I.

Business Organizations Rules Outline Types of Business Organizations A. Sole proprietorship: one person owns the business, one person manages the business, and one person conducts the business 1. BLD: A business in which one person owns all the assets, owes all the liabilities, and operates his/her personal capacity 2.Sole proprietorship can be incorporated. B. General partnership: 2 or more people plan to share profit/losses and share ownership/control. DO not need to file anything to get general partnership. 1. BLD: A partnership in which all partners participate fully in running the business and share equally in profits & losses (though the partners monetary contributions may vary) C. Limited partnership (LP): Need to file form with Secretary of State stating that you intend to form LP. 1. BLD: A partnership composed on one or more persons who control the business and are personally liable for the partnerships debts (called general partners), and one or more persons who contribute capital and share profits but who cannot manage the business and are liable only for the amt of their contribution (called limited partners). a. General partner can be corp or real person 2. Characteristics: a. Investors have limited liability. Limited partner will not lose his/her personal assets but, instead, will lose the persons investment into corp. b. Need at least 1 general partner, who agrees to incur personal liability. D. Limited Liability Partnership (LLP): Need to file a form with Secretary of State stating that u intend to form LLP. (LLP is growing form of bus org) 1. Difference b/w LLP & LP: NO general partner is need for LLP, but is required for LP. Partners in LLP are limited partners 2. Advantage that LP has over LLP: More established law dealing with LP, so u know the roles and responsibilities of LP more clearly than with LLP. E. Corporations: are artificial creations that are formed to make money for the people who own the corp. Corporations form to avoid liability 1. BLD of corporation: An entity (usually a business) having authority under law to act as a single person distinct from the shareholders who own it and having rights to issue stock and exist indefinitely 2. Corporation is a separate person (stemmed from 14th A DPC) a. People apply for a charter to get corp & that corp acts legally as a person. When corp goes for charter, it is state that gives corp power; thus, people of US are ones giving corps power they hold. After filing, corp will get certificate of incorporation. Then, 1st organizational meeting will be held & Bd of Directors will appoint officers & draft constitution establishing internal relationships with Bd of Directors & shareholders & internal relationship with Bd of Directors & officers, & other rules, such as how many bd of directors, how often will bd of directors meet, etc. b. Corps can borrow $, can sue in ct, can enter Ks, own prop b/c corp is a separate person. c. Corp is special person b/c corp is ONLY designed to make profits for shareholders. 3. 4 characteristics of corporations (Corps MUST have ALL 4 characteristics to be corp) a. Limited liability: Shareholders have limited liability, which means that shareholders are ONLY liable to extent that he/she invested w/in corp. Shareholders are NOT held personally liable in breach of K or tort cases. b. Free transferability of shares: shares are freely transferable; this means there is a market for transferring of the shares. i. 2 situations where corporate shares are NOT completely transferable: 1

II.

III.

1.If there is a small closely held corp, there would be no market for these shares AND 2.If P holds shares that are not profitable, but could have been profitable if corp was run better. (remember: Board of Directors manages corp-> centralization of management). c. Continuity of existence: NO matter what happens, corp will continue to exist until it is orally dissolved and state corp law provides for process of dissolution. i. Thus, even if there is a small corp with one person and that one person dies, the corp will continue to exist because the corporation, itself, is an individual person. Death of owners/shareholders does NOT terminate entity, since shares can be transferred. d. Idea of centralized management: NOT everybody gets to manage corp & management of corp is centralized. Management is centralized with officers & directors. Each is charged by law with specific duties to corp & its shareholders 4. Doc of birth for corp: article of incorporation 5.Once corp is born, doc called bylaws is drafted which governing rights of parties 6.People who invest in corp=shareholders 7.Interest investors purchase in corp=stock F. Limited Liability Company (LLC): new bus org that is a limited company (most comparable to corp) 1. LLC investor=member. Members have limited liability (liable only to the extent of percentage of interest in company) 2. LLC provides limited partners with limited liability & 1 person is elected as general partner, who will incur personal liability. a. Note: General partner can either be real person or corp 3. LLC may have 2 characteristics of corporation BUT NO more than 2 of these characteristics. This, LLC can have: a. Limited liability only b. Limited liability + free transferability of shares c. Limited liability + continuity of existence d. Limited liability + idea of centralized management 4.Doc of birth for LLC: article of organization 5. Once LLC is born, doc called operating agreement is drafted which governing rights of parties. 6.People who invest in LLCs= members 7.Interest investors purchase in LLC=LLC interest 8.Types of LLC a. Manager managed LLC: have bd of managers who does management. Management is centralized as does corp. Most analogous to corps. b. Member managed LLC: Most analogous to general partnership. Each member can participate in management. Types of sectors A. Public sector: government B. Private sector: companies 1.Private sector within private sector=public corporation a. Public corporation is a type of corporation where the shares are sold amongst the public and has public shareholders. Public corps are part of the private sectors. Terminology A. Insiders: work for corp & serve as directors 1. Inside directors: serve on bd and work for bd as officers B. Outsiders are bd members but do NOT work for co 1. Outside directors: ONLY serve on bd and do NOT work for corp (NOT officers). NOT all outside directors are independent. Might have outside director that does bus with corp or 2

IV.

serves as consultant. If there is some relationship b/w corp and outside director, then not independent C. Independent: No relationship with co D. Interested: Interested is more narrow than independent. Asks: Does this person have financial interest in the transaction 1. Self interest: direct financial interest or control E. Leverage buyout: a purchase of co financed by relatively small amt of equity (common stock) & large amt of debt, which provides leverage. Often, assets of co are sold to pay off part of debt. F. Market value of co: price of each share of stock G. Stock: equity in co. Stockholder is ONLY paid when co makes profit. Interest depends on future of co. 1. Different classes of stock: Class A stock will have certain rights that favor Class A stock over Class B stock. H. Notes & bonds: promises to the corp where they agree to give specific amt of money at specific date. Bond diametrically opposes the idea of equity & stock. Notes & bonds are a kind of debt. I. Preferred Stock: hybrid of equity & debt. Once co is dissolved & upon that liquidation, debt holders are paid first, then preferred stockholder, and lastly, common stockholders are paid. Preferred stockholders are still NOT debt holders. Stockholder w/ preferred stock is preferred over common shareholder/stockholder, but NOT as preferred as debt holders. 1. Ex: preferred stockholders in Benihana case 2.Preferred stockholders do NOT usually have voting rights unless something happened, such as they have not been paid dividends from time after time. Sometimes, terms will allow preferred to gain voting rights. 3.Preferred shareholders receive income in form of dividends. J. Common stockholder: shareholders typically with the voting rights. Common stockholders are the last ones to receive assets/funds from liquidation. K. Conversion: Idea that one security can be exchanged for another, i.e., common stock for another co. Most instances convertible bond or convertible preferred share is convertible in same stock of same co. 1. Act of conversion: decision to be made of holder of stock/bond that is convertible (when & where to convert) 2. Terms of what is to be converted: set at time that convertible security was issued. L. Redemption: right of co to re-purchase its own shares or call shares in. 1.Co has right of redemption. M. 2 types of options: 1. Puts: right to sell security 2. Call: right to buy security N. Closely held corporations: 1 primary reason for investing in closely held corp to work for co & to get return on investment. Dividends might not be issue in closely held corp. As long as person works for co, then dividends might not be issue because that person would be getting salary (get return on investment because they are getting earnings in return). 1. Problem with closely held corps: investors know each other. By definition, investors are not on exchange (market is only for publicly held co). Thus, in publicly held co, they can buy & sell shares BUT no one in closely held co buys & sells shares O. Book value: accounting net worth of corp, divided by number of shares outstanding (seen in Jordan case) Nature and Purpose of Corporation A. 4 characteristics of corp: (look above) 1.Limited liability 2.Free transferability of shares 3

3.Continuity of existence 4.Idea of centralized management B. Types of people involved in corp 1. Shareholders: person who invests in corp (holds/owns share(s)) a. Equity: As shareholder, shareholder has equity in corp. Shareholder will ONLY benefit if corp is successful. b. Shareholders elect the directors as decision makers for corps (decisions supposed to be in best interest of corp NOT individual interest of directors). 2. Board of Directors: ultimate managers of the corp; set policies, monitor compliance of laws, responsible for big decisions of co, responsible for identifying & appointing officers, who operate corp from day to day a. BLD: The governing body of corp, elected by the shareholders to establish corporate policy, appoint executive officers, and make major business and financial decisions 3. Officers: people operating/monitoring day to day operations of corp a. BLD: A person elected or appointed by the Board of Directors to manage the daily operations of a corp, such as a CEO, president, secretary, or treasurer 4. What about employees who work for corp or consumers or suppliers or creditors? 2 views: a. 1st view: Corporation includes 3 constituents; these include officers, board of directors, & shareholders. This is called contractarianism. b. 2nd view: Corp includes 3 constituents, but also need to include creditors, consumers, suppliers, and employees Officers and directors make decisions & these decisions impact non-shareholder group. This is called communitarianism: corps cannot operate without non-shareholder groups (employees, consumers, suppliers, and creditors). i. 1 argument is that one way to maximize profits is to practice communiatrianism. If u do well by these non-shareholder groups by treating them well, in long run, it will be good for shareholders. c. RULE: Corp may consider all those affected, including non-shareholder groups, but must ultimately serve needs of shareholders (most maximize shareholders profits). C. Role and Purpose of corp: To maximize profit/wealth of shareholders. 1.Managers (bd of directors) manage corp in best interests of corp & shareholders in order to maximize profits. 2. Corp is allowed to make charitable donations but limited to reasonable contributions AND need to be in best interest of corp AND CANNOT be pet charity or pet donation or donation that is made b/c CEO believes in this org (A.P. Smith Mfg Co v. Barlow (NJ case)). a. 1 of power of corps=power to make donations b. Charitable donations benefit corps b/c companies make donation in order to promote good will (public relations-> corps name gets out); AND presuming charities are good for US, then donating to charities is good thing for US & corp benefits b/c corp is a citizen of US (Corp benefits when country benefits). i. Thus, by donating $, corp as citizen of US is promoting US to be better society c. Shareholders position in opposition of charitable donation in A.P. Smith Mfg Co: Elephant bumping: fundraiser for corp always takes an elephant with him when fundraiser goes to call on another elephant. And soliciting elephant, as fundraiser goes though little pitch, nods and receiving elephant listens attentively, and as long as visiting elephant is appropriate large, then fundraiser gets $$. i. Note: $ that these CEOS is donating to charities is not coming out of their pockets b/c if it would be an individual CEOs donation &NOT from corp. Need to make corp look good, so donation comes from corp to promote corps rep NOT individual CEOs rep. 4

d. Different state laws for charitable donations: Basic rule of corporate choice of law in all states is that the law of the state corp controls on issues relating to corps internal affairs. i. DE statute: Every corp created under this chapter shall have the power to . . . (9) Make donation for the public welfare or for charitable, scientific or educational purposes, and in time of war or other national emergency in aid thereof . . . . 1. DE statue states that charitable donations are OK BUT statute does NOT say anything about charitable donation having to benefit corp in addition to benefitting beneficiary. ii. C/L: A.P. Smith Mfg Co case provides C/L rule that charitable donation has to have benefit for corp; cannot be pet donation; and needs to be reasonable donation. iii. NY: general powers of corps, the power to make donations, irrespective of corporate benefit, for the public welfare or for community fund, hospital, charitable, educational, scientific, civic or similar purposes, and in time of war or other national emergency in aid thereof. a. NY statute states that corp can make charitable benefit, but dont care about corp benefit iv. CA: gives corps the power to make donations, regardless of specific corporate benefit, for the public welfare or for community fund, hospital, charitable, educational, scientific, civic or similar purposes. a. CA statute states that corp can make charitable benefit, but dont care about corp benefit. v. PA statute: provides, as part of its rules on duties of directors, that directors may, in considering the best interests of the corp, consider the effects of their actions on any or all groups affected by such actions, including shareholders, employees, suppliers, customers and creditors of the corp, and upon communities in which offices or other establishments of the corp are located. This provision then goes further by providing that the directors shall NOT be required, in considering the best interests of the corp or the effects of any action, to regard any corporate interest or interests of any particular group affected by such action as dominant or controlling interest or factor. a. PA statute says when considering whether to close the factory, may also consider the interests of corp and the non-shareholders, such as employees, suppliers, creditors, and consumers. This is communitarianism view. 3. Deference of judges: judges are not bus experts, cts are going to defer to a controlling shareholder, bd of directors, & officers b/c they are the bus experts. Ct will NOT interfere with bus decisions UNLESS issue deals with something shareholders were receiving from start of corp, such as special dividends (as seen in Dodge v. Ford Motor Co (Mich case)). a. Note: Usually decision about dividends is up to bd of directors, NOT ct. But, here Dodge trying to prohibit Ford brothers from profiting from Ford via special dividends and using these special dividends for Dodge company competing with Ford. b. RULE: Bd of directors alone has power to declare a dividend and to determine its amount, cts will defer to bus judgment of bd of directors unless decision seems capricious or arbitrary, as seen with special dividends in Dodge v. Ford Motor Co. c. Business Judgment Rule: Cts will not substitute their judgment for bd of directors; it will defer unless fraud, illegality or conflict of interest is shown (rule cited in Shlensky v. Wrigley (Ill case)). (Ct in Shlensky stated tat Wrigley did NOT breach fiduciary duty b/c there was no fraud, illegality, or conflict of interest). d. Rule: when P, minority shareholder, is arguing that judgment of director is bad, need concrete ev/facts to show that with installation of Ps idea, shareholders wealth would be maximized. i. For ex, Shlensky did not present concrete ev/facts to show that installation of lights on the baseball field would have been profitable. P here should have forced D to present 5

ev that only having day games was profitable; and this would have shown that Wrigley failed to analyze that having only day games was profitable & in best interests of corp; this would have shown breach of Wrigleys fiduciary duty. e. Note: Both Dodge and Wrigley did not care about maximization of shareholders profits. f. Two Standards of Evaluation of the bus judgment rule: i. Dodge subjective state of mind of CEO considered ii. Schlensky look at objective reality of circumstances. 1. Ex of Schlensky objective reality, hypo on pg 8: if u treat consumers & employees well, that is better for long-term financial interest of shareholders & corp D. Promoters and Corporate Entity: deals with Ks entered into before incorporation of corp. 1. In Southern-Gulf Marine Co No. 9, Inc. v. Camcraft, Inc. (La case), K for sale of vessel had been signed by Mr. Dudley Brown, as Pres of Camcraft, Inc. and by Mr. D.W. Barrett, both individually and as Pres of SGM b/c SGM was NOT incorporated at time K was made. B/c value of vessel had gone up, ct decided as matter of equity that SGM should win. a. If parties enter a K before corp has formally been formed, then the parties may still be treated as corp as a matter of equity. B/c Camcraft acted as if they were dealing with a corp, would not be allowed to get out of it for technicality. Thus, there are equity principles for Ks that occur pre-incorporation. b. When P enters into K with corp; need to make sure that corp exists and make sure that corp has enough capital to cover a judgment (if the corp does NOT have enough capital, then u need to get a written personal guarantee that P can recover by holding account person personally liable) c. If corp is NOT incorporated at time K was made, then enter into the K, but ask to hold person personally liable. Then, once corp is properly formed & incorporated, then personal liability is terminated & corp becomes liable. 2.Important Rules: a. RULE: If it can be shown that there is a de facto corp or corp by estoppel, shareholder is granted limited liability and corporate veil will apply. b. RULE: Promoter owes fiduciary duty to Corp 3.Types of corporations a. De jure corp: corp organized under laws of particular state. i. De jure corp: A corp that has complied strictly with all of the mandatory provisions for incorporation CANNOT be attached by any party (even the state). b. De facto corp: corp that is not formed pursuant to any law, but ct treats entity as corp b/c of facts and circumstances. i. When applying de facto corp, need to look at facts at perspective of organizer of promoters (in SGM case, it was SGM); what were the organizers thinking. ii. To become a de factor corp, need to ask: 1.Whether organizer (Barrett of SGM here) had legal right to incorporate entity (for ex, there is no legal right to incorporate if corp will be involved in illegal activity); 2. Organizer needs to show that organizer made a good faith effort to incorporate; and 3.Organizer acted as though the corp was a corp all along 4. Applied to SGM case, Barrett did all 3 & corp could have been considered a de facto corp. c. Corporation by estoppels doctrine: Person who contracts w/entity he treats as corp is estopped from denying corp existence later i. When a corp is NOT given de jure or even de facto status, its existence as a corp may be attacked by any 3rd party. However, there are situations where cts will hold that attacking party is estopped to treat the entity as other than a corp. 6

When applying doctrine of corp by estoppel, need to look at facts from perspective dealing w/ entity that did not incorporate correctly (in SGM case, it would be Camcraft) iii. Need to ask: 1. Person dealing with corp thought it was dealing with corp all along (in SGM case, Camcraft acted as if it was working with corp all along); and 2. If person dealing with corp is allowed to argue that it is a not a de jure corp, then that person would be enjoined a benefit/windfall. In SGM case, Camcraft would earn a windfall/benefit b/c it would sell vessel at higher price (value of vessel had gone up during transaction) 3. In SGM case, this is why Camcraft had been stopped from arguing that SGMA was not a de jure corp & SGM could not get out of K. d. Objective of de facto corp & corp by estoppel is the same. Objective is to argue that, even though corp is not de jure corp, corp might still be considered a corp under either de facto corp doctrine or corp by estoppel doctrine. i. Legal significance: Ultimate objective is to establish limited liability. When shareholder invests in corp, shareholder will only incur limited liability to that persons investment in corp & will NOT be held personally liable, meaning that personal assets are protected. e. Note: Do not need to establish de facto corp 1st to apply corp by estoppel doctrine f. Note: One does NOT need both de facto corp & corp by estoppels. E. Corporate Entity and Limited Liability 1. Business Diagram: circles are for flesh and blood individuals, squares are for corp. 2. Piercing corporate veil (aka alter ego): P is suing individual shareholder individually & holding shareholder personally liable. Piercing the corporate veil destroys vertical boundaries. Once these boundaries are pierced, then P can reach D individually for personal liability. When the ct holds that shareholder is personally liable, then P has pierced corporate veil. a. Ex of piercing corporate veil case=Walkovsky v. Carlton (NY case) i. Ct held that Cartlon did NOT operate in its individual capacity & P failed to prove that Carlton used these companies as alter egos (did not pierce corporate veil) or for his personal purposes . Here, Carlton observed corporate formalities; reason why P lost. ii. Inadequate insurance and assets are not enough to pierce corporate veil. And NO fraud was found in Walkovsky case. iii. Note: Carlton did not sue under enterprise liability. b. BLD: The judicial act of imposing personal liability on o/w immune corporate officers, directors, or shareholders for the corps wrongful acts. c. Piercing corporate veil is an equity concept. Fraud or promote injustice is element to prove piercing corporate veil. d. If P pierces corporate veil, then P becomes shareholder /stockholder in the other corps owned by D shareholder (meaning P now has stocks in those corps. As a shareholder, P would ONLY benefit if companies make profits. e. Piercing corporate veil is an exception to limited liability. f. NY: i. In NY, to pierce the corporate veil, need to prove fraud or some injustice. In vast majority of cts, need to prove fraud to pierce corporate veil. ii. In NY, P may be able to pierce the corporate veil if individual does NOT follow corporate formalities. i. decisions are being made for their benefit and NOT the entitys.

ii.

