1

INTRO TO AGENCY 1) Sole Proprietorship: no separate identity from the owner; unlimited liability for obligations incurred in the course of business. 2) Agency law: a fiduciary relation that arises when the principal manifests assent to an agent that the agent shall act on the Ps behalf and subject to his control, and the agent manifests assent or otherwise consents so to act. a) An objective test. Depends on what they did, not what their intent was. b) Morris Oil v. Rainbow Trucking: i) Morris went after Dawn for money, thinking Dawn was Rainbows principal. ii) The agreement between Dawn and Rainbow stated that Rainbow may create liabilities of Dawn in the ordinary course of business. Also, it does not need to bind 3rd parties who deal with one of them in ignorance of their agreement. iii) This was a case of undisclosed agency: An agent for an undisclosed principal subjects the principal to liability for acts done on his behalf if they are in the usual course of business, EVEN IF the principal has previously forbidden the agent to incur such debts so long as the transaction is in the usual course of business engaged in by the agent. iv) The undisclosed principal is subject to liability to 3rd parties with whom the agent contracts where such contracts are in the usual course of the agents business, even if the contract is contrary to the express directions of the principal. v) Ratification: a principal may be held liable for the unauthorized acts of his agent if the principal ratifies the transaction AFTER acquiring knowledge of the material facts of the transaction. c) Questions to ask: i) Is there a principal-agent relationship? ii) Did the agent have the authority to bind the principal? iii) Did the agent act within the scope of his employment? d) Types of Agents: i) General Agent: authorized to conduct a series of transactions involving continuity of service ii) Special Agent: authorized to conduct only a single transaction of a series of transactions NOT involving continuity of service e) Types of Principals: i) Disclosed: 3rd party has notice that the agent is acting for a principal and has notice of the principals identity ii) Partially disclosed/unidentified: 3rd party has notice that the agent is acting for a principal but does NOT have notice of the principals identity iii) Undislosed: 3rd party has NO notice that the agent is acting for a principal f) Authority: i) Actual Authority: the Ps words or conduct would lead a reasonable person in the agents position to believe that P wishes the agent to act. If the agent has actual authority and acts within the scope of employment, the P is bound. (1) Expressed Actual Authority: P specifies exactly what agent is to do. P is liable to 3rd parties. (2) Implied Actual Authority: implied or inferred from words, customs, and relations between the parties. (a) Incidental Authority: type of implied authority; authority to do incidental acts that

2 are reasonably necessary to accomplish an actually authorized transaction, or that usually accompany a transaction of that type. ii) Apparent authority: agent has apparent authority to act on a Ps behalf in relation to a 3rd party T if the Ps or the agents manifestations to T would lead a reasonable person in Ts position to believe that the principal had authorized the agent to so act. If the agent has apparent authority and acts within the scope of that authority, P is bound. iii) Inherent Authority: (1) an agent may bind a P in certain cases even if the agent did not have actual or apparent authority (2) a disclosed or partially disclosed principal is liable for an act done on his behalf by a general agent, even if the principal had forbidden the agent to do the act, if: (a) the act usually accompanies or is incidental to transactions that the agent is authorized to conduct, and (b) the third person reasonably believes the agent is authorized to do the act. iv) Acquiescence: if the agent performs a series of acts of a similar nature, the failure of the P to object to them is an indication that he consents to the performance of similar acts in the future under similar conditions. Hoddeson: i) Hoddeson was a customer; there was a cash sale of furniture to him without a receipt. ii) No apparent authority b/c the person who sold the furniture could not be identified and it could not be determined that he was an employee (agent) of the store. iii) Principals create the agency relationship, not the agent. iv) Here, there was no express, implied, or apparent authority. v) Hoddeson should have sued on a tort estoppel theory. Tarnowski v. Resop (fiduciary duty of agent to principal): i) R was Ts employee (agent). He was hired to investigate and gather info. T decides hes going to buy a business based on Rs investigations. T then discovered that R only did a superficial investigation and that he took a bribe from the seller of the business. R clearly breached his fiduciary duty to T. T got rescission of the sale and sues R for accepting the bribe and to recover damages for his lax investigation. ii) R loses b/c he violated his fiduciary duty. Principal T gets back whatever he lost, plus whatever R gained from the transaction. iii) Agents should be loyal to their principals. Reading v. Atty General: i) Reading was hired by someone during WWII to use his uniform for 20,000 lbs. The English govt sued him. Court found against Reading as an agent of the army, he wasnt supposed to use his position to benefit himself, even if the principal didnt lose anything and was not directly harmed. Its just unfair b/c he was unjustly enriched by using his position for personal gain. Jensen & Meckling: Agency costs are associated with agent-principal relationships: i) Monitoring of the agent by the principal: watching him to make sure hes doing his job ii) Bonding expenditures by the agent: getting hired, keeping the job iii) Residual losses: using the Xerox for personal purposes, personal calls on company phones/company time, internet surfing on company computers, etc.

g)

h)

i)

j)

PARTNERSHIPS 1) Partnership: an association of two or more people to carry on, as co-owners, a business or profit. Question of what the partners intended to do via their implicit or explicit actions. a) Unlimited joint and several liability of the partners if all money is lost, partners lose their

3 equity and creditors can go after the partners for what the creditors lost. Partnerships are the AGGREGATE of the individual partners. A person or corporation cant join a partnership without the consent of the partners (delectus personi) Co-ownership connotes joint control of the business Martin v. Peyton (1927) (Does profit-sharing = partnership?) i) UPA 7(4): profit sharing is prima facie evidence of a partnership UNLESS profits were received in payment for debts, wages, rent, annuity, loan interest, or consideration for the sale of a good-will of a business. ii) Here, the creditor had a right to veto, right to force everyone to resign, right to choose the person who manages; looks a lot like a partnership. iii) But there was no partnership here b/c the profit-sharing didnt cross the line b/c the provisions were negative, and the creditor wasnt running the business. Lupien v. Malsbenden (1984) (what does constitute a partnership): i) A finding that a partnership exists may be based on evidence of an implied or express agreement to pool their money and efforts in a business with the understanding that a community of profits will be shared. ii) NO ONE FACTOR is determinative. iii) Malsbendens loan was not really a loan there was no interest charged, it was not disbursed in installments, and it was not to be repaid in installments, but upon the sale of the cars. iv) Malsbenden also participated in the control of the business and actually did so on a day-today basis. v) Thus, there was a partnership here. Presence/absence of these 4 elements is evidence, but not a requirement, of a partnership: i) Agreement to share profits ii) Agreement to share losses iii) Mutual right of control or mgmt. of the business iv) Community of interest in the venture Summers v. Dooley (1971) (decisionmaking authority of a partner): i) There was a 50/50 partnership, plaintiff hired a 3rd person without the consent of the defendant. The dissenting partner was then charged with the resulting costs of the hiring partners decision. This was no good. ii) It is unjust to permit recovery from one partner of an expense that was incurred thru a unilateral decision of the other partner. iii) UPA 18(h): any ordinary business disagreements/differences may be decided by a majority of the partners; bigger issues need UNANIMOUS consent of the partners. Sanchez v. Saylor (2000) (appropriate means of relief for disagreement between partners): i) Without an enforceable agreement covering circumstances of disagreement, when both partners in a 2-man partnership disagree on a prospective business transaction, DISSOLUTION, not an action for breach of fiduciary duty, that is the appropriate avenue of relief. If there is an agreement/contract, that governs. The UPA only comes in when there is not governing provision or no contract at all. RNR Investments v. Peoples First Community Bank (2002) (partnerships and apparent authority): i) RNR defaulted on a mortgage. The lender bank sues RNR. ii) Even if a general partners actual authority is restricted by the terms of the partnership agreement, the general partner possesses the apparent authority to bind the partnership in

b) c) d)

e)

f)

g)

h)

i) j)

4 the ordinary course of partnership business, UNLESS the 3rd party knew that the partner lacked authority. iii) Here, the bank did NOT know that the partner lacked authority, so the partnership is bound. iv) A 3rd party needs ACTUAL knowledge of the limitation in the case of ordinary business matters. Northmon Investment Co. v. Milford Plaza Associates (2001) (non-ordinary transactions unanimity required) Davis v. Loftus (2002): i) UPA: income partners (gross return) are not real partners. ii) Income partners no profit/loss sharing not partners no partnership liability. Indemnification and Contribution: i) Partners are individually liable to partnership creditors for partnership obligations. ii) As between partners, however, each is liable only for his share of partnership obligations. iii) A partner has a right to be indemnified by the partnership. iv) The partnership has a right to require contribution from one or more partners. v) The obligation to indemnify a partner is a partnership liability, and the obligation to make contribution is a liability of the partner. Partnership Interests and Partnership Property i) Rapoport v. 55 Perry Co. (NY 1975): Partners are allowed to freely assign partnership profits (not the partnership interest itself) without the consent of the parties. ii) Under the UPA, although a partner does not own partnership property, he does own his interest in the partnership, his share of the partnership. iii) Although a partnership interest is assignable, a partner cannot assign his partnership interest if it would substitute the transferee as a partner in the transferors place, b/c as a rule, no person can become a partner w/o the consent of all the partners. iv) When a partnership interest is assigned, the assignment normally is not a full transfer of the interest. Dissolution of a Partnership i) Can happen whenever a partner wants ii) Happens whenever theres a change of a partner, but the partnership doesnt go away. Most agreements say that the partnership continues; can avoid termination of the partnership, but cannot say that the partnership isnt dissolved. iii) UPA 31: Causes of dissolution (1) Definite term (2) Express will of the partner (3) Death, bankruptcy, court decree, etc. (4) Its a significant right, but not one without limitations. Comparison between Corporation and Partnership (subject to changes via contract):
Corporation Liability Transferability SHs have limited liability Shares are freely transferable (however, oppression of msh can limit transferability msh in a CC may not have a market to rely on). SH cannot bind the corp. Partnership Partners have unlimited liability Limited generally need unanimous vote. UPA 18(g). (However this can be Kd around) Partners can bind if act is within ordinary course of business. UPA 9.

k) l) m)

n)

o)

p)

Authority

5
Management SHs have no say unless on the board. (Centralized, but SHs can get rid of board and run directly). Separate Legal Entity Can last forever (however, K can stipulate end of the corp). Double Taxation: (1) income, (2) dividends (can avoid by paying as compensation) Certificate of incorporation must be filed with Sec of state. All partners have a right to participate to be consulted in pship decisions, to info, etc. UPA 18(e). (or, can form mgt committee to run the firm much like a board). Aggregate of partners (under RUPA, treated as separate entity) Typically for a limited term (however, it can be modified by K to last indefinitely) No double taxation. Partners taxed as individuals. None. One can end up in a partnership without knowledge or intent.

Status Continuity / Term Taxation Formalities

CORPORATIONS 1) Characteristics of the Corporation: a) Limited liability: SHs not personally liable for corporate obligations b) Free transferability of ownership interests c) Continuity of existence: legal existence of a corporation is perpetual unless a shorter term is stated in the cert. of incorporation d) Centralized mgmt.: BoD; SH has no right to participate in mgmt. e) Entity status: can exercise power and have rights in its own name. f) Privately held enterprises: more complex (alternate forms discussed below). 2) Anyone 18 and over can set up a corporation; no minimum capital requirement ($1); very easily done by just filing the certificate of incorporation. Once the corporation is established, all the rules of corporate law apply. The incorporator adopts the by-laws, issues shares, selects the BoD. 3) Selecting a state of incorporation: a) A corporations internal affairs are governed by the law of its state of incorporation. Torts and contracts b) Close corporations tend to incorporate locally, in the state of its principal place of business. Doing-business and franchise taxes may overlap so the corporations tax bill might be lower, which is important for small corporations, but not as much for large publicly held corporations. c) Publicly held corps tend to be incorporated in DE b/c if its friendly laws. Why are its laws friendly? i) Race-to-the bottom theory: lets make our laws friendly to corporations so they will choose us ii) Race-to-the-top theory (for both, see pp. 202-203): States choose DE not b/c the laws are lax, its b/c theyre good and effective 4) Creating or Organizing the Corporation: a) Incorporator files a certificate of incorporation, articles of incorporation, or charter b) Initial Directors: i) There must be a way for naming initial directors before stock is issued, or for issuing stock before directors are elected by the SHs. (1) 2 ways to do this: (a) NY Method: Corporations incorporators have the powers of SHs until stock is issued, and the powers of directors until directors are elected (b) DE Method: Initial directors can be named in the cert. of incorporation; the functions of the incorporators pass to the directors when the cert is filed and

6 recorded. 5) Conflicts of interest governed by corporate law: a) Traditional conflicts: involve self-interest transactions between mgrs. and their corporations b) Positional conflicts: involve actions by managers to maintain/enhance their positions 6) Modules of corporate law: a) State statutory law: enables corporations to be organized, provides corporations w/various endowments, and facilitates corporate transactions b) State judge-made law: sets level of care required of officers and directors, regulates traditional conflicts of interest, and gives content to remedial structures to protect SH rights and resolve SH claims. c) Federal law: regulates traditional conflicts directly and regulates positional conflicts indirectly (like SOX and the Securities Acts) d) Private ordering or soft law: like the rules of major stock exchanges regulate positional conflicts directly, by requiring an independent board and committees to monitor the corporations executives. DEBT V. EQUITY AND CAPITAL STRUCTURE 1) The Corporate Life Cycle: a) Bringing in capital thru DEBT or EQUITY i) Debt: borrowing (1) Bonds: debt secured by specific assets; safest; bondholder always gets paid; security interest; failure to pay, go over other assets ahead of creditors, gets to go after collateral (a) Control: 1 (b) Business returns: 1 (2) Debentures: unsecured debt; not as safe as bonds; no legal requirement to pay (a) Control: 1 (b) Business returns: 1 ii) Equity: bringing in money; ownership interest (1) Preferred (a) Risk of loss: 6 in case of liquidation, preferred equity gets paid before common equity (b) Control: 1 (c) Business returns: 1 (d) Preferred SHs are paid dividends after creditors are paid but before common SHs. (e) Preferred shares have the disadvantages of both debt and common shares without their advantages. But they attract investors b/c they tend to pay higher dividends. Also, dividend payments to corporate SHs are partially nontaxable. (2) Common (a) Risk of loss: 4 greater b/c you get paid last. But if the profit is big then you could be sizably rewarded. (b) Control: 10 (right to elect directors, etc) (c) Business returns: 10 iii) So its a trade-off: common stock is the riskiest but also potentially the most profitable. iv) If a preferred SH gets a contract to convert into common then that gives them greater returns if the corporation is successful. v) Convertibles vi) Ways a company can cash out their investors (venture capitalists): (1) Be sold to a bigger company and made a subsidiary (2) Going public (2 types)

7 (a) Public owns them, but controlling shares are owned by a small group of people (like family for example) (b) No controlling SHs; owners are spread out (3) How to protect SHs from opportunistic behavior? Thats what corporate law aims to do. (a) From mismanagement (b) From theft by officers and directors Leveraging: a) Using someone elses money to make more money b) For example, using low-interest loan proceeds and putting it into a bank account with a higher interest rate. c) Leveraging is good when the company does well, but is disastrous if it doesnt do well it may cause the company to go into bankruptcy. Legal capital rules: statutory rules that deal with the raising of capital, primarily equity capital a) Primarily common or preferred shares b) Number of shares authorized is in the cert of incorporation c) For example: 1000 shares authorized i) Company sells 100 shares to X, Y, and Z (total of 300): the shares are authorized, issued, and outstanding. ii) Statute requires that the people give consideration for the shares. NY the use of promissory notes and promises of services to be rendered can be consideration. iii) Preemptive rights: gives the SH the right to buy the same proportion of shares as he did before. Generally, they are provided for in the articles of incorporation. These are valuable to a minority SH in a close corporation. But generally, large publicly held corporations do not have preemptive rights b/c theyre too cumbersome people can just buy stocks in the stock market. Par: the minimum amount that shares must be sold for. a) Stated capital: par value times the total amount of shares authorized b) Either set low par or no par. c) Bonus stock: shares given away for no consideration in return d) Discount stock: shares sold for cash, but cash less than par value e) Watered stock: shares sold for property or services worth less than par value i) Liability: the board is liable to creditors for the difference between the amount paid and par value f) Par price used to assure that all purchasers bought at the same price. But in modern times, with full disclosure, SHs are informed of the prices paid by others and par no longer provides disclosure. Insolvency: a) Equitable Insolvency: corporations inability to meet day-to-day costs; if equitably insolvent, cant pay dividends. b) Bankruptcy meaning of insolvency: having liabilities in excess of assets

2)

3)

4)

5)

ISSUANCE OF SHARES AND DIVIDENDS 1) Issuance of stock: sale of stock by the corporation (only stock that has been authorized in the cert of incorporation can be issued) 2) Authorized but unissued stock: authorized stock that has not yet been issued 3) Issued stock/outstanding stock: authorized stock that has been issued 4) Treasury stock/authorized and issued but not outstanding stock: stock that a corporation previously issued and repurchases

8 5) Distributions to SHs: a) Dividends: making pro rata distributions of cash/security/interests in other kinds of property b) Repurchasing shares: another means by which SHs receive funds from the corporation i) Financial limitations on a corporations stock repurchase: (1) Corporate assets flow out to SHs. To creditors, repurchase of stock is the same as a dividend. Modern statutes (though not NYs) treat them together as distributions. (2) Under traditional statutes, the corporation is permitted to purchase its own stock out of capital for certain specified purposes: (a) Eliminating fractional shares (b) Collecting or compromising a SHs indebtedness to the corporation (c) Paying dissenting SHs for their shares pursuant to the exercise of appraisal rights (d) Most important: redeeming or purchasing redeemable stock (3) When to permit a repurchase? (a) Most courts: Corporation must pass equitable insolvency test at least twice once at the time of contract with respect to the entire amount, and at the time of each payment with respect to the amount of the installment (payment is sometimes made in installments). c) Paying SH-employees inflated salaries: most commonly used in closely held corporations d) Liquidation: paying each SH his pro rata share after paying off SHs. e) Traditional dividend statutes: i) Capital impairment (aka capital-and-surplus or balance-sheet) test ii) Earned surplus (income statement) test iii) Creditors get little protection from traditional dividend statutes. f) Equity traditionally divided into Stated Capital and Surplus i) Stated capital (aka capital stock): consists of the total par value of issued stock that has par value, plus any other amounts allocated to capital by the board. ii) Surplus accounts: (1) Earned Surplus (income statement test): dividends can be paid out of capital surplus ONLY if specifically permitted (2) Capital Surplus (balance-sheet test): portion of surplus that is derived from sources OTHER than earnings, such as amounts paid for stock in excess of the stocks par value; dividends can be paid out of capital surplus UNLESS specifically prohibited. (a) 2 types of capital surplus: (i) Paid-in surplus: excess of the total sale price of newly issued stock, over that portion of the sale price that constitutes par value OR is otherwise allocated by the board to stated capital. (ii) Reduction surplus: amount by which stated capital is reduced through corporate action pursuant to statutory authority. 6) Liability of Directors for Improper Dividends: a) Governed by creditors law and corporate law b) Liability for improper repurchase of stocks will be treated the same way as improper dividends c) State corporate statutes tend to emphasize the liability of directors i) Either permit directors to raise a defense of good faith reliance on defined financial statements, or ii) Condition directors liability on bad faith or lack of due care, or both. iii) Measure of recovery: either full amount of an improper dividend or the injury suffered by creditors or SHs up to the amount of distribution. iv) Director who is held liable for an improper dividend distribution is entitled to contribution from other directors who voted for it.

