Corporations Outline

The Law of Agency Relevant statutes: R3A 1.01, 2.01-2.07, 3.01-3.11, 4.01-4.02, 7.07, 8.01-8.03, 8.06 Agency law is essential because it allows for hierarchical organization and delegation which

facilitates large scale enterprise Agency defined

o R3A 1.01: Agency defined: Agency is the fiduciary relationship that arises when one person (a principal) manifests assent to another person (an agent) that the agent shall act on the principal’s behalf and subject to the principal’s control, and the agent manifests assent or otherwise consents so to act.

o Test for agency 1: Did alleged principal manifest assent to the alleged agent that the agent shall

2: Act on the principal’s behalf, and 3: Subject to the principal’s control, and 4: Did the agent manifest assent or otherwise consents so to act?

Termso Agents may be

Employee/servant: when P has a right under his deal w/A to control the details of the way in which the agent goes about her task

Independent contractor: when P’s rights of control are less extensive – no control of details, but right to fire

Special agents (agency limited to a single act or transaction) General agents (agency contemplates a series of acts or transactions)

o Principals may be Disclosed

3rd parties transacting with agent understand agent is acting on behalf of a particular principal

Undisclosed 3rd parties unaware of principal & believe agent is principal

Partially disclosed 3rd parties aware they are dealing w/an agent but don’t know identity of principal

Terminationo Principal or agent can terminate an agency at any timeo In no event will an agency continue over the objection of one of the parties

Forming an agency relationshipo Formed by offer and acceptanceo Parties’ characterization/subjective intent does not control

Agency relations may be implied when the parties have not explicitly agreed to an agency relationship

Cargill, Inc. (seedco. gets loan w/lots of oversight and control from Cargill) Rule: An agency relationship may be proved by circumstantial evidence which

shows a course of dealing between the two parties Cargill argues it’s a debtor-creditor relationship as opposed to agency

relationship because it’s common for creditors to impose conditions; but perhaps not so many conditions

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Authority of Agento Actual Authority: R3A 2.01

Based on the words and actions of the principal, the agent reasonably believed that the principal gave the agent the authority What reasonable person in agent’s position would infer from principal’s conduct Not what the principal subjectively intended

Includes incidental/implied Authority to take the steps ordinarily done in connection with facilitating the

authorized acto Apparent Authority: R3A 2.03

3rd party reasonably believes by relying on acts of principal that agent has authority Agent cannot ordinarily establish his own authority by asserting it; it must be

based on reasonable manifestation by principal White v. Thomas (Simpson bought 217 acres on behalf of D, sold 45 to P)

D’s secretary did not have express, implied or apparent authority to sell 45 acres Rule: declarations of an alleged agent may be used to corroborate other evidence

of the scope of agency, but agency cannot be shown solely by his own declarations or actions in the absence of the principal

o Inherent Authority Not conferred on agents by principals but represents consequences imposed on

principals by law Gallant Ins. Co. v. Isaac (insurance agent agrees by phone to change car covered)

Inherent agency power derives not from authority, apparent, or estoppel, but from the agency relation itself.

Rule: An agent has the inherent authority to bind the principal if 1) act usually accompanies/is incidental to the tasks it is authorized to perform 2) the third party reasonably believes the agent had authority to perform the

act in question due to the agent’s direct and indirect manifestations, and 3) 3rd party not on notice that agent does not have authority to perform the act

Tends to be applied when it would be unjust/inequitable to do otherwise Liability

o Agency by Estoppel R3A 2.05: person can be held liable despite not making any manifestation that an

actor has authority as an agent, if a third party justifiably makes a detrimental change in position because a transaction is believed to be on the person’s account and 1) the person carelessly caused the belief, or 2) having notice of the belief, the person did not take reasonable steps to notify

the third party of the factso Undisclosed Principal

R3A 2.06: Undisclosed principal liable to 3d party for agent’s actions without actual authority if he knows of agent’s actions and their likelihood to induce others to change their positions, but fails to try to prevent them

o Agency by Ratification R3A 4.01: accepting benefits under an unauthorized contract will constitute

acceptance of its obligations as well as its benefits

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o In Tort In general, principals are

Liable for torts committed by employees Not liable for torts committed by independent contractors

Only the employer-employee relationship ordinarily triggers vicarious liability for all torts committed within the agent’s scope of employment.

R3A 2.04 Respondeat Superior An employer is subject to liability for torts committed by employees while acting

within the scope of their employment Humble Oil (car rolls out of a gas station and strikes P and 3 kids)

Holding: court finds employer-employee relationship, thus D is liable How to distinguish employee from independent contractor

o Control and supervision over the contractor/employee’s actions Governance of Agency Relationships

o Agency Cost Monitoring cost: expenditures on monitoring the actions of the agent Bonding cost: expenditures by agent to reduce agency costs Residual losses: the costs incurred from divergent principal and agent interests

despite the use of monitoring and bondingo Fiduciary Duties

Obedience: to the documents creating the relationship Duty of loyalty: to exercise legal power over the subject of the relationship in a

manner that the holder of the power believes in good faith is best to advance the interest or purposes of the principal or beneficiary (most important duty in agency)

Duty of care: duty to act in good faith, as one believes a reasonable person would acto R3A 8.01: agent has a duty to act loyally for the principal’s benefit in all matters

connected with the agency relationshipo R3A 8.03: an agent has a duty not to deal with the principal as or on behalf of an adverse

party in a transaction connected with the agency relationshipo R3A 8.06: Principal’s consento Tarnowski v. Resop (agent misrepresents the nature of a jukebox route)

Rule: all profits made by an agent in the course of an agency belong to principal Rationale: don’t want to create incentives for agents to seek their own profits

In addition, under RA 407(2), fees and expenses directly traceable to harm caused by D’s wrongful acts are also recoverable This is a fiduciary duty case; were it a tort case, P would have to have been

injured to recover in torto Gleeson (lessee of 160 acres also the trustee)

Trustee cannot deal with trust property for his own benefit When testatrix died, D had a choice: tenant or trustee?

Rule in agency is different Agent can deal with property in his own self interest if

Good faith, disclosure, and fair dealingThe Law of Partnership Partnership Basics

o Relevant statutes

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UPA: 6-9, 12-16, 18, 25-27, 31, 36, 40(h)-(i) RUPA: 201-203, 301, 403, 404, 501-503, 807(a), 1001, 1002 LLCA: 18-201, 18-303

o Definition: UPA 6: association of two or more persons to carry on as a business as co-owners

o Default contractual form that can be contracted aroundo Characteristics

Share control and profits Each partner votes on partnership matters (18e) Each contributes capital as need w/other partners (18a) New partners added only w/unanimous vote (18g)

J&S liability for business debts caused by wrongful acts (15a) Joint liability for other debts (15b)

At will or for a set term Subject to dissolution by any P and when any P dies or withdraws

RUPA fixes somewhat in holding that GP need not be reorganized with each partner change more stable form

Each partner is the other’s agent (9)o Entity status of Partnership

UPA § 25: Tenancy in partnership Quasi-entity; creates some degree of stability

RUPA § 201: Partnership is entity distinct from partners See also RUPA §§ 303, 306, 307

o Partnership vs. corporation Higher transaction costs Less stable (not infinite) Personal liability Difficult to transfer partnership interest

o Central Problem of Partnership: conflict between owners Contrast with central problem of agency (agent-principal)

Partners are fiduciaries/agents of the partnership (UPA 21, 9)o Opportunities that arise because of the partnership belong to the partnership

Meinhard v. Salmon (leased property in at 42nd and went into partnership) Salmon’s duty to Meinhard in practical terms:

Duty to disclose the business opportunity? Duty to give him first right of refusal?

Rule: Partners owe to each other, while their enterprise continues, the duty of the finest loyalty; not just honesty, but the punctilio of an honor the most sensitive…

Holding: Salmon should have disclosed the opportunity Meinhard Rationale: Salmon got the info about the 2nd contract b/c of the partnership

o Either partner can bind the partnership 9(1): Every partner is an agent of the partnership and binds the partnership for normal

activities unless that partner has no authority in that matter, and the recipient knows it

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National Biscuit (2 grocers, one wants to buy bread, the other doesn’t) Purchase of bread an “ordinary matter connected with the partnership business,”

thus Stroud could not restrict Freeman’s authority to purchase bread and thus bind the partnership in liability for those purchases

9-2: w/o authorization from other partners (unanimous?), partners cannot perform unusual, nonoperational activities

Authority to bind firm unless 3rd party knows of limitation on authority Partnership Formation

o UPA 7: determination of whether a partnership exists 1: persons not partners to each other are not partners as to third persons 2: joint tenancy or property, part ownership, etc does not by itself establish p-ship 3: sharing of revenues does not of itself establish p-ship 4: receipt of a share of profits is prima facie evidence of a p-ship

unless payment is:installment payment of debt, wages of employee/rent to landlord, annuity, interest on a loan, consideration for the sale of goodwill or other property

o Factors to help determine if there’s a partnership Interest in net profits – suggests interest in management – suggests partnership Contribution of labor and skill; contribution of capital is not controlling Voluntary contract Intention / consent to do the acts that constitute a partnership

But don’t need the intent to establish a partnershipo Vohland v. Sweet (man works in a nursery)

Cites 7-4 as prima facie evidence of a p-ship; there was profit sharing here It can be inferred that the parties intended to do the things which amount to the

formation of a partnership, regardless of how they may later characterize the relationship.

Partnership Governance & Issues of Authorityo Mostly UPA – default, not mandatoryo Control/Governance

18a: equal sharing of profits and losses 18e: all partners have equal rights in management and conduct of p-ship business 18g: unanimous consent required to admit a new partner to p-ship 18h: majority vote on disagreements about matters connected with the p-ship; an act

requiring a modification of p-ship contract requires unanimous consento Liability

9: partners liable for acts done by each other in the course of business 9-2: not liable for acts outside scope of partnership

13: p-ship bound by partner’s wrongful act in the ordinary course of p-ship business 15: J&S for debts caused by wrongful acts; joint for other debts 16: estoppel: if outsider reps himself as partner and anyone relies on it, he is liable to

that person 36: withdrawing partner liable for liabilities at time of withdrawal and during windup

Partnership Creditor’s Rights o Jingle Rule (UPA § 40(h) & (i)) old rule

Partnership creditors

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Have priority over partnership assets Do not have priority over individual assets

Personal creditors Have priority over individual assets of including partnership profits Do not have any right to partnership assets (UPA § 25(c), RUPA § 501)

o Modern Rule (Bankruptcy Amendments of 1978 & RUPA § 807(a)) Partnership creditors

Have priority over partnership assets and equal claim to individual assets Personal creditors

Have equal claim to individual assets and no right to partnership assets The difference: personal creditors and partnership creditors have equal rights to the

personal assets of the partners modern rule is more friendly to partnership creditors

Dissolution and Disassociationo Under the UPA (§§ 26- 40)

Dissolution (§ 29) Change in the relation of the partners caused by any partner ceasing to be

associated w/ partnership in carrying on of the business (except by assignment) Assignment (§ 27)

Does not of itself dissolve the partnership If dissolution occurs, assignee entitled to his assignor’s interest

Withdrawal Partner always has the power to withdraw at any time, but not always the right

(i.e. may be subject to damages if wrongful) Causes of Dissolution (§ 31)

Not wrongful End of specified term or particular undertaking Express withdrawal when no definite term or particular undertaking Unanimous consent of all non-assignee partners Expulsion of any partner in accordance with granted power Illegality going forward Partner/partnership bankruptcy

Wrongful Withdrawal where express term prohibits dissolution Withdrawal in violation of fiduciary duties.

Note: Most contracts say that withdrawal doesn’t, w/o specific condition, lead to dissolution Gives each partner less power Partnership is more stable, so more valuable to clients and creditors

Page v. Page (partners in a linen supply business wind down) Partnership found to be terminable at will

o No implied agreement to continue business for term long enough to recoup investment; at most only a hope of that.

Limited Liability Formso Limited Liability: business creditors cannot proceed against personal assets of investors

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o Rationale: Creditors need only rely on partnership credit, not personal assets (unless they secure a guarantee)

o Limited Partnership (LP) Limited partner: investor

Contributes capital No management role; maybe rights to appoint/remove a general partner Liability limited to the amount contributed; no personal liability

General partner: manager Has unlimited liability, just like a regular partner Can have a general partner that is a corporation without much capital; this limits

what a 3d party can go after Seems to create no issue w/r/t parties that have notice, but torts? Perhaps should require these LPs to have insurance, rather than min. cap.

o Limited Liability Partnership (LLP) Creates limited partner liability w/r/t professional liability, e.g. torts (i.e. malpractice)

o Limited Liability Company (LLC) Most contractual freedom Dominant form when the company is not publicly traded Creates limited liability w/r/t partnership liability, such as through torts; partners

liable only after the whole firm has been so held Can contract around fiduciary duties to some degree Can elect to have pass-through taxation

Members pay the tax, not the company (no double-taxation, like for a corp.) “Check the box” taxation Can’t do this if shares are publically traded

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The Corporate Form Relevant Statutes

o DGCL: 101, 102, 102(b)(6), 106-109, 111, 121, 122, 141, 142, 151(a), 160(c), 211, 242 General

o Economic Reasons for A legal personality, distinct from investors and managers, that has indefinite life

Stability (as against partnerships) Limited liability for investors (investors have limited liability, corporations unlimited)

Investors can only lose what they invest; no personal liability Makes capital cheaper, attracts investors Reduces monitoring costs, w/r/t managers and other shareholders Makes shares fungible, since value is only based on PV of income stream Allows managers to take more risk by facilitating portfolio diversification As against LLC

LLC more dynamic; corporation has less contractual freedom But corporation necessary if you need public capital

Free transferability of shares Can transfer the whole interest, including governance rights Incentivizes managers to act efficiently Permits development of large capital markets

Specialization/centralization of investors and management Investors can contribute capital without knowledge Management can contribute knowledge without contributing capital

Possibility of capital markets Limited liability → cheaper capital → more investors → more investment

opportunities + possibility of diversification → markets for capitalo Types of corporations

Public corporations Funded through capital markets Rational passivity (Collective Action Problem)

Most investors don’t have incentive to research the firm b/c the number of shares each has isn’t enough to make a big difference

Close corporations Few shareholders Incorporate for tax or liability purposes, not capital-raising Differences from public corporations

Not subject to SEC regulations Less collective action problem

Also: Controlled vs. In the Market General Structure

o Internal affairs Relationship between managers, board, and shareholders Internal Affairs Rule: IAs governed by law of the state of incorporation

o Charter / certificate of incorporation / articles of incorporation DGCL § 102(b)(1)-(7)

Director’s liability for duty of care can be eliminated or limited – 102(b)(7)

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This is the reaction to Van Gorkom Enabling – can create structure best for that business Amendments to

DGCL § 242 Board initiates Requires shareholder vote (default: simple majority)

o Bylaws DGCL § 109 Operating rules Shareholders have power to adopt – DGCL § 109(b)

Can also give the power to the board (see Blasius) Otherwise, board can adopt bylaws only prior to corporation’s receipt of any

payment for stock, or if they are initial directors named in chartero Shareholder rights

Right to sell Right to sue Right to vote Right to dividends when issued Information Rights

State law generally mandates little disclosure Theory is market will require it But see SEC ’34 § 14

List of shareholders unless company proves improper purpose - § 219 Non-objecting beneficial owners if proper purpose - § 219 Books & records if proper purpose – DGCL § 220

Court will tailor access to the purpose shown BUT, do not own the corporation; only hold shares of stock

Board of Directorso Rationale and Criticism

Rationale: Response to rational passivity; shareholders elect board, who appoint management

Criticism: Directors factually don’t have time to devote to job; should be full-timeo Exclusive legal right to manage business affairs – DGCL § 141(a)

Initiates all important action (including initiating committees) Designates management Automatic Self-Cleansing v. Cunninghame (55% of voters want to sell assets)

Shareholders passed a resolution to sell company’s assets w/55% vote Charter said “management of the business” vested in the board, except by

extraordinary resolution of 75% vote Board refuses to sell assets

Court says this is a board decision; it doesn’t have to listen to shareholders if not in corporation’s best interest.

