Corporations Outline

Professor Milton Regan

Basic Corporate Law Concepts

Two Basic Kinds of Corporations

Close Corporation
Shares are privately owned by a small group of shareholders
o Typically the founders and initial investors
Combination of ownership and control
o Shareholders are officers and directors
Open Corporation
Shares are open to the public and listed on an exchange
o Many widely dispersed shareholders
Separation of ownership and control
o Board has control of the company
o Shareholders have limited rights do not own in any meaningful
sense
Corporate Actors
Stockholders
Contract Residual financial and basic voting rights in return for capital
o Can only vote on matters specified in statutes, by-laws and
articles of incorporation
o Can amend the by-laws or approve amendments to the by-laws
Board of Directors
Elected by stockholders to manage or supervise corporations business
Officers
Elected by the board of directors
Stakeholders
Creditors, employees, customers and the community
Shlensky v. Wrigley
o Rational business practice to consider stakeholders when making
corporate decisions
Corporate Securities
Debt
Secured/unsecured bonds, debentures or notes Lowest risk with
lowest expected return
o Receive fixed payments of interest over time and return of
capital upon maturity
o Priority over equities in the event of liquidation
Convertible Debentures
o Allow the bondholder to convert the bond into common stock
Equity

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Preferred Stock Medium risk with medium expected returns

o Receive fixed dividends, with the right to be paid before common
stock
o Priority over common stock in the event of liquidation
Common Stock Highest risk with highest expected returns
o Receive dividends at the discretion of the board
o Last in line in the event of liquidation

The Corporation and Society

Two Questions of Basic Corporate Theory
(1) For whose benefit should corporations be run?
(2) What is the best way to ensure that corporations are run in their
benefit?
The Corporation as the Shareholders Agent (Private Property/Contractarian
Model)
(1) Corporations only social responsibility is to increase profits within
the boundaries of the law
o Private Property
Shareholders are the owners and principles of the
corporation
Directors are the agents of the shareholders must
operate in the shareholders best interest
o Contractarian
Shareholders bear the most risk
(2) Must protect the shareholders interests
o Private property
Increase information in voting
Allow the adoption of bylaws to restrain directors
Increase fiduciary duties
o Contractarian
Allow market forces to control mismanagement (prices,
takeovers)
Problems with these theories
o Private Property
Shareholders do not own the corporation do not have the
entire bundle of sticks
Shareholders do not have the interests of the corporation
in mind
o Contractarian
Shareholders can diversify investments to limit risk
Market is not perfect/efficient will not accurately reflect
value of company
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Dodge v. Ford Motor Co.

o Fords refusal to pay special dividends was a breach of their duty
of care
o Directors discretion is to be exercised to attain profit for the
stockholders
Cannot reduce profits to decrease cost of buying a car for
the public
The Corporation as a Societal Entity (Team Production Theory)
(1) Corporations have an obligation to take into account broader
societal interests in corporate decisionmaking
o Should think of consumers, political groups, creditors, employees
and communities
(2) Must give the board considerable discretion
o In the best decision to decide how to meet expectations of all
parties
o Cannot favor one interested party over another
Citizens United v. Federal Election Commission
o The First Amendment prohibits the government from suppressing
political speech on the basis of the speakers corporate identity
Corporation is an association of individuals a legal fiction
that their rights extend out of
o Unfair restriction to force corporations to speak only through a
PAC restricting the corporations speech itself
Government has no interest in equalizing the relative
ability of individuals and groups to influence elections
Theodora Holding Corp. v. Henderson
o Corporation can make a reasonable donation where members of
the board do not agree with the specifics of the donation
There is a recognized obligation of corporations towards
philanthropic, educational and artistic casuses

Corporate Federalism

Internal Affairs Doctrine

The law of the state of incorporation governs the internal affairs of
the corporation, regardless of the state in which the suit is brought
o Internal affairs are the allocations of authority among directors,
officers and shareholders (not other constituencies)
Need for predictability and efficiency of corporate operations and law
McDermott Inc. v. Lewis
o The structure of voting rights in a corporation is a matter of
internal affairs the laws of the state of incorporation apply to
dispute about voting rights

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Panamanian law allows a subsidiary to have a voting share

in their parent company
Effectively allows the parent corporation to have a voting
share in itself
California Pseudo-Foreign Corporation Statute
Certain provisions of California law governing corporate affairs applies
to a foreign corporation if:
o (1) More than half of its property, payroll and sales are within
California; and
o (2) More than half of its voting securities are held by California
residents
Wilson v. Louisiana Pacific Resources
o California law can constitutionally govern internal affairs of a
corporation with sufficient contacts in California if incorporated in
another state
Even though the two states have different voting laws
o No issue of inconsistent regulation or uncertainty applies to
corporations incorporated in California as well
Everyone knows what to expect when they choose to do
business here
Anti-Takeover Statutes
If a bidder acquires over a certain threshold of a targets stock, they
are prevented from voting that stock without the majority approval of
remaining shareholders
o Often upheld against Commerce Clause claims because of lack of
discrimination and the internal affairs doctrine
CTS Corp. v. Dynamics Corp. of America
o Indiana anti-takeover statute does not violate Commerce Clause
even if it dampens commerce because it is not discriminatory to
out of state bidders
Neutral to inter-state and intra-state commerce
o Internal affairs doctrine applies to laws governing voting
requirements
Amanda Acquisition Corp. v. Universal Foods Corp.
o Wisconsin statute delaying merger after a tender offer does not
violate the Commerce Clause because it is not discriminatory to
out of state bidders
Neutral to inter-state and intra-state commerce

Forming a Corporation

General Partnership (default assumed by law)

