TABLE OF CONTENTS
SECTION
I.
II.
III.
IV.
V.
VI.
VII.
VIII.
IX.
X.
XI.
XII.
XIII.
XIV.
XV.
TITLE
Introduction
Partnerships and LLCS
Independent Proxy Proposals
ECMT
Delaware
Fiduciary Duty, Shareholders, Business Judgment Rule
Conflicting Interest Transactions
Shareholder Litigation
Indemnification and Insurance
Corporation and Allocation of Risk
Mergers
Hostile Acquisitions
Securities Regulation
Insider Trading
Non-IT under 10b-5
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17
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20
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28
32
32
I.
INTRODUCTION
A. Corporation provides
1. limited liability for its owners,
2. perpetual existence independent of its owners,
3. centralization of management in persons who need not be owners, and free
transferability of ownership interests.
B. Contractual Implications of Corporations
1. Types of Contracting
a)
Discrete contracting:
(1)
no preexisting obligations; team is formed for limited purposes;
bounded rationality limits the parties’ ability to contract around all possible
situations, and to form contingencies for those situations.
b) Relational contracting:
(1)
contracting based on relationship helps avoid some of the issues
with bounded rationality.
C. Sole Proprietorship and the Law of Agency
1. Sole Proprietorship
a) Business owned, controlled by one person, contracts with others to provide services,
supplies, labor, etc.
(1)
At common law, this mutual asset creates at-will relationship of
principal and agent. Discrete contracts define the terms of the relationship.
One team member has substantially more team-specific capital at risk than
other team members; has the most to gain or lose from success/failure.
Increase in team-specific risk leads to opportunism posed by sole proprietor
(costly to make mgmt decisions efficiently).
2. At-Will Employment
a)
Foley v. Interactive Data Corp., California Supreme Court
(1)
Repeated assurances of job security and an employment policy that
outlines the steps for proper termination are sufficient to establish an
implied-in-fact employment contract that supersedes an employment-at-will
arrangement. At-will employment motivates employers to provide more
favorable work conditions in order to keep attrition low.
3. POLICY
a)
Generally governed by democracy
(1)
Question the reliability and potential for free riding from such a
democracy. Avoid with contractual obligations and increased involvement.
(2)
Contrast with option of putting smaller subset of members in
charge of decision making (internal or external parties? Bias?).
(3)
Ego and hubris lead some companies to assume that the company
can always do it better than the rest of the market (even if they cannot), and
end up spending more internally than they would by outsourcing.
4. Transaction Cost Factors
a)
Bounded rationality
(1)
ability to act rationally is bounded by knowledge base; the result of
bounded rationality is incomplete contracting
b) Opportunism
(1)
advantage gained by a relatively stronger knowledge base; pursuit
of self-interest. Partner is more exposed to other’s opportunistic behavior
(risk) once a team-specific investment is made. The opportunistic party has
greater leverage over its partner, but this creates the risk of withdrawal by
the less-advantaged party, which would destroy value for both parties.
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c)
Team-specific investment
(1)
value creation through merger, sharing of specific activities, but
diseconomies can result when relationship is formed or dissolved. The
value of the investment when put to team use is greater than when put to
the next best use. When only one party makes the team-specific investment,
the other party has a greater incentive to act opportunistically, as the first
party is more strictly bound to the arrangement.
(2)
The non-investing party could potentially be bound by 1) legal
obligations/contracts, 2) markets, and 3) relationships (establishment and
maintenance).
d) POLICY
(1)
There are issues of collective action that come up, and the bounded
rationality associated with cognitive limitations.
(2)
Partnering with others increase transaction costs, opportunism and
collective action issues that add to the overall cost of operation. Although
fiduciary relationships can decrease transaction costs to the organization,
such an assumption relies on the ability of the organization to contract
around all possible future outcomes stemming from the relationship.
5. Agency Law
a) The manifestation of consent of one person that another shall act on his or her behalf
and subject it to his or her control. The key consideration is that the agent acts on behalf
of the principal as desired by the principal.
b) POLICY
(1)
The principal prevents the agent from acting irresponsibly on
behalf of its self-interests, thus decreasing agency costs, by giving the agent
incentives to remain faithful, or implementing some contractual obligation
or enforcement regime. Agents are monitored through contractual
obligations, termination and compensation.
c) Community Counseling Service, Inc. v. Reilly, 4th Circuit
(1)
An employee that forms relationships with its employer’s clients
for his own personal gain, and while still employed by the employer, has
breached its fiduciary duty, and is obligated to give its employer its rightful
share of the fees collected.
(2)
The employee can avoid liability by holding solicitations from
clients until its employment has ended, contracting with its employer to
allow it to form relationships with clients. Consider the conflicts of interest
and the fiduciary duty implications in determining when to allow the
employee to act on its own behalf.
6. Authority
a) Without any form of authority, the principal absorbs the ability to form all
contractual obligations, which increases transaction costs.
b) Actual authority
(1)
the principal manifests his consent directly to the agent. It may be
express or implied. If actual authority exists, the principal is bound by the
agent’s authorized actions even if the party with whom the agent deals is
unaware that the agent has actual authority, and even if it would be
unusual for an agent to have such authority
(2)
Blackburn v. Witter, California Court of Appeals
(a)
Apparent authority exists when an employer profits from the
conduct of its agent, provides the information from which the client
commits a fraud or misrepresentation, and is in the best position to
prevent the incident from happening (Least Cost Avoider).
(b)
Furthermore, had the employer and agent contracted around
the principal’s liability (through indemnification) it is possible for the
indemnity to be valid, although there is an implicit balancing of the
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client’s rights with the terms of the contract. Consider whether the
client was in the position to determine the reasonableness of the terms.
c) Apparent authority
(1)
when an agent is without actual authority, but the principal
manifests his consent directly to the third party who is dealing with the
agent. Based on position and past dealings.
d) Inherent authority
(1)
springs from the desire to protect the reasonable expectations of
outsiders who deal with an agent.
D. Selection of Joint Ownership
1. Joint ownership
a) Team-specific skills and investment will be distributed among team members. Selfmonitoring is more efficient than having one member attempt to learn enough to monitor
other members.
2. Issues to consider with respect to jointly owned firms
a)
b)
c)
d)
e)
f)
g)
Voting rules
Monitoring
Right to withdraw money from the team
Collective action issues
Rational apathy
Nexus of contracts
Communitarian
3. Challenges of Passive Ownership
a)
Determining what rights to give investors in exchange for their money:
(1)
Right to vote out bad management
(2)
Control over disbursement of funds for big-ticket items
(3)
Fiduciary Duty
(4)
Right to Exit
(5)
Markets
(6)
Governance
4. The role of markets in solving agency problems
a)
Product market:
(1)
a poorly managed company cannot make its products/services
efficiently, and will lose its competitive position
b) Capital market:
(1)
poor management will spread a bad reputation to the capital
markets, and if the market does not trust the management, it will not loan
money (riskier investment, higher interest).
c) Labor market:
(1)
being discharged or poorly performing in one job makes it more
difficult to enter the labor market and find new employment
d) Wall Street Rule:
(1)
Shareholders can sell stock. The price at which investors exit is not
favorable if management is poor (stock price goes down to reflect poor
management).
e) Market for corporate control:
(1)
greater value by buying a company and breaking it up or
reorganizing it, than by simply changing management, fear of losing
management position
5. Consider the tax implications of different organizational forms
6. Default Rules
a)
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Tailored
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(1)
designed to give contracting parties the exact rule that they would
themselves choose if they were able to bargain costlessly over the matter in
dispute (private ordering).
b) Majoritarian
(1)
designed to provide investors with the result that most similarly
situated parties would prefer; makes assumptions about the contracting
needs of investors and provide rules that will suit a large number of them.
c) Penalty
(1)
designed to motivate one or more contracting parties to contract
around the default. The goal is to force the parties to specify their own
rules ex ante, instead of relying on a default rule provided by law.
E. The Role of Entity Law
1. Shareholder/Director Relationship
a) Shareholders have only limited power of management and control. Their power is
exercised indirectly through the election or removal of directors. Directors have general
powers of management and control.
2. POLICY
a) Broad agreements among shareholders that attempted to resolve questions that are
the responsibility of the board of directors were against public policy and unenforceable,
but courts upheld control arrangements where only "slight impingements" were involved
that injured no one, and all the shareholders had approved. However, at common law not
even unanimous agreement by the shareholders could validate a major impingement on
the statutory schemes.
II.
PARTNERSHIPS AND LIMITED LIABILITY COMPANIES
A. General Rules
1. Partnership is default (unless sole proprietorship)
2. Partnership dissolves if one partner leaves. Must reestablish partnership relationship
between remaining parties.
3. Partners have unlimited joint and several liability (including personal liability) for all
partnership obligations.
4. Each partner shares equally in management ability and has the power to bind the
partnership legally.
B. Limited Partnerships
1. GPs share control; LPs provide financing alone without management responsibilities,
are essentially passive investors.
2. QUESTION
a) Agency problems are resolved by limited partnerships because they separate the
financial interests from the business interests. Those who invest the money are only
liable to the extent of their investment; there is no means by which to sacrifice the
business for purely financial gain. Opportunistic behavior on the part of the limited
partner has no impact on the performance of the business, because the LP is not involved
in day-to-day operations. On the other hand, the General Partner is self-monitored
because it is liable, personally, for firm performance. Therefore, while an LP is only
liable to the extent of its investment, the GP can be personally liable, which ensures that
it will manage the business more responsibly. Liability extends to GPs as joint and
several liability, but LPs are liability only to the extent to his or her investment in the
partnership
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3. QUESTION
a) How can a GP be protected from personal liability? Form an LLC/Inc holding
company that acts as an LP for the partnership, then serve as the GP in individual
capacity.
4. Limited Liability Partnership formation
a) File appropriate paperwork in the state in which the corporation or limited
partnership will be incorporated
b) Partnership agreement
5. Limited Liability Company
a) Formed by filing constitution (articles of organization or certificate of formation)
with secretary of state.
b) Adopt/file operating agreement (limited liability company agreement) that specifies
in more detail the particular rights, obligations, and duties of the LLC’s managers and
members. In some jurisdictions, especially Delaware, you can form a single member
LLC
c) LLC statutory default rules normally assign all management functions to members,
who, as a result, have powers similar to those of partners in a general partnership.
d) LLC statutes provide two governance forms: one analogous to the general
partnership as the normal default rule, and one more analogous to the corporation or
limited partnership as the normal second choice (members manage the LLC as a default;
the other option is to be manager-managed).
e) Default tax rules in LLC statutes have been amended to reduce the easy exit that
characterizes the default rules of general partnership law (no double taxation).
C. FIDUCIARY DUTY IN PARTNERSHIP
1. Fiduciary Duty
a)
Each partner owes the others a fiduciary duty.
(1)
What is the duty? To act most honestly and credibly, in the best
interests of the partnership.
(2)
When is the fiduciary duty breached? When one individual
sacrifices the interests of the organization for its own self-interest.
b) Meinhard v. Salmon, Supreme Court
(1)
Fiduciary duty is not honesty alone, but a higher standard of
honor, and that duty is breached when one partner pursues a business
opportunity that could have benefited the partnership. It does not,
however, apply to marketplace contracts that are formed on a regular
basis. Fiduciary duty does have finite limits, depending on the term of the
relationship.
(2)
QUESTION
(a)
Duty is imposed on the party who did not act with the interests
of the group in mind. If he did not want to be bound to the relationship
indefinitely, he should have contracted for that. Again, consider who is
the LCA, and who could have prevented the breach via proper contract
terms. RUPA 403(c), 404(b)
c) Exxon Corp. v. Burglin, 5th Circuit, RUPA 403, UPA 20
(1)
No fiduciary duty is breached when the contract between private
parties expressly contracts around such duties. Without such
modifications, there would be a fiduciary duty. When parties bargain
around and modify fiduciary duties, they obtain more flexible, beneficial
results than the fiduciary duties would have provided. The contract
modifications are the exact thing that penalty default rules are attempting
to create.
2. Partnership Statutes
a) RUPA 403(c) outlines the duty to disclose. The statute does not necessarily override
common law notions of fiduciary duty.
