordinary business. (2) 50% does not equal majority. o Rationale: protects partners bc (1) partners must find all partners to make a decision and (2) makes creditors willing to deal with partnership. o Application: partnership of 2 need both to agree. Partnership of 5 need 3 to agree. This doesnt depend on ownership stake. Contributions come from labor, capital, land, etc. Just look at bodies for voting. Termination of Partnerships: UPA 29 Dissolution: the change in the 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. UPA 31 Statutory Triggers of Dissolution: By expiration of agreed upon term specified in the partnership agreement. By the express will of any partner. By the expulsion of any partner pursuant to agreement by other partners. By circumstance which makes the partnership or its business illegal. Death of a partner. Bankruptcy of a partner or the partnership. Decree of the court. Consequences of Termination: Wind-Up (also called liquidation): Orderly processes of telling everyone you are going out of business. Includes the liquidation of assets to cash in order to satisfy creditors and distribute the partners the value of their respective interests. Rule: Partners can contract to opt out of statutory requirements of immediate dissolution & wind-up so long as agreement does not infringe on creditors rights. o
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Partners can customize off the shelf terms and those customized terms control. The agreement controls but you cant contract away fiduciary duties. In the absence of such an agreement the statute controls. Rationale: efficient to permit parties to negotiate their own terms. Also if you could not contract around the statute then each partner would have tremendous hold up power by threatening to trigger dissolution at any time. Adams v. Jarvis (accounts receivable, K-ing around statute) o Court upholds partnership agreement that allows for 1 years profits upon withdrawal i/o statutory default which would dissolve the partnership and equally distribute the assets after liquidation. o Holds that parties can K around dissolution rules-the agreement supersedes the partnership law if theres a conflict between underlying law and the agreement itself. Rule: statutory dissolution requires a sale of the assets and an equal distribution of cash among the partners. Dividing the physical assets (division in-kind) is not an acceptable solution. Rationale: Efficient b/c the business will usually be worth more whole i/o piecemeal (wealth maximization). Also, since partners can K around the statute fair. If remaining partners want to retain assets they can purchase them at the sale and give the withdrawing partner his fair share. Dreifuerst v. Dreifuerst (dissolution w no agreement) o 2 brothers want to dissolve partnership with the 3rd and give him the money-losing mill instead of selling the assets. o No partnership agreement statute controls. o UPA 38: on dissolution, get cash, not in kind division. o Court requires all mills associated with the partnership to be sold and for the proceeds to be divided equally. Cant divvy up the assets. Rule: statutory dissolution of partnership is constrained by fiduciary duty. If dissolution is in bad faith breach damages. Page v. Page (dissolution of partnership of unequal contributions) o Partner wants to dissolve unprofitable partnership so that he can be the sole proprietor of new linen business for incoming military base. o Court rejects TCs implied term of partnership (until investment is repaid) but announces that right to statutory dissolution is subject to fiduciary duty. o Lesson: statute does not protect partners making asymmetrical contributions b/c it assumes equality between partners. In asymmetrical situation you would advise partners to K around it to protect partner making greater contribution. But if theres no bad faith, then no problem. Financial Statements of Partnership: (1) Balance Sheet: simple statement of assets, liability & equity, reported as of a certain date. Use a plug number on the liability side to balance the balance sheet. o Plug number = partnership capital. To get something to balance you need a fixed date in time. This is hard bc assets and liability are always in flux. (Adams v Jarvis) Partnership capital: difference between the assets and the liabilities. o If + partnership is profitable. o If - partnership is unprofitable.

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(2) Income Statement (or Statement of Profits & Losses): revenue and expenses that flow through the business throughout the year. (3) Capital Accounts: what every partner has in the partnership. Limited Partnership (LP) Q: Where is the control? If partner exercises control liability. If no control partner is shielded from liability, liability is limited to what is put into the business.. Limited liability protects the partners individual assets by limiting partnership creditors to partnership assets. Role of General Partner in LP: LPs must have 1 general partner w/unlimited liability and the rest may be limited partners. General partner is liable for all the partnership debts. Role of Limited Partners in LP: Limited partners may not participate in control (mgmt.) of partnership except for basic voting rights on major decisions (ex. dissolution). Rule: Control = liability. Delaney v. Fidelity Lease Limited partners held liable where they exercised control through dummycorporation. Unresolved across the circuits whether corporation can be general partner. Tax Benefits of LPs: Eligible for pass-through tax benefits of small partnership avoid double taxation. o Pass Through Taxation: Income of the LLP passes through to individual partners and is taxed as their individual income. o Double Taxation: Compare with income of corporations which is subject to double taxation since it is taxed first as the corporations income and then again when distributed to shareholders as dividends. Limited Liability Partnership (LLP): Definition: a general partnership in which partners retain limited liability. So called limited partners provide capital and are liable only to the extent of their investment. Liability Characteristics: Limited liability only with respect to partnership liabilities arising from the negligence, malpractice, wrongful act or misconduct of another partner or agent of the partnership not under the partners direct control. With respect to other sources of liability the limited liability partners are subject to general liability. Distinctions from LP: there is no general partner with unlimited liability and complete control. There is no partner who is purely a general partner or purely a limited partner. Limited liability partners retain equal control over the operations. Limited Liability Company (LLC): Provides limited liability for members while allowing them to exercise control. A hybrid entity btwn a corp and a partnership. LLC can be member-managed or manager-managed: Member Managed LLC: o Members have authority to bind the LLC, similar to a partnership. o Voting in an LLC is in proportion to capital contributions, not 1 vote per body, as in partnership. o Fiduciary duties are parallel to those of a partnership. Manager-Managed LLC:
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o Members cannot bind the LLC by voting. o Only managers have fiduciary duties. Transferability: similar to partnership, members cannot transfer their member interest in an LLC without unanimous consent of members; however they can transfer their financial rights to individual creditors. Liability to 3rd Parties: neither managers nor members are individually liable for LLC obligations. Liability is owned by the LLC. Check the Box Rules: new tax rules permitting unincorporated business to elect how they will be taxed. Will likely result in an increase of LLCs because of the generous liability protection.

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CHAPTER 4: THE CORPORATE FORM The Corporate Form o Corporate Distinctions: (1) Closely Held v. Public Closely Held: held by a small number of people who are also typically the officers and directors. Controlled by identifiable group. Publicly Held: held by public shareholders. Shareholders do not participate in the management of the corporation. (2) Controlled Corporations v. Diffusely Held Corporations Controlled Corporations: there is a shareholder or group of shareholders holding more than 50% of the stock control voting rights control management. Diffusely Held Corporations: no controlling shareholder no control voting block management exercises control. o Formation: Historical: formation required a special statute of incorporation issued by the state legislatures. Modern: DL Gen. Corp. Law 101: if you fill out this paperwork and pay a small fee then you can be a corporation. Note: modern incorporation statutes are default rules you can always K around them. Formation Theories: Race to the Bottom or Race to the Top? Background: o Doctrine of Internal Affairs: the governance of the corporation is dictated by the State of incorporation. Internal affairs are considered everything that relates to the legal relationships between the corporate participants. E.g. Shareholders rights, directors fiduciary duties, etc. o Taxes: (1) Doing Business Tax: paid to the state where you do significant business (i.e. have a corporate campus). (2) Franchise Tax: paid to the state of incorporation. Calculated based on the number of corporate shares outstanding. (1) Race to the Bottom: Cary o Argument: competition for franchise tax will result in States writing statutes that are very favorable to corporate managers. Managers decide where to incorporate and states want to attract them States are racing to the Bottom. o Concern that this will result in less protection for shareholders. (2) Race to the Top: Winter o Argument: Corp. laws must protect shareholders at the expense of management otherwise the long-term prospects for the company are not good. o If shareholders are not protected stock goes down ripe for takeover management at risk. Concludes managers will incorporate in States will higher protection for shareholders for this reason States are racing for the Top.

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Note: Easier for corporations to raise capital in States w/ law that protects shareholder b/c shareholders are more likely to buy shares. o Support: DL provides the weakest protection for managers against hostile takeovers and remains the State with the highest incorporation rate. Support for Theories: Inconclusive although many commentators favor Race to the Top. o (1) Event Studies: what happens when a corporation decides to reincorporate in DL? If stock goes up Race to the Top supported. If stock goes down Race to the Bottom supported. Criticism: Re-incorporations tend to happen when another event is also taking place (i.e. a merger) impossible to isolate the effect of the re-incorporation. o (2) DL law is now a very special thing and that may have value in itself and have a profound effect. DL judiciary & Bar are very sophisticated stable law. Analysis of either approach that fails to consider these factors is not entirely dependable. Attorney POV: you will always recommend DL as the State of incorporation because that is where you can best predict the legal risks. Case law is well developed. Appeals go right to he S. Crt. Actual Processes of Incorporation: Charter: Certificate of Incorporation = Article of Incorporation = Charter Enabling statutes simplify incorporation process. Corps legal life begins when its charter is filed. Requirements: Charter must include: name, purpose (usu. for any lawful purpose, address of agent, number of shares the company is authorized to issue, the incorporator (person filing the document). Amendments: Only by shareholder vote. Bylaws: Specific provisions re: the governance of the company. o Ex. how the shareholder meetings and directors meetings are run, how you vote, what happens with the share certificates. Must conform with both the corporation statute and the corporations charter. DGCL 109(b). Amendments: controlled by the Board of Directors. Strategy: keep the charters as bare as possible and put the important provisions in the bylaws, since the Board of Directors can control them.
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Essential Characteristics of Corporations o (1) Limited Liability: Shareholders are not responsible for the debts of the corporation; only liable up to the amount of their investment Creditors of the corporation can only move against the corporate assets. Benefits: (1) Very easy to value the shares. o Value cant fluctuate with the personal wealth of the shareholders b/c of limited liability structure. (2) Makes it more likely that people will invest in risky businesses. (3) Incentives monitoring of corporations management since in the event of a default, the creditors will only have access to the corporations assets. (4) Reduces the transaction costs of contracting for credit b/c if corporate entity owns asset then creditor can do a centralized investigation (i/o investigating every shareholder). o (2) Transferability of Shares: Easy to transfer shares because it is easy to value the shares. Benefits: o (1) Enhances monitoring protects shareholders If corporate managers are doing a bad job it is more likely that a takeover artist will acquire the shares. o (2) Easier to raise capital o (3) Centralized Management: Shareholders elect the Directors Directors appoint Officers. DL Gen. Corp. Law 141: governs structure and requirements for Board of Directors. o Rule: Only the Board of Directors manages business of the corporation. Board has the final say unless a shareholder vote unseats them. Charlestown Boot & Shoe Co. v. Dunsmore Shareholder litigation unsuccessful where a Board of Directors ignores the advice of a turn around expert. Board within its rights to hire expert and then ignore his advice. o Rule: Monitoring Model: Goal is for Directors to monitor the company by sanctioning officers. Jennings v. Pittsburgh Mercantile Co. Didnt read Corporation not responsible for CEOs commission where he executed a deal without their permission and against their wishes. No express authority and no inherent authority because CEO had reason to know Board would disprove action. Rationale: court is concerned that recognizing inherent authority here would disincentive monitoring by the board since, if even when they say no, the officer can still engage in transaction no value to the monitoring. o Here transaction was more unique than in Menard, no manifestation from principles. Agents can vest themselves in apparent authority but it must be believable/reasonable. Menard, Inc. v. Dage-MTI, Inc. (Opposite of Jennings, above, CEO had inherent authority to sell land.) Court finds corporation liable for commission on unauthorized sale of land by CEO because of inherent authority doctrine. CEO is the head and arms of the corporation anything he does is an act of the corporation.

CHAPTER 5: DEBT, EQUITY, & ECONOMIC VALUE

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Fundamental Financial Aspects of the Corporate Form Pro/Con of Debt & Equity o Debt: Pro: (1) Leverage Advantages o Turning a profit from investing borrowed money generates a higher ROI b/c less money of your own at risk. o Risk is that if the stock goes down you owe more than you earned. (2) Tax Advantages o Interest payment treated as an expense tax deferred. Con: (1) Agency Costs o Managers and debt-holders have different risk profiles Managers may be more inclined to risk big if company is close to insolvency since they will lose their jobs either way. o Managers will not work as hard as debt-holders (std. agency costs). (2) Costs of financial distress o Vicious cycle where suppliers are less likely to deal with companies in the swirl you cant get company out of a hole. (3) High risk of bankruptcy due to acceleration clause provision. o Equity: Definition: financial terms that refer in general to the extent of ownership interest in a venture. Equity refers to the financial or accounting definition that a owners equity in a business is equal to the businesss assets minus its liabilities. Pro: (1) Generates cost-free capital in exchange for giving up partial ownership. Con: (1) Loss of control. (2) Agency Costs: managers may engage in activity that does not benefit the shareholders (ex. steak dinners). Capital Structure: Describes a corporations division between debt and equity. o Debt: borrowing money Basic Characteristics: (1) Principal: amount that is lent, paid at maturity. (2) Interest payment: payments that have to be paid every few months pursuant to a stated interest rate (ex. 6%). (3) Term: assuming here that we are only considering long- term debt. Pro: Debt is tax deferred because the money used for interest payments comes out of the corporations expenses before the total net income for tax purposes is calculated. Con: Acceleration Clause: if corporation misses a payment, the creditor can demand the entire debt payable immediately huge threat of bankruptcy if you miss an interest payment. Types of Debt: (1) Priority: where you come in line with regard to the corporations assets. Applies to regular payouts as well as bankruptcy payouts. o (a) Priority = paid first o (b) Subordinated = paid second Whether you are a priority or a subordinate creditor depends upon your K. Creditors can K for status. (2) Security: mortgage lending.

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(a) Secured: a certain asset secures the loan. In case of insolvency, secured creditor can point to a certain asset and take that first. Note: If the security has depreciated to the extent that it is less than the value of the debt, the secured creditor is in the same position as other creditors with respect to the balance of their debt. o (b) Unsecured: no particular asset to point to. o Equity: raising capital by selling shares Con: tax disfavored. Money to pay dividends is taxed twice, once as part of the corporations total net income and again when the money is converted to dividends to pay shareholders. Types of Equity: (1) Preferred Stock o Preference over common stockholders with respect to (a) Regular payments of dividends Dividends: are pro rata payments by the corporation to equity shareholders based on corporate earnings. Dividends can take many forms: cash, property, common shares, preferred shares, debt, even rights to whiskey during wartime liquor controls. Under US corporate law the declaration of dividends is within the discretion of the BOD, limited by the corporations financial and legal ability to pay. (b) Liquidation payments during bankruptcy. o Senior to common stock as to dividends and liquidation rights but junior to the claims of debtholders and creditors. o Note: Preferred stockholders only have a preference with respect to payments of dividends if the Board decides to issue them. Payment of dividends is entirely at the Boards discretion. (2) Common Stock o Residual claimants Receive dividend payments after preferred stockholders have been paid in full and receive whatever is left in a bankruptcy proceeding. o Common stockholders have the voting rights. Theory: consistent with the idea that risk takers want to and should exercise control. Efficiency: If risk takers can take only take after everyone else has been paid they will be the most attuned to corporate waste KH Efficient. Basic Concepts of Valuation, Risk & Diversification o Valuation occurs under two situations: (1) Absolute certainty (2) Uncertainty o (1) First Fundamental Principle of Valuation: $1 today is worth more than $1 tomorrow Certainty $1 today is worth more than $1 tomorrow. Why? (1) Time value: if you have the money now you can invest it and earn interest. (2) Value consumption in the present v. consumption in the future General Application: a = amount
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r = rate of interest n = number of periods o Future Value Formula: FV = a * (1+r)n Ex. What is the (future) value of $100 received today if the interest rate is 5% and the period is 1 year? 100 * 1.05 to the 1st = $105 o Present Value Formula: PV = a / (1+r)n Ex. What is the present value of $100 to be received one year from today if the interest rate is 5%? $100 / 1.105 = $95.24 General Principle: the lower the interest rate, the higher the present value. Why? Costly for you to wait. Discount rate is in the denominator of the equation, so the result is larger. Interest rate determines how costly it is for you to wait. Rule: managers must always take a project with a positive net present value. Rationale: if managers only take projects with positive net present value they will necessarily be doing what the shareholders want by acting to increase the value of the corporation. Net Present Value: Goal: to determine whether an investment in a project is worthwhile. Tool: Allow managers to reduce everything to a single point in time in order to make a good decision and invest only in projects with a positive net present value. Application: Problem on p. 117 o Should you borrow $10k at interest rate of 8.5% for 1 year? o Need to determine the future value. A = $10k, R = 8.5% At the end of next year if you undertake this project you will owe the bank $10, 850. o Not worth it if guaranteed return is at a loss or break-even point but what if return is guaranteed at 10%? The only time it is interesting is if you are promised 10% will end up at the finish of the year $11k. o Net present value: - Cost + Present Value of Return Dont forget to calculate the present value of the return. Need to know the present value of the $11k. o Formula: -$10k + a / (1=r)1 o Use 8.5% interest rate o -$10k + $11k / (1.085) o -$10k + $10,138.25 o Net present value = $138.25 (2) Second Fundamental Principle of Valuation: $1 for sure is worth more than $1 with risk. Uncertainty $1 for sure is worth more than $1 with risk. Sources of Risk: o Risk of no payment at all. o Risk of payment of another amount. o Risk of payment at another time. Consequences of Risk: o Rule: downside losses are weighted more heavily than the upside gains.

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Rationale: individuals have declining marginal utility of wealth the more you have the less it means. Measures of Risk: o (1) Expected Value (weighted average): Multiply the probability of each outcome by the amount received in that outcome. Ex. You have a coin if it comes up tails you get $0, if it comes up heads you get $50. To get the expected value you multiple $0 by 50% and $50 by 50%. o (2) Variance: Degree of dispersion of actual returns around the expected return. Greater spread greater risk. o (3) Value of Future Risky Return: Must account for: (1) Time value of money (interest) (2) Risk o Use present value formula and incorporate time value and risk into discount rate. R in the world of uncertainty has the time value of money and the risk associated with that money embedded in it. R in the world of certainty is just the set interest rate.
o

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Types of Risk: (1) Unsystematic Risk (Idiosyncratic Risk): risk associated with a particular business. Examples: o A strike: GM workers strike has no direct impact on Microsoft. o Expiration of a patent: directly affects company holding the patent but not the rest of the market. o Martha Stewart case: announcement of the verdict directly affected the stock of Martha Stewart Omnimedia but not the rest of the market. (2) Systematic Risk (Market Risk): risk that relates to the entire market. Examples: o War or Inflation: both have depressive effects on the entire economy. Diversification: Possible to diversify your portfolio so that you are not subjected to unsystematic risk b/c event that causes stock A to plummet, raises stock B. Effect: because of diversification, there is no longer a risk premium for holding stocks with unsystematic risk good investors have portfolios that contain no unsystematic risk. Note: Portfolios still contain systematic risk because investors are well compensated with market premium. Greater risk premium greater risk adjusted discount rate. Models for Determining Roles of Prices in Securities Markets: (1) Discounted Cash Flow Models Generally used by the investment community to value companies, looks at the companys anticipated future cash stream and then, after making assumptions about risk free interest rates and company risk, figures how much present cash would produce that future stream. The present cash value reps how much the business is worth (2) Efficient Capital Markets Hypothesis (The Chicago School): stock market prices rapidly reflect all the public information bearing on the expected value of individual stocks. Effect: laypeople can rely on the securities market without doing their own evaluation. Difficulties in Utilizing Models: (1) Abstractions in fundamental assumptions (2) Difficulties in collecting, verifying and analyzing information. Determinants of Capital Structure: Estimating Cost of Debt: (1) Nominal interest rate (unreliable) (2) Market rate on similar debt (preferred) Estimating Cost of Equity: calculating shareholders expected return (implicit cost of equity) (1) Dividend Discount Model: o Formula: expected dividends over future periods divided by the market price of the security = expected rate of return (2) Capital asset pricing model: o Formula: measures the sensitivity of stock to systemic risk. (3) Historical average equity risk premia: o Historically, equity returns 8% more than risk free rate of the economy. o Most commonly used.
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Formula: risk free rate (T-bill rate) + 8%.

CHAPTER 6: THE PROTECTION OF CREDITORS Protection of Creditors (Voluntary creditors) o Theory: we must protect creditors to ensure the availability of a reasonable amount of debt in society so that worthwhile corporate projects get financed. o Rationale: Creditors will restrict debt if they are inadequately protected we must mitigate the effect of limited liability to prevent shareholders from taking advantage of creditors. Also provides protection for other stakeholders (ex. employees). o Approach: Q: What are the available mechanisms for the protection of creditors? (1) Mandatory Disclosure Rules (Federal & State) (2) Capital Regulation: Distribution Constraints o (a) Capital Surplus Test (NY) o (b) Nimble Dividend Test (DL) o (c) Modified Retained Earnings (CA) o (d) Fair Market Value Test (RMBCA) (3) Other (EU) o (a) Minimum Capital Requirements o (b) Capital Maintenance Requirements o Balance Sheet Definitions: (1) Stated Capital: the capital in the corporation at its moment of inception Calc: number of shares multiplied by the par value of each share. o Note: Franchise Tax uses par value as part of the calculation so often par value is a penny or less. (2) Retained Earnings: profits not yet distributed to shareholders. (Net Income). (3) Capital Surplus: (# Shares) (Market Price) (# Shares) (Par Value) Difference between par value & actual selling price of share, multiplied by total number of shares. (4) Surplus: Capital Surplus + Retained Earnings (5) Shareholders Equity: plug number that balances. Difference between the assets and the liabilities columns. o (1) Mandatory Disclosure Rules: Federal Predicated on the Efficient Capital Markets Hypothesis Requires quarterly disclosure and when X happens (ex. loan is issued). State Do not necessarily subscribe to the Efficient Capital Markets Hypothesis. Utilize capital regulation methods (below). No state laws require any mandatory disclosure. State wants to woo corps so they get the tax benefits from them, filling fees, etc. o (2) Capital Regulation: Distribution Constraints Rationale: regulations that require corps to keep money in the corp. This ensures that entire surplus is not used to pay shareholder dividends thereby protecting creditors by maintaining enough funds to pay immediate equity obligations. (a) Capital Surplus Test (NY): No surplus no dividends. Dividends may only be paid out of surplus, not stated capital.

