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I. Introduction
1. Sole Proprietorship
a. You cannot be a Sole proprietorship and share
ownership or else you are a proprietorship, or
more often called a partnership.
b. Any type of business can have employees,
including a sole proprietorship
c. The sole proprietor is compensated for his labor,
his role as an investor, his ideas and his
management.
i. In general the law tends to allocate control
along with risk
ii. An employee in the context of working for
his employer is his agent.
iii. A bank may loan the employer money but
the employer still controls the company
because he has the risk, although they may
place restrictions on the loan, like requiring
it to be used for the kind of business
specified.
1. borrowing money from the bank is
debt, money owed that must be paid
back
2. money invested in a business is
equity, it does not need to be paid
back, does not have an interest rate,
and usually it entitles one to
participate in the upside
3. The people who are shareholders are
also the owners of the business and
residual claimants, they get profits.
a. Creditors are someone to whom
you owe money.
b. Partnerships are not usually
used in business anymore
because they do not protect
people from liability
c. sometimes the manager does
not have complete control, the
people who put in the most
money have most of the risk
and therefore most of the
control
2. The difference between public and private companies.
1
a. Public Companies
i. The public can buy and sell stock in it.
b. Private Company
i. It can be very difficult to sell your stock, making the
issue of control so important, the shareholders that
do not have control can find themselves stuck with
worthless stock and no control, a minority stake you
cannot do anything with or get rid of. There are
many things that can protect someone like a buy sell
agreement which can let someone out of ownership
at a latter date.
2
AGENCY LAW
3
You can form an agency relationship without knowing. The
Cargill court says “there must be an agreement, but not
necessarily a contract between the parties.”
General Notes:
i. The law of agency in Torts is Respondiot
Superior/Vicarious Liability
ii. It is the ability to exercise control that is relevant not
the actual exercise of control, but it doesn’t help to
actually exercise control.
4
iii. Agency law reaches a little farther then your sense of
fairness, it is a very far reaching doctrine, partly
because the principal will probably have more
money.
5
When you have a case of apparent authority when the
agent goes beyond their actual authority they are liable
to the principle for violating their fiduciary duty.
If there is apparent authority not only can the third
party enforce the contract against the principle, but also
the principle can enforce the contract against the third
party even though it is apparent not actual authority.
- Ratification: If the principle decides to adopt a contract
negotiated by an unauthorized person. It can be ratified
to the agent or to the third party.
Ratification
“A” acts without authority (of any kind) and
there is no grounds for estoppel.
“P” will only be bound if “P” ratifies the
contract
Ratification requires
A valid affirmation by “P”
To which the law will give effect
What types of acts constitute an affirmation by
the principal?
Affirmation can be express or implied
Principal must know or have reason
to know all material facts
Will be denied legal effect where
necessary to protect the rights of an
innocent third party
Also includes estoppel. (Note that estoppel is not truly a
form of authority. It is a bar to raising defenses to the
authority claim.)
- Inherent: Arises solely from the designation by the
principal of a kind of agent that ordinarily possesses
certain powers. Usually comes up in situations with an
undisclosed principle, or where an agent exceeds their
authority. A catch all. Inherent agency extends the
principal’s liability to acts that the principle has
prohibited to the agent but that are within the scope of
authority that agents engaged in similar activities
usually possess. (this is similar to the liability of
partners even if the partner committing the act has
concealed his membership in the partnership)
In undisclosed principal cases, what is the scope of
the agent’s authority?
“the principal is liable for all the acts . . . which
are within the authority usually confided to an
agent of that character” Watteau
6
Restatement § 195 “agent enters into
transactions usual in such business and on the
principal's account”
Authority v. Power
An agent may bind the principal even when the
agent lacks any form of actual authority
“A power is an ability on the part of a
person to produce a change in a given legal
relation by doing or not doing a given act.”
Restatement § 6
An agent’s power to bind the principal is
broader than an agent’s authority to bind the
principal
E.g., estoppel
Gorton v. Doty
Facts: parent loaning car to coach if he drives
She could not have really protected herself with a contract,
because it is not binding on a third party, although she
could then go recover from the alleged agent.
Doty really should disclaim any control over the use of her
car or if she had rented them the car then she would just
be operating a business and not acting as a principal.
7
Gay Jenson Farms v. Cargill
Facts: Warren grain elevator, Cargill big seed company
finances them with loans
Factors:
1. Cargill's constant recommendations to Warren by
telephone;
2. Cargill's right of first refusal on grain;
3. Warren's inability to enter into mortgages, to
purchase stock or to pay dividends without Cargill's
approval;
4. Cargill's right of entry onto Warren's premises to
carry on periodic checks and audits;
5. Cargill's correspondence and criticism regarding
Warren's finances, officers salaries and inventory;
6. Cargill's determination that Warren needed "strong
paternal guidance";
7. Provision of drafts and forms to Warren upon which
Cargill's name was imprinted;
8. Financing of all Warren's purchases of grain and
operating expenses; and
9. Cargill's power to discontinue the financing of
Warren's operations.
Cargill found to be principal.
The difference between banks and companies acting like
Cargill is that banks do not tinker with day to day
operations.
8
Servants and independent contractors
Principle and Agent are big categories within that context there is a
subcategory of master servant or independent contractor, you can
have an agency relationship that doesn’t fall under master servant.
• Why does the distinction matter?
– Vicarious liability depends not only on whether an agency
relationship existes, but also on the kind of agency
relationship that is involved.
– Master is liable for servant’s torts.
– Principal generally not liable for the torts of an
independent contractor
• What is the distinction?
– A servant’s physical conduct of the task is controlled or is
subject to the right of control by the master
• Note that the master does not have to actually
exercise control over what the agent does; he or she
merely needs to have the right to control the agent's
physical performance of the assigned task
– An independent contractor’s performance of the task is not
subject to the principal's control.
Consequences
P liable if A w/in P not liable except P not liable in
Scope of employment in special cases agency law
Independent Independent
Archaic Servant Contractor Contractor
(agent-type) (nonagent)
Nonagent
Nonservant
Modern PC Employee independent
agent
contractor
9
Nonagent
Restatement Nonemployee
Employee service
3d agent
provider
Liability in Tort
10
Was Lane on a frolic and detour?
Did Lane have a purpose to serve US?
Discards purpose test, not all courts agree.
Friendly goes with a fairness not a cheaper cost avoider
theory, and comes up with a broad understanding of
foreseeablity, that it is not foreseeable that he will turn the
wheels but it is foreseeable that sailors will go out and
drink and in coming back something might happen.
Three issues:
1. If some harm is foreseeable: Liability, even if the
particular type of harm was unforeseeable
2. Conduct by the servant which does not create
risks different from those attendant on the
activities of the community in general will not give
rise to liability
3. The conduct must relate to the employment
Not all courts accept (see, e.g., Clover v. Snowbird Ski
Resort), most courts now require a total abandonment of
the employment to constitute a frolic.
11
Sun Oil should be liable because it has a relatively
large interest in the successful operation of the
station
Deep pocket
Any supplier with a deep pocket and any connection
to the accident should be held liable
Risk spreading
Much like deep pocket.
Risk prevention
Liability should arise from control or right to control
the harmful activity
Holding oil companies liable causes them to instruct
their service stations to get insurance
Economic analysis
Cheaper cost avoider
Fairness
Compensation for losses
Retribution for morally blameworthy conduct
12
Sam’s belief is relevant to apparent
authority, but not implied authority
Planning implications?
The church should tell Bill he does not
have the authority to hire someone, and let
people know that all hiring has to be done by
the church
13
Ampex confirming shipping, and an internal memo from
Kay’s boss says we made this big deal and Kays is in
charge of all communications with Joyce
On what type of authority is Joyce relying?
Apparent authority, not actual authority, Kays did not
have authority to sign this letter. Nor did his boss.
The internal memorandum has significance in proving
apparent authority if you assume Joyce new about the
memorandum, and it supports the argument that there
was silence and Ampex wasn’t denying the contract.
Broad category of implied authority is “a kind of
authority arising solely from the designation by the
principal of a kind of agent who ordinarily possesses
certain powers” (Lind)
Actual implied authority: act of putting agent in
such a position leads agent to reasonably believe
he has authority
Apparent (“implied”) authority: act of putting
agent in such a position leads third party to
reasonably believe agent has authority.
All authority that is not express is implied.
Implied Authority is NOT a separate category.
What should Ampex have done to protect itself?
Again, train its agents and give notice to potential
third parties.
Form contract requiring approval by contract
manager.
Watteau v. Fenwick
Facts: Beerhouse manager, Humble, owned beerhouse and
then sold it but stayed as the manager. Beerhouse
manager only allowed to purchase certain things, he buys
other things, manager’s name is still on the door.
Humble didn’t have actual authority because he as the
agent could not have reasonably believed the scope of his
authority to include that ability,
Apparent authority?
No, the principle did not do anything to manifest to the
third party that the agent had that authority.
Inherent authority?
Yes, “the principal is liable for all the acts . . . which are
within the authority usually confided to an agent of that
character”
Former Authority
14
Sometimes you have to take steps to let people know that they no
longer have authority.
Botticello v. Stefanovicz
Facts: Couple each owns undivided half interest in the property,
tenants in common. Walter leases with an option to purchase
without consulting Mary. Plaintiff moves in pays rent and makes
improvements, Mary cashes checks. Plaintiff tries to exercise the
option, Mary says no
Court says that the martial relationship is not enough to make one
spouse the agent of the other
A marriage is not the same as a partnership.
The only real question here is did she ratify it by accepting rent
Court said no just being married doesn’t imply consent
15
it agency by estoppel, court says new trial so you have the opportunity
to argue estoppel.
Apparent authority and estoppel are similar, but in estoppel the third
party has to alter their position in order to win, and estoppel only binds
the principal not the third party.
On remand, what will Hoddeson have to prove to make out a
case of estoppel?
Acts or omissions by the principal, either intentional or
negligent, which create an appearance of authority in the
purported agent
The third party reasonably and in good faith acts in
reliance on such appearance of authority
The third party changed her position in reliance upon the
appearance of authority
Where agent had authority (of any kind) contract is binding on
both P and T.
Estoppel only binds P
16
From transactions with principal (Restatement § 389)
Use of position (Reading)
Usurping business opportunities from principal (Singer)
“Grabbing and Leaving” (Town & Country)
Most of the stuff gets fixed by disclosure, or else it is not up to the
agent to decide whether the amount is too small to report or whether it
is wrong or not
Particular Dutie
of Loyalty
Reading v. Regem
17
Facts: British sergeant while on duty goes on ride on trucks of
smugglers to help them get through without being inspected and
gets paid for it.
Crown wants money he earned
Court awards Crown money because the only reason he got the money
was because he was acting as their agent.
Court says if his position as an agent more than affords him the
opportunity for getting the money, but rather plays a predominant part
in his getting the money then he is accountable for it to his master.
“The Agent has a duty to act solely for the benefit of the principal in all
matters connected with his agency.” Restatement 2 section 387
Remedy? Constructive trust, meaning you are in reality holding the
money for the principal.
Why should we give the Principal a property right in the secret profits
of its Agent if the Principal is not damaged?
We want to discourage it, not give any incentive to engage in behavior
we consider wrong.
Note that the holding is not dependent on a measurable loss of value
to the Crown.
18
Moral condemnation
X-ref Meinhard v. Salmon: “punctilio of an honor the
most sensitive”
Full Time and Attention Provisions
Issues?
Outside activities
uncompensated
compensated (such as being a director of another
firm)
No provision for board waiver
Moonlighting?
Writing the Great American Novel?
19
Duties that trans
relations
The duty not to compete ends when the agency relationship ends, but
the duty of confidentiality extends beyond the termination of agency.
They are different duties, you cannot do much about the duty not the
compete at least in CA, but with the duty of confidentiality you can and
some people use it to extend the duty not to compete.
Non-Compete Clauses in CA
• By statute, CA law prohibits non-compete agreements “of any
kind…”
• Caveats:
– Breadth of CA statute is narrower than § 393:
• Post-employment covenants against recruitment of
customers/clients or coworkers are not proscribed.
– Other “close by” fiduciary duties unaffected:
• Post-employment covenants not to disclose/use trade
secrets;
– Express statutory exceptions
List of “factors”
To determine whether Information = “Trade Secret”
DUTY OF CONFIDEN
Information not widely known outside the firm.
Information is not widely known within the firm.
Firm tries to guard the information.
20
Information valuable both inside and outside firm.
Large costs incurred to develop information.
Information could not cheaply be duplicated.
21
PARTNERSHIP
All partners are agents of the partnership. UPA §9 … and thus each
partner owes the same fiduciary obligations that any agent owes a
principal;
Defining Characteristics:
1. For-profit, unincorporated business
2. Two or more “owners”(A & B)
3. Partners each make contribution to business (capital, labor, land,
etc)
4. Partners share profit/loss;
5. Partners jointly enjoy rights of control/management;
Caveats:
1. P-ships can vary by K many rules
22
2. P-ships hire external capital/labor without adding new partners,
one of the determining factors to determine if the new
employees or the lenders are partners is control, and sharing
profits and losses
What’s at Stake?
• Liabilities: All partners are agents of partnership and can
therefore obligate the partnership...
– …and thus all partners are personally liable on such
obligations
• Joint liability for partnership debts
• Joint & Several liability for “wrongful” act of a partner
• Control Rights: Also shared among the partners;
• Return: Profits shared equally among the partners;
– Shared pro rata on dissolution of partnership
– “Forced Sale” rights upon dissolution
• “Regulatory posture”:
– Tax treatment; regulatory classification, flow through
taxation means the partnership does not pay taxes on
profits, the individual partners do, with corporations there
is double taxation
Default rule votes based on one vote per person, not pro rata on
shares
UPA §18 provides that: “The rights and duties of the partners in
relation to the partnership shall be determined, subject to any
agreement between them, by the following rules: … (e) All partners
have equal rights in the management and conduct of the partnership
business.”
23
– …once a partnership, no need to follow default rules!
– The “trick” for organizations worried about partnership
status, but who dislike the UPA default rules:
• Either live with more default rules, or take care to
contract around them in fashion that formally resembles
them.
24
– PAs often allow for partner w/o capital contribution
• Usu. when partner has already contributed
labor/expertise
• Control
– Partnership Agreements (PAs) frequently designate one
person to have managerial power;
• Rights on Dissolution
– In such partnerships, the partner contributing capital would
have a right to her capital
All partners are agents of the partnership. UPA §9 … and thus each
partner owes the same fiduciary obligations that any agent owes a
principal;
25
agreement and exercise any rights consistently with the
obligation of good faith and fair dealing.
(e) A partner does not violate a duty or obligation under this [Act]
or under the partnership agreement merely because the
partner’s conduct furthers the partner’s own interest.
(f) A partner may lend money to and transact other business with
the partnership, and as to each loan or transaction, the rights
and obligations of the partners are the same as those of a
person who is not a partner, subject to other applicable law.
Young v. Jones
Partnership by estoppel
Investors relied on audit done by PW Bahamas, try to sue PW-US under
partnership by estoppel
Held:
No evidence of actual partnership
Plaintiffs did not show that they relied on any holding out by PW-
US
Reliance is an element of estoppel
Duties o
Agen
26
Some Examples...
• UPA § 20:
– Obligation to render true and full information on all things
affecting P-ship
• UPA § 21:
– Partners must account for profits from any transaction
connected with formation/conduct/business of P-ship
• UPA § 22:
– Each partner has a right to a formal accounting of her
rights/interests.
Partnership Opportunities
• A Partner must disclose the partnership opportunity
• Then the managing partner(s) must decide whether to act on
that opportunity
• BUT, that decision must be made in good faith.
Doctrine of Organizational Opportunities
To what extent do business opportunities of which a fiduciary
learns belong to the firm rather than the individual?
Agency Restatement § 387: “Unless otherwise agreed, an
agent is subject to a duty to his principal to act solely for
the benefit of the principal in all matters connected with
his agency.”
Corporate opportunities doctrine
Boundaries of the standard; or “there are distinctions of degree”
Joint enterprise/venture v. general partners
Andrews v. Cardozo
During the partnership v. at its end
UPA (1997) § 404(b)(1)
Geographic?
No liability if a “location far removed”
Status of partner (Managing v. silent)
Cardozo is ambiguous both as to the standard and its boundaries
Meinhard v. Salmon
27
Facts: One partner goes behind the back of the other partner and
negotiates to develop a new building after the partnership is to end.
• Why did Cardozo side with Meinhard?
– In particular, where did Salmon go wrong?
The trouble about his conduct is that he excluded his
coadventurer from any chance to compete, from any
chance to enjoy the opportunity for benefit that had come
to him alone by virtue of his agency.
• What should Salmon have done?
– DISCLOSE!
• Would disclosure alone suffice?
– “The punctilio of an honor most sensitive”
– “The thought of self was to be renounced”
• Cardozo seems to suggest that more might be required… Does
Salmon have to give Meinhard the opportunity to be a partner in
the new venture???
Policy: Is Meinhard the right default?
Hypothetical bargain
If partners can withhold new information—such as the
discovery of a new business opportunity—from each other,
then each has an incentive to drive the other out so as to
take full advantage of the information
As each incurs costs to exclude the other, or to take
precautions against being excluded, the value of the firm
declines
A legal rule vesting the firm with a property right to the
information and requiring disclosure is more efficient
Suppose Meinhard and Salmon want a different rule. Maybe that
neither partner owes fiduciary duties to the other. Is that valid?
Compare UPA (1997) § 404(b)(1) and § 103(b)(3)
Partnership agreement “may not . . . (3) eliminate the duty
of loyalty under Section 404(b) . . . but: (i) the partnership
agreement may identify specific types or categories of
activities that do not violate the duty of loyalty, if not
manifestly unreasonable”
Note the difference between a prospective waiver and a
“ratification” after the fact RUPA §103(b)(3) (ii)
Bane v. Ferguson
Facts: Bane retired from Isham, Lincoln & Beale and became entitled to
a pension that would end if the firm dissolved. Later ILB merged
with Rueben & Proctor. The merger turned out to be a disaster
and the merged firm dissolved. Bane sues, claiming
mismanagement in arranging the merger.
28
Held: “Nor can Bane obtain legal relief on the theory that the
defendants violated a fiduciary duty to him; they had none.”
At the time of the alleged violation, was Bane a partner in ILB?
No, he had a contractual relationship with the firm.
Although some might argue Bane continued to have
“partner-like” status, at least with regard to the firms
viability and profit.
The Court says ILB had no duty to Bane and even if there is a
duty the defendants are protected by the business judgment rule
(or something like it).
Harming the partnership would normally be thought of as a
violation of the duty of care, but maybe such conduct can
also be thought to be disloyal – at least if egregious
enough.
29
1. They contacted their clients in December in a way that did not
fairly give the clients a choice to stay with PC, they gained an
unfair advantage over PC(their former partners) in breach of
their fiduciary duties.
2. Until December, they lied to their partners about their plans
to leave.
A partner has an obligation to render on demand true and full
information of all things affecting the partnership to any
partner. UPA §20
Fiduciaries may plan to compete with the entity to which they owe
allegiance, “provided that in the course of such arrangements they
do not otherwise act in violation of their fiduciary duties.”
• (1) Does the holding imply that M & B have an affirmative duty
to inform the other partners of their plans to leave?
– No
• (2) Suppose that the defendants had never lied about their
intentions, and had made an announcement on private
letterhead,
– the morning after they leave the firm;
– making clear that clients could stay with firm;
Okay
Meehan is not the last word on client contact.
Context (i.e., motivations, actors, and partnership
agreement) is critical.
30
Grabbing and Leaving: Permissible v. Impermissible
Conduct
Negotiate with
Negotiate
Locate office Negotiate with associates
merger with
space fellow partners (can’t steal
another firm associates, but can
make plans known)
Contact clients
Not inform
before Remind clients
Contact clients clients of right
announce of right to
before leaving to have
departure have counsel
(probably can’t say firm counsel of own
of own choice
come with me, but choice
can relay plans)
Take client
Take desk files
files
Sent
Senttotoclients
clientswith
withwhom Does
whom Doesnot
noturge
urgeclient
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sever
lawyer had an active attorney-
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disparaging of former firm
31
Lawlis v. Kightlinger & Gray
Facts: partner becomes an alcoholic, other partners outline a series of
steps for him to take, they sign agreement that specifically says
no second chances, starts drinking again, partners outline a
series of steps for him again and this time he recovers, demands
his full partnership position back, Wampler notifies him that they
are going to recommend his severance, and they remove all files
from his office, then they vote to fire him.
Held:
Wrongful dissolution claim
Rejected by court; Wampler simply announced what
the other partners intended to do he did not dissolve
the partnership without the vote called for in the
agreement.
Breach of fiduciary duty – claiming they violated the
implied duty of good faith and fair dealing firing him for the
predatory purpose of increasing the partner to associate
ratio
Partners had right to do as they did by contract
(“guillotine” clause(no cause expulsion)) and
breached no fiduciary duty
Self interest alone does not make for a breach of fiduciary duty, it is
true they will make more money by kicking him out, but that does not
mean they are kicking him out for that purpose
32
Disassociation – when a partner leaves a law firm, instead of having
the partnership dissolved and then reformed without the partner who
left
Under the RUPA 601 there are three instances when a partner can be
disassociated
33
(b)A person admitted as a partner into an existing partnership
is not personally liable for any partnership obligation
incurred before the person’s admission as a partner.
