Business Organizations 2001 IShaffer

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001
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I. INTRODUCTION TO CORPORATIONS............................................................................................................5 1. Course Goals......................................................................................................................................................5 2. Applicable Rules.................................................................................................................................................5 A. INTRODUCTION TO CORPORATIONS. [1-15]......................................................................................................................................5 1. Historical Sketch of the Corporation.................................................................................................................5 2. Regulating the Modern Corporation: The Search for Accountability................................................................6 B. INTRODUCTION TO THE ECONOMICS OF THE FIRM. [16-26]{SKIM}......................................................................................................6 C. INTRODUCTION TO THE LAW OF CORPORATIONS: CORPORATE ACTORS AND FIDUCIARY PRINCIPLES. [18-46]..........................................7 1. Basic Terms and Concepts.................................................................................................................................7 2. Fiduciary Principles.........................................................................................................................................10 PROBLEM: CHESAPEAKE MARINE SERVICES [PART I] [37]..................................................................................................................11 D. THE SCHNELL DOCTRINE. EQUITABLE LIMITATIONS ON LEGAL POSSIBILITIES. [46-52]........................................................................12 PROBLEM: CHESAPEAKE MARINE SERVICES [PART II] [46]................................................................................................................13 E. CONSTITUTIONAL CONCEPTIONS OF THE CORPORATION: REGULATING THE CORPORATIONS INTERNAL AFFAIRS; STATE TAKEOVER STATUTES. [53-87]........................................................................................................................................................................................14 1. Corporation as a Person..................................................................................................................................14 2. The First Amendment.......................................................................................................................................15 3. Regulating Corporations Internal Affairs.......................................................................................................15 F. AMBIGUITY OF CORPORATE PURPOSE: CHARITY GIVING. [88-107]..................................................................................................17 1. The Doctrine of Ultra Vires..............................................................................................................................17 2. Modern Limitations on Corporate Charitable Giving.....................................................................................18 G. AMBIGUITY OF CORPORATE PURPOSE: SOCIAL RESPONSIBILITY. [107-126]......................................................................................21 1. Corporate Social Responsibility Trends...........................................................................................................21 2. Judicial Approaches.........................................................................................................................................21 3. What is Corporate Responsibility?...................................................................................................................22 II. AUTHORIZING, EMPOWERING AND CONSTRAINING THE CORPORATE ACTOR: STATE LAW REGULATION...........................................................................................................................................................24 A. INTRODUCTION TO BASIC FINANCIAL ACCOUNTING.[187-206] (SEE THE SPREAD SHEETS WITHIN THE NOTES FOR MORE INFO ON ACCOUNTING).................................................................................................................................................................................24 1. Financial Terminology and important concepts:.............................................................................................25 2. Introduction to Financial Analysis...................................................................................................................25 PROBLEM: PRECISION TOOLS [PART III] [187].................................................................................................................................26 B. INTRODUCTION TO CORPORATE SECURITIES. AUTHORIZATION OF STOCK.[220-237]...........................................................................26 1. Types of Financing...........................................................................................................................................26 2. Authorization and Issuance of Equity Securities (stock)..................................................................................27 PROBLEM: PRECISION TOOLS [PART V] [220]..................................................................................................................................28
BUSINESS ORGANIZATIONS II - Shaffer Page 2 of 131 Karl Bekeny/Spring 2001 C. REGULATION OF LEGAL CAPITAL. PAR VALUE.[242-252]..............................................................................................................29 PROBLEM: PRECISION TOOLS [PART VI] [243].................................................................................................................................30 D. PAYMENT OF DIVIDENDS AND OTHER DISTRIBUTIONS.[252-258, 263-278].....................................................................................31 1. Delaware Corporation -- Dividend Rules.......................................................................................................31 2. RMBCA Corporation Dividend Rules...........................................................................................................31 1. Public Corporations.........................................................................................................................................31 PROBLEM: PRECISION TOOLS [PART VII] [252]................................................................................................................................32 MICHAEL JENSEN: ECLIPSE OF THE PUBLIC CORP..............................................................................................................................33 E. EMPOWERING OFFICERS; ISSUES OF AGENCY.[347-363]..................................................................................................................33 1. The Relationship Model:..................................................................................................................................34 Fiduciary.............................................................................................................................................................34 Owners Dividends..........................................................................................................................................34
Fiduciary..........................................................................................................................................................34 Agency............................................................................................................................................................34 Contracts.......................................................................................................................................................34 2. Action by Executives: Agency Principles and the Authority of the Corporate Officer....................................34 F. FORMAL REQUIREMENTS FOR BOARD ACTIONS.[363-368]..............................................................................................................36 G. CORPORATE COMBINATIONS; SHAREHOLDER VETO AND EXIT RIGHTS.[368-386]..............................................................................37 1. Shareholders Veto and Exit Rights.................................................................................................................37 Note: A and B Shareholders are covered under statutory merger rules............................................................43 2. De Facto and De Jure (by-law) Approaches...................................................................................................43 H. SHAREHOLDERS RIGHTS OVER BOARD ACTIONS; ASSET SALES.[386-391]......................................................................................44 1. Approval of Corporate Transactions................................................................................................................44 PROBLEM: LAFRANCE COSMETICS [PART II] [386]...........................................................................................................................45 I. SHAREHOLDERS POWER TO INITIATE ACTIONS & SHAREHOLDERS RIGHTS TO INFORMATION.[391-416]................................................46 1. Shareholder Meetings; Procedural Concerns..................................................................................................46 2. What Actions Can Shareholders Initiate?........................................................................................................48 3. Board Responses to Shareholder Initiatives.....................................................................................................49 4. Shareholders Right of Inspection....................................................................................................................51 J. DRAFTING AND OTHER ISSUES RELATING TO CLOSELY HELD CORPORATIONS, INCLUDING LARGE JOINT VENTURES: CUMULATIVE VOTING , SUPRA-MAJORITY VOTING, QUORUM REQUIREMENTS, SHARE TRANSFER RESTRICTIONS, DEADLOCK & DISSOLUTION.[417-424, 437-440, 449-451, 452-457, 465-467, 490-492].......................................................................................................................................53 1. Control Devices Relating to Shareholder Voting.............................................................................................54 2. Dealing with Dissension, Deadlock, Oppression and Dissolution. [p.466]....................................................57 III. FEDERAL LAW I. SHAREHOLDING VOTING CONTROLS. [P.515-618]..............................................57 A. ROLE OF SHAREHOLDERS IN CORPORATE GOVERNANCE. THEORIES OF THE FIRM; INTRODUCTION TO SECURITIES & EXCHANGE ACT.[515539].............................................................................................................................................................................................58
BUSINESS ORGANIZATIONS II - Shaffer Page 3 of 131 Karl Bekeny/Spring 2001 1. Theories of the Firm. [p.516]...........................................................................................................................58 2. Introduction to the Securities and Exchange Act.............................................................................................58 B. DYNAMICS OF SHAREHOLDER VOTING.[540-561]..........................................................................................................................59 1. The Collective Action Problem. .......................................................................................................................60 2. An illustrative case: Dual Class Recapitalizations. [p. 549]...........................................................................60 C. FEDERAL REGULATION OF PROXY SOLICITATIONS.[561-573]..........................................................................................................61 1. Proxy Rules as they Apply to Management. [p. 562].......................................................................................62 2. Proxy Rules as they Apply to Shareholders.[p. 568]........................................................................................64 D. THE ROLE OF INSTITUTIONAL INVESTORS.[573-594].....................................................................................................................65 1. Constraints on Institutional Investors..............................................................................................................65 2. Institutional Investors and Monitoring.............................................................................................................66 E. FEDERAL REGULATION. SHAREHOLDER PROPOSALS[594-618].........................................................................................................67 1. Evolution of The Shareholder Proposal Rule...................................................................................................67 2. The Rule in Operation......................................................................................................................................68 IV. STATE LAW FIDUCIARY DUTIES: LITIGATION BEFORE STATE COURTS.[P. 619-826]...............72 A. THE ROLE OF OUTSIDE DIRECTORS IN CORPORATE GOVERNANCE.[619-657]...................................................................................73 1. How Boards of Directors Operate [p.622]......................................................................................................73 2. Do Independent Boards Matter? [p.635].........................................................................................................74 WHAT CAN OUTSIDE DIRECTORS CONTRIBUTE? PG 619....................................................................................................................75 B. DIRECTORS DUTY OF CARE.[658-684].......................................................................................................................................76 1. The General Standard of Care.........................................................................................................................76 C. THE BUSINESS JUDGMENT RULE.[685-705].................................................................................................................................80 D. THE BUSINESS JUDGMENT RULE AND ILLEGAL CONDUCT.[718-721]...............................................................................................86 E. LIMITATION OF DIRECTORS LIABILITY.[P. 721-732, & 740-746]..................................................................................................87 FASHION, INC. PART III [PG. 721]..................................................................................................................................................90 F. INTRODUCTION TO CONFLICTS OF INTEREST AND THE DIRECTORS DUTY OF LOYALTY. [P. 747-767]....................................................91 STARCREST CORP. PART I [PG 753]................................................................................................................................................93 G. DUTY OF LOYALTY AND FAIRNESS DOCTRINE. [P. 767-782]..........................................................................................................94 H. DUTY OF LOYALTY AND EXECUTIVE COMPENSATION. [P. 782-796].................................................................................................96 1. Interested Director and Conflict of Interest Transactions...............................................................................97 2. Fairness............................................................................................................................................................97 3. Judicial Review.................................................................................................................................................97 4. Executive Compensation..................................................................................................................................97 I. CORPORATE OPPORTUNITY DOCTRINE. [P. 796-817].......................................................................................................................98 1. Traditional Corporate Opportunity Doctrine..................................................................................................98 2. What is Corporate Opportunity?......................................................................................................................99 3. When May a Corporate Manager Take An Opportunity for Herself?...........................................................100
BUSINESS ORGANIZATIONS II - Shaffer Page 4 of 131 Karl Bekeny/Spring 2001 4. Remedies for the Taking of a Corporate Opportunity....................................................................................101 J. DUTY OF MAJORITY SHAREHOLDERS. [P. 817-826] NOTE: THIS IS ALL COURT GENERATED...............................................................102 V. FEDERAL LAW II. DUTY OF DISCLOSURE..............................................................................................103 A. FEDERAL REGULATION. DUTY OF DISCLOSURE TO SHAREHOLDERS. [P. 827-838]...........................................................................103 1. Implied Private Rights of Action Under the Proxy Rules...............................................................................105 B. LIABILITY FOR FAILURE TO DISCLOSE. [P. 838-852]....................................................................................................................106 1. Materiality......................................................................................................................................................106 2. Causation........................................................................................................................................................108 C. FEDERAL REGULATION. LIMITS TO LIABILITY. [P.852-878]..........................................................................................................109 1. Informational vs. Constructive Fraud............................................................................................................109 D. DISCLOSURE AND SATE LAW REMEDIES. [P.878-893].................................................................................................................111 1. Lost State Remedies........................................................................................................................................111 2. Fault...............................................................................................................................................................111 3. State Law Duty of Disclosure.........................................................................................................................112 VI. FEDERAL LAW III. REGULATION OF AND OPERATION OF SECURITY MARKETS: INSIDER TRADING. 114 A. INTRODUCTION TO SECURITIES TRANSACTIONS. [896-905 &909-927]..........................................................................................114 1. Economic Theory, Securities Markets and Securities Transactions..............................................................114 2. The Common Law Background to Insider Trading.......................................................................................115 Court rules for widow who came to director and asked if there was going to be a dividend. Court holds that because an officer acts in a relation of scrupulous trust and confidence that his behavior is therefore also subject to the closest scrutiny. [Kansas Rule]......................................................................................................................................116 B. FEDERAL REGULATION OF INSIDER TRADING : RULE 10B-5. [P. 927-947].....................................................................................117 1. The Scope of the Rule.....................................................................................................................................118 C. RULE 10B-5 CONTINUED. TIPPING. [P. 947-969]........................................................................................................................119 1. Regulation of Trading on Non-Public Information........................................................................................119 D. INSIDER TRADING (CONTINUED). OHAGAN. [P. 969-984]..........................................................................................................121 E. THE AFFIRMATIVE DUTY TO DISCLOSE. [P.984-987 & 989-999]{SKIM 999-1007}......................................................................124 1. Disclosure Duties of Corporations.................................................................................................................124 2. Elements of a 10b-5 Action for Disclosure Fraud..........................................................................................127 3. Federal Regulation Section 16 [p. 1007] (Not Assigned)...........................................................................130
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I.
Introduction to Corporations. 1. Course Goals. (1) Learn Technical Terms/Concepts, (2) Learn Applicable Rules, (3) Look at Economic Theory, (4) Look at Public Policy, (5) Look at Ethical Issues, and (6) Learn Practical Skills. 2. Applicable Rules. (1) State Law (RMBCA/Del. Code) (2) Common Law (Tort Law) [Fiduciary Duty, Duty of Loyalty, Duty of Care] (3) Federal Law (1934 Securities & Exchange Act). What are the problems with Corporate Governance? Division between Ownership & Control. Federalism Issues. What does the Securities & Exchange Act Authorize? What Can States do?
A. Introduction to Corporations. [1-15] 1. Historical Sketch of the Corporation. Traditionally corporate existence could only be granted by the king (sovereign). Churches and charities were often granted a corporate charter. Then with the development of trading of joint stocks in the 16th century corporate charters were granted to other types of businesses. The East India Company is an example of one of the first corporations. TODAY Corporations Still Receive Their Charter Form The Sovereign (The State Of Their Incorporation). Most corporations incorporate in the State of Delaware because of its advantageous corporate statutory law. State corporation statutes are referred to as enabling statutes (in general the statutes set up a default framework). What is a Corporation? Four Basic Characteristics: 1. Separate, Perpetual Entity. 2. Limited Liability (up to value of capital contributions) 3. Centralized Management. 4. Transferability.
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2. Regulating the Modern Corporation: The Search for Accountability. a) Economic Theory. 1. Chancellor Allen. Our Schizophrenic Conception of the Business Corporation and Ambiguity in Corporation Law Private Contractarian Approach (Private Property): Nexus of Contracts; Enabling Statutes; Market Based. [Contractarians believe that corporate law embodies the terms the parties have chosen]
(a)
Social Enterprise Approach (Social Entity): State/King gives Commission and authorizes what one can do; Looks at Multiple Constituencies; Concession Theories. [Traditionalists believe that managers control shareholders and that the law should encourage shareholder voting power, broad disclosure rights, and strong fiduciary protection.
(b) 2. (a)
Hirschman. Exit, Voice and Loyalty Exit [If managers self-deal then shareholders can sell their shares]. Voice [If shareholder democracy is encouraged shareholders can voice their concerns rather than being forced to exit].
(b)
Loyalty [If over time there is some loyalty in the relationship then you are more likely to maximize some of the welfare].
(c)
b) Alternative Theory 1. Komesar. (a) Buy or Sell Shares.
B. Introduction to the Economics of the Firm. [16-26]{skim} The corporation is an investment vehicle for raising large amounts of capital and operating large enterprises. However, this separation between ownership/shareholders and control/managers makes the corporation a breeding ground for opportunism. Corporate law allocates risks between shareholders and managers in an attempt to minimize shareholder-manager conflict and maximize the overall success of the corporation.
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a) Risk The division between ownership and control creates Agency Costs. Managers and employees who do not have as large and economic stake in a corporation as an owner would may shirk their responsibilities (shirking refers to not working hard) or self-deal. Of course there are other types of risks that are out of the hands of the parties (weather, war, etc...). In a planning context a lawyer needs to thinks about the different parties risk preferences and plan accordingly. b) Allocating Risk Allocating risk may reduce cost of shirking and stealing. Allocate risk to the employer/owner: Supervise, Contract, Buy Insurance.
Allocate risk to the employee/management: Give employee a stake in the company, eg. Stock options, bonuses based on sales or performance, salary based on performance. (Note: this may help to prevent some of the shirking). C. Introduction to the Law of Corporations: Corporate Actors and Fiduciary Principles. [18-46] 1. Basic Terms and Concepts. (a) Corporation. Life Span Formation and Duration. A corporation arises when articles of incorporation are filed with a state official. RMBCA 2.03. Corporate existence is perpetual , regardless of what happens to shareholders, directors, or officers. Financial Rights Claims on Assets and Income Stream. Financial rights are allocated according to shares. RMBCA 6.01. Distributions, from surplus or earnings, must be approved by the board of directors. RMBCA 6.40. Directors and officers have no right to remuneration, except as fixed by contract. Firm Governance Authority to Bind and Control. The corporation has a centralized management structure. Its business is under the management and supervision of the board of directors. RMBCA 8.01.
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Officers carry out the policies formulated by the board. RMBCA 8.41. Shareholders elect the board, RMBCA 8.03, and decide specified fundamental matters; they cannot bind the corporation. Transferability of Ownership Interests. Corporate shares are freely transferable unless there are specific written restrictions. RMBCA 6.27. Liability to Outsiders. Shareholders have limited liability for corporate obligations. RMBCA 6.22. This is also true for directors and officers acting on behalf of the corporation. Corporate participants can lose only what they have invested unless there is fraud or an inequity justifies piercing the corporate veil. Often, large creditors of small corporations will demand that corporate participants personally guarantee the corporations obligations, thus reducing the significance of corporate limited liability.
(b)Corporate Statutes. Sources of Law. Revised Model Business Code (RMBCA). RMBCA 2.02 Articles of Incorporation. [p. 18]
(a) Must include: (1) name of corporation, (2) Number of Shares corporation is authorized to issue, (3) Corporations address, and (4) Name & Address of Each Incorporator. (b) what you may include: purpose for which the corporation is organized, indemnification provision.
Delaware General Corporation Law (DGCL). DGCL 102. Contents of Certificate of Incorporation. [p. 299]
(a) Must include: (1) name of corporation, (2) Corporations address, and (3) Name & Address of Each Incorporator, (4) purpose for which the corporation is organized, (5) Number of shares the corporation is authorized to issue. (b) what you may include: contain any provision for managing the business and regulating the affairs of the corporation that is not inconsistent with the law , provision limiting liability of shareholders, limit duration.
RMBCA 2.06 Bylaws. [p. 21]
DGCL 109. By-Laws. [p. 305]
BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001 (a) must have bylaws. (b) Bylaws may contain any provision for managing the business and regulating the affairs of the corporation that is not inconsistent with the law or the articles of incorporation.
Page 9 of 131 (a) Before the stock is paid for BOD can revoke, but once paid only a vote of the shareholders has this power. The power to adopt, amend or repeal may also be given to the BOD through the CIC, but this does not take away the shareholders rights. (b) The by-laws may regulate the business in anyway so long as they do not conflict with either the AIC or the Law.
RMBCA 3.01 Purpose. [p. 22]

(a) Only requisite purpose is that the Corp. is in a lawful business, otherwise, they AIC can specify even more.
DGCL 102(a)(3). [p. 298]

