Corporations Tests BASICS

- State law o Fiduciary duties

- Federal law o Mandatory disclosures o Accountants and auditors

- How shareholders are protected o Laws against fraud and unfairness o Ability to sell their shares in a stock market o Holding stock in portfolios

- How management is disciplined o Competitive markets o Capital markets o Stock price

Limited Liability

- Is it a limited corporation? o How is it formed?

File articles of incorporation w/ Sec of State Filing fees

o Who is liable? Limited to the value of shares of each investor

o Who has control? Board, elected by shareholders (but can modify by K to resemble

partnership) - Did corporation effectively incorporate under DGCL?

o Did corp file certificate of incorporation w/ Sec of State, w/ Name of corp Name and address of registered agent Nature of biz (any lawful activity) Description of corp’s stock and relations among stockholders Name and address of incorporator Optional provisions

• Limits on directors or shareholders • Supermajority vote of shareholders, or quorums

o Unanimity recommended if only 4 shareholders • Limits on duration • Provisions imposing personal liability • Preemptive rights • Provision allowing corp to opt out of monetary damages for

duty of care o Were bylaws properly amended?

By director vote

o If incorporation is defective, Is it a de facto corporation? Cranson

• Is there a law authorizing the corp? • Is there a good faith effort to comply w/ the law?

o Hiring atty who makes mistakes not enough • Is there an actual exercise of corporate powers?

Is it a corp by estoppel? Cranson • Envelope from IBM addressed to corp is enough b/c shows

that IBM assumed it was dealing w/ a corp. • Of no use in torts claims; does apply in contracts claims

- Corporate formalities o DGCL §211b: directors are elected at an annual meeting o DGCL §211d: board may call special meeting o DGCL §212a: one vote per share unless cert of incorp says otherwise o DGCL §216: majority quorum unless cert of incorp says otherwise o DGCL §212b: in a large publicly traded corp, most votes are by proxy. In

DE, proxies are good for 3 years. - Who has control?

o DGCL §141(a): “The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors.”

§141(c)(2): board can delegate to committees, but CANNOT delegate:

• anything that requires stockholder action • amendment of certificate of incorporation • recommendation to stockholders to sell, lease, or exchange

all or substantially all of corp’s property and assets • recommendation to stockholders of a dissolution of the

corporation • adoption, amendment, or repeal of bylaws

- Did the board act in good faith? DGCL §141(e) o Board is fully protected in relying in good faith on the records of the corp,

and on info, opinions, reports or statements presented to the board by any officer or employee, board committee, or any other person as to matters the member reasonably believes are within such other person’s professional or expert competence and who has been selected w/ reasonable care by or on behalf of the corporation (accountant, atty, etc).

- Can the privileges of limited liability be taken away (piercing the veil)? o Shareholders can be held personally liable for the corp’s debts o Does the alter ego or instrumentality rule apply?

Was the sole owner of a corp alleged to have treated corp’s assets as his own; not w/ appropriate dignity? If ∆ directly treats corp as personal property, or forms parent or subsidiaries and fails to treat them separately, then veil can be pierced.

PUT Laya v Erin o Is there inadequate capitalization?

Minton: Can pierce if there is inadequate capitalization, even if there is no fraud/wrongdoing

• There is no statutory minimum of capital required to form corporation, but can pierce the corporate veil when capital is trifling compared to the actual needs of the corporation. Look to the standards of the industry, or the state insurance requirement if there is one.

Walkowsky: insufficient $ alone is not enough to pierce; also need failure to follow corporate formalities.

o Is there fraud? If you represent as the sole owner of the corp, and figures of

assets/liability are false (too high or too low), can pierce the corporate veil, IF misrepresentation is MATERIAL.

Corporate Purposes

- Corporate purpose is primarily for the benefit of shareholders o Dodge v Ford: Henry Ford can’t decide to reduce price of cars instead of

increasing corporate profits - If want part of the purpose to be for charity,:

o 1) must be reasonable in amount o 2) must be an indirect benefit for the corporation

Ex (Smith v Barlow): supporting the free enterprise system - PUT Dodge v Ford and Smith v Barlow - Constituency statutes

o Unocal: in takeover defense, it was suggested that board didn’t take into account creditors, employees, etc

o Revlon: limited Unocal constituency holding to situations when dissolution is inevitable.

Duty of Care

- Duty to perform w/ that diligence, care and skill which ordinarily prudent persons would exercise in similar circumstances.

- BASIC STANDARD o Л has burden of persuasion o 1) Bates v Dresser: Duty to supervise: one bite rule

1) was there a red flag/was director placed on notice that something was amiss? Yes

2) did director inquire? Here, bank director liable when employee bookkeeper stole $,

director had warning that $ was missing and an employee was likely at fault, employee had low income but many stocks and a new car, yet director accepted book reports w/o investigation.

o 2) Barnes v Andrews: standard amplified Duty to perform w/ skill of person in like position

• Minimum level of competence, understanding business • Duty to keep one’s self informed

• Director only went to one board meeting and thus did not learn of production delays

Must show causation: • 1) show violation of duty • 2) show violation was proximate cause: the only or primary

factor o 3) Francis v United Jersey Bank: standard amplified

Must be competent, understand the rudiments of the business and financial statements, habitually attend meetings (absence is considered concurrence), habitually review financial statements (lack of knowledge is not a defense), and comply with laws, and if something is wrong and don’t know how to fix it, duty to consult outsiders or atty.

Proximate cause modified: • Violation of duty does not have to be only cause; only

needs to be a substantial factor. o Mrs Pritchard’s failure to review financial

statements or consult an atty were a substantial factor. It does not matter that her sons’ fraud also contributed to the injury.

o 4) Caremark: Director has a duty to attempt in good faith to ensure that an

adequate corporation information and reporting system (compliance system) operates, to make sure the company is complying with laws.

• It is not enough to respond when suspicion presents itself.

o Did director know or should have known facts which would prompt an ordinarily prudent person to investigate or change corporate practices?

o Here: Directors not held liable b/c did not lack good faith in monitoring or conscientiously permit known violations of anti-referral law to occur. When Caremark was investigated, it increased its supervision

o Miscellaneous NOTE: Duty of care suits are hard to win b/c:

• Л has BOP • In DE, gross negligence standard applies • §102(b)(7) opt out provision • business judgment rule defense

o directors can rely on the reports of officers, committees, and outsiders

Does the business judgment rule defense apply to the ∆ corp? SEE below

Standard is higher for insider or bigger corp Standard:

• Most states: negligence • Delaware: gross negligence

- BUSINESS JUDGMENT RULE DEFENSE: a defense to duty of care violation claims

o Standard in DE: gross negligence o Smith v Van Gorkom:

A director or officer will not be held liable if a business judgment is:

• (1) disinterested (no conflict of interest), o If there is a conflict of interest, duty of loyalty

applies • (2) reasonably informed (did a reasonable investigation,

did not make a decision until had all material info available to them), and

o 141(e) “directors are fully protected in relying in good faith on reports made by officers”

does not include oral comments o Here: Directors approved leveraged buyout

agreement after only 2 hours’ consideration, no written terms were presented, most people weren’t aware of the merger proposal until 1 hour before the meeting.

o Here: A premium is not adequate basis to decide the fairness of an offering price b/c only shows the value of one share, w/o considering cashflow, etc. If no adequate reports from people that are informed about corp’s assets, must do a valuation. Should have found out if this was the best price they could get (in the best interests of the shareholders)

o Here: Directors based their decision on representations by one person, Romans, which did not constitute a report they could reasonably rely on under DGCL §141(e).

o Here: Shareholder vote did not cure the merger b/c shareholders were not fully informed of all facts material to their vote on the merger.

o See also Walt Disney, Aronson(2) for reasonably informed

• (3) the director or officer reasonably believes that the business judgment is in the best interests of the corp

o (decision, at the time it was made, cannot be viewed as entirely irrational)

o Presumption that directors acted on an informed basis, in good faith and in the honest belief that the action was taken in the best interests of the corp.