(c) An obligation of a partnership incurred while the
partnership is a limited liability partnership, whether
arising in contract, tort, or otherwise, is solely the
obligation of the partnership. A partner is not personally
liable, directly or indirectly, by way of contribution or
otherwise, for such an obligation solely by reason of being
or so acting as a partner. This subsection applies
notwithstanding anything inconsistent in the partnership
agreement that existed immediately before the vote
required to become a limited liability partnership under
Section 1001(b).
Personal creditor seeks to attach firm assets. Can the creditor
seize partnership property to satisfy the debt?
No, because the partner can’t touch partnership
property and the creditor can’t touch more than the
partner, the creditor can get in front of money
coming out of the partnership in proportion to the
ownership interest of the partner in the partnership
Hint: UPA (1997) § 501 and 504(e)
§ 501
A partner is not a co-owner of partnership property and has
no interest in partnership property which can be
transmitted, either voluntarily or involuntarily.
§ 504(e)
This section provides the exclusive remedy by which a
judgment creditor of a partner or partner’s transferee may
satisfy a judgment out of the judgment debtor’s
transferable interest in the partnership.
Is the creditor out of luck?
No they can get in between some of the money
coming out of the partnership.
Hint: UPA (1997) § 504(a)-(b)
(a) On application by a judgment creditor of a partner or
of a partner’s transferee, a court having jurisdiction
may charge the transferable interest of the judgment
debtor to satisfy the judgment. The court may
appoint a receiver of the share of the distributions
due or to become due to the judgment debtor in
respect of the partnership and make all other orders,
directors, accounts, and inquiries the judgment
debtor might have made or which the circumstances
of the case may require.
34
(b)A charging order constitutes a lien on the judgment
debtor’s transferable interest in the partnership. The
court may order a foreclosure of the interest subject
to the charging order at any time. The purchaser at
the foreclosure sale has the rights of a transferee.
Partnership Capital
Initial capital contribution
A partner may contribute labor.
Capital Account:
The way you keep track of what you have put into
the partnership is the capital account.
A running balance reflecting each partner’s ownership
equity
UPA (1997) § 401(a)
Each partner is deemed to have an account that is:
(1)credited with an amount equal to the money
plus the value of any other property, net of the
amount of any liabilities, the partner
contributes to the partnership and the
partner’s share of the partnership profits; and
(2)charged with an amount equal to the money
plus the value of any other property, net of the
amount of any liabilities, distributed by the
partnership to the partner and the partner’s
share of the partnership losses.
Allocation of profits increases capital account
Allocation of losses decreases capital account
Taking a “draw” (distribution) decreases capital account
Alice Bob
Year 2 Capital
Account $9,000 $0
Balance
Year 3 Profit $2,000 $2,000
Solutions:
Agreement can state that the managing partner can issue a call for
additional funds and provides that if any partner does not provide the
funds called for, his share is reduced, according to the existing
formula. This is sometimes referred to as pro rata dilution.
The right to buy new shares in a company are called pro rata rights
your right to participate in any new investment at the same
percentage of your interest in the business, you want that to prevent
dilution (other people buying more of the company or you selling more
pieces of the company your share of the company decreases), and
36
punishes those who don’t reinvest, and it increases your returns the
right to invest at the same price can be incredibly useful if the shares
are becoming more valuable
37
partnership, unless the partner had no authority to act for
the partnership in the particular matter and the person with
whom the partner was dealing knew or had received a
notification that the partner lacked authority.”
Held:
• Since a majority of the partners did NOT vote to end Freeman’s
authority to buy bread on credit from Nabisco, the partnership
was not bound by Stroud’s objections.
• The partnership is bound by Freeman’s orders since he is an
agent of the Partnership
• If the Partnership is bound, then so is Stroud
• The only way for Stroud to end his potential liability was to
dissolve the partnership and notify the suppliers.
If he had gone out and bought diamonds then the question would be is
this in the ordinary course of business.
You could argue you are changing the nature of the partnership so you
need unanimity.
Planning: What terms could be inserted into a partnership
agreement to avoid these problems in the future?
Allocate controlling interests;
Appoint a “tie-breaker”;
Require unanimous partner consent before doing business
with a supplier (and notify creditors).
38
Court says plaintiff was not deprived of any legal right as a result of his
reliance on the statements. The partnership agreement sets forth in
detail the relationship between the partners and no mention is made of
plaintiff’s status in the Washington office, and the partnership
agreement seemed to embody the complete intentions of the parties
as to the management of the firm.
Breach of Contract
Under the partnership agreement partners could be admitted and
severed from the firm and the partnership agreement could be
amended by majority approval. The merger could be considered either
as the admission of new partners or the making of a new or amended
agreement, and thus majority approval was all that was required, and
a post facto change in plaintiff’s vote would be of no effect.
Plaintiff claims that the merger was such a fundamental change in the
nature of the partnership as to require unanimous approval, but
common law and statutory standards can be overridden by agreement.
Breach of Fiduciary Duty
The basic fiduciary duties are: 1) a partner must account for any profit
acquired in a manner injurious to the interests of the partnership, such
as commissions or purchases on the sale of partnership property; 2) a
partner cannot without the consent of the other partners; acquire for
himself a partnership asset, nor may he divert to his own use a
partnership opportunity; and 3) he must not compete with the
partnership within the scope of its business.
What plaintiff is alleging concerns failure to reveal information
regarding changes in the internal structure of the firm. No court has
recognized a fiduciary duty to disclose this type of information.
Background Knowledge
– Under UPA 1914, when even one partner leaves the
partnership it is dissolved, the agreement may
however contain a provision specifying that the
remaining partners will continue as partners under
the existing agreement in a continuation agreement.
– Under UPA 1997, if a partner retires pursuant to an
appropriate provision in the partnership agreement
there is a dissociation rather than a dissolution.
When there has been a dissociation, the partnership
continues as to the remaining partners and the
dissociated partner is entitled, in the absence of an
agreement to the contrary, to be paid an amount
39
determined as if “on the date of dissociation, the
assets of the partnership were sold as a price equal
to the greater of the liquidation value or the value
based on a sale of the entire business as a going
concern without the dissociated partner.” §701(a)
and (b)
Termination
3
Termination
Dissolution
Dissolution Winding Up
40
Dissolution by court order. E.g. lunatic, UPA (1914) § 32(1)
(a)
Term Partnerships
Explicit term
Duration specified in partnership agreement
Specific purpose/object specified in partnership agreement
Implicit term
Term implied by the nature of the partnership
purpose/objectives. (e.g. the partnership plans to build
and sell new condos at the “Site.”)
41
After dissolution, the partnership must be wound up, absent
agreement among the partners to carry on the business.
Assuming that the business will not be continued, the
winding up process generally contemplates that the firm’s
assets will be distributed to the partners.
Authority of partners to act on behalf of partnership terminated
except in connection with winding up of partnership business.
UPA (1914) § 33; UPA (1997) § 804.
UPA (1914) § 18
“The rights and duties of the partners in relation to the
partnership shall be determined, subject to any agreement
between them, by the following rules:
“(a) Each partner shall be repaid his contributions, whether by
way of capital or advances to the partnership property and share
equally in the profits and surplus remaining after all liabilities,
including those to partners, are satisfied; and must contribute
towards the losses, whether of capital or otherwise sustained by
the partnership according to his share in the profits.”
UPA (1914) § 40
§ 40(b): subject to contrary agreement, upon dissolution
partnership assets should be distributed as follows: “(I) Those
owed to creditors other than partners, (II) Those owed to
42
partners other than for capital and profits, (III) Those owed to
partners in respect of capital, and (IV) Those owed to partners in
respect of profits.”
§ 40(d): "partners shall contribute, as provided by [§18(a)] the
amount necessary to satisfy the liabilities [set forth in § 40(b)]. . .
."
What is the Default Rule?
Losses should follow profits
Buyout Agreements
What are the major concerns:
Restricting the right to sell “stock” to whomever I please.
Providing the right to force the company or other owners to
buy back my “stock”.
What provisions might be included in our buy-sell Agreement?
Right of First Refusal
Right to require purchase of my stock
Right of First Refusal and right of company to
purchase on dissociation are not the same, right of
first refusal is the right to preempt the sale you want
to carry out, not the company forcing you to sell.
Stock Transfer restrictions
Right of Company to purchase on death, disability,
dissociation.
Traditional buy-sell
One person gets to decide if they want out. I want to
activate buy-sell. The other person gets to set the
price. Other person gets to decide whether they
want to buy or sell at that price.
What devices can be used to establish price?
Appraisal
Formula
Book Value - add up the value, subtract the liabilities,
sometimes this is more than the value sometimes it is less
Buy sell arrangement that sets the price
Fixed amount
43
Even though this was a limited partnership we are using the
general partnership rules because Nordale was a general
partner.
The partners argue that his conduct, in contravention of the
partnership agreement, gave the court the power to dissolve the
partnership and allow them to carry on the business by
themselves.
§32 (1914) authorizes a court to dissolve a partnership when:
2. A partner becomes in any other way incapable of
performing his part of the partnership contract.
3. A partner has been guilty of such conduct as tends to affect
prejudicially the carrying on of the business.
4. A partner willfully or persistently commits a breach of the
partnership agreement, or otherwise so conducts himself in
matters relating to the partnership business that it is not
reasonably practicable to carry on the business in partnership
with him
Held:
Court says filling the complaint did not constitute a dissolution of
the partnership requiring the liquidation of the assets and
distribution of the net proceeds of the partners.
If filling the complaint was a dissolution then he would get the
current market value of the real estate which had gone up.
Review
(1) Under UPA (1914) dissociation of a partner
automatically triggered dissolution.
Regardless of whether disassociation breached Partnership
Agreement.
(2) Under RUPA §§ 701 and 801, dissolution may or may
not be triggered.
(3) But the “wrongfulness” of the dissolution (or the
dissociation) does affect the options of the parties after
dissolution or dissociation
E.g., forced sale; continuation option; suit under wrongful
dissolution
44
E.g. buyout price less damages and potential delay until end of
term
(4) Term of p-ship may be implied from other evidence
(5) Watch out for implied duties! Dissociation may
constitute breach of Partnership Agreement if in bad faith
or if the purpose is to freeze out -- breach of fiduciary
duty.
Wrongful Dissolution
• Critical question revolves around characterizing whether the
dissolution that occurred breached any express/implied terms in
the Pship Agrmnt. or occurred before the end of the Pship Term
– If “yes” => Wrongful; If “no” => Legitimate
• Two frequent situations:
– X dissolves partnership, asserting that it is a partnership at
will. Y objects, claiming that the partnership is for a term,
or for completion of a specific uncompleted task;
– X dissolves partnership, using authority given in P.A. Y still
objects, claiming that X’s decision is in bad faith,
constituting a breach of fiduciary duty.
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continue. IfIfothers
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45
• A partner who wrongfully dissociates will have to wait for
payment until the end of the term or undertaking, unless
she can show a court that there will be no “undue
hardship” to the business of the partnership. RUPA §701(h)
It is calculated at the time the dissolution occurred, then
plus interest.
Policy: What effect might the court’s ruling in Jewel have on future
law firm dissolutions?
– Incentive to dump cases right before dissolution
Meehan v. Shaughnessy
Facts:
• The Parker Coulter Partnership Agreement provides that PC
is entitled to a “fair charge” for cases removed by a
departing partner.
• PC takes all other unfinished business that is not removed
and is NOT required to pay any charge, fair or otherwise.
• This is different from the Jewel rule which was the default
rule
Held:
46
• For cases improperly removed, MB must pay damages
(less overhead) (i.e. disgorge profits)
– Winds up being 89.2% which is what their
percentage would have been had they stayed at PC.
– Money treated as constructive trust like with breach
of agent’s duty of loyalty cases.
47
• Limited Partner Liability in Limited Partnerships
• ULPA (1976): “A limited partner shall not
become liable as a general partner, unless, in
addition to the exercise of his rights and
powers as a limited partner, he takes part in
the control of the business.”
– What constitutes control?
• Holzman
• 2 Limited liability partners 1
general partner, limited
partners decided themselves
what crops to plant, to fire
the general partner, and the
agreement allowed two of
the three partners to draw
checks from partnership bank
accounts.
• RULPA (1985) § 303(a)
– Only limited partners who participate in control
can be held liable
– They can be held liable only to those who
reasonably believe based on the limited
partner’s conduct that they are a general
partner.
• But cf. Mount Vernon: A limited partner
who disregards the limited partnership
form to such an extent that he becomes
substantially the same as a general
partner has unlimited liability regardless
of a plaintiff’s knowledge of his role. At
the same time, a limited partner may
have unlimited liability for exercising less
than a general partner’s power if the fact
that he acted as more than a limited
partner was actually known to the
plaintiff.
• The Final Word: If a limited partner is known by
the creditors to be a limited partner then it
does not matter if they participate in control, it
has to be really egregious control and then the
Mount Vernon kicks in and they are liable.
• RULPA (1985) § 303(b)
– provides “ a limited partner does not
participate in control solely by consulting with
and advising a general partner with respect to
the business of the limited partnership.
48
CORPORATIONS
Introduction
49
Shareholders entitled to vote on:
Election of directors (MBCA §§ 8.03-.04)
Any amendments to the articles of
incorporation and, generally speaking, by-laws
(MBCA §§ 10.03, 10.20)
Fundamental transactions (e.g., mergers;
MBCA § 11.04)
Odds and ends, such as approval of
independent auditors
4. Liquidity
• Secondary trading markets
5. Flexible capital structure
Capital structure:
The permanent and long-term contingent
claims on the corporation’s assets and future
earnings issued pursuant to formal contractual
instruments called securities
Many ways to package such claims; e.g.,
stocks and bonds
6. The corporation is an entity with separate legal existence from
its owners
1. Legal fiction, but a useful one
2. Possesses (some) constitutional rights
3. Separate taxpayer
S Corporation
• Statutory creation of tax code.
– Usually a “close” corporation
• Principal advantage:
– Combines pass-through taxation with limited liability.
• Disadvantages:
– Constraints on # of shareholders, types of shareholders
(other companies can’t hold stock), capital structure you
can only have one type of stock capital structure, limits on
how you can deduct pass-through losses.
A simpler structure, usually a small closed corporation
Advantages: pass through taxation, and limited liability
Up till LLC’s it was the best thing to use for pass through taxation and
limited liability
A c corporation is the normal corporation
50
– The bondholder is entitled to receive a stream of payments
in the form of interest over a period of years
– At the end of the bond’s prescribed term (i.e., at maturity),
the bondholder is entitled to the return of the principal
• Creditors; not owners
• Equity securities (a.k.a. shares) represent “the units into which
the proprietary interests in the corporation are divided”
– Residual claimants: equal right to participate in
distributions of the firm’s earnings and, in the event of
liquidation, to share equally in the firm’s assets remaining
after all prior claims have been satisfied
– A limited right to participate in corporate decision making
by electing directors and voting on major corporate
decisions
Issuance of stock
• Board of directors prerogative.
– Shareholders involved only if:
• Board wants to sell more shares than are presently
authorized in its charter
• Board of directors wants to issue a new class of
shares not authorized in the charter
– So long as the charter authorizes the class of shares in
question and there are sufficient authorized but unissued
shares, the board is free to sell shares for “any valid
purpose” as long as the corporation receives adequate
consideration for the shares.
51
The incorporation process
Choosing a state of incorporation
Paul v. Virginia (US 1869) A state may not exclude a foreign
corporation engaged in interstate commerce
Foreign = another state
Alien = another country
= Inc.
(MBCA § 2.03)
1. Draft articles 2. File articles
of incorporation with Secretary
of State (not
The Colin Powell)
Contents:
Mandatory terms (MBCA §
Incorporator 2.02(a))
(MBCA § 2.01) Optional terms (MBCA §
2.02(b))
Post-Incorporation
• Draft bylaws (MBCA § 2.06)
• Organizational meeting (MBCA § 2.05)
– Name directors, if necessary
– Adopt bylaws
– Appoint officers
• Issue stock
Final Steps:
(1) Adopt By-Laws
(2) Issue Stock (SEC Filings)
(3) Appoint Officers
Promoters
• Promoter: Someone who purports to act as an agent of the
business prior to its incorporation. A “promoter” is a person who
identifies a business opportunity and puts together a deal,
forming a corporation as the vehicle for investment by other
people.
52
Principal Problem w/ Promoters:
Enter agreements and contracts with 3d parties on behalf of an as-yet
fictional corporation
1. Once the articles are filed, does the corporation become a party to
the contract?
– Yes, but not automatically. The corporation must “adopt”
the contract.
– Adoption can be effected:
• Expressly (typically by a novation); or
• Implicitly (e.g., ratification by acceptance of benefits)
– The corporation might even acquire rights under the
contract as a third party beneficiary.
2. Once the articles are filed, is the promoter liable if the corporation
breaches the contract?
– MBCA § 2.04
– All persons purporting to act as or on behalf of a
corporation, knowing there was no incorporation
under this Act, are jointly and severally liable for all
liabilities created while so acting.
– What if corporation adopts the contract?
– Promoter needs to be released from liability by other party
to the contract
3. If the articles are not filed, is the promoter liable on the contract?
– Yes. Absent an agreement to the contrary, the promoter
remains liable on the contract if the corporation never
comes into existence. MBCA § 2.04.
– It is possible that the would-be investors in the never
formed corporation are liable under partnership law,
especially if they are sharing profits and control.
4. If the articles are not filed or are defectively filed, can the
defectively formed entity (or individuals) enforce the contract?
53
• Wrinkle # 2:
– A defective incorporation:
• Contract called for a Texas corporation, but
firm incorporated in Cayman Islands.
• Result
– Camcraft is estopped to deny SGM’s corporate status
– Hence, SGM may sue to enforce the contract
• Rule?
– A third party who dealt with the firm as though it
were a corporation and relied on the firm, not the
individual defendant, for performance is estopped
• Fine distinction to be drawn between de facto corporation
and corporation by estoppel
Generic Questions
• Is it improper to incorporate your business for the express
purpose of avoiding personal liability?
– No its okay.
• Is it improper to split a single business enterprise into multiple
corporations so as to limit the liability exposure of each part of
the business? [recall Southern-Gulf Marine]
54
– No its okay.
Limited Liability
• MBCA § 6.22(b): “… a shareholder of a corporation is not
personally liable for the acts or debts of the corporation except
that he may become personally liable by reason of his own acts
or conduct”
Walkovszky v. Carlton
Facts: fragmented taxi corporation
Plaintiff Offered Two Theories:
1. All 10 corporations were part of a single enterprise
• Court’s Reaction?
– Not wrongful
55
– Drew distinction between veil piercing, gets to
shareholders, and enterprise liability, gets to larger
corporation
• What would plaintiff have to show in order to recover under the
enterprise theory?
– That Carlton did not respect the separate identities of the
corporations
• Assignment of drivers
• Use of bank accounts
• Ordering of supplies, etc
Then he could get to the assets of the other
corporations
2. Multiple corporate structure was an unlawful fraud on the public
• Court’s Reaction?
– Plaintiff’s injury unchanged by ownership structure
• By what standard will the Walkovsky court decide whether to
pierce the veil and hold Carlton liable?
– Where a shareholder uses control of the corporation
to further his or her own, rather than the
corporation’s, business, he or she will be held liable
for the corporation’s acts and debts on a principal-
agent theory.
There are three separate legal doctrines that the plaintiff might invoke
in a case like Walkovsky: (a) enterprise liability; (b) respondeat
superior (agency); and (c) disregard of the corporate entity (“piercing
the corporate veil”)
56
Basic Q: Did sister corps transgress Corp-Corp boundaries (integrated
resources for a common business purpose)?
Agency Law
– The court makes no distinction between PCV and agency
theory.
– However, issues of fraud, adequate capitalization, etc.,
ought to be irrelevant to liability under this Master/Servant
agency theory.
– Agency theory does not work well to impose liability on
individual shareholders like Carlton, since they are likely to
have authority to act as corporate offices or employees so
their acts of control will not be in their role as
shareholders.
– Agency is more useful in some parent-subsidiary situations
where e.g. executives of the parent who have no official
role in the subsidiary take control of the subsidiary.
57
avoid its responsibilities to creditors; or that one of the other
corporations will be “unjustly enriched” unless liability is shared by
all.
• Even if it was
necessary, is the case
for piercing the
company he only owns
half of equally strong?
if you don’t allow it then it creates a big incentive to put you
money in jointly owned corporations, but you are saying that
because he was stealing from Andre Andre should be able to lose
everything in the corporation, but he was mingling assets and
things with Tie-Net.
• While other states are similar, they are more “muddied” than
that stated here.
Second Prong
• Is it enough that the creditor will be unable to collect the full
amount owed unless the court pierces the veil?
– No. Sea-land is especially explicit on that point. There must
be something more: e.g., fraud or unjust enrichment.
• Is a shareholder who avoids personal liability by definition
unjustly enriched?
– More likely with torts, because you could argue with
contracts people take that into account when
contracting with the corporation
With reverse piercing you get out of the place of the shareholder, and
instead get in with the creditors of the corporation.
58
The alter ego doctrine is part of piercing it is a synonym for a unity of
purpose, a blurring of the lines between the barriers of the firms, can
also refer to a new company created that is essentially a part of an
older one.
