TABLE OF CONTENTS

1. INTRODUCTION TO THE LAW OF ENTERPRISE ORGANIZATION...................................................................................................61.1. EFFICIENCY AND THE SOCIAL SIGNIFICANCE OF ENTERPRISE ORGANIZATION........................................................................................7

1.1.1. Wealth Creation and the Corporate Form of Organization............................................................................................71.1.2. What Do We Mean by Efficiency?............................................................................................................................................7

1.1.2.1. Pareto Efficiency........................................................................................................................................................................71.1.2.2. Kaldor-Hicks Efficiency (The Rule of Wealth Maximization).....................................................................................7

1.2. LAW FROM INSIDE AND OUT: SHARED MEANINGS AND SKEPTICISM......................................................................................................71.2.1. The Outside and the Inside........................................................................................................................................................71.2.2. Fairness and Efficiency...............................................................................................................................................................7

1.3. DEVELOPMENT OF THE MODERN THEORY OF THE FIRM..........................................................................................................................71.3.1. Ronald Coase’s 1937 Insight.....................................................................................................................................................71.3.2. Transaction Cost Theory............................................................................................................................................................71.3.3. Agency Cost Theory......................................................................................................................................................................7

2. ACTING THROUGH OTHERS: THE LAW OF AGENCY............................................................................................................................82.1. INTRODUCTION TO AGENCY........................................................................................................................................................................82.2. AGENCY FORMATION, AGENCY TERMINATION, AND PRINCIPAL’S LIABILITY..........................................................................................8

2.2.1. Formation........................................................................................................................................................................................82.2.2. Termination....................................................................................................................................................................................92.2.3. Parties’ Conception Does Not Control....................................................................................................................................9

Jensen Farms Co. v. Cargill Inc. (p. 18)......................................................................................................................................................92.2.4. Liability in Contract.....................................................................................................................................................................9

2.2.4.1. Actual and Apparent Authority............................................................................................................................................9 White v. Thomas (p. 22)...................................................................................................................................................................................9

2.2.4.2. Inherent Authority....................................................................................................................................................................9 Gallant Ins. Co. v. Isaac (p. 26).......................................................................................................................................................................9

2.2.5. Liability in Tort...........................................................................................................................................................................102.3. THE GOVERNANCE OF AGENCY (THE AGENT’S DUTIES)........................................................................................................................10

2.3.1. The Nature of the Agent’s Fiduciary Relationship..........................................................................................................102.3.2. The Agent’s Duty of Loyalty to the Principal....................................................................................................................10

Tarnowski v. Resop (p. 36)..........................................................................................................................................................................112.3.3. The Trustee’s Duty to Trust Beneficiaries.........................................................................................................................11

In re Gleeson (p. 38)....................................................................................................................................................................................... 11

3. THE PROBLEM OF JOINT OWNERSHIP: THE LAW OF PARTNERSHIP........................................................................................113.1. INTRODUCTION TO PARTNERSHIP...........................................................................................................................................................11

3.1.1. Why Have Joint Ownership?...................................................................................................................................................113.1.2. Agency Conflicts Among Co-Owners....................................................................................................................................11

Meinhard v. Salmon (p. 47)......................................................................................................................................................................... 113.2. PARTNERSHIP FORMATION......................................................................................................................................................................12

Vohland v. Sweet (p. 52)............................................................................................................................................................................... 123.3. RELATIONS WITH THIRD PARTIES..........................................................................................................................................................12

3.3.1. Who Is a Partner?.......................................................................................................................................................................123.3.2. Third-Party Claims Against Departing Partners.............................................................................................................123.3.3. Third-Party Claims Against Partnership Property.........................................................................................................133.3.4. Claims of Partnership Creditors to Partner’s Individual Property..........................................................................13

3.4. PARTNERSHIP GOVERNANCE AND ISSUES OF AUTHORITY.....................................................................................................................13 NABISCO v. Stroud (p. 61)............................................................................................................................................................................13

3.5. TERMINATION...........................................................................................................................................................................................133.5.1. Accounting for Partnership’s Financial Status and Performance.............................................................................13

Adams v. Jarvis (p. 65)................................................................................................................................................................................... 13 Dreifuerst v. Dreifuerst (p. 69)...................................................................................................................................................................14 Page v. Page (p. 73)......................................................................................................................................................................................... 14

3.6. LIMITED LIABILITY MODIFICATIONS OF THE PARTNERSHIP FORM......................................................................................................143.6.1. The Limited Partnership.........................................................................................................................................................143.6.2. Limited Liability Partnerships and Companies...............................................................................................................14

3.6.2.1. The Limited Liability Partnership....................................................................................................................................143.6.2.2. The Limited Liability Company..........................................................................................................................................14

4. THE CORPORATE FORM.............................................................................................................................................................................14

4.1. INTRODUCTION TO THE CORPORATE FORM............................................................................................................................................144.2. CREATION OF A FICTIONAL LEGAL ENTITY.............................................................................................................................................15

4.2.1. A Note on the History of Corporate Formation................................................................................................................154.2.2. The Process of Incorporating Today...................................................................................................................................164.2.3. The Articles of Incorporation, or “Charter”......................................................................................................................164.2.4. The Corporate Bylaws..............................................................................................................................................................164.2.5. Shareholders’ Agreements......................................................................................................................................................16

4.3. LIMITED LIABILITY...................................................................................................................................................................................164.4. TRANSFERABLE SHARES...........................................................................................................................................................................174.5. CENTRALIZED MANAGEMENT...................................................................................................................................................................17

4.5.1. Legal Construction of the Board............................................................................................................................................184.5.1.1. The Holder of Primary Management Power.................................................................................................................18 Automatic Self-Cleansing Filter v. Cunninghame (p. 103).............................................................................................................18

4.5.1.2. Structure of the Board..........................................................................................................................................................184.5.1.3. Formality in Board Operation............................................................................................................................................18 Fogel v. U.S. Energy Systems, Inc. (p. 107)............................................................................................................................................18

4.5.1.4. A Critique of Boards...............................................................................................................................................................184.5.2. Corporate Officers: Agents of the Corporation................................................................................................................19

Jennings v. Pittsburg Mercantile Co. (p. 110)......................................................................................................................................19 Grimes v. Alteon (p. 112)..............................................................................................................................................................................19

5. DEBT, EQUITY, AND ECONOMIC VALUE................................................................................................................................................195.1. CAPITAL STRUCTURE................................................................................................................................................................................19

5.1.1. Legal Character of Debt............................................................................................................................................................195.1.1.1. Maturity Date: A critical advantage of bonds, from the perspective of investors, is that the investor generally faces less risk as a creditor than as an equity older because creditors have a legal right to periodic payment of a return (interest) and a priority claim over the company’s shareholders on corporate assets in the event that the corporation defaults. If creditors are not paid on time, they can sue on their contract......................205.1.1.2. Tax Treatment: Interest paid by the borrower is a deductible cost of business when the firm calculates its taxable income...................................................................................................................................................................................... 205.1.1.3. Subordinated Debt.................................................................................................................................................................205.1.1.4. Bonds.......................................................................................................................................................................................... 20

5.1.2. Legal Character of Equity........................................................................................................................................................205.1.2.1. Common Stock: Equity has not the right to payment but (usually) the right to vote on certain important matters. Equity securities generally possess control rights in the form of the power to elect the board of directors. The charter contains the specifics of the firm’s equity securities.........................................................................205.1.2.2. Residual Claims and Residual Control: Common stock holds the residual claim on the corporation’s assets and income. After the company has paid its expenses and paid interest to creditors, whatever is left is available for the payment of dividends..............................................................................................................................................20

5.2. BASIC CONCEPTS OF VALUATION.............................................................................................................................................................205.2.1. The Time Value of Money........................................................................................................................................................205.2.2. Risk and Return..........................................................................................................................................................................205.2.3. Diversification and Systematic Risk....................................................................................................................................21

5.3. VALUING ASSETS.......................................................................................................................................................................................215.3.1. The Discount Cash Flow (DCF) Approach..........................................................................................................................215.3.2. The Relevance of Prices in the Securities Market...........................................................................................................21

6. THE PROTECTION OF CREDITORS.........................................................................................................................................................216.1. MANDATORY DISCLOSURE.......................................................................................................................................................................216.2. CAPITAL REGULATION..............................................................................................................................................................................21

6.2.1. Financial Statements.................................................................................................................................................................226.2.2. Distribution Constraints..........................................................................................................................................................226.2.3. Minimum Capital and Capital Maintenance Requirements.........................................................................................22

6.3. STANDARD-BASED DUTIES......................................................................................................................................................................226.3.1. Director Liability........................................................................................................................................................................22

Credit Lyonnais Bank Nederlands (p. 141)..........................................................................................................................................22 North American Catholic Educational Programming Foundation, Inc. v. Gheewalla (p. 143).......................................23

6.3.2. Creditor Protection: Fraudulent Transfers.......................................................................................................................236.3.3. Shareholder Liability................................................................................................................................................................23

6.3.3.1. Equitable Subordination......................................................................................................................................................23 Costello v. Fazio (p. 145)...............................................................................................................................................................................23

6.3.3.2. Piercing the Corporate Veil.................................................................................................................................................23

Sea-land Services, Inc. v. The Pepper Source (p. 152).....................................................................................................................24 Kinney Shoe Corp. v. Polan (p. 157).........................................................................................................................................................24

6.4. VEIL PIERCING ON BEHALF OF INVOLUNTARY CREDITORS....................................................................................................................24 Walkovszky v. Carlton (p. 161)..................................................................................................................................................................24

7. NORMAL GOVERNANCE: THE VOTING SYSTEM.................................................................................................................................257.1. THE ROLE AND LIMITS OF SHAREHOLDER VOTING................................................................................................................................257.2. ELECTING AND REMOVING DIRECTORS...................................................................................................................................................25

7.2.1. Electing Directors.......................................................................................................................................................................257.2.2. Removing Directors...................................................................................................................................................................25

Campbell v. Loews Inc. (p. 173).................................................................................................................................................................257.3. SHAREHOLDER MEETINGS AND ALTERNATIVES......................................................................................................................................267.4. PROXY VOTING AND ITS COSTS...............................................................................................................................................................27

Rosenfeld v. Fairchild Engine & Airplane Corp. (p. 179)................................................................................................................277.5. CLASS VOTING...........................................................................................................................................................................................277.6. SHAREHOLDER INFORMATION RIGHTS....................................................................................................................................................277.7. TECHNIQUES FOR SEPARATING CONTROL FROM CASH FLOW RIGHTS..................................................................................................28

7.7.1. Circular Control Structures....................................................................................................................................................28 Speiser v. Baker (p. 186)...............................................................................................................................................................................28

7.7.2. Vote Buying..................................................................................................................................................................................28 Schreiber v. Carney (p. 193)........................................................................................................................................................................28

7.7.3. Controlling Minority Structures............................................................................................................................................287.8. THE COLLECTIVE ACTION PROBLEM.......................................................................................................................................................297.9. THE FEDERAL PROXY RULES...................................................................................................................................................................30

7.9.1. Rules 14a-1 Through 14a-7: Disclosure and Shareholder Communication..........................................................307.9.2. Rule 14a-8: Shareholder Proposals.....................................................................................................................................30

Carpenters’ Pension Fund Proposal and Supporting Statement (p. 214)...............................................................................31 CA v. AFSCME (p. 220)................................................................................................................................................................................... 31

7.9.3. Rule 14a-9: The Antifraud Rule.............................................................................................................................................32 Virginia Bankshares, Inc. v Sandberg (p. 230)....................................................................................................................................32

7.10. STATE DISCLOSURE LAW: FIDUCIARY DUTY OF CANDOR...................................................................................................................32

8. NORMAL GOVERNANCE: THE DUTY OF CARE.....................................................................................................................................338.1. INTRODUCTION TO THE DUTY OF CARE..................................................................................................................................................338.2. THE DUTY OF CARE AND THE NEED TO MITIGATE DIRECTOR RISK AVERSION..................................................................................33

Gagliardi v. Trifoods International, Inc. (p. 241)................................................................................................................................338.3. STATUTORY TECHNIQUES FOR LIMITING DIRECTORS AND OFFICER RISK EXPOSURE.........................................................................33

8.3.1. Indemnification..........................................................................................................................................................................33 Waltuch v. Conticommodity Services, Inc. (p. 243)...........................................................................................................................33

8.3.2. Directors and Officers Insurance..........................................................................................................................................348.4. JUDICIAL PROTECTION: THE BUSINESS JUDGMENT RULE......................................................................................................................34

Kamin v. American Express Co. (p. 250)................................................................................................................................................348.4.1. Understanding the Business Judgment Rule....................................................................................................................348.4.2. The Duty of Care in Takeover Cases: A Note on Smith v. Van Gorkom......................................................................35

Smith v. Van Gorkom (p. 255)....................................................................................................................................................................358.4.3. Additional Statutory Protection: Authorization for Charter Provisions Waiving Liability for Due Care Violations......................................................................................................................................................................................................35

8.5. DELAWARE’S UNIQUE APPROACH TO ADJUDICATING DUE CARE CLAIMS AGAINST CORPORATE DIRECTORS FROM TECHNICOLOR TO EMERALD PARTNERS..............................................................................................................................................................................................35

Cede & Co. v. Technicolor (p. 259)............................................................................................................................................................35 Emerald Partners v. Berlin (p. 260).........................................................................................................................................................35

8.6. THE BOARD’S DUTY TO MONITOR: LOSSES “CAUSED” BY BOARD PASSIVITY.....................................................................................36 Francis v. United Jersey Bank (p. 262):..................................................................................................................................................36 Graham v. Allis-Chalmers Manufacturing Co. (p. 268)....................................................................................................................36 In re Michael Marchese (p. 272)................................................................................................................................................................36 In Re Caremark (p. 278)................................................................................................................................................................................37 Stone v. Ritter (p. 285)...................................................................................................................................................................................37 In Re Citigroup (p. 285).................................................................................................................................................................................37

8.7. “KNOWING” VIOLATION OF LAW.............................................................................................................................................................37 Miller v. AT&T (p. 291).................................................................................................................................................................................. 37

9. CONFLICT TRANSACTIONS: THE DUTY OF LOYALTY.......................................................................................................................38

9.1. DUTY TO WHOM?.....................................................................................................................................................................................389.1.1. The Shareholder Primacy Norm...........................................................................................................................................38

A.P. Smith Manufacturing Co. v. Barlow (p. 299)...............................................................................................................................389.1.2. Constituency Statutes...............................................................................................................................................................39

9.2. SELF-DEALING TRANSACTIONS................................................................................................................................................................399.2.1. Early Regulation of Fiduciary Self-Dealing.......................................................................................................................399.2.2. The Disclosure Requirement.................................................................................................................................................39

Hayes Oyster Co. V. Keypoint Oyster Co. (p. 304)..............................................................................................................................399.2.3. Controlling Shareholders and the Fairness Standard...................................................................................................39

Sinclair Oil Corp. v. Levien (p. 310)..........................................................................................................................................................409.3. THE EFFECT OF APPROVAL BY A DISINTERESTED PARTY.....................................................................................................................40

9.3.1. The Safe Harbor Statutes.........................................................................................................................................................40 Cookies Food Products v. Lakes Warehouse (p. 315)......................................................................................................................40

9.3.2. Approval by Disinterested Members of the Board.........................................................................................................41 Cooke v. Oolie (p. 322)...................................................................................................................................................................................41

9.3.3. Approval by a Special Committee of Independent Directors......................................................................................429.3.4. Shareholder Ratification of Conflict Transactions.........................................................................................................42

Lewis v. Vogelstein (p. 327)........................................................................................................................................................................ 42 In Re Wheelabrator Technologies, Inc. (p. 328).................................................................................................................................42

9.4. DIRECTOR AND MANAGEMENT COMPENSATION.....................................................................................................................................439.4.1. Perceived Excessive Compensation.....................................................................................................................................439.4.2. Option Grants and the Law of Director and Officer Compensation..........................................................................43

Lewis v. Vogelstein (p. 332)........................................................................................................................................................................ 439.4.3. Regulatory Responses to Executive Compensation.......................................................................................................449.4.4. The Disney Decision..................................................................................................................................................................44

In re Walt Disney Co. (p. 341).....................................................................................................................................................................449.5. CORPORATE OPPORTUNITY DOCTRINE...................................................................................................................................................44

9.5.1. Determining Which Opportunities “Belong” to the Corporation..............................................................................449.5.2. When May a Fiduciary Take a Corporate Opportunity?...............................................................................................45

9.6. THE DUTY OF LOYALTY IN CLOSELY-HELD CORPORATIONS.................................................................................................................45 Donahue v. Rodd Electrotype Co. (p. 351)............................................................................................................................................45 Smith v. Atlantic Properties Inc. (p. 359)..............................................................................................................................................45

10. SHAREHOLDER LAWSUITS.....................................................................................................................................................................4610.1. DISTINGUISHING BETWEEN DIRECT AND DERIVATIVE CLAIMS..........................................................................................................4610.2. SOLVING A COLLECTIVE ACTION PROBLEM: ATTORNEYS’ FEES AND THE INCENTIVE TO SUE..........................................................46

Fletcher v. A.J. Industries, Inc. (p. 367)...................................................................................................................................................4610.3. STANDING REQUIREMENTS....................................................................................................................................................................4710.4. BALANCING THE RIGHTS OF BOARDS TO MANAGE THE CORPORATION AND SHAREHOLDERS’ RIGHTS TO OBTAIN JUDICIAL REVIEW 47

10.4.1. The Demand Requirement of Rule 23..............................................................................................................................47 Levine v. Smith (p. 376)................................................................................................................................................................................ 47 Rales v. Blasband (p. 381)............................................................................................................................................................................48

10.4.2. Special Litigation Committees.............................................................................................................................................48 Zapata Corporation. v. Maldonado (p. 389).........................................................................................................................................48 In Re Oracle Corp. (p. 395)...........................................................................................................................................................................49 Joy v. North (p. 403)........................................................................................................................................................................................50

10.5. SETTLEMENT AND INDEMNIFICATION...................................................................................................................................................5010.5.1. Settlement by Class Representatives................................................................................................................................5010.5.2. Settlement by Special Committee......................................................................................................................................50

Carlton Investments v. TLC Beatrice international Holdings, Inc. (p. 409)............................................................................5010.6. WHEN ARE DERIVATIVE SUITS IN SHAREHOLDERS’ INTERESTS?.......................................................................................................50

11. TRANSACTIONS IN CONTROL................................................................................................................................................................5111.1. SALES OF CONTROL BLOCKS: THE SELLER’S DUTIES...........................................................................................................................51

11.1.1. The Regulation of Control Premia.....................................................................................................................................51 Zetlin v. Hanson Holdings (p. 416)...........................................................................................................................................................51 Perlman v. Feldmann (p. 417)....................................................................................................................................................................51

11.1.2. A Defense of the Market Rule in Sales of Control.........................................................................................................52 In re Digex (p. 428)......................................................................................................................................................................................... 52

11.2. SALE OF CORPORATE OFFICE................................................................................................................................................................5311.3. LOOTING.................................................................................................................................................................................................53

Harris v. Carter (p. 429)................................................................................................................................................................................5311.4. TENDER OFFERS: THE BUYER’S DUTIES..............................................................................................................................................53

Wellman v. Dickinson (p. 439)...................................................................................................................................................................54 Brascan Ltd. v. Edper Equities Ltd. (p. 435).........................................................................................................................................54

11.5. THE HART-SCOTT-RODINO ACT WAITING PERIOD............................................................................................................................54

12. FUNDAMENTAL TRANSACTIONS: MERGERS AND ACQUISITIONS............................................................................................5512.1. INTRODUCTION.......................................................................................................................................................................................5512.2. ECONOMIC MOTIVES FOR MERGERS......................................................................................................................................................55

12.2.1. Integration as a Source of Value.........................................................................................................................................5512.2.2. Other Sources of Value in Acquisitions: Tax, Agency Costs, and Diversification..............................................5512.2.3. Suspect Motives for Mergers................................................................................................................................................5512.2.4. Do Mergers Create Value?.....................................................................................................................................................55

12.3. THE EVOLUTION OF THE U.S. CORPORATE LAW OF MERGERS...........................................................................................................5512.3.1. When Mergers Were Rare....................................................................................................................................................5612.3.2. The Modern Era........................................................................................................................................................................56

12.4. THE ALLOCATION OF POWER IN FUNDAMENTAL TRANSACTIONS......................................................................................................5612.5. OVERVIEW OF TRANSACTIONAL FORM.................................................................................................................................................56

12.5.1. Asset Acquisition.....................................................................................................................................................................57 Katz v. Bregman (p. 453).............................................................................................................................................................................. 57 Thorpe v. CERBCO (p. 456)..........................................................................................................................................................................57

12.5.2. Stock Acquisition.....................................................................................................................................................................5812.5.3. Mergers.......................................................................................................................................................................................5812.5.4. Triangular Mergers.................................................................................................................................................................58

12.6. STRUCTURING THE M&A TRANSACTION..............................................................................................................................................5912.6.1. Timing..........................................................................................................................................................................................5912.6.2. Regulatory Approvals, Consents, and Title Transfers................................................................................................5912.6.3. Planning Around Voting and Appraisal Rights..............................................................................................................5912.6.4. Due Diligence, Representations and Warranties, Covenants, and Indemnification........................................5912.6.5. Deal Protections and Termination Fees..........................................................................................................................6012.6.6. Accounting Treatment...........................................................................................................................................................60

12.7. TAXATION OF CORPORATE COMBINATIONS.........................................................................................................................................6012.7.1. Basic Concepts..........................................................................................................................................................................6012.7.2. Tax-Free Corporate Reorganizations...............................................................................................................................60

12.8. THE APPRAISAL REMEDY......................................................................................................................................................................6012.8.1. History and Theory.................................................................................................................................................................6012.8.2. The Appraisal Alternative in Interested Mergers........................................................................................................61

In re Transkaryotic Therapies (not in CB)............................................................................................................................................6112.8.3. The Market-Out Rule..............................................................................................................................................................6212.8.4. The Nature of “Fair Value”....................................................................................................................................................62

12.9. THE DE FACTO MERGER DOCTRINE.....................................................................................................................................................62 Hariton v. Arco Electronics, Inc. (p. 481)...............................................................................................................................................62

12.10. THE DUTY OF LOYALTY IN CONTROLLED MERGERS.........................................................................................................................6312.10.1. Cash Mergers or Freeze-Outs............................................................................................................................................63

Weinberger v. UOP, Inc. (p. 486)...............................................................................................................................................................6312.10.2. What Constitutes Control and Exercise of Control....................................................................................................64

Kahn v. Lynch Communication Systems, Inc. (p. 497).....................................................................................................................6412.10.3. Special Committees of Independent Directors in Controlled Mergers..............................................................6512.10.4. Controlling Shareholder Fiduciary Duty on the First Step of a Two-Step Tender Offer..............................65

In re Siliconix Shareholder Litigation (p. 504)....................................................................................................................................65 In re Pure Resources, Inc. (p. 504)...........................................................................................................................................................65

13. PUBLIC CONTESTS FOR CORPORATE CONTROL.............................................................................................................................6613.1. INTRODUCTION.......................................................................................................................................................................................66

Smith v. Van Gorkom (p. 513)....................................................................................................................................................................6613.2. DEFENDING AGAINST HOSTILE TENDER OFFERS.................................................................................................................................66

Unocal Corp. v. Mesa Petroleum Co. (p. 515).......................................................................................................................................66 Unitrin v. American General Corp. (p. 521)..........................................................................................................................................66

13.3. PRIVATE LAW INNOVATION: THE POISON PILL...................................................................................................................................67 Moran v. Household International (p. 525):........................................................................................................................................67 Versata Enterprises v. Selectica (p. 532)...............................................................................................................................................68

13.4. CHOOSING A MERGER OR BUYOUT PARTNER: REVLON, ITS SEQUELS, AND ITS PREQUELS..............................................................68

Smith v. Van Gorkom (p. 533)....................................................................................................................................................................68 Revlon v. MacAndrews & Forbes (p. 541).............................................................................................................................................68

13.5. PULLING TOGETHER UNOCAL AND REVLON.........................................................................................................................................69 Paramount v. Time (p. 547)........................................................................................................................................................................ 69 Paramount v. QVC (p. 554).......................................................................................................................................................................... 69 Lyondell Chemical Co. v. Ryan (p. 568)..................................................................................................................................................70

13.6. PROTECTING THE DEAL.........................................................................................................................................................................7113.6.1. “No Shops/No Talks” and “Fiduciary Outs”.....................................................................................................................7113.6.2. Shareholder Lock-Ups............................................................................................................................................................71

Omnicare v. NCS HealthCare (p. 579).....................................................................................................................................................71 Orman v. Cullman (p. 587 n. 7):.................................................................................................................................................................72

13.7. STATE ANTITAKEOVER STATUTES........................................................................................................................................................7213.7.1. First- and Second-Generation Antitakeover Statutes (1968-1987).......................................................................72

CTS Corp. v. Dynamics Corp. of America (p. 589)..............................................................................................................................7313.7.2. Third-Generation Antitakeover Statutes (1987-2000)..............................................................................................73

13.8. PROXY CONTESTS FOR CORPORATE CONTROL.....................................................................................................................................73 Schnell v. Chris-Craft Industries (p. 598)..............................................................................................................................................73 Blasius Industries v. Atlas Corp. (p. 599)...............................................................................................................................................74 Mercier v. Inter-Tel (p. 604)........................................................................................................................................................................74 Hilton v. ITT (p. 604):.....................................................................................................................................................................................74

13.9. THE TAKEOVER ARMS RACE CONTINUES.............................................................................................................................................7513.9.1. “Dead Hand” Pills.....................................................................................................................................................................7513.9.2. Mandatory Pill Redemption Bylaws..................................................................................................................................75

Unisuper v. News Corp. (p. 610)................................................................................................................................................................75

14. TRADING IN THE CORPORATIONS SECURITIES..............................................................................................................................7614.1. COMMON LAW OF DIRECTORS’ DUTIES WHEN TRADING IN THE CORPORATION’S STOCK...............................................................76

Goodwin v. Agassiz (p. 616)........................................................................................................................................................................7614.2. THE CORPORATE LAW OF FIDUCIARY DISCLOSURE TODAY................................................................................................................76

14.2.1. Corporate Recovery of Profit from “Insider” Trading................................................................................................76 Freeman v. Decio (p. 622)............................................................................................................................................................................ 77

14.2.2. Board Disclosure Obligations Under State Law.............................................................................................................7714.3. EXCHANGE ACT §16(B) AND RULE 16................................................................................................................................................7714.4. EXCHANGE ACT §10(B) AND RULE 10B-5..........................................................................................................................................78

14.4.1. Evolution of Private Right of Action Under §10............................................................................................................7814.4.2. Elements of a 10b-5 Claim....................................................................................................................................................78

14.4.2.1. Elements of a 10b-5 Claim: False or Misleading Statement or Omission.........................................................78 SEC v. Texas Gulf Sulphur Co. (p. 633)....................................................................................................................................................78 Santa Fe Industries v. Green (p. 639)......................................................................................................................................................79 Goldberg v. Meridor (p. 643)......................................................................................................................................................................79

14.4.2.2. Elements of 10b-5 Liability: Equal Access Theory....................................................................................................7914.4.2.3. Elements of 10b-5 Liability: Fiduciary Duty Theory................................................................................................80Elements of 10b-5 Liability: Misappropriation Theory................................................................................................................80 Chiarella v. United States (p. 649)............................................................................................................................................................80 Dirks v. SEC (p. 653)....................................................................................................................................................................................... 80 United States v. Chestman (p. 662)..........................................................................................................................................................82 United States v. O’Hagan (p. 667).............................................................................................................................................................82

14.4.2.4. Elements of 10b-5 Liability: Materiality......................................................................................................................83 Basic Inc. v. Levinson (p. 672)....................................................................................................................................................................83

14.4.2.5. Elements of 10b-5 Liability: Scienter............................................................................................................................8314.4.2.6. Elements of 10b-5 Liability: Standing, in Connection with the Purchase or Sale of Securities.................8414.4.2.7. Elements of 10b-5 Liability: Reliance............................................................................................................................84 Basic Inc. v. Levinson (p. 679)....................................................................................................................................................................84

14.4.2.8. Elements of 10b-5 Liability: Causation.........................................................................................................................8514.4.3. Remedies for 10b-5 Violations...........................................................................................................................................85

Elkind v. Liggett & Myers, Inc. (p. 686)...................................................................................................................................................8514.4.4. The Academic Debate.............................................................................................................................................................86

14.4.4.1. Insider Trading and Informed Prices...........................................................................................................................8614.4.4.2. Insider Trading as a Compensation Device................................................................................................................86 Are Deal Makers on Wall Street Leaking Secrets? (p. 695)...........................................................................................................86

1. INTRODUCTION TO THE LAW OF ENTERPRISE ORGANIZATION The study of corporate law is about the relationship between those who finance and those who manage. The agency relationship can be thought of as the simplest form of business organization. General partnership is a somewhat more stable form of relationship and the simplest form of jointly owned business

firm.1.1. EFFICIENCY AND THE SOCIAL SIGNIFICANCE OF ENTERPRISE ORGANIZATION

The modern law of organizational forms is premised on the idea that facilitating individuals’ efforts to create wealth is wise public policy.1.1.1.Wealth Creation and the Corporate Form of Organization Corporation law deals with the creation and governance of the private legal entities that are the principal

economic actors in the modern world. It addresses such important issues as how corporate enterprises are created and capitalized, how power over

their internal affairs is distributed, how their economic performance is monitored, and what mechanisms exist to improve their performance.

The corporate form dominates in all instances where technology creates economies of scale.1.1.2.What Do We Mean by Efficiency? Corporation law succeeds to the extent that it enables individuals to increase their utility.

1.1.2.1.Pareto Efficiency Pareto reasoned that a given distribution of resources is efficient when, and only when, resources are

distributed in such a way that no reallocation of resources can make at least one person better off without making at least one other person worse off.

While Pareto efficiency is important, is has serious drawbacks: It is agnostic about the legitimacy of the original distribution of assets within a society. It is virtually impossible for courts or legislatures to make important decisions that do not make someone

worse off. Even voluntary agreements among private parties sometimes fail the Pareto efficiency test because they

impose uncompensated costs on third parties.1.1.2.2.Kaldor-Hicks Efficiency (The Rule of Wealth Maximization) An act (or a rule) is efficient if at least one party would gain from it after all those who suffered a loss were

fully compensated. A transaction is efficient if the aggregate monetary gains to the winners exceed the aggregate monetary losses

to the losers-that is, the total wealth of the affected parties increases.1.2. LAW FROM INSIDE AND OUT: SHARED MEANINGS AND SKEPTICISM

1.2.1.The Outside and the Inside When empiricists study law, they do so from an external vantage point, while those practicing law have an

interior perspective.1.2.2.Fairness and Efficiency Judges and lawyers, as well as academic commentators, ought to use efficiency in the production of wealth as the

principal standard for evaluating current law, but courts rarely do so. Efficiency is a controversial judicial standard, in part because determining what counts as a “cost” and “benefit” in

a world of incomplete markets, strategic behavior, and informational asymmetry inevitably involves guesswork. Courts have used the language of moral reasoning when they are forced to make decisions. When traditional corporation law addresses “fairness,” it generally refers to fairness to shareholders. Because

shareholders are the residual claimants to the corporation’s income and assets, protection of their interests through a fairness norm is generally consistent with increasing total corporate wealth and with moving toward a Kaldor-Hicks efficient state.

1.3. DEVELOPMENT OF THE MODERN THEORY OF THE FIRM

1.3.1.Ronald Coase’s 1937 Insight The assumption that informed markets costlessly bring together buyers and sellers at an equilibrium price simply

ignores many of the problems that real economic activity must solve. Firms exist because, in a world of positive transaction costs, it is sometimes more efficient to organize complex

tasks within a hierarchical organization—with its established authority and compensation structures—than on a market.

Firms permit transactions, especially complex and reiterated transactions, to be accomplished more cheaply than they could be effected on markets.

1.3.2.Transaction Cost Theory The firm is a set of transactions cost-reducing relationships or governance structures.1.3.3.Agency Cost Theory Agency theory addresses how the actions of one actor (the “agent”) affect the interest of another (the “principal”). Agents in the economic sense typically act with respect to property that principals “own.”

According to agency theorists, a transaction may be motivated, in part at least, to serve an interest of a controlling agent rather than the interest of her principal.

The firm could be understood as a complex of “contracts” between owners of the various factors of production of the firm. Management is seen as offering to investors a share of the utility that can arise from centralizing information and expertise in a single enterprise.

To the extent the incentives of the agent differ from the incentives of the principal herself, a potential cost will arise that is termed an “agency cost.”

The risks and rewards of managers may be out of alignment with the interest of shareholders. What is ownership?

One who has an equity stake, that is, one who is a residual claimant (this is what distinguishes an owner/residual claimant from a lender or contract holder, who has a fixed claim)

One who has control (rather than relying on a contract) E.g., control over employee vs. contract with independent contractor

Non-profit organizations problematize ownership because, by definition, they do not distribution and do not have residual claimants.

Firms are not always owned by entrepreneurs – non-profits are one example, but so are firms like GE, which have millions of shareholders, and co-ops, which are owned by their customers.

A foundational theory is that firms are always owned by those who contract with the firm. The most effective way to minimize transaction costs is to allocate ownership to those with the highest transaction costs.

Model problem: Contract manufacturing Why doesn’t Harris Teeter manufacture its own crackers?

Economies of scale (quantity) and scope (variety) Why don’t Harris Teeter and Trader Joe’s own a manufacturer together?

Anticipated conflicts between owners What other reasons to contract manufacture exist?

Exit rights Lack of experience and expertise in an industry Personal and social motivations Eliminate element of risk associated with status as residual claimant Minimizing risk-bearing, in particular, is important. This is seen in limiting the reach of a shareholder’s

debtors; debtors can seize stock, but cannot force the company to liquidate assets. This is important because a firm’s value is greater than the sum of its parts (a point seen when we

discuss stock selling at multiples of the combined value of its assets) Corporations exist, in part, for this reason – contract alone cannot bar creditors of an owner from

seizing assets; corporate law alone can accomplish this. This is one of the ways in which corporate law is like property law; it is not just the rights of the

corporation and its shareholders that are affected by the relationship, but also all third-parties who do business with them.

Also like property, limitations on liability run both ways—a shareholder’s creditors cannot reach the corporation’s assets and vice-versa.

There are three primary types of agency costs: monitoring costs (costs owners expend to ensure agent loyalty), bonding costs (costs that agents expend to assure owners of their reliability), and residual costs (costs that arise from the differences of interest that remain after monitoring and bonding costs are incurred).

The corporation gives rise to agency problems. Conflict between managers and investor/owners Ability of majority owners to control returns in a way that discriminates against minority owners. Third-parties who are likely to confront imperfections in contracting that expose them to the prospect of a

firm’s behaving opportunistically toward them. Unless the law or the parties craft protections from these risks, contracting parties will demand higher returns to contract with the firm.

The corporation reduces the transaction costs of complex economic contracting, but it does so at the risk of creating agency problems that must be constrained if it is to succeed.

2. ACTING THROUGH OTHERS: THE LAW OF AGENCY2.1. INTRODUCTION TO AGENCY

The simplest form of joint economic undertaking occurs when one person extends the range of her own activity by engaging another to act for her and be subject to her control. Such a relationship is called an agency.

Agency can create legal relationships between strangers—principals and the third parties with whom their agents interact.

2.2. AGENCY FORMATION, AGENCY TERMINATION, AND PRINCIPAL’S LIABILITY

2.2.1.Formation

Restatement 3d Agency: “Agency is a fiduciary relationship that arises when one person (a ‘principal’) manifests assent to another person (an ‘agent’) that the agent shall act on the principal’s behalf and subject to the principal’s control, and the agent manifests assent or otherwise consents so to act.”

An agency is a consensual relationship between the principal, who grants authority to another to bind her in certain respects, and the agent, who accepts that responsibility.

Characteristics of Agency Relationships Voluntary Fixed or indefinite Specific (agency limited to a single act or transaction) or general Disclosed, undisclosed, or partially disclosed Agent acts on behalf Agent subject to control

Employment (when a principal has a right under his deal with the agent to control the details of the way in which the agent goes about her task)

Independent contractor NB: a single individual can simultaneously hold more than one agency relationship as to the same interaction

(firm associate as to firm and to client)2.2.2.Termination Either the principal or the agent can terminate an agency at any time. If the contract between them fixes a set term of agency, the principal’s decision to revoke or the agent’s decision

to renounce gives rise to a claim for damages for breach of contract.2.2.3.Parties’ Conception Does Not Control Agency relations may be implied even when the parties have not explicitly agreed to an agency relationship

Jensen Farms Co. v. Cargill Inc. (p. 18) Facts: Farmers sell grain to Warren Seed & Grain Co., which in turn sells 90% of grain to Cargill. When

Warren goes bankrupt, the farmers sue Cargill, arguing that Warren was Cargill’s agent. Cargill not only loaned Warren money, but also exerted significant control over Warren (right of entry for audit, correspondence and criticism regarding management, requirement that Warren obtain Cargill’s approval to enter into mortgages, purchase stock, or pay dividends).

Holding: An agency relationship may exist whether or not the principal or agent defines it as such or even desires it to be such if the relationship is functionally a principal-agent one.

Reasoning: The Cargill-Warren relationship was so visible that it seems equitable to vindicate the farmers’ reliance.

2.2.4.Liability in Contract2.2.4.1.Actual and Apparent Authority An agency is an arrangement that confers legal power on the agent and gives rise to duties by both the

principal and the agent. Both parties must manifest their intention to enter an agency relationship. Agent’s Ability to Bind

Sometimes a party will acknowledge an agency relationship exists, but argue the agent lacks authority to bind the principal in a certain matter: Actual authority: what the agent should have inferred about the extent of his authority. It includes

incidental authority (power to do what is necessary & proper) by default. Apparent authority: what a third-party should have inferred about the agent’s authority.

White v. Thomas (p. 22) Facts: White gives Simpson authority to purchase property for up to $250,000. Simpson bids much more

than this and wins. When she realizes this, she agrees to sell of some of the land to Thomas. White declines to make the transfer.

Holding: White is not bound by Simpson’s agreement with Thomas. Simpson clearly lacks actual or inherent authority and the appellate court holds she also lacked apparent authority, asserting the extent of an agent’s authority cannot be show solely by his own declarations or actions in absence of the principle. This has to be the holding; otherwise anyone could make himself another’s agent.

In apparent authority cases, what is accepted as evidence is tremendously important.2.2.4.2.Inherent Authority Inherent Authority: gives a general agent the power to bind a principal to an unauthorized contract as long as

a general agent would ordinarily have the power to so contract and the third party does not know that matter stand differently in this case. This is important when, for example, the agent represents or implies that his is acting on his own behalf.

Inherent authority gives agents a bare minimum authority. The policy actually benefits principals because it makes it more likely that third-parties will deal with agents.

Gallant Ins. Co. v. Isaac (p. 26)

Facts: The principal, Gallant, sells car insurance through its agent Thompson-Harris. Thompson-Harris agreed to insure plaintiff’s car effective immediately, even though the paperwork had not been processed. The principal denied coverage when the plaintiff had an accident because its agent lacked authority to issue modified policies without the principal’s approval.

Held: Gallant is bound because Thompson-Harris and Gallant had a course of dealing in this manner, which the plaintiff reasonable relied on (even though there is no evidence that the plaintiff so relied or was even aware of the practice).

Reasoning: Least-cost monitoring; while in White it was the third-party, in Gallant, it is the insurer. In White, the third-party was clearly dubious as to the agent’s authority, while in Gallant, the third-party had no reason to be suspicious.

Agency by estoppel: failure to act when knowledge and opportunity to act arise plus reasonable reliance by a third-party. Inherent authority focuses on the reasonableness of the third-party, while agency by estoppel looks to

the reasonableness of the principal’s behavior. Agency by ratification: if the principal accepts the benefit of a transaction, the agent had authority.

2.2.5.Liability in Tort Only a particular kind of agency relationship, the employer-employee relationship, ordinarily triggers vicarious

liability for all torts committed within the agent’s scope of employment. Rest. (3rd) Agency) §7.07: An employer is subject to vicarious liability for a tort committed by its employee acting

within the scope of employment. An employee is an agent whose principal controls or has the right to control the manner and means of the

agent’s performance of work. Whether an agent is an employee or independent contractor thus becomes critical.

There’s circular reasoning at play: we assign liability because we want people to exert control and people exert control because they are liable.

Humble Oil v. Martin (p. 30) Hoover v. Sun Oil Co. (p. 32)The station operator negligently allowed a car to roll away, striking pedestrians.

An employee was fueling a car and lit a cigarette which started a fire

Humble set hours of operation. Operator set hours of operationOperator sold only Humble products. Operator could sell non-Sunoco ProductsHumble held title to goods operator sold on consignment.

Operator took title to goods.

Lease was terminable at will. Lease was terminable annually.Rent was partly based on amount of Humble’s products sold and Humble paid large percentage of operator’s costs.

Operator had ‘overall risk of profit and loss,’ though received subsidies from Sunoco to ensure competitiveness.

Humble could require periodic reports.No written reports required, but representative from Sunoco visited weekly in advisory capacity.

Held: Humble liable. Held: Sun not liable. In both cases, the stations are franchises. The franchisee is a part-owner and is responsible for day-to-day

operation (unity of residual claims and control). All franchisees benefit if franchises are well-run. If the holdings were based on least-cost monitoring the station owners/operators should be liable. If the concern

is that the plaintiffs be compensated for injuries, the principals should also be liable. Coasian theory posits that if transaction costs between franchisor and franchisee are low, it doesn’t matter how

we allocate liability, because they’ll contract around it.2.3. THE GOVERNANCE OF AGENCY (THE AGENT’S DUTIES)

2.3.1.The Nature of the Agent’s Fiduciary Relationship In common law, an agent is a fiduciary of her principal. The fiduciary is bound to exercise her good-faith judgment in an effort to pursue, under future circumstances, the

purposes established at the time of creation of the relationship. The fiduciary’s duties fall into three general categories:

Duty of obedience to the documents creating the relationship Duty of loyalty to exercise power in good faith to best advance purposes of the principle and not for personal

benefit Duty of care to act in good faith, as a reasonable person would act, in becoming informed and exercising

power2.3.2.The Agent’s Duty of Loyalty to the Principal Restatement (3d) Agency Duty of Loyalty

§ 8.02 An agent has a duty not to acquire a material benefit from a third party in connection with transactions conducted or other actions taken on behalf of the principal or otherwise through the agent’s use of the agent’s position.

