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I. OBJECTIVES This chapter is intended to acquaint students with the management structure of corporations and the duties and liabilities of those who manage corporations. A student should know: A. The objectives and powers of corporations. B. The functions of boards of directors. C. The process by which directors are elected. D. The formalities of valid board actions. E. The various proposals for changing corporate governance. F. The recent changes in corporate governance imposed by the Sarbanes-Oxley Act of 2002. G. The authority of officers. H. The special rules for managing close corporations. I. The fiduciary duties of directors and officers. J. The operation of the business judgment rule and how directors can comply with it. K. The tactics directors can adopt to fight hostile takeovers of the corporation and the legality of the directors' tactics. L. The liability of the corporation for its agents' torts and crimes. M. The rules for insurance and indemnification of directors and officers. ANSWER TO INTRODUCTORY PROBLEM A. The board of directors should comply with the business judgment rule. The board must make an informed decision and have a rational basis to believe that the decision is in the best interests of the corporation. The rule applies because the board has no conflicts of interest. KRNP can help the board meet its duty by making a reasonable investigation into the acquisition of Ballmax, including the value of Ballmax and its fit with the products and strategy of Clestra. KRNP should investigate connections between the board members and the Ballmax to ensure than no board member has a conflict of interest. KRNP must inform the board of its findings prior to the boards consideration of the acquisition to give the directors time to read and digest the report. At the board meeting, KRNP should make an oral presentation and take questions from the directors. KRNP should advice the board to take adequate time to evaluate the facts provided by KRNP. When the board makes its decision, it should ensure not only that the decision fits with the facts revealed by the reasonable investigation but also with the firms strategy. B. The board should comply with the intrinsic fairness standard because one of Clestras directors has a conflict of interest due to his familys ownership of the Virginia Hatchets. The decision to acquire naming rights to the stadium must be fair to the corporation, that is, one that would be made by reasonable persons acting at arms length. KRNPs role in this decision is virtually identical to its role under the business judgment rule, including making a reasonable investigation and informing the board of the facts. In addition, KRNP should investigate the extent of the directors conflict of interests and ensure that the conflict is fully disclosed to the board. KRNP should advise Clestra that only the disinterested directors consider the decision to obtain naming rights, which at least will shift to the corporation the burden of disproving unfairness if there is litigation. It may result in some courts applying the business judgment rule. In addition, the KRNP should ensure that the
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decision of the board so closely fits with the facts revealed by the reasonable investigation and the firms strategy that the decision to acquire naming rights is fair to the corporation. C. The board should adopt the tactics in Figure 1 on page 942 that deter a hostile bid. These include putting shares in the hands of friendly shareholders, incorporating in a state with a control share law, having a stock trading surveillance program, and perhaps having a poison pill, although shareholders rights plans are typically found invalid when challenged by hostile bidders. An important tactic is the boards adopting a long-range acquisition strategy, because it will justify virtually any hostile takeover defense and help the board meets its fiduciary duty under the Unocal test, which applies when a board is taking steps to oppose a hostile takeover bid. If Clestra has, for example, a long-run strategy to be an independent consumer products company that can nimbly respond to consumer demands, the board may oppose an acquisition by a company that threatens that strategy. Having an acquisition strategy, like Time, Inc. did in the Paramount v. Time case, will help Clestras board prove that it had a reasonable grounds to believe that the acquisition posed a threat to corporate policy and effectiveness and that its defense tactics were reasonable in relation to that threat, two elements of the Unocal test. III. SUGGESTIONS FOR LECTURE PREPARATION A. Introduction Preview the material in this area by explaining that a corporation is managed by its board of directors, which often delegates much authority to board committees and the officers. Next, note that corporation law restricts the managerial discretion of directors and officers. Such restrictions exist in the objectives and powers of the corporation, the authority of management, and the fiduciary duties of management. B. Objectives of the Corporation 1. Compare the profit motive and the other motives of corporations. Note that a corporation may be acting socially responsibly yet be maximizing profits simultaneously. 2. Note that the courts have allowed corporations to act socially responsibly for many years. Dodge v. Ford (which appears on page 967 in Chapter 44), a 1919 case, evidences only one of the judicial attitudes toward socially responsible conduct as of that date. Courts at that time permitted management to act socially responsibly in ways other than maximizing shareholder profit. You may point out that the first corporations in the United States were permitted to exist only because they served socially important functions, such as providing water or operating toll roads. It was only after general corporation laws proliferated in the late 19th Century that the profit maximization objective dominated. Example: Problem Case #1. This is the Revlon case that was previously a text case. 3. Ethics in Action: Corporate Constituency Statutes (p. 930): Discuss the corporate constituency statutes that were passed in response to the Revlon decision. Check whether your state has such a statute. Isnt it essential that corporate managers consider the interests of many corporate constituencies when making an important decision? All the ethical theories we studied in Chapter 4 require consideration of many constituencies. A profit maximizer must consider shareholders, employees, clients, customers, suppliers, and the community, at a minimum, to determine which action will be received well by these groups and lead to firm profitability. A utilitarian must consider the costs and benefits to everyone in order to optimize social utility. A rights theorist must weigh the rights of different constituents. A person who acts according to Kants categorical
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imperative must consider the impact on others in order to determine how he would will others to act. A justice theorist has to consider which of many constituents is most needy. 4. Log On (p. 929): This document frames the corporate constituency statute debate. Some critics view such statutes as granting directors handy rationalizations for justifying too broad a range of actions. Others believe that statutes merely reinforce what directors have done for years when attempting to maximize shareholder profits. 5. Mention Section 2.01 of the ALI's Principles of Corporate Governance: Analysis and Recommendations. The ALI Corporate Governance Project recommends that during the conduct of business a corporation may take ethical considerations into account and may devote resources to public welfare, humanitarian, educational, and philanthropic purposes, whether or not corporate profit and shareholder gain are thereby enhanced. The ethical considerations taken into account must be reasonably regarded as appropriate to the responsible conduct of business by a significant portion of the community. Excluded are ethical considerations that are likely to violate the fair expectations of the shareholders taken as a whole. The Corporate Governance Project is an important work and has appeared to have potential to impact significantly the development of corporate law in the area of social responsibility. However, the Revlon case and the state legislatures' reaction to that case appear to have stolen much of the limelight from the Corporate Governance Project. C. Corporate Powers 1. Distinguish corporate powers from corporate objectives: a corporation has the objectives of maximizing profits and acting socially responsibly; a corporation has the power to do certain acts, such as manufacture computers or contribute to the United Way, which aid it in its accomplishment of its objectives. 2. Note the sources of a corporation's powers and the sources of limitations on a corporation's powers: state statutes and corporate documents, especially the articles of incorporation. 3. Tell students that few limitations exist on a corporation's powers today. Modern statutes empower a corporation to do anything legal. The articles of incorporation rarely limit a corporation's powers. 4. Briefly review the history of the ultra vires doctrine. a. Note that ultra vires problems rarely exist today for two reasons: 1) Modern statutes do not permit a party to a contract to use ultra vires as a defense to a contract. Explain the reason for not allowing either party to a contract to use ultra vires as a defense: each party intended to be bound by the contract; it is merely fortuitous that the contract was ultra vires. 2) Nearly every corporation has a purpose clause that allows it to engage in any lawful act. For example, a coal mining corporation's articles may have a purpose clause that states the following: the corporation is organized for the purpose of mining coal and engaging in any other lawful activity. Such a corporation is not limited by its purpose clause. b. Explain the situations in which ultra vires may be asserted. Note the reasons for allowing ultra vires to be asserted in these situations. 1) Shareholder suit to enjoin an executory ultra vires contract, when the party dealing with the corporation knew the contract was ultra vires. This rule allows a shareholder to force the corporation to comply with its purpose clause. 2) A corporate suit against management for causing damages to the corporation by committing an ultra vires act.

