BUSINESS ORGANIZATIONS OUTLINE

I. Introduction
1. Sole Proprietorship
a. You cannot be a Sole proprietorship and share
ownership or else you are a proprietorship, or
more often called a partnership.
b. Any type of business can have employees,
including a sole proprietorship
c. The sole proprietor is compensated for his labor,
his role as an investor, his ideas and his
management.
i. In general the law tends to allocate control
along with risk
ii. An employee in the context of working for
his employer is his agent.
iii. A bank may loan the employer money but
the employer still controls the company
because he has the risk, although they may
place restrictions on the loan, like requiring
it to be used for the kind of business
specified.
1. borrowing money from the bank is
debt, money owed that must be paid
back
2. money invested in a business is
equity, it does not need to be paid
back, does not have an interest rate,
and usually it entitles one to
participate in the upside
3. The people who are shareholders are
also the owners of the business and
residual claimants, they get profits.
a. Creditors are someone to whom
you owe money.
b. Partnerships are not usually
used in business anymore
because they do not protect
people from liability
c. sometimes the manager does
not have complete control, the
people who put in the most
money have most of the risk
and therefore most of the
control
2. The difference between public and private companies.

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a. Public Companies
i. The public can buy and sell stock in it.
b. Private Company
i. It can be very difficult to sell your stock, making the
issue of control so important, the shareholders that
do not have control can find themselves stuck with
worthless stock and no control, a minority stake you
cannot do anything with or get rid of. There are
many things that can protect someone like a buy sell
agreement which can let someone out of ownership
at a latter date.

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 AGENCY LAW

Agency is a relationship that results from the manifestation of

consent by P to A that A shall act on P’s behalf and subject to P’s
control, and A’s consent to so act. Restatement of Agency
(Second) §1

When the agent is acting outside the scope of the agency

you cannot sue the principal.
 Was the conduct of the same general nature as, or
incident to, that which the servant was employed to
perform
• See Restatement of Agency § 229
 Was the conduct substantially removed from the
authorized time and space limits of the employment
• “Frolic and detour”
 Whether the conduct was motivated at least in part
by a purpose to serve the master
 Most courts now require a “total abandonment” of
the employment to constitute a frolic and detour
• Some Exceptions:
- Even if A acts outside scope, M may still be liable:
• M’s intent,
• M’s negligence
• Reliance by 3rd parties on “apparent” scope.
• Principal retains control over the aspect of the
work in which the tort occurs
• Principal engages an incompetent contractor
(Majestic analysis questions 1-2)
• Activity contracted for is inherently dangerous, a
nuisance per se (An activity that creates a
“peculiar risk of harm to others unless special
precautions are taken”)
• Nondelegable duty (usually statutory like a
building code, but can be broader) - A duty so
important to the community that the principal
should not be allowed to farm it out to another.

The third party can also be held liable to the principal

A principal is liable on contracts made by an agent on the

principal’s behalf.

Control can be established by a condition precedent. Gorton v.

Doty (you don’t need compensation)

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You can form an agency relationship without knowing. The
Cargill court says “there must be an agreement, but not
necessarily a contract between the parties.”

Control can be established in more than one way, if you have a

situation where you have the option of not following a
suggestion, but if the advisor is financing you and they
can stop at anytime it may still be control even if you don’t
follow all the suggestions. Gay Jenson Farms v. Cargill

The principal needs to effectuate control but the control does

not have to be completely effective, and the control does
not have to be completely related to the wrong.

Marital relationship not enough to make one spouse the agent

of another. Botticello v. Stefanovicz

In order for an agent to avoid liability, he must reveal not

only that he is acting on behalf of a principal, but the
identity of the principal. The 3rd party has no obligation to
ask. Atlantic Salmon A/S

A creditor becomes a principal at the point at which it assumes

de facto control over the conduct of the debtor. Restatement 14
O

Supplier: One who contracts to acquire property from a third

person and convey it to another is the agent of the other only if it
is agreed that he is to act primarily for the benefit of the other
and not for himself. Restatement § 14K
Comment: Factors indicating that one is a supplier, rather
than an agent, are: (1) That he is to receive a fixed price
for the property irrespective of price paid by him. This is
the most important. (2) That he acts in his own name and
receives the title to the property which he there after is to
transfer. (3) That he has an independent business in
buying and selling similar property.

General Notes:
i. The law of agency in Torts is Respondiot
Superior/Vicarious Liability
ii. It is the ability to exercise control that is relevant not
the actual exercise of control, but it doesn’t help to
actually exercise control.

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 iii. Agency law reaches a little farther then your sense of
fairness, it is a very far reaching doctrine, partly
because the principal will probably have more
money.

5 Distinct Ways to Form an Agency Relationship

– Actual Express Contractual Duties: Principal & Agent
explicitly agree that A has power to act on P’s behalf
and subject to P’s control
• Actual Express Authority (AEA)
– Actual Implied Contractual Duties: Relationship
between P & A is such that court can reasonably infer
parties intended to delegate A power to act on P’s
behalf and subject to P’s control
We have this category because sometimes we don’t tell
our agent everything we want the agent to do, but it is
still within the relationship of agent and principle.
There is an incentive with implied authority for the
principle’s instructions to be clear or else there will be
more implied authority than you wish.
Under apparent authority the third party can still
enforce a contract against the principle even if he did
not now that agent was acting as an agent for the
principle.
Implied authority often depends on industry customs.
• Actual Implied Authority (AIA)
- Apparent: “Apparent authority is the power to
affect the legal relations of another person by
transactions with third persons, professedly as an agent
for the other, arising from and in accordance with the
other’s manifestations to such third persons.”
Restatement § 8
Apparent authority depends on communications
between the principle and the third party the
principle somehow gives appearance that the agent has
authority, a manifestation of authority, and the actual
authority is not there.
There is a requirement of reasonableness it usually
turns on what is customary and reasonable in the
community.
Apparent authority exists only where there is some
connection between the third party and the principal.
You must always look at how the third party
learned of the agent’s alleged authority and ask
whether the principal reasonably can be said to
have been the source of that knowledge.

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 When you have a case of apparent authority when the
agent goes beyond their actual authority they are liable
to the principle for violating their fiduciary duty.
If there is apparent authority not only can the third
party enforce the contract against the principle, but also
the principle can enforce the contract against the third
party even though it is apparent not actual authority.
- Ratification: If the principle decides to adopt a contract
negotiated by an unauthorized person. It can be ratified
to the agent or to the third party.
Ratification
 “A” acts without authority (of any kind) and
there is no grounds for estoppel.
 “P” will only be bound if “P” ratifies the
contract
 Ratification requires
 A valid affirmation by “P”
 To which the law will give effect
 What types of acts constitute an affirmation by
the principal?
 Affirmation can be express or implied
 Principal must know or have reason
to know all material facts
 Will be denied legal effect where
necessary to protect the rights of an
innocent third party
Also includes estoppel. (Note that estoppel is not truly a
form of authority. It is a bar to raising defenses to the
authority claim.)
- Inherent: Arises solely from the designation by the
principal of a kind of agent that ordinarily possesses
certain powers. Usually comes up in situations with an
undisclosed principle, or where an agent exceeds their
authority. A catch all. Inherent agency extends the
principal’s liability to acts that the principle has
prohibited to the agent but that are within the scope of
authority that agents engaged in similar activities
usually possess. (this is similar to the liability of
partners even if the partner committing the act has
concealed his membership in the partnership)
In undisclosed principal cases, what is the scope of
the agent’s authority?
“the principal is liable for all the acts . . . which
are within the authority usually confided to an
agent of that character” Watteau

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 Restatement § 195 “agent enters into
transactions usual in such business and on the
principal's account”

The legal consequences of an agent’s acts DO NOT depend

on the type of authority the agent possessed.
To prove agency you must prove (1) that an agency
relationship existed and then (2) what kind (or kinds) of
authority the agent possessed.
Usually you can have more than one type of authority.
The reason you bother saying not to do something even if
there is a custom is that: most agents will listen, then you
have a claim against the agent, and maybe you take steps
to let people know.
Often when there is either apparent or inherent there is the
other, however, note the difference between the two in a
situation like Watteau where the third party did not even
know there was a principal. In that situation there is no
manifestation by the principal to the third party, but there
can still be inherent authority, as in Watteau where
ordinarily the goods would be supplied to that type of
establishment (such a transaction would be normal in the
business).

Authority v. Power
 An agent may bind the principal even when the
agent lacks any form of actual authority
 “A power is an ability on the part of a
person to produce a change in a given legal
relation by doing or not doing a given act.”
Restatement § 6
 An agent’s power to bind the principal is
broader than an agent’s authority to bind the
principal
 E.g., estoppel

Gorton v. Doty
Facts: parent loaning car to coach if he drives
She could not have really protected herself with a contract,
because it is not binding on a third party, although she
could then go recover from the alleged agent.
Doty really should disclaim any control over the use of her
car or if she had rented them the car then she would just
be operating a business and not acting as a principal.

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Gay Jenson Farms v. Cargill
Facts: Warren grain elevator, Cargill big seed company
finances them with loans
Factors:
1. Cargill's constant recommendations to Warren by
telephone;
2. Cargill's right of first refusal on grain;
3. Warren's inability to enter into mortgages, to
purchase stock or to pay dividends without Cargill's
approval;
4. Cargill's right of entry onto Warren's premises to
carry on periodic checks and audits;
5. Cargill's correspondence and criticism regarding
Warren's finances, officers salaries and inventory;
6. Cargill's determination that Warren needed "strong
paternal guidance";
7. Provision of drafts and forms to Warren upon which
Cargill's name was imprinted;
8. Financing of all Warren's purchases of grain and
operating expenses; and
9. Cargill's power to discontinue the financing of
Warren's operations.
Cargill found to be principal.
The difference between banks and companies acting like
Cargill is that banks do not tinker with day to day
operations.

Cargill Situation Planning Solutions

It may be that there was a loan officer in the company that
did not want to mess up their loan record.
Reduce Cargill’s control by setting strong standards in
advance, avoid the biggest mistakes lenders make like:
veto power, putting a person in control over the company,
or providing assurances of payment to the other creditors.
Take on additional control, since you are already the
principal make sure it is done right. Like McDonalds, one
of the benefits of that is that you can go to any McDonalds
in the world and know what to expect. But even if one of
McDonalds’ restaurants does not do something they are
required to do McDonalds is still liable because with control
comes the power to police.
It might have been okay to say we are going to have you
talk to an outside consultant instead of coming in yourself.

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Servants and independent contractors
Principle and Agent are big categories within that context there is a
subcategory of master servant or independent contractor, you can
have an agency relationship that doesn’t fall under master servant.
• Why does the distinction matter?
– Vicarious liability depends not only on whether an agency
relationship existes, but also on the kind of agency
relationship that is involved.
– Master is liable for servant’s torts.
– Principal generally not liable for the torts of an
independent contractor
• What is the distinction?
– A servant’s physical conduct of the task is controlled or is
subject to the right of control by the master
• Note that the master does not have to actually
exercise control over what the agent does; he or she
merely needs to have the right to control the agent's
physical performance of the assigned task
– An independent contractor’s performance of the task is not
subject to the principal's control.

Independent Contract Types

• Nonservant agent (a.k.a. agent-type independent contractor)
– Subject to limited control by P with respect to the chosen
result
– Has power to act on A’s behalf
• Nonagent independent contractor (a.k.a. nonagent service
provider)
– Perhaps less control on P’s part
– No power to act on A’s behalf

Consequences
P liable if A w/in P not liable except P not liable in
Scope of employment in special cases agency law

Independent Independent
Archaic Servant Contractor Contractor
(agent-type) (nonagent)

Nonagent
Nonservant
Modern PC Employee independent
agent
contractor

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 Nonagent
Restatement Nonemployee
Employee service
3d agent
provider

Liability in Tort

“A master is subject to liability for the torts of his servants

committed while acting in the scope of their employment.”
Restatement (Second) § 219(1)

Sequential analysis of tort liability

Is there an agency relationship between P and A?
Is A P’s servant or independent contractor?
If servant, was conduct within scope of employment?

Agent Tort Liability:

Agent basically is always liable for torts she commits
Though the principal may be as well

Humble Oil & Refining Co. v. Martin

Facts: Car at gas station rolls away hits somebody, oil
company sued, operator of the gas station required to
follow orders
Humble found liable for the acts of the operator’s
employee
Key factor: Whether Humble has a legal right to control
Schneider’s “physical conduct” on job. (that is the manner
in which the job is performed rather than the result) See
Restatement of Agency (Second) § 2.

Is there an argument that Humble might have made but

didn’t that could have absolved it of liability despite the
court’s finding that a M-S relationship existed?
Yes, that it is outside of the scope of the M-S relationship

Hoover v. Sun Oil

Facts: employee drops cigarette, recommendations not
orders, sun oil logos

Bushey & Sons v. United States

Facts: drunk sailor coming back to boat loosens wheels
US defends on scope of employment grounds
Was conduct of same nature as that authorized?

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 Was Lane on a frolic and detour?
Did Lane have a purpose to serve US?
Discards purpose test, not all courts agree.
Friendly goes with a fairness not a cheaper cost avoider
theory, and comes up with a broad understanding of
foreseeablity, that it is not foreseeable that he will turn the
wheels but it is foreseeable that sailors will go out and
drink and in coming back something might happen.
Three issues:
1. If some harm is foreseeable: Liability, even if the
particular type of harm was unforeseeable
2. Conduct by the servant which does not create
risks different from those attendant on the
activities of the community in general will not give
rise to liability
3. The conduct must relate to the employment
Not all courts accept (see, e.g., Clover v. Snowbird Ski
Resort), most courts now require a total abandonment of
the employment to constitute a frolic.

Majestic Realty Associates, Inc. v. Toti Contracting Co.

Facts: employee of independent contractor goofed in
demolishing building
This case is an exception in that the principle is being held
liable for the acts of an independent contractor.
They are liable because it was an inherently dangerous
activity, Negligence per se.
The policy behind the decision is to get your contractor to
get insurance when doing inherently dangerous activities.
The court signals that hiring an independent contractor
without enough insurance could be like hiring one that is
incompetent.
The court distinguishes “inherently dangerous” activity
from “ultra-hazardous” (serious risk which cannot be
eliminated) which is strict liability.

Policy: When to apply vicarious liability?

Appearances
Sun Oil should be liable because if creates the
appearance of responsibility
Residual interest

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 Sun Oil should be liable because it has a relatively
large interest in the successful operation of the
station
Deep pocket
Any supplier with a deep pocket and any connection
to the accident should be held liable
Risk spreading
Much like deep pocket.
Risk prevention
Liability should arise from control or right to control
the harmful activity
Holding oil companies liable causes them to instruct
their service stations to get insurance
Economic analysis
Cheaper cost avoider
Fairness
Compensation for losses
Retribution for morally blameworthy conduct

Principal’s Liability in Contract

Restatement § 144: a principal “is subject to liability upon contracts

made by an agent acting within his authority if made in proper form
and with the understanding that the principal is a party”

Mill Street Church of Christ v. Hogan

Facts: handyman hires brother to help him as he had done
in the past
Sam sues for workers comp from church, has to be an
employee, Bill had to have authority to hire Sam
Sam is a subagent of the church because Bill had actual
implied and apparent authority to hire Sam.
Actual Implied Authority
 Why?
 Implied authority “includes such powers
as are reasonably necessary to carry out the
duties”
 Did agent believe based on present or
past conduct that he had authority?
 Job needed two men and the church had
let him hire Sam in the past
 No clear instructions to the
contrary expressed to agent, even if in
principal’s “mind”
 Sam’s belief relevant?

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  Sam’s belief is relevant to apparent
authority, but not implied authority
 Planning implications?
 The church should tell Bill he does not
have the authority to hire someone, and let
people know that all hiring has to be done by
the church

Lind v. Schenley Industries, Inc.

Fact: Told by president that he would be assistant to
Kaufman but that he had to talk to Kaufman, Kaufman told
him about a 1% commission he would get, company says
Kaufman never had this authority to give him this salary
Court said Kaufman had apparent authority, no actual
authority
Analysis: The court confuses actual implied authority with
both apparent authority and inherent authority, and the
court opines wrongly that proof of a specific form of
authority is not required.
Restatement § 8 requires a “manifestation” by the principal
to the third party to support apparent authority. What was
Park & Tilford’s manifestation to Lind?
 Installing Herrfeldt as sales manager and
clothing him with authority to make
representations re employment on PT’s behalf.
Apparent authority is a question of fact and often turns on
what is customary in the field.
• Planning: What should Park & Tilford have done?
o You could have a department like human
resources and everyone gets an employee
manual and everyone knows that they can’t
get a raise or promotion without the human
resources department’s consent. An employee
manual is usually used to disclaim liability for
these types of things. You can make a belief in
the authority unreasonable by notice (actual or
constructive through an employee manual or
something). Train Herrfeldt and Kaufman not
to make these sorts of offers. Insist on written
employment contracts with managerial
employees.

370 Leasing Corporation v. Ampex Corporation

Facts: Joyce signs contract with signing block for Ampex
and never sends it back, he also has a letter from Kays at

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 Ampex confirming shipping, and an internal memo from
Kay’s boss says we made this big deal and Kays is in
charge of all communications with Joyce
On what type of authority is Joyce relying?
Apparent authority, not actual authority, Kays did not
have authority to sign this letter. Nor did his boss.
The internal memorandum has significance in proving
apparent authority if you assume Joyce new about the
memorandum, and it supports the argument that there
was silence and Ampex wasn’t denying the contract.
 Broad category of implied authority is “a kind of
authority arising solely from the designation by the
principal of a kind of agent who ordinarily possesses
certain powers” (Lind)
 Actual implied authority: act of putting agent in
such a position leads agent to reasonably believe
he has authority
 Apparent (“implied”) authority: act of putting
agent in such a position leads third party to
reasonably believe agent has authority.
 All authority that is not express is implied.
 Implied Authority is NOT a separate category.
 What should Ampex have done to protect itself?
 Again, train its agents and give notice to potential
third parties.
 Form contract requiring approval by contract
manager.

Watteau v. Fenwick
Facts: Beerhouse manager, Humble, owned beerhouse and
then sold it but stayed as the manager. Beerhouse
manager only allowed to purchase certain things, he buys
other things, manager’s name is still on the door.
Humble didn’t have actual authority because he as the
agent could not have reasonably believed the scope of his
authority to include that ability,
Apparent authority?
No, the principle did not do anything to manifest to the
third party that the agent had that authority.
Inherent authority?
Yes, “the principal is liable for all the acts . . . which are
within the authority usually confided to an agent of that
character”

Former Authority

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Sometimes you have to take steps to let people know that they no
longer have authority.

Ratification, Estoppel, Agent’s Liability

Botticello v. Stefanovicz
Facts: Couple each owns undivided half interest in the property,
tenants in common. Walter leases with an option to purchase
without consulting Mary. Plaintiff moves in pays rent and makes
improvements, Mary cashes checks. Plaintiff tries to exercise the
option, Mary says no
Court says that the martial relationship is not enough to make one
spouse the agent of the other
A marriage is not the same as a partnership.
The only real question here is did she ratify it by accepting rent
Court said no just being married doesn’t imply consent

Planning: Botticello could have shown her the contract, or explained it

to her and then if she still accepted the rent the ratification argument
would work

The agency rules relating to undisclosed principals apply to

partnerships.

Distinguish Ratification from Actual Authority Created by Acquiescence

“(1) Acquiescence by the principal in conduct of an agent whose
previously conferred authorization reasonably might include it,
indicates that the conduct was authorized; if clearly not included in the
authorization, acquiescence in it indicates affirmance.
(2) Acquiescence by the principal in a series of acts by the agent
indicates authorization to perform similar acts in the future.”
Restatement § 43

Hoddeson v. Koos Bros.

Facts: Fake furniture salesman takes plaintiff’s money
Why isn’t this a case of the apparent authority of an apparent agent?
No holding out by Koos that tall man was its agent.
Why doesn’t Koos’ failure to police its sales floor constitute the
requisite manifestation?
“A manifestation is conduct by a person, observable by
others, that expresses meaning.” Restatement (Third) § 1.03
cmt. b.
Although omission can be a manifestation here it is not.
Court holds that if you don’t watch your store well enough in some
situations you are estopped from disclaiming responsibility, court calls

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it agency by estoppel, court says new trial so you have the opportunity
to argue estoppel.
Apparent authority and estoppel are similar, but in estoppel the third
party has to alter their position in order to win, and estoppel only binds
the principal not the third party.
 On remand, what will Hoddeson have to prove to make out a
case of estoppel?
 Acts or omissions by the principal, either intentional or
negligent, which create an appearance of authority in the
purported agent
 The third party reasonably and in good faith acts in
reliance on such appearance of authority
 The third party changed her position in reliance upon the
appearance of authority
 Where agent had authority (of any kind) contract is binding on
both P and T.
 Estoppel only binds P

Agent Liability on the Contract

• Disclosed Principal
None
Two exceptions:
 Clear intent of all parties that agent be bound
 Agent made contract but without authority
• Party to the contract?
• Fraud/deceit?
• Implied warranty of authority (bulk of jurisdictions)
(Restatement section 329)
Agent is not a party to the contract, but 3rd
party is entitled to: “the amount by which he
would have benefited had the authority
existed.”
• Partially disclosed or undisclosed principal
Agent treated as though a party to the contract
Third party must elect who to sue

Fiduciary Obligations: What duties do P and A owe to each

other?
Agent’s Fiduciary Duties
 Care (i.e. duty not to “shirk” on the job)
 Loyalty (i.e. Don’t Steal from the firm!)
 Kickbacks, bribes or gratuities (Restatement § 388) Even
gratuities given after the fact
 Secret profits

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  From transactions with principal (Restatement § 389)
 Use of position (Reading)
 Usurping business opportunities from principal (Singer)
 “Grabbing and Leaving” (Town & Country)
Most of the stuff gets fixed by disclosure, or else it is not up to the
agent to decide whether the amount is too small to report or whether it
is wrong or not

Particular Dutie
of Loyalty

Under §388 of the Restatement of Agency (Second): “Unless otherwise

agreed, an agent who makes a profit in connection with transactions
conducted by him on behalf of the principal is under a duty to give
such profit to the principal.”

Atlantic Salmon A/S v. Curran

Defendant selling salmon representing himself as a corporation when
in fact he wasn’t, at some point had a company called Marketing
Designs, Inc.
Because there was no principal he became the de facto principal.
Black Letter Law: If an agent wants to avoid liability, he must reveal
not only that he is acting on behalf of a principal, but the identity of
the principal. The 3rd party has no obligation to ask.
Planning: What should the plaintiff’s have done to protect themselves?
A credit check, or they could have checked with the secretary of state.

Reading v. Regem

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 Facts: British sergeant while on duty goes on ride on trucks of
smugglers to help them get through without being inspected and
gets paid for it.
Crown wants money he earned
Court awards Crown money because the only reason he got the money
was because he was acting as their agent.
Court says if his position as an agent more than affords him the
opportunity for getting the money, but rather plays a predominant part
in his getting the money then he is accountable for it to his master.
“The Agent has a duty to act solely for the benefit of the principal in all
matters connected with his agency.” Restatement 2 section 387
Remedy? Constructive trust, meaning you are in reality holding the
money for the principal.
Why should we give the Principal a property right in the secret profits
of its Agent if the Principal is not damaged?
We want to discourage it, not give any incentive to engage in behavior
we consider wrong.
 Note that the holding is not dependent on a measurable loss of value
to the Crown.

General Automotive Manufacturing Co. v. Singer

Court says he was Automotive’s agent and owed them the profits he
made on the side
He argues that he is allowed to do it because they were beyond the
capacity of Automotive
But he is the manager of Automotive so he has to work for the sole
benefit of the Principal
Court says he should have disclosed, and it would have been in
Automotive’s discretion to reject the work, and to take any profits from
assigning the work, by failing to disclose he violated his duty to act
solely for the benefit of his principal.
What if GA wanted the job, but Singer thought GA would do a bad job,
could he warn the customer?
No, but he could quit, it is not his right to warn the customer
Why wasn’t Singer decided as a breach of contract case?
Automotive would only get compensatory damages Automotive’s lost
profits from not doing the work, not disgorgement of Singer’s profits.

Breach of Contract v. Fiduciary Duty

 Contract:
 Remedy: Actual damages
 No moral condemnation
 Need to interpret the contract (e.g. “work 5 and ½ days”)
 Breach of fiduciary duty:
 Remedy: Disgorgement

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  Moral condemnation
 X-ref Meinhard v. Salmon: “punctilio of an honor the
most sensitive”
Full Time and Attention Provisions
 Issues?
 Outside activities
 uncompensated
 compensated (such as being a director of another
firm)
 No provision for board waiver
 Moonlighting?
 Writing the Great American Novel?

Town & Country House & Home Service, Inc. v. Newbery

Facts: Special quick and assembly line type house keeping, employees
steal client list which was difficult to cultivate for this special type of
house cleaning, employees contact only people on the list but after
their employment has ended.
Court says the client list was a trade secret
Was it possible to allege that defendants breached their duty not to
compete?
Yes, because they advertised specifically to her customers, the
problem is not that they left and started their own competing business
You are not allowed to compete when you are still the agent of the
principal
Suppose Alice a 3rd party competitor spies on the T&C trucks to get the
client list?
She would not be liable because she is not an agent so she can
compete with the principal.
If you have an independent basis for gathering the information you are
okay, even if you are a past agent, you can’t compete while you are
still an agent though.
If they could have got the list from hiring a private detective but they
decided to just avoid the trouble and use it because they already had it
in their minds what is the difference?
Because we want to impose that hassle, that barrier, before they can
use the principal’s information.

19
 Duties that trans
relations

The duty not to compete ends when the agency relationship ends, but
the duty of confidentiality extends beyond the termination of agency.
They are different duties, you cannot do much about the duty not the
compete at least in CA, but with the duty of confidentiality you can and
some people use it to extend the duty not to compete.

Non-Compete Clauses in CA
• By statute, CA law prohibits non-compete agreements “of any
kind…”
• Caveats:
– Breadth of CA statute is narrower than § 393:
• Post-employment covenants against recruitment of
customers/clients or coworkers are not proscribed.
– Other “close by” fiduciary duties unaffected:
• Post-employment covenants not to disclose/use trade
secrets;
– Express statutory exceptions

DUTY NOT TO COMP

• Sale of assets & goodwill of a business
• Non-compete agreements among partners
• Non-compete agreements among members of LLC

List of “factors”
To determine whether Information = “Trade Secret”

DUTY OF CONFIDEN
 Information not widely known outside the firm.
 Information is not widely known within the firm.
 Firm tries to guard the information.

20
  Information valuable both inside and outside firm.
 Large costs incurred to develop information.
 Information could not cheaply be duplicated.

Uniform Trade Secrets Act

(Cal. Civ. Code § 3426 (1999))
• Trade secret = information (including a formula, pattern,
compilation, program, device, method, technique, or process)
that:
– (1) Derives independent economic value, actual or
potential, from not being generally known to the public or
to other persons who can obtain economic value from its
disclosure or use; and
– (2) Is the subject of efforts that are reasonable under the
circumstances to maintain its secrecy.

Consequences of Trade Secret Liability:

• Injunctive Relief
– Actual or threatened.
– Term: Life of T.S. “plus”
• Damages
– Actual Damages
– Unjust Enrichment of Misappropriator
– Reasonable Royalty (retrospective/prospective)
– PUNITIVE DAMAGES (up to 2X)
• Attorneys’ Fees for bad-faith litigation
– (Either party)

21
 PARTNERSHIP

A partnership is an association of two or more persons to carry on as

co-owners a business for profit” UPA Section 6(1)

All partners are agents of the partnership. UPA §9 … and thus each
partner owes the same fiduciary obligations that any agent owes a
principal;

An agreement is necessary to form a partnership.

• No formalities are required to form partnership...

– …so long as enterprise “walks & talks” like one...
– …which includes a number of factors, including:
• Intent (express or implied); Risk sharing (i.e.
profit and loss); Elements of sharing of control;
Rights on Dissolution

Partnerships are the only type of entity (a sole proprietorship is not

really an entity) that you don’t have to file anything with the state, it is
very cheap to set up a partnership, with a corporation you need an
attorney.

No body ever uses a partnership in the real world.

Sources of Partnership Law

• Statutory Body of Law:
– Uniform Partnership Act (1914):
• Adopted by every state except La.
– Revised Uniform Partnership Act (1997);
• Adopted in about half the states, including CA
– (These are called the “Default Rules”, used to fill in gaps.
Even if you want the default rule to govern you should still
put it in the agreement.)
• Common Law Cases

Defining Characteristics:
1. For-profit, unincorporated business
2. Two or more “owners”(A & B)
3. Partners each make contribution to business (capital, labor, land,
etc)
4. Partners share profit/loss;
5. Partners jointly enjoy rights of control/management;
Caveats:
1. P-ships can vary by K many rules

22
 2. P-ships hire external capital/labor without adding new partners,
one of the determining factors to determine if the new
employees or the lenders are partners is control, and sharing
profits and losses

What’s at Stake?
• Liabilities: All partners are agents of partnership and can
therefore obligate the partnership...
– …and thus all partners are personally liable on such
obligations
• Joint liability for partnership debts
• Joint & Several liability for “wrongful” act of a partner
• Control Rights: Also shared among the partners;
• Return: Profits shared equally among the partners;
– Shared pro rata on dissolution of partnership
– “Forced Sale” rights upon dissolution
• “Regulatory posture”:
– Tax treatment; regulatory classification, flow through
taxation means the partnership does not pay taxes on
profits, the individual partners do, with corporations there
is double taxation

Default rule votes based on one vote per person, not pro rata on
shares

UPA §18 provides that: “The rights and duties of the partners in
relation to the partnership shall be determined, subject to any
agreement between them, by the following rules: … (e) All partners
have equal rights in the management and conduct of the partnership
business.”

UPA §31 provides that: “Dissolution is caused: (!) Without violation of

the agreement between the partners, … (b) By the express will of any
partners when no definite term of particular undertaking is specified.”
That leaves the problem of what happens to the partnership property
upon dissolution. UPA § 18 provides in part, (a) Each partner shall be
repaid his contributions … and shall share equally in the profits and
surplus.”

Fenwick’s Caution: Even though P-ship agreements can alter most

rights/duties between partners, bending the default rules too far is
risky: It risks a legal finding that no partnership existed in the first
place

Lack of formality => Principal Tension:

– Though “fit” with default rules helps to determine status...

23
 – …once a partnership, no need to follow default rules!
– The “trick” for organizations worried about partnership
status, but who dislike the UPA default rules:
• Either live with more default rules, or take care to
contract around them in fashion that formally resembles
them.

Fenwick v. Unemployment Compensation Commission

Beauty store with receptionist, agreement says partnership,
receptionist gets 20% of profits if there are any, but no control, did not
bear losses, or other elements
Professor thinks there was a partnership
Factors: Return, Risk, Control, Duties, and Duration(can either sever)
UPA § 7(4)
“In determining whether a partnership exists: … (4) The receipt
by a person of a share of the profits of a business is prima facie
evidence that he is a partner in the business…
But …
The Act further provides that sharing of profits is prima facie
evidence of partnership but “no such inference shall be drawn if
such profits were received in payment … as wages of an
employee,” and it seems that is the legal inference to be drawn
from the factual situation here.
This case is saying that if you are too successful as a transactional
attorney in giving your client all of the control then there is not a
partnership

Partners vs. Owner/Employee

• Type of Claim on Firm:
– Employees: Usu. no capital contribution; fixed salary (+
bonus)
– Owner: Initial contribution; residual claim of firm value
• Control
– Owner usually has significant control; Ee: Little/none
• Duration: Limited or for the life of the business
– Owner: usually entitled to stay in business indefinitely
– Ee: fixed term employment contract or “at will”
• Liability to Third Parties
– Owner yes;
– Ee: none
• Contributions/Rights on Dissolution
– Ee: can’t force dissolution, and only gets wages due
– Owner: can force dissolution and gets residual surplus
But is it so simple?
Implications of the UPA as a default, “form contract”
• Risks (Upside and Downside)

24
 – PAs often allow for partner w/o capital contribution
• Usu. when partner has already contributed
labor/expertise
• Control
– Partnership Agreements (PAs) frequently designate one
person to have managerial power;
• Rights on Dissolution
– In such partnerships, the partner contributing capital would
have a right to her capital

Partnership Fiduciary Duties

All partners are agents of the partnership. UPA §9 … and thus each
partner owes the same fiduciary obligations that any agent owes a
principal;

RUPA §404 General Standards of Partner’s Conduct

(a) The only fiduciary duties a partner owes to the partnership
and the other partners are the duty of loyalty and the duty of
care set forth in subsections (b) and (c).
(b)A partner’s duty of loyalty to the partnership and the other
partners is limited to the following:
(1) to account to the partnership and hold as
trustee for it any property, profit, or benefit
derived by the partner in the conduct and
winding up of the partnership business or
derived from a use by the partner of
partnership property, including the
appropriation of a partnership opportunity;
(2)to refrain form dealing with the partnership
in the conduct or winding up of the
partnership business as or on behalf of a
party having an interest adverse to the
partnership; and
(3)to refrain from competing with the
partnership in the conduct of the
partnership business before the dissolution
of the partnership.
(c) A partner’s duty of care to the partnership and the other
partners in the conducting and winding up of the partnership
business is limited to refraining from engaging in grossly
negligent or reckless conduct, intentional misconduct, or a
knowing violation of the law.
(d)A partner shall discharge the duties to the partnership and the
other partners under this [Act] or under the partnership

25
 agreement and exercise any rights consistently with the
obligation of good faith and fair dealing.
(e) A partner does not violate a duty or obligation under this [Act]
or under the partnership agreement merely because the
partner’s conduct furthers the partner’s own interest.
(f) A partner may lend money to and transact other business with
the partnership, and as to each loan or transaction, the rights
and obligations of the partners are the same as those of a
person who is not a partner, subject to other applicable law.

Young v. Jones
Partnership by estoppel
Investors relied on audit done by PW Bahamas, try to sue PW-US under
partnership by estoppel
Held:
 No evidence of actual partnership
 Plaintiffs did not show that they relied on any holding out by PW-
US
 Reliance is an element of estoppel

 Under what theory could Plaintiffs have proceeded against PW-

Worldwide?
 Apparent Agency, which has the added advantage of no
requirement of a showing of reliance.
 But, remember the Holiday Inn case.

Duties o
Agen

26
Some Examples...
• UPA § 20:
– Obligation to render true and full information on all things
affecting P-ship
• UPA § 21:
– Partners must account for profits from any transaction
connected with formation/conduct/business of P-ship
• UPA § 22:
– Each partner has a right to a formal accounting of her
rights/interests.

