Professional Documents
Culture Documents
AGENCY
Restatement 2d § 1
Agency is the fiduciary relation which results from the manifestation of consent
by one person to another that the other shall act on his behalf and subject to his
control, and consent by the other so to act.
Restatement 3d § 1.10
Agency is the fiduciary relationship that arises when one person (a “principal”)
manifests assent to another person (an “agent”) that the agent shall act on the
principal’s behalf and subject to the principal’s control, and the agent manifests
assent or otherwise consents so to act.
§1.03: Manifestation
A person manifests assent or intention through written or spoken words or other
conduct.
Restatement § 144: P is subject to liability upon contracts made by A acting within his
authority if made in proper form and with the understanding that P is a party.
§6.01: Agent for a disclosed principal:
When an agent acting with actual or apparent authority makes a contract on behalf of a
disclosed principal,
(1) the principal and the third party are parties to the contract; and
(2) the agent is not a party to the contract unless the agent and the third party agree
otherwise.
Holding
Cargill argued that its relationship with Warren was purely contractual. In contrast, the
plaintiff farmers argued that the web of contracts between Cargill and Warren had
become so strong that their relationship had evolved into an agency relationship
comparable to a sole proprietorship.
Holding?
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That an agency relationship did exist between the defendants.
Controlling Creditor
Restatement § 14 O: When does a creditor become a principal?
A creditor who assumes control of his debtor's business for the mutual benefit of
himself and his debtor, may become a principal, with liability for the acts and
transactions of the debtor in connection with the business.
Creditor becomes a principal at that point at which it assumes de facto control
over the conduct of the debtor
Nine factors re control
Comment a to Restatement § 14 O
A security holder who merely exercises a veto power over the business acts of his
debtor by preventing purchases or sales above specified amounts does not
thereby become a principal.
However, if he takes over the management of the debtor's business either in person or
through an agent, and directs what contracts may or may not be made, he
becomes a principal, liable as any principal for the obligations incurred thereafter in
the normal course of business by the debtor who has now become his general
agent.
The point at which the creditor becomes a principal is that at which he assumes de
facto control over the conduct of his debtor, whatever the terms of the formal
contract with his debtor may be.
Comment (f)(1) states (Vol. 1, page 44), “In the debtor-creditor context, most courts are
reluctant to find relationships of agency on the basis of provisions in agreements
that protect creditors’ interests. … An unusual example to the contrary is A. Gay
Jenson Farms, Inc. v. Cargill … .”
3
← -Disclosed principal: a principal is disclosed if when an agent and a third party
interact, the third party has notice that the agent is acting for a principal and the third
party.
← -Undisclosed principal: when an agent and 3rd party interact, the 3rd party has no
notice that the agent is acting for a principal.
← -Unidentified (partially disclosed) principal: 3rd party knows there’s a principal, but
does not know who it is.
-Ways to create an agency:
• By agreement
• Ratification – the authority comes after the contract is signed.
• Estoppel – when a principal negligently or intentionally allows a 3rd party to
believe there is an agency when there isn’t.
-Agents acting with authority may bind principals
• Authority is the starting point for analysis of contract actions.
• Authority also is an element in vicarious liability-based tort actions against the
principal.
-Actual Authority: § 2.01: An agent acts with actual authority when, at the
time of taking action that has legal consequences for the principal, the agent
reasonably believes, in accordance with the principal’s manifestations to the
agent, that the principal wishes the agent so to act.
• §3.01: Creation of actual authority:Actual authority, as defined in § 2.01, is
created by a principal’s manifestation to an agent that, as reasonably
understood by the agent, expresses the principal’s assent that the agent take
action on the principal’s behalf.
• Actual Express Authority: Principal intentionally confers on Agent.
• Actual Implied Authority (incidental authority): Principal can’t always think of
everything that it would authorize Agent to do.
o Policy: AIA carefully places the incentive to draft good instructions on
the right party. If P wants A to do X, but to do it only in a certain
idiosyncratic manner, AIA gives it the incentive to draft its authorization
carefully.
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-AA: Apparent authority [aka ostensible authority] AA depends on the
communication between P and TP (though this may be accomplished through an
agent, by authorizing the agent to make any statement to TP, creating apparent
authority, that the principal might have made directly).
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both AEA and AA are present.
A requirement for AA is that TP justifiably relies on P’s communication
of consent for A to act on his behalf.
§ 1.04(8) Subagent:
A subagent is a person appointed by an agent to perform functions that the agent has
consented to perform on behalf of the agent’s principal and for whose conduct the
appointing agent is responsible to the principal. The relationship between an
appointing agent and a subagent is one of agency, created as stated in § 1.01.
Restatement § 26:
authority to do an act can be created by written or spoken words or other conduct of the
principal which, reasonably interpreted, causes the agent to believe that the
principal desires him so to act on the principal’s account
“Finally, in this case, Sam Hogan believed that Bill Hogan had the authority to hire him
as had been the practice in the past. To now claim that Bill Hogan could not hire
Sam Hogan as an assistant, especially when Bill Hogan had never been told this
fact, would be very unfair to Sam Hogan.”
-Dweck v. Nasser
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• Issue: does an attorney not on the record have lawful authority to settle a
lawsuit on behalf of the client/principal, as an agent?
• Who is the attorney of record here, Shiboleth or Heyman? Did Shiboleth have
apparent authority?
• Holding: Court finds apparent authority by evidence from Shiboleth’s letter to
Nasser. Finds implied authority given Nasser’s directions to Shiboleth to settle
the action and the close personal business relationship shared.
Ratification
Ratification is the affirmance of a prior act done by another, whereby the act is given
effect as if done by an agent acting with actual authority.
A person ratifies an act by:
Manifesting assent that the act shall affect the person’s legal relations, or
Conduct that justifies a reasonable assumption that the person so consents.
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Ratification does not occur unless:
• The act is ratifiable as stated in § 4.03,
• The person ratifying has capacity as stated in § 4.04
• The ratification is timely as stated in 4.05, and
• The ratification encompasses the act in its entirety as stated in § 4.07
Restatement § 82: Ratification is the affirmance by a person of a prior act which did not
bind him but which was done or professedly done on his account, whereby the act,
as to some or all persons, is given as if orignially authorized by him.
Restatement § 83: Affirmance is either (a) manifestation of an election by one on
whose account an unauthorized act has been done to treat the act as authorized,
or (b) conduct by him justifiable only if there were such an election.
Ratification
• A acts without authority (of any kind) and there are no grounds for estoppel
o we will talk about estoppel in the next case- but in brief, it is conduct
leading TP to believe A has AA- if there were grounds for estoppel, you
wouldn’t need an ex post authorization – the law would impose an
agency to protect the TP.
P will only be bound if P ratifies the contract
How does P ratify?
• Must be a contract or act that would have been valid if authorized initially
[can’t be illegal, for example]
o P must have been in existence when the unauthorized act was done
o Ratification must be effected with the same formalities that would have
been necessary for the unauthorized act – equal dignities rule
How does P ratify?
• Affirmation
o Principal must know or have reason to know all material facts
[including that A purported to act for him]
o Can be express or implied [harder to prove]
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(1) express affirmation by the principal;
(2) implied affirmance through acceptance of the benefits of the transaction at a time
when it is possible to decline to accept such benefits
How does P ratify?
(3) implied affirmance through silence or inaction—a principal can’t wait forever before
repudiating an unauthorized transaction, a rule based largely on notions of
economic fairness; we don’t give the principal a put;
(4) implied affirmation through bringing a lawsuit to enforce the contract.
• Ratification will be denied legal effect where necessary to protect the rights of
innocent third party
o No intervening events: TP withdraws, P loses capacity, change in
circumstances, lapse of time. TP is treated as an offeror, who can
withdraw anytime prior to acceptance [absent option contract, part
performance or promissory estoppel]
Boticello v. Stefanovicz
• Husband and wife own farm as tenants in common. H offers to lease, with
option to purchase, to Plaintiff. W states that she would not sell the property
for less than agreed upon price. P unaware of wife’s ownership share. P does
not do title search, and makes improvements on property. P elects to take
option. H&W refuse. P sues for specific performance.
• Issue: Did H act as W’s authorized agent? If not, did W ratify?
• Holding: no agency found. Wife did not ratify.
Agency by Estoppel
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induced to make a detrimental change in position because the transaction is
believed to be on the person’s account, if
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Section 4: RAISING ADDITIONAL CAPITAL
-Statutory Review
• §103(a): UPA sets out the default rules “to the extent the partnership
agreement does not otherwise provide.” The parties can, for the most part,
provide whatever terms they want.
Exceptions are listed in § 103(b), including:
o the partnership agreement cannot restrict the right to access for books
and records under §403(b);
o can’t eliminate the duty of loyalty under §404(b), but can curtail it;
o unreasonably reduce the duty of care under §404(c) eliminate the
obligation of good faith and fair dealing under § 404(d), etc.
• § 301: sets out agency power of partners to bind the partnership to third
parties: each partner is an agent for the partnership for the purpose of its
business, and each partners’ acts for apparently carrying on in the ordinary
course of the partnership business binds the partnership, unless the partner
had no authority and the third party had notice of this fact.
Partner’s Authority
• UPA (1914) § 9(1): “Every partner is an agent of the partnership for the
purpose of its business, and the act of every partner, including the execution
in the partnership name of any instrument, for apparently carrying on in the
usual way the business of the partnership of which he is a member binds the
partnership, unless the partner so acting has in fact no authority to act for the
partnership in the particular matter, and the person with whom he is dealing
has knowledge of the fact that he has no such authority”
• § 401: sets out partner’s rights and duties between and among
themselves only- not third parties: Some of the default rules [imposed
unless the parties agree otherwise] that we have talked about include:
o (b) profits are split equally, losses like profits;
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o (c) partnership must reimburse/indemnify partners for liabilities in the
ordinary course of the partnership;
o (f) each partner has equal rights in the management and conduct of
the business.
o (j) In the absence of an agreement to the contrary, matters arising in
the ordinary course of the business may be decided by a majority of
the partners.
o Amendments to the partnership agreement and matters outside the
ordinary course of the partnership business require unanimous
consent of the partners.
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o Under UPA § 401(j), in the absence of an agreement to the contrary,
matters arising in the ordinary course of the business may be decided by a
majority of the partners.
• Under UPA § 301(1): every partner is an agent for the partnership for the
purpose of its business.
• So Summers and Dooley are agents for the partnership, for the purpose of its
business, which is a trash collection business.
• Under UPA § 301(1), acts of the partners for apparently carrying on in the
ordinary course of the partnership business bind the partnership, unless the
partner had no authority to act for the partnership on this, and the third party
involved had notice.
