lkjlskd = ex
ad;fkj=text added from a reliable source
dsfkj=text added by me
adfkjh = txt IDK or don't understand or not gone over in class
adsLFKJ= SUMARY OF ABOVE
sdg;js;dkgj = result of a precondition
aslgkjasv= precondition
ewltkjwe = case facts
sdg;k = case ruling
wdqgl;k = case rationale
qwd;lk = important
Adfkad: Super important info
Kjqsf: other important info like issue, QP, etc.
Adflkj: my info or summary of a section
Adf;kj: heading
d.gkj: helpful info (to help understand the section)
Qdfkg: rationale
Akgj: HOLDING
Alkdj: watch out!
ASD:j: my questions
sd;glk: rule
AND
flklkd: how to use the rule in a sentence
sdg;l exception to rule
afklj incorrect maybe?
*statutes wont be touched
Jerry Markham LAW 6062 - Business Organizations
FIU Law
Spring 20115
Corporations and Other Business Enterprises
CHAPTER 1 INTRODUCTION TO BUSINESS ASSOCIATIONS
I.
History of Corporations
A. First Business Entities
1) 16-th century joint-stock companies:
a) Dutch West India Company (New York), Hudson Bay Company
b) Settled America through use of joint-stock companies
c) Charters granted by King
2) Constitution gave power to issue charters to States (who would issue the charters via statutes)
3) McCulloch v. Maryland. Congress could also issue corporate charters under necessary and proper clause
4) Trustees of Dartmouth College v. Woodward (1819): Justice Story - Corporation is
a) an “artificial person”
b) possessing immunities, privileges and capacities in its collective nature that does not belong to the individual persons
composing it
c) endowed with powers exercised through its members that subsist only in the corporation itself
1
Louis v. Ligget Co. v. Lee (1933) – Justice Brandeis dissent
a) SC overturned a fee imposed by the State of Florida on large chain store business interests. The Court held that the fee
was directed at, and thus discriminated against, large corporate chains.
b) Brandeis urged his fellow Justices to recall the original constraints placed on corporations and the reasons for those
constraints.
c) Historically, Incorporation for business initially limited
 LIMITED PURPOSE Usually for large capital ventures; in 1875 privilege extended for every lawful business
purpose
 LIMITED TERM. Early statutes limited life to fixed terms of 20, 30, 50 years
 LIMITED CAPITAL. Limited capital based on type of business
 LIMITED POWERS. No holdings in other companies
 Certain states favored for incorporation (New Jersey); lower costs, no or low annual taxes and least restrictive law
 States relaxed their corporate laws to avoid individuals circumventing those laws through foreign incorporation
 “The removal by the leading industrial States of the limitations upon [***949] the size and powers of business
corporations appears to have been due, not to their conviction that maintenance of the restrictions was
undesirable in itself, but to the conviction that it was futile to insist upon them; because local restriction would be
circumvented by foreign incorporation.”
 Size of large corporations gives them great social significance, such that it thwarts small business not attached to
smaller private enterprises
 “Through size, corporations, once merely an efficient tool employed by individuals in the conduct of private
business have become an institution-an institution which has brought such concentration of economic power that
so-called private corporations are sometimes able to dominate the state.”
Corporation Law Generally
Delaware Incorporation
1) continues to be the state of incorporation of choice because of
2) its permissive corporate legislation
3) the expertise of Delaware courts on complex corporate law issues
B. Revised Model Business Corporation Act (1984)
1) Adopted by the ABA, modeled on the 1993 Illinois Act
2) Not a uniform law but a drafting guide for legislation
3) ABA Committee on Corporate Laws revises
C. Separation of Ownership from Control
1) Stockholders are passive and directors are active (in control of management)
2) Utility Maximization
a) Creates conflict of interest (the way the managers spend $$ is not lways in the best interest of the investors)
b) Manager’s desire to utilize their utility does not necessarily lead to maximizing value of firm
3) Neoclassical Economists (Chicago School) Contractual View
a) To overcome conflict from separation of ownership managers must have incentive compensation agreement tied to
wealth of shareholders
 BOND the Manager: Stock options or bonuses that compensate for company profit
 SIGNAL to Investors: Manager’s resolve to maximize firm wealth, allowed firm value not to be discounted by
investors
 MONITOR and police management through outside boards and independents.
b) Agency Costs: Costs of bonding, signaling, monitoring and otherwise deterring management indiscretions
c) Fiduciary v. Contractual Model of Corporate Management
 Corporation is nexus of contracts (intercompany) and place reliance on market to discipline manager’s behavior
instead of fiduciary duties
 Market forces assure corp managers do not overreach in negotiating contracts otherwise no one will buy corp stock
5)
II.
2
CHAPTER 2 AGENCY AND
PARTNERSHIPS
Agency Principles
General rule: Agents are liable for the acts done by them or their employees within the scope of their employment (but the
shareholder won’t be liable)
Agency= the fiduciary relationship which results from the manifestation of consent by one
person [the principal] to another [the agent] that the [agent] shall act on [the principal’s] behalf
and subject to [the principal’s] control, and consent by the [agent] so to act.
(i)
(ii)
(iii)
one person acting on behalf of another
the agent (A) is acting subject to the principal’s (P) control
and both A and P have consented to (i) and (ii)
Requirements for agency:




fiduciary relationship from manifestation of consent by one person (Principal) to the another (Agent)
that agent shall act on behalf of the principal
subject to the control of the principal
consent by the agent to act
The principal can give the agent:=Manifestation of P’s consent can be:
Actual authority
Implied
Express
Apparent authority -bank teller thief
Ratification of agent’s conduct
Significance: Agency relationship creates unlimited liability to Principal for acts of Agent
CA: Not that good a fit because in corporations we want managers to take risks to make profit = Basic rule of
business is risk reward – business is all about taking risk – law wants to incentivize risk taking =More risk,
greater reward
A.
Authority of Agent – = Manifestation of P’s Consent to A do P’s bidding
1) Actual Authority (there was an agreement)
a) PRINCIPAL GIVES TO AGENT
b) Express Authority – specific authorization to do act
c) Implied Authority – follows/implied from express grant of authority to do act
d) Need not be written
e) As lawyers, we want to manifest consent by Actual Authority
2) Apparent Authority (there was no agreement)
a) PRINCIPAL GIVES TO 3RD PARTY – clothes him even though never agreed
b) exists in absence of actual authority if 3RD party given reason to believe agent authority exists by PRINCIPAL
c) comparable to ESTOPPEL
d) Principal by his actions creates Apparent Authority and is liable to 3d parties
e) AGENT cannot create his own Apparent Authority
3
3)
 But may be liable to 3rd party on basis of Estoppel or Breach of Warranty of Authority
f)
As lawyers, we want to avoid creating Apparent Authority
g) Corporate titles can create Apparent Authority
Ratification:
a) PRINCIPAL’S consent to Agent’s acts after-the-fact
 express communicated to the third party relying thereon
 by affirmative action of principal ???
b) Binds the Principal
c) Difficult to prove
4)
Test for Agency
a)
b)
c)
d)
Authority
 Is there Actual Authority?
1. Express by agreement
2. Implied by CONTROL and relationship
3. Disclaimer will not work to dispute Actual Authority
 Is there Apparent Authority?
1. Did principal do something that would lead 3d party to reasonably believe that was your agent?
2. DISCLAIMER to 3d party may work to disclose Apparent Authority
 Was there Ratification?
Scope of Authority
 Was the Agent acting within the scope of his authority? (Factual Question)
1. Courts generally interpret broadly
 If not within Scope of Authority  P not liable
Consent
 Did X-Agent consent to agency?
 Did X-Principal consent to agency?
ALSO SEE LIABILITY
5)
Independent Contractor v. Agent (Restatement 3d of Agency)
a) INDEPENDENT CONTRACTOR (P not liable for contractorl?)
 Fixed price
 Person / company has independent business
b) AGENT
 Commission
 Person acts in his or her name, not corporate name
6)
Gay Jenson Farms v. Cargill I: CONTROL ex.  Agency? Yes.
a)
b)
c)
Facts: Δ/Cargill defaulted on a contract made with Π/Warren, and is seeking to recover
losses. Δ/Cargill had taken over Warren’s business—could not make business decision w/o
Δ/Cargill’s approval, and Warren
agreed to sell most of its grain to Δ.
Issue: Whether Δ/Cargill became Warren’s principal, whether Warren became Δ/Cargill’s
agent?
Holding: Yes Agency P is liable: Δ/cargill completely took
over W’s business. Δ/Cargill became a principal with liability for the transactions entered
into by its agent Warren


7)
It means that a Lender must be careful in attempting to protects its security to not cross the line by too
much control or active participation in the borrower’s operations / assets or lender will become the
principal and liable
def of agent is someone who submits themselves to the control of someone else---this was a
manifestation of assent to be controlled by someone else
DUTIES of AGENT to P
a) Agent is a fiduciary with duties to principal:
4
b)
c)
Duty of Care
 Comparable to negligence
 A reasonable standard of care
Duty of Loyalty 
duty to act solely for the benefit of the principal; not deal with the principal as an
adverse party; and give profits to principal while working for them.
Exception : customary gratuities
 Exception to Exception: Unless gratuity adverse to principal (bribes)
Agency: Who is Liable to 3rd party: P AND A? or Just P? 3rd party to who?
Ultimate rule: If A was authorized and P was undisclosed or partly disclosed
 both P and A are liable on the contract with Third party
Ultimate rule: If A fully disclosed P to 3rd party  A not liable
3rd party
Ultimate rule: As long as A was acting with actual or apparent authority P can enforce that contract against Third party
A
Ultimate rule: 3rd party would not have dealt with agent if principal was disclosed to that 3 rd party  3d party not bound
=


