Corporations

I.

II.

Introduction: The Separate Legal Entity

a. Solomon v. Solomon, England
i. When Solomon gave loan to the corp., he didnt give it to himself, though
he owned 99.4%; so he should be treated as any other creditor
b. Lee v. Lee, England
i. widow sued corp. that husband sole-owned for compensation for death in
work-related accident; court said widow gets compensation since there
was written employment agreement between Lee & the corp.
c. Agency problems
i. corporate law is trying to find system to minimize agency problems
ii. 3 types
1. shareholders & management
2. minority & majority shareholders
3. creditors & shareholder
iii. 2 causes
1. information gap between the principal & agent
2. conflict of interest between principal & agent
Limited Liability (LL)
a. Financial Effects
i. Features of the Corporation
1. Separation between ownership & control
2. Indefinite duration
3. Flexibility of shares (transfer, separate, etc.)
4. Limited Liability
a. shareholders not responsible for debts of corp.
ii. Expected return
1. weighted average (based on probability) of all possible outcomes
iii. Risk
1. probability that actual return different from expected return, and by
how much
a. usually expressed as a bell curve
2. greater the range of possible outcomes, greater the risk
3. finance assumes investors are risk averse
4. LL provides incentive for corp. to take risks
iv. risk premium
1. compensation investors require for assuming risk
b. Agency cost of debt
i. LL imposes externality on involuntary creditor (tort victim)
1. when LL externalizes risk on innocent person & courts decide it
was abused, courts take it away piercing the corporate veil
ii. LL turns share into homogenous product
iii. without LL, identity of shareholder would matter (rich risk more)
1. would make stock market less efficient
iv. LL lets investors share risk over much larger pool

III.

Protection of Creditors
a. Piercing the Corporate Veil
i. Sea-Land Services, Inc. v. Pepper Source, 7th Cir., 1991, p. 242
1. Pepper Source stiffed SL on the freight bill; SL said PS and other
corp. just alter egos of Marchese, asked for reverse piercing to
go after Marchese & all other subsidiaries
2. Van Dorn test, 2 requirements
a. unity of interest or ownership
i. fail to maintain adequate corp. records/formalities
ii. commingling of assets
iii. undercapitalization
iv. treating assets as its/his own
b. adherence to fiction of separate corp. existence would
either sanction a fraud or promote injustice (bad purpose)
i. after remand, court says unjust enrichment here
ii. showed nexus between injury & fraud here, he
purposely made sure there wouldnt be enough $
3. reverse piercing sued other corps. as well as Marchese so that
they could become creditors, jump ahead of other creditors in line
ii. Kinney Shoe Corp. v. Polan, 4th Cir., 1991, p. 248
1. Industrial stiffed Kinney on sublease payment, Polan owned Ind.
but didnt put in any capital, Ind. had no assets, filed bankruptcy
2. Added 3rd prong to test, was it reasonable for sophisticated
investor to know about undercapitalization? if so, no piercing
a. permissive, not mandatory requirement for contract cases
i. why protect large creditors
b. if you have no capitalization at all, you wont get
protection from this 3rd prong
3. here, inadequate capitalization used to satisfy 2nd & 3rd prongs
b. Inadequate Capitalization (IC) & Enterprise Theory
i. 2 types
1. no investment shareholders invest minimal amount
2. high leverage companies put in small equity & large debt
a. increases expected return, but also risk
b. for sophisticated creditors, this is ok because theyll
correctly determine amount of risk & price accordingly
ii. doctrine of inadequate capitalization protects non-sophisticated creditors
& tort creditors
iii. Minton v. Cavaney, CA, 1961, p. 238
1. girl drowns in pool owned by corp., tries to enforce judgment
against corp. against shareholder who wasnt orig. party, loses
2. must give shareholder chance to relitigate, has more incentive than
the corp. w/ no assets to challenge the tort claim
3. instances when you can pierce the corporate veil
a. commingling of assets (Van Dorn alter ego test)
b. when shareholders guarantee the debt

i. can also do this through contract/tort law

c. when theres IC & shareholders participate in management
i. effectively limits to closely held corps.
ii. IC not alone enough when piercing to get to human
whos not shareholder participating in management
iv. Slottow v. Fidelity Federal Bank, 9th Cir. (CA), 1993, p. 240
1. in CA, IC of subsidiary alone enough to pierce to get to parent co.
v. Arnold v. Browne, CA, 1972, p. 240
1. IC alone doesnt require piercing, just an element to meet prongs
vi. Truckweld Equipment v. Olson, WA, 1980, p. 241
1. IC alone not enough if its due to financial difficulties
vii. Radaszewski v. Telecom Corp., 8th Cir., 1992, p. 241
1. if theres some type of insurance, subordinated loan, etc., then
theres no inadequate capitalization capital neednt be equity
viii. Enterprise Liability Theory (EL)
1. Fletcher v. Atex, 2nd Cir. (DE), 1995, p. 220
a. Atex wholly owned sub. of Kodak (sole shareholder), sold
all assets to independent 3rd party & changed its name
b. court says theyre not in fact one company
i. cash mgmt. system (move to parent) doesnt create
alter ego liability
ii. Kodak lacked sufficient influence over Atex
1. needed to show sub. promoting parents
interest or other informal intervention
2. Walkovszky v. Carlton, NY, 1966, p. 226
a. cab co. has many subs, each owning 1 or 2 cabs, 1 hits man
b. under EL, court says need to show that various entities are
the same in terms of accounting, etc, then can access the
assets of all the entities
i. doesnt work here, since subs. have no $
c. court suggests agency theory, need to show person using
corp. for personal business outside corps scope of business
i. once proven for 1 shareholder, get all others since
theyre liable for the actions of their rep.
ii. need agent acting w/in authority given by principal
iii. here shareholder principal, company agent
d. couldnt pierce here cause tough to prove unity of interest
e. also no IC since they had min. insurance
c. Equitable Subordination, Fraudulent Transfers, Legal Capital & Dividends
i. equitable subordination in bankruptcy, claims of controlling shareholder
may be subordinated to claims of others
1. unlike piercing, not liable for all debts, only money needed to be
given as loan to have adequate capitalization
2. Gannett Co. v. Larry, 2nd Cir., 1955, p. 259
a. Gannett bought corp., used as supplier, didnt try to make $
b. court subordinated Gannetts claim to other creditors

3. Arnold v. Phillips, 5th Cir., 1941, p. 260

a. Arnold started brewing co. w/ little $, gave loan to have
enough capital to start operations, then later more loans
b. court subordinated 1st loan, but not 2nd
i. 1st loan = capital, otherwise not enough $ to start up
ii. 2nd loan given to avoid financial difficulties
4. Benjamin v. Diamond, 5th Cir., 1977, p. 261
a. 3 conditions for equitable subordination
i. claimant must have engaged in some type of
inequitable conduct
ii. misconduct resulted in injury to creditors or
conferred unfair advantage on claimant
iii. not inconsistent w/ provisions of Bankruptcy Act
ii. Fraudulent Transfers, Legal Capital & Dividends
1. did shareholders get something of value w/o paying for it w/ value
2. par value amount written on share when issued
a. formerly couldnt sell share for price lower than this
b. now, statutes allow corp. to issue shares w/ $0 par value or
change par value
3. paid-in surplus/capital amount share sold for above par value
4. reduction surplus/capital amount par value is lowered
5. earned surplus total profit earnings minus total distributions
6. capital surplus part of surplus from sources besides stated capital
7. stated/legal capital stockholders permanent investment in corp.
a. par value of stock
b. any additional part added by the board
c. supposed to protect creditors because you cant make share
distribution below legal capital
d. also cannot make distribution below insolvency
requirement from UFTA and Bankruptcy Act
8. insolvency
a. liabilities in excess of assets, OR
b. inability to pay debts as they come due
9. Capital Impairment Statute: whether assets > liabilities + capital
a. can distribute from paid-in capital unless mgmt. says no
10. Earned-Surplus Statute: looks at accumulated profits
a. can distribute dividends only on profits, not paid-in capital
b. cant distribute from paid in capital unless mgmt. says ok
11. Difference between Two Tests for legal capital: whether or not you
need board resolution to distribute to the point of legal capital
12. Substantive test for fraudulent conveyance
a. should not take any action that will bring you into
insolvency in sense of ability to pay bills as they come due
b. this is true protection for creditors, not legal capital test,
unless somehow thats set higher than this test
13. Klang v. Smiths Food & Drug Centers, DE, 1997, p. 1250