9 v) A director who is held liable may also be entitled to reimbursement from SHs who received the dividend with knowledge of its illegality d) Creditors law, in contrast, tends to emphasize the liability of SHs. TAXATION 1) Income-deduction = taxable income-tax rate = profit 2) Example: Two people, X and Y, are setting up a company. X has a patent for $15K, $25K market value. Y has $25K in stocks and bonds which have a $50K market value. a) Corporation: transfer the assets to the corporation. Issue shares in return. Y sells his stocks and bonds for $50K and realizes a $25K profit. He has to pay taxes. Same with Xs patent theres a gain. b) Partnership: Partnership interest in return. It would normally be viewed as a sale. The tax code allows transfer without immediate tax consequences (tax free business establishment). c) X and Y each have 100 shares in the company. X sells to Z for $100K. X has to pay taxes on the difference between $100K and $15K. d) Corporations and partnerships are treated similarly in terms of setting up a business. 3) But corporations and partnerships are significantly different from a tax perspective. a) Partnership: no separate tax liability, individual partners pay taxes. b) Corporation: separate legal entity, corporation pays tax first and then SHs have to pay tax too (double taxation). 4) To avoid double taxation (corporation is taxed on its profits, and when the profit dividends are distributed to the SHs, the SHs pay taxes on the dividends): a) Form a partnership b) Dont pay out dividends and keep it in the business; but then the government may interfere with this scheme c) Pay out as salaries; then no corporate tax and individual pays as like partnership tax; but then the government could also monitor you if you pay out too much as salaries. d) Borrow from the SHs and pay back thru interest, which is a tax deduction. Again, the government may interfere e) Simpler way: Form an S corporation, which allows you to be a corporation with the benefit of partnership taxation. All the corporate income is taxed to the SHs, whether or not the income is actually distributed to them. Limitations: no more than 75 SHs, no foreign investors, only one class of stock. ALTERNATIVE BUSINESS ORGANIZATIONS 1) Limited Partnerships (LP): creatures of statute; cert of LP must be filed in the office of the Secretary of State (RULPA 201). a) RULPA 101: partnership formed by two or more persons under the laws of the state and having one or more general partners and one or more limited partners. b) Tax liability: limited partners have limited liability. There must be at least one general partner who has unlimited liability. c) Can create an LP where the general partner is a corporation. 2) Limited Liability Companies (LLC): noncorporate entities that are created under special statutes a) owners have limited liability and the LLC is an entity so it can hold property and sue and be sued (like corporations) b) LLC has great freedom to structure its internal governance by agreement (like general partnerships) c) Member-managed LLCs (default rule unless agreement provides otherwise): authority rules are similar to those of general partnerships

10 d) Manager-managed LLCs: authority rules are similar to those of corporations e) Members rights: i) Financial rights include right to receive distributions; financial rights are transferable. ii) Governance rights include right, if any, to participate in mgmt, to vote on certain issues, and to be supplied with information. f) Authority in DE: unless otherwise provided in the LLC agreement, each member and manager has the authority to bind the LLC. 3) Limited Liability Partnerships (LLP): like general partnerships, except liability of general partners is less extensive (limited tort liability and limited liability for all partnership debts and obligations); must be registered with the appropriate state office. a) LLPs are distinguished on the basis of liability, not tax. b) CA and NY only permit professional firms (like law firms) to be LLPs. c) Partners still remain liable at least up to their investment in the firm. Statutes also preserve whatever liability partners may have under the common law. i) Example: In DE, the LLP shall not affect the liability of a partner for his own negligence, wrongful acts or misconduct, or any under his direct supervision. VALUATION ACCOUNTING CONCEPTS 1) Accountants need to be independent they cannot have any material interest in the companies theyre working on. This is to protect investors. 2) Cash method of reporting: focuses on when cash comes in and out of a business 3) Accrual method of reporting: focuses on when earnings are earned or when expenses are due; all publicly traded companies must use this method b/c its less subject to manipulation 4) Companies dont like anything except an unqualified approval opinion from auditors. 5) The Balance Sheet: Double-Entry Bookkeeping a) Assets = Liabilities + Owners Equity b) Current Assets: assets that can be converted to cash within a year i) Marketable securities: securities that trade in a market ii) Accounts receivable: money thats coming to a company, usually from sales iii) Inventories: what a company makes (if manufacturing) or sells. c) Fixed Assets: stuff like land, building, machinery, office equipment d) Assets are listed at the lower of cost or current value to keep the numbers conservative and guard against fraud. e) The left side must always equal the right side f) The rights and claims an entity holds against others (assets) must equal the rights and claims others hold against it (its creditors with respect to liabilities and the owners as residual claimants with respect to equity). g) There will be two entries for every transaction. h) GAAS: generally accepted auditing standards auditors must adhere to these i) GAAP: generally accepted accounting principles dictate how things are reported j) Entries on a balance sheet do not necessarily reflect real or market values; they reflect only book value i) The real value of a company will often be higher than book value. (1) Problems with book value: (a) Cost-based accounting (how much you bought the asset for minus depreciation) could undervalue the companys worth b/c the lower figure is displayed on the balance sheet doesnt tell the market value. (b) Depreciation (c) Intangible Assets (like Mickey Mouse)

11 k) Depreciation is determined by a straight line formula so the actual net worth of the asset may be much higher or lower than the figure for owners equity recorded on the sheet. l) Some of the most valuable assets of a company are never listed on the balance sheet, like Mickey Mouse, b/c they arent connected to any concrete financial transactions. Same is true of patents, trademarks, goodwill, etc. 6) The Income Statement: a statement for a period of time, giving a summary of earnings between balance sheets a) Balance sheets how the present status of the assets and the source of assets resulting from all transactions since the business was formed. b) Difference between a balance sheet and an income statement is that balance sheets speak of a particular date, while income statements cover a period of time between successive balance sheet dates. i) Assume income statement for a month: Professional Income Monthly expenses Loss = Net Income ii) For this particular month this net income would appear on the balance sheet. VALUATION FINANCIAL CONCEPTS 1) Valuation: future-oriented; an educated guess of what future investments will be worth; nothing more than a guess. To a potential creditor or investor, the value of the business is important they look to it to determine how much to lend and to evaluate the risks associated with making the loan or investment. The business earning ability is important. 2) Calculating Present Value a) Assume you want to invest 350K now with the expectation of realizing 400K a year from now. You should go ahead if the PV of the expected 400K payoff is greater than the investment of 350K. So the question ends up being What is the value today of 400K to be received one year from now, and is that present value greater than 350K? b) The PV of 400K one year from now must be less than 400K a dollar today is worth more than a dollar tomorrow b/c the dollar today can be invested immediately (opportunity costs). c) PV of a delayed payoff = C1 (amount of delayed payoff) x Discount Factor (less than 1) d) Discount Factor = 1/1+R (rate of return). Used when there is a finite period. e) Example: government securities maturing in one year; yield 7%. How much do you have to invest in them in order to receive 400K at the end of the year? i) 400K x 1/1+0.07 = 100K/1.07 = $373,832 ii) You committed $350 K so your Net Present Value (NPV) is $23, 832. This means your investment is worth more than it costs, b/c it make a net contribution to value. Looks like a good investment. f) Any investment needs to be compensated for risk, inflation and opportunity costs. g) Why do we need to know the PV of a future amount? So we know how much to invest to get the amount at the end of the year or if someone was offering you an investment you want to know what the current value is. 3) Liquidation Value: the amount for which the assets of the company could be sold, LESS the liabilities owed; does not reflect business potential. 4) Book Value: see above under Balance Sheet 5) Earnings Approach: a) Investors are interested in the companys ability to earn and not in the value of its assets. b) A business is valued by finding the PV for a future expected return. Thus, you must determine: i) How much the business will generate (amount) ii) For how long (duration) iii) What rate do we apply in calculating future returns? (rate of return)

12 (1) Inflation (2) Opportunity Costs (3) Risk 6) Capitalization of Earnings: finding the present value of a future return in perpetuity; same idea as discounting but for an infinite period, not a finite period. a) Example: 100K. Risk, inflation, etc. result in expected rate of return of 20%. So, how much would be needed to invest now (PV) to earn 100K/year forever at 20%? i) A (annual return of 100K)/R (rate of 20%) = PV (500K). The amount you need to invest now to earn 100K a year forever at 20% is 500K. ii) How to come up with A? Look at how the company has been doing in the past. iii) Where do you find the earnings? Look at the income statements b) The higher the risk and the rate, the lower the present value. 7) Cash Flow as Earnings: a) Net income. Actual cash the corporation received. Gross income minus expenses. b) Depreciation is added back b/c its already been paid for (its not really a cash expense). 8) Net Present Value rule: accept investments that have positive net present values 9) Rate of return rule: accept investments that offer rates of return in excess of their opportunity costs of capital 10) In Re Taines: a) How to figure out the fair value of the business (1-hr photo chain) the day before the proceeding was commenced. i) Ways to calculate value: (1) Net asset value: cant be used b/c the corporation has chosen to go on as a business and not liquidate (2) Market value: the attraction a stock has in the market and the extent to which the movement of this stock reflects the judgment of the buyers and sellers; cant be used b/c this was a close corporation (3) Investment value: to find what a prudent informed investor would be willing to pay in order to buy the entire business as a going business, considering its assets, liabilities, tangibles, and intangibles this is the one chosen by the court. b) Capitalization rate used was cash flow, not reported profits. CAPITAL MARKETS 1) Given the limitations on the SHs inspection right and the limited obligations to report under state law, corrective action was taken to ensure that SHs are provided with adequate info at the corporations expense. These rules are the 34 Act and the rules promulgated by various stock exchanges. 2) Stock Markets: where debt and equity securities are bought and sold; provides liquidity for investors. Differences between various stock markets concern the types of securities that are traded, how trading is conducted, and who the buyers and sellers are. a) Primary Markets: where the original sale of securities by the government and corporations occurs. i) Corporation is the seller, and the transaction raises money for the corporation. Transaction handled by investment bankers. ii) Public offerings: selling securities to the general public; must be registered with the SEC. iii) Private placements: negotiated sale involving a specific buyer; sold to highly sophisticated, private financial institutions to avoid the cost in a public offering. Does not need to be registered with the SEC. b) Secondary Markets: markets in which securities are bought and sold after the original sale; the

13 investors who do the initial buying trade their shares on the secondary market. The stock market as we know it is a secondary market. i) Market prices of shares are set by investors. They reflect how much investors THINK shares are worth, not how much theyre actually worth. ii) Investors are much more willing to buy securities in a primary market when they know that those securities can later be resold if desired. iii) Two types of secondary markets: (1) Auction Market: (a) Like the NYSE, the American Stock Exchange, and regional exchanges. (b) The auction or exchange has a physical location (2) Dealer Market (a) Dealers buy and sell for themselves, at their own risk (b) Dealer markets in stock and long-term debt are called OTC markets (like the NASDAQ) (c) Most trading in debt securities takes place OTC c) Listing: i) Stocks that trade on an organized exchange are said to be listed on that exchange. ii) In order to be listed, firms must meet certain minimum criteria concerning asset size and no. of SHs. iii) NYSE has the most stringent requirements of the exchanges in the nation. EFFICIENT MARKET THEORY 1) Efficient Capital Market Hypothesis: the numerous active traders in the stock market react quickly and efficiently to information. a) Whenever new information is available about a company, it is immediately reflected in the price of the shares. b) The only factor that will change the value of a companys shares is new information b/c the current share price contains all currently available information. c) Therefore, the share price in an efficient market can reflect how well a corporation is run. d) Forms of Market Efficiency: i) Weak form: prices reflect the information contained in the record of past prices ii) Semistrong form: prices reflect not just past prices but all other published information iii) Strong form: prices reflect all the information that can be acquired by painstaking analysis of the company and economy. e) This theory has been subject to criticism. i) Some have contended that it only applies to shares that are widely traded and followed. ii) People are not rational. Information is not symmetric. There are phenomena such as the herd mentality, noise trading, and irrational exuberance (like with dot.com stocks in the late 90s). iii) Also, if it were true, that means that no one would be able to beat the market consistently, but there are such investors who do. f) Thus, we hold the market to be generally, but not always, efficient g) Implications for law and policy: i) For example: Hostile takeovers (1) Market price of stock: $15 (2) Tender offeror who wants to buy, offers directly to SHs $20/share (3) Management thinks the price is too low and opposes the takeover (4) Should the law facilitate this transaction or not? Considerations are based on the efficient market theory. The tender offeror is only willing to pay 20 if he thinks he can

14 sell if for 25. Spend money to make money, right? The price is reflective of what the offeror thinks that the company isnt being run well, and thus the market price is lower than it should be. Based on this, everyone benefits SHs benefit b/c theyre getting more money, society benefits by having a better-run company, and the offeror benefits b/c they can raise the worth of the stock and make money. PROMOTERS LIABILITY AND DEFECTIVE INCORPORATION 1) Subscription Agreement: would-be SH agrees to purchase a corporations stock when it is issued to him at some future date. Sometimes, the corporation has not yet been formed the agreement is then called a pre-incorporation subscription agreement. a) Most statutes now provide that pre-incorporation subscriptions are IRREVOCABLE for a specified period of time UNLESS all subscribers consent to a revocation or the agreement otherwise provides. 2) Pre-incorporation transactions by promoters (shouldnt and doesnt happen very often now b/c forming corporation is so easy, but it used to be important b/c it wasnt as easy to form corporations in the past): a) Promoter: a person who transforms an idea into a business by bringing together the needed persons and assets, and superintending the various steps required to bring the new business into existence. The promoter is an agent acting for a nonexistent principal. b) Liability: i) When a promoter makes a contract for the benefit of a contemplated corporation, he is PERSONALLY liable on the contract and remains so even after the corporation is formed, UNELSS its clear by the language of the contract that that was the intent of the parties. ii) Exception: If the party who contracted with the promoter KNEW that the corporation was not in existence at the time of contracting, and nevertheless agreed to look solely to the corporation for performance, the promoter is not deemed a party to the contract. Such an agreement may be express or implied. c) A corporation that is formed after a promoter has entered into a contract on its behalf is NOT bound by the contract, without more. i) However, the corporation may become bound in several ways: (1) Ratification (2) Adoption (3) Novation (4) Proposition made to the promoters is a continuing offer to be accepted or rejected by the corporation when it comes into being. (5) Upon acceptance, becomes an original contract on its part (6) Liability also sustained on the ground that corporation, by accepting the benefits of a contract is estopped to deny its liability on the contract. 3) Defective Incorporation (again, should not happen that often): a) De Jure Corporation: organized in compliance with the requirements of the state of incorporation; all that is needed is substantial compliance. i) Substantial compliance is determined on a case by case basis, according to the nature of the unsatisfied requirement and the extent to which compliance has been attempted. ii) De jure corporations status cannot be attacked by either private parties or the state. b) De Facto Corporation: exists when there is insufficient compliance to constitute a de jure corporation vis--vis a challenge by the state, but is sufficient to treat the enterprise as a corporation with respect to third parties. i) Corporation status can be invalidated by the state, but not by creditors or other persons who have had dealings with the corporation.

15 ii) Requires a colorable attempt to incorporate and some actual use/exercise of corporate privileges good faith attempt. c) Estoppel (no good faith attempt): i) A party who has dealt with an enterprise on the basis that it was a corporation is estopped from denying the enterprises corporate status. ii) To avoid this, make sure you incorporate. iii) A decision based on the estoppel theory will normally turn heavily on the plaintiffs conduct, it may have only a limited precedential effect on future cases. LIMITED LIABILITY PIERCING THE CORPORATE VEIL 1) Two social policies at play: a) Limited Liability: makes investments less risky; good for investors, but may not be good for society at large; also, less risk may mean less gain. b) No limited liability: protects the public; but makes investments more risky 2) Corporate Disregard or the Alter Ego Theory: SHs should be personally liable for corporate debts. a) Before invoking the theory, a plaintiff must first establish an independent basis to hold the corporation liable (liability for a tort or contract claim). b) Once the plaintiff has done this, if the corporation has insufficient assets to satisfy a judgment, plaintiff may then seek to pierce the veil that protects the individual SHs, or parent corporation, from liability for the corporations debt. 3) Piercing rarely happens to large publicly held companies. It happens to close corporations and to parent companies in parent-subsidiary relationships. Should piercing happen more often? Should there be a differentiation between contract claimants and tort claimants? a) Contract claimants can modify the agreement to cover recovery of debts. b) Tort claimants cant arrange for recovery of debts, b/c they usually dont foresee their injury (like getting into an accident). So they should be able to pierce more often, right? But this is not the case. 4) Fletcher v. Atex (2d. Cir. 1995) (computer keyboard users v. Atex and its parent, Kodak): a) To prevail on an alter ego theory of liability, plaintiff must show that the two corporations operated as a single economic entity such that it would be inequitable to uphold a legal distinction between them. Factors to be considered: i) Whether the corporation was adequately capitalized ii) Whether the corporation was solvent iii) Whether dividends were paid, corporate records kept, officers and directors functioned properly, and other corporate formalities were observed iv) Whether the dominant SH siphoned corporate funds v) Whether the corporation simply functioned as a faade for the dominant SH. b) Plaintiff must also demonstrate an overall element of injustice or unfairness. c) Here the plaintiffs allegations were insufficient to establish the degree of domination necessary to disregard Atexs corporate identity. d) Presence of a joint cash mgmt system does not demonstrate undue domination. e) No siphoning of Atexs funds into Kodaks account f) Presence of Kodak employees at meetings with Atexs CFO and comptroller was also appropriate g) Some degree of overlap of board members of the parent and sub is also okay and is not inconsistent with maintaining separate business operations. h) No overall element of injustice.

16 i) Other theories that failed: i) Agency theory: plaintiffs offered no evidence that defendant authorized or appeared to authorize the manufacturer to act on its behalf. ii) Apparent manufacturer theory: defendant could not have been liable where it was not the seller or distributor iii) Concerted tortious theory: no evidence that defendant and manufacturer agreed to commit a tortious act or that defendant provided substantial assistance/encouragement to the manufacturer to act tortiously. 5) Walkovsky v. Carlton (SH of NY cab corporations and tort claimant) (NY 1966): a) Defendant was SH of 10 corporations, each of which had two cabs registered in its name and carried the minimum auto insurance required by law. Although independent of one another, the corporations were alleged to have operated as a single enterprise. b) Vertical piercing (up to Carlton); horizontal piercing (to all the other corporations) c) Plaintiff needs to prove that all the cab corporations were all agents of each other, and that Seon Corp. and Carlton were one entity. She also has to demonstrate that Seon was undercapitalized and that Carlton created the other corporations to pad his liability. d) Courts will pierce the corporate veil whenever necessary to prevent fraud or to achieve equity. e) But the corporate form will not be disregarded merely b/c the assets of the corporation and the mandatory insurance coverage of the cab that hit the plaintiff are insufficient to assure her the recovery she sought. f) Plaintiff relied on the WRONG THEORY she relied on fraud, not agency. If it is not fraudulent for the owner-operator of a single cab corporation to take out only the minimum required liability insurance, the enterprise does NOT become fraudulent merely b/c it consists of many such corporations. g) Bottom line: its not sufficient just to say that a SH set up a corporation to avoid personal liability. 6) Minton v. Cavaney (CA 1961): a) Defendant Cavaney admitted in interrogatories before his death that the corporation was duly organized but never functioned as a corporation. It is also undisputed that there was no attempt to provide adequate capitalization, and Cavaney was also treasurer, secretary, director, and equitable owner, and actively participated in the conduct of the business. b) HOWEVER, Cavaney or his estate CANNOT BE HELD LIABLE for the debts of the corporation b/c he WASNT A PARTY TO THE ORIGINAL ACTION and the judgment in that action is not binding upon him unless he controlled the litigation leading to the judgment. 7) Arnold v. Browne (CA 1975): evidence of inadequate capitalization is at best just one factor to be considered by a court in deciding whether or not to pierce the corporate veil. BUT 8) Slottow Bank v. American Casualty Co. (9th Cir. 1993): in CA, inadequate capitalization of a sub may alone be a basis for holding the parent liable for acts of the sub. 9) Radaszewski v. Telecom Corp. (8th Cir. 1992) (insurance might be enough): a) Collet test: i) In order to pierce, plaintiff must show, inter alia: ii) That the defendants control of a sub has been used by the defendant to commit a fraud or wrong, or iii) To perpetrate the violation of a statutory or other positive legal duty, or iv) Dishonest or unjust act in contravention of plaintiffs legal rights. b) But if the sub is financially responsible, whether by insurance or otherwise, the policy behind this test is met. 10) Sea-Land Services v. Pepper Source (7th Cir. 1993): a) SL sought to pierce PSs corporate veil and make Marchese personally liable for the judgment

17 owed to SL, and then reverse-pierce Marcheses many other corporations so that they would also be on the hook. SL alleged that all the corporations were alter-egos of each other. b) ILs 4-factor test: there must be such unity of interest and ownership that the separate personalities of the corporation and the individual or other corporation no longer exist i) Failure to maintain corporate records or comply with corporate formalities ii) Commingling of funds/assets iii) Undercapitalization iv) One corporation treating the assets of another corporation as its own c) Circumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice. d) The test was clearly satisfied here piercing is warranted: i) None of Marcheses corporations even held a single corporate meeting ii) The corporations borrowed money from each other, which left PS totally undercapitalized iii) Marchese used the corporate bank accts. to pay for all kinds of personal expenses iv) Marchese and his corporations were unjustly enriched, and Marchese used the corporate entities as playthings to avoid his responsibilities to creditors v) Marchese was the dominant force behind all the corporations and was responsible for the manipulation and diversion of corporate funds. 11) Kinney Shoe Corp. v. Polan (4th Cir.) (adds a stipulation for contract creditors): a) WVs test is substantially similar to the tests above, but this is added: i) For contract creditors (like banks) capable of protecting themselves (permissive and not mandatory): if, based on an investigation, the corporation is grossly undercapitalized, and the institution still lends to the corporation, the party will be deemed to have assumed the risk of the gross undercapitalization and will NOT be permitted to pierce the corporate veil. 12) Direct Liability: a) Parent is sought to be held liable WITHOUT piercing the subs veil, on the ground that the parent directed the subs operations, or a relevant portion of those operations, and is therefore DIRECTLY liable as a primary wrongdoer for wrongs that were committed in the course of those operations. See US v. Bestfoods (US 1998). 13) Equitable Subordination of SH Claims: a) Its unfair for insider creditors to stand in parity with other creditors. b) When a corporation is in bankruptcy or receivership, creditors invoke this theory, asking the court to order SHs in their capacity as creditors to go to the end of the line. The test is similar to that of piercing the corporate veil. i) More limited than piercing: (1) SHs lose all of their contribution to the corporation but not their personal assets ii) But also easier than piercing ULTRA VIRES 1) Transactions outside the corporate entity sphere; were characterized as unenforceable against the corporation b/c beyond the corporations powers, and unenforceable by the corporation b/c of lack of mutuality. 2) Powers and Purposes: a) In theory, ultra vires was applicable for two questions: i) Whether a corporation had acted beyond its purposes (had engaged in a type of business activity not permitted under its certificate) ii) Whether the corporation had exercised a power not specified in its certificate. 3) Ultra vires was always regarded as unsound: a) Even in early cases, corporate powers could be implied as well as explicit