3rd party is bound by K to P
2-WAY STREET: 3rd Party generally liable to Principal even if agency or principal not disclosed
EXCEPTION: NO DISCLOSURE of P to 3rd party: Undisclosed Principal: where agent misrepresents agency
and 3rd party would not have dealt with agent if principal was disclosed to that 3 rd party  3d Party not bound
Why not Disclose Agency?
1. Oil company buying land or oil leases, may not want 3d parties to know we are one of the world’s largest oil
companies or prices would be shot up

A liable to 3rd party?
Fully Disclosed P to 3rd party A not liable but P is liable to 3d party

Undisclosed P to 3rd party  A and P liable to 3d party
(ex. you tell the person you are acting on behalf of a principal but you do not disclose there is a P and who that is)

d)
e)
Partially Disclosed P to 3rd party A and P liable to 3d party
(ex. you tell the person you are acting on behalf of a principal and you disclose there is a P but you do not disclose
who that P is)
Agent’s Fiduciary Duties Generally:
 We don’t know what they are
 We don’t know how far they extend
Fiduciary Duties cannot be reduced or waived by contract
5
B.
Vicarious Liability under the agency theory (Might happen might happen)
1) PRINCIPAL vicariously liable for acts of Agent
a) EXCEPT WHEN Agent is not acting w/in scope of his authority
Employers are vicariously liable, under the respondeat superior doctrine, for negligent acts or omissions by
their employees in the course of employment (sometimes referred to as 'scope and course of employment')
=The principal is vicariously liable of the acts of the agent.
* Plaintiff must show that the agent was acting within the scope of his or her agency.
b)
Franchise Agreement
 Not an agent, an independent contractor
 AUTHORITY:
1. No Actual Agency Authority
 But may create Apparent Authority
 Apparent authority cannot be disclaimed: Disclaimers of independently owned and operated franchises do
not relieve Franchisor or liability
 Doctrine of Apparent Agency why use franchises here? Because franchises typically are not agents
and therefore, Franchisors are not liable for the acts of the Franchisee but see below:
 Franchisee’s have No Actual Agency Authority but Franchisee may have Apparent Authority
 Franchisor/Franchisee relationship (or other similar relationships) may be deemed Agency if 3rd party
is led to believe and reasonably relies to his detriment that Franchisee is an agent of Franchisor 
creates apparent authority Franchisor will therefore become vicariously liable as principal for
negligent acts of Franchisee as agent
Franchisor will therefore become liable as principal for negligent acts of Franchisee as agent
DOCTRINE OF APPARENT AGENCY (do NOT CONFUSE with Apparent Authority)
Apparent agency creates an agency relationship that does not exist. If, because of the words or conduct of P, T relies on
A, believing that A is subject to P’s control, then P is liable for A’s torts. Apparent agency has been used to hold a
franchisor, such as McDonald’s, liable for the torts of a franchisee because the actions of McDonald’s led the tort
victim to believe that the restaurant belonged to McDonald’s, not the franchisee. 9
Requirements for Doctrine of Agency (for vicarious liability of P to 3rd party)
1. Δ (Principal) acts to lead reasonable person to conclude operators or employees (tortfeasor) worked
for Principal
 Uniformity, national advertising, common menus, signs, uniforms and logos not apparent
authority though?
2.
3.

Л actually believes other party is Agent (Franchisee) of Principal (Franchisor)
Л relied to his detriment upon duty of care of negligent Agent
Disclaimer of control or agency in Partnership Agreement is not conclusive
 Courts look at control of franchisor over franchisee
 Large obvious disclaimer
(do NOT CONFUSE Apparent Agency with Apparent Authority)
“Apparent authority” is a Contracts concept, expanding the authority of an actual agent.
“Apparent agency” is a Torts concepts, expanding tort liability to the Torts of someone who is not actually an
agent.
“By contrast, the applicability of the doctrine of apparent authority is much more
limited in tort cases. Ordinarily, a plaintiff who is injured by the negligence of a
putative agent would be hardpressed to demonstrate that the injury resulted from
reliance upon the agent's apparent authority” McDonald’s case
6
because there is no reliance on apparent authority
The Court also reasoned *69 that applying apparent agency in a medical malpractice case
where a patient submits to treatment in reliance upon the hospital's judgment with respect
to the physician's qualifications is justifiable.
In contrast, a plaintiff who is struck by a vehicle and then claims reliance on the fact that
the driver was an agent of the vehicle owner would have a difficult task establishing that
reliance. See id  but they could establish agency theory!
2)
Termination of Agency
a) Principal may terminate at any time even if there is a breach of K with agent Principal remains liable under the
contract and may be subject to damages
b) Because agency creates liability, Principal must have the right to cut it off
A.
Generally – Identification
1) DEFINITION:
Agency= the fiduciary relationship which results from the manifestation of consent by one
person [the principal] to another [the agent] that the [agent] shall act on [the principal’s] behalf
and subject to [the principal’s] control, and consent by the [agent] so to act.
(iv)
(v)
(vi)
one person acting on behalf of another
the agent (A) is acting subject to the principal’s (P) control
and both A and P have consented to (i) and (ii)
=did two people agree that one agent would direct the actions of another principal?
=was there an agreement?
(1) ACTUAL AUTHORITY (express or implied) both parties consented, or
Ex. Board of directors would have to meet and authorize the bestowment of
authority on an agent.
Implied authority- contract for you (agent) to build my house (implied yhat you
would clear lumber, etc.)
Express authority- I tell you (agent) have the authority to do this, to do that, etc.