A Caveat within Partnerships

• Many cases hold that partners owe fiduciary duties not only to
the partnership as an enterprise, but also to each other as
individuals
– Not at issue with agency law (where the principal is only
one person).
– Generally not so in corporations law (where SHs usually
don’t owe fiduciary duties to each other)

Partnership Opportunities
• A Partner must disclose the partnership opportunity
• Then the managing partner(s) must decide whether to act on
that opportunity
• BUT, that decision must be made in good faith.
Doctrine of Organizational Opportunities
 To what extent do business opportunities of which a fiduciary
learns belong to the firm rather than the individual?
 Agency Restatement § 387: “Unless otherwise agreed, an
agent is subject to a duty to his principal to act solely for
the benefit of the principal in all matters connected with
his agency.”
 Corporate opportunities doctrine
Boundaries of the standard; or “there are distinctions of degree”
 Joint enterprise/venture v. general partners
 Andrews v. Cardozo
 During the partnership v. at its end
 UPA (1997) § 404(b)(1)
 Geographic?
 No liability if a “location far removed”
 Status of partner (Managing v. silent)
 Cardozo is ambiguous both as to the standard and its boundaries

Meinhard v. Salmon

27
Facts: One partner goes behind the back of the other partner and
negotiates to develop a new building after the partnership is to end.
• Why did Cardozo side with Meinhard?
– In particular, where did Salmon go wrong?
The trouble about his conduct is that he excluded his
coadventurer from any chance to compete, from any
chance to enjoy the opportunity for benefit that had come
to him alone by virtue of his agency.
• What should Salmon have done?
– DISCLOSE!
• Would disclosure alone suffice?
– “The punctilio of an honor most sensitive”
– “The thought of self was to be renounced”
• Cardozo seems to suggest that more might be required… Does
Salmon have to give Meinhard the opportunity to be a partner in
the new venture???
Policy: Is Meinhard the right default?
 Hypothetical bargain
 If partners can withhold new information—such as the
discovery of a new business opportunity—from each other,
then each has an incentive to drive the other out so as to
take full advantage of the information
 As each incurs costs to exclude the other, or to take
precautions against being excluded, the value of the firm
declines
 A legal rule vesting the firm with a property right to the
information and requiring disclosure is more efficient
 Suppose Meinhard and Salmon want a different rule. Maybe that
neither partner owes fiduciary duties to the other. Is that valid?
 Compare UPA (1997) § 404(b)(1) and § 103(b)(3)
 Partnership agreement “may not . . . (3) eliminate the duty
of loyalty under Section 404(b) . . . but: (i) the partnership
agreement may identify specific types or categories of
activities that do not violate the duty of loyalty, if not
manifestly unreasonable”
 Note the difference between a prospective waiver and a
“ratification” after the fact RUPA §103(b)(3) (ii)

Bane v. Ferguson
Facts: Bane retired from Isham, Lincoln & Beale and became entitled to
a pension that would end if the firm dissolved. Later ILB merged
with Rueben & Proctor. The merger turned out to be a disaster
and the merged firm dissolved. Bane sues, claiming
mismanagement in arranging the merger.

28
Held: “Nor can Bane obtain legal relief on the theory that the
defendants violated a fiduciary duty to him; they had none.”
 At the time of the alleged violation, was Bane a partner in ILB?
 No, he had a contractual relationship with the firm.
Although some might argue Bane continued to have
“partner-like” status, at least with regard to the firms
viability and profit.
 The Court says ILB had no duty to Bane and even if there is a
duty the defendants are protected by the business judgment rule
(or something like it).
 Harming the partnership would normally be thought of as a
violation of the duty of care, but maybe such conduct can
also be thought to be disloyal – at least if egregious
enough.

Grabbing and Leaving:

Meehan v. Shaughnessy
Facts: Partners want to leave firm,
1. Approached Cohen, another partner, and asked her to join
them in the new firm of Meehan Boyle & Cohen (MBC). She
agreed.
2. They asked three associates to follow them to MBC. They
agreed.
3. Two of the departing lawyers met with one of the clients to
convince it to route its business to MBC. It agreed.
4. After notifying the firm on November 30, 1984, that they
would form MBC January 1, 1985, they wrote letters to their
clients inviting them to move their business to MBC.
The partnership agreement varied from usual fiduciary duties,
with regard to taking work with you.
PC alleged:
1. Boyle told one of the other lawyers who was leaving
(Schafer) to manage his cases in a way that would
defer payment to 1985.
2. When a PC partner left (in an unrelated affair), Boyle
reassigned most of his cases to Schafer and himself.
 The PC partnership agreement required that departing
partners give the firm 3-months’ notice. For reasons not
explained, PC waived this requirement.
 The agreement also provided that partners could take with
them pending cases, so long as they paid the firm an
appropriate fee.
Held:
MBC breached their duties to the partnership, but how?

29
1. They contacted their clients in December in a way that did not
fairly give the clients a choice to stay with PC, they gained an
unfair advantage over PC(their former partners) in breach of
their fiduciary duties.
2. Until December, they lied to their partners about their plans
to leave.
A partner has an obligation to render on demand true and full
information of all things affecting the partnership to any
partner. UPA §20
Fiduciaries may plan to compete with the entity to which they owe
allegiance, “provided that in the course of such arrangements they
do not otherwise act in violation of their fiduciary duties.”
• (1) Does the holding imply that M & B have an affirmative duty
to inform the other partners of their plans to leave?
– No
• (2) Suppose that the defendants had never lied about their
intentions, and had made an announcement on private
letterhead,
– the morning after they leave the firm;
– making clear that clients could stay with firm;
Okay
 Meehan is not the last word on client contact.
 Context (i.e., motivations, actors, and partnership
agreement) is critical.

30
Grabbing and Leaving: Permissible v. Impermissible
Conduct
Negotiate with
Negotiate
Locate office Negotiate with associates
merger with
space fellow partners (can’t steal
another firm associates, but can
make plans known)
Contact clients
Not inform
before Remind clients
Contact clients clients of right
announce of right to
before leaving to have
departure have counsel
(probably can’t say firm counsel of own
of own choice
come with me, but choice
can relay plans)

Keep plans Deny plans

confidential when asked

Take client
Take desk files
files

Many firms explicitly ban such behavior in partnership agreements,

thus altering the fiduciary duties.
ABA Standards: Guidelines for Notice to Clients
Notice
Noticeisismailed Sent
mailed Sentpromptly
promptlyafter
afterchange
change

Sent
Senttotoclients
clientswith
withwhom Does
whom Doesnot
noturge
urgeclient
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sever
lawyer had an active attorney-
lawyer had an active attorney- her relationship with former
her relationship with former
client
clientrelationship firm
relationship firmand
anddoes
doesnot
notrecommend
recommend
hiring
hiring the lawyer’s(though
the lawyer’s (thoughitit
Related can
cansay
saylawyer
lawyerwilling
willingtoto
Relatedtotoopen
openand
andpending
pending
matters continue
continueherherresponsibilities)
matters for which lawyerhad
for which lawyer had responsibilities)
direct personal responsibility
direct personal responsibility
totothe
theclient
clientimmediately Makes
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candecide
decide
before
before thechange.
the change. whether to stay
whether to stay
IsIsbrief,
brief,dignified,
dignified,and
andnot
not
disparaging of former firm
disparaging of former firm

31
Lawlis v. Kightlinger & Gray
Facts: partner becomes an alcoholic, other partners outline a series of
steps for him to take, they sign agreement that specifically says
no second chances, starts drinking again, partners outline a
series of steps for him again and this time he recovers, demands
his full partnership position back, Wampler notifies him that they
are going to recommend his severance, and they remove all files
from his office, then they vote to fire him.
Held:
 Wrongful dissolution claim
 Rejected by court; Wampler simply announced what
the other partners intended to do he did not dissolve
the partnership without the vote called for in the
agreement.
 Breach of fiduciary duty – claiming they violated the
implied duty of good faith and fair dealing firing him for the
predatory purpose of increasing the partner to associate
ratio
 Partners had right to do as they did by contract
(“guillotine” clause(no cause expulsion)) and
breached no fiduciary duty
Self interest alone does not make for a breach of fiduciary duty, it is
true they will make more money by kicking him out, but that does not
mean they are kicking him out for that purpose

How do we square the court’s approval of the guillotine provision with

Cardozo’s famous proclamation in Meinhard that partners should be
selfless?
They can be selfless with regard to themselves, but that doesn’t mean
they have to be selfless with regard to the other partner’s interest, but
any way any selflessness is trumped by the contract
 Assume no expulsion provision in partnership agreement.
May firm expel Lawlis or otherwise disassociate itself from
him?
 Consider:
 UPA (1914) § 32(1)(b) or (d) incapable of
performing his part of partnership contract, or
willfully or persistently commits a breach of the
partnership agreement, or otherwise so
conducts himself in matters relating to the
partnership business that it is not reasonably
practicable to carry on the business in
partnership with him
 RUPA §601

32
Disassociation – when a partner leaves a law firm, instead of having
the partnership dissolved and then reformed without the partner who
left
Under the RUPA 601 there are three instances when a partner can be
disassociated

Effect of Assigning Partnership Interest

Putnam v. Shoaf
Facts:
The Shoaf’s are actually being paid to take over Mrs. Putnam’s
interest in the partnership
They discover that the bookkeeper has been embezzling from
the firm. They sue and recover 68k.
Mrs. Putnam claims she was entitled to this recovery.
Held:
 Putnam loses
She had no specific interest in the unknown damages to
separately convey or retain, and she conveyed her
partnership interest to the Putnams.
 Is the court treating the partnership as an entity or an
aggregate?
An entity
 UPA (1997) § 201(a): “a partnership is an entity
distinct from its partners”
 UPA (1997) § 203: “Property acquired by a
partnership is property of the partnership and not of
the partners individually.”
The point is when you buy an interest in a partnership you are buying
the whole thing

Creditors’ Access to Firm and Personal Assets

A partnership is a separate entity UPA 201, 203
You don’t own a third of everything the partnership owns, but you own
a third of the partnership
 Creditor of firm seeks to attach personal assets of a partner to
collect debt. Allowed?
 Yes, but many states require that the creditor first
proceed against the partnership
 Hint: UPA (1997) § 306
(a) “Except as otherwise provided in subsections (b) and (c),
all partners are liable jointly and severally for all
obligations of the partnership unless otherwise agreed by
the claimant or provided by law.”

33
 (b)A person admitted as a partner into an existing partnership
is not personally liable for any partnership obligation
incurred before the person’s admission as a partner.
(c) An obligation of a partnership incurred while the
partnership is a limited liability partnership, whether
arising in contract, tort, or otherwise, is solely the
obligation of the partnership. A partner is not personally
liable, directly or indirectly, by way of contribution or
otherwise, for such an obligation solely by reason of being
or so acting as a partner. This subsection applies
notwithstanding anything inconsistent in the partnership
agreement that existed immediately before the vote
required to become a limited liability partnership under
Section 1001(b).
 Personal creditor seeks to attach firm assets. Can the creditor
seize partnership property to satisfy the debt?
 No, because the partner can’t touch partnership
property and the creditor can’t touch more than the
partner, the creditor can get in front of money
coming out of the partnership in proportion to the
ownership interest of the partner in the partnership
 Hint: UPA (1997) § 501 and 504(e)
§ 501
A partner is not a co-owner of partnership property and has
no interest in partnership property which can be
transmitted, either voluntarily or involuntarily.
§ 504(e)
This section provides the exclusive remedy by which a
judgment creditor of a partner or partner’s transferee may
satisfy a judgment out of the judgment debtor’s
transferable interest in the partnership.
 Is the creditor out of luck?
 No they can get in between some of the money
coming out of the partnership.
 Hint: UPA (1997) § 504(a)-(b)
(a) On application by a judgment creditor of a partner or
of a partner’s transferee, a court having jurisdiction
may charge the transferable interest of the judgment
debtor to satisfy the judgment. The court may
appoint a receiver of the share of the distributions
due or to become due to the judgment debtor in
respect of the partnership and make all other orders,
directors, accounts, and inquiries the judgment
debtor might have made or which the circumstances
of the case may require.

34
 (b)A charging order constitutes a lien on the judgment
debtor’s transferable interest in the partnership. The
court may order a foreclosure of the interest subject
to the charging order at any time. The purchaser at
the foreclosure sale has the rights of a transferee.

Partnership Capital
 Initial capital contribution
 A partner may contribute labor.
 Capital Account:
 The way you keep track of what you have put into
the partnership is the capital account.
 A running balance reflecting each partner’s ownership
equity
 UPA (1997) § 401(a)
Each partner is deemed to have an account that is:
(1)credited with an amount equal to the money
plus the value of any other property, net of the
amount of any liabilities, the partner
contributes to the partnership and the
partner’s share of the partnership profits; and
(2)charged with an amount equal to the money
plus the value of any other property, net of the
amount of any liabilities, distributed by the
partnership to the partner and the partner’s
share of the partnership losses.
 Allocation of profits increases capital account
 Allocation of losses decreases capital account
 Taking a “draw” (distribution) decreases capital account

Alice Bob
Year 2 Capital
Account $9,000 $0
Balance
Year 3 Profit $2,000 $2,000

Year 3 Draw $1,000 $1,000

Year 3 Capital 35
Account $10,000 $1,000
Balance
Partnership Profits
 Profits divided equally per capita(person) not pro rata. UPA
(1914) § 18(a); UPA (1997) § 401(b)
 Partnership agreement provides for profits to be divided: 90% to
Alice; 10% to Bob. Agreement silent on losses. How are losses
allocated?
 Losses follow profits, absent contrary agreement. UPA
(1914) § 18(a); UPA (1997) § 401(b)

Raising Additional Capital

The Free Rider Problem

Solutions:
Agreement can state that the managing partner can issue a call for
additional funds and provides that if any partner does not provide the
funds called for, his share is reduced, according to the existing
formula. This is sometimes referred to as pro rata dilution.

Another approach is called penalty dilution, where the partnership

agreement might provide that if the managing partner determines that
additional funds are needed, new points will be offered to the partners
at a price of $250 each. (This would be called 4 to 1 dilution, since the
original points were sold for $1,000)

Another approach requires partners to make loans to the partnership,

pro rata, when called upon by the managing partner to do so. The
loans might for example bear interest at three percent above the
prime rate, with no distributions to be made to the partners until the
full amounts of the loan and interest are paid. The tough problem is to
specify the consequences of a failure of a partner to comply with a
request for loan money. One possibility is to allow the non-defaulting
partners to make the loan and compensate them for doing so by
providing for repayment of, say, 110 percent of the amount loaned,
plus interest.

The right to buy new shares in a company are called pro rata rights
your right to participate in any new investment at the same
percentage of your interest in the business, you want that to prevent
dilution (other people buying more of the company or you selling more
pieces of the company your share of the company decreases), and

36
punishes those who don’t reinvest, and it increases your returns the
right to invest at the same price can be incredibly useful if the shares
are becoming more valuable

Another approach is to provide in the partnership agreement that the

managing partner can sell new partnership shares to anyone at
whatever price can be obtained. This is comparable to a corporation
selling new shares of its common stock in order to raise new equity
funds.

Resolving Disagreements among Partners

• The UPA grants all partners the (default) “all partners have equal
rights in the management and conduct of the partnership
business,”
– UPA § 18(e)
• But if the partners disagree, whose viewpoint wins out?
– Hint: UPA § 18
§ 18(h) “any difference arising as to ordinary matters
connected with the partnership business may be decided by a
majority of the partners.”

National Biscuit Company v. Stroud (decided under UPA (1914) not

(1997))
Facts: Stroud and Freeman formed a partnership to run a grocery
store. Stroud told National Biscuit that he would not be
personally liable for any more bread it sold to the store.
Freeman ordered more bread and National Biscuit sued Stroud
for payment.
 Remember: full personal liability for debts of the
partnership. If the partnership is liable on the contract,
then so is Stroud.
UPA § 9(1) (1914):
Every partner is an agent for the partnership for purposes of its
business, and act of every partner … for apparently carrying on
in the usual way the business of the p-ship … binds the p-ship,
unless
– the partner so acting has in fact no authority to act for the
partnership in the particular matter, and
– the person with whom he is dealing has knowledge of the
fact that he has no such authority.
UPA 1997 changes it to: UPA (1997) § 301(1): “Each partner is an
agent of the partnership for the purpose of its business. An act of
a partner, including the execution of an instrument in the
partnership name, for apparently carrying on in the
ordinary course the partnership business or business of
the kind carried on by the partnership binds the

37
 partnership, unless the partner had no authority to act for
the partnership in the particular matter and the person with
whom the partner was dealing knew or had received a
notification that the partner lacked authority.”
Held:
• Since a majority of the partners did NOT vote to end Freeman’s
authority to buy bread on credit from Nabisco, the partnership
was not bound by Stroud’s objections.
• The partnership is bound by Freeman’s orders since he is an
agent of the Partnership
• If the Partnership is bound, then so is Stroud
• The only way for Stroud to end his potential liability was to
dissolve the partnership and notify the suppliers.
If he had gone out and bought diamonds then the question would be is
this in the ordinary course of business.
You could argue you are changing the nature of the partnership so you
need unanimity.
 Planning: What terms could be inserted into a partnership
agreement to avoid these problems in the future?
 Allocate controlling interests;
 Appoint a “tie-breaker”;
 Require unanimous partner consent before doing business
with a supplier (and notify creditors).

Day v. Sidley & Austin

(Illustrates extent to which courts allow partnership agreement to
derogate from statute)
Facts: firms merge, Washington office becomes run by co-chairmen,
partner claims he was promised to be the chair of the
Washington office when he joined the firm and that the decision
to appoint co-chairmen was made prior to the merger and
defendant’s concealment of that decision was a material
omission and without that prior information his vote of approval
for the merger would not have been given.
Day’s Three Main Claims:
 Misrepresentation: S&A’s executive committee engaged in
material misrepresentations that induced his assent, and thus
agreement is voidable
 Breach of K: He had a contractual right to remain the sole chair
of the DC office
 Breach of Fiduciary Duty: Secrecy of EC about merger
negotiations/consequences
Misrepresentation
Defendants claim that any possible taint of plaintiff’s vote in favor of
the merger is of no consequence because only a majority was required.

38
Court says plaintiff was not deprived of any legal right as a result of his
reliance on the statements. The partnership agreement sets forth in
detail the relationship between the partners and no mention is made of
plaintiff’s status in the Washington office, and the partnership
agreement seemed to embody the complete intentions of the parties
as to the management of the firm.
Breach of Contract
Under the partnership agreement partners could be admitted and
severed from the firm and the partnership agreement could be
amended by majority approval. The merger could be considered either
as the admission of new partners or the making of a new or amended
agreement, and thus majority approval was all that was required, and
a post facto change in plaintiff’s vote would be of no effect.
Plaintiff claims that the merger was such a fundamental change in the
nature of the partnership as to require unanimous approval, but
common law and statutory standards can be overridden by agreement.
Breach of Fiduciary Duty
The basic fiduciary duties are: 1) a partner must account for any profit
acquired in a manner injurious to the interests of the partnership, such
as commissions or purchases on the sale of partnership property; 2) a
partner cannot without the consent of the other partners; acquire for
himself a partnership asset, nor may he divert to his own use a
partnership opportunity; and 3) he must not compete with the
partnership within the scope of its business.
What plaintiff is alleging concerns failure to reveal information
regarding changes in the internal structure of the firm. No court has
recognized a fiduciary duty to disclose this type of information.

Rights to Manage the Partnership

• Recall that under UPA § 18e
– Each partner has equal rights to manage ==> right to a
voice; to be consulted

Background Knowledge
– Under UPA 1914, when even one partner leaves the
partnership it is dissolved, the agreement may
however contain a provision specifying that the
remaining partners will continue as partners under
the existing agreement in a continuation agreement.
– Under UPA 1997, if a partner retires pursuant to an
appropriate provision in the partnership agreement
there is a dissociation rather than a dissolution.
When there has been a dissociation, the partnership
continues as to the remaining partners and the
dissociated partner is entitled, in the absence of an
agreement to the contrary, to be paid an amount

39
 determined as if “on the date of dissociation, the
assets of the partnership were sold as a price equal
to the greater of the liquidation value or the value
based on a sale of the entire business as a going
concern without the dissociated partner.” §701(a)
and (b)

Default rule is that losses follow profits

Dissolution must be carried out in good faith.

Expulsion provisions (review)

• Allow the partners, on a specified majority vote, to remove a
partner.
– Recall:
• In UPA jurisdictions, expulsion is in reality a
“dissolution” of the partnership, followed
immediately by a reconstitution with all non-expelled
partners.
• Fiduciary duties constrain exercise of such provisions, but only as
regards certain motives:
– Self-interest, freeze-outs, bad faith, etc.
– Otherwise, partnership law gives a fairly wide berth

Dissolution v. Going out of Business

 Dissolution is not the same as going out of business:
 A dissolution is simply the “change in relationship of the
partners caused by any partner ceasing to be associated in
the carrying on” of the firm’s business. UPA (1914) § 29.

3 Phases of Demise for a Partnership under the U.P.A.

1 2 3
1

Termination
3

Termination
Dissolution
Dissolution Winding Up

The Right to Dissolve

 “there always exists the power, as opposed to the right, of
dissolution”—Collins v. Lewis
 Dissolution by will of one or more partners. E.g., UPA
(1914) § 31(1)(b)
 Dissolution by operation of law. E.g. death, UPA (1914) §
31(4)

40
  Dissolution by court order. E.g. lunatic, UPA (1914) § 32(1)
(a)

Causes of dissolution (UPA § 31)

• “Extraneous” Causes:
– Death, bankruptcy, impossibility, and/or special equitable
decree (see § 32).
UPA § 32(1)
• Commands dissolution decree in the event that:
(a & b) A partner becomes incapacitated from performing;
(c) A partner’s misconduct prejudicially affects business;
(d) A partner willfully/persistently breaches PA or otherwise
conducts him/herself in a way that makes the ongoing
relationship impractical to carry on;
(e) The business can only be operated at a loss;
(f) Other circumstances render dissolution equitable;

Term Partnerships
 Explicit term
 Duration specified in partnership agreement
 Specific purpose/object specified in partnership agreement
 Implicit term
 Term implied by the nature of the partnership
purpose/objectives. (e.g. the partnership plans to build
and sell new condos at the “Site.”)

Disassociation and Dissolution: UPA (1997)

Disassociation Business continued per Article

§ 601 7
Purchase of disassociated partner’s
interest (§ 701)
Disassociated partner not
automatically released for
obligations before disassociation(§
703)
Business dissolved per Article
8
Events of dissolution (§ 801; x-ref §
601(1))
Business must be “wound up”

Dissolution: Effect on Partnership

41
  After dissolution, the partnership must be wound up, absent
agreement among the partners to carry on the business.
 Assuming that the business will not be continued, the
winding up process generally contemplates that the firm’s
assets will be distributed to the partners.
 Authority of partners to act on behalf of partnership terminated
except in connection with winding up of partnership business.
UPA (1914) § 33; UPA (1997) § 804.

Continuation per Agreement: Effect on Partnership

 Technically creates a new partnership
 Recall confusing treatment of this issue in Putnam v. Shoaf
 Creditors of former partnership automatically become creditors
of new partnership. UPA (1914) § 41.

Continuation per Agreement: Effect on Departing Partner

 Departing partner entitled to accounting
 Fair value of partnership
 Interest from date of dissolution in event of unreasonable
failure to pay
 Departing partner remains liable on all firm obligations unless
released by creditors. UPA (1914) § 36; UPA (1997) § 703.

Continuation per Agreement: Effect on New Partners

 If a new partner joins the firm when it continues after a
dissolution, the new partner is also liable for the firm’s old debts,
but such liability can only be satisfied out of partnership
property. UPA (1914) § 41(1); UPA (1997) § 306(B).
 The new partner can not be held personally liable for the
old debts, unless he or she expressly agrees to be so held.

UPA (1914) § 18
 “The rights and duties of the partners in relation to the
partnership shall be determined, subject to any agreement
between them, by the following rules:
 “(a) Each partner shall be repaid his contributions, whether by
way of capital or advances to the partnership property and share
equally in the profits and surplus remaining after all liabilities,
including those to partners, are satisfied; and must contribute
towards the losses, whether of capital or otherwise sustained by
the partnership according to his share in the profits.”
UPA (1914) § 40
 § 40(b): subject to contrary agreement, upon dissolution
partnership assets should be distributed as follows: “(I) Those
owed to creditors other than partners, (II) Those owed to

42
 partners other than for capital and profits, (III) Those owed to
partners in respect of capital, and (IV) Those owed to partners in
respect of profits.”
 § 40(d): "partners shall contribute, as provided by [§18(a)] the
amount necessary to satisfy the liabilities [set forth in § 40(b)]. . .
."
What is the Default Rule?
 Losses should follow profits

Buyout Agreements
 What are the major concerns:
 Restricting the right to sell “stock” to whomever I please.
 Providing the right to force the company or other owners to
buy back my “stock”.
 What provisions might be included in our buy-sell Agreement?
 Right of First Refusal
 Right to require purchase of my stock
 Right of First Refusal and right of company to
purchase on dissociation are not the same, right of
first refusal is the right to preempt the sale you want
to carry out, not the company forcing you to sell.
 Stock Transfer restrictions
 Right of Company to purchase on death, disability,
dissociation.
 Traditional buy-sell
 One person gets to decide if they want out. I want to
activate buy-sell. The other person gets to set the
price. Other person gets to decide whether they
want to buy or sell at that price.
 What devices can be used to establish price?
 Appraisal
 Formula
 Book Value - add up the value, subtract the liabilities,
sometimes this is more than the value sometimes it is less
 Buy sell arrangement that sets the price
 Fixed amount

G&S Investments v. Belman

Facts: Partner Nordale becomes a crack head, causes a lot of problems
G&S want to kick him out of the partnership they sue for
dissolution, Nordale objects, he dies, then G&S try to exercise
the buy out clause in the agreement
Law:

43
 Even though this was a limited partnership we are using the
general partnership rules because Nordale was a general
partner.
The partners argue that his conduct, in contravention of the
partnership agreement, gave the court the power to dissolve the
partnership and allow them to carry on the business by
themselves.
§32 (1914) authorizes a court to dissolve a partnership when:
2. A partner becomes in any other way incapable of
performing his part of the partnership contract.
3. A partner has been guilty of such conduct as tends to affect
prejudicially the carrying on of the business.
4. A partner willfully or persistently commits a breach of the
partnership agreement, or otherwise so conducts himself in
matters relating to the partnership business that it is not
reasonably practicable to carry on the business in partnership
with him
Held:
Court says filling the complaint did not constitute a dissolution of
the partnership requiring the liquidation of the assets and
distribution of the net proceeds of the partners.
If filling the complaint was a dissolution then he would get the
current market value of the real estate which had gone up.

Funding the Buyout Clause

 Buyout triggered by death
 “Key man” life insurance funds buyout
 Buyout triggered by retirement
 Use pension fund?
 Buyout by partners or by partnership?
 Lump sum or installment?

Review
(1) Under UPA (1914) dissociation of a partner
automatically triggered dissolution.
Regardless of whether disassociation breached Partnership
Agreement.
(2) Under RUPA §§ 701 and 801, dissolution may or may
not be triggered.
(3) But the “wrongfulness” of the dissolution (or the
dissociation) does affect the options of the parties after
dissolution or dissociation
E.g., forced sale; continuation option; suit under wrongful
dissolution

44
 E.g. buyout price less damages and potential delay until end of
term
(4) Term of p-ship may be implied from other evidence
(5) Watch out for implied duties! Dissociation may
constitute breach of Partnership Agreement if in bad faith
or if the purpose is to freeze out -- breach of fiduciary
duty.

Wrongful Dissolution
• Critical question revolves around characterizing whether the
dissolution that occurred breached any express/implied terms in
the Pship Agrmnt. or occurred before the end of the Pship Term
– If “yes” => Wrongful; If “no” => Legitimate
• Two frequent situations:
– X dissolves partnership, asserting that it is a partnership at
will. Y objects, claiming that the partnership is for a term,
or for completion of a specific uncompleted task;
– X dissolves partnership, using authority given in P.A. Y still
objects, claiming that X’s decision is in bad faith,
constituting a breach of fiduciary duty.

The Stakes (UPA § 38)

“Non-Wrongful”Partners
“Non-Wrongful” Partners “Wrongful”Partners
“Wrongful” Partners

Righttotoforce
Right forceliquidation
liquidationand
andpro-
pro-
ratadistribution
rata distributionofofP-ship
P-ship Noliquidation
No liquidationright
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property/assets
property/assets

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Option continueP-ship
P-shipatat Nooption
No optiontotocontinue.
continue. IfIfothers
others
terminationwith
termination withother
otherpartners
partners do,wrongful
do, wrongfulpartner
partnermay
mayhavehavetoto
whoremain
who remain waitfor
wait forshare
share

Righttotobring
Right bringlegal
legalaction
actionagainst
against
“wrongful”party
“wrongful” party(if
(ifany)
any)for
for Nolegal
No legalcause
causeofofaction.
action.
breachingPA
breaching PA

Wrongful Dissociation Under RUPA

• Under RUPA a partner who wrongfully dissociates will be
entitled to the greater of liquidation value of going concern
value (its value as an operating business, Amazon
example), Minus damages. RUPA section 701(b and c)

45
 • A partner who wrongfully dissociates will have to wait for
payment until the end of the term or undertaking, unless
she can show a court that there will be no “undue
hardship” to the business of the partnership. RUPA §701(h)
It is calculated at the time the dissolution occurred, then
plus interest.

Dividing Profits / Losses

Jewel v. Boxer
Facts: law firm breaks up, no written partnership agreement
Held: In the absence of a partnership agreement, the UPA
requires that attorney’s fees received on cases in progress upon
dissolution of a law partnership are to be shared by the former
partners according to their right to fees in the former
partnership, regardless of which former partner provides legal
services in the case after the dissolution.
It is unclear whether RUPA 401(h) gets us out of Jewel or not

Last Comments on Jewell

• Champion v. Superior Court (CA, 1988):
– Chose not to follow Jewel in case of withdrawal of partner
(but PA agreement provided for survival of p-ship).
• If a partner withdraws, but...
• her share is not large portion of firm’s work...
• then there is no pro-rata sharing imposed during
winding up phase.
• RUPA § 401(h):
– A partner is not entitled to remuneration for services
performed for the partnership, except for reasonable
compensation for services rendered in the winding up of
the business of the partnership.

Policy: What effect might the court’s ruling in Jewel have on future
law firm dissolutions?
– Incentive to dump cases right before dissolution

Meehan v. Shaughnessy
Facts:
• The Parker Coulter Partnership Agreement provides that PC
is entitled to a “fair charge” for cases removed by a
departing partner.
• PC takes all other unfinished business that is not removed
and is NOT required to pay any charge, fair or otherwise.
• This is different from the Jewel rule which was the default
rule
Held:

46
 • For cases improperly removed, MB must pay damages
(less overhead) (i.e. disgorge profits)
– Winds up being 89.2% which is what their
percentage would have been had they stayed at PC.
– Money treated as constructive trust like with breach
of agent’s duty of loyalty cases.

• What would you have asked PC to include in the

Partnership Agreement to improve MB’s result?
A fair share cost for PC

Unlimited Liability in General Partnership UPA v. RUPA

• UPA (1914) § 15 “All partners are liable: (a) Jointly and
severally for everything chargeable to the partnership
under sections 13 and 14 [i.e., mainly torts]; (b) Jointly for
all other debts and obligations of the partnership....”
• UPA (1997) § 306(a): “... all partners are liable jointly and
severally for all obligations of the partnership unless
otherwise agreed by the claimant or provided by law”
Compare
• MBCA § 6.22(b): “... a shareholder of a corporation is not
personally liable for the acts or debts of the corporation
except that he may become personally liable by reason of
his own acts or conduct”

Rise of unincorporated limited liability entities

• Limited partnerships
Defined: A partnership formed by two or more persons and
having one or more general partners and one or
more limited partners.
Formation: The limited partnership is formed by filing
documents required by statute.
• Typically filed with Secretary of State
Tax aspects:
• Pre-Tax Reform Act of 1986, significant tax shelter
advantages
• Post-TRA, those advantages eroded but still widely
used to generate passive losses
General Partner Liability in Limited Partnerships
• Full personal liability
• BUT!
– Corporation may serve as general
partner
• Limited liability companies (LLCs)
• Limited liability partnerships (LLPs)
• Limited liability limited partnerships (LLLPs)

47
 • Limited Partner Liability in Limited Partnerships
• ULPA (1976): “A limited partner shall not
become liable as a general partner, unless, in
addition to the exercise of his rights and
powers as a limited partner, he takes part in
the control of the business.”
– What constitutes control?
• Holzman
• 2 Limited liability partners 1
general partner, limited
partners decided themselves
what crops to plant, to fire
the general partner, and the
agreement allowed two of
the three partners to draw
checks from partnership bank
accounts.
• RULPA (1985) § 303(a)
– Only limited partners who participate in control
can be held liable
– They can be held liable only to those who
reasonably believe based on the limited
partner’s conduct that they are a general
partner.
• But cf. Mount Vernon: A limited partner
who disregards the limited partnership
form to such an extent that he becomes
substantially the same as a general
partner has unlimited liability regardless
of a plaintiff’s knowledge of his role. At
the same time, a limited partner may
have unlimited liability for exercising less
than a general partner’s power if the fact
that he acted as more than a limited
partner was actually known to the
plaintiff.
• The Final Word: If a limited partner is known by
the creditors to be a limited partner then it
does not matter if they participate in control, it
has to be really egregious control and then the
Mount Vernon kicks in and they are liable.
• RULPA (1985) § 303(b)
– provides “ a limited partner does not
participate in control solely by consulting with
and advising a general partner with respect to
the business of the limited partnership.

48
 CORPORATIONS

Introduction

P-Ship & Corporate Status Compared

General Partnership Corporation
Lim. Liab. No (but PA can have Yes (but creditors may
indemnity provisions) seek guarantees)

Free transf No (default) Yes (default)

Continuity At will (default) Indefinite (default)
Fid. Duties Care/loyalty (def/imm) Care/loyalty (def/imm)
Mgmt. Decentralized (default) Centralized (default)
Flexibility Excellent Sometimes Awkward
Formation Informal Formalities Req’d
Tax “Pass-through” Double on earnings; Corp
Treatment only on losses.

In a corporation only the board of directors have a duty of care and

duty of loyalty not the shareholders because they are not a part of the
management.

