Corporate Limited Liability Rarely used b/c it is antithetical to the theory of the corporation was an entity Only impose

se liability on shareholders, not directors or officers Occurs only in close corporations. It has never been applied in a corporation with more than 9 shareholders. Approaches: o Alter-ego (CA/IL, Roman Catholic) o Mere-instrumentality (2nd Circ, Carte Blanche (singapore) v. diners club) o Unity of ownership (Sea-Land Services) o Excessive control or domination (VA approach) o Dummy or a shell or a sham (VA approach) o Enterprise Liability (Walkovszky v. Carlton) Different approaches to K and tort cases (policy suggestions) (undercapitalization is a central factor) o K: P usually has dealt directly with the corporation. In the absence of fraud, she assumes the risk of loss. She could have insisted on a personal guarantee from the shareholders o Tort: interacted with the corporation involuntarily. (P getting hit by a truck) The question is whether the shareholders should be able to transfer a risk of injury to members of the general public the answer should depend on whether the corporation was adequately capitalized to cover the reasonably foreseeable risks in its particular business. If the corporation was plainly undercapitalized, perhaps the P should be able to PCV and to look to the assets of the shareholders. In order to pierce a corporations veil, there are two categories of transgressions which must be established: o There must be such unity of interest and ownership that the separate personalities of the corporation and the shareholder)s no longer exist; AND o Circumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice.

DIRECT / DERIVATIVE ACTIONS (p. 156 Ace)

Direct Actions o SH makes a claim in her own name against the corp or against director/officer of the corp for a wrong that was done directly to her. o Often brought as class action if the wrong complained effected many shareholders o Examples of direct lawsuits - a suit to: Compel the dividend payments Enjoin an activity that is ultra-vires Claim security fraud Protect certain shareholder rights ex: right to vote on certain matters A suit in which a shareholder has been denied rights (redemption rights, or the right to inspect the corps book and records) A suit involving a shareholder/employee, who is fired and forced to sell stock and is suing to recover his job and/or stock Derivative Actions o A suit in equity against the corporation to force the corporation to sue a third party, which has hurt the corporation and the corporation has failed to act. o Remedy: equitable injunction forcing the corporation to take some action to address some harm to the corporation. Examples A claim that a director has violated his duty of care to the corp by making a bad deal with an outside 3 rd party A claim that an officer has misappropriated a corporate opportunity (or committed some other duty of loyalty violations); and the corporation failed to take action against her A claim that a third party who has contract with the corporation has breached that contract and the board has failed to take action against that 3rd party A claim that senior managements salaries are excessive A suit seeking to prevent management practices which are calculated to prevent challenges to current management Direct v. Derivative o Only shareholders can bring derivative suits, not creditors o Derivative: any remedy goes to the corp o Direct: remedy goes to the SH o Derivative: corp is required to pay for shareholders attorney fees, PROVIDED that the shareholder is successful in the suit o Derivative has many more procedural hurdles Additional requirements to bring a derivative law suit: vary from state to state o Contemporaneous ownership see p. 158 of ACE

o Shareholders holding less than 5% of the corps outstanding stock is liable for the costs associated with bringing an unsuccessful derivative suit o In some states, not DE, SH must purchase a bond when bringing a derivative suit to cover the potential costs to the corporation of an unsuccessful suit. Demand requirement o Most states require that the shareholder approach the Board and demand that the Board pursue litigation before the shareholder is allowed to bring a derivative suit in the name of the corp o If the demand is made on the Board and the Board determines not to bring the suit Demand is protected by BJR This is why P usually seek to avoid making demand on the Board o Demand is excused when asking the Board to bring a suit would be futile In NY, Marx v. Akers (p. 28 Chao) In DE, demand is deemed futile if: Grimes v. Donald A majority of the Board has a material financial or familial interest in the transaction A majority of the Board is incapable of acting independently for some other reason such as domination or control (usually by an individual who is interested); or The underlying transaction is not the product of a valid exercise of business judgment. o Since the BJR is inapplicable where the Board did not exercise any business judgment (nonfeasance, oversight cases), it may be argued that a demand is automatically excused o This is not true o If demand is NOT excused, then the Board (or majority of disinterested directors) may dismiss the action, and that dismissal will typically be protected under BJR o If demand is excused but the shareholder makes the demand anyways, then the futility argument is forfeited, and the Board then has the right to hear the demand and to dismiss the claim Boards generally settle demand excused cases, BUT a recalcitrant Board intent upon resisting a derivative suit can use a SLC to regain control of the litigation even when demand is excused. Special Litigation Committees (SLC) = committee of disinterested Board members and some outsiders that evaluate the lawsuit o Based upon the recommendation of the SLC, the board can still move to dismiss a derivative action, and that dismissal would subject to the protection of the BJR o A dissatisfied shareholder might be able to attack the SLCs judgment on limited grounds: Decision was procedural defective (usually substantive interpretation is protected by BJR) The SLC failed to act independently, in good faith, and with a reasonable investigation. NY: more deferential to SLC - Auerbach Other: require stricter scrutiny of the SLC -- Zapata Corp o DE: addition requirement that the court exercise its own business judgment in evaluating the decisions to dismiss Zapata Corp This means that BJR does not protect the Boards decision to dismiss Auerbach (NY) deferential to SLCs decision making due to BJR protection o Judicial inquiry is permissible with respect to two aspects of the committees work: The SLCs disinterested independence The adequacy and appropriateness of the procedures by which the decision was made In examining the committees procedures, a reviewing court may o Explore whether the areas and subjects the committee investigated were reasonably complete o The court may also determine whether the inquiry was conducted in good faith The court would look for proof that the investigation was restricted in scope, shallow in execution, pro forma, or half hearted o Relevant factors: # of hours spent, whether the committee had independent legal counsel and other advisors HOWEVER, the court must respect the Boards substantive interpretation and therefore cannot consider the evidence that the SLC had discovered, the factors that the committee considered Zapata (DE) rejected Auerbachs conclusion that BJR applies to the SLCs recommendations o After an objective and through investigation, committee may cause the corporation to file a motion to dismiss the derivative action The motion should include a written record of the committees investigation and its findings and recommendations o To decide whether to dismiss the action, the court applies a two-pronged test: The court should inquire into the independence and good faith of the committee. The court also should inquire into the bases supporting the committees recommendations. [burden is on the corporation to prove independence, good faith, and a reasonable investigation] If the first prong is satisfied, the court may apply its own business judgment to the issue of whether the case is to be dismissed. Zapata provides no real standards for a court to institute its own business judgment but it provided that the trial court should consider the following: o The corps interest in having the suit dismissed o Or, the matter of law and public policy o

