Corporatations outline - Paredes
ECONOMIC AND LEGAL ASPECTS OF THE FIRM
The Economic Backdrop – p. 1-12
- Comparative Search for Best Investment
- Risk and Return – decisions on how to invest
o Risk averse
o Risk neutral
o Risk preferring
- Transaction Costs and Choice of Organizational Form
o Transaction cost factors
 Bounded rationality – cognitive ability is imperfect or limited
 Opportunism – self-interest seeking with guile; use an advantage to
gain the system
 Team specific investment – investments made that are still valuable
after you’re gone; hard to withdraw bc you’ll lose a lot of money
o The Limits on Organizing Production as an Implicit Team
o Discrete and Relational Contracting
 A response to the threat of opportunism in implicit teams – explicit
team by discrete contract
 Relational K-ing – response to the defects of discrete K-ing that
doesn’t cover every contingency – governance structure that will allow
them to solve problems when, and if, they arise
Implicit Team  Discrete K  Relational K  Organize as a Firm
 This is a move from exchange to hierarchy and control in an
effort to decrease transaction costs
The Sole Proprietorship and the Law of Agency – p 12-37
1. Introduction
2. Agency Law and the Choice of Sole Proprietorship Form
a. Agency – the manifestation of consent of one person that another shall act on
his or her behalf and subject to his or her control  can be proven by
circumstantial evidence, you don’t need a specific K. Can be terminated at
any time by either party
b. Agency Costs – risk of agent being lazy or disloyal
i. Deal with by
1. terminating the relationship
2. compensation structure that has the effect of aligning the agency
with the principle  stock options
3. Fiduciary duty – the law – duty to act in a correct manner
4. Market – reputation considerations
3. Fiduciary Limits on Agent’s Right of Action
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a. Fiduciary duty can be described as a device for economizing on transaction
costs (default rule; Ks are necessarily incomplete). It doesn’t’ specify what can
be done or not, but imposes a general obligation to act fairly
b. Fiduciary duty obliges the fiduciary to act in the best interests of his client or
beneficiary and to refrain from self-interested behavior not specifically
allowed by the employment K
c. Socially optimal fiduciary rules approximate the bargain that investors and
agents would strike if they were able to dicker at no cost
4. Limits on the Proprietor’s Right to Discharge an EE at Will
a. Default is employment at will
5. Agency law and Relations with Creditors
a. The authority an agent has in representing a principle
i. Actual – when principal manifests his consent directly to the agent
ii. Apparent - arises when an agent is without actual authority, but the
principal manifests his consent directly to the third party who is dealing
with the agent. ER must bear the risk of loss from agents, that
reasonably appear to outsiders to fall within the scope of the agent’s
authority.
iii. Inherent – implied term in the K bw a principal and all who deal with
his agents
b. disputes bw principals and 3rd parties over the authority of agents can be put
into 2 cat
i. agent exceeds her authority
ii. opportunistic action
The Road Ahead p 37 - 53
The theory of the firm  Bearle and Means  separation of ownership and control;
problems of conflicts of interest – Problems solved by Fed Sec laws
1. Selection of Joint Ownership
a. Organizing Team Production as a sole proprietorship or jointly owned Firm
i. Sole proprietorship – typically chosen when one team member, the
owner, has substantially more team-specific cap at risk than other team
members and, therefore, has the most to gain or lose form the success or
failure of the team
ii. Joint Ownership – when team specific skills and investment will be
distributed somewhat equally among team members. Mutual selfmonitoring is more efficient than having one member attempt to learn
enough to monitor other members
b. The challenge of passive ownership  primarily the SH
i. Joint ownership creates a need for rules determining how decision
making authority will be allocated bw and among joint owners
ii. Joint ownership creates a need for voting rules
iii. The need for monitoring agents: BOD
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1. jointly owned firms with a large number of passive owners will
almost certainly find it efficient to limit the management powers
of passive owners and to delegate day-to day ownership powers
to owners and agents who specialize in management
2. All owners grant to the monitors – the BOD – control over the
management specialists, and all agree that this control is to be
used to protect the expectations of the passive owners.
c. The need for rules governing exit
2. The Role of Entity Law
a. Default v. Immutable Rules – p 44
i. Default Rules – types from which lawmakers can choose
1. Tailored rules - 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
2. majoritarian rules – designed to provide investors with the result
that most similarly situated parties would prefer
3. Penalty default rules – 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
ii. Fiduciary Duty and the Nexus of Ks approach (contradicts Bearle nd
Means)
1. you should think of the firm as a series of implicit and explicit
Ks and market relationships bw and among owners, agents,
creditors, customers, and affected communities.
2. ultimately, there will be some loss due to agency cost but they
are less important than Bearle & Means suggested. Attempts to
correct agency costs will do more harm than good (by stifling
innovation)
3. A lot of guys don’t like this
b. Liability as to Outsiders
c. (Tax) Relations to Government
i. Double taxation – only an issue for certain types of corps – C corps
1. Not for partnerships, LP, LLC, or S corps – these are pass thru
2. The corp pays tax on profit; when the corp distributes dividends
or stock is sold for cap gains, there is another tax on SHs
3. Tax can determine organizational form
3. The Role of Markets in fiduciary duties
a. Product Market – if you don’t run the co well, then you won’t be making the
product efficiently and you will be out done in the market; also reputational
concerns
b. Capital market – if management isn’t running the business well, it’s going to
cost more money to raise cap bc it’s not as profitable
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c. Labor market – if you’re part of a management team and you get dischared bc
you do shit work, it’s going to be hard to find another job
d. Wall Street Rule – the ability to exit: sell stocks
e. Markets for corp control – think possible take over.
4. State v. Fed Law
5. Use of Corporations and Other Forms of Business Associations
PATNERSHIPS AND LL COS
A. Introduction p 55-65
1. Traditional Noncorporate Business Associations
a. The General Partnership UPA 6,7,15, 18, 31, 38; RUPA 301, 306, 401, 601,
801
i. Partnership law provides a set of standard form, off-the-rack rules for
persons who wish jointly to own and operate a firm
ii. A general partnership requires only a statutorily specified mutual
manifestation of consent. The association of 2 or more persons to carry
on as co-owners a business for profit creates a partnership – once this is
met gen partnership law determines rights and duties of the partners.
iii. If there is no partnership agreement, then the default partnership rules
take over.
iv. Governance – there’s generally an equal ownership, risk management
rights  they jointly own and run the business together and each partner
has the right to act on behalf of the partnership to bind it
v. Withdrawal – partnership ends when any one of the partners wants to
leave
vi. Liability – each partner is jointly and severally liable for all of the
obligations of a partnership, and that liability is unlimited – extends to all
of your assets
 problem is that any of the partners can go out and bind the
partnership and incur obligations that all the partners are
obligated to, to everything they have
vii. Fiduciary duty – partners owe each other fiduciary duties. So long as
the partner is acting within the scope of his authority and incurs
obligations, you are still liable to the obligation even if you charge
fiduciary duty claims against that partner
viii. Tax – partnerships are pass-thru entities
b. Joint Ventures – associates join to exploit a particular opportunity
i. Two or more persons must enter into a specific agreement to carry on
an enterprise for profit
ii. Their agreement must evidence their intent to be joint venturers
iii. Each must make a contribution of prop, financing, skill, knowledge, or
effort
iv. Each must have some degree of joint control over the venture and
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v. There must be a provision for the sharing of both profits and losses
c. The limited Partnership RULPA 101, 201, 202, 303, 403
i. To be a LP, must have at least one gen partner and one limited partner.
To create a LP, the Gen partner must execute a certificate of limited
partnership, setting forth certain basic info about the partnership and
which sets forth everyone’s obligations, and then file the cert with the
Sec of St in the jurisdiction of choice
ii. Like a GP – association of 2 or more people to carry on a business for
profit
iii. Difference in structure – you have one or more general partners and
one or more limited partners
iv. Governance – GPs have control, LPs are passive and can’t exert much
control. LPs are just along for the ride
v. Liability – LPs are not jointly and severally liable, just as their control
is limited, so is their liability. The LP’s liability is limited to the
investment in the partnership, but if the LP participates in the control
of the business, he or she is liable only to persons who transact
business with the limited partnership reasonably believing, based upon
the limited partner’s conduct, that h elimited partner is a general
partner. GPs in limited partnerships are jointly and severally liable
vi. Structure – for the GP to avoid complete liability, he can set up
Paredes LLC, an entity that has limited liability, and the entity will be
thru which Paredes will be the GP. Simply insert some entity that has
limited liability that he can control. So, the LLC will be the GP. So,
put like 1000 bucks in the LLC and that is the entity that will be the GP
and that is all that it’s liable for.
1. The way to get Paredes on the hook is to make him sign a K that
makes him promise to be on the hook.
vii. Tax – pass thru
1. Emergence of LL Entities as the norm
a. Limited Liability Co ULLCA 202, 203, 303, 404, 601, 701, 801
i. Before the LLC came around and you wanted LL, you go LP route or
corp route
 The problem with the corp route is double taxation
 LPs give you LL as long as you’re a limited partner. From a tax
perspective, they’re fine bc they’re pass thru. But, you don’t get
any control as a limited partner
ii. We want LL, good tax outcome, and control
iii. Formation – Have to file with the Sec of St – art of org. Also have to
file an operating agreement (LLC) agreement) – analogous to the
partnership agreement and sets out duties and obligations. These can be
oral or written. In a lot of jurisdictions (DE) you can have a single
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member LLC – they are residual claimants (get the profit and bear the
loss)
iv. Governance – the default is that they’re member managed – members
make the decisions, similar to the GP in the partnership context. The
alternative is hiring a manager. Even if you hire a manger, the members
usually maintain control over big ticket items. If members participate in
control, they don’t lose their LL
v. Liability – the members and the managers, everybody, has LL
vi. Tax – Pass thru
vii. These days the LLC is the entity of choice – flexibility in governance, LL,
favorable tax.
2. Continuing Role of General Partnership Law
B. Fiduciary Duty p 65-82
UPA 20, 21, 22; RUPA 403, 404, 405; ULLCA 408, 409, 410
 The traditional Framework
a. Each partner owes a fiduciary to each other partner – fiduciary duty is that
you have to act in the best interest of your partner over your own interest.