(2) APPARENT AUTHORITY a reasonable 3rd party would believe the agent had
authority. Created by the principal’s actions, NOT the agent’s
Ex. bank teller (principal) asked bank guard to watch the bank register while she goes to the
bathroom. Bank guard ends up accepting customer deposits and stealing $$. Bank guard
was behind the register and had “apparent authority” because a reasonable third party (the
customer) would believe the bank guard was an agent and could accept his money on behalf
of the corp.
Can be created by RATIFICATION: we can make someone an agent by having the principal
ratify the conduct
 Youa re sent a statement that says “Unless you object to this trade, you ratified this conduct
even if you did not make the trade”
7


Acquiescence ~ratification
Principal can terminate the agency at anytime
Key principles of Agency:

The agent will bind the principal if they are acting within the scope of their authority (ex. agent can sign a
contract on behalf of the principal if authorized)

The principal has unlimited liability whenever the agent is acting within the scope of their employment
[Key Question-like 99% of cases -  was the agent acting within scope of employment?]

Agent is not liable for actions if acting within scope of their employment
3)
4)
5)
B.
Agency relationship creates unlimited liability to Principal for acts of Agent
Fiduciary duty came from law of trust for child wards
a) Not that good a fit because in corporations we want managers to take risks to make profit
b) Basic rule of business is risk reward – business is all about taking risk – law wants to incentivize risk taking
 More risk, greater reward
There can be de facto and de jure agency relationships
Identifying Agency Relationships
1)
Gay Jenson Farms v. Cargill I: CONTROL  Agency? Yes.
a)
b)
c)
Facts: Δ/Cargill defaulted on a contract made with Π/Warren, and is seeking to recover losses.
Δ/Cargill had taken over Warren’s business—could not make business decision w/o Δ/Cargill’s
approval, and Warren
agreed to sell most of its grain to Δ.
Issue: Whether Δ/Cargill became Warren’s principal, whether Warren
became Δ/Cargill’s agent?
Holding: Yes Agency P is liable: Δ/cargill completely took over
W’s business. Δ/Cargill became a principal with liability for the transactions entered into by its
agent Warren

d)
e)
It means that a Lender must be careful in attempting to protects its security to not cross the line by too much
control or active participation in the borrower’s operations / assets or lender will become the principal and liable
 def of agent is someone who submits themselves to the control of someone else---this was a manifestation of
assent to be controlled by someone else
RULE: AGENCY relationship
 May be proved by circumstantial evidence (i.e. course of dealing) a
And need not be contractual or labeled as agency
1. Course of dealing
2. Active participation in operations of Agent
3. Interference in internal affairs of Agent
4. Too many controls or restrictions on decisions/activities of Agent
5. Agent acting for benefit of Principal
 Requires CONSENT OF PRINCIPAL
1. Consent need not be express
 It means that a Lender must be careful in attempting to protects its security to not cross the line by too much
control or active participation in the borrower’s operations / assets or lender will become the principal and liable
FACTS:
 Action to recover on a contract for sale of grain.
 Warren in bankruptcy and owes farmers whose grain it had purchased
 No assets, so Лs (small farmers) looked for deep pockets (Cargill)
 Cargill provides financing to Warren
8

f)
g)
h)
Лs (small farmers) claimed Warren was agent of lender Cargill and Cargill was jointly liable with Warren as
principal for Warren’s debts to Л.
 Aggressive Financing.
 Loan started at $175K > $300K > $750K > $1.25M > Warren $3.6M in debt to Cargill and $2M in debt to Лs
(the loan turned into huge amounts!!!) def o principal agent is someone who submits themselves to the control
of someone else---this was a manifestation of assent to be controlled by someone else
BACKGROUND: Cargill is one of world’s largest grain dealers. Small farm communities have an elevator where grain
is stored: farmers sell to elevators, grain buyers buy from elevator. Soviet Union needs grain after crop disasters.
Cargill bought 1/3 of US crops and sold it to the Soviet Union. Cargill needed a source of grain and that is why it
entered into transaction with Warren. D/Cargill supplied financing to elevators nationwide to keep them going.
REASONING:
 Cargill became liable for Warren’s debts to Лs as principal because of its
1. its course of dealing
2. control and influence over Warren
3. amount of control over Warren
 Not buyer-supplier because
1. Not independent business
2. Not at fixed price but based on cost
 Duty of loyalty; Warren could not compete with Cargill in grain business
 Warren’s decisions not independent of Cargill’s interest
Cargill errors creating agency:  Cargill had control of Warren and both agreed to it