Good faith means not knowingly unlawful o Л must prove

Duty of care was violated Causation damages

o Policy: want directors to take risks Bigger risks → greater likelihood of greater rewards for

shareholders Rational shareholders can diversify away firm-specific risk

through a portfolio o Safe harbor: DGCL §102(b)(7) adopted after Van Gorkom

the shareholders may modify the corporation’s charger to eliminate money damages for breach of the duty of care, so long as the director has acted in good faith w/o knowingly violating the law and w/o obtaining any improper personal benefit.

Cannot eliminate monetary damages for duty of loyalty - WASTE DOCTRINE: executive compensation

o Payment can’t be so large as in substance and effect to amount to spoliation or waste of corporate property.

o Rogers v Hill: Л has burden to prove that a bonus payment has no relation to value of services for which it was given and is in reality a gift.

Otherwise, the majority stockholders have no power to give away corporate property against the protest of the minority.

• Bylaw authorizing payments to pres and VP of American Tobacco Company on top of their salaries, 10% of excess profits, is enough for a jury question on waste.

o NOTE: cts are split on whether someone who voted against the bylaw can bring a suit.

o Walt Disney: ∆s can be held personally liable to the corporation for directors knowing or intentional lack of due care regarding an executive’s employment contract and termination agreement.

Director violated fiduciary duty by failing to negotiate in an adversarial and arms-length manner: Ovitz violated fiduciary duty to Disney by not negotiating honestly and in good faith so as not to advantage himself at the expense of his shareholders.

Ovitz should have negotiated w/ compensation committee, instead of w/ a personal friend.

To do this right: Ovitz should have negotiated w/ a disinterested board, made sure special counsel for the transaction was disinterested, and told Ovitz there is a choice w/ risks: follow the right procedures so cannot be liable, or do it your way w/ Eisner and get a huge bonus.

o Stock options for executives State corporate law applies

Dilution danger: if company sells stock worth $75 to execs for only $50, can no longer sell to the public for $75

Consultant manipulation: There are ways for compensation consultants, such as Graef Crystal) to justify pay raises for execs by using comparative studies, etc, when a pay raise might actually be waste.

Motivation argument: overpayment can motivate execs to work harder making money for the company

• Counterarg: marginal productivity theory applies. This arg is easy to assert but difficult to prove.

Superior executive trap: If executive is the best around, comparative studies of appropriate salary don’t really apply. Also, what if the exec threatens to quit if his bonus is cut, but the company fears shareholders will sue if bonus is not reduced?

Duty of Loyalty

- 3 kinds o 2 corps w/ one director person on each side (board interlock) o individual director engages in a transaction w/ his own corp o parent-subsidiary: parent owns a controlling interest less than 100% and

engages in a transaction w/ its subsidiary - Modern view (by 1960s): no transaction of a corp w/ any or all of its directors

is automatically voidable by shareholder suit, whether there was a disinterested majority of the board or not; courts review the K under rigid and careful scrutiny, and invalidate it if it is found to be unfair to the corp.

- ∆ has burden of persuasion except in the case of safe harbor statutes (more demanding than duty of care)

o Safe harbor: DE 144 1) were material facts about director’s interest and about the

transaction disclosed to the board? 2) was the transaction approved by a disinterested majority of

directors? Then: BOP shifts to Л to prove that an interested transaction

was unfair If P shows a conflict, D can still validate K if show that the

transaction was fair under Gries. PUT Marciano v Nakash

- Globe Woolen: someone can violate duty of loyalty even if they don’t vote. If you have a conflict of interest, you should recuse yourself from discussion and approval.

o Board interlock case: 2 corps w/ a common director engage in a transaction (Director person is on both sides)

Here: Maynard was on the Boards of Globe (mills) and Utica (power), and held stock in Globe but not Utica. Maynard negotiated K whereby Utica had a losing K, due to miscalculation

by Utica and undisclosed expected increase in power usage by Globe. At approval meeting, Maynard remained silent.

• Maynard violated duty of loyalty owed Utica. Refusing to vote creates assumption of fairness and approval; it does not create a disinterests vote. Director can only remain silent if all is equitable and fair.

- Gries Sports v Cleveland Browns: arms-length transaction required o Board interlock

Modell owned 53% of Browns; Gries owned 43% of Browns. Modell formed CSC,and owned 80% of it. Browns brought CSC, no arms-length negotiation, Gries claims Modell overvalued the price.

When the parties controlling the transaction are on both sides, presumption of deference to sound business judgment drops

• (1) Was transaction approved by a majority of disinterested shareholders and independent directors?

o No: Browns directors received a financial benefit

from the transaction (they were shareholders of both Browns and CSC and CSC minority stock was redeemed).

Berick not independent b/c was dominated by Modell and would get fired if did not do what Modell said.

• (2) Was the transaction intrinsically unfair to the corp and its minority shareholders? Strict scrutiny applies.

o Yes: Price was not based on valuations, etc; price

was decided b/c it was beneficial to eliminate directors’ personal debts

Should have had a range of prices, if possible

- Policy: don’t want a transaction to favor one of the contracting parties; want it to be fair, like b/tw 2 strangers.

- History o 1880: any K b/tw a director and his corp was voidable by the corp or its

shareholders (one shareholder alone enough), w/o regard to its fairness. This was overinclusive and unworkable and did not allow conflicts

of interest that might actually benefit the corp o 1910, more relaxed: was K approved by a disinterested majority of

directors? Yes: valid as long as, if challenged, ct does not find it unfair or

fraudulent No, by an interested board of directors: K voidable by corp or its

shareholders w/o regard to its fairness. - 3 types

o Did individual director engage in a transaction w/ his own corp? o Board interlock: Did 2 corps w/ a common director engage in a

transaction (Director person is on both sides)? Prohibited by §8 of the Clayton Act if either firm has $1m in assets

or profits o Parent-subsidiary: Did parent corp engage in a transaction w/ a

subsidiary, w/ parent owning a controlling interest but less than 100%? - CORPORATE OPPORTUNITY DOCTRINE

o DE elements: (1) Is the opportunity in the same line of business as the

corporation, or a line in which the corporation has an interest or expectancy?

