Corporations Long Outline I.

Introduction - Basic Principles Efficiency -Pareto efficiency: Resources are distributed such that no reallocation of resources can make at least one person better off without making at least one other person worse off (Pareto-optimal) -Transfers are Pareto efficient when create a net utility gain, or at least one party experiences a gain and no party experiences a loss -This kind of efficiency isnt used much in corps: it assumes the original distribution of assets is legitimate, and it limits the negotiation space for welfare-improving trades -Kaldor-Hicks efficiency: An act/rule is efficient if at least one party would gain from it after all those who suffered a loss as a result of the transaction or policy were fully compensated -Aggregate monetary gains to winners > aggregate monetary losses to losers (inc. in total wealth) -This is the type of efficiency used in corps: it still assumes the original distribution is legitimate, but it is more workable than Pareto -Courts rarely use the language of efficiency to justify their decisions; they use the moral term fairness. Possible that they mean fairness to SH; b/c SH are claimants to corporations income/assets, protecting their interests is consistent with increasing total corporate wealth (K-H efficiency) Modern Theory of the Firm Coase: transaction costs -Costs associated with transactions b/w market participants are substantial; firms exist because it can be more efficient to organize complex tasks w/in a hierarchical organization than on a market -When complex transactions involved, market forms of transacting require too much negotiation or wasted effort to discover best prices Agency cost theory -Reliance on agents gives rise to specific form of transactions costs -Agents seen as maximizers of their own interests rather than interests of their principals -To the extent the incentives of the agent (i.e., person or interest that possesses discretionary power over some aspect of the principals investment in the relationship) differ from the incentives of the principal herself, a potential cost will arise Agency cost is any cost associated with the exercise of discretion over the principals property by an agent -Examples: salaries/benefits (in case of corporate managers); failure to optimize firm value (because managers dont get all the gains from risky decisions but do bear a lot of the costs if the choices are bad) -Three general sources of agency costs: 1. Monitoring costs (costs that owners expend to ensure agent loyalty) 2. Bonding costs (costs that agents expend to ensure owners of their reliability) 3. Residual costs (costs that arise from differences of interest) -The corporation gives rise to agency problems: conflict b/w managers and investor/owners; ability of majority owners to control returns in a way that discriminates against minority owners; agency problem b/w firm and all other parties with whom it transacts (e.g., creditors) II. The Law of Agency 1. Agency Formation and Termination Formation

-Restatement: Agency relationship arises when one person (principal) manifests assent to another person (agent) that agent shall act on principals behalf and subject to principals control, and agent manifests assent or otherwise consent so to act -Types of agents: (1) special agents agency limited to single act/transaction; (2) general agents agency contemplates series of acts/transactions. -Types of principals: (1) disclosed third parties transacting w/agent understand that agent is acting on behalf of a particular principal; (2) undisclosed third parties are unaware of a principal and believe that agent is himself a principal; (3) partially disclosed third parties understand that they are dealing with an agent but do not know the identity of the principal -Principals control: Agent can be (1) employee/servant principal controls details of way agent goes about the task; or (2) independent contractor principal has less control, agent exercises independent judgment over task -Agency relationships may be implied even when the parties have not explicitly agreed to an agency relationship, see Jenson Farms (below) Termination -Either the principal or agent can terminate an agency at any time -Agency will never continue over objection of one party (no specific enforcement), but revocation/ renunciation may give rise to claim for damages for breach of K if there was a fixed set term of agency -If a principal grants authority for a stated term, authority expires automatically at conclusion of term. If no term is stated, authority terminates at the end of a reasonable term. A special agency terminates when the specific act contemplated is performed or after a reasonable time has elapsed. Jenson Farms Co. v. Cargill, Inc. (Minnesota 1981) Facts: Warren bought grain from farmers and resold to Cargill in exchange for loans from Cargill. Warren and Cargill entered into several short-term agency relationships in which Warren contracted on Cargills behalf with various farmers. Cargill also reviewed Warrens operations and expenses and recommended that certain actions be taken. By the end, Warren was heavily indebted to Cargill and Cargill wanted to make Warrens business decisions. Farmers sued Cargill and Warren because Warren defaulted on contracts made with farmers for sale of grain. They alleged that Cargill was jointly liable for Warrens indebtedness because it acted as Warrens principal. Holding: Cargill acted as Warrens principal and is liable for Warrens debts. Reasoning: An agreement may result in the creation of an agency relationship even though the parties did not call it an agency and did not intend the legal consequences of the relation to follow. The existence of the agency may be proved by circumstantial evidence showing a course of dealing b/w the two parties. In this case, by directing Warren to implement its recommendations, Cargill manifested its consent that Warren would be its agent. Warren acted on Cargills behalf in procuring grain for Cargill. Many factors indicate Cargills control over Warren. Here Cargill was an active participant in Warrens operations rather than simply a financier. There was a paternalistic relationship. Notes: The level of control and the nature of the interest mattered here. The actions were not just those of a lender; Cargill tried very hard to keep Warren alive. 2. Liability in Contract What is necessary to create the agency relationship is for the agent to reasonably understand from the action or speech of the principal that he has been authorized to act on the principals behalf. Thus, the scope of the actual authority conferred on the agent is that which a reasonable person in the position of A would infer from the conduct of P. Incidental authority = authority to do those implementary steps that are ordinarily done in connection with facilitating the authorized act. Apparent authority = authority that a reasonable third party would infer from the actions or statements of P, even if P has otherwise explicitly limited A unbeknownst to the third party. (One more type of authority inherent, see below)

White v. Thomas (Arkansas 1991) Facts: White had employed Simpson to do various things for two years. White instructed Simpson to attend a land auction and bid up to $250,000 on a 220-acre farm, except for three acres with a house. He gave her a blank check. Thomas attended the auction and was the successful bidder on the three-acre tract. Simpson bid too much on the remaining 217 acres and offered to sell Thomas some of the lands around the house (45 acres). White closed on the 217 acres but repudiated Simpsons other actions and refused to sell to Thomas. Thomas sued for specific performance of the K signed with Simpson. Holding: Simpson had no authority to sell Whites property; White was not bound by Simpsons actions. The K does not have to be specifically enforced. Reasoning: Simpson was not expressly authorized to sell Whites property; nor did she have the implied [sic; incidental?] authority to K to sell a portion of it to Thomas, as that act was not necessary to accomplish her assigned task of purchasing the entire tract. White did not hold Simpson out as having the authority to sell (no apparent authority). The two types of transactions, buying/selling, are not so related that a third person would reasonably believe that authority to do one carried with it authority to do the other. Neither agency or the extent of the agents authority can be shown solely by his own declarations/ actions in the absence of the principal. Notes: Apparent authority can only be inferred from Ps actions/statements. Inherent authority- is not conferred on agents by principals but represents consequences imposed on principals by the law. Inherent power gives a general A the power to bind a P, whether disclosed or undisclosed, to an unauthorized K as long as a general A would ordinarily have the power to enter such a K and the third party does not know that matters stand differently in this case. (Restatement 2nd Agency 161, 194, Restatement 3rd Agency 2.06) Gallant Insurance Co. v. Isaac (Indiana 2000) Facts: Gallant (P) sells car insurance to Isaac (T) through its agent Thompson-Harris (A). Policy states that any changes would have to be authorized by P. On 12/2, T buys a new car, which A agrees to insure effective immediately. A and T agree that T will come in to sign paperwork on 12/5. In the meantime, on 12/4, T gets in a car accident. On 12/5, T fills out the paperwork as planned, and reports the accident. P denies coverage because A was not authorized to renew Ts policy without authorization from P. Holding: A had the inherent authority to bind coverage by P. The insurance policy was in full force, and P has to give coverage to T. Reasoning: Neither an actual nor apparent authority theory applies to this case. Inherent agency power indicates the power of an agent that is derived not from authority, apparent or estoppel, but from the agency relation itself. This inherent authority exists for the protection of persons harmed by Ps A. In this case, As renewal of Ts policy constitutes an act which usually accompanies or is incidental to insurance transactions that A is authorized to conduct. A acted within the usual and ordinary scope of its authority. T could have reasonably believed, based on As conduct, that A had authority to orally bind coverage. (Ts past dealings were all done through A; there was no communication between T and P, so it was reasonable for T to take As representations at face value.) T had no reason to know of Ps policy regarding authorization of changes. Notes: This theory of inherent power is useful when P is undisclosed (no apparent authority). Agency by estoppel or ratification- where As act is not authorized by P or is not within any inherent agency power of A, P may still be bound by As acts by estoppel/ratification (Restatement 3rd Agency 2.05). Customary elements of estoppel: failure to act when knowledge and an opportunity to act arise, plus reasonable change in position on the part of T. Alternatively, accepting benefits under an unauthorized K will constitute acceptance (affirmance) of obligations as well as benefits. (4.01, 4.07) 3. Liability in Tort

P is liable for torts committed by employees/servants, but not by independent contractors. (Only the employer-employee agency relationship ordinarily triggers vicarious liability for torts committed within As scope of employment.) *Restatement 3rd Agency 2.04 (respondeat superior), 7.07 (when is an employee acting w/in scope of employment) -Issues of inherent/apparent authority are not relevant to tort cases. -In determining whether the relationship is a master/servant one, the idea is to determine who has control and who can best prevent the harm caused by A. -Policy considerations: Vicarious liability is an incentive to make sure that P takes enough care to supervise his servants (deterrence). On the other hand, if P isnt supposed to be supervising, he shouldnt be held liable. As who are employed for longer periods of time are more likely to be considered servants because P is more used to monitoring him closely. (If A is paid by unit of time, master/servant; if by job, independent K) Humble Oil & Refining Co. v. Martin (Texas, 1949) Facts: Humble (Principal) Schneider (manager, servant?) Attendant (servant) (tort) Third Party A customer brings in a car for servicing. Both he and the employee on duty forget to put the emergency brake on. The car rolls away and kills a third party. Third party sues Humble Oil; Humble argues that it isnt liable because Schneider is an independent K, not a servant. Holding: Schneider was Humbles servant, and so accordingly were Schneiders assistants who were contemplated by the K. Humble is liable for the tort. Reasoning: The facts that neither Humble, Schneider, nor the station employees considered Humble an employer/master; that Schneider paid and directed the employees; and that the agreement between Humble and Schneider expressly repudiated Humbles authority over employees are not conclusive in light of other evidence bearing on Humbles power to control the details of the station work as regards Schneider himself, and therefore as to employees which it was expressly contemplated that he would hire. Schneider had very little business discretion. The agreement required him to do anything Humble might tell him to do (explicit right of control in Humble). Notes: Humble is paying the business costs. For the relationship to make sense, Humble has to monitor closely (because of agency costs). Close monitoring means a more master/servant relationship. Hoover v. Sun Oil (Delaware, 1965) Facts: Sun Oil (master) (K) Barone (servant?) Employee (servant) (tort) Hoover Employee lights a cigarette while fueling a car. The car explodes. P sues employee, Barone, and Sun Oil. Sun Oil argues that Barone was an independent K and therefore the negligence of his employee could not result in vicarious liability. Holding: Barone was an independent K; no vicarious liability is imposed on Sun Oil. Reasoning: The service station was primarily a one-company outlet and represented to the public, through advertising, that it sold Suns products/service. But, the lease K and dealers agreement failed to establish any relationship other than LL-T and independent K. Sun had no control over the details of Barones day-to-day operation. Sun offered advice, but Barone was under no obligation to follow it. Notes: Barone controls his own costs, is more of a real entrepreneur. He would be the one more able to prevent the accident in this case. The two cases compared: who set the hours of operation; was A selling products other than Ps; lease termination; overall ownership; control of on-site employees? Also key is the manner of payment. Schneider was paid out of gross (didnt assume any loss); Barone was paid out of net (had to assume losses, less subsidized). Getting paid out of net makes A take more control. -Have to look at business practice side of things as well as the contractual provisions. -We place liability on the cheapest cost avoider.

4. Agents Duties A is a fiduciary of P legal power over property held by the fiduciary is held for the sole purpose of advancing the aim of a relationship pursuant to which he came to hold the property. -Fiduciary is bound to exercise good-faith judgment in an effort to pursue the purposes established at the time of creation of the relationship -Three fiduciary duties: 1. Duty of obedience (Restatement 3rd Agency 8.09) 2. Duty of loyalty- duty to exercise legal power over the subject of the relationship in a manner that the holder of the power believes in good faith is best to advance the interest or purposes of P and not to exercise such power for a personal benefit 3. Duty of care- duty to act in good faith, as one believes a reasonable person would act, in becoming informed and exercising any agency/fiduciary power Duty of Loyalty- Restatement 3rd Agency 8.01-8.03, 8.06 -Agent cant take secret profits; has to make full disclosure; fair dealing requirements; no adverse dealing -Remedies are quasi-punitive, with deterrence goals Tarnowski v. Resop (Minnesota 1952) Facts: P (Tarnowski) wants to buy a jukebox business. He hires Resop (A) who does no research and says he finds a good one, but its a bust and A is taking a $2000 secret commission from the business owners to sell their bad business. (A wasnt committing fraud; he didnt know the business was bad.) P paid $11,000 down on the business but discovered that As representations were false. P rescinded the sale and demanded the return of his money. The sellers refused, but P sued them and got the money back. In this suit, P is suing A to recover damages for various losses involved in the transaction. Holding: A violated the duty of loyalty. A has to give P attorneys fees, expenses, and the $2000 secret commission. Reasoning: All profits made by A in the course of an agency belong to P, whether they are fruits of performance or the violation of As duty. It doesnt matter if P has suffered no damage or even that the transaction has been profitable to him. Rule: If A has received a benefit as a result of violating his duty of loyalty, P is entitled to recover from him what he has so received, its value, or its proceeds, and also the amount of damage thereby caused. P is entitled to be indemnified for any losses. In this case, Ps attorneys fees and expenses of suit were directly traceable to the harm caused by As wrongful act. Notes: The remedy overcompensates, but it is more about deterrence. We over-deter in individual instances to compensate for not catching every A who does this. This is different from just negligence; we dont like bad actors and want not just optimal but maximum deterrence. Trustees Duty to Trust Beneficiaries- Restatement 2nd Trusts 203, 205, 206 -The private trust is a legal device that allows a trustee to hold legal title to trust property, which the trustee is under a fiduciary duty to manage for the benefit of the beneficiary. The trust resembles the agency relationship: trustee has power to affect beneficiarys interests. It differs from agency: trustee is subject to terms of the trust, as they have been fixed by the trusts settler/creator- trustee not ordinarily subject to the control of the beneficiary. -General rule: even if no breach of trust, any benefit trustee gets from trust is illegal. In Re Gleeson (Illinois 1954) Facts: Gleeson dies; Colbrook, a close friend and tenant, is executor and trustee under her will, which benefits her three children. Gleeson had been leasing land to Curtin before her death. Right after Gleesons death the lease expires and Colbrook cant find anyone else to take it, so he leases the land to his own partnership. Colbrook says he raises the rent on himself. Holding: Any profits gained from the trust must be given to the trust. A trustee cannot deal in his individual capacity with the trust property.

Reasoning: Good faith and honesty of the trustee, or the fact that the trust sustained no loss on account of the trustees dealings, dont matter as long as trustee is self-dealing with the trust property. Trustee should have decided whether to be tenant or trustee; he was not allowed to be both. Notes: This case involves the violation of a per se rule (bright line) that a trustee has the obligation to turn all profits over to the beneficiary. Gleeson is like a P in an agency relationship, but here, is not around to monitor trustees behavior, so the court is harsher to protect the beneficiaries interests. In general, trust rules are stricter than agency rules because its personal (so beneficiaries are more dependent); theres a larger disparity of knowledge among the parties. III. Partnership 1. Introduction Partnership multiple parties own the business and have a claim on profits/net return (equity stake). Its not debt: theres no hard claim, partners only get whats left over. Each partner is both principal and agent. Important partnership principles -Ordinary business matters decided by majority vote; extraordinary matters must be unanimous -Every general partner is an agent of the partnership and can bind the partnership -Partnerships have unlimited liability; partners are liable for torts and Ks of the partnership Tenancy in partnership- a form of tenancy providing that the partnership, rather than the individual partners, exercises true ownership rights over partnership property, exercises true ownership rights over partnership property, and in the event of bankruptcy/liquidation, this form of title gives creditors of the partnership first priority over the claims of the creditors of individual partners. Reasons for creating a partnership Sometimes partners go into business together b/c they cant afford to finance the business on their own. Its an alternative to taking out loans b/c after a certain point, selling an ownership stake may be a cheaper way to raise capital than attempting to borrow more funds. Or, whatever the costs of co-ownership, after a certain point they may be lower than the agency costs of the debt contract. -When creating a partnership, the division of gain/loss and control is subject to negotiation- outcome depends not so much on fairness as on the relative bargaining positions of the parties. Agency conflict among co-owners (b/w controlling and minority co-owners) -Joint venture = a circumscribed partnership limited to a single investment project Meinhard v. Salmon (New York 1928) Facts: Two joint venturers. Salmon took a 20-year lease to operate a hotel. Salmon ran the hotel and Meinhard provided half the capital. The profits were split 60-40 for the first 5 years and then 50-50. The venture was circumscribed to last the length of the lease. When the lease was almost over, Gerry (owner of property) came to Salmon to discuss Salmon leasing the entire block of land, not just the hotel. Gerry didnt know about Meinhard. They signed a new 80-year lease, which Salmon did not tell Meinhard about. Meinhard sued because he wanted an opportunity to get in on the new venture. He argued that the new project was connected to the earlier project that they were both involved in. Holding: Meinhard gets to participate in the new project (one share less than 50%). Salmon had a duty to give Meinhard a chance to compete for the new deal, and he breached that duty of loyalty. Reasoning: Joint venturers, like co-partners, owe to one another, while the enterprise continues, the duty of the finest loyalty. A trustee is held to something stricter than the morals of the marketplace. Not honesty alone, but the punctilio of an honor the most sensitive is the standard of behavior. Courts of equity are rigid when it comes to this duty. Salmon was a fiduciary, for himself and another. If Gerry had known this, he would have given both partners the opportunity to join in the new project. The preemptive opportunity was what Salmon kept to himself when he was under a duty to give Meinhard the chance to compete. It doesnt matter that Salmon wasnt intending to defraud Meinhard.

Dissent: Where the trustee or partner takes no new lease but buys the reversion in good faith, there is no direct appropriation of the expectancy of renewal. Here there is no offshoot of the original lease. And there was no fraud, dishonesty, or unfairness present in this transaction. Notes: In the first place, Meinhard wasnt entitled to participate, he was just entitled to have the chance to compete to participate. -Discussion of various policy reasons for/against the possible outcomes: what Salmon did; what the fiduciary duty required Salmon to do; Cardozos remedy 2. Partnership Formation Partnerships can be implied by courts based on inferences about the consent of the parties. Partnership in Fact: UPA 6-7 -Sharing net profits, but not gross returns, is prima facie evidence of partnership liability. Reason: sharing net profits means youre also sharing in the risk and therefore have some control. -Intent to share in profits and responsibilities can trump form. Partnership by Estoppel: UPA 16(1), RUPA 308 -If a person represents self as a partner (or consents to others making such a representation), and a third party reasonably relies on that representation and does business with the enterprise, then the person who is represented as a partner is liable on the transaction, even if not in fact a partner. (UPA restricts to creditors, while RUPA expands to all transactions) -To have partnership status, you need (1) voluntary K of association for purpose of sharing profits and losses- under 7(4), receipt of share in profits is prima facie evidence of this; and (2) intent on part of principals to form a partnership for that purpose. Vohland v. Sweet (Indiana 1982) Facts: Tree nursery. Sweet does apprenticeship with Vohland Sr. When he dies, Vohland Jr. takes over and renames it Vohlands Nursery. Starting in 1963, Sweet gets paid 20% of the net profits of the nursery, but there is no explicit agreement. Sweets 20% share is called (erroneously) commission. Vohland handles all the finances/books, does sales; Sweet manages physical aspects of the nursery. In 1979, Sweet sues to dissolve the partnership, i.e., wind up, sell assets, and distribute proceeds. Vohland argues, saying Sweet put in no capital, just a salesman. Holding: There was a partnership. The parties intended to do the things which amount to the formation of a partnership, regardless of how they may have later characterized the relationship. The central factor in determining the existence of a partnership is division of profits. Reasoning: Under UPA 7(4) receipt by a person of a share of the profits is prima facie evidence that he is a partner. A partnership may be formed by the furnishing of skill/labor; it doesnt have to be property or money. A partnership can commence only by the voluntary K of the parties with the intention of the parties to share the profits as common owners thereof. The intent requirement is an intent to do those things which constitute a partnership; it doesnt matter if they intended to actually create a partnership. Notes: Contracting out of liability wont work; it doesnt matter what you call the relationship. In this case the court was likely stretching the facts to help Sweet because he was being led on. For example, if the company had gone bankrupt, would a bank have been able to nail Sweet as a partner? Probably not.

3. Liability to Third Parties

General partnership form includes unlimited personal liability for partners, so partnership law is in part defined by the rights of creditors vis--vis the assets of express/implied partners. -Three principal issues re: creditor rights (1) who is a partner? (2) when can an exiting/retiring partner escape liability for a partnership obligation? (3) how are claims to a partners personal assets balanced against the claims of other (non-partnership) creditors of that person? *UPA 15: Jointly/severally liable for firm torts; jointly liable for firm Ks

*RUPA 306: Jointly/severally liable for both firm torts and Ks; BUT under 307(d) firm creditors must exhaust firm assets before pursuing a partners personal assets. (1) Who is a partner? Example 1: what about someone who contributes no assets, but rather services (sweat equity), and gets the greater of $5,000 or 1/3 of the profits? Arguments in favor of partner: getting share of profits is prima facie evidence of being a partner (UPA 7(4)), name on tax forms (intent to form partnership), you dont have to make a capital contribution to be a partner (Vohland). Arguments against: fact that he gets $5000 no matter what looks more like wage (doesnt have as much risk re: loss). Question marks: how much control does he have?, has he represented himself as a partner? *He probably is a partner. Example 2: what about someone who gives one of the partners $15,000 capital (which all the partners know about) and gets half of one partners profits (which the other partners dont know about)? Argument against: you cannot be a partner unless all partners agree so all partners have to know about one another (UPA 18(g)), also his profits were paid out as interest on a loan, which is an exception to the prima facie profits rule (UPA 7(4)(d)). *He is probably not a partner. Example 3: what about someone who loans the business $50,000 and is to receive interest in an amount equal to 25% of the profits and has a veto of expenditures over $10,000? Is he liable as a partner to a bank who extends credit to the business? *Probably not. Argument against: not partner by estoppel because did not consent to being represented as a partner (UPA 16(1)/RUPA 308), income being received is just interest on a loan (UPA 7(4)(d)). (2) Claims against departing partners When a partner withdraws from a partnership but other partners continue the business, the exiting partner is liable for partnership obligations incurred prior to departure, but no longer exercises control over the capacity of the continuing business to satisfy those obligations. *UPA 36(2), RUPA 703(c): releases departing partner of partnership debts if court can infer an agreement between the continuing partners and the creditor to release the withdrawing partner *UPA 36(3), RUPA 703(d): releases departing partner from personal liability when a creditor renegotiates his debt with the continuing partners after receiving notice of the departing partners exit Policy considerations: on one hand, making it too easy for departing partners to escape debts would create incentives for partners to leave when trouble appeared on horizon; on other hand, making it too hard to escape liability would allow continuing partners to bind the departing partner who no longer has control over partnership decision-making externalizing some of the risk of the partnership. (3) Third-party claims against partnership property If business assets werent segregated, and business/personal assets of investors would be available to both business/personal creditors, business creditors would be unable to monitor the claims of personal creditors with whom they would have to compete for assets in the event of insolvency. This would decrease willingness to K with jointly owned businesses. Segregating assets makes contracting easier. *UPA 25: partnership property is owned by the partners as tenants in partnership this joint ownership affords to individual partners no power to dispose of partnership property, so it becomes de facto business property *RUPA 501/502: straightforward entity ownership (the opposite of the aggregate theory that the individual partners own the property); partners rights are transferable If a partner does not own his partnerships assets in any ordinary sense, he nevertheless retains a transferable interest in the profits arising from the use of partnership property and the right to receive partnership distributions. Two-level ownership structure that characterizes partnerships: the contributors of equity capital do not own the assets themselves but rather own the rights to the net financial returns that these assets generate, as well as certain governance or management rights (UPA 26-27, RUPA 502-503)

(4) Claims of business creditors to partners individual property Old approach: Jingle Rule (UPA 40) gave partnership creditors priority in all partnership assets and gave first priority to the separate creditors of individual partners in the individual assets of those partners Todays approach: Parity Rule (78 Bankruptcy Act 723, RUPA 807(a)) partnership creditors still have first priority in partnership assets, but they are also placed on parity with individual creditors in allocating individual partners personal assets -Note that in all cases, business creditors always get first priority on partnership assets -As to claims against individual assets personal creditors get first priority if (1) UPA is controlling state law and (2) partnership is not in Chapter 7 bankruptcy and thus 723 doesnt apply. Partnership creditors get parity treatment if (1) RUPA is controlling state law or (2) 723 applies (partnership is in Ch. 7 and individual partner is in bankruptcy). (Looking ahead note: personal creditors have no claim on corporate assets, and vice versa.) 4. Partnership Governance and Issues of Authority Default rule is that any dispute about ordinary matters of the firm must be resolved by majority vote, but acts in contravention of the partnership agreement must be done unanimously. In other words, ordinary acts of any partner is binding on all other partners unless contravened/prevented by majority vote. -Rationale: give partnership more flexibility by not letting minority partners hold up ordinary business decisions make partnership more of an entity and less of an aggregate of individuals. -Note that this is a default rule and can be contracted around by creating a different authority structure. National Biscuit Co. (Nabisco) v. Stroud (North Carolina 1959) Facts: Stroud and Freeman entered into a general partnership to sell groceries. There were no restrictions on Freemans power/authority as a general partner. Purchase and sale of bread were ordinary and legitimate business of the grocery. Stroud told Nabisco that he personally would not be responsible for any additional bread Nabisco sold to the grocery. BUT Nabisco then, at Freemans request, sold and delivered $170 worth of bread to the grocery. Stroud and Freeman dissolved the partnership, and Stroud didnt want to have to pay Nabisco- he wanted to cancel the sale of the bread. Holding: Activities within the scope of the business cannot be limited except by a majority of partners. Stroud was not a majority and thus he is bound to Freemans sale of the bread. Reasoning: What any partner does with a third person is binding on a partnership (in a general partnership, at least). Under UPA 18(h), Stroud could not restrict the power/authority of Freeman to buy the bread, because it was an ordinary matter of the business, and Stroud himself was not and could not be a majority of the partners. Notes: This case illustrates the majority rule that half of a two-person partnership is not a majority for purposes of making firm decisions within the ordinary course of business. -Note that voting is based on equal votes, not ownership interest. (E.g., A owns 80%, B and C each own 10%, but A cant block what B and C want to do. This is in contrast to a corporation. But remember, this arrangement can be contracted out of.) Rationale: no matter how much or little you own, you still have the risk of unlimited liability. *UPA 9(2): If a partner does something not consistent with carrying on the business of the partnership, its not binding on the other partners unless a majority agrees. -Third parties should generally ask to see authorization by a majority of partners. 5. Termination (Dissolution and Disassociation) Partnerships can be dissolved/wound up at any time by any partner. But, one does not get wind-up rights if the partnership agreement says otherwise (Adams) The default rule is partnership at will: anyone can dissolve at any time (Page) BUT fiduciary relationship tempers purely opportunistic dissolution

When winding up, more fair to sell business and pay off in cash rather than dividing assets (because of loss of going concern value; also because of need to protect creditors) (Dreifuerst) -Going concern value: cash flows you expect from business in the future, discounted for time UPA Dissolution (29): defined as any change of partnership relations, e.g., the exit of a partner Winding up (37): orderly liquidation and settlement of partnership affairs Termination (30): partnership ceases entirely at end of winding-up *Under UPA, any partner can force a wind-up of the partnership (38(1)). Different from RUPA. Wrongful dissolution (38(2)): departing partner has no claim on good will value RUPA Disassociation (601): a partner leaves but the partnership continues, e.g., pursuant to an agreement Dissolution (801): the onset of liquidating partnership assets and winding up its affairs *Under RUPA, disassociation can happen without dissolution. Dissolution here means termination. -Note that partners can contract around these default rules in their partnership agreements. Most agreements hold that withdrawal doesnt automatically cause dissolution (creates stability). Wrongful disassociation (602): can disassociate wrongfully, but are liable for damages Adams v. Jarvis (Wisconsin 1964) Facts: Adams withdraws from the three-doctor clinic partnership. He contends that his withdrawal constitutes a dissolution that requires winding-up. UPA 38(1) states that when dissolution is caused in any way, except in contravention of the partnership agreement, each partner, as against his co-partners, unless otherwise agreed, may have the partnership property applied to discharge its liabilities, and the surplus applied to pay in cash the net amount owing to the respective partners. The clinics partnership agreement stated that the withdrawal of a partner shall not terminate this partnership but that Adams should get 5/12 * 1/3 of the profits in the year of his withdrawal. (The agreement indicated that Adams should not immediately get his share of the assets.) Adams wants the assets dissolved and divided now because he fears that the other partners will collect on the accounts receivable before the end of the year. (He wants court to enforce UPA, not the agreement.) Holding: The agreement is enforceable (trumps UPA), and the partnership does not have to be wound up. Reasoning: The agreement contemplates that the partnership would continue to exist between the remaining partners. If the agreement provides for continuation, sets forth a method of paying the withdrawing partner his agreed share, and does not jeopardize the rights of creditors, the agreement is enforceable. UPA does not invalidate this enforceable contract. When Adams withdrew, the partnership was not wholly dissolved so as to require complete winding up of its affairs. UPA 38(1) applies only unless otherwise agreed, so the distribution of assets should be made pursuant to the agreement. Adamss bargaining position was equal in the negotiations leading up to the agreement, so its not invalid on public policy grounds. Because the court is enforcing the agreement, Adamss eventual share of profits is dependent on the management of business affairs of the continuing partners for the remainder of the year; the continuing partners stand in a fiduciary relationship to Adams and are obligated to conduct the business in good faith. Notes: Is the case decided correctly? YES: Dissolving the partnership immediately would have hurt the other partners (bills are outstanding); the remaining partners fiduciary duty will ensure that they dont screw Adams. NO: The partnerships accounting methods (bills not recorded until actually paid) means that Adams income is understand and wont get enough money; the other partners could rip Adams off. Consequences of statutory dissolution- what if the agreement is silent on form in which assets are distributed? Majority rule: auction off the entire business, as per UPA 38(1) Dreifuerst v. Dreifuerst (Wisconsin 1979)

Facts: No partnership agreement. There is an at-will partnership among three brothers to run two feed mills, and it is winding up. The trial court divides the assets, giving one mill to one brother and the other mill to the other two brothers. (In-kind division) UPA 38(1) is applied. Holding: UPA 38(1) does not permit in-kind distribution unless the partners agree to it in the partnership agreement. UPA 38(1) allows a non-wrongfully dissolving partner to force a sale unless otherwise agreed. Here the assets must be sold. Reasoning: A partnership at will has no definite term or particular undertaking and can rightfully be dissolved by the express will of any partner. Rightfully dissolving partners have the right to wind up the partnership by having the business liquidated and receiving their share of the surplus in cash. Policy reasons against in-kind distribution: protect creditors (in-kind distributions may affect a creditors right to collect the debt owed since the assets may be worth more as a whole than they are divided up); sale provides more accurate means of establishing market value. Notes: RUPA 402, 801, 802, 804 codify the holding of this case. Why would a partner want in-kind distribution? If you dont have enough cash to buy the assets back at auction; avoid generating tax liability. Remember, you can always K around whatever valuation system is in UPA/RUPA. Usually even if theres no partnership agreement, partners work it out themselves. Limiting partners right to dissolve under UPA 31(1)(b) UPA 31(1)(b): a partnership may be dissolved by the express will of any partner when no definite term or particular undertaking is specified UPA 38(2): even though partnerships are terminable at will (unless a definite term is specified/implied), partners have fiduciary duties to act in good faith when dissolving the partnership. Page v. Page (California 1961) Facts: An oral partnership agreement to run a laundry (linen supply co.). Both partners contribute $43K in original equity capital, and Big Page (active partner) loans the partnership another $47K through his wholly-owned corporation. Just when business seems about to turn a corner, Big Page seeks to dissolve the partnership. Little Page claims that Big Page is trying to take an opportunity for himself stemming from the new air force base built nearby. Trial court says partnership is for a term, not at-will, so Big Page cant dissolve. Holding: Partnership is at-will and can be dissolved subject to fiduciary duties. Reasoning: There was no agreement to continue the partnership for a term. The understanding was no more than a common hope that the partnership earnings would pay for all the necessary expenses. Such a hope does not establish even by implication a definite term or particular undertaking as required by UPA 31(1)(b). There is no showing of bad faith, but this contention is irrelevant to the issue whether the partnership is for a term or at-will; in any case, Little Page is protected by fiduciary duties. (38(2)) If Big Page acted in bad faith, the dissolution would be wrongful and he would be liable for damages. Notes: Big Page can dissolve, but he may face consequences. Court is sensitive to the possibility of exploitation. Little Page is vulnerable- his right to force a sale is not sufficient protection because hell lose if theres an auction (Big Page is a major creditor and will probably be the only bidder). Little Page is also more vulnerable than Meinhard in Meinhard v. Salmon because there, there was a term; here, LP can be forced out at any time. It would have been smarter for LP for the partnership here to be set up as a term as well, to protect the weaker partner when there is a disparity in power. 6. Limited Liability Modifications of the Partnership Form Features of a general partnership: (1) a dedicated pool of business assets, (2) a class of beneficial owners (the partners), and (3) a clearly delineated class of agents authorized to act for the entity (the partners). The separation between the partnership as a legal entity and the investors who finance it can be further increased by adding limited liability as a 4th element. Limited liability means that business creditors cannot proceed against the personal assets of some/all of a firms equity investors. (Business creditors can only rely on the partnership assets.)