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a) Such suits are usually derivative suits initiated by nonmanagement shareholders of the corporation. Derivative suits are covered in Chapter 44 on pages 970-974. The corporation must prove that it was harmed by management's ultra vires act. b) Note that management is not automatically liable. A manager who has committed an ultra vires act may escape liability by proving that she exercised the care normally expected of corporate managers. 3) Action by the attorney general. You may want to mention this. We let the students cover this material themselves during their reading of the book. 5. Note that the powers of nonprofit corporations are not limited by the Model Business Corporation Act but may be limited by the articles. Ask your students why it may be wise for a nonprofit corporation to limit its purpose. Point out that such a clause would encourage managers to act within the limited scope of the enterprise. Nonetheless, the corporation may not use the ultra vires defense to avoid liability on a contract exceeding its purpose clause. D. The Board of Directors Much of the material here can be learned by a student by himself. We recommend devoting little time to the formalities here, saving time for more important issues, such as corporate governance proposals and management's duties to the corporation. 1. Function of board a. Note that boards in large publicly held corporations mostly only oversee management by officers. b. Name the common board committees and define their functions. c. Note that the Sarbanes-Oxley Act of 2002 requires audit committees comprising independent directors for public companies. 2. Election and removal of directors. You may wish to assign or to refer to Chapter 44's discussion on this subject at pages 957-961. a. Number of directors. Note that the modern rule is to permit corporations to have only one director. Many statutes, however, require a corporation to have at least three directors, unless the corporation has fewer than three shareholders, in which case, it may have as few directors as it has shareholders. b. State that directors are elected and removed by shareholders. 1) Distinguish between straight voting and cumulative voting. Refer to the discussion on straight voting and cumulative voting in Chapter 44 at pages 958959. Note the purposes of cumulative voting: to allocate control among shareholders and to allow minority shareholders to obtain representation on the board of directors. 2) Discuss class voting. Refer to the discussion on classes of shares in Chapter 44 at page 959. 3) Note that shareholders may remove directors with or without cause at any time, absent a contrary provision in the articles. Example: Problem Case # 3. c. Indicate that all directors may be elected yearly or that they may be elected in classes, allowing them to serve terms of up to three years. Note that having classes of directors reduces the effectiveness of cumulative voting, as is discussed in Chapter 44. d. Proxy solicitation process
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1) Explain the mechanics of proxy solicitations, taking care to define the two uses of the term proxy. 2) Explain why a corporation and its management will solicit proxies: to ensure that a quorum of the shares are present and to ensure that management will obtain shareholder approval of management's slate of directors. 3) Note the practical effect of management's solicitation of proxies: it ensures management's perpetuation in office. Ask your students whether the proxy solicitation process upsets the traditional corporate model that shareholders elect directors. 4) Note that sometimes shareholders opposed to management will solicit proxies, which they will vote for director nominees opposed to present management. When management and opposing shareholders solicit proxies in competition with each other, we have a proxy fight (or proxy battle or proxy contest). Management nearly always wins a proxy fight, because most shareholders opposing management sell their shares rather than fight management. This is an application of the Wall Street rule, which is defined on page 932. 5) Improving Corporate Governance. a) Review the proposals for changing (improving) corporate governance on pages 932 and 933. You may want to review or assigned Chapter 4s material on corporate governance at this time. See pages 76 and 82-88. Ask the students to criticize each proposal. Ask students whether they have other proposals to change corporate governance. b) Attempt to define the goals of corporate governance rules. Ask students whether corporate governance rules should increase the efficient management of business, promote increased profitability, increase shareholder participation in management decision-making, or make management more responsible to shareholders, employees, customers, suppliers, other business constituents, or the general public. Ask students whether they can think of any other goals. Can and should corporate governance rules attempt to achieve several goals at once? For example, can some corporate governance rules increase shareholder participation and promote increased profitability at the same time? c) Ask students why they think the traditional corporate governance model withstood the heavy criticism mounted against it during the 1970s and survived with few changes. The answer probably lies more in the pragmatic than in the philosophic: investors recognized that they could realize larger profits by investing in the most profitable businesses and selling unprofitable investments rather than interfering with the management of corporations. That philosophy may change after the ethical debacles of the early 2000s. Well watch that closely. d) The Global Business Environment: Corporate Governance in Germany (p. 934): Some critics laud Germanys corporate governance structure as a model. American corporations are not required by statute to have labor representatives on their boards of directors, and few have chosen voluntarily to place labor representatives on their boards. e) Grimes v. Donald (p. 933). The court held that the board of directors had not illegally delegated the board's duties and responsibilities to Donald, the CEO, by agreeing to make a high severance payment to Donald if the board interfered with his management of the corporation.