The purpose of the corp must only be that it is behaving lawfully.
(c) Organic Documents. The Articles of Incorporation and The By-laws. (d)The Corporate Actors. Stockholders/Shareholders own the corporation in that they own its stock. Shareholder approval must be obtained before a corporation can engage in certain fundamental transactions (merger or the sale of all its assets). Board of Directors, elected by shareholders, directly control the corporation. They are responsible for managing or supervising the corporations business. (e) Corporate Securities. Authorized, Issued, Outstanding Shares. What is the difference between authorized and issued shares? Authorized: Shares board is authorized to sell. Issued: Shares that have been sold. What is the difference between issued and outstanding shares? Issued: Shares that have been sold. Outstanding: Issued shares less what the board has bought back from the market. Why have outstanding shares? Issuing shares is a way to raise capital. By setting out in the Articles of Incorporation the number of shares that the board is authorized to sell share dilution can be prevented.
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Categories of Rights, Classes of Shares. What rights are inherent in shares? Right to Dividends. Preferred Shares gets preference with dividends. Common Shares no preference with dividends. Right to Vote. There is such a thing as Preferred no voting right stock. Common Shares always must have a right to vote. Conversion Redemption Rights. Corporation may have right to buy back shares or bonds at a set price. (protects against takeovers) Residual Rights. When corporation is liquidated then .....? Equity v. Debt. Equity Shareholder Equity = Shares Debt Secured bonds that can be traded on the market. 2. Fiduciary Principles. Fiduciary Duty. Breach of Fiduciary Duty. Business Judgment Rule is a shield that protects the Board; it creates a presumption in favor of the board. However, there are limits to applying BJR (Cant be a dummy or a figure head). Breach of Duty by the Board: Bayer v. Beran (1944). [p.39] FACTS: Board votes on radio advertising campaign (opera program/sponsor). Corporations presidents wife sings on the program. Shareholders bring a derivative suit (meaning a suit on behalf of the corporation) because of what they perceive as a breach of fiduciary duty for choosing to sponsor an opera program versus a variety show. [Was there self-dealing? Burden is on board.] HOLDING: Court holds that this decision was within the boards discretion (Business Judgment Rule). Court found no breach because wife did not get paid much and the board voted before they knew that presidents wife would be singing. Breach of Loyalty. Breach of Duty by Shareholders:
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Gamble v. Queens County Water Co. (1890). [p. 44] FACTS: Shareholder builds a water system on his own. Shareholder then sells this to Corporation he is a shareholder of (votes in favor of the transaction). HOLDING: Court holds that shareholder can vote as he pleases (Vote his Shares). Note, in this case we were dealing with a minority shareholder. The result would be different if we were looking at a majority shareholder. Yet, For the Court to Act a case must be made that the majority shareholders action so far opposed the corporations interest that no one would have acted in this manner. Note this case highlights the distinction in roles and duties between shareholders and directors. Note, there may be two exceptions to the BJR in this context: (1) if the majority was fraudulent and only out to harm the minority shareholders, (2) the majority was simply oppressive to the minority. Problem: Chesapeake Marine Services [Part I] [37] BJR-This shields the management from ex post facto judicial review for their managerial actions. Note, Apple can block the proposed method for raising capital because he own 1/3 of the common stock and it would take 2/3 vote for a change of the AIC. Note, there is a desire to dampen this type of vote because the AIC are like the constitution of the corporation. How can you retrieve capital? (1) issue equity, debt, mortgage property, sell property, OR MERGE. Voting Law: RMBCA 7.25 Voting Requirement: (a) A majority of votes entitled to be cast constitutes a majority (b) there are special rules for amending the AIC, want to protect their sanctity, 7.27 Greater Quorum or Voting Requirements, (b) must meet the same quorum requirements and be adopted by the same vote and voting groups already required or proposed to be adopted, IF THEY ARE GREATER. Note, RMBCA 10.03 Amendment by BOD and Shareholders (c) allows the BOD to condition their submitted amendment on anything, (e) Note: Conditions from BOD in 10.03(c) is o.k. so long as the requirement is greater than the default, must be at LEAST a majority of those who are allowed (Shares) to vote for quorum, any restriction can only be larger; therefore, essentially this is the legal minimum. RMBCA 8.01(b) BOD governs the corp and they have great discretion, basically having to operate within the law and the AIC, or potentially the by-laws. RMBCA 2.02 (a) tells what must be in the AIC, (b) what AIC may set forth, 6.01(a) AIC must describe the class of shares and # each class authorized to issue, set forth preference, limitations, and relative rights of each class of shares, which must be identical to those of the same class and described in the AIC. 7.27, 8.01(b) The BOD shall manage the corporation, subject to limitations of the AIC or shareholder agreement under 7.32,
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10.01(a) corporation can add or delete any provision it may wish from AIC. (b) shareholders never have a vested property right in the corporation. 10.03(a) the proposed amendment must be adopted by the BODs., 11.03 Share exchange, 12.02(a) A sale, lease, exchange, or other disposition of assets, other than a disposition described in 12.01 (usual course of business stuff) requires approval of the corporations shareholders if the disposition would leave the corporation without a significant continuing business activity. Del. Code 102(a)(4) Tells what the AIC should set forth, 141(a) The corporation shall be managed by the BODs, except as provided in the CIC, 216 The CIC or By-laws determine quorum and those votes required for corporate transaction approval, no # quorum requirement shall be under 1/3, ABSENCE OF CIC OR BY-LAW SPECIFICATION (1) majority unless CIC at shareholder meetings is quorum, (2) in all votes other than election of BOD, majority is good enough for approval, (3) directors shall be elected by a plurality, 242(b)(1)-the BOD shall propose an amendment that shall be set forth for majority approval and therefore acceptance by the shareholders. There is a process here that does include a BOD recommendation and brief description of the proposed changes. D. The Schnell Doctrine. Equitable limitations on legal possibilities. [46-52] Schnell v. Chris-Craft Industries, Inc. (1971). [p. 47] FACTS: Board of Directors moved annual shareholder meeting up a month(Del. Code/yes), held the meeting in the boondocks, and did not release a list of shareholders (Federal Law) in order to prevent shareholders from electing a new board of directors. HOLDING: Board of Directors did nothing to technically violate Delaware law, 109(a) would allow the director to confer, adopt, repeal or amend the by-laws. Yet, Court orders an injunction because inequitable action does not become permissible because it is legally possible. Court was bothered by the board of directors self-dealing in trying to perpetuate their existence. This type of behavior goes against shareholder democracy. What options are available to Shareholders? Exit (sell shares on market) or Exercise Voice(vote). Bove v. Community Hotel Corp. of Newport. RI (1969) [p. 49] FACTS: Preferred Class of Shares w/right to dividends for 24 years. Board knows that they will not get a unanimous vote from the preferred class shareholders to go
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through w/amendment which will terminate the preferred shareholders rights. Board wants to eliminate the preferred shareholders right to dividends so that the board can raise capital by selling shares (people will not buy shares if they wont get any dividends because of the preferred shares). Board creates a new corporation and proposed to merge the old corporation into the new one and get rid of the preferred stock . Merger only requires 2/3 vote from the shareholders. HOLDING: Court refuses to enjoin the merger. Court cites the BJR, merger in the interest of 2/3 of shareholders (why enjoin to protect 1/3 minority), court does not want to create exceptions that will interfere with M&A deals.
Doctrine of Independent Legal Significance If one provision of state corporate code says that you can do x but somewhere else in the code it says that you cant do x, you can do x. How do we reconcile Schnell and Bove? To start with there is a difference in the significance from recapitalization and reorganization. However, there is also no threat of injuring corporate democracy in Bove, and the BOD is seeking to act in the benefit of the corporation, not themselves.
Problem: Chesapeake Marine Services [Part II] [46] Evaluating three potential claims by Apple:
1. The First claim is whether the was unwise. That is, did the board breach its duty of due care to the corporation (Chesapeake) and its shareholders. Here the members of the board can refer to the BJR in defense of their actions. 2. The second claim is whether the BOD action was unfair. That is, did the BOD breach a duty of loyalty to the corporation and it shareholders. You are told that both the corp and the lamberts invested in the new subsidiary, named CMS Shipyard, Inc. (Shipyard). The issue is whether the corporation received a fair number of shares in Shipyard for its investment (a division with a fair market value of $375,000) compared to the Lamberts for their investment ($75,000 in cash). To make this determination, you must do some simple math. The bottom line is to compare the number of shares that the Lamberts received for $375,000. here are the math calculations: a. What is the value of total assets of Shipyard? Shipyard will have assets of $525,000=$375,000 ($375,000 FMV of Shipyard)+$150,000 cash (subscription price of 1,500 shares at $100 per share). b. What is FMV of each Shipyard share? Since 3,500 shares issued, each share has a real value of $150 ($525,000/3,500) c. What investment made by Lamberts? Lamberts get 750 shares at $100 per share=$75,000 investment. d. What is FMV of Lamberts shares? Value of Lambert ownership=$122,500 (or 750 shares x $150 per share); so for 75,000 investment, they receive $112,500 value.
BUSINESS ORGANIZATIONS II - Shaffer Page 14 of 131 Karl Bekeny/Spring 2001 e. What is investment made by Chesapeake? Chesapeake contributed the assets of its Shipyard division with a FMV of $375,000. f. What is FMV of Chesapeake shares? Chesapeake gets 2000 shares whose value is $300,000 (or $150 per share value x 2000); but FMV of division was $375,000. Clearly the current structure is unfair to Chesapeake and needs to be changed to protect the Lamberts from a claim that they have breach their duty of loyalty. 3. The third claim is whether the transaction is unlawful because Chesapeake is doing indirectly (raising capital through the issuance of new shares) what it cant do directly. It cant do this directly because of the provisions in its AIC that (i) limit the number of authorized shares to 1,000 and (ii) require a 2/3rds vote to amend the AIC. There are two lines of applicable cases. Under Schnell, there are equitable limits as to what actions the board can take, even if technically legal under a provision of the state corporate statute. This exception applies in order to preserve corporate democracy. Under Bove and the doctrine of independent significance, a board can accomplish actions that otherwise would be prohibited through a reorganization or recapitalization that is authorized by a separate provision of the state corporate statute. In the Chesapeake case, should Schnell or Bove apply?
Derivative Suit Is an action in equity brought by a shareholder on behalf of the corporation. The action is brought against the corporation for failure to bring an action in law against some third party, most often an unfaithful or careless manager. The corporation is the real party in interest is a nominal defendant and the plaintiff-shareholder controls the suit. RMBCA 7.40-7.47.
E. Constitutional Conceptions of the Corporation: Regulating the Corporations Internal Affairs; State Takeover Statutes. [53-87] 1. Corporation as a Person. Corporate personality makes possible the aggregation of capital and the convenience of a business entity capable of contracting, owning property suing, and being sued. For commercial purposes, state and federal law largely respects the corporation-as-person metaphor. (Trustees of Dartmouth College v. Woodward (1819) The State could not amend the charter because the charter was within the constitution which constituted a K between the state and the college) The charter may provide for 1. Immortality, 2. individuality, 3. management of affairs, 4. Holding of property.
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Commerce Clause. Corporations are protected against state restrictions that burden interstate commerce. Due Process Clause (property interests). Corporate property is protected against governmental deprivation under the Due Process Clauses of the Fifth and Fourteenth Amendments. (Santa Clara County v. Southern Pacific Railroad (1886) Corp entitle to EP under the 14th Amendment). (Minneapolis & St. Louis Railway Co. v. Beckwith (1888) corp is also entitled to the due process of law. NO PROTECTION or limited rights: Self-incrimination, unreasonable searches and seizures, due process (life and liberty), political (noncommercial) speech. (Hale v. Henkel (1906) protects the corp from illegal searches and seizures under the 4th Amendment, but there are no 5th Amendment incrimination protections. 2. The First Amendment. Corporations have a limited First Amendment First Amendment right to express themselves as to commercial matters such as advertising their products. First National Bank of Boston v. Bellotti, (1978) [p. 58] HOLDING: Supreme Court held that a state cannot forbid a corporation from expressing its views on a state referendum, even when the referendum does not materially affect the corporations business. 3. Regulating Corporations Internal Affairs. Internal Affairs Doctrine. Choice of law rule which permits the parties though the incorporation process to fix the law that applies to their corporate relationship, wherever litigation is brought. Thus, the law of the state of incorporation governs the internal affairs of the corporation.
Internal Affairs refer to the rights of shareholders, the fiduciary duties of directors, and the procedures for corporate actions among others. Some states (CA) regulate the internal affairs of corporations that have substantial operations in the state but are incorporated elsewhere. State Anti-Takeover Statutes. (These are basically regulating Tender Offers)
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Today most states, including Delaware, have enacted anti-takeover statues. The policy behind this is that hostile takeovers hurt the local economy and tax base. There are Three Generations of anti-takeover statutes. First Generation. {Edgar v. MITE Corp. US [p.76]} The Ill statute set up timetables and requirements for outside tender offers. It was held unconstitutional (1) Violation of policy of neutrality within the Williams Act, part of the Security and Exchange Act and (2) ICC prevents state laws which regulate interstate commerce. Second Generation. CTS US 1987 Supremes uphold, why:
Williams Act-not a problem because (1) Not necessarily any delay, (2) even if delay, not unreasonable, (3) State reg, if Congress wants different, then let them say so explicitly. Commerce Clause Violation Art I, 8. Indiana need not define these commodities as other states do; it need only provide that residents and non residents have equal access to them.
Third Generation. Amanda Acquisition 7th Cir., 1989 Control Share Statutes, Business Combination Statutes, Delaware Statue, Fair Price Statutes, Appraisal Statutes. There are pros and cons to these statues. Pro: protect local communities, tax base, and shareholders; prevent stripping of corporate assets. Con: allows management to be lazy, shirk, etc... CTS Corp. v. Dynamics Corp. of America, [p.77] {second-generation antitakeover statute} FACTS: Dynamics contends that the Indiana Anti-takeover statute is unconstitutional because it discriminates against out-of-state entities. The statute, which applied only to corporations incorporated in Indiana with significant Indiana shareholdings, required disinterested shareholders (excluding the bidder and management) collectively vote to approve the voting rights of any bidder who sought to acquire a controlling interest in the corporation. That is, until the body of shareholders voted to enfranchise, the bidders control shares would not carry voting rights. HOLDING: Statute is constitutional and not inconsistent with the Williams Act. It does not prohibit any entity, resident or non-resident, from offering to purchase , or from purchasing shares in Indiana corporations, or from thereby attempting to gain control. It only provides better regulatory procedures designed to protect the corporations shareholders. The statute does not interfere with the bidding process
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and comports with the traditional power of states to regulate the internal affairs of domestic corporations. Amanda Acquisition Corp. v. Universal Foods Corp., [p.83] {Third Generation Business Combination Statue} FACTS: Amanda was a shell (debt and junk bonds) with a corporate purpose to takeover Universal. Amanda wanted to merge with Universal and strip Universal of its assets. Under Wisconsin statute the existing board has to approve the deal otherwise the bidder has to wait 3 years after buying shares to merge with the target or acquire more than 5% of its assets. HOLDING: Statute is constitutional. Judge Easterbrook thinks it is a foolish statute because corporations will leave Wisconsin. Note: this does not seem to be the case. Delaware has enacted anti-takeover statutes and seems to be doing just fine.
F. Ambiguity of Corporate Purpose: Charity Giving. [88-107] Corporations represent independent concentrations of economic power. Some argue that corporations represent social and political power as well. Mason and others argue that the corporation lacks legitimacy because managers are accountable to no one. Whose interests should the corporation seek to serve? Two views: (1) Berle believed that corporations should serve shareholders at all times (profit making). [Corporate Democracy] Market forces, government regulation, and the mechanics of corporate governance constrain managers discretion. (2) Dodd believed that corporations should serve the community (social service) as well as its shareholders (profit making). [Managerialism] Berkshire Hathaway, Inc. permits each shareholder to direct the corporation to donate a certain amount per share to the charity of the shareholders choice. [p. 107] 1. The Doctrine of Ultra Vires.
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Ultra Vires, is a common law doctrine from the nineteenth century. It literally means beyond the power. Under the Ultra Vires Doctrine a corporation may not engage in activities outside the scope of its powers as stated in the corporations charter. Thus, when applied the doctrine invalidated actions that went beyond the corporations purpose as stated in the corporations charter. Ashbury Railway Carriage & Iron Co. v. Richie, (1875) [p. 91] FACTS: Railway hires Richie to construct a railway line in Belgium. The corporation repudiates the contract after Richie had done some of the work on the ground that it lacked the power to hire Richie. Richie brings suit. HOLDING: House of Lords holds that a corporation whose charter authorized it to sell or lend all kinds of railway plant, to carry on the business of mechanical engineers and general contractors, etc. exceeded its purposes in purchasing a concession to build and operate a railroad in Belgium. Today the doctrine of ultra vires has little life left in it. RMBCA 3.04 Ultra Vires. ...the validity of a corporate action may not be challenged on the ground that the corporation lacks or lacked power to act ... except as provided in subsections: (b)(1) which allows shareholders to bring suit and enjoin the corporation from entering into or continuing unauthorized action, and (b)(2) which allows the corporation to bring suit on its own or by another on its behalf [derivative suit] to enjoin the corporation from entering into or continuing unauthorized action. 2. Modern Limitations on Corporate Charitable Giving. State enabling statutes authorize general purpose clauses and virtually unlimited powers. RMBCA 3.01 Purposes, a corporation has the purpose of engaging in any lawful business unless the articles of incorporation provide for a more limited purpose. DGCL 101 (b)...Purposes, A corporation may be incorporated or organized under this chapter to conduct or promise any lawful business or purposes, except as may otherwise be provided by the constitution or other laws of this state. DGCL 102 (a)(3) Contents of Certificate of Incorporation,
RMBCA 3.02 General Powers, a corporation has the power to (5)
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sell, mortgage ... or otherwise dispose of all or any of its property, (6) purchase ...or otherwise acquire...any other entity, (12) pay pensions,...and share option plans, (13) make donations for the public welfare or for charitable, scientific, or educational purposes.
The purpose of the corporation is to engage in any lawful act or activity for which corporations may be organized under Delaware Corporation Law except if the articles of incorporation state otherwise
DGCL 122 (9) Specific Powers. Make donations for the public welfare or for charitable, scientific or educational purposes, and in time of other national emergency in aid thereof.
Thus, today the ultra vires doctrine only applies when: (1) a corporation acts in a manner restricted by the corporations articles of incorporation, or (2) the corporation engages in activities not directly related to profit seeking, such as charitable giving, so as to constitute a waste of corporate assets. Note: WASTE is really what is left of the Ultra Vires doctrine. This may include golden parachutes or heavy compensation programs for company executives. A.P. Smith Manufacturing Co. v. Barlow, (1953) [p,89] Court upholds the validity of a corporate gift to Princeton University. Note that the company argued and the court accepted the argument that the gift advanced the companys long-run business interests. Theodora Holding Corp. v. Henderson, (1969) [p. 95] FACTS: Theodora holding company brings suit against Henderson and other individuals, challenging that the gift Alexander Dawson, Inc. made to the Alexander Dawson Foundation (camp for underprivileged boys). Theodora sought an accounting and appointment of a liquidating receiver for Alexander Dawes. [ Background, family controlled company, family fighting, ex-wife wanted money to go to a charitable foundation she and her daughter, a board member, supported.] HOLDING: Applies A.P. Smith, holding that the gift in question is valid because it was within reasonable limits as to amount and purpose (cost shareholders less than 80K and went to benefit troubled youth). The factors to consider are there going to be any short-term (this is deductible and has no big effect, look it helps balance the corporate balance sheet) or long-term benefits (this would include social welfare etc.).
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Thus, courts generally have accepted that corporations have implicit powers to make charitable gifts that in the long run may benefit the corporation. See Theodora Holding Corp. Moreover, if the gift is tax deductible, corporate law treats it as a reasonable exercise of corporate powers [BUSINESS JUDGMENT RULE] See Kahn v. Sullivan and I.R.C. 170 (deduction for corporate giving limited to 10 percent of the corporations taxable income).
Kahn v. Sullivan, (1991) [p.97] FACTS: This is an appeal from the approval of the settlement of one of three civil actions brought be shareholders. Each civil action alleged corporate wasting of assets and challenged a decision by Occidentals board through a special committee of Occidentals outside directors to make a charitable donation to construct and fund an art museum to house the now deceased Occidental CEOs, Dr. Armand Hammer, (300-400 million dollar collection). Occidental is headquartered in Los Angeles, Art museum was built in Los Angeles. Before he died, Dr. Hammond made the proposal to the board. The board investigated and hired a law firm to prepare a memorandum regarding the relevant issues the board should consider regarding the proposal. Special Committee decides to establish museum next to corporate offices and notes that museum would create a new cultural landmark in L.A. The museum was to be named the Armand Hammer museum and Occidentals name would be placed in various places throughout the museum. {Public Recognition/advertisement argument} [Lawyers made a lot of money in negotiating the settlement]. HOLDING: The court of chancery did not abuse its discretion in approving the settlement, its findings of fact are supported by the record. Per the holding in Theodora Holding Corp, the court of chancery applied a reasonableness test. Not every charitable gift constitutes a valid corporate action but here given the net worth of Occidental, its annual net income before taxes, and the tax benefits to Occidental, the gift was within reason. Note: (1) By using a BOD committee of outside directors, there appears to be no self-dealing, breaking the fiduciary duty of loyalty. (2) There doesnt appear to be any waste because the entire deal seems reasonable. If corporate largesse is demonstrably unrelated to corporate benefits (e.g. when the gift is excessive) the transaction may be attacked as ultra vires. Such corporate altruism may also constitute corporate waste, a fiduciary breach of care. However, if the money is then
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only used for the managers, such as in self-dealing, then this would be a breach of the duty of loyalty. G. Ambiguity of Corporate Purpose: Social Responsibility. [107-126] 1. Corporate Social Responsibility Trends. More and more corporations are attempting to take a stance and act on social issues (the environment, workers rights but only after pressure from shareholders or public at large) 2. Judicial Approaches. Dodge v. Ford Motor Co., (1919) [p. 110] FACTS: Action brought by Dodge brothers, two minority shareholders, against Ford Motor Company, Henry Ford, and other members of the board of directors, to compel payment of a dividend, to enjoin construction of the River Rouge plant, and for other relief. The lower court ruled for the Dodge brother and ordered the Ford Corporation to pay a 19 million dollar dividend and enjoined it from building the River Rouge plant. Ford appealed. Henry Ford stated: My ambition is to employ still more men, to spread the benefits of this industrial system to the greatest possible number, to help them build up their lives and their homes. To do this we are putting the greatest share of our profits back into the business. Ford wanted to build more cars and sell them at a lower price so more people could enjoy the benefits of a car. His goal was to employ a large amount of people at good wages, to provide the public with cars at a fair price, and not to make an awful profit. This policy ended up bringing Ford enormous success. HOLDING: A business corporation is organized and carried on primarily for the profit of the stockholders. The lower courts ordering of payment of the dividend is upheld. However, the plant may be built. The proposed expansion of the Ford Company is within the province of the board. [BJR] Shlensky v. Wrigley, (1968) [p.115] FACTS: Plaintiff sought damages and an order that defendants cause the installation of lights in Wrigley Filed and the scheduling of night baseball games. Defendant argued that baseball is a daytime sport and that night games will deteriorate the surrounding neighborhood and in turn the value of the stadium. HOLDING: Court holds that it is within the Board of Directors business judgment to make this kind of decision. The lower courts order of dismissal is affirmed.
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3. What is Corporate Responsibility? Milton Friedman, Capitalism and Freedom (Shareholder Capitalism)
1.
There is one and only one social responsibility of a corporation to use its resources and engage in activities designed to increase profits so long as it does not break the law. 2. Elliot Weiss, Social Regulation of Business Activity: Reforming the Corporate Governance System to Resolve an Institutional Impasse (Altruistic Capitalism) Corporations are creations of law, and have as their ultimate purpose the welfare of society. In early days corporations could achieve this goal by promoting their financial wellbeing. However, today corporations must promote social welfare through altruistic capitalism. [make decisions as if corporation bore all the transactions costs] He purposes the national directors corps, members appointed by the president. Would require large corporations to draw 2/3 of its directors from the corps. 3. ALI 2.01 (1) is Friedman, (2) is Weiss, and (3) is Theodora Holding, principles of Corporate Governance: Analysis and Recommendations (A Conglomerate of all the Ideas) The corporations purpose is to enhance corporate profit and shareholder gain but do so by not breaking the law and optionally taking into consideration ethical considerations and optionally making a reasonable amount of money to philanthropic purposes. 4. Norman Redlich, Lawyers, The Temple, and the Market Place Lawyers have a professional duty to refuse to approve of, or participate in, transactions which the lawyer believe is unlawful, no matter the costs involved to the lawyer. A lawyer in rendering advice to a client should exercise independent professional judgment and render candid
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advice including unpleasant facts and alternatives a client may be disinclined to confront. Constituency Statutes-These state laws allow for the BOD to consider other things than shareholders when making their management decisions, this would include how can management keep its job. These typically were applied together with anti-take over statutes.
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Authorizing, Empowering and Constraining the Corporate Actor: State Law Regulation.
II. A. Introduction to Basic Financial Accounting.[187-206] (See the spread sheets within the notes for more info on accounting) When you look at a balance sheet you want to find out about the profitability of the corporations operations, the value of its assets, and whether the corporation will be able to meet its financial obligations as they come due. Look at the corporations liquidity, debt coverage, equity and cash flow. The two basic financial statements are the balance sheet and the income statement. When you are faced with a balance sheet look at the current assets and the fixed assets (left side) and the liabilities and equity (right side). Some Basic Terms: Assets = liabilities + equity. Assets are both tangible and intangible property owned by the corporation and will be listed in terms of decreasing liquidity (the ability to be converted into cash on the balance sheet) Current Assets include cash and other assets which in the normal course of business will be converted into cash within a year of the date of the balance sheet. Fixed Assets sometimes referred to as property, plant, and equipment, are the assets a firm uses to conduct its operations (as opposed to those it holds for sale). Accounts Receivable, money that customers owe the corporation. Liabilities represent money the corporation owes. They are divided into current and long-term. Equity represents the owners interest in the firm ($ they put into it)
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1. Financial Terminology and important concepts: a) Accrual Accounting-This is verse Cash Accounting. (1)Revenue Recognition-The revenue is recognized when it is earned. (2)Expense Recognition-Matching, This forces a match up between paying out salaries, utilities, etc. and what exists. b) Retained Earnings- (Retained Earnings=Net Income Dividends) c) Working Capital-(Current Assets-Current Liabilities) d) Operating Income-(Before interest + Taxes) 2. Introduction to Financial Analysis. a) Liquidity Analysis. Does the firm have sufficient money or convertible assets that can be used to meet financial obligations as they come due? Working Capital = the difference between current assets and current liabilities. Current Ratio = divide current assets by current liabilities. ** Liquidity Ratio = divide quick assets (things with high liquidity) by current liabilities. ***Analysts prefer current assets to be at least twice as large as current liabilities.
b) Debt Coverage Analysis. Creditors are interested in a corporations ability to pay its debt on time. Debt: Equity Ratio = divide long-term debt by the book value of its equity. A ratio of 1:1 indicates that the firm is relying principally on borrowed capital.
c) Equity Analysis In valuing a firm analysts tend to focus on equity accounts and income statement. Also, look for trends in revenues and earnings.
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d) Cash Flow Analysis. Compare a corporations income and cash flow statement. Problem: Precision Tools [Part III] [187] (See attached printout of spread sheet) B. Introduction to Corporate Securities. Authorization of Stock.[220237] Someone investing money in a corporation either wants to get their money and exercise some control of how things go in the corp. [planning perspective, what does your client want?] 1. Types of Financing. The corporation provides a structure for financing business operation and defining the financial rights to the firms income stream. Corporate financing comes form three sources: (1) (2)
Equity financing which can be in the form of either common stock (voting rights) or preferred stock (preference with dividends), Debt financing (corporation owes a 3rd party money bonds are secured debt and debentures are unsecured debt),
(3) Corporate Earnings (reinvest inside $). DGCL 221 allows corporations to issue debt securities that have voting rights. While DGCL 151 allows corporations to issue stock with no voting rights, so long as one class of stock has voting rights. See also RMBCA 6.01.
Concern of Financing: Same As Always (1) Who has control, (2) What is the income, (3) What are your rights on liquidation. Control Income Voting Rights Dividends (Equity) Interest Payment (Debt) Rights Upon Liquidation 1. Debt (preferential) 2. Equity (Subordinate) Note: Different duties apply to equity, the BOD has a fiduciary duty to you, not so with debt. Note: Length of the debt is 10-20 years and then it ends. (Equity can go to perpetuity, The Difference here is the level of risk.
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Potential Rights of Preferred Shareholders with Dividends 1. Cumulative 2. Participation-could get paid along with common stock, pro rata. 3. Voting Rights-These may exist when dividends are not paid. 4. Redeemable-You want out of investment, or company wants back for resale. 5. Convertible-Turn into common stock at
2. Authorization and Issuance of Equity Securities (stock)
Debt Security 1. No voting, conversion, participation, or redemption rights, but they could potentially be incorporated under K. 2. Protection comes from Covenants: a. Negative-No dividend, no treasury stock. The company may have to keep certain ratios.
Authorized Shares = shares of stock corporation may authorize as specified in the articles of incorporation. 2.02(a)(2)-the number of shares the corporation is authorized to issue. Authorized but Unissued = authorized shares that have not been sold to shareholders. Authorized and Issued or Outstanding = authorized and sold. 6.03 Issued and Outstanding Stock Treasury Shares = share that are authorized but have not been issued. 6.31(a). This stock is once again unissued because it was purchased back by the corporation.
# of authorized shares is stated in the Articles.
RMBCA 2.02(a)(2), and DGCL 102(a)(4) require that the articles of incorporation include the number of shares that a corporation is authorized to issue and describe certain characteristics of those shares(what class with what rights). If there is no more stock left to issue you have to amend the articles to authorize more. If a corporation issues all the shares authorized in its articles of incorporation, it must amend the articles to authorize additional shares before it can issue more stock. An amendment must be recommended by the board of directors and approved by holders of at least a majority of its outstanding (issued) stock. See RMBCA 10.03 and DGCL 242.
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RMBCA 10.03(e)-Unless provided GREATER requirement in the AIC, then approval of the amendment requires the approval of the shareholders at a meeting at which a quorum consists of at least a majority of the votes entitled to be cast on the amendment exists Official Comment 3 If a quorum exists, then under sections 7.25 and 7.26 the amendment will be approved if more votes are cast in favor of the amendment than against it by the voting group or separate voting groups entitled to vote on the plan. Poison Pill Plans hinge on having a class of stock that in a merger context of which the board does not approve the shares may only be redeemed at (a really high price). Making the cost of purchase extremely high.
Preemptive Rights: Allows shareholders right to purchase a percentage of new issue, to prevent dilution of your shares value. Works in one of two ways: 6.30 The Shareholders of a corporation do not have a preemptive right to acquire the corporations unissued shares except to the extent the AIC so provide.
(1) a. Michael (M) and Jessica (J) are the largest voting common stock shareholders; therefore, having the greatest amount of risk, but also the greatest chance for success. As a result, they want to have as much control of the corporation, so that it might make money, as is possible. Note: That Bernie (B) still has the trump vote on any major BOD action because M and J cannot get above 50% alone. The preferred stock or debt security aspect of Bs invest give him likely no control, although there may be allowed some voting privileges under the preferred stock for major votes (mergers, etc.). However, he would not have the hands on with the day to day business that M and J would. The Star and Stern plus the bank likely only want their money and may look for Bonds (secured debt) to get paid of with, and with a certain amount of interest. They may also put in quite a bit of protections, like a right to force bankruptcy, have the principal come do, or have a sinking fund so some of the money is paid out continually. Note: these bonds while difficult for the corp arent all bad in that they are tax deductible. Note: that the more debt the leveraged that PTC becomes. b. M and J will be paid back through several ways; 1. a salary for running the corp, 2. dividends on their common stock, 3. and increased value in their stock. B and Stern and Star will get paid at regular intervals (in accordance with the K) and with interest. The timing and how much the interest really is, is dependent on the K. c. M and j have the potential to recover the most capital, but they also have the greatest risk, hence their heightened control of the corporation. On the other hand, B has a mixed bag, he is fairly diversified. He will get paid out on his debt securities the principal and likely some interest, but he may also may make a little more if the company does well and his common stock soars. Stern are Star are the safest here with 12% interest and the $750,000 immediately due it PTC defaults on any payment. (2) a. B has a difficult decision, because part of his money is in common stock, so he wants to see the corp do well. Yet, he wants the security of having a secured payment. However, along with any kind of payment puts more leverage on PTC to get the job done. Preferred stock may be good for B in that it allows him to receive (a dividend preference and a liquidation preference). These are the protections, but on the other hand with a conversion ratio he can jump in at anytime if the corp is doing well or he wants more control , plus with the potential for voting rights, B may be able to get a good deal. On the other hand, the stock may carry redemption rights for either the
Problem: Precision Tools [Part V] [220]
BUSINESS ORGANIZATIONS II - Shaffer Page 29 of 131 Karl Bekeny/Spring 2001 corp or B. If for the corp, the stock may be bought out from underneath B if the stock becomes to expensive. On the other hand, if B can get redemption rights, secured by a sinking fund which allows the corp to assure their ability to pay off their debt, then preferred stock may be a happy medium between common stock and debt securities. The debt securities will likely not have any participating rights, but they may have a conversion right so that you could enter into equity. Of course, the debt is also tax deductible which is beneficial to PTC. (3) If PTC is already paying $90,000 a year to Stern and Star in interest on their required investment, but to add the new $400,000 would force PTC to pay another $20,000 in interest a year. Requiring profits of at least $110,000 just to pay off their interest. While the note does allow for the payment of Stern, Bank, and B first, there is the concern that PTC will have earnings over the $50,000, but then that they will not be able to pay off Stern, Star, and the bank, and therefore have nothing for B and whoever else. (4) a. B could not include a preemptive right provision because under 6.30(b)(4) holders of shares without general voting rights may not have preemptive rights with respect to any class of shares. Under Delaware 102(b)(3) this would likely be allowed, but the right would have to be in the AIC. b. The benefit M and J have is their control of the group so it is unclear why they would give that up. They are the ones who are taking the risk. c. Under 10.03 M and J could amend the AIC to allow for more shares, and they could get the quorum and the majority vote. B therefore could probably not get the requisite amount of votes necessary to limit the amount of shares. Unless B had a conversion right that would give him the voting power to change the authorized shares. Note: 10.03(a) adopt by the BOD, 10.03(b) the shareholders must then approve, 10.03(c) the BOD may condition their recommendation on any basis. Official Comment 3, 7.25Simple majority is o.k., 7.26.
C. Regulation of Legal Capital. Par Value.[242-252] The concepts of par value, stated value, and legal capital are concepts which only apply in Delaware. Par value-is a made up figure that represents the amount that must be paid so the shares can be issued as fully paid and nonassesable. This figure was originally created to protect creditors from investors who would use fraud to create things like watered stock. To prevent watered stock: DGCL 162 provides that shareholders are liable for the sum necessary to complete the amount of an unpaid balance of the consideration for which shares were issued. DGCL 152 provide that the boards judgment as to the value of property exchanged for stock is conclusive, absent fraud (future services is invalid consideration) (The reasoning behind this par value was that Watered Stock could be issued, shares issued for property whose value is overstated. This scenario was difficult for creditors. RMBCA Today: RMBCA 25 requires that the full consideration for which such shares wereto be issued. 6.21(b) The mention of shares does not necessarily include shares with par value. The consideration could be tangible, intangible, future service, or a promissory note. Without-Par Stock: 2.02(b)(2)(iv)-This deals with the problem of watered stock, but limits on distributions to shareholders continue to apply.
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Liability: RMBCA 6.22(a): Shareholders are liable for the consideration for which the shares were authorized to be issuedor specified in their subscription agreement. Note: Under the RMBCA there is no par value or stated capital, there can be no watered liability. Stock can also be sold for the promise of future services. See RMBCA 6.21 (b). Shareholder liability is limited to the payment of the consideration for which the shares were issued, which is totally up to the BODs, 6.21(c). See RMBCA 6.22. DGCL Today: DGCL 151(a) any or all of which classes may be of stock with par value or stock without par value. Consideration Without Par Value: DGCL 153(b) Shares of stock without par value may be issued for such consideration as may be determined from time to time by the BOD, or by the stockholders if the certificate of incorporation so provides. Liability: DGCL 162(a): You have to pay the unpaid balance for whatever the shares were issued.
1. Question 2a. Is it necessary for PTC to assign par value in Del? -No not necessary; can have no par stock-see DGCL 151(a) and 102(a)(4). 2. Question 2b. Consequence of $100 par value in Del? Stated capital of 500K (have 5,000 shares x $100 par value) Consequence of $1 par value? Stated capital of $5k & Surplus of 495K Note: PTC balance sheet: total assets of $6 million, total liabilities of $5.5 million and the equity account of $500K-what now doing is driving the equity account into 2 items: stated capital and surplus. FREE TO CHOSE, BUT SUBJECT TO THE FOLLOWING CAVEATS: 1. If cant include $90,000 of goodwill in assets, then net assets (assets-liabilities)=$410,000, so if issue 5,000 shares, need chose a par value less than $100/share. 2. If must value real property at book value so net equity =$10,000 (i.e. does not include $400,000 from the accounting at fair market value of the building and the land); if issue 5,000 shares, cant have par value greater than $2/share. 3. Question 2c. If issue no par stock in Del, any further action of BOD? a. Can issue no par stock under DGCL 102(a)(4), but BOD need act at date of issuance (if for cash) or within 60 days (if for property other than cash) to allocate some of the consideration to capital and the rest to surplus, or all will be considered stated capital under DGCL 154. Note: Definition of stated capital under DGCL 154 as amount of consideration so determined to be capital in respect of any shares without par value. 4. Question 2d. a. In Delaware what consideration can PTC receive? Can PTC accept Michaels Note? 1. OK for cash, property, services rendered (sweat equity) under DGCL 152(1). 2. BUT would have a problem for the note if par value set at less than 100-prob is that under DGCL 152, the capital stock is not deemed fully paid and nonassessable if the amount of consideration received in such form listed under (1) is less than the stated capital. (This does not include notes). b. No problem if par value of 1 because Michael pays $100,000 in cash & PTC can allocate the value of the note to surplus (permissible under DGCL 152(2)). c. Can consideration b for future services? For an executory K? -Not under DGCL 152 because must receive a binding obligation to pay balance of purchase price.
Problem: Precision Tools [Part VI] [243]
BUSINESS ORGANIZATIONS II - Shaffer Page 31 of 131 Karl Bekeny/Spring 2001 5. Question 3?a. under RMBCA, is it necessary to set par value?-RMBCA eliminates concepts of states capital, par value & Surplus. b. How account for sale of stock to Michael on balance sheet?-the $100,000 cash and $100,000 note will go on the left hand side as assets and the $200,000 total consideration will go on the right hand side as equity. c. Under RMBCA, can PTC accept a promissory note or future services?-yes, note & future services good consideration under RMBCA 6.21(b).
D. Payment of Dividends and Other Distributions.[252-258, 263-278] Problem on page 252. A shareholder cannot usually compel the payment of dividends (Dodge they were able to). However, a shareholder can bring suit when dividends were paid that should not have been paid out. A corporation can distribute its assets to shareholders in a variety of ways: (1)dividends, (2)capital/liquidating distributions, (3)stock redemptions, (4) corporate repurchases. Dividends can take the form of a stock dividend, cash dividend, or stock split. 1. Delaware Corporation -- Dividend Rules
Legal Capital = par value x outstanding shares Redemption: 160(a)(1) Cannot redeem when the capital of the corporation is Stated Capital = par value x outstanding shares impaired, or would become impaired. Dividends may be paid out when there is surplus also nimble dividends may be paid out of current earnings even when surplus (capital or earned) is unavailable. DGCL 170. SURPLUS NO SURPLUS 170(a)(2)-in case there shall be no such surplus, out of its net profits for the fiscal change the AIC so that you may get more year in which the dividend is declared Under the RMBCA you apply the equity/insolvency and preceding fiscal year. of 6.40 (c). and/or the the balance sheet test You have to meet both tests if the 154 is: (1) total assets total liabilities Note: assets (2) corporation wants to issue a dividend. = net 1.40(6) Surplus as defined by DGCL distribution, does not net assets =dividends, you can do these even when insolvent. subtract capital from equal stock surplus. RMBCA 6.40(c)(1) [Equity Insolvency Test] prohibits distributions if after giving it - Capital Stock = Capital Surplus effect the not be able = due. This is a ASSETS corporation wouldLIABILITIESto pay its debts as they come Paid in surplus EQUITY liquidity test!!! Has nothing to do with ownership stated, legal) $6 million $5.5 million (Capital; interest. Retained earnings (Surplus) RMBCA 6.40(c)(2) [Balance Sheet Test, or Net Insolvency Test] Prohibits distributions if after giving it increases surplus. Reducing par value reduces than the sum Note: Reducing legal capital effect the corporations total assets would be lesslegal capital. 2. RMBCA Corporation Dividend Rules of its total liabilities plus the amount that would be needed if the corporation were dissolved at the time of distribution to satisfy the preferential rights of shareholders whose preferences are superior to those receiving the distribution. ** No Cushion is required. (Distributions<shareholder equityliquidation Preferences) Note: 8.30(b) In making their decisions BODs may rely on opinions, reports, statement.
244(4) Transferring to Surplus, can 154 Surplus Calculation:
1. Public Corporations.
Dividends or reinvestment??? Many different scholars give their spin on how to allocate capital. Dividends forces a corp to be more efficient but also puts it at risk in bad times, if it cannot pay off debt. Too much debt is dangerous.
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Time of Measurement: 6.40(e)(3)-all distribution tests, NOT including reacquisition or indebtedness is the DATE OF AUTHORIZATION, IF PAYMENT OCCURS WITHIN 120 DAYS AFTER AUTHORIZATION. If after 120, THEN THE DATE OF PAYMENT MUST BE USED!
Stock Redemption: 1.40 A distribution would include a stock redemption so the same rules apply.
Problem: Precision Tools [Part VII] [252]

1. a. Legal Capital=$500,000 Therefore, there would be no surplus to pay out of because the required capital alone is $500,000, so they are simply even, although there is $100,000 in retained earnings. While under 170(a)(2) allows payment out of the net profits, that only equals $90,000. b. Legal Capital=$5,000, therefore, there is $495,000 dollars in capital left over which under 244(4) (for par value change go to 242(3)-reduce in AIC then get a BOD resolution) may then be transferred to surplus to be paid out as a divided. c. Under both tests $200,00 will clearly not be a problem, because there is plenty of cash to pay the debts, and the Balance Sheet Provides for $600,00 before the liabilities would exceed the assets. 2. a. Legal Capital=$500,000, therefore, under this stock redemption, which it is important to note is a form of distribution under the law, so in Delaware under 160 (a)(1)-paying $500,000 would deplete all the surplus $100,000, and without the ability under 244(4) to transfer any stated capital because the par value is $100. b. It would appear that even with a $1 par value that there would be $595,000 available, which would then NOT cause impairment of the capital under 160(a)(1). Since, only $5,000 would be needed to pay off the aggregate par value under 244(4). c. Under RMBCA there would be no problem because there is still $600,000 available. 3. It is unlikely that the shareholders may compel payment of dividends, this would generally be considered a business decision which should be left up to the BOD. When there has been allowed this demand it is with generally closely held corporations, such as in Dodge v. Ford. In Gottfried the court would not hear the argument but delineated the suggestion of a Bad Faith test. Which they say The essential test of bad faith is to determine whether the policy of the BOD is dictated by their personal interests rather than corporate welfare. The BODs are fiduciaries to their stockholders.
Kamin v. American Express, (NY 1976)[p. 263] FACTS: The directors of American Express faced the choice of liquidating a bad stock investment at the corporate level (take a corporate tax deduction or distributing the stock to shareholders as a special dividend (taxable event for shareholders). Although, the choice seemed obvious the board opted for the stock dividend option, and shareholders sued. (Bd. thought that a dividend would look good to the market and liquidation would have adversely affected the companys net income figures. HOLDING: Court applies the BJR and finds that the boards concerns were sufficient. Warren Buffet: Letter to Shareholders, Berkshire Hathaway, Inc.
BUSINESS ORGANIZATIONS II - Shaffer Page 33 of 131 Karl Bekeny/Spring 2001 Unrestricted earnings should be retained only when there is a reasonable prospect-backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future-that for every dollar retained by the corporation, at least one dollar of market value will be created for owners.
Michael Jensen: Eclipse of the Public Corp.