Association of two or more people formed by a partnership agreement

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o Either at-will or for a defined period

o If at-will, dissolved by any partner withdrawal
Each partner has an equal voice
o Majority decisionmaking
Personal liability
Limited Partnership
Partnership with general and limited partners formed by filing a
certificate with the state
o Dissolved by a withdrawal of the general partner
General partners manage the partnership and have personal liability
o Limited partners are passive investors without personal liability
Corporation
Legal entity separate from the shareholders formed by filing articles of
incorporation with the state
o Perpetual life
Board of directors manage the everyday operation of the corporation
with majority rule
o Common shareholders elect the board and vote on major matters
No shareholder liability
Reinecke v. Danforth
o Founder of a corporation is not a present or former client of the
corporations counsel, the corporation was the client
Thus the founder does not hold the confidentiality privilege
Limited Liability Company
Legal entity distinct from members formed by an operating agreement
and filing articles of organization with the state
o Perpetual life
Member-managed with voting rights according to capital contribution
o Can be manager-managed if specified in operating agreement
and articles of organization (members still vote on major
matters)
No member liability
Can choose to be taxed as a corporation or a partnership
o Corporations profits are double-taxed at the corporate level
and at the shareholder level
o Partnerships profits pass-through only taxed when the
partner receives them
Elf Atochem North American, Inc. v. Jaffari
o Arbitration provision in an LLC operating agreement is valid even
if the LLC itself did not sign the agreement so long as both
members did
Law of LLC allows great flexibility and freedom of contract
to govern relationships

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Accounting and Financial Reporting

Valuation Basics
No objective truth when reporting the financial accounting and
valuation of a company
o Considerable amount of latitude that people will take advantage
of in a manner that suits their interests
CEO and CFO must sign off on the financial statements of a company
o Liable if they had reason to believe that any of the
representations were false
Balance Sheet
Snapshot of the companys financial position
Assets = Liabilities + Equity
Analyzed in two ways
o Current ratio current assets divided by current liabilities
Ability to pay short-term obligations
o Debt/Equity ratio Long-term debt divided by equity
Reliance on debt to run operations
Assets (classified in order of liquidity)
Cash
Accounts receivable
o Amounts owed for goods and services already provided
Notes or loans receivable
o Notes or loans the company has yet to collect
Inventory
Fixed (long-term) assets
Intangible assets
Liabilities
Current liabilities (must be paid within 1 year)
o Accounts payable
o Demand notes payable
o Accrued expenses payable
Long-term liabilities (due more than one year from date)
Equity
Paid in capital
Retained earnings
Accounting Principles
Accrual Accounting
Matching Principle
o Firm must allocate the expenses it incurs to generate revenues
to the period in which it recognizes the revenues
Realization principle

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o Firm must recognize revenue in the period in which it earns it,

even if not paid in that period (either not yet paid or prepaid)
Cash Accounting
Record expenses and revenues in the period the cash is
distributed/received
Statement of Income
Net Sales
Operating Expenses
o Cost of goods sold
o Depreciation
o Administrative expenses
o Research and development
Gross Profit
o Net sales minus costs of goods sold
Net Income
o Net sales minus all expenses (including tax and interest)

Financial Structure of the Corporation

Corporate Capital Structure
Company, if using corporate securities, must raise funds so that
investors finds rights embodied in securities attractive enough to
justify investment
o Tax considerations
Interest paid on bonds is deductible for the investor,
dividends paid are not
o Leverage and allocation of risk
More debt means more leverage, which means more profit
but also more risk for shareholders
Debt-holders will be paid regardless
o Options
Equity-Linked Investors, L.P. v. Adams
o Directors have a fiduciary duty to the corporation, not to one
specific type of investor
Duty to any one group of investors is determined by the
terms of their investments (typically common > preferred)
Only a breach of a fiduciary duty if they act in bad faith
DGCL 157. Rights and Options Respecting Stock
o Every corporation may create and issue rights or options entitling
holders to acquire shares of stock of any class
Subject to any provisions in the articles of incorporation
MBCA 6.21. Issuance of Shares

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o Issuance of shares (or other securities convertible to shares)

requires the approval of shareholders at a meeting in which at
least of a majority of the votes entitled to be cast is present, if:
Consideration in return is not cash or its equivalent; and
Voting power of shares will comprise more than 20% of the
voting power of the shares outstanding before the
transaction

Piercing the Corporation Veil

Piercing the Corporate Veil Test

Three prong test to determine when to pierce the corporate veil and
impose liability on a shareholder or equitable owner (all must be met)
o (1) Control not mere majority or complete stock control, but
complete domination
Not only finances, but of policy and business practice in
respect to the transaction attacked so that the corporate
entity had no separate mind, will or existence of its own
o (2) Control was used by the defendant to commit fraud or wrong,
to perpetrate the violation of a statutory or other positive legal
duty, or dishonest and unjust act in contravention of plaintiffs
legal rights
Of which undercapitalization at the outset is evidence of
o (3) Control and breach of duty must proximately cause the injury
or unjust loss complained of
Walkovsky v. Carlton
o Cannot pierce the corporate veil without showing that there is a
substantial unity of interest between the corporation and its
shareholders
Shareholder must be conducting business through the
corporation in his personal capacity
o Cab company was undercapitalized but had enough insurance to
meet their liabilities
Radaszewski v. Telecom Corp.
o Cannot pierce the corporate veil due to bad business judgment,
must show purposeful fraud or wrongdoing
Insurance would have been enough to cover the claim had
the insurance company not been insolvent
Freeman v. Complex Computing Co., Inc.
o Can be liable through a piercing of the corporate veil as an
equitable owner if one exercises sufficient control over the
corporation and uses it to harm the plaintiff
Even if not a shareholder, can be liable if you control the
entire corporation

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o However, no showing that defendant used that control to commit

fraud or other wrong that harmed the plaintiff
Kinney Shoe Corp. v. Polan
o Corporate veil pierced when sole shareholder creates a grossly
undercapitalized sham corporation only to obtain limited liability
Cannot bestow the benefits of a corporate form that was
not properly maintained
Gardemal v. Westin Hotel Co.
o Parent corporation cannot be held liable for the acts of a
subsidiary through a piercing of the corporate veil, unless:
Subsidiary is organized as a mere tool or business conduit;
or
Two corporations are not operated as separate entities
o No evidence that the operations of the two corporations were so
integrated or that the subsidiary was a mere conduit
OTR Associates v. IBC Services, Inc.
o Parent corporation can be held liable for the acts of a subsidiary
corporation when the corporate form is used merely as a shield
behind which fraud or other injustice is sought to be done by
those who have control of it
Blimpie subsidiary was created to insulate the parent from
liability without any other purpose
Effects of Imposing Liability
Public Corporation
o Shareholders must monitor other shareholders
o Shareholders must monitor management
o Management will be risk averse
o Shares will be less fungible due to uncertainty
o Investment in stock will be less attractive relative to other investments
Close Corporation
o No issue of monitoring other shareholders or management (all
shareholders are familiar and are likely management)
o All other concerns remain