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Points for Discussion: What reasons did the court give to support its holding? First, the contract did not foreclose the board from exercising its statutory powers and fulfilling its fiduciary duty. The court likened the delegation of duties to Donald to a decision to engage in a certain business, which preempts the corporation from entering other businesses, but nonetheless is reasonable. Second, the market for business executives requires the board to compete for top executives by paying large salaries and giving them high termination payments, which are legal unless excessive. Third, and most important, the board may choose to breach the contract and interfere with Donald's duties and responsibilities, constructively or actually removing him from office. Even though the cost of breaching the contract with Donald may be high, the board has final say whether to allow Donald to pursue his course of action or to pursue the action desired by the board. The court concluded that the cost was not so high in relation to the size of DSC that the board would be unlikely to interfere or terminate Donald if it wished to do so. e. Vacancies on the board. Note the power given to the board here. There is no need to seek shareholder approval between annual shareholders' meetings. Instead, directors may fill vacancies, even if they create the vacancies themselves by increasing the size of the board. f. Removal of Directors. Shareholders may remove directors with or without cause at any time, absent a contrary provision in the articles. Example: Problem Case # 3. 3. Meetings a. Need for formal meetings. Note that directors may take actions at a meeting, including one by telephone. Or they may take actions without a meeting if each director consents in writing to the action taken. b. Notice of Meetings 1) Note that a director is entitled only to notice of special board meetings, which under most statutes (but not the MBCA) must state the purpose of the meeting. Under the MBCA, the notice must be given two days before the meeting. Note that if notice is defective to any director, the action taken at the meeting is invalid. 2) Waiver of notice. A director may waive her objection to defective notice in either of two ways: attendance at the meeting without objection or written waiver delivered to the corporate secretary either before or after the meeting. (Some states require the written waiver to be obtained before the meeting is adjourned.) c. Quorum requirement. Usually, a quorum is a majority of the directors. E. Officers of the Corporation 1. Appointment of officers. Note that officers are selected by the directors. List the officers of the usual corporation; note that the MBCA permits flexibility in determining the officers a corporate may have. 2. Authority of Officers. State that officerswho are agentshave only the powers conferred upon them. Therefore, like agents, they may have express, implied, or apparent authority. And a corporation may ratify officers' previously unauthorized actions. Unlike other agents, they may have inherent authority by virtue of their offices. [You may want to note that such inherent authority is comparable to the implied authority that an agent has by virtue of her title. In fact, you may want to analyze inherent authority as a subset of implied authority.] Example: Problem Case #2.
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F. Managing Close Corporations Compare the roles of shareholders in close corporations with shareholders' roles in publicly held corporations. Note that many close corporations are essentially incorporated partnerships, in which each shareholder wants to participate in management, or at least be employed by the corporation. In addition, shareholders of close corporations often wish to dispense with the traditional formalities of management, such as having regular board meetings. Such management formalities may be unnecessary to protect the rights of close corporation shareholders, since close corporation shareholders are involved in the day-to-day management of the corporation. Yet, close corporations create opportunities for a majority shareholder to dominate the corporation to the detriment of minority shareholders. Although domination or oppression may sometimes provide a legal right of action for the dominated shareholders (as is explained at page 948 in this chapter and at page 975 in Chapter 44), often domination is legal, even if detrimental to minority shareholders. The management formality and shareholder domination problems may be anticipated by good business and legal planning. 1. Reducing Management Formalities. Many statutes now permit close corporations to dispense with the board of directors and to allow the shareholders to manage the corporation as if it were a partnership. Such statutes recognize that many close corporations are merely incorporated partnerships. Note that dispensing with the board is an election: a close corporation may choose to use a board of directors. 2. Preventing Domination of Close Corporation Shareholders. You may want to assign and cover Chapter 44s material relevant to close corporation planning at this time, which will allow you to cover all the major issues regarding the allocation of power in closely held corporations. See pages 958-960 and 970. Note the two ways to prevent domination when a close corporation has a board of directors: restricting board discretion and requiring supermajority votes for board actions. a. Restricting board discretion. Explain that modern statutes grant shareholders unlimited power to limit board discretion. Give a few examples of restrictions: 1) Requiring mandatory annual dividends. 2) Prohibiting the termination of a shareholder's employment. 3) Requiring shareholder approval to hire employees. b. Requiring supermajority votes. Explain how supermajority votes protect minority shareholders. Note that it is imperative that the minority shareholders have representation on the board, unless they have other rights that ensure they will obtain a return on their investments. Supermajority voting requirements can be used to protect the same interests as restrictions on board discretion: 1) Unanimous approval to change the dividend rate or amount. 2) Unanimous approval to terminate a shareholder's employment. 3) Unanimous approval to hire new employees. c. Log On (p. 936): Californias secretary of state provides assistance to those forming close corporations. Does your state? G. Managing Nonprofit Corporations Legally, managing nonprofit corporations is very similar to managing for-profit corporations. Practically, nonprofit corporations are usually managed far more informally that for-profit corporations. However, as liability concerns increase for all business organizations, including nonprofit businesses, it becomes prudent for nonprofit businesses to be more deliberate in their decision-making, especially with regard to important decisions. This means that the dayto-day managers should involve the directors in all decisions that are not ordinary and fully inform the directors prior to or during to their consideration of a matter. Note the purpose of the MBCA's optional provision requiring that no more than 49% of the directors of a public service corporation may be financially interested in the business of the
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corporation: to reduce the risk that the directors win run the corporation for their personal benefit, not the public benefit. H. Directors' and Officers' Duties to the Corporation. 1. Introduction. Start by stating the three duties that managers owe to the corporation: a. To act within their authority. b. To exercise due care. c. To be loyal to the corporation. Expand upon each of these, especially the last two. 2. Duty of care a. Prudent person standard. Note that the MBCA standard refers to the prudent person, not the prudent businessperson. Note also that the standard may be increased, but not decreased, because of the special skills of a particular manager. Example: Problem Case # 4. Note that managers will not be judged in light of the 20-20 vision of hindsight. Everyone knows what to do after history reveals one's mistakes. A manager need merely consider the information available at the time the decision was made. b. Good faith and reasonable belief 1) Reasonable investigation. Before making a decision, managers must make a reasonable investigation in an attempt to discover the material facts that affect a business decision. For some decisions, such as hiring a low-level employee, very little is required. For other decisions, such as selling a profitable product line, a great investigation is required. Note that management is permitted to rely upon corporate staff and outside consultants. Such reliance is common, especially when the corporation is buying or selling product lines and considering proposed mergers and other business combinations. In such situations, the board will rely upon financial reports audited by independent accountants and valuations of investment bankers. 2) Best interests of the corporation. The good faith standard requires the managers to believe honestly that they are acting in the best interest of the corporation. In a manager believes that she is acting contrary to the corporation's best interests, she should not engage in the activity. This requires the directors to act in accordance with the firms strategies. c. The Business Judgment Rule. 1) Note the consequence of the applicability of the business judgment rule: a court will allow management's decision to stand; it will not substitute its judgment for the judgment of management. 2) Indicate the difficulty courts have judging the wisdom of business decisions made by corporate managers. Judges and jurors are often not trained or experienced in business. Their only knowledge of the business of the corporation is based upon evidence presented in court, which is sketchy and incomplete. We like to say, "Judges have no business education, no business experience, and no business judging business managers." Note the effect on business managers if they had to fear liability for every business decision that lost money for the corporation: the managers would be more concerned about liability than about doing what is best for the corporation in the long run. They would take fewer risks, turning down projects that are likely to return huge profits even though there is a small risk that project may generate large losses. The result is that the law would encourage managerial decision-making that would not maximize the total wealth of society.

