Corporations OutlineMcDonnell, Fall 2004

I. Introduction – The Nature of the Firm and Agency1. Introduction to Corporate Law

A. Sources of Corporate law1. State corporate law (Delaware, RMBCA)2. federal securities law3. exchange rules (NYSE, NASDAQ)4. private rules (certificate of incorporation, bylaws, agreements)5. accounting rules6. other laws (e.g. anti-trust, labor, employment, environment, etc.)

B. Forms of Business Entities1. Sole proprietorships2. Corporations3. Partnerships4. LLP’s/LLC’s

C. Forms of financing1. Debt

a. Personal liabilityb.Creditors have a claim on assetsc. Return is set at the interest rate

2. Equitya. Higher riskb. Greater possible returnc. Investors have less of a claim on the company’s assets if there is no return of capitald. Retained earnings

i. Most important way to fund expansionD. Corporation advantages

1. diversified holdings2. limited liability (to amount of the investment)3. shareholder liquidity (free transferability of interests)4. Centralized management coordination (board)5. Duration- continuity of existence

E. Corporate disadvantages1. Conflicts of interest

a. Controlling shareholder v. minority shareholdersb. Shareholders v. board or managers (the most important issue)c. shareholders v. creditorsd. employees v. managerse. Employees v. shareholders

2. formalities (shareholder meetings records, etc.)3. Double taxation

F. Corporate Issues1. What does the law do to regulate manager misbehavior?

2. But what other mechanisms do shareholders enact to regulate manager misbehavior and how does the law affect them?

a. compensation (performance based)b. managerial labor marketc. shareholder votesd. monitoring (directors/big shareholders/auditors)e. takeover threatf. product competition and bankruptcyg. norms (ethical rules/morals)h. shareholder suits

2. For whom the Corporation be run?A. Corporate power (Del. Statute): Powers conferred upon the corporation:

1. To make contracts of guaranty and suretyship2. To participate with others in any corporation, partnership, or other association3. To make donations for public welfare/charitable/scientific/educational purposes. (SUBJECT TO REASONABLENESS TEST!)

B. ALI Principles (p. 38)1. Sec. 2.01: A corporation should have as its objective the conduct of business activities with a view to enhancing corporate profit and shareholder gain.(b) Even if corporate profit and shareholder gain are not thereby enhanced, the corporation, in the conduct of its business:

(1) Is obliged, to the same extent as a natural person, to act within the boundaries set by law.(2) May take into account ethical considerations that are reasonably regarded as appropriate to the responsible conduct of business; and(3) May devote a reasonable amount of resources to public welfare, humanitarian, educational, and philanthropic purpose

C. Traditional problem areas1. Guaranties: this power can only be exercised in furtherance of the corporate business.2. Donations: General view: objective of the business corporation is to conduct business activity with a view to corporate profit and shareholder gain.

a. Traditional view: a corporation could use its resources for public welfare if the use was likely to produce a direct benefit to the corporation.b. Modern view: REASONABLENESS TEST: Use of corporate resources for public welfare is limited to its reasonableness. Direct benefit test DROPPED on either of 2 grounds:

(1) Profit maximization view: use of corporate resources for public welfare are profit-maximizing and within the board’s business judgment. (Wrigley)(2) Legitimate end view: use of corporate resources for public welfare is a legitimate end in itself on ground that:

i. it maintains a healthy social system that serves the long-run corporate purpose.ii. social policy to maintain diversified centers of charitable activity which justifies corp. support.

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D. Corporate Constituency Statutes Defense: say that corporations are allowed and in some states, are required to take into account other interests than the shareholders

1. Not used much in court; unenforceable because most statutes allow for the consideration of other interests but no requirement to actually do so2. How can they be used? As a defense to shareholder actions when a corporate officer does not sell the company.

a. But not often used because management would rather argue that the decision is in the best interest of shareholders.

E. Employee vs. Shareholder Interest Conflicts: Policy ArgumentsHypo: Tender offer to sell corp., buyer plans to fire all employees.1. Shareholder protection argument: Protect shareholders since they take on risks that other participants don’t.

a. Other groups can protect themselves contractually; shareholders have a harder time of protecting themselves.b. Shareholders are the residual claimants as they get paid what gets leftover after other groups have taken what they are owed contractually.c. Marketability of shares is a counter-argument: shareholders can always sell.d. Shareholders are uniquely suited to bear the risk by diversifying

2. Employee protection argument: Protect employees since they take risks in being specially trained and thereby, harder to switch to other jobs.

a. Society is also hurt by having these employees not working elsewherei. employees are specially trained and thus, more value when working for the specific firm

F. Creditor vs. Shareholder Interest Conflicts: Policy Arguments1. When a company becomes insolvent, the residual claimants, in effect, become the creditors because of the limited liability of the shareholders2. Shareholders become less risk-averse and thus, DE courts have allowed for fiduciary duty runs to the creditors when the company hits insolvency.3. Fiduciary duty in Delaware:

a. When company is doing well, fiduciary duty to shareholders.b. When company is close to insolvency, fiduciary duty to the institution of the company.c. When company is in insolvency, fiduciary duty to creditors

G. Why have rules on the company in the first place?1. Best economic decision= best public net social benefit

a. some social costs are not born by the company = externalityb. Responsibility of legislatures is to internalize these externalities, let society through other rules (regulatory) internalize these costs.

i. Problems: May not work, enforcement problems; if these measures don’t work, we may need to rely on individual actors

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3. Agency - AuthorityA. Why might there be a need to have a special area of law for law of agency?

1. Protection of third parties.2. To have bright line rules directing the behavior of principals and agents otherwise, contracts between P’s and A’s may be very tedious and difficult

B. Morris Oil Co. v. Rainbow Oilfield Trucking Inc.1. Inherent authority Rule: An agent for an undisclosed principle subjects the principle to liability to 3p’s for acts done on his account if they are usual or necessary in such transactions, even if contrary to principal’s express directions.

Reasons:a. ability of the enterprise to spread the risk from lossesb. proper allocation of resources by requiring the enterprise to include in the price of its goods the costs of accidents which are closely associated with the enterprise’s operations.c. P is in a position control/monitor A and placing the risk of loss on P could lead to greater safetyd. More equitable to place liability on the P because it provides greater assurance that the 3P will be paid (social preference to protect 3P)

4. Secret Instructoins Rule: Secret instructions or limitations placed upon the authority of A must be known to 3P dealing with A, or P is bound.5. Ratification Rule: P is held liable for the unauthorized acts of his agent if the P ratifies the transaction after acquiring knowledge of the material facts. 6. Benefit Retainment Rule: Where P retains the benefits or proceeds of its business relations with A with knowledge employed by the agent in generating the proceeds.7. Agency-In-Fact Rule: If the fact pattern fits the pattern of an agency relationship, a court will find the fact that the relationship is an agency one.8. Notes

a. Agent= person who acts on behalf and subject to the control of anotheri. general: authorized to conduct a series of transactions involving continuity of service.ii. special: authorized to conduct only a single transaction, or only a series of transactions not in continuity of service.

b. Principal= person on whose behalf and subject to whose control an agent acts.

i. Disclosed= 3P knows A is acting on behalf of P and knows P’s identity.ii. Partially disclosed= 3P knows A is acting on behalf of a P, but does NOT know P’s identity.iii. Undisclosed= 3P does NOT know A is acting on behalf of a P.

c. Agency= fiduciary relation which results from: (1) the manifestation by one person to another that (2) the other shall act on his behalf and (3) subject to his control, and (4) consent by the other to so act.

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d. General 3P Liability of P= P becomes liable to a 3P as a result of an act/transaction by A done on the principal’s behalf, if A had:

(1) actual, apparent, or inherent authority.i. actual authority= if P’s words or conduct would lead a reasonable person in the agent’s position to believe that the P had authorized him to so act.

ia. Expressib. Implied= often incidental authority (authority to do incidental acts that are reasonably necessary to accomplish an actually authorized transaction)ic. If A has actual authority, P is bound even if 3P didn’t know A had actual authority.

ii. Apparent authority= if the words or conduct of the principal would lead a reasonable person in 3P’s position to believe that the principal had authorized the agent to so act.

ia. Power of position= apparent authority can be created by appointing a person to a position

iii. Inherent authority= Not actual, not apparent or estoppel; exists for the protection of persons harmed by or dealing with a servant or other agent (like respondeat superior)

ia. Rest. 161= More or less apparent authority (for disclosed or partially disclosed P)ib. Rest 194= For undisclosed P, if A subjects his P to liability for acts done on his account, if usual or necessary in such transactions, although forbidden by the principal to do them.

v. Ratification=if A purported to act on the principal’s behalf, and the principal, with knowledge of the material facts, either:

(1) affirms the agent’s conduct by manifesting an intention to treat the agent’s conduct as authorized, (2) engages in conduct that is justifiable only if he has such intention.

vi. Acquiescence= If in the past, P let A do certain things, the failure of the P to object to them is an indication that he consents to the performance of similar acts in the future under similar conditions.