(1) Limited Partnerships ULPA/RULPA Limited partners share in profits without incurring personal liability for business debts. All limited partnerships must have at least one general partner, with unlimited liability, in addition to one or more limited partners. General partner is treated like a member of an ordinary partnership (personally liable, may bind to third parties, etc.). Limited partner may participate in profits but enjoy liability limited to his partnership contribution; may not participate in management/control beyond voting on major decisions such as dissolution. -Limited partnerships have to be registered (unlike general partnerships) -Two-tier tax treatment for publicly traded companies (enterprise is taxed on its entity income, and its investors are taxed again at individual rates when that income is distributed) instead, LPs get passthrough taxation (only the individual partners are taxed; no tax on the LP) -General partners have fiduciary duties toward limited partners. Structuring payment so that GPs get their payment as a lump sum at the end of the agreement also creates a unity of interest b/w GPs and LPs. -Old test: control test limited partners who remain passive escape personal liability for partnership debts. Rationale: those who can actively shift assets out of the firm, or make risky decisions, should be held personally liable to prevent opportunism against partnership creditors. -New test: RULPA 303 adopts control test but says a limited partner who participates in control is liable only to persons who transact business w/the partnership believing, based on limited partners conduct, that limited partner is a general partner (if you label yourself a LP, you can exercise control and not be personally liable) UPA 303 (2001) abandons control test limited partner is not personally liable for partnership liabilities even if the limited partner participates in the management and control of the enterprise. Rationale: statusbased liability shield The control rule is now defunct. But LP agreements generally vest complete control in hands of general partners. (2) Limited Liability Partnerships These are general partnerships in which partners retain limited liability, at least for certain liabilities and limited periods. LLP statutes limit liability only w/respect to partnership liabilities arising from the negligence, malpractice, wrongful act, or misconduct of another partner or an agent of the partnership not under the partners direct control. -K liability is still joint and several. -LLP statutes create a capitalization or insurance requirement to offset the limited personal liability of the partners. (to offset the risk of not being able to pay tort creditors) (3) Limited Liability Companies Internal relations among investors in the LLC (members) are governed by general/limited partnership law. Members may operate the firm and serve as its agents (like GPs), or elect managers to do so (as in LPs or corps), the resignation of a member may or may not lead to dissolution, etc. -Like LPs, LLCs must file a copy of their AOC with the secretary of state -Unlike LPs, the members of an LLC enjoy limited liability even when they exercise control over the business in much the same way a GP would *The rise of LLCs was tax-driven: IRS regulations (up until 1997) said that LLC would be taxed like a corp. if it had 3+ of 4 characteristics, but otherwise would get pass-through taxation. (The 4 characteristics were (1) limited liability for the owners of the business, (2) centralized management, (3) freely transferable ownership interests, and (4) continuity of life.) During this era, LLC drafters tried to fail the corporate resemblance test by lacking both free transferability of interests and continuity of life. They put restrictions on transfer (e.g., requiring members to consent to transfers of interest) and limits on continuity of life (could set LLC for a term, or require dissolution w/exit of any member).

 In 1997 the rules changed to implement check the box regulations. The four-factor test was abandoned in favor of allowing all new unincorporated businesses (GPs, LPs, LLCs, LLPs) to choose whether to be taxed as partnerships or corporations (as long as they dont use a corporate statute and your interests arent publicly traded). -IRS Reg. 7701-1 to-3: check the box regulations -BUT IRS Reg. 7704(a): enterprises w/publicly traded equity face two-tier taxation -LLCs can now combine pass-through treatment for tax purposes with limited liability, participation in control by members (w/o loss of limited liability), free transferability of interests, and continuity of life. There is more flexibility under LLC statutes than corporate statutes in the form of near-complete freedom to opt out of default rules. -The LLC is flexible- an empty vessel. IV. The Corporate Form 1. Introduction Characteristic Investor ownership Legal personality Limited liability Transferable shares Centralized/delegated mgmt. under elected board GP X X LP X X X X LLC X X X X Corp. X X X X X

The Corporate Form: PRO: Investors can enter/exit by selling shares (easy) No problems of personal liability (creditors rely on business assets only) Prevents minority investors from holding up firm by threatening to dissolve it Third parties know who theyre dealing with Cheaper to create than GP, LP, or LLC CON: Partners have more control in partnerships Partners have ability to force liquidation Partners can tell investors they can rely on personal assets A corporations legal characteristics have complementary qualities: limited liability makes free transferability more valuable (reduces costs associated with transfers of interest b/c value of shares is independent of assets of owners), free transferability permits development of large capital markets, which are also advanced by the presence of centralized management -U.S. corporations are regulated by the law of the state of incorporation, not where they do business. Public corporations vs. closely held corporations Closely held corporations: have few SH; tend to incorporate for tax/liability purposes rather than capital raising purposes; may drop features of corporate form Public corporations: tend to incorporate to raise capital in public capital markets; adopt all characteristics Controlled corporations vs. corporations w/o controlling SH Controlled corporations: a single SH or group exercises control through its power to appoint the board Corporations w/control in the market: no single SH/group exercising control; but anyone can purchase control in the market by buying enough stock; while control is in the market, practical control resides with the existing management of the firm

2. Creation of a Fictional Legal Entity -Corporation is considered a separate person in the eyes of the law -Corporate form reduces costs of contracting for credit: having corporate assets delimits the pool of assets that creditors can rely on, so dont have to investigate asset holdings of all separate joint venturers -Corporation status as fictive legal entity allows it to have an indefinite life- increases stability -Over 20th c., general laws of incorporation gradually dropped mandatory regulation of internal corporate governance. Now typical statutes are non-regulatory enabling statute with few mandatory features. Process of incorporating: RMBCA 2.01-2.04 (1) A person, the incorporator, signs documents and pays fees (2) The incorporator drafts/signs the articles of incorporation (RMBCA)/certificate of incorporation (DGCL) also known as the corporations charter. This document states the purpose and powers of the corp. and defines all its special features (3) The charter is then filed with the secretary of state, along with a filing fee (4) The secretary of state issues the corporations charter, signed by the secretary (5) The first acts of business are electing directors, adopting bylaws, and appointing officers (at an organizational meeting) Articles of incorporation- may contain any provision that is not contrary to law It MUST provide for voting stock, a board of directors (the incorporators elect the initial board), and SH voting for certain transactions; name the original incorporators; state corporations name and its business; fix its original capital structure But, transactional freedom is the overriding concept- the AOI can set out whatever customized features of the corp. you want, e.g., classes of voting stock The charter MAY establish the size of the board or include other governance terms, like procedures for removing directors from office Corporate bylaws They must conform to both the corporation statute and the corporations charter (DGCL 109(b)) They fix the operating rules for the corp.s governance: existence/responsibilities of corporate offices, size of board, annual meeting date DGCL gives SH inalienable right to amend the bylaws (109(b)); others limit this power to the board. SH agreements -Contracts between SH and the corporation -Often address questions like restrictions on disposition of shares, buy/sell agreements, voting agreements -Courts will specifically enforce them where all SH are parties, but if not all SH are parties, enforcement will turn on whether agreement is fair to non-party SH 3. Limited Liability Technically, neither corps nor SH have limited liability. Corps have unlimited liability, and SH, by reason of their SH status alone, have no liability for the debts or obligations of the corp. Limited liability simply means that SH cannot lose more than the amount they invest. -These things can be contracted around: a SH can undertake by K to be corporate guarantor -Limited liability encourages risk-averse SH to invest in risky ventures; also increases incentives for banks or other expert creditors to monitor their corporate debtors more closely -Decreases need to monitor managers; makes diversification and passivity a more rational strategy and so reduces cost of operating the corp. -Limited liability makes shares fungible 4. Transferable Shares

Equity investors in the corporate entity legally own something distinct from any part of the corporations property: they own a share interest. This share (or stock) is their personal legal property, and generally (i.e., absent special restrictions imposed by charter/contract), such a share may be transferred together with all rights that it confers -Transferability allows firms to conduct business uninterruptedly as identities of owners change- avoids complications of dissolution and reformation in partnerships -This encourages the development of an active stock market, which facilitates investment by providing liquidity and by facilitating the inexpensive diversification of the risk of any equity investment -Also serves as a constraint on the self-serving behavior of managers 5. Centralized Management -Advantages: can achieve economies of scale in knowledge of the firm, its technologies and markets. -Problem: investors are rationally apathetic (b/c of cheap diversification of risk) -Theres a collective action problem re: SH, but corporate law tries to mitigate it by specifying when SH votes are required, what info SH must be given, and that SH must be able to vote in convenient ways that do not require physical attendance at a SH meeting -Corporate law tries to mitigate the agency problem by requiring, as a default rule, that management be appointed by a board of directors that is elected by the SH (DGCL 141) -Initiation and execution of business decisions are managements jobs, whereas monitoring and approving business decisions are the boards jobs. This separation serves as a check on the quality of delegated decision making and makes board a focus for control mechanisms based on directors legal duties. *Not even 100% of SH can force the board to sell the company. The board has to initiate such activities and SH can only ratify or deny. If the SH want to sell and the board opposes, they have to replace board. Automatic Self-Cleansing Filter Syndicate v. Cunninghame (England 1906) Facts: McDiarmid and friends own 55% of the shares of ASCF. ASCF charter vests control in the board, subject to regulations by extraordinary resolution of 75% of SH. McDiarmid and friends bring such a resolution to sell the companys assets; resolution fails 55%-45%. McDiarmid then asks the court to order the board to sell the assets (he wants to change the requirements for making the board act). Holding: The mandate of the directors can only be altered under the machinery of the articles. The court will not force them to sell the assets. Reasoning: The directors general authority is limited by the extraordinary resolution provision. Therefore, if it is desired to alter the directors powers, it has to be done by such a 75% vote. The mandate which must be obeyed is not that of the majority, it is that of the whole entity made up of all the SH, as expressed through the articles. Concurrence: The articles are a K b/w the members of the company. The extraordinary resolution provision is a stipulation that cant be interfered with absent misconduct on the part of the directors. Notes: The board has the ability to block the sale unless 75% of SH approve (they dont). Although the board has the primary power to direct/manage the business and affairs of the corp. (DGCL 141), it rarely exercises nitty-gritty management power. Instead, it designates managers, or a chief executive officer who in turn nominates other officers for board confirmation. -But directors, acting as the board, have broad powers: appoint/compensate/remove officers, delegate authority to subcommittees of board/officers, declare and pay dividends, amend bylaws, initiate and approve certain extraordinary corporate actions (amendments to articles, mergers, sales of all assets, dissolutions), make major business decisions. -In default of special provisions in the charter, members of the board are elected to 1-year terms -Corp. statutes generally permit charters to create staggered boards, in which directors are divided into classes that stand for election in consecutive years (up to three classes under DGCL 141(d))

-Corporate directors are not legal agents of the corporation; governance power resides in the board (not in the individual directors sitting on it). Directors act as a board only at a duly constituted board meeting and by majority vote (unless charter requires supermajority vote on an issue). The insistence on meeting formally is an effort to discourage the manipulation of board decision making. -Critique: directors have little time to spend on their director duties (directors of some large corporations meet only a single day, 4-8 times a year). There is a gap b/w what boards are expected to accomplish and the time/knowledge available to them to do it. Directors are not legally considered to be agents; officers are the true agents of the corp. and are therefore subject to fiduciary duties. Generally, corporate charters empower the board to appoint officers and remove them with or w/o cause. The board usually has the power to delegate authority to officers as it sees fit. Jennings v. Pittsburgh Mercantile Co. (Pennsylvania 1964) Facts: Mercantile is a publicly held corp. with 400 SH, 9 directors, and a 3-member executive committee of directors. Egmore (Mercantiles VP, treasurer, corporate officer, and director), along with Stern (financial consultant), instruct Jennings to solicit offers for a sale and leaseback of its real property in order to raise money for modernization. Egmore tells Jennings that the executive committee he controls has the power to accept an offer, and he eventually accepts through Stern. But the board rejects. Jennings sues for his commission. Mercantile argues that Egmore did not have the authority to do the deal, so Mercantile is not bound. Jennings argues that Mercantile is bound through Egmores apparent authority. Holding: An agent cannot invest himself with apparent authority; it emanates from the actions of the principal, not the agent. There was no apparent authority here for Egmore to accept a sale offer. Reasoning: For Mercantile the proposed sale/leaseback was not a transaction in the ordinary course of business- it was unusual and unprecedented. So, the necessary apparent authority would be authority to enact an extraordinary transaction. Apparent authority = authority which, although not actually granted, the principal (1) knowingly permits the agent to exercise, or (2) holds him out as possessing. In order for a reasonable inference of the existence of apparent authority to be drawn from prior dealings, the dealings have to be similar to the act for which the principal is sought to be bound now, and also a degree of repetitiveness. But Egmores usual acts (mostly just soliciting offers) are dissimilar to this act (of accepting a sale offer), so we cant infer apparent authority to do this act from those other acts. Policy: dont want to extend the usual scope of authority which attaches to the holding of various corporate offices, or undercut the proper role of the board of directors in corporate decision-making. The extraordinary nature of this transaction placed Jennings on notice. Notes: The court doesnt want to undermine the authority structure of the corp. by letting individuals aggregate power. This fits in with the overall law of agency. The idea is that we dont want A going off doing something P doesnt want, so when A does, we dont hold P liable. We dont want to let individual officers bind the board b/c then board loses ability to manage and monitor the corp. However, this case creates a line-drawing problem. What if Egmore sat on the board, was the CEO, etc.? V. Debt, Equity, and Economic Value 1. Capital Structure Hierarchy of claims on a corporations cash flow (More Junior) Common Stock Equity Preferred Stock Equity Subordinated Debt Debt Bank Debt/Notes Debt (More Senior) Mortgage Debt (secured) Debt Capital structure = the mix of debt and equity claims that the corporation issues to finance itself.

Businesses can raise capital by selling two kinds of long-term legal claims to its assets: (1) debt (borrowing money), and (2) equity (selling ownership claims in the corporate entity). -Debt has more legal protection than equity- creditors have a contractual right to receive interest and to be repaid their principal at a stated maturity date. SH do not have any right to payment. But, SH have a right to vote and can expect to receive dividends (although only when board declares). We give SH the vote even though theyre the most junior claimants b/c they are incentivized to run the company efficiently and are the least protected by K or charter. Legal character of debt -A loan agreement allocates risks and responsibilities b/w the debtor and creditor, or among several classes of creditors -The advantage of debt/bonds (from investor perspective) is that the investor generally faces less risk as a creditor than as an equity holder b/c creditors have a legal right to periodic payment of a return (interest) and a priority claim over the SH on corporate assets in the event of corporate default. They can sue on K. Also, tax- interest paid by the borrower is a deductible cost of business when calculating taxable income, whereas no deduction is available for dividends/distributions paid to SH Legal character of equity -SH can vote to elect directors. Stock carries one vote per share (unless charter specifies otherwise). So equity has the right not to payment but to vote on certain important matters. Common stock possesses control rights in the form of the power to elect the board of directors. -After the company has paid expenses and paid interest to creditors, whatever is left over may be given out as dividends to SH. -Preferred stock is equity security on which the charter confers a special right/privilege/limitation. Generally it carries a stated dividend, but payable only when declared by the board (although sometimes if board doesnt declare dividends, preferred SH get voting rights also or even board seats, depending on the charter). It is less risky than common stock b/c it has preference over common stock in liquidation as well as dividends. 2. Basic Concepts of Valuation Four basic finance concepts: (1) time value of money, (2) risk and return, (3) systematic risk and diversification, and (4) capital market efficiency. (1) Time value of money the difference b/w having one sum today or the same sum at some future point. -Money is more valuable now because you can use it during the waiting period. -Present value = the value today of money to be paid at some future point. Example: if $1 in ten years is worth what 38.5 cents is worth today, 38.5 cents is the present value of receiving $1 in ten years. -Discount rate = the rate that is earned from renting money out for one year in the market for money; tells us how to calculate present value. Higher discount rates mean you have a lower present value. -Future value = value of what you presently have, in the future. FUTURE VALUE: FV = PV (1 + r)n (n = number of years) PRESENT VALUE: PV = FV / (1 + r)n ANNUAL RATE: r = (FV/PV)1/n 1 -Net present value: the present value of a project. Pay today and get returns later. The NPV discounts to present value both what youre paying now and the returns that will come in, and adds them up. Profitable projects have a positive NPV. (2) Risk and return -Expected return = weighted average of payouts = (total return x probability) added up for all possibilities -To calculate PV of an investment, discount the expected return. Even if two expected returns are the same, we consider one to be riskier if the payouts are more volatile. (10/20 vs. 5/25) -The additional amount that risk-averse investors demand for accepting higher-risk investments in the capital markets = the risk premium = the difference b/w the risk-adjusted rate and the risk-free rate

-Risk-adjusted rate = discount rate reflecting both the time discount value of money and the market price of the risk involved PV = expected return / (1 + risk premium + discount rate) (To get Net PV, take answer to above, and subtract costs/what youre putting in) -Why are investors risk averse? Declining marginal utility of wealth (losses hurt more than gains help); variable outcomes inflict large transaction costs (trying to K around the risk) (3) Diversification and systematic risk -If you invest in multiple risks instead of putting all your eggs in one basket, youre more likely to suffer both gains and losses and come out somewhere in the middle. The overall risk is lower. Investments are therefore packaged (diversified) to reduce risk. Since investors can hold portfolios, risky investments such as stock should be priced to reflect fact that investors neednt bear all the risk associated with holding that single investment. -But there is still some systematic risk- the risk of, for example, the entire economy going up or down. No amount of diversification can fully get rid of it. Risk-averse investors still demand premiums for it. (4) Capital market efficiency Efficient Capital Market Hypothesis: We should trust the market to value the assets of a corporation, incorporating all public information in pricing what the cash flows are worth. 3. Valuing Assets Discounted cash flow (DCF) valuation = predicting all future cash flows, and using a discount rate to bring those cash flows back to the present to yield a net present value Step 1: estimation of all future cash flows generated by the asset (can be uncertain) Step 2: calculate an appropriate discount rate (usually, calculate a weighted-average cost of capital, which is calculated as the weighted average of the cost of debt and the cost of equity, where the weights are the relative amounts of debt and equity in the capital structure) -A measure of systematic risk associated with securities: By looking at the trading history of the stock and how the stock price moves in relation to the stock market as a whole, some scholars believe that the amount of systemic risk in a stocks returns can be estimated (as a coefficient beta) -Efficient capital market hypothesis (ECMH)- see above section. We assume that stock market prices rapidly reflect all public information bearing on the expected value of individual stocks. Questions arising in real-world valuation proceedings how do courts treat the cost of equity and the relevance of the market price of stock for valuation purposes? In re Emerging Communications Inc. Shareholder Litigation (Delaware 2004) Facts: The primary defendant is the controlling SH, who was trying to justify the $10.25 per share that he paid to the minority SH in the company. The court tried to calculate the companys cost of equity. The issue became whether a premium was appropriate in these circumstances. Holding: The small firm/small stock premium was appropriate. The super-small firm premium and the hurricane risk premium were not. The stock market price merits little/no weight in valuing the stock. Reasoning: There is evidence that stocks of smaller companies are riskier than securities of large ones, and therefore command a higher expected rate of return in the market. This company is small, but is also a utility protected from the hazards of the marketplace; it is well-established and has no competition. The risk of unrecoverable hurricane damage is not so embedded in the companys business as to require a structural increase in the cost of equity. A more rational approach would be to factor the risk into the companys cash flow projections. Delaware law recognizes that, although market price should be considered in an appraisal, the market price of shares is not always indicative of fair value. Moreover, the record shows that the companys stock was not traded in an efficient market. VI. The Protection of Creditors

Corporate law protects creditors b/c the corporate feature of limited liability exacerbates traditional problems of creditor-debtor relationships. Two reasons- easier to misrepresent assets, and easier to move assets out of the corp. after getting a loan. Limited liability makes corps take more risks w/assets because the personal assets of the SH/directors/etc are protected from the creditors. -Most creditor protection comes in the form of K, but contracting is costly -So, we also have default provisions of law that protect all creditors regardless of their K mandatory disclosure requirements for corp. debtors, capital regulation (usually de minimis), standard-based duties. 1. Mandatory Disclosure This is seen as a solution to the problem of misrepresentation -Federal securities law imposes these requirements on public corporations -But, state law does not use these requirements much to protect closely held corporations (creditors can still ask for info, but corps are not required to disclose)

2. Capital Regulation (Ex Ante Restraints)

Examples of capital regulation: requiring investors to contribute a minimum amount of capital to the corp. and restricting the amount of capital that can be removed -These restrictions are usually de minimis and do not (should not) do the bulk of creditor protection Financial statements -Balance Sheet = represents financial picture of a business organization on one particular day -Limitation: entries reflect historical costs instead of current market values -Assets (property, goodwill, outstanding claims) and liabilities (debts payable to others) must always be in balance SH equity is what usually brings them into balance (is a plug figure) -SH equity divided into 3 parts: stated (legal) capital, capital surplus, and earned surplus (accumulated returned earnings) Stated capital: value that SH transferred to the corp. at time of original sale of stock to the original SH; not available for distribution; derived from par value of stock Capital surplus: excess capital when stock is sold for more than its par value Retained earnings: amount earned by the corp. but not distributed to SH as dividends -Income Statement = represents the results of the operation of the business over a specified period -Limitation: account of profit/loss doesnt reflect actual amount of cash made available to owners in the year- so the figure represented as net profit may not be same as $ available for distribution Distribution constraints = ex ante constraints- limits on what can be paid out -If you hold yourself out as having $X to creditors, law wants to make sure you keep that amount available for those creditors. These protections arent used much. Ex ante, we want to encourage creditors to protect themselves through K. Four main dividend tests used as constraints: (1) Stated capital distribution test (capital surplus test) (NY Business Corp. Law 510) You cant make a distribution that would impair stated capital or make you insolvent; you cant pay a dividend if you will be unable to pay debts as they become due; you must have a trust fund for creditors that you cant touch; you can only pay dividends out of surplus. This is not a real protection b/c the corp. can deplete stated capital down to 1 cent under state law (as long as approved by the SH). (2) Nimble dividends test (DGCL 170) Like New York test, but in addition to/instead of capital surplus, you can pay dividends out of your net profits in the current/preceding year; you can pay out if youre on an upward trajectory; board can transfer

stated capital associated w/no par stock into the surplus account. Not much protection for creditors here either b/c corp. can manipulate balance sheet to not reflect negative retained earnings. (3) Modified retained earnings test (CA Corp. Code 500) Two-part distribution test actually trying to protect creditors. Corp. can pay dividends either out of retained earnings or out of assets as long as assets remain 1.25 times greater than liabilities and current assets current liabilities. (4) Modern test (RMBCA 6.40) You cant make a distribution that would render the corp. insolvent; liabilities cannot > assets; corps may use the real economic value of the corp. under the rationale that the book value is too low. This tends to undermine creditor protection. Minimum capital & capital maintenance requirements- these are either truly minimal or nonexistent -Neither DGCL nor RMBCA has a minimum capital requirement -Not effective b/c even if corps cannot dip into minimum capital to pay SH, normal business activity can deplete the capital; also, the money is required when corp. is incorporated, and then it is immediately invested so no longer available to creditors Pros and cons of these requirements: (+) attempts to protects creditors and thereby opens up investment opportunities. (-) creditors can protect selves through K; the amount is arbitrary; it constrains investment opportunities- corps should be available to anyone w/o costing too much to start.

3. Standard-Based Duties (Ex Post Remedies)

These are the most important creditor protections in the U.S. Law imposes duties to protect interests of creditors- people subjected to these duties are directors, fellow creditors, and SH. -Give creditors some remedy after insolvency -Prof. K thinks the main theme is fraudulent conveyance law Director liability -Directors owe obligation to creditors not to render the firm unable to meet its obligations to creditors (e.g., by making distributions to SH) Uniform Fraudulent Transfers Act establishes the obligations -Delaware courts say that when a firm is insolvent (but not yet in bankruptcy proceedings), directors owe a duty to consider interests of corp. creditors (not just SH)- b/c SH incentives get skewed when the corp. is near insolvency Credit Lyonnais Bank Nederland v. Pathe Communications Corp. (Delaware 1991) Facts: The corp. began to go under. The board was presented with several offers that could give various results depending on whether they litigated and, if so, whether they won/lost. Holding: When near insolvency, board cannot consider SH welfare alone but should also consider the welfare of the community of interests constituting the corp. Reasoning: The possibility of insolvency skews incentives, exposing creditors to the risk of opportunistic behavior. Creditors would be in favor of accepting a settlement offer as long as it was more than what the corp. owed to the creditors (so the creditors could get all their money back). But, the SH would not want to accept a settlement offer barely above that amount b/c then after the corp. paid its debts they would be left with practically nothing. SH have diversified portfolios and so are more willing to accept the risk of litigation because the payout might be bigger (in which case they get $), but if the corp. loses they dont individually lose very much, while the creditors get screwed. Notes: As a matter of policy we always want to be maximizing the value of the corp. But here, maximizing the firm value does not maximize what the SH get. Three conflicting interests: SH, creditors, and firm as a whole. By making the board think about the creditors, we are making them think more about long-term value than short-term SH interests (even though their duty is usually with the SH).

Problems: knowing when youre near insolvency; conflicted director loyalties; overcompensation of creditors who have already charged high risk premiums *Note that there was a 2007 case, North American Catholic Educational Programming (also from Delaware) that specifically held that a solvent corp. operating in the zone of insolvency had to owe their primary duty to the SH. That contradicts the Credit Lyonnais holding. Fraudulent transfers -Obligation imposed on parties contracting with a (near-)insolvent debtor to give fair value for the cash or benefits they receive, or risk being forced to return those benefits to the debtor. -Prevent debtors from shifting assets to favored creditors or taking on new ones before going under -Designed to void transfers by a debtor that are made under circumstances unfair to creditors -Voids transfers made for the purpose of delaying, hindering, or defrauding creditors. Creditors can attack a transfer on two grounds (1) UFTA 4(a)(1), 7: present or future creditors may void transfers made with the actual intent to hinder, delay, or defraud any creditor of the debtor (2) UFTA 4(a)(2), 5(a)-(b): creditors may void transfers made w/o receiving a reasonably equivalent value if the debtor is left w/remaining assets unreasonably small in relation to its business or the debtor intended/believed/reasonably should have believed he would incur debts beyond his ability to pay as they became due or if debtor is insolvent after the transfer (see also U.S. Bankruptcy Code 548, 544(b)) Basically, this doctrine allows creditors to void transfers by establishing that they were either actual or constructive frauds on creditors. This doctrine is mostly used during bankruptcy proceedings. Example of a fraudulent conveyance: the leveraged buyouts of the 1980s. Corporations borrowed $, then bought back their public stock using their assets as collateral. (They basically traded equity for debt.) Existing creditors were hurt; case law came out both ways. The issues were whether the companies overpaid to retire their own stock and whether they were left with unreasonably small capital. -If the conveyance was fraudulent, who has to pay? In reality its usually the investment bankers to whom all the fees were paid (managers are typically judgment proof) We have to be mindful of the policy that we dont want to deter good transactions (no overdeterrence). Also, courts may have hindsight prejudice and arent specialists in these complicated transactions. Equitable subordination (SH Liability) -One of two doctrines (other one is veil piercing) in which SH may find selves liable to corporate creditors or have any loans they have made to the corp. subordinated to others creditors -Courts invoke this doctrine when they feel compelled to recharacterize debt owed by the corp. to its controlling SH as equity U.S. Bankruptcy Code 510(c)(1): permits subordination of a debt claim under principles of equitable subordination -This principle is usually invoked only in the bankruptcy context -Equitable subordination protects unaffiliated creditors by giving them rights to corp. assets superior to those of other creditors who happen to also be significant SH in the firm. (in other words, set aside claims of SH/other insiders until claims of outside creditors are satisfied) Q: when do we do this? At least two requirements to invoke this doctrine: (1) the creditor has to be an equity holder and typically an officer of the company (see subordination rule for partners claims against a partnership, UPA 40(b)), (2) the insider-creditor must have behaved unfairly or wrongly toward the corp. and its outside creditors. Policy: We dont want to subordinate as a default rule b/c it would further compromise limited liability, which we already do through veil piercing, and we dont want to discourage controlling SH to lend money to corps if they are in better position than third parties to make loans. Costello v. Fazio (9th Cir. 1958)

Facts: Three-member partnership; the 3 members made initial capital contributions soon after it was organized. Soon thereafter the partnership was incorporated and 2 of the partners withdrew a lot of their initial contributions by having the partnership issue them promissory notes. The business goes bankrupt and they try to recover their promissory notes. Holding: Claims of controlling SH will be deferred/subordinated where a corporation in bankruptcy has not been adequately or honestly capitalized or has been managed to the prejudice of creditors, or where to do otherwise would be unfair to creditors. These three loans are subordinated. Reasoning: As the trustee argues, if the partners are allowed to get at the assets in the same parity with general unsecured creditors, theyll get a portion of the capital that should be used to satisfy the claims of creditors before any capital investment can be returned to the owners/SH of the bankrupt co. Witnesses testified that at the time of incorporation, capitalization was inadequate; the company had little hope of financial success; the corporation needed all the money the partnership had before the capital was reduced; and the only reason they incorporated was to protect their personal interests. By acting for their own personal/private benefit, the partners hurt the corporation and its creditors. The loans fail the tests of being justifiable and being arms length bargains. Notes: The court seems harsh on these guys because of the intentional undercapitalization and the element of misrepresentation (dishonesty). The court might not have been so tough if it had just been a case of starting up an undercapitalized corporation. Here it looks more opportunistic at the expense of creditors to take money away. Could this case have been brought under UFTA 4? You could argue that it was a deliberate fraud on the creditors (4(a)), or that it left the corporation with unreasonably small capital (4(b)). However, unlike an LBO, where managers change other creditors equity into debt, here they are creating their own debt. Also, unlike an LBO, which deals with present creditors, here the transfer happened before credit. 4. Piercing the Corporate Veil Piercing the veil = the equitable power of the court to set aside the entity status of a corporation to hold its SH liable directly on K/tort obligations. Courts dont want to let the corporate form be exploited for fraud -The guidelines for veil piercing are vague, but courts use various factors (including but not limited to): Disregard of corporate formalities Mingling of corporate/personal interests Thin capitalization Small numbers of SH Active involvement by SH in management Tests usually consist of two components: (1) evidence of lack of separateness (the factors listed above), and (2) unfair/inequitable conduct (the wild card in these cases) -Courts usually dont pierce against public corporations, passive SH, minority SH, or if all formalities are followed and theres nothing funny going on with corporate accounts. Various formulations of the test: Lowendahl test (NY): veil-piercing requires complete SH domination and corp. wrongdoing that proximately causes creditor injury Van Dorn test (7th Cir, applied in Sea-Land): veil-piercing requires such unity of interest/ownership that the separate personalities of the corp. and the individual (or other corp.) cease to exist; and circumstances such that adherence to the fiction of separate corp. existence would sanction a fraud/promote injustice Laya test (applied in Kinney Shoe): requires unity of interest/ownership such that the separate personalities of the corp. and the individual SH no longer exist; and an inequitable result would occur if the acts were treated as those of the corp. alone, BUT if both prongs are satisfied, theres still a potential third prong- D can prevail by showing assumption of risk Sea-Land Services Inc. v. The Pepper Source (7th Cir. 1991)