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3) Review the elements of the business judgment rule. Note that the rule is essentially a restatement of the duty of care discussed earlier. Note especially the role consultants can play in helping the board meets the requirements of the business judgment rule. We cover this in the text in a new subsection on pages 938-939. a) Informed basis. This requires the board to make a reasonable investigation prior to making a decision. b) No conflicts of interest. There should be no self-interest. For example, self-interest exists if there is self-dealing. There must be no doubt that the manager is acting only with his corporation's interest in mind. c) Rational basis. Note the apparent contradiction in the business judgment rule: in determining whether the manager has a rational basis for the decision, the court is second-guessing the manager: the court applies a gross negligence standard in determining whether the decision is reasonable. Hence, the business judgment rule does not absolutely forbid judicial inquiry into the reasonableness of a manager's decision. A low-level review of reasonableness is required by the rule. d) Because many of our students will be consultants, we spend most of class time covering how to help clients comply with the business judgment rule. The new material on page 938 to 939 matches what we tell our students to do when advising corporate clients. e) Omnibank of Mantee v. United Southern Bank (p. 939). Gray was liable for the bank's losses on the loans because he failed to comply with the business judgment rule, as expressed by the Principles of Corporate Governance. Points for Discussion: Why did Gray fail to comply with the business judgment rule? The court said he did not take sufficient steps to protect the loan because he did not receive adequate security for the loan, perfect the bank's security interest in the subcontract rights, inform the prime contractor of the bank's interest in the subcontracts and demand that payments under the subcontract be directed to the bank, and monitor Piecara's performance of the subcontract and have Piecara pay the bank as he received payment under his subcontract. The court in particular pointed out that Gray took a greater risk by accepting accounts receivable as security, because receivables are merely the intangible right to receive payment from another. The court also thought Gray should have taken greater precautions because the subcontract securing the loan was being performed 1,500 miles away from the bank. Additional Points for Discussion: Ask your students whether they agree with the court. This loan was probably small in relation to the total assets of USB. Although USB is complaining now, do your students think that USB would have wanted Gray to do all the things that the court pointed out he should have done? Would such actions have been cost effective in most loan cases? Should it be relevant that Gray relied on financial statements that indicated that the loans were adequately backed by Mirage's promise to pay? Note that at the least Gray should have perfected the security interest. If you students have already covered secured transactions, this is a good case for pointing out the importance of bank executives knowing secured transactions law so they do not make documentation errors. f. Additional Examples: Problem Case ## 5 and 5. 4) Criticism of the business judgment rule