g. Undercapitalization: Prime condition for piercing exists when corp is undercapitalized given liabilities, debts, & risk it reasonably could be expected to incur. Walkovszky case: ex showing that liability insurance as ev of undercapitalization. h. Two part test for piercing corporate veil from Sea Land Services, Inc. v. Pepper Source (Illinois test BUT most jurisdictions apply this 2 part test) (Van Dorn test): i. First, there must be such unity of interest & ownership that the separate personalities of corp & individual [or other corp] no longer exist (unity of interest & ownership b/w individual shareholder (In Sea-Land case, Marchese) and the corp who breached K (In Sea-Land case, Pepper Source)). This has to be shown by P; AND ii. Second, circumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice (showing of piercing the corporate veil would show a fraud or promote injustice). P must prove this. iii. P MUST show both prongs. iv. If have strong case of unity of interest and ownership can overcome a weak argument of fraud and vice versa. In practical matter, the factors all overlap. v. To show #1: there are 4 factors (for determining whether a corp is so controlled by another to justify disregarding their separate entities): 1.The failure to maintain adequate corporate records or to comply with corporate formalities (complying with corporate formalities); 2.The commingling of funds or assets (commingling of funds b/w the individual shareholders and the corp being sued); 3.Undercapitalization; AND 4.One corp treating the assets of another cop as its own (If there is more than 1 co is owned by individual whose personal assets at risk, has that individual shuffled funds among these co) 5.Note: DO NOT need to prove all 4. The more proven, the stronger the argument. vi. To show #2: P MUST prevent evidence of such wrong (fraud or injustice). 1. Unsatisfied judgment is NOT enough to show fraud or injustice to pierce corporate veil. These Ps are coming to ct b/c of the unsatisfied judgment. Fraud & injustice is much more than an unsatisfied judgment. i. Alter ego theory makes a parent liable for actions of a subsidiary, which it controls, but it does NOT mean that where a parent controls several subsidiaries, each subsidiary then become sliable for the actions of all other subsidiaries. There is NO respondent superior b/w subagents. (from Roman Catholic Archbishop of San Francisco v. Sheffield (CA case)) i. Thus, if there is parent co that owns more than 1 subsidiary, it does not mean that other subsidiaries will be liable even if 1 subsidiary is liable under piercing corporate veil. ii. Remember: Even if parent corp would be liable if 1 of those subsidiaries is liable, piercing corp does not get to assets to subsidiaries, Ps need to argue reverse piercing or enterprise liability. j. Note: When talking about piercing corporate veil, been talking about small closely held corp. Enron was large publicly held co. The veil of a large publicly held co is NEVER pierced. Piercing corporate veil ONLY occurs when dealing w/ closely held co. i. In bankruptcy, shareholders get NOTHING. Any of funds raised on liquidation goes to creditors, NOT shareholders. k. Whether issue of veil-piercing can be resolved by SJ: Ct in In re Silicone Gel Breast Implants Products Liability (Alabama case) held yes. Ordinarily, fact-intensive nature of issue will require that it be resolved only through a trial. SJ can be proper if ev presented could lead to but 1 result. 8

Ct in In re Silicone Gel Breast Implants Products Liability held that need to look at totality of circumstances in determining whether a subsidiary may be found to be the alter ego or mere instrumentality of parent corp. Ct listed factors to consider; these include: (the 1st 5 apply to any parent-subsidiary relationship) 1.Whether parent and subsidiary have common directors or officers 2.Whether parent and subsidiary have common bus depts. 3.Whether parent & subsidiary file consolidated financial statements & tax returns 4.Whether parent finances subsidiary 5.Whether parent caused incorporation of subsidiary 6.Whether subsidiary operates with grossly inadequate capital 7.Whether parent pays the salaries and other expenses of subsidiary 8.Whether subsidiary receives no bus except that given to it by parent 9.Whether parent uses subsidiarys prop as its own 10. Whether daily operations of 2 corps are NOT kept separate 11. Whether subsidiary does not observe basic corporate formalities, such as keeping separate books and records and holding shareholder and bd meetings. 3.Reverse piercing: a. Ex case arguing first piercing corporate veil and then reverse piercing=Sea-Land Services, Inc. v. Pepper Source i. Ct held that SeaLand (P) won. Corporate veil was pierced. 4 factors applied: 1. No corporate formalities (no meetings); 2. Commingling of funds-> M used corporate funds for personal needs; 3. PS has no assets; 4. M did shuffle funds 1. Note: 1 bank account, 1 office would show enterprise liability NOT piercing the corporate veil. b. Once P pierces corporate veil to impose liability on D shareholder, then P could argue reverse piercing. In reverse piercing, P can get to assets of other corps. P is treated as a creditor in reverse piercing and NOT as a stock holder. 1st people to get paid when companies make money are the creditors. If u hold a debt (a creditor of company), u have a promise to be paid a speicic amt of money in some pt of the future. c. In order to show reverse piercing of other cos veils, need to apply 2 part test of Van Dorn in the perspective of other 3 companies. i. Note: CANNOT argue piercing the corporate veil and then argue enterprise liability. d. Note: Reverse piercing and piercing corporate veil show a difference b/w equity & debt. 4. Enterprise Liability: when sole shareholder fails to treat all corps as separate companies, but instead, treats them all as 1 enterprise. NEED to show fraud. a. If P wins, all corps are then liable under enterprise liability. b. Enterprise liability destroys the horizontal boundaries and allows P to get to assets of all the corps BUT not the personal assets of D, sole shareholder. c. Enterprise liability is an equity concept. d. NY: P needs to show fraud to prove enterprise liability. Vast majority of cts have this rule. e. Argument: Under enterprise liability, shareholder treated all corps as 1. f. Note: P could have argued enterprise liability instead of piercing corporate veil & reverse piercing in Sea-Land Services v. Pepper Source. g. Question: Does P become creditor in enterprise liability like in reverse piercing? i. NO. In reverse piercing, need to pierce corporate veil. Once the corporate veil is pierced, then P can hold D personally liable. Once that happens, P becomes creditor and then reverse piercing can be applied. BUT, in enterprise liability, P never becomes creditor. Applying different analysis for enterprise liability. For enterprise 9

i.

liability, need to determine whether several corps are being run as 1 co, if that is happening, then Ps can reach assets. 5. Agency theory: P would have to establish that D as master/principal controls that co so much that he used this co to further his own business. Whether D treated co as an agent. a. If P is able to satisfy agent theory, then P can get to personal assets of D shareholder. 6. Difference b/w piercing the corporate veil, enterprise liability, & agency theory: The language used to get to the result is different. Result of piercing the veil and agency theory leads to the same result (P reaches the shareholders assets), BUT enterprise liability gets a different result (P reaches the assets of corps owned by the shareholder). Enterprise liability and reverse piercing get to the same result. 7. There might be differences depending on who the creditor is (either tort or K creditor). For ex, Walkovszky was a tort creditor, while Marchese in SeaLand case was a K creditor. Difference b/w K and tort creditors is that K creditor gets to research/investigate the credit of the borrower, and if K is breached, it will be limited to the assets of the corp (should have known that there were not enough assets in the borrowers corp). In addition, K creditor can ask for certain thing s to ensure that creditor will be paid (ask for personal guarantee on the debt from the borrower). If tort creditor, will only get the money of the corp, if corp has enough assets. If they do not have enough assets to cover the suit, it seems as if the D is unjustly enriched as opposed to the K creditors. a. Some factors matter more & which factors matter more differ w/ who creditor is (K or tort creditor): i. For tort creditor, need to emphasize as lawyer, most relevant that company was undercapitalized. That argument would not work as much for K creditor b/c he assumed the risk in making that K with borrower 1. Argument: Was company adequately capitalized? Would also have to apply piercing corporate veil test. Ask whether there was a unity of interest of ownership & interest. Would it sanction fraud or injustice. Would look at all factors, but would emphasize other aspects, i.e., capitalization that would weigh much more heavily than in a K case. ii. For K creditor, need to emphasize corporate formalities. Fraud aspect is also very relevant for K creditors. Ask whether borrower is going to breach K or not (will have to investigate creditor worthiness of borrower-> what prop does borrower own). 1.If there is no fraud & K creditor entered into K, then creditor assumed risk that borrower would NOT repay loan. 2. Major difference b/w tort and K cases is that in K cases, P had an opportunity in advance to investigate financial resources of corp and had then chosen to do bus w/ it. Thus, in K cases, intention of parties & knowledge of risks assumed in entering into K are factors to be assessed in making determination as to whether corporate veil should be pierced. iii. In re Silicone Gel Breast Implants Products Liability articulates difference b/w tort & K case. 1st thing need to do is determine whether creditor is K or tort creditor. 8. Parent corporation v. Subsidiary: A corporation owns all shares of common stock of another corp. 1st corp is generally referred to as parent corporation and 2nd as subsidiary. Parent corp is any co that owns 50% or more of the voting share of the subsidiary, which is what the other co is called. a. Why would parent choose this form of org rather than simply run all its activities out of a single corp w/ divisions for separate activities? One reason is generally the parent, like any other shareholder, is not liable for the debts of the subsidiary, so parent can undertake an activity without putting at risk its own assets, beyond those it decides to commit to the subsidiary. Like an individual shareholder, however, a corporate shareholder must be aware of the danger that if it is not careful, the creditors of the subsidiary may be able to 10

pierce the corporate veil of the subsidiary. The parent must also be careful not to become directly liable by virtue of its participation in the activities of the subsidiary. 9. General Partners v. Limited partners: (Frigidiare Sales Corp v. Union Properties, Inc. (Wash case) dealt w/ this & talked about role differentiation & importance of following corporate formalities) a. General partners: personally liable for any debts that partnership has. K/Tort creditor can go after not only assets of partnership, but also personal assets of partner i. RULE: General partner is personally liable, jointly or severarlly, for debts of partnership b. Limited partners: have at least 1 general partner (personally liable) and rest of partners enjoy limited liability. Would confer limited liability to partners, but would also allow for tort/K claimer to be able to look towards personal assets of one of members of partnership (general partner). c. Rule: Once a limited partner engages in management of partnership, limited partner becomes a general partner, which means he/she no longer enjoys limited liability, but can be held personally liable. i. RULE: Limited partners are not personally liable, but may become liable if engage in management of partnership; only limited as long as they are passive ii. Note: All states now allow general partner to be a corp. Rules have been put in place so that no flesh and blood person would be personally liable. iii. Note: Every limited partnership must have at least one general partner F. Shareholder Derivative Actions (Procedural aspect of Derivative Suit) 1.Direct v. Derivative suits: a. Direct suit: suit where shareholder suffering direct harm. harm is to shareholder, him/herself NOT to corp. i. BLD: A lawsuit to enforce a shareholders rights against a corp. ii. Ex of direct suits: class action and individual action iii. Ex of direct suit: Eisenberg v. Flying Tiger Line. Inc., where NY ct held that voting right is about harm to shareholder himself NOT corp. iv. Abdication claim is direct suit according to ct in Grimes v. Donald b. Derivative suit: suit where shareholders are indirectly harmed, it was corp that was directly harmed. Harm is to corp. i. BLD: A suit by a beneficiary of a fiduciary to enforce a right belonging to the fiduciary; esp., a suit asserted by a shareholder on corps behalf against third party (usually a corporate officer) b/c of corps failure to take some action against 3rd party. ii. When corporate manager (officer or director) fails to act or conduct, shareholders have right to step in foot of the corporation and bring suit in behalf of corporation against the officer. Derivative suit is an equitable remedy as measure of fairness. If the shareholders do not hold bd accountable, then who will? iii. Corporation can only act through its managers or directors on its behalf, even though, corp is its own person. Officers & managers have complete control over shareholders $. B/c shareholders have $ in corp, they can hold directors accountable 1. Need to balance the interest of shareholders to hold officers and directors accountable when they breach their fiduciary duty against the directors in making the decisions that they were appointed to make iv. Derivative action is one in equity rather than at law b/c at law, shareholder cannot bring suit b/c shareholder has no standing b/c harm that occurred is harm against corp. But as matter of equity, ct can create this remedy in order to avoid injustice. v. Derivative litigation is subject to abuse by Ps. 11

Threat of Derivative Strike Suits: A person w/ relatively small stake in residual value of bus might be tempted to bring derivative suit for primary purpose of being bought off. Requiring Ds to make payment to corp reduces this temptation for complaining shareholder. It makes little difference to complaining shareholders attorney, however, who is usually real party in interest. Attorney for a prevailing shareholder suing derivatively may obtain his fee from corp. He may therefore legitimately demand some payment in connection with a settlement 1.Most people who have small interest in co will NOT bring derivative action. vii. Limits on Derivative Action: In an effort to limit strike suits and o/w protect against over-deterrence, virtually all corp statutes limit shareholders who may bring derivative suits, & many states have enacted statutes requiring P-shareholder in a derivative suit, under certain circumstances, to post a bond or other security to indemnify corp against certain of its litigation expenses in event that P loses suit. NY is one who has posting of bond/security before P brings derivative suit. 1.P has to post security before they initiate proceedings in amt equal to reasonable amt for expenses incurred by corp for the suit if corp loses. If P wins, then bond $ is given back. Posting of bond prevents frivolous suits. a) States have plenary powers to require individuals with small holdings to post security for expenses (from Cohen v. Beneficial Industrial Loan Corp (SCT case dealing with NJ statute). 2. NY Business Corporation Law section 627: required P suing derivatively on behalf of corp to post security for corporations costs viii. Settlements & Attorney Fees in derivative action: 1.If a derivative action is settled before judgment, corp can pay legal fees of P & of Ds. If, on the other hand, a judgment for $ damages is imposed on Ds, except to extent that they are covered by insurance, they will be required to pay those damages & may be required to bear the cost of their defense as well. a) It is in the interest of D to settle. ONLY way directors can be indemnified, i.e., pay for their legal fees, is if they settle case before allowing it to go to judgment. Thus, when settled, directors are covered by insurance & entitled to indemnification (co pays for the cost of the defense). 1. If a judgment is entered against D, D may not be entitled to indemnifications, but corp may be able to party of it through insurance b) P is anxious to settle case b/c P wants to avoid litigation costs. 1. On Ps side real party in interest in derivative action often is attorney b/c Ps attorneys earn huge fees. c) Ex: Occidental case (pg 22 of big outline) 2.Ct in which derivative suit is filed MUST approve any settlement. c. DE Law: Grimes v. Donald provides another distinction for direct v. derivative suits: Grimes says NOT ONLY going to look at who is harmed, but also going to look at what remedy P is seeking. i. If P is seeking monetary or compensation for corp b/c corp has been harmed, then that is derivative suit. ii. If P is asking to undo something (injunctive effect), then that is direct suit. iii. Note: DE cts still look at harm. iv. NY only look at harm!!!!! NY does not follow this distinction 2.Other definitions: a. Holding co.: co that confines its activities to owning stock in another co, a subsidiary company. All holding co are parents and involve parent subsidiary relationship. NOT all holding co are parents. 12

vi.

b. Operating co.: co that provides goods and services c. Merger: occurs when 1 company is absorbed into another. Absorbed co seeks to exist as a separate entity. Absorbing co usually maintains its name and its identity (not the case in Eisenberg v. Flying Tiger Line, Inc. (NY case)). As consideration, shareholders are given shares in new merged company. In order to get merger, need 2/3 approval from shareholders. d. Abdication claim: The act of renouncing or abandoning privileges or duties, esp. those connected with high office (BLD) i. Abdication claim-> based on DE corp law 141(a): bus is managed by bd NOT CEO (Chief Executive Officer) (from Grimes v. Donald (DE case)). e. Outside directors: ONLY serve on bd & do NOT work for corp (NOT officers). NOT all outside directors are independent. Might have outside director that does bus with corp or serves as consultant. If there is some relationship b/w corp & outside director, then not independent. f. Inside directors: serve on bd & work for bd as officers g. Independent: NO relationship with co h. Interested: Interested is more narrow than independent. Interested asks: does this person have financial interest in the challenged transaction. 3.Timeline of Derivative Action a. MUST Post security/bond in NY& NJ before derivative action can be brought. Also need to know amt of shareholders shares. i. Note: DE do NOT have to post security/bond & do NOT need to know amt of shareholders shares. b. Before P can file derivative suit, P needs to make demand on board, which requires writing letter to bd & asking bd to initiate suit; this prevents frivolous suit & saves times & $ for corp. 1.Two types of demand: a) Demand to initiate suit OR b) Demand for bd to take corrective action c. When P makes demand, bd has right to refuse shareholder (P) demand. In most cases, bd refuses demand. Bd needs to explain why as a matter of law bd is refusing demand. i. Bds decision to refuse demand is protected by the bus judmgnet rule d. P will then argue that refusal of demand was wrongful. If refusal of demand is valid exercise of P judgment, then P loses. P has no other recourse. Ps ultimately lose these cases b/c directors and officers managing affairs is protected by business judgment rule. P will need to show that bus judgment rule does not apply, to do this, P would need to show that bd breached fiduciary duty (this is substantive-> chapter 5) e. Q becomes whether demand was required or excused. Demand will be excused, if demand was futile. f. If demand is excused, then P can go to ct and file derivative suit. g. Corp can then motion to dismiss suit or motion for Summary Judgment. Bd appoints special litigation committee to determine whether suit should proceed or be dismissed. 1 reason why special litigation committee would chose to have case dismissed is b/c it is not in best interest of corp to litigate case. h. This ends procedural part of derivative litigation 4. Business judgment rule: rule of the ct to defer to decision made cos officers & directors, ct is not going to let shareholders interfere with those decisions a. Bus judgment rule=rule of deference.