Review
• Piercing the corporate viel (per Sea-land)
– The corporation was the controlling shareholder’s alter
ego; and
– Adherence to limited liability would “sanction a fraud or
promote injustice”
• Enterprise liability
– Such a high degree of unity of interest between the two
entities that their separate existence had de facto ceased
– Corporations not operated as separate entities, resources
are integrated to achieve a common business purpose.
59
(1) Manifestation from P to third party of Principal/Agent,
or Master/Servant?
(1) Reasonable Belief
(2) [Detrimental Reliance]
Corporate shareholders:
• One interpretation of case:
– Courts are less rigorous with requirements for proof when
the “piercee” shareholder is a corporation;
Policy: In fact, some have argued that such a rule makes
sense as a normative matter.
When you pierce the corporate veil the shareholder has unlimited
liability
There have been no cases involving piercing for publicly owned
corporations
60
• Ultra Vires Doctrine:
– Action by officers or board of directors contrary to
corporate purpose (usually as stated in charter)
– Considerably less important than it used to be:
• Most corporations have broad charter provisions
• DGCL §§ 101(b); 121(a); 124
• Today, such claims are usually couched in terms of
“wasting” corporate assets
Held: Court says they that a corporation can give a gift.
61
• Minority Oppression/Close Corporation
– Dodges can’t easily dump their shares.
Bottom Line:
– While BJR gives discretion to managers in
deciding how to pursue the corporation’s
objective (e.g., maximize SH profits), the
“waste” limitation withholds such discretion
for decisions about whether to do so.
– Thus, in spite of BJR’s protection,
management must be able to offer a
rational basis for decision.
Shlensky v. Wrigley
Facts: Shlensky was a minority shareholder in corporation that owned
the Chicago Cubs and operated Wrigley Field. P.K. Wrigley
owned 80% of the stock, refused to install lights. Cubs
consistently lost money, probably attributable to poor home
attendance which was probably attributable to lack of night
baseball. Wrigley refused to institute night baseball because he
believed that baseball was a day-time sport and that night
baseball might have a negative impact on the neighborhood, and
he says he is not motivated by profits.
• Wrigley wins
Rule of law:
– In the absence of a showing of fraud, illegality or self-
dealing by the directors, their decision is final and not
subject to review by the courts
• This is the Business Judgment Rule
– Since the courts won’t review such decisions, plaintiff has
no standing to sue
– Court assumes decision benefited Cubs, sights plausible
reasons.
62
There are fiduciary duties of the board, and they cannot be waived in
the abstract. So if you want to tailor you business for the well being of
society and you have specific provisions designed to that effect then
you can enforce those provisions. But you can’t ask minority
shareholders to waive their rights in the abstract.
When you want to use your business for your moral, political, or
charitable agenda and there are other shareholders then the BJR will
not protect you.
Fiduciary Duties
• Duty of Care
• Regulates thoroughness and diligence in performing tasks.
• Limited by BJR.
• MBCA § 8.30(a): “Each member of the board of directors,
when discharging the duties of a director, shall act: (1) in
good faith, and (2) in a manner the director reasonably
believes to be in the best interests of the corporation.
• This is a negligence standard
• Almost all duty of care issues are resolved by the business
judgment rule.
• Duty of Loyalty
• Regulates self-dealing transactions by management.
• No BJR shield
63
• Fraud
• Illegal conduct
• Self-dealing
• Egregious misconduct
Overcoming the BJR
Aronson v. Lewis (Del. 1984):
• BJR does not protect corporate fiduciaries if their
actions:
(1) are not in the honest belief that action is in best
interests of corporation…or
(2) are not based on an informed investigation…or
(3) involve a conflict of interest.
• How plaintiff go around BJR?
– Illegality or fraud;
– Conflict of interest alleged (DoL)
• How plaintiff go through BJR?
– Poor/hasty investigation of choices available and
consequences?
– Was there a “rational basis” for decision?
Reconciling the DoC and the BJR
• The duty of care tells directors don’t be negligent
– Standard of conduct is aspirational
• Business judgment rule insulates directors from liability for
simple negligence
MBCA Provisions
• § 8.30 Standard of Conduct
– “Each member of the board of directors, when discharging
the duties of a director, shall act: (1) in good faith, and (2)
in a manner the director reasonably believes to be in the
best interests of the corporation”
• § 8.31 Standard of Liability
– (a) A director shall not be liable to the corporation or its
shareholders for any decision to take or not to take action,
or any failure to take any action, as a director, unless the
party asserting liability in a proceeding establishes that:
• (1) any provision in the articles of incorporation
authorized by section 2.02(b)(4) or the protection
afforded by section 8.61 for action taken in
compliance with section 8.62 or 8.63, if interposed as
a bar to the proceeding by the director, does not
preclude liability; and
• (2) the challenged conduct consisted or was the
result of:
• (i) action not in good faith; or
• (ii) a decision
64
• (A) which the director did not reasonably
believe to be in the best interests of the
corporation, or
• (B) as to which the director was not
informed to an extent the director
reasonably believed appropriate in the
circumstances; or
• (iii) a lack of objectivity due to the director’s
familial, financial or business relationship with,
or a lack of independence due to the director’s
domination or control by, another person
having a material interest in the challenged
conduct ...
• (v) receipt of a financial benefit to which the
director was not entitled or any other breach of
the director’s duties to deal fairly with the
corporation and its shareholders that is
actionable under applicable law.
65
• Prtizker says he wants a million shares at $38.
This is a lock up.
o Lock up – why would Pritzker want this?
He is guaranteed at least $17. Plus he
may deter the bidding. It may also take
value out of the deal, and somebody who
was competing would have to pay more
than he was willing to pay.
Van Gorkom tells senior management about the deal,
and they hated the deal.
TU BOD approves the merger after 2 hour meeting,
no written studies or other documentation.
BOD approves revised deal. Shareholders approved
the deal.
This is a class action because the wrong was done to
the shareholders. In a derivative action by
shareholders, the wrong is done against the
company.
Trial court ruled in favor of the board because of the
bjr.
Business Judgment Rule does not protect:
• Fraud
• Illegal conduct
• Self-dealing
• Egregious misconduct, and
• No protection for an uninformed decision
Held:
• RULE - Says that we are not reviewing your
substantive decision. But we can review
procedural defects.
• The legal test for procedural challenges to BJR:
o Not enough procedure, no subsequent
correction, no SH cleansing of breach
o If not did SH approval of deal “cleanse”
breach
Rule = Normally this does. But the
approval must be informed. There
is cleansing when there is an
uninformed decision by
shareholders.
o Factors for “entire fairness” Cinerama v.
Technicolor
The timing
Initiation
66
Structure of the transaction
Disclosure to and approval by the
shareholders
Aggressive bargaining by fiduciary;
Fiduciary’s knowledge of business;
Whether outside valuation advice
sought;
Magnitude of premium over market
price;
Surmountability of “lock-ups” by
3rd parties
o Damages – board has to pay the
difference between $55 and the market
value . That difference may be 0 because
that was a fair price. This is an
affirmative defense that was available.
The Board’s Reliance on Chairman
- DGCL § 141(e) provides a defense for directors who rely on
reports from officers. Why didn’t § 141(e) apply here?
o Van Gorkom was uninformed
o BoD had a duty to make inquiry into the basis of Van
Gorkom’s opinion … can’t rely blindly, good faith not blind
reliance
Rule:
No protection for an uninformed decision
The determination of whether a business judgment is
an informed one turns on whether the directors have
informed themselves “prior to making a business
decision, of all material information reasonably
available to them.”
Gross negligence is the standard for determining
whether a business judgment reached by a board
was an informed one.
Who has burden of proof?
• Party attacking boards decision
67
o What “Costs” Result from Judicial Review
Hindsight bias may discourage risk-taking
Interference with internal governance
Judicial decisionmaking not subject to market
discipline:
In theory Firms whose managers make bad decisions
are weeded out in Darwinian selection
DGCL § 102(b)(7)
– Duty of Care (still) a default rule, but permits “indemnity”
provisions.
• Effectively allows charter to limit/eliminate personal
liability for directors’ breach of DoC.
– Duty of Loyalty; fraud doctrines still immutable
• But see DGCL § 122(17)
Practice Points
• After Van Gorkom (as before), ∆ s always assert BJR in DoC
actions;
• Anticipating this, π s tend to plead faulty procedure rather than
substantive “waste”
– Or, by arguing fraud/illegality/DoL
– Note: Plaintiffs must show existence of duty, breach (BJR),
causation, and damages
• Actions often easier for π s under federal law if company is
publicly traded.
68
• Remember: BJR only protects people who don’t have a conflict of
interest.
69
– Was Old Board therefore liable?
– No, because they brought in an executive compensation
expert. § 141 (e) defense (Delaware law)
– Court adds some pre-conditions to § 141(e) defense:
– the expert defense only applies if you have
asked them about their qualifications and it is
within their expertise.
Why did Eisner come out this way and Van Gorkom come out the other
way?
– Van Gorkom involved a final period problem
– Brehm involved much smaller amount in relative
terms
– Van Gorkom Board wholly abdicated its role
• Van Gorkom rests on the absence of a
sufficient record of any deliberative process
• In Brehm board at least hired an expert
What is the relationship between the bjr and the duty of care in this
case?
Here we are not even getting to the BJR rule because of
the expert defense.
70
The Business Judgment Rule and the Duty of Care
No
BJR Applies: Court abstains
Illegality
Frau Conflict No decision
d? No Egregious
of
Interest decision
N?
? Uninformed
Yes decision
BJR rebutted Yes Waste
Federal or state
Fraud claims
BJR rebutted Yes
Duty of Loyalty
BJR Illegality
Rebutted: No Decision
Did Yes Egregious decision
defendant Uninformed
violate decision
No DoC? Yes Waste
No Decision
Defendants Calculate
Win damages
see Van
Gorkom
71
o Role of business judgment rule?
None:
• Rule has no application where directors
have failed to exercise business
judgment — i.e., failed to make a
decision
• Note that the rule DOES protect a
Decision not to act.
- Is Pritchard automatically liable, because BJR doesn’t
apply?
o No. Plaintiff still has to show that Pritchard breached her
duty of care.
- Did Pritchard breach her duty of care?
o Yes – inattentive – facts that she was old, depressed,
drunk, and ignorant of business were no defense, she is
liable for losses caused by acts of insiders, like officers,
directors and shareholders.
• Even if she breached her duty of care, was it the proximate
cause of injury to plaintiffs?
– i.e., could Mrs. Pritchard have done anything about it?
• Duty to be informed:
– “Obligation of basic knowledge and supervision”
– Read and understand financial statements
– Object to misconduct and, if necessary, resign
– Sue the wrongdoers?
– Upon discovery of an illegal course of action, a director has
a duty to object and, if the corporation does not correct the
conduct to resign.
– Usually a director can absolve himself from liability by
informing the other directors of the impropriety and voting
for a proper course of action. A director who is present at
a board meeting is presumed to concur unless his dissent
is entered into the minutes of the meeting or filed promptly
after the meeting.
• Could Prichard have invoked right to rely on other
director’s/subordinates’ reports/opinions?
– Yes, but a director may not rely on subordinates when they
notice subordinates acting inappropriately.
72
organizations that receive Medicare/Medicaid funds from paying
doctors to refer patients to firm.
• Feds prosecute and civilly sue Caremark
• Caremark settles; pays $250 million
• Shareholder sues Caremark board “derivatively”
• Caremark settles shareholder suit
• Agrees to pay plaintiff attorney fees of $1 million
• Settlement requires court approval
Rules of Law:
• Does business judgment rule apply?
• No – this was a lack of oversight case; no board
decision
• Did board violate its duty of care?
• Not decided due to procedural posture
• Probably not – no evidence of “sustained failure to exercise
… oversight”
Director liability for breach of the duty of care may arise in two
distinct contexts, from a board decision that results in a loss
because that decision was ill advised or negligent, and from an
unconsidered failure of the board to act in circumstances in
which due attention would, arguably have prevented the loss.
The first case will typically be subject to review under the bjr
assuming the decision was the product of a process that was
either deliberately considered in good faith or was otherwise
rational.
Held:
• Does the board have a duty to adopt a law compliance program?
– Although court says absent grounds to suspect deception,
neither corporate boards nor senior officers can be charged
with wrongdoing simply for assuming the integrity of
employees and the honesty of their dealings on the
company’s behalf.
– Allen says yes: must “attempt in good faith to assure … a
corporate information and reporting system” to ensure
compliance with the law
Where a claim of directorial liability for corporate loss is
predicated upon ignorance of liability creating activities within
the corporation, only a sustained or systematic failure of the
board to exercise oversight such as an utter failure to attempt
to assure a reasonable information and reporting system
exists will establish the lack of good faith that is a necessary
condition to liability.
What would an “adequate” law compliance program include?
• Policy manual
• Training of employees
• Compliance audits
73
• Sanctions for violation
• Provisions for self-reporting of violations to regulators
Sarbanes-Oxley
– Makes it easier to prosecute securities fraud, particularly
financial fraud.
– Imposes greater responsibility on senior management and
directors, particularly independent directors and audit
committee members, by requiring them to take a
substantially more proactive role in overseeing and
monitoring the financial reporting process, including
disclosure and reporting systems and internal controls
– Does not purport to change the common law duty of care,
but increases civil and criminal enforcement authority over
the conduct of corporate officers and directors,
• No question that potential civil liability for directors
will be greater after Sarbanes-Oxley
The goals of Sarbanes-Oxley
Is to have some accountability for what goes into financial
statements, that more goes into financial statements, less
is hidden, and that the average investor can understand
more from looking at those financial statements.
Sarbanes-Oxley Audit Committee Requirements
• Section 301 of Sarbanes-Oxley orders SEC to adopt rules
mandating that:
• The audit committee shall receive reports from the
independent auditors regarding critical accounting polices
and practices, discussions that have taken place with
management regarding alternative treatments of financial
information under GAAP, and any accounting
74
disagreements and other material written communications
between the auditors and management
• The audit committee must establish procedures to receive
and address complaints regarding accounting, internal
control and audit issues, and to provide company
employees an opportunity to make confidential,
anonymous submissions regarding accounting and auditing
matters
YES
H a s tra n s a c tio n
b e e n " c le a n se d " ?
(D G C L § 1 4 4 )
YES NO
B u r d e n o n D e fe n d a n t
C o n flic t o f In te re s t? T r a n s a c tio n V o id a b le
(D ire c t; In d ire c t) b y C o r p o r a tio n
NO
B u r d e n o n P la in t iff
T r a n s a c tio n V a lid
DGCL § 144:
(a) Informed, Disinterested
BoD approves; “or”
(b) Informed SHs ratify; “or”
(c) Transaction is Substantively
Fair to corp.
75
Transaction b/t corp and another corp in which
fiduciary has [substantial?] financial interest
(Lewis)
Family transactions (Bayer)
If “yes”, transaction is voidable by corporation
These kind of questions really depend on what the specific
statute says.
Bayer v. Beran
This case is under the old regime
Facts: big radio advertising spending, CEO/Director’s wife gets hired.
Plaintiffs claim the radio advertising chosen for the benefit of the
wife.
BJR does not apply because of duty of loyalty is the question
here
Burden of proof with regard to breach of fiduciary duties is not
clear, but assume that once the plaintiff has shown there is
a conflict of interest it is up to the defendant to show that
it was okay even though there was a conflict of interest, to
show not only the good faith of the transaction but also to
show its inherent fairness.
Held: That her participation in the program may have enhanced her
prestige as a singer is no ground for subjecting the directors to
liability, as long as the advertising served a legitimate and a
useful corporate purpose and the company received the full
benefit thereof.
Why do they win?
– Tennyson did not get unreasonable pay
– The program was not designed to further her career
– The company obtained its money’s worth from the
radio campaign
– Non-fiduciary duty issue
– Transaction was ultra vires (illegal as beyond
corporation’s power) because no formal board action
– Holding?
– Very fact oriented analysis
– Formal procedure desirable
– But informality ok here, the directors were
executives in the company that constantly
communicated and they discussed the radio
plan, and they took a later vote that ratified
the action.
76
Facts: two private corporations same board different shareholders,
boards allow one corporation to use the land of the other
corporation at very low rent, shareholders sue
Court says that since the directors were serving on both boards they
have the burden of showing that the transaction was fair and
reasonable, and if they show that it will not be voided.
• How to cleanse: NY BCL § 713
Note first: financial indirect conflict ONLY if substantial
interest.
Three Alternative ways to cleanse:
• Disclosure to BoD & approval
– Quorum requirements
• Disclosure to SH & approval
– No apparent Quorum req’t
• Defendant can show transaction fair & reasonable at
time of approval
• Compare: DGCL § 144
Merely a financial interest for a conflict of interest.
Three Alternative ways to cleanse:
• Disclosure to BoD & approval
– No quorum req’t; but majority of disinterested
req’t
• Disclosure to SH & approval
– No apparent Quorum req’t
• Transaction fair at time of approval
– Burden of Proof?
77
No Breach Regardless
Basic of Fiduciary's Actions
Roadmap
NO No Breach
NO
Does
Fiduciary
Appropriate?
NO YES Breach
Is Prospect
a "Corporate X1
Opportunity"?
Properly X2
Reject?
No Breach Regardless
C YES
of Fiduciary's Actions
Interest / Expectancy /
Necessity
Line of Business
Guth v. Loft , 5 A.2d 503, 514 (Del. 1939): “Where a corporation is engaged in a certain
business, and an opportunity is presented to it embracing an activity as to which it has
fundamental knowledge, practical experience and ability to pursue, which, logically and
naturally, is adaptable to its business having regard for its financial position, and is one that is
consonant with its reasonable needs and aspirations for expansion, it may be properly said
that the opportunity is in the line of the corporation’s business.”
Corporate Opportunity?
The question is does the corporation have an interest, an
expectancy, or a necessity.
An interest is a contractual right, an expectancy is not a
contractual right, but something they should be offered like
a renewal right, and a necessity is something the
corporation needs to continue its business.
Also is it within the company’s line of business, not just today but
in the future, Guth v. Loft
Some states also do a fairness test, was it fair or equitable to the
corporation, hard to predict.
78
Some states combine the interest expectancy with the line of
business test
Source Based Defenses – the source of the opportunity came to the
individual in his individual capacity, for his skills or something.
Incapacity Based Defenses – the corporation could not have taken the
opportunity even if they wanted to, these types of defenses tend
to work better when they can be objectively verified by some
outside measure, like look the company did not have the money,
rather than they did not want to deal with them
“Cleansing” a Conflict
Cal. Corp. Code § 310; DGCL § 144:
• Full Disclosure to SH & approval
– Interested director should not vote shares
• Full Disc. to BoD/committee. & app./auth./rat.
– Note: § 310 – “just & reasonable” caveat, in California you
not just have to get approval it has to be just and
reasonable approval.
• Director bears burden of proving transaction just &
reasonable/entirely fair at time of approval
– Extremely difficult in corporate opportunity contexts
The Delaware corporate law was recently amended giving
corporations the power to . . . (17) Renounce, in its certificate of
incorporation or by action of its board of directors, any interest or
expectancy of the corporation in, or in being offered an
opportunity to participate in, specified business opportunities or
specified classes or categories of business opportunities that are
presented to the corporation or one or more of its officers,
directors or stockholders.
Broz v. PriCellular
Facts: Defendant sole shareholder in RFBC and on the board of another
cell phone company CIS
79
– Broker named Rhodes offers Mich-2 to Broz in Broz’s
RFBC capacity
– Wearing his RFBC hat, Broz buys Mich-2
– CIS board did not formally clear purchase, although
informal ok by CEO and some other directors
– PriCellular had also bid on Mich-2, but Broz out-bid it
– PriCellular acquires CIS
– PriCellular sues Broz for taking corporate opportunity
Delaware Law: What is the Test?
• A corporate opportunity exists where:
– Corporation is financially able to take the opportunity
– Opportunity is in the corporation's line of business
– Corporation has an interest or expectancy in the
opportunity
• Interest: Something to which the firm has a
better right
• If officer bought land to which the
corporation had a contractual right, the
officer took an “interest”
• Expectancy: takes something which, in the
ordinary course of things, would come to the
corporation
• If the officer took the renewal rights to a
lease the corporation had, the officer
took an “expectancy”
• Factors or elements?
– Unclear
• Relevance of corporation’s capacity?
– Not dispositive
– Lessens defendant’s burden by showing good faith
• Relevance of board approval or lack thereof?
– Not required
– Board approval creates a safe harbor
Held:
– Broz did not usurp a corporate opportunity
– Why?
• He learned about it in his personal capacity
• CIS was not financially capable taking the
opportunity
• It was in CIS’s line of business but it had no
cognizable interest or expectancy
• They were getting out of that business
• They had sold off several similar franchises
• Key players told Broz it was ok to go ahead
• He was under no duty to consider the future
uncertain plans of PriCellular.
80
Conflicts Under the American Law Institute Principles of
Corporate Governance
• ALI § 5.05
• Bifurcates inquiry:
• Was the opportunity in question a “corporate opportunity”
as defined by § 5.05(b)?
(1) Any opportunity to engage in a business activity
of which a director or senior executive becomes
aware, either:
(A) [i] In connection with the performance of
functions as a director or senior executive, or
[ii] under circumstances that should reasonably
lead the director or senior executive to believe
Subsection 5.05(b)(1) that the person offering the opportunity
applies to both officers and expects it to be offered to the corporation; or
directors (B) Through the use of corporation information
or property, if the resulting opportunity is one
that the director or senior executive should
reasonably be expected to believe would be of
interest to the corporation; or
(2) Any opportunity to engage in a business activity
of which a senior executive becomes aware and
knows is closely related to a business in which the
corporation is engaged or expects to engage.