IV.

a. shareholders claim SFDs repurchase plan violated

minimum capital requirements
b. court finds that the statute doesnt require particular method
of calculating surplus
c. court will defer to boards judgment & allow corp. to make
distribution beyond what balance sheet says it can
i. lets board revalue to reflect economic reality
d. burden of proof on plaintiff to show that directors failed to
fulfill their duty to evaluate the assets on the basis of
acceptable data and by standards which they are entitled to
believe reasonably reflect present values
e. basically chooses true econ. value over balance sheet value
f. governs both payment of dividends & repurchases
14. Liability of directors for improper dividends governed by state law
15. Liability of shareholder for improper dividends
a. common law if solvent & receive in good faith, not liable
b. statutory rules
i. corp. statutes
ii. Uniform Fraudulent Transfer Act
iii. Bankruptcy Law
16. Financial limitations on corp. repurchases of its own stock
generally the same as for dividends
a. most statutes allow repurchase for certain purposes
i. eliminating fractional shares
ii. compromising shareholders indebtedness to corp.
iii. paying dissenting shareholders
iv. redeeming or purchasing redeemable stock
The Corporate Form & The Capital Structure
a. Articles of Incorporation (Charter)
i. Name of Corporation
ii. Maximum amount for which corporation is authorized to issue shares
iii. Registered Agent of the corporation
iv. Incorporators
v. Statement of purpose
vi. Directors & Officers
vii. Any other special arrangements
b. Procedure for change
i. Board of directors recommends change
ii. Shareholders approve DE need majority of those entitled to vote
iii. Changes must be filed
c. First meeting elect board of directors & adopt by-laws
d. Changing by-laws
i. in DE, shareholders can change, Board can also change if charter permits
e. Hierarchy
i. State Law Articles of Incorporation By-Laws
f. Modes of Corporate Finance (through either debt or equity)

V.

i. Common stock equity interests in the corporation, voting rights, right to

dividends, right to whatever is left after liquidation
ii. Debt - fixed claim against the corp.
iii. Preferred Stock last in line of all creditors, before common shares in
dividends & liquidation rights; right to fixed dividend, corp. cannot pay
any $ to common shares until they pay fixed div., usually no vote
1. cumulative every year you dont pay preferred div., becomes
debt that must be paid before any div. is paid to common shares
2. participating get regular div. in addition to fixed div.
g. Debt
i. Types
1. secured debt
2. floating charge over assets of corp.
ii. call option gives you right to buy specific asset on a pre-determined date
for a pre-determined price (exercise or strike price)
1. warrants when exercised, company must issue a new share
2. rights options issued only to existing shareholders when stock
price is above strike price
iii. put option right to sell something at pre-specified price & time
iv. convertible bond call option to exchange bond for shares
The Voting System
a. Allocation of Legal Powers
i. Board created to deal with agency problem between mgmt. & shareholders
ii. Charlestown Boot & Shoe Co. v. Dunsmore, NH, 1880, p. 167
1. directors manage the business
2. protects minority interests through fid. duties
iii. shareholders can fire directors
1. anytime for cause
2. in DE, 141(k) interpreted to mean you can fire w/o cause
a. exception is classified (staggered) board
iv. board cant fire directors w/o statutory authority
v. directors independent, but officers must obey shareholders
vi. Schnell v. Chris-Craft, DE, 1971, p. 169
1. board tried to move up date of shareholder meeting to prevent
shareholders from winning proxy fight, court says no
a. cannot interfere w/ the process
vii. Blasius Industries v. Atlas Corp., De, 1988, p. 171
1. directors tried to block largest shareholders bid to take control by
adding 8 new members of his choice to 7 member board by adding
2 more members themselves
2. court said even if acting w/ good faith, must let shareholder decide
3. set standard of review for board attempts to frustrate allocation of
powers between shareholders & board compelling justification
a. this is intermediate standard between BJR & entire fairness
viii. Condec Corp. v. Lunkenheimer Co., DE, 1967, p. 179

VI.

1. cant issue shares for improper purpose, including taking voting

control from others
ix. Stroud v. Grace, DE, 1992, p. 181
1. Blasius doesnt apply because shareholders approved
2. Blasius only applies when interference w/ voting mechanism is
achieved by direct actions of directors
x. shareholder must have right to fire dir., cant change in charter or by-laws
xi. shareholders need director approval to change charter
xii. either can change by-laws
xiii. directors appointed by shareholders, unless to fill vacancy
xiv. cumulative voting allows minority SH to pool votes to elect bd. member
b. Proxy Rules
i. Proxy voting is governed by 14(a) of Securities Exchange Act
ii. SEC rule 14a-2 says rules apply to any solicitation of less than 10 people
iii. Rule 14a-3 requires certain information be included in the proxy statement
iv. Rule 14a-9 says no statement that is false or misleading re: a material fact
v. J.I. Case v. Borak, SCOTUS, 1964, p. 291
1. shareholder can bring private action for proxy violation
2. implied cause of action, not explicitly in fed. law or proxy rules
vi. Mills v. Electric Auto-Lite Co., SCOTUS, 1970, p. 292
1. proposed merger, claimed proxy was misleading because it failed
to mention that all the directors recommending approval were
nominated by other company in merger
2. must show there was a material misrepresentation
3. dont need to show causation, only that proxy was an essential link
in the process that led to the decision
a. need to show that in reality you need a majority of votes
from the process
4. only get attorneys fees if theres substantial benefit to SH
vii. TSC Industries v. Northway, Inc., SCOTUS, 1976, p. 298
1. test for materiality is substantial likelihood that a reasonable
shareholder would consider it important in deciding how to vote
viii. Virginia Bankshares, Inc. v. Sandberg, SCOTUS, 1991, p. 300
1. implied cause of action applies to misstatements that are opinion
2. no recovery here since they didnt need votes from minority
3. if majority has enough votes, minority still has state law claim
ix. Wilson v. Great American Industries Ps action not barred if they lost
appraisal right or some other state remedy through Ds false statements
x. Shidler requires fault for liability in 14(a) actions
xi. Gerstle says negligence is sufficient for liability under rule 14a-9
xii. Reimbursement rules
1. Rosenfeld, p. 327 get reimbursement for policy issues for
reasonable expenses, but not personal issues (fight for control)
2. incumbents get reimbursement whether they win or lose
3. insurgents only if they in & w/ approval of shareholders
To Whom Do Fiduciary Duties Run

VII.