13

Deference b/c we want to encourage good people to take position of directors b/c if they are constantly under risk of personal liability, then would not have able bodied directors. 5.Requirement of Demand on Directors a. Issue: Whether demand was required or excused. b. Demand ONLY applies when have derivative suit. Demand does NOT apply to direct suits. c. Rule: If demand is required & P does NOT make it & brings suit directly to ct, suit will be dismissed. d. Rule: Once P makes demand and bd refuses demand, that judgment is protected by bus judgment rule (Grimes v. Donald). e. RULE: Demand is excused when it is futile f. 3 purposes of demand requirement: i. Relieve cts from deciding matters of internal corporate governance by providing corporate directors with opportunities to correct alleged abuses; ii. Provide corporate bds with reasonable protection from harassment by litigation on matters clearly within discretion of directors; and iii. Discourage strike suits commenced by shareholders for personal gain rather than for benefit of corp. g. DE law of demand excusal (for derivative suits ONLY): Grimes v. Donald (DE case) i. DE General Corporations Law 141(a): bus affairs are to be managed by bd and those decisions are protected. 1.It is NOT the shareholders role to manage decisions; instead, shareholders have passive role unless shareholders are also directors & officers. ii. DE law is derived from futility exception to demand in Aronson v. Lewis (DE ct stated that demand requirement is a recognition of fundamental precept that directors manage business and affairs of corp). Q is whether this bd is unable to make an unbiased, unprejudiced decision because bd has some interest in the transaction. There are three bases for excusing demand (P only needs to prove 1 out of 3) (if P can prove 1 of these, then demand is excused & P can go straight to ct): 1. Is there a possibility of arguing on behalf of P that majority of bd has material interest in transaction? P has to come up with particularized facts & these facts have to create a reasonable doubt about bds independence/bias by stating that bd had material interest in transaction that P is complaining about. Interest can be financial, familial, self-interest. This deals with self interest of the bd & deals w/ majority of bd a) Self interest: direct material financial interest. It can be your own financial interest or your familys financial interest. Very narrow def of self interest in DE. Note that this def was criticized in Oracle BUT this is still def b) Just b/c majority of bd approves a transaction does NOT mean demand should be refused b/c of self-interest. 2. Even if bd is not conflicted & do not have direct material interest, are they in some way controlled or dominated by an individual that does have a material interest OR a) Whatever P is challenging, need to take a look at underlying transaction, & ask is challenged transaction a result of valid exercise of bds business decision. (Difficult to prove). 3. Need to prove these prongs from Aronson test with particularity. How is this done without discovery? Ct states in Fn 11: In Rales, ct undertook to describe some of those tools at hand: Although derivative Ps may believe it is difficult to meet the particularization requirement of Aronson b/c 14

i.

they are NOT entitled to discovery to assist their compliance with Rule 23.1, they have many avenues available to obtain information bearing on subject of their claims. For ex, there is a variety of public sources from which details of a corporate act may be discovered, including the media and governmental agencies such as SEC. In addition, a stockholder who has met procedural requirements and has shown a specific proper purpose may use summary procedure embodied in 8 Del.C. section 220 (shareholder right to inspect books and records; this is true in both NY and DE) to investigate the possibility of corporate wrongdoing. iii. DE law: Once demand is made, it is deemed to be required and P cannot argue that P should not have made demand and demand was really excused here, so therefore, demand is excused. h. NY law for demand excusal: Marx v. Akers (NY case) i. 3 bases for demand excusal: Need particularity, not conclusory statements (Only need 1 of 3 bases for demand to be excused) (elaborated from demand futility of Barr v. Wacktman) 1.If the majority of the bd is self interested in challenged transaction, then demand should be excused. a) Self interest: direct financial interest or control. 2.P needs to show that a majority of bd failed to fully inform themselves of challenged transaction to degree that is reasonably necessary 3.Decisions that are protected business judgment rule need to be fully informed ii. That transaction itself was not a valid exercise of business judgment (like DE). i. Universal demand i. ALI would require a written demand unless P makes a specific showing that irreparable injury to corp would o/w result. If bd rejects a demand, ALI would subject bds decision to an elaborate set of standards that calibrates deference afforded decision of directors to character of claim being asserted. ii. Model Bus Corp Act section 7.42 requires demand, but permits derivative P to file suit within 90 days of demand unless demand is rejected earlier and to file even earlier if corp would o/w suffer irreparable injury. iii. Legislatures of at least 12 states-Arizona, CT, Florida, Georgia, Michigan, Mississippi, Montana, Nebraska, NH, NC, Virginia, & Wisconsin-have adopted universal demand requirement. iv. Universal demand minority approach where demand is automatically required. NY and DE do not follow universal demand j. Individual recovery in derivative action i. Ex: Lunch v. Patterson (Wyo 1985): Pat Patterson, Birl Lynch, and RC Lynch had carried on an oil-field consulting bus in corporate form. Patterson owned 30% of common stock and Birl Lynch and RC Lynch each owned 35% each. Patterson quit working for corp and set up his own consulting bus. Thereafter, Birl Lynch and RC Lynch increased their own pay and paid excess compensation. Patterson filed a derivative action to recover excess salaries from the Lynches. Wyoming Supreme Ct awarded damages as an individual in amt 30% of amt in excess. ii. This prevents from wrongdoers from benefitting. 6. Role of Special Committees in derivative actions: Demand has been excused but corp does NOT want litigation & corp selects special litigation committee to determine whether to proceed w/ litigation or not. a. Issue: Should ct defer to decision of special litigation committee & apply bus judgment rile to decision made by special litigation committee?

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b. DE General Corporations Law 141(a) & 141(c): This gives the board the power to form a committee even if demand was made. This committee can be adopted to hear the case and decide whether refusal should be accepted or not. c. Fn 10 in Zapata Corp v. Maldonado: When stockholders, after making demand & having their suit rejected, attack bds decision as improper, bds decision falls under bus judgment rule & will be respected if the requirements of rule are met . . . . That situation should be distinguished from instant case, where demand was NOT made, & power of bd to seek a dismissal, due to disqualification, presents a threshold issue. . . . i. Distinction: Decision of bd to refuse demand is automatically protected by bus judgment rule. Bds decision to terminate a suit that P filed b/c P concluded that demand was excused & special litigation committee moves to dismiss it, q becomes whether ct will apply bus judgment rule & defer decision. d. NY Rule: Auerbach v. Bennett (NY case) i. Cts do NOT automatically apply bus judgment rule where demand has been excused b/c dealing w/ bd w/ problems. Thus, cts intervene by looking at special litigation committees good faith, process followed, & if members on committee were independent. e. DE Rule: Zapata Corp. v. Maldonado (DE law) i. Ct in Zapata Corp states that shareholders have right to initiate, while bd has right to control suit. ii. DE takes it 1 step further than NY by stating that DE ct will give its own analysis 1. First, Ct should inquire into independence & good faith of committee & bases supporting its conclusions. Limited discovery may be ordered to facilitate such inquiries. Corp should have the burden of proving independence, good faith and a reasonable investigation rather than presuming independence, good faith and reasonableness. If ct determines either that committee is NOT independent or has NOT shown reasonable bases for its conclusions, or if ct is not satisfied for other reasons relating to process, including but not limited to good faith of committee, ct shall deny corps motion. If ct is satisfied under Rule 56 standards that committee was independent and showed reasonable bases for good faith findings and recommendations, ct may proceed, in its discretion to next step. 2. Second step provides the essential key in striking balance b/w legitimate corporate claims as expressed in a derivative stockholder suit and a corps best interests as expressed by independent investigating committee. Ct should determine, applying its own independent bus judgment, whether motion should be granted. 3. Difference b/w NY & DE approach: DE will exercise independent deference when demand has been excused, but NY does not. a) Note: Suppose u are counsel to special litigation committee of DE corp, appointed to decide whether to seek dismissal of a derivative suit. What advice would u give as to how committee should proceed? How, if at all, would your advice be difference in case of NYcorp? 1. In all jurisdictions, the procedure should be the same. Different approaches to judicial deference with regard to special litigation committee. Need to make sure no connections b/w special litigation committee & corp (independence) & that there is good faith and adequate procedure is followed (Need advise need to hire experts that are needed to ensure a thorough investigation). Make sure person in special litigation committee is disinterested. 2. Difference is that in DE Ps have slight chance of winning because DE cts exercise own investigation. 4. DE law: In re Oracle Corp. Derivative Litigation (DE case): dealt with independence of special litigation committee (NY also requires this). a) Ct here applied Zapata rule. To be independent for requirement of special litigation committee, cannot have connections, such as old university, which u 16

V.

teach at or donate money to, or continuing relationship b/w prof & student, small, tight knit community. These in turn depend on the nature of the relationship. f. Two Alternatives for Special Litigation Committee Selection i. Ask judges to appoint the special master; this takes it out of the bds hands completely ii. Have nomination committee under Rule 141(c) and should ONLY composed of major shareholder, institutional shareholders, such as pension funds or banks that hold huge shares or large holdings in public companies Duties of Officers, Directors, & Other Insiders (substantive aspect of derivative suit) A. Obligations of Bd of Directors: Bd of directors owes fiduciary duties to shareholders & corp 1. DUTY OF CARE: mitigated by DE General Corp Law section 102(b)(7) 2. DUTY OF LOYALTY (involves conflict of interest (such as self-dealing, unfairness standard applied to disinterested ratification by bd v. wasteful standard applied to disinterested ratification by controlling shareholder), corporate opportunity doctrine) (NY section 713: only says directors; ct likely to treat officers the same way, only minority say no; ratification AND DE section 144: says both officers and directors) 3. OBLIGATION OF GOOD FAITH (Good faith is NOT a fiduciary duty that stands alone BUT an obligation and, according to Stone v. Ritter, is part of duty of loyalty) (arises in 2 contexts: executive compensation AND oversight) B. Duty of care 1.Duty of care is ONLY relevant to bd of directors a. Issue: Is this transaction a satisfaction of bds duty of care or breach of care? i. Need to determine this issue in order to determine whether bus judgment applies or not. 2.Directors are normally, by law, held to have duty of management of corp. These duties are normally delegated to officers; thus, directors must supervise officers. Legal duties of directors & officers are owed to corp; thus, performance of these duties is usually enforced on behalf of corp brought by an individual shareholder in derivative suit. 3. Kamin v. American Express Co (NY case) Derivative suit (brought by American Express shareholders) a. NY statute protecting duty of care: Articulation of duty of care that ordinarily prudent person would exercise. b. Standard from this case for whether directors breach duty of care= gross negligence i. Cts will defer to directors decision as long as there is no fraud, illegality, no breach of duty of loyalty, no breach of duty of care where it was gross negligence. Business judgment rule provides broad immunity rule for mistakes. Mistakes are to be expected. c. Policy reasons for applying bus judgment rule: i. Cts are NOT in best positions to decide these business decisions. ii. Directors would NOT take any risks (over cautious decision making where no risks or very little risks are taken & profits of shareholders will NOT be maximized. 4. Smith v. Van Gorkom (DE law): Direct suit b/c harm to shareholders NOT to corp (unusual case which ct held bd liable for breach of duty of care) (brought by Trans Union shareholders a. Holding: Here, bd breached duty of care to directors by failing to investigate. Van Gorkom had failed to investigate intrinsic value of the co was. Bd voted on merger without seeing merger agreement & voted on amendments without seeing amendments. And, bus judgment rule did NOT apply. b. Rule: Smith v. Van Gorkom requires bd to undertake certain process that shows due deliberation & consideration & if bd engaged in such process that would satisfy duty of care. Bd NEEDS to get all information possible regarding transaction. 17

CEO, Van Gorkom, cannot just boss bd around. It is about the process. Bd needs to exercise due care during this process. 1.For ex, if bd needs outside experts, such as financial advisors, then for bd to exercise due care, need to get them. ii. Note: Case does NOT give a formula on how to satisfy this duty of care. c. DE General Corporations Law section 141(e): directors are fully protected in relying in good faith on reports made by officers. i. BOD is able to rely on reports & info prepared by exec & experts if BOD (1) reasonably relied (2) in good faith (3) on expert who was competent to advise and was (4) selected w/ reasonable care ii. ONLY protects directors who relied on reports in good faith. Here, oral report was not a report that would qualify under section 141(e) b/c it was given by Van Gorkom for 20 minutes, who himself was uninformed about value of co. Also, bd cannot say that it was reasonable to rely on this oral report in good faith b/c bd never asked qs that would have found out that Van Gorkom did not know the answers himself. d. Duty of care includes: i. Duty to carefully investigate; ii. Duty of inquiry; AND iii. Duty of due deliberation e. Legislative response to Smith v. Van Gorkom: i. DE General Corporation Law section 102(b)(7): (In suit for damages ONLY) allows any corp to include in its certification of incorporation: A provisions eliminating or limiting personal liability of a director to corp or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provisions shall NOT eliminate or limit liability of a directors: (i) For any breach of the directors duty of loyalty to corp or its stockholders; (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; (iii) under section 174 of this title [relating to payment of dividends]; or (iv) for any transaction from which the director derived an improper personal benefit . . . . 1.Allows corp to provide provision in Articles of Incorporation for eliminating personal liability of directors for breach of fiduciary duty UNLESS: 1. Breach of duty of loyalty; 2. Acted in Bad faith 2.B/c of passage of statute, this has made it hard to hold bd liable for duty of care. 5.Two ways to approach bus judgment rule: a. Minority approach: ct provided a standard of review/liability (gross negligence) by which ct will judge directors behaviors. If we take the standard of review approach, then directors have to exercise care that an ordinarily prudent person would take and look at gross negligence standard (Kamin v. American Express Co) i. Should not act recklessly or grossly negligently; if so, Business Judgment Rule does NOT apply b. Abstention approach (more popular approach): cts will abstain from duty of care qs & will not entertain idea of breaching duty of care standard unless there is some other allegation of conduct against bd (one of following: 1.fraud or illegality in making its interest, 2. bd has not have self interest or COI and has not breached its duty of loyalty, or 3. acted in bad faith.) i. Rule of judicial deference, based on presumption that Board of Directors acts in good faith ii. Cts will abstain from duty of care analysis UNLESS fraud, illegality, or COI or some egregious process irregularity iii. SPLIT (NOT jurisdictional) 18

i.

1.Majority: ONLY Fraud, Illegality, or COI 2.Minority: all 4 above 6. Francis v. United Jersey Bank (NJ case) a. This case is NOT brought by shareholder BUT by bankruptcy trustee (creditor). When co becomes bankrupt, creditors step in shoes of shareholders. (different than Kamin v. American Express Co. AND Smith v. Van Gorkom) b. Another difference: This case deals with nonfeasance (failure to monitor under duty of care), while American Express AND Van Gorkom deal with misfeasance. i. Nonfeasance: failure to act when duty to act existed 1.Ex: Mrs. Ps failure to monitor. Ct held that she needed to stay informed, read the books & records & listen to minutes of meetings. 2.In cases involving nonfeasance, causation issue requires determining what reasonable steps a director could have taken and whether those steps would have prevented loss. Failure to act must be substantial factor in producing harm. ii. Misfeasance: lawful act performed in wrongful manner 1. Ex: Misfeasance is grossly neg decision seen in Trans Union & American Express cases. c. Rule: Bus judgment rule protects both misfeasance & nonfeasance. d. Rule: Duty of care=monitor/supervise i. Bd of directors must take steps to be reasonably informed to corp activities; should be up to date on financial affairs of corp ii. RULE: BOD members can generally rely on honesty of subordinate, execs UNLESS on notice of possible illegal acts. e. Generally, a director should have a basic understanding of corps bus & knowledge about its ongoing activities, which require a general monitoring of its affairs & policies. Director has responsibility to attend bd meetings & regularly review financial statements. If there is illegal conduct, director has duty to object, & possibly take reasonable means to prevent such conduct or resign. In this case, Mrs P did not fulfill any of directors obligations. Director also has duty to corporate clients. C. Duty of Loyalty a. Conflict of interest is breach of duty of loyalty. i. Ct is skeptical & will scrutinize transaction & would NOT defer to bds decision to enter into transaction with director. Thus, bus judgment rule will NOT apply when there is conflict of interest. There is NO presumption in favor of businesss decision making. b. Issue: deals with what should happen when there is officer or director interested in challenged transaction. c. Directors owe duty of loyalty to corp. This means that directors MUST place interests of corp above their own personal gains. d. Statutes dealing with COI situations: deals with what should happen when there is director OR officer interested in a challenged transaction i. NY Section 713 Interested Directors (a) No K or other transaction b/w a corp and one or more of its directors, or b/w a corp and any other corp, firm, assn or other entity in which one or more of its directors are directors or officers, of have a substantial financial interest, shall be either void or voidable for this reason alone or by reason alone that such director or directors are present at the meeting of the board, or of a committee thereof, which approves such K or transaction, or that his or their votes are counted for such purpose: [This defines COI] (1) If the material facts as to such directors interest in such K or transaction and as to any such common directorship, officership or financial interest are disclosed in good faith or known to that bd or committee, and the bd or committee approves such K or transaction by a vote sufficient for such 19

purpose without counting the vote of such interested director or, if the votes of the disinterested directors are insufficient to constitute an act of the board as defined in section 708 (Action by the bd), by unanimous vote of the disinterested directors; [need to make full disclosure of all material facts with regards to COI to bd AND get disinterested director vote]OR (2) If the material facts as to such directors interest in such K or transaction and as to any such common directorship, officership or financial interest are disclosed in good faith or known to the shareholders entitled to vote thereon, and such K or transaction is approved by the vote of such shareholders [Need to make full disclosure AND get shareholder vote. Statute does NOT state whether shareholder has to be disinterested or NOT. However, NY cts have read into statute, a requirement for disinterestedness]. (b) If a K or other transaction b/w a corp and one or more of its directors, or b/w a corp and any other corp, firm, assn or other entity in which one or more of its directors are directors or officers, or have a substantial financial interest, is not approved in accordance with paragraph (a), the corp may avoid the K or transaction unless the party or parties thereto shall establish affirmatively that the K or transaction was fair and reasonable as to the corp at the time it was approved by the bd, a committee or the shareholders [deals with fairness of challenged transaction. If a COI is defined as in (a) in preamble but dont have full disclosure or ratification under (a)(1) or (a)(2), then look at the fairness of the challenged transaction. Burden of proof lies with D directors to prove fairness of challenged transaction]. (c) Common or interested directors may be counted in determining the presence of a quorum at a meeting of the bd or of a committee which approves such K or transaction. (d) The certificate of incorporation may contain additional restrictions on Ks or transactions b/w a corp and its directors and may provide that Ks or transactions in violation of such restrictions shall be void or voidable by the corp. (e) Unless o/w provided in the certificate of incorporation of the by-laws, the bd shall have authority to fix the compensation of directors for services in any capacity. 1. Bayer v. Beran (NY case) is example where section 713(b) was at issue. Here, ct held that duty of loyalty was NOT breached by bd b/c decision was in good faith & challenged transaction was fair. Facts showed FAIRNESS. a) Steps to take in COI analysis: 1. If presence of COI, ct will undertake scrutiny at bds conduct with regards to challenged transaction. Ct will NOT defer to decision of bd for challenged transaction. Bus judgment rule will NOT apply. b) Note: NY law NOW requires majority of directors to be independent or outsiders. ii. DE Section 144: Interested directors; quorum (a) No K or transaction b/w a corp and 1 or more of its directors or officers, or b/w a corp and any other corp, partnership, association, or other org in which 1 or more of its directors or officers, are directors or officers, or have a financial interest, shall be void or voidable solely for this reason, or solely b/c the director or officer is present at or participates in the meeting of the bd or committee which authorizes the K or transaction, or solely b/c any such directors or officers votes are counted for such purpose, if [defines COI]: (1) The material facts as to the directors or officers relationship or interest as to the K or transaction are disclosed or are known to the bd of directors or the committee, and the bd or committee in good faith authorizes the K or transaction by the affirmative votes of a majority of the disinterested directors, even though the disinterested directors be less than a quorum [just because u have COI, that COI is not in violation of duty of loyalty if material facts are disclosed or known to disinterested directors; director ratification]; OR (2) The material facts as to the directors or officers relationship or interest and as to the K or transaction are disclosed or are known to the shareholders entitled to vote thereon, and the K or transaction is specifically approved in good faith by vote of the shareholders [just because u have COI, that COI is not in violation of duty of loyalty if material facts are disclosed or known to disinterested 20

shareholders. Statute does not state disinterested, but DE cts have read the requirement in. Shareholder ratification]; OR (3) The K or transaction is fair as to the corp as of the time it is authorized, approved or ratified, by the bd of directors, a committee or the shareholders [Burden is placed on co to demonstrate transaction was fair]. (b) Common or interested directors may be counted in determining the presence of a quorum at a meeting of the bd of directors or of a committee which authorizes the K or transaction 1. Benihana of Tokyo v. Benihana (DE case) a) At issue here is Section 144(a)(1), bd knew of material facts of COI (common directorship & his interest in purchase of preferred stock), BUT still upheld transaction. Ct held that there was COI b/c there was common directorship b/c this individual served on bd of 2 companies that were doing business with each other. b) Note: Ct scrutinized whole bd b/c bd approved of transaction. 2. Corporate Opportunities (Subset of duty of loyalty): Duty of loyalty of directors & officers to corp prevents them from taking opportunities for themselves that should belong to corp. a. Ex: Director may NOT use corporate prop or assets to develop her own bus or for other personal uses. b. Defenses to charge of usurping corporate opportunity i. Individual capacity: Ds may claim that opportunity was presented to them in their individual capacities, and not as fiduciaries of corp. ii. Corporation unable to take advantage of opportunity: Law is now that an officer or director may take advantage of corporate opportunity if it is disclosed to corp first and corp is unable to take advantage of it. c. Rule: Directors or officers are allowed to take any opportunity as long as opportunity is NOT corporate opportunity. i. Rule: If opportunity is corporate, then need to make formal offer. L would tell C that C needs to offer corporate opportunity formally & ask bd to formally reject offer. ii. Rule: If corp, by independent directors or shareholders, turns down an opportunity, then fiduciaries may take advantage of opportunity. iii. Remedies: If fiduciary has usurped a corporate opportunity, then corp has following remedies: 1. Damages: When opportunity has been resold, profits made by fiduciary may be recovered by corp 2. Constructive trust: Corp may force fiduciary to convey prop to corp at fiduciarys cost. d. 4 elements to determine whether opportunity is corporate opportunity: i. Is the co financially able to take opportunity for itself? Does the company have enough funds to take advantage of the corporate opportunity? ii. Whether the corporate opportunity is within the business of the corporation. iii. Whether corporate opportunity is interest or expectancy. 1.Cts define it in lay terms. Do they expect opportunity or do they have an interest? 2. Some cts apply narrower def: whether an interest is anything in which the corp has a contractual right. Expectancy is simply whether this opportunity is expected to receive in the ordinary course of bus? iv. Whether the corporate opportunity creates a conflict b/w director or officers interest and the interest of corp. e. Broz v. Cellular Information Systems, Inc. (DE case): Ex of case where corp was financially unable to act on corporate opportunity and D did NOT usurp corporate opportunity. 21