Nature of agency relationship: directors are agents, not for a bare majority of the shareholders, but the company as a whole

o Obligated to obey legal documents creating its authority b/c of Duty of Obedienceo Boards increasingly active in last decade; maybe too much

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o Default: elected for 1 year termso Staggered board

Limits the removal power 3 terms in Del, 4 terms in NY

Corporate officerso Appointed by board resolutiono Agents of the corporation; subject to the fiduciary duty of agents

Subject to apparent authority rules Jennings v. Pittsburg Mercantile (real estate broker gets stiffed)

Mercantile officers (agents) asked Jennings to solicit offers for a sale and leaseback w/ no actual authority from Mercantile board to . Mercantile refused to pay Jennings his commission. Jennings sued.

No apparent authority b/c Jennings relied on agent’s actions, not Board’s. Rule: An agent cannot by his own words invest himself with apparent

authority; such authority emanates from the actions of the principal and not the agent.

Prior dealings establish apparent authority only if these dealingso 1) have a measure of similarity to the act in question, ando 2) have a degree of repetitiveness

Holding a corporate office cannot establish apparent authorityo Not by itself

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Raising Capital Capital Structure

o Leverage = the ratio between debt and equity More debt means higher leverage

o Debt Features

Holder has the right to declare default when The principal isn’t paid on maturity date The interest isn’t paid and there’s an acceleration clause

Stated interest rate or zero-coupon bond (no interest rate, just payout) Can be customized by covenants Can have different seniority levels, which varies risk and price

Disadvantages Cash-flow drain – the stated interest rate must be paid May be more expensive to refinance Possible default if company doesn’t pay, which means company might go into

bankruptcy or have to borrow from another creditor at higher rate of interesto Equity

Features Indefinite commitment – no maturity date Residual interest on corporation’s assets and income (unlimited upside)

Right to dividends when and only when declared by the board No right to declare default/participate in bankruptcy distribution if not paid

Advantages for Managers At a certain point, debt is too expensive

Common vs. Preferred Stock Common: default Preferred

Def: Equity security on which charter confers special right, privilege, or limitation

Typically has preference over common stock for liquidation and dividends Usually doesn’t vote when dividend is current; if not current, can have vote

Valuation Conceptso Time value of money

Why? The use of money is valuable PV = (FV) / (1 + r) PV * (1 + r) = FV FV/PV = 1 + r 100 = 110 / 1.10 100 x 1.10 = 110 110/100 = 1.10

Present value (PV) is the value today of the money to be paid at a future point Discount rate (r): base rate earned from renting money in market Discount factor (1 + r) Future value (FV)

NPV: PV of amounts received minus amounts invested Rate of return: % earned if you invest Relationship between PV and discount rate is inverse; higher DR lower PV

PV of 100 at 8% = $92.60 PV of $100 at 4% = $96.15o Risk and Return

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Risk: volatility of expected returns Expected Return: weighted average of the value of the investment

ER = (Returns Success)x(Probability Success) + (Returns Failure)x(Probability Failure) Then: Discount the expected return to present value

Appetites for Risk Risk neutral: concern only for expected return of investment Risk averse (majority position)

Systematic vs. Unsystematic Systematic – risks for the whole system Unsystematic – risks for individual firms

Risk premium Def.: additional amount risk-averse investors demand for accepting higher-risk

investments in the capital markets; compensation for unpleasantness of volatility Risk adjusted rate: risk free rate plus the risk premium

The higher the risk higher the risk premium higher the risk adjusted rate Risk premium = risk adjusted rate – risk free rate Most investors are risk averse, so demand a risk premium

Problem Hotel wants to borrow $10m; offers to repay $11.3m Bank’s risk assessment: 95% chance paid in full, 5% chance of receiving 0 Risk free rate: 6.5% Risk premium: 2% Risk adjusted rate: 6.5% + 2% = 8.5% Nominal interest rate paid on the loan: 13% ER = $11.3 x .95 + 0 x .05 = $10.735m NPV if risk neutral: -10m + 10.735m/1.065 = ~80k NPV if risk averse: -10m + 1.0.735/1.065 = ~-106k

o Diversification Can eliminate unsystematic risks through diversification Diversified portfolio has less total risk than individual components, so investor

demands lower risk premium Problem

Risk free rate: 6% Mets and Yankees both have 50% chance of winning world series If Mets win, stock worth $100; if Mets lose, stock worth $50 If Yanks win, stock worth $100; if Yanks lose, stock worth $50

ER of both investments is $75 These investments are perfectly diversifiable because they offset each other

o Therefore the discount rate is the risk free rateo Therefore PV is $75/1.06 = $70.75

Valuation of Assets: Discounted Cash Flow Approach (DCF)o Estimate all future cash flows

Use a terminal value to calculate for finite number of years NPV = C0 + (C1/1+r) + (C2/(1+r)2) + … + (Cn/(1+r)n)

o Calculate the discount rate Weighted-average cost of capital (WACC)

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WACC = weighted average cost of debt + weighted average cost of equity Cost of debt calculated using current yields

o The interest rate firm would pay today, not the historical interest rate of existing debt

Cost of equity calculated using one of the methods belowo Cost of equity

Capital asset pricing model (CAPM) Links the asset’s risk to the volatility of the asset’s price Cost of equity = risk free rate + (equity premium)(Beta)

Risk free rate: traditionally the U.S. Treasury bond rate Equity Premium: historical amount that equity returns on investments above

the risk free rate Beta: based on the amount that the company’s stock varies with the market

o If the stock is as risky as the market, Beta = 1o If the stock is more volatile than the market, Beta > 1

o Efficient capital market hypothesis (ECMH) Stock market rapidly reflects all public information bearing on expected value of

stocks (semi-strong form)o Problem from Corporate Finance Notes

Investment opportunity: $1000 investment today In one year: 50% chance of $1500 payoff, 50% chance of $1100 payoff Risk free rate: 5% Risk premium on this project: 5% Risk adjusted rate: 10%

ER = 1500 x .5 + 1100 x .5 = $1300 PV = $1300/1.10 = $1182 NPV = -$1000 + $1182 = $182

Investor invests $1000 at T0 and wants to sell the equity at T0. Value of equity = $1182 (discounted?) Return on equity if strong economy: (1500-1182)/1182 = 27% Return on equity if weak economy: (1100-1182)/1182 = -7%

Investor borrows $400 to pay for part of the $1000 initial investment Borrows at 5% rate

Debt is riskless b/c creditors have first claim & guaranteed cash flows of 1100 Cash flows for debt holders: -$400 at T0, $420 at T1

Cash flows for equity holders: 1500 – 420 = 1080 or 1100 – 420 = 680 EV of cash flows = (1080 + 680)/2 = 880 Equity value = 1182 – 400 = 782 Return on equity if strong economy (1080 – 782)/782 = 38% Return on equity if weak economy (680 – 782)/782 = -13%

Levered equity is riskier than unlevered

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Balance Sheet Assets

o Current assets E.g. cash, accounts receivable, inventories

o Fixed assets E.g. land, machinery, buildings

Liabilitieso Debt

Stockholders Equity (difference between assets and liabilities) is divided into three accountso One: Stated Capital/Legal Capital/Capital Stock

Def: All or portion of value that shareholders transferred to the corporation at the time of the original sale of the company’s stock to original shareholders

Par Value Stock Par Value: Arbitrary dollar amount stated in charter and stock certificate Stated Capital = Par Value x # of issued & outstanding shares If stock price > par value, excess goes to capital surplus Reducing stated capital requires charter amendment to reduce par value

No Par Value Stock Discretionary portion of sale price set aside as stated capital – DGCL § 154

o Two: Retained Earnings Def: Profits not distributed to shareholders Managers may put money into retained earnings when it has better investment options

than the stockholders or to protect themselveso Three: Capital Surplus

Def: Difference between Total Equity and (Stated Capital + Retained Earnings) Assets = Liabilities + Equity

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The Protection of Creditors Relevant Statutes

o DGCL §§ 154, 170; UFTA §§ 2-5, 7 General

o Types of creditors Commercial creditors

Mostly protected by contract and disclosure Involuntary creditors

Tort victims Have to rely on insurance

o Rationale for Creditor Protections Effect of limited liability exacerbates problems of debtor-creditor relationship

Three Primary Strategies to Protect Creditors Mandatory Disclosure

Disclosure offers some promise of controlling debtor opportunism through misrepresentation

Governed by federal securities law; state law rarely uses mandatory disclosure to protect creditors of closely held corporations

Capital Regulationo Largely obsolete these days; not doing the work of creditor protectiono Rationale: Contractual terms expensive to achieve; default terms give assuranceo Financial Statements

See balance sheet above Typically reflect historical costs instead of current economic (market) values

Book value may differ a lot from current market valueo Distribution Constraints

Can pay dividends out of NYBCL 510: dividends may be paid only out of surplus, may not be paid out of

stated capital DGCL 170: dividends may be paid out of capital surplus, or, if no capital surplus,

net profits in current or preceding fiscal year (nimble dividend test) Revaluation surplus – DGCL § 154

Def: market value of assets may be more than historical value on balance sheet – reevaluate the assets to reflect the higher value

Add increase to capital surplus, but must disclose the revaluation Preferred stock

Right to receive dividends If dividends aren’t paid as scheduled, they accumulate Have to pay dividends to preferred stock before common stock

Right against dividend distribution If Total Capital < Value of All Preferred Stock, then no dividends can be paid

until deficiency eliminated - DGCL § 170o Minimum Capitalization Restrictions

In U.S., have been removed for corporations Rationale: Normal business activity can easily dissipate capital

Standard-Based Duties

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o Director Liability Traditionally, directors’ obligations to corporation; in most states of world, advancing

interests of corporation also advances creditors’ interests But, when firm is w/in a “zone of insolvency,” interests may diverge

In such a case, directors should consider the welfare of the community of interests that constitute the corporation, not just shareholders

o Protection against Fraud: Uniform Fraudulent Transfers Act (UFTA) Remains important today Present or future creditors may void transfers when… (UFTA § 4)

One: debtor had actual intent to delay, hinder, or defraud creditors, OR Two:

(1) no fair consideration and (2)(i) debtor is left with remaining assets unreasonably small in relation to its

business, or (2)(ii) debtor intended, believed, or reasonably should have believed he would

incur debts beyond his ability to pay as they became due Fair Consideration: bargained for consideration close to what a reasonable person

would expect (courts reluctant to question when close)o Shareholder Liability to Corporate Creditors

Available when… P has an equitable right (e.g., against fiduciary) Legal remedies are inadequate Usually done when there’s a wrongful act and an abuse of the corporate form by

one or small group of shareholders Equitable Subordination

Definition: When fairness requires that debt owed by a corporation to controlling shareholders be characterized as equity

“A means of protecting unaffiliated creditors by giving them rights to corporate assets superior to those of other creditors who happen to also be significant shareholders of the firm.”

Test/Requirements Creditor is equity holder (typically company officer), and Insider creditor must have behaved unfairly or wrongly toward the corporation

and its outside creditors Costello v. Fazio (partners issued notes & lowered the working capital)

Prior to transition to corporation, partners significantly depleted their capital in the company by writing loans to themselves.

Rule: when partners convert their capital contribution into loans, thereby leaving the corporation grossly undercapitalized to the detriment of creditors, their claims will be subordinated to those of general unsecured creditorso Fraud and mismanagement are not necessary preconditions to equitable

subordination.

