You are on page 1of 93

I. Agency and Partnership a. The Law of Enterprise Organization b. Acting through Others: The Law of Agency c.

The Problem of Joint Ownership: The Law of Partnership II. The Corporate Form a. The Corporate Form b. Debt, Equity, and Economic Value c. The Protection of Creditors III. Normal Governance a. Normal Governance: The Voting System i. Class Voting ii. Shareholder Proposals b. Normal Governance: The Duty of Care c. Conflict Transactions: The Duty of Loyalty i. Effect of approval by a disinterested party d. Executive Compensation e. Shareholder Lawsuits i. Demand Refused/Excused Summary ii. Special Litigation Committees IV. Extraordinary Governance a. Transactions in Control i. Tender Offers b. Fundamental Transactions: Mergers and Acquisitions i. Statutory mergers ii. Asset acquisition iii. Compulsory Share Exchange iv. Triangular Mergers v. Summary of Voting & Appraisal Rights vi. Appraisal Decision Tree vii. Duty of Loyalty in Controlled Mergers c. Public Contests for Corporate Control i. Unocal ii. Poison Pill iii. Revlon V. Federal Regulation of Trading in the Corporations Securities i. Trading in the Corporations Securities ii. fRule 16 iii. 10b5 elements I. Agency and Partnership
The Law of Enterprise Organization

a. The Law of Enterprise Organization i. Three Basic Goals of Corporate Law 1. Facilitating relationships among the owners of the corporation (shareholders) 2. Facilitating the relationship between shareholders and the managers of the corporation 3. Facilitating contracting between shareholders and other stakeholders in the business (creditors) a. To a much lesser extent than the other goals ii. Tools 1. Transaction Cost Economics a. Coase, Williamson b. when there are costs to transacting, owners of various resources will contract in order to reduce costs and share efficiency gains

c. firm as a "nexus of contracts" d. particularly useful for how corporate law is doing with goals 1 & 3 2. Agency Cost Theory a. Jensen & Meckling b. managers (agents) may make uneconomic decisions for the firm that are in personal interest of managers but hurt shareholders (principals) c. generally about goal 2 (rltnshp btw owners & managers) d. also implicated in goals 1 & 3 i. situations of dominant/controlling shareholder that has power normally held by managers, used to make decisions not in best interest of firm and/or other shareholders ii. goal 3: worried about shareholders who control firm indirectly through board making decisions w/creditors $$ that are only good for indirectly controlling shareholders e. Three kinds of agency costs i. Monitoring ii. Bonding - costs agents incur in limiting ability to hurt principal/ensure reliability & loyalty to principal 1. example: restrictions on stock trading by executives iii. Residual 1. most serious costs iii. The Objective of Corporate Law: Increase welfare through economically efficient arrangements 1. Types of Efficiency a. Pareto efficiency - where no one can be made better off without making someone worse off i. severely limits the possibility of welfare-improving trades ii. assumes that the original distribution of assets is legitimate b. Kaldor-Hicks efficiency - transaction/move produces total gains sufficient to compensate all those who suffered any loss (net gains bigger than net losses) i. doesn't rely on losers actually being compensated ii. still assumes initial wealth distribution is legit iii. more workable than Pareto, generally accepted among corporate law scholars as the proper definition of "efficiency" c. all moves that are pareto efficient are Kaldor-Hicks efficient, but NOT vice versa i. pareto is tiny subset of Kaldor Hicks 2. Puzzle: courts rarely use language of efficiency to justify decisions a. but when they talk about "fairness"/moral reasoning in opinions, do so in terms of "fairness" to shareholders, which often means the efficient course bc of fiduciary duty 3. Jonas hypothetical a. Costs of apt & hotel i. if it costs a firm $70,000 to rent apt (preferred by Jonas), $19,300 for hotel, cost to firm of apt is $50,700 ii. when Jonas is full owner, these costs are the same for him as to the firm iii. when Jonas is 10% owner, cost to him of apt is $7000, cost of hotel is $1930, so cost to him is $5070 b. What will he do with given benefit to him of apt i. if incremental benefit of apt is $100,000 1. 100% owner = apt 2. 10% owner = apt ii. if incremental benefit of apt is $10,000 1. 100% owner = hotel 2. 10% owner = apt iii. problems of agency cost arise when incremental benefit of apt is btw $50,700 & $5,070 1. in this range, it is not Kaldor-Hicks efficient for Jonas to take apt, but he might anyway bc it is efficient for him 2. when its not the agent's money, not as careful with it

3. this would be a residual agency cost


Acting through Others: The Law of Agency

b. Acting through Others: The Law of Agency i. Definition: Restatement (Third) of Agency 1.01 1. Agency is the fiduciary relation that arises when one person (a principal) manifests assent to another person (an agent) that the agent shall act on the principals behalf and subject to the principals control, and the agent manifests assent or otherwise consents so to act ii. Agency Law 1. agency relationship arises out of consent 2. core of the agency relationship: Agent (A) can bind principal (P) to a third party (T) a. this is its economic value in contract 3. Background rules relevant to agency a. Formation b. Termination c. P's liability for A's authorized and unauthorized contracts, and for torts committed by A d. A's duties to P 4. Formation a. Types of Agency i. scope: special agents (limited to a single act or transaction) v. general agents (series of acts or transactions) ii. disclosure to T: P disclosed; P undisclosed; P partially disclosed (existence known but unidentified) iii. right to control: employee/servant v. independent contractor 5. Termination at will a. agency relationships are not specifically enforceable, only monetary damages for violation 6. Parties Conception Does Not Control a. Jenson Farms Co. v. Cargill, Inc. (Minn. 1981) p18 i. Principle: An agency relationship may be created through a circumstantial course of dealing, even if the parties had no explicit agreement or did not intend such a relationship ii. Facts: Warren operates grain elevator, buying grain from farmers and selling to buyers. 90% grain sold to Cargill, which also lent $$ to Warren to keep it running. It fails w/o paying farmers for some of the grain they'd bought. Farmers go after Cargill since Warren doesn't have $$ iii. Holding: Warren was acting as Cargill's agent, and is liable for its debts iv. there was no express intent to form an agency relationship v. Court defines elements of agency relationship as 1. restatement of agency defn 2. manifestation of consent that one wants other act as agent, and that agent consents to doing so vi. Court: nine factors demonstrate Cargill's control over Warren 1. question is how these factors are different than in a typical lender/borrower situation a. fact is that most of these factors would arise in most debtor/creditor relationship b. those that are unique not as important bc Warren never implemented the recommendations 2. more unique features a. constant recommendations by telephone b. right of first refusal on the grain c. correspondence & criticism regarding finances, officers salaries, and inventory d. Cargill determining Warren needed "strong paternal guidance" 3. standard features a. inability to enter mortgages, purchase stock, or pay dividends w/o Cargill approval

b. right of entry onto premises for periodic checks and audits c. Power to discontinue financing vii. note: most creditors include a clause saying this is not an agency relationship, but this probably won't have a huge effect on outcome of court decisions 7. Liability in Contract a. Looking at principal's liability in contract to third parties when agent enters into contracts b. legal implications flow from the existence of an agency relationship i. liability for debts accrued by agent, torts committed by the agent, agent owes duties to principal etc. c. three types of agent authority that can lead to this i. actual authority 1. Restatement (Third) 2.01 (p22): An agent acts with actual authority when, at the time of taking action that has legal consequences for the principal, the agent reasonably believes, in accordance with the principals manifestations to the agent, that the principal wishes the agent so to act 2. Type of authority a reasonable person in A's position would believe they have based on P's conduct 3. Includes implied and incidental authority 2.02 (1) a. actions calculated to achieve the express act that has been authorized 4. dependent on agent's perspective ii. apparent authority 1. Restatement (Third) 2.03: Apparent authority is the power held by an agent or other actor to affect a principals legal relations with third parties when a third party reasonably believes the actor has authority to act on behalf of the principal and that belief is traceable to the principals manifestations 2. authority that a reasonable third party would infer from the actions/statements of P 3. White v. Thomas (Ark. 1991) p22 a. Principle: "While the declarations of an alleged agent may be used to corroborate other evidence of the scope of agency, neither agency nor the extent of the agent's authority can be shown solely by his own declarations or actions in the absence of the party to be affected" b. Facts: P (White) gives A (Simpson) authority to bid up to $250,000 for land, A bids $327,500. A realizes mistake, and sells part of land to T (Thomases), who own adjacent house. P upset when he finds out, but closes on land purchase, but refuses to sell portion of land to T. T sues P for specific performance. c. Holding: Specific performance overturned bc agent had no apparent authority d. no apparent authority bc P never made any direct or indirect representations to the T that A was authorized to sell i. authority to buy does not lead to authority to sell 4. possibly an omission could lead to apparent authority, but if this is the case it is more likely to work through the mechanism of estoppel iii. inherent authority/power 1. dropped by third restatement but still alive in common law 2. authority a court creates when there is no actual or apparent, but court thinks it would be wrong to let the principal off the hook 3. generally an agent can bind the principal (whether disclosed or undisclosed) to an unauthorized contract, if the agent would ordinarily have the power to enter such a contract and 3rd party doesnt know that matters stand differently, Restatement (2nd) Agency 8A, 161, 194 4. Third Restatement of Agency eliminates references to this concept a. no section comparable to 8A b. note says we don't need this concept bc it doesn't add anything when we have the concepts of apparent, estoppel, and restitution

i. but unclear this is true, e.g. Gallant c. Estoppel to Deny Existence of Agency Relationship 2.05 i.A person who has not made a manifestation that an actor (supposed agent) has authority as an agent and who is not otherwise liable for the transaction, is subject to liability to a third party who is justifiably induced to make a detrimental change in position because the transaction is believed to be on the persons account if: ii.The person intentionally or carelessly caused such belief, or iii.Having notice of such belief and that it might induce others to change their positions, the person did not take reasonable steps to notify them of the facts. d. Restitution of Benefits 2.07 i. If a principal is unjustly enriched at the expense of another person by the action of an agent or a person who appears to be an agent, the principal is subject to a claim for restitution by that person 5. Gallant Ins. v. Isaac (2000) p26 a. Principle: A court looks to the agents direct and indirect manifestation and determines whether the third party could have reasonably believed that the agent had authority to conduct the act in question. b. Facts: P sells car insurance to T through A. Policy states that any changes would have to be authorized by P. On Dec. 2, T buys a new car, which A agrees to ensure effective immediately w/o payment first. A and T agree that T will come in to fill out paperwork and pay on Dec. 5. On Dec 4, T gets into a car accident. On Dec. 5, T reports the accident and fills out paperwork as planned at A. P denies coverage for accident bc A was not authorized to renew T's policy w/o payment w/o authorization from P. c. Holding: Court finds P must cover T bc A's approval of the policy occurred under inherent authority i. no actual authority bc P directed A to get prior authorization before changes ii.no apparent authority bc P never represented to T that A could renew w/o authorization iii. in fact, paperwork term says A does not have authority to bind principal d. Factors leading to inherent authority i. overall transaction was in ordinary course of business with the principal ii.common practice to tell clients bound before payment, even if that was wrong iii.principal did not take any steps to make sure consumers knew not bound until formalities complete iv. even though they knew Thompson's common practices e. to avoid liability, P would have to try to put up more noticeable signage on this rule i. but might not work if agent is still contradicting f. possible that we could impose liability through estoppel by showing Gallant "carelessly" caused T's belief that agent had authority to bind coverage immediately i. but if Gallant didn't know about it, this can't be shown g. restitution probably doesn't really get her anywhere iv. Why the differences in outcome for White v. Gallant? 1. sophistication of the third parties 2. sympathetic position of the principals 3. repeat nature of transactions/transactions cost a. with property transaction, not difficult for third party to check with principals b. with insurance, much more of a mess for double checking insurance 8. Principals Liability in Tort a. Restatement (3d) of Agency 2.04: Respondeat Superior - An employer is subject to liability for torts committed by employees while acting within the scope of their employment

i. Restatement 3rd Agency Law 7.04: Agents acting with actual authority 1. A principal is subject to direct liability to a third party harmed by an agent acting within the scope of actual authority. (or the behavior is later ratified Restatement 3rd Agency Law 7.03) ii. Restatement 3rd Agency Law 7.05 1. A principal is liable is the harm was caused by the principals negligence in selecting, training, retaining, supervising, or otherwise controlling the agent. iii. Restatement 3rd Agency Law 7.08: Agent Acts with Apparent Authority 1. A principal is subject to vicarious liability for a tort committed by an agent with apparent authority, when the actions of the agent constitute the tort or enable the agent to conceal its commission. iv. 7.07 Employee Acting Within Scope of Employment 1. Conduct of a servant is within the scope of employment when performing work assigned by the employer or engaging in a course of conduct subject to the employers control. 2. An employees act is not within the scope of employment when it occurs within an independent course of action not intended by the employee to serve any purpose of the employer. 3. It is a question of fact, depending upon the extent of departure, whether or not an act, as performed in its setting of time and place, is so different in kind from that authorized, or has so little relation to the employment, that it is not within its scope. 4. Servant vs. Independent Contractor a. An employee is an agent whose principal controls or has the right to control the manner and means of the agents performance of work, and b. The idea is to determine control and whether or not the principal can prevent the harm caused by the agent. c. The fact that the work is performed gratuitously does not relieve a principal of liability. b. Requirements for Principal Liability i. agent has to be an employee/servant, independent contractor is not enough 1. Distinction made based on who is in a position to take care to avoid accidents ii. act giving rise to tort must be w/in scope of employment c. Bad incentives created by this scheme i. more incentive to create more independent contractors, so even if value added by exerting some measure of control, may decline to do so in order to lower risk of liability d. Gas station cases - is the oil company liable for incidents at service stations? i. Liability: Humble Oil (Exxon) v. Martin (1949) p30 1. Facts: Humble leases station & equipment to Schneider, sells him oil & repairs cars. Customer brings car, forgets parking brake & attendant didn't check, it rolls away and hits people 2. Factors showing master/servant relationship a. Humble paid sizeable operation bills b. Schneider required to do things directed by the company c. little discretion residing in Schneider d. lease agreement terminable at will by Humble ii. No Liability: Hoover v. SunOil (Sunoco) (1965) p32 1. fire starts in back of car being refueled bc attendant is smoking 2. Factors showing not enough control a. Barone had a lot of discretion. b. Barone had a minimum and maximum rent in addition to profits. i.Separates business interests, Barone has risk. c. He was allowed to sell competitors products. i.Limits Suns ability to control and mandate.

d. He did not make reports to Sun. e. Determines his own hours of operation. f. He wasnt required to follow the advice of Sun. iii. Why do gas stations set their businesses up this way, why do they want them branded instead of independent retailers? 1. creation of brand loyalty, since oil is more of a commodity 2. but use franchisees bc want someone who's more invested in the business to run it a. management by central bureaucracy doesn't get the level of service you want 3. franchise owners in the best position to monitor, but oil companies better able to afford damages when things do occur iv. Variations in gas station arrangements 1. Hours of operation a. H/S: Company b. S/B: Manager 2. Selling of products a. H/S: company products only b. S/B: non company products also sold 3. Title to goods a. H/S: C b. S/B: M 4. Lease a. H/S: terminable at will b. S/B: terminable once annually 5. Rent a. H/S: based at least in part on amount of products sold, C pays 75% operating costs b. S/B: M has overall profit/loss risk, but did get subsidies for competitiveness 6. Oversight/reporting a. H/S: C required periodic reports b. S/B: no reports required 7. Most important factor probably risk of profit and loss/payment of utility bills a. Humble bearing large fraction of the costs, gives them stronger incentive to control the behavior, wouldn't give the $$ unless had some monitoring authority built in b. also the fact that the lease is terminable at will gives Schneider strong incentive to do what Humble says iii. The Governance of Agency (The Agents Duties) 1. The Nature of the Agents Fiduciary Relationship a. Fiduciary duties Applied in Four Different Contexts i. Agency ii. Trust iii. Partnership iv. Corporations b. All duties laid out in Restatement (3d) of Agency Chp. 8 (supp35) c. Three main duties i. Obedience, 8.09, duty to obey the principals commands ii. Care, 8.08, 8.10, duty to act in good faith, as one believes a reasonable person would act, in becoming informed and exercising an agency or fiduciary power (antinegligence/malfeasance) iii. Loyalty, 8.01, etc 1. pervasive obligation always to exercise fiduciary power in a manner that the holder of the power believes in good faith to be the best to advance the interest or purpose of the beneficiary and not to exercise such power for personal benefit (anticheating/nonfeasance)

2. An agent has a fiduciary duty to act loyally for the principals benefit in all matters connected with the agency relationship. 8.01 3. An agent has a duty not to acquire a material benefit from a third party in connection with transactions conducted or other actions taken on behalf of the principal or otherwise through the agents use of the agents position. 8.02 4. An agent has a duty not to deal with the principal as or on behalf of an adverse party in a transaction connected with the agency relationship. 8.03 a. The agent may not compete with the principal or assist his competitors. 8.04 iv. Legal power over property held by the fiduciary is held for the sole purpose of advancing the aim of the relationship pursuant to which she came to control that property. 1. Cant use property or confidential information for the agents own purposes or those of a third party. 8.05 v. The fiduciary is bound to exercise her good-faith judgment in an effort to pursue, under future circumstances, the purpose established at the time of creation of the relationship. d. 8.06 creates a carveout if certain terms are satisfied i. must be consent, disclosure, fair terms, good faith ii. want the exception to the blanket rule in order to facilitate mutually beneficial transactions iii. so for prob. 1 on p35, when agent selling your house buys it at half the value of surrounding houses, argue: 1. lack of good faith, didn't disclose material facts, terms of the deal aren't fair iv. why require disclosure in addition to fair terms? 1. hard for courts to know exact amounts property could be sold for or when a price is unfair 2. not enough protection for principal otherwise bc he couldn't always show a price was unfair, even if it was v. all three cases related to this, the plaintiff wins 1. shows courts take agent's duty of loyalty to principal very seriously 2. The Duty of Loyalty a. Tarnowski v. Resop (1952) p36 i. Principle 1: all profits made by an agent in the course of an agency belong to the principal, whether they are the fruits of performance or the violation of an agent duty. ii. Principle 2: The right to recover profits made by the agent in the course of the agency is not affected by the fact that the principal, upon discovering a fraud, has rescinded the contract and recovered that with which he parted. iii. Facts: agent took $2000 secret commission from third party for having principal buy third party's jukebox business, agent deliberately lied to principal about business by inflating apparent value. Plaintiff discovers this after making down payment, sues both sellers and agents. Plaintiff wins against sellers, who return almost entire down payment ($9500/$11,000) and deal is voided. iv. Holding: Plaintiff gets from agent the secret commission and all costs associated with failed transaction as damages (total of $5200) v. Plaintiff is overcompensated for his losses after the addition of the $2000 commission 1. useful for deterrence purposes vi. important for agent to be responsible since difficult to detect the awarding of a secret commission 1. chances of detection are low 2. may think principal will just go after seller if transaction blows up b. Trusts i. Established by settlor ii. legal entity like corporation or partnership 1. pool of assets held & administered by trustee for benefit of beneficiaries of the trust 2. trustee and her creditors can't get hands on the assets of the trust 3. limited liability

a. creditors of the trust can't go after the beneficiaries iii. In re Gleeson (1954) p38 1. Principle: All profits a trust administrator gains from a trust must be accounted for, even if there has been no breach of loyalty 2. Facts: Mary Gleeson dies; Con Colbrook, a close friend and tenant is the executor and trustee under her will, which benefits three children (1 is a ward). Lease for the land is up soon after she dies, he is now in a conflict position because he is both trustee and tenant. After asking two competent children, stays on the land for another year, increasing payments by 67%, then finds tenant at the end of that year. Con files a semiannual report, beneficiaries collectively object that he didn't account for his profits from the land when he was the tenant 3. Holding: Under 203, Con as trustee must account for profits, even if there hasn't been any breach a. no evidence that what he did hurt anybody, and some reason to believe it helped them since he increased his rent, and if he had abandoned the tenancy, its possible there wouldn't have been a replacement renter 4. Children probably sued bc the incompetent is represented by a guardian who is required to act in the best interest of the child and sue iv. Why the stricter rule in trusts than in regular agency relationships for agent/trustee to deal with the principal? 1. trust is set up to protect people who are vulnerable, so the risk that something bad would be done is higher 2. also principal is really the settlor, and often dead 3. trusts typically not used to hold operating assets, usually cash & liquid investments, so likelihood of a deal that will increase welfare is very low
The Problem of Joint Ownership: The Law of Partnership

c. The Problem of Joint Ownership: The Law of Partnership i. Why have joint ownership? 1. joint venture is a form of partnership, but focused on a single project, while joint partnership is more open ended with more activities a. all of the owners of a joint venture are considered principals, so all liable for the debts of the business as if they were a single principal i. also agents of each other b. share equally in control as a default 2. there's a limit to how much projects can be funded with debt a. becomes too risky for investors after a certain point b. also comes with interest payments, and a limit soon after starting on how much of these businesses can afford c. bad incentives for the people who are borrowing 3. talent acquisition/retention ii. Agency conflicts among co-owners 1. Meinhard v. Salmon (Ny Sup. Ct. 1928) p47 a. most important business law case, authored by Cardozo b. Principle: very high standards will be applied in deciding whether one partners behavior in dealing with another partner violates the duty of loyalty c. Facts: Meinhard & Salmon are joint venturers, Salmon manages, Meinhard supplies some of capital & is passive. Salmon takes 20 year lease from Gerry to operate the hotel. Hotel owner knows only about Salmon, he gets 60% profit for first five years, then 50-50 for next 15. losses split equally. When first lease about to run out, different Gerry presents Salmon w/new opportunity: lease whole block for 80 yrs. Salmon accepts for his own corporation w/o informing or consulting Meinhard; Meinhard now suing for breach of loyalty bc he wants a piece of the action

d. Holding: Salmon breached duty of loyalty, and Meinhard must be involved with the same control/profit relationship as previously, though he must pay for his interest e. Fiduciary duty at the very least was to give his partner equal chance to compete, since it came to him by virtue of his agency i. had to present the information to Meinhard ii. Possibility that he had to do more is left open, but not resolved f. memorable/important paragraph "punctilio" i. "Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior" p49 2. Possible venture terms the parties might have thought about ex ante a. Same Term Option i. Meinhard participates in any new opportunity on the same terms as in the 20 year joint venture ii. similar to Cardozo's actual remedy iii. Salmon might not like this if the rewards of a later venture will come about bc of his efforts, so would reduce Salmon's initiative to look for other ventures if Meinhard will get half the profits even w/o any work, and he might insist on greater level of profits for himself iv. also a problem figuring out which new ventures are subject to this rule and which aren't b. Competition/Renegotiation i. Salmon must inform Meinhard, who is free to compete for, or renegotiate over, any new opportunity ii. Cardozo suggests this is what Salmon's fiduciary duty required iii. if there actually is competition over this lease, clear beneficiary is Gerry bc likely to get a better price; whoever gets the opportunity will be the loser by paying more c. How Salmon did it i. can keep the new opportunity or offer a piece to Meinhard, as he likes ii. would have been better for Salmon ex post, but ex ante Meinhard might have required higher percentage of profits iii. might also cause Salmon to focus on the future at the neglect of the joint venture iv. would also incur capital expenses at end of 20 year lease bc would only incur half the costs but would get all of the benefits, while Meinhard would be faced with unnecessary costs with no benefits 3. Suppose Cardozo's goal was to punish Salmon to make parties think about what to put in a. penalty/default rule - if you don't set it up, court will institute a rule that will make at least one party unhappy so they'll think about these issues while contracting iii. Partnership Formation 1. same as joint venture, but not limited to a particular purpose 2. does not need to be registered, exists in common law a. courts can infer the existence from actions of the parties, even if one denies it 3. UPA 6 Partnership Defined A partnership is an association of two or more persons to carry on as co-owners a business for profit 4. UPA 7 Rules for Determining the Existence of a Partnership a. profits prima faciae evidence of partnerships but not revenues bc profits indicates concern w/expenses as well and shows greater control/care of business i. also true in RUPA 202(c) 2-3 5. Courts generally look at a. Profits i. Allocation of risk ii. Costs b. Control over the Enterprise c. Intent 6. Vohland v. Sweet (1982) p52 a. Principle 1: the parties conception of whether theres a partnership doesnt control

b. Principle 2: someone can be a partner even if they do not make a capital contribution to the business, but instead contribute their talents c. Facts: Sweet is gardener. When old owner dies and new takes over, Sweet paid 20% of net profits of Vohland Nursery. No explicit agreement. Sweets 20% share is (erroneously) called commission. In 1979, Sweet sues to dissolve partnership d. $60,000 at stake, argument is that profits were used to build up the inventory, so Sweet is entitled to 20% of the available stock e. Vohland argues this is a sole proprietorship, Sweet was paid on commission f. Holding: provision of labor is enough to show partner, and that profits were used for inventory, so he's entitled to his % g. Court notes that Net profits is prima facie evidence of a partnership UPA 7(4) iv. Partnership Relations with Third Parties 1. Relevant statutory provisions a. Each partner is an agent of the partnership RUPA 301 b. Acts in the ordinary course of business bind other partners RUPA 301(1) c. UPA 9: Partner Agent of Partnership as to Partnership Business Apparent Authority i. (1) Every partner is an agent of the partnership, and the act of every partner for done in the course of the ordinary course of business of the partnership binds the partnership, unless the partner has no authority to act for the partnership in the particular matter, and the person with whom he is dealing has knowledge of the fact that he has no such authority. ii. (2) An act which is not for the ordinary course of business in the usual way does not bind the partnership unless authorized by the other partners. iii. (3) Unless authorized by the other partners or unless they have abandoned the business, one or more but less than all the partners have no authority to: 1. (a) assign the partnership property in trust for creditors or on the assignees promise to pay the debts of the partnership 2. (b) dispose of the goodwill of the business 3. (c) Do any other act which would make it impossible to carry on the ordinary business of a partnership, 4. Confess a Judgment, 5. Submit a partnership claim or liability to arbitration or reference iv. (4) No act of a partner in contravention of a restriction on authority shall bind the partnership to persons having knowledge of the restriction. d. UPA 11: Partnership Bound by Admission of Partner i. An admission or representation by any partner concerning partnership affairs within the scope of his authority is evidence against the partnership. e. UPA 12: Partnership Charged with Knowledge of or Notice to Partner RUPA 102(f) i. Absent fraud committed by or with the consent of the partner, the partnership is charged as having: 1. The notice given to any partner of anything relating to partnership affairs, 2. The knowledge of the partner acting in a particular matter, and the knowledge of any other partner who reasonably could and should have communicated it to the acting partner f. UPA 13: Partnership Bound by Partners Wrongful Act RUPA 305(a) i. The partnership is liable for the acts or omissions of its partners that cause loss or injury to any person not a partner or for any penalty when: 1. The partner is acting in the ordinary course of the business of the partnership, or 2. With the authority of his co-partners. g. UPA 14: Partnership Bound by Partners Breach of Trust RUPA 305(b) i. The partnership is bound to make good the loss: 1. Where one partner acting within the scope of his apparent authority receives money or property of a third person and misapplies it; and

2.

3.

4.

5.

6.

2. Where the partnership in the course of its business receives money or property of a third person and the money or property so received is misapplied by any partner while it is in the custody of the partnership. Rights of Partnership Creditors a. UPA 15: PRs jointly and severally liable on partnership torts; jointly liable on P'ship contracts b. RUPA 306: PRs jointly and severally liable on partnership torts & contracts i. BUT partnership assets must be exhausted before pursuing personal assets (307(d)) c. bottom line is if you're a general partner, you're exposed Three Aspects of Creditors Rights a. Whom can creditors pursue? Who is a partner? b. When can an ex-partner escape partnership debts? c. How do partnership creditors fare in competition with personal creditors for assets when the partnership and its partners are all bankrupt (common scenario)? Partnership by Estoppel a. Somewhat analogous to apparent authority doctrine b. will be personally liable for partnership debts even if not really a partner IF i. a person represents himself as being a partner in an enterprise (or consents to others making the representation) ii. AND a third party reasonably relies on the representation (actual reliance required) and does business with the enterprise c. Note on reliance i. UPA 16(1) lang says this applies only when someone gives credit to the partnership ii. But RUPA 308 expands to all transactions, and this has been followed even in UPA context Third Party Claims Against Retiring/Departing Partners a. Baseline is liability exposure for partners who leave partnership b. But UPA 36 provides several ways to escape further risk associated with the partnership? i. (1) The dissolution of the partnership does not of itself discharge the existing liability of any partner ii. (2) By agreement between the creditor, the departing partner, and the remaining partners. Remaining partners can agree to assume the existing obligations of the dissolved partnership. 1. Such agreement may be inferred from the course of dealing between the creditor having knowledge of the dissolution and the person or partners continuing the business. iii. (3) Where a person agrees to assume the existing obligations of a dissolved partnership (remaining partners), the partners whose liability has been assumed are discharged from the liability of a creditor who, knowing about the agreement, consents to a material alteration in the nature or time of payment of such obligations. 1. Usually applies to the release of a departing partner when a creditor renegotiates old debt with the remaining partners. 2. The Material Alteration Exception: A withdrawing partner can be released from partnership debts if the creditors and partners renegotiate. Material alteration is the nature or time of payment of obligations might discharge liability. UPA 36(2)-(3) and RUPA 703. c. If a partner withdraws, the partner remains liable on the debts that accrued while he was a partner.(may have to cough up his personal assets to pay creditors). Partners in this situation are at risk yet without control. Third Party Claims Against Partnership Property a. The partnership creates a segregated pool of assets that partners can only get their hands on by dissolving the partnership. b. UPA 25: speaks about joint ownership but is constructed to act entity property of the partnership rather than of the individual partners

i. critical feature is that individual partners have virtually no power to dispose of partnership property, thus transforming this property into de facto business property. ii. (2) a partner cannot possess or assign rights in partnership property, a partners heirs cannot inherit it, and a partners creditors cannot attach or execute upon it. c. Though partners dont own partnership property, they do have a transferrable right in their share in the partnership profits and partnership distributions. UPA 26, 27; RUPA 503, 504 i. BUT UPA 27 (2) assignee of profit interest has no right to participate in management of the partnership or access to the accounting ii. RUPA 504 and UPA 28 permit individual creditors of partners to obtain a charging order, which is a lien on the partners transferrable interest that is subject to foreclosure unless it is redeemed by repayments of the debt. 7. Claims of Partnership Creditors to Partners Individual Property a. Partnership assets must be exhausted before creditors can go after individual assets b. Creditors of individual partners can't reach partnership assets before partnership creditors c. Partnership creditors and Individual creditors have equal priority access to individual property , Bankruptcy Act of 1978 723 (c), RUPA 8-7 (a) v. Partnership Governance and Authority 1. Default Rule any dispute about ordinary matters of the firm will be decided by majority vote, but any acts outside the ordinary course of business or in contravention of the partnership agreement must be done unanimously. UPA 18(h); RUPA 401(j) 2. National Biscuit v. Stroud (p61) a. Rule: One partner in a 2-partner partnership is not a majority for purposes of making firm decisions within the ordinary course of business. b. Facts: Stroud and Freeman are partners in Strouds Food Center (SFC). Stroud tells Nabisco he he personally would not be responsible for any bread delivered to SFC after Feb. 6th. Nabisco nevertheless delivers bread after Feb. 6th, worth $171.04, to SFC at the request of Freeman. Partnership dissolves on Feb. 25th. c. Holding: Stroud is liable for the bread because his decision was not a majority decision and Freeman, therefore, could bind the partnership on an ordinary matter connected with the partnership business. d. If there had been 3 partners, and two voted against it, theyd have to notify Nabisco in order to not be bound by the 3rd partners orders e. Crane on Partnership: The partnership being a going concern, activities within the scope of the business should not be limited, save by the expressed will of the majority deciding a disputed question; half of the members are not a majority 3. UPA 18(h) Any difference arising as to ordinary matters may be decided by a majority; but no act in contravention of any agreement between the partners may be done rightfully w/o the consent of all partners (RUPA 301) vi. Partnership Dissolution & Disassociation 1. Under UPA a. Dissolution 29: any change of partnership relations, e.g., the exit of a partner b. Winding up 37: orderly liquidation and settlement of partnership affairs c. Termination 30: partnership ceases entirely at the end of winding up d. These definitions make partnerships unstable 2. Under RUPA a. Disassociation 601: a partner leaves but the partnership continues, e.g., pursuant to agreement i. Provision gives all the ways in which disassociation may happen b. Dissolution: 801: the onset of liquidating of partnership assets and winding up its affairs c. Solves UPAs instability problems 3. Dissolution summary

a. An exiting partner does not get wind-up rights if the partnership agreement specifies otherwise (Adams v. Jarvis) i. RUPA 701(b): Disassociating partner who doesnt insist on wind-up rights gets the higher of the liquidation or gowing concern rates b. If partner is kicked out of the partnership i. Under UPA could not get going concern value or insist on wind-up rights ii. Under RUPA are entitled to a claim on going concern value, minus the damages you caused c. When parties dont specify, default rule is partnership at will; anyone can dissolve at any time (Page) i. BUT: Fiduciary relationship tempers purely opportunistic dissolution (Page) d. When winding up, it is more fair to sell the business and payoff in cash rather than dividing the assets (Dreifuerst) e. Appraisal Alternative: Have an appraisal of the business and pay the withdrawing partner his pro rata share i. Avoids the need to actually sell the business ii. Full sale is usually better than appraisal b/c it includes the market value (real market test) iii. BUT appraisal may sometimes be better: 1. Sale of business has high transaction costs 2. Tiny businesses may not have a liquid asset market 3. Often, the only interested buyers are your ex-partners who wont pay a fair price 4. The Ability of partners to opt out of statutory wind-up in a partnership at will a. Adams v. Jarvis p65 i. Rule: If the partnership agreement provides for continuation, sets forth a method of paying the withdrawing partner his agreed share, does not jeopardize the rights of creditors, the agreement is enforceable (under the UPA) ii. Rule: One does not get wind-up rights if the partnership agreement specifies otherwise (UPA 38) iii. Facts: Dr. Adams withdraws from three-doctor partnership; contends that his withdrawal constitutes a dissolution that requires a winding up. Partnership Agreement says withdrawal of a partner will not terminate the partnership (contract 15). in this event, get 1/3 profits based on date of year partner withdraws, and certain other specified rights, in contradiction to UPA language of winding up with remaining cash distributed iv. Lower court history: Trial court finds this is a dissolution so it must be wound up and he gets 1/3 of the accounts receivable v. Rationale: if UPA provision were interpreted strictly, there would be too much instability, not everyone is sophisticated enough to draft contract exactly right vi. Court looks at UPA 38(1) - saying unless otherwise agreed, ptship paroperty can be applied to discharge liabilies and net out in cash 1. UPA 38 applies only unless otherwise agreed: UPA 38 contemplates a discontinuance of the day-to-day business when one partner leaves, but does not forbid other methods of winding up vii. key phrase in agreement is that the partnership shall not terminate in the event of withdrawal, but defines withdrawal as not dissolving, so chicken and egg with the UPA provision 1. should have said the withdrawal will not lead to a wind-up/termination 5. Mode of liquidation in a statutory wind-up a. Dreifuerst v. Dreifurst p69 i. Rule: the UPA does not allow in-kind distribution of partnership assets unless there is an agreement to do so ii. Rule: if at least one partner wants a sale, and there's no agreement to the contrary, there will be a sale

iii. Facts: three brothers in at-will partnership that's winding up, one brother wants assets sold and proceeds used to pay off creditors & divide btw them. trial court instead divides assets in kind, giving one mill to two brother, second mill to the other brother iv. Holding: assets must be sold off and proceeds divided v. Rationale: cash sale creates a pot creditors can reach, distributed property harder to reach to satisfy debts, also sale is best method of establishing true value of assets, ensuring a fairer distribution, statute itself seems to contemplate a sale rather than distribution in kind vi. Precedent Rinke v. Rinke allowed in-kind distribution only when there were no creditors b. UPA 38(1): When dissolution is caused in any way, except in contravention of the partnership agreement, each partner, as against his co-partners . . , unless otherwise agreed, may have the partnership property applied to discharge its liabilities, and the surplus applied to pay in cash the net amount owing to the respective partners. 6. Fiduciary/equitable limitations on the ability to force a dissolution of a partnership a. Page v. Page p73 i. Like Meinhard v. Salmon in the facts ii. Rule: A partnership may be dissolved by the express will of any partner when no definite term or particular undertaking is specified. UPA 31(1)(b) iii. Rule: Partners may impliedly agree to continue in business until a certain sum of money is earned, Mervyn Investment v. Biberor until certain debts are paid Vangel v. Vangel iv. Rule: Bad faith is irrelevant for determining if the partnership is for a term or at will, although still relevant in examining actions after dissolution 1. ???? is this true? v. Facts: Two brothers running laundry, both partners contribute $43,000 and Big P loans another $47,000 through his wholly-owned company. Business loses $$ for awhile, and just when it turns a corner Big P seeks to dissolve. Little P claims Big P is trying to take an opportunity for himself stemming from new Air Force base vi. Lower court: Trial court finds that the partnership is for an implied term rather than at will => Big P can't dissolve vii. Holding: Partnership was at will and could thus be dissolved at any time, but Big P still has fiduciary duties towards little P like in Meinhard viii. If Big P later appropriates an opportunity, will show wrongful dissolution leading to damages for Little P 7. Other Relevant statutory provisions a. UPA 17: LIABILITY OF INCOMING PARTNER i. The new person is liable for all the obligations of the partnership arising before his admission as though he had been a partner when such obligations incurred, except his liability will only be satisfied out of the partnership property. b. RUPA 804: PARTNER'S POWER TO BIND PARTNERSHIP AFTER DISSOLUTION. i. Subject to Section 805, a partnership is bound by a partner's act after dissolution that: 1. (1) is appropriate for winding up the partnership business; or 2. (2) would have bound the partnership under Section 301 before dissolution, if the other party to the transaction did not have notice of the dissolution vii. Limited Liability Modifications of the Partnership Form 1. Means creditors can't go after personal assets of people in the partnership 2. To get these forms, you must register entity with the state a. provides notice to creditors and third parties that this liability is limited 3. These non-corporate forms have proliferated bc corporate forms subject to double level of taxation 4. Limited Partnerships a. arose in 1850s b. two types of partners i. general partners subject to full liability

ii. limited partners give up control in the firm in return for limited liability 1. Control Test no longer exists since the LP must compete with the LLP and LLC. 2. ULPA 303: abandons the control test, a limited partner is not personally liable for partnership liabilities even if the limited partner participates in management and control. c. Generally governed by the Uniform Limited Partnership Act (ULPA) or the Revised Uniform Limited Partnership Act (RULPA) d. constraints on general partners i. limited partners try to align incentives through compensation schemes (%) ii. but there's also still fiduciary duty iii. reputational concerns, need to raise additional capital e. 5. Limited Liability Partnerships a. what exactly is limited varies from state to state i. vicarious negligence ii. torts caused by other partners iii. if protect from all liability, question whether that will be respected in other states w/different statutes 6. Limited Liability Companies a. avoids double taxation b. statutes first established in the mid-1970s c. initially, to not be double taxed, IRS applied 4 factor test to see if corporation i. if you have 3, enough like corporation to be taxed like one 1. lawyers would design agreements to fail 2/4 factors a. restrictions on transferability & entity life ii. the four factors 1. limited liability for owners 2. management is centralized 3. freely transferable ownerships interests 4. entity continuity (indefinite) life d. 4 factor test scrapped in 1997, IRS Reg. 7701-1 to 3 i. allow all new unincorporated businesses to choose taxation as partnership or corporation e. today, corporations usually preferred over this form i. much more case law with corporations than LLCS ii. for many, issue of double tax doesn't arise bc they end up failing iii. if it goes public, will be taxed as a corp. no matter how its organized IRC 7704(a) iv. problem diminishing over time bc dividend tax rate has been low 1. 2003: Jobs and Growth Tax Relief Reconciliation Act reduces taxation of dividends to 15% through the end of 2008. 2. 2005: Tax Increase Prevention and Reconciliation Act extends reduction through the end of 2010. 3. 2009: Obama Administration plans to increase dividend tax rate to 20%, for households earnings more than $250,000. II. The Corporate Form
The Corporate Form

a. The Corporate Form i. Introduction to the Corporate Form 1. Core Characteristics of the Corporate Form
General Partnership Investor Ownership X Limited Partnership X Limited Liability Company X Corporation

Legal Personality Limited Liability Transferable Status Centralized management under an elected board

X X X

X X X

X X X X

a. Investor Ownership b. Legal Personality c. Limited Liability d. Transferable Shares e. Centralized Management under an Elected Board 2. Benefits of the Corporate Form a. Eliminates messy problems of personal liability i. creditors rely only on business assets ii. although creditors may ask a company owner to cosign a loan to the corporation personally, in order to contract around limited liability b. Allows investors to enter & exit the firm i. all they have to do is buy or sell shares c. Prevents minority investors from trying to hold up the firm by threatening to dissolve it d. Makes it easy for third parties who contract with the firm to know whom they are dealing with as an authorized agent i. Board resolution provides all necessary assurance 3. Structural Features of Corporations a. Holdings i. closely held v. widely held shareholders 1. small group can control in closely held 2. in widely held control is dispersed ii. Creation of a Fictional Legal Entity 1. Structural Features of the Corporate Charter Marketplace a. US firms not constrained by HQ, place of business, or operational factors in choosing b. State of incorporation dictates which corporate law rules apply under "internal affairs" doctrine c. states charge annual franchise taxes i. range from $10 flat fees to $100,000+ ii. dependent on different features such as income, assets, etc. d. Can reincorporate in a second state i. create a new corporation in the new state ii. then do a tax-free merger of the existing corporation into the new one iii. typical costs ~$70,000 in 2000 iv. requires shareholder approval e. half of all companies incorporated in Delaware, nowhere near as common for HQ state... i. corporate case law extremely extensive ii. dispute resolved promptly in specialized court not offered in other states iii. believed to insulate directors from personal liability iv. courts often deferential to board directors in disputes w/other parties v. Delaware v concerned about losing corps to other states 2. The Process of Incorporating Today a. See RMBCA 2.01-2.04 b. An individual called an incorporator signs the requisite documents and pays necessary fees c. Incorporator drafts and signs a document called either the articles of incorporation (RMBCA) or the certificate of incorporation (DGCL), colloquially called the charter

i. State the purpose and powers of the corporation and define all of its special features, with great flexibility being afforded to the designer of the firms legal structure 1. Purposes of the corporation are typically put forth in an extremely broad statement. ii. Instead, Bylaws have the guts of the Corp, not the charter. (To change the bylaws, you only need a vote by the board of directors ) See RMBCA 2.06 d. After charter is duly executed it is filed with the designated public official, usually the secretary of state. i. Filing also identifies the corporations principal office within the state, or if there is none, the name of the agent in the state upon whom process may be served ii. A filing fee is due at this time e. In Delaware a corporations legal life begins with the filing of the charter (DGCL 106), in other states it may only begin when the secretary of state issues the charter f. The first acts of a newly formed corporation are electing directors, adopting bylaws, and appointing officers which takes place at an organizational meeting 3. The Charter/Articles of Incorporation a. usually very sparse b. Name of Company c. Address d. Purpose (usually "any lawful act") e. capital structure i. classes, number of common shares, rights of preferred shareholders f. much more difficult to change than bylaws g. Amendment Process, DGCL 242(b)(1) i. see list of possible amendments suppl. Page 220 ii. Must be initiated by the BOARD, NOT shareholders iii. Must be approved by an absolute majority of all outstanding voting shares or the majority required in the article to be changed, and a majority of the voting shares of each class entitled to vote. iv. A class is entitled to vote either under the articles of incorporation or if the change would seriously affect the shares 242(b)(2) suppl. P.221 v. Some states allow appraisal rights, Delaware doesnt 4. Corporate Bylaws contents a. Can be amended by Board or directly by shareholders i. In Delaware shareholders can ALWAYS amend on their own initiative, this right cannot be contracted away DGCL 109(b) ii. The charter may confer the power to amend the bylaws on the board in addition to shareholders but not in lieu of them. DGCL 109 1. The fiduciary duty of loyalty may invalidate an abuse of the power to modify and invalidate bylaws b. May contain any provision not inconsistent with law or charter DCGL 109(b) c. Generally, fix the operating rules for the governance of the corporation i. Ex: the existence and responsibilities of corporate officers, functioning of the board and committee structure, annual meeting date or formula for calculating it ii. Stockholders iii. Board of Directors iv. Committees v. Officers vi. Stock vii. Indemnification viii. Miscellaneous d. Lawyers role comes in at figuring out financial division btw the parties iii. Key Benefits of the Corporate Form (Easterbrook & Fischel) 1. Benefits of Limited Liability

a. Reduces need to monitor agents (managers) i. you have less $$ at risk, so lower cost threshold for benefit b. Reduces need to monitor other shareholders i. with full liability, if other shareholders have less $$ than you, it increases your chance of having to pay c. Makes shares fungible i. with full liability, value of the share is dependent in part on your wealth and wealth of others ii. which also facilitates takeovers (?) d. facilitates diversification i. with full liability, minimize exposure by holding only one company e. Enlists creditors in monitoring managers i. bc creditors bear some downside risk ii. will charge higher interest rate to compensate 2. Benefits of Transferable Shares a. Permits takeovers -> disciplines management b. allows shareholders to exit w/o disrupting business c. bc of LL, shares are fungible -> facilitates active stock markets, increasing liquidity iv. Effects on Torts of Limited Liability 1. Limited liability includes too much investment in risky industries bc the businesses & shareholders don't internalize all the costs 2. Corporation may be involved in a socially desirable business but shareholders don't have means to pressure the managers to take adequate precautions bc they won't bear full cost of the injury 3. Limits company size to uneconomic scale a. makes sense to do 10 companies w/1 drill each rather than 10 drills in one company bc if there's an accident, don't want victim to be able to take all the assets, but rather only one b. inefficient for operation, but makes sense from the companies liability perspective v. Centralized Management 1. Legal Construction of the Board a. DGCL 141(a): The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors i. Automatic Self-Cleansing Filter Syndicate Co., Ltd. v. Sunninghame (1906) p103 1. Rule: Board members are not required by duty to follow the wishes of a majority shareholder, but rather the wishes of all of the shareholders as a group 2. Facts: McDiarmid and friends own 55% of ASCF. ASCF charter vests control in board, subject to regulations by "extraordinary resolution" of 75% of shareholders. McDiarmid and friends bring such a resolution to sell the company's assets; resolution fails 55% to 45%. McDiarmid then asks the court to order the board to sell the assets 3. Holding: majority shareholders cant overrule the board 4. Why was the company set up this way to be difficult to overrule the board? a. organizers were affiliated with the board b. in order to protect minority investors who own less than 50% shares i.investors need protection from each other ii. The board is not the agent of the shareholders. iii. The board is a quasi principal: it can act independent of what the shareholders want to do. iv. We rely heavily on their expertise v. Though the shareholders by a majority vote can vote in new directors. b. Boards Powers i. Power to appoint, compensate, and remove officers, ii. Power to delegate authority to subcommittees of the board, iii. Power to amend the companys bylaws, iv. Exclusive power to initiate and approve certain extraordinary corporate actions 1. Amendment to the articles of incorporation

2. Mergers 3. Sales of all assets 4. Dissolutions v. Power to make all major business decisions 1. Products company will offer 2. Product prices 3. Wages will pay 4. Financing agreements will enter into c. Structure of the Board i. By default all members of the board are annually elected for one year terms. ii. Corporation statutes generally permit corporate charters to create staggered (classified) boards, in which the directors are divided up into classes that stand for election in consecutive years. In Delaware there can be up to three, DGCL 141(d) iii. The Charter may provide for board seats to be elected by certain classes of shareholders iv. The board has inherent power to establish standing committees and may delegate responsibilities to them 1. Matters that, by statute, require board action cannot be delegated to a committee for final action. d. Formality in Board Operations i. Governance power resides in the board of directors, not in the individual directors ii. The bylaws indicate what constitutes a quorum and proper notice of meetings 1. Statutes usually provide minimums See 141(b) iii. Directors act as a board only at board meetings and by majority 1. Some states allow members to give their unanimous written consent to the corporate action in question w/o an in-person meeting DGCL 141(f) iv. Meeting formally helps alleviate manipulation of board decisions v. Cannot give proxy to others 2. Corporate Officers: Agents of the Corporation a. Corporate officers, unlike directors, are unquestionable agents of the corporation and therefore subject to the fiduciary duty of agents b. Jennings v. Pittsburgh Mercantile Co. (Pa. 1964) p110 i. Principle: Without more, a single director is not considered to have the authority of a full board, ii. Facts: Mercantile is a publicly-held corporation w/400 shareholders, 9 directors, and a three-member executive committee of directors. Egmore (VP and Treasurer, corporate officer, and director), along with Stern (financial consultant) instruct Jennings to solicit offers for a sale and leaseback of its property. Egmore tells Jennings that the exec committee has the power to accept and offer, and eventually does so through Stern, but board rejects and Jennings sues for his commission. Mercantile argues Egmore didn't have authority for the deal, and so Mercantile isn't bound. jennings argues Mercantile is bound through apparent authority of Egmore iii. Holding: for Mercantile bc no apparent authority; there must have been a representation of the principal, but here its just Egmore iv. Rationale: allowing recovery would undercut the ability of boards to control their agents
Debt, Equity, and Economic Value

b. Debt, Equity, and Economic Value i. Capital Structure 1. Types of Corporation Cash Flow (junior to senior claims) a. Common stock i. carries right to vote in election of directors ii. must be at least one class iii. most ubiquitous form of stock

b. Preferred stock i. comes with liquidation preference entitled to be paid a certain amount b4 common holders get anything at dissolution ii. specified dividend; no requirement to pay, but can't pay anything to common shareholders b4 these iii. can be thought of as a soft & flexible form of debt (but still classed as equity) c. Subordinated debt i. contractually subordinated to the claims of other debt holders d. Debt (or notes) i. entitled to whatever remains after collateral used up to pay secured claims e. Secured Debt i. backed by collateral; holders have a priority claim to this value ii. Basic Valuation: Future & Present Values 1. FV=PV(1+r)n PV=FV/(1+r)n r=(FV/PV)1/n - 1 a. Where FV is future value; PV is present value; r is annual interest rate or discount rate; n is number of years b. Note: As r increases, PV decreases 2. examples p121 a. Net present value problems p122 i. What is the net present value of borrowing $10,000 at an 8.5% interest rate, and repaying it in a year, given the same discount rates? 1. r=7% NPV=$10,000 -$10,140.19 = -$140.19 a. ie only take the loan if your future cash flows will be above $140.19 (?) 2. r=8.5% NPV = $10,000-$10,000=0 iii. Two Stories about Risk Aversion 1. Declining marginal utility of wealth a. if money is worth more the less you have, losses give more pain than identical gains bring pleasure 2. OR Variable outcomes inflict large transaction costs 3. Risk Premium: amount of extra $$ you must receive to accept a larger risk 4. Two ways to value risk a. two step method i. conceptually correct ii. find the certainty equivalent (CE) in future $$ of the payout, thereby incorporating risk as a smaller numerator iii. then, discount the CE by the risk free discount rate (ie the market interest rate on 1 yr T bill) b. single step method i. more commonly used ii. increase the discount rate, thereby incorporating risk as a larger denominator. Specifically, discount by (rf (risk free rate) + risk premium) 5. Three conceptually distinct operations in calculating risk in deciding whether to extend loan (125) a. calculates the EV of the payment it is promised i. ie adjusts for loss of EV arising from the hotel's risk of default b. adjusts the EV downward to reflect the intrinsic unpleasantness of the risk of default i. ie to reflect its risk aversion c. it discounts to adjust for the time value of money i. the bank does 2 & 3 simultaneously by using the 8.5% discount rate. It could do all three simultaneously by using an even higher discount rate, say, 14% or so 6. Systematic and Unsystematic Risk a. Diversification - when some of your investments negatively correlated w/other investments, decreases the amount of risk

b. If it is going to be a big one-shot exposure, then you worry a lot; but if there are a bunch of little exposure, then the worry is less; this is the point of diversification c. Systematic risk is risk that cannot be diversified away; this will be the only risk bumped by discount rate iv. Valuing Assets: Discounted Cash Flow analysis 1. price per share x number of shares = estimated value of business 2. reliant on efficient capital markets hypothesis a. share price reflects all available information about performance of firm b. best available estimate of the true value of the company c. not clear this is necessarily true though i. someone who would pay higher runs out of capital ii. purchase based on guessing how other people will behave later d. but taken seriously bc know has to be right to some extent, if not entirely
The Protection of Creditors

c. The Protection of Creditors i. more of these in Europe; US is more debtor-friendly, so more relaxed take ii. How Shareholders can hurt Creditors 1. Misrepresentations 2. Removing assets iii. Summary of Legal Strategies for Protecting Creditors (complementary, not exclusive) 1. Mandatory Disclosure a. not done in US for nonpublic corporations b. federal securities law imposes extensive obligations on public companies c. pros: transactions cost savings d. cons: potential confidentiality costs (info to competitors) 2. Capital Regulation a. distribution constraints i. done in US, but in such a way that its almost meaningless b. minimum capital requirements i. not done in US c. capital maintenance requirements 3. Equitable/Fiduciary Constraints a. Director Liability b. Creditor/Shareholder Liability: Fraudulent Conveyance c. Shareholder Liability: Equitable Subordination & Piercing the Corporate Veil iv. Capital Regulation 1. Net Assets/Shareholder Equity Accounts a. This category is fundamental to regulation, but is not a constraint in and of itself b. this is the category on the balance sheet that makes assets=liabilities i. assets - liabilities = net assets ii. liabilities + net assets = assets c. made up of three components i. stated capital (not available for distributions) 1. determined by "par value" stated on stock, can choose whatever amount you want 2. stated capital = par value/share * # of shares 3. if stock is no par, board must set aside a discretionary part of sale price DGCL 154 ii. capital surplus 1. difference btw sales price and retained earnings iii. retained earnings (two categories = "surplus") 1. available for distribution, but havent yet been distributed d. The equity remaining in the corporation undistributed to the shareholders must be at least the stated capital

2. Distribution Constraints a. New York Bus Corp. Law 510 (capital surplus test) i. can only pay distributions out of surplus (510(b)) ii. and distributions cant render firm insolvent. iii. NOTE: NYBCL 516a4 allows board to transfer funds out of stated capital into surplus if authorized by shareholders. b. DGCL 170(a) (nimble dividend test) i. may pay dividends out of (A) capital surplus + retained earnings ii. OR (B) if no surplus, net profits in current and/or preceding fiscal year. (the greater) iii. NOTE: DGCL 244(a)(4) allows board to transfer funds out of stated capital into surplus for no par stock. iv. Rationale for this test is a desire to reward companies that have been growing c. Cal. Corp. Code 500 (modified retained earnings test) i. may pay dividends out of (A) retained earnings ( 500a) or (B) out of assets (500b1), if ratio of assets to liabilities remains at least 1.25, and CA>=CL (500b2) d. RMBCA 6.40(c) i. may not pay dividends if 1. cant pay debts as they come due ( 6.40c1) 2. OR assets would be less than liabilities plus the preferential claims of preferred shareholders ( 6.40c2) ii. BUT: board may meet the asset test using a fair valuation or other method that is reasonable in the circumstances ( 6.40(d)). 3. Minimum capital requirements a. not used in the US, in decline elsewhere b. even if you have one, if there's no maintenance requirement, can take capital out later so it can get dissipated i. but maintenance requirements are very strict, bc this rule is always binding, and the capital $$ can't be distributed as shares or in business operations c. prevents some people with limited resources from starting socially desirable businesses d. Capital Maintenance rules i. Pros: greater security for creditors ii. Cons: if you require minimum capital, may have capitals that are forced to liquidate prematurely when they would have become profitable later v. Standard-Based Duties 1. Director Liability a. Attempts to change director incentives so theyll consider interests of creditors b. Accomplished through UFTA, statutory restrictions on payments, some common law c. Credit Lyonnais Bank Nederland v. Pathe Communications Corp. (Delaware 1991) i. Rule: When near insolvency, board cannot consider SH welfare alone but should also consider the welfare of the community of interests constituting the corp. ii. Facts: The corp. began to go under. The board was presented with several offers that could give various results depending on whether they litigated and, if so, whether they won/lost. iii. Reasoning: The possibility of insolvency skews incentives, exposing creditors to the risk of opportunistic behavior. Creditors would be in favor of accepting a settlement offer as long as it was more than what the corp. owed to the creditors (so the creditors could get all their money back). But, the SH would not want to accept a settlement offer barely above that amount b/c then after the corp. paid its debts they would be left with practically nothing. SH have diversified portfolios and so are more willing to accept the risk of litigation because the payout might be bigger (in which case they get $), but if the corp. loses they dont individually lose very much, while the creditors get screwed iv. But remember this case is not majority rule 2. Fraudulent Conveyances & UFTA 4

a. Fraudulent conveyance law imposes an effective obligation on parties contracting with an insolvent company, or soon to be insolvent debtors, to give fair value for cash or benefits they receive, or risk being forced to return those benefits to the debtors estate. i. Its designed to prevent debtors from shifting assets to favored creditors or taking on new creditors before going under. b. UFTA 4 is the critical provision for this subject i. (a) A transfer made . . . by a debtor is fraudulent as to a creditor, whether the creditors claim arose before or after the transfer was made . . . if the debtor made the transfer . . . 1. (1) with actual intent to hinder, delay, or defraud any creditor of the debtor; or 2. (2) without receiving a reasonably equivalent value in exchange for the transfer. . . and the debtor: a. (i) was engaged or about to engage in a business transaction for which the remaining assets of the debtor were unreasonably small. . . or b. (ii) intended to incur. . . or reasonably should have believed that he [or she] would incur debts beyond his [or her] ability to pay as they came due. . . 3. Shareholder Liability a. Equitable Subordination i. subordinating yours to others in effect means there won't be any $$ left for you, bc of the low amount of money usually left afterwards ii. Equitable subordination only appears in the context of bankruptcy, unlike fraudulent conveyance. 1. Difference from fraudulent conveyance doctrine is size of asset pool doesn't increase, but claims get rearranged iii. Equitable subordination allows bankruptcy courts, when compelled by considerations of equity, to recharacterize debt owned by the company to controlling shareholders as part of their equity. iv. Equitable subordination applies to corporations, not partnerships. Loans made by partners are automatically subordinated. UPA 40. The partners get paid second in the order of calling. v. Compared to veil piercing: When the veil is pierced, the shareholder is ordered to pay the corporate debts: hes fully personally liable, as if the shareholder was a partner. But here, the shareholders claims are merely placed in line behind the debts owed to nonshareholders vi. Typical requirements for equitable subordination to be imposed 1. Creditor must be an equity holder and typically an officer of the company 2. The insider-creditor must have, in some fashion, behaved unfairly or wrongly toward the corporation and its outside creditors. vii. Why do we want shareholders to not be automatically subordinated? 1. shareholders will know more than outside creditors, may be only ones willing to lend in situations where it looks bad w/o inside info viii. Costello v. Fazio (9th Cir. 1958) p145 1. Rule: even without fraud, inequitable practices can lead to subordination 2. Facts: when company's not doing well, take their partnership into a corporation, put some of their equity into notes and then leave more equal amounts of equity in the corporation. conversion of much of the equity into debt, raising relative priority positions of Fazio and Ambrose. business is incorporated, leading to limited liability. corporation fails not long after conversion. creditors claim deceived into thinking there was a large equity cushion & they thought they were investing into a partnership 3. Lower court: there was adequate capitalization and no need to subordinate 4. Holding: partners should be subordinated 5. Rationale: even though no fraud, gross undercapitalization and inequitable conduct towards creditors not justified "within bounds of reason and fairness" a. experts said clear its grossly undercapitalized

b. some soft misrepresentation 6. if company had limped along for 5 years instead of going under right away, probably would have gone the other way a. would have suggested capitalized enough & given creditors time to get used to new corporate structure b. Piercing the Veil i. allows one or more creditors to go after one or more shareholders of the corporation to satisfy debts company can't pay ii. doctrine is a mess, most jurisdictions have different tests iii. generally tests consist of two components 1. evidence of "lack of separateness" a. e.g., shareholder domination, thin capitalization, no formalities/co-mingling of assets 2. unfair or inequitable conduct a. wildcard as to what counts for this iv. probably no piercing 1. against public corporations 2. against passive shareholders 3. against minority shareholders 4. if all formalities are observed and nothing "funny" with the accounts v. Formulations of the test 1. Lowendahl test (NY): veil-piercing requires (1) complete shareholder domination of the corporation; and (2) corporate wrongdoing that proximately causes creditor injury 2. Van Dorn test (7th Cir. - applied in Sea Land): a. (1) such unity of interest and ownership that the separate personalities of the corporation and the individual [or other corporation] no longer exist. Look to: i. Failure to maintain adequate corporate records or corporate formalities ii.Comingling of funds or assets iii. Undercapitalization iv. One corporation treating the assets of another corporation as its own b. and (2) circumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice 3. Laya test (applied in Kinney Shoe) a. (1) unity of interest and ownership such that the separate personalities of the corporation and the individual shareholder no longer exist; and (2) would an inequitable result occur if the acts were treated as those of the corporation alone. b. BUT says (3) if defendant can show plaintiff assumed the risk, no veil piercing vi. Summary of the Piercing Cases

1. vii. Sea-land Services, Inc. v. The Pepper Source (7th Cir. 1991) p152 1. involves reverse piercing - going after other corporations owned by the one you'd generally be piercing against

a. with regular piercing, you could only get the equity of larger owner's other corporations, but reverse piercing means going in and taking a position equal to the creditors of the other corporation, not the subordinated equity status it would get from taking the owner's position b. problem with this practice is that it hurts the creditors of the other corporations 2. Principle: Mere failure to have your claim paid does not constitute injustice such to allow veil piercing 3. Facts: Sea-Land wins a judgment against Pepper Source, but before the payment became due, Pepper lost all its assets it was dissolved for failure to pay taxes. Pepper is one of many corps owned by Marchese. Sea-Land wants to pierce the veil to get to Marchese, and then reverse-pierce to get to his other corps. 4. Lower court: Van Dorn test satisfied, this promoted injustice 5. Holding: First prong of unity of interest is met, but remanded to District to determine second prong 6. Subsequent history: District said there was injustice bc Marchese had committed tax fraud and lied to Sea-Land, 7th cir affirms viii. Kinney Shoe v. Polan (4th Cir. 1991) p157 1. Rule 1: Third prong of the Laya test is permissive, not mandatory 2. Rule 2: when nothing is put into a company, it provides no protection of other assets 3. Rule 3: Undercapitalization and a lack of corporate formalities is enough to pierce 4. Facts: Deft Polan has two companies: Industrial (no assets) and Polan, Inc. (assets). Kinney gives Industrial a sublease of its plant in Dec. 1984, Industrial gives sublease to Polan @ 1/2 rent; both subleases signed by Polan himself. trying to shield assets in Polan, Inc. from Kinney in case Industrial defaults. Other than the Kinney sublease, Industrial had no assets, income, or bank account; it issued no stock certificates b/c nothing was ever paid into it. The first rental payment to Kinney was paid out of Polans personal funds, and no further payments were made. Kinney obtains judgment against Industrial for $166K in unpaid rent, then sues Polan individually to collect 5. Lower court: finds for Polan finding that Kinney had assumed the risk under the third prong of the test (Kinney should have known about Industrial's undercapitalization) 6. Holding: for Kinney, saying third prong of "risk assumption" not applicable here 7. Application of first two prongs is different than Sea-land/Van Dorn bc doesn't require injury beyond lack of repayment 8. How 4th circuit addresses third prong a. only supposed to apply to financial institutions b. when its clear the "owner" was just creating a shell, third prong doesn't apply vi. Veil-piercing for involuntary creditors 1. Walkovszky v. Carlton (NY 1966) p161 a. Principle: Undercapitalization alone is not enough to pierce as long as the minimum legal capitalization requirements are met and formalities followed b. Facts: Walkovszky struck by a cab owned by Seon Corp and seeks to hold major shareholder Carlton personally liable. turns out each corporation has two cabs, no assets, and minimum insurance. Plaintiff alleges comingling of funds btw the cab companies, unity of services, etc. But no comingling of personal and business funds for Carlton c. Holding: Court of Appeals dismisses the complaint for failure to state a claim, with leave to file amended complaint d. Where are the sources of cash in the corporation? i. insurance - but can probably only get the insurance $$ from the one cab that hit him ii. cabs themselves - but heavily mortgaged so can't get much iii. medallions - given by the city, but they're judgment proof

e. Rationale: assets being moved between companies not enough to pierce the veil, complainant needs to show in complaint that $$ were being funneled for Carltons personal convenience & w/o observing formalities f. Keating dissent says if you haven't adequately capitalized for typical risks, we will pierce, even if you have required insurance i. But this creates uncertainty; says we'll determine afterwards how much capital should be there ii. pushes out relatively successful owners with sufficient resources to have coverage, and left with cab industry run by people with no assets who aren't deterred by veil piercing 2. Successor Liability for Torts (when corporation has dissolved) a. DGCL 278 & 282: shareholders remain liable pro rata on their liquidating dividend for three years b. RMBCA 14.07: same, provided the corporation publishes notice of its dissolution c. Successor Corporation Liability: product line test in some jurisdictions i. may hold acquiror liable if it buys the dissolved corporation's business intact and continues to manufacture same product ii. any sophisticated buyer who buys business as a going concern will contract for indemnification for tort liability or pay less iii. so only way for shareholder to escape long-term liability through dissolution is to sacrifice the going-concern value of the business and keep only the piecemeal liquidation value III. NORMAL GOVERNANCE
Normal Governance: The Voting System

a. Normal Governance: The Voting System i. Basic Features: The Role and Limits of Shareholder Voting 1. Shareholders vote on three kinds of matters: a. election of directors; b. organic or fundamental changes, e.g., mergers, sales of all assets, corporate dissolutions, charter amendments c. shareholder resolutions 2. Registered shares: each share has a holder of record, which facilitates getting in touch with the ultimate beneficial holder (unlike bearer system in France & Germany). 3. Proxy system: if you cant attend the annual shareholder meeting (ASM), you can still vote by finding a representative (proxy) who goes to the meeting and votes on your behalf. 4. State law mandatory rules: all state statutes except one require an annual meeting for election of directors; quorum requirements. 5. State law default rules: all state statute statutes permit special meetings and action by written consent, though default varies. 6. Shareholder Meetings and Alternatives a. What can be voted on at annual meetings i. The election of the board ii. The adoption, amendment and repeal of by-laws iii. The removal of directors iv. The adoption of shareholder resolutions that may ratify board actions or request the board to take certain actions b. Special meetings i. Usually the only way shareholders can take action between annual meetings ii. DGCL 211d allows board to call, or anybody authorized by charter or bylaws iii. RMBCA 7.02 allows board or somewhere between 0-25% shareholders (contractually set, 10% default) to call a special meeting c. Action by written consent i. DGCL 228: unless charter provides otherwise, 50% +1 of shares can act at any time to do any action that could be taken at a meeting of shareholders through signed written consent

ii. RMBCA 7.04(a) requires unanimous written consent 7. Cumulative Voting a. each shareholder gets votes equal to number of shares owned x number of seats to be filled. b. Improves likelihood of minority representation on the board, bc they can all pool their votes and win one candidate, whereas w/straight voting theyd be defeated on each c. Ex: Family Corp. has 300 shares outstanding; A owns 199 shares and B owns 101 shares. Family Corp. has a three-person board elected to annual terms. i. Straight Voting: A would win each seat 199 to 101. ii. Cumulative Voting: B casts 303 shares all for one candidate => guaranteed to get one seat on the board, because As 597 votes cannot be divided three ways so that all three are greater than 303. ii. Electing and Removing Directors 1. Every corporation must have: a. A board of directors, even if the board has only a single member. DGCL 141(a) b. At least one class of voting stock i. In the absence of any customization in the charter, each share of stock has exactly one vote, DGCL 212(a) ii. The right to appoint the board of directors is more valuable to common stock investors than any other class of investors, since many others receive periodic payments or can contract for additional rights. c. Annual election of directors DGCL 211(b) (doesnt mean must elect all at once) 2. Corporate law facilitates the election of directors by creating a flexible framework for holding the annual meeting of shareholders a. State statutes fix a minimum and maximum notice period (e.g. 10-60 days DGCL 222(b)) b. Quorum requirement for the general meeting i. Set in the charter or bylaws but may not be less than one third. DGCL 216 c. Shareholders who are registered as of the record date are legally entitled to vote at the meeting (e.g. DGCL 211(c)) i. 10-60 days before the meeting DGCL 213(a) 3. Staggered Boards: Boards whose directors are elected at different times a. (1/3 elected at board meeting each year, each serving a 3 yr term) DGCL 141(d) b. Also called classified board c. Cannot remove a director from a classified board except for cause DGCL 141(k)(1) d. Implication: An outsider cant take control of a board at the annual meeting; must go through at least 2 cycles e. MA has mandatory classified boards f. How these inhibit takeovers: i. Delay problem: takes at least one year and as long as two years to gain board control. ii. Two election problem: no ability for a hostile bidder to get an up-or-down vote on its bid at a single point in time iii. Firm offer problem: firm offer eliminates the need for the target shareholders to assess how well the bidder would run the firm, but making a firm offer effectively gives target shareholders a (free) put option for their shares for the duration of the bid 4. Charter Provisions a. Shareholders cannot amend the charter without the boards consent b. Shareholders CAN amend the bylaws under DGCL 109 even if the Board objects c. Amend bylaws to Increase the size of the board i. BUT DGCL 223(a) says the Board of Directors can fill any vacancies on the board ii. Shareholders may amend the bylaws to provide that the shareholders, rather than the Board of Directors fills the vacancies d. Shareholders may amend the bylaws to remove the classified board, then remove directors without cause

e. For best protection: Boards should put anti-takeover devices into Charter, which SHs cannot unilaterally change 5. State law in all jurisdictions generally bars directors from removing their fellow directors, for cause or otherwise, in the absence of express shareholder authorization a. But Shareholders can contract around the majority voting rules 6. DGCL 141(k) Any director or the entire board can be removed with or without cause by the holders of a majority of the shares then entitled to vote at an election of directors, except the following a. (i) Unless the certificate of incorporation otherwise provides, in the case of a corporation whose board is classified. Shareholders may affect such removal only for cause; or b. (ii) In the case of a corporation having cumulative voting, if less than the entire board is to be removed, no director can be removed without cause if the votes cast against his removal would be sufficient to elect him. iii. Proxy Voting and its Costs 1. Because shareholders are unlikely to actually attend shareholder meetings, board and its officers are permitted to collect voting authority from the shareholders in the form of proxies a. See DGCL 212(b) and (c) (supp205) 2. Proxies are revocable unless the holder has contracted for the proxy as a means to protect a legal interest or property, such as an interest in the shares themselves. DGCL 212e 3. Federal law governs the solicitation and exercise of proxies under 14 of the 34 Act 4. Reimbursement rules can differ on at least three dimensions: a. Amount: reimburse all, part, or nothing? b. Conditionality: do you need to win to be reimbursed? c. Bias: favor incumbents, insurgents, or neither? 5. Rosenfeld v. Fairchild Engine & Airplane Co. (NY 1955 p179) a. Froessel Rule: Management can be reimbursed for any reasonable business expenses incurred during a proxy contest, and insurgents can be reimbursed if successful & expenses ratified by shareholders b. Facts: During proxy context, incumbents spent $106,000 and reimbursed themselves from the company treasury. Spent $28,000 for which they were not reimbursed because they were voted out. The Insurgent reimbursed the incumbents the $28,000 and reimbursed themselves. SH ratified insurgents reimbursement. One stockholder brings derivative action seeking return of all reimbursements to the corporate treasury. c. Holding: Reimbursement of incumbents & insurgents proxy expenses were reasonable d. In practice, rule biased for management bc they can always show some business need e. If its established that incumbents spent funds for personal power/gain and not for the good of the company, no reimbursement 6. Choice of bias in rule affects how much gain there must be to the company before insurgents will run a proxy contest

a. b. So under this rubric, value enhancing transfers will always be prevented from happening i. But transfers are most likely to go through under Super Froessel rule
Class Voting

iv. Class Voting 1. When a majority of the votes in every class of stock that is entitled to vote must approve a transaction (DGCL 216 [4]) a. Can also be made more than the majority in bylaws 2. This assures that transactions are fair not only to shareholders in the aggregate but that it is fair (or does not disadvantage) shareholders in subgroups. See RMBCA 10.04, 11.04(f) 3. Class voting also gives classes a veto right which could be abused or used opportunistically. 4. Because investors are usually sophisticated, the differences in the classes are usually factored into the prices of the stock 5. When there is Class voting a. Authorization to create a class of shares with rights superior to an existing class (See NY 804(a)(3); RMBCA 10.04(5) & 10.04(6)) i. Would require a vote to issue a senior preferred stock class over the regular preferred class ii. Would not cover 1 million new shares of the existing preferred stock issued at a discount UNLESS the discount affects the shares themselves instead of the price of the shares iii. Delaware is less clear. DGCL 242(b)(2): class voting only if it adversely affects the preferred shareholders as a class. 1. Delaware seems to protect legal rights not economic rights, and here preferred shareholders legal rights are not changed, economic rights are just diluted b. Alteration in the rights of a security/adversely affects the class, or reduce the par value of shares (See DGCL 242(b)(2); RMBCA 10.04(3); NY 804(2)) i. If it adversely affects the rights of only some shares in the class those become a separate class for the vote. c. Increase the number of authorized shares (DGCL 242(b)(2)) i. Usually there are more authorized shares than issued shares so managers can issue more without a class vote ii. NY does not require a class vote in this circumstance. v. Shareholder Access & Information Rights 1. Very hard to get info about a corporation under state law w/o a fight a. This excludes publicly traded companies, for which federal law mandates extensive disclosure 2. Two types of information shareholders interested in

a. Shareholder List b. Books & Records / Financial, accounting, board meeting records, etc. 3. Different approaches in different states a. Delaware (DGCL 220(c)) i. books and records - burden on shareholder to show proper purpose ii. list - burden on corporation to show improper purpose iii. DGCL 220(b): a proper purpose means a purpose reasonably related to the persons interests as a stockholder b. RMBCA 16.02, 16.01(e) (specifically enumerated docs) i. if shareholder shows proper purpose, can get shareholder list, excerpts from board minutes, shareholder meeting minutes, and accounting records c. New York - hybrid approach i. statutory right to inspect key financial statements, stock list, and shareholder meeting minutes if proper purpose (624(a)-(e)) ii. and 'catch-all' under 624(f) for books & records 4. Why harder to get books & records than list? a. transaction costs associated with lots of records are higher b. trade secrets/sensitive business information in records vi. Separating Control From Cash Flow Rights 1. concern this responds to is that those voting won't have proper incentives a. if its a manager who has the votes, will probably improperly concentrate on private benefits 2. Circular voting structures a. banned in most jurisdictions, including Delaware (DGCL 160(c) & (d)) i. can't vote stock when a corporation owns majority of a second corporation ii. point is to protect from managers using shares in their own corporation to establish a controlling voting bloc iii. prohibits voting of stock owned directly or indirectly iv. Structures designed with the intention of getting around 160(c) will be invalidated: 1. stock held by corporate subsidiaries might in some circumstances belong to the parent and thus be prohibited from voting, even if the parent does not hold a majority interest of the shares entitled to vote for the directors of the subsidiary. 2. A director holding that position at multiple companies not technically implicated, but courts will strike down if they see the practical effect as bad b. Classic 160(c) problem (look @ slides) i. Parent Co. owns 55% stock in subsidiary 1. Parent co owned 40% by general public, management owns 20% 2. subsidiary then purchases 40% of parents stock 3. If subsidiary is allowed to vote shares on parent, parent management control is essentially 60% voting control of Parent Co. a. gives management incentive to run parent co. for its own good and not the shareholders w/o a check b. financial interest of management is 25%(ish) considering liquidation value c. Round and Round (look @ slides) i. ExploitCorp, with CEO MBP 1. 45% general public 2. 10% MBP 3. 45% Follow, Inc. a. MBP Director here b. 30% Exploit Corp ii. Can Follow Inc shares be voted in Exploit decisions? 1. yes because Exploit does not own a controlling/majority voting share in Follow,Inc. a. If Exploit owned 51% FollowInc shares, they could not be voted 2. this is problematic if MBP has control over how Follow,Inc. votes its shares

a. if FollowInc has a 70% shareholder, that SH will control b. but if all other FollowInc shareholders are disbursed, this is a potential problem 3. MBP's multiple director position is not implicated as a problem in 160c a. but as a practical matter, this gives him a controlling interest in Exploit if he can control Follow's vote (45%+10%=55%) d. Speiser v. Baker (Del. Ch. 1987) p186 i. Principle: the court will expansively interpret the voting prohibition of 160c to prevent injustice to public shareholder ii. Facts: Speiser seeks to compel ASM of Health Med under DGCL 211(c); Baker has frustrated quorum requirements by not attending. Baker states that at the ASM Speiser will remove Baker as a director of Health Med by voting the shares of Medallion (that Speiser controls), in violation of Speisers fiduciary duty to Health Meds shareholders. Baker counterclaims that Chems shares held by Health Med should not be votable under 160(c). Chancellor Allen grants Speisers 211(c) claim requiring Health Med to holds its ASM, but treats Bakers 160(c) counterclaim as a separate issue. iii. Holding: HealthMeds 42% of HC stock cant be voted in Health Chem 1. Would give Speiser majority control after his 10% share iv. Opinion's reasoning for deciding stock block can't be voted 1. goes beyond just textual language to the purpose behind 160(c) a. reads language not just as prohibition against voting (directly or indirectly) stock belonging to the corporation b. but also as prohibition against voting stock belonging (directly or indirectly) to the corporation v. Company thought they'd gotten around 160c bc stock owned was only 9% of the vote 1. but by interpreting belonging this way, more expansively, essential control of 95% of company holding shares in Health Chem is enough to show ownership (if 9% voting share was converted, it would be 95% ownership) vi. Key to scheme is control of HealthMed done by common stock, and capital provided by operating company 1. which is there to avoid a lawsuit for self-dealing vii. who's hurt by the scheme? 1. public shareholders of healthchem a. unable to oust Speiser & Baker, who do not have an incentive to maximize return to HealthChem 3. Vote Buying a. Common law ban against separating voting rights from equity interest restriction on irrevocable proxies i. Attaching the vote to the equity interest ensures that an unnecessary agency cost will not come into vision; dont want interest party to buy votes b. Why not have a market for votes? i. stockholders would sell votes for less than they're worth bc of collective action problem ii. suppose IBM shareholder mtg coming up 1. Fried wants to elect a candidate a. f he's elected share price will go down by $1 b. needs 50% of people to sell proxies to get person on board c. offers 50cents/vote for first 50% of people i.might sell anyway bc you figure your one vote won't make a difference c. Schreiber v. Carney(Del. Ch. 1982) p193 i. Principle: vote buying is not per-se illegal, but it is subject to fairness review and/or shareholder ratification ii. Facts: Texas Intl wants to merge w/Texas Air. Jet Capital has 35% stake in Texas, Intl. which is effective veto power (preferred stock) Jet threatens to block merger unless it can exercise warrants, but doesnt' have the $$ to exercise. TI wants to loan the funds so that Jet

can exercise them. Special TI committee of three independent directors hires independent counsel and bankers and concludes that the loan makes sense. TI board & a majority of independent shareholders approve the deal. But after this, some shareholders challenge the transaction as vote-buying and corporate waste iii. Holding: Deal is not void; any voidability was cured by shareholder approval iv. Precedent Brady v. Bean 196 involved corporation that was going to sell assets & liquidate, not giving much to shareholders, so they oppose it 1. creditors went to large shareholder and paid him to support the transaction 2. this was voided as contrary to public policy a. this distinguished from the present case bc of transparency v. seems to be little cost to the company & shareholders from this loan vi. want a restriction on vote buying bc we're worried about shareholders extracting large amounts of surplus, imposing higher transaction costs 1. but there's a question whether people would really hold up deals they'd benefit from a. high risk approach 2. if the prohibition were just on holding up deals for no reason, easy for people demanding payment to come up with a reason they should be paid 4. Controlling Minority Structures a. Dual class equity structures i. high vote & low vote stock ii. when does this make sense for letting insiders keep control when a company goes public? 1. might have some values they want it to fulfill which are not just economic interest 2. value their control sufficiently highly that they don't really care whether public shareholders pay somewhat less than they would otherwise a. ie Google iii. controller is held in such high esteem by investors that they are happy to surrender control 1. ie Warren Buffett b. Pyramiding i. not very common in US, more common in Asia ii. controller owns 51% of A, which owns 51% of B, which owns 51% of C iii. so controller has 13% economic stake in C c. Cross ownership i. Voting rights used to control the corporate group are distributed over the entire group rather than concentrated in the hands of a single company/SH (horizontal cross-holding) ii. Also not popular b/c we impose a tax on transfers btw corporations vii. The Collective Action Problem 1. Voting is one of the mechanisms that allows shareholders to influence the corporation's direction a. big weakness of this model is the collective action problem b. Easterbrook & Fischel excerpt p205 voting will rarely have effect except in extremis 2. Hedge Funds do a better job at shaking up management than institutional investors a. more profit incentives b. usually thought to have done well, but concern that they overvalue short term interests over long term viii. Federal Proxy Rules 1. Securities Law a. slightly different legal culture than state corporate law b. cases decided by federal judges, not DE judges i. DE judges more interested in preserving the franchise; judges do 'right thing' ii. many DE judges former corp lawyers, fed judges not specialists c. New actor in the SEC, Congress lets them fill in the detail 2. Proxy Rules: Basic Framework a. Securities Act of 1933 ("33 Act")

i. deals with disclosure procedures that companies must follow when selling securities on the public markets b. Securities Exchange Act of 1934 ("34 Act") i. establishes (among other things) disclosure requirements for corporations after they've gone public. ii. All public companies are subject to proxy regulation under Sec. 14a of the Act c. Regulation 14A (Rules 14a-1 through 14a-12) i. substantive regulation of the process of soliciting proxies and communication among shareholders d. Schedule 14A i. what you need to disclose in a "full dress" proxy solicitation statement
Shareholder Proposals

3. Shareholder Proposals (Rule 14a-8/ 240.14a-8) a. "town meeting rule" b. allows investors to introduce certain types of proposals in management's own proxy materials c. becomes an important tool for inputting corporate governance d. Requirements i. must hold $2000 or 1% of the corporation's stock for a year (b)(1) ii. Must file w/management 120 days before (e)(2) iii. may not exceed 500 words (d) iv. subject matter constraints e. management allowed to exclude proposals for various reasons (14a-8(i)) p440-41 i. Thirteen grounds 1. improper under state law for shareholders 2. implementation violate state/federal/foreign law 3. violation of proxy rules (false or misleading, e.g.) 4. special interest/personal grievance 5. relates to operations <5% assets/earnings 6. absence of power/authority (on behalf of company to implement) 7. function of management in ordinary business operations 8. relates to an election of directors a. used to be read as applying to a particular election b. but now read as any procedural rules for the future 9. conflicts w/companys proposal 10. substantially implemented 11. duplication of anothers submission 12. resubmission w/in 5 yrs if first time it failed miserably 13. relates to a specific amount of dividends ii. burden is on company to justify exclusion f. historically two types i. corporate social responsibility 1. asked board to do something in interest of broader community/society 2. emerged in the 1960s, (Vietnam War) 3. almost exclusive type of proposal through end of 1980s ii. corporate governance 1. tend to be more successful 2. Carpenters' Pension Fund p214 is a popular type of proposal a. shareholders trying to change bylaws to elect Board by majority vote instead of plurality i.under plurality system, as long as board choice gets at least 1 'yes' vote, they're elected even if everyone else withholds their vote

ii.but doesn't specify what they want to happen to these directors b. Board opposes this measure bc they say it was substantially implemented i.HP changed their corporate governance policy to require any incumbent board member who doesn't get majority yes votes to tender their resignation ii.also claim inconsistent w/ 141b 3. DE law now allows resignations triggered by directors not getting a certain # of votes 4. DE law now has a provision saying that if theres a bylaw provision putting in majority voting, that can't be amended by directors g. Lobbying in Favor of Shareholders: CA v. ACSFME (Del. 2008) p220 i. Principle 1: 141a trumps 109b (ie 109 is not an exception), but 109b allows process/procedure bylaws that don't require a particular substantive provision ii. Principle 2: Proposals that could force directors to violate their fiduciary duties are unallowable iii. Facts: Pension fund wants to change rules for reimbursement of proxy access board candidates. Proposal to amend bylaws so that board must reimburse shareholders in successful election of its candidates to <50% of the board. CA does not want to include this proposal, so it asks SEC to exclude, they ask DE courts for answers to 2 qs before deciding iv. Questions for DE courts 1. Is this a proper action for shareholders under DE law? 2. would the proposal, if enacted, cause CA to violate any DE law to which it is subject? v. Main statutes at issue (conflicting) 1. DGCL 109b - "bylaws may contain any provision, not inconsistent w/law or w/the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs, and its right or powers of its stockholders, directors, officers, or employees 2. 141(a): The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may otherwise provided in this chapter or in its certificate of incorporation. 3. first gives power to stockholders, but second says resides with directors vi. Holding: this proposal is allowed under state law, but because it could force directors to violate their fiduciary duty by reimbursing candidates running for personal or petty reasons, not for the good of the firm, it is not allowed vii. What if proposal was the same, except to amend the charter instead of the bylaws? 1. footnote suggests this would be ok, but didn't suggest this bc the board would have had to agree 2. also, can't actually change the content of the director's fiduciary duty by putting something in the corporate charter h. Putting it all together: A Victory for Shareholder Democracy? i. Even uncontested director elections are not a sure thing due to majority vote requirements: Corporate law now facilitates, and many companies have now adopted, a requirement that directors are elected by a majority (not plurality) of the votes cast. Majority voting uncommon in firms other than top 200-300. ii. Shareholder proxy access makes contested director elections more likely: SEC ruled in August 2010 that a 13% shareholder (or shareholder group) that has held stock for 3 years can place nominees on the companys proxy statement for up to of the total board seats. Business Roundtable sued, tied up in court, wont go into effect in 2011. iii. New rule on broker voting gives activists more influence in director elections: July 2009 SEC rule prevents brokers from voting discretionary shares in uncontested director elections, which gives more power to institutional investors. iv. eProxy makes it cheaper to run an insurgent slate: Reduces costs of distributing proxy materials, and likely gives more power to institutional investors. 1. But hasnt actually been used yet

v. Delaware Supreme Court invites 14a-8 resolutions that require reimbursement of shareholder proxy expenses: AFSCME decision rejects the specific resolution at CA but leaves the door open through better drafting. 4. The Anti-Fraud Rule (Rule 14a-9) a. This section prohibits false or misleading proxy statements. b. This used to be enforced only by the SEC, but then in Borak (1964), the Supreme Court recognized an implied private right of action under 14a-9. Corporations or shareholders could sue for injunctive relief and/or damages. c. Injured Shareholders must show: i. Materiality: a misrepresentation or omission in a proxy solicitation must be material 1. If there is a substantial likelihood that a reasonable shareholder would consider a fact important in deciding how to vote (TSC Industries) ii. Culpability: The Supreme Court has not determined a standard of culpability (negligence or scienter intentionality or extreme recklessness- circuit split) iii. Causation: Mills eliminated any reliance requirement-- must now only show that proxy statement was an essential link in voting process, not that the shareholder relied on the statements in voting. iv. Remedies: injunctive relief, rescission, or monetary damages d. Supreme Court reads the implied right of action under 14a-9 narrowly e. Virginia Bankshares (1990) p230 i. Rule: statement of director opinion is enough to be material ii. Rule: to show a director opinion to be false/misleading, must show there are underlying facts that are not as directors characterized them; a showing of disbelief in ones own opinion is not enough iii. Rule: a statement made that affects an unnecessary shareholder event does not show causation in order to allow recovery iv. Facts: "Freeze out" merger of Bank into VBI -- public shareholders get $42 per share cash on recommendation of outside banker. Board doesn't need shareholder approval, but holds a vote anyway. Bank has 85% of its own shares, so it has a majority already. Bank board in proxy materials urges vote for a plan, materials say $42 is "high" and "fair" price. Dissenting shareholder brings suit claiming violation of 14a9 v. Holding: proxy contained a material misstatement, but no recovery bc it was not an essential link in accomplishing the merger vi. Lower court: jury awards an extra $18/share, 4th Cir affirms vii. Note: vote necessary to stop minority shareholders from voiding transaction for conflict of interest under VA corp law 1. but Court says vote only freezes rights under VA statute if vote is made based on all 'material facts' but bc the info is false, they haven't lost the right to bring an action 2. Dissent responds that this relies on state defn of material being same as fed, which hasn't been shown
Normal Governance: The Duty of Care

b. Normal Governance: The Duty of Care i. a very weak backstop on the voting system 1. if directors in place make a bad decision before you can vote them out, you can make a claim under this and hopefully recover some $$ from the director ii. not codified under DE law, but articulation in ALI Principles of Corporate Governance Sec. 4.01(a) 1. reflect what DE courts have developed iii. Kind of a negligence standard, but most companies have law protecting D&O from this (risk aversion) 1. More aspirational than an actual source of liability iv. Duty of Care ALI 4.01(a) 1. A director or officer has a duty to the corporation to perform the director's or officer's functions a. in good faith

b. in a manner he reasonably believes to be in the best interests of the corporation c. with the care that an ordinarily prudent person would reasonably be expected to exercise in a similar position in like circumstances (key prong) 2. note that this is not whats actually applied in DE cases, just a helpful clear formulation a. but try not to get too caught up in ideas about good faith, thats separate duty really v. Statutory Techniques for Limiting D&) Risk Exposure 1. Framework for D&O Liability a. Business Judgment Rule (RMBCA 8.31(a)(2)): presumes that the duty of care standard has been met i. Least costly method, bc it stops a lawsuit sooner. the rest only kick in once a lawsuit has determined a director owes damages b. Waiver of Liability (DGCL 102(b)(7)): 90% of Delaware companies eliminate D&O liability for duty of care violations (self insurance for gross negligence) i. Located in the certificate of incorporation c. Indemnification: may indemnify for D&O actions in good faith (DGCL 145(a)) and for those beyond those provided by statute but still in good faith (145(f)). d. D&O Insurance: corporation may buy D&O insurance whether or not the corporation would have the power to indemnify such person against such liability. (DGCL 145(g)). e. Reimbursement of legal expenses: even if not in good faith, success in a legal action requires indemnification for legal expenses (DGCL 145(c)). 2. Indemnification a. Waltuch v. Conticommodity Services, inc. (2d Cir. 1996) p243 i. Rule: Company charters can not provide indemnification under 145(a) & (b) regardless of director bad faith; there must be good faith showing for indemnification under those provisions ii. Rule: Success in a lawsuit requiring repayment of costs includes any escape from a judgment, regardless of good faith iii. Facts: Waltuch is VP & Chief Metals Trader for Conti, When silver prices crash, he becomes target of lawsuits by speculators & an enforcement proceeding brought by the CFTC for fraud and market manipulation. Private actions, Conti settles for $35 million, Waltuch dismissed but has $1.2 mil in unreimbursed legal fees. In CFTC action, Waltuch agrees to a penalty that includes a $100,000 fine and a six-month ban on buying or selling futures contracts from any exchange floor, and spends another $1 million in unreimbursed legal fees. Waltuch brings suits against Conti for indemnification of his $2.2 million, under Conti's charter Art 9 (no explicit good faith req.) and under DGCL 145c. parties stipulate he did not act in good faith iv. Holding: Art 9 is a violation of DE law, since DGCL 145(a) requires good faith for indemnification, but Waltuch is entitled to $1.2 million under 145(c) 1. No good faith requirement under 145(c) v. Court reads 145(a)'s requirement of good faith into all the other provisions of 145, including f; can't pay director if they did not act in good faith vi. Court says "succeeding on the merits or otherwise" means escape from a judgment for whatever reason vii. Does Waltuch decision make sense as a policy matter? 1. does if you can reincentivize directors through insurance, otherwise directors may worry shareholder may accuse them of not acting in good faith 3. Judicial Protection of the Business Judgment Rule a. Different in every state, but core idea is: courts should not second-guess good-faith decisions made by independent and disinterested directors i. courts will not decide whether the decisions of corporate boards are either substantively reasonable (by reasonable person test) or sufficiently well-informed b. ALI Sec. 4.01(c), RMBCA Sec. 8.31(a)(2) A director or officer who makes a business judgment in good faith fulfills the duty under this section if the director or officer:

i. (1) is not interested in the subject of the business judgment; ii. (2) is informed with respect to the subject of the business judgment to the extent that the director or officer reasonably believes is appropriate under the circumstances; and iii. (3) rationally believes that the business judgment is in the best interests of the corporation. c. Chancellor Allen: The [business judgment] rule in effect provides that where a director is independent and disinterested, there can be no liability for corporate loss, unless the facts are such that no person could possibly authorize such a transaction if he or she were attempting in good faith to meet their duty. d. How the rule works: i. P has to prove disloyalty or gross negligence; if does so, burden shifts onto board member to prove entire fairness of the transaction ii. BJR is a rebuttable presumption in favor of director discretion iii. Note that it only comes into play when there is an actual judgment (i.e., not when board/director remains passive) iv. Where this does not apply, corporations are likely to have mechanisms in place to limit shareholder recovery in other ways e. Rationales for the BJR i. Institutional competence: courts not competent to make ex post second guesses ii. Agency problems: without it, directors would be too risk-averse iii. Allocation of power in corp.: want power to stay with directors, not SH (not risk-averse enough) f. Kamin v. AmEx (NY 1976) p250 i. Rule: Court will not intervene unless the board or directors acted illegally or unconscientiously, or the acts were fraudulent, or collusive, and destructive of the rights of shareholders. Errors in judgment are not sufficient to intervene ii. Facts: in 1972 Amex acquires 2 mil shares of DLJ common stock for $29.9 mil; by 1976 stake only worth $4 mil. Amex declares a special inkind dividend distributing the shares to shareholders. 2 shareholders files suit to enjoin the distribution, or for monetary damages, claiming waste of corporate assets bc Amex could sell the shares and use the capital loss to offset capital gains, reducing the tax liability of the firm resulting in a tax savings of $8 million. but defendant directors claim possibility was considered but rejected due to negative impact on accounting profits which would hurt their share price iii. Holding: No liability bc directors acted w/in the realm of the BJR iv. Plaintiffs allege self interest bc 4/20 directors get compensation based on earnings/income 1. court dismisses this bc 16 others who would dilute this influence 2. also all compensation based in some part on earnings, not enough to disqualify g. Note on BJR/Duty of Care in Takeover Cases: Smith v. VanGorkom (Del. 1985) p255 i. Discussed in greater detail later ii. responsible for Delaware's enaction of DGCL 102b7 1. allows corps to put provision in charter preventing shareholders from recovering from directors who violate duty of care iii. Rule: the BJR does not apply when directors failed to inform themselves in approving a takeover iv. Rule: Only gross negligence in making a decision can lead to a duty of care violation v. Claim: Breach of duty of care by acting in uninformed manner vi. Facts: TransUnion has net operating losses that can be applied to taxable income and reduce tax burden, but company not generating much income that it can be used against. Acting mainly on his own, CEO VG arranges a sale to Pritzker for $55/share. VG calls special board meeting, board approves w/o input from any outsiders after <2 hours. TransUnion shareholder sues claiming breach of duty of care. no allegation of conflict of interest, but claims board did not act in informed manner vii. Lower court: Chancery court approved merger saying protected by business judgment rule

viii. Holding: directors had been "grossly negligent, so court can look at the substance of the transaction 1. no determination yet of whether there are damages, remanded to district court; case later settled for an extra $1.87/share, no evidence the price was particularly unfair ix. How to reconcile this w/earlier BJR? 1. here this looks rushed and done w/o adequate info 2. process based v. substantive charge 3. however, in the end likely this is just a precursor to cases requiring a higher standard in merger/takeover cases x. when this came down, corporation directors very unhappy 1. lawyers happy bc this means you have to get advice before making decision 2. Ibankers too, so you get advice saying share price is fair 3. insurers happy bc demand for D&O insurance went up precipitously xi. in the wake of this, DE legislature enacts 102b7 (supp 163) 1. companies can limit director's personal responsibility for duty of care, but can't eliminate for lack of good faith, intentional misconduct, knowing violation of the law, or breach of duty of loyalty 2. more than 90% of companies enact these provisions; probably expensive/difficult to recruit directors w/o this 4. Delawares Unique Approach to Adjudicating Due Care Claims Against Corporate Directors a. Doctrine is messy, lots of confusion over how to handle duty of care claims b. Cede v. Technicolor (Del. 1993) p259 i. Rule: A breach of the duty of care without injury is enough to rebut the BJR ii. Rule: It is the responsibility of the defendants to show that a transaction made in breach of the duty of care is entirely fair (price & process) iii. Facts: Tech CEO negotiates to sell to Perelman for $23/shre, 100% premium over pre-bid share price. Disinterested board uses loose procedure to approve transaction, no credible valuation, not "shopped" to other buyers, etc. In appraisal proceeding, Chancellor find value of stock is $21.60/shre. Dissenting shareholders bring suit anyway charging violation of duty of care iv. Chancery Court: no violation bc no injury; real share value lower than sale price v. Holding: BJR does not apply, remanded for directors to show entire fairness vi. Chancery Ct remanded: directors met burden of showing completely fair transaction c. Cede sets up messy interaction when there is a 102b7 provision i. how soon in the litigation process can a court dismiss directors from litigation charging them with liability in a transaction in which they had no conflicting financial interest? ii. Malpiede v. Townson (Del. 2001): when a company has a 102b7 provision and the only claim is duty of care, the complaint should be dismissed 1. Alternate stating: a complaint must allege a breach of the duty of loyalty to survive a motion to dismiss iii. McMillan v. InterCargo Corp. (Del. Ch. 2000): when there is a 102(b)(7) clause, for a breach of loyalty claim to survive a motion to dismiss, it must plead particularized facts in support of such a claim; allowing general allegations to go forward would defeat the aims of the clause d. Emerald Partners v. Berlin (Del. 2001) p260 i. Rule: when there is an interested controlling shareholder, an entire fairness analysis must be performed, before the effects of a 102(b)(7) provision can be considered 1. Note: if transaction is not held to be entirely fair, independent directors must show this is the result only of care breaches, not loyalty, in order to avoid liability ii. Facts: Hall is CEO & 52% owner of May, he has May buy 13 corporations controlled by Hall. Transaction negotiated and approved by May's independent directors. Emerald Partners, a minority shareholder in May, brings suit alleging that the transactions were unfair to May. Hall declares bankruptcy and is out of the picture. May has a 102(b)(7) clause

iii. Chancery Court: dismisses the complaint against remaining directors w/o conducting an "entire fairness" analysis bc all that's left is duty of care claims, e. Duty of Care w/o 102(b)(7) i. Is board reasonably well informed? 1. Yes: Protected by business judgment rule, duty of care claim dies 2. No: Is there gross negligence? a. No: No duty of care violation. Plaintiffs cannot recover. b. Yes: Can defendants prove entire fairness? i.Yes. Plaintiff cannot recover. ii. No. Plaintiffs can recover damages. f. Duty of Care with 102(b)(7) i. Path of analysis: 1. Does P allege only doc violation, or fail to present particularized facts supporting dol claim, in firm w/102b7 provision? a. Y: c dismissed b. N: to step 2 2. Can P overcome presumption of BJR? a. N: c dismissed b. Y: to step 3 3. is there gross negligence or other reason for requiring def to show entire fairness? a. N: plaintiffs can't recover b. Y: to step 4 4. can defendants prove entire fairness? a. Y: c dismissed b. N: to step 5 5. was lack of fairness entirely b/c care violation? a. Y: defendants don't have to pay b. N: defendants must pay 5. The Boards Duty to Monitor: Losses Caused by Board Passivity a. Monitoring Duty: Director should look at the books and be aware of what is going on b. Response Duty: Director may have an obligation to stop certain behavior, resign, and hire a lawyer to threaten suit i. BUT Barnes v. Andrews: No liability for failing to stop general mismanagement, which is hard to do c. Francis v. United Jersey Bank (NJ 1981) p262 i. Rule: Directors are under a continuing obligation to keep informed about the activities of the corporation, including regularly attending the board meetings and reading financial statements ii. Rule: Directors are only immune from liability if they rely on things like outside counsel, financial statements and company related representations that they have no reason to suspect to be fraudulent iii. Rule: if directors discover illegal action, they have a duty to object, and resign if the conduct isnt stopped iv. Facts: The directors of a reinsurance firm are the founders widow and her two sons. The sons begin making large loans to themselves and never paying them back. The mother elderly, sick, alcoholic, uninformed and does nothing to prevent it. Some SH come along and sue the widow (now dead) for failing to comply with the duties to act and monitor. Ms. Pritchard (Ms. P) didnt read the financial statements and did not question the actions of the officers of the company (her sons). v. Holding: Mrs. P is liable vi. Analysis in cases of negligent omissions calls for determination of the reasonable steps a director should have taken and whether those steps would have averted the loss. Causation

may be inferred where you can conclude that the failure to act would produce a particular result, and that result has followed. d. Graham v. Allis-Chalmers Manufacturing Co. (Del. 1963) p268 i. Rule: BJR does not apply in cases of omissions ii. Rule: Directors are entitled to rely on employee honesty and integrity until some sort of red flag; until there is a red flag, directors are not responsible for monitoring for specific misconduct. iii. Facts: Non-directors employees (middle managers) engaged price-fixing. The directors cant use the BJR because they didnt make a decision at all. Shareholder brings derivative suit to recover for the corporation. iv. But note that Caremark decision seems in tension with this e. In re Michael Marchese p272 i. Facts: Chancellor Corp. acquired MRB in 1999 but CEO and other officers forged documents showing the transaction taking place in August 1998 in order to consolidate MRB earnings a year earlier. Audit committee members Marchese and Peselman received a report from outside auditor challenging 1998 acquisition date but did not follow up. New auditors signoff on 1998 acquisition date. Marchese certifies 1998 10-KSB, but resigns from the board in 1999 and expresses concerns to the SEC. ii. Actions caused company to violate 10(b) of the Exchange Act by signing Form 10KSB. iii. Outcome: Marchese agreed to undisclosed settlement for recklessly ignor[ing] signs pointing to improper accounting treatment. f. In re Caremark Intl Inc. Derivative Litigation (Del. Ch. 1996) p278 i. Rule: Boards have an affirmative duty to have an information, reporting and monitoring system in place ii. Rule: Generally where liability is predicated on directorial ignorance of liability creating activitiesonly a sustained or systematic failure of the board to exercise oversight will establish the lack of good faith. iii. Facts: Caremark is a publicly traded health care provider subject to the complex provisions of Anti-Referral Payments Law: basically, youre not supposed to pay MDs to refer patients whose treatment is paid for by Medicare or Medicaid. Caremark had always had an ethics guidebook, an internal audit plan, and a toll-free confidential ethics hotline. Price Waterhouse gave control system a clean bill of health. But despite it all, lower-level officers apparently engaged in enough misconduct to cost $250 million. Shareholders file derivative suit seeking recovery from the board of directors, claiming breach of the duty of care. iv. Holding: no breach bc directors had an adequate monitoring system. v. May only require a system to protect fundamental aspects of the corporation with vulnerability to illegality. g. Stone v. Ritter (Del. 2006) p285 clarifies Caremark i. Caremark articulates the necessary conditions predicate for director oversight liability: (a) the directors utterly failed to implement any reporting or information system, or (b) having implemented such a system, consciously failed to monitor its operations, thus disabling themselves from being informed of risks or problems requiring their attention. Imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations. h. In re Citigroup Inc. Shareholder Derivative Litigation (Del. Ch. 2009) p285 i. Rule: Directors responsibility to monitor does not extend to monitoring for systemic risk ii. Facts: Citis high amount of toxic assets harm company during recession. Shareholders bring suit alleging inadequate systems monitoring the companys risk in the subprime mortgage market. Argue public reports on market deterioration should have served as red flags. Company has 102(b)(7) waiver iii. Holding: no liability for failure to monitor subprime market i. Note on Sarbanes-Oxley Act of 2002

i. 404: requires that CEO of firms regulated under Sec. Exchange Act of 1934 periodically certify that they have disclosed to the companys independent auditor all deficiencies in the design or operation, or any material weakness, of the firms internal controls for financial reporting. ii. CONS: compliance costs are high and have pushed some smaller companies out of public markets (or at least out of New York into foreign markets) iii. PROS: forces companies to take a hard look at their control systems, which might have long-term benefits 6. Knowing Violations of the Law a. It is a breach of fiduciary duty to act as a director in a way that violates the law, even if that is in the financial interest of the company b. Miller v. AT&T (3d Cir. 1974) p291 i. Rule: BJR doesnt insulate directors from liability for illegal actions, even if they profit the company ii. Facts: Shareholder suit against AT&Ts board, alleging that AT&T is refusing to collect on a $1.5 million loan made to the Democratic National Committee during the 1968 election. Shareholders bring a derivative action claiming that this is an illegal campaign contribution, in violation of federal law. iii. Lower court: dismisses the suit for failure to state a claim c. However, directors can be indemnified for this i. under 145(g), you can insure directors for whatever insurance companies will sell policies
Conflict Transactions: The Duty of Loyalty

c. Conflict Transactions: The Duty of Loyalty i. 2 types of transactions where courts look much more closely 1. conflict transactions (director/controlling shareholder on both sides) 2. fundamental transactions leading to termination of corporation (merger, dissolution) ii. This duty is the core of the fiduciary doctrine. 1. The other two controls (duty of care, SH right to appoint directors) are weak b/c do not limit the boards discretion to enter specific transactions. a. But there may be actions over which it may be sensible to limit board discretion. 2. This chapter looks at controls on corp. actions that are interested (in which a director or controlling SH has a personal financial interest). iii. DUTY OF LOYALTY **applies only to interested parties** 1. Requires a director/officer/controlling SH to exercise his institutional power over corporate processes or property (including info) in a good-faith effort to advance the interests of the company. 2. Stated negatively, requires such a person who transacts with the corp. to fully disclose all material facts to the corp.s disinterested representatives and to deal with the company on terms that are intrinsically fair in all respects. They may not deal w/the corporation in any way that benefits themselves at its expense. iv. To Whom is the Duty of Loyalty Owed? 1. "to the corporation" a. but this is not particularly clear, that's just contracts b. masks that interests of different stakeholders are not the same c. clear that there is a duty to the shareholders i. but which shareholders? only the current, or to future investors as well? d. what about creditors? i. when in vicinity of insolvency, may make sense to take in larger views (previous case) e. employees, customers, community, society at large? 2. Shareholder primacy norm a. Dodge v. Ford Motors (1919) p297

i. Facts: Ford eliminates dividends, saying he will use the saved $$ to reduce the price of cars to help consumers, shareholders sue ii. Holding: Court says can't run company to benefit public at large, owes duty of loyalty to shareholders first b. 2 things have changed since Dodge v. Ford i. corporate law changed somewhat 1. constituency statutes in 30+ states, explicitly saying boards can take into account the interests of constituencies other than shareholders 2. DE does not have one, but several DE cases say when management has not decided to put company up for sale, they can take into account interests of non-shareholder parties to the extent that will enhance long term shareholder value 3. enacted bc of 80s wave of hostile takeovers opposed by management ii. lawyers have gotten executives to frame whatever they're doing as in the interest of shareholders, not other stakeholders c. Corporate Charitable Giving i. A.P. Smith Manufacturing Co. v. Barlow (NJ 1953) p299 1. Rule: Corporate charitable giving is allowed 2. Facts: company gives modest donation to Princeton University, challenged by shareholder as w/o power to make it 3. Holding: company is authorized to make donation bc 4. NJ 1930 statute allows companies to maintain philanthropic activities as directors judge to protect corporate interest 5. NJ 1950 statute allows charitable contributions up to 1% total capital 6. Rationales: corporations entitled to pursue the greater social good, might be in the interest of this particular corporation to improve Princeton, statutes clearly authorize this ii. Hypotheticals 1. suppose company donates to a controversial cause allegedly in corporation's best interest a. ie contraception donating to pro-choice organization 2. what if its a favorite charity of a corporate customer or director? a. some say its shareholder $$, so they should decide, not the board b. problem is that this is frequently a way to pay off directors c. generally disfavored in todays corporate world v. Self-Dealing Transactions 1. D&O may not benefit financially at the expense of the corp. in self-dealing transactions. 2. Statutory Provisions a. RMBCA 860-863 861: nondisclosure is subject to fairness review, but directors must have good reason for failure to disclose. Disinterested review by board BJR (not entire fairness). b. DGCL 144: self-dealing transactions will not be voidable solely b/c of a conflict of interest; if they are adequately disclosed and approved by a majority vote of disinterested SH or directors fair. Undisclosed transactions are subject to fairness review (not void per se). c. ALI 5.02: evidence of nondisclosure is sufficiently unfair to make a transaction per se voidable (Hayes Oyster Co.) 3. Disclosure Requirement a. Valid authorization of a conflicted transaction between a director and her company requires the interested director to make full disclosure of all material facts of which she is aware at the time of authorization b. State ex rel. Hayes Oyster Co. v. Keypoint Oyster Co. (Wash. 1964) p304 i. Rule: nondisclosure by an interested director is inherently unfair and will lead to a voidable transaction

ii. Facts: Coast Oyster Co., of which Verne Hayes is a 23% director and shareholder, has cash flow problems and Verne convinces them to sell 2 oyster beds. Verne teams with Engmann to form Key Point which buys the beds after shareholders approve the sale (Hayes obviously voted his 23% in favor and had enough proxies for a majority vote). Hayes has a 50% interest in Key Point, which he did not disclose to Coast. Coast's new management discovers what Verne has done and brings suit to recover Verne's and Hayes Oyster's secret profits. don't want to get rid of or renegotiate contract, just want 50% interest turned back over to the company iii. Holding: Coast entitled to recovery of profits from transaction w/ undisclosed interest iv. no showing that he violated his fiduciary duty in this transaction, fairness is not in dispute 1. employment contract said entitled to pursue oyster ventures through his other company, so arguably what he was doing v. court emphasizes that fairness is very hard to figure out after the fact, don't know where in the possible range a price would have ended up had there been full disclosure 4. Controlling Shareholders and the Fairness Standard a. Corp. law recognizes a fiduciary duty on the part of controlling SH to the co. and its minority SH b. Control in this context should be determined by a practical test rather than a formalistic one. c. Theres a conflict of values b/c even though controlling SH have duty of fairness, are also SH and therefore entitled to pursue own investment interests d. Can be seen as a duty to consider other SH interests fairly whenever the corp. enters into a K w/the controller or its affiliate e. Sinclair Oil Co. v. Levien (Del. 1971) p310 i. Rule: Fairness review is required only if the parent receives something from the subsidiary to the exclusion of, and detriment to, minority shareholders of the subsidiary. ii. Facts: Sinclair owns 97% of Sinven, both involved in oil; dividends paid to shareholders prevent the company from exploring and producing more, minority shareholders bring suit, Sinclair says this should be BJR iii. Lower court: No BJR, Sinclair owes Sinven fiduciary duty, and fails entire fairness standard iv. Holding: BJR kicks in bc this was not a self-dealing transaction, since all shareholders treated equally v. Under BJR, motives of larger dividends dont matter unless plaintiffs can show they were improper
Effect of approval by a disinterested party

vi. Effect of approval by a disinterested party

1.

2. Safe Harbor Statutes a. Provide a transaction is not voidable solely because of self-dealing, as long as certain other requirements are met b. NYBCL 713, Cal. Corp. Code 310 c. DGCL 144 - Transaction btw corporation and director not voidable solely for this reason if i. material facts disclosed and authorized in good faith by a majority of disinterested directors; OR ii. material facts disclosed and are known to stockholders and approved in good faith by stockholder vote; OR iii. fair to the corporation as of the time it is authorized, approved or ratified by the board of directors, a committee, or the stockholders iv. But note this provision doesn't say how courts will review these 1. leaves open that they could be voidable for another reason d. Cookie's Food Products v. Lakes Warehouse (Iowa 1988) p315 i. Rule: Approval by the board is only makes the transaction not per se void, the court must perform an additional fairness review for the transaction to be acceptable. ii. Facts: company enters into distributorship w/minority shareholder Herrig who owns several other companies. Herrig markets this effectively and sells a lot of it. Herrig buys out Cookies and becomes majority shareholder & director, entering into several more successful self-dealing contracts with Cookie's, which take out about half of the cash flow. minority shareholders bring suit alleging contracts grossly exceed value of services rendered & that Herrig did not fully disclose the benefit he would gain. shareholders upset bc not getting dividends & stock is not publicly traded, so v difficult to sell iii. Lower court: finds no breach of fiduciary duty and rules for Herrig iv. Holding: for Herrig bc the transaction passes fairness review v. Iowa statute at issue v similar to DGCL 144, but does not say "solely" 1. so this statute less conscious of the possibility that the transaction could be voidable for another reason, but court basically reads solely into it vi. court isn't actually looking at the terms of the contracts that were entered into, but more looking at the overall effect, have a hard time imagining that Cookie was hurt by these vii. Dissent argues court should find against Herrig bc he didn't meet his burden 1. Herrig gave no proof showing his rates were fair market price for anything 2. profitability of the company doesn't escape scrutiny for the contracts 3. Approval by Disinterested Members of the Board a. Cooke v. Oolie (Del. Ch. May 2000) p322 i. Rule: BJR will be applied to transactions where the interested director is not a majority shareholder, when the interest is fully disclosed and transaction is approved by a majority of disinterested directors ii. Facts: TNN has four directors, 2 of whom are creditors. Board votes unanimously to pursue an acquisition by USA. minority shareholders bring suit, claiming the 2 directors breached their fiduciary duty by "pursuing the proposal that best protected their personal interests as creditors, rather than pursue other proposals that offered superior value to TNN's shareholders iii. Holding: BJR applies, summary judgment for defendants iv. Court find several things important 1. technically 144 did not apply bc not classic self-dealing (no financial interest in USA) 2. fact that disinterested directors approved it gives it legitimacy v. Difference from Cookies 1. in Cookie's Herrig had appointed the other directors/had control to remove them 2. no such controlling shareholder in Cooke, so more likely directors are actually independent 4. Approval by Special Committee of Independent Directors

a. Use of a Special Committee is the most common template for transactions b/w subsidiary and parent, which involve the greatest risk of overreaching i. Parent corporations have obligation to treat subsidiaries fairly; judicial review is prevalent b. The Special Committee must be properly charged by the full board, comprised of independent members, and vested w/ resources to accomplish its task i. Committee often retains I-bankers and lawyers to advise it 1. The method of their compensation may be important c. The Special Committee must not only get a fair deal, but the best deal available. i. A finding that the deal is within a range of reasonableness is not sufficient to shift the burden of proof to the P. In re First Boston Shareholders Litigation d. In a controlled transaction the committee process only serves to shift the burden of fairness to P to prove unfairness e. Unless there is board approval, the special committee will not disable entire fairness review, but it can bolster the Ds evidence of fairness f. Entire fairness doctrine will always be used when the controlling shareholder is the interested one i. Though burden may shift to Ps if theres approval 5. Shareholder ratification a. Lewis v. Vogelstein (Del. Ch. 1997) p327 i. Rule: if a majority of shareholders were interested in the transaction, then ratification will have no legal effect ii. Rule: Shareholder approval is ineffective if a transaction constitutes corporate waste iii. Waste is where there's an exchange of corporate assets for consideration that's so small that it lies beyond a reasonable acceptance 1. theory is that could be considered coerced separation from property, which no one should be forced to do, so only unanimity will allow this b. In re Wheelabrator Technologies, Inc. (Del. Ch. 1995) p328 i. Rule: effect of shareholder ratification on standard of review depends on whether its btw director & corporation or controlling shareholder & corporation 1. no controlling shareholder BJR 2. controlling shareholder - fairness rule, but ratification shifts burden to the plaintiff ii. rationale: court still very wary of controlling shareholders, recognize that they have a lot more manipulative powers over the corporation 1. given this, can't escape fairness review just bc you convinced some of the other shareholders
Executive Compensation

vii. Executive Compensation 1. Perceived Excessive Compensation a. why do people get more worked up about this than other highly paid members of society? i. probably bc of the chummy culture btw boards setting pay and the CEOs, shareholder $$, etc. b. Court doesn't want to scrutinize these much, so often decline to review process i. not necessarily a bad thing, since courts not set up to review 2. History of Executive Pay a. 1950s it was low, but high tax bracket, so prob didn't matter much to them b. pay took off in 1960s i. some people think this is bc of free agency of pro athletes ii. at this time, paid mostly through salaries and bonuses, and not very connected to performance of firm c. 1980s empirical analyses of exec pay begins i. bad incentives bc decisions don't affect them personally

ii. institutional investors start asking for compensation through equity for CEOs iii. boards initially resisted bc didn't want to have salary cut for risky options d. Clinton elected w/a promise to cap exec salaries @ $1 million (or at least limit deductibility) i. early 1990s Congress enacts tax code provision saying this ii. but exception written in saying if pay is performance based it will be deducted to full value e. After these changes i. execs paid <$1 mil saw their salaries jump ii. boards start giving a lot of pay in the form of options 3. Option Grants and the Law of Officer & Director Compensation a. Option terminology i. Call Option - right to buy a share at a specified price ("strike price") 1. Compare: a put option is the right to sell a share at a specified price 2. Ex: Call option on XYZ Corp., currently trading at $100, with strike price of $100. If XYZ stock price goes to $120, option holder can "exercise" the option, buy a share at $100, and sell it for $120, realizing a profit of $20 3. "At the Money" call option: strike price = current market price 4. "In the Money" call option: strike price < current market price 5. "Out of the Money" call option: strike price > current market price b. Problems with options i. over time, stock prices go up just bc of market trends, even if company itself isn't doing well ii. incentives to game the system iii. focus on raising price in short term rather than the long term iv. backdating v. ratcheting - don't want to pay at the lower percentile w/in the industry c. Lewis v. Vogelstein (Del. Ch. 1997) p332 i. Rule: If there is a good faith determination by a reasonable board or committee that under the circumstances the corporation will receive a proportionate benefit, and there is shareholder ratification then the stock option grant is subject to BJR treatment (i.e. classic waste standard) d. Interested Loans i. Board may authorize interested loans (ie to directors and officers) when the loan or guarantee benefits the corporation -DGCL 143 ii. 402 of Sarbanes-Oxley prohibits any corporation with publicly-traded shares (or a subsidiary) from directly or indirectly extending credit to any director or officer of the corporation 1. People were getting huge loans from companies that were forgiven by the board and sometimes never paid back 4. The Disney Case a. Michael Eisner basically an imperial CEO, put personal friends on board, probably only got away w/it bc he was a great CEO b. other people eventually force him to groom some sort of successor, persuade Michael Ovitz to leave his job and join c. looking at contract, can see that Ovitz would make more money being fired than he would have working there d. when Ovitz was hired, market capitalization of Disney went up $1 billion e. a year later, clear that Ovitz isn't working out. Litvak loosely investigates possibility of termination for cause, due to Ovitz poor performance, but doesn't keep notes or seek outside legal advice f. Ovitz is fired w/o cause, triggering $140 million compensation package g. Complaint brought as violation of duty of care i. this dismissed, bc Disney hs 102(b)(7) provision but plaintiffs allowed to re-plead h. New complaint allowed to move forward

i. Chancery opinion suggests directors "consciously and intentionally disregarded their responsibilities" and didn't care if their decisions caused the corporations loss i. Discussion of Chancery opinion i. increased market cap w/Ovitz hiring doesnt show good decision, bc unlikely the market looked @ employment agreement, just happy that a successor was hired 1. if they had understood agreement, might have reacted even better if it was properly structured ii. Liability will attach based on an absence of good faith on behalf of the directors 1. Disney has a 102(b)(7) clause 2. it is possible to violate the duty of care but still act in good faith a. ie gross negligence w/o consciously disregarding their duties will be indemnified in this situation iii. Holding: no bad faith in the hiring of Ovitz iv. Holding: no bad faith in the firing of Ovitz 1. Eisner had authority to fire unilaterally 2. firing him was consistent w/his duty as fiduciary (& relied on gen counsels opinion that couldnt be fired for cause) 3. True even though Eisner a. Failed to keep the board as informed as he should have b. Acted without specific board direction or involvement in recruiting Ovitz c. Prematurely issued a press release that placed pressure on the board to approve Ovitzs compensation package j. Supreme Court affirms the Chancery Court i. In order to overcome the BJRs presumption of good faith a P must prove bad faith by a preponderance of the evidence, or to overcome the presumption of being informed, must prove that the directors failed to inform themselves of all reasonably available material information before making a business decision. 1. Bad Faith: authorizing a transaction for some purpose other than a genuine attempt to advance corporate welfare or when a transaction is known to violate the law. (both duty of care and loyalty) a. Intentional dereliction of duty falls under bad faith. (conscious disregard for ones responsibilities) b. Indifference and inaction in the face of a duty to act is disloyal to the corporation c. MUST have a duty to act to show bad faith! ii. If the Ps successfully rebut the presumption of the BJR then the burden to prove entire fairness switches the Ds. iii. Bad faith bypasses DGCL 102(b)(7). Upon a showing of bad faith the board and/or officers may be personally liable not withstanding a 102(b)(7) provision in the charter. iv. Stone v. Ritter used to clarify good faith standard 1. there is no duty of good faith you can use directly to impose liability on a director a. it is indirect 2. really a part of the duty of loyalty a. loyalty violations not cognizable only for financial conflicts/fiduciary violations b. can show that duty of loyalty is violated by a lack of good faith viii. Corporate Opportunity Doctrine 1. When Does an Opportunity Belong to the Corporation? a. There are several common law tests out there: i. Line of Business Test: The business opportunity belongs to the corporation if it sufficiently related to the firms existing line of business. Guft v. Loft 1. Factors affecting this determination: a. How the matter came to the attention of the director, officer, or employee

b. How far removed from the core economic activities of the corporation the opportunity lies; and c. Whether corporate information is used in recognizing or exploiting the opportunity ii. Interest and Expectancy Test: looks to the corporations particular ties with the disputed opportunity rather than to generic nature of opportunity. The expectation or interest must grow out of an exiting legal interest, and the appropriation must to some degree prevent the company from effecting the purpose of its creation. iii. Fairness test: in addition to the line of business, the court would look into factors such as how manager learned of the opportunity, if it was generated out of corporate property, and other fact-specific indicia of good faith and loyalty to the corporation. b. ALI 5.05: narrow conception of corporate opportunity i. Directors: Opportunities offered to the company, discovered through information provided by the company, in which the company has an interest or expectancy 1. Narrower definition of corporate opportunity b/c director may have another fulltime job 2. Need to keep people sitting on company boards, so recognize their split loyalty ii. Managers: Expansive Line of business test 1. Broader b/c corporate officer, who spends all his time w/ corporation and loyalty is greater c. ALI 5.12: Corp opportunities taken by SH. It would be interesting to look at how the Sinclair case would have been decided under this rule. The Court more likely would have reached the same decision under this test anyway since the subsidiary in Venezuela didnt seem to have further drilling opportunities available to it. 2. When May A Fiduciary Take a Corporate Opportunity? a. Some courts have held that a fiduciary can take an opportunity if the corporation is not in the financial position to do so. b. Most courts accept a boards good-faith decision not to pursue an opportunity as a complete defense to a suit challenging a fiduciarys acceptance of a corporate opportunity on her own account i. This defense is effective only if a court is persuaded that the decision to reject a valuable opportunity on financial grounds is the genuine business judgment of a disinterested decisions maker. c. DE Courts very often use the line of business/fairness test. i. Two Steps 1. Was it a corporate opportunity? 2. If so, was there some reason why the corporation couldnt take the opportunity such that it could go to the fiduciary? a. Corporation lacked financial ability to take advantage of it b. Corporations board decided not to accept the opportunity d. DGCL 122(17): authorizes waiver in the charter of the corporate opportunity constraints for officers, directors, and shareholders. Applies to waivers for specific business opportunities or specified classes or categories of business opportunities. i. Motivated by the growing culture of interlocking boards, in which entrepreneurs from closely related businesses would sit on each others boards.
Shareholder Lawsuits

d. Shareholder Lawsuits i. If a corporation gets injured, who should have the right to bring the suit? 1. normally the board decides whether to bring suit 2. but what if the defendant is an officer or director or controlling shareholder? a. Board may be conflicted, so we allow shareholders to bring suits in certain cases ii. US makes these suits easier and more attractive than almost any other jurisdiction

1. result is that plaintiff lawyers have gotten v wealthy & used $$ to lobby Congress to keep rules favorable to them iii. Distinguishing between Direct and Derivative Claims 1. Two types of suits a. Derivative suits - brought on behalf of corporation i. Most fiduciary duties cases (and virtually all self-dealing cases) are derivative suits. Theses claims essentially propose two wrongs: failure to bring suit of a corporate claim (usually because those in charge of the corporation caused the wrong); and the underlying claim. Any recovery goes to the CORP and not the individual SH. b. Direct suits - brought by shareholders on their own behalf i. either individually or in class action ii. if voting rights are impaired, dividend payments, securities violations (Van Gorkom was a class action because shareholders were injured directly because they were forced to sell their firm at too low a price). 1. Recovery in class actions goes to the shareholders. iii. Direct Actions do not suffer from many of the procedural hurdles of a derivative suit. 2. Distinction btw 2 types are blurry a. Tooley purports to clarify distinction, but some subsequent caselaw that has reblurred b. basic question is i. has the injury been suffered by the corporation? ii. will recovery go to the corporation? iii. if both are yes, then derivative c. problem is that most transactions involve both 3. Hypothetical on p365: Board issues 15 percent block of stock at 10 percent discount in return for voting it against insurgent candidates. That stock proved to be the margin of victory in defeating insurgents. What type of suit should a disgruntled public shareholder bring? a. derivative suit claim is corporation could have gotten more $$$ from the shares it sold to him b. direct claim is that shareholder's voting rights have been diluted by these shares; remedy for this would be disqualification of new stockholders votes, and change composition of board iv. Solving a Collective Action Problem: Attorney Fees and the Incentive to Sue 1. Up to the court to decide how much attorneys get 2. Usually btw 20-30% 3. always get paid in cases where plaintiffs prevail in litigation a. pay in 90% of settled cases 4. Computer Associates (1999) a. Article about large award of +$500 million b. Contingency fee arrangement usually 1/3, but lawyer here says he wont ask for that c. In 3 cases w/awards this large, fees were <10% of the award 5. Common fund a. when lawyer achieves financial recovery for many people, can take fee out of this fund b. but what if achievement/benefit is not financial? c. Fletcher v. AJ Industries (1968) p367 i. plaintiff's lawyer negotiates settlement that initially involves no monetary recovery but reduces bad director's influence over board ii. monetary claims are referred to future arbitration iii. Court holds monetary fees due to attorneys bc they achieved substantial benefit for corporation, even if not financial 1. shift from traditional common fund doctrine requiring pot of $$ in order to give attorney payment d. Problem with Fletcher doctrine is that we don't really know how to value the benefit, or even if it really is a benefit i. if costs saved by settling instead of going to trial are counted as benefits, doesn't this incentivize bringing frivolous suits?

v. Standing Requirements in a Derivative Suit 1. premised on the assumption that screening for qualified litigants increases the quality of shareholder litigation. (these are designed to keep attorneys from buying into actions; but dont have much bite today since plaintiffs attorneys can always FIND such shareholders.) FRCP 23.1, RMBCA 7.41; ALI 7.02 2. Must own shares throughout course of litigation a. Plaintiff who is cashed out in a merger no longer has standing 3. Must own shares at time of the wrong/injury (Contemporaneous Ownership) a. don't want people buying their way into lawsuits b. sense that if you held at time of injury, then you suffered a loss 4. Most Adequate Plaintiff Rule: The plaintiff must fairly and adequately represent the interests of the SHs. (no obvious conflicts of interest.) a. Eliminates the race to the courthouse b. The challenge is bringing institutional investors into the game. They dont want to be plaintiffs. 5. The complaint must specify what action the plaintiff has taken to obtain satisfaction from the companys board or state with particularity the plaintiffs reasons for not doing so. 6. potential suggested requirements a. owning 2% i. plaintiffs attys often keep a lot of people around who only have a few shares vi. Balancing the Rights of Boards to Manage the Corporation and Shareholders Rights to Obtain Judicial Review
Demand Refused/Excused Summary

1. Summary/Review of Dismissal of Lawsuit a.


Avoiding Demand Delaware Universal Non-Demand; subject to the Levine/Aronson Test with Rales exception BJR of the boards decision to dismiss the suit ALI Universal Demand; Must make demand unless irreparable injury (7.03) BJR of the boards decision to dismiss the suit 7.10(a)(1) RMBCA Universal Demand; Must make demand unless irreparable injury (7.42) Independent board burden on P to show bad faith or uninformed; Interested board burden on D to show good faith and informed decision 7.44(e) Burden on P to plead facts establishing self-interest at the time of the determination Same as above

Demand Refused For Duty of Care Violation

Demand Refused for Duty of Loyalty Violation

Cannot plead self-interest after the Speigel v. Buntrock presumption.

Demand Excused SLC later seeks dismissal

Zapata Test (Burden on D)

reasonable belief in fairness (fairness-lite) of the boards decision to dismiss the suit 7.10(a)(2) Same as above

b. 2. The Demand Requirement of Rule 23 a. shareholder plaintiffs are supposed to first bring a request to file a lawsuit to the board itself i. theory is that board is in control of management ii. but problem is that plaintiff is often asking board to sue its own members or related parties b. Two situations where suit can go forward w/o Board approval i. Board wrongful refusal 1. if board declines, court will decide whether that denial was wrongful 2. but very hard to convince a court that the refusal was wrongful 3. if shareholder goes to a board with a demand, essentially conceding the board's independence (Speigel v. Buntrock (Del. 1990) a. point possibly qualified by Scattered v. Chicago Stock Exchange (Del. 1997) ii. demand excused 1. shareholders start derivative lawsuit w/o demand 2. board intervenes to say should have brought demand 3. plaintiff can convince court that demand would have been futile c. When is demand excused? i. Aronson Demand Futility Test 1. demand futile if under particularized facts, reasonable doubt created that a. directors are disinterested and independent, AND b. the challenged transaction was otherwise the product of a valid exercise of business judgment ii. Levine v. Smith (Del. 1991) p376 1. Rule: demand futility test is disjunctive, proving either of the two elements is sufficient, but standard is very high to meet this 2. In 1984, GM buys Perot's company, and in doing so made Perot largest shareholder with 0.8% stock, and put him on board. Hopes that putting him on board would shake up the company 3. Board decides to buy out Perot's shares along w/an agreement to no longer speak publicly ill about management after he angers them all 4. Shareholders bring derivative action claiming breach of fiduciary duty 5. Chancery court rejects demand futility claim bc a. plaintiffs did not plead facts sufficient to create reasonable doubt of independence b. didn't rebut presumption of valid business judgment 6. Del. Sup. Ct agrees with outcome of Chancery Court 7. But Horsey applies a disjunctive test

a. you can show demand is futile by proving either a or b b. found no facts that independent directors were compromised c. facts don't show enough to rebut business judgment since directors not compromised d. application makes demand futility v difficult to prove, even though theoretically disjoining makes it easier for plaintiffs iii. Aronson/Levine Demand Futility Test: Plaintiff must 1. establish that the directors are interested or dominated -- and hence incapable of passing on a demand; OR 2. create a reasonable doubt with particularized facts that the challenged transaction is protected by the business judgment rule 3. (Much easier for the plaintiff with a disjunctive test rather than conjunctive) iv. Rales v. Blasband (Del. 1993) p381 1. Rule: When the board on whom demand must be made is not the same board that made the decision being challenged, only the first prong of the Aronson test applies a. Question then is whether the complaint creates a reasonable doubt that the board of directors could have properly exercised its independent and disinterested judgment in responding to a demand. 2. application of test in double derivative suit 3. shareholder Blasband owns stock in Easco w/controlling shareholders Rales bros. Bros did a $100 million offering of notes through Easco supposedly for investments, but invested quite a bit in junk bonds issued by Drexel when Drexel was foundering. Suit alleges the investment in this was a breach of Rales bros duty of loyalty to Easco and that it was done as a favor to CEO/director of Drexel. 4. Soon after deal but b4 suit, Rales bros merge Easco into a subsidiary of Danaher, which they also control a. so shareholder is now a shareholder in Danaher and no longer Easco. Rales bros sit on board of Danaher w/6 others, no officers 5. Procedural points: a. Case brought in federal district court, question certified to DE Sup Ct whether demand is excused/what demand futility test requires b. Technically Blasband doesn't meet req of being part of company that suffered injury, but can still be satisfied when shareholder holds stock in surviving company from merger i."double derivative" suit 6. Injury suffered: breach of fiduciary duty, junk bonds invested in took $14 million loss (20%) 7. Court says first prong of Aronson test is appropriate, but second is not a. Action that is being challenged here was not made by the same board as the one on whom you would have to make demand b. All the court should care about here is whether the board on whom the demand must be made is disinterested, regardless of what the earlier board did 8. Situations in which demand board will be different than acting board a. Where a majority of the directors making the original decision have been replaced, b. Where the subject of the derivative suit is not a business decision of the board, or c. Where the decision being challenged was made by the board of a different corporation 9. Applying the first prong, court finds current board is not independent, and so demand is excused a. (assuming Aronson test in disjunctive is fulfilled for subs board) b. 3/8 directors were on board of subsidiary whose action is being attacked

i.some reason to believe they would face liability, so they are interested c. these 3 control 2 other directors' employment as executive managers & large shareholders i. those 2 other directors are interested too 10. How does this compare to the independence analysis in Levine? a. here, question is whether ties w/other members of the board affect independence i. greater willingness on the part of the court to think of the underlying lawsuit as creating interestedness b. this test feels stricter on the directors than in Levine i.similar personal interests in Levine that were a basis of the lawsuit were not considered by the Court in making the decision in that case c. underlying factual difference may make court more likely to let case go forward here i. here, directors had indicated the $$ would be used for other purposes, then done something else ii.lying to shareholders, in a way that benefits the directors (self-dealing) d. note: that Aronson test must be satisfied for subsidiary board as well
Special Litigation Committees

3. Special Litigation Committees a. Boards on whom demand was (or would likely be) excused would create subcommittees who would hire outside lawyers and determine from the firm's point of view whether the litigation should continue i. 99% of the time, the committee would recommend dismissal to the court ii. this after plaintiffs and lawyers may have invested years in the case b. One line of cases said as long as committee was independent and in good faith, court would accept committee recommendation i. see Auerbach v. Bennett (NY 1979) c. Policy argument against giving them lots of deference i. unclear that the committee is really that removed from the board, and you've already found board should be excused 1. when the committee is other directors, can't count on them to make decisions that will be adverse to other directors on the board d. DE does not treat SLCs as deferentially e. Zapata v. Maldonado (Del. 1981) p389 i. plaintiff files derivative suit, demand excused. 4 years in company appoints 2 new independent directors who serve as an SLC, who then recommend that the court dismiss the suit. ii. Chancery Court rules that shareholders have an independent, individual right to continue a derivative suit for breaches of fiduciary duty, even if the corporation does not want to iii. Sup Ct holds that when companies bring SLC decision, court must make 2 step inquiry 1. review the procedures used for setting up & operating the SLC 2. court will use its own independent business judgment to decide whether the suit should continue a. even if first prong is fulfilled iv. corporation should have the burden of proving independence, good faith, and reasonable investigation v. Court holds this creates a policy balance between 1. corporations not trampling on right to bring action of shareholders, BUT 2. the corporation can rid itself of detrimental litigation vi. does find that under DGCL 141(c), a board is empowered to set up an SLC and act through it, so this committee is appropriate vii. There has been much criticism of having the Court apply its own business judgment

f. Analysis of Independence and Investigation of SLC i. In re Oracle Corp. Derivative Litigation (Del. Ch. 2003) p395 1. Rule: SLC independence is a highly individualized inquiry 2. Alleged insider trading lawsuit is brought against a number of people on the board. Two Stanford professors are put on the SLC and they have no financial ties with Oracle. But Oracle has made huge donations to Stanford and Ellison (accused director) is known around the community and at Stanford. Another member of the board has also made personal donations to Stanford and is an alumnus. SLC produces +1000 page report recommending dismissal of lawsuit. 3. Judge says that anyone that would accuse Ellison of insider trading would be a social outcast. 4. Holding: SLC has not proved its independence due to the web of influence among different people in the case. 5. Rationale: Remember that the SLC bears the burden of proving its independence. The law cannot simplify human motivations just based on pure economics. People are attached to social institutions. The SLC has not proven its independence b/c of the substantial ties among the SLC, the defendants, and Stanford. Even if its possible that these ties are not affecting the SLC, the SLC has not proven that. This does not mean that the court is questioning the subjective good faith of the committee members. ii. What does it mean for the court to exercise its own Business Judgment? 1. We have 2 cases to consider: Zapata and Joy. 2. Possible alternative to Zapata: more rigorous effort to ensure independence of directors on SLC a. See Michigan Laws 450.1107, 495 (p406) 3. Zapata: Public Policy and Deterrence. a. Zapatas factors for the court to consider: how compelling the corporate interest in dismissal is when faced with a non-frivolous lawsuit; and when appropriate, the court should give special consideration to matters of law and public policy in addition to corporations best interests. b. By policy the court might mean deterrence. We arent sure what it really means. 4. Joy v. North (2d Cir. 1982) p403: Cost/Benefit Analysis of Lawsuit for Company a. Facts: In a diversity case, the court predicted that Connecticut would adopt the Zapata approach to derivative suits and, exercising its business judgment, rejected a SLCs motion to dismiss. b. Holding: Where the court determines that the likely recoverable damages (discounted by the probability of a finding of liability) are less than the costs to the corp. in continuing the action, it should dismiss the case. (direct costs imposed on corp. by litigation > potential benefits) c. Reasoning: The opinion discusses why its not ridiculous to allow a Court to be making these kinds of judgments at this stage. The burden here is on the moving party (SLC) to show that the action is more likely than not to be against the interests of the corp. The function of the courts review is to determine the balance of probabilities as to likely future benefit to the corp. NOT to render a decision on the merits, fashion the appropriate legal principles or resolve issues of credibility. The courts function is not unlike a lawyers determining what a case is worth for purposes of settlement. Theres some discussion of which costs may be taken into account. d. This decision basically asks the court to do what a loyal board would do. e. It makes the second step of the Zapata test (court applying own BJ) MANDATORY rather than permissive. f. Finds that only direct costs should be included, not indirect

i. What elements might be left out of the picture by this analysis? Certain costs (reputation of corp.), certain benefits (deterrence value of litigation aggregate), insurance issue (pay ex ante probability of costs) g. Potential argument against this approach: Joy only looks at ex post benefits (recovery, corp. change) and costs (litigation costs), whereas Prof. K argues that we should look at ex ante benefits (deterrence) and costs (D&O insurance) as well his argument is we should make payment of attorneys fees contingent on credible showing that the settlement had plausible deterrent value, or that it resulted in a net gain to the corp. not funded by the D&O insurers. vii. Settlement and Indemnification 1. Settlement by Class Representative a. Shareholders formally invited to participate in considering merits of settlement terms, but few do, occasionally institutional shareholders may object 2. Settlement by Special Committee of Independent Directors a. Carlton Investments v. TLC Beatrice Holdings (Del. Ch. 1997) p409 i. Rule: if settlement negotiated by an SLC is w/in a reasonable range, it will likely be upheld ii. Reginald Lewis does a leveraged buyout (LBO) of Beatrice Foods with the help of some banks. Lewis ends up w/45% of Beatrice & banks get 20%. Beatrice pays Lewis $19.5 million in compensation payment just before he dies. One of the big bank shareholders brings derivative suit alleging self-dealing and waste. iii. The company appoints an SLC, which eventually negotiates a settlement for Lewis' estate to pay Beatrice $14.9 million plus interest in installment payments over seven years. Plaintiff objects to settlement and brings suit in DE Chancery Court 1. this type of action odd for SLC, note the guy is dead so its less complicated interest relationships iv. Allen upholds the settlement as reasonable, but notes he is uncomfortable applying the second prong of Zapata (court business judgment) 3. When Are Derivates Suits in Shareholders Interest? a. Payouts in these cases usually through D&O Insurance i. But shareholders lose $$ through litigation, since beyond premium costs, must pay lawyers and insurance administrative costs 1. lots of leakage in the system ii. But w/o the system, will have more self-dealing 1. question is whether deterrence effect of plaintiff's lawyers is worth the cost of the system 2. no one really knows, but most people think current system is better than no system at all IV. EXTRAORDINARY GOVERNANCE
Transactions in Control

a. Transactions in Control i. Why is having control desirable? 1. private benefits a. capture salary, perks, prestige b. satisfaction of control, running the company as you see fit 2. public benefits a. you think you have a strategy for making the business run better ii. Two ways to get control 1. Buying a controlling block from a previous controller a. legal question: when you pay a premium to the current controller for the shares, does the seller have to share the premium w/the minority shareholders? 2. Making a tender offer

iii. Sale of Control Blocks: The Sellers Duties (Rights seller of controlling shareholder owes to minority shareholders) 1. Note that this is not a common transaction, as its rare for large corporations to have a controlling shareholder 2. The Regulation of Control Premia a. The Market Rule: the common law rule, universal in US is that the controlling shareholder is entitled to sell control to anyone (except looters) and receive a control premium without any obligation to minority shareholders. i. The sale of control is a market transaction that creates rights and duties between the parties, and not with minority shareholders absent looting, conversion of a corporate opportunity, fraud or bad faith. (Zetlin v. Hanson Holding Inc.) ii. Want to facilitate control transactions based on presumption that they increase the efficient use of assets b. Exceptions to the Market Rule i. Corporate Opportunity/Asset (Perlman) ii. Corporate action required (Digex) iii. Sale of Office iv. Screening for Looters c. Zetlin v. Hanson Holdings, Inc. (NY 1979) p416 i. unless there is looting by the buyer, conversion of a corporate opportunity by the seller, fraud or other acts of bad faith, buyer and seller are free to transact at a premium price ii. note that control block can be less than 50% of shares iii. Plaintiffs had argued minority shareholders should have an equal opportunity to participate in receiving the premium by selling shares on same terms as controller d. Exception 1: (Corporate opportunity/asset) Perlman v. Feldmann (2d Cir. 1955) p417 i. during Korean War, shortage of steel and a price freeze (more demand than supply). Feldmann is director/CEO/controller of Newport Steel. Sells stake to a buyer of steel for $20/share when stock is trading at $12/share. Feldmann resigns w/his director to let Wilport take over the board. ii. Shareholders bring suit alleging Feldmann sold a corporate opportunity (control over steel supply) for personal gain, which the company could have used for its advantage, in violation of his fiduciary duty iii. Trial court finds that $20/share is a reasonable value for a controlling block and rules for Feldmann iv. Holding: In circumstances like this, when sale of shares results in loss of corporate asset and previous controller gets a profit, he is accountable to the company for the profit v. Finds triple violation of his fiduciary duty, remedy is sharing the premium w/the minority shareholders individually e. Exception 2: In re Digex, Inc. v. Shareholders Litigation (Del. Ch. 2000) p428 i. Rule: In cases where the corporation must act to facilitate a transaction, it should do so only when it is beneficial to the corporation and all of its shareholders. Arguably, the corporations independent directors have a duty to bargain with the controller to extract part of the control premium for minority shareholders. (McMullin v. Beran) ii. drew a sharp distinction between the controlling shareholders right to exercise her voting power for her private benefit, and her management duty to exercise corporate power for the benefit of all shareholders. iii. owned by Intermedia (52% stock, 94% voting power, board control) IM seeks to sell Digex stake; Digex board appoints a Special Committee of independent directors to review potential transactions. Worldcom originally interested, but later decides to acquire IM instead of Digex iv. Bc worldcom would be an interested stockholder of digex after acquiring Intermedia, Worldcom sought a waiver of DGCL Sec. 203

1. Digex board grants the waiver, Chancery Court rules that IM's use of power over the company to force this through might violate burden to show fairness. should have tried to extract something for minority shareholders 3. Note on efficiencies of sale of control a. hypothetical inefficient sale of control i. 90 shares total, 45 trade in the market, 45 held by the controller. Old controller is asked to sell to a new controller ii. Category: Old Controller/Looter 1. Total firm value: 1000/900 2. Private benefit: 100/500 3. Net firm value: 900/400 4. Minority share price: 10/4.44 iii. Old Controller values the stake at $450 (share value) + $100 (private benefit) = $550 ($12.22/share) 1. Looter values it at $700 (500 pb + 200 sv) ($15.56/share) 2. under market rule, looter will reach a deal with old controller to buy a. sale at a price btw 12.22 & 15.56 iv. from a social point of view, bad thing bc total firm value has gone down $100 w/same inputs v. if equal opportunity rule applied, and $12.22/share had to be paid for 90 shares = $1100 1. payment would be more than total value and transaction would not happen b. hypothetical efficient sale of control i. 90 shares total, 45 trade in the market, 45 held by the controller. Old controller is asked to sell to a new controller ii. Category: Looter/Efficient buyer 1. Total firm value: 900/1350 2. Private benefit: 500/100 3. Net firm value: 400/1250 4. Minority share price: 10/13.89 iii. Looter values stake at 15.56/share, $700 total (see above) 1. efficient buyer values it at $725 (625 sp + pv) 2. under equal opportunity, efficient buyer can offer up to 15/share (1350/90) a. deal will not go through 3. under market rule, efficient buyer can offer up to $725 ($16/share, 725/45 = 16.11) a. deal will go through iv. Sale of Corporate Office (Exception 3 to Market Rule) 1. can't sell corporate office to effect transaction 2. The 10% Block and Ratification rules: Case law generally distinguishes between sales of control and sales of office on the basis of: a. The % of shares sold (in neighborhood of 10%, court may find sale of control is really sale of office) AND i. if you are selling more than a 10% block of stock, you can transfer corporate offices b. Whether the other shareholders ratify new the officers (& other indicia its not a bad deal for shareholders) i. Why the difference between bigger % of bloc and smaller % of bloc? 1. If you are a looter what do you really want? a. You want as small a stake as possible so that when the stock price goes down you dont want to lose too much on that end while looting. b. The efficient buyer wants a large stake because they are adding value to the company and want to benefit from that. 3. Carter v. Muscat p428 a. sale of 9.7% block of managements stock w/agreement to step down for new directors b. held to be ok

4. Brecher v. Gregg p429 a. sells 4% block coupled w/agreement to step down, causing board to select buyer as replacement b. held to be illegal 5. Differences: Carter/Brecher a. Carter v. Muscat Brecher v. Gregg
Size of Control Block Premium Received by Seller Fate of Newcomer(s) Holding 9.7% 4%

slightly above market (AKS p.428) Directors re-elected by shareholders Upheld

35%

CEO fired by board Disgorgement of control premium

v. Exception 4 - selling to a looter can make you liable 1. Harris v. Carter (Del. 1990) p429 a. Carter owns 52% Atlas, sells stake to Mascolo and Carter directors resign from board. Mascolo & friends completely loot Atlas, increasing ownership to 78% and divert a lot of value to private benefits. Mascolo disappears (judgment proof), so minority shareholders bring suit against Carter directors b. Holding: majority shareholder's obligation is that if there are red flags suggesting dishonesty, they need to investigate c. says that here, indication is that there could be red flags so need to investigate further d. this duty is based in tort law, not corporate law
Tender Offers

vi. Tender Offers: The Buyers Duties 1. In 1960s, this area was unregulated a. frequent "Saturday Night Specials," rapid fire offers with short time horizons i. seen as coercive bc people don't know who the acquirers are or what they plan on doing, so fears that if they didn't tender, companies could be looted or become illiquid ii. Irrational for an individual not to tender, but rational for the collective not to tender 2. 1968 Williams Act with 4 elements a. 13d Early Warning System i. requires disclosure whenever anyone acquires more than 5% of the stock ii. Detailed discussion: 1. Basic rule 13d-1(a) a. Investor must file a 13D report w/in 10 days of acquiring 5%+ beneficial ownership b. Partial exemptions for Qualified Institutional Investors and passive investors 2. Updating requirement 13d-2 a. must amend 13D promptly on material change (~+/-1%) 3. Key definitions a. a "group" acting together to buy, vote, or sell stock (13d-5b1) counts as a single actor for these requirements b. beneficial owners means power to vote or dispose of stock 13d-3(a) 4. Groups often don't want to disclose bc stock price will likely go up a. suspect he's seeking to control, so premium will go up b. usually try to buy in small amounts so as not to push up stock price

b. 14(d)(1) General Disclosure i. requires tender offeror to disclose identity and future plans, including any subsequent going-private transactions c. 14(e) Anti-Fraud Provision i. prohibits any fraudulent, deceptive, or manipulative practices in connection with a tender offer. d. 14(d)4-7 Terms of the Offer i. governs substantive things like duration and equal treatment ii. Detailed discussion: 1. 14e-1 Tender offers must be open for 20 business days a. allows other companies to come in and bid b. auction atmosphere increasing target premiums c. if original company wants to discourage others from jumping in, will start at a higher price d. problem with auctions is that it may cause some efficient transactions to not go through bc of the transaction costs & tender offers i.less $$$ in aggregate bc fewer transactions, loss of disciplinary tool for managers ii.Response is that it makes individual tenders more efficient, and doesn't have much impact on the number of takeovers e. note though that benefit for acquiror of auction is even if you lose, raise of share price means you can make a lot of $$$ from the sale of it later 2. 14d-10 Tender offers must be made to all holders; all purchases must be made at the best price 3. 14d-7 Shareholders who tender can withdraw while tender offer is open 4. 14e-5 Bidder cannot buy "outside" tender offer e. Terms benefit targets, making it more costly for an acquiror to get control 3. What counts as a tender offer a. "Market/street sweeps" where companies go through a broker and buy big chunks of stock in a short time i. SEC thinks these should be counted, and have convinced some courts b. SEC developed Wellman 8 factor test i. Wellman v. Dickinson 1. company made simultaneous phone calls to 30 institutional & 9 large individual investors and told they had 1 hour to decide whether to sell their stock for a large premium. Had been told to expect an important call about the shares, but no other details. 2. NY lawyers had tried to set this up as a non-tender offer, but it was murky. they thought if they limited number to whom solicited, that would be ok. 3. Court found this is a tender offer anyway despite being made to a limited number of parties bc it satisfied enough of the other factors ii. 8 factors 1. active and widespread solicitation 2. made for a substantial percentage of the issuer's stock 3. premium over the prevailing market price 4. terms are firm rather than negotiable 5. whether the offer is contingent on the tender of a fixed minimum number of shares 6. whether the offer is open only for a limited period of time 7. whether the offerees are subject to pressure to sell 8. whether public announcements precede or accompany a rapid accumulation iii. no firm test of how many need to be fulfilled to count as a tender offer, but the more there are the more likely it is c. Brascan v. Edper Equities Ltd. (SDNY 1979) p435

i. Holding: share purchase not a tender offer when only one of 8 factors is satisfied ii. Edper owns 5% of Brascan (Canadian co.) and is turned down when it proposes friendly acquisition. Edper engages broker Connacher to buy shares; Connacher contacts 30-50 institutional investors and 10-15 individual investors and buys 10%, mostly from those people, on April 30th. Canadian authorities then ask intentions, he says no plans to buy more stock at that time. w/o further announcement, Edper buys another 14% the next day in the same fashion iii. No: Most of Williams Act doesn't apply bc Brascan is a Canadian company iv. Suit brought under 14e, which to apply requires it to be a tender offer v. Board asks for divestment of shares as a remedy 1. Edper would probably take control and fire them, so they want him gone vi. Judge questions whether 8 factor test should be applied/is controlling, but applies it anyway 1. only factor met is large percentage of stock 2. two factors slightly met a. premium & contingent on a certain number of shares d. How do we reconcile Wellman & Brascan? i. amount of pressure put on investors 1. short time frame 2. no room to negotiate on price ii. possibly the judge in Wellman thought fairness to shareholders required something, used tools at hand to achieve it
Fundamental Transactions: Mergers and Acquisitions

b. Fundamental Transactions: Mergers and Acquisitions i. Justifications for Requiring Shareholder Approval of Fundamental Transactions 1. too big & too important to be left to boards alone a. but then why don't "bet the company" decisions in the normal course of business require shareholder vote? 2. Don't require managerial expertise a. dissolution, M&A look more like investment decisions than management decisions 3. Pose special agency problems a. most of these transactions terminate rltnshp btw shareholders & incumbent managers ii. Motives for Acquisitions 1. Efficiency motive a. economies of scale i. manufacturing physical assets b. economies of scope i. extending good management talent to a broader base c. vertical integration d. replacing bad management e. diversification 2. Redistributive motives a. shifting value from govt (NOL's/tax) b. creditors (LBO's) c. consumers (monopoly pricing) 3. Bad motives a. hubris, overestimation of synergies, empire building iii. Ways to get Control 1. Buying stock in a company a. controlling shareholder gets indirect access to assets of target 2. Purchase assets and bring into your corporation 3. Merger or consolidation

a. Either one surviving corporation, or new corporation created 4. Compulsory share exchange (non Delaware) iv. Overview of Transactional Form
Statutory mergers

1. Statutory mergers DGCL 251 (& 253?) a. Steps i. Acquiror & Target boards negotiate the merger ii. Proxy materials are distributed to the shareholders as needed iii. T shareholders always vote ( 251(c)); A shareholders vote if A stock outstanding increases by >20% ( 251(f)) 1. A also votes if charter is modified or security of As surviving shareholders will be exchanged or modified iv. If a majority of shares outstanding approves, T assets merge into A, T shareholders get back A stock (or other consideration). Certificate of merger filed w/sec. of state v. Dissenting shareholders who had a right to vote get appraisal rights 1. value reviewed by courts b. DGCL 253: Mergers of a 90% owned subsidiary do not require a vote by the other 10% shareholders. i. The board of the subsidiary doesnt have a say. ii. But you cant amend the articles of incorporation. (would put you back in 251 otherwise) iii. Protection of the 10%, is appraisal rights in order to get a fair price.

c. A d.
Asset acquisition

2. Asset acquisition DGCL 271 a. Why to structure this way i. A isn't subject to liabilities of T 1. with some exceptions: tort "successor liability" and environmental cleanups ii. to avoid a vote of A shareholders 1. but under stock exchange rules, if company issues +20% shares, these require a vote iii. get out of appraisal rights iv. tax advantage 1. details of this won't be on the exam 2. won't have to pay as much on sale of assets 3. although seller has to recognize gain on buying of assets, but if they have tax losses, not a big deal v. BUT higher transaction costs b. Steps i. Boards of the two firms -- A and T -- negotiate the deal. ii. Only Ts shareholders get voting and appraisal rights (because only T is being bought).

c.

iii. Transaction costs are generally higher because title to the actual physical assets of the target must be transferred to the acquirer. iv. After transfer, selling corporation usually liquidates the consideration received (e.g., cash) to its stockholders.

d. e. To what extent do you have to give a target company's shareholder the right to vote, i.e. when does what is happening become an asset acquistion? i. DGCL 271 target voters must approve when sale of substantially all the assets ii. Katz v. Bregman (Del. Ch. 1981) p453 1. Facts: As part of broader divestment strategy, Plant Industries decides to sell its Canadian operations (Plant National), which constitutes 51% of its assets, 45% of its revenues, and 52% of its operating income. Idea is to take proceeds to shift to another line of business. 2. Holding: A sale satisfies the 'substantially all' test when it sells more than half its assets, including changing its type of business drastically iii. Thorpe v. CERBCO (Del. 1996) p456 1. sale of 68% of assets 2. when trying to figure out if something is substantially all, look not just at the %, but at qualitative effects a. is it out of the ordinary course, and does it "substantially affect[] the existence and purpose of the corporation" iv. Hollinger v. Hollinger Intl. (Del. Ch. 2004) p456 1. substantially all means almost everything 2. 56-57% not enough to meet when it holds other viable businesses
Compulsory Share Exchange

3. Compulsory Share Exchange (RMBCA 11.03, NOT in DGCL) a. target company becomes wholly owned subsidiary of the acquiror b. advantages over mergers i. tax treatment of a tender offer

c.

d. Two-Step Merger: allows firms in Delaware to perform basically the same result as the compulsory share exchange. i. Transaction One: A tender offer for most or all of the shares at an agreed upon price. ii. Second Transaction: A merger between the target and a subsidiary of the acquirer. This removes minority shareholders often at the same price as the tender offer. 1. Sometimes the second step may be in cash rather than stock of the parent. 2. The target corp ends up as a wholly owned subsidiary of the purchasing corp. The target corp though remains as a shell, its statute continues to exit, etc. iii. Benefits of this form: Unlike a merger, youre safe from the targets liability since its maintained as a separate corp. Youve also preserved the identity of the target corporation and goodwill (things like reputation, etc. will continue to live on). Its easier to spin the target off later if the acquirer wishes to sell. e.
Triangular Mergers

4. Triangular Mergers a. Done by the acquirer in order to avoid risk of gaining all of the imperfect liabilities of the target company b.

c. Steps i. A forms a wholly owned subsidiary (B) ii. A gives B merger consideration in return for all of Bs stock iii. B & T then merge, with T shares cancelled after distribution of consideration iv. This leaves A owning all of B/T, which owns Ts assets & liabilities v. This structure gives A a liability shield d. Forward triangular merger: when B is the surviving corporation e. Reverse Triangular merger: when T is the surviving corporation (but still owned by A) f. When using the reverse triangular merger then, there is no requirement for a SH vote b/c the issuance of new shares and the whole operation can go through without any sort of vote from the SH. This is an anomaly in the DE law that is just there. The board can put as many shares into the acquisition vehicle used (the subsidiary) but it wont require a vote. i. There may be an exchange commission requirement at about the 18% threshold, but the funny thing is that there is NO state law that requires a SH vote under this structure. v. Structuring the M&A Transaction 1. Timberjack merger example p466 a. Article 1: Tender offer i. Rauma Acquisition Corp (Purchaser/Subsidiary) will make 25/share offer in cash for all shares (1.01) ii. under Williams Act iii. Purchaser has option to extend offer if they get btw 50-90% of shares

1. DGCL 253 says if controlling shareholder gets +90%, it can merge w/o shareholder vote iv. Purchaser can extend w/permission of target, raise the price, lower the minimum required 1. obligated if plus 70%, but may be ok w/buying if it's above 50%, depending b. Article 2: The merger i. Purchaser merges into Timberjack (reverse triangular merger) ii. TJ shareholders who tendered get cash for their shares iii. Rauma-Repola Oy (Parent) gets control of TJ shares in the end c. Why use the tender offer? i. possibly short form possibility ii. if you get +50% shares, then you know what the outcome of the shareholder vote will be iii. prevents someone else from coming along and making a more attractive offer d. Post merger directors are purchaser, most merger officers are from Timberjack vi. Appraisal Rights 1. Shareholder right to be paid in cash when you dissent from certain transactions 2. complicated rules that don't make a lot of sense a. some people use this, but its not generally considered very attractive
Summary of Voting & Appraisal Rights

3. Summary of Voting & Appraisal Rights


T Voting Rights Statutory Merger (DGCL 251, RMBCA 11.02) Yes need majority of shares outstanding (DGCL 251(c) or majority of shares voted (RMBCA 11.04(e)) No unless > 20% shares being issued (DGCL 251(f) RMBCA 11.04(g) Yes if T shareholders vote, unless stock market exception. Only available to dissenting. (DGCL 262, RMBCA 13.02) Asset Acquisition (DGCL 271, RMBCA 12.01-.02) Yes if all or substantially all assets are being sold (DGCL 271(a)); or no significant continuing business activity (RMBCA 12.02(a)) No though stock exchange rules might require vote to issue new shares Yes under RMBCA if T shareholders vote, unless stock market exception. Only available to dissenting. (RMBCA 13.02(a)(3)); No in DE, unless provided in charter DGCL 262 Share Exchange (RMBCA 11.03) Yes need majority of shares voted (RMBCA 11.04(e)

A Voting Rights

Appraisal Rights

No unless > 20% shares being issued (RMBCA 11.04(g) Yes, unless stock market exception. Only available to dissenting. (RMBCA 13.02(a)

4. mechanics given in DGCL 262 a. notice at least 20 days b4 shareholder mtg 262d1 b. submit written demand for appraisal b4 vote, and then vote against/refrain from voting 262d1 c. if merger approved, petition filed in Chancery Court w/in 120 days of effective merger 262e d. court holds valuation proceeding to determine fair value of shares w/o merger benefit 262h e. no class action device available, but Court can apportion fees among plaintiffs as equity may require 262j 5. In re Transkaryotic Therapies (Del. Ch. 2007) a. Slim majority of Transkaryotic (TKT) shareholders approve the sale of their company to Shire Pharmaceuticals for $37 per share cash. On the record date (June 10, 2005), Cede & Co. was holder of record for 29.7 million shares, and voted 12.9 million in favor of the merger and voted against or abstained with 16.8 million shares. Hedge funds and arbitrageurs owned 2.9 million shares through Cede and voted against the merger; then bought 8.1 million shares through Cede before the close of the deal and sought appraisal for all 11.0 million shares. b. TKT sought summary judgment on the grounds that the hedge funds must prove that each share that they seek appraisal for was voted against the merger. c. Chancellor Chandler denies summary judgment and allows the shareholders to seek appraisal on all 11.0 million shares.

d. M&A Deal Commentary (May 2007): A likely effect of this decision will be to encourage aggressive investors (for example, hedge funds and arbitragers) to examine every cash merger in Delaware for suitability for appraisal claims with the goal of either negotiating a settlement of the claims after the merger or convincing an appraisal court that the value of the shares was higher than the merger price. 6. When you get Appraisal Rights: Market Out Rule DGCL 262(b)(1) a. No appraisal rights in an asset acquisition, unless provided for by charter 262(c) b. Get appraisal in a statutory merger, if theres a shareholders vote 262(b) c. But you don't get rights if your shares are market-traded, or company has 2000+ shareholders, or shareholders not required to vote on merger 262(b)(1) i. thought seems to be that if you can sell it on public market, don't need appraisal rights ii. doesn't have to be stock of the acquirer. if they want to give cash but not trigger appraisal rights, they can purchase a basket of market traded stocks and distribute those d. BUT theres exception to this rule 262(b)(2) i. do get appraisal rights if your merger consideration is anything other than shares in surviving corporation or shares in third company that is exchange-traded or has 2,000 shareholders (with de minimis exception for cash in lieu of fractional shares)
Appraisal Decision Tree

e. Decision tree:

f. 7. what is to be valued in the appraisal process? a. 3 approaches i. value of minority shares 1. ie apply a minority discount (bc youre not controlling) ii. value as pro rata claim on going concern value 1. ie no minority discount but no claim on benefits of the deal 2. intended goal under Del. case law (Glassman v. Unocal) 3. uses Disounted Cash Flow methodology (Weinberger) iii. value as pro rata claim on going concern value, including deal benefits 1. most desirable for dissenting shareholders 2. rejected by Del code 8. how do you value what you get as a remedy? a. Market value of shares i. share price, if shares are traded b. Earnings Value i. last 3 years of earnings, capitalized using a price-to-earnings ratio c. Asset Value i. net assets, valued @ liquidation value vii. De facto mergers: Hariton v. Arco Electronics (Del. 1963) p481 1. Loral buys Arco in arms-length asset acquisition after negotiation following formal asset procedures. Arco shareholder brings suit claiming right to appraisal bc de facto merger

2. Holding: even if economic effect is the same as a merger, if formal procedures for another type were followed, appraisal rights won't be extended a. claims to defer to legislature b. when holder bought stock, knew this was a possibility
Duty of Loyalty in Controlled Mergers

viii. Duty of Loyalty in Controlled Mergers 1. Creates bad incentives for normal business if you make it easier to squeeze out minority shareholders a. harder to raise capital if minority shareholders know this could happen to them b. incentive to do freeze outs even if it doesn't generate value i. as long as transaction costs are less than the value controller can divert from minorities 2. Freeze Out Merger controlled under DGCL 251 a. 50% controller of ABC arranges a merger btw ABC corp. and dummy corp. (wholly owned by controller) in which ABC minority shareholders receive cash for shares b. v common in the 1970s when stock prices were crashing and controllers thought they could capture value i. courts had said appraisal was exclusive remedy, but difficult so many didn't use ii. courts don't like this 3. started tightening up, Singer v. Magnavox, 1977 a. permitted shareholders to bring class actions in addition to appraisal, on grounds that shareholder breached entire fairness to minority shareholders b. established per se rule: a freezeout w/o a colorable business purpose breaches entire fairness i. getting rid of minority shareholders doesn't count as a business purpose... c. established that minority shareholders' remedy was so called "rescissory damages" aka monetary equivalent of rescission i. ie if worth 10 @ time of merger, cashed out for 8, 2 years later its at 14 ii. recovery is now @ 6/share, instead of 2/share 4. Weinberger v. UOP, Inc. (Del. 1983) p486 a. Signal owns 50.5% of UOP and holds 6/13 UOP board seats. Signal decides to buy the remainder of UOP. A&C (directors of both) write report that up to $24 share would be a good investment for Signal, study not shared w/UOP. Signal board offers $21/share (55% premium over market), conditioned on approval by a majority of the minority shareholders. UOP CEO says seems generous, but doesn't attempt to negotiate, UOP board approves w/hastily drafted fairness opinion. 52% of total outstanding minority shares approve the merger. Plaintiff UOP shareholders bring a class action challenging the transaction as a breach of the UOP board's fiduciary duty b. standard of review is entire fairness (fair process & fair price) w/burden on the interested party i. represents shift from business purpose of Singer c. process concerns: i. using info they gained from being director of target to help controller w/o disclosing to target ii. fairness letter written hastily, but told target that it was carefully considered iii. motivated by Signal's desire to purchase & pushed through v quickly d. Say in footnote that they should have used an independent committee i. can't expect perfection, but must make all possible steps to try 5. Typical structure of parent-subsidiary freeze-out transaction a. Parent notifies target of going private or minority squeeze out proposal i. press release announcing proposal ii. subject to special committee approval b. Target sets up Special committee of independent directors

i. hire ibankers and lawyers c. Parent negotiates w/Special Committee and hopefully eventually agree on a price d. Judicial scrutiny of this structure: i. entire fairness standard ii. directors have burden of proof iii. BUT burden can be shifted to plaintiffs when: 1. properly functioning special committee (only independent directors & real negotiating power) 2. and approval of transaction by majority of minority shareholders (i.e. closing conditioned on their approval) 6. Rabkin v. Philip A. Hunt Chem Co. (Del. 1985) p494 a. Olin buys control block in Hung, and contracts that if it cashes out the minority w/in 12 mo. it would pay minority shareholders the same it paid for control block. waits just over 12 months then cashes out at lower price. minority bring suit claiming breach bc Olin deliberately waited in order to avoid paying b. Chancery says absent deception, Weinberger says appraisal is full remedy c. Sup Ct reverses, saying appraisal is not necessarily sole remedy, it "may not be adequate in certain cases, particularly where fraud, misrepresentation, self-dealing, deliberate waste of corporate assets, or gross and palpable overreachign are involved" d. note for us: is there really wrongdoing here? 7. What Constitutes Exercise of Control: Kahn v. Lynch (Del. 1994) p497 a. Rule: the mere existence of a special committee doesnt shift the entire fairness burden, it must be shown that the committee had real bargaining power b. Alcatel owns 43% of Lynch. Lynch wants to buy Telco but supermajority provision gives Alcatel veto power. Alcatel says acquire our subsidiary Celwave instead. Lynch board appoints a committee of independent directors to negotiate w/Celwave. Independent Committee unanimously opposes combination. Alcatel withdraws Celwave, but offer to acquire the remaining 56.7% of Lynch @ $14. IC reconstituted to negotiate w/Alcatel, rejects first bid prices. But after Alcatel threatens a hostile bid if they don't take $15.50/share, IC recommends it. Minority shareholders bring suit against alcatel directors alleging breach of fiduciary duty c. Chancery Court rules for Alcatel bc IC made it a sufficiently arms-length agreement d. Holding: SCs negotiating ability was compromised by Alcatels influence over the company 8. Controlling Shareholder Fiduciary Duty on the First Step of a Two-Step Tender Offer a. In re Siliconix Shareholder Litigation (Del. Ch. 2001) p504 i. Rule: when controlling shareholder tries to acquire through tender offer, as long as it is not coercive, there is no duty to pay a fair price ii. Facts: Vishay owns an 80.4% stake in Siliconix; wants to acquire the remaining 19.6%. In February 2001, Vishay announces a tender offer at $28.82 cash (a 10% premium) for the remaining Siliconix stock, and requests the opportunity to discuss its tender offer with a special committee of independent, non-management Siliconix directors who are unaffiliated with Vishay. Siliconix sets up a Special Committee consisting of two directors and negotiations begin.In May 2001, Vishay launches an exchange offer of 1.5 shares of Vishay for each Siliconix share. Minority shareholder challenges the offer as an inadequate and unfair price. iii. Chancery Court refuses to apply entire fairness scrutiny: Vishay was under no duty to offer any particular price, or a fair price, to the minority shareholders of Siliconix unless actual coercion or disclosure violations are shown. . . . In short, as long as the tender offer is pursued properly, the free choice of the minority shareholders to reject the tender offer provides sufficient protection. b. In re Pure Resources, Inc. Shareholders Litigation (Del. 2002) p504 i. Unocal Corp. holds 65% of Pure Resources, Pure CEO Hightower holds 6%, and Pure managers hold another 11%. Pure board has eight members: 5 Unocal designees, 2

Hightower designees, and 1 joint designee. Unocal makes a surprise exchange offer at a 27% premium to market price, contingent on getting to 90% ownership of Pure. Pure forms a Special Committee, consisting of two Pure directors who are plausibly independent of Unocal. ii. Special Committee negotiates with Unocal, fails to adopt a poison pill (that would give it veto power), and finally recommends against the exchange offer to Pures minority shareholders. Unocal nevertheless goes ahead, and Pure minority shareholders bring suit seeking an injunction to block the offer. iii. Holding: injunction will be issued because the process was coercive as applied 1. Bankers didnt present substantive evidence underlying their conclusions 2. Target managers & directors w/stock were inappropriately included in necessary approving majority of the minority iv. The majority stockholder owes a duty to permit independent directors on the target board adequate time to react to the tender offer, by at least hiring their own advisors, providing the minority with a recommendation, and disclosing adequate information for the minority to make an informed judgment. v. There is no duty that requires the controlling shareholder to allow the Special Committee to have the use of a poison pill if he can block its adoption or redemption through his directors. vi. Stockholders are entitled to a fair summary of the substantive work performed by the investment bankers upon whose advice the recommendation of their board as to how to vote on a merger or tender rely. vii. follows the Siliconix (Solomon) line moreso than the Lynch line 1. kind of between the two, but see more as tightening the Siliconix standard than loosening Lynch 9. Tender Offer Roadmap a. Acquisition offer is only non-coercive when: (In re Pure) i. It is subject to non-waivable majority of the minority tender condition; ii. The controlling stockholder promises to consummate a prompt 253 merger at the same price if it obtains more than 90%; and iii. The controlling shareholder has made no retributive threats. (i.e. to stop paying dividend) b. Target board independent directors must have a role i. free rein & adequate time to react ii. hiring own advisors iii. providing minority w/a recommendation iv. disclosing adequate info for minority to make informed judgment c. Details of fairness opinion must be disclosed i. summary of substantive work
Public Contests for Corporate Control

c. Public Contests for Corporate Control i. Defending Against Hostile Tender Offers 1. Defensive Tactics and how They're Regulated by the Courts 2. Hostile transactions are <5% of deals a. but still important bc legal rules may play a role in suppressing these b. friendly deals done in the shadow of this as a possibility c. discipline management to keep shareholders happy
Unocal

3. Unocal v. Mesa (Del. 1985) p515 a. U stock trading @ $33, M quietly buys 13% then makes tender offer for 37% @ 54/share. M discloses plan to freeze out remaining 50% for junk bonds worth ~$45/share, if successful in

first stage. U board meets to review, Goldman reports minimum cash value in liquidation is $60/sh b. Board decides on a "defensive recapitalization" i. self-tender for 30% of the shares at $72/sh in debt securities and tender for the remaining 20%, also @ $72/sh, if Mesa gains 50% 1. M excluded from both steps of plan c. M brings suit to enjoin defensive measures, which would then allow the hostile tender to proceed d. Chancery Court offers preliminary injunction e. Mechanics of these offers i. M setup coerces shareholders to sell 1. don't tender a. M wins - $45 b. M loses - $33 2. tender a. M wins - $49-54, depending on how many tender b. M loses - $33 ii. With Unocal Defense 1. Don't tender a. M wins - $72 from Unocal b. M loses - $33 pre-bid price 2. Tender a. M wins - $54-72 (depending on # tendered) b. M loses - $33 pre-bid price f. M suit argues discriminatory self-tender is unfair i. Sup Ct rejects, says discriminatory self-tender is ok for 2 reasons 1. if M could tender in, offer would subsidize M's raiding activities 2. defensive measure to protect shareholders, and M doesn't need to be protected against itself g. Holding on Standard of Review i. defensive tactics are allowable when 1. there is a threat; AND 2. they are reasonable in relation to the threat posed a. was the defensive tactic coercive or preclusive? b. if not, does it fall w/in range of reasonableness? h. b/c of the risk that a board may be acting in its own self-interest, judicial review above the BJR standard may be needed. This is an intermediate standard btw BJR and entire fairness i. A corp.s board does not have unbridled discretion to defeat any perceived threat by any Draconian means available. They may not act solely or primarily out of a desire to perpetuate themselves in office or take inequitable 4. Unitrin v. American General (Del. 1995) p521 a. updates Unocal standard in 3 ways i. Under Unocal/Unitrin, Ts directors, not the plaintiff, bear the burden of showing that the defensive action was proportionate in response to the threat. ii. Substantively, action that is preclusive or coercive will fail the test. iii. Passing the preclusive/ coercive (non-draconian) test, it will be upheld if w/in a range of reasonable action. (This prong is operationally similar to the BJR.) (2 part second step) b. This is a high water mark of Unocal cases, giving the board maximum discretion c. American Gen. makes a hostile takeover bid; Unitrin's board resists by installing a poison pill and repurchasing 20% of its shares. Share repurchase increases Unitrin directors' stake enough to give the board a solid veto power over a freeze out transaction d. Chancery Court finds threat of substantive coercion i. upholds pill as proportionate, but holds repurchase as disproportionate under Unocal

e. Del. Sup. Ct reverses i. If directors' defensive tactic is not coercive or preclusive and is w/in a range of reasonableness, it will pass Unocal and get business judgment deference f. Why are these tactics reasonable? i. not coercive, not forcing shareholders to do anything ii. not preclusive, don't prevent an acquirer from taking over 1. can launch a proxy contest to take over board (directors own only 28%), then use control to dismantle pill, then change charter and get rid of provision allowing directors to block a merger w/the acquirer g. How the burden of proof works i. defendant directors have burden of showing proportionality ii. if def. shows proportionality, burden shifts to P to show breach of fiduciary duty, e.g. entrenchment, lack of good faith, or being uninformed iii. If D fails to show proportionality, D gets a final opportunity to show entire fairness of the transaction h. Note: difference btw structural and substantive coercion i. structural - second tier at lower price 1. this can objectively be shown ii. substantive - even if same price, terms of the deal are bad for shareholders 1. but this is a lot fuzzier
Poison Pill

ii. The Poison Pill 1. idea is that certain concentrations of stock trigger provisions diluting the stock so concentrator can't win 2. Flip-in pills: each outstanding right flips into a right to acquire some number of shares of the targets common stock of a small percentage of the market price of the stock. If all right holders do this, the aggregate effect is to increase the proportionate holdings of all SH except the triggering person. Flip-in pills are adopted by board vote; SH vote not necessary as long as the board has the requisite provision in the charter allowing it to issue blank check preferred stock. 3. Flip-over pills: when triggered, create a right to buy some number of shares of stock in the corp. whose acquisition of target stock had triggered the right. They compel the targets board to put terms in any merger agreement w/the acquirer that will force the acquirer to recognize flip-over rights. 4. implementing a "flip in" poison pill a. step 1: Rights plan adopted by board vote. shareholder vote not necessary if charter allows board to issue blank check preferred stock b. step 2: rights are distributed by dividend and remain "embedded" in the shares c. step 3: triggering event occurs (never does) when prospective acquirer buys >10% of outstanding shares. Rights are no longer redeemable by the company and soon become exercisable d. step 4: rights are exercised. all rights holders are entitled to buy stock at half price, except the acquirer whose right is cancelled 5. impact of triggering Circon Pill (see slide) a. Circon has 13.2 million shares outstanding, trading @ $12/share i. market cap of $158 million b. Surgical buys 2.0 million shares (15%) at $12/share ($24 million investment) c. This triggers pill, 11.2 million Circon rights become exercisable i. shareholders pay in $784 million (11.2m x $70 per right) 1. for this price, receive $1568m worth of stock (based on 2x price) 2. 130.7m new shares ii. new market cap is $158m + $784m = $942m d. New shares outstanding = 144m

i. 13.2m + 130.7m e. New share price = $6.54 i. $942/144 f. Outcome: i. hostile bidder now owns 1.4% of the target, or 2.0 million shares worth $13.1million ii. All other shareholders own 98.6% of the target, worth $928.8 million (compared to $918.3 million pre pill) 1. Surgical's loss value is gained to shareholders 6. These are legal a. before any hostile bidders appear b. as long as they are not arbitrarily not redeemed (ie. cancelled) after hostile bidder shows up 7. Moran v. Household (Del. 1985) p525 a. what can a company do before a bidder even comes along to defend itself from a takeover? b. case 'blesses' the "poison pill" c. Household bd adopts poison pill by 14-2 vote on advice of Wachtell i. two triggers: 30% tender offer, and acquisition of 20% of the shares ii. first vote against it is largest shareholder who'd been making noise about possibly acquiring iii. second vote just didn't know if it was legal and didn't want novel publicity d. Chancery Court upholds pill as legit exercise of BJ, Moran appeals e. 2 questions: i. do they have statutory power to do this? ii. does the enaction of the pill survive under Unocal? f. Holding: DGCL 157 & 151 give Board the authority to enact this plan i. 157 board can issue options or rights to purchase shares as long as consistent w/cert of incorp ii. 151(g) stock can be issued by board resolution even if not expressly in cert g. Looking at Unocal standard in Moran i. threat the poison pills respond to is general threat of increasing number of takeovers ii. reasonable bc acquirer could always run proxy contest to take over board & get rid of pill h. Case notes that although pill enaction is protected by BJR, doesn't say anything about validity of actions taken in response to an actual hostile takeover bid i. if a real bid materializes, will look at their actions at that time ii. another section not here elaborates that this is not absolute, they can not arbitrarily reject an offer even if they have a pill 8. Forced pill redemptions a. Cases demanding this occurred when boards used pills to protect company-sponsored alternatives to all cash tender offers b. Later expressly disapproved by Del. Sup Ct in Time Warner dicta c. But Del. SC still asserts that boards have ongoing fiduciary duty to redeem the pill if its no longer reasonable in relationship to the threat of an acquisition offer d. Moran v. Household Intl (Del. 1985): The Rights Plan [I.e., poison pill] is not absolute. When the Household Board of Directors is faced with a tender offer and a request to redeem the Rights, they will not be able to arbitrarily reject the offer. . . . The ultimate response to an actual takeover bid must be judged by the Directors actions at that time, and nothing we say here relieves them of their fundamental duties to the corporation and its stockholders. (emphasis added) e. City Capital Associated v. Interco (Del. Ch. 1988) p531 i. Chancery Court requires target board to redeem a stock rights plan that the company used to protect its recapitalization alternative to a hostile, all-cash, all-shares tender offer f. Grand Metropolitan v. Pillsbury (Del. Ch. 1988) p531

i. required redemption after concluding Pillsbury's own restructuring proposal not as good as that offered by Metro 9. Another note: what's the validity of the flip over pill? a. allowing people to get stock in the acquirer b. unclear: Looking back on the Household fight, [Delaware Vice Chancellor Steve] Lamb was still wondering how it could be that the directors of one company can be allowed [to] send their own shareholders to plunder the stock of another company at a discounted price that they unilaterally determine in advance. He rolled his eyes and smiled: I just dont know. iii. Choosing a Merger or Buyout Partner: Revlon, Its Sequels, and Its Prequels 1. Smith v. Van Gorkom (Del. 1985) p533 a. also discussed in duty of care section b. seen as a precursor to Revlon c. acting mainly on his own, arranges sale of his company to Jay Ptrizker for $55/share d. Sup Ct found directors violated the duty of care by being grossly negligent in approving the sale/merger i. this was abnormal for duty of care, so commentators think courts were coming up w/higher standard for company sales e. Bottom line is that directors need to take a lot of care when arranging sales
Revlon

2. Revlon, Inc. v. Macandrews and Forbes Holdings, Inc. (Del. 1986) a. Perelman makes a hostile all-cash tender offer for Revlon at $47.50/sh when stock trading at $25.Revlon board adopts a poison pill and tenders for 20% of its own shares with notes. the recapitalization permits Revlon to subject itself to specialized debt covenants that restrict the sale of assets, which in turn makes an LBO more difficult. Perelman undeterred, raises his offer w/promise of more if Revlon redeems the pill b. Frostmann Little enters as a "white knight" and eventually agrees to pay $57.25, gets an "asset lockup" a "no-shop" provision, and a breakup fee, in exchange for supporting the par value of the notes which had faltered in the market. Perelman increases his offer to $58, and bring suit to enjoin the defensive tactics and deal protection devices that Revlon used to preserve its deal w/Forstmann c. Chancery Court rules for Perelman and enjoins the asset lockup, no-shop provision, and breakup fee d. Why is Revlon so much more in favor of Forstmann? i. preserving value of Notes ii. management knew Perelman would fire them e. Court holds that there is a duty of care violation by favoring one bidder over another in a way that does not maximize the total value going to shareholders f. matters whether the violation is one of duty or loyalty bc of 102(b)(7) provisions g. When a board ends an intense bidding contest on an insubstantial basis, and where a significant by-product of that action is to protect the directors against a perceived threat of personal liability for consequences stemming from the adoption of previous defensive measures (here, the notes), the action cannot withstand Unocal scrutiny h. take on this is that if you're in the process of selling the company, duty is to maximize shareholders i. BUT if the company is not necessarily going to go out of existence, you can only take account of other constituencies to the extent that their interests help shareholders in the long term j. "Revlon duties" i. when sale or breakup of company becomes inevitable, director's role is changed from defenders of the corporation to auctioneers charged w/getting the best price for the shareholders. Directors' role remains an active one, changed only in the respect that they are charged w/the duty of getting the highest price k. Lock-up & No Shop Provisions

l. 3. Revlon duties clarified: Barkan v. Armstead Industries (Del. 1989) p545 a. Must create level playing field among bidders i. [W]hen several suitors are actively bidding for control of a corporation, the directors may not use defensive tactics that destroy the auction process. . . . When multiple bidders are competing for control . . . fairness forbids directors from using defensive mechanisms to thwart an auction or to favor one bidder over another. b. market check required if there's only a single offer i. When the board is considering a single offer and has no reliable grounds upon which to judge its adequacy, . . . fairness demands a canvas of the marketplace to determine if higher bids may be elicited. c. exemption allowed in (very) limited circumstances i. When . . . the directors possess a body of reliable evidence with which to evaluate the fairness of a transaction, they may approve the transaction without conducting an active survey of the marketplace. iv. Open questions after the three big cases 1. answered subsequently to some degree 2. Moran: when will a court force a target board to redeem its pill because it has "arbitrarily rejected" a takeover offer? 3. Unocal: what constitutes a threat to the corporation justifying a preclusive defense? How far beyond something that is structurally coercive? a. partially addressed by Unitrin, goes beyond structural 4. Revlon: what triggers Revlon duties? v. Pulling Together Unocal and Revlon 1. Paramount Communications, Inc. v. Time, Inc. (Del. 989) p547 a. Time & Warner agree for a stock for stock merger in which Warner gets 62% of surviving company. Various deal protection devices including "cross options" to deter third-party bidders. companies spend a lot of time deciding which CEO/management continues, eventually settle b. Paramount then makes an all-cash hostile bid for 100% of Time shares, first @ $175, then $200. Time then rejects the offer based on a (revised) fairness opinion which values the shares for as much as $250, even though in merger valued them @ $150/share c. Time gets nervous about letting shareholders vote on Warner when Paramount is there, so Time borrows $10 billion and uses it to make a cash tender offer for Warner d. Paramount brings suit to enjoin Time's defensive tactics under Unocal; Time shareholders join suit and also assert a Revlon claim e. Holding: Dissolution was not inevitable, so Revlon duties were not triggered. Under Unocal, the response was reasonably related to the threat. f. Holding 1: No Revlon duties triggered i. if they had been, Time would have been required to get the best possible price g. Case says Revlon triggered when i. a corporation initiates an active bidding process seeking to sell itself, or effects a reorganization involving a clear break-up of the company ii. where, in response to a bidder's offer, a target abandons its long-term strategy and seeks an alternative transaction involving the beak up of the company

i. They are not per se illegal ii. Lock-ups which draw bidders into the battle benefit shareholders, similar measures which end an active auction and foreclose further bidding operate to the shareholders detriment. iii. Similarly a no shop provision is usually impermissible when a boards primary duty becomes that of an auctioneer responsible for selling to the highest bidder. iv. Whats wrong with this particular lock-up? The Board uses it to stop the bidding process. If the lock-up is actually used to bring in another bidder or somehow extract value then it would be ok.

h. Holding 2: Unocal is triggered i. Threats present in this situation 1. shareholders won't know price is too low 2. shareholders might elect to tender into offer in ignorance or mistaken belief of the strategic benefit that a business combination with Warner might produce 3. timing of offer is such as to confuse shareholders ii. Responses are reasonable 1. when a company is pursuing a long-term strategy, it is entitled to do whatever it takes to protect its ability to carry out that strategy a. most anything done to carry out this strategy is reasonable 2. aimed at carrying forward a pre-existing transaction in an altered form, not at "cramming down" a management alternative 3. not preclusive bc Paramount could bid for the combined entity 2. Three kinds of Possible Threats That OK Defensive Measures (Gilson & Kraakman) a. Structural coercion (two tier offer) b. opportunity loss i. hostile offer might deprive target shareholders of the opportunity to select a superior alternative offered by management (Time) c. Substantive coercion i. risk that shareholders will mistakenly accept an underpriced offer bc they disbelieve management's representations of intrinsic value 3. Paramount v. QVC (Del. 1994) p554 a. Paramount agrees to be acquired by Viacom, controlled by Redstone (HLS 47), for Viacom stock and cash worth ~$70. The deal gives substantial deal protection measures to Viacom: no shop agreement; $100 million breakup fee; and 19.9% stock option lockup. QVC (Diller) jumps the deal with an offer to acquire Paramount for $80 in cash and then stock; when negotiations stall Diller makes a hostile $80 cash tender offer for 51% of Paramount, with a planned back-end squeeze-out for $80 in QVC stock. Viacom matches QVC at $80, and then raises its price to $85 in cash and stock, but leaves the deal protection unchanged except for a new fiduciary out. QVC goes to $90; Paramount rejects as excessively conditional but makes no effort to explore the conditions or negotiate with QVC. b. QVC brings suit claiming that Paramount was in Revlon-mode; Chancery Court agrees and strikes down all the impediments to the QVC offer. c. Del Sup Ct: There is a change in control because shares once held in a fluid market will become subject to a controlling shareholder, so Revlon applies d. The disparity in value could not be justified on the basis on the directors long-term strategy, b/c the change in control wouldnt let them follow that strategy anyway e. should have modified provisions that stopped company from extracting the most concessions from both companies i. must create a level playing field ii. its ok to give termination, lock up fee, etc. in order to induce someone to make a bid; the problem is that the no-shop is too tight, it prevents the board from talking w/other bidders, and the stock lockpup is so draconian and expensive that it seemed more than what was necessary to convince viacom to bid f. aftermath: i. Paramount had to hold an auction, told V & Q to submit best offers by 4pm 12/20, shareholders vote for competing bids by tendering shares, auction ends when one bidder gets 51%. bidders can change at any time, but absolute deadline is 21/ ii. QVC is high bidder at first w/$92/share, Viacom counterbids $107/share, w/back end price guarantee. QVC counterbids $110, but no back end guarantee iii. 75% tender into Viacom, Viacom accepts 50.1% of Paramount stock for $107/share cash, and later completes its second-step stock-swap 4. Revlon triggers after QVC

a. When a company enters into a transaction where shareholders will end up as minority shareholders in a controlled enterprise, that constitutes a sale of the company b. More likely to be triggered when payment is all cash, rather than stock i. Paying w/ your own stock reflects the boards view of the business opportunities and potential synergies of the transaction ii. Its easier for a court to compare cash offers to see which is higher; comparing stock is harder; evaluating synergies is more w/in the boards expertise c. relative sizes not focused on in these cases, but reasoning suggests if one is much bigger, it should be triggered i. if they're being swallowed, what they're getting isn't essentially different from cash 5. Open Questions from Moran/Unocal/Revlon and some answers a. a b. b Case Holding Open Questions Some Answers c. c Installing a pill is When will a court force Rarely (in practice, never, postd. d Act I: authorized by Delaware a target board to Time): Board is not required to Moran e. e statute and survives redeem its pill give up a long-term strategic f. f intermediate scrutiny because it has plan unless there is clearly no g. g under Unocal arbitrarily reject[ed] basis to sustain the corporate h. h the offer? strategy. (Time) i. i Defensive tactics will be What constitutes a Valid threats are: structural j. j Act II: judged using threat to the coercion (see Unocal), Unocal k. k intermediate scrutiny: (1) corporation justifying opportunity loss (see Time), and l. l must be a perceived defensive action? substantive coercion (cf. Time, m. m threat; and (2) tactics see Unitrin). n. n must be reasonable in relation to the threat o. o posed. p. p q. q Act III: When Revlon duties are What is a sale of the Sale or breakup of the company r. r Revlon triggered target board firm sufficient to trigger (Time) or sale of control (QVC) s. s must maximize the Revlon duty, and triggers Revlon duties; t. t immediate shareholder just what does this substantive requirements are value duty consist of? level playing field and market u. u check (Barkan). v. v w. w 6. Lyondell Chemical v. Ryan (Del. 2009) a. Question after this case is whether we are back to pre-Van Gorkom jurisprudence b. On July 9th 2007, Bassell CEO Blavatnik negotiates with Lyondell CEO Smith and eventually offers to pay $48 per share in cash to acquire Lyondell, but requires tight deal protections. Lyondell board agrees to the deal after extremely expedited process and no market canvass for a higher bid. On November 20th 2007, Lyondell shareholders approve the sale by more than 99% of voted shares.Shareholder plaintiff nevertheless allege that price was inadequate and directors breached their Revlon duties. c. Lyondell had a 102(b)(7) waiver, so question is whether the Lyondell board acted in good faith. d. Delaware Chancery Court allows claim to proceed on duty of loyalty claims against the board. e. Delaware Supreme Court accepts interlocutory appeal. f. Court finds biggest potential violation was duty of care, when board was i. all directors disinterested and independent ii. generally aware of companys value and prospects iii. considered the offer w/in time constraints of buyer iv. assistance of legal and financial advisors vi. Protecting the Deal

1. A lockup is any contract, collateral to the M&A transaction, that is designed to increase the likelihood that the parties will be able to close the deal. a. Asset lockup: Gives the acquirer the right to buy specified assets of the target at a specified price, once a triggering event, such as the purchase of the company by another bidder, has occurred. These are virtually nonexistent since Revlon. b. Stock option lockup: Gives the acquirer the right to buy a specified number of shares of the target (typically 19.9%) at a specified price, typically the deal price in the protected transaction. Stock option lockups appeared in approximately 25% of deals in 1999 (e.g., 19.9% cross-options in the American Home Products/Warner Lambert deal). These are no longer common because they were used to limit the use of pooling accounting which is no longer available. c. Breakup fee: Gives the acquirer a cash payment in the event of non-consummation. They compensate a friendly buyer for spending time, money, and reputation negotiating the deal. Termination fees also may be used to protect synergies and benefits that the deal would produce if consummated. Breakup fees appeared in approximately 50% of deals in 1999 (e.g., $2.5 billion breakup fee in Exxon/Mobil deal). Usually are 2-4% of deal price. 2. When there is no change in control deal protections are judged under Unocal, where there is a change in control a court will look to see if the deal protections are consistent with the boards Revlon duties by looking at: a. How early in the process the lock-up was given? i. Has there been a market canvass ii. Has substantial time passed b. Does it enhance the value that shareholders receive? i. Does it scare off potential bidders? c. Range of legitimate triggers i. Failure of the board to recommend a negotiated deal because of a higher offer ii. Rejection in a shareholder vote iii. A later sale of assets to another firm 3. DGCL 251 now allows a force the vote provision 4. No Shops/No Talks and Fiduciary Outs a. very common in todays deals. b. under QVC, courts have shown they're very suspicious of these types of terms i. lawyers have added fiduciary out provisions, so despite clause, if they feel its part of their duty to do so, they can 5. shareholder lockup a. some of target firm's shareholders agree to vote their shares in favor of the friendly transactions 6. Omnicare v. NCS HealthCare (Del. 2003) (p579) a. NCS in trouble; board begins exploring strategic alternatives in late 1999. 2001: Omnicare offers to buy NCS for $270 million but negotiations break down. January 2002: Genesis offers to buy NCS, but demands fully locked up deal to prevent a higher bid from Omnicare. Genesis & NCS agree to a exclusive negotiating period through July 2002. Omnicare faxes higher offer, but NCS does not respond. July, 2002: Genesis-NCS announce stock-for-stock deal. Board approves, with Outcalt (NCS Chairman) and Shaw (NCS President) committed to vote their shares (>50% votes) in favor. August, 2002: Omnicare launches competing cash offer for NCS at twice value of Genesis offer. October, 2002: NCS board recommends the Omnicare offer as a Superior Proposal. Genesis nevertheless forces the vote on its merger agreement as permitted under DGCL 251(c) (now 146). b. Omnicare brings suit to invalidate the stockholder lockup agreement; Delaware Chancery Court upholds the agreement under Unocal analysis. c. Sup Court invalidates the lockup agreement, says it should have included a fiduciary out provision

d. Deal protections were preclusive and coercive as used here, but lock ups are not per se invalid e. Coercive: a response is coercive if it is aimed at forcing upon stockholders a managementsponsored alternative to a hostile offer. A stockholder vote may be nullified by wrongful coercion where the board or some other party takes actions which have the effect of causing the stockholders to vote in favor of the proposed transaction for some reason other than the merits of that transaction. f. Preclusive: a response is preclusive if it deprives stockholders of the right to receive all tender offers or precludes a bidder from seeking control by fundamentally restricting proxy contests or otherwise. g. Deal protections are subject to Unocal just like defensive measures in response to a threat. i. Look at how they work together, not just if they are individually legal h. note that if NCS had told Genesis at the beginning that it couldn't include such a strict provision, they probably wouldn't have gotten the deal i. current Chancery Court refuses to cite this case, so courts may be moving away from it 7. Orman v. Cullman a. Purported to apply Omnicare but came out the other way. b. The merger agreement had essentially the same deal protections as Omnicare. i. Unlike Omnicare the minority can still vote down the deal, but if they do that then they will not see another deal for 18 months. 1. This looks coercive, but the court upheld the agreement because the minority could say no, and the agreements were shareholder lock-ups rather than director lock-ups. Shareholder lockups cannot coerce the other shareholders. ii. What is the difference between a person as a director controlling shareholder, opposed to shareholder controlling shareholder? 1. Shareholders in general dont have a fiduciary duty to other shareholders, but the controlling shareholders do (different than directors) c. Cuts against the holding in Omnicare vii. State Anti-Takeover Statutes 1. The second generation of antitakeover statutes tried to maintain a balance between the interests of offerors and targets. a. Examples: fair price statute-deterred coercive two-tier offers by requiring same $$ given to those in second step, control share statute-requires a disinterested shareholder vote to approve or ratify the purchase of shares by a person crossing a % threshold (without ratification the shareholder loses voting rights) 2. CTS Corp. v. Dynamics Corp of America (US SC 1987) p589 a. IN has control share acquisition statute prohibiting a bidder from voting its shares beyond 20% ownership unless approved by disinterested shareholders (SHs other than bidder and insiders). Dynamics challenges this statute as preempted by Williams Act and Commerce Clause. b. Court of Appeals struck down as preempted by Williams Act c. SC legitimated anti-takeover statutes d. Distinguishes from earlier statute that was struck down bc doesnt give management the same advantages over shareholders & doesnt require approval by Sec. of State. e. Basically promulgated that a statute is consistent with the Williams Act and Commerce Clause if it allows a bidder to acquire shares even if the statute makes that acquisition less desirable under certain circumstances. 3. State Regulation of Hostile Takeovers a. Acquiring a Control Block i. Control share acquisition statutes (27 states): prevent a bidder from voting its shares beyond a specific threshold (20-50%) unless a majority of disinterested shareholders vote to approve the stake.

ii. Other constituency statutes (31 states): allow the board to consider non-shareholder constituencies. iii. Pill validation statutes (25 states): endorse the use of a poison pill against a hostile bidder. b. Second Step Freeze Out i. Business combination (freeze-out) statutes (33 states): prevent a bidder from merging with the target for either three or five years after gaining a controlling stake unless approved by the targets board. ii. Fair price statutes (27 states): set procedural criteria to determine a fair price in freezeouts. c. Two Extreme AntiTakeover Statutes i. Disgorgement Statutes (Pennsylvania & Ohio): require bidders to disgorge short-term profits from failed bid attempts => prevents bidders from recouping bid costs through toeholds. ii. Classified Board Statute (Massachusetts & Maryland): provides classified boards for all companies incorporated in the state (with opt-out possible). 4. DGCL 203: Anti-Takeover Statute a. Bars business combinations between the acquirer and target for 3 years after the acquirer passes the 15% threshold unless: i. 203(a)(1): Takeover approved by target board before the bid occurs (board out clause), or ii. 203(a)(2): Acquirer purchases more than 85% of shares in a single offer (i.e., moves from below 15% to above 85%) excluding inside directors shares, or iii. 203(a)(3): Acquirer gets board approval and 2/3 vote of approval from disinterested shareholders (i.e., minority who remain after takeover) b. Interestingly this would not encourage a bidder to acquire shares in a tender offer because all the people that would have voted in his favor have tender so the minority consists of those who appose the transaction viii. Proxy Contests for Corporate Control 1. Importance of the Proxy Contest Safety Valve a. Before the pill (1970s-1985): board control is an inevitable consequence of buying a majority of the shares: i. Bidder makes a tender offer and gains a majority of the shares ii. Board will almost certainly resign because independence is doomed. iii. If directors stay they will be voted out over one (no SB) or two (SB) annual elections. b. After the pill (1985-present): board control is a prerequisite to buying a majority of the shares: i. Bidder launches a proxy contest to replace the targets board over one (no SB) or two (SB) annual elections. ii. Once in office, the new directors redeem the pill, thus clearing the way for the hostile bidder to proceed with its bid 2. Schnell v. Chris-Craft Industries, Inc. (Del. 1971) p598 a. Dissidents negotiate with management up to last possible moment, in hopes of avoiding fullfledged proxy contest. Incumbent board strings the dissidents along in negotiations and then, when only a couple of months left before annual meeting, incumbent board amends by-laws to advance meeting date by one month to mid-December (and, for good measure, moves the meeting to an obscure town in upstate New York). b. Effect: too little time for dissidents to organize and solicit proxies. c. Boards excuse: wanted to avoid Christmas mail crush in sending out the solicitation materials and getting back the proxy cards. d. Dissidents bring suit seeking an injunction to postpone the meeting; the Chancery Court recognized this as a sleazy, hard-ball tactic, but refuses to grant injunction.

e. Court holds that although moving the date of the meeting was legally permissible under Delaware law, it is not allowable here bc the motivation for moving the meeting date was done for an inequitable purpose. i. inequitable action does not become legally permissible simply because it is legally possible. f. Somewhere in between business judgment rule (bad faith) and pure equity. i. Closer to equity in that the court refused to blindly accept the reasons that the directors gave for moving the meeting date and looked to the actual effect the action had on stockholders. Delaware courts seem less inclined to defer to management overtures when stockholder voting is involved 3. Blasius Industries, Inc. v. Atlas Corp. (Del. Ch. 1988) p599 a. Blasius Industries, a 9% shareholder of Atlas, announces its intention to solicit shareholder consents to increase size of board from 7 to 15, and to fill new seats with Blasius nominees. Objective is to execute a restructuring plan. Atlas preempts campaign by immediately amending its bylaws to add two new board seats, and fills board seats with its own candidates. Blasius brings suit to enjoin board packing tactic. b. The court concluded that the board was not acting out of a self-interested entrenchment motivation or bad faith. (Does not fall under Schnell because there was not an inequitable motivation) c. Shareholders have two protections against perceived inadequate business performance: selling their stock, and replacing the board. You cannot have defensive measures and disrupt their vote. i. Voting is such a fundamental form of governance that its never ok to act just to stop a vote, even if you think thats in the interest of the company ii. The justification in Moran for allowing poison pills was the availability of the stockholder vote. d. The board unintentionally violated their duty of loyalty e. Rule: When a board acts for the primary purpose of impeding the exercise of stockholder voting power, the board bears the burden of demonstrating a compelling justification for such action. i. Combination of staggered board + pill is powerful anti-takeover device b/c it takes a long time to replace the board, which is necessary in order to redeem the pill (much harder to wage proxy contest) 4. MM Companies v. Liquid Audio (Del. 2003) p604 a. LA not doing well, MM offers $3 per share to acquire, later lowers to $2.50. After LA refuses MM offer, announces a stock for stock merger w/Allicance. MM forces LA to hold its annual meeting, at which MM plans to challenge 2 incumbent directors up for re-election, propose bylaw amendment expanding board from 5 to 9. LA adds 2 directors, increasing board to 7 b. MM sues alleging violations of Blasius and Unocal c. Chancery Court upholds LAs defensive tactics under Unocal, and declines to apply Blasius "compelling justification" standard i. Court seems to say what LA did would not have prevented MM from board control if shareholders had approved d. Sup Ct reverses, holding Blasius applies bc "primary purpose" of LA's actions was to reduce the MM directors' ability to control the board 5. Hilton v. ITT (D. Nev. 1997) p604 a. Jan. 1997 Hilton announces $55/share TO for ITT, plans for a proxy contest @ ITT's annual stockholder meeting to replace all directors b. ITT takes defensive measures: sells several non-core assets, files objections w/regulatory bodies, delays annual mtg by 6 mo. to Nov. 1997 c. July 97 ITT announces Comprehensive Plan to split ITT into 3 entities i. ITT destinations w/93% assets and a staggered board, ITT Destinations charter requires 80% vote for (1) removal w/o cause, (2) repeal of staggered board

d. Hilton brings suit to enjoin the Comprehensive Plan e. Basically instituting a staggered board w/o shareholder consent f. Court says this is a preclusive because it precludes shareholders from exercising a right that they currently possess. i. It violates Blasius and Unitrin to spin off a bulk of assets to defeat a hostile takeover ix. The Takeover Arms Race Continues 1. Structural Defenses (aka "shark repellents") (listed least to most potent) a. golden parachutes i. large payments to management team and sometimes to employees (silver parachutes) in event of takeover ii. reduces value of firm should it be acquired iii. not that potent bc amounts usually not that large relative to target value b. anti-greenmail provision i. prohibits board from buying back a stake from large blockholder at premium price c. supermajority voting provisions d. poison pill e. staggered board i. typically will need at least two meetings to get control f. dual class stock i. majority of voting rights concentrated in one class of shares held by relatively few people 2. Tactical defenses a. Things that can be done w/assets when bidders show up b. Greenmail (+ standstill agreement): Agreeing to purchase a bidders shares at an attractive price. c. Leveraged Recapitalization: Issuing new debt to buy back shares or issue a cash dividend. d. Pac Man Defense: Making a bid for the bidder e. Bulking Up: Buying another company to make a hostile acquisition more difficult. f. Crown Jewel Defense: Selling off key assets g. White Knight defense: Seeking out a friendly acquirer, typically at a higher price than the hostile bid. h. White Squire defense: Seeking out a friendly party willing to buy a substantial stake as a defense against the bidder. 3. Types of Poison Pills and their Treatment a. Flip Over b. Flip In i. may be illegal in CA c. Chewable i. disappears if fair price criteria are met 1. e.g., fully financed, 100% offer for a 50% or more premium over current market price d. Slow Hand i. may not be redeemed for a specified period of time after a change in board composition ii. illegal in DE but legal in Maryland, VA, Penn, GA iii. struck down in DE p606 MentorGraphics v. Quickturn 1. trial court said violation of Unitrin & Unocal disproportionate response to any threat identified by board 2. Sup Ct used dift reasoning, set can't put something in place that future board can't redeem e. Dead Hand Pill i. may only be redeemed by "continuing directors" after new board comes in ii. illegal in DE but legal in Maryland, VA, Penn, GA iii. struck down in DE p606 in Carmody v. Toll Brothers 1. no creating 2 classes of directors w/o authorization in company's charter

f. No Hand i. may not be redeemed by current or future boards for the life of the pill ii. illegal in DE but legal in Maryland, VA, Penn, GA 4. Shareholders Counterattack: Restrictions of the Use of the Pill a. Mar. 2006, Bebchuk submits 14a-8 proposal (shareholder entitlement for proposal in proxy statement) to Computer Associates to amend bylaws so that CA could only adopt a pill through unanimous board vote, and any pill so adopted would automatically expire after 1 year unless ratified by shareholders b. SEC refuses to grant a "no-action" letter that would allow CA to omit from proxy c. June 2006: DE chancery ct refuses to rule on validity, citing ripeness problems d. Sept. 2006: 41% shareholders vote in favor i. large amount for a first showing e. legal issue same as in CA v. AFCSME i. to what extent can shareholders who are entitled to amend bylaws put in bylaws that purport to control the decisions of the board? ii. DGCL 109(b) says may contain any provision relating to business of corporation and right or powers of its stockholders, directors, etc.... iii. DGCL 141(a) doesn't have director behavior controlled by bylaws f. Boards don't like this bc its designed to allow hostile acquirer to redeem a pill enacted by a staggered board in a single meeting i. if this were in place, boards would try to enact pills right b4 shareholder mtg 5. Unisuper v. News Corp (Del. Ch. 2005) p610 a. deals w/slow hand pill b. reincorporating from Australia to DE i. Aus. had very shareholder friendly law ii. to help convince investors, board agrees to a "board policy" that any poison pill adopted by the News board would expire after one year, unless shareholders approve an extension c. when potential hostile bidder appears, board installs a pill, and announces that going forward it might not hold to its board policy d. one year later, it extends pill in contravention to earlier policy e. shareholders file suit in DE alleging breach of contract f. Court rules for shareholders i. distinguishes Quickturn, saying it was about tying hands of future boards ii. this is about shareholders tying hands of future boards, and that's ok bc the shareholders are the principals V. FEDERAL REGULATION OF TRADING IN THE CORPORATIONS SECURITIES
Trading in the Corporations Securities

a. Trading in the Corporations Securities i. Policy reasons to prohibit Insider Trading 1. the party to the transaction w/o inside information gets hurt economically 2. may affect people's decision to disclose information 3. puts price pressure on the stock market 4. adds a risk premium to the stock market bc preople are less confident in the market 5. if inside trading induced someone who was not otherwise going to sell to sell, that person loses the surplus they would have gotten if they hadn't sold until later (assuming stock later goes up) 6. if inside trading does not induce someone else in, then you've displaced someone else who would have purchased it 7. high velocity traders are the ones who are most likely to be hurt by this trading ii. Common Law of Directors Duties When Trading in the Corporations Stock 1. Most important rules are federal, but before that there were state laws 2. state laws generally said director trading, etc. when anonymous is usually acceptable 3. Goodwin v. Agassiz (Mass. 1933) p616

a. Agassiz and MacNaughton are directors and officers of Cliff Mining Company and officers of another mining company. On May 14th, 1926, a newspaper discloses that Cliff Mining has stopped exploration on its property. Meanwhile, in March 1926, a geologist writes a report identifying the possibility of copper deposits in Cliff Minings property. In May 1926, Agassiz and MacNaughton anonymously buy shares from Goodwin, on the Boston Stock Exchange, based on favorable non-public information contained in the geologists report. Goodwin claims that he would not have sold had he known the geologists information, and brings suit to rescind the transaction b. Court holds officers in one corporation don't owe a fiduciary duty to the stockholders in a way that would make this trading a breach of fiduciary, but when a director does this personally, it will be closely scrutinized. if you do it anonymously on the open market, not as much of a big deal iii. Corporate Recovery of Profit from Insider Trading 1. Who is injured by insider trading? a. One theory: fiduciary theory corporation owns inside information and is therefore entitled to any profits made by its agents trading on it Not adopted by Freeman 2. Freeman v. Decio (7th Cir. 1978) p622 a. Decio is largest shareholder, chairman of the board, and president of Skyline Corp. Resigns in Sept. 72, in Nov. 72 Sykyline announces an unexpected 17% drop in earnings b. Freeman brings a shareholder derivative suit alleging that Skyline deliberately overstated its earnings for the previous 2 quarters, and that Decio and others sold Skyline stock knowing that the earnings had been overstated c. Circuit court (on its way to) saying no liability bc the corporation was not injured. since this is a derivative suit on behalf of the corporation, can't be any recovery. if the corp had been injured, then there could be a recovery, but there wasn't i. Injury as a prerequisite for remedy d. p625q2 how can individual shareholders be injured when the corporation is not if shareholders claim the residual value? 3. Board Disclosure Obligations Under State Law a. Closely parallels federal disclosure duty under 10b-5 b. Directors duty of candor under state law requires them to exercise honest judgment to assure disclosure of all material facts to SH; but failure to disclose unlikely to give rise to liability unless intent to mislead
fRule 16

iv. Exchange Act 16(b) and Rule 16 1. 16(a): statutory insiders (directors, officers, 10% SH) must file public reports of any transactions in the corp.s securities w/in two days of the trade under Sarbanes-Oxley 403 a. Officer status defined functionally as access to non-public info in the course of employment 2. 16(b): statutory insiders must disgorge any profits on purchases and sales w/in any six-month period a. Strict liability rule intended to deter statutory insiders from profiting on inside information b. Exemption for unorthodox transactions, e.g., short-swing profits in takeovers if no evidence of insider info c. How to calculate profits? (Gratz v. Claughton): match any transactions that produce a profit i. no offset for other transactions that produce losses 3. Insider Trading Stock Sales a. Tyco: Kozlowski and his CFO sold more than $500 million of Tyco stock back to the company since 1999 while publicly declaring that they rarely, if ever, unloaded their shares. b. Enron: Lay unloaded more than $100 million of Enron stock over 2000-2002. In 2001 alone, he sold $25.7 million in company stock as the share price fell from $80 to less than $50 c. Global Crossing: From 1999 to November 2001, executives sold more than $1.3 billion of company stock, with Winnick cashing in approximately $735 million worth.

v. Exchange Act 10(b) & Rule 10b-5 1. 10(b) is a broad grant of rulemaking power under which the SEC may devise rules that: a. Applies when any sort of material misrepresentation is made w/ respect to sale of securities b. Reaches public AND private (closely-held) corporations 2. Rule 10b-5: It shall be unlawful for any person, directly or indirectly, to: a. (a) employ any device, scheme or artifice to defraud, b. (b)make any untrue statement of material fact or to omit to state a material fact necessary in order to make the statements made not misleading, or c. (c) engage in any act, practice, or course of business which operates as a fraud or deceit upon any person in connection with the purchase/sale of any security. d. (c) is the one that most proscribes insider trading, but possibly (a) also. e. Has two major branches: one dealing w/misrepresentation, the other dealing w/omissions (insider trading) 3. Evolution of Private Right of Action Under 10 a. In Kardon v. National Gypsum the court found an implied private remedy for violation of 10b5 because the intent of the enactment is exclusively or in part to protect an interest of the other as an individual, and the interest invaded is one which the enactment is intended to protect.
10b5 elements

4. Elements of a 10b-5 claim a. False or misleading statement i. or omission Chiarella, Dirks, O'Hagan b. Materiality: what a reasonable shareholder would consider important i. Basic - probability x magnitude test c. Scienter: specific intent to deceive, manipulate, or defraud (Ernst & Ernst) i. may be inferred from reckless or grossly negligent behavior d. Standing: must be a purchase or sale of securities (Blue Chip Stamp) e. Reliance/Causation: presumption of reliance on the integrity of market price (Basic) f. Injury/Damanges: disgorgement rule (Liggett) g. A,b,& c needed for all claims; d,e,f for private litigants 5. Three Theories for 10b-5 Liability a. Equal Access Theory - all traders owe a duty to the market to disclose or refrain from trading i. Cady Roberts, Texas Gulf Sulphur b. Fiduciary Duty Theory - In order to establish that an insider violates 10b-5 by breaching a duty to disclose or abstain to an uninformed trader, you have to show there was a specific pre-existing legal relationship of trust and confidence between the insider and the counterparty i. (Chiarella, Dirks) c. Misappropriation Theory - "a person who has misappropriated nonpublic information has an absolute duty to disclose that information or refrain from trading" i. Burger dissent in Chiarella 6. Cady Roberts Abstain or Disclose Rule (SEC 1961) a. Analytically the obligation rests on two principal elements: first, the existence of a relationship giving access . . . to information intended to be available only fora corporate purpose and not for the personal benefit of anyone, and second, the inherent unfairness involved where a party takes advantage of such information, knowing it is unavailable to those with whom he is dealing. 7. 10b-5 False or Misleading Statement or Omission a. SEC v. Texas Gulf Sulphur Co. (2d Cir. 1968) p633 i. In October 1963, Texas Gulf Sulphur geologists make a valuable discovery of an extremely rich zinc/copper deposit. TGS President Stephens instructs them to not tell anybody, including other TGS employees and directors, so that they can buy up the rest of the land

needed. In February 1964, TGS issues stock options (= calls) to its top executives, all of them who at least something about the new discovery. And as information inevitably trickles through the organization, everybody starts trading. In April, TGS issues a misleading press release to quiet speculation. SEC brings a 10(b) action against everybody; District Court finds Crawford, Clayton, and Coates liable but dismisses the suit against twelve other TGS insiders. ii. Holding: All transactions in TGS stock/calls by individuals who knew about the drilling results were made in violation of 10b-5. (Equal Access Theory) iii. Reasoning: 10b-5 is based on policy that all investors trading on impersonal exchanges have relatively equal access to material info. Rule 10b-5 requires you to either disclose the info or abstain from trading. In this case, there was no disclosure or abstinence. When is a fact material? You balance the probability that the event will occur and the anticipated magnitude of the of the event, in light of the totality of the company activity. b. Note that you can magnify this effect by getting call or put options when you know price will change c. Santa Fe Industries Inc. v. Green (US SC 1977) p639 i. Facts: Santa Fe gradually increases its stake in Kirby from 60% to 95% and then decides to do a short-form merger under DGCL 253. Morgan Stanley appraises the fair market value of Kirbys assets at $640/share and values Kirbys stock at $125/share. Santa Fe offers $150/share in the short-form merger. Minority SH forego their appraisal remedy but bring suit alleging 10b-5 violation by Santa Fe for obtaining a fraudulent appraisal, appropriating value from the minority SH, and offering $25 above the Morgan Stanley stock valuation to lull minority SH into tendering. ii. Holding: There was no deception or manipulation and therefore did not violate 10(b)/Rule 10b-5. iii. Reasoning: There was no omission or misstatement in the info statement accompanying the notice of merger. The SH choice was fairly presented and they were furnished with all relevant info. Manipulation means practices that are intended to mislead investors by artificially affecting market activity. iv. It wasnt Congress intent to bring w/in 10b-5 alleged breaches of fiduciary duty. Also, theres no express private right of action for violations of 10(b), and we dont imply one where its unnecessary to ensure the fulfillment of Congress purposes. 1. We dont want to federalize corp. conduct traditionally left to state regulation. This might be a breach of fid. duty but cant go after it under 10b-5. d. Goldberg v. Meridor (2d Cir. 1977) p644 i. Press releases describing the stock-for-assets transaction fails to disclose certain material facts concerning the value of Maritimecors assets. UGO minority shareholder challenges the transaction as fraudulent and unfair in that the assets of Maritimecor were overpriced. ii. Holding: You can bring a 10b-5 derivative action on the basis that the transaction b/w a corp. and a fiduciary/controlling SH was unfair if the transaction involved stock and material facts concerning the transaction had not been disclosed to all SH. (Exception to Santa Fe v. Green) iii. Reasoning: There is deception of the corp. (in effect, of its minority SH) when the corp. is influenced by its controlling SH to engage in a transaction adverse to the corp.s interests (in effect, the minority SH interests) and there is nondisclosure or misleading disclosures as to the material facts of the transaction. iv. Notes: The press release interferes w/SH exercising their state rights. Theyve been affirmatively misled. v. Under Goldberg, a plaintiff must show (1) a misrepresentation or nondisclosure that (2) caused a loss to the SH. (A popular way to do #2 is to allege that a remedy was foregone as

a result of the lack of full disclosure; argument is that if disclosure were made, SH could have sought injunctive relief against the proposed transaction under state law.) 8. Fiduciary Duty Theory a. In order to establish that an insider violates 10b-5 by breaching a duty to disclose or abstain to an uninformed trader, you have to show there was a specific, pre-existing legal relationship of trust and confidence between the insider and the counterparty b. Chiarella v. United States (US SC 1980) p649 i. Sup Ct case rejecting SEC's view that anyone with possession of inside information has a duty to disclose or abstain from trading (rejecting equal opportunity theory) ii. Chiarella is employed in a financial print shop (Pandick Press) and is able to figure out the identity of the target from code names in merger documents. Chiarella buys the targets stock before the deal is announced and sells immediately afterwards; over 14 months he realizes a gain of $30,000. SEC begins investigating his activities and Chiarella eventually enters into a consent decree agreeing to return his profits to the sellers of the shares. iii. Jury finds Chiarella guilty of violating 10(b) of the 34 Act and 10b-5. Second Circuit affirms, and the U.S. Supreme Court grants cert. iv. Holding: Chi isnt guilty bc he worked for acquirer, not target, so no RETAC v. Holding: an insider violates 10b5 by breaching a duty to disclos/abst if they have a preexisting relationship of trust and confidence (RETAC) with the person with whom they are trading (shareholders of the firm whose stock youre buying) vi. end of case has a theory that you could be liable if you misappropriate info from a source 1. but not argued to jury, so not considered 2. this is endorsed in O'Hagan vii. Who has a RETAC to the public shareholders of the company under Chiarella? 1. Clear that officers and directors owe a RETAC to the shareholders 2. but what about other employees of the corporation a. probably yes 3. what about investment bankers? a. probably not, but will depend on precise contours b. Dirks fn14 (p 656) says these types of quasi insiders can be considered as having a fiduciary relationship w/shareholders, but this doesn't automatically arise, it depends on the understanding of the parties c. 2 big problems post Chiarella i. what do you do about "market insiders" like Chiarella himself? 1. addressed in misappropriation theory ii. what do you do about tippees? 1. Dirks d. Dirks v. SEC (1983) p653 i. Dirks is investment advisor; learns from Secrist, a former officer of Equity Funding (EF), that EF is inflating assets. Dirks does research on EF, including interviewing employees. He discusses info w/clients, many of whom then sell EF stock. Price of EF begins falling precipitously, NYSE halts trading. CA insurance authorities impound records, discover evidence of fraud. SEC files complaint. WSJ publishes story based on his info. ii. SEC sues Dirks, finds in admin proceeding he aided adn abetted in violations of 10b-5 by informing clients of alleged fraud, but only censures him iii. Sup Ct reverses the SEC iv. Rule: A tipper is liable when they tip for a personal benefit, and a tippee trades. v. Rule: A tippee is liable only when the tipper would be liable, and the tippee knows or should have known that tipper breached duty by sharing information vi. Court: all disclosures of confidential corporate information are not inconsistent with the [insider's] duty vii. benefit is defined based on objective criteria

1. pecuniary gain, reputational benefit, quid pro quo, "gifts" to trading relative or friend viii. Court understands lots of useful information is provided to analysts and institutional investors by corporate insiders, and a rule that said anyone w/this info can't use it would make it difficult to communicate with analysts ix. Blackmun dissent 1. wants to know why Dirks can escape liability for trading on info coming from Secrist, when Secrist himself could not trade on it a. answer is that Secrist did not breach bc he did not disclose for personal benefit, so can't be liability for Dirks 2. also argues shareholder is harmed the same way no matter who trades, so why should insider's purpose matter? a. we don't care just about people's losses; we also care about getting this type of info into market e. Questions i. could CEO be allowed to do insider trading in return for a lower salary? 1. under Chiarella theory, could be ok if the corporation's charter allows that fiduciary duty to be waived 2. although this has never happened ii. lawyers and investment bankers? 1. under Dirks fn14, leaves open possibility that corporation could enter into a contract with the service providers to allow them to use some of information in trading. a. although again, never been done f. SEC responses to Chiarella & Dirks i. Reg FD 1. text on p660 2. companies can not make selective disclosure of material information 3. if something is disclosed, must be disclosed to the entire public at the same time o if a company accidentally makes it available to a few people, must remedy by quickly making it available to everyone o no private right of action under this o only civil penalties for violation, but companies take this very seriously o enacted in 2000 o what if this existed for Dirks? couldn't have been used against Dirks bc he was not an issuer or working on behalf of an issuer (243.100a) o what about the employees Dirks talked to? 4. only if you could make the arg that employees were acting on behalf of company, but strong argument that these were unauthorized and the company would not support them ii. Rule 14e-3 1. Text: a. (a) It is a violation of the 34 Act 14(e) to purchase or sell securities on the basis of information that the possessor knows, or has reason to know, is non-public and originates with the tender offeror or the target or their officers. b. (d) It is a violation of 34 Act 14(e) for a possessor to communicate the information described in (a) under circumstances in which the tippee is reasonably likely to trade of that information. 2. imposes a duty on people who obtain info on tender offer originating with offeror or target 3. basically applies equal access principle of 10b-5 to the narrower area of tender offers

4. Example: Michael Milken "accidentally" blurts out he's financing Revlon's takeover at a party, partygoers then have brokers buy Revlon stock a. could SEC have gone after him w/o 14e-3? b. no, bc the shares that were traded were the target, and Milken had no relationship w/Revlon i.even if he did, he got no personal benefit from this (arguably) 5. but with 14e-3, bc the info originated from the offeror, everyone in the situation is liable 9. Misappropriation theory under 10b-5 a. US v. Chestman (2d Cir. 1991) p662 i. Ira Waldbaum, pres & controlling shareholder of Waldbaum's decides to sell out to A&P in friendly deal. Plan is for Ira to sell his control block for $50/share, simultaneous tender offer for public shares ii. Ira tells his sister Shirely about the deal, who tells her daughter Susan, who tells her husband Keith Loeb. And despite warnings at each step in the cahin not to tell anyone, Loeb calls his stockborker, Chestman, sto say he has accurate info that Waldbaum is about to be sold iii. Loeb buys for himself; Chestman buys for himself, Loeb, and other clients iv. NASD begins an investigation; Loeb pays a fine and agrees to cooperate, and Chestman is indicted on 14e-3, mail fraud, and 10b-5 violations v. Procedural history: Jury finds Chestman guilty on all counts, Chestman appeals, and Second Circuit panel reverses on all counts. Second Circuit agrees to rehear en banc vi. as to 14e-3, only real question is whether SEC had authority to enact, answered affirmatively vii. 10b-5 claim 1. misappropriation theory claim is that (1) Loeb breached a RETAC with Waldbaum family or Susan Loeb and (2) Chestman knew that Loeb had done so a. K Loeb (tipper), Chestman (tippee) 2. Misappropriation theory fails because there's no evidence of a RETAC btw Loeb & Waldbaum/Susan a. K Loeb is an extended family member from originator, "nephew in law" b. kinship alone does not create a RETAC c. "don't tell" isn't enough to create confidential expectation d. no evidence of continuing agreement to keep things confidential beyond normal marital relationship with wife 3. fiduciary theory would not work here because a. Ira disclosed information not for personal benefit, but for administrative convenience of selling shares b. so no original breach of the fiduciary duty by the one with RETAC, so can't succeed b. SEC responds to this with Rule 10b-5(2) p666 i. a duty of RETAC arises whenever 1. (1) a person agrees to maintain info in confidence; 2. (2) two people have a history, pattern or practice of sharing confidences such that the recipient of material non-public information knows or reasonably should know that the person communicating the information expects that the recipient will maintain its confidentiality; or 3. (3) a person receives or obtains material non-public information from a spouse, parent, child, or sibling, unless the recipient can demonstrates that, under the facts and circumstances of that family relationship, no duty of trust or confidence existed ii. if this rule applied in Chestman 1. (3) creates a rebuttable presumption of RETAC, so Loeb would be liable unless he could rebut this iii. hypo: suppose lawyer's SO sees docs out w/o her knowledge, can the SO trade?

1. presumption under (3) doesn't apply bc unmarried 2. must look at the facts of their relationship under (2) to see if it is met 3. if the SO can trade, can the SO hire a lawyer and compensate them by sharing the nonpublic info? a. yup, not a problem as long as there's no original breach c. circuit split as to validity of misappropriation theory d. US v. O'Hagan (1997) p667 i. Grand Met hires law firm D&W to represent it in acquisition of Pillsbury, O'Hagan is a partner of DW but does no work on the deal. O'Hagan begins buying Pillsbury stock & call options in his own name. DW withdraws from representing Grand Met, GM then announces tender offer for Pillsbury. O'Hagan then sells stock for $4.3 million profit ii. SEC brings criminal charges and trial court convicts O'Hagan, but Eighth Circuit reverses all of O'Hagan's convictions iii. US Sup Ct grants cert to resolve the circuit split as to misappropriation theory iv. Fiduciary theory does not create liability bc he's not an officer or director of Pillsbury 1. if he had been a lawyer for Pillsbury, he'd be a quasi-insider and likely liable under this theory v. Court finds liability under 10b-5 bc misappropriated info from the law firm & his client 1. deception essential to this theory involves feigning loyalty vi. Suppose O'Hagan had told the firm and client that he was going to trade 1. wouldn't have been liable bc under Santa Fe, disclosure means there's no deceptive device, and so no liability vii. if he had traded, and then disclosed after, would be too late bc he deceived while trading, can't cure after the fact viii. if he had disclosed just to the law firm, but not the client 1. not enough, bc need full disclosure to both proximate and ultimate source of information ix. if someone broke in and stole the information 1. probably no liability under 10b-5 because there was no deception e. SEC v. Mark Cuban (Sept. 2000) i. Cuban (Mavericks owner) is largest shareholder in Mamma.com, a public company. In 2004, CEO calls Cuban and tells him that he has confidential info for him, and Cuban agrees to keep the info confidential. CEO tells Cuban the company is pursuing a private investment in public equity (PIPE) offering and asks Cuban if he wants to participate. Cuban reacts angrily because of dilutive effect on existing shareholders and is futher upset bc "now I'm screwed. I can't sell." Cuban then sells his entire position, avoiding losses of $750,000 when the PIPE is announced and Mamma.com's stock price drops ii. SEC brings charges against Cuban under misappropriation theory for 10b-5 liability iii. Federal district court dismisses the charges, because Cuban's agreement to keep the info confidential did not include an agreement not to trade. Court finds unilaterally saying "I can't sell" does not constitute an agreement iv. Sep. 2010 5th Cir reverses, remands to district to consider whether "keeping info confidential" implies not trading it v. if you wanted to use fiduciary theory, would have to do it through Mamma's CEO 1. but CEO wasn't providing info for personal benefit, he was doing it for corporate fundraising, and asked Cuban to keep it quiet f. No clear bright-line test for whhat constitutes insider trading vi. Since 1980s, SEC haspassed two statutes to deal with insider trading amending 1934 Act 1. 1984 ITSA & 1988 ITSEA (p671) 2. 20A creates a private right of action for any trader opposite an insider trader, with damages limited to profit gained or losses avoided a. this means that if SEC gets to it first, not usually much $$ left for the private trader

3. 21A(a)(2) allows civil penalties up to three times the profit gained or loss avoided (even if evidence not strong enough for criminal) a. makes sense bc difficult to detect, so to deter need to do more than just recover 4. 21A(a)(1)(B) "controlling person" may be liable too, if the controlling person "knew or recklessly disregarded" the likelihood of insider trading and failed to take preventitve steps 5. 21A(e) bounty hunter provision, which allows SEC to provide 10% of recovery to those who inform on insider traders a. but agencies will typically fight you pretty hard on actually getting these $$ (seems to undermine purpose) vii. 10bElements: Materiality 1. Basic Inc. v. Levinson (1988) p672 o Basic in merger talks w/CE for two years about possibility of being acquired at premium price. After rumors, three times during this period Basic issues statements denying its in talks. Afterwards, Basic says it didn't want to drive CE away by inviting competition o Basic shareholders who sold after first public denial of merger file suit claiiming 10b-5 violations by Basic directors o District court grants summary judgment to defendant directors bc the negotiations were not destined to lead to a merger "with reasonable certainty" o 6th Cir reverses, finding that otherwise immaterial merger discussions become material when Basic denied their existence o Materiality standard: "an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote...there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available" drawn from earlier case TSC Industries, Inc. v. Northway, Inc. o Test in the context of merger negotiations, weigh probability of occurence & magnitude of effect fact specific inquiry o Court rejects the Third Circuit's test "agreement in principle" merger negotiations are not material unless the parties have reached a point where there's an agreement in principle as to the price and structure of the transaction advantages/rationales of this rule bright-line rule easily administered by managers and courts preserves confidentiality of merger negotiations for longer, increasing likelihood of completing merger Court says this means you just have to say "no comment" or stay silent a. won't overwhelm investor with overly detailed and trivial information 2. US v. Martha Stewart a. 12/27/01 Merrill Lynch stockbroker Bacanovic tells assistant Faneuil to inform Stewart that Sam Waksal & others are selling shares of ImClone stock b. 12/27/01 Stewart sold 3,928 shares of ImClone at $58/share c. 12/28: ImClone announces FDA rejected app for cancer drug Erbitux d. 12/31 ImClone stock price falls to $46.50 e. June 02, Waksal is arrested for insider trading, and SEC begins investigating Stewart f. Stewart denies wrongdoing, claiming that (1) she had a pre-existing order to sell when ImClone price went below $60 (stop loss order) (2) she did not speak with Waksal and did not have any inside information on 12/27 g. after consprigin w/Stewart, Bac alters the printed wks to try to concoct a stop-loss order after the fact, using ink that was different than the old ink h. Stewart is convicted for conspiracy, obstruction of justice, and lying to investigators, and serves five months in federal prison i. If Waksal had told Stewart ImClone would fail application

o o

i. she would be liable as a tippee under fiduciary theory bc he is an insider, and he would be liable as tipper j. If Waksal told Bac it would be rejected, and Bac told Stewart i. If Waksal telling for improper interest, and Stewart knows this and that it came from Waksal, she could be liable k. But what Waksal (corporate insider) saidd is that he wanted to sell all of his shares i. assume this is material 1. most people would consider sale of a large amount of stock by CEO as material 2. but won't want to make this material, bc then CEOs could never sell stock, bc they would always be violating 10b-5 bc they would know they're selling before they sell l. under fiduciary theory, 1. would need to show that the info he was selling all his stock was improperly disclosed to broker in breach of his duty a. bc his sale is in breach of fiduciary duty, this info facilitated it, making it a breach 2. AND that Stewart was aware the info had been given by Waksal in breach of his duty ii. under misappropriation theory, would have to show the info was nonpublic 1. argue Bac. misappropriated the info m. Fall 2010 Expert-Network Investigation i. problem showing materiality ii. even though in the aggregate, info about industry may be material, probably that individually they are sub-material, ie wouldn't move the stock price very much n. Insider Trading Tips usually not really worth it reasonable likelihood that you will be discovered trade in small amounts software programs won't be as likely to pick up your trading activity more likely to fit your trading pattern from the past i. don't do it if anyone else knows about it

viii. 10bElements: Scienter 1. Must be a specific intent to deceive, manipulate or defraud (Sup Ct case Ernst & Ernst) a. some courts say gross negligence is sufficient to infer intent (p676) 2. 10b5-1 adopted to clarify whether "use" or "knowing possession" of nonpublic material info at the time of the trade is what leads to liability a. some courts had said being in knowing possession is enough b. others have said SEC must prove that you would not have traded but for the information c. Trade is "on the basis of" insider information if the person was aware of the information at the time, unless you can demonstrate i. (1) proof that a person had given instructions, or entered into a binding contract, or adopted a written plan to purchase/sell before acquiring information ii. (2) the contract, instruction, or plan either (a) specified the amount of securities to be traded and the price, or (b) included a written formula or algorithm for determining the amount and price, or (c) did not permit the person to exercise any subsequent influence over how, when, and whether to trade; and iii. (3) the trade was pursuant to the contract, instruction or plan 3. However, unclear this is really as effective as desired a. these are typically selling plans, not buying plans (due to compensation agreements); executives are still allowed to cancel these plans/instructions b. so if they get inside info that stock will go up, they cancel c. but remember there are high transaction costs to buying/selling, and must weigh these costs against potential gain/chances of getting inside info at any given time ix. 10bElements: Standing

1. only relevant in private actions 2. Blue Chip Stamps p678 a. Rule: private plaintiffs in civil suits must be purchasers or sellers of securities to have standing to sue b. Rule: Deciding not to buy stock on the basis of a misleading document does not give standing under 10b-5 c. Rationale: court worried liability would become too expansive x. 10bElements: Reliance 1. difficult to show the type of reliance usually used in common law fraud bc of class action status a. but court is unwilling to throw out reliance entirely 2. Basic v. Levinson p679 a. Rule: reliance must be shown in a 10b-5 action b. Rule: reliance can be shown through a rebuttable presumption that traders are relying on the integrity of the market price in making their trades c. uses "fraud on the market" theory, which assumes that there are reasonably efficient markets such that anything a company says will get integrated into the stock price, and people rely on the integrity of that price d. 2 Ways a company can rebut reliance i. any showing that severs the link btw the misrepresentation and price received/paid ii. show that the market price reflected the truth, and not the company's representation 1. ie here, if market makers disbelieved company denial and thought merger negotiations were going on iii. show the individual plaintiffs who sold knew the falseness of the misrepresentation, but would have sold anyway 1. maybe for antitrust concerns, political pressures, etc iv. but practically, almost impossible to show either of these e. White concurrence argues Sup Ct not qualified to assess credibility of efficient markets theory i. was well accepted then, but not as much now ii. highly possible courts will not continue relying on this 3. Question about accuracy of efficient market hypothesis a. 1907: Royal Dutch and Shell combined assets but remained separate companies: shares traded in US, UK. RD has 60% cash flow, Sh 40% i. if markets efficient, market caps should be in ratio of 60/40 ii. but (slide) chart shows, there is large variation in their relative values, and rarely at the level expected by EMH iii. could make a lot of $$ by buying a lot of the undercapitalized one, and sell short the overcapitalized, expecting two prices to converge eventually iv. this is what Long Term Cap Mgmt did, and they lost $$ on the pair trade, bc the gap btw them got bigger instead of smaller 1. shows arbitrage theory doesn't always work in practice xi. 10bElements: Causation Courts require transaction causation AND loss causation o transaction causation - but for defendant's fraud plaintiff would have entered on different terms/would not have entered easy to show w/EMH of info incorporation into stock price o loss causation - must show fraud is approximate cause of the loss, and wasn't affected by an intervening event Loss ex: o ABC operates a commercial storage facility saying its at full capacity, when really only acting at 50% capacity. discloses it has no fire insurance. investor purchases, it then burns to the ground. 1. can't show loss causation bc proximate cause is the fire and not the misrepresenation xii. 10bElements: Damages

Elkind v. Liggett & Myers p686 o L&M tells certain analysts about neg earnings announcement to be publicly disclosed the next day. (Liability w/o benefit bc pre-Dirks). Clients sell 1800 shres at $55/share, after announcement price drugs to ~$46 o District Court finds 10b-5 liability and calculates damages using the "out of pocket" method calculates difference btw price plaintiffs paid, and the "true value" of the stock when bought o Second Circuit says disgorgement measure is correct, not out-of-pocket Avoiding losses scenario o (look at slides) o Out-of-pocket measure: Price paid minus "true value" when bought. Here, P can recover ($48-$40) * 10,000 shares = $80,000 o Causation in fact measure: not really used by courts o Disgorgement measure: Post purchase decline due to disclosure, capped at gain by tippee. Here, same as out-of-pocket measure by assumption ($80,000), capped at gain by tippee ($50,000) = $50,000 Potential class is anyone buying stock btw the time the tippees trade & the time information is revealed to the market Disgorgement measure leads to very small amounts of recovery o leads to lots of other remedies in order to deter

Hierarchy of Federal Civil Remedies under ITSA and ITSFEA 21(d): SEC can seek disgorgement of trading profits 20A(a): if SEC fails to act, or if any trading profits left over after SEC has acted, contemporaneous traders can seek disgorgement as well. 21A(a)(2): SEC can seek civil penalties up to three times the profit gained or loss avoided, in addition to disgorgement.

Penalties are getting toughter, probably more monitoring going on Academic Arguments Against Insider Trading Rules Compensation: Insider trading increases incentives to create valuable information (Fischel 1984) Communication: Insider trading provides a valuable and credible mechanism for communicating information to the marketplace (Fischel 1984) Not unfair: outsiders will pay less for securities because of the possibility of insider trading, and so will still achieve the expected rate of return Enforcement: Impossible to enforce, and mechanisms we have are very costly this is a less prevalent argument than it was 10 years ago a.

You might also like