Corporate Authority

Board and Shareholder Authority

DGCL 141. Board of Directors
o Business and affairs of corporation shall be managed by the
board of directors except as otherwise provided here or in
articles
Board Composition and Structure
Audit Committee

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Responsible for the appointment, compensation and oversight of the

corporations public accounting firm
Responsible for monitoring the corporations financial transactions and
financial reports
Compensation Committee
Oversees the form and amount of senior executives compensation
Nominating Committee
Responsible for nominating candidates for the board of directors
Responsible for deciding whether current directors should be
nominated for reelection
Agency Law
Many relationships in the corporation are agency relationships, giving
rise to fiduciary duties of care and loyalty
o Corporation/Shareholders Board
o Board Managers
Agents may have the power to legally bind the principal in legal
relationships with third parties
o Actual authority
Express or implied from the principal
o Apparent authority
Reasonable that third party believes the principal
consented to give the agent authority based on statements
and actions of the agent
o Inherent authority
Reasonable that third party believes the agent has
authority based on the position of the agent (does not
depend on representations)
Assumed a CEO has authority to bind a corporation in
transactions entered into in the ordinary course of
business
o Ratification
Principal can ratify the act of the agent who at the time did
not have authority to bind
Ratification can be inferred from the acts (or nonaction), words or conduct of the principal
Counsel will often insist on receiving adequate evidence that
individuals acting on behalf of a corporation have authority
o Statutory law, articles of incorporation, bylaws, resolution of the
board, etc.
Summit Properties, Inc. v. New Technology Electrical Contractors
o Vice President of Finance had apparent authority to sign lease on
behalf of the corporation because the lessor reasonably relied on
the representations the corporation made

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Further, by failing to take action against the lease after it

was notified, the corporation ratified the authority and thus
the lease
Menard, Inc. v. Dage-MTI, Inc.
o President of a corporation has the inherent power to bind the
corporation to a contract so long as the contract is within the
ordinary scope of his duties
And the third party has no notice that he lacks authority

Close Corporations
Close Corporations
Courts may look to two things to define a corporation as close
o Integration of ownership and management
o Number of stockholders and the nature of the market for the
stock
Due to the illiquid nature of the investment in a close corporation,
courts are more tolerant of deviations from the norm
Hobby Lobby Stores, Inc. v. Burwell
o Rights of a close corporation are derivative of individual rights
corporation is a legal fiction
Must protect the rights of the underlying stakeholders by
inferring those rights on the corporation
Alignment of Shareholder Control
Shareholder Voting Arrangements
Straight voting
o One share equals one vote for one director
o Directors with most votes are elected
Cumulative Voting
o One share equals one vote for every open director position
o May cumulate all of your votes for one position
Classified Voting
o Divide voting stock into two or more classes, each of which is
entitled to elect one or more directors
Limitation Devices on Shareholder Voting
Voting Trust
o Convey legal title of stock to a trustee pursuant to the terms of
an agreement
o Shareholder becomes a beneficiary of the trust, entitled to
receive dividends
Irrevocable Proxy
o Shareholder gives proxy to vote shares to someone else
o Cannot be revoked for the specified life of the proxy
Vote Pooling Agreements
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o Agreement between shareholders to vote together on designated

questions
Restrictions on Board Discretion
Shareholder agreements
Can modify traditional corporate structure if set forth in the articles of
the bylaws
Must be approved by all shareholders at the time of the agreement
High Voting Requirements
Require percentage of the vote to pass any action so high that any one
(or group) of shareholders effectively retain a veto power
Smith v. Atlantic Properties, Inc.
o Minority shareholder, in a close corporation that requires a
unanimous vote for corporate action, may not repeatedly vote
against an action for personal reasons if the action would be in
the best interest of the corporation
Shareholders, even though expected to vote in self
interest, must exercise votes in good faith
Restrictions on Transfers
Right of First Refusal
Before selling shares to a third person, must offer to the corporation (or
its shareholders) on the same terms
If given to shareholders, it is relative to their stake in the corporation
First Option Provision
Offer to the corporation at a price and on terms fixed by agreement
Consent
Transfers conditioned on the consent of the board of directors or other
shareholders
Sale Option
Withdrawing shareholder can receive an option to sell her shares to the
corporation or the remaining shareholders upon the condition of a
specified event
Buy-Sell Agreement
Corporation or remaining shareholders are compelled to purchase the
shares of another shareholder upon the occurrence of specified events
Dissension and Oppression
Minority stockholder is oppressed if the reasonable expectations of
the minority shareholders investment is frustrated
o Burden then shifts to the defendant to show that there is a
rational and legitimate business purpose for the oppression
o If the defendant meets their burden, it shifts to the plaintiff to
show that it is not the least intrusive means of doing so
Remedies for Oppression
o Courts often have the statutory power to dissolve the corporation
if a shareholder establishes that:
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(1) The directors are deadlocked, and the deadlock cannot

be broken by shareholders and it is injuring the corporation
or impairing the conduct of tis business;
(2) The shareholders are deadlocked and have not been
able to elect directors for two years
(3) Corporate assets are being wasted; or
(4) Those in control of the corporation are acting in a
manner that is illegal, oppressive or fraudulent.
o Defendants have the burden of proving that an alternative viable
remedy is available
Wilkes v. Springside Nursing Home, Inc.
o Majority shareholders in a close corporation owe minority
shareholders a strict duty of the utmost good faith and loyalty
Unless a legitimate business purpose can be demonstrated
to justify a breach of that duty
Minority reserves the right to demonstrate the same
objective could be achieved through less
oppressive/harmful action
Nixon v. Blackwell
o Corporate directors owe a fiduciary duty of fair, but not
necessarily equal, treatment to all shareholders
Matter of Kemp & Beatley, Inc.
o If majority shareholders take actions that substantially defeat the
reasonable expectations of minority shareholders, they have
engaged in oppressive conduct and the court may order forced
dissolution of the corporation
Burden is then on the defendants to show that an
alternative viable remedy is available
Bonavita v. Corbo
o Even if there is a legitimate business purpose for the majoritys
action, cannot defeat the reasonable expectations of the minority
if it is not the least intrusive means of doing so
Dissolution of the Limited Liability Company
Courts are more likely to respect the parties contractual
understandings in an LLC than in a Corporation
o Grounded on principles of freedom of contract
Haley v. Talcott
o Court may dissolve an LLC when it is not reasonably practical to
carry on the business in conformity with the LLC agreement
So long as the LLC agreement does not otherwise provide a
sufficient exit mechanism

