Kamar - Corporations Outline - Spring 2007

Kamer, Corporations, Fall 2006Grade: A

- INTRO TO CORPORATIONS

- Goals of corporate law to facilitate the creation and governance of private legal entities

that are the principle economic actors in the modern world reduce all forms of agency costs, establish standard contracting terms with business organizations establish internal governance structures create and transfer property right and partition assets

- Problems addressed by corporate law Erects corporate form and legitimates property rights Facilitates relationships among co-owners, corporations, and

management (horizontal agency problem) Facilitates the relationship between shareholder & management of

corporation (vertical agency problem) Facilitates contracting between shareholders and other stakeholders

(creditors, etc.).

- Best to align the incentives of the firm and its agents. Need to align incentives of managers vs. investors/owners minority vs. minority shareholders firm vs. external parties

- What is efficient?o Pareto Efficiency/Optimality: something, or some change in the law, is

efficient when that change makes at least someone better off and no one is worse off

o Kaldor-Hicks efficiency: when there is a net utility gain, the law is desirable

When all parties affected experience a net gain in utility

- If human nature is to not work as hard for someone else as you would for yourself, why not just do it yourself?

o Specializationo Size – sometimes you can do something better by doing it on a larger scale

(economies of scale)

- Coase, The Nature of the Firm: it’s a matter of transaction costs o If you do every single transaction yourself it can get too mucho Cost reducing relationships

- Agency costs:o monitoring (watching what the agent is doing), o bonding (giving people incentives to do the right thing for you even when

you aren’t watching, ex: designing compensation),


o residual costs (whatever is left after you’ve done the other two and agents still aren’t acting exactly as you want the to)

- Duties an Agent owes to the Principal: o Fiduciaryo Disclosureo Governance: sum allocation of powers between the principal and the

agent, maybe some key decisions you want the principal to make instead of entrusting it to the agent

- Two types of Agencyo independent contractor (agent decides how to perform the job), o employer-employee (principal tells agent exactly how to perform the

service)

- Justifications for Agencieso Economies of scaleo Focus expertiseo Specialization

The bigger you are the more you need to specialize

- Formationo Res. Agency §1: Agency is the fiduciary relation that results from

o Manifestation of consent by P to A that the other shall act on his behalf and subject to his control and

o Consent by the other to so acto Types of Agency Relationships:

o Special agent: agency limited to single act / transaction

o General agent: series of transactions / actso Disclosed agent: 3rd party knows agent acting for

principalo Undisclosed agent : 3rd party unaware of principal

and believes agent is principle. The 3rd Party is contractually bound to undisclosed principal

o Partially disclosed : 3rd party knows that the negotiating party is an agent, but does not know identity of principal

- Jenson Farms v. Cargill (p. 18, 1981) Parties Conception does not control/ Implied Agency

Jenson Farms v. Cargill, (Minn. 1981) p. 16o Facts: Warren Seed Co. and Cargill enter into a

security arrangement. Warren’s indebtedness


exceeds its credit line. Cargill learns that Warren has falsified records. Cargill refuses additional funding. Warren defaults and breaches its contract with the farmers. The farmers sue Cargill stating that it is jointly and severally liable.

o Issue: Can the courts infer a principal/agent relationship?

o Holding: Yes, there was a principal/agent relationship. Cargill exercised sufficient control over Warren to create such a relationship. Cargill manifested consent to be agent; Many factors show control beyond normal debtor-creditor relation. Control indicates consent to agency relationship. Thus liability attaches if creditor has too much control. (banks beware!)

o Didn’t matter to the court what the contract was, but as a practical matter what the actual relationship was like essence of their relationship was that of principal-agent

o If you have a principal agent relationship, and the agent incurs some debt to a third party, the third party can sue the principal to recover (principal is liable)

- Liability in Contracto Agreements within the scope of A’s authority: What a reasonable

person in A’s position would infer from P’s conduct Actual/express authority: What a reasonable person in A’s

position would infer from P’s conduct Incidental/Implied - authority for steps ordinarily done in

connection w/ authorized activity Apparent authority – what a reasonable 3rd party would infer

from A’s actions even if A doesn’t have authority and was specifically precluded

3rd party has a right of action against P, who can sue A Equitable remedy to prevent fraud / unfairness to 3rd party

Inherent authority (conferred by law) – general agent may bind P to unauthorized K as long as a general agent would ordinarily have power to enter such a K & 3rd party doesn’t know that matters differ in this case (RST § 161, 194)

Thus P bound by A’s contract Burden falls to P if there is ambiguity; protects against

undisclosed P Ratification: actual authority after the fact

- Think about Best Cost Avoider in Principle-Agent relationships

- White v. Thomas (Ark., 1991, p. 22)


o White authorizes his assistant to go to an auction and bid up to $250,000 to a tract of land, she accidentally bids above that amount (another couple, π, bought attached land with home on it)

o Assistant agrees to sell part of that land she bid on π in order to lower the total price to $250,000

o Principal returns and refuses to honor the contract to sell part of the land to π

o Π sues for breach of contract, principal counters that she was not authorized to sell anything

o Inherent authority must be incidental, her authority was to buy, not to sell, and those are different enough that authority to sell not inherent in authority to buy (not necessary for completion of her job)

Same logic for implied authority, not implied that she could sell the land and definitely not express

o Apparent authority: principal never led π to believe that agent had authority to sell the property, only the agent’s word suggested she had authority

Who is in the best position to avoid this misunderstanding? Here, the court says that if the principal never communicated with the third party, how can the principal be the least cost avoider

The third party here is the person who turned a blind eye – in a large real estate deal should have followed up and ensured that agent actually had authority she was asserting

- Caveat: some cases have gone differentlyo Lind v. Schenley (3d Cir. 1960)

When you call someone executive vice president, it is fair that a lower-level employee would assume this person had the authority to offer him a raise

- Gallant Insurance v. Issac (2000)(pg 26) - Issac tries to change the insurance policy with the insurance broker during the

temporary coverage period- Insurance company says that all the paperwork has to be faxed and payment made

before insurance kicks in- Issue of insurance broker says - Discussion- You could take every part where Court says inherent authority and replace with

apparent authority- Kamar thinks this case really shows how courts mistake stake apparent authority- Kamar says you do need some action on behalf of principal (or some clear

inaction)

- Watteau v. Fenwick (KB)(1892) - Situation where 3rd party doesn’t realize he’s not principal- Alehouse not with owners name on it but with Bartender’s name on it- Principal told agent not to buy a certain type of drink, but agent does anyway


- Then doesn’t pay, so 3rd party go after them for money- No apparent authority because 3rd party didn’t know principal existed- No actual authority because guy is clear don’t buy it- Inherent authority with Apparent authority- Kamar says he doesn’t see what principal did wrong here

- Humble Oil v. Martin , 1949, p. 20- Car at gas station rolls out and his Martin- Fault of gas station attendant- They go after the oil company themselves instead of gas station operator, not

Schneider – the operator- Question: Is Schneider an employee of Humble Oil - Answer: Yes- Humble has decision-making power here, day-to-day control and

o Key: gets a percentage of saleso So assumes part of risk

- Hoover v. Sun Oil , 1965, p. 32- Station attendant Smilick smokes cigarette, cigarette causes fire and there is

damage- Sues Sun Oil- Sun not liable- Rent is somewhat dependant on sale paid to Sun Oil from people

o But minimum and maximumo So Sun Oil not bearing part of risk

- Humble and Hoover show how risk is key, eager to mask other parts of independent contractor relationship – much harder to mask risk

- follow the money, so who will lose what when- Other differences: weekly reports, lease termination- Things Sunaco did that substitute for monitoring

o Incentiveso Longer selection process

Humble Oil v. Martin, (Tex. 1949) p. 25o Facts: Car rolls out of a gas station and hits the

Martins. Humble claims operated by independent contractor so no liability

o Issue: Who is the principal in this relationship?o Holding: Court finds that there existed a master-

servant relationship; Humble liable for the negligent employee.

o Types of relationships: Franchisee relationship : bundled services,

brand name, profit-sharing, mgr must periodically report to Humble & has very


little business discretion, strict control & supervision, Humble pays utilities (biggest expense), Humble gives location & equip & ads

“Commission Sales Agreement”: manager paid from gross revs, not net profits→ good proxy for control because company eats operating costs

Hoover v. Sun Oil Co ( Del. 1965) p. 27o Facts: Sunoco Attendant lights a cigarette while

filling a gas tank. Hoover is seriously burned. Barone, the station owner, gets his gas from Sunoco.

o Issue: Is Sunoco liable for the fire as a principle?o Holding: No. Though the station sold mainly

Sunoco products, the station and equipment were owned by Sunoco, it used Sunoco ads and uniforms, and Sunoco gave weekly rebates on gas, still there was no obligation to Sunoco because there was no reporting requirement, the station assumed overall risk of profit/loss, had a terminable lease, and had title to products.

o payments out of profit vs. out of gross Profit and Loss ownership: proxy for the control relationship

Commission sales agreement: Schneider is paid out of the gross revenue, not the profits. Schneider does not share in profits, is not a partner. Humble Oil pays all of Schneider’s bills to run the station. Humble Oil exercises a lot of control.

Barone does share in the profits of the corporation, and he is paid out of the net. Therefore, Barone exercises greater control.

- Comparison of two cases:- - Humble manager

(Schneider)- Sunoco operator

(Barone)- Hrs of op control - N - Y- Sell non-P

products- N - Y

- Took title to products sold

- N - Y

- Lease termination - At will - Annually- Overall P &

ownership- ~ N - ~ Y

- Control on-site employees

- Y - Y


- Payment - paid out of gross - Paid out of profits

- Fiduciary Duties - Duty of Loyalty

o Gain should be for Principal, avoid conflicts of interesto Incentives different for agent and principalo §387: General Principle: A should act solely for benefit of P win all

matters connected with his agency.o §388: Duty to Account for Profits Arising out of Employment. Cannot

use confidential information against P. Acting as an Adverse Party:

o §389: Acting as Adverse Party w/o P’s Consent – duty not to deal w/ P as adverse party in agency transaction w/o P’s knowledge

o §390: Acting as Adverse Party w/ P’s Consent – must deal fairly w/ P and disclose all relevant facts fully. Market price discrepancy is evidence that transaction unfair; also whether P depends on A’s advice

- Duty of Careo Don’t be negligento Incentives are aligned for agent and principal here mostly

- Duty of Loyalty more effective as legal tool than Duty of Careo Easier to prove for judges, etc. finding conflict of interest much easier to

show) – much more difficult to show that breach of duty (negligence) breach of duty instead of just misfortune

o Care is easier to see, but once you find loyalty it is easier to prove

- Tarnowski v. Resop (Minn 1952, p. 36)o Principal hires agent to investigate route of jukeboxes that wants to buy,

agent gets kickback from sellers to do superficial investigation and falsify reports to make look better, principal buys route based on investigation

o Principal successfully sues sellers and recovers all his expenses, then sues agent for amount of kickback

o Right to recover profits made by the agent in the course of the agency not affected by fact that principal already recovered what he lost from third party

o Loyalty and care

- PARTNERSHIPS RUPA §202(a) – A partnership is the association of two or more

persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership

UPA §15: Partners are Jointly liable for Torts and J&S liable for Contracts vs. RUPA §306: Partners are J&S liable for Torts and


Contract, but RUPA §307(d): must exhaust business assets before pursuing personal assets.

- Pamela example - Pamela needs more money, but already has borrowed money, subsequent

borrowers want higher level of interest because first lender (Walter) claim is senior to theirs

- So say to abe and Bill, you won’t get fixed interest, I can’t afford and Walter doesn’t like either

o So become partners – if I am profitable you make a lot- No clear answer to when you want to borrow and when to make someone equity

holdero Depends on risks involved

- Formed by agreemento Just like agency though, not required that partnership law has to be

written as governing affairso If they act like partners, but were silent on what they actually are,

they’re partners

- Vohland v. Sweet (Ind. App. 1982) p. 47- Facts: Vohland (the elder) gives Sweet, the nursery man, 20% of net returns (no

explicit agreement) of nursery business. Sweet’s income tax stated he was a self-employed salesman at the nursery; money paid Sweet was listed as “commissions” in V’s income tax return. V handled all financial books and made most of the sales. V alone took up loans. S managed the physical aspects of the nursery. When V dies, Vohland (the younger) takes over. Sweet tries to dissolve partnership and get his share of business (wind-up, sell assets and distribute proceeds).

- Issue: Is Sweet a partner by inference?- Holding: Yes, a partnership may be implied, even by contribution of sweat

equity. The Court of Appeals held that: (1) evidence that plaintiff received a 20% share of nursery's profits presents a prima facie case (UPA §7(4)) to support a finding that a partnership existed and that plaintiff had a 20% interest in inventory of the nursery, and (2) bare assertion, unsupported by authority, that neither of alleged partners in nursery had any interest whatever in nursery stock planted on leased land did not comply with appellate rule requiring citation of authority and cogent argument, thus waiving such issue.

- Note: The more inventory Sweet provides, the less he gets paid. Unless Sweet were a co-owner, he would have a perverse incentive to keep inventory low so as to keep his profits higher. Thus, Sweet believed he had a stake in the business

- Note 2: If Vohland had faced bankruptcy, court likely would not have found that Vohland sincerely believed that Sweet was a partner.

- Rules controlling a partnership- Control (§401) – majority decides ordinary matters (body not share);

unanimity required if matters unusual


- Agency (§301) – each partner is an agent to all other partners; all agency obligations carry over (disclosure)

- Liability (§306) – each partner fully liable for debts incurred by partnership if partnership assets insufficient

o explicit agreement to release partner from liabilityo somehow modify the relationship between the partners and a third-party

that removes the departing partner from liability

- Idea of if law just let partners get out and get rid of liability – then the richest partners will leave first

- Idea of buying more time in reorganizing a debt with a third-party- more time- now accrue additional liabilities in this extra time

- Third Party Claims against Partners: Munn v. Scalera (Conn. 1980) p. 51 Facts: Pete and Bob contract to build Munn’s house. Pete

and Bob dissolve their partnership when the house is half built. Munns contract with Bob to complete their house. Bob takes on the duties of the old contract under a new contract with the Munn’s. Munns agree to be a surety for the materials that Bob needs to purchase. Bob is judgment proof, so the Munns sue Pete by suing the original partnership.

Issue: Is Pete liable for the losses from the partnership where his brother and the Munn’s consented to release him from future liability?

Holding: Pete is not liable under § 36(3). More liability is incurred, so the material alternation in the extent of exposure makes it such that Pete is off the hook. Here there was no creditor who extended more credit, but the Munns renegotiated the terms of performance by offering advance payment. Terms were changed to pre-pay and over-pay Bob; Munns had knowledge of this material change and consented to it; this action is against Peter and he’s no longer liable

RUPA §603: Effect of Partner’s Dissociation

- Problem 3.3.1 o Ars, Gratia and Artis form and operate a business, Ars gets $5k or one

third of profits, whichever higher, but have been sharing profits equally among the three of them

o Mayer provided cash, all knew about it, but unbeknownst to the other partners, Artis promise half his share of the profits to Mayer


o (a) Customer is injured because of Artis’ negligence (also contract case caused by Gratia)

Is Ars liable? In a bad year he gets $5k, which sounds like wages, but

counter argument is that in good year gets 1/3 of profits, and in last few years that’s what he’s gotten (doesn’t matter that didn’t contribute capital because contributes labor) so sounds like partnership

If he is a partner, he is liable in tort and contract Mayer?

Not a partner in the business (Argar), but is he a partner in another way?

Might have two partnerships going on, one between the three of Argar, and then one between Artis and Mayer

If yes, is he liable in contract case and/or tort case? Mayer is liable in first case, because he has a partnership

with Artis and Artis has a tort claim against him But much harder to find liability in contract case because

he is not a partner of Gratia If Mayer had loaned Artis 100% of the money, could

maybe get him through principal-agent relationshipo Low, Ars uncle, loaned business $50k for ten years, for 25% of profits and

veto of certain expenditures Is Low liable to bank or other suppliers?

Has a lot of control for just a lender like Cargill case became more of a principal-agent relationship than just a creditor-debtor

Really going to be a factual question, whether or not there was a reliance on the part of the suppliers/bank partner by estoppel

Low will argue he is just a lender, but counter argument is that had control over actions like in Cargill

Also argument that he is partner is interest tied to share of profits

- What happens when a partner leaves the firmo Remains liable for debts/responsibilities incurred before left, but not new

ones incurred afterwardso Can have agreement, even if implied, to release him of liability, or the

remaining partners and creditors can agree to release him from the terms of the agreement

Partners’ Liability provisions: RUPA §306, UPA §13: Partners are liable in tort for the

acts or omissions of co-partners the course of ordinary business even if the action is unlawful


RUPA §306; UPA §17: New partners are not liable for the acts of the firm prior to their involvement.

RUPA §401(f): Partners have equal rights in management and conduct

RUPA §401 (i): Person can become a partner only with the consent of the other partners

RUPA §404: Partners owe one another a duty of care and a duty of loyalty

Creditors who exert too much control can be considered partners by control or by estoppel. (Cargill).

RUPA §703; UPA § 36: A dissociated partner maintains liability for the firm’s actions during the time the partner was active unless there is a waiver by partnership or 3rd parties.

- Conflict between Personal Creditors and Partnership Creditors. Two solutions:

- (1) UPA §40(h) and (i): Jingle Rule: Which Creditors Get Dibs on Whato (A) Partnership creditors get first dibs on partnership assetso (B) Individual creditors get first dibs on individual assets

Both are second in line for the other type of assets.- (2) 1978 Bankruptcy Act §723(c) & RUPA §807(a): Which Creditors Get

Dibs on Whato Partnership creditors get first dibs on partnership assetso Equal Footing for Individual Assets: Neither partnership nor individual

creditors get first dibs on individual assets

- Nabisco v. Stroud (1959) p. 58- Facts: Stroud and Freeman are partners in Stroud’s food. Stroud tells Nabisco

that he personally would not be responsible for bread deliveries. Nabisco still delivers bread at Freemans’ request. Partnership dissolves, Stroud doesn’t want to pay for bread.

- Issue: Can Stroud be held liable for the actions of Freeman?- Holding: In a two person partnership, a majority is greater than one. Stroud

is liable. Bodies count more than contribution of capital.- Note: Preserves value of ongoing business – opposite rule would allow minority

partners to hold up the business

- BALANCE SHEET ISSUES

- Termination of a partnership: Greatest Doctrinal divergence between UPA and RUPA

- Default Rules of Partnership Dissolution - UPA 29, 30, 37 & 38- If partnership for a term, no partnership has right to dissolve before term expires


o You have the power to dissolve but then you’ll be in breech of the partnership agreement

- If at-will then you can dissolve it whenever you want- Winding-up the partnership, terminating partnership- You can contract around default rules though

UPA: Dissolution § 29: Any change of partnership relations, e.g.

exit of a partner, entry, etc. Winding up § 38: Orderly liquidation and settlement of

partnership affairs Termination § 30: Partnership ceases entirely at the end of

winding up Improper disassociation: doesn’t get any claim to

goodwill of the business—can’t get going concern value. No right to windup. Just pro-rata liquidation value minus damages

RUPA: lowers the barrier to enter into/exit partnerships Disassociation § 601: a partner leaves but the partnership

continues, e.g., pursuant to agreement. RUPA § 801: the onset of liquidating of partnership assets

and winding up its affairs Improper disassociation: pro-rata claim on going

concern, minus damages. Going concern value is the cash flow you expect in the future discounted by the time value of money.

- Adams v. Jarvis (Wis. 1964) p. 62- Facts: Dr. Adams withdraws from a partnership. He requests a wind-up and

dissolution.- Agreement: The withdrawal of a partner will not terminate the partnership.

Instead, Adams should get his share (1/3) of the year’s profits for the time that he worked (5 mos.) Trial court finds that the withdrawal works as a statutory dissolution.

- Issue: Should the statute trump the partnership agreement?- Holding: Dr. Adams loses. The partnership is not wound-up, but he does get his

portion of the profits. Agreement trumps the statute because the statute is just a default rule.

- Note: Why does Dr. Jarvis care about the accounts receivable? Why isn’t value of accounts receivable fully reflected in the income statement? Answer: Hospital is using a cash accounting system, so the books only reflect the money that has been paid.

- Dreifuerst (Wis. 1979) p. 66- Facts: Winding-up of an at-will partnership amongst three brothers to run two

feed mills. There is no partnership agreement, so this is a partnership at will. Trial court divides the assets, giving one mill to one brother and the other mill to


the other brothers. UPA S38(1): “When dissolution is caused in any way, except in contravention of the partnership agreement, each partners, as against his co-partners . . ., unless otherwise agreed, may have the partnership property applied to discharge its liability, and the surplus applied to pay in cash the net amount owing to the respective partners.”

- Issue: How should the court divide the assets of an at-will partnership?- Holding: The trial court did not have the right to divide the assets in this way. In

a partnership at-will, all partners have the right to request liquidation. Rule: An exiting partner has the right to insist on sale of the assets and allocation. Asset market is the most efficient and fair allocation of funds and best protects creditors. The market decides the worth of the business.

- RUPA §§ 402, 801, 802 and 804 codify the holding in this case.- Question: Why would the brothers want to separate the mills in-kind? They may

want to continue running the business or they may think that the court gave them the greater valued mill. There may also be tax reasons to avoid selling the business.