He feels the public corp as we know it is on its way out. That is good in his view because instead of pitting management against the shareholder there are now going to be institutions and entrepreneurs financing these corps. Without the old conflict these new corps are more (1) efficient, (2) more employee productivity, (3) more shareholder value.
Alfred Rappapport: The Staying Power of the Public Corp.

The public corp is resilient and will be around for a while. Not to mention, the Leverage Buyout stifles flexibility with the burden of debt, and takes away the best marker of progress, the daily stock price.
Letters to the Editor of the Harvard Business Review

Norris: LBO companies wont be competitive in the long run. Millstein: BOD and competitive product markets should deal with Jensens problems in the public corp. Goizueta: You cannot serve the public interest if you are continually paying down debt.
James Surowiecki: The Taming of the Barbarians: How a rapacious leveraged-buyout firm became a positive force in the corporate economy
One familiar interpretation of KKRs success is that it illustrates the disciplining power of debt. Becoming highly leveraged has forced managers to think seriously about costs, trim overhead, and improve productivity.
E. Empowering officers; Issues of Agency.[347-363] Problems; Agency Relations. [352] (Do for exam prep, but not included in my materials) RMBCA 8.01(b) provides that all corporate powers shall be exercised by or under the authority of, and the business affairs of a corporation shall be managed under the direction of its board of directors. Under RMBCA 8.40(b) a corporation can designate the officers it will have (you dont have to have a secretary of you dont want to). Also see: RMBCA 8.41 (duties are those set forth in bylaws); RMBCA 8.42 Standards of conduct of officers, (a) (1) act in good faith, (2)with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and (3) in a manner he reasonably believes to be in the best interests of the corporation), and
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(b)(2) a officer is entitled to rely on information, opinions, reports, or statements, if prepared or presented by (1) one or more officers who the director feels are competent and reliable, (2) legal counsel or public accountants whom the officer feels are competent. Note: an officer is not acting in good faith if he has knowledge concerning a matter which makes reliance questionable. (c) an officer is not liable for any action taken as an officer, or any failure to take action, if he performed the duties of his office in compliance with this section. RMBCA 8.43 (a) an officer may resign by delivering notice, and (b) the board of directors may remove any officer at any time with or without cause. RMBCA 8.44. (a) appointment does not create contract rights, (b) however if there are contract rights removal or resignation does not affect the officer or the corporation. DGCL 142 sets forth general info
142(a)-Officers, one must be secretary, 142(b) by-law or BOD for time in office, manner of resign or removal, [p.142(c) could require bond, 142(d) Having no officers, 316] does not dissolve the corp, 142(e) Fill vacancies through the by-laws.
For major transactions like mergers or a sale of substantially all of the corporations assets the board must approval of the majority of the shareholders entitled to vote. 1. The Relationship Model: Fiduciary BO D Fiduciary Sharehol ders Owners
Common,
Dividends
Corporation (under BOD) Agency 3rd Officer Contracts Parties s 2. Action by Executives: Agency Principles and the Authority of the Corporate Officer.
A corporation can only act through its employees (agency). The agents must put the corporations interests above their own.
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The corporation may give the agent actual authority [agent believes that the corporation wants him to do something] which may be either express (growing out of explicit words or conduct granting the agent power to do the act) or implied. (from words or conduct taken in the context of the relations between the corporation and the agent). An agent may also bind the corporation through apparent authority. (it looks to outsiders that the agent has the power to do what they are doing). (Note: There must be principal to third party contact). There is also inherent agency power-This is a policy in which the individual who is binding the corp would generally be understood to have the power to act as the corps agent, such as the President. Agency by Estoppel-The 3rd party changes their position on a basis of reliance. Under respondeat superior a corporation will be liable for torts committed by its agents. Finally, a corporation can ratify an agents actions by affirming prior acts or not speaking up against them. Note: ratification can be either expressed or implied, for example, if the BOD just lets the agent continue on with the deal, this would be implied. Lee v. Jenkins Brothers, (2nd Cir. 1959)[p.355] FACTS: Lee sued Jenkins bothers to recover pension payments due to him under an oral contract with Yardley the corporations president. HOLDING: A president under their general authority [inherent authority] has the power to hire and fire employees. Thus, under the theory of apparent authority Jenkins Bothers is bound. Of course Lee has to get around S of F [contract is oral and is for more than one year]. The court affirmed dismissal because this is a question of fact and minds will differ on it. First Interstate Bank of Texas v. First National Bank of Jefferson, (5th Cir. 1991)[p. 359] FACTS: The banks are in negotiations in which FI would buy bonds from FNJ. Boyd a vice president with FNJ after a discussion with FNJs president was under the impression that execution of the agreement was acceptable so he signed. FNJ refused to purchase the bonds on the grounds that Boyd had no authority to sign. HOLDING: A corporation will be liable to a third party under the doctrine of apparent authority if (1) the corporation manifests the agents authority to the third party, and (2) the third party reasonably relies on the agents purported authority as a result of the manifestation.
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A party to a transaction that doubts the authority of the official with whom she is dealing can request a copy of the resolution delegating such authority and the minutes of the board meeting at which the resolution is adopted.
F. Formal Requirements for Board Actions.[363-368] Unless the articles of incorporation or by-laws state otherwise (HAS TO BE GREATER), the vote of a majority of directors present at a board meeting at which there is a quorum are necessary to pass a resolution. See RMBCA 8.24(c). A quorum is usually the majority of the total number of directors unless the AIC provide otherwise (HAS TO BE GREATER). See RMBCA 8.24(a). Action taken in the absence of a quorum is invalid. However, RMBCA 8.21 allows action to be taken without a meeting on the unanimous written consent of the directors. RMBCA 8.20(b) permits board action to be taken by a conference call. RMBCA 8.23(a) [Unless AIC or By-laws hold otherwise] Does NOT require notice for regular meetings. Directors' may waive notice of regular meetings under RMBCA 8.23(a). For special meetings, RMBCA 8.22(b) requires that two days notice be given as to date and time, unless the article of by-laws state otherwise. A director can waive notice in writing or at the special meeting under RMBCA 8.23(b). RMBCA 8.25 authorizes committees of the board. Declaration of a dividend or a merger cannot be delegated to a committee under RMBCA 8.25(e). RMBCA 8.30(b) recognizes the expanding use of committees and permits a director to rely on the reports or actions of a committee on which he does not serve as long as the committee merits his confidence. DGCL 141 states that the majority of the shares entitled to vote will constitute a quorum, they may also have committees. The by-laws may provide for quorum less than a majority, but in no case shall this be less than 1/3 of the total directors. (b)A designated committee may run the corp, but the committee may not amend the AIC. (c) Provides for the confines on the scope of the directors abilities.
1. While a unanimous vote of four directors would not constitute quorum anyway, the first initial problem is that under 8.24(a) the quorum must be a majority of the members or greater, but there
Problem, Widget Corporation [363]
BUSINESS ORGANIZATIONS II - Shaffer Page 37 of 131 Karl Bekeny/Spring 2001 is also an issue of notice. Clearly two days of notice would be required in this case because this deals with the sale of the companys plant and is therefore a special meeting, 8.22(b). 2. Attendance is mandatory, unlike a shareholder who can have a proxy there is a sense among BODs that they must be present for the body to make the important decisions. Why not conference call? 8.20(b). 3. Other alternatives for sale would be (1) the meeting could be over the phone 8.20(a); (2) there may be a unanimous written consent, 8.21(a); (3) the notice may be waived under 8.23; (4) the BOD may hand some of this power over to a committee 8.25(d). 4. The time period for the notice could be made to almost nothing, 8.22(b). Make clear that quorum consists of at most a majority of the BOD 8.24(a). Create a committee which can carry on the general business of the Corp, 8.25.
G. Corporate Combinations; Shareholder Veto and Exit Rights.[368386] Shareholders elect directors annually unless the articles of incorporation provide for staggered terms, in which event the shareholders elect the directors every two or three years. See RMBCA 8.05, 8.06. The shareholders have the power to elect directors exclusively unless there is a vacant seat that needs to be filled. See RMBCA 8.10. Most statutes require more that simple majority approval for certain transactions but rather require a majority of all shares entitled to vote for example in the context of a merger. See RMBCA 11.03(e). 1. Shareholders Veto and Exit Rights. RMBCA: Shareholder Rts of P (surviving Corporation) Vote Dissent Rts Yes 11.03 Yes 13.02 NO No 11.03 NO NO No 13.02 NO Shareholder Rts of T (Acquired Corporation) Vote Dissent Rts Yes 11.03 Yes 13.02 Yes 11.03 Yes 11.03 Yes 12.02 Yes 13.02 Yes 13.02 Yes 13.02
Statutory Merger Triangular Merger Statutory Share Exchange Stock for Assets
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DGCL: Shareholder Rts of P (surviving Corporation) Statutory Merger Triangular Merger Vote Yes 251 NO Dissent Rts Yes 262 NO Shareholder Rts of T (Acquired Corporation) Vote Yes 251 Yes 251 Dissent Rts Yes 262 Yes 262, unless 262(b)(1) applies Delaware Public Market Exception
To which there may be another exception depending on the type of consideration.
Statutory Share Exchange Stock for Assets
NA NO
NA NO
NA Yes 271
NA NO
a) Background Shareholders have no power to initiate fundamental changes. The power they have consists largely of veto rights. For example, under RMBCA 13.02 a shareholder can dissent from a transaction and require the corporation to pay her in cash the value of her shares as determined by a court in an appraisal proceeding, if the transaction which the shareholder voted against is approved by the majority. [appraisal rights]. Dissenters rights are not available for every type of transaction but usually only apply in situations that involve fundamental changes. (1) Statutory Merger. Statutory Merger:
P T shhs T (a) Note T shareholders could receive cash or other property instead of P shares. (b) P and T shareholders have voting rights and appraisal rights. (c) These voting and appraisal rights are subject to exceptions in Delaware and 2 exceptions under the RMBCA. P shhs P shhs/Former T shhs P + T assets
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EXCEPTIONS: RMBCA=2 DGCL=3 Small Scale-This is a merger that does not increase Ps shares by more than 20% (outstanding). 11.03(g), 251(f). There are no vote or appraisal rights for P. T shareholders get voting and appraisal rights. Exception a the Exception Short Form Merger-When a parent company owns more than 90% of tosubsidiary, many 262(b)(2) corporation. corporate statutes allow merger without shareholder approval of eitherThe target shareholder you receive cash 11.05(a). 253(a). Public Market Exception-262(b)(1) appraisal rights or consideration other than Subsidiary get no voting rights, but YES APPRAISAL. are not available if the shares are publicly traded or has shares of P or a 3rd party. Parent gets no voting rights, but YES APPRAISAL for dissenters. more than 2,000 shareholders on record. Because likely
the feeling is that if you dont like the merger sell your
STATUTORY MERGER: P & T are two separate legal entities. The boards get together and decide which one will merge into the other. The boards make a plan outlining this and submit it to the shareholders of both P & T. A majority of the shares of both P & T that are entitled to vote must vote in favor of the merger. See RMBCA 11.01 and DGCL 251(a) If the transaction qualifies as a small scale merger, one that does not increase by more than 20% Ps outstanding stock, no vote of Ps shareholders is required. See RMBCA 11.03(g) and DGCL 251(f). Former shareholders of T become shareholders of P and lose all rights they had as shareholders of T unless they dissent and get appraisal rights. See RMBCA 11.06 and DGCL 259. Shareholder of P retain their rights as shareholders of P but they too have dissenters rights. See RMBCA 13.02 and DGCL 262. No dissenter's rights for P shareholders if the merger is small scale or short form. See RMBCA 13.02 and DGCL 262(b)(1). (1) Short Form Merger IF P owns at least 90% of T prior to merger, the transaction can proceed as a short form merger and no vote by P or Ts shareholders is required. See RMBCA 11.04 and DGCL 253.
P shhs P Corp. Assets/P and S shhs
(2) Triangular Merger (Forward)

T shhs T Corp. T assets
P shhs/former T
P Corp. Assets/P-T shares

T-PS Merger Plan
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P Sub Holds P shares or consideratio
T merges into PS
P-T Corp. Inc. (P Sub) Former T Assets
1. P sets up a new wholly owned sub-S. P capitalizes Merger Sub with its shares or other assets (such as cash). In return, Merger Sub issued all its shares to P. 2. Merger Sub enters into a merger plan with T under which Merger Sub is the surviving corporation. 3. T merges into Merger Sub, and Ts shareholders receive as consideration the assets that Merger Sub received when P capitalized it. 4. After the merger, P continues as the sole shareholder of the surviving Merger Sub, which typically adopts a new, more descriptive name like P-T, Inc. as part of the merger plan.
Note: T shareholders have the same rights they did under the statutory merger. Note: P shareholders do not have any rights. The shareholder of S does, the shareholder is P (The BOD). P can exercise dissenter rights. Thus, Ps board can eliminate its shareholders right to vote on the merger.
P shhs P Corp. Assets/P and S shhs
(3) Triangular Merger (Reverse)

T shhs T Corp. T assets
PS merges into T
P shhs/former T
P Corp. Assets/T shares T Corp. Inc. (P Sub) T Assets
PS-T Merger Plan
P Sub Holds P shares or consideratio
(4) Upstream/Downstream Mergers (Squeeze-Out Merger,

Cash-Out, Freeze-Out)
Parent Shhs P Corp. Assets/Major SH of Sub Minority Subsidiary Subsidia P shhs P Corp. Assets/all Sub Shares +
Former minority shhs-cash
Short Form-NO Vote, YES Appraisal If General Statutory-YES Vote, YES Appraisal
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1. Allows a majority shareholder to squeeze out its minority shareholders. 2. If P mergers into the Sub then it is a Downstream merger, or if the Sub mergers into P then the merger is Upstream. 3. The parent receives the surviving subs stock while the remaining shareholders receive other consideration, like cash or non-voting debt securities. a. If the minority shareholders receive cash then it may be referred to as a cash out merger. In Delaware these mergers are subject to an entire fairness test that requires fair dealing and fair price. Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983).
4.
P
(5) Exchange of Shares (ONLY RMBCA, NOT Delaware)

P shhs, Former T
Pare
Parent
a. P shareholders have NO voting or Appraisal rights. b. T shareholders have voting and
appraisal rights.
Targ et
Targe t
Similar to statutory merger except that here shareholders of T must approve the plan. Under this form the shareholders of T get shares of P in exchange for their shares of T. T becomes a subsidiary of P. Ps shareholders are unaffected and have not rights. P and T boars must put together a plan of exchange agreement. ( 11.02) 2. Shareholders of T must approve the plan. (11.03) 3. Once approved, shares of P are issued to T, or cash, then T shareholders become shareholders of P. They have no further rights as T shareholders unless they dissent (11.06) 4. The status of P shareholders is unchanged. 5. P can either keep T as a Sub, just as in a triangular merger. 6. If P does not want to operate T as a sub, but wishes to end with precisely the same structure as would result from a stat merger, it can then (1) dissolve T, (2) distribute all of its assets to P and having P assume all of its liabilities, or (3) merging T into P in a short form merger.
1.
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(6) Exchange of Stock for Assets

P P Corp. Assets P Corp. Assets/T assets P 1. P SHs have no voting or appraisal rights. 2. T SHs have voting rights, T SHs have appraisal rights ONLY in RMBCA, but no in Del. 262 3. T could receive cash
P shares
T SHs
T assets
T Corp. Assets
T Corp. P SHs
P uses its stock to buy the assets of T. The shareholders of T must approve the sale and have dissenter rights. 1. P purchases all of T assets, giving T, P stock as consideration. 2. T then becomes a shell or a holding company with its only assets the sales proceeds to shareholders pro rata. 3. The T company can then dissolve after paying off its liabilities and distributing the remaining proceeds to the shareholders pro rata.
P P Corp. Assets P P Corp. Assets/T assets P SHs/Former T SHs P Corp. Assets/T assets
P shares
T SHs
T assets
T Corp. shhs) Assets
T Corp. P SHs
Dissolution (T SHs receive P
(7) Tender Offers (Share Acquisition)
Paren t T Targe t
P and T SHs
Paren
BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001 Targ et
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Note: Y shareholders could receive cash or other property instead of P shares. Note: Not covered by statute, T shareholders sell T shares to P only if they so choose, thus, there are no voting or appraisal issues. Note: This could be a friendly acquisition or a hostile tender offer. P can also purchase Ts shares directly from shareholders, either for P stock or property. Ts shareholders dont vote they either accept the offer or they dont. Hence there are no appraisal rights. If it has sufficient stock then P does not have to get approval from its shareholders. (9) Consolidation
Former A and B Comp C
A SHs
Comp A Comp B
B SHs
Note: A and B Shareholders are covered under statutory merger rules. 2. De Facto and De Jure (by-law) Approaches. Where the structure of a corporate combination does not provide for appraisal or voting rights a shareholder needs to argue that there was a de facto or de jure merger. ** Context could be the sale of all a companies assets. Farris v. Glen Alden Corp., (PA 1958) This case applies the de facto merger doctrine and is applied in both of the cases bellow. Hariton v. Arco Electronics, Inc. (Del. 1963)[p.379] FACTS: Shareholder argues that the purchase of all Arcos assets was unfair to stockholders and that the transaction constituted a de facto merger. The shareholder argues that they have appraisal rights. HOLDING: This was not a de facto merger. A corporation has the right to sell all of its assets for stock of another corporation under DGCL 271. (Sounds like doctrine of independent legal significance) Furthermore, if the legislature does not like what is going on then let them go ahead and change the law.
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Terry v. Penn Central Corp., (3rd Cir. 1981)[p.383] FACTS: Shareholder contends that a proposed merger between Colt and Holdings, a subsidiary of Penn, (triangular merger) constituted a de facto merger. HOLDING: This is not a merger and therefore there are no dissenters rights. Once again, the legislatures language is fairly specific, if you dont like it, then they should not be so specific. But PA law under 908 calls for actual combination, which may not happen in a triangular merger.
H. Shareholders Rights over Board Actions; Asset Sales.[386-391] 1. Approval of Corporate Transactions.
Shareholders Vote on Fundamental Changes to the Corporation: RMBCA DGCL Amendment of AIC:..........10.03 242(b)(1) Mergers:.............................11.03 Sale of Substantial Assets12.02 Voluntary Dissolution......14.02 251(c) 271(a) 275(a)
RMBCA 12.01 [p. 136] does not require shareholder approval for sales of substantially all its property in the ordinary course of business. The comment to this section states that a sale of several distinct manufacturing lines while retaining one or more lines is normally not a sale of all or substantially all even thought the lines being sold are substantial and include a significant fraction of the corporations former business (Signal). RMBCA 12.02 [p. 138] requires shareholder approval for sales of substantial all the assets if the sale was not in the ordinary course of business. DGCL 271(a) requires majority stockholder approval for the sale of all or substantially all of the assets of a Delaware corporation. Gimbel v. Signal, (Del. 1974) [p.388] FACTS: Shareholder brings suit seeking a preliminary injunction alleging that approval by Signals board for the sale of its oil division required the approval of the majority of outstanding shares because it constituted a sale of substantially all of Signals assets. HOLDING: The critical factor in determining the character of a sale of assets is generally considered not the amount of property sold but whether the sale is in fact an unusual transaction or one made in the regular course of the business seller. A
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sale of all or substantially all of a corporations assets = one which is unusual. Absent some statutory requirement for shareholder approval, a board is authorized to take all actions it deems necessary in managing a corporations business. In this case the oil division only represented 26% of the total assets of Signal and accounts for 15% of its revenues. Signal is now a conglomerate engaged in the aircraft and aerospace business, the manufacture and sale of trucks, and other businesses. The sale does not constitute the sale of substantially all the assets.
Katz v. Bergman, (Del.Ch. 1981)[p.391] Court held that the sale of assets which constituted more than 51% of its total assets and 45% of its net sales, and that would cause the company to depart radically from its traditional line of business, constituted a sale of substantially all the assets of the corp. and thus required approval from the majority of shareholders.
1. Under 12.02(a) the question is whether the corp would be left without a significant continuing business activity. a. Continuing business activity is set within the statute as 25% of total assets at the end of the most recently completed fiscal year, and 25% of either income from continuing operations before taxes or revenues from continuing operations for that fiscal year b. In the present case, the Sweet violet division was only responsible for 20% of LaFrances net income last year. c. Note: In Delaware the test is unclear, only stating under 271(a) all or substantially all requires shareholder approval in Delaware. But there is no further indication how this should be defined. The Gimbel v. Signal Case make clear that the test should be broken down into two parts.
Problem: LaFrance Cosmetics [Part II] [386]
i. Quantitative, while as much as 45% of net assets has been held to be