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b) RUPA 103 discusses ability to contract around certain statutory provisions.
c) 103(a) – except as otherwise provided in subsection (b), relations between partners
are governed by the partnership agreement.
d) 103(b) – may not eliminate duty of loyalty under 404(b); cannot broadly contract
around 404(b) obligations, but can contract around other terms by providing specific
examples of conduct that the partners agree will not violate fiduciary duty, as long as
those are not manifestly unreasonable.
3. Lovenheim v. Iroquois Brands, Ltd, Supreme Court
a) According to the economic relevance test in I(5), management can exclude
shareholder proposals that are economically relevant unless they are otherwise relevant to
business matters. Information that is otherwise relevant must appear to have
social/ethical significance AND somehow relates to the business (FN 16), in order to be
admitted.
III.
INDEPENDENT PROXY PROPOSALS
A. General Implications of Proxies
1. A company wishing to preserve discretionary voting authority on certain proposals
that might be presented to a vote may be required to advise shareholders of the nature of
such proposals.
a) Should the directors have the discretionary authority to determine what goes on the
proxy statement? No.
B. Rule 14(a)(8)
1. In order to have your shareholder proposal included on a company’s proxy card, and
included along with any supporting statement in its proxy statement, you must be eligible
and follow procedures. Proposal must include relevant, specific course of action, and
shareholder must hold at least $2K in shares, or 1% of shares available by the date of
submission. One proposal per meeting may be submitted, at no more than 500 words.
C. Rule 14(a)(4)(C)
1. Management’s discretionary authority to vote shareholders’ shares is okay, but if the
shareholder plans to solicit proxies, management, in its solicitation, must disclose such
knowledge and give its opinion of the matter to be put on the table, and to outline how
management is going to vote. The other shareholder has not actually presented its proxy
solicitation, but it has not been done yet. Disclosure puts other shareholders and
management on notice. Management may not have the ability to exercise discretionary
authority without taking some additional steps.
D. Long Island Lighting Co v. Barbash, 2nd Circuit
1. The test of Rule 14(a)(1) considers whether the challenged communication seen in
the totality of the circumstances is reasonably calculated and influences shareholder
votes.
IV.
EFFICIENT CAPITAL MARKET THESIS
A. Efficiency:
1. the presence of many buyers and sellers prices move instantaneously to reflect all
public information that is available about securities traded in that market.
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B. Inferences That May Be Drawn From the ECMT:
1. Price movements in any one stock are random in the absence of new market
information
2. Information about historical price movements are not relevant in determining future
prices (weak form efficiency)
3. It is not possible for large institutional investors or other persons to develop and
apply a trading strategy that consistently outperforms the market
4. Persons with access to nonpublic information may consistently outperform the
market (weak, semi-strong and strong form efficiency).
C. Basic, Inc. v. Levinson
1. Look for discussion about “noise” in the market, the frequency with which the
disputed security is traded, other factors unrelated to efficiency, reliance on market price
as a reflection of firm value, etc.
D. Other explanations of fluctuations in market price
1. Economists pointed out that if there were truly a race to the bottom, and management
compensated themselves generously, corporations that reincorporate in Delaware should
suffer a loss in the value of their publicly traded shares under the efficient capital market
hypothesis. Empirical investigations do not reveal such a loss.
V.
WHY DOES DELAWARE WIN THE BATTLE FOR INCORPORATION?
A. Generally
1. Firms want to incorporate where they can 1) pay as little as possible in taxes, 2)
compensate themselves as much as possible in salary, bonuses and stock options, 3) have
access to the most developed court system and services, and 4) receive the most
protection, via anti-takeover legislation, from hostile acquirors.
VI.
FIDUCIARY DUTY, SHAREHOLDER LITIGATION, AND THE BUSINESS
JUDGMENT RULE
A. Escott v. BarChris Construction
1. Due Diligence Defense
a) Non-expert with respect to non-expertised portions must 1) conduct a reasonable
investigation, and 2) have reasonable grounds to believe statement true.
b) Experts with respect to expertised portions must 1) conduct a reasonable
investigation, and 2) have reasonable grounds to believe statement/advice true
c) Non-experts with respect to expertised portions must show 1) no reasonable grounds
to believe statement untrue, and 2) no reasonable investigation required. Reasonableness
is determined by what a prudent businessperson would do in the management of its own
property (Section 11(c))
B. The Fairness Test
1. However, modern trend is the recognition by courts that decisions by disinterested
and independent directors as to the reasonableness and fairness of transactions should be
accepted.
2. These areas include self dealing transactions, corporate opportunities, freeze-out
transactions, and decisions to discontinue derivative litigation.
a)
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Disqualification of Interested Directors:
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(1)
BJ rule: all decision-makers must be disinterested
b) Action by Disinterested Directors:
(1)
Decisions by disinterested and independent directors with respect
to the transaction in question that is itself entitled to business judgment rule
protection, thereby validating the transaction in which the director is
interested.
c) Consider the Danger of Structural Bias:
(1)
The fear that directors by virtue of their close working
relationships and mutual trust and confidence will not make truly
independent and objective evaluations of transactions on behalf of the
corporation. Generally rejected.
d) Transactions With a Partially Owned Subsidiary:
(1)
The standard for evaluating transactions between parent and
subsidiary is that it must be "entirely fair" or "intrinsically fair" to the
subsidiary.
(a)
The parent corporation may nominate and elect all or a
majority of the directors of the subsidiary and thereby name the
subsidiary's management.
(b)
If the transaction involves a proportionate distribution of
assets by the subsidiary to all of its shareholders, the minority have no
basis for complaint on the ground of domination of the management by
the parent corporation.
(c)
To avoid a judicial fairness examination, a parent corporation
with a partially owned subsidiary may place independent and
disinterested directors on the board of the subsidiary. When a
transaction between subsidiary and parent is proposed, the subsidiary
may be represented solely by the outside directors.
(d)
A parent corporation with a partially owned subsidiary may
lawfully eliminate the minority shareholders in the subsidiary through
a cash out merger, thereby making the subsidiary wholly owned rather
than partially owned.
C. Duty of care
1. Test
a) Exercise reasonable care in running the business
b) More than negligent care
2. Violation
a)
In hindsight, the fact-finder sees that something went wrong.
(1)
General concern that if we hold management to too high a
standard of liability, they will become risk-averse which discourages
investment;
(2)
good management will abandon the company; and
(3)
shareholders effectively assume the risk of poor management (it is
incorporated into the price of the stock).
3. Business Judgment Rule
(1)
The court determines whether there has been a breach. Rebuttable
presumption that the business is more informed than the court, and
assumes that managers generally act without self-interest, personal dealing,
and exercised reasonable diligent care, and the court, therefore, will not
second-guess the management’s decision.
(2)
the director is informed with respect to the subject of his judgment
to the extent he reasonably believes to be appropriate under the
circumstances; he is not financially interested in the matter; and he
rationally believes that his business judgment is in the best interests of the
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corporation, or 2) the standard of care under the business judgment rule
was "gross negligence".
4. Shlensky v. Wrigley
a) Pleading that merely alleges the management made a bad decision is insufficient to
show breach of fiduciary duty. Requires fraud, illegality or conflict of interest in the
management’s making of the decision (or actions bordering on such conduct) must be
shown to rebut the presumption.
b) Application of Dodge rule to Wrigley would say that the shareholders’ interests
outweigh the management’s personal opinions about the state of professional baseball.
5. Dodge v. Ford Motor Co., Michigan, 1919
a) A business corporation is organized and carried on primarily for the profit of the
stockholders. The powers of the directors are to be employed for that end. The
discretion of directors is to be exercised in the choice of means to attain that end and does
not extend to a change in the end itself, to the reduction of profits or to the nondistribution of profits among stockholders in order to devote them to other purposes.
Therefore, the interests of shareholders cannot be set aside to satisfy other constituencies.
b) CONTRAST:
(1)
Management is permitted, not required, to take into consideration
interests other than the shareholders’, so long as doing so does not harm the
shareholders. This was designed, not to benefit others, but to give
management a way to benefit itself (Delaware adopts these provisions to
attract corporations).
6. DCC Rule 141(c), (e)
a)
Smith v. VanGorkom, Delaware, 1985
(a)
Failing to bring the merger vote to the attention of the
shareholders constituted a breach of fiduciary duty of care. A breach
of either the duty of loyalty or the duty of care rebuts the presumption
that the directors have acted in the best interests of the shareholders,
and requires the directors to prove that the transaction was entirely
fair. To establish the entire fairness of a transaction or decision if
business judgment rule presumptions are lost, must demonstrate fair
dealing AND fair price.
b) Failure to Act:
(1)
Business judgment rule applies only when "decisions" or
"judgments" are made. If a director fails to participate in the decisional
process, the business judgment rule is inapplicable and the director's
conduct is evaluated under the "prudent man" standard.
(2)
Distinguish between a conscious decision to not take action (BJ
rule) and a failure to take action because no decision was contemplated
(prudent man standard).
7. The Board’s Responsibility to Monitor and Prevent Illegal Activity
a)
In re Caremark Int’l, Delaware
(1)
Generally where a claim of directorial liability for corporate loss is
predicated upon ignorance of liability creating activities within the
corporation, in my opinion only a sustained or systematic failure of the
board to exercise oversight, will establish the lack of good faith that is a
necessary condition to liability. The business judgment rule operates only
in the context of director action. A conscious decision to refrain from
acting may nonetheless be a valid exercise of business judgment and enjoy
the protections of the rule.
D. Fiduciary Duty of Loyalty
1. Generally
a) Act in good faith and best interests of the corporation, not personal best interests
b) i.e. cannot commit extortion, theft, or take business opportunity as own
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c)
cannot be contracted away
(1)
circumstances in which a director personally takes an opportunity
that the corporation later asserts rightfully belonged to it; and
(2)
transactions between the corporation and the director, commonly
called conflicting interest transactions.
2. Duty of Candor
a) Circumstances exist where failure to be completely candid is conclusive evidence of
breach of the fiduciary duty of loyalty, but who makes this determination? It used to be
the courts, but now the courts and legislature are forcing companies to regulate
themselves (through both disinterested directors or disinterested shareholders, with courts
serving a lesser role).
3. Corporate Opportunity Doctrine:
a)
Broz v. Cellular Information Systems, Inc., Delaware, 1996
(1)
If corporate officer or director has business opportunity which the
corporation is financially able to undertake, and is in the line of the
corporation’s business and is of practical advantage to it, it is one in which
the corporation has an interest or a reasonable expectancy, and, by
embracing the opportunity, the self-interest of the officer or director will be
brought into conflict with that of the corporation, the law will not permit
him to seize the opportunity for himself.
(2)
A director MAY NOT take business opportunity for its own if:
(a)
the corporation is financially able to exploit the opportunity
(but if not, not automatically okay; while a director need not lend
money to the corporation to assist it to take advantage of the
opportunity, he also may not hide behind the financial inability
argument and do nothing to assist the corporation in utilizing its own
resources)
(b)
the opportunity is within the corporation’s line of business;
(c)
the corporation has an interest or expectancy in the
opportunity; AND
(d)
by taking the opportunity for his own, the corporate fiduciary
will thereby be placed in a position inimicable to his duties to the
corporation.
(3)
A director MAY take a business opportunity for its own if:
(a)
the opportunity is presented to the director or officer in his
individual and not his corporate capacity;
(b)
the opportunity is not essential to the corporation;
(c)
the corporation holds no interest or expectancy in the
opportunity; AND
(d)
the director or officer has not wrongfully employed the
resources of the corporation in pursuing or exploiting the opportunity.
(4)
CIRCUIT SPLIT:
(a)
Some courts have adopted a pure fairness test; others have
relied primarily on a "line of business" standard. An earlier test, now
largely rejected as too narrow, is that the corporation have an "interest
or expectancy" in the opportunity. One case has applied a "line of
business" test coupled with basic fairness.
4. Common Law Test for Duty of Loyalty:
a) Self-dealing should be evaluated on the basis of fairness with weight also given to
ratification or approval of the transaction by disinterested directors or shareholders.
Transactions that involve fraud, overreaching, or waste may not be ratified by the
directors. The remedy for a breach of the duty of loyalty is generally rescission.
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VII.
CONFLICTING INTERESTS TRANSACTIONS
A. D.C.C 144
1. provides that no conflicting interest transaction shall be void or voidable solely by
reason of the conflict if the transaction:
a) is authorized by a majority of the disinterested directors, or
b) approved in good faith by the shareholders, or 3) is fair to the corporation at the time
authorized.
B. The Effect of Disinterested Approval
1. If the conflicting interest taint is removed from a transaction by disinterested
shareholder or director approval, the business judgment rule and its presumptions are
reinstated, and a dissatisfied shareholder must establish that the conduct was not a valid
business decision to prove that the transaction is unfair to the corporation.
C. Indirect Conflicts of Interest
1. transactions between corporations with a common director are usually judged solely
on a fairness test, though the active participation of the interested director may make the
transaction voidable without regard to fairness.
D. Waste
1. Lewis v. Vogelstein, Delaware, 1997
a) Excessive compensation is found when, in publicly held corporations, compensation
is so large as to constitute spoliation or waste. In assessing compensation levels,
comparison may be made with compensation levels in other corporations. Not common
to find waste.
b) an exchange of corporate assets for consideration so disproportionately small as to
lie beyond the range at which any reasonable person might be willing to trade.
c) The claim is associated with a transfer of corporate assets that serves no corporate
purpose; or for which no consideration at all is received.
d) Must be adequately proved to show a breach of duty of loyalty.
E. POLICY
1. Provisions in articles of incorporation that purport to validate self-dealing
transactions are given limited effect; they may permit the interested director to be
counted toward a quorum and may free self-dealing transactions from adverse inferences.
2. The use of compensation committees (with outside directors) lessens or eliminates
the perception of self dealing.
3. Use a simple reasonableness test and unreasonable compensation to determine if
compensation is merely a scheme to minimize taxes.
a) a compensation committee of the board composed solely of two or more outside
directors to determine the performance goals;
b) the shareholders approval of the goals in advance of payment after disclosure of
material terms; and
c) the certification by the compensation committee that the performance goals and other
material terms have been satisfied.
4. Compensation plans involving stock purchase plans, stock option plans, phantom
stock plans, and stock appreciation rights all provide for compensation based on stock
price performance.
5. Some compensation plans have been attacked on the ground they provide no direct or
indirect benefit to the corporation.
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VIII. SHAREHOLDER LITIGATION (DERIVATIVE SUITS)
A. COMPARE: Direct suit
1. Enforcement by one or more shareholders of a claim based on injury done to them
directly as owners of shares. A derivative suit is a suit by a shareholder to remedy a
wrong to the corporation as such, rather than to the shareholder individually.
B. POLICY
1. One view is that derivative litigation is one of the major bulwarks against
overreaching and misconduct by corporate insiders. A number of judges have expressed
this view as have many academic writers.
2. The opposing view is that most derivative litigation, like securities fraud class
litigation is without substantive merit and is instituted for the benefit of plaintiffs'
attorneys. This view is often stated by attorneys who represent corporations that are
involved in derivative litigation.
3. Should we assume that an interested director is always unable to make a good
decision? Or should we give the director a chance and see what comes out of it? Does it
make sense to judge the interested/disinterested board on its decision post-demand
(whether or not to sue)? No. There are valid business interests against bringing a
lawsuit. Furthermore, all directors should not automatically be assumed to be acting with
a bias. Many businesspeople are able to separate personal and business interests, and
realize that there are situations where personal and business interests can actually create
synergies that benefit everyone.
4. Should 51% be per se sufficient to establish lack of independence? No, because it
depends on who holds the other 49% and what influence they have over the control of the
business.
C. Settlement
1. Most derivative litigation (like securities fraud litigation) is settled and does not go to
final judgment.
2. Agreements as to fees must be approved by the court as part of the settlement
process. Derivative litigation is often settled without any payment of money by third
party defendants to the corporation but by the corporation agreeing to make changes in
procedures and practices.
3. Settlements must be
a) disclosed to shareholders, and
b) approved by the judiciary
4. If not, the settlement itself may become the subject of a derivative suit.
D. Demand (MBCA 7.42)
1. Generally
a) Derivative complaint allege either that demand was first made on the board of
directors or that demand was futile. The theory for requiring a demand is that decisions
with respect to litigation are business questions that should be resolved by the board of
directors. The board of directors should determine whether the claim should be pursued,
settled, or discontinued as not being in the best interests of the corporation.
b) Demand is likely to be futile in derivative suits which allege misconduct by one or
more directors or high level management since it is unlikely that management will be
interested in vigorously pursuing claims against itself or its own members.
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2. Delaware
a) Requires a demand (narrow definition) on directors unless demand is futile.
b) The plaintiff must establish (from particularized facts alleged in the complaint but
prior to discovery) that
(1)
a reasonable doubt is created that the directors making the
decision were not disinterested or independent, or
(2)
the decision being questioned was otherwise not the product of a
valid exercise of business judgment.
c) Cases are described as "demand required" on the one hand, or "demand excused" or
"demand futile" on the other.
d) The classification of a case as "demand required" or "demand excused" has direct
impact on the deference given by courts to a recommendation or decision by the board of
directors or a litigation committee acting on the board's behalf.
e) CONTRAST:
(1)
MBCA (1984) requires demand in virtually all cases and dispenses
with the "demand required"/"demand excused" distinction.
(2)
The deference given by courts to decisions by the board of
directors or a litigation committee is not affected by whether demand is
required.
(3)
The FRCP require a demand on directors or an explanation of why
demand was not made. This is a solely a requirement of pleading and does
not of itself have substantive effect. The FRCP require an allegation that a
demand was made on shareholders or that such a demand was
unreasonable.
(4)
A number of states impose a demand on shareholders requirement.
Applied literally and in all cases, a demand on shareholders would require
an expensive proxy solicitation. MBCA (1984) and most state statutes do
not require a demand on shareholders.
3. Process
a) Go to directors and make a demand on the board explaining the grievances and
desired remedy (lawsuit on behalf of the board).
b) The board considers the matter; if the board decides not to sue, the shareholders can
sue the board for breach of fiduciary duty. Although giving the BOD the “first shot”
does not appear to deter derivative suits, this is technically a business decision, so
management always is the first to attempt to cure the problem. CONTRAST: In
Delaware, must make a pre-suit demand, or have demand excused due to frivolity.
c) Shareholders challenge board’s decision on grounds of lack of business judgment or
breach of fiduciary duty
d) It is more favorable for the plaintiff to get the challenge into court by showing
demand futility because a lower BOP is placed on the plaintiff.
4. Universal Demand Requirement
a) The universal demand requirement requires shareholders to make pre-suit demand in
virtually every circumstance. It is premised on the belief that allowing exceptions to presuit demand imposes excessive additional litigation costs.
5. Aronson v. Lewis, Delaware, 1984
a) Demand can only be excused where facts are alleged with particularity which create
a reasonable doubt that the directors’ action was entitled to the protections of the business
judgment rule.
b) In determining demand futility, the court 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.
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6. Effects of shareholder ratification (Lewis):
a) an effective shareholder ratification acts as a complete defense to any charge of
breach of duty.
b) The effect of such ratification is to shift the substantive test on judicial review of the
act from one of fairness that would otherwise be obtained to one of waste.
c) The ratification shifts the burden of proof of unfairness to plaintiff, but leaves the
shareholder-protective test in place.
d) Shareholder ratification offers no assurance of assent of a character that deserves
judicial recognition.
E. Disinterested Directors
1. What does it mean to be “beholden?”
a) Insoluble relationship between the parties. Must be unable to draw a line between
personal and professional relationship.
2. Rales v. Blasband
a) If a member of the BOD receives a demand from shareholders to sue, it is required to
determine the best method to inform themselves of the facts related to the alleged
wrongdoing and must weigh the alternatives available to it, including the advisability of
implementing internal corrective action and commencing legal proceedings.
b) Operationally, the board must 1) talk to HR about legal implications, 2) perform an
investigation of the company, 3) get people to help who are also disinterested, the
attorneys, 4) inside and outside directors who can impartially evaluate the situation.
F. Standing
1. The plaintiff must show that he was a shareholder when the cause of action arose or
that he later obtained his shares by operation of law. The federal rules impose a similar
requirement.
2. CIRCUIT SPLIT:
a) A few states permit subsequent shareholders to act as plaintiffs if they were not
aware of the claim when they acquired the shares.
3. An equitable principle may prevent persons who acquired most of their shares by
purchase from bringing a derivative suit based on pre-purchase claims.
G. Security for Defendants’ Expenses
1. Statutes in many states require plaintiffs to post security for the defendants' expenses
and allow defendants to be reimbursed for their expenses out of this security if the court
finds suit was brought without just cause. These statutes are designed to discourage
derivative suits brought solely for their settlement values.
2. CIRCUIT SPLIT:
a) Many statutes impose this requirement only on plaintiffs with small holdings.
MBCA (1984) does not contain a security-for-expenses statute. Other states give courts
discretion to impose the security requirement only when the litigation appears frivolous
or baseless. Considerable litigation has arisen with respect to these statutes has arisen, as
plaintiffs seek to avoid being required to post security. A plaintiff who fails to meet the
security-for-expenses or similar procedural requirements will have his suit dismissed.
Such a dismissal is without prejudice to a later refiling by the same or a different
plaintiff.
H. Disposition
1. Application of Business Judgment Rule
a) A controversial issue is the effect to be given to a recommendation or decision by a
litigation committee composed of directors that decides that pursuit of the litigation is not
in the best interests of the corporation.
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2. Delaware
a) In Delaware, in a "demand required" case, the decision by a committee of
disinterested directors (or the entire board of directors if a majority is disinterested) that
meets the requirements of the business judgment rule is given conclusive effect.
b) If the case is a "demand excused" case a recommendation by such a committee is
reviewed by a court, which may evaluate the quality of the decision and, in addition, may
utilize its own independent business judgment as to whether or not to dismiss the
litigation.
c) CONTRAST:
(1)
Under the MBCA (1984), a "good faith" decision to dismiss
litigation that meets the requirement of the business judgment rule is
apparently given preclusive effect. Some states appear not to give
preclusive effect to litigation committee decisions.
I. Recovery
1. Policy:
a) Some courts have allowed innocent shareholders to recover directly on the theory
that wrongdoers should not be permitted to control the use of the proceeds. These cases
are the minority view. In appropriate cases, plaintiffs may obtain injunctive or other
relief.
J. POLICY
1. Potential for conflict of interests. But, also leads to frivolous suits, second-guessing,
high costs, and transaction costs, and time consumption. Attorneys REALLY benefit
from the litigation. Shareholders rarely have the incentive to sue. On one hand, we
don’t want plaintiff’s attorneys bringing frivolous suits, but these law suits also serve a
monitoring effect. Shareholders are in a bind, because they want to protect their interests,
but they would also like some benefit.
K. POLICY FROM CORPORATION’S PERSPECTIVE
1. Balance costs and benefits of enforcing claims via litigation, and generally choose to
pursue only those actions that seem likely to produce a net benefit to the corporation.
Consider gains and losses to the corporation, gains and losses to management.
2. Thus, entrusting all fiduciary litigation to directors’ judgment would arguably result
in less than optimal enforcement of fiduciary duty.
L. Special Litigation Committees
1. If you cannot compile an independent group of investigators, set up a special
litigation committee full of disinterested parties, and charge them with the responsibility
of determining whether to proceed with the litigation (example of board acting through a
committee).
2. However, structural bias can prevent the special litigation committee members from
exercising impartial business judgment (Miller v. Register and Tribune, page 424).
3. Zapata Corp. v. Maldonado
a) The test to determine if the committee has the ability to dismiss the litigation is twoprong:
(1)
the court will inquire into the independence and good faith of the
committee and the bases supporting its conclusion (corporation has burden
of proving independence, good faith, reasonable investigation) and
(2)
applying its own independent business judgment, the court should
determine whether the motion should be granted.
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b) This test does not fly in the face of the BJ Rule because the second step is
discretionary (the court can defer to the committee, or use its own judgment).
c) POLICY
(1)
If the court agrees that the suit should be dismissed, it can grant
the motion to dismiss, pending any equitable terms or conditions (anything)
the Court finds necessary or desirable. Dismissing cases whenever the
court decides would deter anyone from bringing these types of suits. In
some situations, it may be good for shareholders to exert their voting power
and bring action when the think it is necessary. We want to discourage
frivolous suits, but one way fiduciary duties are enforced is through
derivative litigation, so we don’t want to wipe them out. We can also deal
with the “too late in the game” dismissals by imposing a statute of
limitations on the length of time in which a special committee can be
appointed.
d) CONTRAST: The approach in Zapata differs from section 7.44 of the MBCA
because 1) 7.44 only requires that the committee conduct a reasonable inquiry (no
investigation requirement or written report requirement), and 2) 7.44 does not require that
the committee’s conclusions take into account anything other than the issue at hand.
4. A parent-subsidiary merger is much more likely to be found fair if the public
minority stockholders of the subsidiary are represented by a special committee of
independent directors who are not affiliated with the parent.
IX.
INDEMNIFICATION AND INSURANCE
A. POLICY
1. Essential if responsible persons are to be willing to serve as directors.
Indemnification seems entirely appropriate if a person is absolved of charges of
negligence or misconduct in connection with their actions on behalf of the corporation.
B. Indemnification statutes
1. Many state statutes provide expressly that they are not exclusive, and that
corporations may create broader rights of indemnification up to limitations of public
policy.
2. Opt Out
a) Corporations may generally "opt out" of the indemnification statutes by restricting or
eliminating indemnification in the articles of incorporation or bylaws. Conserve limited
resources or limit the right of former directors or officers to demand indemnification.
C. Scope of Indemnification
1. A director with a valid procedural defense is therefore entitled to indemnification
without regard to the merits.
a)
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CONTRAST: California omits the phrase "or otherwise."
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2. Permitted as a matter of discretion (but not as a matter of right) where the defendant
acts in good faith and in the best interest of the corporation but is not successful on the
merits or otherwise in the litigation, for example, by entering into a settlement.
3. A "determination" relates to the eligibility of the officer or director for
indemnification while an "authorization" is a corporate judgment that an appropriate use
of corporate resources is to pay the director or officer the amount so "determined.”
Determinations of indemnification are to be made by directors who are not parties to the
litigation, by the shareholders, or by special legal counsel. Authorization of
indemnification may be made by the board of directors or by the shareholders and is
viewed to be a matter of business policy by the corporation.
4. Under the MBCA (1984), indemnification of an officer, agent or employee who is
not a director is not subject to the limiting principles applicable to indemnification of
directors. An officer (but not employees or agents) has the same right to mandatory
indemnification as a director and may apply for court-ordered indemnification. A director
who is also an officer or employee is limited to the indemnification rights of a director.
5. The MBCA (1984) provides that the corporation has power to pay or reimburse the
expenses of a director in a proceeding in which she is a witness but not a party.
X.
THE CORPORATION AS A DEVICE TO ALLOCATE RISK
A. Piercing the Corporate Veil
1. Traditional Tests
a) Publicly Held Corporation: PCV is a doctrine applicable to closely held corporations
and not to publicly held corporations.
2. Individual Shareholder Liability for Firm Transactions
a)
Contract breach
(1)
In most cases involving transactions in which a third person dealt
voluntarily with the corporation (usually contract claims) the third person
should not be able to PCV and hold the shareholders personally liable
because he has voluntarily dealt with the corporation and "assumed the
risk."
(2)
PCV may apply in consensual cases, however, in unusual
circumstances or where the corporation is being used in an inequitable way.
Many but not all cases accept this approach.
b) Tort claims
(1)
In most cases involving nonconsensual transactions (usually tort
cases) there is no element of voluntary dealing. To recognize the separate
existence of a nominally capitalized corporation in such a case may result in
a shift of the risk of loss to members of the general public.
(2)
The test in these cases should be whether the shareholders
adequately capitalized the corporation in light of the plausible liabilities it
might incur.
(3)
Liability insurance purchased by the corporation should be viewed
as capital for this purpose. The number of these cases, however, is much
smaller than cases involving consensual dealing and the percentage of cases
in this class in which the court permitted PCV is lower than in contract
cases.
3. Artificial Division of a Single Business Entity
4. Transactions Between Related Corporations That Affect Third Parties
a) Since the terms of the transaction between the related corporations are not negotiated
at arms length, there is a possibility that the transaction may be structured in a way
detrimental to third persons. The test for such transactions is good faith and whether the
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terms of the transaction approximate the terms that might be negotiated at arms length if
the corporations were unrelated.
5. Parent/Subsidiary
a)
Confusion of Affairs
(1)
Parent liability for the subsidiary's debts may arise from a failure
to maintain a clear separation between parent and subsidiary affairs.
Conduct such as mixing assets or business affairs, failing to indicate in
which capacity persons with duties in both corporations are acting,
requiring the subsidiary to obtain approval from the parent corporation on
minor matters, or referring to the subsidiary as a "department" or
"division" of the parent, etc., may lead to parental liability.
b) Permissible Activities
(1)
If practices similar to those described in the previous paragraph
are avoided, a PCV argument should be rejected even though one
corporation owns all the shares of the corporation, the corporations have
common officers, directors, or employees; the corporations have common
offices; the corporations file a consolidated tax return and report their
earnings to their shareholders on a consolidated basis and the corporations
work together cooperatively on some matters, e.g. they utilize a centralized
cash management program.
c) Factors for piercing the corporate veil:
(1)
The parent completely controlled the subsidiary;
(2)
the control was used by the defendant to commit a fraud or wrong;
and
(3)
the control and breach of duty is the proximate cause of the injury
or unjust lost complained of.
6. POLICY
a) Usually shareholders are protected from liability, but there are times where third
parties want to claim damages from individuals. When does this situation come up?
(1)
Negligence
(2)
Bankruptcy situations and satisfaction of obligations
(3)
Fraud and misrepresentation
7. Consumer’s Co-op v. Olsen, Wisconsin, 1988
(1)
CONSIDER: who makes the decisions, what is the purpose and
responsibility of the subsidiary, what actions indicate fraudulent behavior,
what is the size of the corporation, how money/compensation packages are
formed, capitalization, corporate formalities, commingling of personal and
corporate assets.
(2)
POLICY FOR LCA: Forces them to contract around the risk and
to build the risk into the interest rate on the credit extended. From a policy
perspective, we are more willing to shift risk to those with deeper pockets.
Also, the creditor might be able to continue assuming some of the risk by
extending additional risk.
(3)
CONSIDER: Capitalization, and whether the firm has been
adequately capitalized, and whether the initial members put enough money
into the corporation to give it a reasonable chance at success? Early on,
companies can incur substantial debt to startup; if they borrow a lot of
money to get additional assets without intending to operate a bona fide
business, it shows an intention to absolve oneself from liability rather than
operate a business. Want to signal to business associates that the business is
solvent. However, there is no obligation to keep adding capital, because 1)
destroys the notion of limited liability, and 2) is wasted if these cash
infusions just keep the business afloat; UNLESS the shareholders
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“distinctly change the nature and function of the business.” Then, there is
an additional responsibility to re-capitalize the business.
(4)
QUESTION:
(a)
Corporation A is using someone else’s money, and has legal
obligations; Corporation B is using own money and is more risky when
using it. Therefore, in limited liability situations, parties are more
likely to engage in extra-risky behavior. If concern is to deter
excessively risky behavior, may be more inclined to respect corporate
form when corporation is equity-financed. If it is debt financed,
allowing to be protected by limited liability would encourage
borrowers to engage in risky behavior, more likely to pierce the
corporate veil to force responsible behavior with other’s money. Also,
if equity financing extends beyond personal investment to money from
stock issuances, risk of insolvency is incorporated into the rate of
return, dividends, etc. Weigh interests of risk-averse and risk-taking
investors.
b) Western Rock Co. v. Davis, Texas Ct. Appeals, 1968
(1)
With involuntary creditors (tort parties), there is no negotiation in
which the risk of acting riskily is absorbed/internalized by interest rates, so
there is no disincentive to engage in risky behavior.
XI.
MERGERS AND OTHER CONTROL TRANSACTIONS
A. Generally
1. Focus on transactions by which control over a company and its assets is transferred to
another company
2. Why do firms merge?
a) Synergies, financial benefits, poorly performing company, undervalued company.
Although we are focusing on the legal aspects of merger, keep in mind the economic and
financial aspects, as well as the agency theories that bring into question whether a merger
is in the best interests of the shareholders, or should necessarily be considered so
3. Statutes
a)
262(b)(1), 262(b)(2)
(1)
Create the market exception to appraisal rights. Shareholders do
not get appraisal rights if their shares are traded on a national securities
exchange, or are designated as a national market system security by
NASDAQ, or the shares are held by 2,000 or more shareholders, AND,
consideration is either stock of the surviving corporation, or publicly traded
stock of some other corporation, or cash in lieu of fractional shares, or some
combination of the three listed above.
b) Statutory Procedure
(1)
A merger must be approved by the board of directors of each
corporation and recommended by them to the shareholders for their
approval (except for short form mergers).
(2)
The shareholders must then approve the transaction. The
traditional voting requirement was two-thirds of all outstanding shares,
voting and nonvoting alike, but the MBCA (1984) and the statutes of many
states require only an absolute majority of the outstanding voting shares.
(3)
A corporation may voluntarily increase the shareholder voting
requirement. Shareholders that vote against a merger have the right of
dissent and appraisal if the plan of merger contains a provision that would
create a right of dissent and appraisal if it were contained in an amendment
to the articles of incorporation.
(4)
Minority shareholders in a subsidiary which is acquired pursuant
to a short form merger have a statutory right of dissent and appraisal. In a
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statutory merger, classes of shareholders may have the right to vote as
separate voting groups on the merger.
B. Process
1. Shareholders of non-surviving corporation get consideration in the form of cash or
securities (or some combination) as part of the deal.
2. Assets and liabilities of the non-surviving corporation pass to the surviving
corporation.
3. A merger will require the approval of the board and the shareholders of both
constituent corporations.
4. Operationally, to effect a merger, must file a certificate of merger with the Secretary
of State.
5. All shareholders are bound by the merger, assuming it achieves the requisite other
votes.
6. Exception to shareholder vote is in “short-form merger” – where corporation owns
90% or more of subsidiary, it can effect a merger without getting shareholder approval.
7. Dissenters (shareholders who do not want to approve the deal) can get appraisal
rights, which generally give them the right to have shares bought out at appraised value
(different from merger consideration).
a) Why have appraisal rights? Encourages “good” thoughts about the corporation,
maintain reputation, merger is essentially a fundamental change in the investment,
change in management structure…
C. General Types of Mergers
1. Consolidation
a) involves the combination of two or more corporations pursuant to statute that results
in all existing corporations disappearing and a new corporation being automatically
created.
b) CONTRAST: MBCA (1984) does not recognize the concept of a consolidation as a
distinct method of combination since it can be achieved through a combination of
statutory mergers.
2. Short Form Merger
a) is a merger of a 90 or 95 per cent subsidiary corporation into its parent. Votes of
shareholders of both parent and shareholder are dispensed with in a short form merger.
3. Down Stream Merger
a)
parent corporation into its subsidiary
4. Up Stream Merger
a)
corporate subsidiary into its parent corporation
5. Cash (Cash Out) Merger
a) Where minority shareholders are treated differently from the majority shareholders
in a statutory merger, Delaware law imposes "entire fairness" and "full disclosure"
standards. Alternatively, a controlling corporation may place independent directors on
the board of directors of the subsidiary and negotiate at arms length with them. It is also
customary to condition the approval of such a transaction on the affirmative vote of a
majority of the minority shares. If done in good faith, these procedures may avoid a full
scale fairness review.
6. Nonstatutory Mergers
a)
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De Facto Mergers:
(1)
A few courts have held that a transaction which has the same
economic effect as a statutory merger must be treated as if it were such a
merger; may grant participants rights that are available by statute only in
statutory mergers, e.g. the right of dissent and appraisal.
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(2)
COMPARE: Many courts reject in the context of an acquisition.
Some courts have accepted this doctrine in the context of product liability
claims in which the purchaser acquired assets but did not assume liabilities.
Commentators generally reject the de facto merger doctrine because it
introduces significant uncertainty into carefully negotiated corporate
transactions.
b) Recapitalization
(1)
Involves an elimination of large arrearages on cumulative
preferred shares. Beneficial. A recapitalization typically takes the form of
either an amendment to articles of incorporation or a down-stream merger
into a wholly owned subsidiary.
c) Going Private
(1)
Usually takes the form of a cash tender offer followed by a
cash-out merger with the remaining public shareholders being compelled to
accept cash; or of a reverse stock split with fractional interests being
compelled to accept cash. The split is set at a level at which all public
interests become fractional interests.
(2)
LBO
d) Voluntary dissolution
(1)
normally requires adoption of a resolution to dissolve by the board
of directors, followed by approval by the specified percentage of
shareholders.
(2)
"Short form" dissolution is available in limited circumstances. A
simplified process of dissolution before commencement of business or
issuance of shares is usually available. Dissolution by unanimous consent of
shareholders is permitted in many states. Such consent can only be obtained
as a practical matter in closely held corporations. Notice must be given to
creditors. Final dissolution is permitted only after all debts and taxes have
been paid or provision made therefore, and all statutory requirements
complied with. Dissolution is evidenced by filing articles of dissolution. The
power to dissolve a corporation voluntarily has sometimes been used as a
device to eliminate minority shareholders. In these cases, courts have
sometimes imposed equitable limitations on the otherwise unlimited power
to dissolve upon compliance with the mandated statutory procedures. State
statutes generally provide that a corporation continues in existence for a
stated period (usually three years) after dissolution during which it may be
sued on claims arising from its pre-dissolution operations.
D. Contracting Around Appraisal and Voting Rights
1. Sale of Assets
a) Tax advantages; pick and choose which assets and liabilities to absorb; control
issues; incentives to complete the deal; selling company can remain in business if it
wants; buyer can avoid shareholder votes, but seller must get shareholder if selling all or
most of the business (12.01-.02, 271)
b) COMPARE: only shareholders of the selling corporation get appraisal rights under
the model code, but no one gets appraisal rights under the Delaware code
c) A sale of all or substantially all the assets of the corporation is usually treated as
a fundamental change in the corporation that requires approval by a majority of the
voting shares. A sale of all or substantially all of the corporation's assets in the
ordinary course of business usually does not require shareholder approval.
(1)
Most sales of all or substantially all of a corporation's assets are not
in the ordinary course of business. Most courts have viewed "all or
substantially all" to mean "a substantial or meaningful part of." Can be
50% of assets.
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d) The right of dissent and appraisal usually exist in connection with a sale not in the
ordinary course of business that requires a shareholder vote.
e) CONTRAST: Some states, however, do not grant a right of dissent and appraisal for
such transactions.
2. Forward Subsidiary Mergers
a) Target company acquires subsidiary; the shareholders of the disappearing
corporation receive shares of the acquiring corporation, not shares of its subsidiary
3. Reverse Subsidiary Mergers
a) Subsidiary acquires target company; Shares of the parent are exchanged for
securities of the corporation to be acquired. Ultimately the acquired corporation becomes
a wholly owned subsidiary of the acquiring corporation.
4. Triangular mergers are favorable because, in addition to the tax and accounting
implications, triangular mergers avoid the shareholder vote (by structure) because the
shareholders own the parent; the board “owns” the subsidiary.
5. Compulsory Share Exchanges
a) MBCA (1984) and the statutes of a number of states permit a corporation to make a
compulsory exchange of shares for cash or other consideration in a corporate
combination even though a minority of the shareholders oppose the transaction. Such a
transaction is subject to the same safeguards as a statutory merger and has the same effect
as a reverse triangular merger: the acquired corporation becomes a wholly owned
subsidiary of the acquiring corporation. Objecting shareholders have a statutory right of
dissent and appraisal.
E. Appraisal Remedies and Fiduciary-Duty-Based Judicial Review
1. Weinberger v. UOP, Inc., Delaware
a) Basic fairness: For the transaction to be "basically fair," most courts require: (1) a
fair price; (2) fair procedures by which the board decided to approve the transaction; and
(3) adequate disclosure to the outside shareholders about the transaction.
(1)
The acquisition did not meet the test of basic fairness to UOP’s
minority shareholders. The price was not fair (since Signal’s own directors
admitted that $24 was a fair price); the procedures were not fair (since
there were no real negotiations between the two companies); and the
disclosure was not fair (e.g., the public was never told about the feasibility
study showing $24 as a fair price).
2. Summary of Weinberger:
a) Eliminates use of business purpose test in cash-out mergers in Delaware
(COMPARE with MBCA)
b) Controlling shareholders owe minority shareholders a fiduciary duty, and cash-out
mergers contain inherent conflict of interest
c) Burden of proof on majority to show entire fairness unless informed vote of parties
including minority shareholders to approve the deal (then, burden shifts to minority to
show deal was unfair)
d) Entire fairness includes fair dealing and fair price
e) Court adopts appraisal as the appropriate remedy, generally, but rejects Delaware
block; confers discretion to fashion other remedies
F. Appraisal and Entire Fairness Relief after Weinberger
1. Appraisal is available for cash-out and third-party mergers; Appraisal is an exclusive
remedy.
2. Issues to consider:
a) Whether or not the valuation of the shares should take into consideration any value
attributable to the merger
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b) Whether or not there should be any discount in the value reflecting the fact that these
are minority interests and that minority interests may not be as readily marketable (no,
there should not)
c) INCORPORATE: ECMT, which is also supposedly an “accurate” reflection of firm
value. Consider what should be included in the calculation of the value, and how much
weight should be put on future business decisions. Also, consider who should do the
valuation of the company, insiders or outsiders. Furthermore, be aware of the structural
bias inherent in calculating firm value, and the fact that those who are familiar with the
business and its industry may incorporate elements into the analysis inappropriately.
G. Tender offer:
1. When hostile bidder offers all of the shareholders one price for their shares.
Technically, management is in the position to accept or reject the tender offer – query
whether management of the target company can reject the tender offer without the
shareholders’ consent.
H. Back-end Mergers
1. Technicolor
a) In back-end mergers, first the hostile bidder acquires a majority of the company’s
shares, then it forces a merger between the parent and the new “subsidiary”. Despite the
two steps, for the purposes of the merger valuation, the pre-stock acquisition price should
be used. Post-merger value creation can be incorporated, but only to the extent that it is
not speculative. Therefore, shareholders who do not participate to the full extent of their
shares in the front end still bear the risk of the result of the two-step merger in the back
end. In other words, shareholders cannot wait until the acquisition takes place to see if
the price of their shares increase, before selling to the bidder.
b) POLICY:
(1)
Arguably, Technicolor is an example of a cash out merger where a
shell corporation is established and the main company is merged into the
shell via the cash-out merger. This type of deal does not consist of two
companies that join to form a new company with a new capital structure. It
is unclear to TAP if this is the type of transaction 262 is intended to protect.
c) COMPARE: The Model Act has a fudge factor incorporated into it, but the DCC
does not.
XII.
HOSTILE ACQUISITIONS
A. The Market for Corporate Control
1. A potential acquirer who seeks control without the consent of the current control
group can
a) make a tender offer seeking to buy sufficient shares to gain control of the board, or
b) launch a proxy fight seeking the authority to vote sufficient shares to gain control of
the BOD
2. The collective action problems found in large corporations with large numbers of
dispersed, passive shareholders can reappear in a hostile acquisition context. If
shareholders lack the ability or sufficient incentive to investigation and act collectively in
response to an offer from an outside party, there is the possibility of shareholder
accepting an inadequate offer.
3. Market for corporate control:
a)
disciplinary hypothesis
(1)
prevent companies from mismanagement
b) synergy hypothesis
(1)
two firms are better than one
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c)
empire building hypothesis
(1)
bigger is better
d) exploitation hypothesis
(1)
we can manage this firm better than they can
e) POLICY
(1)
Always consider agency costs, collective issues that lurk over
shareholders. Bidder seeks out a target, attempts to purchase enough
shares to have effective control, makes a tender offer directly to the
shareholders to acquire their shares at a significant premium over the
trading price. Shareholders have the implicit right to trade freely, but
corporations have significant anti-takeover provisions that punish bidders
who try to acquire control, or make it expensive to acquire the company
(making the target less valuable). As a result of the sue for breach of
fiduciary duty for adopting defensive tactics that deter bidders from buying
shares (is it a true business purpose?) Who has the authority to respond to
an unsolicited offer? How do we allocate that authority?
4. Anti-takeover defenses
a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
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Poison pills (p. 837):
(1)
can always be enacted; read the section for more info. Poison pills
are policies that go into effect once a takeover is enacted that punishes the
shareholders and the target firm. They are special classes of shares that
create additional rights in existing shareholders when a cash tender offer is
made or there are acquisitions of substantial blocks of the target's shares.
(2)
The additional rights may consist of a right to receive assets or debt
from the target corporation (to make it less attractive to an aggressor),
stock in the aggressor corporation in the case of any subsequent statutory
merger, or other rights. “Flip in” – buy more shares at discount and dilute;
“flip over” sell shares at higher price and decrease market price.
Supervoting shares
(1)
shares that carry more than one vote per share. They may be
created and "parked" in friendly hands. The SEC sought to prohibit the
creation
Rule invalid.
Employee stock ownership plans
(1)
may be adopted to "park" large blocks of shares in the presumably
friendly hands of a trustee for employees.
Porcupine provisions
(1)
changes in the manner of election of directors designed to make it
as difficult as possible for an aggressor acquiring more than 50 per cent of
the shares to take control of the corporation.
White Knight
(1)
A more attractive suitor who can fend off hostile bidder.
Acquisitions
(1)
Acquire additional lines of business that are designed to create
antitrust complications for the aggressor, if successful.
Dividends
(1)
drive up the price of the stock, as by declaring an extraordinary
dividend or by beginning a program of repurchasing of their own shares.
Greenmail
(1)
Negotiate with the aggressor to purchase his shares in the target at
a premium (greenmail).
Debt Covenants
(1)
Corporations fearing an unwanted tender offer may create
covenants in debt indentures that make takeovers difficult to complete
without triggering a default.
Lockups
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(1)
Enter into transactions with friendly persons on favorable terms to
make takeovers difficult or unattractive. Lockups may involve the sale of
shares at bargain prices or the grant of options to purchase shares at
current market prices or options to purchase assets at attractive prices.
k) LBO/Stock Repurchase
(1)
A target may make a selective offer to repurchase or redeem its
own shares in exchange for debt obligations but limit the offer by excluding
shares acquired by or behalf of the offeror. A selective offer of this type
may be devastating to the tender offer since the aggressor may end up
owning a corporation saddled with immense debts.
(2)
In Unocal Corp. v. Mesa Petroleum Co., the Delaware Supreme
Court upheld this type of transaction on the basis of an expanded business
judgment rule, discussed below. Shortly thereafter, the SEC adopted the
shareholders of the same class.
(3)
A target may seek to make itself unattractive by engaging in a
leveraged recapitalization or "leveraged recap." Where a leveraged buyout
is proposed, the target is in effect doing what the aggressor is proposing to
do.
B. Unocal Corp. v. Mesa Petroleum Co., Delaware, 1985
1. Upholding an exchange offer of debt for stock that excluded the aggressor from
participation, the Delaware Supreme Court developed a sliding scale business judgment
rule: "A further aspect is the element of balance. If a defensive measure is to come within
the ambit of the business judgment rule, it must be reasonable in relation to the threat
posed. This entails an analysis by the directors of the nature of the takeover bid and its
effect on the corporate enterprise."
2. 1) The board of the target company offering that it has reasonable grounds for
believing that a danger of corporate policy existed as a result of stock ownership. Satisfy
burden by showing good faith and reasonable investigation. Better if target has majority
of outside directors on the board (looks like duty of care obligations to investigate). 2)
The threat must be reasonably related to the threat posed. Is there any substance to the
proportionality prong, or does it reduce it to the business judgment rule by a different
name? It is the business judgment rule.
3. POLICY:
a) Delaware court treats issue as an ordinary business decision and essentially takes the
decision out of the hands of the shareholders. What does that imply for shareholder
rights? Property rights? Do shareholders have the right to a willing buyer? That is not
the issue according to Delaware. As a result, it triggers management’s rights under DCC
144. COMPARE to MBCA.
C. Revlon, Inc., v. MacAndrews & Forbes Holdings, Inc., Delaware, 1986
1. Delaware Supreme Court held that a "lock up" agreement that favored one contestant
in a takeover attempt over another was invalid and should be enjoined since the board of
directors had resolved to sell the corporation and, upon making that decision, the board
had an obligation to get the best possible price for shareholders and could not arbitrarily
favor one contestant over another.
2. The "Revlon Principle," in other words, states that the target must conduct an
auction to insure that shareholders receive the best possible price if it has decided to
sell the corporation.
3. The obligation is to get the best selling price for the shareholders (p. 851):
a) Duty of board had thus changed from the preservation of Revlon as a corporate
entity to the maximization of the company’s value at a sale for the stockholders benefit.
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This significantly altered the board’s responsibilities under the Unocal standards. The
directors’ role changed from defenders of the corporate bastion to auctioneers charged
with getting the best price for the stockholders at a sale of the company.
4. Revlon will generally not be triggered in stock-for-stock companies between two
larger companies (such as the Compaq/HP deal); not the situation if there is a controlling
shareholder.
5. CONSIDER the context in which these cases unfolded (general hostility behind these
acquirers, and their intent).
D. Summary
1. “Triggered Revlon”, or “in Revlon Land” implies imposing a duty to auction the
business and get the best price available to protect shareholder rights. In contrast, Unocal
creates ability to adopt defensive tactics to avoid hostile takeover.
2. QUESTION:
a) When does the board have to comply with Revlon? Unocal? To a large extent,
which duty applies will determine the outcome. How can they be done consistent with
one another? Most deals these days are all-cash, bust-up deals, so the Revlon test may be
less appropriate. Has this particular deal trigger Revlon or Unocal? When is Revlon
triggered, if the deal is not an all-cash, bust-up deal? See TimeWarner.
E. Organic Changes
1. Generally
a) Basic changes in the structure of the corporation typically require approval of the
shareholders. Historically, approval by two-thirds of all shares, voting and nonvoting
alike, was required but the MBCA (1984) and the statutes of many states now only
require approval by an absolute majority of all outstanding voting shares, whether or not
present at the meeting. Procedural protections against abusive changes consist of the
supermajority vote requirement, the right of classes or series of shares to vote as separate
voting groups, and the right of individual shareholders to exercise their statutory right of
dissent and appraisal in specific situations. These protections are statutory and exist only
to the extent statutes so provide.
F. Amendment of Articles
1. With respect to other amendments, MBCA (1984) provides that a majority of the
votes present at a meeting at which a quorum is present is sufficient to approve
amendments unless the amendment creates dissenters' rights with respect to a class. Many
state statutes require a larger percentage vote to approve amendments.
G. Right of Dissent and Appraisal
1. POLICY
a) These procedures were established to enable the corporation to determine how many
shareholders were likely to exercise that right. However, the major purpose of this right is
to monitor the fairness of cash out and other merger transactions in which the corporation
is able to determine the consideration to be paid to minority interests. Appraisal is
generally not a preferred remedy from the standpoint of minority shareholders because it
requires expensive and time consuming litigation and because the corporation with its
extensive assets is an active participant seeking to establish the lowest possible valuation.
However, it does provide a check against overreaching by the corporation in modern
merger transactions.
2. Compare: Several state statutes provide that the statutory dissent and appraisal
procedure is the exclusive remedy for dissenting shareholders. The MBCA (1984) states
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that the remedy is exclusive "unless the action is unlawful or fraudulent" with respect to
the shareholders.
H. Paramount Comm. Inc. v. Time, Inc., Delaware, 1990
1. Revlon does not apply: 1) when a corporation initiates an active bidding process
seeking to sell itself or to effect a business reorganization involving a clear break-up of
the company; and 2) where, in response to a bidder’s offer, a target abandons its longterm strategy and seeks an alternative transaction involving the break-up of the company.
Unocal is satisfied because management acted within business judgment.
2. The long-term strategy clause was relevant because it implied the business judgment
rule, in that it allows the board to justify the refusal of a tender offer on the basis that it is
part of its long-term strategy to diversify, join another team, etc.
3. Defensive measures: 1) consider whether there is any cognizable threat to corporate
policy; and 2) are the defensive tactics reasonable in relationship to the threat posed.
4. COMPARE: In Delaware, the investigation into cognizable threat is nothing
more than duty of care (VanGorkom); but what now qualifies as a cognizable threat
is ANYTHING (deal you want to protect, culture and inadequate pricing…), so
Unocal is nothing more than the business judgment rule, in relation to prong one;
but courts very rarely say that prong one is satisfied, but that prong two is not.
Why? Because courts do not want to address the business judgment test. So, the
test is a very simple business judgment rule under a different name, which is reality.
5. The other aspect of the reasonableness prong is the notion that Paramount has options
post-merger. This factor carries a lot of weight in Delaware cases. Also, courts suggest
that if Paramount’s position were accepted (no defensive tactics) would shift decisionmaking authority from board to courts. As a result, could be interpreted as suggesting a
shift in decision-making authority from board to shareholders.
I. Paramount Communications v. QVC, Delaware, 1993.
1. Deals that involve a sale of control violate the second prong of the Revlon/Unocal
test and therefore require that the company be auctioned to determined a fair price to
shareholders. Implicitly, sale of control leads to new ownership that can change the
strategic direction of the firm at both shareholder and board levels. Covenants were also
overly restrictive.
XIII. SECURITIES REGULATION
A. Generally
1. Both the 1933 and 1934 Acts refer to registration of securities; you should remember
that these are two independent registration requirements, each with its own set of required
disclosure. Most of the 1934 Act applies to larger corporations, those listed on a stock
exchange or having more than 10MM in assets and a class of equity securities held by
500 or more shareholders. An exception t this limited coverage is Rule 10b-5, which
applies to fraud in connection with the purchase or sale of any security, not just those that
are registered under the 1934 Act.
B. POLICY
1. Mandatory disclosure theories emphasize the law’s ability to reduce the costs of
trading. Without it, there may be a lack of incentives to produce information if securities
information has the characteristics of a public good for which the person who incurs the
costs of seeking or producing information cannot block the use of the information by
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others who do not contribute to the costs (free riding). Also, the absence of mandatory
disclosure means there is the potential for waste as rival firms incur expenses to produce
duplicative data banks (costs of duplication). BUT, Critics of the mandatory disclosure
system emphasize the ability of markets and private ordering to protect investors.
Alternatively, securities regulation can be placed in a public choice model in which
different interest groups seek to use the regulatory process for competitive advantage.
C. Misrepresentations or omissions of a material fact under Section 14(a)
(granting/withholding proxy solicitations)
1. TSC Industries v. Northway, 1976
a) Materiality contemplates a substantial likelihood that the disclosure of the omitted
fact would have been viewed by the reasonable investors as having significantly altered
the total mix of information made available.
b) Quasi-bright line rule: less than 5% impact on financials, more than 10% on
financials, material; battle over middle ground; rejected by the SEC.
c) Only if the established omissions are so obviously important to an investor, that
reasonable minds cannot differ on the questions of materiality, is the ultimate issue of
materiality appropriately resolved as a matter of law by summary judgment.
d) CONSIDER Truth on the Market, Fraud on the Market, ECMT
e) Buried Facts Doctrine
(1)
Disclosure must be effective, not technical (buried in footnotes,
MD&A)
D. Reasons, opinions and beliefs
1. Virginia Bankshares v. Sandberg, 1991
a) The truth of directors’ statements of reasons or belief, however, are factual in two
senses:
(1)
as statements that the directors do act for the reasons given or hold
the belief stated, and
(2)
as statements about the subject matter of the reason or belief
expressed.
b) Under Section 14(a), then, a plaintiff is permitted to prove a specific statement of
reason knowingly false or misleadingly incomplete, even when stated in conclusory
terms. A statement of belief may be open to objection only in the former respect,
however, solely as a misstatement of the psychological fact of the speaker’s belief in
what he says. Proof of mere disbelief or belief undisclosed should not suffice for liability
under Section 14(a). Only when the inconsistency would exhaust the misleading
conclusion’s capacity to influence the reasonable shareholder would a Section 14(a)
action fail on the element of materiality. Must have both elements of falseness (the
statement and the subject matter).
E. Elements of Common Law Fraud Applied to Rule 10b-5 (misrepresentation or
omission of a material fact)
1. Basic Inc. v. Levinson, 1988
a) Expressly adopts “total mix” and magnitude/probability test for Section 10b and
Rule 10b-5. There is no valid justification for artificially excluding from the definition of
materiality information concerning merger discussions, which would otherwise be
considered significant to the trading decision of a reasonable investor, merely because
agreement-in-principle as to price and structure has not yet been reached by the parties or
their representatives.
b) Speculative Information
(1)
Adopts the probability/magnitude test to determine whether
information about merger discussions should be disclosed: materiality will
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depend at any given time upon a balancing of both the indicated probability
that the event will occur and the anticipated magnitude of the event in light
of the totality of the company activity.
2. General Materiality under Rule 10b-5
a) Rule 10b-5 applies to a material misstatement or omission, with respect to the
purchase/sale of securities (to establish standing), and scienter, reliance and causation.
Therefore, a private investor must have actually bought or sold shares. The SEC can
bring an enforcement action in the event that the investor did not actual purchase/sell.
b) SEC General Statement:
(1)
Statement made in the past that becomes inaccurate, or statement
made today that was believed to be truthful was never truthful, the SEC
believes there is a duty to correct/update, as long as the statement is
continued to rely on the statement in the marketplace. COMPARE: Not all
courts have adopted such a duty, but those who have have a similar take as
the SEC. If the investing public continues to rely on the statement, the
company must correct, because the statement acts like a continuing fraud.
c) In re Time Warner, Inc. Securities Litigation
(1)
A duty to disclose arises whenever secret information renders prior
public statements materially misleading, not merely when that information
completely negates the public statements.
(2)
The duty to update opinions and projections may arise if the
original opinions or projections have become misleading as the result of
intervening events, but the attributed public statements must have the sort
of definite positive projections that might require later correction (the
statements in this case did not).
(3)
A disclosure duty limited to mutually exclusive alternatives is too
narrow. When a corporation is pursuing a specific business goal and
announces that goal as well as an intended approach for reaching it, it may
come under an obligation to disclose other approaches to reaching the goal
when those approaches are under serious and active consideration.
(4)
POLICY
(a)
interest in deterring fraud in the securities markets and
remedying it when it occurs, versus the interest in deterring the use of
the litigation process as a device for extracting undeserved settlements
as the price of avoiding the extensive discovery costs that frequently
ensue once a complainant survives dismissal, even though no recovery
would occur if the suit were litigated to completion.
d) Safe Harbor for Projections
(1)
1995 Private Securities Litigation Reform Act: created Section 21E
of 1934 Act and Section 27A of 1933 Act create safe harbor for projections.
1) Protects projections about revenues, earnings, dividends, or similar
items, as well as statements of the plans and objectives of management for
future operations, products, or services if the forward-looking statements
are accompanied by meaningful cautionary statements identifying
important factors that could cause actual results to differ materially. The
safe harbor does not protect statements made in an IPO. 2) Statements
made with the actual knowledge that the information was false are
excluded, but plaintiff bears burden of proof that no actual knowledge
existed. BUT…
(2)
The Bespeaks Caution Doctrine provides:
(a)
when an offering document’s forecasts, opinions, or
projections are accompanied by meaningful cautionary statements, the
forward-looking statements will not form the basis for a security fraud
claim if those statements did not affect the total mix of information the
documents provided investors. In other words, cautionary statements,
if sufficient, renders the alleged omissions or representations
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immaterial as a matter of law. So, firms who make a knowingly false
statement but couch it in cautionary language, no liability, because
cannot take advantage of BOTH safe harbors concurrently.
3. Elements for Rule 10b-5 Liability
a)
Federal Court Jurisdiction
(1)
Use of interstate commerce or mails (address, but easily satisfied)
b) An act (fraud, manipulation, deception…)
(1)
Use Basic materiality test
c) Scienter
(1)
Scienter refers to defendant’s mental state regarding a proscribed
act (negligence, recklessness, intentional/purposeful, strict liability).
(2)
After Ernst & Ernst, includes intent (to deceive) and recklessness.
Scienter (reckless) applies to SEC injunctive actions as well.
(3)
COMPARE: A leading Second Circuit case held that negligence
was sufficient to establish liability under Section 14(a), distinguishing this
section from Section 10(b) for which the Court later required a higher
standard of culpability (Ernst & Ernst, holding scienter should be an
element of liability in private causes of action under Section 14(a)).
(4)
Ernst & Ernst v. Hochfelder
(a)
When a statute speaks so specifically in terms of manipulation
and deception, and of implementing devices and contrivances – the
commonly understood terminology of intentional wrongdoing – and
when its history reflects no more expansive intent, we are quite
unwilling to extend the scope of the statute to negligent conduct.
Recklessness: Highly unreasonable omissions, extreme carelessness.
But, where do you draw the line?
(b)
QUESTION:
(i)
How would attorney’s advice weigh into a scienter analysis?
Reliance on lawyer’s advice is not normally reckless, so should be
acceptable. When is calling your lawyer the wrong thing to do? When
you think they’re going to give you advice you don’t want.
d) Reliance and Causation
(1)
Basic, Inc. v. Levinson
(a)
Fraud on the market theory (based on the ECMT) creates a
rebuttable presumption of reliance, unless special circumstances show
otherwise (think ECMT, noise, small corporations).
(b)
POLICY:
(i)
Rebuttable presumption for reliance makes it easier (no longer
impossible) to bring class action suits and omission cases. The problem
with this decision, according to the dissent, is that it is inappropriate to
apply economic theory to legal decisions. Many other factors account for
movements in the market. May not always be appropriate to assume
information is reliable.
(c)
HYPO:
(i)
Company has thinly-traded stock, not followed by analysts.
Should fraud on the market theory be available in that case? No, because
ECMT does not apply. Information is not accurately reflected in the
price, AND people do not put as much reliance in the integrity of the
market to reflect an accurate price.
(2)
e)
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Causation:
(a)
Other side of the reliance coin. What is it if the defendant is
liable for causing the misstatement or omission? What if the market
drops 5%, specific stock drops 10%. How do you value the damages?
How do you allocate the damages? Reverse causation allows the
defendant to show that it is not “liable” for the loss, but that the market
was responsible. Plaintiff bears burden of showing how much of the
loss was attributable to the misstatement (21D(b)(4) of 34 Act).
(b)
CONTRAST with reverse causation under Section 11.
Damages
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XIV. INSIDER TRADING
A. Generally
1. Rule 10b-5 (Fraud in the purchase/sale of securities, insider trading)
a)
First question: Who has standing to sue? When does it apply?
(1)
It is now the case that there is a private right of action under Rule
10b-5.
(2)
The rule only prevents fraud that is in connection with the
purchase or sale of any security. How do you define “in connection with”?
As long as the fraud “touches on” the security, it is generally enough. Also,
it has to be in connection with the purchase/sale of security, so the
purchase/sale of a security must have taken place. Therefore, cannot sue if
“would have bought/sold, or did not buy/sell, but for the fraud.”
(3)
POLICY
(a)
How do you verify what a person would have done?
b) Duty to disclose (10b-5)  insider trading (10b5-1 and 10b5-2)  other aspects of
10b-5
(1)
arises out of clause 2 of Rule 10b-5 – prevents issuer from failing to
state a material fact or to omit to state a material fact necessary in order to
make the statements made, in the light of the circumstances under which
they were made, not misleading…
(2)
SEC: If statements have become inaccurate by the introduction of
some intervening information, or some statement made turns out to be false
when made (statement made thinking it was true), the SEC says there is a
duty to disclose/update if the issuer knows, or should know, that persons
are continuing to rely on the statement or any material portion thereof.
(3)
Therefore: duty to disclose is expanded, and limits to the line item
disclosures in the applicable regulations.
c) Basis for Insider Trading Law
(1)
In Re Cady, Roberts & Co. and SEC v. Texas Gulf Sulphur Co are
the basis for most insider trading law. General principle (Disclose or
Abstain Doctrine): A corporate insider, when in possession of material
nonpublic information, has a duty to either: 1) abstain from trading, or 2)
disclose the information.
d) Other issues surrounding Insider Trading
(1)
What does it mean to trade “on the basis of” the information?
Does the investor actually have to be investing in a certain way to use the
Rule (10b5-1)? Prior to the rule, some courts said being in mere possession
of information is enough to meet the requirement that traded “on the
basis”; other courts said must actually use the information to trade “on the
basis”. It makes sense to require actual use, but how do you prove what
when into the analysis, both consciously and unconsciously? Rule 10b5-1(b)
says that a person trades “on the basis of” material information if the
person making the purchase or sale was “aware” of the material nonpublic
information when making the purchase or sale (p. 762). Rule 10b5-1(c)
contains the affirmative defenses that articulate circumstances where,
although aware of the information, it is highly unlikely that it was used (p.
762).
e) POLICY
(1)
Why have insider trading laws? Market efficiencies (avoid
arbitrage), simply unfair to those who do not have access to the information
(erodes investor confidence in the marketplace); insiders will withhold
information so they can trade information, which would lead to delays in
disclosure; subverts the duty of loyalty to the shareholders; information
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does not belong to the insider, it belongs to the corporation and the
shareholders (property rights); its just bad not to be fair.
(2)
Why permit insider trading? Pricing efficiency (prices more
accurately reflect the price of the stock – strong form market efficiency);
creates a form of compensation to those who are insiders (but where is the
incentive to make the company perform if there are rewards to insiders if
the business tanks); encourages investors to invest because market is more
efficient; if it’s so bad, why do we need to prohibit it? requiring disclosure
may undermine the incentives to create the information in the first place.
Subverts the duty of loyalty. Confidential info belongs to the corporation
(shareholders) and have no private right to trade on such information.
(3)
Insider trading requires more than simply holding inside
information; requires that there is a duty to disclose it (much more narrow
definition than the original insider trading cases discussed above).
2. Time Warner Inc. Securities Litigation, Second Circuit, 1993
a) There is a duty to update opinions and projections if the originals have become
misleading as the result of some intervening event. But, in this case, the public
statements about the negotiations lacked the definitive positive projections that would
require future correction.
b) Not disclosing these other capital-raising techniques made the information about the
strategic alliances misleading because the shareholders’ understanding about how the
company will eventually raise the money and meet the strategic goals will be different if
they know there are other financing options available.
c) Inadequate to allege fraud when cannot identify the source.
d) Conclusion:
(1)
Consider continued duty to disclose/update.
(2)
If a company makes a false statement, determine when the duty to
correct arises.
(3)
The issuer does not have a duty to correct a materially false
statement by a third party, UNLESS the issuer somehow adopts or endorses
this third party statement. In this case, the duty to correct may arise. Not
necessarily a duty to correct a third party’s statement, because it is
effectively that the issuer has made the statement its own.
3. Duty to Disclose/Speak
a)
Chiarella v. US, 1980
(1)
SC held that, where a trader has no duty to disclose, not liable for
insider trading under 10b-5. Hard to claim engaged in fraud when there is
no duty to disclose/speak. When there is a relationship of trust and
confidence, a fiduciary duty to shareholders (p. 1091).
4. Affirmative defenses:
a)
A person can trade without having traded “on the basis…” if, before purchase/sale:
(1)
Entered into binding contract to purchase/sell security;
(2)
instructed another to purchase/sell on behalf;
(3)
adopted written plan for trading securities that is specific as to
quantities/prices, or included formula for calculating price/quantities, or
excluded any outside influence in the calculation of quantity/prices
purchased/sold.
5. Tipper/Tippee Liability
a)
Corporations 2002
Dirks v. SEC, 1983
(1)
Remember to consider the duty element in Chiarella: here, the
tippee who actually trades on the information owes no fiduciary duty to the
marketplace, but the breach of duty is the cornerstone of an insider trading
litigation under 10b-5
(2)
Dirks Test:
Page 33 of 40
(3)
(a)
The tippee assumes a fiduciary duty to the shareholders not to
trade on the basis of the insider information only when the insider has
breached his fiduciary duty to the shareholders by disclosing the
information to the tippee, and the tippee knows or should have known
of the breach. Tippee liability is ultimately a derivative of the tipper
breach. Also, we tell whether or not there has been a tipper breach by
considering whether or not the tipper has received some direct or
indirect “personal benefit” from the breach and the tip giving. If a
friend or relative is involved, still gives rise to liability, although
judged under a different scale. Treated as if the insider engaged in the
trading, then took the proceeds and gave those as a gift. No tipper
breach, no tippee liability.
Remember FN 14 under Dirks.
6. Misappropriation Theory
a)
US v. O’Hagan, 1997
(1)
Rule 14e-3 (p. 852) prohibits trading on the basis of information
with respect to tender offers, whether or not there is a breach of fiduciary
duty.
(2)
Misappropriation theory:
(a)
Person commits fraud in connection with a securities
transaction (purchase or sale), and thereby violates Rule 10b-5, when
he misappropriates confidential information for securities trading
purposes, in breach of a duty owed to the source of the information. A
fiduciary’s undisclosed, self-serving use of a principal’s information
to purchase or sell securities, in breach of a duty of loyalty and
confidentiality, defrauds the principal of the exclusive use of that
information. The misappropriation theory premises liability on a
fiduciary-turned-trader’s deception of those who entrusted him with
access to confidential information.
(3)
THE PROBLEM WITH THIS CASE:
(a)
How can the court say that, although the source/principal
(law firm) has been defrauded, the existence of liability for
misappropriation turns on the non-existent fiduciary duty to the
shareholders of the firm in which securities were bought/sold? Unless
you disagree with insider trading prohibitions, the outcome is the right
one.
(b)
POLICY
(i)
We should really say that, asymmetric information is a classic
market failure that leads to allocative inefficiencies (arbitrage, fairness).
So, there are two baskets of informational asymmetries – bad and good.
Bad ones are where they “fall into” the information by the nature of the
job (insiders), or steal the information. Good ones are where analysts
have informational advantages, but they will eventually bring that
information to the marketplace. They lose the incentive to gain the
information if they are not allowed to have asymmetrical information.
10b-5 really creates a regime that tries to permit/encourage those
informational asymmetries that have the effect of getting information to
the market. On the other hand, we want to get rid of “bad asymmetries.
If this is what we’re trying to do, the O’Hagan result is consistent with
the policy described above.
b) Other issues with Misappropriation
(1)
A duty of trust and confidence exists for the purpose of the
misappropriation theory whenever 1) a person agrees to maintain the
information in confidence, 2) the persons sharing information have a
history, pattern, or practice of sharing confidences such that the recipient
knows or should know that there is an expectation of confidentiality, and 3)
when information is shared with a parent, spouse, child or sibling, unless
recipient can show there was no reasonable expectation of confidentiality.
Corporations 2002
Page 34 of 40
XV.
NON-INSIDER TRADING VIOLATIONS UNDER 10B-5
A. Generally
1. Material misstatements or omissions with respect to the purchase or sale of securities.
a)
Elements:
(1)
(2)
(3)
Standing
(a)
buyer or seller only (not intent to buy or sell); must “touch”
the transaction
Material misstatement/omission
(a)
in connection with the sale/purchase
Scienter
(a)
(Ernst & Ernst) Any state of mind (scienter) that is at least
recklessness (where is the line between reckless and negligent?), and
intent to deceive, is required under 10b-5. Recklessness means extreme
departure from standards of ordinary care. Scienter does not require
actual desire to mislead investors to further some self-serving scheme;
rather, that defendant was aware of state of affairs and could
anticipate the harm is sufficient. SEC was extended to SEC injunctive
actions, as well.
(b)
HYPO:
(i)
As someone at company, what role does it play in scienter if
rely on the advice of counsel, or what role should it play? Reasonable
reliance? Conduct reasonable grounds to believe? See section 11 and
BarChris.
(4)
Reliance
(a)
Basic Inc. v. Levinson
(i)
can be presumed on the basis of materiality and by the fraud
on the market theory; but is a rebuttable presumption based on 1)
market makers have knowledge of false information and incorporate it;
2) true information dissipated the impact of the fraud; and 3) Plaintiff
acted despite actual knowledge of the fraud.
(5)
(6)
(7)
Corporations 2002
(b)
Information need not actually be relied on; it only needs to be
material, in the sense that it could be a factor that is considered in the
decision-making process. The presumption of reliance is most often
found in a case of an omission. Plaintiff needs to show that it is aware
of the misstatement/omission.
Causation
(a)
Negative causation is allowed (Rule 10b-5) by Section
21D(b)(4) of the 34 Act (Private Securities Litigation Reform Act).
Difference between 10b-5 and Section 11 negative causation is that
negative causation is a defense under Section 11, and a burden of proof
for the plaintiff under 10b-5.
HYPO:
(a)
What if plaintiff believed the person making the statement was
a liar? Reliance? Belief in the integrity of the market? Not likely. So
fraud on the market theory presumption is not supported. What about
a person who is completely unaware of how the market works, who
bought for reasons unrelated to the market? Should this person get the
presumption of reliance from the fraud on the market? Not likely, but
should she be able to piggy back on the theory that everyone else who
was aware set the price and she benefited? Maybe. Consider purpose
for buying or selling.
QUESTION:
(a)
Does anyone really rely on the integrity of the marketplace?
What does market integrity even mean? Does anyone really believe
that stock prices reflect the value of the firm? Are we really saying that
Page 35 of 40
there is some sense that stock prices are “honest” and “fair”? Then
does the ECMT theory really apply? What does all the “noise trading”
mean with respect to the fraud on the market theory?
Corporations 2002
Page 36 of 40
Rule
MC 6.21(e)
Title
Future Benefits as
Consideration
7.32 MC
Shareholder
Agreements
8.05(d)
(MC)
8.11 MC
Director
Compensation
8.30(B)
(MC)
MC 11.01
Plan of Merger
Elements
MC 10.04,
11.03(f)(1)
Non-voting shares
and ability to vote
MC 11.03(g)
Small Scale
Merger
MC 11.03
% of votes to
approve merger
Corporations 2002
Description
If the corporation never receives the benefits, the shares are still outstanding, and the corporation can
either 1) seek to recover the consideration; 2) escrow the shares until the consideration is received,
and cancel the shares in the event of default; or 3) forbid the shares from being transferred until it
receives consideration for them.
designed to permit virtually any control arrangement in a corporation that relates to the governance
of the entity, the allocation of the return from the business, and other aspects of the relationships
among shareholders, directors, and the corporation. The agreement must be unanimously approved
by the shareholders; it may appear in the articles of incorporation, the bylaws, or a shareholders'
agreement. An agreement under § 7.32 is valid for ten years unless otherwise provided in the
agreement. It automatically terminates if the shares of the corporation become publicly traded on a
national securities market.
“New investors” must be elected at next annual meeting, even if the term of the person they replace
expires after that.
Directors are entitled to compensation unless articles or bylaws provide otherwise. Common Law:
directors are not entitled to compensation unless 1) extraordinary services, and 2) services were
requested/accepted by corp. officials
Directors are held to an inquiry notice standard, such that they can rely on subordinates who have
competence and expertise in the area of the question, unless the directors know of facts or
circumstances making the reliance unwarranted.
1) Merger’s terms/conditions, 2) how the terms will be effectuated, 3) any amendments on the
survivor’s articles made necessary by the merger, 4) any other terms the corporations have agreed
on.
If the amendment would change the rights of nonvoting class of shares, the class affected by the
amendment must approve the amendment as a class even if it doesn’t otherwise have the right to
vote. Specific situations: 1) increase/decrease the authorized shares of the class; 2) limit/deny a
preemptive right; 3) change shares of a class into a different number of shares of the same class; 4)
change rights, preferences, limitations of the class; 5) create a new class of shares with superior or
substantially the same financial rights or preferences; and 6) increase rights, preferences, number of
shares of any class with superior or substantially the same financial rights/preferences.
Surviving corporation is much larger than the disappearing corporation. Its feature is that it doesn’t
require a shareholder vote of the surviving corporation. Two prerequisites: 1) the number of postmerger voting shares of the survivor must not exceed the number of pre-merger voting shares by
more than 20%, and 2) the merger must not require any change to the survivor’s articles of
incorporation.
Shareholders of surviving corporation: no voting or appraisal rights. Shareholders of disappearing
corporation: voting and appraisal rights.
Most statutes require majority of the outstanding stock entitled to vote. In addition, many statutes
require a 2/3 vote by the outstanding stock of each constituent corporation. Some statutes go further,
requiring majority vote by each class of stock, whether or not the class normally has voting rights.
The rule requires separate approval by a class of shares if the number of authorized shares in the
class will change; the shares in the class will be exchanged or reclassified into another class of
shares; the rights or preferences of the class will be modified; a class of shares with superior rights
Page 37 of 40
Cross-Reference
XVI.
BARCHRIS
MC 11.04
Short Form
Merger
MC 11.06
Survivor rights
MC 12.01
Exceptions to
Steps to Sell
Sale of All or
Substantially All
Assets
Shareholder
Appraisal Rights
MC 12.01-2,
13.02
13.02(a)(4)
MC
MC 13.01(3)
Fair Value for
Appraisal Rights
13.02(b)
Remedies for
Dissenting
Shareholders
MC 13.31
Challenging
Determination of
Fair Value
10b-5 (34
Act)
Insider Trading
13(d) SEC
Disclosure and
Tender Offers
13(d)(3)
Definition of
Person for WA
13(d)-(e),
14(d)-(f)
14(d)(5)
SEC
Tender Offer
Requirements
Tender Offer and
Protection of
Corporations 2002
will be created or the rights of existing prior stock strengthened; the preemptive rights of the class
will be removed or limited; or accumulated but undeclared dividends for the class will be affected.
Recognized by many states, doesn’t require shareholder approval. Prerequisite is that the two
corporations must have a parent-subsidiary relationship; the parent must own more than a stated
percentage of the subsidiary’s stock (90%-95%). BOD for both corporations must approve the
merger. The shareholders of the subsidiary have no voting rights, only appraisal rights. The
shareholders of the parent company have no voting or appraisal rights.
In a merger, the surviving corporation, by operation of law, takes all of the disappearing
corporation’s rights, assets, and liabilities.
A sale in the ordinary course of business. Courts are split on another exception, namely, a sale of
assets where the court is insolvent or otherwise distressed.
Director Approval – by a majority of directors at a properly convened meeting; and Shareholder
Approval – by shareholders of the selling corporation (exceptions). A simple majority of shares is
entitled to vote is generally required. Few require 2/3 majority.
Shareholders of a class of stock are entitled to appraisal rights if they dissent from an amendment
affecting their class of shares by 1) materially and adversely altering or abolishing a preferential
right, 2) excluding or limiting right to vote on any matter, 3) altering or abolishing a preemptive
right, or 4) creating, altering, abolishing a right of redemption.
Fair value is determined immediately before the change in question is announced or takes place,
excluding any appreciation or depreciation in anticipation of the action. The idea behind this timing
is that a shareholder opting out of a corporate change shouldn’t get any reflection of that change.
Appraisal only available, unless fraud or illegality is present. Look for two principal kinds of
situations: crucial information misstated or omitted from proxy statements and other merger-related
documents; unfairness serious enough to constitute fraud
No Misfeasance by Corp/Dissenters: corp. bears costs of proceeding, including the court-appointed
appraiser, except dissenters’ counsel and expert fees.
Dissenters acted in bad faith: must pick up some or all proceeding costs
Corporation acted in bad faith: corp. must pick up some or all counsel and expert fees
Prohibits, in connection with the purchase or sale of any security: the employment of any device,
scheme, or artifice to defraud; any misstatements/omissions of material fact; and any act, practice or
course of business that operates as a fraud or deceit
A private party can (very rarely) seek equitable relief for a 13(d) violation because such relief is only
possible if it is not only equitable, but the plaintiff is facing irreparable harm. Also, disclosure
requirements do not apply to non-voting securities. Acquiring preferred stock triggers 13(d)
disclosure requirements only if the shares have voting rights.
Person includes not only a single person, but also two or more people acting as a partnership, limited
partnership, syndicate, or other group for the purpose of acquiring, holding, or disposing of the
securities of an issuing company.
1) Filing Requirements (ownership exceeds 5%, files Schedule 13D) and 2) Antifraud Requirements
Withdrawal Rights – shareholders can change their minds any time the tender offer is still open
Page 38 of 40
DCC 271
Delaware Approach: appraisal only
available except for cases of fraud,
misrepresentation, self-dealing,
deliberate waste of corp. assets,
gross and palpable overreaching
Section 10b, Section 16(b)
14(d)(2)
Rule 10b-5
14(d)(6)
SEC
Target
Shareholders
14(d)(7)
SEC
14-3 (SEC)
Disclosures in
Proxy Statements
14a-4 (SEC)
Proxy Card with
Proxy Solicitation
14a-7 SEC
Must Mail
Shareholder
Communications
or Give Them a
Shareholder List
Shareholder
Proposal Rule
14a-8 SEC
14a-9 SEC
14(e) SEC
False, Misleading
Statements or
Omissions
Connected with
Proxy
Solicitations are
Prohibited
Tender Offers
102(b)(7)
DCC
Directors’
Liability
144 DCC
Fairness
Corporations 2002
Pro Rata Rule - If the offeror offers to purchase a portion of the corporation’s outstanding stock and
more shares than he wanted are tendered (“oversubscribed”), the offeror must purchase shares pro
rata from each tendering shareholder
Best Price Rule – If the offeror, before the offer expires, increases the price he’s willing to pay for
shares, he must pay that increased amount to everyone whose shares he purchases, including those
who tendered before he increased the price.
Requires disclosure of information to shareholders in connection with proxy solicitations. Proxy
statement must disclose conflicts of interest, management pay, details of major corporate changes to
be subject to a shareholder vote. Any documents given to shareholders as a part of the solicitation
process must first be filed with SEC
Requires that a card be sent with proxy solicitations, which the shareholder can sign and return
indicating whether or not he grants his proxy. If directors are to be elected, the card must include a
means for the shareholder to withhold his authority to vote
This is generally an issue when management wants to undertake an action requiring shareholder
approval, and a group of shareholders opposes the action.
Section 14
Section 14
Section 14
Lets shareholders have their own proposals for action at an upcoming shareholder meeting including
in management’s proxy statement. Such proposals generally involve social issues. There are
significant restrictions on this shareholder right, the two most significant being that the proposal
can’t be contrary to a management proposal, and it can’t relate to a director’s election.
The only other important proxy issue involves proxy contests. The most typical issue in a proxy
contest is who pays for it. Only 14a rule that creates a private right of action for shareholders and
corporations.
Section 14
Fraud is defined as both 1) misstatements and omissions of material fact, and 2) fraudulent,
deceptive, or manipulative acts or practices in connection with any tender offer or request or
invitation for tender offers. There MUST be some material fact misrepresented or omitted even
though the section reads as though deception without material misstatements would suffice.
Reliance is one of the elements necessary in such a claim.
Corporations can put a provision in their articles of incorporation limiting their directors’ liability for
breach of the duty of care, except for intentional misconduct, knowing legal violations, or actions
done in bad faith; authorizes certificates of incorporation to contain a provision eliminating or
limiting the personal liability of a director to the corporation or its stockholders for monetary
damages for breach of the duty of care with certain exceptions. The section only applies to suits for
"monetary damages." Suits for equitable relief to enjoin a transaction and suits based on the breach
of the duty of loyalty are not precluded by that section. A few state statutes apply to suits for
equitable relief as well as to suits for monetary damages.
Any one of director approval or shareholder approval or fairness will remove the taint of a conflict of
interest. However, in practice, courts require fairness regardless of director or shareholder approval.
Rule 10b-5 (14(e) is more broad
than 10b-5, and does not require
buyer/seller
Page 39 of 40
Section 14; TSC Industries
Corporations 2002
Page 40 of 40