• Summers could argue that hiring a new worker is within the ordinary course of
the partnership business, and so he had authority to act for the partnership, and
so the partnership is bound on his contract with the new worker.
• Under UPA § 401(f), all partners have equal rights of management
• Under UPA § 401(j), in the absence of an agreement to the contrary, matters
arising in the ordinary course of the business may be decided by a majority of the
partners.
• Dooley would counter that he refused to consent to the hiring of additional help,
and that here, a majority of the partners did not authorize Summers to hire the
new worker.
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← National Biscuit ← Summers v. Dooley
← ←
14
← Contract binding because: “Stroud ← Contract not binding because “a
was not, and could not be, a majority of the majority of the partners did not consent to
partners” the hiring of the third man”
← ←
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Day v. Sidley & Austin
• Former senior partner seeks damages claiming a substantial loss of income,
damage to his professional reputation and personal embarrassment, which
resulted from his forced resignation.
• Two different firms, S&A and Liebman. Day was in charge of S&A. Two firms
merged and Day has to share chairmanship of merged office with another
person.
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• Upon dissolution, the authority of partners to act on behalf of partnership is
terminated except in connection with winding up of partnership business. UPA
(1914) § 33; UPA (1997) § 804.
• Explicit term
o Duration specified in partnership agreement
o Specific purpose/object specified in partnership agreement
• Implicit term
o Example: When a partner loans money to the firm, to be repaid from
profits, the partnership is for a term until the loan is repaid
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o Page v. Page
“George was asked: ‘[W]as there any discussion with reference to
the continuation of the business in the event of losses?’ He replied,
‘Not that I can remember.’ He was then asked, ‘Did you have any
understanding with Mr. Page, your brother, the plaintiff in this
action, as to how the obligations were to be paid if there were
losses?’ He replied, ‘Not that I can remember. I can't remember
discussing that at all. We never figured on losing, I guess.’ ”
No implied term. Why not?
• Parties’ hope to repay start-up loan out of partnership profits
not enough
o Owen v. Cohen
Implied term found. Why?
• When a partner loans money to the firm, to be repaid from
profits, the partnership is for a term until the loan is repaid
Why a dissolution?
• Dissolution is an appropriate remedy because of Cohen’s
misconduct
• See UPA § 32(1)(c) and (d), which provide that a
partnership may be judicially dissolved where a partner’s
conduct prejudices the carrying on of the business or where
the partner willfully and persistently breaches the agreement
or where he conducts himself in such a way as to make it
impractical to carry on the business with him
Why Sue?
• Judicial determination of status of loan required
• Receiver probably needed for orderly liquidation
• Potential for wrongful dissolution
UPA (1914) § 31(1)(b) v. § 31(2)
Dissolution of a “term partnership” (a.k.a. “partnership
for a term”) prior to expiration of the term is “wrongful”
Adverse consequences; see UPA (1914) § 38(c)
Hence, “there always exists the power, as
opposed to the right, of dissolution”
Proper to repay loan before distributing profits?
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• UPA § 40(b), the following order is observed: (1) The claims
of the firm’s creditors are paid; (2) Claims of a partner other
than those for capital and profits
• So Owen is entitled to repayment of his loan before Cohen
gets anything
Kovacik v. Reed
K and R enter into agreememt to remodel some kitchens. K invested $10,000. R
would superintend and estimate the jobs and share profits 50-50. K did not ask R
to share in losses.
K&R incurred losses. K dissolves the partnership due to non-profitability. K sues
R for half of losses.
Appellate court finds R not liable. K lost capital, R lost labor.
Holzman v. De Escamilla
Partnership went into bankruptcy and Holzman was appointed as trustee of
estate.
Holzman brings action to determine that Russell and Andrews (who were general
partners in limited partnership of Hacienda Farms)
III. CORPORATIONS
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Section 1: PROMOTERS AND THE CORPORATE ENTITY
Categories of Corporations
4. Liquidity
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5. Flexible capital structure:
The permanent and long-term contingent claims on the corporation’s assets and
future earnings issued pursuant to formal contractual instruments called
securities
Many ways to package such claims; e.g., stocks and bonds
Debt securities (a.k.a. bonds, debentures, notes) typically consist of two distinct
rights:
The bondholder is entitled to receive a stream of payments in the form of interest
over a period of time
At the end of the bond’s prescribed term (i.e., at maturity), the bondholder is
entitled to the return of the principal
Bondholders are creditors, not owners
Equity securities (a.k.a. shares) represent “the units into which the proprietary
interests in the corporation are divided”
Residual claimants: equal right to participate in distributions of the firm’s earnings
and, in the event of liquidation, to share equally in the firm’s assets remaining
after all prior claims have been satisfied
A limited right to participate in corporate decisionmaking by electing directors and
voting on major corporate decisions
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Issuance of stock:
If the charter authorizes the class of shares in question and there are sufficient
authorized but unissued shares, the board is free to sell shares for “any valid
purpose” as long as the corporation receives adequate consideration for the
shares.
Process of incorporation:
o File articles with SOS – under MBCA § 2.03, that starts the corporation’s life
o Post incorporation:
o Draft bylaws (MBCA § 2.06)
o Organizational meeting (MBCA § 2.05)
o Issue stock
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o Promoter: Someone who purports to act as an agent of the business prior to its
incorporation
o Promoter retains liability on pre-incorporation contracts unless and until promoter
gets a novation
Pre-incorporation contracts
Possible outcomes for pre-incorporation contracts signed by a promoter:
o Promoter retains liability, corporation has none
o Promoter and corporation both have liability
o Promoter has no liability, corporation has liability
Corporation by estoppel
o Treat firm as though it were a corporation if the [TP plaintiff] person dealing
with the firm:
(1) thought it was a corporation all along and
(2) would earn a windfall if now allowed to argue that the firm was not a
corporation
o This doctrine has nothing to do with the defendant making a good try. It comes
from the injustice created when you try to gain an advantage by changing your
story as to the existence of a fact or legal relationship.
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Southern-Gulf Marine Co., No. 9, Inc. v. Camcraft, Inc.
IOU
Boat
Bowman Barrett
Holding:
o Camcraft is estopped to deny SGM’s corporate status
o Hence, SGM may sue to enforce the contract
Rule of law:
o A third party who dealt with the firm as though it were a corporation and relied on
the firm, not the individual defendant, for performance is estopped
Reasoning:
o On the estoppel claim the court finds that in order to weasel out of a contract due
to the “character of the organization to which it is obligated” the defendant would
need to show its substantial rights might thereby be affected, which it was unable
to do.
o SGM is not a de jure Texas corporation as stated in the contract, but that fact
hasn’t caused Camcraft any substantive problems and Bowman was informed of
the Cayman Islands incorporation and accepted it. So they are estopped from
asserting the plaintiff’s lack of corporate capacity when the Vessel Construction
Agreement was signed.
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When does estoppel apply?
1. After a defective attempt to incorporate, the participants in the venture themselves
cite their defective incorporation in an effort to escape liability on the contract with
plaintiff;
o the court will estop them from asserting the corporation did not exist and
therefore the contract is not enforceable when the contract was made
supposedly on their behalf.
o This would apply in SGM if it were SGM who was trying to avoid liability on
the contract.
2. The more difficult application of the concept is to our actual SGM facts. The
participants in the venture [SGM] ask the court to estop a third party they have dealt
with from denying the existence of the corporation. Seems pretty straight forwards, at
first glance.
o The TP agreed to deal with a corporation, and is trying to weasel out based on
facts that really don't impact it- they are just looking for an excuse to avoid
liability. If they were permitted to deny the existence of the corporation on these
facts, they would get more than they bargained for - a windfall.
Limited Liability
o MBCA § 6.22(b): “… a shareholder of a corporation is not personally liable for
the acts or debts of the corporation except that he may become personally liable
by reason of his own acts or conduct”
o Shareholder losses limited to the amount the shareholder has invested in
the firm—the amount initially paid by the shareholder to purchase his or
her stock
o A corollary of the corporation’s status as a separate legal person; in the
eyes of the law, it is the corporation that incurs the debt or commits the
tort and the corporation which must bear the responsibility for its actions
o Encompasses “piercing the corporate veil”
o Tips to avoid PCV:
Avoid “unity of interest” – respect the separate existence of the
corporation, and your clients probably won’t need to be concerned
about personal liability.
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Hold your statutorily required meetings, keep minutes, elect
officers, etc., but, most important, keep corporate funds and
transactions separate from individual funds and transactions and
not constantly shift money in and out of the corporate account.
Substantial compliance is probably enough.
So what do we need to PCV?
(1) a total disregard for the separate existence of the corporation
(2) Most of the cases and the commentators state that there is a second element that
must be proved: injustice or some such concept.
o Do all courts require that second element?
o No; for some courts, however, a total disregard for the separate existence
of the corporation is enough, on the theory that if the shareholder ignored
the separate existence it would be unjust for the creditor to be required to
respect it.
Veil Piercing
Walkovsky v. Carlton
S e o n C a b C o r p . A B C C o r p . X Y Z C o r p .
Enterprise liability: :
Òonly a larger corporate
entity would be held
financially responsible Ó
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Walkovsky
1
Enterprise liability
• All 10 corporations were alleged to be part of a single enterprise that actually
conducts the business, so plaintiff ought to be able to recover from any or all
of the 10 in the enterprise.
• What does enterprise liability depend on?
o It depends on proof that Carlton did not respect the separate identities
of the corporations—for example, here are some factors to consider in
determining whether two or more corporations have been operated as
a single business enterprise include whether the corporations had:
(1) common employees;
(2) common record keeping;
(3) centralized accounting;
(4) payment of wages by one corporation to another corporation’s
employees;
(5) a common business name;
(6) services rendered by the employees of one corporation on behalf of another;
(7) undocumented transfers between corporations;
(8) unclear allocation of profits and losses between the corporations;
(9) the same officers;
(10) the same shareholders; and
(11) the same telephone number
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Many of these cases place great emphasis on factors like failure to comply with
corporate formalities. Why are such factors relevant?
o Is it enough that the creditor will be unable to collect the full amount owed
unless the court pierces the veil?
← Under Illinois law [the Van Dorn test], to pierce the corporate veil, a court must
find:
(a) a unity of interest and ownership between corporation and shareholder, AND
(b) a situation where failing to PCV would either
(i) sanction fraud [don’t need proof of intent to defraud creditors]; or
(ii) promote injustice.