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Board requires shareholder approval to transfer funds from stated capital to surplus accounts. (b) Nimble Dividend Test (DL 170): Dividends may be paid either from surplus or from net profits from the current or preceding fiscal year; whichever is the greater amount. o Do not add the profits of the two years together, must take one or the other. Board may transfer funds without shareholder approval. (c) Modified Retained Earnings (CA): Dividends may be paid either from surplus or from sale of assets, so long as assets remain 1.25X greater than liabilities and current assets are equal to or greater than current liabilities. More flexible usually more generous to shareholders. (d) Fair Market Value Test (RMBCA) (Most flexible Rule) Dividends may be paid so long as the corporation is still able to pay its debts and its assets remain greater than its liabilities plus the preferential claims of preferred shareholders. Asset Valuation: may use reasonable market valuation methodology!! Pro: most modern, flexible rule. Con: insufficient protection for creditors, especially banks unlikely to see widespread adoption of this rule so long as the banks have strong lobbies. o (3) Other Creditor Protections (EU): (a) Minimum Capital Requirements: must put up X amount of capital at the time of initial incorporation. Pro: provides strong protection for creditors at initial stage of incorporation, when there is typically high risk and limited information. Con: does not provide long-term protection b/c corporation could take out excessive loans after meeting this requirement. US Criticism: standard minimum does not account for differences between companies (i.e. minimum should be different for telecommunications company v. cookie company). (b) Capital Maintenance Requirements: must maintain X amount of capital at all times. Failure to maintain X amount will trigger ability of shareholders to move for insolvency. Pro: provides more long-term protection for creditors. Con: may permit shareholders too much control. US Criticism: want to avoid costs of prematurely pushing corporation into bankruptcy when there is still a chance for recovery. Duties Owed to Creditors: Standard Based Duties o (1) Duties Owed by Directors Rule: In the vicinity of insolvency, duty will shift and is owed to the corporation as a whole and not just to the shareholders. Includes creditors. Vicinity of insolvency duty to the corp Rationale: creditors impliedly negotiated for this additional protection since shareholders willingness to take enormous risks near insolvency is well known. Pro: More secure for everyone involved. Con: (1) Disaggregates when the court is doing its review (ex-poste) from when parties to the K are making their decisions (ex-ante). (2) Maybe bondholders are protected 2x: first with the interest rate and then with this duty?
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Credit Lyonnais Bank Nederland v. Pathe Communications Corp. (Chancellor Allen) in vicinity of solvency directors duties shift to whole corp Hypo: company with single asset of $51M judgment that may be reduced or eliminated on appeal. Discussion highlights the different interests of creditors and shareholders when deciding whether to pursue appeal or settle. (p. 138-139). In the vicinity of insolvency: o Shareholders are more willing than bondholders to take risks Directors have a fiduciary duty not just to shareholders but also to the community of creditors. (2) Duties Owed by Other Creditors Issue Spotting: When 3d party (outside) holds debt argue Fraudulent Conveyance. Fraudulent Conveyance Law: Background: notion that debtors cannot use sham transactions to hide their assets from creditors. UFTA defines certain debtor transactions as fraudulent and allows creditors with matured or maturing claims to void such transactions or to seize the property fraudulently conveyed. Application: Present and future creditors may attack any transfer by the debtor made with any actual intent to hinder, delay or defraud creditors. Present creditors can attack transactions when there is actual or constructive fraud. o Constructive Fraud may be present where: (1) Debtors transfer assets without receiving adequate value. (2) Transfer of assets results in debtor being forced to engage in business with unreasonably small capital (3) Debtor cant pay bills, as they are due after the transfer. Q1: Was reasonably equivalent value exchanged in the transfer? Q2: Do enough assets remain to operate the business? Q3: Can the debtor still pay bills? o If YES no constructive fraud. o If NO constructive fraud. Rationale: assets forced back into the company so that they can satisfy all the corporations liabilities. Recent Applications of Fraudulent Conveyance Law: (1) Leveraged Buyouts o Definition: borrowing money against the company assets to purchase the companys shares at a premium (ex. paying $35 for shares with market value of $20). o Challenge: transfers are made without receiving reasonably equivalent value in return. Possibly other grounds as well. o Result: successful challenges will set aside the transaction but typically only result in bankers losing their fees as it is difficult to trace money given to stockholders. (2) Retention Payments/Severance Payments o Definition: Paying top officers to stay throughout bankruptcy proceedings (ex. $5M for 5 months). o Challenge: transfers are made without receiving reasonably equivalent value in return. Possibly other grounds as well.

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Result: transaction will usually be set aside but there is rarely money left to repay the company. (3) Duties Owed by Shareholders-Shareholder Liability Generally: Shareholders may be liable to corporate creditors or may have loans they made to the company subordinated to other creditors under either equitable subordination or corporate veil piercing Issue Spotting: When director or shareholder (inside) holds debt argue Equitable Subordination. Rule: Equitable Subordination Where inside shareholders-creditors try to put their interests ahead of outside debt-holders, the Court will use equitable power to set aside the transaction, subordinating the shareholder interests to the debt interests, where they should have been all along. Application: Shareholder-creditor is typically an officer of the company. Shareholder-creditor must have behaved wrongly to company or outside creditors. Costello v. Fazio (chged co. form and contribution to elevate themselves in bankr proceeding) Partnership converts into a corporation; partners (now Directors) equalize their investment in the new corporation by taking promissory notes that will be treated as debt in the event of bankruptcy in the amount they had invested in the partnership. Test: whether the transaction can be justified within the bounds of reason and fairness? Court uses equitable subordination doctrine to set aside the transaction b/c the corporation was undercapitalized and b/c directors violated fiduciary duty by acting in own self-interest to the detriment of the corp and creditors. Very slimy. o Undercapitalization not sufficient b/c many start-ups are initially undercapitalized. Piercing the Corporate Veil: Definition: setting aside the entity status of the corporation so that individual shareholders can be held directly liable on contract or tort obligations. When a court refuses to recognize the separate existence of a valid corp and holds the stockholders personally liable for the obligations of the corp, it is said to pierce the corp veil. This is a remedy that is asserted by creditors of the corp usually against the stockholders when the corp is unable or unwilling to make good on its obligations whether arising in K or tort. Rationale: seeks to protect outsiders who deal with the corporation. o Equitable doctrine that pierces the veil of limited liability. Requirements: 2 conditions must generally be satisfied before Court will pierce the veil: o (1) Disrespect to the corporate form. Look for: commingling of corporate & personal assets & liabilities, failure to keep proper records, have meetings, etc. Rationale: those who fail to respect the corporate form cannot later claim its protections. o (2) Injustice or fraud, something the court feels it needs to rectify. Wildcard. Frequently undercapitalization. Approach 1: Apply the Van Dorn Test (2 prongs):
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Q1: Is there disrespect to the corporate form? Unity & interest of ownership such that the personalities of the corporation & individual are merged? If YES go to Q2. If NO veil will not be pierced if the corporate form is preserved. o Q2: Would honoring the corporate veil promote injustice or sanction fraud? If YES pierce the veil shareholders liable. If NO shareholders are not personally liable. Rule: Undercapitalization alone is insufficient to pierce the corporate veil. o Sea-Land Services, Inc. v. The Pepper Source Court uses Van Dorn Test to find O of Pepper Source personally liable to Sea-Land for $87k defaults on K. O commingled his personal and business assets disrespected the corporate form. Court permits Sea Land to reverse veil pierce Os assets: reach through defunct Pepper Source & O to Os other businesses whose assets will be sold to satisfy $87k. P Pepper O other companies assets $87k. SL doesnt want Os personal assets bc theyll be subordinate to the rights of othe creditors in those companies they want actual assets. So court turns to whether theres a separate existence/inequitable context to indicate fraud. Approach 2: Apply the Laya Test (3 prongs, 3rd prong permissive): o Q1: Is there disrespect to the corporate form? Unity & interest of ownership such that the personalities of the corporation & individual are merged? If YES go to Q2. If NO veil will not be pierced if the corporate form is preserved. o Q2: Is there some sort of injustice or fraud in the transaction such that adhering to the corporate fiction would promote inequity? Note: Undercapitalization may be enough much lower standard than Van Dorn Test. o Q3 (permissive): Did the party suing assume the risk of the corporations default? Ex. can assume risk by failing to investigate financing, etc. If YES shareholders are not liable. If NO shareholders liable. o Kinney Shoe Corp. v. Polan Similar facts to Sea Land but opp result O sets up holding company & business. Holding company leases land for business from P. Business goes belly up. P wants to pierce the veil of holding company (which has no assets undercapitalized) to get to Os assets. Court permits piercing & finds 3d prong of Laya Test optional. Not applicable here for equitable result.
o

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Note: possible to achieve different results by applying the Van Dorn & Laya Tests b/c the Laya Test employs a lower standard for injustice apply both. Approach 3: Lowendahl Test o Requires a shareholder with complete domination of the corporation (co-mingling) and corporate wrongdoing that proximately causes the injury.

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Veil Piercing as Applied to Tort Victims (involuntary creditors): Distinction: Tort v. K creditors o (1) Tort creditors do not rely on credit worthiness of corp. when placing themselves in a position of harm. Less sophisticated parties, more sympathetic to courts. o (2) Generally cannot negotiate with a corporate tortfeasor ex ante for K protections from risk. Rule: portfolio of small companies will not be pierced if the corporate form is respected in each instance. o Walkovszky v. Carlton Court will not pierce the veil of Os 10 individual cab companies; each w/minimal insurance to satisfy injured P. P failed to state a cause of action b/c O respected the corporate form in each company insufficient capitalization not enough. Pros: o Easterbrook & Fishchel: rule protects tort victims b/c larger firms are apt to carry more insurance. Piercing would make single cab operators the most profitable less insurance. Cons: o Allen & Kraakman: criticize rule as incentive for companies to structure with assets that are too small for their scale. Alternative: o Hansmann & Kraakman: Argue for unlimited pro rata shareholder liability for corporate torts. Pro Rata: if you own 1% of the corporation you are liable for 1% of the judgment after the corporate resources are exhausted. Limited liability encourages shareholders to behave inefficiently: (1) Spend too little on safety precautions. (2) Over-invest in hazardous industries. Pro Rata shareholder liability for corporate torts would mitigate these risks. Not concerned with effect on securities market b/c more concerned about shareholders risky behavior.

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CHAPTER 7: NORMAL GOVERNANCE: THE VOTING SYSTEM

Shareholders Rights of Shareholders: o Overview: Corporate law protects shareholders investment position thru three principal mechanisms: voting rights, litigation rights to enforce management accountability liquidity rights to sell their shares. o (1) Voting Rights & Election of Directors Types of Voting: (1) Straight Voting: 1 share = 1 vote o Default voting (2) Cumulative Voting: number of shares held multiplied by the number of seats being voted upon. o Rationale: ensures minority representation on the Board b/c minority shareholders can weight their vote for at least one seat on the board. o More common in close corporations. Staggered Boards: DL Gen. Corp. Law 141(d) Annual election of directors. Every director doesnt have to be up for election every yr, just some of them. This is a way to maintain control of a big public company. Statute: permits the Board to be divided into 3 classes of Directors, each up for election at 2-year interval. Effect: takes at least 2 years to gain control of the Board staggered structure protects incumbent Board. Rule: the Board of Directors may not adopt a staggered Board where its goal is to entrench the current Board. Q: Was the staggered Board adopted to disenfranchise shareholders? Test: Court examines circumstantial evidence to determine entrenchment (ex. timing, effect, stated purpose, etc.) Efficiency: must be efficient under the Efficient Capital Market Hypothesis in order to be Kaldor Hicks efficient. o Hilton Hotels Corp. v. ITT Corp. In response to hostile tender offer, ITT spins off 93% of assets into new company with staggered board. ITT developed staggered board to make it harder for Hilton to take it over. Court grants injunction b/c ITTs actions were intended to entrench the current Board. o (2) Shareholder Meetings: Quorum Requirements DL Gen. Corp. Law 216: a valid shareholders meeting requires 50% of the shares present and accounted for in some fashion. Rationale: intended to protect the shareholders from non-representative votes. Annual Meetings & Special Meetings: DL Gen. Corp. Law 211: corporations are required to have annual shareholders meeting. o Typically where regular business of the corporation is handled. DL Gen. Corp. Law 211(d): shareholders may only call a special meeting if the charter permits it.
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Rationale: intended to make hostile takeovers more difficult. Now, Gordon Gecko has to go to the annual meeting. (3) Proxy Voting: DL Gen. Corp. Law 212: shareholders may vote by proxy & corporate management is entitled to collect voting authority by collecting proxies. Proxy cards: sent out by the management to the shareholders to collect the rights to vote. Revocation: shareholders may revoke their proxy authorization by attending the meeting Expenses Incurred in Proxy Contest Generally: Can corporate funds be used to reimburse a large scale proxy fight? The corp usually pays the costs of the defense of a proxy contest. Where a change in control occurs, the corp may also pay the costs of the successful campaign to oust incumbent management. Froessel Rule (Majority): (1) Incumbent Board may incur reasonable expenses related to defense of proxy contest if: o (a) Dispute relates to a policy matter. o (b) Incumbent Directors act in good faith. (2) Proxy solicitation expenses incurred by insurgents will be only be reimbursed if: o (a) Shareholders ratify the reimbursement. o Effect: insurgents expenses are only reimbursed when they win. (3) Courts will disallow reimbursement where: o (a) Money is spent for personal power or advantage. o (b) Amount spent is unreasonable Efficiency: Rule is efficient. o (1) Encourages valid proxy contests by mitigating the cost to insurgents. We want to encourage challenge of bad management. o (2) Discourages frivolous proxy contests b/c people less likely to win less likely to be reimbursed. o (3) a system that required insurgents to be reimbursed would arguable encourage too many proxy fights, while a system that prohibited management from using corp resources to defend itself might discourage competent managers from agreeing to serve and would operate as an effective presumption that an insurgents is as worthy as incumbent management Rosenfield v. Fairchild Engine & Airplane Co. o Illustrates Froessel Rule (Majority). o Most courts have allowed mgmt also to charge to the corp the reasonable expenses of educating stockholders if the controversy involves a policy question rather than a mere personal struggle for control o A successful challenger may seek to have the corp reimburse expenses. As w management expenses, the reimbursement of successful insurgents are permitted if the dispute can be characterized as one over business policy and involving policy rather than personalities. o As a result the corp may end up paying for the expenses of both sides if the challenger is unsuccessful. o Note that virtually every issue may be dessed up as a policy rather than personal issue
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o o

Effect: probably to permit the deduction of all reasonable management expenses.

(4) Class Voting Creating different classes is simplest and most effective way to assure control rights. Especially useful with it is necessary to allocate voting power in different proportions from financial interests. DL Gen. Corp. Law 242(d): shareholders may vote as a class, irrespective of whether a the charter authorizes a class vote, if the amendment would increase or decrease the aggregate number of shares of such class, or alter or change the powers, preferences or special rights of the shares of such class so as to affect them adversely. RMBCA: class vote is contingent on whether a change in X occurs, not whether such change is adverse. Effect: the majority of the votes in every class that is entitled to a separate class vote must approve the transaction for its authorization. Gives each class a veto right. Rationale: provides structural protection for the minority from the will of the majority (common stock holders). Rule: Law does not protect the economic value of preferred stock, just the legal rights. Rationale: Preferred stockholders presumably knew they had no economic protection when they bought the stock. (1) Can layer senior security (priority preferred stock) into capital structure without vote by existing preferred class (2) Mergers do not require class vote by preferred. o Mirror preferred: copy terms of preferred stock from one company to another. Preferred stock holder in Company A now has preferred stock in Company AB no adverse affect no class vote. Information Rights of Shareholders: o DL Gen. Corp. Law 220(b): shareholder may inspect the companys stock ledger, shareholder list and other books and records, for any proper purpose. Proper purpose means a purpose reasonably related to such persons interests as a stockholder. o (1) Stock Lists: identifies stockholders and lists their contact information. Standard of Review: judiciary broadly construes proper purpose to almost mean any purpose at all list is relatively easy to get. Efficiency: Availability of information is consistent with the Efficient Capital Markets Hypothesis. General Time Corp. v. Talley Industries o Court allows stockholder access to the shareholder list so long as his purpose is reasonably related to his status as a stockholder. o Conversely, shareholders must show legitimate interest. Courts will evaluate motive, broadness of request. o (2) Books & Records Standard of Review: judiciary reviews requests for companys books & records with higher scrutiny due to the sensitive and possibly proprietary nature of the information that could place corporation at risk. Ex. trade secrets, cost data, etc. Courts examine: o Identity of the shareholder requesting. o Stated purpose of the request.

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Techniques for separating control from cash flow rights

Ownership and control are separated when a shareholder, for a price, agrees to vote his shares as directed. Background: Early courts condemned corporate vote buying and declared it illegal per se. They doubted the incentives of vote buyers to maximize corp value consistent with the interests of sh and creditors. Special Risks: coerced changes in control, looting (1) Vote Buying

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Courts limits the separation of financial rights in stock and voting rights You cant sell your right to vote while keeping the stock and you cant sell the stock without also selling with it the right to vote The legitimacy of vote buying may depend on whether the buyer is a fellow shareholder or management o Shs may arguably be free to do whatever they want, but managements use of corp assets to buy votes is problematic and may require a showing that there is no deleterious effect on the corp or the corp franchise o See DGCL 160(c) below Exception: If transferror specifically retains the voting right to protect a legal interest or the corporation is strong enough to support the grant of an irrevocable proxy Schreiber v. Carney (Del) o Texas International Airlines and Texas Air entered merger discussions. Jet Capital was 35% shareholder in Texas International and had effective veto power. Texas International gave Jet a loan (approved by shareholders) so that they would support the merger. o A lg shareholder caing a substantial tax liability of the company were reorganized withdrew its opposition to a proposed reorganization after the corp agreed to laon the shareholder sufficient funds to avoid the tax liabilility o Dissenting shareholder of Texas International sued to enjoin transaction as vote buying o Holding: Corporate vote-buying is permissible if it does not work to the prejudice of other shareholders o Accepting the shareholder had sold his vote by cedeing his discretionary voting power, the court concluded that transfers of coting rights without the underlying economic interest are not necessarily illegal unless the object or purpose is to defraud or in some way disenfranchise the other stockholders. o Since the reorg was meant to benefit the shareholders and the tax related loan was fully disclosed, the court decided there was no fraud or disenfranchisement. o Vote buying must be subject to a test for intrinsic fairness (2) Controlling Minority Structures Includes dual class share structures, stock pyramids and cross-ownership ties all permit a shareholder to control a firm while holding only a fraction of the equity good policy to award voting rights to the investors who claim the corporations residual returns. Nevertheless, the laws policy of aligning control with residual returns is sometimes frustrated. Ex: capital structures with dual-class voting, which misalign control rights and return rights, are not prohibited by law, although they are discouraged by stock exchange listing requirements. The law does proscribe some devices that misalign incentives most notably a statutory prohibition against a corporation voting shares owned by the corporation directly or indirectly. But other structures are possible by which
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a corporations capital may be used to affect ownership and voting of its own shares. DGCL 160(c): Shares of its own capital belonging to the corporation or to another corporation, if a majority of the shares entitled to vote in the election or directors of such other corporation is held, directly or indirectly, by the corporation, shall neither be entitled to vote nor be counted for quorum purposes. Collective Action Problem: o Issue: shareholders habitually approve management action can they effectively govern under this voting system? Easterbrook & Fischel: Shareholders are rationally apathetic. Will rationally ignore the actions of the company because their vote wont change it defer to managers. Professor Black: Institutional investors could overcome collective action problem and effectively govern if Gov. restrictions on shareholder oversight were loosened. Significant holdings less passive. Outside interest due to fiduciary duties (many institutional investors hold stock for other people, pension plans, etc.) Government Efforts to Coordinate Shareholder Action:
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The Problem: Voting by proxy creates opportunities for management over reaching. State law authorizes proxy voting but does not significantly regulate its potential for abuse (DCGL 212(b)). To protect shareholders from management overreaching-common before federal regulation-federal rules promulgated under the Securities Exchange Act of 1934 regulate proxy voting in public corporations. The Response: Fed gov established proxy rules that make it easier for shareholders to communicate with each other, and easier to make sure management is not defrauding them, and allows town meetings. (1) Federal Proxy Rules: Securities & Exchange Act of 1934: regulates information that public companies must provide to their shareholders on an ongoing basis (annually, quarterly, at votes). 14 and Rules: regulate virtually every aspect of proxy voting at public companies. Including: (1) Disclosure requirements to protect shareholders from misleading communications. (2) Substantive regulation of the process of soliciting proxies from shareholders. (3) Town Mtg. Rule (14a-8) permits shareholders access to corporations proxy materials as a vehicle for communicating their proposals. (4) Antifraud Provision (14a-9) permits courts to imply a private shareholder right of action for false or misleading proxy materials. 1992 Amendments to Rule 14a: permits institutional investors to communicate with one another (up to 10) without first launching an expensive, full-scale proxy contest. 14a Rules: 14a-1: Definitions. Broadly defines the term proxy and the term solicitation. o Proxy: includes every proxy, consent or authorization within the meaning of section 14(a) of the Act. The consent or authorization may take the form of failure to object or consent. 14a-2: Exemptions o Solicitations to fewer than 10 shareholders are exempt.
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o Solicitations by shareholders not intended to seek proxies. 14a-3: Proxy statement required for valid solicitation. 14a-4 & 5: Requirements of the form of the proxy. 14a-6: Formal filing requirements for proxies & solicitations. 14a-7: List or Mail Rule o When a shareholder requests a shareholder list so that they can mail materials relating to their proposal, management does not have to disclose the shareholder list if they agree to mail the materials themselves. o Usually, management will mail the materials to protect the list. 14a-8: Town Meeting Rule (Shareholders Proposals) o Shareholders may include materials relating to certain proposals in the proxy statement if: (1) Shareholder has continuously held either $2k or 1% of the companys value for 1 year before proposal is submitted. (2) Proposal is 500 words or less. (3) Proposal is submitted at least 120 days before management is going to mail the proxies. Gives management time to challenge. Note: usually proposal must be drafted as a suggestion in order to withstand managements challenge. Rationale: management is supposed to run the company & can take suggestions but not direction. o Management will seek a no action letter from the SEC on the grounds that: (1) Shareholders proposal relates to the ordinary business of the company within management purview. (2) 14a-8(i): list of reasons including violation of proxy rules, conflicts with companys proposal, duplication. o No action letter: from the SEC, permits management to exclude the shareholder proposal from the proxy materials without being penalized. o Analysis of Shareholder Proposals: Traditional Rule (Current): shareholder proposals are analyzed on a case-by-case basis. Cracker Barrel Rule (Overturned): SEC responded to shareholders use of proposals to highlight social policy issues, by ruling employment proposals could always be excluded under ordinary business exception. Rejected bc seen as inconsistent with a published policy statement of the SEC 14a-9: Standard Anti-Fraud Rule: o In 1964 SC implied a private right of action for individuals to bring fraud claims under rule 14a-9. Borne of concern that the SEC was not keeping up with fraud issues in securities cases. o Plaintiff must show: (1) Materiality: misleading statement or omission must be material.