• If so, was the corporate opportunity properly rejected by
the appropriate corporate actor per § 5.05(a)?
(1) The director or senior executive first offers the
corporate opportunity to the corporation and makes
disclosure concerning the conflict of interest and the
corporate opportunity.
(2) The corporate opportunity is rejected by the
corporation; and
(3) Either:
(A) The rejection of the opportunity is fair to
the corporation;
(B) The opportunity is rejected in advance,
following such disclosure, by disinterested
directors, or, in the case of a senior executive
who is not an executive, by a disinterested
superior, in a manner that satisfies the
standards of the business judgment rule; or
(C) The rejection is authorized in advance or
ratified, following such disclosure, by
disinterested shareholders, and the rejection is
not equivalent to a waste of corporate assets.
81
• What effect does rejection have under § 5.05(a)?
• How rejected determines standard of review
• Judicial review not foreclosed
• Plaintiff has burden of proving that rejection did not
satisfy BJR
• The so-called “refusal to deal” defense; see also
• Financial incapacity (Broz)
• Technical capacity (Singer)
• Functional capacity (Broz)
• None recognized by ALI § 5.05
SHAREHOLDER TRANSACTIONS
Basic principles
Shareholders acting as shareholders owe one another no
fiduciary duties
Controlling shareholders can owe fiduciary duties to the minority
controlling shareholders can control the board
Where a shareholder vote is required a court may
scrutinize whether that shareholder used the vote in an
unfair manner.
In general, transactions between a controlling S/H and the corp.
are subject to an intrinsic fairness test.
The controlling S/H will have the burden of proving the
transaction was fair to the corporation.
BUT only when a potential for self-dealing is present in the
arrangement. (i.e. when the controlling S/H can receive
something at the expense of the corp. (or the minority
S/H.))
Courts usually presume dominance at 25%.
Virtually all successful suits against dominant SHs are for duty-
of-loyalty: I.e., causing board to effect a non-pro-rata distribution
of corporate assets.
As with interested directors, once plaintiff makes this showing,
burden shifts to the defendant SH to “cleanse”…
82
Court Identifies 2 Standards of Review
Business judgment rule
BoP on plaintiff to rebut
Intrinsic fairness
BoP on defendants to show transaction was fair to
Sinven
How does court select standard of review?
Intrinsic fairness used when dominant
shareholder has received a benefit to the
exclusion and expense of the minority
shareholders of the subsidiary.
Issue 1: Dividend Policy
Standard of review?
Business Judgment Rule
Why?
Minority got pro rata share of dividends so
although self-dealing it was not to the
detriment of the minority
Issue 2: Expansion Policy
Sinclair used Sinven exclusively to develop Venezuela
properties
Business judgment rule
Plaintiff could identify no opportunity Sinclair
usurped from Sinven so although self-dealing not
detriment to the minority
This is an important point, the source of the
opportunity matters, if you get squeezed out of an
opportunity that came to you then intrinsic
fairness, if the opportunity comes to Sinclair they
don’t have to give it to Venezuela, they haven’t
taken an opportunity that was Venezuela’s.
Issue 3: Breach of Contract
Sinven sold its oil to International (another Sinclair
subsidiary)
International breached contract
Sinven did nothing
Standard?
Intrinsic fairness
Sinclair got the oil without having to comply with
contract duties
Suppose nonenforcement of contract had been
approved by a majority of the disinterested directors
and then also by a majority of the disinterested
shareholders (a.k.a. a “majority of the minority”)?
83
Shifts BoP to plaintiff to show transaction was
unfair – Wheelabrator
??? Back to BJR
Might turn on how disinterested the directors
were.
If the action is ratified instead of approved, then
standard is unclear under DGCL
Decomposing Ownership
Debt is not an ownership interest, and debt holders are not owed
fiduciary duties.
Equity
First you pay off debt and then you pay off equity.
Zahn v. Transamerica
(this case is about insider information, not conflict of interest)
Facts: Transamerica was the controlling shareholder of Axton-Fisher
Preferred stock: Not relevant
Class A stock: 2/3 owned by Transamerica
Class B stock: Almost all owned by Transamerica
Transamerica had elected majority of the board
Class A
Annual dividend of $3.20
Entitled to liquidation dividend 2x that of Class B
Convertible into Class B at option of holder
Callable by corporation at $60/share plus accrued but
unpaid dividends
Class B
Annual dividend of $1.60
Entitled to liquidation dividend ½ that of Class A
Not convertible
Not callable
Plaintiff’s allege
Transamerica caused Axton-Fisher’s board to call the Class A
shares for redemption at $80
$60 call price plus $20 in unpaid dividends
After the Class A was redeemed, the Firm was then liquidated
Allegedly to appropriate for Transamerica the increased
value of tobacco inventory
Plaintiff claims Class A would have received $240 per share if not
called before liquidation
When the boards duties to class A and class B conflict, what
should the board do?
84
The board has a duty to its lowest class of shareholders, to
the shares that are most common.
Fliegler v. Lawrence
Facts: Lawrence along with the other Agau directors decide the
corporation can’t purchase land, so they form the US Antimony
Co. and transfer the land to it, and give Agau an option to
purchase the land in the future. Agau eventually exercises that
option with shareholder ratification and the shareholders sue.
Why didn’t shareholder ratification under DGCL §144(a)(2)
protect the transaction?
The vast majority of voting shareholders weren’t
disinterested and the shareholders.
Held:
Court holds for the defendant because it was intrinsically fair.
Bottom Line:
• Unlike conflicted transactions involving directors/senior
execs
– In which informed SH ratification virtually disposes of
the claim (absent waste, fraud, illegality)
• ...When the conflict of interest involves a controlling SH
– The only method for cleansing is intrinsic/entire
“fairness”, with the initial burden on the dominant SH
– Disinterested SH ratification shifts burden
• Note: This is INCONSISTENT with wording of §
144
– Plaintiff can still win by showing intrinsic/entire
unfairness
85
Summary of “Cleansing”
(YOU DON’T REALLY NEED TO KNOW ALL THE PERMITATIONS OF BURDEN SHIFTING)
DoCSuit
Suit DoLSuit
Suit DoLSuit
Suit
DoC DoL DoL
(Director/Officer) (Director/Officer) (DominantSH)
SH)
(Director/Officer) (Director/Officer) (Dominant
§§144
144Not
NotBinding
Binding
§§144
144Not
NotBinding
Binding (a)Infm’d
Infm’dBoD BoDVote
Vote
(a)
(a) Infm’d BoDVote
Vote Generally nonohelp,
Generally help,
(a) Infm’d BoD
GenerallyBJR
BJR§§144 144Binding
Binding unlessmin
min
Generally unless
BJR doesn’t apply
(a) Infm’d BoDVote
Vote directors
BJR doesn’t apply (a) Infm’d BoD directors
gogototoDoC
DoCand/or
and/or - -Disinterested:
Disinterested:BJRBJR (b)Infm’d
Infm’dSH SHVote
Vote
(b)
(c) - Interested: go to (c) - Disint’d: gogototo
- Disint’d:
(c) - Interested: go to (c)
(b)Infm’d
Infm’dSH SHVote
Vote (b) (b)Infm’d
Infm’dSH SHVote
Vote (c1)
(b) (c1)
Absolute Defense - Disinterested: BJR - -Int’d:
Int’d:gogototo(c2)
(c2)
Absolute Defense - Disinterested: BJR
- Int’d: go to (c) (c) Fairness
- Int’d: go to (c) (c) Fairness
(c)Fairness
Fairness (c)Fairness
Fairness 1.1.Plaintiff
PlaintiffBurden
Burden
(c) (c)
-Affirmative - -Defendant
DefendantBurden
Burden 2. Defendant
-Affirmative 2. Defendant
Defense Burden
Defense Burden
(Cinerama) (Merger:
(Cinerama) (Merger:
“Entire”)
“Entire”)
86
consideration especially difficult in the Dominant SH
situation.
DERIVATIVE LITIGATION
• A derivative action is a suit in equity against a corporation to
compel it to sue a third party.
• Definition: simultaneous suits in equity by...
– (1) a SH against corp. to compel it to sue another;
– (2) the actual suit by corp. against that other party
• B/c the SH is suing “in right” of corporation…
– Any remedy from principal suit goes to corporation;
– The corporation is required to pay for the SH attorney’s
fees if suit is successful (or often if it settles).
• Why do we have this? Because you don’t have a cause of action
against the third party.
Direct and Derivative Suits
Direct
Brought by the shareholder in his or her own name
Cause of action belonging to the shareholder in his or her
individual capacity
Arises from an injury directly to the shareholder
Derivative
Brought by a shareholder on corporation’s behalf
Cause of action belongs to the corporation as an entity
Arises out of an injury done to the corporation as an entity
Derivative versus Direct actions
Direct: a suit is direct if it alleges a direct loss to the shareholder.
• Force payment of promised dividend;
• Enjoin activities that are ultra vires;
• Claims of securities fraud/blue sky laws;
• Protecting participatory rights for SHs
Derivative: a suit is derivative if it alleges a loss to the
shareholder that derives from a loss to the corporation.
(quintessential case is suit to force corporation to sue
manager for fraud)
• Breach of duty of care
• Breach of duty of loyalty
• Enjoin “management-retrenching” practices
• It can get hard to say which category it falls under, direct or
derivative.
Principal legal distinction: Is the plaintiff arguing that there was an
injury done to the corporation or was it something personal?
What’s at stake? Well, as noted, there are all these procedural
differences and attorney fee differences between the two. So the
determination is often critical.
87
Unfortunately, the “legal test” for determining whether a complaint
is derivative or direct is pretty vague and difficult to apply.
The basic rule is this: A suit is derivative if the wrong
complained of primarily constituted an injury to the
corporation, but direct if the wrong complained of primarily
constituted an injury to individual shareholders as such.
Nevertheless, courts will often conduct an inquiry into whether the
“gravaman” of the action tends toward corporate injury or individual
shareholder inquiry. But the analysis necessarily implicates
casuistry. Some examples:
• A SH is also an employee, and she was fired and forced to
sell her shares under an ESOP. This would be a direct
action. The harm emanates from her employee status.
• A SH is denied her right to inspect the books of a
corporation. Also direct: This is a right that she can
partake in individually.
• SH is denied right to exercise redemption/exchange/voting
rights. Once again, these are rights that she can
individually exercise as a SH independent of other SHs
• SH complains that directors recklessly investigated
corporate expansion, and turned the firm into a money
loser. This one’s derivative: the SHs only injury is a
general loss of profit -- a right that she can only partake in
pro rata with other SHs.
• Same for suits for corporate opportunities, executive
compensation or other DoL actions.
• Try this one: SH alleges that corporation recklessly
investigated merger possibilities, and thereby agreed to a
low-ball bid, representing to the SHs that it was a good
deal in order to get their approval for the deal. Could be
either (Van Gorkom brought as direct).
• Preferred SH sues to get a dividend paid which corporation
has decided to reinvest in firm (Dodge v. Ford). Seems
derivative, but courts often treat as direct, possibly b/c
remedy goes to SH rather than corp. But goes both ways
potentially.
• SH claims that board has “abdicated” its directorial
authority by entering into a contract that prevents it from
managing the firm (Grimes). Potentially either direct or
derivative (though note that in Grimes the claim of
abdication simply wasn’t sufficient on its own face)
Eisenberg tests
These tests help you decide if it is direct or derivative
Who suffered the most direct injury?
If corporation, suit is derivative
88
To whom did defendant’s duty run?
If corporation, suit is derivative
Called into question by Eisenberg
Plaintiff Qualifications:
Shareholder Status
MBCA § 7.41 limits standing to shareholders
Creditors may not bring derivative suit
Contemporaneous Ownership
MBCA § 7.41(1): Must be a shareholder at the time of
the alleged wrongdoing
Continuing wrongs?
§ 7.42: Must be a shareholder when suit commenced
Many states say also must remain a shareholder
through final judgment
Policy Concerns
To whom does a derivative suit belong?
Corporation
Why didn’t corporation sue?
Maybe good business reason not to sue
But maybe directors or senior managers would be
defendants, so possible conflicts of interest
Derivative suits allow shareholders to hold directors accountable
Supreme Court called it a “remedy born of stockholder
helplessness”
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Potential abuses:
Strike suits:
Nuisance suits brought for settlement value
Meritorious suits:
Settled too easily
Plaintiff-side Incentives
Any recovery goes to corporate treasury, whether by settlement
or trial victory
Lawyer is real party in interest
Lawyer can get contingent fee out of any recovery
BUT corporation also must pay plaintiff’s legal fees if there is a
substantial nonmonetary benefit
Courts quite liberal in finding such benefit
E.g., Caremark
Defendant-side Incentives
Strike suits:
Settle to go away
Meritorious suits against insider defendants:
Indemnification: Corporation must reimburse director’s
expenses if successful defense
Settlement in which director doesn’t pay anything deemed
a success
Combined Effect
Strike suits
Plaintiff counsel has incentive to bring
Management has incentive to pay
Meritorious suits
Management has incentive to settle in ways that ensure
indemnification
Plaintiff lawyer has incentive to settle so as to get on to
next case
Hence, settled too lightly
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• In some states (though not Del), a derivative
claimant with “low stakes” must post security for
corporation’s legal expenses.
• Eisenberg v. FTL Inc.
Facts: Eisenberg, a former shareholder of Flying Tiger,
brought a class action suit to enjoin (i.e., overturn)
a reorganization that allegedly had the intent and
effect of moving the operations of Flying Tiger into a
wholly owned subsidiary, with parent holding
company being inherited by the former SHs of Flying
Tiger. The specifics:
FTC’s Board did all the voting for FTL, but not
SHs of FTC.
Thus, if FTL wanted to merge or sell
all/substantially all assets to another, it
no longer needed approval of public
shareholders.
Claims:
• Eisenberg’s Complaint:
– Deprivation of voting rights to former Flying
Tiger SHs with respect to operating company.
• FTL’s Counter-argument:
– Eisenberg’s claim is derivative. Must post
security under NY law.
• Trial court:
– Held that Eisenberg was required to post
security (as per NY’s law)
Held: Reversed
• NY law (§ 627) on posting security applies...
– only to derivative actions -- not to direct
actions.
• Because harm to voting rights constitutes harm
to a shareholder rather than harm to the
corporation, Eisenberg's claim is direct.
• Test for whether action is direct or derivative?
Court applies the “Lazar” test, a suigenerous test
that states that if a corporation impairs SH’s right to
participate in governance of corporation, that’s a
direct right (granted in the stock certificate), and not
one that is merely incidental to ownership interest at
firm.
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• Cohen v. Beneficial teaches that such statutes are
presumptively substantive parts of state law, and
thus apply to diversity SH litigation
• BUT: If state law itself says that its own bonding
statute is procedural, then the question of posting
security is once again a federal one…
– …and under federal law, no security-for-
expenses statute exists.
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A substantial turnover of the board between the
transaction complained of and the filing of the suit
would make it more difficult to get by this prong you
would have to prove that the new guys are
dominated by the implicated old guys that are still on
the BoD.
Summary So Far:
• SH does not always get her day in court.
– Either board must yield to her demand,
or she must show that demand is futile
• Ostensible Purpose of Demand Requirement
– To stem the “hold-up/strike-suit”
problem, one shareholder should not be
allowed to waste the assets of other
shareholders.
• In Delaware, if demand is made, SH is usually
deemed to have conceded its necessity
– And SH would then have to demonstrate
“wrongful refusal”
– Under Delaware law, where
demand is made the plaintiff is
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deemed to have conceded that it was
required, which in turn makes the
decision of the board on whether to
dismiss a matter of business
judgment, which in turn means that
the plaintiff invariably loses.
And where demand is required, or
made, the plaintiff is not entitled to
discovery.
– Thus, well-advised SHs rarely make
demand, and instead routinely allege futility
(per Aronson rule)
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– Interested directors can’t participate in board
selection of the SLC.
• Zapata: (Minority/Del. Rule). In addition to requiring
SLC’s adequate investigation and disinterested
members, independent judicial scrutiny.
Demand Requirements
SECURITIES
Sources of Law
Securities Act of 1933
Regulates the offering and sale of new securities (primary
markets)
The 1933 is primarily a disclosure (transactional disclosure)
statute, what do you have to do and tell people if you want
to take your company public.
Securities Exchange Act of 1934
Regulates secondary market activity
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Periodic disclosures
Created the Securities and Exchange Commission (a.k.a.
SEC)
Independent agency
Enforce the securities laws
Promulgate rules and regulations to implement those
laws more effectively
The SEC looks at the adequacy of the disclosure, not
the merits.
What are “Blue Sky” Laws
State laws that regulate securities
You have to check the states where the security is being
offered or sold.
There are state and federal laws and you have to comply
with both of them.
Disclosure
Securities Act (1933)
Transactional
Registration statement filed with SEC
Prospectus distributed to investors
Required in connection with any public sale
Securities Exchange Act (1934)
Periodic
Form 10 (once)
Fork 10-K (annual)
Form 10-Q (quarterly)
Form 8-K (episodic)
Only required of registered companies
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Selling Securities under the Securities Act of
1933
Registration
Registration
Statement
Statement
Effective
Filed with SEC
Offers
No Sales
permitted but
selling allowed
no sales
activity Prospectu
SEC review:
s must be
adequacy of
delivered
disclosure, not
merits
Background
When a company goes public they issue new stock for the public
markets, and usually they have the buyers already lined up, the
investment banks kind of market the stocks and they have some
power over who gets to buy the stock, they tend to price the
stock at just below they think it is worth, so that it will go up,
after the lined up buyers buy the stock it goes to a secondary
market after it has been registered through its IPO. Since the
investment banks had control over who gets to buy the stock
they would use it as a currency giving it to people to hold on to
for a short amount of time and then sell it once it goes up to its
real price or give it to their friends. It is not clear that this is
illegal.
The idea is not that the public will read the disclosures, but that
analysts will do so, and there will be enough public sense about
the company.
What is a Security?
§2(1) of the Securities Act of 1933
“The term ‘security’ means any note, stock, treasury stock,
security future, bond, debenture, evidence of
indebtedness, certificate of interest or participation in any
profit-sharing agreement, collateral-trust certificate,
reorganization certificate or subscription, transferable
share, investment contract, voting-trust certificate,
certificate of deposit for a security, fractional undivided
interest in oil, gas, or other mineral rights, any put, call,
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straddle, option, or privilege on any security, certificate of
deposit, or group or index of securities (including any
interest therein or based on the value thereof), or any put,
call, straddle, option, or privilege entered into on a national
securities exchange relating to foreign currency, or, in
general, any interest or instrument commonly known as a
"security", or any certificate of interest or participation in,
temporary or interim certificate for, receipt for, guarantee
of, or warrant or right to subscribe to or purchase, any of
the foregoing.”
Implications of whether it is a security:
• Whether the registration requirements apply to the
transaction?
• Plaintiff’s have a much easier time bringing a fraud claim.
Great Lakes v. Monsanto
Facts:
Monsanto and STI formed NSC as a Del. LLC and put their
Nutrasweet business in it. In 1999 they sold NSC to Great
Lakes.
Great Lakes claims Monsanto & STI didn’t adequately
disclose a competitor’s, Daesang’s, activities, resulting in
overly optimistic projections, which inter alia, violated Rule
10b-5.
Great Lakes claims it was either stock, an investment
contract, or “any interest or instrumentality commonly
known as a ‘security.’”
What is the test for determining if it was a security?
(Landreth) It is unnecessary to apply the Howey
test to transactions involving traditional stock.
Insofar as the transaction involves the sale of
an instrument called stock, and the stock bears
the five common attributes of stock
enumerated in Forman the transaction is
governed by the securities laws. (Great Lakes)
As well as having the five characteristics to be
traditional stock the transaction must be an
investment transaction and not a commercial
transaction. This is determined by applying
the Howey test.
Howey test for determining if something is an
“investment contract”
A contract, transaction or scheme whereby a
person invests money
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Anything constituting legal consideration
for purposes of contract law should
satisfy the first prong of the Howey test
In a Common Enterprise
Horizontal Commonality between
investors satisfies common enterprise
element, court split whether vertical
commonality between a promoter and an
investor satisfies.
Horizontal Commonality requires a
pooling of investors’ contributions
and distribution of profits and
losses on a pro-rata basis among
investors.
Vertical Commonality is less
stringent, and requires that an
investor and promoter be engaged
in a common enterprise, with the
“fortunes of the investor linked
with those of the promoters.”
Ninth Circuit rule?
Vertical commonality
suffices but the Ninth
Circuit uses a
restrictive definition of
vertical commonality
that requires there to
be a direct correlation
between the
promoter’s returns and
the investor’s returns.
E.g., vertical
commonality
would not exist if
the promoter got
a fixed fee
irrespective of
whether the
investor made or
lost money.
Notice that you will often
have vertical commonality
where you have horizontal
commonality. The pool of
investors as a group typically
99
will be in vertical
commonality with the
promoter of the scheme.
Is led to expect profits
Solely from the efforts of the promoter or
a third party (control)
Virtually no court reads that phrase literally; in
particular, the word “solely” is read as
primarily
The test?