substantially all, this was only in connection with the second part of the test.
ii. Qualitative, Heart of corporate existence and purpose. In the Katz case the
fundamental nature of the corp was changed. 2. Under the RMBCA there should be no problem in making the 120 days since there is a safe harbor, under Delaware there could be more litigation.
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I. Shareholders Power to Initiate Actions & Shareholders Rights to Information.[391-416] 1. Shareholder Meetings; Procedural Concerns. a) The Call RMBCA 7.01 Shareholders Annual Meeting. (a) States that a corporations annual meeting is usually fixed by its bylaws. (b) meeting may be held in or out of the state, (c) the failure to have an annual meeting as specified in the by-laws does not invalidate corporate action. RMBCA 7.02(a) Shareholder Special Meeting. (1) The board of directors, (2) owners of 10% of the shares, or any person authorized by the article of incorporation or the by-laws may call a special meeting of shareholders. RMBCA 7.04(a) The shareholders in Delaware may take unanimous action, but it has to be taken by all the shareholders to be effective, and it must be in writing. DGCL 211 Meetings of Stockholders. (a) meeting may be held in or out of state. (b) by-laws set the date for the annual meeting. (c) failure to have an annual meeting as specified in the by-laws does not invalidate corporate action. DGCL 211 Meetings of Stockholders Only BODs (d) excludes stock ownership as a qualification for calling such a meeting. Note the Shareholders do not have an automatic right to call a special meeting. DGCL 228 Consent of Stockholders in lieu of a Meeting. Authorizes shareholders to act by written consent. Note: only majority in Delaware.
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b) Notice Delaware Notice: 222 Notice of Meeting, 222(b) no less 10 days, or more 60, any shareholder entitled to vote. A company must give written notice of an annual or special meeting to all shareholders entitles to vote at the meeting. See RMBCA 7.05. Only matters within the purpose described in the meeting notice may be considered at a special meeting. See RMBCA 7.02. To satisfy the notice requirement, a board must set a record date prior to the meeting and provide shareholders of record who will be entitled to the vote as of the record date notice. Record date must be at least 70 days before the meeting. See RMBCA 7.07., and DGCL 213. Shareholders can waive notice, either in writing or by attending a meeting and not objecting to the absence of notice. See RMBCA 7.06. ** Bendix Martin Marietta takeover attempt illustrates the importance of timing [p.393]. Martin Marietta was a ten percent shareholder was powerless to call a special meeting any earlier than 10 days after it became a 10 % shareholder. c) Quorum A quorum must be represented at a shareholders meeting, either in person or by proxy, for an action taken at the meeting to be effective. RMBCA 7.25(a) Quorum and Voting Requirements for Voting Groups A quorum usually consists of a majority of shares entitled to vote unless the Articles of Incorporation state otherwise. RMBCA 7.26 permits action to be taken by a single group when the articles of incorporation provide as such. RMBCA 7.27 permits greater quorum or voting requirements. In order to change or delete a greater quorum or voting requirement, necessitates that you first meet the standard now DGCL 216 Quorum and Required Voting for Stock Corporations. A majority usually consists of a majority of shares entitled to vote unless the Articles of Incorporation state otherwise. No quorm under 1/3. DGCL 216 allows a majority of shares to amend a corporations articles of incorporation or bylaws to increase of decrease the quorum requirement. DGCL 214 Cumulative voting, discretion is totally left open to
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in place. RMBCA 7.28(b) provides for cumulative voting when voting for directors, unless the AIC so provide.
the shareholders.
d) Action by Written Consent Shareholders are permitted to act by written consent. RMBCA 7.04(a) requires the consent in writing of all shareholders entitled to vote on an action. Consequently, all shareholders must receive advance notice of the action to be taken. DGCL 228(c) allows a majority of the shareholders entitled to vote on an action to act by written consent but no advance notice is required although notice must be given to none consenting shareholders after the fact. 2. What Actions Can Shareholders Initiate? Auer v. Dressel, (NY 1954) [p. 395] FACTS: Shareholders bring a suit against the company president for not calling a special shareholder meeting pursuant to a by law provision requiring such a meeting when requested by holders of a majority of the stock. The shareholders wanted to endorse the former administration of Auer the corporations past president, amend the articles of incorporation and by-laws to provide that vacancies due to removal be filled only by the shareholders, amend the by-laws to reduce the quorum required from action, and remove four directors for cause. HOLDING: Shareholders could properly make a non-binding recommendation that the corporations former president be reinstated, even thought the recommendation had no binding effect on the board. ** If shareholders have the power to elect they should also have the power to remove. Campbell v. Loews, Inc. (Del Ch. 1957)[p.398] FACTS: This case involved a battle for control of Lowes theaters by two factions. One headed by the president and one headed a shareholder. Both parties enter in to a compromise where they each have 6 representatives on the board. A neutral
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director would be the 13 board member to prevent deadlock. In July of 1957, the neutral director, and three other directors resigned. The president called a special meeting to fill the director vacancies, amend the by-laws to increase the number of directors, and remove two directors from the other side and fill their vacancies. Campbell brought suit to enjoin the special shareholders meeting. HOLDING: Stockholders have the power to remove a director for cause. However, there is nothing in Delaware statutory law which provides for the removal of a director by stockholder action. Yet, 142 mentions removal and the court is satisfied that stockholders have this power. In this case the procedure behind the proxies was not valid because the accused directors were not given an opportunity to present their case to stockholders (DP rights for Corporate directors who will be removed for cause). The court issues a preliminary injunction. Yet, the court held that the President faction could use corporate funds to solicit proxies to remove directors who opposed its business policies. (if the proxies were only of a personal nature the expenditure would not have been proper). ** Remember, Schnell v. Chris-Craft, in which tactics to impede insurgents were held to equitable limitations. inequitable action does not become permissible simply because it is legally possible. 3. Board Responses to Shareholder Initiatives. Blasius Industries, Inc. v. Atlas Corp., (Del.Ch. 1988)[p.403] FACTS: Blasius accumulated Atlas Shares. Blasius delivered to Atlas a signed written consent with precatory resolutions recommending that the board develop and implement a restructuring proposal, that the by-laws be amended to expand the board size, and elect the new directors. The present board viewed this as an attempt to take over the corporation and called an emergency meeting. Blasius brings suit alleging that the special meeting which was voted on by phone and which nominated two new directors and amended the by-laws was self motivated in an attempt to protect the present board. HOLDING: Court holds that the board acted in good faith in response to what it thought would lead to a recapitalization which would harm the company. However, shareholders are entitled to vote to replace incumbent board members. Action designed to principally to interfere with the effectiveness of a vote creates a conflict between the board and the shareholders. The board had time to voice its concerns to shareholders (only a compelling justification would authorize this type of action not informing the shareholders). The board violated its duty of loyalty to the shareholders by calling a special meeting to keep itself in power, even if it was done to protect the corporation it interfered with the shareholders right to vote. The Court held that their actions were unintentional but applying the principle held in Schnell, inequitable action does not become permissible simply because it is legally possible, the Ds in Blasius violated the law. The Court held, I therefore conclude that, even finding the action taken was taken in good faith, it
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constituted an unintended violation of the duty of loyalty that the board owed to the shareholders. (Counter with doctrine of independent legal significance).
The Dead Hand and No Hand concept: DH=The only people who could vote to redeem the rights plan were the current BODs. (Held illegal 1998) NH=Nobody could amend plan for redemption for 6 months. Therefore, no consummation for 90 to 100 days, this was to be shareholder reflection time. The Quickturn case bellow will demonstrate how this flies in the face of 141(a) of the Delaware code. Note that the redemption is of a posision pill, requiring buy back at
Quickturn Design Systems, Inc. v. Howard Shapiro (Supreme Court of Delaware, December 31, 1998) [note book]. The Delayed Redemption Provision [NO HAND] would prevent a new Quickturn BOD from managing the corporation by redeeming the Rights Plan to facilitate a transaction that would serve the stockholders best interests, even under circumstances where the Board would be required to do so because of its fiduciary duty to the Quickturn stockholders. Because the Delayed Redemption Provision impermissibly circumscribes the boards statutory power under 141(a) and the directors ability to fulfill their concomitant fiduciary duties, we hold that the Delayed Redemption Provision is invalid. On that alternative basis, the judgment of the Court of Chancery is AFFIRMED. Problem; LaFrance Cosmetics-Part III:
1. Margaret with over 10% of the shares could under 7.02(a)(b) call for a special meeting of the shareholders. Under DGCL 211(d) there is no minimum percentage for a shareholder or group of shareholders to call a special meeting; therefore, unless the AIC provide then the shareholders may not call a meeting. It is unlikely that the shareholders could actually vote to stop a sale of the Sweet Violet, that is the role of the BOD, but they can provide their feelings to the BOD, and the practical reality is that the BOD may need shareholder votes to approve the sale. Note that 7.32 does apply to close corps, but I am unclear what the reality is here, plus under 7.32(d) this only applies to non-publicly held corps who can achieve a unanimous vote. If the Shareholders dont like something their most appropriate avenue is electing new Directors. 12.01 Official Comments. 2. While really the only way to act is through a properly called meeting, 7.02, the shareholders can approve by a unanimous vote of the shareholders under 7.04(a). 3. Under 8.08(d) it would appear that the shareholders could call a vote to remove a director who does not oppose the sale and replace him under 8.10(1) with someone who does. This meeting could be call under 7.02(2) with the requisite amount of 10% of the shares, and with a stated purpose set up and provided with notice under 7.02(c) and in accordance with the notice requirement of 7.05(c). 8.08(a) allows for a cause requirement, but this requirement does not seem to be easily met. For example, in Campbell demonstrating total self-interest to bring about cause is difficult. 4. Under 10.20 the shareholders have no problem amending the by-laws, additionally, this is no problem under 10.02 if no shares have been issued. However, if there are already shares then under 10.03 it would appear that the shareholders may not initiate an amendment as it requires BOD approval. While the shareholders may amend the AIC or even the by-laws, as the Model demonstrates, it is the BOD who should nominate a new director, not pack from the shareholders. On the other hand, if the amendment goes through under 8.03, then there may be a vacancy to fill which the shareholders may do under 8.10(a)(1). This specifically includes an increase in the number of the BODs. In Delaware, 109 there is no problem for shareholders to amend the by-laws.
BUSINESS ORGANIZATIONS II - Shaffer Page 51 of 131 Karl Bekeny/Spring 2001 5. The BOD could attempt to stop the shareholder vote as in both Blasius and Schnell, but that would be a violation of the duty of loyalty, even in good faith. Blasius. There is the recognition in Blasius as well that this is not a per se rule, because there may be a situation where there is a compelling justification, but not in this case. 6. These answers would likely that in Delaware under 228 the shareholders can do almost anything without even a meeting. Likewise, the shareholders may remove directors under 141.
Stahl v. Apple Bancorp, (Del. Ch. 1990)[p.407] Where corporate directors exercise their legal powers for an inequitable purpose their action may be rescinded or nullified by a court at the instance of an aggrieved shareholder. See Schnell v. Chris-Craft. Whether an action is inequitable does not require a dishonest motive or an inquire in to the directors good faith. A court will have to look at the facts. If shareholder voting is hindered there is a good chance the action is inequitable.
4. Shareholders Right of Inspection. Shareholders are entitled to a right of inspection. However, state statutes vary considerably on this point. RMBCA 16.02 DGCL 220(a) Grants inspection rights to beneficial Limits inspection to stockholders of owners as well shareholders of record, thus making it difficult for record, but divides corporate records shareholders who hold their stock in into two categories: nominee accounts to exercise the (1): right. Under 16.01(e) & 16.02(a), 220(b)-Lays out what you can look shareholders can readily inspect the at and when. proper purpose is articles of incorporations, the byrequired. laws, minutes of shareholder meetings and like documents. Proper purpose=a purpose (2): reasonably related to such persons But to inspect minutes of board interest as a stockholder. meetings, accounting records, or the shareholder list, a shareholder must have a proper purpose and describe with reasonable particularity that purpose and the records to be inspected, which records must be directly connected with that purpose. RMBCA 16.02(b). Under RMBCA 16.04 a corporation is liable for a shareholders costs and fees for refusing inspection unless the corporation can prove that it acted reasonably.
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A remedy for the shareholder would be to request a writ of mandamus from the court ordering that inspection be allowed. a) Proper Purpose DGCL 220(b) defines a proper purpose as a purpose reasonably related to such a persons interest in a stockholder. This type of definition provides no help at all. From case law we know that a shareholder has no right or inspection if his purpose be to satisfy his curiosity, to annoy or harass the corporation, or to accomplish some object hostile to the corporation. See Albee v. Lamson & Hunnard Corp. (MA 1946) [p.409]. State Ex. Rel. Pillsbury v. Honeywell, Inc., (MN 1971)[p.410] FACTS: Petitioner a member of the prominent and wealthy Pillsbury family wanted Honeywell to stop production of its anti-personnel fragmentation bombs used in Vietnam. He purchased shares for the sole purpose of gaining a voice in Honeywell. He requested a shareholder list in order to solicit proxies for the election of new directors and Honeywell refused. Petitioner brings suit. HOLDING: The petitioners motivation to elect new directors is not germane to his or Honeywells economic interest. There was no proper purpose in the request so Honeywell had a right to refuse the records. ** The Power to inspect is the power to destroy. ** This case has not been followed by Delaware Courts. Conservative Caucus v. Chevron Corp. (Del. 1972) [p.413] The court permits shareholders who oppose doing business with Angola to inspect the records, doing business with Angola could bring sanctions and hurt the corporation financially. b) What Comprises a Stock Holder List? One cannot determine who beneficially owns stock from the corporations list of stock holders of record because today most stock is held in nominee accounts which are in street name (Such and such trust). However, depositary trust will prepare a list of all firms holding stock in its name. A corporation can then contact those firms to determine the number of beneficial owners. If an owner does not object then the brokerage firm can give her name to the corporation (this will be done in the form of a NOBO list). Generally, the Official Comments to 16.03 state that a corp will only be required to hand over a NOBO list they already have. Delaware require upon request (shareholder entitled to list) There are two types of lists (1)CEDE, (2)NOBO (Non-objecting beneficial owners). Note: CEDE is the depository
trust company that holds on the brokerage firms shares, and the corporations themselves would
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hold onto the NOBO lists, but in the event that they are not then they dont have to get them as that would difficult.
Delaware requires that corporations deliver to shareholders entitled to inspect stockholder lists both the CEDE (Trust-a list of all the firms holding stock in the name of CEDE) breakdown and the NOBO lists already within the corporations possession. They also require a corp. to obtain a CEDE list if it has not already done so. They will not require the Corp to obtain a NOBO list and hand it over to a shareholder if it does not have a NOBO list itself and does not plan to obtain one. (NOBO lists take some time to get whereas a CEDE list can be obtained instantly. See RB Assoc. of NJ v, Gillette, (Del.Ch. 1981) [Wont require a corp. to get a NOBO list if it doesnt already have one].
For what can they look? Who Can Request to Look at the Stock Ledger? 220(a) Stockholder of record 16.02(f) beneficial owner
220(b) Stockholder has a right for inspection, with proper purpose, reasonably related to the actual list. 16.02(a) any record in 16.01(e), and then under 16.02(b)(3) inspect record of shareholders, provided under 16.02(c)(1-3) that the demand is (1) made in good faith and
Sadler v. NCR Corporation, (2nd Cir. 1991)[p. 415] [NO LONGER GOOD LAW] FACTS: NCR was resisting a takeover bid by AT&T by refusing to redeem a poison pill that presented an obstacle to AT&T. AT&T sought to remove the obstacle by soliciting proxies and removing incumbent directors. AT&T arrange for a NCR shareholder to obtain the shareholder list and request that it provide a NOBO list. HOLDING: The corporation must provide the NOBO lists they didnt already have. This is no longer generally true. J. Drafting and Other Issues Relating to Closely Held Corporations, including large Joint Ventures: Cumulative Voting , Supra-Majority Voting, Quorum requirements, Share Transfer Restrictions, Deadlock & Dissolution.[417-424, 437-440, 449-451, 452-457, 465-467, 490492] Problems associated with the division of management and control can be dealt with through private contracting in closely held corporations. (State Statutory law permits this). The law and economics school like Easterbrook and Fischel love this (contracting). What is a close corporation? It will usually be typified by: (1) a small number of stockholders, (2) no ready market for corporate stock, and (3) substantial majority stockholder participation in the management, direction and operations of the corporation. [looks like a partnership]
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1. Control Devices Relating to Shareholder Voting. a) Cumulative Voting. This is a device designed to assure board representation for minority shareholders. You use a formula: the votes a shareholder is entitled to cast multiplied by the number of directors she is entitled to vote for. [p.422, for formula]
Cumulative Voting Formula: X= S x d +1 D+1
X=Number of shares required to elect Directors. S=Number of shares represented at the meeting. d=Number of directors it is desired to
Example of Cumulative Voting: [Pg 421] (900) x 1 elected) (8) + 1 + 1 = 101 (This is the amount of shares that George will need to get
Note: Multiply the number of votes the shareholder is entitled to cast by the
Under DGCL 214, cumulative voting exists only to the extent that it is provided for under the corporations articles of incorporation. See also RMBCA 7.28(b). BOD Response to Cumulative Voting: (1) The board can counter this by staggering elections of directors. (141(d) and 8.06). (2) Decrease the size of the BOD. 10.20 and 109 (Amend By-laws)
Note: 109 grants the power to amend the by-laws to the BOD if you put in the AIC, NOTICE, under RMBCA there is a presumption until it is stated otherwise. 10.20
b) Devices Outside the Corporate Machinery Voting Mechanisms: 1. Voting Trusts-7.30 (1) Shareholders enter into a written trust agreement. (2) Shareholders transfer some or all of their shares to the trustee, shows on stock transfer ledger with the trustee as the registered holder. (3) The Trust Agreement specifies a term not to exceed 10years. The extension, if one is desired, binds only those who sign it. (4) Beneficiaries and a list of shares transferred to the trust, plus a copy of the agreement must be sent to the principal corporate office. Note: DGCL 218 eliminates the 10-year limit on the duration of the voting trust. Note: 7.31(b)-The voting agreement is specifically enforceable.
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2. Voting Agreement (Voting Pool Agreements)-7.31 Two or more shareholders who agree as to how they will vote. This section is not subject to the previous one. 218(c). 3. Irrevocable Proxy-7.22(d) An appointment of a proxy is revocable unless the appointment form or electronic transmission conspicuously states that it is irrevocable and the appointment is coupled with an interest. Appointments coupled with an interest include the appointment of 212(e) A duly executed proxy shall be irrevocable if it states that it is irrevocable and if, and only as long as, it is coupled with an interest sufficient in law to support an irrevocable power. A proxy may be made irrevocable regardless of whether the interest with which it is coupled is an interest in the stock itself or an interest in the corporation generally.
What is the Interest? Stock-The proxy holder has an option to buy the stock or lends money to the shareholder who pledges the stock as collateral, 7.22(d)(1), (2). Economic Interest in Corporation-Interest in corp although not the stock itself, 212(c) or 7.22(d)(3), (4). Designated by Shareholders-Simply designated to hold the proxies pursuant to the agreement. 7.22(d)(5) under 7.22(f) it terminates
Shareholder Agreements-7.32 In a close corporation shareholders can designate almost anything, but as soon as the corp is to go public, then it may no longer have these agreements. Supra Majority Provisions-Requires either supramajority approval by the shareholders or the BODs. Assists in close corp governance. 1. For Shareholders-Come about either when AIC originally drafted or by amendment. 7.25(a) or (c). In some jurisdictions, supra-majority proposal must also receive supra-majority approval. a. Amend of AIC- 7.27(b). b. Amend of By-laws-10.21(a). 2. For Director Voting-May incorporate requirements either in the AIC or the By-Laws so long as they are not inconsistent with the AIC, 8.24. They could also be incorporated through shareholder agreements, but remember the restrictions under 7.32, that this ONLY applies to close corps.
c) Restriction in Shareholder Voting Agreements. Mason v. Curtis, (NY 19180[p.437]
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The court holds that an agreement between shareholders was invalid because the powers delegated to shareholders were too broad (one of the parties was to act a general manager for a year and shape the corps. policies). McQuade v. Stoneham (NY 1934) [p.439] The court holds an agreement invalid. The terms of the agreement stated that the parties would use their best efforts to keep one another in office as directors and officers and salaries were not to be changed unless there was unanimous consent. A court will not go for an agreement that in effect provides for a sterilized Board. Clark v. Dodge (NY 1936)[p.439] Court validates a similar agreement as the one in McQuade but distinguishes it on the grounds that in the present case there was no attempt to sterilize the board as in Mason and McQuade. The agreement stated that Dodge would vote for Clark as Director and general manager as long as he proved faithful, efficient, and competent. d) High Voting or Quorum Requirements. Supermajority voting requirements for specified matters. However, some courts have held that these are invalid. [p. 449] See Benintendi v. Kenton Hotel, (NY 1945) on the grounds that such a provision was against public policy as it promoted dead-lock and hindered the making of business decisions. A great many legislatures have enacted statutory provisions that authorize, specifically or by implication, high vote requirements in the articles or by-laws. See RMBCA 2.02, 7.25(c) and 8.24(c). A high quorum requirement for either shareholder meetings or board meetings can serve many of the same functions as a supermajority requirement. e) Types of Transfer Restrictions 6.27 Restrictions on Transfer or Registration of Shares and Other Securities 6.27(d)(1) and 202(c)(1) First Option Provision-Obligates the shareholder first to offer the corporation or other persons (separately, consecutively, or simultaneously) an opportunity to acquire the restricted shares; Note: Different than a Right of first refusal in that in a right of first refusal the option comes at the same price and with the same restrictions and conditions as the offer from the 3rd party, but with the First Option Provision the deal comes at the agreed upon terms. 6.27(d)(3) and 202(c)(3) May Require Conditional Approval-Of shareholder disposition of stock from the BOD or the other shareholders. Buy-Sell Agreement-(Death, withdrawal, or deadlock requires the corp to buy and shareholders to sell at a given price). This agreements imposes an obligation to
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purchase, commonly found attached to deceased stockholders estate, these agreements then provide liquidity to the estate. These agreements are typically funded through life-insurance policies taken out on the lives of the principal stockholders. 2. Dealing with Dissension, Deadlock, Oppression and Dissolution. [p.466] There are two main types of situations that create problems of oppression and deadlock: 1. When those who control the corporation pursue a course of action that other shareholders find oppressive, such as freezing out a minority shareholder by cutting them off from both salary a dividends, just holding liquidity stock with current income. 2. When one shareholder or group of shareholders use liquidity rights all the time to frustrate all actions preferred by some other shareholder or group of shareholders. Courts will respond by applying the law of partnership to address these problems. RMBCA 14.34 and 14.30(2) attempt to deal with this. Section 14.30(2), (Shareholder action) grants a court power to dissolve a corporation if a shareholder establishes that (a) the directors are deadlocked, the shareholders can not break the deadlock, and the deadlock is injuring the corporation or impairing the conduct of its business, or (b) the shareholders have been deadlocked and have not been able to elect directors for two years, or (c) corporate assets are being wasted. Section 14.34, authorizes a court to allow any close corporation or one of its shareholders to purchase all the shares owned by the petitioning shareholder at the fair value of the shares.
III.
Federal Law I. Shareholding Voting Controls. [p.515-618]
State corporate statues divorce ownership from control. Shareholders rarely play a meaningful role in selecting directors. The rules governing proxy statements make it impractical for share holders to nominate or solicit support for candidates. Most public corporations are firmly controlled by self-perpetuating boards of directors or by senior corporate officials that those boards have elected.
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A. Role of Shareholders in Corporate Governance. Theories of the Firm; Introduction to Securities & Exchange Act.[515-539] 1. Theories of the Firm. [p.516] Bearle and Means, The Corporation and Private Property. Recognized the separation of management and control. Today, largely management controls public corporations. Bearle and Means believe that shareholders do not play a major role in monitoring management, instead shareholders exercise the Wall Street Rule and sell their shares rather than get involved in the internal affairs of the corporation. These guys are for corporate laws that govern the relationship between management and shareholders. The Contractual Theory, Easterbrook and Fischel, The Economic Structure of Corporate Law. Investment is a voluntary activity and that consequently relationships between shareholders and management should be viewed as essentially contractual in nature. These guys would get rid of a laws that act as a constraint on management. They believe that the market will respond and protect shareholders. The general belief that investment is a voluntary activity, and therefore relationships among shareholders and between shareholders and managers should be viewed as essentially contractual in nature. Butler, agency costs are reduced when contractual terms are agreed upon in the face of market and legal constraints. Clark, bargaining for rules has its problems and its benefits, but there are basic aspects of corporate governance, such as fiduciary duties that may not be bargained around. Brudney, someone who agrees with Bearle and Means points out the contractarian approach is silly because the average investor lacks sufficient information about the stock he is buying. Additionally, Brudney thinks there is a difference from simply random contractual rules and those of the fiduciaries, that they are not one in the same. For example, the Contractual Relationship- focuses on the partys right to benefit themselves, and the limits of that entitlement. On the other hand, Fiduciary Duties-address the obligations of the fiduciary to serve the beneficiary, and the resulting disability from benefiting himself except as specified expressly. Another Way To Look at the Modern Corporation, Roe, the modern corporation lies in technology, economics, and politics. The American system which did not allow for the control from financial intermediaries, because these institutions were made weak due to our decentralized political system. Roe wants to reexamine the evolutionary structure of our corporations. 2. Introduction to the Securities and Exchange Act. Securities Can be Traded in 2 Ways: (1) The 1933 Act, relating specifically to securities that come directly from the company.
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(2) The 1934 Act, relating to securities that are secondary, or traded through markets. (Examples would be the NYSE and the NASDAQ, an over-the-counter market). Note: There are 9-stock exchanges in the US, and two of them are regional. Note: The Stock Broker must be registered with the NASD (National Association of Securities Dealers). This is an SRO (Self-Regulating Organization, however, there is a reserve authority for the SEC, the Security and Exchange Commission). SEE HANDOUT. Application of Section 12(g) Jurisdiction 12 Registration Requirements for Securities: Section 12(a) of the 1934 act [p. 937] sets forth the requirements for what type of securities need to be registered and when they need to be registered. (Basically any security being traded on national exchange). Section 12(b) Procedure for Registration; Information-The security may be issued for the exchange after an application is filed with the exchange itself, and with the SEC. Under Section 12(g) (Exemptions to the General Rule): Equity security Note:
1.
2.
securities, 3(a)(11). The Registration requirement only applies to EQUITY securities. No 12(g)(1) filing requirement if a. Last day of most recent fiscal year, Total Assets do NOT exceed $10,000,000. 12g-4 Certification of Termination of Registration Under Section 12(g)
The termination shall take effect after 90 days or when the commission says so; IF, a. Class of securities Held of Record is LESS than 300, OR b. LESS than 500 persons where the total assets of the issuer (corp) have not exceed Held of Record, 12g5-1, basically anyone $10,000,000 on the last day for the last three years.
Exemption From Section 12(g) does include convertible
1.
who is identified as the owner of a particular security.
Under Section 15(d):