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Critics of management argue that the business judgment rule unduly isolates management from liability for their bad decisions. It is true that very few directors are held liable in the absence of self-dealing. This explains why the Trans Union case (discussed on page 938) surprised some people. Review this case with your students. You may wish to look at the case in its original; it is a long opinion. Ask your students whether they think the directors should have made a more extensive investigation. Tell them that directors almost always obtain an investment banker's report before approving a merger. Note that the court indicated that the board did not look at information concerning the intrinsic value of the corporation. Should a board always be required to look at such information? Clearly it should if there is no regular market for the corporation's shares. But what if the corporation's shares are publicly traded on the New York Stock Exchange? Is not market value the best determinant of the value of shares? Economic and finance theory hold so, yet such thinking has not been generally accepted by lawyers and judges. 5) Recent Changes in the Duty of Care Note the recent changes that make it even more difficult to hold directors and officers liable under the duty of care. Some states have changed the standard to a willfulness or recklessness standard. Other states such as those that have adopted the MBCA permit shareholders to amend the articles to reduce the liability of directors and officers. 6) Opposition to Acquisition of Control A boards' use of tactics to defend against hostile tender offers has created special problems for courts' deciding whether to apply the business judgment rule. Although most enlightened commentators believe that self-preservation is the primary motivation for using defense tactics, courts nearly always find that the boards have no conflict of interest. The Delaware decisions, beginning with the Unocal case, represent a middle ground. a) Go over the defense tactics in Figure 1 on page 942. b) Note the large number of constituencies that the board may consider in choosing to oppose a hostile tender offer. In part, the judicial attitude favoring defense tactics may reflect the judges' disdain for hostile tender offers. [You may wish to refer here to the materials on tender offer legislation, especially the federal law, whose purpose is to promote an auction market for corporate shares. This is covered in Chapter 45 at pages 1018-1020.] Often, the few tender offer defense cases in which the business judgment rule was not applied involved boards that acted quickly to oppose the tender offer without first carefully considering whether the offer was in the best interest of the corporation. In such cases, either the board lacked an informed basis for its decision or the lack of a reasonable investigation proved the board preferred its self-preservation interest over the best interests of the corporation. c) Cover the three elements of the Unocal test on page 941. Paramount Communications, Inc. v. Time, Inc. (p. 943). The court refused to apply the business judgment rule to the decision to oppose Paramount's takeover offer unless the board proved 1) reasonable grounds for believing that a danger to corporate policy and effectiveness existed and 2) the defensive measure adopted was reasonable in relation to the threat posed. Points for Discussion: Ask your students whether they are persuaded by the court's reasoning that there is reasonable grounds for believing that a danger
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to corporate policy and effectiveness existed. Is the court applying the business judgment rule prematurely by stating that the court can't substitute its judgment regarding what is a better deal? Has the court provided a "trump card" for all directors opposing a takeover by validating the directors' concern that shareholders might be ignorant or mistaken as to the strategic benefits of the combination with another company? Can this concern always be raised by directors? Note that the court stated that directors are not obliged to abandon a deliberately conceived plan in exchange for short-term shareholder profit unless there is clearly no basis to sustain the corporate strategy. Does this give too much latitude to directors? Additional Points for Discussion: How important to the court's decision was Time's having negotiated a combination with Warner prior to Paramount's initiation of its takeover? It was the most important fact, for it proved that Time's directors were motivated to combine with Warner for honest business reasons, not merely to defeat a hostile takeover. Additional Example: Problem Case #6. 7) The business judgment rule and derivative suits. You may want to cover this important issue at this point. It is discussed in Chapter 44. In states in which the business judgment rule applies to a shareholder litigation committee's decision not to sue wrongdoing managers, it is nearly impossible to hold managers liable to the corporation, even if they have engaged in self-dealing. Applied in such a situation, the business judgment rule nearly absolutely protects managers against liability. 3. Duties of loyalty a. Introduction 1) Explain the general duty of loyalty, as expressed by Judge Cardozo on page 944. A manager must not have divided loyalties; she must do what is best for the corporation even if doing so is detrimental to her own financial interests. 2) List the duties of loyalty and explain them carefully. b. Conflicting Interest Transactions 1) Explain the conflict of interest that arises when a manager deals with his corporation. Note the divided loyalties that exist and the risk that the manager will prefer his own interests to those of the corporation. 2) Explain the intrinsic fairness standard and how it protects the corporation. 3) Note the burden-shifting effect of a manager obtaining board or shareholder approval of a self-dealing transaction. Approval by itself is not enough to legitimize the transaction. It merely shifts to the corporation the burden to prove the absence of intrinsic fairness. Without approval, the self-dealing manager has the burden of proving intrinsic fairness. Note that unanimous shareholder approval conclusively legitimizes the transaction: intrinsic fairness becomes irrelevant. Note the variety of statutory schemes that dictate the formalities to be followed to obtain board or shareholders approval of a self-dealing transaction. Some statutes permit an interested director to be counted toward a quorum of the board; others do not. Some statutes permit interested directors to vote, but do not count their votes; others prohibit interested directors from voting. Some statutes permit an interested shareholder to vote; others do not. Some statutes require disclosure of only the manager's interest; others require disclosure of all material facts as well.
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4) Ethics in Action: Sarbanes-Oxley Act of 2002 Prohibits Loans to Management (p. 945): The jury is out on the need for and effectiveness of the Sarbanes-Oxley Act. The Acts ban of most loans to management is one reason. For many years, loans have been a part of a managers compensation package. The Act doesnt ban other types of compensation, just loans. Why is a loan any more problematic than a high salary? The ethical justification is to prevent management from looting the corporation, yet other ways of looting the corporation are not banned. A rights theorist would consider the ranking of various rights, including a managers right to receive a loan as a form of compensation, the corporations right to compete for executive talent by offering loans, a corporations right not to have its assets looted, and a corporations right to protect itself from looting through internal corporate policies rather than by a law banning loans. There are other rights to be considered. A utilitarian will consider the laws effect on total social welfare and consider whether the negative effects of the law (eliminating a form of executive compensation) will be overcome by the benefits (making looting harder). A profit maximizer will probably point out that the law interferes with the free market for corporate talent and argue that the board of directors can make loans to manager and at the same time protect the corporation. Note that SOA does not prevent banks and other financial institutions from making loans to their management. c. Usurpation of a corporate opportunity Give the essence of this breach: it is theft or conversion of corporate property. While an opportunity may be intangible, it has value. It can also be understood as competing with the corporation. Discuss the three elements of usurpation: 1) Received in a corporate capacity. 