Facts: Sea-Land wins a judgment against Pepper Source, but before the payment became due, Pepper lost all its assets it was dissolved for failure to pay taxes. Pepper is one of many corps owned by Marchese. Sea-Land wants to pierce the veil to get to Marchese, and then reverse-pierce to get to his other corps. Holding: Remanded to hear evidence on prong two of the Van Dorn test (injustice). Reasoning: The court applies the Van Dorn test (see above). In applying the first test, the court looks to four factors: failure to comply with corp. formalities, commingling of funds/assets, undercapitalization, and one corp. treating the assets of another corp. as its own. Pepper Source meets all these factors. All of Marcheses corporations are his playthings. He is the sole SH of most of them; none of the corps have ever held a single corporate meeting; they dont have articles or bylaws; he runs them all out of the same office; he borrows money from them to pay personal expenses; they borrow money from each other. Thus the first prong of the test is met. For the second prong, fraud or injustice has to be shown. SeaLand here is arguing injustice. Some courts look for unfairness, fraud, deception, or a compelling public interest. Some wrong beyond a creditors inability to collect must result (e.g., unjust enrichment, escape from liabilities, etc.). Sea-Land has not argued any wrong beyond its inability to collect so we have to remand to figure out whether there is such a wrong. Notes: On remand, the court found that Marchese had committed tax fraud (which is why there was no money to give Sea-Land), and the veil was pierced. Could Sea-Land have argued fraudulent conveyance as a wrong for the second prong? The court does seem to emphasize that injustice is about intent of parties, scheming to protect selves under umbrella of limited liability. Prof. K argues that this case was decided wrong and could have been decided under fraudulent transfer. Reverse piercing/substantive consolidation Why does Sea-Land want to reverse pierce? If they get Marcheses assets, that would include stock in those other corps. The thing is, that stock would be the lowest priority when trying to get the corp. assets. If they reverse pierce, they will be on equal footing with other creditors. Prof. K doesnt like reverse piercing b/c it tends to be unfair to the original creditors of the other corps. It qualifies the value of limited liability. As the book says, horizontal piercing makes the corporate form lose its utility as a device for asset partitioning and risk allocation. We want creditors of the other corps to be able to rely on what they think theyre dealing with- the assets of that one corp., not the liabilities of other brother-sister corps. It also hinders the development of internal capital markets that efficiently allocate capital within firms. On the other hand, courts strongly consider ex post fairness considerations. Kinney Shoe Corp. v. Polan (4th Cir. 1991) Facts: Kinney obtains a judgment against Industrial for $166K in unpaid rent, then sues Polan, the sole shareholder of Industrial, individually to collect. Polan owns both Industrial and Polan Industries (PI). Industrial had subleased part of the building it was renting from Kinney to PI. Polan signed both subleases on behalf of Industrial and PI. Neither Industrial nor PI ever held organizational meetings or elected officers. Other than the Kinney sublease, Industrial had no assets, income, or bank account; it issued no stock certificates b/c nothing was ever paid into it. The first rental payment to Kinney was paid out of Polans personal funds, and no further payments were made. Holding: The corporate veil is pierced. The first two prongs of the Laya test are met, and the court declines to apply the third in order to get an equitable result. Reasoning: Piercing the veil is an equitable remedy. A totality of the circumstances test is used in determining whether to pierce the corporate veil, and each case must be decided on its own facts. The Laya test starts with two prongs. (see above) Industrial was not adequately capitalized, and it did not observe any corporate formalities; this resulted in damage to Kinney. This combination of factors, under Laya, is sufficient to pierce the veil in order to hold the SH actively participating in the operation of the business personally liable for breach of K to the party who entered the K with the corp. Polan was just trying to use Industrial as a paper curtain intermediary between PI and Kinney, trying to limit liability. This is the classic veil-piercing scenario for an action to reach the responsible party. The third prong may apply in some cases: a party that is deemed to have assumed the risk of the gross undercapitalization will

not be permitted to pierce the veil. But this prong is permissive, not mandatory. Industrial was a shell. When nothing is invested in the corp., the corp. provides no protection (nothing in, nothing out). Notes: There was no fraud here. Under the Van Dorn test as applied in Sea-Land, there probably would not have been piercing. Here, the conduct is just seen as inequitable. The Laya test applied here seems more favorable to creditors than the Van Dorn test. Shouldnt Kinney have known better? The third prong was devised so as to account for sophisticated creditors that know about such risks. The court forgets this was a K between consenting business parties. In fact, we could even view this as opportunistic on Kinneys part. At the very least, Kinney was sloppy and probably in a hurry when entering into this lease and didnt do enough research re: Industrials assets. This was not a fraudulent conveyance b/c there was never any assets in Industrial in the first place. Studies show that there is much greater chance of veil piercing if there is misrepresentation going on. Fraudulent conveyance vs. veil piercing -Prof K argues that the veil should have been pierced in Sea-Land but not in Kinney. -Why does the law sometimes prefer veil piercing to fraudulent conveyance? From an administrative point of view, when there is a lot of mingling of assets, sometimes the only way to recover them is by piercing through to the personal assets. There is also some punitive aspect to veil piercing. Veil piercing on behalf of involuntary creditors The veil is less likely to be pierced for tort creditors than for K creditors. This seems backwards, as with K situations, there is often misrepresentation before the deal is struck; whereas in a tort situation, there is no ex ante contact between the parties at allthe creditor is just run over by a taxi, for example. Tort creditors do not rely on creditworthiness of a corp. when placing themselves in a position to suffer a loss. They cannot negotiate ex ante for contractual protections from risk. -General rule remains: thin capitalization alone is insufficient grounds for veil piercing. Walkovszky v. Carlton (New York 1966) Facts: P was injured when he was run down by a taxicab owned by the Seon Cab Corp. This is one of many corps, each owning only 1-2 cabs, that has Carlton (defendant) as a stockholder. Each one of these corps has only the minimum automobile liability insurance required by law. Although they seem to be independent, they are allegedly operated as one single entity w/regard to financing, supplies, repairs, employees, and garaging. All are named as defendants. Holding: The veil cannot be pierced to hold Carlton liable, only among the other cab companies. Funds were commingled among the cab companies, but not with Carltons personal assets. Reasoning: You can pierce the veil as to a SH (vertically pierce) when that person is using control of the corp. to further his own rather than the corp.s business. Here P is alleging that this corp. is a fragment of a larger corp. combine acting as one large business. Thats enough for horizontal piercing, but for vertical, would have to allege that the corp. is a dummy for its individual SH who are in reality carrying on the business in their personal capacities for purely personal rather than corporate ends. Here, it is not fraudulent for the owner of a single cab corp. to take out the minimum amount of insurance or for the enterprise to consist of many corps. The insurance issue- if the minimum amount isnt adequate, thats something to take up with the legislature. Dissent: These corps were intentionally undercapitalized for the purpose of avoiding responsibility for acts that were bound to happen. Income was drained out of the corps for the same purpose. The dissent emphasizes the public interest purpose of the corp. to argue that it should be held responsible. But it does make an exception for corps that are facing hard times. Notes: P really wants to get Carlton in this case because hes the only one with money. Even if P pierced the veil of all the other cab companies, P would get almost nothing b/c tort creditors are unsecured creditors at the bottom of the credit totem pole, and they cannot get a hold of the cabs or medallions. Its easier to pierce horizontally than vertically. To pierce vertically, you have to show use for personal gain. What P should do is show that Carltons individual personal funds are involved somehow.

-The book notes that if we regularly horizontally pierced in these situations, tort victims would not benefit, because that regime would favor true single-cab companies, which carry less insurance than large ones. Prof K doesnt buy this argument. He says other factors would operate to make sure there were still bigger cab companies (e.g., economies of scale); and also small companies might be safer. -This case basically lets corps use the corporate form as a cheap substitute for liability insurance. Carter-Jones Lumber Co. v. LTV Steel (6th Cir. 2001) Facts: Chain Corp. is an adequately capitalized corp. with a single SH (Denune), engaging in both legitimate and illegal business. It observes all legal formalities (annual meetings, no commingling of funds, but negative net worth). Denune is intimately involved in the illegal activities, selling transformers containing PCBs he controls the particular transactions that give rise to CERCLA violations/liability. Holding: The veil is pierced. Mere control can be sufficient to trigger veil-piercing. Reasoning: The court uses a three-prong test to determine if a SH is liable for the wrongdoing of the corp. of which he is an owner: (1) complete control over the corp., (2) use of that control to commit fraud or an illegal act, and (3) injury or unjust loss resulting from the control. In this case, there is no real argument about the second and third prongs. Denune wants the court to use a long list of factors to determine whether the corp. is his alter ego. But the court says that veil-piercing is an equitable remedy, so no list of factors can be exhaustive/exclusive; the court doesnt want to be straitjacketed by Denunes list in situations where equity demands that the fiction of corporate personhood be ignored. We dont want SH to get away with no liability for an illegal act when that SH controls the corp. w/regard to that act and harms third parties. Notes: The court here pierces the veil even though there is some degree of separateness because it perceives the injustice to be so bad. Successor liability Corp. dissolves, liquidating dividend paid out to SH, SH remain liable in for suits arising during the corp.s life -DGCL 278, 282: SH remain liable pro rata on their liquidating dividend for 3 years -RMBCA 14.07(c)(3): same as DGCL, provided that corp. published notice of its dissolution Successor corp. liability- in product lines (p.169) -SH can only escape long-term liability through dissolution by sacrificing the going-concern value and keep only the piecemeal liquidation value

5. Limited Liability in Tort- Can It Be Justified?

Limited liability in tort (-) creates incentives for excessive risk-taking by permitting corps to avoid full costs of their activities (+) secure efficient capital financing for corps Prof Ks article argues that limited liability in tort cannot be rationalized for either closely-held or publicly-traded corps. He argues there may be no persuasive reasons to prefer limited liability over a regime of unlimited pro rata SH liability for corporate torts. -Evidence indicates that increasing exposure to tort liability has led to the widespread reorganization of business firms to exploit limited liability to evade damage claims. -Limited liability creates incentives to mis-invest (spend too little on precautions to avoid accidents), encourages excessive entry and overinvestment in unusually hazardous industries, partially externalizes the marginal increase in tort damages, could also create incentive to minimize investment in order to reduce the exposure of the firms owner to tort damages -Proposed timing rule for publicly held corps: liability would attach to SH at the earliest of the following moments: (1) when tort claims in question were filed, (2) when corp.s management first became aware that claims would probably be filed, (3) when corp. dissolved w/o leaving a contractual successor

(Timing problem: conflict b/w administrative complexity and opportunities for evasion)- difficulty of enforcing Profs unlimited liability alternative Alternatives to limited/unlimited liability schemes: mandatory insurance for risky firms; imposing criminal penalties on those who take unreasonable risks; giving tort victims priority over other creditors VII. Normal Governance: The Voting System 1. Role and Limits of SH Voting -Discretion of centralized management is not absolute. -SH three default powers: right to vote, right to sell, and right to sue. -Most basic voting right: right to elect the board of directors. -Rest of normal governance machinery includes calling annual meetings, affording information to SH, voting by proxy, and removing directors from office. -Most important factor affecting SH voting: collective action problem: informed SH voting requires that some investment information be made by a very large # of SH. This would be collectively and individually costly. Any one SHs prospective share of the potential benefit that informed action might produce would probably not justify his personal costs. But also, any one SHs vote is unlikely to affect the outcome of the vote. So any one SH is likely to get the same proportionate share of any benefit no matter whether he invests in becoming informed or not. Economic incentive is to remain passive. (This doesnt really apply to a major SH whose vote is more likely to affect the outcome.) -1934 Securities and Exchange Act sought to empower SH through forced disclosure of info. Overview of the Voting System SH vote on three kinds of matters: (1) Election of directors (2) Organic/fundamental changes (mergers, sales of all assets, dissolutions, charter amendments) (3) SH resolutions. Each share has a holder of record named in the firms registry, as well as a beneficial owner, who actually owns the shares distribution and voting rights. -In close corps these are often the same parties -In public corps the HOR is likely to be Cede, which holds an omnibus share certificate; ordinary SH are beneficial owners at the end of a chain of intermediaries -Information travels DOWN, and proxies travel UP, the chain. Majority vs. plurality voting -If you object to a candidate, you can withhold your vote. If theres a plurality vote this will have little impact; if a majority vote is required, your withholding will matter more. -If SH want majority vote system, board cant overturn that decision (DGCL 216) Proxy system: if you cant attend the annual SH meeting, you can vote by empowering an agent (your proxy) to vote on your behalf. 99% of the time only management (the incumbent board) solicits proxies State law mandatory rules: almost all state statutes require an annual meeting for election of directors and establish quorum requirements State law default rules: all state statutes permit special meetings and action by written consent, though the default varies 2. Electing & Removing Directors Every corporation MUST have a board (even if only a single member) (DGCL 141(a)) and at least one class of voting stock.

-In the absence of customization in the charter, each share of stock has one vote. (DGCL 212(a)) -In public corps, most equity takes the form of voting common stock. -It almost always carries voting rights b/c the right to appoint the board is more valuable to common stock investors than to any other class of investors. They have a greater need than creditors for the default protection of voting rights b/c their security has no maturity date and no legal right to periodic payments. -Another mandatory feature of the voting system is annual election of directors. -Boards can be classified/staggered (same thing) -SH elect some fraction of the board annually, depending on how many classes of directors there are. (DGCL 141(d)- which also says you cant have more than 3 classes on a classified board in Delaware) -Staggered boards tend to entrench boards/manages in ways that deter [value-increasing] hostile takeovers. Staggered boards as takeover defense: delay problem (takes 1-2 years to gain board control); two election problem (no ability for hostile bidder to get an up-or-down vote on its bid at a single point in time) -Corp law facilities election of directors by creating a flexible framework for holding the annual meeting. -Quorum requirement (DGCL 216) -Minimum and maximum notice period (DGCL 222(b)) -Together these requirements prevent the incumbent board from manipulating so that only a small number of people can attend. Cumulative Voting -Usual voting regime is that each share gets one vote, which can be cast for each directorship (board position) that is to be filled at the election. This could in theory allow the holder of a 51% voting block to designate the complete membership of the board, but holder of 49% would be totally excluded. -Cumulative voting is designed to increase the possibility for minority SH representation. Each SH may case a total number of votes equal to the number of directors for whom he is entitled to vote, multiplied by the number of voting shares he owns, with the top overall vote getters getting seated on the board. Removing Directors -At common law, SH could remove a director only for cause -DGCL 141(k) confers broad removal powers on SH. -State law in all jurisdictions bars directors from removing fellow directors, for cause or otherwise, in the absence of express SH authorization (so board cant adopt bylaw authorizing them to do so). But note that SH can give authorization for this (e.g., NYBCL 706) -However, the board can petition a court to remove a director; any court supervising the performance of any fiduciary has inherent power to remove for cause -SH removal is more difficult when a board is classified. DGCL 141(k): when board is classified, directors can be removed only for cause unless charter provides otherwise. *But under 141(k) if board isnt staggered, director/board can be removed with OR without cause by majority of SH at an election -How to remove a board member for cause? call a special SH meeting and vote them out vote them out at annual meeting remove them by written consent (Del: majority; RMBCA: unanimous) -How to gain control of a board after gaining majority vote? (see: Unfireable CEO problem p.182) amending articles of incorporation (but DGCL 242- directors have to propose amendments, and only after that initiation can the SH vote on it) amending by-laws (DGCL 109- SH have inherent right to amend the by-laws; no one, including board, can divest them of that right)

 increasing size of board (but DGCL 223(a)(1)- board fills seats that SH vote to add; however, could amend by-laws to get around this, just a default provision) removing directors (but if board is classified, can only remove for cause; see above. Yet if the classification is in the bylaws, not charter, could amend bylaws and then vote to remove.) 3. SH Meetings & Alternatives What happens at the annual meeting: (DGCL 211) -Election of the board -Vote to remove directors -Vote to adopt SH resolutions to ratify board -Vote to adopt/amend/repeal bylaws actions or request board to take certain action Other things can be done if SH or directors call special meeting -Permit SH vote on fundamental transactions -Initiate action (amend bylaws, etc.) (in some juris.) Policy: letting SH call a special meeting over board objection? -Pro: more investor monitoring of management will lower agency costs and therefore cost of capital -Con: SH meetings are costly for public companies ($ and loss of time by senior execs) How can a SH meeting be called? -RMBCA 7.02: either board or 10% of SH can call a special meeting -DGCL 211(d): board can call a special meeting; SH do not have this power unless charter says so Action by written consent -Any action that may be taken at a SH meeting may also be taken by written consent of a majority of outstanding shares (DGCL 228) -By contrast, RMBCA 7.04(a) requires unanimous written consent 4. Proxy Voting & Its Costs Why proxy voting? SH meetings require a quorum to act. Most publicly financed corps have widely dispersed share ownership. SH are thus unlikely to actually attend SH meetings. In order to get a quorum, board and officers are permitted to collect voting authority from SH in form of proxies. -See DGCL 212(b) for legal structure -A proxy holder MUST exercise the proxy as directed, but on issues for which they have not received specific instruction, can exercise independent judgment -Proxies are revocable (unless holder has contracted for the proxy)- DGCL 212(e) -Costs of proxy voting: one or more people have to incur expenses of soliciting proxies -These expenses are not reimbursed unless insurgents are victorious in proxy fight -Proxy contests are unusual: management usually puts candidates forward. But, when they happen between insurgents and incumbents- gets expensive. Reimbursement rules can differ on 3 dimensions. (1) Amount (all/part/nothing?) (2) Conditionality (do you need to win to be reimbursed?) (3) Bias (favor incumbents/insurgents/ neither?) Rosenfeld v. Fairchild Engine & Airplane Corp. (New York 1955) Facts: During a proxy contest, incumbents spent $106,000 and reimbursed themselves from the company treasury. They spent an additional $28,000 that they were not able to reimburse themselves (because they lost). The victorious insurgents reimbursed the incumbents their $28,000, and additionally reimbursed themselves $127,000 after they got SH authorization to do so. (The SH were never asked to ratify the $28,000 paid to the old board.) An attorney owning 25 shares sued to force both sides to pay their expenses back to the corporation.

Holding: (majority rule) Management can get reimbursed from the business treasury for any reasonable expenses made during proxy contest, but insurgents get reimbursed only if they win and get ratification from SH. Reasoning: Mgmt can get reimbursed whether they win or lose because its a cost of operating the business. If they cant get reimbursed for soliciting proxies, the corp. business might be seriously interfered with b/c of SH indifference and the difficult of procuring a quorum. The directors need to be able to make expenditures for purpose of persuading SH of their position and soliciting support for policy they think (in good faith) is in the best interest of the corp. BUT if the $ is spent for personal power, individual gain, or private advantage, and not in believe that it was in the best interest of the SH/corp., they cant get their money back. Notes: Theres a bias in favor of incumbents. Their reimbursement is unconditional, whereas it is conditional for insurgents. If it was unconditional for insurgents, we would get strategic insurgents. Having reimbursement be unconditional means you only get serious insurgents. (Costs of proxy contests screens for quality- quality would decline under unconditional super Froessel rule) *Decision Tree Analysis under this majority rule (Froessel rule after judge who wrote this opinion)- this is how you answer the question of: how big does the gain to the corp. have to be for it to be worth a proxy contest (for the insurgent)? If insurgent wins, gets % of ownership, times (GAIN minus (the cost of his expense to wage the proxy contest plus mgmts expense to wage the proxy contest)) If insurgent loses, he loses (% of ownership times managements proxy expenses) minus money spent on the proxy that is not reimbursed 5. Class Voting The minority needs structural protection against exploitation by the majority. Class voting -A transaction subject to class voting means that a majority (or higher proportion, as fixed) of the votes in every class entitled to a separate class vote must approve the transaction for its authorization. -Can occur in normal governance context, and also in voting on fundamental transactions need to ensure that transaction is fair to SH in all subgroups (not just in aggregate) -Conferring class votes also gives every class a veto right -General idea (Policy): if a proposed charter amendment adversely affects the legal rights of a class of stock or disadvantages them in some other respect, then it should be adopted only w/concurrence of a majority of the voting power of that class voting separately -RMBCA 10.04 requires class vote whenever an amendment will change certain things (avoids argument re: whether change is adverse or beneficial) (compare DGCL 242(b)(2)) -RMBCA also protects economic and legal interests (i.e., SH can vote if amendment would create a new class of stock senior to theirs in terms of dividend preference); DGCL requires a separate vote only if amendment would alter legal rights of existing security (e.g. if you were increasing the number of shares in that class) -Note that these are default minimum voting requirements, and in DE for example the charter could provide for more voting rights for preferred stock (like if econ. interests affected) 6. SH Information Rights State corp. law leaves function of informing SH mostly to the market (not much mandatory) Federal law mandates extensive disclosure for publicly traded securities DGCL 220, RMBCA 16.02-03, NYBCL 624: SH have a right to inspect the companys books and records for a proper purpose -DGCL 220(b): a proper purpose means a purpose reasonably related to the persons interests as a stockholder

Requests for stock list and books and records treated differently Stock List: this list discloses the identity, ownership interests, and address of each registered owner of company stock. This is readily available to registered owners. Proper purpose for acquiring it is broadly construed, and once its shown, the court doesnt ask whether there are also other improper purposes. An order to produce this list may also require the company to furnish a NOBO list (nonobjecting beneficial owners). This is important for those who want to communicate directly with the real owners/voters of the stock. Inspection of books and records: a request for this places the legit interests of the corp. at risk. Also, meeting this request is more expensive than furnishing a stock list. It may jeopardize sensitive info. So, these requests are reviewed with care. DE: plaintiffs must carry burden of showing proper purposes; court screens out plaintiffs motives and consequences of granting the request. NY: balances value of SH interest to the info against the corp. interest in confidentiality. -Varying approaches DGCL 220(c): for books and records, burden is on plaintiff to show proper purpose; for SH list, burden is on corp. to show improper purpose RMBCA 16.02, 16.01(e): SH list, board minutes, SH meeting minutes, and accounting records if SH shows proper purpose NYBCL 624(a)-(e): statutory right to inspect key financial statements, stock list, SH meeting minutes if proper purpose; 624(f): catch-all for books and records General Time Corp. v. Talley Industries Inc. (Delaware 1968) Facts: Talley Industries makes demand for SH list under DGCL 220 to run a proxy contest against General Times board. Holding: SH is entitled to stock list if he seeks it for a purpose germane to his status as a SH. Reasoning: 220(c) prescribes that the burden of proof shall be upon the corp. to show that the SH desires the list for an improper purpose. There can be no question but that the desire to solicit proxies for a slate of directors in opposition to management is a purpose reasonably related to the SHs interest as a stockholder. Therefore it is proper. Any further or secondary purpose is irrelevant. Notes: This case shows how easy it is to get the SH list, at least in Delaware. 7. Separating Control from Cash Flow Rights Normally its good to have control and cash flow rights held by the same people so that managers are selected by the constituency w/the greatest interest in maximizing corporate value. BUT- sometimes this policy is frustrated. A corporations capital may be used to affect ownership and voting of its own shares. Circular Control Structures DGCL 160(c) -Its illegal for management to vote stock owned by the corporation (want to prevent boards from buying shares in the corp. to finance their own entrenchment). So, directors have to come up with a subsidiary or joint venture in which the company owns only a minority interest. (If the company has a majority interest in the subsidiary and then just uses that to vote, same effect also prohibited.) Structures designed to get around 160(c) are prohibited Speiser v. Baker (Delaware 1987) Facts: Theres a single operating business: Chem. Its SH fall into four classes: the public (40%), Speiser (10%), Baker (8%), and Health Med (42%). Health Med itself is owned by Chem, Speiser, and Baker. Chem, through a wholly owned subsidiary (Medallion), owns 95% of the equity of Health Medwhat Chem owns is an issue of Health Med convertible preferred stock which carries the right to only 9% of Health Meds vote, but if it were converted into common stock, it would be converted into 95% of Health Meds vote. At the moment, the preferred stock is not converted, and Speiser and Baker control Health

Med. If the stock was converted, Chem would control Med Baker and Speiser wouldnt be able to use their control of Med (through Chem) to vote on Chem under 160(c). Holding: The stock held by a corporate subsidiary may belong to the issuer (per 160(c)) and thus be prohibited from voting, even if the issuer does not hold a majority of voting shares of the subsidiary. Reasoning: 160(c) prohibits the voting of stock that belongs to the issuer AND prohibits the voting of the issuers stock when owned by another corporation if the issuer holds (directly or indirectly) a majority of the shares entitled to vote at an election of the directors of that second corporation. In its unconverted state, Chems holding of Med doesnt represent a majority of the voting power of Med, so no problem; BUT 160(c) may prohibit the voting of Meds Chem holdings anyway. 160(c)s prohibition has to do w/shares of its own capital stock belonging to the corporation. Policy: dangers are posed by structures that permit directors of a corp., by reason of their office, to control votes belonging to shares of the companys stock owned by the corp. itself or a nominee/agent of the corp. These structures deprive the true owners of the corporate enterprise of a portion of their voice in choosing who shall serve as directors in charge of the mgmt. Dont want to create a safe harbor for entrenchment schemes implemented thru subsidiaries. Notes: In this situation, its too much like Chem owns shares of itself. You cant get around 160(c) like this. *Court will construe 160(c) broadly. The threat of having the majority vote is just as bad as having the majority vote. Vote Buying Common law ban against separating voting rights from equity interest restriction on irrevocable proxies -Why? Attaching the vote to the equity interest ensures that an unnecessary agency cost will not come into vision; dont want interest party to buy votes BUT vote buying may be okay in DE if there is sufficient independent review and it is in the best interests of the SH Schreiber v. Carney (Delaware 1982) Facts: Jet has 35% stake (effective veto power) in Texas International. Theres a proposed merger between TI and Texas Air. Jet threatens to block the merger unless it can exercise warrants it holds in TI before the merger. Jet claims that it lacks the funds necessary to exercise the warrants, so TI loans them the money. The directors of TI unanimously approve the loan and submit it to the SH for approval. The SH vote in favor of the proposal. A SH in TI challenges the propriety of the loan as vote-buying/waste. Holding: Buying votes is voidable but not void. Each agreement to transfer voting rights w/o transfer of ownership must be examined in light of its object or purpose. (Purpose to defraud/disenfranchise agreement is illegal) This case: not void. (Voidability cured by SH approval) Reasoning: There are two questions: (1) was this vote buying? (2) is vote buying illegal per se? Answers: (1) YES. Vote buying is simply a voting agreement supported by consideration personal to the SH, whereby the SH divorces his discretionary voting power and votes as directed by the offeror. Here TI purchased/removed the obstacle of Jets opposition. (2) NOT necessarily. Old cases say that vote buying is illegal per se if its object is to defraud/disenfranchise the other SH. Policy of not wanting this to happen: potential injury/prejudicial impact which might flow to other SH b/c of the agreement. However, in this case, the agreement was entered into to further interests of TIs other SH. (In fact, they voted in favor of it.) So the rationale for the argument that vote buying is illegal per se ceases to exist when measured against the undisputed reason for the transaction. In fact, vote buying can be practical in widely dispersed corps. We just need a test for fairness. Notes: The low-interest loan to Jet is like a gift/bribe to Jet for its vote (in favor of the merger). If there were no warrants, and Jet just owned a class of preferred stock and wanted to block the merger for whatever reason- would probably be OK as long as SH approved (under this case). Controlling minority structures all entrench minority control and can be used in principle to separate cash flow from control rights

(1) Dual class equity structures -High vote and low vote stock (2+ classes w/differential voting rights) -Designed to get high vote shares in the hands of insiders/mgmt and keep low vote shares among public (can compensate low vote shares with higher dividend if you want) -You cant take an outstanding class of stock and divide it into dual classes of voting, but you can issue new classes of low/no vote stock. -Corp law of some jurisdictions restricts voting ratio b/w high/low vote shares, etc. (2) Stock pyramids -Controller owns 51% of A, which owns 51% of B, which owns 51% of C this minority investor controls C with only about 13% of its cash flow rights. -We tax these, so we dont have too many of them (3) Cross ownership -Voting rights used to control the corporate group are distributed over the entire group rather than concentrated in the hands of a single company/SH (horizontal cross-holding) -Also not popular b/c we impose a tax on transfers b/w corporations 8. Collective Action Problem Problem associated w/widely held firms- rational apathy- SH dont have much in it for them; free rider problem (small SH piggyback on efforts of large SH) -More concentrated shareholding institutional investors have more involvement in corporate governance -More collective action would be possible if institutional investors were less diversified SEC rules (including proxy rules) were relaxed (1992 amendments helped) 9. Federal Proxy Rules *Rules on proxy voting Securities Exchange Act of 1934, 14(a)-(c) all public companies subject to regulation under 14a Four major elements of the proxy rules: (1) Disclosure requirements (to protect SH from misleading communications) (2) Regulation of process of soliciting proxies from SH (3) Town meeting provision (14a-8) permitting SH access to corp.s proxy materials (lets SH piggyback on mgmts proxy statements instead of having to do them themselves) (4) Antifraud provision (14a-9) allowing courts to imply private SH remedy for false/misleading proxy materials **QUESTIONS** Is it a proxy that is governed by the rules? 14a-1, 14a-2 Is it a regulated solicitation that requires filing of proxy statement? 14a-2 Do they still have to file under 14a-6(g) b/c they own 1% or $5 million? If they must file, did they enclose critical info w/ the proxy materials? Were they justified in waiting until they send out the cards to give to SEC and SH under 14a-12? (Ask: is this a proxy solicitation falling under 14a-1? If so, you may have to file a proxy statement unless youre exempted under 14a-2. Possible exemptions: SH cutoff; SH communication w/o intent to seek proxy. Even if exempt, still have to file if meet 14a-6(g).) Rules 14a-1 through 14a-7: Disclosure & SH communication -Unlawful for any person (in contravention of any rule) to solicit any proxy to vote any security registered under 12 of the Act