i)
j)
k)
1:50
Cargill had too much control as lender: Could keep books; could purchase goods as grain agent; proceeds of sale
deposited in Cargill and applied to loan; Cargill had to approve dividends, withdrawals from earnings and sale of
stock
 Cargill interfered in internal affairs of Warren
 Active participant in operations
 Memo: “Warren needs parental guidance”
 Using the other company’s business forms ***
 As loan amount grew – contact grew
 Cargill opened and funded a bank account for Warren
Cargill’s standard financing restrictions (NEGATIVE COVENANTS):
 Right of first refusal on grain – not unusual
 No further encumbrances w/o consent
 No capital expenditures in excess of X
 Annual financial statements
 Audited books and records and allowed to inspect
Where those controls put in place to protect lender’s interest or to serve Cargill’s need for grain?
Warren’s Manifestation of Consent to Agency
 Appointed Cargill
 Shipped 90% of its grain to Cargill
 25% of Warren’s business was seed grain, which Cargill had no role in
APPARENT AUTHORITY a reasonable 3rd party would believe the agent had authority. Created by
the principal’s actions, NOT the agent’s
Everyone knew Cargill wa
Professor thinks oyu could make a pretty good case as well as the implied actual authority
HOLDING: Affirmed jury verdict in favor of Creditor Gay Jenson Farms, finding an agency relationship whereby Cargill is
liable as principal for debts of Warren as agent
 Not one factor alone was sufficient to show control of company
 Totality of circumstances may nevertheless indicate sufficient control and active participation in operations to find
an agency relationship
9

l)
Warren was agent for Cargill as principal
1. Based on Actual Authority
 Warren by its actions manifested consent to agency
 Cargill had de facto control over Warren
 Cargill as Principal is liable for debts of Warren as agent
 Cargill manifested consent to be principal by its actions
Amicus Curiae said you will hurt financing for grain and other agriculture
There should have been agreement/loan arrangement specifying the relationship between Cargill and Warren for anything other than
protecting Cargill’s rights as a creditor. In this case, the record was inadequate as to why Cargill was providing all this “parental
guidance” to Warren.
C.
Fiduciary Obligations
1. Two basic fiduciary duties
a) Duty of Care counterpart to common law negligence
b) Duty of loyalty include to act solely for the benefit of the principal; not deal with the
principal as an adverse party; and give profits to principal while working for them.
2. Basic Rules
a) Agent must act SOLEY for principal & give ALL profits to principal including unexpected
profits
-except gratuities (tips, ex. waitress)
b) Keep confidential information confidential
c) Agent can’t act adversely to principal
-if so, agent must give full disclosure to principal
1)
DUTIES of AGENT / FIDUCIARY
a) Agent is a fiduciary with duties to principal:
b)
c)
Duty of Care
 Comparable to negligence
 A reasonable standard of care
Duty of Loyalty 
duty to act solely for the benefit of the principal; not deal with the principal as an
adverse party; and give profits to principal while working for them.
Exception : customary gratuities
 Exception to Exception: Unless gratuity adverse to principal (bribes)
d)






(can be modified by contract)
Undivided loyalty (exclusively for principal)
Agent must act solely for the principal
No conflicts of interest
Cannot compete – all earnings of agent’s actions while acting as agent to be paid to principal (i.e. insider trading
restrictions), including those from benefit of confidential information
Agent is responsible for returning all profits to ;rinciple (you, the agent, a truck driver, come across a pot of
gold...- you have tor eturn that gold to the principle!!!
Exception : customary gratuities
 Exception to Exception: Unless gratuity adverse to principal (bribes)
Cannot use or disclose confidential information
10
e)
f)
1. Cannot use employer’s information on land to buy land for yourself
2. Insider trading (agent cant disclose info about a stock that may rise or fall)
 Cannot act adverse to the principal w/o the principal’s consent after FULL DISCLOSURE by agent to principal of
all MATERIAL FACTS
1. Material – something you would want to consider in making a decision
2. Cannot take unfair advantage (of disabled, elderly)
3. Can’t advise when it affects me personally (must go to 3d party)
 Includes a concept of GOOD FAITH
Fiduciary Duties Generally:
 We don’t know what they are
 We don’t know how far they extend
Fiduciary Duties cannot be reduced or waived by contract’’
D.
1)
Termination of Agency
a) Principal may terminate at any time even if there is a breach of K with agent Principal remains liable under the
contract and may be subject to damages
b) Because agency creates liability, Principal must have the right to cut it off
Typically, you as a fired employee, may have a claim for damages (300k for salary) but can’t sue to keep you on as an
employee)
2)
Agency: Who is Liable to 3rd party: P AND A? or Just P? 3rd party to who?





