Corporations Law

Professor Stephen M. Bainbridge

1. (10 points) George is Vice-President for Marketing of Zapco Enterprises, Inc., a

Delaware corporation, a manufacturer of video game software used in arcades and home
systems (such as the Ninetendo system). Part of George’s duties is testing competitor
models. One day George leaves work and travels to a near-by video arcade to test a new
game put out by Zapco’s principal competitor. While visiting the arcade, George meets
two young computer software engineers who have developed a new word processing
program for personal computers. After further meetings with the engineers, George
decides the program has promise and offers to help market it. The two engineers set up a
new corporation called “Wordco, Inc.,” and hire George as a marketing consultant.
George is issued 10% of Wordco’s common stock and also gets a commission of $10 for
every copy of the program sold by Wordco. Zapco’s top management is considering
suing George for violating the corporate opportunity doctrine. Please advise Zapco as to
whether the suit is likely to succeed. If you need additional facts, be sure to explain what
additional facts are required to reach a conclusion and explain why those facts are
significant.

2. (5 points) Suppose you own 25 percent of the stock of True Love, Inc., a publisher of
gothic romance novels. On the supposition that the novel market is shrinking, True Love
has decided to start a new division, Amore Comics, to produce gothic romance comic
books. You believe that the Amore Comics venture is doomed, and launch a proxy fight
to install yourself and your literati friends on the board. Incumbent managers fight back
by using corporate funds to hire a public relations firm that will mastermind their tactics.
You file suit challenging that use of the corporate treasury. What result? How would
your answer change if you establish that 80 percent of the stock of the public relations
firm is held by the older brother of the True Love CEO?

3. (20 points) Taimie is the CEO of Target Co., whose shares are traded on the New York
Stock Exchange. On April 1, Taimie receives a call from Beula, the CEO of Buyer Co.,
whose shares are also traded on the NYSE. Beula informs Taimie that Buyer Co. has just
acquired 120,000 of the shares of Target Co., giving Buyer Co. 8 percent of the total
shares outstanding, and that it is considering a tender offer for the rest of Target’s shares
at $9 per share. Beula also says that Buyer Co. has not yet announced its purchase, but
will do so soon. Beula further says that she hopes that any acquisition can be friendly
and that she is calling as a courtesy so that Taimie would not be caught by surprise by a
public announcement. Target’s shares are currently trading at $5 per share.

Taimie calls her personal lawyer, Larry, tells Larry about Beula’s call, and asks Larry if
she can buy Target shares. Larry tells her not to do so. That night, at dinner at home,
Taimie tells her husband, John, about the events of the day. Their son, Sam, happens to
be in the kitchen drinking a beer and overhears the part about the expected Buyer Co.
tender offer. That same evening, John is chatting with one of his golfing pals, Harvey,
and tells Harvey what Beula had said to Taimie. The next morning, April 2, Larry, Sam,
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and Harvey each buy 1,000 shares of Target stock at $5.50 per share. The following day,
April 3, Target and Buyer each issue press releases describing the Buyer purchase and the
prospect that Buyer will make a tender offer at $9 per share. On April 7, Larry, Sam, and
Harvey each sell their 1,000 Target shares for $8.50 per share. What are the liabilities, if
any, of (a) Beula, (b) Taimie, (c) Larry, (d) John, (e) Sam, and (f) Harvey, under Rule
10b-5?

4. (25 points) Bill Kline is a director and CEO of Ajax, Inc., a Delaware corporation.
Ajax’s articles of incorporation include a liability limitation provision as authorized by §
102(b)(7) of the Delaware corporation code. The other 5 members of the board of
directors of Ajax are all close friends of Bill, but none of those 5 directors are employed
by Ajax and none have any business relationship with Bill other than their status as an
Ajax director. Acting in his capacity as CEO, Bill causes Ajax to invest heavily in
financial derivatives. The other board members were unaware of Bill’s actions.
Unfortunately, Ajax’s investments are highly unsuccessful, Ajax loses considerable sums,
and the stock price plummets. A group of shareholders sue Bill for violating his duty of
care. The shareholder suit against Bill does not seek monetary damages. Instead, that suit
simply seeks an injunction forbidding Bill to invest Ajax funds in financial derivatives in
the future. Bill has moved to dismiss the suit on grounds that (a) the shareholders failed
to make demand on the board of directors before filing suit and (b) the business judgment
rule precludes judicial review of his conduct. How should the judge rule and why? How
would your answer change, if at all, if the board of directors of Acme had been fully
informed of Bill’s plans and had unanimously approved those plans after extensive and
careful deliberation?

5. (5 points) The promoter of Acme, Inc., attempted to form Acme by mailing articles of
incorporation to the office of the Secretary of State. Under state law, filing of articles by
mail is permissible. Unfortunately, the articles were long delayed in the mails and were
not officially filed for some weeks. In the interim, the promoter, who assumed that the
articles had been filed and that the corporation existed, entered into a lease on the
corporation's behalf. The lessor had considerable business experience, but did not require
the promoter to guarantee the lease personally. Instead, the lessor knew and expected that
the corporation would be responsible for the lease. When the corporation failed to
perform, however, lessor sought to hold the promoter personally liable. The promoter
argues that only the corporation should be held liable. What result?

6. Albemarle Seeds, Inc. is an undiversified agribusiness, specializing in selling seeds of

food crops to underdeveloped nations. Albemarle Seeds is incorporated in Delaware and
is a reporting company under the Securities Exchange Act of 1934. Albemarle Seeds has
nine directors, three of whom are employed by Albemarle Seeds in various capacities.
None of the other six directors has any affiliation with Albemarle Seeds, except for their
position as a director. The three Albemarle Seeds directors who are employed by it are:
Russ Johansen, who is Albemarle Seeds’ Chairman of the Board and President; Steve Van
Gherkin, who is Albemarle Seed’s Chief Financial Officer; and Bruce Cherbourg, who is
Albemarle Seed’s Secretary and General Counsel. The Board of Directors has authorized
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Johansen, Van Gherkin, and Cherbourg to serve as an Executive Committee of the Board,
empowered to take action in the board’s name in the event of a business emergency. One
of Albemarle Seed’s longest-standing and largest customers is the People’s Republic of
Urbania, a small island nation off the coast of North America. In June 1995, Urbania’s
Minister of Agriculture terminated Urbania’s contract with Albemarle Seeds. In response,
Johansen called an emergency meeting of the Executive Committee. The Executive
Committee unanimously authorized Van Gherkin to pay a $10 million bribe to the
Urbania Minister of Agriculture. The Minister thereafter reinstated Albemarle Seed’s
contract. Even after taking into account the bribe, Albemarle Seeds expects to make a $75
million profit during the 1995-1996 fiscal year alone on the contract with Urbania. The
Executive Committee never disclosed the bribe to the other members of Albemarle Seed’s
board of directors; nor was the bribe disclosed in Albemarle Seed’s proxy statement or
other SEC disclosure documents. In December 1995, the Justice Department indicted
Albemarle Seeds, Johansen, Van Gherkin, and Cherbourg for criminal violations of the
Foreign Corrupt Payments Act. Albemarle Seeds was fined $30 million. Johansen, Van
Gherkin, and Cherbourg were each sentenced to two years in jail. The proxy statement
used in connection with Albemarle Seed’s November 1995 annual shareholders’ meeting
did not disclose the payment of the bribe. The only items voted on at that meeting were
the election of the board of directors (all nine incumbent directors were re-elected,
including Johansen, Van Gherkin, and Cherbourg) and ratification of the board’s selection
of an independent auditor. Susan Shareholder has brought suit against Albemarle Seeds
and its board of directors.
A. (10 points) Count One of Shareholders’ lawsuit is brought under Securities Exchange
Act  14(a), seeking monetary damages. Albemarle Seeds has moved to dismiss Count
One of Shareholder’s lawsuit on grounds that (a) the information in question is not
material and (b) Shareholder’s losses, if any, were not caused by the alleged
nondisclosures. You are the judge. How should you decide the motion?

B. (30 points) Count Two of Shareholders’ lawsuit is brought against all of the members
of board of directors alleging violations of the duty of care. Acme’s board of directors
appointed two new directors, Jesse James and Ned Kelly, to the board. Neither James nor
Kelly had any prior business or personal affiliation with the corporation or any of the
individual defendants. The board then appointed James and Kelly as a special litigation
committee to which the board of directors delegated all of its powers to act on behalf of
the corporation in connection with Count Two of Shareholders’ suit. Acting pursuant to
authority granted them by the board, James and Kelly hired outside legal counsel to
advise them and undertook an extensive and lengthy investigation. Upon the conclusion
of that investigation, James and Kelly determined that Johansen, Van Gherkin, and
Cherbourg had knowingly committed criminal acts on behalf of the corporation, but had
done so in the belief that they were acting in the best interests of the corporation.
Accordingly, James and Kelly concluded that the business judgment rule likely would
protect Johansen, Van Gherkin, and Cherbourg from personal liability and that it
therefore would be of no use for the corporation to pursue legal action against them.
James and Kelly further determined that the other members of the board of directors had
been unaware of the illegal conduct and therefore likewise would be protected by the
business judgment rule. James and Kelly therefore filed a motion with the court, asking
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the court to dismiss Count Two of Shareholders’ suit. How should the court rule and
why?

7. (15 points) Dan owned a number of quick oil change facilities in Detroit. Dan owned
these facilities through X Corporation, in which he was a director and sole shareholder.
Because of a concern about potential liability, Dan organized new corporations,
transferring one of the facilities to each of the corporations. Dan became a director along
with his wife, and sole shareholder of each of the newly organized corporations. Dan was
careful not to intermingle any of his personal assets with those of the corporations, and to
hold shareholder and director meetings for each corporation. However, he had only one
advertisement for all of the facilities, buying of supplies for all facilities was done
through one account, and only one set of business records was kept by him because he
filed a consolidated federal income tax return for all of the corporations. If a money
judgment is obtained against one of the corporations for contaminating the underground
water supply system, and the corporation lacks sufficient assets to satisfy the creditor’s
claims, can the creditor recover against Dan’s personal assets? On these facts of the
preceding question, could a creditor collect its judgment against all of Dan’s corporations
collectively?

8. (10 points) Samantha owns 55 percent of the outstanding shares of voting stock of
ZYX Corporation. All of ZYX's directors were her nominees. Samantha is in dire need of
some quick cash for personal reasons. She therefore proposes to the board of directors
that ZYX institute a stock redemption plan. Pursuant to the plan, ZYX will offer to
repurchase up to 10 percent of the outstanding shares of ZYX stock, on a pro rata basis,
from any shareholders who wish to sell part of their holdings. The board adopts the plan.
Debby, another shareholder of ZYX, objects to the plan. If Debby sues to block the plan
from going forward, will she prevail?

9. (5 points) At a properly noticed meeting of the shareholders of Corp Y, shareholders

owning 1,000,001 shares, of a total issued and outstanding of 2,000,000, attend the
meeting. A proposal to amend the by-laws to institute certain qualifications for the board
of directors receives a total affirmative vote of 499,999 shares. 499,998 shares vote
against the proposal. A holder of 4 shares abstains. If Y is incorporated in Delaware, did
the proposal pass? Would your answer change if Y was incorporated in a state that has
adopted the Model Business Corporation Act?

10. (15 points) When it made its initial public offering 10 years ago, Target Corporation’s
articles of incorporation provided for a staggered board of directors consisting of three
classes of three directors each. Two years ago, Target’s in-house legal counsel advised the
board of directors that the corporation’s industry was in the process of consolidation and
there were an increasing number of corporate takeovers in the industry. Counsel advised
the board of directors to adopt a standard shareholder rights plan (a.k.a. a “poison pill”),
with both flip-in and flip-over provisions. The pill may be redeemed by the board of
directors at any time at nominal cost. After careful deliberation, the fully informed board
of directors decided to adopt the pill so as to provide it with negotiating leverage against
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potential takeover bidders. Last month Raider Corporation initiated an unsolicited tender
offer for all of Target’s outstanding shares at a price of $30 per share. Target’s stock had
been trading in the market in a range of $12-$18 for the last year. After consulting with its
legal and financial advisors, Target’s board of directors rejected the bid from Raider as
offering too low of a price. Target’s board invited Raider to negotiate and to submit a
higher offer, but Raider refused. Target is incorporated in Delaware Raider has filed suit
in the Delaware Chancery Court, asking the Court to invalidate the poison pill. Raider
claims that the combination of the pill and the staggered board unfairly prevents Raider
from making its offer directly to the shareholders of Target. How should the court rule
and why?
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Essay # 1