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Definition: Substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. (2) Culpability: circuit spit as to standard. Some courts use negligence, others use scienter (intentional or extreme recklessness). (3) Causation: is presumed where proxy statement was an essential link in the accomplishment of the transaction. (4) Damages: may be injunctive relief, monetary damages or rescission. o Plaintiff does not have to show: (1) Reliance: no need to prove reliance on the misrepresentation. Different than CL fraud. o Rule: Opinions are actionable when they are material to the shareholders and supported by objective evidence. o Effect: Need to have good faith belief in your opinion and have objective support that your good faith belief is reasonable. o Remedy: rescissory damages (benefit of the bargain) In such cases state law becomes more attractive then fed law even though it may be more difficult to establish liability in a state law action than in fed action under the proxy rules in which mere negligence will suffice If a cause of action based on 10b-5 is also asserted, the claim must allege that the D acted with scienter, (at least recklessly) Virginia Bankshares, Inc. v. Sandberg (SC) First American Bank merged into Virginia Bank shares, parent company of VB hired investment banking firm to give an opinion on appropriate price of shares for minority holders. They concluded $42 was fair prices. Merger approval was approved, directors proxy said it was high value and fair price for stock Shareholders who didnt vote filed a misrepresentation claim alleging violation of 14 and rule 14(a)(9) and breach of fiduciary duties owed to minority shareholders under state law. Federal implied right of action cannot be demonstrated by minority shareholders whose votes are not required to authorize the transaction giving rise to the claim Also, no harm here b/c state law cause of action preserved. Shareholders cant sue base don mistaken beliefs, however they can sue based on misrepresented facts., but here shareholders lose bc no causation. 14a-11: Shareholder Proxy Access Rule o Permits long-term shareholders to place their own nominees on a public companys proxy materials under certain limited circumstances. (1) 35% of shareholders withhold vote for a board candidate. (2) Passage of shareholder resolution during the prior year requesting shareholder resolutions.
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o Widely debated and not yet adopted. (2) Disclosure Laws: Conflict: Fiduciary Duty of Candor (State) v. Federal Securities Laws o State law recognizes a fiduciary duty of candor that applies to Directors and Controlling Shareholders. May create new, non-Federal action. o Historically, tension was minimized b/c State interpreted terms very similarly to Federal never State action w/ out Federal. Limitations on State Suits: (1) Necessity of shareholder action: states will only permit a suit to go forward if shareholder action is required for transaction to proceed. o If shareholder action is necessary state law remedy. o If shareholder action is unnecessary no state law remedy. (2) Continuing Shareholders: shareholders who neither purchased nor sold for the duration of the fraud will have a state law remedy. o States carve out an anti-fraud niche. o Continuing shareholders not protected under Federal Securities Laws expect to see State action. o Malone v. Brincat the DE supreme court abandoned this limitation. Case involved long-term fraud where directors made false filings with the SEC and distributed false financial statements to shareholders o Holding: Whenever directors communicate publicly or directly with shareholders about the corporations affairs, with or without request for shareholder actions directors have a fiduciary duty to exercise care, good faith and loyalty o This cause of action is limited to those who still hold their shares o Still come conflict with federal law o o
o

court expanded the duty of disclosure to include all communications to shareholders, not just those seeking shareholder action. Duty arises whether or not the corp is requesting shareholder action and can be enforced by shareholders claiming individual losses or in a derivative action on behalf of the corp. a claim could be stated on these facts, but implied it was restricted to Ps who still held their shares. directors who knowingly disseminate false info that results in corporate or shareholder harm violate their fiduciary duty and should be held accountable.

o o

CHAPTER 8: NORMAL GOVERNANCE: THE DUTY OF CARE Duties of Directors and Officers (and Controlling Shareholders)
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Summary of 3 Principle Duties: If directors & officers dont breach these duties they cant be prosecuted for any decisions they make. (1) Duty of Obedience: fiduciary must act consistently with the legal documents that create her authority (Ex. charter, bylaws, etc.). (2) Duty of Care: duty not to be an idiot. Decisions must be made in good faith, in the best interests of the corp, and with prudence (3) Duty of Loyalty: duty not be a thief. Duty of Care: Addressed the attentiveness and prudence of managers in performing their decision-making and supervisory functions ALI says a corporate director must perform her functions: o In good faith o In a manner that she believes is in the best interests of the corporation o With the care that an ordinarily prudent person would reasonable be expected to exercise in a like position and under similar circumstances Approach: o Q1: Is there a 102(b)(7) provision in the companys charter?
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DGCL Section 102(b)(7): A corporation can put a provision in its charter eliminating personal liability of directors for breach of duties of care (except if their actions were in bad faith or against the law). 48 of the states have enacted similar laws. o Enacted in response to Smith v Gorkom. o To get around this, duty of care can be considered breach of duty of good faith which is a subset of duty of loyalty-see Stone v Ritter below.. If YES unless bad faith or illegal Directors protected from personal (monetary) liability. If NO go to Q2. Q2: Does the Business Judgment Rule apply? BJR: a rebuttable presumption that directors in performing their functions are honest and well-meaning, and that their decisions are informed and rationally undertaken, basically presumes directors do not breach duty of care. This shields directors from personal liability and insulates board decisions from judicial review. The Business Judgment Rule will protect Directors unless: (1) Directors have failed their Duty to Monitor (i.e. no compliance program (Caremark), or permitting theft (hapless drunk widow)). (2) Waste (3) Illegality or knowing violation of existing regulation (AT&T (40)) o Directors who consciously disregard their responsibilities are liable for violating their duty of good faith. (walt Disney 72) (4) Other: fraud, gross negligence (Smith v. Van Gorkom (98)).
o o really a merger case, court said directors were grossly negligent in approving a merger without being properly informed

If any of the above liability for breach of the Duty of Care. If none of the above Directors receive protection of the Business Judgment Rule. ALIs Principles of Corporate Governance: A Director or Officer must perform his functions: (1) In good faith. (2) In a manner that he reasonably believes to be in the best interests of the corporation.
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(3) With the care that a reasonably prudent person would reasonably be expected to exercise in a like position and under similar circumstances. Standard: negligence or gross negligence. (1) Protection of the Business Judgment Rule: Rule: where the Director or Officer is disinterested in the transaction, there can be no liability for duly informed actions taken in good faith unless they are so unreasonable as to constitute fraud, negligence or gross negligence. Effect: shields Directors & Officers from liability in almost every instance for corporate decision-making. Rationale: Align Interest of the Shareholders with Interest of the Directors Shareholders can diversify their idiosyncratic risk while D & O cannot D & O may be more risk adverse. If D & O are too risk adverse, shareholders will never profit. Protection of the Business Judgment Rule permits good faith risk without consideration of D & O liability permits profitability. o Gagliardi v. Trifoods International, Inc. o Issue: What must a shareholder plead in order to state a derivative claim to recover corporate losses allegedly sustained by reason of mismanagement unaffected by directly conflicting financial interests
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Holding: If officers dont have this protection theyll act too conservatively. They wont make any decisions so they cant make bad decisions, and this is not in the shareholders best interest.

o Shareholders can absorb risk by investing in many companies Advantages: (1) Procedural: converts question into Matter of Law i/o Matter of Fact under the courts jurisdiction less jury trials streamlined. (2) Substantive: clarifies the courts inquiry. (3) Social: social value in defining the right thing. Encourages good behavior. 2 ways to trigger protection of the Business Judgment Rule: (1) Standard of Liability: if the board has made decisions without fraud, illegality, negligence or conflict of interest no liability. (2) Abstention Doctrine: if the courts find that the directors and officers have made their decision without fraud, illegality, negligence or conflict of interest the courts will abstain from looking further. o Kamin v. American Express Co. o Board protected by the business judgment rule where they give shareholders an in-kind dividend of worthless DLJ stock, thereby foregoing a tax benefit, in an effort to hide $26M loss on income statement. o No evidence of conflict, fraud, illegality or negligence Board protected under Business Judgment Rule despite foolish decision. o Board declared a dividend of more than stock was worth o Shareholder brought derivate action claiming that the dividend constituted a waste of corporate assets o Holding: Whether or not to declare a dividend or make a distribution is exclusively a matter of business judgment for the board of directors - so long as it is made in good faith the court will not interfere (2) Duty to Monitor: essentially the duty to pay attention.
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Requirements: A general duty to monitor, be reasonably informed, attend meetings, review financial statements, etc. Violation: results from agency cost of passivity. Failure to act or respond may constitute a breach of the duty to monitor. Rationale: the tone at the top matters. Also, no other sensible group on which to impose liability. Rule: Business Judgment Rule not applicable to duty to monitor cases. Rationale: There is no benefit to the shareholders in protecting D & O from their own laziness. Francis v. United Jersey Bank o Mrs. Prichard (alcoholic widow) breaches her duty of care/monitor by failing to familiarize herself at all with the family reinsurance business of which she was a director. o Court finds that had she paid any attention, her sons theft from the business would have been obvious. Irrelevant that she relied on her sons and was not knowledgeable about the business shouldnt have taken the job. Note: When wrongdoing is discovered, Director usually may insulate himself from liability by 1) objecting and 2) resigning. Fiduciary position may heighten this duty though. Liability of a corporations director to its clients requires a demonstration that: o A duty existed o The directors breached that duty o The breach was a proximate cause of the clients losses Duty to monitor arises when directors and officers receive notice of potential wrongdoing until then can rely on good faith in employees Difficult to determine what sufficient notice is Rule: Duty to monitor arises when D & O receive notice of potential wrongdoing, until then D & O may rely in good faith on employees. Issue: Difficult to determine what is sufficient notice. Recent Trend-Extension of Duty Recent DE courts have used the duty of good faith to impose liability on directors who fail to adequately monitor management misbehavior. By couching the analysis in terms of lack of good faith rather than lack of care, director liability is not subject to exculpation under 102(b)(7) Exculpation of Directors Duty of Care under 102(b)(7): No personal liability for breaches of duty, though director remains liable for breaches of duty of loyalty, acts or omissions not in good faith that involve intentional misconduct or knowing illegality, approval of illegal distributions, and obtaining a personal benefit (such as insider trading). This means, after 102(b)(7), the shareholders, directly or derivatively, cannot sue the directors for gross negligence as to the substance of the decision, they may attack the process, see Caremark Stone v. Ritter (2006): DE Supreme Court clarified that direct oversight is subject to review under the duty of good faith, a subset of the duty of loyalty. Shareholders brought suit alleging that a better monitoring system would have revealed that bank employees had unwillingly allowed bank accounts to be used by a couple of scoundrels running a Ponzi scheme. Federal banking authorities found that the monitoring program was materially deficient and imposed record-setting fines of 50 mill for the defending company. Yet, the
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court did not hold that the directors engaged in a deliberate failure to exercise oversight. That the system failed, according to the court, was not enough to establish a sustained systematic failure of the board to exercise oversight. The court pointed out that subjecting directors to personal liability for employee failures is possibly one of the most difficult theories in corporate law. Graham v. Allis-Chalmers Manufacturing Co.

o Several non-director employees at a 31,000 person company were indicted for violating antitrust laws o No director had any actual knowledge of antitrust activity or had facts which would have put them on notice o Holding: A corporate director who had no knowledge of suspicion of wrongdoing by employees is not liable for such wrongdoing as a matter of law Until put on notice, the board may rely on the trustworthiness of employees here board acted appropriately once they were informed Here it was impossible for the board to know every employee
o o
o

No BJR protection bc no actual decision was made. Directors did not breach their duty of care/monitor by failing to institute monitor system for anti-trust activity where they had no notice of any wrongdoing.
Court finds that knowledge of anti-trust activity 30 years prior was insufficient notice.

Beam v. Martha Stewart Holding: Directors and officers of a corporation do not have a fiduciary duty to monitor the personal, financial and legal affairs of other directors or officers to ensure that their conduct does not harm the corporation Securities Law and SEC impose negligence-based duties on directors in a variety of contexts In the Matter of Michael Marchese o Marchese, an outside director of company Chancellor, served on Chancellors audit committee. Different auditors came to different conclusions and Marchese made no inquiry into why. Turned out the reasons were illegal. o Holding: An outside director of a corporation who serves on its audit committee violates, and causes his corporation to violate, the Exchange Act and Rules by recklessly failing to inquire into the corporations financials when he has knowledge of facts to put him on notice that such an inquiry is warranted Federal Organizational Sentencing Guidelines (1991): uniform sentencing structure for organizations convicted of federal crimes adopted by the U.S. Sentencing Commission. Effect: Incentives implementation of compliance programs b/c sentence/fine is significantly reduced if one is in place. Rule: Board must implement a compliance program in order to satisfy its duty of care. The level of detail in the monitoring system is subject to the Business Judgment Rule. Rationale: Monitoring system is a necessary part of the Boards duty to be informed.
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In re Caremark International, Inc. Derivative Litigation o Court approves settlement related to violation of anti-referral law (doctors cannot receive $ for issuing prescriptions of your product). o Caremark has an extensive compliance program in place (guidebook, training, internal audits, etc.) no breach of care or duty to monitor. o Boards have a duty to make a good faith effort to ensure that the internal controls (what is reported up the ladder) are working and that the info is accurate and there are systems for compliance. o Rejects Allis-Chalmers: compliance program required w/out notice. Knowing Violations Rule: Directors engaged in illegal activity or a knowing violation of an existing regulation will not receive the protection of the Business Judgment Rule, regardless of whether their actions are intended to benefit shareholders. Rationale: Illegal act or knowing violation is always a breach of fiduciary duty. Miller v. AT&T o Whenever BOD engages in unlawful activity, shareholders can recover o Court finds legitimate claim for waste where AT&T makes $1.5M illegal campaign contribution to the DNC by not collecting a debt. Directors are not protected by the business judgment rule if conduct is statutory violation. This was an illegal campaign contribution. Sarbanes-Oxley Act of 2002: 404 requires that the CEO & CFO of public companies personally certify that they have disclosed the companys independent auditor all deficiencies in the design or operation, or any material weakness, of the firms internal controls.

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CHAPTER 9: CONFLICT TRANSACTIONS: THE DUTY OF LOYALTY

Duty of Loyalty: Addresses fiduciaries conflicts of interest and requires fiduciaries to put the corps interests ahead of their own. Corporate fiduciaries breach their duty of loyalty when they divert corporate assets, business opportunities, or proprietary information for personal gain. Requires a corporate director, officer or controlling shareholder to exercise her institutional power over corporate processes or property (including information) in a good-faith effort to advance the interests of the company o Ds, Ors or controlling shareholders may not deal with the corporation in any way that benefits themselves at the corporations expense Duty of Loyalty Requirements: Directors, Officers & Controlling Shareholders must only deal with the company in terms that are intrinsically fair in all respects must be free from conflicts of interest. Approach o Issue Spotting: Most claims for breach of duty of loyalty will be: Self Dealing Fiduciary enters into a transaction with the corp on unfair terms, the effect (from corps standpoint) is the same as if he had appropriated the difference btwn the transactions fair value and the transactions price. A parent corp that controls a partially owned subsidiary can breach its duty to the minority shareholders of the subsidiary if the parent prefers itself at the expense of the minority When parent squeezes out the minority (in a merger or other transaction) and forces minority to accept unfair consideration for their shares Executive Compensation When a director or officer sells his executive services to the corp, diversion can occur if the executives compensation exceeds the fair value of his services. Usurping Corp Opportunity When a corp fiduciary seizes for herself a desirable business opportunity that the corp may have taken and profited form, diversion occurs if the fiduciary denies the corp the opportunity to expand profitably. Disclosure to Shareholders Corp officials who provide shareholders false or deceptive info, on which the shareholders rely to their detriment, not only undermined corp credibility and transparency, but frustrate the shareholders expectations of fiduciary honesty and accountability. Duties of disclosure arise when directors seek a shareholder vote (state law and/or proxy fraud) and when corp officials communicate to stock trading markets (state law, 10b5) Trading on Inside Info Selling Out Entrenchment A manager who uses the corp governance machinery to protect his incumbency effectively diverts control from the shareholders to himself. This prevents shareholders from exercising their control rights-(by voting or selling to a new owner)
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Issue Spotting: Look for Self-Dealing when: (1) Deal is between Corporation & Director (2) Deal is between Corporation & a Controlling Shareholder
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Note: Fiduciary duty of loyalty implied through obligation to be fair for controlling shareholder b/c often the Board is beholden to the controlling shareholder who elects them o Q1: Is there an interested party? (conflicting financial interest in the transaction or beholden to interested party bc of financial or business relationships, or family or social relationships) If Director go to Q3. If Controlling Shareholder go to Q2. o Q2: Was there self-dealing? Apply the Benefit Detriment Test (Controlling Shareholders Defensive Measure). Did the Majority shareholders (Parent) receive a benefit to the exclusion and the detriment of the Minority shareholders (Subsidiary)? If YES go to Q3. If NO claim dismissed. o Q3: Is there an applicable safe harbor statute? If YES analyze under 3 approaches: 1) Disclosure/Approval + Fairness 2) Disclosure/Approval alone 3) Disclosure + Fairness (likely only in close or smaller corps. where disinterested director approval impossible & either no shareholders or no time to submit to shareholders). If NO go to Q4. o Q4: Did the interested party to the transaction disclose all material information relevant to their conflict? If YES go to Q5. If NO transaction is voidable b/c non-disclosure = unfairness (Hayes). o Q5: Was there approval by a disinterested party? If YES go to Q6. If NO Corporation must show Entire Fairness (Fair Process & Fair Price) when challenged (no burden shifting to P b/c no approval). Note: If transactions was between the Corporation & a Controlling shareholder and approved by the Directors o Q6: Which disinterested party approved the transaction? If Disinterested Directors burden shifts to the P P must show waste to overcome the Business Judgment Rule. If Disinterested Shareholders go to Q7. o Q7: Who are the interested parties to the transaction? If Controlling Shareholder burden shifts to P P must show the transaction was not Entirely Fair (Fair Process & Fair Price). If Director burden shifts to P P must show waste to overcome the Business Judgment Rule. Is waste overcome by unanimous shareholder ratification? (Lewis v Vogelstein) (1) Transactions with Directors: o The Disclosure Requirement Del Law: Conflicted fiduciary (director or controlling shareholder) must disclose all material information relevant to the transaction Rule: Disclosure is so critical that failure to disclose is tantamount to unfairness non-disclosure will render transaction voidable. Rationale: Disclosure allows the company to consider all the facts when making a decision. Burden on the party best able to bear it much easier for Director to disclose potential conflict than it is for the corporation to uncover it.
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State ex. rel Hayes Oyster Co. v. Keypoint Oyster Co. (Deal w/ Director) Hayes was Coasts CEO, director and 23% shareholder, also had 35% interest in his familys Oyster Co. Hayes brokered a deal for Coast to sell some Oyster Beds to Keypoint. Hayes and Hayes Oyster had an interest in Keypoint which only one Coast employee knew of. o Coast brought suit alleging Hayes had breached his fiduciary duty by acquiring a secret profit and personal advantage to himself through the deal o Holding: A Corporations director or officer breaches his fiduciary duty to the corporation by failing to disclose the potential profits or advantage that would accrue to him if a transaction involving the corporation were approved o Hayes has to give to Coast what he received from the transaction o Court finds his failure to disclose his interest is a violation of fiduciary duty of loyalty even though the transaction was fair financially. Negotiated fair price falls within a range. o Remedy: Director has to give Coast his 50% stake in Keypoint. Punitive in nature b/c Keypoint is more than made whole. o Rationale: Deterrent. (2) Transactions with Shareholders: Controlling Shareholders and the Fairness Standard Benefit Detriment Test: If the Majority shareholders (Parent) receives a benefit to the exclusion and the detriment of the Minority shareholders (Subsidiary) SelfDealing. Intrinsic Fairness Standard: shifts burden of proof to D (Parent/Majority) to prove its actions were objectively fair. If Self-Dealing Apply Intrinsic Fairness Standard If No Self-Dealing Apply Business Judgment Rule. o Sinclair Oil Corp. v. Levien (Deal w/ Controlling Shareholder) o Sinclair was majority shareholder of board, nominated all members of the board. Minority shareholders brought suit on behalf of Sinven, claiming Sinclair had forced Sinven to pay excessive dividends, denied the opportunities and breached contract on behalf on its subsidiary Sinclair oil Fiduciary duty existed on the part of Sinclair because of the relationship between the two companies Ps Claim intrinsic fairness test should be applied o Holding: Intrinsic fairness test should not be applied to business transactions where a fiduciary duty exists but is not accompanied by self-dealing (i.e. where parent company receives benefit to the detriment or exclusion of minority shareholders of subsidiary). In those cases use Business Judgment Rule o Sinclair did engage in self-dealing when it forced Sinven to contract with its subsidiary intrinsic fairness test applies to this transaction o Transaction was not intrinsically fair to minority shareholders Court finds that Sinclair (Parent) was not engaged in selfdealing when it caused Sinven (Subsidiary) to make huge dividend payments, from which it benefited. Sinclair did not receive anything from Sinven to the exclusion of its Minority shareholders under Benefit

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Detriment Test there was NO self-dealing Court applies Business Judgment Rule. Burden is on P to show that the dealings were not what would be expected in an arms length relationship (departure from traditional self-dealing rule) Note: never self-dealing w/ a pro rata distribution of dividends b/c minority is never excluded. Approval of Disinterested Parties: Safe Harbor Statutes: A self-dealing transaction is not voidable solely because it is interested, you may be able to preserve the transaction over an objection if it is adequately disclosed and approved by a majority of disinterested directors or shareholders or it is fair. Rationale: properly informed and qualified directors are superior at determining the value of a self dealing transaction to the corp than a reviewing judge. DL Gen. Corp. Law 144: An interested directors participation in a transaction will not immediately make the transaction void or voidable if: o (1) Interest is disclosed and a majority of the disinterested Directors ratify the transaction or o (2) Interest is disclosed and a majority of the shareholders ratify the transaction or o (3) The contract is fair to the corporation at the time of ratification. Judicial Interpretations of Safe Harbor Statutes: Approach 1 (Conventional): Courts read the statutory elements as conjunctive require fairness + disclosure + approval by disinterested party. o OR: Satisfying statutory elements does not foreclose judicial review for fairness, which may still void the transaction. o Scholarly Support: Melvin Eisenberg Supports requiring fairness plus disinterested approval & disclosure because: (1) Likely that all directors are friends disinterested directors unlikely to be wary enough of interested directors. (2) Distinction between factually & legally disinterested. o Cookies Food products v. Lakes Warehouse (Iowa)

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Controlling shareholder of BBQ Sauce Co. is profiting from exclusive distributorship, taco royalty and consulting fee and is sued for breach of loyalty. Cookies approached Herrig, a shareholder in Lakes to distribute Cookies product. Cookies sales soared, Herrig gained control of Cookies by buying a majority of its stock replaced 4 of 5 board members. Distribution contract was extended as it was before he become majority shareholder. No dividends were paid to Cookies shareholder due to terms of loan Minority shareholders brought suit alleging Herrig had violated his duty of loyalty Holding: Directors who engage in self dealing must establish that they acted in good faith, honesty and fairness in addition to other requirements Court requires a conjunctive test, fairness/good faith plus statutory element of disclosure & disinterested approval. More than plain meaning of safe harbor statute. Narrower reading. No breach b/c transactions were fair, fully disclosed AND approved by disinterested director. Self-dealing transaction must have the earmarks of armslength transactions before a court can find them fair and reasonable Here D worked hard on Ps behalf, his services were fairly priced and consistent with interests of P Approach 2: Courts may read the statutory elements as disjunctive and let an interested transaction stand without doing a fairness review where there was disclosure and approval by a disinterested party. o Rationale: ratification by the disinterested director cleanses the taint of interest. o Note: More likely to be employed where the interested party is not a top manager or a controlling shareholder. Cooke v. Oolie (DL) Ds were directors and creditors of TNN. They voted to pursue an acquisition proposal that allegedly best protected their personal interests as TNN creditors instead of proposals which had superior value for shareholders. Two disinterested directors also voted in favor of the acquisition

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Holding: An interested directors vote to pursue a transaction that would be beneficial to the director at the expense of the shareholders is protected by the business judgment rule when disinterested directors ratify the vote Court will presume that the vote of a disinterested director signals that the interested transaction furthers the best interests of the corporation despite the interest of one or more directors Courts apply Business Judgment Rule where an independent board ratifies the self-dealing transaction of a TNN Director. Justification is standard notion of equalizing risk between Directors and Shareholders.

Approach 3: Where there is disclosure but no disinterested approval, Courts may still allow the interested transaction to stand if it passes a fairness review. o Disclosure + fairness approval=OK o Note: More likely to be employed where the corporation is small or closed (b/c less likely to have disinterested directors) or where circumstances did not allow time for ratification by disinterested shareholders. Shareholder Ratification of Interested Transactions: Shareholders may ratify actions of the board but law is mindful of certain issues Controlling shareholders are in a better position to manipulate or unfairly influence the process of shareholder vote Disclosure + Approval NOT OK if waste (unless vote is unanimous) Collective Action Problem: shareholder ratification is more complex than principals ratification of agents acts b/c of collective action problems. o Shareholders have different interests, skill levels, etc. Corporate waste doctrine limits the shareholders ability to bind a transaction Even a majority vote cannot protect wildly unbalanced transaction that, on their face, irrationally dissipate corporate assets only a unanimous cote can override finding of waste Rule: Only a unanimous shareholder vote can ratify corporate waste. o Waste: when corporation receives a disproportionately minute benefit for what it is giving up such that it is almost giving away assets. Rationale: waste constitutes a gift of corporate property and no one should be forced to make a gift of their property. Different standards depending on whether the transaction is with a noncontrolling shareholder (more deferential) or a controlling shareholder (less deferential) o Lewis v. Vogelstein (Mattel options case) (DE) Court holds that disinterested shareholder approval will preclude all judicial review except with regard to waste. Holding: Unanimous shareholder approval is required to ratify a conflicted transaction that involves corporate waste Impact of Disinterested Shareholder (& Disinterested Other) Ratification:
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o In Re Wheelabrator Technologies, Inc.:

DL Court charts the effect of different types of approval of interested transactions (see below). WMIs is 22% shareholder (non-controlling) of WTI, increases position to 55% and pays in stock. Independent directors, directors & shareholders, ratify deal. Court holds WTI plaintiffs to the entirely fair standard since shareholders approval sanitized the transaction. No Approval: If Corporation fails to seek approval for an interested transaction they must prove Entire Fairness (Fair Process & Fair Price) when challenged. Holding: A fully informed shareholder vote ratifying an interested-director transaction subjects a claim for breach of directors duties of care and loyalty to business judgment review rather than extinguishing the claim all together Approval does extinguish claim that board acted without due care Claim: Breach of Duty of Loyalty Court holds WTI plaintiffs to the entirely fair standard since shareholders approval sanitized the transaction. Effect: Approval Corporation fails to seek approval for an interested transaction they must prove NO Approval: Ifby disinterested director shifts Entire Fairness (Fair Process & Fair Price) when challenged.
the burden to P. Burden: P must prove waste Approval by the Business to overcome Disinterested Directors Judgment Rule. Rationale: Disinterested Directors approval sanitizes the transaction and eliminates the conflict. Note: To be in this position there can be NO controlling shareholder involved because if the transaction is with the controlling shareholder you will never find Disinterested Directors!!