*NOTE: D. Menard, Inc. Rule : When the nature of the specific transaction undertaken the by agent is unusual or extraordinary and thus sufficient to require inquiry by the third party, if the third party does not perform inquiry, the third party will bear the loss.

C. Should we treat contractual 3P’s differently from tort 3P’s?1. Yeah, contractual 3P’s have more of a duty to investigate2. Protections for tort 3P’s always better (punitives vs. no punitives, etc.)

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4. Agency – Fiduciary DutyA. Tarnowski v. Resop

1. Facts: P hired D to investigate and negotiate a purchase of business. D got bribe from seller. P injured by purchase.2. Issue: Damages recoverable by P?3. Rule: It doesn’t matter that the principal is injured, an agent who breaches his fiduciary duty is liable for both the amount the agent received in breaching his duty (disgorgement- getting the ill-gotten gain), and costs that the principal incurred as a result of the tortuous behavior (attorney’s fees).

a. Deterrence measure: Align the incentives of the agent and the incentives of the principal b. Why disgorgement? Removes the incentive the agent has to violate their fiduciary duty.

B. General Rules & Situations-Issue: When can the agent deviate in acting on behalf of the principal?-Issue: When should we protect 3rd parties when the agent binds the principal?

1. Termination Rule: A principal has power to terminate an agent’s authority at any time, even if doing so violates the K between the P and the A. (But still liable for damages!)2. 3P Liability to P: If A and a 3P enter into a K where P is liable to 3P, then 3P is also liable to P.3. A’s Liability to 3P: Depends on whether the P is disclosed, partially disclosed, or undisclosed:

a. Undisclosed P: If P was undisclosed, A is bound even though P is bound too.

i. NOTE: If 3P gets a judgment against P, then A is discharged from liability.ii. If the principal is nonetheless bound, why is it that the agent is bound? The principal may be judgment-proof.

b. Partially disclosed P: If P was partially disclosed, A is bound even though P is bound too.

i. Reasonable expectation of 3P for A to be liable either solely or as a co-promisor or surety.

c. Disclosed P: If P is bound by A’s act because the A had actual, apparent, or inherent authority, or ratification, A is not bound to 3P.

i. Reasonable expectation of 3P for P to be bound and not A.4. Where P is not bound: If P is NOT bound by A’s act because A didn’t have actual, apparent, or inherent authority, A is liable to 3P.5. Liability of A to P: If A takes an action that she has NO AUTHORITY to perform, but P is bound because A has apparent authority, A is liable to P for indemnity.6. Liability of P to A: If A has acted within her ACTUAL AUTHORITY to perform, P is under duty to indemnify A for payments authorized or made necessary to execute P’s affairs. 7. Indemnification agreements can be made to contract around the rules

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8. Fiduciary duty: When acting in their role as an agent, A has a duty to act in the best interests of the principal9. Acts which VIOLATE an agent’s fiduciary duty

a. Make a profitb. Act as an adverse party to the principal

i. Can act as a competing party after P-A relationship over.c. Act for an adverse partyd. Act for person with conflicting interestse. Compete as to subject matter of agencyf. Use confidential information gained in course of agency

i. NOT OK - trade secrets, written customer listsii. OK- general info and customers you do remember

g. Agent may do all the above things if principal agrees after fair and full disclosure

10. Adverse Party Rule: An agent CANNOT act as an adverse party or for an adverse party without consent

C. R2d Agency Rules1. §13: An agent is a fiduciary w/ respect to matters within the scope of his agency.2.§387 – 396:

a. 387: Unless otherwise agreed, an agent is subject to a duty to his principal to act solely for the benefit of the principal in all matters connected w/ his agency.b. 388: Duty to Acct. for profits arising out of employment to the P.c. 389: Agent cannot act as adverse party (himself) in transaction without Principal’s consent.d. 390: Agent that acts as Adverse Party with P’s consent must deal fairly and disclose to him all facts necessary for P to make judgments unless P said he already knows or doesn’t care to know.e. 391: Agent cannot act for adverse party (for 3rd party) in transaction without Principal’s consent.f. 392: An Agent, with the knowledge of two principals, acting for both of them in a transaction between them, has a duty to act w/ fairness w/ full disclosure between them unless principal said he already knows or doesn’t care to know.g. 393: Agent cannot Compete with Principal as to Subject Matter of Agencyh. 394: Unless otherwise agreed, Agent cannot act for 3rd party that has competing / conflicting interest w/ Principal.i. 395: Agent cannot use or disclose Confidential Information given by P or acquired during course of his agency that would compete or injure the P in any way, unless the matter is of General Knowledge.j. 396: Unless otherwise agreed, after the Termination of Agency, the agent:

(a) Can now compete w/ principal;

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(b) cannot disclose to 3rd party confidential info, but agent can use general info concerning methods of business and names of customers retained in his memory; (c) has duty to account for profits made by sale or use of trade secrets whether or not in competition w/ principal; (d) has duty not to take advantage of an still-subsisting confidential relationship

3. §401: Agent is liable for loss caused to principal by any breach of duty.4. §404: Agent is liable for using Principal’s Asset if use is in violation of duty. Agent is liable for the value of the use OR profit from use (but NOT BOTH.)5. §407: Principal’s Choice of Remedies:

(1) Principal can recover from Agent any benefits Agent received from violating his duty in addition to any damage thereby caused; except that, if violation consists of wrongful disposal of principal’s property, the principal cannot recover its value and also what the agent received in exchange therefore (no double profit).(2) A principal that recovered damages by 3rd party because of Agent’s breach of duty is entitled, nevertheless, to obtain from Agent any profit Agent made from the improper transaction.

D. Covenants Not to Compete 1. Courts only enforce covenants not to compete only if they are reasonable.

a. Limited in terms of time and geographically areab. In CA, no covenants not to compete are enforced unless under very specific circumstances

II. FORMING THE CORPORATIONA. What corporate form should we choose?

1. Partnershipa. Unlimited liabilityb. Informalityc. Decentralized controld. Limited existencee. Pass-through taxation

2. Limited Partnershipsa. General Partners and Limited Partners (Limited Partners have limited liability).b. Limited Partners now can have broad control over the company as well (but not before)c. Pass-through Taxation

3. Limited Liability Partnerships= Limited liability in that tort creditors cannot get at the personal assets of the partners4. Limited liability companies= usually closely held limited liability companies 5. Why choose to be a corporation?

a. attorneys more familiar with corporations than LLCs

B. In What State? State Requirements

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1. INTERNAL AFFAIRS DOCTRINE= if a dispute arises from the relationships WITHIN A CORPORATION (shareholders/directors/officers), the STATE LAW of the state in which you are incorporated governs the dispute.2. Why Delaware often?

a. Delaware have more case law regarding corporations.b. More corporate atty’s in DE, so more infrastructure to handle more cases there.c. DE judges are more specialized in corporate law.d. Procedurally, more cases are decided quickly in DE.e. More corporate counsels are already familiar w/DE law.f. Board/Managers/Lawyers make the key decision as to where to incorporate.

i. Race to the Top theory: manager’s incentives are aligned to the shareholders’ interest (through options, hostile takeover threat, stock market prices etc.) so that the managers will act in the best interest of the shareholders in choosing where to incorporateii. Race to the Bottom argument: the stock market does not price the shares as well as the Race to the Top advocates believe; also argue that even if the price does reflect good information, the link between manager’s incentives with the price of the stock is not that good (Mgr. may choose state which protects agents more).

3. Formalities of starting a corporation:a. write a certificate of incorporationb. DE Corp Law 102(a)(4): must show number of shares company allowed to issue and the class and who is authorized to issue shares; blank stock deferred: gives corporate board the power to issue preferred stockc. bylaws, which detail more the day to day operations of the corporationsd. Must update every year in the states that you are doing business in

4. RMBCA:a. Requirements:

i. corporate nameii. number of shares the corp. is authorized to issueiii. street address of initial registered officeiv. name of its initial registered agentv. name and address of each incorporator

b. Optional provisions:i. Purpose of the corporationii. Management of the business and regulating the powers of the corporation, its board, and shareholders.iii. Definition, limitation, and regulation of the powers of the corporation, its board, and shareholders.iv. Par value, if any, for authorized shares or classes of stockv. Imposition of personal liability on shareholders for the debts of the corporation to a specified extent and upon specified conditions.vi. Eliminating or limiting the liability of a director to the corporation for actions taken as a director except for:

(1) liability for financial benefit received by a director to which he is not entitled.