If co had been financially capable, then first factor would not be satisfy first factor b/c D would have had personal interest in corporate opportunity over bd interest. f. In re eBay Inc. Shareholders Litigation (DE case): ex of case where Ds did usurp corporate opportunity. See application of 4 elements. B/c of usurping corporate opportunity, this proves Ds are conflicting b/c personal enrichment of executives over interest of corp. This decision is NOT protected by bus judgment rule & corp will scrutinize transaction b/c there is COI. g. Competition with corp: Another area of COI arises when a director or officer enters into competition with corp. i. Use of corporate assets, prop, trade secrets, etc: Clearly, a fiduciary may not use corporate assets, prop, materials, trade secrets, etc to form a competing bus ii. Formation of a competing bus: However, a fiduciary without using corporate assets may leave corp and form a competing bus. In some instances, conduct of fiduciary while still with corp and preparing to leave to form new bus is questioned. 3. Dominant shareholders: Looking at duty of loyalty owed by controlling/dominant shareholders to minority shareholders. Asking whether controlling shareholder breached duty of loyalty. Looking at self dealing=type of COI (see this with parent-subsidiary relationship) a. Shareholders, in some cases, have responsibilities to other shareholders. b. Analysis to apply for whether controlling/dominant shareholder breached duty of loyalty (goal: hold majority shareholder accountable for conduct) (from Sinclair Oil Corp. v. Levien (DE case) derivative suit; controlling shareholder case): i. Whether there was self-dealing on part of the controlling/dominant shareholder. Ask whether the controlling shareholder has received something to the detriment or expense of the minority shareholder. 1.Burden of proof to prove self-dealing is on Ps (minority shareholder). ii. If there is self-dealing, then burden of proof shifts from Ps to Ds (controlling shareholder) to show fairness of challenged transaction. 1. Need to ask whether challenged transaction is fair; this is called intrinsic fairness test. 2.Apply intrinsic fairness test in terms of controlling shareholder. iii. Application of bus judgment rule: Once it is determined that dominant shareholder engaged in self-dealing, then bus judgment rules does NOT apply b/c self-dealing is type of COI. Instead of deferring to what bd did, there will be judiciary scrutiny. 1. Business judgment rule: rule of judicial deference where cts defer to decision of directors. 2.Bd is NOT monitoring in independent capacity b/c controlled by dominant shareholder. When there is self-dealing, this means that bd is no longer monitoring in independent capacity & bd does NOT deserve protection of bus judgment rule. 3. If NO self-dealing, then look at conduct of bd & look at bds duty of loyalty, due care, good faith, and if this is ok, then use bus judgment rule. c. Note: Directors have higher duty of loyalty than shareholders have. d. Sinclair Oil Corp. v. Levien (DE case): Controlling shareholder case (derivative suit) i. Applied the controlling shareholder breach of loyalty analysis to hold that there was self dealing with respect to breach of K b/w Sinven (subsidiary co) & Sinclair (parent co; controlling shareholder). B/c there was self-dealing, burden shifted to Ds to prove that challenged transaction (K) was fair. Impossible to argue the breach of K is fair. e. Duty of loyalty of controlling shareholder with respect to liquidation: controlling shareholder needs to provide information to minority shareholder in order to make informed decision what to do with shares upon liquideation. 22

i.

Zahn v. Transamerica Corp (3rd Cir): Transamerica breached duty of loyalty b/c controlling shareholder failed to provide information to class A shareholders in order to make informed decision about whether to chose conversion or redemption of stock. Here, Class A had right of conversion & co had right of redemption. 4. Ratification (approval): whether interested director has COI & COI has been ratified a. Rule: Ratification merely shifts burden of proof to P to demonstrate that there was waste. This does NOT stop ct from scrutinizing transaction. b. Statutes for ratification i. NY section 713: governs COI on part of directors. NY statute section 713 is interested director statute (above page 18-19) ii. DE section 144: is interested director statute. (above pg 19-20) 1. DE section 144(a): defines COI for directors as when director engages in transaction with co. 2. DE section 144(a)(1): states that to sanitize transaction, need disinterested director 3. DE section 144(a)(2): does NOT statute disinterested by ct reads in requirement of disinterestedness for shareholders. 4. Fliegler v. Lawrence (DE case): dealing with ratification of COI a) DE section 144(a)(2) is at issue here. b) Rule: Interested directors are required to prove fairness of transaction even when decision was ratified by shareholders. 5.Ratification & bus judgment rule: a) In re Wheelabrator Technologies, Inc. Shareholder Litigation (DE case): dealt with effect of disinterested ratification on this transaction. 1. DE section 144(a)(2) is at issue here. 2. Ct gave 2 different tests depending on who D is in dicta. i. If P sues bd for breach of duty of loyalty (COI), then in presence of disinterested ratification of such COI, burden will shift from Ds to P & burden that P has to prove is that transaction was wasteful to corporate assets. Standard for waste is very high & difficult to prove. If CANNOT prove waste, then bus judgment rule is applied. ONLY way bus judgment rule cannot be applied is if transaction was wasteful ii. If P sues controlling shareholder for breach of duty of loyalty (COI), then in presence of disinterested ratification of such COI, burden will shift from Ds to P & burden that P has to prove is that transaction was unfair iii. Note: unfairness is less of a burden to prove. iv. Waste = no adequate definition, a really bad trans; no rational basis v. To determine whether controlling shareholder or not, need to ask whether shareholder was controlling or not at time challenged transaction occurred. 3. Note: effect of disinterested ratification by shareholder or director on duty of loyalty is different than disinterested ratification by shareholder or director. For duty of care, q is whether shareholder had full disclosure. D. Obligation of Good Faith: Good faith is NOT a fiduciary duty that stands alone BUT an obligation and, according to Stone v. Ritter (DE case), is part of duty of loyalty 1. Cede & Co. v. Technicolor (DE 1993): Cts use of term triad signaled the then-novel proposition that good faith was freestanding fiduciary obligation having equal dignity with traditional concepts of care & loyalty. 2. Obligation of good faith arises in 2 key areas: executive compensation AND oversight 3.Executive compensation 23

i.

a. In re Walt Disney Co. Derivative Litigation (DE case): defines what good faith is by stating what it means to act in bad faith. Deals with excessive compensation. i. Despite the entire bd of Disney NOT approving of Orvitzs compensation package, a compensation committee decided it. However, this was ok b/c under DE section 141(c), bd was able to delegate its voting power with respect to compensation package onto the compensation committee. 1.DE law section 141(c): states that bd can delegate all its power to committee ii. Issue: Whether Orvitz was compensated excessively ($130 million) after being terminated 14 months after hiring. 1.Disney won BUT Disney bd lacked proper process in making the decision. What Disney bd did not do here was memorialize decisions within meetings b/c bd pretty much came to decisions in bds informal meetings prior to formal meetings. Need minutes to show factors bd considered & discussed; this is what Disney bd lacked. iii. Disney case sets out duty of good faith as third duty. Thus, bd owes three duties: duty of care, duty of loyalty, & duty of good faith. iv. Rule: Cts ONLY look at process due care when looking at duty of care in decisionmaking context. 1. Process due care: Ct asks whether process in which bd took was reasonable (NOT whether decision itself was reasonable) 2. Substantive due care: Cts do NOT undertake qs about substantive due care. Substantive due care asks about reasonableness of bds actual decision (whether bds decision itself is reasonable) v. Rule: Under this decision, proof of bad faith is basis for rebutting bus judgment rules presumption against judicial review of director decision making. Thus, proof of bad faith rebuts bus judgment rule presumption. 1. Bad faith is defined in Disney as: standard for determined whether fiduciaries have acted in good faith is intentional dereliction of duty, conscious disregard for ones responsibilities. Ct stated that deliberate indifference and inaction in face of a duty to act is conduct that is clearly disloyal to corp. It is epitome of faithless conduct. a) Ct provided three categories of fiduciary behavior that are candidates for bad faith pejorative label: 1. Subjective bad faith: fiduciary conduct motivated by actual intent to do harm. 2. Lack of due care: fiduciary action taken solely by reason of gross neg & without any malevolent intent. 3. Intentional dereliction of duty, a conscious disregard for ones responsibilities vi. Criticism: If If Disney case is interpreted literally, intentional decision by bd to break law sounds like dereliction of duty. There is duty on bd & corps of person owe duty to comply with applicable law according to Stone v. Ritter. Cristicism of Disney & Ritter cases b/c sometimes corps will knowingly violate a law b/c after doing a cost-benefit analysis, ct will discover that breaking law actually benefits shareholders. But, bd will not be able to do so b/c bd will be held liable under obligation of good faith under both Disney & Ritter cases. vii. Does bus judgment rule preclude judicial review of merits of decisions made by officers, as well as those of directors? 1. SPLIT in case law. Majority states that officers owe same duty of care & duty of loyalty as bd members owe. Bus judgment rule applies to both decisions of bd & officers & this deference is the same. Thus, cts defer to decisions made by officers & directors in same way. Cts are NOT bus experts & that is why cts defer to both 24

decisions of officers & bd. Directors & officers would not take risk if cts scrutinized every decision. If cts did not defer to decisions of bds, then directors & officers would be too adverse to risk taking & want them to take risks in order to make $ for shareholders. However, as seen recently w/ collapse, cannot have too much risk taking. Thus, need to balance, risk with overly risky behavior. viii. Note: If bd failed to consider an issue, that bd may escape liability b/c in Disney, there must be a known dereliction of duty & known violation of law. If they were merely a violation w/out prior knowledge, then this would be considered neg & Section 102(b) (7) would apply & grossly neg duty of care analysis would apply. Bd would escape liability b/c no known violation of law b. Jones v. Harris Associates (7th Cir): about what good faith is; applies corp rules by analogy b/c mutual fund advisors are fiduciaries. i. Rule: Adviser has fiduciary duty of care & loyalty to mutual fund when negotiating fee. Test is whether investment adviser acted as proper fiduciary. Adviser needs to act honestly as fiduciary and fully disclose all info trustee needs to make decision about fee & fully articulate basis for negotiation. ii. 2 markets: 1. Capital markets constrain executive compensation (investors would go elsewhere). 2. Consumer market constrain executive compensation in this way: if co has to pay executive unreasonable or higher fee, then that co will have to charge more for services or goods at higher prices & will risk losing consumers. Consumers will go elsewhere to buy same products & goods. Market is an imperfect control of executive compensation but it is better than judges deciding executive compensation b/c judges are not accountable to any segment of society 4.Oversight a. Directors are NOT expected to know, in minute detail, everything that happens on a dayto-day basis. At very least, a director MUST have a rudimentary understanding of firms bus & how it works, keep informed about firms activities, engage in a general monitoring of corporate affairs, attend bd meetings regularly, & routinely review financial statements b. Oversight: directors have to implement & install systems that monitor, that exercise oversight, & that report info. Need internal controls to get info to bd of directors i. Bds duty of good faith to exercise oversight in respect to compliance to all applicable law (state, local, fed). Bd needs to install info & reporting system that employees are complying w/ law in publicly held co. Idea is that bd needs to install info & reporting system to exercise oversight about whether cos employees are complying w/ law. ii. Bds duties do NOT end w/ implementation of control system. Bd needs to make sure that program is adequate & that program remains adequate. Thus, bd needs to periodically access whether control system is adequate. Bd needs to make sure & investigate any allegations of bad conduct. For ex, failure to investigate such bad conduct or control system not properly being implemented, P may have case. Bd has to ensure that misconduct does not repeat (cannot have recurrence of misconduct. c. Stone v. Ritter (DE case): deals with bds oversight over officers & employees to be in compliance with fed law. i. Stone v. Ritter clarifies what must be done w/ duty of good faith. In Stone v. Ritter, duty of good faith is defined as part of duty of loyalty. Now, have 2 fiduciary duties; these include duty of care (which was eroded by extension test & DE General Corporations Law section 102(b)(7)) & duty of loyalty (duty of good faith is part). ii. In re Caremark International Derivative Litigation (DE case): Ct of Chancery recognized that: generally where a claim of directorial liability for corporate loss is 25

predicated upon ignorance of liability creating activities w/in corp . . . only a sustained or systematic failure of bd to exercise oversight-such as an utter failure to attempt to assure reasonable info & reporting system exists-will establish lack of good faith that is a necessary condition to liability. iii. Holding: Ct held that fiduciary duty requires bd to comply with law. To do this, bd needs to establish oversight to ensure that employees & officers are complying with law. If bd fails to do so, then bd is not satisfying its obligation of good faith. Thus, compliance program is part of fiduciary duty that bds owe to shareholders as part of their obligation of good faith. Obligation of good faith is part of duty of loyalty iv. Ct approved Caremark standard!!!! 1. Caremark violation is where bd failed to oversee officers & employees & whether officers & employees are complying with law. This is different than knowingly violating the law that is in the best interests of the corporation (ex. Trucking hypo) 2.Ct holds that Caremark articulates necessary conditions predicate for director oversight liability: (a) directors utterly failed to implement any reporting or info system or controls; OR (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention. In either case, imposition of liability requires a showing that directors knew that they were not discharging their fiduciary obligations. Where directors fail to act in face of known duty to act, thereby demonstrating conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith v. Why good faith/bad faith shifted from duty of care to duty of loyalty? It is due to adoption of DE General Corp Law 102(b)(7). 1.DE 102(b)(7) allows provision in certificate of incorporation that eliminates or limits personal liability for duty of care breaches. In statute, bd can be excused or exculpated for liability (bd will not be held personally liable) UNLESS bd engages in conduct listed w/in statute. By analyzing bad faith in loyalty q, it is ensured that companies cannot exculpate or indemnify individual directors. Reason for shift is to ensure Ps can reach kind of conduct that happens as a result of intentionally disregarding duty bd owes. Section 102(b)(7) talks about good faith. 2. Note: Gross negligence is NOT bad faith. Gross negligence goes to q of whether duty of care was breached or not. Note that duty of care has eroded b/c of extension approach & DE section 102(b)(7). 3. Extension approach: Ct will ONLY ask if COI (duty of loyalty), fraud, and illegality. Cts applying extension approach do not examine duty of care 4. Section 102(b)(7) NO longer applies to Caremark claims!!! Section 102(b)(7) ONLY allows corps to adopt regs for duty of care. 5. vi. Legal significance of Disney & Stone v. Ritter: Before Stone v. Ritter, a bd could undertake cost-benefit analysis, bd could decide to break law if it was beneficial to shareholders (see trucking hypo), & had affirmative duty under law that is qualitatively different than now. This type of conduct of bd was considered breach of duty of care & bd did not have to worry about ramifications b/c extension doctrine & DE law section 102(b)(7) eroded duty of care. Thus, same set of facts gave rise to a completely different argument that is reviewable by ct under duty of loyalty. 1. Criticism of Stone v. Ritter: Now, if bd takes cost-benefit analysis of whether to comply or not comply with law and reaches conclusion that it is not in best interests of shareholder and does not comply with law, now bd b/c of Stone v. Ritter is in violation of obligation of good faith (under duty of loyalty). 26

What remedy is available to P who successfully brings a Caremark claim? 1. This is another criticism of Stone v. Ritter. B/c there is nothing to strip away from directors ( b/c directors have not gained anything personally), how are damages measured? Traditionally, in duty of loyalty cases, directors have COI & measure of damages was easy. But, nature of obligation of good faith cases include failure to oversight/failed to comply with law resulting in civil suit charges, which co must likely settled incurring settlement cost; these settlement costs dont benefit directors. Ps argument: if directors exercised oversight, co would never have been sued. Ps remedy: damages but q is how would those damages be measured. It is unfair to bd and unfair to corp that P gets to recover some amt for directors failures d. Bad faith always seems to involve breach of duty of care or breach of duty of loyalty. E. Disclosure & Fairness 1.Disclosure system: a. Securities Act of 1933: i. 1933 Act creates a scheme of mandatory disclosure for initial public distributions of securities by issuers, underwriters, and dealers (primary market). ii. Registration statement: disclosure doc whose contents are ordered by SEC. Registering security require co to file registration statement with SEC. Registration statement is mandatory disclosure. SEC needs to determine whether disclosure in registration statement is adequate. It is burden for promoter to register security. 1. Prospectus: first part of registration statement . Offerer gets prospectus, while SEC gets everything. If offerer wants more info, then need to go to public SEC file dealing with registration statement. 2. From time registration statement is filed to time SEC makes it effective, ONLY written materials that offeror may use are registration statement & prospectus. From effective date to completion of distribution, usually very short pd, sellers may use other written materials, but only in conjunction with registration statement or prospectus. 3. 1933 Act renders issuing corps strictly liable for material misrepresentations or omissions in their registration statements. iii. 2 exemptions of registration statement: 1. Private Placement Exemption (Private offerings under 4(2) of Securities Act) 2. Regulation D: Also private placements BUT provide caps on how much one can offer (safe harbors with specific caps). Thus, Reg D provides a series of safe harbors that issuers can use to come within private placement exemption & avoid or reduce their required disclosure. b. The Securities Exchange Act of 1934 i. 1934 Act primarily regulates securities trading among investors (secondary market). ii. 1934 Act creates scheme of mandatory continuous disclosure for corps that: 1.List securities on national exchange, OR 2.Own at least $5 million in assets & have at least 500 holders of any class of securities, OR 3.File a 1933 Act registration statement that becomes effective. 2.Definition of Security a. Initial q in securities litigation is whether or not instrument or investment at issue is a SECURITY within meaning of SEC Act. b. Determination is important for 2 reasons: i. It indicates whether registration requirements of Securities Act apply to transaction ii. Ps generally have easier time bringing suit under fed securities law than under state C/L fraud rules. Elements of fed securities fraud are easier to prove. 27

vii.

c. In order to come within registration requirement of section 5 of the 1933 Act, offer or sale of prop interest must constitute offer or sale of a security. d. Analysis: i. Howey test (from SEC v. Howey (SCt 1946): Whether instrument or investment at issue is a security within meaning of both Acts ii. B/c security needs to be registered, has it been registered. 1.If no registration, then NO security. iii. Whether exemption (private placement or Reg D) apply. 1.D corp would argue that it is not a security within exemption to be exempt from having to register the security. e. Def of security under Securities Act of 1933 & Securities Exchange Act of 1934: defines security broadly as any note, stock, treasury stock, security future, bond, debenture, . . . , investment K, . . . or, in general, any interest or instrument commonly known as a security. i. Investment K: catch all clause that can apply to any type of transaction that may have started as purely commercial into a security. Investment K would be K or transaction or scheme where investor pays $ to common enterprise with expectation of profit, solely from efforts of others 1. SCt has stated that efforts and profits derived from others does NOT have to be sole derivation of efforts of others, but if it is primarily made by efforts of others, then it could be seen as security. 2. Common enterprise is pooling of funds of investors 3. Thus, investment K defined under Howey as money, common enterprise, & efforts. f. Securities Act defines 3 categories of securities in Section 2(1): i. Any interest or instrument commonly known as security: This would include bonds, stocks, debentures, warrants, etc. ii. Types of securities specifically mentioned in the Act: 1.Pre-organization subscriptions for securities AND 2.Fractional, undivided interests in oil, gas, or other mineral rights. iii. Investment Ks & certificates of participation: 2 most important clauses of section 2(1) are its broad, catch-all phrases: securities are investment Ks & certificates of interest or participation in any profit-sharing agreement 3.What is a security? a. Robinson v. Glynn (4th Cir cas): dealt with limited partners NOT general partners i. Issue: Is LLC interest a security under investment K catch all? 1. Ct applied Howey test. ii. Holding: Ct does NOT tell us whether LLC interest, in general, is a security as a type of investment K. Ct left this q in general open. Ct held that in order to determine whether LLC interest was an investment K, need to determine whether parties had meaningful control. In this case, ct held that this LLC interest was NOT an investment K (NOT a security) b/c Robinson had control & b/c Robinson had control, he had access to info. Thus, P does NOT need protection of statute b/c he has access to info he needs. Ct held that P was NOT a limited partner anymore b/c once limited partner exercises some type of control, then limited partner loses that limited liability. 1.Ct held that LLC interest had NONE of characteristics of a stock. If it does not look like a stock, then cannot be called a stock. ONLY certain people owned LLC interest. a) Characteristics of stock: freely transferable/exchange; investors share amt in proportion to which they own 28