2) Relation to corporate business. Examples: a) An opportunity to buy a toll bridge that takes people to a recreational island owned by the corporation. While operating a toll bridge is a new line of business, it does relate to property in which the corporation has an existing interest. b) An opportunity to buy one-half acre of prime commercial real estate. This opportunity would be in the line of business of a real estate investment business. As for another corporation, it would relate to property in which the corporation has an existing interest if the corporation is looking for land on which to build its corporate office. It would have no relation to the business of a corporation operating a small restaurant and having no plans for expansion. 3) Corporation able to take advantage of the opportunity. 4) Guth v. Loft, Inc. (p. 946). List and go through the elements of usurpation with this case. Points for Discussion: What facts prove that Guth received the opportunity in his corporate capacity? That Megargel contacted Guth about the opportunity when Guth was president of Loft. Nothing in the facts suggests that Megargel contacted Guth other than in Guth's personal capacity; nonetheless, since Loft was interested in buying Pepsi syrup, Guth should have considered the opportunity as having been presented to Loft. This reasoning exhibits that high-level officers are almost always acting in their corporate capacities when an opportunity of interest to the corporation comes to their attention. The
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justification for this reasoning is that high-level officers are hired and paid to be on the lookout for opportunities useful to the corporation. What facts prove that the opportunity had a relation to Loft's business? Loft was in the business of manufacturing syrups. Therefore, manufacturing Pepsi was in its line of business. Also, Guth knew that Loft needed a steady supply of cola syrup to allow it to offer its customers a cola drink. Hence, Loft had an interest or expectancy arising out of Guth's knowledge of Loft's need for a supply of cola syrup. What facts prove that Loft was financially able to take advantage of the opportunity? The trial court found that Loft had the resources to develop the Pepsi business. Also, and more importantly, Guth had used Loft's funds, facilities, and employees to develop the opportunity. Guth's misappropriation of Loft's property placed the equities clearly in Loft's favor, making it easier for the court to find for Loft. Additional Point for Discussion: Note the effect of the court's decision. Loft gets all of Guth's Pepsi shares and all of his dividends received from Pepsi. In other words, Guth is not permitted to benefit at all from his usurpation. He must give the corporation all the benefit he has received. The corporation need merely pay him what he paid for the opportunity. Additional Example: Problem Case #8. d. Oppression of minority shareholders 1) There are many forms of oppression, but they share either of two characteristics: the minority shareholders are singled out for detrimental treatment or the majority shareholders are singled out for beneficial treatment. Phrased this way, oppression looks very much like self-dealing, and the rules applied to oppression cases are similar to those applied to conflict-of-interest cases. 2) You may want to cover at this time Chapter 44s material on oppression by majority shareholders on page 975-976. 3) Freeze-outs. Some of the most interesting oppression cases in recent years have been the freeze-outs cases, especially going private transactions. Going private transactions have increased again as the stock market has taken a tumble. For many small corporations, the negatives of public ownership outweigh the benefits. a) Freezeout Methods. Go though the methods in the textbook: the reverse stock split and the freeze-out merger. The latter was the technique used in the Coggins case on page 949. Use schematics to explain the techniques. In addition, dissolution of the corporation and sale of assets to a corporation owned by the majority shareholders will effect a freeze-out. The minority shareholders receive part of the cash proceeds of the sale. This could be done in reverse, with the sale of assets predating the dissolution. The effect is the same. b) Purposes of freeze-outs. Usually corporations freeze out minority shareholders to eliminate the burden of public disclosure required by the SEC (including disclosure of the salaries of officers) and to eliminate minority shareholders, whose concerns must be addressed when the corporation acts. c) Legality. By itself, a freeze-out is not wrongful. However, it can be accomplished in a wrongful way. Note that although Delaware has abandoned the business purpose test as unworkable, other states follow it. Note the two elements of the intrinsic fairness test: fair dealing and fair price. Ask your students which test they like better. What are the problems with
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each test? The difficulties are determining a proper business purpose, deciding whether the minority shareholders are lying about the purpose of the freeze-out, and calculating a fair price. Note that neither test allows a shareholder to remain a shareholder if the freeze-out transaction is structured legally. These tests make it clear that no one has the right to remain a shareholder unless she has taken contractual precautions to prevent a going private transaction. Coggins v. New England Patriots Football Club, Inc. (p. 949). The court reviewed both the business purpose test and intrinsic fairness test as applied to a freeze-out and decides to apply the business purpose test and the fairness test. Points for Discussion: Why did the court decide that the business purpose test was needed in addition to the fairness test? "[T]he duty of a corporate director must be to further the legitimate goals of the corporation. . . . Because the danger of abuse of fiduciary duty is especially great in a freezeout merger, the court must be satisfied that the freeze-out was for the advancement of a legitimate corporate purpose." Why was there no legitimate corporate purpose here? Because only Sullivan was served by the freeze-out, which would allow him to pay and secure his personal obligations. Ask your students whether the court would have legitimized the freeze-out had it applied only the intrinsic fairness test. Additional Example: Problem Case #7. e. Trading on inside information. We cover this area only briefly at this point. The state law of insider trading is largely of only historical importance. The more important law is federal securities law, which applies to nearly every insider trading transaction. You may wish to cover all the law of insider trading at this point. The federal law of insider trading is covered in Chapter 45 at pages 1015-1017. 4. Ethics in Action: Sarbanes-Oxley Act Imposes New Duties and Liabilities on Management (p. 951): Note the new duties imposed on management of public companies: certifying financial statements and disgorging compensation and profits. 5. The Global Business Environment: Directors Duties around the Globe (p. 950): Not surprisingly, directors worldwide owe duties of care and loyalty to their corporations. 6. Capstone Example: Chapter Introductory Problem (p. 928): This problem requires students to determine which standard of director conduct applies in each conduct. It is a good problem to test their knowledge of the contexts in which the business judgment rule, intrinsic fairness standard, and Unocal test apply and the manner in which the board complies with those standards. I. Disclosure of Merger Negotiations You may wish to refer to the Securities Exchange Act Rule 10b-5 discussion of merger negotiation disclosure, which appears at pages 1012-1015 of Chapter 45. J. Director Right to Dissent Note how directors who disagree with an imprudent or otherwise improper decision of the board may escape liability for damages caused by the decision: the director may not vote to approve the transaction and must attempt to dissuade the rest of the board. K. Duties of Directors and Officers of Nonprofit Corporations Note the similarities in for-profit and nonprofit corporation law, including the ability of a nonprofit corporation to limit or eliminate director liability for breaches of the duty of care. Ask your students whether they would be willing to be an uncompensated director of a