Fiduciary duty doesn’t apply in the marketplace where there’s a one on one,
on the spot transaction
b. UPA 20 – there is a broad duty to disclose info
c. Fiduciaries are bound to act with a punctilio of an honor
d. Three factors relied upon by the ct in Meinhard to evaluate whether something
is an opportunity which should go to the corp (corp opportunity triangle) –
1. how the def came to hear of the opportunity, involves the
relationship bw the opp and the person who took the opp 
2. Def was the managing partner, involves the relationship bw the
corp and the person who took the opp 
3. nexus bw the opp and the existing business of the venture,
involves the relationship bw the opp and the corp (look at
Gevurtz hornbook p 367)
i. The opportunity itself
ii. The corporation
iii. The person who took the opportunity
 Fiduciary Duty and Private Ordering
a. You can K around fiduciary duties, it’s just a matter if you do it effectively 
this is mainly in the case of partnerships, where if something’s not in the
partnership agreement, you fall back onto the default rules. But, you can K
around the default rules
b. Look at notes
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Is there a stat duty to disclose at all? RUPA 403©
o You have to tell the other partner, even if they don’t ask, all info they
need to exercise their rights and agreements under the partnership act
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-
-
-
-
o The point is that based on 403c, there is an argument to be made either
way
UPA 20 – Duty of partners to render info  partners shall render on demand
true and full info of all things affecting the partnership to any partner or the
legal representative of any partner
Common law argument is that he has to
UPA 404b1 – A partner’s duty of loyalty to the partnership and the other
partners is limited to the following: 1) to account to the partnership and hold as
trustee for it any prop, profit, or benefit derived by the partner in the conduct
and winding up of the partnership business….basically, if you use the
partnership in someway or something is available to the partnership, you can’t
take it for yourself, you have to share the proceeds.
There is a reasonable argument that there is a duty to disclose unless they
contract around.
Can they contract around? UPA103 – lists what the partners can K around,
and it’s not everything. The parties can K around anything in 403c. You can’t
K around the 404b loyalty standards, but you can set forth examples of conduct
that partners will agree will not violate fiduciary duty as long as they aren’t
manifestly unreasonable.
In the Problem 2-3, there are no examples, they just try to K around it, and this
they can’t do.
UPA 20 – doesn’t expressly contemplate K around fiduciary duties.
6. Power to Mange and Bind the Firm p 87-88, 92-103
- First question we want to ask is: Is this person a partner?
- Does this person have actual or apparent authority?
- If the person is an agent with no authority, did the third party know
this?
- Think about economics and least cost avoider
1. Responsibility for the Acts of a Gen Partner UPA 9.13.14.15.18; RUPA 301.305.306;
ULLCA 301-303
a. UPA sec 9 – every partner is an agent of the partnership for the purpose of its
business
i. Each partner has the authority to manage and bind the firm
ii. Partnership involves merging of the assets – reasonable for 3rd parties to
assume that the partner has the power to bind the partnership  this is
what sec 9 codifies
iii. A partnership is not bound by the acts of the partner if the partner acting
doesn’t have power to bind the partnership and the person with whom
the partner is dealing knows that the partner doesn’t have such authority
iv. An act of a partner which isn’t apparently for the carrying on of the
business of the partnership in the usual way doesn’t bind the partnership
unless other partners give express permission
b. UPA sec 13 – partnership bound by a partner’s wrongful act
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ii. A partnership is liable for any wrongful act or omission of the partner
when the partner acts in the usual course of business
b. UPA sec 14 – Partnership bound by partner’s breach of trust
i. The partnership is bound to make good the loss where one partner
acting within the scope of his apparent authority receives money or
prop of a third person and misapplies it; and where the partnership in
the course of its business receives money or prop of a third person and
the money or prop so received is misapplied by any partner while it is
in the custody of the partnership
c. ULLCA sec 301 – Agency of members and managers
i. Member managed LLCs – members have agency authority to bind,
similar to GP
ii. Manager managed LLC – managers have authority analogous to the GP
1. The members who aren’t managers in a manager managed LLC
have no authority to bind the LLC
d. Authority of Joint Venturers
i. The authority of a joint venturer to bind the JV is less than the GP to
bind the partnership
ii. There is less of a merging of interests and assets in a JV than in a
partnership
iii. It’s reasonable for the 3rd party to assume that the joint venturer has
less authority than the GP to bind
Participation in Management and control UPA 9, 18e and h; RUPA 301, 401f and j
a. UPA sec 18e – each partner has equal right in the management of the
partnership
b. UPA sec 18h – if there is disagreement, then the way to solve is majority vote
of the partners
c. RULPA 303 – liability to third parties – detrimental reliance test  a limited
partner who impermissibly participates in control is liable only to persons who
transact business with the LP reasonably believing, based upon the limited
partner’s conduct that the limited partner is a general partner
i. There is a list of things (safe harbors) that if a limited partner does will
not constitute participating in control
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CORPORATE FORM AND THE SPECIALIZED ROLE OF SHS
Corp Forms 154 -166
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1) Separation and specialization of function  there are different roles for the SHs,
directors, and officers
SHs – provide capital, elect directors, and they have the right to vote on
certain big ticket items such as a merger, sale of assets, amendments to arts of
inc. Whatever authority they have is exercised by vote.
 SHs have very limited authority to participate in the management of the
corp.
Directors – make major policy decisions and monitor officers.
Officers – run the day to day business; effect the policy decisions made by the
directors.
2) Limited liability – investors and SHs have limited liability to their initial investment
3) Centralized or hierarchical decision making – officers make day to day
decisions, and directors make the big policy decisions.
4) Free transferability – you can freely transfer or sell your shares as a shareholder 
easy exist – “Wall Street Rule”  if a rational SH was dissatisfied with corp policies
or suspected that management was unfit, it was considered more rational to follow
the Wall St Rule and sell shares
5) Perpetual Existence – Corps exist into perpetuity – exist until it is decided to be
dissolved
6) Double taxation – taxation at the entity level, and then at the SH level
- Bearle and Means – theory of the firm, and separation of ownership and control
SHs own the firm and as owners the corp law norms contemplate that
management is delegated to the Board, and the Board delegates authority to
the officers to run day to day business.
Why do SHs delegate this authority? Law forces them to.
 But the logic is that SHs are dispersed and they can’t coordinate, and
they’re rationally apathetic.
 They can’t possibly run the business. It’s inefficient for them to run
the corp. They want someone to run it on their behalf.
Corp law norm that SHs will retain ultimate control by annually voting on
directors
Prob is that the corps officers also have the ability to nominate directors. Bc
SHs can’t get their act together and coordinate, SHs just go along with how
the managers vote. This means that the officers have effective control over
the co bc they’re the ones who nominate the directors for whom the SHs
ultimately vote. What happens is that we have a separation of ownership
and control. The reality is that the officers nominate the directors who are
ultimately voted on by the SHs. The meaningful control is in the hands of the
officers.
Think about agency problems
- There has been an emergence of institutional investors – as an aggregate, they own
over 50% of the stocks traded daily. These guys have a big stake, and they can
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coordinate. So, rational apathy may be less prevalent. Institutions tend to be more
active generally. So, it seems that the Burley and Means theory is failing. SH
participating in control doesn’t affect their LL at all. But, if you have effective
control, you have fiduciary duty to the minority holders.
- Institutional investors can use informal means to exert control  make the board
look bad in public, take out ads in the WSJ, go on Squawk Box.
Obtaining and modifying the Statutory Norms
Formation of a Corporation
- File an art of inc with Sec of State
Art are public docs and they can only be amended with the vote of the
directors and the SHs. Therefore, no amendment if the directors don’t want
it to happen
DE 102 and MBCA 2.02 – shows what you have to include in the articles
- Create classes of Shares
- By-laws – The incorporators or BOD of a corp shall adopt initial bylaws for the
corp. The bylaws may contain any provision for managing the business and
regulating the affairs of the copr that is not inconsistent with the law or the arts of
inc. They fill in the gaps of anything not put in the articles. These are not public.
They can be amended by the directors or the SHs alone, depending on what’s in the
Arts. Default is that board, itself, can change under board’s general power to amend
bylaws
 BOD may be limited if the art of inc reserve that power exclusively to
the SHs in whole or part or the SHs in amending, repealing, or
adopting a bylaw expressly provide that the BOD may not amend,
repeal, or reinstate that bylaw.
- Under MBCA and most state stats, the BOD must first approve an amendment to
articles and recommend that it be adopted before it can be considered by the SHs.
The board thus has a gate keeper fx in this regard. Its favorable recommendation is
necessary before the SHs may even consider a proposed amendment.
- If articles conflict with bylaws, articles control
- Most state corp law norms take the form of default rules; most of these rules may be
changed by private ordering, such as SHs agreements. However, the usual
mechanism for modifying or avoiding corporate law default rules is the inclusion of
the preferred rule in the art of incorporation or bylaws
- SHs agreement – these are usually only used by small cos
- State Corp Laws as Competing Sets of Standard Form Rules
By selecting the state of incorporation, business participants have a means of
choosing the rules they want for their enterprise.
Internal affair doc – cts look to the laws of the incorporating state to
determine the basic rights and duties applicable to the particular corp.
The National Market System and the Efficient Market Hypothesis p 166-174
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National Market System
- Exchanges (NYSE) and
By centralizing all buy and sell orders in a given security, investors
theoretically should receive the best execution of their orders by a continuous
matching of the highest priced buy orders against the lowest priced sell orders
- Decentralized markets (NASDAQ)
Efficient Capital Market
- ownership of stock – may entitle you to one vote, but it entitles you to the right of
the earnings of the co.
- what do you need to evaluate a co’s earnings? You need info. Info matters in
valuing stock, and this takes us to the efficient cap market thesis
- What info does the stock price reflect, and how quickly is that info incorporated into
the stock price
- The ECM thesis is the idea that stock prices reflect info about the co, how efficient a
market is depends on what info is thought to be incorporated in the price and how
quickly the info is integrated into the price
- 3 levels of efficiency
weak form – current stock prices can be figured out from historic stock price
info
semi-strong form – stock prices instantaneously reflect all publicly available
info relevant to the value of traded stocks
 you can’t make any money by relying on public info – everyone knows
the same thing
 most accepted level  gives investors a feeling that they can rely on
stock prices.
 Reduces transaction costs bc the investor doesn’t have to do any
research
 This also lends to the fact that insider info can give an advantage to
anyone who has it.
strong form – price reflects all public and private info
 this means you can’t profit from insider info
o There are other things that affect the market other than the underlying
fundamentals – there are psychological factors
Shareholders’ Governance Role p 174-200
state law limitation on SH’s ability to manage the business.
They can vote, attend annual meetings, can sometimes call special meetings
(don’t have to wait for the annual meeting)
They generally can’t make business decisions or require the directors to make
changes in policy  they can’t have any meaningful control over the
daily business
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- DE 141(a) and 8.01(b) – mandatory rule – The business and affairs of every corp
organized under this chapter shall be managed by or under the direction of the
BOD, except as may be otherwise provided in this chapter or in its certificate of
incorporation.
- In response to all of the Board’s powers, the SH can:
o 1) vote new management and
o 2) you can take some informal efforts (take out full page add in the WSJ)
o SH can also under very limited circumstances, 3) make proposals and put it to
a vote to the SHs
- If SHs want some authority, they have to provide for it in the Art of Inc  The
business of a corporation shall be entrusted to directors, except as otherwise provided in
the articles of incorporation.
- MBCA 8.01(b) and DE 141(a) give all the power to the BOD and are, in form,
default rules, both sections limit the methods of opting out of or contracting around
their default rules to provisions contained in the art of inc. Since the MBCA and the
DE require that amendments to the arts be initiated by the BOD and since directors
will not initiate an amendment curbing their own powers 8.01 and 141(a) effectively
are immutable rules for corporations that do not opt out in the initial arts of inc
- If we assume that in the initial articles, there is no provision for SH power
If the SHs want to amend the articles, they have to go through the directors,
and the directors will say no bc they want all the power. So, if you don’t get
it at the outset in the articles, you don’t get it. Basically SHs can’t
initiate article amendments, if not initially in the articles that they can.
- SH, can however amend the by-laws. Can, they give themselves power through an
amendment of the by-laws? NO  if we give authority to the SHs, then it runs into
Sec 141(a) which says that the directors have authority except as otherwise provided
in the articles. There is a tension here. This is a big issue  sec 109, power to SHs
to initiate a bylaw amendment, but this doesn’t get the SHs anything bc it falls within
the ambit of running the business which is in the jurisdiction of the managers under
141(a)
- SHs are trying to restrict the directors’ ability to do things. But, they can’t create a
bylaw which limits the director’s authority under 141(a).
- Almost all state corp codes provide that the business of a corp shall be entrusted to
directors, except as otherwise provided in the arts
- SH can vote at the annual meeting.
- And, the SH can call a special meeting where they can address certain issues if it’s
provided for in the articles. Board also has a right to call a meeting.
o DE approach is different from the Model Act – Model Act says that a
SH with 10% can call a meeting, DE has no such provision. SH can’t
change the by-laws without a special meeting, which the directors
probably won’t let them have.
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The Forum for Political Persuasion – State law Rules Affecting SH Voting Rights
- The Annual Meeting and election of Directors – directors shall be elected at an
annually held meeting of SHs.
- Special SHs Meetings – MBCA 7.02 – authorizes the holders of 10% or more of a
corp’s stock to call a special meeting. (DE and NY permit a special meeting to be
called by someone other than the board if that alternative is specified in the by laws.)
- Determining SHs Entitled to Vote – SHs entitled to vote are those owning shares
on the record date which can be set bw 60 to 10 days before the meeting
Electing and Removing Directors
- Default rules – directors are elected annually by a plurality rule (one vote per share
basis)
- You can have different classes of stock, and you can give different classes different
rights with respect to the election of board members.
- Removal of directors – by SH vote with or without cause unless provided for in arts
at a special meeting.
- Cumulative voting
The default is straight voting.
Del 214, MA 7.28© - have to provide cumulative voting in the article
Goal is to help minority shareholders – under straight voting the guy with
51% of the votes always wins
A SH can cast a total number of votes equal to the number shares multiplied
by the number of seats being voted on, and they can use these votes anyway
they want.
There are arguments for and against this. Do we want someone who only a
minority voted for
Staggered Boards
- The terms of all directors are staggered so that the term of only one group expires
each year.
- Default is that the Board members serve only one year terms (they can be re-elected)
- Most codes contemplate that there may be longer terms, staggered boards, where
they aren’t all up for re-election at the same time. You can have the board separated
into 2 or 3 groups of as equal size as possible.
If you have 2 groups, each group serves 2 years. If you have 3 groups, each
serves 3 years.
It provides continuity on the Board and that each Board has some experience
– won’t have a new crop of directors
Sec 8.06 – can only provide for the staggered board in the articles.
141d Del – can provide in either the articles or by-laws
The reality is that if you have a classified board, it is much more difficult to
effect a change. It will take at least 2 annual meetings. You can’t just vote
everyone out, it takes longer.
- Staggered Board makes it very hard to effect a change.
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- The problem with a staggered board is that if the market doesn’t think the
management was doing a good job and there is a staggered board, the stock price
should drop bc it is too hard to effect change
Regulating the SH Communication Process - p214
1) SH proposal
2) Proxy – give someone else the right to vote on your behalf during the meeting - 34
Act regulates
- In order for SHs to do anything they’re allowed to do, they have to be able to
communicate along at least 2 dimensions. One, with each other, and two, with
management
- Corp law is state law, but this is one of the areas where Fed Sec Law dominates.
- The SEC regulates the capital markets, the Act that’s implicated for the purposes of
SH communication is the Sec Exchange Act of 34
- There are sometimes proxy fights, there is a fight to get the SHs proxy.
Rules primarily affecting solicitation of proxies by management or SHs – p215
1934 Exchange Act Rules:
- 14a of 34 – gives SEC authority to regulate proxy or consent for securities that are
registered with the SEC
- 14a3 – prohibits any proxy solicitation unless the person is given certain info
- 14a5 – regulates the form of the proxy statement – goal is readability.
- 14a4 – regulates the form of the actual proxy – the proxy card
- 14a9 – prohibits the making of false or misleading statements as to any material fact,
or the misleading omission of a material fact, in connection with a proxy solicitation
Rules regulating SH access to effective means of communication with other SHs
- The SEC has promulgated 2 rules addressing effective SH access to the real SHs’
meeting – the proxy solicitation
1) 14a7 – a corp that is self-soliciting proxies from SHs has to provide assistance
to a requesting SH who wants to solicit its own proxies
 provide a list of SHs
 co can directly mail the competing SHs proxy to the other SHs
 co always chooses the second option bc they don’t want to
release the names of the SHs
2) 14a8 – SH proposal – a qualifying SH may request a corp to include a
SH proposal and an accompanying supporting statement provided by
that SH in the co’s proxy material, but there are a lot of restrictions
 the statement and proposal can’t exceed 500 words
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 The proposal is simply the recommendation that the co or board take
some action, which the SH intends to present at the next meeting
(precatory, not mandatory proposal)
 Only qualifying SH – one who at the time of submitting owns 2000
dollars worth or 1% of the co for a year, and must continue to own the
stock through the date of the SH’s meeting. Can only make one
proposal per meeting.
 14a8(i) – Board can under certain circumstance exclude the SH
proposal
 the board can do this when
 14a8(i)(1) – the board can omit a proposal that is not a proper
subject of SH action under state law  almost all mandatory
proposals (you board have to do the following…) these types of
proposals are all omitted by this. SHs can’t tell board what to do
under state law. The way around this is by recommending that
the board do something (precatory form)
 14a8i5 economic irrelevance test – allows board to omit SH
proposal that relates to business operations accounting for 5%
of corps total assets, net sales and gross earnings if the proposal
is not otherwise significantly related to business (significant
ethical or social concerns that somehow relate to business)
 14a8i7 ordinary business test – you can exclude proposals that
relate to the ordinary business of the corp
o proposals that relate to ordinary business can be excluded,
but proposals that have social significance, even that relate
to ordinary business, can’t be omitted (racial practices)
o Just bc you’re okay under i5, doesn’t mean you’re good
under i7. Cracker Barrel says that certain proposals, even
having to do with ordinary business may not be excluded
if it has social significance
ANALYSIS
1) Did the SH follow the provisions of 14a8 in requesting their proposal to be included
in the co’s proxy material (not exceed 500 words, precatory proposal, is a qualifying
SH)?
2) Is it economically relevant under 14a8i5?
3) Does it relate to the ordinary business of the corp under 14a8i7?
4) If it meets the 2 previous, is there a significant ethical, political, economic or social
concern that somehow relates to business? If so, BOD must include the proposal.
Independent Proxy Proposals
Exchange Rules 14a-4(c ), 5(e) and (f)
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- to avoid all the hassles, and to avoid your proposal being omitted, you can
independently collect proxies from SHs.
- Why would a SH go ahead and solicit its own proxies independently instead of
including it in management’s materials? No limitation on wording. Management
may not omit the proposal. Not limited to one proposal
- So, if SHs don’t want to rely on 14a8, they solicit their own proxies
- As there are a greater number of institutional investors, it is easier to collect the
number of independent proxies you need.
- These pose a real problem to management: if these independent proxy solicitations
haven’t commenced at the time the management has begun soliciting its own
proxies, can management ask the SHs to get discretionary authority to vote against
any independent proxy that comes up later?
- Rule 14a-4c – discretionary authority is okay, they can get the authority to vote SHs
shares, but under certain circumstances, namely that the SH plans to solicit proxies
but hasn’t begun, then management in its solicitation,
o has to give brief disclosure of the material to the SHs and how the
management plans to vote in order to get discretionary authority in its
proxy solicitation.
- What happens once the SH begins its solicitation of proxies? Management may not
have the ability to exercise discretionary authority without taking a few more steps
How the case was done
1) SH tells co its going to issue independent proxies
2) Before SH issues, Co sends original proxies telling the nature of the SH proxy
statement and asks for discretionary authority to vote on behalf of the SHs
3) SH then issues its proxies
4) Co can then send a supplemental proxy solicitation with a line-item for which
UNITE solicited proposals. Co can exercise the original proxy authority unless
the supplemental proxy was sent back with a vote.
- Discretionary authority is typically lost once the SH initiates its proxy solicitation.
- by putting out the supplemental proxy preserved its discretionary authority.
- A co can retain discretionary authority obtained in original proxies if it issues
supplemental proxies after the SH issues independent proxies, so long as the co in
the supplemental proxy – explains to the SHs that it will use the discretionary
authority to vote against the competing proposal and grants the right to the SH a
right to revoke discretion.
- Isn’t this assuming something about silence? Yes
The Chilling Effect of Overbroad Restrictions on Persuasive Communication
SEC must police the solicitation process comprehensively in order to prevent harmful,
non-covered conduct. ON the other hand, overbroad regulation will have a detrimental
chilling effect on SH governance.
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14(a) of the 34 Act makes it unlawful to violate SEC rules when using the mails or any
means or instrumentalities of interstate commerce to solicit proxies, consents or
authorizations regarding securities registered under the Act.
What constitutes a solicitation of proxies?
- 14a-1 – defines solicitation  includes
o any request for a proxy
o any request to execute or not to execute any request for a proxy
o any communications to security holders under circumstances reasonably
calculated to get a proxy (very fucking broad) – can be indirect
communication like ads in the newspaper
Then, there is a carve out exemptions for certain solicitations
- 14a-2(b)2 – exempts solicitations that are not on behalf of the co (SH solicitation)
where the number of people you solicit are 10 or fewer.
- 14a-2(b)1 – exempts certain solicitations made at a time the solicitor isn’t actual
seeking the power to act as a proxy  it’s not a solicitation if it’s not a solicitation
- 14a-1(l)(2)(iv) – exempts SH communication that states how the SH intends to vote
– affords SHs the opportunity to get together to talk about how they’re voting and
why.
- Test – whether the challenged communication seen in the totality of the
circumstances is reasonably calculated to influence SH votes. Determination of the
purpose of the communication depends upon the nature of the communication and
the circumstances under which it was distributed. Deciding whether a
communication is a proxy solicitation does not depend upon whether it is targeted
directly at SHs
SH Access to Corp Records and SH Lists
34 Act 14a7
- Fed and state laws have overlapping jurisdiction over the concern of transmitting
proxy material to SHs being solicited.
- 14a-7 – any SH desiring to make a proxy solicitation at an upcoming meeting may
inform the corp in writing of the planned solicitation and ask the corp to provide
14a-7 assistance.  corp can either mail the proxy for the SH or give the SH a list
of SHs
- State corp laws generally provide SHs with access to SHs’ list on demand not only
for use in connection with proxy solicitation but for other proper purposes.
- Under Del law, the corp seeking to avoid a SH’s request has the burden of proving
that the SH is not motivated by a proper purpose. (categories of prop purpose on
page 256)
Fiduciary Duty, SH Litigation, and the Business Judgment Rule p 259
Fiduciary Duty – duty stems from sec 141(a)
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- A way to deal with agency problems is FIDUCIARY DUTY – a legal monitor of
the corps officers and directors
- Questions
To whom do directors and officers owe a fiduciary duty?
What is the duty?
When is it breached?
- 2 main fiduciary duties
1) Duty of Care – officers and directors have to exercise reasonable care in running
the business – more than negligence standard
 The BOD must be fully informed and have done due diligence in
making decisions (Van Gorkum)
 subject to certain ex post hindsight biases – only look when something
went wrong. We don’t want a disincentive for the directors to take
business risks and don’t want disincentives for people to take
management positions
 Comes up in 2 settings
 Oversight setting – Board is monitoring, making sure officers
are doing what they’re supposed to do. It’s hard to argue that
you were reasonably not paying attention
 Decisional setting – Board is actually making decision.
- Fiduciary duty is owed to the corp – what is the corp?
- Business Judgment Rule – a rebuttable presumption that directors are better than
cts at making business decisions, and that the director acted without self-dealing or
personal interest and exercised reasonable diligent care  if it applies, ct will defer
to management’s decision.
- The BJR can be rebutted by showing that the management violated the duty
of care or the duty of loyalty
- SH has to carry the burden of rebutting the BJR
- IF the Def’s actions don’t at least border on either fraud, illegality, or conflict of
interest in making their decision, the cts shouldn’t interfere.
- Being negligent isn’t enough, there has to be a clear dereliction of duty.
- Dodge v. Ford – the goal of the Board has to be SH profit (SH Primacy), but the
board has discretion in deciding on how to achieve this goal.
Ct held that Ford can decide how to satisfy SH Primacy, defer to him, but
what he can’t do is not do what is in the best interest of the SH
- Inside directors – officers of the co; vested interest in themselves
- Outside directors – not officers of the co; more independent, not conflicted, and
do their job more diligently at the board level.
- Joy v. North – SHs voluntarily assume risk when they buy shares, don’t want to
discourage risk taking by the corp, ct will defer to the Board bc they know better.
- Smith v. Van Gorkom –
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Board blindly followed recommendation of president to sell co to Pritzger.
The BJR did not protect directors bc they were not informed; they failed to
exercise “Due Care.” Although price was at a substantial premium to market
price, directors could not accept Pritzger price without informed investigation
Gross negligence – violated the duty of care
SH vote approving the merger did not ratify or cleanse the directors’ breach
of fiduciary duty bc the proxy material did not adequately disclose material
facts necessary to make the SH vote informed.
Look at p 49 in the Bus Acq book.
Board’s responsibility to monitor and prevent illegal activity
- Caremark
In order to show that the Caremark directors breached their duty of care by
failing adequately to control Caremark’s EEs, Ps would have to show either:
 That the directors knew or
 Should have known that violations of law were occurring and, in either
event,
 That the directors took no steps in a good faith effort to prevent or
remedy that situation, and
 That such failure proximately resulted in the losses complained of
- Ct doesn’t want espionage – Board is entitled to depend on the honesty and integrity
of the EEs, until the Board has reason to lose faith in the EEs
But, isn’t it too late at this point? The illegal activity has already taken place.
- BOARD’S DUTY: So, BOD can’t just rely on EEs and trust them, it has to
go a little further and get a system of controls in place. It has to have
meaningful controls and systems in place to get an adequate flow of info
2) Duty of Loyalty  I think this will be in the essay
- For liability look at 102(b)(7)
- Have to act in the best interest of the corp and the SHs, not your own best interest.
Comes up in 2 primary settings
 1) corporate opportunity
 2) conflict of interest – is director on both sides of the deal?
- Duty of candor aspect – has to disclose pertinent info
The corp Opp Doc – a corp officer or director may not take a business opp for his own if
the corp is financially able to exploit the opp
the opp is within the corp’s line of business
the corp has an interest or expectancy in the opp
by taking the opp for his own, the corp fiduciary will thereby be placed in a
position inimical to his duties to the corp.
- a director or officer may take a corp opp if
the opp is presented to the director or officer in his individual and not his
corp capacity
the opp is not essential to the corp
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the corp holds no interest or expectancy in the opp; and
the director or officer has not wrongfully employed the resources of the corp
in pursuing or exploiting the opp.
- there is a balancing test and no one factor is dispositive
- Generally, a corp fiduciary only has to consider the state of affairs at the time the
opportunity is presented, he doesn’t have to hypothesize on an uncertain future.
Conflict of Interest Transactions
- Concern is that you have a fiduciary on both sides of the deal. The fiduciary will
gain some advantage that is unfair to the corp. The tension is that some conflict of
interest transactions are good for the corp.
- DE 144 – no conflict of interest transaction is void or voidable solely by reason of
the conflict if:
The transaction is authorized by a maj of disinterested directors or
Transaction is approved in good faith by SHs or
 All SHs and directors have to have full information
The transaction is fair to the corp at the time authorized
- BJR is out the window if there is a conflict of interest, but it is reinstated but if any
of the above is true, then the BJR is reinstated.
- The Effect of Disinterested Approval – Lewis v. Vogelstein
- Ct says there are 2 options to SH ratification
End of story – this isn’t the right holding, it doesn’t reflect the law. The
language of 144 says that you can’t bring this suit bc the conflict of interest is
cleansed by ratification, but you can bring other suits.
Waste – a waste entails an exchange of corp assets for consideration so
disproportionately small as to lie beyond the range at which any reasonable
person might be willing to trade. In effect, waste involves a gift. IF there is
any substantial consideration or if there is good faith belief that the
transaction was good, then there is no waste. If it is anything less than, no
reasonable person would do the transaction, then we defer to management.
 What do we need to ratify gift or waste? Unanimous SH vote.
 What kind of incentive do we need to set up to get the effort and
response we want (so that it’s not waste)? Well, maybe we should
check out what everyone else is offering to someone in the same
position.
 There is a concern that executive compensation is out of whack.
ANALYSIS
- Do we have a conflict of interest? If yes, then BJR is out
- Is the director’s action cleansed? If yes, then BJR reinstated
- SH can still bring derivative action for waste if the action is in excess of anything a
reasonable person would believe is right.
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Derivative Litigation – look at page 400 in book for futility.
- What Parades said was that you bring derivative suits when there is harm to
the corp. But, if it is a clear case that the harm is direct to the SH, then you
bring that cause of action.
- Under what circumstances can the SHs bring an action of breach of fiduciary duty?
- Derivative litigation is a claim brought by SH on behalf of the corporation  directors breach
fiduciary duties, SHs can in certain instances bring the suit against the fiduciaries
- If director violates duty of care to corp and this violation causes loss to corp, he will
be personally liable.
- In its classic form, a derivative suit involves 2 actions brought by an individual SH
o An action against the corp for failing to bring a specified suit and
o An action on behalf of the corp for harm to it identical to the one which the
corp failed to bring
- Let’s assume the SHs can’t bring the suit (in MBCA, SH can’t bring suit, it has to
make demand) – well, then the directors get to decide if there will be a suit. The
problem is that the directors don’t want to sue themselves or their buddies.
- But, we also don’t want the SHs to have an easy time to sue the directors.
- To whom do the damages go? The corporation. Technically, the SHs benefit by
some sort of appreciation in the corp. Really, the lawyers get the benefit.
- So, we don’t want all these Ps lawyer bringing all these suits bc that’s shit. But there
is a good part to all of it bc it is a great mechanism to keep management in line.
- Demand Requirement
o if you want to bring a derivative suit, the first thing you have to do is to make
a demand requirement of the board, asking them to bring the suit
 We want to give the board the first shot of handling this bc the
directors handle the business and this is a business decision, so we
give management a shot.
o Well, if the Board decides that they’re not going to bring the suit, the SH can
challenge this decision by claiming breach of fiduciary duty (challenge on the
grounds of BJR).
Futility - It doesn’t always make sense to make a demand requirement – some
demand requests can be considered futile. So, the SH brings the suit without giving the
board a shot.
 In DE you have to make the demand or make the excuse on the
ground of futility. In MBCA, you have to make a demand
o What question does the SH want before the ct? We want it to look like
management was partaking in self-dealing.
o The DE Sup Ct says that a P has to make a demand, if they don’t, they have
to allege facts with particularity indicating that such demand would be futile
 The ct should not apply the Aronson test for demand futility where
the board that would be considering the demand did not make
the business decision which is being challenged in the derivative
suit.
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- There are 2 tests to show futility:
o The Aronson test if the board that is deciding whether to bring the derivative
suit or not is the same one that made the underlying decision
o Another test that looks specifically at the underlying business decision if the
board is not the same that made the decision
 Aronson Test: To show futility, must create reasonable doubt that the
directors, who are deciding to bring the suit or not, are: Independent
and disinterested OR the challenged transaction did not deserve
the protection of the BJR. Only use when the directors who are
deciding made the decision being challenged
o Independence
 Independence means that a director’s decision is based on
the corporate merits of the subject before the board
rather than extraneous considerations or influences 
things that show the directors aren’t independent are
things like the board there was picked by the def or
something like that.
o Interest
 A director is considered interested where he or she will
receive a personal financial benefit from a transaction that
is not equally shared by the stockholders
 Directorial interest also exists where a corporate decision
will have a materially detrimental impact on a director, but
not on the corporation and the stockholders. In such
circumstances, a director cannot be expected to exercise
his or her independent business judgment without being
influenced by the adverse personal consequences resulting
from the decision.
o BJR is significant in the context of a derivative action
 Protections can only be claimed by disinterested directors whose
conduct otherwise meets the tests of business judgment (interest test)
 To invoke the rule’s protection directors have a duty to inform
themselves, prior to making a business decision, of all material info
reasonably available to them
 Test for determining a derivative P’s compliance with
overcoming the BJR
o Whether, under the particularized facts alleged, a reasonable
doubt is created that
 The directors are disinterested and independent or
 Directorial interest exists whenever divided
loyalties are present, or a director has received, or is
entitled to receive, a personal financial benefit form
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the challenged transaction which is not equally
shared by the stockholders.
 The challenged transaction was otherwise the product of a
valid exercise of business judgment.
 The business judgment inquiry focuses on the
substantive nature of the challenged transaction
and the board’s approval thereof.
 Circumstances where futility test, rather than the Aronson approach (to show
futility, must create reasonable doubt that the directors are independent and
disinterested), is appropriate (basically we’re saying it’s futile to make a demand of
the board bc the underlying decision was clearly a breach of fiduciary duty and not
deserving of the BJR protection):
o A majority of the board of directors making the decision have been replaced.
o The subject of the derivative suit is not a business decision of the board
o The decision being challenged was made by the board of a different
corporation
- Duties of directors in considering a derivative suit
o Directors are supposed to determine the best methods to inform themselves
of the facts – get informed. Directors must first determine the best method
to inform themselves of the facts relating to the alleged wrongdoing and the
considerations, both legal and financial, bearing on a response to the demand.
Investigation must be done in good faith.
o Weigh the various alternatives available to you. Do you really have to sue?
Balancing of various alternatives. Board must be able to act free from
extraneous considerations and any economic ties the board has – act in good
faith. Board must weigh the alternatives available to it, including the
advisability of implementing internal corrective action and commencing legal
proceedings.
o So, what do you do when you get the letter? Start collecting some info: talk
to people, look at notes, get some people to help you out, talk to some
lawyers. Might just want outside directors to look at the problem bc they’re
disinterested parties
Dismissal of Derivative Litigation at the Request of an Independent Litigation
Committee of the Board  MBCA 7.44
- The problem is that bc of conflicts, the board may not be able to make the decision
to sue. Let’s assume you have a board that can’t make the decision, what you do is
set up a special litigation committee made up of disinterested directors. You
simply charge them with deciding to continue with the litigation. This is an example
of the Board acting thru a committee
- Structural bias – the committee may act on behalf of the board; prevents the
committee from exercising impartial business judgments. There is some question if
a board member really is ever independent, really ever an outsider. They do sit on a
23
board with the insiders and they probably have connections. Their sympathies may
lie with the inside board. This notion of structural bias is important bc outsiders
may be used a lot in corp law, but they really may not be independent.
- What is the test to determine if the special committee can determine that the
derivative suit can be dismissed? Can they just come in and dismiss? No
- 2 part test to determine if the special committee can dismiss the derivative
action
o the ct will consider into the independence and good faith of the committee
and its investigation in terms of reasonableness. These are usually presumed,
but here you have to show it. Presumptions don’t run in their favor
o If the ct is satisfied on the first part, then the ct may but is not required to
move to a second question in which the ct applies its own independent
business judgment to determine whether or not the motion should be
dismissed (this flies in the face of the BJR). This is a discretionary prong.
Prong 1 may be enough for some cts.
Assuming the ct thinks that the committee satisfies prong 1, and it then uses its own
independent business judgment and it agrees with the committees conclusion, is it
done? Suit dismissed? No. The ct should also look to equitable considerations –
what’s fair?
DE rule is a lot stricter.
ANALYSIS
1)
2)
3)
4)
Is this appropriate subject for derivative suit?
IS P a SH?
Was P a SH at time of the complained of transaction?
Has P made a written demand of the Board (have to make the
demand in MBCA)?
a. Yes - Did Board appoint an independent committee?
i. No – Has P carried burden of showing some
evidence that the board either participated in the
wrongdoing or didn’t have any maj of truly
independent directors?
ii. Yes - Did the committee both act independently
and use reasonable procedures in reaching its
dismissal recommendation?
b. No – Would it be futile?  Aronson Test (only in DE)
i. Did P plead with particularized facts that create
reasonable doubt that
1. maj is disinterested or independent or
2. challenged transaction was protected by BJR
by showing conflict of interest or grossly
uninformed decision making.
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Piercing the Corp Veil
- Key attribute of corp form is LL. This shields SHs from being personally liable for
the corp’s debts, so losses will be limited to their investments
- suits by creditors seeking to impose personal liability on SHs
- The separateness of the corp entity is normally to be respected. However, a corp’s
veil will be pierced whenever corp form is employed to evade an existing obligation,
circumvent a stat, perpetrate a fraud, commit a crime, or work an injustice.
Scholars have identified 3 central dimensions or factors that may affect the likelihood that
veil piercing will occur
1) the distinction bw Ps suing to enforce K claims and those suing to enforce tort
claims
2) the identity of the person hiding behind the veil – more willing to pierce to reach
other corporations than to reach a real person
3) Bc most publicly held corps are not effectively controlled by their SHs, it seems
unlikely that cts would find it equitable or efficient to hold such SHs personally liable
for a corp’s debts
- suits by creditors seeking to impose personal liability on SHs
- A corp’s veil will be pierced whenever corp form is employed to evade an existing
obligation, circumvent a stat, perpetrate fraud, commit a crime, or work an injustice
- Factors for when you pierce when
o The def completely controlled and dominated the corp
o The Def used the corp in a fraudulent way
o There was some harm that resulted
o Corporate formalities weren’t followed: meetings aren’t held; cant distinguish
bw corp and personal prop
- What specifically do we want to take into consideration?
o Capitalization (debt – someone else’s money; equity – your money)
o Corp formalities – board meetings, acting by written consent, keeping
minutes, having officers  if you don’t do this, you’re setting yourself up to
have the corp veil pierced.
o Commingling of personal and corp assets
o Control and domination
- Was there an ultimate injustice that results
Waiver and estoppel – if the creditor continued to offer up money, which caused reliance
on the part of the borrower that he can keep on borrowing, the creditor is in the best
position to stop lending.
K v. Tort claimants (such as environmental, or in the case blasting)
- in K cases, they are voluntary creditors and they can protect themselves
- In tort cases, you are an involuntary creditor.
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- The way in which this risk which is shifted to creditors is that they charge higher
interest rates or force the borrower to get insurance.
- But in torts cases (based on direct or vicarious liability), the transaction of shifting
the burden doesn’t take place. There is no way that the creditor is compensated for
bearing the risk. Since the corp didn’t internalize the cost of the risk there is no
incentive to not avoid the risk. We should be more inclined to pierce bc the lender
couldn’t shift the risk back onto the borrower
=====================================================
Mergers and Other Friendly Control Transactions
- Mergers – 8 keys
o A merger is the combo of 2 corps into 1
o SHs of the non-surviving get consideration in the form of cash or securities
o The assets and liabilities of the target pass to the acquiror
o Generally a merger is going to require the approval of Board and SHs of both
constituent corps. You need maj of SHs (maj of those entitled to vote, not
just of those who vote)
o All SHs are bound by merger
o Short form mergers – if the corp owns 90% or more of a subsidiary it can
effect a merger without SH approval – just need board approval (this is
usually parent/sub mergers)
o Dissenter appraisal rights – those who have dissented can get the right to
have their shares bought out at some appraised value. Dissent bc you think
the deal will decrease the value
 You get appraisal rights bc your rights and obligations change when the
merger occurs. If you don’t want to do the deal, you should get
another option – get bought out at a pre-merger price.
Might want to do the deal to gain some synergies
MBCA
1) 1 for 1 stock exchange
a. have to get approval from both boards
b. Have to get approval from SHs of both cos
c. SHs of both cos get dissenter rights – 13.02
- 11.03(g) – de minimis change exception  action by the SHs of the surviving
corp on a plan of merger is not required if
o the arts of the surviving corp will not differ
o Each SH whose shares were outstanding will hold the same number of shares,
with identical designations, preferences, limitations and relative rights
o The number of voting shares plus the number issuable as a result of the
merger will not exceed by more than 20% the total number of voting shares
of the surviving corp before merger
2) Short form merger
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a. SHs of parent don’t have voter or appraisal rights
b. Sub SHs don’t have the right to vote, but they have dissenter rights
DE
- DE also has a de minimis exception – 251(f)
1) 1 for 1
a. Board and SHs approval
b. Appraisal rights are available to everybody – 262(a)
i. Market exception – do not get appraisal if shares are traded publicly or
are held by 2000 or more SHs and the consideration that you receive is
either stock of the surviving corp or publicly traded stock of some
other corp or cash in lieu of fractional shares or some combination of
those 3 things.
1. the SH is entitled to dissenter’s rights if a corp engages in a
merger and
a. her shares are not publicly traded or
b. her shares are publicly traded but she’s required to accept
merger consideration consisting in part of cash other than
for fractional shares or of shares of publicly traded stock
of a corp that is not the acquiring corp.
2) Short form merger
a. Same as MBCA
Alternative Transactional Forms
- Asset sales
o Have to get SH approval if you’re selling all or substantially all of the assets
o Appraisal rights – in DE no one gets them. In the MBCA, only SHs of
the selling corp get them
- Triangular mergers
o The reasons to do this is to eliminate the voting and appraisal rights that the
SHs of the acquiring parent would otherwise have.
o The acquiring corp BOD are the SHs of the sub, so the SHs of the acquiror
are locked out. The target SHs still get to vote
De Facto Merger Doc – cts will re-characterize an asset sale as a merger
- this claim is brought by those SHs who want dissenter or appraisal rights
- If it looks like a merger, we can get dissenter rights.
- In opposition is the notion of the Equal Dignity Doc – we will treat the
provisions of the code independently; we won’t look at one provision to define
another provision. We will treat an asset sale as an asset sale bc they are legal under
sec DE 271. It is an asset sale, even though it looks a whole helluva lot like a
merger.
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- We can cut out appraisal rights by doing asset sales instead of mergers, and
under DE this is okay.
- Difference bw DE and MBCA – DE allows the cut out of appraisal rights, but
MBCA doesn’t for de facto merger
When a corp combines with another so as to lose its essential nature and alter
the original fundamental relationships of the SHs among themselves and to
the corp, a SH who does not wish to continue his membership therein may
treat his membership in the original corp as terminated and have the value of
his shares paid to him. To refuse him the rights and remedies of a dissenting
SH would in reality force him to give up his stock in one corp and against his
will accept chares in another. If so, the combination is a merger.
Cash out mergers
Weinberger v. UOP – Business Purpose Test and Entire Fairness Test
- Aside – this case was modified by Glassman v. Unocal Exploration  where there is a
-
-
-
-
parent/sub merger, there will be no appraisal rights. We’re not going to apply a strict entire
fairness standard. This is only if this is a 90% merger. This is basically bc this is a short form
merger and for a short form merger, there is no SH vote
This deals with the director’s fiduciary duties to the corp and demonstrates
that a test of fairness is an important criterion for evaluating the propriety of
specific transactions. This test is explicitly a criterion in evaluating
transactions bw corporations with common directors.
Entire Fairness Test
o The test of fairness generally protects the interests of the corp, since wellmeaning officers and directors would not be discouraged form dealing with
the corp and reasonable transactions should not be set aside merely bc of
some formal or technical defect in corp procedure.
o The fairness test protects SHs and creditors alike from overreaching or
unwise transactions.
o Problem: tends to be subjective and elastic
this case is about fairness and merger of a sub into its parent
Signal was in a Superior Negotiating Position, was on both sides of the deal.
Signal did not disclose the $24 would have been fair
SH were not adequately informed
SHs receive appraisal remedy
When you do a transaction where it’s very clear that you’re on both sides of the transaction, ct
says that in these types of instances, the Board has to pass the entire fairness test
Cash-out merger – The majority (buying co) pays cash for the shares of the
minority SHs, the target dissolves and the target SHs get the cash. This affects sole
control to the majority shareholders. There are reasons to push out the minority
SHs – don’t want dissents or fiduciary duties.
The options available to the minority SHs are:
o they can ask for an appraisal,
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 Appraisal will mean fair value with respect to a dissenter’s shares,
means the value of the shares immediately before the effectuation of
the corp action to which the dissenter objects, excluding any
appreciation or depreciation in anticipation of the corp action unless
exclusion would be inequitable (we don’t take in consideration the
value as a result of the merger)
o they can accept, or
o they can argue breach of fiduciary duty - Controlling SHs owe fiduciary duty
to everyone
 you may be able to rescind the deal, if not you get damages, which may
be better than appraisal rights.
- Business purpose Test – a controlling SH had to prove that the cash out merger
had a legitimate business purpose to it, something other than just simply squeezing
out the minority. Appraisal will not be the exclusive remedy to the minority. The
minority had some other value at stake other than the value of the business  some
intangible value other than money.
- What is exactly a legit business purpose? The legit business purpose only
relates to the interest of the parent corp. We don’t have to factor in the
interest of the sub or the target
- Even if you show a legit business purpose, you have to show that the deal was
entirely fair to the minority.
- Policy – We care about the minority interest being oppressed bc if the maj can take
advantage of the min, then people may not be willing to buy minority interests in
cos. So protection for min SH is critical for an efficient securities market.
- NO business purpose test in DE for cash out mergers
- Ct affirmed that controlling SHs owe the min a fiduciary duty, and these cash out
mergers have an inherent conflict of interest. The burden of proof is on the maj to
show entire fairness unless there has been an informed vote of the min SHs
affirming the deal, then the burden shifts to the min to prove that the deal was
unfair.
- The min always has the burden of production to allege there is some unfairness.
- Entire Fairness
o Fair dealing – fairness in the initiation, structuring, negotiation, and
disclosure of the transaction to the minority SHs of the sub
o Fair price – requires an examination of all economic and financial
considerations that affect the intrinsic or inherent value of the sub’s stock.
- The ct adopts appraisal as the appropriate method generally, but is pretty flexible.
And, confers on the Chancery other remedies other than appraisal for fraud, self
dealing, deliberate waste or the such.
- Should the valuation take into consideration any value that results from the merger?
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o MBCA 13.01 – Fair value with respect to a dissenter’s shares, means the value
of the shares immediately before the effectuation of the corp action to which
the dissenter objects, excluding any appreciation or depreciation in anticipation of the
corp action unless exclusion would be inequitable
o DE 262(h) – Same as MBCA
Cede and Co. v. Technicolor, Inc
-
-
-
-
-
MAF acquired Tech in a reverse triangular merger
2 step transaction, which ended up in MAF owning all of Tech
Kamerman announced a plan and the stock tanked after the plan was implemented.
Perelman got interested and announced a cash tender offer (it’s where the bidder will
go directly to the Target’s SHs and makes them an offer at a premium for their
shares) for $23. (To what extent can the target co say no to this?)
Tender offer closes and MAF has 82% of the shares. (this is all the first step)
Second step is squeezing out the min
One of the min SHs seeks out appraisal. The Chancery says that the FV was $21
Issue – which co are we valuing for the appraisal proceedings – the one with
the bad plan or the one that reflects Perelman’s business strategy (which
came before the 2nd step squeeze out)?
Chancery says value under the original plan.
o 262(h) – when we determine FV it is exclusive of any value attributable to the
merger.
o If we were to take into account Perelman’s plan, we’re giving the min value
attributable to the merger. This isn’t what we’re supposed to be giving to the
min bc they don’t want the deal.
o Chancellor reads 262 to say give value “but for” the deal.
o Therefore, don’t take into account Perelman’s Plan
DE Sup Ct says immediately before the merger date, the Perelman plan was in
effect. The merger gains attributable to Perelman’s plan aren’t speculative, the plan
has taken shape. Therefore, it is appropriate for those minority SHs getting cashed
out to get the benefit of Perelman’s plan bc that is the existence of the co preceding
the merger.
These SHs were entitled to the benefit attributable to Perelman’s plan based in large
part due to the fact that the plan was taking shape and not speculative.
So, those SHs who hold out during the tender offer bear the risk at the back end of
the co doing either better or worse right before the date of the merger.
MBCA, by its terms provides some flexibility in the appraisal proceedings.
Stringer
- SH can’t challenge a corp action unless the action is unlawful or fraudulent.
Exclusive remedy is appraisal when there is no unlawfulness
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- If there is a squeeze out, we have to work with fairness – maj has the burden of
showing the deal was fair.  seems like the business purpose test is overturned with
this, and all that is left is the entire fairness test.
Third party transactions (arm’s length mergers) – figure this out and how appraisal
rights work and how the entire fairness doctrine works here (when we looked at it, it
was only when the fiduciary was on both sides of the transaction).
1 for 1 Stock Exchange
MBCA
- Both boards voting
- SH on both sides voting
- SH both sides get dissenter
DE
- Both boards voting
- SH on both sides voting
- SH on both sides get dissenter
- There is a market exception to this, see
above
Short Form Merger
MBCA
- SH of parent don’t get voter or appraisal
- SH of sub have dissenter rights
- Board of Parent is only one with voting
DE
- SH of parent don’t get voter or appraisal
- SH of sub have dissenter rights
- Board of parent is only one with voting
De facto
MBCA
- Target SH get appraisal
- SH of acquiring don’t get voting
- SH of target get voting
DE
- None
- SH of acquiring don’t get voting
- SH of target get voting
CHANGES IN CONTROL: HOSTILE ACQUISITIONS
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The Market for Corp Control
- Since mergers require the voting, first, of the BOD, the BOD can act as gatekeepers,
deflecting any offers that it does not think appropriate.
- There will be concern that the current control group will exercise gatekeeper fx in an
opportunistic fashion, to preserve their own jobs
- Can get around gate keeping abilities
o Dealing bw SH and potential acquirors
1) Tender offers
 Problems with ill informed SHs, and rushed decisions
 First come first serve problems
 Williams Act corrected these problems
2) Potential acquirors start proxy fight seeking authority to vote sufficient
chares
Why are huge premiums paid?
1) Disciplinary hypothesis (creates wealth)
Bidder believes that the target’s assets have not been optimally utilized and
that under superior management they would earn a higher return
2) The Synergy Hypothesis (creates wealth)
Target has unique value to the bidder that is in excess of its value to the
market generally. The value of the combined enterprise is expected to be
greater than the sum of its separate parts as independent companies.
3) The empire building hypothesis (transfers wealth)
Maximize size, not profits
4) The exploitation hypothesis
High premium is paid in partial bid for 51% of the target’s stock – then
squeeze out or
Bidder exploit temporary depressions in the target’s stock price in order to
seize control of the target in a bargain purchase
Hostile Transactions
- The board of the target doesn’t want to do the deal.
- Only have an issue if the board doesn’t want to do the deal and the SHs do.
- Overview of the market for corp control
o If you don’t run your co well, your stock will suffer and someone else will
realize that they can take control and make more money. This means if you’re
running the co, you’ll work hard or you’ll be fired. Market for corp control
can give a great discipline to keep managers in line.
o Market for corp control - Market where these transfers of control of corp take
place
o You effect a change of corp control through
1) Mergers
2) Asset deals
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-
-
3) Tender offers (we’ll focus on this)
4) Voting rights – wage a proxy contest (we won’t focus on this)
o You transfer effective control when a SH acquires an effective maj (not
necessarily 51%, if you have a lot and the next most is minimal) of the
outstanding shares
o You now have the ability to nominate whoever you want
Concerns about agency costs and issues of collective action problems that SHs face
 always lurking when facing corporate control problems
What the deals look like:
o A bidder calls the target’s CEO and they propose a deal. The target’s
management get together and say no.
o If the bidder wanted to do a merger, they can’t do it without the board’s
voting
o The bidder then goes straight to the target’s SHs and offers to buy their
shares through a tender offer.
o The bidder provides proper notice then launches the tender offer, which is
usually at a huge premium to the trading price.
o What management of the target co can do is put in place a series of defense
tactics, which have the effect of fending off the bidder. This doesn’t prevent
the SHs from selling to the bidder, but these tactics makes it hard for the
bidder to gain control or makes the co less valuable to the bidder.
o Defensive tactics – give target management to say no in certain circumstances
on behalf of their SHs
o The target SHs then sue the target management for breach of fiduciary duty
(care or loyalty) bc the bidder left when they were offering a substantial
premium. SHs claim that the management didn’t want to lose their jobs
o Management says they have the SHs best interest in mind and that they have
knowledge of the actual value of the co.
Who has authority to respond to an unsolicited offer – board or target?
o Balance:
1) Board could be acting disloyally
2) SHs may not have the requisite information and bc of collective action
problems may tender too low
Poison Pills
o There are 2 kinds, a flip in and a flip over
o Flip in – once a hostile bidder acquires a certain percentage of a target’s stock,
the pill then gives the target SHs a right to buy shares of the co at a very steep
discount
o Flip over
There are usually 2 tiers to a deal, first a tender offer then a back end
squeeze out.
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-
-
The pill says that in the event of one of the back end mergers, the target
SHs get to buy shares of the new co, after the merger at a steep discount.
The bidder has to accept this warrant bc it acquired it thru the merger
o The board of a co has the authority to redeem the pill. So once the board
decides to do the deal, they can redeem the pill
o Since the board can redeem the pill, acquire a majority of shares by proxy
fight, put in your own board, then undo the pill.
Take care of this by having a staggered board bc now it will take a couple
of years to change the board, and no bidder wants to wait that long  so
it’s really hard to remove the pill
name for various rights given to SHs entitling them to additional securities of the co
upon the happening of certain events.
Usually enacted by the directors, so a primary legal issue is whether the particular
plan is within director authority.
Challenges to the plans may be based on statutes and fiduciary duty
Flip in plan – directors cause the corp to issue certain rights to all current SHs,
often issued as a dividend to these SHs. These rights flower upon a triggering event.
Upon the occurrence of the triggering event, each holder obtains the right to
purchase additional shares of stock in the corp at a discount. The poison is that the
acquiror can’t participate and will find its shares in the target diluted
Flip over – the rights given to SHs are to purchase shares at a discount in any co
into which the target co is merged
These rights usually can be redeemed by the BOD prior to the triggering
event. Thus, there is an incentive for a raider to come to the board before
crossing the threshold.
- The Board effectuates a poison pill, by dividending out a right
- 2 features to a poison pill
o flip in
o flip over
- They distribute a right to purchase shares when someone purchases a threshold of
shares
- Everyone who has the right, except the threshold SH can purchase at a deep, deep
discount  this is the flip in right
- Flip over right  if you try to do this as a reverse merger, the SH will have the right
to buy shares of the acquiror at a deep discount.
POISON PILLS EFFECTIVELY ENDED GREENMAILING
Unocal – enhanced judicial scrutiny test
- Before the BJR is applied to a board’s adoption of a defense measure, the burden
will lie with the board to prove
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1) Reasonable grounds for believing that a danger to corp policy and
effectiveness existed (this prong is basically due care – can only be
violated by gross negligence, look at Van Gorkum); and
2) That the defensive measure adopted was reasonable in relation to the
threat posed (proportionality prong). Board should consider
 Nature of the bid and
 Nature of the threat and determine if the def measures are
proportional
- Unocal test has basically been reduced to the BJR, and therefore lost any bite. The
thing is the cts will defer to the board’s decision in what a threat posed is (the BOD
will probably argue that it’s a threat to corp culture based on Paramount v. Time
Warner), so you’re really left with due care.
Revlon
- Once Corp Control is to be Transferred, duty of directors is to obtain highest price
for SHs – an auction is usually mandated (well, might not need to do an auction if
the BOD has canvassed the market, and thinks that this will be the best deal).
- When conduction an auction for the sale of corp control, this concept of fairness
must be viewed solely from the standpoint of advancing general, rather than
individual, SH interests.
- In doing an auction, if you have two bids that are close, you can end the auction, and
actually choose one of the bidders. The other bidder will claim that there was
prejudice, but the ct will probably allow the board to do this instead of having
another round of biddings which could potentially scare away a good bid (also the
BOD may argue that the bid they chose has a better chance of paying)
- Investment Bankers become empowered by this bc they run the auction. They get
paid by commission, so the higher the price, the better for them and the better for
the SHs
- Revlon duties are triggered with MBO – the responsibility of the board is to get the
best price, but the management buying wants to keep it at a low price.
o Special Duty of Care – the world is going to think that the management is
being favored by the BOD. BOD may have conflicts of interest, and
therefore not be able to fulfill their duty of loyalty.
o If management wins, there is an almost certain SHs lawsuit accusing the board
of favoritism
o Should get an independent committee – must be unbiased, with its own legal
advisors and its own financial advisors.
- 3 clear situations where Revlon applies
1) co initiated the selling of itself and a break up would occur
2) There is a hostile offer on the table and in responding the co effectively
ends it’s long term strategy and finds another bidder which results in
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the abandonment of the long term strategy and may result in the bust
up of the co.
3) Even when there is no bust up of the co, but there is a change in
control, this will trigger Revlon (we’ll see this in QVC)
- In stock for stock deals, which are considered mergers of equals, Revlon isn’t
considered even if a new bidder comes in bc there is none of the threats like bust up
or hostile take over
Time Warner Case
- No Revlon duties in this case – not a bust up deal, didn’t abandon any strategies
- So, we look to the Unocal duties
o Is there a reasonable threat (look at Van Gorkum to see if there was due
diligence and investigation) – what the co argued was that they were trying to
protect their corporate culture
 This is basically saying you can point to anything and say that
there is a threat. So, prong one is the BJR and nothing more –
easy to satisfy by using Time Warner arguments and you used
the duty of care
o are the defensive tactics adequate – ct rarely say that the response is
disproportionate.
Paramount v. QVC
- We have a no-shop, termination fee, lock-up in the agreement
o No-shop  agree not to shop the co as a target, and in some instances won’t
talk to any other bidders. This may be a breach of fiduciary duty. So, there is
a fiduciary out – BOD can talk to other bidders if fiduciary duties require
them to do so. Can’t call other bidders, but if the bidder approaches, then
have a duty to speak with them
- if there is a sale of control then Revlon is triggered.
o We care about control premium bc if we don’t get it now, then we will never
get it.
- Consideration
o If both deals are simply cash and there are no contingencies on the deal, it’s
easy, you have to take the highest price.
o Consideration in most deals it’s a combination of cash and securities. What
that means is that someone has to evaluate the two deals. While in a Revlon
duty, you can’t effectively put in defensive tactics to pick one over the other,
ct does give co discretion to choose which co it wants based on the
consideration. How much discretion does the ct allow the target to make the
judgment about the respective considerations? Looks like a lot
Federal Law Affecting Corp Transactions
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The Importance of Disclosure
 As a general matter, the 33 Act regulates the issuance of securities
 The 34 Act provides for a periodic reporting system for certain cos which are subject
to the act
 The most important thing about the 33 and 34 acts are that they are regulatory
regimes based on disclosure. Investors, if they have the info, can decide where to
invest their money.
Sec 10 under the 34 Act  10b-5: General anti-fraud provision; prohibits material
misstatements and omissions
10b-5 Non-Insider Trading
- makes it unlawful, in connection with the purchase or sale of any security, for any
person, directly or indirectly, by the use of any means or instrumentality of
interstate commerce, or of the mails, or of any facility of any national sec
exchange:
o to employ any device, scheme, or artifice to defraud;
o to make any untrue statement of a material fact, or to omit to state a
material fact necessary in order to make the statements made, in light of the
circumstances under which they were made, not misleading; or
o to engage in any act, practice, or course of business which operates or
would operate as a fraud or deceit upon any person.
- applies to both purchases and sales in all contexts
- there must be some misrepresentation, omission, deception, or fraud in connection
with the purchase or sale of securities.
- The misrepresentation or omission must be of a fact (but cts may find some soft
info is a fact)
START YOUR ANSWER WITH:
- The cts have established that with regard to private recovery for the violation of
Rule 10b-5, a properly stated cause of action must est
- the scienter of the def
- the materiality of any misrepresentation or omission by the def
- the extent of actual reliance by the P on the def’s statements, and the
justifiability of the reliance (frequently translated into a requirement of
due diligence by the P – don’t write this part, I’m not sure about it).
- various elements of 10b-5, non-insider trading:
o have to have standing  have to have been a buyer or seller, and fraud has to
be in connection with a transaction  have to have bought or sold
 Even if you didn’t purchase or sell a security and therefore
don’t have standing, the SEC can still bring suit.
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o You have to have
1) some sort of material misstatement or omission
2) Scienter
3) Reliance
4) Causation
I.
Misrepresentations or Omissions of a Material Fact
TSC v. Northway
- an omitted fact is material if there is a substantial likelihood that a reasonable
SH would consider it important in deciding how to vote.
o There must be a substantial likelihood that the omitted info would have been
viewed by the investor to have altered the total mix of information being
made available
o This standard doesn’t mean the investor would have done something
differently, the test is that the substantial likelihood would have made a
difference in your decision making process
- Truth on the market theory – if in fact the truth is out there on the market and
everyone knows the truth, the theory is that the omission doesn’t affect the total mix
of information. No one relied on the misstatement.
- Buried facts doc – it isn’t good enough to bury the facts where no one can find it.
Basic v. Levinson (had to do with potential merger) - soft information – opinions
- Probability Magnitude Test – a mathematical way to determine the expected
impact of a given fact
- Used when it is uncertain whether an event will or will not occur.
o Materiality will depend upon a balancing of the indicated prob that the event
will occur and the expected magnitude of the event if it were to happen and if
this is sufficiently large it is material.
1) Probability
 Does the deal make sense
 What’s the state of the negotiations
 Boards adopted any resolutions
2) Magnitude
 Size of the cos
 What is the potential premium being paid
 What is the effect on earnings
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- the duty to disclose ongoing merger discussions is that the discussions themselves
aren’t material and there is no duty to disclose, but once the corp decides to disclose,
the info then becomes material and it must be true.
Forward looking statements
Bespeaks Caution Doc – judicially created doc that immunizes certain forward looking
statements if it is accompanied by sufficiently cautionary statements – that what is being
said is potentially wrong
- cautionary language, if sufficient, renders the forward looking statements immaterial
as a matter of law
- Your cautionary statements have to be specific to the forward looking statement that
you’re trying to qualify
- So, what would be sufficient cautionary language?
o If this forward looking statement is accompanied by meaning cautionary
language, it won’t affect the total mix of info to cause problems in terms of
fraud. The forward looking statement is diluted by the cautionary statement
o Limited to forward looking statements, doesn’t cover historical facts
o Why does it only take care of forward looking statements and not historical
o Assume we have a co that states that it holds a valuable patent – this is a
historical fact, if they don’t in fact have a valid patent and they in fact don’t,
they can’t do this, it’s just a plain misstatement, but what if it they had the
patent and it is accompanied by a disclaimer that said that the only way to
know if a patent if valid is if it is challenged. It turns out later that the patent
isn’t valid. Would this cautionary statement immunize the false statement that
they have a valid patent?
o One of the reasons we may want to treat forward looking statements different
from historical statements is that issuers are required to disclose historical
information, so we shouldn’t give them an out here – this is very different
from forward looking statements. Other than known trends that we have to
divulge in the MD&A, we don’t have to give any forward looking statements,
but issuers are encouraged to make the forward looking statements. So, in
order to get the issuers to give forward looking statements, we have to give
these issuers safe harbor through the “bespeaks caution doc.”
- When is a forecast misleading? Should an appraisal amt and the amt ultimately
realized be enough for a basis of liability?
o The difficulty is that forecasts generally turn out to be wrong.
o So, one choice is strict liability – but this a little harsh  the result will be that
issuers just won’t make forward looking statements
o The choice that became the dominant view is that the P has to plea that
there is no reasonable basis for the projection.
o So all the issuer has to do is to have a reasonable basis for the projection
o There is a minority view that an issuer wouldn’t be liable unless the statement
rose to the level of guarantee.
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The general point is that a boiler plate cautionary statement isn’t enough. There are no
bright line rules for what a meaningful cautionary statement is
Virginia Bankshares, Inc. v. Sandberg (proxy)
Reasons, opinions, and beliefs
- should you be subject to liability for fraud based on your opinions – well it depends
on if these opinions are based on some material fact
- First question is, is this material? In this case, yes, bc the belief of the board is the
type of thing that the investors are going to think are important.
- Were the statements made with respect to material facts?
- Ct held that a statement of opinion can be actionable if:
o The board did not in fact hold the opinion stated (ct didn’t believe that 42 was
a high price) and
o The fact underlying the opinion is also misrepresented (42 in fact wasn’t a
high price)
- it is not enough to prove that the board member did not believe the statement
in the soliciting materials. If the facts underlying the statement of opinion or
belief are correctly state, no cause of action will lie  need both
o a false statement or assertion and
o the statement must also relate to something which is in fact false
If statements that were true when made become inaccurate, by some subsequent event, or
some statement which I make which I think is truthful, really isn’t truthful – under either of
these circumstances there is a duty to update or correct so long as investors are continuing
to rely on the statements
In re Time Warner Inc. Sec Litigation
The duty to update and the duty to correct
- 3 issues in this case
1) Does the co have a duty to update optimistic future plans if it turns out
that the plans won’t pan out
 There is a duty to update, but not for simply expressed hopes.
2) Does the co have the duty to disclose alternative plans if under
consideration
 Depends
 Here, it is the case that not disclosing these other techniques of
raising cash made original statements misleading.
 So, you have to look to whether the omitted info is material
3) Is the co responsible for statements in newspapers if made by an
anonymous person?
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 You have to plead fraud with particularity. You can’t allege
fraud when you can’t point to the person who made the
statement
II.
Scienter
- intent to deceive, manipulate, or defraud
Ernst and Ernst v. Hochfelder – in private transactions under 10b-5, you have to have
scienter
- 10b-5 doesn’t extend to negligent behavior
- Scienter refers to a mental state embracing
o the intent to defraud, deceive, or manipulate.
o Also covers recklessness – recklessness is a type of intent
 Highly unreasonable omissions or misrepresentations, which is
an extreme departure from ordinary care, which is known to the
def or should have known
o Carelessness approaching indifference
- Scienter doesn’t mean that the def has an intent to deceive investors, it is enough
that the def is aware of the true state of affairs and knows that there is a good chance
that the investor will be mislead.
III.
Reliance and Causation
Basic v. Levinson
- reliance and fraud on the market theory
- Fraud on the market theory – based on the hypothesis that, in an open and
developed securities market, the price of a co’s stock is determined by the available
material info regarding the co and its business. Misleading statements will therefore
defraud purchasers of stock even if the purchasers do not directly rely on the
misstatements. The causal connection bw the defs’ fraud and the Ps’ purchase of
stock in such a case is no less significant than in a case of direct reliance on
misrepresentations.
o FOTMT is a rebuttable presumption
 Can rebut by showing that the market makers (guys who agree to
buy and sell the securities – being the other guy to the
transaction) or those who effectively set the price were privy to
the truth  truth on the market
 Can also rebut by showing that the P would have bought or sold
regardless if they knew the truth or not  they weren’t relying
on the integrity of the market to buy or sell.
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- Reliance is an element of a 10b-5 cause of action  provides the requisite causal
connection bw a def’s misrepresentations and a P’s injury. Bc most publicly
available info is reflected in market price, an investor’s reliance on any public
material misrepresentation, therefore, may be presumed for purposes of a Rule 10b5 action.
- Causation – the P’s economic loss was caused by the def’s wrongful conduct. If the
P is able to show that the def’s wrongful conduct caused such a loss this will tend to
est the in connection with requirement bw the def’s conduct and the P’s purchase or
sale of securities.
INSIDER TRADING – possible to make money based on the semi-strong form of
efficiency  stock prices instantaneously reflect all publicly available info relevant to the
value of traded stocks
Rule 10b-5 – primary regulator of insider trading
- Abstain or Disclose (classic insider trading) - a corp insider who has material
non-public info about the enterprise is under a duty either to abstain from trading or
first to disclose the non pub info
In defining when insider trading is fraud prohibited by Rule 10b-5, the Sup Ct focused on
silence by one who has such a state law duty to disclose or abstain. This liability is
sometimes described as classic or traditional insider trading. This sec describes extensions
of that liability beyond the classic group, first addressing those who obtain info from the
classic insider and are covered by the extension of that insider’s duty. This group includes
- those who receive info from the insider or the corp for an appropriate purpose
(constructive or temporary insider) and
- those whom the insider tips for an improper purpose (tippee liability)
The second category is somewhat broader based either
- on the duty owed to a non-trading party (misappropriation)
- or one who receives info in the context of a tender offer (Rule 14e-3)
Chiarella – receives info from the corp
- Def’s use of info was not a fraud under 10b unless he was subject to an affirmative
duty to disclose it before trading  without a duty to disclose, merely having the
info and acting upon it doesn’t give rise to liability
- When you don’t have a duty to disclose, you can’t partake in fraud
- A duty to disclose exists when you have a relationship of trust and confidence
- 10b5-1  You have to trade on the basis of the material non public info: in order
to trade on the basis of the info – the person must be aware of the material non
public info when they traded
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You have to trade on the basis of the material non public information. The question
is then, what does this mean? Look at Rule 10b5-1 – prior to the adoption of this rule,
there was a split bw what it meant to trade on the basis of the info. If you possess the
info as an insider, it’s enough. Others say you actually have to use the information. On
the one hand, I may be in possession, but if I don’t use it, then I shouldn’t be punished.
On the other hand, it’s hard to prove if you used the info or not. Second, you may not
think you used the info, but subconsciously you may have used it.
o Affirmative defenses – clause (c )
1) if the person before becoming aware of the info either
2) entered into a binding K to buy or sell or
3) instructed another to buy or sell or
4) had adopted a written plan to buy or sell, then you will be deemed not
to have traded on the info
Tippee liability and constructive insiders
Dirks
- Test
o Tippee assumes a fiduciary duty to the SHs not to trade, only when
1) the insider has breached his fiduciary duty to the SHs by disclosing to
the tippee,
2) and the tippee knows or should have known that there was a breach.
3) Tippee liability is derivative of the tipper breach.
4) We can tell if there is a tipper breach if the tipper receives some sort of
benefit from the breach. The benefit can be either direct or indirect.
This includes tip to a relative or friend – cts will see this as the tipper
actually trading and making a gift to the relative or friend.
o If the tipper has no personal gain, then there is no tipper breach of fiduciary
duty, and if there is no tipper breach of fiduciary duty, there can be no tippee
liability
o Tippers and tippees are both liable
- Footnote 14: Constructive insiders – under certain circumstances, lawyers,
consultants, accountants, underwriters will be treated as an insider
O’Hagen – misappropriation (If the P in Chiarella claimed this, they may have won)
- Classic insider trading – constitutes fraud or deception bc the insider owes a
fiduciary duty to the corp and the SHs
- O’Hagen had nothing to do with the target; he was working for the bidder, so he
owes no duty to target SHs
- The misappropriation theory fills the gap – a person commits fraud in connection
with a sec transaction and violated 10b and 10b-5 when he misappropriates
confidential info for securities trading in breach of a duty owed to the source of the
info (not to the parties on the other side of the trade).
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- 2 part reasoning
o fraud-duty discussion
 Yes there is a fraud. Fraud is an aspect of insider trading.
Fiduciaries undisclosed use of a principal’s info defrauds the
principal’s use of the info
o Is the fraud in connection with the sale or purchase of securities?
 The in connection requirement was satisfied. The ct says that
the fraud is consummated, not when the fiduciary gets the info,
but when, without disclosing the info to the principal, the
fiduciary uses the info to buy and sell securities.
What is the nature of the duty to the source? What is the scope of that duty?
SCOPE OF THE DUTY
- 10b5-2 – the requisite duty of trust and confidence exists for purposes of the
misappropriation theory when
o the person agrees to maintain the info in confidence.
o When the person sharing the info have a history, pattern or practice of
sharing confidences, such that the recipient knows or should know that
there is an expectation of confidentiality
o When info is shared with parent, spouse, child, or sibling, unless the
recipient can show that there is no expectation of confidentiality
- discussion about Rule 14e3 – under the Williams Act (sets up a bunch of rules and
provisions by which tender offers are made) – it prohibits trading on the basis of
material non public info in regards to tender offers; this says nothing about a duty
breach. The question is whether a rule that doesn’t requires a duty breach is beyond
the SEC’s authority – if there is no duty breach, then there is no fraud, and SEC
should only be prohibiting fraud and deceit. Holding – this doesn’t run afoul of the
SEC’s authority, you don’t need a duty breach. The Williams act is about informed
SH choice, not necessarily about fraud, and a rule that allows people to trade on
insider info makes it hard for investors to trade on insider info.
Insider Trading (few words on it)
- to show the limits of the misappropriation theory
- Let’s assume that O’Hagen’s law firm gave him the information to trade with as a
bonus, would that be a problem under the misappropriation theory? The firm may
be liable under a tipper type of theory. Firm may be misappropriating the info from
the co. But, what about O’Hagen? To have liability under the misappropriation
theory, you have to have fraud. But, is there any fraud when the source of the info
gives you permission to use the info? It looks like there is no breach of a duty bc
there is no misappropriation bc he got permission to use it.
- But, we could make the argument that the duty was owed to the co not the firm. In
that case, he misappropriated it.
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- What if he gets the info and he tells the co he’s going to trade it, but they say he
can’t, but he does anyway? There is no misappropriation bc he disclosed it to the
source. For there to be fraud under 10b-5, there has to be some non-disclosure to
the source of the info.
Really, fiduciary duty is only owed to stock holders, not bond holders.
10b-5(2) – this solved the confusion over what constitutes the requisite relationship for
misappropriation
a duty of trust and confidence for the misappropriation theory whenever
1) a person agrees to maintain the info in confidence
2) the person sharing info (source and recipient) have a history pattern or practice of
sharing confidences such that the recipient knows or should know that there is an
expectation of confidence
3) when a person shares info with parent child or sibling, unless the recipient can show that
there was no expectation of confidence
ANALYIS
1) Is there a fraud/duty (not needed when trading on material, non-public
info in regards to tender offers)?
2) Is the fraud in connection with the sale or purchase of a security?
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