- ABA proposal: have a judicial valuation and appraisal of assets, then let the partners who want to continue to work pay off the exiting at-will partner. Exiting partner has appraisal rights, not a right to apportion the assets. (potential transaction costs associated with actual sale v. appraisal)

- Dissolution of Partnership- Partnership-at-term: can convince a court to dissolve it for you, hard but can be

done- Default rule: Dreifuerst, codified in UPA- If partners think default rule is going to be very expensive because of taxes or

transaction costs, can negotiate in the shadow of this rule, can even negotiate after the fact

- Ars, Artis and Gratia- Artis wants to leave the partnership, they want to replace him and bring someone

else in as partner and do the work Artis was doing- If Ars is your client, what contract provisions does he want to protect him?

o Concerned about (§ 36.3?) so he wants to make an agreement with the new partner coming in

o Want some sort of indemnification/reimbursement to protect him from liabilities incurred before he left

o If he just wants to leave, suppose the value of the business is $700k, worth $500k if you sell it to someone else as a whole, and $400k if you sell it in pieces

By default, if partnership at will, Artis can force a sale, which could net as little as 400k and as much as 500k partners have an incentive to negotiate because if keep business intact and keep running it, it’s worth 700k

RPU § 701: The remaining partners will have to pay him the upper of the liquidation value minus the value of Ars’ presence


o Say he was caught getting kickbacks, and he was being asked to leave by the partners, breach of the partnership agreement which means they can force him out, so the value would be less

§ 38.2(c): going to be paid the value of the partnership interest, minus damages and excluding good will (the difference between the asset value and the __?___)

Under new version getting paid the value of the business as a going concern, minus whatever damage he caused with his behavior

- First look to their agreement, otherwise look to default provisions in statutes- UPA § 701: greater of liquidation of assets or what business is worth as going

concern without him

- Page v. Page (Cal.. 1961) p. 70- Facts: Oral partnership agreement between two brothers to run a laundry. Just

when the business starts to make money, the elder Page seeks to dissolve the partnership. The younger Page claims that the elder is trying to take an opportunity. The trial court finds that the partnership is for a term, not at will.

- Issue: Was this a partnership at-will?- Holding: UPA S 31 says that a partner may wind-up a partnership at any point if

the partnership is at-will.- Notes: This is like the inverse of Meinhard v. Salmon. There is a concern that the

older brother will use his superior capital to purchase the business and run it at a profit. If Older brother seeks to purchase business, he would breach his fiduciary duty. Young Page is not protected, because Elder page will be the only buyer of the assets. Passive/Active partners don’t generally enter into partnerships at-will; better to be in a partnership for a term.

- Implicit assumption that market inefficient – because if market was efficient the value would be easy to determine

- Reasons for Cash Payout: o (1) Market Test of Value: sale allows better determination of real market

valueo (2) Protects Creditor’s Rights: easier to pay debt if there is cash, and may

be worth more as going concern than as individual assets.- RUPA §701(b): a disassociating partner who doesn’t insist on wind-up gets: a

higher of: (1) liquidation or (2) going concern value. (This is the pro-rata ownership of the business)

- Limited Partnership- General Partner plus limited partners- Limited partners have limited liability- Used to be the case that to retain limited partnership position couldn’t exercise

any controlo However that’s really not the case anymore

- PE funds are often like this- Limited duration


- LLP (Limited Liability Partnership)- for law and accounting partners- Helps limit liability for other partners torts- Good for helping as malpractice- Everyone is limited, but only from specific liabilities listed in the statute- Also LLLP, limited liability, liability partnerships

- LLC (Limited Liability Company)- Limited liability like corporation- But pass-through taxation

o Originally had to have no more than 3 of the following 4 to still have pass-through taxation

Centralized management Unlimited duration Transferability of shares Limited liability

- But then in 1987 IRS said okay you can have pass-through taxation as long as you don’t have publicly traded shares

- Hugely popular these days- Still some doubt about how Courts are going to treat LLCs?

o For example, how far can you contract around fiduciary duties?

- Subchapter S-Corp- Corp but get pass-through taxation- Have to have less than 75 live human shareholders- Limited liability like corporations- If one corporations buy S-Corp. Can do this without paying tax- If corporation buys an LLC there will be tax on the sale, but if buy an S

Corporation can buy it as a tax free reorganization- Can only have one class of stock- Best if you think you might be acquired some time soon

- CORPORATIONS- Everyone has limited liability- Can sell shares- Centralized management

o Board of Directors elected by majority of shareholderso Much more streamlined, less risk for impasse, than partnershipo Easier for third-parties to deal with business

Know that the board can do everything- Charter

o In order to make changes in the charter you need joint action of Board of Directors and shareholders

o Higher than by-laws, can’t be contradicted by by-laws


o Only subject to statuteso Governed by DGCL 102o Some things that have to be there

Name of corporation, etc. Capital structure

Total number of shares of stock that can be issued Classes and types of stock

- By-lawso Usually either Board or shareholders can do this unilaterallyo Governed by DGCL 109

- Benefits o Eliminates problem of personal liability: creditors can only use corporate

assets o Investors can enter and exit by buying and selling shares

Transferabilityo Prevents minority investors from holding up the firm by threatening

dissolutiono Can incorporate in any state – state of incorporation dictates which state

laws will control the management of your corp. o Centralized management o Considered to be a person in the eyes of the lawo A corporation does not cease to exist when shareholders exito Take on riskier ventures!o Prods creditors to monitor management

- Easterbrook & Fischel p. 92 Reduces need to monitor agents Reduces need to monitor other shareholders Makes shares fungible facilitates takeovers makes it possible for market prices to impound additional info

about value of firms (w/o LL, could not have 1 market price for all shares of corp)

allows investors to accept risky ventures Facilitates diversification Enlists creditors in monitoring managers Full information about the value of stocks?

- Key benefits of the corporate form: (2) Transferability of shares no concern over dissolution or reformation (problem for partnerships) good check on management encourages the development of an active stock market, which facilitates

diversification of investments Provides liquidity

- Key benefits of the corporate form: (3) Centralized management all corps need central coordinator to oversee exercise of

managerial power Management is appointed by elected board of directors


Separation of board and managers allows distinction between the approval of business decisions and their executions

As firms increase in size, it is more difficult for shareholders to monitor management.

Separation of powers: board approves business decisions and managers execute business decisions (necessary transaction cost)

- Mechanics of Creation- Have to file a certificate of corporation with secretary of state (articles of

incorporation) - Corporate charter – constitution of the corporation – usually more high level and

general- Create bylaws – usually more specific- Main differences are how you change and adopt the charter and bylaws

o To change or adopt charter need joint agreement between board and shareholders

o Usually one group or the other (or both) can on its own change/adopt the bylaws

- Charter is only subject to the state statute- Bylaws are subject to the charter and the law- DGCL § 102 (charters), § 109 (bylaws) very important, read these- Need to include in charter the capital structure number of shares of stock the

corporation can issue, what classes of stock and what types of stock going to issueo If one class of stock, typically common stock and these shares have

voting rights and can elect the board of directorso Can also have other classes of stock and set out in charter what rights

these different classes of stock have- Board of Directors – how elected, authority, CEO’s authority, how often board

meets, how notice is given, etc.- Historically charters came with monopoly rights, later there was increasing

pressure on legislatures to adopt general corporation laws to allow anyone to incorporate and get a charter, now anyone who qualifies and files the correct forms can get a charter

- Corporate Law Literature - Cary’s article in Yale Law Journal in 1936

o Race to the bottom, why Delaware wins because it is the worst law possible

Because you are playing to managers, while corporate law is supposed to protect shareholders

- Winter’s article in 1978o Says Cary is wrong, yes states are competing to offer law corporate

decision makers wanto But that’s good, manages don’t want to offer law that’s bad for

shareholders because otherwise shareholders wouldn’t invest in their companies


- Romano (1980s)o States get more corporate franchise tax revenue when more responsive to

demands of corporate power- Macey & Miller (1987)

o Delaware lawyers benefit from Delaware lawo The law invites litigation, so lawyers in Delaware benefito Law goes that way because Delaware lawyers a very powerful interest

group in the state- Bebhcuk (1992)

o Race is to the top in areas of states offering protection to shareholderso Except in areas where redistributive between shareholders and managers

and managers can get a lot of money incentives out of it Delaware is highly distributive in this way

Low protections under duty of loyalty Duty of care will be fine though

- Klausner (UVA sometimes recent)o Law is languageo Value of law is higher when most people use it

(Similar software packages become more valuable when more people use it)

o Use of case law makes the law clear – more predictable Corporations love predictability

o If another state could offer Delaware comparable law Problem is Delaware judges gives laws meeting Also incentive for Delaware to gives law hard to copy

Delaware does that by making application of law dependant on Delaware court distribution

o Maybe not on purpose, just no market discipline on doing this

- Kamar and Kahan (2001)o Expensive to compete with Delaware

Court of Chancellery without a jury Often have to change state constitution

Other states aren’t really competing with Delaware- Dane: the market values DE companies higher- Argument that Delaware is overseen

o Feds will federalize parts that go out of the box too far with things like Sarbanes-Oxley

- Empirically back to square one here, don’t know where race is to

- DGCL 141 is key for Powers of the board

- DGCL 271- Sale of all or substantially all assets of corporation needs initial approval from

board, then shareholder approval.


o Same for charter amendments mergers dissolutions

- Corporation has two ways of financing business activityo Debt

Secure debt Unsecure debt Public debt

Bonds - long-term debt secured by assets Debentures Long-term debt not secured by assets Notes Short term debt not secured by assets Subordinated notes – unsecured and subordinate to other

notes Private debt

Credit from banks and suppliers Creditors deserve to get interest payments every year

o Equity (Ownership) Common stock

Right to get dividends when board decides to give them – many don’t pay dividends for many years

Paying dividends in arrears – have to pay dividends for every year don’t pay it (so if wait five years between payments, have to pay dividends for each year)

Rights always set out in the charter Voting stock

Preferred stock Usually get guaranteed dividends (ex: every year 5%, etc.) Usually no voting rights This is not a statutory provision statute just says you can

design stock anyway you want This is industry practice not statutory DE code: you can leave the rights of the stockholders open

in the chartero Ex: rights of preferred stockholders will be

determined when the board issues themo Board can slice the stock into different series and

decide the rights of the stock as you issue them Blank check preferred

Articles of incorporation left it open for the board decide later

- Discount Rate: PV = FV/(1 + r)t

- Risk Premium- Risk Adjusted Discount Rate


- Diversification- investing in things that move in opposite directions

o Betting on two different sides of the same sporting event- systematic risk v. unsystematic risk

o systematic is risk that is inherent to the system Hard to get away through diversification

o unsystematic is extra risk on top of that Should be able to diversify away

o Risk companies risk is correlated with market is its “beta” How many companies stock moves when market moves

- If market moves 10% and company moves 15%, company has a beta of 1.5

- In re Emerging Communications (Del. Ch. 2004) Supp- Facts: Attorney and I-banker are held liable for recommending a low value.

Huge difference in valuation between the Professor and the Investment Banker. Plaintiffs: company is worth $44.95/share; Defendants: company is worth $10.38/share. Deal price was at $10.25; prior to the deal, the shares were trading at $7/share.

- Holding: Court determines that proper value was $38.05/share. There was reason to believe under these facts that the market price was not reliable. Information available to insiders re: June projections that were not shared with the market. The two valuations were based on different information.

- Small Firm/small stock premium - DE law: market price should be considered in appraisal, the market price of

shares is not always indicative of fair value

- CREDITORS- Creditors can minimize costs:

o Take security interests in particular assetso Negotiate specific covenants that give them early warnings of credit

problemso Usually too costly for small creditors

- Corporate law: 3 protectionso Impose mandatory disclosure duty on corporate debtorso Promulgate (usually de minimis) rules regulating amount and disposition

of corporate capitalo Impose duties to safeguard creditors on corporate participants

- Credit Lyones Example - 12.5 mil, EV of 15.5mil Corporate example – you remember this from the reading- Company is 12 million in debt- Kamar defines best interests of the company as the choice that maximizes the Net

Present Value of the company- Settlement offer I = 12.5 mil


- Settlement offer II = 17.5 mil- - Expect

Value of Company’s Assets

- Expected Value Shareholders’ Claims

- Expected Value of Creditor’s Claims

- Appeal - 25%of51 = 12.75EV

- 70% of 4 = 2.8 EV

- 5% of 0 = 0 EV

- Total EV = 15.5 Mil

- 25% x 39 = 9.75

- 70% x 0 = 0- 5% x 0 = 0- Total EV =

9.75

- 25% x 12 = 3

- 70% x 4 = 2.8

- 5% x 0 = 0- Total EV =

5.8 mil

- Settlement I - 12.5 - 0.5 - 12- Settlement II - 17.5 - 5.5 - 12

- Crux of Problem Cannot identify group of people whose duties run with interests of assets

- Plus in real life these numbers are almost all estimates- So Courts usually give the board discretion here- So we see here how Shareholders prefer risk as opposed to Creditors, and

can saddle the creditors with the risk

- Solvent Company (debt of 3 million)- - Expected


- Expected Value of Shareholder’s Claims


- Appeal - 25%of51 = 12.75EV

- 70% of 4 = 2.8 EV

- 5% of 0 = 0 EV


- 25%of 48 = 12 EV

- 70% of 4 = 0- 5% of 0 = 0

EV- Total EV =

12 Mil

- 25%of 3 = 1 EV

- 70% of 3 = 2.1 EV

- 5% of 0 = 0 EV

- Total EV = 3 Mil

- Settlement I - 12.5 - 9.5 - 3- Settlement II - 17.5 - 14.5 - 3

- Insolvent Company (debt = 60 million)- - Expected


- Expected Value of Shareholder’s Claims


- Appeal - 25%of51 = 12.75EV

- 25% x 0 = 0- 70% x 0 = 0

- 25%of51 = 12.75EV


- 70% of 4 = 2.8 EV

- 5% of 0 = 0 EV


- 5% x 0 = 0- Total EV = 0

- 70% of 4 = 2.8 EV

- 5% of 0 = 0 EV


- Settlement I - 12.5 - 0 - 12.5- Settlement II - 17.5 - 0 - 17.5

- How to use balance sheet in capital regulation and protection of creditors?- Represent particular fund on balance sheet as “permanent capital” that could not

be paid out to shareholders and upon which creditors could rely when extending credit

o Legal or stated capital account- Capital surplus test (NY § 510): bars distribution that would render corporation

insolvent (unable to pay its immediate obligations as they come due) dividends may only be paid out of surplus and not out of stated capital

o But board of directors is entitled to shift any portion of capital account to surplus account if authorized to do so by shareholders

- Nimble dividend test (DE § 170): Pay dividends out of capital surplus, or if no capital surplus, out of net profits in the current or preceding fiscal year

o Can freely transfer state capital stock associated with no par stock into surplus account on its own

- Modified Retained Earnings Test (CA): two-part distribution test pay dividends either out of retained earnings, or out of assets as long as those assets remain at least 1.25 times greater than liabilities, and current assets at least equal current liabilities

- RMBCA § 6.40: Corporations cannot pay dividends if:o Wouldn’t be able to pay debts as they come due, oro Assets are less than liabilities plus the preferential claims of preferred

shareholders- If corporations assets are worth more in economic value than as reflected on

books, free to change assets column to reflect thiso Since no corresponding liability, causes increase in capital surplus account

reevaluation surplus- Only real protection creditors have is under fraudulent transfers act

- Protection from other Creditors DOCTRINE OF FRAUDULENT CONVEYANCE

o Protection of creditors from other creditorso If transfer assets of failing company to single creditor, other creditors

can set aside conveyance or hold creditor responsible for company’s debt

Creditors that get the assets tend to be insiders Concern that shareholders will now wear the hat of creditors and

transfer assets to themselves


o Why would a company favor an outside creditor? Have a company bleeding cash, and need money now, so do

whatever it takes to get cash infusion into the companyo Might be third creditor will lend the money for certain assets, etc. one

last gasp for air by company- spin-off

o paying a dividend in kind, giving stock?o What if you put a lot of assets there and spin-off?o Could mean bad news for creditors – clean parents company and

subsidiary with few assets bearing all the debto Creditors could say fraudulent conveyanceo (Kamar’s example that often stock goes up but bonds drop,

- LBO, buying a company for cash with borrowed moneyo Leveraged a company up

Change the ratio of debt to equity Can pre-pay the company’s debt with new debt if they want So now when have an investment company that wants to buy a

company, company’s debt de facto accelerated, and investment company will pay off all the company’s debt when buy out

- 6.2.3. Minimum Capital and Capital Maintenance Requirements- In US, statutory minimum capital requirements are either truly minimal or

nonexistent- EU: minimal capital requirements more like de minimis screening than

meaningful creditor protectiono Traditionally adopted capital maintenance rules w/ main characteristic to

accelerate point at which failing corporations must file for insolvency- No capital maintenance requirements in US

- Equitable Subordination: Courts of equity use this doctrine to recharacterize debts owed to controlling shareholders as equity rather than debt—this protects unaffiliated creditors by giving them rights superior to creditors who are also controlling shareholders (i.e. subordinates claims of creditor shareholders).

- Generally only invoked in bankruptcy and only when two requirements are met: o (1) the creditor is also a shareholder, and typically an officer of the

company as well, and o (2) the inside creditor has behaved unfairly or wrongly toward corporation

/ outside creditors.- Difference between partnership and corporate context: automatic vs. non-

automatic subordination.o Partners loans are automatically subordinatedo Corporate loans from controlling shareholder - not automatic – because

controlling shareholder has the best information, best position and so don’t want to totally discourage it. This is corporate law, not partnership law.


- Costello v. Fazio (9th Cir. 1958) p. 142- Facts: Originally organized as a partnership, but partners then incorporate and

Fazio and Ambrose pull out most of their money so that each partner only has $2,000 in the corporate fund. Partners trade debt capital for equity capital. Fazio and Ambrose are now unsecured debt holders. However, the corporation is then totally under-funded, and defaults. Copartners are now in the same class as unsecured creditors. Partners keep the business alive so that they can turn over their creditors. Now the partnership creditors are paid off, and they have a new set of corporate creditors.

- Holding: Inequitable shareholder-creditor claims against a bankrupt corporation may be subordinated to general creditors. This firm was undercapitalized and there was action for the partners’ personal or private benefit. A claim that is not within the bounds of reason and fairness, or that does not carry the earmarks of an arm’s length transaction, is inequitable. Where the partners’ claims left the business seriously undercapitalized, to their own benefit but to the detriment of the corporation, these claims should be subordinated to general creditors. The partners took advantage of their fiduciary position.

- Immaterial that withdrawel happened before incorporation, because done with contemplation of incorporation

- Wasn’t fraud, but still don’t get paid first- Constructive fraud – not intent to fraud, but had effects of fraud

- How could this have been different under the Fraudulent Transfer Act?- Future creditors are not protected under constructive fraud in Costello we are

dealing with future creditors, so might not be protected under the act- Only past creditors protected from constructive fraud, and both past and future

creditors protected from actual fraud- If the company had already paid Ambrose (inside creditor), could you have gotten

the money out of him?o Not with equitable subordination, this just means kicked back to the end of

the line, only deals with debt that has not yet been paid by the companyo Here would have to use fraudulent transfer to undo

- Piercing the Corporate Veil for contract creditors: this is the equitable power of the court to set aside the entity status of the corporation and impose tort or contract liability directly on the shareholders.

- Generally consists of two components: o (1) evidence of lack of separateness (shareholder domination, thin

capitalization, no formalities / co-mingling of assets. “Tinkerbell test” – to be protected, shareholder must believe in the separation);

o (2) unfair or inequitable conduct (lying, cheating, stealing, implicit or explicit misrepresentation. This is the wildcard in veil-piercing cases).

Cases where there is generally not piercing: against public corporation; against passive shareholders; minority shareholders; if all formalities are observed and nothing “funny” with the accounts.


Remedy: go beyond corporate assets and get assets of shareholders.

- Sea-land Services v. The Pepper Source (7th Cir. 1991) p. 148- Facts: Sea-Land is a creditor that gets stiffed on the freight bill from Pepper

Source. Sea-Land tries to collect a judgment on Pepper Source, and finds that Pepper Source has dissolved without any assets. Sea-Land then tries to sue Marchese, who has a stable of companies that have limited funds. Sea-Land tries to pierce through to Marchese and reverse pierce to the other corporations. The lower court granted summary judgment in favor of Sea-Land

- Holding: Court applies the Van Dorn test and remands. District Court finds actual fraud and tax fraud. Van Dorn Test (7th Circuit – applied in Sea Land):

o (1) such unity of interest and ownership that separate personalities of the corporation and the individual [other than the corporation] no longer exist;

Four factors are relevant to the first requirement: (1) failure to maintain adequate corporate records or comply with corporate formalities; (2) commingling of funds or assets; (3) undercapitalization; and (4) one corporation treating the assets of another as its own.

o (2) Circumstances such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice. (NOTE: PROBLEMATIC TEST: either real fraud or “injustice.”)

Promotion of injustice requires showing a “wrong” beyond merely that creditor would be unable to collect.

Real proof of fraud in these cases would be unreasonably difficult; colorable business purpose is always present. The injustice prong seems to apply to strategic behavior which results in disappointing legitimate creditor expectations, but is insufficient to prove intent. (Note similarity to norms underlying fraudulent conveyance law—unfairly shifting assets.)

- Note: the lower court circumvented the “injustice” issue of Van Dorn by finding actual fraud.

- Laya test (Applied in Kinney Shoe Corp. v. Polan) (1) unity of interest and ownership such that the separate personalities of the corporation and the individual shareholder no longer exist; and (2) would an inequitable result occur if the acts were treated as those of the corporation alone. BUT: even if these 2 prongs are satisfied, still potential “third prong” – Defendant might still prevail by showing assumption of risk.

- Facts: Kinney shoe is given a deal to invest in WVA. Polan has two corporations: Polan Industries and Industrial. Kinney takes a lease in WVA, and then realizes that it cannot make it in WVA. Kinney then subleases the building to Industrial. Industrial has no assets, but Industrial subleases 50% of its sublease to Polan Industries, which has assets. Polan uses two corporations so that the first corp. protects his personal assets and the second corp. protects his business assets.


Both of Polan’s corporations go bankrupt. Kinney then seeks to pierce the corporate veil and hold Polan personally liable.

- Holding: Court applies Laya test and holds that there was a:o Unity of interest and ownership such that the separate personalities of the

corporation and the individual shareholders no longer existo and to rule otherwise would be inequitableo No discussion of assumption of risk prong because this is discretionary,

not mandatory.- An Kinney was desperate – shouldn’t they have investigated and protected

themselves- 7th circuit would have required the injustice element not necessary here- Would fraudulent transfer have helped here?

o When you use fraudulent conveyance, you have to trace the assetso When company doesn’t keep clear books, you don’t know what was given

to whom when, and maybe all these assets are dissipated across dozens of people and not all in Polan’s hands

o With veil piercing don’t need to trace specific assets- Found that first two prongs satisfy, introduce third prong

o If creditor had reason to know the corporation was undercapitalized then the re is no veil piercing

o But this prong wasn’t applicable hereo Even if prong three applied here, it is not mandatory and doesn’t apply

here- 7th Cir. 2 prong test more important/prevelant

- Study on 160- in 92% of the cases Court finds some sort of “injustice”- Most cases stem from contractual liability

- Veil Piercing on Behalf of Involuntary Creditors (tort)- Difference from contract creditors:

o First, they are not in a position to rely on the firm’s creditworthiness when they put themselves in a position of risk and then suffer loss.

o Second, they cannot negotiate with the firm ex ante for contractual protections from risk. In many cases tort creditor may be unaware of tortfeasor.