On January 15, 2002, Lucius, Chairman and Chief Executive

Officer of Empire, Inc. (“Empire”), delivered a letter to Arthur,
Chairman and Chief Executive Officer of Camelot Corporation
(“Camelot”), outlining the terms of a proposed transaction between
Empire and Camelot. Under the terms of the proposed transaction,
Empire would make a tender offer to pay $60 cash for each share of
outstanding common stock of Camelot. Camelot currently has 35
million shares of common stock outstanding, trading between $40 and
$45 per share over the past six months. Assuming Empire obtained at
least 50% of Camelot’s shares, Empire would cash out any remaining
shares in a merger at $60 per share. As of the date of the letter,
Empire owned less than five percent of Camelot’s shares. Both Empire
and Camelot are incorporated in Delaware.
In response to the letter from Empire, Arthur called a meeting of
the board of directors of Camelot for January 17, 2002. The Camelot
board of directors consisted of six outside directors and three Camelot
officers. The board of directors is staggered into three classes of three
directors each. All directors attended. At the meeting, Arthur provided
each director with a copy of the letter from Empire and discussed
possible responses. None of the directors was inclined to recommend
Empire’s offer to Camelot’s stockholders. Concerns expressed at the
meeting included the following: (1) Based on a presentation by
Camelot’s investment bankers, it appeared that Empire’s offer was at a
lower price than could be obtained if the directors held an auction for
the sale of Camelot. (2) Camelot and Empire are book publishers.
Camelot’s directors expect that a merger with Empire would result in
the loss of a significant number of existing jobs of Camelot’s
employees. This, in turn, would cause substantial changes in the
community where Camelot’s administrative headquarters and primary
manufacturing facilities are located and most of its directors live. (3) In
the view of Camelot’s directors, Empire publishes books and
magazines that appeal to the baser elements of society. Camelot, on
the other hand, tends to appeal to a more intellectual consumer.
Although not as profitable as Empire, Camelot has long shown a
willingness to sacrifice profits in pursuit of its mission. Camelot’s
directors fear that the acquisition by Empire would result in a change in
the focus and quality of Camelot’s publications.
After a lengthy meeting, the board of directors of Camelot
passed a resolution rejecting Empire’s offer as “grossly inadequate”
and “not in the best long-term interests of the stockholders or
employees of Camelot or of the consuming public.” In addition, the
directors authorized Arthur and Galahad, the Chief Financial Officer, to
approach Holy Grail Ltd, a large publisher of religious materials and
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operator of an international chain of religious bookstores, about the

possibility of merging. Because religious publishers like Holy Grail
occupy a segment of the publishing industry that is distinct from
mainstream publishers like Camelot and Empire, a merger with Holy
Grail likely would result in only a small number of Camelot’s employees
losing their jobs. A merger with Holy Grail also would make Camelot
less attractive to Empire or other potential hostile acquirers. Holy Grail
is a publicly-held Delaware corporation.
On February 1, 2002, after a board meeting attended by all
directors which approved the transaction, Camelot announced the
signing of a merger agreement with Holy Grail (the “Merger
Agreement”). Under the terms of the Merger Agreement, Holy Grail
stockholders would receive two shares of Camelot stock in exchange
for each share of Holy Grail stock, or a total of 40 million Camelot
shares. In addition, the Merger Agreement provided for a break-up fee,
pursuant to which Camelot agreed to pay Holy Grail $100 million if
Camelot backed out of the Merger Agreement. Finally, the Merger
Agreement provided that after the acquisition, the surviving entity
would retain the Camelot name, that all of Camelot’s outside directors
would sit on the board of the surviving company, and that Arthur would
be Chief Executive Officer of the surviving company.
The Merger Agreement was unanimously approved by the
Camelot board after receiving a fairness opinion from its investment
bankers. The expected trading value of the combined Camelot/Holy
Grail entity was approximately $47 per share but was expected by
Camelot’s investment bankers to increase gradually over time.
On February 10, 2002, having been thwarted in its attempts to
negotiate a friendly acquisition, Empire announced the
commencement a tender offer for all Camelot shares, contingent on (1)
cancellation of the merger with Holy Grail and (2) the redemption of
Camelot’s stockholder rights plan. The stockholder rights plan had
been adopted by Camelot’s board as a general planning matter some
years before. The plan is a standard second generation poison pill with
both flip-in and flip-over elements, along with a standard window
redemption provision. Under the terms of this tender offer, Empire
would pay $63 cash per share for each share of Camelot common
stock, and promised to pay the same price for shares taken in a back
end freeze-out merger. Assume that as a practical matter, Empire
cannot acquire Camelot if Camelot’s board refuses to redeem or
amend the rights plan.
On February 12, 2002, Camelot’s board met to consider its
position with respect to Empire’s latest offer. All directors attended.
After consulting with its investment bankers, the board elected to keep
the rights plan in place, based on the same concerns that were raised
at the January 17 meeting. The investment bankers delivered their
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opinion that $63 remained an inadequate price for the auction sale of
Camelot. In addition, the board reaffirmed its support for the merger
with Holy Grail.
Empire has sued the directors of Camelot, seeking injunctive
relief with regard to actions taken by the board of directors of Camelot
in response to Empire’s acquisition proposal. Empire alleges that
Camelot’s directors breached their fiduciary duties by pursuing the
merger with Holy Grail even though it offered Camelot’s stockholders
less value than the proposed acquisition by Empire, by refusing to
redeem or amend the stockholder rights plan, and by granting Holy
Grail contractual rights to a breakup fee.

You are a clerk to a Vice Chancellor of the Delaware chancery

court. The Vice Chancellor has asked you to write a bench
memorandum discussing the relevant issues raised by Empire’s suit.
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Essay #2
Section 141 of the Delaware General Corporation Law provides, in part, that the
business and affairs of a corporation “shall be managed by or under the direction of a
board of directors.” The Delaware supreme court has explained that this provision is the
bedrock principle of corporation law, which underlies such critical doctrines as the
business judgment rule: “Under Delaware law, the business judgment rule is the offspring
of the fundamental principle, codified in [Delaware General Corporation Law] § 141(a),
the business and affairs of a Delaware corporation are managed by or under its board of
directors.... The business judgment rule exists to protect and promote the full and free
exercise of the managerial power granted to Delaware directors.” Smith v. Van Gorkom,
488 A.2d 858, 872 (Del. 1985).
The director primacy theory of the firm reflects – and seeks to
explain – this board-centered approach to corporate governance. As a
positive theory of corporate governance, director primacy claims that
fiat — centralized decisionmaking — is the essential attribute of
efficient corporate governance. Hence, as a normative matter, the
central thesis of director primacy is that preservation of the board’s
power of fiat should always be the null hypothesis.
Curiously, however, Delaware § 141 further provides that:
The business and affairs of every corporation organized under this
chapter shall be managed by or under the direction of a board of
directors, except as may be otherwise provided in this chapter or in
its certificate of incorporation. If any such provision is made in the
certificate of incorporation, the powers and duties conferred or
imposed upon the board of directors by this chapter shall be
exercised or performed to such extent and by such person or
persons as shall be provided in the certificate of incorporation.
This provision allows, inter alia, shareholders to run the firm as though
it were a partnership, with decisionmaking being conducted by the
shareholders rather than by a board of directors.
1. When would it make economic sense, in terms of the theories
developed in this course, for shareholders to structure corporate
decisionmaking along partnership lines rather than on the basis
of traditional board of directors-based corporate governance?
2. How would a proponent of the director primacy theory explain
the freedom of shareholders to modify and/or reassign by means
of the articles of incorporation the powers of the board of
directors? In other words, can director primacy be reconciled –
again, using the full suite of economic theories developed in this
course – with the full text of § 141?
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Essay # 3
Southern Columbia Furniture Corporation (“SCFC”) is incorporated in the State
of Columbia. (In case you have not heard, Columbia is a newly created state. Columbia
has no case law relevant to the problem posed here. Relevant (and irrelevant) portions of
the Columbia Corporate Code are appended at the end of the exam.) SCFC has 1 million
shares of common stock outstanding, which are listed for trading on the New York Stock
Exchange and registered with the Securities and Exchange Commission (SEC) under
Section 12 of the Securities Exchange Act of 1934. John Doe owns 280,000 shares of
SCFC stock; no other person owns more than 3% of SCFC’s stock. Doe is chairman of
the board and CEO of SCFC. SCFC has 8 other directors, all of whom were nominated
by Doe; 2 of the other directors are employed by SCFC.
SCFC’s sole business is manufacturing high-quality, hand-crafted residential
furniture. SCFC’s sole manufacturing plant is located in a rural area of Columbia, in
which unemployment is over 25%. SCFC’s plant floor employees earn an average of
$34,000 per year, which makes them the highest-paid work force in their area.
For some years, SCFC’s directors have been aware that the company must make
significant changes in order to remain profitable. Two courses of action were considered:
(1) close the Columbia plant and relocate manufacturing operations to Mexico, where
labor costs will be much lower; or (2) modernize the Columbia plant with precision
equipment, which will significantly raise productivity without sacrificing quality.
Exercising reasonable care, the directors chose the second option.
Unfortunately, SCFC did not have sufficient internal funds to purchase the new
equipment. The board therefore instructed Doe to find external sources of funds. Doe
sought to borrow the money from numerous banks, but was consistently rejected because
of SCFC’s large existing debt burden. Doe then considered an offering of new SCFC debt
or equity securities, but every investment banker that he approached told Doe that such
an offering would not succeed. Doe reported his lack of success to the board, which
began to reconsider moving the operation to Mexico. The board was reluctant to take that
option, however, because of the directors’ sincere concern for their employees and the
community in which the plant was located.
About a week later, Doe received a phone call from James Hanks, the President of
Manning International, the U.S.’ leading manufacturer of high-quality office furniture.
Manning was seeking a strategic acquisition in the residential furniture market. After
discussing SCFC’s situation with Doe, Hanks assured Doe that Manning shared SCFC’s
corporate values. Hanks therefore proposed a solution: SCFC would merge into New
SCFC, a wholly-owned Manning subsidiary, with SCFC as the surviving entity; SCFC
shareholders would receive $25 in cash per share, a $8 premium over the prevailing
market price; Manning would purchase the new equipment SCFC needed. Doe and
Hanks negotiated at some length over two issues. First, Doe tried to get a better price for
SCFC’s shareholders, but Hanks refused to raise the price. Second, because Hanks
planned to close the plant temporarily until the new equipment was installed, Doe asked
Hanks to put SCFC’s employees on half-pay rather than laying them off, which Hanks
agreed to do.
Immediately after his meeting with Hanks, Doe called a SCFC board meeting.
Two days later, Doe presented Hanks’ proposal to SCFC’s board. At the outset, Doe
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stressed that he was strongly in favor of the idea. Indeed, as he told the board, Doe had
agreed to give Manning an option on the 280,000 SCFC shares Doe owned. If anyone
other than Manning announced an intention to acquire control of SCFC, Doe would sell
his shares to Manning at $25 per share. Doe informed the board that Manning was also
requesting that SCFC give Manning an option to purchase 500,000 authorized but
unissued SCFC shares.
All of SCFC’s directors participated in the decision. The board was briefed on the
relevant issues by its financial, legal, and other advisors. SCFC’s investment banker
warned the board that $25 was “within the range of fair value, but its at the very bottom.”
After being questioned by one of the directors, the investment banker conceded that
Manning probably could not afford to raise the price given the amount of money it would
have to invest in new plant equipment. The investment banker concluded by repeating
advice he had been giving for months: “the best thing you can do for your shareholders is
to move the plant to Mexico.” Doe responded: “maybe so, but Manning is the best thing
for everyone concerned.” After three hours of deliberation, the board approved both the
merger agreement with Manning and the stock option Manning had requested.
The merger agreement between SCFC and Manning included the following
provisions:
Section 6.1 Conduct of Business by Pending the Merger. Except as
otherwise contemplated hereby, after the date hereof and prior to the effective
time or earlier termination of this Agreement, unless Manning shall otherwise
agree in writing, SCFC shall: ...
(f) not initiate, solicit, or encourage, and use their respective best efforts to
cause any officer, director or employee of, or any investment banker, attorney,
accountant or other agent retained by SCFC not to initiate, solicit or encourage,
any proposal or offer to acquire all or any substantial part of the business and
properties or capital stock of SCFC, whether by merger, purchase of assets, tender
offer or otherwise; provided, however, that SCFC may furnish information
concerning its business, properties or assets to a corporation, partnership, person
or other entity or group which has made a bona fide offer to SCFC to acquire
SCFC and, following receipt of such an offer, may negotiate and take any of the
actions otherwise prohibited by this Section 6.1(f) with respect to such entity or
group if counsel to SCFC advises the Board of Directors of SCFC that the failure
to furnish such information or negotiate with such entity or group might subject
SCFC’s directors to liability for breach of their fiduciary duties; in the event
SCFC shall receive an offer of the type referred to in this subsection (f) it shall
promptly inform Manning as to any such offer....
Section 7.3 Stockholders’ Approval. (a) SCFC shall promptly call a
meeting of its stockholders for the purpose of voting upon this Agreement and the
transactions contemplated hereby and, subject to the fiduciary duties of the Board
of Directors of SCFC under applicable law, shall use its best efforts to obtain
stockholder approval and adoption (the “Company Stockholders’ Approval”) of
this Agreement and the transactions contemplated hereby. Such meeting shall be
held as soon as practicable following the date of this Agreement. Subject to the
fiduciary duties of the Board of Directors of SCFC under applicable law, SCFC
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will, through its Board of Directors, recommend to its stockholders approval of

the transactions contemplated by this Agreement.
Section 9.1 Termination. This Agreement may be terminated at any time
prior to the effective time, whether before or after approval by the stockholders of
SCFC or Manning: (a) by mutual consent of Manning and SCFC; or (b) by either
Manning or SCFC if (i) the Merger shall not have been consummated on or before
June 15, 1993, (ii) the requisite vote of the shareholders of either Manning or
SCFC to approve this Agreement and the transactions contemplated hereby shall
not be obtained at the meetings, or any adjournments thereof, called therefor, or
(iii) any court of competent jurisdiction in the United States or any State shall
have issued an order, judgment or decree (other than a temporary restraining
order) restraining, enjoining or otherwise prohibiting the Merger and such order,
judgment or decree shall have become final and nonappealable; provided that the
right to terminate this Agreement under this Section 9.1(b) shall not be available
to any party whose failure to fulfill any obligation under this Agreement has been
the cause of, or resulted in, the failure of the effective time to occur on or before
such date.
The stock option between SCFC and Manning included the following provision:
Section 3.9 Termination. This Agreement shall terminate upon termination
of the Merger Agreement in accordance with the provisions thereof, provided,
however, that this Agreement shall not terminate if the Merger Agreement is
terminated because of a willful breach by SCFC of any representation, warranty,
or covenant contained therein or because of failure of SCFC’s shareholders to
approve the Merger Agreement by the requisite vote under applicable law.
Doe’s personal stock option agreement with Manning contains no termination provision.
Two weeks before the SCFC shareholder meeting scheduled to vote on the merger
with Manning, Alliron Furniture Corporation made a tender offer for SCFC. The tender
offer was priced at $35 per share of SCFC stock; with the per-share consideration being
described as $20 in cash and 2 shares of pay-in-kind preferred stock that Alliron’s
investment banker valued at $15. The offer was conditioned on termination of the merger
agreement and stock option between SCFC and Manning.
An emergency SCFC board meeting was called to discuss Alliron’s proposal. At
that meeting, SCFC’s own investment banker stated: “the pay-in-kind preferred is
probably worth somewhere between $9 and $11 per share. Let’s assume that the tender
offer is therefore really worth, say, $30. If so, Alliron’s bid is near, but not quite at, the
top of the range of fair value. The only way Alliron can afford to make this deal work at
that price is if they move the plant to Mexico, which my sources tell me is what they plan
to do.”
1. You are SCFC’s outside counsel. At the board meeting, Doe asks you the
following question: “If we want to, can SCFC get out of its agreements with Manning?”
2. As the board meeting progressed, SCFC’s independent directors became
increasingly uncomfortable with Doe’s presence in the meeting. After all of SCFC’s
advisers and officers had finished their reports, one of the independent directors
suggested that Doe and the 2 other inside directors recuse themselves. You said: “That’s
probably a good idea.” (Why did you say that? Were you right?) Doe stated: “Fair
 13