From Robinson case, limited partner interests are investment Ks b/c limited partners enjoy limited liability, but if limited partners participate in management (exercising control), limited partners are transferring their investment from passive to active investment & no longer have LLC interest. If limited partner exercises meaningful control & acts as manager, then dont need protection from the 1933 & 1934 acts (limited partner becomes general partner). Limited partner wants to maintain limited liability. If passive, then investment K, therefore, a security. iv. Rule from case: Test to determine whether LLC interest is security under investment K catch-all is ask whether P has access to info to make informed decision OR has the actual information to make an informed investment decision. If limited partner has amt of control, then limited partner has access to the information & does not need information from registration statement, then limited partner did NOT invest in a security 4.Registration process a. Section 5(a) of Securities Act: Unless registration statement is in effect as to a security, it shall be unlawful for any person, directly or indirectly: (1) to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to sell such security through the use or medium of any prospectus or o/w . . . (b) It shall be unlawful for any person, directly or indirectly (1) to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to carry or transmit any prospectus relating to any security with respect to which a registration statement has been filed under this title, unless such prospectus meets the requirements of section 10 [specifying the required contents of a prospectus] . . . (c) It shall be unlawful for any person, directly or indirectly, to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to offer to sell or offer to buy through the use or medium of any prospectus or o/w any security, unless a registration statement has been filed as to such security, . . . b. Registration process: Prior to original public issuance of securities, issuer must file a registration statement with SEC. Purpose of registration statement is to disclose all of info needed to determine whether securities offered are a good investment. Most important info in registration statement is digested into a prospectus, a shorter doc that is given to purchaser prior to purchase or at same time as purchased securities are delivered 5. Private placement exemption (Private offerings under Section 4(2) of Securities Act): If fit under this exemption, then do NOT have to register security. P would argue that D is in violation of Securities Act for failing to register security. D would argue that it is NOT public offering but a private one to get exemption. If Section 4(2) does NOT apply, then issue would have needed to register. If issuer did NOT register, then issue in violation & subject to section 12 that imposes civil liability onto issuers for failing to register a security. a. Section 4 of Securities Act of 1933 The provisions of section 5 (registration provisions) shall NOT apply to: . . . (2) transactions by an issuer not involving any public offering b. Relevant factors: i. # of offerees AND their relationship to each other and the issuer, ii. Number of units offered, 1. Raising a large amt of $ or # of units being offered makes it seem as if it is a public offering. iii. Size of offering, AND iv. Manner of offering

iii.

29

1. Manner of offering must not include advertising or securities exchange or investment bankers. If it involves investment bankers, then it more likely be a public offering. Cannot make it look as if it is public investment. c. Doran v. Petroleum Management Corp (5th Cir): i. Issue: Whether sale was part of private offering exempted by Section 4(2) of Securities Act of 1933 from registration requirements of that Act. 1. Ct applied the four factors mentioned above. Ct was NOT convinced that factor 1 was proven. Ct says D MUST show that all offerees had available to them all information that a registration statement would have provided a prospective investor in a public offering. Availability of info means either disclosure or access to relevant info. This is why relationship b/w issuer & offeree is important, such as if relationship was such that it provided offeree access to files & records. Case remanded for determination as to whether offerees knew or had a realistic opportunity to learn facts essential to an investment judgment. ii. To determine whether private placement exemption applies: need to look at all offerees (potential investors) & those who actually purchased. To do this do determine legal of sophistication & access to info to determine whether offering was public or private. 1.To protect potential offerees (purchasers), need to ask if offerees had effective access to info or had info on co; whether investors are sophisticated (any legal/bus training); & were they wealthy to offset any losses. a) Sophisticated investor that is wealthy & has extended legal background BUT lack info or access to info, then investor CANNOT make informed decision. b) If investor has access to info or has info BUT is not sophisticated: sliding scale & depends on other facts, such as whether sophistication is needed or not (ex: patent stock v. not complex investment). 6.Securities Act Civil Liabilities a. Before adoption of Securities Act of 1933, securities fraud was solely matter for state law. b. At C/L, P had to prove that D had misrepresented a material fact. P also had to prove all of other elements of C/L fraud: reliance, causation, scienter, & injury. Ps recovery was limited to amt of loss: difference b/w what he/she paid & what security was worth. c. Congress considered civil liability to private parties to be important deterrent & therefore enacted various express private rights of actions for private parties injured by securities law violations. d. Section 11 of 1933 Act: imposes civil liability for failure to disclose in registration; provides due diligence defense. (text found on pg 71 of big outline) i. Section 11 imposes liability on designated persons for material misstatements or omissions in effective prospectus, unless Ds show that they had after having made reasonable investigation of facts reasonable grounds to believe & actually did believe that statements made were accurate. ii. P MUST prove that any misstatement or omission was of material fact. iii. Material representation or omission MUST be in registration statement. iv. Section 11 (a) 1. Section 11 (a) imposes liability upon: a) Signors of Registration statement b) Underwriters (matchers of buyers and sellers) c) Directors of corp d) Engineers e) Appraisers 30

f) Experts consulted to draft portion of registration statement (Experts under due diligence) 1. Liability limited to portions worked on v. Section 11(b): Due Diligence defense 1. Section 11(b)(3)(A) after reas investigation, if had reasonable grounds to believe statement and did in fact believe; applies to non-experts for non-expertised portions a) Steps: 1. Reasonable investigation 2. Reasonable grounds to believe truth of statement 2. Section 11(b)(3)(B): test for experts for expertised portion is same as (b)(3)(A) a) liability is limited to expertised portions 3. Section 11(b)(3)(C) non-expert on expertised portion; when person w/ knowledge serving as non-expert BOD, only must show no reasonable ground to believe & did NOT believe untrue a) Steps: 1. No reasonable grounds to believe false 2. Did NOT believe to be untrue 4. Section 11(c): reasonable investigation = the level of care would reasonable, prudent man would exhibit in management of his own $$, property 5. Section 11(e) Damages - measure difference b/w original price and price after misleading statement is made vi. Privity & reliance do NOT need to be proven under section 11 as were in C/L. vii. Ds defense under section 11: Standards of due diligence for Ds to avoid liability 1. Test: Cts look at each individual D &, based on his position, his responsibilities, his background, skills, training, & access to info, they determine what he should have done to fulfill obligation to make a reasonable investigation. Test is what kind of investigation a prudent person in Ds position, with same responsibilities, skills, etc, would have made (from Escott v. BarChris Construnction Corp. case). 2. Corp as a separate person: Due diligence defense is NOT available to corp as a separate person a) Corp as separate person has no due diligence defense b/c it is responsible for issuing statement that is supposed to be accurate. If corp failed to do that, then P should be compensated & corp as separate person is held to be strictly liable 3. Issuer: Due diligence defense is NOT available to issuers (held strictly liable). a) Issuer can show that statements made were actually true & thus not misstatement b) Issuer can show that misstatements or omissions were NOT of material facts. c) Issuer can show that P purchaser knew of misleading statements or omissions & invested in securities anyway. 4. Non-experts a) With respect to non-expert portion: To avoid liability, a non-expert must meet following tests of due diligence regarding statements he has made in registration statement:1. Non-expert must actually believe that statements he made were true; AND 2. That belief MUST be reasonable one. In order to have reasonable belief, non-expert must have made a reasonable investigation into facts 1. From class: Due diligence defense of non-experts with respect to nonexpert portion of registration statement: Non-Experts MUST show that after reasonable investigation AND reasonable grounds that statements in registration statement were correct AND that statements were indeed true 31

i. For non-experts for non-expertised portion: after reasonable investigation, non-expert found statements to be true & there is no reason to believe that statements are not true; this is objective. 2. In Escott case, ct indicated that each D would be looked at from standpt of his position, training, & responsibility in registration process to determine what constitutes reasonable investigation necessary to fulfill that partys due diligence responsibility 3. Reasonable investigation for non-expert: Non-expert does NOT have to conduct independent audit of issuer. But, a reasonable investigation does go beyond merely trusting opinions & response of issuers officers as to material facts. i. Reasonable investigation does include resort to original written records such as written Ks to verify fact that issuer really did have back orders it claimed to verify statements in registration statement. ii. Reasonable investigation would also probably have to include examination of issuers facilities, operations, material Ks, corporate minutes & other docs, & major items important to financial condition, etc. b) It has been held that attorney-director of issuer who drafted registration statement for issuer is a non-expert as to registration statement in general (Escott case). c) Non-experts reviewing statements in registration statement made by other non-experts: Non-expert will have to show that due diligence appropriate to his position has been exercised. d) Non-experts reviewing statements in registration statement made by experts: Non-experts are entitled to rely to a greater extent on statements made by experts. 1. Ex: outside director, who is a non-expert, relying on certified financial statements of accountants, who are experts. 2. Non-expert must ONLY show that he did NOT believe statements made by expert were untrue & he had no reasonable ground to believe they were untrue. NO investigation is needed to be made by non-expert in this case. 5.Experts a) Expert portion of registration statement: 1. Standard of diligence required: As to statements made by experts, test is: i. They must actually believe that statements they made are true ii. Belief must be reasonable iii. For experts belief to be reasonable, experts MUST have made a reasonable investigation into facts supporting statements made. Normally, this means that expert must perform up to at least standards of his profession. 2. From class: Due diligence defense of experts with respect to expert portion of registration statement: Experts MUST show that after reasonable investigation AND reasonable grounds that statements in registration statement were correct AND that statements were indeed true. i. For expertise portion, need to look at what was on mind of expert & what expert should have known & what expert actually knew; this is subjective b) Due diligence defense of experts with respect to non-expert portion of registration statement: Experts incur NO liability with non-expertise portion that they did NOT prepare. 6.Due diligence defense is easier to establish with expertise portion. It is harder to establish due diligence defense with regards to non-expert part. Expertise portion is 32

backed up by experts. With regards to expertise portion, experts have higher threshold to maintain than non-experts. e. Escott v. BarChris Construction Corp (NY case): Due Diligence defense i. Analysis: First ask if the registration statement contains misrepresentation &/or omission. Then, ask whether Ds have established due diligence defense with respect to each D to do this need to look at registration statement with respect to which portions were prepared by experts and to which portions were prepared by non-experts. ii. Ct held here that registration statement contained misrepresentations (false info) & omissions and they were material. Then, ct asked which portions were prepared by experts and non-experts and looked at each individual D for his due diligence defense. iii. Material: Term material, when used to qualify a requirement for furnishing of info as to any subject, limits info required to those matters as to which average prudent investor ought reasonably to be informed before purchasing security registered. 1. Matters as to which average prudent investor ought reasonably to be informed: matters which such an investor needs to know before he can make intelligent, informed decision whether or not to buy security. iv. Def of Due diligence: Conducted reasonable investigation on asserted statements that statements were NOT false & everything in registration statement is correct. v. Reasonable investigation/search: Need to look at every doc that is relevant to this transaction (dissecting cos business). Need to look at the background docs relating to registration statement. Need to make sure that registration statement contained only accurate & complete info & that any info that is material is not misleading. vi. Rule: Ls are NOT considered experts in this context 1. Ct held that non-expert portion & expert portion of registration statement need to be looked at differently. 2.Ds had argued that b/c Ls, who are experts, had prepared registration statement, then registration statement is expertise & no variation of due diligence has to be proven. f. Securities Act section 12(a)(1): imposes strict liability on sellers of securities for offers or sales made in violation of 5. 12(a)(1) liability arises i. Ex: Section 12(a)(1) is available where seller improperly fails to register securities ii. Ex: 12(a)(1) available if seller registers but fails to deliver a statutory prospectus, violates gun-jumping rules, or commits any other violation of 5 iii. Main remedy under 12(a)(1): rescission. Buyer can recover consideration paid, plus interest, less income received on security. If buyer is no longer owner of securities he/she can recover damages comparable to those which would be provided by rescission g. Securities Act 12(a)(2): imposes private civil liability on any person who offers or sells a security in interstate commerce, who makes material misrepresentation or omission in connection with offer or sale, & cannot prove he did NOT know of misrepresentation or omission & could NOT have known even with exercise of reasonable care. i. Liability standard: D is held liable for intentional or negligent violations. Note that D has burden of proof to show his nonnegligence. ii. Ps prima face case has 6 elements: (P need NOT show reliance) 1.Sale of security 2.Through instruments of interstate commerce or mails 3.By means of prospectus or oral communication 4.Containing an untrue statement or omission of a material fact 5.By a D who offered or sold security AND 6.Which D knew or should have known of untrue statement (of P pleads Ds knowledge, burden of proving o/w shifts to D). 33

h. Rule 10b-5 (pursuant to section 10(b) of 1934 Act) 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, (1) to employ any device, scheme, or artifice to defraud, (2) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (3) To engage in any act, practice, or course of business which operates or would operate as fraud or deceit upon any person, in connection with purchase or sale of any security i. Securities MUST be involved. Rule 10b-5 applies to ALL types of securities transactions (those on exchange). 1. To obtain jurisdiction, interstate commerce must be involve, i.e., some means of interstate commerce must be used. ii. SEC has express right to bring suit under Rule 10b-5, while private person has implied right to bring suit under Rule 10b-5. 1. RULE: Standing requirement, must be in connection w/ purchase or sale of security a) Standing q: When corp D, if the statement is one in which reasonable investor might rely or is intended to rely it is in purchase or sale of securities 2. Rule: No c/a against those who aid & abet Rule 10b-5 violators (from Central Bank) iii. 4 elements that P MUST prove under Rule 10b-5: 1.Reliance; a) Reliance provides causal connection b/w Ds misrepresentation & Ps injury b) Basic case: Reliance that needs to be proven is reliance on efficiency of market. 2.Causation; a) For causation, MUST show misstatement caused P harm, i.e., overly opportunistic press release, which raises $$$ of security. 3.Materiality; AND a) Standard for materiality=reasonable investor standard 1. Reasonable investor standard: It is a fact specific inquiry to determine whether preliminary merger negotiations are material. Would a reasonable investor consider these negotiations important? 4.Scienter a) P must show intent or recklessness to defraud or manipulate. Neg is NOT enough. 5.Any D found to violate Rule 10b-5 will be sanctioned either criminally or civilly. If civil action, brought by SEC & SEC can also bring crim suit & refer to crim suit to justice dept. 6.Two issues in Rule 10b-5 fact patterns: a) Misrepresentations which are either misstatements or omissions; AND b) Insider trading iv. Section 10(b): applies to ANY security, including securities of closely held corps that are generally NOT subject to Exchange Act & to transactions in gov securities. Section 10(b): It shall be unlawful for any person, directly or indirectly, by theuse 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 & regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors v. Misrepresentations which are either misstatements or omissions 1. Basic Inv v. Levinson (SCt case): looking at materiality and reliance elements 34

a) Issue: materiality & reliance b) Holding on materiality: Ct accepts argument that Basic, as target, did NOT have to disclose its discussion about merger. Problem here is that Basic provided false info. Once Basic answers q, that answer to q CANNOT be misleading & incomplete. Ct held that info about preliminary merger negotiations is material. 1. Rule on materiality: Basic had a duty to speak accurately & complete (CANNOT be misleading or incomplete). c) Holding on reliance: B/c reliance for a class action is hard to prove, ct presumes reliance. Ct applies economic theory of a rebuttable presumption that members of class inappropriately responded to fraud made upon the market (fraud on market theory). This allows ct to state presumption that class relied & allowed class action to proceed. Ct states that even if we do not directly rely on statement by corp b/c we dont understand info (unsophisticated investor) or do not have time to read it (sophisticated investor), we buy & sell stock at prices based on stock analysts, who are doing the reliance. Reliance has changed. Originally, reliance was easier to prove b/c transactions were done face to face. But, now transactions are done via exchanges & stock markets, so reliance that needs to be proven is reliance on efficiency of market. Ct presumed reliance & this was indirect reliance. 1. Fraud on market theory (aka efficient capital market hypothesis): Rebuttable presumption. Since it is an open market, price of stock is dependent on info disclosed. Misleading statement could have affected price of stock. As a result, Ps rely on value of stock to make decisions. It is more accurate to say that Ps are relying on efficiency & integrity of market. 2. Rule on reliance: Even if misstatement is material, P still needs to prove that P relied on omission or misrepresentation. P has burden of proof to show reliance on info or reliance on lack of info given to potential investors. Reliance that needs to be proven is reliance on efficiency of market. d) Note: Whenever target co is being taken over, acquirer thinks that he can operate co in a more cost efficient way. Target goes up. No target or acquirer wants info about potential merger to get out to public b/c this will result in other companies to start bidding & will lead to bidding war. Original target will no longer want to merger, thus, both acquirer & target wants this info to keep confidential. 2. West v. Prudential Securities (7th Cir): false nonpublic info a) Here, Hoffman, securities broker working for Prudential (D), told customers about an acquisition that was NOT impending. Ps here are people that bought Jefferson stock during Hoffmans lying or happened to buy at time rumors were being spread. b) Issue: causation-> Can class action for fraud-on-the-market be maintained in case involving non-public info? 1. NO. Market was NOT affected b/c this lie was private (non-public info). Thus, Ps CANNOT show that Hoffmans lie injured them (no causal link b/w lie & Ps harm). Ct stated that fraud-on-the-market theory did NOT apply b/c private lie. 3. Sante Fe Industries v. Green (SCt case): Ps brought case under Rule 10b-5 & section 10(b) , while arguing for breach of fiduciary duty. Rule 10b-5 & section 10(b) ONLY applies if there is fraud or misrepresentation or nondisclosure. Ps CANNOT bring action under Rule 10b-5 for mere unfairness. a) Section 253 of DE General Corp Law (known as short form merger statute): permits parent corp owning at least 90% of stock of subsidia ry to merge with that subsidiary, upon approval by parents bd of directors, & to make payment in cash for shares of minority shareholders. 35