-Regulation 14A defines these terms broadly -The regulation states the types of info that any person has to provide when seeking a proxy to votedesigned to force disclosure by corps to SH -Had consequence of discouraging proxy fights amendments in 1992 -Limited solicitation in Rule 14a-1(l), created new exemptions in 14a-2 (releasing institutional SH from requirement to file disclosure form before communicating w/other SH) THE RULES: -14a-3: central regulatory requirement: No one may be solicited for a proxy unless they are furnished with a proxy statement containing the info specified in Schedule 14A (unless exempt under 14a-2) -raises question of what is a proxy and a solicitation -14a-1 defines: proxy; can be any solicitation or consent whatsoever (very broad/expansive) -14a-1(l)(iii): solicitation: any communication reasonably calculated to result in securement of a proxy -Studebaker v. Gittlin: mere attempt to get authorization from SH to inspect SH list considered a solicitation of a proxy under 14a-1 -14a-2 exempts 14a-2(b)(2): exemption for solicitations to <10 SH; 14a-2(b)(1) exemption for ordinary SH who wish to communicate w/other SH but do not themselves intend to seek proxies (careful w/this one- if you do this but then later do solicit proxies, your original memo/communication is not exempt- better just to file); 14a-1(l)(2)(iv) exemption for SH announcements on how they intend to vote -14a-4, 14a-5: regulate form of proxy (the actual vote itself) and the proxy statement -14a-6 formal filing requirements -14a-7 list-or-mail rule Short Slate Problem -Short slate: putting up for election less than the full # of directors (e.g. nominating 3 of 9) -Pre-1992 rule: Bona Fide Nominee Rule: you could solicit proxies for your own short slate, but could not fill out the remainder of the positions w/mgmt nominees. Problem: the way the votes fell out, your short slate would almost always lose (your supporters would vote for random assortment of mgmt nominees that would end up getting more votes) -New rule: you can solicit proxies for your own nominees, plus the mgmt nominees that you select. You can run a targeted campaign. Rule 14a-8: SH Proposals -Town meeting rule: entitles SH to include certain proposals in the companys proxy materials PROS: from prospective of SH, has advantage of low costs (can advance a proposal for vote by fellow SH w/o filing w/the SEC or mailing own materials out to SH) CONS: from perspective of corp. mgmt, can be a costly annoyance or even an infringement on mgmts autonomy (want proxy statements to be concise/intelligible, want to control content of communications) -Requirements: must hold $2000 or 1% of corps stock for a year ((b)(1)); must file w/mgmt 120 days before mgmt plans to release proxy statement ((e)(2)); proposal may not exceed 500 words (d); and proposal must not run afoul of subject matter restrictions -13 grounds for excluding proposals from companys solicitation materials: 14a-8(i); burden is on the company to demonstrate grounds for exclusion (g) (Most impt: if relates to ordinary matter of business) -Companies that wish to exclude a SH proposal seek SEC approval (called a no-action letter- meaning that the SEC will not recommend disciplinary action against company if proposal is omitted) -Most 14a-8 proposals fall into 2 categories: deal w/corp. governance or social responsibility Corp. governance proposals: when SH want to enact bylaws limiting range of options open to board in managing the firm (though has to be proper subject of SH action) or imposing structural

reforms on the board (e.g., changing director elections to majority rather than plurality vote). SEC encourages SH to frame these resolutions in precatory form (as recommendations to the board for adoption)- sidestep Qs re: scope of SH authority under state law Corp. social responsibility proposals: mgmt allowed to exclude matters falling w/in ordinary business of the corp. (14a-8(i)(7)); SEC has waffled on social responsibility proposals; now decided on a case-by-case basis after the Cracker Barrel litigation (not automatically excluded; have to include proposals that SH believe are important)- courts look at the subject matter of the proposal (fundamental mgmt tasks?) and degree to which attempt to micro-manage the company (matters too complex for SH as a group to make informed judgment on?) Rule 14a-9: Antifraud Rule -No false/misleading proxy solicitations -Was enforced by SEC but Borak (1964) SCOTUS gave private right of action- became more like a tort statute w/a common law test -Elements of the right: (1) Materiality (if theres a substantial likelihood that a reasonable SH would consider it important in deciding how to vote) (see VA Bankshares) (2) Culpability (varies; can be negligence standard, or requirement of scienter) (3) Causation and reliance (need not prove actual reliance- causation presumed if misrepresentation is material and proxy solicitation was an essential link the in accomplishment of the transaction) (see VA Bankshares) (4) Remedies (injunctive relief, rescission, or monetary damages) Virginia Bankshares, Inc. v. Sandberg (Supreme Court 1990) Facts: FABI (bank holding company) began a freeze-out merger, in which Bank eventually merged into VA Bankshares (VBI), a wholly owned subsidiary of FABI. VBI owned 85% of Banks shares, the remaining 15% in hands of 2000 minority SH. A banking firm told the Bank that $42 a share would be a fair price for the minority stock; the executive committee approved the merger proposal at that price, and full board followed suit. The directors solicited proxies for voting on the proposal at the annual meeting. Directors said they approved the plan b/c of its opportunity for the minority SH to achieve a high value, which they elsewhere described as a fair price for their stock. One of the minority SH challenged this. Holding: The minority SH lose no essential link (causation) b/c minority SH would not have been able to stop the transaction anyway. Reasoning: P alleges that directors had not believed that the price offered was high/that terms were fair. D argues that statements of opinion/belief incorporating indefinite/unverifiable expressions cannot be actionable under 14a-9. First the court considers the actionability per se of statements of reasons, opinion or belief. These statements may be material; BUT next the court considers whether they are statements w/respect to material facts to fall within 14a-9? These statements are factual in two senses: 1, as statements that the directors act for the reasons given or hold the belief stated, or 2, as statements about the subject matter of the reason/belief expressed. Its ok to allow recovery on an allegation that an opinion (like this one: high/fair price) is misleading as long as there is objective evidence of being misleading. But the problem here for P is the causation element. Causation can only be established by showing that the proxy solicitation is an essential link in the accomplishment of the transaction. The ill will theory is too speculative; there was no loss of a state right of action. Concurrence: Concerned about preserving the right of action. We cant presume that a majority SH will always vote in favor of the proposal even if the transaction is unfair to minority SH. Minority SH that have no power to vote down a transaction are the most in need of protection. Notes: There was no requirement here that proxies be solicited- VBI had 85% of the shares so could vote the merger through regardless. So why does Bank try to solicit votes from remaining 15%? Avoid bad press; gives some litigation protection if you have disinterested SH voting for your proposal (less grounds for suit for breach of fiduciary duty). Was this case decided correctly?

YES (Souter): Administrability concerns (dont want too many lawsuits); dont want to have to rely on hypothetical evidence (need to show that transaction would have gone through); federalism concerns (dont want to use 14a-9 to take away state concern- fiduciary duties) NO (Kraakman): Ill will theory (merger might not have gone through b/c of desire to avoid bad SH or public relations); proxy statement essential link b/c was the means to satisfy a state statutory requirement of minority SH approval; minorities need disclosure- voting isnt the only way to block a proposal (also can use court action, negotiation of price increase, etc.) 10. State Disclosure Law: Fiduciary Duty of Candor -Traditional state law: little regulation of proxy solicitation by mgmt. -Now, w/gradual disappearance of substantive regulation, importance of fiduciary duties is growing -DE: a controlling SH making a cash tender offer for stock held by minority SH has a fiduciary duty to make full disclosure of all germane facts (later this principle was also applied to corporate directors, and to proxy solicitations, not just tender offers) VIII. Normal Governance: Duty of Care DUTY OF CARE: reaches every aspect of an officers/directors conduct -Requires them to act with the care of an ordinarily prudent person in the same or similar circumstances -Law insulates D&O from liability based on negligence (as opposed to knowing misconduct) in order to avoid inducing risk-averse management of the firm -With all the protections under the law, duty of care is more aspirational than a source of liability Framework for D&O Liability Business Judgment Rule (RMBCA 8.21(a)(2))- presumes duty of care standard has been met Waiver of liability (DGCL 102(b)(7))- 90% of DE companies eliminate D&O liability for duty of care violations Indemnification (DGCL 145(a))- may indemnify for D&O actions in good faith D&O Insurance (DGCL 145(g))- corp. can buy D&O insurance whether or not the corp. would have the power to indemnify the D&O against such liability Reimbursement of legal expenses (DGCL 145(c))- even if not in good faith, success in a legal action requires indemnification for legal expenses 1. Need to Mitigate Director Risk Aversion -Duty to act as a reasonable person would in overseeing operations -Its no excuse/defense to say that you got no benefit from what you did -ALIs Principles of Corp. Governance (4.01(a)) say that a D/O is required to perform his functions: (1) in good faith (2) in a manner that he reasonably believes to be in best interests of the corp. (3) w/the care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances BUT not just a normal negligence rule: D&O invest other peoples money. They bear the full costs of any personal liability, but receive only a small fraction of the gains of a risky decision. Liability under a negligence standard would discourage D&O from undertaking valuable but risky projects. Gagliardi v. Trifoods International, Inc. (Delaware 1996)

Facts: SH bring an action against the directors of Trifoods. The question is: what must a SH plead in order to state a derivative claim to recover corporate losses allegedly sustained by reason of mismanagement unaffected by directly conflicting financial interests? Holding: In the absence of self-dealing or improper motive, a D/O is not legally responsible to the corporation for losses suffered as a result of a decision that the D/O made/authorized in good faith. Reasoning: SH can diversify the risks of their investments; they dont want directors to be risk averse. Directors, however, enjoy only a small % of any gains earned on risky investment projects, whereas their liability would be joint/several for a loss. So it is in the SH interest to offer protection to D&O from liability for negligence. We want them to face no risk of liability for loss as long as they act in good faith and meet minimal proceduralist standards of attention. The most important protection is the BJR. Notes: The law protects corp. officers and directors from liability for breach of duty of care in many ways- some statutory and some judicial. 2. Statutory Techniques for Limiting D&O Risk Exposure Indemnification -Most statutes prescribe mandatory indemnification rights for D&O and allow an even broader range of elective indemnification rights -Generally allow reimbursement of agents, employees, officers, directors for reasonable expenses for losses of any sort (attorneys fees, investigation fees, settlement amounts, and in some instances judgments) arising from judicial proceedings/investigations -Only limits: the losses must result from actions undertaken on behalf of the corporation in good faith, and cannot arise from criminal conviction -DGCL 145(a), (b), (c) Waltuch v. Conticommodity Services, Inc. (2nd Cir. 1996) Facts: Waltuch (silver trader) worked for Conticommodity. He spent $2.2 million in un-reimbursed legal fees to defend himself against numerous civil lawsuits and an enforcement proceeding. All of the civil suits eventually settled and were dismissed with prejudice; Waltuch himself was dismissed from the suits w/no settlement contribution. The enforcement proceeding was also settled and he paid a penalty. He seeks indemnification of his legal expenses from his former employer. Holding: He can be reimbursed b/c he was successful in his legal action, in the sense that he escaped from an adverse judgment. Reasoning: Waltuch makes two arguments. The first one fails, but the second is successful. The first argument is that 145(f) allows a corp. to grant indemnification outside the limits of 145(a), and that Conti did this with Article 9 of its articles. Article 9 contains no good faith requirement. A corps grant of indemnification rights, however, cannot be inconsistent w/the substantive statutory provisions of 145, notwithstanding 145(f). 145(f) allows the corp. to grant additional rights but does not speak in terms of corporate power- does not free corp. from good faith limit in 145(a) and (b). Article 9 is inconsistent with 145(a) so it exceeds the scope of a corp. to indemnify. However, 145(c) affirmatively requires corps to indemnify for successful defense of certain claims. Success/vindication doesnt mean moral exoneration, it just means escape from an adverse judgment. Here Waltuch didnt have to pay anything. The court doesnt ask why the particular result was reached. D&O Insurance -Provisions authorize corps to pay premia on D&O liability insurance (RMBCA 8.57, DGCL 145(f)) -Reasons to have corporate (not individual) insurance: -Insurance could be cheaper if company acts as central bargaining agent for all its D&O -Uniformity standardizes individual risk profiles -Tax law favors firm-wide coverage (D&O insurance is deductible) -D&O might under-invest in insurance if left to themselves

3. Judicial Protection: The Business Judgment Rule Different in every state, but core idea is: courts should not second-guess good-faith decisions made by independent and disinterested directors courts will not decide whether the decisions of corporate boards are either substantively reasonable (by reasonable person test) or sufficiently well-informed BJR see ALI 4.01(c) duty fulfilled if the director: (1) is disinterested in the subject of the business judgment (test: no conflict of interest/loyalty) (2) is informed with respect to the subject of the judgment to the extent he believes is reasonable under the circumstances (test: gross negligence) (3) rationally believes the judgment was in the best interest of the corp. (good faith) How the rule works: P has to prove disloyalty or gross negligence; if does so, burden shifts onto board member to prove entire fairness of the transaction BJR is a rebuttable presumption in favor of director discretion Note that it only comes into play when there is an actual judgment (i.e., not when remain passive) Rationales for the BJR -Institutional competence: courts not competent to make ex post second guesses -Agency problems: without it, directors would be too risk-averse -Allocation of power in corp.: want power to stay with directors, not SH (not risk-averse enough) Kamin v. American Express Co. (New York 1976) Facts: In 1972 AmEx acquired about 2 million shares of DLJ common stock for about $30 million. By 1976 theyre worth only $4 million. AmEx declares a special dividend to all SH distributing the DLJ shares in kind. Two SH file suit to enjoin the distribution, or for monetary damages, claiming waste of corporate assets b/c AmEx could sell the DLJ shares and use the capital loss to offset capital gains, which allegedly would have resulted in a net tax savings of $8 million. Defendant directors claim that possibility was considered but rejected due to negative impact on accounting profits. Holding: Mere errors of judgment (absent fraud/self-dealing/bad faith) are not sufficient as grounds for equity interference by the courts. Reasoning: Courts wont interfere unless the powers have been illegally or unconscientiously executed; or if the acts were fraudulent or collusive and destructive of the rights of SH. Powers of those entrusted with corporate mgmt are largely discretionary. The question of whether or not a dividend is to be declared or a distribution of some kind should be made is exclusively a matter of business judgment for the board. The SH cannot question the directors decision as long as they act in good faith. More than imprudence or mistaken judgment must be shown. Here, the directors considered alternatives. Theres no claim of self-dealing. Notes: The directors argue this wasnt corporate waste b/c if they had to show the proposed sale on their income statements, the price of their stock would drop. Note that rationally (prong 3 of ALI test) is a lower standard than reasonably. Duty of Care in Takeover Cases Smith v. Van Gorkom (mentioned in greater detail later) (Delaware 1985) Facts: Trans Union is a publicly held company with net operating losses and a CEO (Van Gorkom) who wants to retire. Stock is selling for $35/share. Acting mostly on his own, Van Gorkom arranges a sale to Pritzker for $55/share, cash. Van Gorkom calls a special meeting of the board but gives them no agenda beforehand. Board approves merger after 2-hour meeting. Trans Union SH sues, claiming breach of duty of care. No allegation of conflict of interest, but claim that board did not act in informed manner. Holding: Directors were grossly negligent and thus breached duty of care.

Notes: The first DE case to actually hold directors liable for breach of duty of care in a case in which the board had made a business decision. It led to an immediate revision of statutory law Additional statutory protection: authorization for charter provisions waiving liability -Enactment, after Smith v. Van Gorkom, of DGCL 102(b)(7): validating charter amendments that provide that a director has no liability for losses caused by transactions in which the director had no conflicting financial interest or otherwise was alleged to violate a duty of loyalty -Most states have followed Delaware and enacted similar statutes -This is a waiver only of monetary damages you can still go after an injunction -It cuts down lawsuits in which Ps only theory is a negligence theory -Differs from insurance b/c insurance allows P to get some recovery, whereas the waiver lets P get nothing so it cuts down on lawsuits 4. Delawares Approach to Due Care Claims Against Directors -102(b)(7) waivers are directed only to damages claims; duty of care can still be the basis for an equitable order (e.g., injunctions) Cede v. Technicolor, Inc. (Delaware 1993) Facts: Technicolor CEO negotiated with takeover artist Perelman to sell Technicolor to Perelman for $23/share, representing a 100% premium over the pre-bid share price. The disinterested board is incredibly casual (a la Van Gorkom, above) in approving the transaction. The board gets no credible valuation, the company is not shopped to other potential buyers, etc. In the appraisal proceeding, Chancellor Allen finds that the value of Technicolor stock at the date of the merger is $21.60/share. Nevertheless, SH sue Technicolor directors, claiming breach of duty of care. Holding: Proof of injury is not required to rebut the BJR if there is a breach of the duty of care. Gross negligence w/respect to process is sufficient to put burden on directors to show entire fairness. However, gross negligence doesnt mean the substance was unfair you can have gross negligence and entire fairness. Notes: This case has the effect of increasing director liability exposure. Some issue re: remedy compensatory vs. rescissory damages Interactions b/w Technicolor and 102(b)(7) -When can a case be dismissed? Under a gross negligence standard, court would allow early dismissal, but notwithstanding the 102(b)(7) issue, the entire fairness question would prevent early dismissal. Emerald Partners v. Berlin (Delaware 2001) Facts: Hall (CEO/controlling SH of May) proposes a roll-up in which May would acquire 13 of his companies. Mays independent directors approve, but a minority SH, Emerald Partners, alleges the deal is unfair. Hall goes bankrupt. Can the suit proceed against Mays directors? Holding: When entire fairness is the applicable standard of judicial review, injury or damages becomes a proper focus only after a transaction is determined not to be entirely fair. 102(b)(7) only becomes a proper focus of judicial scrutiny after the directors potential personal liability has been established. Notes: A complaint must allege a breach of the duty of loyalty to survive a motion to dismiss if the company has a 102(b)(7) provision in its charter. 5. Boards Duty to Monitor Losses Caused by Board Passivity If no decision made no BJR protection. -Why? Directors incentives are less likely to be distorted by liability imposed for passive violations of the standard of care than for liability imposed for erroneous decisions.

-Boards of public companies have a particular obligation to monitor their firms financial performance, the integrity of its financial reporting, its compliance w/the law, its management compensation, and its succession planning. The board must monitor largely through the reports of others. Francis v. United Jersey Bank (New Jersey 1981) Facts: P&B is a family reinsurance firm with four directors: Charles Pritchard Sr., Mrs. Pritchard, and their two sons. How it works: primary insurer writes policy, and lays off risk to reinsurers through brokers like P&B, who move premia payments from primary insurers to reinsurers. Charles Sr. starts comingling accounts and making shareholder loans. After he dies, the two sons continue making shareholder loans but no longer pay them back. Firm eventually goes bankrupt. Bankruptcy trustee brings suit against Mrs. Pritchard (and eventually her estate) for breach of duty of care. Mrs. Pritchard was not active in the business and knew virtually nothing of its corporate affairs. She didnt attend any meetings or read the books Holding: By virtue of a directorship, one has the power and responsibility to prevent losses and to deter depredation of other insiders. If the losses arent prevented, the duty is breached. Mrs. Pritchard loses. Reasoning: As a general rule, a director should acquire at least a rudimentary understanding of the business of the corp. So, a director should become familiar w/the fundamentals of the business in which the corp. is engaged. Because directors are bound to exercise ordinary care, they cannot set up as a defense lack of the knowledge needed to exercise the requisite degree of care. There is a continuing obligation to keep informed. Directors are only immune from liability if, in good faith, they rely upon the opinion of counsel for the corp. or upon written reports setting out financial data concerning the corp. and prepared by an independent public accountant, or upon financial statements/books/reports of the corp. Yet the review of financial statements may give rise to a further duty to inquire into matters revealed by those statements. If statements reveal illegal course of action, a director has a duty to object and, if the corp. does nothing to correct the conduct, to resign. Analysis in cases of negligent omissions calls for determination of the reasonable steps a director should have taken and whether those steps would have averted the loss. Causation may be inferred where you can conclude that the failure to act would produce a particular result, and that result has followed. Notes: This case reflects the majority view that there is a minimum objective standard of care for directors- that directors cannot abandon their office but must make a good-faith attempt to do a proper job. HYPO: what if she had read the financial statements and realized what was going on but her sons told her not to worry about it, theyd fix the situation? She would then be considered on notice and would have a duty to either make sure the conduct ended or resign. Graham v. Allis-Chalmers Manufacturing Co. (Delaware 1963) Facts: Allis-Chalmers is a large, decentralized manufacturer of electrical equipment. In 1937 it entered into a consent decree w/ the FTC to stop fixing prices. In the late 1950s, Allis-Chalmers and four midlevel managers pled guilty to price-fixing charges, and the company paid big fines. SH brought a derivative suit against directors and top officers to recover fines on behalf of the corp. Ps theory is that directors breached their duty of care in failing to install controls to prevent the violations. Holding: Absent cause for suspicion (a red flag), there is no duty upon directors to ferret out wrongdoing which they have no reason to suspect exists. Directors win. Reasoning: Knowledge of the consent decrees from 1937 (by 3 directors) did not put the board on notice of the possibility of future illegal price fixing. Directors are entitled to rely on the honesty and integrity of their subordinates until something occurs to them on suspicion that something is wrong. The analysis depends on the circumstances. Notes: The Caremark case might make us question this decision. Policy in favor of this decision: we dont want to induce excessive monitoring by the board, which is most cases is a waste of time- they should focus on more fruitful efforts Policy against this decision: ignores the question of whether the corp. created circumstances that encouraged price-fixing arrangements by way of its corporate structure

-What would a sufficient red flag be? There was a case where it was enough notice when the FDA repeatedly served notice of safety violations at one of a companys divisions Beam v. Martha Stewart (Delaware 2003) Facts: Martha Stewart is chair and CEO of her own company, MSO (she has 94.5% of control rights, 45% of cash flow rights dual class equity). She allegedly trades on inside information about the stock of another company, a biotech firm. After allegations surface and prosecution begins, MSO loses 90% of its market value. Are MSOs other directors liable for failing to ensure that Martha conducted her personal affairs in a manner that would not harm her company? Holding: The board had no duty to monitor Stewarts personal affairs. Reasoning: The company is closely identified with Stewart, but it doesnt follow that the board is required to monitor or control the way she handles her personal affairs. Graham doesnt apply for two reasons: (1) there was no red flag, and (2) that case refers to wrongdoing by the corporation. Stewart is not the corp., no matter how closely aligned with it she is. It is unreasonable to impose a duty of monitoring her personal affairs b/c it would be neither legitimate nor feasible. Notes: If you have a compliance program in effect, youd be shielded from these penalties. So it seems like a corp. would be stupid not to have one. In re Michael Marchese (SEC enforcement action, 2003) Facts: Chancellor Corp. acquired MRB in 1999, but CEO and other officers forged documents showing the transaction taking place in August 1998 in order to consolidate MRB earnings a year earlier. Audit committee members Marchese and Peselman received a report from an outside auditor challenging 1998 acquisition date, but did not follow up. New auditors signed off on the 1998 acquisition date. Marchese certified 1998 date, but resigned from the board in 1999 and expressed concerns to the SEC. Holding: He settled (paid fines) for recklessly ignoring signs pointing to improper accounting treatment. Reasoning: He had knowledge of the disagreement over the dates; he was on notice that there may have been a problem; yet he took no action, recklessly failing to make any inquiry into the circumstances. Basically, lack of action is seen as reckless here. Sometimes, lapses of statutory/administrative standards of business conduct are treated as criminal matters e.g., under environmental statutes -U.S. Sentencing Commission adopted Organizational Sentencing Guidelines setting forth uniform sentencing structure when convicted of federal criminal violations, providing for penalties exceeding those previously imposed on corps. Powerful incentives for firms to put compliance programs in place, to report violations of law promptly, and to make voluntary remediation efforts In re Caremark International Inc. Derivative Litigation (Delaware 1996) Facts: Caremark was a large provider of specialized patient care. It was subject to the Anti-Referrals Payment Law: it must not pay MDs to refer patients funded by Medicare or Medicaid. Caremark had always had an ethics guidebook, an internal audit plan, and a toll-free confidential ethics hotline. Price Waterhouse approved the control system. Nevertheless, Caremarks lower-level officers apparently engaged in enough misconduct to cost $250 million in penalties. SH filed a derivative suit seeking recovery from the board, alleging breach of duty of care. Chancellor Allen approved a settlement in which Caremark directors promised to implement relatively insignificant future safeguards, but the import of this case is in the dicta. Holding: Directors have a duty to take reasonable steps to see that the corp. has in place an information and control structure designed to offer reasonable assurance that the corp. is in compliance w/the law. Reasoning: Director liability in a breach of duty of care case can arise in two contexts. The first is when the board makes a decision resulting in a loss b/c the decision was ill-advised or negligent. (This cant

be judicially determined by looking at the content of the decision, only the good faith or rationality of the process, see Kamin & Van Gorkom.) The second is when loss results not from a decision, but from unconsidered director inaction. The Allis-Chalmers holding isnt really good b/c we cant say that w/o suspicion directors have NO duty to assure compliance w/statutes and regulations. Boards must assure themselves that info and reporting systems exist in the organization that are reasonably designed to provide to mgmt/board timely, accurate info sufficient to allow mgmt/board to make informed judgments re: business performance and compliance w/law. The level of detail appropriate for such an info system is a matter of business judgment. Its important that the board exercise a good faith judgment that the corp.s info/reporting system is adequate to assure board that appropriate info will come to its attention in a timely manner as a matter of ordinary operations. Only a sustained or systemic failure of the board to exercise oversight will establish the lack of good faith thats a necessary condition to liability. In this case there was a good faith attempt to be informed. Notes: This affirmative duty was probably provoked by the new sentencing guidelines. It is now in the SH narrow interest to adopt a control system b/c of the fines the company could face otherwise. Before the sentencing guidelines, it was theoretically possible for illegality to be profitable. Case not in book but discussed in class: Stone v. Ritter (Delaware 2006)- clarified Caremark holding: Caremark articulates the necessary conditions predicate for director oversight liability: (a) the directors utterly failed to implement any reporting or information system, or (b) having implemented such a system, consciously failed to monitor its operations, thus disabling themselves from being informed of risks or problems requiring their attention. Imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations. Note on Sarbanes-Oxley Act of 2002 404: requires that CEO of firms regulated under Sec. Exchange Act of 1934 periodically certify that they have disclosed to the companys independent auditor all deficiencies in the design or operation, or any material weakness, of the firms internal controls for financial reporting. CONS: compliance costs are high and have pushed some smaller companies out of public markets (or at least out of New York into foreign markets) PROS: forces companies to take a hard look at their control systems, which might have long-term benefits 6. Knowing Violations of Law Miller v. AT&T (3rd Cir. 1974) Facts: SH suit against AT&Ts board, alleging that AT&T is refusing to collect on a $1.5 million loan made to the DNC during the 1968 election. SH claim that this is an illegal campaign contribution, in violation of federal law; directors ought to collect debt or be personally liable. Holding: The BJR does not protect directors from liability for illegal acts. Reasoning: Under the BJR, courts dont interfere in corp. decision-making if the judgment of the D&O is uninfluenced by personal considerations and is exercised in good faith. However, where the decision not to collect a debt owed by the corp. is itself alleged to have been an illegal act, different rules apply. The BJR cannot insulate the directors from liability if they breached the prohibition on corp. campaign spending. Even if committed to benefit the corp., illegal acts may amount to a breach of fiduciary duty. We dont want corps breaching public policy made by Congress. SH are within the class for whose protection the statute was enacted the alleged breach of that statute should give rise to a cause of action in those SH to force the return to the corp. of illegally contributed funds. Notes: Why not punish the company as a whole for breaking laws? Theres a balance that needs to be struck b/w SH interests and societys interest in enforcing the laws.

Distinction b/w knowing violations of law and duty of care: think about a board that deliberates with the utmost care to authorize an action that they know to be illegal. under Miller, BJR will not immunize their decision from judicial scrutiny. -More common situation: what about an action that carries only a probability/risk of violating law? IX. Conflict Transactions: Duty of Loyalty This duty is the core of the fiduciary doctrine. The other two controls (duty of care, SH right to appoint directors) are weak b/c do not limit the boards discretion to enter specific transactions. But there may be actions over which it may be sensible to limit board discretion. This chapter looks at controls on corp. actions that are interested (in which a director or controlling SH has a personal financial interest). DUTY OF LOYALTY **applies only to interested parties** Requires a director/officer/controlling SH to exercise his institutional power over corporate processes or property (including info) in a good-faith effort to advance the interests of the company. Stated negatively, requires such a person who transacts with the corp. to fully disclose all material facts to the corp.s disinterested representatives and to deal with the company on terms that are intrinsically fair in all respects. They may not deal w/the corporation in any way that benefits themselves at its expense. 1. Duty to Whom? Basically, directors owe their duty to the corporation as a legal entity. Yet the corporation has multiple constituencies w/conflicting interests: SH, creditors, employees, suppliers, customers -This question matters most when the corp. faces insolvency (when there may not be enough corp. assets to satisfy all obligations to all constituencies) or when it contemplates a terminal transaction for equity investors (e.g., cash merger) Shareholder Primacy Norm -Theme of U.S. corporate law: director loyalty to corporation = loyalty to equity investors -Yet this reflects more of a value than a legal rule (Dodge v. Ford Motor Co. old case that enforces it) -These days, many actions can be justified in terms of increasing long-term value for the corp. (thereby increasing long-term value for SH)- e.g., price reductions, increased employee wages -Question of loyalty would only arise in rare case where board claimed to advance non-SH interests -Competing norm: directors must work to advance interests of all constituencies, not just SH A.P. Smith Manufacturing Co. v. Barlow (New Jersey 1953) Facts: SH challenges modest corporate donation to Princeton University on grounds that the company lacks the power to make it. Some statutes do authorize corporate contributions: 1930 NJ statute allows corps to embark on philanthropic ventures, as directors deem expedient and as in their judgment will contribute to the protection of the corporate interest; 1950 statute allows charitable contributions of up to 1% of total capital w/o SH authorization. P argues these statutes are inapplicable b/c post-date the companys creation. Holding: Contributions are allowed that are w/in the limitations imposed by statute and that are voluntarily made in the reasonable belief that they will aid the public welfare and advance the interests of the private corporation and the community in which it operates. Reasoning: There is a strong public policy in favor of this type of corporate contribution. Yes, there used to be a common law rule that directors could not disburse any corporate funds for philanthropic or other worthy public cause unless the expenditure would benefit the corp. (Dodge). Courts have always applied

this very broadly to enable worthy corporate donations w/indirect benefits to the corps. Modern conditions now require that corps discharge social as well as private responsibilities as members of their communities. That concept in itself justifies this donation, but even working w/in the common law rule, such expenditures may be justified as being for the benefit of the corp. The issue of post-dating is irrelevant b/c theres a law saying that all corp. charters are subject to laws passed in the future. This contribution was not made indiscriminately or to a pet charity in furtherance of personal ends. Notes: These kind of contributions can be justified as good for the corp. because they promote long-term growth. The Court focuses on fact that not only was it in public interest but would advance corp. interest. Constituency Statutes -In wake of leveraged buyouts of the 1980s, legislatures passed statutes that directors have the power (but not the obligation) to balance the interests of non-SH constituencies (creditors, managers, workers, suppliers, customers) against the interests of SH in setting corporate policy. -Delaware does not have one (PA, e.g., does); the RMBCA does not include such a provision either. 2. Self-Dealing Transactions D&O may not benefit financially at the expense of the corp. in self-dealing transactions. RMBCA 860-863 861: nondisclosure is subject to fairness review, but directors must have good reason for failure to disclose. Disinterested review by board BJR (not entire fairness). DGCL 144: self-dealing transactions will not be voidable solely b/c of a conflict of interest; if they are adequately disclosed and approved by a majority vote of disinterested SH or directors fair. Undisclosed transactions are subject to fairness review (not void per se). ALI 5.02: evidence of disclosure is sufficiently unfair to make a transaction per se voidable (Hayes Oyster Co.) Disclosure Requirement Hayes Oyster Co. v. Keypoint Oyster Co. (Washington 1964) Facts: Verne Hayes is the director, 23% SH, and CEO of Coast Oyster, a public corporation. Coast faces cash flow problems, and Verne convinces the board to sell two oyster beds. Verne then suggests to Engman, a Coast employee, that Engman form a new corporation (Keypoint) to buy the oyster beds. Verne arranges for his own family corporation, Hayes Oyster, to help Keypoint with financing, in exchange for which Hayes Oyster receives 50% of the equity in Keypoint. The agreement whereby Hayes Oyster gets 50% equity in Keypoint happens after the Coast board votes to sell, but before Coast SH approve the sale. Coasts new mgmt discovers what Verne has done and sues to recover Vernes and Hayes Oysters secret profits. Holding: Verne loses; an interested transaction can be voided if it is unfair to the corporation, and nondisclosure by an interested director/officer is itself unfair. Reasoning: D&O have a fiduciary relationship to corps and SH. They owe undivided loyalty. They cannot directly or indirectly acquire a profit for themselves or acquire any other personal advantage in dealings w/others on behalf of the corp. There is no mechanical rule that any transaction involving corp. property in which a director has an interest is voidable at the option of the corp.; it cannot be voided if the D&O can show that it was fair to the corp. Verne should have disclosed; he knew he might have some interest in the sale. The SH had the right to know about his interest in order to vote on the transaction. Actual injury isnt necessary to condemn these transactions; we want to promote fidelity. Notes: Is this a good rule? It may have the effect of chilling beneficial transactions. In fact, even though Coast is suing Verne for profits, it doesnt want to rescind the transaction, so they must think it fair. Controlling SH and the Fairness Standard -Corp. law recognizes a fiduciary duty on the part of controlling SH to the co. and its minority SH