GENERAL FIDUCIARY DUTY

Article of Incorporation (AofI) MBCA 2.02(b)(5) o The A of I can limit or eliminate directors personal liab for money damages to the corp or SH for: Action taken Failure to act o But no provision can limit or eliminate liab for: The amt of a financial benefit received by the director to which she is not entitled An intentional inflicted harm on the corp or its SH Unlawful corp distribution Intentional violation of crim law Fiduciary Duty o Create parameters within which the conduct of a corps officers and directors may be measured o Categories: Duty of care (N standard) Articles can limit duty of care (Ex: D wont be liable for damages, only equitable relief) = Del. GCL 102(7) Requires that each member of the Board, when discharging the duties of a director, shall act: o In good faith, o With the care that an ordinarily prudent person in a like position would exercise under similar circumstances; and o In a manner the director reasonably believes to be the best interests of the corporation. MBCA 830(a), Duty of loyalty Requires that fiduciaries put the interests of the corporation ahead of their own interests. It is implicated when a director is involved in conflict of interest o Conflict of interest arises when D or a person related to D Is a party to the transaction, OR Has a beneficial financial interest in the transaction; and then exercises his influence to the detriment of the corporation. MBCA 860. Duty of Care vs. BJR o When a D is sued for violating his duty of care, he may be entitled to BJR protection Rationale: give Ds wide latitude in taking steps to benefit a corp; best judgment w/o fearing for a courts second guess o BJR trigger: Typically, courts will not interfere with the decision of a corporations Board of Directors, provided that decision meets certain standards. The Board of Directors actions will have the protection of the Business Judgment Rule (BJR). In order to prevail in his action, P will need to show that the BJR does not apply in this situation by showing either: fraud, illegality, conflict of interest, bad faith, waste, an egregious or irrational decision, no decision, or an uninformed decision. Shlensky v. Wrigley (Cubs baseball team installing lights); Kamin (directors room is where purely business questions should be resolved) o SUBSTANTIVE Fraud Illegality Conflict of interest (DOL) Auerbach v. Bennett Bad Faith (DOL DE) categories: subjective bad faith = conduct motivated by an actual intent to do harm intentional dereliction of duty, a conscious disregard for ones responsibilities. In re The Walt Disney Co. Acts with a purpose other than that of advancing the best interests of the corp Stone v. Ritter Irrational decision (no business justification) Waste Glazer v. Zapata o PROCEDURAL Uninformed decision (lacking investigation) Smith v. Van Gorkem (court focused on the process by which the board made its decision) Nonfeasance Francis v. UJB, Caremark o Procedural (since BJR doesnt apply, must show breach of the duty of care) No Not liable Burden: P must show that the Board was grossly negligent in failing to inform itself of all material information reasonably available to it and that the decision itself was grossly negligent. Duty of Care (standard, see MBCA 830(a)) solvent? Y: duty to S first, then creditors; N: duty to creditors first, then S

Breach Causation = (usually Corp wouldve lost money anyway, tough to win): but-for AND proximate causation DAMAGE Affirmative defenses to duty of care violations o Outcome was fair (or not detrimental) to the shareholders o Courts will typically look at substantive or intrinsic fairness, not entire fairness The question is whether the price and terms of the transaction were fair to the corporation. Breach of Duty facts: Did not properly oversee the corps operations Was not adequately informed about the corps business, its interests and the relevant issues, before making decisions Did not possess a minimum level of skill and expertise with regard to the role of director for a specific business Unaware of the financial status of the corp (ie. Didnt regularly review the firms financial statements) Did they consult an expert? o If the B hired or consulted an expert, regarding certain matters, the Bs decisions and actions with regard to those matters will later be protected under the BJR as informed decisions. Duty of inquiry (part of DofC): should be clear on what is beyond the scope fo the exps competence Reasonableness: reliance must be reasonable. Caremark Claims failure to act cases Francis v. UJB BJR doesnt apply b/c the B has not taken an action (unless the B has made an affirmative informed decision not to take action) Standard to evaluate Bs duty to monitor the firm (procedural and substantive) both met B is not liable o First, absent suspicion of wrongdoing, there is NO DUTY upon the Board to install and operate a corp. system to find wrongdoing that the Board does not suspect or believe exists o Second, the Board must attempt in good faith to ensure that an adequate reporting system is in place so that the B can obtain the necessary information to make informed decisions (ie. Compliance program) Factual inquiry how to evaluate whether Ds have adequately informed themselves? o Absent a showing of bad faith, a D will not be liable for failure to exercise oversight o Systematic failure of the B to exercise oversight lack of good faith In re Caremark o Some juxn failure to take adequate actions gross N o Substantive (since BJR doesnt apply, must show breach of the duty of care) NO not liable Ex: breaking the law BJR doesnt apply, but meets duty of care b/c $$ Irrational/egregious decision making strong evidence for negligence Duty Of Good Faith o A corporation cannot exculpate for acts or omissions not in good faith. Del 102(b)(7) o BJR presumes that directors acted, inter alia, in good faith o In re The Walt Disney Company Derivative Litigation (Del. 2006) Held: the directors of that corp. did not breach the duty of care or the duty of good faith in approving a deal that compensated Michael Ovitz $130mil for a little more than one years work as an officer The border had done enough home work and reviewed enough expert analysis to be protected by the BJR An act is not in good faith (and therefore cannot be expulcated) if the D acted in intentional dereliction of duty, [or with] a conscious disregard of ones responsibilities o may be shown where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corp, where the fiduciary acts with the intent to violate applicable positive law, or where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties. o Its likely that a breach of good faith breach of Dod and DoL o Stone v. Ritter The obligation to act in good faith is subsumed wholly within the DoL A director cannot act loyally towards the corp unless she acts in the good faith belief that her actions are in the corps best interest. Duty of Loyalty vs. BJR o At CL, allows the corp. to void the contract at will due to conflict of interests. o Modern statutes provide that an interested director transaction is not voidable because of the conflict of interest, if the fiduciary shows one of three things:

That the transaction was approved by disinterested directors, OR DE: even though the disinterested directors be less than quorum Del. 144(a)(1) That it was approved by disinterested shareholders, OR DE: on one hand, it might mean voting stock generally, which would permit voting of the shares held by an interested fiduciary. Del. 144(a)(2) DE: On the other hand, it might mean that only shares held by disinterested persons can vote. Fliegler v. Lawrence, Del. 144(a)(2) That it was intrinsically or substantively fair to the corporation when entered Del. 144(a)(3) Generally, this relates to the price and terms of the deal o The burden is placed on the Def. to prove that the deal was sterilized o Interested directors count toward the quorum, Del. 144(b), and may participate in the meeting and even vote (though their votes do not count toward approval). Del. 144(b) o Bayer v. Beran: Presidents wife hired to sing (Directors bored the burden of proving the fairness of the deal 144(a)(3)) p. 30 Corporate Opportunity Doctrine (DoL subset) o A fiduciary of the corporation may not take, for personal gain, an opportunity like a business venture or a new opportunity or discovery, in which the firm has a property right, and use it for his or her own advantage without first offering it to the corporation. o Corporate opportunity Broz v. Cell Info (DE standard) Is the corporation financially able to take the opportunity? Is the opportunity in the corporations line of business? Including where the firm is headed in the future. Does the corporation have an interest or expectancy in the opportunity? Does an officer or director create a conflict between his self-interest and that of the corporation by taking the opportunity for himself? o Corporate opportunity some other states employ a fairness test Whether the officer or director taking the opportunity would violate equitable standards of what is fair and equitable by corporate standards. o Common defenses Capacity Those charged with usurping corporate opportunity can claim they learned of the opportunity in their individual, rather than corporate, capacity. o NOT A COMPLETE DEFENSE Under DE law, the capacity in which the D learned of the opportunity is a relevant, but not dispositive, consideration. Financial or Technical Inability D will argue that the corporation lacked the money and/or technical ability to exploit the opportunity. It has been suggested that courts should apply a stringent standard to determine financial or technical inability. o The corporation must be practically defunct before the financial incapacity defense will be given weight. o Technically insolvency (ex: inability to pay current bills or to secure credit) is NOT enough The corporation must be on the way down the tubes. o Req. of disclosing the corporate opportunity to the corp Must fully disclose the opportunity AND his or her interest in the opportunity to the Board The Board has what amounts to a right of first refusal on the opportunity Casually inquiring whether the firm is interested in taking the opportunity is inadequate disclosure If the Board did not properly reject the opportunity, and the person takes the opp breaches DoL That breach might still be sterilized by disclosure to, and approval by: o Shareholders and showing that the transaction was fair o Damages A violation of the COD is subj. to various equitable remedies such as constructive trust, so that the benefits that were received in violation of the doctrine are held in trust for the corporation. Of course, any violation may also be subj. to damages

CONTROLLING SHAREHOLDERS FIDUCIARY DUTY

Traditional Rule/Common law o Shareholders of a corporation do not owe fiduciary duties to each other Exception: o A shareholder does have obligations when that shareholder has so much stock that he or she is considered to have control. In such cases, the shareholder has an obligation to minority shareholders in certain duty of loyalty transactions When a controlling shareholder exists, one must ask: o Whether the transaction in question involves a situation in which the dominant shareholder has a conflict or in which the dominant shareholder is receiving benefits at the expense of the minority shareholder or that the minority shareholders do not receive.