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(2) intentional infliction of harm on the corporation/shareholders(3) violation of the rules governing payment of dividends.(4) intentional violations of criminal law.

vii. any provision that is required or permitted to be set forth in the bylaws5. Organizational meetings (Del. Law):

a. If initial directors not named in articles, the incorporators at their organizational meeting, will typical adopt bylaws, fix the number of directors, and elect directors who will serve until the first shareholders’ meeting.

1. PIERCING THE CORPORATE VEILA. General: A shareholder normally has no liability for corporate debts or other obligations.B. Suits by Corporate Creditors against shareholders: To prevail on an alter ego claim under DE law, P must show (Fletcher v. Alex):

1) that the parent and subsidiary “operated as a single economic entity”2) that an “overall element of injustice or unfairness is present”

Important Elements:1. Commingling of assets: using corporate assets for private purposes

a. Policy reason: proof for courts: gives incentives to stockholders to make clear which are corporate assets and stockholder’s personal assets.

2. Lack of corporate formalities: inadequate corporate records, whether stock was issued, whether directors/officers elected

a. Statutory close corporation exception: Many states have these provisions which permit less formal mgmt. and removes lack of formal board meetings or shareholders

3. Undercapitalization: was the corp. organized w/sufficient resources (capital, liab. Insurance, or both) to meet its reasonably expected amount of obligations?

a. undercapitalization alone is not enough, although it may be a factor.b. siphoning off of assets in the form of dividends

4. Domination and control by shareholder: when an individual/corp. that owns most or all of C’s stock so completely dominates C’s policy and practices that C can be said to have no separate mind, will, or existence of its own.5. Misrepresentation: corp. committing a fraud or wrong is sometimes required by cts. MOST IMPORTANT factor. 6. Number and type of shareholder: Usually only applied against corporations with small number of shareholders.7 Type of creditor: K breach vs. Tort K breach creditor MORE LIKELY!

C. Piercing the Wall Between Affiliated Corporations1. Enterprise liability: some opinions suggest it may be permitted where each affiliated corporate entith is not a free-standing enterprise, but only a fragment of an enterprise composed of affiliated corporations. (Walkovsky)

D. Use of Corporate Form to Evade Statutory or Contract Obligations1. Key Q: Was a statute or K that normally applies only to the Corporation also intended to also apply to the corporation’s shareholders?

E. Equitable Subordination (subordinate shareholder debts under 3P creditor debts) may be used in such cases. Stone v. Echo

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E. Walkovsky v. Carlton, p. 2661. Facts: P injured in taxi. Taxi owned by corporation owned by D. D owns many corporations with one or two cabs in each.2. Issue: Can P pierce the corporate veil and hold D personally liable?3. Rule: Courts will pierce the corporate veil:

1) whenever necessary to prevent fraud and achieve equity.2) when anyone uses the corporation to further his own rather than the corporation’s business

4. Dissent: An action lies against shareholders when they provide inadequate capitalization and actively participate in the conduct of corporate affairs.5. Policy arguments for or against limited liability:

a. Encourages risk taking (for);b. Want decision-makers to bear both the cost and the benefits of the decisions they make. (against)

F. Fletcher v. Atex, Inc., p. 266Facts: P sued D’s subsidiary in tort theory.Issue: Can P pierce the corporate veil and hold D personally liable?Rule: -To prevail on an alter ego claim under DE law, P must show:

1) that the parent and subsidiary “operated as a single economic entity”2) that an “overall element of injustice or unfairness is present”

Notes: Factors to look at:1) specific context more than any inherent corporate characteristic2) the likelihood of piercing increases as the number of shareholder decreases. Never happens in publicly held corporations.3) “misrepresentation” is most powerful factor when piercing; followed by lack of substantive separation of the corporation and its shareholders, commingling of activities of corporation and shareholder.4) Piercing is less likely in tort contexts than in contract cases. 5) Piercing is more likely when the defendant behind the corporation is an individual shareholder than another corporation6) Passive shareholders are almost never held liable.

G. Bardle case1.Facts: P (creditor) sued D to pierce veil. D was housing construction corp owned solely by company solely formed by housebuyers.2. Ruling: No misrepresentation P’s will not be able to pierce the veil.

a. Policy: Creditors are better able to exercise due diligence.b. Tort creditors cannot exercise diligence (arg. For unlimited liab. For torts)

H. Equitable Subordination (subordinate shareholder debts under 3P creditor debts) example1. Facts: C-sole shareholder, loans 50K to Seon. Seon owes W 100K. Seon is bankrupt with 75K in assets.2. What result if Carlton like a regular creditor?

a. Each creditor gets 50%. 3. What result if pierce the veil against Carlton?

a. Carlton will have to pay the 25K left owed to W.4. What result if equitably subordinate?

a. Carlton’s loan gets lower priority than other creditors. W gets 75K.

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III. FIDUCIARY DUTIES1. GeneralA. Introduction

1. Shareholders have to agree to certain fundamental changes and amend the bylaws (most corporations, the board can do that as well).

a. Shareholders can pass resolutions but there is no legally operative effect unless it’s in the bylaws that they do.b. Shareholders, beyond that, does not have much power to make decisionsc. The board has most of the power to make decisions

B. RMBCA §-§8.01(a)- Each corporation is required to have a board of directors and the power is vested in the board.-§8.01(b)- Everything is done under the authority of the board subject to limitations in the articles of incorporation-§8.40- Corporate officers are appointed by the board and those officers have authority to appoint other officers if authorized by the bylaws or the board.-§8.40(c)&(d)- one officer assigned to take minutes to director’s and shareholders’ meetings and for maintaining and authenticating the corporation’s records; this officer may hold more than one office in the corporation-§8.41- Fiduciary duty of officers to do their job well-§8.20- Board may hold regular or special meetings anywhere; board may conduct meeting through the use of any means of communication (conference calls)

-Quorum is basically at least half of the board; quorum needed for a board meeting.-but there are notice requirements before having a meeting where not all the board is present, or if those not present at the meeting.

-§8.21- Action may be taken without a meeting if each director signs a CONSENT describing the action to be taken and delivers it to the corporation. (Must be unanimous! )

a. Director’s consent may be withdrawn by a revocation signed by the director and delivered to the corporation prior to delivery to the corporation of unrevoked written consents signed by all the directors.b. Why unanimity? If everyone agrees, then it’s ok but if there’s a disagreement, the other members should hear the arguments so that the dissenting director(s) have a chance to change people’s minds.

C. Board’s primary role today: Monitoring1. Shareholders have a large informational cost problem which is why they can’t monitor.2. Directors are far enough from the day to day operations as to not be biased, yet have enough of a monetary interest as to monitor3. Directors also serve the role as advisors to the management

D. Menard, Inc. v. Dage-MTI, Inc., p. 59Apparent authority based upon the power of position!

1. Rule: Inherent authority= the scope of an agency must be measured ‘not alone by the words in which it is created, but by the whole setting in which those words are used, including the customary powers of such agents.

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Reasoning: The fact that corporation appointed the agent as president gives apparent authority to the president to do what presidents normally do.

2. Rule: An agent’s inherent authority “subjects his principal to liability for acts done on his account which: (1) usually accompany or are incident to transactions which the agent is authorized to conduct, although they are forbidden by the principal, (2) the other party reasonably believes that the agent is authorized to do them, and (3) the other party has no notice that he is not so authorized.3. Policy: If one of two innocent parties must suffer due to betrayal of trust, the loss should fall on the party who is most at fault. Because the principal puts the agent in a position of trust, the principal should bear the loss.4. Policy: Inherent authority furthers the very purpose of delegated authority: to avoid constant recourse by third persons to the principal.5. Notes: 6. Rule: When the nature of the specific transaction undertaken the by agent is unusual or extraordinary and thus sufficient to require inquiry by the third party, if the third party does not perform inquiry, the third party will bear the loss.

E. Ways to Assure Authority in a Transaction1. Get board resolutions authorizing (secretary’s certificate)2. See board resolutions authorizing relevant officers to take actions of specific type expected to recur (secretary’s certificate)3. Make agreement subject to Board ratification after the fact.4. Rely on implied or apparent authority of officer5. Representations in the contract6. Legal opinion of in-house counsel saying they have authority.