(2) Was the opportunity presented to a corporate officer in a corporate rather than individual capacity?

(3) Was the corporation financially able to undertake the opportunity?

o Interest or expectancy test: An opp is corporate if the corp has a “beachhead” in the sense of a legal or equitable interest or expectancy growing out of a preexisting right or relationship.

o * Line of business test: An opp is corporate if a managing officer becomes involved in an activity intimately or closely associated w/ the existing or prospective activities of the corp: Guth v Loft, DE 1939

Director can seize the opportunity if: • 1) Offer is made ton director as an individual and not as an

executive • 2) Corporation is not able to financially undertake the

opportunity • 3) Opportunity is not in the interest or expectancy of the

corporation o Is the opp in the line of the corp’s biz and of

practical advantage to it? Hardware opp not in line of candy co’s biz

• If interests of corp are betrayed, constructive trust imposed on dir (Guth) for benefit of corp.

o Here: Pres of candy co that bought syrup from Coke. Pres had Pepsi shares. Pres dominated candy co through board control, and controlled Pepsi, and caused candy co to become chief customer of Pepsi.

Harris, ME 1995 narrowed the Guth test, and did not look at interest or expectancy: The test really asks whether the opportunity was so closely associated w/ the existing biz activities as to bring the transaction w/in the class of cases where the acquisition of the property would throw the corporate officer purchasing it into competition w/ his company.

• Harris says the corp’s ability to pay for the opportunity is not outcome determinative.

Broz, DE 1996: applied Guth line of business test • To be a corporate opportunity, must:

o come via the corp, not to an individual o corp must be able to finance the opp o corp must have an interest or expectancy in the opp o must be a conflict b/tw fiduciary’s duties to the corp

and the self-interest of the director as actualized by the exploitation of the opportunity.

• Also from Guth: If dir believes, based on one of the Guth factors, that corp is not entitled to the opp, dir may take it for himself.

o Presenting to board creates a safe harbor for director, but it is not required.

• Here: Broz owned RFB and was on board of financially unstable CIS, which was about to be bought out by unstable PriCellular. Broz bought a phone line for RFB w/o offering it to CIS. Broz, dir of CIS (target of an acquisition), did not have a fiduciary duty to present the opp to CIS, b/c opportunity failed the line of business test: opp came to Broz individually; CIS and PriCellular could not pay for it; no envidence that CIS had an interest or expectancy (no tie b/tw line and nature of CIS); Broz’ interest in phone line created no duties that were inimicable to his obligations to CIS.

o Fairness test: Apply ethical standards of what is fair and equitable under the circs. Durfee.

Harris criticizes this test: provides no guidance to the director seeking to measure her obligations. Totally depends on the facts of each case

o Line of business and fairness combined: Miller v Miller. (1) is the opp w/in the corp’s line of business? (2) evaluate the equitable considerations Harris criticizes this test: combines the vagueness of each test

o * ALI §5.05 test: Harris, ME 1995. Must disclose the opportunity to the corporation.

Goal of ALI test is to avoid litigation Is there a corporate opportunity?

• Any opp to engage in a biz activity of which a director becomes aware, either

o In connection w/ the performance of functions as a director, or under circs that should reasonably lead the director to believe that the person offering the opp expects it to be offered to the corp, or

o Through the use of corp info or property, if the resulting opp is one that the director should reasonably be expected to believe would be of interest to the corp, or

• Any opp to engage in a biz activity of which a senior exec becomes aware and knows is closely related to a biz in which the corp is engaged or expects to engage

A director or senior exec may NOT take advantage of a corp opp unless:

• The director or senior exec first offers the corp opp to the corp and makes disclosure concerning the conflict of interest and the corp opp;

• The corp opp is rejected by the corp, and • Either

o The rejection of the opp is fair to the corp o The opp is rejected in advance, following such

disclosure, by disinterested directors, or, in the case of a senior exec who is not a director, by a disinterested superior, in a manner that satisfies the standards of the biz judgment rule, or

o The rejection is authorized in advance or ratified, following such disclosure, by disinterested shareholders, and the rejection is not equivalent to a waste of corp assets.

In Harris: Nancy Harris, Golf Club pres, bought land adjacent to club and used it to build a subdivision in her children’s name. Club must show: This was a corporate opportunity; Harris did not offer the opportunity to the club, OR the Club did not reject the offer properly (Harris can defend on the basis that taking the opportunity was fair to the corporation)

- CLOSE CORPORATIONS: Heightened Fiduciary Duties o Accountability mechanisms (diff from corp managers)

Heightened fiduciary duties Shareholder voting as an accountability mechanism is often

nullified by a voting arrangement No mandatory disclosure obligations under federal securities

law—but fraud enforcement under Securities Exchange Act Rule 10b-5

o Compare to accountability mechanisms for corp managers: Fiduciary duties Shareholder voting Mandatory disclosure system and fraud litigation

o Danger: minority stockholders are vulnerable to oppression (freezeout) from the majority stockholders.

o Is it a close corporation? DGCL

• 341(a): parties must elect to be a close corporation • 342 eligibility requirements:

o 1. Fewer than 30 shareholders o 2. All of these shareholders’ stock must be subject

to 1+ restrictions under section 202 a) A restriction must be noted conspicuously c) A restriction on the transfer of securities

of a corp is permitted if: • 1) the holder of the restricted

securities must offer to the corp or any other holders a prior opp to buy the restricted securities

• 2) the corp or holder is obligated to buy securities which are the subject of an agreement to buy

• 3) corp or other holders are required to consent to the transfer

• 4) transfers to designated persons or classes of persons are prohibited if designation is not unreasonable

o 3. No public offering of stock • How do you define the value of shares NOW to be

transferred at a future time? Ways to do this: o Original price: this will probably be worth less than

the value of a successful close corp’s stock o Book value: based on original cost and may be

considerably less than current fair market value. o Earnings value, or capitalization of earnings: must

use an appraiser Donahue, MA 1975

• Small # of stockholders • no ready market for the corporate stock • substantial majority stockholder participation in the

management, direction and operations of the corp. o Donahue: Did stockholders violate fiduciary duty of good faith and

loyalty owed other stockholders in the operation of the enterprise? Must not act self-interested or w/ avarice or expediency if a corp makes an offer to majority stockholders, it must also

offer all other stockholders (including minority stockholders an equal opportunity to sell shares to the corp at the same price.

• Policy: o all stockholders should have equal access to

benefits of stock purchases o majority stockholders should not be allowed to use

their control to establish an exclusive market in

previously unmarketable shares from which minority stockholders are excluded.

Here: Rodd corp had 6 shareholders. Rodd bought shares from majority stockholder Harry Rodd at a high price, but refused to buy a similar portion of plaintiff-minority stockholder’s shares for the same price, leaving plaintiff with an unmarketable share.

o Wilkes, MA 1976: Applied Donahue duty w/ a 2-part test: • (Facts): 4 stockholders shared ownership and management

of the corp. Relations b/tw plaintiff Wilkes and the other 3 turned sour, and the other 3 terminated Wilkes’ salary and caused him to leave the board.