18 b) Ultra vires was NOT a defense to corporate tort/criminal liability c) It also could NOT be used to reverse completed transactions d) Regarding part performance: i) Majority view: nonperforming party, having received a benefit under the contract, was ESTOPPED from asserting the ultra vires defense ii) Minority view (federal view): part performance did NOT have an estoppel effect; performing party was permitted to recover in restitution e) Ultra vires comes up very infrequently today b/c incorporation is much easier, but it sometimes still comes up. f) Modern statutes explicitly empower corporations to make guarantees and become partners. 4) NY ultra vires: a) Goodman v. Ladd Estate Co. (OR 1967): i) Plaintiffs are recent SHs of Westover. Wheatley, a director of Westover, took out a loan. The bank wanted a guarantee. The original guarantor was Ladd, but it would only do it if Westover guaranteed it. But Westover couldnt. The plaintiffs are trying to stop Westover from having to pay Ladd. ii) Theyre saying the loan was ultra vires this loan had no business reason. iii) ORs ultra vires statute is very similar to NYs 203: the use of ultra vires is not valid UNLESS the action is inequitable, in which case a SH can enjoin it. iv) But the plaintiffs lost b/c they argued that the mere fact it was ultra vires made it inequitable. But this makes the statute superfluous. Ultra vires does NOT equal inequitable. Something more has to be present, like collusion or something, to make it inequitable. v) Also, if there are dirty hands (if a SH participated in the ultra vires act), he cannot thereafter attack it as ultra vires. 5) DE ultra vires: a) Inter-Continental Corp. v. Moody (TX 1966): i) Ultra vires defense was barred under the TX statute (which is like the DE statute), even if the 3rd party actually knew that the corporation lacked authority to enter into the transaction. ii) However, a SH can enjoin an ultra vires act even if he has been solicited to do so by the corporation, if the SH is NOT the corporations agent. 6) Corporate Responsibility a) Dodge v. Ford Motor Co. (MI 1919) (not characterized as an ultra vires case, but the underlying principle is there): i) Henry Ford stopped paying meaty dividends to SHs; plaintiffs are upset b/c theyre not getting paid. Ford instead mandated that money be reinvested in the corporation, so it could be kept within the company. Ford also wanted to improve production and reduce the price of autos. He wanted to be a nice guy and give back to society. ii) The court sides with the plaintiffs. iii) A board cannot conduct the affairs of a corporation for the merely incidental benefit of SHs and for the primary purpose of benefiting others; primary purpose of a corporation should be to benefit the SHs and make sure they get paid. iv) So what role does a corporation have in society? Should it look beyond the SH constituency? Does a corporation have a responsibility to those other than SHs? (1) NYBCL 717(b): suggests that directors can look beyond SHs when making decisions. (a) This may seem altruistic, but there is a cynical reason: It was passed in the 80s to protect mgmt who were afraid of hostile takeovers by giving mgmt the opportunity

19 to cite non-SH constituencies in their business decisions. v) How could Ford have won this case? (1) By saying that lowering the prices could have helped the company, good-will argument of broadening consumer base. (2) By saying that lowering prices would expand the market and sell more cars which in turn will result in more profits and hence benefit to SHs. b) A.P. Smith Mfg. Co. v. Barlow (NJ 1953) (charitable contribution to Princeton Univ.): i) SHs contend that the cert of incorporation does not authorize the contribution to the university and the company does not have the common-law power to make it. ii) That the NJ statutes which authorize the contribution may not be applied to the corporation, which was created long before their enactment. iii) Court held that the corporations contribution was valid. The SHs should not be allowed to disregard long-term modern obligations to the rest of society. iv) In NY: NYBCL 110 Reservation of Powers statute: changes in legislation apply retroactively. c) Modern statutes (like DEs): Donations should be reasonable in amount, bear some reasonable relation to the corporations interest, and not be so remote as to arouse the SHs opposition. Direct corporate benefit is not necessary, but corporate interest should still be a motive. d) Standard modern view: ALI Section 201: Supports charitable contributions OBJECTIVES OF CORPORATION/NATURE OF CORPORATE LAW 1) Theory of the Firm: a) Coase: activities will be included within a firm when costs of using markets (contracts) exceed the costs of direction by authority. b) Alchian and Demsetz: disagree with Coase; emphasized the role of team production within the firm and the role of agreement and monitoring in team production. c) Jensen and Meckling (Law and Economics approach dominant theory today): most organizations are simply legal fictions which serve as a nexus for a set of contracting relationships among individuals. i) Contracts = reciprocal arrangements d) Dual Nature of the Firm: i) Firms exist in part when the cost of inducing action through giving directions is LESS than that of inducing action through making real contracts ii) Firms are a combo of bureaucratic hierarchies and a set of reciprocal arrangements. PUBLICLY HELD CORPORATIONS 1) Shareholdership in Publicly Held Corporations a) Berle & Means: publicly held corporations divorced control from ownership; b/c ownership is highly dispersed, SHs may own the corporations, but managers end up controlling it. b) This poses a collective-action problem b/c: i) If all SHs in a corporation own only very small percentages of the corporations stock, then they will be rationally apathetic why should they care, b/c they have such a small stake in it. ii) This also leads to proxy contests, which lead to more control for mgmt, for whom the costs of voting are very low, almost nonexistent. c) But the pattern of shareholdings has evolved from highly dispersed to partially concentrated, b/c of institutional investors. i) Like private and public pension plans, banks, insurance companies, investment companies,

20 and foundations (universities and churches) ii) B/c of institutional investors, shareholdings have become increasingly concentrated, leading to improved coordination between SHs. However, their role is still affected by various forces: (1) Social forces: conflicts of interest: the Wall Street Rule: Old cultural norm against voting against mgmt; if you dont like them, sell, dont vote against them. (2) Legal forces: (a) The DOL and ERISAs fiduciary provisions (i) a private pension plan trustee must make voting decisions seriously and cannot follow the Wall Street Rule. iii) The shift from SH passivity to activity: (1) Led by public pension funds use of the indexing strategy (mimics the market in the sense that the fund contains the same proportion of each equity on a given market as does the market itself). (a) Under indexation, an institutional SH who doesnt like corporate mgmt cant just sell and therefore has an incentive to be active in voting and monitoring. (i) Ideas behind indexing: efficient capital markets hypothesis (see above) and diversification. (2) Constraints on institutional investors activity: (a) Limited holdings: they should have a diversified portfolio and are forbidden from holding more than a fixed % of stock of a given corporation (i) Leads to freeriding: I.Is arent likely to engage in monitoring or voting that: 1. Goes beyond that which the investor can be expected to engage in during the normal course of its shareholding capacity 2. Would require significant expenditures 3. Increases the value of the investors holding by LESS than the costs of the activity 4. Would result in no economic benefit besides the increased value of that holding (ii) But these conditions frequently arent satisfied b/c: 1. Voting requires little effort 2. One vote can kill more than one bird 3. Unless the investor indexes, it must monitor its portfolio companies anyway 4. The costs of being an SH has dropped 5. If a voting decision has an obvious and dramatic effect on the value of a stock then beyond-the-normal-course voting activity will often be costjustified 6. It may be more cost-effective to vote than to sell. 7. ERISA requires I.Is to vote in a way that maximizes the value of their shares (only true for defined benefit plans, not defined contribution plans, which are much more common) iv) Areas in which I.Is can play a meaningful role: (1) They can assess the corporations governance structure (2) They can assess proposed structural changes like mergers (3) They can meaningfully assess overall management performance (4) They may play a role in corporate business and policy and in the dismissal of CEOs v) Forms of institutional involvement: (1) Voting (2) Making proposals about the structure or rules of corporate governance

21 (3) Electing representatives of institutional investors as directors (4) Consulting with mgmt (a) Possibly the most effective, but theres a relationship between voting and consulting the threat that an I.I will bring an issue to vote is an incentive for mgrs to take their concerns seriously during consultation. SECURITIES REGULATION OVERVIEW 1) The 34 Act: a) Aims to protect investors. b) Created the SEC and gave it the power the register, regulate, and oversee brokerage firms, transfer agents, clearing agencies, and the SROs. c) Identifies and prohibits certain types of conduct in the markets and provides the SEC with disciplinary powers over regulated entities and persons. d) Empowers the SEC to require periodic reporting of info by companies with publicly traded securities. e) Requires full disclosure (mostly of financial information) in registration statements, forms, and prospectuses so investors can learn about the new company. Liability attaches to failure to fully disclose. f) Corporate Reporting: companies with more than $10M in assets whose securities are held by more than 500 owners must file annual and other periodic reports, which are available to the public. i) Annual 10-K: includes audited financial statements, managements discussion of the corporations financial condition and results of operations, disclosure regarding legal proceedings, executive compensation, conflict of interest transactions, etc. ii) Quarterly 10-Q: financial data prepared in accordance with GAAP; mgmts report, legal proceedings, defaults on senior securities iii) 8-K within 4 business days after the occurrence of certain specified events: (1) Change in control of the corporation (2) Acquisition/disposition of a significant amount of assets (3) Change of accountants (4) Termination of material definite agreements (5) Departure of a director or principal officers (6) Amendments to articles or bylaws (7) Amendments to corporations code of ethics (8) Waivers of a provision of the corporations code of ethics 2) The Underwriting Process a) Firm commitment: assures the issuer of a specified amount of money at a certain time and shifts the risk of the market to the investment bankers b) Best-efforts: i) Companies that are not well established might not be able to find an underwriter that will give a firm commitment and assume the risk of distribution. Therefore, they customarily distribute their securities thru firms that merely undertake to use their best efforts. ii) Companies that are well-established might use these underwriters to save distribution costs. c) Companies could also forego underwriting and do a dutch auction to avoid the underwriting costs. INTRO TO MERGERS AND ACQUISITIONS 1) The policy behind M&A: a) To increase the overall value of the firm: Company A is worth 3 and company B is worth 2. A

22 should acquire B only if AB will be worth more than 5. If AB is worth 6 or more, then A should acquire. b) Merger or Consolidation: i) Statutory merger: (1) B merges into A. B loses its existence. The board and SHs of both companies need to approve the merger. (2) Full disclosure required. (3) Statutory mergers are rare. ii) Consolidation: (1) Both A and B merge into new company C. (2) A and B both lose their separate existence. (3) Happens when both A and B have significant identities and want to combine to form a new company iii) Triangular merger: (1) A forms a wholly owned sub, A1. B merges into A1. B SHs receive A stock in exchange for their B shares. Shares of A1 owned by A are unaffected. (2) Used when A wishes to keep the assets acquired from B in a separate corporation. (3) One common reason is that B is in a business fundamentally different from A; when you dont want to consolidate the assets, liability, and income from A with those of the newly acquired business for financial reporting purposes. (4) Bs SHs vote, and A1s SHs vote. As SHs lose the right to vote. iv) Reverse triangular merger: (1) Assume that it is critical that the corporate entity of B remain intact. (2) A has a sub, A1. A1 merges into B. (3) Shares of A1 (all owned by A) will be converted into shares of B. (4) Shares of B outstanding before the merger will be converted into shares of A. c) Sale of Assets: i) Assets for cash or debt securities: (1) In the end, there are still two corporations (2) A has the assets of both A and B; B has cash or debt securities. ii) Assets for stock: (1) B transfers substantially all of its assets in exchange for shares of A stock (usually common or voting stock preferred). Two options thereafter: (a) B remains alive as a holding company A owns the assets of both corporations, B is an SH of A. (b) B is liquidated and the shares of A are distributed to the B SHs in liquidation, d) A acquires the stock of B: i) B is NOT a publicly held company: (1) A negotiates with the B SHs. Depending upon the consideration from A, the former B SHs have either cash or A stock or other A securities. (2) After the deal, B is a sub of A. ii) B is a publicly held company: (1) Tender Offer: (a) A publishes an offer to the SHs of B to purchase their shares of B. A must comply with the Williams Act, and 14(d-f) of the 34 Act. (2) A offers its own shares or debt securities to B SHs. (3) Whichever course is taken, B ends up being a sub of A. iii) Tender offers dont really happen nowadays. A usually threatens a proxy fight to get rid of Bs directors and then get friendly B directors to conduct the sale. Also b/c of Poison Pills

23 and White Knights. ALLOCATION OF POWER AND INTRO TO MONITORING 1) SHs Power a) SHs elect the board of directors. They also vote on mergers, amendments of bylaws and the cert. of incorporations, and dissolution of the corporation. b) Although they are owners, they dont have a lot of voice 2) Removal of Directors a) Removal by SHs i) SHs CAN remove a director FOR CAUSE, even in the absence of a statute that so provides. ii) SHs CANNOT remove a director WITHOUT CAUSE, in the absence of SPECIFIC authority to do so under the statute, the cert of incorporation, or the by-laws. b) Removal by the Board i) In the absence of a statute, the board CANNOT remove a director, with or without cause. ii) Whether the cert of incorporation could change this rule is uncertain a few statutes allow removal of directors with cause if the cert so provides. c) Removal by the Court i) Cases are split on whether a court can remove directors for cause ii) Some statutes permit removal for specified reasons such as fraudulent/dishonest acts. 3) Charlestown Boot v. Dunmore (NH 1880): a) Plaintiffs action in trying to vote someone who was not a director to help in the closing of its affairs, was inoperative and void. b) Statute says that the business of a dividend paying corporation shall be managed by the board of directors. The only limitation upon the judgment/discretion of the directors is such as the corporation, but its by-laws and votes, shall impose. c) If the whole corporation tries to exercise powers which by the charter are lodged elsewhere, its action shall be rendered void. d) There is no principal-agent relationship between SHs and directors, respectively. Thus, the SHs cannot force the directors to do anything. 4) Schnell v. Chris-Craft Indus. (DE 1971) (SH democracy): a) SHs sued to enjoin corporation from advancing the date of the annual SH meeting. Corporation claimed it was allowed to advance the date thru amendments to the DE business law. b) Although the bylaws and the statute lets the directors change the date, its not equitable to do so. By moving the meeting, the board is taking unilateral action without SHs approval to limit SHs right to vote. c) These were inequitable purposes, contrary to principles of corporate democracy. d) Inequitable actions would not be allowed to stand simply b/c they were permitted by law. e) The directors wanted to use their power to keep themselves in power. DE wants to protect the voting rights of the SHs. 5) The Monitoring Model (almost universally adopted by large publicly held corporations): a) Mgmt function in publicly held corporations is exercised by the senior executives (not the board). b) Primary (though not exclusive) function of the board is to select, regularly evaluate, fix the compensation of, and, where appropriate, to replace the senior executives; to monitor the conduct of the corporations business to evaluate whether the business is being properly managed; and to review, and, where appropriate, approve, major corporate plans and policies. c) Effectuating the mgmt function requires that the board consist of at least a majority of directors who are INDEPENDENT of the senior executives. d) The limited role of the board is the result of critical constraints imposed by modern board

24 practices: i) Constraints of time (1) Board committees deal with special issues, not general corporate welfare (2) Publicly held corporations are far too complex to be managed by directors who are very much part-time. ii) Constraints of information (1) Distribution of info in corporation is highly asymmetrical; officers typically control the flow of info to the board. iii) Constraints of composition: (1) Number of seats on a board are usually held by insider directors, by the corporations own executives. 6) Auer v. Dressel (NY 1954): a) The directors of R. Hoe & Co. removed Joseph L. Auer as president. Class A stockholders had the power to elect nine of 11 directors. The bylaws required the president to call a special meeting when asked by a majority of stockholders entitled to vote at such a meeting, so over 55% of class A stockholders asked the new president to call a meeting. The new president refused to call the meeting claiming that none of the stated purposes for the meeting were proper for class A stockholders. b) Is it proper for the class A stockholders to call a meeting to vote on a resolution indorsing Auer to be reinstated as president? Yes. c) The shareholders have a right to express themselves, even if they cannot by the resolution actually effect the change. 7) General Datacomm Industries v. WI Investment Board (DE 1999): a) Defendant state investment board submitted a proposed bylaw to plaintiff corporation for consideration at its annual SH meeting. The bylaw would limit the right of plaintiffs board to reprice certain stock options. b) Plaintiff then sought to have the bylaw declared invalid b/c its cert of incorporation gave its board of directors the right to amend its bylaws, and to enjoin defendant from having its proposed bylaw adopted. c) Court found that b/c there was no guarantee that the bylaw would be adopted, and b/c plaintiff was not threatened by imminent, irreparable harm, and b/c the issues involved an unsettled area of law that was too important for a hasty decision, court DENIED plaintiffs motion. d) FN 2: Whats the point of giving SHs the right to amend bylaws and then the board having the right to remove them? BOARD AND OFFICER ACTIONS 1) Formalities Required for Action by the Board: a) Meetings: Directors can act only as a body. Usually, directors must act at a duly convened meeting at which a quorum is present. b) Notice: Formal notice is not required for a regular board meeting; if the meeting is a special one, notice of date, time, and place must be given to every director. c) Quorum: consists of a majority of the full board (a majority of the authorized number of directors, not simply a majority of the officers then in office). d) Voting: the affirmative cote of a majority of those present (not only of those voting) is required for action. e) Consequences of noncompliance (usually applies only to closely held corporations, where formalities are not followed; in publicly held corporations, failure to follow formalities will render board action ineffective). i) Unanimous explicit, but informal, approval: most modern courts would hold that explicit

25 but informal approval by all the directors is effective where a person who has contract with a corporate officer has been led to regard his transaction with the corporation as valid. (1) Modern statutory rule: board can act by written consent even without a meeting. f) Committees: rules governing board procedures are applicable to committees as well. 2) Authority of Corporate Officers a) President: i) Has apparent authority to bind his company to contracts in the USUAL and REGULAR course of business, but not to contracts of an EXTRAORDINARY nature. (1) What constitutes as extraordinary consider: (a) Economic magnitude of the action in relation to corporate assets and earnings (b) Extent of risk involved (c) Time span of the actions effect (d) Cost of reversing the action (2) Generally, any action that would make a significant chance in the structure of the business enterprise or in the structure of control over the enterprise. (3) Actual authority: found in the cert of incorporation, bylaws, or board resolutions; or derived from a pattern of past acquiescence by the board for boards ratification of a specific transaction. b) CEO, Chairman of the Board: often, one and the same person/title. c) VPs: unclear what apparent authority does d) Secretary: apparent authority to certify records of the corporation; other than that, close to nil. e) Treasurer: close to nil. f) Ratification: i) Even if an officer lacks both actual and apparent authority, the corporation may be bound by the officers act in entering into a contract or other transaction on its behalf, if the board later ratifies the officers act. ii) Ratification may occur where a corporation, knowing all of the facts, ACCEPTS and USES the PROCEEDS of an unauthorized contract executed on its behalf. 3) Mosell Realty Corp v. Schofield (VA 1945) (extraordinary matters outside the scope of a close corporations presidents apparent authority): a) Close corporation; directors were also SHs and officers. b) Court held that the corporation was not bound b/c the president lacked authority to enter into a contract to sell the corporations principal asset (real estate). c) The presidents apparent authority extended to executing the necessary leases and to doing such things as were incidental thereto. d) The authority to sell the property was lodged in the board; the corporation could be bound only by a formal action of the board or by written consent of the SHs. e) Presidents authority insufficient b/c sale of the corporations major asset was considered to be an extraordinary matter and he did not have the apparent authority to sell. It was outside the usual course of business. DERIVATIVE AND CLASS ACTIONS 1) Derivative Suits: suit on behalf of the corporation against either corporate fiduciaries (directors, officers, management, etc.) or third persons who have committed wrongful acts that deplete or divert corporate assets and affect SHs by reducing the value of their shares. a) Extremely complex b) Social policy; cost/benefit analysis c) The derivative suit and disclosure requirements of the securities acts constitute the two major legal bulwarks against managerial self-dealing.

