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1. Agency & Partnershipa. Introduction

i. Limitations of Corporate Law . Corporate law is not going to be the cure-all to social problems caused by corporations. Consider other sources of law.

ii. Mechanisms Other Than Corporate Law available to stakeholders 1. Shareholder pressures --- selling shares 2. Pressures by the market --- private equity firms coming in3. Pressures by the community 4. Supplier pressures --- through contract5. Consumers --- consumer protection laws, tort, antitrust laws6. Employees - labor protection laws, unions, ability to walk away7. Management - ability to walk away8. Creditors --- contract law, bankruptcy law,9. Government --- regulatory law, taxation

b. Agencyi. General notes .

1. Agency Costs a. Transaction Costs. Start-up costs involved with finding the

employee. b. Agency Costs is a sum of

i. Monitoring Expenditures : Audits. Making sure the books add up. Security cameras.

ii. Bonding Expenditures : Training (especially when the skills are applicable only to the particular employer). Where this is true, there is an incentive to holding onto that particular job. Docking pay when cash register comes up short.

iii. Residual Loss: The remaining gap between principal and agent even when monitoring and bonding costs factored in.

c. Why such costs arise: (1) impossible to eliminate gap, (2) eliminating gap is not cost-effective. For example, monitoring costs exceed savings (or marginal monitoring costs exceed marginal savings).

2. What Does Corporate Law Do? a. A Traditional View: Reduce agency costs. See Jensen and

Meckling:b. Tensions Managed by the Corporate Form: Agents owe duty of

loyalty.i. Management and shareholders. Corp Law Reduce this.

ii. Among shareholders. Corp Law Reduce this.iii. Shareholders and other stakeholders (creditors, etc).

Corp Law Not much effect on this.ii. Agent’s Duty of Loyalty

1. Tarnowski v. Resop (Minn. 1952) (18)

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a. Facts: Plaintiff (principal). Defendant (agent). Third party sellers. Sellers bribe the def (agent) to encourage the principal to make a bad investment. In a separate suit, the principal was made whole vis a vis the third party.

b. Majority: i. Bribe

1. Rule The agent owes fiduciary duty to the principal: the point of allowing the claim is to ensure that he honors the fiduciary duty.

2. Rule : principle is that all profits made by an agent in the ourse of an agency belong to the principal

3. Law demands fidelity from an agent to the principal. Any violation is actionable. It doesn’t matter that no actual injury to the principal resulted.

4. Enough that agent placed himself in such relations that he might be tempted by his own interests to disregard those of principal.

5. Here def agent received a commission from third party for making a false representation to his principal. Entitled to recover the bribe that agent received.

ii. Damages1. What about litigation costs? This is just basic

tort law: damages from tort should encompass all foreseeable damages arising from that tort.

2. Here Principal should get litigations expenses arising out of the collateral suit (i.e. the suit against the sellers).

c. Evali. Policy: This rule minimizes the misalignment of

interests. The point is not to give restitution to a particular principal: it’s to make sure agents in general do not betray loyalties to principal.

ii. Principal wins here big time. He gets made whole and gets the bribe.

2. Reading v. AG (HL)a. Facts: The agent sues military to get his illicit profits back.

Reading was making use of resources (uniform) bestowed on him by the principal (UK army). This would have been okay to do on the side. But Reading made use of his position as an agent of the Crown. See Restatement Third of Agency §8.05.

b. Eval: i. In Tarnowski, the principal actually was harmed by the

conflict of interest. In Reading, the principal suffered no harm at all but still, agent is required to disgorge benefit he received. It would not have even mattered if, on

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balance, the principal benefitted. (Of course, there are side arguments to be made that the Crown was harmed by loss of reputation).

ii. Consider the jockey example: T offers to pay A jockey if A wins. Even though P presumably also wants A to win, A must disgorge benefit. Even here there is a potential misalignment of interest, e.g., how hard the jockey drives the horse.

iii. **The Law Reduces Agency Costs. Having rules like the material gain rule, or use of principal’s property rule avoids the need for extensive monitoring costs by the principal.

iii. Authority of an Agent 1. Morris Oil Co. v. Rainbow Oilfield Trucking (NM 1987) (2)

a. Facts :i. Pl. sued to recover funds due for diesel fuel delivery.

One def.(Dawn) held receipts from the other bankrupt defendant (Rainbow).

ii. Issue: Is Dawn (an undisclosed principal) subject to liability to Pl. (third party)?

b. Majority : An undisclosed principal is subject to liability to third parties with whom the agent contracts where such transactions are usual in the business conducted by the agent even if contract is contrary to the express direction of the principal

i. Was there agency1. Billing being done by Dawn. Dawn is taking a

cut. Dawn has complete control over Rainbow.2. Dawn was undisclosed agent.

ii. Is Dawn Liable?1. Rules of undisclosed agency say he is liable

where liability was incurred by agent in the usual course of business.

iii. Ratification1. Besides, dawn expressly ratified

c. Eval :i. What Type of Authority is At Issue in Morris? It can’t

be actual authority. The contract provides that Rainbow needed to seek permission from principal to make a certain transaction, and Rainbow failed to do so.

2. Inquirya. Always think about the three parties involved: the principal, the

agent, and the third party.3. Is There an Agency Relationship?

a. Party Labeling. i. Party labeling of relationship does not control. It can be

determined after the fact by a court. See R3 § 1.01-102. (6-7)

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ii. Policy: principals cannot contract their way out of obligations to third parties. Also, parties may not sometimes be aware of the legal ramifications of their relationships.

b. Evidence of Agency Relationship . Exception for “ordinary business of terminal management.”

4. Disclosure of Principal. a. Undisclosed principal : third party neither knows that there is a

principal nor the principal’s identity. b. Disclosed principal , where third party knows identity of

principal, either because of disclosure by the principal or by the agent.

c. Partially disclosed/unidentified principal , where third party knows there is a principal, but does not know identity.

5. Principal’s liability to 3 rd persons for agent’s contracts (for torts is respondeat superior (7-8))

a. Rule : principal liable to 3rd person on K entered into by an agent if agent had actual, apparent or (traditionally) inherent authority to act on principal’s behalf or principal ratified it.

b. Theories of authority : i. Actual Authority (from perspective of agent)

1. If acts/words would lead a reasonable person in an agents position to believe the principal wishes agent to so act.

2. Principal bound, regardless if disclosed or undisclosed to 3rd party.

3. (If he is held liable, then agent is entitled to indemnification from the principal).

4. Actual authority can be express or implied. Actual authority = objective reasonableness + subjective belief

5. Hypos See Ill. 4 at SB 46. Also, modify hypo such that the release-of-claims statement were present on all checks. Would it matter for actual authority? Well, it depends. Even if a reasonable person might reasonably believe they had actual authority, if the particular agent does not believe it, then there is no actual authority.

6. Changed Circumstances : Consider situation where A is authorized to keep accounts up to date and positive balance, but no authority to release claims. P is now unavailable. In order to keep accounts positive, A must now release claims. A believes that if P aware of changed circumstance, P would want to modify instruction. Then A has actual authority to release claims. Three criteria:

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a. Changed circumstanceb. Unavailability of principalc. A reasonably believes that if P knew

about changed circumstance, P would have authorized A to take otherwise unauthorized action

7. This is a compromise solution to the problem of changed circumstances versus A exceeding scope of authority.

8. Consider Ill. 6 at SB 47. If principal manifested desire to have lawn reseeded to meet golf-standard (whatever the reason, even if not for benefit of amusement park), then A would have actual authority.

9. What about if no manifestation by the principal, but A really believed P would want it. No actual authority, since such attribution would not be reasonable.

10. Scope of Agent Action. Whether an agent has actual authority will often depend on the nature of the instructions given: i.e. whether it’s of the form, complete task X, or of the form, do X, Y, Z, etc. I.e. depending on the task, the agent, the principal might give the agent more or less discretion.

ii. Apparent Authority (from perspective of 3rd party)1. If acts/words would lead a reasonable person in

3 rd Party’s position based on manifestations of principal OR agent.

2. Often goes hand in hand with implied actual authority. Issues created where perhaps actual authority s more limited that what is apparent to 3rd persons.

3. An undisclosed principal case can’t be apparent, because by definition as soon as 3rd party knows there is a principal, it is not an undisclosed.

iii. Inherent Authority 1. inherent authority allows the agent to exceed

the scope of its authority even when expressly so limited by the principal where agent is taking actions usual or necessary to perform certain authorized transactions.

2. Assume task X is customary to accomplish Y. However, P tells A to do Y, but not to do X. Under inherent authority, if A does X, P might be bound, notwithstanding his express instruction.

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3. Inherent Authority no longer in vogue. But some jurisdictions recognize it.

c. Ratification (14)i. It does not matter whether there was a complete lack of

agency in the first place (above) if there is after-the-fact ratification.

ii. No matter what theory of authority is relied upon, the principal is subject to full liability. That is, the extent of liability does not depend on the theory of authority being relied upon.

iii. Ratification can either happen expressly or implicitly through actions. Test: Principal bound to 3rd party if agent purported to act on principal’s behalf and principal – with knowledge of material facts – either (1) affirms agent’s conduct by manifesting intent to treat past conduct as authorized OR (2) engages in conduct that is justifiably only if he has such an intention.

iv. Policy: Concern that the P would benefit from the transaction (for example, by accepting payment), but then try to get out of liability by arguing lack of authority. P would then get a windfall without any of the risk.

d. Acquiescence (14)i. Principal’s failure to object to agent’s actions that is

fairly interpreted as acquiescence e. Termination of agent’s authority (15)

i. Principal can terminate agency relationship at any time.6. Liability of 3 rd Person to Principal (15)

a. Whenever principal is liable to 3rd party, 3rd party is also liable to principal.

b. Thus, it’s possible for a 3rd party to be sued by an undisclosed principal.

c. Policy: General presumption in contracts that obligations can be transferred to other parties.

d. Exception . i. In a case of undisclosed principal, if either the principal

or agent knows that if the 3rd party knew who the principal was, the 3rd party would not have entered into the contract, then 3rd party is not liable to the principal.

7. Liability of Agent to 3 rd Person (15)a. If principal would be liable under above rules, agent’s liability to

3rd persons depends on whether principal disclosed or noti. Principal disclosed

1. Agent not bound to the 3rd personii. Principal undisclosed [i.e. agent claiming to act on won

behalf]1. Both agent and principal bound

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2. Courts vary in whether they discharge one of the parties where 3rd party obtains judgment…(16)

iii. Partially disclosed principal 1. Both agent and principal bound

b. If principal would NOT be liable (due to lack of authority etc.)i. Agent liable to 3rd party

8. Liability of Agent to Principal (16)a. If principal liable but agent had no actual authority (principal

was liable b/c of agent’s “apparent authority”), then agent is liable to principal for any damages

b. Courts unsettled over cases of princiapl’s being bound by “inherent authority”

9. Liability of Principal to Agent (17)a. If agent acted within actual authority, principal is under a duty

to indemnify agent for any payments made for executing principal’s affairs (17)

b. Indemnification, so can pass along liability to principal. c. Agent’s goal: make sure he has actual authority (since right to

indemnification turns on existence of actual authority)

c. Partnership i. What makes a partnership

1. Review: Existence of Partnership. In determining whether a partnership existed, the party’s intent is not dispositive. Consider actual relationship, including factors like: (1) the economics of the relationship (entitled to profits?), (2) management and control (though sometimes lenders will reasonably want some degree to control to protect their investment) (this is a sort of trap: the more control, the more likely a court is to find a partnership and hence liability).

2. Rule: Party intent is not necessary to establish a partnership relationship. In fact, even if the parties explicitly do not wish to create a partnership, a partnership might nevertheless be established. Hilco Property Services (49)

3. Martin v. Peyton (NY 1927) (49)a. Facts :

i. Peyton and co-defendant lent KNK (a partnership) liquid securities, secured by illiquid securities, and informational and control rights over the firm.

ii. Martin (a third party) sues and wants to go after Peyton and co; in order to do so, Martin must establish a partnership relationship between KNK. (KNK and its partners are presumably judgment proof.)

iii. Defs argue this is a contract not an instrument creating a partnership

b. Majority: i. Rule Explicit agreements that something is not a

partnership are not controlling – where a transaction

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bears all the aspects of a loan, no partnership arrangement will be found.

ii. Here Consider (1) economics of deal, and (2) management structure.

1. Economics. Peyton and co lent KNK 2.5M in liquid securities, so KNK could use those securities to secure a 2.M bank loan in cash. In addition to return, Peyton and co entitled to 40% of profit to be within 100K and 500K. What is actual rate of return? Depends on profitability and date of return.

2. Control. Peyton and co have right to look at books. Their assets are segregated from the rest of the firm. Veto power over speculative investments. Hall managing partner. 1M insurance policy on Hall’s life. Other partners must submit resignation letters, to be held onto and accepted in case they disagree with Hall and trustees. Peyton and co can become partners in the business.

iii. Given the nature of the industry and the firm’s particular history, it was natural for the lenders to protect themselves. This was a loan and not a partnership.

c. Eval: 4. Lupien v. Malsbenden (Maine 1984) (53)

a. Facts : Same litigation posture as Martin. Third party is going after a person who is an arguable partner of an insolvent business. In both cases, there was an investor and the question is what kind of investor: partner or lender?

b. Majority : This was a partnership, not a creditor arrangementi. Malsbenden was basically running the business.

ii. The loan to which def. refers to was not a real loan -- there was no interest rate.

iii. Regardless of the intent of these two parties, this was a partnership

c. Eval: i. Policy: Well, entitled to upside; then should be

burdened to downside. Furthermore, this structures incentives in the right way. Someone who is entitled to all the upside, but no downside, is not going to act optimally. Furthermore, someone who is actually in control of the business can actually control whether or not the business does well; this is not true of a pure creditor.

ii. Is this a partnership? (56-57)

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1. Four part test (used by some courts) as evidence of – perhaps not a requirement – of a partnership

a. Agreement to share profitsb. Agreement to share lossesc. Mutual right of control/managementd. Community of interest in the venture

2. “An association of two or more persons to carry on as co-owners a business for profit” UPA and RUPA. § 6

iii. § 7. Why the difference in treatment between “gross returns” and “profits”? (1) Everything is paid out of gross returns. (2) The essence of the business is to create profit.

iv. Aggregate v. Entity Theory. Why is entity theory better? Ability to sue and be sued. Hold property; transfer property. Under aggregate theory, there need to be sui generis rules for partnerships to deal with these issues; under entity theory, the stuff just works.

ii. Management 1. Summers v. Dooley (Idaho 1971) (60)

a. Default rule: Decisions must be decided by majority of partners provided no other agreement speaks otherwise.

2. Sanchez and Covalt (NM 2000) (61)a. Majority : The majority voting rule applies even though there is a

prospectively advantageous business opportunity. When they can’t agree the partner’s remedy is dissolution not an action for breach of fiduciary duty.

b. Eval: court not going to interfere with the partnership’s business, (i.e. making a determination whether opportunity should have been taken) only will enforce procedural rules

3. Note on management of partnership (63)a. Review: Partnership Decision-making. For “ordinary course of

business,” need a majority of partners. This does not depend on respective stakes of the partners. For either matters outside of the ordinary course of business or changes to the partnership agreement, need unanimity. These are default rules.

b. Review: Partner Right of Participation. Every partner must be consulted on the decisions of the partnership. This is so even though a mere majority can bind the partnership. Why? (1) Better decision-making. (2) Inform all partners of matters involving partnership. Some partners might want to leave.

c. Voting : The majority voting rule does not depend on how much equity each partner has. Thus, in a two partner business, where one has 90% of equity, and other has 10%, still (unless agreement provides otherwise), each still only has one vote.

d. Principals and Agents. In partnerships, the principals are the agents.

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e. Parties can navigate from these default rules. i. If agreement clearly vests decisions in managing partner

or committee, non-managing partners are blocked from objecting solely by claiming it wasn’t arrived by majority default rule.

ii. By resolving these issues on procedural grounds, courts are incentivizing parties to engage in express private contracts.)

f. Dissolution: A partner can always escape by leaving the partnership. UPA. Partners can leave at any point. RUPA. Partnerships can buy out partners. Partnerships are fragile. (see 63-65)

g. Partnership agreement includes the course of conduct.iii. Authority of a Partner (66)

1. Northmon Investment Company v. Milford Plaza Associates (NY 2001) (66)

a. Facts: One partner wants to get into a 99-year lease. The other does not. The partner who wants the lease argues that each partner has the right to bind the partnership with respect to a third party (i.e. each partner has apparent authority; see RUPA § 301).

b. Majority : i. Rule that a partner can bind the partnership to

transactions in the ordinary course of partnership’s business

ii. Besides, the lease cannot be deemed “ordinary” as it is for 99 years

c. Eval: i. Actual Authority: each partner is also an agent 67)

1. Lack of Actual Authority. Partnership is not bound if there is

a. No actual authority AND b. 3rd party has knowledge of lack of

actual authority or circumstances suggest bad faith

2. Statements of Authority. Optional filings with the state. If statement says partner lacks authority, there is no obligation for third party to learn. If statement says partner has authority, then third party can rely on it.

ii. Apparent Authority. So long as within the ordinary course of business of the firm or of the business of which the firm participates, a partner can by the rest. (This was unclear with UPA).

1. If outside ordinary course. Need some sort of explicit authorization. 3rd party, to protect self, needs to make sure that the partner is in fact duly authorized to engage in such transaction.

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iii. Ratification applies…Even if partner had no authority to enter into transaction, partnership can subsequently ratify the transaction by express statement or conduct consistent with ratification

iv. Recap: In matters in the ordinary course of business, each partner has actual authority to bind partnership in transaction. Exceptions: third party either aware of lack of authority or received notice of lack of authority…In matters outside of the orindary course of business, need approval of all partners.

iv. Partner’s Duty of Loyalty (74)1. Meinhard v. Salmon (NY 1928) (75)

a. Facts . Salmon enters into a lease and then into an agreement with Meinhard, who invest money into the venture. Between Salmon and Meinhard, there is complete proft- and loss-sharing. Salmon provides expertise; Meinhard provides capital. They’ve both made a lot of money. Salmon approached by current landloard about getting in on a lucrative property. He does not inform Meinhard. Meinhard sues to get a piece of the action.

b. Majority i. Partners owe each other a duty of loyalty.

ii. Salmon got the opportunity rather than Meinhard only because of a coincidence, i.e. because he was the managing partner.

iii. He got the opportunity because of the joint venture; though the project itself fell outside the scope of the joint venture.

iv. Salmon had the obligation to disclose opportunity to his partner

c. Dissent. This was a completely new business; and not an offshoot of the original joint venture.

d. Eval i. Scope of Duty. How large is the scope of the partnership

relationship? Does it extend to a lease that begins after the joint venture ends

ii. Remedy. Pl. gets half of the new company getting the lease. But def. still gets controlling stake.

iii. How broadly should the scope of the fiduciary duty be understood? This depends on the scope of the fiduciary duty itself. Cardozo: the duty is going to be understood as far as the particular opportunity itself. Dissent: this was a joint venture, not a general partnership; thus, the duty should be interpreted narrowly.

iv. Case: Tension b/w Cardozo wrt to scope of joint venture. Cardozo contrues it at least broadly enough to . By contrast the dissent wants to construe narrowly to encourage individual productivity absent intent by the parties.

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v. Liability of Limited Partners (98)1. General notes :

a. Unlike general partnerships, limited partnerships are creatures of statute. Filing with the state is mandatory.

b. Tease apart ownership and control. Idea of limited liability. Before, in general partnership, partners had unlimited liability. In the limited partnership, it is possible to have limited liability.

i. Why have unlimited liability? To make sure managers internalize all risks and rewards. Otherwise, it’s possible for managers to take bad bets, because some of the costs are externalized.

ii. Why limited liability? (1) Attract investors; subsidizes risk-taking/innovation, (2) It’s a way to protect investors who do not have the information the managers have about the expected utility of the venture. That is, an investor is going to be very reluctant to invest (and be open to unlimited liability) in a venture in which there is an information asymmetry

iii. Why not just loan? (1) Well, there’s a capped upside for loan, and possibility of total loss. Loans are preferred for low-risk opportunities. (2) Loans can only be so big.

2. Gateway Potato Sales v. GB Investment (Az 1991) (98)a. Facts :

i. Supplier creditor did not adequately protect itself by checking that a partnership was backed by the pockets of a general partner.

ii. Supplier did not know it was dealing with a limited partnership.

Majority: iii. General rule : limited partners have no personal liability

unless they exercise controliv. Old law : could not exercise any control [similar line-

drawing issue to Cargill and Payton]v. Intermediate law : It was hard to draw this line, so states

created Safe harbors; if acted outside safe harbors, could be liable; but these were hard to generalize across

vi. New law : If limited partner participation in business is not substantially the same as the general partner, then liable only to persons who transact business with limited partnership with ACTIVE KNOWLEDGE of participation in business.

b. Eval. i. LLPs: Being a partner meant you had unlimited liability.

Generally we want investors fully incorporate the risks of their conduct. So why would we ever insulate investors from full liability? Perhaps to incentivize some risk-taking in some circumstances. Many types of enterprises might never get off the ground. Also in light

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of information asymmetries b/w investors and entrepreneurs it might insulate the investors.

2. The Corporate Forma. Introduction

i. Corporation is a separate legal entity – separate from its shareholders – created by filing Certificate of Incorporation with the state (112)

ii. Central characteristics of corporation: (112)1. Separate legal entity . Has rights in its own name. Can sue or be sued,

can own real property. Partnerships don’t always have that, depending on state law.

2. Limited liability : shareholders not personally liable for corporate obligations. Managers also usually not personally liable if acting within their authority (treated as agents), unlike in general partnership where partners liable. Enables development of secondary market. Biggest difference b/w partnerships and partnerships.

3. Free transferability of ownership interests: viable option – care less who the other shareholders are if we all have limited liability. Liquidity to the investors. Facilitates capital formation**Unlike a partnership interest which may not be transferred unless all partners agree (depends on partnership agreement). Also close corporations are different given that limitations are allowed.

4. Perpetuity of existence . Usually perpetual unlike partnerships or LLCs which have more of a limited timeframe.

5. Centralized management (under oversight of board) . Shareholders do not have right to manage. In contrast, a general partnership all partners have right to participate.

6. Investor ownership : while partnerships are also investor-owned. Contrast with co-op for example, where their interest is not maximum return on investment, but rather something else. Homogenous interest in maximizing value of company.

7. Taxation Implications : While shareholders also responsible for taxation for dividends etc, unlike partnership (where profits flow through to the individual partners) the corporation itself as a legal entity is liable for profits and losses – double taxation therefore.

a. C corp : Dominant form – double taxation.b. S corp : extra requirements (usually small # shareholders etc.)

and possibility of pass-through taxation.b. **Architecture of the law: corporations need to comply with each of these:

i. Federal securities law (e.g. Sarbanes-Oxley)ii. State statutory law,

iii. State judge-made law, iv. Private ordering (self-regulatory organizations like NYSE and soft law)v. Company’s own certificate of incorporation and by-laws

c. Which State Law Governs i. VantagePoint Venture Partners v. Examen (Del. 2005) (114)

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1. Facts : a. Vantage Point (a DE limited partnership) is investor and

dominant holder in Examen (a DE corporation). Merger agreement signed Feb. 17 with another company. If DE law applies, Vantage Point can block the vote.

b. On March 3, Examen filed suit in DE. A few days later Vantage Point filed suit in CA. The question is whether DE or CA law applies (which have different voting rules).

c. DE requires voting rules. CA law requires certain foreign corporations to conform to a broad range of internal affairs provisions to the exclusion of law of state of incorporation.

d. DE court decides first (while CA action stayed) that case governed by “internal affairs doctrine” – decides that §2115 of CA Corp. Code conflicts with DE law and this was a choice of law question, while VantagePoint argues DE must either apply §2115 of CA Corp. Code or find it unconstitutional.

2. Majority :a. Under CTS Corps. (U.S. 1987) internal affairs doctrine is a long-

standing choice of law principle which holds that only one state – the state of incorporation – should have authority to regulate internal affairs of corporation (e.g. voting etc.).

b. In addition, it has Constitutional underpinnings. All players have a right under DPC to know which law applies and under Dormant Commerce Clause, state cannot regulate internal affairs of foreign corporations.

c. Policy : need uniformity – hence need one law (the law of state of incorporation) to govern the relations for the sake of stability of intra-corporate relationships.

d. Here : Examen’s internal affairs – including VantagePoint’s voting rights – must be adjudicated exclusively according to law of state of incorporation – here DE law.

3. Eval :a. Merger complete on April 5. By the time opinion is decided,

Examen no longer exists and has been merged. b. Constitutional issue: 14th Amdt. Due Process and the Commerce

Clause. The case that they rely on is a Dormant Commerce Clause case. Court rejects this argument b/c if every state applies their internal laws only to those companies incorporated in their states, that would discourage interstate commerce. The challenge not addressed by the court is that it doesn’t actually resolve the issue here. It is debatable if the court gets the Constitutional law correctly.

c. Unlike CTS, CA is not trying to reach out and affect extra-territorial , rather control its own corporations. Professor DeMott’s critique is that corp’s business shifts so hard to apply this consistently.

d. Core of the case is that we want internal affairs to be stable . d. Selecting State of Incorporation

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i. A company can incorporate wherever it wants. Usually it will be the local state (for tax reasons), but often DE.

ii. Delaware has been particularly successful (123)1. *One of the theories is that there is a race-to-the bottom. States give

perks and protections to management to attract their companies (even where it might be bad for broader social welfare and not ideal for shareholders).

2. *Race to the top is the flip view. Competition for capital creates the best legal regime to which everyone flocks….

3. *Network effect – where value increases as you get more uses – the actor in the lead has the benefit to the detriment of others. Something to be said for consistent DE law, its corporate-competent judges and bar. Easier to use for others. Likely to stay dominant.

iii. For a long time NJ was the leader. Activism from Woodrow Wilson leads corporations to flock to DE. DE’s dominance since explained by its stability of its legislative climate.

iv. Even DE is company friendly, sometimes a state like DE might want to take legislative action to avoid feds. taking harsher action that will preempt the state law.

e. Organizing a Corporation i. Pre-incorporation agreements

1. Would-be shareholder agrees to purchase stock when it is issued at a future date, usually after corp. has incorporated in the pre-incorporation period (130).

2. Also known as subscription agreement - promise to buy stock in the future when entity created. These are lawful and enforceable- and under DE law, they are irrevocable for 6 months absent agreement to the contrary.

ii. After incorporation a privately held company seeking to go public must. (128)1. Under law of some states (e.g. NY), the incorporator has the power of

directors until directors are elected and power of shareholders until stock is issued.

2. Under law in other states (e.g. DE), initial directors can be named in certificate of incorporation.

iii. Certificate of incorporation 1. Designates the classes and number of stock authorized to be issued. The

board also has power to issue stock, within the limits authorized in the certificate of incorporation. (129)

2. Del. law is typical in a mix of mandatory things that must go into certificate of incorporation and a number of optional things.

3. Certificate of incorporation tend to be short and sweet. iv. By-laws

1. Types of things covered by bylaws :a. Notice of meeting: Note that state statutes will typically have

default rules for cases where specifics not defined (see e.g. §228 on p. 644 in SB)

i. Annual meeting required ii. Special meetings are optional.

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1. Management doesn’t like institutional investors calling special meeting.

iii. Written consent - If there is no explicit bar on written consent, this will be another way for shareholders to do things on their own initiative.

b. Quorum i. Will affect how easy/hard to change things

ii. Ordinary matters versus significant changes c. Election of directors

i. (plurality vs. majority; straight vs. cumulative – see section on that below)

2. See also section “Role of Bylaws in allocation of power b/w Board and Shareholders” below and at 182-84

f. Corporate Form & Capital Structurei. Basic types of financial securities

1. Stock (131)a. Common stock :

i. Holders of equity interests in the firm. It is a **residual interests,** with a claim to what is left after all senior claimants have been satisfied.

ii. One type of security that every public corporation will issue.

b. Preferred stock : i. Holders have a first claim – but a contingent one - if

directors are able & willing to pay a dividend or if corporation liquidates they have preferred position against common stock only (not against senior position of creditors).

ii. Not every company had preferred stock. For public corporations often do not have preferred stock (although there might be authorization to do so). More likely in small companies.

iii. Possible preferences:1. Voting rights2. Dividends: cumulative add up over time even if

not paid out one year. Difference from loans is that dividends are discretionary as opposed to obligatory.

3. Liquidation rights not just when a company folds but also when it gets acquired at a premium by another company.

a. The main issue in negotiation is whether preferred stockholders will be participating or non-participating….Company pays off the debt first, then preferred stockholders, and then either common stockholders

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or common + preferred (participating) stockholders.

b. Alternative: right to convert preferred shares into common stock. Mandatory conversion feature – company may force all preferred stockholders to convert into common stock – as a way to prevent preferred stockholders from holding the company hostage.

c. Convertibles, classified stock, derivatives :i. These days the above can be cut up and repackaged in

various ways – derivatives are securities whose underlying value ultimately depends on the value of the stock.

ii. The above categories may be issued in several sub-classes (classified common)

iii. These are instruments in a secondary market, the money does not go directly to the company

2. Debt (133) unlike dividends for preferred stock, interest on debt is obligatory

a. *Trade debt: short term debt owed for goods or services rendered in 30, 60, 90 days. This shows up as “accounts payable” on the balance sheet.

b. *Bank debt: commercial-bank loans, which show up as “loans payable” on the balance sheet.

c. *Bonds & debentures: These are long term securities. They shows up as “bonds payable” on the balance sheet. Indentures are contracts set out the terms of the bonds. Bond-holders are merely third-party beneficiaries of the indenture b/c the direct beneficiary is a trustee who administers the payments of interest and responsible for monitoring and enforcing compliance with all the covenants.*

d. Notes : these are basically bonds not issued pursuant to an indenture – usually shorter term and unsecured.

3. Other :a. Warrant : in exchange money now to option to buy certain to

buy.ii. Normal Requisite for Valid Shareholder Action

1. Notice of meeting required to shareholders of record (139) The date will be fixed by by-laws or by statutory limits.

2. Quorum under statutory limits usually majority necessary unless certificate of incorporation says otherwise.

3. Voting a. Ordinary matters usually majority of quorum unless statute or

certificate of incorporation says otherwise.b. Fundamental changes usually requires a greater %age of

quorum

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c. Written Consent without a meeting is allowed by most statutes if certain conditions satisfied.

iii. Election of Directors (141)1. Staggered boards

a. AKA “classified” to ensure continuity (like U.S. Senate) and nowadays as a **defense against a hostile takeover b/c it would take multiple consecutive annual shareholder meetings to replace a majority of a board of directors.** A way to entrench management. Only can be removed for cause

b. Institutional investors however have pushed back on staggered terms as part of corp. governance reforms.

2. Straight & Cumulative voting a. Straight voting where a shareholder can cast for each

directorship to be filled a number of votes equal to the number of shares she holds. Under this setup a minority can never elect even a single director over opposition of majority.

i. A has 30 votes with 3 seats open, can only cast 30 for each.

b. Under cumulative voting a shareholder can distribute among her nominees in any way she pleases a number of votes equal to the number of shares she holds times the number of directs to be elected. This allows minority shareholders to get more people on the board and have representation.

i. A has 30 votes with 3 seats open, can cast 90 for one votes.

3. Plurality voting a. Under general rules, shareholders act only by majority vote, but

in election of directors a plurality vote usually suffices. These days majority voting becoming the norm. Sometimes institutional players will just withhold their votes to try to get management to get changes they want to.

4. Short slates a. Dissident shareholders have increasingly run a slate of

candidates for less than all of directors to be elected. This has several advantages. See 145. For example, challengers have no interest in challenging ABC, but want to run XY against DE. Previously a person voting had to forgo the right to vote on ABC. Now insurgents can run ABCXY, which makes it easier to run.

iv. Removal of Directors 1. By shareholders

a. Shareholders can remove a director for cause typically (common law) but cannot do so without case in the absence of explicit authority to do so

2. By Boarda. Statutes vary by state. In absence of statute, board cannot

remove a director either with or without cause. Unclear if a certificate of incorporation can change this rule.

3. By Court

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a. Statutes vary by state. Cases are divided on whether a court can remove directors for cause in absence of statute

g. Corporate Form & Corporate Financei. Assets = Liabilities + S/H Equity: as corporation makes money it accumulates on

the other side of the equation in equity. (see 23) If assets go up, those additional net proceeds that directly increases the amount of equity (assuming liabilities stay stable). As liabilities go up, equity goes down.

ii. Risk & Diversification (40-43)1. Expected return:

a. Simply a probability of future return (that says nothing about profitability)

b. To get profitability (expected rate of return) you just take the expected return and divide it by original investment.

2. Risk and uncertaintya. Even where expected return is the same (as an average) there

can be various amounts of risk (see example on 41) meaning that risk is understood as a combination of probability of deviation from the expected return and the amount of that deviation. (42)

iii. Objective and Conduct of the Corporation (154-164)1. Maximization of shareholder wealth

a. Most basic is that corporation to be primary run for pecuniary benefit of its shareholders.

b. The traditional is that what is good for the corporation is good for the shareholder. However in real world, the interests of shareholders and managers not always aligned. E.g. amount of risk-taking or whether to liquidate during a bankruptcy.

c. A second competing – increasingly dominant – conception is directly focused on welfare of shareholders, regardless on the independent welfare of corporation. (Hu: 154-55)

2. Other interests a. General notes :

i. Courts become more receptive…but there is usually still a “reasonableness” constraint.

ii. Historically you are either a corporation or a non-profit. There has been some experimentation with dual purpose structures – allowing social enterprise to price things in a way that would not be allowed under traditional corporate code. Critics however say an organization needs to pick a goal to guide the organization.

b. *Dodge v. Ford Motor Co. (Mich. 1919) (156)i. Facts : Henry Ford, who owned majority of stock and

controlled the board declared that no special dividends would be paid out (other than the standard one) so company can reinvest in its business. Minority shareholders brought suit and trial court ordered the payment of dividends

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ii. Majority : A business is organized primarily for the benefit of its stockholders. Ford’s plan of using the profits to further reduce the price of the cars in the coming year will have the immediate effect or decreasing profits and diminishing the value of the company. While directors have a lot of discretion in how they make profit for the shareholders, here the reduction of profits sacrifices the interests of shareholders and it is the duty of courts to enforce the law.

iii. Eval : 1. Surprising how court reads the issue as contrary

to business purpose. It might be that Ford using flowery language about his noble goals to get around antitrust issues. That framing bites Ford in the ass.

2. This is one of the few mandatory rules from which parties may not opt out.

c. A.P. Smith Mfg. v. Barlow (U.S. 1953) (158)i. Facts :

1. Board of directors appropriates a donation Princeton University and when action questioned by stockholders, corporation instituted a declaratory judgment action.

2. At trial company puts forward several witnesses arguing that it is good business to be a responsible player in the community etc.

3. Objecting stockholders argue that certificate of incorporation does not expressly authorize such contributions and any state statutes authorizing the contributions do not constitutionally apply to this company

ii. Majority (Jacobs): 1. Older common-law doctrine said that managers

could not disburse corporate funds for philanthropic or other cause unless it benefited the corporation. **But as economy changed and corporations assumed a greater role they have started giving more and courts have been liberal with what constitutes benefit to the corporations**

2. Supporting an academic institution clearly aids public welfare and can even be squared with the narrow common law rule if we consider the benefit to the corporation the survival of a free enterprise system

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3. State statutes explicitly authorize corporations to cooperate in donating money to civic funds subject to common law limitations.

4. Here it was valid: donation was to a well respected institution (not a pet charity), it was modest in amount and within statutory limitations, it was in good faith support of public welfare.

iii. Eval :1. Here the better coached executives frame the

issue in terms of long term interests.2. Court also recognizes structural changes in

economy that make it necessary to allow corporations to be good citizens.

3. Shareholdersa. Voting and Allocation of Power

i. General notes1. Major players in a publicly held corporation are board, shareholders and

executives2. Board has authority and obligation to use its own discretion to

determine what is in best interest of company – which means that shareholders can express those views and elect new directors but may not compel the current board to do any one thing. This is usually spelled out directly in statutory scheme.

3. Shareholder authority – see Blasius – primary purpose of board action to undermine shareholder board, board must adopt a “compelling justification.” Practically this means that shareholders will win and board will lose. [Information asymmetries. Usually board is expert. But in Blasius board says that board does not have a better ability to make a decision as to who should sit on the board.] We should keep thinking about relative strengths and expertise of board and shareholders.

ii. Distribution of power b/w Board and Shareholders and limits1. Board powers : on one end of the spectrum.

a. Charlestown Boot & Shoe v. Dunsmore (NH 1880) (168)i. Facts : Dunsmore was elected a director in the company.

When it chose to wind up its operations a committee was chosen by shareholders to that purpose. Dunsmore refused to cooperate with its head and as a result corporate assets depreciated. Shareholders then brought suit for damages sustained through losses, as well as negligence. Dunsmore argued he used ordinary care and not answerable for losses.

ii. Majority : The business of a corporation - as defined by its bylaws, is to be managed by its directors and by such officers and agents under their direction as they shall appoint.

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1. Corporation is managed by directors and such officers as they appoint. The state statute does not authorize a corporation to join another officer with the directors to compel directors to act with one who isn’t a director.

2. The vote choosing a committee head to act with directors is inoperative and void.

3. It is the responsibilities of the director to use their discretion to manage the operations of the corporation. Further, this was not the type of decision for which directors will be held liable.

iii. Eval:1. Shareholders of a corporation can remove a

director for cause. They might also be able to remove without cause if charter or bylaws so provides.

b. People ex rel. Manice v. Powell (NY 1911)i. Majority : **Relation of directors to shareholders is like

those of trustee. They exercise their judgment in the in the interest of stockholders and may not be controlled in the exercise of such duty.*

ii. Eval :1. Separation of powers of centralized

management is key – if you want other arrangements you can opt for partnerships, LLCs.

2. Although board sometimes referred to as “agents” of shareholders – this is not a traditional agency relationship since board must exercises its judgment. See statute such as Del. §141(a)

3. Policy : collective action problem for shareholders, and an information asymmetry b/w shareholders and centralized management, management in best position to make day-to-day tradeoffs.

4. What is the recourse of a shareholder ?a. Exit: Sell sharesb. Voting powersc. Publicity

2. Equitable limits on board’s powers : other side of the spectruma. Condec v. Lunkenheimer (Del. Ch. 1967) (170)

i. Eval : Condec sought to acquire Lunkeheimer and was on cusp of majority ownership, but the latter issued shares that diluted Condec’s control. Court held that shares may not be issued for an improper purpose such as a take-over of voting control from others. There may a legitimate business purpose in issuing shares that also

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dilutes another’s control, but that may not be primary purpose.

b. Schnell v. Chris-Craft Industries (Del. 1971) (171)i. Facts : Dissident stockholders filed for injunctive relief

to prevent management from (stealthily?) advancing the date of the annual stockholders meeting from January 1972 to December 1971 – consistent with a new Delaware Corporations Law.

ii. Majority : Management may not amend the bylaws to move up the shareholder meeting date for the purpose of making it hard on dissident stockholders to mount their campaign.

1. Trial court below that management has sought to use the new Delaware Law to perpetuate itself in office and obstruct legitimate efforts of dissident stockholders in exercise their right to undertake a proxy contest against them. This is in violation of established principles of corporate democracy.

2. Dissident stockholders have a legitimate expectation interest in planning their campaign. Surprise is improper.

3. Just b/c management has strictly complied with letter of the new law does not make an inequitable action permissible.

iii. Eval:1. Courts retain an equitable power to limit power

of management where there are doubts that it is being used in the benefit of the shareholders (173)

c. Blasius Industries v. Atlas Corp. (Del. Ch. 1988) (173)i. Facts :

1. Blasius – a hedge fund – is Atlas’s largest stockholder (9%) interested in recapitalization of the company. [Trying to squeeze money out of company or at least squeeze it from management. Arguably this disciplines mgt. by giving them no choice but performing better since they have to make payments on their equity but also make leveraged company vulnerable to swings in market.] Management skeptical and interested in blocking such attempts, having recently gone through reorganization.

2. Blasius gets another institutional investor to deliver to Atlas a signed written consent that would have added to the board from 7 to 15 (max authorized by charter). [In Del. under

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§141(k) it is possible to remove directors unless there is a staggered board. Although there is a staggered board here, b/c only 7 of 15 are filled and there is a written consent provision, Atlas is vulnerable to this quick takeover bid without waiting for annual meeting.] Management reacts by holding an emergency board meeting to amend bylaws in a way to block Blasius from placing a majority of new directors on the board through the consent solicitation.

3. Blasius sues accusing management of a selfishly motivated effort violating the principle in Schnell. Def. argues there was no violation of duty of care, good faith, fidelity.

ii. Majority : 1. An amendment of bylaws is possible, however

here it was taken directly in order to impede a majority of shareholders from adopting the course proposed by Blasius.

2. Board did not act out of self-interest but out of a good faith effort to protect its incumbency in order to thwart implementation of the recapitalization it feared would cause injury to the company. The question is whether such a good faith effort can be squared with board’s role.

3. **In light of the general rule that a board may take good faith action that has the effect of diluting another’s shareholder vote, does this rule apply to an action designed for the primary purpose of interfering with the vote?

4. What is the correct rule? a. Action designed principally to interfere

with effectiveness of a vote inevitably involves conflict b/w a board and shareholder majority and it may not be left to the agent’s business judgment.

b. A per se invalidity rule would strike down in equity any board action taken for primary purpose of interfering. However it would sweep too broadly.***

c. While a per se rule is inappropriate, the defendants have not sufficiently justified their actions (i.e. “compelling justification” test). Board could have informed shareholders of why the Blasius proposal was bad. But it

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instead made the call itself. Ultimately this should have been left to the shareholders.

iii. Eval : 1. Note the courts’ willingness to look at intent of

the multi-member boards in all these three cases.

2. “Business judgment rule” employed in this case is the easiest of different standards of judicial review of conduct of directors for them to satisfy. Here court decided business judgment rule is inapplicable and a more stringent standard compelling justification is required (181-82) The compelling justification test is a high hurdle (like strict scrutiny) and very unlikely to be met.

3. Role of Bylaws in allocation of power b/w Board and Shareholders (182-84)

a. Corp. controlled by statutes, common law, its certificate of incorporation and its bylaws. Certificate trumps bylaws.

b. Bylaws address annual stockholder meeting, quorum requirements, powers of company officers.

c. Importantly, both board and shareholders may usually adopt bylaws (whereas usually only board can propose an amendment to certificate of incorporation, which stockholders can only veto).

d. *Advance notice bylaw requires any shareholder with a proposal at the meeting to give notice to the company. Advanced notice is a big protection to the management but usually to the degree there is ambiguity Courts read these narrowly in favor of proposing shareholder. (182-84)

iii. Corporate governance in practice (193)1. Financial institutions and their advisors (194-203)

a. Traditionally, role of shareholders in publicly held corporations was close to nil due to collective action problems, free rider problem, and “rational apathy” of involving oneself if one has little stake, as management exerted real control. Historical constraints on powers of shareholders have been weakening.

b. Shareholder activism precipitated by a dramatic increase in percentage of stock held by institutional investors (as opposed to individuals). Activism in not always voting with management, originating shareholder proposing, joining movements to oust incumbent directors, holding direct talks with management concerning specific issues or general policies. (194-97)

c. Institutional investors include pension funds, banks, investment companies (i.e. mutual funds), insurance companies, foundations, hedge funds, private equity. While some have ties to management and therefore are not activist, others –

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particularly pension funds and hedge funds – do not and likely to lead in shareholder activism particularly over issues where they have competence and where their independent views are more likely to add value – institutional governance issues and structural changes (e.g. large merger). (198-203)

b. Voting and Proxy Rules i. General notes:

1. Proxies is #1 way actually happens. a. Proxy = the authorization to another to voteb. Proxy = the other person who votes your shares

2. Proxies count toward establishing quorum3. Intersection of state and federal law. State law got there first, but

federal law moved into this field post Great Depression (via Commerce Clause). De minimus exceptions (< $10 M or certain market cap or shareholders, you do not fall under the Act).

4. Proxy is an agency relationship, revocable at any time. If you assign to two different people, the later one is the proxy.

5. Because compliance is expensive.ii. Funding Proxy Contests

1. General notes a. Majority rule is that incumbents may use funds, subject to

reasonableness. Challengers who win can get reimbursed but challengers who lose do not get reimbursed.

2. Rosenfeld v. Fairchild Engine and Airplane Corp . (NY 1955) (212)a. Facts : Derivative plaintiff, a small stockholder sought to compel

the return of over $250,000 paid out of the corporate treasury to reimburse both incumbent and insurgent sides in a proxy contest for their expenses. Proxy fight had to do largely with compensation paid out to a top officer. Reimbursement of insurgents was ratified by shareholders.

b. Majority : In policy contests, corporate funds may be used to pay reasonable and proper expenses incurred in a proxy fight (1) by incumbent directors acting in good faith in soliciting proxies and defending their policies and (2) by successful insurgent groups, where they receive stockholder ratification for such expenses.

i. Incumbent management :1. Other jurisdictions say that management may

look to the corporate treasury for the reasonable expenses of soliciting proxies in a bona fide policy contest.

2. *Rule: When directors act in good faith in a contest over policy, they have the right to incur reasonable expenses for solicitations of proxies.

3. *Policy: incumbent directors must have the resources to defend their policies during a proxy fight from well-funded outsiders. Creating a sweetener for potential directors to serve, to

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make it clear they will have resources avail themselves of any proxy fights in the future.

ii. Insurgents :1. *Also may be reimbursed if in a bona fide policy

contest. Also similar constraints as above. 2. Here majority of stockholders *voted for this

reimbursement* – no need to overrule them.iii. But corporate moneys may not be spent on personal

power contests or where fairness and reasonableness of amounts expended is challenged.

c. Concurring in judgment : i. Need to have only expenses necessary to inform the

shareholders. Some basic expenses (e.g. notice) is always chargeable to corporation, while others – personal power contests - clearly never chargeable to corporation.

ii. *Here. Pl. failed to carry his burden (i.e. mount his prima facie case) to prove that this was a case of unlawful kind of expenditure.

d. Dissenting :i. Incumbents :

1. Rule : Only those expenses reasonably related to informing stockholders concerning corporate affairs are to be allowed.

2. Policy : need to constrain the board, otherwise in light of hands-off rationally apathetic shareholders, board will spend like drunken sailors.

3. *Burden should be on directors to come for the ward with a justification of their expenses, not on the plaintiff.

4. Here the expenses of incumbents (unlike those of insurgents) were never approved by stockholders.

ii. Insurgents :1. **Distinguishing b/w contests over policy

questions and contests over narrow attempts to maintain control are quite impractical. Here, too, the personal is intermixed with the policy.

2. *Unlike incumbents, at the time of their expenses insurgents under no legal duty to inform the rest of the shareholders about policy matters.

3. *Policy: opportunistic insurgents should not be incentivized to wage expensive contests for which shareholders later have to pay a growing price.

e. Eval :

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i. Notice asymmetry between b/w incumbents and insurgents. Even here you only get reimbursed if you win.

ii. Policy : Do we want more judicial scrutiny of these expenditures? It seems under the majority rule it will be very hard to enforce.

iii. Note: Ratification by shareholders is a way to cleanse a potential conflicted transaction by the new (insurgent) board. This sort of ratification is a matter of state law. Del. has recently authorized a corp. to reimburse based on private ordering in the by-laws.

iv. As a matter of empirical fact, these days corporate elections are ho-hum affairs where incumbents freely spend enormous funds hold their seats (218-19). We should think about effect of these numbers on incentives of boards to do a good job.

iii. Inspection of Books and Records 1. General notes :

a. Common law and statutory right of shareholders to get information from company. See e.g. Del Corp Stat §220.

b. Usually so long as there is a proper purpose, you can get access. Usually used to get shareholder lists pre-proxy fights and derivative suits.

2. Saito v. McKeeson (Del. 2002) (224)a. Facts : Del. statute provides for stockholders to be able to

investigate matters “reasonably related to their interests” in the corporation. McKesson Corp. entered merger agreement with HBO. Accounting irregularities lead to reduction of revenues. Saito, holder of McKesson stock, was one of the plaintiffs in a derivative suit, dismissed w/o prejudice because not ready yet. Saito uses statute to get more info about company’s alleged mismanagement.

b. Majority :i. After trial, court found that Saito satisfied the statutory

burden of establishing “proper purpose” for inspection of books and records, but limited him to the following:

1. (Temporal) Only docs created after Saito bought stock since he would have no standing to bring action challenging actions before he held stock:

a. *Inspection rights in statute not defined by standing to bring derivative suit elsewhere in statutes.

b. *Purpose of inspection statute is broader than just bringing suit and therefore inspection must be available even where a derivate suit would be impossible.

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c. Examples of items he can get access to even though they predate his holding stock: (a) ongoing harm (b) activities occurred before but serve as foundation of action you challenging now.

2. Only company docs, not 3 rd party financial advisors:

a. The source of documents generally has no bearing on the right of stockholder’s inspection rights.

b. The issue here, rather, is whether docs are necessary to satisfy Saito’s “proper purpose.”

c. *It appears that since McKesson relied on the 3rd party advisors during the merger, these reports are well within the proper purpose of Saito’s inspection. [KJ: Court also hints that there might be claims against 3rd party advisors directly]

3. Only McKesson files, not HBO since Saito only held McKesson stock:

a. *Reaffirm settled principle that stockholders of parent corp. not entitled to inspect a subsidiary’s books absent showing of fraud or that subsidiary merely the alter ego of parent

b. *However, Saito should have access to any docs that McKesson had received from HBO before the merger.

c. Eval :i. Courts will typically condition access on a showing by

preponderance of evidence a “credible basis” for inferring possible mismanagement. (229) Policy: prevent fishing expeditions.

1. PSLRA stub (229)ii. Companies very nervous about such request, knowing

that it is usually a first step to proxy fight. It is therefore challenging, albeit not impossible. See Del. Gen. Corp. Law §220.

iii. Del. Gen. Corp. Law §220 used to establish threshold issues before one brings suit. After the suit is brought, regular rules of civil procedures kick in (discovery). Discovery can be much broader and more exhaustive.

iv. At common law shareholder has burden of alleging good faith and proper purpose. Many statutes are more

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limited than common law rule. Generally statutes are thought to supplement rather than replace the common law so a suit can be brought both ways. (230)

v. Proper purpose has been recognized to include determining financial condition of corp., ascertaining value of one’s shares, obtaining mailing list for solicitation of proxies. Usually once a court finds a shareholder has a proper primary purpose, any secondary purpose is irrelevant. (230-31). Except where the ulterior motive is really the primary purpose.

vi. In State ex rel. Pillsbury v. Honeywell (Minn. 1971) stockholder requested docs pertaining to Honeywell’s military contracts, admitting later that his only purpose for buying stock was to get company to drop its military business. Petitioner argued that communicating with fellow stockholders was proper purpose but Honeywell argued his interest was not typical stockholder. Held: petitioner’s purpose not proper b/c his only interest in getting company to cease military production. Eval: However Del. courts have disavowed this interpretation of their own law. (231-32)

vii. Courts much more likely to grant access to stockholder lists (for purpose of communication) than to sensitive internal financial data. (232)

viii. Corporation is usually not required to manufacture new items for stockholder if it does not already have access to them. (239)

iv. Stockholder List in a Dematerialized World (232)1. Proxy Distribution and voting rules:

a. Under state law shareholders can appoint proxies to vote their shares at the shareholder meetings. In reality voting occurs almost entirely by use of proxies. Issuers with a class of securities registered under the Securities Exchange Act of 1934 must also comply with federal proxy rules. (232-33)

b. Voting rights depends on the way shares are owned (233)i. Registered owners (aka “record holders”) have a direct

relationship with issuer b/c their ownership listed on issuer’s records. These will usually have right to vote & thus to appoint proxies.

ii. Beneficial owners do not own securities directly but usually through an intermediary (e.g. bank). Most are beneficial these days.

2. Getting the proxy materials to registered owners is easy but what about beneficial owners?

a. IssuerDTCBroker-DealersBeneficial Ownersb. These are usually held in bulk for many brokers and banks in a

central clearinghouse, which is responsible for an “omnibus proxy” transferring its right to vote to its participating

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brokers/banks, who in turn respond with the number of beneficial owners. The issuer then gets proxy materials to intermediaries who get it to beneficial owners, who do not have a voting card but only an instruction form (VIF) telling intermediary how to vote their shares. *Historically brokers/dealers were permitted to vote shares on uncontested matters without instruction from beneficial owners, but under new NYSE rule broker/dealers can still do that except not on board elections. This creates a burden on companies on issuers. (233-35)

3. Role of third parties (236-37)a. Transfer agents maintain records of security holders for issuersb. Proxy service providers help with distribution of proxy materialc. Proxy solicitors are like campaign consultants for contested

raises. Big expense during proxy fights. They help figure out who all the beneficial owners are.

d. Vote tabulators (often done by transfer agent)e. Proxy advisory firms often retained by institutional investors.

(Mutual funds now have to disclose how they’re voting).4. Issuer communication with shareholders

a. Issuer doesn’t know who the beneficial owners are. i. NOBOs (non-objecting beneficial owners) are ones that

give names of beneficial owners to issuer ii. OBOs (who object). These are largely mutual funds and

other institutional investors. Nearly 50-60% of all stock is held by OBOs. This presents a real limit to ability to communicate both in sense of knowing identity and expense even where it is known (237-38).

b. When a shareholder places an info request, you only get as much info as issuer has. If issuer has no info on beneficial owners, requester won’t get it either.

v. SEC’s Proxy Rules (244-50)1. Securities Exchange Act, authorized SEC to promulgate rules (245)2. These detailed rules prescribe exactly how proxy form must look3. They allow “short-slates” that can allow shareholders to split votes b/w

insurgents and incumbents 4. Rules prevent bundling unpopular action inside a popular one by

requiring separate voting on unrelated matters5. Rules require disclosure of key information in connection with

transactions that shareholders are asked to approve (e.g. mergers)6. Proxy ballot must be pre-filed with SEC before meeting but there are

some exceptions (248)7. Note that the term “proxy” and “solicitation” are extremely broad and

therefore rules accordingly apply *very broadly.* Any way you tell someone how to vote it counts as a “proxy solicitation.” For example an advertisement placed in a newspaper has been held to be a proxy solicitation. (248-50)

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a. 14a-1 provides exceptions from the definition and 14a-2 provides further exceptions, however, for example solicitation made to fewer than 10 people [Rule 14a-2 (b)(2)] or advisory firms or institutional advisors publicizing how they’re going to vote. These have been key to allow some information to flow without heavy regulations.

8. How much info you have to send depends on who is sending it. Note the amount of information that needs to be shared (annual report, compensation, etc.)

vi. Shareholder Proposals under Rule 14a-8 1. **Rule 14a-8 permits a shareholder initiated proposal to be included on

management’s proxy statement, if the shareholder has been a beneficial owner of 1% or 2,000 of corp’s voting shares for at least a year – but corp. is permitted to exclude for a number of enumerated reasons.

a. First, double check if shareholder complied with procedural requirements under the rule.

b. Second, look at 14a-8(l) for all reasons company can exclude it.2. Cannot be used for director elections. But under some circumstances

company must incorporate into their materials.3. *If company wants to exclude shareholder proposal, company must

submit reasons to SEC (citing past no-action letters for precedent), which then – if agrees – sends a “no-action letter” that shareholder proposal is omitted; otherwise, if SEC disagrees, management must include it. Note: no-action letters are not reviewable “orders” of an agency under APA. (251)

4. See empirical data about proposals: variations among proponents, amount of support, etc. 252-54. Corporate governance proposals more likely to pass. Boards are not obligated to act on shareholder proposals and there is little shareholders can do other than trying to vote them out – but we know how hard that is!

vii. Materially Misleading Proxies and Rule 14a-9 1. J.I Case Co. v. Borak (U.S. 1964) (256)

a. Eval : SCOTUS held that there is an implied private right of action for violation of the Proxy Rules, although previously nothing had provided for this. *Policy: given limited SEC resources, private right of action enables improved enforcement. This is the granddaddy of Mills, TSC, and Virginia Bankshare. Because private right of action is implied, its scope is unclear and following cases flesh it out – causation, materiality…

2. Cort v. Ash (U.S. 1975) (256)a. Eval : Court narrowed Borak and identified several factors for

determining if a private remedy is implicit in a statute not expressly providing for one: (1) Does statute create a federal right in favor of plaintiff? (2) Indications of legislative intent to create or deny such a remedy (3) Is it consistent with underlying purpose of legislative scheme? (4) is this something traditionally

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left to state law? Since then court has gotten even more narrow for implied right of action.

3. Mills v. Electric Auto-Lite (U.S. 1970) (257) (freeze-out merger)a. Facts :

i. Shareholders bring suit seeking to have merger set aside b/c it was allegedly a result of misleading proxy solicitation.

ii. Owner structure: Am. ManufacturingMergenthelerAuto-Lite. For merger to occur need 2/3. Mergentheler trying to merge in with Auto-Lite.

iii. They allege that proxy statement sent out by Electric Auto-Lite seeking approval of merger with Mergenthaler Linotype Company did not inform the shareholders that all directors were nominees of Mergenthaler (which had majority ownership) [i.e. an omission]

iv. The issue is what are the elements of the cause of action? B/c it is an implied cause of action nothing in statute to guide courts.

v. Dist. court found a “material omission” and after holding a hearing on the causal connection, found that b/c merger approval needed 2/3s control, the vote was a result of minority owners also voting for merger. Therefore a connection existed.

vi. Cir. court reversed on causation – b/c hindsight makes it impossible to accurately look at causal connect, if def. can prove the fairness of terms of merger, it will be taken as a sign that sufficient shareholders would have approved the merger even without the misleading representation on the proxy. Cir. Court appears concerned about flood of litigation by lower standard of causation.

vii. Question presented is what sort of causal connection must be shown b/w a misleading proxy statement and the merger to establish a cause of action.

b. Majority (Harlan): Once plaintiff establishes materiality (a fact that would have affected voting behavior), he does not also need to prove causation.

i. Cir. Court wrong to do such retroactive analysis: *A judicial appraisal of merger’s merits cannot be substituted for actual informed vote. Such a holding suggests that any procedurally bad vote curable by retroactive judicial analysis of the merits.*

ii. Policy : this line of reasoning subverts congressional intent, rights of small shareholders to fair process; relative institutional competence of courts to do ex-post

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analysis of merits; the Cir. Court’s test is bad b/c even if price is fair doesn’t preclude possibility of causation.

iii. The Act and the rules expressly require that the defect be significant (i.e. not trivial). Here the district court found that the misstatements were “material.” No need for courts to add to this requirement, as the Cir. Court did.

iv. What sort of relief is appropriate? No matter if it’s prospective or retrospective. Courts have discretion sitting in equity.

1. Set aside merger, if equitable2. Monetary damages (accounting)*

c. Eval :i. This court awarded attorney’s fees, which later brought

a flood of litigation after which court created a “substantial benefit” test to try to stem the tide.

ii. Materiality : In TSC Industries v. Northway (U.S. 1976) SCOTUS addressed definition of materiality. Generally defined as the significance of an omitted/misrepresented fact to a reasonable investor . *Policy: can’t define materiality as too low a threshold (e.g. what a reasonable investor might want to know) b/c management will bury shareholders in minutia to protect itself against liability. More optimal level of disclosure.* *Appropriate standard of materiality is “an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.” (262) It is an objective test. [However court also recognizes that investors are different – institutional versus conservative individuals – so there is a need to be aware when applying the objective standard.]

4. Virgina Bankshares v. Sandberg (U.S. 1991) (264) (freeze-out merger)a. Facts :

i. Virginia Bankshares seeks to merge with a Bank (where it owns 85% of Virginia Bankshares). It seeks a freeze-out merger via proxy solicitation. Note parties didn’t have to get shareholder approval but b/c the merger was conflicted (why?) they sought shareholder approval to neutralize any future problem.

ii. Proxy describes merger as opportunity for minority stockholders to achieve a “high” value at a “fair” price.

iii. Sandberg did not give proxies and after approval of merger sought damages in court for violation of statute and Rule 14a-9, saying that under Mills, she only needs to show materiality of alleged misstatements.

iv. Dist. and cir. court found violation.v. Question presented is

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1. Whether a statement couched in conclusory or qualitative terms purporting to explain reasons for recommending certain corporate action can be materially misleading within the meaning of Rule 14a-9 and

2. If it is actionable by minority shareholders whose votes not required by law to authorize the action subject to proxy solicitation.

b. Majority (Souter):i. Issue 1: Are misleading statements of opinion

actionable? 1. Certainly a statement of opinion or belief is

material. See definition in TSC Industries.2. Disagree with def. argument that recognizing

liability for statement of beliefs invites litigation based on un-provable issues of opinion. Statements of opinion are factual to the degree that (a) directors hold that belief and (b) imply reasons for beliefs expressed. **The statement that the price is “fair” is independently verifiable.** What is not actionable however are the internal thoughts of directors but so long as there is factual basis, then it is actionable.

3. Here there is objective evidence tending to show the proxy statement exaggerated the benefits.

4. Under 14(a) a plaintiff is permitted to prove a specific statement of reason knowingly false or misleadingly incomplete even when stated in conclusory terms. Not willing to adopt def’s test which would impose no liability where the (misleading) proxy materials are supplemented with accurate data that discloses the real facts. You don’t escape liability by mixing the misleading with the accurate. [i.e. when doing the materiality test need to look at the full mix of facts available to the plaintiff and all the circumstances.]

5. Two levels – is the underlying fact as to which statement is being made material? Is the statement of opinion material? Courts conflate these two questions.

ii. Issue 2: Can a member of a class of minority shareholders whose votes are not required by law or bylaw to authorize the transaction sue?

1. No. Under state law the minority shareholders did not have to vote on the merger (b/c

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company already had majority stake). For this reason there is no legal harm that is actionable.

2. [Souter assuming pl. is not losing any state rights, where this case is still actionable. Under state law plaintiff can still pursue this claim. Therefore not actionable.]

c. Eval :i. In Wilson v. Great American Industries (2nd Cir. 1992)

two companies merging. Plaintiffs, who had been minority shareholders in one of them alleged that material misstatements in proxy statement caused them to vote for merger. 2nd company had more than enough shares to approve merger. Unlike Virginia Bankshares, state law provided holders who voted against merger with a means of receiving an appraisal remedy. Held: Virginia Bankshares did not bar pl’s action. Unlike that case there was an actual loss that occurred. (271)

ii. Bottom line: if shareholder seeks to set aside a vote on claim of misstatements/omissions must do not more than prove materiality. (272)

iii. If a proxy statement is materially misleading and majority of shareholders vote in favor, does a shareholder who did not grant a proxy in reliance of the misleading statement have standing under Rule 14a-9? DC Cir. has held yes in Cowin v. Bresler.

iv. Mens rea requirement for making false statements? In Gerstle v. Gomble-Skogmo (2nd Cir. 1973) Judge Friendly held that negligence is the proper standard to establish liability (273)

5. Business Roundtable v. SEC (DC Cir. 2011) (supplement)a. Facts : Business Roundtable and Chamber of Commerce petition

for review of SEC’s proxy rule 14a-11, which would have required companies to include shareholders' director nominees in company proxy materials in certain circumstances. They argue there is a violation of APA procedure under §551.

b. Majority :i. Rule 14a-11 is arbitrary and capricious

c. Eval :i. Dodd-Frank authorized this sort of thing. Most

commentators strongly support the rule, which ended up being far narrower (weaker) than originally wanted.

ii. The only point is to get one of your names on the company’s card.

iii. Limitations: 1. Cannot be used by anyone who has any intent

to take over the company2. 3% of shares for 3 years

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3. Max nominate 1 director or 25% of directorsiv. Alternative is private ordering (which DC Cir appears to

be endorsing) – Del. has amended corp. code that shareholder may adopt bylaws that will allow this same approach.

v. While 14a-11 failed, short slates help insurgent shareholders even if not as much as the rule.

c. Limited liability and its exceptions (282)i. General notes :

1. Standard rule is that shareholders (by statute) and managers (by agency principles) have no liability for corporate obligations. The only thing they stand to lose are their investments.

2. Policy behind limited liability rules : a. Transforms equity security into a homogeneous good because

investors price it equally allowing for a healthy secondary market

b. Encourages capital formation & diversification (investment in many different companies, reducing overall risk and cost of capital)

c. Reduce costs of due diligence, a transaction cost that will discourage investment (as shareholders are exposed)

d. Encourage innovation, risk-taking behaviore. Enables secondary trading in equitiesf. Keeps costs down, enabling allocation of global capital in U.S.

versus abroad3. Occasionally no liability rule has been criticized, suggesting that across

the board liability for some things (e.g. torts)4. However, there are some extreme cases where the limited liability rule

is lifted (283)5. Tests announced by courts or piercing the corp. veil similar but

application varies. (299)6. Empirically, courts never impose liability on public shareholders, but

sometimes make parent company liable for subsidiary. 7. §102(b)(6) default is limited liability but allows company board to

navigate away from limited liability rule. It is optional, rather than mandatory.

ii. Fletcher v. Atex (2nd Cir. 1995) (283) [corp. sued]1. Facts :

a. Pls. filed suit against Atex, a wholly owned subsidiary of Kodak (i.e. Kodak is a sole shareholder) for repetitive stress injuries caused by computer keyboards manufactured by def.

b. Pls. had multiple theories of liability, including that Atex was merely Kodak’s alter ego, b/c Kodak dominates Atex.

c. Dist. court rejected and granted summary judgment for def. Pls. appeal.

2. Majority : Plaintiff fails as a matter of law to establish the degree of domination necessary to disregard corporate identity and impose liability on parent company (sole shareholder).

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a. Under NY choice-of-law principles, Del. law applied. Del. law recognizes “alter-ego theory” of liability where corporate veil pierced when pl. shows * *(1) parent and subsidiary operate as single economic unit [sub-factors: is the subsidiary adequately capitalized, solvency, if subsidiary functioned independently with its own corp. formalities honored, if parent company siphoned (or commingled) subsidiary’s funds, if subsidiary functioned as parent’s façade] and (2) there is an element of injustice/unfairness.**[the fact that pl. might go uncompensated if sues judgment-proof shell of a subsidiary is not “unfairness” for this purpose. It needs to be more than that] The bar for disturbing the corporate form is high.

b. Looking at sub-factors def. has demonstrated Atex followed corporate formalities separate from Kodak.

c. Pl’s arg is unconvincing as to the first prong:i. Atex’s participation in Kodak’s cash management

system is fine. It does not demonstrate “complete commingling” i.e. no siphoning. Overall financial health not affected by this system.

ii. Kodak’s requiring Atex to seek approval before major corporate decision is typical of parent corporations. Not pure alter-ego, façade.

iii. The overlap in boards was negligible. Even under Del. law you could have far greater overlap and still not be enough. Need more than just this…

iv. Presence of Kodak logo in Atex materials does not demonstrate the two companies operated as single entity. (KJ: External representations may be relevant but sloppy marketing, as opposed to fraudulent marketing, is not dispositive)

d. Pls. offer no evidence of second prong (injustice)3. Eval :

a. Piercing the veil is not something a court is eager to do.b. Here it was probably more expensive to keep Atex as a separate

subsidiary, but might have kept it around in such a way for the very purpose of shielding themselves form liability.

iii. Walkovszky v. Carlton (NY 1966) (289) [individual sued]1. Facts : Pl. alleges he was injured when he was run down by a cab owned

by Seon Cab Corp. Def. here is a stockholder in 10 cab corps each owning a few cabs. Pl. alleges these are all run as one single entity and the corporate veil should be pierced to extend liability to def.

2. Majority : a. There is a difference b/w corporations being run together as an

entity and corporations merely serving as dummies for individual stockholder’s personal gain. Potentially both justify piercing the corp. veil but in first case a larger corp. entity would be liable while in latter case an individual would be liable [KJ: It is easier to pierce the veil on parent that is a corporation than a

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parent who is an individual. Easier to argue that sub. and parent are one “economic unit” where they are corporations than where you are trying to mix sub. corporations and individuals. Creditors, too, would be much more hesitant, less certain to do business with subs. if they might always be exposed to claims against other subs just b/c owned by the same individual. Whereas that analysis is simpler where parent is a corporation.]

b. Here i. Def. operated corp. pursuant to state law. Just b/c

insurance bought pursuant to the law was inadequate for pl’s recovery is a choice left for legislature.

ii. There are no allegations that he was conducting business in his individual capacity.

iii. No indication that def. commingled personal finances with those of corporations.

3. Dissent : a. This is 1 of 10 such corporations organized by def. – each with

only a couple of cabs, each undercapitalized to avoid responsibility liability beyond what statute required.

b. At the very least the matter should not be disposed of on the pleadings by dismissal of complaint

c. It’s against public policy to allow individuals to set up flimsy corporations only to escape personal liability.

4. Eval : .a. Foreseeable victim going uncompensated b/c cab company was

not required to carry greater insurance.b. Note that this seems like an abuse of the corporate form,

however, majority still leaves the door open by dismissing without prejudice and allowing pl. to bring the case against individual def.

c. KJ : Particularized facts of each cased matter a lot given the balancing test. Undercapitalization

iv. Minton v. Cavaney (Cal. 1961) (294) [individual sued]1. Facts :

a. Seminole corp. operated a swimming pool. Pl’s daughter drowned and after a suit, pls. recovered a judgment that has remained unsatisfied. In a separate suit, pls. sued Cavaney, the director & treasurer or corp.

b. Seminole had no assets to operate. The def. was also the director and secretary and treasurer of the corp. According to def’s own statement it never functioned as a corporation. Looks like a shell.

c. Court granted relief and def. appeals.2. Majority :

a. Pls. introduces evidence that Seminole never functioned as a real corporation.

b. Def. argues that pl’s evidence is not enough to hold him liable under “alter ego” doctrine b/c pl’s fails to show (1) unity of

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interests and ownership that separate identities of corp. and individual no longer exist [again sub-factors include commingling of funds, providing inadequate capitalization, directly meddling in corp. affairs] and (2) injustice/unfairness would result from treating corp. as separate entity.

c. Here : i. No attempt to provide adequate capitalization

ii. Def. was both director and secretary/treasureriii. Actively participated in corp. affairs.

d. (From court’s point of view, in spite of def. being a lawyer, he agreed to take on obligations where he took on the duties of a director)

e. But : pls did not allege any evidence on issue of Seminole’s negligence relying solely on previous judgment. Def is right that they cannot be held liable for Seminole’s debts without opportunity to relitigate the issues (probably b/c there was no real trial the first time – maybe a default judgement)

3. Eval :a. Note the test here is similar to Atex, but b/c the def. is an

individual rather than a corporation, the test is reworded a bit (commingling, instead of syphoning; holding oneself out as corp.)

b. Undercapitalization is an agency cost. It might benefit one group but not others. Factors we look at to see if company is undercapitalized (1) leverage (i.e. debt relative equity) (2) riskiness of the business.

c. Arnold v. Browne (Cal. App. 1972) said that evidence of undercapitalization is one factor – an important factor, but it is not sufficient by itself to pierce the veil. (297)

d. Slottow Fidelity v. American Casualty (9th Cir. 1993) said undercapitalization may be sufficient to pierce the corp. veil (297) What is important is the parent-sub. context and also here we have a case of “woefully inadequate” capitalization (i.e. highly leveraged and risky).

e. Radaszewski v. Telecom (8th Cir. 1992) to pierce corp. veil must show – among other things – that def’s control of subsidiary was used to commit fraud, wrong, violation of legal duty. While undercapitalization may be enough to create an inference of wrongdoing, here subsidiary had adequate insurance coverage which means it was financially responsible. A lot of fairness concerns go away and also indicates that intent by corporation to be able to cover its own debts. (297-98)

f. Berkey v. Third Ave. Ry. Co. (NY 1926) Cardozo explains public policy of overcoming usual non-liability rule is to prevent people from abusing corp. form to escape liability. (298)

g. Note on direct liability i. In addition to piercing-the-veil cases, I parent-subsidiary

context are cases in which a parent is sought to be held

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directly liable as primary wrongdoer on the ground the it directed the subsidiary’s operation. For example in U.S. v. Bestfoods (U.S. 1998) gov’t sought to hold parent company liable for subsidiary’s enviro pollution. SCOTUS reversed Cir. Court’s vacating liability. It said that CERCLA rested liability not only on ownership but “operation” and remanding back to Dist. Court to determine if the parent company had a significant role such that it “operated” the facilities in question, as distinct from more run-of-the-mill oversight by parent over subsidiary. (300-01)

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4. Creditorsa. Ways of raising money

i. Retained earningsii. New debt

iii. Issue new equity securitiesb. Why issue debt :

i. Tax advantage : Generally considered cheaper, b/c interest payments are tax deductible (while dividend payments are not)

ii. Reducing agency costs . Corp. has to make interest payments, which might be a way to discipline management by encouraging them to plan cash flow and not to whittle down corporate reserves.

c. Indentures i. These are contracts . Like the Del. network effect, NY is used very often for

indentures.ii. Personal guarantee will allow you to go after person’s assets. These are

frequently included as an incentive to have business make its payments.d. Protections provided for (voluntary and involuntary) creditors

i. There is much more protections for shareholders but as a general matter the law does not provide such protections to creditors…

ii. Creditors don’t have voting rights (other than in bankruptcy) and therefore have less say.

iii. Directors have obligations only to shareholders not to creditorsiv. For this reason creditors try to spell out their rights super-clearly as can be seen

in indentures.v. Protections include Bankruptcy Code, Uniform Fraudulent Transfer Act,

equitable subordination, and limitation on dividends under creditor’s rights law … outside of these the main remedies are contractual based on the language of the indenture.

1. Bankruptcy Code §548 / Uniform Fraudulent Transfer Act §4 a. You can undo certain transactionsb. Must show:

i. When there is actual intent to defraud ORii. When there is constructive intent:

1. Value received < reasonably equivalent valued AND

2. Concern about insolvency2. **Equitable subordination of Shareholder Claims

a. **Equitable subordination: when corp. in bankruptcy, controlling shareholder’s claims may be subordinated to claims of others (e.g. preferred shareholders) under certain circumstances. Known as “Deep Rock” doctrine. (135) **

b. Comparison with Piercing : Equitable subordination is less drastic – it merely ranks the investment lower, while piercing fundamentally opens up his liability beyond his investment. Therefore courts will find it easier to subordinate (based on evidence of misuse for example) (136)

3. **Limitation on Dividends under creditor’s rights law

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a. Two set of bodies of law govern: (948)i. Creditor’s rights (or fraudulent-conveyance) law : center

on concept of insolvency and emphasize the liability of shareholders for the receipt of improper dividends. Insolvency defined two different ways, although it is possible to be insolvent in one sense but solvent in other ways:

1. *Inability to pay debts as they come due: this def. embodied in most corp. dividend statutes. Liquidity crisis (cash flow). The law is that as long as you can pay your debts as they come due, you cannot be forced into bankruptcy.

2. *Liabilities in excess of assets: embodied in **Bankruptcy Code and Uniform Fraudulent Transfer Act.** (balance sheet). Once you are into bankruptcy, this definition becomes more…

ii. State corporation law : emphasize the liability of directors for the payment of improper dividends.

b. Advantage is that you can go after directors. But thought to be pretty toothless.

c. Case law has interpreted this not only as a restriction on shareholders (e.g. share repurchase)

e. Factors effecting interest rate i. Business risk – promises made by debtor in the covenants

ii. Seniority – paying a higher rate to subordinated creditors (e.g. suppliers) and lower rate to higher ranked.

iii. Collateral – require company to set aside certain assets in the event of bankruptcy, you have first rights. Must be a filed claim with the state to put the world on notice.

iv. Features 1. Redemption rights – based on expectation on trend in prevailing

interest rates2. Convertibility – possibility of upside in exchange of a little less interest.

f. In a public company, you can get all the disclosed documents, in private company that will be unavailable. So one of the things creditors will want with a private company is to get a right to information to have better way to make a decision.

5. Fiduciary Dutiesa. Duty of Care

i. Basic standard of care 1. General notes :

a. A director must exercise the same care that a reasonably prudent person would exercising under the circumstances. Two scenarios:

i. Malfeasanceii. Nonfeasance (Francis)

b. See basic components of that duty in Francis.c. Elements:

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i. Fiduciary obligation that runs to plaintiff.??ii. Breach

iii. Causation (will be an easier way to cut off liability esp. in non-feasance)

2. Francis v. United Jersey Bank (NJ 1981) (420)a. Facts :

i. Def. is a director of a reinsurance brokerage which operated as a close family corporation with def. and 2 children as directors, and they also serving as officers (management).

ii. Managers (her children) commingled funds contrary to industry practice. Trial court found massive misappropriation of money belonging to the clients of the corporation. They start covering payments coming due with client’s money. Ultimately file for bankruptcy.

iii. Def. director (mother) knew virtually nothing about this. **Trial court found she never made any effort to discharge her responsibilities.**

iv. Issue is def’s individual liability in negligence for failure to prevent misappropriation of funds by children (directors & officers).

b. Majority :i. Finding liability rests on def’s duty to clients and breach

of that duty, which was a proximate cause of their losses.

ii. Duty & standard of care 1. **NJ business corp. statute makes incumbent

on directors a duty of care to act as ordinary prudent persons would under similar circumstances in like positions, which includes usually:

a. Acquire at least a rudimentary understanding of the business of the corp. Lack of knowledge is not a defense.

b. Obligation to keep informed about activities of corp. Ignorance of misconduct not a defense.

c. Only responsible for general monitoring, not day-to-day, of affairs and policies.

d. Regular attendance of board meetingse. Familiarity with financial status by

review of financial statements (depending on industry). This might give rise to duty to inquire further into matters revealed by those statements. **Duty to object if discover illegal

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action and to resign if no corrective measures are taken. **

f. Seek advice of counsel.g. **Under some circumstances, duty to

prevent illegal conduct by co-directors; in an appropriate case by threat of suit. **

2. Standard will differ depending on the circumstances. The duties might be different b/w a small family-held corporation and a large publicly-traded one.

3. **Duty depends, too, on the obligee.**a. Relationship to stockholders is that of

a fiduciary.b. Relationship to creditors differs on the

type of business. Banks [and reinsurance brokers] also exercise role as fiduciary for depositors/creditors.

iii. Breach : 1. In reinsurance industry the industry practice

requires treating the brokerage business akin to a bank – they held money in trust, which gave rise to a fiduciary duty.

2. Def. should have read the fin. statements, known, and acted on the information that money was being misappropriated. Def. breached her duty.

iv. Causation :1. Analysis - if she had acted would it have avoided

the loss?2. Given the duty to clients in reinsurance

business, her duties extended beyond mere objection/resignation to reasonable attempts to prevent the misappropriation of funds.

3. Here her failure to act contributed to the escalation and continuation of the corruption.

4. While analysis of inaction is admittedly hard, there is reason to believe that causation here can be inferred because if she had objected, it would’ve prevented the losses

v. Damages full amount of the losses. c. Eval :

i. KJ : Some concern about holding director 100% liable for inaction in light of another party’s active malfeasance. Often it will be the causation prong that will limit what we see in these cases.

ii. Why not business judgment rule ? Usually arises after a decision was made (not nonfeasance)

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iii. Aronson v. Lewis (Del. 1984) – dir. liability is predicated upon concepts of gross negligence. (432)

iv. Many have criticized the “gross negligence” standard arguing for one flexible across-the-board “reasonable care under the circumstances.” (433)

ii. Business Judgment Rule 1. General notes :

a. Business judgment rule essentially creates a gap between standard of conduct and standard of review. Usually in terms of “rational basis.” The level of review in this case is really minimal.

b. Policy : relative institutional role of courts c. Note the difference b/w standards of conduct and standards of

review (437-39) We have a pretty high standard of conduct, setting the bar high for directors. But because of questions of institutional competence etc.

d. What triggers the business judgment rule :i. Did board make decision

ii. Decision-making process is reasonable [clarify]1. Informed themselves 2. Decision making process reasonable

iii. Good faith1. Never satisfied where violation of the law

iv. No actual conflict of intereste. If business judgment rule not triggered, the standard of review

and standard of conduct are the same, which practically means it is a negligence standard

2. Kamin v. American Express Co. (NY Supreme 1976) (433)a. Facts :

i. In this stockholder derivative action plaintiffs allege certain in-kind dividend – a distribution of certain shares (as opposed to selling them at a significant loss) to shareholders – is a waste of corporate assets because it non-deductible for taxation purposes and results in $8 million tax loss.

ii. Essentially management and directors disagree about the effects on the stock price of either of these two courses of action. (If you believe in efficiency in market then AmEx’s stock price should already incorporate the loss even before it was floated in the tax statement. Directors disagree.)

iii. Pls. also allege that there was a conflict of interest since 4 of the directors had a stake in the outcome. Note that where there is a conflict of interest, the business judgment rule will never kick in.

iv. Pls. seek injunction or damages. Directors claim that posting the loss in the publicly disclosed balance sheet will actually be bad for the stock price.

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b. Majority : Whether to declare a dividend is exclusive matter of business judgment (no problem here)

i. The allegation goes to a question of business judgment. Rule: mere errors in judgment not actionable in court (only something more like bad faith, fraud, etc.) Specifically, a dividend is the exclusive providence of directors’ business judgment. Not enough to allege as pls. do here that directors made an imprudent decision.

ii. Nor is this actionable in negligence, which demands the neglect of some legal duty.

iii. Here **The board considered and unanimously rejected the plaintiff’s proposal when they first brought it.** They gave the issue appropriate consideration. Directors are entitled to exercise their honest business judgment on the information before them and to act within their corporate powers. Courts are not suited to second guess these decisions.

c. Eval :3. Smith v. Van Gorkom (Del. 1985) (439)

a. Facts : i. Longtime CEO solicited a leveraged buyout merger offer

from an outside investor, and acting on his own arbitrarily arrived at a $55 share price (even though analysis showed that it was at the lower range of what firm could get).

ii. **Terms: 90 days, no solicitation of offers (makes it impossible to get real bidders), no propriety information sent to other bidders (makes it impossible to get real bidders), financing condition (allowing buyer to walk away); and sweetener for the buyer…all these terms made it effectively impossible for the “market test” to work.

iii. **CEO calls a board meeting without telling them the purpose and quickly gets the board to accept the offer without their investigating, receiving any written report, seeing any evaluation done, or seeing the agreement, without showing the merger to their investment bankers.**[they did not become informed that is reasonable in light of the circumstances. This is a major change.]

iv. After staff pushback, revised agreement the agreement is amended such that appears to strengthen the terms of the market test, but in reality do not do that.

v. Class action brought by shareholders of def. Trans Union seeking rescission of merger into outside investor’s (def) wholly-owned subsidiary.

vi. Lower court held for defs. finding that because board considered the merger several times it fell within the

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business judgment rule. (i.e it was informed and not reckless). Chancery court looks at the whole long-time period. [Whereas this court says that the first meeting produced a binding agreement, so must look more specifically at that specific meeting]

b. Majority : i. The business judgment rule is a presumption that

decision was an informed one. It can be overcome. The usual standard of conduct is gross negligence.

ii. The inquiry here is two-fold :1. Did directors reach an informed business

judgment at the first meeting? Noa. Directors did not adequately inform

themselves as to CEO’s role in forcing the “sale” of the company and establishing the $55 per share price. Directors were uninformed as to the intrinsic value of the company. [All the circumstances demonstrate a rushed decision, uninformed by any report, without any prior notice.] Directors were duty bound to make more of an inquiry. At minimum directors were grossly negligent in approving the sale upon two hours consideration.

b. Def’s args. that $55 was over the $38 market price, and that the board agreed to a “market test” to get a better offer are unavailaing.

i. Using the market price is fallacious. What would have been necessary is an assessment of the value of the whole enterprise. No directors requested that information making the meeting clearly based on a lack of information about the company’s value.

ii. The market test argument fails because the Merger Agreement barred active solicitation of outside offers. There was nothing in there that supports def. board members arg. that market test was real or that they could withdraw and take a higher offer.

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2. Were the defects at first meeting subsequently cured at the later two board meetings? No

a. The later meeting was designed to remedy staff revolt by extending “market test” however board again approved it without scrutiny. The cumulative effect of the amendments, however, was to actually reduce rather than extend the “market test.” Meanwhile CEO and outside investor moved quickly to seal the agreement. The board acted grossly negligently and its actions did nothing to cure defects of its initial negligence at the first meeting.

b. **Def’s arg. that stockholder approval cured any defects is also not persuasive b/c only an informed body of stockholders can cure (ratify) the defect and here stockholders lacked material information.

c. Dissenting i. Application of the business judgment rule is wrong. The

Board was highly qualified and well informed about eh affairs of the company. The board here was fully engaged in the process (even required amendments). Board did not act in a grossly negligent manner. [Dissent focused on directors generally being informed, while majority emphasizing not just general expertise but actual information in this decision]

d. Eval :i. One way to think about the business judgment rule as

reviewing the merits of a decision for minimum rationality assuming the procedural elements of the duty of care are satisfied under the reasonableness standard. (456-57).

ii. Note this is not a derivative suit but a direct shareholder suit.

iii. *Business judgment rule did not apply b/c the requirements of the rule (see above) was not met – directors did not have adequate information for making the decision that they did.

iv. Note Del. Stat. §141(e), which allows Board to allow on good faith presentation by corporation staff, finding that there was reason to suspect that the presentations by staff at the first board meeting were not on point – they were very preliminary and did not take in the

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intrinsic worth of the company. Board effectively blindly relied.

v. These days boards might get an outside investment bank to come in and render an opinion about the fairness of the price which will provide board with cover.

vi. The court is being emphatic here about the board member’s duty to enquire. Court emphasizing that Board should be asking if this is a fair price and was the process by which analysists got to the price were appropriate?

vii. What seems to convince the board is the significant premium paid over the market price of shares trading at that point at $38. However, there is a strong argument that stock price is not a good indicator for a company’s actual value. Reason to believe the public prices do not reflect inside information. Here effectively court saying that the premium is good but not good enough.

viii. Del. Stat. §102(b)(7) liability shield was passed after this decision to allow exculpatory provisions

ix. Note: high scrutiny involved in this case regardless what the court calls it probably due to the type of transactions

iii. Duty to Monitor, Compliance and Internal Controls : 1. General notes :

a. Caremark suggests a duty to have a compliance system in place2. In re Caremark International (Del. Ct. Chan 1996) (457)

a. Facts : i. Caremark subject to a criminal investigation with fed.

and state authorities based on alleged violation of laws applicable to healthcare providers.

ii. Caremark takes a number of actions to strengthen its internal controls and assure compliance with company policy and federal law. The criminal case pleads out, including recognition that no senior executive participated or was willfully ignorant of any wrongdoing.

iii. Shareholders file this derivative action for breach of fiduciary duty by essentially allowing the criminal violations to occur.

iv. The case is settled and before the chancellor for approval.

b. Majority : Board has an affirmative duty to attempt in good faith to assure that a corporate information and reporting system exists and is adequate

i. The question is the proposed derivative settlement is fair and reasonable.

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ii. Question is whether directors are liable for failure to monitor on the negligence theory? **That begs the question what is the board’s responsibility with responsibility to monitor the company’s internal operations?**

iii. Delaware Sup. Ct. says that absent suspicion of wrongdoing directors have no duty to surveil employees, but this holding must be read narrowly not broadly that Board has no responsibility to assure adequate reporting system in place in the corporation.

iv. But a number of factors have changed since that decision: Federal criminal law seems to be demanding more of corporations…companies have also undergone a lot of changes….etc.

v. **Duty: Director’s duty includes the good faith attempt to assure that corporate reporting system exists and failure to do so under some circumstances – in theory - may render a director liable for losses.

vi. **Liability: In negligence claim predicated on director’s nonfeasance plaintiff must make out that the failure was sustained or systematic.

vii. Here the settlement on balance is fair and reasonable. Plaintiffs, in fact would have a hard time making out their claim. Here there was a good faith attempt to be informed of relevant factors and there was no indication of sustained or systematic failure to exercise oversight.

c. Eval :i. **The court creates a new affirmative duty, although it

suggests that liability may attach at a different level.ii. What are elements of a reporting compliance system ?

1. Oversight by board committee2. Chain of reporting up3. Training4. Policies (e.g. whistleblower protections,

confidentiality)5. Internal discipline

iii. Sarbanes-Oxley provides a minimal floor for what a public company must have with respect to reporting requirements. Ads a new section to SEC submissions, including vouching for financial statements and vouching for other disclosures based on CEO/CFO’s review and internal and external auditors. Requires an audit committee with at least one financial expert with authority to investigate by hiring outside counsel. State law will add more often.

iv. Liability Shields : 1. General notes :

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a. Even where breach is established there are three elements that may reduce or eliminate personal liability for directors

i. Direct limits (i.e. risk of loss moved from director to company)

1. See Del. Stat. §102(b)(7) which provides a liability bar but excludes failure of duty of loyalty, acts or omissions in bad faith, or knowing violation of laws. Only applies to monetary damages (not injunctive relief).

ii. D&O Insuranceiii. Indemnification

2. Malpiede v. Townson (Del. 2001) (471)a. Facts :

i. *Firm subject to a bidding contest between 3 bidders. One of them ultimately bids the highest but conditioned the acceptance on a “no-talk provision.”

ii. When second bidder comes in higher, firm’s board feels it must reject the higher offer b/c of “no-talk” provision.

iii. *Plaintiffs file a class action for damages caused by termination and rejection of the higher offer based on a breach of fiduciary duty theory.

iv. Court of Chancery dismisses the complaint.b. Majority :

i. The primary issue is whether board was grossly negligent in failing to implement a routine defensive strategy to negotiate a higher bid.

ii. Although plaintiffs unlikely to overcome the business judgment rule we assume that they state a valid due care claim.

iii. The issues then becomes whether the firm’s corporate charter’s exculpatory clause will bar this suit?

iv. The complaint does not allege any violates that fall within the exception to the exculpatory provisions authorized by 102(b)(7). The claim about duty of loyalty fails. Although CEO had a stake in getting the dominant bidder, there is no evidence that he dominated the board.

v. The rest of the claim – the negligence claim – is clearly barred by the exculpatory provision.

vi. *Policy statute allows corporations to bar liability of directors for money damages in negligence actions (but not for bad faith, duty of loyalty) in order to encourage risk-taking.

c. Eval :i. Again money damages barred but not injunctive relief.

ii. §102(b)(7) designed not to allow to get a party into court.

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iii. But once you get into court at the trial stage, Emerald Partners v. Berlin (Del. 1999) says that the burden of demonstrating good faith is upon the party seeking the protection of the statute. (470)

v. Directors’ and Officers’ (D&O) Liability Insurance :1. General notes :

a. See examples on 1539 in statutory supplementb. Often a director will be entitled to corporate indemnification for

losses sustained in suits against her, but not always (e.g. not in negligence suits). So corporations often purchase D&O insurance. (476-77).

i. Reimbursement to corporation for indemnifying directors to manage the cash flow for the company

ii. Personal coverage for directors can even be negotiated c. However, this doesn’t fully protect directors, given that classes

of claims not covered, there are policy limits, and **only covers claims made while the policy was in force – i.e. claims made during coverage period even if the offense transpired before the policy was in effect **

d. Further insurer may not be liable if it can establish certain defenses (see 477)

e. In terms of incentives this means that plaintiffs – going after the policy – will sometimes under-plead their case to go after those claims that are covered by the policy.

b. Duty to Act in Good Faith i. General notes :

1. xii. In re the Walt Disney Co. Derivative Litigation (Del. 2006) (479)

1. Facts : a. **President of Disney was terminated early with a $140 million

severance package. Shareholders bring a derivative action against him and directors alleging breach of duty of good faith b/c he was unqualified, b/c he was pushed heavily by Michael Eisner, b/c no one seemed to have reviewed his employment contract before the meeting.

2. Majority :a. At least three categories of fiduciary behavior are potential

candidates for “bad faith” label:i. Subjective bad faith – i.e. actual intent do harm. None

here.ii. Gross negligence – i.e. breach of due care.

1. But this cannot also constitute bad faith by itself because from legal point of view these duties must remain distinct from each other.

2. Legislature intent is clearly to keep these two separate: (1) Del. Stat. §102(b)(7) which provides for exculpatory clauses specifically excludes bad faith acts. (2) Similarly

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indemnification statute allows for indemnification but not for violation of duty of to act in good faith.

iii. **Intentional dereliction of duty: conscious disregard for one’s responsibilities. **

1. This is the proper standard – a vehicle through which to address claims that are in between the extremes of intentional bad conduct and negligence.

2. **Examples: acting intentionally for purpose other than best interests of corp.; acts with intent to violate applicable law; intentionally fails to act in face of known duty to act, demonstrating conscious disregard for his duties.**

3. Eval :a. In Stone v. Ritter (Del. 2006) court said that where directorial

liability for corporate loss is predicated upon ignorance of bad conduct in the corporation only a sustained or systematic failure of board to exercise oversight will establish lack of good faith necessary to establish liability. See Caremark.

i. **Violation of duty of good faith does not by itself give rise to liability. It is more likely to be an element of duty of loyalty.** [up to this time good faith was considered on the same level as duty of loyalty and good care, but where court is saying good faith is but an element of the other two primary duties] Duty of good faith is an element of duty of loyalty.

ii. Caremark articulates necessary conditions predicate (a) directors utterly failed to implement any reporting system or controls OR (b) having implemented such a system consciously failed to monitor these are violations of loyalty.

c. Duty of Loyalty i. General notes

1. Elementsa. Duty of loyaltyb. Breachc. Damages

2. After business judgment rule, duty of care has less bite than duty of loyalty

3. Today this is where most of the litigation is. Two types of self-dealing come up:

a. Direct self-dealing (i.e. director getting paid to do some service)b. Indirect self-dealing (e.g. Director in one company is also an

officer in another company which has a contract).4. Historically voidable but no longer. Now governed by statute.

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5. If person doesn’t get prior approval or doesn’t cure the party that engaged in self-dealing has the burden of demonstrating substantive fairness

a. Terms: are these fairb. In the best interest of corporation?

6. This is a fact-intensive inquiry, so the burden of proof is often dispositive of the case:

a. The fact that director may lose his job is not a type of conflict that may give rise to self dealing (see below)

b. Sole proprietor that might lose a significant business that can be sufficient (see below)

7. Statutory regimes often have procedural checks on the substantive fairness:

a. Approval of transaction by disinterested directors and/or shareholders.

b. Del. interpreted the statute differently from Iowa. See end of section.

ii. Gantler v. Stephens (Del. 2009) (486)1. Facts :

a. **Board put company up for bid and receives offers. Management stalls (preferring taking the company private instead)…leaving only 1 offer in place. In spite of positive assessment from the independent financial advisor, board rejects the offer.

b. Board moves forward on “privatization” plan and approves it (**reclassifying the shares, which takes away shareholder’s voting rights**) and submits for SEC approval. Shareholders narrowly approve the reclassification.

c. Plaintiffs in derivative action complain that directors breached their fiduciary duty in rejecting a valuable opportunity to sell the company – against the advice of their own financial advisor. Basis for complaint has to do with conflict-of-interest (inadequate process), not just a bad decision on the merits like argued in Van Gorkom

2. Majority :a. Rejection of bidders

i. Does business judgment rule apply?1. Was decision made in good faith pursuit of a

legitimate corp. interest?2. Did Board do so “advisedly”?

ii. Directors : 1. **Not every time a director is concerned about

losing their jobs is by itself sufficient to create a conflict of interest. Needs to be something more substantial (material)

2. To get past 12(b)(6), pls. must state a cognizable claim that the defs. acted disloyally that would rebut the business judgment rule.

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3. Here pl. has done that, demonstrating that the majority of the board was actually conflicted (by their own admission – they had a direct material financial stake in the outcome) which suffices to rebut the business judgment presumption.

iii. Officers :1. **In addition, we hold that fiduciary duties of

loyalty and care apply equally to corporate officers, as they do to directors. ***[significant holding, but doesn’t come up very much]

2. Here defs breached duty of loyalty as officer for the same reason they breached the duty as directors: i.e. not preparing the due diligence materials and stalling the deal.