Statute does NOT require consent of, or advance notice to, minority shareholders. However, notice of merger must be given within 10 days after its effective date, & any stockholder who is dissatisfied with terms of merger may petition DE Ct of Chancery for decree ordering surviving corp to pay him fair value of his shares, as determined by ct-appointed appraiser subject to review by ct. b) Appraisal (dissenter) rights: Rights that minority shareholders have & these rights are under statute. Minority shareholders go to ct & ask for ct to appoint appraiser. Ct will appoint appraiser to determine what minority shareholders should receive. Then, ct will make its decision based on info provided by appraiser. c) Nondisclosure: Another type of situation sometimes arising is where D does NOT disclose material facts. Issue is whether P would have acted differently if P had known of material facts. 4. Deutschman v. Beneficial Corp (3d Cir case): a) Issue: Does P who traded in stock options in reliance on misstatements made by corporate management have standing to sue under section 10(b)? b) Option K gives its owner right to buy (call) or sell (put) a fixed # of shares of specified underlying stock at given price (striking price) on or before expiration of date of K. Market price for options is directly responsive to changes in market price of underlying stock info affecting that price. B/c market value of option K is responsive to changes in market price of underlying stock, holders of option Ks are susceptible to 2 separate types of deceptive practices: insider trading & affirmative misrepresentation. 1. Affirmative misrepresentation is at issue in this case. 5. Rule on standing: Option MUST be considered a security in order for Ps to have standing. vi. Insider Trading 1. Insider trading: Typical problem involves situation where someone related to corp (such as officer or director or shareholder owning large amt of stock) is in position to have inside information about how corp is doing, &, hence, what corps stock is, or will be, worth. This person (insider) then buys stock w/ advantage over seller or sells it w/ advantage over buyer. Issue concerns what duty corporate insider may owe to other party. 2.Different theories dealing with inside information: a) When insiders trade material info without disclosing to public (insider trading) (Chiarcella case) b) Tippe/tipper liability (Dirks case) c) Misappropriation theory (OHagan case) 3. Goodwin v. Agassiz (Mass case): a) This case was brought under state law for fiduciary duty. Goodwin case is different than Texas Sulfur case b/c Texas case brought under fed laws, Rule 10b5 & Section 10(b). b) Issue: Whether non-public info was material & should have been disclosed to shareholder. 1. Ct held NO b/c director of co (D) did NOT owe shareholder (P) any fiduciary duty. D ONLY has fiduciary duty of loyalty & care to corp. i. Prof says there is problem with cts analysis. Most cts say that fiduciary duty is owed to both shareholders & corp; this is evolution. 4. SEC v. Texas Gulf Sulphur Co (2d Cir) a) 2 suits involved in this lawsuit: 1 against corporate insiders for insider trading AND 1 against co itself for issuing false statement in press release 36

b) Issues: 1. Was there insider trading? YES i. Ct held that b/c Ds traded based on this info, that means info was material. ii. Then, have person who waited for announcement, but traded an hr after info went public. Is this person considered an insider trader? Maybe insider & should wait even longer for people to analyze this info & for those people to act on this info. Ct left this open q iii. Bottom-line: Insiders should wait until insiders are NOT at an advantage over public potential purchasers 2. Did false statements made in press release constitute violation of Rule 10b-5? YES c) Essence of Rule 10b-5 is that anyone who, trading for his own account in securities of corp, has access, directly or indirectly, to info intended to be available only for corporate purpose & not for personal benefit of anyone may NOT take advantage of such info knowing it is unavailable to those with whom he is dealing, i.e., investing public d) Rule for insider trading: Anyone in possession of material inside info MUST either disclose it to investing public, or if he is disabled from disclosing it in order to protect corporate confidence, or he chooses not to do so, must abstain from trading in or recommending securities concerned while such inside info remains undisclosed. e) Test for materiality: Info is material if a reasonable investor would believe that info was necessary to complete an investment. (reasonable investor standard goes towards materiality). f) Rule that TGS case gives: Insiders have to disclose material, non-public info before insiders do trading (insiders cannot buy stock w/out disclosing material, non-public info). This is called disclose or abstain rule 1. If insider wants to purchase or sell stock, insider needs to disclose or insider has to abstain from buying or selling stock. 2. Insiders CANNOT profit from insider trading. Insiders have to wait for info to be announced AND DISSEMINATED. If insiders traded before announcement & dissemination, then traders in violation of Rule 10b-5. g) Elements of insider trading: Reliance, materiality, scienter, & causation 1. Scienter: Neg is NOT enough for scienter. Dont have to show intent to influence investors, but if there were reckless to influence investors, then scienter is satisfied for requirement of Rule 10b-5. 5. Dirks v. SEC (SCt case) a) Here, Secrist was original tipper. Dirks is tippee. Then, Dirks becomes tipper when Dirks passes info to his clients. b) Issue: Whether tipper violated fiduciary duty when giving tip to tipee. c) Holding: SCt held that tippee had no fiduciary duty & no violation under Section 10(b) & Rule 10b-5. d) Rule from Dirks ->SCts approach to tipper-tipee analysis: Determining whether tippee violated Rule 10b-5 depends on whether tipper violated fiduciary duty when tipper gave that tip to tippee. SEC (P) has to show that tippee knew that tipper breached fiduciary duty by giving tip. If actual knowledge cannot be found, then next q to determine is if tippee should have known (objective test after no actual knowledge). 1. Ex: Suppose Secrist had disclosed inside info (not involving fraud) to Dirks b/c of bribe from Dirks. Dirks then advised his clients to sell their Equity 37

Funding stock. Dirks, of course, would have violated Rule 10b-5. Would his clients also have violated rule? i. Secrist is insider & original tipper. Dirks is original tippee. This q is asking whether, if Dirks committed fraud, are clients liable? New tippees are clients & Dirks became tipper. What did clients know or should have known is factual q to ask. Thus, did Dirks get info as a result of fiduciary breach? Rule: Dirks inherits that fiduciary duty, and if clients should have known or known that he received info from breach of fiduciary duty, then clients can be liable. Here, all would violate Rule 10b-5 if clients knew or should have known about bribery, which breached fiduciary duty 2. SCt sees Rule 10b-5 as an anti-fraud provision. SCt does NOT think we should all have access to info. SCt is concerned with whether there is fraud & is there a violation of breach of duty of liability. If there is no fraud, no fiduciary duty, & no breach of duty of loyalty of tipper, then no Rule 10b-5 liability on tippee (tippee does NOT violation Rule 10b-5. 3. To determine whether Rule 10b-5 was violated, need to ask if tipper (insider) received personal benefit. i. Q for breach of duty of loyalty: is there personal benefit? ii. Tippee is not liable unless tipper gained personal benefit by giving this tip. When we are talking about personal benefit, are we talking about enhancing rep of that person? Case law is not clear. But most commentaries conclude SCt is talking about tangible, real benefit. But no cases that clearly sets out what benefit is. iii. Q of whether revenge is considered a tangible, real benefit to be a personal benefit. iv. If tipper and tippee routinely exchange stock tips, benefit is getting info in future; that is tangible, real benefit, & exchange would violate Rule 10b-5. e) Definition of fiduciary duty by SCt in Dirks: DUTY OF LOYALTY 1. Fundamental issue with breach of such loyalty is if insider elevates his/her personal interest before the interests of corp. Ct in Dirks provided narrow def of fiduciary duty. ONLY q with respect to tipper is whether tipper earned a personal interest that would ultimately result in a breach of fiduciary duty. 2. Duty of care is removed from analysis f) Hypo: lets say Secrist is an insider who finds out equity funding is going to be taken over. Nature of info is material. Would Dirks be liable for insider trading for info that he overheard on the elevator? 1. That is NOT insider trading. No duty owed. Misoverhearing is NOT misasppropriation. g) Fair Disclosure: Regulation FD: requires corporate executives to give info about their company to analysts only if they are giving info to public or making it available to public. This reg requires that critical non-public info revealed to public at same time (ex: available on internet at time executive gives info to public). 1. In 2000, SEC adopted Regulation FD to create non-insider trading-based mechanism for restricting selective disclosure. If someone acting on behalf of public corp discloses material nonpublic info to securities market professionals or holders of issuers securities who may well trade on basis of info, issuer must also disclose that info to public. Where disclosure is intentional, issuer must simultaneously disclose info in manner designed to convey it to general public. Hence, for ex, if issuer holds briefing for selected analysts, it must simultaneously announce same info through, say, a press release to widely disseminated news or wire service. SEC encouraged issuers to make use of Internet & other new info technologies, such as by webcasting conference calls with analysts. Where disclosure was NOT intentional, as where a corporate officer let something slip, issuer must make public disclosure promptly after senior officer learns of disclosure. 38

6.

2 different approaches of insider trading: SEC v. SCt a) SCts approach: SCt bases on whether there is fiduciary duty. SCt asks q of whether insider traders breach a fiduciary duty to shareholders and corp. SCt banned insider trading b/c it is fraudulent & breach of fiduciary duty. 1. Prevailing law: If there is breach of fiduciary duty by insider trader, then violation of Rule 10b-5. 2. SCt rejects notion that we all should have equal access to info. SCt raises notion that some people have better access than others. SCt is concerned about making stock analysts job useless. SCt wants to encourage stock analysts work; SCt does that with fair disclosure b) SEC approach: SEC wants to make playing field as equal as possible by giving equal access to info. All about level playing field. 1. Problem with SEC approach: unequal access to info is reason why stock analysts perform job they do. Dont want to put the stock analysts out of their job. 7. Chiarella v. US (SCt case) a) Facts: Printing co had been retained by acquiring corp in connection with tender offer for shares of another corp. Acquiring co made every reasonable effort to keep id of tender offer target a secret, even from employees of printer. Chiarella, by virtue of his job & ingenuity, correctly identified target & bought shares of its stock through a broker. When tender offer was announced, target shares rose in value & Chiarella sold his shares at a profit. When his conduct was brought to light he was fired & he agreed to give up his profit. He was indicted for violating section 10(b) & Rule 10b-5, b) Holding: SCt held that Chiarellas conduct was NOT a violation b/c he was NOT an insider of corp whose shares he had traded, that is, target corp. SCt concluded that duty to abstain arises from relationship of trust b/w corps shareholders & its employees. Since there was no relationship b/w Chiarella & shareholders of corps whose shares he traded, he had no duty to disclose or abstain. 8. Temporary Insider doctrine: states that professionals, such as Ls, retained by firms do become temporary insiders & that is fiduciary duty that can be breached. If breach fiduciary duty, then violation of Rule 10b-5 9. Misappropriation theory: New liability of theory with respect section 10(b) & Rule 10b-5 coming from OHagan case & SCt accepted it. a) Misappropriation theory: looking whether trader owes fiduciary duty to source of information as opposed to looking for fiduciary duty b/w insiders and corp b) Misappropriation theory under Act ONLY requires deception be in connection with purchase or sale (do NOT need deception of identifiable individual). 1. SCt emphasizes deception of failure to disclose under misappropriation theory 2. Rule: If disclosed, no deceipt or manipulation 3. Rule: A entity CANNOT misappropriate its own information. 4. RULE: Liability will pass if trader, misappropriates information i. Requires a rule prohibiting dissemination, b/c w/out no deception c) Ex: If have fiduciary who fails to disclose info belonging to his principal/ source of that info & then trades on that info for personal gain, that is fraud under rule 10b-5 under misappropriation theory. Here, failure to disclose info. d) US v. OHagan (SCt case) 1. OHagan, while D&W (law firm in which OHagan worked at) was representing Grand Met, OHagan purchased call options for Pillsbury stock; 39

VI.

this was before Grand Met publicly announced its tender offer for Pillsbury stock. Ct held that by OHagan taking this info from firm & firms client, OHagan is liable under misappropriation theory. i. Note: Grand Met (acquiring co) is NOT OHagans client, but his firms client. e) U.S. v. Chestman (2d Cir case) 1. Ira informed sister of selling Waldbaums to A &P. Then, sis told her daughter. Daughter told H. H told info to his stock broker, Chestman, who then bought Waldbaums stock for his own account & accounts of other clients. Chestman was accused of violating Rule 10b-5. 2. Ct held that a person violates Rule 10b-5 when he misappropriates material nonpublic info in breach of fiduciary duty or similar relationship of trust & cconfidence & uses that info. Ct further held that in absence of any ev that husband regularly participated in confidential bus discussions, familial relationship standing alone did NOT create fiduciary relationship b/w H & W or any members of wifes family. Hs actions did NOT give rise to requisite breach of fiduciary duty. 3. Rule 10b-5(2): was adopted in response to Chestman. It gives non-exclusive list of 3 situations where duty of trust & confidence is presumed for misappropriation theory i. such a duty exists whenever someone agrees to maintain info in confidence. (Express promise of confidence) ii. such a duty exists b/w 2 people who have pattern or practice of sharing confidences such that recipient of info knows or reasonably should know that speaker expects recipient to maintain infos confidentiality. iii. such a duty exists when someone receives or obtains material nonpublic info from a spouse, parent, child, or sibling (Spouse, parent, child or sibling) Problems of Control A. Two ways to take over co: 1. Market for corporate control: announce tender offer by freezing out minority shareholders. 2. Proxy fight: fight between insurgents and incumbents B. Proxy Fights: result when insurgent group tries to oust incumbent managers by soliciting proxy cards and electing its own representatives to bd. Insurgent group might try to replace existing bd through proxy fight, or use proxies to fight any defensive measures that management hopes to implement. Proxy fights are subject to 1934 Securities Exchange Act & to state corporate statutes. 1. Difference b/w large publicly held cos & small, closely held co: W/ large publicly held cos with many shareholders, shareholders are expected to be passive investors. When small closely held co, shareholders are expected to be active investors. In small closely held co, investor usually serves as both shareholder & director. 2. Proxy: shareholders right to vote may be allocated to another NOT owning shares via proxy. Under corporate law, shareholders may appoint an agent to attend meeting & vote on their behalf. That agent is shareholders proxyholder (aka proxy). a. Proxy is generally revocable at any time, such as by grant of subsequent proxy, or by shareholder personally attending shareholder meeting & voting. b. When talking about proxy, talking about suggestions from shareholders on how bd should run co. 40

c. B/c few shareholders of public corps attend annual meeting, outcome will generally depend on which group has collected most proxies. 3. Proxy or proxy card: doc by which shareholder appoints agent a. Thus, proxy can be used to describe vote or paper on which shareholder votes on. 4. Proxy statement: statement sent to shareholders asking shareholders to vote a certain way, asking to submit to agency relationship. In proxy statement, need to describe terms of sale or merger that is being voted on. 5.Strategic Use of Proxies a. Levin v. MGM, Inc. (NY case): deals with insurgents taking over i. Issue: reimbursement ii. Rule: To be reimbursed, need to show that proxy fight is policy battle NOT purely personal or personnel. b. Rosenfeld v. Fairchild Engine & Airplane Corp (NY case): deals with reimbursement i. Rules for reimbursement: 1. Corp cannot reimburse either incumbents or insurgents unless there is policy fight (NOT personal or personnel) (Threshold q). Only expenses that are to be reimbursed are those that are proper and reasonable. a) Ex where personal fight NOT policy: Women need to run cosmetics co b/c women want control of co. Here, women are insurgents. Neither insurgents nor incumbents would get $ b/c not policy dispute. 2. Incumbents get reimbursed if they win or lose. Do NOT need any ratification for incumbents to be reimbursed. 3. Insurgents are ONLY reimbursed if they win & if shareholders ratify/approve that payment. c. Rule 14a-7 of 1934 Act: Gives management a choice to either mail insurgents proxy statements to shareholders directly and charge group for cost OR give over shareholder list & let it distribute its own material. B/c management often prefers to keep list confidential, it generally opts for former. i. Rule does not supersede any state law that exists 6.Regulation of Proxy fights under Securities Exchange Act of 1934 a. Section 12 of 1934 Act: Requires co to register its securities with SEC & thereafter to file periodic reports on cos financial condition, if cos securities are (i) traded on regulated securities exchange OR (ii) traded over counter & co has assets of at least $10 million AND 500 or more shareholders of class of equity securities, such as common stock. i. Cos that have registered with SEC are called registered companies. b. Section 14 of 1934 Act: regulates solicitation of voting proxies from shareholders of cos registered under section 12. Section 14(a) of 1934 act: It shall be unlawful for any person, by use of mails or by any means or instrumentality of interstate commerce or of any facility of national securities exchange or o/w to solicit or to permit use of his name to name to solicit any proxy or consent or authorization in respect of any security (other than exempted security) registered on any national securities exchange in contravention of such rules and regs as SEC may prescribe as necessary or appropriate in public interest or for protection of investors (12 of 1934 Act). i. Section 14(a) prohibits people from soliciting proxies in violation of SEC rules. 7.Private Actions for Proxy Rule Violations a. Rule 14a-9 (text of statute on pgs 95-96 of big outline): prohibits materially false or misleading statements or omissions in proxy statement. Cts have held that private c/a is implied under section 14. i. RULE 14a-9: Prohibits solicitation of a proxy by a statement containing either: 1.(1) a false or misleading declaration of material fact OR 41

2.(2) an omission of material fact that makes any portion of the statement false or misleading ii. RULE: ct have power to grant all necessary remedial relief, i.e. either rescission, damages or both. b. J.I. Case Co v. Borak (SCt case): i. SEC has expressed right of action under section 14 of 1934 Act. ii. Issue: Whether there is implied right of action under Rule 14a-9. iii. Rule: Yes, there is implied right of action under Rule 14a-9. c. Mills v. Electric Auto-Lite Co (SCt case): i. Facts: Proxy materials did NOT disclose that M controlled 54% of D & Ds bd of directors. Merger occurred already. Suit was to set merger aside based on false or misleading statements in proxy materials. ii. Issue: Whether omission caused harm (causation) (link b/w defect in proxy material & harm caused to shareholders) iii. Holding: P has to show that misstatement or the omission is material. The fact that needed 2/3 vote for merger is what made this proxy solicitation material. P showed causation b/c proxy solicitation was essential link to get merger through. However, merger was fair & Ps were NOT harmed. Thus, P could NOT recover any damages b/c no harm. Fairness of merger is relevant to damages. d. Seinfeld v. Bartz (CA case): i. Facts: Shareholder (P) brought derivative suit against corp & directors alleging that Ds violated section 14(a) of Securities Exchange Act of 1934 & Rule 14a-9 by issuing proxy statement that contained misleading statements & omissions of material fact. ii. Standard: materiality of TSC Industries: q of materiality is what would a reasonable investor need & is important in deciding to vote. What a reasonable investor would consider important to exercise his/her vote iii. Rules: 1.Proxy solicitation material cannot be misleading. If misleading, then violation of Rule 14a-9. 2.Omission CANNOT be material a) RULE: Omission must be material AND cause P harm 1. To show omission was material: i. Must look at statement/omission ii. AND proxy solicitation itself b) RULE (causation): P must show: 1. Misstatement was material 2. Solicitation itself was an essential link in accomplishing trans (causation) i. some minority ct, dont require prong #2 8. Shareholder proposals: As an alternative to independent proxy solicitation, shareholder may serve notice on management of his intention to propose action at shareholders meeting. Shareholder may ONLY propose such action if (i) he would be entitled to vote at shareholders meeting to which managements proxy statement relates & (iii) he is shareholder at time proposal is submitted. a. Issue: Whether shareholder proposals will be included in proxy statement. i. Shareholder will draft proposal & supporting statement & send it to co to include proposal in proxy. ii. If management opposes proposal, then shareholder may also include 200 word statement in support of proposal, which management must also send out with its own proxy statement if proposal conforms to proxy rules. 42

If management opposes shareholder proposal, it must file proposal & reasons for opposing it with the SEC. SEC will review proposal & give an indication of whether it agrees or disagrees with management (i.e., whether it would issue a no action letter if management omits proposal from its proxy solicitation). No action letter indicates SEC agrees with management. b. Rule 14a-8 shareholder proposals: This rule addresses when co MUST include shareholders proposal in its proxy statement & identify proposal in its form of proxy when co holds an annual or special meeting of shareholders. i. Rule 14a-8 is formatted in q & a format. ii. Rule: If shareholder seeking to submit a proposal meets certain eligibility & procedural requirements, corp is required to include proposal in its proxy statement & identify proposal in it form of proxy, UNLESS corp can prove to SEC that given proposal may be excluded based on 1 of 13 grounds enumerated in regs.1 of these grounds is Rule 14a-8(i)(8). (a) Question 1: What is proposal? A shareholder proposal is your recommendation or requirement that co and/or its bd of directors take action, which u intend to present at meeting of cos shareholders. Your proposal should state as clearly as possible course of action that u believe co should follow. If your proposal is placed on cos proxy card, co must also provide in form of proxy means for shareholders to specify by boxes a choice b/w approval or disapproval, or abstention. Unless o/w indicated, word proposal as used in this rule refers both to your proposal, and to your corresponding statement in support of your proposal (if any). [Paragraph (a) tells us what a proposal is] (b) Question 2: Who is eligible to submit proposal, & how do I demonstrate to co that I am eligible? (1) In order to be eligible to submit proposal, u must have continuously held at least $2,000 in market value, or 1%, of the company's securities entitled to be voted on the proposal at the meeting for at least one year by the date you submit the proposal. You must continue to hold those securities through the date of the meeting . . . . (i) Question 9: If I have complied with the procedural requirements, on what other bases may a company rely to exclude my proposal? [(i)(1)-(i)(12) provides list of reasons for excluding shareholders proposals] (1) Improper under state law: If the proposal is not a proper subject for action by shareholders under the laws of the jurisdiction of the company's organization; NOTE to paragraph (i)(1): Depending on the subject matter, some proposals are not considered proper under state law if they would be binding on the company if approved by shareholders. In our experience, most proposals that are cast as recommendations or requests that the board of directors take specified action are proper under state law. Accordingly, we will assume that a proposal drafted as a recommendation or suggestion is proper unless the company demonstrates otherwise. Class Notes: 1 of the most common ways to find their proposals excluded. When a proposal orders directors to do something, instead of recommending the directors from doing something, then gets excluded. Note that proposal does not have any mandatory effect. Bd does not have to do; it just gives them an idea of what shareholders want. What is wrong with a proposal in demanding bd to do something? These are not decisions that shareholders get to make. Management or affairs is to be only undertaken by bd of directors NOT shareholders. (2) Violation of law: If the proposal would, if implemented, cause the company to violate any state, federal, or foreign law to which it is subject; NOTE to paragraph (i)(2): We will not apply this basis for exclusion to permit exclusion of a proposal on grounds that it would violate foreign law if compliance with the foreign law could result in a violation of any state or federal law. (3) Violation of proxy rules: If the proposal or supporting statement is contrary to any of the Commission's proxy rules, including Rule 14a-9, which prohibits materially false or misleading statements in proxy soliciting materials; 43

iii.