Y if a fully informed, majority of the minority shareholder have no approved the transaction, the dominant shareholder will probably need to show that the transaction was fair to the corp. either through intrinsic fairness, or in the case of a merger, entire fairness If a fully informed majority of the minority shareholders has approved the transaction, then the transaction may still be challenged But the burden shifts to the minority shareholder to show that the transaction was not fair to the corp. Who is a controlling shareholder? o Basis for imposing fiduciary obligations on a controlling shareholder is not mere ownership of the specified amount of stock INSTEAD, its the creation of an agency relationship between the shareholder and the board of directors. o The question is whether a majority of the board lacks independence from the allegedly controlling shareholder. Must be done on a case-by-case basis o DE Law: A shareholder is deemed to have control if the shareholder either owns a majority of the voting stock or exercises control over corporate decision-making. If the shareholder owns less than 50% of the voting stock, P must show evidence of actual control of corporate conduct. Parent-Subsidiary Transactions o Controlling shareholder = a parent corporation which holds enough stock in a subsidiary to call the shots for the subsidiary o Issues arises when a minority SH of the subsidiary who sues the parent for oppression o These cases do not fall within the statutory provisions for self-dealing but they raise CL fiduciary questions of basic fairness o Sinclair Oil v. Levien (Del. 1971) Owned 97% of Sinven, Entire Board was filled with parents people P owned 3%, and he brought a derivative suit on behalf of Sinven against Sinclair Parent corps do owe fiduciary duties to their subsidiaries. The ultimate question is whether the dealings between the two were fair. Fairness inquiry may take either of two forms: BJR: the burden was on the P to show that the parent was guilt of gross or palpable overreaching. (tough burden on the P) intrinsic fairness: once the P showed self-dealing, the burden shifts to the D to show that the entire deal was fair. (tough burden on the D) Step 1: self dealing? Whether the parent received something that the subsidiary minority SH did not. N b/c the minority SH received the same pro-rata dividend as parent Step 2: fairness was assessed under BJR Parent won Claim #1: P had usurped opportunities belonging to Sinven by buying land for oil exp in other countries. BUT no opps available in Venezuela Claim #2: Had Sinven contract to sell all its crude oil to another Sinclair subsidiary at set prices. Told sub to cancel K and harmed Sinven court held that to be self dealing b/c parent benefited at the cost of sinven o Then the court applied intrinsic fairness test Parent cant met the burden by proving that Sinven could not produce to obtain K minimums Conflicts between Classes of Stock o Zahn v. Transamerica P was a minority SH of AFT and he challenged a decision by AFTs Board to redeem a class of AFT shares prior to liquidation of the company AFT had 3 classes: 1) Preferred shares with a par value of $100, a cumulative dividend preference of $6 per year, and a liquidation preference of $105 plus accrued dividends; 2) Class A common stock; Class B common stock. Class A and Class B are involved: Differed in 5 areas: Class A had dividend of $3.20; Class B had a $1.60 annual dividend. Class A could be called by the firm on 60 days notice at $60/share; Class B could not be called. If the firm was liquidated Class A was entitled to receive twice as much per share as Class B. Class A shares were convertible to Class B shares at the holders option at any time on a share-for-share basis. Class A stock had no voting rights, unless there were four successive failures to pay quarterly dividends. Class B had full voting rights. D owned almost all of the Class B shares and about 2/3s of Class A stock. AFT was going to be liquidated. Ds directors redeemed the Class A shares without disclosing the extent of the appreciation of the inventory and without disclosing their intent to liquidate the firm. 2. D breached fiduciary duty Ds directors took an action intended to extract a nonpro rata benefit for the parent at the expense of the minority. a. Class A redemption was effected at the direction of the principal Class B shareholder in order to benefit the Class B stock in preference to the Class A. Close corporation o The line of demarcation will be whether the companys stock is publicly traded, which means that its securities are registered under for public sale under federal law.

CONTROL IN CLOSELY HELD CORPORATIONS

If its not, the courts will consider it a close corporation Public v. Close Corporation absence of a market out o So people invest to get dividends, but they rarely issue dividends bc money is reinvested o The minority shareholder typically depends on his salary as the principal return on his investment, since the earnings of a close corporationare distributed in major part in salaries, bonus, and retirement benefits. - Wilkies Close corps often employ stock transfer restrictions to ensure that outsiders can become stockholders only in certain circumstances Some states make the right of first refusal automatic, other states you need to spell it out Minority Shareholder/employee need to: Law of Contract o Nego an employment contract that requires the corp to employ her for a given period, terminable only for cause o Nego a buy-sell agreement, which would require the corp to buy her stock upon some triggering event (ie. Fired) In the Articles of Incorp/By laws o Require unanimous attendance for quorum or unanimous votes for corp acts creates deadlock Solution: buyout the other, or voluntary dissolution If they cannot agree, one shareholder may petition for involuntary dissolution (this is not good bc it kills a viable business, and the going value of most corp is greater than the sum of the assets, sold off piecemeal in dissolution.) Private ordering decision making authority o Issue arises when shareholders attempt to agree not only on what to do as shareholders, but also on what they will do when elected to the board. While shareholders may act selfishly, or even irrationally, directors may not act in similar fashion because they are bound by fiduciary duties to all of the shareholders. o Voting Trusts (p. 142 of ACE) 2 or more shareholders place their shares in trust. Trustee is responsible for voting the shares. Trust agreement: how long the trust will last and how the shares will be voted. o Vote Pooling Agreements 2 or more shareholders entered into an agreement which states that the parties share will be voted in a certain way, based upon some criteria (flip a coin) may used to elect directors; may cover only a portion of a shareholders shares or all of their shares, may delegate control to an individual with lesser ownership % A vote pooling agreement CANNOT fully protect minority shareholders from oppression by the majority, even if it ensures that all shareholders are elected to the Board A majority of directors can still have the power to harm minority shareholders Thus, shareholders frequently adopt agreements restricting director discretion: provide that all shareholders shall be appointed as officers set out specific requirements as to salary, dividends, pensions, tenure, etc. o Shareholder Agreements (Ingle) has a wider coverage than Vote Pooling Transferability restrictions, corps rights to repurchase stock, voting/control. o Irrevocable Proxies given to one individual to increase that persons control. coupled with an interest irrevocable so long as the interest does not expire Proxies are typically revocable Interest job with the corp, a loan made to corp, or some other interest in the firm A manager may have control w/o owning any shares o Cases McQuade v. Stoneham (NY) vote pooling agreement is NOT OKAY The Stonehams (3) were principal owners of the Giants baseball team. They agreed to vote their stock to elect each other to the Board of Directors (this is okay!), and then, as directors, to appoint each other to specified positions as officers, and set salaries (void) Board matters require independent judgment. There is no tolerance for sterilized agreements If the directors agree in advance to limit that judgment, shareholders do not receive the benefit of their independence agreement is void as against public policy Clark v. Dodge (NY) vote pooling agreement is OKAY Clark owned 25% and Dodge owned 75% of the stock of two corps. Dodge was a passive investor and Clark managed the business. They agreed that Dodge would the general manger and would receive of the income. Clark in turn agreed that he would disclose the secret formulae to Dodges son and, upon Clarks death without issue, to bequeath his interest in the corp to Dodges wife and children. This runs afoul of McQuade bc 2 SHs were making decision about pay and positions Held: bc they were the only shareholders in the corp, so their agreement could not hurt anyone. Rule: absent potential harm to bona fide purchasers of stock or to creditors or to stockholding minorities, there is no justification to invalidate a contract that impinges slightly on the principle of director primary. Shareholder unanimity exception o Shareholders may agree on how they will vote on certain matters as directors (such as dividends or the election of officers) if ALL of the shareholders have entered into the agreement.