• (1) Can the controlling group (majority stockholders) demonstrate a legitimate business purpose for its action?

o majority is allowed some room to maneuver in establishing the business policy of the corporation

o Here: majority has not shown a legitimate business purpose for severing Wilkes from the payroll and refusing to reelect him; it was a freezeout.

• (2) If yes, can the minority shareholders show that the same legitimate business objective could have been achieved through an alternative course of action less harmful to the minority’s interest?

o Deadlock Avoidance and Dissolution DGCL 350

• Stockholders of a close corp who own a majority of the voting stock can enter a written judgment to supplant the board in part or whole in management of the corp

DGCL 351 • Certificate of incorp can say that corp shall be managed by

stockholders rather than a board DGCL 354

• Close corp stockholders can make agreements to treat a close corp like a partnership

Special remedies: • 352: custodian • 353: provisional director • 355: dissolution, see below

Dissolution • DGCL 355: Shareholders can dissolve corp • Kemp, NY 1984: NY Biz Corp Law 1104a allows

dissolution when a corp’s majority is doing “oppressive action” toward the complaining stockholders, if stockholders have 20% or more. Test or oppressive conduct:

o Did the majority conduct substantially defeat expectations of the minority that, objectively viewed, were both reasonable under the circs and central to plaintiff’s decision to join the venture?

Here, Plaintiff had a reasonable expectation that he would be paid dividends in the form of extra compensation bonuses, per Kemp’s long-standing policy.

Ex: oppressive to job, dividends, etc Interested Mergers

- Weinberger: o When directors of a corp are on both sides of a transaction, they must

demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain.

Fairness has 2 parts (examine as a whole, but unfair price can outweigh fair dealing):

• Duty of loyalty requires Fair dealing o Factors: how transaction was timed, structured,

initiated, negotiated, disclosed to the directors; how director and stockholder approval were obtained

o Includes a duty of candor: one w/ superior knowledge may not mislead any stockholder

o Here: Signal, majority owner of UOP, bought out

UOP. 4 UOP directors were also Signal directors. Weinberger was former shareholder of UOP, suing b/c merger eliminated UOP minority shareholders and gave them an inferior price for their shares

decision took only 4 days; no arms-length negotiations b/c Crawford just said $20-21 is a fair price; lack of disclosure of $24 suggested price to minority stockholders; lack of disclosure of cursory preparation of Lehman fairness opinion.

o Should have done: had an independent committee negotiate the transaction.

• Duty of loyalty requires Fair price o Factors: assets, market value, earnings, future

prospects, other elements that effect value of co’s stock

o How price should be proven: DE’s block method of valuation is

inappropriate.

Broadened the appraisal remedy: By any valuation techniques or methods which are generally considered acceptable in the financial community

o Here: feasibility study named $24, not $21 o Appraisal remedy is not the only remedy available when there is

fraud, misrepresentation, self-dealing, deliberate waste of corporate assets: shareholder can also seek injunctive relief, so can negotiate new terms.

o Weinberger also held that the business purpose requirement is no longer in force in DE b/c does not protect minority shareholders.

Biz purpose test said that even if insiders pay a fair price, they can’t make a transaction whose sole purpose is to eliminate the minority stockholders; there must be another valid corporate purpose.

Some states still apply this test. - Is a party on both sides of the transaction?

o Ct will examine the transaction more rigorously. - Litigation strategy: challenge the merger before it occurs or after the fact?

o More evidence might be available after the fact o But then it is harder to unscramble.

- Burden of persuasion rules: Weinberger o Same for all duty of loyalty cases: o Plaintiff must show conflict. If successful, o Has the transaction been approved by an informed vote of a majority of

the disinterested stockholders? Yes: Plaintiff must prove unfairness No: Defendant must prove fairness.

Derivative Claims

- Direct o A wrongful act that is separate and distinct from any corporate injury,

such as an act that denies or interferes w/ the rightful incidents of share ownership.

o Can’t be estopped by corp or board o Ex: claim that corp defrauded a shareholder when it sold him stock o Note: if material misreps or omissions can be alleged, must use direct

litigation instead of derivative. - Derivative

o Shareholder’s right to sue derives from corp’s right to protect its assets o A wrongful act that depletes corp assets and injures shareholders only

indirectly, by reason to the prior injury to the corp. o Note: if material misreps or omissions can be alleged, must use direct

litigation instead of derivative. o Policy:

compensate shareholders for losses suffered as a result of officer or director violations of duties of care or loyalty or the waste doctrine

avoids multiple lawsuits better protects creditors ensures equal treatment of shareholders w/in each class The director demand requirement is consistent w/ the notion that

directors are the shareholders’ representatives to manage the corporation.

o Advantages of derivative litigation: Deters some corporate greed Deters corps from wasting assets Accumulates some of the winnings of the litigation to the corp for

the equitable protection of creditors and shareholders If shareholder wins, Л is entitled to reimbursement of expenses and

atty's fees from the corp (RIGHT?) o Consequences (procedural) of derivative litigation:

Shareholder must meet standing requirements • Such as contemporaneous ownership

Shareholder must satisfy demand requirements • May have to demand that the board bring the action on

behalf of the corp Shareholder must post a security bond in some jurisdictions to

cover ∆’s litigation expenses o In the 1970s, special litigation committees arose as an alternative to

derivative litigation. o Demand

Demand required: Most states require that before a derivative suit can be brought, Л must make a demand on the board, asking the corporation to take over the suit. If board declines, the ct will often dismiss the suit.

Demand excused: Many states excuse the demand on the board in certain circs, such as where demand is likely to be futile (e.g. the entire board is accused of wrongdoing, or of being under the wrongdoer’s thumb).

3 Court approaches to demand: • Auerbach, NY 1979

o Ct will defer to business judgment of Special Litigation Committee and not examine its recommendation to dismiss the derivative claim if:

(1) its members were disinterested, and (2) it used adequate and appropriate

investigative procedures and methodologies • Miller, IA 1983

o Directors who are being sued in a derivative action may not appoint an independent committee (SLC)

for the purpose or recommending dismissal of the derivative suit, b/c the board is biased.

• Zapata, DE 1981 (see below) • “Disinterested person” approach:

o Disinterested person = not a party, or is a party but corp shows that claim is frivolous

o If 1+ disinterested persons appointed by the ct has made a determination in good faith after conducting a reasonable investigation and concluded that the derivative proceeding is not in the best interests of the corp, ct shall dismiss the derivative proceeding.

Is demand excused? Use Zapata and Oracle. • Zapata, DE 1981

o Demand on the board is required except when demand would be futile, or there otherwise is a wrongful decision not to sue.

Futile: a majority of the board has a conflict of interest

o When demand is futile, board may delegate authority to seek termination of a derivative suit to a disinterested minority of the board.

o When an independent committee dismisses a derivative suit, ct should decide if dismissal was proper using this 2-part test:

(1) Did committee act independently and in good faith?