Corporation shareholders don’t pay taxes unless there is a dividend.

Critical corporate attributes

1. Legal personality
2. Limited liability
See, e.g., MBCA § 6.22(b):
“Unless otherwise provided in the articles of incorporation,
a shareholder of a corporation is not personally liable for
the acts or debts of the corporation except that he may
become personally liable by reason of his own acts or
conduct.”
3. Separation of ownership and control
 MBCA § 8.01(b): “All corporate powers
shall be exercised by or under the authority of, and the
business and affairs of the corporation managed by or
under the direction of, its board of directors….”

49
  Shareholders entitled to vote on:
 Election of directors (MBCA §§ 8.03-.04)
 Any amendments to the articles of
incorporation and, generally speaking, by-laws
(MBCA §§ 10.03, 10.20)
 Fundamental transactions (e.g., mergers;
MBCA § 11.04)
 Odds and ends, such as approval of
independent auditors
4. Liquidity
• Secondary trading markets
5. Flexible capital structure
 Capital structure:
 The permanent and long-term contingent
claims on the corporation’s assets and future
earnings issued pursuant to formal contractual
instruments called securities
 Many ways to package such claims; e.g.,
stocks and bonds
6. The corporation is an entity with separate legal existence from
its owners
1. Legal fiction, but a useful one
2. Possesses (some) constitutional rights
3. Separate taxpayer

S Corporation
• Statutory creation of tax code.
– Usually a “close” corporation
• Principal advantage:
– Combines pass-through taxation with limited liability.
• Disadvantages:
– Constraints on # of shareholders, types of shareholders
(other companies can’t hold stock), capital structure you
can only have one type of stock capital structure, limits on
how you can deduct pass-through losses.
A simpler structure, usually a small closed corporation
Advantages: pass through taxation, and limited liability
Up till LLC’s it was the best thing to use for pass through taxation and
limited liability
A c corporation is the normal corporation

Debt and equity securities

• Bonds and other debt securities typically consist of two distinct
rights:

50
 – The bondholder is entitled to receive a stream of payments
in the form of interest over a period of years
– At the end of the bond’s prescribed term (i.e., at maturity),
the bondholder is entitled to the return of the principal
• Creditors; not owners
• Equity securities (a.k.a. shares) represent “the units into which
the proprietary interests in the corporation are divided”
– Residual claimants: equal right to participate in
distributions of the firm’s earnings and, in the event of
liquidation, to share equally in the firm’s assets remaining
after all prior claims have been satisfied
– A limited right to participate in corporate decision making
by electing directors and voting on major corporate
decisions

Capital structure terminology

• Authorized shares: The articles must specify the number of
shares the corporation is authorized to issue.
• Outstanding shares: The number of shares the corporation has
sold and not repurchased.
• Authorized but unissued shares: shares that are authorized by
the charter but which have not been sold by the firm.
• Treasury shares: shares which were once issued and
outstanding, but which have been repurchased by the
corporation
– The MBCA has eliminated the concept of treasury shares,
so that reacquired shares under the RMBCA are simply
classified as authorized but unissued shares.

Issuance of stock
• Board of directors prerogative.
– Shareholders involved only if:
• Board wants to sell more shares than are presently
authorized in its charter
• Board of directors wants to issue a new class of
shares not authorized in the charter
– So long as the charter authorizes the class of shares in
question and there are sufficient authorized but unissued
shares, the board is free to sell shares for “any valid
purpose” as long as the corporation receives adequate
consideration for the shares.

Corporations: Sources of Law

• Statutory and Case Law within each state
• Because of specificity of codes, the relative incentive to contract
around corporate code may be smaller

51
The incorporation process
Choosing a state of incorporation
Paul v. Virginia (US 1869) A state may not exclude a foreign
corporation engaged in interstate commerce
Foreign = another state
Alien = another country

The Incorporation Process

= Inc.
(MBCA § 2.03)
1. Draft articles 2. File articles
of incorporation with Secretary
of State (not
The Colin Powell)
Contents:
Mandatory terms (MBCA §
Incorporator 2.02(a))
(MBCA § 2.01) Optional terms (MBCA §
2.02(b))

Post-Incorporation
• Draft bylaws (MBCA § 2.06)
• Organizational meeting (MBCA § 2.05)
– Name directors, if necessary
– Adopt bylaws
– Appoint officers
• Issue stock
Final Steps:
(1) Adopt By-Laws
(2) Issue Stock (SEC Filings)
(3) Appoint Officers

Promoters
• Promoter: Someone who purports to act as an agent of the
business prior to its incorporation. A “promoter” is a person who
identifies a business opportunity and puts together a deal,
forming a corporation as the vehicle for investment by other
people.

52
Principal Problem w/ Promoters:
Enter agreements and contracts with 3d parties on behalf of an as-yet
fictional corporation
1. Once the articles are filed, does the corporation become a party to
the contract?
– Yes, but not automatically. The corporation must “adopt”
the contract.
– Adoption can be effected:
• Expressly (typically by a novation); or
• Implicitly (e.g., ratification by acceptance of benefits)
– The corporation might even acquire rights under the
contract as a third party beneficiary.
2. Once the articles are filed, is the promoter liable if the corporation
breaches the contract?
– MBCA § 2.04
– All persons purporting to act as or on behalf of a
corporation, knowing there was no incorporation
under this Act, are jointly and severally liable for all
liabilities created while so acting.
– What if corporation adopts the contract?
– Promoter needs to be released from liability by other party
to the contract
3. If the articles are not filed, is the promoter liable on the contract?
– Yes. Absent an agreement to the contrary, the promoter
remains liable on the contract if the corporation never
comes into existence. MBCA § 2.04.
– It is possible that the would-be investors in the never
formed corporation are liable under partnership law,
especially if they are sharing profits and control.
4. If the articles are not filed or are defectively filed, can the
defectively formed entity (or individuals) enforce the contract?

Promoters and fiduciary duties

• Promoter owes fiduciary obligation to corporation she promotes.
– Duty of Loyalty
• (render information; not to compete; not to act as
adverse party w/o consent)
– Duty of Care and Skill
• Creates a potential problem with circularity:
– Who benefits from the promoters’ fiduciary duties before
corp. is formed & shares sold?

Southern-Gulf Marine Co. No.9, Inc. v. Camcraft, Inc.

• Wrinkle # 1:
– Here the corporation seeks to enforce a contract
made on its behalf before it was incorporated

53
 • Wrinkle # 2:
– A defective incorporation:
• Contract called for a Texas corporation, but
firm incorporated in Cayman Islands.
• Result
– Camcraft is estopped to deny SGM’s corporate status
– Hence, SGM may sue to enforce the contract
• Rule?
– A third party who dealt with the firm as though it
were a corporation and relied on the firm, not the
individual defendant, for performance is estopped
• Fine distinction to be drawn between de facto corporation
and corporation by estoppel

Distinction between de facto corporation and a corporation by

estoppel
De facto – you thought you were a corporation and did everything right
but somebody else messed up, means the court might give
you limited liability because the third party thought they were
dealing with a corporation
Corporation by estoppel - you hold yourself out as a corporation and
the other side believes you are a corporation and
they would get a wind fall by saying you are not a
corporation. Tort victims don’t fall under
corporation by estoppel because they did not
contract with the false corporation.

Related Doctrines Addressing “Defective” Corporations

• De Facto Incorporation: Treat improperly-incorporated entity
as corporation if organizers:
1. tried to incorporate in good faith,
2. had a legal right to do so, and
3. acted as if a corporation.
• Incorporation by Estoppel: Treat as proper corporation if
person dealing with the firm
1. thought firm was a corporation all along;
2. would earn a windfall if now allowed to argue that the firm
was not a corporation.

Generic Questions
• Is it improper to incorporate your business for the express
purpose of avoiding personal liability?
– No its okay.
• Is it improper to split a single business enterprise into multiple
corporations so as to limit the liability exposure of each part of
the business? [recall Southern-Gulf Marine]

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 – No its okay.

Limited Liability
• MBCA § 6.22(b): “… a shareholder of a corporation is not
personally liable for the acts or debts of the corporation except
that he may become personally liable by reason of his own acts
or conduct”

Policy: Is L.L. a good idea?

(a) SHs’ incentive to monitor management?
lowered
(b) SHs’ incentive to monitor each other?
lowered
(c) Creation of a developed trading market for shares?
improved
(d) Outsiders’ incentive/ ability to monitor management?
(e) SHs’ ability to diversify portfolio?
improved
(f) Incentive to impose negative externalities on third
parties?
Creates a much greater incentive to invest
• Externalities
– Allows Carltons of the world to avoid some of
the social cost of their activities
• Encourages excessive risk-taking

“Piercing the Corporate Veil”

Policy: “Externalities” and the (In)Voluntary Creditor

• Voluntary Creditors (e.g., Lenders, Employees)
– Ex ante negotiations with firm...
– …easy to find out whether firm is incorporated.
– Thus: Can demand more attractive Prices/Interest Rates to
adjust for increased risk
• Involuntary Creditors (e.g., Tort victims)
– No ex ante negotiations...
– Thus: Cannot demand higher “price”
• Must depend on existence of insurance, changing
their activity levels, etc.

Walkovszky v. Carlton
Facts: fragmented taxi corporation
Plaintiff Offered Two Theories:
1. All 10 corporations were part of a single enterprise
• Court’s Reaction?
– Not wrongful

55
 – Drew distinction between veil piercing, gets to
shareholders, and enterprise liability, gets to larger
corporation
• What would plaintiff have to show in order to recover under the
enterprise theory?
– That Carlton did not respect the separate identities of the
corporations
• Assignment of drivers
• Use of bank accounts
• Ordering of supplies, etc
Then he could get to the assets of the other
corporations
2. Multiple corporate structure was an unlawful fraud on the public
• Court’s Reaction?
– Plaintiff’s injury unchanged by ownership structure
• By what standard will the Walkovsky court decide whether to
pierce the veil and hold Carlton liable?
– Where a shareholder uses control of the corporation
to further his or her own, rather than the
corporation’s, business, he or she will be held liable
for the corporation’s acts and debts on a principal-
agent theory.

There are three separate legal doctrines that the plaintiff might invoke
in a case like Walkovsky: (a) enterprise liability; (b) respondeat
superior (agency); and (c) disregard of the corporate entity (“piercing
the corporate veil”)

Policy: What incentives are created by the court’s refusal

to PCV?
• The insurance will stay at the minimum, and the
capital will remain low

Avoidance of personal liability is easy: respect the corporate

formalities and take out the minimum insurance
Avoiding enterprise liability is more difficult. Need separate books and
bank accounts for each corporation, plus careful accounting for
supplies, for borrowing of drivers, etc…

Alternative Approaches to reach beyond corporate assets

Agency Law: Was corp. an agent of defendant (Rest. §1)?
“Vertical” Piercing (Conventional)
Allows one to reach the SH’s assets
Basic Q: Did SH transgress SH-Corp boundaries plus injustice
“Enterprise Liability
Allows one to reach the sister Corp.’s assets

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Basic Q: Did sister corps transgress Corp-Corp boundaries (integrated
resources for a common business purpose)?

Agency Law
– The court makes no distinction between PCV and agency
theory.
– However, issues of fraud, adequate capitalization, etc.,
ought to be irrelevant to liability under this Master/Servant
agency theory.
– Agency theory does not work well to impose liability on
individual shareholders like Carlton, since they are likely to
have authority to act as corporate offices or employees so
their acts of control will not be in their role as
shareholders.
– Agency is more useful in some parent-subsidiary situations
where e.g. executives of the parent who have no official
role in the subsidiary take control of the subsidiary.

Should we distinguish between tort victims and contract creditors?

– Note that most courts do not make this distinction (but see
Silicone Implants)

Sea-Land v. Pepper Source

Facts: Defendant owns a bunch of corporations himself, and half of
another one, no corporate meetings, or articles of incorporation,
etc.
Plaintiff claims they were alter egos of the defendant that he used for
his personal gain
• “Black Letter” Illinois Law
TWO conjunctive elements for a PCV claim:
(a) Unity of interest and ownership, and
(b) Refusing to allow PCV would either
– (i) sanction fraud or
– (ii) promote injustice.
As for part (a) of the test the Illinois cases focus on four factors:
“(1) the failure to maintain adequate corporate records or to
comply with corporate formalities, (2) the commingling of funds
or assets, (3) undercapitalization, and (4) one corporation
treating the assets of another corporation as its own.”
As for part (b) the Illinois test does not require proof of intent to
defraud creditors, either the sanctioning of a fraud (intentional
wrongdoing) or the promotion of injustice, will satisfy the second
element.
Held:
Sea-land has failed to prove the second element, it would be shown
if it could establish that Marchese used these corporate facades to

57
 avoid its responsibilities to creditors; or that one of the other
corporations will be “unjustly enriched” unless liability is shared by
all.
• Even if it was
necessary, is the case
for piercing the
company he only owns
half of equally strong?
if you don’t allow it then it creates a big incentive to put you
money in jointly owned corporations, but you are saying that
because he was stealing from Andre Andre should be able to lose
everything in the corporation, but he was mingling assets and
things with Tie-Net.
• While other states are similar, they are more “muddied” than
that stated here.

Factors Relevant to Control/Unity of Interest Prong

• Commingling of funds
• Undercapitalization
• Disregard for corporate formalities:
– Failure to hold shareholder meetings
– Failure to hold board meetings
– Failure to keep minutes of said meetings
– Failure to keep separate books
– Failure to issue stock
– Failure to appoint a board
– Failure to adopt charter or by-laws
One factor in California is the formation and use of a corporation to
transfer to it the existing liability of another person or entity.

Second Prong
• Is it enough that the creditor will be unable to collect the full
amount owed unless the court pierces the veil?
– No. Sea-land is especially explicit on that point. There must
be something more: e.g., fraud or unjust enrichment.
• Is a shareholder who avoids personal liability by definition
unjustly enriched?
– More likely with torts, because you could argue with
contracts people take that into account when
contracting with the corporation

With reverse piercing you get out of the place of the shareholder, and
instead get in with the creditors of the corporation.

What reverse piercing allows you to do is to get to the assets of the

company were the defendant is a shareholder along with the creditors.

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The alter ego doctrine is part of piercing it is a synonym for a unity of
purpose, a blurring of the lines between the barriers of the firms, can
also refer to a new company created that is essentially a part of an
older one.

Review
• Piercing the corporate viel (per Sea-land)
– The corporation was the controlling shareholder’s alter
ego; and
– Adherence to limited liability would “sanction a fraud or
promote injustice”
• Enterprise liability
– Such a high degree of unity of interest between the two
entities that their separate existence had de facto ceased
– Corporations not operated as separate entities, resources
are integrated to achieve a common business purpose.

In re Silicone Gel Breast Implants Products Liability Litigation (They

misapplied the law, but it is good for plaintiffs.)
Facts: Bristol owed all the stock and ran the show in breast implant
company
First claim: (Vertical Piercing)
• Legal requirements for such a claim:
– “Best of” compilation of factors [225-26] ex.:
• grossly inadequate capital
• subsidiary receives no business except that
given to it by the parent
– “Extra” element – fraud, misrepresentation
• How does the court treat this omission of the second
element?
– Distinguishes tort from contract claims
• Says in tort cases there is a presumption for
the second element
• But it is questionable whether this is a tort case
there are contract aspects in products liability.
Second claim: (Direct Liability)
• Restatement 2d of Torts § 324A:
– Liability of one who gratuitously but negligently
provides services that are necessary for protection of
3rd party.
• Aggressive marketing by Bristol may make them directly
liable.

• Are there any other theories plaintiffs might use to attach

liability to Bristol?
– Apparent Agency/Authority

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 (1) Manifestation from P to third party of Principal/Agent,
or Master/Servant?
(1) Reasonable Belief
(2) [Detrimental Reliance]
Corporate shareholders:
• One interpretation of case:
– Courts are less rigorous with requirements for proof when
the “piercee” shareholder is a corporation;
Policy: In fact, some have argued that such a rule makes
sense as a normative matter.

Review: “Piercing the Veil”

• Nearly every jurisdiction employs a 2-part test:
1. Unity of ownership/interest
2. Disallowing would be “inequitable”
*Conjunctive (but has some “sliding scale” properties)
• Neither part of test is clean:
– Unity: multiple factors (e.g., formalities, domination,
commingling, “thin” capitalization)
– Inequitable conduct: (Illegality, torts, fraud, other “unfair”
business practices, usually need more than inability to
compensate Plaintiff)
• Test applies to either vertical or reverse PCV.

When you pierce the corporate veil the shareholder has unlimited
liability
There have been no cases involving piercing for publicly owned
corporations

Review: Avoiding “Piercing”

• Respect corporate formalities
– Governance structure, minutes
– No commingling of assets, – not taking out dividends when
money is owed to creditors
• If not respected, things are murky
– Inadequate Capitalization
– Torts: Inadequate Capitalization
– Contracts: Fraud/Misrepresentation
– Individual vs. Corporate SH.

AP Smith Mfg. v. Barlow

Facts: Corporation makes gift to university, president says it was in the
long term interest of the corporation
• SH Claims:
– (1) Decision to make a $1,500 donation to Princeton
University was ultra vires;

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 • Ultra Vires Doctrine:
– Action by officers or board of directors contrary to
corporate purpose (usually as stated in charter)
– Considerably less important than it used to be:
• Most corporations have broad charter provisions
• DGCL §§ 101(b); 121(a); 124
• Today, such claims are usually couched in terms of
“wasting” corporate assets
Held: Court says they that a corporation can give a gift.

Planning: It is possible for corporations to adopt charter provisions

expressly limiting or prohibiting charitable contributions. Such
provisions are unheard of.

Dodge v. Ford Motor Co.

Facts: Ford declares he is not going to ever give out any more special
dividends, starts raising wages, and says he will continue to do
so even if it is not in the corporation’s best interest
• What relief were the Dodge boys seeking?
– To require FMC to issue special dividends
– To enjoin the construction of the River Rouge plant
Holding:
– FMC must issue the special dividends
– FMC can continue with its construction plans
• Why did the court decline to enjoin the expansion of
the plant?
• “The judges are not business experts”
• Implicates the business judgment rule
• What standard of review does court announce re dividend
decisions?
– Courts will generally leave dividends to the discretion of
the directors
– But will intervene if refusal to pay amounts to “such an
abuse of discretion as would constitute a fraud, or breach
of … good faith”
– Under BJR, courts won’t scrutinize decisions about how to
maximize profits; but they will scrutinize decisions about
whether to do so.
– Why doesn’t Ford meet this standard?
• Ford ran the company as an “eleemosynary” institution
– “A business corporation is organized and carried
on primarily for the profit of the stockholders. The
powers of the directors are to be employed for
that end.”
• Latent Antitrust Concerns
– Promoting competition among manufacturers

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 • Minority Oppression/Close Corporation
– Dodges can’t easily dump their shares.
Bottom Line:
– While BJR gives discretion to managers in
deciding how to pursue the corporation’s
objective (e.g., maximize SH profits), the
“waste” limitation withholds such discretion
for decisions about whether to do so.
– Thus, in spite of BJR’s protection,
management must be able to offer a
rational basis for decision.

Publicaly Traded Companies

If this was a publicly traded company then you don’t have as
much of a right to force the company to issue dividends.
Because it is a publicly held company you can easily sell your
share.
Usually in these cases a minority shareholder is trying to stop the
majority holder from giving a dividend.
You can’t give out dividends that would render the company
insolvent.
There are limits on dividends but they are usually how much
money the company has, etc.

Shlensky v. Wrigley
Facts: Shlensky was a minority shareholder in corporation that owned
the Chicago Cubs and operated Wrigley Field. P.K. Wrigley
owned 80% of the stock, refused to install lights. Cubs
consistently lost money, probably attributable to poor home
attendance which was probably attributable to lack of night
baseball. Wrigley refused to institute night baseball because he
believed that baseball was a day-time sport and that night
baseball might have a negative impact on the neighborhood, and
he says he is not motivated by profits.
• Wrigley wins
Rule of law:
– In the absence of a showing of fraud, illegality or self-
dealing by the directors, their decision is final and not
subject to review by the courts
• This is the Business Judgment Rule
– Since the courts won’t review such decisions, plaintiff has
no standing to sue
– Court assumes decision benefited Cubs, sights plausible
reasons.

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There are fiduciary duties of the board, and they cannot be waived in
the abstract. So if you want to tailor you business for the well being of
society and you have specific provisions designed to that effect then
you can enforce those provisions. But you can’t ask minority
shareholders to waive their rights in the abstract.

When you want to use your business for your moral, political, or
charitable agenda and there are other shareholders then the BJR will
not protect you.

Fiduciary Duties
• Duty of Care
• Regulates thoroughness and diligence in performing tasks.
• Limited by BJR.
• MBCA § 8.30(a): “Each member of the board of directors,
when discharging the duties of a director, shall act: (1) in
good faith, and (2) in a manner the director reasonably
believes to be in the best interests of the corporation.
• This is a negligence standard
• Almost all duty of care issues are resolved by the business
judgment rule.
• Duty of Loyalty
• Regulates self-dealing transactions by management.
• No BJR shield

Two Ways of Thinking about the Business Judgment Rule

• As an abstention doctrine
– Court will not review BoD decision, there is a presumption
of good faith and against judicial review of duty of care
claims, the court will abstain from reviewing the
substantive merits of the director’s conduct unless the
plaintiff can rebut the bjr’s presumption of good faith by
carrying the burden and showing the directors, in reaching
their decision, breached one of the fiduciary duties – good
faith, loyalty, or due care. If the rule is rebutted it the
burden shifts to the directors so show the “entire fairness”
of the transaction.
– Preconditions:
• No fraud
• No illegality
• No self-dealing
• Decision not egregious
• As a standard of liability
– No liability for negligence, has to be gross negligence or
recklessness
– Instead liability based on:

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 • Fraud
• Illegal conduct
• Self-dealing
• Egregious misconduct
Overcoming the BJR
Aronson v. Lewis (Del. 1984):
• BJR does not protect corporate fiduciaries if their
actions:
(1) are not in the honest belief that action is in best
interests of corporation…or
(2) are not based on an informed investigation…or
(3) involve a conflict of interest.
• How plaintiff go around BJR?
– Illegality or fraud;
– Conflict of interest alleged (DoL)
• How plaintiff go through BJR?
– Poor/hasty investigation of choices available and
consequences?
– Was there a “rational basis” for decision?
Reconciling the DoC and the BJR
• The duty of care tells directors don’t be negligent
– Standard of conduct is aspirational
• Business judgment rule insulates directors from liability for
simple negligence
MBCA Provisions
• § 8.30 Standard of Conduct
– “Each member of the board of directors, when discharging
the duties of a director, shall act: (1) in good faith, and (2)
in a manner the director reasonably believes to be in the
best interests of the corporation”
• § 8.31 Standard of Liability
– (a) A director shall not be liable to the corporation or its
shareholders for any decision to take or not to take action,
or any failure to take any action, as a director, unless the
party asserting liability in a proceeding establishes that:
• (1) any provision in the articles of incorporation
authorized by section 2.02(b)(4) or the protection
afforded by section 8.61 for action taken in
compliance with section 8.62 or 8.63, if interposed as
a bar to the proceeding by the director, does not
preclude liability; and
• (2) the challenged conduct consisted or was the
result of:
• (i) action not in good faith; or
• (ii) a decision

64
 • (A) which the director did not reasonably
believe to be in the best interests of the
corporation, or
• (B) as to which the director was not
informed to an extent the director
reasonably believed appropriate in the
circumstances; or
• (iii) a lack of objectivity due to the director’s
familial, financial or business relationship with,
or a lack of independence due to the director’s
domination or control by, another person
having a material interest in the challenged
conduct ...
• (v) receipt of a financial benefit to which the
director was not entitled or any other breach of
the director’s duties to deal fairly with the
corporation and its shareholders that is
actionable under applicable law.

Kamin v. American Express

Facts: American Express gives stockholders stock
They say by giving us the stock in kind you lost a huge tax
benefit, and the failure to do so was a violation of their duty of
care.
Held:
BJR, no bad faith or dishonest purpose and no neglect of their
duties because they did make a choice.
The conflict of interest with the 4 directors doesn’t matter
because the other 16 directors didn’t have a conflict of interest
and they approved it to, so loyalty was not a problem.

BJR and the Requirement of an Informed Decision

Smith v. Van Gorkom
Facts: Trans Union is unable to get tax benefits, chairman Van Gorkom
decides to sell company to get the benefits, negotiations with
financier Pritzker for Trans Union Corporation to be bought
through a leveraged buy out at $55 – Romans(financial analyst)
doesn’t say this is how much our company is worth, he says how
much the company could borrow.
 The merger
• Former TU shareholders get cash as part of the
merger.
• In this case for each share worth $38 they get
an iou for $55 in the short future.

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 • Prtizker says he wants a million shares at $38.
This is a lock up.
o Lock up – why would Pritzker want this?
He is guaranteed at least $17. Plus he
may deter the bidding. It may also take
value out of the deal, and somebody who
was competing would have to pay more
than he was willing to pay.
 Van Gorkom tells senior management about the deal,
and they hated the deal.
 TU BOD approves the merger after 2 hour meeting,
no written studies or other documentation.
 BOD approves revised deal. Shareholders approved
the deal.
 This is a class action because the wrong was done to
the shareholders. In a derivative action by
shareholders, the wrong is done against the
company.
 Trial court ruled in favor of the board because of the
bjr.
 Business Judgment Rule does not protect:
• Fraud
• Illegal conduct
• Self-dealing
• Egregious misconduct, and
• No protection for an uninformed decision
Held:
• RULE - Says that we are not reviewing your
substantive decision. But we can review
procedural defects.
• The legal test for procedural challenges to BJR:
o Not enough procedure, no subsequent
correction, no SH cleansing of breach
o If not did SH approval of deal “cleanse”
breach
 Rule = Normally this does. But the
approval must be informed. There
is cleansing when there is an
uninformed decision by
shareholders.
o Factors for “entire fairness” Cinerama v.
Technicolor
 The timing
 Initiation

66
  Structure of the transaction
 Disclosure to and approval by the
shareholders
 Aggressive bargaining by fiduciary;
 Fiduciary’s knowledge of business;
 Whether outside valuation advice
sought;
 Magnitude of premium over market
price;
 Surmountability of “lock-ups” by
3rd parties
o Damages – board has to pay the
difference between $55 and the market
value . That difference may be 0 because
that was a fair price. This is an
affirmative defense that was available.
The Board’s Reliance on Chairman
- DGCL § 141(e) provides a defense for directors who rely on
reports from officers. Why didn’t § 141(e) apply here?
o Van Gorkom was uninformed
o BoD had a duty to make inquiry into the basis of Van
Gorkom’s opinion … can’t rely blindly, good faith not blind
reliance
Rule:
 No protection for an uninformed decision
 The determination of whether a business judgment is
an informed one turns on whether the directors have
informed themselves “prior to making a business
decision, of all material information reasonably
available to them.”
 Gross negligence is the standard for determining
whether a business judgment reached by a board
was an informed one.
 Who has burden of proof?
• Party attacking boards decision

Evaluating the Standard

- The “reasonably available” standard requires an in-depth study:
o Valuation study
o Discussion of course of the negotiations
o Review of actual contract
- Policy: Is this an appropriate standard?
o Information is costly
o Where is point of diminishing returns?

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 o What “Costs” Result from Judicial Review
 Hindsight bias may discourage risk-taking
 Interference with internal governance
 Judicial decisionmaking not subject to market
discipline:
 In theory Firms whose managers make bad decisions
are weeded out in Darwinian selection

Business Judgment Rule post-Van Gorkom

 A standard of liability
 Directors may be held liable for gross negligence in failing
to make an informed decision
 A rule of abstention
 Will court review substance of BoD decision?
 No
 Court will examine decisionmaking process
 The extent to which BoD made an informed
decision

Planning: What do we do now to make a proposed merger safe (or

safer) from attack?
 Get an outside expert. Get a fairness opinion.
 Get Lawyers to review the contracts
 Board members should now insist on insurance

DGCL § 102(b)(7)
– Duty of Care (still) a default rule, but permits “indemnity”
provisions.
• Effectively allows charter to limit/eliminate personal
liability for directors’ breach of DoC.
– Duty of Loyalty; fraud doctrines still immutable
• But see DGCL § 122(17)

Practice Points
• After Van Gorkom (as before), ∆ s always assert BJR in DoC
actions;
• Anticipating this, π s tend to plead faulty procedure rather than
substantive “waste”
– Or, by arguing fraud/illegality/DoL
– Note: Plaintiffs must show existence of duty, breach (BJR),
causation, and damages
• Actions often easier for π s under federal law if company is
publicly traded.

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 • Remember: BJR only protects people who don’t have a conflict of
interest.

Challenging Process: Lessons from Van Gorkom & progeny

1. While BJR creates a presumption that the board’s decision was
informed…
…plaintiff can rebut presumption by showing that prior to
making decision, board was grossly negligent (or reckless)
in informing themselves about material information
reasonably available to them.
2. Defendants found to have breached their DoC procedurally
can still defend on other grounds (e.g., causation):
• Transaction was “entirely fair” to corporation
(Cinerama)
• Fully-informed SHs voted to approve board’s action
(Van Gorkom)

Business Judgment Rule and “Good” Corporate Governance,

WASTE
Brehm v. Eisner
Facts: Disney board gives Ovitz a contract with incentives to induce a
non-fault termination.
Plaintiff’s Allegations:
• Old Board violated its duty of care and committed waste in 1995
when it approved the compensation package
• New Board violated its duty of care and committed corporate
waste in 1996 when it approved non-fault termination
What is corporate waste?
– A transaction “that is so one sided that no business person
of ordinary, sound judgment could conclude that the
corporation has received adequate consideration” (a pretty
extreme standard)
– What did plaintiff need to prove to show process due care
violation?
– Board was grossly negligent in failing to inform itself of all
material information reasonably available to it
– Can the board consciously make a decision to take the risk that it
lacks key information?
– Yes in some ways, you can say I have enough information
here
– Court says the board must inform itself of information
within its “reasonable reach”
– Did the Old Board inform itself of all material information
reasonably available?
– No … didn’t calculate the potential expense associated
with a non-fault termination

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 – Was Old Board therefore liable?
– No, because they brought in an executive compensation
expert. § 141 (e) defense (Delaware law)
– Court adds some pre-conditions to § 141(e) defense:
– the expert defense only applies if you have
asked them about their qualifications and it is
within their expertise.
Why did Eisner come out this way and Van Gorkom come out the other
way?
– Van Gorkom involved a final period problem
– Brehm involved much smaller amount in relative
terms
– Van Gorkom Board wholly abdicated its role
• Van Gorkom rests on the absence of a
sufficient record of any deliberative process
• In Brehm board at least hired an expert
What is the relationship between the bjr and the duty of care in this
case?
Here we are not even getting to the BJR rule because of
the expert defense.

70
 The Business Judgment Rule and the Duty of Care
No
BJR Applies: Court abstains

Illegality
Frau Conflict No decision
d? No Egregious
of
Interest decision
N?
? Uninformed
Yes decision
BJR rebutted Yes Waste
Federal or state
Fraud claims
BJR rebutted Yes
Duty of Loyalty

BJR Illegality
Rebutted: No Decision
Did Yes Egregious decision
defendant Uninformed
violate decision
No DoC? Yes Waste
No Decision

Defendants Calculate
Win damages
see Van
Gorkom

Francis v. United Jersey Bank

Facts: Widow is director, but inactive, Pritchard boys: Charles Jr. &
William other directors, father had said Charles would “take the
shirt off my back,” embezzled large sums in form of “loans.”
Why do creditors have standing to sue for fiduciary duty breach?
 Because insurance companies are similar to a bank
in that they are holding people’s money in trust they owe
fiduciary duties to their creditors.
- Plaintiff alleged a breach of duty of care by Pritchard

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 o Role of business judgment rule?
 None:
• Rule has no application where directors
have failed to exercise business
judgment — i.e., failed to make a
decision
• Note that the rule DOES protect a
Decision not to act.
- Is Pritchard automatically liable, because BJR doesn’t
apply?
o No. Plaintiff still has to show that Pritchard breached her
duty of care.
- Did Pritchard breach her duty of care?
o Yes – inattentive – facts that she was old, depressed,
drunk, and ignorant of business were no defense, she is
liable for losses caused by acts of insiders, like officers,
directors and shareholders.
• Even if she breached her duty of care, was it the proximate
cause of injury to plaintiffs?
– i.e., could Mrs. Pritchard have done anything about it?
• Duty to be informed:
– “Obligation of basic knowledge and supervision”
– Read and understand financial statements
– Object to misconduct and, if necessary, resign
– Sue the wrongdoers?
– Upon discovery of an illegal course of action, a director has
a duty to object and, if the corporation does not correct the
conduct to resign.
– Usually a director can absolve himself from liability by
informing the other directors of the impropriety and voting
for a proper course of action. A director who is present at
a board meeting is presumed to concur unless his dissent
is entered into the minutes of the meeting or filed promptly
after the meeting.
• Could Prichard have invoked right to rely on other
director’s/subordinates’ reports/opinions?
– Yes, but a director may not rely on subordinates when they
notice subordinates acting inappropriately.

In re Caremark Int’l Inc.

What do you do when your company is doing something illegal? (this is
not a bjr case)
Facts: Caremark is a managed care health company subject to the
Anti-Referral Payments Law, which prohibits managed care

72
 organizations that receive Medicare/Medicaid funds from paying
doctors to refer patients to firm.
• Feds prosecute and civilly sue Caremark
• Caremark settles; pays $250 million
• Shareholder sues Caremark board “derivatively”
• Caremark settles shareholder suit
• Agrees to pay plaintiff attorney fees of $1 million
• Settlement requires court approval
Rules of Law:
• Does business judgment rule apply?
• No – this was a lack of oversight case; no board
decision
• Did board violate its duty of care?
• Not decided due to procedural posture
• Probably not – no evidence of “sustained failure to exercise
… oversight”
Director liability for breach of the duty of care may arise in two
distinct contexts, from a board decision that results in a loss
because that decision was ill advised or negligent, and from an
unconsidered failure of the board to act in circumstances in
which due attention would, arguably have prevented the loss.
The first case will typically be subject to review under the bjr
assuming the decision was the product of a process that was
either deliberately considered in good faith or was otherwise
rational.
Held:
• Does the board have a duty to adopt a law compliance program?
– Although court says absent grounds to suspect deception,
neither corporate boards nor senior officers can be charged
with wrongdoing simply for assuming the integrity of
employees and the honesty of their dealings on the
company’s behalf.
– Allen says yes: must “attempt in good faith to assure … a
corporate information and reporting system” to ensure
compliance with the law
Where a claim of directorial liability for corporate loss is
predicated upon ignorance of liability creating activities within
the corporation, only a sustained or systematic failure of the
board to exercise oversight such as an utter failure to attempt
to assure a reasonable information and reporting system
exists will establish the lack of good faith that is a necessary
condition to liability.
What would an “adequate” law compliance program include?
• Policy manual
• Training of employees
• Compliance audits

73
 • Sanctions for violation
• Provisions for self-reporting of violations to regulators

A decision to cause the corporation to violate the law is not protected

by the BJR
– If the BJR were a standard of liability, then
directors are liable
– But if the BJR is an abstention doctrine, then
directors are not automatically liable. Instead, the court goes
on to ask whether the decision was a reasonable one.