← To determine whether (a) exists, courts look at four factors:
← (w) the lack of corporate formalities,
← (x) the commingling of funds and assets,
← (y) under-capitalization, and
← (z) the use by one corporation of assets of another [which sounds to me a lot like
commingling]
Introduction
Derivative suit:
A suit in equity against a corporation to compel it to sue a third party.
The quintessential derivative suit is a suit by a shareholder to force the firm to sue a
manager for fraud.
Direct Derivative
Alleges a direct loss to the Alleges a loss to the
shareholder
Direct and Derivative Suits shareholder that derives
Brought by the shareholder from a loss to the
in her own name corporation.
Cause of action belonging Brought by a
to the shareholder in her shareholder on
individual capacity corporation’s behalf
Arises from an injury Cause of action belongs
directly to the shareholder to the corporation as an
entity
Arises out of an injury 28
done to the corporation
as an entity
MBCA § 7.41(1):
A shareholder may not commence or maintain a derivative proceeding unless
the shareholder:
o was a shareholder of the corporation at the time of the act or omission
complained of or became a shareholder through transfer by operation of
law from one who was a shareholder at that time;
So creditors may not bring derivative suit.
MBCA § 7.41(2): Plaintiff Qualifications: Fair and Adequate Representative
A shareholder may not commence or maintain a derivative proceeding unless
the shareholder:
o Fairly and adequately represents the interests of the corporation in
enforcing the rights of the corporation.
MBCA § 7.42: more support that plaintiff must be a shareholder:
No shareholder may commence a derivative proceeding until:
Written demand has been made upon the corporation to take suitable action;
and
90 days have expired from the date the demand was made unless the
shareholder has earlier been notified that the demand has been rejected by the
corporation or unless irreparable injury to the corporation would result by waiting
for the expiration of the 90-day period.
What do bond posting statues add to this and how do they work?
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These statutes create liability for the corporation’s reasonable expenses if the
suit fails by requiring posting of security for the reasonable expenses by
shareholders owning less than some set percentage or dollar amount of shares
who brings a derivative suit.
Plaintiff Argues:
o the series of corporate maneuvers were designed to dilute his voting rights
and his ability to control the air freight company
o the reshuffling deprived him and other shareholders of their voting rights
with respect to the operating company (FTL, then renamed FT).
o HOW? Is Eisenberg really hurt by the reorganization?
o Before the merger, he could vote on fundamental changes to FT and elect
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the FT board.
o Now, he can vote on fundamental changes to FTC (the holding company
his FT stock was converted into) and elect the directors of FTC.
o Because FTC wholly owns FT (the new operating company), and those
FTC directors vote the FT stock, they vote on the fundamental changes to
FT and elect its directors.
o Eisenberg’s interest is a bit more indirect than before, but not by much.
o Eisenberg has not lost much by way of voting rights.
o Moreover, Eisenberg could not muster the 1/3 necessary to challenge the
reorganization anyway.
o If he could not contest this reorganization, he could hardly hope to
accomplish much with a direct vote on the operating company.
Defendant Argues
o FT claimed that Eisenberg’s suit was derivative, and moved for him to be
required to post security for the corporation’s costs.
o Why did defendant do that instead of answering the merits?
A procedural hurdle that they wouldn’t lose anything to try.
Issue: Direct or Derivative?
Court finds action to be personal and not derivative.
What about the note and question on individual recover in the Wyoming
derivative action on page 241- Lynch v. Patterson?
Unusual fact pattern: in stockholder derivative action, trial court did not
err in awarding judgment in favor of minority stockholder as an individual
rather than to corporate treasury, as corporate recovery would simply
return funds to control of wrongdoers, and as ordering payment to
corporate treasury would risk necessitating subsequent suit by minority
stockholder to compel directors to declare dividend or apply the funds to
legitimate corporate purposes.
The court said: Direct recovery assures that Patterson will reap
some benefit from his lawsuit. We refuse to order payment into the
corporate treasury in this case and risk necessitating a subsequent suit by
Patterson to compel the directors to declare a dividend or apply the funds
to legitimate corporate purposes.
How can they just do that?
They can do it because it is an equitable procedure;
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The Requirement of Demand on the Directors
Demand
Most states require plaintiffs in derivative suits to approach the board and
demand that it sue the alleged wrongdoers.
If demand is required, the failure to make demand is a procedural barrier and the
suit will be dismissed [unless and until the demand is met]
Marx: NY Law
o According the Marx court [which sets the standard for demand excusal
under NY law], the purpose of the demand requirement is:
to relieve courts from deciding matters of internal corporate
governance by giving the directors the opportunity to correct the
alleged abuse
provide corporate boards with reasonable protections from
harassment suits on matters within the board’s discretion
discouraging strike suits commenced by shareholders for personal
gain and not for the benefit of the corporation
According to the Grimes court [which sets the standard for demand refusal under
Delaware law], the purpose of the demand requirement is:
o “by requiring an exhaustion of intercorporate remedies, the demand
requirement invokes a species of alternative dispute resolution procedure
which might avoid litigation altogether.”
o If litigation is beneficial, the corporation, not the shareholder, can control
the proceedings.
o If demand is excused or wrongfully refused, the stockholder can control
the litigation.
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Therefore BoD should have some say in whether to go forward
Demand futility
o What is the most accepted excuse for not making a demand?
o What is standard for demand futility?
o Del: Grimes v. Donald
o NY: Marx v. Akers
o Both the Delaware and New York approaches to the demand futility
inquiry boil down the following inquiry:
o Is the board of directors so clearly disabled by conflicted interests
that its judgment cannot be trusted?
If so, absent intervention by a special litigation committee,
the shareholder should be permitted to go forward.
If not, the board should be allowed to decide whether the
litigation should proceed.
Statutory authority re: the demand:
o we looked at this statute already for the proposition that shareholder standing is
required to bring a derivative suit. But it also sets out the concept of “universal
demand.”
o MBCA § 7.42: Universal demand: “No shareholder may commence a derivative
proceeding until … a written demand has been made … and 90 days have
expired from the date the demand was made … unless irreparable injury to the
corporation would result by waiting for the expiration of the 90-day period”
o FRCP 23.1: The complaint shall allege “the efforts, if any, made by the plaintiff to
33
obtain the action the plaintiff desires from the directors … and the reasons for the
plaintiff's failure to obtain the action or for not making the effort
o Implies that demand itself may be waived –
o Law in most states excuses demand if futile
o What mechanism is there in the MBCA that provides for internal corporate
review of a demand?
o MBCA § 7.44 provides two alternatives for internal corporate review
of the demand:
o A derivative proceeding shall be dismissed by the court on motion by the
corporation if one of the groups specified in subsection (b) or subsection
(e) has determined in good faith, after conducting a reasonable inquiry
upon which its conclusions are based, that the maintenance of the
derivative proceeding is not in the best interest of the corporation.
o Unless a panel is appointed pursuant to subsection (e), the determination
in subsection (a) shall be made by:
o A majority of qualified directors present at a meeting of the board of
directors if the qualified directors constitute a quorum; or
o A majority vote of a committee consisting of two or more qualified directors
appointed by majority vote of qualified directors present at a meeting of
the board of directors, regardless of whether such qualified directors
constitute a quorum.
Bottom line:
o If the independent (i.e., disinterested) directors constitute a quorum,
the demand may be reviewed by the board. Whether or not the
independent directors constitute a quorum, the independent directors
may appoint by majority vote a committee of two or more independent
directors.
o If either the board or committee determined in good faith after
conducting a reasonable investigation upon which its conclusions are
based that the maintenance of the derivative proceeding is not in the
best interests of the corporation the court shall dismiss the complaint.
o Under the MBCA’s version in 7.44(e), upon motion by the
corporation, the court may appoint a panel of one or more independent
persons to determine whether the suit should go forward. If that person
recommends dismissal, the court shall dismiss the action unless
plaintiff can prove the independent panel failed to act in good faith or
34
failed to conduct a reasonable inquiry upon which its conclusions were
based.
o Who has the burden of proof on this issue?
If a majority of the board was independent at the time
that determination was made, the burden of proof with
respect to the board’s independent disinterest and the
adequacy of its investigation is on plaintiff.
If a majority of the board was not independent, the
burden of proof is on the defendant.
Grimes v. Donald
Direct v. Derivative:
o The initial issue was whether Grimes’ complaint was derivative or direct.
o The court tells us that “although tests have been articulated many times, it is
often difficult to distinguish between a derivative and an individual action…. The
distinction depends on “the nature of the wrong alleged and the relief, if any,
which could result if plaintiff were to prevail.”
o Were plaintiff’s claims direct or derivative?
o The complaint alleged:
abdication by the board of its duties [direct claim] as per the court,
but is the court correct?
breach of the duty of care [derivative claim],
waste via excess compensation [derivative claim].
Plaintiff’s abdication claim: the severe financial costs [penalties]
that the corporation will incur if it tries to interfere in Donald’s
management will “inhibit and deter the Board from exercising its
duties under § 141(a).”
With respect to the abdication claim, Grimes sought only to have
the agreements declared invalid and, as such, that claim was
deemed direct.
o Court used standard of Business Judgement rule
o Quick and dirty on the BJR: courts should not second-guess the
business judgment of the directors; the principal function of the business
judgment rule is, or at least ought to be, to protect officers and directors
from liability for violation of their DOC.
o Under the BJR, a board decision to incur the risk of such a financial
35
penalty in order to attract a senior manager was entitled to protection.
o “If an independent and informed board, acting in good faith, determines
that the services of a particular individual warrant large amounts of money,
whether in the form of current salary or severance provisions, the board
has made a business judgment… [that] will normally receive the
protection of the BJR unless the facts show that such amounts, compared
with the services to be received in exchange, constitute waste or could not
otherwise be the product of a valid exercise of business judgment.”
o “If demand is made and rejected, the board rejecting the demand is
entitled to the presumption of the BJR unless the stockholder can allege
facts with particularity creating a reasonable doubt that the board is
entitled to the benefit of the presumption.”
o “If there is a reason to doubt that the board acted independently or with
due care in responding to the demand, the stockholder may have the
basis ex post to claim wrongful refusal. The stockholder then has the right
to bring the underlying action with the same standing which the
stockholder would have had, ex ante, if demand had been excused as
futile.”
o Problem for plaintiffs from the BJR presumption:
1. Under Delaware law, where demand is made the plaintiff is
deemed to have conceded that the demand was required
[waiver of any claim that demand is excused],
2. which, in turn makes the decision of the board on whether to
dismiss a matter of business judgment,
3. which, in turn means that the plaintiff loses.
o Under Delaware law, can plaintiff’s demand ever be excused?
Plaintiff must allege particularized facts showing why he was justified in
not making the demand.