- Walkovszky v. Carlton (N.Y. 1966) p. 157- Facts: Plaintiff severely injured when run down by taxicab owned by one

defendant, operated by another. Also sued defendant Carlton who was stockholder of 10 corporations, each owning only a few cabs that were part of overall fleet. Assets of companies are worthless – cabs are mortgaged and medallions are judgment-proof. They carry the statutory minimum for liability insurance and have no other assets.

- Incentive to engage in overly risky behavior since can shield assets from risky business activity by holding multiple corporations


- Holding: The plaintiff has not produced sufficient evidence that the individual defendant was operating the various companies in his individual capacity. The plaintiff is really trying to allege fraud in the complaint but the companies in this case complied with the law.

- NY rule on veil-piercing: Courts will pierce the corporate veil whenever necessary to prevent fraud or to achieve equity. Specifically, when an individual defendant uses the corporation to further his own rather than the firm’s interests, then he should be liable for the corporation’s acts. However, thin capitalization alone is insufficient to pierce the corporate veil for tort liability.

- Enterprise liability – piercing liability across all corporations, court willing to do this

o But Court won’t actually to the guy himself

- Carter-Jones Lumber v. LTV Steel (6th Cir. 2001, p. 166)- Here liability is to the state for criminally polluting the environment- Is there a different standard for veil piercing under this federal act than veil-

piercing for creditors?- Seems to be yes sufficiently capitalized, followed corporate formalities, etc.

and still found liable for pollution- Based on Supreme Court decision in Best Foods

o But this seems to give the same standard for veil-piercing under CERCLA as for creditors

o Just in this case found someone at parent company of wholly owned subsidiary that broke CERCLA also

- Hansmaan and Kraakman article (p. 170)- Especially want to pierce veil for tort creditors and involuntary creditors, because

most exposed to hazards of limited liability- But because of court focus on fraud, etc. they actually get less protection than

contract creditors- Don’t want to encourage investment in businesses that are too risky- Solution: pro rata limited liability

o Liability proportionate to shares held in company- Why assume limited liability for torts anyway?- Might be doable, but not the law today

- CHAPTER 7 - NORMAL GOVERNANCE: THE VOTING SYSTEM

- What Shareholders Can Vote On - Elections- Charter, by-laws- Mergers (DGCL 251)


- Sale (DGCL 271)- Dissolutions- Resolutions (creature of federal law)

o Standard rule about proxies being revocable (although can be irrevocable)

- Board decides about a “record date” for who can vote as of a certain day

- Removing a director with cause takes a lot – they have to be a real villain according to Kamar, just bad management isn’t enough

- Can I just remove them because I own them?o Well , yes unless it’s classifiedo DGCL 141, 141(K)

- The Unfireable CEO Problem (p. 182)- Revesz CEO and substantial shareholder w/ 25% of stock of Village- Kagan takeover artist, want to control company- Revesz, amendments to bylaws classifies the board- R:

o Amends charter so that only board can amend bylawso Enacts cumulative votingo Staggered (classified) board (9 members, 3 elected per year)

- Kagan buys 51% o f shares (R has 25%)- Delay tactic take three years of voting to remove the board (staggered), or two

years to gain majority- Also changes charter to cumulative voting - have as many votes as shares times

positions voting for (ex: have 100 shares and there are 3 seats up for election, get 300 votes that he can split up as he likes can give all 300 to one person, or split among the three seats)

o Regular voting: choose one person per seat, all of your votes go to that person (each person you vote for gets all 100 of your votes)

- If combine cumulative voting with classified board, can buy even more time than just each measure alone

o Instead of Kagan taking control of one third of the board each year, she’ll only get 2/3 per year, and will take the full three years for her to gain a majority

- Suppose Kagan can petition the court to call a special shareholder meetingo Articles incorporation = chartero Can she get rid of the cumulative voting by amending the charter?o § 242(b)(1) & (2) – charter amendments must be initiated by the board,

not the shareholders (though must be signed off on by the shareholders- Can she amend the bylaws (§ 109)

o No – only the board can amend the bylaws (see R’s charter amendment)o But if she could amend the bylawso Can she increase the size of the board by amending the bylaws? As long as

the charter allows a maximum above what is currently in place


If bylaws says 9 members, and not addressed in the charter – will this help her?

Now there will be a bunch of vacancies – who gets to fill them? § 223(a)(1) – vacancies filled by directors unless otherwise

directed by bylaws, so she needs to amend the bylaws If she changes the board to 27, with cumulative voting, he’ll get

four more (in addition to the 9 he already has) for 13 total, and she’ll get 14, so she’ll have a majority

To figure out how many directors someone will get with cumulative voting: (new directors + 1)(Opposing party votes – 1)/(votes cast)

Round down As long as she expands the board enough, she’ll be able to swamp

the board with her people and she’ll get the majority- § 216 DCL – company can have in the bylaws a provision that says a majority

must elect the board of directors even if no one runs against them- Can she destagger the board? Yes, since she’ll have the majority because then,

when the board isn’t staggered, she can remove the directors without causeo Can’t dismiss without cause if board is staggered or cumulative voting

- § 141(d): can stagger the board in the initial bylaws or in the bylaws adopted by shareholders, so the board cannot restagger itself

- Could she dissolve the company? No, you need both shareholders and must be initiated by the board § 275

- Charters are stronger than bylaws, so if want to erect your defenses against corporate contests, do it in the charters

o Charter requires board initiation to change, and then shareholder voteo Amending bylaws is easier because shareholders can initiate on their own

- Nowadays you have to work really hard to convince shareholders to go to staggered boards need shareholder support because has to be either in the bylaws or the charters

- Today a lot of pressure on companies to destagger their boards

- Staggered Boards - The most powerful defense a board has against takeover is a classified board.

o Companies with staggered boards much less likely to cave in during hostile takeover (Bebchuck study)

- Staggered boards are bad for shareholders in other ways:o 2005 study: Companies without staggered boards valued higher than

companies with staggered shares in marketo CEO turnover and compensation less sensitive to company performanceo Likelihood company will adopt proposals by shareholders is lowero Board less likely to be challenged in proxy fightso More insulated from market control

- Delaware limited to up to three classes for a boardo NY limits you to four classes


- Cumulative Voting - You get your number of votes times the number of directors being elected, and

then can place them for whatever director you’d like- It’s basically proportional representation- Used to be used for minority representation on the board of directors- Now it is used to further entrench boards- Formula for how many directors you can get:

o (New directors +1)(vote – 1)/(vote cast)

- Shareholder access initiative: proposal to allow shareholders to nominate minority candidates in company’s proxy statements under certain circumstances the shareholders will be able to demand that included in the company’s proxy statement a certain number of candidates representing the shareholders to run against the incumbent board members

- Idea of you have liability risk in a proxy statement- Costly to prepare- Costly to circulate- Liability in it- So overall pretty deterring

- Rosenfeld v. Fairchild Engine and Airplane (NY 1955) p. 183 - Facts: During proxy context, incumbents spent $106,000 and reimbursed

themselves from company treasury. Spent $28,000 for which they were not reimbursed b/c they were voted out. Insurgent reimbursed incumbents $28,000 and reimbursed themselves. Shareholders ratified insurgents’ reimbursement.

- Issue: Should both sides of a proxy contest be reimbursed?- Holding (Froessel rule): Board is allowed to reimburse all reasonable costs

incurred in a proxy contest supporting its own candidates (it’s about policies, not persons!). Insurgents reimbursed only if they are successful and have shareholder ratification. Note: the Froessel rule serves as a screen to insurgents because they have no guarantee of being reimbursed unless they have a reasonable chance at prevailing.

- Makes an area where it would be efficient to takeover but not worth the proxy cost risk

- Class Voting: - 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 it to be authorized

- DGCL §242(b)(2) – holders of outstanding shares of a class shall be entitled to vote as a class upon a proposed amendment, whether or not entitled to vote thereon by the certification of incorporation, if the amendment would

o Increase or decrease aggregate number of authorized shares of such class

o Increase or decrease par value of the shares of such class or


o Alter or change powers, preferences or special rights of the shares of such class to affect them adversely

- Voting regimes present risk that majority blocks will advance own interests – minority needs protection

- Under NY Law: Section 804(3): if a new class of shares is issued that is superior to the rights of the existing stock, there is a class vote to decide whether to create this stock.

- DE v. NY: Delaware law requires a class vote if the rights of the securities are changed 242(b)(2), but it does not make reference to the effect or issuance of a new class of stock.

- Note that the statute provides the minimum protections for senior class, but there can be more protections in the charter or by other contract

- Shareholder Information Rights- § 220 DGCL- Access under DGCL § 219 or 220?

o Under § 219 Can see list, without contact information, for 10 days before

meeting (so too late)o Under § 220: Have proper purpose, so can get access to records as long

as have proper purpose courts will compel inspection of stock list- State corporate law in the US leaves function of informing shareholders largely to

the market. By contrast, federal securities law and SEC rules mandate extensive disclosure for publicly traded securities

- Common law (codified in Delaware statute) grants shareholders two rights: request “stock list” and inspect “books and records” if you have an appropriate purpose

- Stock list: discloses identity, ownership interest, and address of each registered stock owner. (Remember, individuals typically are not registered; their brokers are, but individuals are NOBOs (nonbeneficial stock owners), and this list may also be disclosed)

o easy to get access too allows insurgents to initiate proxy fights

- Inspection of books and records:o Far more expensive than stock list and can jeopardize proprietary or

sensitive informationo Much harder to get access to companies will typically litigate to protecto Burden is on the shareholder to establish a proper purpose to inspect books

and records.- NY law: statutory right to inspect key financial statements, balance sheet, and

income statements, for the rest courts reserve common law power to compel inspection in proper cases

- General Time Corp v. Tally Industries - DE § 220 (state supp p. 201)- Burden on corporation to show stockholder requesting list for improper purpose


- General Time: noticed in Tally’s president’s deposition statements which caused ∆ to believe π attempting to obtain list to acquire General Time stock for illegal purposes

- Tally has primary purpose that is legitimate (solicitation of proxies to run opposition candidates for director)

- Court: any secondary purpose is irrelevant, what matters is that has shown proper purpose and so is entitled to production of stockholder list

- Vote Buying

- Schreiber v. Carney (Del. Ch. 1982, p. 203)- Shareholder held 35% of voting rights, company needed those votes for merger,

shareholder opposed it b/c of expensive tax liability, also held warrants- With a little money could convert warrants and avoid tax liability, so company

made a loan to company so it could do so- Independent committee negotiated terms and submitted for approval to

shareholders, required majority of shareholder votes other than the 30% owner- Court: no harm no foul, only illegal if trying to defraud or disenfranchise

other shareholders

- Ichan blurb (p. 207)- Today have very sophisticated corporate technology – there are much more

elegant ways of vote buying today which don’t directly fit into Schreiber case- Ex: buy derivite securities

o Right to buy the stock at a certain price – call optiono Right to sell the stock at a certain price – pull option

- Hedge funds: new breed of aggressive investors, placing bets on how the company will do

- Can buy a pull option, which will make you rich if the company loses value, and then you buy voting rights and gain from its losing value

o If had bought stock, would have lost money when company value depreciated

o So just buy votes so can destroy company don’t lose from stock cash flow rights, and make a killing off the put option

- Ichen: so sold call option, and retained pull option, essentially won’t have the stock tomorrow but has the voting rights in the meantime

- So combination of pull options and call options will essentially separate the cash flow rights from the voting rights

- Borrowing stock- Vibrant market in borrowing stock- Borrow stock, rent it for a couple days buy the stock with right to sell back at

certain date- Institutional investors tend to rent the stock (just like when you put your money in

the bank, and it loans it out to make money)


- So hedge funds borrow stock for that one critical day to get voting rights (b/c board has to announce in advance what day will determine voting rights record date)

- So borrow stock for one day, vote it, then return it to the lender- But don’t care what happens to this company after the vote, could be for a number

of reasons that want to vote even if don’t have stock in that companyo Ex: want to vote so company buys another company you have a stock in,

so the sale will go through and you make a ton of money off of that- But if you’re an institutional investor, why would you lend your stock to someone

who is planning to destroy the company, or who doesn’t have the companies best interest in mind

o So don’t you think institutional investors would raise the rent? Turns out they don’t

o Argue that have fiduciary duty to make money for the holders, and if they can do it by rental they should

o Kamar: probably won’t last for long, either regulators will get involved or institutions will wise up

o Going to see increasingly more and more shareholder involvement in the voting mechanism

o But if voting mechanism is rotten because the people who are voting aren’t really the people you think are voting, then really just polishing a rotten apple

o Might be regulation, but also market might fix itself

- Stock Pyramids- If want to have disproportionate voting power, buy 51% of stock, of company that

owns 51% of another company, that owns 51% of another company, etc.- Effectively gives control of the all the companies in the chain- So only costs you approximately 12.5% of cost of lower company to control it- Doesn’t happen much in this country because of tax consequences- When company pays shareholder dividends, there are taxes on it- So each time the money moves up a level in the pyramid, have to pay taxes on it,

very quickly becomes less profitable- Only way to get exemption from tax is to get 80% in the company, but then might

as well get 100% and make it a private company- Tax law adopted this way precisely to discourage this form of ownership structure- The farther you get away from the original company, the less cash flow you get

but still retain conrol

- Dual class capitalization- Have at least two classes of common stock, and give one class more voting rights

than the other (example, ten votes per share and other class get one vote per share)- Founders, etc. then hold the super-voting stock, and then sell the other class to

others


- SEC tried passing rule that said can’t recapitalize single class company into a dual class company, but struck down because SEC doesn’t have the right to deal with corporate governance, that is for the states

- SEC strong-armed exchanges to adopt this rule on their own, because listing exchanges have their own listing rules

- So all the listing exchanges adopted the rule that had been struck down, but no one cared at that point because hostile takeovers had subsided and had alternative anti-takeover remedies, and institutional investors figured it out and refused to vote in favor of this recapitalization (takes a charter amendment so shareholders had to sign off)

- Rule: Still ok to go public for the first time with dual class capitalization, and can spin off companies with dual class stock

- 85% of dual class firms, the stock with the super voting power is not tradedo On average higher voting stock holders have 40% of the cash flow rights

and 60% of the voting rights- Ex: NY Times

o Publishing industry lends itself well to controlo Psychic controlo Still controlled by founding family

- Companies with founders name in company name are more likely to have dual class capitalization

- How does this affect shareholder value?o With single stock

More entrenched, so less market influence on controlling party But also, when have so much stock, act more like an owner and

interests more aligned with company Value of company increases when ownership of management when

management owns more than 25%o Dual class

Companies with a greater wedge have less value So greater separation of voting rights from cash flow rights

decrease companies value because don’t have that alignment check

- Bebchuk, Kraakman, Triantis, Stock Pyramids, Cross-Ownership, and Dual Class Equity (p. 209)

- -Dual class share structures: single firm issuing two or more classes of stock with differential voting rights

o Planner can attach all voting rights to fraction of shares assigned to controller and no voting rights to remaining shares offered to public

o Most common form in US- Pyramid structure

o Most common world-wideo Minority shareholder holds a controlling stake in an holding company,

which owns a controlling stake in an operating company- Cross-ownership structure


o Horizontal cross holding of shares that reinforce and entrench power of central controllers

o Make control over company less transparent- Latter two are unpopular in US because of tax penalties for pyramid structures

and stringent regulatory and reporting requirements

- Easterbrook & Fischel, Voting in Corporate Law (p. 213)- Voting rarely any function except in extremis- No vote expects vote to decide the contest no/diminshed incentive to study

firm’s affairs and vote intelligently- Today voters not fungible those with more shares do not face collective action

problem to same extento Investment companies, pension trusts, some insiders

- Collective action problem may be overcome by aggregating shares

- Black, Next Steps in Proxy Reform - Legal rules limit oversight of corporations and the size of financial institutions in

US- Banks, insurers, mutual funds: legal limits on ability to hold large percentage

stakes- Uncertain law legal risk, discouraging oversight by institutional fiduciaries- Institutions own half the equity in American public companies- If law changed, institutions would do more monitoring

- Pozen, Institutional Investors: The Reluctant Activists (p. 216)- Robert Pozen

o Before you celebrate institutional investors as cure for collective action problem, keep in mind that they have their own agency costs

o Institutional investors are just people working for the big company, and they're not getting paid to incentivize them to do best things for the firms

- Kahan & Rock, Hedge Funds in Corporate Governance and Corporate Control (p. 216)

- Hedge funds emerging as shareholder activists, helping to overcome class agency problem publicly held corporations

- Incentives to monitor:o Incentivized to maximize returns to fund investors b/c of fee structureo Often manager invested significant portion of own personal wealth in fundo Benefit directly from achieving high absolute returns

- Hedge funds may be the solution!o They're like institutional investors (they have a lot of money) and their

compensation (much higher fees) gives them incentive to try to generate more value

Problem is, as we saw yesterday, value to themselves may not be the same as value for everybody else

They may destroy company to increase value for themselves


o The Federal Proxy Rules: the rules of voting in a public company Proxy solicitation: Any solicitation reasonably expected to result

in the procurement of a proxy §14(a)(1)(L)(iii) Background:

Rules are promulgated after the Great Depression Securities Act of 1933 (“33 Act”) deals with disclosure

procedures that companies must follow when selling securities on public markets. Covers initial offering of securities when you first go public

Securities Act of 1934 (“34 Act”) establishes (among other things) disclosure requirements for corporations after they have gone public. All public companies are subject to proxy regulation under Section 14(a) of the Act.

Regulation 14A: substantive regulation of the process of soliciting proxies and communication among shareholders

Schedule 14A: What you need to disclose in a full-dress registration statement

1992 Amendments: Changed rule that shareholders couldn’t speak to one another about the company through proxies w/o approval from the SEC of their proxy statement

Four Major Elements of Proxy Rules Disclosure requirements and a mandatory vetting regime Substantive regulation of the process of soliciting proxies A “town meeting provision” 14(a)(8) that permits

shareholders to gain access to corporate proxy materials at a low-cost. (Cheaper for investors to get things on the company proxy)

General anti-fraud rule 14(a)(9) allowing courts to imply a private SH remedy for false or misleading proxy materials

Section 14(a) of 1934 Securities & Exchange Act makes it illegal, in contravention of any rule the commission may adopt, to solicit any proxy to vote any security under § 12. Regulation 14A contains the implementing rules.

The basic scheme of the Regulation is to state with great detail the types of information that any person must provide when seeking a proxy to vote a covered security.

These rules apply not only to an issuing corporation but also to a third party who might seek to oust incumbent management by proxy fight.

o Had the unintended consequence of actively discouraging proxy fights.

o 1992 Amendments released institutional shareholders, in some circumstances, from


requirement to file a disclosure form before they could communicate with other shareholders about a corporation

Rules 14a-1 through 14a-7: Disclosure and Shareholder Communication

Rule 14a-1: defines proxy as any solicitation or consent whatsoever.

o The breadth of these terms protected management from shareholder attack because of the expenses of

o 1992 Amendment provided exemption of solicitations that

do not seek to act as a proxy are disinterested in the subject matter of the

vote and own less than $5 million in stock or are managers paying for the solicitation at

their own expense Rule 14a-2: Most proxy solicitations are subject to

regulations. Exceptions for:o Solicitations by registrants, those opposing mergers,

etc., and beneficial owners cannot be exempt.o Solicited by less than 10 shareholderso Shareholders who wish to communicate but don’t

seek to act as proxies Rule 14a-3: Information to be Furnished to Security

Holderso Central regulatory requirement of the proxy ruleso No one may be solicited for a proxy unless they are

or have been furnished with a proxy statemento When the solicitation is made on behalf of the

company itself and relates to an annual meeting for the election of directors, it must include considerable info about the company

o Solicitors who are not part of management must disclose their identity, their holdings, and the financing of their proxy campaign.

o 1992 rule made it so that 14a-3 could be delivered through alternative media, reducing transaction costs.

Rules 14a-4 and Rule 14a-5: The Form of the proxyo Procedural rules as to what must be contained in the

proxy.o Shareholders vote individually on each proposal.

E.g., proxy must instruct SHs that they can withhold support for a director by crossing through the name.


o Short slate rule: The 1992 amendment required that the form of the proxy provide for a separate vote on each matter presented. Thus, dissident can also solicit votes for some but not all of management’s candidates for the board.

Rule 14a-6 and 14a-12: formal filing requirementso File 5 copies must be sent 10 calendar days before

the statements are mailed to shareholderso Still have to file (though not full proxy statement) if

acted under 14(a)(2)(b) and own 1% of stock or $5 million

Rule 14a-7: List-or-mail ruleo Management must either provide a dissident

shareholder with a list of shareholders or mail the dissident’s proxy statement for her.

Rule 14a-8: Shareholder Proposals (Town Meeting rule) Shareholders can include some of their proposals in the

corporation’s proxy materials Shareholders must hold $2,000 or 1% of the corporation’s

stock for 1 year Must file with management 120 days before management

plans to release its proxy statement Proposal limited to 500 words Proposal must not run afoul of subject matter restriction Management can ask to exclude shareholder information in

the corporation’s proxy materials if that informationo Would impede state lawo Is a proposal related to ordinary business (BJR)o Relates to a matter <5% of businesso Relates to the election of directorso Conflicts with company’s proposalo Burden is on the company to demonstrate grounds

for exclusion Mostly relate to corporate governance, such as poison pills

or structural reforms of the board, or general social responsibility, such environmental or personnel practices.