b)
3rd party is bound by K to P
2-WAY STREET: 3rd Party generally liable to Principal even if agency or principal not disclosed
EXCEPTION: NO DISCLOSURE of P to 3rd party: Undisclosed Principal: where agent misrepresents agency
and 3rd party would not have dealt with agent if principal was disclosed to that 3rd party  3d Party not bound
Why not Disclose Agency?
1. Oil company buying land or oil leases, may not want 3d parties to know we are one of the world’s largest oil
companies or prices would be shot up
A liable to 3rd party?
Fully Disclosed P to 3rd party A not liable but P is liable to 3d party
Undisclosed P to 3rd party  A and P liable to 3d party – NO APPARENT AUTHORITY (a reasonable person
would not believe it is apparent that A is P’s agent)
(ex. you tell the person you are acting on behalf of a principal but you do not disclose there is a P and who that is)
Partially Disclosed P to 3rd party A and P liable to 3d party
(ex. you tell the person you are acting on behalf of a principal and you disclose there is a P but you do not disclose
who that P is)
A NOT contractually only Ks? liable for P when acting under the scope of his Actual or Apparent Authority
A NOT liable when FULL DISCLOSURE of P to 3rd party why?
A is liable when A acted outside scope of agency duties (w/o P’s authority)
T will be liable to P if P would have been liable to T.
P cannot sue 3rd party when A did not act by Actual or Apparent Authority
P can sue 3rd party when A acted by Apparent Authority (a reasonable person would believe it is apparent
that A is P’s agent) (if T knew who he was dealing with (P), he should have known better than to cross
him)Thus, if T fails to deliver the goods or services contracted for by A  P can enforce that contract against
T so long as A was acting with actual or apparent authority because A might have been agent for P.
11
P can sue 3rd party when A acted by Actual Authority(if T knew who he was dealing with (P), he should
have known better than to cross him)
E.
F.
c) Principal must indemnify Agent from liability when acting with Actual Authority unless otherwise agreed
Authority of Agent – = Manifestation of P’s Consent to A do P’s bidding
1) Actual Authority (there was an agreement)
a) PRINCIPAL GIVES TO AGENT
b) Express Authority – specific authorization to do act
c) Implied Authority – follows/implied from express grant of authority to do act
d) Need not be written
e) As lawyers, we want to manifest consent by Actual Authority
2) Apparent Authority (there was no agreement)
a) PRINCIPAL GIVES TO 3RD PARTY – clothes him even though never agreed
b) exists in absence of actual authority if 3RD party given reason to believe agent authority exists by PRINCIPAL
c) comparable to ESTOPPEL
d) Principal by his actions creates Apparent Authority and is liable to 3d parties
e) AGENT cannot create his own Apparent Authority
 But may be liable to 3rd party on basis of Estoppel or Breach of Warranty of Authority
f)
As lawyers, we want to avoid creating Apparent Authority
g) Corporate titles can create Apparent Authority
3) Ratification:
a) PRINCIPAL’S consent to Agent’s acts after-the-fact
 express communicated to the third party relying thereon
 by affirmative action of principal ???
b) Binds the Principal
c) Difficult to prove
CHART - Authority, Liability and Disclosure
AUTHORITY
Disclosed
Actual
Apparent
Undisclosed
Partially Disclosed
A not liable to 3rd party
A and P liable to 3rd party
rd
3 party liable to P
3rd party liable to P*
A not liable but P is liable A and P liable to 3rd party


* Unless A misrepresents agency + 3rd party would not have dealt with A if he
disclosed ?? to him
if A was authorized and P was undisclosed , then both are liable on the contract
with Third party.
G.
Vicarious Liability under the agency theory
1) PRINCIPAL vicariously liable for acts of Agent
a) EXCEPT WHEN Agent is not acting w/in scope of his authority
b)
Franchise Agreement
 Not an agent, an independent contractor
 AUTHORITY:
1. No Actual Agency Authority
 But may create Apparent Authority
 Apparent authority cannot be disclaimed: Disclaimers of independently
owned and operated franchises do not relieve Franchisor or liability
 Doctrine of Apparent Agency why use franchises here? Because
franchises typically are not agents and therefore, Franchisors are not
liable for the acts of the Franchisee but see below:
12


2)
Franchisee’s have No Actual Agency Authority but Franchisee may
have Apparent Authority
Franchisor/Franchisee relationship (or other similar relationships)
may be deemed Agency if 3rd party is led to believe and reasonably
relies to his detriment that Franchisee is an agent of Franchisor 
creates apparent authority Franchisor will therefore become
vicariously liable as principal for negligent acts of Franchisee as
agent
Franchises
a) 2 types: Service or Product
b) Advantages to everyone
 Allows entrepreneur with limited capital to purchase a developed product or
service
 Franchisor provides advertising for which entrepreneur benefits
 Often includes standards and uniformity requirements
A. Vicarious Liability
1. The principal is vicariously liable of the acts of the agent. Plaintiff must show
that the agent was acting within the scope of his or her agency.
Butler v. McDonald’s Corporation
[P must actually believe employees were agents of franchisor for
apparent authority]
Facts: Patron (Π) opened a door which shattered injuring his hand. Π
suing Δ because he seeks
to hold Δ liable because of the nature and
relationship between Δ and the franchised restaurant.
Issue: Whether the Δ is liable under an agency theory and whether
defendant had the right to
control the franchise restaurant operator’s
activities and operations.
Holding: Yes, D is vicariously liable.
Court setup three elements to prove an apparent agency:
(1) franchisor acted in a manner that would lead a reasonable
person to conclude that
the operator and or employees of the
franchise were employees or agents of the D
(2) that the Π actually believed the operator and or employees
of the franchise were
agents or servants of the franchisor; and
(3) that the Π thereby relied to his detriment upon the care
and skill of the allegedly
negligent operator and or employees of
the franchise.
c)
RULE: Right of Principal to control the work of the Agent is key element of agency
relationship
 Agent: consents to acting for benefit of and under control of Principal
 Independent Contractor acts for benefit of another but not subject to his control
 Franchisor/Franchisee relationship may be Agency under the Doctrine of Apparent
Agency if 3rd party is led to believe and reasonably relies to his detriment that
Franchisee is agent of Franchisor
13
1.
d)
e)
H.
Franchisor will therefore become liable as principal for negligent acts of
Franchisee as agent
FACTS: Personal injury lawsuit against franchisee includes franchisor McDonalds
liable as principal in an agency relationship with franchisee.
 Δ (injured party) claims Franchisor / Л (McDonalds), due to its control via
standards and uniformity of Franchisee, was principal of Franchisee/Operator
(Cooper) liable for the negligence of its Franchisee/Operator
REASONING:
 Precedent Difffers: Rights under Franchise Agreement to control “uniformity and
standardization of products and services” are seen as agency in one case Hoffnagle
and not another Miller
Ex. McDonalds is severe on uniformity- everything has to be the same between
franchisees=agency!
 Was there Actual Authority?
1. There may have been based on McDonald’s control through Franchise
Agreement of franchisee operations
Vicarious Liability under the agency theory
1) PRINCIPAL vicariously liable for acts of Agent
a) EXCEPT WHEN Agent is not acting w/in scope of his authority
b)
Franchise Agreement
 Not an agent, an independent contractor
 AUTHORITY:
1. No Actual Agency Authority
 But may create Apparent Authority
 Apparent authority cannot be disclaimed: Disclaimers of independently
owned and operated franchises do not relieve Franchisor or liability
 Doctrine of Apparent Agency why use franchises here? Because
franchises typically are not agents and therefore, Franchisors are not
liable for the acts of the Franchisee but see below:
 Franchisee’s have No Actual Agency Authority but Franchisee may
have Apparent Authority
 Franchisor/Franchisee relationship (or other similar relationships)
may be deemed Agency if 3rd party is led to believe and reasonably
relies to his detriment that Franchisee is an agent of Franchisor 
creates apparent authority Franchisor will therefore become
vicariously liable as principal for negligent acts of Franchisee as
agent
2.
Franchisor will therefore become liable as principal for negligent acts of
Franchisee as agent