Shareholder Authority
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Voting
What can shareholders vote on?
Elect/remove directors
o With or without cause unless articles say otherwise
o Directors must be given notice and opportunity to meet
accusation
Approve proposed amendments to the articles of incorporation
o But cannot propose
DGCL 109 Propose and approve amendments to the by-laws
o Articles may allow the directors to adopt, amend or repeal
bylaws, but this does not take it away from the stockholders
Approve significant transactions
Approve conflicted transactions
When can shareholders vote?
Annual meetings
o Date specified in the by-laws
Special meetings
o DGCL 211. Meetings of Stockholders
Special meetings of stockholders may be called by the
board or by any person authorized in the articles or the
bylaws
o MBCA 7.02
Called by an member of the board, owners of 10% of stock
or anyone authorized in the articles
Meeting requirements
o Shareholders must be given notice of all meetings in which they
are entitle to vote
o Record date is set only shareholders of record on that date
can vote
o MBCA 7.04. Action without meeting
Action requiring a meeting can be taken without one if
written consent by all shareholders entitled to vote on the
action
Articles can allow for consent by minimum number of votes
required
How can shareholders vote?
In person at the meeting
Vote by proxy
o Give consent for someone else to vote on your behalf
Shareholder Voting Dynamics
Costs of shareholder informing themselves is typically outweighed by
the expected returns from informed voting
o Collective action problem
Structuring Corporate Combinations
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Market Exception to appraisal rights

o No need for appraisal rights if the market will serve the same
purpose
o Requires the stock to be traded publicly
(1) Statutory Merger
o Target is merged into Purchaser all of T shares are converted
into P shares
o MBCA
Voting Requirements
Majority of Ts outstanding shares required
Ps shareholders only vote if there is a dilutive share
issuance
Appraisal Rights
Ts shareholders have appraisal rights unless
market exception
Ps shareholders do not have appraisal rights unless
entitled to vote on merger
o DGCL
Voting Requirements ( 251)
Majority of both T and Ps outstanding shares must
approve the merger (unless short-term merger)
Ps shareholder approval not required if Ps
outstanding voting stock is not increased by 20%
Appraisal Rights ( 262)
Ts shareholders have appraisal rights if the market
out exception does not apply
Ps shareholders have appraisal rights if they were
entitled to vote on the merger and the market out
exception does not apply
(2) Triangular Merger
o Target is merged into a newly created subsidiary of Purchaser
to shield P from liability
o MBCA
Voting Requirements
Majority of Ts outstanding shares must approve the
merger
Ps shareholders vote only if there is a dilutive share
issuance
Appraisal rights
Ts shareholders have appraisal rights unless
market exception applies
Ps shareholders have appraisal rights only if they
were entitled to vote on the merger

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o DGCL
Voting Requirements
Majority of Ts outstanding shares must approve the
merger
Only Ps board must approve the merger (Ps
shareholders do not own shares in the subsidiary)
Appraisal Rights
Ts shareholders have appraisal rights if the market
out exception does not apply
Ps shareholders do not have appraisal rights
(3) Statutory Share Exchange
o Target shareholders receive Purchasers shares in exchange for
their stock T becomes a subsidiary of P
o MBCA
Voting Requirements
Majority of Ts outstanding shares must approve
P shareholders only vote if there is a dilutive share
issuance
Appraisal rights
Ts shareholders may seek appraisal unless the
market exception applies
Ps shareholders do not have appraisal rights
o DGCL
Does not recognize the statutory share exchange
(4) Sale of Assets
o Target sells assets to Purchaser in exchange for P stock or other
consideration
o MBCA
Voting Requirements
Majority of Ts outstanding shares must approve the
sale
P shareholders only vote if there is a dilutive share
issuance
Appraisal Rights
Ts shareholders have appraisal rights if there is no
market exception
P shareholders do not have appraisal rights
o DGCL
Voting Requirements
Majority of Ts outstanding shares must approve the
transaction
Appraisal Rights
No appraisal rights
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(5) Tender Offers

o Purchaser offers to purchase Target shares directly from T
shareholders
o DGCL 251. Merger of Consolidation of Domestic Corporations
(h) After a tender offer, shareholders of the target
corporation that have not tendered do not need to vote for
a merger if:
Market exception applies; and
Consideration paid in merger is the same paid in the
tender offer
Initiating Action
Scope of Board/Shareholder Power
DGCL 109(b)
o By-laws may contain any provision relating to the business of the
corporation, the conduct of its affairs, and its rights or powers or
the rights or powers of its stockholders, directors, officer and
employees
DGCL 141
o Authority of the board of directors is plenary
Unless otherwise stated elsewhere in the articles of
incorporation or the DGCL
o Directors may be removed with or without cause by the holders
of a majority of shares entitled to vote
Auer v. Dressel
o Stockholders have inherent power to remove directors for cause,
regardless of by-laws giving that power to the board
Thus the board must call a meeting to remove directors at
the shareholders request
Blasius Industries v. Atlas Corp.
o Board cannot undertake action with the primary purpose of
interfering with shareholder voting, even if in the good faith
pursuit of the corporations best interest
Business Judgment Rule is for everyday management of
the corporation, not the shareholder/board power structure
Cannot have the agent define the authority granted by the
principal
Proxy Solicitation
DGCL 112. Access to Proxy Materials
o Bylaws may provide that corporation is required to include in its
proxy materials individuals nominated by a stockholder, subject
to procedures and conditions
DGCL 113. Proxy Expense Reimbursement
o Bylaws may provide for the reimbursement by the corporation of
expenses incurred by a stockholder in soliciting proxies in
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connection with the election of directors, subject to procedures

and conditions
SEC Shareholder Proposal Rule 14(a)-8
o The board can omit a shareholders proposal on a proxy
statement that:
Is not proper under state law
Is misleading or false
Does not meet a minimum economic test (5% of sales,
assets or earnings) and is not otherwise significantly
related to the companys business
Involves ordinary business operations (DGCL 141)
Relates to an election for membership of the board
Lovenheim v. Iroquois Brands
o A proposals significant relation to the companys business is not
related to economic significance
Includes policy questions important enough to be significantly
related to the issuers business
Ordinary Business Decisions vs. Process and Procedure
DGCL 102(b)(1)
o Articles of incorporation may contain:
Any provision for the management of the business and for
the conduct of the affairs of the corporation
Any provision creating, defining, limiting and regulating the
powers of the corporation, directors and the stockholders
DGCL 109(b)
o By-laws may contain any provision relating to the business of the
corporation, the conduct of its affairs, and its rights or powers or
the rights or powers of its stockholders, directors, officer and
employees
CA, Inc. v. AFSCME Employees Pension Plan
o Shareholders can amend the by-laws to dictate the process and
procedures by which the board acts
But cannot adopt by-laws that mandate the decision itself

Disclosure Duties to Shareholders

Securities and Exchange Act 14(a)
Two Requirements for Challenging a Misleading Proxy Statement
(1) Proxy statements are prohibited if they contain a material
misstatement or omission
o Material if there is a substantial likelihood that the disclosure of
the omitted fact would have altered the total mix of information
available to a reasonable investor
Can include a belief (Basic) or opinion (Virginia
Bankshares)
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o TSC Industries, Inc. v. Northway, Inc.

A fact is material if there is a substantial likelihood that a
reasonable shareholder would consider it important in
deciding how to vote
Must have a significant propensity to affect the
voting process, but not necessarily change to vote
itself
o Basic, Inc. v. Levinson
Misstatements about merger negotiations can be material
statements of fact depending on probability that event
would occur and the anticipated magnitude of the event
Probability indicia of interest in the transaction at
high corporate levels
Magnitude size of the entities and the potential
premiums over market value
o Virginia Bankshares v. Sandberg
A statement of belief (opinion) by a board of directors can
be a material misstatement if the statement of belief is
false (not what they actually believed)
Must show (1) they lied about what they believed
and (2) that the stated belief was not the true state
of the world
o Gantler v. Stephens
If statement would not be material, but it is disclosed and it
is misleading, it may become material
Statement that board carefully considered a merger
offer prior to privatization, while not necessary,
becomes material once disclosed
(2) Plaintiff must show that the misstatement or omission caused a
loss
o (a) Must show that the proxy solicitation was an essential link
in the transaction that the shareholders vote was required for
the transaction; or
o (b) Must show that you were mislead into voting for the
transaction which led to a loss in appraisal rights
o Virginia Bankshares v. Sandberg
Proxy statement must be required for the transaction to go
through for there to be an injury to the shareholders
No injury if the transaction would have gone through
anyway
o Mills v. Electric Auto-Lite Co.
If proxy solicitation was required for transaction, omission
or misstatement not required to have caused shareholders
to vote the way they did

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Only need to show that proxy solicitation was an

essential link

Duty of Care

Board Decisionmaking
Duty of Care
Board of Directors owes a fiduciary duty of care to the corporation and,
through the corporation, the shareholders
o Must act in the corporations best interests
o Must exercise reasonable care in making decisions and in
overseeing the corporations affairs
Business Judgment Rule
Presumption that in making a business decision, the directors of a
corporation acted:
o (1) On an informed basis
o (2) With a rational business purpose
In order to rebut these presumptions, the plaintiff must show
(respectively):
o (1) Gross negligence
Want to protect incentive to take risks
o (2) Waste
Must show the transaction wholly lacks consideration
If the plaintiff rebuts either, the board cannot show entire fairness
because (1) shows lack of fair process and (2) shows lack of fair
outcome
o However, board can show that the transaction caused no harm
Smith v. Van Gorkom
o Rebuttable presumption that a boards business decision is
fully informed, made in good faith and in the best interests of
the corporation
Statutory Exculpation of Directors
Provision in the articles of incorporation can reduce directors personal
liability for violations of the duty of care (not loyalty)
o Want to preserve incentive for directors to take risks
o Want to fairly limit damages relative to the directors culpability
DGCL 102. Contents of Certificate of Incorporation
o (b)(7) Articles may contain provision eliminating or limiting
personal liability of a director to the corporation/stockholders for
breach of fiduciary duty, but may not eliminate liability for:
Breach of duty of loyalty
Acts or omissions in bad faith
Intentional misconduct or violation of law
Improper personal benefits
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Indemnification
State corporate statutes allow for the articles, by-laws, or private
contracts to provide for indemnification of the directors by the
corporation
o State statutes are either permissive, mandatory or
comprehensive (both)
Insurance
D&O policies what two separate but integral parts
o (1) Reimbursement to the corporation for its lawful expenses in
connection with indemnification of the director/officer
o (2) Coverage of claims against corporate directors/officers in
their corporate capacity

Duty of Good Faith

Board Oversight
Duty of good faith is an extension of the duty of loyalty
o Breached by a conscious disregard of duty to take action to fulfill
a fiduciary duty (Stone)
Board of Directors has a duty to the corporation to make good faith
efforts to ensure that adequate corporation information and reporting
systems exist
o Level of detail of the systems oversight is a question of business
judgment
o Only applicable to the monitoring of employee conduct, not
business risk
Lack of good faith can be shown by:
o Sustained or systemic failure to establish a reasonable
information and reporting system
o Failure to investigate or respond reasonably and adequately to a
red flag
DGCL 141. Board of Directors
o (e) Director (or committee designated by board) is protected in
relying in good faith upon the records of the corporation, or upon
such information presented to the corporation by any of its
officers, employees, committees, or any professional or expert
Graham v. Allis-Chalmers Manufacturing Co.
o Absent cause for suspicion (red flag), there is no duty upon
directors to install and operate a corporate system of espionage
to ferret out wrongdoing
Directors are entitled to rely on the honesty and integrity
of their subordinates until something puts them on
suspicion
In re Caremark International Inc. Derivative Litigation