Section 15(d) Imposes Obligations Comparable to 12 for Public Offerings under the 1933 Act
1.
2.
The Duties under this section are suspended if the security is registered under section 12. Also, suspend registration, unless year of actual registration, if security class is held by less
B. Dynamics of Shareholder Voting.[540-561] What Shareholders can do: Shareholders must approve certain transactions that affect the structure of the corporation such as amendments to the articles of incorporation, mergers, and sales of assets. Shareholders can also amend corporate by-laws. The latter is usually done at the required annual meeting. Most shareholders votes are cast by proxy (Rule 14a-9 governs proxies). State statutes such as RMBCA
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7.22 authorize shareholders to vote by proxy. Thus, while state law validates the process of proxy voting Federal law governs it. Self Regulating Organizations (SROs) like the NYSE and NASDAQ also play a role in fair corporate suffrage, getting information to shareholders. RMBCA 7.22. Proxies [p. 49] The statute permits shareholders to vote in person or by proxy, it limits the validity of the proxy to a period of 11 months from the date of its execution unless the appointment specifies a longer period. 1. The Collective Action Problem. Most theories of corporate law , as well as the federal system of proxy regulation, assume that shareholder voting plays a central role in corporate governance. Yet, the fact remains that shareholders use their franchise as a monitoring device only infrequently. Clark, Corporate Law. [p.545] When shareholder vote they engage in collective action. Collection action is saddled with the problems of Rational Apathy and the temptation of shareholders to take a Free Ride. Investors are unlikely to spend the time reading proposals sent to them (rational apathy) and are likely to rely on someone else to read it and act for them (free ride). 2. An illustrative case: Dual Class Recapitalizations. [p. 549] Shareholders gave proxies for recapitalizations that were not in their best interest by changing their voting rights by adopting amendments. The SEC responded by enacting Rule 19c-4. The rule identifies situations in which shareholders are disenfranchised and prohibits companies from continued access to the national securities exchanges if they take such action. (Court held SEC did not have power to do this NO LONGER VALID). But SROs like NYSE have implemented similar self governing rules. a) Business Roundtable v. Securities and Exchange Commission. (D.C. Cir. 1990) [p. 553] FACTS: The Business Roundtable is a group of businessmen that get together and talk about business and corporate law. Anyway, the Roundtable files suit against the SEC for implementing Rule 19c-4. The Roundtable contends that the SEC exceeded its authority and did not have the power to create a new rule. The SEC argued that it had authority under section 19(c) language that states that the SEC has the authority to promulgate rules otherwise in furtherance of the purposes of the exchange act. The only problem is that dont have anything to support this,
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they argue section 14 power to regulate the proxy process but the court does not buy this. HOLDING: This type of rule is for state corporate governance law to determine. No where in the legislative history is there support for the creation of a rule that protects one vote per one share. b) How the Proxy Process Works.[p.558] The Annual Meeting: The Board of Directors selects a meeting date (usually fixed in the by-laws). The Board then sets a record date to determine which shareholders are entitled to receive notice of the meeting. Shareholder Voting: Usually done in the form of a proxy which generally states that the shareholder will vote with the boards recommendations. Filing Proxy Materials: Management files proxy materials with the SEC. Once filed with the SEC, the SEC staff will review the materials. The company will wait for comments before sending anything to shareholders. Identifying the Shareholders: Street Names: NOBO (non-objecting-beneficial-owner) lists. The corp must attempt to communicate with the beneficial owners. Objections to the proxy: If a shareholder wants to counter a proxy solicitation they have to duplicate the process for their own proxy materials. Counting the Proxies: At the meeting proxies must be counted and votes recorded (usually handled by an outside firm).
A. While generally speaking the shareholders will tend to be rationally apathetic, because it does not make sense for them to actual do the research to potentially benefit the company, they actually save more by doing nothing or simply voting for the statute quo. This generally is known of as the prisoners dilemma. However, in this case this problem is not quite as glaring because the institutional directors are known for acting collectively, and with 55% of the outstanding shares of the UNI company they may have a greater risk which would warrant the research. The institutional shareholders, however, may see the present situation as a threat to their investment, because the stock option is an incentive to do better work for the company, so maybe there really is no research involved in which case they just vote NO, having nothing to lose.
Universal Netware, Inc. Part I, A, B, C, D
C. Federal Regulation of Proxy Solicitations.[561-573] Section 14(a) and Rules 14a-1 through 14a-7 of the 1934 act govern proxy solicitations.
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These rules apply to every company that has a class of securities listed on a stock exchange or has a class of securities owned by 500 or more holders of record and assets of at least $10,000,000. See 12(b), (g). 1. Proxy Rules as they Apply to Management. [p. 562] Rule 14a-9 prohibits inclusion of materially false or misleading statements in proxy solicitations. Rule 14a-3 requires that every proxy solicitation by management be accompanied or preceded by a definitive proxy statement, which is 14a-3(a) concurrently furnished. 14a-3(b) If the proxy concerns electing directors then an annual report must also be included. 14a-3(c) 7 copies of the report that went to security holders must also be sent to the Commission. Has to be sent to the commission no later than when it was sent to the security holders. Rule 14a-4 regulates the form of the proxy. Rule 14a-6 requires management to file preliminary copies of its proxy statement and form of proxies with the SEC at least 10 days prior to disseminating those materials to shareholders. Note: Under 14a-6(a) there are some exceptions for the preliminary filing requirement for what appear to be regular or annual meetings or security holder meetings that might include , an election of directors, approval of accounts, etc. However, this would not include a solicitation in opposition. 14a-7-The registrant must provide either a list or actually mail the proxy solicitation materials to any record or beneficial holders of a security. 14a-7(2)(i)-generally speaking the preferred choice would be to mail the list so that the solicitors would not be able to know whom the names and addresses of the security holders. Note: That the mailing of the proxy solicitation materials is at the solicitors expense. 14a-7(b)(1)(i), the requesting security holder has the option to either receive the list or have the info mailed out if, the request is in response to a going private move by the registrant under 13e-3. What is a solicitation? Rule 14a-1 defines solicitation to include: 14a-1(l)(1)(i) any requests for a proxy whether or not accompanied by or included in a form proxy; 14a-1(l)(1)(ii) any request to execute or not to execute, or to revoke a proxy; or 14a-1(l)(1)(iii) the furnishing of a form of proxy or other communication to security holders under circumstances reasonably calculated to result in the procurement, withholding, or revocation of a proxy. [like an ad or a letter] Note: 14a-1(l)(iv)(A) Stating how and why a security holder intends to vote, even through the newspaper is o.k. Studebaker Corp. v. Gittlin, (2nd Cir. 1966)[p.564]
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Gittlin obtained support from 42 other shareholders for permission to inspect corporate records in preparation of an attempt to take over the board of directors. The court held that this was a violation of the proxy rules. (no filing done). SEC v. Okin (2nd Cir. 1943) [p.564] A letter which was a part of a continuous plan intended to end in solicitation was a violation of the proxy rules (no filing done). Brown v. Chicago,(Rock Island 1) (7th Cir. 1964) [p. 565] Ad which informed the public about an issue pending before a government agency served a independent purpose to inform the public rather than influence Rock Island Shareholders. No violation of the Rules, no one had started to solicit proxies at this point. Union Pacific RR v. Chicago, (Rock Island 2) (N.D.Ill. 1964)[p.565] Court rules that report distributed to shareholders was reasonably calculated to influence a shareholders decision whether to grant a proxy or not constituted a solicitation and therefore constituted a violation of the proxy rules. Proxy solicitation had begun and nothing was filed with the SEC. Smallwood v. Pearl Brewing Company, (5th Cir. 1974)[p.565] Two months before soliciting proxies a company advised its shareholders of a merger. The court held that the letter was not a communication reasonably calculated to result in the procurement of a proxy (nothing in the letter mentioned the proxy). Long Island Lighting Company v. Barbash, (2nd Cir. 1985)[p. 566] FACTS: LILCO was the focus of a local political campaign in which the candidate urged public ownership of the utility. The politician acquired sufficient shares to demand a special shareholders meeting to consider his proposal. A group which supported the politician, Citizens to Replace LILCO, published a newspaper article accusing LILCO of mismanagement and passes onto taxpayers the costs of the construction of a new nuclear power plant. LILCO complained that the ad constituted an unfiled proxy solicitation. HOLDING: Rule 14a-6(g) requires that solicitations in the form of speeches, press releases, and television scripts be filed with the SEC. The proxy rules do cover this type of communication, it was reasonable calculated to influence the shareholders votes. Dissent by Judge Winter: Points out this is a first amendment issue. The ad was addressed to the public and concerned a local political issue. ** For the group to have published the add without violating the proxy rules at that time, they would have needed to file a proxy statement with the SEC, receive staff clearance, and circulate copies of that statement to all shareholders, and file the add with the SEC at least 10 days before publishing it. ** The SEC relaxed its rules because it was concerned that the requirements were discouraging shareholder participation.
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2. Proxy Rules as they Apply to Shareholders.[p. 568] The rules have been relaxed so that a shareholder can request that management include a shareholder proposal in a proxy. Rule 14a-2 There are several exemptions to the filing, disclosure, and distribution requirements, the exemption exists under the proxy solicitations. There are two major categories of exemptions: (1) Exemption to Rules 14a-3 to 14a-6 to 14a-15, BUT NOT INCLUDING, 1400-6(g), 14a-8 and 14a-10 (These are the Anti-Fraud provisions): a. Solicitations by persons not seeking proxy authority and without a substantial interest in the matter. 14a-2(b)(1). i. Note: There are exceptions to the exemptions: 14a2(b)(1)(i-x). Pg. 1131 b. Nonmanagement solicitations to less than 10 persons, Rule 14a2(b)(2). c. Advice by financial advisors in the ordinary course of their business, provided they disclose any interest in the proxy contest and receive no special fees from others for giving the advice, 14a2(b)(2). (2) Exemptions from all the proxy solicitation rules: a. Communications by brokers to beneficial owners seeking instructions on how to vote the owners shares, 14a-2(a)(1). b. Requests by beneficial owners to obtain proxy cards and other information from brokers that hold their shares, 14a-2(a) (2). c. News paper advertisements that identify the proposal and tell shareholders how to obtain proxy documents Rule 14a-9 (This section basically allows you to sue the issuer or anyone else who violated these rules) prohibitions still apply to prohibit material false and misleading statements. Under Rule 14a-1 a shareholder can make an announcement of how she intends to vote her shares with an explanation of why. Not deemed a solicitation so this type of information can be published, broadcast, or disseminated to the media without limitation by the rules. The revised proxy rules have encouraged shareholder activism. (labor unions, political, and religious groups have become more vocal). However, sometimes these groups are subject to the more stringent proxy rules that apply to management. Rule 14(b)-Requires brokers and dealers to pass on proxy information to their clients.
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Rule 14(c)-What info you must provide before an annual or other meeting, basically the same as solicitation, unless you have already initiated one. Section 13(d) requires any person who becomes an owner of 5 percent of the stock of a registrant to file a schedule 13D within 10 business days of acquisition. Page 1013-1014 of the code book. Rule 13(d)-5(b)(1) defines person to include a group and a group will be deemed to have acquired the shares of its members when two or more persons agree to act together for the purpose of acquiring, holding, voting, or disposing of security interests. GAF Corp. v. Milstein, (2nd Cir. 1971)[p. 572] Four members of the Milstein family who together owned excess of 10% of the corporations stock were held to be in violation of section 13(d) by failing to timely file schedule 13D. Azurite Corp. Ltd. V. Amster & Co., (2d Cir. 1995)[p.573] Defendants were not liable for announcing their proxy contest plans at an earlier date (they eventually filed schedule 13D). The court held that under 13D there is no requirement to make predictions of future behavior or to disclose tentative or inchoate plans. Unless a course of action is decided upon or intended, it need not be disclosed as a plan or proposal under item 4 of schedule 13D.
B. The real question here is when do you have to file a proxy solicitation? You would have a failure to file under 14a-6, and a failure to provide a proxy statement and form under 14a-3. Under Smallwood v. Pearl Brewing Company there would appear to be in problem with the statement, as it is more just information of a plan and not a solicitation. The situation was held to not be totally innocuous was not overwhelmingly prejudicial either. Legal standard: The letter was not a communication reasonably calculated to result in the procurement of a proxy. This of course, is the exact opposite of the Barbash case. Are you contacting the record shareholders before you are allowed to, or are you simply providing them with information? Linch is a Security Holder and so may himself say his mind under 14a-1(l)(iv)(A) speak his mind, but in this case the BOD is speaking. C. As a security holder, 14a-1(l)(iv)(A) Herbert Rogers could express his views through the media, explaining why he felt that the plan was not a smart one and it would never be considered a solicitation, therefore, exempting Herbet from 14a-3 to 14a-5. He could likely achieve some of his goals be going after institutional shareholders for help. Herbet, not running afoul of the exceptions to the exemptions under 14a-2(b)(1)(i-x), may also directly approach the institutional shareholders in this case.
Universal Netware, Inc. Part I, A, B, C, D
D. The Role of Institutional Investors.[573-594] 1. Constraints on Institutional Investors. Institutional Investors, like pension funds, are starting to play a larger role in corporate governance. A shareholder shoe owns a large percentage of stock is
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more likely to engage in monitoring. Thus, the division between management and control is not as wide as when Bearle and Means did their famous study. However, collective action problems plague institutional investors making them less effective as they could be at monitoring. Furthermore, many government regulations also hinder their activity. See Black, Agents Watching Agents: The Promise of Institutional Investor Voice. [p.575] An active shareholder or shareholder group, owning a 5% stake in an issuers stock triggers filing requirements under section 13(d). active shareholder must report its holdings and plans on schedule 13D (a passive shareholder can file the much shorter schedule 13(g)-(under 13(d)-5(b)(1) this would include groups of people too)-in order for this to apply they would have to allege that they are not seeking control of the company). Owning a 10% (Beneficial owner) or BOD or officer stake can trigger shortswing profits which need to be forfeited under section16(b). Shares owned by pension funds are voted by employees who often share the same views as management. 2. Institutional Investors and Monitoring. Bernard Black, Agents Watching Agents: The Promise of Institutional Investor Voice. [p. 577] Product, Capital, Labor, Corporate Control. Problems: Institutional Voice means: (1) asking one set of agents to watch another set of agents, (2) requiring a number of institutions, including different types of institutions to join forces to exercise influence, and (3) corporate managers can watch there watchers (pension funds). Also money managers of institutional funds diversify -- which gives them less incentive to worry about company specific concerns. Black argues for reform that focuses on the process of voting rather than substantive governance rules. Meliven Eisenberg, The Structure of the Corporation: A Legal Analysis, [p.581] Institutional Investors have taken the position that their primary obligation is to their own beneficiaries. But, do they also owe an obligation to their fellow shareholders? Eisenberg argues no. He feels that the primary duty of an institutional investor is to protect the interests of its own beneficiaries, they are not equipped to oversee management.
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John Coffee, Liquidity versus Control: The Institutional investor as Corporate Monitor, [p.582] Institutional Investors have many reasons to remain rational apathetic. Investors that want liquidity may hesitate to accept control. Other scholars argue that institutional investors will come to dominate corporate management, Coffee disagrees for the latter reasons. Coffee feels that the law needs to intervene to give the institutional investors incentive to monitor. He feels investors have become more active because voice has become less expensive with relaxation of federal laws. Edward Bock, The Logic and (Uncertain) Significance of Institutional Shareholder Activism, [p.585] Bock argues that competition amongst money managers acts to prod managers into acting (investors may feel betrayed or that the manager is shirking their duties by not checking out the companies he is investing in for the investors).
Universal Netware, Inc. Part I, A, B, C, D D [1]. There are several potential problems in this case. (1) While the statement itself may be
exempt under the proxy solicitation rules section 14a-2(b)(1), NOT 14a-2(b)(1)(vi)-since there are more than 5% of corps shares within the BOD, because they would have had to have filed a 13D. Likewise, they may be exempt from solicitation rules since they could be contacting under 10, 14a2(b)(2). [2]. Individual shareholders are likely to be rationally apathetic, but institutional shareholders, since they own more of a stake, may have more interest. Their desire to execute an informed vote grows exponentially, and therefore they may have real interest in getting the vote done correctly. [3]. The fiduciary duties to the beneficiaries is likely to be fine so long as she thinks that her decision is likely in their best interest. Since not deputizing directors, there will probably be no 16(b) duty, and therefore the only concern is 14a-3 to 14a-6 violations. [4]. The main criticism would be that institutional investors are not proper for management. That to assume the duties of a board member would be to place them in conflict with their duties to their beneficiaries. The institutional investors would likely also have to give up liquidity for control, something that they would likely not want to do.
E. Federal Regulation. Shareholder Proposals[594-618]. 1. Evolution of The Shareholder Proposal Rule. In the 1970s shareholders became more concerned with social issues such as the environment and diversity. They became less concerned with corporate governance. Campaign GM in 1970 was the first major successful effort in this respect. The group pushed through a proposal asking GM to set up a shareholder committee for corporate responsibility. The proposal got
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only 2.73% of the votes at the meeting but GM changed its policies and shortly thereafter nominated its first black director. 2. The Rule in Operation. Rule 14a-8. Proposals by Security Holders [p.1062] sets forth the requirements for what, when and how shareholders can bring a shareholder proposal that the board of directors is forced to include in a proxy statement it is sending out to shareholders. Under R. 14a-8(1), the shareholder advancing the proposal must be a record or beneficial owner of at least 1% or $2,000 in market value of the securities entitled to vote and have held the securities for at least one year. Under R.14-8(2) the shareholder must provide his name, address, number of shares he owns, etc..., (3) the proposal should be submitted timely, (4) only one proposal may be submitted and (b)(1) it must include a supporting statement not exceeding 500 words and (b) (2) should identify the proponent. Yet, R. 14a-8(i)(1) sets forth exceptions which allow a issuer/corporation to omit a proposal from its proxy statement and form proxy under any of the following circumstances: (1) (Improper Under State Law) if the proposal is not the proper subject for action by security holders. NOTE: this will depend on state law. For example, a proposal that mandates certain action by the Board of Directors may not be a proper subject matter for shareholder action, while a proposal recommending or requesting action may be proper; S.E.C. v. Transamerica Corp, (3rd. Cir. 1947)[p.597] Set forth the standard for what is a proper purpose under Rule 14a-8(i)(1). A proper subject is one that a shareholder may properly bring to vote under the law of a companys state of incorporation. In this case, however, the Court did uphold the propriety of elections of independent auditors, changing procedures to amend the companied by-laws, and requiring a report of the annual meeting be sent to shareholders. However, this is better dealt with because it is precatory in nature (advisory), note this is similar to Auer v. Dressel. (2) The proposal asks the board to do something illegal; (3) (Violation of Proxy Rules) the proposal is contrary to SEC proxy rules and regulations, like a violation of Rule 14a-9 (a material false or misleading statement); (4) If the proposal relates to the redress of a personal claim or grievance or if it is designed to benefit the claimant and this interest is not shared by the security holders at large;
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(5) (Relevance) the proposal relates to operations which account for less than 5 % of the registrants total assets and for less than 5 % of its net earnings and gross sales, and is otherwise not significantly related to the registrants business; Lovenheim v. Iroquis a report on forced geese feeding was found to be important even though it was less than 5%. (6) The proposal deals with matters beyond the boards power to effectuate (ultra vires); (7) (Management Functions) the proposal relates to matters relating to the conduct of ordinary business operations or the registrant; Medical Committee For Human Rights v. SEC, which held that management could not exclude a initiative to force Dow Chemicals not to consider the use of napalm. Then the SEC changes course and said in Cracker Barrel Old Country Store, SEC (1992) NO Action Letter, that employment practices such as EE or Affirm Action could be excluded as ordinary course. This was upheld by the 2nd circuit, New York City Employees Retirement System v. SEC (1995) (The case that codified Cracker), however in 1998 the SEC announced its return to a case-by-case analysis. Allowing for no exceptions when social policy. (8) The proposal relates to the election of an officer; this prevents dissidents from clogging the companys proxy statement with their own candidates. (9) The proposal is counter to a proposal to be submitted by the registrant at the meeting; (10) (Substantially Implemented) the proposal has been rendered moot; mainly because the company is already doing what the shareholder asks. (11) (Duplication) the proposal is substantial duplicative of a proposal previously submitted to the registrant by another proponent and the proposal will be include in the materials; (12) (Resubmissions) the proposal deals with substantially the same subject matter of a proposal that was submitted to security holders in the last five years that failed to get 3 percent on its first try, or 6 percent on its second try, or 10 percent after three tries. (13) (Specific amount of dividends) the proposal relates to specific amounts of cash or stock dividends. This is a fundamental part of corporate law, that the BOD has the discretion to declare dividends, without shareholder initiative or approval. If there is no proper exclusion above for one of the reasons, then under 14a-8(m) it must be included but the registrant may include the reasons that it feels it is a bad idea.
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The shareholder may also use 14a-8(k) to have the SEC determine that a violation is occurring, and ask for enforcement from the federal court. a) No Action Letters.[p.599] Rule 14a-8(j) provides that the registrant/issuer must send materials to the SEC if it decides to omit a proposal (Basis for a No Action Letter). If the company decides to omit a proposal it will request a no action letter from the SEC. Roosevelt v. E.I. Du Pont de Nemours & CO., (D.C. Cir. 1992)[p.600] A shareholder has an implied right of action under Rule 14a-8 to challenge an omission in court. Transamerica-Since the time of this case the companies have traditionally acquiesced to the decision of the SEC because it is not worth litigating the issue. However, technically, like the individual shareholder right above, the SEC then can also bring an injunction seeking a court order that the proxy statement must be included. b) Substantive Grounds for Omission.[p.601] Most often registrants will omit proposals under the grounds of Rule 14a-8(i) (1) not a proper subject, (5) not significantly related to the companys business, or (7) involves ordinary business operations. Both (i)(1) and (i) (7) depend on application of the law of the issuers state of incorporation. Auer v. Dressel, (NY 1954)[p.601] FACTS; Whether the president of a company was required to call a shareholders meeting that had been demanded by a shareholder who held sufficient stock to satisfy the statutory requirement. (the meeting concerned the rehiring the president). HOLDING: The court held that the meeting had to be called because it involved significant matters even if the shareholders vote would not bind the board. Under Rule 14a-8(i)(1), mandatory resolutions do not have to be included while recommendations should be included (Note to paragraph (i)(1). Then, you need to ask what is the subject matter of the proposal, if it involves ordinary business it may be omitted under Rule 14a-8(i)(7). The antithesis of ordinary business is public policy. Thus, under 14a-8(i)(7), even is the proposal relates to ordinary business it cannot be excluded if it relates to public policy. Amalgamated Clothing and Textile Workers Union v. Wal-Mart Stores, Inc., (SDNY 1993)[p.602]
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FACTS: Shareholders challenge Wal-Mart for omitting their proposal from the proxy statement and form sent to shareholders for matters to be voted on at the annual meeting. The proposal dealt with equal opportunity and affirmative action policies. Wal-Mart contends that these are ordinary business matters which may be excluded under 14a-8(i)(7), in Delaware 141(a) leaves the conduct of ordinary business in the hands of corporate directors and officers. HOLDING: Proposals which deal with significant public policy concerns although the also deal with ordinary business matters (a power plant operating a nuclear power plant) may not be omitted under Rule 14a-8(i)(7). [Court looks at no action letters as a sort of common law on this issue to reach its result]. However, in this case and on this particular topic, EEO programs, the SEC has found that they are excludable as involving ordinary business because they relate to employment policies. Note, the court modifies the proposal so that it can be submitted to the shareholders. ** AS of 1997 the SEC reversed its position on EEO programs, and it appears that these proposals will no longer be considered ordinary business matter [p.617]. Lovenheim v. Iroquois Brands, Ltd., (D.D.C. 1985)[p. 611\ FACTS: This is an animal right case addressing the force feeding of geese to make pate. A shareholder, Lovenheim, submits a proposal to Iroquois in the form of a resolution regarding the force feeding of geese to make pate that Iroquois imports and distributes, the resolution recommended the forming of a committee to look at the issue. Iroquois omits the proposal on the grounds that it does not significantly relate to Iroquois business under Rule 14a-8(c)(5) [its annual revenues are $141 million and pate sales were only $79,000 the last year, and only $34,000 in assets are related to pate. HOLDING: The meaning of significantly related to issuers business does not solely hinge on Economic significance. During the 1970s proposals relating to only 1% of a companys were not allowed to be omitted because the proposals raised important policy questions to be considered important enough to be considered significantly related to the issuers business. The court granted Lovenheims request for a preliminary injunction. Medical Committee for Human Rights v. SEC, (D.C. Cir. 1972)[p.614] A proposal against the use of Napalm submitted to Dow Chemical could not be omitted even though it related to less than 1% of Dows overall business. Court focused on the fact that board was not manufacturing Napalm for business reasons but for patriotic ones 14a-8(i)(7). Note that this was kind of overturned by Cracker Barrel, but is now again likely the law. Carter v. Portland General Electric, (OR 1961)[p.616] The court affirmed managements refusal to include in the proxy statement a shareholder statement in opposition to management plans for construction of a
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dam. The court held that the proposal was not a proper subject for shareholders under Rule 14a-8(i)(1). Be on the look out for proposals to amend the by-laws of a corporation (depends on the state law and the provisions in the by-law, like is it made unamendable by BOD) that could be a 141(a) violation and therefore a 14a-8(i)(1) violation, SEC takes the position that NJ law does not prohibit this kind of shareholder action but held the opposite in a case involving Delaware law and possibly NY (will depend on state law). [p.618]. Universal Netware, Inc. Part II, A, B
A. 14a-8(b), seeing as they have $3,200, which has been held for over a year, then they are
eligible to submit a proposal. However, the group may run afoul of 14a-(i)(5) since they do not affect 5% of the companies total assets, or arguably is not significantly related to the companys business. However, they may make the argument under Lovenheim v. Iroquis that the policy is significantly related as it will help prevent the Lay Off of 1,000 UNI employees. Likewise, while Cracker Barrel letter may have some influence, because an employment decision would appear to be part of a companies ordinary business operations, it is not determinative as of the SECs 1998 decision, to under 14a-8(i)(7) to examine the social policy of all proposals. However, if this case is going on in Delaware, because not all states do not allow a shareholder by-law proposal, the SFSJ may violate DGCL 141(a) and therefore 14a-8(i)(1), because the SFSJ would essentially be interfering with the management function. Note: There are also some statements, that could be construed as fraudulent, in violation of 14a-9, such as when they say, company disregard for EEs, they need some proof. Furthermore, if the statement were more of a recommendation, then it would not be as likely to violate 14a-8(i)(1), and some of the other statutory provisions. B. It would appear that the plan would be a problem because it would likely violate Delaware code 141(a), a situation which the Delaware Supreme Court held in Quickturn made the NO Hand or Dead Hand Provision unlawful, and therefore in violation of 14a-8(i)(1) of the SECs proxy code.
State Law Fiduciary Duties: Litigation before State Courts. [p. 619-826]
IV. Fiduciary duties are one of the critical elements in the relationship between shareholders and management. Disclosure lies at the heart of much of the law of fiduciary duties. For example: (1) A director must be fully informed in order to gain the protection of the business judgment rule; (2) Disinterested shareholders or directors must be fully informed in a conflict of interest transaction in order to validate the transaction or to shift the burden of proof in litigation challenging the transaction; (3) A director may be guilty of appropriating a corporate opportunity if she does not disclose the opportunity to the board before taking it for herself.
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Fiduciary duties are owed to the corporation. Yet, fiduciary breaches are usually are challenged by shareholders in derivative litigation brought on behalf of the corporation (management is unlikely to bring a suit against itself). A. The Role of Outside Directors in Corporate Governance.[619-657] 1. How Boards of Directors Operate [p.622] Management has three principal functions: (1) enterprise decisions concerning operational and business matters, (2) ownership issues such as initiating a merger or constructing takeover defenses, and (3) oversight such as reviewing senior executives performance and ensuring corporate compliance with legal norms. State statutes give the BOD wide latitude in how they can operate. However, one thing a board cant delegate is the decision to issue a dividend or not.
RMBCA 8.01 Requirements for and Duties of Board of Directors[p.75] (b) All corporate powers shall be exercised by or under the authority of, and the business affairs of the corporation managed under the direction of, its Board of Directors. DGCL 141(a) Board of Directors, Powers, Number, etc... [p. 251] The business and affairs of every corporation ...shall be managed by or under the direction of a board of directors.
As of late there has been much discussion concerning the use of outside directors to assist in the monitoring of management in general, thus reducing agency costs. However, outside directors are usually directors or high level management of other corporations they do not really have the time or incentive to monitor. Moreover, outside directors usual lack the expertise that management does in the company. Directors are often not willing to question and second guess each other (collegial atmosphere). Elliot J. Weiss, The Board of Directors, Management, and Corporate Takeovers: Opportunities and Pitfalls [p. 623] Four factors that constrain outside Directors to carry out their job: 1. Most Directors hold demanding jobs elsewhere. 2. Most Directors lack experience in the business of the company on which they sit.
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3. They rely on company executives to provide the information. 4. Directors have little in the way of financial incentives and face little in the way of legal pressures to perform effectively. Bayless Manning, The Business Judgment Rule and the Directors Duty of Attention: Time for Reality [p.625]
Outside directors (meaning not management of the corporation) are part-time people. They simply do not have the time or the incentive to stay on top of everything when they only meet on a one-and-a-half-day-a-monthbasis. Actions at the meetings are usually by consensus. The board only has limited time so only some things are put on the agenda. The directors must rely on others for information, reports, and updates (often committees of the board). Plus as Weiss points out, there is this corporate culture that wants the statue quo anyway. Agenda Setting is very important, but this will typically be set by management.
How Manning Thinks the BOD Should Operate Their Managing Powers 2 Exceptions To Agenda Setting 1. 2. Functional Management-This is the BODs ability to hire and fire the CEO and other top management. Internal Information System-Auditing system put in place so management officers and the BOD are getting clear and accurate info. (Note: To not do this may cause BOD liability).
2. Do Independent Boards Matter? [p.635] Directors who are independent of management can act to reduce agency costs within a large corporation by checking management overreaching and vetoing unwise management proposals. However, often outside directors do not want to rock the boat they usually defer to a CEO who stands behind her proposals and prefer to resign quietly rather than challenge the CEO publicly. Outside directors, especially those that are executives of other corporations, have a structural bias against taking actions that conflict with the interests or preferences of a corporations managers. Some scholars argue that boards should have directors that represent the interests of constituencies other than shareholders, such as employees. Others argue that directors should be drawn
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from groups that are not part of the traditional corporate establishment. (a) Note: With oversight and disclosure is also the push for an audit committee, in fact, the ALI 3A.05(Comment C) recommends that all companies with at least 2,000 shareholders and $100 million have an audit committee, they will typically review financial statement and reports. The committee should be made up of disinterested individuals. Should provide proper incentives for management but avoid over compensation. (b) Who are the Outside Directors? Most of the directors on major corps are outside directors. (c) How Do we Define Independent ALI 1.23 looks to a Dir without a significant financial interest in the transaction, and who does not have a significant relationship with a senior executive. o Such as working for the firm, transaction of $200,000 or more with the corp, working for a firm employed by the corp. National Association of Corp Dir, you are independent if: o Never EE of the corp., not relative of anyone in company, you provide no service to company, is not EE of firm providing major service to company, receive no comp other than dir fees. The Council of Institutional Investors add someone who is EE by foundation or University who receives substantial funds, part of interlocking directorate in which corp CEO sits on BOD of another corp who EEs the director. (d) Structural Bias? This is when a mind set exists that prevents outside directors from breaking with the CEO or managers view of the situation, preventing them from voting against their CEO and acting independently. (e) Constituency Directors? This would include groups such as EEs, who would be disinterested, but who would also care a great deal about the corp. However, the obvious pitfall is that they would lack experience and training. What Can Outside Directors Contribute? Pg 619
1. Section ALI 3A.01 suggests publicly held corporations should have a majority of outside directors. This may be beneficial, and clearly the statute looks favorably upon it, but it is still unclear how much of an affect outside or independent directors actually have on the corp. 2. While outside directors are supposed to oversee the company, etc. They do have their constraints, and are forced to rely on inside directors and other corporate managers. The Outside directors, however, with their experience can act as a check which keeps the managers in line and
BUSINESS ORGANIZATIONS II - Shaffer Page 76 of 131 Karl Bekeny/Spring 2001 the company focused on the shareholders best interest. Of course, the real problem is as Weiss points out, (1) the dirs dont have time, (2) they often lack experience in the specific business which they are overseeing, (3) they depend in inside dirs for their information, (4) there is no real incentive for these dirs to step up and do what is best for the company and reign in the inside directors. 3. A,B,C 4. -Clearly the benefit of the BODs is their ability to step in and keep the corp managers in check when they feel that they are behaving in a manner which might be detrimental to the corporation. On the other hand, as Manning points out, with highly technical and diversified companies, it may be difficult for these dirs to know what is the best option and the preferred practice in a particular area. The people who serve as dirs may also be diverse, and the reality is that if the CEO is the largest shareholder etc, they are likely to receive a lot of deference, and in this case how independent are these outside dirs. Of course, there is also the problem that the inside dirs here are outside dirs at your independent dirs company, and so do these independent dirs really want to cause turmoil when they may be attempting a similar move at their own company. Of course, then as well for professional and constituency dirs, while totally independent they are likely to lack either the knowledge in general, or the practical knowledge of the real business world.
B. Directors Duty of Care.[658-684] Directors, officers, and controlling shareholders are obligated to act in the corporations best interests, principally for the benefit of the shareholders. The duty of care addresses the attentiveness and prudence of managers in performing their decision making and supervisory functions. The business judgment rule presumes that directors and officers carry out their functions in good faith, after sufficient investigation, and for acceptable reasons. Unless, this presumption is overcome, courts abstain from second-guessing well-meaning business decisions even when they are flops. 1. The General Standard of Care. Statutory Standards: Under MBCA 8.30, a director must: If These Actions Are Done The BOD did NOT Breach Duty of Care (1) Discharge his duties in good faith, (2) Discharge his duties in a manner he reasonably believes to be in the best interests of the corporation, and (3) Become informed in performing his decision-making and oversight functions with the care an ordinarily prudent person in like position would reasonably believe Common Law Standards: The Delaware Supreme Court has stated that a party challenging a business decision must show either the directors failed to act: (1) in good faith, (2) in the honest belief that the action taken was in the best interests of the company, and (3) on an informed basis. Aronson v. Lewis 1984 Facets of Duty of Care: (1) Good Faith, be honest, not have a conflict of interest, and
not approve or condone illegal activity.
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(2) Reasonable Belief, board decisions must be related to furthering the corporations interests, and (3) Reasonable Care. Directors must be informed in making
decisions (possess minimal levels of skill and expertise).
Francis v. United Jersey Bank, (NJ, 1981)[p.661] FACTS: Mrs. Pritchard was the widow of the founder of Pritchard & Baird, a closely held reinsurance brokerage business. After her husbands death she became a director, but was inactive and knew virtually nothing about the business. She never read the firms annual financial statements, which revealed that her sons were taking client funds in the guise of shareholder loans. Suit was brought by a bankruptcy trustee against the widow and her two sons. After her husbands death Mrs. Pritchard was listless and started drinking, she died during the proceedings and her sons stood to benefit from her estate. (The desire to add the estate to the bankruptcy pool may explain the courts duty of care analysis. HOLDING: Court held Mrs. Pritchard liable for failing to become informed and make inquiries. [Mrs. Pritchards laxity proximately caused the losses to the corporation. She could have brought her sons illegal misappropriations to the attention of insurance officials.] As a general rule a director should acquire at least a rudimentary understanding of the business or the corporation. If one feels that he does not have sufficient business experience to qualify him to perform the duties of a director, he should either acquire the knowledge by inquiry, or refuse to serve as a director. There Must Also Be at Least A Basic Dir Understanding: The NJ Business Corporation Act, in imposing a standard of ordinary care on all directors, confirms that dummy, figurehead and accommodation directors are anachronisms with no place in New Jersey Law. RMBCA 8.30(a)-Refers to care that an ordinarily prudent person in a like position would exercise. Duty of Inquiry An offshoot of the business judgment presumption entitles directors to rely on information and advice from other directors, officers, employees, and outside experts. See RMBCA 8.30(e)(1-3). However, directors cannot hide their head in the sand and claim reliance if they have knowledge or suspicions that make reliance unwarranted. That means that management directors with greater familiarity with the corporation have a greater duty to independently verify information. Graham v. Allis-Chalmers Manufacturing Co., (1963)[p.667]
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FACTS: Shareholders bring a derivative action on behalf of Allis-Chalmers against its board of directors and four non-director employees to recover damages which the corporation had to pay because of an antitrust suit for price fixing. The board considered a compliance system but decides against it because it seemed unwarranted. HOLDING: Under the BJR, directors are not liable for failing to institute a antitrust compliance program because there were no grounds to suspect it was needed (Where is the Red Flag)(obvious signs). Unless the director knew of or suspected bid-rigging, they were not obligated to install a monitoring system. (Note however, that management was pushing for an increase in profits at a time when there was a down turn in the market perhaps influencing mid-level managements illegal actions). Board inaction (failure to implement a monitoring system) is protected only if the failure was a conscious exercise of BJ. Good faith inaction is protected by the BJR. Under RMBCA 8.30(b), official comment, in matters of legal compliance a director may depend on the presumption of regularity, absent knowledge or notice to the contrary. More recent Delaware cases suggest that a board may have a duty to install corporate information and reporting systems to detect illegal conduct. See Caremark International, below. (stricter federal sentencing guidelines for companies who fail to implement compliance programs now days encourage boards to implement programs or else proceed at their own peril) In re Caremark International Inc. Derivative Litigation, (1996)[p.672] FACTS: Suit involves claims that the members of Caremarks board of directors breached their fiduciary duty of care to Caremark in connection with alleged violations by Caremark employees of federal and state laws and regulations applicable to health care providers. Caremark was under criminal investigation and entered an agreement in which it would pay $250 million to the government. The shareholders want to recover this money, the parties agree into settlement negotiations. Court approves the settlement. Notice That Delaware Had What Appeared to Be Straight Negligence Standard For a plaintiff to establish that a director breached their duty of care they would need to show that: (1) The directors knew, or (2) Should have known that violations of law were occurring and, in either event, (3) That the directors took no steps in a good faith effort to prevent or remedy that situation, and
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(4) That such failure proximately caused the losses complained of. Under the facts of this case the directors had set up a system, experts told them that the payments to physicians for referrals while questionable were legal, they had a right to rely. No evidence of bad faith. HOLDING: A directors obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, render a director liable for losses caused by non-compliance with applicable legal standards. If directors set up some type of monitoring system (BJR), then they will not be held liable even if the systems fail to prevent wrongdoing. The monitoring system would provide that much more protection. There is a policy for BJR: 1. The shareholders are the ones who actually take the risk. 2. Do you really want courts to make business decisions? a) Due Care and Criminal Liability [p. 682] The business judgment rule does not protect corporate illegality. Three cases in book, all involve environmental or food and drug violations. Compliance programs instituted because of the sentencing guidelines which are insufficient to mitigate a corporations criminal liability will often be used in a derivative suit to show that a director did not act reasonably in carrying out her oversight duties. Problem, Fashion, Inc. Part I
RMBCA 8.30(b) refers to the duty of care as through the eyes of the ordinary prudent person in a like position, therefore requiring at least a minimal amount of knowledge in overseeing the company. While it is unclear whether the ordinary person is a CEO, fashion designer, or Joe off the street, the Dir does have to properly inform themselves about the on goings of the corp unlike the woman in Francis, and while this does not require indepth analysis, I mean you may rely even upon your fellow dirs, or managers of the corporation, this merely requires that she take the time to solicit their advice, and that she can look at financial statement and see when the corporation is taking a terrible turn, she cannot behave as a dummy or figurehead dir. Peters would also want to determine if a monitoring system were in place, and if not may request that one be instituted, and she could also be then protected under the BJR from the Caremark decision. Note: Peters should also request an indemnification agreement that would protect her from personal liability. Under Francis Peters duty, if she finds some illegal activity, is to then (1) object, (2) and if the conduct is not corrected to then resign.
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C. The Business Judgment Rule.[685-705] The BJR is a rebut table presumption that directors in performing their functions are honest and well-meaning, and that their decisions are informed and rationally undertaken. (Does not apply when self-dealing or illegality).
BJR Presumption (1) That the BOD acted in Good Faith, (2) that they reasonably believed that they were acting on behalf of the corp, (3) they used reasonable diligence in their monitoring and inquiry.
BJR shields directors from personal liability and insulates board decisions from review. PP why Presumption is Good: BJR encourages people to serve as directors, take business risks, and avoids judicial meddling. Delaware Supreme Court has suggested that the BJR involves both procedural and substantive due care. Procedural Due Care = implicates the process used in reaching a decision. Substantive Due Care = raises the question of whether the complaint states a claim of waste of assets (no person of ordinary sound business judgment would deem the transaction worth what the corporation paid or received). Neither DGCL 141 nor RMBCA 8. 30(d) specifically adopt the BJR. BJR is a creature of common law. a) The Scope of the Business Judgment Rule Joy v. North, (2nd Cir. 1982)[p.687] FACTS: Book does not give facts in book to talk about BJR. HOLDING: Under the BJR, a corporate officer who makes a mistake in judgment as to economic conditions, consumer tastes or production line efficiency will rarely, if ever, be found liable for damages suffered by the corporation. The policy behind this is: (1) shareholders voluntarily undertake the risk of bad business judgment when they invest in a corporation, (2) courts recognize that after-the-fact litigation is an imperfect device to evaluate a corporate business decisions, and (3) it is in the interest of shareholders that directors take risks and that the law not create incentives for overly cautious corporate decisions.
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BJR does not apply in situations in which the corporate decision lacks a business purpose, is tainted by a conflict of interest, or results from an obvious and prolonged failure to exercise oversight or supervision. Smith v. Van Gorkom, (1985) (This is the Transunion case) [p. 688] Standard of Care to Rebut Presumption is Gross Negligence. The court held should respect the BOD role under 141(a), cites Aronson v. Lewis. FACTS: Context is a friendly cash-out merger. Van Gorkom, Trans Unions CEO, initiated, negotiated and advocated a merger agreement whose terms may have favored the acquirer, Pritzker. Shareholders brought a class action challenging the boards failure to become sufficiently informed. The board failed to: (1) inquire about Van Gorkoms role in setting the merger terms, (2) review merger documents, (3) inquire in to the fairness of the price being offered for the shares and the value of the unused tax credits, (4) inquire the view as to fairness of price of the CFO, Romans, (5) seek an outside opinion from an investment banker as to price fairness, and (6) to postpone the decision which was made at a two-hour meeting without prior notice and without there being an emergency. The board argued that they had a right to rely on Van Gorkoms oral presentation outlining the merger terms and Romans opinion at the meeting. The Court disagreed. (Odd for the court to intervene, no allegations of bad faith or self-dealing [self-dealing overtones for Van Gorkam who was retiring and stood to make money on the stock he owned]). HOLDING: Directors of Trans Union Corporation are liable for not informing themselves adequately when they approved and recommended the sale of the company in a negotiated merger to shareholders (also violated a duty of disclosure). The BJR cannot be applied to shield the directors. NOTE: What if the board had done all these things? There is little to suggest that the board might have extracted a better deal. However, now boards of directors who receive unsolicited offers for their companies can put off an unwanted buyer on the ground that Delaware law requires them to take their time to first become fully informed.
Smith v. Van Gorkom, (The Trans Union Case)
1. Only 2 hour meeting, rubber stamping. 1. Experience, not dummies or figureheads (Francis) 2. Never actually read the proposal, (Should have exec summary). 2. Time sensitive issue. 3. CEO, CFO, Blind reliance, not 141(e) protection. 3. Good faith no self-dealing. 4. Cash-Out merger->end of the day someone else is taking over. 4. Reasonable belief transaction was in SHHs interest. 5. They did not get any further valuation. 5. Shhs did not approve the agreement. 6. The BODs could have asked for more time. 6. $17 dollars above the market value, 15% premium. 7. The BODs should have looked at cash flow statement. 7. Rely on 141(e) independent council, CFO, Gorkon. 8. Really pressure on self-dealing. 8. They met 3 times over multiple
Why This is a Good Decision
Why Bad Decision
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Problem, Fashion, Inc. Part II [p. 685]