Preference for precatory resolutions: shareholders sidestep questions on the scope of shareholder authority under state law

Rule 14a-9: The Anti-Fraud Rule Broad-range rules that let shareholders bring suits in federal

courts attacking disclosures made to them by managers Proscribes false or misleading statements that are

MATERIAL (likely to influence how reasonable shareholder votes); No predictions; Nothing that impugns


the character of associates without factual foundation; Failure to follow proxy form

SCOTUS recognizes a private right of action under §14a-9 (JI Case v. Borak) p. 227

Elements of Private Right of Action for Fraud under §14a-9o False or misleading statement that’s material (it

influenced the Reasonable SH to vote)o Level of culpability (negligence or scienter)o Causation – Fraud must be an essential link to the

challenged transaction (no reliance necessary)o Reliance NOT necessary in 14a-9 actions, though it

is an element of fraud in common lawo Remedies: Injunctive relief, rescission or monetary

damages (Mills)

- Virginia Bankshares v. Sandberg (1990) p.229- Facts: “Freeze-out” merger of Bank into VBI – public shareholders get $42 per

share cash on the recommendation of an outside banker. Bank urges the vote for the plan and states that the $42 is a “high” and “fair” price. Shareholders bring suit alleging a violation of 14a-9; jury awards $18 additional per share, and 4th Circuit affirms.

- Issue: Are false statements on a proxy solicitation actionable?- Holding: Judgment for Defendant. Statements are actionable under Rule 14a-9 if

(i) there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote and (ii) the statements are with respect to material facts (based TSC Industries, Inc. (1976) and Blue Chip Stamps). However, minority shareholders, whose vote was not required for approval of a transaction, can demonstrate compensable damages required for a private action under § 14(a) if the proxy solicitation was an essential link in the accomplishment of the transaction. In this case, no state-law claim was lost, so there is no private right to action

- Concurrence/Dissent: There is no authority to limit § 14(a) to protecting only those minority shareholders whose numerical strength could permit them to vote down a proposal. In this case, the conclusion that no state-law remedy was deprived rests on the assumption that Virginia uses the same standard of “materiality” as federal proxy rules. Otherwise, Π has lost her state-law remedy.

- Study by Steve Choi from NYU in 2000, looking at shareholder proposals before and after rules reform

- Hypothesiso That more insider ownership would mean less likely to get shareholder

proposals- His study confirmed this

o Post-reform, there should be no change in level of support that these kinds of proposals get


o Counter-argument = if you make it easier to have shareholder proposals, there will be less support

Study showed drop in support Choi explained this by saying maybe there was change types of

proposals being offered Types of shareholder proposals: (1) governance and (2)

public interest Governance proposals are often settled outside voting

setting Public interest proposals are not usually settled and go to

votes, so drop in support --> finds that what caused the drop in approval rate of

proposals was increase in public interest proposals

- Majority voting vs. plurality voting (p. 224)- Is this a major proposal?

o Rather than responding to shareholders, company sends "no action letter" to SEC asking to have proposal excluded

Argued that proposal was not going to make a substantial difference b/c company had already adopted it in substantially the same way:

o Proposal wants to have bylaw rule that you can only win board election w/majority votes

- Company has policy that's slightly differento SEC says company has to include proposal cause it's different than

company policy So company includes proposal in statement and also explains why

management doesn't like it

Proposed 14(a)(11): Shareholder Proxy Access Rule Long-term shareholders will have the power to place their

own nominees on a public company’s proxy materials under limited circumstances:

o A 5% group of people who have held shares for two years can nominate a short slate of 1, 2, or 3 directors to run against specified management directors on the company’s proxy upon the occurrence of either:

35% of shareholders withheld vote on board nominee during prior annual meeting, or

Successful resolution brought by 1% of SHs requesting nomination rights during prior meeting

Requires a 2 year process (1st year to get the trigger, 2nd year for the vote to occur); would potentially shift a lot of power to institutional shareholders.


o State Disclosure Law: Fiduciary Duty of Candor: History:

State law usually did not regulate proxy solicitation outside of common law fraud claims.

As the substantive protections in state corporate law decreased and the importance of fiduciary duties increased, the courts became more involved in regulating proxy solicitations.

Fiduciary Duty: In 1976 the Delaware Supreme Court held that a controlling shareholder making a cash tender offer for stock held by minority shareholders has a fiduciary duty to make full disclosure of all germane facts (Lynch v. Vickers Energy Corp. (Del. 1977)). This principle has been extended to directors and to proxy solicitations.

Delaware Approach: Duty of Candor: Delaware law has focused on governance rather than market disclosure and has been careful to avoid potential conflicts with federal proxy law by limiting state regulation to situations where shareholders are being asked to take some action.

However, in Malone v. Brincourt (Del. 1998) the court reversed course and applied a duty of candor to all communications by directors to shareholders, either indirectly or directly.

Partial rationale for the Malone exemption is that the shareholders held their shares (rather than selling) and were therefore not covered by Rule 10b-5 (anti-fraud)

o Proxy Rules decision tree Is it a proxy that is governed by the rules? §14(a)(1) & (2)? Is it a regulated solicitation that requires filing of proxy

statement? §14(a)(2)? Do they still have to file under 14(a)(6)(g) b/c they own 1% or

$5 million? If they must file, did they enclose critical information with the

proxy materials? Were they justified in waiting until they send out the cards to

give it to SEC and shareholder under §14(a)(12)?

- FIDICIARY DUTIES

- Three ways to protect shareholders- Voting- Lawsuit after you get swindled- Selling your stock


- Entire Fairness Test (DE Law) - What will happen to you if it had been shown that you breached duty of loyalty or

duty of care?o You have to actually show that the transaction was entirely fair to

shareholders- So breach of fiduciary duty doesn’t mean you lose, just that you have to prove it’s

fair (which means you’re probably on your way to losing)- Burden varies for plaintiff or defendants having to produce fairness

- Limitations on fiduciary duty liability - Three sources

o Business judgment rule If you don’t have any reason to believe board messed up, court will

defer to board’s business judgment because courts don’t want to make business judgment second guessing

- Insurance and indemnification- Exculpation

- Gagliardi v. Trifoods International, Inc. (Del. Ch. 1996) p. 241- Facts: Shareholders sue directors of TriFoods for mismanagement- Issue: What must a shareholder plead to state a claim of mismanagement?- Holding: Officers are not liable for decisions made in good faith. Shareholders

shouldn’t want directors to be risk averse. “The [business judgment] ‘rule’ in effect provides that where a director is independent and disinterested, there can be no liability for corporate loss, unless the facts are such that no person could possibly authorize such a transaction if he or she were attempting in good faith to meet their duty.”

- DGCL §145- - Plaintiff - Coverage - Condition - Mandatory?- (a) - 3rd Party - Expenses

liability settlement

- Good faith

- No

- (b) - Corporation - Expenses - Good faith and not adjudged to be liable

- No

- (c) - Any - Expenses - Successful - Yes

- (e) - Any - Expense advancement

- Repay if not entitled

- No

- (f) - Any - Any - Not in - No


contravention of other parts of §145

- Waltuch v. Conticommodity Services, Inc. (2d. Cir. 1996) p. 243- Facts: Waltuch seeks indemnification for his legal expenses under DGCL 145(c)

because he is dismissed from the lawsuit. Conti says that Waltuch was not successful; he got the benefit of having his charges dropped because Conti settled the case.

- Holding: Waltuch prevails because he “succeeded” on the merits by not having been found personally liable.

- Company had provision in laws (article nine) that doesn’t seem to require good faith for indemnification

- Holdingo Court says (f) cannot be applied to counteract (a)o So article nine isn’t legal under DGCLo But gets indemnified under another provision (c)

- Directors and Officers Insurance (D&O)- DGCL § 145 (g): A corporation may purchase liability insurance on behalf of a

director, officer, employee or agent of the corporation- RMBCA § 8.57: A corporation may purchase and maintain insurance for

directors or officers of the corporation.- Could a board raise the salaries for directors and officers and allow them to bear

their own risk? Perhaps, but this is not done in practice, likely because it is cheaper for a firm to negotiate the rate of D&O insurance rather than an individual, both officers and shareholder benefit from firm-sponsored D&O insurance, and this is another means to hide the total amount of management compensation

- American Express Case - American Express buys stock in DLJ and then stock price drops and they have to

get rid of it, they could eithero Sell the stock and get a nice big capital gains losso Give the stock as a dividend to all their stockholders, which is what they

do, but then they don’t get to deduct capital gains on it (costs them about 8 million dollars in capital gains tax they probably have to pay because they can’t offset the tax)

- Lawsuit isn’t for acquiring the stock, its for not getting the capital gains write-off by doing it through dividends and costing money

- Reason company did it was because it would have changed their income statement, by doing it through dividends they didn’t have to show this loss for accounting purposes

o So they give it as a dividend (makes them look better to Wall Street)- Court says they don’t agree with business rationale but its not up to them


- Plaintiff says but personal gain of 4 directors on board, compensation related to earnings per share, had a conflict of interest

- But approval of other 16 of 20 directors cleanses it because its approval by a neutral decision-maker

- Holding: Decision to pay a dividend is protected under the business judgment rule. Mere errors of judgments are not sufficient grounds to interfere in the decisions of management.

- Business Judgment Rule - Wanting decision to be based on law rather than fact so judges and not the Jury

would decide it- Desire for a good process

- DGCL §145(g) Insurance- You can pretty much buy insurance for anyone you want

- We don’t have the same circumscribing of buying insurance for directors- But if you think about it the insurance company is going to apply some constraints

- Smith v. Van Gorkom- Facts: Trans Union Corp. is a publicly held company with unused net operating

losses and a CEO who is looking to retire. CEO arranges a sale to Pritzker at $55/share. (Stock is selling for $35/share). Pritzker wants a decision in 48 hours, so CEO calls a special meeting of the board, but does not give them an agenda in advance. Board approves the merger after a 2 hour meeting. A class of shareholders sue and claim a breach of the duty of care because the board did not act in an informed manner.

- Holding: (3-2) The managers were “grossly negligent” in failing to carefully consider the offer. BJR does not protect grossly negligent actions, and the case is remanded for damages.

- Aftermarth of Smith v. Van Gorkom:- Rise in D&O premia- Delaware legislature enacts Section 102(b)(7) which validates charter

amendments that provide that a corporate director has no liability for losses caused by transactions in which the director had no conflicting financial interest or otherwise was alleged to violate a duty of loyalty.

- DGCL § 102(b)(7) (p. 155 Stat. Supp.): Contracting around the duty of careo (b): The certificate of incorporation may also contain…

(7): 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 as a director, provided that such provision shall not eliminate or limit the liability of a director for

Any breach of the director’s duty of loyalty


Acts or omissions not in good faith, involving intentional misconduct, or knowing violation of the law

Unlawful payment of a dividend or stock purchase (under § 174)

Transactions where the officer received an improper personal benefit

102(b)(7) eliminates damages, but doesn’t eliminate plaintiff’s other remedies (injunctive relief).

- Lawsuit still painful to directors- have to go be deposed and testify- miss work time- on front page of wall street journal- This is all avoided if you have exculpatory provision, but not with insurance

o In fact if a company has insurance, less economic incentives for company to fight as hard

- Ohio General Corporation Law vs. DGCL:o Higher burden of proof – clear and convincing evidenceo Higher scienter requirement – deliberate intent to cause injury to the

corporation

- Cinerama, Inc v. Technicolor, Inc. (CEDE III) (Del. 1995) p. 262 (The Technicolor Dialogue)

- Facts: Technicolor CEO negotiates to sell the company to Perelman for $23/share. This is 100% premium over pre-bid share price. Disinterest board is very casual (as in Van Gorkom), and approves the transaction. It gets no credible valuation, and the company is not shopped to other potential buyers. In appraisal proceedings, Technicolor is valued at $21.60/share. Disinterested shareholders still bring suit.

- Issue: What happens when BJR doesn’t apply because there is gross negligence?- Holding: The sale was entirely fair.- Chancery Court (Allen): “Absent proof of self-interest that casts upon the

director the burden to prove the entire fairness of an interested transaction, a shareholder-plaintiff must prove by a preponderance of the evidence that director negligence did cause some injury and must introduce sufficient evidence from which a responsible estimation of resulting damage can be made.”

- Del. Supreme Court (Horsey): “[B]reach of the duty of care, without any requirement of proof of injury, is sufficient to rebut the business judgment rule. . . . A breach of either the duty of loyalty or the duty of care rebuts the presumption that directors have acted in the best interests of the shareholders, and requires the directors to prove that the transaction was entirely fair.”

- Chancery Court (Allen): “I find myself unable to conclude that [this was not] a completely fair transaction.”

- Del. Supreme Court (Holland): Affirmed.- Technicolor Takeaways:

o Duty of care does not require P to show injury (Cede II).


o Gross negligence with respect to process is sufficient to put burden on directors to show entire fairness (Cede II).

o BUT: gross negligence doesn’t necessarily mean that the substance was unfair – you can have gross negligence and the transaction can still be entirely fair (Cede III).

- Emerald Partners v. Berlin (Del. 2001) p. 264- Facts: Hall, CEO/controlling shareholder of May, proposes a roll up to acquire 13

companies. May’s independent directors approve, but a minority shareholder alleges that the deal is unfair. Hall goes bankrupt, and shareholders try to continue suit against directors. Chancery Court dismisses the complaint without an “entire fairness” analysis because only duty of care claims remain, which may waived under Section 102(b)(7).

- Holding: Supreme Court reverses: “where 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. Section 102(b)(7) becomes a proper focus of judicial scrutiny after the directors’ potential personal liability has been established.”

- Kraakman’s note: Note that the courts have circumvented Section 102(b)(7) by not dismissing “duty of care” cases at the outset for failures to state a claim. As a realist point, these suits will likely settle.

- Orman v. Cullman (Chancery, 2002) - Can only dismiss under 102(b)(7) if you have a very clear case of duty of care

(and not duty of loyalty)- (But Kamar doesn’t know how actually useful this is for you today in reality)

- Disney - Complete disregard of duties is bad faith, so remand and court of chancery has to

hear the case- Chancery court said not enough evidence to show bad faith- Left us with a standard of good faith as well as duty of care and duty of loyalty

- Graham v. Allis-Chalmers Manufacturing Co. (Del. 1963) p. 271- Facts: Allis-Chalmers is a large, decentralized company that made electrical

equipment. In 1937, it enters into a consent decree with the FTC to stop price fixing. In the late 50s, four mid-level managers plead guilty. Shareholders bring a derivative suit against directors to recover fines on behalf of the corporation. Plaintiffs allege that the directors breached their duty of care in failing to install internal controls to prevent violations

- Derivative suit: Suits shareholders bring on behalf of the company against the directors to recuperate losses sustained by the company.

- Holding: No liability. Directors are allowed to delegate management, and they only have a duty to install internal controls. However, directors have no duty to always be suspicious of their management.

- Note: BJR only applies to acts, not omissions.


- Directors did not have duty to investigate managerial abuse before their regular monitoring suggested anything was even wrong

- Directors are entitled to rely on honesty and integrity of subordinate directors until something occurs to put them on suspicion that something is wrong

- Absent such cause, no duty to install and operate corporate system of espionage to ferret out wrongdoing

- Board has the duty to monitor when there is a red flag

- Martha Stewart Case - Weren’t supposed to actually sneak after her to see what she was doing- Might have made company personally liable to Stewart

- Marchese Case - Guy was outside director and went ahead and blew whistle to SEC that there was

accounting fraud- He was found liable for signing fraudulent statements before he left firm- Bottom line outside director must make sure that financial statement is at least

accurate

- In re Caremark International Inc. Derivative Litigation (Del. Ch. 1996) p. 276- Facts: Caremark, a large provider of specialized patient care, is subject to the

Anti-Referral Payments Law: it must not pay MDs to refer patients funded by Medicare or Medicaid. Caremark has an ethics guidebook, an internal audit plan, and a toll-free confidential ethics hotline. In addition, PWC gave Caremark a clean bill of health. However, there is lower level violation of the anti-referral payments law. The parties seek to settle.

- Holding: The settlement is fair. Allen takes this opinion to announce a change in Delaware law to increase the duty of management after Allis-Chalmers.

- Court: not the same rule as Allis-Chambers, don’t need the red flag, always have these monitoring obligations

- Nowadays can lose a lot of money by not having a monitoring system in place- Here company had everything in place you could imagine to prevent this, so no

liability- Always put a system in place

- Stone v. Ritter - Court says Caremark is the law in DE- But to find breach of monitoring obligations, have to show that action was in bad

faith – says that in Disney that this meant careless, disregard, recklessness – in any case serious dereliction of duty

- Puzzling part: Court says it knows that there has been some discussion on whether duty to act in good faith is third fiduciary duty

o Court says this is not an independent duty. Any breach for duty of bad faith is really a duty of loyalty claim

But notes there can be breach of duty of loyalty even in good faith


- but Caremark really about duty of care- Possible huge expansion of duty of loyalty!

o Which wouldn’t be covered by indemnities etc.

- Sarbanes-Oxley - Kamar doesn’t like how the casebook deals with this

o It’s only making sure that the financial statements are accurate, not dealing with other stuff

- Whether or not you violated your duty of care, can be illegal under federal law- Have to have all these control systems in place

o Have to verify they are effectiveo Have to get an outside auditor to sign off on them

- Miller v. AT&T (3d. Cir. 1974) p. 282- Facts: AT&T refuses to collect money from the DNC. Shareholders sue, saying

that this is a violation of the federal election laws and corporate waste. Lower court dismisses the case as protected under BJR for failure to state a claim.

- Holding: Intentional violation of the law cannot be protected under the BJR even if claimed to be in best interests of corporation. Shareholders are within the class that the law is designed to protect.

- DUTY OF LOYALTY

- Dodge v. Ford Motor Co. (Henry Ford explained that he eliminated dividends in order to give price reductions to the public; Court held he could only seek to maximize shareholder benefit).

- If you’re generous, be generous at your own expense- Can’t not pay dividends and use price to lower costs even if it’s a good thing for

business- Note: this is an old case, and it is one the few that advocates shareholder primacy

as a rule of law probably because Ford expressly stated that he was acting in the interest of non-shareholders.

- Some states have constituency statutes- DE does not

- A.P. Smith v. Barlow (N.J. 1953) p. 288- Facts: Shareholders sue a corporation for making a charitable donation to

Princeton University.- Holding: Court holds that charitable notion acceptable as being in pursuit of the

corporation’s long-term interests. Contribution is permissible; comports with NJ statute which explicitly allows up to 1% of capital and surplus to be used for charity as directors “deem expedient.” Donations, particularly to prestigious universities, have a long term corporate benefits.

- Allis-Chalmers case


- Company involved in anti-trust violations n 1930s and 50s- Lawsuit against several, but not all members of board

o How did they choose them? They were the ones who knew about this history of the 30s

- Two reasons to hold disinterested directors liable for breach of careo Knowledge and expertise

- Update: In Re Emerging Communications Inc., Shareholder Litigation (2004, p. 126)

- Conflict of interest transaction (related-party transaction)- Controlling shareholder decided to cash out minority shareholders (went private)

this can be done by against wishes of minority shareholders by merging two companies together both controlled by same shareholder subject to judicial review

- Board signed off on this, shareholder lawsuit against directors- Obviously controlling shareholder knew that price not right (because he set it) but

what about the rest of the board- One of the directors had a substantial amount of market and financial

experience he should have known the price wasn’t right, so he was held responsible even though the rest of the board without that kind of experience weren’t held responsible

- DE Supreme Court justice sitting as trial judge, so instead of appeal case settled- So here special knowledge was enough to hold director liable, even though he

didn’t actively do anything wrong- This is the law today you can draw distinction between directors and hold

some liable and others not

- Breach of loyalty examine each director’s interest individually

- Casebook divides into three categories- Self-dealing/conflict of interest generally- Executive Compensation- Corporate Opportunity

- Three important concepts:- Identify duty of loyalty situation- Find element of disclosure- If you want to show that, based on disclosure, some independent body signed off

- The law has moved from never allowing self-dealing transactions to now sometimes offering them:

- Sometimes it’s a benefit to the company for there to be a self-dealing transaction- Small, closely held companies

o CEO knowing more about his own company Has confidence in his ability

o Less analysts tracking the company


- Service industry, often harder to value because of their businesso Expect greater divergence between outsiders values and insiders values

- Hayes Oyster Co. v. Keypoint (Wash. 1964) p. 294- Facts: Hayes is director, CEO, and 23% shareholder of Coast Oyster. He

convinces the board to sell two oyster beds. After this, but before shareholders approve, Verne enters into an agreement with a Coast employee to form Keypoint to buy the beds (Verne’s family corporation, in which he is a 25% equity-holder, gets 50% of Keypoint’s equity). Verne doesn’t disclose, and Coast sues for the “secret profits” (i.e., Hayes Oyster’s 50% interest in Keypoint).

- Verne’s argument: Entire fairness should be applied, and the deal was substantively fair.

- Holding: Nondisclosure itself is per se unfair. Actual injury is not the principle upon which the duty of loyalty law proceeds in condemning this contract. Fidelity in the agent is what is aimed at, and the law will not permit the agent to put himself in a situation where he may be tempted by his private interest.

- RMBCA § 8.61(b)(3) – states that conflicted transactions are ok if they are “established to have been fair to the corporation.” But this likely would lead to the same outcome as Hayes Oyster – disclosure is necessary for fairness.

- DGCL §144 – a conflicted transaction requires disclosure of all facts material to the transaction or that the transaction be fair; but a Delaware court would still likely come down with Hayes Oyster in requiring disclosure as an element of fairness, unless there’s a very good reason for not disclosing.

- How much needs to be disclosed? Delaware says all “material” facts, but does this mean you have to state the best price you’ll accept? Some Del. courts have suggested that it doesn’t go that far. Even if there is disclosure, next part of the inquiry is: what standard of review will the court apply?