Wade 21

o Board has a duty to make good faith efforts to ensure that

adequate internal corporate information and reporting system
exists
Level and detail of systems oversight is a question of
business judgment
o Lack of good faith shown by a sustained or systemic failure to
establish a reasonable information and reporting system
Or by a failure to investigate/respond reasonably and
adequately to a red flag
Stone v. Rittner
o Duty of good faith is an extension of the duty of loyalty, not the
duty of care
Conscious disregard of responsibilities by failing to put in
place an adequate compliance system is an act of bad faith
breach of loyalty
ATR-Kim Engineering Financial Corp. Araneta
o Directors who fail to act as an independent and impartial
fiduciary, and fail to monitor another director, are acting in bad
faith
Thus are liable as if they were the director wronging the
corporation
In re Citigroup Inc. Shareholder Derivative Litigation
o Directors violate their duty to the corporation by failing to
properly monitor employee conduct, not business risk
Business decisions, like the assumption of risk, are
analyzed under the business judgment rule

Duty of Loyalty
In General
Managers must put the Corporations interests before personal
interests
o It is presumed by courts that managers are:
Disinterested
Independent
To allege breach of Duty of Loyalty, must show:
o (1) Interested Party (Manager, Director, Officer); or
o (2) Must show that party is incapable of making an independent
judgment
Cleansing Interested Director Transactions
DGCL 144. Interested Directors
o An interested director transaction will not automatically be void
solely because of the interest if either:

Wade 22

There has been informed, disinterested (and independent)

board approval or informed shareholder approval (majority
of minority); or
The transaction is fair to the corporation
MBCA 8.61-63. Judicial/Director/Shareholder Action
o Directors conflicting interest transaction is not judiciable if:
Authorized by the affirmative vote of a majority of
disinterested directors (no less than two), so long as:
Disinterested directors were informed (of interest)
Disinterested directors deliberated alone
Authorized by the affirmative vote of a majority of
disinterested shareholders, so long as:
Disinterested shareholders were informed (of
interest)
It was fair to the corporation
When making a decision, Board can cleanse the transaction to
protect themselves against breach of duty of loyalty claims
o Once cleansed, the challenger is only left with a duty of care
claim thus the Business Judgment Rule applies
Transaction can be cleansed in two ways
o Majority of independent, disinterested, and informed board
members approve the transaction; or
o Transaction is submitted to the shareholders and approved by an
informed and uncoerced majority of the minority (of disinterested
and independent shareholders)
If not cleansed, board has the opportunity to prove that the transaction
was nonetheless fair to the corporation must show:
o Substantive Fairness fair in consideration and other terms of
the transaction
o Procedural Fairness Process of decision and directors conduct
Cleansed by an Approval of Disinterested and Independent Directors
Interested Director transaction can be valid and subject to BJR if:
o A majority of the disinterested and independent directors
approve the transaction; and
o Material facts as to directors interest are disclosed or known to
that majority
Benihana of Tokyo, Inc. v. Benihana
o Transaction involving an interested director obtains the benefit of
the BJR if the transaction is approved by a vote of the
independent and disinterested directors
So long as the material facts as to the directors
relationship/interest are disclosed or known to the
remainder of the board
In re eBay, Inc. Shareholders Litigation

Wade 23

o Remaining directors are not independent and disinterested when

the interested directors are controlling shareholders
Remaining directors have stock options that are
dependent upon the controlling shareholders continuing to
vote them in
In re Walt Disney Company Derivative Litigation
o In order to show that remaining directors are not disinterested or
independent, must show that they are beholden to the interested
party
Cannot exercise business judgment independent of the
interested party
Cleansed by Majority of Minority Shareholders
Interested director transaction can be valid and subject to BJR if
approved or subsequently ratified by shareholders, so long as:
o Majority of disinterested and independent shareholders approve
the transaction;
o Material facts as to the transaction and the directors interest
were disclosed to the shareholders; and
o There is no coercion present
Lewis v. Vogelstein
o Shareholder ratification shifts the burden to shareholders to
overcome the business judgment rule must show waste
So long as the approval was validly obtained must be
informed of all relevant terms and conditions and noncoercive
Harbor Finance Partners v. Huizenga
o Once disinterested and independent shareholders ratify a selfdealing transaction with an informed and non-coerced vote, a
waste challenge serves little purpose
Corporate Opportunity Doctrine
Director, officer or managerial employee cannot divert to themselves
any business opportunity that belongs to the corporation if:
o It is one the corporation can financially undertake;
o Is within the line of the corporations business and is
advantageous to the corporation; and
o Is one in which the corporation has an interest or a reasonably
expectancy
Director, officer or managerial employee can take the corporate
opportunity if presented to the corporation and the corporation rejects
it
o Rejecting corporate decision-makers must be informed,
disinterested and independent

Wade 24

Duties of Controlling Shareholders

Standard of Review for Cash-Out Transactions
Controlling shareholder will use a cash-out merger to terminate other
shareholders equity interest in the corporation by forcing them to
accept cash for their stock
o Merges the partially owned target into a completely owned
subsidiary, with the completely owned subsidiary paying cash for
the target stock
o As controlling shareholder, can force the target to accept the
offer
Self-Dealing Transactions
If a controlling shareholder engages in self-dealing, the court will
review the transaction under intrinsic/entire fairness instead of the
BJR
o Self-Dealing:
Controlling shareholder is on both sides of the transaction;
and
Controlling shareholder receives a benefit to the exclusion
and at the expense of the subsidiary
o Intrinsic/Entire Fairness:
Burden of proof shifts to the controlling shareholder to
show that the transaction was fair to the corporation
Must show:
Substantive Fairness fair in consideration and
other terms of the transaction
Procedural Fairness Process of decision (informed)
and directors conduct
Sinclair Oil Corp. v. Levien
o A parent corporation must pass the intrinsic fairness test only
when its transaction with its subsidiary constitutes self-dealing
Transaction is self-dealing when the subsidiary does not
share in the benefit of the transaction, and the transaction
is to its detriment
Weinberger v. UOP, Inc.
o In order for there to be procedural fairness, minority shareholders
must be informed of all material information regarding the
merger
When information is gathered from target to determine
purchase price, must disclose the purchase price to the
targets shareholders
Independent Committees
If an independent committee is used in the negotiation process, the
burden of entire fairness shifts to the plaintiffs if:

Wade 25

o The committee has genuine bargaining power that it can exercise

with the controlling shareholder at arms length; and
o The controlling shareholder did not dictate terms of transaction
(coercion)
Kahn v. Lynch Communications Sys., Inc.
o A minority shareholder can still be a controlling shareholder if
they dominate corporate affairs
Effective veto power can make a minority shareholder a
controlling shareholder
o Independent committee will not shift the burden to the plaintiffs
when the committee does not have genuine bargaining power
Without the real power to say no, committee will not be
found to have genuine bargaining power
Independent Committees Coupled With Majority of the Minority
Business Judgment Rule applies when, from the controlling
shareholders first overture, the merger has been subject to both:
o Negotiation and approval by an independent committee of
directors with genuine bargaining power; and
o Approval by an un-coerced, fully informed vote of a majority of
the minority of investors
In re MFW Shareholders Litigation
o Once a transaction is subject to both procedural protections, the
limited benefits of entire fairness review are not worth the
added costs
Closer to an arms length transaction can protect
themselves with an informed vote, and gain bargaining
power with a committee
o Benefit of BJR gives directors incentives to employ maximum
procedural safeguards
Standard of Review for Alternatives to Cash-Out Mergers
Short-Form Merger DGCL 253
If parent corporation owns at least 90% of the subsidiarys outstanding
shares, can engage in a short-form merger
o Must file a certificate setting forward its ownerships and the
terms of the merger
o Must inform the subsidiarys minority shareholders of the terms
and advise them of their appraisal rights
Does not require any action by the board or shareholders of the
subsidiary
o Thus, they are not given the right to judicial review of the
transaction
Tender Offers and Short-Term Mergers
Often, a corporation will commence a tender offer conditional on
receiving 90% of the targets stock

Wade 26

o Once they obtain this threshold, they can commence a shortterm merger without any opposition or judicial review
Tender Offers will be subject to a process-based voluntariness review
o (1) Offer has to be subject to a non-waivable requirement that is
approved by a majority of the minority
o (2) Controlling shareholder must promise to effectuate
immediately a short-form merger at the same price as the tender
offer
o (3) Controlling shareholder must made no retributive threats
(coercion)
o (4) Controlling shareholder must permit the independent
directors on the board time and authority to react to the tender
offer, hire their own advisors, and make a recommendation
In re Pure Resources Inc. Shareholders Litigation
o Tender offers are subject to a voluntariness review - requires
full disclosure and lack of coercion
Must still give deference to shareholder decisions that are
voluntary and informed
o Shareholders ability to decline tender offers does not remove all
threats of structural coercion
Prisoners dilemma, informational advantages, etc.

Shareholder Litigation

Direct and Derivative Actions

Direct actions
o Action brought in the name or right of a holder to redress an
injury sustained by, or enforce a duty owed to, the holder
Likely in the form of a class action
Derivative actions
o Action brought in the name or right of a corporation by a holder
to redress an injury sustained by, or enforce a duty owed to, a
corporation
Shareholder represents the corporation (fiduciary in
character) to vindicate interest of all shareholders
Tooley v. Donaldson, Lufkin & Kenrette, Inc.
o Two questions to ask to determine if injury is derivative:
Who suffered the harm the corporation or the
shareholders as individuals?
Who would receive the benefit of any recover or other
remedy the corporation or the shareholders as
individuals?
The Demand Requirement
Excusal of Demand
Three requirements of derivative litigation stockholder must:
Wade 27

o Retain ownership of the shares throughout the litigation;

o Make pre-suit demand on the board; and
o Obtain court approval of any settlement
When is demand excused?
o Boards decision whether or not to carry forward with litigation
after shareholder demand is entitled to the BJR
o Thus, in order to avoid demand, must create a reasonable doubt
that:
(1) Majority of directors are disinterested and independent
(2) The challenged transaction was otherwise the product
of a valid exercise of business judgment (Duty of care/duty
of loyalty not breached)
o Temporal point of view
If board that would be demanded is the one who made the
challenged action:
Must apply review to the time of the challenged
action
Where they disinterested and independent then?
If board that would be demanded is not the one who made
the challenged action:
Must apply review to the time of the decision not to
review
Are they disinterested and independent now?
Aronson v. Lewis
o Demand will only be excused where facts are alleged with
particularity which create a reasonable doubt that the directors
action was entitled to BJR
Not enough to show interest that board would be
defendants in the lawsuit requested
Rales v. Blasband
o If seeking to avoid demand to a board that did not make the
challenged business decision, the BJR cannot apply to that
decision with respect to them
Must examine if they can impartially consider the merits of
the challenge without influence by improper considerations
Special Litigation Committees
Corporations often form a Special Litigation Committee (SLC) to
consider whether or not to move forward with a demanded lawsuit
o Thought to insulate the board from any interest that would
invalidate BJR
Two step analysis for reviewing SLC recommendation
o (1) The court should inquire into the independence and good
faith of the committee and the bases supporting its conclusions

Wade 28

o (2) The court should determine, applying its own independent

business judgment, whether the motion should be granted
Includes considering constituencies the board/SLC could
consider
Zapata Corp. v. Maldonado
o When reviewing an SLCs recommendation to the board, but be
weary of the inherent structural bias
Definition of Director Independence
Cleansing Context
o To prove a director is not independent, must show that he is
more willing to risk his reputation than his relationship with the
interested director he is beholden to
Highest burden to meet least skeptical
Demand Futility Context
o To prove a director is not independent, must show reasonable
doubt that he is more willing to risk his reputation than his
relationship with the interested director he is beholden to
Medium burden to meet less skeptical
SLC Context
o Independence turns on whether a director is, for any substantial
reason, incapable of making a decision with only the best
interests of the corporation in mind
Lower burden to meet more skeptical