G. Manager’s Duties1. Problems with legal reforms on judging directors/officers and their decisions

a. adds greater risks to the directors/officers so that fewer people will want to be directors/officersb. penalizes risk-taking behaviors so directors/officers will be less willing to take riskier decisions that may be beneficial to the corporation.c. judges are not in the best position to judge the discretion of officers/directors

2. Ways to Limit Managers:a. Compensation (performance-based, equity)b. Managerial labor market (can hire a new manager)c. Shareholder votesd. Monitoring (directors, big shareholders, auditors)e. Takeover threatf. Product competition & bankruptcyg. Social Normsh. Shareholder suits

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2. DUTY OF CARE - BASICSA. Business Judgment Rule

1. General: Presumption that in making a business decision, the directors of a corporation will act on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the corporation.

a. Reasoning: Shareholders voluntarily undertake the risk of bad business judgment.b. Reasoning: After-the-fact litigation is an imperfect device to evaluate corporate business decisions. c. Reasoning: Potential profit often corresponds to potential risk, shouldn’t create incentives for overly cautious decision-making.

i. Shareholders can diversify risks by diversifying investments.2. Business Judgment Rule ANALYSIS: A decision by directors/officers is proper if NO:

(1) fraud , (2) illegality ( Miller v. AT&T ) or (3) conflict of interest in making their decision is shown(4) Gross Negligence (Van Gorkom)

i. Time of deliberation?ii. Evidence of intrinsic value?iii. Reliance on advice of how many directors?

*Note: Bd. has right to rely on officer’s reports under certain circumstances (DGCA §141(e)).

iv. Any outside valuations?v. Type of transaction=time of deliberation.

a. Reasoning: Corporate directors, not courts, should resolve questions of policy and business judgment.

C. Miller v. AT&T1.Illegal Action Rule: An illegal action taken by the directors, even for the benefit of the corporation, is an appropriate basis for finding breach of the director’s fiduciary duty to the corporation.

C. Smith v. Van Gorkom 1. Facts: D = board of directors, P = shareholders; D didn’t examine all reasonable material info before accepting offer; P sues.2. Gross Negligence Duty of Care Rule: Directors violate their duty of care if they were grossly negligent in failing to inform themselves.

a. It’s not enough that they received a premium price over market (not enough evidence of intrinsic value).b. Bd. only deliberated for 2 hours.c. Bd. Only relied on advice of one director, the CEO.d. No outside valuations.e. Merger acquisition requires more deliberation.

4. Note: Rushed decisions do not always breach duty of care. (Cintron)D. In re Caremark International, Inc. Derivative Litigation

1. Facts: Caremark violating law by making pymts. And had to pay penalties. D=board who mandated compliance policies and audits. P=shareholders who sued.

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4. Rule: To find a breach of duty of care, P’s must show that: (ALL)(1) D’s either knew or should have known that violations of law were occurring(2) D took NO steps in good faith effort to prevent or remedy the situation,(3) such failure proximately caused the losses.

5. Articles of Incorporation Limits on Personal Liab. of Directors: DE Law allows the articles of incorporation to contain a provision eliminating or limiting director’s personal liability but NOT for Breach of loyalty AND NOT for bad faith acts/omissions which involve intentional misconduct or a knowing violation of the law.

E. ALI Principles on Duty of Care1. §4.01: A director/officer has a duty to perform their functions in good faith, in a manner that is in the best interest of the corporation, and with a care that an ordinarily prudent man would be expected to exercise.

a. Includes an obligation to make an inquiry ONLY WHEN circumstances would alert a reasonable director or officer to the need for it.b. A Director/Officer is entitled to reasonably rely on materials and persons.

2. §4.01: The board may delegate any function to committees of the board/officers3. §4.01: A director/officer who makes a business judgment fulfills the duty of care if:

(1) he is not interested in the subject of the business judgment; AND(2) he is reasonably informed of the subject of the business judgment; AND(3) he rationally believes that the business judgment is in the best interests of the corporation (wide discretion)

F. RMBCA Business Judgment Rule: won’t be liable unless the plaintiff shows:1) action NOT in good faith2) the decision the director did NOT reasonably believe to be in the best interests of the corporation, or3) the director was NOT informed to an extent the director reasonably believed appropriate in the circumstances, or4) a sustained failure of the director to devote attention to ongoing oversight of the business and affairs of the corporation or a failure to devote timely attention, by making (or causing to be made ) appropriate inquiry, when particular facts and circumstances of a significant concern materialize that would alert a reasonably attentive director to the need therefore.

Business Judgment Rule flowchart1) Conflict of Interest?

YDuty of Loyalty Analysis N Bad Faith?

2) Bad Faith?Y-No protectionN reasonably informed?

3) Reasonably informed?N No protectionY Honest Rational believe in best interest of the company?

4) Honest Rational belief in best interest of the company?Y ProtectedN No protection

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3. DUTY OF LOYALTYA. General: Duty to promote the interests of the corporation without regard for personal gain.B. 1st Question: Is the director an INTERESTED DIRECTOR?

1. ALI §1.23: if director has business/financial/familial relationship to party to the transaction/conduct, and that relationship would reasonably be expected to affect the director’s or officer’s judgment in a manner adverse to the corp.

a. -:ALI §1.3(a)(1)- when interested – look @ definition of associate- “spouse, child, sibling, parent, or same home”

2. RMBCA §8.60: Three ways a D can have a conflicting interest:-§8.601- Is the interest of a type that would reasonably exert influence or judgment?

(1) If D is the other party(2) If transactions involves a “related person” (closely related family/individuals/trusts/estates and persons where D is linked in a fiduciary capacity)

-More bright Line= cousins don’t count!(3) Economic involvement of certain other persons (if director is a director/employee/gen. partner in other co./any individual who is a general partner/employer/principal of D)

C. General: Self-Interested Business Dealings with Corporations1. GENERAL Effect on the transaction? Does it make it voidable?

a. CL: an interested K is voidable at the option of the corp. b. MODERN VIEW: Most cts. say that interested transactions are voidable by the corporation only if the K is found to be unfair to the corporation.

i. DISCLOSURE Requirement: The failure of an interested director to make full disclosure is in itself “unfair”

ia. “Full Disclosure”: Requires disclosure of all matters affecting the value of the property involved and perhaps also the amount of the director’s profit.Ib. Doesn’t require disclosure of tax consequences. Eliasberg.Ic. New proxy rules probably do require tax consequences disclosure.

ii. FAIRNESS Requirement: Even if there’s full disclosure, most cts. generally hold that the transaction is still voidable if it is unfair to the corp. in price, terms, or conditions. (TWO PRONG TEST)

(1) Substance fairness: trying to figure out what price you would have reached if you had an arms length bargaining process.(2) Procedural fairness: Replicate arms-length process?; DISCLOSURE?; Disinterested directors actively involved?; Outside evaluations?ia. Burden of proving fairness is on the interested director. (Cookie Food Products, Inc. v. Lakes Warehouse Distributing Inc.)ib. Fairness where no ability to disclose: Where disclosure to an independent board is not possible (interested director controls a majority of the bd.), interested transaction will be upheld if fair and reasonable to the corporation.

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1. An interested transaction may be cleansed w/ disinterested board approval, shareholder approval, or if the transaction is FAIR.

2. Effect on Interested Director’s right to participate in meeting authorizing transaction?a. Statutes: Most statutes today permit an “interested” director to be counted in determining the presence of a quorum.

3. Effect of Outside Director Ratification (Three Approaches)(1) Some cts. hold that the transaction is cleansed and cannot be attacked by the corporation(2) Others hold that such ratification shifts the burden of proving “unfairness” to the corporation. (often if there is controlling shareholder, this standard applied)(2) Some cts. that BJR then applies (if no controlling shareholder, often this standard is applied)

4. Effect of shareholder ratification after full disclosure?Note: CL: an interested K is voidable at the option of the corp.

a. UNANIMOUS RATIFICATION RULE: If after full disclosure, the shareholders unanimously ratify the interested transaction, the corp. will be estopped from later challenging the trans.

i. NOTE: No such estoppel is invoked UNLESS there is full disclosure.ii. This bars shareholder suits on behalf of the corp. but does NOT bar creditor’s suits if the effect of the action was to deplete corp. assets & make the corp. insolvent and thus, unable to pay its debts.

b. LESS-THAN-UNANIMOUS RATIFIICATION RULE: TWO ISSUES:1. Can we include interested shares in the vote?

-Analyze what happens if interested shares are included and what happens if interested shares not included!-DGCL §144(a)(2)- doesn’t specifically say it has to be disinterested SH votes (just ”entitled”)

2. What standard of review is used assuming shareholder ratification?THREE APPROACHES:

(1) Complete Ratification: Some cts. hold the transaction cannot be attacked by the corp.

a. Policy: Unless unanimous shareholder approval, this standard appears suspect.

(2) Burden-shifting standard: Others hold that such ratification shifts the burden of proving “unfairness” to the corporation. (Eliasberg v. Standard Oil) (3) Waste standard: Unless there’s waste, then it’s OK. If there’s waste, the ct. must examine the facts to determine if they fall within the realm of business judgment.

a. Policy: Protecting shareholder-interest if shareholders, approved, why should ct. intrude if they say ok?