3. Chancery court wrong to dismiss this on 12(b)(6)

b. Ratification of “Privatization” plan i. Chance court was wrong to dismiss this count after

finding that majority of directors approved the Reclassification lacked independence.

ii. Common law shareholder ratification is properly applied to circumstances where a fully informed [**i.e. full disclosure of material facts.**] shareholder vote approves director action that does not legally require shareholder approval. (i.e. ratification does not apply where approval is required by statute) **The statutory vote and the ratification vote must be separate given their different funcitons* The effect of ratification is to subject the challenged director action to the business judgment rule (as opposed to extinguishing the claim altogether). Nothing alters the long established principle that only a unanimous shareholder vote can ratify void acts such as fraud, waste, gift.

iii. Here : ratification could not cure the problem b/c a shareholder vote was statutorily required. In addition because proxy was materially misleading that precludes ruling as a matter of law that vote was fully informed. Therefore there was no “ratification” and it was erroneously dismissed

3. Eval :a. Note shareholder ratification does not extinguish review – it

merely allows business judgment rule to kick in.b. If get past 12(b)(6),

i. Def can argue no conflictii. Even if conflict, outcome was fair and in interest of

corporationiii. LS: What are the elements of the violation of loyalty??

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c. Finish reading 493-96 i. Traditional rule – any conflict used to automatically

render the transaction void or voidableii. Modern rule – now never voidable. Now allows more

self-dealing transactions.iii. Lewis v. S.L. & E (2nd Cir. 1980) (496)

1. Facts : a. Brothers and sisters have shares of two small family-held

corporations, landlord company and tenant company.b. The boards are the same and one company (landlord)

effectively exists for benefit of another (tenant). And the one functions as a shell w/o regular board meetings etc.

c. At death of father they agree that those who only held stock in one corp. (landlord) would sell those to the other siblings.

d. As date approached one of the brothers who agreed to sell came to believe the corp. was undervalued. When his siblings refused to grant access to financial data, he sued alleging wasting the assets causing tenant firm to lease space from landlord firm at unreasonably low rents. Trial court placed burden of proving waste on pl.

e. District court found for def. and landlord company. On appeal pl. argues district court improperly place the burden of proving claim of waste on him.

2. Majority :a. **Burden was on defs. to demonstrate transaction were fair

and reasonable.**b. Business judgment rule protects defs. but presumes no conflict

of interest. Where pl. attacks on conflict-of-interest, business judgment rule will not protect a review of the merits.

c. Under NY Stat. a conflicted transaction will be set aside unless proponent of transaction affirmatively establishes that it was fair and reasonable. Therefore burden on def.

d. Here defs had to demonstrate that rent paid by one company to another was fair and reasonable. Defs. here failed to carry that burden. (a) valuation of property suggests fair rent was higher (b) argument that renter company couldn’t have paid more in rent appears inaccurate.

3. Eval :a. **If burden was placed differently, it is arguable that the case

would come out differently. As a practical matter whoever has the burden of proof is more likely to lose in close cases such as this.

iv. Cookies Food Products v. Lakes Warehouse (Iowa 1988) (513)1. Facts :

a. BBQ company founded. One of its shareholders executes an exclusive distribution contract and sales skyrocket. Ultimately he buys up enough shares to himself become the majority stockholder.

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b. Some changes precipitate the lawsuit including (1) compensating him for use of his storage facilities (2) he also takes on a role in product development getting royalties (3) receives additional compensation

c. Derivative suit against majority shareholder alleging sums paid to him grossly exceeding value of the services rendered and breach of fiduciary duty to corporation b/c the arrangements did not fully disclose benefit to him.

d. Trial court found that def. breached no duties and his compensation was fair and reasonable and that def. withheld no information from directors.

2. Majority : a. Fiduciary duties :

i. Plaintiffs allege a violation of duty of loyalty. ii. In common law as a fiduciary one may secure for

oneself business opportunity but must be done with full discloser, good faith, and consent of all concerned. Court review this strict scrutiny.

iii. State statute also provides that a director may engage in self-dealing without violating the duty of loyalty under any 1 of 3 circumstances.

iv. Do not think that the statute crowds out the common law duty to show “good faith, honesty, and fairness” in self-dealing.

b. Burden appropriately placed on def. to demonstrate…c. Bottom line is that the 4 agreements at issue all benefited the

company as demonstrated by its financial success. The fees charged to def. appear reasonable

3. Dissent : Just because the business is profitable doesn’t mean the terms are particularly fair to the shareholders. [KJ: Dissent is right that majority is a bit wowed by the success but not doing narrow analysis of the agreements.]

4. Eval :a. The court here interprets the statutory scheme in such a way as

to interplay with common law. Even though statute is disjunctive the court reads it to require that the burden be on person who is conflicted to show that they acted in good faith, honesty, and fairness.

b. The effect of approval of self-interest transactions by disinterested directors. There may be reason for courts to scrutinize self-interested transaction, even where they have been approved by disinterested board. Some states allow that and some preclude judicial review. Approaches differ:

i. Express requirement of substantive fairness even if approved

ii. Express requirement that approval be in “good faith” – whatever that means

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iii. Like Cookies, many statutes change common law rule that self-interested transactions are voidable w/o regard to fairness, rather than to preclude review for fairness. In contrast Del. Supreme Court said that approval by fully informed disinterested directors (or stockholders) permits invocation of business judgment rule (523)

c. Note on waste and shareholder ratification i. Waste = exchange of corp. assets for consideration so

disproportionately small as to be unreasonable. It is effectively a gift.

ii. But if there is any substantial consideration received by corp. and if there is good faith judgment that at the time transaction is worthwhile, there should be no finding of waste

iii. Waste cannot be approved by disinterested board therefore has greater bite as a limit.

iv. Board that commits waste normally also violates business judgment rule.

v. Gantler held that shareholder ratification only extinguishes a claim that directors lacked authority – all other instances shareholder ratification subjects directs challenged director action to business judgment review.

d. Board Committees i. Types:

1. Standing - Which committees a corp. has sends signals to outside worlda. Compensation – now required by Dodd-Frank and required to

have independent policy. b. Audit – now required by Sarbanes-Oxley, including a member

with financial expertise. Oversee auditing, monitoring, regulatory compliance, whistleblowers, internal controls, risk-management.

c. Nominating/Corporate governance2. Ad-hoc:

a. Mergerb. If faced with self-dealing, special committee composed of

disinterested directors to negotiation the part of the board to cure defects.

ii. See SDGCL §141(c)(2) [603]1. Members have to be directors – since they are the ones that owe the

fiduciary duty2. Source of authorization:

a. By-lawsb. Authorization by the board of directors

3. Power has very broad power with only limited limitations – can’t amend bylaws or take action on things that by law must go to stockholders. Other than that they can act for the board.

e. Executive Compensation

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i. General notes :1. Picking CEO is one of the most important decisions a board can make2. A lot of questions over compensation relate to the degree to which

managers’ interests are aligned with those of shareholders. (524-27)3. Compensation typically has two components:

a. Short term : i. *salary,

ii. *bonuses, etc. has incentive features but not usually linked to stock performance so kind of like minimal amount an exec. can receive

b. Long term : i. *restricted stock (typically don’t vest until 5 years

incentivizing for CEO to stick with company), ii. *stock options (right to buy stock at price on day of

grant later in time) Purpose was to align the interest of the executive with those of shareholders using the metric the investors most care about.

1. See Black-Schol’s formula for factors that affect the actual value of the stock options (535-36)

2. The idea is to incentivize CEOs to take risks, since they are shielded against losses.

3. Reason stock options became more popular include (1) significant tax incentives, including IRS Code §162(m) (2) favorable accounting treatment for balance sheet (3) industry norms, such as in Silicon Valley where cash-strapped but growing companies can attract highly-motivated employees.

iii. Long term incentive plans (like bonuses but awarded for performance over several years).

c. Recent Developments at federal level i. Sarbanes-Oxley authorizes claw-back provisions for top

executives who receives incentives based on faulty financial statements (e.g. Kenneth Lay)

ii. SEC adopted new provision requiring new disclosures in connecting with proxy statements (Compensation Discussion and Analysis, CD&A)

iii. Economic crisis has caused more people to question the exorbitant executive compensation

iv. Shareholders non-binding resolutions typically approve the compensation [?]

d. See In Re Walt Disney above. Reason to think that the relationship between board and executives will not effectively police compensation. Del. courts however have been hesitant to use the duty of loyalty to police executive compensation.

ii. Ryan v. Gifford (Del. 2007) (527)1. Facts :

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a. Here plaintiff (a shareholder) filed a derivative action, alleging violation of the letter of the company’s stock options plan caused by backdating the stock options grants to some of the lowest days of trading, such that bring a windfall to CEO and managers. Defendants are CEO and members of board compensation committee.

b. Alleges breach of fiduciary duty of loyalty and due carec. *Plaintiffs rely on statistical analysis that demonstrated that the

practice at the firm, compared to a control, significantly overperformed the market combined with fact that stock options do not grand board discretion to alter the exercise price. Grant of stock is consistently on lowest point during a window of time. Pl. says this rebuts the business judgment rule.

d. Def. assert pls. fail to state a claim because does not have enough to rebut the business judgment rule or otherwise to allege waste, intentional acts or for personal gain.

2. Majority : a. A board’s knowing and intentional decision to exceed the

shareholders grant of authority raises doubt whether such a decision is a valid exercise of business judgment.

b. Under business judgment rule, there is a presumption of good faith and honest belief, but it can be overcome by showing of bad faith…[KJ: Court saying any time something is not in good faith it is a breach of duty of loyalty. Admittedly not consistent with how courts describe “good faith” elsewhere.]

i. Examples include: acting intentionally for purpose other than best interests of corp.; acts with intent to violate applicable law; intentionally fails to act in face of known duty to act, demonstrating conscious disregard for his duties.**

c. Here *intentional violation* of shareholder approved stock option plan (which said price of option is price on the day of the grant) AND fraudulent disclosures re: compliance together sufficiently constitute conduct that is a breach of the duty of loyalty and therefore an act of bad faith. This is enough to rebut the business judgment rule and survive motion to dismiss. **

d. Unjust enrichment – b/c CEO retains alleged backdated options, that is enough to get past motion to dismiss

3. Eval :a. Note backdating may not be per se violation – the issue here is

that stock options in this case expressly requiring the date to coincide with date of grant.

b. Sarbanes-Oxley has imposed higher disclosure requirements (a short 2-day window) appear to have addressed some of these practices.

c. Another way a board can achieve a similar effect, however, is to grant stock options shortly before the company makes a big announcement that is highly likely to bump up the stock price.

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This practice is known as “springloading.” Another is “bullet dodging” if price is going to go down, where you grant option after it has come out.

d. Controversy about absolute compensation of CEOs, the relative disparity with worker salaries, and the greatest of all – the disparity with corporate performance (533-35)

e. Effect of fed. tax rules on exec. compensation: tax rules provide highly favorable treatment of stock options. (535-36)

f. Corporate Opportunity Doctrine :i. General notes :

1. Going to vary by state and fairly fact-intensive inquiry.2. Corporate opportunity doctrine overlaps with other responsibilities

owed under the duty of loyalty….ii. Northeast Harbor Golf Club v. Harris (Maine 1995) (537)

1. Facts : a. Def. was president of the local golf club. Real estate broker

contacts her as the President about adjacent land up for sale. Def. buys property in own name w/o disclosing the purchase to the board until after the fact. Tells board she has no plans to develop it.

b. Later she buys more land which she learned about more by happenstance and less in her direct role as President.

c. Ultimately def. conveys some property to children and starts to develop the properties, which goes up in value significantly.

d. Def. is forced to resign as pres. of club, and board becomes opposed to development and sues for breach of fiduciary duty.

e. Trial court found club probably wouldn’t have been able to buy the same land due to its own financial constraints. Emphasizing def’s good faith court finds for def.

2. Majority : Adopt the ALI testa. Policy of the corporate opportunity doctrine is that a corporate

fiduciary should not serve both the corporate and personal interests at the same time. Their primary purpose is to serve corporation. Of course, they must have some ability to pursue personal business interests that does not conflict with corp’s.

b. There are multiple ways to define the scope of the corporate opportunity doctrine

i. Line of business test (DE/Guth) is what trial court relied on

1. *This is really a multi-factor test common in Del. Is conduct fall into line of corp’s business such as to come into conflict with corp’s goals; did opportunity come to officer in personal or professional capacity; in taking the opportunity will officer be competing with corp; did officer wrongly appropriate company assets. [Financial means should not be a factor, because that is not a predictable factor – a company can

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sometimes get credit if faced with a good opportunity; in addition, the financial means are to some degree in control of officer in the first place.]

2. Test suffers from several weaknesses - concept difficult to apply.

ii. Fairness test (MA/Durfee): applied in some test has no principle to apply than broad feeling of fairness; nor does it give officers and board members guidance.

iii. Combination test (MN/Miller): combines the uncertainty of one test with the vagueness of the other. Equitable analysis means court has a lot of discretion regarding how they implement. “Corporate opportunity” is narrowly defined.

iv. (AL/Lagarde) also suffers from vagueness and narrowness (such that doesn’t catch deviant). See 547.

v. (MN/ALI approach : see §5.05 defines “corp. opportunity” broadly, and strictly requires strict disclosure prior to taking advantage, the corp. must then reject the opportunity. A good faith but defective disclosure may be ratified/cured after-the-fact.

1. ALI construes “corp. opportunity” much more broadly and must be presented to the board. It incentivizes ex-ante clearing of the opportunity than Del’s ex-post analysis…

2. On the other hand overbroad test might clog the board with reviewing decisions. And it the test reads like a statute…

3. [note there are 3 potential actionable sources of information, including an opportunity not directly coming the way of the officers by way of her position (see 543) and below]…

4. Here financial means is not a factor in figuring out if something is a corporate opportunity, although it is relevant as to whether it is fair to the corporation…

3. Eval :a. Different types of corporate opportunities : (549)

i. Corp. director/manager becomes aware of opportunity through the use of corporate information or his corporate position. Here the duty to turn it over to corp. is clear.

ii. Business opportunity is closely related to the corporation’s business even if corp. director/manager becomes aware of opportunity independently. Here the duty to turn it over to corp. is a bit less clear and *may depend on the actor’s position in the corporate hierarchy* with people closer to the top the more

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plausible that one owes such a duty. Higher-ups have more of a clear duty to the institution and should not be seeking out opportunities in advantage. Lower staff are not bound as tightly and should feel freer to do things on the side.

b. Ability of corporation to take the opportunity –(549-50) importance of factor varies by state. Different scenarios:

i. If corp. director/manager takes opportunity after it as rejected by board, the ability of corporation to take the opportunity becomes important as to fairness and feasibleness of board’s rejection.

ii. If corp. director/manager takes opportunity before it as rejected by board, the ability of corporation to take the opportunity should not be a factor as it should’ve been given to corp. to decide first. This is position taken by ALI.

c. Relationship with other doctrines : (551) These three principles may overlap but do not have to so must think of them separately. See ALI Principles of Corporate Governance §§ 5.05 – 5.06

i. Corporate-opportunity principleii. Use-of-corporate assets principle

iii. Noncompetition principled. *In Re eBay Shareholders Litigation(Del. Ch. 2004)

i. Goldman, a consultant to eBay is being accused by “rewarding” the eBay leadership for their business (with Goldman) by giving the IPO shares to them before they go public.

ii. Court found that complaint gives reasonable inference that insider directors accepted a commission that rightfully belonged to eBay but was improperly diverted to them, even if not actionable in corporate opportunity doctrine under DE/Gurth test (b/c investment is not eBay’s line of business) (552-53).

iii. KJ : One must think as to whether the conduct at issue is actionable under other elements of the duty of loyalty even if not actionable under one of them. (see above) Here this is actionable under the use-of-corporate assets.

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Approval Conflicted Director & Shareholder

Controlling Shareholder

Approval by majority of disinterested board

Business judgment rule, or can raise claim for waste (Del.)

[Shaped by §144a. Note Cookies (Iowa) where fairness inquiry even after approval but in Marciano (Del. p. 523)]

Entire fairness. Burden shifts to challenger. See Lynch

Approval by disinterested, informed shareholders

No business judgment rule. Ex-post vote obviates self-dealing.Only actionable for waste/gift§144a

Entire fairnessBurden shifts to challenger. See Lynch

No approval (or ineffective approval)

Entire fairness

Burden on dir/officer – (a) terms fair (b) transaction in interest of corp.

Entire fairness

6. Controlling Shareholders and Close Corporations a. Duties of Controlling Shareholders

i. General notes :1. Inquiry:

a. Who is the common stockholder to whom primary obligation is owed (to the degree there is a conflict)?

i. i.e. transaction must be fair to minority stockholdersb. But also must balance more contractual-like rights of preferred

stockholders, like a duty of candor, good faith (Zahn), fair dealing

ii. Kahn v. Lynch Communication System (Del. 1994) (567)1. Facts :

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a. Alcatel acquired 30% of Lynch and later held 43% and came to designate 5 of 11 board members.

b. **Lynch wants to combine with another firm, but Alcatel suggests first explore option of combining with another Alcatel subsidiary.**

c. Lynch board forms independent committee to explore merger. Their outside investment advisors suggest that Alcatel’s proposal overvalued the subsidiary. Independent committee expressed unanimous opposition to merger. Merger withdrawn. [At this point the committee appears quite independent]

d. Alcatel then seeks to acquire the entire equity interest in Lynch, but Independent Committee determined the share offer was too low…After several rounds, Lynch board approves, faced with Alcatel’s threat to proceed with an unfriendly tender offer at a lower price and believing it had no other practicable options.

e. Pl. sued to enjoin & get money damages for acquisition of Lynch by Alcatel via cash-out merger. Pl. alleges Alcatel, as controlling shareholder, breached its fiduciary duties to Lynch and its shareholders by dictating merger at unfair price.

f. Trial court found that repeated rejection from Lynch simulated an arms-length negotiation such that merited shifting the burden of persuasion from def. to pl. and later found no breach and entered judgment in favor of def.

g. The question is whether the merger was negotiated by an independent committee?

2. Majority : The exclusive standard of judicial review in examining the propriety of an interested cash-out merger by a controlling/dominating shareholding shareholder is entire fairness.

a. Usually the fiduciary duty attaches when a shareholder is the dominant shareholder at more than 50%.

b. Controlling shareholder in such a context bears the burden of proving its entire fairness by demonstrating (1) fair dealing and (2) fair price. Showing that action taken was as though each of the contending parties had in fact exerted its bargaining power at arm’s length is strong evidence that it was fair. Because in a parent-subsidiary context no court could be certain whether the terms fully approximate what a truly independent parties would have achieved in an arm’s length negotiation, the best way to provide protections for minority shareholders is to adhere to the entire fairness standard of judicial review.

c. In an interested merger, the controlling/dominating shareholder proponent bears the burden of proving entire fairness.

d. ***Any shifting of the burden at least two conditions must be satisfied (1) majority shareholder must not dictate the terms of the merger and (2) special committee must have real bargaining power***[to be a quasi-arms length negotiation]

e. Here :

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i. ****The question is whether Alcatel with 43% nevertheless can be treated as a dominant shareholder? Yes, practically Alcatel threatened to block several decisions such as to control the board in its position as significant stockholder. As a result Alcatel owed fiduciary duties of a controlling shareholder to other Lynch shareholder. ****

ii. The Independent Committee’s ability to bargain at arm’s length with Alcatel was suspect form outset. Here independent committee effectively caved to Alcatel’s pressure. In the end the question is whether the committee had the power to say no to Alcatel’s final

offer. iii. Here the def’s arg. and lower court’s conclusion that

Indep. Committee appropriately simulated an arms-length transaction is not supported by the record. The trial court erred in shifting the burden wrt the “entire fairness” to pl.

3. Eval :a. Committee must be independent (able to engage in meaningful

negotiations, including power to say no, no threats made)b. Inquiry is two-part :

i. Is the majority shareholder controlling?ii. Should the burden shift?

1. (two part test above)c. If you don’t have fair price, you don’t really get remedies, so

that is the far more determinative factoriii. Zahn v. Transamerica Corp . (3rd Cir. 1947) (553)

1. Facts : a. **Class A stockholder sues TransAmerica alleging that after the

company came into control of the board of Axton-Fisher, knowing the enormous value of the tobacco which the latter was holding, it conceived a plan to appropriate that value for itself by redeeming the Class A stock and then liquidating Axton-Fisher.

b. Class A and Class B both receive dividends (2:1) but after that they are equal. Redemption option at the discretion of the company - $60 on Class A. Class A has a right of conversion (AB) and a liquidation preference (2:1). Both classes at the time have voting rights. KJ: Depending on the worth of the company liquidation, redemption or conversion will be more or less valuable to the two classes.

c. The issue is what are the Board’s duties to different Classes of stock, whose interests may not be the same.

d. Def. moves to dismiss.2. Majority :

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a. The law imposes on majority stockholders the same fiduciary relationship as imposed upon directors. Majority has a fiduciary relationship towards the minority. Board has duty of candor.

b. If challenged the burden is on the director or stockholder not only to prove good faith of transaction but also its inherent fairness.

c. There is a big difference as to whether stockholder votes as a stockholder (where self-interest OK) and when votes as a director (where must be voting in the interest of all stockholders, including minority)

d. The issue ultimately is whether Transamerica’s board members on the board could vote to redeem Class A shareholders for the benefit of Transamerica.

e. Here the directors of Axton-Fisher were not independent but were mere instruments of Transamerica, who undertook the Class A redemption in order to profit from it. The charter gave directors this power but it presumed directors would be acting disinterestedly consistent with their fiduciary obligations. Here the board did not act disinterestedly and liability which flows must be imposed upon Transamerica, which constituted the board and controlled it.

3. Eval :

a. See 560-61 b. This is line of cases where majority using

info to detriment of minorityiv. In re Trados Inc. Shareholder Litigation (Del. Ch. 2009) (579)

1. Facts : a. VC firms have Board members on Trados. Common stockholder

of Trados sues for breach of fiduciary duty arising out of transaction where it became wholly owned subsidiary of SDL.

b. Tries to rebut the application of the business judgment rule by showing there is a conflict among directors in going through with the merger and allocate the proceeds such that benefited only preferred stockholders and common stockholders received nothing.

c. Pl. alleges that because 4 of board members represent VC firms and the 2 others are conflicted b/c their compensation is such that they get a big boon from buyout and also go on to lucrative position in the new merged firms. [You will want to go through such factors] while common shareholders got nothing.

d. Pl. alleges that directors shouldn’t have sold the company in the first place, because the business is operating better.

2. Majority :a. The interests of the two classes of stockholders are clearly not

aligned [just like prior case] As a general rule on the margins management should prefer the interest of the common

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stockholders (because preferred stockholders protected by contract-like protections) Ultimately we want companies to operate in a way to maximize the value of the company, which is best aligned with the residual claimants in the form of common shareholders. [Note the directors do not owe a profit to common shareholders, so directors may reasonably sell a company but it is clear that these interests were not taken into account].

b. Here There is a reasonable inference of divergence of interest, plaintiff can avoid dismissal b/c demonstrated that director defendants were interested or lacked independence with

c. respect to this decision.3. Eval :

a. Note, one thing preferred stockholders could have done was to bribe the shareholders and get their approval, which will be cheaper than litigation.

b. Close Corporations i. General notes :

1. Close corporations are a subset of private corporations (whose shares not publicly traded), but ones that have **only a small number of shareholders and characterized by owner-management (304). **

2. Because they effectively resemble partnerships, courts and legislatures and shareholders have tried to enable such corporates to get treatment that is a bit different from publicly held corps. (304).

a. (1) Legislatures have given special treatment to close corpsi. State states are on a range from ones that make no

special provisions to NY and Del. which follow a unified approach up to a point but add special provisions for corps not listed on a national securities exchange or quoted by members of securities association to, finally, those that provide an integrated set of provisions applicable only to corps that formally designate themselves statutory close corporations and opt in to those provisions. (305)

ii. The opt-in is a safe harbor but *what about the many close corporations that don’t elect to make use of the safe harbor?* Courts have varied if those that don’t elect nevertheless merit a certain special solicitude for their size (majority) or if the “safe harbor” is actually the only way to get special treatment (Del.) (306-07)

b. (2) Shareholders try to contract around traditional corporate defaults

c. (3) courts treat them differently. ii. Voting Agreements

1. General notes a. Courts sympathetic to voting arrangements b/c they thus avoid

having to answer how to treat close corporations different from corporations generally.

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b. But there are some limitations WRT core board functions see McQuade.

c. Two arrangements : i. (a) agreement b/w a subset/faction of stockholders

want to coordinate to further their interests ii. (b) agreement b/w all holders to set up voting rights in

a way not consistent with defaults under state law. (other than pro rata)

2. Ringling Bros. v. Ringling (Del. 1947) (308) [reception to private ordering]

a. Facts : i. Ringling’s 7-person board controlled by 3 stockholders

(under a cumulative vote system). 2 stockholders had a [faction-type] agreement with Right of First Refusal and voting terms such that each voted on 2 directors of their choice and agreed on a 3rd, such that they would dominate board with 5 directors (of a total of 7). There is an arbitration clause.*

ii. Their agreement breaks down; they go to arbitrator, but one side refuses to follow the direction of the arbitrator, there is disagreement of who is the rightful 3rd director, and pl. institutes this action.

iii. Chancery court found agreement was lawful and ordered a new election (i.e. granted specific performance) where plaintiff was allowed to vote def’s vote as their proxy.

b. Majority :i. **Agreement is valid under Del. law. Shareholders may

contract to vote one way or another.ii. [The consideration here is the legal promises the parties

made to one another. i.e. forgoing freedom to vote how one wants is consideration.]

iii. Here 1. The arbitration clause here is reasonable and

arbitrator’s decision ought to stand.**2. Def’s failure to vote according to the agreement

constitutes breach of the agreement.iv. Remedies :

1. However, Chancery court was wrong to invalidate the election and to order specific performance giving plaintiff proxy power to vote def’s shares. **There is nothing in the text of the agreement that would allow arbitrator to have such power.**

2. Instead the appropriate remedy is letting the results of the election stand, but disregarding the shares voted by the def. [i.e. 6 people are on the board]

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3. Because this remedy leaves 1 vacancy on the board, the case is remanded to the Chancery Court to decide what to do with that vacancy.

4. [KJ: Another remedy might be to put the shares into a trust such that a third party will exercise the voting rights consistent with agreement. This would be a more structurally sound way at that time to enforce the agreement……case law and statutory schemes move away from see Del. Corp. Stat. §218(c), which allows an irrevocable proxy as a form of specific performance. Note most small potatoes corporations don’t incorporate in Del. so Del. assumes that those who incorporate in Del. are sophisticated enough that they can decide to take the mandatory provision]

c. Eval :i. Voting agreements come in two flavors: (1) parties

agree in advance on the exact way they will vote (2) only agree to vote together in a manner TBD later. (314)

ii. Remedies : money damages usually inadequate. While here court doesn’t recognize an irrevocable proxy to the other party, such is a remedy in some states/cases. (315)

iii. The proxy arrangement runs into a tension with the principles of agency law (316) *Usually agency relationship is terminable at will.*

iv. Note Right of First Refusal can be a deterrent b/c 3rd party will never know more than seller about worth. If price undervalues the actual worth, then other party to agreement will likely exercise their right to option. In other words, 3rd party will only hold on to shares where they are worth less than the price being asked.

iii. Voting Trusts 1. General notes

a. A mechanism for separating voting rights from the beneficial ownership of the shares for a limited period of time. (316)

b. Today statutes explicitly recognize and regulate voting trusts. Failure to comply treated different from invalidating the trust agreement to more leniently (317)

c. Voting trusts may have a purpose overlapping with voting agreements. Courts sometimes take one of these and find that in reality it is another in substance and apply the law governing. (318)

iv. Agreements Controlling Decisions that are Within The Board’s Discretion 1. General notes :

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a. Given the usual statutory provision that business of corporation managed by the Board, under what conditions may agreements control those decisions?

2. McQuade v. Stoneham (NY 1934) (320) [limitations on shareholder agreements]

a. Facts : i. Pl. bought shares of stock from def. and they entered

into agreement **where they would serve on the board specific positions and imposes limitations on the distribution of money: no change in salaries, by-laws or anything else would take place except on unanimous consent of all parties.**

ii. **When the others vote plaintiff off the board by the remaining stockholders, he brings suit alleging violation of the agreement. Pl. argues agreement enforceable so long (as here) dir. acts loyally.

iii. Lower courts found violation and green-lighted damages

b. Majority :i. It is clear that shareholders may unite to elect directors,

however shareholder agreements may not abrogate the independent judgment of directors. [This is similar to the limits we saw above on shareholders power on dictating to the board of directors. Part of the reason we’re particularly concerned here is because there were other shareholders beyond the litigants here and directors must have freedom to exercise judgments to the other shareholders]

ii. Here the contract must be held to be illegal and void so far as it precludes the board from changing officers, salaries or policies except by consent of contracting parties.

c. Eval :i. But see Clark v. Dodge (NY 1936) [Backing away from

above limits in some cases] where court narrowed McQuade to its facts (323) **To the degree that all shareholders in close corp. are party to the agreement, courts will be more open to allow parties to contract with respect to such internal decisions.

3. Galler v. Galler (Ill. 1964) (324)a. Facts :

i. Two brothers own a pharmacy business, in which they are joint shareholders. Late in life they sign an agreement for financial protection of their families and to ensure equal control post-death.

ii. After the other brother’s death, remaining brother breaches the agreement. Deceased brother’s widow brings suit to enforce the agreement.

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iii. Lower court found the agreement void b/c at odds with corporations statute.

b. Majority :i. Policy : close corporations are different – the

shareholders cannot send shares on the market and must be able to protect themselves by way of agreements. The trend is by courts to treat close corporations as sui generis (allowing deviation from other corporate norms)

ii. Here The agreement is generally enforceable subject to two limitations: **(1) can’t injure public creditors or minority shareholders and (2) can’t directly violate statutory scheme.** Its purpose is reasonable. Its duration is reasonable [court reads in a reasonable limitation on duration] Its individual sections regarding elections, dividends, salary are all kosher.

iii. The agreement is not vulnerable to attack .c. Eval :

i. Rule of thumb about enforceability is to see if third parties who might not be party to corporation that are harmed.

ii. Close corporations can distribute money in many ways, including salaries. It doesn’t have to be consistent with value provided, so long as it is fair and consistent. On remand this court read in intent to have parity b/w the families. Court reads-in an intent for parity (330)

v. Fiduciary Obligations of Shareholders in Close Corporations 1. General notes :

a. Massachusetts is the majority approach2. Donahue v. Rodd Electrotype Co. (Mass. 1975) (336)

a. Facts : i. Plaintiff is a minority shareholder in a close corporation.

Defendants (directors/largest stockholders) caused the corp. to repurchase some of the shares from the largest shareholder. When the pl. offered to sell her shares at the same price, the corporation turned down the offer.

ii. Pl. brings suit alleging a violation of their fiduciary duty to her as minority stockholder.

iii. Trial court found for def. and appeals court affirmed.b. Majority :

i. Close corps: 1. Close corporations are characterized by small

size, no ready market for stock, stockholders often serving as managers and directors.

2. Trust and confidence essential on such a small scale

3. **Policy: Minority shareholders can be vulnerable to the whims of the majority and it

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can be in a catch-22 because unable to sell off its stocks if they want out. They might be trapped in a bad situation

4. For these reasons stockholders in a close corp. owe one another substantially the same fiduciary duty as partners owe one another. This is a strict standard of good faith, more rigorous than usual standard for public corporations. (340) [high standard]

ii. Equal Opportunity 1. **Above holding means that equal opportunity

must be offered to all stockholders.**a. Majority cannot use its control of corp.

to provide a market for shares of only some but not all shareholders.

b. This also improperly operates as a preferential distribution of assets inconsistent with fiduciary duty.

2. Denial of equal opportunity by controlling stockholders is actionable

3. [Note unlike buy-back agreement in public context, where each person’s relative ownership stakes stay the same, here the a shift in ownership, which may be good or bad to the minority shareholders.]

iii. Here : 1. Strict duty applies to corporation here b/c it is

close corp. 2. The duty was breached b/c pl. was not offered

an equal opportunity to sell their stocks to the corporation.