• Was the biz judgment rule satisfied? o Was there a reasonable

investigation? • Burden on committee

(2) If no, ct applies its own independent business judgment to decide if the case should be dismissed.

• Is the suit in the corp’s best interest?

o Ct compares out of pocket costs of litigating to benefit in proceeding w/ the litigation.

o Jay v North, 2d Cir, 1982: Moving party must

show that the action is more likely than not to be against the interests of the corp

Not in best interests of corp: if likely recoverable damages discounted by probability of a finding of liability are less than the costs to the corp in continuing the action

o SLC wins unless COI or SLC’s decision was irrational.

o Problem w/ Zapata: Creates a way for the board, pretrial, to

estop a claim against a majority of directors. This counters the demand requirement’s purpose: to ensure board autonomy in managing the corp by providing a channeling mechanism to ensure that the board can review all litigation decisions the board does not have a conflict with.

Did not say when demand is required. When is demand excused? Aronson, DE 1984

• Л must allege particularized facts that show: o Aronson facts not particular enough:

Director Fink owns 47% of stock • Л should have shown facts that show,

through relationships, that the directors are under Fink’s control

Director Fink personally selected each director

• Л should have shown facts about care and sense of responsibility; not the method of election

• A reasonable doubt is created that o Note: standard raised from reasonable inference to

reasonable doubt o (1) the directors are disinterested and

independent, and to be independent, director’s decision must

be based on the corporate merits of the subject rather than extraneous considerations or influences

Disinterested if transaction was approved by a majority of disinterested directors. If not,

then don’t go to step (2); reasonable doubt is created

o (2) the challenged transaction was otherwise the product of a valid exercise of business judgment

must look at factual background Walt Disney, DE 2003

• Aronson (2): Board should not approve a K whose terms they don’t understand; Board should perform a reasonable investigation rather than rely on what management tells them. Verbal description not enough; make sure you see docs, a valuation study.

Board’s approval of Ovitz’s employment K was not a valid biz judgment under Arsonson (2): • Old Board: meeting barely discussed

Ovitz, no presentations on the agreement, Board passed off details to Ovitz & Eisner, did not question Eisner’s grant of a non-fault termination

• New Board: did not meet to discuss non-fault termination, even though Board approval was required, never tried to negotiate w/ Ovitz before he left, blindly allowed Eisner to give $38m in cash and $3m in stock options to friend Ovitz

• Directors consciously and intentionally disregarded their responsibilities, making decisions w/o adequate info, w/o caring about the injury to the corp and its stockholders

• Board should have: not approved a K whose terms they didn’t understand, performed a reasonable investigation rather than relying on what management tells them. Verbal description not enough; make sure you see docs, a valuation study.

• SO: if directors are independent, demand is required o Policy: make sure a shareholder exhausts his

intracorporate remedies; provide a safeguard against

strike suits, recognize that directors, not shareholders, manage the biz and affairs of corps.

• Note: this case made it harder for a Л to win Oracle, DE 2003

• How to tell if a board member is independent: o SLC has burden to prove that there is no

material issue calling into doubt its independence.

• Applied Zapata, and added this independence test: o Is the director, for any substantial reason,

incapable of making a decision w/ only the best interests of the corp in mind?

Is director impartial and objective: is the director beholden to an interested person, via personal or other relationships?

• Love, friendship, & collegiality are influences, in addition to domination/control by other board member(s)

• But social relationships, such as country club membership, do not threaten independence

Here: issue of material fact b/c undisclosed significant ties b/tw corp (Oracle), and Stanford, which employs 2 SLC members.

When an SLC moves to terminate a derivative action, SLC has burden of persuasion, to show that there is no material issue of fact calling its independence into question.

Shareholder Voting Rights

- Type of voting (varies by state statute) o see theories (notes p37-8)

Proxy Expenses - Will corporation reimburse proxy contest expenses in a vote contest?

Rosenfeld v Fairchild Engine, NY 1955: LOOK UP CASEBRIEF o A corporation can pay the proxy expenses of its own directors if:

(1) contest must involve a conflict over policy, and not just a personal power contest

(2) expenses must be reasonable in amount • What does this include? • Note: opens the door for a waste claim.

o If outsider loses, not entitled to reimbursement. o If outsider wins, can be reimbursed but might need a shareholder vote.

- SEA 14a-8: communicating w/ other shareholders to solicit proxies for shareholder proposal, or against management proposal

o Applies to corps covered by §12 and 12g-1 of the SEA: w/ securities listed on a national exchange, or traded in the over-the-counter market w/ 500 or more holders of a class of stock, and $10m in assets.

o A shareholder can circulate a proposal for action on issues other than director nominations if the shareholder satisfied the eligibility requirements of 14a-8(b), number and length requirements of 14-8(c)-(d) and is not excluded under 14a-8(i): improper under state law, personal grievance, relevance, and ordinary business operations. This means that the corp pays to distribute the proposal to all the shareholders.

- Dual class voting, DGCL §151 o State law permits dual classes of stock under DGCL §151. Very

occasionally dual class patterns have been held to violate equity limitations on directors or their corporations:

Lacos Land Co, DE 1986 • Director’s duty of loyalty to shareholders was violated

when director tried to reorganize voting rights to increase his % by threatening to vote against transactions in the corp’s best interests unless his voting position was secured.

• This case said there are very few restrictions to dual class voting

Zahn v Transamerica Corp, 3d Cir 1947 • Duty of loyalty violated when parent corp tried to increase

the value of its shares in liquidation by causing the redemption of a separate class of stock before liquidation, w/ no persuasive reason for doing so.

o The key point is that usually Delaware and other states will allow corporations broad latitude to design any capital structure they choose, subject to equitable limitations.

Mergers

- History o 19th Century: Jacksonian hostility toward big entities.

Mergers required supermajority votes (2/3 of shareholders) Appraisal remedy protected dissenters: disapproving shareholders

could terminate their membership in the corp and receive the value of their shares

o 20th Century: Corporate law no longer has size constraints or discourages

mergers Appraisal remedy is not as available High voting requirements are eliminated Shareholders in public corps are instead protected by their ability

to sell shares in a stock market. o DE Merger Law

DGCL 251b: Merger must be approved by majority vote by shareholders in both firms

DGCL 262: shareholders are entitled to the fair value of their shares (appraisal rights)

Exceptions to 251b or 262 (situations when these rights aren’t granted):

• Surviving corporations: 251f: No vote of stockholders in a corp surviving a merger is required if:

o A) the merger agreement does not amend the certificate of incorporation

o B) after the merger, shares of stock remain identical to before the merger.

o C) No more than 20% of common stock employed. No appraisal right often for survivor’s shareholders. DGCL 262b1: acquired corp’s shareholders will vote and may be entitled to appraisal rights.

Parent-subsidiary or short-form mergers, 253: • If parent owns at least 90% of subsidiary,

o no vote for surviving parent or subsidiary shareholders

o no appraisal rights for parent Stock market exception: 262b1: No appraisal rights for

shareholders whose stock was either: • In a firm listed on a national exchange, or • Held by 2000+ shareholders

De Facto Mergers, 271: In DE, a de facto merger does not require an appraisal remedy. If there is a sale or lease of all or substantially all assets, there is a vote, but no appraisal.