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*NOTE: A shareholder who received full disclosure and yet, still voted to approve the interested transaction would be estopped from bringing a suit on unfairness grounds.

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4. STATUTE LAW ON INTERESTED TRANSACTIONSa. DE §144: Interested transactions may NOT be per se voidable by the corp. if:

(1) full disclosure AND approval by maj. of disinterested bd. OR(2) full disclosure AND approval of maj. of shareholders OR(3) the transaction is fair to the corp. (2 Prong)

(1) Substance fairness: trying to figure out what price you would have reached if you had an arms length bargaining process.(2) Procedural fairness: Replicate arms-length process?; DISCLOSURE?; Disinterested directors actively involved?; Outside evaluations?

(b) Interested directors may be counted towards presence of a quorum in bd./committee Meeting authorizing the transaction.

b. Is Fairness required? (Differing standards!)i. CA: Fairness required if approved by directors but NOT required if approved by shareholders.ii. ALI §5.02: Requires fairness notwithstanding full disclosure and approvaliii. RMBCA §8.61: Eliminates fairness requirement if other statutory requirements met:

ia. Approval by maj. of qualified (def. §8.62(d)) directors (not less than 2) of the board after full disclosure.ib. Approval by maj. of qualified shares (not owned by interested director) after full disclosure.

c. Count interested shareholder’s shares in vote?i. NO – Californiaii. Maybe – Delaware, NY

5. Measure of Damages: May rescind or affirm the K and hold the D liable for damages

a. Usual measure of damages= unfair profit

C. Parent Subsidiary Transactions Problems (Duty of Loyalty to Minority shareholders)Basic Underlying Issue: Was the transaction fair to the subsidiary? Did the parent make a decision that created a benefit to itself at the detriment of the subsidiary?

1. Burden/General: Where there is self-dealing, the BURDEN is put on the Parent2. No exclusion=no self-dealing Where the parent did NOT receive something from the subsidiary to the exclusion or detriment of the minority shareholders, there is NO self-dealing and thus, the BURDEN is on the minority shareholders. (Sinclair Oil Corp.)

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D. Managerial Compensation TWO QUESTIONS: 1. DULY AUTHORIZED by Disinterested Board or by Disinterested Shareholders?

a. Issues (STANDARD Duty of Loyalty Analysis):i. Interested director counted for quorum purposes?ii. Interested director’s vote counted?iii. The effect of shareholder ratification? Good UNLESS WASTE or FRAUD shown.

2. Is the compensation REASONABLE? (more likely to look at closely-held corp.)NOTE: VERY DEFERENTIAL TO THE BOARD!

a. General: Good faith and the BUSINESS JUDGEMENT RULE protect disinterested directors from liab. Cts. reluctant to second-guess business decisions as to the value of employee’s services. (Mlinarcik)b. Waste Limitation: Notwithstanding approval by disinterested directors/disinterested shareholders, Board has no power to waste corp. assets.

i. Must show legally sufficient consideration to corporation.Ia. Invalidated compensation for past services. (Adam v. Smith)

c. Bonuses: Except where there has been an express/implied understanding that they may be granted if conditions warrant, there is NO consideration for them.

i. Shareholder approval EXCEPTION: Reasonable bonuses may be paid to officers and employees if approved unanimously by disinterested shareholders after shareholders are given notice of director’s interest, ABSENT FRAUD or WANT OF POWER in the corporation.

d. Stock Options: BEARD RULE: A corporation must expect to receive benefit from stock option plan (otherwise waste!).

i. Rational Belief Standard: so long as there is “rational belief” that the company is getting something back, no waste.

Ia. Sometimes stricter standard enforced because cts. fearful that disinterested shareholders=uninformed shareholders

ii. Kerbs comment: plan allowing employees to exercise options six months after leaving the co. would be invalid.

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E. Corporate Opportunities1. Irving Trust Per se rule: “Inability” of solvent corporation to take advantage of opportunity is NEVER an excuse for officers to take advantage of the opportunity themselves.

a. Policy: Allowing this excuse would essentially allow officers and directors to not use their best efforts to ensure that the corp. would have ability to take advantage of the opportunity.b. Other jx’s use a more flexible approach but burden on D to show that the co. couldn’t afford the opportunity.

2. Where Corporation Unwilling to take Advantage? ALI Rule (p. 177); Requires:(1) Full disclosure(2) Give company opportunity(3) Company must reject it4) Either:

(A) Rejection is fair(B) Business judgment rule rejection by disinterested directors or disinterested executive superior(c) Rejection is authorized or ratified in advance following disclosure by disinterested shareholders and rejection is not waste of corporate assets.

3. Did the D take a Corporate Opportunity? Use Guth Rule and Guth Corollary.Test: Did officers learn about it as a corporate officer? Y Guth Rule; N Guth Corollary.d. Guth Rule:

(1) If there is presented to a corporate officer or a director a business opportunity, (2) which the corporation is financially able to undertake,(3) is, from its nature, in the line of the corporation’s business and is of practical advantage to it,(4) is one in which the corporation has an interest or a reasonable expectancy,(5) and, by embracing the opportunity, the self-interest of the officer or director will be brought into conflict with that of his corporation,(6) the law will NOT permit him to seize the opportunity for himself.

e. Guth Corollary(1) If the business opportunity comes to a corporate officer or director in his individual capacity rather than in his official capacity,(2) and the opportunity is one which, because of the nature of the enterprise, is NOT essential to his corporation,(3) and is one in which it has no interest or expectancy,(4) the officer or director is entitled to treat the opportunity as his own, and the corporation has no interest in it(5) if, of course, the officer or director has not wrongfully embarked the corporation’s resources therein.

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f. What is a corporate opportunity? Case Factors:a. Director’s/Officer’s Capacity in dealing (Rapistan Corp.)b. Corporate plans and expectations: if the corp. has a present interest or “tangible expectancy” in the opportunity in the sense that it has a specific need for it, has resolved to acquire it, or has actively considered its acquisition. (Burg)

i. “useful”/”same line of bus.”= NOT enough (Burg) c. Funds used: Were the corp.’s property, information, funds used in discovering/acquiring the opportunity? Were the facilities or employees used in developing the opportunity?

i. “Hard” assets more likely to be found a violation than “soft” assets.

g. ALI Definition of Corporate opportunity:1) Any Opportunity to engage in a business activity of which a director or senior executive becomes aware either:

(A) In connection with the performance of functions as a director or senior executive, or under circumstances that should reasonably lead the director or senior executive to believe that the person offering the opportunity expects it to be offered to the corporation,(B) Through the use of corporate information or property, if the resulting opportunity is one that a director or senior executive should reasonably be expected to believe would be of interest to the corporation; or

2) Any opportunity to engage in a business activity of which a senior executive becomes aware and knows is closely related to a business in which the corporation is engaged or expects to engage.

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IV. SHAREHOLDER LITIGATIONA. Introduction

1. Derivative suit: claim that management’s breach reduced the residual value of the business (thus, hurt all shareholders) & the shareholder is suing derivatively in the name of the corp.2. Direct suit: Suit to enforce some other right (e.g. right to inspect shareholder list) that injured a single shareholder3. Derivative strike suit: Bringing a derivative suit for the primary purpose of being bought off.

a. Limits to strike suits: i. Requiring defendants to make direct payments to corporationii. Requiring the complaining shareholder to exhaust internal remedies before bringing suit.

4. FRCP 23.1: Complain shall allege, w/particularity, the efforts made by the plaintiff to obtain the action he desires from the directors or the reasons for his failure to obtain the action or for not making the effort.

B. Exhaustion of Internal Remedies1. Demand Requirement: Shareholder must first make a sincere effort to induce the directors to remedy the wrong complained of. Then after BOD refuses, s/h can sue.

a. Excuse DE/NY 2 prong test: P’s must plead PARTICULARIZED FACTS that must create a REASONABLE DOUBT that:

1) Directors are disinterested and independent, AND 2) the challenged transaction was NOT , otherwise, valid exercise of business judgment (Analyze under Van Gorkom!)*Note: Once you meet the “disinterested and independent” test, the BJR test becomes inapplicable. Aronson.

b. ALI: Written demand required but may be excused due to a specific showing of irreparable injury to the corporation would result .

2. Marx (NY) Demand Futility Excuse: Must allege with particularity that ONE of the following exists:

1) Majority of directors are interested/not independent3) Majority of directors are not reasonably informed4) Decision so egregious that not sound business judgment (DE may NOT allow)

Demand Requirement in States Where Demand Can be ExcusedDemand Made?

-Y=Refused?-Y=Refusal Justified? (business judgment rule, but not as much deference)

-N=May Sue-Y=Suit Dismissed

-N=Board Sues-N=Excused?

-Y=Shareholder may sue Committee may recommend dismissal-N=Suit Dismissed.

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3. What happens after refusal? -Levine v. Smith Rule (NOTE: BAD RULE!): When the board refuses a shareholder’s demand, an inquiry into board disinterest and independence is NOT required.

a. Reasoning: Court says that by making the demand, P have conceded that the directors were not interested and were independent; so P can only argue that they did not use their business judgment.

i. Business judgment rule protection: Not very likely to succeed because P has to show that the board did not follow procedural protections

b. Policy effect: No demands will be made as P’s do not want to lose their argument that the board was interested or not independent.

i. Undercuts the policies behind a demand requirement!-Policy: To get rid of strike suits.-Policy: To give the board opportunity to settle the case.-Policy: Retaining board authority over the suit.

-Grimes v Donald= undercuts Levine; Court will consider facts within the demand process that show that the board is not disinterested/lack of independence.-Zapata Corp. v. Maldonaldo, p. 867 (Special litigation committees OK!)

-Under DE law, board has power to set up committees giving complete control of the litigation to the committee (For ALI, §7.08 & §7.09)

-BALANCE COMPETING INTERESTS/POLICIES:-if corporations can consistently wrest bona fide derivative actions from well-meaning derivative P’s through committee mechanism, derivative suit will lose its teeth.-If corporations can’t get rid of strike suits/meritless suits, these meritless suits will create a harm to the corporation in the form of litigation costs.

-Zapata Special Litigation Committee Evaluation Two Step Test: (1) Independence and good faith of the committee and the bases supporting its conclusions?

-Limited discovery.-Corporation have burden of proving independence, good faith, and a reasonable investigation.

(2) Court applies its own independent business judgment -Purpose: to allow for further consideration in cases even though committee can establish its independence and sound bases for its good faith decision (in cases where the court has some skepticism)-Reasoning: Hindsight bias is not as big a problem here.-Reasoning: Courts are more qualified to use their own judgment as to whether litigation should go forward than in other types of business judgments.

-Alford (NC): A court should assess the committee’s recommendation by evaluating the adequacy of the materials prepared by the corporation that support corporation’s decision to settle or dismiss the derivative suit along w/P’s evidence that:

a. The committee, though independent, is NOT qualified;b. False and/or incomplete information was supplied to the committee because of the non-adversarial way in which it gathered and evaluated information;

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c. Structural bias inherent in board-appointed special litigation committees eviscerates P’s opportunities as minority shareholders to vindicate their rights.

NY v. DE v. NC Comparison (Board Refusal, SLC Evaluation)  New York Delaware North Carolina

Board Refusal when demand required

Business judgment review

Business Judgment Review

Independent Review

Lit. com. Recommends when demand excused

business judgment Review Independent Review

Independent Review

DE v. RMBCA v. ALI (Shareholder Suit Allegations)  Delaware RMBCA ALIAllege majority of board violated duty of loyalty

Excused; lit. com. Gets independent rev.

Indep. Com. Recommendation gets BJR, burden on Corporation

Indep. Com. (board?) recommendation to dismiss. gets intermediate review or strict scrutiny

Allege majority of board violated duty of care

Excused; lit. com. gets independent rev.

Board or com. Recommendation gets BJR, burden on Plaintiff

Indep. Com. (board?) recom. gets BJR.

Allege Minority violated duty of loyalty

Not excused (usually); board refusal gets BJR

Board or com. Recommendation gets BJR, burden on Plaintiff

Board or com. Recom. Gets intermediate review or strict scrutiny depending on underlying claim.

Allege Minority violated duty of care

Not excused (usually); board refusal gets BJR.

Board or com. Recommendation gets BJR, burden on Plaintiff

Board or com. Recommendation gets BJR.

**Intermediate Review= Committee must show that the decision was “adequately informed and reasonably determined to be in the best interest of the corporation.”

-Make more detailed as to why it’s dismissing and how it informed itself.

POLICY REASONS FOR SHAREHOLDER DERIVATIVE SUITS:FOR (Against Demand!):

-Method of aligning board interests with shareholder interests-Lowers agency costs-Strong Method of accountability to shareholders

AGAINST (For Demand!):-Leads to corporate waste from strike suits. -Method of harassment of Board for decisions that are within the bounds of its discretion-To give the board an opportunity to settle the case (For Demand Req.)-Retaining board authority over the suit (For Demand Req.)

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V. VOTING AND CORPORATE CONTROL1. Shareholder Democracy and Who VotesA. Shareholder Voting and the Pursuit of Shareholder Interests

1. Berle & Means: Control over the proxy machinery gives management a nearly overwhelming advantage against insurgents; dispersal of ownership disconnect between directors’ interests and shareholders’ interests

Counters:a. Federal proxy regulation: anti-fraud rules are plaintiff-friendlyb. Rise of institutional investorsc. Takeover risk

2. Other mechanisms (Stock options) better align directors’ interests w/shareholders’ interests.

Barriers to Active Shareholder Voting-Rational Apathy-Free Rider Problem-Easy Exit (the Wall Street Rule)-Management pressure on fund managers/Conflicts of interest

Counter-Trends-Growth of institutional investors-Securities laws (’34 Act)-Other market limits on managerial misbehavior

3. Who’s allowed to vote?a. in most states, just shareholders are allowed to vote for board of directors

i. altho DE allows bondholders as long as the certificate of incorporation so provides.

b. Preferred shareholders normally do not get the right to vote but if you haven’t paid them in a long enough time, they get the right to vote.c. if you go into bankruptcy, debtors take over control of the corporationd. Shareholders are usually the voters because they are the residual claimants and so decisions affect them at the margins.

4. What matters can Shareholder vote on?-Election of directors-Under some circumstances, removal of directors-merger, if board approves-sale of substantially all assets, if board approves-dissolution if board approves-amending certificate of incorporation, if board approves-amending bylaws, board approval not required** Shareholders vote AFTER the board has approved it. Shareholders do NOT get to initiate changes on their own.-EXCEPTION: Shareholders can amend the bylaws on their own initiation

5. Note: Annual shareholder meetings are required under state law.

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6. Blasius Holding: Where a board action is taken for the primary purpose of interfering with the effectiveness of a shareholder vote, the board must demonstrate a compelling justification for such action.

a. Compelling justifications in M&A context: too low a price, buyer would not effectively be able to run the corp.b. Policy: Shareholders have only 2 forms of protections: 1) Shareholder voting, and 2) Selling their stock; to remove one would be a serious detriment to the shareholder.c. Hilton Hotels I: Failure to hold an annual meeting that has not been set and is not yet required to be set does NOT impede the shareholder franchise in breach of any fiduciary duty.d. Unilever: A fundamental change in voting rights (creating a preferred class w/a right to vote) requires a shareholder vote.e. “de facto merger doctrine”: If a transaction functions like a merger, some cts. require that shareholders be accorded the same voting rts. That they would have had had the transaction been structured as a merger.

8. Unocal/Blasius Test: (enhanced Duty of Care rule) (M&A Takeover Defenses)In circumstances where a board has adopted defensive measures in response to a takeover threat, in addition to the usual business judgment rule test requiring good faith and reasonable investigation,

(1) Does the board have reasonable grounds for believing a danger to corporate policy and effectiveness exists?(2) Is the board’s response reasonable in relation to the threat posed?

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2. Federal Rules of Proxy Solicitations and Proxies (Rules 14a-1, 14a-2)

A. Securities Exchange Act of 1934 (aka the ’34 Act)1. Mandatory Disclosure- before you sell securities, you must file a registration statement with the SEC.2. Anti-fraud Rules- Private enforcement, SEC enforcement, and possibly DOJ/Criminal enforcement if fraud is really bad3. Ongoing Periodic Disclosure requirements (10Q’s & 10K’s)

B. Proxy Solicitation1. Voting by proxy- designation of someone else who is going to be at the meeting who will vote in a voter’s place.

a. Berle and Means identified abuse of the proxy solicitation process – the company would send out proxies with minimal disclosure such that voters would just be told what to do on the proxy without opposing viewsb. Rule 14a-3- requires a proxy statement (with a great amount of disclosure) when you solicit a proxy c. Rule 14a-3 mandates the structure of the proxy itself. d. Rule 14a-9: Anti-fraud rules applicable to proxy solicitations

2. PROXY FORM RULES (Rule 14(a)(4)(a))a. 14(a)(1)- Boldface indication of whether or not the proxy is solicited on behalf of the issuer’s board of directors or on whose behalf the solicitation is being made.b. Mgmt must state how it intends to vote the shares represented by the proxy.c. Provide S/H ability to withhold vote or strikeout candidated. Must issue an annual report and a proxy statement.d. No proxy shall give authority to:

1. to vote for the election of any person to any office for which a bonafide nominee is not named2. To vote at any annual meeting other than the next meeting3. To vote w/respect to more than one meeting4. Consent to any action other than that proposed in proxy stmt.

e. Proxy must come with Proxy stmt.f. Rule 14a-4(c) allows a company to give itself discretionary voting authority at annual meeting w/respect to matters as to which the company had not received notice by a date 45 days before the date in the current year corresponding to the date in the prior year’s annual meeting.

e.g. if co. last year mailed its proxy stmt on Mar. 31, then the notice date this year would be Feb 14 (45 days before Mar. 31) unless notice was given to the company by that date of a S/H proposal, the company could write its proxy so as to give itself discretionary voting authority w/respect to the new proposal or any issues raised during the meeting.

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4. Things wrong w/Proxy Form on p. 680 (Good one on p. 1404 of Supp.)a. 14(a)4(a) requires bold face on who it is solicited by. Should say BOD and not Mgmt.b. Should not say “in shareholder’s interest.” not impartial.c. Must identify each vote item separately, here there are 2 items: 1) select BODs and 2)Provide for Cumulative voting. The form didn’t separate them.d. Should not provide mgmt. recommendation in the proxy form itself.e. need extension option.f. Need to provide ability to vote against mgmt. and put in list of names and space to strike out the name or say no/yes to each person.

5. Policy Concerns of the Proxy Rulesa. Balancing the need for greater disclosure in proxy solicitations with the interest in making it easier for shareholders to dialogue and communicate on different proposals.

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C. Proxy Solicitation Rules Analysis___________________________________________________________________________-Is communication a “solicitation”?

-N- Not covered by proxy rules-Y- Exempt under 14a-2(a)? Proxy Solicitation Rules DO NOT APPLY TO:

-Y= Not covered by proxy rules-N= Exempt under 14a-2(b)? Proxy statement rules do not apply (but 14a-9 Anti-Fraud rules still apply).

-N=Full proxy rules apply.-Y=Antifraud rule 14a-9 applies (and a few others).

_____________________________________________________________________________a. Rule 14-a-1(l): A solicitation includes:

(1) A request for a proxy, (2) The furnishing of a form of proxy or other communication to security holders under circumstances reasonably calculated to result in the procurement, withholding, or revocation of a proxy, (actual furnishing a form to a shareholder when someone asks you for a form)(3) Any communication to security-holder in an attempt to influence a proxy vote*Note: A shareholder’s public announcement of how the shareholder intends to vote on any matter does NOT constitute a proxy solicitation under Rule 14a-1(1)(2)(iv).*Note: No notice required for published, or broadcast, or oral solicitations.

b. Rule 14a-2(a): Exempts solicitations from:(1) voting trustees (i.e. brokers/banks)(2) Any solicitation by a person in respect to securities of which he is the beneficial owner(3) Neutral newspaper advertisements

c. Rule 14a-2(b)(1): Broad exemption where the soliciting person: (1) is NOT seeking PROXY AUTHORITY (i.e. doesn’t furnish a proxy card or proxy revocation form) AND(2) does NOT have a SUBSTANTIAL INTEREST in the subject matter of the vote.

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3. Shareholder ProposalsA. Rule 14a-8: Corporation is required to include shareholder proposal in the proxy statement.

-Details: Shareholder must have held the shares for at least one year, must hold at least $2000 worth of shares, and must submit the proposal 4 months in advance.

-Basis for Exclusions:1) Improper subject for shareholder action under state law2) Would violate law3) Would violate proxy rules4) Relates to a personal grievance or special interest5) Relates to under less than 5% of assets, net earnings, and gross sales.6) Company lacks power to implement7) Relates to an election8) Conflicts with company’s proposal9) Already substantially implemented10) Duplicates another proposal11) Already defeated with less than specified percentages12) Relates to amount of dividends13) Relates to the conduct of ordinary business operations.

a. Includes employment-related matters (Cracker Barrel)i. 1998: SEC changed rule back to case-by-case basis.

14) Relates to general political and moral concerns (Medical Committee)*Note: If included, these shareholder proposals are likely to be voted down anyways.

B. Medical Committee for Human Rights v. SEC: Shareholder proposals either motivated by general political and moral concerns, or related to the conduct of Dow’s ordinary business operations are excludible.

1. Reasoning: Congress intended proxy solicitations as a vehicle for corporate democracy, not a general purpose forum for shareholders to complain about whatever they want leads to corporate waste2. Note: DE law provides that company’s Certificate of Incorporation may be amended to change, substitute, enlarge or diminish the nature of the company’s business3. Note: Burden is on the issuer to demonstrate that exclusion is proper under Rule 14a-8.

C. Roosevelt v. E.I. Du Pont de Nemours: A shareholder may bring a private action to enforce Rule 14a-8.

1. Note: Cracker Barrel: SEC will allow the exclusion of employment-related matters as conduct of ordinary business operations; EXCEPT executive compensation.2. To strengthen the argument that a proposal must be submitted to shareholders, frame them as amendments to corporation’s bylaws. Brotherhood Teamsters General Fund

a. EXCEPTION: Poison pill by-law amendments: excludible on the basis that pill amendments to the by-laws are improper subjects for shareholder action under DE state law.

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4. New Corporate Governance ReformsA. Proposed Rule 14a-11: which would allow shareholders, under certain conditions, to have their nominations to the board included in the proxy under certain conditions.

1. RULE: ONE of two triggering events must occur:(1) A board nominee receives more than 35% withhold votes.(2) A shareholder proposal (under Rule 14a-8) to opt in to the Rule receives a majority vote.*Note: Must hold for shareholder nominees for 1-2 years after triggering event.*Note: corp only has to include the nominee of shareholder who holds the most shares (in cases of more than one nominating group)

2. Condition: Nominating shareholders (together) must have held at least 5% of shares for at least 2 years.

a. pretty stringent (difficult) requirementb. Can nominate only a limited number of candidates:

i. 1 if 8 or fewer on boardii. 2 if between 8 and 20 on boardiii. 3 if 20 or more on board.

3. Concerns on proposed Rule 14a-11a. Secret control contests: but SEC has said that hostile bidders cannot use this Rule.b. Shareholder nominees may lead to politicized boards (special interest board nominee): boards may become too divided and may not work too well.

i. Counter-arguments: (1) Limited number of shareholder nominees, (2) special interest shareholder nominees still have to beat out the corporate slate, (3) shareholders still need to vote them onto the board(4) shareholders are not as likely to vote a board member who is perceived to be special interest

ia. Counter: Dumb shareholder rationale/most shareholders are ignorant and do not read the proxies.

c. Good qualified directors may be discouraged in serving on the Board if they are targeted out for shareholders to vote out.d. Unfair to small shareholders

4. Why need triggering events? Why not make it available all the time?a. Potentially costly and you want to limit it to times when there’s an indication that the voting process is ineffective or when shareholders feel that the proxy voting process is ineffective.

B. Rules that have passed (Sarbanes Oxley Act – Summer 2002)1. Creates Public Company Accounting Oversight Board to regulate accountants, imposes limits on non-audit services provided by auditors.2. Audit committees: responsible for appointing and overseeing auditors; must be independent; must establish internal complaint procedures.3. CEO & CFO Certifications: no material misstatements or omissions, financial statements fairly present financial condition; have established and evaluated internal controls; auditor must also report on the internal controls

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4. New rules for attorneys practicing before the SEC: up the ladder reportinga. if an attorney sees a violation of fiduciary duty/securities law, you have to report it to either the CEO or the chief legal officer & you have to watch how they respond to it, if they don’t respond to it properly, you have to report to the Board of Directors.

i. attorney-client privilege- the client is the corporation, NOT the individual; so you do not have the privilege here. ii. Huge debate whether to require a noisy withdrawal (by attorney) if the board doesn’t act on report of attorney. Doesn’t look like it’s going to happen though.

5. Ban on loans to directors and officers6. Civil and criminal penalties for retaliation against whistleblowers.7. Mandated rules on securities analyst conflicts, studies of ratings agencies, investment banks8. Note: Insurance/Corporate indemnity may allay some fear of CEO’s BUT insurance companies will not insure against KNOWING MISBEHAVIOR;

a. Even if insurance co does insure, insurance company becomes a new monitor.9. Note: legally, Companies CANNOT indemnify for KNOWING MISBEHAVIOR10. Broad policy of Sarbanes Oxley: Getting GATEKEEPERS (Auditors, lawyers, securities analysts) actively involved in preventing fraud and securities violations.

C. NYSE Corporate Governance Rules1. Majority of directors must be independent2. Tightened definition of independence3. Regular meeting of non-management directors4. Major committees: nominating, compensation, audit; all must have only independent directors5. Shareholders must approve equity compensation plans6. Must adopt and disclose corporate governance guidelines, code of business conduct and ethics.