-Control in this context should be determined by a practical test rather than a formalistic one. -Theres a conflict of values b/c even though controlling SH have duty of fairness, are also SH and therefore entitled to pursue own investment interests duty to consider other SH interests fairly whenever the corp. enters into a K w/the controller or its affiliate Sinclair Oil Corp. v. Levien (Delaware 1971) Facts: Sinclair owns 97% of Sinvens stock and dominates Sinvens board. Sinven is involved in oil production in Venezuela. Sinvens minority SH sue Sinclair, claiming Sinvens excessive dividends bar Sinvens corporate development. Holding: The BJR should be applied because there was no self-dealing, and under the BJR the dividends and decisions about (not) expanding Sinven are fine. Reasoning: When there is self-dealing, we apply the intrinsic fairness test (which shifts the burden of proof to the self-dealer). This usually happens where the parent has received a benefit to the exclusion and at the expense of the subsidiary (the parent, by virtue of its domination of the sub, causes the sub to act in a way that the parent receives something from the sub to the exclusion of, and detriment to, the minority SH of the sub). This was not self-dealing here b/c a proportionate share of the dividend money was received by the minority SH; Sinclair received nothing from Sinven to the exclusion of the minority SH. So we apply the BJR. Under the BJR, the motives for causing the declaration of dividends dont matter unless P can show that the motives were improper and the dividends were corp. waste. P claims only that the dividend payments prevented Sinven from expanding, but Sinven received no business opportunities that were usurped by Sinclair. The decision of which of Sinclairs subs got to implement Sinclairs expansion policy was a matter of business judgment. Notes: Note that even though the dividends determine which test shall be applied, the test is mainly applied to something else entirely the lack of corporate expansion. 3. Effect of Approval by a Disinterested Party Effect of Approval by a Disinterested Party Competing Approaches (Burden of proof in parentheses) Neither board nor shareholders approve Disinterested directors authorize (ex-ante authorization) Disinterested directors ratify (ex-post ratification) Shareholders ratify RMBCA 8.61/DGCL 144 Entire fairness (D) Ali Principles of Corporate Governance Entire fairness (D)

BJR (P): Cooke v. Oolie, Reasonable belief in fairness (P): RMBCA 8.61(b)(1) and ALI 5.02(a)(2)(b) Comment 2 BJR (P): RMBCA 8.62(a) and Entire Fairness (D): ALI 5.02(c), Comment 1 5.02(a)(2)(A), 5.02(b) Waste standard (P) Waste standard (P) - shareholders shareholders can ratify anything can ratify anything short of waste short of waste *DE almost always applies entire fairness when interested party is controlling SH DELAWARE: Controlling SH Non-controlling SH Disinterested SH Approval Fairness, burden on P (Kahn) BJR (144(a)(2)) (Wheelabrator) Disinterested Director Fairness, burden on D BJR (144(a)(3)) (Cooke) Approval (Weinberger) No Approval Fairness, burden on D Fairness, burden on D (144(a) (1)) Safe Harbor Statutes -Initially sought to permit boards to authorize transactions in which a majority of directors had an interest

-Most U.S. jurisdictions now have them DGCL 144, NYBCL 713, Cal. 310 -Almost all provide that a directors self-dealing transaction is not voidable solely because it was interested, so long as it is adequately disclosed and approved by a majority of disinterested directors/SH, or it is fair. two possible interpretations: (1) Literal interpretation: not voidable solely b/c interested if disinterested board or SH approval, but court still needs to do fairness inquiry (*this is the one most followed see Cookies Food) (2) Broad interpretation: never voidable if disinterested board/SH approval court avoids fairness inquiry Cookies Food Products v. Lakes Warehouse (Iowa 1988) Facts: L.D. Cook forms Cookies, Inc. to produce BBQ sauce. Cookies enters into a distributorship agreement w/ a minority SH, Herrig. The distributorship succeeds. Soon Herrig buys out Cook, becomes a Cookies director and its controlling SH (with 53%) and then enters other self-dealing Ks, which together absorb half the companys cash flows. Minority SH allege that Herrigs payments from these Ks grossly exceeded the values of services rendered and that Herrig failed to fully disclose the benefit he would gain from them. Holding: Herrig wins; his compensation was shown to be fair and reasonable. (Meet one of the exceptions of safe harbor statute you have to pass fairness review) Reasoning: Iowa safe harbor statute says you can self-deal w/o violating the duty of loyalty IF (1) you disclose to the board, who authorizes, (2) you disclose to SH, who authorize, or (3) the K/transaction is fair and reas. to the corp. Meeting one of these does not mean that you automatically meet the duty of loyalty, it just means the transaction isnt void/voidable outright. Theres an additional element of good faith, honesty, and fairness. To establish fairness you have to show not only a fair price but also a showing of the fairness of the bargain to the interests of the corp. Herrig was the driving force behind the corp.s success, and the board considered this when approving the transactions. Dissent: Just b/c the corp. was successful doesnt mean these transactions were fair. Herrig didnt meet his burden of showing fair market value. Notes: The SH are upset b/c they think Herrig is overcompensating himself the corp. is doing well but the SH are not getting any benefit from it. Also, they cant sell their stock b/c the corp. is closely held. The courts review here looks kind of like BJR entire fairness review would have looked at the prices. Approval of Disinterested Members of the Board -In Delaware, approval by disinterested directors merely shifts the burden of proving fairness in a controlled transaction to the plaintiff challenging the deal; it does not transform standard to BJR (in the case of a controlling SH) (Kahn v. Lynch) -But if the interested transaction is b/w the company and a single director who is NOT a top manager or controlling SH, dangers are less, and approval by other disinterested directors can protect SH interests more, so courts are more deferential to the boards decision. -Disinterested board members must be financially disinterested only friendship is irrelevant Cooke v. Oolie (Delaware 2000) Facts: The Nostalgia Network (TNN) has a board w/ four directors, including Oolie and Salkind, who were also creditors. Board votes unanimously to pursue a proposal to be acquired by another company (USA). Minority SH bring suit, claiming that Oolie and Salkind breached their fiduciary duty by electing to pursue a particular acquisition proposal that best protected their personal interests as TNN creditors, rather than pursue other proposals that offered superior value to TNN shareholders. Holding: Oolie/Salkind win. Under DGCL 144(a)(1), apply BJR to actions of interested director (who is not controlling SH) if he discloses interest and a majority of disinterested directors ratify the transaction. Under the BJR the transaction is OK. Reasoning: 144 doesnt explicitly apply to this case- b/c it only applies to transactions b/w a corp. and its directors (or another corp. in which directors have a financial interest), and also b/c no transaction has occurred yet. But the court applies it anyway b/c of policy rationale the disinterested directors

ratification cleanses the taint of interest b/c they have no incentive to act disloyally and should only be concerned w/advancing the interests of the corp. So if they ratify, transaction is presumably OK. Notes: Today in DE there is a possibility of entire fairness review but the trend is toward giving BJR protection to cases where SH and the board approve a transaction. Also note this might have turned out differently if the Del. Supreme Court had decided it (it was chancery court)- chancery judges more willing to defer b/c theyre the ones who have to make the actual valuations of fair prices and they understand how difficult it is to make those value judgments with 100% confidence Approval by a Special Committee of Independent Directors -Most common technique to defend against SH lawsuits -DE: special committee must be properly charged by the full board, comprised of independent members, and vested w/the resources to accomplish its task -They have to understand that their mission is not just to get a fair deal, but the best available deal -Even if committee process done well, it only shifts the burden of proving fairness from the D to P, who will have a substantial evidentiary burden SH Ratification of Conflict Transactions -SH can ratify acts of board, but b/c theyre a collectivity, the law must limit the power of an interested majority of SH to bind a minority that is disinclined to ratify a submitted transaction -Power of SH to ratify self-dealing transactions is limited by corporate waste doctrine- even majority vote cannot protect wildly unbalanced transactions that, on their face, irrationally dissipate corporate assets When majority of disinterested SH ratify an interested transaction, the transaction is subject to BJ review and burden shifts to P to prove waste Lewis v. Vogelstein (Delaware 1997) Facts: Deals w/compensation of directors w/ stock options. Board realizes this is self-dealing and try to get SH approval. Majority ratify, but minority challenge. Holding: Informed, uncoerced, disinterested SH ratification of a transaction in which corp. directors have a material conflict of interest has the effect of protecting the transaction from judicial review except on the basis of waste. Reasoning: Under corporate waste doctrine, plaintiffs can win even w/disinterested SH ratification. Judicial standard for determination of waste: waste entails an exchange of corp. assets for consideration so disproportionately small as to lie beyond the range at which any reas. Person might be willing to trade. Most often the transfer serves no corp. purpose. In re Wheelabrator Technologies, Inc. (Delaware 1995) Facts: Wheelabrator (WTI) was bought by Waste Mgmt Inc in a merger transaction. SH brought derivative action claiming that WTI directors breached their duties of care/loyalty. 4 of WTIs 11 directors were officers of Waste (which owned 22% of WTIs stock). Holding: Approval by fully informed, disinterested SH pursuant to DGCL 144(a)(2) (applying to interested transactions b/w corp. and its directors NOT controlling SH) invokes the BJR and limits judicial review to issues of waste, w/burden of proof on the plaintiff. Reasoning: In no case has the Del. Supreme Court held that SH ratification automatically extinguishes a claim for breach of duty of loyalty. Rather, the operative effect of SH ratification in these cases has been to change the standard of review to the BJR (burden of proof on P), or to leave entire fairness as review standard (also w/burden of proof on P).

4. Director and Management Compensation DGCL 145

Compensation is technically self-dealing, but different b/c compensation is necessary. Traditionally, employee compensation as a core matter of business judgment for board.

Agency problem: a fixed salary is unlikely to do enough to induce a manager to accept risky projects that may be beneficial from a long-term SH perspective. Alternative: incentive compensation based on performance of individual managers (or of the co. as a whole) though this can create additional agency costs as managers are more willing to break rules to earn more $ when incentives are higher for them -These days most of CEO compensation is in the form of equity (< half is salary and bonus) Option Grants & The Law of D&O Compensation SH or disinterested directors often ratify compensation to give extra legal insulation, but compensation agreements are not subject to ordinary law of director conflicts. Why? (1) Corps must pay compensation; (2) courts are poorly equipped to determine fair salaries b/c of unique character of particular managers Lewis v. Vogelstein (Delaware 1997) Facts: Options were accepted as an appropriate compensation method at this time. There was a one-time grant of $85,000 in options. SH alleged corporate waste. Holding: The case needs to go to trial for determination of facts re: whether the grant of options was an exchange from which a reasonable board would expect to receive a proportional benefit Corporate Governance and SEC Regulatory Responses -Compensation committee of the board generally sets compensation of top officers -1993 SEC rules enhanced disclosure rules, requiring detailed public disclosures about compensation of top corporate officers goal: increase transparency -Increased transparency might pressure directors to keep all forms of compensation reasonable; or it might accelerate compensation growth rates even further or push compensation into other, more difficult to detect, forms DISNEY -Executive compensation was an area of corp. governance to witness erosion of BJR in the 90s Facts: To help solve succession problems, Ovitz is persuaded to leave his $20-million-a-year job at CAA to join Disney as President. Eisner (CEO), Litvack (GC), Russell (chairman of compensation committee) and Bollenbach (CFO) are heavily involved in negotiations, but other board members are only partially informed and approve the employment agreement after cursory review and discussion. Disney market capitalization goes up by $1 billion (4.4%) on announcement. One year later, the Disney board votes to terminate Ovitzs employment agreement w/o cause, due to Ovitzs poor performance. Litvack investigates possibility of termination for cause but does not keep any notes or seek outside legal advice. Despite Ovitzs poor performance, the board awards him $7.5 million bonus for his services during 1996. At the beginning of 1997 Ovitz receives a $140 million severance package under the terms of his employment agreement (for 15 months of service). SH bring derivative suit alleging waste and breach of duty of care. In re the Walt Disney Company Derivative Litigation (Delaware 2003) *Denial of Motion to Dismiss* Holding: The facts alleged, if true, portray directors consciously indifferent to a material issue facing the corp. and thus their actions would be outside the BJR. Where a director consciously ignores his duties to the corp., causing economic injury to SH, his actions are either not in good faith or involve intentional misconduct- and thus they fall outside 102(b)(7) liability waiver. Reasoning: P alleges some hasty/careless hiring practices when Ovitz was hired. There are some allegations of being influenced by personal friendship. The board wasnt scrutinizing very closely, with regard to either the hiring or the firing. The facts suggest that the directors knew that they were making material decisions w/o adequate info or deliberation, and that they simply did not care if the decisions caused the corp. and its SH to suffer injury or loss. Notes: This was at the motion to dismiss stage, the court was accepting everything P said as true. In re the Walt Disney Company Derivative Litigation (Delaware 2005) *The Trial*

Holding: With respect to hiring Ovitz, the board did not act in bad faith and were at most ordinarily negligent under BJR, ordinary negligence is insufficient to constitute breach of duty of care. With respect to firing him, Eisner had the power to do so and the board was under no duty to act; Eisner was acting in good faith. Reasoning: Standard for determining whether the fiduciary acted in good faith: intentional dereliction of duty, a conscious disregard for ones responsibilities. Deliberate indifference and inaction in the face of a duty to act is conduct that is clearly disloyal to the corp. To act in good faith, a director must act at all times w/ an honest of purpose and in the best interests and welfare of the corp. Presumption of BJR creates presumption of good faith. In order to overcome that presumption, P must prove act of bad faith by a preponderance of the evidence P must prove by preponderance of evidence that presumption of BJR does not apply b/c the directors breached fiduciary duties, acted in bad faith, or made an unintelligent or unadvised judgment by failing to inform themselves of all material info reasonably available to them before making their decision. If P cannot do this, D will prevail. If P can rebut presumption of BJR, the burden would shift to D to prove entire fairness. -Eisners actions were pretty bad and not good for the co., but were made in good faith b/c they were taken with the subjective belief that his actions were in the best interests of the co. (acting swiftly and decisively to hire Ovitz) Notes: It seems like there was clearly some reconsideration b/w the 2003 and 2005 decisions; they thought twice about using the bad faith standard. Clearly Bad Faith (non-indemnifiable): Fiduciary conduct motivated by an actual intent to do harm 5. Corporate Opportunity Doctrine Question of when a fiduciary may pursue a business opportunity on his own account if this opportunity might belong to the corp. Cases focus on the rules of recognition when is an opportunity corporate rather than personal? Also, when can a corporate opportunity be taken? What remedies available? *See also: Perlman v. Feldmann, infra Which Opportunities Belong to the Corp.? Three possible tests: (1) Expectancy or interest test gives narrowest protection to the corp. expectancy or interest must grow out of an existing legal interest, and appropriation of the opportunity will in some degree balk the corp. in effecting the purpose of its creation (2) Line of business test any opportunity falling w/in a companys line of business is a corporate opportunity (anything a corp. could reasonably be expected to do = corp. opportunity) (3) Fairness test diffuse test relying on multiple factors When May a Fiduciary Take a Corp. Opportunity? -Some courts say you can do this if the corp. is not in a financial position to do so -Whats critical is whether board has evaluated the question of whether to accept the opportunity in good faith; most courts accept a boards good-faith decision not to pursue an opportunity as a complete defense -But, presenting the opportunity to the board is not required in Delaware; its just a safe harbor if you do In re Ebay, Inc. Shareholders Litigation (Delaware 2004) Facts: Ebay hires Goldman Sachs as lead underwriter for its 1998 IPO and 1999 secondary offering, and as financial advisor in its 2001 acquisition of PayPal. During this same period, Goldman gives shares in hot IPOs to Ebay directors, allegedly to show appreciation for Ebays business and to enhance Goldman Probably Bad Faith (non-indemnifiable): Intentional dereliction of duty, conscious disregard for ones responsibilities Clearly not Bad Faith (indemnifiable 102(b)(7)): Fiduciary action taken solely by reason of gross negligence and w/o malevolent intent

Sachs chances of obtaining future Ebay business (a practice known as spinning). SH sue, claiming that Ebay directors usurped a corporate opportunity. Holding: SH win. Directors took a corporate opportunity based on line of business test. Reasoning: No one disputes that Ebay financially was able to exploit the opportunities in question. Also, Ebay was in the business of investing in securities. Thus, investing was a line of business for Ebay. Investing was integral to Ebays cash management strategies and a significant part of its business. Ebays officers conduct placed them in a position of conflict w/their duties to the corp. These allocations were a form of corp. discount or rebate for past/future banking services. Notes: Separate grounds for liability: an agent is under a common law duty to account for profits obtained personally in connection w/transactions related to his company; poss. breach of fiduciary duty of loyaltyaccepted a commission/gratuity that rightfully belonged to Ebay but that was improperly diverted to them. DGCL 122(17) explicitly authorizes waiver in charter of the corporate opportunity constraints for officers, directors, or SH. 6. Duty of Loyalty in Close Corporations Often have a different structure characterized by a unified corps statute, which explicitly permits planners to K around statutory provisions through general opt-out clauses (RMBCA 8.01(b)) -Some states have specialized close corp. statutes DGCL 341-356 DGCL 342 defines eligible close corps as those that have, inter alia, 30 or fewer SH -Note that UGFAL will NOT be applied in Delaware Donahue v. Rodd Electrotype Co. (Massachusetts 1975) *DELAWARE HAS REJECTED THIS* Facts: The companys (Rodds) directors were Charles Rodd, Frederick, and their lawyer. Its SH were Harry Rodd (33%), Harrys kids- Charles, Frederick, and their sister (16% each), and Widow Donahue and her son (20%). The company buys half of Harrys stake for $800/share, reflecting book and liquidation value. The company refuses to buy Donahues shares for $800/share. (It had previous offered $40 and $200/share.) Donahue sues the board and company to rescind the purchase of Harrys shares, alleging violation of fiduciary to her as minority SH. Holding: P wins. The distribution was a breach of fiduciary duty b/c the Rodds failed to accord Donahue an equal opportunity to sell her shares to the corp. (Rule: in close corps, SH owe each other the duty of utmost good faith and loyalty [UGFAL], which requires equal opportunity of each SH to sell a ratable number of his shares to the corporation at the same price.) Reasoning: A close corporation is typified by: (1) a small number of SH, (2) no ready market for the corp. stock, and (3) substantial majority SH participation in the mgmt, direction and operations of the corp. Its similar to a partnership in that the relationship b/w SH must be one of trust UGFAL duty. In corps in general, SH can hardly ever challenge dividend or employment policies (w/in BJR), but in big corps they can try to sell their shares. The problem is, in close corps, a market for shares is not available. And they cant be dissolved like partnerships. (Quotes Meinhard v. Salmon punctilio paragraph.) When a close corp. reacquires its own stock, the purchase is subject to the additional requirement (besides good faith and w/o prejudice to creditors/SH) of UGFAL. To meet this test, have to give all SH equal opportunity to sell at same price. Rationale: dont want to let majority SH get special advantages and disproportionate benefit. Notes: Minority SH are seen as vulnerable b/c their exit opportunities are limited. This case was an example of judicial activism. Delaware later rejected this holding b/c there may be good business reasons for repurchases and we dont want to regulate them too heavily. Note there was no allegation here that the price being paid to Rodd was too high. Donahue wanted out b/c there was no way her stock would ever get dividends; the Rodds had better ways (salary) to get money out of the co. -Critics say this case fails to anticipate what the parties would have bargained for ahead of time. Its more likely they would have made a buy-out arrangement on contingencies like retirement.

Smith v. Atlantic Properties Inc. (Massachusetts 1981) Facts: Wolfson, M.D., and three lawyers (Smith, Zimble, Burke) are equal SH in a real estate company, Atlantic. Wolfson arranges for the charter to require an 80% SH vote for any corp. action to prevent the other three SH from ganging up on him. Wolfson continually vetoes dividends. The IRS assesses penalty taxes ($40,000) for unreasonable accumulation of corporate earnings and profits. The other SH sue to remove Wolfson as a director and force him to reimburse the penalty taxes and related expenses. Holding: Ps win. Wolfson took risks inconsistent w/any reasonable interpretation of UGFAL duty. Reasoning: Cases may arise in close corps in which majority SH may ask protection from a minority SH. The 80% provision here essentially reverses the usual roles of majority and minority SH (minority becomes ad hoc controlling interest). The question is whether the veto power possessed by a minority may be exercised as its holder may wish w/o a violation of UGFAL duty? No. Notes: After Donahue and this case, many courts feared that UGFAL, if left to grow unrestrained, could decrease the value of the corporate form. Wilkes v. Springside Nursing Home Inc. (Massachusetts Sup. Ct. 1976) Pulled back from UGFAL by recognized the right of selfish ownership (QUGFAL: qualified UGFAL) -If controlling SH could demonstrate legit business purpose for actions, no breach of duty unless minority SH can prove that same legit objective could have been achieved thru means less harmful to minority. X. Shareholder Lawsuits 1. Distinguishing between Direct and Derivative Claims (1) Derivative Suits a. An assertion of a corporate claim against an officer or director or third party, which charges them w/a wrong to the corporation b. Directors technically owe loyalties to corp. itself, so these are suits alleging breaches of fiduciary duties (e.g., self-dealing cases); also, allegation of loss of value of co. as whole c. REMEDY: b/c claim is corporate, recovery goes directly to corp. itself but legal fees are recoverable d. Special procedural hurdles (FRCP 23.1) designed to protect boards role (2) Direct/Class Actions a. A gathering together of many indiv or direct claims that share common aspects b. Claim is to recover damages suffered by individuals directly b/c they are SH (impaired voting rights, dividend payments, securities violations) e.g., Van Gorkom (alleged lack of adequate consideration b/c company sold for too little) c. These are suits arising under federal securities laws d. REMEDY: recovery goes to plaintiffs Tooley v. Donaldson, Lufkin & Jenrette, Inc. (Delaware 2004) Facts: Minority SH brought suit as a direct/class action alleging that board had breached a fiduciary duty to them by agreeing to a 22-day delay in closing a proposed cash merger. (Deprivation of time value) Holding: Suit dismissed. Test for distinguishing b/w direct and derivative: (1) who suffered the alleged harm (the corp. or the suing SH); (2) who would receive the benefit of any recovery or other remedy (the corp. or the SH individually)? Reasoning: In this case, the SH had no individual right to have the merger occur at all. Notes: While the claim was shared by all SH and thus was not special it was nevertheless individual Gentile v. Rossette (Delaware 2006)

Facts: SinglePoints CEO/Director Rossette owned 61% of shares and held $3 million in convertible debt in SinglePoint. In 2000, he negotiated w/the only other board member at the time (Bachelor) to change the conversion ratio for the debt from $.50 of debt per share to $.05 of debt per share. The two then called a special meeting of SH to approve an increase in the # of authorized shares from 10 to 60 million, in order to enable a conversion at the new ratio, but the minority SH were not informed of this underlying purpose. After SH approved, Rossette converted $2.2 million of debt into equity, increasing his stake in the company from 61% to 93%. Minority SH sued claiming breach of fiduciary duty. Holding: Ps claim is both direct and derivative. Reasoning: In addition to the derivative claim, the court found a direct claim from an extraction from the public SH, and a redistribution to the controlling SH, of a portion of the economic value and voting power embodied in the minority interest. The public SH were thus harmed, uniquely and individually, to the same extent that the controlling SH is benefited. 2. Attorneys Fees and the Incentive to Sue (Solving Collective Action Problem) Collective action problem: no single investor has a strong incentive to invest time and money in monitoring mgmt. If the SH suit is to be plausible for enforcing fid duties in widely held corps, the law must construct an incentive system to reward small SH for prosecuting meritorious claims attorneys fees Plaintiffs attorney receives nothing when derivative suit is dismissed b/c there is no recovery and no benefit. When suit succeeds on merits or settles, corp. benefits from any monetary recovery or governance change resulting from the litigation. But the corp. also generally bears bulk of litigation costs on both sides- must pay P a sum for costs that ranges from very small to 30% Fletcher v. A.J. Industries, Inc. (California 1968) Facts: SH derivatively sue the companys directors, alleging that Ver Halens domination and Malones excessive salary damaged the corp. The suit settles. The settlement (a) reduces Ver Halens influence over the board, and (b) removes Malone as treasurer, and (c) refers all monetary claims to arbitration. The settlement provides for attorneys fees only if arbitration yields a monetary award, but Ps attorneys apply for fees anyway. Holding: Substantial benefit rule: the successful P in a SH derivative action may be awarded attorneys fees against the corp. if the corp. received substantial benefits from the litigation, although the benefits were not pecuniary and the action had not produced a fund from which they might be paid. Reasoning: This rule is a variation of the common fund doctrine. You can still award attorneys fees to a successful P from a common fund, but the existence of a fund is not a prerequisite of the award. Policy: derivative suits are an effective means of policing corp. mgmt. and we dont want to inhibit them by limiting the compensation of successful attorneys to cases producing a monetary recovery other benefits could also accrue to the corp. So what is a substantial benefit? Meets the standard if the results of the action maintain the health of the corp. and raise the standards of fid relationships and of other economic behavior, or prevent an abuse which would be prejudicial to the rights and interests of the corp. or affect the enjoyment of protection of an essential right to the SH interest. Settlement vs. final judgment doesnt matter. In this case, the benefits were the immediate changes in corp. mgmt. Dissent: Policy counterargument: if a common fund is not a prerequisite to fees, the corp. may have to liquidate assets to pay fees, even though resulting harm to the corp. might outweigh the benefits of suit. Notes: What if were talking about a settlement. Do the litigation costs saved by settling a substantial basis for the purpose of attorneys fees? What if this was the only benefit? Ex post: this is a benefit, because litigation costs $/time/stress and distracts mgmt from the business. Ex ante: not a benefit, b/c could be an incentive for P to bring frivolous suit knowing that mgmt. will try to settle to make go away. Strike Suits suits w/o merit brought to extract a settlement by exploiting the nuisance value of litigation and personal fears of liability

Attorney incentives- awarding % of recovery amount may cause them to settle too soon, but paying hourly rates may cause them to spend too much time litigation relative to likely settlement outcome 3. Standing Requirements Premise: screening for qualified litigants increases quality of SH litigation Various requirements: FRCP 23.1 (which Del. follows), RMBCA 7.41, ALI 7.02 FRCP 23.1 (& Delaware): (1) P must be a SH for duration of action (2) P must have been a SH at time of alleged wrongful act/omission (dont want P to buy lawsuits); most restrictive of the rules, but not that impt. b/c contemporaneous SH are easy to find (3) P must be able to fairly and adequately represent interests of SH (no conflicts of interest) (4) P must specify what action he has taken to obtain satisfaction from the board (forms the basis of the demand requirement, see below) or state reason for not doing so 4. Balancing Boards Mgmt Rights and SHs Rights to Judicial Review

Delaware Derivative Suit Tree

Board refuses relaxed BJR (Levine, Speigel) Corporation brings suit Suit proceeds SLC recommends Zapata two-step dismissal (e.g., Carlton) or settles SLC

P makes demand

Board does not refuse Demand excused (e.g, Rales)

Case continues

P doesnt make demand => Aronson/ Levine twoprong test

No SLC Demand required (e.g., Levine)

Case continues

Suit dismissed

Demand Requirement of Rule 23 Traditional rule that a derivative complaint must allege w/particularity the efforts, if any, made by P to obtain the action he desires from the directors or comparable authority, or the grounds for not doing so. The Aronson demand futility test: In determining demand futility, the Court of Chancery must decide whether, under the particularized facts alleged, a reasonable doubt is created that: (1) the directors are disinterested and independent, and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. Hence, the Court must make two inquiries, one into the independence and disinterestedness of the directors and the other into the substantive nature of the challenged transaction and the boards approval thereof. Levine v. Smith (Delaware 1991)

Facts: In 1984, GM buys EDS from Ross Perot in a deal that makes him GMs largest SH and puts him on GMs board. But Perot goes bananas while on the boarde.g., publicly criticizes GM for making second rate cars. Eventually GMs board pays Perot $742 million for his GM stock, notes, and his agreement not to wage a proxy contest or to publicly criticize GM. A 3-person committee and the full board approve the deal. Without making demand, SH bring a derivative action claiming fid. breach, and argue that requesting GMs board to take action would have been futile. Holding: SH lose under the Aronson demand futility test. Reasoning: The demand requirement represents a procedural restatement of bedrock principles: that the directors, and not SH, manage the business/affairs of the corp. and so the directors are the ones responsible for deciding whether to engage in derivative litigation. The Court applies the Aronson demand futility 2-part test, see above. The premise of a SH claim of futility of demand is that a majority of the board has a financial interest in the transaction or lacks independence/failed to exercise due careon either showing its assumed that the board cant exercise its power to pursue derivative claims directly. For prong (1) a P must show that the board is either dominated by an officer/director who is the proponent of the challenged transaction or that the board is so under his influence that its discretion is sterilized. For prong (2) P must plead particularized facts creating a reas. doubt as to the soundness of the challenged transaction sufficient to rebut the BJR presumption. (Two alternative hurdles.) Here, under prong (1), P argued that directors were not independent, but they failed to create a reas. doubt w/ their pled facts. Under prong (2), P argues that directors acted w/too much haste and were uninformed, but fail here too. Notes: This case converts the Aronson test from and to or (in terms of what P must accomplish)- but because P accomplishes neither, still loses. If you make demand, and its refused, the bar is even higher b/c you waive the right to allege impartiality. (Spiegel v. Buntrock: P concedes board independence by making demand.) Irony: the doctrine is about safeguarding the boards authority over the corp. asset of the derivative suit, but the rule is structured to discourage plaintiffs from ever making demand. Comparison of Demand Futility Approaches Delaware: in practice, demand is rarely made due to Spiegel v. Buntrock (1990) presumption, and court screens based on two-part Aronson/Levine test: P must establish EITHER that directors are interested/dominated OR must allege facts that create a reas. doubt of the soundness of the challenged transaction. RMBCA: must make demand unless irreparable injury (7.42). If demand is refused, SH may continue by alleging w/particularity that board is not disinterested (7.44(d)) or did not act in good faith (7.44(a)). ALI: must make demand unless irreparable injury (7.03), and if demand is refused and SH continues, court will review board motions to dismiss derivative suits using a graduated standard: BJR for alleged duty of care violations (7.10(a)(1)) and reas. belief in fairness for alleged duty of loyalty violations (7.10(a)(2)), except no dismissal if P alleges undisclosed self-dealing (7.10(b)) Rales v. Blasband (Delaware 1993) Facts: P Blasband owned stock in Easco, which was controlled and managed by the Rales brothers (wellknown takeover artists). The Rales brothers do a $100-million public debt offering through Easco, and invest the proceeds in Drexel junk bonds when Drexel is on its last legs and the DOJ is hot on Milkens trail. The suit alleges breach of duty of loyaltythat Eascos junk bond investment is a quid pro quo for Drexels (Milkens) past favors to the Rales brothers. After the bond issue, but before the suit, the Rales brothers merge Easco into a subsidiary of Danaher. Thus, Blasband has become a SH of Danaher instead of Easco. The Rales brothers own 44% of Danaher but claim they do not manage it; they merely sit on its board with six other directors. Q: Is demand excused?