enough. I won’t participate as a director. But I want all of you to know that in my
capacity as a shareholder I will never agree to the Alliron deal and will do everything I
can do to make sure that Manning wins.” After several hours of deliberation, SCFC’s
independent directors voted 4-2 to reject Alliron’s proposal and go forward with the
Manning merger. Those voting for the Manning merger articulated three reasons for
doing so: (1) Doe’s opposition would make it hard for Alliron to win; (2) Manning’s offer
was within the range of fair value; and (3) Alliron’s offer would be detrimental to SCFC’s
employees. Alliron thereupon filed a lawsuit in the Columbia Chancery Court seeking a
judicial declaration that the merger and stock option agreements between SCFC and
Manning were invalid. Alliron filed a separate lawsuit in the Columbia Chancery Court
seeking a judicial declaration that the stock option agreement between Doe and Manning
was invalid. In your capacity as SCFC’s outside lawyer, SCFC’s board has asked you to
file a motion seeking to have both lawsuits dismissed. Write the brief in support of the
motion.
 14

Essay # 4

All questions in this part relate to the following facts: As our story begins, East
Publishing Co., Inc. (“East Co.”) is incorporated in the state of Delaware. As its common
stock is listed on the New York Stock Exchange, East Co. is registered with the Securities
and Exchange Commission (“SEC”) under Section 12(a) of the Securities Exchange Act
of 1934, as amended (“Exchange Act”). East Co.’s principal place of business is located
just outside Charlottesville, Virginia.
East Co. presently has about 50 million shares outstanding. About 40% of the
outstanding shares are owned by institutional investors, mainly bank trust departments
and pension and mutual funds. East Co.’s board of directors has 12 members, four of
whom are senior executive officers of the corporation. In aggregate, the board owns about
6% of the outstanding shares -- the bulk of which is held by the four insiders.
East Co.’s principal line of business traditionally has been the publishing of law
school texts, practitioner handbooks and case reporters. East Co. has fairly modern
production facilities, a loyal and productive work force and a strong reputation in the
legal publishing market.
For many years, East Co. experienced impressive growth in earnings. When its
earnings reached $4 per share in 1985, the stock price hit an all-time high of $80 per
share. In 1986, however, East Co. adopted a long-term strategic plan designed to
significantly diversify East Co.’s business. East Co.’s board of directors believes that the
traditional law school publishing business faces many challenges from new educational
technologies. In particular, the board focused on the following potential problems and
opportunities: (1) the market for law school study aids has increased dramatically, but
East Co. publishes virtually no study aids; (2) many lawyers want a variety of legal texts
to be made available on computer data bases, but East Co. has no experience with
marketing computer software and services; and (3) many states now require extensive
continuing legal education, but East Co. does little if any publishing directed at that
market. The board determined that East Co. should attempt to expand its business to
include each of these three areas. Since each area requires considerable expertise, East
Co. determined that the simplest and most cost-effective means of entering these new
businesses would be to acquire existing firms already competing in the relevant markets.
In a 1987 leveraged buyout, East Co. acquired Filbert Law Outline, Inc.
(“Filbert”), the leading producer of law school study aids. In a 1989 triangular merger,
East Co. acquired Home Legal Education Satellite Network, Inc. (“Network”), the
second-largest producer of continuing legal education programs and materials. East Co. is
continuing to search for an appropriate acquisition candidate in the computer data base
field.
Unfortunately, since the strategic plan was put into place, earnings have tailed off
and the firm’s stock market price declined steadily to a present price of around $25 per
share. East Co.’s management attributes the decline to temporary factors, especially the
generally adverse economic conditions and the need to service debts incurred in acquiring
Filberts and Network. Management firmly believes that earnings will again rise when the
strategic plan is completed.
 15

A. While East Co.’s directors and senior officers believe that their long-term
strategic plan will produce great results for East Co.’s shareholders in the none too distant
future, they are beginning to fear that they may not have time to complete the strategic
plan. Several friendly brokers have alerted East Co.’s Chief Executive Officer of rumors
about an possible hostile takeover bid. The trading volume of East Co.’s common stock
has inexplicably increased substantially in recent days, a suspicious occurrence which
lends some credence to the rumor. Worse yet, the investment banking firm of Dewey,
Cheatham & Howe (“Dewey”) is rumored to be touting East Co. as a prime takeover
candidate. Dewey supposedly believes that East Co. is a prime candidate for a “bust up”
takeover, in which the bidder makes a highly leveraged offer and sells off unprofitable
divisions after taking control. Dewey also supposedly believes that Filbert and Network
are prime candidates for divestiture.
You have just come from a meeting with senior East Co. management and
representatives of East Co.’s investment banking firm. Both management and the
investment bankers are confident that East Co.’s strategic plan will produce long run
gains for East Co.’s shareholders that will outweigh any possible short-term gain from a
hostile takeover. At the conclusion of the meeting, East Co.’s CEO instructed you to
develop a defensive strategy that will ensure that East Co. has sufficient time to complete
its strategic plan. The basic goal is to deter any hostile takeover bid from being made
during the next two to three years. A secondary goal is to create delaying hurdles so that
if a hostile bid is made the bid will be slowed sufficiently to allow East Co.’s managers to
assess and implement alternative options.
You are East Co.’s chief outside counsel. The CEO has asked you to brief him on
the following points:
1. What defensive strategy is likely to achieve the best outcome for the
corporation and its shareholders?
2. What legal hurdles will your chosen strategy face if a hostile bidder or
some other shareholder challenges the validity of your proposed course of action? Be
sure to discuss the extent to which your defensive strategy is vulnerable to legal
challenge. How could you make it less vulnerable?
3. As East Co’s lawyer, do you have any ethical qualms about undertaking
this assignment (either in terms of your own personal ethics or in terms of your
professional responsibility as a member of the bar)?
B. The defensive strategy you designed for East Co. seems to have worked (at
least for the moment), as no hostile takeover bid has emerged in the six months since it
was announced. So everyone’s attention has returned to implementing East Co.’s long-
term strategic plan.
Grant Data Systems, Inc. (“Systems”), is a computer data base and software
company. East Co.’s CEO believes Systems is a prime candidate for acquisition by East
Co. Systems produces precisely the sort of products East Co. needs in order to enter the
legal computer software and data base business. Upon learning of this opportunity, East
Co.’s board eagerly directed East Co.’s CEO to meet with Systems’ CEO for preliminary
negotiations.
The structuring of the offer is a matter of some delicacy. East Co.’s management
is very concerned with the possibility of a shareholder rebellion against the long-term
 16

strategic plan. Accordingly, it is deemed essential to avoid any requirement that East
Co.’s shareholders approve the Systems acquisition. (FYI: East Co. has 25 million
authorized but unissued shares). Second, as a result of the generally adverse economic
conditions and the costs incurred by virtue of East Co.’s prior acquisitions, East Co. has
virtually no cash reserves. East Co.’s lenders are also unwilling to extend significant new
credit. Accordingly, East Co. cannot use significant amounts of cash in the acquisition. In
light of these constraints, East Co.’s CEO approached Systems with an initial offer,
pursuant to which East Co. would acquire Systems in return for a package of East Co.
debt and equity securities valued as the equivalent of $500 for each System share.
Systems’ CEO is also its sole stockholder. She is willing to at least consider East
Co.’s offer and is sufficiently interested to have authorized her lawyers to meet with East
Co.’s lawyers. At the same time, however, Systems’ CEO is very skeptical of East Co.’s
so-called long-term strategic plan. She is not sure it will work; worse, she is very
concerned that it is making East Co. a logical target for a bust-up takeover. Any
acquisition therefore must be structured so as to permit her to get Systems back in the
event of a bust-up takeover of East Co. Accordingly, she would prefer an acquisition
technique that would leave Systems as an intact company (i.e., a wholly or partially
owned subsidiary of East Co).
1. Assume that System’s CEO agrees to the proposed acquisition. From East
Co’s perspective, what form of acquisition best accomplishes their purposes at the lowest
possible cost? From System’s perspective, what form of acquisition best accomplishes its
purposes with the greatest possible benefit? For purposes of this problem, you may ignore
tax and accounting issues. You also need not consider valuation or pricing issues.
2. Assume that East Co and Systems have decided to structure the
acquisition as a triangular merger. East Co will create a new, wholly-owned subsidiary
named “NewCo,” which will be capitalized with the East Co debt and equity securities to
be used as consideration in the merger. NewCo will be incorporated in Delaware.
Systems and NewCo will then merge, with NewCo as the surviving entity. A disgruntled
institutional shareholder learns of the proposed acquisition structure. Said shareholder
argues that it is entitled to voting and appraisal rights in connection with the proposed
merger. Is it correct?
3. Assume for purposes of this question only, that Systems’ CEO is not the
only shareholder of Systems. Rather, her ex-husband received 15% of Systems’ shares as
part of their divorce settlement. Systems’ CEO wishes to make sure that her ex-husband
gets nothing out of the proposed acquisition. Accordingly, she suggests to East Co that
the transaction be structured as a sale of her Systems’ stock to East Co at a substantial
premium. This will leave East Co as a majority shareholder of Systems, with the ex-
husband retaining his minority stake of 15 percent. What, if any, would be legal
consequences of putting this plan into effect?
a. Assume that the acquisition is structured as a sale of stock by Systems’
CEO to East Co. What are the likely business consequences to East Co of the ex-
husband’s position as a minority stockholder of Systems?
b. Assume that East Co wishes to eliminate the ex-husband as a shareholder
of Systems. How might such a goal be accomplished? What, if any, would be the legal
consequences of doing so?
 17

C. The consummate skill of East Co.’s and Systems’ counsel and financial
advisors has produced a tentative agreement to a triangular merger at a price to be
determined later. As is common in acquisitions these days, East Co.’s board wants to play
a very active role in the process. As is also common, they have asked their legal counsel
to brief them on their fiduciary duties in connection with the decisionmaking process.
1. You are East Co.’s chief outside legal counsel. What are the board’s
fiduciary duties in connection with the proposed transaction. Pay particular attention to
clearly defining the process and procedures by which the board should conduct its
deliberations. What steps should the board take to minimize their liability exposure in
connection with making the decision to merge with Systems?
2. Assume for purposes of this question only that both East Co and Systems
are publicly-held corporations subject to the federal Securities Exchange Act of 1934. At
what point in the negotiating process must they disclose the fact that negotiations are
underway?
D. East Co.’s board has tentatively approved the proposed merger and the parties
have now turned to drafting the acquisition agreement. Counsel for Systems has proposed
that the following provisions for inclusion in the draft merger agreement:
Section 7.1: Best Efforts. Subject to the terms and conditions provided
herein, each of the parties agrees to use its best efforts to take, or cause to be
taken, all action and to do, or to cause to be done, all things necessary, proper or
advisable under applicable law and regulation to consummate and make effective
the Mergers in accordance with the terms of this Agreement and Plan of
Reorganization, subject, however, to the vote of shareholders of each party. In
case at any time after the Merger Date any further action is necessary or desirable
to carry out the purposes of this Agreement or the Merger Agreements, the proper
officers or directors of the parties shall take all such actions.
The board of directors of each party hereby further agree that they shall
recommend to their respective stockholders that the stockholders vote to adopt
and approve the Merger and shall use their best efforts to solicit from their
stockholders proxies in favor of adoption and approval and take all other action
necessary or helpful to secure a vote of stockholders in favor of the Merger.
Section 7.2: Negotiations with Other Parties. Each of the parties agree that
they and their affiliates will not, directly or indirectly, solicit, initiate or encourage
submission of proposals or offers from any person relating to the acquisition or
purchase of all or a portion of the assets of, or an equity interest in, said party.
Further, the parties shall not participate in any negotiations regarding, or furnish
to any other person any information with respect to, or otherwise cooperate in any
way with, or assist or participate in, facilitate or encourage, any effort or attempt
to do or seek to acquire a substantial part of the assets or equity of said party.
Section 7.3: Cancellation fees. East Co. hereby agrees to pay to Systems
the sum of $25 million in the event that the Merger is not consummated by
December 31, 1991 or in the event that any other party acquires more than 25
percent of the outstanding voting shares of East Co.
Counsel for Systems has also proposed that the parties enter into a Share Exchange
agreement separate from the merger agreement. The proposed Share Exchange
 18