How much effort must the promoter put
into the project, as opposed to the
investor’s efforts, in order for the
expectation of profits test to be
met?
The critical inquiry is “whether the efforts
made by those other than the
investor are the undeniably
significant ones, those essential
managerial efforts which affect the
failure of success of the enterprise”
It is immaterial whether the shares in the
enterprise are evidenced by formal certificates
or by nominal interests in the physical assets
employed by the enterprise
Note that it is the investment scheme that is
the security, not the enterprise—not the land
or the citrus trees.
Five most common feature of stock (Forman):
The right to receive dividends contingent upon
an apportionment of profits
Negotiability
The ability to be pledged or hypothecated
Voting rights in proportion to the number of
shares owned
The ability to appreciate in value
Nothing falls under “any interest or instrument
commonly known as a ‘security’” that does not fall
under an investment contract.
Was Great Lakes investment in NSC a security and,
therefore, subject to 10b-5???
No.
It was not traditional stock because although
they meet the five Forman factors, but it was
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not an investment transaction but a
commercial transaction under the Howey test
because there was no common enterprise, and
did not involve profits solely form the efforts of
others because Great Lakes could remove
managers, and it was not an investment
contract for the same reasons.
Why would Monsanto and STI owe a duty to Great Lakes?
There is a fiduciary duty of sorts that is owed to
potential or acquiring shareholders created by the
securities act.
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The general rule is a limited partnership interest is a
security.
LLCs
Limited liability, no double taxation, flexible.
Two kinds one managed by the members, one managed by a manager
Primary Markets
Public offerings can be useful
Especially the IPO, can bring money into the company
But very expensive:
Costs associated with registration process
Lawyers
Accountants
Printers
Delay
Disclosure costs
Competitors get access to proprietary information
Subject to antifraud regime
On-going regulatory exposure
1934 Act periodic disclosure
Proxies, etc…
102
Private placement memorandum
Access to files and records
Number of units offered
Size of the offering
Manner of offering
No general advertising or solicitation
103
Everything else
Under §(a)(4) experts are not liable for misstatements in the
“non-expertised part of the document.
Under §(b)(3)(A) w/respect to “non-expertised” portions, the non-
experts must show that after reasonable investigation, they had
reasonable grounds to believe, and did believe, that the
statements were true.
Under §(b)(3)(B) roughly the same test applies to the liability of
the experts with respect to the expertised portion.
Under §(b)(3)(C) w/respect to expertised portions, the non-
experts must show that, they had no reason to believe, and did
not believe, that the statements were misleading.
Under §11(c) test for reasonable investigation and reasonable
belief:
The level of care that a prudent person would exercise if
his or her own money were at stake.
Note a defendant may reduce the damages she owes by
showing that part of the damages resulted, not from the
misstatements in the document, but rather from other
causes.
Defendant has the burden of showing that its misconduct
did not cause the plaintiff’s damages.
Defendants, other than the issuer, have the burden of
showing that they were not negligent in the preparation of
the registration statement.
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security, matters such an investor needs to know before he
can make an intelligent, informed decision.
Were there material misstatements?
Yes. They were prevalent in the 1961 figures. These
figures were “unaudited.”
Were there material misstatements in the 1960 figures (the
expertised portions)?
Yes, some
Due-diligence Defense
Bar-Chris
No due-diligence defense because they are the issuer
Only the parts of the registration statement audited by PM
were expertised
Vitolo (President) & Pugliese (VP) – directors
Little education and didn’t understand.
Court calls that irrelevant, directors have a standard of
care and V&P should have hired lawyers to review
registration statement for them.
Kircher (Treasurer-director)
Court doesn’t believe him and suggests he purposely fed
false info to Peat Marwick.
Brinbaum – director
Recently out of law school and did not investigate the
accuracy of the registration statement.
Grant (outside counsel) – director
Sued only as director not as counsel. Drafted registration
statement and did not investigate whether the answers he
received from the Company were true. No liability as an
attorney, but as a director, he has to investigate the
accuracy.
Peat Marwick – Outside auditors
PM assigned young Berardi to audit, and Berardi took the
BarChris officers at their word. He inadequately checked
statements, so PM can not claim it exercised due diligence.
RULE 10b-5
Exchange Act §10b-5 and Rule 10b-5
Section 10b provides:
It shall be unlawful for any person, directly or indirectly, by the
use of any means or instrumentality of interstate
105
commerce or of the mails, or of any facility of any
national securities exchange.—
(b) To use or employ, in connection with the purchase or
sale of any security registered on a national securities
exchange or any security not so registered, any
manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the
Commission may prescribe as necessary or appropriate in
the public interest or for the protection of investors.
• Notice that §10b applies to any security, including securities of
closely held corporations that generally are not subject to the
Exchange Act.
Rule 10b-5
It shall be unlawful for any person, directly or indirectly, by the
use of any means or instrumentality of interstate commerce, or
of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to
omit to state a material fact necessary in order to make
the statements made, in the light of the circumstances
under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business
which operates or would operate as a fraud or deceit upon
any person,
in connection with the purchase or sale of any security.
Justice Dep’t: Willful violations are a felony (see Securities
Exchange Act § 32(a).
SEC: Brings civil actions.
Private parties?
No express cause of action.
Supreme Court implied private right of action in
Superintendent of Insurance v. Bankers Life &
Casualty Co. (1971).
“The existence of this implied remedy is simply
beyond peradventure.” Herman & MacLean v.
Huddleston (1983).
“in connection with the purchase or sale of any
security” Only purchasers or sellers have standing to
sue – Blue Chip Stamps v. Manor Drug Stores
Blue Chip plaintiffs decided NOT to buy due to fraud but
had no standing
Plaintiffs said you had to sell your stock by law and
you didn’t want to so you made it look worse than it
was so we wouldn’t buy, and if we would have
bought we would have made a lot of money.
106
If you sue under 10b-5 you end up in federal court as
opposed with breach of a fiduciary duty which is a
state law issue.
If a low level person comes out and says something
incorrect the company has a duty to come out and
correct the statement
107
“whether there is a substantial likelihood that a reasonable
shareholder [or investor] would consider the fact
important” – TSC Indus., Inc. v. Northway Inc. (1976)
Whether there is a substantial likelihood that a reasonable
investor would consider the omitted fact important in
deciding whether to buy or sell securities
Effects of this standard?
Under this materiality standard, insiders will
seldom be able to defend their trades by
arguing that information is immaterial.
But how do we apply when faced with uncertain
and contingent facts?
“a highly fact-dependent probability/magnitude
balancing approach” (Basic)
Doesn’t the fact that an insider traded on a piece of
information, itself demonstrates materiality?
Materiality Factors
Nature of the information
Company response
Market response
Conduct of insiders
Reliance
To establish fraud at common law, a plaintiff must
affirmatively prove reasonable reliance on deception.
Not so under 10b-5 doesn’t have to be reasonable.
Traditionally, under 10b-5 if the case involved an
affirmative misrepresentation, courts required the plaintiff
show that he or she relied on the misrepresentation.
Material Omissions…
If the case involved a failure to disclose, courts
adopted a rebuttable presumption of reliance –
Affiliated Ute Citizens of Utah v. US (1972)
But Basic is a misrepresentation case…so what could
the Court do?
Fraud on the market theory.
Presumption that investor relied on
integrity of market price—so investor
need not have seen misrepresentation
Invoked when?
Material Public misrepresentation
Efficient market
How can defendant rebut fraud on the
market presumption?
108
Market not deceived (their
misrepresentation did not effect
the market price.)
Corrective statements
Show that specific plaintiffs would
have sold anyway
Note that any requirement of showing actual
reliance has class certification implications
with some of these things there is going to be some overlap,
especially with reliance and causation
• Rule: Fraud only needs to “touch and concern” a purchase or
sale
109
Sometimes materiality shifts depending on who
we are talking about.
Reliance
Material Omissions…
If the case involved a failure to disclose, courts
adopted a rebuttable presumption of reliance –
Affiliated Ute Citizens of Utah v. US (1972)
But Basic is a misrepresentation case…so what could
the Court do?
Fraud on the market theory.
Presumption that investor relied on
integrity of market price—so investor
need not have seen misrepresentation,
sophisticated analysts rely on the
information and they control large
financial resources and set the market
price.
Invoked when?
Material public misrepresentation
Efficient market
How can defendant rebut fraud on the
market presumption?
Market not deceived (their
misrepresentation did not effect
the market price.)
Corrective statements
Show that specific plaintiffs would
have sold anyway
Note that any requirement of showing actual
reliance has class certification implications,
that you could never bring a class action under
10b-5.
110
Easterbrook argues that even if professional
investors had heard the lie, they would have
discounted it once events made it clear that no one
was planning to buy Jefferson. If they discounted the
lie, the price of Jefferson stock would have returned
to earlier, lower levels.
Judge says it is a horizontal demand curve, there is
no demand for Jefferson stock per se such that
increasing the demand would increase the price, as
the price goes up it doesn’t matter, major investors
are not going to chose to buy less of the stock they
are going to chose to buy none of the stock, they are
choosing a stock to diversify their portfolio, they
want a specific combination of risk and return, so
they will just not buy that stock when it does not fit
and will buy another stock that fits that balance, the
price of stock will only change when investors who
control enough funds acquire new information about
the stock about the return they can expect.
111
The Pommers would have paid less if they had known
that Medtest had not obtained the patent yet
Under what circumstances should West and/or Medtest be
held liable?
West is not liable if he didn’t know the Pommers
were negotiating to buy from Manning. (Sceinter)
Medtest is liable only if West was acting as its agent.
What are the Pommers damages?
The difference between $200,000 and the amount an
investor would have had to pay who was fully
apprised of the pending patent whether or not the
patent actually issues.
The measure is what would the plaintiffs have
received but for the false denials, but the company is
going to say the false denial kept the merger going
and without it the price would have gone down, so no
damages.
112
Under 10b-5 manipulation has a very specific
meaning, practices that artificially affect
market activity for the purpose of misleading
investors.
The Federal
Wash Sales
Manipulator enters a purchase order and a sale order at
the same time through the same stockbroker
Ownership of the stock does not change but creates
the appearance of activity in a security
Matched Sales
Manipulator enters a purchase order with one stockbroker
and a sale order, at the same time and at the same price,
States
with a different broker
Sometimes involves multiple manipulators acting
together (so-called “cross sales”)
Shareholder liability
Matched purchase and sale transactions create the
false appearance of active trading
Corporate governance
Evading Santa Fe
Acme makes a very popular product
Acme’s annual report makes a great many glowing
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INSIDER TRADING
Policy:
• Why is insider trading illegal?
– Does economic analysis suggest a theory that has both
justificatory and explanatory power?
– Or should we just repeal the whole thing?
• Deregulatory arguments:
– Market efficiency
– Executive Compensation, and if shareholders don’t like it
they won’t invest in such a firm, or if they don’t mind they
won’t invest and then why should the SEC care,
– Most of it goes undetected, conveying to the public that
stock market trading is an unrigged game anyone can play
and that might be misleading
• Regulatory arguments:
– Fairness
– Property rights
• Question: Who gets harmed?
• Shareholders who
Sold? Well maybe they would have sold anyway
• Shareholders who
kept shares? Not unless the price is dropping
• Other Arbitrageurs?
Definitely harmed, but maybe it is a risk of the profession
• Acquired firm? Probably not unless you have more and more
people buying up stock on behalf of the acquirer
• The acquirer? They
might have to pay more for the firm they are acquiring
• Society
– Efficient “pricing” of
shares?
– Opportunity cost of
Corporations’ efforts
• There is an argument you don’t need 10b-5 to deal with
this because they can require that the investment bankers
not disclose and if they do then there are contract
damages there.
• If we have to strict of a rule then we can’t have stock
analysts that meet with management and try to evaluate
the company
Distinguish Between
• “Generic” 10b-5 violations (which do not involve inside
trades) and “Insider Trading” 10b-5 violations (which do.)
115
• Government (SEC) enforcement actions against violators
and private rights of action by contemporaneous traders
– Damages vs. fines and/or imprisonment
– Necessity of showing Reliance and Transaction/Loss
causation
The word insider does not appear anywhere in 10b-5, this is important
to remember because 10b-5 was created to address fraud, so the
expansion of 10b-5 to encompass insider trading really only happens
when the insider had some duty.
• Insider trading liability is premised on an omission of
material fact
– Problem: Liability for omission can only be imposed
where defendant had a duty to disclose
• Silence is not fraudulent absent a duty to
speak
– Whence comes the insider’s duty to speak?
116
Facts: Exploring mine, president demands secrecy because land
prices will go up before they can purchase the land (so
there was a good corporate justification for nondisclosure,
until the land acquisitions had been completed), insiders
trade, corporation at first denies media claims.
Posture and Holding:
• SEC action against
both individual defendants and corporation
Defendants:
The Corporate Defendant
• Why was TGS
charged with violating 10b-5?
– TGS was not a
purchaser or seller
• Status as such is only
relevant to private party plaintiff standing to
sue
– “In connection with”
• Satisfied if the press
release “would cause reasonable investors
to rely thereon” and “cause [such investors]
to purchase or sell a corporation’s
securities”
Insider Defendants
• Legal rule re insider
trading?
– Where an insider has
material nonpublic information the insider must
either disclose such information before trading or
abstain from trading until the information has
been disclosed THIS IS NOT THE LAW TODAY
– “Disclose or Abstain”
Cady-Roberts THIS IS NOT THE LAW TODAY
• Policy: Rationale for
rule?
– The federal insider
trading prohibition was intended to assure that
“all investors trading on impersonal exchanges
have relatively equal access to material
information”
Held: CA2 reverses some of the individual dismissals, and
reverses TGS dismissal.
– Note: Coates waits
till just after the press release is released, court says
not okay
117
• Ct holds that insiders must wait until info. has
had a “chance” to percolate through the
market.
• Would it be different today?
• Probably, because of the internet
Who is an Insider?
• Exchange Act § 16(b): Officers, directors, and 10% shareholders
– § 16(b) also requires such insiders to report changes in
their ownership stake, and to disgorge “short-swing”
profits from quick purchase or sale.
– But in addition, cases can involve what are known as
TEMPORARY Insiders (Harder Cases):
• Dirks.
• This will usually mean any agent who, because of
their position, is given access to trade-secret like
knowledge that is reasonably expected to be
confidential. Thus, this can include various
contractual privies, former executives, families of
insiders, etc. This is why the trading of the firm’s
geologist (not a statutory insider) is also proscribed.)
118
Going down the securitie
49 •
but it was not to the shareholders.
Dissent (Burger)
– First articulation of the “misappropriation” theory of
Insider Trading
119
Dirks v. SEC
Facts: Dirks tells his clients what he has learned from a former officer
that company is cooking books, his clients sell the stock, he
doesn’t trade. Brought up as a tipping tippee.
Held: Secrist owed a duty of some kind, but he did not breach that
duty
• Secrist’s duty to corp/SHs:
– Was he a “statutory” insider?/Did Secrist Actually
Owe a Duty to the EFA and its SHs?
• No. Secrist DID have a duty to SHs, but it was
NOT a statutory duty. He was not a
director/officer/large SH under §12. Rather he
was a former Officer.
• But, recall in TGS, the statutory label is only
sufficient (not necessary)
• Definition of a “temporary” insider: Fn
14.
• The basis for recognizing this
fiduciary duty is not simply that
such persons acquired nonpublic
corporate information, but rather
that they have entered into a
special confidential relationship in
the conduct of the business of the
enterprise and are given access to
information solely for corporate
purposes.
– If so, does Dirks “inherit” Secrist’s “Cady/Roberts”
duty (disclose or abstain)
• Not unless the insider breaches(and personal
benefit test) a fiduciary duty in disclosing, and
tippee has constructive knowledge.
120
– Does Dirks “pass it on” to his tippees?
• Court: NO. For tippee to inherit duty: Tipper
must be tipping for personal benefit.
Obviously, Dirks’ tippees have nothing to
inherit, since Dirks did not inherit a “Cady-
Roberts” duty from Secrist.
• Holding re tipping?
– In general, the tippee’s liability is derivative of the
tipper’s, “arising from his role as a participant after
the fact in the insider’s breach of a fiduciary duty.”
– A tippee therefore can be held liable only
when:
• The tipper breached a fiduciary duty(and
personal benefit test) by disclosing
information to the tippee, and
• The tippee knows or has reason to know
of the breach of duty
Tipper Liability
• Tippers...
– May Be Liable for their tippee’s trades.
• Even if tippees themselves not liable
under Dirks, tipper can still be liable
under the first half of Dirks test.
– Who give bad tips can be sued by their tippees!
– Tippers who trade: liable as insiders if Dirks test satisfied
SEC v. Switzer
Facts: Barry Switzer overheard CEO telling his wife something at a
track meet. Switzer and his pals traded on the info.
Held: Given the facts, Switzer is not liable. He is neither an insider nor
a constructive insider. Platt is not liable since a tipper violates a
fiduciary duty in giving the tip only if he profits from the breach
and Platt did not profit here. Plus even if telling the wife was a
breach of a fiduciary duty Switzer would have had to have known
or have had reason to know it was a breach
Disclose or Abstain
• The disclose or abstain regime still is present. However,
the question is “Who must disclose or abstain?” When
does the rule apply.
• Note also, that given the frequently existing confidentiality
restrictions, this becomes more of an abstain rule.
121
Is subject in
possession of
material, non -
public, info?
YES
122
Temporary insider
theory outlaws trading on the basis of nonpublic information by a
corporate “outsider” in breach of a duty owed not to a trading
party, but to the source of the information.
Full disclosure to the source of the information of plans to trade
on the information forecloses liability under the misappropriation
theory because then there is no deception, but there still might
be a state law breach of duty of loyalty.
Even when the duty doesn’t cross over, if you take information in
breach of a duty then you are still liable.
Under this theory Chirella would have been liable
Under this theory fiduciaries of the acquiring company are also
liable even though they have no fiduciary duty to the soon to be
acquired company.
The fraud is not the trading but how you acquired the
information.
According to the court there were duties to the law firm and to
the client and they were both breached
Held: 10b-5 convictions reinstated
• A fiduciary’s undisclosed use of information belonging to
his principal, without disclosure of such use to the
principal, for personal gain constitutes fraud(deception) in
connection with the purchase or sale of a security and,
thus, violates 10b-5.
– Duty of Trust & Confidence owed in misappropriation
case (under new SEC guidelines (Rule 10b5-2) when:
• Person agrees to maintain information in
confidence
• There is a history of sharing confidences so
recipient of the info knows or should know that
the person communicating the info expects the
recipient to maintain confidentiality
• Person receives the information from a spouse,
child, parent, or sibling (unless the recipient
can prove that he had no reason to know that
the information was confidential).
– Note that this is a “non-exhaustive” list.
• “Misappropriation” theory consistent with § 10(b) and Rule
10b-5
– Statute/Rule proscribe “deception” by trader “in
connection with purchase/sale” of securities.
– In this case, deception works through undisclosed
use of the principal’s info; and purchase/sale
requirement clearly met.
– Santa Fe Industries does not contradict this outcome.
Misappropriation can’t be about just any breach of
fiduciary duty, deception is required.
123
• To escape 10b-5, O’Hagan need only disclose
(to whom?)
• Probably Hagan should disclose to the
law firm and the Grand Met
• Which must give him permission?
• If you literally read the case you don’t
need permission from anyone, they just
say you have to disclose
124
trust and confidence, the rule has not been
tested yet.
US v. Willis
• But in U.S. v. Willis, a psychiatrist traded on inside
information learned from a patient in the course of
therapy.
– Relevant part of the Hippocratic Oath: Whatsoever
things I see or hear concerning the life of men, in my
attendance on the sick or even apart therefrom,
which ought not to be noised abroad, I will keep
silence thereon, counting such things to be as sacred
secrets.”
Held:
– Court determined that, based on the Hippocratic
Oath, the requisite breach of fiduciary duty had
occurred.
– Problem w/identifying relationships which are
“inherently fiduciary” in nature. Note that issues
relating to the nature of the fiduciary duty are
routinely swept under the rug.
– The real test involves a fiduciary duty that
relates to the information and relates to not
using the information for insider trading, so
not just any fiduciary duty will qualify.
125
Is subject in
possession of
material, non- NO
public, info?
YES
126
the offerer; or any subordinate officer, directer, partner,
executive, or "temporary insider" to buy any securities,
options, convertibles at any time prior to the tender offer,
unless he first makes that information publicly known
along with its source.
• Elements of a typical 14e-3 action:
– Possession of inside info. regarding tender off.
– Materiality of information
– Knows or has reason to know the info came from an
insider, director or ind.
– Purchase, sell, (or cause to be purchased/sold)
security/derivative of offeror or target without first
disclosing info to trading partner, if the bidder has
commenced or has taken substantial steps toward
commencement of the bid (e.g. formulation of a plan,
arrangement of financing, preparing tender offer
materials).
• Strict Liability:
– No breach of duty required
• Only applies to tender offers.
Penalties
• Administrative hearings against defendants under the
SEC’s direct regulation (brokers, dealers, etc.)