In some states, the courts will hold a vote pooling agreement to be enforceable, provided that: The shares of the corporation are closely held; None of the shareholders, who were not parties to the agreement, object; AND Terms of the agreement are reasonable. Private Ordering Exit Rights o Restrictions on Transferability Close corporation shareholders often include restrictions on share transferability in the articles of incorporation or in a shareholder agreement. These restrictions commonly take the form of either a right of first refusal or, more aggressively, an outright prohibition of transfer without the consent of the other shareholders. o Right of First Refusal: A right of first refusal is triggered when the shareholder receives an offer from an outsider. The right gives either the corporation and/or the other shareholders an option to purchase the shares on the same terms and conditions offered by the outsider. Ex: If Purchaser offers Shareholder $120,000 for the latters stock, the right of first refusal gives the corporation and/or other shareholders an option to buy the stock for $120,000. o Buyout Agreement protects a minority shareholder Or a shareholder agreement containing buy out provisions Entitling the minority shareholder to force the company to buy his or her shares under certain circumstances, such as a freeze out o Statutory dissolution forcing a dissolution Result in payment for their interest in the dissolution process or in a settlement with the majority shareholder block Minority protection mechanisms o A shareholder agreement protecting the minority shareholders right to be on the Board and/or to be an officer if everyone agrees o A employment agreement assuring the minoring shareholder of a certain position with the corporation and a salary o Mandatory dividends req. certain dividends be paid might be included in the corps Article of Incorporation TRANSFER OF CONTROL CONTROL PREMIUM $ P. 155 OF ACE Fiduciary Duties of MAJORITY Shareholders in FREEZE OUTS Freeze Out occurs when the majority shareholder or block of shareholders earns a return at the expense of the minority shareholders. o Channeling corporate funds to the controlling shareholder block and depriving other shareholder(s) of the opportunity to share in funds paid out by the company o Minority shareholder is blocked from holding a paid position by majority shareholder o Majority does not pay dividends so that none or little of the corp profits are distributed to its shareholders o Only corporate funds which are paid out are paid in the form of salary to those shareholders who are also employees Analyzing freeze out: o It is important to keep in mind that is is not just the actions or circumstances that are relevant in evaluating a freeze out situation. It is also the INTENT behind the actions and circumstances. Ps burden: must be able to show a breach of duty and that the majority group is diverting profits of the corporation to themselves to the exclusion of the frozen out shareholder and therefore depriving the frozen out shareholder of his or her rightful return on his investment Delaware Rule - Sinclair Oil v. Levien (Del. 1971) o Essentially duty of loyalty prevents self-dealing so that the shareholder may not take the profits of the corporation for herself and deny those profits to the minority shareholders o This duty is subject to a fairness analysis Ex: controlling shareholder pays herself a reasonable salary and does not pay dividends Its difficult for the minority shareholder to show that such action is unfair. It would be easy if the controlling shareholder paid herself a salary well in excess of a reasonable salary, leaving no funds to distribute to the minority shareholder Massachusetts Rule Less strict reading of Donahues strict good faith standard and most protective of minority shareholders o Wilkes v. Springside Nursing Home P was one of the four shareholders, all of whom were employed by the corp. After a disagreement, the other three had the P fired. Steps: P must show that the controlling shareholders treated her oppressively. o Generally, oppression describes any unfair deprivation by controlling shareholders of a minority shareholders rights of participation. It may be participation in governance, distributions, and employment almost any perquisite of ownership. Donohue (unequal distribution of corporate assets) If P is able to satisfy the first step, then the burden shifts to the defendants to show a legitimate business reason for the action (this step protects management prerogatives, such as firing for cause or because of the need to downsize)