Agreement provides that each party to the merger shall have an option to trigger an
Exchange of shares. In the event either party triggers the Exchange, East Co. shall
transfer 5,000,000 authorized but unissued shares of East Co. common stock to Systems.
In return, Systems shall transfer 500,000 authorized but unissued shares of System
common stock to East Co. (The parties’ financial advisors have determined and opined
that this 10 to one ratio represents fair and adequate consideration to support the
contract.) The option becomes exercisable if a third party acquires more than 25 percent
of the outstanding voting shares of East Co. at any time prior to the closing of the Merger.
1. Assume for purposes of this question that you are East Co’s chief outside
counsel. The East Co. board of directors is basically in favor of Systems’ proposals. One
board member was heard to exclaim: “Dang! This should put a crimp in old Dewey’s
nether regions, eh? ... Oops, I guess I shouldn’t have said that, should I have?” As our
friend’s “oops” suggests, the board is very concerned that they comply fully with their
fiduciary obligations to East Co.’s shareholders. At the same time, they are also very
concerned with completing the acquisition of Systems as the final link in the strategic
plan. In addition to these general concerns, East Co.’s board has a few specific concerns.
The board has therefore asked you to consider a couple of specific issues:
a. First, is it necessary for the Share Exchange to involve a mutual exchange
of shares? Why can’t Systems simply give East Co. an option to buy Systems shares?
b. Second, would it be a good idea to propose a so-called “fiduciary duty
out” proviso in each of the proposed provisions (i.e., Sections 7.1 to 7.3 and the share
exchange agreement)? Such a proviso might, for example, read as follows: “nothing in
this section shall relieve either Board of Directors of their continuing duties to their
respective shareholders.”
2. Assume for purposes of this question that you are Systems’ chief outside
counsel. Systems’ CEO has asked why your proposed Sections 7.1 and 7.2 apply to her.
Do these provisions preclude her from negotiating with other offerors? If so, why did you
include them? (The honest answer is that you pulled them from your standard form
contract without stopping to think about it.) Do these provisions make sense for your
client from either a business or legal perspective?
E. Dick Borash is a Boston-based investor who is trying to make a name for
himself as a major player in the takeover game. Borash has identified East Co. as a
vulnerable but desirable takeover candidate. If he succeeds in acquiring East Co., Borash
plans to terminate management’s long-term strategic plan. He also expects to sell Filbert
and Network, using the proceeds of those sales to help finance the acquisition debts he
plans for East Co. to assume. In light of his plans to divest Filbert and Network, Borash
would also like to complete any acquisition of East Co. before it merges with Systems.
Borash has taken a few preliminary steps in his plan to acquire East Co. First, he
purchased about 250,000 shares of East Co. stock on the open market.
Second, Borash met with two friends of his: John Jessup and Ted Lamont. Jessup
is a mutual fund manager whose Pilgrim Fund owns about 400,000 East Co. shares.
Lamont is a bank trust officer whose trust account portfolios contain a total of 450,000
East Co. shares. Jessup and Lamont are equally dissatisfied with East Co.’s current
management and commended Borash for his interest. However, because of their positions
as fiduciaries, they believe that they should not directly participate in a control contest for
 19

East Co. They did, however, give Borash the names of several other large East Co.
stockholders he could approach.
Third, Borash met with five of the stockholders whose names Jessup and Lamont
suggested. All five agreed to assist Borash and to serve as directors of East Co. if the
takeover bid is successful. The following table describes each of the five shareholders
and sets forth their current East Co. stockholdings:
James Aranow, an individual 200,000 shares
Jack Einhorn, an individual 100,000 shares
Clark Berlstein, an individual 150,000 shares
Polybid Inc., a Delaware corporation 600,000 shares
Techa S.A., a Panamanian corporation 450,000 shares
With respect to Polybid, Borash actually met with Howard Leslie, its CEO and Chairman.
Polybid is a public corporation, listed on NASDAQ, whose shares are held widely. No
one person or entity owns more than 5 percent of Polybid’s shares. Polybid’s board of
directors has approved Leslie’s decision to cooperate with Borash.
With respect to Techa, Borash actually met with Vincent Tito, Techa’s Chairman.
Tito is a Swiss investor with many interests. Seventy-five percent of Techa’s shares are
owned by Vincenio S.A., a Swiss corporation. The other twenty-five percent is owned by
a number of investors, no one of whom owns more than 5 percent of Techa’s shares.
Fifty-one percent of Vincenio’s outstanding shares are owned by Tito Investments S.A., a
Swiss corporation, which in turn is wholly owned by Tito. The remaining forty-nine
percent of Vincenio’s shares are owned by a number of investors, no one of whom owns
more than 5 percent of its shares. Tito is CEO and Chairman of both Vincenio and Tito
Investments. Not surprisingly, the boards of directors of all the relevant companies have
approved Techa’s decision to cooperate with Borash.
Borash is considering two courses of action, which he calls Option A and Option
B. Option A would involve a cash tender offer at $55 per share for all of East Co.’s
outstanding shares not already owned by Borash or one of his five colleagues. A possible
alternative, which Borash calls Option A-1, would involve making such a cash tender
offer but then withdrawing the offer and buying large blocks of stock from institutional
investors and arbitragers.
Option B would involve a series of open market purchases in which Borash and
his colleagues would attempt to buy at least 51 percent of East Co.’s shares without
making a formal tender offer.
Borash has asked that you serve as his legal counsel and that you brief him on the
following issues:
1. Borash and his colleagues would like to continue to purchase stock on the
open market. When must such purchases be disclosed on Schedule 13D?
2. Assuming that Borash must now, or soon will have to, file a Schedule 13D
statement, what must be disclosed in Items 2, 4, and 6 of the Statement?
3. To what extent, if any, would Option B be subject to the tender offer rules
under Securities Exchange Act Sections 14(d) and 14(e)?
 20

4. Assume for purposes of this question only that Borash approached yet
another East Co shareholder, named Susan Sheridan. Ms. Sheridan was not interested in
actively participating in Borash’s acquisition effort, but agreed to tender her shares to
Borash if he made a tender offer. She also asked Borash to keep her informed of
developments. Borash agreed to do so. What, if any, are the legal consequences of their
agreement?
F. Borash initially decided to make a series of open market purchases in which
Borash and his colleagues would attempt to buy at least 51 percent of East Co.’s shares (a
plan he still refers to Option B) as the best way to structure the transaction, but is keeping
an open mind as to the transaction’s final structure and may change his mind at a later
date if events warrant. Item 4 of his initial Schedule 13D, which statement was timely
filed and amended as needed, stated:
Item 4. Purpose of Transaction. The parties have determined to make a
large equity investment in the issuer. From time to time, as market conditions
warrant in the view of the parties, the parties may purchase or sell shares of the
issuers common stock on the open market.
Shortly before filing his initial schedule 13D, Borash entered into a brokerage contract
with Lloyd Milkman & Co. (“Milkman”), the well known brokerage firm specializing in
takeover stocks. The contract provides that (1) Milkman will purchase up to 4.9% of East
Co.’s outstanding common stock; (2) Borash will reimburse Milkman for any losses
suffered by Milkman in connection with those acquisitions; and (3) Milkman will pay
over to Borash any profits realized in connection with those acquisitions, less its usual
brokerage fee plus an additional 5%, including any profits realized by tendering or
otherwise selling the shares to Borash. This agreement has not been disclosed in any of
Borash’s filings.
Borash ultimately changes his mind and, pursuant to SEC Rule 14d-2(d)
announces that he will make a statutory cash tender offer at $40 per share for any and all
of East Co.’s outstanding shares of common stock in the near future. Shortly thereafter
Borash in fact commences such a tender offer, but his Schedule 14D-1 fails to disclose
that he plans to withdraw the offer before taking down any tendered shares and thereafter
obtain control by purchasing large blocks of stock from institutional investors and
arbitragers.
1. You are East Co.’s chief outside legal counsel. Your crack private
investigator has turned up all of the foregoing facts. East Co.’s CEO has instructed you to
bring suit against Borash and his associates for violations of the Williams Act. In large
part, the CEO is motivated by a desire to delay Borash long enough for East Co. to
explore its options and take other defensive measures. To the same end, East Co.’s CEO
also urges you to “drag your feet” in conducting the litigation. Discuss the following
issues: (1) will you bring the lawsuit; (2) if so, on what grounds; and (3) will you “drag
your feet” during the litigation?
2. Borash asks the East Co board to terminate the proposed Systems
acquisition and to redeem East Co’s poison pill. East Co’s board refuses to take either
step. Borash brings suit, alleging that their decision violates their fiduciary duties. What
result?
 21

3. After completing this block of material, go back and review Discussion

Problem 4. What effect, if any, do the cases discussed in this part of the course have on
your analysis of that problem?
G. For purposes of this Problem, you should assume that the merger agreement
between East Co. and Systems included all three clauses as proposed by Systems’ counsel
in Discussion Problem D. In addition, you should also assume that East Co. and Systems
separately entered into the Share Exchange Agreement as proposed by Systems’ counsel
in Discussion Problem D.
Two days after Borash commenced his tender offer for East Co., East Co.’s
management announced that (1) Systems had triggered the Share Exchange option
described in Discussion Problem 4; (2) East Co. had filed a lawsuit in the United States
District Court for the District of Delaware against Borash and his associates alleging
numerous violations of the Williams Act. Under the circumstances, Borash’s associates
believe that the group should withdraw its tender offer for East Co. and terminate the
takeover effort. They authorize Borash, however, to make one last effort at rescuing
something from the wreckage of their plans.
As of the date in question, East Co.’s common stock is trading at a price of $50
per share. Borash and the other members of his group own about 5.5 million shares of
East Co. common stock.
Borash proposes the following transaction: Borash and his group will exchange
their 5.5 million East Co. shares for 550,000 authorized but unissued shares of Systems
common stock. As a result of this transaction, Systems will own a total of 10.5 million
shares of East Co. common stock (5 million from the Share Exchange and 5.5 million
from the exchange with Borash et al). East Co. will thereupon purchase all 10.5 million
shares from Systems at whatever price those two companies agree upon. Systems and
East Co. will thereafter merge as planned, with each Systems shareholder receiving $525
in cash per share of Systems stock. If East Co. agrees to go along with this plan and also
to dismiss the pending litigation, Borash and his associates will agree to vote their newly
acquired Systems shares in favor of the merger and will further agree not to seek to
acquire control, directly or indirectly, of East Co. for a period of 10 years.
You are Borash’s chief legal counsel. He has asked you to tell him whether there
are any legal impediments to going forward with the transaction as proposed.
 22

CORPORATE FINANCE
Review Questions

© 1999 Stephen M. Bainbridge

Although the exam will be in an objective format, you may find these old essay
exam questions useful as a review. Please do not ask me for answers to these questions—
I do not have them.

I.
Corporation is considering purchasing a new piece of capital equipment. The
initial puchase cost of the equipment will be five hundred thousand dollars ($500,000).
The equipment has a five year useful life, at the end of which time it will be sold for
scrap value (estimated to be $50,000). The equipment will generate three hundred and
fifty thousand dollars ($350,000) in revenues the first year of operation. Revenues will
decline by five percent (5%) each year therafter. Operating expenses will be $100,000
during the first year of operation. Operating expenses will increase by four percent (4%)
each year thereafter. Assuming a discount rate of 10 percent, should the company
undertake this project? For ease of calculation, you may assume that all annual profits
accrue and that all annual operating expenses are incurred at the end of the operating
year. Show your calculations. Round decimals to two places and show only whole dollar
amounts. (Some of you may be familiar with the internal rate of return methodology. Do
not use that method to answer this problem.)

II.
Judge Ralph Winter has described the business judgment rule as follows:

"While it is often stated that corporate directors and officers will be liable for
negligence in carrying out their corporate duties, all seem agreed that such a
statement is misleading. ... [T]he fact is that liability is rarely imposed upon
corporate directors or officers simply for bad judgment and this reluctance to
impose liability for unsuccessful business decisions has been doctrinally labelled
the business judgment rule. Although the rule has suffered under academic
criticism, it is not without rational basis. ...

"Whatever its merit, however, the business judgment rule extends only as far as
the reasons which justify its existence. Thus, it does not apply in cases, e.g., in
which the corporate decision lacks a business purpose, is tainted by a conflict of
interest, is so egregious as to amount to a no-win decision, or results from an
obvious and prolonged failure to exercise oversight or supervision."

Judge Winter went on to describe the policies underlying the business judgment rule as
follows:
 23

"[S]hareholders to a very real degree voluntarily undertake the risk of bad

business judgment. Investors need not buy stock, for investment markets offer an
array of opportunities less vulnerable to mistakes in judgment by corporate
officers. Nor need investors buy stock in particular corporations. In the exercise
of what is genuinely a free choice, the quality of a firm's management is often
decisive and information is available from professional advisors. Since
shareholders can and do select among investments partly on the basis of
management, the business judgment rule merely recognizes a certain
voluntariness in undertaking the risk of bad business decisions. ...

"[B]ecause potential profit often corresponds to the potential risk, it is very much
in the interest of shareholders that the law not create incentives for overly
cautious corporate decisions. Some opportunities offer great profits at the risk of
very substantial losses, while the alternatives offer less risk of loss but also less
potential profit. Shareholders can reduce the volatility of risk by diversifying
their holdings. In the case of the diversified shareholder, the seemingly more
risky alternatives may well be the best choice since great losses in some stocks
will over time be offset by even greater gains in other. Given mutual funds and
similar forms of diversified investment, courts need not bend over backwards to
give special protection to shareholders who refuse to reduce the volatility of risk
by not diversifying. A rule which penalizes the choice of seemingly riskier
alternatives thus may not be in the interest of shareholders generally."

Judge Winter's argument implicitly rests on one of the economic theories we studied in
this course. Which theory is Judge Winter using? Assuming that theory to be valid, does
his application of this theory in fact explain the business judgment rule as he has
described the rule? Explain. (You need not offer an alternative explanation for the
business judgment rule.)