- DGCL §144(a) (common/self-interested director count towards quorum)- (1) Disclosed or known, good faith authorization by a majority of

disinterested directors- (2) Disclosed or known to shareholders and they specifically approve in good

faith- (3) It’s fair at the time it’s authorized by board, a committee, or shareholders

- How would the statute be interpreted in DE?- § 144(a)(3): so it is ok if entirely fair but don’t want to get to this test- Answer in Weinburger v. UOP (p. 499)- Test of entire fairness: two prongs

o Fair dealingo Fair price

- Not a bifurcated test, must be examined as a whole


- Bottom line: fair dealing is important, difficult to persuade court of fair dealing when there is failure to disclose an interest in the transaction

- More you replicate a true arms-length process, going to be easier to be able to play some cards close to your chest if you don’t, court is going to expect you to be very honest about everything

- Marciano v. Nakash (535 A. 2d 400, DE 1987)o Two factions in closely-held company disclosure would not have

helped to get any approval from the other sideo Technical oversight to fail to disclose interest, so didn’t matter because

wouldn’t have helped the transactiono But very special case by and large need disclosure

- MBCA § 8.61(b)(3): fairness requires disclosure if director doesn’t comply can get equitable relief, damages and/or sanctions

- Deterrence point: difficult to learn about self-dealing transaction, if don’t have punitive damages insider has no incentive to disclose (otherwise either don’t get caught and so keep money, and if do get caught, just give it back)

- Item 404 (supp. p. 498): (federal law)o 8(a): even if have only indirect interest, if have interest that exceeds 10%

in entity that deals with the company, you must disclose it, if less than 10% maybe important, maybe not

o in excess of $60,000o over 5% of voting securitieso maybe of immediate familyo For Publicly traded companieso Make disclosure in SK, financial report due at end of fiscal year, not about

disclosing before the transaction

- Safe Harbor Statutes: conflicted transactions can be approved or ratified by disinterested parties.

- Most jurisdictions have adopted such statutes in order to make sure conflicted transactions aren’t always voidable by the corporation. Examples: DGCL § 144, NYBCL § 713, Cal. Corp. Code § 310.

o Possible interpretations: A transaction isn’t voidable solely because it is interested, as long

as it is adequately disclosed and approved (i.e. by disinterested parties), or it is fair.

Broader plausible reading: A transaction is never voidable if it is fully disclosed and approved, or if it is fair.

However, Courts have resisted this broader reading

- Cookies Food Products v. Lakes Warehouse (Iowa 1988) p. 303- Facts: Herrig is distributor of Cookies’ BBQ sauce, and he becomes the

controlling shareholder and a director. Herrig enters into self-dealing contracts with Cookies, all of which are successful for the corporation; however, the company doesn’t pay dividends.


- Issue: Is it enough to satisfy one of the three prongs of the safe harbor statutes, or must there also be a showing of fairness?

- Holding: Directors who engage in self-dealing also have to establish fairness. In this case, the success of the company leads the court to believe that the deals were fair. The transactions were approved by disinterested shareholders, and even with the fairness review this transaction was fair

- Dissent: Fairness cannot be established without inquiry into the fair market price.

- Other interpretation of what constitutes “full disclosure”:- Delaware – Chancery Court retains power to look at fairness, but doesn’t have

to.- RMBCA § 8.61 – stronger safe harbor statute (pro-majority): takes review down

to the business judgment rule.- ALI § 5.02 – other extreme, always requires entire fairness (pro-plaintiff).

- Shareholder Approval: In re Wheelabrator (Del Ch. 1995) p. 316- If the interested transaction is between a corporation and a director, and

shareholders approve, BJR applies.- If the interested transaction is with a controlling shareholder, and a “majority of

the minority” approves, fairness review remains but the burden shifts to the plaintiff.

- Two circumstances:o Controlling shareholdero Don’t have controlling shareholder, but still have self-dealing transactions

(ex: director)- In both cases have disinterested entity approve it- Whenever you have a conflict of interest decision, the same standard will apply - Most DE cases point in same direction, if have disinterested decision making

body without majority shareholder, virtually in business judgment territory which means plaintiff loses

- Lewis v. Vogelstein (Del. Ch. 1997) p. 322- Facts: Shareholders approved a compensation plan drawn up by a self-interested

board comprising a large one-time option grant.- Opinion: Chancellor Allen reviews the existing Delaware standard, and

concludes that it is the normal standard for waste; notes that courts are not good at evaluating compensation decisions, and that institutional shareholders will likely do a better job at monitoring.

- Holding: Even though the waste standard applies, Allen forces a trial since this option grant is sufficiently unusual.

- Corporate Opportunity Doctrine- not supposed to compete with a company if you’re a fiduciary, including an

outside directoro Difficult because you want outside directors with experience in the

industry


- 122-17 DGCLo company can opt out of corporate opportunity doctrine

- Broz v. Cellular Information Systems (Del. 1996) p. 332- Facts: CIS is in financial difficulty. Broz, a CIS director, bids on a license for his

other company RFBC. Broz doesn’t present the opportunity to the board, but is told by two officers that CIS isn’t interested, CIS is in bad financial shape. PriCellular is negotiating to buy CIS. Broz buys the license; PriCellular buys CIS; PriCellular sues Broz for taking a corporate opportunity.

- Standards in case law:o In same line of businesso Company has interest or expense in ito How you came to know of it

Did you use company assets to discover ito Is taking the opportunity going to put you in conflict with the

company- Holding: Applied to the facts: No corporate opportunity here – it was the line of

business, but no financial ability to take it, and had no expectancy or interest (at the time it was divesting itself of similar holdings), and Broz took care not to usurp corporate opportunities, wasn’t inimical to corp’s interests.

- Note: If this had been a corporate opportunity, Broz should’ve presented to the board. It is not enough to informally go to directors.

- In re eBay Shareholders Litigation (Del. Ch. 2004) p. 74 Supp - Facts: Goldman wants eBay’s business, so it misuses a corporate opportunity to

help eBay higher ups by giving them allocations of IPO stock (very lucrative, the stock “pops” after going public and makes a lot of money).

- Holding: Court finds this a clear corporate opportunity: investing in these sorts of securities is within eBay’s line of business, eBay had the financial wherewithal to pursue the investment, and eBay would have enjoyed this opportunity if it had not gone to the top management.

- Alternative holding – also a violation of fiduciary duty under agency principles. Agent is responsible for profits earned in connection with performing her duties for the principal.

- Essentially taking bribe from investment company- Getting this freebie was corporate opportunity of ebay, shouldn’t have been kept

by directors should have been given to all shareholders- Kamar: this is a stretch to use the corporate opportunity doctrine

- Telxon v. Meyerson (802 A. 2d 257, DE SC 2002)- If you have corporate opportunity and get permission from the CEO, it’s not

enough- How do you reconcile with Broz?

o No conflict, because in Broz not a corporate opportunity- If corporate opportunity must get permission


- DGCL § 217: company can opt out of this corporate opportunity doctrine by putting it in charter or board action, but best to do with shareholder approval because otherwise might bring lawsuit claiming breach of loyalty by opting out.

- Shareholder Lawsuit- Background: Derivative and Direct Claims- Derivative suits

o An assertion of a corporate claim against an officer or director (or third party), which charges them with a wrong to the corporation

Said to represent 2 suits in one Against the directors, charging them with improperly

failing to sue on the existing corporate claim The underlying claim of the corporation itself (that the

corporate directors have failed to bring) Directors owe their loyalty to the corporation itself, which is why

alleged breaches of obligations by directors and officers most often arise in the context of derivative suits. If the officers breach their duty to the corporation, damages should go back to the corporation.

- Direct actions, o usually brought as class actions (See F. R. Civ. P. 23 ) under federal

securities lawso To recover damages suffered by individuals directly (or to prevent injury

to these individuals) because they are shareholders Plaintiffs may bring suits for both types of harm.

- COMPARING/CONTRASTING DIRECT AND DERIVATIVE CLAIMS: - The derivative suit advances a corporate claim whereas the direct suit alleges

harm to the shareholders.o Sometimes (but rarely) courts approve direct payment to minority

shareholders in derivative litigation, which blurs the line between the two suits

However, this offends the formal character of corporate law and may be unfair to corporate creditors

Derivative suits have procedural hurdles designed to protect the board of directors’ role as the primary guardian of corporate interests. See F.R. Civ. P. 23.1 (derivative actions).

- Both suits provide for:o Settlement and release only after noticeo Opportunity to be heardo Judicial determination of fairness of the settlemento Successful plaintiffs are customarily compensatedo Can get nonmonetary relief in both types of suitso Attorney’s fees

In practice, treated similarly


o Standing issues- Derivative - contemporaneous ownership – must own stock at time damage was

cause and lawsuit brought- In what case will you find no shareholder to bring a lawsuit?

o Acquisition – shareholders cashed out and want to sue board for breach of duty, won’t have any shareholders because all the shareholders are gone have to turn to class action

o Demand requirement FRCP 23.1: first must go to the board and tell board to bring a lawsuit before you can bring your own

Can get around it by showing board’s bias and that demand was futile

Don’t have to do this for class action because suing on behalf of yourself and not the company

Class action just need to have owned when the harm was done

o § 145: Indemnification changes depending on whether or not suit brought on behalf of the company

- Tooley v. Donaldson (Del. 2004, p. 372)- Breach of fiduciary duty by delaying date of closing for merger- Shareholders brought suit for time value of the lost time- Court:

o Who suffered the alleged harm?o Who’s going to receive the benefit of cover?

- No claim because shareholders had no individual right to have to merger at all cannot be direct/class action suit

- No damage to company either – how can the company suffer loss from changing hands tomorrow instead of today?

- Had there been a breach of fiduciary duty it would have been a direct claim

- Gentile v. Rossette (Del. 2006)- Controlling shareholder also CEO, company issued him convertible debt (could

convert to common stock)- Got board, after the fact, to sweeten the conversion rate (he get more common

stock for his debt)- Company sold to third party (another company) which filed for bankruptcy- Once sold, shareholders had been cashed out, and can’t sue new bankrupt owner,

so really didn’t want this to be a derivative suit wanted it to be direct suit- With overpayment claims, even though normally appears as harm to company

only, if there is a controlling shareholder, and minority shareholders, it will be a direct harm to the minority shareholders

- By giving him so much more stock, diluted both voting and economic power of minority shareholders, which was a direct claim

- People mostly bring class action when its acquisition related, and mostly derivative suits when other stuff


- Solving a Collective Action Problem: Attorneys’ Fees and the Incentive to Sue- Plaintiffs’ attorneys have an interest in bringing either type of suit

o Plaintiffs’ attorneys get fees if they are part of litigation that creates a common fund to benefit all shareholders

Many shareholder suits against the directors and officers of public companies are initiated by the plaintiffs’ bar

In form, these attorneys are the economic agents of their shareholder clients

In substance, they are legal entrepreneurs motivated by the prospect of attorneys’ fees

- When a derivative suit succeeds on the merits or settles (usual outcome)o The corporation is said to benefit from any monetary recovery or

governance changeo The corporation and its insurer also generally bear the bulk of litigation

costs on both sides The company is likely to have advanced the cost of defense to its

managers and it must usually pay the Π a sum for “costs”- The role of lawyer as bounty hunter creates its own agency problem

o Perverse incentives: Plaintiffs’ lawyers can initiate “strike suits” – suits without merit –

simply to extract a settlement by exploiting the nuisance value of litigation and the personal fears of liability

Corporate defendants may be too eager to settle because they bear at least some of the costs of litigation personally (e.g. depositions, risk of personal liability) but they do not bear the cost of settling

Awarding attorneys a % of the recovery may encourage premature settlement

o Lodestar formula: alternative fee rule Pays attorneys a base hourly fee for the reasonable time expended

on a case, inflated by a multiplier to compensate for unusual difficulty or risk

But this rule creates the opposite incentive to spend too much time litigating

- Some courts have experimented with auctioning the rights to represent the corporation (or class) to the law firm that makes the best bid

- “security for expenses” statutes: permit corporate defendants to require plaintiffs (or their attorneys) to post a bond to secure coverage of the company’s anticipated expenses in the litigation

o See e.g. NYBCL § 627; Cal. Corp. Code § 800 Started in the 1940s

o Seems to have failed in practice: s are rarely forced to post bonds and are almost never charged with the litigation costs of corporate defendants

o What about auctioning the right to be the lead attorney? 5 law firms want to be the lead attorneys – want not sell the lawsuit


to the firms? Maybe sometimes better to get structural changes to company than

cash, and these firms won’t care about that (when derivative lawsuit)

Might affect the way court treats the case when plaintiff and sole benefactor is lawyer instead of shareholders

What law firm has enough money to put up all this money off front?

Or, instead of law firm getting everything, can bid competitively which firm will do it for the smallest percentage

No control for quality No single best solution

o Federal securities cases auctioned, but haven’t seen state cases auctioned yet

- Federal Private Securities Litigation Reform Act of 1995o Designed to discourage non-meritorious suitso Number of class actions has not decreased

- Fletcher v. A.J. Industries, Inc. (Cal App. 1968) p.352- Facts: Shareholders of A. J. Industries bring a derivative suit against the company

and its directors alleging domination by Ver Halen and excessive salary to Malone that resulted in damage to the corporation. Settlement specified that plaintiffs’ attorneys could only be awarded fees if the corporation revived a monetary award in the arbitration proceedings, but plaintiffs’ attorneys applied for fees anyway. The trial court granted plaintiff’s attorneys’ fees and costs (totaling $67,000) because “substantial benefits had been conferred” upon the corporation by the settlement

- Settlement: Plaintiffs negotiate to (a) reduced Ver Halen’s influence over the board; (b) removed Malone as director and corporate treasurer; and (c) referred all monetary claims to arbitration.

- Issue: What is the substantial benefit? - Holding: Appellate court affirms lower court finding of substantial benefit.

Derivative suits are an effective means of policing management, and it is not significant that the benefits accrued from settlement, not final judgment. Compensation should not be limited only to cases that produce monetary recovery – non-pecuniary benefits are very real. “Substantial benefits” accrue if the court finds that the results of the action:

o “maintain the health of the corporation and raise the standards of ‘fiduciary relationships and of other economic behavior,’” or

o “prevent an abuse which would be prejudicial to the rights and interests of the corporation or affect the enjoyment or protection of an essential right to the stockholder’s interest.”

- Dissent: This is a slippery slope!


- Note: Ex post the settlement is a real economic benefit because the litigation has already been commenced. However, ex ante the settlement is not necessarily a benefit if settlements incentivize plaintiffs’ attorneys to bring suits.

o Double agency problem: π attorney thinks about himself (better to settle than lose), ∆ also have agency costs because if settle they aren’t going to have to change much, cost born by insurance company

- Problem: encourages frivolous lawsuits b/c know will settle, meritorious suits settle too soon

- How do you calculate the fees?o Court estimates the benefit and does some calculation when there are

structural changeso Done in the shadow of going through lawsuit and winning some casho At trial gets percentage

- What are the right incentives?- Is there anything percentage of the recovery leaves out?

o Any cost to the company not captured in the recovery? Reputational damage Managerial time Insurance premiums will go up All these costs are ignored by lawyer focused on the recovery

o What are some benefits not taken into account when only looking at cash recovery?

o One option is to delay recovery until suit passes benchmark of motion to dismiss, but don’t want to scare away meritorious suits

- Choi, Fisch & Pritchard- After law (Private Securities Litigation Reform Act 1) was enacted, saw increase

in the number of cases where public pension funds took the lead role in lawsuits, but private investment companies didn’t

- Attorney’s fees smaller when public pension funds take over the case- But can’t conclude from this that law works

- Standing- Matters when shareholders first learn about the claim- So if harm occurred in 1988, but find out about it in 1996, need contemporaneous

ownership in 1996- Standing Requirements

o Standing requirements for a derivative suit are established both by statute and court rule (10 Del. Code Com. § 327 and F. R. Civ. P. 23.1

Plaintiff must be a shareholder for the duration of the lawsuit. This rule has bite chiefly in the context of corporate mergers and dissolutions.

Demand requirement (see below) Demand excused cases (see below)


o RMBCA § 7.41: Plaintiff must have been a shareholder at the time of the alleged wrongful act or omission and must be able to “fairly and adequately” represent the interests of shareholders, meaning in practice that there are no obvious conflicts of interest

o ALI § 7.02: Plaintiff must 1) have held the security before or because of the allegedly wrongful conduct, 2) continue to hold the equity during the course of the lawsuits, 3) comply with the demand requirement or be excused, and 4) can “fairly and adequately” represent the interests of shareholders.

- The Demand Requirement:- 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.” Fed. R. Civ. P. 23.1 (Delaware has the identical rule)

- Baseline rule is that the plaintiff must make a demand – this balances the board’s business judgment with the plaintiff’s interest in review.

- Levine v. Smith (Del. 1991) p. 364- Facts: In 1984, GM buys EDS from Ross Perot in a stock transaction that makes

Perot GM’s largest shareholder (with 0.8% of GM’s stock) and puts Perot on GM’s board. Perot starts criticizing GM publicly, and 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. A three-person committee and the full (22-person) board approve the deal. Shareholders bring a derivative action, claiming breach of fiduciary duty, arguing that demand would have been futile.

- Lower court: The 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.

- Holding: Affirmed. Court applies the Aronson Demand Futility Test: in Levine: A demand is futile if a reasonable doubt is created that

- Test: must show that directors either not independent/objective/neutral or decision not covered by business judgment rule to avoid demand requirement

- Note: the test that the courts apply is disjunctive, not conjunctive, as the original test implied.

- Are they objective? Are the conflicted – this can be measure directly or indirectlyo Can’t expect people who think they will be held liable to bring a lawsuit

against themselves or their peers- To get around demand requirement must either show:

o Too interestedo Particularized facts creating a reasonable doubt as to the soundness of the

challenged transaction


- Rales v. Blasband (Del. 1993) p. 368- Facts: Shareholder/plaintiff Blasband owns stock in Easco, a company that is

controlled and managed by the Rales brothers. Rales brothers do a public debt offering of $100 million in notes, officially to finance investments, but they instead invest the proceeds in Drexel junk bonds a t a time when Drexel (owned by Milkin) is on its last legs and the DOJ is hot on Michael Milkin’s trail. The suit alleges a 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. After the deal but before the shareholder suit, the Rales brothers merge Easco into a subsidiary of Danaher, which they also control. When 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 they just sit on the board, along with six others.

- Issue: Is Demand excused under the substantive law of Delaware? (This case was in Del. Court on certification from the District Court.)

- Holding: Demand is excused: This suit does not require application of the second prong of the Aronson test (valid BJ). The current Board was not involved in the challenged transaction, so there is no review for valid BJ. Inference: second prong of test protects acting board members, but it does not extend to future board members who should have greater objectivity, so plaintiffs cannot attack the competency of the new board that didn’t make the contested decision. This case satisfies the first prong because there is reasonable doubt that the independent directors act independently.

- Kraakman: Though the court says it only applies the first prong, it looks like they are also applying the second prong. The court says that the independent directors are under the thumb of the Rales brothers. The decisions made by the Rales brothers on the old board infect the new board because the Rales brothers are still board members, so there is a transitive business judgment duty.

- Note: This case is a double derivative suit. Shareholder of a new company (Danaher) brings suit against another company (Easco) to bring a suit against the Rales brothers.

- Note 2: footnote 10 of the opinion says that the plaintiffs could use Del. Code Section 220 as an information-gathering tool to gain information to strengthen the pleadings.

- Demand requirement treated as substantive and not merely procedural

- Two points- You must pay attention to the language of the cases, and the practice of the cases

o If make demand of the board and board rejects it, you will have a difficult time bringing suit, because by bringing demand you are saying you don’t think the board is conflicted, so no one brings demands anymore

o Courts are now the ones evaluating these suitso But doesn’t the Court already have to find these facts later (that not

covered by business judgment rule, etc) why do it twice? Weeding out process dress rehearsal for actual trial Like having trial but without depositions, witnesses and


testimonies All the court has before it is the complaint assume all facts in

plaintiff’s favor and decide whether or not have a case Defendant’s usually wait until after this motion to dismiss decided

- Don’t always have to rush to the courts, under ALI principals of corporate governance opposite rule (look at MBCA b/c followed in many states)

o Always have to go make a demand, but making a demand doesn’t prevent you from then bringing a lawsuit

- Special Litigation Committees (Derivative Lawsuits)- Can you get the lawsuit dismissed after survived demand requirement – Maybe- Board appoints committee of directors who are “above reproach”

o Usually add new board members to be in committeeo Choose new outside law firmo Investigate the company and suit, determine whether or not should

continue the suit- Background: two schools of thought re: deference to a SC:

o Zapata Corp v. Maldonado (Del.) gives the court the authority to review the independence of the SC

o New York courts say that mere existence of an SC entitles corporation to BJ deference without judicial second-guessing

NY: business judgment rule once establish that committee is independent and acting in good faith, business judgment rule applies

- Zapata Corp v. Maldonado (Del. 1981) p. 375- 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, recommends that the court dismiss the suit. 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: Defendants have a right to form SLC committees, but shareholders do not need to comply with the SLC’s recommendation. Two step test: to apply when SLC recommends dismissal

o Court should inquire into the independence and good faith of the committee

o Court should apply its own business judgment to establish if the committee made a good faith decision.

How compelling is the corporate interest? Matters of law and public policy

- Note: the court applies its own business judgment at the SC stage, but it doesn’t apply the same standard at the demand stage.

- Inefficiency: A court may allow a non-beneficial suit to go forward at the demand stage, the SLC then decides to dismiss, and the court may agree. However, there


may be an over-deterring effect because of the costs incurred to get to the second stage of review (SLC review)

- Plaintiff has original burden of proof (under demand requirement) to show board is biased now moved into second phase, and the burden is on the board/special committee to show reliable

- Many states have adopted this two prong test (or similar)

- Joy v. North (2d Cir. 1982) p. 381 (Applying Zapata)- Winter: Winter goes through a cost/benefit analysis and exercises his business

judgment. The burden is on the moving party to demonstrate that the action is more likely than not to be against the interests of the corporation. Winter also notes that the court’s function here is not unlike a lawyer’s determination of what a case is worth for purposes of settlement. The Court has greater competence/independence is making this sort of review.

- Holding: judicial scrutiny of special litigation committee recommendations should be limited to a comparison of the direct costs imposed upon the corporation by the litigation with the potential benefits

- Dissent: The majority has gone beyond Zapata by saying that the court must apply its own business judgment rule. The court is not in a good position to make this judgment.

- COMPETING APPROACHES TO THE COURT’S EXERCISE OF BUSINESS JUDGMENT

- Zapata (Delaware approach): “The Court of Chancery should, when appropriate, give special consideration to matters of law and public policy in addition to the corporation’s best interest.”

- Joy v. North: “The court’s function is thus not unlike a lawyer’s determining what a case is ‘worth’ for purposes of settlement.”