FIDUCIARY DUTIES IN CLOSE CORPORATIONS

If the defendant makes such showing, the plaintiff may still win if she shows that the legitimate business purpose could be met by a less restrictive alternative. That is, is there some way the corp. could achieve its purpose without harming the plaintiff? The court will then attempt to balance the legitimate business purpose against the practicability of the proposed less harmful alternative Employee/minority shareholder FREEZE OUT - Exception to MAJORITY shareholders fiduciary duties Controlling shareholders can use employment agreements to their advantage to secure their rights to terminate the employment of an employee who is also a minority shareholder o Ingle v. Glamore Motor Sales o Plaintiff, Phillip Ingle, sued Defendants, Glamore Motor Sales, Inc. et al., for wrongful termination and a breach of a fiduciary duty owed to Plaintiff through his status as a minority shareholder. P and D entered into a shareholder agreement under which P could be fired for any reason and his shares could be bought at a specified price. o Issue: whether Plaintiff minority shareholder is owed a fiduciary duty by the majority to keep Plaintiff in his position at Defendant company. o Rule: Absent an employment contract, an employee is an at-will employee when his shareholder agreement provides a buyback provision of his shares if they are terminated for any reason. o Held: When he was fired, he ceased to be an employee, and the divestiture of his shares followed as a logical matter by virtue of the shareholders agreement. Duty to Disclose (to Minority Shareholder): Majority must always keep the minority in the loop o Jordan v. Duff and Phelps P sought damages or a rescission of the sale of his shares sale to his former employer, Defendant Duff and Phelps, Inc., because Defendant did not disclose to Plaintiff information about a potential buyout. Rule: A closely held corporation has a duty to disclose a potential merger or buyout when attempting to buy shares from an unwary shareholder, even if the deal has yet to reach an agreement as to price or structure of the deal. Fiduciary Duties of MINORITY Shareholders to MAJORITY (flipped) o Smith v. Atlantic Properties p. 38 4 shareholders bought equal amounts of stock in a real estate venture. Each shareholder could veto any proposed corporate action due to a supermajority provision (80%). Wolfson used his veto power to prevent the corporation from paying dividends. The other shareholders alleged that Wolfsons use of his veto power constituted a breach of fiduciary duty. Not paying dividends led to tax issues which led to more significant problems. Holding/Reasoning: A veto power vested in the majority shareholders should be subject to fiduciary analysis. Wolfsons use of his veto power violated those duties because it subjected the corporation to an unnecessary assessment of penalty taxes Smith Rule: Minority shareholders owe majority shareholders a fiduciary duty in the same manner that majority owners owe minority shareholders, and therefore the majority can seek judicial intervention for decisions that are unjustifiable for the corporations interests.

DISSOLUTION
I. Overview A. All states have provisions under which a shareholder may seek involuntary dissolution of the corporation 1. If granted, dissolution leads to a winding up and liquidation of the firm, followed by a distribution of the firms remaining assets to creditors and then to shareholders. B. MBCA 14.40 (p.470) II. Dissolution on Grounds of Oppression and the Reasonable Expectation Standard A. Oppression: Conduct that substantially defeats a minority shareholders reasonable expectations. (In re Kemp & Beatley) 1. Reasonable Expectation Standard These reasonable expectations are those that (a). Objectively viewed were reasonable under the circumstances; (b). Known (or should have been known) to the majority, and; (c). Were central to the petitioners decision to joint the venture. 2. Oppression means more than disappointment The very reasons for participating must have been defeated. B. Mueller clarifies many aspects of the Reasonable Expectation Standard: 1. Reasonable expectations can include participation in management of corporate affairs. 2. The minoritys expectation of employment must be balanced against the board of directors ability to exercise its business judgment and run its business efficiently. a. The act of termination in and of itself is NOT an act of oppression. III. Buyout in Lieu of Dissolution A. Dissolution is an extreme remedy. B. Many firms will be worth more if they were split up and sold off in pieces This counsels against granting dissolution, which would lower firms value to everyone (both the complaining shareholder AND the defendants). 1. Judges have equitable discretion to order a stock buyback in lieu of dissolution even in the absence of express statutory authorization. (Alaska Plastics v. Coppock)

a. Alaska Plastics: Three investors owned Alaska plastics, but one transferred half his shares to his ex-wife (Muir) in a divorce settlement. i. Three original owners paid themselves fees, but no dividends. Muir sued and court ordered Alaska plastics to buy Muirs shares at their fair value. b. Alaska Law: i. Alaska corporate law permits shareholders to sue for dissolution, and, if a P meets the requirements for dissolution, Alaska courts have equitable power to order such a buyback in lieu of dissolution. ii. To get dissolution in the first place, P must show oppression or fraud. The clear trend is toward statutory provisions allowing the court to order a buy-out at a fair value (to be set by the court). o 14.34 of the MBCA Triggers by involuntary dissolution The petitioning shareholder will have to make a showing (such as oppressive behavior) that would justify an order of dissolution The statute seem to permit a buy-out only of the petitioning shareholder

MERGERS AND TAKEOVERS

Fundamental corporate changes generally cannot be approved only by the board of directors. They must also be approved by shareholders In most states, these events are considered fundamental: o Amendment of the articles of incorporation o Merging into another corp o Acquire the companys stock in a share exchange o Sale of substantially all the business assets o Conversion to another form or business o Dissolution o Involuntary dissolution (but court or govt official) Procedure for fundamental change (for all changes) o Board of Directors initiates and approves the matter o The Board must inform the shareholders that it recommends the fundamental changes o The Board calls a special meeting of shareholders to consider the change (there must be a quorum, corp can adjust the # of shares that will constitute a Q. Default rule: stat provides that the Q must be at least a majority of the shares entitled to vote) If SH approves deal goes thru If they reject it deal dies o If we have a quorum, there is considerable divergence on what vote is required to approve a fundamental change Traditional 2/3 of the votes entitled to vote supermajority of the shares entitled to vote, not just shares in general. = TX, OH, MA Majority majority of the shares entitled to vote Modern MBCA 10.03(e), 7.25(c) Requires approval only by a majority of the shares actually voting on the fundamental change. o If the change is approved by shareholders, the corp goes thru with the change. But dissenting SH may have a dissenting shareholders right of appraisal which allows them to force the corp to buy their stock o In most fundamental changes, the corp must inform the state by delivering a document summarizing the change, which is filed with the state officer Dissenting Shareholders Right Of Appraisal Generally, the right exists for: o Holders of voting stock in a disappearing corp. in a merger o Shareholders of a corp. that transfers substantially all its assets o Shareholders of a company whose shares are acquired in a share exchange Limitation on the availability of the right in many states o Not available if the corporations stock is publicly traded or if it has a large number of shareholders (typically 2,000 or more) Rationale: a disgruntled SH can sell her stock on the pubic market In most states, Shareholders must take three steps to exercise their right of appraisal, see, e.g. Del. 262, MBCA 13.21 o Before the SH vote on the matter, she must file with the corporation a statement of her objection to the proposed change and of her intent to demand payment if the deal is approved o The SH must abstain or vote against the proposed change o Within a set time (usually 20 days) after the official notification from the corp that the change was approved, the shareholder must make a written demand to be bought out and must tender her stock to the corporation