Approval by Disinterested Shareholders

Claim: Breach of Duty of Care Effect: Shareholder ratification + Disclosure will extinguish any claim for breach. Claim: Breach of Duty of Loyalty Effect: Shareholder ratification + Disclosure shifts the burden to P to prove transaction was unfair.

Transaction w/ Director Burden: P must show waste. Standard: Approval by disinterested shareholders gave Directors protection of the Business Judgment Rule waste is the only option to overcome it.

Transaction w/ Controlling Shareholder Burden: P must show the transaction was not entirely fair to the corporation. Entirely Fair: Fair Process & Fair Price Standard: Much lower burden.

Rationale: Differences in standards reflects variances in the Courts institutional confidence in Directors & Shareholders. o Directors: Courts are more confident in Directors more deferential protection of the Business Judgment Rule. o Shareholders:
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Duty of Care: Shareholders are competent to evaluate these claims unnecessary to utilize judicial resources. Duty of Loyalty: Shareholders may mistakenly view any conflict as harmful need to use judicial resources to ensure that worthwhile but interested transactions can go forward. Bifurcation in standards between Transactions w/Controlling Shareholders & Directors b/c transactions w/Controlling Shareholders are inherently more suspect Courts less deferential. Special Committees for Mergers of a Parent and a Subsidiary o Special committees of independent directors are often used to assure that a deal is fair, and appears, fair between and parent company and a subsidiary of it. Requirements: Independent members, Properly charged with authority to sign the best deal possible, With proper resources (bankers, lawyers etc) o Who: comprised of disinterested directors o Why: goal is to ensure that an interested transaction, typically between a parent and its subsidiary is conducted at as much arms length as possible. o Requirements of a Valid Special Committee: (1) Independent members. (2) Properly charged: have authority to negotiate the best deal possible. (3) Proper resources: have their own investment bankers, lawyers, etc. o Effect: Special Committee has real power b/c Court will be skeptical of those deals, which the Special Committee failed to approve. Special Concerns: o (1) Corporate Opportunities: litigated when a shareholder believes a fiduciary breached a duty by usurping an opportunity belonging to the corporation. Rules of Recognition: (1) Corporation had to be financially able to exploit the opportunity. (2) Opportunity has to be within the same line of business the corporation is in. o Note: subsidiaries typically have a narrowly defined business objective so as to protect all new opportunities for the parent company under the line of business provision. (3) Corporation has to have a legal interest or expectancy in the opportunity. (4) Taking of the opportunity has to violate some sort of duty that the director owes to the corporation. o Conjunctive Fairness Test: must hit all factors. o Note: court may also look at how fiduciary became aware of the opportunity (personal or corporate capacity?). o Note: some courts will apply only a Line of Business Test or Expectancy or Interest Test. Relevant questions: o Whether an opportunity is corporate o Under what circumstances may a fiduciary take a corporate opportunity o What remedies are available when a fiduciary has taken a corporate opportunity illegitimately 3 tests used: (1) Expectancy or Interest Test o Most narrow test o Look to the firms practical business expectancy or interest in a particular opportunity

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(2) Line of Business o Classifies any opportunity falling within a companys line of business (existing or anticipated) as its corporate opportunity (anything the company reasonably could be expected to do) o Relevant factors: How the matter came to the attention of the director, officer or employee How far removed from the core economic activities of the corporation the opportunity lies Whether corporate information is used in recognizing or exploiting the opportunity (3) Fairness Test o Focuses on the fairness of holding the manager accountable for his outside activities o More diffuse, relies on multiple factors o Some relevant factors: How a manager learned of the opportunity Whether she used corporate assets in exploiting the opportunity Other fact specific indicia of good faith and loyalty Approach: Corporate Opportunity o Q1: Is the alleged breach of fiduciary duty a usurpation of a corporate opportunity (4 factor conjunctive test)? (1) Corporation had to be financially able to exploit the opportunity. (2) Opportunity has to be within the same line of business the corporation is in. (3) Corporation has to have a legal interest or expectancy in the opportunity. (4) Taking of the opportunity has to violate some sort of duty that the director owes to the corporation. If YES go to Q2. If NO no liability. o Q2: Was there disclosure (defense)? If YES no liability. If NO liable for breach of loyalty. o Defenses: (1) Disclosure: Board of Directors passed on the opportunity in good faith Complete Defense. Not necessarily required to disclose to the entire Board. (2) Corporation is not financially capable of pursuing the opportunity. (broz) o Broz v. Cellular Information Systems, Inc. Court finds no breach of loyalty where Broz (CIS Director) buys cellular K for his own company after CIS CEO passes on the opportunity (disclosure) and where CIS was financially unable to pursue the opportunity. Couldnt have bought it if they wanted to Parties: CIS sues Broz post-merger suggesting he should have considered interests of PC (merger partner) Court rejects b/c merger too speculative. Test: conjunctive fairness test.

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In re Ebay Inc. Shareholders Litigation Goldman Sachs was the underwriter for ebay. GS rewarded individual ebay officers and directors with IPOs managed by GS. Ebay was in the business of investing in securities Shareholders of ebay filed derivate action against those directors and officers on the grounds that such conduct usurped a corporate opportunity that rightfully belonged to ebay, which regularly invested in marketable securities, and constituted a breach of fiduciary duty of loyalty Defendants argue the ipos were collateral investment opportunities and not within the corporations line of business or an opportunity in which the corporation had an interest or expectancy Holding: This was a usurpation of a corporate opportunity because ebay regularly and consistently invests in marketable securities, and the defendants accepted this opportunity instead of offering it to the corporation This was not advice, it was a reward and an incentive to do further business with them Even if it was not a corporate opportunity, the defendants, as agents of the company, were not free to accept the offer from a company it was doing significant business with (especially when it can be viewed as an inducement) breach of duty of loyalty (2) Closely Held Corporation Generally: Shareholder disputes are unique in the close corporation context because: (1) There is no public market for the shares (2) Shareholders owe each other a higher duty of loyalty, similar to partnerships. o Meinhard v. Salmon: Not just officers and directors, but also shareholders owe fiduciary duty of the utmost good faith and loyalty. An extremely high duty o Require utmost trust, confidence and loyalty among members for success Corporate Codes Specialized Close corporation statutes for companies with less than 30 shareholders o It gets easy for majority shareholder to take advantage of minority shareholders because there is no ready market for shares Issue Spotting: Look for duty of loyalty issue in close corporations when the corporation is repurchasing shares. o Controlling stockholders in a closely held corp are subj to a strong fiduciary duty to minority stockholders when repurchasing shares (Donahue) 2 Repurchasing Rules: (1) Pro Rata: close corporation must offer each stockholder an equal opportunity to sell a pro rata percentage of their shares to the corporation at an identical price. o Ex. If corporation offers to buy 30% of As stock at $100 per share they must make the same offer to B. o Rationale: Ensures good faith of D & O. o Pro: Permits all insiders to monetize their shares.

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Con: Directors may elect not to repurchase any shares and compensate the target shareholder with larger compensation, retirement package, etc. (2) Discretionary: close corporation may repurchase shares at their discretion with no special duties to minority shareholders. o Delaware Rule. o Pro: much more flexible for the corporation. o Con: does not necessarily permit insiders to monetize their shares. Donahue v. Rodd Electrotype Co. o Rodd (Controlling shareholder) causes corporation to reacquire 45 of his shares. Donahue (minority shareholder) who refused to ratify the action, offers to sell her shares on the same terms as Rodd but was refused. o Donahues (minority) sue when Rodd sons (Directors) refuse to repurchase their shares when buying out the balance of their Fathers shares (majority) so that he can cash out for retirement. o Donahue sued to rescind purchase of Rodds stocks o Rule: Where a closed corp will repurchase shares from one shareholder, it has a fiduciary duty to offer that price to all shareholders. Its the courts role to protect people with unequal bargaining power. Controlling stockholder owes a duty of good faith and loyalty directly to other stockholders. o Court uses pro rata rule Rodds must make the same repurchasing offer to all shareholders. o Court defines close corporation as: Small number of shareholders No market for the shares (primary feature of a closely held corp) The majority of the shareholders are involved in making the decisions for the corporation like a partnership. o Criticism: Easterbrook & Fischel argue that Court misses the point in focusing on repurchases and s/have focused instead on how close corp. manages retirement of controlling shareholders.
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Problems: How do you know the real value of the shares? How do you fix the plaintiffs situation?

Wed expect any 3rd party to value the shares by using present discounted value of the cash flow of the stock. However, close corporations are unlikely to pay dividends. They pay higher salaries and give other perks instead for tax reasons. Further, the shares dont have a market value since theyre not publicly traded. Thus, the Mass Supreme Court says that once the directors pick a price, everyone is entitled to sell shares at that price. Here, the $800 was taken from the book value. (Book value is usually low and doesnt account for all factors). Will this rule really protect minority shareholders? Probably not. Corporations will probably find other
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ways to get the money out without repurchasing shares, such as paying a retiring bonus).

What if we want to give CEOs the option of slowly bowing out? The problem of CEOs not leaving is especially bad in close corporations b/c their cash flow comes from the corporation.

Use of Corporate Profits Regulation of Corporate Philanthropy o Judicial Review of Decisions Dodge v. Ford Motor (1919) o Mandatory Disclosure o Substantive Rules o A.P Smith Manufacturing Company A.P. Smith made a $1500 donation to Princeton Shareholders questioned the corporations authority to do so Holding: Court says it is ok for corporations to make donations list this they have this power Making donations to charitable institutions is good for the public and can be beneficial for the corporation Court does impose limits on gift-giving cant be too high (then its waste), needs to aid the public and the corporation o Kahn v. Sullivan Chairman, CEO and largest stockholder tears down a parking garage to build a museum for his art. Makes a settlement with shareholders is it valid Court evaluates the action of the shareholders claim on a very low standard uses Business Judgment Rule Only way to invalidate a claim is to show that it is waste Court says this company is so profitable that this is not big deal, therefore ok

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CHAPTER 14: TRADING IN THE CORPORATE SECURITIES Additional Obligations of Directors and Officers (and Insiders) Inside Information o Definition: information that comes to you while you are a Director, Officer or Employee of the corporation. o Major Questions: What does insider trading accomplish, good or bad, for the disclosure of trading information and thus the allocational efficiency of the capital markets? How does, or night, insider trading interact with explicit contractual arrangements between insiders and the corporation? o 2 Analytic Focuses: (1) Economic Analysis (Chicago School & Gentile) This is NOT the actual law!! Be aware of it but focus more on Policy! Efficient Capital Market Hypothesis is predicated on the dissemination of information limitations on that are inherently problematic. Economic Justification for Limitations on Insider Trading: o Import of disclosure in the securities context is different in any other market b/c non-disclosure costs entire market. o If public distrust of the market reaches a certain threshold much harder for companies to raise capital b/c individuals will not invest economy will suffer. o Argument: Regulations on insider trading should be limited Only person really harmed is the acquirer who has to pay more. Courts should focus on protecting the acquirer (confidentiality agreements) and trust that the market will correct itself as to shareholders. o Response: There are strong policy considerations that support regulating insider trading b/c it just feels wrong. (2) Policy Analysis (Caselaw) Based much more on the unquantifiable feeling that there is something wrong/unfair with insider trading. o Common Law & Black Letter Law: Majority Rule: No Duty Rule Liability to shareholder was based solely on actual fraud, like the concealment of a material fact. o Carpenty v. Danforth (NY) Minority Rule: Pure Disclosure Rule Directors and officers were required to disclose all the information they have before transacting with any shareholder. o Oliver v. Oliver (GA 1903) Middle Ground (Plurality): Special Facts & Circumstances Test Directors and officers do not owe a duty to disclose facts when trading in a face-to-face transaction with shareholders; the duty only comes into place where there are special facts or circumstances. Special facts or circumstances may be: o (1) Where you conceal your identity as a director or an officer. o (2) Where you have significant facts having a dramatic impact on price. Strong v. Riptide (1909)
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Inside Info & Public Market Transaction: No special duty of disclosure attaches to a Director possessing inside information where the transaction occurs on the public stock exchange. Goodwin v. Agassiz President and directors of Cliff Mining Co purchased Goodwins stock in that company through a broker. Prior to the sale the directors knew of a belief that there were mineral deposits in certain corporate land. Did not disclose that information so that the company could buy adjacent land. Goodwin sued to force a recission of the sale claiming Ds had breached their fiduciary duties by failing to disclose the information Holding: While a director of a corporation may not personally seek out a stockholder for the purposes of buying his shares without disclosing information not accessible to the stockholder, his fiduciary duty does not preclude all dealing in the corporations stock when there is no evidence of fraud No breach where Adassiz (Director) purchased Goodwins (shareholder) shares on the public exchange without first disclosing inside information re: a favorable mining report. Fiduciary Duty Theory: inside information is a corporate asset under agency law; the corporation is entitled to the profits of its agents from trade on inside information. Adopted by some State courts. Rejected by Federal courts. o Freeman v. Decio (corporate recovery of profit) 7th Cir. Federal Court rejects Freemans (shareholder) claim of fiduciary breach where Decio (CEO of RV Co.) trades on inside information re: earnings b/c information is not a corporate asset. Court analogizes information to corporate opportunity may belong to D & O or to Corporation. Whether this type of trading is unfair cannot be subject to a per se rule. Duties Under Securities and Exchange Act 10(b): 10(b): Prohibition against fraud in the purchase or sale of securities. It shall be unlawful for any person to use or employ a manipulative or deceptive device or contrivance in contravention of such rules and regulations that the Commission has laid out. Rule 10(b)(5): In connection to the sale or purchase of any security it is unlawful to: (a) Employ any device, scheme or artifice to defraud. (b) Make any misstatement or omission or material fact. (c) Engage in fraud or deceit on any person. o Note: Material misstatement can typically be construed under (a) or (c). Omission is much harder to categorize. Generally: the knowing misuse of material, nonpublic, info entrusted to a person with duties of confidentiality. Claim under Rule 10(b)(5) requires: (1) Evidence of false or misleading statement about a material fact in connection to the sale or purchase of securities. (2) Made with intent to deceive. (3) Reasonable reliance on misstatement by buyer or seller of security that caused harm. o Similar to CL Fraud.
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Note: very difficult to prove fraud from insider trading under State Law. Rule 10(b) (5) provides an alternative. Addressing Omissions & the Bases for the Duty to Disclose: Approach 1: Theory: Equal Access Theory o Taking advantage of inside information is inherently unfair. o Therefore, all market participants have a duty to refrain from trading on inside information to equalize the risk. Far reaching Rule: Disclose or Abstain o When an insider has material, non-public information, he must either disclose the information before trading or abstain from trading. Pro: Easily understandable. Con: Illogical if you consider other informational inequities. Adopted by: SEC & 2d Cir. o SEC v. Texas Gulf Sulfur Co. (2d Cir. 1969) (didnt disclose) President of Texas Gulf instructed exploratory committee not to disclose positive results of drilling, had them stop in order to help purchase all the land which contained the deposits. Several officers who knew of the drilling purchased stock in the company and the company offered stock options to officers and employees whose salaries exceeded specified amounts. SEC sued Texas gulf, claiming they violated rule 10b-5 sought to compel recission of those securities transactions which violated the act Holding: Anyone in possession of material inside information must either disclose it to the investing public, or if ordered not to disclose it to protect corporate confidence, abstain from trading in the securities while the information remains undisclosed SEC: press release is not false but is misleading. Laid down the equal access theory everyone must have access to the same information corporation has no duty to disclose info to adjacent landowners b/c trying to negotiate best price for shareholders but they do adopt the Disclose or Abstain Rule w/respect to insider trades. Reaction: SC does not endorse such strong regulation and limits Federal cause of action under Rule 10(b)(5). Tries to preserve remedies under State law to protect Federal courts from excessive insider trading claims. o Santa Fe Industries Inc. v. Green (SC 1977) Once a company discloses, plaintiffs have no federal remedy, just state remedies. SC is concerned with over-litigation. o
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Rule 10b-5 action challenging unfair merger. Federal securities law requires only disclosure, not management fairness to shareholders. Facts: This is the SCs first shot at defining 10b-5 liability. Santa Fe owned 60% of Kirby Lumber. They bought 95% of Kirbys stock on the open market. Once they owned 95%, they used the DE short form merger statute to merge the corporations. The problem was that the shares were appraised at $150/share. Offers to buy shares for $150 because of minority share rule that when someone owns more than 90% of shares it can purchase any minority shares by giving
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notice and paying a fair price no point in holding a shareholder meeting when someone has 90% of votes o o o However, in a disclosure about the companys assets, it appeared the stock was worth $650/share. Shareholders sued claiming a 10b-5 violation. Resulted in Santa Fe and Kirby merging Problem with this claim is that 10b-5 doesnt allow for a private right of action

Short form merger: All states have it. If you own over 90% of the stock in a company, you dont need to hold a vote on a merger because the minority cant win. You send shareholders a letter and tell them how much youll give them for their shares. Holders can take it or go to court for an independent appraisal.

o o
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Holding: Where complainants complain about adequacy of disclosure, they have to show a misstatement or omission. Here, there was nothing misleading about the disclosure. Thus, no claim under 10b-5. The information was out there. Shareholders shouldve just challenged the appraisal in court. They could have argued that despite disclosure, they got an unfair price. Court says there was no deception or manipulation because all of the information they needed was available to them hard to say they violated rule 10b-5 if they didnt hide information Manipulation refers to practices such as wash sales, matched orders, or rigged prices that are intended to mislead investors by artificially affecting market activity none of this occurred Court limiting application of rule 10b-5 to situations where there is manipulation Court says that there is a clear state law remedy available which is a breach of a fiduciary duty Key Points: unless disclosure had been misleading no liability. Unfairly low price does not amount to fraud.

Wheres the gap? The stock had never traded above $95/share. They were offered $150/share. Why did they think they deserved $650? This looks like a closely held corporation. It had few shareholders. Thus, there wasnt a lot of liquidity, so the price they traded at did not reflect what was on the books. However, if a company was buying them, the price theyd pay would be based on the value of the assets, not the market price. Per Gentile, maybe the shareholders werent getting such a bad deal after all.

Approach 2: (A) Theory: Fiduciary Duty Theory o There can be no breach of a duty to disclose inside information to other traders where no relationship of trust & confidence exists between insider and shareholders. o Rejects Equal Access Theory and resulting broad duty to disclose.
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Allows courts to do case-by-case review and selectively target insider trading o Adopted by: Supreme Court Pro: Courts can do case-by-case review and selectively target insider trading. Adopted by: Supreme Court o Chiarella v. US D was a printer, saw information that one corporation was attempting to secure control of another used this information to make a profit Rule: If no relationship of trust and confidence btwn target and trader, then no duty. Insiders who obtain material, nonpublic info bc of their corporate position-directors, officers, employees or controlling shareholders, have the clearest 10b-5 duty not to trade. Chiarella (employee of Printing Co.) used inside information gleaned from tender offer certificates to trade, making $30k. Court distinguishes between Chirella & Director. Here, no relationship of trust & confidence w/shareholders no duty to disclose no omission no fraud. SC explicitly rejects Equal Access Theory. (B) Theory: Expanding the Fiduciary Duty Theory Tipper/Tippee o Tippers: insiders and outsiders with a confidentiality duty who knowingly make improper tips are liable as participants in illegal insider trading. The tip is improper if the tipper expects the tippee will trade and anticipates reciprocal benefits. This liability extends to sub-tippers who know or should know a tip is confidential and came from someone who tipped improperly. Tipper or subtipper can be held liable even though she does not trade, so long as a tipee or subtippe down the line eventually does. o Tippees: Those without a confidentiality duty inherit a 10b-5 abstain-or-disclose duty if they knowingly trade on improper tips. A tippee is liable for trading after obtaining material, nonpublic info that he knows (or has reason to know) came from a person who breached a confidentiality duty. Sub-tippees tipped by a tipee assume a duty not to trade, if they know (or should know) the info came from a breach of duty. o Strangers: a stranger with no relationship (of trust or reciprocity) to the source of material, nonpublic info has no 10b-5 duty to disclose or abstain (Chiarella). Strangers who overhear the info or develop it on their own have no 10b-5 duties. o

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Application: A Tippee assumes a fiduciary duty to shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the Tippee and the Tippee knows or should know that there has been a breach A Tipper improperly gives inside information if he gives the information in order to secure a personal benefit in exchange Along with inside information, Tipper will pass fiduciary duty and breach to Tippee if: (1) Tipper has a relationship of trust & confidence w/corporation. (2) Disclosure was a breach. (3) Tippee has reason to know that: (a) Tipper has relationship of trust and confidence w/corporation, and (b) Disclosure is likely a breach. Test: Was Tippers disclosure a breach of trust & confidence? Q1: Will an insider personally benefit from his disclosure? If YES disclosure is a breach of duty. If NO disclosure is not a breach of duty Note: Low standard using objective criteria very easy to find evidence of personal benefit. Rationale: recognizes that early application of Fiduciary Duty Theory left entire class of independent insiders unaccounted for. Dirks v. SEC (SC 1983) Rule: If a tipper is breaching her duty to shareholders, then the tippers breach taints tippee liability all the way down the line. Dirks (securities analyst) receives tip on corporate fraud from disgruntled low-level employee (Secrist). Encourages clients to dump the stock and when fraud becomes public, is accused of 10(b)(5) violation. Holding: It is possible for Tippees to be inherit the duty and breach but not here employee was too low-level to have a fiduciary relationship and did not gain from disclosure SC recognizes that tippers may pass duty & breach to tippee but Secrist was too low-level to have fiduciary relationship & did not gain from disclosure disclosure breach. Protecting securities analysts b/c of their market function. Dissent: personal gain should be irrelevant since shareholder is harmed regardless. Note: FN in Dirks establishes that there is such a thing as a temporary insider. Working closely w/someone who has duty rubs off on you. Significantly broadens reach of doctrine. Temporary Insider: insiders who are retained temporarily by the company in whose securities they trade-ex: accountants, lawyers, and investment bankers, are viewed as having the same 10b-5 duties as corporate insiders. (Dirks) SEC Response:
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Regulation FD: If a company is about to or required to make a public statement they must disclose to everyone at once. Goal: to stop companies from disclosing to favored analysts early. Rationale: selective disclosures undermine the idea of inherent fairness & shape the market. Rule 14e-3: A blanket prohibition to anyone trading on knowledge of a tender offer. This was the SECs response to the courts interpretation of 10b-5 (the diff duties). Applies only to tender offers, not negotiated or other mergers. Imposes a duty on any person who obtains inside information about a tender offer that originates either with the offeror or the target to disclose or abstain from trading. Applies regardless of whether there was pre-existing fiduciary obligation to respect the confidentiality of the information.