Grimes test for demand futility:
The three usual bases for excusing demand as futile are:
(1) a majority of the board has a material or familial interest in the challenged
transaction;
(2) a majority of the board is incapable of acting independently, maybe
because it is dominated or controlled by the alleged wrongdoer; or
(3) the challenged transaction was not the product of a valid business
judgment.
36
As a result, well-advised plaintiffs in Delaware almost never make demand, since
the board always says no and the BJR presumption supports the board.
So the issue to be litigated is whether demand is excused.
Aronson v. Lewis (1984) OLD LAW – MODIFIED AND BUILT INTO GRIMES
o Aronson introduces the concept of “reasonable doubt” into this analysis. The case
creates a test for trial courts to see if the failure to make a demand was justified by using
discretion to determine whether the particularized facts alleged in the complaint create a
reasonable doubt that:
the directors are disinterested and independent for purposes of responding to the
demand; ;
OR [Aronson court says and, but acts like it’s or; and the NY courts in Marx
specifically interpret the branches of this test as “disjunctive”]
the challenged transaction was otherwise the product of a valid exercise of
business judgment [and thus protected under the BJR
o Self interest, for these purposes, is defined in terms of direct financial
interest in the challenged transaction;
o the fact that a majority of directors voted to approve the transaction—and
therefore are named as defendants—does not constitute self-interest and
will not excuse demand.
SUMMARY
If demand is required and made, it will invariably be refused;
then BJR applies to the decision to dismiss the lawsuit and plaintiff
loses.
Demand may be excused if plaintiff’s allegations raise reasonable
doubt about self interest or the protection of the business judgment
rule, but then the directors can appoint a special litigation committee
as in Zapata [see footnote 13].
where demand is excused, the corporation may still move to dismiss
Marx v. Akers
the suit as not in the best interests of the corporation. The
What recommendation
is this court’s viewmay come from
on derivative a special
actions committee of independent
in general?
directors, as in Zapata.
o “By their very nature, shareholder derivative actions infringe upon the
managerial discretion of corporate boards… Consequently, we have
historically been reluctant to permit shareholder derivative suits, noting
that the power of the courts to direct the management of the corporation’s
affairs should be ‘exercised with restraint.’”
o “the object is for the court to chart the course for the corporation which the
directors should have selected, and which it is presumed that they would
have chosen if they had not been actuated by fraud or bad faith. Due to
37
their misconduct, the court substitutes its judgment ad hoc for that of the
directors in the conduct of its business.”
Rule of law: under NYBCL § 626(c), plaintiff has to “set forth with particularity
the efforts of the plaintiff to secure the initiation of such action by the board, or
the reasons for not making such effort.”
Three prong disjunctive standard:
o Majority of directors interested in challenged transaction
o Directors failed to inform themselves to degree reasonably appropriate
o Challenged transaction so egregious that it could not have been the
product of sound business judgment of the directors
1
1
38
Auerbach v. Bennett
“we confront a special instance of the application of the BJR and inquire whether
it applies in its full vigor to shield from judicial scrutiny the decision of a three
person minority committee of the board acting on behalf of the full board not to
prosecute a shareholder’s derivative action.”
“As all parties and both courts below recognize, the disposition of this case on
the merits turns on the proper application of the business judgment doctrine, in
particular to the decision of a specially appointed committee of disinterested
directors acting on behalf of the board to terminate a shareholders' derivative
action. . . . In this instance our inquiry, to the limited extent to which it may be
pursued, has a two-tiered aspect.”
Does court agree?
o Ultimate decision covered by business judgment rule
o But judicial inquiry permitted with respect to:
Disinterested independence
Adequacy of investigation
o Burden of proof?
o On plaintiff
While the court may properly inquire as to the adequacy and appropriateness of
the committee’s investigative procedures and methodologies, it may not under
the guise of consideration of such factors trespass in the domain of
business judgment.”
Demand really excused?
o Court assumes demand excused, but was it?
Marx v. Akers test:
• Majority of BOD Interested?
• BOD failed to inform itself?
• Transaction egregious?
Zapata v. Maldonado
The lower court opinion found BJR does not confer power on BOD to terminate a
derivative suit.
How does the BJR apply to this case?
o Here, the evaluation of the Committee/BOD decision not to sue only
becomes relevant when plaintiff protests it. The BJR then is raised as a
defense to the attack on the decision.
39
This court views the case as having 3 focuses:
o Whether the lower court was right in finding that the shareholder had an
individual right to maintain the derivative action.
o What is the corporate power under Delaware law of an authorized board
committee to cause the dismissal of litigation instituted on behalf of the
corporation.
o What is the role of the Court of Chancery in resolving conflicts between
stockholders and SLCs?
ISSUE #1: the lower court found that once a shareholder made a demand and it
was refused, the shareholder somehow had an independent individual right to
continue the derivative action over the objections of the corporation- is this an
accurate statement of the law?
ISSUE #2: What is the corporate power under Delaware law of an authorized
board committee to cause the dismissal of litigation instituted on behalf of the
corporation?
ISSUE #3: What is the role of the Court of Chancery in resolving conflicts
between stockholders and SLCs?
o Rule of law: Delaware standard for reviewing SLC recommendations is a
two step approach:
Delaware standard for reviewing SLC recommendations?
o Zapata Two-Step
Step 1:Inquiry into the independence and good faith of the
committee
• Inquire into the bases supporting the committee’s
recommendations
• The corporation has the burden of proving independence,
good faith, and a reasonable investigation
Step 2: Court may go on to apply its own business judgment as to
whether the case is to be dismissed
• The court will undertake an independent inquiry into whether
the suit should be dismissed.
• The court can consider matters of law and public policy in
addition to the corporation’s best interests.
Zapata far more intrusive judicial review than usual. Why?
o Context: Demand was excused because board disabled from acting due
to conflicted interests
40
o Committee appointed by the disabled board
o Potential for structural bias – “there but for the grace of God, go I”
History
• LLCs introduced in Wyoming in 1977
• LLC is the first new legal business concept since the S corp (1950s)
• Created as a vehicle for ownership of real estate and development of oil, gas and
other mineral rights
Tax Treatment
• The IRS initial position [pre-1988] was that LLCs should not be treated as a
partnership [i.e., taxable entities]
• In 1988, IRS ruled that LLC could qualify for partnership-like tax treatment
• In 1997, IRS further liberalized with “check the box” regulations that give
unincorporated associations the ability to choose their tax status without regard
to the entity’s nontax legal characteristics
Why so popular?
• They provide a standard form contract that incorporates many of the most
attractive features of partnerships and corporations.
• The LLC is an unincorporated business organization that can provide its
members with pass through tax treatment, limited liability, and the ability to
actively participate in firm management.
Funding
• Members typically contribute capital
• Capital contribution may be cash, property, services rendered, a promissory
note, or other obligation to contribute cash, property, or to perform services. See
ULLCA § 401.
Liability
41
• Members stand to lose capital contributions, but their personal assets are not
subject to attachment
Tax Consequenses
• Income and losses pass through to members
• LLC does not pay taxes at the entity level, so profits are not subject to double
taxation
• Capital gains flow through to owners and retain their tax attributes (i.e., are
subject to lower rates)
Financial Interests
Profit and Loss Sharing
• Absent contrary agreement, most LLC statutes allocate profits and losses on the
basis of the value of members' contributions
• Compare partnership law’s equal division default rule
Withdrawal
• Member may withdraw and demand payment of his/her interest upon giving the
notice specified in the statute or the LLC's operating agreement
Management Rights
o absent contrary agreement, each member has equal rights in the management of
the LLC; see ULLCA §404(a)(1)
o Most matters decided by majority vote, see ULLCA § 404(a)(2)
o Significant matters require unanimous consent, see ULLCA § 404(c)
o E.g., merger, admission of new member, dissolution, etc...
o Two Flavors
o Manager-managed LLCs: see ULLCA § 404(b)
42
o Member-managed LLCs: see ULLCA § 404(a)
o Derivative actions:
Member may bring an action on behalf of the LLC to recover a
judgment in its favor if the members with authority to bring the
action refuse to do so
Section 1: FORMATION
File articles of organization the designated State office. ULLCA § 202(a)
43
o Required and optional contents set forth in ULLCA § 203
o Filing fees plus minimum franchise tax
o Other formation tasks:
o Choose and register name: LLC statutes generally require the name of the
LLC to include the words limited liability company, the abbreviation LLC,
or similar phrases. ULLCA § 105
Effect of, see Water, Waste & Land v. Lanham
o Designate office and agent for service of process
o Draft operating agreement – the basic contract governing the affairs of a limited
liability company and stating the various rights and duties of the members
44
o The Col. SC holds: “the statutory notice provision applies only where a TP seeks
to impose liability on an LLC’s members or managers, simply due to their status
as members or managers of the LLC. When a TP sues a manager or a member
of an LLC under an agency theory, the principles of agency law apply
notwithstanding the LLC Act’s statutory notice rules.”
o How does these facts work out under standard agency law?
o Under common law agency rules, A has liability on a partially disclosed
agency – to avoid liability, A must fully disclose both the agency and the
identity of P.
o How is this a partially disclosed agency? It sounds undisclosed - and both
Clark and Lanham are agents for the undisclosed LLC!
o The court tells us that the partially disclosed agency exists because Clark
and Lanham failed to disclose the existence OR identity of the LLC.
o Yikes. This sounds much more like an undisclosed agency. The court
seems a little mixed up on the definition of partially disclosed agency, as
evidenced by this language from the full opinion:
“For these reasons, we conclude that where an agent fails to
disclose either the fact that he is acting on behalf of a principal or
the identity of the principal, the notice provision of our LLC Act,
section 7- 80-208, cannot relieve the agent of liability to a third
party.
When a third party deals with an agent acting on behalf of a limited
liability company, the existence and identity of which has been
disclosed, the third party is conclusively presumed to know that the
entity is a limited liability company and not a partnership or some
other type of business organization.
Where the third party does not know the identity of the principal
entity, however, the situation is fundamentally different because the
third party is without notice and the law does not contemplate that
he has any way of finding the relevant records.”
45
Elf Atochem North America, Inc. v. Jaffari
o Can the parties say whatever they want in their LLC Agreement?
o As long as they are not violating any law, they can.
o Does plaintiff claim direct or derivative claims?
o Can LLCs be sued derivatively, like corporations?