26 d) Many derivative actions will be won or lost on the basis of procedural issues that do not go to the merits of the case e) Derivative suits allow a representative SH to take over the litigation from recalcitrant mgrs and prosecute it on the behalf of the corporation. f) Though a concern, strike suits (suits brought just for the nuisance value and not truly motivated by the clients interests) are relatively uncommon. g) Settlements and attorneys fees in derivative suits have to be approved by the court. Has to do with the fact that theres no true plaintiff in derivative suits. 2) Who can bring a derivative suit? a) Contemporaneous Ownership Rule: Plaintiff must be an SH at the time the action is begun, and must remain an SH during the duration of the action. i) Exceptions to the rule: (1) Devolution: a non-contemporaneous owner can bring a derivative suit if his shares devolved upon him by operation of law, like in an inheritance. (2) Continuing-wrong theory: A plaintiff can bring a suit alleging a wrong that began before he acquired his shares, but continued thereafter; usually have to prove that he was an SH at the time of the transaction or any part of it. (3) 34 Act 16(b): suit may be brought by the owner of any security without qualification. b) SHs standing is lost if original corporation merges. Exceptions to this: i) Where the merger is subject to the claim that it was perpetrated merely to deprive SHs of the right to bring a derivative action and ii) Where the merger is in reality a reorganization that does not affect the plaintiffs ownership of the business enterprise. c) Creditors CANNOT bring derivative suits. i) However, if the corporation is insolvent (regardless whether it filed for bankruptcy), the directors owe fiduciary duties to the creditors. In such a case, the creditors can bring an action against directors for violation of those duties. ii) Banks and bank directors may owe a duty to creditors even while the corporation is solvent. d) Some statutes give officers or directors the right to bring a derivative action. e) The corporation MUST be a party to the derivative action. f) NYBCL 626: plaintiff in a derivative suit must be a holder of shares or of voting trust certificates or a beneficial interest in such shares or certificates. g) NYBCL 627: plaintiffs may have to post a bond/security; if they lose, that can be used to pay expenses for the other side. Not mandatory, but its there. Acts as a disincentive to bring frivolous suits. i) DE: does NOT require the posting of a bond. DE has an interest in the litigation being in DE, b/c it feeds the legal industry there. h) Where statutes are silent, courts normally define shareholdership very expansively: unregistered SHs will qualify, legal ownership is not required. 3) Personal Defenses: a) SHs are BARRED from bringing a derivative action if: i) She participated in the alleged wrong ii) She consented to the wrong or explicitly ratified it iii) She is guilty of laches (negligence or undue delay in asserting a legal right or privilege) iv) She acquiesced in the wrong by failing to object (not all cases, tho) b) Theory: plaintiff is estopped from bringing an action or lacks clean hands. c) Tainted share rule: if a SH is barred from bringing an action via a personal defense, so is any transferee of that SH. 4) Direct suits: personal suits brought by SHs for their losses due to corporate faults that

27 interfere with the rights that are traditionally viewed as either incident to ownership of stock, or inherent in the shares themselves. a) Tooley v. Donaldson, Lufkin, & Jenrette, Inc. (DE 2004) (does away with the special injury requirement): i) Plaintiff SHs alleged that members of the board breached their fiduciary duties by agreeing to a 22-day delay in closing a proposed merger. They argue that the suffered a special injury b/c they had an alleged contractual right to receive the merger consideration without suffering the 22-day delay arising out of the extensions under the merger agreement. ii) Court of Chancery: b/c the delay affected ALL SHs equally, plaintiffs injury was NOT a special injury, and this action is a derivative action at most and not a direct action. A special injury is a wrong that is separate and distinct from that suffered by other SHs. Lower court also found that plaintiffs could not bring a derivative action b/c they sold their shares and no longer had standing. iii) This court says: use of the special injury concept is not helpful. iv) How to determine whether a SHs claim is derivative or direct: (1) Who suffered the alleged harm the corporation or the individual SHs, and (2) Who would receive any recovery or other remedy, the corporation or the individual SHs? v) The SHs claimed direct injury must be INDEPENDENT of any alleged injury to the corporation. He must demonstrate that the duty breached was owed to the SH and that he can prevail without showing an injury to the corporation. vi) B/c a derivative suit is brought in behalf of the corporation, the recovery must go to the corporation. A SH who is directly injured, however, does retain the right to bring an individual action for injuries affecting his legal rights as an SH. vii) Here, there is NO DERIVATIVE CLAIM asserting injury to the corporation. There is no relief that would go to the corporation. But it doesnt necessarily follow that the complaint states a direct claim. It actually states no claim at all. Direct actions are procedurally preferred. Theyre also preferred as to avoid multiplicity of suits by each injured SH, to protect the corporate creditors, and to protect all the SHs since a corporate recovery benefits all equally. There are cases that could be either direct or derivative. A direct action is not precluded simply b/c the same facts could also give rise to a derivative action. a) For example: proxy rule violations: i) They can be a direct suit b/c it interferes with the SHs voting right ii) They can be a derivative suit b/c it involves mgmts fiduciary obligations. Pro rata recovery: each SH who is entitled to participate in a pro rata recovery gets a share of the recovery equal to her percentage ownership of stock. a) Cases in which pro rata recovery is decreed: i) To prevent wrongdoers from sharing in the recovery, which might happen if the recovery went back to the corporate treasury ii) Where most of the SHs are subject to personal defenses iii) Injured corporation has been merged iv) Residual cases The Demand Requirement in Derivative Actions a) Reasons for demand: i) Deter strike suits ii) Sometimes the board can cure harm without litigation iii) BJR courts shouldnt decide whats best for the corporation iv) Deter harassment by frivolous litigation

5) 6)

7)

8)

28 b) Problems with Demand: i) If the board is tainted, it may dismiss an action that is in the best interests of the corporation. ii) Derivative suits are more than just about cost-benefit they aim to deter wrongful conduct. c) If a majority of the directors are DISINTERESTED AND INDEPENDENT, a plaintiff has to make demand. d) If the board is TAINTED (a majority is not disinterested or independent), then demand can be excused. In this case, the tainted board then sets up an SLC to investigate whether or not the suit would be in the best interests of the corporation (apply Zapata in this case if DE law applies). e) To Bring a Derivative Suit, a plaintiff must show either: i) She made demand to the board, or ii) Demand is excused (demand is futile) must set out reasons for not seeking demand (1) Futility tests: (a) DE Approach: (i) Plaintiff has burden of proof (ii) Must plead with PARTICULARITY that 1. There was reasonable doubt either a. Majority of directors were NOT disinterested (including independent directors not effectively controlled by interested directors), or b. That the transaction was NOT a result of valid business judgment (b) NY approach: Marx v. Akers (derivative suit alleging overcompensated directors during hard times at IBM) (i) NYBCL 626(c): in any SHs derivative action, the complaint shall set forth with particularity the efforts of the plaintiff to secure the initiation of such action by the board or the reasons for not making such effort. (ii) Demand would be futile if a complaint alleges with PARTICULARITY that 1. Majority of directors were NOT disinterested/NOT independent, or 2. Directors failed to be reasonably informed about the transaction, or 3. Directors failed to exercise BJ when approving transaction. (iii) NY rejects DEs reasonable doubt standard as too subjective. (iv)Not sufficient merely to name a majority of the directors as parties defendant with the conclusory allegation of wrongdoing or control of wrongdoers. (c) Universal Demand (ALI): demand must always be made f) Zapata Corp. v. Maldonado (DE 1981): i) Company lost a tax break company was harmed so plaintiff brings a duty of loyalty suit. ii) Plaintiff argues duty of loyalty (self-dealing). Demand was excused; this goes to litigation. iii) A special litigation committee (SLC) was set up 2 new directors on the committee hired lawyers and investigated. It was decided that litigation was not a good idea. iv) DE Approach only applicable in SLC situations (1) Ask whether the directors are acting in good faith, whether they are independent, and whether they did a good investigation (burden is on directors) (2) Court applies its own independent business judgment of whether the litigation is good or bad. g) Example: i) You have a board of 10 directors, 6 of which are interested and 4 of which are disinterested. Majority of directors are not disinterested. Demand is excused, go ahead and file the suit. Apply the Zapata test. ii) If 6 are disinterested, and 4 are interested, you have to make demand. Dont apply Zapata

29 test. h) Demand on SHs i) Not the law in DE, but other states have this to bet SH vote approval of derivative suits. SHAREHOLDER MEETING AND INFORMATION 1) Formalities required for SH action: a) Meeting and notice: special meeting notice must state the purpose of the meeting. i) Special meetings: held by the company or SHs prior to the annual meeting ii) Annual SH meeting: required by state law b) Quorum: a majority of the shares entitled to vote is necessary for a quorum, unless the cert of incorporation sets another figure. Lowest is 1/3. c) Voting i) Ordinary matters: affirmative vote of a majority is needed ii) Fundamental changes: like amendments to the cert of incorporation, merger, sale of large assets, and dissolution often requires 2/3 vote. iii) Election of directors: requires only a plurality vote; candidates who receive the most votes are elected iv) Written consent: typically permit SHs to act by written consent in lieu of a meeting. 2) SH Informational Rights Under State Law a) Saito v. McKesson HBOC, Inc. i) 4 SHs brought suit alleging breach of fiduciary duty, which was later dismissed b/c there wasnt enough in the complaint. They brought a derivative suit that the corporation was harmed. Lower court suggested that plaintiff could request more information to support the complaint. ii) Saito demanded inspection of corporate documents and records; he wants enough info to bring a derivative suit. iii) What are the limitations on a SHs statutory right to inspect corporate books and records? iv) Del. C. 220: enables SHs to investigate matters reasonably related to their interest as SHs including, among others, possible corporate wrongdoing. This includes documents prepped by 3rd parties and docs predating the SHs first investment in the corporation. v) DE common law: SH has the right to inspect for any proper purpose the corporations stock ledger, list of SHs, books and records. vi) Requirements: (1) SH has to state the purpose (2) Purpose has to be proper (reasonably related to such persons interest as an SH) (3) Inspection is limited to those books and records that are necessary and essential to accomplish the stated proper purpose. vii) The limitation: (1) The date on which an SH first acquired the corporations stock does NOT control the scope of records available under 220. If activities that occurred before the purchase date are reasonably related to the SHs interest as an SH, then the SH should be given access to records necessary to an understanding of those activities. If there is prior wrongdoing, you could argue that there is a continuing wrongdoing. Then bring a derivative suit. viii) The financial advisors documents: (1) The source of the docs and the manner in which they were obtained by the corporation have little or no bearing on an SHs inspection rights. The issue is whether the docs are necessary and essential to satisfy the SHs proper purpose.

30 ix) The HBOC documents (1) SHs of a parent corporation are NOT entitled to inspect a subs books and records, absent a showing of fraud or that a sub is in fact the mere alter ego of the parent. 3) SHs Inspection Rights a) Common law: i) SH acting in good faith has a right to examine the books and records at reasonable times. ii) Today, statutes that are more limited than the common law govern. b) What does proper mean? Determining the financial condition of the corporation and ascertaining the value of the SHs shares. c) If there are mixed purposes: if the primary purpose is proper, secondary purpose that might be improper is irrelevant. d) SH lists: easier to get than financial and business information. PROXY RULES 1) Definitions: a) Proxy holder: person authorized to vote shares on a SHs behalf b) Proxy form: written instrument in which such an authorization is embodied c) Proxy solicitation: process by which SHs are asked to give their proxies d) Proxy statement: a written statement sent to SHs as a means of proxy solicitation e) Proxy materials: proxy statement and proxy form. 2) Proxy Solicitations: a) 34 Act governs disclosure in proxy solicitation materials b) Solicitations must disclose all important facts concerning the issues on which holders are asked to vote. 3) Overview of Proxy Rules a) Reasons for proxies: i) SHs in publicly held corporations are often geographically dispersed ii) A given shareholding will normally represent only a small fraction of a SHs total wealth (his time is more efficiently used when he votes by proxy) b) 14a-2 provides that the proxy rules apply to every solicitation of a proxy with respect to securities registered pursuant to section 12 of the act, with certain exceptions (like if the total number of persons solicited is less than 10) 4) Types of required disclosure under the Proxy Rules: a) Transactional disclosure: i) 14a-9 antifraud regulation (1) requires full disclosure in connection with transactions that SHs are being asked to approve (2) proxy materials must be given to the SHs first before solicitation b) Periodic disclosure: i) requires certain forms of annual disclosure; ii) to be distinguished from the annual report on Form 10-K that the corporation must file with the SEC. 5) Proxy Fights: fights over how the SHs should vote a) Regulated by 14a-11 requires the filing of certain information by insurgent directors. b) Competing slate of directors; one side wants to put in new directors to shake up the company c) Fights over issues, like the Datacomm case d) Could be issue of corporate governance or an issue of social or political importance e) Fight to replace directors somebody wants to take over the company i) In order to make a hostile takeover, you cant make a tender offer anymore; you have to

31 have a proxy fight to change the directors. Once you get your directors in, then you make your tender offer. This then makes it a friendly takeover. 6) Private Actions Under the Proxy Rules a) J.I. Case Co. v. Borak (US 1964): An SH can bring a private action for violation of the Proxy Rules, although neither the 34 Act nor the Proxy rules themselves explicitly provide for such an action. b) Cort v. Ash (US 1975): In determining whether a private remedy is implicit in a statute not expressly providing one, these factors are relevant: i) Is the plaintiff one of the class for whose especial benefit the statute was enacted? ii) Is there any indication of explicit/implicit legislative intent to create or deny such a remedy? iii) Is it consistent with the spirit of the legislation to imply such a remedy for the plaintiff? iv) Is the cause of action one traditionally relegated to state law, in an area basically the States concern, so that it would be inappropriate to infer a cause of action based solely on federal law? (Federalism concerns) v) The Supreme Court looks more at legislative intent. c) Mills v. Electric Auto-Lite Co. (US 1970): i) Like Borak, the asserted wrong is that a merger was accomplished thru the use of a proxy statement that was materially false/misleading. ii) What causal relationship must be shown between such a statement and the merger to establish a cause of action based on the violation of the Act? iii) Section 14(a) declares it unlawful to solicit proxies in contravention of SEC rules, and SEC Rule 14a-9 prohibits solicitations containing any statement which is false/misleading with respect to any material fact, OR which omits to state any material fact necessary in order to make the statements therein not false or misleading. iv) Where the misstatement or omission in a proxy statement has been shown to be material, that determination itself undoubtedly embodies a conclusion that the defect was of such a character that it might have been considered important by a reasonable SH who was deciding how to vote. v) Where there has been a finding of materiality, an SH has sufficiently showed causation between the violation and the injury for which he seeks redress if he proves that the proxy solicitation itself, rather than the particular defect in the solicitation materials, was an ESSENTIAL LINK in the accomplishment of the transaction. d) TSC Industries v. Northway (US 1976): i) How to define materiality: (1) An omitted fact is material if there is a SUBSTANTIAL LIKELIHOOD that a reasonable SH would consider it important in deciding how to vote. There must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of info made available. e) VA Bankshares v. Sandberg (US 1991): i) A statement couched in conclusory or qualitative terms purporting to explain directors reasons for recommending corporate action can be materially misleading under 14a-9. ii) Under the TSC definition of materiality: there is no room to deny that a statement of belief by corporate directors about a recommended course of action, or an explanation of their reasons for recommending it, can take on the same importance referenced in the TSC Courts decision. Thus, statements of reasons, opinion, or belief are actionable. iii) Under 14(a), a plaintiff is permitted to prove a specific statement of reason knowingly false or misleadingly incomplete, even when stated in conclusory terms. However, the mere

32 disbelief or undisclosed motivation alone is insufficient to satisfy the element of fact that must be established under 14(a). iv) The difference between a merely misleading statement (possibly mixed in with true statements and thus not material) and one that is materially so: (1) If it would take a financial analyst to spot the tension between one and the other, whatever is misleading will remain materially so, and liability should follow. (2) Only when the inconsistency would exhaust the misleading conclusions capacity to influence the reasonable SH would a 14(a) action fail on the element of materiality. v) Here, evidence fell short of compelling the jury to find the materiality of the misleading statement neutralized. f) Where an SH seeks to set aside or enjoin a transaction approved by the SHs on the ground that the approval was solicited by a proxy statement that involved misstatements or omissions, all he needs to do to prove materiality is to prove causation. g) If a proxy statement is materially misleading or omits to state a material fact and a majority of SHs vote in favor of the action proposed by the proxy statement, does an SH who did NOT grant a proxy in reliance on the statement have standing under 14a-9? Yes. h) Standard of Fault: i) Gerstle v. Gamble-Skogmo (2d Cir. 1973): negligence is enough. ii) Adams v. Standard Knitting Mills, Inc. (6th Cir. 1980): scienter should be required iii) Shidler v. All American Life & Fin. Corp. (8th Cir. 1985): no strict liability iv) Supreme Court has NOT formally adopted a standard of fault for a 14a-9 action. v) Most circuits have adopted negligence as the standard. SHAREHOLDER PROPOSALS 1) 14a-8: provides opportunity for SHs holding a small amount of a companys securities to have their proposal present in the proxy materials with managements other proposals for a vote at an annual or special meeting of SHs. 2) 14a-8(i)(7) provides a basis for excluding a proposal that deals with a matter relating to the companys ordinary business operations. a) Proposals that relate to ordinary business matters but that focus on sufficiently significant social policy issues are NOT excludable. b) Proposals involving the management of the workforce, such as the hiring, promotion, and termination of employees relate to ordinary business matters. 3) Bright-line analysis to proposals concerning equity or cash compensation: a) May exclude proposals that relate to general employee cash compensation matters in reliance on 14(a)-8(i)(7). b) May NOT exclude proposals that concern only senior executive and director compensation in reliance on 14a-8(i)(7). 4) 14a-8(i)(7) submissions concerning proposals that relate to SH approval of equity compensation plans (stock options): a) Proposals that focus on equity compensation plans that may be used to compensate only senior executive officers and directors: may NOT be omitted from proxy materials b) Proposals that focus on equity compensation plans that may be used to compensate senior executive officers, directors, and the general workforce: i) No regard to dilutive effect: may be omitted from proxy materials ii) Would result in material dilution: may NOT be omitted c) Proposals that focus on equity compensation plans that may be used to compensate the general workforce only i) No regard to dilutive effect: may be omitted

33 ii) Would result in material dilution: may NOT be omitted. 5) No-Action Letters Interpreting 14a-8: a) No-action letter: states that if the SH proposal is omitted from the proxy statement, no action will be taken by the SEC (omission ok) b) Can also state that the proposal must be included, but still called a no-action letter. 6) Medical Committee for Human Rights v. SEC (DC Cir. 1970): a) SHs basically tried to tell company what they could or could not manufacture. But thats not allowed b/c its an ordinary business decision. b) Court sides with Medical Committee manufacturing napalm wasnt a good business decision. i) Political issue of manufacturing napalm: its something thats completely within Dows control. But the decision to make napalm actually harms the company. Directors seem to have been motivated by political reasons. 7) Amalgamated Clothing and Textile Workers v. Walmart Stores (2d Cir. 1995): a) Plaintiffs, a clothing and textiles union and three religious organizations, filed an application for an award of attorney's fees and costs against defendant, a large retail corporation, following the court's ruling enjoining the corporation from omitting plaintiffs' shareholder proposal from the company's proxy material for a shareholder's meeting. b) Plaintiffs conferred a substantial benefit on the shareholders of the corporation in vindicating the communication and voting rights of all of corporation shareholders. In light of the benefits conferred, the corporation's shareholders should share in the costs of this litigation by an assessment of plaintiffs' attorneys' fees and costs against the corporation. The fact that plaintiffs' proposal was tied to a general social grievance did not eliminate the possibility of fee shifting because all of the shareholders received a common benefit. c) Significant policy for the company cannot be excluded. d) Common benefit rule: where litigation has conferred a substantial benefit on the members of an ascertainable class. PROXY EXPENSES 1) Rosenfeld v. Fairchild Engine and Airplane Corp. (NY 1955): a) SHs derivative action where plaintiff sought to compel the return of funds paid out of the corporate treasury to reimburse both sides in a proxy contest for their expenses. b) Court held that since defendants acted in good faith in a contest over policy, they had the right to incur reasonable and proper expenses for the solicitation of proxies and in defense of their corporate policies. c) SHs have the right to reimburse successful contestants for reasonable and bona fide expenses incurred by them in any such policy contest, subject to court scrutiny. d) Management can get reimbursed for reasonable and proper proxy expenses. e) State law does very little to limit managements use of proxy expenses. 2) Who Pays for Proxy Fights? a) Generally, parties pay their own expenses. b) But when mgmt. uses their expenses, they use the corporations money. c) Existing directors are paid out of the corporate treasury. d) Under what conditions should they be paid? i) If the proxy contest is about policy mgmt has the right to use corporate money ii) If its about staying in power cannot use corporate money FIDUCIARY DUTY DUTY OF CARE 1) Duty of Care: have to act in a non-negligent manner; imposed to protect investors