Approach 3 Theory: Misappropriation Theory o 10b-5 liability arises when a person trades on confidential info in breach of a duty owed to the source of the info, even if the source is a complete stranger to the traded securities (US v OHagen). o The deceitful misappropriation of market-sensitive information is itself a fraud that may violate Rule 10(b)(5) when it occurs in connection with a securities transaction. In effect, the deception is on the source and the trading with another party. o Breach of fiduciary relationship existing between the individual with inside information and the source of that information. Typically an employee/employer relationship. Duty to other traders is irrelevant. Defense: full disclosure to source of intent to trade absolves liability under the misappropriation theory b/c eliminates deception element. Trader still may be liable for breach of loyalty to source. Pro: Broad scope (reaches lawyers, accountants, etc.) & reflects intuitive wrong of insider trading. Con: No civil recovery for uninformed traders who dont own information. Adopted by: Supreme Court & 2d Cir. o United States v. Chestman (2d Cir. 1991) Rule: Kinship (familty relationship) does not give rise to a fiduciary duty. Waldbaum told members of his family he was going to sell the corporation. Chestman learned this info from Loeb who was married to Waldbaums niece. Chestman then purchased the stock for himself, Loeb and others. Charged for violating 10(b)(5) and 14(e)(3) Chestman (Trader) is not guilty of 10(b)(5) insider trading b/c alleged misappropriator Loeb (client/in-law) did not have a fiduciary relationship with wife or Waldbaum family.

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Chestman cannot be liable as tippee absent tippers being in a fiduciary relationship with source of misappropriated info. Chestman would have had to get some benefit for it to be a breach. Telling his wife isnt a big enough disclosure to hold him liable. (overruled by 10b5-2) Holding: Fiduciary duty cannot be imposed unilaterally by entrusting a person with confidential information and mere kinship does not itself establish a confidential relationship Here there was no fiduciary relationship or relationship of trust of confidence (functional equivalent) Conviction stands for violation of 14(e)(3) because no showing of duty is necessary Duty of Confidentiality in Missappropriation Cases: The duty of trust or confidence in misappropriation cases is clearest when confidential info is misappropriated in breach fo an established business relationship, such as investment banker-client or employer-employee. The duty is less clear in other business and personal settings. o In an attempt to provide clarity, the SEC has adopted a rule that specifies when a recipient of material, nonpublic info is deemed to owe a duty of trust or confidence to the source for purposes of misappropriation liability-Rule 10b5-2(b) o SEC Response to Chestman: Rule 10b5-2: Nonexclusive definition of when people have formed a relationship of trust and confidence: (1) When a person agrees to maintain information in confidence. (2) Whenever two persons have a history, pattern, or practice of sharing confidences and the recipient of that information should reasonably know that speaker expects the information to be kept confidential. (Ex. CEO & Wife). (3) You get the information from your parent, child, spouse or sibling. Note: If you fall into one of the above categories then there is a rebuttable presumption that the relationship of trust and confidence exists. o United States v. OHagan (SC 1997) Rule: misappropriation theory: duty runs between the source and recipient of the info, not the source and the shareholders. OHagan was a partner at the law firm hired to represent Grand Met regarding a potential tender offer for the common stock of Pillsbury. OHagan didnt work on the deal, did buy 2,500 Pillsbury options. OHagan (law partner) is guilty of violating 10(b)(5) under misappropriation theory for purchasing options of Pillsbury stock after hearing rumbling of tender offer at firm. Breached duty to law partners (source). Supreme Court adopts misappropriation theory.

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Holding: A person who trades in securities for personal profit, using confidential information misappropriated in the breach of a fiduciary duty to the source of the information violates 10b5 OHagan owed a duty of loyalty and confidentiality to his law firm and the firms client Actions fall squarely within the behaviors the Exchange Act sought to eliminate to insure the maintenance of fair and honest markets Effect: 3 theories cast a wide net. Combination of Equal Access Theorys strict duty, the creation of temporary insiders (Dirks) & the expansive reach Misappropriation Theory (OHagan) almost every insider is exposed to liability. Short Swing Profits: Exchange Act 16(b): Background: To deter price manipulation by insiders in public corporations and encourage insiders to acquire long-term interests in their corporations, section 16 of the Securities and Exchange Act of 134 requires specified insiders to report their trading in their companys securities, and authorizes the corp to recover from these insiders any profits made on stock purchases and sales in a narrow 6 mo period, so called short swing trading profits. 16(b): requires statutory insiders to disgorge to the corporation any profits made on short-term turnovers in the issuers shares (purchases and sales within six month period). 16b imposes automatic, strict liability on qualifying officers, directors, and 10 % shareholders who make a profit in short swing transactions within a 6 month period. No proof of intent is required. Recover is to the corporation and suit may be brought either by the corporation or by a shareholder in a derivative suit. Statutory Insider: 10% shareholders, Officers & Directors. Goal: Strict liability rule to prevent insiders from profiting on inside info. Criticism: o (1) Underinclusive: insider trading doesnt necessarily involve short swing transactions. o (2) Overinclusive: short swing transactions dont necessarily involve insider information. Compared to Rule 10b-5 o 16(b) is broader and narrower than the insider trading prohibitions of 10b-5. Narrower bc: Limited to trading in securities of registered companies during a 6 month window, it is narrower than 10b-5 which applies to all companies and regardless of holding periods. Broader bc: by covering any trading during a 6 month period, whether or not based on inside info, 16(b) is also broader than 10b-5 which requires a showing that trading was based on material, nonpublic info. Administrative Problems: o (1) Calculating profits on short swing transactions. o (2) Difficulty in defining coverage (Who is an officer?). Officer or director at either sale or purchase. Official status at the time of either purchase or sale is sufficient. Theory is

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that by trading when he was an officer or director, the insider had access to nonpublic info (3) Difficulty in defining scope of application (purchase or sale.)

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CHAPTER 10: SHAREHOLDER LAWSUITS Two Types of Shareholder Lawsuits o (1) Derivative Action: 2 suits in 1 Step 1: Shareholder brings claim against Directors & Officers of the corporation, alleging harm to the corporation (and derivatively, to the shareholders) by their failure to sue on an existing corporate claim. Step 2: Underlying corporate claim, brought by the D & O against the corporation. Ex, Breach of Loyalty where D makes high interest rate loan to the corporation harmed corporation harmed shareholders. Derivative suits generally enforce fiduciary duties of directors, officers, or controlling shareholders-duties owed to the corporation. Nature of Derivative Litigation: the derivative suit is 19th century equity jurisdictions solution to the dilemma created by 2 inconsistent tenets of corp law: (1) corp fiduciaries owe their duties to the corp as a whole, not individual shareholders, and (2) the board of directors manages the corps business which includes authorizing lawsuits in the corp name. Derivative litigation breaks the stranglehold the board would otherwise have over fiduciary accountability. History of 2 suits in 1: In theory, the shareholder (1) sues the corp in equity (2) to bring an action to enforce corp rights. Although the modern derivative suit is treated as one action the historical notion of two suits survives. This spawns procedural effects, for ex, fed jury trial rights arise if they would have existed in a suit by the corp, generally when the suit seeks damages, Court must also have jurisdiction over the individual defendants (Shaffer v Heitner held that quasi in rem action base don sequestration of Ds directors shares in DE corp insufficient to create personal jurisdiction. Recovery: Derivative litigation enforces corporate rights. This means any recovery in derivative litigation generally runs to the corp. The shareholder P shares in the recovery only indirectly to the extent her shares increase in value bc of the corp recovery. The shareholder P also benefits indirectly by the deterrent value of an award or when equitable relief forbids or undoes harmful behavior. What happens when corporate liability is empty? If corp is no longer in existence or if liability would produce a windfall for new owners, court have sometimes allowed injured shareholders to recover directly in proportion to their holdings (Donahue v Rodd Electrotype Co) o (2) Direct Action Shareholder brings claim of individual harm against the corporation. Here a shareholder is suing on her personal capacity to enforce her right as a shareholder. Unlike a derivative action, a direct action is not brought on behalf of the corp. Direct suits are those in which shareholders seek to enforce rights arising from their share ownership (as opposed to rights of the corp). To avoid the host of procedural requirements that apply to derivative suits, shareholders will often seek to characterize their suit as direct These suits generally vindicate individual shareholder structural, financial, liquidity, and voting rights. Usually filed as class action suits. Ex. Shareholders lose voting rights in restructuring harmed shareholders. Derivative Actions o Approach: Q1: Are the procedural requirements of the derivative suit met? Standing requirement: P must be a shareholder when the wrong occurred AND when the suit is brought
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Demand requirement: P must deliver demand or demand must be excused as futile. o P will not make demand (Universal Non-Demand Rule) go to Q2. Q2: Is Ps failure to make a demand excused because demand would be futile? Apply Aronson Test P must: o (1) Establish that Directors are either interested or dominated such that they are incapable of evaluating the suit against Board in any meaningful way, OR o (2) Establish that rejection of presuit demand was an invalid exercise of the Boards business judgment. This can be shown by establishing conflict of interest, bad faith, grossly uninformed decision making, or a significant failure of oversight. o Note: to make this showing, the P must point to specific facts (before discovery) that tend to show either that the board is now untrustworthy to respond to the demand or that the underlying transaction was improper. This test places a heavy burden on derivative Ps seeking review of board operational decisions. Aronson held that just bc the D owned a controlling block fo the companys stock and selected directors did not create a reasonable doubt concerning directors independence. Also found no waste where director would be compensated regardless of performance. If P establishes demand futility derivative suit will proceed. Corporation will form an SLC. SLC will then make a motion to dismiss go to Q3. Q3: Should the SLCs motion to dismiss be granted? Apply Zapata Test: o Q1: Is the SLC truly independent and acting in good faith? If YES go to Q2 (discretionary). If NO SLC motion to dismiss denied. o Q2: According to the Courts independent business judgment, was the SLCs recommendation correct? If YES motion to dismiss derivative suit granted. If NO motion to dismiss derivative suit denied. In NY apply Auerbach Test: o Q1: Is the SLC independent and acting in good faith? If YES SLC motion to dismiss granted. If NO SLC motion to dismiss denied. Collective Action Problems: Corporation pays all attorneys fees in a derivative action. Technically, claim being litigated is on behalf of the corporation corporation pays. This is contrary to the prevailing American rule that each litigant bears his own expenses. The theory is that the P produced a benefit to the corp and they should be reimbursed for their effort Result: the plaintiffs attorney is a bounty hunter for the corp whose fees are contingent on award from the court or settlement. This makes attorney the real party in interest, attorneys often bring suits to the attention of shareholders and have greatest stake in the outcome
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Double Agency Problem: D & O (corporations agents) have incentive to settle quickly to minimize bad press & litigation costs. Plaintiffs bar (corporations agent though shareholder) has incentive to bring suit. o Strike suits: non-meritorious suits brought by the Plaintiffs bar to extract settlement. Result: Concern that there will be too many strike suits by Plaintiffs Bar and that Corporations will enter too many settlements for nuisance payments. Common Fund Doctrine: Plaintiffs attorneys in derivative actions can only recover fees from a corporations common fund. The common fund is made up of monies the corporation receives from the litigation attorneys eat what they kill. Rule: Substantial Benefit Rule Plaintiffs attorneys in derivative actions can recover fees from the corporation if the corporation received a substantial benefit from the litigation. Substantial Benefit not necessarily monetary, may be governance reforms. Rationale: Derivative suits are beneficial to the shareholder we want to encourage the Plaintiffs Bar to bring these suits even where they are unsure that the result will be a monetary reward to create a common fund. Pro: Con: Creates huge incentive for quick settlement by Plaintiffs Bar as soon as any substantial benefit is realized. Does not encourage push for the harder reforms. Collective Action Problem Solution: Corporation pays all attorneys fees in a derivative action Technically, the claim being litigated is on behalf of the corporation so corporation pays Other times attorney fees are paid at the end of the trial Fletcher v. A.J. Industries, Inc. Fletcher brought a derivate suit alleging directorial mismanagement. Settlement was reached between Fletcher, the corporation and various directors which curtailed power, replaced board members etc. Attorneys fees were awarded by the court on the theory that the action had substantially benefited the corporation Holding: Even though the corporation receives no money from a derivative suit, attorneys fees are properly awarded if the corporation has substantially benefited from the action as they did here General Rule: Attorneys fees only awarded to the prevailing party when authorized by statute or by agreement between the parties Exception - Common Fund Rule: If a party brings an action to preserve, protect or create a common fund, he is entitled to attorneys fees Exception - Substantial Benefit Rule: If the corporation receives a substantial benefit from the derivative action, even if nonmonetary, recover of attorneys fees should be allowed o Extension of common fund rule Procedural Requirements: Standing Requirements: goal is to screen potential shareholder litigants so that quality of derivative litigation is improved (Fed. R. Civ. P. 23.1). (1) Plaintiff must be a shareholder for the duration of the suit.

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(2) Contemporaneous Ownership Rule: P must have been a shareholder at the time of the wrongful act or omission. o Attempt to prevent P from buying 1 share and then post-litigating. (3) P must be able to fairly and adequately represent the interests of the shareholders. o Meaning there are no obvious conflicts of interest (4) Complaint must specify what action the plaintiff has taken to obtain satisfaction from the companys board (demand requirement) or state with particularity the plaintiffs reason for not doing so o Demand is required unless it is futile assumption is that the board is unlikely/unable to consider objectively the merits of the suit o Stated in FRCP 23 and in DL Law o Note: Intended to balance the shareholders right to bring a derivative suit against the Boards right to run the corporation w/sound business judgment. If Demand is properly refused Ps rights to initiate action on behalf of the corporation are terminated b/c Board is acting within its proper managerial scope. If Demand is wrongfully refused P retains the right to initiate an action on behalf of the corporation. The Demand Requirement of Rule 23 o 2 concerns (Demand always triggered, and SLCs): o If demand is required: The board decides the fate of the claim and their decision is subject to the business judgment rule Once you make a demand you cannot later claim that it should have been excused o If demand is excused: Claim goes forward, board cannot dismiss Judicial Screening Mechanisms: Court ultimately decides whether a derivative suit may proceed by deciding whether the demand requirement has been met. (1) P makes a presuit demand and the Board rejects it: Q1: Is rejection a valid exercise of the Boards business judgment? o If YES no derivative suit. o If NO derivative suit. (2) P does not make a presuit demand on the grounds that it would be futile since the Board is not disinterested: (A) To establish the futility of demand, P must either: o Aronson Test (Disjunctive Test) (1) Establish that Directors are either interested or dominated such that they are incapable of evaluating the suit against Board in any meaningful way, OR (2) Establish that rejection of presuit demand was an invalid exercise of the Boards business judgment. Plead particularized facts that create reasonable doubt as to the soundness of the transaction sufficient to rebut the presumption that the business judgment rule attaches to the transaction.

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Show that the challenged transaction was not protected by the business judgment rule because of conflict of interest, bad faith, grossly uninformed decision making or significant failure of oversight Needs to be the same board who made the decision that demand is being made on

Effect:

P satisfies either prong derivative suit proceeds. P satisfies neither prong derivative suit dismissed. o Rationale: illustrate that Directors decision whether or not to bring a suit is the same as any other business decision. o Levine v. Smith Shareholders of GM brought several derivative actions involving a transaction where Ross Perot (D), a director and largest shareholder, and others sold back their holdings of GM Class E stock for $743 million dollars repurchase was in response to disagreements over management Suit (against all directors and Perot) alleged that the transaction paid Perot a premium for his shared for the sole reason of stopping his criticism Shareholder did not demand the board comply with their request because demand was futile since the GM directors lacked independence Holding: To withstand dismissal of a derivative action, a plaintiff shareholder claiming demand futility or wrongful demand refusal must allege particularized facts that overcome the business judgment rule presumption Court uses Aronson Test says shareholder did not demonstrate that GM outside directors were so manipulated, misinformed and misled that they were subject to managements control and unable to exercise independent judgment also did not demonstrate that majority of board failed to exercise due care (B) In practice, DL Courts employ: o Universal Non-Demand Rule: If P makes a presuit demand P automatically concedes that the Board is not interested or dominated. Eliminates first prong of the Aronson Test. Effect: no plaintiff will ever bring a presuit demand. (C) Double Derivative Suit: Shareholder of Parent Company brings demand to the Parent Board Parent Board brings demand to the Subsidiary Board. o Ex. P owns stock in A. A enters stock-for-stock merger with B. Now, B owns A. P has shares in B any corporate claim by P must be against Bs Board. o Test: At the time the complaint was filed, was the Board of Directors receiving the demand interested or dominated such that they could not be expected to respond to Ps demand in a meaningful way (by exercising proper business judgment)? First prong only of the Aronson Test. Note: Depending on whether you are arguing for P or D, you can apply the Test as it is stated, or use Veasys application
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below where the underlying transaction is used to prove Board is interested. P Veasys application. D Test as stated. o Rationale: Full Aronson Test is not appropriate here because the Board receiving the demand was not initially involved in the transaction in question irrelevant whether original Board exercised sound business judgment in approving the underlying transaction. Rales v. Blasband P brings double derivative suit where Rales Bros. (Directors) buy junk bonds as a favor to Milkien. Wanted to get subsidiary company to make an action against the owner of the parent company Business judgment rule is inapplicable here because the board of the subsidiary did not make the decision being questioned Aronson Test does not apply in a double derivative suit. Court uses new test to determine that demand is excused b/c Board is interested. Unusual that Veasey uses evil transaction to prove interest s/be irrelevant to inquiry. Only question to ask here is whether the board that would be addressing the demand could impartially consider its merits without being influenced by improper considerations (is demand futile?) Holding: In a derivative action where demand excusal is asserted against a board that has not made that decision that is the subject of the action, the standard for determining demand excusal is whether the board was capable of impartially considering the actions merits without being influence by improper considerations o Director is considered interested when: He will receive a personal financial benefit from a transaction that is not equally shared by the stockholders Special Litigation Committees (SLC): SLC: a subset of the Board of Directors, comprised of the independent Directors, charged w/ evaluating Ps suit and determining if pursuing it is in the corporations best interests. Authorized by DL Gen. Corp. Law 141(c). Committee then issues a report and makes a decision In Delaware, after demand is excused as futile courts will listen to SLC with suspicion Use of SLC can protect you from second prong of Aronson Note: SLC will always recommend bringing a motion to dismiss Ps suit. SLCs have shown a remarkable disposition for director defendants. In the vast majority of cases, SLCs refuse to continue the suit against a colleague. Background: During the 1970s BODs responded to a spate of derivative litigation with an ingenious device. The board, whose members were usually named as Ds for
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various infractions, appointed a special litigation committee of disinterested and often recently appointed directors to decide whether the suit should go forward. Judicial Review of SLC motion to dismiss: (1) Zapata Test (DL/Majority, heightened scrutiny, demand excused cases): Used in Delaware for SLC recommendations is demand-excused cases Background: In DE, when demand on the board is excused as futile, the courts listen to the SLC, but with suspicion. In Zapata Corp v Maldonado, the DE S Crt agreed there might be subconscious abuse by members of the committee asked to pass judgment on fellow directors. Applies to SLC recommendations only in demand-excused cases. Q1: Is the SLC truly independent and acting in good faith? o Procedural inquiry-the Ds must carry the burden of showing the committee members independence from the Ds, their good faith, reasonable investigation, and the legal and factual bases for the committees conclusions. If there is a genuine issue of material fact as to any of these counts, the derivative litigation proceeds o If there is genuine issue of material fact to any of the above the litigation proceeds o Look at: how the SLC members are related to the rest of the Board (Oracle). If YES go to Q2 (discretionary). If NO SLC motion to dismiss denied. Q2: According to the Courts independent business judgment, was the SLCs recommendation correct? o Substantive inquiry-this is far more intrusive than even the fairness test applicable to self dealing transactions. It recognizes that judges are particularly adept to evaluate the merits of litigation and that judicial incentives to further the interests of the corp are perhaps stronger than those of an SLC. o More intrusive that entire fairness test of self dealing transactions o Look at: best interests of the corporation by balancing financial & policy issues (Joy v. North & CB). o Note: 2nd Prong of the Zapata Test is discretionary but if a Court chooses not to use it they will have to justify that decision. If YES SLC motion to dismiss granted. If NO SLC motion to dismiss denied. Zapata Corp. v. Maldonado Maldonado initiated a derivative suit, excused from making demand because all board members were defendants. 4 years later board members changed, appointed independent investigation committee composed of two new directors to investigate the litigation. Committee voted to dismiss the action Holding: SLCs are ok use Zapata test to determine the independence of the SLC Zapata 1st Prong: In re Oracle Corp.

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Shareholders brought derivate action asserting insider trading by 4 members of board of directors o Oracle forms SLC, appointed two board members who joined after the alleged breaches both were professors at Stanford and agreed to forego SLC-related compensation if it was deemed to impair their impartiality Report failed to state that their were material ties between the defendants an Stanford. One of the SLC members had been taught by one of the defendants o Holding: SLC bears the burden of persuading the judge that there is no material fact calling into question their independence. Here, the SLC failed to demonstrate the absence of material fact. SLC was dominated by someone with a strong interest in the outcome, not acting in food faith for the investigation o Oracle found lack of SLC independence despite being composed of unnamed board members and its use of reputable outside law firm, bc SLC members had long standing professional/academic relationships with principal Ds. o Expansive definition of insider. o Chancellor Strine says never trust the Board Court should always make the substantive decisions b/c any contact w/Board jeopardizes the SLCs independence. o Concludes Oracle SLC (Stanford Profs) is not independent after examining Boards remote financial & professional ties to Stanford. Zapata 2nd Prong: As a practical matter Courts balance financial (fees, negative publicity, employee distraction) and policy considerations (deterrence, insurance) to determine what is in the companys best interests. o Joy v. North: o SLC recommended dismissal o Holding: A SLCs recommendation for dismissal must be supported by a demonstration that the derivate action is more likely than not to be against the interests of the corporation Decision to pursue litigation should be looked at like an investment decision will the corporation make more money if it pursues litigation or if it settles? o Courts have expertise in determining whether lawsuits should be terminated judicial review therefore not onerous or difficult o SLC not afforded business judgment rule o Suggests judicial review of SLC decision s/be just like any other investment decision: limited to analysis of initial costs of litigation balanced against the present discounted value of the net future benefits. Should be economic only, NO policy analysis. Litigation has positive net value SLC motion to dismiss denied. Litigation has negative net value SLC motion to dismiss granted. o Criticism: Pure cost analysis is underinclusive b/c overlooks important policy/peripheral concerns. (1) Policy: Deterrent Effect Pursuing cost prohibitive short-term suit may be sound business judgment if: o
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Corporate employees are less likely to misbehave. o Shareholders are less likely to sue. (2) Peripheral: Insurance Insurers give lower premiums to Corporations that sue their Boards b/c they are policing their D & O. If you never sue higher insurance premiums. Note: Zapatas 2nd Prong is an exception to the norm of judges refusing to second-guess D & O business expertise. Exception occurs b/c: o (1) Institutional confidence in courts ability to evaluate legal decisions (i.e. whether or not to pursued litigation). o (2) No hindsight bias b/c decision is current. Second prong of the Zapata Test essentially means that substantive decisions to pursue derivative litigation are left to the Courts. (2) Auerbach Test (NY/Minority): Unless the plaintiff can show the committees members were (1) themselves interested or (2) had not acted on an informed basis, the committees recommendations were entitled to full judicial deference under the business judgment doctrine Q: Is the SLC independent and acting in good faith? o If YES SLC motion to dismiss granted. o If NO SLC motion to dismiss denied. Settlement & Value of Derivative Actions: Fair & Reasonable Standard: Q: Is the proposed settlement fair and reasonable in light of the factual support for the alleged claims and defenses in the discovery record before it? Fair & Reasonable is the default standard for judicial review of settlements. To decide whether to approve a settlement, the court has broad discretion to consider: o The terms of the settlement, including recovery by the corp (or other relief) and any reimbursement of expenses (including attorneys fees) to the shareholder P and to the individual Ds o The outcome that might have resulted from a trial, discounted by the inherent uncertainty of litigation, the costs caused by the delay of trial, additional litigation expenses that the corp might be required to pay the Ps, additional indemnification payments to the D if they are successful or if indemnification is determined to be appropriate, disruption of business and possible negative publicity bc of trial, and increased insurance premiums if recovery at trial is higher than in settlement. Rationale for Judicial Review: Everyone but the shareholders has an interest in a quick settlement D & O to avoid negative publicity and plaintiffs attorneys to lock down fees. Rule: can K for a different standard. Carlton Investments v. TLC Beatrice International Holdings, Inc. o Plaintiff claims breach of fiduciary duty where the SLC approves an inadequate settlement. Diff from other cases bc here SLC settled (usually almost always recommend dismissal) o Court reviews settlement under the Zapata Test since that is what the parties contracted for. o