III.
In answering all the questions in this Part, make the following assumptions: (i)
zero transaction costs; (ii) investors have perfect information about Leverco's expected
cash flows; (iii) the proposed transactions will not affect Leverco's future investment
decisions; (iv) the interest rate on Treasury securities is 6% per year, and the interest rate
on Leverco's debt is 7% per year; (v) prior to the recapitalization, Leverco was expected
to earn $5.00 per share for 1994; (vi) Leverco stock and debt trade in an efficient market;
(vii) Leverco's debt can be called at its face value; (viii) no taxes; and (ix) investors
behave rationally.
1. Leverco is currently financed with debt with a face value and market value of
$50,000,000, and 1,000,000 shares of common stock, with a total market value of
$50,000,000 ($50 per share). Leverco announces that it plans to recapitalize as of
January 1, 1994, by issuing common stock, and using the proceeds to retire all of its
outstanding debt. What effect will the recapitalization transaction have on the market
value of Leverco's outstanding common stock?
 24

2. After reviewing your answer to the preceding question, Leverco decided that
the recapitalization transaction would not provide a sufficient increase in firm value to
justify undertaking it. Instead, Leverco decides to increase its annual dividend from 50
cents/share to one dollar per share. What effect will this decision have on the market
value of Leverco's common stock?
3. Assuming for purposes of this question only that the increased dividend will
increase the market value of Leverco's common stock, when will Leverco's stock price
change to reflect the recapitalization?

IV.
All of the sub-parts of Question V relate to the following set of facts: XYZ
Corporation was incorporated in the state of Delaware on December 11, 1981. At its
inception, 1,000 shares of common stock were issued. Each share of common stock has a
par value of one dollar ($1.00). Each share of stock was issued in return for cash
consideration in the amount of twenty dollars ($20.00) per share. There have been no
subsequent stock issuances. XYZ is able to pay its debts as they come due in the
ordinary course of business.
XYZ's net profit for fiscal year 1992 was seven thousand dollars ($7,000.00).
XYZ's net profit for fiscal year 1993 was three thousand dollars ($3,000.00). As of
December 31, 1993, XYZ's balance sheet reads as follows (assume that the asset figures
represent both the historical cost and the present fair market value of all assets and
liabilities if liquidated):

ASSETS LIABILITIES AND SHAREHOLDERS' EQUITY

Cash .......... $ 6,250 Accounts payable ........ $ 10,500

Accounts
receivable .... $ 4,000 Bank Loans Outstanding .. $ 35,500

Inventory ..... $ 17,250 Total Liabilities .. $ 46,000

Store/Land ... $ 35,500 Capital ................. $ 1,000

Total Assets .. $ 63,000 Surplus ................. $ ?

Total Shareholders'
Equity .................. $ ?

1. As of December 31, 1993, the amount of surplus which should be recorded on

XYZ's balance sheet is?
 25

2. What is the maximum dividend XYZ can pay from all sources for fiscal year
1993? (Explain briefly, but be sure to give a dollar amount).
3. Assume for purposes of this question only that XYZ was incorporated in a
state which has adopted the Revised Model Business Corporation Act. What is the
maximum dividend XYZ can pay for fiscal year 1993 under those facts? (Explain
briefly, but be sure to give a dollar amount)?
4. For purposes of this question, go back to the original statement of facts; i.e.,
assume that XYZ was incorporated in Delaware. Assume that XYZ paid no dividends
from any source for fiscal year 1993. On January 10, 1994, XYZ sold an additional
1,000 shares of common stock (par value: $1.00) to Sue Shareholder. Shareholder paid
$10 per share in cash. If the board fails to specify what portion of the consideration is to
be allocated to capital, what effect will this transaction have on XYZ's balance sheet?

V.
ABC Corp. is a Delaware corporation. All of ABC's outstanding debt and equity
securities are registered with the SEC under the Securities Exchange Act of 1934 and
were issued in public transactions registered with the SEC under the Securities Act of
1933. All of ABC's outstanding equity and debt securities are traded on the New York
Stock Exchange.
ABC has 1 million convertible debentures outstanding. The debentures have a
face value of $1,000 and an annual coupon rate of 8%. The trust indenture covering these
debentures contains the following provisions:
Section 4.3 Reorganizations. If any capital reorganization or
reclassification of the capital stock of the Company, or consolidation or merger of
the Company into another corporation, or the sale of all or substantially all of its
assets to another corporation, shall be effected in such a way that holders of
Common Stock shall be entitled to receive stock, securities or assets with respect
to or in exchange for Common Stock, then, as a condition of such reorganization,
reclassification, consolidation, merger or sale, the Company or such successor or
purchasing corporation, as the case may be, shall execute with the Trustee a
supplemental indenture providing that the Holder of each Debenture than
Outstanding shall have the right thereafter and until the expiration of the period of
convertibility to convert such Debenture into the kind and amount of stock,
securities or assets receivable upon such reorganization, reclassification,
consolidation, merger or sale by a holder of the number of shares of Common
Stock into which such Debenture might have been converted immediately prior to
such reorganization, reclassification, consolidation, merger or sale.
Section 5.1 Call. The Company shall have the right to call any or all of
the debentures, pursuant to the following provisions: (a) The Company shall
have the right, at its sole option, and election, to call the debentures, at any time
and from time to time at a call price of $1,050 per debenture plus an amount equal
to all accrued, but unpaid interest thereon;
(b) If less than all of the debentures at the time outstanding is to be called,
the debentures so to be called shall be selected by lot, pro-rata or in such other
manner as the Board of Directors may determine to be fair and proper.
 26

6.1 Conversion (a) Each debenture may, at the option of the holder
thereof, be converted at any time or from time to time into fully paid and
nonassessable shares of common stock at the rate of $40.00 of face value of such
debenture for each share of common stock, upon surrender to the Company of the
certificate or certificates representing such debenture so to be converted, duly
assigned in blank for transfer. As used herein, the term "Conversion Value" shall
mean and refer to the price of each share of common stock into which the
debenture may be converted, as adjusted from time to time in accordance with this
section. ...
(c) If at any time, or from time to time, the Company shall change, as a
whole, any class of stock into which the debentures are then convertible, into the
same or a different number of shares, with or without par value, of the same or of
any other class or classes (hereinafter in this paragraph called "New Stock") any
holder of the debentures, upon conversion thereof, shall be entitled to receive, in
lieu of the stock which (on conversion immediately prior to such change) he
would have become entitled to receive, but for such change, a number of shares of
New Stock equivalent to the number that would have been issued for such shares
of stock as he would have been entitled to receive on conversion immediately
prior to such change. The Conversion Value then in effect shall thereupon remain
unchanged or shall be proportionately increased or decreased, as the case may be,
in the ratio which the number of shares of stock so changed shall bear to the
number of shares of New Stock.
No adjustments have ever been required with respect to the Conversion Value of the
debentures.
In June 1993, the value of ABC's common stock was $23 per share. During that
month, ABC announced that it would be acquired by XYZ Corporation. XYZ is a
Delaware corporation, all of whose outstanding debt and equity securities are registered
with the SEC under the Securities Exchange Act of 1934 and were issued in public
transactions registered with the SEC under the Securities Act of 1933. All of XYZ's
outstanding debt and equity securities are listed for trading on the New York Stock
Exchange.
The acquisition is structured as a triangular merger: ABC is to merge with
NewCo, a wholly owned XYZ subsidiary, with ABC as the surviving entity. Following
the merger, ABC's common stock will be deregistered with the SEC and delisted from
trading on the stock exchange. In the merger, shareholders of ABC will receive for each
share of ABC stock a package of XYZ common stock and cash in lieu of fractional shares
with a market value of at $30 per share. The merger agreement makes no provision for
ABC's convertible debentures.
1. Setting aside whatever legal claims the holders of ABC's convertible
debentures may have in this case, have the holders of ABC's debentures suffered any
economic injury as a result of merger transaction?
2. Assume for purposes of this question only both that the holders of ABC's
convertible debentures were injured by the merger and that they have standing to pursue
any relevant legal claims. You are counsel to a large mutual fund company, which is the
largest holder of ABC's convertible debentures. Your client wishes to bring suit against
 27

ABC and/or XYZ. On what grounds might such a suit be brought? Would such a suit be
likely to succeed? (Be sure to discuss the remedies, if any, your client might have
available.)
3. Assuming that both the New York Stock exchange and the primary market for
ABC's securities are efficient, would your argument on behalf of the ABC convertible
debenture holder be stronger or weaker?
VI.
1. Assume that you have $150.00 in your bank account today; you opened the
account one year ago; your initial deposit was the only deposit you've made; you've made
no withdrawals; the bank account has paid interest at 5% for the last year, compounding
annually. If your account was just credited with its interest for the first year, how much
was your initial deposit?
2. Two years ago, you deposited $100 in a bank account that pays 8% interest,
compounding quarterly. If your account was just credited with your last quarterly interest
payment for the second year, how much money do you now have in your account?
3. This question relates to Smith Drugstores, the firm described in the problem on
pages 161-168 of the Mitchell and Solomon text. Use the Dewing capitalization of
earnings chart (p. 147 of Mitchell and Solomon) to select an appropriate capitalization
rate for Smith Drugstores. Once you have done so, use the capitalized earnings method
of valuation to determine the value of a share of Smith Drugstores's common stock.
(Explain briefly, being sure to give a numerical answer and to specify which of the
Dewing categories you selected.)

VII.
All of the sub-parts of Question VII relate to the following set of facts: ABC
Corporation was incorporated in the state of Illinois on December 11, 1981. (Illinois has
adopted the Revised Model Business Corporation Act.) At its inception, 1,000 shares of
common stock were issued. Each share of common stock has a par value of one dollar
($1.00). Each share of stock was issued in return for cash consideration in the amount of
twenty dollars ($20.00) per share. There have been no subsequent stock issuances. ABC
is able to pay its debts as they come due in the ordinary course of business.
ABC operates a sporting goods retail store. The business is well-established in
the community, but has proven to be quite vulnerable to adverse general economic
conditions. During the 1991 recession, for example, ABC's business dropped-off quite
substantially. ABC's managers have little specialized training or knowledge, but have
proven to be highly competent and skilled retailers.
As of December 31, 1994, which date marked the end of ABC's 1994 fiscal year,
ABC's balance sheet read as follows (assume that the asset figures represent both the
historical cost and the present fair market value of all assets and liabilities if liquidated):
BALANCE SHEET

Assets Liabilities and Shareholders' Equity

Cash $ 4,550 Accounts payable $ 27,000

 28

Accounts
receivable $ 29,800 Bank Loans Outstanding $ 35,500

Inventory $ 4,150 Total Liabilities $ 62,500

Store/Land $ 34,500 Capital ................. $ ?

Total Assets $ 73,000 Surplus ................. $ ?

Total Shareholders'
Equity .................. $ ?

SELECTED FINANCIAL DATA FOR FISCAL YEAR 1994

Earnings: $1.15 per share

Return on Equity: 12.1%

Beta (estimated): 1.125

Return on Wilshire 5000: 15%

Return on 3-month treasury obligations: 3%

1. As of December 31, 1994, the amount of capital that should be recorded on

ABC's balance sheet is?

2. As of December 31, 1994, the amount of surplus that should be recorded on

ABC's balance sheet is?

3. ABC's board of directors wishes to use a 20 percent payout rate in setting the

dividend for fiscal year 1994. Would a dividend in that amount (be sure to specify the
 29

dollar amount you believe this formula gives) be lawful under Illinois law? Explain

briefly?

4. Based on the financial statements and the additional information provided in

the foregoing questions, calculate the per share value of ABC's common stock using each

of the methods identified below. You may assume for purposes of this question only that

the dividend proposed in problem 3 of this Part I was lawful and has been paid. Be sure

to show the formula you believe to be appropriate to the specified and your calculations:

a. Annuitized constant dividends

b. Annuitized growing dividends

c. Capitalized earnings

d. Book value

VIII.
H.R. 10, “The Common Sense Legal Reforms Bill,” was one of the ten items
included in the House of Representatives Republican Conference’s “Contract with
America.” Among other things, H.R. 10 originally contained a provision that would have
required plaintiffs who bring suit for securities fraud under Securities and Exchange
Commission Rule 10b-5 to show actual reliance on any alleged misrepresentations or
omissions. In effect, this legislation would have reversed the Supreme Court’s decision
in Basic, Inc. v. Levinson (MS p. 239) by invalidating the so-called “fraud on the market”
presumption of reliance.
During his testimony in support of H.R. 10, a well-known academic economist
made the following observation: “Although the fraud on the market presumption at first
blush appears to comport with modern financial economics, on close examination it does
not do so. Efficient capital markets theory does not require the presumption, while
portfolio theory suggests it is at least unnecessary and perhaps inappropriate.” A
confused congressman has asked you to write a brief memorandum that both explains and
critiques the professor’s argument.
 30

Question 1 (30 minutes): In January 1992, Andy decided to quit his job as a
professor at the University of Columbia in order to pursue his childhood dream of
becoming a famous bluegrass musician. Andy and three other local musicians formed a
bluegrass band called "Andy and the Back-Ups": Andy on guitar and vocals; Bella on
fiddle; Charlie on banjo; and Delta on various percussion instruments. Each band
member owned his or her own instruments, but the group needed collectively-owned
lighting and sound equipment. Because Andy was the only band member who had any
savings, Andy agreed to loan the band the money needed to buy the necessary equipment.
The other band members agreed that until the loan was paid off half of the proceeds of
any gigs would go to Andy as payments on the loan, with the other half being divided pro
rata after other expenses had been paid. Once the loan is paid off, all proceeds will be
divided pro rata after expenses. (At all times relevant to this problem, the loan was still
outstanding.)

On June 1, 1992, Andy drove himself and the other band members to an out of
town gig using his personal van. After the gig, Andy rode home with his wife in her car.
He asked Charlie to drive the other band members and their equipment home in Andy's
van. Charlie agreed to do so. Unfortunately, on the way home, Charlie negligently
caused an accident involving the van and a car driven by Homer. Homer was badly
injured.

Because Andy is the only band member with any significant assets, Homer would
like to be able to hold Andy personally liable for his injuries. Discuss any business
organization law claims Homer may have against Andy. Identify any business
organization law defenses Andy might raise. Who is likely to win the lawsuit?