§ 8.03 An agent has a duty not to deal with the principal as or on behalf of an adverse party in a transaction connected with the agency relationship.

§ 8.06 (1) Conduct by an agent that would otherwise constitute a breach of duty does not constitute a breach if the principal consents to the conduct, provided that (a) in obtaining the principal’s consent, the agent (i) acts in good faith, (ii) discloses all material facts that the agent should know would reasonably affect the principal’s judgment . . . .

Tarnowski v. Resop (p. 36) Facts: Agent/defendant took secret commission from seller for a deal on behalf of principal/plaintiff. Plaintiff

receives $9,500 of $11,000 down payment back from seller. Plaintiff also receives agent’s secret commission and all costs associated with recovering from the seller, for a total of $5,200. (Thus, less recovery costs, plaintiff comes out ahead).

Held: It is acceptable for the plaintiff to recover over and above damages because we want a strong deterrent effect on agents acting this way.

§8.02 is treated as a default provision of the principal-agent contract.2.3.3.The Trustee’s Duty to Trust Beneficiaries The private trust is a legal device that allows a “trustee” to hold title to trust property which the trustee is under a

fiduciary duty to manage for the benefit of another person, the trust beneficiary. The trustee is subject to the terms of the trust, as these have been fixed by the trust’s settlor.

In re Gleeson (p. 38) Restatement (2d) Trusts § 203: The trustee is accountable for any profit made by him through or arising out

of the administration of the trust, although the profit does not result from a breach of trust. Facts: Gleeson appoints her tenant trustee of a trust which includes the property he leases from her. Gleeson’s

trust comes into force two weeks before the tenant/trustee’s lease was up for renewal. The tenant/trustee discussed the matter with the beneficiaries and got their approval to renew the lease at a higher rate of rent and find a new tenant the next year.

Held: Despite absolutely no bad faith, the tenant/trustee must return to the trust any profit from his lease. Reasoning: The tenant/trustee is dealt with so harshly because of evidentiary concerns, lack of clarity

regarding “fairness” and high associated enforcement costs. If the settlor is deceased, the trustee may be locked into place, making the trustee’s fiduciary obligations the

only check on the trustee’s behavior.3. THE PROBLEM OF JOINT OWNERSHIP: THE LAW OF PARTNERSHIP

3.1. INTRODUCTION TO PARTNERSHIP

The general partnership is the earliest and simplest form of a jointly owned and managed business. With respect to third parties, the law of partnership closely follows agency law. With respect to the relations among partners, numerous common law rules deal with the internal problems of

these small, jointly managed firms. Rules give distinct legal treatment to partnership property: “tenancy in partnership,” which provides that

ownership rights over partnership property, and in practice, in the event of partnership bankruptcy or liquidation, this form of title gives creditors of the partnership first priority over the claims of the creditors of individual partners.

In partnership, the primary agency problem is not the conflict between the agent or manager and the owner—the paradigmatic problem in the law of agency—but potential conflict among the joint owners.

3.1.1.Why Have Joint Ownership? At a certain point, selling an ownership stake may be a cheaper way to raise capital than attempting to borrow

additional funds. If the people who are the inferior claimants also have control, prior claimant are more likely to receive

satisfaction on money lent (since owners are residual claimants). Asset partitioning: assets are owned by the firm, not by the owners. As a result, lenders and contractors who deal

with the firm have priority as compared to the owners’ creditors. This gives creditors more confidence in transacting with the firm. This relationship would not be possible through contracting alone.

3.1.2.Agency Conflicts Among Co-OwnersMeinhard v. Salmon (p. 47)

Facts: Meinhard supplies ½ capital; Salmon supplies the rest and manages the property they’ve leased. At the end of the lease, a new lease is offered to Salmon, which Salmon accepts without telling Meinhard.

Held: Meinhard is entitled to ½ interest in the deal. Reasoning: Salmon took advantage of a benefit (the opportunity to take a new lease) that belonged to the

joint venture, not to Salmon alone. Salmon should have given Meinhard notice as to the opportunity so that Meinhard could compete for it if one

or both did not want to continue as joint venturers. This seems to benefit the lessor at Salmon’s expense. The remedy given (same proportional shares in second lease as in first) may diminish Salmon’s incentive

to seek new opportunities.

If Salmon has the option to retain the opportunity and compensate Meinhard in some other way, Salmon might heavily invest in ways that make the opportunity even more attractive.

Notable for: Cardozo’s ‘punctilio’ admonition: “Joint venturers, like copartners, owe to one another, while the enterprise continues, the duty of the finest loyalty. Many forms of conduct permissible in a workaday world for those acting at arm’s length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the “disintegrating erosion” of particular exceptions . . . Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd. It will not consciously be lowered by any judgment of this court.”

Possible Terms for Allocating New Opportunities (from better to worse from Meinhard’s perspective)1. Same Term Option: Meinhard participates in any new opportunity on the same terms as in the 20-year

joint venture. (This is close to Cardozo’s remedy: Meinhard got a 50% participation in the new deal, just like the old deal.)

2. Competition/Renegotiation: Salmon must inform Meinhard, who is free to compete for, or renegotiate over, any new opportunity. (Cardozo suggests this is what Salmon’s fiduciary duty required.)

3. Salmon’s option: Salmon can keep the new opportunity or offer a piece to Meinhard, as he likes.3.2. PARTNERSHIP FORMATION

Key Features of General Partnership All partners are liable as principals All partners are general agents of the partnership* All partners are jointly and severally liable for debts of the business All partners share equally in control*

* Can be altered by contract NB: No one actively organizes this way anymore, but courts sometimes impute general partnerships) UPIA § 7: Partnership Formation:

(3) The sharing of gross returns does not of itself establish a partnership…(4) The receipt by a person of a share of the profits of a business is prima facie evidence that he is a partner in the business, but no such inference shall be drawn if such profits were received in payment:

(a) as a debt by installments or otherwise;(b) As wages of an employee or rent to a landlord,(d) As interest on a loan(e) As the consideration for the sale of a good-will of a business or other property

Vohland v. Sweet (p. 52) Facts: Sweet was paid 20% of profits. Sweet wants it considered a partnership so he can sue to dissolve. He

seeks this because much of the profits to which he is entitled have been reinvested and can’t be liquidated short of dissolution.

Held: No error in finding the existence of a partnership. Reasoning: Though the parties conceived of the arrangement as resulting in Sweet being paid a ‘commission,’

as in Jensen v. Cargill, the parties’ conception of the relationship doesn’t control.3.3. RELATIONS WITH THIRD PARTIES

Three principal issues rise under the topic of creditor rights: Who is a partner for purposes of personal liability to business creditors? When can an exiting or retiring partner escape liability for a partnership obligation? Since a partner’s liability on a partnership debt can be satisfied from a partner’s nonpartnership property, how

are such claims to an individual partner’s personal assets to be balanced against the claims of other (nonpartnership) creditors of that person?

3.3.1.Who Is a Partner? Ars Gratia Artis Problem (p. 55) The whole partnership is charged with the business-related torts of any partner under §13. Whether a party is a

partner is defined under §7. A party who receives a share of profits is presumptively a partner. §7 contains codification of exceptions.

In order for a partnership to exist, the partners need to consent to the structural elements of a partnership, but need not agree to be called a partnership.

Slide 19# 23# Partnership by estoppel: If a person represents himself as being a partner in an enterprise (or consents to others

making the representation) and a third party reasonably relies on the representation (actual reliance required) and does business with the enterprise, then the person who was represented as a partner is personally liable on the transaction, even though that person is not in fact a partner.

Somewhat analogous to apparent authority doctrine.

3.3.2.Third-Party Claims Against Departing Partners Liability of Retiring Party (§36)

A would-be former partner is only released from liability when the remaining partner(s) and creditor(s) so agree (agreement can be inferred).

Where a party assumes the debts of a dissolved partnership, the retiring partner is released from liability to creditors who, knowing the new situation, agree to material alteration in the nature or time of payment of such obligations.

3.3.3.Third-Party Claims Against Partnership Property A fundamental characteristic of all business entities is a segregated pool of assets available to secure business

debts. Partnership property owned by the partners as “tenants in partnership” affords to individual partners virtually no

power to dispose of partnership property, thus transforming the property into de facto business property. If a partner does not own her partnership’s assets in any ordinary sense, she nevertheless retains a transferable

interest in the profits arising from the use of partnership property and the right to receive partnership distributions.

The contributors of equity capital do not “own” the assets themselves but rather own the right to the net financial returns that these assets generate, as well as certain governance or management rights.

3.3.4.Claims of Partnership Creditors to Partner’s Individual Property With respect to partnership property, the partnerships’ creditors are always first in line. With respect to partners’ property if the partnership is insolvent, partnership creditors are on equal footing with

personal creditors under Federal Bankruptcy law (§723 of the Bankruptcy Code – the parity rule). This is different from the old (jingle) rule, which gave creditors of individual partners priority over creditors

of the partnership with respect to individual partners’ personal property. With respect to partners’ property if the individual is insolvent, it depends on state law, which may follow RUPA

and give partnership and individual creditors equal footing (parity rule) or may follow UPA and give personal creditors priority (jingle rule). Thus, as to claims against the individual assets of partners, partnership creditors are subordinated to the

claims of a partner’s creditors if (1) UPA is controlling state law and (2) §723 does not apply (that is, the partnership is not in Chapter 7 or the individual partner is not in bankruptcy). Partnership creditors receive parity treatment if either (1) RUPA is controlling state law or (2) §723 applies (the partnership is in Chapter 7 or the individual partner is in bankruptcy)

3.4. PARTNERSHIP GOVERNANCE AND ISSUES OF AUTHORITY

Any decision related to ordinary matters may be decided by a majority of partners (but one of two is not a majority) under §18(h), but no act in contravention of any agreement between the partners may be done rightfully without the consent of all the partners.NABISCO v. Stroud (p. 61) Facts: Stroud and Freeman are partners. Stroud tells Nabisco he personally would not be responsible for any

bread delivered after February 6. Nabisco nevertheless delivers after February 6. The partnership dissolves on February 25.

Held: Stroud could not restrict Freeman’s power and authority to engage in ordinary business matters. Stroud is liable for debts owed to Nabisco, even though Stroud warned Nabisco he would not be responsible for the debt.

3.5. TERMINATION

3.5.1.Accounting for Partnership’s Financial Status and Performance A firm’s balance sheet is a simple statement of the assets that it holds, the liabilities that it owes, and the

difference between the two, which is the equity that the partners have in the firm. The income statement reflects the results of transactions in which the firm has engaged over a set period, often a

year. The capital account will have a report that records the effects on the partners’ capital of the operations of the

business over the year.Adams v. Jarvis (p. 65)

Facts: Dr. Adams withdraws from the three-doctor “Tomahawk Clinic” partnership; contends that his withdrawal constitutes a “dissolution” that requires a winding-up under UPA, even though this is contrary to the partnership agreement.

UPA § 38(1): “When dissolution is caused in any way, except in contravention of the partnership agreement, each partner, as against his co-partners . . . , unless otherwise agreed, may have the partnership property applied to discharge its liabilities, and the surplus applied to pay in cash the net amount owing to the respective partners.”

Under UPA: Dissolution (§29): any change of partnership relations, e.g., the exit of a partner. Winding up (§37): orderly liquidation and settlement of partnership affairs. Termination (§30): partnership ceases entirely at the end of winding up.

Under RUPA: Disassociation (§ 601): a partner leaves but the partnership continues, e.g., pursuant to agreement. Dissolution: (§ 801): the onset of liquidating of partnership assets and winding up its affairs.

Held: The provisions in UPA that govern relationships between partners can be modified by the partners. The partnership agreement is valid, and Dr. Adams’ withdrawal does not constitute a dissolution of the partnership as to the remaining partners.

Dreifuerst v. Dreifuerst (p. 69) Facts: Winding-up of at-will partnership among three brothers to run two feed mills. No partnership

agreement. Trial court declines one brother’s request for a sale of the assets; instead, gives one mill (St. Cloud) to the defendant brother and other mill (Elkhart Lake) to the two plaintiff brothers. The brothers disagree about valuation, or else in-kind valuation and separation would be satisfactory to all.

Held: The trial court’s approach is rejected; winding-up of the business and sale in cash is required. UPA §38(1): “When dissolution is caused in any way, except in contravention of the partnership agreement,

each partner, as against his co-partners . . . , unless otherwise agreed, may have the partnership property applied to discharge its liabilities, and the surplus applied to pay in cash the net amount owing to the respective partners.”

Page v. Page (p. 73) Facts: Both parties contribute equity capital, but Big Page also contributes debt. Just when the partnership

turns a corner, Big Page seeks to dissolve the partnership. Little Page claims Big Page is forcing him out. Held: Unless otherwise agreed to by the partners, any partner can dissolve the partnership at any time

(partnership at will unless otherwise specified). NB: The court warns Big Page that he has a fiduciary duty not to withdraw in bad faith.

3.6. LIMITED LIABILITY MODIFICATIONS OF THE PARTNERSHIP FORM

The general partnership form has the bare minimum of features necessary to establish an investor-owned legal entity: (1) a dedicated pool of business assets, (2) a class of beneficial owners (the partners), and (3) a clearly delineated class of agents authorized to act for the entity (the partners).

The separation between the partnership as a legal entity and the investors can be further increased by adding limited liability, which means that business creditors cannot proceed against the personal assets of some or all of a firm’s equity investors.3.6.1.The Limited Partnership Limited partners share in profits without incurring personal liability for partnership debts. Limited partners may

not participate in management or control; if they do, they risk losing their limited liability protection. Policy rationale: limited partners don’t have control, so they shouldn’t share in liability. Why use limited partnership rather than a corporation when both limit liability? To remove control from the

parties who would otherwise be shareholders with control rights.3.6.2.Limited Liability Partnerships and Companies

3.6.2.1.The Limited Liability Partnership LLP: general partnership with certain kinds and degrees of limited liability. They are often restricted to use

by professionals. Limit liability only as to partnership liabilities arising from the negligence, malpractice, wrongful act, or

misconduct of another partner or an agent of the partnership not under the partners’ direct control.3.6.2.2.The Limited Liability Company LLC: offers a broader range of liability protection than LLPs. Today, they are functionally very similar to

corporations. LLC statutes generally offer more flexibility than corporate statutes in the form of near-complete freedom

to “opt out” of default rules, but “S corps” may participate in tax-free reorganizations with C corporations. The decision as to what entity form is chosen is frequently a function of tax liability. Because corporate

earnings are doubly-taxed, there are advantages to entity forms that incur only pass-through taxation. Until 1997, LLCs were taxed like a corporation if they possessed three or more of the following four corporate

characteristics: (i) limited liability for the owners of the business, (ii) centralized management, (iii) freely transferable ownership interest, and (iv) continuity of life.

The tax incentives for organizing in these variations on partnership changed in 1997 when the IRS switched to “check the box” rules which allowed unincorporated businesses to choose whether to be taxed as partnerships or corporations.

Why don’t all businesses elect partnership taxation? If corporation income tax rates are lower than individual income tax rates, retaining corporate earnings

may be preferable; small corporations (“S” corporations) have some of the same tax advantages of partnerships; any firm that is publicly-held is forbidden from electing partnership treatment.

4. THE CORPORATE FORM4.1. INTRODUCTION TO THE CORPORATE FORM

Core Characteristics GP LP LLC Corp

Investor ownership X X X XLegal personality X X X XLimited liability X X XTransferable shares X X XCentralized management under an elected board

* X

Indefinite existence * X X X* If so chosen

Benefits of the corporate form: The corporation emerged as a response to the limitations of the partnership for financing. Limited liability makes free transferability more valuable by reducing the costs associated with transfers of

interest (the value of shares is independent of the assets of their owners) Free transferability permits the development of large capital (equity or stock) markets, which are also advanced

by the presence of centralized management. These characteristics combine to make the corporation a highly efficient legal form for enterprise organization,

especially where large aggregations of capital are required and complex operations demand specialized management.

The corporate form also: Eliminates problems of personal liability – creditors rely only on business assets Allows investors to enter and exit firm; all they have to do is buy or sell shares Prevents minority investors from holding up the firm by threatening to dissolve it Makes it easy for third parties who contract with the firm to know whom they deal with is an authorized

agent. All they need is a board resolution. Close Corporations: Closely held corporations (so named because they have few shareholders) are often businesses

that incorporate for tax or liability purposes rather than for capital-raising purposes. Controlled Corporations: Corporation in which a single shareholder or group of shareholders exercises control

through its power to appoint the board. Where there is no such person or group, control is said to be “in the market.” As long as control is in the market, practical control resides with the existing management of the firm.

4.2. CREATION OF A FICTIONAL LEGAL ENTITY

The corporation is considered a separate person in the eyes of the law. Because its principal investors need not execute the transaction or even agree to it, the information and coordination

costs of closing the transaction are minimal. Enabling corporations to own assets delimits the pool of assets upon which corporate creditors can rely for

repayment. Thus, the doctrinal fiction of an artificial entity vastly reduces the costs of contracting for credit.

The status of the corporation as a fictive legal entity allows it to have an indefinite “life,” which enhances the stability of the corporate form.4.2.1.A Note on the History of Corporate Formation The law of the state of incorporation governs the internal affairs of a corporation, including such matters as who

votes, on what, and how often. U.S. firms are not constrained by HQs, place of business, or other operational factors in choosing where to

incorporate. NB: You must maintain an agent in the state of incorporation upon whom process can be served.

The state of incorporation dictates which corporate law rules apply under the ‘internal affairs’ doctrine. Corporations are attracted to states of incorporation based on whether the state offers:

Favorable terms, including fiduciary duties Judiciary experience and position Creditor’s rights Franchise fees Speed & ease of incorporation

States attempt to attract incorporating entities because the states collect incorporation fees and franchise taxes and attract business for professionals who assist corporations, who in turn pay income tax to the state. Delaware, as a smaller state, is highly responsive to lobbying groups (like affected professionals) who want to

keep incorporating in Delaware an attractive option. Further, franchise fees make up a larger portion of Delaware’s revenues.

The desire to attract corporations can lead to a race to the bottom to attract managers or a race to the top to attract shareholders, depending on the critic.

Arguably, a state will come to optimal compromises to attract both mangers and shareholders, but problematically, competing states externalize costs to the remaining 49 states. Losers include tort victims; whether there’s a race to the bottom or top in respect to managers and shareholders, there’s clearly a race to the

bottom regarding tort creditors, in a scenario similar to the situation between beneficiaries of spendthrift trusts and their creditors. There was a race between states to deregulate: authorizing corporations to own the stock of other

corporations (permitting the holding company structure, which, in turn, made possible corporate joint ventures and networks of corporations related by ownership); allowing corporations to have indefinite/perpetual existence; permitting organization for any lawful purpose; relaxing capital requirements; and allowing corporations to amend their certificates of incorporation, own and vote stock of other corporations, own land without limit, and merge with other corporations.

The typical corporation statue of today is a nonregulatory “enabling” statue with few mandatory features. As corporate management’s freedom to act grew under the enabling approach of modern statutes, and as

shareholders of public companies grew more numerous and disaggregated, courts came to give greater weight to judicially-created “fiduciary duty” of corporate directors and officers, and the federal government began to regulate public companies through securities law.

4.2.2.The Process of Incorporating Today An “incorporator” signs the requisite documents and pays the necessary fees. The incorporator drafts and signs a document called the articles of incorporation (under RMBCA) or the

certificate of incorporation (under the DGCL) (also known as the corporation’s charter). The AOI state the purpose and powers of the corporation and define all of its special features. The company charter will contain any customized features of the enterprise. After it is duly executed, the charter is filed with a designated public official. Upon filing, a fee will be due. After the articles are filed and the fee is paid, the secretary of state issues the corporation’s charter. The first acts of business in a newly formed corporation are electing directors (if initial directors are not

named in the charter), adopting bylaws, and appointing officers. NB: Reincorporation requires shareholder approval.4.2.3.The Articles of Incorporation, or “Charter” The articles of incorporation may contain any provision not contrary to law. The charter must provide for voting stock, a board of directors, and shareholder voting for certain transactions. The corporate charter will contain the most important “customized” features of the corporation, should there be

any. If it is to have some governance oddity, this condition must be spelled out in the charter. The charter must name the original incorporators, the name of company, its address, purpose (usually “any lawful

act”), original capital structure (classes, number of common shares, rights of preferred shareholders, if any), and other miscellaneous provisions.

The charter may establish the size of the board or include other governance terms.4.2.4.The Corporate Bylaws The bylaws must conform to both the corporation statue and the corporation’s charter. Bylaws fix the operating rules of the governance of the corporation. The bylaws should establish the existence and responsibilities of corporate offices; the size of the board of

directors or the manner in which the size of the board is to be established; an annual meeting date or a formula by which such a meeting date will be fixed. The bylaws might have other provisions relating to stockholders, board of directors, committees, officers,

stock, indemnification, and miscellaneous topics. Under DGCL §109, shareholders have the inalienable right to amend the bylaws.4.2.5.Shareholders’ Agreements Shareholders’ agreements typically address such questions as restrictions on the disposition of shares, buy/sell

agreements, voting agreements, and agreements with respect to the employment of officers or the payment of dividends.

4.3. LIMITED LIABILITY

Corporations have unlimited liability, and shareholders, by reason of their shareholder status alone, have no liability for the debts of the corporation. Shareholders cannot lose more than the amount they invest. Limited liability vastly simplifies the job of evaluating an equity investment. The ability of the corporate form to segregate assets may encourage risk-averse shareholders to invest in risky

ventures. Limited liability may increase the incentive for banks or other expert creditors to monitor their corporate debtors

more closely. The chief purpose of limited liability is to encourage investment in equity securities and thus to make capital more

available for risky ventures. Limited liability can be waived through contract between owners and creditors; this is particularly useful in small

businesses where owners will be unable to secure credit without so waiving.

A firm’s creditors can include banks & bond holders, employees, suppliers, landlords, tort victims, intermediate claim holders (such as, perhaps, venture capitalists, who may straddle the line between debt and equity holders), trade creditors (such as plumbers and electricians), and utility suppliers. The creditors most likely to insist on a personal guarantee of debt are banks and large landlords.

By using limited liability, you can pick and choose priority of creditors in respect to personal assets. Limited Liability in Contract (p. 97)

The costs generated by agency relations are outweighed by the gains from separation and specialization of function. Limited liability reduces the costs of this separation and specialization.

If we assume that owner’s personal liability must be joint and several, rather than proportional, limited liability in contract can lead to:1. Decreased need for shareholders to monitor managers Shifts monitoring to lenders, increases interest rate2. Decreased need for shareholders to monitor each other3. Promotes free transferability of shares The value of a share does not change depending on whose hands it is in4. Allows market prices to impound information about the value of firms5. Allows diversification6. Facilitates optimal investment decisions Rather than mere avoidance of risk and monitoring costs

Real benefit: the increased availability of funds for projects with positive net values Limited Liability in Tort (course materials)

Encourages mis-investment and over-involvement in hazardous activity, which is exacerbated by contractual debt, because this debt can be prioritized. This leads to taking fewer precautions than appropriate to the risk and externalizing this cost to tort victims.

Is unlimited liability in tort on a pro rata basis feasible? Hansmann and Kraakman argue yes, because many companies are now owned by wealthy individuals and institutions and the pro rata share of unlimited liability is unlikely to bankrupt them

However, transaction costs make it likely that only the wealthiest shareholders will be pursued by tort victims which means shares will have less value to these wealthy owners, thus distorting share value.

4.4. TRANSFERABLE SHARES

Equity investors in the corporate entity legally own something distinct from any part of the corporation’s property: they own a share interest.

Such a share may be transferred together with all rights that it confers. Transferability permits the firm to conduct business uninterruptedly as the identities of its owners change, which

avoids the complications of dissolution and reformation. Absent limited liability, the creditworthiness of the firm as a whole could change, perhaps fundamentally, as the

identities of its shareholders changed. Limited liability and transferability are complementary features of the corporate form.

The ability of investors to freely trade stock encourages the development of an active stock market. An active market, in turn, facilitates investment by providing liquidity and by facilitating the inexpensive diversification of the risk of any equity investment.

If investors see value in agreeing to restrictions on transfer, all jurisdictions provide mechanisms for permitting agreements to that effect.

The free transferability of stock complements centralized management in the corporate form by serving as a potential constraint on the self-serving behavior of the managers of widely held companies.

4.5. CENTRALIZED MANAGEMENT

Centralized management can achieve economies of scale in knowledge of the firm, its technologies and markets. Shareholder designated boards of directors, not investors, are accorded the power to initiate corporate transactions

and manage the day-to-day affairs of the corporation. Among the foundational problems for modern corporate law is the determination of the set of legal rules and

remedies most likely to ensure that these managers will strive to advance the financial interests of investors without unduly impinging on management’s ability to manage the firm productively.

The are at least three aspects of this problem: What can the law do to encourage managers to be diligent, given that shareholders choose the directors who

designate managers? How can the law assist shareholders in acting collectively vis-à-vis managers, especially in the case of widely held

companies with many small shareholders? Rational apathy: in large corporations with dispersed ownership, investors who are active bear all the costs

of activity, but receive only part of the benefits. How can the law encourage companies to make investment decisions that are best for shareholders?

Corporate law attempts to mitigate the agency problem by requiring, as a default rule, that management be appointed by a board of directors that is elected by the holders of common stock in the company.

The formal distinction between a corporation’s board and its management permits a distinction between the approval of business decisions and their initiation and execution.

The additional distinction between a corporation’s board and its shareholders is principally a device for reducing the costs of corporate decision making.

Empowering boards to act in opposition to the will of shareholder majorities can provide a check on opportunistic behavior by controlling shareholders.

The board is usually elected by the firm’s shareholders, which helps to ensure that the board will act in the interest of the company’s owners, that is, its residual claimants.4.5.1.Legal Construction of the Board

4.5.1.1.The Holder of Primary Management Power Automatic Self-Cleansing Filter v. Cunninghame (p. 103)

Facts: McDiarmid and friends own 55% of Automatic Self-Cleaning Filter (ASCF). ASCF charter vests control in the board, subject to regulations by “extraordinary resolution” of 75% of shareholders. McDiarmid and friends bring such a resolution to sell the company’s assets; resolution fails 55% to 45%. McDiarmid then asks the court to order the board to sell the assets.

Held: The board is the agent of shareholders acting as one, not of 55% of shareholders, so the board must follow the articles of incorporation (a work of the whole) over 55% when the articles do not consider 55% sufficient.

Reasoning: The court upholds the article’s effort to protect minority shareholders. The articles of incorporation always control. Usually a board’s duty to the corporation and to the shareholders perfectly cohere, but that is not the

case here; DGCL §271 reaches the same result: (a) Every corporation may at any meeting of its board of directors or governing body sell . . . all

or substantially all of its property and assets . . . as its board of directors or governing body deems expedient . . . when and as authorized by a resolution adopted by the holders of a majority of the outstanding stock of the corporation entitled to vote thereon.

(b) Notwithstanding authorization or consent to a proposed sale . . . by the stockholders . . . , the board of directors or governing body may abandon such proposed sale . . . subject to the rights, if any, of third parties under any contract relating thereto.

Typically, shareholders may not take matters into their own hands, except by voting out directors; the board makes decisions, some of which must be ratified by shareholders.

The board of directors has the primary power to direct or manage the business and affairs of the corporate, but usually designates managers to do so. The managerial powers of the board include the powers to appoint, compensate, and remove officers; the power to delegate authority to subcommittees of the board, to officers, or to others; the power to declare and pay dividends; the power to amend the company’s bylaws; the exclusive power to initiate and approve certain extraordinary corporate actions, such as amendments to the articles of incorporation, mergers, sales of all assets, and dissolutions; and more generally, the power to make major business decisions, including deciding the products the company will offer, the prices it will charge, the wages it will pay, the financing agreements it will enter, and the like.

4.5.1.2.Structure of the Board In default of any special provisions in the charter, all members of the board are elected annually to one-year

terms. The charter may provide that board seats are to be elected by certain classes of stock. The board has inherent power to establish standing committees for the effective organization of its own

work, and it may delegate certain aspects of its task to these committees or to ad hoc committees. Corporation statutes generally permit corporate charters to create staggered boards.

Since the early 1990s, institutional shareholders have generally opposed staggered boards because they plainly enhance management’s ability to resist hostile takeovers.

4.5.1.3.Formality in Board Operation Corporate directors are not legal agents of the corporation. Governance power resides in the board of

directors, not in the individual directors who constitute the board. Directors act as a board only at a duly constituted board meeting and by majority vote (unless the corporate

charter requires a supermajority vote on an issue) that is formally recorded in the minutes of the meeting. Proper notice of these meetings must be given and a quorum must be present.

Fogel v. U.S. Energy Systems, Inc. (p. 107) Facts: U.S. Energy had a four-member board of directors, which consisted of the CEO and three outside

directors. Just before a scheduled board meeting, the three outside directors convened and decided to fire the CEO. The outside directors then went to the boardroom and announced their decision to the CEO, who then left the building. Two days later, the CEO called a special meeting of shareholders for the purpose of removing the other directors from office and electing replacements.

Held: The Delaware Chancery Court held that the three outside directors had not held a valid board meeting to fire the CEO and the CEO thus retained the authority to call the shareholder meeting.

4.5.1.4.A Critique of Boards Most corporate statutes do not mention the position of CEO, the most important single organizational role in

the large majority of corporations. Unlike the CEO, most directors cannot in the time available consider the merits of any significant number of

complex corporate decisions or second-guess the judgments of the corporation’s full-time officers, who are intimately versed in the company’s business affairs. In most instances, directors of a large corporation meet only between four and eight times a year. Moreover, directors customarily receive their information about the corporation through the filter of

documents and presentations put together by the corporation’s officers. These practical limitations make the role of the “outside,” or independent, director on the boards of major

U.S. corporations one of the last great amateur roles in American life.4.5.2.Corporate Officers: Agents of the Corporation The corporate officers, unlike directors, are unquestionably agents of the corporation and are therefore subject to

the fiduciary duty of agents.Jennings v. Pittsburg Mercantile Co. (p. 110)

Facts: Mercantile is a publicly-held corporation with 400 shareholders, nine directors, and a three-member executive committee of directors. Egmore (Mercantile’s VP and Treasurer-Controller, corporate officer, and director), along with Stern (“financial consultant”), instructs Jennings to solicit offers for a sale and leaseback of its real property in order to raise money for modernization. Egmore tells Jennings that the executive committee has the power to accept an offer, and eventually does so through Stern. But the board rejects, and Jennings sues for his commission. Mercantile argues that Egmore did not have authority to do the deal, and therefore Mercantile is not bound. Jennings argues that Mercantile is bound through apparent authority of Egmore.

Held: The agent’s words or acts on their own are not sufficient to establish apparent authority. Further, a sale and leaseback of all assets is not an ordinary transaction in the course of business – it is an extraordinary transaction. Executive officers are agents, not principals. The board, as a board, is the principal. Restatement 3d Agency §2.03: Apparent authority is the power held by an agent or other actor to affect a

principal’s legal relations with third parties when a third party reasonably believes the actor has authority to act on behalf of the principal and that belief is traceable to the principal’s manifestations.

Grimes v. Alteon (p. 112) Facts: A CEO attempted to enter an oral contract to sell 10% of any new issue of stock to an existing

shareholder who wished to maintain his proportional shareholdings. Held: The CEO lacked authority; such a contract constituted a “right” in the company’s securities and thus

required board approval. This construction was required by the fundamental social policies of protecting the board’s power to

regulate corporate capital structure and ensuring the certainty of property rights in corporate sales.5. DEBT, EQUITY, AND ECONOMIC VALUE

5.1. CAPITAL STRUCTURE

A business corporation raises capital to fund its operations by selling legal claims to its assets and prospective cash flows by: Borrowing money through the issuance of debt instruments. Selling ownership claims in the corporate entity by issuing equity securities.

Usually, those who buy corporate debt have a contractual right to receive a periodic payment of interest and to be repaid their principal at a stated maturity date. If a corporation fails to make any of these payments, the creditor has legal remedies. The creditor typically also gets a contractual right to “accelerate” payment of the principal amount if the debtor

defaults. The debtor generally must pay its creditors the amounts currently due before the debtor can distribute funds or

other things of value to equity owners. Debt is more secured than equity and senior claims more secured than junior ones.

Most equity claims on corporations take the form of common stock. Its holders have no right to any periodic payment, nor can they demand the return of their investment from the

corporation, nor can they typically tell the firm’s managers what to do; they merely have a right to vote. Common stockholders can expect to receive dividends, but they get those dividends only when the corporation’s

board of directors so declares. Equity vs. Debt

Equity residual claims, control rights, no tax deductibility Control is enforced by collective action in the form of voting

Debt fixed claims (interest + principal), covenants, acceleration, tax deductibility Covenants enforced by suit

5.1.1.Legal Character of Debt Debt securities are contracts; the debt contract—the loan agreement—has great flexibility in design. Thus, when we speak of the legal “characteristics” of debt, to a large extent we are talking about general patterns

of contract terms. The legal “characteristics” of debt are largely general patterns of contract terms. The loan agreement allocates

risk and responsibilities between the debtor and creditor and, in more complex companies, among each of several classes of creditors. Maturity Date: A critical advantage of bonds, from the perspective of investors, is that the investor generally

faces less risk as a creditor than as an equity holder because creditors have a legal right to periodic payment of a return (interest) and a priority claim over the company’s shareholders on corporate assets in the event that the corporation defaults. If creditors are not paid on time, they can sue on their contract.

Tax Treatment: Interest paid by the borrower is a deductible cost of business when the firm calculates its taxable income.

5.1.1.1.Subordinated Debt Like debt because the claim is senior to equity claims; the payments are fixed; covenants are used. Like equity because the claim is junior to other types of debt; covenants, if extensive enough and flexible

enough, begin to look like control.5.1.1.2.Bonds A form of debt in which the loan is taken from a large number of loans The instrument that creates the bond is called an indenture. Bonds have collective action problems, so they often have an indenture trustee, who must enforce the terms

of the bond if any of the bondholders petitions for them to be upheld. Any lawsuits for enforcement will be paid from collective bond payments, so that the costs are

automatically spread out.5.1.2.Legal Character of Equity

Common Stock: Equity has not the right to payment but (usually) the right to vote on certain important matters. Equity securities generally possess control rights in the form of the power to elect the board of directors. The charter contains the specifics of the firm’s equity securities.Residual Claims and Residual Control: Common stock holds the residual claim on the corporation’s assets and income. After the company has paid its expenses and paid interest to creditors, whatever is left is available for the payment of dividends.

Preferred Stock: An equity security on which the corporate charter confers a special right, privilege, or limitation. Like debt because they carry a stated dividend (like interest rate obligation, but payable only when declared

by board); typically has preference over common stock in liquidation and dividends; does not carry voting rights (control) in ordinary circumstances.

Like equity because there is no fixed claim; it is junior in security to traditional debt; carries conditional voting rights.

5.2. BASIC CONCEPTS OF VALUATION

The four basic finance concepts that are important for understanding value are: Time value of money Risk and return Systematic risk and diversification Capital market efficiency5.2.1.The Time Value of Money Present value is the value today of money to be paid at some future point. The discount rate tells us how to

calculate present values. The discount rate is the rate that is earned from renting money out for one year in the market for money.FV = PV (1 + r)n

PV = FV / (1 + r)n

r = (FV / PV)1/n – 1where FV = future value; PV = present value; r = annual interest rate (or discount factor); n = number of years

Projects for which the present value of the amount invested is less than the present value of the amount received are positive net present value projects. Investing in such projects is a good idea for investors; if they play out as expected, they will pay out more than is needed to compensate for the time value of money. Their rate of return is higher than the market rate of return.

Interest is the money you are promised when you lend out money or the amount you have to pay if you borrow money.

5.2.2.Risk and Return The expected return is the sum of possible outcomes, weighted by the probability of each outcome occurring.

Expected return does not measure risk or uncertainty. While people are generally risk averse, they are sensitive to what the risk is; uncertainty as to two strong outcomes is preferable to certainty as to weak outcomes.

If the expected payoffs are the same, people will prefer the less-risky options. When expected payoffs differ, people’s risk-aversion is highly idiosyncratic.

The additional amount that risk-averse investors demand for accepting higher-risk investments in the capital markets is termed the risk premium. The risk premium does not compensate the investor for the possible out-of-pocket losses associated with the

probability than an investment might fail; instead, the risk premium is compensation for the intrinsic unpleasantness of volatile returns to the risk-averse investors who dominate market prices.

Risk can be valued by increasing the discount rate (r) by the risk premium.5.2.3.Diversification and Systematic Risk Investments can be combined to reduce risk. Investors are averse only to risks that they bear; thus, a risky investment held as part of a portfolio that includes

other equally risky investments is likely to be worth more to its owner than it would be if it were held alone. Since investors can hold diversified portfolios, risky investments should be priced to reflect the fact that

investors need not bear all the risk associated with holding a single investment. However, not every risk is diversifiable—there is always some level of market (systematic) risk that even the

most diversified investor must bear, and for which the risk-averse investor demands a premium. Most projects involve a combination of diversifiable and undiversifiable risk; the appropriate risk premium and

risk-adjusted discount rate depend only on the undiversifiable portion of the risk.5.3. VALUING ASSETS

5.3.1.The Discount Cash Flow (DCF) Approach Estimate all future cash flows generated by the asset, then calculate an appropriate discount rate – usually the

weighted average cost of capital (WACC).5.3.2.The Relevance of Prices in the Securities Market The efficient market hypothesis posits that the prices of securities reflect well-informed estimates, based on all

available information, of the discounted value of the expected future payouts of corporate stocks and bonds; that is, market prices aggregate the best estimates of the best-informed traders about the underlying present value of corporate assets. Prices in an informed market should thus be regarded as prima facie evidence of the true value of traded

shares. Whether the market price of a company’s shares also reflects the value of the entire company is a more complicated question.

6. THE PROTECTION OF CREDITORS Fundamentally, the problems of corporate creditors are no different from those of any other creditors, but corporate law

does not leave creditor protection solely to general law; it provides creditors with additional protections, even though it does not attempt to protect other classes of corporate stakeholders.

Apparently, lawmakers believe that the core corporate feature of limited liability greatly exacerbates the traditional problems of debtor-creditor relationships. Limited liability can have this effect in two ways: It opens opportunities for both express and tacit misrepresentation in transactions with voluntary creditors. It makes it possible and sometimes attractive to shift assets out of the corporation after a creditor has extended credit

to the corporation. These opportunistic moves would lose much of their appeal if shareholders did not have the shield of limited liability. Creditors can minimize the costs of such forms of opportunism by exercising vigilance and negotiating for contractual

protections, but these protections are costly and some forms of debtor opportunism are so blatant that no amount of contracting can offer protection from them.

Corporate law generally pursues three basic strategies in its limited efforts to protect creditors:1. Mandatory Disclosure Duty

SEC requirements2. Capital Regulation

Distribution constraints Minimum capital requirements* Capital maintenance requirements*

*More common in the EU3. Fiduciary Duty Constraints

Director liability Creditor liability: fraudulent conveyance Shareholder liability: Equitable subordination and piercing the corporate veil

6.1. MANDATORY DISCLOSURE

Insofar as debtor opportunism turns on misrepresentation, mandatory disclosure offers some promise of controlling it.

Federal securities law imposes extensive mandatory disclosure obligations on public corporations.

6.2. CAPITAL REGULATION

Terminology: Stated capital: a reserve for creditors and others who have claims against the firm that is generally not available

for distribution. Par value: amount of stated capital that corresponds to each share of stock outstanding.

Capital surplus: the difference between the initial sale price of the stock and the par value of the stock. Retained earnings: shareholder equity less stated capital and capital surplus.

Regulation of the capital committed to the corporation is a very direct means by which the legal system can attempt to protect against some of the risks that creditors face (but it dose not provide a strong protection under U.S. corporate law).6.2.1.Financial Statements Accounting is a standardized method for describing a firm’s past financial performance. The balance sheet represents the financial picture of a business organization as it stands on one particular day, in

contrast to the income statement, which presents the results of the operation of the business over a specified period.

The principal limitation of the entries on the balance sheet is that they typically reflect historical costs instead of current economic values. Book value may differ quite a bit from the current economic value of an asset. Assets include all of a business’s tangible property, intellectual property, goodwill, and outstanding legal

claims against third parties. Liabilities include all debts of the business payable to others. Shareholders’ equity represents the difference between the asset values and the liability values. This is the

amount of equity or the ownership stake that shareholders have in the business (the book value of the owners’ economic interests). It is comprised of stated capital, capital surplus, and retained earnings.

The income statement suffers limitations as well—its account of profit or loss does not reflect the actual amount of cash that a business throws off in the year.

6.2.2.Distribution Constraints New York Bus Corp. Law § 510 (capital surplus test): may only pay distributions out of surplus (§510(b)), and

distributions cannot render the company insolvent. NYBCL § 516(a)(4) allows board to transfer out of stated capital into surplus if authorized by shareholders.

DGCL § 170(a) (“nimble dividend” test): may pay dividends out of capital surplus + retained earnings, or net profits in current or preceding fiscal year (whichever is greater). DGCL § 244(a)(4) allows board to transfer out of stated capital into surplus for no par stock.

California Corporate Code § 500 (“modified retained earnings test”): may pay dividends either out of its retained earnings (§ 500(a)) or out of its assets (§500(b)(1)), as long as ratio of assets to liabilities remains at least 1.25, and capital assets ≥ capital liabilities (§500(b)(2)).

RMBCA § 6.40(c): may not pay dividends if you can’t pay debts as they come due (§ 6.40(c)(1)); or assets would be less than liabilities plus the preferential claims of preferred shareholders (§ 6.40(c)(2)), but board may meet the asset test using a “fair valuation or other method that is reasonable in the circumstances” (§ 6.40(d)).

6.2.3.Minimum Capital and Capital Maintenance Requirements Within the U.S., statutory minimum capital requirements are either truly minimal or entirely nonexistent (neither

the DCGL nor the RMBCA requires a minimum capital amount as a condition of incorporation). Minimum capital requirements cannot be an effective creditor protection because the requirement is fixed at the

date of organization of the corporation. Even if companies cannot dip into minimum capital to pay shareholders, normal business activity can easily dissipate a company’s capital. For this reason, jurisdictions in the EU have traditionally adopted capital maintenance rules in conjunction

with minimum capital rules. The capital maintenance rules accelerate the point at which failing corporations must file for insolvency.