Protecting and Selling Control

Basics of Acquiring Control

Mergers
o Bidder gives an offer to the target companys board
If approved by the board, will be submitted to the
shareholders for approval
If rejected by the board, will never be sent to the
shareholders for approval
Tender Offers
o Bidder gives an offer directly to the shareholders to purchase
their stock at a premium
If successful, will vote in a new board to approve a merger
o Common features of a tender offer
Conditioned on receiving a certain percentage of shares
Conditioned on the redemption of a poison pill
Opportunistically timed for when directors are up for
election
o Proxy Contests

Wade 29

Bidder will often engage in a preemptive proxy contest to

replace the board and redeem a pill before shareholders
tender to the bidder
Proxy rules apply
Takeover Defenses
o Poison Pill (Shareholder Rights Plan)
Upon the occurrence of a triggering event, shareholders
have the pro rata right to purchase a new series of stock at
a discount
Except the bidder thus dilutes their interest and
increases costs of obtaining control
o Staggered Board
In bylaws or articles, corporations can divide board into
classes that are voted in at different times
Increases the time required for a successful bidder to
take control of the target board
o DGCL 203. Business Combinations with Interested Stockholders
(a) Corporation shall not engage in any business
combination with an interested stockholder (15%) for 3
years following time they became interested stockholder,
unless:
Combination was approved before they became
interested;
Interested shareholder owns 85% of stock; or
Approved by at least 2/3 of the outstanding voting
stock not owned by interested stockholder
(b) Subsection (a) does not apply if articles say otherwise
Structural Coercion as a threat
o Board believes that the structure of the tender offer creates a
risk that shareholders will tender at an inadequate price
If offer is front loaded (for 50%), shareholders will tender so
that they are not left out to dry
Substantive Coercion as a threat
o Board believes companys strategic plan will deliver more value
than the premium offer, but stock market has not reflected that
Thus, risk that stockholders might tender in ignorance or
upon a mistaken belief
Judicial Review of Takeover Defenses
Proactive Defensive Measures
Defensive measures taken by the board prior to any threat are subject
to the business judgment rule
Defensive Measures in Response to a Threat

Wade 30

When defensive measures are taken in response to a threat to

corporate control, the board must meet the two-prong Unocal analysis
to receive BJR protections
o (1) They had reasonable grounds to believe that a danger to
corporate policy and effectiveness existed (and it was not in their
own self interest to remain in power); and
o (2) The defensive measure adopted was proportionate to the
threat posed
Directors may only take into account non-shareholder interests if doing
so provides some rationally related benefits for the shareholders
o If substantive coercion, defensive measures may only be utilized
for a limited time sufficient to ensure shareholders receive
information necessary to make an informed decision
Unocal Corp. v. Mesa Petroleum
o Board may consider any relevant constituency to the corporation
when determining if there is a threat to the corporation
Reasonable to repurchase stock from shareholders to
defeat a perceived threat to the corporation
Paramount Communications, Inc. v. Time, Inc.
o Unocal does not apply to defensive measures taken proactively
when entering the entertainment business
However, Unocal does apply to the maintenance of those
defensive measures once the threat appeared
o Can take intangible factors into account to determine if there
was a reasonable fear of threat
Air Products and Chemicals, Inc. v. Airgas, Inc.
o Threat of arbitragers selling at a price that the board reasonably
believes is inadequate is reasonable
Staggered board and poison pill are a proportionate
response to that threat
o Significant amount of deference to the board in determining what
is a reasonable response to a threat
Defensive Measures when the Corporation is Up For Sale
Once the sale of a corporation is inevitable, the interests of anyone
other than the shareholder may not be taken into account
o Regardless of presence of threat to corporate control
o Can only implement defensive measures designed to get
shareholders a higher price
Will be judged under a reasonableness standard
Corporation is up for sale when:
o There will be a break-up of the corporate entity
o There will be a change in control
Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.

Wade 31

o When corporation is up for sale, directors duty changes from

maintaining the company as a viable corporate entity to
maximizing shareholder benefit
Lyondell Chemical Co. v. Ryan
o Board is not up for sale unless the board itself takes action to
transfer control
Mere presence of bidders is not sufficient
Paramount Communications, Inc. v. Time, Inc.
o Revlon does not apply without evidence that the board would
lose control of the corporation
Paramount v. QVC
o Once competitive bidding begins that would cause a change in
corporate control, the target board must maximize shareholder
value
Cannot fail to critically examine the competing transactions
and negotiate with both bidders
Defensive Measures that Frustrate Shareholder Voting
There must be a compelling justification if defensive measure
adopted either:
o (1) With the primary purpose of impeding the effectiveness of a
shareholder vote for
The election of directors; or
A change in control
o (2) With the effect of precluding an effective shareholder vote
Is an effective shareholder vote realistically attainable?
Carmody v. Toll Brothers
o Dead hand provision accompanying a poison pill is preclusive
Compels shareholders who want fully functioning board to
vote for incumbent directors Makes proxy contest
realistically unattainable
Blasius Industries, Inc. v. Atlas Corp.
o Board needs a compelling justification to take measures
impeding the effective exercise of the shareholder vote
Unitrin Inc. v. American General
o Defensive measures giving the board an effective veto
percentage of shares upon the purchase of 15% by any bidder
was not preclusive
Bidder could wage a proxy war with 14.9% to get the
approval of remaining shareholders still realistically
attainable
Chesapeake Corporation v. Shore
o Defensive measure requiring supermajority vote (giving board a
veto) was preclusive, and there was no compelling justification

Wade 32

Clearly intended to impede the effectiveness of the

shareholder vote
Substantive coercion is not a compelling enough
justification
Mercier v. Inter-Tel, Inc.
o Suggestion Unocal is a better standard that Blasius when
reviewing defensive measures effecting the shareholder vote on
the election of directors or changes in corporate control
o Applying Law The defensive responses postponing date of
vote are not preclusive or coercive, thus Unocal
Substantive coercion is a reasonable threat
Defensive measures postponing date of vote are
proportionate
Air Products and Chemicals, Inc. v. Airgas, Inc.
o Defensive measure is not preclusive if it is not reasonably
attainable to gain control in the short-term but is within two
years

Wade 33