34 2) Sliding Scale: a) At the top: Loyalty (self-dealing) i) Burden of proof is on defendant; both process and substance b) At the bottom: Care (mismanagement) i) Burden of proof is on the plaintiff to show that decisionmaking process was negligent or grossly negligent; just process ii) If plaintiff can carry the burden, burden then shifts to defendant to show that transaction was entirely fair. c) More scrutiny is applied as you go from care to loyalty. d) DE has created a third category between loyalty and care that applies in takeover situations (Unocal) a proportionality test. 3) NYBCL 717: Director shall perform his duties in good faith and with the degree of care which an ordinarily prudent person in a like situation would use under similar circumstances a) Elements: i) Negligence (gross negligence for DE) ii) Causation b) A director may be found grossly negligent if he violates these duties: i) Does not monitor the business ii) Fails to attend meetings iii) Fails to learn anything substantive about the corporations business iv) Fails to read financial statements v) Fails to get help when he sees that things are seriously wrong vi) Otherwise neglects to go through standard notions of diligent behavior 4) Francis v. United Jersey Bank (NJ 1981) (dead father; sons were stealing from corp; wife was found liable): a) Close corporation; family reinsurance business. Patriarch dies, wife and sons become directors (sons were probably directors before fathers death). Sons commit improprieties (stealing from the company), but the wife doesnt know. b) NY corporation, but NJ law applies b/c all parties are in NJ and all actions occurred in NJ. Usually, NY law would apply b/c thats the state of incorporation, but that wouldnt make much of a difference here b/c the laws are similar. c) Corporate directors are personally liable for violating their duty of care by failing to prevent wrongful acts by other corporate officers, if: i) They owed a duty to the victim ii) They were negligent in monitoring the other officers, and iii) Their negligence was the proximate cause of the injury. d) Lack of knowledge is no defense to the duty of care. e) In NJ, directors are immune from liability if, in good faith, they rely on the corporations legal counsel, independent public accountants reports, or internal reports approved by the chairman or CEO. f) Upon reviewing financial statements and finding improprieties, the director has a duty to object, and if that fails, to resign, seek legal advice about the actions, or even threaten suit. g) Greater action is required where the corporation is either large or publicly held, or engaged in business bearing on the public interest, like banking. h) Similar fiduciary duties are generally not owed to corporate creditors, unless i) The corporation is insolvent, or ii) The business and/or creditors are of a special class, involving an unusual degree of trust i) Here, plaintiffs business was a reinsurance brokerage, which is a special class of business b/c

35 of its banklike function and the unqualified trust and confidence reposed by client-insurers in entrusting brokers with payments meant for reinsurers. j) Test of proximate cause for negligent omissions: i) Determine what steps director should reasonably have taken, and whether those steps would have averted the loss. ii) Act/failure must be a SUBSTANTIAL FACTOR in producing the harm. k) Usually, directors absolve themselves from liability if they alert the other directors of the impropriety, vote against it, and resign if outvoted. l) Greater steps may be required if the corporation is insolvent or is in the special trust class. m) Law does not require that the report the impropriety, just that they resign and clean their hands. i) Pinto does not think this should be the rule for all family-run, close corporations. 5) The Business Judgment Rule (BJR): a) Kamin v. AmEx (NY 1976): i) Have directors violated their duty of care by ordering dividends which do not maximize tax savings? No. ii) Neglect as mentioned in DEs statute refers to neglect of duties malfeasance or nonfeasance NOT negligent misjudgment. iii) DEs BJR: Corporate directors decisions on dividends are NOT actionable as breaches of care without fraud, self-dealing, bad faith, or oppression. The manner and amount of distributions is exclusively a matter of business judgment for the directors. iv) BJR does not cover nonfeasance, only decisions. v) Here, even if the directors decision imprudently lost tax advantages, this imprudence is NOT actionable absent bad faith, which was not alleged here. vi) Directors of DE-incorporated businesses are rarely found liable for the consequences of their mistaken judgments, IF those judgments were taken in good faith and upon reasonable deliberation. vii) Protects corporate decisionmaking; courts should not be making business decisions. b) Smith v. Van Gorkom (DE 1985): i) TransUnion was trading for $39/share on the market. VG, on the verge or retirement, offered TransUnion to Pritzker for $55/share. But VG did not own all the shares of TransUnion, so he was not the owner, so to speak. Pritzker wanted the option to buy a million shares at $39/share. Since he doesnt own the company, VG has to go to the shareholders. At the 2-hour meeting, senior management doesnt like the idea and they threaten to resign. There wasnt any valuation. There was no copy of the agreement. But to shareholders, the sale of the company for $55/share looked awesome. ii) Have corporate directors who sell the corporation without determining its true value breached their duty of care? Yes. iii) A properly informed decision is one where directors inform themselves of all material information reasonably available to them, and directors are liable ONLY if grossly negligent. iv) Here, directors were grossly negligent in approving the initial LBO agreement b/c they (1) Did not examine defendant VGs role in negotiating and pricing the sale (2) Never calculated target corporation TransUnions intrinsic value, (3) Adopted their decision after only 2 hrs consideration, w/o prior notice and w/o any need for rush, (4) Replied solely on VGs presentation without examining the documents.

36 v) Directors cannot assume that when they are about to sell a corporation, any price above the current market price is necessarily fair. vi) A proper company valuation does not necessarily require external valuations or an IBankers fairness opinion, but it requires at least some study. vii) Here, both TransUnions directors and VG were grossly negligent in initially approving the LBO agreement and approving the LBO revisions without reading them. viii) In practice, this case has driven almost all directors to commission an independent IBankers valuation and fairness opinion prior to selling the corporation to shield themselves from liability. c) DE 102(b)(7) and NYBCL 402(b): i) Limits personal liability for breach of duty of care, but NOT bad faith or intentional wrong. ii) Can amend cert of incorporation (by a majority vote) to write off the duty of care the cost of litigation is not worth it, even if the directors are grossly negligent. iii) All states have enacted some kind of statute like this. iv) As a result, its almost impossible to bring an action on breach of duty of care today. v) In order to bring such an action, plaintiff has to plead bad faith. vi) If plaintiffs can plead well-pleaded facts that only suggest a duty of care case, then the case will be dismissed. But if the complaint can also allege enough facts to show a possible duty of loyalty or bad faith claim, then the case goes forward and 102(b)(7) becomes an affirmative defense, in which case the defendant bears the burden of establishing that theyre protected by the statute. vii) Net effect: pure duty of care cases youre out of luck b/c most publicly traded corporations have this provision in their charter. But you may proceed on a bad faith or loyalty claim. d) In re The Walt Disney Co. Derivative Litigation (DE 2003): i) SHs brought a derivative action against defendant Walt Disney Co. for blindly approving the hiring of a new president and his subsequent non-fault termination (golden parachute for shitty president). ii) Must the plaintiff SHs complaint for breach of fiduciary duties be dismissed based on the corporate limitation of director liability or the BJR? No. iii) The directors failed to exercise ANY business judgment in good faith. As such, the BJR does NOT relieve the directors of liability for their actions. iv) Directors owe the corporation and their SHs a duty of good faith. v) While the BJR protects directors when making a well-informed, reasoned decision, it does not exempt them from the duty to investigate corporate activity and act in the corporations best interests. e) Duty of care cases are rare today. f) Bad Faith: falls between subjective bad intent and gross negligence; a conscious disregard of ones responsibility; somewhere between the duty of care and the duty of loyalty. 6) Duty to Ensure that the Corporation has Effective Internal Controls a) In re Caremark International Derivative Litigation (DE 1996): i) See facts on p. 37 of notes. ii) SH derivative actions filed alleging breach of duty of care. iii) The parties proposing settlement bear the burden of persuading the court that it is in fact fair and reasonable. iv) Plaintiff SHs claim that the directors allowed a situation to develop and continue which exposed the corporation to enormous legal liability and that in doing so they violated a duty to be active monitors of corporate performance. They do not claim either director self

37 dealing or loyalty-type problems. v) Graham v. Allis-Chalmers Mfg. (DE 1963): absent cause for suspicion the directors have no duty to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists. vi) Court narrowly interprets Graham: 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 companys behalf. vii) The settlement is fair and reasonable. Plaintiffs claim is weak. In order to show that the directors breached their duty of care by not adequately controlling Caremarks employees, plaintiffs must show: (1) Directors knew or should have known that violations of the law were occurring, and (2) That the directors took NO steps in a good faith effort to prevent or remedy the situation, and (3) That such failure proximately resulted in the losses complained of. viii) Only a sustained or systemic failure of the board to exercise oversight will establish the lack of good faith that is a necessary condition to liability. b) SOX: explicitly provides that officers of publicly traded companies must disclose their assessment of their internal controls and the accountants have to do so too. i) This is expensive for the companies, but the purpose is to prevent harm to investors. ii) Changes under SOX: (1) Lead partner has to be rotated every 5 years (2) Accountants report to audit committee now (all outsiders, not insiders) (3) Audit committee must set up a system for whistleblowers to come forward (4) CEO and CFO must certify documents (5) Committees must have independent directors (6) Market rule: the non-executive directors are required to meet without the inside directors so that they could talk (7) Most major stock option plans and major changes have to be approved by the SHs (preempted state law). c) Internal control: a process, effected by an entitys BoD, mgmt, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in 3 categories: 1) Effectiveness and efficiency of operations 2) Reliability in financial reporting 3) Compliance with applicable laws and regulations 4) Internal control over each of these consists of 5 interrelated components: a. The control environment b. Risk assessment c. Control activities d. Information and communication e. Monitoring 5) A system of internal control is effective only if all 5 components are operating effectively. The boards role is to use due care to assure itself that an internal control structure is in existence, is appropriate, and is effective. Its responsibility is NOT to ensure that specific controls are failsafe. d) Miller v. AT&T (3d Cir. 1974) (illegal acts dont fall within the BJR): i) Plaintiffs SHs brought a derivative action centering upon AT&Ts failure to collect a $1.5M debt from the DNC, which essentially amounted to AT&Ts making a contribution to the DNC in violation of a federal prohibition on corporate campaign spending.

38 ii) Where the decision not to collect a debt owed to the corporation is itself alleged to have been an illegal act, the BJR does not apply. iii) Roth v. Robertson (NY 1909): even though committed to benefit the corporation, illegal acts may amount to a breach of fiduciary duty in NY. iv) Abrams v. Allen (NY 1947): directors must be restrained from engaging in activities which are against public policy. v) Illegal activities are in a class by themselves. e) 2 types of statutes relevant to the criminal liability of officers/directors: i) Makes corporate managers criminally liable for unlawful corporate acts if the managers themselves performed or caused the performance of the act. (1) Example: People v. Film Recovery Systems (IL 1985) (employee who died of cyanide fumes; president, plant mgr., and plant foreman were found guilty of murder, but later pled guilty to lesser charges). ii) Responsible-Corporate-Officer doctrine: Makes managers criminally liable for the unlawful acts of employees over whom they have the power of control, even if that power was not exercised. (1) Example: US v. Park (US 1975) (CEO responsible for sanitary conditions even though he had subordinates who were supposed to oversee individual warehouses; his position and relationship were not too attenuated). (2) Limits on this doctrine: Meyer v. Holley (US 2003): arose under the FHA (a) Under traditional principles of agency law, person A is not vicariously liable for the acts of person B unless B was not only under or subject to As control, but acted FOR AND ON Bs behalf. Under these principles, an owner or officer of a corporation is usually not vicariously liable in those capacities b/c a corporate employee acts on behalf of the corporation, not an owner or an officer. INDEMNIFICATION 1) D&O liability insurance: technically indemnification insurance a) Includes corporate reimbursement and personal coverage b) All policies cover most liabilities arising in connection with claims based on a violation of the duty of care owed to the corporation, and many or most policies would normally cover liabilities for duties of care owed to the general public. c) Most policies exclude a variety of claims, however. d) Written on a claims-made basis, but sometimes have modifications. e) Enron & WorldCom: directors not allowed to pay settlements with insurance. 2) Indemnification in Duty of Care Suits a) Corporation is required to indemnify a director/officer when i) He is completely successful in defending the suit, and ii) When the corporation has bound itself to indemnify. b) NYBCL 722: i) Direct suit: corporation may indemnify D/O against judgments, fines, settlements, and reasonable expenses, if the D/O acted in good faith and in the interest of the corporation. ii) Derivative suit: corporation may indemnify D/O against amounts paid in settlement and reasonable expenses. No indemnification for settlement of a pending or threatened action or any matter to which the person was adjudged to be liable. DUTY OF LOYALTY 1) Self-dealing, corruption, lining ones own pockets; Burden of proof is on defendant; court looks at process and decisions, no 102(b)(7). This is where you want to be as a plaintiff. Its easier to

39 recover if you plead loyalty. 2) Examples: a) Directors/officers from one corporation being on both sides of a contract b) Having two corporations in which the interested directors hold shares enter a contract (Lewis v. SLE) c) Self-dealing, possibility of corruption 3) General rule by 1960: no transaction of a corporation with any or all of its directors was automatically voidable at the suit of an SH, whether there was a disinterested majority of the board or not; but that the courts would review such a contract and subject it to rigid and careful scrutiny, and would invalidate the contract it if was found to be unfair to the corporation. 4) Lewis v. SLE Inc. (2d Cir. 1980): a) Intra-family dispute over the management of two closely-held affiliated corporations. Plaintiff is Donald Lewis, a shareholder of SLE. LGT is affiliated with SLE. Defendants were Alan, Leon, and Richard, all brothers of Donald. b) Donald claims that his brothers wasted SLEs assets by causing SLE to lease business premises to LGT from 1966-1972 at an unreasonably low rental. c) Donald argued that the district court improperly put the burden of proving his claims of waste on him, and that since defendants failed to prove that the transactions in question were fair and reasonable, he was entitled to recover. Court agreed. d) NYBCL 713(b): a contract between a corporation and an entity in which its directors are interested may be set aside UNLESS the PROPONENT of the contract shall establish affirmatively that the contract or transaction was FAIR AND REASONABLE TO THE CORPORATION at the time it was approved by the board. Thus, when the transaction is challenged in a derivative action against the interested directors, THEY have the burden of proving that the transaction was fair and reasonable to the corporation. e) So, Richard, Alan, and Leon had the burden of proving the rent was fair and reasonable. They failed to carry their burden. f) The evidence essentially showed that they used SLEs assets to enrich LGT (the one they considered the real corporation) and themselves, to the detriment of SLE. 5) Analysis: a) Plaintiff sues for breach of duty of loyalty b) Defendant bears the burden of showing ENTIRE FAIRNESS (both substantive and procedural) i) Terms are fair; price is fair ii) Entering into the contract is in the corporations best interest (even if the terms are fair) iii) Entering into the contract as a reasonably informed decision c) Defendant claims full disclosure and disinterested director/SH approval i) Full disclosure: regarding the conflict of interest and material facts of the transaction ii) Disinterested directors: no pecuniary interest, no financial or family ties d) 4 Approaches: i) DE: burden shifts to plaintiff, uses BJR (must prove fraud or waste) ii) NY: burden shifts, but fairness is still an issue (plaintiff must prove unfairness) iii) Burden does not shift: defendant must prove fairness iv) ALI: burden shifts, and (1) With SH approval: BJR applies (2) With director approval: plaintiff must show that reasonable directors could not have concluded that the transaction was fair modified BJR, because courts look into the transaction (3) Regarding interested director transactions: contract is voided if not disclosed, even if it

40 was fair 6) Remedies for Violation of the Duty of Loyalty: a) Traditional remedy: restitution (either rescission or an accounting for the difference between the contract price and fair price). b) Legal sanctions for violation of the duty of loyalty are usually less severe than legal sanctions for duty of care. c) But in some cases, remedies for violation of duty of loyalty may make the director worse off than he was before the wrong. For example: i) Where the director sells property to the corporation at an unfairly high price, and the value of the property drops below its fair value at the time of the transaction, rescission may leave him worse off than if he had sold the property to a third party. ii) A director or officer who violates the duty of fair dealing may be required to repay the corporation any salary he earned during the relevant period in addition to making restitution of his wrongful gain. iii) Courts have also sometimes awarded punitive damages against the directors or officers who breached their duty of loyalty. iv) ALI: provides that a director or officer who violates the duty of fair dealing should normally be required to pay attorneys fees and other expenses incurred by the corporation in establishing the violation. 7) Procedural Fairness a) Talbot v. James (SC 1972): i) Talbot owns property in SC and James recommends that they pool their assets and build apartments on the property. They agreed to enter a K in which the Talbots would put their property in a corporation and James would receive 50% of the shares of the corporation in exchange for his work for them. James arranged for numerous things (listed on p. 620). Under statute, shares have to be issued for consideration, and past services are considered adequate consideration. James got the mortgage and entered into a construction contract with the company. He was on both sides of the transaction. There was a falling out between the Talbots and James and the Talbots bring an action for breach of fiduciary duty, alleging self-dealing (duty of loyalty; conflict of interest). ii) Courts are willing to say that even if a contract is substantively fair, it will not pass muster unless it is also procedurally fair. 8) Rehashing of the NY and DE Rules for Duty of Loyalty a) NYBCL 713: i) Requires disclosure of all material facts as to the directors interest (more disclosure required than IAs statute) ii) 713(b) says that if 713(a) is not complied with, then the common law applies fairness has to be proven. iii) If 713(a) is proven: shifts the burden of proving unfairness to the plaintiff, but the fairness inquiry is still retained court can still look at substantive fairness if it wanted to. b) DE Courts (except the Supreme Court): i) If the statute is satisfied, BJR applies ii) Very hands-off; DE trusts the decisions of independent directors (whereas in NY and IA, theres less trust). iii) However, DE makes an exception for contracts with controlling SHs they will NOT apply the BJR to that kind of contract, even if approved by the independent directors. This is a change to the common law. 9) Cookies Food Products v. Lakes Warehouse (IA 1988): a) Herrig of Lakes Warehouse (defendant) agreed to distribute Cookies BBQ sauce. Cookies did

41 very well. L.D. Cook of Cookies then decided he wanted out and offered to sell his shares. Herrig ended up buying Cooks shares and became the controlling shareholder. He then replaced some of the board members. Cookies new board then approved a royalty fee to be paid to Herrig for a new taco sauce, the recipe of which he developed. b) This is a derivative suit brought by the minority shareholders of Cookies, a closely held corporation. Theyre suing for violation of duty of loyalty (possibly b/c they didnt get dividends the company is doing well, they cant sell their shares to anyone but Herrig, and theyre not getting their returns). c) IA statute (much like DEs statute): 3 sets of circumstances under which a director may engage in self-dealing without clearly violating the duty of loyalty: i) Disclosure to the board or committee which authorizes, approves, or ratifies the contract or transaction without counting the votes of such interested director. ii) Disclosed to the SHs entitled to vote on the transaction and they authorize the contract/transaction by vote or written consent. iii) Contract/transaction is fair and reasonable to the corporation. d) The court says that even if you get board or SH approval, you still have to prove fairness. e) Herrig wins in the end court says that Herrigs services were neither unfairly priced nor inconsistent with Cookies corporate interest. He did great for Cookies. 10) Effect of Approval by Disinterested Directors of Self-Interested Transactions a) Most states, including NY, have adopted a statute that deals with the effect of approval of disinterested directors of self-interested transactions. b) Many states require that approval of the disinterested directors be in good faith, and such requirement could be implied. The good faith requirement opens the door to judicial scrutiny of the fairness of self-interested transactions approved by disinterested directors. c) Many of the remaining statutes can be interpreted to change the common law rule that selfinterested transactions are voidable without regard to fairness, rather than to preclude review for fairness. d) DE, in contrast, holds that approval by fully informed disinterested directors or SHs permits the invocation of the BJR and limits judicial review to issues of gift or waste with the burden of proof upon the party attacking the transaction. e) It is widely believed that regardless of the form of the statute, outside of DE, approval by disinterested directors will not prevent a court from reviewing self-interested transactions for obvious unfairness. i) ALI: makes this rule explicit by adopting a test intermediate between the BJR and a fullfairness test in cases where self-interested transactions have been approved by disinterested directors. (1) Where there is an authorization by the disinterested directors, the complainant must show that disinterested directors could not have reasonably believed the transaction to be fair to the corporation. COMPENSATION AND WASTE 1) Waste: a) Entails an exchange of corporate assets for consideration so disproportionately small as to lie beyond the range at which any reasonable person might be willing to trade. b) Most often claim is associated with a transfer of corporate assets that serves no corporate purpose, or for which no consideration at all is received. In other words, a gift. c) BJR does not protect waste. d) SHs cannot ratify waste. e) If a plaintiff can allege and ultimately prove that a transaction is a waste, that its not protected

42 by the BJR, that SHs cannot ratify it, there might be liability. f) SH Ratification i) In addition to a claim that ratification was defective b/c of incomplete information or coercion, SH ratification is subject to a claim by a member of the class that the ratification is ineffectual b/c: (1) A majority of those affirming the transaction had a conflicting interest with respect to it, or (2) The transaction that was ratified constituted waste SHs cannot ratify waste except by a unanimous vote. ii) If its NOT waste, informed, uncoerced, disinterested SH ratification of a transaction in which corporate directors have a material conflict of interest has the effect of protecting the transaction from judicial review. 2) Compensation: a) BJR applies; courts do not think they are in the position to dictate how much executives should be paid. Theyre hoping that the markets, SHs, etc. will take care of it. But it doesnt seem to be taken care of. b) Generally, SHs bring derivative suits alleging waste of corporate assets by excessively compensating executives. c) But its very difficult for plaintiffs to show waste in a compensation case. DERIVATIVE SUITS THE DEMAND REQUIREMENT (INDEPENDENT DIRECTORS) 1) For demand futility tests, see above. 2) More on what Marx v. Akers (NY 1996) says: a) Directors are self-interested in a challenged transaction where they will receive a direct financial benefit from the transaction which is different from the benefit to SHs generally. b) A director who votes himself a raise in directors compensation is always interested b/c that person will receive a personal financial benefit from the transaction not shared in by SHs. c) But in this case, plaintiff did not allege enough to show waste. There were no factually-based allegations of wrongdoing or waste or fraud which would, if true, sustain a verdict in plaintiffs favor. CORPORATE OPPORTUNITY 1) Northeast Harbor Golf Club, Inc. v. Harris (ME 1995): a) Defendant Harris was the president of the corporation until she was asked to resign. The corporations major asset was the golf course. The adjacent property where the club had a right of way and easement was up for sale. The broker called the defendant thinking that the corporation would be interested in buying, but Harris instead bought the property under her own name. She informed the corporation, but it took no action. Harris also purchased other surrounding lands and told the board. The corporation took no action. b) Corporate Opportunity Doctrine i) Line of Business Test (DE test): (used by the trial court): If there is a business opportunity presented to the director or officer which the corporation is (1) financially able to undertake, and (2) is in the line of the corporations business, and (3) is one in which the corporation has an interest or reasonable expectancy, and the director/officer embraces the opportunity, he will be brought into conflict with the corporation. ii) The trial court did NOT find this to be a corporate opportunity b/c the corporation could not afford it and the corporations business was operating a golf course, not being a developer.