3. **On remand: Relief available either (1) having maj. stockholder buy back the shares or (2) corp. should buy pl’s shares at same rate.** [corporation may have liquidity constraints that prevent them from buying up the shares.]

c. Eval : i. If this was a challenge under regular law for public

corporations, this could come up as a violation of duty of loyalty complaint, which would be judged under the entire fairness standard, which would be harder.

ii. This decision was a big deal since it was among the first to introduced a significantly higher standard for close corporations.

iii. ***In Rosenthal v. Rosenthal (Me. 1988) state supreme court articulated 4 specific duties owed by business associates in close corps. to each other. (343-44)

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3. Wilkes v. Springside Nursing Home (Mass. 1976) (344) [narrowing Donahue]

a. Facts : i. *Close corp. formed by 4 amigos, each becoming a 25%

shareholder and a director. They are getting annual payouts in the form of “salary.”*Here “salary” was really the main way that shareholders were receiving the payouts.

ii. Gradually things sour between the 4, and the 3 defendants try to squeeze out the plaintiff, the 4th amigo. The defs. established salaries, but leaving plaintiff off. At annual meeting they do not reelect def. and try to get him to sell his shares below what they’re worth.

1. Due diligence, care2. Good faith3. Info disclosure4. Not to use information (like equal treatment

test)b. Majority :

i. This case falls under Donahue as this is a close corporations. On one hand termination of minority’s employment denies an equal return on an investment.

ii. On the other hand, courts have hesitated to interfere with the internal operation of corporations (such as hiring of officers).

iii. For this reason strictly applying the “good faith” standard to this case will unduly hamper close corporations. [Court moves away from that absolutist language of Donahue, recognizing need for majority to pursue legitimate business interests]

iv. **The proper inquiry is a case-by-case approach where courts ask it is still expanding the reach of the rule based on the reasonable expectations that pl. had in acquiring the shares? If so, (1) can controlling group demonstrate a legitimate business purpose for its action? (2) if so, minority stockholder can demonstrate that same legitimate objective could’ve been achieved through an alternative course of action less harmful to minority’s interest (3) court then must balance the legitimate business purpose, if any, against the practicability of a less harmful alternative.**

v. Here : No apparent legitimate business purpose has been suggested. Appears to have been a deliberate freeze-out. Remand to lower court to determine damages based on his “salary” since that was the way these shareholders were receiving their payouts.

c. Eval :

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i. While scales back on language in Donahue with the “reasonable expectation” language.

ii. Arguably “legitimate business purpose” can be broad – perhaps it was legit to buy out one member…

iii. Ways corp. can get money to stockholders: 1. Dividends2. Repurchases3. Salary

iv. Note that parties could have contracted in more detail here, but often in close corporations parties do not do this so courts are forced to analyze this ex-post

4. Smith v. Atlantic Properties (Mass. App. 1981) (350)a. Facts :

i. 4 amigos each own 25% of real estate corp. with each act of board requiring 80% (i.e. allowing each director to hold a veto).

ii. Disagreement whether to use earnings for repairs or dividends. 1 amigo refuses to vote for dividends but as a result IRS penalizes corp. for unreasonably accumulating earnings.

iii. Trial court held amigo was liable to corp. for penalties.b. Majority :

i. The question is the extent to which veto power possessed by minority may be exercised before there is a violation of a fiduciary duty referred to in Donahue and Wilkes?

ii. Here 1. The 80% provision reverses the usual roles of

majority and minority stockholders, w/ minority becoming an ad hoc controlling interest.

2. Amigo was warned of dangers of an assessment of a penalty. He *recklessly* ran a serious risk of IRS penalty inconsistent with a duty of good faith and loyalty.

3. Trial judge justified in charging him with out-of-pocket expenditure…

c. Eval :i. Imposition of fiduciary duty on minority holder is very

unusual – highly unique to closed corporations.5. Merola v. Exergen Corp. (Mass. 1996) (352)

a. Facts : i. Plaintiff, a former employee and minority stockholder of

def. corporation, brought suit against majority stockholder for terminating his employment arguing that this was a violation of his fiduciary duties. Essentially he is trying to piggyback on Wilkes – alleging that he had an expectation of becoming a stockholder through his employment.

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ii. Trial court found for pl. and Appeals Court affirmed.b. Majority :

i. While generally termination can be done at will, termination of minority shareholder’s employment may present a situation where majority interest has breached its fiduciary duty to the minority interest.

ii. In Wilkes this court found that “freeze out” was unfair b/c that corp. had a practice of dividing available resources of corp. by way of salaries to shareholders who participated in operation of enterprise.

iii. *Here unlike Wilkes, there was no general policy regarding stock ownership and employment, no expectations of continuing employment because they purchased stock. The ownership of stock was not directly tied to employment. Unlike Wilkes he was not a founder, nor was he ever required as such to buy stock, nor was his position and stake in corporation significant, nor was his salary one and the same as the distribution. Further, when pl. sold his stocks back to corp. he admits that he received a fair price for them.**

iv. Although there was *no legitimate business purpose* for terminating pl, neither was termination contrary to established public policy *[i.e. there was no reasonable expectations of employment as a threshold matter]. * Policy: majority must have some room to maneuver in establishing business policy. There was no breach by majority shareholder of fiduciary owed to a minority shareholder under Donahue.

c. Eval :i. *Court also seeking to protect at-will employment and

unwilling to depart from that in a case like this like looks like a standard employment dispute.

ii. This case again narrows the case law, holding specifically that something like this is not “reasonable expectations” and narrowing the Wilkes opinion to its facts – i.e. co-founders freezing each other out.

vi. Restrictions on the Transferability 1. General notes :

a. Restrictions – two questions:i. When is this triggered?

ii. What is the valuation?b. Traditional norm of corp. law is free transferability of shares; in

partnerships a partner may not transfer all of his rights w/o the unanimous consent of all of his partners (354)

c. Courts gradually began becoming more sympathetic to restrictions on transferability in close corporations as a practical matter *to keep the corporation in the family etc.* (355)

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d. These days “reasonable” restrictions are held valid and enforceable. (364) Three sorts of restrictions commonly used in close corps:

i. ROFR : offered first to corp., shareholders, or both on same terms as to third parties. These are least restrictive and widely upheld. Only useful if corp. has the cash to buy shares.

ii. First Options : offered first to corp., shareholders, or both based on pre-agreed price. Restrictiveness really depends on difference b/w option price and fair price at time it is triggered. Courts pretty liberal in allowing this.

iii. Consent restraints : require prior permission of board or shareholders. Most restrictive of the three. As FBI below suggests, modern trend is for courts becoming more tolerant. However validity remains uncertain in the absence of a statute or authoritative precedent (365). Corp. can block even if it has no cash on hand to buy up the shares.

iv. Mandatory Sales : goes much further allowing repurchase of shareholder’s stock upon occurrence of specified contingency even if stockholder wants to retain the stock (e.g. upon termination from work or upon death of stockholder). Good for stockholders given that otherwise there is no market for their shares in close corp.(365-66).

e. Problems of interpretation : These all give rise to recurring problems of interpretation…courts give restrictions on transfer a strict interpretation.

f. Valuation techniques other that market pricing (which is impossible for close corporations) (366-68)

i. Book value : courts will generally enforce unless difference from other measures so great as to lead to conclusion of fraud, mistake, etc.

ii. Earnings : iii. Specific amount set by contract : usually subject to

periodic revision at agreed-upon intervals. iv. Third-party appraisal : at the time of transferv. UCC

2. FBI Farms v. Moore (Ind. 2003) (355)a. Facts :

i. A family formed the corporation with 4-member board, which adopted transfer restrictions – *prior approval of board and Right of First Refusal (first to corp. then to other stockholders of record, then to any blood member of family)*

ii. During divorce proceedings one board member (ex-husband) awarded monetary judgment, secured by a

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lien on his shares that were awarded to the other board member (ex-wife)

iii. When judgment remained unsatisfied, ex-husband sought to foreclose and buys back the shares at a sheriff’s sale. *There was no effort by either corporation or sheriff’s dept. to comply with transfer restrictions*

iv. Ex-husband instituted this suit seeking a declaratory judgment that the attempted cancellation of the shares by defs. was invalid and that the shares were freely transferable (i.e. that he owns the shares and that the original transfer restrictions no longer apply to him)

v. Trial court found for pl., finding him the lawful owner and restriction on transfer (prior approval, blood relatives) “manifestly unreasonable” and unenforceable. Appeals court affirmed.

b. Majority : Restrictions on corporate share transfers may require approval of the transfer by the corporation’s Board, at least in family corporations.

i. *Statute allows reasonable restrictions on transfer in articles, bylaws, or shareholder agreement, if conspicuously noted on the instrument, for any reasonable purpose. Policy is to allow shareholders to protect personal relations. The transfer restrictions are treated as contracts. Here the parties were bound by this contract.

ii. Rights of first refusal (ROFR) OK, but waived1. *Corp. had actual notice of the sheriff’s sale but

failed to exercise the ROFR.*2. Because they didn’t raise their ROFR, they

waived that right. 3. *Policy: otherwise holder of ROFR would have a

perpetual option.*Concern with perpetual uncertainty to the owner and gamesmanship by corp.

iii. Restrictions on transfer with board consent OK1. *Under statute restrictions are allowed so long

as they are “reasonable” – i.e. they serve a legitimate purpose of the party imposing them and not an absolute restriction on alienability.

2. See factors (360)3. Reasonableness evaluated at the time of

adoption.4. Policy for enforcement of these restrictions is to

encourage entering into formal partnerships 5. Here statute explicitly authorizes a provision

that requires pre-approval of transferiv. Restrictions on Transfer except to “blood members of

family” OK

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1. Family has an interest in protecting ownership in the hands of family waivers. [Narrowly applicable to family owned corporations as a subset of close corporations]

v. Restrictions as applied to involuntary transfers 1. Agree that sheriff’s sale transferred the shares

to ex-husband – Policy: the restrictions may not interfere with the rights of third parties, including creditors.

vi. Price : transfer restrictions make the shares worth less. What ex-husband ends up holding the shares (transfer is valid), but the restraints are valid, so these restrictions continue. [363]

Eval:vii. Evangelista v. Holland (Mass. App. Court 1989) court

enforced shareholder agreement that allowed corp. to buy out for $75,000 the estate of any deceased shareholder, even though stock was worth at least $190,000. Court said that questions of good faith/loyalty do not arise when all the stockholders in advance enter into an agreement for purchase of stock. (363)

viii. Jensen v. Christensen & Lee (Wis. App. 1990) court said that pl. who was discharged such that triggered a stock buyout at a low purchase price stated a claim for breach of fiduciary duties based on conflict of interest (368)

3. Nemec v. Shrader (Del. 2010) (368) a. Facts

i. Big players in Booz Allen owned a lot of shares, which were subject to a one way redemption option w/in 2 years of their retirement.

ii. Booz Allen knowingly bought the shares back before a big project went through that significantly increased the shares’ book value.

iii. Plaintiffs sued for breach of *implied covenant of good faith and fair dealing.* [i.e. looking to contract law]

b. Majority i. The terms of the contract were clear and the court has

no role in enforcing a contract that a party wishes it had negotiated. [These were sophisticated players] There was no breach and parties received exactly what they had originally bargained for.

ii. In addition if company had not redeemed the shares as they did other shareholders might have had an actionable claim for favoring retired stockholders to the detriment of existing stockholders. (369-70)

c. Dissent

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i. Where there is a contract, the party must further a legitimate interest…*you can have an action that is consistent with contract but where doing so arbitrarily, you are violating the implied duty, there would be a cognizable claim.

ii. Here Booz Allen could have waited without incurring any prejudice to itself. (371)

d. Eval :i. Compare to Zahn v. Transamerica where one group of

shareholders benefited at the extent of another. There they had redemption and a conversion right. Only defs had to give notice so that shareholders would be able to get the value.

ii. Unlike the multiple classes of shares in Zahn here there is only one class of shareholders. Here is a purely allocation decision between common shareholders. Majority is looking at the interests of the other shareholders, while dissent is looking more narrowly at the corporate entity itself and decision to allocate among common shareholders is not for corporation.

iii. Note, too, in Del. courts do not look at close corporations unless corporation explicitly takes advantage of provisions…

vii. Dissolution & Remedies :1. General notes :

a. Two scenarios: i. (1) deadlock:

1. Even if you have a deadlock, you don’t automatically have right to dissolution (esp. where pl. has dirty hands).

ii. (2) oppression:1. What are reasonable expectations of

shareholders (over the entire existence of corp.)2. Did majority take an action that substantially

defeats those expectations. [hard test to meet in practice]

b. Not an issue for public corporations b/c shareholders always have a way out (sell shares, vote for diff’t director)

c. This is again here given the limited options 2. Deadlock

a. Wollman v. Littman (NY App. Div. 1970) (371)i. Facts :

1. Two groups have equal representation on the board of directors. They each bring suits each other.

2. Lower courts agreed that effective mgt. impossible and mandate dissolution.

ii. Majority :

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1. However, here dissolution would accomplish exactly the wrongful purpose that defendants are charged with (i.e. squeezing out their fellow directors and competing with this corporation). That would reward bad actors.

2. What is necessary is a full trial on the issuesiii. Eval :

1. KJ: Deadlock is necessary but not sufficient to get dissolution.

2. A number of statues provide for involuntary dissolution on a showing of deadlock. Don’t need 50/50 deadlock – it could be any block that deadlocks the corporation. Dissolution is usually discretionary even if deadlock is demonstrated (372)

3. Oppression & Mandatory Buy-out a. General notes :

i. Courts traditionally hesitant to order dissolution of profitable businesses…**academics come to suggest that for a close corporation a remedy comparable to dissolution – free exist through a mandatory buy-out of minority’s interests on the minority’s demand – should be available.** (373-74)

ii. *Often statute will have a minimal threshold (as percentage of shares) before minority can bring suit, to keep frivolous suits out of the courts.

iii. Usually dissolve or buyout: the buyout option prevents minority from holding out and oppressing the majority after the finding of oppression

b. Matter of Kemp & Beatley (NY 1984) (374)i. Facts :

1. Two longtime employees (who are minority shareholders) of the close corporation left, while continuing to own their shares. Subsequently the company froze them out by changing its distribution such that money was no longer awarded based on shares owned but now by services performed to the company.

2. Pls. sue under NY statute allowing dissolution of close company where controlling faction is found guilty of “oppressive action” toward complaining shareholders.

3. Lower court found that dissolution was appropriate but conditioned it upon the corporation’s being permitted to purchase pl’s stock.

ii. Majority :

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1. Statute allows dissolution for illegal, fraudulent, and oppressive conduct. The policy of statute is to protect the expectations of shareholders in a close corporations, including participating in management decisions and drawing a salary.

2. “Oppressive” conduct is such that substantially defeats the reasonable expectations of stockholders [all shareholders, not just the plaintiff in this case]

3. The statute requires courts to order dissolution if it’s the only feasible means to protect the pl’s expectations and rights of any substantial number of stockholders. In other words, courts need to determine if some remedy short of dissolution is a feasible means satisfying the pl’s interests.

4. Steps :a. Pl. sets forth prima facie case of

oppression and invokes the statute to demand dissolution.

i. (1) reasonable expectations ii. (2) defeat of those expectations

[Note: pl’s dirty hands make it impossible to bring claims]

b. Def. demonstrates existence of an adequate alternative remedy.

c. Court figures it out, and can condition dissolution on a buyout.

5. Here : a. *Corp. had a history of awarding

dividends in the form of bonuses. Policy was abruptly changed to a performance-model business after pls. leave the corp. suggesting a “freeze out” The action was “oppressive” within meaning of the statute.

b. Def. has not suggested any alternative remedy. Therefore lower court decision affirmed. Dissolved. [no buyout option]

iii. Eval :1. **Meisleman v. Meiselman (NC 1983)

suggested that reasonable expectations can change over time and must be ascertained by examining the entire history of the relationship from start to finish. (380-82)**It is not just the initial investment but ongoing personal stake in the company.

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a. If there was never a policy for bonuses likely Kemp would have come out differently.

b. If there was a good faith effort by company after the fact, that would probably still be OK (not-oppressive) if reasonable shareholder should have expected that changes made.

2. 3 ways of defining “oppressive” (383)a. Breach of fiduciary duty of good faith

and fair dealingb. “Utmost good faith and loyalty” as

articulated in Donahue abovec. “Reasonable expectations” as

articulated in Kemp above3. Duty of care and duty of loyalty do not do a lot

of work in the close corporation context (384)4. Finish 388-393

c. LLCs i. General notes:

1. Combine elements of corporate and partnership law. B/c this ia a new form, LLC statutes are highly variable. (395)

2. Mostly organized in the state where business was located.3. Formation : Formed by filing a bare-bones “articles of organization” and

drafting the “operating agreement” (396)4. Management : Two flavors: either manager-managed or member-

managed5. **Authority: Has to do with who has authority to bind the entity.

Members can grant or withdraw power on any one member to act in a way that binds the LLC. But in manager-managed LLC only managers have authority. (397) ** Member without authority who binds himself to a 3rd party – that 3rd party contract will be enforced but member will be liable to other members.

6. Voting : Members usually vote per capita (1 person 1 vote) but sometimes pro rata based on financial interest.

7. Fiduciary duties .: courts borrow from corporate and partnership case-law. (397) Derivative actions usually permitted.

8. Members interest : financial interest is freely transferrable, but governance rights usually transferable only with unanimous consent of all members. (398)

9. Limited liability may be overcome if conditions for veil piercing are satisfied. (399)

10. Dissolution : (399)11. Taxation : very flexible. They can get pass-through taxation benefits.

ii. Piercing the LLC Veil :1. Kaycee Land v. Flahive (Wyo. 2002) (400)

a. Facts : *Pl. claims def. LLC caused environmental contamination on its property. The LLC has no assets. Pl. seeks to pierce the

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LLC’s veil and hold the managing member individually liable. There are no allegations of fraud.

b. Majority :i. Before piercing corporate veil court must be satisfied

that there is such a unity of interest that adhering to fiction of separate existence sanctions fraud or injustice.

ii. **Factors to look at:1. Commingling of funds (failure to segregate,

diversion, etc.)2. Failure to keep separate records 3. Undercapitalization4. Identical ownership

iii. This is an equitable doctrine. In general no reason to treat LLC any differently from corporations. Equitable remedy of piercing the veil is an available remedy. *Factors for piercing LLC veil presumably would not be identical.* [since LLCs serve a slightly different purpose]

iv. Here : factual record is too skimpy to make a rulingc. Eval :

i. This is good because otherwise people who would want to defraud investors would be insulated from liability.

ii. Adherence to corporate formalities is a key factor that courts also look at. But part of the point of forming LLCs in the first place is not to be found by all these formalities. So this should not usually be a factor in veil piercing the way it is in corporate context.

iii. Fiduciary Duties 1. Salm v. Feldstein (NY App. Div. 2005) (405)

a. Facts : i. Both parties members of an LLC an owned auto

dealership. Manager-managed LLC. Def. bought pl’s membership interest for $5 million then turned around and sold the dealership to third party for $16 million.

ii. The LLC operating agreement did not prohibit this sort of thing. We don’t even know if def. disclosed it to pl. the party did not necessarily have any rights under agreements.

iii. Pl. sued for breach of fiduciary duty and fraud.iv. Trial court granted def’s motion for summary judgment.

b. Majority :i. As managing member, def. owed his co-member (the

pl.) a fiduciary duty to make full disclosure of all material facts…[duty of candor]

c. Eval :i. Courts skeptical whenever a party does something in

secret, like here and subsequent cases in this section. Suggests there is something amiss.

2. VGS v. Castiel (Del. Ch. 2000) (406)

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a. Facts :i. Virtual Geo-satellite LLC, formed with 3 corporations.

Majority owner owned 63%, with others owning 12%, and 25%. The 3-person board of managers with Castiel owning a controlling share and having himself and Quinn on board, and Sahagen representing himself on the board as the third person.

ii. **Agreement allowed major action to be taken by a simple majority vote of the board of managers rather than rely on the default position of the statute which requires a majority vote of the equity interest.**

iii. Sahagen, a minority manager convinces Quinn, Castiel’s 2nd board member to defect to him and without notice to the Castiel, they fold LLC into a new corporation by written consent, diluting the majority owners share to a minority share and visa versa. Although they are given stock in proportion to membership units in prior LLC, the reason control flips is that Sahagen gets additional 2 million shares of a new class of preferred stock in exchange for his loan.

b. Majority :i. Read literally, Del. statute allows written consent

without notice. However equity requires that statute be read to allow written consent by actual majority, not the “illusory, will-of-the-wisp” majority here.

ii. Here Sahagen and Quinn acting in secret and failed to discharge their duty of loyalty to him in good faith. They ought to have given Castiel notice if they thought what they were doing was really in the best interests of LLC.

iii. Merger is rescindedc. Eval :

i. Even if def. was right and Castiel was a bad manager, there will be very little remedy for him. The system allows bad management to exist….parties presumed ot be sophisticated enough…

3. Solar Cells Inc. v. True North Partners LLC (Del. Ch. 2002) (409)a. Facts :

i. Plaintiff corporation teamed up with defendant True North to form First Solar LLC to commercialize solar power with plaintiff contributing proprietary technology and def. contributing financing (50-50 arrangement).

ii. Operating agreement divided up the membership units and the allocation of managers, with plaintiff receiving 2 and *def. receiving 3 managers.* Def. manages the LLC.

iii. Def. True North provides more in loans with option to **convert some of it into membership units or retain investment as a loan with liquidation preferences.**

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iv. Ultimately the Def’s 3 managers meet and by written consent merge LLC into another LLC owned by def. True North without notifying the pl. The end result would be that pl. would go from owning 50% of LLC’s membership units to 5% of the surviving company.

v. Pl. sues to request a TRO enjoining the merger…Def. argues that pl. had already waived conflict of interest in the LLC agreement.

b. Majority :i. Def. owed pls a fiduciary duty. It appears here that they

acted in a way that surprised the plaintiffs (they failed to mention it). These do not appear to be actions of fiduciaries acting in *good faith* (as LLC agreement still requires, and which court would have read-in even if it were absent)

ii. The fact that Operating Agreement permits actions by written consent of majority of the managers does not give a fiduciary free reign to approve any transaction he sees fit regardless of the impact on those to whom he owes a fiduciary duty.

iii. **The actions make it likely that defs would be required to show the entire fairness of the proposed merger (i.e. fair dealing and fair price).

1. Fair dealing : surprise to pls. Pl’s share was diluted form an equal (50%) to only 5%...Does not sound like fair dealing.

2. Fair price : Reasonable probability that court will not find the valuation of to be a fair price…

iv. Irreparable harm : def’s args unconvincing. *Losing the ability to play an active role in management is irreparable harm.*

c. Eval :i. [Unlike prior case, they use their conversion rights to

take control and go through with merger.]ii. KJ : Note as long as you have fair price, fair process

might not matter. See Kahn above.iii. **Advantage of LLC is flexibility but few default rules,

whereas corporations have extensive default rules, and also the only way to go public so more appropriate for organizations striving to grow etc

iv. Courts police the outer bounds in the body of law where LLC in general have a lot of flexibility even with respect to fiduciary obligations imposed to directors and managers by private ordering (e.g. self-dealing, competing etc.)

7. Corporate Controla. General notes :

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i. Why buyer might be willing to pay premium for control (In other words when someone willing to buy at a premium ask which of the above is the buyer after)

1. Managementa. Without control, there is a risk that controlling shareholders will

loot, mismanage operation.b. With control, can increase the value of operation.

2. Private benefits of controla. Salaries, contracts, etc.

i. See e.g. Cookies -- still subject to “entire fairness” standard

3. Illegitimate/illegal benefits (at the extreme)a. Looting, etc.

ii. Why it might be good for minority shareholders to have a majority shareholder:1. Presence of agency costs means it is better to have a controlling

shareholder to stay on top of management and oversee operations.2. On the flip side, there is a new agency cost – the tension b/w the

minority shareholders and majority shareholders. b. Sale of Control

i. Zetlin v. Hanson Holdings (NY 1979) (587) 1. Facts :

a. Plaintiff owned 2% of firm an def. owned a controlling share of 44%, which they sold at a significant premium to a third party.

b. Pl. argues that minority stockholders are entitled to an equal opportunity to share equally in the premium paid by the seller.

2. Majority :a. **U.S. majority rule: Settled law is that [outer limits:] absent

looting of assets, conversion of corp. opportunity, fraud or other bad faith acts -- the controlling stockholder is free to sell the controlling interest at a premium.

b. Pl’s argument would require an open offer (tender offer) every time and would be a radical departure from practice.

3. Eval :a. *Andrews: arguing for an equal opportunity (588-90)

i. Spreads risk b/w selling controlling shareholder and minority stockholders…majority seller will retain a share in the company after the sale, creating an incentive not to sell to an apparent looter, *to do due diligence.

ii. Each stockholder is entitled to share proportionately in the profits of the enterprise…

b. Reply to Andrews (above) (590-591)i. As a practical matter no controlling stockholder will

want to sell anything less than all 100% of their shares. The rule therefore would put a damper on beneficial transactions ---buyers would only come in when they can buy 100% of the corporation & it would impose higher price on the purchaser.…that would in turn would reduce the # of buyers.

c. Andrews reply:

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i. Seller will have to take out a loan from a lender to raise the 100% of the purchase price.

d. KJ: Very few have adopted the Andrews view but UK has a “mandatory bid” rule – buyer must make the same bid to all shareholders. The U.S. is more laissez faire leaving the premium to the controlling shareholder…UK rule prevents bad transactions but also stops good ones and US rule catches fewer…

ii. Perlman v. Feldmann (2nd Cir. 1955) (591) 1. Facts :

a. *Steel corporation is profitable but benefits especially from tight steel market and their special “Feldmann Plan” where they get interest-free advances from end-users and use it to invest in production. *

b. Derivative action to compel accounting and restitution of (allegedly) wrongful gains accrued to defs as a result of sale of their controlling interest in the corporation which at the time comes with a very valuable corporate opportunity to allocate the steel in times of shortage and the Feldmann Plan.

c. Def. – a controlling shareholder and a director – sold their stake in the steel company end users of steel…

d. District court held that price was fair and in this situation there was nothing owed to minority shareholders.

2. Majority :a. Under state law, as maj. stockholder and director, def. owes a

fiduciary duty to corp. and minority stockholders. *[KJ: Don’t make too much as to whether this is a director or shareholder.]

b. Def’s conduct does not conform with the high demands of conduct expected from a fiduciary. Burden on def. to establish their undivided loyalty…

c. Here def. obviously acted in self-interest and to the detriment of the corporation and minority shareholders who lose the advantages of the special “Feldmann Plan”

d. ****Remanded…Correctly brought as a derivative action but damages flow to the minority shareholders rather than to the whole corporation (even though this is a derivative suit). If it went back to corporation, the new buyer would benefit from this….[KJ: No bright line rule where a court balancing the equities will pay it to shareholders]

3. Eval :a. What makes this case different from the usual laissez faire rule

is that seller was on specific notice that new owners were going to throw aside the lucrative “Feldmann Plan” or build up local patronage. This is not in the best interest of the company…

b. Another way to look at this is that the premium to controlling shareholder is far more than usual premium for controlling share but corporate opportunity which seller sought to benefit from.

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iii. Brecher v. Gregg (NY 1975) (596)1. Facts :

a. **Shareholder derivative suit brought against founder, director and largest stockholder (who owns 4%) for selling his shares at a premium to a third-party corporation which bought them at a significant premium in exchange for def’s agreement to immediately resign and bring in the buyer’s nominees.**

b. Def. achieves what he promised – in spite of only 4% share he gets the buyer’s people elected to the board.

c. Plaintiffs allege def. effectively sold his corporate office and thus breached his fiduciary duty.

2. Majority :a. *Yes, a director’s agreement to transfer only a small percentage

of shares in exchange for a premium and promise of resignation constitutes a breach of fiduciary duty as an illegal sale of control. *[we are worried that buyer wants control to extract private benefits of control possibly looting etc.]

b. But other def. directors not liable since they were not involved in the negotiation and did not benefit.

3. Eval :a. <10% is considered below which courts don’t consider control

(even though arguably in fact ) … skepticism that such a person might want to loot the company b/c the stake is so low

b. > 50% you can probably sell the voting sharingiv. Essex v. Yates (2nd Cir. 1962) (599)

1. Facts : a. Def, the chairman of the board of corp., signed a contract in

which he agreed to sell his shares of stock at a premium.b. Provision included an option for buyer to request seller’s

resignation and resignation of majority of directors from the board seriatim, which would allow the rest of members to choose successor per the charter & bylaws.

c. When closing set to occur, def. rejected the deal because the price of stock had gone up and he wants out.

d. Pl. brings suit and district court (in diversity) grant’s def’s summary judgment motion on basis that contract was illegal and against public policy.

2. Majority :a. Section on directors not severable.b. [It is established law that it is illegal to sell corporate office or

management control accompanied by insufficient or no stock to carry voting control.

c. However buying a controlling share of stock in a corporation does legitimately come with voting control. Due to staggered election of board, it would have taken 18 months of majority stockholder to acquire managing control on the board.

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d. The question is whether an agreement can accelerate the transfer of that control where there is a practical certainty that buyer will end up with control?

e. While Feldmann says director may not profit from facilitating action which is detrimental to interests of corp., here there is no suggestion that transfer carried any such threat. At low percentage of stock you clearly can’t sell office because it is so low.

f. *Policy: in the interest of M&A, deals, and the economy to accelerate the inevitable changeover in control.

g. On remand burden should be on party claiming illegality to demonstrate that somehow the purchaser of 28% here would in fact not have control to vote in their board if awaited regular annual meeting]

3. Concurring (Friendly) a. The operation contemplated here - mass seriatim resignation

directed by selling stockholder and filling vacancies – is contrary to reasonable expectations of minority shareholders that they will get to vote. ***What parties can do is agree to hold a special meeting after the sale where the election may proceed…A real robust market test should be a condition of closing, since we do not know <50% if the supposedly controlling shareholder (buyer) will actually exercise control.

b. In reality just because seller was able to exercise control with <50% doesn’t mean the buyer will actually be able to do so.

c. There is however very little New York state case law to guide this court. In fact majority approach is hard to apply in practice as it is hard to predict ex ante if buyer will in fact end up with control. Far better to leave the development of this doctrine to the development of NY state courts.

4. Eval :a. xx

c. M&A i. General notes :

1. Modes :a. Statutory merger**b. Asset salec. Stock for stock**d. Triangular merger

i. Forwardii. Reverse**

2. See also Van Gorkom aboveii. Asset Sale :

1. General notes a. This is a sale of assets, according to laws of contractb. Advantage of Asset Sales (over statutory merger)

i. Acquiring company can pick and choose what to buy, leaving liabilities that

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c. Drawbacks of Asset Sales (over statutory merger)i. Transaction costs are significant – must go contract by

contract, asset by asset – timing and costlyii. Tax benefits

d. DGCL §271(a) requires a shareholder vote when selling “substantially all” assets

e. To protect the expectations of the investors.f. For big decisions, the operational expertise of managers (which

makes us usually leave day-to-day decisions to mangers) not significant

g. Agency costs arise with respect to significant changes. ?h. DGCL §271(b) says shareholders cannot force the deal to go

through – only approve it.i. Acquiring corporation’s board needs to approve it, but

shareholders do not. i. Except when consideration is stock and you are issuing

over 20% more shares that you have outstanding (NYSE rules not Del. law).

j. Target corp’s board of directors and shareholders have to approve the transaction.

k. The big difference from statutory merger : In Delaware neither will target corporation’s nor acquiring corporation’s shareholders will not have appraisal rights in this scenario, which is one reason corporations are using this vehicle instead of statutory merger.

l. Assignment issues :i. Ask for notes

2. Hollinger v. Hollinger International. (Del. Ch. 2004) (809)a. Facts :

i. Pl. is controlling shareholder in def. corporation. ii. Pl. seeks preliminary injunction preventing def. from

selling Telegraph Group – its indirect wholly owned subsidiary – to third party.

iii. Issue is whether decision must be approved by vote since it involves “substantially all” assets within the meaning of DBC §271

iv. [Note the issue here has nothing to be with fair value for the deal – it appears that the price is good.]

b. Majority :i. **The inquiry as to whether transaction involve

“substantially all” assets within the meaning of DGCL §271 is fact-sensitive and contextual. Test: Does it (1) involve sale of assets “quantitatively vital to the operation of corp” and (2) “substantially affects the existence and purpose of corp.”?**

ii. Is Telegraph Group quantitatively vital to operations of def? [quantitative]

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1. No, it has plenty of other significant assets with a strong record of profitability.

2. It is one of two groups owned. Constitutes less than 60% of def’s asset value…

3. *Not just assets, but even EBITDA (profitability) calculations also support the fact that def. company will still survive

4. Def. can be profitable without Telegraph.iii. Does the sale “substantially affect the existence and

purpose” of def? [qualitative]1. This has to do with economic quality of the

asset as distinct from others that they now possess…(not quality of publication).

2. [This qualitative test will be more relevant where an integrated company sells off some core function even if retains vast other holdings.. ….e.g. if Coca Cola sells off the recipe]

3. Here sale does not strike at the heart of the corp as it retains comparable profitable newspapers in its possession

c. Eval :i. To the degree the asset sale is a substitute for a merger,

the target company that is selling its assets, will usually then dissolve after the sale. There are equitable doctrines in place to prevent this from leaving liabilities only…

iii. Appraisal Remedy 1. General notes :

a. Originally any major change had to be approved by all stockholders under © contract clause. But ground shifted significantly

b. Today dissenters in both acquiring company and target company often have right to receive cash for their shares (appraisal) for various types of corporate transactions.

c. But circumstances where states grant appraisal rights vary widely…with some providing for appraisal liberally in a range of situations but **Del. is parsimonious providing only for M&A.**

i. Del. allows corp. to navigate § 262(c)1. Process . § 262(d). 20 day notice during which

minority must place a “written demand for appraisal”. Then at the meeting shareholder must either vote against or abstain. Then during 120 period, shareholder must file request with the court of chancery. See DGCL § 262(e). No class action available.

a. Drag along : minority shareholders may try to get a premium. [ask for others notes here – see p. 608]

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http://www.investopedia.com/terms/d/dragalongrights.asp#axzz1pmVZepIq

b. A contractual provision to support the merger, that contacts away the appraisal rights.

c. What the minority get in exchange is presumably a better price for the shares. Some protection in the fact that majority shareholder is willing to take the price…

2. Circumstances . a. Rule : Anytime you have a statutory

merger, everyone has to vote.b. DGCL § 262(b)(1) creates exceptions to

the rule. i. if company is publicly traded –

presumably because it is far easier to sell and receive fair value for the shares

ii. Short-form/small scalec. § 262(b)(2)

i. Exception from exception : Restores right the right to any situation where getting cash instead of shares in surviving corporation. Presumably if you’re getting cash, you’re happy and your interest in corporation is over.

3. Valuation when exercised .a. Valuation methods vary, as well. (813-

14)b. [3 ways: 1-minority discount 2-x 3-

new value expected from merger] [ask for others notes here]

c. Most take the 2nd approach, including Delaware

d. ***Not always clear whether statutory provision of appraisal remedy precludes shareholders from seeking equitable relief (e.g. injunction, rescission). Arms-length transactions the appraisal is likely to be the exclusive right, but if there is fraud, self-dealing transaction, minority will still be able to seek injunctive relief.

i. Majority rule is that mere availability of appraisal does not preclude suits for fraud, unfair self-dealing by fiduciaries etc.(815)

ii. Plus parties can almost always bring suit alleging transaction didn’t not follow the appraisal statute

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procedurally, or there was misrepresentation or it is not authorized by statute (814)

iv. Statutory Mergers (816) – combination pursuant to agreement with the surviving corporation succeeding by operation of law.

1. Two common scenarios a. Create social valueb. In between – ones that don’t add or destroy value but shift it

between different interest groups (e.g. govt, shareholders, etc.)c. Destroy value

2. Scenariosa. Synergies b/w companies

i. Vertical – e.g. buying supplierii. Horizontal merger

b. Diversify the cash flow – smoothing effects on the cash low stream, however it might be an expensive way to diversify, and not necessarily in interest of shareholders.

c. Problematic i. Eliminate competitors perhaps in a way that is

problematic. [This is where anti-trust law comes in]ii. Empire building (e.g. sexy media companies)

iii. Loot 3. Assignment issues :

a. Ask for notes 4. ***DGCL §§ 251(a)-(e) authorizes mergers and spells out process:***

a. *Negotiationb. *Preliminary agreement (“letter of intent”) signed (conditioned

on shareholder approval)c. *Board and shareholder of both acquiring and target company

must approved. Articles of merger filed with statee. *Cash or stock issued by surviving corporation exchanged for

stock of disappearing/target corp.f. *Law operates to pass all assets and liabilities of

disappearing/target corp. to acquiring/surviving corp.5. Merger means A merges into B, but consolidation means A and B merge

and become C.6. Increasingly exception shave been carved that allow statutory mergers

by something less than majority vote of outstanding shares of each constituent.

a. Small-scale mergers (817-818)i. When B merging into A, A’s shareholders do not have to

vote for it for 20% threshold A’s operationii. DGCL §§ 251(f)

b. Short form (cash-out) mergers (818-819)i. DGCL §§ 253

ii. Parent-subsidiary mergers can be effected simply by vote of parent’s board w/o vote of shareholders,

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without appraisal rights, and often w/o vote of subsidiary’s board.

iii. **These days even for subs owned by as little as 90%iv. To the degree there is a minority shareholder, they

operate effectively as a cash-out – parent can force minority to sell.

v. De Facto Mergers (820)1. General notes:

a. Courts essentially want to treat de facto mergers to ensure that parties are protected the way they would be in asset sales.

b. Two modes: i. Stock-for-assets combinations: this is a way to A to

avoid assuming all of B’s liabilities. A exchanges its stock for B’s assets, and B dissolves distributing A’s stock to B’s shareholders.

1. See notes on “asset sales” aboveii. Stock-for-stock combinations: A issues its stock directly

to B’s shareholders in exchange for B stock. No approval by B necessary since it takes no action.

1. Advantages: a. Target corporation remains intact –

maintains the liability shieldb. No assignment issues

2. Two ways to acquire target corporation’s stock:a. Private offer b. Tender offer

3. Operationa. MBCA – mandatory possible – Target

board of directors must approve. b. Delaware – cannot do mandatory – to

impose it on everyone c.

c. Viewed as a de facto merger, then it usually will require a vote by both A’s and B’s shareholders, triggering appraisal rights.

d. Viewed as a purchase by A of B’s assets, this usually does not require A shareholder approval and does not trigger appraisal rights. Sale of substantially all assets by B, however, will require shareholder approval and B will have appraisal rights (but not in Del). (821)

2. **Hariton v. Arco Electronics (Del. 1963) (821)a. Facts :

i. Two companies effected a stock-for-assets sale. ii. B’s shareholders approve the sale of assets, but plaintiff

is minority who voted against – brings suit alleging sale was illegal **because avoids appraisal rights** to minority shareholders.

b. Majority : Stock-for-assets sale is legali. Pl. is right that this achieves the same result as a merger

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ii. This is based on sale-of-assets statute which is separate from merger statute. Each has **independent legal significance.****

c. Eval :i. Triangular Mergers and Share Exchanges :

1. Pros: Tax law usually treats statutory merger better than stock combinations and advantages in that operation by law makes paperwork less

2. Cons: But of course stock combinations go around voting and appraisal rights and avoids liabilities of disappearing corp.(831-33)

ii. Triangular merger designed to give the best of all worlds – the form of a merger but without necessarily assuming the liabilities of disappearing corp. Note that triangular mergers may allow subversion of shareholder voting and appraisal rights [Note that triangular mergers may allow subversion of shareholder voting and appraisal rights! (832)]

1. Forward : Acquiring corporation negotiates and agreement with target corporation. Acquiring corporation forms a Subsidiary, whose assets are only made up of merger negotiations. Then target corporation merges into the Subsidiary which now owns all of the target corporation’s assets and liabilities by operation of law.

a. This has the advantage of the stock-for-stock exchange, because there remains a perfect liability shield, which otherwise wouldn’t exist in a straight merger.

b. A’s shareholder’s are shut out of the process and no right to appraisal, because the decision in hands of Subsidiary’s shareholders (which is going to be A) (831)

2. Reverse : Acquiring corporation negotiates and agreement with target corporation. Acquiring corporation forms a Subsidiary, whose assets are only made up of merger negotiations. Then subsidiary corporation merges into the target corporation which now owns all of the target corporation’s assets and liabilities by operation of law.

a. The only advantage are tax and creates fewer assignment issues than the forward triangular. Now more popular than the forward. (832)

vi. Freeze-outs

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1. General notes :a. Involuntary elimination of minority shareholder’s equity interest

takes the following forms:i. Dissolution freezout : where majority stakeholder

dissolves the corporation to get hold of its assets and cash-out the minority shareholders has been held illegal in many cases. (833)

ii. Sale-of-assets freezout : majority shareholder organizes a new corporation that he controls, and then causes the first corporation to sell its assets to the new one for cash or notes. Also has been disapproved in many cases. (833)

iii. Debt/Redeemable-Preferred Mergers : majority shareholder organizes a new corporation that he controls, and then causes the first corporation to merge into the new one…? (833)

iv. Cashout merger : ? (834)b. Recurrent issue is whether such transcations are permissible if

effected with no business purpose other than increasing the controlling shareholder’s portion of the pie.

2. Weinberger v. UOP (Del. 1983) (834) [cash-out merger]a. Facts :

i. In 1974, Signal Companies, Inc. acquired 50.5% of UOP, Inc.'s newly issues shares and through tender offer. Signal becomes controlling shareholder and nominated and elected 6 of the 13 directors on UOP's board.

ii. In 1977, Signal became interested in acquiring the rest of UOP through a cash-out merger – they had 2 directors of UOP using inside information doing the feasibility analysis [this is the main problem here] – and decide to buy at any price up to $24 per share. As UOP’s majority shareholder, Signal owed a fiduciary duty to both its own stockholders and UPO’s minority. [review] .

iii. **Signal and UOP arrive at price of $20-21 per share. UOP CEO, appointed by Signal, supports the price. Lehman Brothers, the outside advisor to UOP, supported the price (although it was hasty).**

iv. Signal's board unanimously voted to propose a merger at $21 per share. Upon receiving this offer, UOP's board voted to accept and urged the shareholders to approve the merger. The merger was approved (including by *majority of the minority shareholders*) and became effective in May, 1978. UOP merges into a wholly-owned subsidiary of Signal.

v. Plaintiff brought a class action on behalf of the minority shareholders of UOP, challenging the fairness of the merger agreement.

b. Majority :

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i. When directors of a corporation are on both sides of a transaction they are required to demonstrate their utmost good faith and inherent fairness of bargain. Directors serving on boards of parent and sub. owe both corporations the same duty.

ii. Plaintiff must allege specific acts of fraud, misrepresentation or other misconduct to demonstrate unfairness. Enough to demonstrate some basis for invoking the fairness obligation.

iii. At that point, majority shareholder shows by preponderance of evidence that transaction is fair (i.e. fair dealing and fair price).

1. if corporate action has been approved by informed vote of *majority of the minority* shareholders,

2. If truly independent committee of Board or they need to be acting in a way that exclude the conflicted directors altogether.

iv. Burden shifts to plaintiff to show that transaction was unfair to minority

v. Business purpose test : Del. rejects this test but other states recognize the test. All you need to show that there is some legitimate benefit to the corporation. (Arguably here there are synergies such that would satisfy the test, which is not overly rigorous)

vi. Here 1. Signal-designated directors on UOP board still

owed UOP & its shareholders an uncompromising duty of loyalty.

2. Fair dealing : Committee must be independent. There was no informed vote of stockholders b/c material information was withheld under circumstances amounting to breach of fiduciary duty. (Two common Signal-UOP directors participated in decision making process on UOP board, knowing about an internal Signal report suggesting that $24 was the fair price but not disclosing to the outside directors.) The decision was rushed, as was Lehman’s evaluation – it was not meaningfully negotiated – it was dictated by Signal.

3. Fair price : Appropriate to be more liberal with valuation and use any technique that are considered acceptable in financial community… The price does not have to be $24 but what is weird here is that UOP insiders know the reservation price of the buyer in a way that has no similarity to an arm’s length transaction

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4. Remedy : too late to undo this transaction so the appropriate remedy is damages based on the correct valuation standard. [Remedy should be an appraisal under DGCL §262. ] [overruled: when you are claiming a breach of fiduciary duty, you are not limited to appraisal. It can be the full range of remedies although you can take appraisal rights…][the significance is not the remedy but the effect on ability to certify a class action] Follow a more liberal, less rigid approach to the valuation process than what has previously been permitted. [Appraisal rights is the value of company as a going concern. Here however court says that value of the synergies is included.]

5. Therefore, burden did not shift to plaintiff and transaction unfair.

c. Eval :i. The way to get a proper transaction here is to get an

independent committee with real outsider advisors. See Kahn for more.

ii. Other courts will nevertheless impose a “business purpose” element in the analysis. See Coggins v. New England Patriots (Mass. 1986) NY requires it too.

iii. What is “proper business purpose”? It confers some general gain on the corporation. [conjunctive/disjunctive?] (849-50)

iv. See also Kahn v. Lynch3. Glassman v. Unocal (Del. 2001) (850)[short-form merger – §253

provides appraisal rights]a. Facts :

i. Unocal owed 96% of UXC…Merger in the works by way of exchange of shares. It is carried out short form merger pursuant to DGCL §253.

ii. Plaintiffs file a class action on behalf of UXC minority holders alleging a violation of Weinberger’s entire fairness standard.

b. Majority :i. **Reconcile fiduciary’s duty to establish entire fairness

with less demanding requirements of the short form merger statute. Statute authorizes elimination of minority stockholders without any entire fairness…

ii. Can a minority shareholder who is eliminated under the short-form statute still bring a challenge under the entire fairness claim?

iii. In a short-form merger, there is no “dealing” of any sort – no formal merger negotiations – only a unilateral

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decision my 90% majority to take control of the whole entity while minority holders get appraisal rights.

iv. **To serve its purpose §253 must be construed to obviate requirement to establish entire fairness. **Absent fraud or illegality** appraisal is the exclusive remedy. (No right to rescission)

v. Weinberger is right that valuation must be based on all relevant factors…

vi. Still in place**Further, although entire fairness not necessary in short-form merger, the duty of full disclosure remains at the point where minority holder decides whether to seek appraisal or accept merge consideration.** (e.g. material information, like in the tobacco case…Zahn)

c. Eval :i. xx

4. Solomon v. Pathe (Del. 1996) (853) [tender offer]a. Facts :

i. CLBN already controlled 89.5% of Pate and held a tender offer for remaining shares.

ii. Plaintiff instituted class action on behalf of Pathe minority holders alleging tender offer was unfair (due to inadequate price) [entire fairness], coercive, and breach of CLBN’s duty of loyalty as controlling stockholder and Pathe board acted improperly by failing to assess the tender offer independently.

b. Majority :i. In a case of a totally voluntary tender offer, courts do

not impose any right of shareholders to receive a particular price…An allegedly voluntary tender offer may be problematic if (a) coercion is present or (b) there is materially false or misleading disclosures to shareholders. [LS: Courts only look at procedural kashrut, not substantive fairness of price]

ii. Here there is no allegation of anything coercive or misleading

c. Eval :i. Contrast with Weinberger

ii. Bottom line that tender offer + short form = merger 5. In re Pure Resources Shareholder Litigation (Del. Ch. 2002) [tender offer]

a. Facts : i. Unocal, owned 65% of Pure Resources, made attender

offer for the remaining 35% effectively only if a majority of the shares not owned by Unocal were tendered.

ii. Shareholders in Pure Resources sought to enjoin the tender offer on the ground that the entire fairness standard was applicable to the transaction and price was inadequate to satisfy the standard.

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iii. Unocal argued entire fairness only applicable to a negotiated transaction, not a vol. tender offer. Further Solomon v. Pathe governed.

b. Majority : i. Right now two standards appear to apply creating some

incoherence in the state law:1. Entire fairness protects minority shareholders

from unfairness in negotiated transaction. Lynch line of cases

2. Tender offer (followed by a §253 short-form merger) emphasizes free flow of capital b/w willing sellers and buyers so long as no fraud or coercion. Solomon v. Pathe line of cases.

ii. The preferable policy choice is to continue to adhere to the more flexible Solomon approach, while giving some greater recognition to the inherent coercion concerns that motivate the Lynch line of cases.

iii. Our law should consider an acquisition tender offer by a controlling stockholder non-coercive when:

1. It is subject to a non-waivable majority of the minority tender condition. Actually unaffiliated people. Actually voluntarily tendering. Not those who might have other reasons (e.g. current officers who want to save their skin)

2. Controlling stockholder promises to consummate a prompt §253 short-form merger if obtains more than 90%.

3. Controlling stockholder has made no retributive threats

iv. At the same time majority stockholder owes a duty to permit the independent directors on the target board freedom and time to react to the tender offer.

v. For their part independent directors have a duty to undertake in good faith an assessment etc.

vi. Here 1. The majority of the minority condition was

improperly calculated. Otherwise fine.2. Procedural protections imposed short of entire

fairness.c. Eval :

i. Related to the cashout merger’s purpose of eliminating the minority stockholders is the “going dark” objective. A process by which a public company reduces the number of public stockholders below the threshold required by SEC and ceases to be an Exchange Act reporting company. (not all minority eliminated, but enough). Rule 13e-3 imposes significant disclosure requirements for certain such transactions. And there is

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an implied right of action for misrepresentations committed in 13e-3 transactions. (857)

ii. Allow for disparate treatment – does not impose the full entire fairness standard

Weinberger(actual merger)

In re Pure Resources(Tender offer + short form)

Test Entire fairness; def’s procedural protections shift burdens of proof back on plaintiff

Conditions:1) Majority of

minority shareholders

2) Independent committee to advise shareholders

3) X

These protections not a significant as Weinberger b/c unlike that, this is not a real negotiation in reality.

Safeguards under best practices

(1) informed majority of minority shareholders OR (2) independent negotiating committee see Kahn v. Lynch(in reality best to ensure both in case court finds it wasn’t good enough)

Independent committee actually negotiates a price

Risk of class action under entire fairness

Majority of minority tendering; no fraud or misstatements; promise to consummate short-form; no retribution

Acquiring company should do its duty.

No risk of class action. Only appraisal right

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iii.vii. Hostile Takeovers & Defending Control

1. General notes :a. Policy : General idea among economists is that threats of

takeover make officer work harder, and thus a barrier to takeover is suspect. Also about assets utilized in the best way.

b. See Definitions (858-62)c. Williams Act (862-67)

i. Amended Securities Exchange Act sectionsii. Policy :

1. Information problems2. Collective action problems

iii. **Early warning reporting requirements 13(d):1. Anyone acquiring over 5% as a beneficial owner

of any class of securities in public company must file with SEC within 10 days. [As soon as disclosure comes out the price of stock usually trends up, as public thinks you are set on acquisition]

2. Differentiates b/w “passive” owners and those intent to control…Schedule 13G (862) This is used by mutual funds, pension funds etc. [unless they’re in cahoots] You have an ongoing duty to update and to the degree that your intentions change.

3. **Acting in concert may trigger reporting requirements** The definition for acting in concert if fairly broadly

4. Hart-Scott-Rodino provides additional requirements, effectively lowering the reporting thresholds.

iv. What constitutes a tender offer 1. Not completely settled – archetypal public bids

to the world clearly covered but private offers made to a limited number of potential sellers

2. ***Some courts use 8-factor test (863) 2nd Circuit in Hanson Trust v. SCM said that whether something a tender offer turns on whether there is a likelihood that unless the Act’s rules are followed there will be a substantial risk that solicited shareholders will lack information needed to make a carefully considered appraisal or offer. *** We have no bright line test for what is a “tender offer”? The 8-factor test is still used to see if there is (863)

v. Filing requirement: Schedule TO***

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1. 14(d) requires any person who makes a tender offer for a class of reqgistered securities that would result in that person owning more that %5 of the class.

vi. Regulation of the terms of tender offer in 14(d) and rules***

1. ***Minimum duration – at least 20 business days. Tender offer must be open for 20 business days (i.e. 4 weeks) in order to allow proper deliberation and give more opportunities for competing bids to come in.

2. ***All-holder rule: in 14d-10 requires that a bidder must make a tender offer open at the same price and on the same terms to all holders of the class of securities. Under Supremacy Clause it displaces contrary state law. (865)

3. ***Best-price rule: in 14d-10 provides that price paid to any security holder must equl the heist price that bidder pays to any other security holder during the tender offer (865)

a. In Field v. Trump 2nd Cir. said that bid started, cancelled, and later re-announced was really the same bid.

b. Other courts have preferred a bright-line approach focused on formal announcements.

4. ***Withdrawal right: under 14(d)(5) of Williams Act, a shareholder can withdraw unaccepted shares at any time after 60 days from date tender offer announced (865-66) Also under Williams Act one can withdraw the shares at any act even if you tendered. That means acquirer will not know how much they have until the tender offer closes.

5. Proration : under Rul 14d-8, if a bidder makes a partial tender offer (less than 100% of target company’s securities) and more securities are tendered during the tender offer than bidder accepts, he must accepted all tendered securities up to desired %age on a pro rata basis. (866)

vii. Obligations of the target’s management 1. Rule 14e-2 requires the board of the target

corporation to notify shareholders about the position they are taking & reasons:

a. Recommend acceptanceb. Recommend rejectionc. Neutral

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d. Unable to take position2. Any person who solicits or makes

recommendation to shareholders in respect of a tender offer must also file per Rule 14d-9. This includes statements required to be made by target’s board.

viii. Shareholder have various information available to them: Schedule TO is what bidder must disclose. Schedule TO D 9 where board of target company evaluates the offer and responds to the offer. That should be an honest assessment since there are also fraud provisions. That way shareholders have time and adequate information to shareholders make an adequate decision.

ix. Tender offers by issuers : Under 13(e) governed similarly to regular tender offers

x. Anti-fraud provision - 14(e) ensures information is truthful. Parallels the requirements of Rule 10b-5 (scienter, fraud on the market approach to causation..)

xi. Private Actions : target’s shareholders have standing to sue under several of the above provisions of Williams Act. Bidder can’t sue for tamages, but can sue for injunctive relief. Target’s shareholders can sue for injunctive relief under some provisions.

2. Unocal v. Mesa Petrolium (Del. 2001) (868) [skipped by accident]a. Facts :

i. Two-tier offer: $54 on front end (stock trading at $33).ii. Able to offer so much b/c planning to sell of the target

company by way of third party financing --- usually expected value as an ongoing concern is greater than liquidation power but here it is different because current management appears to be destroying value (and threat of takeover might be a good thing)

iii. Unocal rejected the offer, then deciding that they are on a good path, management stays the course here. They make effort to get themselves informed by hiring Goldman to evaluate price and put a lot of time into trying to figure out if this is an appropriate offer.

iv. Decided to pursue a self-tender – if Mesa got 37% to bring it up to 50% it would tender at $72 on the back tier. But that only becomes effective only if the $54 words. Shareholders would be worried that not enough people would tender at $54, such that you are never going to get either. As a result they make a modification [making it available to everyone except Mesa to get them for their 30% of shares]

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v. What is the standard to use to evaluate it? Deferential business judgment rule or enhanced scrutiny in entire fairness test.

b. Majority :i. Two part test (often described as enhanced scrutiny):

(see 872)1. The court business judgment rule as long as

they reasonably believe there is an actual threat existed

a. [here a risk of shareholders tendering in spite of price being lower than what value is worth. Here court has no problem finding this was coercive]

2. Demonstrate their response was reasonable in response to threat posed.

a. [Here court it was a reasonable response – (1) the greater the magnitude of the threat the greater room for directors to fashion a defense (2) xxxxxxxxxxxx. The discrimination against Mesa is held to be OK because this is but a mild variation on raiders being greenmailed in the past.]

ii. [Rationale: Generally risk of losing job does not = self-dealing and self-interested; but it takes away ability to be 100% objective; high scrutiny involved in this case regardless what the court calls it probably due to the type of transactions]

c. Eval :i. Today under Williams Act all-holder rule (applies to

everybody) and best-price rule would prevent this. Note that an acquirer can still entice the incumbent directors and officers in target company by a lucrative severance package that is not covered by the above rules.

ii. Also under current law the more coercive the offer the more the room the board will have to take action to defend themselves. Federal law and state law work together to protect…

3. Unitrin v. American General Corp. (1995) (877) [skipped by accident]a. Facts: Tender offer from American General towards Unitrin

which takes several defenses measures (1) adopt a poison pill (2) adopt a repurchase program for their own shares, like Unical above. Here hostile bidder trying to challenge the defense mechanism erected specifically in face of their bid. Charter has provision that said if someone more than 50% of shares tries to effectuate a transaction, you need majority of continuing directors or 75% of shareholder vote needed to approve it.

b. Majority:

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i. Unical inquiry: 1. Is there a threat here ? Three types of threats

possible (1) opportunity loss (2) structural coercion (3) substantive coercion [KJ: Kind of paternalistic, but recognizes information asymmetries.] is it draconian?

2. Defensive measures : a. Threshold: Is it measure is (1)

draconian and (2) coercive b. Reasonable ? Suggests it is reasonable

here.c. Eval :

i. See this case for a revised standard in Unocal expands the test and adds element of “substantive coercion” and adds the In Re Gaylord threshold element in the test. Court being pragmatic. 23% as good as 25% in practice

viii. Poison pills (AKA Shareholders Rights Plan)1. Board doesn’t need to ask shareholder to enact a poison pill, but the

corporate charter must have a “blank check” pursuant to §157 (a) how much shares and (b) what kind. Some shares must be authorized but not yet issued such that board has the authority to set the terms of those shares.

2. See summary of sample poison pill on on 1497, preamble on 1501 in Supplement:

a. Right attached to every share but not exercisable until a triggering even.

b. 15% most common thresholdc. Once it becomes exercisable it is worth, shareholder can get as

many shares as you want at a discount.d. Everyone except the 15% acquirere. KJ: Effect is to dilute the value of the shares if acquirer goes

through. This is a transfer away from acquirer to everyone else. [Note that similarly in Unocal self-tender to everyone except acquirer was OKed by the court]

f. Giving board flexibility to change its mind gives them second opportunity, but on the flips side the greater discretion dilutes the deterrent value.

g. “Redeeming” poison pill – Board can take it away before the triggering event. Primary purpose is to not prevent takeovers but prevent takeovers that are not endorsed (and hence redeemed) but the board.

h. Protection against squeeze-out (AKA “flip-over”) <???>3. ***Moran v. Household International (Del. 1985) held that a corp’s

board could validly adopt a “shareholder rights plan” (i.e. a poison pill), which def. corp. had put in place pursuant to §157 which allows boards to issue shares in the future after founding. Court noted that although it was green lighting the strategy, the board is still held to the same

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fiduciary standards as always. Per se kosher. So long as there is an option to redeem subject to fiduciary obligations, that will be the point of scrutiny. (880)

a. KJ: Easternbook doesn’t like this because it wards off potential hostile overtures which might be good because even if they fail they send a signal to shareholders that target company is not being run as efficiently as it could.

4. *Dead hand: In Carmody v. Toll Brothers (Del. Ch. 1998) court declared the dead-hand pill (i.e. provision providing that rights could only be redeemed by directors who adopted the plan or their designated successors) invalid because

a. *It interferes with shareholder voting franchise without a compelling justification under Blasius

b. *Impermissibly creates voting-power distinction among directors w/o authorization in the articles of incorporation.

c. *It is “disproportionate” defensive measure under Unocal/Unitrin (881)

5. In contrast in Invacare v. Healthdyne Technologies(N.D. Ga 1997) upheld the dead hand pill (881)

6. *Delayed redemption is a sequel to dead-hand control, b/c I provides that if a majority of directors are replaced by stockholder action the newly elected board cannot redeem the rights for six months if the purpose or effect is to facilitate a transaction with a “third purpose”. It has been held invalid under Del. law in Quickturn Design Systems v. Shapiro (Del. 1998) because it impermissibly interferes with board’s discretion and discharge of its powers. (881-82) §141(a) says directors can do whatever they want. Can’t prevent them. Again other courts have held it kosher.

ix. Air Products & Chemical Inc. v. Airgas (Del. 2011) (883)1. Facts :

a. *Air Products launched hostile bid to acquire Air Gas (and ultimately abandoned it.)

b. *Source of trouble was both a poison pill and a staggered boardc. *Airgas has a provision that allows a special meeting so long as

super-majority.d. Air Products got nominated 3 of its directors promising to take a

“fresh look” at the offer and promising them to be independent.e. The 3 directors were elected, but after looking at the numbers

they joined the outside directors to in view that $70/share was inadequate.

f. Air Products challenged the validity of board’s refusal to redeem the poison pill…“Argument boils down to…Airgas’s defensive measures make the possibility of Air Products obtaining control of the board and removing the pill realistically unattainable in the very near future.”

g. The issue here is (1) what set of defenses adopt initially and (2) how to use the defenses appropriately. This case is not about

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whether these defenses can be adopted but at what point does the board must redeem.

2. Majority : [LS: WHY IS THERE NO UNOCAL QUESTION #1 – WHETHER THREAT CREDIBLE? DOES COURT JUST SKIP IT B/C OBVIOUSLY SO?]

a. Is it coercive i. A defensive maneuver is coercive if forces a

management-sponsored alternative on the shareholders. Here: nothing of the sort.

b. The issue is whether the def’s board action is actually preclusive? No

i. Del. supreme court has already held that a combination of a staggered board and a poison pill do not per se constitute a preclusive defense.

ii. Not preclusive so long as obtaining control at some point in the future is realistically possible

iii. Here acquirer merely delayed, not precluded. In fact it has two options under the charter, which examined below:

1. Call a special meeting to remove Airgas board by 67% supermajority vote

a. The key question here is whether this is something attainable?

b. This must be more than a mere “mathematical possibility” or hypothetical.

c. *Here such a victory is not realistically attainable but, Air Products has another option:

2. Wait until next annual meeting to wage proxy contest

a. Here such a victory only demands a simply majority of the voting stockholders. All Air Products needs to do is stick around until the next meeting. At that point it is very possible.

c. Reasonableness of board response i. Evaluated in context of specific threat identified.

ii. Here : independent outside board members with outside financial advice concluded the price was inappropriate, so they are responding to a legitimately articulated threat.

iii. **Further, Air Products chose to run three independent directors, who ended up siding against the takeover. Air Products got what it wanted. There is no basis for concluding that the response was anything but reasonable.

3. Eval :

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a. Still possible after this case to envision a case where the bidder gets his Board members elected who – unlike here – actually run on a platform supporting the merger. In that case the signal would be that shareholders really want the deal to go through. If the Board pushes back, if they can’t get anything, it is possible Board would have to redeem the pill (i.e. “just say no” will be deemed to be illegally preclusive)... Holding out for two full years would be a violation of fiduciary duties if the bid is likely to go through. On the other hand we are yet to see that sort of case decided.

b. Here court very influenced by the fact that the bidder’s 3 directors actually opposed the bid.

c. (Here staggered board + poison pill makes the firm particularly impervious to hostile bids).

d. KJ: “Preclusive” and “coercive” test might be good because it creates better incentives to guide corporate counsel, as opposed to “reasonableness” alone which is a vaguer standard to try to follow.

x. Revlon v. MacAndrews & Forbes Holdings (Del. 1986) (890)1. Facts :

a. Faced with an offer, Revlon’s board of directors took a number of defensive actions.

i. *Repurchase: in exchange for senior subordinated notes. They built additional covenants in into the notes that themselves provide additional bar to takeover, but may be waived by company under certain circumstnaces. [Vast majority of shareholders participated, becoming noteholders]

ii. *Poison Pillb. Bidder goes hostile and make increasingly higher bids…c. *Revlon authorizes additional defensive actions:

i. Admit that they will have to sell of the company (b/c pressure of increasing bids) and go white knight: Negotiation with Forstmann, which was made privy to internal Revlon financial data to exclusion of others…

ii. *Forstmann bid conditioned deal-protection devices: a “lock-up” option to purchase some of Revlon’s assets at discount if the deal falls apart, a “no-shop” agreement to deal exclusively with them, and $25 million cancellation fee. There are also golden parachutes for Revlon executives

d. Revlon board approves the proposal.e. MacAndrews (controlling stockholder in hostile corp.) sought

injunction to enjoin their defensive actions f. Pl. alleges that Revlon is inevitably going to be dissolved and

that any consideration with Forstmann was improper b/c it rested on consideration of constituencies other than stockholders

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g. Trial court granted a temporary injunction2. Majority :

a. As long as directors of target corp. legitimately conclude a takeover bid is not in the corp’s interests they are free to take defensive action so long as they act with due care.

i. Poison Pill kosher per se. Moran. Here it was reasonableness and made for purpose per Unocal. Board wanted to protect the company from a the initial low bid by acquirer interested in selling off the company for parts. Nor did it impermissibly stop the negotiation – if anything it increased the bidding to new heights.

ii. Repurchase : generally kosher, but also must be held ot Unocal standard. Here it is kosher for same reasonas as above

b. ***However once a dissolution becomes inevitable, Board’s duties change from preserving company to getting the best price available for their equity (***i.e. maximize short-term shareholder wealth – not long-term concerns or interests of any other parties. Often this means having an auction…). At this point concern for non-stockholder interests is inappropriate…***

i. Here evidence indicates that once dissolution was inevitable, Revlon’s directors instead were trying to shore up the Notes (thus interests of noteholders) instead of the equity owners.

1. While lock-up are not per se illegal, the option had a destructive effect on the auction process. Its purpose again appeared to primarily to protect the noteholders over the shareholders’ interests.

2. No shop also not per se illegal, also stopped the bidding and therefore fails under Unocal

ii. Also where the two bidders were making analogous offers, it is inappropriate for managers to favor the white night (e.g. providing insider financial info) the detriment of the hostile bidder.

c. In such case not entitled to deference under business judgment rule.

3. Eval :a. Deal protection devices may be good to get a bidding war going

but here you were using them to foreclose a bidding war, while refusing to deal with one of them.

b. Revlon is about making sure that shareholders get the premium that they can expect to get during change of control.

xi. Paramount Communications v. Time Inc. (Del. 1989) (900)1. Facts :

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a. *Time seeks to expand synergistically into video programs. Board approves its outreach to Warner Brothers (given significant synergies).

b. *Debate b/w Warner Brothers about cash acquisition, which Time prefers (to control board and preserve its culture), versus stock-for-stock swap (which Warner prefers). Stock-for-stock looks more like a merger rather than Warner being bought out. Real issue is whether this is merger of equals or acquisition of one company by another.

c. *Ultimately they agree on stock exchange rate, which included nice golden parachutes for Warner’s leaders, an balanced board, with a special committee Time’s board approves.

d. (Del. law requires only vote by Warner’s shareholders)e. Time’s board also adopts defensive tactics – no-shop clause and

confidence letters.f. Paramount wades into this by announcing an all cash tender

offer for Time’s stock at $175 per share. Time’s board studies and rejects this offer, finding the price insufficient.

g. **Concerned that shareholders might like the offer [shareholder have to approve the issuance of 20% shares per NYSE rules]*, Time decides to change its stock-for-stock deal with Warner Brothers into an all-cash acquisition [which did not require shareholder approval].

h. Paramount makes a 2nd bid at $200 per share and is again rejected by Time board.

i. Paramount sues asserting a Revlon claim arguing that Time effectively put itself for sale, triggering Revlon duties and requiring board to enhance short-term shareholder value to treat all interested acquirers equally. Also assert a Unocal claim arguing that court below erred finding that Time’s board had a reasonable grounds to believe that Paramount posed a cognizable threat and a danger to Time, that their investigation was incomplete, and that response was not “reasonable.”

2. Majority :a. The issue here is did Time’s board, having developed a strategic

plan of global expansion via merger with Warner, come under fiduciary duty to jettison its plan and put the corporation’s future in hands of its shareholders -- The key threshold question is whether Time by entering into the proposed merger with Warner Brothers put itself up for sale?

b. Revlon claim : i. Revlon duties may be triggered where

1. (1) corp. expressly puts itself up for bid [including where when minnow acquires a while, it might be interpreted as putting itself up for bid]

2. (2) in response to bidder’s offer, a target abandons its long-term strategy and seeks

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alternative transaction also requiring breakup of company (e.g. Revlon itself)

3. (3) Transaction results in change of control – where the resulting entity has another controlling shareholder. Not well defined, but two common scenarios:

a. After transaction there will be a single controlling shareholder, where before it lies in a diffuse base Paramount

b. Whale-minnowii. (KJ: Even in Revlon, directors have some discretion to

look at factors other than price; but you still have to engage in process to get the best price possible, which is what would’ve doomed Time under Revlon analysis)

iii. (Courts will look at both procedural elements and substantive elements)

iv. Here However, Time never made the dissolution of entity inevitable in negotiating with Warner Brothers (as in Revlon).

v. The fact that Time adopted defensive maneuvers is insufficient to invoke Revlon. These are merely subject to Unocal analysis.

c. Unocal claim :i. Initial deal b/w Time & Warner : Plenty of evidence that

initial decision to merge with Warner was entitled to protection of business judgment rule. This is a strategic decision that management reasonably can make.

ii. Restructured deal : This is a defensive technique to which Unocal applies.

1. Threat Plaintiff’s argument that because the offer was in reasonable it did not represent a “threat” reads the test too narrowly. Price is not the only factor in the flexible Unocal analysis. KJ: Here court allows Directors making a judgment paternalistically for shareholders.

2. Reasonableness of response : Directors are not obliged to abandon a deliberately conceived corporate plan for a short-term shareholder profit unless there is clearly no basis for sustaining the strategy. Here management did not try to “cram down” on its shareholders a management-sponsored alternative but rather just try to get the prior plan implemented.

3. Eval :a. If you wanted to no differ from court’s analysis, one can argue

that by creating such a massive entity you are realistically not able to be by acquired by anyone, arguably it is “preclusive” but

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this demonstrates, as does Air Products, just how weak the “preclusive” standard is.

b. Paramount v. QVC Network (Del. 1994) was very analogous with third party (QVC) coming in offering higher price. **Deal protections included no-shop provisions, termination fee, stock x**. Viacom counteroffers with higher price but deal protections still in place. QVC counteroffers with higher price. and being spurned. Here he owns 85% of Viacom, he is going to continue to have over majority stock after the deal is consummated. Revlon applies because there is a change in corporate control, even though it is not an actual break-up. Worry about squeeze-out, not having any possibility of a premium. x

c. (Finish notes on Revlon pp. 914-20)d. Timing : Revlon duties do not apply in until xxx. See Lyondell v.

Ryan (Del. 2009) where target company didn’t reject right away nor accept right away but entered a period of wait-and-see. Here court allows target the leeway to have that time before Revlon duties attach. This determines the type of duties that attached and the scrutiny that decision receives.

e. Lyondell also discusses §102(b)(7) applies to damages, but so far we have only seen injunctive relief. Therefore §102(b)(7) does not apply (and that duty of care still has a lot of life in this area where the relief is injunctive.

d. Deal Protections --- protecting one deal and fending off against others – this is all done under Unocal standard

i. General notes 1. These are effectively fiduciary duty of care claims (be it Revlon or

Unocal)2. Why have deal protection

a. It is a sweetener that adds certainty for bidders (like a liquidated damages clause)

b. Encourage companies (bidders) due diligence c. Increases the likelihood that deal goes through. Of course if it

deal protection (e.g. penalty) is too high, it becomes coercive.3. Operation

a. Deal protections are meant to kick in after signing (before shareholder vote and closing) where there is always a necessary delay (and the source of significantly uncertainty)

4. Types a. No-shop

i. Can’t talk to other biddersb. Termination fee

i. Compensation if deal falls apartii. Common with 3% being the norm

iii. Suggests that any other bidder better pay over 103% for it to make sense for target.

c. Stock Lock-up:

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i. A gift to purchase some of assets at discount ii. Selling off “crown jewels”

iii. Very rarely used after Paramountd. Asset lock-up e. Force the vote f. Stock initiation deal [??] see QVC deal where 19.9% target stock

at initial dealii. Omnicare v. NCS Healthcare (Del. 2003) (922) [Deal protection devices]

1. Facts : a. NCS stocks tumble and company in default… NCS a target of

acquisition bids by Genesis and Omnicare. NCS invited Omnicare to discuss possible acquisition in a bankruptcy sale…*

b. NCS also forms an independent committee to consider alternatives. But Board retained ultimate authority to approve. Committee and board share legal/financial counsel.

c. *Independent committee reaches out to Genesis, which wants assurances that if they pursue a merger, it will be able to consummate the transaction. *This is at first a much more attractive deal b/c it does not require going through bankruptcy and willing to partially pay off NCS’s creditors/shareholders. An exclusivity agreement is signed to make the deal bulletproof other bidders (here Omnicare) and the rest of the merger is negotiated (including voting agreement), with independent committee doing some work to improve the terms of the deal.

d. Shortly thereafter Omnicare reaches out with proposed deal. Any negotiations with Omnicare constituted breach of the exclusivity agreement, but NCS uses their letter to get better terms from Genesis. Genesis improves terms but requires prompt approval….Final merger agreement contains no talk clause and termination penalty. Also there is a voting agreement. At next day meeting board approves the deal. Under a provision in merger agreement authorized by §251(c), it was gonna go to shareholders for approval, regardless of what board recommended

e. Tri-partite defense (1) voting agreement, (2) the §251(c) provision, and (3) fiduciary out clause. §251(c) usually requires a board to decide this is in the best interest of corp and then shareholders has to vote. This contracts around that.

f. For its part Omnicare committed itself to a tender offer which is much better. As a result boar withdraws its recommendation that stockholders vote in favor of merger and financial advisor withdrew his recommendation too.

g. Class of all holders of Class A common stock are suiting NCS board members and Genesis.

2. Majority : a. Deal protection devices require enhanced scrutiny of Unocal.

There is an inherent conflict b/w a board’s interest in protecting

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a merger it has approved and the stockholders’ right to make the final decision to approve or not approve merger

b. Under Unocal must look to see if defensive devices are preclusive/coercive before looking at the reasonableness of proportionality determination.

c. Here we have the tri-partite defense between the voting agreement, the §251(c) provision, and theo fiduciary out clause

d. Under the Unocal standard (see great enunciation on page 931) the deal is impermissibly coercive because stockholders are required to vote and for minority stockholders the vote is therefore a fait accompli. The transaction would proceed no matter how good that alternative proposal from Omnicare…It is thus preclusive, too. **

e. Further, here NCS board disabled itself from exercising its own fiduciary obligations. Board could not execute an agreement that prevented form discharging its fiduciary duty.**

3. Dissent : a. Certainty for companies is super important. **Here there is

reason to think there wouldn’t have been any bid at all if there was no deal protection.

b. Majority announces a per se bright-line rule that seems to apply regardless of circumstances leading up to the agreement and the fact that **controlling stockholders** decided to vote for it. There was therefore no coercion.

c. Unocal scrutiny is incorrectly being applied. Here we have a proportionate response to a perceived threat.

4. Eval : a. Majority thinks that all steps of Unical are violated (coercive,

preclusive, unreasonable).b. Dissent is saying certainty has very real value to both acquirer

and target. You are actually handicapping directors’ fiduciary obligations because you’re taking away their ability….A market check is built in b/c shareholders decided to --- [as a matter of policy most analysts think dissent is in the right – it is odd to say this is “coercive” of shareholders][however there is reason to think that the facts are indeed preclusive in their effect under Unocal. But on the other hand it is preclusive b/c majority of stockholders already agreed, which is different from Unical worry about board acting contrary to interests of the shareholders.]

c. The stage of the process where deal protections kick in will matter.

d. Do you have ability to talk to other bidders? e. KJ: One of the clearest effects of this decision they will get a

fiduciary out, which allows target corporation to get out of agreement, which bidders hate. A target will still have to pay a termination fee, which is considered as a separate matter

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(which target can also try to argue is coercive/preclusive) As a practical matter, you will not see many targets try to get out.

f. 935-938 skipped

8. Shareholder Suitsa. Intro :

i. General notes :1. Many (1) procedural complexities and (2) ** policy issues of allowing

shareholders to impose the cost on corporation with possibly negligible gains to themselves and major windfall to plaintiffs lawyers**** (724)

2. However otherwise we fear that without class action suits, directors and other incider players will not bring suit, and at the same time per-share benefit is so negligible that individual shareholders suits won’t work.

3. **We are trying to balance agency costs b/w what is in corporations best interest and whether managers will do on their own initiative and the other one is (2) attorney’s driving litigation which may not be aligned with shareholders

4. Who can bring claim :a. Shareholders :

i. Usually broadly defined. **You can be a beneficial owner and not a shareholder of record**

ii. Timing: if corp. merged at the time of the suit then not actionable

b. Bondholders/Creditors : usually not allowed even where they have bonds convertible to shares of equity, although some inconsistency in the case law. **We want to maximize residual value.

c. Directors : usually may not bring suite except where authorized (e.g. NY)

d. Corporation must be joined in the suit as a defendant even though ostensibly shareholders bringing suit in name of corporation. (726)

5. KJ: A derivative suit is in the name of the corporation, but it is not considered to be a class action.

6. KJ: Usually recovery goes to the whole corporations. Only in rare cases is there a pro-rata exception where remedy flow to harmed shareholders. See Perlman v. Feldmann above.

ii. Tooley v. Donaldson, Lufkin & Jenrette (Del. 2004) (727)1. Facts :

a. Plaintiff seeks to pursue this case as a class action, rather than as a derivative suit, to try to avoid the procedural requirements of the latter.

b. AXA a majority holder in DLJ. Credit Suisse trying to buy DLJ and holds a tender offer, which per merger agreement was allowed to be extended under two circumstances…

c. Credit Suisse decides to postpone 2. Majority :

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a. Old cases demonstrate a lot of confusion b/w how to distinguish derivative suits and individual suits. These old tests are overruled.

b. Need an easy-to-apply consistent standard.c. The test : looking at the complaint:

i. **Who suffered the harm? Could the plaintiff prevail without showing the harm of the corporation?

ii. Who should receive remedy? **d. Here

i. There is no derivate suit possible because there is no injury to the corporation.

ii. Just because there is no derivative suit doesn’t mean there is an individual suit. This rights of the plaintiffs do not ripen until the merger agreement triggers the original shares to be sold. Plaintiffs have no rights.

3. Eval :a. Finish bottom half of 733

b. Contemporaneous ownership i. Bangor Punta Operations v. Bangor & Aroostook RR (U.S. 739) (739)

1. Facts :a. Defendant held had once held 98% of the stock in plaintiff RR,

which claimed that he had engaged in acts of mismanagement, misappropriation and waste in controlling their affairs.

b. District court dismissed the action, and held that current 98% owner was the real party in interest; that it had paid a fair price and received fair value; that it would be the principal beneficiary of any damages recovered that that it could not have satisfied the contemporaneous ownership rule had it not been evaded by having the corporation bring suit in its name. You want the best price. Market already providing a check on incentives.

c. The contemporaneous ownership rule provides that the complaining shareholder in a derivative action must have been a shareholder at the time of the wrong of which he complains to bring the action.

d. Court of appeals reversed, holding that the benefit of any damages recovered would accrue to the public through the improvements in corporation’s economic position. Any windfall to majority owner irrelevant.

2. Majority (Powell): Equitable principles preclude use of corporate fiction to evade the “contemporaneous ownership rule”

a. Courts must look behind corporate entity to the true substance of the claims and actual beneficiaries and where disregard corp. form where it is used to defeat overriding public policy.

b. Here : majority shareholder will be the principle beneficiary of any recovery, but he cannot bring suit in its own name b/c of contemporaneous ownership bar.

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c. Further , it is settle principle of equity that a shareholder may not complain of acts of corp. mismanagement fi he acquired his shares from those who participated/acquiesced in alleged transactions. This is esp. the case where shareholder purchases shares at a fair price and then tries to turn around and have corp. recover against the vendor for prior corporate mismanagement. This would be pure windfall.

3. Dissent (Marshall): a. But what about the other minority shareholders? Don’t they

deserve duty to seek recover for the wrongs they suffered.b. What about the 20 other people?

4. Eval :a. This is not a derivative suit. It is a corporation seeking to enforce

its own rights b/c it has a different controlling shareholder than who controlled before.

b. §23.1(b)(1) requires contemporaneous ownership – i.e. ownership at the time the harm was committed.

c. KJ: The shares were discounted b/c you knew harm occurred, now you cannot try to get a windfall by getting damages when in fact it was reflected in the purchase price.

d. KJ: In a public company –shareholder base changes daily so the contemporaneous requirement is imperfect since there will always be someone who plaintiffs lawyers can find who was an owner at the time.

e. [Derivate litigation historically grounded in equitable claims – here this is explanation why court looking past legal equity to the real beneficiaries – there is a hint of unclean hands analysis]

f. Most jurisdictions now have a version of the contemporaneous shareholder rule. However several exceptions exist (747)

i. **Devolution by operation of law: can bring derivative action if shares devolved “by operation of law” (e.g. inheritance) from someone who was a shareholder at the time. No “windfall” rationale here.

ii. **Continuing wrong theory: Where alleged wrong began prior to shareholder’s acquisition of stock but continued thereafter. **However, there is wide divergence about how broadly or narrowly to apply the test.** Core idea: if payments still due or part of it still ongoing, there is possibility as using it as basis for circumventing the rule.

iii. **§16(b): directors and officers selling and buying activity within 6 month period must be disgorged

iv. **Wrong undisclosed at the time the transaction. It is not reflected in the price you’re paying for the shares. This is a matter of contention between ALI and Model Act.

g. The rule doesn’t really work that well in public corporations because there will always be (tens of) thousands of people who

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are shareholders at the time...arguably doesn’t do any work and a lot of people still getting a windfall

i. In addition does the price even respond to the wrong?ii. Also in theory priced into share price some reflection of

future events are going to be (including litigation).c. Demand Requirement

i. General notes :1. There was a requirement that shareholder was to make a demand on

the board before bringing suit. It was unclear when that requirement was excused (e.g. when it was futile b/c majority directors not disinterested) and what was the consequence of not making the demand (748-49)

2. LS: What makes for a “wrongful” refusal - i.e. pl. makes demand, board refuses and moves to dismiss, but court allows it to go forward?

3. Operation:a. Demand made & corp decides

i. Agrees ii. Rejects – court comes in to review [In Del. a business

judgment rule, which means pl. likely loses]b. No demand made & court decides whether demand excused

i. If court finds excusedii. If not excused

4. Note: order of operaitons in 776-7775. In reality when courts decide whether demand was excused courts

really look at the merits of the suit and where a lot of case law gets made.

6. Independence : see Martha stewart case/Oracle belowii. Marx v. Akers (N.Y. 1996) (749)

1. Facts : a. Marx, a shareholder in IBM, commenced a derivative action

alleging that def., a former CEO, and others, violated their fiduciary duty and engaged in self-dealing by awarding excessive compensation to other directors on the board.

b. Def. moved to dismiss for failure to state a claim and serve a demand on the IMB board to initiate a lawsuit based on these allegations.

c. Trial court dismissed the complaint stating Marx failed to make demand or demonstrate it would’ve been futile.

2. Majority :a. Basic rule is that before bringing action, pl. must make a

demand unless excused b/c it is futile. Policy for demand rule: (1) relieve case load by providing opportunity for internal resolution (2) protect boards from harassment (3) discourage nuisance suits

b. Need to balance concerns about derivative suits and letting shareholders bring claims where it is evident directors will refuse to bring those claims. There are two approaches

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i. **Delaware rule: applies a two-pronged test every time to see if failure to make demand is excused. But approach has been criticized (752) Easy to not make the demand, but where it is made the Board’s decision reviewed under deferential business judgment rule.

ii. **Universal bright-line rule: would require demand every time, as ABA suggested. Deference to the board. Wait 90 days (unless irreparable harm). Close will engage in closer scrutiny as to whether board’s decision was kosher.

c. New York : Demand on board of directors futile where plaintiff alleges with particularity that (1) majority of Board interested in transacitons, (2) failed to reasonably inform themselves about it, or (3) failed to exercise their business judgment in approving transaction(755)

i. Here : Pl. argues demand excused b/c directors awarded generous compensation packages…

ii. **Motion to dismiss as to compensation paid to IMB executive officers was properly granted b/c here only 3 directors benefited from the compensation scheme and plaintiff failed to allege that a majority of the board was interested in the outcome. The failure to make demand therefore not excused.**

iii. **But the demand as to compensation paid to the directors they are automatically self-interested the challenged transaction where they receive a financial benefit from that transaction that is different from benefit to shareholders generally. Therefore demand as to directors is excused.**

iv. But plaintiff failed to state a claim b/c by statute corporations can provide compensation to their board members, so allegation that they voted themselves compensation is not enough to give rise to a cause of action. Courts will not undertake to review fairness of salaries unless wrongdoing/oppression or abuse of fiduciary duty shown. See FN 3: They acknowledge the “entire fairness” test but this is not time of the proceeding where they do so. Here complaint does not state a claim – there is no demonstration of fraud, no waste. **KJ: Court worried about this type of suit coming up every time in every corporation. Really want to provide a check on a suit challenging a run-of-the mill (market norm) executive compensation suit.

iii. Eval :1. **Delaware rule: Aronson v. Lewis (Del. 1984) (772) court said that

Zapata left unanswered the question when is demand futile and excused? Demand is futile and excused where Directors/officers are under influence which sterilizes their discretion and they cannot be

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considered proper persons to conduct litigation on behalf of corp. But the question is where to draw the line? Test: Did plaintiff plead particularlized facts where reasonable doubt created that:

a. Directors are disinterested and independent ORb. Challenged transaction was otherwise the product of a valid

exercise of business judgment. [highly deferential]2. ** In Grobow v. Perot (Del. 1988) (773) court said that no specific

criteria necessary for determining “reasonable doubt” – it is a case-by-case approach. **Flexibility in how courts engage in this analysis. In theory is the test is the same

3. Model Act (based on universal rule) bars any actions in the 90 day period after making demand. The only exception is a case of “irreparable injury” that would result by waiting (758-59)

4. In re PSE&G Shareholder Litigation (NJ 2002) (774) demonstrates an analogous but slightly modified test in NJ

5. Indepdnentce -- The law is not clear see the two cases in the gray areas. See two cases below

6. Excuse of Demand : In Beam v. Martha Steward (Del. 2004) derivative action plaintiff (a minority holder) did not make a demand on the board before bringing suit. Board consisted of 6 members. Court found Stewart’s potential civil and criminal liability for the same acts that related to derivative claim rendered her an interested party but that just because several others on the board were friends with her didn’t make them automatically interested. Del. supreme court said that mere friendship not enough to make a party interested such as to excuse a demand requirement. Burden on the plaintiff to plead more to rebut the presumption of independence (775) There will be naturally greater scrutiny from the public suggesting courts don’t need to come in.

7. Special Litigation Committee : In In re Oracle Corp (Del. Ch. 2003) a derivative action against directors for alleged insider trading a 2-person litigation committee moved to dismiss the action and the issue arose whether the members of the committee were independent. On the basis of some professional interrelationships between the members of the independent committee and those directors who were being accused, chancellor concluded that there was reasonable doubt about the impartiality of the committee. (776-777)

a.iv. Zapata v. Maldonado (Del. 1981) (765) (introduced independent committee

concept into Del. law)1. Facts :

a. **Plaintiff instituted a derivative suit against defendant; he was excused from making a prior demand on the board because they were all defendants in the suit.

b. **Board had changed membership while litigation pending and – four years later – it appointed an “independent Investigation Committee” composed of two new directors to investigate the alleged wrongdoing and decide what to do. **[Remember committees can act in the full power of the board of directors]

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c. Committee recommended dismissing the action b/c it was contrary to company’s best interests.

d. The issue is whether an independent committee has power to dismiss the action?

2. Majority : a. Clearly a board may delegate powers to an independent

committee under §141(c). They can even act for the board and move to dismissed the litigation if they so desire.

b. However, the risk is that this mechanism will then go too far to eviscerate even legitimate derivative litigation.

c. Need to balance legitimate derivative claims with board’s legitimate need not to be controlled by runaway disgruntled shareholders.

d. Some courts use the rule of business judgment, but business judgment is not the appropriate test at this stage of derivative litigation, where the case was initially properly filed, where four years elapsed, and where circumstances justify caution and scrutiny of board action.

e. After committee does a thorough objective, investigation and files a motion to dismiss, court should apply a two-step test:

f. Where prior conflict excused plaintiff from making a demand, a newly appointed independent committee an move to dismiss the derivative suit if

i. Step 11. Following factors :

a. (1) Corporation has proved independence of committee.

b. (2) Did they have a reasonable basis for its conclusion

c. (3) Acting into good faith. 2. **Burden on corp. to demonstrate this (not

presumed). 3. Step 1: If court not satisfied, it will deny the

defendant corporations’ motion. If it is satisfied, it goes to Step 2 below. **

4. Court will engage in limited discovery – close scrutiny.

ii. (2) Court feels it should be granted applying its own independent business judgment. Applying its own business judgment, intended to thwart instances where corporation actions meet the criteria in Step 1 but the result does not appear to satisfy the spirit. Court can second guess the judgment, but in reality this never happens. All the action is in the Prong 1. Serious questions of institutional competence of court second-guessing the independent committee if process was good.

3. Eval :

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a. x d.Indemnification

i. General notes 1. Common law not clear, but now yes by statute (779)2. ***Policy: (779) [agency law]

a. Encourage innocent directors to resist unjustified charges (which can be expensive) rather than settle

b. Induce responsible people to serve as directors [similar rationale for D&O insurance and exculpation provision under 102(b)(7)]

c. Discourage strike suits. 3. §145 – actor had to have acted pursuant to his official capacity

a. (a) Optional right to indemnification.i. Direct suits – has to be in good faith and in

corporation’s interest or at least not opposed to corporation’s interest.

ii. KJ: possible to engage in criminal activity and have it covered if meet the requirement of “good faith” reasonable behavior.

b. (b) Optional right to indemnification.i. Derivative suits

ii. You have a strong incentive to settle xxxiii. “except that no indemnification shall be made in

respect of any claim..” Higher incentive to settle than under direct suits above

c. (c) Mandatory: settlements not covered – only dismissalsd. (g) Insurance: [review D&O]

i. You can insure for a broader range of circumstances than what you would have to indemnify.

ii. Benefit: even if company bankrupt you have coveragee. (k) Exclusive Jurisdiction to hear attorney’s fees cases.

ii. Waltuch v. Conticommodity Services, Inc. (2nd Cir. 1996) (780)1. Facts :

a. Several suits against officer Waltuch settled by his employer Conti, for $35 million. All claims dismissed.

b. Waltuch was dismissed form the suits with no contribution but incurred over $2 million in legal expenses, with $1.2 million for defense of private civil actions.

c. Waltuch sued seeking indemnification from Conti, alleging that Conti’s certificate of incorporation provided for indemnification unless individual was liable for negligence/misconduct. **Plain language does not contain a “good faith” requirement as Del. statute requires.

d. **Conti now argues that its own indemnification charter provision is invalid to the extent that it requires indemnification of those who acted in bad faith. **Walruch argues Del. statute does not exclusive and Conti’s indemnification provision stands.

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e. District court denied indemnification request. It found that although (a) statute requires a showing of good faith (b) settlement is not covered by the statute’s indemnification requirement

2. Majority :a. Statute allows corp. to go beyond the minima, but does not

permit corp. to bypass the good faith requirement in §145(a) (that director being indemnified was acting in good faith)

i. Delaware cases hold that a corporation indeed may provide indemnification rights that go “beyond” the rights provided by §145(a), but at the same time the rights provided must be “consistent with” §145(a).

ii. Other options are available see 787 iii. **Anything inconsistent with the good faith

requirements (like what Waltuch advocating) would allow the exception that swallows the rule. **Also good policy reasons.

iv. Here : since Waltuch chose not to argue he was acting in good faith, he cannot claim the indemnification. Because he stipulated, we don’t know exactly what goes into figuring out “good faith.”

b. Indemnification mandate includes those cases where a third-party settlement.

i. §145(c) requires that officer/director who prevail in their defense “on the merits or otherwise” get indemnified. [note here there is no inquiry about good faith although you still have to show that this was in an official capacity]

ii. **District court [incorrectly] found that Waltuch prevailed on his individual claims only b/c Conti settled in the other suit, so he did not prevail within the meaning of the statute

iii. It is widely accepted that dismissal of claims with prejudice constitutes a successful outcome. The fact that that occurred in a settlement is irrelevant under statute.

iv. Here Waltuch prevailed in his defense of the private civil claims – that Conti settled the claims for him does not relieve the obligation to indemnify him for $1.2 million

3. Eval :a. In the future what can the company do after this case?

i. Hold off getting the dismissal conditioned on his paying in.

b. He only “successful or otherwise” where the suit was dismissed against him, but not against the other gov’t suit where he settled those charges.

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c. In Del. that you had a right to indemnification and had to bring suit, you have the right to fees in the second suit to get your fees. In NY you don’t get the second round of fees.

d. There are ongoing questions about the scope of indemnification to “agents” which is allowed by many statutes as well as whether defendant director/officer has to be acting in an official capacity. The ends of the scale of personal versus official are clear, but the gray area is unclear. (791)

e.Plaintiff Counsel Fees : i. General notes :

1. For both benefits or derivative claims – regardless of the nature of claim2. No adjudication or settlement necessary – can be in pending case –

regardless of the way the suit ends – usually dismissed, mooted, etc.3. **Policy: Award of attorney’s fees to incentivize derivative suits which

otherwise would probably never take places since direct benefit to the plaintiffs is sometimes minimal. Also to avoid free-riding that would otherwise occur where plaintiff would expend money but other shareholders free ride.

4. Where fees granted under two scenarios a. Common fund – monetizeable benefits to corporationb. Corporate benefit – less tangible benefits

i. E .g. changing policy or corporate disclosure5. One way that defendant can try to get out of this with derivative suits –

defendant can quickly settle – weird incentives with plaintiffs lawyers can settle for higher fees with fewer injunctive relief. That is why we have settlement approved by the court.

ii. Tandycrafts v. Initio Partners (Del. 1989) (798)1. Facts :

a. Initio the largest shareholder in Tandycrafts sought a temporary injunction against holding of Tandycraft’s annual meeting on grounds that proxy statement was materially misleading.

b. When Tandycraft made supplemental disclosures Initio seeks attorney’s fees

2. Majority : Court may order payment of attorney’s fees and costs to a plaintiff whose efforts result in the creation of a common fund or conferring of a corporate benefit.

a. **Court will check to see if there was a (a) meritorious/colorable claim (b) corporate benefit (c) still pending. Definition of “corporate benefit” is elastic. [unlike a derivative suit or class action there is no common fund] It doesn’t have to be quantifiable. A change in corporate policy or disclosure - if attributable to the filing of a meritorious suit – may justify an award of attorney’s fees.

b. (d) causation: Once the action benefiting corp. followed the filing of a meritorious suit, burden on corp. to demonstrate lack of causation. For example old internal documents pre-litigation.

c. Here change followed filing of suit and burden on Tandycraft to demonstrate lack of causation

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3. Eval :iii. Sugarland v. Thomas (Del. 1980) (800)

1. Facts : a. *Shareholders in Sugarland initiated a derivative suit due to

their belief that price corporation was considering for a tract of land was inadequate.

b. *Chancellor ordered the board to entertain competitive bids that produced a significantly better price for corporation.

c. Plaintiffs then seek attorney’s fees from Sugarland2. Eval :

a. Court hesitant to give plaintiffs too much and awarded 20% of the difference between the initial offer and the second offer. As to the higher third offer that later came in, it wasn’t clear what was the role, so gives them 5%. KJ: There is no science here.

3. Eval :a. Criteria largely based on amount recovered – usually 20% of

recovery, but see other cases that suggest the value of lawyer’s time (“lodestar”) should be dominant factor. The incentives of the amount recovered arguably better b/c it gets attorneys to get higher deals rather than lodestar. (802-04) Lodestart still works well for intangible “corporate benefits” that are impossible to quantify. Courts continue to do both methods, using lodestar to double check or alternative to the traditional amount recovered.

9. Securities Regulation and Insider Tradinga.General notes :

i. Policy concerns1. Deter bad behavior & promote good behavior2. At the same time not to over enforce so as to facilitate socially valuable

rules (e.g. Transaction costs of enforcement)3. At the same time concern of underenforcement if there are collective

action problems etc.4. Also note that we have SEC enforcement in securities law context and

class, but in fiduciary duty context gov’t enforcement unavailableii. Two lines matter a lot:

1. Where do we draw the line of substantive liability 2. Challenges of imperfect enforcement

b.Market Efficiency Hypothesis i. Policy: Purposes of efficient markets

1. Transparency in markets facilitates decisions. 2. **#1: How we allocate capital – if doing well they are more productive

use. How money moves from savers/investors to borrowers/corporations***

3. Evaluating director/manager performance. Might be able to identify agency costs. If we have more accurate pricing we know if they are doing a good job.

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ii. Prices of stocks follow a “random walk” (43-47)iii. **Three ideal models of market efficiency distinguished by degree of

information:1. **Weak market efficiency: prices reflect information about past prices.

Impossible to make superior profits by charting trends in the past. **2. **Semistrong market efficiency: prices reflect all **publicly

information** available. Prices adjust to any new announcement quickly. **Presumably this doesn’t exactly work this way b/c if no one engages in any information gathering, this wouldn’t work. Presumably you can’t just sit back and benefit. A lot of securities regulation are about trying to achieve this level of efficiency.

3. **Strong market efficiency: prices reflect all information that can be acquired by painstaking analysis. **Even insiders can’t earn a profit.

iv. But we know that in bubble time prices depart from their fundamental price (see behavioral psychology) attitudes towards risk, beliefs about probabilities...comeback:

v. Arbitrage: Perhaps sophisticated investors operate more efficiently, arbitrage will pick up the difference. However institutional limitation mechanisms (see 46-47).

c. Intro: Antifraud Provision: Section §10(b) of 1934 Act and Rule 10b-5 i. Securities laws seek to achieve efficient markets

1. Disclosure requirements that reduce costs of information gathering and relatively more efficient. ***Ongoing disclosure and precommitment assures investors. Consistent disclosure makes comparisons***

2. Prosecution of fraud to assure accuracy of information3. Regulating insider trading – mixed views b/c it impedes “strong market

efficiency” for insiders but ensure efficiency for non-insiders.ii. Tension in law:

1. Adopted for the purpose of investor protection which permeates SEC to this day. But as a practical matter SEC worried about ensuring efficient capital market (national market improvement securities act of 1996 sets out goal of capital formation)

iii. Note there is still an element of opting out here b/c a company that goes private they don’t have to do these requirements

iv. Wharf v. United International (U.S. 2001) (609)1. Facts :

a. Defendant sold an option to plaintiff in an oral agreement that was never reduced to writing.

b. When pl. tried to exercise option def. refused.c. Plaintiff Private right of action alleges defendant secretly

intended never to honor the option. Does that violate 10(b)?2. Majority (Breyer):

a. Statute says xxx. Rule 10b-5 says bars 4 types of *schemes to defraud* in connection with purchase or sale (standing)

b. ***Prima facie case – pl. must demonstrate that def. used one of four kinds of manipulative devices (above) to which the Rule refers and must satisfy other requirements:

i. Interstate (jurisdiction)

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ii. Scienteriii. Materiality iv. Reliance v. Loss causation (prox. cause)

c. No reason to give weight to def’s argument that statute and rule do not cover oral agreements.

d. Similarly, def’s argument that statute and rule only cover misrepresentations w.r.t. value of securities only is unavailing. Even taking their interpretation – by secretly not planning to honor the option, the option was valueless.

3. Eval :a. Private rights of action : Borak; Cort v. Ash.b. Not a particularly significant case

d.PSLRA & SLUSA i. Congress scales back on perceived nuisance suits initiated ot extract settlements

that benefitted only the class action lawyers…ii. PSLRA of 1995 added (613-15)

1. *“lead plaintiff” requirement for private suits, a result of Congress’s desire to provide the suit’s attorney with a real client and encourage financial institutions to step forward as the class representative. Rebuttable presumption that party with greatest lawyers should be the lead plaintiff. In reality only a small minority of lead plaintiffs are institutional investors (614)

2. **Pleading must set forth with particularity facts creating a strong inference of knowledge or recklessness ** in order to withstand a motion to dismiss. Discovery has to wait until motions to dismiss ruled on.

3. Proportionate fault. Def. only liable for portion of pl’s loss that is attributable to def’s misconduct.

4. **Discovery not possible until party gets past motion to dismiss, barring strike suits**

5. **FRCP 11 sanctions must be ruled on suas ponte in every suit**6. (LS: PSLRA also removed securities fraud as a predicate for civil RICO)

iii. **SLUSA of 1998 was a response to more suits being filed in state courts of post PSLRA. In SLUSA Congress to confer exclusive jurisdiction to federal courts for class actions involving such suits. (615)

1. Delaware carveout for suits likely to raise state law issues(615)e.Elements of standing, “In Connection With” and Scienter

i. Standing/In Connection With :1. Purchaser-seller

a. ** “In connection” very broad. Arguable parties can bring contract claims, too.

b. **In Blue Chips Stamps v. Manor Drug Stores (U.S. 1975) only buyer or seller of stock had standing to bring private action under 10b-5. (615) **

c. **The most significant bite is to bar private actions by persons who claim they would have sold stock that they owned had they not been induced to retain the stock by misrepresentation or

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omission in violation of the rule. (617) **Policy: concern about nuisance suits based on far-fetched arguments about what plaintiffs would’ve bought or sold. A highly imperfect determination (617)

d. Definition of “sale” is very expansive and picks up cases where shares are involved as consideration in a merger or even where substantive change occurs via amendment of articles of incorporation (617)

e. SEC proceedings are not affected since doctrine only for private actions

f. Injunctive relief sometimes had been excepted from buyer-seller requirement but lately courts have applied the requirement the same in injunctive context (617)

g. SLUSA means “holders” who don’t buy-sell must go to fed. court. Where Blue Chips doctrine means action squelched. Merrill Lynch v. Dabit (617-18)

2. In connection with a. Courts have interpreted the term broadly…”any statement that

is reasonably calculated to affect the investment decision of a reasonable investor will satisfy the requirement” (618) Perhaps at its broadest where statement made in a medium on which investors rely.

b. **Although the plaintiff must be a buyer-seller, the defendants do not have to be (618)

c. See SEC v. Zandford (618)ii. Scienter

1. Early case law in Ernst & Ernst v. Hochfelder (U.S. 1976) requires scienter for 10b-5 claims, defined as “intent to deceive, manipulate, or defraud” but decisions since have held that recklessness satisfies the scienter requirement, suggesting a knowing disregard (619)**

2. Pleading scienter : is harder now given PSLRA’s heightened “strong inference” standard. (620)

a. How does PSLRA affect the recklessness standard that courts have recognized? **A number of circuits concluded that PSLRA did not alter the definition of scienter (621) **Recklesseness will suffice.

b. Does the Second Circuit test for satisfaction of the standard (which Congress adopted in PSLRA) is available to the plaintiff? **SCOTUS is not clear but suggests that a “cogent and compelling” pleading – what is not clear if just demonstrating (1) motive and (2) opportunity (which is what Second circuit uses) is appropriate. (620-21)

3. Forward Looking statements : a. Policy – encourage forecasts, and protect companies from being

held liable for b. what would make a future-looking statement (e.g. forecast

about expected profits) actionable? (622)

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c. PSLRA provides 2 “safe harbors” for most forward-looking statements (e.g. predictions) where (1) accompanied by **“meaningful cautionary” statements identifying factors that would cause actual results to differ. ** (622) or (2) that the def. made the statement knowing its falsity.

d. **Also remember high degree of specificity in alleging scientere. **Oral representation**f. Under (court created?) doctrine of “bespeaks caution” forward-

looking relief not actionable if accompanied by meaningful cautionary language. **Inquiry is highly fact-specific. **Boilerplate lingo won’t protect def. ** Narrower that exception for PSLRA Particularly relevant where facts at issue not covered by PSLRA safe harbor [which in practice is boilerplate] (623)

f. Duty to Disclose / Omissions i. Most 10b-5 actions for affirmative misstatements. But also less frequently for

failure to disclose material facts (623)ii. Generally disclosures beyond what is statutorily required is a matter of business

judgment. (623) Exceptions include:1. *If makes a misleading/inaccurate statement (even by accident) and

later learns of it, duty to correct if statement is still “alive” and relevant (624)

2. When officials of company have made an implied representation that information they have reviewed (as prepared by outsiders) are true (624)

3. Under duty to correct erroneous rumors resulting from leaks by corporation or its agents (624)

4. *Half-truths (624)5. *Some circuits say that there is a duty to update an earlier forward-

looking statement that was correct or reasonable when made but later comes to be materially misleading. Some courts have so held. (625) *To the degree there is stale information between 8K disclosures.. Many courts disagree….

g.Causal Relationship i. General notes :

1. **Transaction causation: def’s violation (fraud) caused plaintiff to purchase security. But for omission, pl. would not have purchased (636) [This concept is conflated with reliance] [subjective causation]**

2. **Loss causation: Def’s wrongful act not only [transaction causation] but also must have been the source of plaintiff’s losses. (636) [This concept is conflated with proximate cause][objective causation]**

3. Note : SEC enforcement actions do not have to raise causation4. This is particularly hard for plaintiffs to allege in a case of an omission.

Note that in the field of materiality of an ommision: For ommissions and affirmative misrepresentations: In TSC Industries v. Northway (U.S. 1976) SCOTUS said that *appropriate standard of materiality is “an omitted fact is material if there is a substantial likelihood that a

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reasonable shareholder would consider it important in deciding how to vote.” (262) It is an objective test.

ii. Affiliate Ute Citizens v. U.S. (U.S. 1972) (637) [reliance: omission/non-disclosure]1. Facts : Gov’t awards shares in various assets to the members of the Ute

tribe. Bank is both a custodian for the shares and also a “market maker”. The bank misrepresents [omits informing them about the actual] worth of the shares and buys them substantially below the market price. ** Information it omits clearly material.

2. Majority :a. Because defendants were market makers they had an

affirmative duty under the Rule to disclose material facts to buyers. [i.e. a duty to speak].

b. (Don’t have to prove reliance in case of omission - a material omission creates reliance) All that is necessary is that facts withheld be material in that a reasonable shareholder would consider it important in making the decision

c. A way to rebut it is to say that plaintiffs actually had the actual information from another source

3. Eval :a. In omission/nondisclosure cases: Although Ute seems to do

away with reliance requirement altogether in cases of omission, cases since have said that it merely established a presumption – i.e. defendant can still rebut this presumption by showing plaintiff would have followed same course of conduct even with disclosure. (638)

b. In affirmative misrepresentation cases: Reliance remains relevant but may be fairly straightforward and easy to prove where one demonstrates that the misrepresentation was material and plaintiff traded based on that misrepresentation soon thereafter. In some cases burden (as in omission cases) will then shift to def. to rebut presumption. (639)

iii. Basic Inc. v. Levinson (U.S. 1988) (639) [reliance] [materiality]1. Facts :

a. *Basic in preliminary merger talks but makes 3 public statements denying that any merger negotiations are going on.

b. Later the company merges.c. Plaintiffs are prior shareholders who say that they relied on the

misstatements to sell their shares at artificially depressed price. Sue for damages under 12b-6.

d. District court dismissed the suit, but circuit court reversed finding the statements material and accepting the “fraud-on-the-market theory” to create a resbuttable presumption that plaintiffs relied on the material misrepresentation.

2. Majority (Blackmun)a. *Materiality: accept the objective materiality from TSC

i. TSC Industries is the present standard for materiality for omissions (substantial likelihood that disclosure of

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omitted fact would have been viewed by the reasonable investor.

ii. Speculative nature of preliminary mergers makes it difficult to know what a reasonable investor would have wanted.

iii. **2nd Circuit is a balance b/w probability and magnitude of event. This is a very fact-specific inquiry.*** The greater the magnitude the greater materiality.

b. Reliance : accept the “Fraud on the market” presumption**i. ***“Fraud on the market” theory creates a

presumption of reliance given that in a market any material misstatement will quickly affect price…

ii. We have dispensed with proof of reliance where a duty to disclose material information had been breached. Ute (above). Similarly dispensed with reliance in some cases. Mills v. Electric Auto-Lite.

iii. ***But presumption is rebuttable. Presumption only applies where there is a robust market

1. There were people who knew the reality and price therefore was not affected.

2. Do it individually – disaggregate the class.3. Eval :

a. Fraud on the market presumption only applies where there is a robust market such that price will reflect the information on the market.

b. Cammer v. Bloom (D.N.J. 1989) sets fort 5 factors as indicative of a security likely to be traded in an efficient market such that the fraud on the market approach to causation can be used to certify a class including (1) % shares traded weekly (2) analysists following (3) presence of market makers/arbitrageurs (4) eligibility for SEC disclosure (5) responsiveness of price to new informaiton (648)

c. See SCOTUS in Erica John Fund v. Hallibruton (U.S. 2011) (648) h.Secondary Participants After Central Bank

i. General notes1. Policy: we want to discourage aiding and abettors (e.g. lawyers,

accountants) who play a critical role in the corporation’s disclosures. Indeed now securities laws under some circumstances actually require independent certification of disclosure statements. They play a key role in the operation of the market. For this reason a lot of lower courts assumed there was aiding and abetting liability.

2. §10(b) and Rule 10b-5 originally interpreted to cover aiding and abetting but that changed after Central Bank of Denver v. First Interstate Bank of Denver (U.S. 1994). SCOTUS rejected aiding and abetting liability for suit under §10(b) reasoning that it would extend liability too broadly and be contrary to prior holdings requiring plaintiff’s reliance (625)

3. **In Stoneridge ii. Pacific Investment Mgt. v. Mayer Brown (2d Cir. 2010) (627) [Secondary parties[

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1. Facts : a. Refco, a now bankrupt broker, concealed significant losses

through a series of sham loans designed to evade regulators.b. Plaintiffs allege that misleading and false statements on several

Refco disclosure documents, some of which reference that Mayer Brown represented Refco.

c. **Plaintiff cannot hold Refco liable possibly b/c they are in bankruptcy. So going after the law firm, albeit can’t use aiding and abetting liability after Central Bank. They utilize the door left open that says that secondary actor can still be held liable.

d. District court dismissed claims against Mayer Brown on account that there was no aiding and abetting liability under 10(b) and 10b-5.

2. Majority :a. 10b-5(b) claims

i. **Even after Central Bank bars aiding and abetting liability, SCOTUS has said that secondary actors (e.g. lawyers, accountants) may be liable assuming they meet all the requirements for primary liability.

ii. Substantial participation test used by some circuits, but this is hard to implement. It is also going to cause over-deterrence since …

iii. Attribution requirement developed after Central Bank as a way of differentiating actionable versus non-actionable claims is the way to go. A secondary actor can only incur primary liability under Rule 10b-5 for statements attributed to that actor at the time of dissemination. (i.e must be based on their own articulated statement, or on a statement by another that has been explicitly adopted by the secondary actor)

1. Attribution consistent with and necessary to show reliance, which is an element of a 10b-5 case.

2. **It is a bright line rule of liability that is easy apply. It promotes certainty in securities markets.

iv. Here claims were properly dismissed b/c statement in Refco’s disclosure statements in no way attributed them to Mayer Brown. Therefore plaintiffs cannot show reliance on any of their statements.

b. 10b-5(a) and (c) claims (“scheme liability”) i. Again no reliance possible. It was Refco that filed the

fraudulent financial statements…nothing Mayer Brown did made it inevitable for Refco to record the transactions as it did. We’re not going to revisit scheme liability after Stoneridge.

3. Eval :

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a. Note that this is a really extreme case – with extreme liability by Refco.

b. In Janus Capital Groups v. First Derivative Traders (U.S. 2011) SCOTUS said that to “make” a statement within the meaning of Rule 10b-5, it must be the person or entity with the ultimate authority over the statement, including control In other words, one who prepares or publishes a statement on behalf of another is not its maker. Speaker liable, not the speechwriter. ** Similar to the bright-line test, like the attribution test above, but not exactly clear how it shakes out(634-35).

c. Not all courts follow the Pacific Investment Management approach. A competing substantial participant approach soe circuits impose broader liability on those who edit, draft, review reports (635)

d. **Note SEC enforcement actions are broader in scope and cover knowing aiding and abetting (635)

10. Insider trading :a.Common Law Background

i. 12b was meant to be a broad-based anti-fraud provision, not meant to catch insider trading (656)

ii. Majority rule : is that director or office could trade no insider information without disclosing. Exceptions:

1. Kansas rule : officer/director hold the inside information in trust for corporation and where they use the info not in their interest that is a violation of the duty. But duty seems to extend to only shareholders. Asymmetry b/w shareholders and not shareholders.

2. Special facts approach : but special factors were not clear…unmanageable standard.

iii.b.Federal Disclose/Abstain Requirement

i. General notes :1. Rule comes out of SEC proceeding. 2. http://www.sec.gov/news/speech/speecharchive/1998/spch221.htm 3. See also p. 91 in casenote supplement4. Bottom line is that insiders often have valuable information that is not

public, companies will often do “blackout periods” at the end of each quarter. 10b-5 also creates safe harbors that provide affirmative defenses in litigations…

5. 10b-5 generally deals with omissions, but it can also be affirmative misrepresentation

6. Three scenarios a. Classic theory. Chiarella.b. “constructive insider” Dirks FN 14.

i. Dirsks FN 14: "constructive insiders" – outside lawyers, consultants, investment bankers or others – who legitimately receive confidential information from a corporation in the course of providing services to the corporation. These

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constructive insiders acquire the fiduciary duties of the true insider, provided the corporation expected the constructive insider to keep the information confidential.

c. Misappropriation theory. O’Hagan7. Puts/calls – all covered by 10b-5

a. Put : right to sell in the future at an exercise price (option)i. Buyer of put is betting stock will fall

ii. As the price goes lower than exercise price, holder of the put makes money on the spread because it forces the writer of the put to buy back at the higher exercise price

b. Call : right to buy in the future at an exercise price (option)i. Buyer of call is betting the stock will rise

ii. As the price goes higher than exercise price, holder of the call money on the spread because it forces the writer of the call to sell at the lower exercise prices

c.ii. In re Cady, Roberts & Co. (SEC, 1961) (657)

1. Obligation rests on 2 rationales (1) corp. purpose (2) unfair to others on the market.

2. KJ: Courts have since added more layers to this analysis. Courts have been motivated by both elements

iii. SEC v. Texas Gulf Sulfur Co. (2d. Cir. 1968) (658)1. Facts :

a. Texas Gulf found valuable mineral deposits and required employees to keep findings confidential.

b. Board, not aware of findings, issues stock options to officers, directors (including people who knew the material developments about valuable deposits)

c. With rumors swirling Texas Gulf issues public denials, carefully worded but arguably misleading. [KJ: also even if announcement not misleading once they make announcement they have duty to update/correct] Finally announce what they found a couple of weeks later.

d. Issue : who knew what and were any trades suspect?2. Majority (Waterman):

a. Disclose or obtain – Rule 10b-5 is based on equal access to information. Anyone in possession of insider information must either disclose or to abstain from trading.

b. **Materiality (is it important to the reasonable investor) depends on magnitude/likelihood. Here sufficient likely that outsiders would’ve found this information material. It is material that insiders themselves traded in it immediately after they learned – a type of security they never bought before – suggesting materiality. [Note that the district court found it not material]

c. When do you sufficiently disclose information? Even though a few officers bought right as announcement made…need time to

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get information to market and for trading activity to adjust the price. Today 5-8 minutes probably…It is a question of market absorbing the information.

d. Scope of duty and liability i. Top managers: duty to disclosure to the information to

the board at the time the options grant was made. [Possible that they are liable in state fiduciary duties – a valuable asset is being transferred by company to officers. Value to some secrecy.]

ii. Junior officers: can rely on top managers to make disclosure (effectively exculpated).

3. Concurring (Friendly):a.

4. Eval :a. Note on “Use” test under Rule 10b-5 (672)

iv. Chiarella v. U.S. (U.S. 1980) (673) [duty to stockcholders of company?]1. Facts :

a. Financial printer makes a killing on insider knowledge b. 2nd Cir. used a broad theory on a duty to the marketplace – if

you have access to information that could be basis for liability.2. Majority (Powell)

a. Cady says not just access to information, but a relationship. Not just access to information per se (i.e. a narrow duty)

b. Here defendant did not owe a duty. He is not an insider. Not even a “temporary insider” does work because those owe a duty only to the corporation (not an acquiring company as here).

3. Dissent (Burger)a. Anyone wants to know this information (misappropriation

theory)4. Eval :

a. Even if 10b-5 applies narrowly, a broader scope on the eve of the tender offer says we have authority under also 14(e) (untrue fraud provisions regulating tender offers). See Rule 14e-3 (which is very broad) which SEC promulgated in response (but in only governs tender offers specifically)

b. Statute is not clear - plus there is overlap with other sources of obligation…just b/c something seems wrong shouldn’t mean it is liable specifically under 10b-5

v. U.S. v. O’Hagan (U.S. 1997) (680) [duty to employer/client]1. Facts :

a. **O'Hagan was a partner in a law firm retained to represent a client corporation, Grand Met, in a potential tender offer for the common stock of the Pillsbury Company. **

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b. When O'Hagan learned of the potential deal, he began acquiring options in Pillsbury stock, which he sold after the tender offer for a profit of over $4 million.

c. **O’Hagan was not working on this particular deal, which is why he thought he was not breaking the law.

d. When prosecuted, O'Hagan argued, essentially, that because neither he nor his firm owed any fiduciary duty to Pillsbury, he did not commit fraud by purchasing Pillsbury stock on the basis of material, nonpublic information.

e. [Traditional liability doesn’t attach, nor does temporary insider – he only has a duty to law firm which is representing acquirer, but the trading occurring in target corporation, where there are no duties]

2. Majority : O'Hagan committed fraud in connection with his purchase of Pillsbury options, thus violating Rule10b-5, based on the misappropriation theory

a. Misappropriation theory : is it valid? i. “Deceptive device” – the insider trader is deceiving

not the person who entrusted the confidential information (with whom there is a fiduciary duty)

1. KJ: There is still “a fiduciary duty” to the source of the information….Runs in a weird way…

2. Now disclose or abstain not about disclosing info on the market or abstain, but rather disclose to your own client. If partner says no you can’t do that, presumably no longer liable under 10b-5 (however there might very well be liability under other statute) KJ: In effect in this context, this is a an “abstain” rule because no one will actually disclose for variety of institutional reasons.

3. KJ: Indeed “disclose” means different from what “disclose” means under the classical theory. Here disclosure of intent to buy...

ii. “In connection with securities” the use of the misappropriated information constitutes the breach.

b. 14e-3 : is appropriate under Securities Exchange --- kosher with respect to tender offers. KJ: This is a prophylactic rule that can be broader than core activity.

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i. Pragmatic – it is OK to obviate requirement for fiduciary obligation in this context given the importance.

3. Dissent (Scalia)a. This is a criminal statute, where the rule of lenity applies, b. Moreover, we only care about the party to the sale of

transaction, not liability for some reason related to employee-employer information sharing is beyond the intent of the rule.

4. Dissent (Thomas)a. Text of 10b-5 doesn’t reach this. But we have mail fraud

and state fraud claims. No need to stretch 10b-5…5. Eval :

a. If you could only bring this under mail fraud statute…SEC wouldn’t be able to enforce it – only USAO

b. What’s the scope of the fiduciary relationship upon which the misappropriation theory rests?

i. 2nd cir has said it involves “discretionary authority and dependency” (691) SEC has countered by introducing a bright-line test for close family relationships in Rule 10b-5-2 to try to deal with scope.

ii. Enumirated list of duties - http://taft.law.uc.edu/CCL/34ActRls/rule10b5-2.

1. Situation of confidence2. Long-term pattern of past dealing where

confidential information expected3. Family – assuming a fiduciary duty in that

context, subject to affirmative defense by defendant.

iii. This is not an exhaustive list of all situations.vi. Dirks v. SEC (N.Y. 1996) (693) [tippers/ tippees – under classical theory]

1. Facts :a. Dirks is an analyst (tippee) who receives material information

about fraud at a company from insider/tipper.b. Tippee tries to get WSJ interested, which is not. He also tells his

institutional clients who quickly dump big holdings, sending the stock dropping.

c. NYSE stops trading. d. DOJ views him as a hero. But SEC brings suit against Dirks

(tippee) for insider trading in violation of 10b-5, because he did not broadly disclos.

2. Majority : "tippees": those who receive information from the insider tipper, are liable if they knew or had reason to believe that the tipper had breached a fiduciary duty in disclosing the confidential information

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and the tipper received a direct or indirect personal benefit from the disclosure [including reputational benefit]

a. Rule i. Tippee’s duty is derivative of tipper’s duty - if they

breach the knew or should’ve known that tipper breached by disclosing and the tipper is breaching his fiduciary obligation

ii. Tipper’s duty depends on whether one is doing it for personal gain. [KJ: Just insider getting on phone with analysis to drum up the good news will not create liability. By contrast, getting on the phone with a friend to get a favor, even a softer quid pro quo, that will create liability. The line is a bit fine. Courts will look especially for a pattern …]

b. Policy : encourage security analysts who are doing due diligence for their clients. Requirement of personal benefit for tipper therefore to protect the whistleblower tipper.

3. Dissent (Blackmun)a. **Regardless of good faith, there were shareholder injured here

by the falling stock price. The purpose of rule is to create an efficient capital market.

b. Tipper is an insider clearly shouldn’t trade on information – so why should he be able to tip a tippee who is then able to run with information?

c. Even if you want to limit liability on personal gain, he is still calling a tippee who he wants to engage in trading activity **

d. **Blackmun also claiming that tippee is not a hero, he should’ve done more to get the information out to the public.

4. Eval :a. We have problems of proof. See the Schweitzer case (A

overhearing B), in which case there would be no liability because tipper wasn’t doing it for personal going, seeming to obviate tippee’s liability.

b. KJ : The tipper/tippee liability has been construed narrowly on these facts.**

c. Usually will have joint and several liability against both tipper and tippee. Usually SEC will give to tipper rather than tippee.

d. Regulation FD (702-3): Adopted in 2000 and remains controversial. Nowadays, to the degree that CEO has call with analysts, has to have the disclosure public. What public means is a combined inquiry – is it reasonably likely to provide disclosure – companies will file 8K and a press release, which suffices.

i. SEC was concerned that analysts were not forthcoming because they were given preferential information access, although less bad reasons for selective disclosure.

ii. SEC was concerned in loss in investor confidence in the market in general

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e. Enforcement by SEC of civil vs. criminal by USAO (704)…i. SEC has authority to seek treble damages under §21(a)

under civil suit. 2nd Cir recently reversed a case where defendants did not actually profit from the deal. Criminal charges remain possible but burden higher.

ii. Private right of action exists. But hard to bring because of difficult due to problems from proof. Further under §20(a) the most the def. can be liable of is disgorgement and whatever SEC already received, those will be subtracted.

c. Liability for Short-Swing Trading - §16(b) i. General notes

1. Unlike 10b-5, which is minimalistic and case law fills in, here this is very rule-based.

2. Preceded Williams Act before 13(d) and somewhat disclosure.3. 16(b) doesn’t apply with tipper/tippee, misappropriation – all those

things covered by 10b-5.ii. Rule 16 :

1. *16(a)(reporting requirement) serves a prophylactic end and mandates that any insider: officers, directors and beneficial owners over >10% in any specific class of equity shares must report changes in the beneficial ownership of any equity security of the company ( known as statutory insiders). (704-05)

a. The forms are fairly minimal – see syllabus2. 16(b) (short-swing ban) is an absolute bar on buying and selling within

period of 6 months (regardless of abuse of inside information) strict liability (705)

a. Any profits made must be disgorged.b. This has come to be criticized over time by those who think 10b-

5 now does all the work and this provision needlessly restrains execs.

c. It is however different from 10b-5 as it is expressly focused on corporate insiders (706)

iii. Purpose/policy1. 16(a) promotes disclosure to help enforce 16(b) obligation

a. Also general disclosure function.b. There is a sense today that there are market signals still

significant – soft information, even if not actionable as insider trading

2. 16(b) is an easy strict liability regime. a. Incentivizes long-term investment and growth, not short-term

profiteering. Bias against people who deal in their own stock.b. Eliminate incentives to play around with announcements etc. c. Broader in scope that 10b-5 barring not just overt insider

trading but in general using the soft institutional knowledge accumulated to the insider.

d. 10b-5 is harder to enforce, so this bright line rule creates….iv. Various ways of computing profits under 16(b) (707-08)**

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1. Bottom line is that “lowest purchase price, highest sale price” -- essentially means highest possible liability

v. Application – two approaches, with noticeable effect only on the margins:1. Under “objective” (automatic) approach, the provision is interpreted to

cover all transactions within its lieteral reach, regardless of any culpability or access to actual insider information

2. Under “subjective” (pragmatic) approach, in borderline cases (esp. in new transactions for example) it might be interpreted more flexibly to impose liability only if the insider actually had access to inside information and there is abuse (709)

a. Kern County Land v. Occidental Petroleum Corp . (U.S.) (709) [pragmatic approach before unorthodox cases, designed to mitigate the sting of the strict liability rule]

i. Company A ended up after B’s merger with shares of C, its competitor. Not wanting to hold on to them, it gave its competitor C option to acquire the shares, but B-C alleged A had to disgorge the short-swing profits.

ii. SCOTUS found that in a borderline/unorthodox transaction, courts have to look at the Congressional intent. Here A was an outsider to C, no chance that the sale was tained by insider information. Having them disgorge does not advance the goals of the statute (710)

b. Failed takeover bids (710)i. The threshold necessary requirement for application of

the pragmatic approach has later been held by courts to be an involuntary transaction (e.g. an option where seller/buyer has no control over the timing of the transaction).

ii. Voluntary liable automaticallyiii. In voluntary courts look at access to insider

knowledge to determine liabilityiv. Three things: don’t worry too much about it – this is a

very narrow and usual exception1. Involuntary 2. No access ot insider information3. No control as to whether transaction occurred

v. Besides now options are clearly treated as underlying equities.

vi. *Who is an “Officer” (714)1. Under automatic view , the title matters2. Under pragmatic view , the inquiry is more into whether said employee

had access to inside information.3. Nowadays SEC adopted a **function-based approach** (714-15) Titles

do still matter, but not exclusively – they will look at the underlying function.

vii. Attribution of ownership under 16(a) and (b) (711)

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1. Issue is when should an equity that is not legally owned by a person nevertheless be attributed to the person for purpose of this section. SEC Rules address this

a. Whether person is a more-than-10%-owner for reporitn gpurpose(711)

i. Rule 16a-1(a)(1) emphasizes control over the stock. This includes being part of a collusive group (712) This is for reporting purposes

b. What constitutes beneficial ownership for reporting and liability purpose (712) Short swing is broader than above for reporting purposes

i. Rule 16a-1(a)(1) emphasizes pecuniary interest in the equity securities (opportunity to profit)

viii. Timing of ownership 1. 10% Beneficial owner

a. First purchase that gets one 10% threshold also not actionable, said SCOTUS (713)*

b. Once one gets below 10%, later sales are not covered by 16(b) if one is not also a director/officer, held SCOTUS (713)*

2. Officer/director changes a. Any time the transaction occurs on the other side of the

becoming an officer/director, you are coveredb. Appears that 16(b) does apply to a short-swing transaction by a

director/officer even where he was not such both at one end and another end (713) But purchases made before one becomes a director/officer not coved per Rule 16a-2. (713)

d.Corporate Recoveries for Inside Trading Under State Law i. **Diamond v. Oreamuno (N.Y. 1969) (749)

1. Facts : a. This is a derivative action for breach of fiduciary

duty**[property of company cases we did early in the semester]

b. Issue is liability of officers/directors for insider trading – allegedly they sell of their stock in their own company knowing about declining sales and before stock plunged.

c. **Def. argue that there was no injury to the corporation in any way from their gains.

d. They also held the stocks for more than 6 months, avoiding federal liability under 16(b).

e. **Defs argue that it would be redundant to have liability both under federal law and state cause of action – plus argue preemption of state law by federal law

2. Majority (Fuld): a. Well established that a person who acquires special knowledge

by virtue of fiduciary relationship is not free to exploit it for personal benefit and must account to his principal for any profits

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b. Lack of damages to the coproraiton has never been considered an essential requirement for cause of action founded in breach of fiduciary duty . The purpose of action is deterrent, not compensatory.

c. As a fiduciary , insider may not appropriate that asset for his own use even if he causes no injury to corporation

d. Besides, there is some intangible injury in form of investor relations, company reputation, etc.

e. Precedent on the federal side in the form of 16(b), so does Restatement of Agency.

f. Federal law doesn’t preempt state law: Def’s argument that he would be subject to double liability is not convicing because nothing in 16(b) demonstrate’s congress’s intent to create an exclusive remedy. Nor does right now the federal law provide an effective remedy [LS: note this is written before O’Hagan etc.]. Therefore there is high desiralility of having a state-law remedy. Allowing private remedies under state law will increase deterrence.

3. Eval : a. Recent Delaware holding agrees with this Diamond but

demonstrates more limited approach (721)

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