Reliance1. Notice may not be sufficient in this case as under RMBCA 8.22(b) requires that two days notice be given as to date and time. 2. The reports are not from private investors. a. The CEO. b. Accountants (Financial Statements, prepared by the targets accountants), but under what principles are these being analyzed? c. CFO, who knows if he is disinterested. Loren can likely rely on both the CFO and CEO, but of course under 8.30(e)(1), Loren has to believe that they are reasonably competent. There may be some question in this case not as to competence, but rather as to if Lane was behaving in good faith. Note: Lorens knowledge of the relationship between Lane and the Uniteds CEO may be the red flag which should require Loren to greater question the choice and seek further inquiry. i. Loren needs to assure that some proper form of due diligence has been done. Independence Why is this a special meeting? The relationship between Lane and the CEO of United should raise some serious questions as to the decisions being made here. Once again, this may be the red flag that Loren could be held responsible under Francis for. Negotiates-Likewise, it was Lane who negotiated the deal and it is simply being sprung on Fashions BOD. Timing-Was this really an emergency, something that had to be decided that day? Isnt United the corporation who should be begging for the deal with Fashion, without the infusion of cash they are going to go bankrupt, therefore, it would appear that a well dickered deal would allow Fashion some time to consider a drastic action. The target company, however, in this is in distress. This case does seem a lot like Van Gorkom, like Loren and the rest of the BODs could be held liable for a failure to properly inform themselves if this deal does not go through. Consider what the BODs did not due in Van Gorkom and it seems similar to this case, The board failed to: (1) inquire about Van Gorkoms role in setting the merger terms, (2) review merger documents, (3) inquire in to the fairness of the price being offered for the shares and the value of the unused tax credits, (4) inquire the view as to fairness of price of the CFO, Romans, (5) seek an outside opinion from an investment banker as to price fairness, and (6) to postpone the decision which was made at a two-hour meeting without prior notice and without there being an emergency. What about Lorens Liabilities? Loren could express her concern by voting NO, also by voicing her concern during the meeting, should could then finally resign, but without taking such drastic steps, Loren could also abstain, which would mean that she would not approve the merger under 8.24(d)(2). An abstention is not approving of the BOD action. The fact that Loren is an outside director probably does not matter, as Manning would suggest.
BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001 If the BJR presumption is overturned: 1. The analysis changes process to substance. 2. The Burden of proof also changes from the P to the D.
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b) Due Care and the Business Judgment Rule [705-721] Bayless Manning The Business Judgment Rule and the Directors Duty of Attention: Time for Reality The relationship between the business judgment rule and the duty of care is complex. Both require the director to be informed however duty of care cases apply an ordinary negligence standard while BJR cases apply a gross negligence standard. The BJR, of course, is intended to remove courts from scrutinizing the substance of specific decisions, but both the BJR and the duty of care can involve judicial examination of the directors process. Feels Only 2 Elements Are Legitimate for Realistic Standard of Care: (1) Alertness to potentially significant corporate problems. (2) Obligation of deliberative decision making on issues of fundamental corporate concern. Often courts will mix the analysis of the two. Stuart R. Cohn Demise of the Directors Duty of Care: Judicial Avoidance of Standards and Sanctions Through the Business Judgment Rule. Courts often have difficulty distinguishing between the duty of care and the BJR. In Brane v. Roth (Ind.Ct.App.1992), a grain hedging case [p.708] the court held that the BJR does not protect directors who fail to inform themselves of all material information reasonably available to make their decision and that failure to provide adequate supervision of the manager who was hedging was a breach of their duty of care.
NO BJR rule applies, seems to be dumb cases, exceptions
Caremark and Brane suggest that directors may lose protection of the BJR with respect to transactions that are both part of on-going monitoring and a specific business decision if, after the decision, the directors do not exercise reasonable care in supervising the effects of the decision.
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In Hoye v. Meek (10th Cir. 1986) In a suit by the trustee in bankruptcy, the trial court held that Meek had breached his duty of care by failing to curb the extent of the investment and to monitor the companys investment decisions and results, and by delegating excessive authority to his son. -The holding surrounds a failure to make the basic inquiries, even good faith would not be enough for this case, because as the court in Francis held, you cannot use ignorance as justification, there is a minimum intelligence requirement. -The director must be diligent and careful to get BJR in performing his duties. c) Reliance Under RMBCA 8.30(b) official comment, a director must make a judgment as to the reliability and competence of the source of information upon which he proposes to rely. RMBCA 8.30(b)(3) permits directors to rely on a committee if the director reasonably believes the committee merits confidence. RMBCA 8.30(b) Inherent in the concept of good faith is the requirement that, in order to rely on a report, statement, opinion, or other matter, the director must have read the report or statement in question, or have been present at a meeting at which it was orally presented, or have taken other steps to become generally familiar with its contents. d) Causation There are two types of breach of duty of care cases: (1) nonfeasance cases[Francis & Graham] the idea being that if the directors had carried out their duties with more diligence that they would have been able to prevent the loss, and (2) transactional cases [Van Gorkom] the idea being that if the directors had not approved some specific transaction a loss to the corporation could have been avoided. For a director to be liable the plaintiff will have to show causation. However, Not every care breach creates liability. Some courts require that the challenger show that the directors action or in action proximately caused damage to the corporation. Barnes v. Andrews (S.D.N.Y. 1924) [p. 711] (Tort Action, NOT controlling for fiduciary duty). FACTS: A director is the friend of the president of a corporation. The extent of the directors involvement is speaking with his friend about what is going on with the
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corporation when they are out together socially. The corporation goes into bankruptcy. HOLDING: The director is not liable because even if he had been involved, the bad business judgment of the president would have still lead the corporation into financial trouble. When directors disregard management abuse courts readily find proximate cause. Courts are less likely to find proximate cause when directors are inattentive to mere mismanagement. [It doesnt make sense to hold a director liable for business mistakes that are themselves protected by the BJR]. Cede & Co. Technicolor, Inc., (Del. 1993) [p.714] (CEDE II) HOLDING: A breach of either the duty of loyalty or the duty of care rebuts the presumption that the directors have acted in the best interest of the shareholders, which requires the directors to prove that the transaction was entirely fair. In this case, directors had breached their duty of care by failing to inquire about negotiation and terms of a merger. The court required the defendants to prove the challenged transactions entire fairness as to price and process. Proximate cause becomes an affirmative defense if the directors can prove that the transaction was fair, because if fair, how would they be the cause of the damages then? Cinerama, Inc. v. Technicolor, (Del. 1995) [p. 715] (CEDE IV) To require proof of injury as a component of the proof necessary to rebut the BJ presumption would be to convert the burden shifting process from a threshold determination of the appropriate standard of review to a dispositive adjudication on the merits. Thus the injury or damages analysis (based upon causation) does not enter into play until after a determination that the transaction was not entirely fair.
Chain of Questions 1. BJRis presumption rebuffed, gross negligence. IF YES 2. Is the transaction entirely fair? IF YES 3. O.K., IF NOTliability may be possible.
e) Rebutting the Presumption of the Business Judgment Rule To overcome the BJR a plaintiff has to prove either: (1) Fraud, illegality, or conflict of interest, or (2) Lack of a rational business purpose, or (3) Gross negligence.
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Under RMBCA 8.31, a director can become liable for: (only if the corps charter does not limit liability) (1) An action not in good faith, or (2) A decision the director did not reasonably believe to be in the corporations best interests, or (3) A decision as to which the director was not adequately informed, or (4) Action resulting from the directors lack of objectivity or independence, or (5) A sustained failure to be informed in discharging the directors oversight functions, or (6) Receipt of an improper financial benefit. Entire fairness test as applied in Cede. =
Once the BJR presumption has been rebutted defendant directors need to prove that the transaction was fair (fair dealing and fair price). Weinberger v. UOP
D. The Business Judgment Rule and Illegal Conduct.[718-721] The duty of loyalty addresses fiduciaries conflicts of interests and prohibits fiduciaries from putting their own interests ahead of the corporations. Corporate fiduciaries breach their duty of loyalty when they divert corporate assets, opportunities, or information for personal gain.

Flagrant Diversion: Stealing
Self-Dealing: Fiduciary enters into a deal with corp. on unfair terms, or in a merger context forcing minority shareholders to accept an unfair price for their shares. Executive Compensation: Compensation exceeds fair value of Directors services.
Usurping Corporate Opportunity: Fiduciary takes what could have been a corporate opportunity for herself.
Trading on Inside Information: Fiduciary buys or sells on material inside information..

Selling Out: accepting a bribe
Entrenchment: Uses corporate machinery to protect his incumbency.
Miller v. American Telephone & Telegraph, (3rd Cir. 1974)[p.718]
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FACTS: Shareholders bring a suit against AT&T for failing to collect an outstanding debt of $1.5 million which the Democratic National Committee owed them for services provided during the 1968 national convention. The y argued that this amounted to AT&T making an illegal contribution to the DNC in violation of federal law. HOLDING: Directors cannot be insulated from liability under the BJR on the ground that the contribution was made in the exercise of sound business judgment, what was done may have violated a federal statute for whom shareholders are a protected class. Reversed and remanded to see if the directors violated the statute. E. Limitation of Directors Liability.[p. 721-732, & 740-746] D&O insurance, Indemnification clauses in employment contracts, and Statutes which limit liability. Courts have held that in breach of duty cases each director who voted for an action, acquiesced in it, or failed to object to it becomes jointly and severally liable for all damage that the decision proximately caused the corporation. Under, RMBCA 8.24(d), a director who attends a meeting is presumed to have agreed to the action, unless the minutes of the meeting reflect the directors dissent or abstention. In response to the decision in Smith v. Van Gorkom, D&O insurance premiums went up and many directors declined to serve for fear of liability. To address this many states, such as Delaware, now allow charter amendments the shield directors for breaching their duty of care. Note: These standards are NOT self-executing (Both require shareholder ALI 7.19 approval) Prin. of RMBCA 2.02(b)(4); 2.02(b)(5) DGCL 102(b)(7) Corporate 3rd party indemnification Contents of the Governance Articles of Incorporation Certificate of The ALI does not Incorporation. permit complete exculpation of directors; the corporation can never reduce the amount for which directors can be held liable to less than the directors annual compensation.
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(4) a provision eliminating or limiting the liability of a director to the corporation or its shareholders for money damages for any action taken, or any failure to take any action, as a director, EXCEPT liability for (A) the amount of a financial benefit received by a director to which he is not entitled; (B) an intentional infliction of harm on the corporation or the shareholders; (C) a violation of section 8.33; or (D) an intentional violation of criminal law. No Liability for Money Damages to corporation or shareholders, except liability for: 1. Financial benefits he received to which he is not entitled. 2. Intentional infliction of harm on the corporation or its shareholders. 3. Approving illegal distributions, or 4. An intentional violation of criminal law.
No exceptions for breached of the duty of loyalty or acts or omissions not in good faith.
A provision eliminating
or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director No personal liability for breaches of duty, though director remains liable for: 1. Breaches of duty of loyalty. 2. Acts or omissions not in good faith or that involve intentional misconduct or knowing illegality. 3. Approval of illegal distributions, and 4. Obtaining a personal benefit (such as by insider trading).
DGCL 145: (a) Provides for indemnification of Directors, Officers, and Employees. Only applies in third party actions not derivative suits and only reimburses attorney fees and judgments. Moreover, the person must have been acting in good faith and believed that they were acting in the best interest of the corporation. (b) Applies to derivative suits but only permits reimbursement of attorney fees. (c) Indemnification required if person successful on the merits of a suit against him. Statute Variances Among States for Liability 1. Indiana-Even if there is a breach of care, the BOD would not be held liable unless their actions were willful misconduct. 2. Virginia-The Director damages have a ceiling, the greater of either the years salary, or $100,000. 3. Most States-Allow for private K within limits of the statute. Indemnification: 16.21(a)-If a corp indemnifies a director, or provides them an advance, then they must report this indemnification to the shareholders in writing.
Two Factors in Seeking Indemnification 1. Whether the Director was successful in defending the action, and 2. Whether the Director, though unsuccessful in her defense, was justified in her actions.
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Good Practice in Seeking Indemnification 1. Put the indemnification in the AIC. 2. Could get a shareholder vote that would place the indemnification in the AIC. 3. However, could be done through private K with the BOD, and then you would also ask for D & O insurance.
Mandatory Indemnification
If a Director is sued because of her corporate position and she defends successfully, the corp is obliged under all state statutes to indemnify the director for litigation expenses, including attorneys fees. (RMBCA 8.52, Cal 317(d), Del 145(c)).
1. 2.
What Does It Mean to be Successful on the Merits? This would include basically anyway in which a suit is dismissed, either procedurally, or on the merits. (RMBCA 8.52, DGCL 145(c)).
Permissive Indemnification
Indemnification to the extent successful-Delaware looks to the extent in which the Director is able to be successful, 145(c). Merritt-Chapman & Scott Corp. v. Wolfson (1974). (requires success on the merits). a. Note: This rule may create a plea bargaining problem, for this reason, the RMBCA 8.52 requires that you be wholly successful.
Waltuch v. Conticommodity Services, Inc. (2nd Cir. 1996) [p.732] FACTS: Waltuch, a silver trader, seeks indemnification of his legal expenses from his former employer. The articles of incorporation require his employer to indemnify him for his expenses in both private and federal actions. Also argues that he was successful on the merits under section 145(c). Silver market crash case. HOLDING: Under 145 (c) mere success is vindication enough. Waltuch should be reimbursed it does not matter that he won because of a settlement which dismissed the suit against him. See RMBCA 8.54(a)(3).
Third Party Actions

A director must be deserving to be entitled to indemnification in an action brought by a third party-such as when the EPA sues for illegal dumping or investors claim securities fraud. o Indemnification Criteria: The Director must have acted in Good Faith (8.51(a)(1), DGCL 145(a)). There was a reasonable belief by the Director that her actions were in good faith (8.51(a)(2), DGCL 145(a)). The Director in a criminal proceeding had no reasonable cause to believe that her actions were unlawful-a standard that goes beyond whether she acted in good faith. (8.51(a)(3), DGCL 145(a)).
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Coverage: Director sued by 3rd party, indemnify for (1) litigation expenses, (2) personal liability, (3) an out of court settlement, (4) the imposition of penalties or fines. Procedure: Court Ordered may determine if the director meets the criteria for Statutes tell us who Indemnification COURT ORDER 1. Court Order, Is fairly and reasonably entitled to indemnification in view of all the relevant permissive indemnification. (1) circumstances. DGCL 145(b). 145(d). Directors not party 8.55(b), If unsuccessful, you may still get indemnity even if ineligible or liable to the corp, (Expenses and liability). (2) Shareholders 8.55(b)(3), 145(b)(4). (RMBCA does not include BODs 2. The standard is the same as Delaware above, but 8.54(2) you may only provide directors shares, DGCL any shareholder may vote. expenses. (3) Committee of non-party directors. 8.55(b)(1), 145(d)(2). (4) A special Ind Counsel appointed by the BOD (including interested, or Committee of BOD) (8.55(b), only can determine if he meets the criteria. In Delaware, only nonInterpretation of the of litigation expenses in the Note: Most statutes allow for the payment Indemnification Statutes form of an advancement. RMBCA 8.53, 145(e). Case-by-Case procedure: Many statutes require a specific, case-by-case determination RMBCA 8.53(a) that the director is entitled to permissive indemnification. RMBCA 8.55 (1) Director must affirm entitlement to permissive indemnification. (2) The Director must take to repay the advancement if he is not entitled to it. InvalidThose who move forward to get him payment of the advancement must not know (3) of Inconsistent: Some statutes may be inconsistent with indemnification provisionsanything that the by-laws, AIC, or private K, in which case these indemnification of found within would preclude indemnification. statutes may not apply. RMBCA 8.58. a. No security needed, just good faith statement, 8.53(b), dont want to discriminate against directors who dont have so much money. DGCL 145(e) The By-laws orrequire a case-by-case determination, and advances can be made if (1) Do not Contract Indemnify, Even Though Not in Statute: Some states allow indemnification without it being found within the state statute. 145(f) required in the articles, the by-laws, or a contract.
Advancement of Litigation Expenses
Note: Most statutes do not allow corps to indemnify directors adjudged liable to the 8.57, 145(g). corp, if the action was brought by the corp or its shareholders (derivative). have been Note: Although this seems to be indemnification when there should not (RMBCA 8.51(d)(1), DGCL 145(b)). some, theory is that the director could have gone out and gotten the insurance themselves anyway. Note: The corp cover? out Improper expensesbenefit, (2) Bad faith, (3) Illegal What does it can pay (1) litigation personal to a director who settles the case, if the director meets the criteria for a permissive indemnification, 8.51(e). compensation, (4) libel or slander, (5) Knowing violations of law, (6) Other willful misconduct.
Actions By premiums comes the Corporation DERIVATIVE Note: D & O Insuranceor On Behalf offrom the compensation of the directors.
Insurance
Fashion, Inc. Part III [pg. 721]
Facts: This was a final vote regarding the acquisition, the vote was 10 yes, 1 abstention; required $750 million capital infusion; decline in share price of 50%; shareholder brings derivative suit. 1. The BOD can advance expenses of $100K a. May BOD authorize: A board may authorize permissively under Del code 145(e) and RMBCA 8.53. b. Procedure: Delaware requires an undertaking to repay. i. RMBCA 8.53 requires: (1) written affirmation of good faith belief that has met 8.51 standards or is protected under 2.02(b)(4); and (2) written undertaking to repay funds if not entitled under 8.52 and determined that did not meet standards under 8.54 & 8.55. Note: Could condition on providing security, but not required.
BUSINESS ORGANIZATIONS II - Shaffer Page 91 of 131 Karl Bekeny/Spring 2001 c. Appropriate Decision-maker? RMBCA 8.55-determination of indemnification must be authorized by (1) disinterested directors, (2) special legal counsel, including as selected by directors where dont have 2 disinterested ones, (3) shareholders. i. Delaware has no express provision regarding expenses-DGCL 145(d) covers indemnification. ii. Who is special counsel? -must have no prior professional relationship. d. Can Directors otherwise receive up-front coverage of expenses if BOD does not wish to grant in circumstances? Yes-by court order if (1) put in articles, by-laws, resolution or indemnification agreement; (2) if not so covered, can only receive indemnification after the suit is successful, whether on the merits or otherwise. 2. Indemnification? a. amount in facts: (1) of expenses of $1 million; (2) settlement for $15 million to corp; (3) $10 million paid by D&O insurance. a. May the corporation make payment under Del Law? i. DGCL 145(b)-permissive; may indemnify for expenses (including attorney fees) if acts in good faith & reasonable belief re corporations interests. ii. Note: cannot cover amounts paid in settlement other than expenses (i.e. the $5 million)-but query if Delaware court will not award if believes reasonable in circumstances (treat damages and settlement expenses similarly). b. May corporation make payment under RMBCA? i. RMBCA 8.51(a)-permissive indemnification-may indemnify if (1) in good faith & reasonable belief that in the best interests of corporation, where act in official capacity or (2) permitted under 2.02(b)(5). -Note: does not require to meet due care standard under 8.30(b). -But, RMBCA 8.51(d)-cannot indemnify in derivative proceeding, except for expenses where the director has met relevant standard under 8.51(a)(2)(d) (1). (i.e. good faith & reasonable belied in corporations best interests) (Unless ordered by the court under 8.54(a)(3)). c. Key Issues re expenses? (1) whether amount is reasonable; (2) whether met appropriate standards of good faith and reasonable belief in corporate interests. d. Procedures? Same as above for RMBCA. i. DGCL 145(d)-similar to RMBCA. e. Court-ordered indemnification? RMBCA 8.54 -why?-to protect minority or dissident directors.
F. Introduction to Conflicts of Interest and the Directors Duty of Loyalty. [p. 747-767] Be on the look out for self dealing transaction both direct and indirect. See RMBCA 8.60(1)(i) and (ii) [subchapter F -definitions. The duty of loyalty requires a manager to place the corporations best interests and those of the stockholders above her own. Subchapter F to the RMBCA recognizes that self-dealing transactions can be both fair and beneficial to a corporation. The Real Question: As Robert Clark stated: The principal difficulty in this area of the law is establishing appropriate criteria for measuring the validity of the transaction. Victor Brudney, Contract Law and Fiduciary Duty in Corporate Law: There has been a dilution from the CL duties of fiduciaries, and this is important in that it helps reign in the BOD and Officers, even though they
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have found multiple ways to get around. But on thing is clear, contract doctrine is not strong enough and does not provide the needed protections. Brudney points out that modern law justifies its position on modern market tendencies and the reputation of the corporate directors, but this he feels is an unlikely place to find real control. They dont have any of these real concerns, but if there were concerns about their actions they could receive control through consent that would be readily agreed to by the shareholders, etc. a) The Common Law Standard. No transaction of a corporation between itself and any of its directors is automatically void able at the suit of a shareholder, whether there is a disinterested majority of the board or not who approves the transaction today courts review the transaction and look for unfairness to the corporation before invalidating the transaction.
How Do we Define Self-Dealing? Direct and Indirect Self Interest:

Direct Interest: The Classic example of the corp and the director being parties to the same transaction. 8.60(1)(i)-Sales and purchase of property, loans to and from the corp., the furnishing of service by a nonmanagement director (like outside counsel). Indirect Interest: When corp action in connected with another person or entity that the director has a strong personal or financial tie with. (1) Corp transaction with directors close relatives. 8.60(1)(i), (3), which defines related person to include the spouse, child, grandchild, sibling, parent, or family trust. (2) Significant Financial Interest. 8.60(1)(i), (ii) (Another entity in which director has a significant financial interest or in which he is a director, partner, agent, or EE). (3) Between Companies With Interlocking Directors. 8.60(1)(ii) The BODs have different
Shlensky v. South parkway Building Corp., (Ill. 2d, 1960)[p.756] FACTS: Shareholders sue to recover money lost through self-dealing transactions approved by an interested majority of the board of directors (fixture purchases at low prices, and low rent to corporation that directors owned or were connected with). HOLDING: Transactions between corporations with common directors may be avoided only if unfair. The directors who would sustain the challenged transaction have the burden of overcoming the presumption against the validity of the 144(a)(3) transaction by showing fairness. The directors in this case breached their duty of The loyaltycontract corporation. to the or transaction
IS FAIR as to the corporation as of the time it is authorized, approved or ratified, by the BODs, a committee thereof, or the
b) The Statutory Approach [fairness tests] Note: Similar to RMBCA ratification.
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DGCL 144(a), a transaction shall not be void solely because it involves an interested director if: (1) The material facts are disclosed to Board or a Committee, and a majority of disinterested directors authorized the transaction, even though they lack quorum; or (2) The material facts are disclosed to the shareholders, and the shareholders vote to approve the transaction, or (Note: this does not state disinterested shareholders). Remillard Brick Co. v. Remillard-Dandini Co., (Cal. App. 1952)[p.761] FACTS: Plaintiff, a minority shareholder, alleged that the majority directors of the manufacturing companies used their power to have the manufacturing companies enter into contracts with the sales corporation, so that the manufacturing companies were stripped of their sales function, and that through the sales corporation, the directors realized profits which should have gone to the corporation. HOLDING: The directors used their majority power to their own advantage. While a transaction is not voidable simply because an interested director participated, it will not be upheld if it is unfair to the minority stockholders. Fliegler v. Lawrence, (Del. Sup. 1976) [p.765] (Notice the Significance of This Case!!!) HOLDING: It would require disinterested shareholder approval of an interested director transaction before shifting the burden of proof from the interested director to the challenging shareholder, even though section 144 does not contain such language. (plaintiff must prove unfairness). Marciano v. Nakash, (Del. 1987) Case of a deadlock at both shareholder and the director level, the court found this to be a fair transaction. Oberly v. Kirby, (Del, 1991) The key to upholding an interested transaction is the Shlensky-neither disclosure body. approval of some neutral decision-makingnor shareholder assent can convert a dishonest
transaction into a fair one.
Cinerama, citing Kahn, Chancellor Allen sums up what is likely the modern rule. as construed by our SC recently, compliance with the terms of section 144 does not restore to the BOD the presumption of the business judgment rule; it simply shifts the burden to plaintiff to prove unfairness.
Once there is the demonstration of conflicting interest, then the BJR presumption has been rebutted and the new issue surrounds the fairness of the transaction. However, in response to this problem the legislature has made a sharp distinction between interested and disinterested directors, and if you are disinterested you are also going to be applied
There is NO BJR Presumption for Self-Dealing Cases:
Starcrest Corp. Part I [pg 753].

7 member BOD: (1) Elizabeth Adams CEO
The Committee: 1. Brown=ID 2. Grey=ID 3. Diamond=IP (probably, but open for debate). Note: Grey dissents from the committee vote. Committee recommends $6.5
BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001 (2) Paul Baker CFO, Yes (3) Robert Crown VP Sales, Yes (4) Linda Diamond GC, Yes (5) Brown, Yes (6) White, Yes (Does not appear at the meeting) (7) Grey, NO
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(a) 144 Well the question here is whether Diamond is disinterested or not, because it she is then the committee could have approved the transaction by 2-1. However, given her EE position (likely dominated by Elizabeth, Cleveland Browns) with the company, and here relation and dependency on Elizabeth, it is likely she is interested and therefore 144(a)(1) committee approval fails. Arguably there was also not a majority of disinterested directors voting in favor at the BOD meeting, since Grey voted NO and White did not attend, therefore failing 144(a)(1), but the shareholders did approve the vote, but of the 54% that approved, only 14% were likely not from the Adams family. In the Fliegler v. Lawrence case the court held that the shareholder approval had to have been by a majority of the disinterested shareholders, even though, it is important to note that this language is not in the statute. Note: That there are questions as to whether Elizabeth really Material disclosure, also required by 144(a)(1). Questions to ask when determining if the director is independent include (1. how were they appointed, 2. do they have a financial interest, 3. are there family ties, 4. or are they being dominated.) (b) 8.61 and 8.62 Under 8.60(1)(i) there is no doubt that Elizabeth has a conflict of interest, as she will receive the benefit of her deal with the corp. The BODs are allowed to rely on the committee, but the committee has to be disinterested. Here, one side would say you are relying on a 1 to 1 vote. While the other side would say there was a 5-1 BOD approval of the transaction. Under 8.62(a) a BOD vote of two qualified (8.62(d) means not part of transaction, or familial or financial interest, or EE Relationship, it is for this reason that there are only 3 disinterested dirs) a qualified director would suffice, but there are not two in this case because Grey votes no and White does not appear at the meeting. Therefore, there is neither committee or BOD ratification. Under 8.63(a) shareholders may also ratify, but they must be qualified, which would not include under 8.63(c) Elizabeth or her familys 40% share. Plus while there may have been adequate disclosure of material facts under 8.62(a), there has been no disclosure that the facts tell us regarding the shareholder vote under 8.63(a)(3). Therefore, likely there has been a breach of the duty of loyalty in this case. Note: Dutywhen there is a finding in RMBCA under 8.62thefairness based upon That of Loyalty and the Different approach to of BJR procedure, then transfer to the BJR, this is unclear in Delaware, which likely requires that then you RMBCA 8.63get BJR, Official Comment 8.61(i), if comply with 8.62 or 8.63, after ratification a fairnessattach. be applied, on shifting the burden to the challenger. The only are immune from test still See 8.61(b)(1-3) to Lewis. consideration then becomes waste, see how it applies. DGCL 144Under the case law, Cinerama citing Kahn, only shift burden to P to prove
G. Duty of Loyalty and Fairness Doctrine. [p. 767-782] Fairness Test You need to prove both substantive and procedural fairness to meet the entire fairness test. (1) Nonvoidability Statutes-144(a) interested transaction shall not be void or voidable solely for the reason that a director is interested; however, this has been held, as this outline identifies that (Remillard and Fliegler) the transaction may still be o.k., but that an assessment of FAIRNESS is still required. Yet, other courts like Marciano hold that the burden of proving unfairness now shifts to the challenger.
Delaware requires entire fairness, Weinberger v. UOP (1983), which include