The burden then falls on the corp to accept or reject the SHs demand o The corporation may reject and offer a lower figure o MA: the corp makes first determination of the value, and proffers that amount to the SH; if she rejects it, she then states what she thinks the value is At some point, either the corp or shareholder will file suit for an appraisal o Often corp must do this w/in 60 days of the SH demand, failure corp must pay what the SH demanded o In same states, the corp must institute litigation if two parties dont agree on the value of the SHs stock When the matter is litigated, the court will appoint an appraiser to assess the value of the stock The goal is to determine the value immediately before the fundamental change took place o After the litigation, courts in many states are empowered to award attorney fees either to or against the corp depending upon the good faith with which the parties set their estimate of FV DE courts method of appraisal - DE block or weighted averages, looks at 3 factors: very subjective, traditional o Net asset value o EPS o Market value of the company before the fundamental change took place The DE courts then weights these factors as it sees fit on the facts of the case Weinberger v. UOP method more liberal approach o proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court. After determining the value of the dissenting shareholders stock, some courts would then discount that value in 1 of 2 ways: o Minority discount not having enough voting strength to affect corporate decision making o Lack of marketability there is no market on whch she can sell her stock In most states, appraisal seems to be the exclusive remedy unless the action taken was fraudulent or oppressive. o Typ arg: change was undertaken not for some legitimate corporate purpose, but to squeeze out minority shareholders if the company hasnt been sold rescind the merger if the company has been sold sue for rescissory damages - $ recovery that would put them in the position they would be in had the change not been approved. FREEZE-OUT/CASH-OUT MERGER: o Typical structure: triangular merger. P. 1 o Common issue: conflict of interest between majority shareholder and minority shareholder o Weinberger v. UOP After the P shows self-dealing, the D has the burden of showing that the deal was fair under the entire fairness test D must show that the transaction was: o Procedurally fair (looking at the overall course of dealing, such as who initiated the deal), AND o Substantively fair (looking at the price and terms) Note: if the transaction is approved by an independent committee of directors or an informed majority of the minority SH, the burden of prof will shift from the majority shareholder to the shareholders fight the transaction to show that transaction was unfair (although the standard is still entire fairness). The Weinberger court also dismissed the relevance of the need for controlling SH to satisfy the business purpose test. Not every objection to a fundamental change will justify a suit for rescission or rescissory damages Weinberger: if the SHs complaint is that the financial terms of the cash-out merger are inadequate, appraisal is her only remedy STATUTORY SHORT FORM MERGER o Must be authorized by state law In many states, such as CA, a majority SH may perform a cash out merger w/o shareholder approval, providing the majority SH holds a certain significant % of the corps outstanding stock CA + DE 90%, represents a typical requirement o Structure: tender offer to eliminate any remaining minority SHs statutory SF mergers Simpler and easier than a (non SF) cash out merger De Facto Merger Doctrine o Trigger: when a company manipulates the form of a deal to avoid a result which would have applied had the deal been accomplished in a more traditional manner. (ie. Merger) o Accepting rule: form over substance standard merger process Farris v. Glen Alden Corp o Rejecting rule: respecting form DE, Hariton v. Arco Electronics Hostile Takeovers o A bidder trying to oust the incumbent board of a target corporation o If the target is a public company 2 basic models of takeover Tender offer

Proxy fight Tender offer (deals between the bidder and SHs not fundamental change do not require the target boards approval (right under the Boards nose) The aggressor makes a public offer of cash or its stock Those shareholders who accept the offer tender their stock to the bidder The goal is to obtain a majority of the stock so the tender is conditioned upon a given % of the shares actually being tendered if the % is not reached, then the deal fails and the bidder does not buy the stock when a cash tender offer is made, the open market price of the target will increase (Arbitrageurs will buy the target cos stock in the open market and tender it at the offer price, which also drives up the market price) Disclosure: Williams Act: requires anyone making a cash tender offer for a registered corp to disclose various things: source of funds used in the offer, the purpose for which the offer is made, and any contracts or understandings the acquirer has regarding the target. The target must respond publicly to the offer. bootstrap LBO use the targets CF to pay off the junk bonds Proxy fight/contest Aggressor competes with the incumbent management of the target to obtain enough proxy appointments to elect a majority of the board Sometimes used to encourage the incumbent board to consider a consensual merger of the target into the aggressor CEOs sometimes receive golden parachutes severances for managers whose companies are taken over (incentive to not oppose the deal that would benefit the shareholders) Proxy can be used in conjunction with tender offer (buy a substantial minority position thru the open market, then use a proxy contest to obtain enough additional shares to replace the incumbent board.) Disclosure: a solicitation from more than ten shareholders requires compliance with the SEC proxy regulation 11.4. SEC requires that participants file info with the SEC and the securities exchanges at least 5 days before the solicitation begins o Participants include anyone who contributed more than $500 to finance the contest. Must include their identity, interests in the corp, etc. Williams Act requires anyone who acquires more than 5% of the voting stock to file a disclosure statement w/in 10 days thereafter Its an uphill battle for the aggressor Incumbent management has access to corp assets to fight the contest Have access to defensive tactics Shareholder apathy generally favors management (those who might respond to a cash tender may be likely to answer a call for their proxy) Very expensive Defensive Tactics White knight more congenial bidder Buying a business that increases the chances that the threatened takeover will give rise to antitrust problems by concentrating too much power in a business area Adopting voting procedures that make it difficult for a bidder who acquires a majority of the voting shares to replace the Board Suing for an injunction to stop the proposed takeover alleging violations of the William Act or antitrust laws Issuing additional shares to friendly persons to make a takeover more difficult (lockup) Increasing the dividend or otherwise driving up the price of shares to make the take over price unattractive Greenmail - Buying off the bidder Running up debt obligations to make seizing the company less attractive Repurchasing the corps stock in the market to drive up the price Most effective poison pill, aka shareholder rights plan Triggering event when the aggressor acquired a given % of the corps stock the corp will issue debt/equity to the remaining shareholders at a bargain price. This dilutes the aggressors ownership interest and makes it impractical for the aggressor to take control o Poison pill usually provide that the Board may voluntarily disarm the pill before it is triggered Bidder could buy shares slightly below the $ that triggers the pill, then seek a proxy fight to replace eough directors to cause the target to disarm the pill o In response, head hand provision only board members in the office at the time the plan was approved may vote to redeem the rights granted by the plan (DE: violates the basic principle that the current board of directors has control of corporate affairs; other states: upheld) o Some Corps have adopted a no hands poison bill, cannot be disarmed o chewable poison pill gives the targets board to set time to negotiate before the pill becomes effective Unocal v. Mesa (Del) the court held for the Boardthe review is under a more objective standard and less deferential to the board thant BJR Because of the inherent danger that directors might be protecting their jobs by undertaking a defense enhanced judicial scrutiny Two prongs o Initial burden is on the directors, who must first show that they had reasonable grounds for believing that a danger to corporate policy or effectiveness existed This burden is satisfied by showing good faith and reasonable investigation