- Difference between Joy and Zapata, when it comes to application, probably not that big

- Beam v. Martha Stewart (Del. Ch. 2003) p. 78 Supp.- Facts: Martha Stewart found an opportunity to sell large blocks of stock in MSO to a ready buyer.- Holding: Court comes to the intuitively right conclusion that it is not a corporate

opportunity – couldn’t be that every time a director sold stock in the company she was appropriating a corporate opportunity. More difficult was fitting the obvious answer into the 4-part test:

o Financial ability to exploit was present.o Not within the line of business. Company sells homemaking advice, not

stock.o No expectancy or interest. No showing that MSO was in need of

additional capital, and it had available a ready liquid market.o Was Stewart placed in a position inimical to the interests of MSO? No, no

evidence of bad faith. All together, balance of the factors indicates not a corporate opportunity.


- Π – demand excused b/c Martha Stewart had 94% of votes (de facto controlling shareholder)

- Directors in company, though no personal interest in her insider trading, they are not independent b/c either get their salary from Martha Stewart Living or good buddies of hers

- Court: personal friendship is not enough to taint director to render director too interested

o Court very formalistic: no financial interest, direct family interest

- In re Oracle Corp. Derivative Litigation (Del. 2003, p. 402)- Independence test: whether director is, for any substantial reason, incapable of

making decision with only the best interests of the corporation in mind- Two committee members tenured professors at Stanford (no fund-raising duties)- Defendants had substantial ties to Stanford through activities and donations- SLC bears burden of proving independence failed here b/c not just matter of

economic independence (must also consider human nature)

- Notes (p. 412)- Power to appoint SLC based on § 141(a) means all committee members must

be directors

- Carlton Investments v. TLC Beatrice International Holdings, Inc. (Del. Ch. 1997) p. 386

- Facts: Reginald Lewis (HLS ‘68) 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.

- Independent and good faith by SLC committee, proposed settlement falls within range of reasonable solutions to problem presented

- Holding: In applying Zapata, court accepts the parties’ settlement as one reasonable compromise to the suit.

- Note: Court doesn’t want to apply its own BJR, and it allows the parties to contract around court-imposed BJ. Settlement is better than court’s BJ

- SECURITIES TRADING- Hard to find fiduciary duty not to insider trade under state law

o Except in CA- Mostly done federally

- Exchange Act §16(b) and Rule 16


- Section 16(a): Statutory insiders (directors, officers, and 10% shareholders) must file public reports of any transactions in the corporation’s securities within two days of the trade (under Sarbanes Oxley Section 403).

- “Officer” status is defined as access to non-pubic information in the course of employment.

o Until recently, insiders could report: Up to ten days after end of a month in which they traded. Up to 45 days after the end of the fiscal year

o §403 of Sarbanes-Oxley: now, filing must happen within 2 days of trade, unless SEC grants extension. It’s rarely granted extensions.

- § 16(b): cannot benefit from short-swing transactions purchase and sell within 6 months while insider, corporation can sue you to recover this benefit, shareholder can sue you derivatively on behalf of corporation

o look six months into past, and six months in the future from reportable event. Count number of shares purchased, and sold. Match them together to determine the profit realized. Match any transaction that produces a profit

o Only case where shareholder can bring derivative suit under federal lawo SEC does not have the power to enforce Section 16(b). This is left to

shareholder groups. Strict liability rule, meant to deter Profit disgorgement: insiders must disgorge corp of any profits

made on shore-term turnovers in the issuer’s shares (purchases and sales w/in 6 month periods)

- § 16(a)(2)(C): Reportingo Must report when become statutory insider (Form 3), and whenever you

change your beneficial ownership of the corporation (Form 4, must be filed within 2 days of transaction)

o Form 5 annual report for everything not reported in form 4 during the year (filed 45 days before end of calendar year)

o Changed by Sorbannes-Oxley Act- Transactions occurring within 6 months after cease to be an officer or director,

subject to § 16 - You have plaintiff have prerogative to match anyway you want, as long as have

enough shares within period to match

- Option Backdating- A lot of the directors get paid in options stock based compensation

o For tax purposes cheaper for the companyo Don’t have to expense the option for financial statement purposes until

they are exercise (makes earnings per share look higher)- Value of option depends on the difference between the exercise price and the

current stock price- Executives want exercise price to be as low as possible- Strong disincentive for companies to issue options to executives below the current

stock price, because then the option has to be expensed right away


- Rule 16- 2002 Sorbannes Oxley Act – amended period for filing form 4 (disclosing change

in official ownership) to w/in 2 days of transaction (formerly 10 days after month ended)

o SEC rule implementing act- Another change: form 4 must now include option grants

o Options used to not be considered change in beneficial ownership – would only report them in form 5 (catchall annual disclosure, filed 45 days after calendar year)

o Does it matter? Not about short-swing transactions Before you could choose a date for your options when stock price

was low

- So if today stock price is 30, and 6 months ago it was 20, date options back to day 6 months ago so doesn’t have to go on balance sheet

- Wall Street Journal article one year ago, went and checked all the company stock prices with option grant, of 365 days somehow picked the day the stock price the lowest SEC started investigating

- Harron and Lie, 83 JFE 271 (2007)o Since new section went into place, significant drop in option back-dating

(or at least drop in suspicious option dates)o Not everyone complies and some companies still wait before reporting

option grant SEC hasn’t been enforcing strictly

- EXCHANGE ACT §10(B) AND RULE 10B-5- 1934 Act §10: granted broad power for SEC to promulgate rules regulating

securities on national exchanges.o Section 10b: “It shall be unlawful to use or employ, in connection with the

purchase or sale of any security registered, 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.

- Evolution of Private Right of Action Under §10o Rule 10b-5: most important rule in §10. Written on a napkin by Milton

Freeman, seemed like small step at the time. 10b-5: It shall be unlawful:

To employ any device, scheme, or artifice to defraud; To make any untrue statement of material fact or omit to

state a material fact necessary in order to make the statements made, in the light of the circumstances in which they were made, not misleading; or

To engage in any part, practice, or course of business which operates or would operate as fraud or deceit upon any


person in connection with any purchase or sale of any security.

Rule gives rise to implied private right of action. Kardon v. National Gypsum.

- Elements of a 10b-5 Claimo General Fraud Elements

False or misleading statement Of material fact that is

o Made with intent to deceive another Upon which that person

Reasonably relies. Additionally:o Elements specific to 10b-5

Person relying must be a buyer/seller of stock Harm must be to trader Misleading statement must be made in connection with

purchase/sale.

- Eric Lie on options pricingo Wait after good news is released, let stock price go up, then backdate

option

- Jesse Fried proposalo Executives can trades stocks till their hearts are content

BUT gives investors a few days heads up that they are trading

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 note 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.”

Three theories about why insider trading is illegal:- Equal Access Theory: All traders owe a duty to the market to disclose or refrain

from trading on non-public corporate information- Fiduciary Duty Theory: In order to establish that an insider violates 10b-5 by

breaching a duty to disclose or abstain to an uninformed trader you have to show that there was a pre-existing legal duty.

- Misappropriation theory: Insider information is the property of the corporation, and so it doesn’t matter who is defrauded but that information that belongs to the company is appropriated for personal use. More like corporate opportunity doctrine.

Series of cases developing this doctrine:- TGS (2d. Cir, 1968)- Chiarella (1980)- Dirks (1983)


- Chestman (1991)- O’Hagan (1997)

SEC v. Texas Gulf Sulphur (2nd Cir. 1968) p. 592- Facts: In Oct. 1963, Texas Gulf Sulphur geologists make a valuable discovery of

copper/zinc deposit. TGS president Stephens instructs them not to tell anyone, including TGS employees and directors. TGS issues stock options (“calls”) to its top executives, all of them who at least know something about the new discovery. In addition, information trickles through the company and everyone starts trading. In April, TGS issues a misleading press statement. SEC brings a 10(b) action against everybody.

- Holding: The court establishes a broad theory of liability/equal access. No one has the right to trade on information that is not available to all traders. This test identifies who is an insider, but the doctrinal problem is that this test doesn’t identify the nature of the fraud required for the 10(b)(5). This means that the court must establish an affirmative legal duty whose breach would constitute fraud.

- Anyone in possession of material information must either disclose it to the investing public, or if cannot (corporate confidentiality, etc.) must abstain from trading in or recommending the securities concerned while information remains undisclosed

- Dicta: there is a broad duty of fairness

Chiarella v. United States (1980) p. 608- Facts: Chiarella is a printer who is able to figure out the identity of a target

corporation from the 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 to disgorge his profits. Jury finds Chiarella guilty.

- Holding: Chiarella is of the hook. There was no special relationship between he and the company, and so he owed no duty to the sellers. Chiarella pieces his information together from information from the buyers, not the sellers. He has no contractual relationship to the shareholders of the target firm. However, the jury instructions assert the equal opportunity rule, not the acquiring corporation duty rule; therefore, there was no RETAC presented at trial, so no 10b-5 violation.

- Note: Chiarella gets off because the theory of harm to the target wasn’t presented to the jury, but he might have violated the misappropriation duty. The court does not discuss whether violation of the misappropriation duty would be sufficient to violate 10b-5.

- Court: he lacked duty to shareholders of the companies he’s trading in (got information from bidder companies), rejects equal access theory

- SEC had another theory not an insider, but had a duty to the acquiring company but court rejects that because that company (shareholders) not harmed

o Early strings of misappropriation theory


Dirks v. SEC: (1983) p. 612- Facts: Dirks is an investment advisor who wants to investigate allegations that

Equity Funding’s stock is overstated. He receives this information from Secrist, a former officer of Equity Funding, that Equity has overstated its assets. Though company heads deny that there is any wrongdoing, some company insiders tell him that there was fraud. Dirks, who did not own stock in the fund nor did his firm, openly discusses this information with his clients and investors. Price of stock begins falling. Dirks also urged the WSJ to publish an article on fraud allegations. SEC brings suit against Dirks, and censures him a 10b-5 violation.

- Issue: Did the insider’s tip constitute a breach of the insider’s fiduciary duty?- Holding: Conviction is overturned

o There was no relationship between Dirks and the firm (he was not its agent or fiduciary).

Tippers did not violate their duty – they wanted to expose fraud (whistleblowing) and did not personally benefit from the information

Don’t want an overarching rule banning analysts from ferreting out market inaccuracies.

Absent personal gain, no duty is breached this will be a case-by-case inquiry

reaffirms Chiarella – “no duty to disclose where person who traded on inside information was not the corporation’s agent, was not a fiduciary, or was not a person in whom sellers of securities placed trust”

Secrist owed a duty of trust and confidence if he had traded, but he did not benefit from the transaction. Therefore, Dirks is not liable.

Tippee liability is like aider/abettor/accessory liability- Dissent: Personal gain is not an element of the duty. This test will allow

insiders to use external agents to disseminate information to clients. Whenever there is asymmetry of information, the uninformed shareholder will be harmed. But only some of these harms can be legally pursued.

- Different Now- Regulation Fair Disclosure

o Changed policyo Now, any person who discloses information about the company, if

disclosure is planned it must be made simultaneously to the entire market (press release, etc.)

o If unintential/unplanned, must promptly release same information to entire market

o This is a change the behavior protected by the Court in Dirk’s is no longer legal

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.


- Reintroduces equal access theory in small, but important, realm of corp takeovers.Duty (RETAC) exists between family members. United States v. Chestman

- 10b5-2: defines “Duties of Trust and Confidence” (like RETAC). Includes: agreement to maintain confidence; history or practice of sharing confidences; receiving nonpublic info from spouse, sibling, parent, child.

Regulation FD (“Fair Disclosure”): new regime for selective disclosure of corp info (to brokers, analysts, journalists).

- If disclosure intentional: must make public disclosure simultaneously.- If disclosure unintentional: must make public disclosure promptly.

1983: bunch of neighbors at a BBQ told by drunk Michael Milken that advancing a tender for Revlon

- § 14e-3: equal access doctrine for tender offers- Suppose merger and so § 14e-3 doesn’t apply- Are these neighbors insiders? Temporary insiders? - What about with RegFD?

o Doesn’t cover Michael Milken because isn’t a company spokesperson (doesn’t work for Revlon) and neighbors not the specific people covered by FD (stock analysts, etc.)

United States v. Chestman (2d cir. 1991) p. 619- Facts: Chestman is the broker for Keith Loeb, who is the nephew-in-law of

Waldbaum, who agrees to sell his company to Great Atlantic and Pacific Tea Company (A&P). Loeb receives information from his wife who gets it through her mother who hears it from her brother Ira, that Waldbaum stock is going up. Loeb calls Chestman and asks him for his advice on what to do with the stock. Chestman purchases Waldbaum stock for himself, Loeb, and his other clients. Chestman argues that he purchased this stock based on his own info. The SEC brings suit and the lower court convicts.

- Issue: Can Chestman be held liable if it is not proven that Loeb breached a duty not to misappropriate data?

- Holding: 14e3 conviction is maintained, 10b-5 is overturned. The SEC has the power to promulgate 14e3 to move beyond common law fraud, and 14e3 is within SEC’s rule promulgating power to regulate tender offers, so the 14e3 conviction is reinstated. There is no proof that Loeb owed a duty to his uncle-in-law, so there is no misappropriation. Chestman is not the tippee of a misappropriator.

- Note: Keith has no direct contact with Waldbaum, but the court doesn’t find that he has acquired the duty, though tenuous, through the numerous family connections. Misappropriation fails because Loeb has no fiduciary duty to his wife or the Waldbaum family.

- Today, this case would have been decided differently: SEC 10b5-2: Information obtained from a spouse gives rise to fiduciary duty of confidentiality.

- SEC didn’t like the outcome


o 10b5-2(b)(3): lists circumstances under which relationship of trust and confidence

o Rebuttable presumption of relationship of trust and confidence between family members

o So under this Loeb probably would have been found to have fiduciary duty and been in breach

United States v. O’Hagan (1997) p. 624- Facts: O’Hagan is a partner in the law firm of Dorsey & Whitney that is

representing Grand Met in its tender offer for Pillsbury. O’Hagan learns of this information from his work, and then he buys 2500 call options in Pillsbury stock (or 250,000 shares). O’Hagan controls more stock than anyone else in Pillsbury, and sells his stock at a profit of $4.3 million. However, the Eighth Circuit reversed the lower court’s conviction.

- Note: O’Hagan was on the PLI circuit lecturing on insider trading when he committed this crime.

- Issue: Is the misappropriation theory valid under 10b-5?- Holding: Conviction reinstated – the misappropriation theory is a valid. O’Hagan

was an insider of Grand Met, but his purchase of Pillsbury was still a misappropriation of info obtained from his law firm.

- Breach of duty owed to source law firm and client defrauded- Fraud consummated at sale or purchase so related to sale or purchase of

securities- Not every use of information is misappropriation, must be some element of

deception o Need relationship of trust and confidence with source of information

Carpenter v. United States (early SC case)- Facts: WSJ columnist regularly disclosed contents of the column to his friends

before publication. This column was so influential that it always affected share prices. Columnists’ friends made a lot of money.

- Court splits 4-4 on whether 10b-5 applies because it has not yet adopted the misappropriation theory, but upheld the mail and wirefraud charge.

o Today, to convict under the misappropriation theory, lawyer would have to prove that the journal and readers had a proprietary interest in the column’s information, and the columnist violated his duty to the readers.

Empirical Studies after Reg FD- Results have been helpful – there is now more information in market rather than

less

- Anti-fraud rules (prohibition against misleading investors) arise in many different situations

o Proxy solicitation- § 14 SEA, Rule 14(a)(9) – Virginia Bankshares v. Sandberg

(cannot mislead shareholders when soliciting proxies)


o Rule 10b-5 – illegal to defraud investors- Two applications:

Company must be honest when communicating with investors and the market (other than in the context of proxy solicitation)

Insider tradingo Who cannot trade on inside information? o Fraudulently misleading omission (this is how the

law tends to catch insiders trading on nonpublic information, should abstain from trading until information public)

o Misappropriation theory

Components of insider trading violations- Fraudulently misleading information- Materiality- Scienter (mental state)- Standing- Reliance/causation- Damages

Applicable to both forms of 10b-5 violations

Materiality- Not illegal to trade on inside information, can trade on soft information (not

material enough), just not bombshell information (material enough)- Insiders systematically do better than the market when they trade (16b – 6 month

limitation)- Information that would be viewed by the reasonable investor as having

significantly altered the ‘total mix’ of information available

Material: what would a reasonable shareholder consider- Basic Inc v. Levinson (1988) p. 62

o Facts: Basic and Combustion are in merger talks for two years, but Basic makes press statements denying this. Plaintiffs sell stock based on the press releases, and then sue when the merger is announced. Plaintiffs appeal the district court’s ruling of summary judgment saying that the press statements were a material breach. Sixth circuit reverses, finding that otherwise immaterial merger discussions becomes material when Basic denied their existence.

o Holding: Reasonable investor test: information regarding a merger discussion is significant to the reasonable trader’s decision to sell. Materiality must be determined on a case-by-case basis, and only a closing of a transaction will be sufficient to render merger discussions material. Probability x magnitude test

o Corporation could still remain silent (say “no comment”)


o Note: other courts had decided otherwise that merger discussions were not material. It is likely that the court wanted to protect the merger negotiations and allow denials of talks as proper business judgment. Lying about talks is a way to protect a deal, and shareholder may lose out on valuable deals. This is possible, but the board should encourage competition. The harm may actually be felt by the takeover artist who wants to protect his deal.

o Endorses a net present value calculation

Scienter- Not enough to defraud investors, must having something like intent to defraud

(negligence is not enough)- Half the circuits infer scienter from behavior

o If you have acted in way so reckless that can infer acted with scienter that is enough (especially at the pleading stage)

- 1995: Public Securities Litigation Reform Acto Must plead specific facts to give strong inference of scientero Not enough to just assert acted with scienter, must allege specific facts

- Two studieso Johnson, Nelson & Preacher, Do the Merits Matter More?

- Accounting variables and abnormal insider sales are predictors of these lawsuits

- Aggressive use of accounting on balance sheet predictor of incidence of lawsuit and size of outcome

- Insider trades show no affect on outcome, just incidence of litigation

o Steve Choi- Before PSLRA you could get real settlement value out of cases

with no clear indicia of fraud- Now, how the size of the settlement indicia of how serious the case

was - Many serious cases that were possible beforehand are no longer

possible- Yes getting rid of some frivolous lawsuits, but also blocking

meritorious claims which lack hard evidence, so mixed bago Kamar

- Problematic to measure value of case by size of settlement because product of the legal rules already in place

- Before PSLRA could get a serious settlement by scaring defendant’s and under new rules can’t get a settlement

- Seems that size of settlement not an independent, objective measure of the strength of the lawsuit, it’s the strength of the lawsuit under the existing legal rules

- So not surprising that under new rules have lower settlements when don’t have hard evidence of aggressive accounting, etc.


Rule 10b5-1- Escape hatch for insiders who want to trade but don’t want to be charged with

10b-5 violations- If have an automatic trading system, or hands off approach, etc. cannot be sued

for insider trading- Safe harbor- A lot of executives use 10b5-1 have individuals who trade for them, don’t

communicate with them directly about specific stocks- Article:

o Individuals who have this kind of trading programs make more money than those who don’t

- So those who use safe harbor and have broker do all their trades for them making more money than other insiders and the market

o Nothing in the rules says anything about when you end your trading program

o People who make abnormal returns mysteriously end trading program just before something big happens SEC threatens that will lose safe harbor if do that, but people still do

o Walking fine line in trading on news that probably would be material under 10b-5

Standing- must be a purchase or seller of securities- However, can bring a suit under 14e3 even if you don’t buy or sell because this is

a broad rule for tender offers

Blue Chips- Π chose not to purchase stock because of material false statement- In order to have standing must be a trader during the relevant period- Not to say that couldn’t have lost money, just the law doesn’t protect you unless

you were a trader

Reliance/Causation- In common law fraud must show reliance- In 10b-5 have reverse presumption- Basic : rebuttable presumption that everyone in class relied on the false statements

o Fraud-on-the-market: Enough that those who heard misleading information traded on that information, because when they traded on it the market was affected, others who did not hear the information relied indirectly on it because of this change in the market price

o Efficient capital market hypothesis: stock prices at any given point in time reflect publicly available information about the company, but not private (insider) information (semi-strong version of hypothesis)

- Some argue that stock prices already reflect value of the insider information (harder case to make)

Dura Pharmaceuticals v. Broudo (US 2005, p. 699)


- Issued upbeat statements about asthma inhaler being approved by FDA, then stock price dropped after disappointing earning results

- Then later FDA didn’t approve inhaler, stock price drops 5% on one day, then a few days later it recovers

- Clear lie about FDA approval (or statement at least reckless)- Court: News wasn’t all about inhaler, market barely reacted- Commentators: creates incentive to release good and bad news together because

then creates a wash

Elkind v. Liggett & Myers (2d. Cir. 1980) p. 640- Facts: Liggett & Myers tells certain analysts about a negative earnings

announcement to be disclosed the next day. Analysts’ clients sell shares at $55, then the share drops to $46 at the announcement.

- What is the appropriate measure of damages?o Traditional out-of-pocket measure – difference between market price and

sale price Equation: Price paid minus true value when bought Here plaintiff

can recover $48-$40 * shareso Causation-in-fact measure or loss from the erosion of the market price –

recover the loss in value that was caused by tippee’s trading. – perhaps too late in the game/doesn’t consider changes in value before when he should have disclosed

Equation: Price decline by D’s wrongful trading. $50-$48 * shares

- Disgorgement measure: recover post-purchase decline in market price, but limit it to the amount earned by the tippee.

o Equation: Post-purchase decline due to the disclosure, capped at gain by tippee = disgorgement measure capped at gain to the tippee.

- Holding: Third option provides optimal deterrence.o Note: it does not make sense to pursue tippee’s gains because these are

generally minimal; suits are generally brought for out-of-pocket damages.