This is an acceptance by the court of the transaction if it was in the corporations best interest. Substantive Fairness Has Two Aspects: Objective Test-The self-dealing transaction must replicate an arms length transaction by falling into a range of reasonableness. Courts will carefully scrutinize the terms, especially the price. Corporate Value-The transaction must be of particular value to the corporation, as judged by the corporations needs and the scope of its business. Both of these tests involve significant meddling into business judgment matters. Note: When it is difficult to determine whether the agreement is substantively fair, it is often much easier to palate if there does exist some procedural safeguards. Shlensky Factors for Fairness: (1) Did the corporation receive full value for it purchase? (2) Corporations need for the property. (3) Corps ability to finance the purchase.
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Substantive Fairness
This would generally surround the issue of BOD approval. The examination of this question has several components: (1) Disclosure-This means different things to different people, some times just the conflict of interest, but the fairer test seems to look to all material facts that might affect the BOD or committee decisions. Oyster. (2) Composition of BOD or Committee Approval: a. Puma upheld disinterested directors development and approval of deal with companys main family. (Some have held merely presumption when approval of disinterest. b. ALI-applies modified fairness and burden-shift. RMBCA Subchapter F, this is conclusive. c. Who is Disinterested? i. He is not directly or indirectly interested in the transaction (NO money or relations). ii. He is not DOMINATED by the interested director. A director is dominated when he acts as requested without independent judgment, Cleveland Browns. iii. ALI 1.18 disinterested director is one that is not party to transaction or indirectly interested. 8.60 qualified director. NOT party to
Note: In Delaware, if you are procedurally cool, then you shift the burden to the P to demonstrate Substantive unfairness!!
Ratification
Courts will give significant deference to a corporate decision, which has been ratified. Ratification by Shareholder Majority-When a majority of disinterested shareholders ratify a decision, and they are not dominated by interested parties, then generally the defendant does not have to show fairness. Rather, the burden switches to the P to demonstrate: (1) There was waste (Aronoff, burden placed on challenger), (2) the shareholders were NOT informed, (3) transaction was illegal, (4) The transaction was ultra vires because of a limit found in the AIC. Courts remain suspicious if ratifying majority is interested. (Remillard and Fliegler cases in which required, intrinsic fairness. 8.62(a) Qualified BOD ratification. Note: RMBCA 8.63(b)-vote by an interested shareholder is not counted for shareholder ratification. Note: RMBCA 8.63(c)-Nonetheless, many statutes permit a majority of shares held by disinterested shareholders to constitute a quorum. Unanimous Ratification-If self-dealing is ratified unanimously by all the shareholders or by a sole
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Delaware Waste Standard = (Michelson v. Duncan (Del. 1979)-The action was improvident beyond explanation, entails an exchange of corporate assets for consideration disproportionately small as to lie beyond the range at which any reasonable person would trade. Most often the claim is associated with a transfer which serves no corporate purpose or for which no consideration is received at all (in effect a gift to the recipient). However, if there is any substantial consideration and if there is a good faith judgment that under the circumstances the transaction is worthwhile there should be no finding of waste.
Lewis v. Vogelstein, (Del.Ch.1997)[p.776] (Chancellor Allen) FACTS: Shareholder suit challenges a stock option compensation plan for the directors of Mattel, Inc., which was approved or ratified by the shareholders of the company at its 1996 annual shareholder meeting. HOLDING: The effect of informed ratification is to validate or affirm the act of the agent as the act of the principal. Informed, uncoerced, disinterested shareholder ratification of a transaction in which corporate directors have a material conflict of interest has the effect of protecting the transaction from judicial review except on the basis of waste. See Waste Doctrine, above. The court concluded that the shareholders complaint should not be dismissed because the one time option grants which were approved were unusual enough to require a waste analysis. (1) Disclosure Procedural fairness requires full disclosure of the existence of a conflict and of other material information concerning the substance of the transaction. H. Duty of Loyalty and Executive Compensation. [p. 782-796] Note: To avoid the uncertainty of the judicial determinations of self-dealing, Subchapter F of the RMBCA and the ALI principles of corporate governance adopt a safe harbor test meant to assure the validity of self-dealing transactions if properly approved.
RMBCA Subchapter F [only 6 states have adopted, meant to be a bright line test]: RMBCA 8.61(b) validates a directors conflict of interest transaction if:
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(1) The transaction is disclosed to and approved by a majority of qualified (but not less than two) of qualified directors/disinterested directors, or (2) Disclosed to an approved by a majority of qualified shareholders, or (3) Established to be fair, whether disclosed or not. 1. Interested Director and Conflict of Interest Transactions. Sections 8.61(a)& (b) and 8.60 define who interested persons are. 2. Fairness A fair price is any price in that broad range which an unrelated party might have been willing to pay or willing to accept ... following a normal arms length business negotiation, in light of the knowledge that would have been reasonably acquired in the course of such negotiations. See comments to 8.61 Terms of the Transaction. 3. Judicial Review Official comment to RMBCA 8.61(b) states that judicial review of an informed decision by disinterested directors is limited to the care, best interests, and good faith criteria of RMBCA 8.30. 4. Executive Compensation One of the most common forms of corporate self-dealing. When executive compensation is approved by disinterested directors then it is subject to business judgment review. Could see on exam in the form of bonuses, stock options, pension plans, and or course regular salary. Stock grants, options, and repurchases require board approval under RMBCA 6.24. Reviewing and approving executive compensation can be delegated to a committee of outside directors. RMBCA 8.25. In Re Walt Disney Corp Derivate Litigation (Del, 1998) The facts of this case deal with the duty of loyalty, and whether this was breached by Eisner in approving a Presidential spot in Disney with an incredible severance package. In this case, there was not even an issue because Eisner himself was not interested, as the Court found, because they were merely friends, acquaintances. The Court begins with the application of the BJR, and then looks for specific facts to rebut the presumption. The Ps must demonstrate that (1) Eisner was personally interested because of his relationship, but court will not find business relationships alone make Eisner interested; (2) now look at the domination of the other directors: Disney, Litvack, and Nunis-They are all EEs so they may or may not be dominated by Eisner, but the reality is that Disney is such a major shareholder he just couldnt be dominated.
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Gold-Disneys personal attorney, so he is NOT dominated by Eisner. Stern-Interested architect because he receives a great deal of money from Eisner. ODonovan-A priest who is the President of Georgetown Univ. his only problem is that his school got money, but he did not, this is a large enough distinction for the court from the Kahn case, where the directors actually received money. Bowers-No doubt makes more money on the board than as an elementary school teacher, but it may be important to remember that PP says we want more poor people on boards so she is not interested. Russell-This man is Eisners attorney so he is obviously interested. Note: At the end of the day, since Eisner himself is not interested, the BJR will apply and the deal is o.k. this does not foreclose an examination based upon waste or care breaches, but not loyalty. Lewis v. Vogelstein, (Del.Ch. 1997) [p.793] FACTS: Involved shareholder ratification of a one-time stock option for corporate officers and directors. HOLDING: Applies the waste standard in the context of a shareholder ratified stock option for officers and directors. I. Corporate Opportunity Doctrine. [p. 796-817] The corporate opportunity doctrine is a subset of the duty of loyalty doctrine, it balances the corporations expansion potential and the managers entrepreneurial interests. A corporate fiduciary cannot take a business opportunity for herself if it is one that the corporation can financially undertake; is within the line of the corporations business and is advantageous to the corporation, and is one in which the corporation has an interest or a reasonable expectancy. See Guth v. Loft (Del. 1939)[p.796]. The problem on the exam will be separating which opportunities should be turned over to the corporation and which can remain with the manager to be exploited. 1. Traditional Corporate Opportunity Doctrine A corporate manager cannot usurp corporate opportunities for his own benefit unless the corporation consents. The plaintiff ahs the burden of proving the existence of a corporate opportunity. Farber v. Servan Land Company Inc., (5th Cir. 1981)[p.798] FACTS: Majority shareholders buy land adjacent to land the corporation owns and runs as a golf course. Minority shareholder brings suit saying that the shareholders who bought the adjacent land usurped a corporate opportunity.
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HOLDING: There was a corporate opportunity in this case and shareholders did not decline it. Attempted ratification by interested shareholders does not prevent a derivative suit. The corporation is entitled to the profits the majority shareholders realized. Court goes through 4 step analysis: (1) Did a corporate opportunity exist?, (2) Did the stockholders decline the opportunity by failing to act?, (3) Did the shareholders ratify the transaction?, and (4) Did the corporation receive a benefit in selling its assets in conjunction with the land the majority shareholders purchased? 2. What is Corporate Opportunity? Look for diverted corporate assets, existing corporate interests, line-of-business test. Also, watch out for a problem in which the director is involved with many corporations (to whom is the duty owed?, brings in the BJR. See Johnston v. Greene (Del. 1956)) [p.806] This older Delaware case points out that it is up to the director to decide where the opportunity goes, which would include himself. Interest or Expectancy: the fact that directors had undertaken to negotiate in the field on behalf of the corporation, or that the directors had knowledge the corporation was in need of the particular business opportunity, or that the business opportunity was seized and developed at the corporations expense with the facilities of the corporation. (Thorpe v. CERBO, Inc., Del 1996). One analysis is whether the opportunity came to the corporate manager in his individual or his corporate director role? If receive info as an individual, may be evidence that this was not a corporate opportunity. Broz v. Cellular Information Systems (Del 1996). (In this case a director purchased a cellular phone license and the other directors did not seem interested. Note: There was no financing in this particular case, but the discussion with the BODs was found to be sufficient inquiry, a move which Clark and Brudney DO NOT like, because they question how anyone can know if financing is available without full disclosure to the BOD first? Note: That the ALI 5.05(a)(1) requires full disclosure to the corporation and reveals the conflict of interest and the opportunity that exists. Line of Business: the opportunity falls within the corporations line of business, applies beyond a corporations existing operations. The court compares the new business with the existing operations to determine if the new project is functionally related to the corporations existing or anticipated business, the manager must obtain corporate consent before exploiting it. A functional relation exists if there is a competitive or synergistic overlap that suggests that the corporation would have been interested in taking the opportunity itself. Example, Miller v. Miller Minn 1974. Fairness: is it fair and equitable that the corp. did not get the opportunity. (Durfee v. Durfee (Mass 1948))-whether fair for director to take transaction.
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Miller v. Miller (MN 1974)[p.805] [Combines Line of Business with Fairness], applied the following factors in determining fairness: (1) The nature of the officers relationship to the management and control of the corporation, (2) Whether the opportunity was presented to him in his official or individual capacity, (3) His prior disclosure of the opportunity to the board of directors or shareholders and their response , (4) Whether or not he used or exploited corporate facilities, assets, or personal in acquiring the opportunity, (5) Whether the acquisition harmed or benefited the corporation, (6) All other factors bearing on the directors good faith in acting toward the corporation which ordinarily prudent men would exercise under similar circumstances. The Eclectic Approach The combination by some modern courts of a narrower expectancy test and a broader line-of-business test. ALI Principles 5.05 How do we define a corporate opportunity? A business opportunity that1. A director or senior executive becomes aware of in his corporate capacity; 2. A director or senior executive should know the outside party is offering to the corporation; 3. A director or senior executive, who became aware of it through the use of corporate information; should know the corporation would be interested in; 4. The senior executive knows is closely related to the corporations current or expected business. Therefore, under the ALI Principles corporate executives are subject to line-ofbusiness and expectancy restrictions, while outside directors are subject only to expectancy restrictions. Lewis v. Fuqua Del 1985-Some courts apply a fairness test on top of the expectancy/line-of-business tests. Note: The question of fairness surrounds, how fair is it to hold the manager accountable for his outside activities. 3. When May a Corporate Manager Take An Opportunity for Herself? Burg v. Horn, (2nd. Cir. 1967)[p.807] FACTS: Part-time managers of a closely held real estate business acquired other properties with the tacit consent of their co-shareholder. The co-shareholder knew from the start that the managers held and managed other similar properties. The properties acquired by the managers although in the same line of business of the business had not been offered to it or sought by the business. [crazy case where the defendants buy slum apartments with money from the partnership] HOLDING: The co-shareholders informal acquiesce to the managers outside entrepreneurialism led the court to conclude they had not usurped a corporate opportunity. [Schaffer agrees with the dissent, that this was a taking of a corporate
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opportunity, the defendants bought the slum apartments with partnership money and the partnership was in the business of slum housing] Note: However, that the Ds were merely shareholders, that they were not directors or managers, this may provide some of the problem. Factors: (1) They were already in the business; (2) They were not fulltime EEs. 4. Remedies for the Taking of a Corporate Opportunity. Remedies include: (1) Lost profits, (2) Profits taken from the corporation, and (3) Imposition of a constructive trust on the new business or the subject matter of the opportunity such as land.
Problem Starcrest Corporation-Part II [pg. 797]

Traditionally the Farber case laid out an analysis of whether there was a corporate opportunity in this case and whether it was improperly taken from the starcrest company. The factors to consider are (1) Did a corporate opportunity exist?, (2) Did the stockholders decline the opportunity by failing to act?, (3) Did the shareholders ratify the transaction?, and (4) Did the corporation receive a benefit that would have righted any wrong? First, there are several ways to look at corporate opportunity, (a) Interest or Expectancy, while the casino is in the Bahamas, a place outside the US, where Starcrest was looking, the company had specifically spoken about opening a casino. Note: The Broz case held that it might be relevant how White came across the deal, whether it was as a director, or in his own personal circles; (b) Line of Business, while starcrest is not presently in the casino business, there was some indication that they were planning to be in the casino business, and this would be good enough for the line of business; (c) Fairness Starcrest did not Get Opportunity, this is best examined through the Miller v. Miller factors, which when considered demonstrate that i. He is a new and independent director, ii. It may be that White got the deal in his private capacity, iii. While there was no prior disclosure, iv. He did not use any of starcrest resources, v. the deal did not harm starcrest, but it was a profit. Arguably this deal was a corporate opportunity, but it may be important to note that White did not receive the benefit in this case, but Petro Inc. did, a company he may even owe more of a duty to since he is the CEO of the company. In this type of situation the Johnston v. Greene case has held that the director can chose who gets to receive the corporate opportunity, and that it may be himself. Also note, however, that this is an older Delaware case. The ALI, 5.05, which Brudney and Clark would support point to the Pre-disclosure and rejection of the corporate opportunity. For example, under 5.05(a) White did not offer the deal to the Board, let it be rejected, or allow for ratification. However, is this really a corporate opportunity: (1) White did not become aware of the deal through work, 5.05(b)(1)(A), and he did not use corporate means to come across the deal, 5.05(b)(1)(B), on the other hand, White did know that casinos were an area of interest that the BOD was interested in 5.05(b)(2). Note: However, that Whites best defense may be that he never did take advantage of the corporate opportunity under 5.05(a), but that the Petro company did. However, would it matter if we knew that White was Petros largest shareholder? Maybe.
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J. Duty of Majority Shareholders. [p. 817-826] Note: This is all court generated. Courts impose fiduciary duties on controlling shareholders that parallel those of directors and officers. Yet, how is this so if the only real duty of the shareholder is to make a lot of money? There are several situations in which the majority shareholders have a duty to their minority counter parts: (1) Business transactions-parent-sub (been set up on unfair terms) (2) Freeze-out mergers, (Weinberger v. UOP) Here you will have to set up a fairness standard. (3) Dividends Payments, (Ford v. Dodge), payout of too few, or (Sinclair v. Levein), pay out of too many dividends. (4) Share transactions, issuance (only to the majority ay an unfair price). redemption (Zahn). share exchanges, (majority could change their old shares for new ones). Be on the look out for parent-subsidiary dealings.
How Does the ALI Deal With This Situation? The ALI imposes a duty of loyalty, which is satisfied when: 5.10(a)(1)-(2) (1) The transaction is fair to the corporation when entered into; OR (2) The Transaction is authorized in advance or ratified by disinterested shareholders following disclosure concerning the conflict of interest and the transaction does not constitute waste of corporate assets at the time of the shareholder action. Note: Unlike interested director transactions, approval by a majority of disinterested directors will not affect the standard by which the transaction is reviewed, but it will shift the burden of proof to a shareholder challenging the
Sinclair Oil Corp. v. Levin, (Del. 1971)[p. 819] (Note: This is a squeeze-out merger) FACTS: Minority shareholders of Sinven, a partially owned (97 percent) Venezuelan subsidiary of Sinclair Oil, challenged three sets of parent-subsidiary dealings: (1) Sivens high-dividend policy, (2) Sinclairs allocation of projects to other affiliates, and (3) Sinvens failure to enforce contracts with other Sinclair affiliates. HOLDING: Court assumes the propriety of parent-subsidiary dealings. The burden is on the minority shareholder to show the dealings were not those that might be expected in an arms length relationship, this is known as the intrinsic fairness standard. (1) Dividend claim: BJR, no self-dealing because minority shareholders are also getting paid on the dividend. (2) Denial of expansion Opportunity, anyone of the subsidiaries should have the opportunity, the court will not now question that. (3) Breach of K: Allowed late payments, did not enforce, this really was a breach of K.
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Trans World Airlines, Inc. v. Summa Corp., (Del.Ch.1977)[p. 825] FACTS: Hughes owns all the stock of Toolco. Toolco owned 78% of TWA. TWA wanted to purchase new planes but was forced to go through Toolco. Toolco could not obtain financing for quite some time. TWA sought an accounting and damages for the delay. HOLDING: Court applies the intrinsic fairness rule. Toolco was unable to prove that it did not cause damage to TWA. Court held that the transaction between the parent and subsidiary was not fair and cost minority shareholders money. V.
Federal Law II. Duty of Disclosure.

When considering the duty of disclosure owed to the shareholder as a decision-maker, it is necessary to examine how that duty has developed under both federal and state law and how those two bodies of law interrelate. Claims of inadequate disclosure in violation of the proxy rules have become a vehicle for plaintiffs obtaining federal jurisdiction rather than attempting to establish a breach of fiduciary duty under state law. A. Federal Regulation. Duty of Disclosure to Shareholders. [p. 827838] Corporations registered pursuant to the 1934 Securities Act get information to the public/shareholders through various filing requirements. Securities Exchange Act requires corporations to file certain documents with the SEC. See 13 [p. 943].
Section 13 applies to every issuer of a security registered pursuant to section 12 of the 1934 Act. It also applies to persons who indirectly or directly acquire more than five per cent of any security registered under section 12. Such persons must file a statement with the SEC, and the corporation whose stock they bought (issuer). See 13(d).
The statement must include the: (A) Background, identity, residence and citizenship of the purchaser...; (B) The source and amount of funds or other consideration used in making the purchases...; (C) If the purpose of the purchases is to acquire control of the business of the issuer, then any plans or proposals related to this; (D)... (E) Information as to contracts (JV, transfer of the securities, loans, put or call options). (2) If material changes occur then an amendment must be filed.
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(3)When two or more persons act as a partnership, limited partnership, syndicate, or other group [INSTITUTIONAL INVESTORS] for the purpose of acquiring, holding or disposing of securities of the issuer, such group shall be deemed a person for purposes of this subsection.
Who Has to Make Disclosure? (1) Issuer 14a (14a-3 proxy statement) 14b-Requires bank and broker to deliver a statement 14c-Even if you didnt solicit proxies you still have to offer comparable information. 13a-Ongoing reporting requirements, Form 8-K, 10-K, 10-Q (2) Shareholders 13d-5% or more, identity and background. 13g-once you are a 13d shareholder then you have ongoing requirements, but if not seeking control you can file on this (short form) only having to disclose your identity and background. (3) Management 13e-They must disclose their background, etc.
The More Important Question is Now How do you Enforce These Duties? (1) The SEC can enforce these rules themselves. (2) Will there be a private right of action?
In re Matter of United States Steel Corporation, (SEC 1979) [p. 842] HOLDING: The SEC found that U.S. Steel had violated the reporting requirements of 13(a) when it failed to disclose the companys frequent violations of environmental requirements, which resulted in fines to the company. It was the pattern of the companys behavior combined with its attitude toward the environmental violations that caused the SEC to charge disclosure violations. There are a line of cases addressing questionable illegal corporate payments and practices. [p. 843] Disclosure about management integrity is limited to situations where the rules specifically mandate disclosure or where the conduct has had a materially adverse economic impact on the corporation. Registered Corporations must file annual reports on Form 10-K (Rule 13a-1) [p. 1037]; current reports on Form 8-K (Rule 13a-11) [p. 1038]; quarterly reports on form 10-Q (Rule 13a-13)[p.1038];
FORM 8-K [p. 1202]
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Must file Form 8-K when: (1) change in control of registrant, (2) acquisition or disposition of assets, (3) bankruptcy or receivership, [1-3 file within 15 days of occurrence of event] (4) changes in registrants certifying accountant, (6) Resignations of registrants directors. May file Form 8-K when: (5) other events. [4-6 file within 5 days].
FORM 10-K [p. 1205]
Must file annual report with in 90 days of the close of the fiscal year end. As to business, properties, legal proceedings [furnish info as required by Regulation S-K]. Also, must include submission of matters to a vote of shareholders if the matter was submitted during the fourth quarter of the fiscal year. FORM 10-Q [p.1208] Must file Form 10-Q within 45 days after the end of each of the first three fiscal quarters of each fiscal year. Includes Financial information, legal proceedings, changes in securities, defaults upon senior securities, submission of matters to vote of security holders, other information (discretional), exhibits and reports on Form 8-K.

Regulation S-K [p.1237]
Reports on managements discussion and analysis of financial condition and results of operation as well as executive compensation.
Regulation S-X [Shaffer mentioned but not in book]
1. Implied Private Rights of Action Under the Proxy Rules. Federal Courts have inferred a private cause of action for shareholders to seek relief for violations of the SEC proxy rules. Section 14(a) declares it unlawful to solicit proxies in contravention of Commission rules, and SEC Rule 14a9 prohibits solicitations containing any statement which ... is false or misleading with respect to any material fact, or which omits to state any material fact necessary in order to make the statement therein not false or misleading.
J.I. Case Co. v. Borak, [p. 829] FACTS: A stockholder brought suit against J.I. Case Company charging deprivation of the pre-emptive rights of respondent and other shareholders by reason of a merger
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between Case and the American Tractor Corporation. It is alleged that the merger was effected through circulation of a false and misleading proxy statement. The stockholder brought two claims: (1) breach of directors fiduciary duty to the stockholders, and (2) violation of 14(a). The main issue in the case was whether the stockholder could bring a private suit under section 14(a). HOLDING: A right of action exists as to both derivative and direct causes under section 14(a). NOTE: nothing in 14(a) provides for an express cause of action and the court did not look at legislative intent. The right is judicially implied.
Note: 27 provides exclusive jurisdiction to the federal courts for violating the statute. Note: 14 purpose is to protect investors. Note: The problem is that 18 of the code already creates liability for misleading statements. The biggest problem with this section is notice the complexity of requirements, it is found on pg. Frame work for Analysis 1. Is there a Misrep? 2. Was it material? 3. Is their Causation between lie and result? 4. Did damages occur. 5. What attorneys fees are available?
Cort v. Ash US 1975 (The Court begins to curtail the private right under federal law). Refused a private right of action under the Federal Election Campaign Law. Note: This case does not overturn Borak but it does begin to provide some standards. If I get a problem where I need to determine whether an implied private right of action exists, there are several questions which I will want to answer: 1. Is the plaintiff one of the class for whose special benefit the statute was enacted? 2. Is there any indication of legislative intent, explicit or implicit, either to create or deny the private remedy? 3. Is it consistent with the underlying purposes of the legislative scheme to imply such a remedy? B. Liability for Failure to Disclose. [p. 838-852] 1. Materiality.
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TSC Industries, inc. v. Northway, Inc., [p.838] [Rule 14a-9] FACTS: National Industries acquired 34% of TSC Industries Stock by purchase from the founding family, and then placed five of its nominees on TSCs board of directors. The two companies agreed to a sale of TSCs assets to National in exchange for stock and warrants of National. A joint proxy was issued by the two companies. A shareholder of TSC sued for violation of Section 14(a) and Rule 14a-9. The shareholder claimed that the proxy statement failed to state that the purchase of 34% of the stock (which was disclosed) gave it control of TSC. HOLDING: An omitted fact is material if there is a substantial likelihood that a reasonable shareholder 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 information made available. Court finds that the omitted facts were immaterial because the disclosures that were given revealed the nature of Nationals relationship with TSC and alerted a reasonable shareholder to the fact that national exercised a degree of influence over TSC. Remember not every misstatement or omission is material. Watch out for what should be a state claim for breach of fiduciary duty. See Golub v. PPD Corp. (8th Cir. 1978), Wallerstein v. Primerica Corp, (E.D.N.Y. 1988), Justin Industries, inc. v. Choctaw Securities, (5th Cir. 1990). [p. 844-845] US Steel 1979-The SEC found disclosure violations for a pattern of environmental violations, which the company showed an indifference to. Levine v. NL Industries 2nd 1991-Court held that failure to disclose costs of environmental violations under 10b-5, court using steel case found that this would generally be true, however, in this context there was indemnification from the government. SEC v. Klavex 1975-Kicks backs arranged by candidate for director, no matter how small had to be disclosed. The corp has a right to know of the potential integrity of the director. (general quality and integrity of management). Cooke v. Teleprompter F.supp. 1971-Material that it was not disclosed that a candidate for BOD had been convicted of bribing public officials. SEC v. Joe Schlitz-13a court found failure to disclose illegal or improper payments made to induce the sale of the companys products was material because of the bearing it had on the integrity of management.
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Note: The courts now tend to limit disclosure about management integrity to those situations where the rules specifically mandate disclosure or where the conduct has had a material adverse economic impact on the corporation. Gaines v. Haughton 9th Cir. 1981-Emphasis of disclosure is on quantitatively significant data. Material will not include alleged violations of the law. Gould v. PPD 8th Cir. 1978-There is a difference between disclosure and state law fiduciary violations, you cannot make an individual disclose their perhaps improper characterization of motives. 2. Causation. If the facts of a merger are disclosed and the shareholders go ahead and vote for what is an unfair transaction, then an action under Rule 14a-9 cannot be maintained. Mills v. Electric Auto-Lite Co., [p.846] FACTS: Shareholders bring suit against Electric Auto-Lite Company under Rule 14a9 and 14(a). The shareholders alleged that the proxy statements used in a merger of Electric and American Manufacturing Corp. were misleading in that it told Auto-lite shareholders that the board of Directors approved the merger without informing them that all of the directors were nominees of and under the control and domination of Merganthaler (Auto-lite had merged into this corp). HOLDING: There is an implied private right of action for violation of 14(a) [Borak]. However, a shareholder must establish that the defect was of such a character that it would have a significant propensity to affect the voting process. Where there has been a finding of Materiality, a shareholder has made a sufficient showing of casual relationship between the violation and the injury for which he seeks relief if the shareholder can establish that the proxy solicitation established an essential link in effectuating the transaction. The shareholders have showed enough to sustain their cause of action. Note: Where there has been a finding of materiality, a shareholder has made a sufficient showing of causal relationship between the violation and the injury for which he seeks redress, if, as here, 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. The concept of causation has been separated into two tests: (1) Loss Causation = the transaction caused harm to the plaintiff (relatively easy to demonstrate) e.g. in Borak, the shareholders got less for their shares than the shares were worth.
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(2) Transaction Causation = requires the plaintiff to show that the defendants violation caused the company to engage in the transaction in question (harder to prove) e.g. in Mills the loss was occasioned by the merger and the merger was caused by the solicitation of proxies to secure sufficient votes for its approval. C. Federal Regulation. Limits to Liability. [p.852-878]. Accurate information is necessary in order to preserve the integrity of the voting process. However, what happens when transaction does not require shareholder decision making? Then Shareholders can attempt to bring a suit under 10(b) and Rule 10b-5. Rule 10b-5 prohibits both false and misleading statements and fraudulent acts and practices in connection with the purchase or sale of any security.
There 1. Informational vs. Constructive Fraud. is a material non-disclosure; AND They lost their State remedy.
Santa Fe Industries, Inc. v. Green, [p.855] FACTS: A parent company merges with its majority owned subsidiary after giving minority shareholders notice of the merger and an information statement that explained their rights to a state appraisal remedy. The parent stated that the a valuation of the subsidiarys assets indicated a $640 per share value, even though the parent was offering only $125 per share, an amount slightly higher than a valuation of the subsidiary by the parents investment banker. HOLDING: Unless the disclosure had been misleading no liability could result. An unfairly low price cannot amount to fraud absent deception. Rule 10b-5 regulates deception, not unfair corporate transactions or breaches of fiduciary duties. Here all pertinent facts were disclosed by the persons charged with violating 10(b) and Rule 10b-5. Therefore, there was no deception through nondisclosure to which liability under those provisions could attach. Thus, full disclosure forecloses liability under the misappropriation theory. Goldberg v. Meridor, (2nd Cir. 1977) [p.859] FACTS: Goldberg brings suit against Meridor under Rule 10b-5 challenging the sale of Meridors sale of essentially all its assets in exchange for stock and the assumption of its debts (two press releases were issued, the press releases failed to disclose conflicts of interest). (1) What was not disclosed: a. current liability exceeds net equity; and b. He overstated the value of the assets. HOLDING: The complaint should be treated as if it had alleged that the press releases were materially misleading and that one of UGOs directors was deceived or not fully informed as to the effects of the transaction. Minority Shareholders
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state a cause of action when claiming that they were lulled into not seeking to enjoin a merger because of the boards deceptive disclosures. A misstatement would be material if shareholders were lulled into forgoing an injunction (state remedy) that was available under state law and necessary to prevent irreparable harm to the corporation. The court found that the statement violated the fundamental purpose of the act. Further Requirements: 1. Healey v. Catalyst (3rd Cir. 1980)-In order for the Goldberg rule to apply there must have been a reasonable Note: probability that had the info been proper disclosed that a There exists a state court may have granted an injunction. higher 2. Alabama Farm Bureau Mutual Casualty v. American threshold Fidelity (5th Cir. 1979)-Only need to show under 10b-5 is that in the 9th and 7th a state law claim was available, not that you would have Circuits. succeeded, but that a possible claim existed. 3. Wright v. Heizer (7th Cir. 1977) & Kidwell v. Meikle (9th Cir. 1979)-(1) Insist that claim must have been available under state law, and (2) That state court would have granted relief. 4. Field v. Trump (2nd Cir. 1988)-They reaffirmed the Goldberg holding, but limited it to circumstances when there exists an intent, or willful misconduct of a self-serving nature, and NOT simple mismanagement or breach of a fiduciary duty. Virginia BankShares, Inc. v. Sandberg, [p.873] FACTS: First American Bankshares began a freeze out merger in which First American eventually merged into Virginia Bankshares. A statement was made that the board of directors believed that $42 a share would be a fair price for the minority stock that would be purchased so the merger could be completed. Most minority shareholders gave the proxies to First American. Sandberg, a minority shareholder, did not. Sandberg brings suit against First American under 14(a) and Rule 14a-9. Sandberg also brings state law claims for breach of fiduciary duty against First American. HOLDING: Knowingly false statements of reasons may be actionable even though conclusory in form. Disbelief or undisclosed motivation, standing alone, is insufficient to satisfy the elements of fact that must be established under section 14(a). Sandberg has failed to show the equitable basis required to extend the 14(a) private action. Theabanks proxy solicitation was not the essential link in Elements for 14a-9 Claim, Duty of Disclosure to Shareholders effectuating Omission (Note: the minority shareholders context) 1. Misrep or the merger, Must be in Shareholder voting votes were not required by law or 2. Materiality=TSC-substantial likelihood that material fact would have beenthe claim. reasonable corporate bylaw to authorize the transaction giving rise to important to shareholder in their vote. The Court used Mills requiring them only to show that Herskowitz-extended the 3. Culpability-Gould- applies negligence standard to an outside director, and the statement ofthe Gould negligence(a) Material, and (b) That it was the essential link in the merger BOD was standard to: a. Investment bankers process.
b. Accountants, etc.
4. Causation-There are two types: Note: It is still unclear what standard applies, a. Loss Causation-Is it fair? while Causation Act provides was a Merger which required Voting. (essential link). b. Transaction11 1993 -1. Mills-This for negligence, 10b-5 of the2. Va Bankshares v. type of 1934 Act requires a Sandberg-NO need for vote, so NO transaction scienter. Adams in fact did apply scienter. causation. 3. Wilson-While vote not necessary, w/o, because of misrep, gave up state appraisal right, HARM.
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D. Disclosure and Sate Law Remedies. [p.878-893] 1. Lost State Remedies. Wilson v. Great American Industries, Inc., [p.878] FACTS: Following the merger of Chenango industries into Great American Industries, minority shareholders of Chenango sued Great American, Chenango, and various officers and directors connected with those corporations. The shareholders alleged that defendants violated Rule 14a-9 because of omissions and material misrepresentations in a joint proxy statement/prospectus issued in connection with the merger. HOLDING: A minority shareholder, who has lost his right to a state appraisal because of a materially deceptive proxy, may make a sufficient showing of causal relationship between the violation and the injury for which he seeks redress. The injury sustained by the minority shareholder powerless to effect the outcome of the merger vote is not the merger but the loss of his appraisal right. The deceptive proxy constitutes an essential link in accomplishing the forfeiture of this state right. When defendants choose to issue a proxy plaintiffs have a right to a truthful one. Although a finding of materiality in a proxy solicitation may satisfy the elements of loss and transaction causation for forfeited state appraisal rights, plaintiffs must also prove that they in fact lost state appraisal rights. The case is remanded to determine this. There can be transaction causation where a materially misleading proxy statement causes a shareholder to forfeit his appraisal rights by voting in favor of the proposed corporate merger. 2. Fault
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Virginia Bankshares left open the question of whether the standard of culpability to which the directors will be held in a section 14(a) action is negligence or scienter. The two principal liability provisions of the federal securities laws provide different answers. Section 11 contains an explicit negligence standard. Rule 10b-5 requires the more exacting test of scienter. Lower Federal courts are divided [p. 883]: Gould v. American Hawaiian Steamship Co., (3rd Cir. 1976) applied the negligence standard in a section 14(a) case to an outside director. Adams v. Standard Knitting Mills, (6th Cir. 1980), applied the scienter standard in a section 14(a) case to an outside accountant. 3. State Law Duty of Disclosure. Note: While fed law might be thought to control under the supremacy clause, in Delaware there is the carve out from the fed regulations that provide state court options, they are referred to as the Delaware Carve Out-they are for (1) derivate claims and (2) Breach of duty to shareholder claims. State law has regulated proxy solicitations longer than the federal government. However, there are fewer cases as state courts are reluctant to embroil themselves in the internal affairs of the corporation. (a) Under What Circumstances Does the Duty Arise?
Those who are in a fiduciary relationship to the shareholders, including at least directors and controlling shareholders, owe shareholders a duty of disclosure. As a general rule, those not in a fiduciary relationship with shareholders do not owe them a duty of disclosure. [Zirn Del] Additionally, corporate fiduciaries are not responsible for the failures of non-fiduciaries to disclose. The duty of disclosure arises when a fiduciary asks the shareholders to act as corporate decision makers. [Lacos Land Del] [Stroud Del actual language of quote] Thus, directors and controlling shareholders have a duty to disclose when they place the shareholder in a position in which she has to decide whether to sell her stock or seek appraisal rights, whether in a traditional merger, a tender offer by a controlling shareholder or a tender offer by the corporation for its own shares [Lynch, Glassman, and Eisenberg], and short-form mergers, even though no shareholder vote is required. [Shell] [p.888-889]
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(b)
Materiality Under State Law.
Fiduciaries must disclose all material information. See Rosenblatt v. Getty Oil Co., (Del. 1985). [p. 890] The court adopted the TSC materiality standard. In determining whether a fiduciarys omission of information or false statement in a disclosure is material it is irrelevant. Fiduciaries are held to a standard of strict liability for violations of the duty of disclosure: they are held liable for its breach whether or not they are acting in good faith (this type of decision is outside the scope of the BJR). [Arnold v. Society Savings Corp.] Once you start a statement, you will be held liable if any part of it is a misrep. (c) Voluntary Disclosures and Lost State Remedies. The Delaware Supreme Court has indicated that a duty of full and fair disclosure arises whenever directors are either required to seek a shareholder vote or elect to do so. See Stroud v. Milliken Enterprises, Inc. (Del. 1989)[p.892]. (d) Malone v. Brincat (Del 1998)-The BOD in this case overstated the financial condition of mercury to the shareholders of the corp. 1. This case would clearly have been a 10b-5 violation, but under 13(a) of 1934 Act, did not fulfill 10k requirement by misstating earnings, profits and net equity. 2. An issue is that there is no shareholder vote, merger, or sale or purchase of all the assets. So there will be no proxy solicitation required. a. In Delaware, however, there are disclosure requirements whenever you (i) vote, (ii) even when shareholder voting not required, (iii) Merger, short form, whatever. Shareholders are entitled to rely upon the truthfulness of all information disseminated to them by the directors they elect 3. Delaware, the disclosure rules only covers those who have a fiduciary duty. 4. Who has standing? It is only the shareholders. Note: In this case there is some suggestion that only a derivative claim would survive that courts standards, but the problem is the shareholders will have to re plead this claim. Note: The class action would likely not work because it may be impossible to demonstrate reliance for each member of the class. The derivative claim is only unattractive because of the procedural hurdles that stand in the way. 5. There seems to have to be a requirement of scienter, that the directors have to know there is a material mistake.
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Federal Law III. Regulation of and Operation of Security Markets: Insider Trading.
VI. A. Introduction to Securities Transactions. [896-905 &909-927] What does this have to do with corporations? Regulation of Securities Transactions often:
(1) involves corporate management and thus necessarily involves fiduciary duties, and (2) affects the market for a corporations stock and thus implicates the markets role in the corporate governance system. 1. Economic Theory, Securities Markets and Securities Transactions There are two types of public securities markets: (1) Stock exchanges (NYSE, American Stock Exchange, etc.) [floor with specialists, dealers, and traders, who buy and sell for customers and themselves], and (2) NASDAQ Market (National Association of Securities Dealers Automated Quotation System) [over-the-counter market, electronic inter-dealer quotation system]. The market is not perfect. Information is not complete. Not all securities trade at their inherent value. Yet, people still continue to try and out perform the market and make money. When you look at the market you will see investors behaving rationally but most often irrationally (buying or selling with the rest, the lemming effect). Economic Theory and Insider Trading. Two views: (1) Insider trading is bad, it's like playing with a marked deck. Not fair to other investors to use corporate information for your own gain. This distorts the value of the stock and wrecks havoc on the market. Wang, The Law of Conservation of Securities insider trading harms those who are unable to trade because an insider bought the shares. These individuals are preempted. It also harms
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traders who are induced to buy or sell disclosure may protect these individuals but not those that have been preempted. Delayed Disclosure. Allowing insider-trading will in the markets efficiency because insiders will have an incentive to delay the release of information (disclose). Portfolio Theory and the Cost of Capital. Investors will take into account insider trading and allocate risk by not paying as much for the securities, which hurts the firm by reducing capital. (2) Law and economics followers argue that insider trading is beneficial to the market and should not be prohibited. They believe that insider trading will permit smoother changes in stock prices. Easterbrook and Fischel believe that this is away to compensate managers and thus it encourages them to take risks, which will benefit investors (everyone gets a bigger piece of the pie). 2. The Common Law Background to Insider Trading. Today the law governing the trading of securities is largely federal ( 10 (b) and Rule 10b-5). However, state law as it relates to insider trading remains relevant for two reasons: (1) federal law builds on common law concepts, and (2) shareholders in close corporations still rely on state law. (a) Duty to Shareholders and Investors.
Goodwin v. Agassiz, MA (1933) [p.910] FACTS: Stockholder brings suit against defendant officer and directors for not disclosing to him as a stockholder their knowledge of a novel theory that would possibly permit the corporation to extract more copper from a mine. Stockholder had sold his stock Note: stockholder was a sophisticated investor. HOLDING: Court holds that the lower court dismissal was valid. Directors and officers owe a fiduciary duty only to the corporation and are under no affirmative obligation to disclose material non-public information when purchasing or selling securities in an impersonal market. However, under the special facts doctrine a
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plaintiff may be afforded a remedy when non-disclosure amounts to unconscionable behavior by the insider. See Strong v. Repide, (1909). [Goodwin represents the majority rule.] Note: Under the Special Facts Test the Ds were not held liable, because the court had two problems with the case. (1) The duty of insiders is to the corp, NOT individual shareholders. (2) Privity between buyer and seller does not exist in anonymous trading. Strong v. Repide, U.S. (1909) [p. 912] Where a director personally seeks a stockholder for the purpose of buying his shares without making disclosure of material facts within his peculiar knowledge and not within reach of the stockholder, the transaction will be closely scrutinized and relief may be granted in appropriate instances. [Special Facts Doctrine] Hotchkiss v. Fischer, KN (1932) [p. 914] Court rules for widow who came to director and asked if there was going to be a dividend. Court holds that because an officer acts in a relation of scrupulous trust and confidence that his behavior is therefore also subject to the closest scrutiny. [Kansas Rule] (b) Duty to the Corporation. Traditional common law approach was that a corporate insider did not ordinarily violate his fiduciary duty to the corporation by dealing in the corporations stock, unless the corporation was harmed.
Diamond v. Oreamuno, NY (1969) [p.914] FACTS: Derivative action for breach of fiduciary duty for using inside information to reap large profits which rightfully belonged to the corporation. This was a computer company whose stock fell off the planet after they could not keep up with their business. HOLDING: Court holds that officers and directors are 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 -- the officer or director had beached their fiduciary duties to the corporation. If a corporate officer has inside information that the corporation is about to purchase or sell securities, or to declare of to pass a dividend, profits made by him in stock transactions undertaken because of his knowledge are held in constructive trust for the principal.
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The court answered the question of where was the harm in this case by bringing forward the point that no harm need be shown, that the corp has a higher claim, since their EE should not be able to unjustly enrich themselves. The Court also felt that there may have been harm in that the inside trading hurt the corps reputation and thus the marketability of its stock.
Freeman v. Decio, 7th Circuit (1978) [p.920] FACTS: Court decides whether Indiana would adopt the holding in Diamond. HOLDING: A corporation may not recover the profits of corporate officials who trade in the corporations securities on the basis of inside information. Court reasoned that the corporation is not harmed. Follows: Schein v. Chasen, FL (1975).
B. Federal Regulation of Insider Trading : Rule 10b-5. [p. 927-947] The authority for the adoption of Rule 10b-5 is 10(b) of the Securities Exchange Act of 1934. Section 10(b) is a catchall, it authorizes the Commission by rules and regulation to prohibit or regulate the use of any other manipulative or deceptive practice, which it finds detrimental to the interests of the investor.
Rule 10b-5 Implied Private Action for Damages.
Kardon v. National Gypsum Co. (E.D.Pa.1946), Was the first to hold that Rule 10b-5 supported an implied private action for damages. (Confirmed by Superintendent of Insurance v. Bankers Life & Casualty Co., (U.S. 1971)). 10(b) and Rule 10b-5 make it unlawful for a director, senior executive, other employee of a public corporation, or temporary insider (derivatively) to use material nonpublic information to purchase or sell that corporations stock. See Texas Gulf Sulphur and Chiarella.
However, it is not unlawful for a person who is not an insider, temporary insider, or tippee (a stranger) to trade in a corporations stock simply because they possess information not available to other traders. It is unlawful for an insider or temporary insider, acting in a breach of a fiduciary duty owed to corporation, to disclose to another (tip) material , nonpublic information about that corporation.
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See page 955. [outlines possible scenarios] In re Cady, Roberts & Co., (S.E.C. 1961) [p. 928] FACTS: S.E.C. brings a 10b-5 action against Cady, a brokerage firm, and Gintel, one of its partners. An associate at Cady gives Gintel material information concerning the cutting of dividends in a company that Gintel owned shares in before the information is released to the public. HOLDING: Held that Gintel violated 10b-5. Holds that a corporate insider who possesses material, nonpublic corporate information has an obligation to disclose the information or abstain from trading in the corporations securities. 1. The Scope of the Rule.
Rule 10b-5 gives rise to two distinct duties: (1) A duty not to trade on inside information, and (2) Duties relating to disclosure of that information. For silence to be fraudulent there must have been a duty to disclose that information. If there is no duty then it cannot be fraud to remain silent. Note: this was the rather large problem with the original 10b-5 analysis as it focused on misrepresenting material facts.
Securities and Exchange Commission v. Texas Gulf Sulphur Co., [p. 930] THIS CASE AFFECTS ANYONE WITH MATERIAL INFORMATION! FACTS: S.E.C. brings suit against Texas Gulf Sulphur for violating 10(b) and Rule 10b-5 among other things. Texas Gulf was exploring Northern Canada for mineral deposits. They found a huge mineral deposit. Before this information was made public the company made a public announcement downplaying the importance of the find. Before and after this time insiders bought stock and exercised calls and options. HOLDINGS: (1) All transactions in TGS stock or calls by individuals apprised of the drilling results were made in violation of Rule 10b-5. (2)Rule 10b-5 is violated whenever assertions are made in a manner reasonably calculated to influence the investing public if such assertions are false or misleading or are so incomplete as to mislead irrespective of whether the issuance of the release was motivated by corporate officials for ulterior purposes. The Abstain or Disclose Test
The core purpose of Rule 10b-5 is to make sure that all investors have equal access to information. The court states that (1) Anyone in possession of material information must either disclose it to the investing public, or, if he is disabled from disclosing it in order to protect corporate confidence, or he chooses not to do so, (2) Must abstain from trading in or recommending the securities concerned
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Materiality. Whether information is material within Rule 10b-5 depends upon the balancing of both (1) the indicated probability that the event will occur, and (2) the anticipated magnitude of the event in light of the totality of the company activity. C. Rule 10b-5 continued. Tipping. [p. 947-969] 1. Regulation of Trading on Non-Public Information. Chiarella v. United States, (U.S. 1980) [p. 947] STRANGER (This is the framework for the Abstain or Disclose test). NOTE: THE 10B-5 DUTIES NO LONGER TO JUST ANYONE!
APPLY
FACTS: S.E.C. investigates Chiarella, an employee at a financial printer. S.E.C. and Chiarella enter into a consent decree where Chiarella will give back money he made using inside information he got from his job. Then D.O.J. files a criminal suit against Chiarella. Chiarella is found to have violated 10(b). Supreme Court grant certiorari and reverses conviction. HOLDING: A person who learns from the confidential documents of one corporation that it is planning an attempt to secure control of a second corporation does not violate 10(b) when he fails to disclose the impending takeover before trading in the target companys securities if he does not have a duty to disclose it. In this case Chiarella had no fiduciary duty to the prospective buyers. Chiarella was not a corporate insider and he received no confidential information from the target company. There can be no fraud absent a duty to speak. A duty to disclose under 10(b) does not arise from the mere possession of nonpublic market information. Dissent, Burger: 10(b) and Rule 10b-5 mean that a person who has misappropriated nonpublic information has an absolute duty to disclose that information or to refrain from trading. SECs Response, 14e-3, prohibiting during the course of a tender offer, trading by anybody (other than bidder) who has material, non-publicmaterial nonpublic that Tipper = a person who discloses info about the offer he knows was obtained information. through either bidder or target. THIS IS REALLY APPLICABLE WHEN THERE IS NO FIDUCIARY FOR MISAPROP, BECAUSE 14E-3 DOES NOT REQUIRE ONE. Tippee = a person who receives material nonpublic Tipper = a person who discloses information from a tipper. If the tippee subsequently discloses the information, he becomes a tipper as well as a tippee and the person to whom he discloses becomes a sub-tippee. Tippees of corporate insiders have been held liable under 10(b) because they have a duty not to profit from the use of inside information that they know is confidential and know or should know came from a corporate insider. Thus, the tippees liability is derivative in that it is based on the tippers breach of
there can be no violation by the tippee.
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Dirks v. Securities and Exchange Commission, [p.956] TIPPEE/TIPPER FACTS: Dirks, an officer at a broker-dealer firm, received material nonpublic information regarding on going fraud from Secrist, a former officer (insider) of a corporation. Dirks had no connection to the corporation. Dirks investigates the fraud and urges the Wall Street Journal to write an article. Dirks discloses the fraud information to investors who relied on it in trading in the shares of corporation (sell) before the information is made public. The SEC censures him because even though he violated 10b-5 he helped uncover fraud. HOLDING: There was no actionable violation by Dirks. In the absence of a breach of duty to shareholders by insiders, there was no derivative breach by Dirks. If an insiders tip constituted a breach of the insiders fiduciary duty then the tippees actions will be considered a derivative breach and the tippee will be liable. The test to use in determining whether the insider breached their fiduciary duty is whether the insider will benefit, directly of indirectly, from his disclosures. Thus, absent some personal gain, there has been no breach of duty to the stockholders. And absent a breach by the insider, there is no derivative breach. There must be a breach of the insiders fiduciary duty before the tippee inherits the duty to disclose or abstain. There can be no duty to disclose where the person who has traded on inside information was not the corporations agent, fiduciary, derivative fiduciary, or a person in whom the sellers of the securities placed their trust and confidence. (A third party such as a lawyer or accountant may become a constructive insider and in turn a fiduciary of the shareholders when corporate information is revealed legitimately to them).
Misappropriation Theory.
Holds that a person commits fraud in connection with a securities transaction, and thereby violates 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes. Chiarella and Dirks did not address whether section 10(b) or Rule 10b-5 make it unlawful for a person who has no connection to a corporation to trade that corporations securities on the basis of material,
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non-public information that he misappropriated from some third party. Circuit courts were divided on this issue. Three circuit courts have concluded Two circuits reject the that it is unlawful for someone misappropriation theory. outside a corporation to trade on the See United States v. Bryan (4th Cir. basis of misappropriated information. 1995), United States v. OHagan (8th See United States v. Newman (2nd Cir. Cir. 1996), revd U.S. 1997. 1981), S.E.C. v. Clark (9th Cir. 1990), S.E.C. v. Cherif (7th Cir. 1991). Rationale: That where a fiduciary has misappropriated information for the purpose of buying and selling securities, the nexus between the misappropriation and the misappropriator's trading satisfied the in connection with requirement of 10(b). Rationale: Misappropriation theory is invalid because the person injured by the misappropriators breach of fiduciary duty was not a participant in any relevant securities transaction. Thus, even if misappropriation somehow could be viewed as deceptive, the deception did not have the necessary connection to a purchase of sale of securities. Decided after Central Bank.
THE
Decided before Central Bank. NOW,