Piercing the Corporate Veil

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Definition: Equitable power of court to set aside entity status of corporation to hold shareholders liable on contract or tort obligations Rationale: the corporate form can’t be used to commit fraud

Test/Requirements Such unity of interest and ownership that separate personalities of corporation

and individual no longer existo Factors: Disregard of corporate formalities, commingling of funds,

undercapitalization, one corporation treating the assets of another corporation as its own

AND, failure to pierce the veil would sanction fraud or promote injustice Cases – Voluntary Creditors

Sea-Land v. Pepper Source – this case is pro-Do Marchese owned 5 businesses, including PS. Commingled and misused

funds. Sea Land had judgment against PS. Sea Land tried to pierce corporate veil to get judgment satisfied by Marchese / sibling companies.

o Court says unsatisfied judgment is not enough to establish “fraud or promotion of injustice;” there must be a wrong additional to that, but something less than an affirmative showing of fraud E.g. parent corp that caused sub’s liabilities and its inability to pay for

those liabilities would escape them (more on bottom p. 155) Kinney Shoe v. Polan – this case is pro-P

o Polan formed Polan Industries and Industrial. Kinney subleased to Industrial. Industrial subleased part to Polan Industries. Industrial didn’t pay rent. Industrial had no assets – a shell to protect Polan from liability.

o Court allowed Kinney to pierce corporate veil because Polan disregarded corporate formalities, and both this disregard and gross undercapitalization harmed Kinney

o West Virgina test Unity of interest such that separate personalites no longer exist Would result be inequitable if acts treated as those of the corp. alone Optional third prong: when reasonable for a third party. (e.g. bank or

other lending institution) to do diligence on the corporation, it will be charged with the knowledge that a reasonable credit investigation would disclose. (DC applied this prong; appellate court did not)

o Bubb thinks Kinney should have known what was going on Cases – Involuntary Creditors

Walkovszky v. Carlton (2 cabs per corporation) – this case is pro-Do Court is unwilling to pierce the veil: owner had observed the corporate

formalities, respected distinctions between corporate asset poolso Dissent argues that this is abuse, and that state policy can’t be allowed to

leave victims uncompensatedo Remedy lies not with the court, but with insurance (and the legislature)o Perverse incentives

To simply observe corporate formalities while skimping on repairs, holding the minimum insurance, etc

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Voting Relevant Statutes

o DGCL 141(a), (b), (d), (k), 151(a), 211-214, 216, 218-220, 222-223, 225, 228, 231, 242 General

o Shareholders have three basic rights Right to vote: most important Right to sell (if disappointed w/company’s performance) Right to sue (if there’s a breach of fiduciary duty)

o Basic problem with shareholder voting Collective action problem: incentives for any individual shareholder to free ride far

outweigh incentives to actively monitor the company; your vote doesn’t matter When do shareholders vote?

o At shareholder meetings – DGCL § 211 Special (§ 211(d)) or annual – required; date set in accordance w/bylaws Can bring an action to force a meeting if one hasn’t been called in 13 months –

DGCL § 211(c) Require quorum – DGCL § 211 Notice must be between 10 and 60 days before meeting – DGCL § 222-b

o By written consent DGCL § 228 Can do anything you can do at a meeting Setting record date in such a situation

o Voting by giving proxies to vote to “agent” (usually management) – DGCL § 212(b) Usually empowered to vote on any matter that may come before the meeting. Revocable at any time Content of proxy materials subject of federal regulation. [See below - § 14(a) of 1934

Act and Rule 14a] What do shareholders vote on?

o Amendment of charter – DGCL § 242(b)(1) Class always has the right to vote on an amendment if the action is adverse to the

class – DGCL § 242(b) Del. court interpreted this to only protect changes to things in the stock certificate

o Bylaws – DGCL § 109(a)-(b) Limited by DGCL § 141(a), which gives Board power to supervise business and

affairs of the corporation; not clear where limit is, howevero Directors

Election of directors – DGCL § 211 Removal of directors – DGCL § 141(k)

Default: can remove director with or w/out cause 141(k)(1): unless board is classified, then (unless provided for in the

certificate of incorporation) you must show cause; otherwise the purpose of classified boards is defeated

Action for contested election - DGCL § 225 (also empowers directors)o Extraordinary transactions

Mergers – DGCL § 251(c) Target company always votes Acquiring company sometimes votes (see below p. 45)

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Class voting in mergers Default: all classes of stock vote on a merger unless charter states otherwise –

DGCL § 212(a) Sale of all assets - DGCL § 271(a)

After approval, board can still abandon unilaterally - DGCL § 271(b) Dissolution - DGCL § 275

o Precatory Resolutions (when permitted to enter company proxy materials) E.g. “Stop doing business in South Africa” in 1970s Note: advance notice bylaws require early submission to the company of any

shareholder-originated agenda item for annual meeting, which limits the time when proxy contests can be mounted.

How are votes countedo Straight vs. Cumulative Voting

Straight Voting 51% shareholder can elect all board members

Cumulative Voting: each shareholder casts total # of votes equal to the # of directors he can vote for, multiplied by # of voting shares Ensures minority representation BUT, can expand Board as a way to dilute voting power of minority block Example: A owns 199 shares. B owns 101 shares. 3 directors

With straight voting, A votes for all 3 directors. With cumulative voting, B casts 303 votes (101 x 3) and A cast 597 (199 x 3).

Each can divide up their votes among any directors. B definitely gets to pick one director.

With cumulative voting, either the whole board has to be removed, or a director can only be removed if the amount of votes to remove him is ≥ the amount of votes needed to elect him – DGCL § 141(k)(1)

o Plurality vs. Majority Voting Plurality wins a director election unless changed by bylaw – DGCL § 216 Majority of outstanding shares needed to vote on mergers (if they require a vote) and

charter amendments Separating Control from Cash Flow Rights

o Law places restrictions on this for the sensible reason that we want to keep the residual claimants in control so that the controllers of the firm have incentives to maximize the total value of the firm

o Circular Control Structures DGCL 160(c)

A corporation cannot vote shares of the corporation that belong to it A corporation (1) cannot vote shares that belong to another corporation (2) if (1)

holds a majority of the voting shares in (2) Speiser v. Baker (complicated ownership structure gave Speiser control)

Rule: Stock in corp. 1 held by a corporate subsidiary may, in some circumstances “belong to” corp. 1, and thus be prohibited from voting, even if the issuer does not hold a majority of shares entitled to vote for the election of directors of the subsidiary.

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Even though the structure does not violate the letter of the law, it violates its spirit: chancery courts are policy oriented, asking what’s best for business

o Vote Buying Definition: a voting agreement supported by consideration personal to the

stockholder, whereby stockholder divorces his discretionary voting power and votes as directed by offeror

Old rule: buying votes is illegal per se Modern rule: voidable but look at the process

Schreiber v. Carney (35% shareholder loaned money to approve merger) Texas International loaned Jet Capital funds to exercise warrants in order to

prevent Jet’s voting against (effectively vetoing) TI’s merger with Texas Air. Jet received a low-interest loan in exchange for approving merger.

Test for vote buying: does vote buying agreement have object and purpose to further shareholder welfare?o If yes, and approved by

The board, voidable transaction subject to entire fairness review Maj. of independent shareholders, subject to business judgment rule

o Controlling Minority Structures Three main types: each type intended to entrench minority control

Dual class share structures Rationale: beneficial for companies owned/controlled by founders Common in the US, e.g. Google, NYTimes Permitted at founding, but SEC prohibits NYSE and NASDAQ from listing

shares with unequal voting rights unless initially offered to the market in that structure

Stock pyramids Most popular worldwide; not in the US because of tax on intercorporate

dividends Cross ownership ties

Common in Asia with many family owned conglomerates Collective Action Problem and Voting

o Collective Action Problem and Voting Rational Passivity: Costs of voting (time, info costs, etc.) outweigh benefit

However, institutional shareholders and cheaper communication costs, and agents of shareholder organization have lowered collective action costs

Cure for the problem: Mutual funds? Pozen suggest they have little incentive to monitor because

they just take a management fee Hedge funds? Kahan argues that they do have proper incentives since they get

a proportion of each year’s returns in addition to the fee System responses to collective action problem, which reduce costs of voting

Voting by proxy SEC mandated disclosure by issuer in connection with votes

Reduces information costs Evolution of “agents” of institutional investors who contract with institutional

investors to study company proposals and make recommendations

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Institutional Shareholders Service Reimbursements of reasonable costs in connection with proxy fight

Must be ratified by shareholder (always is) Rosenfeld v. Fairchild

o Rule: Directors acting in good faith may incur reasonable and proper expenses for solicitation of proxies and in defense of corporate policies Stockholders can also vote to reimburse successful insurgents ex post

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Proxy Rules General

o Federal rules originate with Securities Exchange Act of 1934, chiefly 14(a)-(c)o Four major elements

One: disclosure requirements & mandatory vetting regime to allow the SEC to assure the disclosure of relevant information

Two: substantive regulation of the process of soliciting proxies from shareholders Three: specialized town meeting provision that permits shareholders to gain access to

the corporation’s proxy materials and to thus gain a low cost way to promote certain kinds of shareholder resolutions, and

Four: general anti-fraud provision that allows courts to imply a private shareholder remedy for false or misleading proxy materials

o 14(a) states that the SEC will promulgate rules Thus the rules are a byproduct of the administrative, not the legislative process

o 14-a-3 contains the central regulatory requirement of the proxy rules No one may be solicited for a proxy unless they are, or have been, furnished with a

proxy statement containing the information specified in schedule 14ao “Solicitation” has been interpreted very broadly by the SEC, such that investors risk legal

action if they say almost anything about an upcoming election w/out filing a 14A Sometimes exacerbates the agency problem because it can make it more difficult for

shareholders to communicate about managemento Exemptions – DGCL 14a-2(b)

Exempts solicitations to less than 10 shareholders TarPERS problem: wants to wage a proxy campaign by circulating a memo

14a-3: before soliciting a proxy, must put together a preliminary proxy statement and file it with the SEC

Is this memo a solicitation? 14a-1-l-iii: the term “solicitation” includes:

furnishing of a form of proxy or other communication to security holder under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy

Exemption under 14a-2-b-1? Solicitation is interpreted very broadly by the SEC, but even if determined not to

be a solicitation, SEC says as soon as you use the b-1 exemption, you can’t solicit a proxy later in that season

Access to shareholder list? 14a-7: no; company can furnish the list or mail materials to shareholders itself

If it chooses the latter, it can stick proxy solicitor with the tab DGCL § 219: yes, if you can show a reasonable purpose

14a-8: Shareholder Proposals on Proxy Statementso Shareholders are entitled to include certain proposals in the company’s proxy materials

Excluded: non-management nominations for director Advantage: low cost

Don’t have to file with the SEC Don’t have to mail materials to shareholders

o Grounds for exclusion of shareholder proposals from corporation’s proxy materials

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Shareholder proposals must satisfy certain formal criteria: Must state shareholder’s identity, the number of proposals, the length of

supporting statement, and the subject matter of proposal In addition, there are thirteen grounds of exclusion

E.g. approval of proposal would be improper under state law, the proposal relates to a matter of ordinary business (which are the province of the board)

If management gets a no-action letter from SEC saying they can exclude X proposal, then what? Can still wage a proxy battle on your own; it’s expensive, but always an option

o Corporate Governance Proposals HP Example

Pension fund wants director election to be based on majority vote; under DGCL it’s plurality Rationale: under plurality system, withholding votes has no power; under

majority system, it does HP adopts policy in response that if a director doesn’t receive a majority, he has

to tender his resignation to the board, which board can accept or reject SEC declines HP’s no-action letter (14a-8-j), saying HP’s policy did not

substantially implement the carpenters’ proposal Carpenters’ proposal narrowly lost at the shareholder meeting DE legislature amended the DGCL to make majority voting work better

DGCL 141-b now provides that a resignation conditioned upon the director failing to receive a specified vote for reelection can be irrevocableo This functionally implements the carpenter’s proposal, if not procedurally

Majority voting rules have swept the nation’s charters CA v. AFSCME (proposal to allow successful proxy fighters to be reimbursed)

Holding one: such a proposal was a proper action by shareholders under DE law 109a vests power in shareholders to adopt amend or repeal bylaws Must be read in conjunction with 141a: the business of every corporation shall

be managed by or under the direction of a board of directorso Court finds that bylaws must regulate the process by which decisions are

made but not substantive business decisionso This bylaw was about process, although it appeared to be about substance

Holding two: the proposal if adopted would cause the corp. to violate DE law Does not violate DGCL or CA’s articles But it does violate common law

o If it allowed a proxy fighter with bad motivations to loot the company it would cause the directors to violate their fiduciary duties if they reimbursed such a person’s proxy costs

o Bubb: court could allow the bylaw but read in a “fiduciary out”o Corporate Social Responsibility Proposals

SEC has withdrawn the bright line rule from Cracker Barrel which allowed employment-related CSR proposals to be categorically excluded from proxy statements, and replaced it with the prior rule, under which such proposals would be considered on a case by case basis

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New test: two considerations in making the determination One: Subject matter of the proposal

Management of the workforce would generally be excludable, except in such case as the proposal focuses on significant social policy issues

Two: the degree to which the proposal seeks to micromanage the company on issues that shareholders would not be qualified to make an informed judgment on Might apply when the proposal is super specific or imposes timeframes, etc

Balance sought between allowing shareholders to assert their will over management w/o letting management be overwhelmed by crazy, expensive proposals with no chance of passing

14a-9: The Anti-Fraud Rule for Proxy Statementso Implied Private Right of Action

A private right of action exists under SEC ’34 § 14(a) and Rule 14a-9 allowing investors hurt by a fraudulent statement to sue for damages

o Elements Materiality: a fact is material if there is a substantial likelihood that a reasonable

shareholder would consider the fact important in deciding how to vote – Bankshares Culpability: Negligence (2d & 3d Cir’s) or intentionality/recklessness (6th Cir.) Causation and Reliance: Causation of injury presumed if misrepresentation is material

and proxy solicitation was “essential link in the accomplishment of the transaction” Remedies: Injunctive relief, rescission, monetary damages

o Virginia Bankshares (VBI owns 85% of Bank; solicits proxies 4 freeze-out cash merger) Proxy statement contained conclusory statements that merger presented opportunity

to achieve “high” value for company’s shares and that price “fair.” Materiality

Ds argue conclusory statements cannot be material w/in meaning of 14a-9 Rule: knowingly false statements that are conclusory may nevertheless satisfy the

“materiality” prong if they can be proved false by available evidence Causation

Can it be shown by minority shareholders whose votes are not required by law or corporate bylaw to authorize the corporate action subject to the proxy solicitation?