• Note: most other states allow an appraisal for sales of assets, and allow the de facto merger doctrine.

Triangular mergers: DE statute says • Target stockholders have a right to vote on the merger. • Parent corp (sole stockholder) has a right to vote on the

merger. • But parent corp stockholders do not have the right to vote

on the merger and do not have appraisal rights. Tender offers

• If acquiring corp buys stock interest in a target through a tender offer, there is no voting right or appraisal right for either the acquiring corp’s or the target cor’s shareholders.

o Appraisal Remedy DE block approach

• Purpose: to give stockholders the value of the stock at the moment of the merger (the “going concern” value.

• Factors that could come up: o Market value

Has never been given more than 50% weight in appraisal

o Asset value Based on a current appraisal, rather than

book value o Dividends

Only significant if unpaid o Earnings value

Average last 5 years, multiply by a multiplier

o Any other facts which throw light on future prospects of the firm that was merged.

o Note: using all of these factors avoids undue reliance on market value, and recognizes that each factor alone can be speculative.

• Criticisms: o Highly subjective o Shows a hostility to market value in appraisals yet

creates a stock market exception o Appraisal costs are uncertain; ct has discretion

Tender Offers

- 2 ways to take over an unwilling target co: o Proxy contests o Tender offers

Cheaper Offer can be limited to a fixed period of time If offer fails, offeror might be able to get rid of some of its stock

w/o loss to the target co or a larger aggregate Can be made by cash, securities, or both 2 ways

• Friendly: part of a merger • Hostile: unsolicited, and heavily litigated

o How it works: bidder makes an offer to each of the individual stockholders of the target corp, to buy their shares. If a majority tender (sell) to the bidder, the bidder has control of the target.

- Why do hostile takeovers occur? Hypotheses: o Disciplinary hypothesis: tender offers replace inefficient managers w/

more efficient managers. o Synergy hypothesis: b/c of unique characteristics of the bidder, a target

may be worth more to it than to the market generally o Empire building hypothesis:

takeovers are not motivated by the best interests of the offeror’s shareholders, but by the desire of its managers to get higher compensation or prestige b/c of its bigger size or visibility of the new consolidated firm, or to reduce bidder’s risk of takeover.

o Exploitation hypothesis:

bidders attempt to exploit the “prisoner’s dilemma” or collective action problems experienced by dispersed target shareholders through the offering of unsatisfactorily low prices with the knowledge that the target shareholders may accept them, even if they regard them as low, b/c of concerns about lower future stock market prices

- Is a merger subject to enhanced judicial scrutiny? o Unocal: when a board adopts defensive measures in response to a hostile

takeover proposal that the board reasonably determines is a threat to corporate policy and effectiveness. This also applies to the adoption of a stockholder’s rights plan, even in the absence of an immediate threat.

o Revlon: when the board enters into a merger transaction that will cause a change in corporate control; when the board initiates an active bidding process seeking to sell the corp; when the board makes a break up of the corporate entity inevitable; etc.

- Defensive measures: Unocal, DE 1985: When a target tries to repulse hostile bidder via share repurchases (offering a higher price for its own shares than the bidder is offering, in order to make the target’s shareholders less likely to tender to the bidder), the target MAY exclude the bidder from participating in the share repurchase program, IF:

o (1) Cheff: Threat must pose a danger to the corp’s welfare (not just to the directors and management’s interest in staying in office)

∆ has burden to show threat to corp; biz judgment rule is not proper analysis

Policy: ensure best interests of corp and its shareholders are at stake

Here: • Mesa’s offer posed a threat to the corp’s welfare b/c was

coercive: offer price ($54) was substantially lower than value ($72)

• Securities to be offered to minority shareholders were junk bonds worth much less than $54

• Designed to stampede shareholders into tendering at the 1st tier, even for an inadequate price, out of fear of what they would receive as remaining minority holders (junk bonds)

Omnicare adds: • Board must show good faith and reasonable investigation in

order to satisfy its burden of proof • Proof is materially enhanced if it is approved by a board

comprised of a majority of outside directors or an independent committee

o (2) (added by Unocal): Defensive measures (such as exclusion of acquiring corp from share repurchase program) must be reasonable in relation (proportional) to the threat posed.

Factors: • Inadequacy of price offered

• Nature and timing of offer • Questions of illegality • Impact on constituencies other than shareholders (creditors,

customers, employees, suppliers & distributors, the community generally)

• Risk of nonconsummation • Quality of securities being offered in the exchange • Basic stockholder interests at stake

Here: reasonable in relation to threat b/c is consistent w/ the fairness principle that minority holder should receive substantial equivalent in value to what he had before.

Omnicare, DE 2003 changes Unocal’s proportionality analysis to a 2-part test (see 2a and 2b):

• Note: 3-2 decision • Analyzed under Unocal, NOT Revlon, b/c Revlon is

being strictly construed. • Facts:

o Genesis and Omnicare were offering competing bids for NCS.

o Omnicare made an offer. o Then Genesis made better offer, so long as no one

else could bid (exclusivity agreement, so G could not be outbid by O); agreement also said holders must vote even if board didn’t recommend the transaction; no fiduciary out clause for NCS. G also locked up transaction w/ a voting agreement w/ 2 NCS stockholders (Shaw and Outcalt) who combined owned a majority of NCS.

o Board recommended G offer to holders. o O made a better offer and NCS withdrew its reco o NCS stockholders sued to enjoin NCS-G

transaction. • [Unocal (1): Here, there is a threat: the possibility of

losing the Genesis offer and being left w/ no comparable alternative transaction

• 2a) : board must show that the merger deal protection devices adopted in response to the threat were not coercive OR preclusive

o Coercive: aimed at forcing upon stockholders a management-sponsored alternative to a hostile takeover

Did the board or another party take actions which have the effect of causing the stockholders to vote in favor of the transaction for some reason other than the merits of the transaction?

Here: coercive b/c stockholder vote would not be effective b/c of the coercion that predetermined the outcome of the merger: the voting agreements, the lack of a fiduciary out clause—made it impossible for the Genesis proposal to not be approved or any other proposal to be considered.

o Preclusive: deprives stockholders of the right to receive all tender offers or precludes a bidder from seeking control by fundamentally restricting proxy contests

o Here: agreement of board to present merger agreement to shareholders for a vote under DE §251(c), even if board no longer recommended the merger, coupled w/ agreement of majority stockholders to vote in favor of the merger, in the absence of an effective fiduciary out clause, was both preclusive and coercive and therefore unenforceable.