6.3. STANDARD-BASED DUTIES

6.3.1.Director Liability Under certain circumstances, directors owe an obligation to creditors not to render the firm unable to meet its

obligations to creditors by making distributions to shareholders (failure here can lead to personal liability for directors).

These obligations are chiefly established by the Uniform Fraudulent Transfers Act §4:(a) A transfer made . . . by a debtor is fraudulent as to a creditor, whether the creditor’s claim arose before or after the transfer was made . . . if the debtor made the transfer . . .

(1) with actual intent to hinder, delay, or defraud any creditor of the debtor; or(2) without receiving a reasonably equivalent value in exchange for the transfer. . . and the debtor:

(i) was engaged or about to engage in a business transaction for which the remaining assets of the debtor were unreasonably small. . . or

(ii) intended to incur. . . or reasonably should have believed that he [or she] would incur debts beyond his [or her] ability to pay as they came due. . .

Credit Lyonnais Bank Nederlands (p. 141) In managing the business affairs of a solvent corporation in the vicinity of insolvency, circumstances may

arise when the right (both the efficient and the fair) course to follow for the corporation may diverge from the choice that the shareholders (or the creditors, or the employees, or any single group interested in the corporation) would make if given the opportunity to act.

North American Catholic Educational Programming Foundation, Inc. v. Gheewalla (p. 143) Held: Creditors could not assert a direct claim but did have standing to assert a derivative claim against an

insolvent corporation. Reasoning: Recognizing that directors of an insolvent corporation owe direct fiduciary duties to creditors

would create uncertainty for directors. Directors of insolvent corporations must retain the freedom to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation.

6.3.2.Creditor Protection: Fraudulent Transfers Fraudulent conveyance law imposes an effective obligation on parties contracting with an insolvent—or soon to

be insolvent—debtor to give fair value for the cash or benefits they receive, or risk being forced to return those benefits to the debtor’s estate.

The statue provides a means to void any transfer made for the purpose of delaying, hindering, or defrauding creditors.

Creditors may attack a transfer on two grounds: Present or future creditors may void transfers made with the actual intent to hinder, delay, or defraud any

creditor of the debtor. Creditors may void transfers made without receiving a reasonably equivalent value if the debtor is left with

remaining assets . . . unreasonably small in relation to its business or the debtor intended . . . believed . . . or reasonably should have believed he would incur debts beyond his ability to pay as they became due or the debtor is insolvent after the transfer.

Fraudulent transfer doctrine permits creditors to void transfers by establishing that they were either actual or constructive frauds on creditors.

6.3.3.Shareholder Liability Shareholders may either find themselves liable to corporate creditors, or have any “loans” they have made to the

company subordinated to other creditors under the doctrines of equitable subordination and corporate veil piercing.6.3.3.1.Equitable Subordination Courts of equity invoke the equitable subordination doctrine when they feel compelled, by considerations of

equity, to recharacterize debt owed by the company to its controlling shareholders as equity. Equitable subordination is a means of protecting unaffiliated creditors by giving them rights to corporate

assets superior to those of other creditors who happen to also be significant shareholders of the firm. The requirements are that (1) the creditor be an equity holder and typically an officer of the company and (2)

the insider-creditor must have, in some fashion, behaved unfairly or wrongly toward the corporation and its outside creditors.Costello v. Fazio (p. 145) Facts: The partnership began to encounter difficulties. Two partners converted capital (nominally) into

notes during corporation formation. They nevertheless retained control. The notes earned no interest and were recallable on demand.

Held: The “notes” held by former partners will be treated as the least senior debt. Reasoning: “[C]laims of controlling shareholders will be deferred or subordinated to outside creditors

where a corporation in bankruptcy has not been adequately or honestly capitalized, or has been managed to the prejudice of creditors, or where to do otherwise would be unfair to creditors.”

Most creditor rights that really matter are contractual ones; weak rules exist because efficient and effective creditors contract around them and weak creditors don’t lobby.

6.3.3.2.Piercing the Corporate Veil Veil piercing refers to the equitable power of the court to set aside the entity status of the corporation to hold

its shareholders liable directly on contract or tort obligations. Tests go under various names: “agency test;” “instrumentality of the individual”; “alter ego of the

individual;” etc. Generally consist of two components:

Evidence of “lack of separateness,” e.g., shareholder domination, thin capitalization, no formalities/co-mingling of assets (“Tinkerbell test” – to be protected, shareholder must believe in the separation)

Unfair or inequitable conduct – this is the wildcard in veil-piercing cases. Probably no piercing: against public corporation; against passive shareholders; minority shareholders; if all

formalities are observed and nothing “funny” with the accounts.

Formulations of the doctrine: Lowendahl test (NY): veil-piercing requires (1) complete shareholder domination of the corporation;

and (2) corporate wrongdoing that proximately causes creditor injury. Van Dorn test (7th Circuit – applied in Sea Land): (1) such unity of interest and ownership that the

separate personalities of the corporation and the individual [or other corporation] no longer exist; and (2) circumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice.

Laya test (applied in Kinney Shoe): (1) unity of interest and ownership such that the separate personalities of the corporation and the individual shareholder no longer exist; and (2) an inequitable result would occur if the acts were treated as those of the corporation alone. BUT: if both prongs satisfied, there is still a potential “third prong”—defendant might still prevail by showing assumption of risk.

Sea-land Services, Inc. v. The Pepper Source (p. 152) Facts: The Pepper Source contracted with Sea-Land to ship products and then failed to pay its freight bill.

Marchese is the sole shareholder of PS, as well as several other corporations. He ran them all out of the same office, using the same expense accounts, borrowing from them and lending to them interest-free. Sea-Land seeks to pierce the veil of Pepper Source and reverse pierce other corporations dominated by Marchese.

Held: Reverse grant of summary judgment by district court in favor of Sea-Land. Reasoning: Marchese utterly failed to adhere to corporate formalities; the court looks to whether failure

to pierce would sanction a fraud or (lower standard) promote injustice, but this standard is more than simply a creditor’s inability to collect. The vagueness of “promote injustice” seems to reflect our ambivalence regarding limited liability

itself. Why reverse pierce rather than take share ownership? Sea-Land wants to be on level footing with

other corporate creditors and superior to Marchese’s personal creditors (debt claim rather than equity claim).

Kinney Shoe Corp. v. Polan (p. 157) Facts: Polan owns Industrial and Polan Industries. Industrial (which has no assets) signs lease with

Kinney, then subleases to Polan Industrial. Held: The court rejects the district court’s application of a third prong regarding whether Kinney

assumed the risk of Industrial defaulting. Reasoning: The court looks to whether (1) separate personalities of corporation and shareholder no

longer exist and (2) an inequitable result would occur if the acts were treated as those of the corporation alone. Veil piercing unfairness usually is found when assets are shifted in ways that seem designed to defeat

liability—but may be less than fraud. If engaging with a large corporate creditor, you should discuss possible corporate veil piercing

openly; sophisticated creditors will require personal guarantees of small business owners. Summary of Veil Piercing Cases:

District Court Circuit CourtSea-Land Services Pierce – Van Dorn test satisfied Don’t Pierce – Remanded for factual

inquiry on second prongKinney Shoe Don’t Pierce – Assumption of risk under

third prong of LayaPierce – Third prong not applicable here

6.4. VEIL PIERCING ON BEHALF OF INVOLUNTARY CREDITORS

Walkovszky v. Carlton (p. 161) Facts: Each corporation has two cabs, no assets, and minimum insurance. Walkovszky was struck by a cab owned

by Seon Corp (driven by Marchese), and seeks to hold Carlton (stockholder of ten of these cab corporations) personally liable. Walkovszky wants Carlton held personally liable because the cars are heavily mortgaged and the insurance policies are car-specific.

Held: Court of Appeals dismisses the complaint with regard to Carlton for failure to state a claim, with leave to serve an amended complaint.

Reasoning: Fundamental problem for involuntary creditors – there is no lobby on their behalf. Substantive Consolidation

Substantive consolidation is an equitable remedy in bankruptcy that consolidates assets among corporate subsidiaries for the benefit of creditors of the various corporate subsidiaries; the corporate holding company structure is ignored for the purpose of distributing assets in bankruptcy.

This can be problematic because if bankruptcy courts regularly collapse entities in an exercise of their equitable powers, the corporate form will lose its utility as a device for “asset partitioning” and risk allocation.

Countervailing considerations of ex post fairness run strong and deep in bankruptcy proceedings. Dissolution and Successor Liability

Many small firms undertaking dangerous activities are not only thinly capitalized but also likely to dissolve and liquidate before the full extent of their potential tort liability becomes known.

Although shareholders can escape all liability through the simple act of dissolving the corporation and abandoning its assets, it may be more difficult to escape tort costs by selling the corporation’s assets due to the doctrine of successor liability. When assets have shifted to a new entity, but the corporation remains intact, we allow liability to follow the

corporation. Liability will follow if assets continue to look and be arranged as they were when they were in the original

organization. Upon dissolution, the rule in Delaware is that shareholders remain liable pro rata on their liquidating

dividend for three years (§§ 278 & 282). RMBCA §14.07 establishes the same rule as Delaware, provided the corporate publishes notice of its

dissolution. Many jurisdictions have the product line test – if the buyer continues to manufacture the same line of

products, it will be held liable; any sophisticated buyer will contract for tort indemnification or pay less if it purchases the business as a going concern.

The only way for shareholders to escape long-term liability through dissolution is to sacrifice the going-concern value of the business and keep only the piecemeal liquidation value.

7. NORMAL GOVERNANCE: THE VOTING SYSTEM7.1. THE ROLE AND LIMITS OF SHAREHOLDER VOTING

Very few public companies restrict the board’s managerial power in their charters. Instead, equity investors in public corporations rely largely on the default terms built into corporation law to control the agency costs of management.

The default powers of shareholders are: The right to vote on (1) the designation of the board, (2) certain fundamental corporate transactions (mergers,

sales of all assets, corporate dissolutions, charter amendments), and (3) shareholder resolutions; The power to sell their stock if they are disappointed with their company’s performance; and The right to sue their directors for breach of fiduciary duty in certain circumstance.

Basic Features of the Voting System: Registered shares: each share has a holder of record, which facilitates getting in touch with the ultimate

beneficial holder (unlike bearer system in France & Germany). Proxy system: if you can’t attend the annual shareholder meeting (ASM), you can still vote by finding a

representative (proxy) who goes to the meeting and votes on your behalf. State law mandatory rules: all state statutes except one require an annual meeting for election of directors;

quorum requirements. State law default rules: all state statutes permit special meetings and action by written consent, though default

varies. Collective action problem: any one shareholder’s prospective share of the potential benefit that informed action might

produce would probably not justify her personal costs, and any one shareholder’s vote is quite unlikely to affect the outcome of the vote. Thus, a shareholder is likely to get the same proportionate share of any benefit, without regard to whether she invests in becoming informed and voting intelligently.

The greater a shareholder’s stake is, the less she suffers from this problem of ‘rational apathy.’ Growing institutional portfolios, cheaper costs of communication between institutions, and the evolution of new

agents of shareholder organization have created ownership and coordination structures that fall between the extreme cases where collective action costs are nonexistent (because the corporate has a controlling shareholder) or preclusive (because stockholding is highly diffuse).

Thus, the regulation of shareholder voting and proxy solicitation really does matter for the typical public corporation today.

7.2. ELECTING AND REMOVING DIRECTORS

7.2.1.Electing Directors Every corporation must have a board of directors and every corporation must have at least one class of voting

stock. Common stock carries voting rights because common shareholders have a greater need for the default protection

of voting rights than other investors in the enterprise. Another mandatory feature of the voting system is the annual election of directors, but a corporation’s actual

notice period, quorum requirement, and record date will be established by the charter or in a bylaw.7.2.2.Removing Directors At common law, shareholders could remove a directors only “for cause.”

Campbell v. Loews Inc. (p. 173)

Establishes that a director is entitled to certain due process rights when he or she is removed for cause, but it is unclear what constitutes “good cause.”

DGCL §141(k): Any director or the entire board of directors may be removed, with or without cause, by the holders of a majority of the shares . . . , except as follows:(1) Unless the certificate of incorporation otherwise provides, in the case of a corporation whose board is classified . . . shareholders may effect such removal only for cause; or(2) In the case of a corporation having cumulative voting, if less than the entire board is to be removed, no director may be removed without cause if the votes cast against such director’s removal would be sufficient to elect such director if then cumulatively voted at an election of the entire board of directors . . . .

Cumulative Voting: each shareholder gets votes equal to number of shares owned times number of seats to be filled. The directors with the most votes get the seats. Example: Family Corp. has 300 shares outstanding; A owns 199 shares and B owns 101 shares. Family Corp.

has a three-person board elected to annual terms. Straight Voting: A would win each seat 199 to 101. Cumulative Voting: B casts 303 shares all for one candidate => guaranteed to get one seat on the board,

because A’s 597 votes cannot be divided three ways so that all three are greater than 303. Implication: Cumulative voting system improves likelihood of minority representation on the board.

Staggered Boards A staggered makes it more difficult for a shareholder to gain control of the board of directors.

A shareholder may have ways to disassemble a staggered board by packing the board with new directors or remove directors without cause and replace them with new directors

The difference between unitary and staggered boards becomes most relevant in the context of a hostile takeover bid. The invention of the “poison pill” made control of the board a prerequisite for acquiring a company’s shares; a staggered board makes board control more difficult.

DGCL §242(b)(1): (b) Every amendment [to the certificate of incorporation} shall be made and effected in the following manner: (1) If the corporation has capital stock, its board of directors shall adopt a resolution setting forth the amendment proposed, declaring its advisability, and either calling a special meeting of the stockholders entitled to vote . . . or directing that the amendment proposed be considered at the next annual meeting of the stockholders.

DGCL §109(a): After a corporation has received any payment for any of its stock, the power to adopt, amend or repeal bylaws shall be in the stockholders entitled to vote . . . provided, however, any corporation may, in its certificate of incorporation, confer the power to adopt, amend or repeal bylaws upon the directors . . . . The fact that such power has been so conferred upon the directors . . . shall not divest the stockholders or members of the power, nor limit their power to adopt, amend or repeal bylaws.

DGCL §223(a): Unless otherwise provided in the certificate of incorporation or bylaws: (1) Vacancies and newly created directorships resulting from any increase in the authorized number of directors elected by all of the stockholders having the right to vote as a single class may be filled by a majority of the directors then in office . . . .

Takeover: a shareholder attempts to gain voting control of the board so he can replace the board who will then appoint new management. Example (p. 174): The CEO, a 25% shareholder, has the board recommend and shareholders approve an

amendment to the articles of incorporation vesting the power to amend the bylaws solely in the board and to provide for cumulative voting. The directors then amend the bylaws to provide that the number of directors shall be fixed at nine and divided into three equal classes. Later, a takeover artists accumulates 51% of the shares. By simply voting out directors, it will take the TA 3 years to gain control of the board. In the interim, the

TA risks enormous conflicts with management. The TA will not be able to simply fire board members without cause in Delaware. The TA will not be able to amend the articles of incorporation because she needs the board to propose

the amendment. The TA will be able to amend the bylaws – under DGCL §109(a), shareholders always have power to

amend the bylaws. She should pack the board of directors and eliminate the staggered board. If she’s willing to fire

everyone, she can do so. Cumulative voting is only a problem if she wants to retain some board members – in the case of a

corporation having cumulative voting, if less than the entire board is to be removed, no director may be removed without cause if the votes cast against such director’s removal would be sufficient to elect such director if then cumulatively voted at an election of the entire board of directors.

If the classification requirement was put in the articles of incorporation, the TA would be hamstringed. Takeovers are advantageous because of high acquiror valuation and their usefulness in disciplining

managers, but disadvantageous in that they distort capital and acquirors often overpay.7.3. SHAREHOLDER MEETINGS AND ALTERNATIVES

Shareholders may vote to adopt, amend, and repeal bylaws; to remove directors; and to adopt shareholder resolutions that may ratify board actions or request the board to take certain actions.

Special Meetings: DGCL § 211(d) allows board to call a special meeting. RMBCA § 7.02 allows board or 10% of shareholders to call a special meeting.

Action by written consent: DGCL § 228 provides that any action that may be taken at a meeting of shareholders may also be taken through written consent of holders of the number of voting shares required to approve that action at a meeting attended by all shareholders. RMBCA § 7.04(a) requires unanimous written consent.

7.4. PROXY VOTING AND ITS COSTS

Shareholder meetings require a quorum to act. To gather a quorum, the board and its officers are permitted to collect voting authority from shareholders in the form of proxies.

While proxy voting allows public shareholders to “meet,” it does not remedy their collective action problem. Proxy voting relies on one or more persons to incur the initial (and substantial) expenses of soliciting proxies.

On one hand, the costs of soliciting proxies are a matter of normal governance because subsidizing these costs from the corporate treasury is essential for the operation of annual shareholder meetings. On the other hand, authorizing the board to expend corporate funds on its own re-election seems to permit a kind of self-dealing.

This raises the question whether the law ought to encourage insurgent shareholders to solicit proxies by reimbursing their reasonable expenses as well. Under current law, such expenses are not reimbursed unless the insurgents are successful.

Reimbursement rules can differ on at least three dimensions: Amount: reimburse all, part, or nothing? Conditionality: do you need to win to be reimbursed? Bias: favor incumbents, insurgents, or neither?

Recent Developments: New eProxy Rules (Rule 14a-16): Incumbents and insurgents can file proxy materials on a website, substantially

reducing proxy solicitation costs. Shareholder proxy access makes contested director elections more likely: Under an SEC rule adopted last August,

a 3% shareholder (or shareholder group) can place nominees on the company’s proxy statement. New rule on broker voting gives activists more influence in director elections: July 2009 SEC rule prevents

brokers from voting discretionary shares in uncontested director elections, which gives more power to institutional investors.

Two ways to vote in elections in Delaware corporations: ####Rosenfeld v. Fairchild Engine & Airplane Corp. (p. 179) Facts: Classic derivative suit – brought by attorney who owns 25 shares, attempting to force both sides in proxy

contest to reimburse corporation for their proxy expenses. Incumbents spent $106K, for which they reimbursed themselves from the corporate treasury, and another $28K for which they were never able to reimburse themselves. Insurgents generously reimburse incumbents for the additional $28K. Insurgents spent $127K, for which they reimbursed themselves after shareholder resolution authorizing reimbursement. (Shareholders apparently never asked to ratify insurgent generosity to the old board.)

Holding: Full reimbursement permissible; incumbents always get reimbursed for reasonable expenses attributable to issues of principle or policy and insurgents may be reimbursed if they get a shareholder resolution authorizing the reimbursement.

Reasoning: We always reimburse incumbents because we don’t want them to be too timid; we don’t always reimburse incumbents because it might encourage frivolous suits. When dissidents triumph, shareholders have decided that their expenses were made in a good-faith effort to

advance a corporate interest, but without shareholder ratification, reimbursements to successful dissidents might be attacked as self-dealing.

Developments in Proxy Solicitation in Delaware: Plurality voting: candidate with the most votes wins, even if the candidate doesn’t get a majority Majority voting: candidate must receive a majority of votes to be seated, so a candidate in an uncontested election

can still lose The moral authority is what matters most in a “Just Say No” campaign.

7.5. CLASS VOTING

To the extent the interests of classes of shareholders diverge, the minority needs structural protection against exploitation by the majority; this protection is offered by the class voting requirement. Usually classes are used to separate cash flow rights from control.

A transaction that is subject to class voting simply means that a majority (or such higher proportion as may be fixed) of the votes in every class that is entitled to a separate class vote must approve the transaction for its authorization.

Conferring class votes gives each class a veto right; such rights can themselves be used opportunistically.7.6. SHAREHOLDER INFORMATION RIGHTS

State corporate law in the United States leaves the function of informing shareholders largely to the market. By contrast, federal securities law and the rules promulgated by the SEC mandate extensive disclosure for publicly traded securities.

At common law, shareholders were recognized to have a right to inspect the company’s books and records for a proper purpose.

The stock list discloses the identity, ownership interest, and address of each registered owner of company stock. An inspection of books and record may jeopardize proprietary or competitively sensitive information. Approaches to shareholder access:

Delaware approach: for books & records, burden is on shareholder to show proper purpose; for shareholder list, burden is on corporation to show improper purpose (DGCL § 220(c)).

Specifically enumerated documents (RMBCA): shareholder list, excerpts from board minutes, shareholder meeting minutes, and accounting records if shareholder shows “proper purpose” (RMBCA § 16.02, § 16.01(e))

Hybrid approach (New York): statutory right to inspect key financial statements, stock list, and shareholder meeting minutes if proper purpose (§ 624(a)-(e)); and “catch-all” under § 624(f) for books & records.

7.7. TECHNIQUES FOR SEPARATING CONTROL FROM CASH FLOW RIGHTS

It is ordinarily good policy to award voting rights to the investors who claim the corporation’s residual returns. In this way, managers are selected by the corporate constituency with the strongest interest in maximizing corporate value.

Nevertheless, the law’s policy of aligning control with residual returns is sometimes frustrated, which can lead to inefficiencies and improper incentives.7.7.1.Circular Control Structures DGCL §160(c): a corporation may not vote its own shares, directly or indirectly

“Shares of its own capital stock belonging to the corporation or to another corporation, if a majority of the shares entitled to vote in the election of directors of such other corporation is held, directly or indirectly, by the corporation, shall neither be entitled to vote nor be counted for quorum purposes.”

Speiser v. Baker (p. 186) Facts: Health Chem has 4 shareholders – public, Speiser, Baker, and Health Med. Health Med is controlled by

Speiser and Baker. Health Chem, through Medallion, holds the remaining 9% of Health Med, but its stock can be converted to hold 95% of the vote.

Holding: Health Chem does not have a majority of shares entitled to vote, but a majority of voting shares do “belong to” Health Chem, at least under these circumstances, even though it doesn’t legally hold a majority of voting rights or functionally control Health Med.

Circular ownership creates issues regarding deceptive or misleading structures and agency conflicts.7.7.2.Vote Buying At common law, vote buying was impermissible; votes and share ownership must go hand-in-hand.

Attaching the vote firmly to the residual equity interest ensures that an unnecessary agency cost will not come into being. Separation of shares from votes introduces a disproportion between expenditure and reward.

Schreiber v. Carney (p. 193) Facts: Jet Capital Corp. had effective veto power of Texas International, which would like to merge with Texas

Air. The merger would result in negative tax consequences for JCC. JCC demands a loan to enable it to exercise warrants (which are similar to stock options) in exchange for not vetoing the merger. Independent directors and counsel for Texas International determine that the loan makes sense and Texas International’s shareholders voted to ratify the loan decision.

Holding: While this was vote-buying, it is not void because the purpose of the vote-buying was not fraud or disenfranchisement, but was in the interest of shareholders and was ratified by the shareholders.

Empty voting: when someone holds voting rights, but has no financial stake in the share Examples: Buying X # of shares and shorting X # of shares; buying shares at Y price and committing to sell

them at a later date at Y price. This can be hugely problematic competitors or those who have insurance on the company’s debt (fire

insurance) have incentive to destroy the company and can lead the company to ruin through empty voting.7.7.3.Controlling Minority Structures Dual class share structures, stock pyramids, and cross-ownership ties permit a shareholder to control a firm while

holding only a fraction of its equity. Each of the three basic controlling minority structure forms firmly entrench minority control. The controlling

minority structure (CMS) form can be used in principle to separate cash flow rights from control rights. The most straightforward CMS form is a single firm that has issued two or more classes of stock with

differential voting rights. Modern rule: You can use dual-class structures if, and only if, the structure is introduced at the IPO.

The most popular structure for erecting CMS structures worldwide is the corporate pyramid structure, in which a controlling minority shareholder holds a controlling stake in an operating company that, in turn, holds a controlling stake in an operating company.

Cross-holding structures differ from pyramids chiefly in that the voting rights used to control the corporate group are distributed over the entire group rather than concentrated in the hands of a single company or shareholder. Cross-ownership permits a controller to exercise complete control over a corporation with an arbitrarily small claim on its cash flow rights. Cross-holdings have the advantage of making the locus of control over a company group less transparent.

Neither pyramids nor cross-ownership are popular in the U.S. because the U.S. imposes a significant tax penalty on moving corporate distributions through two or more levels of corporate structure.

7.8. THE COLLECTIVE ACTION PROBLEM

Even a one-share, one-vote rule cannot protect shareholders who habitually approve management proposals. Shareholder passivity aggravates agency problems between shareholder and managers.

Easterbrook & Fischel, Voting in Corporate Law: Because voting is expensive, the participants in the venture will arrange to conserve on its use. When many are entitled to vote, none of the voters expects his votes to decide the contest. Consequently none of

the voters has the appropriate incentive at the margin to study the firm’s affairs and vote intelligently. Those who have more shares, such as investment companies, pension trusts, and some insiders, do not face the

collective action problem to the same extent. Nonetheless, no shareholder, no matter how large his stake, has the right incentives at the margin unless that stake is 100 percent.

We expect voting to serve its principal role in permitting those who have aggregated equity claims to exercise control. Short of aggregating, however, some sort of collective information-generating agency is necessary. In a firm, the managers serve this function, and consequently, it is unlikely that voters would think themselves able to decide issues for themselves with greater insight than the managers do. No wonder voters delegate extensively to managers and almost always endorse their decisions.

Take-home: The solution to the collective action problem is to allow larger investors; current proxy rules are not ideal because professional investors don’t need information dumbed down and smaller investors won’t use the information they are given, dumbed down or not.

Black, Next Steps in Proxy Reform: A shareholder who owns a large percentage stake in a company will do more monitoring than a shareholder who

owns a small stake, but legal rules keep financial institutions smaller than they would otherwise be. Rules that encourage shareholder oversight of corporate managers are few and weak. In a different legal environment, financial intermediaries could monitor the actions of corporate managers. If legal

restrictions were loosened, the percentage stakes held by the largest institutions would likely grow, and monitoring incentives would be correspondingly stronger.

Take-home: We don’t have large shareholders because we have constructed barriers to large shareholding, and this has negative consequences for shareholder monitoring. Morley is skeptical:

Mutual funds have never been active We have these restrictions because there were very serious conflicts of interest We don’t want Wall Street controlling America Banks need very low-risk investments

Pozen, Institutional Investors: The Reluctant Activists: For most institutions, the approach to shareholder activism is straightforward: to decide whether and when to

become active, an institutional investor compares the expected costs of a course of action with the expected benefits.

Most fees for money managers are set on the assumption that institutional investors will usually function as passive money managers rather than as activists. The fees do not cover heavy intervention on the part of the money manger. In contrast, advisory fees for a venture capital fund are typically much higher, based on the assumption that venture fund managers will be actively involved with most of their portfolio companies.

Take-home: Money managers get paid a portion of assets under management; outside venture capital funds, the portion is not large enough to incentivize activism.

Kahan & Rock, Hedge Funds in Corporate Governance and Corporate Control: Hedge funds are emerging as the most dynamic and most prominent shareholder activists. This generates the

possibility that hedge funds will help overcome the classic agency problem of publicly held corporations by dislodging underperforming managers, challenging ineffective strategies, and making sure that merger and control transactions make sense for shareholders.

Twenty years ago, similar stories were told about “institutional investors”—mutual funds, pension funds, and insurance companies. While, on the whole, the rise of these traditional institutional investors has probably been beneficial, they have hardly proven to be a silver bullet.

The incentives for hedge funds to monitor portfolio companies differ in several important respects from those of traditional institutional investors. Hedge fund managers are highly incentivized to maximize the returns to fund investors. The fee structure

gives hedge fund managers a very significant stake in the financial success of the fund’s investments.

Many hedge funds strive to achieve high absolute returns, rather than returns relative to a benchmark, so hedge funds benefit directly and substantially from achieving high absolute returns.

Take-home: Is this good? Conflict of interest and empty voting are concerns.7.9. THE FEDERAL PROXY RULES

The federal proxy rules consist of four major elements:1. Disclosure requirements and a mandatory vetting regime that permit the SEC to assure the disclosure of relevant

information and to protect shareholders from misleading communications;2. Substantive regulation of the process of soliciting proxies from shareholders;3. A specialized “town meeting” provision (Rule 14a-8) that permits shareholders to gain access to the corporation’s

proxy materials and to thus gain a low-cost way to promote certain kinds of shareholder resolutions; and4. A general antifraud provision (Rule 14a-9) that allows courts to imply a private shareholder remedy for false or

misleading proxy materials. The rules are mandatory, incredibly complicated, and detailed. Because there is no competition (unlike with state

laws), it’s more difficult for corporations to vote with their feet. Lobbying is also a problem managers are far better organized than shareholders. Sarbanes-Oxley is a disaster, but it served a political need.

Securities Act of 1933 (“33 Act”): deals with disclosure procedures that companies must follow when they sell securities on the public markets for the first time. Says companies must “register” with the SEC.

Securities Exchange Act of 1934 (“34 Act”): establishes (among other things) disclosure requirements for corporations after they have sold securities on the public markets for the first time. All public companies are subject to proxy regulation under § 14(a) of the 34 Act.

Regulation 14A (Rules 14a-1 through 14a-12): substantive regulation of the process of soliciting proxies and communication among shareholders. The goal of proxy rules is to provide clear information so shareholders can make informed decision. However,

more regulation makes it less likely that people will solicit proxies because of the associated expense. Whether the proxy rules or other legal barriers impede collective action by shareholders depend not only on the

rules themselves but the identify of the shareholders; large, passive institutions might well be deterred by the prospect of a lawsuit when scrappy value investors, hedge funds, and other activist shareholders are not.

Securities laws online: http://taft.law.uc.edu/CCL/xyz/ sldtoc.html 7.9.1.Rules 14a-1 Through 14a-7: Disclosure and Shareholder Communication 14a-1: Defines “solicitation” and other key terms.

“Solicitation” includes any request for a proxy (this has been very broadly interpreted by the SEC). Solicitation does not include statements by a shareholder that simply indicate how the shareholder will vote.

14a-2: Defines which “solicitations” trigger the proxy rules. The following are wholly or partially exempted: Solicitations in which the solicitor does not seek proxy authority. Newspaper ads which do no more than state the issue and describe how a full proxy statement may be

obtained. Less than 10 persons are solicited. Attempts to form a group for purposes of a majority election proposal under the new 14a-11.

14a-3: Contains the central requirements about the kinds of information that must be furnished to shareholders by anyone soliciting a proxy, including: A proxy statement conforming to Schedule 14A and disclosing information about the solicitor’s identity,

securities holdings, purposes and other matters; If the solicitor is the company itself (i.e., the “registrant”)

Recent balance sheets and income statements Description of the registrant’s business Names and biographical information about members of the board of directors

14a-4 to 14a-7: Technical requirements for drafting and mailing of proxy statements. 14a-12: Allows solicitations prior to the furnishing of a proxy statement if the solicitor later provides a full proxy

statement to each person solicited. 14a-13 to 14a-18: Various technical requirements7.9.2.Rule 14a-8: Shareholder Proposals 14a-8: Authorizes shareholders to place their own proposals on a registrant’s proxy, subject to elaborate

restrictions that allow a board to exclude proposals. In order to be eligible to submit a proposal, a shareholder must have held at least $2,000 in market value or

1% of a corporation’s securities for one year. Shareholders may only submit one proposal per annual meeting and it may not exceed 500 words. Companies may exclude the proposals on the following grounds:1) The proposal is not a proper subject for action by shareholders under state law2) The proposal would cause the company to violate any law3) The proposal violates the proxy rules4) The proposal relates to a personal grievance or other interest not shared by the shareholders at large

5) The proposal relates to operations which account for less than 5% of the company’s total assets and gross sales6) The company lacks the power or authority to implement the proposal7) The proposal deals with a matter relating to the company’s ordinary business operations8) The proposal seeks to oppose or nominate individual candidates for a particular director election or otherwise to influence the outcome of a particular director election9) The proposal conflicts with the company’s own proposals10) The proposal has already been substantially implemented by the company13) The proposal relates to a specific amount of a dividend

From the perspective of a shareholder, this has the advantage of low costs; from the perspective of corporate management, this is at best a costly annoyance and at worst an infringement on management’s autonomy.

Most Rule 14a-8 shareholder proposals fall into one of two categories: corporate governance or corporate social responsibility. Corporate governance matters address issues ranging from executive compensation to “internal” corporate

governance proposals such as the separation of the chairman and CEO roles to “external” corporate governance proposals such as dismantling poison pill or staggered board takeover defenses. These proposals, which are often brought by labor unions or institutional investors, are now common

and frequently win significant shareholder votes. An important governance question today is the extent of the shareholders’ ability to enact bylaws that limit

the range of options open to the board in managing the firm. The SEC will not mandate access to the company’s proxy statement if the matter on which shareholder

action is sought is not a proper subject of shareholder action under state law.Carpenters’ Pension Fund Proposal and Supporting Statement (p. 214)

Facts: On October 7, 2005, the Carpenters’ Union Pension Fund asks HP to include in its proxy statement for its upcoming annual meeting a proposal to require nominees for the board of directors to receive a majority of the vote cast in order to be elected or re-elected to the board. On November 2, 2005, HP counters (through its board, which is how it must act – no CEO action here) by adopting a new policy requiring a director who was elected with less than a majority of the vote to tender his resignation to the board. HP seeks a no-action letter from the SEC authorizing HP to exclude the Carpenters’ proposal from the proxy.

Held: The SEC denied HP’s request for a no-action letter Reasoning: What the Carpenters proposed and what HP adopted were fundamentally different things.

Rule 14a-11, The Shareholder Proxy Access Rule 14a-11: Allows shareholders to include director nominees on the registrant’s proxy statement.

(b) A shareholder nominee shall be included in a registrant’s proxy statement if the following conditions are satisfied: 1) The nominating shareholder individually or with a group of other shareholders holds at least 3% of the total voting power of the corporation;2) The nominating shareholder or group has held 3% for at least three years and will hold 3% through the date of the election;7) The nominating shareholder or group files a statement regarding their intent with respect to continued ownership of the registrant’s securities after the election;8) The nominating shareholder or group is not holding any of the registrant’s securities with the purpose or effect of changing control of the registrant(d) Registrants only have to include a total of one nominee or a number of nominees equal to 25% of the board, whichever is greater. If one director or 25% of the board has already been elected under this rule and has terms that will extend past the upcoming election, the company does not have to include any nominees in the present election.

CA v. AFSCME (p. 220) Facts: CA submits a 14a-8 proposal to amend the bylaws to reimburse shareholder for “reasonable expenses”

incurred in the successful election of its candidates to less than 50% of the board. CA seeks a no-action letter from the SEC to exclude the proposal.

Issues: (1) Is the AFSCME proposal a proper subject for action by shareholders under Delaware law? (2) Would the proposal, if adopted, cause CA to violate any Delaware law?

Held: (1) Yes (2) Yes – its fiduciary duty DGCL §109(b): “The bylaws may contain any provision, not inconsistent with law or with the certificate

of incorporation, relating to the business of the corporation, the conduct of its affairs, and its right or powers of its stockholders, directors, officers, or employees.”

DGCL §141(a): “The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation.”

Corporate Social Responsibility Proposals (p. 225)

Under Rule 14-8a, companies may exclude shareholders’ proposals that deal with matters relating to a company’s ordinary business operations.

In 1991, the SEC agreed that Cracker Barrel could omit a proposal to prohibit employment discrimination on the basis of sexual orientation.

Generally speaking, federal law (SEC) is influenced by lobbyists. In corporate matters, the most powerful lobbyists are managers. States are accountable – through competition with other states – in a way that the SEC is not.

In 1997, the SEC reversed its holding in Cracker Barrel and its bright line rule against employment-related proposals and moved to a case-by-case analysis. This means that most proposals that survive 14a-8(7) are going to touch on significant policy issues, but

they must not attempt to micromanage the corporation (but because the proposals are limited to 500 words, almost none will minutely define requirements).

7.9.3.Rule 14a-9: The Antifraud Rule 14a-9: Gives shareholders the right to sue a person soliciting a proxy for false or misleading statements.

No solicitation subject to this regulation . . . shall be made by means of any proxy statement . . . containing any statement . . . which is false or misleading or omits any material fact necessary in order to make the statements therein not false or misleading . . . .

Private suits by investors alleging injury as a result of a violation of the federal securities laws have emerged as an important device for enforcing these laws.

The federal courts have implied private rights of action under the securities acts. The elements include: Materiality: a misrepresentation or omission can trigger liability only if “there is a substantial likelihood that

a reasonable shareholder would consider it important in deciding how to vote.” Culpability: Second & Third Circuits (Delaware) have adopted a negligence standards; the Sixth Circuit has

required proof of intentionality or extreme recklessness. Causation and Reliance: a plaintiff need not prove actual reliance on a misrepresentation; causation is

presumed if a misrepresentation is material and the proxy solicitation “was an essential link in the accomplishment of the transaction.”

Remedies: Courts might award injunctive relief, rescission, or monetary damages.Virginia Bankshares, Inc. v Sandberg (p. 230)

Facts: “Freeze-out” merger of Bank into VBI (the buying company gained a majority of shares and minority shareholders were forced to accept cash for their shares; their votes are so small they have no hope of preventing the merger). Public shareholders get $42 per share cash, on recommendation of outside banker. Even though it didn’t need to under Virginia law, VBI solicited proxies from shareholders. The solicitation included statements that the board believes $42 is “high” and “fair” price. Dissenting shareholder brings suit claiming violation of 14a-9; jury awards $18 more per share; 4th Circuit affirms.

Held: Statements of “reasons, opinions or belief” may be material, if there is information that shows that what the director reasons, opines, or believes is false (and the director knows or suspects this). However, because the corporation wasn’t required to solicit proxies and had sufficient votes without the minority shareholders, the court held the plaintiff couldn’t show damages. The plaintiff argues that (1) the majority shareholders might not have been willing to vote for an openly

unfair plan, even if it advantaged them and (2) the misleading statement may have barred them from a state remedy.

Court’s response: (1) too speculative (2) state claim does not necessarily appear to be barred. Justice Kennedy, in dissent, appears to be trying to substitute some federal standard of fairness.

Lessons learned: Don’t make evaluative statements (“high” or “fair) and don’t solicit unneeded proxies; it’s better to give minority shareholders no information rather than potentially misleading information. However, Delaware now imposes a fiduciary duty when directors communicate with shareholders even if

proxy solicitations are not allowed.7.10. STATE DISCLOSURE LAW: FIDUCIARY DUTY OF CANDOR

State law has traditionally done little to regulate proxy solicitation by management. A plaintiff could always charge the common law tort of fraud if she could prove all of its difficult elements—a knowingly false statement of a material fact, relied upon, with the effect of causing injury.

In the twentieth century, there have been two major themes in this area: (1) the gradual disappearance of substantive regulation and (2) the growing importance of fiduciary duties.

Until recently, most of the Delaware cases minimized potential conflict between state corporate law and the massive body of federal regulatory and judicial law governing corporate disclosure by crafting the state law duty of candor to look like the federal law and by limiting the fiduciary duty of candor to circumstances in which a corporation asked shareholders to take action of some sort. The state law was concerned with the governance of the corporation, not with disclosures to the market (which is

the subject of the federal securities laws). Malone v. Brincat (p. 237)

Facts: The directors made false filing with the SEC and distributed false financial statements to shareholders, which allegedly caused the complete ruin of the company.

Holding: The Delaware Supreme Court affirmed dismissal of the complain in deference to SEC, but stated a view of the merits that permitted the plaintiffs to replead. The Delaware Supreme Court stated: “Whenever directors communicate publicly or directly with shareholders about the corporation’s affairs, with or without request for shareholder actions directors have a fiduciary duty . . . to exercise care, good faith, and loyalty . . . . The sine qua non of director’s fiduciary duty is honesty.

Reasoning: Since these shareholders did not sell their shares, the Delaware court stated they would not be protected by SEC Rule 10b-5.

8. NORMAL GOVERNANCE: THE DUTY OF CARE8.1. INTRODUCTION TO THE DUTY OF CARE

The duty of care reaches every aspect of an officer’s or director’s conduct, since it requires these parties to act with “the care of an ordinarily prudent person in the same or similar circumstances”

Despite its sweeping scope, the duty of care is litigated much less than the duty of loyalty, primarily because the law insulates officers and directors from liability based on negligence in order to avoid inducing risk-averse management.

8.2. THE DUTY OF CARE AND THE NEED TO MITIGATE DIRECTOR RISK AVERSION

ALI §4.01(a): A director or officer has a duty to the corporation to perform the director’s or officer’s functions:(1) in good faith,(2) in a manner that he or she reasonably believes to be in the best interests of the corporation, and(3) with the care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances.

Corporate directors and officers invest other people’s money. They bear the full costs of any personal liability, but they receive only a small fraction of the gains from a risky decision. Liability under a negligence standard therefore would predictably discourage officers and directors from undertaking valuable but risky projects.Gagliardi v. Trifoods International, Inc. (p. 241) Held: The business judgment rule in effect provides that where a director is independent and disinterested, there

can be no liability for corporate loss, unless the facts are such that no reasonable person could possibly authorize such a transaction if he or she were attempting in good faith to meet their duty.

Reasoning: We don’t want managers to be overly risk adverse, because investors can diversify away idiosyncratic risk. Although the business judgment rule eliminated the downside risk of liability, managers bear other downside risks, like being removed from office. Without the business judgment rule, the manager would bear all the downside risks of loss, but only a fraction of the upside benefits. One problem with our banking system is that liability is flipped; bankers have upside incentives, but little or

no downside risk. The business judgment rule is a common law rule and creates a presumption that the duty of care has been

satisfied; proof of failure to satisfy the duty of care merely removes the presumption against liability; it does not automatically void the decision or warrant damages.

The law protects corporate officers and directors from liability for breach of the duty of care in many ways. Statutory law authorizes corporations to indemnify the expenses incurred by officers or directors who are sued

by reason of their corporate activities. DGCL §145:

(a) A corporation shall have power to indemnify any person who was a party to any threatened, pending or completed suit, whether civil, criminal, administrative or investigative, by reason of the fact that the person was a director, officer, employee or agent of the corporation . . . against expenses (including attorneys’ fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by the person . . . if the person acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had not reasonable cause to believe the person’s conduct was unlawful. (c) To the extent that a . . . director or officer . . . has been successful on the merits or otherwise . . . such person shall be indemnified against expenses . . . .(f) The indemnification . . . granted pursuant to the other subsections of this section shall not be deemed exclusive of any other rights to which those seeking indemnification . . . may be entitled under any bylaw, agreement, vote of stockholders or disinterested directors.