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Proposed settlement negotiated by an SLC is to be reviewed under the Zapata standard o In general, when reviewing settlements, the court must consider whether the proposed settlement is fair and reasonable in light of the factual support for the alleged claims and defenses in the discovery record before it o Summary: Pros/Cons of Derivative Suits Pros: Method of policing fiduciary breaches, which would otherwise be rampant. Increase Corporations Value: o (1) Actual monetary recovery o (2) Beneficial change in governance structure o (3) Deterrent effect Cons: Costs include litigation fees, insurance premia, & impact of neg. publicity. Alternatives: Trust institutional investors to bring the suit on behalf of other shareholders. Viable alternative b/c institutional investors are typically largest shareholders, have in-house counsel and may be fiduciaries. Related Concerns (Chapter 9 continued) o Corporate Gift-Giving/Charitable Contributions: Duty of Loyalty: 2 Competing Norms (1) Shareholder Primacy Norm: directors must act primarily to advance shareholder interests. (2) Corporate Constituency Norm: directors must act to advance the interests of all constituencies in the corporation (employees, shareholders, etc.). Competing norms are implicated when evaluating corporations charitable gifts. Rule: Corporations may make charitable gifts as long as there is some benefit to the corporation and gift is not 1) unreasonable or 2) made to a directors pet charity. Rationale: (1) Good for America good for business. (2) Unnecessary to have stricter limitations because market will regulate. If the gifts are unreasonable shareholders will dump the stock. o A.P Smith Manufacturing Co. v. Barlow Shareholders object to corporations $1500 gift to Princeton University b/c they claim it should have been paid in dividends. Court upholds Corporations right to make a charitable gift b/c public interest and long-term interest of Corporation (creating good will) support the practice. o Director & Officer Compensation: Executive compensation = necessary self-dealing transaction. Background: Executive compensation is the most common form of corporate self dealing. But the rendering of managerial services by corp executives is also an indispensable corporate activity. For this reason, executive compensation receives special judicial deference. When approved by disinterested and ind directors, executive compensation is subject to business judgment review. Types of Compensation Plans: (1) Salaries (2) Incentive Based Compensation: Option Packages. o

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Goal: align interests of management and shareholders by tying managements compensation to the performance of the company. o Challenges: (1) Valuation over time is difficult b/c options are worthless on the day they are granted. (2) Courts not equipped to evaluate special talents (value) of corporate managers. Dilemma of Executive Compensation Senior executives, particularly in public corps, have significant sway over board decision making. As a result, the boards setting of executive compensation raises many of the same concerns as are raised in any other self-dealing transaction: o (1) the executive predictably will prefer his own interests and (2) the board will predictable accede to the executives wishes, at the expense of corporate interests. But treating executive compensation like any other self-dealing transaction would force courts regularly to place a value on a particular executives services to the corp, often without a working knowledge of the corp, the particular value of the executive, or the market value of similar executives. o some say judicial deference is warranted bc most large corps link executive pay significantly to corp performance. o Others question the sufficiency of internal process and market limits alone. Excessive CEO payment cause for concern o Shareholder advocates attack many common features of executive compensation Too high, doesnt sufficiently punish failure, procedures used to set compensation not sufficiently disinterested and common sweeteners like golden parachutes as excessive o CEOs get fired more frequently today, may account for rise in compensation (less job security) o As incentive based plans became more popular the public perceived the compensation as excessive the standard for judicial review for compensation plans became less deferential Standards of Judicial Review for Compensation Plans: As incentive based plans became more popular the public perceived the compensation as excessive the standard of judicial review for compensation plans became less deferential. Traditional: Business Judgment Review o Shareholders must prove waste to rebut its protection. o Must show either that the board was grossly uninformed or that the compensation was a waste of corporate assets-that is, the compensation had no relation to the value of the services promised and was really a gift. New: Classic Waste Standard o Could a reasonable board conclude from the circumstances that the corporation may reasonably expect to receive a benefit proportional to the compensation o Court will consider: the relation of the compensation to the executives qualifications, ability responsibilities, and time devoted. The corps complexity, revenues, earnings, profits, and prospects.
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The likelihood incentive compensations would fulfil its objectives. The compensation paid similar executive in comparable companies. o Rationale: faith in institutional investors, assume they are paying attention high burden of proof okay. Directors failure to manage compensation and option plans appropriately could lead to suit for breach of care (not just loyalty) Shareholders or disinterested directors often ratify the compensation of the CEO and other board members in order to provide an extra measure of legal insulation Compensation agreements are not subject to the ordinary law of director conflicts more deferential o Lewis v. Vogelstein Shareholder ratification cleanses the transaction and shifts the burden to the shareholder challenger to show waste. Shareholders bring claim for breach where Directors are granted a one-time grant of option, like a gift. Court adopts classic standard of waste to evaluate the option grant. Concludes options in this instance are suspect. When determining whether stock option grants constitute actionable waste, a could should accord substantial effect to shareholder ratification Criticism: waste standard does not provide adequate protection for shareholders b/c it is such a high standard to overcome & there are compensation experts readily available to rebut their claims. Note: Directors failure to manage compensation & option plans appropriately could lead to suit for breach of care (not just loyalty!). The Walt Disney Company Derivative Litigation This case illustrates the courts deferential approach to executive compensation. Directors entered into employment agreement with Ovitz, agreement included a large package if he was fired without good cause or if he resigned with corporations consent Ovitz was a friend of Disney chairman Eisner Agreement was approved by Compensation committee and the board in place at the time There was little to no discussion made of the agreement Final agreement differed substantially from the one agreed to but the board did not meet again to approve it Shareholders brought a derivative suit claiming the directors breached their fiduciary duties of loyalty, good faith and due care by entering into the employment agreement and then terminating it without cause. Also claimed the agreement constituted corporate waste P claims Directors breached their duty of care by approving compensation plan where Ovitz collects $140M for getting fired.

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Holding: A claimed breach of directorial fiduciary duties will survive dismissal where it is alleged with particularity that directors have intentionally and consciously disregarded their responsibilities regarding a material corporate decision Here board did not adequately inform themselves or consider Eisner & Ovitzs friendship Court did not hold executives liable said if package had been made post-Enron decision might have been different Court suggested that the directors had breached their duty to act honestly and in good faith leaving open the possibility that the companys exculpation provision under 102(b)(7) would not shield the directors from personal liability. However court concluded that the directors had not breached their fiduciary duties even though their conduct fell significantly short of the best practices of ideal corporate governance. Chancery court concluded that enticing Ovitz to leave his high profile position in Hollywood required making significant financial assurances if he were ever terminated. The failure of the directors to analyze the full ramification o the pay package was at most ordinary negligence The court however hinted that the result might be different for a present day package approved in an era that has included Enron and Worldcom debacles, and the resulting legislative focus on corporate governance. Duty of care (i/o loyalty) claim b/c majority of Board was independent Aronson 1 irrelevant. SEC & Congressional Response to Compensation Plans: SEC: 1993 Amended Disclosure Rules o Mandated disclosure of Compensation Tables for top 5 officers. Pro: Allows shareholders to more easily estimate D & O compensation. Con: D & O could use public information for salary negotiations. o Rationale: If there is disclosure Institutional Investors will police & litigate where necessary. Congress: Sarbanes Oxley Act 404 o Provision prohibits loans to D & O, used to bridge liquidity gap between actual compensation and standard of living proportional to D & O compensation w/fully realized options. o Rationale: Congress believed loans were (1) being used to help CEOs buy more options than what they were already granted or (2) forgiven.

Sarbanes-Oxley Act: In 2002, responding to stories of management abuse in companies hit by scandal, Congress took aim at abusive compensation practices. Congress has stepped in to provide constraints: Prohibits personal loans from companies to directors and executive officers w limited exception for loans to insiders in the ordinary

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course of business, such as credit cards offered by a bank to its executives on the same terms as offered to other customers.
o

Additional disclosure. Annual proxy statements now must include all compensation and explain why the compensation was awarded. Per Gentile, this has probably contributed to the rise of CEO compensation, because the CEOs can see how much the others are getting, and think theyre entitled to the same.

Sarbane-Oxley Act (2002): Requires the SEC to permit shareholder regulations on things like compensation. Compensation is determined by a committee of independent directors and subject to ratification of the shareholders. The Act also bans all loans to officers and directors. o Effect of Sarbanes-Oxley: the federal prohibition, which displaces stae law, has forced companies to reassess such common practices as travel advances, personal use of company credit cards, retention bonuses, indemnification advances by the company, loans from 401(k) plans, and cashless exercise of stock options (where company or a broker gives the executive a short term loan so the executive can exercise the options and then repay the loan once he sells the underlying shares). Accounting Issues: Options have no value until they are exercised options do not count as a cash expense for corporations accounting. Pressure on Congress to legislate option as a cash expense. Indemnification & Insurance: Background: To encourage qualified individuals to accept corporate positions and take good faith risks for the corporation, corporate statutes permit (and sometimes mandate) the corporation to indemnify directors and officers against liability arising from their corporate position. Directors and Officers insurance supplements this protection. Indemnification: the corporations reimbursement of litigation expenses and personal liability of a director sued bc she is or was a director. In general, applies when the director is or was (or is threatened with being made) a defendant in any civil, criminal, administrative, or investigative proceeding. A directors indemnification rights continue even after she has left the corporation. Bc of indemnifications potential to frustrate other goals and policies, a directors right to indemnification and the power of the corporation to indemnify depend on whether: o The director was successful in defending the action or o The director, though unsuccessful in her defense, was justified in her actions (for example, by seeking in good faith to promote the corps interests in a legally ambiguous situation). Generally indemnification rights are fixed by K or the corporations constructive documents (articles of incorporation or bylaws) D & O Liability Insurance: provides useful but limited protection against costs and liabilities for negligence of misconduct not involving dishonesty or knowing bad faith, and for false or misleading statements in disclosure documents. Most candidates would decline to serve as a director of a publicly held corp unless protected by a D&O policy. o these are complementary to indemnification
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(1) DL Gen. Corp. Law 145: corporation may amend charter to indemnify its D & O to 1) protect them for personal liability and 2) reimburse expenses they incur defending themselves if D & O have acted in good faith and not in opposition to the corporations interests. Good faith requirement cannot be ignored 145(a): apples to Direct Actions. In generally, the corporation may indemnify nondirector officers, employees, and agents to the same extent as directors. 145(b): applies to Derivative Actions. o Rule: 145(a) & 145(b) are subject to the threshold requirement that the D or O acted in good faith. 145(c): requires that D be successful on the merits or otherwise before Corporation will indemnify expenses. o If a director is sued bc of her corp position (such as for approving a corp decision or issuing a corp statement) and she defends successfully, the corp is obligated under all state statutes to indemnify the director for litigation expenses, including attorney fees. o The right of the successful director to claim repayment of expenses is available whether the suit was brought on behalf of the corporation or by an outside party. o The right protects a director from the corps faithless refusal to indemnify a director who successfully defends a suit arising from her corp position. o Success on the merits or otherwise: ex: when the suit is dismissed for lack of evidence or on a finding of nonliability after trial. Success otherwise can include on procedural grounds under most statutes (ex: dismissed bc P lacked standing or SOL has run). A director, however, is not deemed successful if the claim is settled out of court. DE requires indemnification to the extent the director is successful, compelling the corp to reimburse a partially successfully directors litigation expenses related to those claims or charges she defends successfully-but see Waltuch below o Rule: Ds vindication does not have to be moral to trigger indemnification. Any escape from adverse judgment, criminal or civil, is enough. o Rationale: Congress has likely let this pro D & O interpretation stand b/c of intense lobbying. Waltuch v. ContiCommodity Services, Inc. Silver Trading VP eligible for indemnification under 145(c) where he did not contribute to settlement of $35M P was a silver trader for firms clients. Clients brought suit against him when silver prices fell. All suits were eventually settled and dismissed with prejudice pursuant to settlements where the company paid over $35 million. Waltuch did not contribute to settlements and was dismissed from suits.

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Conti argues Waltuch himself was not successful because the suits were settled due to Contis efforts Holding: Escape from adverse judgment or other detriment, for whatever reason, is determinative. Success = Vindication His non-contribution satisfies on the merits or otherwise indemnification. Aggressive reading of 145(c). Note: no conflict where D & O use corporate funds to purchase insurance to defend against shareholder lawsuits b/c in some instances the shareholders may favor settlement to maximize investment (ex. nuisance suits). Pros and Cons of Indemnification o Pros: encourages responsible persons to accept a position as a director, encourages innocent directors to resist unjust charges, discourages groundless stockholder litigation o Cons: indemnification in connection with some wrongful acts such as self-dealing would effectively nullify fiduciary duty and would presumably therefore violate public policy. (2) DL Gen. Corp. Law 102(b)(7): eliminates personal liability for breaches of the duty of care but maintains personal liability for breach of loyalty and breach of good faith. Response to Smith v. Van Gorkum New Companies may include provision in their original charter Existing companies require shareholder approval to amend the charter Permits corporations to include a clause in their charter indemnifying D & O from money damages for a breach of fiduciary duties, so long as it is (1) no breach of duty of loyalty and (2) not an act or omission that is in bad faith or is a knowing violation of the law. o DL Legislatures response to TransUnion Directors being held personally liable for gross negligence in Smith v. Van Gorkum. Note: Between 102(b)(7) and Business Judgment Rule there is no longer liability for minor breaches of the duty of care. Shareholders may still recover though for a duty of care violation but judgment cannot include monetary relief (injunctive okay). Enactment: o New companies: may include this provision in their original charter. o Existing companies: require shareholders approval to amend the charter. Rationale: Limit Liability! Protect D & O where there is no insurance. Effect: prevent duty of care breaches into being elevated to duty of loyalty suit. o McMillan v. Intercargo Corp. Shareholders sue where protracted auction period leads to lower price for acquisition of Intercargo. Must make weak duty of loyalty claim b/c of 102(b)(7) provision in charter cant bring duty of care violation suit dismissed b/c fail to state claim. Rule: Courts are likely to interpret extreme breaches of Directors duty of care (gross negligence) as a breach of the duty of good faith defeats 102(b)(7) indemnification personal liability.

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There is no provision allowing for indemnification for breach of duty of good faith How: Shareholders can waive liability for breaches of duty of care by approving 102(b)(7) provision but cant waive breaches of duty of good faith. o Duty of Good Faith in DL law is still a work in progress. Why: Policy rationale. If there were no liability ever Directors have no incentive to satisfy their duty of care. We need liability for deterrent effect. Technicolor Litigation: Perleman acquires Technicolor for more than 100% premium but Board is lax in reviewing the transaction. Lower court says There was no harm from the breach, therefore there is no breach o (1) Chancery Court: Tort Approach Shareholders were paid over 100% premium no harm from breach no breach. Business Judgment Rule protection. Delaware courts says harm is irrelevant, breach is the issue o D must prove entire fairness because Business Judgment Rule is not applicable where there is gross negligence o (2) DL SC: Fiduciary Approach Harm irrelevant, breach is the issue. Standard: D must prove entire fairness b/c business judgment rule N/A where there is gross negligence. Entire Fairness: Fair Process & Fair Price o

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CHAPTER 11: TRANSACTIONS IN CONTROL Significant Transactions: Structural Changes Sale of Control Blocks: Approach: o Apply the Market Rule unless: (1) Sale of Corporate Opportunity (2) Sale of Corporate Office (3) Sale to a Looter o Controlling blocks of stock command a higher market price (control premia) than noncontrolling shares because: (1) Private benefits of control: salary, perks, prestige. (2) You actually believe that you can run the company more profitably regain investment in future sale. Note: Controlling blocks do not necessarily equal 51% of the corporations shares. Court interpret control as a practical matter so that in some instances 10% could be a control block is there is only a remote possibility of acquiring a larger stake. o Market Rule (CL): Minority shareholders are not entitled to share in the premia of a control sale. Holder of control block may sell his shares at the highest price possible w/out including the minority b/c the sale of control is market transaction that only creates rights and duties between the parties. o general rule is that a controlling shareholder has the right to sell his controlling stock at a premium, ie, for an above market price that is not available to other shareholders. Rationale: Minority shares do not have the same attributes as controlling shares, (no private benefits of control) do not command the same price. This rule reflects the fact that controlling stock normally sells at a higher price than noncontrolling stock. The rule also serves a policy purpose by facilitating the transfer of control from less efficient to more efficient hands. Zetlin v. Hanson Holdings, Inc. Hanson sold his controlling interest (44%) at a premium price per share. Zetlin brought suit contending that minority shareholders were entitled to an opportunity to share equally in any premium paid for a controlling interest in the corporation Holding: This was ok o Minority shareholders are entitled to protections against abuse by controlling shareholders, they are not entitled to inhibit the legitimate interests of other stockholders o Court uses market rule to protect premia for control sale of 44% of the company, minority shareholders are not entitled to share in the premia. o Court is concerned that without this rule, transfer of stock could only occur through tender offers. Alternative: Equal Opportunity Rule: Minority shareholders are entitled to their shares to a buyer of control on the same terms as the seller of control. o Some commentators have urged that where a purchaser offers to purchase control of a corp at a premium, the controlling shareholders owe a fiduciary duty to provide all shareholders with an equal opportunity to participate, i.e. the controlling shareholder must arrange that the offer be made to all shareholders on a pro rata basis.
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There is little case support for this doctrine and it has been specifically rejected in various cases. Rationale: Fairness. Opposition: It would result in fewer beneficial control transfers and leave inefficient management entrenched Exceptions to the Market Rule: Market rule will not apply where there is the: (1) Sale of Corporate Opportunity: o Rule: Courts will not permit a controlling shareholder to exclusively enjoy the control premia where there is a collective corporate opportunity associated with the sale of the control block. When this is the case, minority shareholders must be included. o Rationale: Violates fiduciary relationship of controlling shareholder to the other shareholders. Perlman v. Feldmann Feldman - Dominant shareholder, chairman of board and President negotiated a sale of Newport steel to a syndicate (this was during the Korean War so demand was at a high). Minority shareholders brought derivative action for loss of an opportunity to take advantage of plan to profit from the war. Also evidence that another purchaser had originally approached Feldman to merge with Newport in that transaction all shareholders would have shared in control premium Holding: Controlling shareholders are liable for the loss of profits to the minority shareholders Directors and dominant stockholders stand in a fiduciary relationship to the corporation and to the minority stockholders as beneficiaries thereof In a time of market shortage, where a call on a corporations product demands an unusually high premium, the fiduciary may not appropriate to himself the value of the premium Plan allowed corp. to circumvent wartime price limitations on steel by taking low interest rate loan from potential buyer supplementing steel price inc. $ to shareholders. No Control No Plan. o Equal Opportunity Rule: Minority shareholders are entitled to sell their shares to a buyer of control on the same terms as a seller of control. o Rationale: Fairness to Minority when there is suspicion of Majority. o Criticism: Easterbrook & Fischel People dont buy control blocks for private benefits of control (too limited) but b/c they want to 1) improve company or 2) loot company alternatives to Market Rule do not benefit minority shareholders b/c they jeopardize any sale at all decreases chance of replacing poor management. (2) Sale of a Corporate Office:

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Where management sells their small amount of stock at a premium and agrees to resign in favor of the buyers Board appointees at the conclusion of the sale. Paying premia for control of Corporate Office, not shares. o Rule: Market Rule will not operate where the sale is explicitly of a corporate office. o Rationale: Against public policy. Brecher v. Gregg: Gregg received 35% control premium on a sale of his 4% block of stock in exchange for promise to secure the appointment of the buyers candidate for CEO and election of two members to the board Stockholder sued Gregg to return control premium to the company Holding: Gregg has to disgorge profits. Paying a premium for control when purchasing only 4% of outstanding shares is contrary to public policy and illegal Court orders ex-CEO to disgorge profits where he sold 4% of corp. at a 35% premium & agreed to get buyers guy appointed to Board as CEO. 35% premium for 4% shares is against public policy. o Note: Where sale is not explicitly of a corporate office but a change in management follows, courts will not always reject the transaction. Carter v. Muscat: Court upholds sale where Management sells 10% & resign b/c shareholders re-elect buyers new D at the next meeting. (3) Sale to a Looter: o Controlling shareholders breach their fiduciary duties to the minority shareholders if they transfer their controlling shares to a person or group whom they know or have reason to know will deal unfairly with the corporation. o Looter: someone who will from their control position extract private benefits of control sufficient to destroy the company. Principal type of case in this category is a sale of controlling shares to a purchaser whom the controlling shareholder knows or has reason to know intends to loot the corporation. o Rule: If circumstances would alert the reasonably prudent seller of a control block to be suspicious of buyers honesty (looter) duty to make a reasonable investigation and exercise reasonable care in the sale. Red Flag Notice Duty. o Rationale: Fiduciary Duty of Care. Majority shareholders are in a better position to investigate than minority shareholders. Harris v. Carter Carter sells his stake in Atlas (52%) to Mascolos who loot the company & shareholders bring suit. Court finds Carter has a duty to screen. SALE OF CONTROL SUMMARY: Although the general rule is that a majority or controlling shareholder may sell her controlling interest at a premium, there are exceptions where:
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The controlling shareholder is in reality selling directorships or other corporate officers (ex: where a nonmajority shareholder sells her stock at a premium and causes the controlling directors to resign) An outside party seeking control of the corp proposes to purchase the corporations assets or to merge with the corportation and the controlling shareholder convinces the outsider to purchase only his shares The controlling shareholder deals with the minority shareholders without making full disclosure of the terms of his sale (ex: where the controlling shareholder must first purchase sales form the minority shareholders in order to sell sufficient control to a third party at a premium) The controlling shareholder knows that the transferee will look the corporation Duties of Sellers (Targets) & Buyers: o Tender Offer: offer of cash or securities to the shareholders of a public corporation in exchange for their shares at a premium over market price. not defined in the Williams Act or SEC rules. Generally: An orthodox tender offer is easy to recognize: a bidder publicly announces an offer to buy a specified number of shares at a premium within a specified period, subject to specified terms. But sometimes stock purchase programs, though not presented as a tender offer, involve the kinds of high pressure tactics that led to the Williams Act. The prospective acquirer of a target corporation makes a public offer to purchase shares directly from shareholders, bypassing the BOD. o Target company=Company to be acquired Tender offer is technically an offer for target stockholders to tender their shares for purchase by the bidder upon the terms of the offer. The shares tendered are not usually purchased immediately by the bidder. Federal law effectively prohibits the immediate purchase of tendered shares. The price is set at a premium over current market price so as to attract tenders. o Application: Seeking control through open market purchases is problematic-rarely will enough shareholders be selling at market for a bidder to acquire a control block. A tender offer forces the question. The bidder greatly increases its chances by publically offering to buy a specified number of tendered shares during a specified period at a premium over prevailing market prices. A tender offer operates much like a retailers Saturday night special at never again prices Hostile Takeover Application: When a corp is publically held, a bidder can go over the heads of unwilling mgmt and woo the shareholders directly The bidder can appeal to the shareholders wallets by seeking to buy a controlling block of shares at above market prices. To reach dispersed public shareholders quickly and minimize the risk of falling short, the bidder will publicly offer to buy shares at a premium above the market price on the condition that a sufficient number are submitted (tendered) within a specified period (a tender offer). A successfully tender offer, unlike a proxy contests, gives the bidder a majority equity position and the assurance of control. o Function: to amass a controlling block of a publicly held company that lacks a controlling shareholder.