MUST have a fiduciary out clause! • 2b) If not coercive or preclusive, was the defense

reasonable? o Board must show that their response was within a

range of reasonable responses to the threat perceived

o Defensive devices must be proportionate to the perceived threat to the corp and its stockholders if the merger transaction is not consummated

• Defensive measures also unenforceable b/c of lack of fiduciary out clause.

o NCS-G agreement left out fiduciary duty clause; NCS thus did not owe a duty to its shareholders to sell to a higher bidder. A board cannot limit its fiduciary duties, by trying to leave the vote entirely to the shareholders, when a majority has already agreed to vote for the merger.

o This was unfair b/c: Minority holders are powerless b/c Shaw

and Outcalt have a majority and have agreed to vote for the transaction.

Minority’s only protection is the fiduciary duty owed them by the directors.

• Should have done: o Don’t put anything in writing. Then you can’t be

busted

No one is saying there is a fiduciary duty when shareholders acting as shareholders; there is only a fiduciary duty when shareholders are also acting as directors. So don’t write up a contract that omits a fiduciary out clause. Avoid the whole situation by not writing anything up. Right?

Majority thought that Shaw and Outcalt were directors, and therefore the deal protection device violated fiduciary duty

Dissent said Shaw and Outcalt are shareholders, and so they do not have a fiduciary duty to sell to the highest bidder, and so they can sell to any bidder they want, and fiduciary duty was not violated, and this transaction should have been forced

o Veasey dissent: given the facts of this case, the better rule is that the biz judgment rule should apply but even under Unocal the proportionality inquiry should take into account that the contractual measure protecting this merger agreement were necessary to obtain this deal.

NOTE: The SEC later reversed Unocal for companies subject to the SEA. (SEE 1206, n 4)

- REVLON: Does board have a duty to get best price for shareholders; instead of using defensive measures?

1) Is firm breakup inevitable? 2) Is there a change in control? 3) Did the board put the corporation up for auction?

o Yes Board has a duty to get best price for shareholders. Must run an auction

• Must treat all bidders equally. Defensive measures no longer available. Lockups (advantages given to one bidder over others that make it

more likely that that bidder will win, and discourage other bidders) only OK if don’t end auction; must be used to expand the competition by inspiring other competitors to make bids; cannot destroy competition by precluding other bidders b/c violates duty to get highest bid for holders.

• Here: o Pantry Pride made hostile takeover bids to Revlon;

bids rejected. Revlon used defensive measures: repurchase, and not purchase (poison pill).

o Then, R created lockup w/ white knight Forstmann: R offered 2 subsidiaries at a low price to F only, and said no one else can bid.

o B/c F was already a bidder, the lockup ended the auction rather than enhancing it. R violated duty by accepting F bid before PP made its final bid.

o Lockup unenforceable. Federal Proxy Fraud

- Rule 14a-9 o No solicitation ... shall be made by means of any proxy statement ...

containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact, or which omits to state any material fact necessary in order to make the statements therein not false or misleading or necessary to correct any statement in any earlier communication with respect to the solicitation of a proxy for the same meeting or subject matter which has become false or misleading.

So, ask: • (1) Is a particular statement or omission false and

misleading? • (2) Is the statement or omission material?

o A material fact does not have to be expressed in certain words.

These things could be misleading: • Predictions as to specific future market values • Material which directly or indirectly impugns character,

integrity or personal reputation, or directly or indirectly makes charges concerning improper, illegal or immoral conduct or associations, without factual foundation.

• Failure to so identify a proxy statement, form of proxy and other soliciting material as to clearly distinguish it from the soliciting material of any other person or persons soliciting for the same meeting or subject matter.

• Claims made prior to a meeting regarding the results of a solicitation

Policy: Want to promote the free exercise of the voting rights of stockholders by ensuring that proxies are solicited w/ explanation to the stockholder of the real nature of the questions for which authority to cast his vote is sought.

- Borak: a private cause of action is implied under 14a-9 o Applies to direct AND derivative claims o Here: Л-shareholder sued ∆-corp to enjoin a merger, alleging deprivation

of preemptive rights of shareholders by a merger. Л claimed merger was effected through a circulation of a false and misleading proxy statement by those proposing the merger.

- Mills: No causation required: Л only must show: o 1) there was a material misrepresentation.

o 2) the proxy solicitation itself, rather than the particular defect in the solicitation materials, was an essential link in the accomplishment of the transaction.

Do NOT have to prove that the proxy solicitation actually had a decisive effect on the voting.

o Here: Л-shareholders sued ∆-co Autolite, which merged into Mergenthaler, claiming the merger was accomplished through the use of a proxy statement that was materially false or misleading.

Лs claim proxy statment was misleading b/c of an omission of a COI: 11 of Autolite's directors were nominees of Mergenthaler and under the domination and control of Mergenthaler.

- TSC v Northway: Basic materiality standard o An omitted fact (or misrepresentation) is material if there is a

substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.

Do not have to give voters an enormous amount of trivial or cumulative info.

Here: Л, TSC shareholder, sued TSC and its acquirer, National, claiming that their joint proxy statement was incomplete and materially misleading b/c failed to state that the transfer of Schmidt’s interest in TSC to National gave National control of TSC. NO:

• These facts were not material: o Dual allegiances of TSC and National directors o Both co’s had reported in SEC filings that TSC

could be called a subsidiary of National o Facts that indicate the unfavorability of the terms to

TSC shareholder, • Because proxy statement reported that 5 directors were

from National, and National owned 34% of TSC. Additional omitted facts not so obviously important that reasonable minds could differ on their materiality.

- Basic v Levinson: TSC materiality standard applies to forward-looking statements, too.

o If information has bearing on a 5% price move on the shareholder’s stock, it is material, and you can be held liable for a misrepresentation made in pre-merger negotiations.

How to tell if there is a 5% move: • Probability of event occurring, x magnitude for the specific

corporation o * 5% doesn’t come from this case, it comes from Staff Accounting

Bulletin (SAB) No. 99 o Here: Basic was negotiating a merger. NYSE asked Basic if it was

negotiating a merger and it said no this counts as a misrepresentation, even though there was not an agreement yet, and negotiations were only

tentative. Basic should have said (1) don’t want the info to go public, or (2) it can’t make a material misrepresentation.

- VA Bankshares: statements of reasons, opinions, or beliefs can be both misrepresented and material.

o If they are knowingly false and misleading This includes

• (i) Statements that misstate the speaker’s reasons o Ex: here, where directors did not believe $42 was in

shareholders best interests, but they told shareholders it was in their best interests so they would vote for the merger, b/c directors wanted to stay on the board

• (ii) Statements that mislead the stated subject matter o Here, that $42 was a fair price, when really $60 was

fair Policy: Statements of reasons, opinion or belief are material b/c

shareholders know that directors have superior knowledge and expertness, and b/c of the common knowledge that state law obliges directors to act in the shareholders’ interest

o Here: FABI owned 85% of Bank, wanted to get rid of the 15% minority shareholders, so FABI and Bank entered a merger agreement, whereby Bank merged into subsidiary of FABI. FABI hired investment banking firm to give opinion on value of minority shares; said $42. Proxy solicitation said price was “fair” and gave shareholders a “high value.” Did not disclose that shares were worth $60.

Л, minority shareholder, sued for soliciting proxies in violation of 14a-9 b/c directors didn't beliefe offered price was high or merger terms were fair, but they recommended the merger b/c it was the only way they could remain on the board.

- SAB No. 99: Both quantitative and qualitative measures of materiality can be used. There are numerous circs in which misstatements below 5% could be material if qualitatively material.

o Ex of qualitatively material: If director violates law and goes to jail If misstatement arises from an item capable of precise

measurement or from and estimate, and, if so, the degree of imprecision inherent in the estimate

If misstatement makes a change in earnings or other trends If misstatement hides a failure to meet analysts’ consensus

expectations for the enterprise If the misstatement changes a loss into income or vice versa If the misstatement concerns a segment or other portion of the

registrant’s biz that has been identified as playing a significant role in the registrant’s operations or profitability

If the misstatement affects the registrant’s compliance w/ regulatory requirements

If the misstatement affects the registrant’s compliance w/ loan covenant or other contractual requirements

If the misstatement has the effect of increasing management’s compensation—for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation

If the misstatement involves concealment of an unlawful transaction

- Bespeaks Caution Doctrine: o A false statement is not considered material if it is accompanied by

cautionary language in the relevant corporate document. o Ex: “exploring the possibility” is possibility and can’t be considered

misleading o 2 limitations on the doctrines (Donald Trump case):

only applies to forward looking statements vague or blanket disclosures, which merely warn that the

investment has risks, do not count. o Note: cts will not apply the bespeaks caution doctrine if ∆s were aware or

should have been aware of a misrep or omission and chose not to disclose it.

Rule 10b-5

o It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange,

(1) to employ any device, scheme, or artifice to defraud, (2) to make any untrue statement of a material fact or to omit

to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

• imposes a duty to correct and a duty to update previous material disclosures. These duties are limited to statements attributable to the firm.

(3) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection w/ the purchase or sale of any security.

2 basic types of cases:

- Insider trading o Usually omission cases

Omission or misrepresentation must be MATERIAL o Also: trading while in possession of material nonpublic info

- False corporate statements Elements

- Standing o Blue Chip Stamps:

In a private lawsuit, Л must be an actual purchaser or seller (Birmbaum rule)

• Can be purchaser or seller of an option Offeree in consent settlement of a lawsuit does NOT have standing

- Scienter (culpability) o Historical: use Ernst &Ernst

You can always bring a 10b-5 case if can show actual intent (knowledge) to defraud or deceit

Can never bring 10b-5 on basis of negligence FN 12: recklessness left unanswered, but every circuit has since

said recklessness is allowed o Forward looking: use SEA §21E

Standard is now limited to actual knowledge - A fraud: misrepresentation or omission

o Materiality see above

- Reliance o Misrep: reliance is an element o Omission: reliance is NOT an element o Basic v Levinson

Fraud on the market presumption: • Л can normally presume reliance if a false statement is

made and stock price moves as a result; Л does not have to prove actual reliance (that actually read the statement; only show that Л paid the stock price).

o Policy: if had to prove reliance, would have to show that each Л read or were somehow aware of the statement, each Л would have to be subject to cross, and would have to show how became aware of the statement. It would be very difficult to form a class.

• Presumption is rebuttable in 2 ways: o 1: If person relying on stock price knew there was

fraud, person cannot claim reliance o 2: Presumption is limited to active trading on

securities market. ∆ can show this is not the kind of market Basic was referring to, so Л must prove reliance.

- Duty to disclose: omission cases o Can only bring suit for an omission if there is a duty to disclose. o Chiarella

“any person” = any person w/ a duty to disclose Any employee is an agent and subject to the duty, just like

officers/directors 1) There must be a duty.

• If disclose Can trade • If don’t disclose can’t trade until disclose

2) duty to employer reserved • stephens’ concurrence adopted in modified form in

O’Hagan 3) misappropriation duty reserved

• Burger: adopted in modified form in O’Hagan o Dirks

Duty element reaffirmed but not only applies to insiders, but also constructive insiders (FN 14): outsiders doing certain work: attys, accountants, etc provided w/ info for a corporate purpose w/ an expectation of confidentiality

• Not insiders, but become insiders b/c an insider consciously gave him inside info

Tipper/Tippee: • Tipper: tip must be provided consistent w/ culpability

standards, violating fiduciary duty. Judge says could involve selling info. Look at Dirks facts for typical case: trying to end a fraud and to trade ahead of the end of the fraud. SEC and subsequent courts were horrified by the decision b/c Dirks was able to take advantage of insider info.

o O’Hagan Did ∆ misappropriate info by breaching a fiduciary relationship w/

the source of the info? Affirms 14b3: SEC not required to prove fiduciary duty Adopted Burger’s misappropriation theory from Chiarella, in

criminal cases • wrongful taking of info simultaneously involving • deception on the source of the info

o must not inform person what you are going to do (duh)

• Theory: protect integrity of securities markets from abuses by outsiders. Looked at underlying purpose of the act, not just plain language, to justify a very aggressive interpretation of 10b-5.

o After O’Hagan 10b-5-2(a)(3): If one family member provides info to another

family member, must look at all family members together to see if there is misappropriation or wrongful tipping.

o Texas Gulf Insiders may accept stock options w/o disclosing material info to

the issuer IF the insider is NOT a member of top management Disclosure not required all the time; there may be business

judgment reasons not to disclose sometimes. - Fraud must be “in connection” w/ securities trade

o Texas Gulf Sulphur

Corporation didn’t have to buy or sell stock to be ∆, just had to make statement roughly contemporaneously w/ the buy or sell

• Did it cause investors to rely on it and in connection therewith cause them to purchase or sell a corp’s securities? (Is it probably that this info will move the price by more than 5%?)

o O’Hagan When ∆ w/ potential fiduciary duty to law firm or corporate bidder

employed by law firm deceives them and trades WHAT HAPPENS?

Tipper/tippee theory wasn’t working very well. RULING? Regulation FD

- Does not give rise to a private cause of action - Prohibition on selective disclosure of material information to (1) a broker-dealer;

(2) an investment adviser; (3) an investment company; or (4) a holder of issuer’s stock.

o So, if you make this disclosure, you have an obligation to disclose the same info

Simultaneously if intentional disclosure (streaming webcasts) w/in 24 hours (“promptly”) if not done intentionally

- Exceptions: Public disclosure not required (do not have to satisfy FD) if info is disclosed to:

o A person who owes a duty of trust or confidence (Dirks FN 14) (are a FN14 insider)

o A person who agrees to maintain info in confidence (signed a confidentiality agreement)

o Credit rating agency o In connection w/ the public offering under 1933 Securities Act

- Policy: strengthen SEC’s ability to prosecute tipper/tippee when no misappropriation

This led to adoption of 10b-5-1

- PUT text - 10b-5-1(b): person making purchase or sale must be aware of presence of

nonpublic info (was a memo circulated? Were they informed by someone?) - 10b-5-1(b)(1): a defense

o you are allowed to trade on basis of material nonpublic info if you have earlier entered a contract in writing w/ broker that says anytime stock reaches price of X, I want it sold. This is a perfect defense to a 10b-5 claim.