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nonprofit public benefit corporation--such as Big Brothers, Big Sisters--if the corporation's articles did not limit their exposure to liability. L. Tort and Criminal Liability 1. Torts. Agents are always liable for their own torts. Corporations are liable for their agents' negligent and intentional torts if committed within the course and scope of employment. Refer to the principles of respondeat superior in Chapter 36. 2. Crimes. Review the evolution of the law to its present state of imposing criminal liability upon corporations for criminal acts requested, authorized, or performed by the board, an officer, a policy making employee, or a high-level administrator. Also, corporations are liable for the crimes of their mere agents when the agents act in the course of their employment. In addition, the corporation can be liable without regard to its intent when the corporation violates a criminal statute designed to protect the public welfare. United States v. USX Corp. (p. 952). The court held that the corporation, ADS, was responsible for the illegal dumping because it accepted the toxic material and selected the site at which it was illegally dumped. White and Charles Carite were not liable, because they did not actively participate in the decision where to dispose of the toxic material. Points for Discussion: ADS, the corporation, is liable for the actions of its employees who arranged for the illegal dumping. White and Charles Carite, however, as the sole shareholders, officers, and directors, are not liable unless they personally participate in the illegal dumping or have knowledge that a subordinate has selected an illegal site and they acquiesce in the subordinate's action. While White was involved in the day-to-day management of the business, he supervised the sales and administrative staff and had no involvement with the operational decisions, including the selection of dumping sites. Charles Carite had little involvement with day-do-day management; it was his brother Tony who managed the people who dumped the toxic waste. If anyone, Tony Carite should be liable for the illegal dumping. Additional Example: Problem Case #9. M. Insurance and Indemnification 1. As if the business judgment rule and recent changes in the duty of care were not enough, insurance and indemnification exist to isolate directors and officers from the financial burden of being found liable to the corporation for mismanaging the corporation. Insurance and indemnification can compensate a manager for other liabilities incurred as well. All large publicly held corporations buy liability insurance for their directors and officers. Insurance should be purchased by any corporation with directors having a liability risk. 2. Go through the indemnification rules. We deleted Figure 2 that was in the 11th edition on page 926, but have included it in this instructors manual. You may want to reproduce it on the board and go through it. Note the different treatment and rationale for limits on the power of the corporation to indemnify managers, depending on who is the plaintiff and whether the action is criminal. Note that a director who acts in good faith will be able to escape financial detriment nearly entirely. Only those who receive a financial benefit will suffer nearly certain financial loss. Example: Problem Case #10. 3. Ethics in Action: Expanding Indemnification (p. 954): The ethics questions in this box place students in the positions of shareholder and director, showing that ones viewpoint may affect ones decisions, unless one is well grounded ethically. A rights theorist will probably have difficulty justifying expanded indemnification of directors on the grounds that the corporations right to be protected from poor judgments by a director is more important than a directors right to avoid financial liability when she acts carelessly and in bad faith. Applying the categorical imperative, would one not will others to act at least
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in good faith? Would one want others merely to be held to a standard that they not intend to harm the corporation and not receive an improper financial benefit? Utilitarian analysis would probably conclude that society loses when directors escape the financial burden of their imprudent and bad faith decisions. A profit maximizer would probably come to the same conclusion. It is hard to see why the market for corporate executive talent would require extending protection to a director who acted in bad faith. A director should not fear promising that minimal amount of due care. A shareholder would argue that the corporation will not maximize its profits if it selects as a director someone who wants protection from careless and dishonest errors in judgment. IV. RECOMMENDED REFERENCES See the references in Instructor's Manual Chapter 41. ANSWERS TO PROBLEM CASES 1. The court held that the directors were required to maximize shareholder profit. The Unocal test did not apply, because the directors had decided to sell the company. Having made that decision, the directors object was not the protection of the corporate enterprise but to sell it to the highest bidder. Shareholders would have been harmed by the lock-up option because it would have caused Pantry Pride to withdraw its takeover bid, even though its bid was higher than Forstmann's bid. Pantry Pride would have withdrawn, because the two divisions that were the subject of the lock-up option were very valuable and would have been sold for less than fair value. Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. S. Ct. 1986). 2. Pine Belt. In the absence of a specific resolution from the board of directors, a corporate officer has no authority to pay from corporate funds the personal debt of a corporate officer. He may only pay debts of the corporation. Also by virtue of his office, a president has no authority to manage the business. Hence, in the absence of power bestowed upon him by the board, he may not sign checks for the corporation. In this case, the board required two officers' signatures, not just the signature of the president. First National Bank of Ruston v. Pine Belt Producers Co-op, 363 So.2d 1201 (La. Ct. App. 1978). 3. No. Mrs. Goode was properly removed from the board by a vote of a majority of a quorum of shares of the corporation. As the court pointed out, the directors have no power to remove fellow directors, even if, as here, the bylaws permit director removal by directors. Even though the meeting was called as a directors meeting and there was ambiguity whether the meeting was a shareholders or directors meeting, since the directors and shareholders were the same, the purpose of the meeting to remove Mrs. Goode was disclosed before the meeting, and all the shareholders attended the meeting, the court preferred substance over form and concluded that the meeting was both a shareholders and a directors meeting. Although the court made a correct decision here, can your students think of reasons why properly naming the type of meeting may be essential in other close corporation situations? What if in this context, notice were given of a directors meeting to remove a director, and one of the director/shareholders did not attend because she knew directors could not remove other directors. If a shareholder meeting were held with the one director/shareholder not attending, it would be inappropriate to validate the shareholder meeting. Or suppose that because the director/shareholder believes it is a directors meeting, the director/shareholder does not attempt to determine how many shares are owned by each shareholder and to convince them to vote a certain way in advance of the meeting. Notice the effect of Mr. Goode's abstaining. It granted control of the corporation to the Manns, who held 50 of the 75 shares voted at the meeting. Also, note that this case is a classic example of the need for close corporation shareholders to protect themselves from