Egregious board decisions

• In Caremark, court limits liability for egregious decisions. When
can directors be held liable for egregious decisions?
– Only where directors acted in bad faith or followed an
irrational decisionmaking process
– No “objective” review of substance of decision

Sarbanes-Oxley
– Makes it easier to prosecute securities fraud, particularly
financial fraud.
– Imposes greater responsibility on senior management and
directors, particularly independent directors and audit
committee members, by requiring them to take a
substantially more proactive role in overseeing and
monitoring the financial reporting process, including
disclosure and reporting systems and internal controls
– Does not purport to change the common law duty of care,
but increases civil and criminal enforcement authority over
the conduct of corporate officers and directors,
• No question that potential civil liability for directors
will be greater after Sarbanes-Oxley
The goals of Sarbanes-Oxley
Is to have some accountability for what goes into financial
statements, that more goes into financial statements, less
is hidden, and that the average investor can understand
more from looking at those financial statements.
Sarbanes-Oxley Audit Committee Requirements
• Section 301 of Sarbanes-Oxley orders SEC to adopt rules
mandating that:
• The audit committee shall receive reports from the
independent auditors regarding critical accounting polices
and practices, discussions that have taken place with
management regarding alternative treatments of financial
information under GAAP, and any accounting

74
 disagreements and other material written communications
between the auditors and management
• The audit committee must establish procedures to receive
and address complaints regarding accounting, internal
control and audit issues, and to provide company
employees an opportunity to make confidential,
anonymous submissions regarding accounting and auditing
matters

“Modern” DoL Analysis

T r a n s a c tio n V a lid

YES

H a s tra n s a c tio n
b e e n " c le a n se d " ?
(D G C L § 1 4 4 )
YES NO

B u r d e n o n D e fe n d a n t
C o n flic t o f In te re s t? T r a n s a c tio n V o id a b le
(D ire c t; In d ire c t) b y C o r p o r a tio n

NO

B u r d e n o n P la in t iff
T r a n s a c tio n V a lid

DGCL § 144:
(a) Informed, Disinterested
BoD approves; “or”
(b) Informed SHs ratify; “or”
(c) Transaction is Substantively
Fair to corp.

The duty of loyalty goes around the business judgment rule.

The duty of loyalty used to mean if you breached it and engaged in a
transaction then any contract into which you entered was void or
voidable at the shareholder’s request.
The old way was to ask:
Is there a conflict of interest?
Direct
Transaction b/t corporation and fiduciary
Indirect

75
 Transaction b/t corp and another corp in which
fiduciary has [substantial?] financial interest
(Lewis)
Family transactions (Bayer)
If “yes”, transaction is voidable by corporation
These kind of questions really depend on what the specific
statute says.

Bayer v. Beran
This case is under the old regime
Facts: big radio advertising spending, CEO/Director’s wife gets hired.
Plaintiffs claim the radio advertising chosen for the benefit of the
wife.
BJR does not apply because of duty of loyalty is the question
here
Burden of proof with regard to breach of fiduciary duties is not
clear, but assume that once the plaintiff has shown there is
a conflict of interest it is up to the defendant to show that
it was okay even though there was a conflict of interest, to
show not only the good faith of the transaction but also to
show its inherent fairness.
Held: That her participation in the program may have enhanced her
prestige as a singer is no ground for subjecting the directors to
liability, as long as the advertising served a legitimate and a
useful corporate purpose and the company received the full
benefit thereof.
Why do they win?
– Tennyson did not get unreasonable pay
– The program was not designed to further her career
– The company obtained its money’s worth from the
radio campaign
– Non-fiduciary duty issue
– Transaction was ultra vires (illegal as beyond
corporation’s power) because no formal board action
– Holding?
– Very fact oriented analysis
– Formal procedure desirable
– But informality ok here, the directors were
executives in the company that constantly
communicated and they discussed the radio
plan, and they took a later vote that ratified
the action.

Lewis v. S.L. & E., Inc.

76
Facts: two private corporations same board different shareholders,
boards allow one corporation to use the land of the other
corporation at very low rent, shareholders sue
Court says that since the directors were serving on both boards they
have the burden of showing that the transaction was fair and
reasonable, and if they show that it will not be voided.
• How to cleanse: NY BCL § 713
Note first: financial indirect conflict ONLY if substantial
interest.
Three Alternative ways to cleanse:
• Disclosure to BoD & approval
– Quorum requirements
• Disclosure to SH & approval
– No apparent Quorum req’t
• Defendant can show transaction fair & reasonable at
time of approval
• Compare: DGCL § 144
Merely a financial interest for a conflict of interest.
Three Alternative ways to cleanse:
• Disclosure to BoD & approval
– No quorum req’t; but majority of disinterested
req’t
• Disclosure to SH & approval
– No apparent Quorum req’t
• Transaction fair at time of approval
– Burden of Proof?

The Doctrine of Corporate Opportunities

• Usurpation by an officer or director for personal gain of some
prospective business venture or development in which the firm
has a property right
• Flip-side of interested director transactions
– Note potential for overlap if opportunity also involves a
contract with firm
• Part of Fiduciary Duty of Loyalty
– Limits corp. fiduciary’s ability to pursue new business
prospects individually without first offering them to corp.
– It does not apply to employees, just senior management
and board of directors.
– Usually the cause of action for this belongs to the
corporation, not the shareholders, so it usually comes up
as a derivative action
– There is no obligation to disclose corporate opportunities,
there is an obligation not to take corporate opportunities.

77
 No Breach Regardless
Basic of Fiduciary's Actions
Roadmap
NO No Breach
NO
Does
Fiduciary
Appropriate?
NO YES Breach
Is Prospect
a "Corporate X1
Opportunity"?

A YES Does NO No Breach

Fiduciary Does
Disclose? Fiduciary
NO
Appropriate?
YES
B YES Does Corp.
Breach

Properly X2
Reject?
No Breach Regardless
C YES
of Fiduciary's Actions
Interest / Expectancy /
Necessity

Line of Business

“Fairness” & Hybrid Tests

“Incapacity” Based Defenses

“Source” Based Defenses

Guth v. Loft , 5 A.2d 503, 514 (Del. 1939): “Where a corporation is engaged in a certain
business, and an opportunity is presented to it embracing an activity as to which it has
fundamental knowledge, practical experience and ability to pursue, which, logically and
naturally, is adaptable to its business having regard for its financial position, and is one that is
consonant with its reasonable needs and aspirations for expansion, it may be properly said
that the opportunity is in the line of the corporation’s business.”

Corporate Opportunity?
The question is does the corporation have an interest, an
expectancy, or a necessity.
An interest is a contractual right, an expectancy is not a
contractual right, but something they should be offered like
a renewal right, and a necessity is something the
corporation needs to continue its business.
Also is it within the company’s line of business, not just today but
in the future, Guth v. Loft
Some states also do a fairness test, was it fair or equitable to the
corporation, hard to predict.

78
 Some states combine the interest expectancy with the line of
business test
Source Based Defenses – the source of the opportunity came to the
individual in his individual capacity, for his skills or something.
Incapacity Based Defenses – the corporation could not have taken the
opportunity even if they wanted to, these types of defenses tend
to work better when they can be objectively verified by some
outside measure, like look the company did not have the money,
rather than they did not want to deal with them

“Cleansing” a Conflict
Cal. Corp. Code § 310; DGCL § 144:
• Full Disclosure to SH & approval
– Interested director should not vote shares
• Full Disc. to BoD/committee. & app./auth./rat.
– Note: § 310 – “just & reasonable” caveat, in California you
not just have to get approval it has to be just and
reasonable approval.
• Director bears burden of proving transaction just &
reasonable/entirely fair at time of approval
– Extremely difficult in corporate opportunity contexts
The Delaware corporate law was recently amended giving
corporations the power to . . . (17) Renounce, in its certificate of
incorporation or by action of its board of directors, any interest or
expectancy of the corporation in, or in being offered an
opportunity to participate in, specified business opportunities or
specified classes or categories of business opportunities that are
presented to the corporation or one or more of its officers,
directors or stockholders.

Consequences of Corporate Opportunity status

1. The D/O must disclose the existence of the Corp. Opp. (and
her conflict of interest) to the board/SHs.
2. Corp. has right of first refusal on project
– But can choose to give it to fiduciary…
– Difficult issues:
• Does disclosure/rejection have to be “formal”?
• Is it subject to same three “cleansing” criteria
as for D.o.L.?
3. Remedy: Gains-based (constructive trust)
– Injunctive relief & punitive damages also.

Broz v. PriCellular
Facts: Defendant sole shareholder in RFBC and on the board of another
cell phone company CIS

79
 – Broker named Rhodes offers Mich-2 to Broz in Broz’s
RFBC capacity
– Wearing his RFBC hat, Broz buys Mich-2
– CIS board did not formally clear purchase, although
informal ok by CEO and some other directors
– PriCellular had also bid on Mich-2, but Broz out-bid it
– PriCellular acquires CIS
– PriCellular sues Broz for taking corporate opportunity
Delaware Law: What is the Test?
• A corporate opportunity exists where:
– Corporation is financially able to take the opportunity
– Opportunity is in the corporation's line of business
– Corporation has an interest or expectancy in the
opportunity
• Interest: Something to which the firm has a
better right
• If officer bought land to which the
corporation had a contractual right, the
officer took an “interest”
• Expectancy: takes something which, in the
ordinary course of things, would come to the
corporation
• If the officer took the renewal rights to a
lease the corporation had, the officer
took an “expectancy”
• Factors or elements?
– Unclear
• Relevance of corporation’s capacity?
– Not dispositive
– Lessens defendant’s burden by showing good faith
• Relevance of board approval or lack thereof?
– Not required
– Board approval creates a safe harbor
Held:
– Broz did not usurp a corporate opportunity
– Why?
• He learned about it in his personal capacity
• CIS was not financially capable taking the
opportunity
• It was in CIS’s line of business but it had no
cognizable interest or expectancy
• They were getting out of that business
• They had sold off several similar franchises
• Key players told Broz it was ok to go ahead
• He was under no duty to consider the future
uncertain plans of PriCellular.

80
 Conflicts Under the American Law Institute Principles of
Corporate Governance
• ALI § 5.05
• Bifurcates inquiry:
• Was the opportunity in question a “corporate opportunity”
as defined by § 5.05(b)?
(1) Any opportunity to engage in a business activity
of which a director or senior executive becomes
aware, either:
(A) [i] In connection with the performance of
functions as a director or senior executive, or
[ii] under circumstances that should reasonably
lead the director or senior executive to believe
Subsection 5.05(b)(1) that the person offering the opportunity
applies to both officers and expects it to be offered to the corporation; or
directors (B) Through the use of corporation information
or property, if the resulting opportunity is one
that the director or senior executive should
reasonably be expected to believe would be of
interest to the corporation; or
(2) Any opportunity to engage in a business activity
of which a senior executive becomes aware and
knows is closely related to a business in which the
corporation is engaged or expects to engage.
• If so, was the corporate opportunity properly rejected by
the appropriate corporate actor per § 5.05(a)?
(1) The director or senior executive first offers the
corporate opportunity to the corporation and makes
disclosure concerning the conflict of interest and the
corporate opportunity.
(2) The corporate opportunity is rejected by the
corporation; and
(3) Either:
(A) The rejection of the opportunity is fair to
the corporation;
(B) The opportunity is rejected in advance,
following such disclosure, by disinterested
directors, or, in the case of a senior executive
who is not an executive, by a disinterested
superior, in a manner that satisfies the
standards of the business judgment rule; or
(C) The rejection is authorized in advance or
ratified, following such disclosure, by
disinterested shareholders, and the rejection is
not equivalent to a waste of corporate assets.

81
 • What effect does rejection have under § 5.05(a)?
• How rejected determines standard of review
• Judicial review not foreclosed
• Plaintiff has burden of proving that rejection did not
satisfy BJR
• The so-called “refusal to deal” defense; see also
• Financial incapacity (Broz)
• Technical capacity (Singer)
• Functional capacity (Broz)
• None recognized by ALI § 5.05

SHAREHOLDER TRANSACTIONS
Basic principles
 Shareholders acting as shareholders owe one another no
fiduciary duties
 Controlling shareholders can owe fiduciary duties to the minority
 controlling shareholders can control the board
 Where a shareholder vote is required a court may
scrutinize whether that shareholder used the vote in an
unfair manner.
 In general, transactions between a controlling S/H and the corp.
are subject to an intrinsic fairness test.
 The controlling S/H will have the burden of proving the
transaction was fair to the corporation.
 BUT only when a potential for self-dealing is present in the
arrangement. (i.e. when the controlling S/H can receive
something at the expense of the corp. (or the minority
S/H.))
 Courts usually presume dominance at 25%.
 Virtually all successful suits against dominant SHs are for duty-
of-loyalty: I.e., causing board to effect a non-pro-rata distribution
of corporate assets.
 As with interested directors, once plaintiff makes this showing,
burden shifts to the defendant SH to “cleanse”…

Transactions Between Parent and Subsidiary Corporations

Sinclair Oil v. Levien
Facts: liquidating Sinclair Venezuela
 Minority objected to three aspects of Sinclair-Sinven relationship
– which ones?
1. Sinven’s large dividends
2. Sinven prevented from expanding
3. Contract between Sinven and another Sinclair subsidiary
was breached, and Sinclair did not cause Sinven to
enforce.

82
Court Identifies 2 Standards of Review
 Business judgment rule
 BoP on plaintiff to rebut
 Intrinsic fairness
 BoP on defendants to show transaction was fair to
Sinven
 How does court select standard of review?
 Intrinsic fairness used when dominant
shareholder has received a benefit to the
exclusion and expense of the minority
shareholders of the subsidiary.
Issue 1: Dividend Policy
 Standard of review?
 Business Judgment Rule
 Why?
 Minority got pro rata share of dividends so
although self-dealing it was not to the
detriment of the minority
Issue 2: Expansion Policy
 Sinclair used Sinven exclusively to develop Venezuela
properties
 Business judgment rule
 Plaintiff could identify no opportunity Sinclair
usurped from Sinven so although self-dealing not
detriment to the minority
 This is an important point, the source of the
opportunity matters, if you get squeezed out of an
opportunity that came to you then intrinsic
fairness, if the opportunity comes to Sinclair they
don’t have to give it to Venezuela, they haven’t
taken an opportunity that was Venezuela’s.
Issue 3: Breach of Contract
 Sinven sold its oil to International (another Sinclair
subsidiary)
 International breached contract
 Sinven did nothing
 Standard?
 Intrinsic fairness
 Sinclair got the oil without having to comply with
contract duties
 Suppose nonenforcement of contract had been
approved by a majority of the disinterested directors
and then also by a majority of the disinterested
shareholders (a.k.a. a “majority of the minority”)?

83
  Shifts BoP to plaintiff to show transaction was
unfair – Wheelabrator
 ??? Back to BJR
 Might turn on how disinterested the directors
were.
 If the action is ratified instead of approved, then
standard is unclear under DGCL

Decomposing Ownership
Debt is not an ownership interest, and debt holders are not owed
fiduciary duties.
Equity
First you pay off debt and then you pay off equity.

Zahn v. Transamerica
(this case is about insider information, not conflict of interest)
Facts: Transamerica was the controlling shareholder of Axton-Fisher
 Preferred stock: Not relevant
 Class A stock: 2/3 owned by Transamerica
 Class B stock: Almost all owned by Transamerica
 Transamerica had elected majority of the board
 Class A
 Annual dividend of $3.20
 Entitled to liquidation dividend 2x that of Class B
 Convertible into Class B at option of holder
 Callable by corporation at $60/share plus accrued but
unpaid dividends
 Class B
 Annual dividend of $1.60
 Entitled to liquidation dividend ½ that of Class A
 Not convertible
 Not callable
Plaintiff’s allege
 Transamerica caused Axton-Fisher’s board to call the Class A
shares for redemption at $80
 $60 call price plus $20 in unpaid dividends
 After the Class A was redeemed, the Firm was then liquidated
 Allegedly to appropriate for Transamerica the increased
value of tobacco inventory
 Plaintiff claims Class A would have received $240 per share if not
called before liquidation
 When the boards duties to class A and class B conflict, what
should the board do?

84
  The board has a duty to its lowest class of shareholders, to
the shares that are most common.

Fliegler v. Lawrence
Facts: Lawrence along with the other Agau directors decide the
corporation can’t purchase land, so they form the US Antimony
Co. and transfer the land to it, and give Agau an option to
purchase the land in the future. Agau eventually exercises that
option with shareholder ratification and the shareholders sue.
 Why didn’t shareholder ratification under DGCL §144(a)(2)
protect the transaction?
 The vast majority of voting shareholders weren’t
disinterested and the shareholders.
Held:
Court holds for the defendant because it was intrinsically fair.
Bottom Line:
• Unlike conflicted transactions involving directors/senior
execs
– In which informed SH ratification virtually disposes of
the claim (absent waste, fraud, illegality)
• ...When the conflict of interest involves a controlling SH
– The only method for cleansing is intrinsic/entire
“fairness”, with the initial burden on the dominant SH
– Disinterested SH ratification shifts burden
• Note: This is INCONSISTENT with wording of §
144
– Plaintiff can still win by showing intrinsic/entire
unfairness

85
 Summary of “Cleansing”
(YOU DON’T REALLY NEED TO KNOW ALL THE PERMITATIONS OF BURDEN SHIFTING)
DoCSuit
Suit DoLSuit
Suit DoLSuit
Suit
DoC DoL DoL
(Director/Officer) (Director/Officer) (DominantSH)
SH)
(Director/Officer) (Director/Officer) (Dominant

§§144
144Not
NotBinding
Binding
§§144
144Not
NotBinding
Binding (a)Infm’d
Infm’dBoD BoDVote
Vote
(a)
(a) Infm’d BoDVote
Vote Generally nonohelp,
Generally help,
(a) Infm’d BoD
GenerallyBJR
BJR§§144 144Binding
Binding unlessmin
min
Generally unless
BJR doesn’t apply
(a) Infm’d BoDVote
Vote directors
BJR doesn’t apply (a) Infm’d BoD directors
gogototoDoC
DoCand/or
and/or - -Disinterested:
Disinterested:BJRBJR (b)Infm’d
Infm’dSH SHVote
Vote
(b)
(c) - Interested: go to (c) - Disint’d: gogototo
- Disint’d:
(c) - Interested: go to (c)
(b)Infm’d
Infm’dSH SHVote
Vote (b) (b)Infm’d
Infm’dSH SHVote
Vote (c1)
(b) (c1)
Absolute Defense - Disinterested: BJR - -Int’d:
Int’d:gogototo(c2)
(c2)
Absolute Defense - Disinterested: BJR
- Int’d: go to (c) (c) Fairness
- Int’d: go to (c) (c) Fairness
(c)Fairness
Fairness (c)Fairness
Fairness 1.1.Plaintiff
PlaintiffBurden
Burden
(c) (c)
-Affirmative - -Defendant
DefendantBurden
Burden 2. Defendant
-Affirmative 2. Defendant
Defense Burden
Defense Burden
(Cinerama) (Merger:
(Cinerama) (Merger:
“Entire”)
“Entire”)

“Intrinsic” vs. “Entire” Fairness

 The Wheelabrator case utilizes the notion of “entire fairness”,
whereas other cases focus simply on “fairness”
(sometimes called “intrinsic fairness”)
 Difference:
 Substantive/Intrinsic Fairness: Solely a substantive
consideration (terms of deal = arm’s length K)
 Requires that the transaction reflect terms one would
expect in an arm’s length transaction.
 Basic inquiry– consideration paid for the value
transferred.
 Applies to generic DoL disputes
 Entire Fairness: Fair substance plus fair dealing
 Applies to DoL disputes involving a dominant SH
when the complained of transaction is a merger, or
anything else (e.g., charter amendment) that
requires a SH vote
 Entire fairness involves the process by which the
transaction was done. Involving, e.g., timing,
structure, negotiating process for the deal (even if
the price was fair). It makes the fairness

86
 consideration especially difficult in the Dominant SH
situation.

DERIVATIVE LITIGATION
• A derivative action is a suit in equity against a corporation to
compel it to sue a third party.
• Definition: simultaneous suits in equity by...
– (1) a SH against corp. to compel it to sue another;
– (2) the actual suit by corp. against that other party
• B/c the SH is suing “in right” of corporation…
– Any remedy from principal suit goes to corporation;
– The corporation is required to pay for the SH attorney’s
fees if suit is successful (or often if it settles).
• Why do we have this? Because you don’t have a cause of action
against the third party.
Direct and Derivative Suits
 Direct
 Brought by the shareholder in his or her own name
 Cause of action belonging to the shareholder in his or her
individual capacity
 Arises from an injury directly to the shareholder
 Derivative
 Brought by a shareholder on corporation’s behalf
 Cause of action belongs to the corporation as an entity
 Arises out of an injury done to the corporation as an entity
Derivative versus Direct actions
Direct: a suit is direct if it alleges a direct loss to the shareholder.
• Force payment of promised dividend;
• Enjoin activities that are ultra vires;
• Claims of securities fraud/blue sky laws;
• Protecting participatory rights for SHs
Derivative: a suit is derivative if it alleges a loss to the
shareholder that derives from a loss to the corporation.
(quintessential case is suit to force corporation to sue
manager for fraud)
• Breach of duty of care
• Breach of duty of loyalty
• Enjoin “management-retrenching” practices
• It can get hard to say which category it falls under, direct or
derivative.
Principal legal distinction: Is the plaintiff arguing that there was an
injury done to the corporation or was it something personal?
What’s at stake? Well, as noted, there are all these procedural
differences and attorney fee differences between the two. So the
determination is often critical.

87
 Unfortunately, the “legal test” for determining whether a complaint
is derivative or direct is pretty vague and difficult to apply.
The basic rule is this: A suit is derivative if the wrong
complained of primarily constituted an injury to the
corporation, but direct if the wrong complained of primarily
constituted an injury to individual shareholders as such.
Nevertheless, courts will often conduct an inquiry into whether the
“gravaman” of the action tends toward corporate injury or individual
shareholder inquiry. But the analysis necessarily implicates
casuistry. Some examples:
• A SH is also an employee, and she was fired and forced to
sell her shares under an ESOP. This would be a direct
action. The harm emanates from her employee status.
• A SH is denied her right to inspect the books of a
corporation. Also direct: This is a right that she can
partake in individually.
• SH is denied right to exercise redemption/exchange/voting
rights. Once again, these are rights that she can
individually exercise as a SH independent of other SHs
• SH complains that directors recklessly investigated
corporate expansion, and turned the firm into a money
loser. This one’s derivative: the SHs only injury is a
general loss of profit -- a right that she can only partake in
pro rata with other SHs.
• Same for suits for corporate opportunities, executive
compensation or other DoL actions.
• Try this one: SH alleges that corporation recklessly
investigated merger possibilities, and thereby agreed to a
low-ball bid, representing to the SHs that it was a good
deal in order to get their approval for the deal. Could be
either (Van Gorkom brought as direct).
• Preferred SH sues to get a dividend paid which corporation
has decided to reinvest in firm (Dodge v. Ford). Seems
derivative, but courts often treat as direct, possibly b/c
remedy goes to SH rather than corp. But goes both ways
potentially.
• SH claims that board has “abdicated” its directorial
authority by entering into a contract that prevents it from
managing the firm (Grimes). Potentially either direct or
derivative (though note that in Grimes the claim of
abdication simply wasn’t sufficient on its own face)

Eisenberg tests
These tests help you decide if it is direct or derivative
 Who suffered the most direct injury?
 If corporation, suit is derivative

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  To whom did defendant’s duty run?
 If corporation, suit is derivative
 Called into question by Eisenberg

Plaintiff Qualifications:

Shareholder Status
 MBCA § 7.41 limits standing to shareholders
 Creditors may not bring derivative suit

Contemporaneous Ownership
 MBCA § 7.41(1): Must be a shareholder at the time of
the alleged wrongdoing
 Continuing wrongs?
 § 7.42: Must be a shareholder when suit commenced
 Many states say also must remain a shareholder
through final judgment

Fair and Adequate Representative

 MBCA § 7.41(2): Named plaintiff must be a fair and
adequate representative of the corporation’s interests
 On what grounds might one challenge a plaintiff’s
fairness or adequacy?
 Conflicted interests, such as bringing suit for
unrelated strategic purposes
 Unclean hands

Security for Expenses Statutes

 NJ provides that a shareholder who brings a derivative suit and
who owns less than 5% of the stock or stock worth $50,000 is
liable for the corporation’s reasonable expenses if suit fails
 Corporation can ask court to require such a plaintiff to post a
bond to secure such expenses before suit goes forward

Policy Concerns
 To whom does a derivative suit belong?
 Corporation
 Why didn’t corporation sue?
 Maybe good business reason not to sue
 But maybe directors or senior managers would be
defendants, so possible conflicts of interest
 Derivative suits allow shareholders to hold directors accountable
 Supreme Court called it a “remedy born of stockholder
helplessness”

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  Potential abuses:
 Strike suits:
 Nuisance suits brought for settlement value
 Meritorious suits:
 Settled too easily

Plaintiff-side Incentives
 Any recovery goes to corporate treasury, whether by settlement
or trial victory
 Lawyer is real party in interest
 Lawyer can get contingent fee out of any recovery
 BUT corporation also must pay plaintiff’s legal fees if there is a
substantial nonmonetary benefit
 Courts quite liberal in finding such benefit
 E.g., Caremark

Defendant-side Incentives
 Strike suits:
 Settle to go away
 Meritorious suits against insider defendants:
 Indemnification: Corporation must reimburse director’s
expenses if successful defense
 Settlement in which director doesn’t pay anything deemed
a success

Combined Effect
 Strike suits
 Plaintiff counsel has incentive to bring
 Management has incentive to pay
 Meritorious suits
 Management has incentive to settle in ways that ensure
indemnification
 Plaintiff lawyer has incentive to settle so as to get on to
next case
 Hence, settled too lightly

3 “Procedural” Hurdles to the derivative action

1. Bonding Requirements – put up money in case you lose
2. Demand Requirement - you have to ask the board to do what
you want first
3. Special Litigation Committees

First Hurdle: Security Requirement

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 • In some states (though not Del), a derivative
claimant with “low stakes” must post security for
corporation’s legal expenses.
• Eisenberg v. FTL Inc.
Facts: Eisenberg, a former shareholder of Flying Tiger,
brought a class action suit to enjoin (i.e., overturn)
a reorganization that allegedly had the intent and
effect of moving the operations of Flying Tiger into a
wholly owned subsidiary, with parent holding
company being inherited by the former SHs of Flying
Tiger. The specifics:
FTC’s Board did all the voting for FTL, but not
SHs of FTC.
Thus, if FTL wanted to merge or sell
all/substantially all assets to another, it
no longer needed approval of public
shareholders.
Claims:
• Eisenberg’s Complaint:
– Deprivation of voting rights to former Flying
Tiger SHs with respect to operating company.
• FTL’s Counter-argument:
– Eisenberg’s claim is derivative. Must post
security under NY law.
• Trial court:
– Held that Eisenberg was required to post
security (as per NY’s law)
Held: Reversed
• NY law (§ 627) on posting security applies...
– only to derivative actions -- not to direct
actions.
• Because harm to voting rights constitutes harm
to a shareholder rather than harm to the
corporation, Eisenberg's claim is direct.
• Test for whether action is direct or derivative?
Court applies the “Lazar” test, a suigenerous test
that states that if a corporation impairs SH’s right to
participate in governance of corporation, that’s a
direct right (granted in the stock certificate), and not
one that is merely incidental to ownership interest at
firm.

• In some states, there is another avenue to escape security-

posting statutes

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 • Cohen v. Beneficial teaches that such statutes are
presumptively substantive parts of state law, and
thus apply to diversity SH litigation
• BUT: If state law itself says that its own bonding
statute is procedural, then the question of posting
security is once again a federal one…
– …and under federal law, no security-for-
expenses statute exists.

Second Hurdle: Demand Requirement

• Most states require SHs in derivative suits first to approach
Board of Directors and demand that they pursue legal
action…
• … unless the SH can claim a valid excuse.
• Related issues:
• When is demand requirement excused?
• If the demand would be futile
• If not excused, what recourse does SH have
if Board decides not to pursue?
• Does making the demand affect one’s
subsequent rights to bring a derivative
action?
– The basic Test
2-Part test from Aronson v. Lewis (1984):
• Demand requirement excused only if such a demand
would be “futile.” I.e., whether there is a reasonable
doubt that
– (a) Directors are disinterested & independent,
AND
– (b) Challenged transaction was product of
valid exercise of business judgment.
• Is this test conjunctive or alternative?
• Alternative

The First (and trickier) Part of Test: Deals with CURRENT

decision-making capabilities of the board rather than
the board’s capabilities at the time of the alleged
wrong. First prong asks whether the BoD has the
ability to reach a disinterested decision about
whether it’s in the corporation’s best interests to
pursue litigation.
This is a relatively unclear area of law. But what the first
test seems to require is that a majority of the board
is either DIRECTLY implicated in the wrongdoing or
are DOMINATED by those who are.

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A substantial turnover of the board between the
transaction complained of and the filing of the suit
would make it more difficult to get by this prong you
would have to prove that the new guys are
dominated by the implicated old guys that are still on
the BoD.

The second (much easier) part of the test: Deals with

whether the action(s) that motivate the complaint
itself are likely to be protected by the BJR in
litigation.
In what circumstances is something NOT protected by the
BJR?
Sidestepping:
Duty of Loyalty
Illegality/Fraud
Blasting Through:
Procedural Challenges to Decision:
(“Procedural Duty of Care”)
Substantive Challenges: (“Substantive DoC”;
or “Waste”)

• If you make a demand and then a disinterested

majority of the board says no then usually the BJR
protects them.
• If demand excused, Board cannot dismiss
– Caveat 1: Can still move for dismissal, often on
advice of Special Litigation Committee
– Caveat 2: If demand excused but still made, SH
waives any possible excuse claim

Summary So Far:
• SH does not always get her day in court.
– Either board must yield to her demand,
or she must show that demand is futile
• Ostensible Purpose of Demand Requirement
– To stem the “hold-up/strike-suit”
problem, one shareholder should not be
allowed to waste the assets of other
shareholders.
• In Delaware, if demand is made, SH is usually
deemed to have conceded its necessity
– And SH would then have to demonstrate
“wrongful refusal”
– Under Delaware law, where
demand is made the plaintiff is

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 deemed to have conceded that it was
required, which in turn makes the
decision of the board on whether to
dismiss a matter of business
judgment, which in turn means that
the plaintiff invariably loses.
And where demand is required, or
made, the plaintiff is not entitled to
discovery.
– Thus, well-advised SHs rarely make
demand, and instead routinely allege futility
(per Aronson rule)

Third Hurdle: Special Litigation Committees

• 2-part test for demand-excused cases in which an SLC
has recommended dismissal:
– Did SLC act independently, in good faith, and with
a reasonable investigation (with the burden of
proof on defendants), and
– Does dismissal pass independent judicial inquiry
into business judgment?
• Vested with decision-making power of board about
whether to pursue litigation.
• If the SLC decided against, it would cause the
corporation to make a motion to dismiss the action.
• Once the committee has found out its information,
the court gives a lot of deference for what the
committee thinks is in the best interest of the
corporation.
• But the court will scrutinize the procedures used to
investigate the underlying facts and determine the
existence of possible legal liability.
• As such, it’s likely going to take a finding of GROSS
NEGLIGENCE or RECKLESSNESS in the
INVESTIGATIVE process to overturn the process of an
independent SLC;
• And a finding of WASTE to overturn the SUBSTANTIVE
content of its decision.
• Competing Approaches
• Auerbach: (Majority rule) No substantive scrutiny of SLC
– Showing that SLC was disinterested and
conducted an adequate investigation, ends
inquiry.
– SH must show wrongfulness/lack of info.
• Miller: SLC not valid if structurally biased:

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 – Interested directors can’t participate in board
selection of the SLC.
• Zapata: (Minority/Del. Rule). In addition to requiring
SLC’s adequate investigation and disinterested
members, independent judicial scrutiny.

Demand Requirements

YES SH action proceeds in

BoD/SLC name of Corp.
recommends
pursuing?
YES NO

Demand SH action cannot proceed

Made/Pled? unless decision
NO
SH action cannot “wrongful” (Grimes)
REQUIRED proceed
Demand
Required or Excuse Presumed
Excused? Waived (Grimes)
YES
EXCUSED Demand
Made/Pled?
YES SH action proceeds
SLC
NO in name of Corp.
Excused if π pleads with particularity recommends
facts that create reasonable doubt about pursuing?
(1) Directors' disinterestedness &
independence (at litigation); NO SH action proceeds
(2) The exercise of sound business unless defendant can
judgment (at time of alleged wrong); pass 2-pt Zapata test
Aronson v. Lewis; Brehm v. Eisner.

SECURITIES

Sources of Law
 Securities Act of 1933
 Regulates the offering and sale of new securities (primary
markets)
 The 1933 is primarily a disclosure (transactional disclosure)
statute, what do you have to do and tell people if you want
to take your company public.
 Securities Exchange Act of 1934
 Regulates secondary market activity

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  Periodic disclosures
 Created the Securities and Exchange Commission (a.k.a.
SEC)
 Independent agency
 Enforce the securities laws
 Promulgate rules and regulations to implement those
laws more effectively
 The SEC looks at the adequacy of the disclosure, not
the merits.
 What are “Blue Sky” Laws
 State laws that regulate securities
 You have to check the states where the security is being
offered or sold.
 There are state and federal laws and you have to comply
with both of them.

Purposes of Securities Laws

 Full disclosure
 Make sure that investors have all the information they
need to make informed decisions
 Prevention of fraud
 Agency cost problem re disclosure – how to make a
credible bond?