The statutory law also authorizes corporations to purchase liability insurance for their directors and officers.8.3. STATUTORY TECHNIQUES FOR LIMITING DIRECTORS AND OFFICER RISK EXPOSURE

8.3.1.Indemnification Most corporate statutes prescribe mandatory indemnification rights for directors and officers. Generally, these

statutes authorize corporations to commit to reimburse any agent, employee, officer, or director for reasonable expenses for losses of any sort arising from any actual or threatened judicial proceeding or investigation. The only limits are that the losses must result from actions undertaken on behalf of the corporation in good faith and that they cannot arise from a criminal conviction.

Waltuch v. Conticommodity Services, Inc. (p. 243) Facts: Waltuch is Vice President and Chief Metals Trader for Conticommodity Services (“Conti”). When silver

prices crash, he becomes the target of lawsuits by angry silver speculators and an enforcement proceeding brought by the Commodity Futures Trading Commission (CFTC), for fraud and market manipulation. In the private actions, Conti settles for >$35 million; Waltuch is dismissed with no settlement contribution, but incurs $1.2 million in unreimbursed legal fees. In the CFTC action, Waltuch agrees to a penalty that includes a $100,000 fine and a six-month ban on buying or selling futures contracts from any exchange floor, and spends another $1 million in unreimbursed legal fees. Waltuch brings suits against Conti for indemnification of his $2.2 million, under Conti’s charter and under §145(c).

Holding: Waltuch is entitled to indemnification under §145(c) for his expenses pertaining to private lawsuits. Reasoning: Waltuch was successful “on the merits or otherwise” when the suit was dismissed without

Waltuch having paid a settlement. DGCL §145(b): If the plaintiff brings an action as a derivative suit on behalf of the corporation, rather

than on the plaintiff’s own behalf, and names an officer, director, employee or agent, then the corporation may indemnify, with the following limitations: The corporation may only indemnify expenses and attorneys’ fees and not an actual judgment or

amounts paid in settlement. Even expenses and attorneys’ fees can’t be reimbursed unless a court determines that the defendant

is “fairly and reasonably entitled to indemnity” despite the adjudication of liability. 8.3.2.Directors and Officers Insurance Group policies, financed by the corporation, place the financial muscle of an insurance company behind the

company’s pledge to make whole those directors who suffer losses as a result of their good faith decisions.8.4. JUDICIAL PROTECTION: THE BUSINESS JUDGMENT RULE

The business judgment rule means that courts will not decide whether the decisions of corporate boards are either substantively reasonable by the “reasonable prudent person” test or sufficiently well informed by the same test.

ALI §4.01(c): A director or officer who makes a business judgment in good faith fulfills the duty under this section if the director or officer: (1) is not interested in the subject of the business judgment;(2) is informed with respect to the subject of the business judgment to the extent that the director or officer reasonably believes is appropriate under the circumstances; and(3) rationally believes that the business judgment is in the best interests of the corporation.Kamin v. American Express Co. (p. 250) Facts: In 1972 Amex acquired 2.0 million shares of DLJ common stock for $29.9 million; by 1976 the stake was

worth approximately $4.0 million. Amex declares a special dividend to all shareholders distributing the DLJ shares in kind. Two shareholders file suit to enjoin the distribution, or for monetary damages, claiming waste of corporate assets because Amex could sell the DLJ shares and use the capital loss to offset capital gains, which allegedly would have resulted in a net tax savings of $8 million. Defendant directors claim that this possibility was considered but rejected due to negative impact on accounting profits; move for summary judgment.

Holding: Summary judgment in favor of defendant. Reasoning: While there is an element of self-interest (declaring a special dividend makes the company look better

and gives directors a better salary, while selling at a loss is a better choice as a practical matter), the court rejects this argument, stating that every board decision can affect the financial statements and holding for plaintiffs here would mean all board decisions are conflicted if salary is based on earnings.

8.4.1.Understanding the Business Judgment Rule A decision constitutions a valid business judgment (and gives rise to no liability for ensuing loss) when it (1) is

made by financially disinterested directors or officers (2) who have become duly informed before exercising judgment and (3) who exercise judgment in a good-faith effort to advance corporate interests.

Disinterested directors who act deliberately and in good faith should never be liable for a resulting loss, no matter how stupid their decisions may seem ex post. The business judgment rule allows courts to convert what would otherwise be a question of fact—whether

the financially disinterested directors who authorized this money-losing transaction exercised the same care as would a reasonable person in similar circumstances—into a question of law.

The business judgment rule also allows courts to convert the question “Was the standard of care breached?” into the related, but different questions of whether the directors were truly disinterested and independent and whether their actions were not so extreme, unconsidered, or inexplicable as not to be an exercise of good-faith judgment.

Directors who risk liability for making unreasonable decisions—or even for failing to become reasonably informed or engaging in appropriate deliberation before acting—are likely to behave in a risk-averse manner that harms shareholders.

Thus, corporate law announces a legal duty to behave as a reasonable director would behave but applies a rule that no good-faith decision gives rise to liability as long as no financial conflict of interest is involved.

Why? There is social value to announcing a standard that is not enforced with a liability rule; most board members will decide how to act based on several considerations, not only on their risk of personal liability.

8.4.2.The Duty of Care in Takeover Cases: A Note on Smith v. Van GorkomSmith v. Van Gorkom (p. 255)

Facts: Trans Union Corp. is a publicly held company with unused NOL’s (net operating losses) and a CEO (Jerome Van Gorkom) looking to retire. Stock is selling for $35 per share. Acting mainly on his own, Van Gorkom arranges a sale to Jay Pritzker’s company for $55 per share cash. Van Gorkom calls a special meeting of the board but does not give them an agenda beforehand; board approves the merger, and deal protection features, after two hour meeting. Trans Union shareholder sues, claiming breach of the duty of care. No allegation of conflict of interest, but claim that the board did not act in an informed manner in agreeing to the deal.

Holding: Chancery Court approves the transaction, finding that board approval fell within protection of the business judgment rule. Delaware Supreme Court reverses, 3-2, finding that the directors had been “grossly negligent.”

Reasoning: The decision hinged on the fact that the directors didn’t adequately inform themselves. The court took issue with the process of the directors’ decision, not the substance of it. This was a major outlier in duty of care jurisprudence.

8.4.3.Additional Statutory Protection: Authorization for Charter Provisions Waiving Liability for Due Care Violations

The Delaware legislature responded to Smith v. Van Gorkom by passing DGCL §102(b)(7): The certificate of incorporation may contain . . . A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty . . . , provided that such provision shall not eliminate or limit the liability of a director:1. For any breach of the director’s duty of loyalty; 2. For acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law4. For any transaction from which the director derived an improper personal benefit.

8.5. DELAWARE’S UNIQUE APPROACH TO ADJUDICATING DUE CARE CLAIMS AGAINST CORPORATE DIRECTORS FROM TECHNICOLOR TO EMERALD PARTNERS

Section 102(b)(7) waivers are directed to damage claims. The directors’ duty of care still can be the basis for an equitable order, such as an injunction.Cede & Co. v. Technicolor (p. 259) Facts: Technicolor CEO Kamerman negotiates with takeover artist Perelman to sell Technicolor to Perelman for

$23 per share, representing a 100% premium over pre-bid share price. Disinterested board is incredibly casual (à la Van Gorkom) in approving the transaction: gets no credible valuation, company is not “shopped” to other potential buyers, etc. Dissenting shareholders bring suit against the Technicolor directors claiming breach of the duty of care. This took place before Smith v. Van Gorkom and before Delaware adopted § 102(b)(7).

Holding: The Chancery Court noted lapses of care, but found no evidence that the board’s action caused injury, because shareholders received a premium on their stock. The Delaware Supreme Court reversed, holding that the business judgment rule does not apply in cases of gross negligence. On remand, the transaction was successfully defend as fair, despite breach of duty of care.

Reasoning: Duty of care does not require plaintiff to show injury. Gross negligence with respect to process is sufficient to put burden on directors to show entire fairness. However, gross negligence doesn’t necessarily mean that the substance was unfair – there may be gross negligence in a transaction that is completely fair. Take-home: When there is a defect in process, the business judgment rule may not apply and directors must

show fairness.Emerald Partners v. Berlin (p. 260) Facts: Hall is Chairman, CEO, and 52% owner of May’s common stock. Hall proposes a “roll-up” transaction in

which May would acquire thirteen corporations controlled by Hall. Transaction is negotiated and approved by May’s independent directors. Emerald Partners, a minority shareholder in May, brings suit alleging that the transactions were unfair to May. Hall later declares bankruptcy and is out of the picture.

Holding: Chancery Court dismisses the complaint against the remaining directors without conducting an “entire fairness” analysis because all that is left are duty of care claims, which May had waived under §102(b)(7). Supreme Court reverses. “[W]hen entire fairness is the applicable standard of judicial review, . . . injury or damages becomes a proper

focus only after a transaction is determined not to be entirely fair [citing Cede II] . . . §102(b)(7) only becomes a proper focus of judicial scrutiny after the directors’ potential personal liability for the payment of monetary damages has been established.”

Reasoning: We first must decide whether duty of care or loyalty was breached, then whether damages would be appropriate, and finally whether damages have been waived. We only waive damages if directors have not violated the duty of loyalty. The inquiry is:

(1) Was there a breach of duty of care or loyalty? If yes:(2) Was the transaction entirely fair? If not,(3) If it was a breach of duty of care and the company has a §102(b)(7) waiver, no liability. If it was a breach of duty of loyalty, damages awarded.

8.6. THE BOARD’S DUTY TO MONITOR: LOSSES “CAUSED” BY BOARD PASSIVITY

The relatively few cases that actually impose liability on directors for breach of the duty of care are not cases in which a decision proved disastrously wrong but cases in which directors simply failed to do anything under circumstances in which it is later determined that a reasonably alert person would have taken action.

Directors’ incentives are far less likely to be distorted by liability imposed for passive violations of the standard of care than for liability imposed for erroneous decisions, so it is not surprising that actual liability is more likely to arise from a failure to supervise or detect fraud than from an erroneous business decision.Francis v. United Jersey Bank (p. 262): Facts: Pritchard & Baird is a closely-held reinsurance firms with four directors: Charles Pritchard Sr. (founder),

Mrs. Pritchard, and two sons Charles Jr. and William. Primary insurer writes the policy to the insured, and then gets reinsurer to take on some portion of the risk, e.g., primary insurer takes the first $X in liability, and then the reinsurer takes the rest. Reinsurance brokers like P&B move premium payments and loss payments from primary insurers to reinsurers and back. Charles Sr. starts the practice of co-mingling accounts and making “shareholder loans” which he pays back; after he dies, Charles Jr. and William run the business, continue the practice of “shareholder loans,” but don’t pay the money back. Firm goes bankrupt; trustees in bankruptcy bring suit against Mrs. Pritchard (and eventually her estate) for negligence in the conduct of her duties as a director of the corporation.

Holding: Mrs. Pritchard had a duty not to merely object and resign but to make reasonable attempt to prevent the misappropriation of the trust funds; she breached that duty and caused plaintiffs to sustain damages for which her estate must be held liable.

Reasoning: There is a minimum objective standard of care for directors; directors cannot abandon their office but must make a good-faith attempt to do a proper job.

In general, boards of public companies have a particular obligation to monitor their firm’s financial performance, the integrity of its financial reporting, its compliance with the law, its management compensation, and its succession planning. The board must monitor largely through reports from others. The board authorizes only the most significant corporate acts or transactions; the lesser decisions that are made

by officers and employees can, however, vitally affect the welfare of the corporation. The failure of appropriate controls can result in extraordinary losses following monitoring failures.Graham v. Allis-Chalmers Manufacturing Co. (p. 268) Facts: Allis-Chalmers is a very large, decentralized public corporation that makes electrical equipment. In 1937, it

entered into a consent degree with the FTC to stop fixing prices on condensers and turbine generators. In late 1950s, Allis-Chalmers and four mid-level managers plead guilty to price-fixing charges, pay big fines. Shareholder brings derivative suit against directors and top officers to recover on behalf of the corporation for the violations of law in the late 1950s. It is clear that the defendant directors had no knowledge of anti-trust violations, so the theory is the directors breached their duty of care by failing to institute a system of watchfulness to prevent those violations.

Holding: The directors are not liable. Reasoning: The directors were not grossly inattentive to their duty to actively supervise and manage the

corporate affairs; directors are entitled to rely on the honesty and integrity of their subordinates until something occurs to put them on suspicion that something is wrong. Directors here did not recklessly repose confidence in an obviously untrustworthy employee, refuse or

neglect cavalierly to perform their duties as directors, or ignore either willfully or through inattention obvious danger signs of employee wrongdoing.

In Re Caremark (below) puts in place a duty to implement a compliance system even before misconduct is suspected

In re Michael Marchese (p. 272) Facts: Chancellor Corp. acquired MRB in 1999 but CEO and other officers forged documents showing the

transaction taking place in August 1998 in order to consolidate MRB earnings a year earlier. Audit committee members Marchese and Peselman received a report from outside auditor challenging 1998 acquisition date but did not follow up. New auditors sign-off on 1998 acquisition date. Marchese certifies 1998 10-KSB, but resigns from the board in 1999 and expresses concerns to the SEC.

Holding: Marchese agreed to undisclosed settlement for “recklessly ignor[ing] signs pointing to improper accounting treatment.”

Reasoning: The mens rea standard applied is recklessness. Since 1990, SEC enforcement actions have been a powerful and frequently used weapon to secure compliance with

the federal securities laws. SEC enforcement director: “We intend to continue following closely in our investigations on whether outside

directors have lived up to their role as guardians of the shareholders they serve . . . . We will exercise particular scrutiny in considering the role of directors in approving or acquiescing in transactions by company management.”

Federal Organizational Sentencing Guidelines The United States has begun to sometimes treat lapses from statutory or administratively mandated standards of

business conduct as criminal matters. Federal statutory law has been a powerful engine of this movement. Sarbanes-Oxley (2002) requires CEOs and CFOs to certify that they have developed internal control and

compliance systems and to disclose any weakness to outside auditors. The Federal Organizational Sentencing Guidelines are so draconian that corporations are rarely charged, much

less convicted, of crime because it is a death sentence. The threat of conviction is almost always enough to ensure a corporation’s complete compliance.

In Re Caremark (p. 278) Facts: Caremark is a publicly traded health care provider and is subject to the complex provisions of Anti-Referral

Payments Law: basically, you’re not supposed to pay MDs to refer patients whose treatment is paid for by Medicare or Medicaid. Caremark had always had an ethics guidebook, an internal audit plan, and a toll-free confidential ethics hotline. Price Waterhouse gave control system a clean bill of health. But despite it all, lower-level officers apparently engaged in enough misconduct to cost $250 million. Shareholders file derivative suit seeking recovery from the board of directors, claiming breach of the duty of care. Case is before Chancellor Allen because the judge has an obligation to review for fairness a settlement in a derivative suit. Chancellor Allen is asked to approve a settlement in which the Caremark directors promised only to implement relatively insignificant additional safeguards to increase Caremark’s ability to comply with the ARPL in the future.

Holding: The settlement is fair and reasonable. Reasoning: In the event that a firm’s internal controls fail to prevent a loss and the CEO did not identify any

weakness in the control system to the auditors, there is little risk of directorial liability unless the board’s failure to prevent a loss resulted from a systematic failure to attempt to control potential liabilities. When a board makes a decision, content is off-limits and only process will be examined for violation of good

faith or rationality. As to failure to act, we look to whether the board makes a good faith judgment that the corporation’s information and reporting system is in concept and design adequate to assure the board receives timely, appropriate info. No failure here because there is not sustained and systemic failure of the board to exercise oversight.

This case imposes a duty to put a compliance system in place even before misconduct is suspected (differs from Graham v. Allis-Chalmers, above).

Stone v. Ritter (p. 285) Facts: AmSouth shareholders brought suit against their directors for failing to detect a scheme among certain

employees which led to a $40 million fine against the company. Holding (endorsing Caremark): Absent any red flags, in order for directors to be held liable for lack of oversight of

officers and employees there must be a finding that directors either:(1) “utterly failed to implement any reporting or information system or controls,” or (2) having implemented such system or controls, “consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.” and: “imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations.”

In Re Citigroup (p. 285) Facts: Citigroup is deep into so-called “toxic assets,” which leads to massive losses by late 2007. Plaintiffs allege

that board should be liable under Caremark for failing to “make a good faith attempt to follow the procedures put in place or fail[ing] to assure that adequate and proper corporate information and reporting systems existed that would enable them to be fully informed regarding Citigroup’s risk to the subprime mortgage market.” Plaintiffs argue that public reports on deterioration of subprime mortgage market should have served as “red flags.” Citigroup has a 102(b)(7) waiver in its charter.

Holding: Duty to monitor for fraud or other criminal activity is not the same thing as duty to monitor for business risk. Caremark is limited to the first duty; if plaintiffs allege bad judgment, they win only if they can show bad faith or failure of procedure regarding acts of misconduct or criminal activity.

8.7. “KNOWING” VIOLATION OF LAW

Miller v. AT&T (p. 291) Facts: Shareholder suit against AT&T’s board, alleging that AT&T is refusing to collect on a $1.5 million loan made

to the Democratic National Committee during the 1968 election. Shareholders bring a derivative action claiming

that this is an illegal campaign contribution, in violation of federal law. District Court dismisses the suit for failure to state a claim.

Holding: Shareholders are entitled to recover when directors knowingly commit unlawful acts – the business judgment rule will not insulate directors from knowing violations of the law.

Reasoning: We let shareholders sue in these circumstances because they help detect and enforce violations of the law. Clean Air Hypo: Decision is whether to use a lower grade of fuel in operating a large plant. Lower grade will

create an 85% chance of violating the Clean Air Standards Act at least once a month; best estimate is 3.5 times per month. Fine per violation, if detected, is $10,000 per violation. Using the lower grade of fuel would save more than $80,000 per month. Distinguished because (1) conduct is actually beneficial to shareholders and (2) Act is intended to benefit

public, not designed with the purpose of protecting shareholder interests. Under §145(a) & 102(b)(7), corporations can’t indemnify against knowing violations.

9. CONFLICT TRANSACTIONS: THE DUTY OF LOYALTY The core of fiduciary doctrine is the duty of loyalty. Corporate law imposes specific controls on two classes of corporate actions: (1) those in which a director or controlling

shareholder has a personal financial interest and (2) those that are considered integral to the continued existence or identity of the company.

Interested corporate actions include self-dealing transactions between the company and its directors, but they also extend to other transactions, such as appropriations of “corporate opportunities,” compensation of officers and directors, and even relations between controlling shareholders and minority shareholders.

The duty of loyalty requires a corporate director, officer, or controlling shareholder to exercise her institutional power over corporate processes or property (including information) in a good-faith effort to advance the interest of the company. A corporate director, officer, or controlling shareholder may not deal with the corporation in any way the benefits

themselves at its expense.9.1. DUTY TO WHOM? Directors owe their duty to the corporation as a legal entity, yet the corporation has multiple constituencies with

conflicting interests, including stockholders, creditors, employees, suppliers, and customers. When a solvent corporation pursues its regular business activities, the interests of its management, creditors,

employees, and stockholders are largely congruent with the interests of its equity investors. The question of whose interests ultimately count is of principal importance when the corporation faces insolvency or

when it contemplates a terminal transaction for equity investors. As a firm approaches insolvency, the rationale in favor of shareholder primacy loses force, because

shareholders have little downside risk and great incentive to gamble.9.1.1.The Shareholder Primacy Norm That director loyalty to the “corporation” is, ultimately, loyalty to equity investors is an important theme of U.S.

corporate law. There is widespread sentiment that a corporation should be managed for the benefit of its shareholders.

In response to the growth of hostile takeovers, which frequently increase the value of the firm through externalizing costs, some legislatures passed “other constituency” statutes that allowed directors to consider interests other than shareholders’, such as employers, suppliers, customers, and even communities affected by their decision. Under these statutes, directors are entitled to consider short- and long-term interest of the corporation; the

resources, intent, and conduct of any person seeking to acquire control of the corporation; and any other pertinent factors.

PCBL 1715(a) is one example; like most, it is an enabling, no mandatory or default, rule. Though these statutes seemed earth-shattering at the time, they really do much that the business judgment

rule doesn’t. Lynn Stout, Five Theories Competing with Shareholder Primacy Norm

1. Market inefficiency2. Capital “lock in”3. Team production theory

Non-shareholders often make firm-specific investments and we need directors’ intervention to prevent shareholders from exploiting these people.

4. Universal shareholder5. Prosocial shareholder

Shareholders generally don’t want the company to engage in antisocial behavior, even if it is profitable Rights of shareholders: vote, sell, and Sue

Voting is a weak right because of collective action problems, dual class share structures, lack of direct voting on a number of important decisions, use of takeover defenses and other issues.

A.P. Smith Manufacturing Co. v. Barlow (p. 299) Facts: A.P. Smith Manufacturing Company made a grant to Princeton University. The certificate of

incorporation did not expressly authorize the contribution. Stockholders objected to the gift. Holding: Contribution permitted. Reasoning: The rationale in support of corporate gift-giving offered in the case isn’t terribly compelling, but

the business judgment rule will almost always protect directors because some kind of rationale can be crafted (i.e., reference to long-term corporate benefits)

9.1.2.Constituency Statutes The question “To whom do directors owe loyalty?” had much more economic import in the LBO transactions of

the 1980s. In these transactions, buyers would typically offer shareholders a high premium price for their shares and then, when they had control, sell off significant assets, lay off workers, increase debt on the company’s balance sheet, and replace senior management. In most cases, these changes increased the value of target companies, partly at the cost of imposing

uncompensated losses on nonshareholder constituencies. Managers often resisted being taken over, but in justifying their resistance to high-premium cash offers, they

could not persuasively resort to a vision of maximizing long-term economic value of shareholders. Thus, managerial advocates turned to the rationale that directors owe loyalty to something apart from the shareholders alone: the corporation, understood as a combination of all its stakeholders.

State legislatures enacted statues that provided that directors have the power (but not the obligation) to balance the interests of nonshareholder constituencies against the interests of shareholders in setting corporate policy.

9.2. SELF-DEALING TRANSACTIONS

Directors and officers may not benefit financially at the expense of the corporation in self-dealing transactions. The law might simply prohibit all (direct or indirect) transactions between directors or officers and the corporation.

An alternative approach would be to permit interested transactions that are “fair” but to proscribe those that are not. Ideally, the legal regime should be simple (like the preclusion alternative0 but discriminating (like the screening

alternative), and it should operate without requiring (or inviting) litigation in every such transaction.9.2.1.Early Regulation of Fiduciary Self-Dealing Beginning in the early twentieth century, courts would uphold a contract between a director and the corporation

if it was (1) fair and (2) approved by a board comprised of a majority of disinterested directors. A contract that did not meet both tests was voidable.

Under early twentieth-century law, an interested director’s attendance at a board meeting could not be counted toward a quorum on a question in which he was interested. This rule meant that a corporation could not act to authorize a contract in which a majority of the board was personally interested. There was, however, good reason to make some of these contracts binding. One response to this dilemma was

for shareholders to put into the corporation’s charter a provision allowing an interested director to be counted toward a quorum.

Courts continued to require directors to prove that such transactions were fair—that is, these transactions remained voidable following “interested” approval but only if they were unfair or inadequately disclosed.

9.2.2.The Disclosure RequirementHayes Oyster Co. V. Keypoint Oyster Co. (p. 304)

Facts: Verne Hayes is director, 23% shareholder, and CEO of Coast Oyster, a public corporation. Coast faces cash flow problems and Verne convinces the board to sell two oyster beds. Verne then suggests to Engman, a Coast employee, that Engman form a new corporation (Keypoint) to buy the oyster beds. Verne arranges for his own family corporation, Hayes Oyster, to help Keypoint with financing, in exchange for which Hayes Oyster receives 50% of the equity in Keypoint. The agreement whereby Hayes Oyster gets 50% equity in Keypoint happens after Coast board votes to sell, but before Coast shareholders approve sale. Coast’s new management discovers what Verne has done and brings suit to recover Verne’s and Hayes Oyster’s “secret profits.” Trial court rules for Verne.

Holding: Trial court reversed; Verne is made to disgorge profits. Reasoning: Nondisclosure alone is problematic, even though the deal was fair

Self-dealing transactions invoke requirements of (1) disclosure, (2) fairness, and (3) disinterested approval.

Requiring a corporate fiduciary to disclose his or her interest in a proposed transaction with the corporation is only the first step. The difficult question is just what must be disclosed beyond the simple fact of self-interest.

Recall Meinhard v. Salmon: some forms of behavior open to traders in the market are not available to fiduciaries. Among these forms is a range of disingenuous actions that fall short of fraud.

The holding in Hayes Oyster isn’t a perfect reflection of current law; the Delaware standard is that a director must disclose all material information – far more, on its face, than would be disclosed in an arm’s-length transaction (such as reservation price – but this is not enforced)

Federal securities law requires disclosure not only to board, but also to shareholders, even if they will not vote on the matter, if the transaction is over $120,000.

9.2.3.Controlling Shareholders and the Fairness Standard Corporation law has long recognized a fiduciary duty on the part of controlling shareholders to the company and

its minority shareholders. A shareholder with less than 50% of the outstanding voting power of the firm may have a fiduciary obligation by

reason of the exercise of corporate control. A shareholder with 50% or more of the vote will probably owe such a duty, despite evidence that it did not in fact exercise control.

The dominant value is that a controlling shareholder’s power over the corporation, and the resulting power to affect other shareholders, gives rise to a duty to consider their interests fairly whenever the corporation enters into a contract. The subsidiary value is the entitlement of all shareholders—even controlling shareholders—to vote in their

own interests.Sinclair Oil Corp. v. Levien (p. 310)

Facts: Sinclair Oil Company owns 97% of Sinven’s stock and dominates Sinven’s board. Sinven is involved in oil exploration and production in Venezuela. Sinven minority shareholders bring suit against Sinclair Oil for paying excessive dividends that prevented Sinven’s industrial development. Sinclair responds that dividends and other decisions should be judged under business judgment rule. Chancellor finds that Sinclair owed Sinven a fiduciary duty and applies the intrinsic fairness test; finds that Sinclair did not sustain its burden of proving that the dividends were intrinsically fair to the minority shareholders. Sinclair Oil appeals.

Holding: The Chancellor erred in applying the intrinsic fairness test; the business judgment rule should have been applied. Sinclair meets its burden under the business judgment rule.

Reasoning: The entire fairness rule comes into play when the parent, by virtue of its domination of the subsidiary, causes the subsidiary to act in such a way that the parent receives something from the subsidiary to the exclusion of, and detriment to, the minority shareholders. There was no such self-dealing here, so the business judgment rule protects the parent. No business opportunities came to Sinven, so Sinclair didn’t take any business opportunities from it. The trend in Delaware is to extend the entire fairness rule to every act of the controlling shareholder.

This is concerning to controlling shareholders because litigating entire fairness claims is expensive and outcomes are uncertain.

Corporate opportunity doctrine: an opportunity only belongs to a corporation if it came to a controlling shareholder or agent by virtue of his relationship to that corporation. If this is not the case, depending on the jurisdiction, the corporation to whom the opportunity

belongs may have right of first refusal or at least right to disclosure.9.3. THE EFFECT OF APPROVAL BY A DISINTERESTED PARTY

9.3.1.The Safe Harbor Statutes Safe harbor statutes initially sought to permit boards to authorize transactions in which a majority of directors

had an interest. They provide that a director’s self-dealing transaction is not voidable solely because it is interested, so long as it is

adequately disclosed and approved by a majority of disinterested directors or shareholders, or it is fair. DGCL §144: Interested Directors and Officers

(a) No contract or transaction between a corporation and . . . its directors or officers or any other corporation in which its directors or officers have a financial interest . . . shall be void or voidable solely for this reason . . . , if:

1) The material facts as to the director’s or officer’s relationship . . . and as to the transaction are disclosed . . . and the board or committee in good faith authorizes the contract or transaction by the affirmative vote of a majority of the disinterested directors; OR2) The material facts . . . are disclosed . . . to the shareholders entitled to vote thereon . . . and the . . . transaction is specifically approved in good faith by vote of the shareholders; OR3) The . . . transaction is fair as to the corporation as of the time it is authorized, approved or ratified, by the board of directors, a committee or the shareholders.

(b) Common or interested directors may be counted in determining the presence of a quorum . . . . In sum, a transaction won’t be voided solely on the basis of interestedness if one of the three conditions are

met: Disclosure of material facts + disinterested director approval Disclosure of material facts + shareholder approval Transaction is fair (+ approved)

Cookies Food Products v. Lakes Warehouse (p. 315) Facts: L.D. Cook forms Cookies, Inc. to produce and distribute his original barbecue sauce. Cookies enters into

a distributorship agreement with one of its minority shareholders, Duane “Speed” Herrig. Distributorship proves so successful that in a matter of years, Herrig has bought out Cook, become the controlling shareholder (with 53%), becomes a director, takes control of the board, and entered into several more self-

dealing contracts with Cookies, all of which are successful, but which take out about half the company’s cash flows. Minority shareholders bring suit alleging that self-dealing contracts “grossly exceeded the value of services rendered” and that Herrig did not fully disclose the benefit he would gain. Trial court finds no breach of fiduciary duty and rules for Herrig.

Holding: Affirmed; Herrig did not breach his duty Reasoning: The compensation Herrig received was fair and reasonable, and Cookies’ board knew that he was

interested. Take-away: Allows judicial review for fairness once the statute’s conditions have been satisfied (this is

the most common approach).9.3.2.Approval by Disinterested Members of the Board Under traditional interpretation of safe harbor statutes, the approval of an interested transaction by a fully

informed board has the effect only of authorizing the transaction, not of foreclosing judicial review for fairness. This narrow judicial interpretation is plausible when a conflicted transaction is between the controlling

shareholder and the corporation, since there are grounds to suppose that even “disinterested” directors are not fully independent from a controlling shareholder.

But an interested transaction between the company and a single director who is neither a top manager nor a controlling shareholder does not pose the same dangers. Here full disclosure and approval by disinterested directors can arguable protect shareholder interest. IN this context, courts can be expected to be more deferential to the decision of an independent board.

Melvin Eisenberg, Self-Interested Transactions in Corporate Law The real question is whether a self-interested transaction that has been approved by disinterested directors

after full disclosure wills till be subject to a test of fairness, or will be accorded the protection of the business judgment rule.

There are two reasons why such a transaction should be subject to some sort of fairness test. First, directors are unlikely to treat one of their number with the degree of wariness with which they

would approach a transaction with a third party. Second, it is difficult if not impossible to utilize a legal definition of disinterestedness in corporate law

that corresponds with factual disinterestedness. If a self-interested transaction that ahs been approved by “disinterested” directors is substantively unfair, it

can normally be inferred that either the approving directors were not truly disinterested or that they were not as wary as they should have been because they were dealing with a colleague.

But in an “interested” transaction, what effect should reasonably “disinterested” procedure have on a derivative suit claiming that he transaction constituted a breach of loyalty if the “interested” actor was not an employee or a controlling shareholder? One possibility would be to dismiss the derivative suit for failing to state a claim in light of the board’s

approval, unless the shareholder could plead fraud. Second, a court might apply the business judgment rule to the substance of the transaction—that is, the

transaction is not actionable so long as it is not irrational or egregious. Finally, a court could give the approval a more modest effect by simply shifting the burden of proving

fairness from the defendant to the plaintiff. Casebook commentary: if there is clear evidence of unfairness, then the Chancery Court might review and

decide to void (fairness review will be applied and plaintiff will have burden)Cooke v. Oolie (p. 322)

Facts: The Nostalgia Network (“TNN”) has a board with four directors, including Oolie and Salkind. Board votes unanimously to pursue the USA acquisition proposal. Minority shareholders bring suit, claiming that Oolie and Salkind breached their fiduciary duty by “electing to pursue a particular acquisition proposal that . . . best protected their personal interests as TNN creditors, rather than pursue other proposals that . . . offered superior value to TNN’s shareholders.”

Holding: Business judgment rule applies; summary judgment for defendants Reasoning: Because disinterested directors approved the transaction, so the business judgment rule applies.

This is a duty of loyalty, not duty of care, case. Chancery judges, who personally face the daunting task of valuation, seem institutionally inclined to avoid it

wherever they can do so responsibly. Thus, the Chancery cases have invoked business judgment-like review where it seems fair. The Delaware Supreme Court, however, is not exposed to the same institutional pressures because it can simply remand cases for valuation. The Delaware Supreme Court may be more receptive to judicial valuation because it is less exposed to the weaknesses of the process. Kahn v. Lynch Communications Corp. (p. 324): The Supreme Court cabined the tendency to invoke business

judgment review by Chancery judges in cases involving controlled mergers (where one individual is the controlling shareholder in two corporations that she wishes to merge).

In re Siliconix Shareholders Litigation: The Court of Chancery held that a controlling shareholder has no obligation to pay a fair price in a noncoercive tender offer to minority shareholders.

In re Western National Corporation Shareholders Litigation: the Court of Chancery applied business judgment review to a merger between two corns, both controlled by the same shareholder, after investigating in detail the independence of the target’s board and its special committee of independent directors, and finding that its minority shareholders had approved the merger on full information.

Regarding an interested transaction between an company and one or two of its directors who are not affiliated with a controlling shareholder, the Court of Chancery is likely to employ business judgment review as long as the remaining disinterested directors who approve the transaction cannot be shown to be misinformed, dominated, or manipulated in some fashion. If the terms of a deal are sufficiently egregious to raise strong suspicions in their own right, the Court of

Chancery can be expected to require the defendant explain the transaction as one that represents a fair deal to the company.

9.3.3.Approval by a Special Committee of Independent Directors Parent companies have a clear obligation to treat their subsidiaries fairly. Techniques that assure the appearance

as well as the reality of a fair deal are useful. The special committee of disinterested independent directors is the most common such technique.

To be given effect under Delaware law, a special committee must be properly charged by the full board, comprised of independent members, and vested with the resources to accomplish its task. Committee members must understand that their mission is not only to negotiate a fair deal but also to obtain

the best available deal. A committee must “just say no” when a controlling shareholder refuses to consider advantageous alternatives

unless the controller proposes terms that are their financial equivalent. Every aspect of the operation of the special committee is important in assuring that its recommendation receives

judicial respect. Almost universally, the committee will retain outside investments bankers and lawyers to advise it.

Even if the committee process is done well, it only shifts the burden of proving fairness from the defendant to the plaintiff in a controlled transaction, but the shareholder plaintiff who attacks the transaction will bear a substantial evidentiary burden if the process is well executed.

9.3.4.Shareholder Ratification of Conflict Transactions Generally speaking, shareholders may ratify acts of the board, but:

The law must limit the power of an interested majority of shareholders to bind a minority that is disinclined to ratify a submitted transaction.

The power of shareholders to affirm self-dealing transactions is limited by the corporate “waste” doctrine, which holds that even a majority vote cannot protect wildly unbalanced transactions that, on their face, irrationally dissipate corporate assets.

Lewis v. Vogelstein (p. 327) Ratification contemplates the ex post conferring upon or confirming of the legal authority of an agent in

circumstances in which the agent had no authority or arguable had no authority. To be effective, the agent must full disclose all relevant circumstances with respect to the transaction to the

principal prior to the ratification. The agent must act not only with candor, but with loyalty. An attempt to coerce the principal’s consent

improperly will invalidate the effectiveness of the ratification. Shareholder ratification may be held ineffectual (1) because a majority of those affirming the transaction had

a conflicting interest with respect to it or (2) because the transaction that is ratified constituted a corporate waste.

Informed, uncoerced, disinterested shareholder ratification of a transaction in which corporate directors have a material conflict of interest has the effect of protecting the transaction from judicial review except on the basis of waste.

In Re Wheelabrator Technologies, Inc. (p. 328) Delaware Court of Chancery articulated a different formulation of the possible consequences of shareholder

ratification:1. The plaintiffs’ claim is extinguished entirely Applies when the only issue is some minor duty of care problem (like Smith v. Van Gorkom) and the

court is not terribly concerned about risks of transaction; duty of care cases only; and when there is some lack of corporate authority

2. The conflicted transaction is reviewed under the business judgment rule. Applies to an ordinary conflicted transaction; duty of loyalty cases when the person is not a majority

shareholder.3. The plaintiffs’ claim is reviewed under the entire fairness standard. Applies to conflicted transactions; duty of loyalty cases when person is the majority shareholder.

The more worried we are about the transaction, the more we want the court to seriously review the transaction.

As the transaction gets sketchier, the value of shareholder approval gets lower. Effect of Approval by a Disinterested Party (Burden of Proof in Parenthesis)

DGCL §144 RMBCA §8.61 ALI §5.02Neither board nor shareholders approve

EF (D): but see Siliconix EF (D) EF (D)

Disinterested directors authorize

BJR (P): Cooke, but see Cookies (EF, if controller?)

BJR (P): §8.61(b)(1) & Comment 2

Reasonable belief in fairness (P): §5.02(a)(2)(B)

Disinterested directors ratify

BJR (P): same as above BJR (P): §8.62(a) & Comment 1

EF (D): §5.02(c), 5.02(a)(2)(A), 5.02(b)

Shareholders ratify BJR/Waste (P): but see Wheelabrator (EF, if controller?)

Waste (P) Waste (P)

9.4. DIRECTOR AND MANAGEMENT COMPENSATION

Compensation is a necessary form of self-interested transaction. Compensation plans that are wisely structured and closely monitored can better align the interest of managers and shareholders, and thus reduce the agency costs of management.

The most valuable “asset” of a senior manager is his skill and specialized knowledge of his firm. But managers, like other employees, cannot easily diversify their “investment” in the firm. This fact will tend to make managers risk averse.

Compensation structures must respond to this by providing a substantial part of manager compensation in the form of fixed, short-term claims (salary), which will reduce the amount that a manager has at risk.

However, a fixed salary is unlikely to do enough to induce a manager to accept risky projects that nevertheless are valuable from a long-term shareholder perspective. Incentive compensation based on the performance of individual managers or, where this cannot be monitored, on the performance of the company as a whole, can be an antidote to management slack.

However, managers are more likely to “game” incentive pay schemes at the monetary stakes increase, so incentive compensation increases agency costs.9.4.1.Perceived Excessive Compensation Shareholder advocates attack many common features of top executive compensation, including its overall level

(for being too high), its form (for not sufficiently punishing failure), the procedures used for setting compensation (for being insufficiently disinterested), and the common sweeteners in compensation contracts, such as “golden parachutes,” that reward executives for standing aside gracefully in the sale of their companies.

9.4.2.Option Grants and the Law of Director and Officer CompensationLewis v. Vogelstein (p. 332)

Nowadays, option grants are generally reviewed under the business judgment rule (old doctrine said otherwise). If board members approve option grants for themselves, shareholders may ratify. The effect of shareholder ratification is to cause the option grant to be reviewed under a “waste” standard, rather than a “reasonableness” or “fairness” standard.

Option Terminology: Call Option: right to buy a share at a specified price (the “strike price”) (Compare: a Put Option is the right to

sell a share at a specified price). A call option is never less than worthless (no risk of negative payoff, as would be the case for someone

holding the stock if prices declined) Example: Call option on XYZ Corp., currently trading at $100, with strike price of $100. If XYZ stock price goes

to $120, option holder can “exercise” the option, buy a share at $100, and sell it for $120, realizing profit of $20.

“At the Money” call option: strike price = current market price “In the Money” call option: strike price < current market price “Out of the Money” call option: strike price > current market price

Valuing options Valuation is difficult because of timing; frequently the option is not currently exercisable and/or is

exercisable over a period of time. Because option terms aren’t always standardized, the market isn’t deep enough in some cases to provide a

value estimate. Stock Options as Compensation for Executives

Strike price is usually current market price; this gives executives incentive to act in ways that will increase the market price of the firm. However, executives might not hold control over increasers of stock price.

Awarding stock options rather than stock takes away the downside risk to the exec, but awarding stock gives the recipient the market value of the stock instantly.

We prefer options so directors are not overly risk-averse. Corporate Loans

Under the Sarbanes-Oxley Act, loans to directors or senior officers are illegal for public corporations. The government doesn’t want compensation masked as debt that will never be repaid.

9.4.3.Regulatory Responses to Executive Compensation In 1993 and 2006, the SEC implemented regulations that required public disclosures regarding top executive pay.

This drove up compensation; no one wanted to have executives who were worth less than average. SOX requires that companies have directors and executives repay bonuses if financials must be restated. Tax deductability of executive salaries is limited to the first $1 million, unless part of incentive compensation plan

(to encourage the use of incentive plans).9.4.4.The Disney Decision

In re Walt Disney Co. (p. 341) Facts: Eisner, Disney’s CEO, convinces Ovitz and Disney’s Board to have Ovitz come on as second-in-

command. The board made only a cursory review of Ovitz as candidate for Disney President. Little over a year later, Disney’s board votes to terminate Ovitz without cause due to Ovitz’s poor performance. Disney’s general counsel investigates the possibility of termination for cause by does not keep any notes or seek outside legal advice. Under the terms of his employment agreement, Ovitz receives a $140 million severance package

Holding: Eisner did not breach fiduciary duty in entering the employment agreement with Ovitz because he honestly believed Ovitz would be a positive influence on the corporation. Eisner then made a reasonable business judgment in exiting the agreement (so no violation of fiduciary duty). The board was not under a duty to act in exiting the agreement, so again, no violation of fiduciary duty.

Reasoning: Amounts of executive compensation are reviewed under business judgment rule unless there is a conflict of interest. NB: Defendants’ motion to dismiss had to be denied because the facts alleged suggested that the directors

consciously and intentionally disregarded their responsibilities; a §102(b)(7) waiver cannot waive liability for acts in bad faith (which includes deliberate disregard of the duty of care). Incidentally, deliberate disregard of the duty of care also gets around the business judgment rule.

The Disney court provided a spectrum of behavior for identifying “bad faith” conduct. On one end of the spectrum, fiduciary conduct that is “motivated by an actual intent to do harm” constitutes “classic, quintessential bad faith.” On the other end of the spectrum, grossly negligent conduct, without any malevolent intent, cannot constitute bad faith. In between lies conduct that involves “intentional dereliction of duty, a conscious disregard for one’s responsibilities”; “such misconduct is properly treated as a non-exculpable, non-indemnifiable violation of the fiduciary duty to act in good faith.”

The most basic duty of every fiduciary may be said to be the duty to exercise good faith in an effort to understand and to satisfy the obligations of the office.

Disney establishes that there can be a level of director neglect or inattention that might lead a court to find that the directors were not seriously trying to meet their duty, in which event the protection of the charger amendment authorized by §102(b)(7) may not offer protection.

Post-Disney, Delaware law apparently reflected the following formal structure of director liability for inattention: First, mere director negligence—lacking that degree of attention that a reasonable person in the same or

similar situation would be expected to pay to a decision—does not give rise to liability. Second, facts that establish gross negligence may (as in Smith v. Van Gorkom) be the basis for a breach of

duty finding and result in liability for any losses that result However, under §102(b)(7) such liability for gross negligence alone can be waived.

Third, such waivers however may not waive liability that rests in part upon breach of the duty of loyalty and, under the statutory language, that inability to waive damages is extended to acts (or omissions) not done in “good faith.” In the event of this extreme level of inattention, neither the business judgment rule nor the waiver authorized by §102(b)(7) will protect the defendant from liability.

NB: Self-dealing violated duty of loyalty, not duty of care9.5. CORPORATE OPPORTUNITY DOCTRINE

Corporate opportunity cases focus on when an opportunity is “corporate” rather than personal and hence off-limits to the corporation’s managers.

The corporate opportunity doctrine is a special application of the duty of loyalty. The chief questions that arise in the corporate opportunity context concern whether an opportunity context concern whether an opportunity is corporate, the circumstances under which a fiduciary may take a corporate opportunity, and the remedies that are available when a fiduciary has taken a corporate opportunity illegitimately.9.5.1.Determining Which Opportunities “Belong” to the Corporation There are three general lines of corporate opportunity doctrine:

The first includes those cases that end to give the narrowest protection to the corporation by applying an “expectancy or interest test”

The second test, known as the “line of business” test, classifies any opportunity falling within a company’s line of business as its corporate opportunity Factors affecting this determination include (1) how this matter came to the attention of the director, officer, or employee; (2) how far removed from the “core economic activities” of the corporation the opportunity lies; and (3) whether corporate information is used in recognizing or exploiting the opportunity. This is the most common approach, used in Meinhart & Sinclair Oil)

Finally, some courts employ a more diffuse test that relies on multiple factors—a “fairness” test—to identify corporate opportunities. This test considers factors such as how a manager learned of the disputed opportunity, whether he or she used corporate assets in exploiting the opportunity, and other fact-specific indicia of good faith and loyalty to the corporation, in addition to a company’s line of business.

9.5.2.When May a Fiduciary Take a Corporate Opportunity? Incapacity is related to disinterest and implies that a corporation’s board has determined not to accept the

opportunity. In either event, it is reasoned, a fiduciary should be free to take the opportunity. Most courts accept a board’s good-faith decision not to pursue an opportunity as a complete defense to a suit

challenging a fiduciary’s acceptance of a corporate opportunity on his own account. This defense is effective only if a court is persuaded that the decision to reject a valuable opportunity on

financial grounds is the genuine business judgment of a disinterested decision maker. The fiduciary who takes the opportunity bears the burden of establishing this defense.

9.6. THE DUTY OF LOYALTY IN CLOSELY-HELD CORPORATIONS

Donahue v. Rodd Electrotype Co. (p. 351) Facts: Rodd Electrotype has three directors: Charles Rodd, Frederick Rodd, and an unnamed lawyer. It is owned

33% by Harry Rodd (co-founder and father of Charles and Frederick); 16% each among Charles, Frederick, and their sister; and 20% by the two Donahues, wife and son of the other co-founder. The company, acting through Charles, buys half of Harry’s stake for $800 per share, which reflects book and liquidating value. Euphemia Donahue (wife) offers to sell her family’s shares on the same terms, but the company refuses. The company had previously offered to buy the Donahue shares for amounts between $4 and $400 per share, which had been rejected. Euphemia brings suits against the directors and the company to rescind the purchase of Harry’s shares. Trial court finds that transaction had been carried out in good faith and with inherent fairness.

Holding: Shareholders in closely-held corporations owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe one another. Stock repurchases have to be available to all shareholders on the same terms.

Court defines a close corporation as having:(1) A small number of shareholders This is a problem because with a low number of shareholders, it’s more likely that there is a majority

shareholder.(2) No ready market for shares This is a problem because there are liquidity concerns; limited exit opportunities and no requirement to

produce audited financial statements However, even in public companies, you can take assets out of bad managers’ hands, which means you

have to sell at a low price(3) Majority shareholders that are also managers This is a problem because of freeze-outs (valuation by managers, not market) and other ways managers can

extract benefits Easterbrook & Fischel, Close Corporations and Agency Costs

Fiduciary duties are a substitute for what the parties would have chosen if they had bargained for it in advance; we treat what they would have done ex ante as the desirable state because we believe their envisioned arrangement maximized value. But in applying this vision to the Donahue (or any other) case, we encounter problems because we don’t know

what the parties would have wanted.Smith v. Atlantic Properties Inc. (p. 359) Facts: Dr. Wolfson purchases land for $50,000, then sets up Atlantic Properties, Inc., with equal shares for Smith,

Zimble, and Burke who each contribute $12,500. Wolfson puts in a charter provision requiring an 80% shareholder vote to approve any action, effectively giving each of the four shareholders veto power. Wolfson testifies that he included the provision to prevent the others from “ganging up” on him. Atlantic Properties does well, but Wolfson continually vetoes the payment of any dividends, partially for personal tax reasons and partially due to personal animosity towards the other shareholders. IRS assesses penalty taxes totaling approximately $40,000 for unreasonable accumulation of corporate earnings and profits. Smith, Zimble, and Burke bring suit to remove Wolfson as a director and to have him reimburse Atlantic for the penalty taxes and related expenses. Trial court finds that Wolfson breached his fiduciary duty and holds him liable for the penalty taxes.

Holding: Trial court ruling affirmed; Wolfson’s behavior was unreasonable and he should be liable for the penalty taxes.

Reasoning: We want to give effect to contracted terms, but if we insist on enforcing terms that lead to absurd results, we will force parties to expend enormous sums on specifying extremely precise terms; instead, the court sees the parties’ agreement as made against the background of good faith. Compare to Donahue; here the parties did contract ex ante for the situation in question, but the court ignores

their agreement.10. SHAREHOLDER LAWSUITS There are two principal forms of shareholder suits: derivative suits and direct actions, which are customarily brought as

class actions. A class action is simply a gathering together of many individual or direct claims that share some important common

aspects. The claim in such a suit is to recover damages suffered by individuals directly because they are shareholders. The derivative suit is an assertion of a corporate claim against an officer or director which charges them with a wrong

to the corporation. Such an injury only indirectly harms shareholders. The derivative suit is said to represent two suits in one: the first suit is against the directors, charging them with

improperly failing to sue on the existing corporate claim. The second suit is the underlying claim of the corporation itself.

These suits typically allege that the corporation’s directors have failed to vindicate its claims because they themselves are the wrong-doers and so would be the defendants in the resulting suit.

Fiduciary duties can deter misconduct only if the shareholders can bring claims of fiduciary breach to court.10.1. DISTINGUISHING BETWEEN DIRECT AND DERIVATIVE CLAIMS

The derivative suit advances a corporate claim, which implies that any recovery that results should go directly to the corporation itself.

Derivative suits have a number of special procedural hurdles designed to protect the board of directors’ role as the primary guardian of corporate interest. A suit that is correctly characterized as a derivative suit may be dismissed if it does not satisfy the provisions of Rule 23.1 of the Federal Rules of Civil Procedure.

The class action and the derivative suit share important commonalities: both require plaintiffs to give notice to the absent interested parties; both permit other parties to petition to join in the suit; provide for settlement and release only after notice, opportunity to be heard, and judicial determination of fairness of the settlement; and in both actions, successful plaintiffs are customarily compensated from the fund that their efforts produce.

Friendlier, Inc. Example (p. 365) Facts: The board of Friendlier, Inc., defeats a coalition of insurgents at the annual shareholders’ meeting by

issuing a 15% block of common stock to the Friendship Investment Company, which agrees to vote the stock favorably to the board. The stock was issued at a 10% discount to the prevailing market price.

Holding: Pursue a direct suit; a derivative suit, if successful, would give Friendship 15% of the recovery. A derivative suit (and the remedy of vote cancellation) is not appropriate for internal conflict. Membership in the class is restricted to shareholders who held at time of injury (these shareholders can/will

sell at a depressed price, retaining the right to share in favorable judgment; if we sold right to recover along with the stock, the stock price would include the value of potential favorable judgment.

10.2. SOLVING A COLLECTIVE ACTION PROBLEM: ATTORNEYS’ FEES AND THE INCENTIVE TO SUE

If the shareholder suit is to be plausible for enforcing fiduciary duties in widely held corporations, the law must construct an incentive system to reward small shareholders for prosecuting meritorious claims. Such a system has evolved out of the court of equity’s practice of awarding attorneys’ fees to plaintiffs whose litigation created a common fund that benefited others as well as the plaintiff herself. Positives: This arrangement addresses collective action problems in using suits to enforce fiduciary duties Drawbacks: Companies and managers are risk averse and costs of litigation are high, so there are opportunities

for extortion-like behavior regarding non-meritorious claims; settlement is common and safe, so claims may be settled too easily and too early.

Fletcher v. A.J. Industries, Inc. (p. 367) Facts: Shareholders pursued a derivative action alleging that the corporation had been damaged due to

mismanagement by one of its directors. Ultimately, a settlement was negotiated, but whether the corporation was entitled to monetary recovery was to be determined in the future (though corporate reorganization was to be performed immediately).

Held: If pursuit of a shareholder claim is successful, the plaintiff’s lawyer can be paid out of the resultant fund, if damages are monetary, or by the corporation directly if there is no fund.

Reasoning: The corporation received substantial benefits as a result of the action and its settlement; the stockholder should be compensated for pursuing this action.

Agency Costs in Shareholder Litigation Legally, the plaintiffs’ lawyers are agents of shareholders, just as the corporate defendants are fiduciaries charged

with acting for the corporation and, ultimately, for its shareholders. But both sides have important financial interests at stake: fees for the lawyers and potential liability for corporate officers and directors.

Plaintiffs’ lawyers may initiate strike suits, or suits without merit, simply to extract a settlement by exploiting the nuisance value of litigation and the personal fears of liability—even if unfounded—of officers and directors.

Corporate defendants may be too eager to settle because they bear at least some of the costs of litigation personally, but they do not bear the cost of settling, which is borne by the corporation or its insurer. Parties will almost certainly be indemnified under Officers and Directors Insurance if they settle, but under

§135(b), the corporation cannot indemnify them if they are found to have acted in bad faith. A director who settles will be deemed to have prevailed “otherwise,” triggering mandatory §135(c)

indemnification of officers who prevail “on the merits or otherwise” Agency problems also arise when shareholder litigation is meritorious and corporate managers face a serious

prospect of liability. In this case, plaintiffs’ attorneys and corporate defendants—if these defendants remain in control of the corporations—have an incentive to settle on terms that are mutually advantageous but that allow the defendants to fully escape personal liability for their conduct.

The law of presuit demand and the law of dismissal by independent board committees can be understood as judicially created measures intended to fine-tune the power and incentives of plaintiffs’ lawyers to prosecute shareholder suits.

10.3. STANDING REQUIREMENTS

Standing requirements, which screen who may bring a derivative suit, are established both by statute and by court rule. They are premised on the assumption that screening for qualified litigants increases the quality of shareholder litigation. The plaintiff must be a shareholder for the duration of the action The plaintiff must have been a shareholder at the time of the alleged wrongful act or omission The plaintiff must be able to “fairly and adequately” represent the interests of shareholders (there are no obvious

conflicts of interest) The complaint must specify what action the plaintiff has taken to obtain satisfaction from the company’s board or

state with particularity the plaintiff's reason for not doing so It used to be a race to the courthouse, because only the class plaintiff's lawyer gets paid; now, most jurisdictions give

standing to plaintiff with largest unconflicted interest (most adequate plaintiff) on the grounds that this plaintiff will best supervise litigation.

10.4. BALANCING THE RIGHTS OF BOARDS TO MANAGE THE CORPORATION AND SHAREHOLDERS’ RIGHTS TO OBTAIN JUDICIAL REVIEW

When a shareholder-plaintiff should be empowered to take a corporate claim out of the hands of the board, against the will of management, is an issue that can arise in several contexts: When a company moves to dismiss a derivative suit on the ground that the shareholder-plaintiff has made a

presuit demand on the board, but the board has refused to bring the suit. Here, the court must decide whether or not to defer to the board’s business judgment in electing not to

prosecute the action When the shareholder-plaintiff does not make demand on the board, on the ground that the board could not

exercise disinterested business judgment. Here the court must pass on the validity of the plaintiff's excuse for not making presuit demand.

When the board seeks to terminate a derivative suit at a later point in the litigation, after the suit has already survived the company’s initial motion to dismiss.

In connection with settlement of shareholder suits, and especially in the rare case in which a derivative case is settled over the objection of a derivative plaintiff.

10.4.1. The Demand Requirement of Rule 23 A derivative complaint must “allege with particularity the efforts, if any, made by the plaintiff to obtain the action

he desires from the directors or comparable authority . . . or the grounds for not making the effort.” Aronson Demand Futility Test:

“Our view is that in determining demand futility the Court of Chancery in the proper exercise of its discretion must decide whether, under the particularized facts alleged, a reasonable doubt is created that: (1) the directors are disinterested and independent, and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. Hence, the Court of Chancery must make two inquiries, one into the independence and disinterestedness of the directors and the other into the substantive nature of the challenged transaction and the board’s approval thereof.”

Levine v. Smith (p. 376) Facts: In 1984, GM buys EDS from Ross Perot in a stock transaction that makes Perot GM’s largest

shareholder, with 0.8% of its stock, and puts Perot on GM’s board. As Perot discovers how GM is run, he goes bananas – starts criticizing GM publicly for making “second rate cars.” GM pays Perot $742 million in exchange for: his GM stock, notes, and an agreement not to wage a proxy contest or to publicly criticize GM’s management. Deal is approved by a three-person subcommittee of the board, and then by the full (22-person) board minus Perot. Shareholders bring derivative action claiming breach of fiduciary duty; argue that demand is excused because it would have been futile. Chancery Court rejects the demand futility claim

because (a) plaintiffs did not plead particularized facts sufficient to create a reasonable doubt as to the independence of the GM board, and (b) did not rebut the presumption that the decision was an exercise of valid business judgment. The question from Aronson is whether the plaintiff has to create reasonable doubt as to one of the factors or both of them. The factors are: The directors are disinterested and independent The challenged transaction was otherwise the product of a valid exercise of business judgment.

Holding: Either factor will be sufficient to demonstrate demand futility: “The premise of a shareholders claim of futility of demand is that a majority of the board of directors either has a financial interest in the challenged transaction or lacks independence or otherwise failed to exercise due care.” However, neither factor was met here.

Under the Aronson/Levine Test in Delaware for demand futility in derivative suit, the plaintiff must: Establish that the directors are interested or dominated – and hence incapable of passing on a demand; or Create a reasonable doubt, with particularized facts, that the challenged transaction is protected by the

business judgment rule. Speigel v. Buntrock (p. 380): In Delaware, if a shareholder asks the board to pursue the suit, he concedes that the

board is independent and disinterested with respect to the question to be litigated. This rule has the effect of foreclosing demand; all suit is pursued on demand futility. With universal demand or universal nondemand, the court will ultimately have to pass on the board’s ability

to fairly deal with the issue the litigation presents. A universal demand rule allows the court to do so with more information, but entails more time and cost by the board.

Comparison of Demand Futility Approaches Delaware: in practice, demand rarely made due to Speigel v. Buntrock presumption, and court screens based

on two-part Aronson/Levine test: P must establish either that directors are interested/dominated or must allege facts that “creat[e] a reasonable doubt of the ‘soundness’ of the challenged transaction.”

RMBCA: must make demand and wait 90 days unless irreparable injury (§7.42), and if demand is refused shareholder may continue by alleging with particularity that board is not disinterested (§7.44(d)) or did not act in good faith (§7.44(a)).

ALI: must make demand unless irreparable injury (§7.03), and if demand is refused and shareholder continues, court will review board motions to dismiss derivative suits using a graduated standard: business judgment rule for alleged duty of care violations (§7.10(a)(1)) and reasonable belief in fairness for alleged duty of loyalty violations (§7.10(a)(2)), except no dismissal if plaintiff alleges undisclosed self-dealing (§7.10(b)).

Rales v. Blasband (p. 381) Facts: Shareholder/plaintiff Blasband owns stock in Easco Handtools, a company that is controlled and

managed by the Rales brothers (well-known takeover artists). Rales Brothers do a public debt offering of $100 million in notes, officially to finance debt repayments and operations expansion, but they instead invest the proceeds in Drexel junk bonds at a time when Drexel is on its last legs and the DOJ is hot on Milkin’s trail. The suit alleges breach of the duty of loyalty – the investment is the quid pro quo for Drexel’s past favors for the Rales brothers personally, in helping them finance their earlier takeovers with junk bonds. Shortly after the deal but before the shareholder suit, the Rales brothers merge Easco into a subsidiary of Danaher, which they also control. So at the time the suit is brought, the shareholder/plaintiff is no longer a shareholder of Easco but is instead a shareholder of Danaher. The Rales brothers own 44% of Danaher, but all they do now is sit on the board, along with six others.

Holding: Demand is excused. Reasoning: If the board at the time suit is filed is different from the board at the time the challenged

transaction are different (which often happens in mergers or changes of ownership), we only apply the first prong of the Aronson/Levine test. Since this board is not the one that engaged in this dubious transaction, we omit the second prong of the Aronson/Levine test. Whether the board is independent or not turns on, in part, the merits of the suit. Here, the Rails brothers and Caplin are interested because they might be held liable in the suit. The court identifies the tactic of naming the board as defendants so the plaintiff can show demand futility

as a potential problem. Thus, the court imposes the requirement that the plaintiff show there is a substantial likelihood that the director is going to be liable.

10.4.2. Special Litigation CommitteesZapata Corporation. v. Maldonado (p. 389)

Facts: Plaintiff files a derivative suit in Delaware; demand is excused, and four years into the litigation, the Zapata board appoints two new independent directors who serve as a special litigation committee (SLC). The SLC investigates the action – and like virtually all SLCs, it recommends that the court dismiss the suit. The Chancery Court rules that shareholders have an independent, individual right to continue a derivative suit for breaches of fiduciary duty, even if the corporation does not want to.

Holding: Zapata two-step: (1) the court should inquire into the independence and good faith of the committee and the bases supporting its conclusion. The corporation should have the burden of proving independence, good faith, and a reasonable investigation. (2) The court should determine, applying its own independent business judgment, whether the motion should be granted. If the committee fails in the first prong, we don’t bother to apply prong 2. If the committee meets the first prong, whether to apply prong 2 is the court’s discretion.

If the court had to apply prong 2, the application of that prong would be subject to appellate review. The second prong is astonishing. Courts don’t have business judgment.

Reasoning: The problem with SLCs is that they can always be set up to recommend against pursuing litigation. What the Zapata court was faced with was the end of derivative litigation forever. Zapata states that the court should, when appropriate, give special consideration to matters of law and

public policy in addition to the corporation’s best interest. NB: It is somewhat odd that a court may second-guess the board’s evaluation of a derivative action when

demand is excused, but not when demand was required but the board rejected suit. Delaware Derivative Suit Decision Tree

In Re Oracle Corp. (p. 395) Facts: Derivative complaint alleges insider trading by four Oracle directors: Ellison (major donor to Stanford),

Henley, Lucas (Stanford alum and major donor to Stanford) & Boskin (a Stanford economics professor). Oracle appoints Profs. Grundfest and Garcia-Molina from Stanford to the board as a two-person SLC with complete authority to respond to the litigation. SLC produces 1,110-page report concluding that Oracle should not pursue the plaintiffs’ claims against the defendant directors. Plaintiffs challenge independence of the SLC in Delaware Chancery Court. One of the two members of the special litigation committee was a corporate law expert, former commissioner of the SEC, and serving out of personal interest and a sense of public duty. Roughly speaking, insider trading occurs when a person has information about a company that is both

material and non-public and uses this information in buying/selling in the market. This is very illegal. Holding: The court finds that the special litigation committee fails the first prong of the Zapata two-step; the

committee is held to lack independence (though good faith and reasonable investigation are not a concern). Reasoning: The directors were newly appointed to the board for the specific purpose of serving on the special

litigation committee and all the decisions of the special litigation committee were made in private meetings. The committee had its own counsel and conducted extensive investigation. The members, however, were held to be interested because they were both professors at Stanford, and Stanford was and stood to continue to be a beneficiary of major donations by the members of the Oracle board. The case is designed to illustrate that the definition of independence for a special litigation committee

can be fairly broad – general social ties and sense of institutional loyalty. The members of the special litigation committee here seem no more or less independent than managers are from their board.

The Chancellor doesn’t want to exercise ‘business judgment’ as a judge, but also doesn’t want to see derivative litigation foreclosed, so he places enormous weight on the first prong.

This opinion is fairly extraordinary; ordinarily special litigation committees are permitted to serve their function (especially if they learn from Oracle).

NB: The corporation has the burden of satisfying the Zapata test, rather than the plaintiff of proving it isn’t met.

Joy v. North (p. 403) Majority: “The court’s function is thus not unlike a lawyer’s determining what a case is ‘worth’ for purposes of

settlement.” The majority says courts, in exercise of the second Zapato prong, should weigh the amount and

probability of liability; attorney’s expenses, indemnification costs, distraction of key personnel, and lost profits from negative publicity.

Dissent: the Zapata two-step asks more questions than it answers; there are so many considerations that the court lacks the knowledge and expertise to properly weigh. The dissent is concerned that the majority is making the second prong mandatory (but it’s not clear the

majority really imposes this requirement). Joy differs from Zapata in that there does not appear to be consideration for ‘matters of law and pubic policy’

under the rule in Joy. For board skeptics and reformers, an alternative to the Zapata rule might be a more rigorous effort to ensure the

independence of the directors who sit on the special litigation committee.10.5. SETTLEMENT AND INDEMNIFICATION

10.5.1. Settlement by Class Representatives

The parties are strongly driven to settle in the typical derivative (or class action) suit. Litigation becomes increasingly costly as a suit progresses through discovery, and the prospect of a trial imposes the further risk that all suit costs will be lost in the end.

Directors will generally have a right to indemnification of reasonable defense costs if the action settles. If an action goes to trial, however, there is a risk of personal liability that can be indemnified only with court

approval. A director’s directors and officers insurance coverage will typically exclude losses that arise from “fraud” or self-dealing, while settlement allows the proceeds of the D&O insurance policy to be used. Further, the corporation cannot indemnify officers that are adjudged to be liable to it. However, it can

purchase liability insurance for its officers, directors, and agents, whether or not the corporation would have the power to indemnify them against such liability.

Thus, (1) most suits settle and lead to an award of attorneys’ fees; (2) of the settling suits, about half result in monetary recovery; (3) D&O insurance pays for most or all of the settlement fund in most cases and (4) officers and directors never face out-of-pocket costs.

After the lawyers negotiate a settlement, the court approves the form of the notice of settlement that is conveyed to the shareholders. While shareholders are formally invited to participate in considering the settlement’s merits, few ever do in public companies.

10.5.2. Settlement by Special Committee Plaintiffs resist because they might wish other terms of settlement. We can expect special litigation committees to

offer settlement on terms more favorable to directors (their colleagues) than plaintiffs would. Carlton Investments v. TLC Beatrice international Holdings, Inc. (p. 409)

Facts: Reginald Lewis does an LBO of Beatrice Foods with the help of some banks. Lewis ends up with 45% of Beatrice and banks get 20%. Beatrice pays Lewis $19.5 million in compensation payment just before he dies. One of the big bank shareholders brings derivative suit alleging self-dealing and waste. The company appoints an SLC, which eventually negotiates a settlement for Lewis’s estate to pay Beatrice $14.9 million plus interest in installment payments over seven years. Plaintiff objects to the settlement and brings suit in the Delaware Chancery Court.

Holding: Defendants did not breach their fiduciary duties in connection with the board’s approval of the compensation package.

Reasoning: The court evaluates the special litigation committee’s decision using the Zapato two-step. It finds the special litigation committee’s procedure was reasonable and the special litigation committee independent. It then exercises its business judgment and finds the settlement reasonable. (Loosely follows Joy v. North) The plaintiff's claim of breach of fiduciary duty succeeds only if director has a direct financial interest in

the issue (here, compensation of the CEO); the issue is whether the director is interested. The breach of duty of care claim succeeds if plaintiff can get past the business judgment rule by showing

(i) bad faith – deliberate disregard of duties or that directors are interested or (ii) a Smith v. Van Gorkom situation – gross negligence/utter failure to follow reasonable procedure (NB: (ii) is not enough to get past a §102(b)(7) waiver.

A waste claim does not work because the corporation did not give away something for absolutely nothing.

Take-home: It is extremely hard to challenge the substance of executive compensation. The claim has to be shoe-horned into the above procedural-type claims.

10.6. WHEN ARE DERIVATIVE SUITS IN SHAREHOLDERS’ INTERESTS? Corporations pay premiums to insurers, who pay recoveries to the corporation itself, as well as to plaintiffs’ and

defendants’ attorneys. It seems the corporation is paying itself and paying insurers and attorneys for the privilege of doing so, but the

corporation has the right to insure itself of risk. Benefits and Costs of Shareholder Derivative Suits:

The suit may confer something of value on the corporation and the prospect of a suit can deter wrongdoing that might otherwise happen in the future.

However, litigation imposes direct costs on a company (litigations costs and insurance costs).11. TRANSACTIONS IN CONTROL Transactions in shares have traditionally escaped regulation by corporate law. What shareholders do with their own

property has been seen as their own business. Over the past 50 years, however, corporate law has come to recognize that share transactions on the market cannot be wholly isolated from the core agency problems of corporate law.

Investors can acquire control over corporations in two ways: By purchasing a controlling bloc of shares from an existing control shareholder.

The incumbent controller will demand a premium. The acquirer may expect to finance the control premium by extracting larger private benefits that the incumbent controller already does, by putting the company’s assets to more profitable uses, or by doing both.

By purchasing the shares of numerous smaller shareholders.

In the absence of ex ante regulation, antitakeover defenses, or ex post derivative litigation, a looter could exploit the collective action problem of disaggregated shareholders by buying 51% of a target corporation at a high price and later appropriating a large part of the value of the remaining 49% as a private benefits.

A variety of regulatory measures directed at acquirors—from minimum tender offer periods to mandatory cash-out rights for minority shareholders—mitigate the collective action problem of target shareholders and thereby reduce the risk of inefficient takeovers, but do so only at the price of also reducing the number of efficient control transfers.

Managers who control preclusive defensive tactics have a great deal of leverage to bargain on behalf of their shareholders, but can also use that power to block efficient transfers for selfish reasons.

11.1. SALES OF CONTROL BLOCKS: THE SELLER’S DUTIES

Issues regarding the sale of the control block once it is obtained:(1) the extent to which the law should regulate premia from the sale of control(2) the law’s response to sales of managerial power over the corporation that appear to occur without transferring a controlling block of stock(3) the seller’s duty of care to screen out buyers who are potential looters11.1.1. The Regulation of Control Premia While some non-U.S. jurisdictions have statutes that require any acquirer of a control block to offer to acquire all

shares at the same price paid in the control transaction, U.S. jurisdiction do not afford such a right. The common law rule, or “market rule,” is that sale of control is a market transaction that creates rights and

duties between the parties, but does not confer rights on other shareholders. A critical tradition attacks both the fairness and efficiency of the market rule and proposes instead premia-

sharing alternatives. Under the “equal opportunity rule,” shareholders would be entitled to sell their shares to a buyer of control

on the same terms as the seller of control.Zetlin v. Hanson Holdings (p. 416)

Facts: Hanson Holdings and Sylvestri family together own 44.4% of Gable Industries, and sell their controlling block to Flintkote Co. for $15 per share at a time when the Gable stock is selling for $7.38 per share. Minority shareholder Zetlin brings suit challenging the transaction, claiming that minority shareholders should have an equal opportunity to share in any premium paid for a controlling interest.

Holding: New York Court rejects equal opportunity rule Reasoning: “Absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts of

bad faith, a controlling stockholder is free to sell, and a purchaser is free to buy, that controlling interest at a premium price.” Articulates the baseline rule

Perlman v. Feldmann (p. 417) Facts: Korean War triggers a steel shortage, but a semi-official price freeze and rationing of steel supply

prevent steel suppliers from directly extracting gains. Some steel sources gain nevertheless by obtaining interest-free loans in exchange for commitments to sell steel later. Feldmann is director, CEO, and controller of 37% of Newport Steel shares. Feldmann sells his stake to Wilport Syndicate, an end-user of steel, for $20 per share when the stock is trading at $10-$12. Feldmann resigns with his directors to allow Wilport to take control of the board. The shareholders of Newport bring suit alleging that Feldmann sold a corporate opportunity (control over steel supply) for personal gain, which the company could have used for its advantage (e.g., through the “Feldmann Plan”), in violation of his fiduciary duty to the corporation. Trial court finds that $20 per share was a reasonable value for a controlling block and rules for Feldmann.

Holding: To the extent that Feldmann’s price included a bonus, he is accountable to the minority stockholders. Plaintiffs are entitled to recovery in their own right, instead of in right of the corporation.

Reasoning: You can’t sell to someone who you reasonably should know will exercise control to the detriment of the firm (market rule is thus qualified) Gives legal support for according minority shareholders a claim on control premia.

11.1.2. A Defense of the Market Rule in Sales of Control Easterbrook & Fischel, Corporate Control Transactions

Investors’ welfare is maximized by a legal rule that permits unequal division of gains from corporate control changes, subject to the constraint that no investor be made worse off by the transaction.

The premium price received by the seller of a control bloc amounts to an unequal distribution of gains. However, this unequal distribution reduces the costs to purchasers of control (because the purchaser need only buy the control bloc and not all shares at the higher price), thereby increasing the number of beneficial control transfers, and increasing the incentive for inefficient controllers to relinquish their positions.

If we treat control as a “corporate asset,” which would require that premiums paid for control go into the corporate treasury, or adopt the “equal opportunity” rule, which would entitle minority shareholders to sell their shares on the same terms as the controlling shareholder, it will stifle transfers of control.

Thus, minority shareholders would suffer, as the likelihood of improvements in the quality of management declined.

The best remedies for looting are based on deterrence rather than prior scrutiny. The costs of deterrence are probably much lower than the costs of dealing with looting through a system of prior scrutiny that would scotch many valuable control shifts as a byproduct.

How Much Do Delaware Courts Really Believe in the Controller’s Right to a Control Premium?In re Digex (p. 428) Facts: An acquirer first approached the board of the partly held subsidiary of the controller with a

lucrative offer. The controller arranged to sell itself to the acquirer in lieu of selling the subsidiary, thereby excluding the subsidiary’s minority shareholders from a premium deal.

Holding: The controller was entitled to use its voting power as a shareholder to block a deal between the subsidiary and the acquirer, but the controller violated a duty of fairness to minority shareholders when it pressured the subsidiary’s board to waive the applicability of DGCL §203 in order to facilitate its sale. §203 prevents a party who purchases control of Delaware corporation from pursuing a cash-out

merger to eliminate minority shareholders for a period of three years unless the company’s board approves ex ante or certain other technical requirements are met.

Reasoning: The board may waive the §203 constraint only for the benefit of the corporation and all of its shareholders—not just its controlling shareholder. If vigorously construed, this norm seriously weakens a controlling shareholder’s entitlement to the whole of a control premium. If a §203 waiver must be justified on the basis of a corporate benefit, the board must either conclude that the transfer itself is good for the corporation or must extract some benefit from the controller to justify cooperation. Even when §203 is not at issue, boards are frequently asked to cooperate with potential buyers of

control; here, too, a decision to cooperate arguably requires a benefit for the corporation itself or the minority shareholders.

Efficient vs. Inefficient Sales of Control Inefficient Sale:

90 shares total: 45 trade in the market, 45 are held by the controller. The old controller is asked to sell to a new controller:

Old Controller LooterTotal Firm Value $1,000 $900Private Benefit $100 $500Net Firm Value $900 $400Minority Share Price $10/share $4.44/share

Analysis: Old Controller values the stake at $450 + $100 = $550, or $12.22/share. Looter values the stake at $700, or $15.56/share.

Efficient Sale:90 shares total: 45 trade in the market, 45 are held by the controller.

Looter Efficient BuyerTotal Firm Value $900 $1,350Private Benefit $500 $100Net Firm Value $400 $1,250Minority Share Price $4.44/share $13.89/share

Analysis: Looter values the stake at $15.56 per share (see previous). Under EOR, Efficient Buyer can offer up to $1,350/90 or $15.00/share, which is insufficient. Under market rule, the deal goes through, because Efficient Buyer can bid up to $725 for Looter’s stake, which Looter values at $700.

11.2. SALE OF CORPORATE OFFICE

Basic rule: You can’t sell corporate office, even though you can sell shares that will give someone the right to appoint nominees to corporate office, because we want to unite ownership and control. The law tracks functional reality; if it looks like sale of corporate office, it probably is.

Carter v. Muscat (p. 428) Facts: The board of the Republic Corporation appointed a new slate of directors as part of a transaction in which

the company’s management sold a 9.7% block of its stock to a new “controlling” person at a price slightly above market.

Holding: The court upheld the re-election of the new directors at the annual shareholders meeting Brecher v. Gregg (p. 429)

Facts: Gregg, the CEO of a public company, received a 35% control premium on the sale of his 4% block of stock, in exchange for his promise to secure the appointment of the buyer’s candidate as the company’s new CEO and the election of two of the buyer’s candidates to the board of directors. Gregg temporarily delivered, but the company’s board soon rebelled and fired the buyer’s handpicked CEO.

Holding: A stockholder of the company successfully sued Gregg derivatively and forced him to disgorge his control premium to the company.

Reasoning: Paying a premium for control while purchasing only 45 of a company’s outstanding shares is “contrary to public policy and illegal.”

Comparison:Carter v. Muscat Brecher v. Gregg

Size of “Control” Block 9.7% 4%Premium Received by Seller “slightly above market”

(AKS p.438)35%

Fate of Newcomer(s)

Directors re-elected by shareholders CEO fired by board

Holding Upheld Disgorgement of control premium It is better to: have significant control block (keeps ownership united with control); keep control premium low

(premium is for control, not purchase of corporate office); be reelected (a sign that shareholders approve, low likelihood of looting)

11.3. LOOTING

Harris v. Carter (p. 429) Facts: Carter Group exchanges its 52% in Atlas for the Mascolo Group’s stake in ISA. Pursuant to agreement,

Carter directors resign from the Atlas board and Mascolo takes over. Minority shareholders bring suit against the Mascolo directors alleging that they looted all of Atlas assets: diluting minority interest in Atlas by issuing Atlas stock for worthless ISA stock; buying a worthless chemical company owned by Mascolo; and engaging in various other self-dealing transactions. Minority shareholders bring suit against the Carter directors alleging that ISA is a totally bogus firm, and that Carter should have been alerted by the suspicious financial statements that Mascolo offered for ISA. Comes before the Chancery Court on a motion to dismiss.

Holding: Where circumstances would alert a reasonably prudent person to a risk that the buyer is dishonest or in some material respect not truthful, a duty devolves upon the seller of a control stake to make such inquiry as a reasonably prudent person would make and generally exercise such care so that others who would be affected by his actions should not be injured by wrongful conduct.

Reasoning: This standard is similar to tort law liability, with a negligence standard. The seller must act reasonably. While a strict liability standard would better discourage inefficient transfers, it would also stifle efficient ones. In this case, Carter seems to be the least-cost-avoider, at least in comparison to minority shareholders. We impose penalties on Carter rather than solely on looters because they are likely to be judgment proof.

11.4. TENDER OFFERS: THE BUYER’S DUTIES

Large public companies in the United States generally do not have a controlling shareholder, so an investor who wishes to purchase a control stake in a widely held company must do so by aggregating the shares of many small shareholders. The buyer might approach the largest of the small shareholders singly, or the buyer might make a general offer – a

tender offer – that is open to all shareholders. The Williams Act sought to provide shareholders sufficient time and information to make an informed decision about

tendering their shares and to warn the market about an impending offer. The regulatory structure of the Williams Act has four principal elements: Early Warning System (§13(d)): requires disclosure whenever anyone acquires more than 5% of the stock.

Basic Rule (Rule 13d-1(a)): investor must file a 13D report within 10 days of acquiring 5%+ beneficial ownership. Partial exemptions for Qualified Institutional Investors and passive investors. Investors might want to keep their investment secret to avoid driving up the purchase price or triggering

takeover defense mechanisms. If you want to acquire a control stake, 13D reports tell you who you can buy from.

Updating requirement (Rule 13d-2): must amend 13D promptly on acquiring material change (~ +/- 1%) Key Definitions: “beneficial owner” means person with the power to vote or dispose of stock (13d-3(a));

“group” is anyone who acts together to buy, vote, or sell stock (13d-5(b)(1)). Each group member deemed to beneficially own each member’s stock.

General Disclosure: (§14(d)(1)): requires tender offeror to disclose identity and future plans, including any subsequent going-private transactions.

Anti-Fraud Provision (§14(e)): prohibits misrepresentations, nondisclosures, and “any fraudulent, deceptive, or manipulative” practices in connection with a tender offer.

Terms of the Offer (§14(d)(4)-(7)): governs the substantive terms of the tender offer, e.g., duration, equal treatment.

14e-1: Tender offers must be open for 20 business days (helps lessen the pressure to rush into the decision without adequate information)

14d-10: Tender offers must be made to all holders; all purchases must be made at the best price 14d-7: Shareholders who tender can withdraw while tender offer open 14e-5: Bidder cannot buy “outside” tender offer

These provisions work together to protect shareholders from high pressure sales tactics, give management time to respond, give shareholders and news media the opportunity to investigate a would-be purchaser, and give competitors the opportunity to engage in a bidding war.

Wellman v. Dickinson (p. 439) Facts: Sun Company buys 34% of Becton Dickinson in a “brilliantly designed lighting strike”: simultaneous phone

calls to 30 large institutional shareholders and 9 wealthy individuals, at a fixed price substantially above market but left open only for one hour. “The lawyers indicated that the law regarding tender offers was still murky and that the concept of a tender offer had not been precisely defined. The lawyers wanted to structure a ‘privately negotiated’ transaction. Fogelson [of Wachtell, Lipton] and Charles Nathan of Cleary, Gottlieb felt this required that those solicited be limited in number. One felt that up to 60 solicitees was safe; the other argued for an upper limit of 40, but within those limits the lawyers felt there would be no problem.” “There was an extended discussion of strategy . . . considering (1) open market purchases, (2) a conventional tender offer, and (3) private purchases. In the face of a hostile target, a conventional tender offer was not considered attractive. It was felt that it would lead to competitive bidding which would make the desired acquisition more expensive.”

Holding: The court develops an 8 factor test to determine whether a solicitation is a de facto tender offer subject to the requirements of the Williams Act, and each of the eight factors was present except widespread solicitation. Eight factor test:1. “Active and widespread solicitation”2. “The solicitation is made for a substantial percentage of the issuer’s stock”3. “A premium over the prevailing market price”4. “The terms of the offer are firm rather than negotiable”5. “Whether the offer is contingent on the tender of a fixed minimum number of shares”6. “Whether the offer is open only for a limited period of time”7. “Whether the offerees are subjected to pressure to sell their stock”8. “Whether public announcements of a purchasing program . . . precede or accompany a rapid accumulation”

Brascan Ltd. v. Edper Equities Ltd. (p. 435) Facts: Edper owns 5% of Brascan (Canadian company) and is turned down when it proposes a friendly

acquisition. Edper engages Connacher to buy shares; Connacher contacts 30-50 institutional investors and 10-15 individual investors and buys 10%, mostly from them, on April 30th. In response to a demand from Canadian officials Edper announces that it has no plans to buy any more shares at that time. Nevertheless, without further announcement, Edper buys another 14% the next day, bringing total stake to 29%. Brascan brings suit claiming violation of ’34 Act §14(e) and Rule 10b-5 (general antifraud provision).

Holding: Not a de facto tender offer Reasoning: It only clearly met one Wellman factor—solicitation made for large % of the target’s stock (but

arguments in the opposite direction are quite plausible)11.5. THE HART-SCOTT-RODINO ACT WAITING PERIOD

Designed to give the FTC and DOJ the opportunity to block deals that violate anti-trust laws. From a corporate law point of view, it is important because of the waiting period the HSR imposes before a bidder

can commence her offer (similar to a stricter §13(d) requirement). Minimum waiting period before closing a transaction (§18a(b)(1)(B)):

30 days for open market transactions, mergers and negotiated deals; 15 days for cash tender offers; May be extended for another 30 days (10 days for cash tender offers) if DOJ or FTC makes a Second Request

(§18a(e)(2)) Who must file ((§18a(a)(2)):

The acquirer in all deals > $212 million; An acquirer with assets or sales > $106 million and a target with assets or sales > $11 million (or vice versa), if

the deal involves assets or securities > $53 million.12. FUNDAMENTAL TRANSACTIONS: MERGERS AND ACQUISITIONS

12.1. INTRODUCTION

Among the most important transactions in corporate law are those that pool the assets of separate companies. There are three legal forms for such transactions: the merger, the purchase (or sale) of all assets, and (in RMBCA jurisdictions) the compulsory share exchange. A merger is a legal event that unites two existing corporations with a public filing of a certificate of merger,

usually with shareholder approval. The “surviving corporation” subsequently owns all of the property and assumes all of the obligations of both parties to the merger.

An RMBCA share exchange closely resembles certain kinds of mergers in its legal effects.

Acquisitions comprise a generic class of “nonmerger” techniques for combining companies, which generally involve the purchase of the assets or shares of one firm by another. Following an acquisition, the acquiring corporation may or may not assume liability for the obligations of the acquired company.

12.2. ECONOMIC MOTIVES FOR MERGERS

The corporate form partitions business assets into discrete pools under the management of particular management teams. The law of M&A transactions provides quick and inexpensive ways to reform the partitioning and management of corporate assets.12.2.1. Integration as a Source of Value Gains from integrating corporate assets arise from what economists term economies of “scale,” “scope,” and

“vertical integration.” Economies of scale result when a fixed cost of production is spread over a larger output, thus reducing the

average fixed cost per unit of output. This source of efficiency often explains horizontal mergers between firms in the same industry.

Economies of scope spread costs across a broader range of related business activities. Vertical integration, a special form of economies of scope, may arise by merging a company backward, toward

its suppliers, or forward, toward its customers. Contracting through the market can be expensive.12.2.2. Other Sources of Value in Acquisitions: Tax, Agency Costs, and Diversification M&A transactions are often said to generate value for three other reasons:

Tax: Corporations with tax losses may set those losses off against income in subsequent years. This ability to carry an NOL is valuable only if its owner has sufficient taxable income to absorb it. A corporation that lacks sufficient income might prefer to find a wealthy merger partner rather than waste its NOL.

Agency Costs: As a company’s stock price declines because the market anticipates that its incumbent managers will mismanage in the future, it becomes more likely that an outsider buyer can profit by purchasing a controlling block of stock and replacing the incumbent managers. Realizing maximum returns from replacing managers will generally require that the target company

merge with a subsidiary of the acquiring company. Diversification: M&A transactions are sometimes said to increase corporate value by diversifying a company’s

business projects, thus smoothing corporate earnings over the business cycle (but this shouldn’t add value, because investors can diversify on their own)

12.2.3. Suspect Motives for Mergers There are also opportunistic motives to enter mergers that increase shareholder value or management

compensation at the expense of another corporate constituency. One example is a squeeze-out merger, in which a controlling shareholder acquires all of a company’s assets at

a low price, at the expense of its minority shareholders. Another form of opportunistic merger is one that creates market power in a particular product market and

thus allows the postmerger entity to charge monopoly prices for its output. Finally, “mistaken” mergers destroy value because their planners misjudge the difficulties of realizing merger

economies. Common errors include underestimating the costs of overcoming disparate firm cultures; neglecting intangible costs, such as the labor difficulties that might follow wholesale layoffs; and failing to anticipate the added coordination costs that result merely from increasing the size of a business organization.

12.2.4. Do Mergers Create Value? The general weight of the evidence indicates that, measured by immediate stock market price reaction to the

merger’s announcement, on average, mergers do create value. Targets generally win, while acquirers break even, or lose on average.

12.3. THE EVOLUTION OF THE U.S. CORPORATE LAW OF MERGERS

The history of U.S. merger law is one of constantly loosening constraints. The fundamental move in this evolution occurred when the law became willing to treat equity investors as a class of interests that could, except where fiduciaries duties were triggered, be adequately protected by majority vote and a right to a statutory appraisal of fair value.12.3.1. When Mergers Were Rare Mergers were rare until roughly 1890 because legislatures created business corporations by special acts of

incorporation and shareholders naturally lacked the power to amend these legislative charters. Beginning around 1840, however, the enactment of general incorporation statutes permitted shareholders to

incorporate on their own initiative, but until around 1890, stat incorporation law barred shareholders from amending their charters (which a merger would require) without unanimous consent.

12.3.2. The Modern Era Technological change in the last decades of the nineteenth century increased the efficiency scale of many injuries.

Toward the end the nineteenth century, corporation statutes were amended to permit mergers and charter amendments that received less than unanimous shareholder approval, providing that they were recommended by the board and approved by a majority of a company’s shareholders.

Today, Delaware and many other states allow mergers to proceed with the approval of only a bare majority of the outstanding shares.

In exchange for removing the unanimous shareholder consent requirement, states established the shareholders’ right to dissent from a proposed merger and demand an “appraisal”—or judicial determination of the cash value of her shares—as an alternative to continuing as a shareholder in the new, merged enterprise.

In the mid-twentieth century, states greatly liberalized the permissible forms of merger consideration. Originally shareholders of a merging company could receive only equity in the surviving company in

exchange for their old shares. Under the mid-century statutes, the range of possible forms of consideration moved beyond securities in the surviving corporation to include all forms of property—most notably cash.

Thus, from at least mid-century onward, it has been possible under state law to construct a “cash-out” merger, in which shareholders can be forced to exchange their shares for cash as long as the procedural requirements for a valid merger are met.

12.4. THE ALLOCATION OF POWER IN FUNDAMENTAL TRANSACTIONS

The merger is the most prominent among a handful of corporate decisions that require shareholder approval. It is a universal requirement that shareholder approve material amendments of the articles of incorporation, the basic

“charter” of the corporation. If it is useful for investors to be able to rely on any constraint in the charter, then the law must preclude unilateral

amendment of the charter by the board. To protect investors’ reasonable expectations, the law must provide a shareholder veto over all transactions that

might effectively amend the charter. Thus, shareholder must approve both corporate dissolution, which nullifies the corporate charter, and corporate mergers, in which the surviving corporation’s charter may be amended.

Two major considerations ought to determine the allocation of decision-making power within organizations: who has the best information, and who has the best incentives Managers will generally have much better information regarding a company’s business and all of its proposed

transactions, but managers may have incentive problems. Rationally, principals will reserve power to veto those matters that are most economically significant and in which

they have some capacity to exercise informed judgment. In the corporate context, these criteria suggest that dispersed shareholders will wish to decide at most only very

large issues (those that affect their entire investment) and will wish to decide only issues that they can be expected to decide with some competence (‘Investment-like” decisions rather than “business” decisions). The general contours of corporate law follow this logic.

Mergers require a shareholder vote on the part of both the target and the acquiring company, except the acquiring company’s shareholders do not vote when the acquiring company is much larger than the target (DGCL §251(b)).

Sales of substantially all assets require a vote by the target’s shareholder, but purchases of assets do not require them to do so.

The M&A transactions that require shareholder approval are those that change the board’s relationship to its shareholders most dramatically, reducing the ability of shareholders to displace their managers after the transaction is completed.

It seems possible that concerns relating to shareholder future control over managers, rather than size or shareholder competence, are the binding functional determinants of when the law requires a shareholder vote.

12.5. OVERVIEW OF TRANSACTIONAL FORM

There are three principal legal forms of acquisitions: (1) the acquirer can buy the target company’s assets, (2) the acquirer can buy all of the target corporation’s stock, or (3) the acquirer can merge itself or a subsidiary corporation with the target on terms that ensure its control of the surviving entity. Statutory Merger (DGCL §251):

1. A(cquiror) & T(arget) boards negotiate the merger2. Proxy materials are distributed to shareholders as needed (see below).3. T shareholders always vote (§251(c)); A shareholder vote if A stock outstanding increases by > 20%

(§251(f)).a. We allow A’s shareholders to vote in some circumstances because their holding may be diluted if

> 20% shares are issued.4. If majority of shares outstanding approves, T assets merge into A, T shareholders (traditionally) receive A

stock. Certificate of merger is filed with the secretary of state.5. Dissenting shareholders who had a right to vote have appraisal rights.

Asset Acquisition (DGCL §271)1. Once again, the boards of the two firms -- A and T -- negotiate the deal.2. But now, only T’s shareholders get voting and appraisal rights (because only T is being “bought”).3. Transaction costs are generally higher because title to the actual physical assets of the target must be

transferred to the acquirer.

4. After transfer, selling corporation usually liquidates the consideration received (e.g., cash) to its stockholders.

a. If A pays T’s shareholder with cash in acquisition of assets, it doesn’t need the shareholders of A to vote in favor of the merger. Even if it s is on the NYSE, which usually requires shareholder vote whenever new stock is issued, paying cash avoids triggering the vote requirement.

Mergers vs. Asset Acquisitions: While a merger unites assets and liabilities, asset acquisition allows A to accede only to T’s assets but not T’s

liabilities. Some caveats, however: if T’s assets constitute an “integrated business,” A may be hit with successor

liability under tort claims if T has dissolved and paid out a liquidating distribution to its shareholders. Likewise, if T’s assets constitute hazardous environmental conditions, A may be liable for cleanup expenses. If we didn’t have these caveats, it would be easy to avoid liability in these circumstances.

In an asset acquisition, A gets a stepped up basis, while in a merger, A gets a carryover basis In each of these transactional forms, the acquirer can use cash, its own stock, or any other agreed-upon form of

consideration. Each form has particular implications for the acquisition’s transactions costs (including its speed), potential

liability costs, and tax consequences.12.5.1. Asset Acquisition The acquisition of a business through the purchase of its assets has a relatively high transaction cost (but a low

liability cost). The purchase of assets presents a standard set of contracting problems. Each individual step (identify assets, conduct due diligence, establish representations and warranties,

negotiate covenants, fix price and terms of payment, transfer titles) is costly, and in the case of purchasing a large firm, aggregate acquisitions can be quite large.

A sale of substantially all assets is a fundamental transaction for the selling company, which requires shareholder approval

Katz v. Bregman (p. 453) Facts: As part of a broader divestment strategy, Plant Industries decides to sell its Canadian operations (Plant

National), which constitutes 51% of its assets, 45% of its revenues, and 52% of its operating income. Idea is to take the proceeds and shift to a different line of business (making plastic drums instead of steel drums). Plant CEO Bregman agrees to sell Plant National to Vulcan, even though Universal offered a higher bid. Plaintiff shareholders seek an injunction against the deal, alleging that shareholder vote is required because the deal sells “all or substantially all of its property and assets.”

Holding: ½ means all Reasoning: Court appears concerned that CEO was selling the subsidiary to the second-highest bidder and

used ½ means all” to require a shareholder vote. In most cases, much more than ½ is required to mean substantially all (see Hollinger, Inc. v Hollinger, Intl. (p. 457), where an asset accounting for 56% of the corporation’s value was not ‘substantially all’ because that means ‘essentially everything’)

Thorpe v. CERBCO (p. 456) Facts: CERBCO was a holding company with three subsidiaries, including Insituform. CERBCO’s stock in

Insituform comprised 68% of its assets and was CERBCO’s primary income-generating asset. CERBCO’s public shareholders wanted CERBCO to sell Insituform. The controlling shareholders of CERBCO, however, wanted to sell their controlling interest in CERBCO instead.

Holding: A sale of Insituform shares, comprising 68% of CERBCO’s assets, would have been subject to a shareholder vote under DGCL §271.

Reasoning: The need for shareholder approval is to be measured not by the size of the sale alone, but also on the qualitative effect upon the corporation. It is relevant to ask whether a transaction is out of the ordinary course and substantially affects the existence and purpose of the corporation. NB: RMBCA does not require vote on the sale of assets unless the business does not continue to exist after

the transaction (quite permissive to sellers over shareholders).12.5.2. Stock Acquisition A second transactional form for acquiring an incorporated business is through the purchase of all, or a majority of,

the company’s stock. To acquire a corporation in the full sense of obtaining complete dominion over its assets, an acquirer must

purchase 100% of its target’s stock, not merely a control block. Moreover, as a practical matter, acquirers typically do not want a small minority of public shares outstanding (there are costs to being a public company). Corporate law recognizes the legitimacy of the desire to eliminate a small public minority through easy-to-

execute short form merger statutes, which allow a 90% shareholder to simply cash out a minority unilaterally. When the parent owns >90% of each class of stock in a subsidiary, it can merge the subsidiary into

another company without a shareholder vote – all the parent must do is have the subsidiary’s board

adopt a resolution setting forth the consideration to be paid to the subsidiary’s minority shareholders and approving the merger.

Some states offer acquirers and willing targets the statutory device of a compulsory “share exchange” transaction. This is, in effect, a tender offer negotiated with the target board of directors that, after approval by the requisite majority of shareholders, becomes compulsory for all shareholders. The acquiring company’s stock (or other tender offer consideration) is then distributed to the target’s shareholders pro rata, while the acquirer becomes the sole owner of all of the stock of the target. The result is a form of acquisition that receives the tax treatment of a tender offer without the attendant

holdup problems of a true tender offer or the awkward residue of a minority of public shareholders. RMBCA §11.03 provides for a compulsory share exchange, but Delaware does not. Unlike a merger, where there is one surviving corporations, under compulsory share exchanges there are two

survivors (this is functionally similar to a triangular merger). Two-Step Merger

Delaware instead has a hybrid acquisition form that produces almost the same result; the “two-step” merger, in which the boards of the target and the acquirer negotiate two linked transactions in a single package.

The first transaction is a tender offer for most or all of the target’s shares at an agreed-upon price. The second transaction is a merger between the target and a subsidiary of the acquirer, which is to follow the

tender offer and remove minority shareholders who failed to tender their shares.12.5.3. Mergers A merger legally collapses one corporation into another. The management teams of the corporations, aided by

lawyers and often by investment bankers, prepare a merger agreement for board approval. After the board formally authorizes the execution of this agreement, the board will in most instances call a shareholders’ meeting to obtain shareholder approval of the merger.

In most states, a valid merger requires a majority vote by the outstanding stock of each constituent corporation that is entitled to vote.

The voting common stock of the “target” or collapsed corporation always have voting rights. The voting stock of the surviving corporation is generally afforded statutory voting rights on a merger except

when three conditions are med: (1) the surviving corporation’s charter is not modified; (2) the security held by the surviving corporation’s shareholders will not be exchanged or modified: and (3) the surviving corporation’s outstanding common stock will not be increased by more than 20%. Mergers satisfying these conditions have too little impact on the surviving corporation’s shareholders to

justify the delay and expense of a shareholder vote. The stock exchanges and NASDAQ require a listed corporation to hold a shareholder vote on any transaction

or series of related transactions that result in the issuance of common stock (or convertible preferred stock) sufficient to increase outstanding shares by 20%. Unlike corporate statutes, the stock exchange rules require approval of 50% of shares voting on the matter as opposed to 50% of outstanding shares.

Following an affirmative shareholder vote, a merger is effectuated by filing a certificate of merger with the appropriate state office. The governance structure of the surviving corporation may be restructured in the merger through the adoption of an amended certificate of incorporation and bylaws, which will have been approved by the shareholders as part of the merger vote.

Shareholders who disapprove of the terms of the merger must dissent from it in order to seek, as an alternative, a judicial appraisal of the fair value of their shares.

12.5.4. Triangular Mergers The surviving corporation in a merger assumes the liabilities of both constituent corporations by operation of

law. Preserving the liability protection that separate incorporation provides to the acquirer is almost always a highly desirable business goal.

The acquirer has a strong incentive to preserve the liability shield that the target’s separate incorporation confers. This can easily be done by merging the target into a wholly owned subsidiary of the acquirer (or by merging the subsidiary into the target).

The maintenance of the liability shield is the premise for the triangular merger form. In this structure, the acquirer (A) creates a subsidiary (S). A transfers merger consideration into S in

exchange for all S’s stock. T then merges into S (forward triangular merger) or S merges into T (reverse triangular merger). At the time of merger, merge consideration is distributed to T’s shareholders and T’s stock will be cancelled. A will own all the stock of S, which will own all of T’s assets and liabilities.

No matter which company (S or T) is the survivor, its charter can be restated at the merger to include the governance terms and capital structure that parties deem desirable. The merger agreement will be entered into by all three parties. In practice, the merger consideration will not be transferred first to the S but will be distributed at the closing of the transaction directly from A to the holders of T’s shares in consideration of the cancellation of those shares.

12.6. STRUCTURING THE M&A TRANSACTION

To choose the right structure for an M&A transaction, the lawyer, banker, and client must consider the interaction of many variables, including costs, speed, liabilities, information known and unknown, accounting treatment, regulatory hurdles, and threats from alternative acquirers.

Merger agreements may contain specialized provisions not found elsewhere: (1) lock-up provisions, which are designed to protect friendly deals from hostile interlopers, and (2) fiduciary out provisions. There may also be standstill agreements, which bar hostile activity before the agreement is closed, as well as

confidentiality provisions.12.6.1. Timing An all-cash, multistep acquisition is usually the fastest way to lock up a target and assure its complete acquisition.

An all-cash tender offer may be consummated 20 business days after commencement under the Williams Act. By contrast, a merger will generally require a shareholder vote of at least the target shareholders, which, in turn,

will involve several months for clearance of the proxy materials with the SEC and solicitation of proxies under the proxy rules.

If stock constitutes any part of the deal consideration, the two-step structure generally does not provide a significant timing advantage because the stock to be issued generally must be registered with the SEC, which takes several months to complete. Thus, most deals using 100% stock consideration are structured as one-step director or triangular mergers.

12.6.2. Regulatory Approvals, Consents, and Title Transfers In a sale of assets, title transfers may impose substantial cost and delay. Thus, reverse triangular mergers are the

cheapest and easiest methods of transfer because they leave both preexisting corporations intact. Stock purchases are much simpler to conclude than asset purchases.

Planners will attempt to choose a structure that minimizes the cost of obtaining regulatory approvals or consents under contracts needed to close the transaction. Planners will wish to make the transfer of corporate assets as cheap as possible.

12.6.3. Planning Around Voting and Appraisal Rights From the planner’s perspective, shareholder votes and appraisal rights are costly and potentially risky.

Ordinarily, planners will choose a structure that voids or minimizes such requirements. Planners are particularly wary of structures that trigger class votes for holders of preferred stock, since these

votes may enable the holders of such securities to extract a “holdup” payment in exchange for allowing the deal to proceed.

12.6.4. Due Diligence, Representations and Warranties, Covenants, and Indemnification Hostile takeovers will rarely provide much opportunity for due diligence. Risk and uncertainty will accordingly be

greater. In negotiated transactions, the representations and warranties contained in a merger agreement will facilitate the

due diligence process by forcing the disclosure of all the target’s assets and liabilities. Target warranties and representations are particularly useful when there is a solvent corporation or

individual to stand behind them. Warranties and representations have their greatest use in private deals—that is, where control is acquired

through any method from a single entity or small group. A typical covenant offered by a target in a merger agreement will provide that the business will be operated only

in the normal course from the date of the signing of the agreement to the closing. Another typical covenant will require the target to notify the buyer if it learns of any event or condition that

constitutes a breach of any representation or warranty. Additionally, a standard covenant is a pledge by the target to use its best efforts to cause the merger to close

(usually subject to a fiduciary out). In addition, the parties will customarily indemnify each other for any damages arising from any

misrepresentation or breach of warranty. The agreement will effectively allocate the burden of undiscovered noncompliance to the party making the representation.

12.6.5. Deal Protections and Termination Fees Among the most important terms of a friendly merger agreement are those terms that are designed to assure a

prospective buyer that its investment in negotiating in good faith with a target will result in a closeable transaction.

Acquirers tender before merging to keep out hostile bidders (between the time the merger agreement is signed until the shareholder vote, the target is a sitting duck). Tender offers last 20 days, while M&As take at least 3 months. The acquirer uses a tender offer to prevent others from purchasing control of T.

12.6.6. Accounting Treatment In a direct merger, the surviving corporation will typically record the assets acquired at their fair market value. To

the extent that the merger consideration exceeds this amount, the survivor will record the excess as an intangible asset, “goodwill,” which is not amortized but rather subject to a periodic assessment for impairment.

12.7. TAXATION OF CORPORATE COMBINATIONS

12.7.1. Basic Concepts

Federal taxes are levied on income, which includes gains in the value of investments as they are realized and recognized.

The shareholders of the target corporation will generally realize a gain or loss upon the sale or exchange of their stock in either an individual transaction or a corporate transaction. An important aspect of tax planning for M&A transactions is to attempt to defer the recognition and realization of any realized shareholder gain.

The federal income tax code contains specific provisions defining the characteristics of tax-free reorganizations. Compliance with these provisions makes these transactions nonrecognition events.

12.7.2. Tax-Free Corporate Reorganizations The Code does not recognize taxable gain for transactions that, in economic substance, merely reorganize

ownership interests without fundamentally changing the identity of the owners. Section 368 delineates three ways of obtaining control over a business. Because the concept that drives the §368

safe harbor is continuity of ownership, the consideration that A uses to acquire control must be solely or predominantly stock: IRC §368(a)(1)(A) (“A Reorg”, statutory merger): mergers & consolidations executed pursuant to state law,

provided that A’s stock must constitute a substantial and meaningful portion of the total consideration. Up to 50% boot allowable.

IRC §368(a)(1)(B) (“B Reorg”, stock acquisition): A acquires solely in exchange for its voting stock (or the voting stock of its parent) at least 80% of T’s stock. No boot allowed.

IRC §368(a)(1)(C) (“C Reorg”, asset acquisition): A acquires “substantially all” of T’s assets in exchange for A’s stock. Up to 20% boot allowable.

Qualifying a transaction as a tax-free reorganization under one of these provisions generally means that there is no recognition of gain by sellers except to the extent they receive “boot.”

Sellers will take a carryover cost basis in the stock they receive and buyers assume the carryover basis of the transferors in the target stock or assets they acquire.

An A reorganization offers great flexibility to the corporate planner. An A reorganization must meet three principal requires in addition to being a merger or consolidation under state law: There must be a business purpose, not merely a tax avoidance purpose for the test; The reorganization must satisfy a continuity of interests test; The reorganization must satisfy the continuity of business enterprise requirements.

12.8. THE APPRAISAL REMEDY

12.8.1. History and Theory The shareholder vote is the shareholders’ principal protection against unwise or disadvantageous mergers or

other fundamental transactions. Every U.S. jurisdiction provides an appraisal right—the right to a judicial appraisal of the fair value of one’s shares

—to shareholders who dissent from qualifying corporate mergers. The Delaware corporate law statute mandates appraisal only in connection with corporate mergers and then

only in certain circumstances (DGCL §262). It is often said that the appraisal remedy was granted as a quid pro quo when legislatures first permitted the

authorization of mergers to be effectuated with less than unanimous shareholder approval. A judicial appraisal was a way to provide a liquidity even for such a shareholder, who previously could have

prevented the alteration of her investment simply by vetoing a proposed merger. With increased liquidity of equity markets, the question is whether there are other justifications for this

remedy that give it continuing utility for publicly-traded firms.12.8.2. The Appraisal Alternative in Interested Mergers Today the appraisal remedy tends to be invoked either in nonpublicly traded firms or in transactions in which

shareholders have structural reasons to think that the merger consideration may not be “fair value.” The appraisal remedy is rarely invoked in arm’s-length mergers, arguably because without conflicts of interest,

most arm’s-length mergers achieve something close to market price. Where there is a controlling shareholder or some other reason to doubt that the shareholder vote fairly

reflects the independent business judgment of a majority of disinterested public shareholders, some judicial remedy to assure fairness is necessary.

Any merger involving a self-interested controlling shareholder continues to provide a compelling justification for the appraisal remedy or something like it.

The law has also provided an equitable remedy in the form of fairness review when minority shareholders challenge the self-interested transaction. In some aspects, an appraisal action is easer for shareholders to bring.

The plaintiff need only establish her bona fides as a dissenting shareholder to seek appraisal and need not show that the board or a controlling shareholder breached a fiduciary duty.

In most aspects, however, an action alleging breach of entire fairness seems more favorable to plaintiffs. A plaintiff in an appraisal proceeding is entitled to claim only a pro rata share of the fair value of the

company without regard to any gain caused by the merger or its expectation.

In a fiduciary “fairness” action, the defendant must prove that a self-dealing transaction was fair in all respect, and if he fails, the possible remedies are very broad.

Plaintiffs can bring a fairness action as a class action on behalf of all affected shares and not just the small minority who will typically dissent from the merger and seek appraisal.

Traditional law dealt with the overlap between an appraisal and a suit for breach of fiduciary duty by making appraisal the exclusive remedy of shareholders who complained that the merger consideration was inadequate or unfair. Glassman v. Unocal Exploration (p. 477): Delaware Supreme Court held that appraisal is the exclusive

remedy of minority shareholders cashed out in a §253 short-form merger. Weinberger v. UOP, Inc. (p. 477): Delaware Supreme Court modernized the appraisal remedy as to long-

form mergers by approving of the use of modern valuation techniques and by attempting to unite the appraisal remedy and the equitable action against a fiduciary.

Setting Up an Appraisal Claim (DGCL §262):1. Shareholders get notice of appraisal right at least 20 days before shareholder meeting (§262(d)(1)).2. Shareholder submits written demand for appraisal before shareholder vote, and then votes against (or at

least refrains from voting for) the merger (§262(d)(1)).3. If merger is approved, shareholder files a petition in Chancery Court within 120 days after merger

becomes effective demanding appraisal (§262(e)).4. Court holds appraisal hearing.In re Transkaryotic Therapies (not in CB) Facts: Slim majority of Transkaryotic (TKT) shareholders approve the sale of their company to Shire

Pharmaceuticals for $37 per share cash. On the record date (June 10, 2005), Cede & Co. was holder of record for 29.7 million shares, and voted 12.9 million in favor of the merger and voted against or abstained with 16.8 million shares. Hedge funds and arbitrageurs owned 2.9 million shares through Cede and voted against the merger; then bought 8.1 million shares through Cede before the close of the deal and sought appraisal for all 11.0 million shares. TKT sought summary judgment on the grounds that the hedge funds must prove that each share that they seek appraisal for was voted against the merger.

Holding: Chancellor Chandler denies summary judgment and allows the shareholders to seek appraisal on all 11.0 million shares.

M&A Deal Commentary (May 2007): “A likely effect of this decision will be to encourage aggressive investors (for example, hedge funds and arbitragers) to examine every cash merger in Delaware for suitability for appraisal claims with the goal of either negotiating a settlement of the claims after the merger or convincing an appraisal court that the value of the shares was higher than the merger price.” Importantly, you must forego merger consideration and wait for settlement of the claim.

Shareholder Voting & Appraisal SummaryStatutory Merger (DGCL §251, RMBCA §11.02)

Asset Acquisition (DGCL §271, RMBCA §12.01-.02)

Share Exchange (RMBCA §11.03)

T Voting Rights

Yes – need majority of shares outstanding (DGCL §251(c)), or majority of shares voted (RMBCA §11.04(e))

Yes, if “all or substantially all” assets are being sold (DGCL §271(a)) or no “significant continuing business activity” (RMBCA §12.02(a))

Yes – need majority of shares voted (RMBCA §11.04(e))

A Voting Rights

Yes, unless <20% shares being issued (DGCL §251(f), RMBCA §11.04(g))

No (though stock exchange rules might require vote to issue new shares)

Yes, unless <20% shares being issued (RMBCA §11.04(g))

Appraisal Rights

Yes if T shareholders vote, unless stock market exception (DGCL §262, RMBCA §13.02). Also get appraisal rights in short-form mergers (DGCL §§ 253(d), 262(b)(3))

Yes under RMBCA if T shareholders vote, unless stock market exception (RMBCA §13.02(a)(3)); No in Delaware, unless provided in charter (DGCL §262(c))

Yes, unless stock market exception (RMBCA §13.02(a))

12.8.3. The Market-Out Rule Section 262 of the DGCL grants the right of judicial appraisal to all qualifying shares of any class in a merger

effectuated under the general merger statute (DGCL §251). However, this remedy is denied under the Delaware appraisal statute (and others – see RMBCA §13.02(b))

when shares of target corporations are traded on a national security exchange or held of record by 2,000 registered holders.

Additionally, appraisal is denied if the shareholder were not required to vote on the merger.

Notwithstanding the above, appraisal is restored if target shareholders receive as consideration anything other than (i) stock in the surviving corporation, (ii) any other shares traded on a national security exchange, (iii) cash in lieu of fractional shares, or (iv) a combination of those items. There is a de minimis exception for cash in lieu of fractional shares.

Thus, shareholders in a privately traded firm will always have appraisal rights, but shareholders in a public company with more than 2,000 shareholders have no appraisal rights in a stock-for-stock merger. It is difficult to justify withholding appraisal in stock-for-stock mergers when shares are publicly traded but

granting appraisal rights in cash-out mergers.12.8.4. The Nature of “Fair Value” The appraisal right is a put option—an opportunity to sell shares back to the firm at a price equal to their “fair

value” immediately prior to the transaction triggering the right. Approaches to Valuation (in order of increasing desirability for dissenting shareholders)

(1) value as minority shares, that is, apply a minority discount; This is equivalent to the market-out rule

(2) value as pro rata claim on going concern value, that is, no minority discount but no claim on the benefits of the deal; or

(3) value as pro rata claim on going concern value, including the benefits from the deal. Delaware law clearly defines the dissenting shareholder’s claim as a pro rata claim on the value of the firm as a

going concern. Traditionally, Delaware law determined fair value for appraisal purposes by a technique known as the Delaware block method. This technique examined a number of factors relating to a firm’s value including: Market Value of Shares: share price, if shares are traded. Earnings Value: last three years of earnings, capitalized using a price-to-earnings ratio. Asset Value: net assets, valued at liquidation value.

After Weinberger, the discounted cash flow (DCF) method became the most common valuation technique in appraisal cases. Each side presents through an expert a detailed evaluation of the firm, with a projection of future cash flows and an estimate of the appropriate cost of capital for discounting those expected cash flows to present value.

12.9. THE DE FACTO MERGER DOCTRINE

Some U.S. courts have accorded shareholder voting and appraisal rights to all corporate combinations that resemble mergers in effect. These courts have reasoned that when a de facto merger has the same economic effect as a de jure merger, shareholders should have the same protection.

The counterargument is that corporate law contains a large element of formalism; this is not ‘mere formality,’ but rather a source of utility that permits people to accurate predict the legal consequences of their activities.

Delaware courts and most U.S. courts take the formalist side of the argument. A self-identified sale of assets that results in exactly the same economic consequences as a merger will nonetheless be

governed by the (lesser) shareholder protections associated with a sale of assets and not the full panoply of merger protections.Hariton v. Arco Electronics, Inc. (p. 481) Facts: Loral buys all of Arco in an arms-length asset acquisition after months of negotiating and two rejected

offers. Shareholders approve the transaction, Arco transfers all of its assets to Loral, Loral transfers its stock to Arco, Arco dissolves and distributes the Loral stock to its shareholders (i.e., classic asset acquisition for stock). Arco shareholder brings suit claiming right to appraisal because the deal was a de facto merger.

Holding: The shareholder does not have a right to appraisal. Reasoning: The Delaware legislature has decided to give appraisal rights to mergers but not asset acquisitions.

The shareholder knew this could happen. Treating this as a de facto merger with attendant appraisal rights is a slipper slope. Take-home: Functional rationales for appraisal rights are totally incoherent.

12.10. THE DUTY OF LOYALTY IN CONTROLLED MERGERS

Controlling shareholders owe to the corporation and its minority shareholders a fiduciary duty of loyalty whenever the exercise any aspect of their control over corporate actions and decisions. All shareholders, however, have the right to vote their shares in their own best interest. Thus, there is some tension between a controlling shareholders’ exercise of voting rights, which can arguably reflect her own “selfish” self-interest, and her exercise of “control” over the corporation or its property, which cannot.

The exercise of control gives rise to an obligation of fairness when the control does what other shareholders cannot (such as access non-public corporate information).

Controlled mergers expose minority shareholders to an acute risk of exploitation, but asset sales and reverse stock splits can also be freeze-out techniques.12.10.1. Cash Mergers or Freeze-Outs Freeze outs are the ultimate conflicted transactions. Minority shareholders are at risk of experiencing negative tax

consequences, having their long-term interests frustrated, and/or receiving a low price. Why Permit Freeze-outs?

Efficiency – firms that go private don’t have to meet the reporting requirements that apply to public companies

Remove collective action problem Eliminate majority-minority conflicts Financing (a parent may want to own a subsidiary completely to use it as collateral in financing) Eliminate the risk/threat of shareholder litigation Enable more robust protection of (legitimate) private corporate data

While freeze-outs have value, there are drawbacks, primarily in the form of equity issues for minority shareholders and inefficient abuses of freeze-outs by a controller to extract value from minority shareholders. Appraisal isn’t a perfect remedy here (why?) which helps to explain heightened judicial scrutiny in this area.

Forms of Freeze-outs: Merger Tender offer Reverse stock split Asset acquisition

Most are statutory mergers; if majority shareholder holds more than 90% of shares, it will be a short-form merger.

In freeze-out mergers, the controlling shareholder sets up a dummy corporation that merges with the target firm and minority shareholders are cashed out (DGCL §251).

Cash-out mergers (or freeze-outs) reemerged as a controversial topic during the 1960s and 1970s when a period of low stock market prices followed after a boom in public offerings of stock. The low stock value allowed many controlling shareholders to cash out public shareholders at prices substantially below the prices these investors had paid for the same shares a short time before. Such transactions often occurred when the pro rata value of the assets held by these companies far exceeded the market value of their minority shares. A “cash-out” even at a premium price allowed the controlling shareholders to capture a disproportionate share of the company’s value.

The SEC adopted Rule 13e-3 under the Williams Act specifically to require uniquely extensive disclosure in going-private transactions, while courts wrestled with the task of protecting minority shareholders without banning freeze-outs altogether.

Singer v. Magnavox (not in casebook): Permitted shareholders to bring class actions, in addition to appraisal proceedings, challenging freezeout mergers on the grounds that the controlling shareholder breached its fiduciary duty of entire fairness to minority shareholders. Established a per se rule: a freezeout without a colorable business purpose did breach entire fairness duty

(and “getting rid of minority shareholders” doesn’t count as a business purpose). Established that minority shareholders’ remedy was so-called "recissory damages" a.k.a. the monetary

equivalent of rescission.Weinberger v. UOP, Inc. (p. 486)

Facts: Signal owns 50.5% of UOP and holds six board UOP seats out of thirteen. Signal board decides to buy the remainder of UOP. Arledge and Chitiea (UOP and Signal directors) write report that any price up to $24 per share would be a “good investment” for Signal; study is shared with Signal board but not with UOP. Signal board offers $21 per share, a 55% premium over pre-bid market price, conditioned on approval by majority of the minority UOP shareholders. UOP CEO Crawford makes no effort to negotiate with Signal, and UOP board approves the offer with a hastily-drafted fairness opinion from Lehman Bros. Signal directors Walkup and Crawford withdraw from the UOP board meeting approving the transaction, but were involved in the negotiations up to that point (and persuade Crawford to sell the deal). 52% of total outstanding minority shares approve the merger. Plaintiff UOP shareholders bring a class action challenging the transaction as a breach of the UOP board’s fiduciary duty. Chancery Court rules for defendant directors.

Holding: The board did not meet its duty of entire fairness. There are two components of entire fairness: fair dealing (procedural) and fair price (substantive). They can’t be bifurcated.

Reasoning: UOP should have appointed an independent negotiating committee of its outside directors to deal with Signal at arm’s-length. If this was done, the burden would shift to the plaintiff to show unfairness. Ordinarily, ratification by disinterested directors triggers business judgment rule. We require a higher

standard of proof as to conflicted transactions involving a controlling shareholder than we do conflicted transactions involving senior officers because we think a single director probably can’t sway the board, whereas a controlling shareholder would have the power to vote his wishes through (and/or fire directors who stand against him); in a controlled transaction, there is no such thing as a truly disinterested director.

To protect a freeze-out, the freezor must show arm’s-length bargaining. The following are helpful: A vote of majority of minority of the shares Independent negotiating committee – it should make demands to demonstrate a real back-and-forth Serious fairness opinion Evidence of real deliberation and negotiation

New approach to valuation established; the standard Delaware block method is rejected in favor of proof of value by any generally-accepted techniques or methods of valuation. Damages caused by the merger are included, however, including tax consequences, drop in value, and lost opportunities. Whether valuation includes a fair share of synergy gains available in the merger is unclear (The court

seems to say yes, but DGCL §262(h) clearly say no). The appraisal remedy is now recissory damages (making shareholders totally whole); this is an attempt

to make appraisal as valuable as entire fairness (because the court wants appraisal to be the only remedy, undoing Singer). The court’s attempt to make appraisal the exclusive remedy (outside of fraud, misrepresentation, and

self-dealing) is ineffective. As a functional matter, you can still bring a class action to challenge the entire fairness of a freeze-out merger (see Rabkin, p. 494)

The court also rejects business purpose as a per se rule (again undoing Singer), but allows it to continue to serve as a favor in determining entire fairness.

Appraisal Suit vs. Breach of Fiduciary Duty Claim Appraisal may not be available because of the “market-out” provision. Unlike an appraisal suit, an action claiming breach of fiduciary duty can be brought before the

effectuation of the merger, which provides the plaintiff an opportunity to request a preliminary injunction.

Plaintiffs claiming breach of fiduciary duty receive the benefits of the deal at closing even as they pursue the suit.

Suits for breach of fiduciary duty can be, and most often are, brought as class action, which affords counsel a means to get paid from the class settlement.

Plaintiffs can bring a fairness action as a class action on behalf of all affected shares and not just the small minority who will typically dissent from the merger and seek appraisal. The size of the group represented has a great impact on negotiating leverage and the fee expected by the lawyer.

12.10.2. What Constitutes Control and Exercise of ControlKahn v. Lynch Communication Systems, Inc. (p. 497)

Facts: Alcatel owns 43.3% of Lynch Communications; Lynch wants to buy Telco but supermajority provision gives Alcatel veto power and Alcatel proposes that Lynch acquire Celwave (owned by Alcatel) instead. Lynch board appoints a committee of independent directors to negotiate with Celwave. Dillon Read (Alcatel’s banker) recommends as 0.95 exchange ratio to the Lynch independent committee (IC); Thomson McKinnon (IC’s banker) concludes that 0.95 would overvalue Celwave. Based on this advice, the IC unanimously opposes a Celwave/Lynch combination. Alcatel withdraws the Celwave proposal but makes an offer to acquire the remaining 56.7% of Lynch at $14 per share cash. IC is reconstituted to negotiate with Alcatel, rejects $15.00 as inadequate, but finally recommends a $15.50 per share offer on threat of a hostile bid from Alcatel. Lynch disinterested directors then approve the freezeout merger. Minority shareholders bring suit against the Alcatel directors alleging breach of fiduciary duty as controlling shareholder. Chancery Court rules for defendants because the IC had “appropriately simulated a third-party transaction, where negotiations are conducted at arms-length and there is no compulsion to reach an agreement.”

Holding: Attempting to meet the formalities required in Weinberger shifts the burden of proof to plaintiffs only if the independent committee is sufficiently independent, a burden that is not met here.

Reasoning: This committee was not independent because the controlling shareholder was “holding a gun” to their head.

12.10.3. Special Committees of Independent Directors in Controlled Mergers Assuming a properly constituted, diligent, and well-advised special committee of independent directors, courts

may (1) treat the special committee’s decision as that of a disinterested and independent board, which merits review under the deferential business judgment rule or (2) continue to apply the entire fairness test, even if the committee appears to have acted with integrity, since a court cannot easily evaluate whether subtle pressure or feelings of solidarity have unduly affected the outcome of a committee’s deliberation. In Kahn v. Lynch Communication Systems, the court seemed to suggest that even a truly independent

committee decision could only shift the burden of proving the unfairness of the transaction to the plaintiffs. In In re Western National Corp. Shareholders Litigation, however, the court gave to the action of the

independent board committee the respect it would accord an action approving an arm’s-length transaction.12.10.4. Controlling Shareholder Fiduciary Duty on the First Step of a Two-Step Tender Offer A controlling shareholder who sets the terms of a transaction and effectuates it through his control of the board

has a duty of fairness to pay a fair price. If the controlling shareholder does not “force” a transaction on the board through the actions of his board

appointees but merely “offers” the transaction to the board, which then acts to accept the offer through its independent directors, the controlling shareholder must still pay a fair price, although the burden lies with an objecting shareholder to prove its price unfair.

In re Siliconix Shareholder Litigation (p. 504)

Facts: Vishay owns an 80.4% stake in Siliconix; wants to acquire the remaining 19.6%. In February 2001, Vishay announces a tender offer at $28.82 cash (a 10% premium) for the remaining Siliconix stock, and requests the opportunity to “discuss its tender offer with a special committee of independent, non-management Siliconix directors who are unaffiliated with Vishay.” Siliconix sets up a Special Committee consisting of two directors and negotiations begin. In May 2001, Vishay launches an exchange offer of 1.5 shares of Vishay for each Siliconix share. Minority shareholder challenges the offer as an inadequate and unfair price. Chancery Court refuses to apply entire fairness scrutiny: “Vishay was under no duty to offer any particular price, or a ‘fair’ price, to the minority shareholders of Siliconix unless actual coercion or disclosure violations are shown. . . . In short, as long as the tender offer is pursued properly, the free choice of the minority shareholders to reject the tender offer provides sufficient protection.”

Holding: A shareholder who skips the board altogether and “offers” a transaction directly to the public shareholders in the form of a tender offer has no duty to pay a “fair” price, as long as such an offer is not “coercive.” The controlling shareholder does have a fiduciary duty to make adequate disclosures, however.

Reasoning: Entering such a transaction is voluntary on the part of minority shareholders; if they don’t like the price, they can remain shareholder and force the controller to cash them out, in which event they will have the protection of an appraisal right. An acquisition tender offer by a controlling stockholder is non-coercive only when:

(1) it is subject to a nonwaivable majority of the minority tender condition;(2) the controlling stockholder promises to consummate a prompt § 253 merger at the same price if it obtains more than 90% of the shares; and(3) the controlling stockholder has made no retributive threats.

If a target’s special committee is slow or negotiations break down, a controlling shareholder can go around the special committee by launching a tender offer.

In re Pure Resources, Inc. (p. 504) Facts: Unocal Corp. holds 65% of Pure Resources, Pure CEO Hightower holds 6%, and Pure managers hold

another 11%. Pure board has eight members: 5 Unocal designees, 2 Hightower designees, and 1 joint designee. Unocal makes a surprise exchange offer at a 27% premium to market price, contingent on getting to 90% ownership of Pure. Pure forms a Special Committee, consisting of two Pure directors who are plausibly independent of Unocal. Special Committee negotiates with Unocal, fails to adopt a poison pill (that would give it veto power), and finally recommends against the exchange offer to Pure’s minority shareholders. Unocal nevertheless goes ahead, and Pure minority shareholders bring suit seeking an injunction to block the offer.

Holding: Even a tender offer can be coercive, and this offer was because its “majority of the minority” vote requirement included within the definition of the “minority” Pure stockholders who were affiliated with Unocal as directors and officers.

Reasoning: An acquisition tender offer by a controlling stockholder is non-coercive when: (1) it is subject to a non-waivable majority of the minority tender condition; (2) the controlling stockholder promises to consummate a prompt §253 merger at the same price if it obtains more than 90% of the shares; and (3) the controlling stockholder has made no retributive threats. Target board independent directors must have role: “[T]he majority shareholder owes a duty to permit

the independent directors on the target board free rein and adequate time to react to the tender offer, by (at the very least) hiring their own advisors, providing the minority with a recommendation as to the advisability of the offer, and disclosing adequate information for the minority to make an informed judgment.”

Details of fairness opinion methodology must be disclosed: “Stockholders are entitled to a fair summary of the substantive work performed by the investment bankers…”

NB: These conditions apply only when the person launching the offer was a controlling shareholder at the outset of the offer.

13. PUBLIC CONTESTS FOR CORPORATE CONTROL13.1. INTRODUCTION

Control contests give acquiring managers the opportunity to capitalize on the new value created by different plans or better skills, and they give target shareholders the opportunity to share in this new value. The threat of a takeover has the salutary effect of encouraging all managers to deliver shareholder value, making control contests an important potential constraint on manager-shareholder agency costs.

Historically, there were two avenues for initiating a hostile change in control: (1) the proxy contest – the simple expedient of running an insurgent slate of candidates for election to the board and (2) the ender offer – the even simpler expedient of purchasing enough stock oneself to obtain voting control rather than soliciting the proxies of others. In recent years, the proxy contest and the tender offer have often merged into a single hybrid form of hostile

takeover, as the law’s acceptance of increasingly potent defensive tactics has made it difficult to pursue either avenue alone.

Smith v. Van Gorkom (p. 513)

Facts: Trans Union Corp. is a publicly held company with unused NOL’s (net operating losses) and a CEO (Jerome Van Gorkom) looking to retire. Stock is selling for $35 per share. Acting mainly on his own, Van Gorkom arranges a sale to Jay Pritzker’s company for $55 per share cash. Van Gorkom calls a special meeting of the board but does not give them an agenda beforehand; board approves the merger, and deal protection features, after two hour meeting. Trans Union shareholder sues, claiming breach of the duty of care. No allegation of conflict of interest, but claim that the board did not act in an informed manner in agreeing to the deal. Chancery Court approves the transaction, finding that board approval fell within protection of the business judgment rule.

Holding: Delaware Supreme Court reverses, 3-2, finding that the directors had been “grossly negligent.” Casebook Authors’ Interpretation: This is the first installment in a series of attempts by the Delaware Supreme

Court to impose an intermediate standard of review on anti-takeover measures. This case is a duty of care outlier because it is an M&A transaction, and corporate control transactions are subject to higher standard than the business judgment rule.

13.2. DEFENDING AGAINST HOSTILE TENDER OFFERS

Unocal Corp. v. Mesa Petroleum Co. (p. 515) Facts: Unocal stock trading at ~$33 per share. Mesa Petroleum (Pickens) quietly buys 13% of Unocal’s stock and

then makes a tender offer for another 37% at $54 per share in cash. Mesa discloses its plan to freeze out the remaining 50% for junk bonds worth ~$45, if successful in the first-stage tender offer. Unocal board meets to review the offer; Goldman reports to the board that the minimum cash value in a liquidation would be $60 per share cash. Board decides on a “defensive recapitalization”: self-tender for 30% of the shares at $72 per share in debt securities, and tender for remaining 20%, also at $72 per share in debt securities, if Mesa gains 50% (and Mesa excluded from the offer). Mesa brings suit to enjoin the defensive measures, which would then allow the hostile tender offer proceed.

Holding: Intermediate standard of review (between lax business judgment review and tough entire fairness review) for defensive measures in hostile takeover settings. The standard consists of two steps:

(1) Directors had to have reasonable grounds for believing there was a threat to the corporation. (Directors can consider the impact of the takeover on corporate constituencies other than shareholders in deciding whether there was a threat to the corporation). (2) Directors’ response has to be reasonable in relation to the threat.

Reasoning: Practitioners have essentially stopped making two-tiered tender offers (where offeror offers to buy one set of

shares in a tender offer at one price, and then offers a lower price to those who get cashed out at the back end) because if they make a coercive tender offer, it gives the target board license to take extraordinary defensive measures.

NB: Boards no longer have discriminatory self-tenders as a take-over defense; the following year the SEC banned discriminatory tender offers by both companies and outsiders.

Unitrin v. American General Corp. (p. 521) Facts: American General makes a hostile takeover bid; Unitrin’s board resists by repurchasing 20% of its shares.

Share repurchase increases the Unitrin directors’ stake from 23% to 28%, and gives the board a solid veto power over a freeze-out transaction (due to 75% vote requirement for transactions with a >15% shareholder). The Chancery court finds a threat of “substantive coercion” and upholds the pill as proportionate to the threat, but strikes down the repurchase as disproportionate under Unocal. Unitrin appeals to the Delaware Supreme Court.

Holding: Justice Holland reverses: “[I]f the directors’ defensive response is not draconian (preclusive or coercive) and is within a ‘range of reasonableness,’ a court must not substitute its judgment for the board’s.”

Reasoning: Rearticulation of Unocal’s “Reasonable in Relation to Threat” Requirement:1. Second step of Unocal is a two-part inquiry: was the defensive tactic “coercive” or “preclusive,” and, if not,

does it fall within a “range of reasonableness.”2. Defendant directors have burden of showing proportionality.3. If the defendant shows proportionality, burden shifts to plaintiff to show breach of fiduciary duty, e.g.,

entrenchment, lack of good faith, or being uninformed.4. If the defendant fails to show proportionality, the defendant gets a final opportunity to show entire fairness of

the transaction. Thus, under Unical/Unitrin:

The target’s directors, not the plaintiff, bear the burden of going forward with evidence to show that the defensive action was proportionate to a threat.

Action that is “preclusive” or “coercive” will fail to satisfy Unocal’s test. Assuming that a defensive measure passes the preclusive/coercive test (= not draconian), then it is will satisfy

Unocal so long as it is “within a range of reasonable action” (= business judgment rule).13.3. PRIVATE LAW INNOVATION: THE POISON PILL

The invention of the poison pill was tremendously effective in preventing takeovers, but it remains highly controversial.

While commentators and institutional investors generally believe that hostile tender offers are a useful device for disciplining corporate management, managers themselves believe that vulnerability to hostile bids is a profound weakness in the corporate governance structure because it exposes disaggregated and disorganized shareholders to abusive tender offers.

Implementing a “Flip In” Poison Pill Step 1: Shareholder approval is not necessary as long as the board has the requisite provision in the charter

allowing it to issue blank check preferred stock. Thus, almost every company has an implicit poison pill.

Step 2: Rights are distributed by dividend and remain “embedded” in the shares Step 3: Triggering event occurs (it never does) when prospective acquirer buys > set percentage (frequently 10 to

15%) of outstanding shares. Rights are no longer redeemable by the company and soon become exercisable. Step 4: Rights are exercised. All rights holders are entitled to buy at the discounted (usually half) price, except the

acquirer, whose right was cancelled. Some corporations include provisions permitting distribution of cash, assets, or other securities in place of

common shares if there aren’t enough common shares available (because this number is limited by the articles of incorporation) – Pyrrhic strategy.

Sometimes the rights might not be distributed at all unless some event occurs Alternative strategy

A pill with a higher triggering threshold is actually scarier to potential acquirers because it means you will lose even more when the pill is activated.

Poison pills are legal/fair because everyone gets the rights; if the acquirer does something that disqualifies him from exercising his rights, then he has to suffer the consequences; there’s no breach of contract on the part of the corporation.

Other Types of Pills Flip over pill allows shareholders of the target other than the bidder the right to buy stock in the acquirer at a

substantially discounted price. In order to be effective, the acquirer must complete a merger; if he doesn’t the flip over pill isn’t effective. Not clear that this is legal.

Chewable pill: pill disappears if fair price criteria are met Slow hand pill: pill that may not be redeemed for a specified period of time after a change in board composition

Illegal in Delaware Dead hand pill: pill that may only be redeemed by the ‘continuing directors’

Illegal in Delaware No hand pill: pill that may not be redeemed by current or future boards for the life of the pill (usually ten years).

Illegal in DelawareMoran v. Household International (p. 525): Facts: In August 1984, on a “clear day,” Household International board adopts a poison pill by a 14-2 vote, on the

advice of Wachtell, Lipton and Goldman Sachs. Two triggers: announcement of a 30% tender offer, and acquisition of 20% of the shares. Directors Moran and Whitehead (co-Chairman of Goldman, Sachs) vote against; Moran, largest shareholder and potential acquiror, brings suit to enjoin the pill as outside the board’s authority and an invalid exercise of business judgment. Chancery Court upholds the poison pill as a legitimate exercise of business judgment; Moran appeals.

Holding: There is no categorical rule that all poison pills are valid or invalid; each must be analyzed under the Unical test. (1) Did the board respond to a threat? (2) Was the response reasonable? If so, business judgment rule applies

Reasoning: Boards have authority to adopt poison pills, but each takeover attempt/response is judged individually and there is continuous review.

Forced Pill Redemption The best way to pull a pill is through a proxy battle, but combined with staggered boards, pills are, in practice,

impossible to defeat. Moran v. Household Intl (Del. 1985): “The Rights Plan [I.e., poison pill] is not absolute. When the Household Board

of Directors is faced with a tender offer and a request to redeem the Rights, they will not be able to arbitrarily reject the offer. . . . The ultimate response to an actual takeover bid must be judged by the Directors’ actions at that time, and nothing we say here relieves them of their fundamental duties to the corporation and its stockholders.” (emphasis added)

City Capital Associates Ltd. Partnership v. Interco (Del. Ch. 1988): Chancery Court requires target board to redeem a stock rights plan that the company used to protect its recapitalization alternative to a hostile, all-cash, all-shares tender offer.

Grand Metropolitan Pub. Ltd. Co. v. Pillsbury (Del. Ch. 1988): Chancery Court required Pillsbury to redeem its poison pill after concluding that Pillsbury’s own restructuring proposal was not as good as a hostile all-cash offer from Grand Met.

Versata Enterprises v. Selectica (p. 532) Facts: Selectica adopts a poison pill that gives every stockholder except the acquiror a new share of stock if the

pill is triggered. Selectica had adopted a 15% trigger at the time of its IPO, but reduced the trigger to 5% after Versata began threatening to take control. The Selectica board argued that the pill was necessary to protect tax net operating losses (NOLs) which had accumulated in the corporation and which would be lost if control of the company changed hands. Versata argued that the NOLs would never be used, because Selectica was a perpetually money-losing company and would never have income against which the NOLs could be used.

Holding: The combination of poison pills and staggered boards is not preclusive of a change in control under the Unitrin standard, even though in fact this combination makes a takeover impossible.

13.4. CHOOSING A MERGER OR BUYOUT PARTNER: REVLON, ITS SEQUELS, AND ITS PREQUELS

The board’s entrenchment interest can affect not only its takeover defenses but also its choice of a merger or buyout partner, because management can obtain a variety of benefits in “friendly” deals. Traditionally corporate law treated decisions to initiate merger proposals as business judgments as long as

management did not have a conflicting ownership interest, but in the 1980s, the Delaware Supreme Court examined the board’s fiduciary duty in arranging for the “sale” of a company.

Smith v. Van Gorkom (p. 533) It’s not about takeover defenses (Unocal), but selecting a merger partner (Revlon). Apparently not very important in this context; Morley doesn’t seem to believe it stands for what the CB editors

think it stands for. Leveraged Buyout

Step 1: Buyer borrows large amounts of cash and uses it to acquire all or almost all of the target’s stock. Step 2: Buyer uses its control of the corporation to cause the corporation to raise large amounts of cash:

(a) Buyer causes the corporation to take out a huge loan(b) Buyer sells off many of the corporation’s assets.

Step 3: Buyer pays itself the cash as a dividend and uses the cash to pay off Buyer’s original loan. Alternately, Buyer can combine steps 2 and 3 by having the corporation assume the loan.

When all is said and done, the corporation has a new owner, who owns all or substantially all of the corporation’s shares, and the corporation has a great deal of debt.

Revlon v. MacAndrews & Forbes (p. 541) Facts: Perelman makes a hostile all-cash tender offer for Revlon at $47.50 per share when the stock is trading at

$25 (a 90% premium). Revlon board adopts a poison pill and tenders for 20% of its own shares with notes. The recapitalization permits Revlon to subject itself to specialized debt covenants that restrict the sale of assets, which in turn makes an LBO more difficult. But Perelman is undeterred – he raises his offer to $50, $53, and finally to $56.25 per share, with the promise of even more if Revlon redeems (i.e., gets rid of) its pill. Forstmann Little enters as a “white knight” and eventually agrees to pay $57.25; gets an “asset lockup,” a “no-shop” provision, and a breakup fee, in exchange for supporting the par value of the Notes which had faltered in the market. Perelman increases his offer to $58, and brings suit to enjoin the defensive tactics and deal protection devices that Revlon used to preserve its deal with Forstmann. Chancery Court rules for Perelman and enjoins the asset lockup, no-shop provision, and breakup fee. Directors are opposed to Perelman’s offer because they will lose their jobs and because they don’t want to be

affiliated with Perelman. The directors also worry that they’ll have personal liability for the notes they issued as part of the takeover defense. The noteholders are not pleased by Revlon’s solicitation of Forstmann as a white knight because Revlon is giving Forstmann the opportunity to make its debt more senior to the noteholders’ claims.

Holding: When a “sale” or “breakup” of the company becomes “inevitable,” “the directors’ role [is] changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the company. . . . The directors’ role remains an active one, changed only in the respect that they are charged with the duty of selling the company at the highest price attainable for the stockholders’ benefit.” In Revlon, the court says you can care about non-shareholder interests, but only so far as they help to

maximize shareholder value. Lock-up options are not per se illegal. Deal protection mechanisms are supposed to be designed to get actors

who would not otherwise bid to bid, and they can’t totally shackle the directors and prevent them from accepting a superior bid.

Revlon Duties Clarified: Level Playing Field Among Bidders: “[W]hen several suitors are actively bidding for control of a corporation,

the directors may not use defensive tactics that destroy the auction process. . . . When multiple bidders are competing for control . . . fairness forbids directors from using defensive mechanisms to thwart an auction or to favor one bidder over another.”

Market Check Required: “When the board is considering a single offer and has no reliable grounds upon which to judge its adequacy, . . . fairness demands a canvas of the marketplace to determine if higher bids may be elicited.”

Exemption Allowed in (Very) Limited Circumstances: “When . . . the directors possess a body of reliable evidence with which to evaluate the fairness of a transaction, they may approve the transaction without conducting an active survey of the marketplace.”

13.5. PULLING TOGETHER UNOCAL AND REVLON

Paramount v. Time (p. 547) Facts: Time and Warner agree to a stock-for-stock merger-of-equals in which Warner shareholders get 62% of the

surviving company. Various deal protection devices, including “cross-options” to deter third-party bidders. Co-CEO’s for five years, then Warner’s CEO (Ross) retires and Time CEO (Nicholas) takes over. Ross gets $200 million in cash and options by the time he retires, and $600 million total for Warner’s management team. Paramount makes an all-cash hostile bid for 100% of Time shares, first at $175, then upped to $200. Time’s board rejects the offer based on (revised) fairness opinion from Wasserstein Perella which values the Time shares for as much as $250. Time gets nervous about its shareholder vote, so the deal with Warner is restructured so that Time borrows $10 billion and uses it to make a cash tender offer for Warner (the tender offer avoids the shareholder vote – under the merger, Time was to offer new shares greater than 20% of its outstanding shares). Paramount brings suit to enjoin Time’s defensive tactics under Unocal; Time shareholders join suit and also assert a Revlon claim.

Holding: Revlon is not triggered. Directors are not obliged to abandon a deliberately conceived corporate plan for short-term shareholder profit unless there is clearly no basis to sustain the corporate strategy.

Reasoning: Revlon is not triggered because both before and after the merger control of Time is in the market, so the merger with Warner is not a sale of the company, and Time is not abandoning its long-term strategy (the company is not up for sale) Revlon Triggers: (1) “When a corporation initiates an active bidding process seeking to sell itself or to effect a

business reorganization involving a clear break-up of the company”; (2) “where, in response to a bidder’s offer, a target abandons its long-term strategy and seeks an alternative transaction involving the break-up of the company.” Three Kinds of Possible Threats:

Structural coercion: “the risk that disparate treatment of non-tendering shareholders might distort shareholders’ tender decisions” (Moran problem)

Opportunity loss: “a hostile offer might deprive target shareholders of the opportunity to select a superior alternative offered by management”

Substantive coercion: “the risk that shareholders will mistakenly accept an underpriced offer because they disbelieve management’s representations of intrinsic value.”

This case seems to invoke the second and third types of threats. Unocal analysis: The court finds a threat (shareholders are too stupid to know that Paramount’s offer is too

low) and finds Time’s response reasonable (Time had a long-term business strategy and changing the deal structure with Warner was necessary to protect that strategy).

Under the framework set up in Paramount v. Time, the board can always survive the Unocal analysis, so Unocal means nothing; you can always say the price is too low, so we’re back to the business judgment rule. As long as the board has a plan, even if it’s a poor one, it doesn’t have to abandon it for short-term

shareholder profit.Paramount v. QVC (p. 554) Facts: Paramount agrees to be acquired by Viacom. The deal gives substantial deal protection measures to

Viacom, but QVC nevertheless jumps the deal. Viacom matches and then raises QVC’s offer, but leaves the deal protection unchanged. QVC re-raises, but Paramount rejects the offer as ‘excessively conditional’ while making no effort to explore the conditions or negotiate with QVC. QVC files for an injunction, claiming Paramount was in Revlon-mode.

Holding: Paramount was in Revlon-mode; all impediments to the QVC offer are struck down. Reasoning: The standard for application of Revlon is that Revlon applies if a change in control is occurring.

When control of the corporation is vested in the fluid aggregation of unaffiliated shareholders, transactions that result in shifting their role to a minority equity voting position in the surviving company require payment of a control premium to the unaffiliated shareholders.

But if Paramount already had a controlling shareholder, no control premium would be owed to the minority shareholders (they didn’t have control before, so they can’t demand a control premium now; this was the case in Paramount v. Time).

Revlon mode is more likely (unless target has a majority shareholder) where (1) consideration is in cash rather than stock, (2) the merger is a whale/minnow transaction rather than a merger of equals, and (3) the acquiror has a controlling shareholder rather than being widely held. 1 & 2 relate to the Institutional Competence Theory under Revlon, while 3 relates to the Sale of Control

Theory under QVC. Revlon duties are likely to be triggered when mergers create shareholdings with between 30 and 35% of the voting

rights in widely held companies.

In most circumstances, boards of directors are better able to value companies than are shareholders—but in some circumstances, as when shareholders are or might be cashed out of the postmerger enterprise, boards must maximize short-term value, since this is the only value shareholder are likely to receive.

The more the value of merger consideration depends on synergies between the target and the acquiring company, the more courts will defer to the judgment of the target’s directors. In cash deals, courts will not defer; in stock-for-stock mergers of equals, they will defer a great deal. In the middle range, where the merger represents mixed consideration or the target is vastly smaller than the survivor, courts will inevitably assess deal-protective terms by evaluating the good faith of the corporate directors who approve these terms.

Case Holding Open Questions Some Answers

Act I: Moran

Installing a pill is authorized by Delaware statute and survives intermediate scrutiny under Unocal

When will a court force a target board to redeem its pill because it has “arbitrarily reject[ed] the offer”?

Rarely (in practice, never, post-Time): Board is not required to give up a long-term strategic plan “unless there is clearly no basis to sustain the corporate strategy.” (Time)

Act II: Unocal

Defensive tactics (how and how long a board can resist a hostile takeover) will be judged using intermediate scrutiny: (1) must be a perceived threat; and (2) tactics must be “reasonable in relation to the threat posed.”

What constitutes a threat to the corporation justifying defensive action?

Valid threats are: structural coercion (see Unocal), opportunity loss (see Time), and substantive coercion (cf. Time, see Unitrin). BUT after Time, boards really very rarely have to pull poison pills.

Act III: Revlon

When Revlon duties are triggered, target board must maximize immediate shareholder value (board can implement deal protections to increase price but can not use anti-takeover mechanisms to discriminate among buyers)

What is a “sale” of the firm sufficient to trigger the Revlon duty, and just what does this duty consist of?

Sale or breakup of the company (Time) or sale of control (QVC) triggers Revlon duties; substantive requirements are level playing field and market check (Barkan).

Lyondell Chemical Co. v. Ryan (p. 568) Facts: On July 9th 2007, Bassell CEO Blavatnik negotiates with Lyondell CEO Smith and eventually offers to pay $48

per share in cash to acquire Lyondell, but requires tight deal protections. Lyondell board agrees to the deal after extremely expedited process and no market canvass for a higher bid. On November 20th 2007, Lyondell shareholders approve the sale by more than 99% of voted shares. Shareholder plaintiff nevertheless allege that price was inadequate and directors breached their Revlon duties. Lyondell had a §102(b)(7) waiver (which merely waives directors’ personal liability for damages for breach of duty of care, but doesn’t waive option of injunction), so question is whether the Lyondell board acted in good faith. Delaware Chancery Court allows claim to proceed on duty of loyalty claims against the board. Delaware Supreme Court accepts interlocutory appeal.

Holding: The directors did not beach their duty of loyalty by failing to act in good faith; there is only one Revlon duty, and that is to get the best price for the shareholders.

Reasoning: Revlon applies only when a company has embarked on a transaction on its own initiative or in response to an unsolicited offer that will result in a change in control (Paramount v. QVC holding). Lyondell didn’t breach a duty by not reacting to the threat of a hostile offer because it was merely a specter of possible future action. Acts taken in bad faith are said to be breaches of duty of loyalty, not of duty of care. Corporations can’t waive

liability for bad faith under §102(b)(7). Court finds that once Revlon applied (the active bidding process began), the directors met their duty of care; it was not deliberate disregard of duty of care for them to do nothing in the two preceding months because they were not in a Revlon situation. Personal Liability for Directors

Negligence – no personal liability for directors under business judgment rule Gross Negligence – no personal liability for directors if effective §102(b)(7) waiver Deliberate disregard, self-dealing, or fraud – examples of bad faith that will trigger personal liability

for directors13.6. PROTECTING THE DEAL

Deal Structuring – Lockup Agreements

A lock-up is a contract collateral to an M&A transaction that is designed to increase the likelihood that the parties will be able to close the deal. The two major categories of lock-ups are options to a target’s assets and its stock. Asset lock-ups create rights to acquire specific corporate assets that become exercisable after a triggering event. Asset lockup: Gives the acquirer the right to buy specified assets of the target at a specified price after a

triggering event. Should a third party disrupt the parties’ favored transaction, the target corporation will lose some of its more attractive assets through the exercise of the lock-up rights. Extremely rare in the 1990s.

Stock option lockup: Gives the acquirer the right to buy a specified number of shares of the target (typically 19.9%) at a specified price (typically the deal price in the “protected transaction”). Should a third party disturb the pending transaction, the lock-up provides that the jilted acquirer can participate in the increased value of the target to the extent of its proportionate share in the company’s diluted equity.

Breakup fee: Gives the acquirer a cash payment in the event of non-consummation. They are justified as necessary to compensate a friendly buyer for spending the time, money, and reputation to negotiate a deal with a target. Lump-sum payments no larger than 3 to 4% of the deal price are easily rationalized.

In determining whether a lock-up is consistent with the board’s duties in a Revlon transaction, courts will weigh such considerations as how early in the process the lock-up was given and the value-enhancing nature of its specific terms.

13.6.1. “No Shops/No Talks” and “Fiduciary Outs” For acquirers in corporate mergers, the legal requirement that the target’s shareholders vote introduces an

irreducible contingency into merger contracts. Buyers protect against this risk in two ways: They may seek a large lock-up They may seek certain covenants from the seller that will protect their deal. A target board might be asked to

covenant (a) not to shop for alternative transactions or supply confidential information to alternative buyers, (b) to submit the merger agreement to the shareholders for approval, and (c) to recommend that shareholders approve this agreement. Such terms can serve the interests of target shareholders as well as those of acquirers; without them,

prospective buyers would invest fewer resources in searching for deals and might offer less generous prices.

Counsel for targets have devised the “fiduciary out” clause, but buyers resist them. Where a transaction triggers Revlon duties, however, target counsel typically admonish that the legal risk of failing to have a fiduciary-out clause is unacceptable. Since the Delaware Supreme Court has seemed to declare contracts unenforceable that violate a fiduciary

duty, contract damage may not ever be available against a corporation that abandons a transaction subject to Revlon duties on the grounds that a better deal is available.

13.6.2. Shareholder Lock-Ups Whether or not a transaction constitutes a “change in control,” if the board’s process is deliberate and informed

and the board is truly independent, the law must let the board make business decisions without fear of being second-guessed.

When the transaction does constitute a “change in control” that deference will be expressed in some form of heightened scrutiny; when the transaction is not a Revlon transaction, that deference may indeed be the business judgment rule.

Omnicare v. NCS HealthCare (p. 579) Facts: Omnicare makes offer for NCS but negotiations break down. Genesis is the only one (seemingly)

interested in NCS, but will only make an offer if it can get a fully locked up deal. Part of the deal requires NCS Chairman & President to commit their votes (they hold voting control, even though they own less than 20% of the company; these controlling shareholders sat on the board, but they commit their votes not as directors but as controlling shareholders) and allows Genesis to force a vote. Omnicare comes back with a better offer & NCS recommends the Omnicare offer, but Genesis forces the vote and wins (because controlling voters are committed already). Omnicare brings suit to invalidate the stockholder lockup agreement; Delaware Chancery Court upholds the agreement under Unocal analysis.

Holding: The fact that the contract forces the directors to neglect their fiduciary duties invalidates the contract. But another way to handle the conflict would be to have directors obliged to fulfill their fiduciary duties

but the firm nevertheless liable for breaching the contract. Reasoning:

When Paramount v. QVC says what’s important is whether there’s a sale in control, what it means is whether the minority ought to expect to receive a control premium (which is the case in a public corporate where shareholders hold a control stake in diffuse fashion). Revlon does not apply here because control was not diffusely distributed before the deal.

This side agreement (which is really what makes the agreement preclusive) is a consequence of shareholder action, but the controlling shareholders also sit on the board.

Majority applies Unical and Unitrin here.

Unical and Unitrin seem to apply when the majority is trying to entrench itself; the board no longer gets the deferential business judgment review.

Unical applies when the board is resisting sale. According to the majority, Unical applies whenever deal protections are employed to prevent a

hostile takeover. Unical test: (1) Did the board respond to a threat? (2) Was the response reasonable? If so,

business judgment rule applies Unitrin test: (1) that the deal protections weren’t coercive or preclusive and (2) the response fell

within a range of reasonableness (more permissive than merely being reasonable) Dissent

Unitrin doesn’t apply because there was no meaningful minority stockholder voting decision to coerce. According to the dissent, Unical only applies when the board is using its position to maintain its

employment status. Fiduciary outs are now a mandatory term, even if the parties don’t negotiate them into the agreement.

This was clearly true in Revlon scenarios before this case; the case extends this holding to Unical situations.

Orman v. Cullman (p. 587 n. 7): Facts: Through a dual class structure the Cullman family owns a controlling interest in General Cigar. In

January 2000 Swedish Match agrees to buy out the minority shareholders of General Cigar at $15.25 per share cash, such that Swedish Match would own 64% and the Cullman family would own 36% of General Cigar (with Cullmans still retaining control). The merger agreement contained: (1) no breakup fee; (2) a fiduciary out that allowed General Cigar to consider an unsolicited superior proposal; (3) a class vote of the A and B shares separately; and (4) a majority-of-the-minority approval (effectively) from the Class A shareholders. But – the Cullman family agreed to vote their controlling interest for the Swedish Match transaction, and against any alternative acquisition proposal for 18 months after any termination of the merger.

Holding: Chancery Court (Chandler, C.) upholds the shareholder lockup: “In [Omnicare] the challenged action was the directors’ entering into a contract in their capacity as directors. The Cullmans entered into the voting agreement as shareholders. . . . [Unlike Omnicare,] the public shareholders were free to reject the proposed deal, even though, permissibly, their vote may have been influenced by the existence of the deal protection measures.”

Orman can be distinguished from Omnicare on two bases: (1) since the controlling shareholders in Omnicare were directors, they couldn’t sign the agreement (2) unlike the force-the-vote provision entered into by the board in Omnicare (when combined with the director/shareholder vote commitment), the agreements entered into by the board in Orman did not compel the merger.

§203(a)(3): if you can manage to get the shares in a proxy contest, you just vote out the board and get a new board.

In Revlon mode, the board cannot consider other constituencies or can only consider them to the extent that considering them benefits the shareholders.

13.7. STATE ANTITAKEOVER STATUTES

13.7.1. First- and Second-Generation Antitakeover Statutes (1968-1987) The first generation of antitakeover statutes addressed both disclosure and fairness concerns and was generally

limited to attempted takeovers of companies with a connection to the enacting state. In 1982, the U.S. Supreme Court struck down this approach as preempted by the Williams Act and thus in

violation of the Supremacy Clause. After the first generation of antitakeover statutes was invalidated, a second generation of statutes attempted to

avoid preemption by the Williams Act by maintaining an appropriate balance between the interests of the offers and the targets within the overarching policy of investor protection.

CTS Corp. v. Dynamics Corp. of America (p. 589) Facts: Dynamics makes a hostile tender offer for CTS Corp; brings suit challenging the Indiana antitakeover

statute as preempted by the Williams Act and a violation of the (dormant) Commerce Clause. The Indiana control share acquisition statute prohibits a bidder from voting its shares beyond 20% ownership unless approved by “disinterested” shareholders (i.e., shareholders other than bidder and insiders). Court of Appeals strikes down the statute as preempted by the Williams Act.

Holding: U.S. Supreme Court upholds the Indiana statute; distinguishes the Illinois antitakeover statute struck down in Edgar v. MITE five years earlier.

Reasoning: The Williams Act doesn’t preempt any state statute that may limit or delay the free exercise of power after a successful tender offer. The statute in question does not conflict with the provisions or purposes of the Williams Act and to the limited extent that it affects interstate commerce, this is justified by the state’s interest in protecting shareholders.

13.7.2. Third-Generation Antitakeover Statutes (1987-2000)

After the Supreme Court held in CTS that state antitakeover legislation is consistent with both the Williams Act and the Commerce Clause if it allows a bidder to acquire shares, even if it makes such acquisition less attractive in some circumstances, numerous states adopted similar statutes.

A prominent example is the “business combination statute,” also referred to as the moratorium statute. This type of statute prohibits a corporation form engaging in a “business combination” within a set time period after a shareholder acquires more than a threshold level of share ownership.

Other State Regulation of Hostile Takeovers: Related to acquiring a control block:

Control share acquisition statutes (27 states): prevent a bidder from voting its shares beyond a specific threshold (20-50%) unless a majority of disinterested shareholders vote to approve the stake.

Other constituency statutes (31 states): allow the board to consider non-shareholder constituencies. Pill validation statutes (25 states): endorse the use of a poison pill against a hostile bidder.

Related to Second-Step Freeze Out: Business combination (freeze-out) statutes (33 states): prevent a bidder from merging with the target for

either three or five years after gaining a controlling stake unless approved by the target’s board. Fair price statutes (27 states): set procedural criteria to determine a fair price in freeze-outs.

DGCL §203: DGCL § 203 bars business combinations between acquiror and target for a period of three years after the

acquiror passes the 15% threshold unless: § 203 (a)(1): takeover is approved by target board before the bid occurs; or § 203 (a)(2): acquiror gains more than 85% of shares in a single offer (i.e., moves from below 15% to

above 85%), excluding inside directors’ shares; or § 203 (a)(3): acquiror gets board approval and 2/3 vote of approval from disinterested shareholders (i.e.,

minority who remain after the takeover). It is meant to deter “junk bond”-financed “bust-up” takeovers by preventing acquirers from getting their

hands on the assets of target firms.13.8. PROXY CONTESTS FOR CORPORATE CONTROL

In a world in which a board may unilaterally adopt a poison pill, those seeing opportunity in a change of management have only two alternative: (1) negotiate with the incumbent board or (2) run both a proxy contest and tender offer simultaneously, with closing the tender offer conditional on electing the acquirer’s nominees to the board and the board’s redemption of the target’s poison pill.

Importance of the Proxy Contest “Safety Valve” Before the pill (pre-1985): board control is an inevitable consequence of buying a majority of the shares:

1. Bidder makes a tender offer and gains a majority of the shares2. Board will almost certainly resign because independence is doomed.3. If directors stay they will be voted out over one (no staggered board) or two (SB) annual elections.

After the pill (post-1985): board control is a prerequisite to buying a majority of the shares:1. Bidder launches a proxy context to replace the target’s board over one (no staggered board) or two (SB)

annual elections.2. Once in office, the new directors redeem the pill, clearing the way for the hostile bidder to proceed with its

bid.Schnell v. Chris-Craft Industries (p. 598) Facts: Dissidents are negotiating with management up to the last possible moment, in hopes of avoiding a full-

fledged proxy contest. Incumbent board strings the dissidents along in negotiations and then, when there are only a couple of months left before the annual meeting, the incumbent board amends the by-laws to advance the meeting date by one month to mid-December (and, for good measure, moves the meeting to an obscure town in upstate New York). All of this has the effect of leaving too little time for dissidents to organize and solicit proxies. The excuse that the board gave was that it wanted to avoid the Christmas mail crush in sending out the solicitation materials and getting back the proxy cards. Dissidents bring suit seeking an injunction to postpone the meeting; the Chancery Court recognized this as a sleazy, hard-ball tactic, but refuses to grant the injunction.

Holding: Injunction granted; if the directors act solely with the purpose of entrenching themselves and with no other purpose, that is not allowed.

Reasoning: There is a higher standard of duty when messing with the shareholder vote. Legal power held by a fiduciary may not be deployed in a way that is intended to treat a beneficiary of the

duty unfairly.Blasius Industries v. Atlas Corp. (p. 599) Facts: Blasius Industries, a 7% shareholder of Atlas, announces its intention to solicit shareholder consents to

increase the size of the board from 7 to 15 members, and to fill the new board seats with Blasius nominees. Objective is to execute a restructuring plan for Atlas. Atlas preempts the campaign by immediately amending its bylaws to add two new board seats, and fills the board seats with its own candidates. Blasius brings suit to enjoin the “board packing” tactic.

NB: If the board is staggered, directors cannot be removed without cause. Holding: Unical does not apply when the primary purpose of the board action is to interfere with the shareholder

vote. Reasoning: The “central importance of the franchise to the scheme of corporate governance” requires closer

scrutiny when you interfere with a shareholder vote; in these circumstances, you need a “compelling justification” (higher standard than Unocal). Questions (p. 602): c is most likely to invoke Blasius review, but we can construct an argument for almost

anything to trigger Blasius review. Almost every hostile takeover defense interferes with the shareholder vote in some way. Morley’s interpretation: The board can’t take specific actions to interfere with specific votes, even though

it can do other things. The board bears the heavy burden of demonstrating a compelling justification after the plaintiff has

established that he board has acted for the primary purpose of thwarting the exercise of a shareholder vote. Since manipulations of the voting process can often be characterized as defensive, courts may apply the

Unocal test to them: Review under Unocal is less demanding than review under Blasius. The structure of analysis under either review standard, however, is the same. In both instances, directors have the burden to establish compliance with a standard, and in both

instances, the standard is a relative one. In Unocal, the action must be reasonable in light of something else (a threat that he act is

directed against). Under Blasius, the justification for the act must be deemed compelling in light of something else

(the threat that the act is directed against). The substantive difference is one of emphasis; Blasius requires a very powerful justification to thwart

a shareholder franchise for an extended period. The Delaware Supreme Court’s Time-Warner opinion seems to authorize a target board to take defensive

action if the company is threatened by what the court terms “substantive coercion.” This, in the end, is simply the board’s belief that the tender offer is inadequate and that the shareholders do not understand that fact.

Under Blasius, however, corporate action to defeat a proxy contest cannot be justified by a parallel belief that the voters simply do not understand the foolishness of voting for the insurgent slate.

Mercier v. Inter-Tel (p. 604) Facts: The Inter-Tel board delayed a merger vote by twenty-five days in order to provide more information to

shareholders and because it became clear that shareholders were not going to approve the merger on the original meeting date.

Holding: The board met its two-part burden under Blasius of proving that their action (1) served, and was motivated by, a legitimate corporate objective; and (2) was reasonable in relation to the legitimate objective and not preclusive or coercive.

Reasoning: You can‘t justify interfering with the shareholder vote by alleging substantive coercion (merely arguing the shareholders were too stupid to realize the price was too low – we won’t tolerate the same rationale that we did in Paramount v. Time)

Hilton v. ITT (p. 604): A spin-off is when a parent puts assets in a subsidiary and then distributes shares in its subsidiary to its

shareholders. The spin-off strategy here was designed to avoid a shareholder vote. The Hilton court concluded that “the installation of a classified board for ITT Destinations, a company that

encompasses 93% of ITT’s assets and 87% of its revenues, is clearly preclusive and coercive under Unitrin. The classified board provision for ITT Destinations will preclude current ITT shareholders from exercising a right they currently possess—to determine the membership of the board of ITT.

13.9. THE TAKEOVER ARMS RACE CONTINUES

13.9.1. “Dead Hand” Pills A dead hand pill cannot be redeemed by the “hostile” board that is elected in a proxy fight for a state period of

time. Early versions provided that the company’s pill could be redeemed only by the company’s “continuing

directors,” a term defined to mean directors in office at the time of adoption of the pill or nominated to office thereafter by “continuing directors.” Courts struck these down because they created two classes of directors and unduly conditioned the rights of shareholders to elect new directors. (Carmody v. Toll Brothers, Inc., p. 606)

“Slow Hand” Pills Later versions of the dead hand pill, known as slow hand pills, provided that while generally the board had a

redemption power, it has no such power for the six months following the election of a new board. The Chancery Court struck down the pill by a Unitrin/Unocal analysis.

The Delaware Supreme Court affirmed on the basis that a present board did not have the authority to restrict the power of future boards, through the adoption of stock rights plans, to exercise their managerial judgment (but they really do this all the time). (Mentor Graphics Corporate. v. Quickturn Design Systems, Inc., p. 606)

13.9.2. Mandatory Pill Redemption Bylaws Some opponents of the pill have sought a technique to gain control of the decision of whether or not to implement

a poison pill. The technique developed involves a shareholder bvlaw that requires the board of directors to redeem an

existing pill and to refrain from adopting a pill without submitting it to shareholder approval. Shareholder mandatory pill redemption bylaws present two controversial issues:

Is a bylaw that mandates the board to exercise its judgment in a particular way a valid bylaw? Must managers include materials respecting any such proposal in the company’s proxy solicitation?

Most of the leading Delaware firms have opined that a mandatory bylaw would constitute an invalid intrusion by the shareholders into the realm protected by §141(a) of the DGCL. §109(b): “The bylaws may contain any provision, not inconsistent with law or with the certificate of

incorporation, relating to the business of the corporation, the conduct of its affairs, and its right or powers of its stockholders, directors, officers, or employees.”

§141(a): “The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation.”

The idea is that boards have rights and duties to make independent judgments respecting the management of the firm. Under Moran, the decision to install a stock rights plan falls within this authority. Shareholders—who may in all events elect a different board if they are displeased with the current one—are not given the power to co-manage the firm.

In the case of everyday business decisions, the gains are great and the cost modest in comparison, but equally plainly, the legal infrastructure of corps reflects the belief that agency costs would be too high if, for example, we denied shareholders the power to appoint directors or approve fundamental transactions.

Whether the law should recognize shareholder power to amend the bylaws to eliminate or alter pills raises an “optimal delegation problem”: When are the efficiencies that we gain from delegating authority to centralized managers outweighed by the expected agency costs associated with that delegation? Where does the poison pill fit in the continuum of efficient delegation?

Staggered boards cannot be adopted by board vote, even though they may appear in either the certificate of incorporation or the bylaws *but only in the bylaws if that particular bylaw is approved by the shareholders.* §109(a) gives a default rule giving shareholders the right to amend bylaws and not giving that right to

board members, although many corporations opt out. However, even if they opt out, boards can’t stagger themselves.

Unisuper v. News Corp. (p. 610) Facts: In October 2004, as part of its reincorporation from Australia to Delaware, the News Corp. board

agreed with certain institutional investors to a “board policy” that any poison pill adopted by the News board would expire after one year, unless shareholders approved an extension. One month later, Liberty Media appeared as a potential hostile bidder, the News board promptly installed a pill, and announced that, going forward, it might or might not hold to its board policy. In November 2005, the News board extended its pill in contravention of its earlier stated board policy.

Holding: The contract not to extend the pill is enforceable. Reasoning: This was acceptable even though the general provision is that mandatory pill redemption bylaws

are unacceptable because this was not a bylaw (it was a contract). The board has more freedom to limit its authority through contracts than through the bylaws. §109(b): “The bylaws may contain any provision, not inconsistent with law or with the certificate of

incorporation, relating to the business of the corporation, the conduct of its affairs, and its right or powers of its stockholders, directors, officers, or employees.”

Fiduciary duties are designed to fill gaps in the contractual relationship between shareholders and directors; they can’t be used to silence shareholders and prevent them from specifying what the corporate contract is to say.

Whether it is pro-shareholder (is being able to adopt a poison pill good for shareholders?), but the court doesn’t explore that issue.

If you want to implement a pill redemption, you can (1) put it in the certificate of incorporation, (2) get the shareholders to adopt a mandatory redemption bylaw (but it can’t be very powerful), or (3) cause the corporation to sign a contract with third party for pill redemption.

14. TRADING IN THE CORPORATIONS SECURITIES The obligations of directors, officers, and issuing corporations when dealing in the corporation’s own securities is

primarily an area of federal law.14.1. COMMON LAW OF DIRECTORS’ DUTIES WHEN TRADING IN THE CORPORATION’S STOCK

The common law fraud remedy was generally not available when the buyer or seller simply failed to disclose a material fact without overt deception and it was unavailable to redress the losses of persons trading over impersonal markets, since these investors could not be said to have traded in reliance on statements made by unknown counterparties.Goodwin v. Agassiz (p. 616) Facts: Agassiz and MacNaughton are directors and officers of Cliff Mining Company and officers of another mining

company. Based on surveys done by the other company, Cliff Mining starts exploring on its property in 1925 but ends without results in May 1926. On May 14th, 1926, a newspaper discloses that Cliff Mining has stopped exploration on its property. In March 1926, a geologist had written a report identifying the possibility of copper deposits in Cliff Mining’s property. In May 1926, Agassiz and MacNaughton anonymously buy shares from Goodwin, on the Boston Stock Exchange, based on favorable non-public information contained in the geologist’s report.