46
Kaycee Land and Livestock v. Flahive
Issue: “in the absence of fraud, is a claim to pierce the LL entity veil or disregard
the LLC entity in the same manner as a court would pierce the corporate veil,…
an available remedy against a Wyoming LLC…”
Wyoming law: Section 17-15-113: “Neither the members of a limited liability
company nor the managers of a limited liability company managed by a manager
or managers are liable under a judgment, decree or order of a court, or in any
other manner, for a debt, obligation or liability of the limited liability company.”
ULLCA § 303(a): “A member or manager is not personally liable for a debt,
obligation, or liability of the company solely by reason of being or acting as a
member or manager.”
Cf.: MBCA § 6.22(b): “… a shareholder of a corporation is not personally liable
for the acts or debts of the corporation except that he may become personally
liable by reason of his own acts or conduct”
Minn. Stat. § 322B.303(2): “case law that states the conditions and
circumstances under which the corporate veil of a corporation may be pierced
under Minnesota law also applies to limited liability companies.”
47
1
Section 4: DISSOLUTION
By operation of law:
Upon the happening of any event specified in LLC operating agreement
Vote of members (as specified in operating agreement)
It becomes unlawful to carry on the business
Upon court order:
Economic purpose frustrated
Misconduct by members
48
Kamin v. American Express
Complaint?
If the company had sold the stock, it would have recognized a $26 million tax
loss that could have been offset against its taxable income.
o When it issued the DLJ stock as a dividend, it lost that tax benefit.
o The shareholders recognized dividend income equal to the fair market
value ($4 million) of the DLJ stock, and got a basis in the DLJ stock equal
to that amount.
Plaintiffs calculated the cost of the company’s scheme at $8 million.
Direct or derivative?
o Derivative
Demand made?
o yes, but it was rejected.
“The only hint of self-interest which is raised … is that four of the twenty directors
were officers and employees of American Express and members of its Executive
Incentive Compensation Plan. Hence, it is suggested, by virtue of the action
taken earnings may have been overstated and their compensation affected
thereby. Such a claim is highly speculative ….
“the court will not interfere unless the powers have been illegally or
unconscientiously executed; or unless it be made to appear that the acts were
fraudulent or collusive, and destructive of the rights of the stockholders.”
“Mere errors of judgment are not sufficient grounds for equity interference, for the
powers of those entrusted with corporate management are largely discretionary.”
“The Court will not interfere unless a clear case is made out of fraud, oppression,
arbitrary action, or breach of trust.”
Court states:
“The minutes of the special meeting indicate that the defendants were fully
aware that a sale rather than a distribution of the DLJ shares might result in
the realization of a substantial income tax saving. Nevertheless, they
concluded that there were countervailing considerations primarily with respect
to the adverse effect such a sale, realizing a loss of $25 million, would have on
the net income figures in the American Express financial statement. Such a
reduction of net income would have a serious effect on the market value of
the publicly traded American Express stock.”
49
What if defendant directors had failed to inform themselves about the adverse tax
consequences?
Then there would be a duty of care issue.
Trans Union J a y P r i t z k e r
Merger
M a r m o n G r o u p , I n c .
Timeline N e w C o , I n c .
50
would, in effect, be paid by the competing bidder.
There was some limitation on the freedom of Trans Union to shop around for a
better offer.
There was a dispute about what this limitation was, but the court ultimately
concludes that Trans Union was not completely free to engage in what is referred
to as a market test of the $55 price.
Sept 20: Senior management meeting
Sept 20: BOD meeting
What paperwork was provided??
Opinion
“The record is not clear as to the terms of the Merger Agreement. The
Agreement, as originally presented to the Board on September 20, was never
produced by defendants despite demands by the plaintiffs. Nor is it clear that the
directors were given an opportunity to study the Merger Agreement before voting
on it. All that can be said is that Brennan [corporate counsel] had the Agreement
before him during the meeting.”
The BOD decision was “based solely” on:
VG’s oral presentation
TU’s president Chelberg’s supporting representations
Brennan’s legal advice
BOD’s knowledge of the market history of TU’s stock
Oct 1: First public wrinkle: within 10 days of the press release, key executive
officers threatened to resign.
VG meets with Pritzker who agrees to some modifications as long as VG could
convince the dissidents to stay on the TU payroll for 6 months after the deal
closed
Oct 8: TU BoD approves revised deal
VG gets the senior management team calmed down and back in favor of the
deal; they agree to hire Salomon Bros. to solicit other offers for TU, and they
approved the proposed amendments to the Merger Agreement which had not yet
even been drafted.
Oct 10: amendment to merger agreement delivered to VG and signed by VG,
apparently without reading them
Dec. 19: this litigation was filed, and within 4 weeks, 8 of the 10 BOD were
deposed
51
Jan. 26: BOD has “lengthy” meeting and votes to proceed with the merger
Jan. 27: BOD approves supplement to proxy statement detailing the merger
Feb 10: TU shareholders approve merger by 69.9% to 7.25% (22.85%
abstained)
What Happened to the Old Trans Union Shareholders?
DGCL § 251(b)(5):The plan of merger shall specify “the manner of converting the
shares of each of the constituent corporations into … cash … securities of any
other corporation or entity which the holders of such shares are to receive in
exchange for [their] shares”
Trial court decision
BOD did not “act recklessly or improvidently in determining on a course of action
which they believed to be in the best interests of the stockholders of TU.” BJR –
holds for corporation
looking at market value of TU [$55 was higher than recent historical prices];
business acumen of BOD [116 combined years of experience with TU]; premium
over market price; prospect of other bidders [apparently viewed as unlikely,
although with the no shop, hard to tell].
The trial court somehow concludes that TU was free to accept other offers and
that no legally binding agreement was reached until 1/26/81.
The court decides BOD failed to make an informed decision at its 9/20 BOD meeting
about:
VG’s role forcing the sale and creating the share price;
the intrinsic value of TU –the company they sat on the board of, some for many years
What about § 141(e)
A member of the BOD or a member of any committee designated by the BOD
shall in the performance of such member’s duties be fully protected in relying in
good faith upon the records of the corporation and upon such information,
opinions, reports or statements presented to the corporation by any of the
corporation’s officers or employees, or committees of the BOD, or by any other
person as to matters that the person reasonably believes are within such other
person’s professional or expert competence and who has been selected with
reasonable care by or on behalf of the corporation.
Legal standard from the Smith v. Van Gorkom
What do BOD need to show to be informed?
o Directors need to gather all material information “reasonably available” to
them
52
o The “reasonably available” standard requires an in-depth study:
Valuation study
Discussion of course of the negotiations
Review of actual contract
information about the terms of the offer and their fairness
Corporate Opportunities
Dominant Shareholders
53
Zahn v. Transamerica
Transamerica owned a controlling block of the Class B shares and dominated the management of
Axton-Fisher. Transamerica had elected majority of the board
54
Dividend preference: Class A was entitled to a cumulative annual dividend of
$3.20, then the Class B was entitled to $1.60 and then the two classes shared
equally any excess dividend.
Redemption/conversion preference: company could call the Class A shares
for redemption upon 60 days’ notice at $60 per share plus accumulated
dividends, but Class A shareholders could convert each Class A share into one
share of Class B instead. The B shares are not convertible or callable.
Liquidation preference: upon liquidation, the division of assets was 2:1 in favor
of the Class A.
Voting rights: All the votes were in the class B except when dividends had not
been paid for four successive quarters, then the classes of stock with the
defaulted dividends pick up voting rights like class B (not an issue in the case).
The redemption provision was included to benefit the B shareholders in
situations in which the value of the company had risen to the point where
redemption would force conversion.
Duty of Care
(i) Disclosure. The plaintiffs argued that the proxy material was materially
misleading because it didn’t disclose that the board meeting lasted only three hours.
(ii) Duty of care. Even if (hypothetically) the board didn’t exercise due care, the
shareholders ratified the merger after full disclosure. That’s enough to kill the claim.
(iii) Duty of Loyalty. Even if (hypothetically) the board violated its duty of
loyalty in voting for the merger, ratification changes the burden of proof. But nothing
is simple here. The court sets out a two-part standard:
a. Does it matter whether the shareholders are interested or not? And
what about the language of § 144(a)(2) -- does it require
DISINTERESTED shareholders?
55
i. No. The section provides that an interested transaction is not void if
(a) there is full disclosure and the disinterested directors ratify it, (b)
there is full disclosure and the shareholder ratify it, or (c) it is fair.
The drafters inserted a requirement of disinterest in (a) but not in
(b).
b. Accordingly, ratification ought to be effective to shift the burden of
proof of unfairness to the plaintiffs (under § 144(a)), even if the
shareholders are not disinterested;
i. Courts have held otherwise.
ii. Although perhaps not faithful to the statutory language the
decision does appeal to common sense.
Compensation
56
Chancellor acknowledged that, and so do we.
But, the Chancellor also found that despite its imperfections, the evidentiary
record was sufficient to support the conclusion that the compensation committee
had adequately informed itself of the potential magnitude of the entire severance
package including the options, that Ovitz would receive in the event of an early
NFT.
So is good faith a predicate for BJR protection? And what are the categories of
“bad faith”?
Subjective bad faith: conduct motivated by actual intent to do harm which
clearly constituted bad faith
Lack of due care: does this rise to the level of bad faith? It’s gross negligence
without malevolent intent. This is NOT bad faith.
Intentional dereliction of duty: a conscious disregard for your responsibilities –
this is a non exculpable nonindemnifiable violation of the duty fiduciary duty to
act in good faith, so it’s Bad Faith.
Waste
A plaintiff who fails to rebut the BJR presumptions is not entitled to any remedy
unless the transaction constitutes waste…
[if] the exchange was so one sided that no business person of ordinary, sound
judgment could conclude that the corporation has received adequate
consideration….
The court tells us that the “payment of a contractually obligated amount cannot
constitute waste, unless the contractual obligation itself is wasteful.”
Oversight
A rudimentary understanding of the firm’s business and how it works
To stay informed about the firm’s activities
To engage in general monitoring of corporate affairs
Attend BOD meetings regularly
Routinely review financial statements
57
to exercise oversight will establish the lack of good faith needed for liability.
What is an example of such a sustained or systemic failure?
An utter failure to attempt to assure a reasonable information and reporting
system exists.
Graham: absent cause for suspicion, there is not duty on the BOD to install and operate
a corporate system of espionage to ferret out wrongdoing which they have no reason to
suspect exists.
Caremark: absent grounds to suspect deception, neither corporate boards nor senior
officers can be charged with wrongdoing simply for assuming the integrity of employees
and the honesty of their dealings on the company’s behalf.
Does acting in bad faith trigger an independent basis of liability under Delaware
corporate law?