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Williams Act of 1967: intended to curb abuse of tender offers, where shareholders were under high pressure to accept immediately, by equalizing positions of the offeror and the shareholders. Background: Until 1968 no federal disclosure rules applied to acquisition of a control black for cash, whether through open market purchases or a tender offer. To plug this gap Congress enacted Williams Act, a set of amendments to the SEC Act of 1934, to regulate stock purchases that affect corporate control. (1) 13(d) Early Warning System: each acquirer must disclose their identity and purpose within 10 days of obtaining 5% of the company. Any person (or group) that acquires beneficial ownership of more than 5% of a public corps equity securities must file a disclosure document with the SEC. The disclosure alerts the stock market and the targets management) of a possible change in control. Implication: o Shareholders may sue for injunction if acquirer fails to make 13(d) filing. o Institutional investors may be required to file if significant communication between classifies them as a group. Rationale: signals management and other possible purchasers that people think that something might be wrong with this company ripe for takeover. Rationale: reallocates money from acquirer to target shareholders by notifying shareholders of possible tender so they dont sell prematurely. (2) 14(d)(1) Disclosure Requirements: upon the launch of a tender offer, you must disclose your identity, plans and financing for the company in order to purchase. Target Board must make a disclosure recommending that the shareholders either accept or reject the transaction, or state they cant reach a conclusion. Rationale: want shareholders to make an informed determination. (3) 14(e) Anti-fraud provisions: Prohibits misrepresentations, nondisclosures and any fraudulent, deceptive or misrepresentative practices in connection with a tender offer. Note that 14(e) does not contain the 10b-5 sale or purchase language. This suggests that even those who did not enter into a securities transaction, namely shareholders who did not tender and investors who did not purchase, may be protected by 14(e) even though they would lack standing under 10b5. Rationale: unproductive and inefficient to allow trades based on fraudulent information. Implication: o Shareholders have a private right of action to enforce 14(e). (4) 14(d) Substantive Regulation of Terms of Offer: Minimum Time: Offer must be held open for 20 days (originally 7 then extended to 20 by SEC). o Rationale: SEC is concerned that the average investor will be unable to fairly evaluate the offer in 7 days. Contrary to Efficient Capital Markets Hypothesis. o Pros: (1) Allows time for management to respond. (2) Encourages auctions by allowing time for other potential acquirers to place competitive bids. Best Price Rule: you have to pay the same best price for all shareholders that tender into the offer. Each shareholder must be paid the best price paid to any other shareholder (14d-10(a)(2)). If consideration alternatives are provided

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(such as choice of cash or debentures) each shareholder can choose. (14d10(c)(1)). Mandatory Pro Rata Requirement: if you are only purchasing 51% of the shares then you have to purchase 51% of the shares from each shareholder who tendered. o When the bidder seeks only a portion of all the shares (a partial tender offer) and shareholders tender more than the bidder seeks, the bidder must purchase the tendered shares on a pro rata basis. o Ex: Assume the bidder seeks 50% of the targets stock and 75% is tendered, the bidder must purchase 2/3 (50/75) of each shareholders tendered shares (disregarding fractions) and then return the unpurchased shares. (14d-8) No Outside Purchases: The bidder cannot purchase outside the tender offer while it is pending Auction Debate: One purpose of Williams Act 14(d) 20-day time frame is to generate auctions. Pros: o (1) Permits target shareholders to maximize returns on shares. o (2) Limits tender offers. Too many would be inefficient b/c of expense. Cons: o (1) Reduces rate of return for the first person on the scene (the party who bears the initial research costs, etc.) could discourage potential acquirers from investigating potential targets inefficient b/c we want poorly managed companies to be taken over. Arguments: If people conduct tender offers to realize the private benefits of control argue to limit auctions b/c it is inefficient for $ to change hands repeatedly. If people conduct tender offers to improve the company argue to encourage auctions b/c efficient to have optimal management. De Facto Tender Offers: Williams Act does not define tender offer to avoid being underinclusive some room in the courts identification of a tender offer. The principal legal issue involved in such transactions is whether the transaction should be viewed as a tender offer subject to the requirements of the Williams Act Wellman v Dickinson held that a simulatenous offer to purchase shares of the target corp made to some 40 institutional and other investors by telephone in a single eveing is a tender offer that must be registered under the Williams Act Wellman Test: 8-factor test promulgated by the SEC for identifying a tender offer: (1) Active and widespread solicitation of public shareholder. (2) Solicitation is made for substantial percentage of the issuers stock. (3) Offer price is for a premium over market price. (4) The term of the offer are firm rather than negotiable. (5) Whether the offer is contingent on the tender of a fixed number of shares. (6) Whether the offer is open only for a limited period of time. (7) Whether the offerees are subject to pressure to sell their stock. (8) Whether public pronouncements of a purchasing program precede or accompany a rapid accumulation. Brascan Ltd. v. Edper Equities Ltd. o Court finds no de facto tender offer where Edper, 5% stakeholder in Brascan (Canadian), responds to refusal for friendly takeover by
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purchasing 25% of shares from institutional investors at a premium on the US markets through a securities company. o Court applies Wellman Test very generously. The Hart-Scott-Rodino Act Waiting Period Intended to give FTC and the Department of Justice the proactive ability to block deals that violate anti-trust laws Filing is always required for transactions in excess of $212 million

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CHAPTER 12: FUNDAMENTAL TRANSACTIONS: MERGERS & ACQUISITIONS

Motivations for Mergers: o Good (value enhancing): (1) Economies of Scale: being able to spread your fixed costs over a wider group of assets. Ex. Sunk cost of a factory spread over larger output reduces the fixed cost per unit. (2) Economies of Scope: being able to spread costs across a broader range of related businesses. Ex. Company A uses Company Bs marketing team post-merger. (3) Vertical Integration o Bad (value depleting): (1) Exploitation of tax advantages (2) Mistaken Mergers: where planners misjudge difficulties of achieving merger economies. (3) Empire Building/Acquiring Monopoly Power Note: Anticompetitive Mergers are illegal and subject to Federal Regulation. Types of Mergers & Acquisitions: o (1) Asset Deals Transaction: Where there is a literal, physical transfer of assets from the target to the acquirer, for which the targets shareholders receive cash or securities. a corps business is no more than the sum of its tangible and intangible assets, and selling al of the corps assets effectively transfers control. Result: Target is left with a big hole in it where the asset used to be. If hole represents all or substantially all of the targets assets liquidation. Afer selling all or substantially all of its assets, the corps existence does nto automatically terminate, instead it becomes a shell or holding co whose only assets consist of the sales proceeds. The corp can dissolve after paying its liabilities and distributing the remaining sales proceeds to the shareholders pro rata. o (2) Stock Deals Transaction: Where the targets shareholders sell their stock to the acquirer in exchange for cash or securities. Result: Target becomes a wholly owned subsidiary of the acquirer, but its pre-merger assets and liabilities remain the same. o (3) Mergers Transaction: At the effective time the target company is merged into the acquiring company and the target shareholders stock automatically converts into the right to receive consideration stipulated to by the merger (either cash or securities). In a statutory merger, the acquiring corporation absorbs the acquired corporation, the acquired corporation disappears, and the acquiring corp becomes the surviving corp. Merger occurs by operation of law. Magic words: At the effective time. Result: Target completely disappears into Acquirer which is now the Surviving Corporation. o (4) Forward Subsidiary Mergers Transaction: At the effective time the target company is merged into an acquisition subsidiary (shell company) of the acquirer and the target shareholder stock automatically converts into the right to receive consideration stipulated to by the merger (either cash or securities).

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Result: Target completely disappears into the Acquisition Subsidiary, which is the Surviving Corporation, and becomes a subsidiary of the Acquirer through the Sub. o (5) Reverse Subsidiary Mergers Transaction: At the effective time the acquisition subsidiary (shell company) of the acquirer is merged into the target company whose shareholders stock automatically converts into the right to receive consideration stipulated to by the merger (either cash or securities). Result: Acquisition Subsidiary completely disappears into the Target, which becomes a subsidiary of the Acquirer and the Surviving Corporation. o Subsidiary Mergers Generally: Expect a subsidiary merger where the target comes with certain liabilities or risks (ex. environmental risks). Allows the acquirer to protect its creditors because the creditors of the target are limited to the targets assets to satisfy their debt. Difference between forward and reverse subsidiary mergers is largely semantic. When a parent corp owns 90% or more of a subsidiary, many corporate statutes allow the subsidiary to be merged into the parent without approval by shareholders of either corp. DGCL 253. Only approval of the parents BOD is required. Rationale for this streamlined short form procedure is that approval by the subsidarys board and its shareholders is preordained, and the parents shareholders will not be materially affected since the parent already holds at least a 90% interest in the subsidiary. The subsidiarys minority shareholders are protected at 2 levels: o The fiduciary rules applicable to the parent as controlling shareholder in a squeeze-out transactions o Appraisal remedies, which statutes automatically grant minority shareholders in a short form merger. Shareholder Voting: o DL Gen. Corp. Law 251: Mergers must be approved by a vote of the majority of the outstanding shareholders. o DL Gen. Corp. Law 271: Shareholders are required to vote to approve a sale of assets if it is a sale of all or substantially all of the corporations assets. o Rule: All of substantially all of a corporations assets usually means close to 80% of the companys book value. o Occasionally Courts will re-interpret this standard for fairness purposes: Katz v. Bregman Court issues injunction for sale of a subsidiary representing 51% of the corporations assets and 45% of the corporations revenues b/c represents all or substantially all of the corporations assets under DL 271 requires shareholder vote. Fairness rationale, court was reaching b/c something inherently suspect where CEO accepted lower bid. Test is whether the change of business activity implicit in the sale is sufficiently important that it should be submitted to the stockholders for approval. Challenges to Mergers & Acquisitions o (1) Appraisal Rights Background: Fundamental changes occur by majority rule. This gives the corp the flexibility to adapt to new conditions, while avoiding minority transigence. But it also risks majority opportunism. To protect the minority, corporate statutes universally provide an appraisal remedy that assures liquidity rights to certain dissenters who opt out of majority rule in specified fundamental transactions.
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Under the procedure these dissenting shareholders can insist after the transaction on being paid the fair value of their shares in cash. Some statutes make this the exclusive remedy for shareholders challenging certain corp transactions. DL Gen. Corp. Law 262: Appraisal Rights Delaware statute grants appraisal rights only in connection with mergers. However, the DE courts recognize that the appraisal remedy may not be adequate in certain cases, particularly where fraud, misrepresentation, self dealing ,deliberate waste of corp assets, or gross and palpable overreaching are involved. Appraisal rights are limited to shareholders who: o (1) Continuously hold shares from announcement to completion of merger (262(a)). o (2) Vote against the merger (262(a)). o (3) File a written request for appraisal within 20 days prior to the effective date of the merger (262(d)). Shareholder who satisfies these conditions may exercise appraisal rights within 120 days of merger (262(e)). Market Out Rule (262(b)): Appraisal rights are not available to shareholders who: o (1) Receive stock in the surviving corporation as consideration for the merger. Effect: Eliminates appraisal rights in stock deals. o (2) Hold stock in a company traded on a public exchange. o (3) Hold stock in a company with more than 2k shareholders. Rationale: Not concerned with appraisal rights in these instances b/c dissenting shareholders can sell their shares and obtain fair market value. Pro: Dont have to prove any breach of duty, just that the price is unfair. Con: Dissenting shareholder bears all the costs for appraisal proceeding. Note: If different classes of stock receive different consideration in the merger possible that they have different appraisal rights. Appraisal Valuation: Claim = fair value at the time of the vote without reference with the possible effect of the merger on the value. Measures: o (1) DL Block Method (No longer used in DL!!) Courts take weighted average of: Asset value (10%): from the balance sheet. Earnings Value (60%): from the income statement, usu. earnings per share. Market Value (30%): from the market. If there is no market price (companies shares are not traded in the market) court will make analogies. Pro: Information for calculation is readily available. Con: Irrelevant b/c financial markets use DCF valuation. Courts mostly abandoned the block method since it fails to recognize that shares, like any other investment, are valuable bc they represent a promise of future income. o (2) Discounted Cash Flow (DCF) Future cash flows (dividends) are discounted to the present value. Relies on expert testimony for market analysis.
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Pro: Relevant to the financial markets, as opposed to DL Block which is based on historical information. Con: Easy to disagree about the underlying factors Ps & Ds experts end up with widely different calculations Court usually hires its own expert. In re Vision Hardware Group, Inc. (DL Valuation) o Vision accumulated debt and was on the verge of bankruptcy. Trust company purchased all of visions debt at a deep discount, and implemented a merger agreement which cashed out Visions public shareholders o Court rejects DL Block method in favor of more market relevant DCF method. o Court valued debt at face value instead of market value said in an appraisal proceeding shareholders are entitled to the fair value of their shares without accounting for any element of value arising from the accomplishment or expectation of the merger o favors Defendant Acquirers b/c debt lowers value of company fair price per share is lower. o In this case court says it was a liquidation o Rationale: provides incentive for Acquirers to rescue failing companies. If debt is valued at market cost of transaction is prohibitively high. o Efficient because it provides incentive for acquirers to rescue failing companies. If debt is valued at market value the transaction is probatively high o Fairness: Court focuses on the fact that but for this transaction; company would be in liquidation. Fairness Remedy Stockholder of acquired company can bring an action alleging breach of entire fairness Defendant (controlling shareholder) must prove that a self-dealing transaction was fair in all respects Plaintiff may receive recissory damages Not clear that this is still a feasible remedy This is the exclusive remedy in short-form mergers (2) De Facto Mergers (Form v. Substance Debate) De Facto Merger Doctrine (Substance): If transaction is substantively & effectively a merger rights associated with a merger (ex. appraisal) are triggered. If the asset sale has the effect of a merger, shareholders receive merger type voting and appraisal rights. P uses to make claim for voting or appraisal rights but rejected by DL Courts. Under the judicially created de factor merger doctrine, a handful of courts have interpreted the statutory merger provisions to give shareholders in functionally equivalent asset sales the same protections available in a statutory merger. Equal Dignity Rule (Form): A merger and an acquisition transaction each has its own formalities & rights Courts give each equal dignity. In DE courts accept that corporate management can structure a combination under any technique it chooses. To maximize flexibility, form trumps substance. Each combination technique, including its particular protections, has its own legal significance-an equal dignity rule.
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Effect: If transaction is structured & identified as a merger Courts will treat it as a merger. If transaction is structured & identified as an asset deal Courts will treat it as an asset deal. Rationale: Formalistic requirements exist so that individuals can predict the legal consequences of their actions. If people choose to structure a transaction a certain way & comply with its formal requirements Court will not surprise them with liability. Equal Dignity is the rule in DL!! Criticism: The use of de facto merger doctrine to imply shareholder protection not explicity provided by statute has been widely criticized. In the modern corp, shareholders have no assurance the corps business, its capital structure, or share ownership will remain stable. In fact, modern shareholders purchase their shares with the expectation (and often the hope) of control transfers. Hariton v. Arco Electronics, Inc. (DL adopts Equal Dignity Rule) Rejecting the de facto merger doctrine and refusing to imply merger type protection for shareholders when the statute does not provide it. Loral acquires all of Arcos assets in an asset for stock deal Arco shareholders are now Loral shareholders. Court rejects Ps (former Arco shareholder) de facto merger argument for appraisal & applies the Equal Dignity Rule transaction is an asset deal. (3) Unfair Treatment of Minority Shareholders The Duty of Loyalty in Controlled Mergers Controlling shareholders owe to the corporation and its minority shareholders a fiduciary duty of loyalty whenever they exercise any aspect of their control over corporate actions and decisions o All shareholders have the right to vote in their own best interest SEC Rule 13e-3 (Williams Act) Requires uniquely extensive disclosure in going-private transactions Freeze-Out Mergers: When acquiring company buys majority of voting shares in Target. After the merger shares held by acquiring company treated differently than shares held by target company. Buying company keeps shares, Target shareholders receive other consideration. o If target shareholders receive cash it is called a cash out merger o Subject to 3 layers of protection that apply to every merger plus selfdealing rules o Delaware Law: Freeze-out mergers are subject to review under an entire fairness test that requires fair dealing and fair price (Weinberger v. UOP) Court applies entire fairness review because mergers between parent and subsidiary are inherently coercive The underlying claim is breach of loyalty (A) Issue Spotting: Freeze-out (cash-out) merger between a Parent and a Subsidiary. Generally: the parent and subsidiary agree to a merger under which the subs minority sh receive cash or other consideration for their shares. The parent retains the subs shares and becomes its sole shareholder or the subsidiary merges into the parent as a new division. Acquirers use a freeze out merger to consolidate control, thus giving them unfettered access to corp assets to repay their takeover debt. There is an inherent conflict of interest bc the parents wants to minimize its payment of the minority shareholders.
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Minority is particularly vulnerable bc the parents both controls the subs board and has voting power to approve the transaction over the minoritys opp. Apply: Entire Fairness Review because Mergers between Parent and Subsidiary are inherently coercive (Strine in Pure Resources). o The concept of entire fairness includes fair dealing (how the transaction was timed, initiated, structured, negotiated, disclosed, and approved) and fair price. o Underlying claim is a Breach of Loyalty claim. o Inherent coercion b/c we believe that arms length negotiating by independent committee of Subsidiary (Weinberger FN7) is impossible b/c difficult for committee to be truly independent (Kahn/Emerging Communications). Where cash-out Mergers are done at arms length shareholders are limited to Appraisal Rights. Test: Entire Fairness (Weinberger): o (1) Fair Process: Subsidiary must form independent negotiation committee, comprised of disinterested directors, to negotiate with Parent at arms-length (FN 7). Rationale: Independent committee will push Parent to highest price maximize shareholder value. Full Disclosure of material information (but not necessarily best price). o (2) Fair Price: Determined by DCF valuation measure. o Note: Initial burden to prove Entire Fairness on D. Burden will only shift to P if transaction is: (1) Negotiated by an independent negotiating committee w/ real bargaining power AND (2) Approved by majority of minority shareholders. (B) Issue Spotting: Blended Tender/Merger: Tender offer by Controlling Shareholder to acquire the rest of the companies shares through a tender offer followed by a short- form merger. DL Gen. Corp. Law 253 (Short-Form Merger): Permits a unilateral cashout merger w/out shareholder approval where you control 90% of the shares. This does not require the consent of either the subsidarys board or its shareholders. o Q1: Is the tender offer free from structural coercion? If YES Entitled to less strict review. If NO Entire Fairness review. o Structural Coercion: tender offer is not structurally coercive where: (1) Approved by a majority of the minority shareholders. (2) Short form merger is done at the same price (including the same mix of cash & securities) as initial tender offer. (3) Controlling stockholder makes no retributive threats. o Pure Resources (see below). Merger Cases: Weinberger v. UOP, Inc. o Signal (Parent) buys out UOP (Subsidiary) in a freeze-out (cash-out) merger, approved by majority of shareholders.
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Signal fails to disclose memo re: highest bid to either independent directors or minority shareholders violates controlling shareholders fiduciary duty of disclosure. o Case Rule: Tries to establish appraisal as shareholders exclusive remedy for dissatisfaction w/merger consideration but allows for entire fairness action where there is something suspect (misrepresentation, fraud, etc.) in the transaction. o Court rejects DL Block in favor of DCF. o Footnote 7: Subsidiary must establish independent negotiating committee to satisfy Fair Process. o Here the procedures used were questionable: no disclosure of study of companys value, no meaningful negotiation with outside directors, parent initiated and structured the deal Rule: Appraisal is not the exclusive remedy for a shareholder complaining about merger price if there is something suspect in the transaction or a breach of fiduciary duty question. o Rabkin v. Phillip A. Hunt Chemical Corp. Buyer of control block contracted with seller that if the buyer completed a cash-out merger within 12 months of purchasing control it would pay the minority shareholders no less per share than it had to acquire it. Buyer waited a little longer than 12 months and cashed out minority at lower price Minority shareholders complained of breach of fiduciary duty because the controlling shareholder knew within 12 months that it would effectuate the cash-out transaction but it deliberately waited longer Holding: Court denies dismissal, says case could continue to be litigated Can bring appraisal action and claim for breach of fiduciary duty at the same time o Cede v. Technicolor Inc. Court permits entire fairness action against Perleman, even though initial merger was negotiated at arms length for a fair price. Why: conduct between first and second step of merger, when Perleman is the Controlling Shareholder, is suspect. This is so even though under Williams Act, the terms of the first and second step were the same because he had started to add value to the company by restructuring. Time value of money exacerbates. Incentive: takeover artist will want to complete transaction quickly to avoid being subjected to entire fairness review. Rules: o (1) Less than 51% can constitute control of company. o (2) An independent negotiating committee that does not exercise real bargaining power will not shift the burden of proving entire fairness. Kahn v. Lynch Communications:
o

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Controlling shareholder Alcatel proposes Lynch acquire a subsidiary of Alcatel. Independent committee says no, Alcatel offers to acquire Lynch. Offer rejected, then makes final offer, says if offer is rejected it will make an unfriendly tender offer. Offer is approved. Minority shareholder brings class action suit. If deal is approved by committee of independent directors the burden is not automatically shifted to the challenger to show lack of entire fairness. Must also have 2 other factors: o Majority shareholder must not dictate the terms of the merger o The special committee must have real bargaining power that it can exercise with the majority shareholder on an arms length basis If this is met, burden shifts to P to demonstrate unfairness of the transaction Court rejects Lynchs independent negotiating committee as not independent enough because Alcatel exercised too much influence (threatened hostile tender offer) no burden shift Shareholder owes a fiduciary duty if it owns a majority interest in or exercises control over the business affairs of the corporation o Rule: Courts will examine relationships extensively to determine independence of directors Makes it difficult to shift the burden to P where any connection defeats independence In re Emerging Communications Inc., Shareholder Litigation o Really a valuation case o Parent orchestrated going private transaction o Process and price were seriously flawed o Directors of partially owned subsidiary held jointly and severally liable o CEO breached his duty of loyalty by being on both sides of the unfair transaction o Lawyer breached his duty of loyalty and/or good faith by assisting the CEO in furthering his antithetical interests o Outside director who seemed to know the merger price was unfair breached his duty of loyalty o Other directors on the board protected by 102(b)(7) o Valuation by court of stocks fair value o Court says it is ok to apply a small stock premium so long as party demonstrates that it is appropriate o If company is insulated from risk it is not appropriate to apply a premium even if the company is small o If director has unique knowledge that transaction is unfair he violates his duty of loyalty by ignoring it Blended Tender/Merger Cases: Pure Resources Inc., Shareholders Litigation
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o Tender offer by Unocal (Parent) for Pure Resources (Sub.). Tender offer by parent for subsidiary If Parent/Sub merger inherent coercion apply Entire Fairness. o To find no coercion the offer must Be subject to a majority of minority tender condition Include a promise to engage in a prompt back end merger at the same price as the tender offer Not involve retributive threats If Parent/Sub blended tender/merger not inherently coercive apply less stringent standard unless there is evidence of structural coercion apply Entire Fairness. o Rationale: (1) Policy: inherent coercion less of an issue where people are freely trading stock. (2) Wealth maximization: incentive free exchange.