P makes two arguments for causation One: acquirer wouldn’t have gone through with transaction w/o minority

shareholder approval, for PR reasons Two: proxy statement was a means to satisfy a state statutory requirement of

minority shareholder approval as a condition of making the merger unvoidable Court rejects one (too speculative) and two (no indication that minority

shareholder approval would render the merger invulnerable to later attack) Bubb: court got it wrong here on causation; look at the big picture: SEC adopted this

rule to ensure proxy solicitations are not fraudulent or misleading; agrees with dissent Dissent

No authority demonstrates that 14a protects only minority shareholders whose numerical strength would permit them to vote down a proposal

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The Duty of Care Duty of care

o ALI § 4.01(a) A corporate director or officer is required to perform his or her functions

1) in good faith, 2) in a manner that he or she reasonably believes to be in the best interests of the

corporation, and 3) with the care that an ordinarily prudent person would reasonably be expected to

exercise in a like position and under similar circumstanceso Litigated less than loyalty, because the law insulates officers and directors from liability

based on negligence in order to avoid inducing risk averse management of the firm The Need to Mitigate Director Risk Aversion

Reasonable person negligence standard can’t be applied in determining liability It would make directors prohibitively risk averse In shareholders’ interest to offer sufficient protection to directors from liability

o Gagliardi v. Trifoods (shareholder deriv. suit to recover losses due to mismanagement) Rule: w/o facts showing self-dealing or improper motive, a corporate officer or

director is not legally responsible to the corporation for losses that may be suffered as a result of a decision that an officer made/directors authorized in good faith. In other words, a shareholder cannot state a claim based on mismanagement Rationale: If the rule were otherwise, boards would not undertake any risky

projects even if in the best interests of shareholders Statutory techniques for limiting D&O risk exposure

o Indemnification – DGCL § 145(a)-(f) Corporation can indemnify (i.e. pay the expenses of X) for

Losses from actions done on behalf of corporation in good faith – 145(a) Losses resulting from criminal liability if agent had no reason to believe he

committed a crime – 145(a) Legal fees in derivative lawsuits when director acted in good faith, unless he’s

held liable in a judgment and Ct. Ch. doesn’t approve indemnification – 145(b) Indemnification under (a) or (b) must be by independent actors - 145(d)

Other rights to indemnification under bylaws, etc. – 145(f) Court interprets this to include a good faith requirement due to 145(a) Waltuch v. Conticommodity (P corners silver mkt; sued)

o P was employed by D Conticommodity at the time of actions in question; wants indemnification from Conti for legal expenses

o Rule: 145(a) does not permit indemnification of officers if the officer failed to act in good faith, notwithstanding 145(f)’s permission to grant indemnification rights outside the limits of 145(a). Any article of a corporate charter inconsistent with 145(a)’s good faith requirement is unenforceable.

Expenses incurred in advance of action (assuming agent not liable) – 145(e) Mandatory indemnification if director is successful on the merits – 145(c)

Waltuch (again) Rule: Escape from an adverse judgment (including settlement), as opposed to

“winning,” counts as success for the purposes of 145(c)

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Success includes anything besides an adverse judgment; result matters, not why No indemnification for breach of duty of loyalty or gross negligence

o D&O Insurance – 145(g) Corporations can pay the premiums on D&O liability insurance

Judicial protection of D&Os from liability for breaches of the duty of careo Business Judgment Rule

Definition from Citigroup: The BJR is a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action was taken in the best interest of the company Burden is on P to rebut the presumption: To rebut, P must allege gross

negligence (failure of directors to avail themselves of all material and reasonably available information) or allege interestedness or disloyalty to the corp.

ABA Definition: a decision constitutes a valid business judgment when It is made by financially disinterested directors or officers Who are duly informed before exercising judgment Who exercise their judgment in a good faith effort to advance corporate interests

Rationale Procedural: Converts factual question into legal one, insulates D&O’s from jury Substantive: Courts don’t trust their judgment on subst.; look at process instead Shareholders benefit – Directors shouldn’t be so risk averse

o Kamin v. American Express D Amex bought DLJ shares, which declined in value. Board gave shareholders

shares of DLJ in kind. P says if D sold DLJ instead, would’ve gotten tax savings. P’s theory of liability: corporate waste Court: no fraud, self-dealing, or bad faith; errors of judgment are not sufficient as

grounds for interference; more than imprudence or mistaken judgment must be shown Duty of Care in Takeover Cases: Smith v. Van Gorkom

o Smith v. Van Gorkom (TransUnion has valuable NOL; CEO wants to retire) TransUnion sells itself to Pritzker for a price that was never negotiated or discussed;

Price was far above market but shareholder sues alleging breach of duty of care Holding: grossly negligent behavior (in context of merger) by disinterested directors

didn’t merit business judgment protection First DE case to hold directors liable for breach of duty of care in which the board

made a business decision Best interpreted as the first stab at articulating a corporate law of takeovers, rather

than the duty of care having biteo 102(b)(7)

Validated charter amendments that provide that a director has no liability for losses caused by transactions in which the director had no conflicting financial interest and had not otherwise breached the duty of loyalty

102(b)(7) waivers directed to damages; thus directors’ duty of care can still be the basis for an equitable order, e.g. an injunction

Technicolor on breaches of duty of careo Cede v. Technicolor (takeover; appraisal less than price paid by acquirer; min. sues)

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Lower Court: absent proof of self-interest, a shareholder plaintiff must prove by a preponderance of the evidence that director negligence did cause some injury Like a tort principle; damages must be shown for recovery

DSC rejects tort analogy One: Breach of the duty of care, w/o proof of injury, is sufficient to rebut the

business judgment presumption. Two: A breach of the duty of care or the duty of loyalty requires directors to

prove the transaction was entirely fair Takeaways:

Duty of care violation does not require P to show injury Damages can be calculated in different ways, e.g. rescissory damages

Gross negligence w/r/t decision making process is sufficient to put burden on directors to show entire fairness

But: gross negligence doesn’t necessarily mean that the substance was unfair – even with gross negligence the transaction can be entirely fair

102(b)(7) aims to limit director liability; Technicolor expands it At pleading stage, P must allege duty of loyalty violation with particularized facts

if corp. has 102(b)(7) - Malpiede Board’s Duty to Monitor: Losses “Caused” by Board Passivity

o Sins of omission rather than commission Incentives less likely to be distorted by liability imposed for passive violations;

Thus less of a need for business judgment deference by courtso Basic rule: Directors personally liable if they

(1) breach their duty to monitor that (2) proximately causes loss

o Director duties (from Francis – mom director negligently lets sons loot company) Know the company’s business

Not day to day, but in general Attend meetings

If absent, presumed to concur in actions taken unless dissent filed Read and review financial statements

Directors generally immune from liability if they rely on the opinion of counsel or independent auditors or the officer responsible for them

Usually directors absolved from liability by informing other directors of impropriety But: “Mrs. Pritchard’s duties extended beyond objection and resignation to

reasonable attempts to prevent the misappropriation of the trust funds”o Unclear if the standard is different for sophisticated directors, e.g. lawyers and i-bankerso Red Flag Doctrine

Absent cause for suspicion, directors are entitled to trust their subordinates and need not take affirmative action (e.g. install and operate a corporate system of espionage)

Graham v. Allis-Chalmers (non-directors indicted for antitrust; derivative suit) Rule: Directors are entitled to rely on the honesty and integrity of their

subordinates until something occurs to put them on notice something is wrong BUT, there is an oversight duty: board must make good faith judgment that there’s

system in place that is adequate to assure timely delivery to Board of appropriate info Caremark (Del. Ch. -- healthcare business, questions about patient referrals)

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Rule: Where a claim of directorial liability for corporate loss is predicated upon ignorance of liability-creating activities within the corporation, only a sustained or systematic failure of the board to exercise oversight will establish the lack of good faith that is a necessary condition to liability 102(b)(7) came into being as a result of Van Gorkom, and requires bad faith

(more than gross negligence) for a duty of care violation Disney tells us what is needed to find bad faith:

o Bad faith Motivated by actual intent to do harm Intentional dereliction of duty, conscious disregard for responsibilities

o Not bad faith Gross negligence

Departs from Allis-Chalmers standard in imposing a duty (red flags no longer necessary), but high standard for finding a breach

Stone v. Ritter (DSC) (see also p. 34) Endorses Caremark approach to duty of monitor; bad faith must be alleged Test for director oversight liability:

1) directors utterly failed to implement any reporting or information system or controls, or

2) having implemented such a system or controls, consciously failed to monitor or oversee its operations

Court notes bad faith conduct by fiduciaries is a violation of the duty of loyalty Bubb: if you have a duty to monitor case or a duty of care case when there’s a

102(b)(7) waiver, you must plead and argue bad faith and duty of loyalty Citigroup (suit following 08 crash alleging failure to monitor and manage risks)

Twist on Caremark: that standard is about failure to monitor employee misconduct; here it’s failure to monitor business risk

Rule: Under both Caremark and 102(b)(7) for oversight liability, show bad faith

o Director consciously disregarded an obligation to be reasonably informed about the business

o Director consciously disregarded the duty to monitor/oversee the biz. Holding: 102(b)(7), Caremark, and BJR place extremely high burden on P to

state a claim for personal director liability for failing to see business risk Board’s duty to obey positive law

o No business judgment protection for director authorization of an illegal acto Miller v. AT&T (donations to the DNC in violation of campaign finance laws)

Rule: BJR cannot insulate D directors from liability if they did in fact breach a campaign finance law, even if it was an exercise of sound business judgment.

o Duty to obey the law can be seen as a judge-created overlay on the fid. duty structure Makes sense for knowing violations of the law, but what if it’s uncertain? Does this prevent directors from taking any risk of violating the law?

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The Duty of Loyalty General

o Definition: Duty to exercise institutional power over corporate processes or property in a good faith effort to advance the company’s interests

o Applies to (1) Directors, (2) Officers, (3) Controlling Shareholders Controlling shareholders: Formal Test (≥50%) or Practical Test

Duty owed to whom?o Technically, duty is owed to the corporation; but that doesn’t always settle it…o Issue most important in context of (1) insolvency and (2) terminal transactionso Two views

Shareholder Primacy (traditional American norm: Dodge v. Ford) Corporate form exists to maximize shareholder welfare (which may be argued to

maximize welfare of other constituencies in process) Corporate Constituencies

Corporations exist only b/c states created them to advance public interest by protecting all corporate constituencies (after all, can’t get limited liability by contract)

Constituency Statutes Directors have the (but not the obligation) power to balance interests of

shareholder and non-shareholder constituents (in order to advance long-term shareholder interests?)

Not adopted in Del. or in the MBCAo Court defers to directors when they justify actions based on long-term corporate benefits

Smith v. Barlow (Corporation gave charitable grant to Princeton) Court affirms charitable corporate gift Rationale: Modern conditions (wealth has shifted from private to corporate

hands) require that corporations acknowledge and discharge social as well as private responsibilities as members of the communities in which they operate

Self-Dealingo General

Fiduciaries who transact with corporation may not benefit at its expense Fiduciaries who transact with corporation must

(1) fully disclose all material facts to corp.’s disinterested representatives and (2) deal on intrinsically fair terms

o Evolution of the law of trusts Old rule: trustee can’t deal with trust property or with trust beneficiary Modern rule: trustee can deal with the beneficiary w/r/t the trust property if:

(1) The beneficiary is competent (2) Full disclosure to the beneficiary (3) The transaction is fair

By 1910, this was applied to corporation lawo Disclosure Requirement

Full disclosure allows the corporation to exercise independent judgment Hayes Oyster

Hayes is director and CEO of Coast Oyster. Board approved Hayes’s plan to sell oyster beds to Keypoint. Hayes didn’t disclose his interest in Keypoint

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Court orders H’s interest in beds returned to Coast (effectively rescinding) Rule: Not every interested transaction is voidable, but nondisclosure by an

interested director is inherently unfair. Rationale: We don’t want courts making these decisions as to whether it’s

fair in a particular situation; fully informed boards should Injury to corp. or intent to defraud not nec.; fidelity in the agent is what matters

Extent of disclosure requirement Recall Meinhard: some forms of behavior open to traders in the market not

available to fiduciaries DE standard for disclosure is DGCL 144: all material information relevant

But courts have formed their own testso Weinberger (p. 48): special committees of independent directors to

simulate arm’s length negotiationso Kahn (p. 48): fiduciary not required to state best price he’d pay or accept

o Controlling Shareholders and the Fairness Standard Sinclair v. Levien (Oil company paying dividends out of subsidiary it controls 97%)

Intrinsic fairness test: burden on D to prove its transaction was objectively fair Rule: to invoke the intrinsic fairness standard when the situation involves a parent

and a subsidiary 1) the parent must have received a benefit at the expense of the subsidiary 2) the fiduciary duty must be accompanied by self-dealing

Holding: no self-dealing here b/c minority shareholders also received dividends; business judgment rule applies

Approval by a Disinterested Party (Board, Independent Committee, Shareholders)o Safe Harbor Statutes

DGCL § 144 No transaction voidable solely (solely is the key word; even if conditions below

are met, transactions still voidable) because it involved self-dealing if Disclosure to board & good faith approval by maj. of disinterested directors or Disclosure to shareholders and good faith approval by maj. of shareholders, or Transaction is entirely fair

Quorum: Interested directors can count toward quorum – 144(b) Cookies (D-controlled bbq sauce company contracts with D-owned distributor)

Iowa statute w/r/t self-dealing transactions has roughly same reqs as DGCL 144 Rule: For a self-dealing transaction not to be void, director must establish that

One: one of the following threeo Disclosure to board and approval by a maj. of disinterested directors, oro Disclosure to shareholders and approval by a majority of shareholders, oro Transaction is fair and reasonable, AND

Two: The director has acted in good faith, honesty and fairness.o Approval by disinterested members of the board

Under the terms of the statute in Cookies and DGCL 144, requiring fairness in addition to disinterested board approval seems to strain the language However, conventional interpretation is that disinterested board approval only

authorizes the transaction but does not foreclose judicial review for fairness

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Eisenberg: two reasons the fairness test should apply to interested transactions even w/ board approval One: directors are unlikely to treat one of their number with the degree of

wariness with which they would approach a transaction with a 3rd party Two: it is difficult if not impossible to utilize a legal definition of

disinterestedness in corporate law that corresponds with factual disinterestedness Cooke v. Oolie (Ds make loan to TNN; 5 mos later Ds pick loan 2 that’s best for Ds)

Rule: The court will presume that the vote of a disinterested director signals that the interested transaction furthers the best interests of the corporation despite the interest of one or more directors

Rationale: the disinterested directors have no incentive to act disloyally and should be only concerned with advancing the interests of the corporation. Bubb: not realistic way to look at actual incentives but a sound legal doctrine

in that it keeps courts out of the boardroomo Approval by a special committee of independent directors

Most common technique for assuring the appearance as well as the reality of a fair deal in controlled transactions between a subsidiary corporation and its parent

Operation of the committee Requirements in Delaware

Independent members Real bargaining power Vested w/ sufficient resources (retain outside bankers and lawyers for advice) Understanding that goal is to obtain not only fair but best available deal

Effects of the Committee (if well executed) Shifts the burden of proving fairness from D to P (P must show unfairness)

o Shareholder ratification of conflicted transactions Requirements for valid shareholder ratification

Lewis v. Vogelstein (generous stock option plan put to shareholder vote) Rule: Shareholder ratification invalid if:

o A majority of affirmative shareholder votes had conflict of interest, oro The transaction is a corporate waste

Corporate waste is OK if the vote is unanimous Corporate waste def.: exchange of corporate assets for consideration so

small that no reasonable person would be willing to make the trade Effect of valid shareholder ratification

Wheelabrator (disinterested shareholders approved acquisition of WTI by WM) Rule: The operative effect of shareholder ratification in duty of loyalty cases

has been eithero To change the standard of review to the business judgment rule, oro Leave “entire fairness” as the review standard, but shift the burden of

proof to the plaintiff Two types of ratification decisions give rise to duty of loyalty claims

o If vote involves interested controlling shareholder, P must prove fairness Normally parent-subsidiary mergers

o If vote involves interested directors, business judgment rule applies

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o Fairness Requirement: Burden Issues P has initial burden to establish (1) fiduciary duty and (2) self-dealing

e.g., parent on both sides of parent-sub dealings If P fails, business judgment rule applies If P succeeds, then

With no approval by majority of disinterested 3d party, burden shifts to D to prove entire fairness of transaction

With approval by majority of disinterested 3d party (Ct. Ch. approach)… Business Judgment if

o Low risk that fiduciary dominated the board, ANDo Terms of deal not sufficiently egregious to raise suspicionso see Cooke v. Oolie

P must prove lack of entire fairness if…o High risk of fiduciary dominance (e.g., majority shareholder), (see

Cookies Food Products), ORo Egregious terms (or perhaps burden on D here)

Interested Director TransactionsStandard of Review(Burden of Proof)

DGCL 144 ALI 5.02

Neither board norShareholder approval

Entire Fairness (D)144(a)(3)

Entire Fairness (D)

Disinterested directors authorize

BJR (P)Cooke v. Oolie144(a)(1)

Reasonable belief in fairness (P)§5.02a-2-b

Shareholders ratify BJR / Waste (P)Wheelabrator144(a)(2)

Waste (P)

Controlling Shareholder Transactions (usually parent-sub)Standard of Review(Burden of Proof)

DGCL 144 ALI 5.02

Neither board norShareholder approval

Entire Fairness (D)Sinclair (board approval, but not disinterested)

?