a. Dodge v. Ford Motor Co., SCOTUS, 1919, p. 139

i. Ford tries to stop div. payments to cut cost of cars to consumers
ii. corps primary purpose is to benefit stockholders, board cant take action
w/ primary purpose of benefiting others & only incidental benefit to SH
b. A.P. Smith Manufacturing v. Barlow, NJ, 1953, p. 141
i. board tried to donate to Princeton, SH objected, claimed ultra vires
ii. court said w/in corp. power to donate to private U under common law &
NJ statutory law
1. common law donation must benefit corp., but rule is applied so
that benefit can be indirect
2. NJ law says can give to schools as long as institution doesnt own
over 10% of corp. & $ not more than 1% of capital and surplus
c. most states have statutes that donation must be reasonable in light of corps
financial condition & be reasonably related to corps interests
d. other constituencies
i. Unocal, p. 148 bd. can block takeover (& consider other groups besides
SH), but actions must be reasonable in relation to the threat posed
ii. Revlon, p. 149 bd. can concern w/ various corp. constituencies, but for
any action must be some rationally related benefit accruing to SH
iii. Katz, p. 149 directors must max. long term interests of SH, this may
sometimes come at the expense of others, but thats not breach of fid. duty
iv. Credit Lyonnais, p. 150 near bankruptcy, directors have duty not only to
SH, but also to general corp. enterprise (take into account creditors)
Duty of Care
a. Basic Standard
i. Francis v. United Jersey Bank, NJ, 1981, p. 520
1. good director should prevent misappropriation of trust funds by
other directors be informed & monitor other directors
2. standard of care is gross negligence
a. facts need to show complete avoidance of all duties
3. duty to creditors once you file for bankruptcy
4. higher duty of care when managing financial institution
ii. Barnes v. Andrews, NY, 1924, p. 533 need to show causation for
business omissions, would business have succeeded if directory went to
meetings & participated in business
iii. Aronson v. Lewis, DE, 1984, p. 532 standard is gross negligence,
directors have a duty to inform themselves
iv. Kamin v. American Express, NY, 1976, p. 536
1. question of whether to declare a dividend is a matter of business
judgment for board of directors
2. Business Judgment Rule defer to decision of board unless its
shown that board acted w/ fraudulent motive or in own interests
a. limit of BJR is rational business strategy did they think
v. Smith v. Van Gorkom, DE, 1985, p. 549
1. directors approved cash out merger after CEOs short presentation
2. court said it was not informed decision (grossly negligent)

a. relied on CFOs price determination for leveraged buyout

b. didnt try to learn true value, get written documentation, etc
3. to rely on report, must believe person giving it is qualified to do so
4. so directors did not get protection of BJR
vi. DGCL 102(b)(7) response to concerns over director liability
1. applies to duty of care violations that are negligent or possibly
grossly negligent
2. no monetary damages, but can get nonmonetary damages
vii. Brane v. Roth, IN, 1992, p. 567
1. directors of grain co-op didnt buy insurance against price changes
2. no BJR, didnt make any meaningful attempt to be informed
3. 2 questions
a. is decision w/in business of firm
b. if w/in scope of business, do you have duty to consider it
viii. Parnes v. Bally Entertainment, DE, 1999, p. 567
1. board cannot accede to directors demand for a bribe is irrational
ix. DE courts gradually developing new fid. duty good faith
1. if you violate good faith, you wont be saved by 102(b)(7)
b. The Business Judgment Rule
i. In re Caremark International, DE, 1996, p. 569
1. board has duty to at least consider installing some internal
monitoring mechanism in the corporation
2. under new fed. sentencing guidelines, exposure for liability so
high and exemptions from installing program so big that its
irrational not to even consider it
ii. corporate officers can be found liable to third parties for tortious acts
iii. Emerald Partners v. Berlin, DE, 1999 said that 102(b)(7) is a shield from
liability, but burden of proving good faith is on the defendant
iv. can also buy Directors & Officers Liability Insurance
v. Criminal liabilities of D&O 2 types of statutes
1. liable for unlawful corporate acts if manager themselves performed
or caused performance of the act People v. Film Recovery System
2. liable for unlawful employee acts over whom they have power of
control U.S. v. Park, p. 597
vi. Malpiede v. Townson, DE, 2001, Supp. 70
1. shareholders upset the board didnt put in a poison pill
2. court held 102(b)(7) applied & dismissed SHs due care claim
vii. McCall v. Scott, 6th Cir., 2001, Supp. 78
1. duty of care claims can arise when:
a. ill-advised board decision resulted in a loss
b. due attention would have prevented loss
2. duty of care claims based on recklessness or intentional
misconduct are not barred by 102(b)(7)
viii. if its a normal business decision, courts tend to use abstention rule (BJR)
ix. if its substantial decision, like selling corp., courts tend to show less
deference to boards decision, use gross negligence standard of review

VIII.

x. corp. can indemnify directors with no limitations against 3rd party suits
xi. corp. can indemnify board in SH suit when they win
1. when they lose, depends on if they acted in good faith, etc.
Duty of Loyalty
a. conflicts of interest that result in some taking are violation of duty of loyalty
b. to be conflicted director, general rule is financial benefit
i. family relationships may also qualify
ii. Sarbanes-Oxley has made test stricter, may go beyond initial family
c. Self Dealing
i. Lewis v. S.L.&E., Inc., 2nd Cir., 1980, p. 602
1. 2 closely held corps, same directors but not same shareholders
2. burden shifts to directors to show transaction was fair & reasonable
a. bring in experts & look at what appropriate price would be
b. show that the price was fair equal to market price
i. also show it was in corps best interests
1. Fill Buildings, MI, 1976, p. 620
3. traditional remedies are rescission/restitution
a. difference between actual lease price and market price
ii. Cookies Food Products, IA, 1988, p. 622
1. IA safe harbor law has 3 provisions that allow a director to engage
in self-dealing w/o clearly violating duty of loyalty
a. disclosure & approval by disinterested directors
b. disclosure & approval by shareholders
c. contract is fair & reasonable to corp. this is required
2. here, court said deal was ok, approved by disinterested directors
a. company had made such huge profit, maybe hes worth it
3. DE courts would require shareholders to be disinterested as well
a. DGCL 144
iii. Cooke v. Oolie, DE, 2000, Supp. 84
1. if conflicted party is controlling owner & disinterested board
approves, then entire fairness w/ burden shift to P to prove unfair

Across: Conflicting Party

Down: Procedure for Approval

Director/Officer

Controlling Owner

Disinterested Board
Disinterested Shareholders
None

BJR/Waste
Waste
Fairness

Fairness & shift burden to P

Fairness & shift burden to P
Fairness

d. Waste, Compensation, Ratification

i. waste means that no rational person would agree to such a transaction,
essentially its a gift
ii. Harbor Finance Partners v. Huizenga, DE, 1999, Supp. 92
1. Vice chancellor takes issue with the rule that if a waste claim is
adequately plead & proven, then ratification has no effect
a. thinks courts should trust shareholders
b. there are enough protections given already
c. waste test should be satisfied by majority approval