Holding: Demand is excused. In situations such as this one, the test is: demand is excused as futile if Ps allegations create a reas. doubt that the board addressing the demand was impartial- that it could have properly exercised its independent and disinterested business judgment in responding to the demand. Reasoning: The thing that makes this case tricky is that the Danaher board, considering Blasbands demand, is not the one that approved the transaction Blasband challenges. Where there is no conscious decision by directors to act or refrain from acting (as here), the BJR has no application. So the Aronson test cannot be applied in these situations. We just look to see if the Danaher board is interested. How? A director is considered interested where he will receive a personal financial benefit from a transaction that is not equally shared by the SH; and also where a corp. decision will have a materially detrimental impact on a director, such that the director will be influenced by adverse personal consequences of the decision. The Rales brothers and Caplin (members of both boards) were def. interested b/c a decision to bring suit against them would have financially significant consequences for them. The other directors were also interested b/c they were beholden to the Rales brothers or otherwise under their influence such that their discretion was sterilized. Special Litigation Committees -There is no basis in positive law (statute) for a procedure under which a court, upon motion of a special committee of disinterested directors (SLC), may dismiss a derivative suit already under way (either b/c has no merits or costs > benefits). But many state courts adopted such a procedure under the pressure of increasing SH suits in 70s-80s. -SLC is not triggered in every case (unlike demand requirement) -Jurisdictional divide: Delaware (Zapata) gives a role to the court itself to judge the appropriateness of a SLCs decision to dismiss a suit, vs. other jurisdictions (NY) that apply a rule that, if committee is independent and informed, its action is entitled to BJR deference w/o judicial second-guessing Zapata Corp. v. Maldonado (Delaware 1981) Facts: P files a derivative suit in Delaware. Demand is excused, and four years into the litigation, the Zapata board appoints two new independent directors who serve as an SLC. The SLC investigates the action and like virtually all SLCs, recommends that the court dismiss the suit. Q: when (if at all) should a SLC be permitted to cause litigation, properly initiated by a SH in his own right, to be dismissed? Holding: Two-Step Test. First, the Chancery Court should inquire into the independence and good faith of the SLC and the bases supporting its conclusions (corp. has burden of proof). Second, if the SLC meets that test, the C. C. should determine, applying its own independent business judgment, whether the motion should be granted. Reasoning: Generally, a SH cannot be permitted to invade the discretionary field committed to the judgment of the directors and sue in the corp.s behalf when the managing body refuses. However, we cant let the boards refusal be determinative in every instance- the board cant dismiss a suit if it would be a breach of their fid duties to do so. We want to find a balance where the derivative suit is still effective in policing mgmt, but not overly detrimental to the corp. The BJR would be too deferential to apply here b/c of the risk of the situation (empathy of directors for other directors). Courts substantive judgment in step (2) will require balancing many factors, including law and public policy. Yes, there is a danger of judicial overreaching but we think its outweighed by the fresh view of a judicial outsider. In re Oracle Corp. Derivative Litigation (Delaware 2003) Facts: Derivative complaint alleges insider trading by four Oracle directors: Ellison (major donor to Stanford), Henley, Lucas (Stanford alum and major donor to Stanford), and Boskin (a Stanford economics professor). Oracle appoints Profs. Grundfest and Garcia-Molina from Stanford to the board as a twoperson SLC w/complete authority to respond to the litigation. The SLC produces a 1,110-page report concluding that Oracle should not pursue the plaintiffs claims against defendant directors. P challenges the independence of the SLC in chancery court. Holding: Applying the Zapata two-step test, the SLC has not met its burden of showing independence.

Reasoning: Remember that the SLC bears the burden of proving its independence. The law cannot simplify human motivations just based on pure economics. People are attached to social institutions. The SLC has not proven its independence b/c of the substantial ties among the SLC, the defendants, and Stanford. Even if its possible that these ties are not affecting the SLC, the SLC has not proven that. This does not mean that the court is questioning the subjective good faith of the committee members. Joy v. North (2nd Cir. 1982) Facts: In a diversity case, the court predicted that Connecticut would adopt the Zapata approach to derivative suits and, exercising its business judgment, rejected a SLCs motion to dismiss. Holding: Where the court determines that the likely recoverable damages (discounted by the probability of a finding of liability) are less than the costs to the corp. in continuing the action, it should dismiss the case. (direct costs imposed on corp. by litigation > potential benefits) Reasoning: The opinion discusses why its not ridiculous to allow a Court to be making these kinds of judgments at this stage. The burden here is on the moving party (SLC) to show that the action is more likely than not to be against the interests of the corp. The function of the courts review is to determine the balance of probabilities as to likely future benefit to the corp. NOT to render a decision on the merits, fashion the appropriate legal principles or resolve issues of credibility. The courts function is not unlike a lawyers determining what a case is worth for purposes of settlement. Theres some discussion of which costs may be taken into account. Notes: This decision basically asks the court to do what a loyal board would do. It makes the second step of the Zapata test (court applying own BJ) MANDATORY rather than permissive. What elements might be left out of the picture by this analysis? Certain costs (reputation of corp.), certain benefits (deterrence value of litigation aggregate), insurance issue (pay ex ante probability of costs) *Joy only looks at ex post benefits (recovery, corp. change) and costs (litigation costs), whereas Prof. K argues that we should look at ex ante benefits (deterrence) and costs (D&O insurance) as well his argument is we should make payment of attorneys fees contingent on credible showing that the settlement had plausible deterrent value, or that it resulted in a net gain to the corp. not funded by the D&O insurers. (Want P to come up with real benefit, like cash beyond cost of attorneys fees, or to show that the alleged wrongdoers are in some way punished.) Possible alternative to Zapata: more rigorous effort to ensure independence of directors on SLC -See Michigan Laws 450.1107, 495 5. Settlement and Indemnification Settlement by Class Representatives -Parties are strongly driven to settle in derivative suits -D&O generally have a right under a companys bylaws to the indemnification of reasonable defense costs, including any amounts paid if the action settles. But if an action goes to trial, theres a risk of personal liability that can be indemnified only w/court approval. Trial imposes uncompensated risk -D&O insurance coverage will typically exclude losses that arise from fraud/self-dealing, while settlement allows the proceeds of the D&O insurance policy to be used Settlement by Special Committee Carlton Investments v. TLC Beatrice International Holdings, Inc. (Delaware 1997) Facts: Reginald Lewis does an LBO of Beatrice Foods with the help of some banks. Lewis ends up with 45% of Beatrice, and the banks get 20%. Beatrice pays Lewis $19.5 million in compensation payment just before he dies. SH Carlton alleges improper motives on the part of D&O, alleging self-dealing and waste. The company appoints an SLC, which eventually negotiates a settlement for Lewiss estate to pay Beatrice $14.9 million plus interest in installment payments over 7 years. Carlton objects to the settlement.

Holding: The settlement is OK. Under step 2 of Zapata, the result reached has to be irrational or egregious for a court to overturn the SLCs judgment. Reasoning: The judge here is uncomfortable with the court exercising own business judgment; courts should not make such judgments but for reasons of legitimacy and for reasons of SH welfare. 6. When are Derivative Suits in SH Interest? A derivative suit can increase corp. value in two ways: (1) It may confer something of value on the corp. (recovery of past harms inflicted; governance change that prevents bad managers from inflicting harm in the future) (2) It (or the threat of one) can deter wrongdoing that might otherwise happen in the future There are two costs of derivative suits: (1) They impose direct costs of litigation (2) They impose indirect costs on the corp. and its SH directors must be compensated ex ante for their expected litigation costs (D&O insurance) XI. Transactions in Control Purchasing control is de facto purchasing the company (an idea built into the corp. form). Control is a loose concept. Formally: 51% of shares, but can be higher or lower depending on the size of other SH and how control may be exercised practically. Controlling blocks of stock sell for a premium on the market. 1. Sales of Control Blocks: Sellers Duties Regulation of Control Premia Market Rule: sale of control is a market transaction that creates rights and duties b/w the parties, but does not confer rights on other SH. (no requirement that an acquirer of a control black has to offer to acquire all shares at the same price paid in the control transaction) (Zetlin) Alternative: Equal Opportunity Rule: minority SH would be entitled to sell their shares to a buyer of control on the same terms as the seller of control Zetlin v. Hanson Holdings, Inc. (New York 1979) Facts: Hanson Holdings and Sylvestri family together own 44.4% of Gable Industries, and sell their controlling block to Flintkote Co. for $15 per share at a time when the Gable stock is selling for $7.38 per share. Minority SH Zetlin brings suit challenging the transaction, claiming that minority SH should have an equal opportunity to share in any premium paid for a controlling interest. Holding: Adopts the market rule and rejects the equal opportunity rule. Reasoning: Absent looting of corp. assets, conversion of a corp. opportunity, fraud or other acts of bad faith, a controlling SH is free to sell, and a purchaser is free to buy, controlling interest at a premium price. The premium is the added amount an investor is willing to pay for the privilege of directly influencing the corp.s affairs. But the equal opportunity rule would be bad b/c it would require that a controlling interest be transferred only by tender offer. This is such a radical change it would have to be done by the legislature if at all. Perlman v. Feldmann (2nd Cir. 1955) Facts: Setting: Korean War, steel shortage, semi-official price freeze and rationing of steel supply. Feldmann is director, CEO, and controller of 37% of Newport Steel shares. He sells his stake to Wilport Syndicate for $20/share when the stock is trading at $10-12/share. Feldmann resigns with his directors to allow Wilport to take control of the board. SH bring suit alleging that Feldmann sold a corporate

opportunity (control over steel supply) for personal gain, which the company could have used for its advantage (e.g., through the Feldmann Plan), in violation of his fid duty to the corp. Holding: Because the control premium was gotten by a stolen opportunity (breach of a fid duty), Feldmann has to share the control premium with the minority SH. Reasoning: Normally, the control premium is valuable b/c it gives the controller the right to control the company (make major decisions, etc.) But this control had an additional value in the ability to circumvent the federal price and supply controls. That premium belonged to the entire corporation, not just the controlling SH. The ability to earn money on that premium was the corporate opportunity that Feldmann appropriated. The court also hints that this was an unpatriotic act in a time of war. Notes: This case isnt trying to establish a general rule of having to share control premia. Its more a corp. opportunity case. Note that the remedy went straight to the SH, not the corp.- if it had, that would have been a double win for Wilport since theyre already benefiting from the corp. opportunity. Easterbrook & Fischel Defense of the Market Rule -A buyer will pay a premium if it thinks it can run the co. better or if it will get some benefit from control (synergy creating a bigger pie) -To evaluate the effect of the market rule vs. the equal opportunity rule we should look at the effect of the choice on an obviously bad (value-reducing) transaction. The equal opportunity rule eliminates value-reducing sales of control blocks, but its possible that it might over-deter In re Digex Inc. SH Litigation (Delaware 2000) Facts: Intermedia owns 52% of Digex stock and 94% of its voting power. Intermedia seeks to sell its Digex stake. Worldcom is originally interested, but changes its mind to acquire Intermedia instead of Digex. Because Worldcom would be an interested SH of Digex after acquiring Intermedia, it sought a waiver of DGCL 203, which would have prevented Worldcom from freezing out the Digex minority for three years. Digex board grants the waiver. Holding: Failure to extract something for Digexs minority SH in exchange for the waiver violates the boards duty of fairness to the minority SH. Reasoning: The board may waive the 203 constraint only for benefit of entire corp., not just the controlling SH. Such a waiver must be justified on the basis of a corp. benefit, so the board must either conclude that the transfer itself is good for the corp. or must extract benefit from the controller. Notes: This norm seriously weakens a controlling SHs entitlement to the whole of a control premium. Now if some corporate action needs to be taken in the course of a sale, minority SH have a hook to get something for themselves. 2. Sale of Corporate Office *Sale of control is OK, sale of office is not OK* Carter v. Muscat (NY 1964) Brecher v. Gregg (NY 1975) Size of Control Block 9.7% 4% Premium Received by Seller Slightly above market 35% Fate of Newcomer Directors re-elected by SH CEO fired by board Holding Upheld as sale of control, not sale Disgorgement of control premium of office *It depends which sale (of control/of office) is the ancillary or main subject of the transaction *It depends on the magnitude of the holdings of the seller (more shares w/in your control you care more about the value of the shares; less shares in your control you care more about private benefits and will have less incentive to run the company efficiently)

3. Looting (Duty to Screen Against Selling Control to a Looter) Harris v. Carter (Delaware 1990) Facts: Carter Group exchanges its 52% in Atlas for the Mascolo Groups stake in ISA. Minority SH bring suit against Mascolo directors alleging that they looted all of Atlas assets: diluting minority interest in Atlas by issuing Atlas stock for worthless ISA stock; buying a worthless chemical company owned by Mascolo; and engaging in various other self-dealing transactions. Minority SH bring suit against the Carter directors as well, alleging that ISA is a totally bogus firm, and that Carter should have been alerted by the suspicious financial statements that Mascolo offered for ISA. Holding: When the circumstances would alert a reas. prudent person to a risk that his buyer is dishonest or in some material respect not truthful (a looter?), a duty devolves upon the seller to make such inquiry as a reas. prudent person would make, and generally to exercise care so that others wont be harmed. Reasoning: Controlling SH owe a fiduciary duty to the corp. A SH has to take care when exercising the right to sell shares. The right is limited and has conditions. This theory comes from tort doctrine. Notes: Why impose seller liability? Prevent inefficiency from the beginning (ex ante deterrence); might not be able to catch the looter later on; concept of the seller as gatekeeper. 4. Tender Offers: Buyers Duties -An investor who wants to buy control in a widely held corp. (no controlling SH) has to aggregate shares of many small SH tender offer: offer of cash or securities to the SH of a public corp. in exchange for their shares at a premium over market price. (Although note you can also get control with the help of the board, which is what chapter 12 covers) Williams Act of 1967 regulates cash tender offers- buyer must provide sufficient time/info to SH to make an informed decision about tendering their shares, and to warn the market about impending offer. The Act does not define tender offer. Four elements of the Act: (1) Early Warning System, 13(d): requires disclosure whenever anyone acquires more than 5% of companys stock (alerts the public and the companys managers) a. Rule 13d-1: must file 13D report w/in 10 days of acquiring 5%+ beneficial ownership b. Rule 13d-2: must amend 13D promptly on acquiring material change (+/- 1%) c. Beneficial owner means power to vote or dispose of stock d. Remedy for violation: probably injunction until disclosure is made e. This might apply to SH who get together to coordinate their votes f. Why have this requirement? Want to disclose b/c stock will go up on the market (as will the price of the tender offer), mgmt will begin a defensive campaign (2) General Disclosure, 14(d)(1): requires tender offeror to disclose identity, financing, and future plans, including any subsequent going-private transactions (3) Anti-Fraud Provision, 14(e): prohibits any fraudulent, deceptive, or manipulative practices in connection w/a tender offer a. Mens rea requirement: knowledge or extreme recklessness, depending on jurisdiction b. You can still bring suit under this even if result is that you dont tender your shares (4) Terms of the Offer, 14(d)(4)-(7): governs the substantive terms of the offer, e.g., duration, equal treatment. a. Rule 14e-1 mandates that tender offers be left open at least 20 business days. b. Rule 14d-10 requires bidders to open their tender offers to all SH and pay all who tender the same best price. c. Rule 14d-7: SH who tender can withdraw while the offer is still open. What is a tender offer?

Theyre usually self-identifying. Wellman v. Dickinson (New York 1979) Facts: Sun Company bought 34% of Becton by simultaneously calling 30 institutional SH and 9 individuals, offering a fixed premium price, open for only one hour. Suns lawyers felt this strategy was a private purchase rather than a tender offer since the number of solicited SH was limited. They decided to go with the limited-price private purchases b/c a tender offer might lead to bidding, which would make the desired acquisition more expensive. Holding: The solicitation campaign was a de facto tender offer subject to the Williams Act requirements because all but one (the 1st) of 8 factors were present. 8-Factor Test: (1) active and widespread solicitation, (2) solicitation is made for substantial percentage of issuers stock, (3) premium over the prevailing market price, (4) terms of the offer are firm rather than negotiable, (5) whether the offer is contingent on the tender of a fixed minimum number of shares, (6) whether offer is only left open for limited period of time, (7) whether offerees are subjected to pressure to sell, (8) whether public announcements of a purchasing program precede/accompany rapid accumulation Brascan Ltd. V. Edper Equities Ltd. (New York 1979) Facts: Edper owns 5% of Brascan (Canadian company) and is turned down when it proposes a friendly acquisition. Edper engages Connacher to buy shares; Connacher contacts 30-50 institutional investors and 10-15 individual investors and buys 10%, mostly from them, on April 30. In response to a demand from Canadian officials, Edper announces that it has no plans to buy any more shares at that time. Nevertheless, w/o further announcement, Edper buys another 14% the next day, bringing total stake to 29%. Brascan brings suit, claiming violation of Williams Act 14(e) and Rule 10b-5. (only 14(e) applies though b/c even though the company is Canadian, shares purchased on U.S. stock market) Holding: Edper did not violate the Williams Act because this was not a de facto tender offer. Reasoning: Only one factor of the Williams test was met. There was no widespread solicitation. It was not contingent on a fixed number of shares being offered. It did not put out an offer at a fixed price. Etc. The only one that WAS met was (2), solicitation for a substantial percentage of issuers stock. 5. The Hart-Scott-Rodino Act Waiting Period -Second legal constraint besides the Williams Act -If there are no antitrust issues, the HSR Act affects only the timing of transactions (1) Minimum waiting period before closing a transaction: 18a(b)(1)(B) a. 30 days for open market transactions, mergers, and negotiated deals b. 15 days for cash tender offers c. May be extended for another 30 days (10 days for cash tender offers) if DOJ or FTC makes a second request (2) Who must file: 18a(a)(2) a. The acquirer in all deals over $212 million b. An acquirer w/assets or sales over $106 million and a target with assets or sales over $11 million (or vice versa) if the deal involves assets or securities over $53 million. These waiting periods sometimes create de facto auction periods. -Arguments against: this will cause to reduce total number of value-increasing takeovers; it encourages free riding (the first bidder is the one who invests in searching for a company to take over) so it wont be worth it for companies to search for targets as much -Arguments for: it enhances the efficiency of individual takeovers, w/o having much impact on the number of value-enhancing transactions- ensures shares go to highest valuing bidder, not first discovery -It tends to shift transaction gains to target SH XII. Fundamental Transactions: M&A

These are transactions that pool the assets of separate companies into either a single entity or a dyad of a parent and a wholly owned subsidiary. Three legal forms: (1) merger, (2) purchase (or sale) of all assets, and (3) (in RMBCA jurisdictions) the compulsory share exchange. (see more about all of these in section 4 below) Merger = legal event that unites two existing corporations with a public filing of a certificate of merger, usually with SH approval. Usually, one of the two absorbs the other and is the surviving corp. Acquisitions = non-merger techniques for combining companies, generally involving purchase of assets/shares of one firm by another Justifications for SH Approval of Fundamental Transactions -Too big, too important but why dont other big (bet the company) transactions require approval? -Dont require managerial expertise dissolution, M&A look more like investment decisions than mgmt -Pose special agency problems final period for incumbent managers 1. Economic Motives for Mergers Efficiency motives (increasing the size of the pie): economies of scale/scope, e.g., manufacturing efficiencies, extending mgmt talent to a larger asset base; vertical integration; replacing bad mgmt; diversification Redistributive motives: shifting value from govt (carrying NOL forward), creditors (LBOs), or consumers (monopoly pricing) Bad motives: hubris, overestimation of synergies, empire building (all possibly driven by poor economic incentives) 2. Evolution of U.S. Corporate Law of Mergers Movement away from rigid, prohibitive law to more flexible regulation -Modern era: cash consideration (no restrictions on using cash as consideration since 1950) 3. Overview of the Transactional Form Asset Acquisition DGCL 271 -Transaction costs can be higher, but liability is lower (you pick up the assets of T but not liabilities, if you restructure the assets). (If you dont restructure, could get saddled w/successor liability.) Steps: (1) Boards of the two firms, A and T, negotiate the deal. (2) Only Ts SH get voting and appraisal rights (because only T is being bought). (3) Title to the actual physical assets of T must be transferred to A, so transaction costs are generally higher than in mergers. (4) After transfer, T usually liquidates the consideration received (e.g., cash) to its SH. Question: when does a co. sell all or substantially all of its assets? There doesnt have to be a 100% sale in order to require a SH vote. Katz v. Bregman (Delaware 1981) Facts: As part of a broader divestment strategy, Plant Industries decides to sell its Canadian operations (Plant National), which constitutes 51% of its assets, 45% of its revenues, and 52% of its operating income. The idea is to take the proceeds and shift to a different line of business, namely making plastic drums instead of steel drums. Plant CEO Bregman agrees to sell Plant National to Vulcan, even though

Universal offered a higher bid. SH sue to seek an injunction against the deal, alleging that a SH vote was required b/c the deal sold all or substantially all of the co.s property and assets. Holding: This was a sale of substantially all of the assets. Reasoning: The proposal after the sale to embark on a manufacture of plastic drums represents a radical departure from Plants historically successful line of business. Notes: The court may be reaching/stretching a bit here b/c uncomfortable w/upholding the transaction w/o a SH vote- it seems a little shady b/c the corp. is not selling to the highest bidder. Note that no later court has approached this level of liberality in interpreting all or substantially all. Thorpe v. CERBCO (Delaware 1996) Facts: CERBCO stock in Insituform constitutes 68% of CERBCOs assets. CERBCOs public SH want CERBCO to sell its shares in Insituform. Holding: This would be a sale of all/substantially all assets, requiring a SH vote. The test: The need for SH approval is to be measured not by the size of the sale alone, but also by the qualitative effect on the corp. Thus it is relevant to ask whether a transaction is out of the ordinary course and substantially affects the existence and purpose of the corp. Stock Acquisition -Purchase of all, or a majority of, a companys stock -Purchasing control by buying stock is just a SH transaction w/o altering corp.s legal identity something more is needed to result in a full-fledged acquisition -Acquirer has to get 100% of Ts stock short-form merger statutes allow a 90% SH to simply cash out a minority unilaterally (DGCL 253) -A different way to accomplish this Compulsory share exchanges: its a tender offer negotiated w/ Ts board that, after approval by a requisite majority of SH, becomes compulsory for all SH As stock (or other consideration) is then distributed to Ts SH pro rata, while A becomes the sole owner of all of Ts stock. T is then a wholly owned subsidiary of A. -Benefits: you shield A from Ts liabilities, preserve identity of T -DE does not have a compulsory share exchange statute, but has two-step merger: A makes a tender offer for most/all of Ts shares at an agreed-upon price, which T promises to recommend to its SH, and then T merges with one of As subsidiaries same result as CSE Mergers DGCL 251 -Lower transaction costs, but A assumes all of Ts liabilities. Steps: (1) A and T boards negotiate the merger. (2) Proxy materials are distributed to SH as needed. (3) Ts SH always vote (251(c)); As SH vote if A stock outstanding increases by >20% (251(f)). (4) If majority of shares outstanding approve, Ts assets merge into A, Ts SH get back A stock. Certificate of merger is filed with the sec. of state. (5) Dissenting SH who had a right to vote have appraisal rights. -Higher or special voting requirements can be adopted in the charter Triangular Mergers -Preserve liability shield in b/w A and T T merged into a wholly owned subsidiary of A, or vice versa -No requirement to have As SH vote, and no appraisal rights (anomaly in DE law) Forward Triangular Mergers -A forms subsidiary. A transfers merger consideration to sub in exchange for all of subs stock. -T merges into sub. -Merger consideration distributed to Ts SH, and their T stock will be cancelled.

-After merger, A will own all of outstanding stock in sub, which in turn will own all of Ts assets and liabilities. Reverse Triangular Mergers -Same as above, but T is the surviving corp. -Ts SH nonetheless have their shares converted into the merger consideration -More popular b/c this way you preserve the goodwill and reputation of T 4. Structuring the M&A Transaction Timing Want to make acquisition as fast as possible All-cash, multistep acquisition is the fastest way to lock up a T and assure complete acquisition But, if stock constitutes any part of the consideration, the 2-step structure does not provide a significant timing advantage- so usually one-step or triangular mergers Planning Around Voting and Appraisal Rights From planners perspective, SH votes and appraisal rights are costly and risky, so either try to condition transactions on these happening, or try to choose structure avoiding them completely Dont want to trigger class votes for holders of preferred stock- might extract holdup payment Due Diligence, Representations and Warranties, Covenants, Indemnification Buyer always wants reliable info about T In negotiated transactions, representations/warranties in merger agreement will facilitate the due diligence process by forcing disclosure of all Ts assets and liabilities Establish conditions for closing transaction and allocate risks b/w parties Agreements effectively allocate burden of undiscovered noncompliance to party making the representation Accounting Treatment In a direct merger, the surviving corp. typically records assets acquired at their fair market value If merger consideration exceeds total of FMV of assets, as it ordinarily will b/c business organization and intangible assets of T contribute value to it, survivor will record excess as goodwill Lawyers as Transaction Cost Engineers facilitating these transactions BARRIER LAWYER RESPONSE Diff. expectations about Build in contingent payments: Earn-out or clawback value of company Diff. time preferences Negotiate timing of payments Asymmetric info Build in representations, warranties, indemnification, opinions Imperfect info Negotiate to sellers knowledge vs. to the best of sellers knowledge vs. to the best of sellers knowledge and after diligent investigation 5. Taxation of Corporate Combinations General Rule: a reorganization that qualifies under IRC 368 is tax-free under IRC 354 no recognition of gain to the seller, except to the extent that they receive boot; A gets carry-over basis in stock or assets acquired, T gets carry-over basis in stock received (Boot = permissible consideration other than stock of A) Three transaction forms for non-recognition of gain:

-IRC 368(a)(1)(A) (A Reorganization, statutory merger): mergers & consolidations executed pursuant to state law, provided that As stock must constitute a substantial and meaningful portion of the total consideration. Up to 50% boot allowable. -IRC 368(a)(1)(B) (B Reorganization, stock acquisition): A acquires solely in exchange for its voting stock (or the voting stock of its parent) at least 80% of Ts stock. No boot allowed. -IRC 368(a)(1)(C) (C Reorganization, asset acquisition): A acquires substantially all of Ts assets in exchange for As stock. Up to 20% boot allowable. 6. Appraisal Remedy This is a form of SH protection in mergers. The SH non-unanimity rule for authorization of mergers established that SH interests are held subject to the exercise of collective SH judgment. -SH who vote against a transaction but are outvoted have the right to a judicial appraisal of the fair value of their shares, and the right to sell them back to the company at the appraised value. Every U.S. jurisdiction provides an appraisal right. (DGCL 262) -A merger might have meant that a SH would have been forced to accept an illiquid investment in a new company in which he had no desire to invest judicial appraisal a way to provide liquidity for such a SH (However, now our equity markets are very liquid so this is not a rationale justifying costs of appraisal) SH get notice of appraisal right at least 20 days before SH meeting (262(d)(1)) SH submits written demand for appraisal before SH vote, then vote against (or at least refrains from voting for) the merger (262(d)(1)) If merger is approved, SH files petition in Chancery Court w/in 120 days after merger becomes effective demanding appraisal (262(e)) Court holds valuation proceeding to determine the shares fair value exclusive of any element of value arising from the accomplishment or expectation of the merger (262(h)) No class action device available, but Chancery Court can apportion fees among plaintiffs as equity may require (262(j)) Appraisal rights arent available in every kind of merger And they can be gotten around if you do a de facto merger Market-Out Rule 262(b)(1) Precludes appraisal as an available remedy in stock-for-stock mergers of most public companies (when shares of T are traded on a national security exchange or held of record by 2000 registered holders); appraisal also denied if SH were not required to vote on the merger (So- if youre a SH in a firm with <2000 SH and you are required to vote on the merger, you will always get appraisal rights. If not, no appraisal rights.) 262(b)(2) you DO get appraisal rights if your merger consideration is anything other than shares in the surviving corp. or shares in a third company that is exchange-traded or has 2000 SH Nature of Fair Value -Delaware law clearly defines the dissenting SHs claim as a pro rata claim on the value of the firm as a going concern -Delaware appraisal statute seeks to measure fair value of dissenting shares, free of value that might be attributed to the merger, but including elements of future value present at time of merger -Discounted cash flow (DCF) method- uses projection of future cash flows and an estimate of the appropriate cost of capital for discounting those expected cash flows to present value In re Vision Hardware Group, Inc. (Delaware 1995)

Facts: Better Vision (Vision) starts in 1988 w/ $500,000 investment from SH; eventually accumulates $125 million in debt and never makes any money. Five years later, Trust Company of the West (TCW, a vulture fund) buys the debt at a deep discount, gets warrants to buy 51% of Visions stock, and attempts to cash out the minority SH for $125,000. Independent board approves the transaction but SH vote is dominated by new TCW shares. Dissenting SH seek appraisal. Both parties agree that the companys assets are worth about $90 million, but dispute whether the co.s stock is worth $39.9 million or zero. Holding: The appropriate valuation of the companys debt for 262 purposes is the dollar value of the legal claim that the debt represented. Thus, the shares held by the public SH excluding value attributable to the merger and its cash infusion and no substantial value. Reasoning: But for the TCW proposal and its effectuation, Better Vision was a going concern heading immediate into bankruptcy and liquidation. The holder of the debt by the time of the merger (TCW) had the right to enforce the legal liability and force the company into bankruptcy. Summary: Shareholder Voting & Appraisal Statutory Merger (DGCL 251, RMBCA 11.02) T Voting Rights Yes need majority of shares outstanding (DGCL 251(c) or majority of shares voted (RMBCA 11.04(e)) Yes unless < 20% shares being issued (DGCL 251(f) RMBCA 11.04(g) Yes if T shareholders vote, unless stock market exception (DGCL 262, RMBCA 13.02) Asset Acquisition (DGCL 271, RMBCA 12.01-.02) Yes if all or substantially all assets are being sold (DGCL 271(a) or no significant continuing business activity (RMBCA 12.02(a) No though stock exchange rules might require vote to issue new shares Yes under RMBCA if T shareholders vote, unless stock market exception (RMBCA 13.02(a)(3); No in DE, unless provided in charter DGCL 262 Share Exchange (RMBCA 11.03) Yes need majority of shares voted (RMBCA 11.04(e)

A Voting Rights

Yes unless <20% shares being issued (RMBCA 11.04(g) Yes, unless stock market exception (RMBCA 13.02(a)