Disinterested directors authorize (SC/IC)

Entire Fairness (P)Kahn

?

Shareholders ratify (majority of minority)

Entire Fairness (P)Wheelabrator/Kahn

?

Disney: “if Ps succeed in rebutting the presumption of the BJR, burden shifts to Ds to prove by a preponderance of the evidence that the challenged transactions were entirely fair to the corporation.” ??

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Executive Compensationo General

D&O Compensation is a necessary, self-dealing transaction Goal of Compensation: align the incentives/economic interests of the director/officer

and the company by Recruiting talented people & motivating them to work hard for company’s benefit

BUT, agency Problems Shareholders want risk-neutral managers, but are too dispersed Fixed, short-term compensation claims (e.g., salary)

Reduce amount that manager has at risk at any moment But not enough to make manager accept risky projects of long-term value

Performance-based Compensation helps solve risk-averse problemo Requirements / Standards for Compensation in General

Common Law Rule on Compensation Grants Disney (Ovitz turns out not to be a good CEO; $140m NFT payment)

Charter had a 102(b)(7) waiver; Ps had to show the board acted in bad faith Definition of bad faith announced by court

o Bad faith Motivated by actual intent to do harm Intentional dereliction of duty, a conscious disregard for one’s

responsibilitieso Not bad faith

Gross negligence Eisner’s actions don’t rise to bad faith; at most, negligence

o Disjuncture between the standards of conduct announced by the court and those enforced by the court in terms of liability

SEC Disclosure Rules Disclosure of pay of top 5 officers

Sarbanes-Oxley § 302 If a company has to restate financials as a result of misconduct, CEO and CFO

must give any bonuses, incentive based pay, and/or trading profits realized in the 12 months after the incorrect information was publicly disclosed

Dodd-Frank Say on pay rule which requires a nonbinding shareholder resolution every 1, 2, or

3 years on whether the pay at the company is approved by shareholderso Stock Options and Grants Thereof

Rationale for Stock Option Compensation Performance: Incentive to increase stock price and take risks (no downside) Mergers: Clause that causes vesting when the company merges and isn’t the

surviving company – incentive for M&A Tax Law: Corporation can’t deduct employee compensation above $1 mil for top

5 employees unless the compensation is related to productivity Disadvantages of Stock Option Compensation

Performance: When the stock declines below option price, CEO loses incentive to get it back up (as solution, company might give CEO new options)

Stock price can be poor indication of performance (except perhaps CEO)

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Alternative metrics Relative performance: how is company doing relative to its industrial peers? Product development innovations Development of the next generation of management / succession plan

Rule for Validating Option Grants: Waste/Business Judgment (Waste) Validation requires judicial finding that reasonable board could conclude

that corporation could reasonably expect to receive a proportionate benefit Lewis v. Vogelstein

o Rejects D’s motion to dismiss on waste grounds, but says institutional shareholders now strong enough that shareholder assent is a more rational means to monitor compensation than judicial determinations of the fairness or sufficiency of consideration

(Business Judgment) Good faith determination by disinterested board or committee, esp. if ratified by disinterested shareholder vote, entails BJR

o Policy question: Is CEO compensation out of control? Arguments that it is

Multiples of shop-floor wages Arguments that it isn’t

Parallel growth of the American economy (correlation w/ mkt. cap and DOW) Higher CEO turnover CEO skill Worth it to the shareholders Response to shop-floor multiples divergence

Globalization constrains shop-floor worker’s pay Duty of good faith and 102(b)(7)

o Is there a “Duty of Good Faith” Not a separate duty, but grounds and participates in all fiduciary duties Del. says there’s no separate duty of good faith – Stone v. Ritter

The fiduciary duty violated by failing to act in good faith is the duty of loyalty Thus the duty of loyalty is not limited to cases of conflict of interest; it

encompasses cases where the fiduciary fails to act in good faith. (see p. 28)o Director Liability and DGCL § 102(b)(7)

Negligence: No liability for negligent director action (see Gagliardi) However, liability possible for inaction (see Francis, but her level of inattention

went beyond negligence) Gross Negligence

Liability possible for gross negligence (see Smith v. Van Gorkom) However, waivable if charter contains § 102(b)(7) provision

Breach of Duty of Loyalty Liability not waivable under 102(b)(7) for breach of duty of loyalty and actions

done in bad faith Bad faith includes intent to harm intentional dereliction of duty, and conscious

disregard for one’s responsibilities (see Disney p. 33)

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Corporate Opportunitieso Fiduciary cannot…

Wrongfully take an opportunity that equitably belongs to the corporation Compete w/ corporation w/o full disclosure and proper permission from the board

o Determining what constitutes a “corporate opportunity” Expectancy or Interest Test

Whether opportunity w/in firm’s legal/practical business expectancy or interest Line of Business Test

Whether the corporation could be reasonably expected to exploit opportunity Consider: (1) how opportunity came to attention of fiduciary, (2) how far

removed from “core economic activities” opportunity is, (3) whether corp. info used to recognize/exploit opportunity

Fairness Test How fiduciary learned of opportunity Whether corporate assets used to exploit Other fact-specific indicia of good faith and loyalty to corporation Company’s line of business

Bubb: tests bleed into each other and are not entirely distinguishableo When a fiduciary may take a corporate opportunity

Disclosure and Rejection Did the fiduciary disclose the opportunity to board? Was the decision the business judgment of a disinterested decision maker?

Burden of showing this is on the fiduciary who took the opportunity Non-disclosure

Possible in Del. under Broz v. Cellular Information Disclosure is a safe harbor, not a requirement

o Waiving corporate opportunity constraints DGCL § 122(17) – Corporation may waive corporate opportunity constraints in

charter increasingly common for tech companies with interconnected boardso Duty of Loyalty in Close Corporations

Treated differently than public corporations Minorities can be at mercy of controlling shareholders Like partnerships:

Small number of shareholders/partners Illiquid market for shares/partnership interest Shareholders/partners often run the company

Not like partnerships: Partnerships at will; partners have exit options Not necessarily the case in closely held corporations

Donahue (minority shareholder sues retiring controlling dir. who sold shares back) Equal opportunities rule: if a controlling shareholder causes the corporation to

buy his shares, the corporation has a duty to offer an equal price to minority shareholders.

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Shareholder Lawsuits Types of Shareholder Suits

o Direct Claims/Class Actions under FRCP 23(b)(3) Claim to recover damages suffered by individuals directly because they are

shareholderso Derivative Suits

General Assertion of claim on behalf of corporation against officer or director charging

them with wrong to corporation 2 suits in one

Suit against the directors for failing to sue the third party Suit against the third party, the underlying substantive claim

Advantages Bring claims of fiduciary breach to court on behalf of disaggregated shareholders Encourage monitoring

Disadvantage maybe too many lawsuits, or wrong type of lawsuits

o Distinguishing between direct actions and derivative suits Test from Tooley

Who suffered the alleged harm? The corporation got hurt derivative suit Suing shareholders individually got hurt class action

Who would receive the benefit of the remedy? The corporation derivative suit Shareholders class action

Derivative Suits: Requirementso See FRCP 23.1; Del. adopts similar ruleso Standing

One: Must be a shareholder at all times during the suit Rationale: assure right interests

Two: Must have been a shareholder at the time of the wrong unless you acquired the shares through the operation of law (e.g., you inherited the stock) Rationale: bias against buying up lawsuits

Three: P must be able to fairly and adequately represent shareholder interests Chiefly has bite in the context of mergers/dissolutions, when Ps may cease to be

shareholders because the corporation in which they own shares disappears Bubb: these are not particularly meaningful; demand requirement is what matters

o Demand Requirement Two options

Make demand of the board to bring the suit itself which must then be reviewed for wrongfulness under business judgment standard (rare in DE) OR

Plead futility: i.e. that the board would not be able to consider the demand in an independent and disinterested fashion, and therefore demand is excused

Futility of Demand Test (Aronson/Levine Test)

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In what circumstances does a board lose its authority under 141(a) to decide whether or not to prosecute a suit?

Two prong test for demand futility (PLEADING stage) One: does complaint rebut with well-pleaded facts the threshold presumption

of director independence or disinterest by raising a reasonable doubt that a majority of the boardo Had a financial interest in challenged transaction, oro Lacked independence (i.e. board dominated by transaction proponent), oro Otherwise failed to exert due careo NB: Court is focused on the challenged transaction; Bubb says inquiry

should be about whether board could properly consider the demand The two are related, but court doesn’t spell this out; it should

OR Two: if P cannot show directors are interested, does complaint plead

particularized facts sufficient to create reasonable doubt that the challenged transaction was the product of a valid exercise of business judgment?o Was the board grossly negligent? Was there bad faith?

Levine v. Smith (Perot: GM sells shitty cars; board buys his stock to shut him up) Committee of outside directors negotiated, approved buyback Court said Ps failed to raise reasonable doubts of independence, sound BJ

Delaware vs. ALI Universal demand rule: ALI: P must demand that the directors file suit; if

rejected, she can then bring suit Universal non-demand rule: DSC assumes that if you make demand, you concede

that the board is independent; if this is conceded, only the second prong of the Aronson-Levine test is open to you

o Special Case: If a company merges with another company Cash Merger

P is no longer a shareholder, so no standing Stock Merger (Parent-Subsidiary)

Double Derivative Suit definition: P shareholder of parent corporation seeks recovery for cause of action belonging to subsidiary corporation.

Rales v. Blasband (Ds sold company to Aqu.; issued bonds, bought junk bonds)

Prong 2 of the Aronson test challenging the actual transaction does not apply:o 1) where a business decision was made by a company’s board but a

majority of the directors making the decision have been replacedo 2) where the subject of the deriv. suit is not a bus. decision of the boardo 3) where, as here, the decision being challenged was made by the board of

a different corporation Test for demand futility in a double derivative suit: prong 1 only

o Does complaint create, with particularized factual allegations, a reasonable doubt that, as of the time the complaint was filed, the board could have properly exercised its independent and disinterested business judgment in responding to the demand?

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Bubb: this is the 1st prong of Aronson, properly applied to the demand, instead of the transaction: “more satisfying analysis b/c the point of demand futility is plead that board couldn’t respond to the demand.

Court will not adopt a universal demand requirement or require that P demonstrate a reasonable probability of success on the meritso Requiring reasonable probability too onerous pre-discovery

Court found demand excused b/c there was reasonable doubt that majority of Danaher board could act independently, b/c beholden to Rales bros

NB: must plead futility on BOTH boards; this case only about the parent board Incentive Issues / Attorney’s Fees

o Attorneys are the solution to the collective action problem w/r/t shareholder suits Typically receive 20-25% of any monetary recovery Point of allowing these lawsuits is to create incentives for corporate officers to abide

by their fiduciary dutieso When attorneys fees are awardable

Common fund doctrine Definition: When a lawsuit creates a common fund for claimants, attorneys fees

can be taken out of that Substantial benefit rule

Definition: attorneys who prosecute a lawsuit can be awarded attorneys fees if the lawsuit gives the corporation a substantial benefit, even if the benefits were not pecuniary and the action did not produce a fund from which fees might be paid Sufficient to find substantial benefit: (from Fletcher)

o One action helped maintain the health of the corporation and raise standards of fiduciary relationships, or

o Two prevented an abuse which would prejudice corporate rights & interests

Fletcher v. A.J. Industries (suit alleges board domination; remedy is new board) Rule: governance changes resulting through a settlement, as well as

avoidance of litigation costs through settlement, can be enough of a benefit to have the corporation pay attorneys fees

Dissent: substantial benefit rule may force corporations to liquidate assets Substantial benefit is good from a policy perspective because it creates incentives

for plaintiffs’ lawyers to not only seek monetary damages but equitable remedies when they are more appropriate.

o Calculation of Attorney’s Fees Percentage of award rule

Incentives for premature settlement May create incentives for attorneys not to seek nonmonetary relief

# of hours worked rule Incentives for lawyers to run up hours

Ways to deal with a derivative suito Motion to Dismiss

Failure to state a claim – FRCP 12(b)(6) Failure to make a demand (but see above on demand futility) – FRCP 23.1

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o Special Litigation Committee General

SLC is initiated by the board under DGCL 141(c), investigates (generally with the help of an outside law firm), and suggests dismissal or settlement

Usually composed of 2 directors not on Board at the time of the transaction. Delaware’s Two Step Test for analyzing SLC recommendations to dismiss

Zapata v. Maldonado (derivative action; two new board members SLC) One: first, the Court should inquire into

o the independence of the committeeo the good faith of the committee ando the bases supporting its conclusiono (burden is on the corporation to show these things)

Two: the court should determine, applying its own independent business judgment, whether the motion should be granted.o Kaplan held that whether to proceed to step two was in court’s discretion

Question: why can a court second-guess the board’s evaluation of a derivative action when demand is excused a la Zapata but cannot do the same when demand was made and the board rejected suit?