Disclosure
 Securities Act (1933)
 Transactional
 Registration statement filed with SEC
 Prospectus distributed to investors
 Required in connection with any public sale
 Securities Exchange Act (1934)
 Periodic
 Form 10 (once)
 Fork 10-K (annual)
 Form 10-Q (quarterly)
 Form 8-K (episodic)
 Only required of registered companies

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 Selling Securities under the Securities Act of
1933

Registration
Registration
Statement
Statement
Effective
Filed with SEC

Offers
No Sales
permitted but
selling allowed
no sales
activity Prospectu
SEC review:
s must be
adequacy of
delivered
disclosure, not
merits

Background
When a company goes public they issue new stock for the public
markets, and usually they have the buyers already lined up, the
investment banks kind of market the stocks and they have some
power over who gets to buy the stock, they tend to price the
stock at just below they think it is worth, so that it will go up,
after the lined up buyers buy the stock it goes to a secondary
market after it has been registered through its IPO. Since the
investment banks had control over who gets to buy the stock
they would use it as a currency giving it to people to hold on to
for a short amount of time and then sell it once it goes up to its
real price or give it to their friends. It is not clear that this is
illegal.
The idea is not that the public will read the disclosures, but that
analysts will do so, and there will be enough public sense about
the company.

What is a Security?
 §2(1) of the Securities Act of 1933
“The term ‘security’ means any note, stock, treasury stock,
security future, bond, debenture, evidence of
indebtedness, certificate of interest or participation in any
profit-sharing agreement, collateral-trust certificate,
reorganization certificate or subscription, transferable
share, investment contract, voting-trust certificate,
certificate of deposit for a security, fractional undivided
interest in oil, gas, or other mineral rights, any put, call,

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 straddle, option, or privilege on any security, certificate of
deposit, or group or index of securities (including any
interest therein or based on the value thereof), or any put,
call, straddle, option, or privilege entered into on a national
securities exchange relating to foreign currency, or, in
general, any interest or instrument commonly known as a
"security", or any certificate of interest or participation in,
temporary or interim certificate for, receipt for, guarantee
of, or warrant or right to subscribe to or purchase, any of
the foregoing.”
 Implications of whether it is a security:
• Whether the registration requirements apply to the
transaction?
• Plaintiff’s have a much easier time bringing a fraud claim.
Great Lakes v. Monsanto
Facts:
 Monsanto and STI formed NSC as a Del. LLC and put their
Nutrasweet business in it. In 1999 they sold NSC to Great
Lakes.
 Great Lakes claims Monsanto & STI didn’t adequately
disclose a competitor’s, Daesang’s, activities, resulting in
overly optimistic projections, which inter alia, violated Rule
10b-5.
 Great Lakes claims it was either stock, an investment
contract, or “any interest or instrumentality commonly
known as a ‘security.’”
 What is the test for determining if it was a security?
 (Landreth) It is unnecessary to apply the Howey
test to transactions involving traditional stock.
Insofar as the transaction involves the sale of
an instrument called stock, and the stock bears
the five common attributes of stock
enumerated in Forman the transaction is
governed by the securities laws. (Great Lakes)
As well as having the five characteristics to be
traditional stock the transaction must be an
investment transaction and not a commercial
transaction. This is determined by applying
the Howey test.
 Howey test for determining if something is an
“investment contract”
 A contract, transaction or scheme whereby a
person invests money

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  Anything constituting legal consideration
for purposes of contract law should
satisfy the first prong of the Howey test
 In a Common Enterprise
 Horizontal Commonality between
investors satisfies common enterprise
element, court split whether vertical
commonality between a promoter and an
investor satisfies.
 Horizontal Commonality requires a
pooling of investors’ contributions
and distribution of profits and
losses on a pro-rata basis among
investors.
 Vertical Commonality is less
stringent, and requires that an
investor and promoter be engaged
in a common enterprise, with the
“fortunes of the investor linked
with those of the promoters.”
 Ninth Circuit rule?
 Vertical commonality
suffices but the Ninth
Circuit uses a
restrictive definition of
vertical commonality
that requires there to
be a direct correlation
between the
promoter’s returns and
the investor’s returns.
 E.g., vertical
commonality
would not exist if
the promoter got
a fixed fee
irrespective of
whether the
investor made or
lost money.
 Notice that you will often
have vertical commonality
where you have horizontal
commonality. The pool of
investors as a group typically

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 will be in vertical
commonality with the
promoter of the scheme.
 Is led to expect profits
 Solely from the efforts of the promoter or
a third party (control)
 Virtually no court reads that phrase literally; in
particular, the word “solely” is read as
primarily
 The test?
How much effort must the promoter put
into the project, as opposed to the
investor’s efforts, in order for the
expectation of profits test to be
met?
The critical inquiry is “whether the efforts
made by those other than the
investor are the undeniably
significant ones, those essential
managerial efforts which affect the
failure of success of the enterprise”
 It is immaterial whether the shares in the
enterprise are evidenced by formal certificates
or by nominal interests in the physical assets
employed by the enterprise
 Note that it is the investment scheme that is
the security, not the enterprise—not the land
or the citrus trees.
 Five most common feature of stock (Forman):
 The right to receive dividends contingent upon
an apportionment of profits
 Negotiability
 The ability to be pledged or hypothecated
 Voting rights in proportion to the number of
shares owned
 The ability to appreciate in value
 Nothing falls under “any interest or instrument
commonly known as a ‘security’” that does not fall
under an investment contract.
 Was Great Lakes investment in NSC a security and,
therefore, subject to 10b-5???
 No.
 It was not traditional stock because although
they meet the five Forman factors, but it was

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 not an investment transaction but a
commercial transaction under the Howey test
because there was no common enterprise, and
did not involve profits solely form the efforts of
others because Great Lakes could remove
managers, and it was not an investment
contract for the same reasons.
 Why would Monsanto and STI owe a duty to Great Lakes?
 There is a fiduciary duty of sorts that is owed to
potential or acquiring shareholders created by the
securities act.

 Does 10b-5 apply to close corporations?

 Yes, per Landreth
 Does 10b-5 apply to general partnerships?
 Circuit split:
 Goodwin v. Elkins (3d Cir.): A bright line standard
that says that because partners have a legal right to
control the firm a general partnership interest is
never a security
 Williamson v. Tucker (5th Cir.): Look beyond the bare
scope of partnership law and consider the economic
realities. A security might be present if (1) the
partnership agreement deprives one or more partner
of his legal control rights, essentially leaving him in
the position of a limited partner; (2) the investor is so
inexperienced or unknowledgeable in business affairs
as to be incapable of exercising his or her legal
rights; or (3) the investor is so dependent on some
unique entrepreneurial or managerial ability of the
promoter that the investor cannot exercise
meaningful partnership powers.
 The 10th Circuit adopted only the first prong of
Williamson. Hence only a contractual
deprivation of control rights would result in
finding that a general partnership interest is a
security.
 Does 10b-5 apply to limited partners?
 Limited partners have limited control rights
 RULPA gives greater rights
 Some courts therefore adopt per se rule that limited
partnership interests are securities
 But limited partners can exercise considerable de
facto control. E.g., Holzman v. de Escamilla.

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  The general rule is a limited partnership interest is a
security.

LLCs
Limited liability, no double taxation, flexible.
Two kinds one managed by the members, one managed by a manager

Primary Markets
 Public offerings can be useful
 Especially the IPO, can bring money into the company
 But very expensive:
 Costs associated with registration process
 Lawyers
 Accountants
 Printers
 Delay
 Disclosure costs
 Competitors get access to proprietary information
 Subject to antifraud regime
 On-going regulatory exposure
 1934 Act periodic disclosure
 Proxies, etc…

Public Offerings v. Private Placements

 Private Placements are exempt from the Securities Act and
therefore registration.
 Securities Act § 4(2)
 “Section 4. The provisions of section 5 shall not apply
to…
 (2) transactions by an issuer not involving
any public offering….”

Private Placement Test

 Four factors:
 Number of offerees and relationship to issuer
 Offerees’ knowledge and sophistication
 Offerees’ access to information
 Required of all investors or all offerees?
 Depends on the offeree
 How much information required?
 “the information a registration statement
would have afforded”
 How may information be provided?

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  Private placement memorandum
 Access to files and records
 Number of units offered
 Size of the offering
 Manner of offering
 No general advertising or solicitation

Important Civil Liabilities

 1933 Act § 11
 Fraud in the registration statement
 Due diligence defense
 1933 Act § 12(a)(1)
 Strict liability for illegal offers and sales in violation of §5
 Rescission remedy
 1933 Act § 12(a)(2)
 Fraud in a prospectus or oral sales communication in
interstate commerce
 Defendants who conduct a reasonable investigation cannot
be held liable.
 Implied private rights of action
 1934 Act § 10(b) and SEC Rule 10b-5
 1934 Act § 14(a) and proxy rules

Civil Liability under Section 11

• §11 is the principal express cause of action directed at fraud
committed in connection with the sale of securities through the
use of a registration statement
• does not apply to exempt offerings
 Under §11 the following parties are liable if the registration
statement contains an untrue material fact or omits a material
fact that causes the statement to be misleading:
 Those who sign the registration statement, which is most
of the important people.
 Directors
 Experts
 underwriters
 The Issuer has no defenses.
 All other parties have “due-diligence” defenses.
 Potential defendants can be thought of as two groups
 Experts
 Everyone else
 Registration Statement can be thought of in two parts
 The parts prepared by certified experts

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  Everything else
 Under §(a)(4) experts are not liable for misstatements in the
“non-expertised part of the document.
 Under §(b)(3)(A) w/respect to “non-expertised” portions, the non-
experts must show that after reasonable investigation, they had
reasonable grounds to believe, and did believe, that the
statements were true.
 Under §(b)(3)(B) roughly the same test applies to the liability of
the experts with respect to the expertised portion.
 Under §(b)(3)(C) w/respect to expertised portions, the non-
experts must show that, they had no reason to believe, and did
not believe, that the statements were misleading.
 Under §11(c) test for reasonable investigation and reasonable
belief:
 The level of care that a prudent person would exercise if
his or her own money were at stake.
 Note a defendant may reduce the damages she owes by
showing that part of the damages resulted, not from the
misstatements in the document, but rather from other
causes.
 Defendant has the burden of showing that its misconduct
did not cause the plaintiff’s damages.
 Defendants, other than the issuer, have the burden of
showing that they were not negligent in the preparation of
the registration statement.

Escott v. BarChris Construction Corp.

Facts:
 BarChris constructed bowling alleys, but collapsed in the Great
Bowling Craze Bust of the early 1960’s.
 Shortly before going under, it issued some debentures
 In the registration for those debentures it misstated its financial
condition.
 The debenture holders brought a class action under §11 of the
1933 Act.
 The sued: BarChris who signed the registration statement, the
underwriters (Drexel), the directors and the accountants (Peat
Marwick)
 Were there misstatements?
 Yes, easy call.
 What is the difference between a material misstatement and a
plain old misstatement?
 Material means information an average prudent investor
ought reasonably to be informed before purchasing the

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 security, matters such an investor needs to know before he
can make an intelligent, informed decision.
 Were there material misstatements?
 Yes. They were prevalent in the 1961 figures. These
figures were “unaudited.”
 Were there material misstatements in the 1960 figures (the
expertised portions)?
 Yes, some
Due-diligence Defense
 Bar-Chris
 No due-diligence defense because they are the issuer
 Only the parts of the registration statement audited by PM
were expertised
 Vitolo (President) & Pugliese (VP) – directors
 Little education and didn’t understand.
 Court calls that irrelevant, directors have a standard of
care and V&P should have hired lawyers to review
registration statement for them.
 Kircher (Treasurer-director)
 Court doesn’t believe him and suggests he purposely fed
false info to Peat Marwick.
 Brinbaum – director
 Recently out of law school and did not investigate the
accuracy of the registration statement.
 Grant (outside counsel) – director
 Sued only as director not as counsel. Drafted registration
statement and did not investigate whether the answers he
received from the Company were true. No liability as an
attorney, but as a director, he has to investigate the
accuracy.
 Peat Marwick – Outside auditors
 PM assigned young Berardi to audit, and Berardi took the
BarChris officers at their word. He inadequately checked
statements, so PM can not claim it exercised due diligence.

Who must file disclosures?

All publicly traded companies and some large close corporations.

RULE 10b-5
Exchange Act §10b-5 and Rule 10b-5
Section 10b provides:
It shall be unlawful for any person, directly or indirectly, by the
use of any means or instrumentality of interstate

105
 commerce or of the mails, or of any facility of any
national securities exchange.—
(b) To use or employ, in connection with the purchase or
sale of any security registered on a national securities
exchange or any security not so registered, any
manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the
Commission may prescribe as necessary or appropriate in
the public interest or for the protection of investors.
• Notice that §10b applies to any security, including securities of
closely held corporations that generally are not subject to the
Exchange Act.
Rule 10b-5
It shall be unlawful for any person, directly or indirectly, by the
use of any means or instrumentality of interstate commerce, or
of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to
omit to state a material fact necessary in order to make
the statements made, in the light of the circumstances
under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business
which operates or would operate as a fraud or deceit upon
any person,
in connection with the purchase or sale of any security.
 Justice Dep’t: Willful violations are a felony (see Securities
Exchange Act § 32(a).
 SEC: Brings civil actions.
 Private parties?
 No express cause of action.
 Supreme Court implied private right of action in
Superintendent of Insurance v. Bankers Life &
Casualty Co. (1971).
 “The existence of this implied remedy is simply
beyond peradventure.” Herman & MacLean v.
Huddleston (1983).
 “in connection with the purchase or sale of any
security” Only purchasers or sellers have standing to
sue – Blue Chip Stamps v. Manor Drug Stores
 Blue Chip plaintiffs decided NOT to buy due to fraud but
had no standing
 Plaintiffs said you had to sell your stock by law and
you didn’t want to so you made it look worse than it
was so we wouldn’t buy, and if we would have
bought we would have made a lot of money.

106
  If you sue under 10b-5 you end up in federal court as
opposed with breach of a fiduciary duty which is a
state law issue.
 If a low level person comes out and says something
incorrect the company has a duty to come out and
correct the statement

Rule 10b-5 Elements

Traditionally, a plaintiff suing under Rule 10b-5 needed to show four
things:
 Scienter: defendant acted with an intent to deceive, manipulate
or defraud.
 State of mind:
 Intent to deceive, manipulate or defraud (Sup. Ct.)
 Reckless disregard of falsity of statement (all circuits
but Sup Ct. has reserved the issue.)
 The 1995 Private Securities Litigation Reform Act
(PSLRA) altered the standard of pleading
recklessness in some circuits. Some circuits now
require pleading detailed facts showing evidence of
deliberate recklessness which raises the standard
back closer to fraud.
 Required in private party litigation – Ernst & Ernst v.
Hochfelder (1976)
 Required in SEC actions – Aaron v. SEC (1980)
 Proximate cause (the misstatement caused the damage)
 Two Types of Causation
 Transaction causation
 Closely related to reliance
 But for the fraud, plaintiff would not have
invested (or sold, etc….)
 Loss causation
 Akin to proximate cause
 Fraud caused the loss
 Where reliance is presumed, court will also assume
transaction causation
 Omissions
 Fraud on the market
 Loss causation not presumed
 Usually turns into a battle of experts.
 Material misrepresentation or omission

107
  “whether there is a substantial likelihood that a reasonable
shareholder [or investor] would consider the fact
important” – TSC Indus., Inc. v. Northway Inc. (1976)
 Whether there is a substantial likelihood that a reasonable
investor would consider the omitted fact important in
deciding whether to buy or sell securities
 Effects of this standard?
 Under this materiality standard, insiders will
seldom be able to defend their trades by
arguing that information is immaterial.
 But how do we apply when faced with uncertain
and contingent facts?
 “a highly fact-dependent probability/magnitude
balancing approach” (Basic)
 Doesn’t the fact that an insider traded on a piece of
information, itself demonstrates materiality?
 Materiality Factors
 Nature of the information
 Company response
 Market response
 Conduct of insiders
 Reliance
 To establish fraud at common law, a plaintiff must
affirmatively prove reasonable reliance on deception.
 Not so under 10b-5 doesn’t have to be reasonable.
 Traditionally, under 10b-5 if the case involved an
affirmative misrepresentation, courts required the plaintiff
show that he or she relied on the misrepresentation.
 Material Omissions…
 If the case involved a failure to disclose, courts
adopted a rebuttable presumption of reliance –
Affiliated Ute Citizens of Utah v. US (1972)
 But Basic is a misrepresentation case…so what could
the Court do?
 Fraud on the market theory.
 Presumption that investor relied on
integrity of market price—so investor
need not have seen misrepresentation
 Invoked when?
 Material Public misrepresentation
 Efficient market
 How can defendant rebut fraud on the
market presumption?

108
  Market not deceived (their
misrepresentation did not effect
the market price.)
 Corrective statements
 Show that specific plaintiffs would
have sold anyway
 Note that any requirement of showing actual
reliance has class certification implications
with some of these things there is going to be some overlap,
especially with reliance and causation
• Rule: Fraud only needs to “touch and concern” a purchase or
sale

Basic Inc. v. Levinson

Facts: Plaintiff are people who sold their stock, after the company
said there was no merger, but before the merger, claiming they
would have got a higher price but for the untrue denial.
 Issues:
 Were Basic’s statements materially false?
 Is this a proper class action, when proof of reliance is
an issue?
 Side-issue
 Where 10b-5 liability is premised on an omission of
material fact, liability can only arise where the
defendant had a duty to disclose
 Did Basic may not have had a duty to disclose the
merger discussions?
 No they did not have a duty to disclose
 If not, what should Basic have done?
 They should have just not commented,
court does not decide if that would have
been enough.
 Why is company liable for something President said?
 Agency law
 General standard of materiality?
 “whether there is a substantial likelihood that a
reasonable shareholder [or investor] would consider
the fact important” – TSC Indus., Inc. v. Northway
Inc. (1976)
 But how do we apply when faced with
uncertain and contingent facts?
 “a highly fact-dependent
probability/magnitude balancing
approach”

109
  Sometimes materiality shifts depending on who
we are talking about.
 Reliance
 Material Omissions…
 If the case involved a failure to disclose, courts
adopted a rebuttable presumption of reliance –
Affiliated Ute Citizens of Utah v. US (1972)
 But Basic is a misrepresentation case…so what could
the Court do?
 Fraud on the market theory.
 Presumption that investor relied on
integrity of market price—so investor
need not have seen misrepresentation,
sophisticated analysts rely on the
information and they control large
financial resources and set the market
price.
 Invoked when?
 Material public misrepresentation
 Efficient market
 How can defendant rebut fraud on the
market presumption?
 Market not deceived (their
misrepresentation did not effect
the market price.)
 Corrective statements
 Show that specific plaintiffs would
have sold anyway
 Note that any requirement of showing actual
reliance has class certification implications,
that you could never bring a class action under
10b-5.

West v. Prudential Securities, Inc.

Facts: Broker lied to clients saying Jefferson was going to be acquired.
 Plaintiffs are the class of investors who bought Jefferson stock
during the time Hofman was lying. (not Hofman’s client’s)
 Held:
 No case. Plaintiffs cannot show that Hofman injured them.
 Fraud on the market theory depends on
dissemination of the information and Hofman only
lied privately. He could not affect the price of
Jefferson stock.

110
  Easterbrook argues that even if professional
investors had heard the lie, they would have
discounted it once events made it clear that no one
was planning to buy Jefferson. If they discounted the
lie, the price of Jefferson stock would have returned
to earlier, lower levels.
 Judge says it is a horizontal demand curve, there is
no demand for Jefferson stock per se such that
increasing the demand would increase the price, as
the price goes up it doesn’t matter, major investors
are not going to chose to buy less of the stock they
are going to chose to buy none of the stock, they are
choosing a stock to diversify their portfolio, they
want a specific combination of risk and return, so
they will just not buy that stock when it does not fit
and will buy another stock that fits that balance, the
price of stock will only change when investors who
control enough funds acquire new information about
the stock about the return they can expect.

Pommer v. Medtest Corporation

Facts:
• Medtest had a technology.
• Manning sells stock to the Pommers .
 At the time of the sale, West (another Medtest
shareholder) told the Pommers that:
 Medtest had a patent on the technology (incorrect at
the time)
 A sale of Medtest to Abbott Labs for a price between
$50 million and $100 million was imminent. (deal
falls through)
 The Pommers sue under Rule 10b-5
Held: The Pommers win on the patent issue.
 Why didn’t Judge Easterbrook believe that the Pommers
were misled by the imminent sale talk?
 Sale price of $50-100 million reveals a lot of
uncertainty so reliance problem
 A sale at $50 million would have been worth $1.5
million to the Pommers, but Manning sold them the
stock for only $200k.
 Why doesn’t the fact that a patent was eventually issued
matter?
 “Good fortune may affect damages, but it does not
make the falsehood any the less material.”

111
  The Pommers would have paid less if they had known
that Medtest had not obtained the patent yet
 Under what circumstances should West and/or Medtest be
held liable?
 West is not liable if he didn’t know the Pommers
were negotiating to buy from Manning. (Sceinter)
 Medtest is liable only if West was acting as its agent.
 What are the Pommers damages?
 The difference between $200,000 and the amount an
investor would have had to pay who was fully
apprised of the pending patent whether or not the
patent actually issues.
 The measure is what would the plaintiffs have
received but for the false denials, but the company is
going to say the false denial kept the merger going
and without it the price would have gone down, so no
damages.

Santa Fe Indus. v. Green

 Santa Fe Industries held 95 percent of the stock of Kirby
Lumber Corp.
 Santa Fe merged Kirby Lumber into itself (at
$150/share) using the Delaware short-form merger
statute
 No shareholder vote required
 Shareholders have the right to have a court
appointed appraisal determine what they
should get for their stock
 Shareholders claim fair price = $772 physical
assets valued at: $640/share
 Plaintiffs (minority shareholders) claim merger violated
Rule 10b-5 because:
 Merger was effected without prior notice to the
minority shareholders and was done without any
legitimate business purpose, but to eliminate the
minority shareholders from the company
 Their shares had been unfairly undervalued
 Plaintiffs are not claiming that they were lied to; rather,
they are claiming a breach of duty because the transaction
was unfair
 Holding:
 Conduct only violates Rule 10b-5 if manipulative or
deceptive, not corporate mismanagement that is a
state issue for breach of fiduciary duty.

112
  Under 10b-5 manipulation has a very specific
meaning, practices that artificially affect
market activity for the purpose of misleading
investors.

The Federal

Wash Sales
 Manipulator enters a purchase order and a sale order at
the same time through the same stockbroker
 Ownership of the stock does not change but creates
the appearance of activity in a security

Matched Sales
 Manipulator enters a purchase order with one stockbroker
and a sale order, at the same time and at the same price,

States
with a different broker
 Sometimes involves multiple manipulators acting
together (so-called “cross sales”)

Shareholder liability
 Matched purchase and sale transactions create the
false appearance of active trading

Corporate governance
Evading Santa Fe
 Acme makes a very popular product
 Acme’s annual report makes a great many glowing

Director/officer fiduciary duties

references to the product

Shareholder rights/duties 113

  Acme routinely ascribes Company X’s stock market
success to the success of the product
 Unbeknownst to the shareholders, however, Acme’s
scientists have established that the product is dangerous
and defective
 Acme’s management continues to manufacture the
product
 The defects are eventually discovered, massive liability
suits ensue, the company goes bankrupt
 Shareholders sue management
 State law claim?
 Duty of Care
 Who wins?
 Probably the BJR protects them
 Rule 10b-5 claim?
 Allege that during the relevant time period (i.e.,
before public awareness of the risks posed by the
product), management knew or recklessly
disregarded the fact that the product was defective
and failed to disclose those facts
 It is possible they could win under these facts, more
an issue of disclosure than Santa Fe.

114
 INSIDER TRADING

Policy:
• Why is insider trading illegal?
– Does economic analysis suggest a theory that has both
justificatory and explanatory power?
– Or should we just repeal the whole thing?
• Deregulatory arguments:
– Market efficiency
– Executive Compensation, and if shareholders don’t like it
they won’t invest in such a firm, or if they don’t mind they
won’t invest and then why should the SEC care,
– Most of it goes undetected, conveying to the public that
stock market trading is an unrigged game anyone can play
and that might be misleading
• Regulatory arguments:
– Fairness
– Property rights
• Question: Who gets harmed?
• Shareholders who
Sold? Well maybe they would have sold anyway
• Shareholders who
kept shares? Not unless the price is dropping
• Other Arbitrageurs?
Definitely harmed, but maybe it is a risk of the profession
• Acquired firm? Probably not unless you have more and more
people buying up stock on behalf of the acquirer
• The acquirer? They
might have to pay more for the firm they are acquiring
• Society
– Efficient “pricing” of
shares?
– Opportunity cost of
Corporations’ efforts
• There is an argument you don’t need 10b-5 to deal with
this because they can require that the investment bankers
not disclose and if they do then there are contract
damages there.
• If we have to strict of a rule then we can’t have stock
analysts that meet with management and try to evaluate
the company

Distinguish Between
• “Generic” 10b-5 violations (which do not involve inside
trades) and “Insider Trading” 10b-5 violations (which do.)

115
 • Government (SEC) enforcement actions against violators
and private rights of action by contemporaneous traders
– Damages vs. fines and/or imprisonment
– Necessity of showing Reliance and Transaction/Loss
causation

The word insider does not appear anywhere in 10b-5, this is important
to remember because 10b-5 was created to address fraud, so the
expansion of 10b-5 to encompass insider trading really only happens
when the insider had some duty.
• Insider trading liability is premised on an omission of
material fact
– Problem: Liability for omission can only be imposed
where defendant had a duty to disclose
• Silence is not fraudulent absent a duty to
speak
– Whence comes the insider’s duty to speak?

As pertains to Insider Trading

• Duty:
– Statutory or “Constructive” insiders have duty not to
trade while in possession of non-public information;
must “disclose or abstain”
• Scienter:
– An insider who trades risks liability if she does so
knowingly or (in most jurisdictions) recklessly
• Materiality:
– “Reasonable Investor” test (see below)
• Reliance
• Proximate Cause

Under the traditional theory of insider trading Rule 10b-5 is violated

when a corporate insider trades in the securities of his corporation on
the basis of material, nonpublic information. Trading on such
information qualifies as a “deceptive device” under § 10(b), we have
affirmed, because “a relationship of trust and confidence [exists]
between the shareholders of a corporation and those insiders who
have obtained confidential information by reason of their position with
that corporation.

Why is Martha Stewart not guilty of insider trading?

She did not get information the FDA was not going to approve the
drug, but that the company executive was selling his stocks

Texas Gulf Sulphur

116
Facts: Exploring mine, president demands secrecy because land
prices will go up before they can purchase the land (so
there was a good corporate justification for nondisclosure,
until the land acquisitions had been completed), insiders
trade, corporation at first denies media claims.
Posture and Holding:
• SEC action against
both individual defendants and corporation
Defendants:
The Corporate Defendant
• Why was TGS
charged with violating 10b-5?
– TGS was not a
purchaser or seller
• Status as such is only
relevant to private party plaintiff standing to
sue
– “In connection with”
• Satisfied if the press
release “would cause reasonable investors
to rely thereon” and “cause [such investors]
to purchase or sell a corporation’s
securities”
Insider Defendants
• Legal rule re insider
trading?
– Where an insider has
material nonpublic information the insider must
either disclose such information before trading or
abstain from trading until the information has
been disclosed THIS IS NOT THE LAW TODAY
– “Disclose or Abstain”
Cady-Roberts THIS IS NOT THE LAW TODAY
• Policy: Rationale for
rule?
– The federal insider
trading prohibition was intended to assure that
“all investors trading on impersonal exchanges
have relatively equal access to material
information”
Held: CA2 reverses some of the individual dismissals, and
reverses TGS dismissal.
– Note: Coates waits
till just after the press release is released, court says
not okay

117
 • Ct holds that insiders must wait until info. has
had a “chance” to percolate through the
market.
• Would it be different today?
• Probably, because of the internet

Who is an Insider?
• Exchange Act § 16(b): Officers, directors, and 10% shareholders
– § 16(b) also requires such insiders to report changes in
their ownership stake, and to disgorge “short-swing”
profits from quick purchase or sale.
– But in addition, cases can involve what are known as
TEMPORARY Insiders (Harder Cases):
• Dirks.
• This will usually mean any agent who, because of
their position, is given access to trade-secret like
knowledge that is reasonably expected to be
confidential. Thus, this can include various
contractual privies, former executives, families of
insiders, etc. This is why the trading of the firm’s
geologist (not a statutory insider) is also proscribed.)

When May Insiders Trade?

• Rule?
– Insiders (e.g. Coates) must wait until the information is
effectively disclosed in a manner sufficient to insure its
availability to the investing public

So at this point there are two paths to go down:

One is more limited related to property rights, one is the securities
fraud path which brings a lot more things into the securities realm.

118
 Going down the securitie

Cady Roberts Texas Gulf Su

1961 1968

The road curves

• Effects:
– Cady Roberts
Federalization
Chiarella v. US: Limits of “Traditional” I-T Liability
Facts: Printer correctly identifies identity of tender offer. He did not
buy stock in– thePublic (SEC)
corporation doing instead
the printing he bought of
stockprivate en
Scope of Liability

in a corporation he had no relationship with, (and therefore he

had no duty to their shareholders).
– Legal theory moves from fiduciar
• Majority:
– Throws out the “level playing field” theory for
fraud
prohibiting insider trading.
– Violation of 10b-5 occurs only if informed trader
owed a duty to the corp/SHs. Did he? No, no
relationship of trust with the shareholders of the
corporations whose shares he traded.
• He had a duty to his principal as an employee,

49 •
but it was not to the shareholders.
Dissent (Burger)
– First articulation of the “misappropriation” theory of
Insider Trading

119

Chiarella and Dirks

 – Reads the relevant sections to mean "that a person
who has misappropriated nonpublic information
(regardless of the duty owed) has an absolute duty
to disclose that information or to refrain from
trading."
– But not adopted by court…..(yet)
A case that places a distinct limit on the traditional I.T. theory.
Articulates the premise that under a "traditional" insider
trading approach, the use of inside information is only a
violation if the possessor has a "duty" to the
shareholders.
Throws out the argument that antifraud provisions are present to
ensure Parity of information.

Dirks v. SEC
Facts: Dirks tells his clients what he has learned from a former officer
that company is cooking books, his clients sell the stock, he
doesn’t trade. Brought up as a tipping tippee.
Held: Secrist owed a duty of some kind, but he did not breach that
duty
• Secrist’s duty to corp/SHs:
– Was he a “statutory” insider?/Did Secrist Actually
Owe a Duty to the EFA and its SHs?
• No. Secrist DID have a duty to SHs, but it was
NOT a statutory duty. He was not a
director/officer/large SH under §12. Rather he
was a former Officer.
• But, recall in TGS, the statutory label is only
sufficient (not necessary)
• Definition of a “temporary” insider: Fn
14.
• The basis for recognizing this
fiduciary duty is not simply that
such persons acquired nonpublic
corporate information, but rather
that they have entered into a
special confidential relationship in
the conduct of the business of the
enterprise and are given access to
information solely for corporate
purposes.
– If so, does Dirks “inherit” Secrist’s “Cady/Roberts”
duty (disclose or abstain)
• Not unless the insider breaches(and personal
benefit test) a fiduciary duty in disclosing, and
tippee has constructive knowledge.

120
 – Does Dirks “pass it on” to his tippees?
• Court: NO. For tippee to inherit duty: Tipper
must be tipping for personal benefit.
Obviously, Dirks’ tippees have nothing to
inherit, since Dirks did not inherit a “Cady-
Roberts” duty from Secrist.
• Holding re tipping?
– In general, the tippee’s liability is derivative of the
tipper’s, “arising from his role as a participant after
the fact in the insider’s breach of a fiduciary duty.”
– A tippee therefore can be held liable only
when:
• The tipper breached a fiduciary duty(and
personal benefit test) by disclosing
information to the tippee, and
• The tippee knows or has reason to know
of the breach of duty

Tipper Liability
• Tippers...
– May Be Liable for their tippee’s trades.
• Even if tippees themselves not liable
under Dirks, tipper can still be liable
under the first half of Dirks test.
– Who give bad tips can be sued by their tippees!
– Tippers who trade: liable as insiders if Dirks test satisfied

SEC v. Switzer
Facts: Barry Switzer overheard CEO telling his wife something at a
track meet. Switzer and his pals traded on the info.
Held: Given the facts, Switzer is not liable. He is neither an insider nor
a constructive insider. Platt is not liable since a tipper violates a
fiduciary duty in giving the tip only if he profits from the breach
and Platt did not profit here. Plus even if telling the wife was a
breach of a fiduciary duty Switzer would have had to have known
or have had reason to know it was a breach

Disclose or Abstain
• The disclose or abstain regime still is present. However,
the question is “Who must disclose or abstain?” When
does the rule apply.
• Note also, that given the frequently existing confidentiality
restrictions, this becomes more of an abstain rule.

121
 Is subject in
possession of
material, non -
public, info?

YES

U.S. v. O’Hagan Statutory insider

Facts:
under §16(a)
O'Hagan was a partner in the law firm representing Grand Met in
(D/O/Prin. SH)?
a potential tender offer for the common stock of a company.
O'Hagan did no work on the Grand Met representation, but knew
about it and purchased stocks.
The Misappropriation Theory of Insider Trading
The "misappropriation theory" holds that a person commits fraud
"in connection with" a securities transaction, and thereby
YES
violates § 10(b) and Rule 10b-5, when he
(1) uses confidential information in breach of a duty owed
to the source of the information (fulfilling the “breach
of duty” requirement)
NO
(2) doesn’t disclose this information to trading partners
(“deception”)
(3) and proceeds to trade on that information.
(“transaction”)
The two theories are complementary. The classical theory
targets a corporate insider’s breach of duty; the misappropriation YES

122

Temporary insider
 theory outlaws trading on the basis of nonpublic information by a
corporate “outsider” in breach of a duty owed not to a trading
party, but to the source of the information.
Full disclosure to the source of the information of plans to trade
on the information forecloses liability under the misappropriation
theory because then there is no deception, but there still might
be a state law breach of duty of loyalty.
Even when the duty doesn’t cross over, if you take information in
breach of a duty then you are still liable.
Under this theory Chirella would have been liable
Under this theory fiduciaries of the acquiring company are also
liable even though they have no fiduciary duty to the soon to be
acquired company.
The fraud is not the trading but how you acquired the
information.
According to the court there were duties to the law firm and to
the client and they were both breached
Held: 10b-5 convictions reinstated
• A fiduciary’s undisclosed use of information belonging to
his principal, without disclosure of such use to the
principal, for personal gain constitutes fraud(deception) in
connection with the purchase or sale of a security and,
thus, violates 10b-5.
– Duty of Trust & Confidence owed in misappropriation
case (under new SEC guidelines (Rule 10b5-2) when:
• Person agrees to maintain information in
confidence
• There is a history of sharing confidences so
recipient of the info knows or should know that
the person communicating the info expects the
recipient to maintain confidentiality
• Person receives the information from a spouse,
child, parent, or sibling (unless the recipient
can prove that he had no reason to know that
the information was confidential).
– Note that this is a “non-exhaustive” list.
• “Misappropriation” theory consistent with § 10(b) and Rule
10b-5
– Statute/Rule proscribe “deception” by trader “in
connection with purchase/sale” of securities.
– In this case, deception works through undisclosed
use of the principal’s info; and purchase/sale
requirement clearly met.
– Santa Fe Industries does not contradict this outcome.
Misappropriation can’t be about just any breach of
fiduciary duty, deception is required.