Model Answer: At least at the outset, Homer can pursue two alternative theories

for reaching Andy's personal assets. The better alternative, from Homer's perspective, is

probably a claim that the band is a partnership. Homer can also argue that Charlie was

acting as Andy's agent at the time the accident occured. For full credit, both claims

should have been evaluated.

The absence of an express partnership agreement on these facts is not fatal to

Homer's claim. UPA Section 6(1) provides that a partnership is an association of two or

more persons to carry on as co-owners a business for profit. All that is required is an

agreement -- explicit or implicit, oral or written -- between two or more parties to act as

co-owners of a business. As such, it is possible to create a partnership without realizing

that you have done so. The relevant question is whether the parties intended to act as co-
 31

owners of a business for profit. If so, the law will treat them as partners, whether or not

they knew that they were creating a legal partnership with specific consequences.

What then are the relevant facts in this case? The single most significant factor is

the parties' agreement to divide profits. UPA Section 7(4) says that in the absence of

evidence to the contrary, division of profits is prima facie evidence that a partnership

exists.
 32

Question 2. You may assume for purposes of this question that Illinois has
adopted the Uniform Partnership Act (1914) as reprinted at pages 603-624 of the 1994
edition of the West statutory supplement used in this course. Governor Edgar has
proposed repealing current Uniform Partnership Act Section 15 and adopting the
following language in its place:

“§ 15. Nature of Partner’s Liability. (a) Except as provided in subsection (b) of

this section, all partners are liable:

“(1) Jointly and severally for everything chargeable to the partnership

under §§ 13 and 14 of this act; and

“(2) Jointly for all other debts and obligations of the partnership; but any
partner may enter into a separate obligation to perform a partnership
contract.

“(b) Subject to subsection (c) of this section, a partner is not liable for debts and
obligations of the partnership arising from negligence, wrongful acts or
misconduct committed in the course of the partnership business by another
partner or an employee, agent or representative of the partnership.

“(c) Subsection (b) of this section shall not affect the liability of a partner for his
own negligence, wrongful acts or misconduct or that of any person under his
direct supervision and control.”

Should the Illinois legislature adopt this bill?

Answer

This question was designed to test your understanding of the basic law and

economics principles discussed in this course. Although we had not spent much time on

limited partnerships or limited liability partnerships, we did cover in other contexts all of

the principles necessary to answer this question. Of particular relevance were our

discussion of the nexus of contracts model of the firm, corporate limited liability, and the

distinctions between close corporations and partnerships.

 33

Analysis must begin with the contractarian theory of the firm and its implications

for the role of legal rules in organizational governance. Nexus of contracts theory

visualizes the firm not as an entity but as an aggregate of various inputs acting together to

produce goods or services. Employees provide labor. Creditors provide debt capital.

Shareholders initially provide equity capital and subsequently bear the risk of losses and

monitor the performance of management. Management monitors the performance of

employees and coordinates the activities of all the firm's inputs. The firm is simply a

legal fiction representing the complex set of contractual relationships between these

inputs. In other words, the firm is not a thing, but rather a nexus or web of explicit and

implicit contracts establishing rights and obligations among the various inputs making up

the firm.

The nexus of contracts theory of the firm has two principal implications. The first

is positive: the contractarian model postulates that the legal rules governing firms are

contractual in nature; they are for the most part default rules that the parties are free to

modify as they see fit. The second is normative: contractarian theory asserts that

corporate and partnership law should be comprised mostly of default rules, and that

mandatory rules should be few and far between.

The positive version of the contractarian model has important implications for our

understanding of the function of organization law. One of Ronald Coase’s key insights

was that bargaining is costly. Bargaining costs are a form of what economists call

transaction costs: the costs associated with effecting a transaction. As the transaction

costs of doing a deal increase, the profitability of the deal correspondingly decreases.
 34

Transaction costs are thus a source of friction in the economy: the higher they get, the

fewer transactions occur.

One function of organization law thus is to lower transaction costs. How does it

do that? Consider this: the legal rules we studied in this course amount to a standard

form contract. You’ve all signed standard form contracts. Suppose you went to rent a

car. You’re not going to bargain with the rental agent. He or she’s going to give you a

pre-printed contract, a standard form contract, that you can either accept or reject as a

whole. Renting a car is thus a very low transaction cost event, because there is no

bargaining. The legal rules we studied are a lot like that: they provide a set of rules that

will govern relationship of the people making up the firm. By doing so, the law saves the

parties from having to bargain over every jot and tittle of their relationship.

Organization law provides a number of distinct standard form contracts amongst

which investors are fairly free to choose: corporations, partnerships, limited partnerships,

limited liability companies, limited liability partnerships, and the like. One of the key

themes of this course was that elimination of differences between the various standard

form contracts was usually undesirable, because eliminating differences in legal rules

between forms reduces the scope of investor choice and thus raises bargaining costs. (Do

you see why? If not, you simply don’t understand the basic building blocks of the

course.) The proposed change would convert general partnerships from a rule of

unlimited owner liability to a rule of limited owner liability. As such, the rules governing

general partnerships would move towards those of corporations, reducing the scope of

investor choice.
 35

Most students got to this point in the analysis (which was pretty much just spitting

back class notes from assignments 1 and 5), but failed to complete the analysis. The

argument in favor of multiple standard form contracts assumes investor heterogeneity.

What if that assumption does not hold? It is possible that investor preferences might be

systematically biased towards a particular rule, such as limited liability. (In other words,

the assumption driving the preceding analysis is that “one size does not fit all,” but we

must also consider the possibility that one size does in fact fit all.) If so, what appears at

first blush to be an undesirable reduction of choice may in fact prove an appropriate

accommodation of investor preferences.

Two questions therefore deserve consideration: (1) is there a class of investors

that would prefer unlimited personal liability; and (2) is the general partnership otherwise

an appropriate standard form contract for this class? Only if the answer to both of these

questions is “yes” can one conclude that the bill should be rejected.

Limited liability is clearly a necessary component of the corporate standard form

contract. Indeed, it seems fair to argue that without the limited liability rule, the

widespread capital investment that made our public corporation-based economic system

successful would not be possible. In the absence of limited liability, it would be almost

impossible to generate the enormous amounts of investment capital needed to operate

large firms. The premise is that individual investors put a small amount of money into a

firm, with the expectation of profit through capital gains and dividends, and that by

having a large number of investors each putting up a small amount of money you end up

with fairly substantial amounts of capital that the firm can put to use. Shareholders

simply would be unwilling to invest those small amounts in the absence of limited
 36

liability. Indeed, most business historians agree that limited liability was one of the most

important factors in the development of the modern public corporation and, as a result,

made possible the evolution of our modern economic system.

The assumptions are quite different in the small firm context, as is exemplified by

the quite different rules governing partnerships. The assumption of partnership law is

that we are dealing with a small number of investors, all of whom are actively involved in

running the firm. This assumption is reflected in a plethora of legal rules: the equality of

decisionmaking power reflected in the one-man/one-vote rule; the rule requiring majority

approval of most actions and unanimous approval of many; the rules allowing all partners

equal information about the firm; the rule that all partners are agents of the firm with

authority to make binding contracts.

All of these rules reflect an assumption of actual involvement, quite different from

the assumption of passive investment reflected in corporate law. With an assumption of

active involvement, the need for limited liability goes out the window. In the first place,

an actively involved partner has plenty of incentives to monitor what the firm is doing,

and the financial stability of his fellow partners, irrespective of the liability rule. Personal

liability thus doesn’t have the adverse incentives that it does in the corporate context.

Indeed, in the partnership area it is a rule of limited that creates perverse

incentives. Does a partner who has full personal liability have incentives with respect to

preventing losses; that is to say, to prevent the firm from incurring either tort or contract

obligations that exceed the firm’s assets? The answer is clearly yes: the partner has a

strong incentive to participate in management to prevent losses from arising and an

incentive to have the firm buy insurance. The partner’s ability to participate in firm
 37

management gives him an ability to act on these incentives. A rule of limited liability

would unnecessarily reduce the partner’s incentives to take adequate precautions against

losses.

In the second place, full personal liability may actually reduce certain transaction

costs. Partnerships should have lower borrowing costs than comparably capitalized

corporations, for example, because the rule of full personal liability ensures that the

creditor will have access to the partners’ deep pockets in the event of firm failure. Full

personal liability also eliminates the potential agency costs between creditors and equity

holders and therefore should further reduce the partnerships’ borrowing costs.

To be sure, the proposed amendment leaves partners fully personally liable to

voluntary creditors. Limited liability for torts and wrongful acts, however, can affect

voluntary relationships. as well as involuntary relationships. The lawyer-client

relationship is a good example. Limited liability in this context probably would result in

higher malpractice premia and lower legal fees. (Do you see why?)

In sum, it appears likely that there is a class of investors for whom unlimited

personal liability may be attractive. It also seems likely that this class of investors will

find that other rules of a general partnership attractive. Adoption of the bill would raise

transaction costs for these investors. A better alternative would be for the Legislature to

preserve the traditional general partnership, while creating limited liability partnerships

as a new standard form contract for those investors who want to avail themselves of both

limited liability and general partnership tax and governance structures.

 38

Question 3. All of the following events took place within the state of Illinois.
This question has several subparts, each of which relate to the following set of facts:
In January 1993, three graduates of the University of Illinois College of Law
banded together to form a law firm: Alice, Bob, and Cecil. Alice contributed 40% of the
original start-up capital; Bob and Cecil each contributed 30 percent. Alice, Bob, and
Cecil entered into an agreement, which contained the following provisions having
relevance to the problem at hand:
(1)Economic and voting rights with respect to the firm would be divided into 100
shares, with all shares having equal voting and economic rights.
(2)Shares would be distributed to the firm's members in proportion to their
original contribution of start-up capital.
(3)Amendments to the agreement are effective if approved by an affirmative vote
of a majority of the outstanding shares.
A. After the business has been running a few months, Alice proposes an
amendment to the agreement, which provides that neither negligent nor grossly negligent
conduct shall be deemed to constitute a violation of the duty of care of the corporation's
officers and directors. Alice and Cecil vote for the amendment, Bob votes against it. Is
the amendment legally enforceable?
B. Assume for purposes of this question only that the amendments at issue in Part
A are legally enforceable. Despite the unpleasantness over the amendments, the three
lawyers remain in business together.
After a few more months, however, both Bob and Cecil realize that they hate
being lawyers. They repeatedly express their frustration and dissatisfaction with the legal
profession to Alice.
Alice also hates being a lawyer, but does not express her feelings to Bob and
Cecil.
Donna is a long-time social friend of Alice. Donna is also a successful big-city
lawyer. Donna sends Alice a letter which states in pertinent part: "I am giving up big-
city life and moving to your town. I am interested in joining or buying an existing law
office. Any ideas?"
Alice sends Donna a reply, which reads in pertinent part: "You might be
interested in my firm."
After her exchange of letters with Donna, Alice calls a firm meeting. At the
meeting, Alice offers to buy Bob's and Cecil's interest in the firm for $100,000 each.
After hard and lengthy bargaining, Bob and Cecil agree to sell their interests to Alice at
$110,000 each. Alice did not inform Bob and Cecil of her correspondence with Donna.
After completing the purchase of Bob and Cecil's interest, Alice enters into
negotiations with Donna to sell the law practice to Donna.
After long and hard bargaining, Donna agrees to pay Alice $550,000 for the law
practice.
1. Assume for purposes of this question only the law firm is organized as a
general partnership under the laws of Illinois. Further assume for purposes of this
question only that Illinois adopted the Uniform Partnership Act in 1919. You may further
 39

assume that Illinois has no relevant case law other than those Illinois cases that appear in
the Klein & Ramseyer casebook. Do Bob and Cecil have any partnership law claims
against Alice? Explain and evaluate any claims.
2. Assume for purposes of this question only that Illinois in 1992 adopted
Revised Uniform Partnership Act. You may further assume that Illinois has no relevant
case law other than those Illinois cases that appear in the Klein & Ramseyer casebook.
How, if at all, would the adoption of the Revised Act affect your answer to Question 1?

Answer

The major points in the correct answer to part 1 of essay question B are as

follows:

1. Illinois law applies.

2. There are no relevant Illinois cases. Accordingly, you must first look to the

statute, which for purposes of this question is the Uniform Partnership Act (UPA).

a. UPA § 20 requires disclosure by partners as to all matters relating to the firm.

Does the potential sale qualify under Section 20 as a matter as to which disclosure

must be made? Various factors should have been discussed here: timing of the

negotiations and transaction, the nature of the information, and the like. Even if

the potential sale qualifies under Section 20 as a matter as to which disclosure is

required, however, Section 20 only requires disclosure upon demand. Because

the selling partners made no such demand, Section 20 is inapplicable.

b. UPA § 21(a) may require Alice to account to her partners if the sale is regarded

as a transaction connected with the conduct or liquidation of the firm. A buyout

of one's fellows partners, followed by a sale of the partnership, is associated with

neither the conduct of the firm or its liquidation. The firm obviously was not

liquidated. Nor is a buyout a matter related to the conduct of the business.

Instead, it is an external matter between the partners.

 40

3. In the absence of Illinois case law and a clear answer from the statute, a court

might resort to leading cases from other jurisdictions. Hence, you were expected to

discuss the Meinhard case, which is the leading partnership duty case. Meinhard dealt

with usurpation of a partnership opportunity. In such transactions, Meinhard imposes a

very strong fiduciary duty that specifically imposes a duty to disclose. Is this case

analogous to Meinhard? Among other things, one might note the broad language

Cardozo used in defining the relationship between partners. On the other hand, this is an

opportunity that affects the interests of the individual partners. As such, it is not an

opportunity that belongs to the partnership itself.

Common mistakes in answering part 1 of essay question B:

1. Besides simply missing the issue, conclusory and/or superficial analysis was

the major problem. In particular, failures to correctly interpret and apply UPA Sections

20 and 21(a) were common. Many people made very simple mistakes in reading the

statute. Most simply asserted that the statutes applied, without any analysis of how the

statutory language might apply to this fact pattern.

2. Treating Alice's conduct as a usurpation of an opportunity belonging to the

partnership, rather than an opportunity affecting the individual interests of the partners.

The major points in the correct answer to part 2 of essay question B are as

follows:

1. Illinois law continues to apply. Meinhard is no longer relevant, however,

because Section 404(c) of the Revised Uniform Partnership Act eliminates common law

fiduciary duties. Put another way, one can only look to the fiduciary duties established

by the statute.
 41

2. Was this transaction a partnership opportunity for purposes of RUPA §

404(b)1)? The answer is almost certainly no. The opportunity arose out of a social

context. There was no certainty as to whether Alice would be able to sell the partnership

to Donna. The interests in question were those of the partners, not that of the partnership

as an entity. Given that the transaction was not a partnership opportunity, § 404(b)(1) is

otherwise inapplicable.

3. RUPA § 404(b)(2) is inapplicable because Alice's conduct is adverse to the

interests of her fellow partners, but is not adverse to the firm as such.

4. RUPA § 404(b)(3) is inapplicable because Alice did not compete with the firm.

5. RUPA § 404(e)'s good faith requirement is inapplicable because the transaction

does not involve and rights or duties under the Act or the partnership agreement.

6. RUPA § 404(c) only requires disclosure if demand is made.

Common mistakes in answering part 2 of essay question B:

1. Failure to properly apply the statute. Simple mistakes in reading the statute.

Absence of any serious attempt to analyze how the statutory language might apply to this

fact pattern.

2. Despite RUPA § 404(a), some people continued to apply the common law

rules.

3. Failing to work through all relevant statutory provisions.

 42

Other Questions

Can you form an agency relationship without realizing it?

Answer: Yes. So long as the principal and agent agree that the agent shall act on the
principal’s behalf and subject to his control, an agency relationship exists. The
parties need not intend the specific legal consequences that follow from such
agreements. In contrast, the corporation, limited liability company, and limited
partnership all must be created by jumping through specific statutory hoops.
Can you form a partnership without realizing it?

Answer. Yes. So long as the partners agree to act as co-owners of a business for
profit, a partnership exists. The parties need not intend the specific legal
consequences that follow from such agreements. In contrast, the corporation,
limited liability company, and limited partnership all must be created by jumping
through specific statutory hoops.

Able, Baker, and Charlie form a partnership. Able contributes 55 % of the partnership’s
capital, Baker contributes 30%, and Charlie contributes 15%. The partners vote on buying
a new computer. Able votes no; Baker and Charlie vote yes. Who prevails?
Answer. Baker and Charlie. Unless the partners agree to the contrary, routine
matters such as this are decided by majority vote on a one-man/one-vote basis.
 43

BUSINESS ASSOCIATIONS
Sample Exam Questions
© Stephen M. Bainbridge 2002
Question 1 (Suggested time: 30 minutes). You may assume for purposes of this question
that Illinois has adopted the Uniform Partnership Act (1914) as reprinted at pages 603-
624 of the 1994 edition of the West statutory supplement used in this course. Governor
Edgar has proposed repealing current Uniform Partnership Act Section 15 and adopting
the following language in its place:
“§ 15. Nature of Partner’s Liability. (a) Except as provided in subsection (b) of this

section, all partners are liable:

“(1) Jointly and severally for everything chargeable to the partnership under §§ 13
and 14 of this act; and
“(2) Jointly for all other debts and obligations of the partnership; but any partner
may enter into a separate obligation to perform a partnership contract.
“(b) Subject to subsection (c) of this section, a partner is not liable for debts and

obligations of the partnership arising from negligence, wrongful acts or misconduct

committed in the course of the partnership business by another partner or an

employee, agent or representative of the partnership.

“(c) Subsection (b) of this section shall not affect the liability of a partner for his own
negligence, wrongful acts or misconduct or that of any person under his direct
supervision and control.”
Should the Illinois legislature adopt this bill? You must use the principles and tools of
economic analysis and public policy developed in this course to answer this question!

Answer
This question was designed to test your understanding of the basic law and economics
principles discussed in this course. Although we had not spent much time on limited
partnerships or limited liability partnerships, we did cover in other contexts all of the
principles necessary to answer this question. Of particular relevance were our discussion
of the nexus of contracts model of the firm, corporate limited liability, and the
distinctions between close corporations and partnerships.
Analysis must begin with the contractarian theory of the firm and its implications for the
role of legal rules in organizational governance. Nexus of contracts theory visualizes the
firm not as an entity but as an aggregate of various inputs acting together to produce
goods or services. Employees provide labor. Creditors provide debt capital. Shareholders
initially provide equity capital and subsequently bear the risk of losses and monitor the
performance of management. Management monitors the performance of employees and
coordinates the activities of all the firm's inputs. The firm is simply a legal fiction
 44

representing the complex set of contractual relationships between these inputs. In other
words, the firm is not a thing, but rather a nexus or web of explicit and implicit contracts
establishing rights and obligations among the various inputs making up the firm.
The nexus of contracts theory of the firm has two principal implications. The first is
positive: the contractarian model postulates that the legal rules governing firms are
contractual in nature; they are for the most part default rules that the parties are free to
modify as they see fit. The second is normative: contractarian theory asserts that
corporate and partnership law should be comprised mostly of default rules, and that
mandatory rules should be few and far between.
The positive version of the contractarian model has important implications for our
understanding of the function of organization law. One of Ronald Coase’s key insights
was that bargaining is costly. Bargaining costs are a form of what economists call
transaction costs: the costs associated with effecting a transaction. As the transaction
costs of doing a deal increase, the profitability of the deal correspondingly decreases.
Transaction costs are thus a source of friction in the economy: the higher they get, the
fewer transactions occur.
One function of organization law thus is to lower transaction costs. How does it do that?
Consider this: the legal rules we studied in this course amount to a standard form
contract. You’ve all signed standard form contracts. Suppose you went to rent a car.
You’re not going to bargain with the rental agent. He or she’s going to give you a pre-
printed contract, a standard form contract, that you can either accept or reject as a whole.
Renting a car is thus a very low transaction cost event, because there is no bargaining.
The legal rules we studied are a lot like that: they provide a set of rules that will govern
relationship of the people making up the firm. By doing so, the law saves the parties from
having to bargain over every jot and tittle of their relationship.
Organization law provides a number of distinct standard form contracts amongst which
investors are fairly free to choose: corporations, partnerships, limited partnerships,
limited liability companies, limited liability partnerships, and the like. One of the key
themes of this course was that elimination of differences between the various standard
form contracts was usually undesirable, because eliminating differences in legal rules
between forms reduces the scope of investor choice and thus raises bargaining costs. (Do
you see why? If not, you simply don’t understand the basic building blocks of the
course.) The proposed change would convert general partnerships from a rule of
unlimited owner liability to a rule of limited owner liability. As such, the rules governing
general partnerships would move towards those of corporations, reducing the scope of
investor choice.
Most students got to this point in the analysis (which was pretty much just spitting back
class notes), but failed to complete the analysis. The argument in favor of multiple
standard form contracts assumes investor heterogeneity. What if that assumption does not
hold? It is possible that investor preferences might be systematically biased towards a
particular rule, such as limited liability. (In other words, the assumption driving the
preceding analysis is that “one size does not fit all,” but we must also consider the
possibility that one size does in fact fit all.) If so, what appears at first blush to be an
undesirable reduction of choice may in fact prove an appropriate accommodation of
investor preferences.
 45

Two questions therefore deserve consideration: (1) is there a class of investors that would
prefer unlimited personal liability; and (2) is the general partnership otherwise an
appropriate standard form contract for this class? Only if the answer to both of these
questions is “yes” can one conclude that the bill should be rejected.
Limited liability is clearly a necessary component of the corporate standard form
contract. Indeed, it seems fair to argue that without the limited liability rule, the
widespread capital investment that made our public corporation-based economic system
successful would not be possible. In the absence of limited liability, it would be almost
impossible to generate the enormous amounts of investment capital needed to operate
large firms. The premise is that individual investors put a small amount of money into a
firm, with the expectation of profit through capital gains and dividends, and that by
having a large number of investors each putting up a small amount of money you end up
with fairly substantial amounts of capital that the firm can put to use. Shareholders
simply would be unwilling to invest those small amounts in the absence of limited
liability. Indeed, most business historians agree that limited liability was one of the most
important factors in the development of the modern public corporation and, as a result,
made possible the evolution of our modern economic system.
The assumptions are quite different in the small firm context, as is exemplified by the
quite different rules governing partnerships. The assumption of partnership law is that we
are dealing with a small number of investors, all of whom are actively involved in
running the firm. This assumption is reflected in a plethora of legal rules: the equality of
decisionmaking power reflected in the one-man/one-vote rule; the rule requiring majority
approval of most actions and unanimous approval of many; the rules allowing all partners
equal information about the firm; the rule that all partners are agents of the firm with
authority to make binding contracts.
All of these rules reflect an assumption of actual involvement, quite different from the
assumption of passive investment reflected in corporate law. With an assumption of
active involvement, the need for limited liability goes out the window. In the first place,
an actively involved partner has plenty of incentives to monitor what the firm is doing,
and the financial stability of his fellow partners, irrespective of the liability rule. Personal
liability thus doesn’t have the adverse incentives that it does in the corporate context.
Indeed, in the partnership area it is a rule of limited that creates perverse incentives. Does
a partner who has full personal liability have incentives with respect to preventing losses;
that is to say, to prevent the firm from incurring either tort or contract obligations that
exceed the firm’s assets? The answer is clearly yes: the partner has a strong incentive to
participate in management to prevent losses from arising and an incentive to have the
firm buy insurance. The partner’s ability to participate in firm management gives him an
ability to act on these incentives. A rule of limited liability would unnecessarily reduce
the partner’s incentives to take adequate precautions against losses.
In the second place, full personal liability may actually reduce certain transaction costs.
Partnerships should have lower borrowing costs than comparably capitalized
corporations, for example, because the rule of full personal liability ensures that the
creditor will have access to the partners’ deep pockets in the event of firm failure. Full
personal liability also eliminates the potential agency costs between creditors and equity
holders and therefore should further reduce the partnerships’ borrowing costs. To be sure,
 46

the proposed amendment leaves partners fully personally liable to voluntary creditors.
Limited liability for torts and wrongful acts, however, can affect voluntary relationships.
as well as involuntary relationships. The lawyer-client relationship is a good example.
Limited liability in this context probably would result in higher malpractice premia and
lower legal fees. (Do you see why?)
In sum, it appears likely that there is a class of investors for whom unlimited personal
liability may be attractive. It also seems likely that this class of investors will find that
other rules of a general partnership attractive. Adoption of the bill would raise transaction
costs for these investors. A better alternative would be for the Legislature to preserve the
traditional general partnership, while creating limited liability partnerships as a new
standard form contract for those investors who want to avail themselves of both limited
liability and general partnership tax and governance structures.

Question 2 (Suggested time: 60 minutes). Albemarle Seeds, Inc. is an undiversified

agribusiness, specializing in selling seeds of food crops to underdeveloped nations.
Albemarle Seeds is incorporated in Delaware and is a reporting company under the
Securities Exchange Act of 1934. Albemarle Seeds has nine directors, three of whom are
employed by Albemarle Seeds in various capacities. None of the other six directors has
any affiliation with Albemarle Seeds, except for their position as a director.
The three Albemarle Seeds directors who are employed by it are: Russ Johansen, who is
Albemarle Seeds’ Chairman of the Board and President; Steve Van Gherkin, who is
Albemarle Seed’s Chief Financial Officer; and Bruce Cherbourg, who is Albemarle
Seed’s Secretary and General Counsel. The Board of Directors has authorized Johansen,
Van Gherkin, and Cherbourg to serve as an Executive Committee of the Board,
empowered to take action in the board’s name in the event of a business emergency.
One of Albemarle Seed’s longest-standing and largest customers is the People’s Republic
of Urbania, a small island nation off the coast of North America. In June 1995, Urbania’s
Minister of Agriculture terminated Urbania’s contract with Albemarle Seeds. In
response, Johansen called an emergency meeting of the Executive Committee. The
Executive Committee unanimously authorized Van Gherkin to pay a $10 million bribe to
the Urbania Minister of Agriculture. The Minister thereafter reinstated Albemarle Seed’s
contract. Even after taking into account the bribe, Albemarle Seeds expects to make a
$75 million profit during the 1995-1996 fiscal year alone on the contract with Urbania.
The Executive Committee never disclosed the bribe to the other members of Albemarle
Seed’s board of directors; nor was the bribe disclosed in Albemarle Seed’s proxy
statement or other SEC disclosure documents.
In December 1995, the Justice Department indicted Albemarle Seeds, Johansen, Van
Gherkin, and Cherbourg for criminal violations of the Foreign Corrupt Payments Act.
Albemarle Seeds was fined $30 million. Johansen, Van Gherkin, and Cherbourg were
each sentenced to two years in jail.
Part A. The proxy statement used in connection with Albemarle Seed’s November 1995
annual shareholders’ meeting did not disclose the payment of the bribe. The only items
voted on at that meeting were the election of the board of directors (all nine incumbent
directors were re-elected, including Johansen, Van Gherkin, and Cherbourg) and
ratification of the board’s selection of an independent auditor. Susan Shareholder has
 47

brought suit against Albemarle Seeds and its board of directors. Count One of
Shareholders’ lawsuit is brought under Securities Exchange Act § 14(a), seeking
monetary damages. Albemarle Seeds has moved to dismiss Shareholder’s lawsuit. You
are the judge. Decide the motion and explain your reasoning.