Different approaches to determining director independence Oracle (D appoints two Stanford profs to its board, then to SLC)

o Test for director independence Focuses on impartiality and objectivity Broad notion of independence and what motivates people

In addition to greed: love, friendship, collegiality Beam ex rel. Martha Stewart (not an SLC!! A demand-futility case)

o Distinction between SLC context and demand futility context Demand futility board presumed independent SLC burden on SLC to establish its own independence

Different approaches to business judgment review of SLC recommendations This is about step two of the test from Zapata Zapata: court should consider matters of law and public policy in addition to

corporation’s best interest Joy v. North: cost benefit approach: where the court determines that the likely

recoverable damages discounted by the probability of a finding of liability are less than the costs to the corporation in continuing the action, it should dismiss the case

New York’s Test One step: if committee well informed and independent BJR

Settlemento Most cases are settled prior to judgment on the merits

Usually lead to an award of attorneys’ fees About half of settlements result in monetary recovery D&O insurance generally pays for the settlement fund D&Os indemnifiable under DGCL § 145(b) Officers and directors almost never face out of pocket costs Still, directors don’t like being sued

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Reputational issues, etc, help preserve the deterrence function of derivative suitso Settlement by Special Committee

Carlton Investments v. TLC Beatrice (SLC recommends settlement) Court determined that the settlement was fair and approves over P’s objection Notes than normally in evaluating a proposed settlement the court does not make

substantive determinations, but since this settlement was negotiation by an SLC “uncomfortably” applies step two of Zapata; result not irrational or egregious

When are derivative suits in a corporation’s interesto May confer something of value on the corporation

Compensation for past harms Forcing a governance change

o Can deter wrongdoing that might happen in the future

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Transactions in Control Why do buyers pay a premium for control? Different theories:

o One: premium for the private benefits of control The power to capture salary, perks, the prestige of being the boss

o Two: premium paid by buyers who have a superior business plan Technical definition of control premium:

o The amount above the current market price of the stock that the control block is traded ato Control premium = K x (Vb/N) + PBCb – K x (Va/N)o Where

A = current controller B = prospective purchaser of control N = the number of outstanding shares K = # of shares owned by A Va = the value of the company under A’s control Vb = the value of the company under B’s control PBCa = the private benefits of control in A’s eyes (irrelevant for this calculation) PBCb = the private benefits of control in B’s eyes

Regulation of Control Premiao Zetlin (owner of 44% of stock w/control of corp sells for $15/share over $7 market price)

Market rule: a controlling shareholder is free to sell, and a purchaser is free to buy, the controlling interest at a premium price unless there is Looting of corporate assets Conversion of a corporate opportunity Fraud or other acts of bad faith

o Perlman v. Feldman (D sells control of Newport Steel to Wilport during Korean War) Holding: Feldmann converted a corporate opportunity to raise the price of steel into a

private benefit for the buyer and extracted that value in the sales price and thereby violated his fiduciary duty to minority shareholders

o Easterbrook on the market rule Market rule (good)

Sale of control can lead to new offers, plans, and arrangements that create gains Premium price rec’d by seller of control block amounts to ≠ distribution of gains

Reduces cost to purchasers of control more efficient Equal opportunity rule (bad)

Minority shareholders entitled to sell their shares on the same terms as controller Increased cost to bidders may cause them to drop out

On Perlman Court’s holding makes a questionable assumption: that the gain resulting from the

Feldman plan was not reflected in Newports price, although the stock was publicly traded and the plan was known to investors

Wilport could not profit from the deal unless The sale of control resulted in an increase in Newport’s value, or Wilports control of Newport was the equivalent of looting

o But there’s no evidence of looting; Newport’s stock price actually went up. So sale must have resulted in an increase in Newport’s value

Sale of Corporate Office

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o Carter v. Muscat (board appointed new dir’s as part of transaction selling 10% of stock) Holding: Court upholds the reelection of the new directors at the annual meeting Looks like a controlling block of stock was sold

o Brecher (D gets 35% premium selling 4% block for appointing buyers candidate to CEO) Holding: Paying a premium for control while purchasing 4% of a company’s

outstanding shares is contrary to public policy and illegal Looks like the 4% was not a controlling block of stock

Lootingo A holder of controlling shares may not knowingly, recklessly, or perhaps negligently, sell

his shares to one who intends to loot the corporation by unlawful activityo Harris v. Carter (D controls A; sells A to M; M loots A; A minority shareholders sue D)

Rule: when transferring control of a corporation to another, if circumstances would alert a reasonably prudent person to a risk that his buyer is dishonest or in some material respect not truthful, a duty devolves upon the seller to inquire into the bona fides of the buyer Like a tort principle: each person owes a duty to those who may foreseeably be

harmed by her action to take such steps as a reasonably prudent person would take in similar circumstances

Looks like red flags doctrine from Alice-Chalmers; relatively weak duty Controlling shareholder has a fiduciary duty toward the corp. like a director has Bubb: since D seller of control got fleeced, it’s likely that reasonable investigation

wouldn’t have discovered M’s plot; D’s incentives were aligned with Ps in that sense Tender offers

o Large public companies in the US generally do not have a controlling shareholdero Someone wishing to purchase control can

Buy shares in the market Make a tender offer open to all shareholders

o Williams Act Rationale: give shareholders time and info to make informed decision about tendering Four principal elements

Early warning to public and management: §13(d) Investor must file a 13D report within 10 days of acquiring 5%+ beneficial

ownership – 13d-1(a) Mandated Disclosure: §14(d)(1)

Tender offeror must disclose identity, financing, and future plans – 14d-3 Within 10 days of offer, subject company’s board has to recommend to

shareholders whether to accept or reject offer – 14e-2 Anti-fraud Provision – §14(e)

Prohibits misrepresentations, nondisclosures, and fraudulent, deceptive, or misrepresentative practices

Once the tender offer is commenced, no insider trading – 14e-3 Regulation of substantive terms

Tender offer has to stay open for a period of at least 20 days – 14e-1 Bidders must open their tender offers to all shareholders and pay all who

tender the same best price – 14d-10 Shareholders who tender can withdraw while tender offer is open – 14d-7

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Key Definitions Beneficial: means power to vote or dispose of stock – 13d-3(a) Group: is anyone acts together to buy, vote, or sell stock – 13d-5(b)(1)

Each group member deemed to beneficially own each member’s stock Brascan (D purchases 24% of P over 2 days; P sues alleging Williams Act violation)

Holding: D’s failure to announce its share purchases was not a violation of 14(e) of the Williams Act or Rule 10b-5

Rationale: bringing such transactions within the scope of the Williams Act would be to be rule that no large scale acquisition program may be lawfully accomplished except in the manner of a conventional tender offer

SEC/Wellman 8-factor test for determining a tender offer *Active and widespread solicitation of public shareholders Solicitation is made for a substantial % of the issuer’s stock *Premium over the prevailing market price Terms of the offer are firm, not negotiable The offer is contingent on the tender of a fixed # of shares The offer is open for a limited period of time The offerees are subjected to pressure to sell their stock Public announcements of a purchasing program precede or accompany a rapid

accumulation

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Mergers and Acquisitions NB: corporate acquisition can take many legal forms; form matters a lot in M&A Stuff to be familiar with

o Statutory merger under 251o Short form merger under 253o Asset acquisitions under 271o Reverse and forward triangular mergers

Motiveso Efficiency

Economies of scale: reducing average cost of production by spreading it over larger output load, e.g., two under-producing factories merge into one and lower costs

Economies of scope: spreading costs across broader range of related business activities, e.g. vertical integration

Replace managemento Redistributive gains

Tax considerations (NOLs valuable but cannot be sold – take from gov’t LBOs (take from creditors Monopolization (take from consumers

o Bad Empire building Hubris

Allocation of Power in Fundamental Transactionso Two considerations should determine allocation of decision-making power w/in orgs.

One: who has the best information? Mgmt. almost always has best information

Two: who has the best incentives? Mgmt. incentives may be misaligned with shareholders on, e.g. sales of firm

o Complete managerial authority not optimal, but complete shareholder consent on every transaction is unworkable

o Optimal: shareholders reserve power to veto matters that are most economically significant and in which they can exercise informed judgment Investment-like decisions, not business decisions.

Ways to Acquire Control of a Businesso One: A can buy all or substantially all of T’s assetso Two: A can buy all of T’s stocko Three: A can merge itself or a subsidiary with T on terms that ensure A’s control

One: asset acquisition / sale of substantially all assets – §271o Shareholder vote on a sale of substantially all assets

A’s shareholders have no statutory right to vote T’s shareholders vote when selling all or substantially all assets

Majority vote of outstanding stocko Definition of “substantially all”

Unclear under §271 Katz v. Bregman (D CEO sells Canadian sub constituting 51% of overall assets)

Rule: 51% of a company’s assets can constitute substantially all of its assets

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NB: there was another bidder that the seller rebuffed; court here is stretching the definition of substantially all to reach the result it thinks is fair; incentivizing competitive bidding to get the highest price for shareholders (Revlonesque)

Hollinger (sale of Telegraph newspapers) Rule: 57% ≠ substantially all of its assets

Thorpe (cont. sh-holders want to block sale of sub, sell their control block to parent) Rule: Need for shareholder approval depends not only on size of transaction but

its affect on the corporation If the transaction is out of the ordinary course and substantially affects the

existence and purpose of the corporation shareholder voteo Advantages and Disadvantages

Advantage: A retains T’s liability shield But, successor liability doctrine w/r/t tort victims and environmental cleanup

Disadvantages: costly and time consuming Two: stock acquisition

o Purchase of all, or a majority of, company’s stocko Full legal control requires ownership of 100% of shares

Problem: minority shareholders can create holdout Solution: share exchange and two-step mergers (also DGCL 253 w/90%+ ownership)

o Share exchange A tender offer negotiated with the target board, that, after approval by a majority of

shareholders, becomes compulsory for all shareholders Result: acquisition receives tax treatment of a tender offer w/o the holdup problems

of a true tender offer or awkward residue of minority of public shareholders But now the shareholders of the target are shareholders in the acquirer??

o Two-step merger (Delaware) Step one: A makes a tender offer for most of T’s shares at an agreed price; board of T

promises to recommend to its shareholders Step two: merger between the target and a subsidiary of A, which follows the tender

offer and removes minority shareholders who failed to tender shares Often the second step consideration is cash rather than stock in A

Three: mergerso Statutory Mergers – DGCL 251

Acquirer and Target boards negotiate a merger in which A will be the surviving corporation and each board votes to approve merger agreement

A acquires all of the assets and liabilities of T Not necessarily the case in an acquisition (see above) T shareholders give up their stock in T and get stock in A (or other consideration)

per merger agreement Each board must approve and recommend merger to shareholders – 251(b) If a majority of shares outstanding vote, certificate of merger filed Shareholder Voting on Mergers

T’s shareholders always vote A’s shareholders presumed to have the right to vote, but need not vote when

A issues < 20% new stock to finance the acquisition – 251(f)(3), and

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Security held by surviving corporation’s shareholders will not be exchanged or modified – 251(f)(2), and

Merger agreement does not amend A’s charter in any respect – 251(f)(1) Rationale: mergers satisfying these conditions have too little impact on the

surviving corporation’s shareholders to justify the delay and expense of a shareholder vote

Dissenting shareholders may have appraisal rights under 263 Advantages and Disadvantages

Advantage: A acquires everything Disadvantage: A gives up liability shield w/r/t T

Known liabilities are priced in, but still a problem of unknown liabilities Short-form mergers – 253

When a shareholder owns 90% stock, no shareholder vote is needed for a merger; Shareholders can get appraisal for fair value by Court of Chancery – 253(d)

o Triangular Mergers (a form of the two-step merger above, more of an asset acquisition?) Two steps

One: A creates a subsidiary, capitalizes it with cash/stock of A Sub negotiates friendly tender offer to acquire majority of T’s shares

Two: subsidiary merges with T Sub pays cash or stock to T’s shareholders at tender If sub survives forward triangular merger If T survives reverse triangular merger

Voting provisions – 251 (NB: get comfortable with 251(f)) Advantages

Retains T’s liability shield Relatively quick

Appraisal Rightso General

Rationale Liquidity when mergers required < unan. vote and markets illiquid (NA now) Possibility of getting cheated (more likely in conflict transaction w/domination)

Appraisal Process – 262 Shareholders get notice of appraisal right 20 days before shareholder vote – (d)(1) Shareholder submits written demand for appraisal before shareholder vote – (d)(1) If merger is approved, shareholder files a petition in Chancery Court within 120

days after merger becomes effective demanding appraisal – (e) Court holds valuation proceeding to “determine [the shares’] fair value exclusive

of any element of value arising from the accomplishment or expectation of the merger.” (h)

No class action device available, but Chancery Court can apportion fees among plaintiffs as equity may require – (j)

Market-out rule – 262(b)(1)-(2) Appraisal denied when (b)(1)

T’s shares are traded on a national security exchange, or

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T’s shares are held by ≥ 2,000 registered holders, or Shareholder approval not required for the merger

Unless merger consideration is other than (b)(2) Stock in the surviving corporation, or Shares in a 3rd company traded on a national security exchange or with >2000

shareholders, or Cash, or Any combination of the above

o Valuation technique – 262(h) What is to be valued – three options:

Value as a pro rata claim on going concern value (DE approach) Includes: all elements of future value, including the fact that the company may

have been a target company in another merger. Excludes: value attributed to the merger.