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domination by the other shareholders by requiring unanimity for certain shareholder and director decisions or obtaining long-term employment contracts. Also, had each shareholder held her own class of shares with the ability to elect one director, Mrs. Mann could have elected herself and been removed only by a vote of her shares. Goode v. Goode, 29 Va. Cir. 409 (Va. Cir. Ct. 1992). 4. Yes. Directors have, at least, the duty to supervise the officers. At a bare minimum, a director should ask for and read the annual financial statements of the corporation and react appropriately to what a reading of the statements revealed. The court rejected the sexism implicit in the argument that she was a simple housewife. There was no reason why the average housewife could not adequately discharge the functions of a director despite a lack of business experience, if she gave some reasonable attention to what she was supposed to be doing. Mrs. Pritchard failed to make any effort to discharge her directorial responsibilities. Had she paid the slightest attention to her duties as a director, she would have known what was happening. Francis v. United Jersey Bank, 392 A.2d 1233 (N.J. Cty. Ct. 1978). 5. The held that the Cubs were not required to "follow the crowd" by having night games like other baseball clubs. The judgment of the directors of a corporation enjoys the benefit of a presumption that it was formed in good faith and was designed to promote the best interests of the corporation. The court believed that the directors acted in the best interests of the corporation. The court was impressed that the long run interests of the Cubs would be served by preserving the surrounding neighborhood, which would make Wrigley Field more pleasant for patrons and maintain the value of Wrigley Field. Note that the Cubs, under different ownership today, have put lights in Wrigley Field and are playing night games. The Cubs rationale for wanting lights is that without lights games must be played during hot days in July and August (causing the players to tire faster during the long season) and that with lights more fans who work will come to games. In addition, without lights the Cubs' home playoff and World Series games that television contracts dictate shall be played at night would have to be played away from Wrigley Field. Ask your students whether a shareholder who sues to force the Cubs to remove the lights would be successful or whether the business judgment rule would protect management. The answer is that the business judgment rule protects Cubs' management. This shows how protective the business judgment rule is, because it protects directors whether they decide to have lights or not to have lights at Wrigley Field. Shlensky v. Wrigley, 237 N.E.2d 776 (Ill. App. 1968). 6. No. The court held that when a corporation undertakes a transaction that will cause a change in corporate control, the directors have an obligation "to seek the best value reasonably available to the shareholders." The court found that the Paramount directors' process was not reasonable and the result achieved for the shareholders was not reasonable. The court ruled that the directors squandered their "final opportunity to negotiate on the stockholders' behalf and to fulfill their obligation to seek the best value reasonably available." Rather than taking advantage of the opportunity, the directors "chose to wall themselves off from material information that was reasonably available and to hide behind defensive measures as a rationalization for refusing to negotiate with QVC or seeking other alternatives." Paramount Communications Inc. v. QVC Network Inc., 637 A.2d 34 (Del. S. Ct. 1994). 7. Delaware law requires that the freeze-out meet the Total Fairness Test, comprising fair dealing and fair price. Some states require that the freeze-out also have a proper business purpose. This case was decided under Minnesota law, which required that the freeze-out not be fraudulent, meaning that the proper procedures were followed, including full disclosure. Sifferle v. Micom Corp., 384 N.W.2d 503 (Minn. Ct. App. 1986). 8. Yes. Becker usurped a corporate opportunity. The opportunity to purchase the Ben Franklin franchise was one in which the corporation was interested and had the financial ability to acquire, was reasonably incident to the corporation's business, and could even be considered
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necessary to the continuation of the corporation's business as its lease was not being renewed. Lindenhurst Drugs, Inc. v. Becker, 506 N.E.2d 645 (Ill. App. 1987). 9. Yes. Because Waderich was responsible for daily operation of the corporation, Waderich was directly involved in the illegal activity. Stanko was guilty because he directed corporate employees to do the criminal acts and because he was in a responsible relationship to the activity that violated the food laws. Cattle King was guilty, because Waderich was acting within the scope of his employment as general sales manager when he committed the crimes, he was authorized by Stanko to do the criminal acts, and he was motivated to benefit the corporation by saving it money. U.S. v. Cattle King Packing Co., Inc., 793 F.2d 232 (10th Cir. 1986). 10. Under the default rule of the MBCA, Gregg Corporation may indemnify the directors litigation expenses, but not the judgment amount they were ordered to pay Gregg, because the directors were found liable to their corporation. To indemnify the directors for their litigation expenses, disinterested shareholders, directors, or independent legal counsel must find that the directors acted in good faith and reasonably believed they acted in the best interests of Gregg. Those standards are likely provable, because the directors acted in what they believed was in the best interest of Gregg in making the loan (to retain the CEO) and forgiving it (the CEO is bankrupt). Were Gregg a public company and the loan made after the Sarbanes-Oxley Act of 2002 took affect, the loan would have been an illegal action, making it more difficult to prove the directors good faith. VI. ONLINE RESEARCH: INDEPENDENT DIRECTORS The NYSEs website is at www.nyse.com and the NASDAQs is at www.nasdaq.com. The NYSEs website has a link to its Corporate Governance proposals in the middle of its homepage. The NASDAQs website has a menu under Inside NASDAQ on the left. In that menu is Legal and Compliance. Click on that link and youll find an FAQ page with Corporate Governance listed. Click on that link. When the instructors manual went to press, the SEC had not yet approved the NYSEs and NASDAQs proposed rules on corporate governance. You can check the current status at the NYSEs and NASDAQs websites. The NYSEs corporate governance proposals include the following: 1) Require listed companies to have a majority of independent directors; 2) Empower non-management directors to serve as a more effective check on management, including regular meetings of non-management directors without management; 3) Require listed companies to have a nominating/corporate governance committee comprising only independent directors; 4) Require listed companies to have a compensation committee comprising only independent directors; 5) Require the chair of the audit committee to have accounting or financial management experience; 6) Grant audit committees sole authority to hire and fire independent auditors and to approve any significant non-audit relationship with auditors; 7) Increase shareholder control over equity-compensation plans for management; 8) Require listed companies to adopt and disclose their corporate governance guidelines; 9) Require listed companies to adopt and disclose a code of business ethics for directors, officers, and employees and to promptly disclose waivers of the code for directors and executive officers;
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10) Required each listed company CEO to certify to the NYSE that the CEO has no reasonable cause to believe that the information provided to investors is not accurate and complete. The NASDAQ proposals are similar and include requiring a majority of independent directors, shareholder approval of stock option plans, greater audit committee independence, ability of all audit committee members to read and understand financial statements, strengthened role of independent directors in compensation and nomination decisions, and codes of conduct for directors and employees.

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Litigation against a Director Arising from the Directors Performance of Her Corporate Duties

Director wins. Director received an improper financial benefit.

Director loses or settles Director did no receive an improper financial benefit.

Indemnification mandatory.

Corporation must pay directors litigation expenses.

Corporation may not indemnify the director.

Indemnification permissible.

Plaintiff is directors corporation.

Plaintiff is not directors corporation.

Criminal action against director.

Corporation may pay directors litigation expenses only.

Corporation may pay directors litigation expenses and judgment or settlement amount.

Corporation may pay directors litigation expenses and criminal fine.

Director must have no reason to believe and no believe her conduct was unlawful.

Director must act in good faith.

Director must reasonably believe she acted in the best interests of her corporation.

Indemnification must be approved by disinterested directors, disinterested shareholders, or independent legal counsel.

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