43 iii) ALI Test (adopted by this court): A director, officer, or senior executive may NOT take advantage of a corporate opportunity UNLESS: (1) The director first offers the corporate opportunity to the corporation and makes disclosure concerning the conflict of interest, AND (2) The corporate opportunity is REJECTED by the corporation, AND EITHER (a) The rejection of the opportunity is fair to the corporation, OR (b) The opportunity was rejected in advance, following such disclosure, by disinterested directors or in the case of a senior executive, by a disinterested superior, in a manner that satisfies the standards of the BJR, OR (c) The rejection is authorized in advance or ratified, following such disclosure, by disinterested SHs. (3) Definition of a corporate opportunity: (a) Any opportunity to engage in a business activity of which a director or senior executive becomes aware, either (i) In connection with the performance of functions as directors, or under circumstances that reasonably lead the director to believe that the person offering the opportunity expects it to be offered to the corporation, OR (ii) Through the use of corporation information or property, if the resulting opportunity is one that the director should reasonably be expected to believe would be interested to the corporation, OR (iii) Any opportunity to engage in business of which ONLY a senior executive becomes aware or knows is closely related to the business the corporation engages in or is expected to engage in. (4) Burden of Proof: (a) A party challenging the taking of the corporate opportunity has the burden of proof UNLESS the party proves that the requirements above are met; then the burden shifts to the director. (5) Ratification of defective disclosure: (a) A good faith but defective disclosure could be cured at any time if original rejection of the corporation is ratified. (6) Special rule concerning delayed offering of corporate opportunity: (a) Relief sought on failure to first offer an opportunity to the corporation is NOT AVAILABLE IF: (i) Such failure resulted from a good faith belief that business activities did not constitute corporate opportunity and (ii) A reasonable time after suit is filed has passed. c) In further proceedings, the court found that the two properties were corporate opportunities and Harris breached her fiduciary duties when she didnt offer it first to the corporation. 2) More on the Corporate Opportunity Doctrine a) Disputes over corporate opportunities usually occur in close corporations. b) Reasons business opportunities may be a corporate opportunity i) The director became aware of the opportunity through use of corporate property, corporate information, or directors corporate position ii) It is closely related to the corporations business. c) Ability of the corporation to take the opportunity: i) Courts are split to what extent this should be a directors defense. ii) Depends on the situation: (1) X offers a business opportunity to the corporation, the corporation rejected it and X thus takes the opportunity. Derivative action is filed and X offers defense that she didnt

44 take it until the corporation rejected it. Plaintiffs bring up the issue of fairness and reasonability of the boards rejection of the opportunity. Corporations inability to take the opportunity is relevant, b/c it may justify the boards rejection. (2) X does not offer the corporation the opportunity, but just takes it. Corporations inability to take the opportunity is not relevant and thus is NOT a defense. 3) Joint Ventures and the Corporate Opportunity Doctrine: a) Meinhard v. Salmon (NY 1928): i) A joint venture existed in which two partners pooled their money in order to lease a building for shops and offices. Defendant partner was more business-savvy and, in an effort to increase his wealth, he entered into an agreement with another businessman to purchase surrounding property as a leasehold estate. The specifics of this transaction were not disclosed to plaintiff partner. ii) Plaintiff claims that Salmon breached his duty of loyalty to him and that Salmon essentially took away the partnership opportunity. iii) Court held that at a minimum, Salmon had a duty to warn and disclose, giving Meinhard the opportunity to bid against him. (keep in mind that this was a partnership) iv) In DE, there is no disclosure requirement. This case seems to follow the ALI requirement. CONTROL MAJORITY DUTY TO MINORITY 1) Zahn v. Transamerica Corp. (3d Cir. 1947): a) There was Class A and Class B common stock; Class A stockholders got paid dividends of $3.20 every year, they had the right to convert from Class A to Class B at a ratio of 1:1, and upon liquidation, they were supposed to get a 2:1 ratio. Class B stockholders had the voting rights. b) Class A common SH class action suit c) Class A stockholders had been allowed to participate in the assets on liquidation of AxtonFisher and had received their respective shares of the assets, Zahn and the other Class A stockholders would have received $240 per share instead of $80. d) If Class A stockholders didnt get their dividends, they got voting rights. Class A stock had possessed equal voting rights with Class B stock since the beginning of 1937. e) On or about May 1944 Transamerica owned virtually all of the outstanding Class B stock of Axton-Fisher. f) The value of Axtons leaf tobacco had risen sharply unbeknownst to the public holders of Class A common stock, but known to Transamerica. g) Transamericas plan was to redeem class A stock, then liquidate. Basically gypping the class A stockholders. They then put their own directors on the board. h) DE law applies as to the extent of the breach (Transamerica was incorporated in DE place of the wrong; fiction imposed by the court) true back then, not really the law now. i) The majority has the right to control, but when it does so, it occupies a fiduciary relation toward the minority, as much so as the corporation itself or its officers and directors. j) The burden is on the director or SH not only to prove good faith of the transaction but also to show its inherent fairness from the viewpoint of the corporation and those interested therein. k) It was the intention of the framers of Axton-Fishers charter to require to board to act disinterestedly if that body called the Class A stock, and to make the call with a due regard for its fiduciary obligations. l) If the allegations of the complaint be proved, it follows that the directors of Axton-Fisher, the

45 instruments of Transamerica, have been derelict in that duty. Liability which flows from the dereliction must be imposed upon Transamerica which, under the allegations of the complaint, constituted the board of Axton-Fisher and controlled it. m) Zahn successfully stated a cause of action. 2) DE has been very rigorous in requiring full disclosure by controlling SHs when they deal with the minority: a) Lynch v. Vickers (DE 1977): majority SH owed a fiduciary duty that required complete candor in disclosing fully all the facts and circumstances surrounding the tender offer. b) Rosenblatt v. Getty Oil Co. (DE 1985): germane facts substituted by material facts and explicitly adopted the materiality test set out in TSC Industries v. Northway above. 3) In most, but not all cases, the target of a suit is the controlling SH and not the directors of the corporation in which the SH holds shares. 2 reasons for this: a) Controlling SH has deep pockets b) The corporations directors are not self-interested in the sense that the transactions between the corporation and the controlling SH will directly profit them; not a traditional conflict, just a positional conflict. 4) Sinclair Oil Corporation v. Levien (DE 1971) (in a parent-sub context): a) Sinclair owned about 97% of Sinvens (its sub) stock. Plaintiff owns about 3000 of 120,000 publicly held shares of Sinven. b) 3 transactions were alleged to be self-dealing (favorite of plaintiffs b/c defendant has burden of disproving it): i) Declaring dividends ii) Deprivation of corporate opportunity iii) Breach of contract. c) Lower court held Sinclair liable for all three. d) By reason of Sinclairs domination, it is clear that Sinclair owed Sinven a fiduciary duty. e) When the situation involves a parent and a subsidiary, with the parent controlling the transaction and fixing the terms, the test of intrinsic fairness, with its resulting shifting of the burden of proof, is applied. No BJR. The basic situation for the application of the rule is the one in which the parent has received a benefit to the exclusion and at the expense of the subsidiary. f) This standard will be applied only when the fiduciary duty is accompanied by self-dealing the situation when a parent is on both sides of a transaction with its subsidiary. Selfdealing occurs when the parent, by virtue of its domination of the subsidiary causes the subsidiary to act in such a way that the parent receives something from the subsidiary to the exclusion of, and detriment to, the minority stockholders of the subsidiary. g) Motives for causing the declaration of dividend payments are immaterial unless the plaintiff can show that the dividend payments resulted from improper motives and amounted to waste. The plaintiff contends only that the dividend payments drained Sinven of cash to such an extent that it was prevented from expanding. Thus, the dividend payments were not self-dealing on Sinclairs part. h) Plaintiff could not point to any opportunities that came to Sinven. Therefore, Sinclair did not usurp any business opportunities belonging to Sinven. i) Sinclairs act of contracting with its dominated subsidiary was self-dealing. Although a parent need not bind itself by a contract with its dominated subsidiary, Sinclair chose to operate in this manner. As Sinclair has received the benefits of this contract, so must it comply with the contractual duties. j) In a parent-sub context, plaintiff now has to show EXCLUSION and DETRIMENT for the duty of loyalty to apply.

46 SALE OF CONTROL 1) Zetlin v. Hanson Holdings, Inc. (NY 1979): a) Minority SHs are entitled to protection against abuse by controlling SHs. They are NOT entitled, however, to inhibit the legitimate interests of the other SHs. It is for this reason that control shares usually command a premium price. The premium is the added amount an investor is willing to pay for the privilege of directly influencing the corporations affairs. b) Its okay for controlling SHs to cash in on their control, aka sell their shares for a premium. 2) Equal Opportunity Rule: a) All SHs should have the opportunity to sell their shares for the same pro rata price b) Whenever a controlling SH sells his shares, every other holder of shares of the same class is entitled to have an equal opportunity to sell his shares, or a pro rata part of them, on substantially the same terms. c) But a pro rata rule has no inducements for the controlling SH to sell. d) The US doesnt really have an equal opportunity rule, unlike some nations in Europe, for example. 3) Tender Offers and the Williams Act: a) Modified Equal Opportunity Rule: i) If someone wants to make a tender offer, they have to comply with the Williams Act, which says that if you make a public tender offer, you are required to make the tender offer to all SHs at the same price, and all the SHs can buy on a pro rata basis. ii) Does not apply to non-tender offers. 4) Gerdes v. Reynolds (NY 1941): a) Defendants Reynoldses and Woodward were officers and directors of Reynolds Investing Company, a DE corporation known as an investment trust that invested in marketable securities (kinda like a mutual fund). The majority of the stock was owned by the Reynoldses. They sold their shares and resigned from the board. The new people came in and stole assets, thus driving the company into bankruptcy. The Reynoldses, of course, would just say we didnt know this was going to happen, its not our fault, etc. Plaintiffs were trustees of the company appointed in a bankruptcy proceeding. b) Liability is asserted against those who sold their stock and resigned as officers and directors upon the grounds i) That the sale of the stock with their resignations and the election of the successor board, was itself illegal b/c it violated fiduciary duties owed to the corporation and the holders of its debentures and preferred stock and its minority common SHs, and ii) That even if the transaction itself was not illegal, it was made so b/c the defendants negligently or in bad faith failed to properly investigate the purchaser or to give advance notice to the other SHs of an impending change of mgmt. c) Officers and directors always stand in a fiduciary relation to the corporation and to its SHs and creditors. Their right to resign is qualified by their fiduciary obligations to others. Neither can they accept pay in any form, direct or devious, for their own resignation or for the election of others in their place. d) Principal factors: i) Nature of the assets which are to pass into the possession and control of the purchasers by reason of the transaction ii) The method by which the transaction is to be consummated iii) The relation of the price paid to the value of the stock. e) Any reasonable person should know that they only reason someone would pay $2 for something thats worth 6 cents is so that they could steal. That would be the only reason

47 anyone would pay such a high premium. This hurts those who dont sell their shares. f) A fiduciary must be reasonably vigilant, and cant say that he didnt know what circumstances plainly showed or that his faith in people was such that obvious opportunities for wrongdoing gave him no inkling that wrongdoing might occur. g) This is an exception to the American rule: You can sell your shares, but not to looters. 5) Perlman v. Feldmann (2d Cir. 1955): a) Derivative action brought by minority stockholders of Newport Steel to compel accounting for and restitution of allegedly illegal gains which accrued to defendants as a result of the sale of their controlling interest in the corporation. Defendant Feldmann was dominant stockholder, chairman of the BoD, and president of the corporation. b) Both as a director and dominant SH, Feldmann stood in a fiduciary relationship to the corporation and to the minority SHs. c) Here, there was no fraud, no misuse of confidential information, no outright looting of a helpless corporation. But the actions of defendants in siphoning off for personal gain corporate advantages to be derived from a favorable market situation do not betoken the necessary undivided loyalty owed by the fiduciary to his principal. d) In a time of market shortage, where a call on a corporations produce commands an unusually large premium, a fiduciary may not appropriate to himself the value of this premium. Such personal gain at the expense of his coventurers seems particularly reprehensible when made by the trusted president and director of his company. e) To the extent that the price received by Feldmann and his codefendants included such a premium, he is accountable to the minority SHs. f) This case is more limited to the theft of a corporate opportunity (narrow reading, not the broader reading that says all such sales should be barred). 6) Brecher v. Gregg (NY 1975): a) Derivative action brought on behalf of LIN by Brecher, a minority SH. Gregg was founder, president, member of the BoD, and principal shareholder. Other defendants were directors. Saturday Evening Post bought Greggs shares. Purchase price was $1.26M more than market price. Brecher contends that Saturday Evening Post paid Gregg a premium for Greggs promise to resign immediately as president, bring about the election of Saturday Evening Posts nominee as his successor to the presidency, bring about the immediate election of three Saturday Evening Post nominees as directors, and ultimately bring about an absolute numerical majority of SEP nominees to the board. Plaintiff contends that the acceptance of this premium amounted to a sale of corporate office, and therefore was illegal. Plaintiff says other defendants were also liable b/c they voted along with Greggs promise to SEP. b) The agreement insofar as it provided for a premium in exchange for a promise of control, with only 4% of the outstanding shares actually being transferred, was contrary to public policy and illegal. c) Gregg must forfeit to the corporation any illegal profit derived from his sale of stock. He should account to the corporation for any profits made in his sale to SEP over and above that which he would have realized, had the sale been consummated in an arms length, over-the-counter transaction. 7) Jones v. H.F. Ahmanson & Co. (CA 1969): a) Class action suit. Plaintiff Jones alleges that a group of former and present United Savings and Loan Assn. shareholders and officers breached their fiduciary duty by creating and operating United Financial, a holding company that owned 87% of the outstanding Assn. stock. United Financial then made several public offerings, from which the company got more than $22M in returns. United Financial then offered to purchase the minoritys stock at a price well below value, but the minority shareholders resisted due to perceived unfairness.

48 b) Controlling SHs owe a fiduciary duty to other SHs absent reliance on inside information, use of corporate assets, and fraud. c) The majority SH has a duty of good faith and inherent fairness to the minority in any transaction where control of the corporation is material. d) By creating United Financial to market the Assns shares to the exclusion of the minority SHs, the majority SHs ensured that no equivalent market would be created for Assn. stock, leaving the minority with the option of either selling their shares to United Financial at whatever price was offered, or keeping their shares. e) Controlling SHs may not use their power to control the corporation for the purpose of promoting a marketing scheme that benefits themselves alone to the detriment of the minority. Their actions must benefit all SHs proportionately. The minority SHs have to be in on the deal too. f) Usually, controlling SHs do not owe the minority a general fiduciary duty. But the CA Supreme Court imposes a general fiduciary duty upon controlling SHs whenever they use their control for a personal benefit. g) This sounds like the Equal Opportunity Rule, and is much broader than what weve seen in other cases. APPRAISAL 1) Appraisal: the right of the SH of a corporation who objects to certain corporate actions to require the corporation to purchase the SHs stock at its value immediately prior to the approval of the corporation action. 2) Piemonte v. New Boston Garden Corp (MA 1979): a) Plaintiff Piemonte is a minority SH in Old Garden. After the majority of the SHs of Old Garden decided to merge that corporation into New Garden, Piemonte and other minority SHs sought an appraisal of and payment for their shares. b) Trial judge used the Delaware Block Approach to valuation: i) Corporation is valued by determining (1) The market value of the companys stock, (2) The value of the companys net assets, and (3) The companys earnings value (a method of valuing a corporation based on its earnings, in which an avg of the earnings of the corporation for the past 5 years is computed, extraordinary gains and losses are excluded, and a multiplier is selected and applied, reflecting the perceived future financial condition of the corporation and the risks of investment). ii) Court then weighs each of the three values based on its opinion of which method provided the best valuation estimate and added the values, adjusted by their relative weights. c) A few years later, DE abandoned this method in favor of an approach that would consider any approach that is generally accepted in financial and appraisal circles for ascertaining property value, such as the discounted cash flow method of valuation. 3) Le Leau v. MG Bancorp, Inc. (1998): a) Valuation of a publicly held corporation. MGB had two subs, which needed to be valuated. Methods: i) Comparative Company Approach: (1) Identify an appropriate set of comparable companies (2) Identify the multiples of earnings and book value at which the comparable companies traded (3) Certain financial fundamentals of MG (return on assets and return on equity) were compared to those of the comparable companies

49 (4) Makes certain adjustments to those financial fundamentals, and (5) Adds an appropriate control premium. ii) Discounted Cash Flow Approach: (1) Projects the future net cash flows available to MGs SH for 10 years after the merger date (2) Discounts those future cash flows to present value as of the merger date by using a discount rate based on the weighted avg cost of capital (3) Adding a terminal value that represents the present value of all future cash flow generated after the 10 year projection period, and (4) Applying a control premium to the sum of 2 and 3. iii) Comparative Acquisition Approach (1) Focus on multiples of MGs last year earnings and its tangible book value (2) Multiples were determined by reference to the prices at which the stock of comparable companies had been sold in transactions involving sale of control. b) MGs remaining assets: having valued the two subs, the valuation expert determined the fair value of MGs remaining net assets and then subtracted liabilities. c) Fair Value Computation: the expert then added the values he had determined under each of his valuation methodologies. d) Court accepted the valuation based on the comparative acquisition method. 4) NYBCL 623(h)(4) and (k); 910(a)(1): a) Requires modern financial valuation b) Clearer in the methodology to be used c) Requires the company to make a good faith offer and turn the money over to the SH d) Can be a shifting of costs between the parties depending on how the parties act in the appraisal e) Forces the parties to negotiate a fair price f) Market exception: NY does not give right of appraisal if the shares are traded in the market, b/c there is a right of exit in the market FREEZEOUTS 1) Freezeout: corporate transaction whose principal purpose is to reconstitute the corporations ownership by involuntarily eliminating the equity interest of minority SHs a) Dissolution Freezeouts (for descriptions, see p. 1082) b) Sale-of-Assets Freezeouts c) Debt or Redeemable-Preferred Mergers d) Cashout Mergers e) Parent-sub freezeout: i) Parent decides it wants to wholly own sub. f) Going Private: i) Family-owned corporation goes public and then goes private by buying out all the public SHs. g) Management Buyout (MBO): i) Management of the company, along with outside investors, take the company private ii) Differs from parent-sub freezeout b/c mgmt does not have a controlling interest in the company iii) Is arguably less problematic than the going private or parent-sub transaction fewer fiduciary issues involved b/c mgmt has a fiduciary duty in their position, but theyre not controlling SHs. iv) Example: RJR-Nabisco (largest MBO/LBO) h) Leveraged Buyout (LBO): a buyout financed by debt (can be an MBO)

50 i) Its okay to go private for the best interests of the corporation so long as the minority is not being treated unfairly. 2) Pros and Cons of Freezeouts: a) Pros: i) Controlling SHs offer higher prices to minority SHs than the market b/c they own it all; controlling SHs think they can make the stock of the company more valuable ii) Eliminating minority SHs can mean avoiding conflicts of interest. b) Cons: i) Concern that majority SH would only buy the corporation when they know that they could take advantage of the low market. Buying it when the stock is low. ii) Increasing the risk controlling SHs taking away minoritys option of when they want to sell and buy. 3) Singer v. Magnavox (DE): freezeouts have to have a business purpose and entire fairness. Weinberger got rid of business purpose business purpose served no purpose b/c one can probably find a business purpose for anything and it doesnt protect anyone. a) NY and MA still use the business purpose test, MA more so than NY. 4) Weinberger v. UOP, Inc. (DE 1983): a) Post-trial appeal by class action plaintiff, a former SH of UOP who challenged the elimination of UOPs minority SHs by a cashout merger between UOP and its majority owner, Signal. Trial court entered judgment for defendants. b) Plaintiff in a suit challenging a cashout merger must allege specific acts of fraud, misrepresentation, or other items of misconduct to demonstrate the unfairness of the merger terms to the minority. c) Even though Signal didnt have to submit it to a vote b/c they had majority control, they wanted to make things look good, so they submitted the merger to a vote by the minority, a majority vote of which was needed for it to go thru. The majority of the minority overwhelmingly approves the merger. d) The Burden of Proof: i) Even though the ultimate burden of proof is on the majority SH to show by a preponderance of the evidence that the transaction is fair, it is first the burden of the plaintiff attacking the merger to demonstrate some basis for invoking the fairness obligation. ii) However, where corporate action has been approved by an informed vote of a majority of the minority SHs, we conclude that the burden entirely shifts to the plaintiff to show that the transaction was unfair to the minority. iii) But the burden clearly remains on those relying on the vote to show that they completely disclosed all material facts relevant to the transaction. iv) Here, material information was withheld under circumstances amounting to a breach of the test of fairness. No burden thus shifted to the plaintiff by reason of the minority SH vote. e) Nothing in Signals Arledge-Chitiea feasibility report (used UOP data to describe the advantages to Signal of ousting the minority at a price range of $21-$24 per share) was ever disclosed to UOPs minority shareholders prior to their approval of the merger. f) Proxy statement also did not disclose the hurried method by which the price of $21/share was agreed upon. g) A 3-page summary of figures instead of the report was given to all UOP directors. Its first page is identical to one page of the feasibility report, but this dealt with nothing more than a justification of the $21 price. Nothing contained in either the minutes or this three-page summary reflects Signals study regarding the $24 price. h) The price of $24 wasnt a big deal to Signal (they wouldnt be losing much), but it was a big deal to UOPs minority SHs they were collectively losing $17M with the $21 price.