• Equitable relief in civil case brought by the SEC:
– Injunctions; e.g., forbidding violator from being
employed in the securities industry
– Disgorgement of profits
– Treble money sanction under ITSA
• Criminal indictment: 20 years jail and up to $5 million fine
for individuals and $25.5 million for corporate defendants
per count
– Exchange Act § 32 makes it a felony
• Private suits—rare
127
SHORT-SWING PROFITS
Section 16(a)
“Every person who is directly or indirectly the beneficial owner of
more than 10 per centum of any class of any equity security . . .
or who is a director or an officer of the issuer of such security . . .
within ten days after the close of each calendar month . . . shall
file with the Commission . . . a statement indicating his
ownership at the close of the calendar month and such changes
in his ownership as have occurred during such calendar month”
Note that this time frame
has been reduced to two
business days following
the trade.
Section 16(b)
“any profit realized by [such beneficial owner, director, or officer]
from any purchase and sale, or any sale and purchase, of any
equity security of such issuer . . . within any period of less than
six months . . . shall inure to and be recoverable by the issuer”
Insiders: § 16(b) applies only to officers, directors, or
shareholders with more than 10% of the stock
§ 16(b) applies only to companies that must register under the
1934 Act
Compare Rule 10b-5, which applies to all issuers
Equity securities
§ 16 applies only to stocks and convertible debt (you have
the right to convert it to equity, stocks)
Compare Rule 10b-5, which applies to all securities
Sale and purchase
§ 16(b) applies whether the sale follows the purchase or
the purchase follows the sale.
Shorting the stock – betting the stock will go
down, you sell the stock you own and then buy
it at a price you pick in advance
Recovery
Any recovery goes to the company
Shareholders can sue derivatively, and a shareholder's
lawyer can get a contingent fee out of any recovery or
settlement
Courts interpret the statute to maximize the gains the
company recovers
128
“This subsection shall not be construed to cover any transaction
where such beneficial owner was not such both at the time of the
purchase and sale, or the sale and purchase, of the security
involved”
129
Facts:
Occidental acquired over 20% of Old Kern’s stock in steps
(so some stock was acquired after it already owned 10%)
through a tender offer.
Old Kern mgt. negotiated a merger w/Tenneco.
Rather than become a minority SH in Tenneco, Occidental
gave Tenneco an option to purchase its stock which could
not be exercised until 6 months after the tender offer
commenced.
Tenneco sues to recover Occidental’s “short-swing” profits.
Two issues:
Did the signing of the merger agreement which gave
Occidental the “irrevocable” right to exchange its
shares constitute a “sale”?
Was entering into the option agreement with
Tenneco a “sale”?
Held: Sale not covered by 16(b). Since Occidental did not have
access to inside information, the situation did not present
an opportunity for abuse.
The exchange did not involve a “sale” within the meaning
of §16(b).
130
PROXY FIGHTS
Shareholder Meetings
• Annual
– MBCA § 7.01
• Special
– MBCA § 7.02
– Different states have variations on who can call a special
mtg. (various officers, directors and shareholders)
• For all SH meetings a quorum (of 50%) is required
• Only SHs who hold stock on the record date can vote.
• Election of directors
• Fundamental changes to the corporation
– Mergers, sales of all assets, corporate dissolutions, charter
amendments, etc.
• Shareholder resolutions
– Resolutions are usually proposed by management (e.g.
ratify an option plan)
– Shareholders may also propose resolutions to request the
board to take specific action (e.g. dismantle a takeover
defense, divest from Burma).
Proxy Voting
• A Shareholder (as principal) may appoint a proxy (a.k.a. proxy
agent) to vote his/her shares at the meeting
• Appointment effected by means of a proxy (a.k.a. proxy card)
– Can specify how shares to be voted or give agent
discretion
– Revocable
– Without the routinized proxy process, the firm would often
find itself w/out a quorum.
Voting
• Rival groups may nominate rival slates of directors, the group
w/the greatest number of votes will find its entire slate elected.
So 51% gets you complete control.
– Note a voting system called cumulative voting exists under
which major shareholders can elect the percentage of the
board members equal (roughly) to the percentage of stock
they control.
– E.g. Alan owns 300 shares and nine directors are being
elected, Alan will have 2,700 votes to allocate as he
chooses.
131
• It shall be unlawful for any person, by use of the mails or by
any means or instrumentality of interstate commerce or of any
facility of a national securities exchange or otherwise, in
contravention of such rules and regulations as the Commission
may prescribe as necessary or appropriate in the public interest
or for the protection of investors, to solicit … any proxy … in
respect of any security … registered pursuant to Section 12 of
this title
What is a Solicitation?
• “Solicit” includes not only “direct requests to furnish, revoke or
withhold proxies, but also ... communications which may
indirectly accomplish such a result or constitute a step in a chain
of communications designed ultimately to accomplish such a
result.”— Long Island Lighting Co. v. Barbash, 779 F.2d 793, 796
(2d Cir.1985).
– An environmentalist group ran newspaper and radio ads
critical of the defendant electrical utility's management.
Incumbent managers sued the environmentalists, alleging
that their ads constituted a proxy solicitation.
• Rule 14a-1(l)(2)(iv) exempts public statements of how the
shareholder intends to vote and its reasons for doing so.
• Rule 14a-2(b)(1), subject to numerous exceptions, exempts
persons who do not seek "the power to act as proxy for a
security holder" and do not furnish or solicit "a form of
revocation, abstention, consent or authorization.“
– Consequently, for example, a newspaper editorial advising
a vote against incumbent managers is now definitively
exempted.
• Rule 14a-2(b)(2) exempts solicitations of 10 or fewer persons.
• Rule 14a-2(b)(3) exempts the furnishing of proxy voting advice
by someone with whom the shareholder has a business
relationship.
132
• Levin was on the MGM board, but didn’t like the way the
incumbents (the O’Brien group) had run the firm.
• Levin organized a proxy fight to outs the incumbents.
• The O’Brien group hired a PR firm and incurred other costs at
corporate expense.
• Levin and pals contested the use of corporate funds by the
O’Brien group.
Held: Judgment for MGM. The expenses were not excessive or illegal.
Reimbursement
Basic rules:
– Can management use corporate funds to pay for expenses
they incur in conducting their proxy solicitation?
• Yes, as long as the amounts are “reasonable” and
the contest involves “policy” questions rather than
just a “purely personal power struggle”—Rosenfeld
• The firm may reimburse incumbents whether they win or
lose.
• The firm may reimburse insurgents only if they win and
only if SHs ratify the payment.
• Majority rule (called Fairchild rule): incumbents always get
reimbursed insurgents get reimbursed if they win
• Reimbursement rules can differ on at least three dimensions:
• Amount: reimburse all, part, or nothing?
• Conditionality: must you win to be reimbursed?
• Bias: favor incumbents, insurgents or neither (neutral)?
• How do we know it is a policy contest?
• What would be a “reasonable” expense?
– Disclosure statements to shareholders
– Telephone solicitations
– In person visits to major shareholders
• Wining and dining said shareholders
133
• Private jet to bring major shareholders to company
HQ
• Giving corporate contract to major shareholder
(conflict of interest)
134
• Allows qualifying shareholders to put a proposal before their
fellow shareholders
– And have proxies solicited in favor of them in the
company’s proxy statement
– Expense thus borne by the company
• What should a shareholder be allowed to include in a Proposal to
other shareholders?
• What should be excluded?
Substantive grounds for exclusion
• The proposal does not concern a proper subject for action by
shareholders (like you guys should fix Outlook, that is not really a
shareholder issue, it for the board) (this element seems to
overlap with number five)
• The proposal is illegal
• The proposal violates the proxy rules (e.g. misleading material)
• The proposal concerns a matter beyond the power of the firm to
effectuate
• The proposal relates to a company’s ordinary business
operations
• The proposal has been submitted in the past and has not
obtained much support.
– Issue with most SH proposals is not whether they will win,
but whether they will get enough support to resubmit the
proposal the next year.
Procedural aspects
• Detailed rules regarding:
– Process for excluding proposal
– Timing
– Stock holdings required
– Length of Proposal
– Submission requirements
• Number
• Prior submissions
• Showing up
Substantive grounds for exclusion
• Precatory (i.e., nonbinding) phrasing
– E.g., Dole:
• “shareholders request the Board of Directors to
establish a committee . . . for the purpose of
evaluating the impact of a representative cross
section of the various health care reform proposals
being considered by national policy makers . . .
Further, the aforementioned committee should be
directed to prepare a report of its findings.”
• Why?
135
• What happens if precatory proposal passes and board refuses to
act?
– BJR
– Rule 14a-8(i)(1):
• A shareholder proposal must be a proper subject of
action for security holders
• It must be an action which it is proper for
shareholders to initiate
• Look to state law to decide that question
– E.g., DGCL 141(a)
• If shareholders not allowed to initiate, still ok if
phrased as proposal
Delaware statute
• Section 220(b):
– Shareholder must make a written demand setting forth a
“proper purpose”
136
– A “proper purpose” is one “reasonably related to such
person’s interest as a stockholder”
• Section 220(c)
– If shareholder only seeks access to the shareholder list,
BoP on the corporation to show that shareholder doing so
for an improper reason
– If shareholder seeks access to other corporate records, BoP
on shareholder to prove requisite proper purpose.
Purposes
• Proper
– Investigate alleged
corporate mismanagement
– Collecting information
relevant to valuing shares
– Communicating with
fellow shareholders in connection with a planned
proxy contest
• Improper
– Attempting to discover
proprietary business information for the benefit of a
competitor
– Secure prospects for
personal business
– Institute strike suits
137
• NY law applies because access to stockholder lists is
a departure from the general rule that the laws of the
state of incorporation control corporate governance
law issues.
138
• AT&T had no right under either NY or Maryland law to
a shareholders’ list
• Under NY but not under Maryland law, its ally Sadler
had such a right
– In Sadler’s name, AT&T asked for both a CEDE and a NOBO
list
• Holding on choice of law: MD or NY?
– New York
– “Access to stockholder lists is a recognized exception to
the internal affairs doctrine ....”
• Review:
– What is internal affairs doctrine?
• Corporate governance issues controlled by law of
state of incorporation.
• Holding on list entitlement?
– AT&T entitled to both lists
– NCR must prepare NOBO list even if not pre-existing
• Delaware law to the contrary
• Delaware only requires preparation of CEDE list
– Why?
• Liberal interpretation of statute – “to facilitate
shareholder communication”
– Note that shareholders are on the NOBO list unless they
ask to be taken off and they never ask to be taken off.
139
SHAREHOLDER VOTING
140
Example
If there are 800 total votes:
In Favor 399
Opposed 398
Abstain 3
Result?
Passes under MBCA
Fails under Delaware (needed 401 to pass)
141
Note that after the subsequent split of A shares and the
sale of new A shares, the promoters still wind up with less
than 50% of the total votes.
Plaintiff argument
What did plaintiffs argue with regard to the validity of the
Class B shares?
That the Class B shares were invalid because they
lacked economic rights
Plaintiffs said that real shares represent the
“proprietary” interests in the corporation
Further, “proprietary” necessarily assumes an
economic interest
Holding:
The Court rejected plaintiffs' argument, holding that the
Class B shares were valid. Why?
A “proprietary” right is not just a right to profits or
distributions; a right to participate in control is also a
proprietary right. Because Class B stock had that right, it
is a valid form of stock.
The proprietary rights conferred by the ownership of
stock may consist of one of more of the rights to
participate “in the control of the corporation, in its
surplus or profits, or in the distribution of its assets.”
Only the right to management incident to ownership
may not be removed.
Note: There is no duty of loyalty issue here because future
shareholders are not owed a duty and they disclosed and
the shareholders chose to buy into it.
Incentive to mismanage
As the value of A shares falls the value of B shares could
rise.
The greater the opportunity for gain, the greater the
value of control.
The greater the mismanagement, (up to a point) the
greater the opportunity for gain.
The combination of these two propositions creates an
incentive for those with control, but little or no investment,
to mismanage and increase the value of their stock.
How else could the original Blackhawk investors have
accomplished the same thing?
Issue themselves the right to elect six directors and then
sell identical shares to the public except the public shares
could elect only 3 directors.
142
Class voting on other issues, so that they would have to be
approved by both classes.
If there were no state law prohibition, sell nonvoting shares
to the public.
If Blackhawk were a smaller close corporation we might
use a voting trust, a vote pooling arrangement or
irrevocable proxies.
143
CONTROL IN CLOSED CORPORATIONS
Galler v. Galler:
“a close corporation is one in which the stock is held in a
few hands, or in a few families, and wherein it is not at all,
or only rarely, dealt in by buying or selling”
i.e., no secondary market for shares
144
Example: J , F and A are starting a
hockey mask production center
Participants Investments
The control is not following the money.
Potential Solutions:
Voting Interes
Stroh stock:
Two classes of stock: A and B; A has the usual
incidents in ownership and B would have nothing but
J ason $10 mil. 20%
a vote (it would be bought for a trivial price) and
would be sufficient to give Alice and Freddie the vote
the want.
Common Stock:
First allocate this stock to the three in proportion to the
Freddie $6 mil. 30%
voting interests they want. Since Alice wants the greatest
interest, she would pay $5 mil. For her 50% interest. But
this means, Freddie should pay $3 mil. for 30% and Jason
should pay $2 mil. for 20%.
The problem is this leaves $8 mil. more for Jason to invest
Alice $5 mil.
and $3 mil. more for Freddie to invest. 50%
So you could have them receive nonvoting common
but they may insist on preferred stock or debt
instead (but remember if you put money in as debt
that money is not shareholder money).
You still have the issues of taxes, dividend
preference, liquidation preference, priority in
bankruptcy, cash availability for regular
interest payments, cash available to repay
principal, etc.
Class specific board members:
Three classes of stock: A, F and J.
A picks 5 board members
F picks 3 board members
J picks 2 board members
Voting Trust:
Jason would place some of his stock in trust and give
Freddie and Alice the right to direct its vote.
145
Statutes generally limit the duration of voting trusts (e.g.
10 yrs).
Vote pooling arrangements
Two or more SHs could make an agreement to pool votes
(sometimes used to avoid legal limitations on voting trusts)
Be wary of means to enforce the pooling arrangement.
Irrevocable proxies:
Although proxies are ordinarily revocable at the instance of
the shareholder, SHs (subject to certain conditions) may
grant irrevocable proxies. Generally such proxies must be
“coupled with an interest” which means that the proxy
holder must have some other interest in the firm.
The irrevocability lasts only as long as the interest.
Voting trust
An agreement among shareholders under which all of the shares
owned by the parties are transferred to a trustee, who becomes
the nominal, record owner of the shares
The trustee votes the shares in accordance with the
provisions of the trust agreement, if any, and is responsible
for distributing any dividends to the beneficial owners of
the shares
Advantages?
No possibility of shareholder deadlock, since everybody
puts their shares in the trust and trustee votes
Disadvantages?
Loss of control.
Duration – most states limit to ten years
Still possible for board to oppress
146
Vote pooling agreements: Enforcement mechanisms
Ringling Bros. v. Ringling
Facts:
Corporation used cumulative voting to elect directors
A mechanism by which the minority gets to elect some
directors
Directors are elected all at once.
Cumulative Voting: each shareholder gets number of
votes = (number of board vacancies) times (number
of shares owned).
May cast all votes for one (or more) member of the
BOD.
Ringling and Haley family factions had a written agreement
under which they were to vote together
Effect of agreement:
Ringling and Haley by combining votes were
able to elect 5
North was able to elect only two directors
In the event of deadlock, the disagreement was to be
determined by an arbitrator, Mr. Loos, who was also their
lawyer
When called upon to arbitrate the dispute, Loos decided
that the Ringlings and Haleys should vote for two
Ringlings, two Haleys, and a Mr. Dunn
The Ringlings did so
But the Haleys defected, casting all of their votes for the
two Haleys
Held: The agreement was valid, but the Haley votes should not be
counted, you cannot force them to vote but if they violate the
agreement their votes don’t count so they are not elected to the
board so we only have six directors, three to three.
If you were Loos, their lawyer, how would you have drafted the
agreement?
An enforcement mechanism for if they can’t agree, like if they
can’t agree one party gets to vote all the shares one year and
the other party gets to vote all of them the next year.
Shareholder agreements
Voting trusts
Vote pooling agreements
(E.g., Ringling)
Shareholder agreements constraining discretion of directors
Very common
Require certain persons as officers
147
Specify compensation and/or dividend policy
Require shareholder approval of board actions
McQuade v. Stoneham
Stoneham, McGraw, and McQuade own stock in the NY Giants
Shareholders agreement by which all agreed that they will
each do their best to elect each other directors and appoint
each other officers at specified salaries
McQuade fell out of favor w/Stoneham and was fired … sued,
seeking specific performance
Holding:
Stockholders may combine to elect directors, the power to
unite is, however, limited to the election of directors and is
not extended to contracts whereby limitations are placed
on the power of directors to manage the business of the
corporation by the selection of agents at defined salaries.
Directors must exercise their independent business
judgment on behalf of all shareholders
If directors agree in advance to limit that judgment, then
shareholders do not receive the benefit of their
independence.
Agreement is therefore void as a restriction on board
independence which is against public policy
Rationale sensible?
Most corporate law rules are just default provisions -- off
the rack rules which the parties are free to alter to meet
their particular needs.
When one is dealing with a close corporation, in which the
SHs naturally would want a greater voice than they would
get in the case of a public corporation, parties should have
even greater flexibility in modifying the off the rack rules
provided by the statute than normally accorded to public
firms.
But how far should this go?
Easily evaded?
Get agreement that he will be elected a director. Have by-
laws state that officers may be removed only for cause or
by the unanimous vote of the directors.
Need to make sure that amending the by-laws
requires unanimous director and/or shareholder
action.
Alternatively, employment contract coupled with stock
buy-out provision.
148
If they fire him, he can get damages and require
them to buy back his stock (so he’s not stuck with his
investment).
Clark v. Dodge
Facts:
Clark and Dodge together owned two drug companies
Clark owned 25%; Dodge owned 75%
In return for Clark revealing a valuable secret formula, Dodge
agreed to vote his shares and vote as a director to assure that
Clark would be a director and general mgr. as long as his
performance was faithful, efficient and competent and would get
¼ of the profits by salary or dividend.
Clark kept his part of the bargain and got fired by Dodge.
Holding:
Dodge reneged on his promise and should pay.
McQuade designed to protect minority shareholders who
were not party to the agreement
Where the corporation has no minority shareholders, the
rule is unnecessary
But note limiting language in contract (“as long as
his performance was faithful, efficient and
competent”); maybe invalid if goes beyond those
limited items
149
Note that the corporation could have used cumulative
voting to elect the board and then no agreement for board
election would have been necessary.
Galler v. Galler
Facts:
Shareholder agreement:
Each family gets 2 board seats
Mandated dividends
Mandatory death benefits
Holding:
Agreement Valid
Unanimity not required if:
The corporation is closely-held
The minority shareholder does not object
The terms are reasonable
Reasonable time
Co. was to pay dividends only if sufficient
earned surplus
The amount payable was reasonable.
Application?
Agreement did not have an unreasonable duration
Company was to pay dividends only if it had sufficient
earned surplus
Death benefit was reasonable
Agreement had a vote pooling component
Valid.
Why not deemed a voting trust?
No attempt to separate ownership of stock from
voting rights
Remedy?
Corporation had been unable to pay mandated $50,000
annual dividends because Aaron’s and Isadore’s salaries
exceeded those to which Emma had agreed
Isadore and Rose must account
Presumably back dividends must be paid
Emma and her appointee on board?
Presumably
They could have allowed the surviving brother to buy out the
other brother’s shares instead of forcing the surviving families to
work together.
Ramos v. Estrada
Facts:
150
The Broadcast Group had a 50% interest (later raised to just over
50%) in Television, Inc. The Ventura Group owned the other
50%.
The Ramoses had 50% of the BG stock and wound up with 25%
of TV
The Estradas and each of the other couples each had 5% of TV
The BG SHs agreed to vote their stock together to elect directors
to TV
If anyone violated the agreement, the others could purchase
their TV shares at cost plus 8% per yr.
This was probably well below market value since the FCC
granted the TV license after the investment was made and
the license must have been valuable.
At a directors’ meeting of TV, Estrada sided w/the Ventura group
ousting Ramos as president of TV
At the next BG meeting the group nominated a slate of directors
that excluded the Estradas
The Estrada’s refused to abide by that vote and the other BG
members contend they had a right to buy the Estradas’ TV stock.
Held:
Jmt. against the Estradas.
Vote pooling agreements like this are valid even if the firm
is not a statutory close corporation. It is not a “failed
irrevocable proxy.”
You cannot have a vote pooling agreement that says
that we will vote these directors who are us and we
will vote this business decision once we are elected.
You can though vote out directors who don’t make
the decision you want them to make. So this is kind
of a way to get around it.
So Ramos used an otherwise valid VPA to circumvent
the McQuade-Clark ban on non-unanimous
agreements about what directors will do.
What did the Estradas do to breach the Agreement?
Refusal to vote for the slate of BG directors which excluded
her; it was not her voting to oust Ramos
The breach is not voting to outs Ramos, because as a
director you are allowed to exercise independent judgment
and the reason the vote pooling agreement is valid is it is
an agreement as to who to vote for as directors not an
agreement as to what the directors are going to do.
Perhaps the Black-letter rule is:
(a) you can agree about how you’ll vote as shareholders,
but
151
(b) you can’t agree about how you’ll vote as directors
Unless we have a closely held corp and the
agreement is signed by all the SHs (and perhaps,
when the nonsigning minority shareholders cannot or
do not object.)
Could the members of BG explicitly agree about how they would
vote as directors?
No, BG was only half of the TV SHs.
Why would Estrada defect?
Because she has leverage even as a minority shareholder
because she can tip the balance.
Hypothetical
Agreement says: Abel will be President, Baker will be V-P, Charlie
will be Secretary, and Delta will be Treasurer
Spells out specific requirements vis-a-vis salary, dividends,
pensions, tenure in office and the like
Is it Enforceable? (Should it be?)
What if Ed is a part of the group and Ed is a 3% SH with no
office?
152
CLOSE CORPORATIONS: ABUSE OF CONTROL AND FIDUCIARY
DUTIES
Introduction
At early common law, shareholders qua shareholders had no
fiduciary obligations to firm or fellow shareholders
Some erosion vis-à-vis controlling shareholders of public
corporations (E.g., Sinclair Oil v. Levien)
More erosion in close corporation
153
Wilkes was improperly frozen out no legitimate business
reason for firing him and not re-electing him
Rule of law:
In a close corporation a majority must have some
legitimate business purpose
If so, burden shifts to minority to show there is a less
harmful alternative to the minority’s interest
If so, court must balance the legitimate business
purpose against the practicability of proposed
alternative
Bottom line:
This leave us with a new standard of fiduciary duty that is less
strict than that which partners owe each other, but stricter than
the BJR at least in Massachusetts, but see Nixon v. Blackwell for
Delaware law.
154
Would the parties have agreed to employment
agreements that did not allow for termination for
cause?
Note how this allows one to bypass McQuade.
Requirement of dividend payments?
Buy-out agreement under which the parties are required to
buy out a disgruntled investor.
What is an argument against expansion of the fiduciary duties
among SHs?
Investors are heterogeneous.
Some investors may prefer more flexibility and less
stringent fiduciary standards, while others prefer
stricter standards and less flexibility.
Under pre-Wilkes law, the former could
incorporate, while the latter could form
partnerships.
Courts maximize investor welfare by letting investors
choose the form best suited to their business, which
requires different legal rules for shareholders and partners.
Could Wilkes have been decided using other principals we
have already covered?
Directors breach of duty of loyalty (self-dealing) for
payment of excessive salaries so BJR would not apply
(note court would probably not order dividends or
hiring of Wilkes)
You could argue that if you are a group acting
together just like a controlling shareholder would so
you have fiduciary duties. Controlling SH group
engaged in self dealing must show inherent fairness.
Smith v. Atlantic Properties (Prof. thinks case is ridiculous but it’s out
there)
Facts:
Shareholder agreement constraining director discretion (to avoid
potential for freeze-outs)
Requires shareholder approval of board actions by a
supermajority (80%) vote
Because each shareholder owned 25% of the stock, each
had an effective veto
Dispute arose as to how earnings should be expended
Majority wants to pay dividends
Wolfson wants to reinvest
Tax implications
Maximum marginal tax rate on ordinary income:
155
Dividends tax as ordinary income
Maximum capital gains tax rate:
Accumulated earnings tax (unreasonable accumulation of
corporate earnings and profits).
Holding:
A minority shareholder, at least where he has a veto power
over corporate action, has fiduciary duties to the majority
Wolfson’s use of his veto power was inconsistent with that
duty because it subjected the corporation to an
unnecessary assessment of penalty taxes
It is just that Wolfson let his bad feelings show too
much and failed to produce a plan for improvements.
Sinclair Analysis
Under Sinclair, if a SH is not controlling, they are not liable.
Since when does a 25% block control a 75% block.
Even if Wolfson is treated as a controlling SH, he gained no
benefit at the expense of the others so no liabiltiy.
To the extent the Wilkes line of cases makes sense, it makes
sense in the context of freeze-outs, NOT SH deadlocks. In a
freeze-out the SH block earns a return at the expense of the
others.
156
later that yr. (A $50 mill. valuation for D&P was being
discussed.)
Hansen let Jordan work through the end of the year so
Jordan could get the higher book value that would then
apply to the sale of his stock.
Jordan worked through December and tendered his stock.
Two years later D&P was eventually acquired in an LBO by
an employee trust.
Jordan sued for rescission
Held:
Jordan has a cause of action under Rule 10b-5 (for failure
to disclose material information) and state law fiduciary
duties. If proven, he would only be allowed a damages
remedy, not rescission.
Posner dissents
157
Easterbrook says D&P could not have fired Jordan
just to prevent his earning money on the merger.
Posner says yes they could. But maybe not in a close
corp. under Wilkes. Because the people doing the
firing on the board are also the people who are going
to benefit. But we also have the shareholder’s
agreement that says that owning stock doesn’t add
any rights as far as employment.
158
TRANSFER OF CONTROL
Control Premium
Why would you want control?
Two main reasons:
o You think you can add value to the company,
maybe by putting in the right people.
o Put yourself in as an officer and give yourself a
nice salary, in a public company with a lot of
shareholder’s this is not going to be scrutinized
as strictly. (but can’t be self-dealing)
Issues
• The purchase and sale of control is subject to special
regulation b/c these purchases are no ordinary purchases
of stock.
• Two main issues:
– The payment of a control premium
• Should a controlling shareholder be free to sell
at that premium? Fairness to the other
shareholders?
– The sale of corporate offices
159
• Courts are often suspicious when a buyer finds
a corporate office attractive enough to pay
money for it.
Frandsen v. Jensen-Sundquist
Facts:
• The Jensen family owned 52% of JSA and JSA owned a
majority of the shares of the First Bank of Grantsburg.
• Frandsen owned 8% of J-S.
• The Jensen family had a right of first refusal agreement
with the minority SH.
• JSA announces a merger w/1st Wisconsin Bank at $62 per
share.
• Frandsen claims he has a right of first refusal.
Held:
• RFR does not apply.
• If the transaction had originally been structured as a
sale of the FBG asset, then there would be no issue
he would have had no case.
• Even the original structure is ok, since a merger is
not the same as a sale of stock.
Control Premiums
• Why would someone pay a control premium?
– They believe that control shares may carry special
benefits in the form of generous salaries, perks, etc.
• Is the noncontrolling SH harmed by this?
160
– Shares may be worth more in the hands of a new
owner b/c the incumbent is doing a poor or avg. job
of managing the business.
• If so, why wouldn’t the buyer, want to buy all
the outstanding shares?
• Risk
Perlman v. Feldmann
Facts:
• Feldmann, family and friends owned 37% of common stock
of Newport, a steel maker, and controlled the corp.
• There was a steel shortage due to the Korean war, but
ethical/reputational restraints kept Newport from raising its
prices.
• Newport did force buyers to pay interest-free advances
(the “Feldmann Plan”)
• The Feldman group sells their shares to Wilport, an end-
user of steel for $20/share (market price was $12/share)
• Plaintiffs sue to force the Feldmann group to share the
control premium.
Held:
• Judgment for the plaintiffs.
• What breach of fiduciary duty did the court have in mind?
• The court thinks that Feldmann has cashed out a
corporate opportunity, namely, the Feldmann Plan.
• Once Wilport has control, it will be able to buy steel
from Newport at posted prices, w/out giving low
interest loans.
• So there will be no more loans to modernize Newport
facilities.
• If this is correct, then perhaps the suit should be against
Wilport; Feldmann just hands over control. Newport is
taking the corporate opportunity
• Dissent finds the majority position confusing; I agree.
• Any suggestion in this case that there may be
something wrong w/premiums for control standing
alone has not been reflected in subsequent decisions
of other courts. View the case as a unique set of
facts.
What you should take from this case is that control premiums are okay
but there is an opportunity to argue that the premium not just for
control but something impermissible and therefore that portion of the
premium is inappropriate.
161
• Yates owned 28% of Republic Pictures and agreed to sell
that interest to Essex.
• As part of the deal, Yates promised to deliver a board
loaded w/Essex nominees
• Yates had board members resign one at a time while the
other board members replaced them w/ Essex nominees.
• When the Republic stock rose, Yates tried to renege on the
deal, claiming that delivery of an Essex dominated board
was legally impermissible.
• District Court awards summary judgment to Yates
Held: Reversed (with three different positions taken by the three
member panel)
• Lumbard:
• The sale of a control block of stock at a premium is
permissible, but sale of an office is not.
• It is okay to received payment for the immediate
transfer of management control to one who has
achieved majority share control but would not
otherwise be able to convert that share control into
operating control for some time.
• Were Essex buying a majority interest in the firm, the
arrangement would be unobjectionable, since Essex
would eventually obtain control of the board, but one
must bear in mind the prohibition of a “naked office
sale.”
• Essex is buying less than a majority, but b/c Republic
is publicly held, Essex’s 28% gives it control of the
board anyway. If so the arrangement is permissible.
Unless Yates can prove that 28% would not let Essex
gain control of the board.
• Clark:
• Cases like this should be decided on their facts
without so much doctrinal guidance. Summary
judgment is improper.
• Friendly:
• Directors owe a fiduciary duty to all SHs, not just to
the controlling SH. When directors replace resigning
directors, they must elect the nominee whom they
believe would best serve the interests of the corp.
Directors who automatically elect the purchaser’s
nominee violate that fiduciary duty. BUT, this
conclusion is unexpected and should not be applied
retroactively so reversal is proper.
• If Yates held only 3% of the stock would the result have
been different?
162
• It would not have been okay because it is clear he is not
selling control, but the directors positions.
• If a 51% SH can demand a control premium, why can’t a
4% SH?
• Is a 4% SH more likely to exploit and less likely to
add value?
• Yes, it is a lot more effort to raise the value of
the company and therefore the value of your
stock rather than just exploit for your own gain.
• Under NY and Delaware law there are restrictions (or
potential restrictions) against removing directors without
cause.
Problems:
Problems p. 714
1. none whatsoever
2. you have to ask about the possibility of a freeze out
163
MERGERS AND ACQUISITIONS
Merger v. Consolidation
Constituent Corporations
Categorizing Deals By Corporate Governance Aspects
Negotiated acquisitions Merger
Target is willing to be bought; key issues:
Mechanics by which the acquisition takes place
Duties of management in selecting and negotiating
with a bidder Ajax
Acme Inc.
Risk that competing bidders will try to buy the target
out from under the initial bidder.
Hostile acquisitions
Corporatio
Key issues:
How can the target defend itself against the raider?
What can the raider do to defeat those defenses?
Often lead to corporate control auctions
Key issue: What can target do to influence the
outcome of the auction? Consolida
Available Techniques
Merger
also Consolidation
Sale of assets
Ajax
Proxy contest
Acme Inc.
Tender offer
Stock purchases
Corporatio
Tender Offers
What is a tender offer?
164
A tender offer is simply a public offer usually made to all
shareholders of the target corporation in which the buyer
offers to purchase target company shares
You simply offer to buy any and all shares tendered
Principal Distinguishing Characteristics
Mergers and sales of assets require approval by the target’s
board of directors.
In contrast, none of the other techniques require target board’s
approval:
A proxy contest does not require board approval, although
a shareholder vote is still required.
A tender offer doesn’t require either board approval or a
shareholder vote — if 50.1% of the shares are tendered to
the buyer, the buyer wins.
A stock purchase will have the same effect as a tender
offer.
When To Bypass The Board?
The board refuses to sell at any price
The board is holding out for a price higher than the bidder is
willing to pay
The board is holding out for side-payments
Mergers v. Asset Sales
Merger takes effect when the articles of merger are filed with the
requisite state official
Key events thereupon take place by operation of law
Statutory sale of assets is much more complicated
As a result, the mechanics of transferring control and
consideration are more complex
165
Sale of Assets
More choice
Target
When a merger becomes effective, the separate existence of all
corporate parties, with the exception of the surviving
corporation, comes to an end
In an asset sale, the target company remains in existence at
least for a little while after the asset sale has been completed
Only title to the assets change hands, both corporations
remain alive.
Ease of transferring assets
2
In a merger, title to all property owned by each corporate party
is automatically vested in the surviving corporation
In an asset sale, documents of transfer must be prepared with
respect to every asset being sold and those documents must be
Target li
filed with every applicable agency
E.g., a deed of transfer will have to be properly filed with
every county in which the target owns real estate.
Bo
Successor liability
Target
typ
Shareholders 166
In a merger, the surviving company succeeds to all liabilities of
each corporate party
In an asset sale, subject to some emerging tort doctrines, the
company purchasing the assets does not take the liabilities of
the selling company unless there has been a written assumption
of liabilities
Ease of passing consideration
In a merger, the consideration passes to nondissenting
shareholders
In an asset sale, the process of distributing the consideration to
the target’s shareholders is more complicated
Since the target is still in existence one option is to
distribute the consideration as a dividend
More often the target is formally dissolved and its
remaining assets (including the consideration paid in the
acquisition) are distributed to its shareholders in a final
liquidating dividend
Shareholder Voting and Appraisal
Avoid voting whenever possible.
Cumbersome and expensive
Might vote No
Appraisal rights (sometimes called “dissenters’ rights”) give
dissenting shareholders the right to demand that the corporation
buy their shares at a judicially determined “fair market value”
The prospect that any significant number of shareholders
exercise them will threaten the acquisition
Shareholder Voting and Appraisal in Standard Merger
Approval
Both company’s boards
Both company’s shareholders
Appraisal
Available to shareholders of both corporations in some
states.
Some states (like Delaware) eliminate dissenters’ rights
(i.e. appraisal rights) for public corporations.
Shareholder Voting and Appraisal in Asset Sale
Delaware § 271 requires approval of a sale of substantially all the
corporation’s assets by the board and shareholders of the selling
corporation
Shareholder approval must be by a majority of the
outstanding shares
Delaware does not require that the shareholders of the
purchasing corporation approve the transaction. Only the board
of the purchasing corporation need approve the transaction
167
Nobody gets appraisal rights under Delaware law in an asset sale
transaction
Mergers: Summing Up
Step 1 (Ex. under Del. law)
T and A boards adopt Merger Agreement
A’s charter can be amended at this point
Allows cash and securities other than Acquirer common as
consideration
Step 2
SH vote at A and T: majority of shares entitled to vote
thereon
Step 3
Filing [M.A. or “certificate”]--merger effective at this point
Appraisal rights
No A.R. if stock of constituent corp is listed--A and T are
both listed; otherwise yes.
Triangular Transactions
Provides the transaction cost-minimizing advantages of an asset
sale, while also providing the advantages of a merger
Buyer sets up a shell subsidiary—call it NewCo
NewCo will be capitalized with the consideration to be paid
to target shareholders in the acquisition — cash, debt or
equity securities of the buyer
NewCo then merges with the target
In a forward triangular merger, NewCo will be the surviving
entity
In a reverse triangular merger, the target will be the
surviving entity
169
Court says: “even though you structured your transaction as a
triangular merger or asset sale, we are going to treat it as a
regular two-party merger”
Result: Buyer’s shareholders get the right to vote and the right to
dissent
Delaware Law
Is de facto merger good law in Delaware?
No, per Hariton v. Arco Electronics
Why did Delaware reject de facto merger doctrine?
Doctrine offends the equal dignity of the merger and asset
sale provisions of the statute
Regulatory Arbitrage OK in Delaware
Court says there is no reason why the statute couldn’t provide
different routes to the same result, with different levels of
shareholder protection. But why?
The statute provides various ways of accomplishing an
acquisition
No one acquisition technique is always appropriate
De facto merger increases uncertainty and eliminates the
advantages of multiple acquisition formats
Pennsylvania Law
Pennsylvania courts latched onto de facto merger at an early
date
Many of the classic cases are Pennsylvania cases
Filled with platitudes like: Form should not be elevated
over substance
The Pennsylvania legislature kept adopting statutes designed to
limit it
Pennsylvania courts eventually got the message and pretty
much stopped using the doctrine
170
GA is losing money—selling assets could mean loss of tax loss
carry forwards
GA owns coal mines
To transfer to List in an asset deal means many deeds and
real estate transfer taxes
Why structure transaction that way?
List sold its assets to Glen Alden for Glen Alden stock
List board and shareholders approved the sale
Glen Alden shareholders get no appraisal rights
List SHs wind up owning 76.5% of GA shares
Why did GA shareholders get to vote?
GA apparently had insufficient authorized but unissued
shares of stock to distribute to L
Accordingly, needed to amend the articles of
incorporation
Under Delaware law, shareholders in a merging corporation had
dissenters’ rights; shareholders in a corporation selling its assets
did not
Under Pennsylvania law, both shareholders in merging
corporations and shareholders in corporations selling their assets
had dissenters’ rights
If merged in a statutory merger, the boards of both and the
shareholders of both would have voted on the merger
If GA sold its assets to L, GA shareholders would have gotten
appraisal rights
Holding? When is a de facto merger is present?
When a transaction so fundamentally changes the nature
of the business as in effect to cause the shareholder to
give up his shares in one company and against her will
accept shares in a different business
On these facts, the court found that there had been the
requisite fundamental change
171
Avoiding Appra
Freeze-out Mergers
Glen A
Appraisal
In theory, quite straightforward
Give shareholders who dissent from the merger the right to
(Penn.
have the fair value of their shares determined and paid to
them in cash
Availability
All appraisal statutes give you appraisal rights
Merger
national securities exchange, Consideration paid is cash
Yes, but complicated
Apprais
Standard merger, Target’s stock is listed on a
172
DGCL § 262(b)
Section 262(b)(1) provides that appraisal
rights shall not be available for targets whose stock is listed
on an exchange or where the target has more than 2,000
record shareholders
But section 262(b)(2) then gives those target
shareholders back appraisal rights if the consideration paid in
the merger is anything other stock
Sale of all or substantially all of Target’s assets?
No
Exclusivity of appraisal
Weinberger held?
Relief for unfair mergers usually is limited to the appraisal
remedy
In cases of fraud, misrepresentation, self-dealing,
deliberate waste of corporate assets or gross and palpable
over-reaching, relief may be available outside appraisal
173
Critical points
Must be approved by the board of directors and a majority
of outstanding shares
Controlling shareholder will have leg up on getting
approval
Once approved, shares of stock of the non-surviving
corporation are transformed by operation of law into IOUs
collectible for consideration promised in the merger
agreement
E.g., in Weinberger the merger agreement provided
that each share of old UOP would be converted into
an IOU for $21
Eliminate costs associated with being publicly held
More flexibility in moving assets around within the firm
Get unencumbered access to target assets
Eliminate issues of fiduciary duty to the minority
Recall Sinclair Oil v. Levien
174
How do we define fairness?
Compare the challenged transaction to the hypothetical
terms that might be reached between two parties dealing
at arms-length
In Weinberger the court equated fairness to the
conduct that would be expected of a disinterested
independent board
Components of “entire fairness”:
Fair dealing
Fair price
175
If a merger is fair to the cashed-out minority, that now
ends the inquiry.
Rabkin v. Olin
Further development of appraisal regime
Key issue: Exclusivity of the appraisal remedy
Facts:
March 1, 1983: Olin bought 63 percent of the outstanding stock
of Hunt from Turner & Newall for $25 per share
Olin agreed that if Olin bought the rest of Hunt stock within
a year, it would pay $25 for that stock as well
Olin stated it had “no present intention” to buy the rest
Court observed, however, that “it is clear that Olin
always anticipated owing 100 percent of Hunt.”
March 23, 1984 (just after the one year period ends): Olin met
with its investment banking firm to plan its purchase of the
remaining stock at $20 per share
Engineered a cash-out merger at $20/share
Plaintiffs rejected an appraisal and challenged the merger
as unfair
The defendant moved to dismiss
Held:
Judgment for the plaintiffs. Why?
Under Weinberger, appraisal “is not necessarily the
stockholder’s sole remedy”
Here, the plaintiffs “seek to enforce a contractual right to
receive $25 per share”
The Court of Chancery must “closely focus
upon Weinberger’s mandate of entire fairness,
based on a careful analysis of both the fair
price and fair dealing aspects of a transaction”
Appraisal Remedy
Under what circumstances is appraisal plaintiff’s exclusive
remedy post-Rabkin?
Rabkin seems to limit appraisal to cases in which plaintiff’s
only complaint is that the price paid is unfairly low.
176
If $20 is not enough for the minority shares, it is difficult to
see why appraisal is not the appropriate remedy
Turner & Newall insisted that Olin wait at least a year before
cashing out the minority. But so what?
Is it just that Olin and Turner & Newall were not candid?
The court seems to interpret the one year rule as
some sort of effort by Turner & Newall to encourage
Olin to pay $25 per share to the minority
shareholders, and some sort of agreement by Olin to
do so
But then why talk about mergers, fair
procedure, fair price, etc. why not just talk
about breach of K.
Remember that this is an appeal from a grant
of a motion to dismiss on the pleadings.
Planning Issue
Why did Turner & Newall insist on the one year commitment?
The one year commitment is a routine item requested by
sellers of control blocks of stock to protect them from
liability for expropriating an acquisition premium
Perhaps, Turner & Newall thought taking a control
premium was unseemly and might result in bad P.R.
Equitable Remedies
Assuming SHs receive “fair value” through the appraisal process,
why might a SH prefer other remedies?
If dissenting SH, X, can enforce equitable remedies, the
court may award her the amount she would have earned
had she been able to invest in the firm. Since it usually
takes several yrs to get to trial, X may have a be able to
get a risk-free investment with the appraisal price being
the downside.
Note that majority SHs often freeze out
minority investors b/c they plan to invest their
own resources in improving the Co. Equitable
remedies effectively give dissenting SHs a
chance to free-ride on this improvement.
If dissenting SH, X, has the right to enjoin or rescind the
merger, she can “hold up” the majority SH for far more
than the fair value of the minority’s shares.
Also, attorney fees and advantage of class action over
individual appraisal actions
177
Facts:
GE wanted to buy RCA’s assets for cash
RCA had both common and preferred SHs
RCA’s articles provided that RCA could redeem the preferred
stock for $100
If GE had bought RCA assets for cash, and RCA had then wanted
to liquidate and distribute the cash to its SHs, it would have been
required to redeem the preferred.
Instead, RCA merged into a GE subsidiary
Pursuant to the merger, Preferred SHs got $40/share and
common SHs got $66
Plaintiff sued for damages, claiming they were entitled to $100.
Held:
Complaint dismissed
The court refused to recharacterize the merger as a “de facto
redemption”, adopting essentially the same equal dignity
approach it used to dismiss a de facto merger claim in Hariton.
Problems:
Hypo 1
Target is in the business of making wooden baseball bats In light
of the increasing cost of the source woods, Target sells all of its
wooden bat manufacturing assets to Acquirer in return for cash It
uses the cash to go into a new line of business: making
aluminum baseball bats Is this a de facto merger?
Does the transaction so fundamentally change the nature of the
business as in effect to cause the shareholder to give up his
shares in one company and against his will accept shares in a
different business?
Relevant factors include: change in board composition;
change in shareholder composition; significant changes in
shareholder values; and significant changes in the
company’s lines of business
Only the latter is even arguably present, and the company’s
business has in fact changed only in a very minor way
Eligibility of Appraisal
Hypo: Sue Shareholder walks into your office
She just got a proxy statement in the mail from Target Co.
Announces that Target’s board of directors has
agreed to merge with Acquirer Co. and solicits
proxies in favor of the merger
178
Pursuant to Delaware § 262(d), also states that
appraisal rights will be available in connection with
the merger
Sue thinks this merger is a lousy idea
Given the facts we have so far, does Sue have any legal
basis for preventing the merger from taking place?
No. If approved by a majority of the shareholders, it
will happen.
179
TAKEOVERS
180
• Keeping one’s interest in the target and one’s takeover plans
secret for as long as possible is crucial for the acquirer.
• § 13(d) of the 1934 Act and the SEC rules thereunder form, in
effect, an early warning system for the target company
Key Required Disclosures
• Identity
• Plans and intentions
– Including whether you intend to seek or are considering
seeking control of the issuer.
• Any contracts, arrangements, understandings or relationships
with respect to the securities of the issuer
Tender Offers
• §§ 14(d) and 14(e) triggered when any person commences a
tender offer for more than five percent of a class of a target’s
equity securities
Commencement of a Tender Offer: Rule 14d-2
1. Transmission of an offer to the shareholders in one of the ways
specified in 14d-2(a).
2. Public announcement of:
– Bidder’s identity, target’s identity, the amount of securities
bidder is offering to buy, and the price
Required Disclosure
• On date offer commences, bidder must file a disclosure
document on Schedule 14D-1 with the SEC
• Most of the information contained in the Schedule 14D-1 also
must be disseminated to the target’s shareholders either by:
1. Long-form newspaper publication of the offer
2. Summary publication and mailing of disclosure statement
• Incumbent management must either mail for bidder
or provide NOBO and CEDE lists
Incumbent’s Response
• Schedule 14D-9 must be filed by target
– Management must state whether they support the offer,
oppose it, or that they are unable to take a position
– Management must also summarize the reasons for its
position
Some Defensive Tactics
• “Greenmail”
– Pay off the potential acquiror to go away (usually by
purchasing her shares above market value)
• Competition
– Find a friendly “white knight” to take over firm
– Allocate “lockup” rights to first/preferred bidder
• Scorched Earth Policy
– Poison Pills
– Share Repurchases at a premium
181
• Turn the Tables
– The “Pac-Man” Defense. The original takeover target
attempts to swallow (takeover) the original bidder.
J udicial A
toward defe
Reasons
Reasons for
for Deference
Deferenc
Cheff v. Mathes
Facts:
• Holland Furnace sold furnaces through the fraudulent tactics.
• Because of the investigation into these practices, the firm was
doing badly.
•Mgrs
•Mgrs are
are supposed
supposed to
to
• Maremont became interested and contacted Holland’s president,
Cheff, about a merger, but Cheff rejected Maremont’s overtures.
• Maremont began buying Holland stock, announced his purchase
make
make day-to-day
publicly and demanded a place on the board.
• Cheff refused.
day-to-day
• Holland investigated and found that Maremont often bought
corp.s to liquidate them at a profit
decisions
decisions and
ct.’s findings. and plan
– Holland employees, aware of Maremont’s interest began
plan
showing discontent. (Note this risk is minimized by trial
long-term
long-term strategy.
firm at a premium over:
strategy.
– his purchase price and over the market price
• Directors discuss whether to buy Maremont’s stock through
Hazelbank, a Cheff family investment firm. But instead decide to
pay greenmail – to buy the stock w/ corp. funds
•Implicit
•Implicit decision:
• Other SHs challenge
decision:NotNot 182
183
Employees were worried about either a liquidation or a substantial
change in sales practices and possible reduction in force should
Maremort take over:
• M’s reputation as a buy-n-burn acquiror
• His articulated views that door-to-door sales
aren’t the way to go;
• His lack of forthrightness about his intention to
acquire company
Thus, even though the trial court found that Maremont was not the
cause of employee unrest, the Ct. finds, that conclusion is not
supported by the evidence.
It’s significant that the court finds the “threat” need not be to SH
value, but can be to something else. We’ll see when and where this
comes up again later.
Interesting Note: The fact that outside directors have to make the
above demonstration suggests that Cheff/Trenkamp can’t simply
defend their DoL claims by showing a “cleansing” under § 144(a)
(outside director vote). Indeed, the whole action of the board still has
to be justified under the “investigation/threat” analysis above.
184
welfare ALONE (even if contrary to SH interests) can justify
a defensive tactic by a board.
• Is bona fide threat sufficient defense for any defensive action?
– i.e., Can BoD “break a birdhouse with a sledgehammer?”
Also the court never really discusses the “proportionality” of the
defensive move by the Holland board -- whether the action was
tailored to the threat. In other words, it cost a lot of $$ to send
greenmail to Maremont. If the monetary threat to the firm is
smaller than the cost of eliminating the threat, what result?
Unocal v. Mesa
Facts:
• T. Boone Pickens's firm, Mesa Petroleum, owned 13 percent of
Unocal, and wanted to take it over.
• Q: Any idea why?
• A: The notes just before the case suggest that Unocal’s breakup
value was higher than its trading value.
• Anyway, Mesa made a "two-tiered front-end loaded tender offer"
for the rest. It would buy 37+ percent of the stock (64 million
shares) for $54 per share (the front-end). It would then cash out
the remainder with junk bonds (ostensibly) worth $54 (the back-
end).
• It’s probably safe to assume (as the court did) that the bonds
were worth less than $54. Because the tender offer would not
have been "coercive" if the bonds were worth the front-end
price, we too assume for purposes of class discussion that the
bonds were worth less than $54.
• To stop the Mesa takeover, Unocal made a competing tender
offer for its own stock at $72/share. Its offer was a bit different.
o (1) It was selective, -- Mesa couldn’t participate. (“Mesa
Exclusion”)
o (2) It kicked in ONLY if Mesa acquired a controlling interest
(i.e., 64 million shares of Unocal stock), Unocal would
purchase notes from all tenderers with notes (IOUs) valued
$72. (“Mesa Purchase Condition”)
• Idea: Unocal’s board hoped it would either make it impossible
for Pickens to get enough takers, or if he did, the defense would
leave Unocal so that there is no value left for him because the
firm is committing to paying out huge sums of money to current
shareholders who don’t sell to Pickens.
• When the shareholders complained about this aspect of the
defense, Goldman Sachs and Dillon Read advised Unocal to alter
the deal. Unocal agreed to buy 50 million of the shares tendered
regardless of whether Mesa acquired 50+ percent.
o Now, Unocal's strategy becomes considerably more
dangerous and costly.
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o SHs WILL now tender, and thus Unocal has to finance the
redemption.
o To do it, Unocal in fact had to borrow, thereby creating
some bankruptcy risk, the financial risk associated with
high leverage.
o This was sort of like scortching the earth before the
invasion! Thus, it still made the acquisition unattractive to
Mesa.
• Mesa sued, arguing that the Unocal directors owed it (Mesa) the
same fiduciary duties they owed all other shareholders. If the
Board arranged for Unocal to repurchase the other shareholders'
stock at advantageous prices, they owed Mesa same treatment.
• Trial court granted a preliminary injunction on Unocal’s offer
(finding that the Mesa exclusion was impermissible), and the
defendants appeal.
The Unocal 2-prong Test
(1) “Threat” Prong
Board acted in Good Faith: After reas. investigation, concludes
that a danger exists to corp. policy & effectiveness.
(2) “Proportionality” Prong
Action must be reasonable in relation to threat posed. (Explicitly
new element)
Court notes that ordinarily, there is a presumption of the duty of care
from BJR But b/c takeover defenses here in this strange netherland
between DoC and DoL, the BJR isn’t quite as permissive here.
But the court goes a bit beyond where Cheff went: Directors subject to
a two-part test (now known as the unocal test). “Threat Prong”
“Proportionality Prong”.
Q: In this case, then what was the threat that the Board was
attempting to fight off?
186
A1: Mesa's offer was coercive and inadequate to SHs (especially
the back end). The danger here would be to the unlucky SHs who
don’t tender, or, if the front end is oversubscribed, to the
tendered shares that get elbowed out. (Btw, Does the incentive
to tender early always mean coercion? NO -- See example before
case).
A2: Pickens had been a greenmailer in the past. (May not
actually be true, but if it is, it means that it’s he (and not existing
SHs) who benefits from “irrationally” depressed stock). (Note of
course, that this leaves open WHY the stock is depressed --
greenmailer may have disciplined management. Moreover, b/c
firm doesn’t have to pay greenmail, it seems like the probability
of success would be relevant).
Q: But at any rate, according to the court, was their measure taken by
Unocal reasonable relative to the threat posed? If so, what
constituencies was it protecting? Was it justified in excluding one of
the shareholders (Mesa)?
A: Yes. Unocal designed its self-tender to stop the Mesa offer, or
at least protecting back- end SHs. (Here, you may want to tease
out the fact that if everyone tendered, they would get pro-rata
participation, and thus would all be a small-part back end and
other part front end SH -- MM theorem may hold).
As to excluding Mesa, this was essential to making the defense
work, the directors could validly do so. Allowing Mesa in would
both fail to stop them, and subsidize their offer.
Unocal Postscript
• Unocal and Mesa eventually negotiated and agreement that let
Mesa participate in Unocal’s self-tender.
• At that point, a Unocal SH sued Mesa under what statute?
– §16(b) Why?
– Mesa argues that self-tender qualifies as an unorthodox
transaction (e.g. Kern County) and is not subject to §16(b)
– The court held Mesa liable under §16(b), stating that the
Kern County exception applies to involuntary transactions,
and this one was voluntary.
187
– Not well developed in Unocal.
• Many subsequent cases seem not to focus on it at
all.
– Unitrin v American Gen. (1995): Del. Supreme Court holds
that proportionality prong has some “teeth”
• Even if bona fide threat exists, protective measure
cannot be “preclusive” or “coercive”
• Court never has defined what those terms mean
I mportanc
Mushroomi
Carves out a specia
Post- Unocal standards of review
measures” and te
• Traditional BJR, exemplified by cases like Van Gorkom
• Traditional duty of loyalty, exemplified by cases like Weinberger
• The new conditional BJR set out by Unocal
• Unocal left two critical questions:
• Which decisions get reviewed under which standard?
• What content should we give the applicable standard in a
given situation?
Deferential
Poison Pills
• First Generation Preferred Stock Pills:
– Lenox: 1983
– Based on “blank check preferred stock”
• How would you get the preferred stock out to the shareholders?
Scrutiny
– Lenox issued a special dividend consisting of nonvoting,
convertible preferred stock, the dividend issuing at the
ratio of one preferred share for every forty shares of
common stock
188
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s
• Antitakeover effect?
– Based on conversion feature of the preferred stock
• Adaptation of standard anti-destruction clause of
convertible securities
– If Lenox was acquired, the preferred stock became
convertible into common stock of the acquiring corporation
at well-below market prices (i.e., a flip-over pill)
• Discriminatory: “interested person” could not
exercise
Beating the First Generation
– Crown Zellerbach pill only kicked in if the bidder tried to
effect a freeze-out merger
– Goldsmith acquired a controlling interest in Crown
Zellerbach but did not effect freeze-out
• Goldsmith suffers no poisonous effects
• On the other hand, since the rights were now
exercisable in the event of a merger, Goldsmith
precluded anyone from merging with Crown
Zellerbach
Second Generation Pills
• Based on rights issued as a pro rata dividend on the common
stock to the shareholders of the target corporation
– Rights are corporate securities that give the holder of the
right the option of purchasing shares
– The rights become exercisable upon some triggering
event, such as:
• Acquisition of a specified percentage of target shares
• Announcement of a tender offer for some specified
percentage of the shares
• Flip-over feature retained
• Flip-in feature added
– Enables shareholders of the target to purchase target stock
or debt at a discount
• Resembles a standard warrant
• Discriminatory: “interested person” not eligible
– Causes dilution in the target shares held by the acquirer
• Grand Met v. Pillsbury: Would have reduced Grand
Met’s interest in Pillsbury from 85% to 56%. Value of
Grand Met’s holdings would have declined by more
than $700 million dollars.
Redemption Features
• Give the board the option of redeeming the rights at a nominal
cost in order to allow desirable acquisitions to go forward
– Window redemption: board retains the ability to redeem
the rights for a specified time period following the issuance
of the rights
189
– White knight redemption: rights redeemed for a
transaction approved by a majority of the “continuing
directors”
Poison Debt
• Target issues bonds or notes with terms that make target less
attractive
– Forbid an acquirer from burdening the target with further
debt
– Forbid an acquirer from selling target assets
– Make a change of control an event of default
• Very effective defense against leveraged takeovers
• No bidder has ever gone forward with a bid in the face of a fully
implemented second generation pill
– In the face of such a pill, the only successful bids have
been:
190
• Where target’s BoD agreed to deal and redeemed pill
• Where bidder successfully conducted a proxy contest
to elect a new board that then redeemed pill
• Where court invalidated pill
• Moran case validated pills but held that the board cannot defeat
a bid by any “draconian” means
• Presaged the pill cases holding that one could not just say no
• A non-coercive offer cannot be permanently blocked by a poison
pill. City Capital Assoc. v. Interco, Inc.
• “When the Household Board of Directors is faced with a tender
offer and a request to redeem the Rights, they will not be able to
arbitrarily reject the offer. They will be under the same fiduciary
standards any other board of directors would be held to in
deciding to adopt a defensive mechanism, the same standard as
they were held to in originally approving the Rights Plan.”
191
• Revlon found a white knight in leveraged buyout specialist firm
Forstmann Little
• Resulting control auction set new standard (or did it?)
• Perelman meets with Bergerac (Revlon CEO)—threatens Take
over at $45/share
• Board adopts defenses:
• Poison pill—per share $65 note at 12% with one year
maturity triggered by purchase of 20%, unless there is an
all shares offer for $65
• Redeemable
• Held: OK per Unocal
• Perelman’s First Offer
• $47.50 all shares all cash; redeem rights plan
• Revlon Bd.:
• Exchange Offer
• Swap 10M shares for 10 year senior subordinated notes at
11.75% + 1/10 share $9 Cumulative Convertible
Exchangeable preferred at $100
• Package value: $57.50
• 87% of shareholders grab it
• Purpose:
• Increase debt load
• Poison business covenants limiting borrowing, asset
sales, and dividends.
• Once the Shareholders hold the Notes with
protective covenants, will they oppose the
offer?
• Suppose management wants to do an LBO?
• “Independent directors” can waive the
covenants
• Held: OK per Unocal
• Several rounds of bidding, with Pantry Pride topping every
Forstmann offer
• Revlon accepted Forstmann's last bid. To end auction, granted
Forstmann an asset lock-up option
• The option gave Forstmann the right to buy two Revlon
divisions at below market price; exercisable if another
bidder gets 40% of Revlon shares
• Also:
• $25 million cancellation fee
• No shop clause
• The Delaware Supreme Court struck down the lock-up (also the
cancellation fee and the no-shop clause)
• Treated the lock-up as a type of takeover defense
• Hence, the lock-up implicated not traditional business
judgment rule analysis but rather Unocal
192
What is the rule of law that emerges from Revlon?
• When the board puts the company up for sale, they have a duty
to maximize the company's value by selling it to the highest
bidder:
– "The directors' role changed from defenders of the
corporate bastion to auctioneers charged with getting the
best price for the stockholders at a sale of the company."
Invalidity of the Lock-up
• Violated the board of directors' fiduciary duties. Why?
– Because the lock-up ended the bidding prematurely: “In
reality, the Revlon board ended the auction for very little
improvement in the final bid”
– Distinguish between lockups that draw a bidder in and
lockups that end an active auction
– “FL had already been drawn in to the contest
on a preferred basis, so the result of the lock-
up was not to foster bidding but to destroy it”
Invalidity of the No Shop
• No shops are NOT per se illegal
• But this no shop required the BOD to treat Forstmann more
favorably than Pantry Pride
– The agreement to negotiate only with Forstmann helped
end the auction prematurely
So what triggers Revlon?
• The “Imminent Break-up” of the target firm
• Cases since Revlon:
– Imminent “Change in Control” of the firm…
• …even if no break-up is to follow
– …from a “fluid aggregation” of dispersed shareholders to a
unified entity or group.
• Paramount v. Time: Did not trigger Revlon
• Paramount v. QVC: Triggered Revlon
• Unifying concept (best guess):
– Were target’s SHs on verge of losing their future ability to
extract a “control premium” for shares?
• Bringing in a white knight or a management buyout in response
to a hostile takeover triggered Revlon. But what else did?
– Revlon was triggered only if the transaction would result in
a change of control
• If control would not change hands, the transaction
was subject only to Unocal
193
– “Under Delaware law there are, generally speaking and
without excluding other possibilities, two circumstances
which may implicate Revlon duties. The first, and clearer
one, is when a corporation initiates an active bidding
process seeking to sell itself or to effect a business
reorganization involving a clear break-up of the company.
However, Revlon duties may also be triggered where,
in response to a bidder’s offer, a target abandons
its long-term strategy and seeks an alternative
transaction also involving the breakup of the
company.”
Defensive Recapitalizations
• Target company typically issues a dividend consisting of cash
(often borrowed) and debt securities, reducing the post-dividend
value of the target's stock to the extent of the distribution
• Target managers and/or the target's employee stock ownership
plan effectively receive the dividend in the form of stock, rather
than cash or debt, at an exchange rate based on the stock's
post-dividend value
– Alternatively, the target may conduct a tender offer in
which public shareholders exchange their stock for cash
and debt
• In either case, management's equity interest increases
substantially vis-à-vis public shareholders
Nonshareholder Constituencies
• Unocal: Target directors may consider the impact of their
decisions on non-shareholder constituencies—i.e., employees,
customers, creditors, communities, and the like
• Revlon? Once their auctioneering role has triggered can the BoD
still consider non-shareholder interests in making decisions about
the auction?
194
• No. Once an auction begins the board may no longer
consider non-shareholder interests.
• Revlon: Even outside the auction setting, cut back on Unocal:
• “A board may have regard for various constituencies in
discharging its responsibilities, provided there are
rationally related benefits accruing to the shareholders.”
• Implication for the threat prong of Unocal: Courts were
reluctant to say that threats to non-shareholder interests
justified takeover defenses
195
Summary of these Cases
• Intermediate Scrutiny in T-O defense context.
– One of two levels
• “Mere” resistance of a takeover
– Unocal duty (threat/proportionality prongs)
– Num. constituencies and time horizons OK.
• Change of Control, Break-up or other event that causes
shareholders to lose the future ability to extract a “control
premium”:
– Revlon duty (modified threat/prop. test)
– Duty to maximize short term SH welfare.
• Consequences of flunking applicable test
– Unenforceability of defensive lock-ups.
– No liability for directors (absent more)
Conclusion
• The conflict of interest present when the board responds to an
unsolicited tender offers differs only in degree, not kind, from
any other corporate conflict
• A conflict of interest does not necessarily equate to
blameworthiness
– Rather, it is simply a state of affairs inherently created by
the necessity of conferring authority in the board of
directors to act on behalf of the shareholders
• We therefore would expect the courts to develop standards of
review for takeover defenses that are designed to detect, punish,
and deter self-interested behavior
Problems:
Hypotheticals
• Suppose that:
– Mesa’s offer had been a one-tier offer at $54 cash per
share (and therefore not coercive to SHs);
– And Pickens had no reputation as a greenmailer;
196
• Under Unocal, which of the following would still be considered
bona fide threats?
– Pickens wanted to liquidate the firm in 5 years
– Pickens wanted to exploit a loophole in Unocal’s
debentures to cheat the bondholders
– Pickens wanted to “downsize the firm”
Given the broad constituencies cited in Unocal, all of these are bona
fide threats to someone who counts.
The difference b/t Unocal and BJR may be very small indeed, other
than the burden shifting to the directors: It may be very easy to
overcome it.
197