No;“although good faith may be described colloquially as part of a ‘triad’ of
fiduciary duties that includes the duties of care and loyalty, the obligation to act in
good faith does not establish an independent fiduciary duty that stands on the
same footing as the duties of care and loyalty. Only the latter two duties, where
violated, may directly result in liability, whereas a failure to act in good faith may
do so, but indirectly.”
Definition of a Security
58
(2) liquidity: the ability to readily sell an investment instrument- providing an exit
strategy; and
(3) risk management: permits diversification and hedging of investments
59
Definition of a Security § 2(a)(1): “The term ‘security’ means any note, stock, ...
bond, debenture, ... investment contract ... or, in general, any interest or
instrument commonly known as a ‘security’.”
Why does this definition matter?
o In order to come within the registration requirements of §5 of the 33 Act,
the offer or sale of a property interest must constitute the offer or sale of a
“security.” And once you have a class of securities registered under § 5,
you must provide the SEC and the market with continuous disclosure
under the periodic disclosure system of the 1934 Act.
o If the item in question is NOT a security as defined in §2(1) of the 33 Act,
then the registration requirements of § 5 are not applicable.
o So your first line of inquiry is to see if you are dealing with a security.
o If so, look to see if there are any exemptions from the registration
requirements available.
Seven statutes:
Only 2 matter for us
Securities Act of 1933: regulates the sale of securities to the public – primary
market
o The 1933 Act defines 3 categories of securities:
(1) any interest or instrument commonly known as a security: things
like bonds, stock, notes, debentures and warrants
(2) types of securities specifically mentioned in the Act: things like
pre-organization subscriptions; fractional, undivided interests in oil,
gas or other mineral rights
(3) investment contracts and certificates of participation: the two
most important clauses in §2(1) are its broad, catch-all phrases
“investment contract” and “certificates of interest or participation in
any profit-sharing agreement.” The SEC and the courts have
applied these phrases to include many financial schemes not
specifically mentioned by the Act as “securities.”
Most of the case law has arisen in connection with the phrase “investment
contract” and, to a lesser extent, to the phrase “unless the context otherwise
requires”.
The courts have fleshed out the concept of the investment contract to cover any
60
investment scheme that triggers the investor’s need for the protection of the
federal securities laws.
61
(3) licensing and registration provisions for securities and
brokers and dealers of securities: the laws provide for the
registration of securities offered for sale in that state, and for all
persons selling securities
Robinson v. Glynn
“The parties have vigorously urged us to rule broadly in this case, asking that we
generally classify interests in LLCs as investment contracts (Robinson’s view) or
non-securities (Glynn’s view).”
What is an Investment Contract - SEC v. Howey (US 1946):
o The Howey test seeks to identify transactions in which investors are
counting on others to manage the enterprise that will produce financial
returns on their investments.
o The definition isolates transactions in which ownership is separated from
control, suggesting the importance of mandatory disclosure and higher
liability standards to ensure that investors allocate capital to its highest-
valued uses.
o SEC v. Howey (US 1946): “a contract, transaction or scheme whereby a
person invests money, in a common enterprise, and is led to expect profits
solely from the efforts of the promoter or a third party”
1. Investment of money: the investment can be cash or non cash
consideration, like checks or money orders or credit. The
investment part is satisfied if you put out consideration with the
hope of some financial return -- producing income or profit. This
excludes the purchase of a consumable commodity or service.
• Anything constituting legal consideration for purposes of
contract law should satisfy the first prong of the Howey test
2. Commonality/common enterprise: This prong focuses on the
question of the extent to which the success of the investor’s interest
rises and falls with others involved in the enterprise. Courts have
developed two tests, depending on the circuit:
• horizontal commonality [between investors]: looks to the
relationship between the individual investor and the other
investors who put money into the scheme. Requires
62
investors share the risk of the enterprise, usually through a
pooling of their funds; e.g., shareholders of a corporation.
• Multiple investors have interrelated interests in a
common scheme - they must share in a single pool of
assets; the investors’ fortunes are interwoven - they pool
resources, share profits and share losses pro rata.
• vertical commonality [between an investor and the
promoter]: looks to the relationship between the investor
and the promoter of the scheme. Requires the promoter and
at least one investor share the risk; a single investor has a
common interest with the manager of his investment;
• this requires a profit sharing arrangement between the
promoter and each investor -- the investor’s fortunes are
inextricably interwoven with and dependent on the fortunes
of the promoter/manager of the enterprise.
3. Expectation of profit from the efforts of others: the expected
return must come from earnings of the enterprise, not merely
additional contributions, and this return must be the principle
motivation for the investment.
• Howey says that the profits must be SOLELY from the
efforts of others; lower courts wrestle with whether “solely”
means only or predominantly or substantially. There is a
split in the circuits about whether to go with the more flexible
interpretation.
• According to the 4th Circuit: The “Supreme Court has
endorsed relaxation of the requirement that an investor rely
only on others’ efforts, by omitting the word “solely” from its
restatement of the Howey test. And neither our court nor our
sister circuits have required that an investor like Robinson
expect profits “solely” from the efforts of others.
• Requiring investors to rely wholly on the efforts of others
would exclude from the protection of the securities laws any
agreement that involved even slight effort from investors
themselves. It would also exclude any agreement that
offered investors control in theory, but denied it to them in
fact. Agreements do not annul the securities laws by
63
retaining nominal powers for investors unable to exercise
them…”
So a nice rule is: stock is always a security, except where stock is not really stock,
in which case it might still be a security if it’s an investment contract
1
• § 5 prohibits the offer and sale of “securities” through the mail or via
interstate commerce without filing a disclosure document called a
registration statement with the SEC;
• § 5 requires that the securities can’t be sold until the registration statement
is declared effective by the SEC; and
• § 5 requires the delivery of a prospectus to everyone who actually buys
the securities, as well as to anyone just offered the securities.
Exempt securities
• §3: Exempt securities: ALWAYS exempt from registration, both when
issued and later when traded.
• These securities were thought to be inappropriate subjects of regulation either
because they were already regulated by some other governmental authority or
because of the intrinsic nature of the securities themselves.
• Exempt offerings remain subject to the anti fraud provisions of the securities laws;
so the SEC can take action against any seller of securities under §17 - the general
anti fraud provisions for the offer and sale of securities, primarily used by the SEC
and the US Justice Department in criminal actions.
• Just because a security is exempt under FEDERAL registration requirements
doesn’t necessarily mean it is exempt from state blue sky registration, and state anti
fraud rules and liabilities.
65
§3: Exempted securities:
• Burden of proving exemption: is on the person claiming the exemption; if
the burden is not met, the exemption is lost, and if they were counting on the
exemption, they have probably now violated §5 which requires registration with
automatic liability for selling unregistered securities under §12(a)(1).
• Exempt securities included:
• Government securities: are those issued or guaranteed by governmental
organizations under §3(a)(2) like U.S. and state notes and bonds
• Commercial paper: short term commercial paper [with a maturity of less
than 9 months] is exempt –they tend to be high quality, negotiable notes
issued for current business operations and typically purchased by banks
and other institutional sophisticated institutional investors, not the general
public.
• Securities subject to non- SEC regulation: some securities are
exempted on the theory that other regulation offers adequate protection to
investors, including:
o §3(a)(2): securities issued by banks;
o §3(a)(5): securities issued by federally or state-regulated S&Ls;
o §3(a)(2): insurance policies and annuity contracts issued by state-
regulated insurance companies
• Securities issued by not for profit issuers: available to for
organizations that operate for religious, educational, benevolent, fraternal,
charitable or reformatory purposes.
Exempt transactions
§ 4: Exempt transactions: these are one-time exemptions based on the type of
transaction -- the way you sell the security. So on resale, the security may need to be
registered, absent some exemption.
• § 4(1): market trading exemption: exemption for persons other than an issuer,
underwriter or dealer for ordinary trading transactions like on stock exchanges or
between investors.
• § 4(2): “private placement exemption” exempts from registration any offering
“by an issuer not involving a public offering” – of course the laws don’t define
“public offering.”
o Under SEC v. Ralston Purina, the court holds that the application of this
exemption turns on whether the particular class of persons affected
needed the protection of the Act. An offering to those who are shown to
66
be able to fend for themselves is a transaction “not involving any public
offering.”
Reg. D:
• really 3 separate exemptions [Rules 504, 505 and 506] for private and small
offerings. The exemptions are available only to the issuer who files an
informational notice called a Form D with the SEC within 15 days of the first sale.
• Which rule you use turns on (1) the dollar amount of the offering; (2) the number
and kind of investors [NOT OFFEREES]; (3) whether the Reg. D offering is part
of some other larger offering; (4) the kind of advertising used; (5) the kind of
information provided to investors.
• Reg. D offerings have a prohibition on “general solicitation” and “general
advertising”
• Reg. D offerings have resale restrictions
67
sign the registration statement]; underwriters, and experts like lawyers,
accountants, investment bankers who have consented to be named as experts –
their liability is limited to the information prepared or certified by them, and
certainly, most of them would prefer not to have any liability.
• § 11 liability is broader than a common law fraud action. All a purchaser
has to do to succeed on a § 11 action is to show :
o (1) that he bought the security in the offering; and
o (2) that there was a material misrepresentations in the registration
statement.
• The plaintiff does NOT have to show scienter, causation or reliance on the
misstatement.
Defenses:
• We should think of the registration statement as having two parts (the parts
prepared by certified experts, and everything else), and the potential
defendants as constituting two groups (the experts, and everyone else). The
defenses available for a misleading registration statement vary according to
those two variables.
Issuers are strictly liable unless they can show one of these affirmative defenses:
• (1) the purchaser knew of the untruth or omission when they bought the security;
OR
• (2) the untruth or omission is not material; OR
• (3) the statute of limitations has run.
For non issuers, there are 3 additional affirmative defenses [their standard is
essentially a negligence standard but they must show they were NOT negligent]:
• resign or take steps to resign and tell the issuer and the SEC in writing that
they have done so, and disclaiming all responsibility for the relevant sections of
the registration statement;
• (2) if the registration statement has already gone effective, written notice to the
SEC and reasonable public notice; and
• (3) due diligence/reasonable investigation defense -- absolves defendants
from liability if they had reasonable grounds for believing and did believe that
there was no omission or material misstatement.
o § 11(c) gives, as a test for reasonable investigation and reasonable belief,
68
the level of care that a prudent person would exercise if his or her own
money were at stake.
o The due diligence defense is popular, but not always successful. The
court will look at the defendant’s knowledge, expertise and status
with regard to the issuer, its affiliates and underwriters, and the
degree of participation by the defendant in the actual registration
process and preparation of the materials.