Appraisal Rights

7. De Facto Merger Doctrine Some U.S. courts adopt a functionalist approach and accord SH voting/appraisal rights to all corp. combinations that resemble mergers in effect- rationale: if its going to have same economic effect as a de jure merger, SH should have same protection -Counterargument: corporate law is all about formalism for a reason- its a source of utility, it permits people to accurately predict the legal consequences of their activities **Delaware takes the formalist side of the argument on this point a self-identified sale of assets that results in exactly the same economic consequences as a merger will nonetheless be governed by the (lesser) SH protections assoc. w/a sale of assets, and not full panoply of merger protections (Hariton) Hariton v. Arco Electronics, Inc. (Delaware 1963) Facts: Loral buys all of Arco in an arms-length asset acquisition after months of negotiating and two rejected offers. SH approved the transaction, Arco transfers all of its assets to Loral, Loral transfers its

stock to Arco, Arco dissolves and distributes the Loral stock to SH (classic asset acquisition for stock). Arco SH bring suit claiming right to appraisal b/c the deal was a de facto merger. Holding: SH lose. Appraisal right is only granted by merger statutes, and this technically was not a merger. Reasoning: Arco continued in existence as a corp. entity following the exchange of securities for its assets. The fact that it continued corporate existence only for the purpose of winding up its affairs by the distribution of Loral stock is of little consequence. 8. Duty of Loyalty in Controlled Mergers Controlled merger- when theres a controlling SH- they have an obligation of fairness because they have the de facto power to do what other SH cant (influence the board, get access to info, etc.) -In these mergers, minority SH are at risk of exploitation like in cash-out/freeze-out mergers Cash Mergers or Freeze-Outs Say X Corp. has a minority SH and a controller. The controller also wholly owns a dummy corp. with lots of cash. Controller arranges a merger b/w X and the dummy corp. in which Xs SH receive cash for their shares. They cant do anything to stop the merger b/c they are in the minority. Why allow a cash-out following acquisition of control? Acquirer might need to merge with T to realize synergy gains; might need to gain title to Ts assets for financing purposes; might have a good idea it doesnt want to share w/minority SH; might wish to avoid costs of carrying SEC-registered subsidiary. Weinberger v. UOP, Inc. (Delaware 1983) Facts: Signal owns 55.5% of UOP, holds 6 of UOPs 13 board seats. Signal decides to buy the remainder of UOP. Arledge and Chitiea (UOP directors and Signal officers) report to Signals board that any price up to $24/share would be a good investment for Signal, but the report isnt shared w/UOPs board. Signal offers $21/share (a 55% premium) conditioned on majority of the minority approval by UOP SH. UOPs board and CEO (Crawford) accept with a hastily-drafted banker fairness option, but fail to negotiate. Signal-UOP directors Walkup and Shumway withdraw from the UOP board meeting approving the transaction, but help to persuade Crawford to sell the deal to the UOP board. 52% of minority shares approve the merger. Plaintiff UOP SH bring a class action challenging the transaction as a breach of the UOP boards fiduciary duty. Holding: SH win. When directors are on both sides of a transaction, they are required to demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain. Reasoning: This transaction did not live up to that standard. The $24/share finding should have been shared with the board so they could have demanded that much. Fairness inquiry has to do with fair dealing and fair price, but its not bifurcated, you look at overall fairness. Here there was not fair dealing (time constraints, little bargaining) or fair price (using DCF analysis). The award should be monetary damages, since the long completed transaction is too complicated to undo. Notes: Before this case, it seemed like you could get either appraisal rights or a class action suit but not both. But this case makes clear that both will be recognized. *In a footnote, the Court intimates that UOP might have been okay if they had appointed an independent negotiating committee of outside directors to deal with Signal at arms length. It would have helped the transaction meet the fairness test. Rabkin v. Phillip A. Hunt Chemical Corp. (Delaware 1985) Facts: Olin Corp. buys a control block in Hunt, and contracts that if it cashes out the minority w/in 12 months it would pay the minority SH the same it paid for the control block. Olin waits 12 months and a bit, and then cashes out the minority SH at less than the original transaction price. Minority SH bring suit claiming breach of fid duty b/c Olin deliberately waited longer than 12 months to avoid paying the

minimum K price. Chancery Court dismisses on that ground that, absent deception, Weinberger mandated appraisal as the only remedy available to minority SH. Holding: Reversed- Weinberger makes clear that appraisal is not necessarily a SHs sole remedy. The appraisal remedy the court approves may not be adequate in certain cases, particularly where fraud, misrepresentation, self-dealing, deliberate waste of corp. assets, or gross and palpable overreaching are involved. SO, on the appraisal/lawsuit issue: -Where theres a claim that D owes fid duties to the public SH (as in parent-subsidiary merger or even two-tier cash-out merger by third party) appraisal is NOT the exclusive remedy for complaints concerning price (can get appraisal OR file class action) -Where there is a straight (one-step) cash or stock merger b/w firms w/no shared ownership interest (an arms length merger), complaints about price alone ONLY get appraisal remedy (no class action) Parent-Subsidiary Freeze-Out: Typical Structure (1) Parent notifies target of going private or minority squeeze-out proposal a. Parent issues press release announcing proposal b. Proposal subject to Special Committee approval (2) Target sets up Special Committee of independent directors a. Special Committee hires investment bankers and lawyers b. Special Committee gets up to speed (3) Parent negotiates w/Special Committee and hopefully eventually agree on price Judicial Scrutiny Apply entire fairness when reviewing minority squeeze-out transactions; D has burden of proof to show that transaction as a whole is fair to minority SH BUT burden of disproving entire fairness shifts to P through: 1- properly functioning Special Committee (e.g., comprised solely of independent directors and having real negotiating power), AND 2- approval of transaction by majority of minority SH (e.g., closing of merger or tender offer conditioned upon approval of majority of the minority) The Weinberger Recipe to pass this test if youre the target: a majority of the minority vote; an independent negotiating committee; a serious fairness opinion; and evidence of real negotiation b/w an independent board committee and the controlling SH. What Constitutes Control and Exercise of Control Kahn v. Lynch Communication Systems, Inc. (Delaware 1994) Facts: Alcatel owns 43.3% of Lynch; Alcatel proposes that Lynch acquire Celwave (owned by Alcatel). The Lynch board appoints an independent committee (IC) to negotiate with Celwave. Alcatels banker and the ICs banker cant agree on price, so the IC unanimously opposes a Celwave/Lynch combination. Alcatel, disappointed, offers to acquire all of Lynch at $14/share. The IC ultimately recommends $15.50 after Alcatel threatens a hostile tender offer. Lynchs disinterested directors approve. But a SH sues Alcatels directors, alleging breach of fid duty as controlling SH. Holding: The IC here was not enough to shift the burden of proof to the plaintiff. Remanded so that Alcatel can try to prove entire fairness. Reasoning: A controlling SH on both sides of a transaction, as in a parent-subsidiary context, bears the burden of proving the transactions entire fairness. An approval of the transaction by an IC or an informed majority of minority SH shifts the burden of proof from the controlling SH to the plaintiff. But, the mere existence of an IC does not itself shift the burden. Two factors are required: (1) the majority SH must not dictate the terms of the merger, and (2) the IC must have real bargaining power that it can exercise with the majority SH on an arms length basis. Here, the ICs ability to bargain at arms length with Alcatel was suspect b/c they had submitted to Alcatels demands in the past. And any semblance of

arms length bargaining ended when the IC surrendered to the ultimatum accompanying Alcatels final offer. Special Committees of Independent Directors in Controlled Mergers Assuming a diligent, sell-advised special committee, what effect should be given to its approval? Two views: Treat it as decision of disinterested and independent board apply BJR Continue to apply entire fairness since court cannot tell which subtle pressures are operating (Kahn) Controlling SH Fid Duty on the First Step of a 2-Step Tender Offer -Whats controlling SH duty when it skips the board altogether and offers the transaction directly to the public SH in form of a tender offer? -Has to disclose all material info respecting offer (1934 Act, 14(e)) -No federal law duty to pay a fair price what about under fid principles? NO In re Siliconix Inc. SH Litigation (Delaware 2001) Facts: Vishay owns an 80.4% stake in Siliconix and wants to acquire the remaining 19.6%. In Feb 2001, Vishay announces a tender offer at $28.82 cash (a 10% premium) for the remaining stock, and asks to discuss its tender offer w/a special committee of independent Siliconix directors. A special committee consisting of two directors begins negotiations. In May 2001 Vishay launches an exchange offer of 1.5 shares of Vishay for each Siliconix share. Minority SH challenges the offer as inadequate/unfair price. Holding: No entire fairness scrutiny. There is no duty to offer any particular price, or a fair price, to the minority SH unless actual coercion or disclosure violations are shown. As long as the tender offer is pursued properly, the free choice of the minority SH to reject the tender offer provides sufficient protection. In re Pure Resources, Inc. SH Litigation (Delaware? 2002) Facts: Unocal holds 65% of Pure, Pures CEO holds 6%, and Pure managers hold another 11%. Pures board has 8 members: 5 Unocal designees, 2 Hightower designees, and 1 joint designee. Unocal makes a surprise exchange offer at a 27% premium to market price, contingent on getting 90% ownership of Pure. Pure forms a special committee, consisting of two Pure directors who are plausibly independent of Unocal. Special Committee negotiates w/Unocal, fails to adopt a poison pill (that would give it veto power), and finally recommends against the exchange offer to Pures minority SH. Unocal nevertheless goes ahead, and Pure minority SH bring suit to block the offer. Holding: The tender offer road map: The offer cannot be coercive o An acquisition tender offer is non-coercive only when: (1) it is subject to a non-waivable majority of the minority tender condition (2) the controlling SH promises to consummate a prompt 253 merger at the same price if it obtains 90% of the shares, and (3) the controlling SH has made no retributive threats. Target board independent directors must have a role o Majority SH owes a duty to permit the independent directors on the target board free rein and adequate time to react to the tender offer, by (at the least) hiring their own advisors, providing the minority with a recommendation as to the advisability of the offer, and disclosing adequate info for the minority to make an informed judgment Details of fairness opinion must be disclosed o SH are entitled to a fair summary of the substantive work performed by the investment bankers XIII. Public Contests for Corporate Control

Why hostile takeovers can be good: -If corp. is badly managed, its share price will decline relative to other companies in the industry. -At that point it can be profitable for a new group to make a tender offer, bringing in more efficient leadership. -Just the threat of a takeover provides incentive for managers to run companies in the interest of SH. (Important potential constraint on manager-SH agency costs.) 1. Defending Against Hostile Tender Offers Unocal Corp. v. Mesa Petroleum Co. (Delaware 1985) Facts: Unocal stock was trading at $33/share. Mesa quietly buys 13% of Unocals stock and then makes a tender offer for another 37% at $54/share in cash. Mesa discloses its plan to freeze out the remaining 50% for junk bonds worth about $45, if successful in the first-stage tender offer. Unocal board meets to review the offer. Goldman reports to the board that the minimum cash value in a liquidation would be $60/share in cash. The board decides on a defensive capitalization: self-tender for 30% of the shares at $72/share in debt securities, and tender for the remaining 20%, also at $72/share in debt securities, if Mesa gains 50% (and Mesa was excluded from the offer). Mesa brought suit to enjoin the defensive measures so that the hostile tender offer could proceed. Holding: If a defensive measure is reasonable in relation to the threat posed by the hostile takeover, it will be upheld as a proper exercise of business judgment (as long as good faith and due care). Reasoning: Boards have a fundamental duty and obligation to protect the corporate enterprise from harm reasonably perceived, irrespective of its source. However, b/c of the risk that a board may be acting in its own self-interest, judicial review above the BJR standard may be needed. A corp.s board does not have unbridled discretion to defeat any perceived threat by any Draconian means available. They may not act solely or primarily out of a desire to perpetuate themselves in office or take inequitable action. In determining whether their defensive act is reasonable in relation to the threat posed, they have to analyze the nature of the takeover bid and its effect on the corp. enterprise. Here, the threat posed was viewed by the board as a grossly inadequate two-tier coercive tender offer. The selective exchange offer was reasonably related to the threats posed; it was designed to defeat the inadequate Mesa offer or at least provide 49% of the SH with $72 of senior debt. Notes: This is an intermediate standard b/w BJR and entire fairness. What is a valid threat? structural coercion (Unocal) opportunity loss (Time) substantive coercion (Unocal, Time) Unitrin v. American General Corp. (Delaware 1995) Facts: AmGen made a hostile tender offer for Unitrin at ~$50/share, a substantial premium over market price. Unitrins board was comprised of 7 people, who collectively owned 23% of the companys stock. After concluding that AmGens offer was inadequate, Unitrins board sought to defend by implementing a poison pill, an advance-notice bylaw, and a tender offer to repurchase 5 million shares (20%). If the buyback was successful, it would increase the directors proportional share ownership to 28%. Holding: If the boards defensive response is not draconian (preclusive or coercive) and is within a range of reasonableness, a court must not substitute its judgment for the boards. Reasoning: The pill and the repurchase program were not coercive or preclusive b/c AmGen could run a proxy contest to replace the Unitrin board. So we have to remand to find out whether they are within a range of reasonableness. If so, the burden will then shift back to plaintiffs to prove that the defensive action was not otherwise a breach of duty (e.g., by being primarily motivated by self-entrenchment).

Notes: This case clarifies the Unocal test in three ways. (1) Under Unocal/Unitrin, Ts directors, not the plaintiff, bear the burden of showing that the defensive action was proportionate in response to the threat. (2) Substantively, action that is preclusive or coercive will fail the test. (3) Passing the preclusive/ coercive (non-draconian) test, it will be upheld if w/in a range of reasonable action. (This prong is operationally similar to the BJR.) This is a high water mark of Unocal cases, giving the board maximum discretion. 2. Private Law Innovation: The Poison Pill Poison pill = SH rights plan, altering allocation of power b/w SH and boards Rights to buy the companys stock at a discounted price are distributed to all SH w/ their stock (embedded in the shares). These rights are triggered (become exercisable) only if someone acquires more than a certain percentage of the companys outstanding stock (e.g., 10% or 15%) w/o first receiving the boards blessing. The person whose stock acquisition triggers the exercise of the rights is himself excluded from buying the discounted stock. His holdings are severely diluted and will end up losing the greatest part of his investment in the company stock. So, buying a big block of stock w/o consent of board will be too expensive to do. -They always have opt-out provisions for friendly bids. -Flip-in pills: each outstanding right flips into a right to acquire some number of shares of the targets common stock of a small percentage of the market price of the stock. If all right holders do this, the aggregate effect is to increase the proportionate holdings of all SH except the triggering person. Flip-in pills are adopted by board vote; SH vote not necessary as long as the board has the requisite provision in the charter allowing it to issue blank check preferred stock. -Flip-over pills: when triggered, create a right to buy some number of shares of stock in the corp. whose acquisition of target stock had triggered the right. They compel the targets board to put terms in any merger agreement w/the acquirer that will force the acquirer to recognize flip-over rights. Does the pill help or hurt SH? Help: if the acquirer cant get control, will have to negotiate during the sale so SH will get a higher price (bargaining leverage) Hurt: could help entrench poor management Moran v. Household International, Inc. (Delaware 1985) Facts: In August 1984, on a clear day, Household Intl board adopts a flip-over poison pill by a 14-2 vote, on the vice of Wachtell and Goldman Sachs. Two triggers: announcement of a 30% tender offer, or acquisition of 20% of the shares. Directors Moran and Whitehead vote against it; Moran, largest SH and potential acquirer, brings suit to enjoin the pill as outside boards authority and an invalid exercise of BJ. Holding: The pill is protected by the BJR for now (in theory), although the ultimate response to a takeover bid has to be judged by what happens at that time (under the Unocal standard). Reasoning: The pill in theory is valid under DGCL 157 (allowing corp. to create/issue rights/options entitling SH to purchase shares). It does not prevent SH from receiving tender offers. It does not destroy the assets of the corp. Compared to other defensive mechanisms, it is less harmful to the value structure of the corp. It does not restrict SH right to conduct a proxy contest. There was no bad faith and the pill was not adopted for entrenchment purposes. The pill is ok under the BJR. Notes: Corp. directors continue to exercise power subject to their fid duty after adopting the pill. Under Unocal, the board might have to redeem the rights issued under the pill if their effect no longer appears reasonable in relation to a threat posed.

 Forced Pill Redemption: **Boards have an ongoing fiduciary obligation to redeem the pill if it is no longer reasonable in relationship to the threat from an acquisition offer** City Capital Assoc. Ltd. target board required to redeem a pill that the company used to protect its recapitalization alternative to a hostile, all-cash, all-shares tender offer (did not constitute sufficient threat to corp. or its SH to justify foreclosing SH from choosing to accept) Grand Metropolitan Public Ltd. Pillsbury required to redeem pill after concluding that Pillsburys own restructuring proposal was not as good as a hostile all-cash offer from Grand Met. -Courts are exercising business judgment in these cases when they weigh pill vs. threat. However, after Time, this rarely happens b/c board is not required to give up long-term strategy unless there is clearly no basis to sustain it *How can you take over a firm if theres a pill in place? Have to wage a proxy contest- replace old board w/new one who will pull the pill. -This is why staggered boards are defensively important. 3. Choosing a Merger or Buyout Partner: Revlon Doctrine The boards entrenchment interest can affect its choice of a merger/buyout partner -Board has a fiduciary duty when arranging a friendly sale as a takeover defense Smith v. Van Gorkom (Delaware 1985) Facts: Trans Union is a publicly held company with unused NOLs (net operating losses) and a CEO (Van Gorkom) looking to retire. Stock is selling for around $35/share. Acting mainly on his own, Van Gorkom arranges a sale to Pritzkers company for $55/share, cash. Van Gorkom calls a special meeting of the board but does not give them an agenda beforehand. Board approves merger, and deal protection features, after a 2-hour meeting. Trans Union SH sues, alleging breach of duty of care. No allegation of conflict of interest, but claim the board did not act in an informed manner in agreeing to the deal. Holding: The board breached its duty of care in not reaching an informed BJ they were grossly negligent in failing to act w/informed reasonable deliberation. Reasoning: The members of the board were required to rely only on Van Gorkoms 20 minute oral presentation of the proposal. The fact of the premium alone did not provide an adequate basis upon which to assess the fairness of the offering price. That premium needed to be assessed in terms of other competent and sound valuation info reflecting the value of the business. The board was not free to withdraw from its agreement later. Remedy: the board is held liable for the difference b/w the $55 and the true value of the shares. Notes: The board was held liable here even though the company sold for a high price. VG just picked a price b/c he wanted to retire. He didnt undertake a true valuation of the corp.; it could have been worth even more. This case was important b/c it was a step in setting a new standard of judicial review for change in control transactions like mergers. Revlon, Inc. v. MacAndrews and Forbes Holdings, Inc. (Delaware 1986) Facts: Perelman makes a hostile all-cash tender offer for Revlon at $47.50/share when the stock is trading at $25 (a 90% premium). Revlon board adopts a poison pill and tenders for 20% of its own shares with notes. The recapitalization permits Revlon to subject itself to specialized debt covenants the restrict the sale of assets, which in turn makes an LBO more difficult. But Perelman is undeterred he raises his offer to $50, $53, and finally $56.25/share, with the promise of even more if Revlon redeems its pill. Forstmann Little enters as a white knight and eventually agrees to pay $57.25; gets an asset lock-up, a no-shop provision, and a breakup fee, in exchange for supporting the par value of the notes which had faltered in the market. Perelman increases his offer to $58 and brings suit to enjoin to defensive tactics and deal protection devices that Revlon used to preserve its deal with Forstmann.

Holding: When a sale becomes inevitable, the directors role changes from defenders of the corporate bastion to auctioneers charged w/ getting the best price for the SH duty to sell the co. at the highest price attainable, for SH benefit. The directors here breached that duty. Reasoning: The original threat posed by Perelman had become a reality. Selective dealing to fend off a hostile but determined bidder was no longer a proper objective. Instead, obtaining the highest price for eh benefit of the SH should have been the central theme guiding director action. By entering the lock-up agreement w/Forstmann on the basis of impermissible considerations at the expense of the SH, the directors breached their duty of loyalty. The merger agreement w/Forstmann was unreasonable in relation to the threat posed. Lock-up agreements are only OK if they draw bidders into the battle and therefore benefit SH; if they end an active auction and foreclose further bidding, they operate to SH detriment and are not OK. Here, the lock-up ended the auction. The real reason for the lock-up was not a legitimate one; the board was trying to protect the noteholders over the SH interest. *When a board ends an intense bidding contest on an insubstantial basis, and where a significant by-product of that action is to protect the directors against a perceived threat of personal liability for consequences stemming from the adoption of previous defensive measures (here, the notes), the action cannot withstand Unocal scrutiny. Notes: Unlike Unocal (where board discretion is high), here the board has a specific duty. Barkan v. Amsted Industries Inc. (Delaware 1989) Clarified Revlon duties Level playing field among bidders o When several suitors actively bidding for control, directors may not use defensive tactics that destroy the auction process. Market check required o When the board is considering a single offer and has no reliable grounds upon which to judge its adequacy, fairness demands a canvass of the marketplace to determine if higher bids may be elicited Exemption allowed in very limited circumstances o When directors possess a body of reliable evidence with which to evaluate the fairness of a transaction, they can approve a transaction w/o conducting active marketplace survey. 4. Pulling together Unocal and Revlon Paramount Communications Inc. v. Time Inc. (Delaware 1989) Facts: Time and Warner agree to stock-for-stock merger of equals in which Warner SH get 62% of the surviving company. Various deal protection devices are enacted, including cross-options to deter third party bidders. CEOs would be co-CEOs for five years, then Warners CEO (Ross) will retire and Times CEO (Nicholas) will take over. Ross gets $200 million in cash and options by the time he retires, and $600 million total for Warners mgmt team. Paramount makes an all-cash hostile bid for 100% of Time shares, first at $175, then upped to $200. Times board rejects the offer based on a fairness opinion which valued the Time shares for as much as $250. Time gets nervous about the SH vote, so the deal w/Warner is restructured so that Time borrows $10 billion and uses it to make a cash tender offer for Warner. Paramount brings suit to enjoin Times defensive tactics under Unocal. Times SH also join the suit and bring a Revlon claim. Holding: Dissolution was not inevitable, so Revlon duties were not triggered. Under Unocal, the response was reasonably related to the threat. Reasoning: Revlon claim There was an absence of any substantial evidence to conclude that Times board, in negotiating w/ Warner, made the dissolution or breakup of the corp. entity inevitable. There are at least two Revlon triggers: (1) when a corp. initiates an active bidding process seeking to sell itself or to effect a business reorganization involving a clear break-up of the company; (2) where, in response to a bidders offer, a target abandons its long-term strategy and seeks an alternative transaction also involving the breakup of the company. Revlon is NOT triggered when the boards reaction to a hostile tender offer

is found to constitute only a defensive response and not an abandonment of the corp.s continued existence. However, in that situation, Unocal duties attach. Here, Times board legitimately decided, in good faith and not dominated by entrenchment motives, that Paramounts offer posed a threat to corp. policy and effectiveness. Its response was reasonably related to the threat and not overly broad. Notes: Time was worried that its SH would reject the merger w/ Warner b/c they wanted the Paramount offer instead (more money in the short term). So the made a highly leveraged cash tender offer to Warner, and if this went forward, then Paramount couldnt buy Time-Warner (it would be too indebted). Paramount Communications Inc. v. QVC Network, Inc. (Delaware 1994) Facts: Paramount agrees to be acquired by Viacom, controlled by Redstone, for Viacom stock and cash worth ~$70. Pre-bid price was $43-45/share. The deal gives substantial deal protection measures to Viacom: no shop agreement, $100 million break-up fee, and 19.9% stock option lock-up. QVC (Diller) jumps the deal w/ an offer to acquire Paramount for $80 cash and then stock; when negotiations stall, Diller makes a hostile $80 cash tender offer for 51% of Paramount, with a planned back-end squeeze out for $80 in QVC stock. Viacom matches QVC at $80, and then raises its price to $85 in cash and stock, but leaves the deal protection unchanged except for a new fiduciary out. QVC goes to $90; Paramount rejects as excessively conditional but makes no effort to explore the conditions or negotiate w/QVC. QVC brings suit claiming that Paramount was in Revlon mode. Holding: When a corp. undertakes a transaction which will cause: (a) a change in corp. control, or (b) a break-up of the corp. entity, the directors obligation is to seek the best value reasonably available to the SH. Because a change of control was going to happen, Paramount directors were supposed to find the best value reasonably available to the SH, which they did not do. Reasoning: This obligation arises b/c the effect of the transaction, if consummated, is to shift control of Paramount from the public SH to a controlling SH, Viacom. A break-up is not essential to trigger Revlon obligations. So the duties were triggered here. And, they were not met. The board gave insufficient attention to the potential consequences of the defensive measures demanded by Viacom. The stock option agreement had some potentially draconian provision. QVCs interest in Paramount could have given the board the opportunity to get a significantly higher value than what Viacom was offering. It should have been clear to the board that the deal protections were impeding the realization of the best value reasonably available to the SH. The disparity in value could not be justified on the basis on the directors long-term strategy, b/c the change in control wouldnt let them follow that strategy anyway. Notes: In applying this rule, courts might look to a de jure or de facto definition of control. Since QVCs analysis rests heavily on policy considerations, it would be likely that a court would gravitate toward a practical test for control rather than a formal one. Here the directors SHOULD HAVE reopened negotiations w/both sides, explored the QVC offer more seriously, gotten rid of Viacom deal protections. Paramounts K w/Viacom was void because it conflicted with fid duties.

Triggering Revlon Three Factors

Revlon-mode less likely All stock Revlon-mode more likely* All cash

Consideration

Merger of equals Size of target versus acquiror Widely held

Whale/ minnow

Institutional Competence Theory (e.g., Revlon)

Acquiror shareholders

Controlling shareholder

Sale of Control Theory (QVC)

* except when target has a majority shareholder

Why does the cash vs. stock distinction matter? -Paying w/ your own stock reflects the boards view of the business opportunities and potential synergies of the transaction -Its easier for a court to compare cash offers to see which is higher; comparing stock is harder; evaluating synergies is more w/in the boards expertise Institutional Competence Argument -Rules underlying Revlon duties turn on assumption that boards generally better able to value companies than SH are- BUT in some circumstances (like when SH will be cashed out), boards must maximize short-term value, since this is the only value that SH are likely to receive -Courts believe that in an all-stock deal b/w two companies of the same size, the board has a substantial advantage over SH (and the market) in evaluating long-term value of the surviving corp. as well as the long-term value of the merger consideration. -Thus courts defer to the views of boards in these cases information advantage (synergies) -Ultimately, test for deciding whether a boards decision to select a merger partner should be respected must be whether the board has shown that it decided in an informed manner and made a good-faith effort to advance the interests of the corp. and its SH Degrees of deference: MOST Merger consideration is stock of company of roughly equal size Merger consideration is mixed OR target vastly smaller (minnow) LEAST Merger consideration is in cash

5. Protecting the Deal (Fiduciary Outs, Lock-Ups) Lock-up = any K collateral to an M&A transaction that is designed to increase the likelihood that the parties will be able to close the deal Asset Lock-Up o Gives the acquirer the right to buy specified assets of the target at specified price (rare)

 Stock Option Lock-Up o Gives the acquirer the right to buy a specified number of the shares of the target (typically 19.9%) at a specified price. Appeared in ~25% of deals in 1999 (rare now) Breakup Fee o Gives the acquirer a cash payment in the event of non-consummation. Appeared in about 50% of deals in 1999. No Shops/No Talks and Fiduciary Outs -No shops/no talks are covenants from the seller protecting the deal- terms found in merger agreements -Target board may be asked not to shop for alternative transactions or supply confidential info to alternative buyers or even not talk to them -These can serve target SH interest by making deals more secure for potential buyers -Fiduciary out clauses specify that if some triggering event occurs (better offer, opinion from outside counsel that board has fid duty to abandon original deal), target board can avoid the K without violating it Shareholder Lock-Ups Omnicare v. NCS Healthcare (Delaware 2003) Facts: With its stock in free-fall, the NCS board begins exploring strategic alternatives in late 1999. In 2001, Omnicare offers to buy NCS for $270 million, but negotiations break down. In June 2002, Genesis offers to buy NCS, but demands a fully locked-up deal in order to prevent a higher bid from Omnicare. Genesis and NCS agree to an exclusive negotiating period. Omnicare reviews its interest but conditions any offer on due diligence. Genesis-NCS announce a stock-for-stock deal on July 29, 2002, with NCS chairman and NCS president committed to vote their shares (>50%) in favor. Omnicare launches a competing cash offer for NCS at twice the value of the Genesis offer. On October 6 the NCS board recommends the Omnicare offer as a superior proposal. Genesis nonetheless forces the vote on its merger agreement as permitted under DGCL 251(c). Omnicare brings suit to invalidate the lock-up agreement. Holding: The deal protection devices failed Unocal b/c they were too preclusive and coercive, and not within a range of reasonableness. (Absolute lock-ups always too preclusive/coercive b/c prevent boards from subsequently discharging their fid. duties) Reasoning: The court expounds on the Unocal analysis. First, the directors have to demonstrate that they had reasonable grounds for believing a danger to corp. policy and effectiveness existed. (Have to show that they acted in good faith after conducting a reas. investigation.) Second, directors have to show that their defensive response was reasonable in relation to that threat. (Have to show that the response was not coercive or preclusive and that it was w/in a range of reasonableness.) Here, the structural defenses were draconian and impermissible b/c they forced the SH to vote for the Genesis merger- any SH vote would have been robbed of its effectiveness. Also, a fiduciary out was required b/c these provisions prevented the board from discharging its fid duties. The board couldnt just abdicate its fid duties to the minority by leaving it to the (majority) SH alone to approve/disapprove the merger agreement. The board SHOULD HAVE negotiated a fid out clause. Notes: RATIONALE for no-absolute-lockup rule: boards have a continuing obligation to discharge the fid responsibilities as future circumstances develop, even after a merger agreement is announced. Dissent: This decision was done by a process that was the quintessential disinterested and informed goodfaith decision. Lock-ups may be necessary sometimes. This one was reasonable in relation to threat. The majority decision will shrink the pool of potential bidders. Orman v. Cullman (Delaware 2004) Facts: Through a dual class structure, Cullman family owns a controlling interest in General Cigar ever since its IPO in 1997. In January 2000 Swedish Match agrees to buy out the minority SH of General

Cigar at $15.25/share in cash, such that Swedish Match would own 64% and the Cullman family would own 36% of General Cigar (with Cullman still in control). The merger agreement contained: (1) no breakup fee, (2) a fiduciary out that allowed General Cigar to consider an unsolicited superior proposal, (3) a class vote of the A and B shares separately, and (4) a majority of the minority approval (effectively) from the Class A SH. But, the Cullman family agreed to vote their controlling interest for the Swedish Match transaction, and against any alternative acquisition proposal for 18 months after any termination of the merger. Holding: The lock-up is OK. Its distinguishable from Omnicare in that case, the challenged action was the directors entering into a K in their capacity as directors. The Cullmans entered into the voting agreement as SH. Unlike Omnicare, the public SH were free to reject the proposed deal, even though, permissibly, their vote may have been influenced by the existence of the deal protection measures. 6. State Anti-Takeover Statutes First and Second Wave: 1968-1987 -wanted to limit hostile takeovers of companies w/connection to the enacting state -addressed disclosure and fairness concerns -tried to avoid preemption by Williams Act by balancing interests of offerors/targets -control share statutes resist hostile takeovers by requiring a disinterested SH vote to approve the purchase of shares by any person crossing certain levels of share ownership in the company that are deemed to constitute acquisition of control usually 20%, 33.33%, 50%, etc. CTS Corp. v. Dynamics Corp. of America (Supreme Court 1987) Facts: Dynamics makes a hostile offer for CTS Corp. and challenges the Indiana anti-takeover statute as preempted by the Williams Act and a violation of the (dormant) Commerce Clause. The Indiana control share statute prohibits a bidder from voting its shares beyond 20% ownership unless approved by disinterested SH (SH other than bidder and insiders). Holding: The statute is upheld. Reasoning: A statute is preempted by the Williams Act if it frustrates the purpose of the federal law. This statute differs from ones that have been preempted in the past. Those statutes operated to favor mgmt against offerors to the detriment of SH. Here, though, the statute protects the independent SH. This furthers the federal policy of investor protection. There is no dormant Commerce Clause problem. A state has authority to regulate domestic corps, including the voting rights of SH. A state has an interest in promoting stable relationships among parties. The act does this by protecting SH, by giving them an opportunity to decide collectively whether a change of control resulting from a takeover offer would be desirable. Third Wave: 1987-2000 -statutes act as ban on immediate liquidation of an acquired entity but not as a bar to takeovers where the acquirer will continue to operate the business of the target DGCL 203 -meant to deter junk bond-financed bust-up takeovers by preventing acquirers from getting their hands on the assets of target firms it bars business combinations b/w A and T for a period of 3 years after A passes 15% threshold -has two exceptions (1) restriction doesnt apply if bidder can acquire 85% of outstanding voting stock in a single transaction (assumption: unity implies lack of coercion) (203(a)(2)); (2) restriction doesnt apply if, after acquiring more than 15% but less than 85%, bidder can secure 2/3 vote from remaining SH (other than itself) (203(a)(3)) as well as board approval (203(a)(1)) this chills partial bids and lowpremium takeovers; might have strange incentives

State Regulation of Hostile Takeovers ACQUIRING A CONTROL BLOCK Control share acquisition statutes: prevent bidder from voting its shares beyond a specific threshold (20-50%) unless majority of disinterested SH vote to approve Other constituency statutes: allow the board to consider non-SH constituencies (weakens Revlon?) Pill validation statutes: endorse the use of a poison pill against a hostile bidder