123
 • To escape 10b-5, O’Hagan need only disclose
(to whom?)
• Probably Hagan should disclose to the
law firm and the Grand Met
• Which must give him permission?
• If you literally read the case you don’t
need permission from anyone, they just
say you have to disclose

Traditional I-T, clarifications

• Gift means a gift from the tipper. It is viewed as the
equivalent of trading in the info and giving the tippee the
money.
• Under the traditional theory, there should be tipper liability
for an insider only, but there are a few (I think incorrect)
cases which have transferred the violation of the insider
tipper to a subsequent outside tippee turned tipper.
• Policy: The reason for the personal benefit requirement is
that the Insider tipper doesn’t just have a duty of
confidentiality, they have a duty of loyalty. It is almost as
though the court has created a duty to refrain from self
dealing in non-public information.

U.S. v. Chestman (Non-traditional cases)

Facts: Waldbaum is about to be acquired by A&P; Ira Waldbaum,
president tells sister Shirley; Shirley tells daughter Susan who
tells husband Keith; Keith tells his broker, Chestman who buys
stock for his own account and his clients. SEC argues Keith
misappropriated info from his wife Susan which he then tipped to
Chestman
– The requisite relationship will be found where one
party acts on the other’s behalf and “great trust
and confidence” exist between the parties.
– Unilaterally entrusting someone w/confidential
information does not by itself create a fiduciary
relationship.
• Even if the disclosure is accompanied by an
admonition such as “don’t tell.”
– Familial relationships in the absence of
evidence that Keith regularly participated in
confidential business discussions are not
fiduciary in nature w/out some additional element.
(So SEC passed Rule 10b5-2)
– But the SEC has promulgated rules that say
that family relationships are relationships of

124
 trust and confidence, the rule has not been
tested yet.

US v. Willis
• But in U.S. v. Willis, a psychiatrist traded on inside
information learned from a patient in the course of
therapy.
– Relevant part of the Hippocratic Oath: Whatsoever
things I see or hear concerning the life of men, in my
attendance on the sick or even apart therefrom,
which ought not to be noised abroad, I will keep
silence thereon, counting such things to be as sacred
secrets.”
Held:
– Court determined that, based on the Hippocratic
Oath, the requisite breach of fiduciary duty had
occurred.
– Problem w/identifying relationships which are
“inherently fiduciary” in nature. Note that issues
relating to the nature of the fiduciary duty are
routinely swept under the rug.
– The real test involves a fiduciary duty that
relates to the information and relates to not
using the information for insider trading, so
not just any fiduciary duty will qualify.

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 Is subject in
possession of
material, non- NO
public, info?

YES

Does Subject owe a

Fiduciary Duty of
14e-3 Liability confidentiality to
• In O’Hagan the Court also held that: the SEC has authority
infoasgenerator?
to adopt rule 14e-3 a prophylactic measure against
insider trading specifically in connection with a tender
offer.
• Section 14e-3: Governs Insider Trading w/respect to
Tender Offers. Prohibits insiders of the bidder and target
from divulging confidential information about a tender offer
YES
to persons that are likely to violate the rule by trading on
the basis of that information.
– Does not prohibit bidder from buying target shares or
from telling its legal and financial advisors about its
plans.
– Targeted at practice of “warehousing”.
• 14e-3 provides that in the process of a tender offer (or
preliminary steps thereof), it is a violation of §14(e) for any
other person with material information relating to such an
YES
Is Info. w/in the scope
offer that he knows or has reason to know is non-public,
and which has been acquired directly or indirectly from,
of Fiduciary Duty?
the offering person; the issuer of the securities sought by

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 the offerer; or any subordinate officer, directer, partner,
executive, or "temporary insider" to buy any securities,
options, convertibles at any time prior to the tender offer,
unless he first makes that information publicly known
along with its source.
• Elements of a typical 14e-3 action:
– Possession of inside info. regarding tender off.
– Materiality of information
– Knows or has reason to know the info came from an
insider, director or ind.
– Purchase, sell, (or cause to be purchased/sold)
security/derivative of offeror or target without first
disclosing info to trading partner, if the bidder has
commenced or has taken substantial steps toward
commencement of the bid (e.g. formulation of a plan,
arrangement of financing, preparing tender offer
materials).
• Strict Liability:
– No breach of duty required
• Only applies to tender offers.

Penalties
• Administrative hearings against defendants under the
SEC’s direct regulation (brokers, dealers, etc.)
• Equitable relief in civil case brought by the SEC:
– Injunctions; e.g., forbidding violator from being
employed in the securities industry
– Disgorgement of profits
– Treble money sanction under ITSA
• Criminal indictment: 20 years jail and up to $5 million fine
for individuals and $25.5 million for corporate defendants
per count
– Exchange Act § 32 makes it a felony
• Private suits—rare

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 SHORT-SWING PROFITS

Section 16(a)
 “Every person who is directly or indirectly the beneficial owner of
more than 10 per centum of any class of any equity security . . .
or who is a director or an officer of the issuer of such security . . .
within ten days after the close of each calendar month . . . shall
file with the Commission . . . a statement indicating his
ownership at the close of the calendar month and such changes
in his ownership as have occurred during such calendar month”
Note that this time frame
has been reduced to two
business days following
the trade.
Section 16(b)
 “any profit realized by [such beneficial owner, director, or officer]
from any purchase and sale, or any sale and purchase, of any
equity security of such issuer . . . within any period of less than
six months . . . shall inure to and be recoverable by the issuer”
 Insiders: § 16(b) applies only to officers, directors, or
shareholders with more than 10% of the stock
 § 16(b) applies only to companies that must register under the
1934 Act
 Compare Rule 10b-5, which applies to all issuers
 Equity securities
 § 16 applies only to stocks and convertible debt (you have
the right to convert it to equity, stocks)
 Compare Rule 10b-5, which applies to all securities
 Sale and purchase
 § 16(b) applies whether the sale follows the purchase or
the purchase follows the sale.
 Shorting the stock – betting the stock will go
down, you sell the stock you own and then buy
it at a price you pick in advance
 Recovery
 Any recovery goes to the company
 Shareholders can sue derivatively, and a shareholder's
lawyer can get a contingent fee out of any recovery or
settlement
 Courts interpret the statute to maximize the gains the
company recovers

/Key statutory language

128
  “This subsection shall not be construed to cover any transaction
where such beneficial owner was not such both at the time of the
purchase and sale, or the sale and purchase, of the security
involved”

Reliance Elec. v. Emerson Elec.

Facts:
 June 16: Emerson buys 13.2% of Dodge in a takeover attempt.
Dodge then merged into Reliance (a “white knight”)
 Aug 28: Emerson sells some shares (3.24%); for the purpose of
reducing his holdings to 9.96%
 Sep 11: Emerson sells remaining 9.96%
Issues:
 Was the June 16 purchase a “matchable” purchase?
 Sup Ct declines to answer
 Assuming the June 16 purchase is matchable, can it be
matched with the Sep 11 sale?
 No. Emerson was not a 10% owner on 9/11

Foremost-McKesson v. Provident Securities

Facts:
 In order to liquidate, Provident agreed to sell 2/3 of its assets to
Foremost.
 In exchange on Oct 20, Provident received cash and Foremost
debentures convertible into > 10% of Foremost stock.
 Oct 24: Provident distributes some debentures to shareholders
 Oct 28: Provident sells remaining debentures and distributes
cash to its shareholders.
 Provident sues for a declaratory judgment that it had no §16(b)
liability.
Issue: Can we match Oct 20 acquisition with Oct 24 disposition?
 Note: This is the issue that was left open in Reliance
 Statutory issue: “This subsection shall not be construed to cover
any transaction where such beneficial owner was not such both
at the time of the purchase and sale, or the sale and purchase, of
the security involved”
Holding?
 In a purchase-sale sequence, the transaction by
which the shareholder crosses the 10% threshold is
not a matchable purchase
 Only purchases effected after one becomes a 10%
shareholder are matchable

Kern County Land Co. v. Occidental Petroleum Corp.

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Facts:
 Occidental acquired over 20% of Old Kern’s stock in steps
(so some stock was acquired after it already owned 10%)
through a tender offer.
 Old Kern mgt. negotiated a merger w/Tenneco.
 Rather than become a minority SH in Tenneco, Occidental
gave Tenneco an option to purchase its stock which could
not be exercised until 6 months after the tender offer
commenced.
 Tenneco sues to recover Occidental’s “short-swing” profits.
Two issues:
 Did the signing of the merger agreement which gave
Occidental the “irrevocable” right to exchange its
shares constitute a “sale”?
 Was entering into the option agreement with
Tenneco a “sale”?
Held: Sale not covered by 16(b). Since Occidental did not have
access to inside information, the situation did not present
an opportunity for abuse.
 The exchange did not involve a “sale” within the meaning
of §16(b).

Planning: What should Occidental’s attorney’s have clarified in the

terms??
 Occidental shall have no 16(b) liability and if it does
Tenneco will indemnify Occidental.
 The reduction of the purchase price will be at
$10/share for each share acquired up to a maximum
of $8,886,230, rather than a blanket credit of
$8,886,230

130
 PROXY FIGHTS

Shareholder Meetings
• Annual
– MBCA § 7.01
• Special
– MBCA § 7.02
– Different states have variations on who can call a special
mtg. (various officers, directors and shareholders)
• For all SH meetings a quorum (of 50%) is required
• Only SHs who hold stock on the record date can vote.
• Election of directors
• Fundamental changes to the corporation
– Mergers, sales of all assets, corporate dissolutions, charter
amendments, etc.
• Shareholder resolutions
– Resolutions are usually proposed by management (e.g.
ratify an option plan)
– Shareholders may also propose resolutions to request the
board to take specific action (e.g. dismantle a takeover
defense, divest from Burma).

Proxy Voting
• A Shareholder (as principal) may appoint a proxy (a.k.a. proxy
agent) to vote his/her shares at the meeting
• Appointment effected by means of a proxy (a.k.a. proxy card)
– Can specify how shares to be voted or give agent
discretion
– Revocable
– Without the routinized proxy process, the firm would often
find itself w/out a quorum.

Voting
• Rival groups may nominate rival slates of directors, the group
w/the greatest number of votes will find its entire slate elected.
So 51% gets you complete control.
– Note a voting system called cumulative voting exists under
which major shareholders can elect the percentage of the
board members equal (roughly) to the percentage of stock
they control.
– E.g. Alan owns 300 shares and nine directors are being
elected, Alan will have 2,700 votes to allocate as he
chooses.

Securities Exchange Act § 14(a)

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 • It shall be unlawful for any person, by use of the mails or by
any means or instrumentality of interstate commerce or of any
facility of a national securities exchange or otherwise, in
contravention of such rules and regulations as the Commission
may prescribe as necessary or appropriate in the public interest
or for the protection of investors, to solicit … any proxy … in
respect of any security … registered pursuant to Section 12 of
this title

SEC Proxy Rules

• 14a-3: Incumbent directors must provide annual report before
soliciting proxies for annual meeting
• Anyone who “solicits” a proxy must provide a written proxy
statement BEFORE soliciting the proxy.
– Free writing generally permitted thereafter.

What is a Solicitation?
• “Solicit” includes not only “direct requests to furnish, revoke or
withhold proxies, but also ... communications which may
indirectly accomplish such a result or constitute a step in a chain
of communications designed ultimately to accomplish such a
result.”— Long Island Lighting Co. v. Barbash, 779 F.2d 793, 796
(2d Cir.1985).
– An environmentalist group ran newspaper and radio ads
critical of the defendant electrical utility's management.
Incumbent managers sued the environmentalists, alleging
that their ads constituted a proxy solicitation.
• Rule 14a-1(l)(2)(iv) exempts public statements of how the
shareholder intends to vote and its reasons for doing so.
• Rule 14a-2(b)(1), subject to numerous exceptions, exempts
persons who do not seek "the power to act as proxy for a
security holder" and do not furnish or solicit "a form of
revocation, abstention, consent or authorization.“
– Consequently, for example, a newspaper editorial advising
a vote against incumbent managers is now definitively
exempted.
• Rule 14a-2(b)(2) exempts solicitations of 10 or fewer persons.
• Rule 14a-2(b)(3) exempts the furnishing of proxy voting advice
by someone with whom the shareholder has a business
relationship.

Levin v. Metro-Goldwyn-Mayer, Inc.

Facts:
• Levin and his friends owned about 11% of MGM stock worth
about $20 million.

132
 • Levin was on the MGM board, but didn’t like the way the
incumbents (the O’Brien group) had run the firm.
• Levin organized a proxy fight to outs the incumbents.
• The O’Brien group hired a PR firm and incurred other costs at
corporate expense.
• Levin and pals contested the use of corporate funds by the
O’Brien group.
Held: Judgment for MGM. The expenses were not excessive or illegal.

Rosenfeld v. Fairchild Engine & Airplane Corp.

Facts:
• Insurgents won control of Fairchild through a proxy fight.
• Incumbents had charged $106K for their won proxy expenses
while in office and insurgents paid them another $26K upon
taking control.
• Insurgents reimbursed themselves $127,000 for their own
expenses and arranged for SHs to ratify that reimbursement.
• Plainfiff SH brings a derivative lawsuit to challenge these
payments.
Held: Judgment for defendants
• The proxy fight concerned questions of corporate policy rather
than simply personal control and the expenses were reasonable.

Reimbursement
Basic rules:
– Can management use corporate funds to pay for expenses
they incur in conducting their proxy solicitation?
• Yes, as long as the amounts are “reasonable” and
the contest involves “policy” questions rather than
just a “purely personal power struggle”—Rosenfeld
• The firm may reimburse incumbents whether they win or
lose.
• The firm may reimburse insurgents only if they win and
only if SHs ratify the payment.
• Majority rule (called Fairchild rule): incumbents always get
reimbursed insurgents get reimbursed if they win
• Reimbursement rules can differ on at least three dimensions:
• Amount: reimburse all, part, or nothing?
• Conditionality: must you win to be reimbursed?
• Bias: favor incumbents, insurgents or neither (neutral)?
• How do we know it is a policy contest?
• What would be a “reasonable” expense?
– Disclosure statements to shareholders
– Telephone solicitations
– In person visits to major shareholders
• Wining and dining said shareholders

133
 • Private jet to bring major shareholders to company
HQ
• Giving corporate contract to major shareholder
(conflict of interest)

Policy: Should insurgents be reimbursed for their expenses they incur

in conducting their proxy solicitation?
– If they win?
– If they lose?
That gives an incentive to spend as much as
possible, but there is already the incentive so
spend enough to make sure you win or else
you won’t get reimbursed.
– If insurgent groups are reimbursed only when they win,
should incumbents be reimbursed when they lose?
It would degrade the quality of the people on the
board, or they would all demand proxy
insurance.

Lovenheim v. Iroquis Brands, Ltd.

Facts: shareholder wants to include information about a resolution he
is going to offer at the shareholders meeting in the proxy
materials
Issues:
• Pâte operations economically “significant”?
– No
• Why included?
– “Otherwise significantly related” includes ethical and/or
social significance
• Not otherwise significant
– Rule 14a-8(i)(5) allows exclusion of proposal that relates to
operations which account for less than 5 percent of the
firm’s assets, earnings or sales, and is not otherwise
significantly related to the firm’s business
Basis for holding?
• The rule itself is ambiguous
• The SEC before the 1983 amendments required inclusion of
important policy questions even where less than one percent of
the firm’s assets or earnings were implicated by the question
• In adopting the five percent test, SEC said proposals that don’t
satisfy the five percent tests can still be included
• Medical Committee decision implied that proposals involving
general political and social concerns were acceptable

Rule 14a-8: Shareholder Proposals

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 • Allows qualifying shareholders to put a proposal before their
fellow shareholders
– And have proxies solicited in favor of them in the
company’s proxy statement
– Expense thus borne by the company
• What should a shareholder be allowed to include in a Proposal to
other shareholders?
• What should be excluded?
Substantive grounds for exclusion
• The proposal does not concern a proper subject for action by
shareholders (like you guys should fix Outlook, that is not really a
shareholder issue, it for the board) (this element seems to
overlap with number five)
• The proposal is illegal
• The proposal violates the proxy rules (e.g. misleading material)
• The proposal concerns a matter beyond the power of the firm to
effectuate
• The proposal relates to a company’s ordinary business
operations
• The proposal has been submitted in the past and has not
obtained much support.
– Issue with most SH proposals is not whether they will win,
but whether they will get enough support to resubmit the
proposal the next year.
Procedural aspects
• Detailed rules regarding:
– Process for excluding proposal
– Timing
– Stock holdings required
– Length of Proposal
– Submission requirements
• Number
• Prior submissions
• Showing up
Substantive grounds for exclusion
• Precatory (i.e., nonbinding) phrasing
– E.g., Dole:
• “shareholders request the Board of Directors to
establish a committee . . . for the purpose of
evaluating the impact of a representative cross
section of the various health care reform proposals
being considered by national policy makers . . .
Further, the aforementioned committee should be
directed to prepare a report of its findings.”
• Why?

135
 • What happens if precatory proposal passes and board refuses to
act?
– BJR
– Rule 14a-8(i)(1):
• A shareholder proposal must be a proper subject of
action for security holders
• It must be an action which it is proper for
shareholders to initiate
• Look to state law to decide that question
– E.g., DGCL 141(a)
• If shareholders not allowed to initiate, still ok if
phrased as proposal

Ordinary Business or Not?

• Disinvestment in South Africa? Include
• Get out of tobacco business? Include
• Get out of nuclear power business? Include
• End affirmative action? Include
• Start affirmative action? Include
• Non-discrimination on basis of sexual orientation? Include
• Non-discrimination on basis of veteran status? Include
• Executive compensation? Include
• Employee compensation? NO

Shareholder inspection rights

• Although §14 of the 1934 Act requires incumbents to either mail
insurgents’ material to SHs or give insurgents a copy of the SH
list, incumbents almost always choose to mail the material
themselves. BUT, SHs also have rights under state law to inspect
the books of a corporation.
• Policy concerns:
– Shareholders have a legitimate interest in using the proxy
system to hold the board accountable
– Insurgents may want to communicate directly with some
major SHs and/or may need access to corporate records
other than shareholder lists.
– Nobody wants a junk mail distributor to get access to the
shareholder list or a competitor to get access to the
corporation’s trade secrets and other proprietary
information

Delaware statute
• Section 220(b):
– Shareholder must make a written demand setting forth a
“proper purpose”

136
 – A “proper purpose” is one “reasonably related to such
person’s interest as a stockholder”
• Section 220(c)
– If shareholder only seeks access to the shareholder list,
BoP on the corporation to show that shareholder doing so
for an improper reason
– If shareholder seeks access to other corporate records, BoP
on shareholder to prove requisite proper purpose.
Purposes
• Proper
– Investigate alleged
corporate mismanagement
– Collecting information
relevant to valuing shares
– Communicating with
fellow shareholders in connection with a planned
proxy contest
• Improper
– Attempting to discover
proprietary business information for the benefit of a
competitor
– Secure prospects for
personal business
– Institute strike suits

Crane Co. v. Anaconda Co.

Facts: Crane announced a tender offer for Anaconda stock
– Crane asked for the shareholder list
• SEC rule would require Anaconda to mail the offer
directly
– Anaconda refused, arguing that Crane wanted the list in an
effort to gain control and that is not a proper purpose. Is
it?
• The fact that it is related to their stock ownership
makes it a proper purpose, and it is good for the
shareholders to know what is happening.
– Note that Crane is an Illinois corp.; Anaconda is a Montana
Corp. Why is suit brought in NY?
• They were forum shopping and they were doing
business there
Holding:
– Communicating with other shareholders about offer was a
proper purpose
Issues
– Statutory interpretation
– Foreign corporations

137
 • NY law applies because access to stockholder lists is
a departure from the general rule that the laws of the
state of incorporation control corporate governance
law issues.

Noneconomic purposes: Pillsbury v. Honeywell, Inc.

Facts:
– Plaintiff belonged to an antiwar group trying to stop
Honeywell from producing anti-personnel fragmentation
bombs for the military
– Pillsbury (not the dough boy company) bought some
Honeywell stock, and requested access to Honeywell’s
shareholder list and to corporate records relating to
production of such bombs. Pillsbury explicitly stated that
he cared only about the morality of Honeywell’s work.
Holding:
– Pillsbury lacks a proper purpose germane to his interest as
a shareholder for requesting the shareholder list or
corporate records
– Purpose based solely on Pillsbury’s pre-existing social and
political views rather than any economic interest
(Remember the Ford Motor case?)
• Limitation: “suit might be appropriate when a shareholder has a
bona fide concern about the adverse effects of abstention from
profitable war contracts on his investment in Honeywell.”
• Why is this case different from Lovenheim (the force fed goose to
make patè case)?
– State law vs. Fed. Law (§14a)
– Stated non-economic reason.
– This is about getting access to the list, not about getting
something on the ballot, and here you need to have a
proper purpose and here it needs to be a little more
economic. (This would be absolutely something that could
get on the ballot.)

There are three types of shareholder lists:

Record List
“street name” CEDE list
NOBO list (Non-Objecting Beneficial Owners)

Which List? Sadler v. NCR Corp.

• Facts
– AT&T launched a tender offer for NCR
• NCR was a Maryland corporation that did business in
New York

138
 • AT&T had no right under either NY or Maryland law to
a shareholders’ list
• Under NY but not under Maryland law, its ally Sadler
had such a right
– In Sadler’s name, AT&T asked for both a CEDE and a NOBO
list
• Holding on choice of law: MD or NY?
– New York
– “Access to stockholder lists is a recognized exception to
the internal affairs doctrine ....”
• Review:
– What is internal affairs doctrine?
• Corporate governance issues controlled by law of
state of incorporation.
• Holding on list entitlement?
– AT&T entitled to both lists
– NCR must prepare NOBO list even if not pre-existing
• Delaware law to the contrary
• Delaware only requires preparation of CEDE list
– Why?
• Liberal interpretation of statute – “to facilitate
shareholder communication”
– Note that shareholders are on the NOBO list unless they
ask to be taken off and they never ask to be taken off.

139
 SHAREHOLDER VOTING

Common Stock as a Bundle of Rights

 Economic rights
 Receive dividends (distribution of profits) when and as
declared by the board of directors
 Residual claim on assets in liquidation
 Voting/Management rights
 Elect directors
 Approve some extraordinary matters
Packaging Rights
 MBCA § 6.01(b)
 Requires at least one class with unlimited voting rights
 Requires at least one class with residual claim
 MBCA is very liberal – some states are more restrictive
 MBCA § 6.01(c)
 Authorizes nonvoting stock and other variants on one
share-one vote
Voting Rights
 Meetings:
 Annual
 Special
 Who can call?
 Compare MBCA § 7.02(a)(2) [BoD, 10% SHs,
plus others authorized in articles] with DGCL §
211(d) [BoD, plus others authorized in articles]
 Action without meeting (a.k.a. written consents):
 Must be unanimous under MBCA.
 Compare DGCL § 228(a)—action by consents okay if
same number of shares consent as would be needed
at a meeting.
Quorum
 In order for shareholders to take action, there must be a quorum
at the meeting. What is the default rule for a quorum? See MBCA
§ 7.25(a).
 A majority of the shares entitled to vote.
Voting
 Under MBCA § 7.25(c)?
 A matter is approved if votes cast in favor are greater than
the votes cast against.
 Under DGCL § 216?
 Decisions must be approved by the vote of a majority of
the shares present

140
Example
 If there are 800 total votes:
 In Favor 399
 Opposed 398
 Abstain 3
 Result?
 Passes under MBCA
 Fails under Delaware (needed 401 to pass)

Special Voting Rules

 Cumulative voting
 Optional system for electing directors
 Voting by groups
 Potentially applicable when corporation has multiple
classes of stock
 (e.g. Preferred Class B may have approval/veto rights over
certain types of transactions.)

Stroh v. Blackhawk Holding Corp.

 Par value:
 Minimum price at which shares may be sold
 Specified in articles of incorporation
 Stock split:
 Effected by changing par value through amendment to
articles
 Here the number of shares was doubled and the par
value was cut from $1 to 50¢
 Used to get more shares into the hands of investors or
lowering the price at which stock’s trade, you can have a
reverse split
Facts:
 Illinois constitution prohibited nonvoting common stock
 Two classes of Blackhawk stock
 Class A – standard common stock with both
economic and voting rights
 Class B – common stock with no economic rights (no
right to ordinary or liquidating dividends) but with
one vote per share
 Structure means Management is unaccountable to
shareholders
 If management would have just issued more class A stock
to gain control they would have made more money, but it
seems they just were control freaks and they assumed the
all class A plan would be overreaching.

141
  Note that after the subsequent split of A shares and the
sale of new A shares, the promoters still wind up with less
than 50% of the total votes.
Plaintiff argument
 What did plaintiffs argue with regard to the validity of the
Class B shares?
 That the Class B shares were invalid because they
lacked economic rights
 Plaintiffs said that real shares represent the
“proprietary” interests in the corporation
 Further, “proprietary” necessarily assumes an
economic interest
Holding:
 The Court rejected plaintiffs' argument, holding that the
Class B shares were valid. Why?
 A “proprietary” right is not just a right to profits or
distributions; a right to participate in control is also a
proprietary right. Because Class B stock had that right, it
is a valid form of stock.
 The proprietary rights conferred by the ownership of
stock may consist of one of more of the rights to
participate “in the control of the corporation, in its
surplus or profits, or in the distribution of its assets.”
 Only the right to management incident to ownership
may not be removed.
 Note: There is no duty of loyalty issue here because future
shareholders are not owed a duty and they disclosed and
the shareholders chose to buy into it.

 Incentive to mismanage
 As the value of A shares falls the value of B shares could
rise.
 The greater the opportunity for gain, the greater the
value of control.
 The greater the mismanagement, (up to a point) the
greater the opportunity for gain.
 The combination of these two propositions creates an
incentive for those with control, but little or no investment,
to mismanage and increase the value of their stock.
 How else could the original Blackhawk investors have
accomplished the same thing?
 Issue themselves the right to elect six directors and then
sell identical shares to the public except the public shares
could elect only 3 directors.

142
 Class voting on other issues, so that they would have to be
approved by both classes.
 If there were no state law prohibition, sell nonvoting shares
to the public.
 If Blackhawk were a smaller close corporation we might
use a voting trust, a vote pooling arrangement or
irrevocable proxies.

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 CONTROL IN CLOSED CORPORATIONS

 Galler v. Galler:
 “a close corporation is one in which the stock is held in a
few hands, or in a few families, and wherein it is not at all,
or only rarely, dealt in by buying or selling”
 i.e., no secondary market for shares

Some Major Deal points

 How decisions will be made
 Who will be directors
 Who will be officers
 Who will do what work
 Salaries and dividends
 Termination
 Bringing in new shareholders
 What do you do when you can’t agree?
 What do you do about a situation where one party is always
being dominated by others?
Investor Passivity Often Not an Option
 No market exit
 Compensation
 Close corporations often don’t pay dividends to avoid
double taxation

Hypo: 4 friends want to form a close corporation. Decisionmaking

issues?
 Deadlock (2-2)
 Oppression (3-1)
Solutions
1. Voting trust
2. Shareholder agreements
a) Agreements relating to election of the board of directors
(a.k.a. vote pooling agreements)
b) Agreements relating to limitation on the board’s discretion

144
 Example: J , F and A are starting a
hockey mask production center
Participants Investments
The control is not following the money.
Potential Solutions:
Voting Interes
 Stroh stock:
 Two classes of stock: A and B; A has the usual
incidents in ownership and B would have nothing but
J ason $10 mil. 20%
a vote (it would be bought for a trivial price) and
would be sufficient to give Alice and Freddie the vote
the want.
 Common Stock:
 First allocate this stock to the three in proportion to the
Freddie $6 mil. 30%
voting interests they want. Since Alice wants the greatest
interest, she would pay $5 mil. For her 50% interest. But
this means, Freddie should pay $3 mil. for 30% and Jason
should pay $2 mil. for 20%.
 The problem is this leaves $8 mil. more for Jason to invest
Alice $5 mil.
and $3 mil. more for Freddie to invest. 50%
 So you could have them receive nonvoting common
but they may insist on preferred stock or debt
instead (but remember if you put money in as debt
that money is not shareholder money).
 You still have the issues of taxes, dividend
preference, liquidation preference, priority in
bankruptcy, cash availability for regular
interest payments, cash available to repay
principal, etc.
 Class specific board members:
 Three classes of stock: A, F and J.
 A picks 5 board members
 F picks 3 board members
 J picks 2 board members
 Voting Trust:
 Jason would place some of his stock in trust and give
Freddie and Alice the right to direct its vote.

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  Statutes generally limit the duration of voting trusts (e.g.
10 yrs).
 Vote pooling arrangements
 Two or more SHs could make an agreement to pool votes
(sometimes used to avoid legal limitations on voting trusts)
 Be wary of means to enforce the pooling arrangement.
 Irrevocable proxies:
 Although proxies are ordinarily revocable at the instance of
the shareholder, SHs (subject to certain conditions) may
grant irrevocable proxies. Generally such proxies must be
“coupled with an interest” which means that the proxy
holder must have some other interest in the firm.
 The irrevocability lasts only as long as the interest.

Voting trust
 An agreement among shareholders under which all of the shares
owned by the parties are transferred to a trustee, who becomes
the nominal, record owner of the shares
 The trustee votes the shares in accordance with the
provisions of the trust agreement, if any, and is responsible
for distributing any dividends to the beneficial owners of
the shares
 Advantages?
 No possibility of shareholder deadlock, since everybody
puts their shares in the trust and trustee votes
 Disadvantages?
 Loss of control.
 Duration – most states limit to ten years
 Still possible for board to oppress

Vote pooling agreements: Shareholder agreements re board election

 Valid?
 Do minority shareholders need protection from
exploitation? BoD has a duty to exercise independent
business judgment on behalf of all shareholders.
 Note that with the exception of some circumstances
involving controlling shareholders, shareholders do not owe
fiduciary duties to one another.
 Practical problems?
 Director deadlock…how solved?
 Director oppression
 Enforceability?
 Specific performance?

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Vote pooling agreements: Enforcement mechanisms
Ringling Bros. v. Ringling
Facts:
 Corporation used cumulative voting to elect directors
 A mechanism by which the minority gets to elect some
directors
 Directors are elected all at once.
 Cumulative Voting: each shareholder gets number of
votes = (number of board vacancies) times (number
of shares owned).
 May cast all votes for one (or more) member of the
BOD.
 Ringling and Haley family factions had a written agreement
under which they were to vote together
 Effect of agreement:
 Ringling and Haley by combining votes were
able to elect 5
 North was able to elect only two directors
 In the event of deadlock, the disagreement was to be
determined by an arbitrator, Mr. Loos, who was also their
lawyer
 When called upon to arbitrate the dispute, Loos decided
that the Ringlings and Haleys should vote for two
Ringlings, two Haleys, and a Mr. Dunn
 The Ringlings did so
 But the Haleys defected, casting all of their votes for the
two Haleys
Held: The agreement was valid, but the Haley votes should not be
counted, you cannot force them to vote but if they violate the
agreement their votes don’t count so they are not elected to the
board so we only have six directors, three to three.
 If you were Loos, their lawyer, how would you have drafted the
agreement?
An enforcement mechanism for if they can’t agree, like if they
can’t agree one party gets to vote all the shares one year and
the other party gets to vote all of them the next year.

Shareholder agreements
 Voting trusts
 Vote pooling agreements
 (E.g., Ringling)
 Shareholder agreements constraining discretion of directors
 Very common
 Require certain persons as officers

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  Specify compensation and/or dividend policy
 Require shareholder approval of board actions

McQuade v. Stoneham
 Stoneham, McGraw, and McQuade own stock in the NY Giants
 Shareholders agreement by which all agreed that they will
each do their best to elect each other directors and appoint
each other officers at specified salaries
 McQuade fell out of favor w/Stoneham and was fired … sued,
seeking specific performance
Holding:
 Stockholders may combine to elect directors, the power to
unite is, however, limited to the election of directors and is
not extended to contracts whereby limitations are placed
on the power of directors to manage the business of the
corporation by the selection of agents at defined salaries.
 Directors must exercise their independent business
judgment on behalf of all shareholders
 If directors agree in advance to limit that judgment, then
shareholders do not receive the benefit of their
independence.
 Agreement is therefore void as a restriction on board
independence which is against public policy
Rationale sensible?
 Most corporate law rules are just default provisions -- off
the rack rules which the parties are free to alter to meet
their particular needs.
 When one is dealing with a close corporation, in which the
SHs naturally would want a greater voice than they would
get in the case of a public corporation, parties should have
even greater flexibility in modifying the off the rack rules
provided by the statute than normally accorded to public
firms.
 But how far should this go?
 Easily evaded?
 Get agreement that he will be elected a director. Have by-
laws state that officers may be removed only for cause or
by the unanimous vote of the directors.
 Need to make sure that amending the by-laws
requires unanimous director and/or shareholder
action.
 Alternatively, employment contract coupled with stock
buy-out provision.

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  If they fire him, he can get damages and require
them to buy back his stock (so he’s not stuck with his
investment).

 If you represented McQuade, what terms would you put in an

employment contract? (See p. 622)
 Duration?
 What happens at the end of the employment term?
 Define termination for cause.
 You want to put in termination for cause
because if you don’t put it in it is going to be
implied in so if you put it in you can narrow it.
 What happens in the case of illness/disability?
 Compensation?
 Bonus formula? How to define profit? Comparison to
other firms in the same industry…
 Job description?
 Clarify areas of responsibility, title, other permitted
activities (e.g. City Magistrate)
 Termination and liquidated damages and duty to mitigate?
 Include buyout agreement for the stock.
 Having no duty to mitigate could be very valuable.