Holding: No duty to disclose Reasoning: Agents of the corporation usually don’t have a duty to disclose information in market transactions

unless special facts are present. Special facts: evidence that the director sought out a specific buyer or seller; the director deliberately created a

misleading impression.14.2. THE CORPORATE LAW OF FIDUCIARY DISCLOSURE TODAY

After the enactment of the federal scheme of securities regulation in 1933 and 1934, fiduciary disclosure law atrophied. The SEC and federal courts aggressively expanded the federal law of disclosure between 1940 and 1975. There were several reasons shareholders opted for federal court relief rather than pressing in state court for change in fiduciary law: First, the 1934 Act provided for national service of process for federal courts. Second, the amendment of the Federal Rules of Civil Procedure made federal courts an attractive place for class-

based litigation. Third, federal courts created remedies for shareholders and investors through the process of implication.

The federal courts aggressively expanded federal investor remedies by implying private rights of action under the federal securities laws.

State fiduciary duty law continues to play an important role in two situations: First, a corporation can bring a claim against an officer, director, or employee for trading profits made by using

information learned in connection with his corporate duties. Second, shareholders can invoke state fiduciary duty to challenge the quality of the disclosure that their

corporation makes to them.14.2.1. Corporate Recovery of Profit from “Insider” Trading Insider trading:

Insider trading allows companies to maintain confidential information, increases management shareholding, and moves stock prices in the right direction.

However, insider trading gives management bad incentives and can be unfair and we don’t need to incentivize information discovery.

If insider trading is generally bad and inefficient, couldn’t we expect corporations to regulate insider trading themselves? The mere fact that we think (and we don’t all think) that insider trading is bad doesn’t justify our current regulatory system.

The fiduciary theory allows corporations to recover damages based on insider information, not simply individuals who own stock in the corporation.

Theory says that the information is a corporate asset, so any profits made from its misappropriation by fiduciary must be disgorged to corporation, even if the corporation suffered no damages.

Two notable aspects of the fiduciary duty theory are: (1) if the nonpublic information is “owned” by the corporation, absent a federal prohibition, a corporation could

allow its agents to trade on it(2) the fiduciary duty theory does not attempt to compensate the uninformed stockholder with whom the insider

trades.Freeman v. Decio (p. 622)

Facts: Arthur Decio is the largest shareholder, chairman of the board, and president of Skyline Corp. Resigns in Sept. 1972; in Nov. 1972, Skyline announces an unexpected 17% drop in earnings. Freeman brings a shareholder derivative suit alleging that Skyline deliberately overstated its earnings for the previous two quarters before Nov. 1972; and that Decio and others sold Skyline stock knowing that the earnings had been overstated. District Court grants summary judgment for Decio; Freeman appeals to 7th Circuit.

Holding: No corporate recovery is allowed for gains made by insider trading if there is no corporate harm. Reasoning: In duty of loyalty cases, it is customary to consider whether, by using a corporate asset to one’s

own advantage, one with a fiduciary duty denied the corporate of some opportunity. The SEC prevented the

corporation from profiting from the insider information, so the corporation didn’t lose an opportunity to make money. Diamond v. Oreamuno, which is not controlling precedent here, was decided in part because of a lack of

other adequate means for preventing insider trading, but in the decade since it was decided, the 10b-5 class action has made substantial advances toward becoming the kind of effective remedy for insider trading that the court of appeals hoped that it might become.

14.2.2. Board Disclosure Obligations Under State Law Although federal law is the principal arbiter of disclosure obligations, there is an important common law duty of

disclosure. The Delaware Supreme Court has gradually articulated a board’s duty to provide candid and complete disclosure to shareholders that closely parallels the federal disclosure duty under Rule 10b-5.

The director’s duty of candor under state law requires them to exercise honest judgment to assure the disclosure of all material facts to shareholders. Failure to disclose a material fact, however, is unlikely to give rise to liability unless this failure represents intent to mislead. Otherwise the common charter waiver of liability for damages under §102(b)(7) will protect directors from good faith (when negligent) failure to adequately disclose.

Federal law creates a remedy for individuals, but not for corporations.14.3. EXCHANGE ACT §16(B) AND RULE 16 Gratz v. Claughton (p. 627): In matching sales with purchases (or purchases with sales) for §16(b) purposes, a court

must take into account all purchases and sales of the same class of securities occurring within six months of the reportable event (both six months in the past and six months into the future). In calculating the profit realized from a sale (or purchase), a covered person must first look back six months and

match the number of shares sold (or purchased) with the same number of shares purchased (or sold). The same process is repeated looking forward six months. One then deducts the lower total purchase price from the amount realized on the reportable sale to determine the profit, if any, that is payable to the corporation.

§ 16(a): Statutory “insiders” (directors, officers, and 10% shareholders) must file public reports of any transactions in the corporation’s securities. “Officer” status defined as access to non-public information in the course of employment.

§ 16(b): statutory insiders must disgorge any profits on short-term turnovers in the issuer’s shares (purchases and sales within any six month period). Exemption for “unorthodox” transactions, e.g., short-swing profits in takeovers, if no evidence of insider

information This section applies whether or not the insider has access to inside information (bright line rule easier to enforce;

there is a strong correlation between being an insider and engaging in short-term trades and having inside information).

Suits may be brought on behalf of a corporation or by the SEC. The rule is both under- and overinclusive; it is underinclusive because insider trading can occur over a period

longer than six month, and overinclusive because short-swing transactions need not involve insider information. Recent SEC rules bring all derivative combinations that track the financial characteristics of an issuer’s securities

under §16(b). Rule for calculating short-term profits is extremely harsh; you match any transactions that produce a profit.

Example from slides: 10% shareholder makes the following trades in a six month window: Purchases - 10 @ $30, 10 @ $40 Sales – 10 @ $40, 10 @ $30 Result: Match purchase of 10 at $30 with sale of 10 at $40 to find § 16(b) liability of 10 shares @ $10 per share =

$100 recoverable to the corporate, with no offset for ‘loss’ on other matched pair. Example from p. 629:

Raj is not an insider until he is made treasurer. When that happens, he has to file requisite forms within 10 days of becoming an insider. From then on, whenever he changes his ownership of securities, he has to file again within 2 days (§16(a)(2)(C)).

He is liable for damages in the amount of $2,200 (40¢ x 3,000 + 20¢ x 5,000) We exclude transactions entered into before a person becomes an insider, but it does apply to transactions

entered into up to 6 months after the person ceases to be an insider.14.4. EXCHANGE ACT §10(B) AND RULE 10B-5 The 1934 Act left open an indirect route for revisiting insider trading. It broadly empowered the SEC to promulgate

rules regulating the trading of securities on national exchanges or through the means of interstate commerce. Section 10: It shall be unlawful to use or employ, in connection with the purchase or sale of any security . . . any

manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may proscribe as necessary or appropriate in the public interest or for the protection of investors.14.4.1. Evolution of Private Right of Action Under §10 It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate

commerce, or of the mails or of any facility of any national securities exchange,(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Courts have interpreted this rule to create a private cause of action. Liability is primarily in two areas:

Misrepresentations and omissions in required and voluntary disclosures Insider trading

14.4.2. Elements of a 10b-5 Claim The elements of common law fraud are: a (1) false or misleading statement (2) of material fact that is (3) made

with intent to deceive another (4) upon which that person (5) reasonably realized, (6) and that reliance causes harm.

In addition to these elements, the language of Rule 10b-5 seems to mandate that the requisite reliance must be by a buyer or seller of stock, the harm must be to a trader in stock, and the misleading statement must be made in connection with a purchase or sale of stock.

Then language of the Rule addresses “omissions.” If this language reaches everyone possessing material nonpublic information, there is a concern that it goes further than authorized by the language of §10(b)14.4.2.1. Elements of a 10b-5 Claim: False or Misleading Statement or Omission At common law, equity imposed an affirmative duty to disclose only when a fiduciary was a party to the

transaction. In order to stretch 10b-5 liability beyond active misstatements, therefore, the federal courts required a theory on which to predicate a duty to disclose. The SEC and the Second Circuit Court of Appeals initially took the aggressive position that any possession

of relevant, material, nonpublic information gives rise to a duty to disclose or abstain from trading. The Supreme Court took a more traditionalist approach in Chiarella, finding it necessary that the insider

breach a fiduciary duty in trading on inside information in order to find 10b-5 liability. More recently, the Supreme Court has adopted the intermediate stance of augmenting the fiduciary duty

theory with the more far-reaching misappropriation theory.SEC v. Texas Gulf Sulphur Co. (p. 633) Facts: In October 1963, Texas Gulf Sulphur geologists make a valuable discovery of an extremely rich

zinc/copper deposit. TGS President Stephens instructs them to not tell anybody, including other TGS employees and directors, so that they can buy up the rest of the land needed. In February 1964, TGS issues stock options (= “calls”) to its top executives, all of whom know at least something about the new discovery. And as information inevitably trickles through the organization, everybody starts trading. In April, TGS issues a misleading press release to quiet speculation. SEC brings a 10(b) action against everybody; District Court finds Crawford, Clayton, and Coates liable but dismisses the suit against twelve other TGS insiders.

Holding: Insiders found liable; any one in possession of material non-public information must disclose Reasoning: Ordinarily there is no free-floating duty to disclose; usually companies only have to disclose at

certain intervals. However, even when the company has no obligation to disclose, if they elect to disclose, the disclosure has to be accurate. Take-home: (1) Everyone has a duty not to trade on inside information, regardless of their

relationship with the company (later altered); (2) materiality depends on the expected value of future events (probability x magnitude)

The Supreme Court’s Effort to Constrain 10b-5 Liability (p. 639) Blue Chip Stamps v. Manor Drug Stores: Claimants must be buyers or sellers of stock; holding stock in

reliance on misstatement is not enough Ernst & Ernst v. Hochfelder: scienter required to bring a 10b-5 claim Santa Fe v. Green: attempted to preserve state law regulation of internal corporate affairs, including the

fiduciary duties that directors and officers owe to the corporation.Santa Fe Industries v. Green (p. 639) Facts: Santa Fe Industries gradually increases its stake in Kirby Lumber from 60% to 95% and then

decides to do a short-form merger under DGCL § 253. Morgan Stanley appraises the fair market value of Kirby’s assets at $640 per share, and values Kirby’s stock at $125 per share. Santa Fe offers $150 per share in the short-form merger. Minority shareholders forego their appraisal remedy but bring suit alleging a 10b-5 violation by Santa Fe for obtaining a “fraudulent appraisal,” appropriating value from the minority shareholders, and offering $25 above the Morgan Stanley stock valuation to lull minority shareholders into tendering. District Court dismisses the claim because there was no “omission” or “misstatement” in the proxy information; Court of Appeals reverses; U.S. Supreme Court grants cert.

Holding: Affirmed; no violation of 10b-5 Reasoning: There is no omission or misstatement when a statement merely neglects to address the

fairness of a proposal or action.

Take-home: Rule 10b-5 applies only if defendant has engaged in some deceptive or manipulative act; fully disclosed acts are not covered if they are merely unfair (the plaintiffs were merely claiming the report was misleading because it didn’t say the price was unfair).

If all # (9:15 April 28), [Rule 10b-5 were extended here to encompass this fact pattern as fraud, it could not easily be contained, and] then state corporate law would cease to matter and all litigation would occur under 10b-5.

Goldberg v. Meridor (p. 643) If D, a director of Corporate C, persuades C’s board, by fraud, to sell him stock, C can sue D under Rule

10b-5 even though it can also sue D for breach of fiduciary duty. Similarly, if C’s board does not sue D, a shareholder could sue D under Rule 10b-5 in a derivative action (if

she can demonstrate that the board’s judgment not to sue D is not deserving of business judgment deference). Goldberg held that a derivative action could be brought under Rule 10b-5 on the basis that the

transaction between a corporation and a fiduciary or a controlling shareholder was unfair if the transaction involved stock and material facts concerning the transaction had not been disclosed to all shareholders. There is deception of the corporation (in effect, of its minority shareholders) when the

corporation is influenced by its controlling shareholder to engage in a transaction adverse to the corporation’s interest 9in effect, the minority shareholders’ interests) and there is nondisclosure or misleading disclosures as to the material facts of the transaction.

To find a violation of Rule 10b-5, there must be (1) deception (2) that caused loss to shareholders (3) that is more than mere nondisclosure of impure motive or culpability. The failure to disclose unfairness is not a material omission; there has to be some verifiable fact. Most commonly, the plaintiff attempts to meet this require by arguing that if full disclosure had been

made, the shareholders could have sought injunctive relief against the proposed transaction under state law.

People can be liable under 10b-5 even if the transaction about which the disclosures are made or not made even if the transaction is fair; we untether 10b-5 liability from fairness.

Omissions The SEC has taken the view that the simple possession of inside nonpublic information – no matter the

circumstance that led to that knowledge – gives rise to a duty to “disclose or abstain” but most courts have tended to emphasize the need for an act of fraud or manipulation.

Three Theories for the Subset of People who are Liable for Trading on Inside Knowledge:14.4.2.2. Elements of 10b-5 Liability: Equal Access Theory All traders owe a duty to the market to disclose or refrain from trading on non-public corporate information.

The basis for this duty is said to be the “inherent unfairness” of exploiting an unerodable information advantage.

Cady, Roberts “Disclose or Abstain Rule” “Analytically the obligation rests on two principal elements: first, the existence of a relationship giving

access . . . to information intended to be available only for a corporate purpose and not for the personal benefit of anyone, and second, the inherent unfairness involved where a party takes advantage of such information, knowing it is unavailable to those with whom he is dealing.

Equal access, in its unqualified form, reaches all conduct that might be popularly understood as insider trading. The victims of insider trading are easily identified: they are all uninformed traders to whom the insider should have disclosed.

However, it is not obvious why the “unfairness” arising from trading on access to superior information defrauds other traders in the absence of misrepresentation or a preexisting disclosure duty. Investors continuously exploit differential access to information; indeed, the effort to profit from such disparities is precisely what keeps securities prices informed.

14.4.2.3. Elements of 10b-5 Liability: Fiduciary Duty Theory In Chiarella, the Supreme Court rejected the equal access theory, ruling that a financial printer who had

traded on confidential foreknowledge of pending takeover bids he gained through his employment did not breach a disclosure duty to other traders by doing so, because he gained his knowledge through the relationship to the bidding company and bought shares in the target company.

In order to establish that an insider violates 10b-5 by breaching a duty to disclose or abstain to an uninformed trader, you have to show there was a specific, pre-existing legal relationship of trust and confidence between the insider and the counterparty. (Chiarella, Dirks)

By isolating a preexisting relationship between insiders and other traders, the fiduciary duty theory supports an analogy to common law fraud that eases the assimilation of insider trading into the statutory prohibition against securities fraud.

The theory allows case-by-case review of the relationship between putative insiders and other traders, and thus permits courts to selectively target insider trading.

However, the fiduciary duty theory fails to answer the question originally raised by the equal access theory, which is how trading on one of many kinds of informational disparities defrauds uninformed traders. As a liability filter, moreover, the fiduciary duty theory is dramatically underinclusive, since it cannot reach such seemingly clear-cut wrongdoing as the printer’s trading in Chiarella.

Elements of 10b-5 Liability: Misappropriation Theory “A person who has misappropriated nonpublic information has an absolute duty to disclose that information

or refrain from trading.” (Burger dissent in Chiarella) Even if the source of the information and the person who trades on the information have no fiduciary

duty to the people with whom the trader is trading. Under this theory, a doctor may not trade on information revealed by a patient who stumbles across the

information on the street.Chiarella v. United States (p. 649) Facts: Chiarella is employed in a financial print shop (Pandick Press) and is able to figure out the identity

of the target from code names in merger documents. Chiarella buys the target’s stock before the deal is announced and sells immediately afterwards; over 14 months he realizes a gain of $30,000. SEC begins investigating his activities and Chiarella eventually enters into a consent decree agreeing to return his profits to the sellers of the shares. Jury finds Chiarella guilty of violating §10(b) of the ‘34 Act and 10b-5. Second Circuit affirms, and the U.S. Supreme Court grants cert.

Holding: No violation. Reasoning: The trader had no relationship with the target company’s shareholders.Dirks v. SEC (p. 653) Facts: Dirks is an investment advisor who receives information from Secrist, a former officer of Equity

Funding, that Equity Funding has vastly overstated its assets. Dirks does research on Equity Funding, including interviewing employees, and discusses this information with his clients, many of whom then sell stock holdings in Equity Funding. Price of Equity Funding begins falling, and California insurance authorities discover evidence of fraud. NYSE halts trading in the stock. SEC censures Dirks for aiding and abetting in violations of 10b-5 by informing his clients of the alleged fraud at Equity Funding.

Holding: No liability Reasoning: The test for liability is whether the insider personally will benefit, directly or indirectly, from

his disclosure. Absent some personal gain, there has been no breach of duty to stockholders; absent a breach by the insider, there is no derivative breach. Elements of Tipper/Tippee Liability

(i) A Tipper knowingly gives MNPI to a Tippee in breach of a fiduciary duty to the corporation(ii) The tipper derives some personal benefit from the disclosure of the information(iii) The tippee trades on the information

Hypotheticals: 1. Jack is an employee of General Industries Inc. (GI). GI about to be charged with criminal violations of the Clean Water Act. Jack tells Jill, an associate at a hedge fund, that he will give her important information if she pays him. Jill pays Jack, Jack gives Jill the info and Jill sells GI stock. Liability (listen to recording at 9:50 on April 26) #2. Same as (1) except that Jack is a lawyer at Dewey, Cheatham and Howe LLP and learns the information in the course of representing GI in preparations for the criminal proceeding. #3. Same as (1) except that Jack is a doctor who treats the CEO of GI and Jack learns the information from the CEO during a check-up. Depends whether the CEO is getting some benefit from Jack; if not, probably no liability under a

fiduciary theory of tipping4. Same as (1) except that Jack learns the information when he overhears two GI employees talking on the subway. No liability; no duty of confidence owed by Jack to fellow passengers (even under misappropriation

theory, but under equal access theory, this would be a violation – tipper/tippee is always irrelevant under equal access)

5. Same as (1) except that Jill is Jack’s girlfriend and offers Jack no payment in return for the information. We think yes. #6. Same as (5) except that Jack tells Jill not to trade on the information, or else he could lose his job. No liability; Jack is not knowingly deriving any benefit. No liability for Jill under fiduciary duty theory

Notes on Dirk & Rule 14e-3 and Regulation FD The SEC appears to have no problem in finding a “benefit” to meet the Dirks requirement in most tipper

tippee cases.

After Chiarella, the SEC moved to reassert its equal access conception with respect to trading on tender offer information by invoking its independent power to regulate tender offenses under §14(e). Thus, SEC Rule 14e-3 imposes a duty on any person who obtains inside information about a tender offer

that originates with either the offeror or the target to disclose or abstain from trading. Regulation “Fair Disclosure”

i. Whenever an issuer or any person act on its behalfii. Discloses any material nonpublic information regarding that issuer or its securitiesiii. [To a broker, dealer, investment advisor, investment analyst or shareholder who is likely to sell]iv. The issuer shall make public disclosure of that information…

a. Simultaneously in the case of an intentional disclosureb. Promptly in the case of an unintentional disclosure

This was a response to the practice of officers and directors disclosing material information to preferred analysts, brokers, or journalists. The release of information was for a corporate purpose and those getting the information could use it, yet the favored few could clearly derive a trading benefit from early access. This practice not only offended a sense of fairness but also threatened to corrupt the integrity of

analysts. But by requiring companies to give information to everyone if they give it to anyone, Reg FD may stifle

the release of information entirely. §243.102: No failure to make a public disclosure required solely by Reg FD [that is, selective disclosure to

favored analysts] shall be deemed to be a violation of Rule 10b-5. This means there is no criminal liability for violation of Reg FD alone.

Congressional and Judiciary Response to Dirks Lower federal courts responded to Chiarella and Dirks by extending the misappropriation theory to reach

outsiders who trade illicitly on confidential information. The deceitful misappropriation of market-sensitive information is itself a fraud that may violate Rule

10b-5 when it occurs “in connection with” a securities transaction. Congressional legislation extends a private action to market trades on the basis of a fiduciary breach

to an employer. Now, the relationship that triggers Rule 10b-5 and the resulting unfairness both refer to the insider’s

source of information. The misappropriation theory can reach almost all forms of insider trading that are commonly

condemned, regardless of whether they involve traditional insiders. It locates a real duty and a “fraud” by focusing on the putative insider’s illicit conversion of valuable information rather than on a fictional relationship between the “insider” and uniformed traders.

Insider trading is wrong not because informational disparities in the market are suspect but because it involves the private appropriation of information rights that belong to someone else.

Rule 14e-3 (a) It is a violation of the ’34 Act § 14(e) to purchase or sell securities on the basis of information that

the possessor knows, or has reason to know, is non-public and originates with the tender offeror or the target or their officers.

(d) It is a violation of ’34 Act § 14(e) for a possessor to communicate the information described in (a) under circumstances in which the tippee is reasonably likely to trade of that information.

Relates solely to tender information from offeror or target which the possessor knows or has reason to know is non-public. But because all information originates from these sources and the mens rea standard is so low, this

applies to virtually all information related to tender offers. This is an equal access theory.

United States v. Chestman (p. 662) Facts: Ira Waldbaum, president and controlling shareholder of Waldbaum’s, a supermarket chain, decides to

sell out to A&P in a friendly deal. Plan is that Ira will sell his control block for $50 per share, and there will be a simultaneous tender offer for public shares in Waldbaum Ira tells his sister Shirley about the deal, who tells her daughter Susan, who tells her husband Keith Loeb. And despite warnings at each step in the chain to not tell anybody, Loeb calls his stockbroker, Chestman, to say that he has accurate information that Waldbaum is about to be sold. Loeb buys for himself; Chestman buys for himself, Loeb, and his other clients. NASD begins an investigation; Loeb pays a fine and agrees to cooperate, and Chestman is indicted on 14e-3, mail fraud, and 10b-5 violations. Jury finds Chestman guilty on all counts, Chestman appeals, and Second Circuit panel reverses on all counts. Second Circuit agrees to re-hear in banc,

Holding: No liability under Rule 10b-5. The Rule 14e-3a conviction stands however. Reasoning: No liability under Rule 10b-5 because there existed no fiduciary or equivalent relationship of trust

or confidence between Keith and the Waldbaum family or his wife to make him liable as a misappropriator.

A fiduciary relationship does not arise simply by entrusting a person with confidential information (when they don’t agree in advance to maintain confidentiality), nor does marriage or familial relationship automatically create a fiduciary relationship. NB: The SEC has undone what the Supreme Court said about familial relationships not creating

fiduciary duties through Rule 10b5-2: A duty of trust or confidence arises, in addition to other circumstances, whenever:

a person agrees to maintain information in confidence; two people have a history, pattern, or practice of sharing confidences such that the recipient

of material non-public information knows or reasonably should know that the person communicating the information expects that the recipient will maintain its confidentiality; or

a person receives or obtains material non-public information from a spouse, parent, child, or sibling, unless the recipient can demonstrate that, under the facts and circumstances of that family relationship, no duty of trust or confidence existed.

However, while the fact that Susan instructed her husband not to disclose is irrelevant to his status as a tipper, it does protect her from liability.

Take-home: The court begins to adopt a misappropriations theory of insider trading.United States v. O’Hagan (p. 667)

Facts: The SEC found James O'Hagan, a partner at Dorsey law firm, guilty of fraud for profiting from stock options in Pillsbury Company based on nonpublic information he misappropriated for his personal benefit. O'Hagan knew that Dorsey's client, Grand Metropolitan PLC, was considering placing a tender offer to acquire a majority share in Pillsbury Company. O'Hagan bought a large number of stock options without telling his firm and later sold his options for a $4.3 million profit. The U.S. Court of Appeals for the Eighth Circuit reversed O'Hagan's convictions under the ’34 Act. The Circuit Court applied the Act only to security-traders who wrongfully use confidential information pertaining to their own companies and ruled that the SEC had exceeded the rule-making authority granted to it by the Act by making it a fraudulent action to trade securities on exclusive non-public foreknowledge of a tender offer.

Holding: A security-trader violates the ’34 Act by trading securities on the basis of misappropriate information pertaining to a company other than his own and the SEC had authority to make Rule 14e-3(a), which forbids security trading on nonpublic foreknowledge of a tender offer.

Reasoning: A security-trader who fails to disclose personal profits gained from reliance on exclusive information is guilty of employing "a deceptive device . . . in connection with the purchase of a security." The security-trader knowingly abuses the duty owed toward the source of information, whether the source is the company he works for or not. The SEC has authority to "define and prescribe means reasonably designed to prevent fraudulent . . . acts . . . in connection with any tender offer." Rule 14e-3(a) of the Exchange Act, adopted under this fraud-prevention authority, forbids security-traders from trading on the basis of information they know should be kept private unless they publicly disclose their trades. The “misappropriation theory” holds that a person commits fraud “in connection with” a securities

transaction, and thereby violates §10(b) and Rule 10b-5 when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. This case directly reverses Chiarella, illustrating the shift from the fiduciary theory to the

misappropriation theory. Securities Exchange Act §14(e): It shall be unlawful for any person to make any untrue statement of a

material fact or omit to state any material fact necessary in order to make the statements made…not misleading, or to engage in any fraudulent, deceptive, or manipulative acts or practices, in connection with any tender offer . . . . The Commission shall . . . by rules and regulations define, and prescribe means reasonably designed to prevent, such acts and practices as are fraudulent, deceptive, or manipulative. Although Rule 14e-3 prohibits acts that are not themselves fraudulent under the common law or

§10(b), it is permissible because the prohibition is “reasonably designed to prevent . . . acts and practices [that] are fraudulent.”

Take-home: Rule 14b-3 is applied in a manner that shows it is an equal access theory and the misappropriations theory is applied by the court (# 9:37 on April 28)

§78t-1: Liability to Contemporaneous Traders for Insider Trading (insider Trading and Securities Fraud Enforcement Act – ITSFEA) # 9:39 on April 28 § 20A: creates a private right of action for any trader opposite an insider trader, with damages limited to

profit gained or losses avoided. Any contemporaneous trader (doesn’t have to be actual counterparty) Damages are limited to the trader’s actual profits

§ 21A(a)(2): allows civil penalties up to three times the profit gained or loss avoided; § 21A(a)(1)(B): “controlling person” may be liable too, if the controlling person “knew or recklessly

disregarded” the likelihood of insider trading and failed to take preventive steps.

§ 21A(e): “bounty hunter” provision, which allows SEC to provide 10% of recovery to those who inform on insider traders;

14.4.2.4. Elements of 10b-5 Liability: MaterialityBasic Inc. v. Levinson (p. 672) Facts: Basic Industries engages in merger negotiations with Combustion Engineering for almost two

years about the possibility of being acquired at a premium price. Meanwhile, there are rumors of a pending deal, which Basic flatly denies (three times). (Afterwards, Basic says that it didn’t want to drive its suitor away by inviting competition.) Basic shareholders who sold after first public denial of the merger negotiations file suit claiming 10b-5 violations by the Basic directors. District court grants summary judgment to the defendant directors because the negotiations were not destined to lead to a merger “with reasonable certainty.” Sixth Circuit reverses, finding that otherwise immaterial merger discussions become material when Basic denied their existence.

Holding: Whether merger discussions in any particular case are material depends on the facts – a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity (rejection of the “agreement-in-principle” test).

Reasoning: In order to assess the probability that the event will occur, a fact finder will need to look to indicia of interest in the transaction at the highest corporate levels. In order to assess the magnitude of the transaction, a fact finder will need to consider such facts as the size of the two corporate entities and of the potential premiums over market value. Reminder: There’s no free-floating duty to disclose; you only must disclose if you trade on the

information. However, if you do disclose, the disclosure must be accurate. Take-home: The case adopted in Rule 10b-5 context the standard of materiality that had been adopted in

other securities regulation contexts (#9:42 on April 28) under TSC Industries: “an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote”; “there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” It’s hard to imagine under this standard that any live and plausible merger negotiates would be

anything but material.14.4.2.5. Elements of 10b-5 Liability: Scienter Common law fraud requires scienter or intention to deceive. The Supreme Court has confirmed that liability

under Rule 10b-5 requires specific intent to deceive, manipulate, or defraud. However, two issues respecting this mental state requirement persist: The first issue regards proof: whether actual intent to deceive must be shown in order to establish

liability or whether scienter may be inferred from conduct that is simply willfully or recklessly negligent. Some courts have held that the appropriate mental state may be inferred from reckless or grossly

negligent behavior. The second issue is one of pleading.

The Ninth Circuit adopted the most permissive standard by holding that the plaintiff needed to state in her pleading only that the defendant had acted with scienter.

The plaintiff is permitted to plead facts about which she has a reason to believe may be true (even if she is not certain).

The Second Circuit applied the strictest test: it required the plaintiff to plead facts that give rise to a strong inference of fraudulent intent. This pleading burden could be satisfied by alleging facts that specified a motive to defraud and an opportunity to do so, if the circumstances pleaded together so constituted the required strong inference.

Congress adopted the Private Securities Litigation Reform Act (PSLRA), which provided that the complaint must state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.

Some circuits take the demanding view that Congress wanted to strengthen the Second Circuit pleading requirement, not merely adopt it, and therefore hold that a plaintiff must minimally plead deliberate recklessness or conscious recklessness as an element of her claim under Rule 10b-5.

Other circuits have concluded that Congress merely intended to adopt the Second Circuit pleading standard.

Rule 10b-5: Trading Pursuant to a Preexisting Plan: Rule 10b-5 defines illicit trading as trading “on the basis of” material nonpublic information if the person

trading was aware of the information at the time of the trade, unless the person can demonstrate that:(1) before becoming aware of the information, she (a) entered into a binding contract to purchase or sell,

(b) gave instructions for the trade, or (c) adopted a written plan to trade; and

(2) the contract, instruction, or plan either (a) specified the amount of securities to be traded and the price, or (b) included a written formula or algorithm for determining the amount and price, or (c) did not permit the person to exercise any subsequent influence over how, when, and whether to trade; and

(3) the trade was pursuant to the contract, instruction, or plan. These defenses are widely used by senior executives. The Rule requires insiders to pre-commit to a

plan before they are in possession of material non-public information if they want to trade without being liable for insider information.

However, there’s gamesmanship – insiders often have fairly good ideas of how material questions are likely to be answered, and in this case, a Rule 10b-5 disclosure insulates them from liability.

There is also a provision for investing entities in which the natural person making the investment on behalf of the entity was unaware of the inside information and the entity itself had implemented reasonable measures to protect against insider trading.

14.4.2.6. Elements of 10b-5 Liability: Standing, in Connection with the Purchase or Sale of Securities Birnbaum v. Newport Steel Corp. held that a plaintiff must have been a buyer or seller of stock in order to have

standing to bring a complaint about an alleged violation of Rule 10b-5. The Supreme Court confirmed this in Blue Chip Stamps et al. v. Manor Drugs. That is, deciding not to buy or not to sell in detrimental reliance on a materially false statement is not

protected under Rule 10b-5.14.4.2.7. Elements of 10b-5 Liability: Reliance Reasonable reliance is an element of common law fraud. Reliance as an element of a Rule 10b-5 claim is more

complex. Reliance issues are particularly implicated when a false statement is made by an insider that affects the

market price of the stock, but a shareholder never hears the false statement. On the assumption that markets are affected by all public information, we might conclude in such a

situation that the price a person gets or pays in transacting in the stock is affected by the false statement.Basic Inc. v. Levinson (p. 679) Facts: Basic Industries engages in merger negotiations with Combustion Engineering for almost two

years about the possibility of being acquired at a premium price. Meanwhile, there are rumors of a pending deal, which Basic flatly denies (three times). (Afterwards, Basic says that it didn’t want to drive its suitor away by inviting competition.) Basic shareholders who sold after first public denial of the merger negotiations file suit claiming 10b-5 violations by the Basic directors. District court grants summary judgment to the defendant directors because the negotiations were not destined to lead to a merger “with reasonable certainty.” Sixth Circuit reverses, finding that otherwise immaterial merger discussions become material when Basic denied their existence.

Holding: A presumption of reliance when misleading statements are disseminated into an impersonal, well-developed securities market is appropriate (fraud on the market theory of reliance).

Reasoning: The fraud on the market theory is based on the hypotheses that, in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business. Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements. The causal connection between the defendants’ fraud and the plaintiffs’ purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations. The market price of shares traded on well-developed markets reflects all publicly available

information, and hence, any material misrepresentations. Where materially misleading statement have been disseminated into an impersonal, well-developed market for securities, the reliance of individual plaintiffs on the integrity of the market price may be presumed (presumption is appropriate for reasons of equity and efficiency).

NB: Any showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price, will be sufficient to rebut the presumption of reliance. You can try to show that the plaintiff paid no attention to market prices or you can try to show

that the market price reflected the true price (free from the influence of a misrepresentation).14.4.2.8. Elements of 10b-5 Liability: Causation In common law fraud, the misrepresentation must be relied on, and that reliance must cause a loss. Private

actions under Rule 10b-5 also require proof of causation. For liability to attach, a misstatement or omission must both “cause” the plaintiff to enter the transaction

(transaction causation) and “cause” the plaintiff’s loss (loss causation). If the plaintiff can satisfy the trier of the fact that she would not have entered into the transaction, had the

material matter been disclosed, the omission will be said to cause the transaction (transaction loss). Determining loss causation in this context closely resembles proof of damages.

In Dura Pharmaceuticals Inc. v. Broudo, the Supreme Court held that the fact that a price was inflated by false statement at the time of purchase was logically insufficient, without more, to establish that a loss on sale after truthful disclosure was caused by the misdisclosure. More facts are necessary to show that the loss resulted from the disclosure.

14.4.3. Remedies for 10b-5 ViolationsElkind v. Liggett & Myers, Inc. (p. 686)

Facts: On July 17, 1972, Liggett & Myers (L&M) tells certain analysts about a negative earnings announcement to be disclosed publicly the next day. Analysts’ clients sell 1,800 L&M shares at ~$55 per share; when negative earnings announcement is disclosed on July 18th, the L&M stock price drops to ~$46. District Court finds 10b-5 liability and calculates damages using the “out-of-pocket” method, i.e., the difference between the price that plaintiffs paid for the stock (~ $52-$55) and the actual “true value” of the stock when bought. Defendants appeal to Second Circuit.

Holding: Damages should be calculated via the disgorgement method, under which the plaintiff is required to prove (1) the time, amount, and price per share of his purchase, (2) that a reasonable investor would not have paid as high a price or made the purchase at all if he had had the information in the tippee’s possession, and (3) the price to which the security had declined by the time he learned of the tipped information or at a reasonable time after it became public. He then has a claim and, up to the limits of the tippee’s gain, can recover the decline in market value of his shares before the information became public or known to him.

Reasoning: To the extent that the disgorgement method makes the tipper and tippee liable up to the amount gained by their misconduct, it should deter tipping. On the other hand, by limiting the total recovery to the tippee’s gain, the measure bars windfall recoveries of exorbitant amounts bearing no relation to the seriousness of the misconduct. It also avoids the difficulties faced in trying to prove traditional out-of-pocket damages based on the true “value” of the shares purchased or damages caused by reason of market erosion attributable to tippee trading. Calculating 10b-5 Damages under different rationales:

Example: The company discovers bad news internally and tippee sells 5,000 shares at $50 – stock falls to $48 as a result. Plaintiff buys 10,000 shares at $48; the bad news is later made public – stock falls to $40 (assumed to be “true value”).

Out-of-pocket measure: Price paid minus “true value” when bought. Here, P can recover ($48 - $40) * 10,000 shares = $80,000.

Measure used when company has made a misstatement about itself. Essentially equivalent to plaintiff’s losses, which could exceed defendant’s gains.

Causation-in-fact measure: Price decline caused by D’s wrongful trading (though not the later disclosure of information). Here, P can recover ($50 - $48) * 10,000 shares = $20,000.

Disgorgement measure: Post-purchase decline due to disclosure, capped at gain by tippee. Here, same as out-of-pocket measure by assumption ($80,000), capped at gain by tippee ($50,000) = $50,000.

Measure used when tippee trades on information. Damages for fraud-on-the-market are calculated differently from damages for insider trading action? (p. 690) Elements of Rule 10b-5 Action:

False or misleading statement or omission: Chiarella, Dirks, O’Hagan Materiality: what a reasonable shareholder would consider important. Basic – probability x magnitude test. Scienter: specific intent to deceive, manipulate, or defraud (Ernst & Ernst), though may be inferred from

reckless or grossly negligent behavior. Standing: must be a purchase or sale of securities (Blue Chip Stamp). Reliance/Causation: presumption of reliance on the integrity of market price (Basic). Injury/Damages: disgorgement rule (Liggett).

14.4.4. The Academic Debate While case law has explored the boarders of impermissible trading, much commentary has toyed with the

question of whether even “core” insider trading is necessarily harmful. Insider trading is an appropriation of information rights that permits informed insiders to earn systematically

higher trading returns than can uniformed outsiders. Not all informational advantages that insiders gain from their fiduciary roles are regulated by law. Existing law

merely bars trading on “material” information—that is, obviously market-sensitive facts—and cannot reach insiders’ informed decisions to refrain from trading. Thus, insiders’ trading returns would exceed those of outsiders even if existing laws were perfectly enforced.14.4.4.1. Insider Trading and Informed Prices Critics of regulation argue that insider trading leads to more informed prices that may actually increase

investor confidence, but investors prefer to maintain their information monopolies as long as possible, and inside information is likely to be publicly disclosed in a matter of days, weeks, or months anyway.

14.4.4.2. Insider Trading as a Compensation Device

There is no reason to believe that managers’ negotiated contracts would correctly anticipate levels of insider trading or that other market controls would operate to check excessive insider trading.

Deregulating insider trading would invite managers and similar insiders to extract large rents at shareholder expense without any real check by the corporation or the market.

Insider trading invites an uncompensated redistribution of returns from uninformed traders to insiders.Are Deal Makers on Wall Street Leaking Secrets? (p. 695) Suspicious stock-rice movements were found prior to 29% of the merger announcements the SEC studies

between 2000 and 2004.

Exam Three hours long 3 questions; last question will assume facts of the second 2 or 3 issue spotters 1 long spotter broken into four different parts – organize response by parts No discussion of policy, but where the application of rules is based on standards, understand and apply those

standards. Ex: veil piercing (talk about the factors, but not why we use those standards instead of others) Anything discussed in class or in the book is fair game Don’t ignore the first portion of the class (agency or partnership) There will be a lot of issues to allow people to differentiate themselves. Economize on your words. Don’t get into

lengthy discussions of law that you’re not applying to the facts. Clearly-wrong answers will hurt you, but useless or irrelevant discussion won’t Understand the big picture and be able to recall things quickly Jurisdiction has DGCL, following precedents, common law of contracts, Uniform Partnership Act or RUPA (extra points

for explaining both if they differ)

DGCL §216 states that the general rule is that a majority is a majority of the votes represented at the meeting (needed for most votes) Only exception is director elections in which the default rule in Delaware is plurality.

Equitable subordination: An equity holder who doubles as a debt holder will have his debt claims treated as equity claims under certain circumstances. Because we don’t want people to behave opportunistically as the corporation approaches insolvency

The duty to monitor is part of the duty of care (not loyalty because it doesn’t involve self-interest). It probably applies to partnerships, just as most of the duties that we discuss in relation to corporations do. It’s not as important in partnerships because usually as a practical matter, partnerships are small and the partners themselves are the agents, so the duty to monitor isn’t relevant.

Rule 14a-11 provides more stringent standards for shareholders to meet for placing a director nominee on corporate proxies that Rule 14a-8, which would otherwise par a weaker motion under Rule 14a-8(8). (# 3:46)

Tippees can be liable even if they have no relationship of trust or confidence to anyone, so long as they know the tipper had a relationship of trust or confidence to the source that was violated. The source can be anyone; not just shareholders. You can’t have a tippee unless there is a tipper – someone who intends to disclose with hope of gain.

Inherent, Apparent, and Actual Authority, Agency by Estoppel and Agency by Ratification Inherent authority: if principal is undisclosed, inherent authority is important to those dealing with the agent

(since they can’t claim actual authority if they didn’t know there was a separate principal) Partnership

Ownership is defined as (1) right to claim residual earnings and (2) right to exercise control. §202 or RUPA and §7 of UPA create presumption of partnership wherever a person shares in net profits, but presumption is rebutable. # look up these provisions.

Three Factors for Veil Piercing: (1) lack of observance of corporate formalities (co-mingling assets, not keeping separate books, parent treating subsidiary as though there is no distinction at all); (2) refusing to pierce would serve an injustice; and (3) under-capitalization.

Board duties are chiefly important when the board faces a takeover attempt and are only relevant when the board has a say in a transaction (so not relevant when one controlling shareholder sells to another). We care about board duties because it has the authority to force people to sell their shares or to prevent them

from doing so in the context of a merger Governed primarily by Unocal, Revlon, and Blasius Unocal duties apply whenever a board resists takeover; Blasius applies whenever the measure the board has

taken interferes with a specific vote (outcome or timing); Revlon applies whenever the board agrees to facilitate a deal in which the minority shareholders give up control.

Duties for controlling shareholders Do not sell to looter (Harris) Higher duties in freeze outs, because they sit on both sides of the transaction

Weinberger roadmap: simulate arm’s length bargaining Practice Exam on Remedies: If shareholders have the right to vote something down, you can discuss that, but really

the right in question is the right to sue. Rights/claims: A breach of fiduciary duty (duty of care or duty of loyalty) claim or an appraisal right in a merger

context Remedies: Injunctions or damages

Duty of care (applies only to directors or officers): hierarchy of misconduct

Negligence – no personal liability for directors under business judgment rule Gross Negligence – no personal liability for directors if effective §102(b)(7) waiver (but you can pursue an

injunction) Deliberate disregard – personal liability for directors Self-dealing (duty of loyalty) or fraud – examples of bad faith that will trigger personal liability for directors