Answer. By virtue of the U.S. Supreme Court’s decision in J.I. Case

Co. v. Borak, an implied private right of action exists under Securities
Exchange Act Section 14(a) and the associated SEC rules
thereunder. In order to establish an actionable violation of Section
14(a), plaintiff first must show that the proxy solicitation contained a
material misstatement of fact or omitted a material fact. Here an
omission with respect to the election of directors is at issue. An
omission is material if “there is a substantial likelihood that a
reasonable shareholder would consider it important in deciding how
to vote.” Your score depended on your ability to analyze the facts
under this standard.
Although causation nominally is an element of the Section 14(a) implied cause of
actions, the U.S. Supreme Court held in Mills that causation is satisfied by a showing
that the proxy solicitation itself (as opposed to the defect) was an essential link in the
accomplishment of the transaction. This standard suggests that any violation
“causes” an injury, because in any transaction requiring shareholder approval, the
proxy solicitation is an essential link if it was necessary to approve the transaction.

Part B. Count Two of Susan Shareholder’s lawsuit alleges that Johansen, Van Gherkin,
and Cherbourg violated their fiduciary duty of care by paying the bribe. Albemarle Seeds
claims that the lawsuit is derivative in nature and has moved to dismiss this count for
failure to make demand. You are the judge. Decide the motion and explain your
reasoning.
Answer. At the very outset, it should be noted that because Albemarle Seeds is a
Delaware corporation, Delaware law applies.
The preliminary issue is whether the lawsuit is direct or derivative. A “direct”
shareholder suit arises out of a cause of action belonging to the shareholder in his or her
individual capacity. It is typically premised on an injury directly affecting the
shareholder and must be brought by the shareholder in his or her own name. In contrast,
a “derivative” suit is one brought by the shareholder on behalf of the corporation. The
cause of action belongs to the corporation as an entity and arises out of an injury done to
the corporation as an entity. The shareholder is thus merely acting as the firm's
representative. Nevertheless, for most procedural purposes the shareholder is treated as
the named plaintiff and the corporation is treated as a defendant.
It is often difficult to tell which type of action a particular case involves. The basic tests
are: (1) Who suffered the most immediate and direct injury? (2) To whom did the
defendant's duty run? Although the fiduciary duties of officers and directors run to both
the corporate entity and the shareholders, the duty of care (which is at issue here) usually
 48

runs to the corporate entity rather than to the shareholders (Van Gorkom being a
prominent exception to the rule). The challenged misconduct did not directly injure the
shareholders. Instead, any injury the shareholder suffered presumably took the form of a
reduction in the value of their stock, which is derivative of the injury (the fine and harm
to reputation) suffered by the corporation. Accordingly, this case involves a derivative
cause of action.
The second question is whether demand is required or excused. The test for excusal of
demand in Delaware is set forth by Aronson v. Lewis as a requirement that plaintiff must
allege specific facts creating a reasonable doubt that: (1) a majority of the directors are
(a) disinterested, and (b) independent of the alleged wrongdoers; or (2) the challenged
transaction was a valid business judgment. Recall that, in Delaware, the court closely
looks for specific facts. Bare allegations aren’t enough.
Plaintiff creates a reasonable doubt as to the disinterestedness of board members by
showing that they have a financial stake in the first tier transaction. Merely being a
named defendant, with the accompanying risk of personal liability, is not enough for the
director to be regarded as interested. Here a majority of the board lacks any financial
stake in the challenged transaction.
Plaintiff creates a reasonable doubt as to the independence of board members by showing
that they are dominated and controlled by the alleged wrongdoers. There is no evidence
of such domination or control on these facts.
Plaintiff essentially creates a reasonable doubt as to whether the challenged transaction
was a valid business judgment by showing that the business judgment rule is unlikely to
protect the directors from liability in connection with the first tier transaction. The
business judgment rule does not protect illegal conduct, but a majority of the board
neither participated in nor was aware of the illegal conduct. The illegality of the first tier
transaction standing alone thus is unlikely excuse demand.
An essential precondition for the business judgment rule to apply is that the directors in
fact exercised business judgment. Where the board made no decision, as in the Allis-
Chalmers case, the business judgment rule has no application. As to a majority of the
board, there was no exercise of business judgment. Accordingly, demand should be
excused.

Part C. Assume for purposes of this question only that Count Two of Susan Shareholder’s
lawsuit was derivative in nature. Further assume, again for purposes of this question
only, that demand was excused with respect to this count of Shareholder’s lawsuit.
Albemarle Seed’s board of directors appointed a special litigation committee, comprised
of three newly appointed directors, none of whom had any prior affiliation with
Albemarle Seeds or with any of the individual defendants. The special litigation
committee included a retired admiral, the dean of the leading state law school, and a
president of a Fortune 500 company. Independent legal counsel was appointed to assist
the special litigation committee. After conducting a reasonable investigation, the special
litigation committee recommended that the court dismiss the lawsuit. Among the bases
for the special litigation committee’s recommendation were the following: (1) Johansen,
Van Gherkin, and Cherbourg were in jail and broke; and (2) although the bribe was
deplorable, the company ended up making a profit on the Urbania contract, even when
 49

one takes the bribe and the fine into account. You are the judge. Will you accept the
special litigation committee’s recommendation or not? Explain. If appropriate, you
should draw on the tools and principles of economic analysis developed in this course to
answer this question.

Answer. Delaware law again controls; specifically, the Delaware Supreme Court’s
decision in Zapata Corp. v. Maldonado. When demand is excused, as is the case here, the
board may appoint a Special Litigation Committee to investigate the alleged incidents
and make a recommendation to the court as to whether or not the litigation was in the
firm’s best interests. Typically the members of the committee are independent,
uninvolved members of the board -- often new board members specifically appointed
with the intent of putting them on the committee. The committee is vested with all of the
powers of the whole board for the limited purpose of deciding what position the
corporation should take in connection with the litigation. The theory, at least the theory
that was explained to the courts, was that the committee could take over and prosecute
meritorious suits, while seeking dismissal of frivolous actions.
The issue presented by a SLC’s recommendation that the suit be dismissed is how much
deference the court should give to the committee’s recommendation. In Zapata, the
defendants argued that the court should apply the business judgment rule to the
committee’s decision (an argument that previously had been accepted by the New York
Court of Appeals in Auerbach v. Bennett). In Zapata, the Delaware Supreme Court
rejected this argument, instead laying out a new set of procedures to be followed in these
cases.
After an objective and thorough investigation, the committee may cause the corporation
to file a motion to dismiss the derivative action. The motion should include a written
record of the committee's investigation and its findings and recommendations. Each side
will be given a limited opportunity for discovery with respect to the court’s mandated
areas of inquiry. In deciding whether to dismiss the action, the court is to apply a two-
step test: (1) The court should inquire into the independence and good faith of the
committee. The court also should inquire into the bases supporting the committee's
recommendations. The corporation will have the burden of proving independence, good
faith and a reasonable investigation. (2) If the first step is satisfied, the court may
nevertheless go on to apply its own business judgment to the issue of whether or not the
case is to be dismissed.
Under the first Zapata step, the court is not only to look at the procedures used by the
committee, but also at the reasonableness of the basis for the committee’s decision. In
other words, Delaware judges not only make sure all the papers are in the file, they also
read the papers to see if they support the committee's conclusions.
The second step of Zapata is intended to catch cases complying with the letter, but not the
spirit, of the first step. In other words, the Zapata court is saying that judges should not
dismiss meritorious derivative suits merely because the board and its committee jumped
through the correct procedural hoops.
Unfortunately, Zapata failed to give judges any standards by which to apply their own
business judgment in the second-step. Zapata merely says that the trial court should
consider such things as how compelling the corporation’s interest is in having the suit
 50

dismissed, which probably just means that the court is supposed to consider whether it
thinks the suit has merit. The trial court also is authorized to consider “matters of law
and public policy,” which could mean everything under the sun.
Although Joy v. North is not a Delaware precedent, it is worth discussing in this context
because it offers a standard by which to apply the second step of Zapata. Judge Winter’s
opinion focuses on whether the litigation is in the best interests of the corporation. The
court is supposed to balance the probabilities as to the likely benefit of the litigation; it
need not resolve uncertainties, only weigh them. Judge Winter comes up with a formula,
comparable to the Hand Formula familiar from Torts:
If cost of litigation to corporation > [(likely recoverable damages) x (probability of liability)], suit must be dismissed.

Note that it is the court which is supposed to determine what figures to plug into this
calculus, not the committee -- although, of course, the court can consider the committee's
views.
Judge Winter elaborates on this formula by identifying the costs which may be
considered: attorney's fees, out of pocket expenses, time spent by corporate personnel
preparing for and participating in trial, and mandatory indemnification (discounted by the
probability of liability). The court may never consider discretionary indemnification or
insurance. Where the likely recovery to the corporation is small in comparison to total
shareholders' equity, the court may also consider two other factors: (1) the degree to
which key personnel may be distracted from corporate business by the litigation and (2)
the potential for lost business.
Your score on this question depended on how well you applied these principles to the
facts at hand.

Question 3. Frank Farmer is the controlling shareholder of Family Farms, Inc. In addition
to 800 acres of prime Minnesota farmland, Family Farms owns a farmhouse that Frank
uses as his personal residence. All of Family Farms’ profits are paid out to Frank as salary
or dividends. Although separate corporate books are maintained and both director and
shareholder meetings are held, other corporate formalities are ignored. Two years ago
Family Farms borrowed $1 million from the First National Bank of St. Paul, giving the
bank a mortgage on the land and farmhouse. Family Farms defaulted on the loan last
month. First National is now seeking to foreclose on the farm and the house. Under
Minnesota’s Farm Homestead Act, a personal residence and up to 80 contiguous acres of
farmland owned by an individual is exempt from foreclosure. The Act does not preclude
foreclosure on all corporate-owned property.
A. You are Frank’s lawyer. Develop a concise corporate law-based legal argument

that would enable Frank to invoke the Farm Homestead Act. (Note: We have NOT

studied the relevant doctrine. The question is designed to test your ability to argue by

analogy to doctrines we have studied.) (20 points)

 51

B. You are the judge. As a matter of sound corporate law policy, should Frank be
allowed to invoke the Farm Homestead Act on the basis of the legal theory developed
in your answer to Question 1? Be VERY brief. (10 points)

Question 4. The following is based on a true story. Ms. Edna Katz is a shareholder of
Johnson & Johnson, Inc., a publicly-traded company registered with the Securities and
Exchange Commission pursuant to the Securities Exchange Act of 1934. Ms. Katz is
eligible to use the shareholder proposal rule, 14a-8. She timely submits the following
resolution for inclusion in Johnson & Johnson’s annual proxy statement:
“When asked why he got paid more than the President of the United States, Babe Ruth once said: ‘I had a better year than he
did.’ Unlike the beloved President of the United States, the President of Johnson & Johnson has not had a very good year.
Earnings are down; dividends are down; the price for our fine company’s stock is down. Accordingly, the shareholders of
Johnson & Johnson hereby RESOLVE that the salary of the President of Johnson & Johnson shall not exceed the salary of the
President of the United States (currently $200,000 per year) as it may be adjusted from time to time.”

Johnson & Johnson’s board of directors has refused to include the proposal in the
company’s proxy statement. Discuss. (20 points)

Question 5. XYZ Corp.’s shares are publicly traded. It manufactures generic drugs—that
is, drugs that have the same chemical content as brand-name drugs approved by the Food
and Drug Administration, but can be sold at a lower price because of lower development
and marketing costs. Generic drugs can be sold without the burdensome proof to the FDA
of safety, etc., that is required for new drugs, but the manufacturer of the generic drugs
must show that its products are in fact equivalent in characteristics to the brand-name
drugs that have met the FDA’s rigorous testing and safety requirements.
On July 15, 2000, XYZ issued a statement that its reported earnings for the preceding
quarter would be substantially lower than for the comparable quarter a year earlier. The
statement failed to reveal that the decline in reported earnings was attributable to an
increase in expenditures for research and development and that these expenditures would
likely generate increased earnings in the future. The price of XYZ shares on July 15th
was $40 per share and the next day fell to $35 per share (though the market in general did
not change at all). On July 16th, Charlie, the CEO of XYZ, bought 1,000 of its shares at
$35 per share. Seven months later he sold those shares for $45 per share.
In July 2001 the FDA began an investigation of XYZ and informed Charlie privately that
it had found what it believed tentatively were some serious quality-control problems in
XYZ’s manufacturing processes. That afternoon, Charlie played tennis with his good
friend Fred and, in the locker room after the game, mentioned to Fred that XYZ had some
serious problems with the FDA. As soon as Fred got back to his office, he called his
broker and instructed the broker to sell all of his 1,000 shares of XYZ at the market price,
$42 per share, which the broker did.
That night, Charlie went home and had a couple of drinks. When his wife came home
from work, he spoke unpleasantly to her, she asked him what his problem was, and he
responded, “The [expletive deleted] FDA is about to shut us down.” Their son, Steve, was
in the next room and heard what his father said. The next day at his college dormitory,
Steve told a friend, Emily, what Charlie had said. Emily called her broker and told him to
sell short 1,000 shares of XYZ. The broker, Helen, knew Emily to be a shrewd investor
and sold short 1,000 shares for her own account.
 52

On August 1, 2001, in response to rumors printed in the financial press and questions
from reporters about an investigation by the FDA, Charlie issued the following statement:
“We are confident that we have no serious problems with the FDA.” On August 2, 1993,
the closing price for XYZ shares was $38 per share, which was $3 per share higher than it
was before Charlie issued his statement.
On August 15, 2001, the FDA released to the press a highly unfavorable report on XYZ
and began proceedings to shut down some of its operations and to require it to recall
some of its products. The FDA report received widespread mention in the financial press.
On August 16, 1993, XYZ stock traded at a new low of $5 per share
Discuss whether any of the following has violated Securities Exchange Act of 1934 §
10(b) and Rule 10b-5: (a) Charlie, (b) Fred, (c) Steve, (d) Emily, (e) Helen, and (f) XYZ
Corp. (40 points)