Class Notes: (3) violation of proxy rules. If u have shareholder proposal that had material misleading statement/omission can be excluded under (3) as violating Rule14a-9. (4) Personal grievance; special interest: If the proposal relates to the redress of a personal claim or grievance against the company or any other person, or if it is designed to result in a benefit to you, or to further a personal interest, which is not shared by the other shareholders at large; Class Notes: personal interest of shareholder can be excluded under (4). (5) Relevance: If the proposal relates to operations which account for less than 5 percent of the company's total assets at the end of its most recent fiscal year, and for less than 5 percent of its net earning sand gross sales for its most recent fiscal year, and is not otherwise significantly related to the company's business; [This was at issue in Lovenheim case] (6) Absence of power/authority: If the company would lack the power or authority to implement the proposal; (7) Management functions: If the proposal deals with a matter relating to the company's ordinary business operations; Class Notes: (7): Deals with management functions if proposal relates to ordinary bus operations, then it can be excluded b/c not proper subject for shareholders action. It is officers who make ordinary bus decisions. This is simple corporate governance matter. (can be excluded under (i)(7) or (i)(1)) (8) Relates to election: If the proposal relates to a nomination or an election for membership on the company's board of directors or analogous governing body or a procedure for such nomination or election; [at issue in AIG case] (9) Conflicts with company's proposal: If the proposal directly conflicts with one of the company's own proposals to be submitted to shareholders at the same meeting. NOTE to paragraph (i)(9): A company's submission to the Commission under this section should specify the points of conflict with the company's proposal. (10) Substantially implemented: If the company has already substantially implemented the proposal; (11) Duplication: If the proposal substantially duplicates another proposal previously submitted to the company by another proponent that will be included in the company's proxy materials for the same meeting; (12) Resubmissions: If the proposal deals with substantially the same subject matter as another proposal or proposals that has or have been previously included in the company's proxy materials within the preceding 5 calendar years, a company may exclude it from its proxy materials for any meeting held within 3 calendar years of the last time it was included if the proposal received: (i) Less than 3% of the vote if proposed once within the preceding 5 calendar years; (ii) Less than 6% of the vote on its last submission to shareholders if proposed twice previously within the preceding 5 calendar years; or (iii)Less than 10% of the vote on its last submission to shareholders if proposed three times or more previously within the preceding 5 calendar years; and Class Notes: Proposals that have been given in the past but have never had much support. (13) Specific amount of dividends: If the proposal relates to specific amounts of cash or stock dividends. iii. Lovenheim v. Iroquois Brands (DDC case): Rule 14a-8(i)(5) 1. Facts: P motioned for preliminary injunction to have proposal NOT excluded from proxy statements. 2. Statute at issue: Rule 14a-8(i)(5): Relevance: If the proposal relates to operations which account for less than 5 percent of the company's total assets at the end of its most recent fiscal year, and for less than 5 percent of its net earning sand gross sales for its most recent fiscal year, and is not otherwise significantly related to the company's business a) Rule 14a-8(i)(5) provides 5% test, which is objective test for relevance. It might be includable if it o/w significantly related to bus; that is subjective part. 1. If it is significantly related to bus, then it cannot be excluded from proposal 3. Issue: Whether proposal was o/w significantly related under excpetion. 44

Holding: YES. Ethical significance=animal cruelty a) Rule: Need to prove both ethical significance AND significantly related to cos bus. If does these 2 things, then should be included. b) Note: Pate production did NOT have significant relationship with rep of co. iv. AFSCME v. AIG, Inc (2d Cir case): election exclusion under Rule 14a-8(i)(8) 1. Issue: Whether shareholder proposal requiring company to include certain shareholder-nominated candidates for bd of directors on corporate ballot can be excluded from corporate proxy materials on basis that proposal relates to election under Securities Exchange Act Rule 14a-8(i)(8) (election exclusion). a) NO. Ct decided that narrow/original interpretation of Rule 14a-8(i)(8) applies. This proposal does NOT relate to particular seat in particular election. 2. Rule 14a-8(i)(8): Relates to election: If proposal relates to a nomination or an election for membership of cos bd of directors or analogous governing body or a procedure for such nomination or election (reason to exclude proposal) a) 2 interpretations of Rule 14a-8(i)(8): 1. Narrow interpretation: excludes only proposals that related to particular seat in particular election (this was the original position) 2. Broad interpretation: Rule allowed to exclude all proposals that concerned corporate elections in general (then SEC changed thinking and this would include this proposal here) C. Abuse of Control (dealing with closely held corp NOT large publicly held corps) (deals with state law) 1. Rule: Majority shareholder in closely held corps have duty similar to that of partners. (from Wilkes case) a. Majority shareholders owe duty of utmost good faith and loyalty to each other (from Wilkes case). 2. RULE: In closely held co, either work for corp and get salary OR get dividends; must have return on investment or opportunity to obtain 3.Three-step Wilkes Test: a. Did this shareholder in closely held owe duty of utmost good faith and loyalty? b. Apply this duty if have minimum shareholder challenging control group (freeze out); control group must show that transaction entered into was for legitimate bus purpose c. If controlling group proves that there was legitimate bus purpose, then minimum shareholder can win if minimum shareholder can show that control group could have accomplished that would have harmed minority shareholder less. 4. Freeze out problem: breaches fiduciary duty of loyalty 5. Rule: Majority shareholder does NOT have to employ shareholder (Ingle case) & majority shareholder does NOT have to pay dividends (Wilkes case). a. Note: Duty of utmost good faith does NOT include right to be employed (Ingle case). b. Note: If have freeze out & dont have leg bus reason, then there is breach of Wilkes duty. If have leg bus reason, then NO breach 6. Wilkes v. Springside Nursing Home (Mass case): Freeze out a. Wilkes was frozen out & suffered 2 financial loss: 1. Return on getting employment salary (can get another job) 2. Return on investment of that co (cannot get that back) b. Issue: Whether there was a legitimate bus purpose for severing Wilkes from corp. i. NO. There was no showing of misconduct & Wilkes performed hi assigned share of duties competently. Ct held that majority shareholders breached fiduciary duty of loyalty by freezing out Wilkes. c. Test: When minority stockholders in closely held corp bring suit against majority alleging breach of strict good faith duty owed to them by majority, ct must analyze action taken 45

4.

by controlling stockholders in individual case. It must be asked whether controlling group can demonstrate legitimate bus purpose for its action. d. Wilkes duty: Wilkes duty applies to closely held corps. Wilkes duty are high duties, strict duties, more analogous to duties that partners owe each rather than publicly held duty unless it involves controlling shareholder of publicly held co. i. Wilkes duty=Controlling shareholder owe minority shareholder utmost/strict good faith & utmost loyalty e. Hypo: Wilkes was underperforming & three controlling shareholders continued to work for co & paid themselves high salaries, arguably excessive salaries. The fact that Wilkes was underperforming, controlling group has leg bus reason to firing him. They may have leg bus reason for paying higher salaries b/c they are filling in for Wilkes. i. What is best line of attack for Wilkes to argue about these excessive salaries? Can argue for COI? 3 arguments 1.Wilkes analysis (this is ONLY for closely held co) 2. SELF-DEALING Sinclair Oil Corp. v. Levien: Analysis to apply for whether controlling/dominant shareholder breached duty of loyalty (goal: hold majority shareholder accountable for conduct) (this is for ALL corps, NOT just closely held corps): a) Whether there was self-dealing on part of the controlling/dominant shareholder. Ask whether the controlling shareholder has received something to the detriment or expense of the minority shareholder. 1. Burden of proof to prove self-dealing is on Ps (minority shareholder). 3. Conflicted director statute (NY Section 713 & DE Section 144): Breach of duty of loyalty-> Ratification of COI a) Interested Bd if director has COI and can benefit must be: 1. Ratified by Bd; 2. Ratified by shareholder; 3. Fair 7.If Wilkes duty NOT trigged, then argue self-dealing a. SELF-DEALING: Analysis to apply for whether controlling/dominant shareholder breached duty of loyalty (goal: hold majority shareholder accountable for conduct) (from Sinclair Oil Corp. v. Levien (DE case) derivative suit; controlling shareholder case): i. Whether there was self-dealing on part of the controlling/dominant shareholder. Ask whether the controlling shareholder has received something to the detriment or expense of the minority shareholder. ii. Burden of proof to prove self-dealing is on Ps (minority shareholder). b. Conflicted director statute (NY Section 713 & DE Section 144): Breach of duty of loyalty-> Ratification of COI i. Interested Bd if director has COI and can benefit must be: 1. Ratified by Bd; 2. Ratified by shareholder; 3. Fair 8. Ingle v. Glamore Motor Sales (NY case) a. Issue: Whether at-will employee acquires protection against being fired simply because he is a minority shareholder in close corp? b. Holding: NO. A minority shareholder in close corp, by status alone, who contractually agrees to repurchase of his shares upon termination of his employment for any reason, acquires NO right from corp or majority shareholders against at-will discharge. Note that K expressly confirmed unavailability of that protection. c. Thus, Ct held that Ingle simply an employee. Employee at will doctrine overrides Wilkes duty (fiduciary duty of utmost good faith/loyalty owed to shareholders) 9. Brodie v. Jordan (Mass): a. Issue: Whether P (wife of deceased shareholder who inherited interest to corp from decedent) was entitled to remedy of forced buyout of her shares by majority. 46

VII.

NO. Ds here had interfered with Ps reasonable expectations by excluding her from corporate decision-making, denying her access to co info, and hindering her ability to sell her shares in open market. b. Ds agreed that they are liable to P BUT argue forced buyout is improper remedy. Ct held that forced buyout of this Ps shares is NOT appropriate remedy. c. Rule: Proper remedy for freeze out is to restore minority shareholder as nearly as possible to position she would have been in had there been no wrongdoing. Controlling group does NOT have to buy her out b/c this would provide more than reasonable expectations. d. P would have been entitled in this case to money damages and possibly an injunction. 10. Smith v. Atlantic Properties, Inc. (Mass case): closely held co a. Here, bylaws provided that corporate decisions must be approved by 80% of stock eligible to vote, effectively giving any one stockholder veto power. In order to get 80%, need all 4 shareholders to vote yes (here 4 shareholders each owning 25%). b. Issue: Whether Wolfson breached his fiduciary duty to other stockholders by repeatedly exercising veto power provided for in bylaws. i. YES. Wolfson refusal to vote in favor of dividends was caused more by his dislike for other stockholders & his desire to avoid additional tax payments than by any genuine desire to undertake a program for improving corps prop. Wilkes duty applies here. Wolfson violated fiduciary duty of utmost good faith. 11. Jordan v. Duff & Phelps, Inc (7th Cir case): Fiduciary duty under state law and under Rule 10b-5 a. Issue under state law: Whether fiduciary duty (strict/utmost good faith & loyalty) that shareholders owe to each other in closely held corp required Duff to tell Jordan about merger (Issue of state law) Wilkes duty issue. i. Majority states that controlling shareholder has duty to tell minority shareholder (employee at will) about merger agreements AND Wilkes duty would have prevent that kind of firing. b. Issue under Rule 10b-5: Whether Duff can fire Jordan for opportunistic reason. Failure to disclose material info under Rule 10b-5. i. Rule: Majority said that majority shareholder CANNOT fire Jordan, minority shareholder, for opportunistic reasons (opportunistic reasons-> to make money for yourself). Duff owed a duty to Jordan to disclose non-public info or abstain from trading under Rule 10b-5 (abstain or disclose rule 10b-5). ii. Majority held that info NOT disclosed was material iii. Opportunistic reasons: would be that Duff let Jordan go in order to keep the profits to himself. iv. 2 step analysis on abstain or disclose Rule 10b-5 put forth by majority in Jordan: 1.Whether reasonable shareholder would respond to info if it had been disclosed. Jordan would have wanted to stay if he knew about merger. 2. If Jordan had chose NOT to quit, could he have been fired by other controlling shareholders for opportunistic reason to capture all benefits. Mergers, Acquisitions, & Takeovers A. Three Methods to Combine companies 1.Statutory merger 2. Asset sales (aka acquisitions) 3. Tender offer (often followed by short-form merger) (take-over) B. Definitions 1. Holding co: A co formed to control other companies, usually confining its role to owning stock & supervising management. 47

i.

2. Appraisal rights: Right for shareholders to sell his shares at fair value, which is appraised value of shares. Appraised value is assessed immediately before transaction. 3. Rescission: would put P back in same positions as if merger was redone 4. Mergers: When 2 firms merge, surviving firm acquires liabilities of acquired firm. Acquiring co inherits all liability (known & unknown liabilities). Assets of merged/consolidated corps become assets of survivor. a. Merger has to be approved by 2/3 approval. b. Ex: Lehman would have merged into Bank of America & this merger would have been accomplished by Bank of America giving cash or Bank of America shares. Then, Lehman would have dissolved & Lehman shareholders get shares of combined co. c. Statutory Mergers: combination accomplished by using procedure prescribed in state corp laws. Under statutory merger, terms of merger are spelled out in doc called merger agreement, which prescribes treatment of shareholders of each corp. i. If statutory merger procedure is used, merger agreement would specify how many shares would go to shareholders of each of 2 corps. ii. If statutory merger procedure is used, approval by votes of bd of directors & shareholders of each of 2 corps would have been required. iii. Shareholders of each corp who voted against merger would be entitled to demand that they be paid in cash fair value of their shares (determined by agreement, or failing agreement, by judicial proceeding); this right to be paid off is called appraisal right. d. Practical Mergers: do NOT use statutory procedure. i. 1 such alternative method would be that corp 1 offer its shares to shareholders of corp 2 in return for their corp 2 shares. Corp 1 would seek to acquire enough corp 2 shares to gain control of corp 2. ii. Since transaction would be b/w corp 1 & individual shareholders of corp 2, no votes of corp 2 directors or shareholders would be requires. iii. Neither would there be any appraisal rights. iv. Once it gained sufficient control of corp #2 (typically, 90 %), corp 1 could use short form merger procedure to merge corp #2 into corp #1. Corp #1 might also acquire Corp #2s shares for cash. It might use subsidiary to accomplish acquisition. 1.Short-form merger: a) RULE: Statutory short form merger does not require permission of minority shareholder b) Requirements (Del Corp Law 253): 1. parent to own more than 90% of stock i. filing of articles of merger w/sec of state ii. no voting required, subject to notice requirement 2. POLICY: Shareholder has right to continue in corp subst. similar to shareholders initial investment v. Common element would be sale by individual corp #2 shareholders of their shares, for shares of corp #2 or for cash 5. Asset Acquisition: Surviving co will ONLY inherit known liabilities NOT unknown liabilities. a. Corp #1 buys all assets of corp #2 for Corp #1 stock or for cash. Here, Corp #1 would deal with Corp #2 rather than with its shareholders. b. If assets-acquisition method has been used, corp #2 would have been left with nothing but shares of corp #2. Ordinarily, it would have been liquidated & distributed these shares to its shareholders. Corp #2 ceases to exist. c. Ex: Asset acquisition where Bank of America would purchase assets of Lehman & in 48

turn for these assets, Bank of America would give cash or give Bank of America shares. Lehman would only own Bank of America shares or money & Lehmans assets would have been taken over. Once assets moved from Lehman, then that co is dissolved (dissolution is procedure described by state law, need to notify secretary of state of dissolution), then assets are liquidated & all that is left is that Lehman has is Bank of America shares in exchange. Then, Lehman shareholders would be paid by Bank of America shares & those shareholders become Bank of America shareholders. d. Steps of asset acquisition: 1. asset acquisition; 2, dissolution; 3. Distribution of shares that it got. U accomplish the same thing as u accomplish in merger with asset acquisition, and that is at issue in Farris case. 6.Take-over: a. Ex: Bank of America would take control of Lehman by acquiring Lehman shares from Lehman shareholders; Bank of America deals with shareholders directly. Take over is begun w/ tender offer. Bank of America can give Lehman shareholders Bank of America shares or Bank of America can give $ to them. When Bank of Americ acquires enough shares (90%), then Bank of America can use short form merger & can be done quickly. C. Mergers & Acquisitions 1.De Facto Merger Doctrine a. MAJORITY RULE: Equal Dignity Doctrine asset sales are equally valid choice, under law, cts will respect them as such if stat procedures followed b. MINORITY RULE: De Facto Merger if the trans results in merger, despite its differing structure, will be treated as merger c. Farris v. Glen Alden Corp (PA case): De Facto Merger proposed & accepted by ct here i. Transaction: Here, larger co sold its assets to smaller co & in return larger cos assets, small co gave shareholders stock. Then, larger co liquidates & sells stock to shareholders. Here, 1 of small cos shareholder files complaint that hw was not allowed his appraisal rights. ii. Ct holds that this transaction (asset acquisition, which prevented shareholders from getting appraisal rights) was a de facto merger & P deserves appraisal rights. De facto merger-> actual substance of transaction was a merger. d. Hariton v. Arco Electronics Inc (DE case): Rejects de facto merger i. Acquiring assets & merger are 2 separate doctrines. Have 2 companies combining for assets acquisition (this was to avoid appraisal rights). Asset acquisition is legal & that there is 2 ways to reorganize/method to combine & each way to combine whether it asset sale or merger deserves equal dignity. e. Aftermath: i. RULE: No such thing as De Facto Non-Merger ii. Legislature abolished de facto merger doctrine, such as PA legislature. iii. DE & NY do NOT adhere to de facto merger f. Appraisal rights vary from state to state i. DE (Hariton case): eliminates appraisal rights for all public companies. This was done b/c why should shareholders com ii. plain about what they are receiving from a transaction if its a public company they can sell their shares on open market so you shouldnt have appraisal rights. iii. NY: will give appraisal rights for dissenting mergers for statutory mergers. NY will not give appraisal rights through an asset acquisition. iv. PA (Farris case): PA gives appraisal rights for asset acquisitions & mergers 2. Freeze out mergers: Publicly held co a. Weinberger v. UOP, Inc (DE case): Freeze out in publicly held co i. Facts: dealt with minority shareholders being frozen out. UOP bd approved of merger of UOP & Signal (controlling shareholder). However, UOP bd had lots of conflicted/ 49

disinterested directors, where they were officers of both Signal & UOP (dual director & officer role). Also, have independent members of UOP with no relationship to Signal also approving of merger. Lastly, majority of the minority shareholders also voted for merger. Suit filed by 1 of minority shareholders (class action) against Signal & its bd, UOP & its bd, & Lehman bros, who wrote fairness opinion (NOT adequately prepared b/c done in a rush). ii. Issue: Whether the dealings were fair (fair dealing) & whether price was fair (fair price). 1. Ct held merger did NOT meet test for fairness. B/c inadequate disclosure, burden of proof remained with Ds, who could NOT prove fair dealing. iii. Rule of fiduciary duty from Weinberger: Duty of loyalty that controlling shareholder owes to minority shareholder. 1. Standard for fairness established by Weinberger ct for cash out mergers requires fair dealing AND fair price. a) Fair dealing: embraces qs of when transaction was timed, how it was initiated, structured, negotiated, disclosed to directors & how approvals of directors and stockholders were obtained 1. Fair dealing requires candid & honesty & that is what is lacking in this case. No bargaining or attempt to get more money for minority shareholders; this was not fair dealing. What most failed with this respect to this merger was that it was NOT fully informed decision. With respect to disclosure made (bd votes first on whether it will recommend it to shareholders; need 2/3 vote of shareholders for merger to happen). Problem is disclosure was NOT adequate .Majority of the minority shareholders (minority voters) did not get the info. 2. Burden of proof is on D to prove fair dealing. b) Fair price: relates to economic & financial considerations of proposed merger, including all relevant factors: assets, market value, earnings, future prospects, & other elements that affect intrinsic or inherent value of cos stock 2. Steps of test for fairness: a) P must articulate some misconduct on Ds part, such as fraud, non-disclosure. b) Then, burden of proof shifted to Ds to prove fairness c) BUT, situation where majority of the minority shareholders approve merger, burden shifts back to P to show fairness, which depends on whether there was full disclosure. d) If no full disclosure, then burden does NOT shift back to P & remains with D. 3. Ct rejected requirement for showing of bus purpose in fairness test. 4. In cases, where controlling shareholder freezes out minority shareholders, there is potential for self-dealing (controlling shareholder will benefit at minority shareholders detriment; this is intrinsic fairness test announced in Sinclair). B/c potential self-dealing, that is why majority shareholder bears burden with respect to fairness & is borne at anytime P alleges fraud, however, if there is full disclosure, then minority shareholder would bear burden. 5. Note: Sinclair rule for duty of loyalty applies to all corps NOT just closely held corps. 6. Note: Wilkes deals with duty in particular duty of loyalty: freeze out in closely held corps, which is different type of freeze out than this freeze out occurring in Weinberger. Weinberger analysis applies to freeze out in the public held corps; this is why called public corp seeking to go private. Weinberger DOES NOT change Wilkes holding!!! b. Coggins v. New England Patriots Football Club, Inc (Mass case): dealt with controlling shareholder being ousted out/frozen out by management. But, here controlling shareholder 50

tries to regain control by buying out all voting shares from other shareholders. B/c expensive, had to borrow $ from banks, which insisted him to restructure corps where income went to repaying loans. To do this, he merged Old Patriots corp into new wholly formed subsidiary BUT cashing out non-voting minority shareholders. This merger was approved by majority of the minority shareholders. P is dissenting non-voting minority shareholder who is trying to undo merger. i. Rule: Controlling shareholder CANNOT transfer personal debt to corp; this is breach of fiduciary duty of loyalty ii. Here, controlling shareholder had no legitimate bus purpose for freezing out minority, but personal to be able to satisfy his own personal debt. Merger could not be undone. iii. To determine fairness in Mass, Mass requires looking to see whether there is legitimate bus purpose (from Coggins case). 1. ON EXAM: need to argue that there is split in whether bus judgment rule is part of fairness test. DE: no bus purpose from Weinberger case. c. Rabkin v. Philip A. Hunt Chem Corp (DE case) i. Rule from case: Appraisal is NOT ONLY remedy. There are three types of remedies: 1.Appraisal; 2. Weinberger type; AND a) Weinberger type: based on fairness. If unfair, then get damages (rescission is 1 ex) 3. Seeking to enforce promise/ K that all relates to fair dealing as seen in Weinberger. D. De Facto Non-Merger: where P tries to argue that transaction is NOT a merger. 1. Rauch v. RCA Corp (2d Cir case): Ct rejects de facto non-merger doctrine. If it is called a merger, then it is a merger. (this was under DE law) E. LLC Mergers 1. VGS, Inc v. Castiel (DE case): dealing with manager managed LLC with 3 person bd of managers. Controlling shareholder is frozen out by other 2 shareholders; they achieved this by merging LLC into corp & out of consideration, 2 shareholders froze out controlling shareholder by giving him certain amt of shares in corp. Castiel lost control. a. Holding: Ct holds, in spite of plain language of DE LLC Act, ct will not allow this kind of action taken by written consent with no meeting & no notice to Castiel, when principles of equity require that Castiel be informed. If Castiel had notice that this was what other 2 wanted to do, Castiel had right to remove Quinn & put someone else in that would vote for him being he had right to appoint 2 individuals on the board. i. Needed to give notice to this merger & disclose ALL info concerning it. F. Hostile Takeovers 1.In hostile takeover, co do NOT want to be taken over. This is different than mergers and asset acquisition, where acquirer approaches target co & negotiates bus combination with management. 2. Shareholders earn huge premiums from acquirers in hostile takeovers. Even though shareholders are getting premium, this hostility is perceived from perspective of directors & officers b/c directors & officers will lose control & hostile bidder/raider is stating that co is not run efficiently and that acquirer could run co more efficiently. 3. First step of hostile takeover: Raider makes tender offer. a. Initial tender offer transaction of acquiring co to target co shareholders NOT management in takeovers. b. Tender offers are simply offers made by acquirer for shareholders to tender (turn over/make available) their shares to acquirer or acquiring co. Offer for the shareholders to turn over the shares and make them available to the acquirer. Purchase of shares ONLY IF acquirer achieves particular target & acquirer will condition sale. If enough shareholders 51

make available enough shares, then acquirer will tender this offer. Fewer shareholders tender and then acquirer can take those shares and turn them over back to the shareholders without a purchase if the condition is NOT met (amt of shares are NOT met). c. In response to tender offer, management of target co puts takeover defense measures in place. It is bd members that install takeover defense measures; & these takeover defense measures are what ct scrutinizes to determine if officers & directors need protection of bus judgment rule. 4. Bus judgment rule in hostile takeovers: comes into play later on in the analysis. Here, have officers & directors that are conflicted b/c if takeover goes through officers & directors will lose control & lose their jobs. Bus judgment rule comes after ct is satisfied that officers & directors need protection of bus judgment rule. And directors & officers have satisfied their enhanced duty. a. RULE: B/c of inherent COI of BOD, BOD must demonstrate good faith and reasonable investigation AND balance to obtain protection of BJR 5. Rule: When faced with Hostile Bid, BOD can serve two types of interests a. To max value for shareholders (Revlon) b. To protect corporate entity (Time) 6. Rule after Cheff + Unocal: Bd MUST show: (to determine whether bds hostile defense takeover measure is immune from judicial review & is given deference under BJR) a. Independent members of bd acted in good faith & with reasonable investigation (as required by BJR) (from Cheff) b. Response (take over defense measure) to threat has to be proportionate to threat i. Thus, reasonable response-> mixed standard, subjective in perceiving the threat and objective would reasonable person perceive the same 7. Cheff (D) v. Mathes (P) (DE case): a. Rule: In Cheff, ct announces that directors MUST have plausible business reason for rejecting hostile takeover bid. b. Takeover defense measure used: Greenmail (do NOT see this takeover defense measure anymore)-> Co buys its own stock from hostile bidder/raider. The purchase of stock is limited to the hostile bidder. i. Problem with greenmail: does NOT protect co from hostile bidders that come along the way after takeover defense measure put in place. ONLY protects co from initial raider. ii. Greenmail is NO longer used b/c Internal Revenue Code poses 50% penalty tax to benefits/proceeds gained by greenmail. c. Test: dependent on whether director is insider or outsider: i. For inside directors, COI is much more direct than it is for outside directors. Outsiders have conflict BUT indirect. ii. Insiders have to satisfy higher burden to get protection from bus judgment rule than outside directors. iii. Insiders prove burden by showing that they have proper business purpose. iv. Outsiders do not have show proper bus purpose BUT in considering hostile bid they conducted a reasonable investigation and acted in good faith. d. Note: another takeover defense measure: self-tender, which is when co offers to buy shares from its other shareholders. 8. Unoval Corp v. Mesa Petroleum Co (DE case): a. Facts: Mesa Petroleum is already shareholder of Unocal owning 13% & at this point Mesa makes offer, which is called two tiered front end loaded tender offer: is offer made to shareholder in order for Mesa to get control of Unocal. This tender offer is made for little over 30 percent (37%), if it is successful, then Mesa gets control; this is first tier or front end of the tender offer. 37% of the Unocal 52

shareholders would get $54/share & now Mesa would have control. Front end is more advantageous for shareholders. Front end get control. Second tier/back end: plan for Mesa to cash out remainder of the shareholders for remainder shares by junk bonds for $54/share. Remainder of shareholders had become minority shareholders b/c Mesa had gained control. They will NOT be cashed out or frozen out BUT get junk bonds. Junk bonds are highly subordinated and equivalent to 2nd or third mortgage. Junk bond has high interest, but it is high risk b/c all the holders are before junk bond holders; so, all other creditors will get paid before junk bond holders. Since junk bonds are high risk & subordinated, they get a lot of return on initial investment. Mesa argues that b/c he is shareholder, Unocal owes Mesa fiduciary duty. i. Junk bonds: debt obligations of corp that are usually subordinate to other debt & bear relatively high level of risk & high interest rate. b. First Takeover defense measure: SELF-TENDER: Unocal made tender offer for its own stock. Self tender offer was made to all shareholders (tender offer of its shares) except to hostile bidder, Mesa. Defense mechanism would go into effect if Mesa got control, then Unocal would purchase all other stock for $72/share & as shareholder, u are going to hold out to tender to Unocal. Unocal was forced to change self-tender b/c with this offer, Mesa would never gain 50% control b/c most shareholders would wait to tender from Unocal. Unocal changed it that Unocal would buy certain amt of shares (50 millions shares) even if Mesa did not gain control. As a result, Unocal is forced to borrow $ to pay stockholders. i. Ct held that Mesa had to be excluded from self tender in order for takeover defense measure to work. c. Second takeover defense measure: REDEMPTION, which is right of co to buy back its own shares. Unocal would buy back 50 million shares. Here, Mesa is complaining that he has right to redemption as well. i. Ct held Mesa is not entitled to redemption. d. Rule: Takeover defense measures by directors MUST be a reasonable response to threat that posed by bidder. Response to threat has to be proportionate to threat. i. Here, Mesas offer was coercive to people at front end & inadequate to the people at the back end & that is offer ct scrutinizes to see if takeover defense measure by the UNOCAL was proportionate to this threat. ii. Only thing that directors needed to show was good faith and reasonable investigation for outside directors and a legitimate purpose. e. Cheff + Unocal=outside directors (independent members of bd) act in good faith & with reasonable investigation as required by bus judgment rule (from Cheff) + Takeover defense measure needs to be proportionate to threat posed by hostile bidder. i. Unocal: When bd implements anti-takeover measure there arises omnipresent specter that bd may be acting primarily in its own interests, rather than those of corp & its shareholders. This potential for conflict places upon directors burden of proving that they had reasonable grounds for believing there was a danger of corporate policy & effectiveness, a burden satisfied by showing of good faith & reasonable investigation. 1.Thus, inside directors are conflicted & danger is that bd will act in its own interest rather than what is best for shareholders. BJR applies BUT NOT right away but after enhanced scrutiny by ct. ii. Unical: In addition, directors must analyze nature of takeover & its effect on corp in order to ensure balance-that responsive action is reasonable in relation to threat posed. f. Suppose Pickens had rep not as greenmailer, but as liquidator. Suppose, for ex, that it had been clear that it was Pickens intent, if he was successful in his takeover attempt, to reduce substantially Unocals exploration & drilling program & fire substantial number of employees involved in that program. What relevance would that have had? i. Unocal ct said can take impact of takeover bid success on other constituents & q would be directors not only are able to consider impact bid (negative impact from 53

target perspective), target directors can also consider if neg impact on nonshareholding groups, such as employees (seen in Cheff), creditors, & consumers. BUT Revlon says that target directors have to show rational benefit for shareholders when considering non-shareholding groups, such as employees, creditors, & consumers. If u put that together w/ role of shareholders, looked at PA charitable donations statute, which is called non-shareholder constituent statute, & said when directors considering in any interests can consider both shareholders & non-shareholding group & see this context. 1.NY and DE does not have non-shareholder constituent statute. 2. It is still on the books for PA. and it was written in response to what we are reading now; thus, it was created in response to takeover context. 9. Revlon v. MacAndrews & Forbes Holdings (DE case): Hostile takeover a. Here, have situation where have raider/hostile bidder, Perelman (CEO of PP) wanted to acquire Revlon BUT Bergerac (CEO of Revlon) refuses b/c of personal reasons. As a result of hostile raider, Revlon implements 2 hostile take over defense measures. As a result, PP offers more money per share BUT ONLY will acquire if Revlon gets rid of poison pill. Revlon then countermoved to give some shareholders $65/share instead of poison pill & exchanged notes for cos shares. But, this move made Revlon less attractive to bidder b/c Revlon was burdened with debt. Then, PP lowered bid. Then, white knight entered pic. White knight=Frostmann. Frostmann asked for three things: cancellation/termination fee, lock up provision, & no shop provision. i. Note: Investment banker told Bergerac that Revlon was worth more if it busted up. b. Take over defense mechanism: Self-tender, poison pill i. Self-tender: initial takeover defense mechanism. Revlon would buy back some stock for $57/share (where PP wanted $40-45/share) ii. Poison pill: second takeover defense mechanism. Revlon would issue poison pill called no purchase rights plan, where Under Revlons plan, if any bidder obtained 20% stock (triggering event), then Revlon shareholders would get right to exchange each share that they own to be payable for $65 payable for 1 yr with 12% interest rate (this makes them creditor instead of equity holder), & this is more valuable than what Purchase Plan is offering. 1. Problem with poison pill: B/c most shareholders will hold out to get this deal, PP will never get 20% and poison pill will never go into effect. iii. Self-tender & Poison pill=pre-bidder defense measures (Hostile defense measures implemented before the bidding war. Pre defense measures are implemented before hostile bidder and are defending against any hostile bidder. iv. Cancellation/termination fee, lock up provision, & no shop provision= postbidder takeover measures (requested by white knight). Post-bidder defense measures are implemented after bidding war (after hostile bidder comes into pic) and defending against specific hostile bidder (here, PP). 1. No shop provision: agreement that target will not shop around for another deals; this was installed after Fortsmann came on bd 2. Cancellation fee: Any agreed fee for time & effort if co canceled on white knight a) If any other co, such as hostile bid wants to outbid white knight, they have to pay an agreed amt 3. Lock up option: gives white knight (F) option to buy valuable assets of the target and gets to buy the targets ground jewels (most valuable assets) promised to white knight for significant low prices 54

Pre-bidder takeover defense measure: protects company from any hostile raider, while post-bidder takeover defense measure: protects against specific hostile raider. c. Holding: Incumbents lose in Revlon b/c no leg bus purpose. i. Ct says need to distinguish b/w earlier and later take over measures. Earlier ones were deemed reasonable while later ones were not. 1.Note: Pre-bidder are not always reasonable. Need to determine whether pre-bidder might harm shareholders from getting info to get best value. 2. Looking at poison pill: Threat-> inadequate value for Revlon shareholders, then Revlon undertook poison pill. Then needs to apply Cheff and Unocal. They acted in good faith. They undertook reasonable investigation of PP and this led them that this bid was too low. Unocal: they were reasonable in relation to the threat that PP posed. 3.Once bidding start b/w F and PP, directors should have understood that sale of Revlon was inevitable & unavoidable & that point Revlon would be sold. In order to pay for acquisition, Revlon would have to be broken up. If PP or F were successful, help to finance the very expensive acquisition by taking busting up and selling assets of Revlon to pay for this acquisition. a) Busting up: when sell crown jewels or 1 division BUT not selling whole co. By selling crown jewel or 1 division, this breaks up co. White knight would ask to sell crown jewels or division in order to pay debt of taking on that co. 10. Paramount Communications v. Time Inc (DE case): a. Facts: Target is Time. NO white knight here to save target co but instead negotiation b/w Time & Warner to merge. Both cos decided to install pre-hostile bid hostile take-over measures to prevent potential hostile takeovers. Paramount was raider & made hostile bid for Time BUT wanted Time-Warner merger to be canceled. Both cos installed defense take-over measures once deal was announced. Deal is merger here. 1. Warner promised Time that it would reject any offers to take it over & vice versa. 2. They also get banks to agree to withhold any financing for take over for either corp; this is called dry up agreement. 3. That there would be triggering event agreed upon them to buy others stock if another bidder came into scene. In response, Paramount increased its price. b. Times argument was that Paramounts bid proposed a threat. Threat Time argued was that Time had certain plans in place, structures, & a Time culture of journalistic integrity, and have negotiated a strategic alliance with Warner (Ct accepts this) c. Paramounts argument: its bid was not inadequate value (Ct rejects this) d. Case did not fit within either category of when Revlon duties apply. No change of control would have resulted from the merger e. Did the merger of Time & Warner deprive Time shareholders of opportunity in future to realize premium for sale of control? After merger, could Paramount, or some other corporation, have mounted a new takeover bid for combined corps? Is that relevant? i. Relevant b/c Time shareholders lost a significant premium. It precluded the time shareholders from getting this $75 dollar premium. It then became too costly to acquire & difficult to consummate b/c of size of Time-Warner. Merger of Time & Warner was effective takeover defense. They are too big to have been bought out. 11. Paramount Communications Inc v. QVC (DE) a. Facts: Paramount is target; QVC is raider. Paramount & Viacom were undergoing friendly negotiations. Then QVC comes onto scene. QVC announces hostile bid for Paramount & Paramount rejects QVC takeover bid & installs takeover measures to counter QVC takeover bid. Paramount had been put up for sale. b. Revlon duties apply b/c change in control during sale of Target co.

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12. Revlon duty: Duty to maximize sale price value for shareholders. Here, Revlon bd did NOT maximize value, but undertook defensive measures to stop bidding war (this is why postbidder takeover measures were NOT reasonable). a. Once it is clear that break up of co is inevitable, then need to consider maximization for short term (right now need to max wealth) NOT long term. b. Revlon duty applies with hostile take-over in 2 situations: i. When it is inevitable that co has to be sold (this will be indicated in facts: sale announced publicly or negotiations to sell co or auction) (QVC case) 1. Sale of co has to be accompanied by change in control (from QVC case): where co was originally public co with many people in charge (controlled by fluid of aggregation of unaffiliated shareholders) and then with sale control is shifted to either be controlling by 1 co or controlled by 1 shareholder. a) Fluid: buying or selling ii. Breaking up co (busting up co) (Revlon case): when co has to sell crown jewels or a division in order for white knight to pay for debt of taking on that co. As a result, co is broken up. (bidding war occurs b/w white knight & hostile raider) c. When there is no change of control during sale of target co or breakup of target co, then Revlon duties are NOT invoked.

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