SECOND-STEP FREEZE-OUT Business combination (freeze-out) statutes: prevent a bidder from merging w/target for either 3 or 5 years after getting controlling stake, unless approved by target board (DGCL 203) Fair price statutes: set procedural criteria to determine fair price in freeze-outs

Two extreme statutes: Disgorgement statutes: require bidders to disgorge short-term profits from failed bid attempts (PA, OH) Classified board statutes: provide classified boards for all companies incorporated in-state, with opt-out possible (MA, MD) 7. Proxy Contests for Corporate Control Since most corps have poison pills now, you have to do a proxy contest with your tender offer, simultaneously. Closing the tender offer is conditioned on electing As nominees to the board and the boards redemption of the targets poison pill. (HYBRID TAKEOVER) New defensive steps to impede insurgent from gathering enough support to oust current board Schnell-Blasius: VERY exacting judicial review, almost reversing BJR assumption Schnell v. Chris-Craft Industries, Inc. (Delaware 1971) Facts: Dissidents are negotiating w/mgmt up to the last possible moment, in hopes of avoiding a fullfledged proxy contest. Incumbent board strings the dissidents along in negotiations and then, when there are only a couple of months left before the annual meeting, the incumbent board amends the bylaws to advance the meeting date by a month (and moves it to an obscure place). All of this has the effect of leaving too little time for dissidents to organize and solicit proxies. The incumbent board made some half-assed excuse having to do with avoiding the Christmas mail rush. Dissidents sue for injunction to postpone the meeting. Holding: Management cannot act for inequitable purposes (perpetuating itself in office; obstructing the legitimate efforts of dissident SH in the exercise of their proxy rights). Reasoning: Inequitable action does not become permissible just because it is legally possible. Management was being sneaky and deceptive. Notes: This is just an expression of the fundamental fid duty of loyalty. Legal power held by a fiduciary cannot be exercised in a way that is intended to treat a beneficiary of the duty unfairly. Blasius Industries, Inc. v. Atlas Corp. (Delaware 1988) Facts: Blasius, a 9% SH of Atlas, announces its intention to solicit SH consents to increase the size of the board from 7 to 15 members, and to fill the new board seats with Blasius nominees. The objective is to execute a restructuring plan for Atlas. Atlas preempts the campaign by immediately amending its bylaws to add two new board seats, and fills the board seats w/its own candidates. Blasius sues to enjoin. Holding: Board cant undertake action designed principally to interfere w/the effectiveness of a SH vote. Reasoning: Motivation matters. Board cant do things principally motivated to prevent or delay the SH from electing a new board. They cant even do this whey they believe in good faith that there is a threat to the corp. (its not just prohibited when theyre acting out of self-interest). Reason: the voting franchises central importance to the scheme of corp. governance. Voting legitimates the exercise of power by D&O over property that they do not own. BJR considerations dont apply in this context. This

kind of board action isnt an exercise of corp. power over its property, but rather a reallocation of power b/w SH and board. This cant be left to the boards business judgment. Note that the board can do some things that might affect the votee.g., stock buybacksas long as not messing w/the vote directly. Hilton Hotels v. ITT Corp. (Nevada 1997) Facts: In January 1997, Hilton announces $55/share tender offer for ITT, and announces plans for a proxy contest at ITTs 1997 annual meeting to replace all of ITTs directors. ITT takes defensive measures: sells several non-core assets, files objections w/gaming regulatory bodies, and delays its annual meeting by six months to November 1997. In July 1997, ITT announces a Comprehensive Plan to split ITT into three entities, including ITT Destinations which will have 93% of the assets and a staggered board. ITT Destinations charter requires 80% vote for removal w/o cause and 80% vote to repeal the staggered board. Hilton brings suit to enjoin the Plan. Holding: The Plan was preclusive and coercive the classified board provision will preclude current ITT SH from exercising a right they currently possess: to determine the membership of the ITT board. Reasoning: The court involved Blasius, holding that the defensive action was directed toward affecting the outcome of the pending proxy contest for control of ITT and holding that no sufficiently compelling justification had been put forward. 8. More Takeover Stuff (Dead Hand Pills, Mandatory Pill Redemption Bylaws) in response to hybrid takeovers Dead Hand Pill: pill cannot be redeemed by the hostile board that is elected in a proxy fight for a stated period of time. They permit a board to limit the ability of SH to designate those w/board power stated differently, recognize a power in current boards to restrict the authority of future boards. -Delaware invalidated in Quickturn (1998): no abstract threat to the corp. made reasonable the imposition on the SH right to have fully functioning directors in place. The present board does not have the authority to restrict the power of future boards. -Note that many standard Ks establish conditions (like liability potential) that constrain the actions of future boards Mandatory pill redemption bylaws -SH bylaws requiring the board of directors to redeem an existin pill and to refrain from adopting a pill w/o submitting it to SH approval DGCL 109(b) vs. 141(a) 109(b): the bylaws may contain any provision, not inconsistent w/ law or the charter, relating to the business of the corp., the conduct of its affairs, and the right/powers of SH, D&O, employees. 141(a): the business and affairs of every corp. organized under this chapter shall be managed by or under the board of directors, except as otherwise provided in this chapter or in the charter -do SH bylaws intrude into the directors realm protected by 141(a)? -policy consideration: balancing optimal delegation efficiencies gained from delegating authority to centralized managers vs. the agency costs associated with that delegation Unisuper v. News Corp. (Delaware 2005) Facts: In October 2004, as part of its reincorporation from Australia to DE, the News Corp board agreed w/certain institutional investors to a board policy that any poison pill adopted by the News board would expire after one year unless SH approved an extension. One month later, Liberty Media appeared as a potential hostile bidder, the News board installed a pill, and announced that, going forward, it might or might not hold to its board policy. In November 2005 the board extended the pill in contravention of the earlier stated policy. SH sued, alleging breach of K. Directors argue K is unenforceable. Holding: The K is enforceable. The SH get to vote on the pill extension.

Reasoning: Theres no problem w/the K under 141(a). Any K a board enters into limits its power; 141(a) does not say a board cannot enter into Ks. The fact that the alleged K in this case gives power to the SH saves it from invalidation under 141(a). The board only has power b/c its not feasible for SH to run corporations- boards power derives from the SH in the first place. Also, theres no fid duty problem. In cases like Paramount, QVC, Omnicare- those Ks were invalidated as breaches of fid duties b/c they took power OUT of SH hands. Theres no risk of entrenchment here. It makes no sense to argue that the board somehow breached its fid duties to SH by agreeing to let the SH vote on a pill extension. Fid duties only exist to fill the gaps in the K relationship b/w SH and directors; fid duties cannot be used to silence SH. Notes: Note that by enforcing the K (letting the SH vote) and ignoring fid duty analysis- the court is ignoring the minority SH because they are the ones who are protected by fid duties. XIV. Trading in the Corporations Securities 1. Common Law of Directors Duties when Trading in Corp.s Stock You used to have to show 5 elements of common law fraud: (1) false statement of (2) material fact (3) made w/intention to deceive (4) upon which one reasonably relied and which (5) caused injury Q re: duty of disclosure Goodwin v. Agassiz (Massachusetts 1933) Facts: Agassiz and MacNaughton are directors and officers of Cliff Mining Co. and officers of another mining company. Based on surveys done by the other company, Cliff Mining starts exploring on its property in 1925 but ends without results in May 1926. On May 14, 1926, a newspaper discloses that Cliff Mining has stopped exploration on its property. Meanwhile, in March 1926, a geologist writes a report identifying the possibility of copper deposits on Cliff Minings property. In May 1926, Agassiz and MacNaughton anonymously buy shares from Goodwin on the Boston Stock Exchange based on favorable non-public information contained in the geologists report. Goodwin claims he would not have sold had he known the geologists info, and brings suit to rescind. Holding: P loses. Agassiz and MacNaughton had no obligation to disclose their theory. Reasoning: The directors of a corp. stand in a relation of trust to the corp. and are bound to exercise good faith in respect to its property and business, BUT they do not occupy that same position of trustee toward individual SH in the corp. Purchases/sales of stock on the stock exchange are impersonal affairs. Ds theory about the copper was just a nebulous hope/expectation. No disclosure was made of it, and the Mining Company was not harmed by the non-disclosure. We dont want to expose Ds to liability by making them disclose all these uncertain theories- people who did act on the theories would sue. Here, P was a sophisticated business party but made no inquiries. Notes: This was the duty as it stood BEFORE enactment of securities laws. Under common law, no fraud on the open market. Federal law of disclosure expanded b/w 1940 and 1975; also implied private rights of action Corporate Recovery of Profit from Insider Trading -Who is injured by insider trading? One theory: fiduciary theory corporation owns inside information and is therefore entitled to any profits made by its agents trading on it Not adopted by Freeman Freeman v. Decio (7th Cir. 1978) Facts: Arthur Decio is the largest SH, chairman of the board, and president of Skyline Corp. He resigns in 1972. Two months later, Skyline announces an unexpected 17% drop in earnings. Freeman brings a derivative SH suit alleging that Skyline deliberately overstated its earnings for the previous two quarters and that Decio and others sold Skyline stock knowing that the earnings had been overstated. Holding: Because theres no injury to the corp., theres no liability.

Reasoning: From a policy point of view it is widely accepted that insider trading should be deterred b/c it is unfair to other investors who do not enjoy the benefits of access to inside info; the goal is not one of equality of possession of info, but rather equality of access to info. There is an argument in favor of insider trading (helps assure that stock prices reflect the best info available), but balance of fairness tips in favor of discouraging it. There have been two approaches. At common law there was no prohibition against insider trading, absent fraud. Some more recent cases, though, have held that insider traders commit a breach of their fid duties to the corp. The problem with that is that there is no injury to the corporation that can serve as a basis for recognizing a right of recovery. You have to ask whether theres any potential loss to the corp. from the use of the info in the trading before deciding to characterize it as an asset. Notes: Pretty much mooted out by federal laws. Common (State) Law Duty of Disclosure -Closely parallels federal disclosure duty under 10b-5 -Directors duty of candor under state law requires them to exercise honest judgment to assure disclosure of all material facts to SH; but failure to disclose unlikely to give rise to liability unless intent to mislead 2. Exchange Act 16(b) and Rule 16 *Strict liability rule intended to deter statutory insiders from profiting on inside information 16(a): statutory insiders (directors, officers, 10% SH) must file public reports of any transactions in the corp.s securities w/in two days of the trade under Sarbanes-Oxley 403 -Officer status defined as access to non-public info in the course of employment 16(b): statutory insiders must disgorge any profits on purchases and sales w/in any six-month period -Exemption for unorthodox transactions, e.g., short-swing profits in takeovers if no evidence of insider info How to calculate profits? (Gratz v. Claughton): match any transactions that produce a profit 3. Exchange Act 10(b) and Rule 10b-5 Rule 10b-5 It shall be unlawful for any person, directly or indirectly, to: (a) employ any device, scheme or artifice to defraud, (b) make any untrue statement of material fact or to omit to state a material fact necessary in order to make the statements made not misleading, or (c) engage in any act, practice, or course of business which operates as a fraud or deceit upon any person in connection with the purchase/sale of any security. (c) is the one that most proscribes insider trading, but possibly (a) also. Has two major branches: one dealing w/misrepresentation, the other dealing w/omissions (insider trading) Three Theories for 10b-5 Liability (1) Equal Access Theory a. All traders owe a duty to the market to disclose or refrain from trading on non-public corporate information. (Cady Roberts, Texas Gulf Sulphur) (2) Fiduciary Duty Theory a. In order to establish that an insider violates 10b-5 by breaching a duty to disclose or abstain to an uninformed trader, you have to show there was a specific pre-existing legal relationship of trust and confidence between the insider and the counter-party (Chiarella, Dirks)

(3) Misappropriation Theory a. A person who has misappropriated nonpublic information has an absolute duty to disclose that information or refrain from trading (OHagan, Burger dissent in Chiarella) ELEMENTS OF A 10B-5 CLAIM *see slide* (went by too fast!) Resemble elements of common law fraud, but reflecting realities of market-based transactions False or misleading statement or omission (in connection w/purchase or sale of stock) Of material fact Made w/intent to deceive another Upon which that person (a trader in stock) Reasonably relies And that reliance causes harm (to the trader in stock) Elements of 10b-5 Liability: False or Misleading Statement or Omission SEC v. Texas Gulf Sulphur Co. (2nd Cir. 1968) Facts: In Oct. 1963, TGS geologists make a valuable discovery of an extremely rich zinc/copper deposit. TGS President Stephens instructs them to not tell anybody, including other TGS employees/directors, so that TGS can buy up the rest of the land needed. In Feb. 1964, TGS issues stock options (= calls) to its top execs, all of whom knew at least something about the new discovery. And as information inevitably trickled through the organization, everybody started trading. In April, TGS issued a misleading press release to quiet speculation. SEC brings a 10(b) action against everybody. Holding: All transactions in TGS stock/calls by individuals who knew about the drilling results were made in violation of 10b-5. (Equal Access Theory) Reasoning: 10b-5 is based on policy that all investors trading on impersonal exchanges have relatively equal access to material info. Rule 10b-5 requires you to either disclose the info or abstain from trading. In this case, there was no disclosure or abstinence. When is a fact material? You balance the probability that the event will occur and the anticipated magnitude of the of the event, in light of the totality of the company activity. The fear about Rule 10b-5 is that it will deplete the ranks of corporate managers by taking away an incentive for them to accept such jobs, but there are other benefits for managers. Notes: The relationship of the defendants was not focused on as crucial. Instead the dicta mentioned a broad duty of fairness not to trade on information not available to other traders. It was intent of Congress that all traders be subject to identical market risks. This is the broadest theory of liability under 10b-5: the equal access theory. It is NOT the law of the land today. Note that calls are options to buy the stock later on at the current price. So if you buy 50 calls now while the stock is $10/share, and then it goes up to $20/share, you can buy 50 shares for $500 even though its now worth $1000. How are outsiders hurt by the kind of insider trading we see here? -Maybe sellers of the stock would be better off, but potential buyers not so much -It makes more sense to look at it in the aggregate. E.g. if the news is bad and insiders sell to you, you are harmed because youll be left with stock thats soon going to decrease in value -Systematic diversion of corporate value- similar idea to self-dealing- appropriating a piece of value in a non-pro rata way thats not going to go to other SH To whom is the DUTY owed? -2nd Cir implies that the duty is to the market, even though there is no such common law duty -Have to disclose even if no preexisting duty to specific groups This duty is what makes this kind of behavior into fraud Santa Fe Industries v. Green (Supreme Court 1977)

Facts: Santa Fe gradually increases its stake in Kirby from 60% to 95% and then decides to do a shortform merger under DGCL 253. Morgan Stanley appraises the fair market value of Kirbys assets at $640/share and values Kirbys stock at $125/share. Santa Fe offers $150/share in the short-form merger. Minority SH forego their appraisal remedy but bring suit alleging 10b-5 violation by Santa Fe for obtaining a fraudulent appraisal, appropriating value from the minority SH, and offering $25 above the Morgan Stanley stock valuation to lull minority SH into tendering. Holding: There was no deception or manipulation and therefore did not violate 10(b)/Rule 10b-5. Reasoning: There was no omission or misstatement in the info statement accompanying the notice of merger. The SH choice was fairly presented and they were furnished with all relevant info. Manipulation means practices that are intended to mislead investors by artificially affecting market activity. It wasnt Congress intent to bring w/in 10b-5 alleged breaches of fiduciary duty. Also, theres no express private right of action for violations of 10(b), and we dont imply one where its unnecessary to ensure the fulfillment of Congress purposes. We dont want to federalize corp. conduct traditionally left to state regulation. This might be a breach of fid. duty but cant go after it under 10b-5. Notes: The Court sees 10b-5 as about to absorb much of corporate law and federalize it (turning state fiduciary duty law into federal securities law). They want to preserve state law regulation of internal corporate affairs, including fiduciary duties. This case turns things around. Goldberg v. Meridor (2nd Cir. 1977) Facts: UGO acquired Maritimecors assets in exchange for UGO stock. Press releases describing the stock-for-assets transaction fails to disclose certain material facts concerning the value of Maritimecors assets. UGO minority SH challenges the transaction as fraudulent and unfair in that the assets of Maritimecor were overpriced. Holding: You can bring a 10b-5 derivative action on the basis that the transaction b/w a corp. and a fiduciary/controlling SH was unfair if the transaction involved stock and material facts concerning the transaction had not been disclosed to all SH. (Exception to Santa Fe v. Green) Reasoning: There is deception of the corp. (in effect, of its minority SH) when the corp. is influenced by its controlling SH to engage in a transaction adverse to the corp.s interests (in effect, the minority SH interests) and there is nondisclosure or misleading disclosures as to the material facts of the transaction. Notes: The press release interferes w/SH exercising their state rights. Theyve been affirmatively misled. Under Goldberg, a plaintiff must show (1) a misrepresentation or nondisclosure that (2) caused a loss to the SH. (A popular way to do #2 is to allege that a remedy was foregone as a result of the lack of full disclosure; argument is that if disclosure were made, SH could have sought injunctive relief against the proposed transaction under state law.) Chiarella v. United States (Supreme Court 1980) Facts: Chiarella is employed in a financial print shop and is able to figure out the identity of the target from code names in merger documents. He buys the targets stock before the deal is announced and sells immediately afterwards; over 14 months he realizes a gain of $30,000. SEC begins investigating his activities and Chiarella eventually enters into a consent decree agreeing to return his profits to the sellers of the shares. But then he gets criminally prosecuted for violating 10(b) and 10b-5. Holding: A duty to disclose under 10(b) does not arise from the mere possession of nonpublic market information. There is no fraud absent a duty to speak, which arises from a relationship of trust and confidence (RETAC). (Fiduciary Duty Theory) Reasoning: The duty to disclose or abstain arises from the existence of a relationship affording access to inside info intended to be available only for a corporate purpose, and the unfairness of allowing a corporate insider to take advantage of that info by trading w/o disclosure. Chiarella was not a corporate insider and he was not under an affirmative duty to disclose the info before trading. He had no prior dealings with the sellers of the stock, he was not their agent, he was not a fiduciary, he was not a person in whom the sellers had placed their trust and confidence. He was a complete stranger. There was no Congressional intent to impose such a broad duty.

Dissent: He may not have violated a duty to corporate SH, but what about everyone else? There is an absolute duty to disclose or abstain. (Misappropriation Theory) Notes: This is where SCOTUS collides w/the second circuit. Its the first criminal conviction the Justice Dept. brings under 10b-5. They dont want him to go to prison; hes a small fish and hes already given back his ill-gotten gains. -How do we know when there is a relationship of trust and confidence (b/w the insiders and the market/ SH)? Where does the duty come from? It didnt exist under common law. We know that directors and officers have a RETAC. Temporary insiders also probably have a RETAC (e.g., corporate investment bankers). *RETAC: liability based on contract, the explicit expectation of confidentiality. When is there a RETAC? 10b5-2 A duty of trust or confidence arises, in addition to other circumstances, whenever: --a person agrees to maintain information in confidence; --two people have a history, pattern, or practice of sharing confidences such that the recipient of material non-public information knows or reasonably should know that the person communicating the information expects that the recipient will maintain its confidentiality; or --a person receives or obtains material non-public information from a spouse, parent, child, or sibling, unless the recipient can demonstrate that, under the facts and circumstances of that family relationship, no duty of trust or confidence existed. Two problems after this: 1- What about tippees people who receive info from insiders and trade on it? We know that insider owes a fiduciary duty b/c of RETAC, but what about the tippee? (see Dirks) 2- What to do about insiders who pick up info but not from the company itself? (Chiarella problem) Dirks v. SEC (Supreme Court 1983) Facts: Dirks is an investment advisor who receives info from Secrist, a former officer of Equity Funding, that Equity Funding has vastly overstated its assets. Dirks does research on Equity Funding, including interviewing employees, and discusses this info w/his clients, many of whom then sell stock holdings in Equity Funding. Price of EF begins falling, and California insurance authorities discover evidence of fraud. NYSE halts trading in the stock. SEC censures Dirks for aiding and abetting violations of 10b-5 by informing his clients of the alleged fraud at EF. Holding: A tippee assumes a fiduciary duty to SH not to trade on material nonpublic info only when the insider (tipper) has breached a fiduciary duty to the SH by disclosing the info to the tippee, and the tippee knows or should know that there has been a breach. There is only a breach when the insider personally benefits directly or indirectly from his disclosure. (Dirks wins.) Reasoning: There is a requirement of a specific relationship (RETAC) (Chiarella)- but unlike insiders who have independent fiduciary duties to the corp. and its SH, tippees usually do not have such relationships. Only some people, in some circumstances, are barred from trading on material non-public info policy: dont want to have an inhibiting influence on market analysts. But, there is a need for some ban on tippee trading. We dont want to let insiders give info to an outsider for the same improper purpose of exploiting the info for their own personal gain. Using personal benefit to determine breach allows courts to use objective criteria. Here, Secrist did not breach his fiduciary duty because he got no personal gain; he only wanted to expose the fraud. Because Secrist didnt breach, neither did Dirks. Dissent: It makes no difference to the SH whether the insider intended to gain personally; the SH has still lost. And Secrist did intend to injure the purchasers of the stock. Notes: Theres an information chain here and only the people at the end of the chain did the trading. Theres no question that Secrist has a RETAC (and duty) so he could not trade w/o violating under Chiarella. Secrist cant do through Dirks what he cant do directly (if Dirks were to have traded). But there was no primary violation of Secrists RETAC.

-A paradox: its the same trading activity, same harm imposed on counter-traders, in one case the trading is legal but in the other case its not. Secrist sells the info, its illegal; he gives the information b/c he wants to expose fraud, Dirks trading is legal. Same impact on the market. Whats the deal? In only one of these cases is the harm legally cognizable. Not every form of info asymmetry is prohibited. Martha Stewart Q- p. 673- under what theory might she be liable for insider trading? -No duty b/w Martha Stewart and ImClone SH no violation under Chiarella -Dirks maybe SEC Steps to Reassert Equal Access Theory (after SCOTUS narrowing of 10b-5) Regulation FD: You cant intentionally release info w/o simultaneously sharing it with everyone (the public). If you unintentionally release info, you have to take reasonable steps immediately to ensure that everyone is informed. (Intention if the discloser knows or is reckless in not knowing that the info being communicated is both material and nonpublic.) -Why did this reg take so long to come out? People were worried it was going to interfere w/distribution of info in the marketplace Schering Plough (2003)- first instance of getting fine under FD (see slide) The jurys still out re: effect. It has some deterrent on releasing info, so prices might be less informed, but theres also something intuitively uncomfortable about selective disclosure. -It only affects the spokespeople for firms, the senior officers. Not lower-level employees. -The reg is really about disclosure to market professionals. Rule 14e-3: imposes duty on any person who obtains inside info about a tender offer that originates w/either the offeror or the target to disclose or abstain from trading. U.S. v. Chestman (2nd Cir. 1991) Facts: Ira Waldbaum, controller of a supermarket chain, decides to sell out to A&P. He will sell at $50/share, while A&P tenders for public shares at the same price. Ira tells sister Shirley, who tells daughter Susan, who tells husband Keith Loeb. But despite warnings, Loeb informs his stockbroker, Chestman, that company is about to be sold. Loeb buys for himself, and Chestman buys for himself, Loeb, and his other clients. NASD begins an investigation. Loeb pays a fine and agrees to cooperate, and Chestman is indicted on 14e-3, mail fraud, and 10b-5 violations. Jury finds him guilty on all counts. Holding: Kinship alone does not create the necessary RETAC for a 10b-5 conviction. (Fiduciary Duty Theory) Reasoning: Chestmans 14e-3 conviction is upheld; the duty to abstain/disclose under that statute does not depend on a pre-existing fiduciary duty. However, Chestmans 10b-5 conviction is overturned; the court follows Dirks tipper/tippee analysis. There is no fiduciary duty b/w Loeb and the Waldbaum family b/c kinship alone cannot create a RETAC, and there was no other fiduciary-like association b/w them. Absent a predicate act of fraud by Loeb, the tippee (Chestman) could not be derivatively liable. Notes: This case was perceived as ridiculous. SEC promulgated a new rule overruling it (10b5-2), creating rebuttable presumption that you owe a fiduciary duty to your spouse so if you get info from them and use it, you will be violating 10b-5. U.S. v. OHagan (Supreme Court 1997) Facts: In July 1988, Grant Met hires the law firm Dorsey & Whitney (D&W) to represent it in its acquisition of Pillsbury. OHagan is a partner of D&W but does no work on the deal. In August, OHagan begins buying Pillsbury stock and call options on Pillsbury stock, in his own name. In September, D&W withdraws from representing Grant Met; less than one month later, Grant Met announces a tender offer for Pillsbury. OHagan sells his call options and common stock for a profit of $4.3 million. SEC brings criminal charges and trial court convicts OHagan.

Holding: A person commits fraud in connection w/ a securities transaction (and thereby violates 10(b) and Rule 10b-5) when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. (Misappropriation Theory) Reasoning: In lieu of the classical theory of premising liability on a fiduciary relationship b/w company insider and purchaser or seller of the companys stock, the misappropriation theory premises liability on a fiduciary-turned-traders deception of those who entrusted him w/access to confidential info. Misappropriation satisfies 10(b)s requirement that chargeable conduct involve a deception device or contrivance, b/c the fiduciarys action dupes the principal, and 10(b)s requirement that the use of info be in connection w/ purchase/sale of security b/c the fraud is consummated not when the fiduciary gets the info, but rather when he uses the info to purchase/sell securities. Note that full disclosure forecloses liability under this theory b/c the deception essential to the theory involves feigning fidelity to the source of the info. (If you tell source youre going to trade, no 10(b) violation.) The misapp. theory comports w/10(b)s language: requires the deception to be in connection w/purchase/sale, not deception of an identifiable purchaser/seller. Notes: If you happen to see some info on your co-workers desk and you trade based on it, you would be guilty of 10b-5 violation under this theory b/c you misappropriated info from your employer (the brokerdealer). Possible defenses: not material info? 78t-1: Liability to Contemporaneous Traders for Insider Trading -Any person who, contemporaneously w/the purchase/sale of securities that is the subject of the insider trading violation, has purchased (where the violation is based on a sale) or sold (where the violation is based on a purchase) securities of the same class may sue the violator for damages. 78t-1(a) -The damages imposed shall not exceed the profit gained or loss avoided in the transaction thats the subject of the violation. 78t-1(b)(1) -This law does not define contemporaneously or what constitutes insider trading- it assumes that courts will continue to employ the standards of the existing case law -It expands potential liability b/c it appears possible under this law for a SH of the target to sue a person who misappropriates info from the bidder. Such a suit could not be brought under 10b-5. (The person suing you does not have to be the person to whom you owe the duty you breached.) Overall Liability Under ITSA (1984) and ITSFEA (1988) (distinct from criminal sanctions) 20A (see above- 78t-1): creates a private right of action for any trader opposite an insider trader, with damages limited to profit gained or losses avoided 21A(a)(2): allows SEC to seek civil penalties up to 3x the profit gained or loss avoided 21A(a)(1)(B): controlling person may be liable too, if the controlling person knew or recklessly disregarded the likelihood of insider trading and failed to take preventive steps 21A(e): bounty hunter provision, which allows SEC to provide 10% of recovery to those who inform on insider traders Elements of 10b-5 Liability: Materiality Basic Inc. v. Levinson (Supreme Court 1988) Facts: Basic engages in merger negotiations w/ Combustion Engineering for almost two years about the possibility of being acquired at a premium price. Meanwhile, there are rumors of a pending deal, which Basic flatly denies, three times. (Afterwards, Basic says that it didnt want to drive its suitor away by invited competition.) Basic SH who sold after first public denial of the merger negotiations file suit claiming 10b-5 violations by the Basic directors. District Court grants summary judgment to D directors. Holding: (Remanded.) An omitted fact is material if there is a substantial likelihood that a reasonable SH would consider it important in deciding how to vote that the disclosure of the fact would have been viewed by a reasonable investor as having significantly altered the total mix of available information.

Reasoning: Policy: the Court acknowledges that some info is of dubious significance, and dont want to set too low a standard of materiality in fear of burying the SH in an avalanche of trivial info. Theres no basis for considering some info (e.g. about a merger) immaterial just b/c the transaction is not set in stone yet. Quotes Texas Gulf Sulphur- balancing the probability of the event and the anticipated magnitude. Notes: We only bar insider trading on bombshell (hard) information. Soft info (about the state of the company/industry) is permitted. SCOTUS here is telling us that its not okay to lie to maximize the value of the company. But theres no duty to reveal material information to the marketplace, either. You just cant lie if you decide to talk. Elements of 10b-5 Liability: Scienter -In 1976 SCOTUS held that liability under Rule 10b-5 requires specific intent to deceive, manipulate, or defraud (Ernst & Ernst v. Hochfelder) -Two issues remain: (1) Proof whether actual intent to deceive must be shown in order to establish liability, or whether scienter may be inferred from conduct that is simply willfully or recklessly negligent (2) Pleading how to satisfy burden to allege scienter in a 10b-5 complaint at the motion to dismiss stage (since if it survives this stage, it will have a settlement value regardless of the merits) PSLRA: Private Securities Litigation Reform Act -Passed in 1995 in response to perception that 10b-5 litigation was getting too aggressive; tried to stem tide of litigation (though has not been successful) -The complaint shall, w/respect to each act or omission alleged to violate this chapter, state w/ particularity facts giving rise to a strong inference that D acted w/ the required state of mind. Rule 10b5-1 (2000) -Clarifies whether it is use or knowing possession of nonpublic material info at the time of a trade that gives rise to liability under 10b-5 You trade illegally when you trade on the basis of insider info if you were aware of non-public material info when you made the purchase/sale. -Affirmative defenses: (1) proof that you gave instructions or adopted a written plan to purchase before you acquired the info; (2) proof that, in the case of an investing entity, the natural person making the investment on behalf of the entity was unaware of the inside info, and the entity itself had implemented reasonable measures to protect against illicit insider trading. -Standard is closer to knowing possession than to use Elements of 10b-5 Liability: Standing (in connection w/ the purchase or sale of securities) -2nd Cir (Birnbaum v. Newport Steel): P must have been a buyer/seller of stock in order to have standing to bring a complaint about an alleged violation of 10b-5. SCOTUS (Blue Chip Stamps v. Manor Drugs): P who did not invest b/c offering document was materially false did not have a claim Elements of 10b-5 Liability: Reliance What if a false statement is made by an insider that affects the market price of the stock, but a SH never hears the false statement? Basic Inc. v. Levinson Part Two (Supreme Court 1988) Facts: (see above) Holding: Presumption of reliance on integrity of market price Reasoning: Notes: Youre presumed to rely on share price so you dont have to show that you read the misrepresentation and traded on that basis. You can sue simply b/c you relied on share price. That goes a long way to eliminating transaction causation from these suits. These fraud-on-the-market suits are typically brought against the company/CEO/whoever makes the statement on behalf the company. Defense for plaintiffs: large number of individuals didnt trade on basis of market price, would have traded anyway (very tough to prove though) Irony: its the SH who didnt sell who have to pay moving $ from one set of SH to other set of SH

TRANSACTION CAUSATION VS. LOSS CAUSATION ABC Corp. operates a commercial storage facility and makes a public representation that it is operating at full capacity, when, in fact, only 50% of its storage space is leased. ABC Corp. also discloses fully (and truthfully) that it has no fire insurance. An investor buys common stock in the company in reliance on these representations. One week after the investment, the facility burns to the ground and the stock becomes worthless. The reliance and transaction causation requirements are satisfied because, had the truth about the facility's capacity been disclosed, the investor would have declined to make the investment. BUT: the loss causation requirement is not satisfied because the proximate cause of the loss was the fire rather than the misrepresentation about capacity. REMEDIES FOR 10B-5 VIOLATIONS Elkind v. Liggett & Myers, Inc. (2nd Cir. 1980) Facts: Holding: Disgorgement Rule. P can recover the post-purchase decline in share price, capped at the gain by the tippee (what tippee got for his shares, minus what the shares declined to). Reasoning: Notes: