Introduction into the Law of Business Corporations and ... · PDF fileIntroduction into the Law of Business Corporations and Unincorporated Business Associations ... of proper corporate

Introduction into the Law of Business Corporations and Unincorporated Business Associations

Copyright 2008 by Christian Hammerl

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Corporations


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Financing the Corporation

Equity Capital: 1. contributions of the original entrepreneurs

2. capital contributed by subsequent investors

3. retained earnings.

Debt Financing: 1. loans or advances from shareholders

2. debt securities (bonds/ debentures)

Interest in Equity Capital expressed as “share(s): “units into which the proprietary interests in a corporation are

divided.” (RMBCA 1.40(22).

Corporations


Financing the Corporation – Equity Securities Typical Provision in certificate of Incorporation:

“Fourth: The total number of shares of all classes of stock which the Corporation shall have authority to issue is (i) [_____] shares of Common Stock, $[_____] par value per share (“Common Stock”), and (ii) [______] shares of Preferred Stock, $[______] par value per share (“Preferred Stock”).”

Authorized Shares: Key concept denoting total amount of capital stock a corporation‟s board may cause the corporation to issue, now and in the future.

“Shares validly issued and outstanding” are shares that are authorized (i.e., taken out of the pool) and have been sold to, and held by, shareholders as a result of proper corporate action.

Shares “issued (but not outstanding)” means that they have been repurchased by the corporation. This is also referred to as treasury stocks.

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Corporations


Financing the Corporation – Equity Securities

Par Value and legal capital. Almost all states have abolished corporate law minimum

capital requirements. The concept of stated capital and par value are remnants of this earlier stage of U.S. corporate law.

“Par value” (Nennwert) is an arbitrarily selected monetary amount , representing the minimum consideration for which a stock may be sold to investors.

Stated Capital = aggregate par value of outstanding shares.

Stated Capital is deducted from the assets of the corporation in determining the “surplus” available for distributions. Thus, it represented the same ides as “Stammkaptial”. i.e., a minimum amount available for the creditors of the corporation.

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Corporations


Financing the Corporation – Equity Securities

Par Value and Legal Capital. Factors relevant in the determination of par value:

Franchise taxes and filing fees are sometimes based on aggregate par value of all authorized stock.

Too high par value makes stock unmarketable in downturn if market price would be below par value. => Amendment of charter required.

Non-par value stock. Alternate, more “modern” approach favored by the RMBCA 6.21. Shares of stock without any fixed value. Board must determine what

represents adequate consideration prior to issuance of shares. If the so determined consideration was received, shares are “fully paid

and non-assessable” i. e., no “Nachschusspflicht”. Shareholders remain personally liable to corporation and its creditors

for any unpaid amounts of consideration specified in subscription agreements RMBCA 6.22(a).

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Corporations


Financing the Corporation –Classes of Stock Common Stock – absent specific provisions to the contrary in the

articles all stock are “common” stock, conferring on its holders the right to Vote RMBCA 6.01 (b) Receive a distribution of residual assets. RMBCA 6.01 (c ) Inspect books and records. RMBCA 16.02 Bring derivative actions RMBCA7.40-7.47 Access financial information RMBCA 16.20

Preferred Stock or any other classes of stock not being common stock must be created by specific designation in articles. Named after “dividend preference” such as “$10 preferred”, i.e., that preferential dividend

must be paid before any dividend can be paid on common stock; in addition may also have

“liquidation preferences” (stated value plus liquidation premium payable prior to any liquidation distribution to common shareholders.

No voting rights (also this may be changed by a provision in the articles.

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Corporations


Role of Board - Consideration for Shares Board is authorized to issue shares. If this right is to be

reserved for shareholders, corresponding reservation must be made in articles. RMBCA 6.21(a).

Consideration not limited to cash. May be anything of value, present or future, e.g. release of claim future services,.. RMBCA 6.21(b)

Board decision of adequacy is conclusive and final.

Shareholder approval is required only, if issuance (non-par) shares

is for a consideration other than cash,

and the shares so issued would amount to 20% or more of the voting power of the corporation outstanding immediately after the issue. RMBCA 6.21(f).

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Corporations


Role of Board - Consideration for Shares Liability for “Watered Stock” Exists only in the context of “par value”

Bonus stock

Discount stock

Excessive consideration for contributions in kind.

Extends both to directors as well as shareholders.

Basis for Liability:

Misrepresentation Theory (Common law). Implies that defendant misrepresented a the capital of the corporation to the creditor. Weak point: requires actual reliance by plaintiff . Thus, no recovery if credit was extended prior to issuance of “watered stock” or, if plaintiff was aware of the existence of w/s.

Statutory obligation theory Liability triggered by breach of statutory obligation not to issue “watered stock”. Reliance irrelevant.

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Corporations


Role of Board - Consideration for Shares Liability for “Watered Stock” See., Bing Crosby Minute Maid Corp., v. Eaton, (1956) 46 Cal., 2d., 484; 297

P. 2d 5. Direct action of judgment creditor of corporation against stockholder of debtor corporation to recover difference between par value of stock purchased by stockholder and lesser actual value of contribution in kind tendered as consideration.

Corporation had been authorized to issue 4,500 shares of stock with a par value of $10 each, defendant, sole shareholder of the corporation had paid only 37,780.03 for the stock. Corporation had purchased frozen food from plaintiff. After the company failed to pay, plaintiff obtained judgment ag. Corporation which remained unsatisfied in part. Plaintiff is seeking to recover difference from defendant .

Held: California, despite, statutory prohibition ag. “watered stock permits recovery only under misrepresentation theory.Plaintiff had relied only on a balance sheet showing an equity position of less than 33,000. and on cash position of corporation.Insufficient for a finding of reliance.

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Corporations


Role of Board - Consideration for Shares

Thin Capitalization or Undercapitalization. Historically, subscription to a certain amount of shares plus

minimum capital was required.

Certain minimum no longer required. Corporation can technically start operations without ever having issued shares - working capital can theoretically be all debt.

Issues remains relevant primarily in an accounting context. No statutorily prescribed debt equity ratios, however 385 IRC.

Reclassification of shareholder loans as equity has momentous repercussions in corporate law.

Interest payments become “constructive dividends”.

Repayment of principal -> return to capital of shareholders.

One of the factors considered in piercing the corporate veil.

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Corporations


Role of Board - Consideration for Shares

Subscription Agreements Pre-incorporation agreements; thus deemed mere offers contingent

upon formation of corporation. RMBCA 6.20 makes them binding for six months. (id., DGCL 165).

Enforceable only if in writing and signed DGCL 166

Consideration may paid only in part upon issuance; however shareholders remain liable for unpaid amount even vis a vis third parties if assets of the corporation are insufficient to pay for debts.

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Corporations


Shares Preemptive Rights Right to acquire shares whenever the corporation issues new shares

necessary to maintain voting power and distributive share, i.e., to avoid “dilution”

Historically, inherent feature in property rights aspect of stockownership. RMBCA 6.30 and most modern statutes deal with preemptive rights on an

“opt –in“ basis.

Reacquisition, Redemption and Conversion Rights RMBCA 6.31 Corporations may buy back its own shares become treasury

stock. If certificate prohibits “recycling” of treasury stock reacquired shares are deducted from the number of authorized shares.

Restrictions on buy backs DGCL 160 Impairment of Capital Improper Purpose entrenchment of board Right of first refusal (redemption) as restraint on alienation

Conversion Rights e.g., right to convert preferred stock into common stock upon the occurrence of certain events.

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Corporations


Shares

Transferability and Restrictions In principal, shares are negotiable instrument and freely

transferable by endorsement. The transfer of shares (unless they are publicly held) is registered only in the books of the corporation.

Restrictions are permissible as long as they

are “reasonable under the circumstances” (RMBCA 6.27 ) and

created either by the articles, by-laws, or agreement

disclosed or legended conspicuously on the face of the share certificate. RMBCA 6.27(b).

Restrictions which entirely destroy any liquidity would be presumably invalid in any jurisdiction.

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Corporations


Shares

Transferability and Restrictions

Major Impact of Securities Laws on Transferability. „33 Act Section 5. Prohibits any sales of securities using the mails

or other interstate means of communication unless based on registration statement filed with SEC and prospectus made available to the public.

Re-sales of restricted securities may also be subject to registration requirement. Shares typically held by “angel investors” may fall under this rule.

Two possible approaches:

Exempt the transaction

Exempt the security (instrument) at issue.

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Corporations


Shares -Major Impact of Securities Laws on Transferability. Attempt to establish that instruments sold are not “securities” Federal definition of “security” includes as threshold the concept of

“investment contract” investment of money in a common enterprise where is investor is lead to expect profits solely from the efforts of others. See, SEC v. Howey Co., 328 U.S. 293 at 298 (1946)

Also states have jurisdiction in the matter; simply claiming a federal exemption does not remove state‟s authority to enforce its own securities laws.

See, Consolidated Mgmt. Group LLC v. Dep’t. of Corporations, (2008) 162 Cal. App. 4th 598; 75 Cal. Rptr.3d. 795. Kansas LLC offered joint venture interests in a gas and oil exploration venture pursuant to a claimed Rule 506 exemption under Reg. D. Investment was offered also to members and affiliates of Chamber of Commerce of Los Gatos, in California. Claim of Federal Exemption rejected. Substance over Form. Court ignored contract language calling for co-

management by all venturers. Yuppies in California had no idea about drilling for oil.

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Corporations


Shareholders & Governance of the Corporation Shareholders Meetings Annual Meetings and Special Meetings RMBCA § 7.01 ANNUAL MEETING

(a) A corporation shall hold a meeting of shareholders annually at a time stated in or fixed in accordance with the bylaws.

RMBCA 7.03(a) (1) “within six months after the en of the fiscal year or 15 months after the last annual meeting.

Comparable under Delaware Law (211 (b) DGCL

(b) Annual shareholders‟ meetings may be held in or out of this state at the place stated in or fixed in accordance with the bylaws. If no place is stated in or fixed in accordance with the bylaws, annual meetings shall be held at the corporation‟s principal office.

(c) The failure to hold an annual meeting at the time stated in or fixed in accordance with a corporation‟s bylaws does not affect the validity of any corporate action.

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Corporations


Shareholders & Governance of the Corporation Shareholders‟ Meetings § 7.04. ACTION WITHOUT MEETING

(a) Action required or permitted by this Act to be taken at a shareholders‟ meeting may be taken without a meeting if the action is taken by all the shareholders entitled to vote on the action. The action must be evidenced by one or more written consents bearing the date of signature and describing the action taken, signed by all the shareholders entitled to vote on the action, and delivered to the corporation for inclusion in the minutes or filing with the corporate records.

Does RMBCA 7.04 or similar 228 DGCL provide authority to dispense entirely with shareholders‟ meetings?

See, Hoschett v. TSI International Software Corp., 683 A. 2d 43 (Del. Ch. 1996).

Delaware Company with 40 shareholders never held shareholders meeting. Majority of voting power submitted consent for the election of directors. Directors managed the affairs of the corporation.

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Corporations


Shareholders & Governance of the Corporation Shareholders Meetings Who may call a shareholder‟s meeting.

Board, president, shareholders holding at least 10% percent of voting stock (may be decreased or increased up to 25% per RMBCA 7.02 (2)).

Notice of Meeting Typically no less than 10 days Special Meeting may not transact any agenda not set forth in Notice.

Some statutes require this also for AGM, unless election of the board is only item on the agenda.

May be waived.

Quorum Typically majority of shares entitled to vote RMBCA 7.25 (a) Can be enlarged or reduced ( one/third; per RMBCA 7.25(a) no

downward limitation.

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Corporations


Shareholders & Governance of the Corporation

Shareholders‟ Meetings Agenda: determined by the board.

No vote on the financial statements of the corporation and appropriation of results. Only securities laws (Sarbanes Oxley) require officers to certify annual accounts.

Potential for abuse: Denial of Access to Corporate Books and Records if sought for allegedly „improper” purposes.

See, Conservative Caucus Research v. Chevron, 525 A.2d 569 (Del. Ch. 1987). Plaintiff sought verified stockholder list as authorized for “proper purpose” by DGCL 220(b) with the intent of communicating with fellow shareholders about the risks connected with Chevron‟s business engagement in Angola. Chevron opposed the request as being made for an” improper purpose”

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Corporations


Shareholders & Governance of the Corporation Shareholders‟ Meetings Improper purposes (Conservative Caucus)

re those “not reasonably related to the economic interest of plaintiff as a stockholder and merely aimed at harassing the corporation and its stockholders. Thus, where information was sought simply to give plaintiff a venue for imposing her social or political views, courts tend to favor a corporation‟s request to deny access. Here, purpose was deemed to be “germane to plaintiff's economic interest as a shareholder” as the alleged intent was to communicate with other shareholders about business risk of doing business in Angola.

Rule 14a-8 under Securities Exchange Act of 1934 („34 Act)„34 Act Requires also unlisted companies to register and file periodic reports if they

have more than $10 mio in assets and 500 equity shareholders. 34 Act Rules regulate proxy solicitation. Allows board to exclude certain types of

shareholder proposals (moot, personal grievances, not significantly related) See, Bodenheim v. Iroquois Brands, Ltd., 618 F. Supp. 554 (D.D.C. 1985) Force

feeding geese for pate at issue. Permitted, because company lost money anyhow.

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Corporations


Shareholders & Governance of the Corporation Shareholders‟ Meetings – Permissible Restraints on Voting Shareholder Voting Agreements

RMBCA 7.32 permits – as long as contained to matters shareholders may vote on. DGCL 218 has removed the10 year limitation imposed by prior law.

Shareholder Voting Trusts RMBCA 7.30 transfer of legal ownership to trustee. Split between

economic interest and membership interest. Must be on file with corporation and is limited to 10 years of duration.

Vote Buying E.g., corporation grants loan to shareholder in exchange for voting in

a specific manner. Prohibited outright under N.Y. Law. But see e..g., Hewlett v. Hewlett-Packard, No. 19513 (Del. Ch. 2002). Deutsche Bank was told it would not get any further business from HP unless it changes its vote support the acquisition of Compaq. Void only if for deleterious reasons (disenfranchisement , fraud).

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Corporations


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Corporations


Management of the Corporation RMBCA 2.02 and 8.01

§ 8.01. REQUIREMENT FOR AND DUTIES OF BOARD OF DIRECTORS(a) Except as provided in section 7.32, each corporation must have a board of directors.(b) All corporate powers shall be exercised by or under the authority of the board of directors of the corporation, and the business and affairs of the corporation shall be managed by or under the direction of, its board of directors, subject to any limitations set forth in the articles of incorporation or in an agreement authorized under section 7.32.

(c) ) In the case of a public corporation, the board‟s oversightresponsibilities include attention to:(1) business performance and plans;(2) major risks to which the corporation is or may be exposed;(3) the performance and compensation of senior officers;(4) policies and practices to foster the corporation‟s compliancewith law and ethical conduct;(5) preparation of the corporation‟s financial statements;(6) the effectiveness of the corporation‟s internal controls;(7) arrangements for providing adequate and timely informationto directors; and(8) the composition of the board and its committees, takinginto account the important role of independent directors.

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Corporations


Board of Directors. Number of Directors: one or more, number may be decreased or

increased as per the by-laws. Election: initial directors may be appointed in articles of organization or must be

appointed incorporator in organizational meeting. Term expires at first annual shareholders‟ meeting or special shareholders' meeting called for the election of directors. (RMBCA 8.05).

Term: Thereafter elected typically for annual terms until next annual shareholders meeting. Possibility of staggered terms.

Power to Elect: (7.28, 8.10) if shareholders, typically one share one vote, unless several classes of

shareholders. Articles may authorize specific numbers of directors to be elected by specific

classes of Shareholders (RMBCA 8.04). By-laws typically provide for authority of the board to fill any vacancies, if

appointment of directors is to be limited to S/H, this must be reserved in the articles.

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Corporations


Directors:

Cumulative Voting (RMBCA 7.28):Articles may provide for deviation from plurality rule. Multiply the numbers of votes by the numbers of directors to be elected and cast the product for a single candidate, or distribute among two or more. Effect can be mitigated by staggered terms.

Removal (DGCL 141(k), RMBCA 8.09):Directors may be removed for cause or without cause at any time by the shareholders (or voting group that had the right to elect her). Historically removal only for cause; a provision to that effect may be retained in the Articles. Articles may also authorize board to remove fellow directors.

Directors may also resign at any time.

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Corporations


Directors – do we need them? RMBCA 7.32 allows for shareholder agreements providing for alternate

governance structures until a company becomes “public”.

Close Corporations: Compliance burden for small business owners too onerous Unintended loss of limited liability protection for failure observe

corporate formalities General business corporation not compatible with structure of family

run business.

Introduction of corporation “light” Close Corporation Delaware” DGCL §§ 341 -356 (1983) Model Statutory Close Corporation Supplement to MBCA (1984) New York BCL § 620 (b) (expanded recognition of shareholder

agreements). See also §§ 609 (f), 616, 709. California Corp. Code §§ 158, 186, 202, 204, 300,418,421,706, 1111,

1800, 1904.

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Corporations


Close Corporations:

Management directly by shareholders, either bypassing the board or by being able to issue directions to directors.

Election must be made in Articles

Only limited number of shareholders allowed (Delaware : 30)

Only one class of shares

Mandatory restrictions on transfer

No public offering of securities

Restrictions must be noted conspicuously on share certificates.

Power to dissolve corporation can be given to individual stockholder(s).

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Corporations


Directors Qualifications; None, per RMBCA or DGCL, unless established in Articles No requirement to be stockholder.

Independence Requirement.8.01 (c) (8) and, for public companies, influence of

Sarbanes-Oxley Act of 2002. §§ 301 (audit committee independence and authority), 302 (corporate responsibility for financial reports), 401-09 (financial disclosures).

Pub. L. 107-204, 116 Stat. 745 (codified in various sections of 15, 18 and 28 U.S.C.); see 17 C.F.R. § 240.13a-15 (2008); 17C.F.R. §229.308T (2008).

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Corporations


Directors

Qualifications: Director Independence

Listing requirements: New York Stock Exchange and NASDAQ‟s adopted rules requiring(1) all listed firms have a majority of independent directors (with independence

defined more strictly than under Sarbanes-Oxley),

(2) non-management directors periodically meet without management present,

(3) that all listed companies have a nominating/governance committee, an audit committee and compensation committee composed entirely of independent directors and

(4) that companies maintain an internal audit function, disclose corporate governance guidelines, and annually certify to the NYSE that they are not aware of any violations

of its standards.

See NASD and NYSE Rulemaking: Relating to Corporate Governance, Exchange Act Release No. 34-48745, (Nov. 4, 2003), 68 Fed. Reg.64154, 64157-59, 64161-64 (Nov. 12, 2003); N.Y. Stock Exchange, Final NYSE Corporate Governance Rules (Nov. 4, 2003).

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Corporations


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Corporations


Directors Actions of the Board. 8.20 Directors may hold general or special meetings which can be attended also

by means of telecommunications. Exceptions to this possibility must be set forth in the articles or the by-laws.

Action without Meetings. 8.21All actions that may be taken in a meeting can be taken in the form of a written unanimous consent signed by each director entitled to vote thereon. The articles or the by-laws can establish exceptions to this rule.

Notice requirement. Applies only if reserved in articles or by-laws. Notice, if required, may be

waived in writing before or after event requiring notice. Quorum, Voting:

Quorum normally majority of directors (may be varied by articles or by-laws to be increased up to 100% and decreased to no fewer than a third of the regular quorum).

A resolution is passed if it is adopted with the affirmative vote of the plurality of the directors present. Majority requirements may be increased by articles or by-laws.

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Corporations


Directors: Committees (8.25). May consist of one or more directors. Interested Directors: Disclosure of interest and abstention from voting normally provides

safe-harbor against liability. DGCL 144 allows interested directors to be counted for a quorum.

Abstaining from a vote by itself does not shield from liability. The office of a director comes with affirmative fiduciary duties. (In re Dairy Mart Convenience Stores, C.A. 14713 (Del Ch. May 24, 1999).

However, there is no duty for an interested director to warn its colleagues against a transaction before abstaining from the vote. See, In re Walt Disney Derivative Litig., C.A. No. 1542, slip op. at 14-15. (Del. Ch. Sept. 10, 2004).

No breach of fiduciary duties by abstaining from attendance at a meeting where compensation of interested director is discussed and decided upon.

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Corporations


Directors:

Core Function: per RMBCA Exercise all corporate powers

Manage business and affairs of the corporation.

Historically, no formal concept of the substance (no catalogue of affirmative duties). However , 8.01 (c) has been added to give effect to recent Delaware law => Caremark Decision. Mentions specifically internal controls and adequate reporting system

Compare: DGCL 141 => No specific list of duties.

Reliance on others: 8.30 (f) and DGCL 141 (k)

Director may rely on employees or professionals (lawyers and accountants) if she reasonably believes them to be reliable and competent in the area of expertise in which the director relies on such a person.

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Corporations


Directors

Delegation of Core Function is permissible w/ limitations:

“under the authority of”, “subject to the direction and oversight” => Officers are a mere reflection of such delegation, they have no germane function in the corporation (at least according to the RMBCA).

Limitation on authority to delegate: Directors may not delegate duties which lie ‘at the heart of the management of the corporation’ Harrison v.

Chapin 415 A.2d 1068 (1980) in Grimes v. Donald 673 A.2d. 1207 (1996).

Shareholders agreements that seek to restrict authority of the board to perform core function are invalid. See, USA Soccer Prop’s. v. Aegis, 1992 U.S. Dist. Lexis 11513, (S.D.N.Y.). This case is interesting as defendants tried, without success to claim close corporation status.

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Corporations


Directors Initiation Power: Control which resolutions are placed to a vote

by shareholders‟ meeting. Right to propose amendments to the Articles. However, control may not be manipulative or create “dead –had‟ plans. Carmody v. Toll Brothers, Inc., 723 A.2d 1190, (Del. Ch. 1998). See also Federal Proxy Rule 14a-8. Lovenheim v. Iroquois Brands, Ltd.,618F.Supp 554 (D.C. 1985)

Exclusive Right to Declare Dividend or make other distributions (RMBCA 6.40) a further core function of the board. Directors have a non-waiveable liability for unauthorized distributions (RMBCA 8.33,, 2.02 (b) (4) (C) and (5) (C).

Dividends: Equity Insolvency Test (RMBCA 6.40 (c) or Legal Capital Test

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Corporations


Equity Insolvency Test (RMBCA 6.40 (c))(c) No distribution may be made if, after giving it effect:

(1) the corporation would not be able to pay its debts as

they become due in the usual course of business; or

(2) the corporation‟s total assets would be less than the

sum of its total liabilities plus (unless the articles of

incorporation permit otherwise) the amount that

would be needed, if the corporation were to be dissolved

at the time of the distribution, to satisfy the preferential

rights upon dissolution of shareholders whose

preferential rights are superior to those receiving the

Distribution.

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Corporations


Dividends

Legal Capital Test: Dividends may be paid out only of

a) surplus or

b) net profits.

DGCL § 170. Dividends, payment; (a) The directors of every corporation, subject to any restrictions contained in its certificate of incorporation, may declare and pay dividends upon the shares of its capital stock, * * * either (1) out of its surplus, as defined in and computed in accordance with §§154 and 244 of this title, or (2) in case there shall be no such surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year . . . ..

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Corporations


Directors: Who are they answerable to? – clearly to the shareholders Fiduciary Duties to external Creditors of the Corporation? “Zone of Insolvency” theory. Credit Lyonnais Bank Nederland

v. Pathe Communications Corp., 1991 Del. Ch. Lexis 215 held that board is not merely agent of shareholders,” but owes a duty to the corporate enterprise.”

2007 Correction: North American Catholic Educational Programming Foundation Inc. v. Ghewalla, 930 A. 2d. 92, 101-03.

Delaware Supreme Court ruled that directors had no fiduciary duties to creditors as individuals; no direct claim by creditors ag. directors. However, as the creditors are stepping into the shoes of the shareholders as residual beneficiaries of an insolvent corporation, they can bring derivative actions.

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Corporations


Directors Substantive Obligations. Traditionally, duties were defined only using the agency

paradigm. Directors were fiduciaries of the shareholders, but duties were defined purely as a matter of procedural „due process‟.

Original Standard: Smith v. Van Gorkom , Del. Supr., 488 A.2d 858 (1985), introduces an element of objective reasonableness, the mere absence of disloyalty and a naïve good faith is insufficient.“In the specific context of a proposed merger of domestic corporations, a director has a

duty under 8 Del. C. 251(b), along with his fellow directors, to act in an informed and deliberate manner in determining whether to approve an agreement of merger before submitting the proposal to the stockholders. Certainly in the merger context, a director may not abdicate that duty by leaving to the shareholders alone the decision to approve or disapprove the agreement. (873). “

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Corporations


Directors: Substantive obligations – Caremark and its progeny. In re Caremark International Inc. Derivative Litigation, 698

A.2d 959 (Del. Ch. 1996). Kick-back scheme to medical providers to induce use of Caremark

products. Derivative action because directors had allegedly failed to introduce measures to prevent illegal conduct. At issue: ”adequacy of internal monitoring and control systems”.

Del. Chancery Court ruling: a) Compliance with duty of care can never be determined by reference to

the content of the decision, only whether the director in fact made good faith effort to be informed and exercised appropriate judgment, is relevant.

b) Duty to Monitor: “boards must exercise a good faith judgment that the corporation's information and reporting system is in concept and design adequate to assure the board that appropriate information will come to its attention in a timely manner as a matter of ordinary operations.”

Note: a) is more lenient than Smith v. van Gorkom.

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Corporations


Directors

Substantive Obligations: Duty to monitor and to provide oversight.

In the first ten years after Caremark, there were two schools of thought, one that considered it as a scarecrow and the other heralded it as cornerstone of corp. compliance.

Caremark was affirmed in Stone v. Ritter, 911 A. 2d 362 (Del. 2006) by the Delaware Supreme Court,. “board has obligation with respect to organization and monitoring of the enterprise to assure that the corporation functions within the law to achieve its purposes.” (968-69). Caremark was also acknowledged as the basis for RMBCA 8.01 (c)

Recent Delaware decisions approach director misconduct falling short of a breach of the duty of loyalty and good faith in terms of „abdication of duty‟ . See, Sample v. Morgan, 914 A.2d 647 (Del. Ch. 2007). Read pp. 14 ss.

Two “independent “ members of compensation committee rubberstamped a plan to

issue shares representing one third of the company‟s value to management.

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Corporations


Directors Substantive Obligations: Other Sources Books and Records Provision of the Foreign Corrupt

Practices Act (“FCPA): §78o(d) of Title 15 : (a) make and keep books, records and accounts,

which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer; and (b) devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that (i) transactions are executed in accordance with management‟s general and specific authorization; (ii) transactions are recorded as necessary * * *.

This applies, regardless of whether bribes are paid to foreign business partners.

Siemens, and now FIAT pays 17.8 million dollars as fine, among other things, for a violation of the books and records provision of the FCPA.

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Corporations


Officers: RMBCA 8.40 In General: Officers have only a ministerial function under the RMBCA, their

authority arises from a delegation of authority by the board. No specific titles or functions are prescribed. Functions, titles are established in by-laws. A failure to appoint officers shall not affect the corporation.

DGCL 142: Similar approach, however, by implication function of Corporate Secretary is contemplated.

Cf.: California CC 5213. Mandates Chairman of the Board and or President, Secretary, and Chief Financial Officer.

Traditional approach (DGCL until 1970) required President, Secretary and Treasurer. In practice, at least two officers are required to satisfy dual signature requirements for filing purposes, bank resolutions and share certificates.

Term: unless appointed for specific term, remain in office until resignation or earlier removal. Removal by board is possible with or without cause at any time.

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Corporations


Officers: Scope of Authority: No statutory grant of authority. As by-laws are only

internal documents of the company, not typically relied upon by third parties. Thus, general principles of agency law apply. President: as a rule of thumb, a president of a corporation has the authority to enter

into contracts in the ordinary course of business of the corporation. Accord. to Walt Disney, president has also inherent authority to hire and fire inferior officers and employees of the company.

Service of Process: process may be validly served on all officers of the corporation.

Duties of officers; are considered agents and fiduciaries of the corporation. Per Walt Disney, have the same range of duties as directors.

Officers are closer to the action and may face a higher degree as scrutiny. Monitoring alone is insufficient. See Burt v. Irvine Co., : “The rule exempting officers of corporations from liability for mere

mistakes and errors of judgment does not apply where the loss is the result of failure to exercise proper care, skill and diligence. ..[they] are not merely bound to be honest; they must also be diligent and careful in performing the duties they have undertaken. They cannot excuse imprudence on the ground of their ignorance of inexperience, or the honesty of their intentions; and, if they commit an error of judgment through mere recklessness, or want of ordinary prudence and skill, the corporation may hold them responsible for the consequences.” 237 Cal. App. 2d 828, 852, 47 Cal.Rptr.392, 407-08 (1965).

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Corporations


Indemnification of Directors and Officers The right to indemnification arises out of the law of agency. Mandatory Indemnification v. Permissive Indemnification. Third party actions v. actions by and on behalf of the company. Mandatory Indemnification: MBCA 8.52, DGCL 145 (c) corporation

is required to indemnify D&Os for litigation expenses including reasonable attorneys fees incurred in defending third party actions. Delaware law requires that its corporations indemnify present or former officers

and directors who are "successful on the merits or otherwise in defense" of any such legal action. 8 Del. C. § 145(c).

On the flip side, however, a corporation is prohibited from indemnifying its officers and directors if they acted in bad faith or in a manner that they did not reasonably believe was in the best interests of the corporation. 8 Del. C. § 145(a); see also Waltuch v. Conticommodity Servs. Inc., 88 F.3d 87, 95 (2d Cir. 1996) (statute does not permit indemnification of officer who did not act in good faith).

In criminal proceedings, the standard is whether the person "had reasonable cause to believe that the person's conduct was unlawful." 8 Del. C. § 145(a).

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Corporations


Indemnification of Directors and Officers “Successful on the merits or otherwise in defense” (Merrit-Chapmann)

Typically, directors and officer who settle their cases without admitting guilt or accepting responsibility for their actions remain eligible for, and in certain cases are entitled to, indemnity for legal fees. RMBCA 8.52 “wholly successful”

In most cases, settling executives also can be indemnified for amounts they agree to pay as part of the settlement.

Other Sources of Obligation. Articles 2.02(b)(5) permits corporations to make obligatory indemnification that

otherwise would be permissive. Removes discretion from the board bylaws or in individual employment agreements. Undertaking to indemnify its

officers and directors and advance them legal expenses.

Advancement of Litigation Expenses. Not required to under Delaware law, but most corporations do. Without advancement, indemnification rights may be moot. U.S. v. Stein, No. 07-

3042-cr (2nd Cir. 8/28/2008) upheld dismissal of indictment because KPMG's decision to stop advancing legal fees for its indicted or "uncooperative" employees was the direct result of unconstitutional government pressure. online.wsj.com/public/resources/documents/ruling-kpmg-20060627.pdf

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Corporations


Indemnification of Directors and Officers.

Permissive Indemnification:

Unsuccessful defense:

Not for improper financial gain

Reasonable belief that actions were lawful and in the corporations best interests.

Actions by and on behalf of the company. (derivative actions)

Abuse of Indemnification.

Companies are often required to pay legal fees of executives who have already damaged company. Tyco, Adelphi. Etc.

Attempt to neutralize blanket indemnification by statutory indemnification provisions.

Risk typically covered by D&O Insurance.

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Corporations


Standard of Conduct for Directors and Officers. RMBCA 8.30 a) Each member of the board of directors, when discharging the duties of a

director, shall act: (1) in good faith, and (2) in a manner the director reasonably believes to be in the best interests of the corporation.

(b) The members of the board of directors, when becoming informed in connection with their decision-making function or devoting attention to their oversight function, shall discharge their duties with the care that a person in a like position would reasonably believe appropriate under similar circumstances.

(c) Duty to disclose material information hitherto unknown to company unless doing so would be illegal or unethical. In connection with the above,

(d) directors may rely on officers, company employees, board committees and outside experts; and,

(e) reports and other work product generated by them, unless the officer has reasons to know that such sources are not reliable.

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Corporations


Standard of Conduct for Directors and Officers. Subjective (“believes”) - objective standard (“reasonably”)

“Care that a person in a like position” standard compare to “ordinarily prudent person” of earlier version. Heightened standard, not “Joe, the Plummer” , but a reasonable director is the person of reference.

Standard of care “ordinary negligence” may be changed by articles to exclude all liability except for:

a) the amount of a financial benefit received by a director to which he is not entitled;

(b) an intentional infliction of harm on the corporation or the shareholders;

(c) a violation of section 8.33 (unlawful distributions); or

(d) an intentional violation of criminal law.

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Corporations


Standard of Liability for Directors and Officers. 8.31 RMBCA

No liability, if conduct is protected by:a) Articles of incorporation limitation.

b) Conflicting interest transaction safe harbor

c) Business opportunities safe harbor, or

Business Judgment Rule:challenged conduct consisted or was the result of:

(i) action not in good faith; or

(ii) a decision

(A) which the director did not reasonably believe to be in the best interests of the corporation, or

(B) as to which the director was not informed to an extent the director reasonably believed appropriate in the circumstances.

(iii) lack of independence (improper financial interest in the outcome) ,

(iv) sustained failure to devote (timely) attention to ongoing oversight, or by failing to make appropriate inquiry, when particular facts and circumstances of significant concern materialize that would alert a reasonably attentive director to the need therefore; or (v) improper financial gain.

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Corporations


Business Judgment Rule recognized in some form in most jurisdictions e.g. in the

context of 717 N. Y. BCL “business judgment rule „bars judicial inquiry into actions of corporate

directors taken in good faith and in the exercise of honest judgment in the lawful and legitimate furtherance of corporate purposes.‟ NorlinCorp. v. Rooney, Pace Inc., 744 F.2d 255, 264 (2d Cir. 1984) [quoting Auerbach v. Bennett, 47 N.Y. 2d 619, 629 (1979)]

Gaillard v. Natomas Co., (1989) 208 Cal. App. 3d 1250, 1264 , 256 Cal. Rptr., 702, 710. “A director is not liable for a mistake in business judgment which is made in good faith and in what the director believes to be in the best interest of the corporation, where no conflict of interest exists”.

Cf. Section 309 California Corporations Code (using the ordinarily prudent person standard.

Delaware: Aronson v. Lewis, 473 A2d 805, 812 (Del 1984)

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Corporations


Business Judgment Rule

BJR is a standard of review rather than a standard of conduct Shields from personal liability, and

Insulates ag. judicial review (BJR doctrine).

Overcoming the BJR: Fraud, conflict of interest, illegality remove BJR protection

( but what if actions of questionable legality further the profit of the corporation? (Forgiveness of loan legitimately to DNC, Cf. Miller v. AT&T, 507 F. 2d 759 (3rd Cir. 1974).

Irrational Conduct –Waste Directors‟ conduct that is “improvident beyond explanation” or “so removed

from realm of reason” that it falls outside the bounds of sound discretion will not be protected by the BJR (RMBCA 8.31(a)(2)(ii)).

Gross Negligence plus failure to make an informed decision: Smith v. Van Gorkom (supra).

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Corporations


Business Judgment Rule Overcoming the BJR Inattention to Management Abuse

Francis v. United Jersey Bank 432 A. 2d 814 (N.J. 1981) Widow becomes director after husband‟s death in closely held financial institution managed (and looted) by her sons. Ignorance, frail health and lack of business acumen are not an excuse.

Delaware Reaction to Smith v. van Gorkom Exculpatory statutesDGCL 202 (b) (7) Corporations may include a provision in their articles eliminating liability for breach of fiduciary duty as a director, except for:(i) breach of duty of loyalty;(ii) acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; (iii) approval of unlawful distributions; or(iv) transactions from which the director derived an improper personal benefit.

Self-Interest(conflict of interest) of Directors DUTY OF LOYALTY

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Corporations


Duty of LoyaltyRestatement of Agency: An agent may not: Acquire Material Benefits Arising out of Position Act as or on Behalf of an Adverse Party Engage in Competition

Gain of improper benefits Self – interest Engaging in Competition Corporate Opportunity Doctrine. Historically, duty of loyalty much more relevant than duty of care. Very few

decisions holding directors liable for breach of duty of care. "Corporate officers and directors are not permitted to use their position of trust and

confidence to further their private interests. . . . . A public policy, existing through the years, and derived from a profound knowledge of human characteristics and motives, has established a rule that demands of a corporate officer or director, peremptorily and inexorably, the most scrupulous observance of his duty, not only affirmatively to protect the interest of the corporation committed to his charge, but also to refrain from doing anything that would work injury to the corporation, or to deprive it of profit or advantage which his skill and ability might properly bring to it, or to enable it to make in the reasonable and lawful exercise of its powers. The rule that requires an undivided and unselfish loyalty to the corporation demands that there shall be no conflict between duty and self-interest. "Guth v. Loft, Inc., 5 A. 2d 503, 510 (Del. Ch. 1939)

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Corporations


Duty of Loyalty: Director‟s Conflicting Interest Transactions RMBCA 8.60 -8.63

Common law: transactions were void or voidable if self-interested directors participated. Tainted transaction could be validated by shareholder approval if all material

facts had been disclosed.

Modern Statutes (DGCL 144):

a transaction shall not be voidable solely for the reason that an interested director participated in the decision, if (1) The material facts are disclosed to the board and a majority of

disinterested directors approves the transaction; or (2) The material facts are disclosed to the shareholders (they must be

disinterested), and the transaction is specifically approved in good faith by a vote of the shareholders; or

(3) The contract or transaction is fair as to the corporation as of the time it is authorized, approved or ratified, by the board of directors, a committee or the shareholders.

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Corporations


Duty of Loyalty: Director‟s Conflicting Interest Transactions RMBCA 8.60 -8.63 NOTE: alternative structure of approval mechanism Disclosure and approval OR “Substantive fairness”

“Entire Fairness” Doctrine: Substantive Fairness: RMBCA 8.61(a)

Objective test: arm‟s length criteria must be met Subjective test: value to the corporation in concreto Fair price = best price

Procedural Fairness: “fair dealing” Adequacy and timeliness of disclosure Composition of negotiating team disinterested directors Role of interested director in initiating, structuring an negotiating of deal Minority shareholder approval; mitigating factor, but no silver bullet.

See Weinberger v. UOP, Inc. 457 A.2d 701 (Del. 1983).

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Corporations


Directors Duties in Takeover/ Change of Control Scenarios

Rationale Directors are not “interested” in the classical sense; however, institutional bias calls for heightened scrutiny.

No requirement to meet “entire fairness” test. Instead

Unocal Standard of Intermediate Reviewit applies if board unilaterally adopts defensive measures. Board must establish:

a) proper corporate purpose

b) adopted measure must be reasonable in view of perceived threat.Unocal Corp. v. Mesa Petroleum Co., 493 A. 2d 946, 955 (Del 1985).

If change of control or sale becomes likely, qualified right to self preservation terminates. Revlon Inc., v. Mc Andrews and Forbes Holdings Inc., 506 A.2d 173 (Del. 1986).

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Corporations


Directors Duties in Takeover/ Change of Control Scenarios

“Revlon Duties” Directors become Auctioneers The directors role changes from defenders of the corporate bastion to

auctioneers charged with getting the best price for the shareholders at a sale of the company.

“Paramount Duties” Paramount Communications v. QVC Network, 637 A. 2d 34 at 48 (Del. 1994) “the directors obligation is to seek the best value reasonably available

to the stockholders”. Fiduciary duty “to obtain, and act with due care on, all information reasonably available” ... to compare the competing offers. Scrutiny of information gathering process.

Omnicare Inc., v. NCS Healthcare, Inc. 816 A 2d. 914 (Del. 2003) Extension also to negotiated acquisitions.

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Corporations


Fiduciary Duties

Controlling Shareholders - Interested Shareholders

Not only the board but also shareholders may have fiduciary obligations.

DGCL 203 prohibits business combinations with interested shareholders ( > 15%) for three years after they became interested shareholders unless interested shareholder acquires at least 85% of voting stock through transaction.

Recall “conflicting interest transactions” DGCL 144 (2) Either disclosure and approval by disinterested shareholders.

The more control the greater the obligations vis a vis minority shareholders.

Requirement of “intrinsic fairness” in lieu of mere approval.

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Corporations


Fiduciary Duties


Exclusion of Minority

Jones v . H.F. Ahmanson & Co., 460 P.2d 464 (Cal. 1969)

Control Group created market for their portion of very thinly traded shares (7,000 shares a $2,400 per share) by transferring them to new affiliate whose shares were widely traded instead of performing a 250:1 stock split as requested by minority. Held: impermissible use of control to the detriment of majority.

Zahn v. Transamerica Corp., 162 F.2d 36 (1947) pp. 399 -403

Abusive redemption of minority class of shares to defeat their liquidation preferences, despite pro forma correctness.

Parent Subsidiary Relationship

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Corporations


Fiduciary Duties


Parent Subsidiary Relationship Transactional Setting

Sinclair Oil Corp. v. Levien 280 A.2d 717 (Del. 1971) pp. 394 – 398

Intrinsic Fairness doctrine applied to dealings of parent company dominant stockholder of subsidiary in respect of

Excessive dividends

Breach of contract entered with subsidiary

Merger Setting Squeeze-Out Mergers

Parent and subsidiary agree to a merger –interest of minority shareholders of sub are terminated involuntarily. Cash-0ut for Minority interest

Singer v. Magnavox Co., 380 A. 2d 969 (1977). Merger could go ahead if it served valid business purpose (anti-”speculation” rule) + fair price was paid.

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Corporations


Fiduciary Duties Parent - Subsidiary Relationship Merger Setting Cash-out for dissenting shareholders Appraisal Remedy

DGCL § 262(h) only remedy available. NO damages. Appraisal of the shares, determining their fair value exclusive of any

element of value arising from the accomplishment or expectation of the merger, together with a fair rate of interest, if any, to be paid upon the amount determined to be the fair value. In determining such fair value, the Court shall take into account all relevant factors ...(Weinberger v. UOP)

The basic concept of value under the appraisal statute is that the stockholder is entitled to be paid for that which has been taken from him, viz., his proportionate interest in a going concern. By value of the stockholder's proportionate interest in the corporate enterprise is meant the true or intrinsic value of his stock which has been taken by the merger. Tri-Continental Corp. v. Battye, 74 A.2d 71,72 (Del 1950).

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Corporations


Fiduciary Duties Parent - Subsidiary Relationship

Merger Setting

Statutory Short –form Statutory Merger (DGCL 253) Authorizes parent co holding 90% of stock of sub to merger

with sub through a unilateral act by simply filing a certificate of merger (board resolution approving the merger and terms of merger). No involvement of board of sub.

Glassman v. Unocal Corp., 777 A.2d 242 (Del. 2001)

Entire fairness doctrine does not apply

Full disclosure doctrine applies to give disenfranchised minority shareholders the choice to accept merger consideration or to seek appraisal

Only remedy: Appraisal Rights.

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Corporations


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Fundamental Changes

I. Mechanics -> Charter Amendments, Amendments of Bylaws

II. Individual Cases:

a) General Amendment

b) Merger

c) Disposition of Assets

e) Dissolution

Corporations


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Fundamental Changes

I. Mechanics

Charter Amendments (Articles, Certificate of Incorporation)

What: RMBCA 10.01 Anything that might have been included in the Articles of Incorporation in the first place (idem, 242 (a) DGCL)

No vested rights flowing from original charter

Generally, no disenfranchisement by majority vote. There is some authority allowing for modification of voting rights.

RMBCA 13.02 (a) (4) grants appraisal rights to dissenting stockholders only in case of a freeze-out (reduction to fraction of shares allowing corporation to redeem them)

DGCL: no remedy. Thus, read articles of incorporation before investing.

Corporations


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Fundamental Changes

I. Mechanics

Charter Amendments (Articles, Certificate of Incorporation)o How:

• Board must pass resolution in favor of amendment and make (RMBCA 10.3)recommendation for shareholders to adopt the proposed amendmentRight of initiative vested with the board. Shareholders may not make the first move.

• Shareholders must, either at annual meeting or special meeting (with proper notice in each case) majority of

all stock entitled to vote thereon (absolute majority) DGCL 242(b) (1)Majority of all votes to be cast thereon (relative majority) RMBCA 10.3 (e)

pass a resolution or take action in writing adopting the amendment.

Corporations


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Fundamental Changes

I. Mechanics

Charter Amendments (Articles, Certificate of Incorporation) Group Voting, if various classes of shares

Secretary must file Certificate of Amendment

Restatement of Articles While technically an amendment, board may file restatement at any time w/0.

shareholder approval. RMBCA 10.5 applies authorizes this also for house-keeping amendments.

Recapitalization Corporation is merged with shell corporation in exchange for securities of

shell corporation. Clean-up of securities structure.

Amendment of Bylaws: RMBCA 10.20 No shareholder approval for board initiated changes, unless amended

provisions affect substantive shareholder rights or amended provisions are reserved for shareholder approval.

Corporations


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Fundamental Changes.

II. Change Events Generic Amendments of Articles (see above)

Mergers.

Special majority requirements in MBCA 11.04(f) (1). All shares threatened with disenfranchisement are authorized to vote as a group, even though they would belong to different classes.

Ordinarily only shareholders of acquired corporation have voting rights, not of acquiring corporation.

Sale of Assets RMBCA 12.01 (“Disposition of Assets”)

No shareholder approval required if transaction is not a “true sale” but a pledge or other disposition of that kind, if it occurs in the ordinary course of business, or results in a distribution assets to the shareholders.

Corporations


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II. Change Events Disposition of Assets not in the Ordinary Course of Business require

shareholders‟ approval if:

True Sale

Sale of “substantially all” of the assets

disjunctive qualitative-quantitative test: assets in question must be quantitatively vital to corporations operation or qualitatively substantial to its existence and purpose.

RMBCA 12.02(a) 25% Test. No shareholder approval necessary if corporation retains

25% of total assets and• 25% of after tax operating income or

• 25% of revenue.

Appraisal rights for dissenting shareholders.

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II. Change Events

Dissolution RMBCA 14.01 Involuntary Dissolution

Voluntary Dissolution RMBCA 14.02

1. Resolution to dissolve.

Tracks the requirements of a charter amendment

Notice to all shareholders, regardless of whether they are entitled to vote or not

If quorum consisting of majority of stockholders entitles to vote exists, relative majority may approve dissolution.

DGCL 275 requires absolute majority.

No appraisal rights for dissenters

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II. Change Events - Dissolution RMBCA 14.01 ss.

Voluntary Dissolution

2. Articles of Dissolution RMBCA 14.03

Corporation is dissolved upon filing articles of dissolution as of effective date stated therein. Corporation becomes

“dissolved corporation” RMBCA 14.05 continues its existence for

3. Winding Up and Dissolution RMBCA 14.05 – 14.09

Collect and liquidate assets, pay claims

For up to 5 years (three years DGCL 275)

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II. Change Events - Dissolution RMBCA 14.01 ss. Winding Up and Dissolution

RMBCA 14.09 Directors‟ DutiesDirectors shall cause the dissolved corporation to discharge or make reasonable provision for the payment of claims and make distributions of assets to shareholders after payment or provision for claims.

Known Claims Notice with cut off date for making claim

Unknown Claims Publication in Newspaper (cut off date.)

Contingent unknown and future claims not barred pursuant to 14.06 and 14.07 RMBCA reasonably anticipated to be asserted within three years after dissolution (e.g., product liability claims) special court proceeding to determine provision.

Guardian ad litem for unknown contingent claims.

Corporations



II. Change Events - Dissolution RMBCA 14.01 ss.

Winding Up and Dissolution - Residual Obligations

Directors

To shareholders for breach of RMBCA 14.09

Creditors if directors have distributed assets without making adequate provisions for liabilities.

Shareholders

To creditors for unsatisfied liabilities up to amount of distribution received.

Successors in Interest

Successor Liability Doctrine

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Documents

Introduction into the Law of Business Corporations and ... · PDF fileIntroduction into the Law of Business Corporations and Unincorporated Business Associations ... of proper corporate