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CHAPTER 13: PUBLIC CONTESTS FOR CORPORATE CONTROL Duties of Sellers: Hostile Takeovers & Defensive Measures o Approach: Unocal as interpreted by Unitrin Issue Spotting: Offer will be cash on the front end and securities on the back end. Remember: Front & Back ends must be the same value b/c of Williams Act. Q1: Are we in Revlon Mode (5 situations)? If YES duty to be an auctioneer. If NO analyze defensive measures under Unocal/Unitrin go to Q2. Q2: Is there a threat? (Unocal) A threat is defined in Unitrin as structural coercion (i.e. risk of confusing the shareholders). Did the board have reasonable grounds to believe that the tender offer posed a danger to corporate policy or effectiveness (enhanced business judgment rule)? If YES go to Q3. o Note: Unitrin provides a very low standard for structural coercion almost anything will qualify. o Note: Paramount v. Time held that even a threat to the companys long-term plan could justify defensive measures. Gentile: If threat to companys long term plan is sufficient to justify defensive measures heightened scrutiny is diluted to the Business Judgment Rule. IF NO there will never not be a threat. Q3: Is the defensive measure draconian (either preclusive or coercive) (Unitrin)? e.g. preclusive (prohibits the sh from doing something) bc it deprived the shareholders of the right to receive all tender offers or coercive (forcing sh to do something) in that it forced the shareholders to accept a managementsponsored alternative? Note that if the boards defensive action involved selling the corp, the duty is to do whatever it can to obtain the highest price for its shareholders, and its actions wil be judged by that standard. o If it is all cash on both ends then it is very difficult for it to be coercive o Self tender can be coercive if you threaten If YES defensive measure prohibited injunction granted. (boards action was improper) If NO go to Q4. Q4: Is the response (defensive measure) within a range of reasonableness to the threat posed (Unocal Intermediate Standard of Review as interpreted Unitrin)? If YES Business Judgment Rule protection, boards action was proper. o But there could still be a separate breach of a fiduciary duty (care or loyalty) if the decision was made harshly, w/o investment bankers, etcbut this would be hard to prove. If NO go to Q5. o Gentile: range of reasonableness review is substantively the same as Business Judgment Review almost impossible for the Board to fail. Q5: Is the defensive measure fair (Entire Fairness Standard)? If YES defensive measure stands. If NO defensive measure enjoined. Note: whether something can be outside the range of reasonableness and yet entirely fair has not been litigated and is nonsensical.
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Application Note: Board of Directors bears the burden of proof for showing threat and reasonableness of response. Note: Unitrin clarifies the earlier Unocal Analysis: The DE court refined the Unocal test, under refined test a court should first direct its enhanced scrutiny first to whether the defensive action was draconian by being either preclusive or coercive. If the court finds that the defensive action was not draconian it should then look to whether it was within a range of reasonable responses to the threat posed by the tender offer. (1) Is there a threat? (2) If so, is the response reasonable in relation to the threat posed? o Unitrin Definitions: Threat: structural coercion. Structural Coercion: risk of confusing the shareholders. If the offer creates a risk that of shareholder confusion about the value of the offer or of their stock in relation to the long-term plan of the company structurally coercive. Draconian: any response characterized as either coercive or preclusive. Coercive: where the defensive measure unduly influences the shareholder to tender into managements offer. Is coercive if its aimed at forcing upon stockholders a mgmt sponsored alternative to a hostile offer. Preclusive: where the defensive measure prevents the shareholders from considering anything at all. Deprives stockholders of the right to receive all tender offers, or precludes a bidder from seeking control by fundamentally restricting proxy contests or otherwise. Eliminates the meaning of the shareholder vote (i.e. locking up a vote w/a white knight before hand). Range of Reasonableness: An action will be sustained if it is attributable to any reasonable judgment. Low Standard. Defensive Measures o Motivations to Adopt Defensive Measures: (1) Protection of Minority Shareholders (2) Preserve long-term plan of the Board for Company (3) Entrenchment of the Board o (1) Revise Corp Governance Structure The board could be staggered thus requiring an additional election cycle to vote in a new board majority. The charter could be amended to require supermajority approval of any mergers and other corp combinations. The charter could be amended to include a fair price provision requiring a price at least equal to the tender offer price in any back-end transaction. These moves were often taken in advance of a bid and required shareholder approval. They made control changes more drawn out and expensive. o (2) Revise Capital Structure The target could offer to repurchase its stock for cash or, a package of new equity and debt securities-an issuer self tender. The target could buy its stock on the open market from people who accumulated blocks of stock in response to the takeover possibility-a market sweep. The BOD could give shareholders the right to buy the targets or the bidders stock at sizeable discounts if the target were ever combined with the bidder-a poison pill. The BOD could issue new debt with poison pill that allowed the debt holders to compel the target to redeem the debt at above market prices in the case of a takeover. The BOD could issue debt securities with covenants restricting any new debt after a takeover or a combination with a hostile bidder.
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These changes to the capital structure, most of which could be effected without shareholder approval, threatened to distribute cash to shareholders or to create new debt (or both) making the target less financially attracticve. Poison Pills (Shareholder Rights Plans): permit the target Board to stop the takeover by diluting the acquirers holdings. Generally: a poison pill is a device adopted by a potential or actual takeover target to make its stock less attractive to a bidder. (1) Flip In Pill Permits the shareholders of the target company to buy heavily discounted shares if a person or group succeeds in acquiring X% of target stock. So everyone who has shares will buy more and drive down the value of the stock. o Usually triggered at acquisition of 15%. o Discount is usually 50%. The right of the (hostile) acquiring shareholder to purchase discounted stock is cancelled when the pill is triggered excluded. Effect: acquirers holdings are severely diluted. (2) Flip Over Pill Allows existing holders to convert into the acquirors shares at a bargain price in the event of an unwelcome merger. Requires the target Board of Directors to include in any merger agreement a provision entitling target shareholders to purchase stock in the surviving corporation at a 2 for 1 price. o Bargaining chip. o Intended to deter a takeover by making a bid very costly Effect: acquirers holding are severely diluted. Criticism: an acquirers purchase of a controlling position will not trigger the pill unless he executes a merger acquirer can circumvent the pill by purchasing 51% and then waiting to elect a new board (who will redeem the pill) before executing the merger (Lord Goldsmith). Adoption: Shareholder approval is not required for Board to adopt Pills. Board adopts the Pill through a resolution, after receiving advice from Investment Banks & Lawyers. Note: The effect of poison pills is to make hostile takeovers impossible b/c acquirer cannot gain control of the company. Poison pills are never actually triggered because hostile acquirer will buy under the trigger and litigate, alleging breach of fiduciary duty in boards failure to redeem the pill Note: Effectiveness is irrelevant b/c hostile acquirer is never stupid enough to trigger the pill & dilute his holdings. Instead, hostile acquirers will buy under the trigger & litigate, alleging breach of fiduciary duty in Boards failure to redeem pill. Effect: Courts, not the Board, will decide whether to redeem a pill in the face of a hostile takeover. Court will typically not force the Board to redeem the pill unless the hostile offer is all cash. N/A w/friendly transactions b/c Board will redeem pill. Note: Adoption of poison pill usually drives down the stock price b/c: (1) Institutional investors will dump stock where there is no way to remove management. (2) Disincentives acquirers from purchasing stock. Response from bidder will be to say there are breaches of fiduciary duties and that pill should be invalidated Other Defensive Measures:
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(3) Find a palatable buyer Mgmt could induce a friendly bidder (white knight) to bid for or merge with the target on an understanding that management would not be replaced. The targets management team could month (alone or with investment partners) its own bid for the target, often financed with debt-a management leveraged buyout-or management LBO. The target could promise the white knight a no-talk clause that precluded the target from soliciting or giving info to other obidders-assuring the white knight it would not be a stalking horse for other bids. Each strategy increased the likelihood of management continuation (4) Buy new business or sell existing ones The BOD could grant an asset lockup that gave a white knight the option to buy parts of the targets business at bargain prices The BOD could sell or option a crown jewel, stripping the most desirable part of the targets business and undercutting the reason for the takeover. The target could buy new businesses or propertieis that would create antitrust or banking regulatory problems for the bidder, as well as diminish the targets debt capacity. These scorched earth defenses, none of which required sh approval, made the target less attractive from a business or regulatory standpoint. (5) Accelerate or Increase Managements Employment Benefits The BOD could grant sr executives golden parachutes that promised severance payments upon a takeover. The board could make pension and stock plans subject to contingent vesting if the takeover succeeded. These arrangements increased the costs of a takeover and softened the blow if one succeeded. Golden Parachutes (Merck Article): makes acquisition of the company more expensive b/c tacks on huge severance payment to managers. Pro: Managers will not stand in the way of a takeover b/c they will get paid for doing nothing shareholders can receive premium w/out hassle. May be challenged under Breach of Loyalty claim b/c transaction is necessarily self-interested. (6) Buy out the Bidder The target could pay greenmail by repurchasing the bidders shares at a premium. Sometimes the target would require a greenmailer to enter into a standstill agreement obligating the greenmailer not to acquire more shares for a specified period. This, at least temporarily, ends the threat. Anti-greenmail: prevents the board from paying greenmail. Greenmail: payment of premium to a controlling shareholder to repurchase their shares. Greenmail (i/o blackmail) occurs when a controlling shareholder tries to get bought out b/c D & O dont know what their strategy is & want to eliminate surprises. Rule: Defensive measures taken by the Board will be subject to a form of intermediate scrutiny by the courts. Unocal Corp v. Mesa Petroleum Co. Mesa (13%) launches two tier front end tender offer for 37% of Unocals shares: $54 in cash on the front end & $54 in junk bonds on the back end. Defensive Measure: Board launches self-tender for $72 per share triggered upon Mesas acquisition of 50% of the shares. o Changes value of the company b/c Unocal has to take on debt to purchase outstanding shares less attractive target. o Impedes control of company b/c Board holds 50%. Mesa is excluded from the self-tender offer b/c Board does not want to finance the takeover.
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Courts Analysis: Intermediate Level of Scrutiny o Is there a threat? o Is the defensive measure reasonable in relation to the threat posed? Here, selective tender is reasonable business judgment rule Board ok. Rule: If there is no threat Boards have the authority to adopt defensive measures in the form of Poison Pills & their decision to do so will be reviewed under the Business Judgment Rule. If the Pill is adopted in response to a threat Boards decision is subject to Unocals Intermediate Scrutiny (Reasonable). Moran v. Household International Inc. Household adopts poison pill in the regular course of business b/c concerned about its attractiveness as a target & the possibility of bust-up takeover. Court finds o that Directors acted in good faith (not for entrenchment) & were authorized by DL 151 & 157 to adopt the pill Business Judgment Rule. 151 is about financing the company not defending it from a hostile bidder o BOD can issue shares and can issue rights over those shares Unitrin Inc v. American General Corp. American General Corp. makes a bid for Unitrin, which the Board effectively blocks by adopting a pill and repurchasing 20% of the outstanding shares. Brings the Boards holdings from 23% to 28% of the total shares. 20% repurchase significant b/c companys charter says that if more than 15% of shares are acquired subsequent merger requires 75% approval, which will never happen if the Board holds 28%. Court refines and clarifies the Unocal analysis: (1) Is there structural coercion (i.e. a threat)? (2) Are the defensive measures draconian (preclusive or coercive)? (3) Is the target boards response within the range of reasonableness? Result: extremely deferential analysis that smacks of the Business Judgment Rule. Here, the defensive measure was not preclusive b/c it did not materially change the deals landscape the Board initially held a significant amount of stock and repurchase program only enhanced their position slightly (23% 28%). Note: despite the extremely deferential Unitrin/Unocal analysis, there remain instances where defensive measures are struck down as preclusive. ITT v. Hilton Hotels (example of preclusive defensive measure) Board spins 93% of its assets into 1 of 3 subsidiaries & adopts staggered Board, w/ same Ds as parent company, to avoid a hostile takeover by Hilton Hotels. Intended to give shares of subsidiary to shareholders as a dividend.

NV Court: defensive measure is preclusive b/c circumvents shareholder vote on Hilton offer shareholders cannot vote on action at the subsidiary level.

Sales of Corporations o Inevitability of Sale of Company When target responds to bidders offer by seeking alternative transaction involving the break-up of the company o Approach: Revlon Duties If youre in Revlon land you have to take out the defensive measures o Issue Spotting: (1) Voluntary sale
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(2) Inevitability of sale: Target responds to bidders offer by seeking alternative transaction involving the break-up of the company (White Knight) (Time). (A) All cash deal. o Institutional Competence Rationale: Shareholders are as competent as Board to evaluate a cash deal (less risk of confusion) Board should act as auctioneer. In a stock deal, greater likelihood that shareholders will be confused re: value more deference to Boards evaluation. (B) Whale/Minnow: purchase by a very large company of a very small company in a stock deal, will trigger Revlon duties for small companys Board. o Rationale: (a) Large companys stock = cash since the acquisition of small company will not impact it. (b) Institutional competence rationale: anyone can evaluate big company competently but w/merger of equals we defer to Board. (C) Sale of Control: if acquirer of diffusely held company has a controlling shareholder Revlon duties triggered. o Rationale: result of sale will be that target company will transfer control to acquirers controlling shareholder control premium. o Note: Courts will evaluate control practically Revlon duties may be triggered where diffusely held company has 30% shareholder post merger. Revlon Duties: To act as an auctioneer for the company maximizing value for the shareholders by obtaining the highest price possible for the shares. Board may only consider the interests of other stakeholders in the context of considering how to raise the sale price. Specifics of Revlon Mode: (1) Level Playing Field: Board cannot favor one bidder over another & cannot use certain defensive mechanisms to destroy the auction process. Rationale: Fairness prevents the board from using defensive mechanisms that favor one bidder over another. (2) Market Check Required: When the board is considering a single offer and has no reliable grounds upon which to judge its adequacy fairness demands a canvas of the market place to determine if higher bids may be elicited. (3) Exemption Allowed in (very) Limited Circumstances: When the directors possess a body of reliable evidence with which to evaluate the fairness of a transaction, they may approve the transaction without conducting an active survey of the marketplace. Rule: Obtaining a premium is insufficient to satisfy the Directors fiduciary duties to the shareholders during a sale. Smith v. Van Gorkom Trans Union directors held grossly negligent where they failed to do any investigation into adequacy of sale price and just relied on the CEO (Van Gorkoms) representation that $55 was fair (# came from internal analysis). Board failed to investigate market or get a fairness opinion from Investment Bankers. Also, auction period here inadequate b/c bids had to be financed. A & K: first indication the DL Courts are looking at change in control transactions w/ a new standard of review, not just Business Judgment Rule. Rule: Where the company is for sale (either voluntarily or due to inevitability/break-up) the Boards sole duty is to act as an auctioneer and obtain the highest price possible for the shareholders consideration of other stakeholders must be subordinate to shareholders.
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Revlon, Inc. v. MacAndrews and Forbes Holdings, Inc. (DL 1986) Perleman makes a hostile offer for Revlon, Board takes defensive measures, including poison pill, repurchase of 20% w/ money from Notes (debt from shareholders) w/restrictive covenants re: selling company assets. Perleman continues to bid and Board enters into preferential deal (including lock up agreement guaranteeing sale of 2 best assets) w/ white knight. Court: Revlon Board violated fiduciary duties by privileging interests of Note holders over shareholders. Allowed lock-up w/ white knight to end bidding breach. Note: Lock-ups may be permissible in some settings, particularly at the beginning stages of sale to generate interest. Problematic at later stages where they favor one bidder over another. More likely to be Revlon over QVC if shares are stock instead of cash? Just Say No Defense: a Board may decide that it is not for sale and just say no to would be acquirers no duty to investigate every offer. However, practically, Boards will respond to shareholder pressure with an alternative transaction that provides shareholders with value comparable to acquirers offer. Rule: If company is not for sale threat to its long-term plan is sufficient to justify defensive measures Unocal analysis. If company is not for sale (Revlon duties) no duty to maximize short-term shareholder value. Paramount Communications Inc. v. Time Inc. o Paramount makes cash bid for Time, as Time is about to merge with Warner, pursuant to its long-term plan to diversify as multimedia co. o Defense: Times makes a tender offer for Warner incurring substantial debt to make itself a less attractive target and avoiding shareholder vote on Time Warner merger. o Revlon & Unocal Analysis: Revlon duties are not triggered b/c sale of company is not inevitable. Time Board entitled to business judgment review under Unocal b/c threat to long-term plan is sufficient to justify reasonable defensive measures. Rule: Sale of Control will trigger Boards Revlon Duties. Rationale: Shareholders only opportunity to realize a premium on shares Board has a duty to maximize shareholder value. Paramount Communications Inc. v. QVC Network, Inc. Paramount is the target, agrees to be acquired by Viacom. Viacom gets a lot of protection including an agreement that the board wont try to sell the company to anyone else. QVC offers more than Viacom but Paramount says there are too many conditions QVC goes to court, says it is clear Paramount is for sale (in Revlon land) needs to strip away defensive measures Paramount says they have a long term plan for the company and QVC is a threat to it When Viacom buys Paramount the controlling shareholder will have a controlling interest in Paramount, and all the shareholder will become minority shareholders Relevant K Provisions:

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(1) Lock-up: Allows the preferred bidder first dibs on targets most desirable assets or a significant chunk of stock, regardless of whether the transaction goes through. Effect: Impossible to find another bidder b/c no one wants the leftovers. (2) Termination Agreement: Stipulates that target will pay bidder $X in the event that the transaction fails to go through. DL Courts usually hold these agreements to 3% of the deals value. (3) No Shop: Prohibits target company from soliciting for another bidder. (4) No Talk: Prohibits target company from communicating with any potential bidder, even if they are unsolicited. Rationales: (1) Recouping Expenses: initial bidder should recoup transaction costs (research, legal, etc.) b/c there is value to having people examining underperforming companies in the marketplace and without deal protections, this process may becomes prohibitively expensive. (2) Unique benefits of the favored transaction. Judicial Review: Courts will usually evaluate deal protective K provisions under Unitrin/Unocal (lax) standard. No Shop/No Talk provisions will be examined more closely b/c stronger deterrent to hostile bidder b/c forces them to proceed w/ transaction blind. Hostile bids are beneficial to the market in certain instances Courts want to protect them. Rule: If deal protection provisions limit Boards exercise of fiduciary duties invalid. Fiduciary Out: K provision that specifies that if some triggering event occurs such that the board has a fiduciary duty to abandon the deal Board may breach the original K without incurring liability for breach. Note: Unclear why this is necessary because it seems that DL Courts will hold any K provision that unnecessarily limits the Boards fiduciary duties to be invalid K damages would not be available for breach. However, uncertainty fiduciary outs still regarded as material for M & A transactions. Perhaps included because it eliminates the need to litigate the first step (i.e. whether the original K provision was invalid)? Omnicare v. NCS Healthcare NCS enters agreement w/Genesis in which deal protective measures ensure 1) that the Genesis deal will be submitted to the shareholders and 2) that the majority shareholders will vote their shares towards the Genesis deal. No fiduciary out provision. Genesis wary of being undercut by Omnicare bid for NCS b/c past history. Court: under Unocal analysis the deal protective measures are preclusive (votes outcome is predetermined) invalid. o Even though there was goin got be a sh vot eon the transaction it was preclusive bc the votes for the lower bid was already locked up in the form of Ks Court is upset that the NCS/Genesis K did not have a fiduciary out b/c allows Board to protect the shareholders & ensures Board does not stop short at the friendly deal. State Anti-takeover statutes First Generation Statues: Illinois Business Takeover Act of 1979 If the target company has a strong connection to Illinois (ex. 10% shareholders = Illinois, incorporated in Illinois, etc.) Secretary of State will mediate any hostile bids on target.
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Bid must be registered with the Secretary of State. 20 day waiting period. Secretary has discretion to hold a hearing adjudicating the fairness of the offer. Policy: ensure states shareholders are adequately compensated. SC: Unconstitutional b/c Williams Act trumps it under the Supremacy Clause (Edgar v. MITE Corp.) Second Generation Statutes: Fair Price Statute: requires that Minority shareholders frozen out in the second step of a two tier offer receive no less for their shares than those who tendered in during the first step. (Establishes procedural rules acquirer must follow to determine back-end price). Control Share Statute: o (1) Requires disinterested shareholder approval for purchase of shares that will result in acquirer holding control position in the company (ex. 20%, 50%). o (2) Permits acquirer to obtain control position by purchasing shares but strips those shares of voting power if a certain threshold is crossed (ex. 20%, 50%). Approval by majority of disinterested shareholders will reinstate the voting rights. CTS Corp. v. Dynamics Corp. of America Statutes valid b/c unlike the Illinois statute, they permit acquisition of shares, even if acquisition less attractive b/c contingencies on share power. Policy: Investor Protection. Third Generation Statutes: Constituency Statutes: Allow or require target board to consider nonshareholder constituencies when determining what response to take to a hostile offer. Redemption Rights Statute: permits shareholders to bring appraisal action whenever a person makes a controlling share acquisition (i.e. 30% or more of corporations stock). DL Gen. Corp. Law 203: Prohibits business combinations between acquirer and target for a period of 3 years after acquirer passes 15% threshold ownership in target company unless certain exemptions are met, such as: (a)(1): Targets Board approves takeover before the bid occurs, including explicitly approving acquisition of 15% of the shares without the DL 203 freeze applying. o Target board must approve transaction while the negotiations for the acquisition are ongoing cant backdate the resolution postacquisition. o Effect: Acquirer will purchase 14% of the target and then force the Board to approve the resolution. (a)(2) Acquirer gains more than 85% of shares in a single offer (i.e. moves from below 15% to above 85%), excluding inside directors shares, or o Note: Almost impossible to do, particularly since management typically holds some percentage of the stock. (a)(3) Acquirer gets board approval and 2/3 vote of approval from disinterested shareholder (i.e. minority who remain after the takeover.) o o o

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Rationale: DL has less incentive to protect in-state constituents b/c constituents of their corporate law are not necessarily in DL incentive to protect shareholders on the back end.

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Proxy Contests Proxy contests provide an alternative method (to hostile takeovers) of gaining control of a company. o An insurgent group competes with management in an effort tto obtain proxy appointments. In the classic proxy fight the goal of insurgents is to elect a majority of the BOD and thereby obtain control, but in some cases contests are waged solely to obtain representations on the board o Strategy: Gain control of voting apparatus gain control of Board gain control of company. o Insurgent group needs to obtain a stockholders list so that substantial stockholders may be identified and contacted personally. o Insurgent group has limited rights under 14a-7 which requires management to provide minimal assistance either by providing a list of stockholder names and addresses or by mailing a communication directly to stockholders at the expense of the insurgent group. o Insurgent group usually purchases a substantial block of shares in the open market before announcing its intentions. Under 1934 Act an insurgent group must file schedule 13D w the SEC within 10 days if it acquires over 5% of any class of the target corps equity securities. Schedule 13D must also be furnished to the target company and to the relevant stock exchange and must be amended within ten days of any purchase of addtl shares. Pros: (1) Less expensive than launching a hostile tender offer. Cons: (1) Two Election Problem: With a Staggered Board there is no ability for a hostile bidder to get an up or down vote on its bid at a single point in time takes at least two elections to gain control of the Board. (2) Firm Offer Problem: firm offer eliminates the need for the target shareholder to assess how well the bidder would run the firm, but making a firm offer effectively gives target shareholders a (free) put option for their shares for the duration of the bid. Also with increasing concentration of shares in the hands of institutional investors, successful proxy contests may become more common. o Rule: Voting is special. Schnell v. Chris-Craft Industries, Inc. A BOD has authority to set the annual meeting date within certain limits set forth in the bylaws. The BOD elects to move the meeting date forward as much as possible solely in order to make the successful solicitation of proxies by the insurgents more difficult. Such an action is invalid bc it has no business purpose. Court issues injunction to prevent Board from advancing the date of annual shareholder meeting & moving it to an obscure town to prevent dissident shareholders from waging a proxy contest for shareholder votes. Although the Board is within its statutory authority to amend the bylaws, the Court issues the injunction b/c amendment here is an impermissible interference with the shareholders right to vote. o Rule: Defensive measure responding to a heated contest for control that somehow alters the governance of the corporation & changes the way the shareholders vote will be stricken. Blasius Industries, Inc. v. Atlas Corp. Atlas is a 10% shareholder in Blasius and wants to restructure Blasius so that it sells its assets, incurs more debt and pays high cash dividends to shareholders. Atlas plans to circumvent Board opposition by increasing size of the Board and electing a majority of Directors.
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Blasius responds defensively by increasing the size of its Board and stacking it w/friendly directors. Court: defensive measure is problematic even though the Board was acting in good faith because voting is special limits appropriate responses to proxy contests. Rule: Limitations on acceptable defensive responses to Proxy Contests defensive measures taken in response to heated proxy contest are more likely to be enjoined. Response Scenarios: A) Incumbent board goes into the market and purchases stock selectively, at a small premium, from large shareholder likely to vote for the insurgents. o Board is likely to lose the suit b/c Courts view the voting rights of shareholders as special. B) Under the same circumstances, incumbent Board sells a large block of shares to shareholders likely to vote for incumbent Board in proxy contest. o Board would likely lose in Court because of the notion that voting is so special. C) Board delays the annual meeting because, as the proxies are coming in, Board sees that it is likely to lose the election & hopes delay will allow them to get more votes. o Not in good faith invalid.

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