Value as minority shares, i.e. apply a minority discount Value as a pro rata claim on going concern value, including benefits of the deal

How claims measured DCF technique

Statutory merger (251) Asset Acquisition (271)T voting rights Yes – need majority of

shares outstanding (251-c)

Yes if all or substantially all assets are being sold (271-a)

A voting rights Yes unless <20% shares being issued and other conditions (251-f)

No (stock exchange rules might require vote to issue new shares)

Appraisal rights Yes if T shareholders vote, unless market-out exception (262)

No unless provided in charter (262-c)

De Facto Mergerso Is it better to treat mergers as a functional concept or a formal/technical concept?o DE courts take the formalist side w/r/t the range of statutory protections available to

shareholders in a corporate combination i.e. they treat asset acquisitions that turn out like mergers as asset acquisitions

o Hariton (T sells assets to A for stock in A; T dissolves, gives A’s stock to shareholders) Rule: The doctrine of de facto merger will not be applied to an asset sale. Appraisal

rights are not granted to shareholders under asset sales (271), but only under proper mergers (251)

Duty of loyalty in controlled mergerso Tension between controlling shareholder’s exercise of voting rights and exercise of

control over the corporation Controlling shareholders have a fiduciary duty of loyalty when exercising control

over corporate actions and decisions Control def.: power to do what other shareholders can’t; e.g. influence the board

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o Cash Mergers / Freeze-out Mergers Typical process

Parent notifies T of going private or minority freeze out proposal Parent issues press release Proposal subject to special committee approval

T sets up special committee of independent directors Generally hires bankers and lawyers

Parent negotiates with special committee and hopefully agrees on price Why do freeze-outs?

Public companies have to comply with SEC regulations Minority shareholders cannot influence board elections but can still assert rights When A and T are in the same business, there may be self-dealing transactions

Minority shareholders can bring duty of loyalty suits Can seek safe harbor under §144 but it’s onerous

Weinberger (Signal is majority shareholder of UOP, wants to buy out minorities; comm. finds up to $24/share good price; doesn’t disclose to UOP board; pays $21) A’s study used T’s data to make a fair price determination of $24/share that was

never disclosed to T’s board or shareholders, which approved the transaction Two Signal directors doing the study were conflicted on both sides; may have

breached their duty to Signal had they disclosed the $24/share price they never should have done this study in the first place

Board approval or minority shareholder approval would have sufficed under 144 to ease the burden from entire fairness, but the conflicts require entire fairness

Rule: Entire Fairness standard has two components, considered holistically One: Fair dealing

o How was the transaction initiated, structured, negotiated, disclosed to directors; how was the approval of stockholders and directors obtained

o Includes the duty of candor Two: Fair price

o What constitutes control Shareholder ratification and independent director approval can ease the burden on

self-dealing fiduciaries of proving entire fairness, but controlled mergers raise special issues

Kahn (Alcatel has 43% stake in Lynch; wants Lynch to buy Celwave; Lynch declines: Alcatel offers to acquire Lynch, threatens hostile tender offer if rejected) Court: Alcatel, w/43% ownership of Lynch, did count as controlling shareholder Rule: Entire fairness standard is the exclusive standard of judicial review in

examining the propriety of an interested cash-out merger transaction by a controlling or dominating shareholder

Burden: begins with the controlling shareholder, but burden shifts to the challenging shareholder plaintiff IF

o An independent committee of directors approves the transaction, OR NB: In Kahn the committee was not independent

o An informed majority of minority shareholders approves the transaction

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Test: a showing that the action taken was as though each of the parties exerted its bargaining power against the other at arm’s length is strong evidence that the transaction meets the test of fairness.

o Special committees of independent directors in controlled mergers Two approaches to judicial review of independent special committees

One: treat the special committee decision like that of a disinterested and independent board business judgment review Not totally banished in Delaware; Western National, court applies BJR

because although A owned 46% of shares, it only nominated 2/8 directors pursuant to a “standstill agreement”

Two: continue to apply the entire fairness test, even if the committee appears to have acted with integrity, since courts cannot easily evaluate subtle pressures and feelings of solidarity between board members Kahn approach

o Controlling shareholder fiduciary duty on step one of a two-step tender offer If a controlling shareholder “offers” a transaction to the board must pay a fair price

under entire fairness review a la Kahn, w/burden on P If a controlling shareholder “offers” a transaction directly to public shareholders in

the form of a tender offer as long as the offer is not coercive, there’s no obligation to pay a fair price business judgment review

In re Pure Resources (Unocal owns 65% of Pure, makes exchange offer, Pure creates special committee, seeks higher offer; Unocal declines, goes ahead with offer) Rule: a tender offer freeze out such as this will be considered non-coercive when

Part one (w/r/t the offer)o One: it is subject to a majority of the minority tender condition

Minority means fully independent from the controlling stockholdero Two: the controlling stockholder promises to consummate a prompt §253

merger at the same price if it obtains more than 90% of the shares, ando Three: the controlling stockholder has made no retributive threats

Part two (w/r/t the independent committee)o The controlling stockholder must give the independent directors on the

target board adequate time to react to the offer by Hiring their own advisors Giving the minority shareholders a recommendation on the offer, and Disclosing adequate information for the minority to make an informed

judgment If such conditions are met business judgment review Holding: Unocal’s offer is coercive because its definition of minority includes

o Stockholders who are affiliated with Unocal as directors and officerso The mgmt. of Pure, whose incentives are skewed by their employment

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Public Contests for Corporate Control General

o Control contests are an important constraint on manager-shareholder agency costs i.e. they don’t want to lose their jobs in a takeover for poor performance

o Two traditional ways to initiate a hostile change in control Proxy contest: run an insurgent slate of candidates for board election

Has returned with the rise of hedge funds and other institutional investors Tender offer: purchase enough stock to obtain voting control

Costlier than a proxy contest, but has the advantage of capturing shareholder attention with promises of cash up front rather than promises of future performance.

o Traditional judicial approach to a board’s response to a hostile takeover attempt If the response was self interested in an immediate financial way entire fairness Otherwise business judgment review Problematic b/c although in hostile takeover situations boards are not interested in the

sense of self-dealing, they are never truly disinterested in efforts to acquire control There was a need to find a middle way

o Begins to change in the 80s Van Gorkom: T board found grossly negligent when it seemed to comply with duties Unocal: articulates for the first time a standard of judicial review btwn BJR and EF Revlon: another type of heightened review short of entire fairness

Defending against hostile tender offerso Unocal (Mesa makes front loaded (coercive) tender offer for Unocal’s stock at $54; back

end is shit bonds; Unocal board offers to buy the backend shares for $72, excludes Mesa) Rule: when a board takes defensive measures in the face of a hostile takeover bid, it

has an enhanced duty which calls for judicial examination at the threshold before the protections of the business judgment rule may be conferred. Two step test

One: has management, in good faith, with reasonable investigation, determined that a threat exists?o Threat: bad price/timing, nature of the deal (coercive tender offer), effects

on non-shareholder constituencies (creditors, customers, employees, etc.) Two: is the defensive measure adopted reasonable in relation to the threat

posed? Two consequences of Unocal

Coercive tender offers stopped because boards could adopt defensive measures SEC adopted rules that banned discriminatory self-tenders of shares

o Unitrin (Amgen hostile tender offer for Unitrin; reacts w/poison pill, share buyback) DSC clarifies the second prong of Unocal

Second prong of Unocal from above Determine whether the defensive measures adopted are reasonable in relation

to the threat posed Rule: If the board’s defensive response is not draconian (preclusive or coercive)

and is within a range of reasonableness, a court must not substitute its judgment for the board’s Preclusive: A response is preclusive if it deprives stockholders of the right to

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receive tender offers or precludes a bidder from seeking control by fundamentally restricting proxy contests or otherwise

Coercive: A response is coercive if it is aimed at forcing upon stockholders a management-sponsored alternative to a hostile offer

Burden on D directors to show board action proportionate and reasonable If they meet their burden, burden shifts back to plaintiffs to show that the

defensive action does not satisfy business judgment review Looks a lot like business judgment review Bubb: despite the fancy complicated doctrine, judges basically just use their

fiduciary duty radar and when it goes off they set things right. However, we have to play the game, and when it comes to Revlon, the structure really does matter

The Poison Pill (shareholders rights plan)o General

Hostile tender offers Pro and Con Pro: useful device for disciplining corporate management Con: exposes disaggregated/disorganized shareholders to abusive t-offer tactics

o Description Nominally: shareholders rights plans are rights to buy a capital asset, e.g. bond, share Really: alters the allocation of power between shareholders and boards How they usually work

Rights plan is adopted by the board Shareholder vote not necessary if corporation has a provision in its charter

allowing it to issue stock Rights to buy the company’s stock at a discount are distributed to all shareholders These rights are triggered if

One: someone acquires more than e.g. 20% of the corp.’s outstanding stock Two: without first receiving target board’s blessing

The person who triggered the rights cannot buy the discounted stock her holdings become extremely diluted

o Moran (Household adopts poison pill triggered when >20% shares bought in the market as a preventative measure to ward off future threats) Holding: boards have authority to adopt shareholder rights plans

151-g: authorizes the issuance of stock 157: authorizes the issuance of rights 141-a is also working here, because there’s inherent power in the board to manage

the company’s affairs Passes Unocal test

One: board determined that there was a threat in the marketplace of coercive two-tier tender offers

Two: Boot strap and bust up takeovers were increasingly common, the board was afraid such takeover would take the form of a two-tier offer

Choosing a Merger or Buyout Partnero Board’s entrenchment interest can affect not only takeover defenses but also its choice of

a merger or buyout partnero Management can obtain benefits in friendly deals

Place on the surviving corporation’s board

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Consulting contracts Termination payments

o Smith v. Van Gorkom ($50-60 good for LBO; board approves sale to Pritzker for $55) Holding: Board was grossly negligent in failing to act with informed reasonable

deliberation in agreeing to the merger proposal; stockholder vote approving the merger does not exonerate the board b/c the board is a fiduciary.

o Revlon (P makes hostile cash tender offer for Revlon; board adopts poison pill and puts debt on balance sheet; P raises bid; Revlon enters agreement w/Forstmann w/lockups) Rule: When a sale/breakup of the company becomes inevitable, the directors’ role

changes from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders Change from Unocal: instead of focusing on other constituencies, must focus on

one thing: maximizing value for shareholders Duty of loyalty issue (end of case says board violated the duty of care)

The company, not the directors, is liable to the noteholders Implausible that directors would risk liability from noteholders

Here, directors’ only obligation is to shareholders (different from Unocal) Lockups not per se illegal:

If the security guaranteed enhances the bidding good If the purpose is to thwart other bidders, as here bad

o Barkan on Revlonland: Level playing field for bidders

When multiple bidders are competing for control, fairness forbids directors from using defensive mechanisms to thwart an auction or to favor one over another

Market check required When the board is considering a single offer and has no reliable grounds on

which to judge its adequacy, fairness demands a canvas of the marketplace to determine if higher bids may be elicited

Exemption allowed in very limited circumstances When directors possess a reliable body of evidence with which to evaluate the

fairness of a transaction, they may approve the transaction without conducting an active survey of the marketplace

Pulling together Unocal and Revlono Paramount v. Time (Time has strategic plan w/Warner; Paramount bids on Time; Time

transforms merger deal into tender offer for Warner; Paramount sues to stop the deal) Rule: Before Revlon duties attach, there must be substantial evidence to conclude that

the dissolution of the target board is inevitable. Two circumstances, without excluding others, which implicate Revlon duties One: when a corporation initiates an active bidding process seeking to sell itself Two: in response to a bidder’s offer, a target abandons its long-term strategy and

seeks an alternative strategy also involving the breakup of the company If the board’s reaction is only a defensive response and not an abandonment of

the corporation’s continued existence, Unocal duties attacho One: substantive coercion (the threat to, e.g. a long term strategic plan)

can constitute a threat under the first prong of Unocal just as much as structural coercion (e.g. a two tiered tender offer)

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o Two: Time’s response was not aimed at cramming down on shareholders a management sponsored alternative, but aimed to carry forward a pre-existing transaction in an altered form reasonably related to the threat

This case establishes the limits of Revlon NB: change of control not the determining factor for triggering Revlon; yes, control of

Time here was in the market before and after merger, but that’s not the test.o Paramount v. QVC (Viacom wants to buy Paramount, makes offer w/3 lock ups; QVC

makes better offer; Paramount does everything it can to not sell itself to QVC) Rule: If a corporation undertakes a transaction which will cause a) a change in

corporate control, or b) a breakup of the corporate entity (does this include simple sales, or does that fall under change in control?), directors’ obligation is to seek the best value reasonably available for the stockholders. In adopting a change in control trigger, the court drew the line at the point at

which public shareholders are excluded from meaningful participation in governance in the combined company, by a controlling shareholder or otherwise De facto definition of control more likely than de jure since QVC’s analysis

rests on policy considerations expect 30-35% control to trigger Revlon Board action in such circumstances subject to enhanced scrutiny (mandated by the

threat of reduced voting power, control premium being sold, traditional DE concern for stockholder voting rights) which takes 2 forms One: Judicial determination regarding the adequacy of the decision making

process employed by the directors Burden on the directors to show they were adequately informed

Two: A judicial examination of the reasonableness of the directors’ action in light of the circumstances then existing Burden on the directors to show that they acted reasonably (not perfectly)

Time did not reject the “change of control” rationale for triggering Revlon duties nor hold that a breakup of the company is essential to give rise to Revlon duties NB: the “not excluding other possibilities” language before the two part test

Revlon duties under QVC In general, directors have the obligation to (from QVC)

Be diligent and vigilant in examining all available offers Act in good faith Get all material information reasonably available to evaluate offers Negotiate actively and in good faith with all considered parties

Strategies for getting the best price for shareholders Conduct an auction – Barkan Market check – Barkan Consider whether (from QVC)

o Defensive measures are reasonable If they limit directors duties to fulfill their fiduciary obligations, they

are invalid and unenforceableo Offers in place are or will continue to be conditionalo Offers in place can be improvedo Offers in place reasonably likely to come to closureo Timing constraints are an issue

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o Viable and realistic alternatives exist Cash vs. stock merger (p. 567-568)

All cash offered triggers Revlon All stock offered in a merger of equals doesn’t trigger Revlon Mixture of cash and stock continuum, court assesses board’s good faith,

perhaps applies Unocal test (Time) Rationale: no plausible information difference between directors and shareholders

when the offer is cash; when it’s stock the directors potentially have an information advantage relative to shareholders Countervailing factor: agency problem boards may want to entrench

themselves in officeo Lyondell (chemical company sells itself to European company for $48/share)

Lyondell has a 102(b)(7) waiver; duty of care not applicable here Holding: directors did not breach their duty of loyalty by failing to act in good faith

in considering and approving the merger Test for breaching the duty of loyalty by failing to act in good faith

Intentional dereliction of duty Conscious disregard for one’s responsibilities

Test for complying with the duty of loyalty by acting in good faith Disinterested and independent Aware of the company’s value Considered the offer with the help of financial and legal advisors

Revlon duties here did not kick when the acquirer filed a 13D in 5/10 signaling its interest, but on 7/10, when the target directors began negotiating the sale of the company.