2. waste test could any person of sound business judgment view the
transaction as fair
iii. Lewis v. Vogelstein, DE, 1997, p. 638
1. granted stock options to directors w/ exercise price = market price
2. unanimous shareholder vote required to approve waste
3. waste is exchange of corporate assets for no consideration
a. Sanders v. Computer Associates, DE, p. 652
4. so in DE, compensation must be so extreme to be a gift before the
court will intervene
a. this is conditioned on getting majority of minority SH
support or disinterested board approving compensation
e. Corporate Opportunity
i. Hawaiian International Finance v. Pablo, HI, 1971, p. 670
1. Pablo working for HIF to buy land in CA, took split of sellers
commission for himself & his realty corp. (Pablo Realty)
2. court ordered him & his corp. to pay back commission
a. why did Pablo Realty have to pay it back?
i. perhaps piercing corp. veil
ii. perhaps breach of fid. duty to 3rd party
ii. Broz v. Cellular Information Systems, DE, 1996, p. 687
1. 4 part test for corp. opportunity
a. is opportunity in corporations line of business
b. is corporation financially able to take advantage of opp.
c. does the corp. have an interest or expectancy in the opp.
i. interest is a clear case that you took something from
the corporation
ii. expectancy is less strong, you didnt take it, but
they mightve expected theyd get thing you got
d. by taking opp. for himself, will fiduciary be placed in a
conflicted position re: his duties to the corporation
2. corollary director may take opportunity if:
a. its presented to director in his indiv. & not corp. capacity
b. opportunity is not essential to the corporation
c. corporation holds no interest or expectancy in the opp.
d. director/officer hasnt wrongfully employed any resources
of the corporation in pursuing the opportunity
3. in DE, director/officer decides whether its a corporate opportunity
a. if its not, then no need to inform the board
i. take risk that theyll later be challenged & lose
b. if it is a corp. opportunity, then need to
i. get regular approval & burden on D/O to show that
its fair, OR
ii. get disinterested director/shareholder approval
1. standard will be then be waste
a. giving up opp. not necessarily waste
b. involves risk/reward

c. might also be kind of compensation

to encourage D/O to find opp. &
bring them to the board
4. if disclosed & both want it, unclear what the standard should be
DE Corp. Opportunity
Disinterested Director

Director/Officer
BJR/waste

Disinterested
Shareholder
None

Waste
Entire fairness

Controlling Owner
Entire fairness + shift
of burden to Plaintiff
Entire fairness + shift
of burden to Plaintiff
entire fairness

iii. Northeast Harbor Golf Club v. Harris, ME, 1995, p. 673

1. prez. of golf club buys surrounding land w/o telling bd. until later
2. ALI test
a. 2 alternatives
i. when D/O first becomes aware of opp. as director or
from corporate information
ii. if officer knows opportunity closely related to corp.
b. then disclose to board
c. if opportunity is rejected by board,
i. must be fair, OR
1. entire fairness, burden on director
ii. must be rejected by disinterested directors or
shareholders in a way that satisfies BJR
1. entire fairness, burden on Plaintiffs
2. to satisfy BJR
a. decision must be fully informed &
made in good faith
b. this then shifts burden, but standard
after burden shift is entire fairness
d. under this test, want board, not director, to decide if it is a
business opportunity
iv. when you sue disinterested director who approved transaction
1. lose any benefit of appropriate approval, move to None column
2. find if approval was breach of duty of care of duty of loyalty
3. if duty of care, may be protected by 102(b)(7)
a. to get by this, must show that breach was in bad faith
4. if duty of loyalty, then director will have to show that transaction
to which he wasnt a part was entirely fair
f. Controlling Shareholder
i. who has control
1. if shareholder has more than 50%
2. if <50%, look to facts to see if he actually dominated the decisions
ii. Zahn v. Transamerica Corp., 3rd Cir., 1947, p. 697

iii.

iv.
v.

vi.

vii.

1. board dominated by class B shareholder voted to call class A

shares, leaving B w/ all value when corp. liquidated & providing
windfall for controlling shareholder Transamerica
2. court claimed there was a breach of fid. duty, but was really a duty
to disclose to provide class A w/ info. to decide whether to convert
a. here, duty to disclose came form contract law
Lynch v. Vickers Energy Corp., DE, 1977, p. 704
1. majority SH had obligation to disclose all information germane to
the transaction at issue when dealing w/ minority
a. anything a reasonable SH would deem important in
deciding whether to sell or retain stock
b. must be complete disclosure, not adequate
Rosenblatt v. Getty Oil, DE, 1985, p. 705
1. material facts substituted for germane
a. underlying concept still the same
Shell Petroleum v. Smith, DE, 1992, p. 706
1. controlling owner decided to merge Shell w/ SPNV; computer
error understated Shells discounted future earnings
2. court said though small, still material
a. doesnt matter if it wouldve changed SH mind, only that it
would have been relevant
Kahn v. Tremont Corp., DE, 1997, p. 713
1. court said using Special Committee to evaluate sale offer did not
shift burden here because it didnt function truly independently
a. all 3 members had connections to controlling owner
2. standard is always entire fairness; can never remove underlying
threat of impropriety
3. can shift burden by using Special Committee
a. must be truly independent
b. must be fully informed & simulate arms length transaction
4. 2 elements of fairness
a. fair dealing
i. focuses on conduct of corp. fiduciaries in
effectuating the transaction
b. fair price
i. economic & financial considerations relied on when
valuing proposed purchase price
Kahn v. Lynch Comm. Systems, Inc., DE, 1994, Supp. 118
1. Alcatel owned 43% of Lynch, when Lynch tried to merge w/ Telco
to get fiber optics, Alcatel refused & pushed merger w/ sub. of
Alcatels parent corp.; when independent committee said no,
Alcatel offered to merge w/ Lynch; director of independent
committee said Alcatel said theyd do hostile takeover if
committee didnt ok price they really thought was too low
2. court said Alcatel controlling shareholder even though it wasnt
majority

a. needed to show facts that controlling owner actually

exercised power given to it by large stake
3. court refused to shift burden committee lost ability to simulate
arms length when they caved to Alcatels demand
viii. Levco Alternative Fund v. Readers Digest, DE, 2002, Supp. 134
1. court said independent committee was flawed
a. didnt look at if transaction fair to Class A
b. clear that Class A suffered at expense of rest of corp.
c. concerned payment to Class B would reduce equity of corp.
2. when deciding who gets what allocation of econ. and voting rights,
this is division of 2 competing groups & role of board to make
decision in a fair manner
3. here there was no clear division of who is last in line, A or B, so
unclear ranking in rights & fiduciary duty runs to all
ix. Goshens Paper
1. 2 Types of Protections for Entitlements
a. Property rule allows only consensual transactions
i. value dependent on subjective evaluation
1. so seller asks for higher price
ii. main cost is negotiation cost
iii. adjudication cost to supervise process of negotiation
iv. majority of the minority rule is liability rule
b. Liability rule majority can force transaction on minority,
but only after paying compensation & subject to challenge
i. value dependent on objective evaluation
ii. main cost is adjudication cost of relying on courts
1. but courts could be wrong
iii. negotiation cost if parties try to guess what court
will say
iv. fairness test is liability rule
2. which rule to apply depends on quality of courts, sophistication of
investors, and transaction costs
3. DE uses liability rule w/ entire fairness
a. demonstrate fair dealing & fair price
b. burden shifts w/ majority of minority approval of
controlling shareholder self dealing
c. when interested party is D/O, standard is BJR
d. DE courts have unique expertise in appraising values
e. theres an active market for corporate control
i. challenges inefficiency w/ takeover threat
f. efficient cap. market w/ sophisticated institutional investors
g. community sensitive to reputation
h. by making self dealing contingent on minority approval, it
gives minority bargaining power
i. controlling indiv. will pay premium for burden shift
i. court prefers to shift from liability rule to property rule

i. does this via burden shift

IX.

Transactions in Control
a. Zeitlin v. Hanson Holdings, NY, 1979, p. 736
i. SH sold controlling block for price including premium, minority objected
ii. court says premium reflects ability to direct actions of the corp.; this is ok
absent looting, corp. opportunity, fraud or other act of bad faith
b. Gerdes v. Reynolds, NY 1941, p. 740
i. classic case of control sold to looter
ii. controlling owner (CO) had no actual knowledge of buyer being potential
looter, so not liable; but directors had duty to investigate buyer
iii. if someone willing to overpay that much, price should trigger some type of
warning sign red flag and directors need to investigate
iv. here, no BJR cause directors were also controlling shareholder
v. even w/o conflict, when selling control of court, BJR a bit tougher (see
Van Gorkum), court wants you to invest more effort for major decision
c. Harris v. Carter, DE, 1990, p. 747
i. CO has duty of care to minority to investigate when theres a red flag
1. normally, just due diligence
a. like In re Caremark
d. Perlman v. Feldmann, 2nd Cir., 1955, p. 750
i. CO sold not only control, but also corporate opportunity; price reflects
part of corp. asset sold, but money only went to Feldmann
ii. rule when CO appropriated some asset of corp. & thats reflected in the
premium, he cant take this part of premium for himself, must give it back
iii. US rule that if all is ok, premium goes to seller this is exception to rule
e. Brecher v. Gregg, NY, 1975, p. 755
i. if selling shares that carry control, thats ok, but its illegal to sell office
1. cant commit to transfer control through resignation of directors if
the block of shares being sold does not carry control
ii. here, only Gregg liable, other directors fired buyer when they discovered
he was not a good person to be on the board
iii. below 10%, presumption by the court you cant commit contractually to
sell control of the corporation
f. Essex Universal Corp. v. Yates, 2nd Cir., 1962, p. 758
i. illegal to sell corporate title or office w/ nothing else
1. must sell some stock as well
ii. if you have >50%, then as part of sale you an commit to appoint
representatives of the buyer to the board
1. election would be a mere formality here
iii. Lombards rule if you have <50%, reach factual issue of whether you
have operating control before you decide if its ok to accelerate transfer of
control & make promise as part of deal
1. must be practical certainty youd win election to have op. control
2. court will decide if you have operating control
iv. Friendlys rule
1. doesnt think court can adequately decide when theres op. control

X.

2. if you think minority holding gives control, then have an election

to show that you have control
v. here, couldnt have an election cause it was classified board, wouldve
needed board approval to change charter & fire all directors
1. supports Friendlys rule that buyers werent sure they really had
enough of a controlling block to have operating control
g. Directors have duty of care & loyalty
i. BJR w/ tightened standard for transactions involving sale or transfer
h. duty of care & loyalty on controlling owner
i. duty of care only if theres something suspicious to make you investigate
Mergers & Acquisitions
a. Legal & Business Structure (see M&A chart)
i. Asset acquisition
1. A pays in cash or shares for all assets of T; get all assets but only
liabilities you agree to take
2. some courts say this is de facto merger, protect Ts creditors and
say T can sue A but not in DE
3. usually 2nd step is that T takes cash/shares, distributes as
dividends, & dissolves
4. T gets vote, absolute majority, A gets no vote unless 20% stock
exchange rule
a. absolute = majority of all votes that could be cast
5. no appraisal rights
ii. Share acquisition
1. A makes tender offer to shareholders of T for shares of T; T
becomes subsidiary of A since A owns shares of T, if T gets paid in
shares, then T shareholders become shareholders of A
2. get liabilities, but theyre contained w/in T
3. no voting/appraisal rights
4. can also approach T directly, make offer to get them to issue new
shares of T; then need to get shares from other direct shareholders
of T somehow, like repurchase
a. if T issues stock that increases outstanding shares by more
than 20%, will need simple majority vote
b. simple = majority of votes actually cast
5. also share exchange, if T shareholders approve, all shareholders of
T must tender shares to A
a. end is the same, T becomes subsidiary
iii. Merger
1. after board and SH approval, by operation of law all assets &
liabilities of T are transferred to A, compensation goes to T
shareholders, T is dissolved
2. A & T can also merge into new corp., both will disappear called
consolidation, is not very popular
3. T & A shareholders get appraisal rights

iv.

v.

vi.

vii.
viii.
ix.

x.
xi.

xii.
xiii.

xiv.

a. DGCL 262(b)(1) exception, when publicly traded

corporations merge stock for stock (or when T gets tradable
stock), then no appraisal rights
Small Scale merger
1. big A buys little T
2. if no changes of the charter, original shares are not changed, and
payment for shareholders of T is not more than 20%, then you can
merge w/o A getting voting or appraisal rights
Short-form merger (Cashout)
1. A owns at least 90% of shares of subsidiary T, As board can decide
to merge sub. into holding company; no voting rights for public or
for Ts shareholders
2. Ts shareholders get appraisal rights
Triangular merger
1. A creates sub S that it owns 100%, transfers payment to S, S
holding shares of A, S & T sign merger agreement, shares of A
move to public, assets & liabilities of T move into S, T dissolves
2. A shareholders get no voting/appraisal rights
Reverse Triangular Merger
1. same procedure, but T survives instead of S
2. keep name of corp. being bought, goodwill, recognition, etc.
Stock exchange rules mandate that if A issues more than 20% of its shares
to complete merger, then As shareholders get to vote simple majority
Katz v. Bregman, DE, 1981, p. 1064
1. if sale of assets is quantitatively vital to operations of the corp. & is
out of the course of ordinary business & substantially affects the
existence and purpose of the corp., then it is beyond the power of
the board of directors so shareholders would have to approve
2. DGCL 271
Thorp v. CERBCO, DE, 1996, p. 1068
1. sale of only profitable subsidiary (of 3) that accounted for 68% of
CERBCOs assets is sale of substantially all assets
Valuation of appraisal rights
1. used to use block system based on an average of earnings,
assets, market price
2. now use discounted cash flow how much will corp. make in the
future discounted to present value
Hariton v. Arco Electronics, DE, 1963, p. 1081
1. stock for assets combo circumvented requirements of a merger,
court said this was ok
Farris v. Glen Alden Corp., PA, 1958, p. 1084
1. court decides its de facto merger, so Ts SH get appraisal rights
2. look to actual consequences, not form of the agreement
3. not followed in DE
Terry v. Penn Central Corp., 3rd Cir., 1981, p. 1094
1. reversed Farris, no de facto merger in PA, no appraisal rights

XI.

xv. Weinberger v. UOP, DE, 1983, p. 1110

1. conflicted transaction freezeout merge
2. plaintiff challenging cash-out merger must allege specific acts of
fraud, misrepresentation, or other misconduct to invoke fairness
test; burden then on majority shareholder to show fairness
3. but when transaction approved by informed vote of majority of
minority, burden shifts entirely to plaintiff
4. to get shift, burden on majority shareholder to show he completely
disclosed all material facts relevant to the transaction
a. here, approval wasnt fair, so no burden shift
b. need to simulate arms length transaction & negotiations
between 2 independent boards, approval of disinterested
directors
c. board must actually have freedom to say no
5. remedy in cash-out is appraisal
6. court said dont have to use block valuation method for appraisal
xvi. Leader v. Hycor, MA, 1985, p. 1071
1. distinguishes Weinberger, block method doesnt have to be used,
but may be used
xvii. In re Valuation of Common Stock of McCloon Oil, ME, 1991, p. 1071
1. follows DE, dissenting shareholders proportional part should not
be discounted due to minority status when setting appraisal value
xviii. Sterling v. Mayflower, DE, 1952, p. 1101
1. conflicted merger, standard is entire fairness w/ burden on
conflicted party
2. here, court found terms fair
a. in share exchange, liquidation value not the measure, but
all relevant factors must be considered in setting value
xix. in DE, dont need business purpose for freeze-out
1. in MA, you do, see Coggins v. Patriots, 1986, p. 1126
xx. Leveraged Buyout A uses assets of T to secure debt used to purchase T
xxi. Management Buyout same as LBO, but management of T is buying T
Public Contest for Corporate Control
a. Williams Act or 1967 adds 13(d), 13(e), 14(d), 14(e), 14(f) to Sec. Ex. Act
i. regulates tender offers
ii. 13(d) if you buy >5%, must disclose who you are, what your plans are,
etc. w/in 10 days
1. 10-day window is used to buy as much as possible so that by end
of 10 days, really end up w/ 10-15% of the shares
2. Rule 13d-2 material changes must be updated
iii. 13(d), 14(d) Disclosure
1. must give all relevant details if you make tender offer
a. who you are, what are your finances, etc.
iv. 14(e) Antifraud
1. must be held open for at least 20 business days
2. must be open to all members of the class

b.

c.

d.

e.

3. must equal the highest price paid to anyone

4. no private acquisitions during tender offer
5. shareholders have right to w/draw after 60 days from when offer
was given if tender hasnt been accepted, can also w/draw any time
while offer is open
6. partial tender offer, bidder must accept all up to the stated
percentage on a pro rata basis
7. prohibits material misstatements, omissions, fraudulent or
manipulative acts
8. Hanson Trust PLC, 2nd Cir., 1985, p. 1138
a. offer to buy stock is tender offer under Williams Act if
theres a likelihood that unless acts rules are followed,
theres substantial risk that solicited SH will lack info.
needed to make carefully considered appraisal of proposal
Unocal Corp. v. Mesa Petroleum Co., DE, 1985, p. 1140
i. 2 tiered, front loaded coercive offer, board tried to stop tender by doing a
self-tender for everyone but Mesa, this is defensive measure
ii. Before applying BJR, need to show that there is a threat to the corp. & that
the response taken is reasonable/proportionate to that threat
1. so this is intermediate test between BJR & entire fairness
2. Blasius is also intermediate test
a. there, directors interfering w/ allocation of power between
shareholders & directors
3. basically, anything will qualify as a threat say price is too low
a. reasonable is non-preclusive, non-draconian
4. board needs to make reasonable investigation into price & value of
the shares ask investment bank for price should get in the deal
5. court said it was ok to exclude the acquirer
Moran v. Household International, DE, 1985, p. 1151
i. board put in poison pill before tender offer Preferred Share Purchase
Rights Plan this is threat to dilute acquirer
ii. court said poison pill is legal, will be judged by Unocal standard when it is
inserted & also when you decide to leave it in or take it out
iii. court says poison pill is not preclusive can still wage proxy fight
Revlon, Inc. v. MacAndrews & Forbes Holdings, DE, 1985, p. 1160
i. once it becomes clear that there will be a change of control or break-up of
the corporation, board has obligation to shareholders to maximize the
value of the shares
1. must adopt procedures, often an auction, thatll max. value for SH
ii. so here, lock up option on crown jewels, no shop, early termination fee
were not ok because they didnt max. value
iii. also, here wasnt ok to put creditors interests above shareholders
iv. whether its breach of duty of loyalty or care depends on if theres conflict
of interest (then its loyalty)
v. removing poison pill signaled willingness by board to sell, triggered duties
Barkan v. Amsted Industries, DE, 1989, p. 11171

f.

g.

h.

i.

i. no duty to conduct an auction, even under Revlon

ii. need some procedure to show why sale price is max. price you can get
1. investment bankers good, but not replacement for true market test
iii. need some reasonable procedure to show that youre trying to max. price
Arnolde v. Society for Savings Bancorp, DE, 1994, p. 1174
i. Revlon duties when
1. corp. initiates bidding process to sell itself
2. in response to offer, corp. abandons long term strategy & seeks to
break up the corporation
3. theres a transaction whose outcome is sale or change in control
Paramount Communications v. Time, DE, 1989, p. 1174
i. Time has plans to merge w/ Warner, decides to conduct tender offer for
Warner when Paramount makes tender offer for Time for more $
ii. court said move to tender offer from reverse triangular merger was a
defensive measure
iii. applied Unocal, said theres threat to Time culture, fear that
shareholders will take more money in short term over long term value of
Warner deal
1. so basically, anythings a threat
iv. switch was reasonable because Time sticking w/ its long term plan
v. no Revlon duties because
1. no change of control, ownership still dispersed throughout market
this is chancery argument
2. this wasnt defensive since Time didnt change its course, simply
followed through w/ its original plan this is DE SC argument
a. not a change of control or a sale
vi. so really forces on SH transaction that causes them to lose nearly 100%
premium they wouldve gotten for their shares in exchange for future
hidden values & synergies
1. DE courts defer to board judgment on values
2. couldve applied Blasius, basically same standard
Paramount Communications v. QVC Network, DE, 1994, p. 1191
i. Paramount wants to merge w/ Viacom, puts in no shop, termination fee,
option that will let Viacom make money even if someone else takes over
ii. switched to 2 tier tender offer when QVC came w/ better offer
iii. when changing from structure of dispersed public ownership to one where
theres a controlling owner, this is change that triggers Revlon duties
iv. so board had duty then to seek max. price for shareholders
1. talk w/ QVC, get rid of no shop, poison pill, etc.
2. cant contract away fiduciary duties, so if Viacom tried to enforce
the earlier contract, it would be void & invalid
v. also wouldve triggered Revlon if they paid cash instead of stock, even if
both companies have dispersed public ownership
1. cash prevents acquired SH from sharing in any supposed synergies
Unitrin v. American General Corp., DE, 1995, p. 1211
i. applies Unocal to boards repurchase program in response to takeover bid

XII.

1. repurchase increased boards 23% share to 28%

2. but court said 23% likely wouldve let them block merger in a
proxy contest anyway
ii. defense measures likely to be draconian if preclusive or coercive
iii. basically, anything goes for management to block
j. Carmody v. Toll Brothers, DE, 1998, p. 1214
i. court says dead hand poison pill is illegal
1. only director who adopted it can remove it
k. Quickturn Design Systems v. Shapiro, DE, 1998, p. 1217
i. court said it was illegal to say that you cant cancel poison pill for several
months after replacing directors
ii. so measures that interfere w/ new boards ability to manage are illegal, but
mechanisms that move SH meeting or something else under current
boards control are approved
Securities Regulation
a. goal is to achieve an efficient market
b. Goshens how markets function
i. insiders smart, can evaluate info., know how to price
ii. information traders sophisticated market pros who collect info., know
how to value it, are rational
1. to get efficient markets, want to facilitate work of info. traders
a. minimize risk & cost of doing function of info. traders
2. their functions (search, verify, analyze, & trade) are very costly,
must compensate for this exploiting disruptions
iii. liquidity traders invest in the market, but not based on information
iv. noise traders irrational traders that invest based on faith, rumors, etc.
1. information traders will always beat them because whatever
conclusion they reach is already reflected in the price
c. Efficient Markets & Fraud & Manipulation
i. Basic Inc. v. Levinson, SCOTUS, 1988, p. 798
1. when does something become material under requirement of Rule
10b-5 of Securities Exchange Act
2. court rejects agreement in principle test & lying test
3. test is probability magnitude test
a. you must balance the probability that the thing will happen
with the effect it will have
i. what is the expected rate of return of the merger
b. lots of uncertainty for management in this test
i. incentive for mgmt. not to trade if unsure
4. violating rules on insider trading require you trade on material
nonpublic information, so determining when something is material
decides when insider trading rules kick in
5. rule for material information is an omitted fact is material if there
is a substantial likelihood that disclosure of the omitted fact would
have been viewed by the reasonable investor as having
significantly altered the total mix of information made available

a. this unifies materiality test for all securities regulation

b. fraud on the market theory replaces reliance
i. presume that the market relied on the wrong
information and the price was therefore wrong
ii. everyone relying on that price thus relied on the
wrong information
c. majority says only need to show you accepted the market
process as an honest process
i. emphasizes market
d. minority says in order to use presumption, must argue that
you actually believed market price truly reflected the value
i. emphasizes price
d. Insider Trading 10b-5
i. Elements of 10(b) and Rule 10b-5 Insider Trading
1. implied cause of action, must be either seller or buyer to bring case
a. Blue Chip Stamps, SCOTUS, 1975, p. 819
2. must show materiality (positive statement or omission)
a. is there substantial likelihood reasonable investor would
deem fact to be material
b. judged by probability magnitude test
3. disclosure need not be only for investors, but any publicly
available information
a. anything the public has the potential to access
b. see In re Carter Wallace, 2nd Cir., 1998, p. 822
i. false ads in medical journals are in connection
with a securities transaction if proven market pros
used them in valuing stock
4. intent
a. intention to defraud or reckless behavior
5. reliance
a. if omission, basically collapses reliance into materiality
i. can rebut presumption by showing plaintiff
wouldve followed same course of conduct even w/
full & honest disclosure Shores, p. 817
b. if positive, then you can presume presumption, fraud on the
market theory, burden shifts to D to show P didnt rely
c. not required for SEC to bring action for injunctive relief
i. see SEC v. Rana, p. 818
6. causation
a. transaction
i. fraud on the market takes away most transaction
causation
b. loss
7. injunctive relief
a. several cases say P in private action for injunctive relief
need not be buyer or seller p. 822

ii.
iii.

iv.

v.

vi.

8. Goshen says that this rule is meant to protect information traders

a. they cant diversify away risk, since all transactions are
triggered by differences in price, they have no way of
knowing if its insider trading or just error
b. so this is a policy choice, who should make market efficient
9. Obligations of Nontrading Corp. under 10b-5 p. 875-6
a. if corp. makes statement that is misleading, though not
intentional or reckless, & later learns it was misleading, it
has obligation to correct it if statement is still alive
b. if a corp. makes public statement thats correct @ time but
later becomes materially misleading, the corp. may have a
duty to update the statement
i. Backman v. Polaroid said duty only applies to
forward looking statements
ii. 1995 Act gives safe harbor for forward looking
statements if accompanied by meaningful
cautionary statements
c. also duty to update materials made by 3rd parties if corp.
has involved itself in preparation such that it implies info.
is true or in accordance w/ companys views
d. may be duty to correct wrong rumors resulting from leaks
by corp. or its agents
Kardon v. National Gypsum, EDPA, 1946, p. 775
1. implies private cause of action under 10b-5
Cady, Roberts & Co., SEC, 1961, p. 778
1. insiders not just directors, officers & controlling stockholders
2. anyone who has relationship giving access, directly or indirectly, to
info. intended only for corp. purpose & not for personal benefit;
and where party takes advantage of such info. knowing it is
unavailable to those w/ whom he is dealing
SEC v. Texas Gulf Sulphur Co., 2nd Cir., 1969, p. 779
1. disclose or abstain rule for trading based on material inside info.
2. test for who is insider is access
a. access creates duty to rest of the market
3. can trade after info. has been disclosed & had a chance to
disseminate to the market so that market has had time to adjust
a. must be sure market had opportunity to respond
U.S. v. Teicher, 2nd Cir., 1993, p. 827
1. rejected distinction between possession & use of inside
information impossible to have the info. in your mind & not
consider it when trading
2. since then, other circuits (9th, 11th) have adopted a use test
Chiarella v. US, SCOTUS, 1980, p. 836
1. printer who discovered inside info. re: tender offer & bought
shares of target found not guilty of insider trading

vii.

viii.

ix.
x.
xi.

2. duty to disclose does not arise from mere possession of nonpublic

information
3. distinguishes from Texas Sulphur, where duty to market came from
fid. relationship to the shareholders
4. court did not apply misappropriation theory because it wasnt
plead in this case
5. misappropriation theory says there is duty towards the source of
the information, so if you trade on that, then you violate 10b-5
a. minority suggests that based on misappropriation theory
you will encounter another duty to the market
b. question becomes, does relationship imply confidentiality?
6. if insider gives you info., then it depends on if you have knowledge
that hes violating duty, that the information shouldnt be disclosed
Dirks v. SEC, SCOTUS, 1983, p. 844
1. analyst got tip from insider about fraud at a company, got his
clients to sell stock while he checked claim
2. court said he had no duty to abstain from use of inside info. here
3. rule re: tippees is if tippee knew or should have known that the
tipper is breaching fiduciary duty by disclosing the info., then the
tippee is liable for insider trading
4. test of whether insider breached fid. duty is whether insider
personally will benefit, directly or indirectly, from disclosure
a. benefit is if they made money, helped reputation, gave info.
that will bring help in the future, gave a gift, etc.
5. dont need personal benefit to establish breach of duty of care
a. but will probably be protected by 102(b)(7)
Regulation FD (Fair Disclosure), 2000
1. restricts practice of selected disclosure
2. intentional disclosure by corp. must be disclosed to market at the
same time
a. applies to everyone involved w/ the corp.
3. AND, if officer inadvertently discloses material facts to analysts or
investment bankers, anyone from investment industry, then
immediately afterwards, they must disclose it to the market
a. applies only to officers in context of disclosing to industry
4. no restriction on person receiving information
rule for tippees is that it goes as long as tippee knows or should have
known source of info. is from person who violated insider duty
under misappropriation, fid. duty is owed to the source, so once you
disclose to the source that you will trade, then theres no deception, so
theres no violation
Rule 10b-5-2, enacted 2000 by SEC
1. when other party agrees to keep info. confidential,
misappropriation theory will apply
2. when theres pattern of exchange of confidential info., there is fid.
duty not to disclose