51 i) Individuals who act in a dual capacity as directors of two corporations, one of whom is parent and the other subsidiary, owe the same duty of good management to both corporations, and in the absence of an independent negotiating structure, or the directors total abstention from any participation in the matter, this duty is to be exercised in light of what is best for both companies. Signal has not met this obligation. j) Entire Fairness test: i) Fair dealing: when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the SHs were obtained (more than just disclosure) ii) Fair price: economic and financial considerations of the proposed merger, including all relevant factors and any other elements that affect the intrinsic or inherent value of a companys stock iii) All aspects of the issue must be examined as a whole. k) Here, the obvious conflicts posed by the study derived from UOP information, for the sole use and benefit of Signal, cannot pass muster. i) Merger initiated and structured by Signal only. ii) Inadequate disclosure to UOP in 4 business days before merger was approved iii) No real negotiations l) There was no fair dealing here, and no meaningful approval of price. 5) Basic rule in DE for appraisal from Weinberger: if the dealing was fair and all you are complaining is an unfair price, then you to go appraisal. If the dealing was unfair, then you go into equity and argue equitable damages. 6) Proposed SEC Rule 13(e)(3): a) When a company is freezing out its public SHs, there needs to be full disclosure by the controlling SH; the transaction also has to be fair. b) But the problem with this is that the feds (SEC) controlled disclosure while fairness was an issue of state law. c) SEC ultimately backed down. d) Actual Rule 13(e)(3): disclosure rule: someone who is taking a company private has to give full disclosure to the investors, including whether the transaction is fair or not, and why. 7) Kahn v. Lynch Communications Systems, Inc. (DE 1994) (Use of independent committee): a) Action originally sought to enjoin the acquisition of defendant Lynch by defendant Alcatel pursuant to a tender offer and cashout merger. b) Class action on behalf of all Lynch SHs. c) Kahn alleged that Alcatel was a controlling shareholder of Lynch and breached its fiduciary duties to Lynch and its SHs. According to Kahn, Alcatel dictated the terms of the merger, made false, misleading, and inadequate disclosures, and paid an unfair price. Lower court ruled in favor of defendants. d) Record does not support the conclusion that the burden of persuasion shifted to Kahn. Therefore, the burden of proving the entire fairness of the merger transaction remained on Alcatel, the controlling SH. e) Lynch wanted to buy Telco, but Alcatel said no. Alcatel proposed that Lynch buy Celwave, owned by Alcatel. But independent committee expressed unanimous opposition. Alcatel then withdrew the Celwave proposal and made an offer to acquire the entire equity interest in Lynch, constituting about 57% of Lynch shares not owned by Alcatel. Offering price was $14 per share. f) Independent Committee thought that price was too low. They eventually agreed upon $15.50. g) Alcatel basically gave the Independent Committee and Lynch an ultimatum: either accept $15.50 or we implement a hostile takeover at a much lower price.

52 h) Arms length bargaining is strong evidence of fairness; so are independent committees. i) But the mere existence of independent committees does not itself shift the burden. At least 2 factors are required: i) Majority SH must not dictate terms of the merger. ii) Committee must have real bargaining power that it can exercise with the majority SH on an arms length basis. j) Rosenblatt: parent-sub merger: approval of a merger by an informed vote of a majority of the minority SHs, while not a legal prerequisite, shifts the burden of proving the unfairness of the merger entirely to the plaintiffs. k) Here, the independent committee wasnt really independent b/c Alcatel applied pressure so they had no real meaningful choice. 8) Wheelabrator Case (DE 1995): a) Plaintiffs disclosure claim: i) Plaintiffs argue that defendants breached their duty of disclosure b/c the proxy statement issued in connection with the merger was materially misleading. ii) However, the assertion that the WTI board could not have considered the merger proposal rests upon an unsupported inference from the fact that the board meeting was three hours long. iii) This inference is unsupported b/c (1) The meeting was attended by WTIs investment bankers and outside counsel who made presentation and answer board members questions. The proxy statement describes in detail the various factors that the board considered in deciding whether to approve and recommend the merger. Plaintiffs offer no evidence that that description was in any way inaccurate. (2) Waste and WTI also had a close business relationship for the past 2 years before the merger. iv) Thus, it is reasonable to infer that WTIs directors already had and were able to use their substantial working knowledge of Waste during the meeting. b) Duty of Care claim: i) Smith v. Van Gorkoms ratification: merger can be sustained notwithstanding the infirmity of the boards actions, if its approval by a majority of the SHs is found to have been based on an informed electorate. c) Duty of Loyalty claim: i) Types of ratification decisions: (1) Interested transaction cases: will NOT be voidable if it is approved in good faith by a majority of the disinterested SHs (a) Standard of review: BJR/waste; burden on plaintiff (2) Transactions between the corporation and its controlling SH (a) Usually, directors have the burden of proof (b) Where the merger is conditioned upon approval by a majority of the minority SH vote, and such approval is granted, (i) Standard of review: entire fairness; burden shifts to plaintiff in this case. (ii) Also applicable in mergers with a de facto (not de jure (owning a majority of the shares)) controlling SH, and in cases involving transactions other than mergers. d) Here, the merger did not involve an interested and controlling SH. There is no contention or evidence that Waste, a 22% SH of WTI, exercised de jure or de facto control over WTI. e) Thus, the standard of review should be BJR with plaintiffs having the burden of proof. 1.

53 TENDER OFFERS POLICIES 1) You cant have hostile mergers b/c boards of both companies have to approve it. If you want to directly buy control of a company, you have to make a tender offer directly to the SHs. 2) Definitions: a) Raider: person or corporation that initiates a tender offer; aka bidder. b) Target: corporation whose shares the raider seeks to acquire. c) White knight: when mgmt of the target wants another bidder to make a tender offer competing bidders to which the target is more friendly. d) Lock-up: a device that is designed to protect one bidder against competition by other bidders. The favored bidder is given an option to acquire selected assets of the target at a favorable price under designated conditions. e) Crown jewels: to defeat or discourage a takeover bid by a disfavored bidder, the targets mgmt may sell or give to a white knight a lock-up option that covers the targets most desirable business or the business most coveted by the disfavored bidder, its crown jewel. f) Fair price provision: requires that a supermajority (usually 80%) of the voting power of a corporation must approve any merger with an acquirer who owns a specified interest in the corporation (usually 20%). g) Junk bonds: bond that has an unusually high risk of default, but correspondingly carries an unusually high yield. h) No-shop clauses: the board that enters into a merger may agree that it will recommend the combination/merger to its SHs, that it will not shop around for a more attractive deal. i) Poison Pills: i) Also known as a rights plan, or a SH rights plan ii) Is a plan under which the directors of a corporation create rights that are distributed to SHs. iii) A device adopted by a corporation to make its stock less attractive to a potential raider. In general, the idea is to make more difficult and expensive for a bidder to acquire the corporation than it would be without the existence of the device. iv) B/c the potential exercise of the rights would dramatically dilute the value of the target stock that the bidder proposes to acquire, the mere potential that the rights will be exercised serve as a deterrent to making a bid in the first place. j) Standstill: i) An SH agrees to limit his stock purchases ii) In a typical standstill agreement the SH makes one or more commitments (1) It will not increase its shareholdings about designated limits for a specified time, it will not sell its shares without giving the corporation a right of first refusal, it will not engage in a proxy contest, and it will vote its stock in a designated manner in the election of directors and other issues. 3) A history of tender offers: a) As long as weve had publicly traded equity, weve had hostile takeovers. They used to happen infrequently and were not on a large scale. In the late 70s and early 80s, they became much more common and occurred on a larger scale. Why? The 70s were a period of high inflation b/c of the oil crisis. High inflation means a negative signal for the stock market b/c of the uncertainty. Thus, stock prices were low in comparison to companies assets. This made them attractive targets for acquisition. Reagan was also elected and enforcements were down. US companies were also viewed as flabby b/c Germany and Japan bounced back from WWII. Huge conglomerates were also created in the 60s which owned vast arrays of businesses. People thought conglomerates didnt work. Some of the hostile takeovers were attacks on these conglomerates. The only conglomerate that has done comparatively well is GE. Attitudes also changed about hostile takeovers on the raider/offeror side. They were no longer

54 viewed as lepers by white shoe law firms and investment banking firms. The use of debt (leveraging) also increased in relation to tender offers. To the extent that you can borrow lots of money, the more you are able to take over big companies. b) Michael Milliken: went to Wharton; wrote his thesis on the high-yield debt (junk bond) market. He showed that if an investor bought a diversified portfolio of high yield debt securities, and the companies goes bankrupt, hes going to go broke. But if they were adequately diversified, the investor would end up earning a significant return. Milliken created a market for high-yield debt. He sold investors on this idea of buying a portfolio of high-yield debt. Milliken was able to supply people who wanted to take over companies with large loans. Once they took over the companies, the loans would be transferred to the companies. Thru Milliken, most companies were open to hostile takeover; no one was immune. Milliken was eventually indicted and convicted of securities fraud and went to jail. 4) Policy arguments regarding hostile takeovers: a) Pro: i) Benefits SHs of both the raider and the target, but primarily the target c/ the raider is coming in with a higher price than the market price, usually in cash. ii) Raider purports to get rid of targets bad mgmt (promoting efficiency) or else why would the raider pay a price higher than the market price? the raider thinks it can raise the stock price even higher than the price it paid. b) Con: i) Market price may not be an accurate reflector of targets value. It may be worth a lot more. ii) Decreases innovation b/c it encourages profits right now (which would raise stock prices) and discourages long-term projects that may be even more beneficial for the company in the long run. iii) Decreases market efficiency and competition. (not that significant) iv) Labor and local communities were harmed b/c of layoffs. Creditors were also hurt b/c of the heavy borrowing. 5) The Williams Act a) Disclosure-oriented: raider is required whenever it makes a tender offer to make full disclosure about themselves, their plans, etc. Kinda like a proxy statement. b) Timing rules: tells you how long the offer should remain open, provides withdrawal rights, etc. designed to protect the target so it cant be rushed into tendering. c) Rule 13(d): requires that when anybody buys 5% or more of the equity of a publicly traded company, they have to file a 13(d) statement within 10 days. This lets people know that someone owns a big chunk of stock in the company (not necessarily always related to tender offers). d) Equal Opportunity Rule (see above): whenever there is a tender offer, the raider must give every SH an equal opportunity in the tender offer, prorated. Also, everyone has the right to tender at the same price (best price rule). e) Broad anti-fraud rule: 14(e): no fraudulent misstatements, omissions of material facts. 6) SEC 14(d) and rules 14(d) and 14(e): regulate terms of tender offers. a) Minimum duration: tender offer must be open for at least 20 business days b) All-holders rule: bidder may not make a tender offer for a class of securities unless the offer is open, at the same price and on the same terms, to all holders of the class. c) Best Price rule: price paid to any holder pursuant to a tender offer must equal the highest price that the bidder pays to any other holder during the tender offer. Also, if the price is raised, it must be retroactive to those who already sold and bidder cannot make private purchases during the duration of the tender offer. d) Withdrawal rights: tendering SH can withdraw tendered by unaccepted shares at any time after

55 60 days from the date the tender offer was disseminated. Can withdraw tendered shares during the entire duration of the offer any extension of the offer. Pro-ration: if a bidder makes a partial tender offer an offer for less than 100% of the targets securities if more securities are tendered than the bidder has offered to accept, the bidder must accept all tendered securities, up to the stated percentage, on a pro rata basis. Obligation of the targets mgmt: i) No later than 10 business days from that on which the tender offer date is first published, the target corporation must notify SHs about the offer and must file a schedule 14D-9. ii) This form requires the reason, solicitation or recommendation, conflict of interest, any negotiation or transaction undertaken that relates to extraordinary transactions such as mergers, etc. Tender Offers by Issuers i) Corporations that tenders for their own stock are subject to obligations similar to those imposed on outside bidders. Anti-fraud Provision: prohibits material misstatements, misleading omissions and fraudulent or manipulative acts in connection with a tender offer or any solicitation in favor of or in opposition to a tender offer. Standing: i) A bidder does not have standing to sue for damages under the Williams Act, b/c the purpose of the act is to protect the targets SHs. ii) Targets SHs have standing to sue for damages under pro rata requirement, equal consideration requirement, anti-fraud requirement, and when appropriate, can seek injunctive relief. iii) Courts are divided on whether a SH of the target has an implied private right of action for damages. iv) Generally, courts have given standing to SHs of the target to seek injunctive relief for violation of Section 13(d); and violations caused by false or misleading filings. v) Majority: corporations do not have standing to sue for damages under section 13(d)s 5% reporting requirement.

e) f)

g) h) i)

TENDER OFFERS 1) Poison Pills a) Moran v. Household International, Inc. (DE 1985): i) Defendant Household was a holding company. There was no actual hostile takeover at the time. The poison pill at issue was a preventive measure. ii) The poison pill: If either a bidder made a tender offer for 30% of Households shares and then merged with Household, OR a single entity or group acquired 20% of Households shares and then merged with Household, the Household SHs would have a right to purchase stock in the surviving corporation at half price. iii) This was a flip over poison pill (not seen today): a device adopted by a target or potential target in which, in the event of a takeover in which the bidder merges with the target, the targets SHs will have the right to purchase stock of the surviving corporation at a bargain price. (1) Flip over poison pills dont work unless you take over 100% of the company. iv) Can a board adopt a poison pill plan as a defensive measure in response to its reasonable fear of a possible future hostile takeover of the corporation? Yes. v) This poison pill plan also does not effectively block any hostile tender offer. The plan is not absolute. The board will not be able to arbitrarily reject a tender offer if one comes along.

56 vi) Test: Modified BJR (Unocal Test): (1) Initial burden is on the directors to show that there was a threat posed by the potential takeover (a) Board cannot use defensive action to merely protect their own positions (b) Must show good faith and reasonable consideration (c) Threats are: (i) Coercive takeover attempts (ii) Offer will leave target with unreasonably large debt (almost insolvent) (iii) Change of business practices that will harm corporations ongoing business or existence. (2) Then directors have to show that they responded reasonably and proportionately to the threat. (a) Proportionality test, not a fairness test. (b) Defensive action cannot be preclusive, or protect 3rd party interests over SHs. (c) Cannot protect creditors interest or boards interests over SHs. (3) If the burden is met, the BJR applies (a) Presumption that directors made a reasonably informed decision under the circumstances in good faith and honest belief that the action taken was in the best interest of the corporation. vii) The pill here was find b/c there were threats out there. Non-redeemable poison pill (dead-hand poison pill): i) Thrown out by the DE court; held to violated DE law by limiting the power of future directors to redeem the pill and thus limited how they carried out their statutory and fiduciary duties. Delayed redemption poison pill: i) Delays redemption by directors for a certain amount of time ii) Also thrown out by the DE court for the same reasons as dead hand poison pills. iii) Quickturn Design Systems, Inc. v. Shapiro (DE 1998): (1) Whether delayed redemption was proper No, it was not. (2) The six month period during which the new board will not be able to redeem was held to violate DE law b/c it interferes with the new boards ability to carry out their statutory and fiduciary duties to the corporation. The old board is, in effect, interfering with and restricting the new boards operation (3) Court says that if directors want to limit the boards power, they can do so through amending the cert of incorporation but not thru a delayed redemption poison pill. International Brotherhood of Teamsters v. Fleming Cos., Inc. (OK 1999): i) Does Oklahoma law restrict the authority to create and implement shareholder rights plans exclusively to the board of directors? No. ii) May shareholders propose resolutions requiring that shareholder rights plans be submitted to the shareholders for vote at the succeeding annual meeting, assuming the cert of incorporation does not provide otherwise? Yes. Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. (DE 1985): i) Pantry Pride kept raising its tender offer price. Once PPs offer was up to $53, it was clear that Revlon was going to be taken over. The duty of the board then changed from preservation of Revlon as a corporate entity to the maximization of the companys value at a sale for the SHs benefit. ii) In other words, the directors role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the SHs at a sale of the company. iii) Regarding the lock-up: It focused on shoring up the market value of the Notes b/c the

b)

c)

d)

e)

57 noteholders were threatening to sue. But the directors shouldnt have been this concerned with the noteholders; they should have been more concerned about the equity owners, b/c their primary responsibility at this stage was to them. iv) Selective dealing to fend off a hostile but determined bidder was no longer a proper objective. Instead, obtaining the highest price for the benefit of the SHs should have been the central theme guiding director action. Thus, the Revlon board could not make the requisite showing of good faith by preferring the noteholders and ignoring its duty of loyalty to the SHs. v) Revlon argued that under Unocal, it could consider corporate constituencies other than SHs. But there are limitations on this. A board may regard various constituencies in discharging its responsibilities, provided there are rationally related benefits accruing to SHs. However, such concern for non-SHs is inappropriate when an auction among active bidders is in progress, and the object no longer is to protect or maintain the corporation but to sell it to the highest bidder. vi) When a board ends an intense bidding contest on an insubstantial basis, and where a significant by-product of that action is to protect the directors against a perceived threat of personal liability for consequences stemming from the adoption of previous defensive measures, the action cannot withstand Unocal scrutiny. vii) Favoritism for a white knight to the total exclusion of a hostile bidder might be justifiable when the latters offer adversely affects SH interests, but when bidders make relatively similar offers, or dissolution of the company becomes inevitable, the directors cannot fulfill their Unocal duties by playing favorites with the contending factions. f) Barkan v. Amsted Industries, Inc. (DE 1989): i) Basic teaching of Moran, Unocal, and Revlon: the directors must act in accordance with their fundamental duties of care and loyalty. ii) A boards actions must be evaluated in light of relevant circumstances to determine if they were undertaken with due diligence and in good faith. If no breach of duty is found, the boards actions are entitled to the protections of the BJR. iii) While Revlon holds that when several suitors are actively bidding for control of a corporation, the directors may not use defensive tactics that destroy the auction process, it does not demand that every change in the control of a DE corporation be preceded by a heated bidding contest. g) TimeWarner case: i) Time was to merge with Warner Bros. But Paramount comes along and says they want to buy Time. Paramount makes a hostile tender offer. TimeWarner cancelled the merger b/c they didnt want a SH vote b/c they knew they were going to lose. Time issues a poison pill. Then Time makes tender offer to buy Warner. Paramount sues and loses. DE said Revlon does not apply to this case b/c the directors of Time have the ability to take a long term view of the merger. They applied Unocal. Very pro-director case. h) Paramount case: i) Paramount enters into a friendly acquisition with Viacom where Viacom was going to buy Paramount. Along comes QVC and they make an offer to buy Paramount. Paramount argues TimeWarner (the case they lost, ironically). DE said Revlon applies here, b/c when Viacom was acquiring Paramount, Viacom was controlled by Sumner Redstone. SHs of Paramount would become SHs of Viacom, but they would become minority shareholders. So what was going on was a sale of control. When theres a sale of control, Revlon applies, you gotta sell it for the highest price. There was no such sale of control in the TimeWarner case.