Academic Debate- Today there is a consensus that insider trading should be prohibited- Most insider trading by executives is to sell before bad news

o Cheaper, don’t need to get funds to invest, just sell before bad news materializes (perverse incentives)

- Allows executives to bribe block holders - Better information to market

Mergers & Acquisitions- Good Motivation for Deals- Economies of scale- Economies of scope- Vertical integration


o Fitting your product to their line and then getting them involved in opportunistic behavior

- Tax (NoL distribution)o Kamar doesn’t think this actually works

- Agency Costs- Diversification

o Smoothing earnings by diversifying business projectso Kamar argument that shareholders would want you to just do one thing

well Managers would want to make their job more stable

- Undiversifying companieso If you invest in multiple start-up technologies, want to follow the one that

does well- Replacing bad management team

o Through hostile dealso Friendly deals with a golden parachute

Bad Motivation for Deals- Squeeze-Out merger- Market power

o Reduce competitiono Possibly monopolistic behavior

- Mistake mergers- Managers who just want more power

o Kamar thinks there are a lot of these deals, especially the bad deals “Empire Building”

History of deals- 1970s

o Lots of diversifying mergers Like GE

- 1980so Lots of deals undoing the diversification of the 1970s

Turns out these conglomerates weren’t doing that wello Deregulation offered a lot of opportunitieso Development of leveraged buyoutso Acceptability of hostile takeovers

- 1990so Lots of stock deals

Buying another public company with your stock This worked because stock prices were very high

Internet boom Lots of golden parachutes

(Traditionally three times annual salary plus bonus)o (If its more than that feds will charge excise tax

Accelerates stock options


o Because mergers are usually at a premium these options are very valuable

Mergers: legally collapse one corporation into another, and the remaining entity is the “surviving corporation.”

- Rights of the parties and effect of the merger:o Target Voting Rights: The voting common stock of the target always has

voting rights, i.e. their approval is required in all cases.o Surviving Shareholder Voting Rights: The common stock of the

surviving corporation is generally required to vote on mergers also. The exception is when the following three conditions are met:

The surviving corporation’s charter is not modified. The security held by the surviving corporation’s shareholders will

not be exchanged or modified. The surviving corporation’s common stock will not be increased

by more than 20%.- Statutory Merger: DGCL §251(f); RMBCA §12.03. (Long-form merger)

o A(cquiror) & T(arget) boards negotiate the merger o Proxy materials are distributed to shareholders as needed o T shareholders always vote (§251(c)); A shareholder vote if outstanding

stock of A increases by > 20% (§251(f)).o If majority of shares outstanding approves, T assets merge into A, T

shareholders get back A stock. Certificate of merger is filed with the secretary of state.

Dissenters who had a right to vote have appraisal rights. Preferred stock holders don’t get a special class vote

- Rules governing mergers:o DGCL §212(a): All classes of common stock vote, unless a stock is

designated as nonvoting.o DGCL §203: The ban on merging with an interested shareholder for 3

years after the shareholder became interested unless conditions are met. Likely passed to ensure that the interested shareholder is not forcing the company into a bad merger.

Structuring the M&A Transaction- The weight of different variables will determine which merger form the

companies follow.- Merger contract protections

o “Lock-Up” Provisions: Designed to protect friendly deals from hostile interlopers.

o “Fiduciary Out” Provisions (See Chapter 13) Standstill Agreements: Bars hostile activity prior to closing on

the merger agreement. Confidentiality Provisions: parties must remain mum.


Timing: In a dynamic market, the conditions that made an acquisition or merger desirable may change. Different agreement structures can affect the speed of the transaction.

- All-cash, multi-step acquisition: Typically the fastest way to lock up a target and assure its complete acquisition. May be consummated 20 business days after commencement under the Williams Act, whereas a merger will require a shareholder vote at least by target shareholders, which will in turn require SEC clearance of proxy materials and solicitation of proxies.

o If stock is part of the deal consideration, then stock must be registered with the SEC, which takes time.

- Regulatory Approvals, Consents, and Title Transferso Reverse triangular mergers are the cheapest method of transfer because

they leave both pre-existing corporations intact, i.e. the target and the subsidiary.

o Avoiding regulatory approval speeds up process- Planning Around Voting and Appraisal Rights – don’t want shareholders

involved; if they are involved, want to be able to give them an ex post remedy (appraisal) so that deal still goes through

- Due Diligence, Representations and Warranties, Covenants, and Indemnification

o Much easier to acquire this information for public companies.o When deal is friendly, ask the target for warrantieso When the deal is hostile, target has no duty to warrant

- Deal Protection and Termination Fees: terms in merger agreements designed to protect friendly deals from interference by hostile bidders.

- Accounting Treatment: survivor records the FMV of the target’s assets. The purchase price – asset value = goodwill. Goodwill is an intangible asset that goes on the asset side of the balance sheet and can depreciate.

DGCL §251(b): Mergers require shareholder vote by shareholders of target and acquirer, except the acquirer’s shareholders do not vote when the acquirer is much larger than target.

- Then file with Secretary of State

DGCL §271: Sales of substantially all assets require shareholder vote, but purchases of assets do not require vote.

General Concept: The transactions that require shareholder vote are those which cause the most dramatic alteration of a board’s relationship to its shareholders. Change in management accountability, not the size of transaction, is the underlying concern.

Statutory merger- Used to need a unanimous shareholder vote, but today just need a majority (or

some variation on that, depending on statute)


o DE requires 50% of votes outstanding means need a lot of people have to cast vote, because will have a quorum requirement (usually 50%) and need to get 50% of all outstanding votes

- Once approved, all assets and all liabilities transfer from target to acquiring company (agreement will specify which is which)

Triangular (Subsidiary) MergerTriangular Mergers: protects the acquirer from acquiring the liabilities of the target. The Mechanics of the Triangular Merger

- The acquirer (A) forms a wholly owned subsidiary (sub-A).o (A) transfers the merger consideration to (sub-A) in exchange

for all of (sub-A)’s stock.- Target and (sub-A) merge. Target shareholders get the merger consideration from

(sub-A), and all Target shares are cancelled.- A now owns all the stock of (sub-A), and (sub-A) owns all of Target’s assets and

liabilities. - Forward Triangular Merger: (sub-A) survives the merger as the new company- Reverse triangular merger: Target survives the merger as the new company.- DGCL § 251(b)

o Could pay with stock of acquiring company, cash, debt securities (essentially borrowing from target and saying pay you later),

o Can also pay with securities/shares of another company - Can’t pay with stock of subsidiary, because then trading public

stock (which is liquid) with private stock (of the subsidiary, which is not liquid) shareholders would never go for that

- This provision allows subsidiary and target to merge, with payment in form of shares in the parent company

- Insulates the parent company from the liabilities of the target courts so far have declined to pierce the corporate veil (when company’s careful)

- Vote o Shareholders of the constituent companies have to vote target and

subsidiaryo Parent is the sole shareholder of the subsidiary, so board of directors and

not shareholders of parent company vote (because parent company not merging with anyone)

- Possible agency problem – maybe thought shareholders wouldn’t approve deal

- Expensive to hold vote, so avoiding vote of parent company shareholders holds expenses down

- If target company is privately held, and only parent company board votes, can close deal before even announcing it (private companies sometimes have only one or a handful of shareholders)

o Time – deal based on current market conditionso If deal is pending for 5 months, employees will be in state of flux because

often job loss after mergers (restructuring)


- Especially a bad thing if deal doesn’t go well and doesn’t close, and then have lost employees

- Used to think that most mergers triangular, but not actually trueo Lots of banking deals lately, and those have been primarily statutory

mergerso Why?

- Tax reasons (for banks)- Regulation Y- Banking subsidiaries don’t have limited liability

- Forward triangular merger- Reverse triangular merger

o If deal is taxable, disaster to do forward triangular merger

Reasons for a Speedy Merger- Possible change in market conditions

o People driving up the priceo Especially if word leaks

So want to go fast so word doesn’t leak- Effects on employees

o Lots of employees will leave now

Double Dummy merger aka Holding Company Merger aka Spaceship- Acquiring (A) company sets up Holding company which has two subsidiaries (S1

and S2)- A mergers with S1, T mergers with S2- Now H owns both A and T- Two Reasons

o Tax In order to qualify for tax free treatment you have to satisfy certain

requirements One is continuity of interests, more reorganization than sale

If shareholders are still shareholders of something Have to show big stock component in the transaction Allows you to use different section (§351 instead of §368

for triangles, §351 is more liberal with how big the stock component has to be)

o Allows you to reincorporate in a completely new placeo Must be big stock component in consideration

40% or more (IRS rule) So if have deal with at least 40% stock, considered tax free

restructure

Stock Purchase- When you buy all the stock- What company can you not buy in a stock purchase?


o Contract between the seller and the buyer – so with publicly-traded companies cannot get 100% of the stock because would need to make a contract with every single shareholder

- Hybrid between merger and stock buy allows stock purchase of publicly traded company

o Public tender offer – literally advertise publicly that want to buy stock for a certain price, and shareholders individually choose whether or not to sell

o So once get large block go to mergero But why the two steps?o Hostile takeover can only be done as a tender offer followed by a merger

- Must have an agreement between the two companies, then board approval, then shareholder vote

o With a majority of the stock can replace the board (this is why you do the tender offer) and then follow with merger (because, surprise, the new board loves the deal and is willing to propose it)

o Tender offer under federal law must be open for 20 days – if price is high enough will get enough shares that will end up with more than majority of stock

- Or could make tender offer for target company stock, get at least 90%, then do short-form merger (in jurisdictions that allow, if have 90% of stock can do automatic buyout of remaining shareholders)

Asset purchase- Sale of substantially all assets is fundamental transaction for selling company and

requires shareholder approval- Can specify which liabilities you want to assume- Successor liability issues though

- Federal Law with environmental hazard liabilities also- Downside is tons of very specific paperwork

o Have to specify everything you are buying- Can be a public target

o But if you get substantially all have to have a shareholder vote

Stock Exchange Rules- If you issue more than 20% of your stock, the major exchanges say you have to

win a vote of all the votes cast (as opposed to statutorily required all the votes outstanding)

Interesting thing about some deals that are “friendly” are really done in the shadow of a hostile deal

- lots of arm-twisting in the dark

Why you pay stock instead of cash in a certain deal (why your stock is good)- You believe your stock is fully-valued- Public target company is offering liquidity to private company

o When public companies announce big stock deal their stock price drops


Can drop because a lousy deal Could be negative signal to market

- You know there’s not agency costs for a private company and that they did their due diligence

- Stock price of acquirer appreciates when it announces stock deal with private target (as opposed to public target)

o Positive signal to market Not a company with collective action problem or agency costs,

agreed to take stock of the public buyer, surely they must have done due diligence and believe stock is worth its price or worth more than cash

- Divestitures usually lead to a really good price- If you issue less than 20% of stock you can speed up things- HUGE DIFFERENCE BETWEEN CASH AND STOCK

o TAXo Kamar says the vast majority of deals with a stock component are tax-free

- Issue with lower earnings per share when you use stock in these dealso Market wants deals that will be accreditive at least a year after closingo Cash doesn’t increase earnings per share!o So it’s just an accounting concept, but it matters in the real world

- Flow-backo Cross-border dealso Investors don’t like stock in foreign markets

Many have restrictions of how much stock they will have in foreign markets so they will dump their stock right away

- Price Pressureo Hedgefunds and arbiters

Shorting funds of acquirer, longing funds of the target

Hollinger v. Hollinger (Del. Ch. 2004, p. 466)- Sale of newspaper groups 56% of value NOT constitutionally all of company’s

assets- Substantially all = essentially everything

Taxonomy- Can categorize deals in different ways

o Hostile v. friendly deals- Not always obvious, because many friendly deals are done under

threat of hostile takeover, sometimes only becomes friendly when goes public

o Private v. public targeto Acquisitions v. divestitureso Stock purchase, cash purchase, purchase with securities/bondso Tax free v taxable

- Requires continuity of interest to be tax free


- Non-stock component of tax free deals is still taxable, but if have taxable transaction the entire thing is taxable (including stock)

How do you deal with information asymmetry inherent to deals?- Representations and Warranties- Due Diligence

“Sandbagging”- Knew something was wrong, decide to close the deal and go ahead and sue

“Collar”- Set range for sock price of acquirer - Travoltas- Egyptians

o These look like the dances

Some investors and much more tax sensitive than others- For example pension funds get tax preferential treatment- Matters for stock basis- And long-term v short-term capital gains

o Did they buy the stock in the last year

Structure- Will generally have several components typical to each transaction, and then just

the details change- P. 476 Merger Agreement

o Three parties – parent, subsidiary (acquisition vehicle) and target- Parent is buying the target, target merging into subsidiary- Triangular merger

o Offer- With initial cash tender offers speed- Don’t have to file proxy statement, all you have to do is file a

tender offer- If doing it as a cash deal, don’t have to register the stock (don’t

have to file with SEC)- Tender offer must be open for 20 days by law (added in Williams

Act)- How do you save time if you have to do the backend merger

anyway? If get more than 90% do short-form merger don’t need a

shareholder meeting, can do it all in one afternoon Afraid of interlopers don’t want a second person to

come and snatch target from your hands Once have your tender offer and get a majority of stock, no

one can take it from you Speed – typically see tender offers for cash


o Article III – Representations and Warranties- Can sue for breach when it’s a privately held company, but not

when it’s a publicly traded company- If find some breach after signing and before closing, you can

rescind the deal contractually or try and renegotiate- If it is a closely owned company, who can sue the shareholder

afterwards- From perspective of seller, its an insurance policy b/c if disclose it

can’t be used against you later- Acquiror also usually makes a few reps and warranties – typically

dealing with financing if cash, care a lot and have more extensive reps when stock deal

o Article IV – Covenants- What parties must do between signing and closing- Ex:

Best effort clause: make best effort to ensure deal comes to fruition

Target not supposed to do anything out of the ordinary, anything that would deplete its cash, etc.

o Article V – Conditions to closing- Most sensitive part of agreement- Three parts: conditions pertaining to both parties, just to acquiror,

and just to targeto Article VI – Termination

- When either party can terminate the dealo Article VII – Misc

- Where all the good stuff is hidden

Other Countries Rules:How else could you do it? What other legal systems could you create?

- Well you could have a rule that the offer has to fit a certain shape, and if it does the board can’t interfere:

o So no two tier offers- Idea of one tier of offer where buyers have to buy the whole thing

o Will tender freely (no pressure) against a normal tender 50% offero So if you like you do ito If you don’t like and other people don’t like it, it doesn’t happeno If you don’t like it and other people like it, it will happen,

And then all the stock will be acquired anywayo So you will FOLLOW YOUR PREFERENCEo Problem of not offers costing more

But what you can do is three things Partners Just buy smaller companies Borrow from Investment Banks for more money


o Idea of adding option that minority shareholders could retain their stock on this tender offer system

Rule in London Offerror is compelled to offer the same terms on the back-

end as on the front-endo Once you make an offer for 30% you have to offer

the resto Nice thing about this solution is that now you don’t need the courts

- Another Solution: Shareholders can tender, but deal only happens if shareholders tender while saying we like this offer

o This is also the law in England!o But Scandinavia and Germany derailed it from all of Europe

Worry about foreigners taking companies Worry about their jobs Legislation was modified and became optional

One optional component was no anti-takeover tactic could have been made without shareholder vote

o Some like England kept it but others don’t Second optional component: breakthrough rule. If a

company has defenses, the defenses break apart if the tender offer hits a certain point

o Seems like only Italy will opt in to this rule Traditional European defenses

Dual class capitalizationo Superior stock voting class

Vandenburg’s in Sweden Shareholders know what they’re get when

they’re buying the stock in this case Tender voting

o In order for shares to have voting power have to hold it for at least a year

Don’t have two-tier tender hostile offers anymore because then it gives the Board an excuse to fight you

- you do see tender offers in friendly deals

Sometimes people are sleepy, there’s a gem there that no one knows until someone discovers it.

- That’s why other bidders bid after someone starts bidding- But then original person can sell and that first person makes money- Greenmailing

o Buying the stock and pressuring board, then the board buys back the stock at a premium for that person

Information- Reps and warranties- Due diligence


o Want to deal with issues early on, not always just looking for a deal breaker or bad guy

o So if find contract with third party that says can’t divest assets without permission, do a merger instead

- So typically you will seeo Termination rights

- Acquiror Reps and warranties must be true as a condition to closing

– usually with materiality qualifiers Correct in all material respects taken as a whole Break down – not only are reps and warranties accurate as

of day of sign, but must be correct as of day of closing – if not, can walk

o After closing – cause of action- Parties will specify what can be sued for- Often set minimum – can’t sue unless.... establishes threshold- Basket – cannot sue for first 10m dollars, but can sue for loss

above that (like a deductible)- Time limits – can only sue for a year after closing- Limit for indemnification (ex: up to 10% acquisition price)- Put money in escrow to ensure recovery - Can you sue them for misrepresentations that you knew were in

there? Sandbagging (knew something was wrong, chose to close the deal anyway and then sue)

Benefit of the bargain – don’t want to argue forever after closing about whether knew about misrepresentation

Generally find one of three – anti-sandbagging clause, allow sandbagging, contract is silent

Things that can go wrong in the future- If target getting stock of acquiror, worried stock price will drop

o Pricing- Flowing exchange rate pricing – formula for price for amount

of money that is going to be paid that is not fixed and depends on value of stock getting

- If cash deal, fixed amount- When stock deal (options)

Fixed exchange ratioo Value of consideration is going to rise or drop with

value of stock of acquiror Fixed value – get as many shares as it takes to keep dollar

value the same Collars – within range either a fixed value, and outside the

range fixed exchange ratio (Travolta); or vice versa (Egyptian) (rare)

o Doesn’t have to be symmetrical


o Walk away right – if stock drops below certain point can walko Can also have mixed cash and stock deal

- Value of cash component will stay the same, but stock component might drop

- Usually have an election clause which lets shareholders choose what they want

If not enough stock for everyone who wanted stock, can pro rate it so everyone also gets some cash

Some investors are more tax sensitive than others – ex: pension funds get more tax benefits so less sensitive to tax incentives

o Investors might have different basis, thereofore differing tax incentives even for people who have same risk

o If stock price change, can equalize the components and everyone who gets cash will get a little less cash, and people who get stock (whose value has gone down) will get a little more stock

Drop whole number of shares being replaced by stock, so change from 50-50 stock and cash to 40-60 or something like that

Why do companies worry about issuing stock?o When stock dilutes it drops earning per share

To qualify for tax free transaction, must have at least 40% (in certain types of transactions) stock exchanged

o What happens if drops and now drop below 40% stock – this will give target a walk away

o So beef up stock – to prevent dilution, often in separate transaction do a repurchase of own stock

o What happens if after closing the target doesn’t perform well?- When value of company depends on employees (service industry)

rather than something fixed (real estate transaction) especially when employees are former shareholders, might not have as much incentive

Ex: accounting firm, car dealershipo Incentive problem

- Sometimes can’t ascertain value of company until you acquire it, especially private company (because no audited financials, etc.)

- So can include an earn-out clause Pay half price now, half over the next three years after

closing depending on how well company doeso Fixes incentive problemso But now if seller, worried about negative effects by

acquiror, etc.o As a practical matter can be fraught with difficulties

- Fiduciary out


Target might want outo Shareholders don’t want deal anymoreo Higher bidder comes along

Promise not to talk to 3rd parties, but if someone surfaces with a superior offer, we’ll have to talk to them if its our fiduciary duty

Can start a bidding waro Material Adverse Change (MAC) clause

- If something really horrible happened to target between signing and closing, buyer can walk away

- Can put in anything you want (negotiated) and also put in what exceptions you want (carve-outs)

- Tyson Foods : Court: long term point of view is appropriate MAC contemplates development that is consequential to a company’s earning power over a commercially reasonable period (usually years, not months)

o Fairness opinion bring down (clause that says condition to closing says this opinion is reaffirmed by opinion of bank as of day of closing)

- Bank must give opinion that fair deal for target’s shareholders- If bank withdraws opinion walk away right for target

o Financing condition- Walk away right for acquiror- If target want to check lending documents to make sure MAC

clause not worse for you than negotiated MAC clause in merger agreement

- If lose financing, acquiror can walk away

Tender Offer- Tender deal doesn’t go through board, it goes straight to the shareholders, then

they have 20 days (minimum) to sell their shares- Sale generally contingent on offeror getting certain number of shares if don’t

reach minimum number, shareholders get their shares back- If friendly deal do it the same way, but allows you to say, this offer has the

blessing of your board

Hostile Deals- Why would target shareholders ever sell stock to you in tender offer?

o Free rider problem- If I want to buy a company, worth $10 per share today and has

$100 shares, I think I can do better because management sucks- If I think I can make the company worth $1500, so offer to buy

stock at more than current market price ($11) and then I keep difference as profit

- But shareholder might think that if I think I’m so smart and am going to raise the price of the company, should demand higher or stick around


- Free rider because depending on new person to create value for you, and depending on other shareholders to sell

o In reality see people tender stock in tender offers quite happily- If company is worth $1500 per share, I might not see $15 per share- Difference between the company value and the share value- Controlling shareholder might appropriate to himself the private

benefits of control, decreasing value of company shareso If two tier tender offer people more likely to rush and sell to make sure get

front-end instead of back-end offero Prisoner’s dilemma

How can we deal with the Prisoner’s Dilemma?- Maybe say that if bidder makes two-tier offer, board can do whatever it wants to

counter if believes it is inadequate- What if we had a rule saying the buyer could only complete the tender offer if he

receives 100%, if the shareholders know this they will tender freely, because if they don’t like the deal it won’t happen, and if like deal and others don’t the deal won’t happen but won’t hurt me because get stock back

- English rule – nice thing is that you don’t need the courts- Trying to create a rule where shareholders will only tender their stock if they like

the offer, without regard to what other shareholders do- Shareholders can tender, but the deal will go through only if shareholders tender

while saying, we like this offer so when tender can tender in protest (check a box on the paper sent in)

o So then the deal goes through only if a majority of the shareholders tender while supporting the deal replicating a vote on the deal

o This is also the law in England – they have both protections- “Tenure” voting don’t have voting power until held stock for one year

Unocal Corp v. Mesa Petroleum Co. (Del 1985)- Mesa buys 13% of stock

o Cheaper to buy when no one knows someone is going for control But 25% of stock triggers a 13(b) filing within 10 days

So everyone knows o Called a “toehold”

- Makes a tender offer for the next 37% of stock for $54 a shareo Says there will be a backend of $54 a share buy in junk bonds

- Has a board of 8 outsiders and 6 insiderso Debate for nine hours and have Goldman Sachs advise them

- Board is going to make going to make tender offero After Pickens makes front-end tender offer, we’re going to take care of the

remaining shareholders than a back-end tender offer Thing is Picken’s tender is at $54, the back-end by the board is at

$72, so everyone is going to wait for $72 and will depress the price But worried about Court implications, etc.