69
Rule 10b-5
Section 10(b):
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.—
(b) To use or employ, in connection with the purchase or sale of any
security registered on a national securities exchange or any security not
so registered, any manipulative or deceptive device or contrivance
in contravention of such rules and regulations as the Commission may
prescribe as necessary or appropriate in the public interest or for the
protection of investors.
Rule 10b-5:
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,
(a) To employ any device, scheme, or artifice to defraud,
(b) 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
(c) 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 with the purchase or sale of any security.
Elements
• Jurisdictional nexus
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,
• Transactional nexus
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
70
facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) 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
(c) To engage in any act, practice, or course of business which
operates or would operate as a fraud or deceit upon any person,
o in connection with the purchase or sale of any security.
• Material misrepresentation or omission
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,
(a) To employ any device, scheme, or artifice to defraud,
(b) 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
(c) To engage in any act, practice, or course of business which
operates or would operate as a fraud or deceit upon any person,
o in connection with the purchase or sale of any security.
• Reliance
o It is a showing of the causal connection between a defendant’s misrep and
the plaintiff’s injury.
o How can this reliance be demonstrated?
One way is to show a breach of a duty to disclose material
information; the SC has held that the necessary nexus between
plaintiff’s injury and defendant’s wrongful conduct is established
due to the breach.
o Traditionally, courts bifurcated the reliance test.
If the case involved an affirmative misrepresentation, courts
required the plaintiff to show that he relied on the
misrepresentation.
If it involved a failure to disclose, they adopted a rebuttable
presumption: absent proof by the defendant to the contrary, they
presumed that the plaintiff relied.
71
o How can defendant rebut fraud on the market presumption?
• Defendant needs to sever the link between the misrep and either the
price of the stock paid to/received by plaintiff or the decision to trade at
the fair market price.
o Market not deceived
o Corrective statements
o Specific plaintiffs would have sold anyway
• Causation
o Plaintiff must show that the misstatement caused the damage. If the
corporation issued an overly optimistic press release, for example, the
plaintiff must show that the statement raised the price of the security.
o The defendant could then try to rebut the claim with evidence that the
misstatement nonetheless did not contribute to the plaintiff’s loss.
• Scienter
o Plaintiff must show that the defendant acted with an intent to deceive,
manipulate, or defraud. Reckless disregard of falsity of statement will
satisfy this requirement too.
o Negligence does not suffice, though numerous subsequent lower court
decisions cases hold that recklessness does
Materiality
General standard of materiality?
o “whether there is a substantial likelihood that a reasonable shareholder
would consider the fact important” – TSC Indus., Inc. v. Northway Inc.
(1976)
But how do we apply when faced with uncertain and contingent
facts?
The SC takes “a highly fact-dependent probability/magnitude balancing
72
approach”based on the 2nd circuit rule in SEC v. Texas Gulf Sulphur [the
materiality of speculative events will depend at any given time upon a balancing
of both the indicated probability that the event will occur and the anticipated
magnitude of the event in light of the totality of the company activity.]
Short-form Merger
No shareholder approval needed
Board of parent corporation approves
Copy of articles of merger filed with Secretary of State and mailed to each
shareholder of subsidiary corporation
Parent must own at least 90% of each class of stock of the subsidiary
corporation
Give notice within 10 days of the effective date of the merger
Shareholders can seek statutory appraisal rights
73
o Santa Fe merged Kirby Lumber into itself (at $150/share) using the
Delaware short-form merger statute
No shareholder vote required
Shareholders can get appraisal rights
Shareholders claim fair price = $772
Plaintiffs claims merger violated Rule 10b-5 because:
o Merger was effected without prior notice to the minority shareholders and
was done without any legitimate business purpose
o Their shares had been unfairly undervalued
Were plaintiffs deceived?
o No omission or misstatement in merger documentation
o Plaintiffs are not claiming that they were lied to; rather, they are claiming a
breach of duty because the transaction was unfair
o Breach of fiduciary duty without fraud not a violation of Rule 10b-5
Manipulation
What is manipulation?
Practices that artificially affect market activity for the purpose of misleading
investors
Examples:
Wash sales
o Manipulator enters a purchase order and a sale order at the same time
through the same stockbroker
Ownership of the stock does not change but creates the
appearance of activity in a security
Matched orders
o Manipulator enters a purchase order with one stockbroker and a sale
order, at the same time and at the same price, with a different broker
Sometimes involves multiple manipulators acting together (so-
called “cross sales”)
Matched purchase and sale transactions create the false
appearance of active trading
74
o Once full and fair disclosure is made, the fairness of the transaction is a
non-issue under federal law
o Creating a federal cause of action here thus would not serve any of the
central purposes of the Act
Implied private right of action
o Courts generally should not create an implied federal cause of action
where the matter is one traditionally relegated to state law
o Here the conduct in question was a breach of fiduciary duty, a matter
clearly the subject of state corporate law
Federalism
o Allowing Rule 10b-5 to reach reach “transactions which constitute no more
than internal corporate mismanagement” would displace state law
o Corporations are creatures of state law
o Courts should not use Rule 10b-5 to preempt state corporate law
75
o The price paid to purchase an option
o What is the strike or exercise price?
o The price specified in the option contract at which the underlying stock can
be bought or sold
o The issuer of the option need not be the issuer or even a holder of the
stock itself
76
information in the first place.
o The fiduciary's undisclosed, self-serving use of a principal's information to
buy or sell securities, in breach of his duty of loyalty and confidentiality
owed to his principal, defrauds the principal of the exclusive use of that
information.
77
Big question: what can insiders do or not do with the stock of their firm, and
when can they do it?
o First question- who are insiders? The court refers to § 16(b)- what is that all
about?
§ 16 of the 1934 Act restricts the conduct of officers, directors and 10%
shareholders. §16(b) deals with short swing profits, a concept we will come back to.
Are insiders always prohibited from investing in their own company, because of
their access to inside information?
o Of course not. The court is very clear on this: insiders duty to abstain or disclose
ONLY arises “in those situations which are essentially extraordinary in nature and
which are reasonably certain to have substantial effect on the market price of the
security if [the extraordinary situation is] disclosed.”
When can an insider trade on inside information?
Insiders must wait to trade until the information has been effectively
disseminated, until the information is effectively disclosed in a manner sufficient to
insure its availability to the investing public. Thus, those who traded before the April
16th announcement
Where an insider violated
hasRule 10b-5. nonpublic information the insider
material
must either disclose such information before trading or abstain
from trading until the information has been disclosed
o So: if a company decides not to disclose (so that, for example, it can purchase land
cheaply), insiders must not buy stock.
o Where an insider has material nonpublic information the insider must either
disclose such information before trading or abstain from trading until the
information has been disclosed
78
o Civil penalties
o Criminal sanctions
Client
Chiarella
Chiarella Investor
Trade
o Foreshadowing of O’Hagan
o The government1
then argued the idea of misappropriation- that he
o The SC reversed the court
had violated a duty to ofthe
appeals andby
acquiror found no 10b-5 violation
misappropriating the
since Chiarella was The
information. not an insider
court of the
declined totarget.
hear that issue, since it had not
o Since been
there submitted
was no relationship
to the jury.at They
all, letdid
alone
takea itrelationship
up later on ofin trust
O’Hagan
between
whichthewe
target’s shareholders
will get to soon. and Chiarella, the target’s
o employee,
Problems he hadthe
from no Chiarella
duty to abstain or disclose.
holding: it’s hard to police tipees who
o “Not every instance of financial unfairness
trade on inside information, since the tipee has no constitutes
independent fiduciary
fraudulent activity
duty to the corporation. under Section 10(b)”
o From
o Dirks: “onlya some
SEC response: tipee persons, under
inherits the some obligation
fiduciary circumstances,to thewill be
barred from trading
shareholders while
whenever heinreceives
possession
insideof information
material nonpublic
from an insider.
information.”
Tipping
Insider
Corporation Investor
Tip
Trade
Tippee
1
Outsiders
o Outsiders [no relationship to the corporation] under O’Hagan have an abstain or
disclose duty when they are aware of material nonpublic information that they got
from a relationship of trust or confidence.
Tippees
o Both inside and outside traders who have this confidentiality duty can be liable as
participants in illegal trading if they knowingly make improper tips.
o So tippees are liable for trading after obtaining material, non public information
that he/she knows or has reason to know came from someone who breached a
duty of confidentiality
80
Dirks v. Securities & Exchange Commission
o In general, the tippee’s liability is derivative of the tipper’s, “arising from his role
as a participant after the fact in the insider’s breach of a fiduciary duty.”
o A tippee therefore can be held liable only when:
o The tipper breached a fiduciary duty by disclosing information to the
tippee, and
o The tippee knows or has reason to know of the breach of duty
o Supreme Court rejects the SEC view that anyone who obtains information from
an insider picks up the insider’s duty
o They divided people who receive inside information into 3 categories:
o Temporary FN 14 [to Dirks] insiders: lawyers and accountants who
enter into confidential relationships with corporations and are given access
to inside information for corporate purposes.
o Tipees who receive information from an insider/tipper in breach of the
insider/tipper’s duty to refrain from profiting on undisclosed information
and who expects that the tippee will buy/sell based on that information
o non-temporary insiders, non-tippees: this group can trade freely.
o Everybody else: non tippee non temporary insiders:
o Strangers with no relationship to the source of the material non public
information have no 10b-5 duty to abstain or disclose.
o Doesn’t matter whether they overhear the material non public information
or develop it themselves.
1. Why did the court absolve Secrist of wrongdoing?
o The Court views § 10(b) as an anti-fraud provision, not as a provision designed
more broadly to ensure that all participants in the market have equal access to
information or that there is a level playing field.
o There is no fraud, says the Court, because Secrist violated no fiduciary
duty in tipping.
o He violated no fiduciary duty because he received no personal benefit.
81
o If Secrist tipped Dirks out of revenge, whether S would have received a
benefit (and therefore violated a fiduciary duty) is less clear.
o If S carelessly discussed the fraud in the elevator, that would not
constitute a fiduciary duty breach under Dirks.
Rule 14e-3:
o Historical background: Chiarella and Dirks created significant gaps in
the insider trading prohibition’s coverage.
o Rule 14e-3 dealing with tender offers was the SEC’s immediate response
to Chiarella, but the rule’s scope is very limited. It is not triggered until the
offeror has taken substantial steps towards making the offer and, more
important, is limited to information relating to a tender offer.
o As a result, most types of inside information remained subject to the duty-
based analysis of Chiarella and its progeny.
o The misappropriation theory filled part of the gap, although it too is limited
in that it requires a breach of fiduciary duty before trading on inside
information becomes unlawful.
o It is not unlawful, for example, to trade on the basis of inadvertently
overheard information
Issues:
o Is a person who trades in securities for personal profit using confidential
Investor
information misappropriated in breach
OÕHagan
of fiduciary duty to the source of that
information liable under Rule 10b-5 and § 10(b)?
o Also, did the SEC exceed its rulemaking authority under § 14(e) by adopting rule
1
82
o The SEC had authority to adopt Rule 14e-3 as a prophylactic measure against
insider trading in connection with a tender offer.
o So is O'Hagan an insider trader or an outside trader?
o He is an outside trader in Pillsbury. He owed no duty to Pillsbury or its
shareholders. But he did owe a duty of trust and confidence to his law
firm, and to the firm's client.
o So the court says this misappropriation is properly the subject of a §10(b)
action since it meets the statutory requirement that there be deceptive
conduct in connection with securities transactions.
Tippers can be liable EVEN IF THEY DON’T TRADE, as long as a tippee down the
line eventually trades.
o Tipees: those with no confidentially duty will INHERIT an abstain or disclose duty
IF they knowingly trade on improper tips. If tippee knows or should know the info
came from a person who breached a duty in sharing, tippee is liable for trading.
Section 16(b)Ditto for sub tippees.
“any profit
o Who realized
are we NOT by [such
talking beneficial
about? owner, director, or officer]
from any purchaseo Strangers and sale, or any sale and purchase, of any equity
with no relationship to the source of the material, non public
security of such issuer . . . within any period of less than six
months . . . shall information
inure to – they
andhave
be NO duty to disclose
recoverable or abstain
by the issuer”and can freely
Insiders trade.
o The section
o Okay, backapplies only to officers,
to misappropriation: Under directors,
O’Hagan, weor seeshareholders
that there can be no
with more than 10% of ANY class of stock.
10b-5 insider trading liability if there is no breach of trust or confidence.
o This is a smaller group of insiders than under Rule 10b-5. (which covers
any “person”)
The statute
oSection applies to officers
6: SHORT-SWING PROFITS and directors if they are officers or
directors at either he purchase or sale;
o it applies to a 10% shareholder only if he or she held more than 10% at
Sectionboth16(a)
the purchase and the sale [which we will come back to in the
“Every person who is directly
Foremost-McKesson case in or indirectly
a few minutes]. the beneficial owner of
more
o No than 10 per
tipping centum
liability, of any class of liability,
no misappropriation any equity security . .insiders
no constructive . or
who is a director
– only TRUE insideror an officer of the issuer of such security . . . within
tenCompanies
days after the close of each calendar month . . . shall file with the
Commission
o The section . . . aapplies
statement onlyindicating
to firms that his must
ownership at the
register under closetheof
the calendar month and such changes in his ownership as have
1934 Act.
occurred during such calendar month”
o This, too, is a smaller group than under Rule 10b-5 which covers public
and private companies - covers all issuers
o § 12: companies must register under the 1934 Act...
If they have a class of stock trading on a national exchange, or
they have 500 or more shareholders and assets of at least $10
million
Under § 12(a), all securities traded on a national exchange need
to be registered [which triggers the periodic disclosure system,
proxy regulation, insider trading, take over regulation] 83
Section 16(b) (cont’d)
Equity securities:
The section applies only to equity securities and convertible debt.
Again, this is narrower than under Rule 10b-5 which covers any security
as defined in the statute, including investment contracts.
Maximize gains
Courts interpret the statute to maximize the gains the company
recovers - the court will match the highest and the lowest trade.
84
Reliance Electric Co. v. Emerson Electric Co.
So how did Emerson get rid of the Dodge stock?
After consulting with counsel, and as part of an integrated transaction, it sold
3.24% and then the remaining 9.96%, both within 6 months of the initial
purchase.
6/16: buys 13.2% [becoming an insider>10%]
8/28: sells 37,000 shares --- down to 9.96% [no longer an insider < 10%]
9/11: sells remaining 9.96%
What was the status of Emerson just before each transaction?
o NOT AN INSIDER on 6/16 when it buys 13.2%
o INSIDER on 8/28 when it sells 37,000 shares
o NOT AN INSIDER on 9/11 when it sells remaining 9.96%
85
purchase or immediately after the purchase?
Can we match Oct 20 acquisition with Oct 24 disposition? Is that Oct.20th a
matchable transaction?
o Note: This is issue left open in Reliance
Statutory issue: “This subsection shall not be construed to cover any
transaction where such beneficial owner was not such both at the time of the
purchase and sale, or the sale and purchase, of the security involved”
Holding?
o In a purchase-sale sequence, the transaction by which the shareholder
crosses the 10% threshold is not a matchable purchase
o Only purchases effected after one becomes a 10% shareholder are
matchable
Indemnification
Saying a director is not liable for X gets you to the same place as saying that the
director is liable for X but that the corporation will indemnify the director against
X.
Saying a director is not liable for X likewise gets you to the same place as buying
insurance against that liability.
86
personal benefit
Noteworthy Points
o Applies only to directors.
Although officers also are subject to a duty of care, they are denied
exculpation by charter provision.
• Arnold v. Society for Savings Bancorp, Inc. (Del.): As to a
defendant who is both a director and an officer, a §102(b)(7)
provision applies only to actions taken solely in his capacity
as a director.
o Limits only the monetary liability of directors—equitable remedies are still
available
o A §102(b)(7) provision is an affirmative defense for a suit for breach of
duty
Shareholder Meetings
• Annual: at a time a place proscribed in the bylaws; the shareholders vote on
matters such as electing directors. Most corporate statutes require that a
corporation hold a shareholders meeting at least annually.
o MBCA § 7.01
• Special: outside the ordinary schedule of meetings.
o MBCA § 7.02
• voting lists: prepared by the corporation prior to each shareholders’ meeting.
• record date: cut off date for ownership determination
• notice:
o written announcement that is sent a reasonable length of time prior to the
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date of the meeting.
o Notice of the special meetings must include a statement of the purpose of
the meeting; business transacted is limited to the stated purpose.
• resolutions:
o corporate business matters are presented in the form of resolutions, which
shareholders vote to approve or disapprove.
Practical reality: action without a meeting
• Typical Annual Meeting
o Nominating committee of the incumbent board of directors nominates a
slate of directors to be elected at next annual meeting
o Incumbent board identifies other issues to be put to vote
o At company expense:
Management prepares proxy statement and card
Management solicits shareholder votes (typically with aid of proxy
solicitor)
• Voting at annual (or special) meetings
o Most matters require a majority of shares present at a meeting at which
there is a quorum
o quorum: the minimum number of shareholders required to transact
business. This is usually satisfied by the presence, in person or by proxy,
of 50% of the outstanding shares present, either in person or by proxy.
o simple v. super majority: at times, more than a simple majority will be
required either by statute or by the corporate charter. Typical examples
include mergers and dissolution and charter amendments.
o What is cumulative voting?
a method of voting designed to allow minority shareholders
representation on the board of directors. When cumulative voting is
permitted or required, the number of members of the board of
directors to be elected is multiplied by the total number of voting
shares.
The result equals the number of votes a shareholder has and this
total can be cast for one or more nominees for directors. All
nominees stand for election at the same time. When cumulative
voting is not required either by statute or under the articles of
incorporation, the entire board can be elected by a majority of
shares at a shareholders’ meeting.
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Example: a corporation has 10,000 shares issued and outstanding.
The minority shareholders hold only 3,000 shares, and the majority
shareholders hold the other 7,000 shares. Three members of the
board are to be elected. The majority shareholders’ nominees are
Allan, Burns and Caleb. The minority shareholders’ nominees is
Davis.
Can Davis be elected to the board by the minority shareholders?
• If cumulative voting is not allowed, the answer is no.
• If cumulative voting is allowed, the answer is yes. The
minority shareholders have 9,000 votes among them [the
number of directors to be elected times the number of
shares equals 3 times 3,000 which totals 9,000 votes].
• All of these votes can be cast to elect Davis. The majority
shareholders have 21,000 votes [3 times 7,000 = 21,000
votes], but these votes have to be distributed among their
three nominees.
The principle of cumulative voting is that no matter how the
majority shareholders cast their votes, they will not be able to
elect all three directors if the minority shareholders cast all of
their 9,000 votes for Davis.
o Proxies: a shareholder (as principal) can appoint someone else (as
agent) to vote on his or her behalf at the shareholders’ meeting. Because
it is not usually practical for owners of only a few shares of stock to attend
shareholders meetings, such shareholders normally give third parties
written authorization to vote their shares at the meeting.
As a practical matter, they are necessary to insure a quorum.
o Proxy voting:
Shareholder appoints a proxy (a.k.a. proxy agent) to vote his/her
shares at the meeting
Appointment effected by means of a proxy (a.k.a. proxy card)
• Can specify how shares to be voted or give agent discretion
• Revocable
o Proxy contests
A shareholder (a.k.a. the insurgent) solicits votes in opposition
to the incumbent board of directors
• Electoral contests: Insurgent runs a slate of directors in
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opposition to slate nominated by incumbent board
• Issue contests: Shareholder solicits votes against some
proposal
What is a Solicitation?
• “Solicit” includes not only “direct requests to furnish, revoke or withhold proxies,
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but also ... communications which may indirectly accomplish such a result or
constitute a step in a chain of communications designed ultimately to accomplish
such a result.”—Long Island Lighting Co. v. Barbash, 779 F.2d 793, 796 (2d
Cir.1985).
• Rule 14a-1(l)(2)(iv) exempts public statements of how the shareholder intends to
vote and its reasons for doing so
• Rule 14a-2(b)(1), subject to numerous exceptions, exempts persons who do not
seek "the power to act as proxy for a security holder" and do not furnish or solicit
"a form of revocation, abstention, consent or authorization”
o Consequently, for example, a newspaper editorial advising a vote against
incumbent managers is now definitively exempted
Proxy Statement: a document in which the solicitor discloses information that may be
relevant to the decision the shareholder must make: annual report; disclosure of conflict
of interests; issues that solicitor plans to raise at the meeting
What goes into a proxy statement?
• Information about the meeting
• Background information directly related to issues to be voted on
o Biographical information about candidates for director vacancies
o Financial data about merger partners (if any)
Other proxy statement rules
• Rule 14a-6(b) re filing with SEC: solicitors must file proxy materials with the SEC
• Rule 14a-7 re mailing: management gets a choice: mail the materials for the
solicitor, at solicitor’s cost, or provide a list of shareholders.
• Rule 14a-9 re fraud
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1 essay with four parts
first 16
second 10
third 12
fourth 12
limit of 4500 characters each.
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