Clark v. Dodge
Facts:
 Clark and Dodge together owned two drug companies
 Clark owned 25%; Dodge owned 75%
 In return for Clark revealing a valuable secret formula, Dodge
agreed to vote his shares and vote as a director to assure that
Clark would be a director and general mgr. as long as his
performance was faithful, efficient and competent and would get
¼ of the profits by salary or dividend.
 Clark kept his part of the bargain and got fired by Dodge.
Holding:
 Dodge reneged on his promise and should pay.
 McQuade designed to protect minority shareholders who
were not party to the agreement
 Where the corporation has no minority shareholders, the
rule is unnecessary
 But note limiting language in contract (“as long as
his performance was faithful, efficient and
competent”); maybe invalid if goes beyond those
limited items

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  Note that the corporation could have used cumulative
voting to elect the board and then no agreement for board
election would have been necessary.

Galler v. Galler
Facts:
Shareholder agreement:
Each family gets 2 board seats
Mandated dividends
Mandatory death benefits
Holding:
 Agreement Valid
 Unanimity not required if:
 The corporation is closely-held
 The minority shareholder does not object
 The terms are reasonable
 Reasonable time
 Co. was to pay dividends only if sufficient
earned surplus
 The amount payable was reasonable.
 Application?
 Agreement did not have an unreasonable duration
 Company was to pay dividends only if it had sufficient
earned surplus
 Death benefit was reasonable
 Agreement had a vote pooling component
 Valid.
 Why not deemed a voting trust?
 No attempt to separate ownership of stock from
voting rights
 Remedy?
 Corporation had been unable to pay mandated $50,000
annual dividends because Aaron’s and Isadore’s salaries
exceeded those to which Emma had agreed
 Isadore and Rose must account
 Presumably back dividends must be paid
 Emma and her appointee on board?
 Presumably
 They could have allowed the surviving brother to buy out the
other brother’s shares instead of forcing the surviving families to
work together.

Ramos v. Estrada
Facts:

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  The Broadcast Group had a 50% interest (later raised to just over
50%) in Television, Inc. The Ventura Group owned the other
50%.
 The Ramoses had 50% of the BG stock and wound up with 25%
of TV
 The Estradas and each of the other couples each had 5% of TV
 The BG SHs agreed to vote their stock together to elect directors
to TV
 If anyone violated the agreement, the others could purchase
their TV shares at cost plus 8% per yr.
 This was probably well below market value since the FCC
granted the TV license after the investment was made and
the license must have been valuable.
 At a directors’ meeting of TV, Estrada sided w/the Ventura group
ousting Ramos as president of TV
 At the next BG meeting the group nominated a slate of directors
that excluded the Estradas
 The Estrada’s refused to abide by that vote and the other BG
members contend they had a right to buy the Estradas’ TV stock.
Held:
 Jmt. against the Estradas.
 Vote pooling agreements like this are valid even if the firm
is not a statutory close corporation. It is not a “failed
irrevocable proxy.”
 You cannot have a vote pooling agreement that says
that we will vote these directors who are us and we
will vote this business decision once we are elected.
 You can though vote out directors who don’t make
the decision you want them to make. So this is kind
of a way to get around it.
 So Ramos used an otherwise valid VPA to circumvent
the McQuade-Clark ban on non-unanimous
agreements about what directors will do.
 What did the Estradas do to breach the Agreement?
 Refusal to vote for the slate of BG directors which excluded
her; it was not her voting to oust Ramos
 The breach is not voting to outs Ramos, because as a
director you are allowed to exercise independent judgment
and the reason the vote pooling agreement is valid is it is
an agreement as to who to vote for as directors not an
agreement as to what the directors are going to do.
 Perhaps the Black-letter rule is:
 (a) you can agree about how you’ll vote as shareholders,
but

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  (b) you can’t agree about how you’ll vote as directors
 Unless we have a closely held corp and the
agreement is signed by all the SHs (and perhaps,
when the nonsigning minority shareholders cannot or
do not object.)
 Could the members of BG explicitly agree about how they would
vote as directors?
 No, BG was only half of the TV SHs.
 Why would Estrada defect?
 Because she has leverage even as a minority shareholder
because she can tip the balance.

Statutory closed corporations are not the same as just closed

corporations.

Hypothetical
 Agreement says: Abel will be President, Baker will be V-P, Charlie
will be Secretary, and Delta will be Treasurer
 Spells out specific requirements vis-a-vis salary, dividends,
pensions, tenure in office and the like
 Is it Enforceable? (Should it be?)
 What if Ed is a part of the group and Ed is a 3% SH with no
office?

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 CLOSE CORPORATIONS: ABUSE OF CONTROL AND FIDUCIARY
DUTIES

Introduction
 At early common law, shareholders qua shareholders had no
fiduciary obligations to firm or fellow shareholders
 Some erosion vis-à-vis controlling shareholders of public
corporations (E.g., Sinclair Oil v. Levien)
 More erosion in close corporation

The “Freeze Out”

 This sections involves one of the most important fiduciary duty
problems in a close corporation is the freeze-out
 In a freeze-out, a controlling SH block earns a return at the
expense of the others.
 Still another reason to draft a buy-sell agreement at the outset.
 Review the buyout material in chapter 2

Note: The earnings of closed corporations are usually distributed in

major part in salaries, bonuses and retirement benefits.

The partnership analogy

Wilkes v. Springside Nursing Home
 Prior Mass. decision – Donahue v. Rodd Electrotype – had
analogized close corporations to partnerships
 Applied partnership-like fiduciary duties to shareholders of
close corporations, utmost good faith and loyalty
 Explicitly invoked Cardozo’s decision in Meinhard v.
Salmon
 Does partnership analogy survive Wilkes?
 Partly
Facts:
 Plaintiff: One of four equal shareholders in a close corporation
(Wilkes, Riche, Quinn and Pipkin [replaced by Connor])
 Each had been a director and officer, worked for the
company, receiving a regular salary
 Firm paid no dividends
 Relations between Wilkes and the other shareholders
deteriorated
 Wilkes gave notice of intent to sell his shares
 He was then stripped of his salary and offices
 He sued, alleging breach of fiduciary duty
Holding:

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  Wilkes was improperly frozen out no legitimate business
reason for firing him and not re-electing him
 Rule of law:
 In a close corporation a majority must have some
legitimate business purpose
 If so, burden shifts to minority to show there is a less
harmful alternative to the minority’s interest
 If so, court must balance the legitimate business
purpose against the practicability of proposed
alternative
Bottom line:
 This leave us with a new standard of fiduciary duty that is less
strict than that which partners owe each other, but stricter than
the BJR at least in Massachusetts, but see Nixon v. Blackwell for
Delaware law.

 What is the court’s policy rationale?

 The majority presumably invested more in the corporation
to purchase voting control, they should have a degree of
control reflecting their investment.
 The minority shareholder presumably knew of the
existence of a controlling block of shareholders when he or
she bought into the firm.
 The minority shareholder therefore assumed the risk
that some decisions would be adverse to his or her
interests.
 What might have been a legitimate business purpose in this
case?
 If Wilkes had been negligent in failing to perform his duties
or in failing to perform them with due care.
 But Wilkes was competent and remained willing to
perform his tasks.
 Once Wilkes was fired, dividends became critically important.
 Note the distinction between public and closely held
corporations.
 How could the parties have arranged things ex ante to avoid this
litigation?
 Shareholder agreement to maintain each other in office.
 Query re enforceability.
 Not telling the directors what to do just
electing them, the officers part is okay because
they all agreed.
 Employment agreement between corporation and Wilkes.

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  Would the parties have agreed to employment
agreements that did not allow for termination for
cause?
 Note how this allows one to bypass McQuade.
 Requirement of dividend payments?
 Buy-out agreement under which the parties are required to
buy out a disgruntled investor.
 What is an argument against expansion of the fiduciary duties
among SHs?
 Investors are heterogeneous.
 Some investors may prefer more flexibility and less
stringent fiduciary standards, while others prefer
stricter standards and less flexibility.
 Under pre-Wilkes law, the former could
incorporate, while the latter could form
partnerships.
 Courts maximize investor welfare by letting investors
choose the form best suited to their business, which
requires different legal rules for shareholders and partners.
 Could Wilkes have been decided using other principals we
have already covered?
 Directors breach of duty of loyalty (self-dealing) for
payment of excessive salaries so BJR would not apply
(note court would probably not order dividends or
hiring of Wilkes)
 You could argue that if you are a group acting
together just like a controlling shareholder would so
you have fiduciary duties. Controlling SH group
engaged in self dealing must show inherent fairness.

Smith v. Atlantic Properties (Prof. thinks case is ridiculous but it’s out
there)
Facts:
 Shareholder agreement constraining director discretion (to avoid
potential for freeze-outs)
 Requires shareholder approval of board actions by a
supermajority (80%) vote
 Because each shareholder owned 25% of the stock, each
had an effective veto
 Dispute arose as to how earnings should be expended
 Majority wants to pay dividends
 Wolfson wants to reinvest
Tax implications
 Maximum marginal tax rate on ordinary income:

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  Dividends tax as ordinary income
 Maximum capital gains tax rate:
 Accumulated earnings tax (unreasonable accumulation of
corporate earnings and profits).
Holding:
 A minority shareholder, at least where he has a veto power
over corporate action, has fiduciary duties to the majority
 Wolfson’s use of his veto power was inconsistent with that
duty because it subjected the corporation to an
unnecessary assessment of penalty taxes
 It is just that Wolfson let his bad feelings show too
much and failed to produce a plan for improvements.

Sinclair Analysis
 Under Sinclair, if a SH is not controlling, they are not liable.
 Since when does a 25% block control a 75% block.
 Even if Wolfson is treated as a controlling SH, he gained no
benefit at the expense of the others so no liabiltiy.
 To the extent the Wilkes line of cases makes sense, it makes
sense in the context of freeze-outs, NOT SH deadlocks. In a
freeze-out the SH block earns a return at the expense of the
others.

Delaware: Nixon v. Blackwell

 Rejects special close corporation fiduciary duties
 Controlling shareholders subject to Sinclair Oil standard
 ESOP life insurance policies normal compensation; so no
violation

Jordan v. Duff and Phelps, Inc.

Facts:
 Jordan worked for Duff & Phelps, Inc. in Chicago as a
securities analyst.
 He held his job under an at-will K so the firm could fire him
when it wished
 Jordan bought (or was buying) 240 shares of D&P stock
which under the terms of the purchase agreement, he had
to resell to the firm at book value if his employment
terminated for any reason.
 When Jordan told his boss Hansen about his plan to move
to Texas, Hansen did not tell Jordan about the old failed
merger talks with Security Pacific. He also didn’t tell
Jordan about a 2nd round of Sec. Pac. talks that began

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 later that yr. (A $50 mill. valuation for D&P was being
discussed.)
 Hansen let Jordan work through the end of the year so
Jordan could get the higher book value that would then
apply to the sale of his stock.
 Jordan worked through December and tendered his stock.
 Two years later D&P was eventually acquired in an LBO by
an employee trust.
 Jordan sued for rescission
Held:
 Jordan has a cause of action under Rule 10b-5 (for failure
to disclose material information) and state law fiduciary
duties. If proven, he would only be allowed a damages
remedy, not rescission.
 Posner dissents

 Why book value not market value?

 Book value is the value of the firm’s assets without
the value of the firm’s reputation.
 He gets book value because it is easier to calculate.
 When the value of stock goes up it is more likely that
the market value will go up faster than the book
value. So when you can fire someone and then they
have to sell you your stock you have to an incentive
to fire them if they get the book value.
 Materiality: Why doesn’t the court care about the fact the
original merger fell through?
 Because we don’t judge these things on what ends
up happening, but what the state of knowledge was
at the time when they should have disclosed.
 Ultimately Jordan must show had he known, he would
not have quit. Even when the second merger failed,
he would have stayed with the firm because based
on the failed proposals, he would have believed that
more were coming.

 Posner versus Easterbrook (This fight is primarily about

materiality)
 Under 10b-5 if someone associated with the
corporation is trading, the corporation must disclose.
 But Posner says the reasons for disclose or abstain
rule don’t apply here since Jordan does not have the
usual choices. Employees who quit can not hold
stock and the firm could have fired him at any time.

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 Easterbrook says D&P could not have fired Jordan
just to prevent his earning money on the merger.
 Posner says yes they could. But maybe not in a close
corp. under Wilkes. Because the people doing the
firing on the board are also the people who are going
to benefit. But we also have the shareholder’s
agreement that says that owning stock doesn’t add
any rights as far as employment.

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 TRANSFER OF CONTROL

Control Premium
Why would you want control?
Two main reasons:
o You think you can add value to the company,
maybe by putting in the right people.
o Put yourself in as an officer and give yourself a
nice salary, in a public company with a lot of
shareholder’s this is not going to be scrutinized
as strictly. (but can’t be self-dealing)

• The control premium problems arise when a buyer

purchases a large block of stock in a corporation. If the
other shares are widely dispersed, the block will often
bring in a per-share price above the stock’s market price
(i.e. the “control premium”)
• Why?
– If B wants a large block of stock and does not buy
dominant shareholder S’s block of shares he will
need either to;
• Launch a tender offer
– B will pay considerably more than the
market price for the shares
• Collect shares on the open market
– Initial purchases on the open market will
often drive up the market price.
– If S is willing to sell, both she and B can gain by
agreeing to transfer the stock for a price between the
market price and the tender offer (or driven-up open
market) price.
– Control means almost everything: You can run the
company as you see fit; appoint your candidates as
officers; and even freeze out minority SHs.

Issues
• The purchase and sale of control is subject to special
regulation b/c these purchases are no ordinary purchases
of stock.
• Two main issues:
– The payment of a control premium
• Should a controlling shareholder be free to sell
at that premium? Fairness to the other
shareholders?
– The sale of corporate offices

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 • Courts are often suspicious when a buyer finds
a corporate office attractive enough to pay
money for it.

Frandsen v. Jensen-Sundquist
Facts:
• The Jensen family owned 52% of JSA and JSA owned a
majority of the shares of the First Bank of Grantsburg.
• Frandsen owned 8% of J-S.
• The Jensen family had a right of first refusal agreement
with the minority SH.
• JSA announces a merger w/1st Wisconsin Bank at $62 per
share.
• Frandsen claims he has a right of first refusal.
Held:
• RFR does not apply.
• If the transaction had originally been structured as a
sale of the FBG asset, then there would be no issue
he would have had no case.
• Even the original structure is ok, since a merger is
not the same as a sale of stock.

Zetlin v. Hanson Holdings

Facts:
• Zetlin owned 2% of Gable Industries; Defendants owned
44%
• Defendants sold their stock at a premium.
Held:
• That’s fine! “Absent looting of corporate assets, conversion
of a corporate opportunity, fraud or other acts of bad faith,
a controlling stockholder is free to sell, and a purchaser is
free to buy, that controlling interest at a premium price.”
• Note that this is the American rule; British law and the EU
both require an acquirer of control blocks of more than
30% to offer to purchase ALL outstanding minority shares,
presumptively at the same price.
This is the general rule: control premiums are allowed as long as you
are selling is really the control.

Control Premiums
• Why would someone pay a control premium?
– They believe that control shares may carry special
benefits in the form of generous salaries, perks, etc.
• Is the noncontrolling SH harmed by this?

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 – Shares may be worth more in the hands of a new
owner b/c the incumbent is doing a poor or avg. job
of managing the business.
• If so, why wouldn’t the buyer, want to buy all
the outstanding shares?
• Risk

Perlman v. Feldmann
Facts:
• Feldmann, family and friends owned 37% of common stock
of Newport, a steel maker, and controlled the corp.
• There was a steel shortage due to the Korean war, but
ethical/reputational restraints kept Newport from raising its
prices.
• Newport did force buyers to pay interest-free advances
(the “Feldmann Plan”)
• The Feldman group sells their shares to Wilport, an end-
user of steel for $20/share (market price was $12/share)
• Plaintiffs sue to force the Feldmann group to share the
control premium.
Held:
• Judgment for the plaintiffs.
• What breach of fiduciary duty did the court have in mind?
• The court thinks that Feldmann has cashed out a
corporate opportunity, namely, the Feldmann Plan.
• Once Wilport has control, it will be able to buy steel
from Newport at posted prices, w/out giving low
interest loans.
• So there will be no more loans to modernize Newport
facilities.
• If this is correct, then perhaps the suit should be against
Wilport; Feldmann just hands over control. Newport is
taking the corporate opportunity
• Dissent finds the majority position confusing; I agree.
• Any suggestion in this case that there may be
something wrong w/premiums for control standing
alone has not been reflected in subsequent decisions
of other courts. View the case as a unique set of
facts.
What you should take from this case is that control premiums are okay
but there is an opportunity to argue that the premium not just for
control but something impermissible and therefore that portion of the
premium is inappropriate.

Essex Universal v. Yates

Facts:

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 • Yates owned 28% of Republic Pictures and agreed to sell
that interest to Essex.
• As part of the deal, Yates promised to deliver a board
loaded w/Essex nominees
• Yates had board members resign one at a time while the
other board members replaced them w/ Essex nominees.
• When the Republic stock rose, Yates tried to renege on the
deal, claiming that delivery of an Essex dominated board
was legally impermissible.
• District Court awards summary judgment to Yates
Held: Reversed (with three different positions taken by the three
member panel)
• Lumbard:
• The sale of a control block of stock at a premium is
permissible, but sale of an office is not.
• It is okay to received payment for the immediate
transfer of management control to one who has
achieved majority share control but would not
otherwise be able to convert that share control into
operating control for some time.
• Were Essex buying a majority interest in the firm, the
arrangement would be unobjectionable, since Essex
would eventually obtain control of the board, but one
must bear in mind the prohibition of a “naked office
sale.”
• Essex is buying less than a majority, but b/c Republic
is publicly held, Essex’s 28% gives it control of the
board anyway. If so the arrangement is permissible.
Unless Yates can prove that 28% would not let Essex
gain control of the board.
• Clark:
• Cases like this should be decided on their facts
without so much doctrinal guidance. Summary
judgment is improper.
• Friendly:
• Directors owe a fiduciary duty to all SHs, not just to
the controlling SH. When directors replace resigning
directors, they must elect the nominee whom they
believe would best serve the interests of the corp.
Directors who automatically elect the purchaser’s
nominee violate that fiduciary duty. BUT, this
conclusion is unexpected and should not be applied
retroactively so reversal is proper.
• If Yates held only 3% of the stock would the result have
been different?

162
 • It would not have been okay because it is clear he is not
selling control, but the directors positions.
• If a 51% SH can demand a control premium, why can’t a
4% SH?
• Is a 4% SH more likely to exploit and less likely to
add value?
• Yes, it is a lot more effort to raise the value of
the company and therefore the value of your
stock rather than just exploit for your own gain.
• Under NY and Delaware law there are restrictions (or
potential restrictions) against removing directors without
cause.

Problems:

Planning Problem p. 702-703

• Ida, Sally and Maria are forming a business to mfctr. and
sell computer components.
– Ida will supervise production
– Sally will be in charge of sales and production
– Maria will put up the money for the start-up phase
but will not play an active role in the business.
• What advice would you give them?
– RFR agreement, tag along provisions, employment
agreements, buyout provisions, mandatory
dividends?
For Maria:
Mandatory dividends
Employment agreements to control salaries
Ida and Sally:
Ways of raising additional capital
All parties:
Buy out agreement
Conflict
• Is there a problem representing al
– Yes

Problems p. 714
1. none whatsoever
2. you have to ask about the possibility of a freeze out

163
 MERGERS AND ACQUISITIONS

Merger v. Consolidation

Constituent Corporations
Categorizing Deals By Corporate Governance Aspects
 Negotiated acquisitions Merger
 Target is willing to be bought; key issues:
 Mechanics by which the acquisition takes place
 Duties of management in selecting and negotiating
with a bidder Ajax
Acme Inc.
 Risk that competing bidders will try to buy the target
out from under the initial bidder.
 Hostile acquisitions
Corporatio
 Key issues:
 How can the target defend itself against the raider?
 What can the raider do to defeat those defenses?
 Often lead to corporate control auctions
 Key issue: What can target do to influence the
outcome of the auction? Consolida
Available Techniques
 Merger
 also Consolidation
 Sale of assets
Ajax
 Proxy contest
Acme Inc.
 Tender offer
 Stock purchases
Corporatio
Tender Offers
 What is a tender offer?

164
  A tender offer is simply a public offer usually made to all
shareholders of the target corporation in which the buyer
offers to purchase target company shares
 You simply offer to buy any and all shares tendered
Principal Distinguishing Characteristics
 Mergers and sales of assets require approval by the target’s
board of directors.
 In contrast, none of the other techniques require target board’s
approval:
 A proxy contest does not require board approval, although
a shareholder vote is still required.
 A tender offer doesn’t require either board approval or a
shareholder vote — if 50.1% of the shares are tendered to
the buyer, the buyer wins.
 A stock purchase will have the same effect as a tender
offer.
When To Bypass The Board?
 The board refuses to sell at any price
 The board is holding out for a price higher than the bidder is
willing to pay
 The board is holding out for side-payments
Mergers v. Asset Sales
 Merger takes effect when the articles of merger are filed with the
requisite state official
 Key events thereupon take place by operation of law
 Statutory sale of assets is much more complicated
 As a result, the mechanics of transferring control and
consideration are more complex

165
 Sale of Assets
More choice

Merger/Asset Sale Tax Consequences

 There are significant tax consequences which frequently dictate
the structure of a merger, combination, reorganization, asset
sale, etc.
 For example, if merger structured as tax-free reorganization, no
tax consequences to shareholders.
 The tax issues involved are beyond the scope of this class, BUT
you need to be aware of their existence.
Ease of transferring control

Target
 When a merger becomes effective, the separate existence of all
corporate parties, with the exception of the surviving
corporation, comes to an end
 In an asset sale, the target company remains in existence at
least for a little while after the asset sale has been completed
 Only title to the assets change hands, both corporations
remain alive.
Ease of transferring assets

2
 In a merger, title to all property owned by each corporate party
is automatically vested in the surviving corporation
 In an asset sale, documents of transfer must be prepared with
respect to every asset being sold and those documents must be
Target li
filed with every applicable agency
 E.g., a deed of transfer will have to be properly filed with
every county in which the target owns real estate.
Bo
Successor liability
Target
typ
Shareholders 166
  In a merger, the surviving company succeeds to all liabilities of
each corporate party
 In an asset sale, subject to some emerging tort doctrines, the
company purchasing the assets does not take the liabilities of
the selling company unless there has been a written assumption
of liabilities
Ease of passing consideration
 In a merger, the consideration passes to nondissenting
shareholders
 In an asset sale, the process of distributing the consideration to
the target’s shareholders is more complicated
 Since the target is still in existence one option is to
distribute the consideration as a dividend
 More often the target is formally dissolved and its
remaining assets (including the consideration paid in the
acquisition) are distributed to its shareholders in a final
liquidating dividend
Shareholder Voting and Appraisal
 Avoid voting whenever possible.
 Cumbersome and expensive
 Might vote No
 Appraisal rights (sometimes called “dissenters’ rights”) give
dissenting shareholders the right to demand that the corporation
buy their shares at a judicially determined “fair market value”
 The prospect that any significant number of shareholders
exercise them will threaten the acquisition
Shareholder Voting and Appraisal in Standard Merger
 Approval
 Both company’s boards
 Both company’s shareholders
 Appraisal
 Available to shareholders of both corporations in some
states.
 Some states (like Delaware) eliminate dissenters’ rights
(i.e. appraisal rights) for public corporations.
Shareholder Voting and Appraisal in Asset Sale
 Delaware § 271 requires approval of a sale of substantially all the
corporation’s assets by the board and shareholders of the selling
corporation
 Shareholder approval must be by a majority of the
outstanding shares
 Delaware does not require that the shareholders of the
purchasing corporation approve the transaction. Only the board
of the purchasing corporation need approve the transaction

167
  Nobody gets appraisal rights under Delaware law in an asset sale
transaction
Mergers: Summing Up
 Step 1 (Ex. under Del. law)
 T and A boards adopt Merger Agreement
 A’s charter can be amended at this point
 Allows cash and securities other than Acquirer common as
consideration
 Step 2
 SH vote at A and T: majority of shares entitled to vote
thereon
 Step 3
 Filing [M.A. or “certificate”]--merger effective at this point
 Appraisal rights
 No A.R. if stock of constituent corp is listed--A and T are
both listed; otherwise yes.
Triangular Transactions
 Provides the transaction cost-minimizing advantages of an asset
sale, while also providing the advantages of a merger
 Buyer sets up a shell subsidiary—call it NewCo
 NewCo will be capitalized with the consideration to be paid
to target shareholders in the acquisition — cash, debt or
equity securities of the buyer
 NewCo then merges with the target
 In a forward triangular merger, NewCo will be the surviving
entity
 In a reverse triangular merger, the target will be the
surviving entity

Acquirer Corp and Ta

Reverse Triangular M

Acquirer Inc. 168

Effect of a Triangular Transaction: Target Perspective
 The target company ends up as a wholly owned subsidiary of the
acquirer
 The former target shareholders either become
shareholders of the acquirer or are bought out for cash
 Target shareholders still get to vote and still get appraisal
rights
Effect of a Triangular Transaction: Acquirer’s Perspective
 From the buyer’s perspective, the parent company itself would
be the only shareholder of NewCo
 As a result, the parent’s board of directors will decide how
to vote the NewCo shares
 The parent company’s shareholders have no corporate law
right to vote, nor to appraisal
Effect of a Triangular Transaction on Successor Liability
 After a triangular merger, the target in effect remains in being as
a wholly owned subsidiary of the true acquirer
 As such, the target is solely responsible for its obligations,
unless the plaintiff is able to pierce the corporate veil and
hold the parent company liable

De Facto Mergers (look at flow chart above)

Dissenters’ Rights
 Two of the most common reasons why people structure
transactions that accomplish the effect of a merger in a non-
merger form are
 Tax benefits
 Dissenters’ rights
Acquirer Corp and Target Corp Plan a Reverse Triangular Merger
 Will Acquirer Corp’s Shareholders Get Voting Rights?
 No ... In a merger, only the shareholders’ of the constituent
corporations are entitled to vote
 Here the shareholders who are entitled to vote are
the shareholders of Target and the shareholders of
NewCo
 The sole shareholder of NewCo is Acquirer
 Acquirer’s board will decide how to vote
NewCo’s shares
 Ditto as to appraisal rights
De Facto Merger Doctrine
 Substance-over-form argument

169
  Court says: “even though you structured your transaction as a
triangular merger or asset sale, we are going to treat it as a
regular two-party merger”
 Result: Buyer’s shareholders get the right to vote and the right to
dissent
Delaware Law
 Is de facto merger good law in Delaware?
 No, per Hariton v. Arco Electronics
 Why did Delaware reject de facto merger doctrine?
 Doctrine offends the equal dignity of the merger and asset
sale provisions of the statute
Regulatory Arbitrage OK in Delaware
 Court says there is no reason why the statute couldn’t provide
different routes to the same result, with different levels of
shareholder protection. But why?
 The statute provides various ways of accomplishing an
acquisition
 No one acquisition technique is always appropriate
 De facto merger increases uncertainty and eliminates the
advantages of multiple acquisition formats
Pennsylvania Law
 Pennsylvania courts latched onto de facto merger at an early
date
 Many of the classic cases are Pennsylvania cases
 Filled with platitudes like: Form should not be elevated
over substance
 The Pennsylvania legislature kept adopting statutes designed to
limit it
 Pennsylvania courts eventually got the message and pretty
much stopped using the doctrine

Farris v. Glen Alden Corp

A reverse triangular merger
Remember Pen has changed this by statute but it is still floating
around out there.
Facts:
 List owned 38.5 % of GA
 L wanted to merge the two companies
 L sold its assets to GA for GA stock
 L then liquidated and distributed the GA stock to its shareholders
 L shareholders wound up owning 76.5 percent of the GA
shares
 Plaintiff, a GA shareholder, claimed that he was entitled to
dissenter’s rights

170
 GA is losing money—selling assets could mean loss of tax loss
carry forwards
 GA owns coal mines
 To transfer to List in an asset deal means many deeds and
real estate transfer taxes
 Why structure transaction that way?
 List sold its assets to Glen Alden for Glen Alden stock
 List board and shareholders approved the sale
 Glen Alden shareholders get no appraisal rights
 List SHs wind up owning 76.5% of GA shares
 Why did GA shareholders get to vote?
 GA apparently had insufficient authorized but unissued
shares of stock to distribute to L
 Accordingly, needed to amend the articles of
incorporation
 Under Delaware law, shareholders in a merging corporation had
dissenters’ rights; shareholders in a corporation selling its assets
did not
 Under Pennsylvania law, both shareholders in merging
corporations and shareholders in corporations selling their assets
had dissenters’ rights
 If merged in a statutory merger, the boards of both and the
shareholders of both would have voted on the merger
 If GA sold its assets to L, GA shareholders would have gotten
appraisal rights
 Holding? When is a de facto merger is present?
 When a transaction so fundamentally changes the nature
of the business as in effect to cause the shareholder to
give up his shares in one company and against her will
accept shares in a different business
 On these facts, the court found that there had been the
requisite fundamental change

 Relevant factors for fundamental change in nature of business

include: change in board composition; change in shareholder
composition; significant changes in shareholder values; and
significant changes in the company’s lines of business

171
 Avoiding Appra

Freeze-out Mergers
Glen A
Appraisal
 In theory, quite straightforward
 Give shareholders who dissent from the merger the right to
(Penn.
have the fair value of their shares determined and paid to
them in cash
Availability
 All appraisal statutes give you appraisal rights

Sale of Assets Apprais

in long-form mergers of closely-held corporations
 Impossible to generalize beyond that
 Whether appraisal rights are available for any
other type of transaction depends on which state’s law
governs
Availability of Appraisal: Delaware Law
 Standard two-party merger?
 Yes
 Standard merger; Target's stock is listed on a
national securities exchange and the consideration is stock in
the acquiring company?
 No (See §262(b)(1))

Merger

national securities exchange, Consideration paid is cash
 Yes, but complicated
Apprais
Standard merger, Target’s stock is listed on a

172
 DGCL § 262(b)
 Section 262(b)(1) provides that appraisal
rights shall not be available for targets whose stock is listed
on an exchange or where the target has more than 2,000
record shareholders
 But section 262(b)(2) then gives those target
shareholders back appraisal rights if the consideration paid in
the merger is anything other stock
 Sale of all or substantially all of Target’s assets?
 No

The Merger as Private Eminent Domain

 Hold-out shareholders have no remedy where they simply want
to keep their target shares
 Majority shareholders may effect a freeze-out merger to
eliminate the minority
 Statute does give disgruntled shareholders a right to complain
about the fairness of the price being paid for their shares;
namely, the appraisal remedy

Exercising Appraisal Rights

 DGCL § 262(a) requires that dissenting shareholders:
1. Hold onto their shares continuously through the effective
date of the merger
2. Perfect their appraisal rights per § 262(d) by sending
written notice to the corporation, prior to the shareholder
vote, that she intends to exercise her appraisal rights (it is
not sufficient to merely vote against the merger at the
meeting)
3. Neither vote in favor of nor consent in writing to the
merger

Exclusivity of appraisal
 Weinberger held?
 Relief for unfair mergers usually is limited to the appraisal
remedy
 In cases of fraud, misrepresentation, self-dealing,
deliberate waste of corporate assets or gross and palpable
over-reaching, relief may be available outside appraisal

Eliminating the Minority

 Getting rid of the minority is fairly straight-forward
 The transaction is usually structured as a back-end,
“freeze-out” merger, typically one of the triangular
transactions

173
  Critical points
 Must be approved by the board of directors and a majority
of outstanding shares
 Controlling shareholder will have leg up on getting
approval
 Once approved, shares of stock of the non-surviving
corporation are transformed by operation of law into IOUs
collectible for consideration promised in the merger
agreement
 E.g., in Weinberger the merger agreement provided
that each share of old UOP would be converted into
an IOU for $21
 Eliminate costs associated with being publicly held
 More flexibility in moving assets around within the firm
 Get unencumbered access to target assets
 Eliminate issues of fiduciary duty to the minority
 Recall Sinclair Oil v. Levien

Class Actions: The Burden of Proof

 Who has the burden of proof that the transaction was fair?
 Depends ... Can shift
 Note that this seems to apply only to class actions, not to
appraisal proceedings
 What determines allocation of BoP?
 Whether the merger has been approved by a majority of
the minority shareholders
Shifting Burden of Proof
 BoP allocation when a majority of the minority shareholders
approved the merger
 Defendant must show that they completely disclosed all
material facts relevant to the transaction
 If defendant makes such a showing, the burden is on the
plaintiff to show that the transaction was unfair to the
minority; but
 If defendant is unable to make that showing, the burden
remains on the defendant to show that the transaction was
fair
 BoP absent shareholder approval
 Plaintiff must come forward with some evidence of fraud,
misrepresentation or misconduct relating to the merger
 Once plaintiff does so, the burden is on the defendant
majority shareholder to show that the merger was fair

The Entire Fairness Standard

174
  How do we define fairness?
 Compare the challenged transaction to the hypothetical
terms that might be reached between two parties dealing
at arms-length
 In Weinberger the court equated fairness to the
conduct that would be expected of a disinterested
independent board
 Components of “entire fairness”:
 Fair dealing
 Fair price

Coggins v. New England Patriots Football Club, Inc. (Mass.)

Facts:
 Sullivan bought the Patriots franchise for $25,000 and
contributed it to a new corp.
 Nine other investors bought equal interests (10,000 shares ea.)
for $25K ea.
 The Patriots Corp. sold 120, shares of nonvoting stock at $5 per
share
 Sullivan is ousted from mgt. and regains control by buying all the
voting shares that he did not own at a cost of $102/share
(approx. $7.8 mil.) paid for with a loan and the banks want him
to use the corporate income to repay the loan.
 Since Sullivan knows that having the corp. assume his personal
loan and repay it is a violation of his fiduciary duty, he tries to
buy out the nonvoting SHs.
 He creates a new corp. which he wholly owns and merges the old
Patriot firm into the new firm, the nonvoting SHs get $15/share
 Each class approved the merger, but Coggins sues to void the
merger
Held:
 The merger was impermissible. Since voiding the merger
is impracticable, Coggins gets damages.
 Note that the court cites Singer, a Delaware case, but under
Delaware law the requisite business purpose, need not be a
corporate business purpose.
 Second if Sullivan had known he needed to show a business
purpose, he probably could have built the appropriate record
(e.g. minority SHs reduce corporate flexibility, public corps. incur
significant auditing and filing expenses)
 By the time of Coggins, Singer had been rejected in Delaware;
Weinberger abandoned the business-purpose requirement for
cash-out mergers.