58 i) Revlon applies when the breakup of the company is inevitable or where there is a sale of control. Absent these situations, Unocal applies (great deference to directors). j) Unitrin case: i) There was a poison pill and self tender. The self tender basically put more power in the hands of the directors. Since they werent tendering their shares (fewer shares in selftender), their percentage ownership goes up. That increase in voting power gave them more leverage in fending off other potential raiders. ii) Three kinds of threats found in hostile situations: (1) opportunity losses, (2) structural coercion (the front loaded 2 tiered tender offer) see pp. 56-57 in notes (3) substantive coercion (mistaken acceptance of an underpriced offer in terms of true value). iii) Here there was substantive coercion SHs of Unitrin may tender on the ignorant belief that they are getting a good price. There has to be at least one of these threats. Then the response. New level of analysis: distinguish the kinds of responses a target company can have (1) if a target institutes something that is coercive for its SHs or it precludes (draconian) a tender offer, then the court would usually strike it down. (2) But if its not coercive or draconian, the courts will look at the reasonableness of it BUT will give directors more deference. k) State Takeover Statutes (a bit like statutory poison pills): i) NYBCL 717(b): constituency statutes, statutes that delay the process by allowing companies to fiddle with the timing, statutes that say when directors are implementing poison pills, they are subject to the BJR. ii) DE and NY: Business combination statute like poison pill, if you buy over a certain % of shares without the approval of the board, youre not allowed to enter into a business combination for 5 years (3 in DE). iii) Why were these statutes passed? Policy implications? Constitutional issues? (1) Edgar case: (a) Williams Act preemption of state takeover statutes this argument lost b/c it was about federal, not state neutrality. (b) Violation of the dormant commerce clause b/c it restricted interstate commerce in shares. (c) Statute was changed so that they were only aimed at corporations incorporated in the state this was constitutional, the Supreme Court said. l) Solomon v. Pathe Communications (DE 1996): i) Delaware courts do not apply the "entire fairness" standard to tender-offer transactions involving a controlling shareholder if the tender offer is not coercive. ii) Specifically, the Court found that "in the absence of coercion or disclosure violations, the adequacy of price in a voluntary tender offer cannot be an issue. SHAREHOLDER VOTING 1) Schnell v. Chris-Craft Industries: (for more, see above) Inequitable conduct, especially interference with SH voting rights, is prohibited, even if technically authorized under the by-laws. 2) Blasius Industries, Inc. v. Atlas Corp. (DE 1988) (Compelling Justification Test): a) Plaintiff SHs argued Schnell, defendants argued BJR b) Directors had good faith in thwarting attempts of insurgents by expanding the board by filling vacancies with their own nominees c) Cannot take voting powers away from SHs, even unintentionally and in good faith

59 d) Court says that conduct that interferes with SH voting receives stringent standard of review: Compelling Justification 3) MM Companies, Inc. v. Liquid Audio, Inc. (DE 2003): a) M&M wants to take over Liquid Audio, but is rejected. Plaintiff does a proxy fight (b/c there was a poison pill), attempting to elect 2 directors out of 5 b/c there was a staggered board term only 2 were up for election, not all the board positions had elections at the same time. This prevents someone from taking over the company right away (defensive tactic). M&M is also proposing to increase the board so they can have a majority right away. M&M wins the 2 director positions. But the number of board members increased from 5 to 7. b) Court says that defendants Liquid Audio had legitimate reasons to do what they did. This looks like Blasius, but its different the primary purpose here was to diminish M&Ms two directors. Since this involved voting rights, it seems that the court should apply Blasius. But Unocal also applies b/c it involves control issues. c) How do we apply both Blasius and Unocal? i) Unocal is the big standard, but Blasius is now part of Unocal. ii) The first thing to do is to apply Blasius first. Defendant has to show a compelling justification for the defensive tactic. Then, if the defendant can prove a compelling justification, then you go to Unocal (reasonable threat and then proportional response). iii) Its rare for a case where defendants win under Blasius but not Unocal, b/c the Unocal is an easier test. Most cases are going to be decided on step number 1 (Blasius). INSIDER TRADING 1) Common law majority rule: insider trading using inside information was allowed. a) Did NOT apply when director/officer engaged in fraud i) Half-truths and omissions counted as fraud ii) Taking affirmative steps to conceal the truth was also fraud iii) False denial of knowledge or information, if effective, was also fraud iv) Special facts exception: but there was no meaningful way to differentiate special facts situations from the other cases, this exception either swallowed the majority rule or made it impossible to administer consistently. 2) Minority rule (KS rule): full disclosure was required, at least for face-to-face transactions. 3) Common law died in practice with the development of Rule 10b-5 under the Securities Exchange Act. 4) Policy: a) The argument for insider trading is that it moves the price of the stock more quickly to reflect the true value of the stock, benefiting all stockholders in the long run. Driving the price the most realistic value is a good thing. The insider information is used to benefit the insiders, but it also trickles down to benefit all SHs. i) But this theory encourages directors and officers to keep information secret. Taken far enough, this may hurt the company and the integrity of the markets in general b/c it makes investing unfair. b) Insider trading becomes a form of theft when you say that the insider information belongs to the corporation. Using it to make a few extra bucks before the information is disclosed is essentially stealing. c) Generally, no duty to affirmatively disclose valuable information in the realm of contract common law. But when asked is there anything I should know and the party says no, thats fraud. But rarely is insider trading a face-to-face transaction its an anonymous market. But in a fiduciary relationship, the fiduciary has to disclose material information.

60 d) Basically, the common law sucked and was ineffective. 5) Diamond v. Oreamuno (NY 1969): a) MAIs share price was going to go down b/c IBMs repair prices went up suddenly. Directors knew about this but did not tell anyone until they sold their shares at $28/share. Once the news is announced, the market price dropped to $11. The directors profited they made $800,000. b) Plaintiffs derivative action seeking to have defendants account to corporation for the gains they realized as a result of insider trading. c) Whether officers and directors may be held accountable to their corporation for gains realized by them from transactions in the companys stock as a result of their use of material inside information yes. d) Defendants contend that there was no damage to the corporation; they acknowledged that they had an unfair advantage over other SHs but b/c there was no damage to the corporation, a derivative suit was not suitable. e) But a corporate fiduciary, who is entrusted with potentially valuable information, may not appropriate that asset for his own use even though in so doing he causes no injury to the corporation. f) Moreover, the defendants may have actually caused harm to the corporation when officers and directors abuse their position in order to gain personal profits, it may cast a cloud on the corporations name, injure SH relations and undermine public regard for the corporations securities. g) Nevertheless, harm to the corporation is not necessary as a public policy matter. Insider trading is still insider trading, whether the corporation ended up losing money, gaining money, or neither. 6) Most insider trading is now regulated by federal law, but not formally preempted, just in practice. Diamond is still good law in NY and NJ, but not in other states such as FL. 7) Section 16(a): a) requires all directors, officers, and 10% owners of publicly traded companies to disclose promptly whenever they buy or sell equity shares of a company. 8) Section 16(b): a) Short-swing profit rule: i) If anyone buys or sells within a 6-month period and during that period the buy/sell shows a profit, that profit belongs to the company (order of the buys/sales not relevant; matches highest sell price and lowest buy price) ii) Specifically allows a derivative suit to recover that profit iii) Strict liability intent and information (or lack thereof) not necessary iv) Aimed to discourage short-term, frequent trading. v) Aimed at 3 specific types of insider trading abuses: (1) To remove the temptation for executives to profit from short-term stock price fluctuations at the expense of the long-term financial health of their companies. (2) To penalize the unfair use of inside information by insiders (3) To eliminate the temptation for insiders to manipulate corporate events so as to maximize their own short-term trading profits. RULE 10B-5 1) Section 10(b) and Rule 10b-5: see statutory packet. WHO IS AN INSIDER 1) Traditional Insider: person who, b/c of a fiduciary or similar relation, is afforded access to nonpublic information from the corporation (directors, officers, attorneys, accountants)

61 2) In re Cady, Roberts, & Co. (1961) (traditional insider trading): a) Administrative action. b) There was a meeting where a decision to cut dividends was made. One of Cadys brokers found out and sold all his securities in the company. SEC found out about it and brought an administrative action against Cady. c) Insiders must disclose material facts which are known to them by virtue of their position by which are not known to persons with whom they deal and which, if known, would affect their investment judgment (traditional insiders). d) Disclose or abstain from trading. e) The obligation to disclose rests on anyone who: i) Has a relationship giving direct or indirect access to info intended to be available only for a corporate purpose and not for the personal benefit of anyone, and ii) Where there is inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing. 3) Texas Gulf Sulphur (2d. Cir. 1968): a) Company discovered ore in one of its fields in Canada. It immediately closed down the mine and spent the next 6 months buying the land in the area. During that 6-month period, insiders began buying shares and options in the stocks. These insiders were geologists, ppl on the board, lawyers, not just high-level executives or directors. b) Court found liability for these insiders. One of the directors tipped his son-in-law and he was liable as a tippor. c) The company itself also issued a misleading press release about what was going on. This also violated 10b-5. 4) Chiarella v. US (US 1980) (market trading, there must be a duty): a) Petitioner Chiarella was a printer and he saw confidential information regarding an acquisition, even though the names were blocked out. He was able, however, to deduce the names of the target companies before the final printing from other information contained in the documents. He purchased stock in the target companies and sold the shares immediately after the takeover attempts were made public. He made more than $30K in the course of 14 months. b) Whether a person who learns from the confidential documents of one corporation that it is planning an attempt to secure control of a second corporation violates section 10(b) of the 34 Act if he fails to disclose the impending takeover before trading in the target companys securities No. c) A purchaser of stock who has no duty to a prospective seller b/c he is neither an insider nor a fiduciary has been held to have NO OBLIGATION to reveal material facts. There must be a duty first. d) Chiarella was convicted of violating 10(b) although he was not a corporate insider and he received no confidential information from the target company. e) His use of that information was NOT A FRAUD under 10b UNLESS he was subject to an affirmative duty to disclose it before trading. f) No duty could arise from petitioners relationship with the sellers of the target companys securities, for Chiarella had no prior dealings with them. He was a complete stranger who dealt with sellers only thru impersonal market transactions. g) A duty to disclose under 10b-5 does not arise from the mere possession of nonpublic market information. i) Dissent (Misappropriation Theory): (1) A person who misappropriated nonpublic information has an absolute duty to disclose that information or to refrain from trading. 5) Dirks v. SEC (US 1983):

62 a) Dirks was an officer of a NY broker-dealer firm. He received information from Secrist, former officer of Equity Funding or America. Secrist said that assets of EFA were vastly overstated b/c of fraudulent corporate practices. Dirk: tippee, Secrist: tippor. b) Neither Dirks nor his firm owned or traded any EFA stock, but throughout his investigation he openly discussed the information he had obtained with a number of clients and investors in the course of his investigation of Secrists allegations. Some of these people sold their holdings of EFA securities. He also contacted the WSJ. c) A duty to disclose arises from the relationship between parties and not merely from ones ability to acquire information b/c of his position in the market. d) Imposing a duty to disclose or abstain solely b/c a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the rule of market analysts, which is necessary to the preservation of a healthy market. e) Not only are insiders forbidden by their fiduciary relationship from personally using undisclosed corporate information to their advantage, but they may not give such info to an outsider for the same improper purpose of exploiting the info for their personal gain. f) The tippees duty to disclose or abstain is derivative from that of the insiders duty. g) A tippee assumes a fiduciary duty to the SHs of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the SHs by disclosing the information to the tippee and the tippee knows or should know that there has been a breach. h) Whether Dirks is liable depends on whether Secrist is liable. In order for Secrist to be liable, he has to have personally gained from the tipping. 6) US v. OHagan (US 1997): 7) Hypos: a) The person you live with, Vice-President of a large company, wants to take you out to celebrate. She's not supposed to tell anybody, but she lets you know that her company just landed a big government contract. Can you call your broker before the deal is announced? Would it matter if you were married? i) Traditional view: Dirks case. Tippor is the your roommate, the VP. You are the tippee. No liability for sharing this information on the part of the VP. It needs to be shown that there is a personal benefit to the VP. If there is no personal benefit, there is no liability under the traditional view. Under the misappropriation view, the tippor needs to a duty to the source of the information in order for there to be liability. The VP did not misappropriate the information b/c she did not give the information for trading purposes. If there is an expectation/history/agreement of confidentiality between you and your roommate, or if youre married (10b-5(2)), then you are liable for insider trading. There also needs to be a personal gain for the VP. If there is no confidentiality or personal gain, no liability. b) You're in the theater lobby at intermission. You overhear a conversation between two persons you know are top executives of a big company. "Our stock should really jump when we announce the merger," says one. Can you buy the stock now? What if they talk about a tender offer of the company? i) No liability under either theory. No personal benefit for the execs. Theres no duty between the would-be tippors (execs) and the tippee (you). Same thing for the tender offer (14e(3)) you have to know or either have reason to know the information came from an insider from either the target or acquirer in the case of a tender offer. Here, you dont have reason to know that the information came from an insider from either side. c) A small textile company calls you in as a marketing consultant. Its president shows you samples of a new fabric that sheds dirt and never wears out. You're bowled over - but too busy

63 to take on the account. Can you buy stock in the company? i) Traditional view: FN 14 of the Dirks case (temporary insiders). What exactly are your employment terms with this textile company? d) You're a personnel executive at Mammoth Oil. You learn that the company has just hit a gusher. You were planning to sell some stock but now decide not to sell until the news is disclosed. Do you face any problems? i) There technically is liability b/c youre benefiting from the nonpublic information. But, since youre NOT trading, there cant be liability. e) You own stock in the company you work for and you've been selling 25 shares each month to make payments on your Ferrari. You learn that the next quarterly report will show a huge, unexpected loss. Can you make your regular sale before the bad news hits? i) You clearly are an insider and you have nonpublic information. But you are not liable b/c you are not trading on the information. Yes, you can make your regular sale before the bad news hits. Knowing possession test or on-the-basis test. SEC rule: 10b-5(1): announces that selling with knowing possession is sufficient for liability, but provides a safe harbor for insiders who want to trade on a regular basis without liability they have to set up a plan f) You have been told by your broker that she has inside information and you buy on her recommendation. It turns out that her information was false. Can you sue your broker? i) You can, but the broker can say that youre liable too b/c you traded on inside information. Impere delecto. Supreme Court said theyre both at fault, but held that brokers should be held to a higher standard, and said that brokers can be sued. g) You are a psychiatrist who is treating the husband of an executive for anxiety about negotiations over his wife's company being acquired. Can you trade? i) No, you cant trade under the misappropriation view. Traditional view is eliminated b/c its the husband of the exec, its removed one step. Misappropriation and 10b-5(2): relationship of confidence. h) You get a call from your broker and you are told that her customers, who are insiders are selling large amounts of stock in their company. You are aware that the FDA is reviewing the companys application for a new drug and will publish its findings soon. Can you sell the stock you own? i) The information was the fact that the insiders were trading. This is not traditional inside information. But it is traditional nonpublic market information. But we have to find a misappropriation by the broker to the source (the corporation). In order for you to be liable as a tippee, it has to be demonstrated that you knew or had reason to know that your broker misappropriated the information. Whats not clear is whether a misappropriatortippor has to have tipped with a personal benefit or not. 11th Cir. has determined that there also has to be a personal benefit for the misappropriator-tippor. i) You are a scientist at a research institute. Tomorrow you are going on television to release a study showing that a major fast-food chain's hamburgers cause baldness - and a Wall Street reaction is likely. Can you sell the stock you own? i) What is your employment agreement with the research institute regarding information? If theres a rule against it, you cant sell. If there isnt, then you can go ahead. This is so b/c Chiarella says there has to be a duty. 8) Regulation FD (full disclosure): enacted in late 90s; explicitly said that in order to provide a more level playing field and concern with market integrity and informational advantages, companies are no longer permitted to selectively disclose information. What companies often did in the past was selectively tell certain people about their goings-on in order to soften the impact of whatever result the news would cause. Companies didnt always do this with intent for personal gain I guess they just wanted to leak the information before it was fully disclosed to the public. But this caused

64 insider trading. Regulation FD said that disclosure had to be made simultaneously to everyone. It attempts to limit the informational advantage. ELEMENTS OF RULE 10B-5 1) Implication of private rights of action: not only for SEC to prosecute, but there is an implied cause of action for private citizens. 2) Standing: Purchaser-Seller Rule: standing is limited to those who have actually purchased or sold the security at issue. a) Blue Chip Stamps v. Manor Drug Stores (US 1975): i) Under the in connection with clause of 10b, only a person who had purchased or sold stock had standing to bring a private action under 10b-5. (1) The most significant bite of the Blue Chip doctrine is to bar private actions by persons who claim they would have sold stock that they owned had they not been induced to retain the stock by misrepresentations, or omissions, that violated 10b-5. But, this isnt as expansive as it seems: (a) Definitions of sale under the Securities Acts are very expansive, and therefore pick up many transactions that do not constitute a sale in the narrowest meaning of that term. (b) The Blue Chip doctrine does not affect the standing of the SEC to bring proceedings under 10b-5, even though the SEC was neither a purchaser or seller (as it never would be, duh). (c) The courts have interpreted the term in connection with broadly. Any statement that is reasonably calculated to affect the investment decision of a reasonable investor will satisfy the in connection with requirement. Defendants need not be a buyer or seller. An action can be brought on the basis of a statement that influences trading but is made by a person who did not himself trade or tip. (d) Several cases have held that a plaintiff in a private action for injunctive relief need not be a purchaser or seller. 3) Materiality (same as 14(a)(9)): the fact omitted or misstated must be one to which the reasonable investor would attach importance in the making of her decision. A fact is a material fact if there exists a substantial likelihood that a reasonable SH would consider it important in deciding whether to purchase or sell a security (TSC v. Northway). a) A fact doesnt have to be outcome determinative to be material. b) Basic, Inc. v. Levinson (US 1988) (MATERIALITY and RELIANCE to what extent common law elements of fraud should be brought in): i) Class action against Basic and its directors asserting that defendants issued false/misleading public statements and thereby violated 10b and 10b-5. Plaintiffs alleged that they were injured by selling Basic shares at artificially depressed prices in a market affected by defendants misleading statements and in reliance thereon. ii) Whether a person who traded a corporations shares on a securities exchange after the issuance of a materially misleading statement by the corporation may invoke a rebuttable presumption that, in trading, he relied on the integrity of the price set by the market. Yes. iii) Expressly adopts the TSC v. Northway standard of materiality for the 10b and 10b-5 context. iv) Probability-magnitude test in connection with mergers: (1) The greater the probability of a merger, the more likely its going to be material; the greater the magnitude of the merger, the more likely its going to be material. (2) Materiality in the merger context depends on the probability that the transaction will be consummated, and its significance to the issuer of the securities. Materiality is to be

65 determined on a case-by-case basis. v) Reliance is an element of a 10b-5 cause of action. (1) Where materially misleading statements have been disseminated into an impersonal, well-developed market for securities, the reliance of individual plaintiffs on the integrity of the market price may be PRESUMED. (2) Any showing that severs the link between the alleged misrepresentation and either the price received or paid by the plaintiff, or his decision to trade at a fair market price, will be sufficient to rebut the presumption of reliance. 4) Scienter: a) Ernst & Ernst v. Hochfelder (US 1976): a private action for damages under 10b-5 needs to allege scienter: an actual intent to deceive, manipulate, or defraud on the defendants part. b) Recklessness satisfies the scienter requirement: highly unreasonable conduct, an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it. CLOSELY-HELD CORPORATIONS CONTROL THE CONTRACT AMONG SHAREHOLDERS EX ANTE CUMULATIVE VOTING CONTROL AND RETURN CONTRACTS INVOLVING DIRECTORS SUPERMAJORITY CONTRACTS RESTRICTIONS ON TRANSFER AND BUYOUTS NON-CONTRACTUAL REMEDIES EX POST JUDICIAL RESOLUTION OF DISPUTES DISSOLUTION AND OTHER STATUTORY REMEDIES EX POST DISSOLUTION PARTNERSHIP