Week later have another meeting, Goldman advises instead of making it conditional on Pickens completing tender offer, make it unconditional

- Facts: Unocal stock is trading at $33/share. Mesa buys 13% of stock, then makes a tender offer for another 37% at $54/share. 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 reviews offer, and Goldman Sachs reports that the minimum cash value in a liquidation should be $60.share. Board decides to undergo defensive recapitalization by making a self-tender for 30% of the shares at $72/share in debt securities, and tender for remaining 20% also at $72/share in debt securities if Mesa gains 50%. Mesa is excluded from the offer. Mesa brings suit to enjoin the defensive measures, which would then allow the hostile tender offer to proceed.

- Issue: is this an interested, improper defensive measure or a proper exercise of business judgment.

- Holding: Applying “enhanced business judgment review,” this was a proper defensive measure because the board acted to protect shareholders who would be coerced to sell on the front end. The back-end sellers will get junk bonds (main threat), and so the shareholders will always choose to sell to Pickens. If the board of directors is disinterested, acts in good faith, with due care, makes a response that is reasonable and proportional to the threat, then its decision will be insulted under BJR.

- Rule of defensive measures:- Does corporation face a reasonable threat?

o Structural coercion: the risk that disparate treatment of non-tendering shareholders might distort shareholders’ tender decisions

o Opportunity loss: a hostile offer might deprive target shareholders of the opportunity to select a superior alternative offered by management

o Substantive coercion: the risk that shareholders will mistakenly accept an under-priced offer because they disbelieve management’s representations of intrinsic value

- Was the corporation’s response proportional to that threat?o Response may not be preclusive.

- Changes post-Unocal (concern that this was overly defensive)o SEC passes rules 13(e)(4) and 14(e)(10)

No more selective tender offer (greenmail)

After this case SEC said companies cannot make self-tender offers that are discriminatory- 14(E)(3)- 14(D)(10)

o Even third parties can’t make discriminatory tender offers Headache for friendly deals because trying to get management to

stay with employment deals and then you start violating 14(D)(10) with your employment agreements

Private Law Innovation: The Poison Pill


- Poison pill: also known as “shareholder rights plan.” Very effective defensive measures against hostile takeover attempts.

o Can be implemented at any time.O Validated by DE Supreme Court in Moran v. Household International.

Adoption of the pill (putting it into bylaws) subject to BJR; decision to use it (turning it on) subject to Unocal test:

look at the hostile party’s offer and decide if defense is proportional.

If not proportional, could force corp to redeem the poison pill. Grand Metropolitan v. Pillsbury. However, court almost never does.

- Types of pillso Flip-over Pill: Gives existing shareholders of the target the right to buy

discounted stock of the acquirer. Target’s board must put terms into the merger to force acquirer to recognize these rights.

o Flip-in Pill: Corporation can dilute the potential ownership interest of the hostile interloper by giving the corporation a right to issue and the existing shareholders a right to buy more stock in the company if a triggering event occurs.

Redemption clause: allows the board to withdraw pill and allow a sale of control/stock/assets (aka “Board Out clause”).

How it Works Board adopts “rights plan” (poison pill). Must be pursuant

to a charter amendment that allows rights plans. No shareholder vote necessary.

Rights distributed to shares (through dividend), remain imbedded there.

If “triggering event” occurs (it never does), then pill not redeemable and rights become exercisable. Example of triggering event: third party acquires >10% of stock without board approval.

All rights holders allowed to buy shares at half price, diluting controller’s stake. However, the acquirer doesn’t get this right. (Shades of Unocal, unequal treatment)

Effect: acquirer is diluted out Benefits:

Efficiency: no restructuring required to protect incumbents. Such restructurings are often costly and wasteful.

Doesn’t trigger SEC rules No shareholder vote required

The Effect of the pill Before the pill (1970s-1985): board control is an

inevitable consequence of buying a majority of the shares:

o Bidder makes a tender offer and gains a majority of the shares


Board will almost certainly resign because independence is doomed.

If directors stay they will be voted out over one (no SB) or two (SB) annual elections.

After the pill (1985-present): board control is a prerequisite to buying a majority of the shares:

o Bidder launches a proxy contest to replace the target’s board over one (no SB) or two (SB) annual elections.

o Once in office, the new directors redeem the pill, thus clearing the way for the hostile bidder to proceed with its bid.

o But then point about how you don’t need the pill in advance – but instead the pill can be adopted at the last minute, perhaps even in response

So just adopt the pill after you have the tender offer

So any Del. Corp. can adopt the pill in the last minute

Moran- Pill with a flip-over component- Court says okay you can go do it

o (But here’s the thing, can buy the company and then just not backend, so no pill)

- So Court in Moran says Pill doesn’t seem that bado (But pill designers got fancy and had the pills flip-in much earlier)

- Would the court in Moran have come to the same conclusion if it was a flip-in pill? Kamar doesn’t know

Cases- Unocal- Revlon- Barkan- Pennance- Netsmart- Paramount- QVC- Santa Fe Pacific- Lukens

Anti-takeover statutes- Described in casebook, will give some background in class

State Takeover Statute- Schnel


- Blasicis- (MM +Liquid Audio)

Poison Pill- slow-hand- dead-hand- Uniciper(sp?)- CA

Revlon v. Mac-Andrews and Forbes Holdings (Del. 1986) p. 520- Facts: Perelman makes a hostile, all-cash tender offer for Revlon at $47.50 per

share when the stock is trading at $25. Offer would break up the company. Revlon board adopts a poison pill and tenders for 20% of its own shares with notes. The recapitalization permits Revlon to subject itself to specialized debt covenants that restrict the sale of assets, which in turn makes an LBO more difficult. Perelman raises his offer to $50, $53, and finally to $56.25 per share, with the promise of even more if Revlon redeems its pill. Forstmann 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. Revlon is now between two potential offers that would both break up the company. 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.

- Job of the board is not to protect the noteholders, it was to protect the shareholders

- Holding: This was violation of board’s fiduciary duty to corporation. A lock-up is not per-se illegal, but this lock-up was geared to thwart Perelman without any benefit to the shareholders. When bidders make relatively similar offers or dissolution of the company becomes inevitable, Board must let market forces operate freely to bring target’s

- The Revlon duty: 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.” (emphasis added)

o Deal protections Asset lockup: right to purchase T’s (Target’s) assets if someone

else wins bidding war No-shop rule: Target not allowed to negotiate with other

companies Termination fee: if company is outbid, Target must pay a price for

ending negotiation.- Pulling Together Unocal and Revlon

o Lockup Post-Revlon


Still allowed, as long as cost is justified by value to shareholders. For example: could be used to ensure highest price for corp Court will likely reject deal protection measures if they’re

too large (like Paramount v. QVC)o Friendly deals must give the Target Board a fiduciary out such that they

can abandon the deal protection if they’re advised by counsel that they’re going to violate fiduciary duties; if agreement lacks such a provision, it is invalid (Omnicare)

o Post-Revlon Cases Clarifying Revlon Duties (Barkan) Multiple bidders: Level Playing Field Among bidders “When

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 requirement: “When the board is considering a single offer and has no reliable grounds upon which to judge its adequacy … fairness demands a canvass of the marketplace to determine if higher bids may be elicited1. Exemption allowed in very limited circumstances.

- Kraakman’s synthesis:o Unocal: board should consider the interest of employees, community,

creditors in deploying defensive tactics. Unocal was trying to prevent against being sold.

o Revlon: board should maximize shareholder profit when the company is being dismantled or sold. At this point, must focus on the interest of shareholders, who are the last to receive compensation. Once a company is being sold, the only party that you can protect is the shareholders because the creditors are now at the whim of the purchasing party.

Can a board legitimately favor other interested parties at the expense of shareholders?

Kraakman: when the company is being sold, no because the shareholders are the last to get compensated, so the board should do its best to protect them. When the company is not being sold, can favor other parties. Revlon is triggered on the sale of a company.

Barkan v. Amsted Industries (Del. 1989, p. 558)- Don’t have to hold an auction- If you can prove to the court that you got the best value, and knew it was the best

value, you don’t have to hold an auction, etc.- But that is the easiest way to prove to court

Financial buyer – someone in the business of buying and selling companiesStrategic buyer – someone in same industry, business who buys company b/c think can run it better, expanding own business, etc.


Netsmart- Sign deal first, but if you find new buyer go ahead and just give us a couple days

to match- Court didn’t like the go-shop provision either, found in violation of Revlon- Selling to financial buyer usually means management stays on- Comfort – not going to seriously consider other deals- Market checks after offers by financial buyers less (successful) b/c management is

comfortable with deal, not really making an effort

Paramount- Warner getting a premium, 12%- Time buying Warner- Time stock goes up- Paramount comes in and bids- But now it goes up so Time is worth more- Time and Warner restructure so Time is making a friendly cash offer with a back

end stock tradeo Because Tender offer is full cash there is not going to be a vote

If you issues more than 20% of stock, have to vote, but don’t need to vote if its cash.

- Lawsuito DE Sup. Court says this is closer to Unoco more than Revlono But doctrine diff than Chancery

Chancery – diffusely held company before merger, diffusely held company after merger – so not really selling the company

Supreme Court – same result, but is Unoco, but rational that company wasn’t sold

Paramount Communications v. Time (Del. 1989) p. 524- Facts: Time and Warner agree to a stock-for-stock dealer in which Warner

shareholders get 62% of the surviving corporation. There are deal protection devices, including “cross-options” to deter third-party bidders. Time will also inherit the combined entity after 5 years when Warner’s CEO steps down. Paramount makes an all-cash hostile bid for 100% of Time shares, first at $174, 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. Concerned about its shareholder vote, Time restructures its deal with Warner so that Time borrows $10 billion and uses it to make a cash tender offer to Warner. Paramount brings suit to enjoin Time’s defensive tactics under Unocal. Time shareholders join suit and also assert a Revlon claim.

- Holding: The deal is approved as a proper exercise of business judgment. Time’s action was reasonable with relation to the threat posed (Unocal). Time has no duty to maximize shareholder value in the short-term. The court rules that Time specifically sought out Warner for business reasons/fit reasons. Shareholders might have voted for Paramount in ignorance or mistaken


belief about the value being conferred. No Revlon duties because there is no change of control.

- Two important factors for Time boardo Distinguished board with clear majority of independent directorso Time actually considered and negotiated transformative transaction for

years before deal occurred- Court: if anything, this deal is closer to Unocal than Revlon

o Court of Chancery: before merger Time company owned by diverse group of shareholders, and will have diverse group of shareholders afterwards not a sale of control

o SC: no, the reason is because there is no break-up in this case- Revlon elucidated

o “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;” or

o where in response to a bidders’ offer, a target abandons its long-term strategy and seeks an alternative transaction involving the break-up of a company.”

- Unocal elucidated:o board’s decision to pull a pill is strictly within its own BJ.o this decision sounds like a “just say no” BJR.

Santa Fe Pacific- Even if there is a great imbalance between two companies its Warner and not

Revlon

Paramount Communications v. QVC (Del. 1994) p. 530- Facts: Paramount agrees to be acquired by Viacom, controlled by Redstone, for

Viacom stock and cash worth ~$70. The deal gives substantial deal protection measures to Viacom. QVC jumps the deal with an offer to acquire Paramount for $80 in cash and then stock; when negotiations stall, QVC makes a hostile $80 cash tender offer for 51% of Paramount; with a planned back-end squeeze-out for $80 in QVC stock. Viacom matches QVC at $80, and then raises its price to $85 in cash and stock, but leaves the deal protection unchanged except for a new “fiduciary out.” QVC goes to $90; Paramount rejects the offer as “excessively conditional,” but makes no effort to explore the conditions or negotiate with QVC. QVC brings suit claiming that Paramount was in Revlon-mode; Chancery agrees and strikes down impediments to the QVC offer

- Holding: Revlon duties are trigged. The board had a duty to explore the QVC offer. Pre-offer, there was no controlling shareholder (widely held company); the purchase of 51% creates a controlling shareholders out of Redstone, who is Viacom’s majority shareholder. Deal protections are struck down.

- Revlon further elucidatedo sale of control with a cash-out merger requires board to apply Revlon

duties.


o When there is a sale of control, the minority shareholders should get a control premium.

An enhanced business judgment test Even if Viacom were widely held, this would still be a Revlon

transaction if there were a cash-out If Viacom were widely held, but this was a stock consideration, no

Revlon duties. Note: The nature of Consideration Matters:

If there is cash, appraisal right AND Revlon duties If a stock merger, no appraisal rights and no Revlon duties

- Contractual argument: Contracts to keep deal protections that go against fiduciary duties are invalid and unenforceable.

- Lock-up options: will the bidder with a lock-up option generally get the deal?o Termination fees can be held to be invalid if the transaction turns into a

Revlon deal.o Argument that these are not very effective because there is an opportunity

cost. Sometimes it is more profitable to lose the auction and get the termination fee.

o After Revlon, no asset lock-ups; only stock lock-ups

In Re: Luckens (Not in casebook)(1999)- Deal of mixed cash and stock (38% stock, 62% cash)- Chancery Court: had to decide whether Revlon applied

o Suit said board breached fiduciary duty b/c failed to max. value in saleo Can breach Revlon duties (failure to get top price) by breaching duty of

care or duty of loyaltyo Calling it a Revlon case won’t tell you whether breached loyalty or careo This was a Revlon case because so much of the consideration was in cash,

which meant that most of the stockholders would be cashed outo If 60% cash or above going to treat it as a Revlon case (footnote in case,

but widely circulated)

Summary: - Sale of company or change in control obligation to get best price you can- Always have obligation to get best value for shareholders but can be long-term

interest if no change control/sale- If have two companies of a similar size, like Time-Warner, might some day be

able to sell at a premium if company is acquired, but amount they will make is fixed today by the exchange ratio

- Should expect future case law to change the doctrine a bit because it isn’t solid

Kamar Prediction – in 10 yrs distinction between Unoco and Revlon will evaporate

Omnicare v. NCS Healthcare (Del. 2003)- Shareholder lock-up – can only be done if target has controlling shareholder (or

significant shareholders


- DGCL § 251(c) – can have force the vote provision in merger agreement (board commits to submitting offer to shareholders, even if decided not to recommend it)

- In NCS combined § 251(c) with fact that had controlling shareholders who committed to voting shares in favor of the deal

o Chairman and President/CEO- Court: lock-up too extreme can’t seal the deal entirely

o But company had been shopping for buyer for two yearso This was a surprise decision providing lock-up was the only way to get

G to buy the companyo If majority of shareholders are willing to commit, why can’t they? o Strong dissent by the two corporate experts on the Court

Cash lockups- No Shops

o Cannot solicit bids or negotiate with alternative buyerso Not allowed to put a provision in your contract that says you can’t

negotiate with third parties unless include a fiduciary out- If board determine would breach fiduciary duties not to negotiate

with alternative buyer, then can negotiate with them without breaching the contract

- ACE v. Capital Reinsurance (747 A.2d 95, 1999)Omnicare v. NCS

- Backgroundo Asset lockups – goneo Stock lockups – on the way out

Cash lockups

State Anti-takeover Statutes- First Generation: address disclosure and fairness concerns

o Williams Act (1968)o First anti-takeover laws (trying to limit hostile takeovers)

Created auction period, required disclosure 37 states followed suit, including Illinois Illinois Act: Struck down by Supreme Court as preempted

by the Williams Act.- Second Generation

o Fair price statute: meant to deter coercive two-tier takeovers. Requires that minority shareholders frozen out in the second step of two-tier takeovers get same price as those in first step. (Today’s version: require supermajority of shareholders to approve two-tier takeover, unless fair price rule included).

o Control share statute: require disinterested shareholders to approve the purchase of shares by any person crossing certain levels of share ownership that constitute “acquisition of control” (usually 20%, 33.3%, and 50% of outstanding shares). Upheld by CTS Corp v. Dynamics Corp of America) p. 549:


- THIRD-GENERATION ANTITAKEOVER STATUTES (1987-2000)O “Business combination statutes:” prohibits corp from engaging in

“business combination” w/in set time period after shareholder acquires share threshold.

Effect: bans immediate liquidation of acquired corp, but allows takeovers where acquirer will continue to operate business of target. Ex: DGCL §203, NYBCL §912.

DGCL §203: No “business combination” (merger) for three years after passing threshold, unless: board approves; acquirer owns 85%; approved by 66% of shareholders.

Effect: acquirers must try for 85% in one fell swoop. Interesting side effect: if you’re short of 85%, the more you

buy, the more powerful a vocal minority becomes (b/c you need 66% of their approval, short of 85% ownership).

DGCL: bans mergers for 3 years, does not ban sale of assets. Applies only to transactions between target and bidder.

NYBCL version bans both mergers and sales of assets.- “Business disgorgement statute:” mandatory disgorgement of profits when

bidder sells stock/assets within set period after becoming controlling shareholder. Adopted in Pennsylvania, Ohio.

- “Redemptive rights statute:” appraisal rights not just for freeze-outs, but when acquirer passes 30% stock ownership (“controlling share acquisition”). Petitioning shareholders get fair price + pro rata share of control premium.

- “Constituency statute:” allow or require boards to consider additional constituencies when deciding how to respond to a hostile takeover offer. Allow broader justifications for defenses.

o Ex: Indiana Code §23-1-35-1. Says board may consider shareholders, suppliers, communities, creditors, other factors. (Do shareholders still own the corp? Yes, because they elect the directors).

- Classified Board Statutes (MA and MD) provide classified boards for all companies incorporated in the state (with opt-out possible)

Modern Techniques for Challenging Corporate Control

Combination proxy fights and tender offers- Makes proxy more credible when increasing own risk levels by investing in

company- Partially to pressure the board, and if win to redeem the pill- See courts protecting free election of board of directors in a much more powerful

way

Schnell v. Chris-Craft Industries (Del. 1971, p. 613)- Facts: With only a couple of months left before the meeting, the board moves it

up and to an obscure town


- Board moved up annual shareholder meeting, made it more difficult for dissident campaign to get ready

- Court: the fact that the board has the power to change the meeting date doesn’t mean the board has the right to move the date

o This was not in good faith breach of fiduciary dutyo Board may be allowed to move the meeting, but it can’t do so to entrench

itself. A fiduciary may not use legal power in a way that is intended to treat a beneficiary of the duty unfairly

Blasius- Facts: Large shareholder intends to solicit to increase the size of the board and to

fill the new seats with friendly directors, but board amends its bylaws to create 2 new seats and fill them with friendly directors to preclude the takeover of a majority of the board

- Holding: Even if the board was acting in good faith, when there is a conflict between the board and a shareholder majority, not a business judgment standard the board can’t use defensive measures that entail removing shareholders right to vote, unless the board’s interest is compelling. This is a strict standard, applies even when directors act in good faith. Almost reverse of BJR: disenfranchisement is presumptively inequitable.

Liquid Audio- Sent letter of intent to buy the company, and to nominate two new directors (out

of 5, board classified, these only ones up for election this year) and shareholder proposal to increase size of board by four

- Board: signed stock merger agreement with white knight, postponed the upcoming shareholder meeting

- Board increased its size by two spots so have 7, and filled with own supporters- Chancery:

o This is different from Blasiuso Key is that in Blasius no matter what shareholders did the board would

have majorityo Here board has 5, added 2 to give them seven, so even if shareholders

passed all the proposals (elect two dissidents and add four new ones) the dissidents would get the majority

o So despite board actions, dissidents can still get everything they want- Shareholders ultimately rejected proposal to increase size of board, but rejected

increasing size of the board- DESC

o Blasius applies and they failed Blasiuso The board did this to make it more difficult for dissidents to challenge

them, can’t block voter franchise to do thato Where is the line drawn between Blasius, Revlon, etc?o Blasius is much harder to get around and convince court what you were

doing is ok


o Standard of review if you do mess with the voting mechanism, you must show compelling reasons

o Yet to see a case where Blasius applies and management wono Question: why do we want to push all shareholder decisions to voting?

- Why are proxy fights preferable to tender offers?- Easy to create formal boundary (one is voting one is tendering

stock) but why treat voting as so special

Van Gorkom – only case where directors held liable for agreeing to a transaction

Procedural context – no witnesses, never hear live testimony, just affidavits written by lawyersDE Courts prided themselves on speed – can get a chancellery decision within a day or twoDE SC would announce judgment same day as arguments, then release written opinion later

Why do people buy companies?- Banks increasingly need to get larger and extend reach- Line extensions – when company looks around at competitors and realizes wants

to expand into some area or expand and acquire smaller competitor- Putting money to work

o Private equity, hedge funds businesses organized for purpose of investing money to make a return for investors

- Lots of these investors are pension funds- Private equity: contract with investor to have call for a certain

amount of money over a certain amount of time Call capital – over certain period investor will make

available to equity fund certain amount of money to invest in deals that firm finds, all firm needs to do is find a deal and then give investor notice and investor will give them the money (up to contract price, usually with limited percentage of total contract amount, say 20%, to be invested in each company)

- “Carry” – if deal is successful they get more than their pro rata share when they exit the deal (sell) (so not long term investors)

- Can only call capital within fixed period of time, so if haven’t called the capital yet the commitment expires

- Firms make a lot of money off of fees and carry – so important for them to pick good deals because the more money they make and the easier it is for them to raise their next fund

- Agendas – can’t underestimate someone’s personal agenda

Reasons for Sales


- Always an exit strategy in a private equity transaction- Non-core business (acquired when building conglomerate and then that goes out

of fashion so trying to get rid of some parts of business that not part of main business)

- Over-leverages (particularly in bankruptcy)- Personal agendas

Participants - Target- Buyer- Senior management- In-house counsel- Boards of directors- Financial advisors- Outside counsel- Accountants- Local counsel- Regualtory counsel- Stockholders- Bondholders- Employees, Customers, and Suppliers- SEC Commission, regulators

Regulation FD – in public companies can’t selectively release information only to certain people

Documents

Kamar - Corporations Outline - Spring 2007