UNDER
SUPREME COURT HAS RULED THAT CRIMINAL LIABILITY 10(B) MAY BE PREDICATED ON THE MISAPPROPRIATION THEORY. D. Insider Trading (continued). OHagan. [p. 969-984] Carpenter v. US (US 1987) [was divided on whether misappropriation theory was o.k., 4 / 4]. United States v. OHagan, U.S. 1997 [p.969] FACTS: OHagan, a partner at Dorsey & Whitney in MN, purchases calls and options for Pillsbury Stock. At the time OHagan did this Dorsey & Whitney was representing a London based company, Grand Met, in a tender offer for the common stock of Pillsbury. OHagan did no work on the tender offer. The SEC initiated an investigation that lead to a 57 count indictment (based on OHagans misappropriation). OHagan was convicted and received a 41 month federal prison term. The court of appeals for the 8th circuit reversed stating that liability under 10(b) and Rule 10b-5 may not be grounded on the misappropriation theory. The U.S. Supreme court granted certiorari. HOLDING: Supreme Court reverses and holds that criminal liability under 10(b) may be predicated on the misappropriation theory.
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Under the traditional theory of insider trading, 10(b) and Rule 10b-5 are violated when a corporate insider trades in the securities of his corporation on the basis of material nonpublic information. Trading on such information is a deceptive device under 10(b) because a relationship of trust and confidence exists between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position within the corporation. See Chiarella. That relationship gives rise to a duty to disclose or to abstain from trading because of the necessity of preventing a corporate insider from taking unfair advantage of uninformed stockholders. This theory also applies to attorneys, accountants, consultants, and others who temporarily become fiduciaries or a corporations. See Dirks. Traditional Theory of Insider Trading Targets a corporate insiders breach of duty to shareholders with whom the insider transacts. Misappropriation Theory of Insider Trading Outlaws trading on the basis of nonpublic information by a corporate outsider in breach of a duty owed not to a trading party, but to the source of the information. Note: disclosure is also to the source of info!
Moreover, a companys confidential information qualifies as property to which a company has a right of exclusive use. See Carpenter v. United States, U.S. 1987. Benefit to Tipper. S.E.C. v. Switzer, (W.D.Okl. 1984) [p.980] FACTS: Switzer, football coach for the University of Oklahoma, is at a track meet and overhears Platt, CEO of Phoenix Resources, tell his wife that he needs to leave town because there was a possibility that Phoenix would be liquidated. Switzer and his friends, knowing of Platts position, made substantial investments in Phoenix. The S.E.C. files suit arguing Switzer and his friends were liable under 10b-5. HOLDING: Under the Dirks test, Switzer and his friends were not liable as tippees because Platt, the tipper, did not breach a fiduciary duty to Phoenixs shareholders by disclosing this information since he did not personally benefit, directly or indirectly, from the disclosure. Since Platt breached no duty there was no way that Switzer and his friends could have derivatively breached a duty. United States v. Libera, (2nd Cir. 1993) [p.980] FACTS: Employees of a magazine printer give out advanced copies of Business Week. The people who received advanced copies trade on this material non-public information.
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HOLDING: As a matter of law the employer-employee relationship was sufficient to establish a duty not to disclose which the printers employees breached by providing advanced copies of the magazine to others. The Tipper/employees could be found liable even if the tipper did not know that the tippee would trade on the basis of the misappropriated information. Constructive Insiders. S.E.C. v. Lund, (C.D. Cal. 1983) [p.981] FACTS: Lund the CEO of Verit Industries was asked by Horowitz a board member of Verit if he wanted to contribute $600K in capital for a joint venture with P&F Industries. Prior to any public disclosure regarding the venture Lund purchased 10,000 Shares of P&F stock, which he subsequently sold at a profit. HOLDING: Lund was liable as a temporary insider since the information was made available to Lund solely for corporate purposes. Family Relationships. United States v. Chestman, (2nd Cir. 1991) [p.981] FACTS: Ira Waldbaum, CEO of Waldbaum supermarkets, tells his sister that he had agreed to sell the Waldbaum chain to A&P. Despite the fact that he told her to keep the information confidential she told her daughter. In turn her daughter told her husband, Keith Loeb, telling him to keep it confidential. Keith Loeb then proceeded to place an order with Robert Chestman, his stockbroker. Loeb told Chestman about the sale. Chestman also buys Waldbaum stock for his own account. HOLDING: Court holds that Loeb had no duty not to disclose and that therefore Chestman could not be derivatively liable as Loebs Tippee. Tippees State of Mind. United States v. Teicher, (2nd Cir. 1993) [p. 982] FACTS: A young attorney provided defendants with information about ongoing or contemplated transactions involving clients of the law firm that employed him. Defendants were in the business in gathering rumors and public reports about publicly traded companies. HOLDING: A violation of Rule 10b-5 occurs when a trade is conducted in knowing possession of material nonpublic information obtained in breach of a fiduciary or similar duty. Remedies for Insider Trading Violations. Pursuant to section 21A of the 1934 Act the SEC is authorized to seek judicially imposed penalties against insiders, constructive insiders, tippers, and tippees of up
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to three times the profits gained or the losses avoided in unlawful insider trading. An insider, tipper, or tippee may be required to disgorge his profits, whether in an SEC or private action, and pay a treble damage penalty. Also at the insistence of the SEC civil penalties of up to 1 million dollars or three times the insiders profits (whichever is greater) may be imposed on employers pursuant to section 21A(b). Informants are paid a bounty. Section 32(a) authorizes criminal penalties of up to ten years in prison and maximum fines of 1 million for individuals and 2 million for non-natural persons (corporations, etc...). The Federal Remedies for Insider Trading

SEC Injunctions and Disgorgment-SEC v. TGS Civil Recovery by Contemporaneous Traders-Securities Fraud Enforsement Act of 1988, limits recovery to traders contemporaneous with insiders. Recovery is the disgorgement of the insiders actual profits realized or losses avoided, reduced by any disgorgement obtained by the SEC under its injunctive powers. Civil Recovery by defrauded owners of confidential information-Owners of confidential information who purchase or sell securities may bring a private action under 10b-5 against inside traders and tippees. Civil Penalties-The act authorizes the SEC to seek a judicially imposed civil penalty against traders and tippees who violate Rule 10b-5 or Rule 14e-3 for up to three times the profits realized (or losses avoided) in insider trading. Exchange Act 21A. Watchdog penalties-Insider Trading and Securities Fraud Enforcement Act of 1988, Congress provides more bite by extending civil penalties to ERs who control insider traders. Bounty rewards-To encourage informants, the 1988 Act grants
E. The Affirmative Duty to Disclose. [p.984-987 & 989-999]{skim 999-1007} 1. Disclosure Duties of Corporations Silence is actionable in connection with corporate disclosures when:
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(1) the company fails to correct misinformation it created and that it is actively circulating in the market, or (2) the company knows that insiders are trading based on information not available to the public. Corporations subject to the reporting requirements of the 1934 Act are required to file annual reports 120 days after the end of their fiscal years, seminal reports within 45 days after the end of the 6month period, and current reports within 10 days after the end of the month in which a reportable event occurred. Generally, corporations are encouraged to make prompt disclosure of material events. Unless adequate and accurate information is available to the public a corporation and its insiders may not trade in the corporations securities without running a risk of violating 10(b) and Rule 10b-5. NYSE states that if unusual market activity should arise before important corporate action or development then the corporation should be prepared to make an immediate public announcement of the matter. [p.984]. State Teachers Retirement Board v. Fluor Corp, (2nd Cir. 1981) [p.987] FACTS: State Teachers, a pension fund, sued Fluor Corporation, a large engineering and construction firm, for alleged violations of Rule 10b-5 and of the NYSE listing agreement and company manual. Fluor had entered into contract negotiations with the South African government. South Africa had them sign a confidentiality agreement, South Africa was working on getting financing through the French government. Rumors began to circulate that Fluor had gotten a large contract and analysts made inquires. Fluor responded with no comment statements. Fluor did nothing until the NYSE asked them to suspend trading. Before this time the pension fund sold shares in Fluor. HOLDING: A company has no duty to correct or verify rumors in the market place unless those rumors can be attributed to the company. See Elkind v. Liggett & Myers, Inc. (2nd Cir. 1980). There is no evidence that the rumors can be attributed to Fluor. Fluor used its business judgment in deciding when to act (this happened shortly after the rumors started, once Fluor was aware of the relationship between the change in market activity and the contract they were negotiating).
Business Judgment Rule and the Duty to Disclose:
Financial Industrial Fund, Inc. v. McDonnell Douglas Corp. (10th Cir. 1973). HOLDING: Material information must be available and ripe for publication before a duty to disclose arises. A company will not be held liable so long as its management exercises reasonable business judgment in deciding on the timing of disclosure. On the facts of this
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case management did not have reliable specific figures prior to disclosure. Basic, Incorporated v. Levinson, (U.S. 1980) [p.1003] FACTS: The case requires the court to apply the materiality requirement of 10(b) and Rule 10b-5 in the context of preliminary corporate merger discussions. Combustion Engineering expressed interest in acquiring Basic when regulation opened up in the mid-seventies (Basic manufactures chemical refractories for the steel industry). During negotiations Basic made Three Public Announcements denying that it was engaged in merger negotiations. During this period shareholders sold stock. Eventually, Basic asked the NYSE to suspend trading and made a public announcement confirming the merger. Former shareholders bring a class action suit against Basic and its directors, asserting that the defendants issued three false or misleading public statements in violation of 10(b) and Rule 10b-5. HOLDING: A fact is material for purposes of Rule 10b-5 if there is a substantial likelihood that a reasonable investor would consider it as altering the total mix of information in deciding whether to buy or sell. Thus, if disclosure of the information would affect the price of the companys stock, the information is material. The court specifically adopted the TSC Industries, Inc. v. Northway, Inc. (U.S. 1976) materiality standard for 10b-5 actions (an omitted fact is material if there is a substantial likelihood that a reasonable shareholder 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 information made available). The court also applied the Texas Gulf Sulphur probability/magnitude test for materiality. Materiality will depend at any given time upon the balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity. Whether merger discussions in any particular case are material will depend on the facts of the case. Materiality depends on the significance the reasonable investor would place on the withheld or misrepresented information. The court rejected the agreement-in-principle as to price and structure as the bright-line test for materiality (mergers discussions can not be a material fact if negotiations were not destined, with reasonable certainty, to become a merger agreement in principle). Furthermore, the court rejects the proposition that information becomes material by virtue of a public statement denying it. Silence absent a duty to disclose is not misleading under 10b-5. A no comment statement is the equivalent of silence. [footnote 17 page 996].
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However, a corporation has a duty to correct, within a reasonable time, a historical statement that the company believed was true when making it but subsequently discovers was false or misleading. Yet, when subsequent events render inaccurate a forward-looking statement that a company believed was true when made and for which the company had a reasonable basis, the company has no duty to update the statement. See Stransky v. Cummins Engine Co., Inc. (7th Cir. 1995). Bespeaks Caution Doctrine: A mechanism by which a court can rule as a matter of law that defendants forward-looking representations contained enough cautionary language or risk disclosure to protect the defendant against claims of security fraud. [p. 997].
21E of 1934 Act provides a safe harbor for forwardlooking statements.
Section 21E(c)(1) provides that an issuer, a person acting on behalf of an issuer, and certain other persons shall not be liable in any private action under the 1934 Act with respect to any forward looking statement if and to the extent that (A) the forward-looking statement is (i) identified as a forward looking statement, and is accompanied by meaningful cautionary statements that identify which portions could change; or (ii) immaterial; or (B) the plaintiff fails to prove that the forward-looking statement (i) if made by a natural person, was made with actual knowledge that the statement was false or misleading; or (ii) if made by a business entity; was (I) made by or with the approval of an executive officer of that entity; and (II) made or approved by such an officer with actual knowledge by that officer that the statement was false or misleading.
2. Elements of a 10b-5 Action for Disclosure Fraud

(a)
Material Misinformation. The defendant affirmatively misrepresented a material fact, or committed a material fact that made his statement misleading, or remained silent in the face of a fiduciary duty to disclose a material fact. Materiality standard is TSC (substantial likelihood that the disclosure of the omitted fact would have been viewed by
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the reasonable investor as having significantly altered the total mix of information made available) and TGS (probability/magnitude test).
(b)
Standing.
Blue Chip Stamps v. Manor Drugs, U.S. (1975) [p.999] HOLDING: Court held that a private action for damages under Rule 10b-5 can only be maintained by a person who actually purchased or sold securities. The court justified its holding in large part by pointing to the speculative nature of a claim brought by a person who can only allege that, had she known the truth, she would have purchased or sold securities, and to the vexatious potential of litigation based on such a claim. Only applies to shareholders who traded shares between the time the misrepresentations were made and the time the truth was revealed.
(c)
Scienter. The defendant knew or was reckless in not knowing of the misrepresentation and intended that the plaintiff rely on the misinformation.
Chiarella v. United States (U.S. 1980) Ernst & Ernst v. Hochfelder (U.S. 1976) [p.1000] FACTS: Hochfelder argued that Ernst & Ernst, an accounting firm retained by First Securities Company of Chicago, had not followed appropriate auditing procedures and thus had failed to discover a scheme by which First Securities president had induced Hochfelder to invest in non-existent accounts. HOLDING: To succeed in a 10b-5 action a plaintiff must prove that defendant acted with scienter an intent to deceive, manipulate or defraud. Section 10(b) was intended to proscribe knowing or intentional misconduct. Hochfelder left open two important questions: (1) Whether reckless misconduct satisfies the scienter requirement, and (2) Whether scienter is required in an S.E.C. injunctive action as well as a private damage action. This last question was answered in Aaron v. SEC (U.S. 1980) which held that scienter is a required element of a Rule 10b-5 offense, no matter who the plaintiff is or what remedy is being sought.
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We still do not know the answer to question one, the Supreme Court has not addressed it. However, federal courts of appeal have uniformly held that reckless misconduct will satisfy the scienter requirement. See Hollinger v. Titan Capital Corp. (9th Cir. 1990), Sundstrand Corp. v. Sun Chemical Corp. (7th Cir. 1977)(gave definition of recklessness, A highly unreasonable omission, an extreme departure from the standards of ordinary care, ... which presents a danger of misleading buyers and sellers that is either known to the defendant or is so obvious that the actor must have been aware of it).
(d)
Privity, Reliance. The plaintiff relied on the misrepresentation. In 10b-5 cases of a duty to speak, courts dispense with reliance if the undisclosed information was material. In 10b-5 cases involving transactions on impersonal trading markets, courts infer reliance from dissemination of misinformation in the trading market. The Supreme Court Adopted the Fraud-On-The-Market Theory to address the problem of proving reliance in openmarket transactions.
Basic, Incorporated v. Levinson (U.S. 1988) [p 1003] QP: Whether it was proper for the courts below to apply a rebuttable presumption of reliance, supported by the fraud-on-the market theory? A: We adopt the fraud-on-the-market theory. The market is interposed between buyer and seller and, ideally transmits information to the investor in the processed form of a market price. Thus, the market is acting as an unpaid agent of the investor, giving her information to make her decision (it is like a face to face transaction in this sense). Causation. The plaintiff suffered actual losses as a result of his reliance. Transaction Causation. Requires the plaintiff show that but for the defendants fraud, the plaintiff would not have entered the transaction or would have entered under different terms a restated reliance requirement.
(e)
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Loss Causation. Requires the plaintiff show that the fraud produced the claimed losses to the plaintiff a proximate cause requirement. Damages. The plaintiff suffered damages. Courts use various theories to measure damages under Rule 10b-5. Punitive damages are not available. 3. Federal Regulation Section 16 [p. 1007] (Not Assigned) Under 16 it is conclusively presumed that, when a director, officer or 10% shareholder buys and sells securities of his corporation within a sixth-month period, he is trading on inside information and must disgorge himself of the profits (goes to issuer, the corporation = the issuer). Officer includes executive officers, chief financial or accounting officers as well as any person who performs significant policy-making functions. See Rule 16a-1(f).
(f)
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Exam Prep Suggestions to Approach

Solicitation Question, and When Do You Have to File With SEC
Then Comply: 1. Whose Jurisdictional rules apply. 14a-3 Proxy 2. Is solicitation really taking place? 14a-1 Statement 3. What does the case law say, Barbash or the Railroad Case. 14a-6 Require that 4. Even if there is a solicitation, is there an you file proxy Exception in this case? 14a-2, for example, statement with the are you receiving less than 5% of shareholder SEC. control?
How To Exam the Duty of Care

There is a basic standard of knowledge which directors are to Have (That you would as Dir exercise care that under 8.30(a) an ordinarily prudent person in a like position would exercise.) Graham v. Allis-Chalmers (reasonable person or Negligence standard for noticing the red flags) Caremark International Derivative Litigation (If you set up the compliance system, that includes within it an auditing system, then you get BJR, requires gross negligence to rebut the presumption)

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BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

b) Alternative Theory 1. Komesar. (a) Buy or Sell Shares.

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

RMBCA 2.06 Bylaws. [p. 21]

DGCL 109. By-Laws. [p. 305]

RMBCA 3.01 Purpose. [p. 22]

DGCL 102(a)(3). [p. 298]

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

RMBCA 3.02 General Powers, a corporation has the power to (5)

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

2. Authorization and Issuance of Equity Securities (stock)

# of authorized shares is stated in the Articles.

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

Problem: Precision Tools [Part V] [220]

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

Problem: Precision Tools [Part VI] [243]

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

Problem: Precision Tools [Part VII] [252]

Michael Jensen: Eclipse of the Public Corp.

Alfred Rappapport: The Staying Power of the Public Corp.

Letters to the Editor of the Harvard Business Review

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

Problem, Widget Corporation [363]

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

Statutory Share Exchange Stock for Assets

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

P shhs P Corp. Assets/P and S shhs

(2) Triangular Merger (Forward)

P Corp. Assets/P-T shares

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

P Sub Holds P shares or consideratio

P-T Corp. Inc. (P Sub) Former T Assets

P shhs P Corp. Assets/P and S shhs

(3) Triangular Merger (Reverse)

P Corp. Assets/T shares T Corp. Inc. (P Sub) T Assets

PS-T Merger Plan

P Sub Holds P shares or consideratio

(4) Upstream/Downstream Mergers (Squeeze-Out Merger,

Former minority shhs-cash

BUSINESS ORGANIZATIONS II - Shaffer Karl Bekeny/Spring 2001

(5) Exchange of Shares (ONLY RMBCA, NOT Delaware)

a. P shareholders have NO voting or Appraisal rights. b. T shareholders have voting and