Good faith requires a showing that the directors acted in response to a perceived threat to the corp and not for the purpose of entrenching themselves in office Reasonable investigation requires a demonstration that the board was adequately informed, with the relevant standard being one of GROSS NEGLIGENCE o If the directors have proved their initial burden, they must next prove that the defense was reasonable in relationship to the threat posted by the hostile bid (this is a notion of balance) Unitrin (Del) (the court discussed the balancing aspect of Unocal) When considering proportionality, a court must first determine whether the boards response to a takeover attempt is coercive of shareholders or preclusive o Preclusive means that the boards effort would make a later tender offer impossible if so, a court may enjoin the boards reaction to the takeover attempt if the boards act is not coercive or preclusive, the court may enjoin it only if it is outside the range of reasonableness under the circ. Revlon v. MacAndrews (Del) When it becomes clear to the Board that the sale of the company is inevitable, the board may not exercise business judgment to prefer one bidder over the other. Instead, its role becomes that of auctioneer, and its duty is to obtain the best possible price for the company. This is also known as the Revlon Duty Problem: it was clear when this duty applies Paramount Communications v. Times (Del) stock for stock merger betw. T and W, Para showed up with an uninvited cash offer to buy T. T&W restructured their deal to have T launch a tender offer to acq. 51% of the Warner stock for cash (pro-management court) Para: the original T&W stock merger triggered Revlon Duty b/c it resulted in change in control. Thus management could not take sides and had to treat Para equally. Held: Revlon did not apply and limited it to cases in which: o The target initiates active bidding to sell itself or to effect a reorganization resulting in a clear break-up of the company o The target reacts to a takeover bid by abandoning its long-term strategy and seeks another transaction that involves the break-up of the company o The T&W merger may have put Time in play, but did not result in its break-up. o Under Unocal defensive tactic was upheld Paramount Communications v. QVC (Del.) Falls under Revlon The target board favored one of the competing aggressors and installed defensive mechanisms Held: Revlon duties applied because the target purused a deal that would result in a change of control and No shop provision is invalid Paramount directors had the following obligaitons: o To be diligent and vigilant in examining critically the Para-Viacom transaction and the QVC tender offers o To act in good faith o To obtain, and act with due care on, all material information reasonably available Including info necessary to compare the two offers to determine which of these transactions, or an alternative course of action, would provide the best value reasonably available to the shareholders. o To negotiate actively and in good faith with both Viacom and QVC Those obligations implicated various issues, including whether or not those provisions and other aspects of the Para-Viacom deal: o Adversely affected the value provided to the Para-shareholders o Inhibited or encouraged alternative bids o Were enforeceable contractual obligations in light of the directors fiduciary duties o In the end would advance or retard the Paramount directors obligation to secure for paramount stockholders the best value reasonably available under the circumstances. Lyondell Chemical Co. v. Ryan (Del, 2009) The court emphasized there is only one Revlon Duty to get the best price for the stockholders at the sale of the company. It explained when that duty arises: o Revlon duties do not arise simply because a company is in play o The duty to seek the best available price applies only when a company embarks on a transaction on its own initiative or in response to an unsolicited offer that will result in a change of control. Because the Targets board had adopted a wait-and-see attitude to a proposed takeover, it had not taken any act that would result in change of control. The court upheld the action under the business judgment rule. Omnicare (Fully Locked Up) ie. Its mathematically impossible or realistically unattainable for another bidder to succeed making closing Fait Accompli Combo of deal protection devices: Specifically enforceable voting agreements committing shareholders with a majority of the voting power to vote for the deal A force the vote provision, and

The absence of an effective fiduciary out, so as to prevent the board from being able to effectively exercise its fiduciary duties, then such deal protection devices are unenforceable These devices were unenforceable b/c: They were preclusive of other deals and coerce stockholders to accept a management-supported transaction (so there is no need to evaluate them further under the range of reasonableness Unocal Standard But they also completely prevented the board from effectively discharging its fiduciary duties (to the extent that merger protection devices purport to require a board to act or not act in such a fashion as to limit the exercise of its fiduciary duties, they are invalid and unenforceable) By completing locking the deal, the NCS board disabled itself from being able to exercise its fiduciary duties upon receipt of a superior offer, when the boards judgment is deemed most important