175
  If a merger is fair to the cashed-out minority, that now
ends the inquiry.

Rabkin v. Olin
 Further development of appraisal regime
 Key issue: Exclusivity of the appraisal remedy
Facts:
 March 1, 1983: Olin bought 63 percent of the outstanding stock
of Hunt from Turner & Newall for $25 per share
 Olin agreed that if Olin bought the rest of Hunt stock within
a year, it would pay $25 for that stock as well
 Olin stated it had “no present intention” to buy the rest
 Court observed, however, that “it is clear that Olin
always anticipated owing 100 percent of Hunt.”
 March 23, 1984 (just after the one year period ends): Olin met
with its investment banking firm to plan its purchase of the
remaining stock at $20 per share
 Engineered a cash-out merger at $20/share
 Plaintiffs rejected an appraisal and challenged the merger
as unfair
 The defendant moved to dismiss
Held:
 Judgment for the plaintiffs. Why?
 Under Weinberger, appraisal “is not necessarily the
stockholder’s sole remedy”
 Here, the plaintiffs “seek to enforce a contractual right to
receive $25 per share”
 The Court of Chancery must “closely focus
upon Weinberger’s mandate of entire fairness,
based on a careful analysis of both the fair
price and fair dealing aspects of a transaction”

Appraisal Remedy
 Under what circumstances is appraisal plaintiff’s exclusive
remedy post-Rabkin?
 Rabkin seems to limit appraisal to cases in which plaintiff’s
only complaint is that the price paid is unfairly low.

What did Olin do Wrong?

 Suppose that at the time Olin bought the initial block from Hunt,
it anticipated buying the minority interest at $20 per share as
soon as possible, and said so. Is there anything wrong with that?
 The law seems to be clear that a premium for control is
unobjectionable

176
  If $20 is not enough for the minority shares, it is difficult to
see why appraisal is not the appropriate remedy
 Turner & Newall insisted that Olin wait at least a year before
cashing out the minority. But so what?
 Is it just that Olin and Turner & Newall were not candid?
 The court seems to interpret the one year rule as
some sort of effort by Turner & Newall to encourage
Olin to pay $25 per share to the minority
shareholders, and some sort of agreement by Olin to
do so
 But then why talk about mergers, fair
procedure, fair price, etc. why not just talk
about breach of K.
 Remember that this is an appeal from a grant
of a motion to dismiss on the pleadings.

Planning Issue
 Why did Turner & Newall insist on the one year commitment?
 The one year commitment is a routine item requested by
sellers of control blocks of stock to protect them from
liability for expropriating an acquisition premium
 Perhaps, Turner & Newall thought taking a control
premium was unseemly and might result in bad P.R.

Equitable Remedies
 Assuming SHs receive “fair value” through the appraisal process,
why might a SH prefer other remedies?
 If dissenting SH, X, can enforce equitable remedies, the
court may award her the amount she would have earned
had she been able to invest in the firm. Since it usually
takes several yrs to get to trial, X may have a be able to
get a risk-free investment with the appraisal price being
the downside.
 Note that majority SHs often freeze out
minority investors b/c they plan to invest their
own resources in improving the Co. Equitable
remedies effectively give dissenting SHs a
chance to free-ride on this improvement.
 If dissenting SH, X, has the right to enjoin or rescind the
merger, she can “hold up” the majority SH for far more
than the fair value of the minority’s shares.
 Also, attorney fees and advantage of class action over
individual appraisal actions

Rauch v. RCA Corporation

177
Facts:
 GE wanted to buy RCA’s assets for cash
 RCA had both common and preferred SHs
 RCA’s articles provided that RCA could redeem the preferred
stock for $100
 If GE had bought RCA assets for cash, and RCA had then wanted
to liquidate and distribute the cash to its SHs, it would have been
required to redeem the preferred.
 Instead, RCA merged into a GE subsidiary
 Pursuant to the merger, Preferred SHs got $40/share and
common SHs got $66
 Plaintiff sued for damages, claiming they were entitled to $100.
Held:
 Complaint dismissed
 The court refused to recharacterize the merger as a “de facto
redemption”, adopting essentially the same equal dignity
approach it used to dismiss a de facto merger claim in Hariton.
Problems:

Hypo 1
 Target is in the business of making wooden baseball bats In light
of the increasing cost of the source woods, Target sells all of its
wooden bat manufacturing assets to Acquirer in return for cash It
uses the cash to go into a new line of business: making
aluminum baseball bats Is this a de facto merger?
 Does the transaction so fundamentally change the nature of the
business as in effect to cause the shareholder to give up his
shares in one company and against his will accept shares in a
different business?
 Relevant factors include: change in board composition;
change in shareholder composition; significant changes in
shareholder values; and significant changes in the
company’s lines of business
 Only the latter is even arguably present, and the company’s
business has in fact changed only in a very minor way

Eligibility of Appraisal
 Hypo: Sue Shareholder walks into your office
 She just got a proxy statement in the mail from Target Co.
 Announces that Target’s board of directors has
agreed to merge with Acquirer Co. and solicits
proxies in favor of the merger

178
  Pursuant to Delaware § 262(d), also states that
appraisal rights will be available in connection with
the merger
 Sue thinks this merger is a lousy idea
 Given the facts we have so far, does Sue have any legal
basis for preventing the merger from taking place?
 No. If approved by a majority of the shareholders, it
will happen.

179
 TAKEOVERS

Two principal ways for Firm A to acquire Firm B:

• Negotiate with a deal with mgmt (“friendly” acquisition)
– Statutory Merger
– Sale of assets
• Purchase shares from the firm’s SHs (“hostile” acquisition)
– Using a “creeping” acquisition or a tender offer
• Might have to pay a “Control Premium”
– Then replace members of the board and engineer a
statutory merger under § 251 or § 253.
• Perhaps squeezing out any remaining shareholders
Tender Offers
• In its basic form, a tender offer is simply a public offer usually
made to all shareholders of the target corporation in which the
buyer offers to purchase target company shares
Most potent weapon in the hostile corporate raider’s arsenal
• Advantages over major alternatives, such as asset sales or
mergers:
– Approval by the target’s board of directors is a necessary
prerequisite to statutory transactions
• Tender offer permits the bidder to bypass the
target’s board and to purchase a controlling share
block directly from the stockholders
Most potent weapon in the hostile corporate raider’s arsenal
• Advantages over major alternatives, such as asset sales or
mergers:
– Until the late 1960s, almost total lack of legal rules
applicable to cash tender offers
• Mergers and proxy contests were subject to a
complex web of federal and state laws
• Imposed substantial disclosure obligations on
acquirers utilizing those techniques
• Typically also imposed delay
Williams Act (1968)
• Federal regulation of tender offers
– Disclosure
– Procedural requirements, albeit mainly to make the
disclosure requirements more effective
• Two principal components:
– § 13(d) requires disclosure of preliminary stock acquisitions
that may lead to a tender offer or other type of acquisition
effort
– §§ 14(d) and 14(e) regulate the actual tender offer itself
Beachhead Acquisitions

180
 • Keeping one’s interest in the target and one’s takeover plans
secret for as long as possible is crucial for the acquirer.
• § 13(d) of the 1934 Act and the SEC rules thereunder form, in
effect, an early warning system for the target company
Key Required Disclosures
• Identity
• Plans and intentions
– Including whether you intend to seek or are considering
seeking control of the issuer.
• Any contracts, arrangements, understandings or relationships
with respect to the securities of the issuer
Tender Offers
• §§ 14(d) and 14(e) triggered when any person commences a
tender offer for more than five percent of a class of a target’s
equity securities
Commencement of a Tender Offer: Rule 14d-2
1. Transmission of an offer to the shareholders in one of the ways
specified in 14d-2(a).
2. Public announcement of:
– Bidder’s identity, target’s identity, the amount of securities
bidder is offering to buy, and the price
Required Disclosure
• On date offer commences, bidder must file a disclosure
document on Schedule 14D-1 with the SEC
• Most of the information contained in the Schedule 14D-1 also
must be disseminated to the target’s shareholders either by:
1. Long-form newspaper publication of the offer
2. Summary publication and mailing of disclosure statement
• Incumbent management must either mail for bidder
or provide NOBO and CEDE lists
Incumbent’s Response
• Schedule 14D-9 must be filed by target
– Management must state whether they support the offer,
oppose it, or that they are unable to take a position
– Management must also summarize the reasons for its
position
Some Defensive Tactics
• “Greenmail”
– Pay off the potential acquiror to go away (usually by
purchasing her shares above market value)
• Competition
– Find a friendly “white knight” to take over firm
– Allocate “lockup” rights to first/preferred bidder
• Scorched Earth Policy
– Poison Pills
– Share Repurchases at a premium

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 • Turn the Tables
– The “Pac-Man” Defense. The original takeover target
attempts to swallow (takeover) the original bidder.

J udicial A
toward defe
Reasons
Reasons for
for Deference
Deferenc
Cheff v. Mathes
Facts:
• Holland Furnace sold furnaces through the fraudulent tactics.
• Because of the investigation into these practices, the firm was
doing badly.

•Mgrs
•Mgrs are
are supposed
supposed to
to
• Maremont became interested and contacted Holland’s president,
Cheff, about a merger, but Cheff rejected Maremont’s overtures.
• Maremont began buying Holland stock, announced his purchase

make
make day-to-day
publicly and demanded a place on the board.
• Cheff refused.
day-to-day
• Holland investigated and found that Maremont often bought
corp.s to liquidate them at a profit

decisions
decisions and
ct.’s findings. and plan
– Holland employees, aware of Maremont’s interest began

plan
showing discontent. (Note this risk is minimized by trial

• Having met resistance, Maremont offers to sell his stock to the

long-term
long-term strategy.
firm at a premium over:

strategy.
– his purchase price and over the market price
• Directors discuss whether to buy Maremont’s stock through
Hazelbank, a Cheff family investment firm. But instead decide to
pay greenmail – to buy the stock w/ corp. funds

•Implicit
•Implicit decision:
• Other SHs challenge

decision:NotNot 182

to sell out/bust up firm

 • Trial court finds that the purpose behind the purchase was to
perpetuate control.
• Looking at the substance of the greenmail transaction, what type
of fiduciary duty does it implicate?
– Duty of Loyalty; Duty of Care; Waste
Basic Test
• Inside Directors (Cheff & Trenkamp)
– Direct Conflict of Interest in their desire to perpetuate
themselves in office. ==> DoL analysis.
• Directors must either show cleansing of the
transaction after full disclosure or “fairness” to
corporation.
• Outside Directors (the conflict is less)
– Lower standard, need to show good faith and reasonable
investigation
– Note there is NO presumption of duty of care (BJR)
– Directors must affirmatively demonstrate:
• Reasonable investigation gave grounds to perceive
danger to corporate policy and effectiveness; and
• Good faith of their actions.
– Professor is going to treat this test like a mini duty of
loyalty analysis we are going to ask did they show good
faith and do reasonable investigation.
(1) Insiders: If a defensive maneuver is executed by insiders, or their
votes are necessary to approve it, or insiders dominate an approving
board, then such transactions will apparently receive a standard DoL
analysis.
Intrinsic vs. Entire? Probably intrinsic, given that they only own a small
fraction of shares, and that the transaction is not a merger.
(2) Outsiders: The court does not jump wholly to the BJR presumption.
Indeed, even the non-interested directors are "called upon to justify
their actions” and thus bear the burden of showing:
...that after a “good faith and reasonable investigation,” they had
“reasonable grounds to believe that a danger existed to corporate
policy and effectiveness” (749).
[NOTE: When we look at Unocal in a few minutes, this will be amended
somewhat]
In this case, the court finds, the outside directors met this test. They
apparently took steps to investigate Maremort’s true aims, and then
reasonably honestly concluded that "there was a reasonable threat to
the continued existence of Holland."
Q: What principal threat was involved? Was it a threat to shareholder
value?
A: No -- it was a threat to employee morale and composition.

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Employees were worried about either a liquidation or a substantial
change in sales practices and possible reduction in force should
Maremort take over:
• M’s reputation as a buy-n-burn acquiror
• His articulated views that door-to-door sales
aren’t the way to go;
• His lack of forthrightness about his intention to
acquire company
Thus, even though the trial court found that Maremont was not the
cause of employee unrest, the Ct. finds, that conclusion is not
supported by the evidence.
It’s significant that the court finds the “threat” need not be to SH
value, but can be to something else. We’ll see when and where this
comes up again later.
Interesting Note: The fact that outside directors have to make the
above demonstration suggests that Cheff/Trenkamp can’t simply
defend their DoL claims by showing a “cleansing” under § 144(a)
(outside director vote). Indeed, the whole action of the board still has
to be justified under the “investigation/threat” analysis above.

Open questions after Cheff: As to “uninterested” directors...

• How is the Cheff test distinct from a BJR approach?
– (Is it just the same test with burden switched to
defendants?)
– On its face, Cheff seems distinct from BJR, on at least two
grounds. First (and more speculatively), “reasonable
investigation” seems more like a negligence standard than
a recklessness standard. Second (more importantly) the
burden of proof is shifted. Unlike the usual BJR case, now
the DIRECTOR has to show good faith and reasonable
investigation rather than having it presumed.
• What constitutes a “threat to corp. policy/effectiveness”?
– i.e., what constituencies matter in determining threat?
• SH (which classes?/in what proportions?).
• Others (BHs? Employees? Customers? Community?)
While the court doesn’t answer this question, directly, it
does signal that at least employee welfare counts in some
respect. Now this could be b/c that’s a long run interest of
SHs, or it could be b/c the court’s taking a broader view of
which constituencies have primacy in such situations.
One thing is clear, however: After Cheff, mgmt’s own job
security doesn’t count as a bona fide threat.
You should also note that corporate constituency statutes
(that we studied after Dodge v. Ford) are highly relevant
here. Pennsylvania’s, for example, would certainly suggest
that reasonable fear for employee/creditor/community

184
 welfare ALONE (even if contrary to SH interests) can justify
a defensive tactic by a board.
• Is bona fide threat sufficient defense for any defensive action?
– i.e., Can BoD “break a birdhouse with a sledgehammer?”
Also the court never really discusses the “proportionality” of the
defensive move by the Holland board -- whether the action was
tailored to the threat. In other words, it cost a lot of $$ to send
greenmail to Maremont. If the monetary threat to the firm is
smaller than the cost of eliminating the threat, what result?

Unocal v. Mesa
Facts:
• T. Boone Pickens's firm, Mesa Petroleum, owned 13 percent of
Unocal, and wanted to take it over.
• Q: Any idea why?
• A: The notes just before the case suggest that Unocal’s breakup
value was higher than its trading value.
• Anyway, Mesa made a "two-tiered front-end loaded tender offer"
for the rest. It would buy 37+ percent of the stock (64 million
shares) for $54 per share (the front-end). It would then cash out
the remainder with junk bonds (ostensibly) worth $54 (the back-
end).
• It’s probably safe to assume (as the court did) that the bonds
were worth less than $54. Because the tender offer would not
have been "coercive" if the bonds were worth the front-end
price, we too assume for purposes of class discussion that the
bonds were worth less than $54.
• To stop the Mesa takeover, Unocal made a competing tender
offer for its own stock at $72/share. Its offer was a bit different.
o (1) It was selective, -- Mesa couldn’t participate. (“Mesa
Exclusion”)
o (2) It kicked in ONLY if Mesa acquired a controlling interest
(i.e., 64 million shares of Unocal stock), Unocal would
purchase notes from all tenderers with notes (IOUs) valued
$72. (“Mesa Purchase Condition”)
• Idea: Unocal’s board hoped it would either make it impossible
for Pickens to get enough takers, or if he did, the defense would
leave Unocal so that there is no value left for him because the
firm is committing to paying out huge sums of money to current
shareholders who don’t sell to Pickens.
• When the shareholders complained about this aspect of the
defense, Goldman Sachs and Dillon Read advised Unocal to alter
the deal. Unocal agreed to buy 50 million of the shares tendered
regardless of whether Mesa acquired 50+ percent.
o Now, Unocal's strategy becomes considerably more
dangerous and costly.

185
 o SHs WILL now tender, and thus Unocal has to finance the
redemption.
o To do it, Unocal in fact had to borrow, thereby creating
some bankruptcy risk, the financial risk associated with
high leverage.
o This was sort of like scortching the earth before the
invasion! Thus, it still made the acquisition unattractive to
Mesa.
• Mesa sued, arguing that the Unocal directors owed it (Mesa) the
same fiduciary duties they owed all other shareholders. If the
Board arranged for Unocal to repurchase the other shareholders'
stock at advantageous prices, they owed Mesa same treatment.
• Trial court granted a preliminary injunction on Unocal’s offer
(finding that the Mesa exclusion was impermissible), and the
defendants appeal.
The Unocal 2-prong Test
(1) “Threat” Prong
Board acted in Good Faith: After reas. investigation, concludes
that a danger exists to corp. policy & effectiveness.
(2) “Proportionality” Prong
Action must be reasonable in relation to threat posed. (Explicitly
new element)
Court notes that ordinarily, there is a presumption of the duty of care
from BJR But b/c takeover defenses here in this strange netherland
between DoC and DoL, the BJR isn’t quite as permissive here.
But the court goes a bit beyond where Cheff went: Directors subject to
a two-part test (now known as the unocal test). “Threat Prong”
“Proportionality Prong”.

Q: What constituencies matter in determining proportionality?

SHs, creditors, customers, employees, community, short-term
speculators (but not BoD or officers).
Q: Does this list of contingencies seem consistent with similar lists of
relevant contingencies we’ve seen earlier (Ford; Pillsbury v.
Honeywell)?
A: No -- It seems to go far afield from these earlier cases. Only in
the Pennsylvania constituency statute do we see such a wide set
of categories.
Q: Given this broad-based set of constituencies, what sorts of things
can be considered “threats”?
A: [753]: Adequacy of price for the SHs, nature/timing of offer,
risk of nonconsummation, quality of instruments exchanged,
questions of illegality

Q: In this case, then what was the threat that the Board was
attempting to fight off?

186
 A1: Mesa's offer was coercive and inadequate to SHs (especially
the back end). The danger here would be to the unlucky SHs who
don’t tender, or, if the front end is oversubscribed, to the
tendered shares that get elbowed out. (Btw, Does the incentive
to tender early always mean coercion? NO -- See example before
case).
A2: Pickens had been a greenmailer in the past. (May not
actually be true, but if it is, it means that it’s he (and not existing
SHs) who benefits from “irrationally” depressed stock). (Note of
course, that this leaves open WHY the stock is depressed --
greenmailer may have disciplined management. Moreover, b/c
firm doesn’t have to pay greenmail, it seems like the probability
of success would be relevant).

Q: But at any rate, according to the court, was their measure taken by
Unocal reasonable relative to the threat posed? If so, what
constituencies was it protecting? Was it justified in excluding one of
the shareholders (Mesa)?
A: Yes. Unocal designed its self-tender to stop the Mesa offer, or
at least protecting back- end SHs. (Here, you may want to tease
out the fact that if everyone tendered, they would get pro-rata
participation, and thus would all be a small-part back end and
other part front end SH -- MM theorem may hold).
As to excluding Mesa, this was essential to making the defense
work, the directors could validly do so. Allowing Mesa in would
both fail to stop them, and subsidize their offer.

Unocal Postscript
• Unocal and Mesa eventually negotiated and agreement that let
Mesa participate in Unocal’s self-tender.
• At that point, a Unocal SH sued Mesa under what statute?
– §16(b) Why?
– Mesa argues that self-tender qualifies as an unorthodox
transaction (e.g. Kern County) and is not subject to §16(b)
– The court held Mesa liable under §16(b), stating that the
Kern County exception applies to involuntary transactions,
and this one was voluntary.

How different is Unocal from the BJR?

• Threat Prong:
– Like Cheff looks very similar (broad constituencies and
time horizons).
– Formally, burden is now on directors, but such broad
justifications seem pretty easy to come up with;
• Proportionality Prong:

187
 – Not well developed in Unocal.
• Many subsequent cases seem not to focus on it at
all.
– Unitrin v American Gen. (1995): Del. Supreme Court holds
that proportionality prong has some “teeth”
• Even if bona fide threat exists, protective measure
cannot be “preclusive” or “coercive”
• Court never has defined what those terms mean

I mportanc
Mushroomi
Carves out a specia
Post- Unocal standards of review

measures” and te
• Traditional BJR, exemplified by cases like Van Gorkom
• Traditional duty of loyalty, exemplified by cases like Weinberger
• The new conditional BJR set out by Unocal
• Unocal left two critical questions:
• Which decisions get reviewed under which standard?
• What content should we give the applicable standard in a
given situation?

Deferential
Poison Pills
• First Generation Preferred Stock Pills:
– Lenox: 1983
– Based on “blank check preferred stock”
• How would you get the preferred stock out to the shareholders?

Scrutiny
– Lenox issued a special dividend consisting of nonvoting,
convertible preferred stock, the dividend issuing at the
ratio of one preferred share for every forty shares of
common stock

188
ce
e

..
)
s
 • Antitakeover effect?
– Based on conversion feature of the preferred stock
• Adaptation of standard anti-destruction clause of
convertible securities
– If Lenox was acquired, the preferred stock became
convertible into common stock of the acquiring corporation
at well-below market prices (i.e., a flip-over pill)
• Discriminatory: “interested person” could not
exercise
Beating the First Generation
– Crown Zellerbach pill only kicked in if the bidder tried to
effect a freeze-out merger
– Goldsmith acquired a controlling interest in Crown
Zellerbach but did not effect freeze-out
• Goldsmith suffers no poisonous effects
• On the other hand, since the rights were now
exercisable in the event of a merger, Goldsmith
precluded anyone from merging with Crown
Zellerbach
Second Generation Pills
• Based on rights issued as a pro rata dividend on the common
stock to the shareholders of the target corporation
– Rights are corporate securities that give the holder of the
right the option of purchasing shares
– The rights become exercisable upon some triggering
event, such as:
• Acquisition of a specified percentage of target shares
• Announcement of a tender offer for some specified
percentage of the shares
• Flip-over feature retained
• Flip-in feature added
– Enables shareholders of the target to purchase target stock
or debt at a discount
• Resembles a standard warrant
• Discriminatory: “interested person” not eligible
– Causes dilution in the target shares held by the acquirer
• Grand Met v. Pillsbury: Would have reduced Grand
Met’s interest in Pillsbury from 85% to 56%. Value of
Grand Met’s holdings would have declined by more
than $700 million dollars.
Redemption Features
• Give the board the option of redeeming the rights at a nominal
cost in order to allow desirable acquisitions to go forward
– Window redemption: board retains the ability to redeem
the rights for a specified time period following the issuance
of the rights

189
 – White knight redemption: rights redeemed for a
transaction approved by a majority of the “continuing
directors”

Example: Household International Pill

• Two triggering events:
– Making of a tender offer for 30% or more of Household’s
shares
– Acquisition of 20% or more of Household’s outstanding
shares by any person or group
• Rights initially “stapled” to common stock
– i.e., not issued in physical form and not able to be sold
separately from the common stock
– Why?
• Minimizes risk that a separate secondary trading
market would develop
• Rights detached from common stock upon either event
– When detached, the rights were immediately exercisable
• Flip-over
– Once detached and exercisable, if the offeror subsequently
effected a back-end merger, the holder of the right can use
the right to purchase $200 worth of the offeror’s common
shares for $100
• Redemption
– If triggered by the making of a tender offer for 30% or
more of the stock, the board would be permitted to redeem
the rights at a price of 50¢ per right at any time prior to
their being exercised
– If triggered by the acquisition of 20% or more of the stock,
nonredeemable
• Why?

Poison Debt
• Target issues bonds or notes with terms that make target less
attractive
– Forbid an acquirer from burdening the target with further
debt
– Forbid an acquirer from selling target assets
– Make a change of control an event of default
• Very effective defense against leveraged takeovers

• No bidder has ever gone forward with a bid in the face of a fully
implemented second generation pill
– In the face of such a pill, the only successful bids have
been:

190
 • Where target’s BoD agreed to deal and redeemed pill
• Where bidder successfully conducted a proxy contest
to elect a new board that then redeemed pill
• Where court invalidated pill

• Moran case validated pills but held that the board cannot defeat
a bid by any “draconian” means
• Presaged the pill cases holding that one could not just say no
• A non-coercive offer cannot be permanently blocked by a poison
pill. City Capital Assoc. v. Interco, Inc.
• “When the Household Board of Directors is faced with a tender
offer and a request to redeem the Rights, they will not be able to
arbitrarily reject the offer. They will be under the same fiduciary
standards any other board of directors would be held to in
deciding to adopt a defensive mechanism, the same standard as
they were held to in originally approving the Rights Plan.”

Shareholder Self-help: Anti-pill Bylaws

• Can shareholders unilaterally adopt a bylaw prohibiting poison
pills?
– Bylaw amendments are one of the very few corporate
actions shareholders allowed to initiate under state law
– Federal shareholder proposal rule (Rule 14a-8) gives
shareholders a mechanism to put a proposed bylaw on the
ballot
– Does DGCL § 141(a) imply substantive limits on the
appropriate subject matter of by laws?
• E.g., could shareholders adopt a bylaw providing that
shareholders must ratify the business model?
• Probably not
• Bylaws historically are about process and rights
respecting the shares themselves, not
corporate governance or business policy
• Bylaw from Teamsters v. Fleming Companies, 975 P.2d 907
(Okla.1999):
– “The Corporation shall not adopt or maintain a poison pill,
shareholder rights plan, rights agreement or any other
form of 'poison pill' which is designed to or has the effect of
making acquisition of large holdings of the Corporation's
shares of stock more difficult or expensive ... unless such
plan is first approved by a majority shareholder vote. The
Company shall redeem any such rights now in effect.”

Revlon v. MacAndrews & Forbes Holdings

• Pantry Pride made a hostile tender offer for Revlon

191
• Revlon found a white knight in leveraged buyout specialist firm
Forstmann Little
• Resulting control auction set new standard (or did it?)
• Perelman meets with Bergerac (Revlon CEO)—threatens Take
over at $45/share
• Board adopts defenses:
• Poison pill—per share $65 note at 12% with one year
maturity triggered by purchase of 20%, unless there is an
all shares offer for $65
• Redeemable
• Held: OK per Unocal
• Perelman’s First Offer
• $47.50 all shares all cash; redeem rights plan
• Revlon Bd.:
• Exchange Offer
• Swap 10M shares for 10 year senior subordinated notes at
11.75% + 1/10 share $9 Cumulative Convertible
Exchangeable preferred at $100
• Package value: $57.50
• 87% of shareholders grab it
• Purpose:
• Increase debt load
• Poison business covenants limiting borrowing, asset
sales, and dividends.
• Once the Shareholders hold the Notes with
protective covenants, will they oppose the
offer?
• Suppose management wants to do an LBO?
• “Independent directors” can waive the
covenants
• Held: OK per Unocal
• Several rounds of bidding, with Pantry Pride topping every
Forstmann offer
• Revlon accepted Forstmann's last bid. To end auction, granted
Forstmann an asset lock-up option
• The option gave Forstmann the right to buy two Revlon
divisions at below market price; exercisable if another
bidder gets 40% of Revlon shares
• Also:
• $25 million cancellation fee
• No shop clause
• The Delaware Supreme Court struck down the lock-up (also the
cancellation fee and the no-shop clause)
• Treated the lock-up as a type of takeover defense
• Hence, the lock-up implicated not traditional business
judgment rule analysis but rather Unocal

192
What is the rule of law that emerges from Revlon?
• When the board puts the company up for sale, they have a duty
to maximize the company's value by selling it to the highest
bidder:
– "The directors' role changed from defenders of the
corporate bastion to auctioneers charged with getting the
best price for the stockholders at a sale of the company."
Invalidity of the Lock-up
• Violated the board of directors' fiduciary duties. Why?
– Because the lock-up ended the bidding prematurely: “In
reality, the Revlon board ended the auction for very little
improvement in the final bid”
– Distinguish between lockups that draw a bidder in and
lockups that end an active auction
– “FL had already been drawn in to the contest
on a preferred basis, so the result of the lock-
up was not to foster bidding but to destroy it”
Invalidity of the No Shop
• No shops are NOT per se illegal
• But this no shop required the BOD to treat Forstmann more
favorably than Pantry Pride
– The agreement to negotiate only with Forstmann helped
end the auction prematurely
So what triggers Revlon?
• The “Imminent Break-up” of the target firm
• Cases since Revlon:
– Imminent “Change in Control” of the firm…
• …even if no break-up is to follow
– …from a “fluid aggregation” of dispersed shareholders to a
unified entity or group.
• Paramount v. Time: Did not trigger Revlon
• Paramount v. QVC: Triggered Revlon
• Unifying concept (best guess):
– Were target’s SHs on verge of losing their future ability to
extract a “control premium” for shares?
• Bringing in a white knight or a management buyout in response
to a hostile takeover triggered Revlon. But what else did?
– Revlon was triggered only if the transaction would result in
a change of control
• If control would not change hands, the transaction
was subject only to Unocal

Paramount Communications v. Time: Change of Control?

• Delaware supreme court indicated Allen’s change of control
analysis was correct “as a matter of law,” but it rejected
plaintiffs’ Revlon claims on “broader grounds”:

193
 – “Under Delaware law there are, generally speaking and
without excluding other possibilities, two circumstances
which may implicate Revlon duties. The first, and clearer
one, is when a corporation initiates an active bidding
process seeking to sell itself or to effect a business
reorganization involving a clear break-up of the company.
However, Revlon duties may also be triggered where,
in response to a bidder’s offer, a target abandons
its long-term strategy and seeks an alternative
transaction also involving the breakup of the
company.”

Defensive Recapitalizations
• Target company typically issues a dividend consisting of cash
(often borrowed) and debt securities, reducing the post-dividend
value of the target's stock to the extent of the distribution
• Target managers and/or the target's employee stock ownership
plan effectively receive the dividend in the form of stock, rather
than cash or debt, at an exchange rate based on the stock's
post-dividend value
– Alternatively, the target may conduct a tender offer in
which public shareholders exchange their stock for cash
and debt
• In either case, management's equity interest increases
substantially vis-à-vis public shareholders

Do Defensive Recapitalizations Trigger Revlon?

• Where a recapitalization transfers effective voting control to
target management, the courts treated the transaction as a
"change in control" of the corporation requiring adherence to
Revlon's auction rule.
• To what extent can management use a poison pill to protect
recap?
– Led to the poison pill cases
– Allowed management to delay the hostile bid long enough
to give the board time to arrange an alternative
transaction

Nonshareholder Constituencies
• Unocal: Target directors may consider the impact of their
decisions on non-shareholder constituencies—i.e., employees,
customers, creditors, communities, and the like
• Revlon? Once their auctioneering role has triggered can the BoD
still consider non-shareholder interests in making decisions about
the auction?

194
 • No. Once an auction begins the board may no longer
consider non-shareholder interests.
• Revlon: Even outside the auction setting, cut back on Unocal:
• “A board may have regard for various constituencies in
discharging its responsibilities, provided there are
rationally related benefits accruing to the shareholders.”
• Implication for the threat prong of Unocal: Courts were
reluctant to say that threats to non-shareholder interests
justified takeover defenses

– The board may evaluate offers on such non-price grounds as the

proposed form of consideration, tax consequences, firmness of
financing, antitrust or other regulatory obstacles, and timing.
– The board may only consider factors relevant to the
shareholders' best interests
– No favoritism
– Any effort to make sure that one side or the other
prevailed, such as giving one side a lock-up, was highly
disfavored
– The board must be adequately informed of the material facts and
engage in a thorough review of available options
– Shopping the corporation—i.e., a fair competition between
multiple bidders—had two functions:
– Gathering information about value of firm
– Constraint on conflicts of interest
– Bottom line?
– Fair competition
– Target directors are given considerable discretion in conducting
a Revlon auction. They need not be passive observers of market
competition.

Relationship between Van Gorkom and Revlon

• Van Gorkom requires that decision to merge be an informed one
– Case implicitly approved shopping the company as a
means of gathering information, but did not require the
directors to do so
• Delaware addressed in Barkan
– Holding: Revlon does not require that every control
transaction be preceded by a bidding contest
– When the board is considering a single offer and has no
reliable grounds for judging its adequacy, a concern for
fairness demands that the market be canvassed
• But when directors possess a body of reliable
evidence with which to evaluate the fairness of a
transaction, they may approve it without an active
survey of the market

195
Summary of these Cases
• Intermediate Scrutiny in T-O defense context.
– One of two levels
• “Mere” resistance of a takeover
– Unocal duty (threat/proportionality prongs)
– Num. constituencies and time horizons OK.
• Change of Control, Break-up or other event that causes
shareholders to lose the future ability to extract a “control
premium”:
– Revlon duty (modified threat/prop. test)
– Duty to maximize short term SH welfare.
• Consequences of flunking applicable test
– Unenforceability of defensive lock-ups.
– No liability for directors (absent more)

Delaware’s Motive-Based Balance

• Motive analysis figures prominently in Delaware decisions
– In other words, under the Unocal/Revlon regime, the board
retains full decisionmaking authority — including the
authority to foreclose shareholder choice — unless it acted
from improper motives

Conclusion
• The conflict of interest present when the board responds to an
unsolicited tender offers differs only in degree, not kind, from
any other corporate conflict
• A conflict of interest does not necessarily equate to
blameworthiness
– Rather, it is simply a state of affairs inherently created by
the necessity of conferring authority in the board of
directors to act on behalf of the shareholders
• We therefore would expect the courts to develop standards of
review for takeover defenses that are designed to detect, punish,
and deter self-interested behavior

Problems:

Hypotheticals
• Suppose that:
– Mesa’s offer had been a one-tier offer at $54 cash per
share (and therefore not coercive to SHs);
– And Pickens had no reputation as a greenmailer;

196
 • Under Unocal, which of the following would still be considered
bona fide threats?
– Pickens wanted to liquidate the firm in 5 years
– Pickens wanted to exploit a loophole in Unocal’s
debentures to cheat the bondholders
– Pickens wanted to “downsize the firm”
Given the broad constituencies cited in Unocal, all of these are bona
fide threats to someone who counts.

The difference b/t Unocal and BJR may be very small indeed, other
than the burden shifting to the directors: It may be very easy to
overcome it.

197