3. members of the same family have fid. duty not to disclose

xii. U.S. v. OHagan, SCOTUS, 1997, p. 855
1. if theres a breach of fid. duty toward source of info., then theres
breach of 10b-5
a. applied misappropriation theory
b. if you disclose plans to trade to source, no 10b-5 violation
2. Rule 14e-3 restricts use of tips w/ regard to takeovers, even when
no violation of 10b-5
a. once youve taken substantial step toward tender offer,
anyone w/ info. from T or A re: takeover cant trade on info
b. disclose or abstain rule
c. SEC can prohibit acts under 14(e) that arent themselves
fraudulent under common law or 10(b) if theyre
reasonably designed to prevent. . . acts & practices [that]
are fraudulent
e. Insider Trading 16
i. 16a Disclosure
1. directors, officers, beneficial owners >10% of stock must disclose
all transactions involving shares of the corp. (shares, options)
2. after Sarbanes Oxley, must disclose w/in 2 business days
ii. 16b Disgorgement
1. forces insiders to disgorge profits from short-swing sales w/in 6
months
2. Gratz v. Claughton, 2nd Cir., 1951, p. 879
a. to calculate profit from insider trades, match highest sale
price w/ lowest purchase price w/in 6 months for the
relevant amount of shares, try to find max. profit
b. p. 884 can find a profit even if he didnt make money
c. this is deterrent measure, not one of justice necessarily
3. cant use trade that brought you up to 10%
4. Kern v. Occidental, SCOTUS, 1973, p. 888
a. 16b doesnt apply since this is unorthodox transaction
i. no access to inside info. since mgmt. was hostile to
takeover bid
ii. most important, transaction was involuntary
1. this is generally required to apply
pragmatic approach
b. insider must first show involuntary, then court will ask if
there was access to inside info.
5. Colan v. Mesa Petroleum, 9th Cir., 1991, p. 903
a. court refuses to apply pragmatic approach in case where
Mesa negotiated to be included in tender offer theyd been
excluded from in Unocal
b. formal 16b rules still apply since it was voluntary
iii. record owner of stock is undoubtedly beneficial owner

XIII.

iv. Rule 13d-3 says beneficial owner (for 10% purposes) is anyone who,
directly or indirectly, through any contract, arrangement, understanding,
relationship, or otherwise has or shares
1. voting power which includes power to vote or direct voting of such
security, AND/OR
2. investment power which includes power to dispose, or to direct the
disposition of, such security
v. so emphasis under 16a-1 is persons control over stock
vi. beneficial ownership for reporting & liability purposes
1. Rule 16a-1(a)(2) says beneficial owner (except for determining
10%) is any person who, directly or indirectly, through any
contract, arrangement, understanding, relationship or otherwise,
has or shares a direct or indirect pecuniary interest in the securities
a. pecuniary interest means opportunity, directly or indirectly,
to profit or share in any profit derived from a transaction in
the subject securities
b. emphasizes pecuniary interest, not control
2. Rule 16a-1(a)(2)(ii)(A) says indirect pecuniary interest includes
securities held by members of immediate family sharing same
household, but this presumption may be rebutted
3. see p. 907, Rule 16a-1(e) for definition of immediate family
4. pecuniary interest includes general partners interest in stock held
by general or limited partnership
5. but shareholders dont have pecuniary interest in stocks owned by
the corp. they own shares of unless theyre controlling shareholder
or they have or share investment control over corps portfolio
vii. p. 908 director/officer liable even if only D/O at one end of the swing
viii. Rule 16a-1(f) says officer means major office title holders (president,
CFO, etc.); any VP in charge of business unit, division or function; any
other officer who does policy making, or any non-officer who does similar
policy making functions
1. looks to function, not title
Shareholder Lawsuits
a. Derivative Suits
i. cause of action belongs to corp., normally board of directors or mgmt.
decides whether or not to bring case, but w/ derivative we let shareholder
initiate & bring on behalf of corp.
ii. damage caused to corp., compensation goes to corp.
iii. standing
1. must be beneficial owner of at least one share
a. creditor cant bring derivative action unless corp. is
insolvent in fact & thus owes fid. duties to creditors
2. must have clean hands
3. must have owned it when the wrong happened, unless wrong is
continuing
a. if continuing, cases are split p. 959

b. also can bring if shares devolved by operation of law, i.e.

inheritance p. 959
c. under 16(b), dont have to own it at time of sales to bring
action to recover short swing profits
iv. corp. must be joined in the suit
v. can grant pro rata recovery, then goes directly to shareholders
1. usually to prevent wrongdoers from sharing in recovery
a. often when corp. has been merged into new corp.
2. also given to balance equity in many cases p. 949
b. Direct Suit
i. can be brought as indiv. or class action
ii. damage caused directly to shareholder, violating some indiv. right of the
shareholder, compensation goes to shareholder
c. difficult to classify most cases as direct or derivative
i. depletes or destroys corp. assets & only hurts SH value is derivative
ii. doesnt deplete or destroy & only interferes w/ rights incident to
ownership or inhering in shares themselves (voting rights) is direct
iii. issuance of stock for purpose of perpetuating or shifting control is direct
iv. controlling vs. noncontrolling shareholder wrongs seem to be direct 945
v. enjoin improperly authorized corp. actions are direct
vi. direct action not precluded simply cause same facts could be derivative
d. Procedure for bringing derivative claim
i. must make a demand to the board to bring the claim or not
ii. board can decide whether to accept or reject demand
iii. if demand is rejected, standard of review is BJR
1. so no one in DE makes demand, cause youll never win
iv. if you dont bring demand, must show why you were justified in so doing
1. standard of review in DE is reasonable doubt that
a. directors are disinterested & independent
b. transaction was the product of a valid exercise of business
judgment
i. plead facts w/ particularity
ii. will be judged case by case, intense factual inquiry
iii. Aronson v. Lewis, DE, 1984, p. 988
2. in NY, Marx v. Akers, 1996, p. 964
a. show that directors are interested, that they didnt inform
themselves to transaction, that it was so outrageous it cant
be based on some business judgment
b. basically same as in DE, only 2nd & 3rd collapse into
second part of DE test standard same as reasonable doubt
v. once standing is established & excuse is proven
1. set up Special Litigation Committee (SLC) to investigate
allegations and decide whether to proceed
a. Zapata Corp. v. Maldonado, DE, 1981, p. 981

e.

f.

g.
h.
i.
j.
k.
l.

i. new blood of disinterested directors may be

appointed to board by now, no connection to what
happened before
ii. even continuation of case is business decision
iii. committee is idea created by judges
iv. court will examine independence of committee &
the content of the report
1. reviews actions of SLC de novo
2. puts themselves in positions of directors &
asks if, given facts, theyd get that decision
v. in NY, review is BJR
vi. in DE, demand on shareholders is excused where alleged wrong could not
be ratified
1. Mayer v. Adams, DE, 1958, p. 994
Cases brought under securities laws now controlled by Private Securities
Litigation Reform Act of 1995, tried to make it harder to bring class actions
i. fee paid to lawyer must be reasonable 25-30%
ii. if frivolous, P must pay Ds costs
Approaches to awarding legal fees in class actions
i. percentage of recovery formula gives attorney some reasonable
percentage of the winnings
ii. lodestar approach based on hours, skill, complexity, etc.
iii. now, almost everyone uses percentage of recovery
iv. fees can be awarded if case settles or corp. takes some corrective action
1. usually P can show that claim was meritorious by surviving motion
to dismiss & having facts that show substantial likelihood of
success, burden then shifts to D to show act wasnt caused by
plaintiffs course of action p. 1013
usually cant indemnify directors against Securities Act violations p. 1042
Clarke v. Greenberg, NY, 1947, p. 1044
i. shareholder must account to corp. for $ from settlement for discontinuing
common law rule was minority owner could discontinue derivative action anytime
i. many jurisdictions now say you need court approval & notice to SH see
p. 1047
Desimone v. Industrial Bio-Test Lab, NY, 1979, p. 1047
i. court will approve proposed settlement of class action if its fair,
reasonable & adequate
Wolf v. Barkes, 2nd Cir., 1965, p. 1051
i. FRCP doesnt require judicial approval of settlement between corp. &
defendant in a derivative suit
class action claims brought in fed. court under securities acts have no
jurisdictional minimum (per class member)