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VI. CLOSE CORPORATIONA. General

1. Definitions vary: Generally corporations that don’t have publicly traded shares.a. More likely to have one or a few shareholders that exercise control.b. Typically, the shareholders are also the top officers; no separation between ownership and control.

2. In DE, close corporation is a corporation that:(1) all issued shares must be held by no more than 30 shareholders(2) all of the issued shares must be subject to one or more authorized restrictions on transfer;(3) The corporation cannot make any “public offering” of its shares within the meaning of the ’33 Act.

3. Different set of issues:a. Protection of minority interests against majority interests. b. Problem with the alienability of shares: difficult to sell shares of closely held corporations.

B. Restrictions on Transfers of Shares1. Reasons that close corp. shareholders want restrictions on the transfer of shares:

a. Guarantees a say in the choice of their fellow workers and decisionmakersb. Preserves initial allocation of controlc. Secures favorable treatment under close corp. statute, tax laws, sec. laws

2. Enforceability: generally, the more onerous the restriction, the less likely a ct. will enforce the restriction or interpret it broadly.

a. Common Restrictions on Transfer:i. Right of first refusal (Allen)ii. Right to consent (Rafe)iii. Holding period time limits (must hold stock a set period of time before can transfer)iv. Limits on transferees

3. Factors considered by cts. on whether to uphold restriction on transfer of shares:a. Corporation’s sizeb. Degree of the Restraintc. Duration of the Restrictiond. Method for determining price.e. Procedure used to adopt the restriction.f. Relationship to pursuing corporate objectivesg. Risk of harm presented by hostile shareholder

3. Allen v. Biltmore Tissue Corp (NY).: A right of first refusal is a reasonable transfer restriction which will be enforced, so long as it does not make it impossible to sell to anyone except the corporation.

a. right of first refusal: the right to buy the shares rather than be sold to someone else/or divested to someone else.b. Balancing Policy Interests:(1) Strong Property Public Policy against unreasonable restraints against free alienation of property.

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(2) Freedom of K is more powerful because the original shareholders are in a better position to decide what is the most efficient way to handle capital; not the courts.

4. Rafe v. Hindin (NY): Absolute restrictions on the transfer of stock for a close corporation are against public policy and unenforceable.

a. Here, w/o consent, there is no way to sell. Whereas in Allen, even if first refusal isn’t exercised, the party can still sell.b. Issue: But what if the call price is a peppercorn, isn’t that basically the same as a person would in no way sell his shares if the call is a peppercorn…?

C. Shareholder Agreements on Electing Directors1. Traditionally, courts have been skeptical about shareholder agreements respecting election of directors.2. Buck Retail Stores v. Harkert: Shareholder’s control agreements are NOT INVALID PER SE.

a. Policy against separation of shareholders from voting of directors: Shareholders have an interest to vote in the best interest of corporations. Outside interest do not have the best interest of corporation in mind.b. Rationale: Freedom of contract; each shareholders get something out of this. Court won’t look at the benefit of corporation.

3. Ringling v. Ringling Bros.-Barnum & Bailey Combined Sons, Inc.: Pooling agreements (agreements between two shareholders to vote the same way) are generally legally binding if they have CONSIDERATION and there is NO FRAUD.

a. Policy against separation of shareholders from voting of directors: Shareholders have an interest to vote in the best interest of corporations. Outside interest do not have the best interest of corporation in mind.

i. Counter-argument: arbitrator designated to determine how the shares shall be voted has the confidence of such shareholders.

b. Policy: Freedom of Kc. Counter-policy: Shareholder agreements don’t allow owners flexibility to vote differently; to change their minds.d. Pooling agreement ISSUES:

i. VOID as against public policy?ii. If VALID, how and against whom will they be enforced?

4. Ways for shareholders to combine votes:a. Shareholder voting agreements b. Supermajority requirements in director electionsc. high/low voting sharesd. voting trusts (DE Sect. 218, RMBCA sec. 7.30)f. Irrevocable proxies (but must couple with an interest)g. Separate classes of shares, each electing a certain number of directors

D. Shareholder Agreements Respecting Actions of Directors.1. McQuade v. Stoneham: Shareholder agreements may NOT agree to control the directors in the exercise of judgment vested in them by virtue of their office to elect officers and fix salaries.

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2. Clark v. Dodge EXCEPTION: If the agreement is in the best interest of the corporation and ALL of the shareholders agree, agreements to restrict the discretion of the board are ENFORCEABLE.

a. Distinguishing fact from McQuade: No interested parties were injured by the agreement.

3. Post-cases NY Law §620 now: If ALL shareholders agree, and it is put in the certificate, then the agreement is ok.

Policy Arguments: -Restricts the board in its ability to run the business affairs of the corporation. Whole idea of corp. to separate ownership from day-to-day operations of the corp. in return for limited liability.-Freedom of K

4. Post-cases DE Law now: If majority agrees, then agreement is ok.

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VII. INSIDER TRADING

A. Rule 10b-5: Unlawful for any person to directly or indirectly, by the use of any means or instrumentality of interstate commerce, or the mails, or of any national securities exchange:

(1) to employ any device scheme, or artifice to defraud(2) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they are not misleading, or(3) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person*in connection with the purchase or sale of any security.

B. Cady Roberts: TWO principal elements to DUTY to DISCLOSE material info or FORGO trading:

(1) Existence of relationship giving access, directly or indirectly, to information intended to be available only for a corporate purpose and not for personal benefit to anyone.(2) the inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing.

C. Harms of Insider Trading:1. Corporate harm

a. Corp. may have developed valuable confidential info which may lose value from insider trading if trading itself reveals the info.b. Allure of “insider trading” gains may divert the attention of employees searching for material undisclosed info.c. Perhaps the market price may discount the price of a stock heavily traded by insiders.

2. Allocational efficiency and the injury of delayed disclosure: could create incentive to delay disclosure impairing efficient allocation of capital by the market.

a. Counter: Insider trading may increase the flow of info to the market3. Investor injury: Unfairness of insider trading may cause investors to lose confidence in the market.

D. Benefits of Insider Trading1. May promote market efficiency by causing prices to more rapidly reflect confidential information.2. Potential gains from insider trading may serve as the most cost-effective incentive that some businesses can employ to encourage managerial risk-taking.3. Limiting insider-trading may do more harm than good if the deterrence measures are very costly

E. ISSUES: What should the SCOPE of the regulations be?1. Policy Thoughts:

a. Reasoning for Narrower Scope: If you have too broad limits on insider trading, you may limit incentives of people to research and get information about companies.

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b. Reasoning for broader scope: Affects the national market if people perceive that there are many insiders who have an advantage over normal people. Want to give people more confidence in the national securities markets.c. Already have mechanisms in place to control insider trading: duty of loyalty violations. Insider trading laws seem redundant.

i. However, SEC is in a better position than private actors to enforce provisions against insider traders.

1. Chiarella: No duty to disclose where the person who has traded on the inside information does not have a fiduciary duty towards the sellers of the security.2. Dirks v. SEC: Tippees inherit insider’s duty to shareholders to disclose info or refrain from trading only when the info has been improperly disclosed to them by insider.

a. RULE: A tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when:

(1) the insider has BREACHED his fiduciary duty to the shareholders of the corp. by disclosing the information to the tippee AND(2) the tippee KNOWS or should know that there has been a breach.

b. Test to see if Insider Breached: Did he stand to personally gain from disclosure to tippee?c. Who counts as an INSIDER?

i. Officers and directors of the corporation.ii. Attorneys, accountants, underwriters, consultants w/formal relationship to the company who have access to confidential information under FN14.

d. Comment: Under §10(b), Mere possession of material, non-public info does NOT give rise to a duty to disclose or abstain. A fiduciary relationship between the insider and the shareholders must already be in place before tippee’s role will be examined.

3. Regulation FD RULE: Corps that reveal info to Analyst (Broker Dealers/ Invest Analyst), they must reveal that info to the ALL Analyst to the Public (no special privilege!)

a. POLICY: Don’t want to give an advantage to institutional investors; want to level the playing field for small investorsb. Doesn’t apply to Attorney, investment banker, or accountant

4. O’Hagan Misappropriation theory: When a fiduciary uses a principal’s undisclosed information for self-serving securities transactions, he misappropriates the principal’s exclusive use of the information for himself, uses a deceptive device and thus, violates Rule 10b-5.

a. Had partner bought shares of buying company, he would have fiduciary duty from the people he bought the shares from and thus, would definitely be a violation under FN 14 in Dirk.b. But he bought shares in target company, whose shareholders he had no fiduciary relationship with and thus, would not be a violation under Dirk.

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