There is only one Revlon duty: get the best price for stockholders at a sale of the company.

Protecting the Dealo Lockups

Historically Options to target’s assets: virtually nonexistent since Revlon Options to target’s stock: nonexistent since FASB changed policy in 2001

Today: Termination Payments Cash payments to A if T elects to terminate merger or fails to close the deal

Scrutiny Often scrutinized under Unocal (as these are a type of defensive measure)

E.g. lockups in a merger of equals with no change in control If the sale of the company becomes inevitable, Revlon applies

Under Revlon, the later in the process the lockup happens, the more lenient courts will be in analyzing it

Triggers for lockups and termination fees Failure of the board to rec. the deal to shareholders in light of a better offer

DGCL §146 now allows for force the vote provisions, which make a board’s decision not to recommend a negotiated acquisition a trigger

Rejection of the negotiated deal by a vote of T’s shareholders A later sale of assets to another firm

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o No-Shop Provisions T board cannot actively solicit other bids and sometimes is restricted from discussions

if someone solicits them Board may have to submit proposed agreement to shareholders and recommend it

Lockups serve a purpose by inducing bidders into the contest who might not enter without the guarantees provided by lockups

Fiduciary duties in conflict with no-shop provision Van Gorkom held T’s board has no fiduciary right to breach a contract

i.e. even if the directors’ fiduciary duty requires them to breach, corporation not privileged to do so if corporation breaches liable for damages

Answer: Fiduciary out If some triggering event occurs (such as a better offer or an opinion from

outside counsel that the board has a fiduciary duty to abandon the original deal), T board can avoid the contract without breaching it.

Uncertainty in the doctrine DSC seems to have held contracts that violate fiduciary duties unenforceable Suggests damages would never be available against a corp. that abandons a

transaction subject to Revlon on the grounds that a better deal is available However, because the law is not clear fiduciary outs still important Also important to signal the good faith of a board’s directors, esp. if the whole

package of lockups will be upheld or struck down togethero Omnicare (A demands force the vote lockup that essentially guarantees it will acquire T)

This is a stock for stock merger Revlon does not apply; Unocal analysis Unocal analysis of the board’s defensive measures

One: threat: the possibility of losing the Genesis offer Two: is the response reasonable: two step test under Unitrin

One: not preclusive or coerciveo Board fails here; the force the vote + voting agreements guaranteed

stockholders would approve the merger, meaning any stockholder vote was robbed of its effectiveness preclusive and coercive

o Defensive measures also unenforceable b/c there was no fiduciary out and the provisions together would prevent the board from discharging its fiduciary duties to minority stockholders.

Two: within a range of reasonableness Holding: the target board did not have the authority to accede to the acquirer’s

demand for an “absolute” lockup. Rests more on the fiduciary issue

NB: this case not comparable to Weinberger (which imposed entire fairness review) because in Weinberger the controlling shareholder was on both sides of the deal

State Anti-Takeover Statutes o DGCL § 203

Corporation may not engage in a “business combination” with a subsidiary any time within 3 years of gaining ownership, unless It acquires 85% or more in the first purchase, or If it acquires between 15% and 85%, it secures 2/3 vote from remaining

shareholders and Board approval

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o Not so important after the development of the poison pill and the Williams Act Hostile tender offers are not successful on their own; board has to pull the poison pill

Proxy Contests for Corporate Controlo In a poison pill world, would be takeoverers have two options

Friendly option: negotiate with the board to get them to remove the pill Hostile option: tender offer + proxy contest

These actions may lead to further defensive steps on part of the targeto Schnell (board moves up the date of the annual meeting to screw over acquirers)

Rule: Actions taken with the intent to frustrate a proxy contest are a violation of the board’s fiduciary duty

o Blasius (board adds two 2 new members to prevent acquirers from adding 8) Holding: A board cannot act for the principal purpose of preventing the shareholders

from electing a majority of new directors. Rule: The central importance of the franchise to the scheme of corporate governance

requires that Unocal not be applied and that closer scrutiny be accorded to such transaction; board; the board must show a compelling justification “The shareholder franchise is the ideological underpinning upon which the

legitimacy of directorial power rests.”o Hilton (Hilton TO/proxy contest; ITT delays meeting, restructures to block Hilton)

Holding: Court applies Unocal, Blasius and Unitrin to find ITT could have found Hilton’s offer inadequate (satisfies Unocal 1?) but finds the installation of a classified board in the spinoff corporation is preclusive and coercive under Unitrin.

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Insider Trading Why is it bad?

o Faith in the market is diminishedo Incentives for managers to move the stock price up and downo Unfair to let officers use privileged information to gain an advantage over others

Fraud at common lawo Five elements

A false statement Of material fact Made with the intention to deceive Upon which one reasonably relied and which Caused injury

o Remedy generally not available solely for nondisclosure w/o overt deceptiono Remedy not available for losses of persons trading over stock exchangeso Director Dealing with Company Shares at Common Law

Majority Rule: director’s only duty is to the corporation; no duty to disclose Minority Rule: (trustee/beneficiary approach) director has duty to disclose material

information when trading with shareholders in a company’s stock Intermediate Rule

Strong v. Repide (P dir. offers to buy shares from D dir., who says nothing) Rule: Where special facts exist, a director has an obligation to disclose these

material facts or refrain from buying corporate stock in a face to face transaction.

Goodwin (D CEO buys own stock after a promising mining survey; P seller sues) Holding: Given that the knowledge upon which D relied in purchasing the

stock was only a speculative theory, D had no duty to disclose it to the seller. Director Dealing with Company Shares (Modern State Law Approach)

o Fiduciary/Agency Theory Corporate officials who deal in corporation’s securities on the basis inside info w/o

securing informed consent breach fiduciary duty to the corporation One rationale: inside information is a corporate asset and the corp. is therefore

entitled to any profits made by its agents by trading on it - Tarnowski Comes from agency law: agent may not use principal’s info for personal profit

BUT, not widely adopted Freeman v. Decio (earnings overstated; CEO sells stock before truth comes out)

Derivative suit: corporation is suing the directors Holding:

o One: Should not expand fiduciary duties so broadly to encompass an abstract injury to the corporation Here there was no actual injury

o Two: Remedies under federal securities laws are more effectiveo State Law Disclosure Obligations

When a board is seeking some shareholder action, such as a vote on merger, now under DE law the board has a fiduciary duty of candor to truthfully disclose all material facts relevant to shareholders’ decision

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Federal Statutory Lawo §16(b) and Rule 16: Ban on short-swing profits

16(b) requires statutory insiders (directors, officers, shareholders with >10% of the corporation’s stock) to file public reports of any transactions in the corp’s securities, w/in 2 days of the trade under SOX §403

A covered person who buys and sells shares within 6 months is conclusively presumed to have done so on insider information

Remedy Corporation has right to disgorgement of insider’s profits Formula: look backwards and forwards 6 months (but transaction before D was an

insider do not count) Pay the highest amount that this generates – inference goes against the insider Have to match the number of shares whichever direction you go

What is included in “purchase or sale” Purchases and sales, obviously Derivative transactions

Swaps, shorts Mergers

Probably: Cash mergers Probably not: Stock for stock mergers

Bottom line: simple, brightline approach Underinclusive: insider trading can occur over a period >6 months Overinclusive: short-swing transactions need not involve insider information

o §10 and Rule 10b-5 Congress in §10 punts to the SEC to develop regulations SEC enacts 10b-5 in 1942

Unlawful for any person…by the use of…interstate commerce or a nat’l exchange To employ any device, scheme or artifice to defraud To make any untrue statement of a material fact or omit to state a material fact

in order to make the statements made…not misleading, or To engage in any act, practice, or course of business which operates as a fraud

or deceit upon any person In connection with the purchase or sale of any security

Originally SEC was intended to bring suit Implied private right of action read in later in Kardon

2d circuit most friendly to IPRAs SCOTUS was for a time; has since pulled back Santa Fe (D owns 95% of stock, does §253 short form cash merger; Ps sue)

o Shareholders don’t bring §262 appraisal suit; allege fraud w/derivative suito Holding: 10b-5 does not encompass breaches of fiduciary duty; it only

prohibits conduct involving manipulation or deception; neither presento Rationale:

§10(b) did not expressly provide a private cause of action Shouldn’t be implied where unnecessary to ensure fulfillment of

Congress’s purposes Fiduciary duty is traditionally a matter of state, not federal, law

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Goldberg (private right of action not totally dead under Santa Fe)o Rule: A derivative action can be brought under 10b-5 on the basis that the

transaction between the corporation and a fiduciary or controlling shareholder was unfair, if the transaction involved stock and P can show A misrepresentation or nondisclosure that Caused a loss to the shareholders

Elements of liability under 10b-5 False or Misleading Statement or Omission (whether there’s a duty to disclose)

Cady, Roberts: Basic duty to disclose arises fromo One: the existence of a relationship affording access to inside information

intended to be only for a corporate purpose, ando Two: the unfairness of allowing a corporate insider to take advantage of

that information by trading without disclosure Equal Access Theory

o Rule: Anyone with inside information must abstain from trading on that information or must publicly disclose the information Broad conception of liability; overinclusive

o Rationale: Inherent unfairness of a party taking advantage of inside info

o Criticism: unclear where the fraud is if there’s no deceptiono Texas Gulf Sulfur (drilling sample suggests large mineral deposit)

Rule: Anyone in possession of material inside information must either disclose it to the investing public, or abstain from trading in or recommending the securities concerned

while such inside information remains undisclosed Rationale: 10b-5 is based on the justifiable expectation of the

securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information

Fiduciary Duty Theoryo Rule: A10b-5 violation requires a breach of a preexisting fiduciary

relationship between the alleged violator and the affected shareholder Reaches a narrower set of insider trading activities; underinclusive

o Rationale: Requirement of preexisting relationship analogizes to fraud Allows case by case review of relationships, thus selective targeting

o Criticism: Does not reach behavior like D in Chiarella Dodges question on how insider trading defrauds uninformed traders

o Chiarella (D printer buys stock in corp inferred from takeover documents) Rule: The duty to disclose stems from a relationship of trust and

confidence; not from the mere possession of nonpublic market info. here D was not a corporate insider & received no info from the

issuer of the stock he purchased (the target) Rationale: We cannot affirm D’s conviction without recognizing a

general duty between all participants in market transactions to forgo transactions based on material nonpublic information.

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Won’t do this without evidence of congressional intent Misappropriation Theory

o Rule: One who misappropriates nonpublic information in breach of a fiduciary duty owed to the source of the information and trades on that information to his own advantage violates 10b-5 Distinguished from fiduciary duty theory: Misappropriation theory

shifts the focus from the trader and counterparties w/which he trades to the relationship between the trader and his source of information

o Criticism No basis for offering recovery to anyone but the employer/client

o Chestman (D and his broker buy stock based on inside info from family) Waldbaum agreed to sell his company; tells sister Shirley, who tells

daughter Susan, who tells husband Keith, who tells broker Chestman, who buys stock for Keith, himself, and clients.

Gov’t convicted Chestman under two theories One: aiding and abetting Keith’s misappropriation Two: tippee of the misappropriated information Both required Keith to have breached his FD to the source

Holding: Keith owed no fiduciary duty to his wife/her family Kinship does not establish a fiduciary duty Confidentiality agreement cannot be imposed unilaterally

can be implied but only from a preexisting FD-like relationship SEC’s Response: Rule 10b-5-2

A person has a duty of trust or confidence for purposes of the misappropriation theory Whenever a person agrees to maintain info in confidence Whenever two persons have a history of sharing confidences Whenever a person receives material NPI from a spouse,

parent, child or siblingo O’Hagan (D works at law firm working on TO for Pillsbury; buys calls)

Holding: Liability may be predicated on the misappropriation theory §10(b) req’s that conduct involve “deceptive device/contrivance”

fiduciary’s feigned loyalty to the principal satisfies this distinguished from Santa Fe: all facts disclosed no deception

§10(b) also req’s deception w/r/t purchase sale of any security does not refer to deception of an identifiable purchaser/seller

Anomalous result: seems like if the fiduciary discloses his plans to the source no liability (but he’d probably be in f’d under other laws)

Materiality General formulation: The significance a reasonable investor would have

placed on the withheld information in deciding how to act – Basic Specific formulation: Balancing of probability that event will occur with the

anticipated magnitude of the event in light of total company activity – Texas Gulf

Basic v. Levinson (companies negotiating merger, denying it publicly)

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o Holding: Materiality in the context of a merger does not require agreement-in-principle

Scienter Definition: specific intent to deceive, manipulate or defraud

o may be inferred from reckless or grossly negligent behavior Pleading: two approaches

o 1) Simply state that D acted w/scienter (9th Cir.) oro 2) Facts that give rise to strong inference of fraudulent intent (2d Cir)

Standing to Sue (necessary for P, not SEC) P must be a buyer or seller of stock. Holding stock in reliance on false

information is insufficient – Blue Chip Stamps Reliance (necessary for P, not SEC)

Rule: Rebuttable presumption that P relied on the integrity of the market priceo Rationale: Fraud on the market

Market price rapidly reflects all available information (ECMH) Misrepresentations artificially inflate/deflate market price

D’s can rebut by showingo (a) misstatement did not affect the priceo (b) P’s decision to trade did not rely on the market price

Causation (necessary for P, not SEC) Rule: Misrepresentation/omission must cause both P’s transaction and loss

o Like but-for causation in tort lawo Dura Pharmaceuticals: more facts needed to show causation

Remedy Rule: Uninformed, deceived investor may recover loss on stock up to

reasonable time after learning of tipped info or public disclosure of it - Elkindo Limited at max to insider’s profitso Rationale: Taking away profits takes away incentive for insiders to trade

Tipper / Tippee cases Rule: Tippee must disclose/abstain only if

Tipper breached his fiduciary duty/ReTAC by tipping, and o Test: Tipper breached FD if he benefits, directly or indirectly, from tip

Tippee knows or should know there’s been a breach Dirks v. SEC (former officer of corp. tells D analyst about fraud; D discloses)

Holding: The tipper got no personal benefit from tipping D, so he didn’t breach his duty therefore D didn’t have a fiduciary duty D not liable

o §14 and Rule 14e-3(a) SEC’s interpretation of 14e-3(a): (validated in Chestman)

Anyone who obtains inside information about a tender offer that originates w/ either the offeror or target must disclose the info or abstain from trading No fiduciary duty or ReTAC required Not quite equal access theory because information has to come from offeror or

target, not just anyone

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