c)
DOCTRINE OF APPARENT AGENCY requires
1. Δ (Principal) acts to lead reasonable person to conclude operators or
employees (tortfeasor) worked for Principal
 Uniformity, national advertising, common menus, signs, uniforms and
logos
2. Л actually believes other party is Agent (Franchisee) of Principal (Franchisor)
3. Л relied to his detriment upon duty of care of negligent Agent
 Disclaimer of control or agency in Partnership Agreement is not conclusive
1. Courts look at control of franchisor over franchisee
2. Large obvious disclaimer
HOLDING: Summary judgment denied because there exists disputes questions of fact
to determine if Δ had sufficient control over franchisee
14
III.
Different Types of Business Organizations
Sole Proprietorship
Individually owned business with no separate
legal status apart from owner not an entity
Partnership
Association of two or more persons carrying on
business for profit of co-owners
Limited Partnership
General Partner w/ unlimited liability manages
the business for passive limited partners (who
invest in the general partners) w/ limited liability
that contribute capital (like shareholders)
Ex. candy store owned by single
person or family (classic bus type-gets
taxed as an individual)
RUPA 1997 Revised Uniform
Partnership Act (default statute - controls
if there is no uniform agreement-controls
over inadvertent partnerships!!!)
RULPA 1976/1985 Revised Uniform
Limited Partnership Act
HYBRID!!!!
General partners  unlimited liability
Passive partners  limited liability
Popular among hedge funds – people who invest
in risky business
Limited Liability Company
1977
Limited Liability Partnership 1991
LLP
Corporation
Business Trusts
Passive partners do not participate in operation
 Require At Least One General Partner, subject to Unlimited Personal Liability.
In Return for No Personal Liability, the Limited Partners give up the right to Control or
Participate in the day-to-day operations of the business.
Incorporated partnership that allows members to
1995 Uniform Limited Liability
be active or passive in management
Company Act
 Limited Liability for all members
 Some states require 2 members (Florida – one member)
If too “corporate” in nature, the court may declare the business a corporation and force it to
pay corporation taxes -–where the profit is taxed twice.
Incorporated partnership
 Limited Liability for Everyone (like LLC) since all Partners are Limited Partners
 Statutory restrictions limit the applicability of LLP to certain professionals, i.e.,
physicians, attorneys, accountants
Separate legal status apart from its shareholders
who have limited liability
 Double taxation: Profits from the business are taxed as a corporation on the front end. (1)
As a separate legal entity from its owners, a corporation makes its own separate Profit and
(2) shareholders pay separate further tax on their portion of the profit (their dividends).
(1) corp (2) shareholders
 S-Corporations –“single pass through tax entity” only the shareholders get taxed =
only single taxation – BUT limited to 75 shareholders and no corporate or
partnership shareholder
Created by Deed or Declaration of Trust
Trustees manage for Beneficiaries
Shaky legal status – not recognized by all states
A. Formation: Some entities require more formality with State or other negotiated
agreements
15
B.
C.
D.
E.
F.
G.
IV.
Sole
Proprietorship
Partnership
Must incorporate in one state, register to do business in others; Minutes,
amendments, etc.
Capital Investment: some entities allow for greater opportunities for capital
investment
Taxation: Some entities are not taxed at the business level, but only as individual
income as to net profits
Management and Control: Management becomes less flexible with some entities,
as majority or unanimous consent may be required or managers act for their own
benefit and not investors
Transferability: Some entity interests are restricted from transfer by agreement or
securities law or by lack of a market for same
Perpetuity: Some entities cease to exist upon death of partner/member.
Liability: Some entities have unlimited personal liability and personal assets may
be seized to satisfy entity debts; others have liability limited to the investment of
the investors (capital contribution)
Advantages and Disadvantages of Different Business Organizations
Formation /
Operation
Simple (money oges in
money goes out) (don't
need to worry about/go
to board of directors for
anything)
Ownership and
Control
Combined
Simple
Partnership Agrmt (I
agree that I do all the
work and you agree to
pay all the $$)-can
manage it any way you
want –its very simple
and very flexible
Combined
Taxes
Taxed once
Taxed once
(and not at
the corporate
level)
Liability
Unlimited
(the poor
family
owners
could have
everything
taken from
them!!!)
Unlimited
(if one
partner
fucks up, the
toher partner
may suffer
the
consequence
s)
Management
Limited to
owner
Transferability
Transferability
Difficult (when the
owner dies, the
business cannot be
easily transferred)
Transferability
Cannot sell ?
There are
regulations
against
transferability so
it is very hard
DANGEROUS-can be
inadvertently formed!!!
Have an informal
business structureTypically partnerships
start out informaly, say
in a garage or dorm,
theyre not thinking
about corps or lawyers,
theyre just tyring to get
their business off the
ground.. once the
business breaks up,
you've got issues as to
who owns the business,
Limited
Partnership
Less Simple
Cert of LP
LP Agrmt
Separate
Allows investment w/o
Limited for
Limited
Partners
Limited
Partner
Transferability
May be restricted
by LPA and
securities laws
16
Popular among hedge
funds – people who
invest in risky business
Unlimited
for General
Partners
does not
manage
General
Partner
manages
Limited
Liability
Company
More complicated
Articles of Org
Flexible: May be
member managed or
otherwise
Operating Agrmt (just
like a partnership
agreement)
Limited
Liability
Partnership
More complicated
Cert of LLP
Partnership Agrmt
Corporations
More complicated
Articles of
Incorporation
Management and
ownership often
divided=separate?
Bylaws
Potential COIs
between
management and
stockholders
Shareholder Agrmts
Disdavntage: managers
may manage for their
own self interest – they
get all the perks (corp
jets, lots of $$) but it
may no be in the best
interest of the investors
Disadvantage: costs
money to run a corp
-Expenses: More
expense in its
operation than
required for other
enterprises.
Taxed may be
passed
through to
members
(pass
through tax
treatment:
you don't get
taxed at llc
level, you get
taxed as an
individual)=h
uge incentive
for smaller
business to
become LLCs
Taxed may be
passed
through to
members/part
ners
Double
Taxation – at
corporate and
individual
shareholder
level
Double taxes:
(1)taxed at
corp level
(2) taxed
upon
distribution
(investors
must pay
income tax on
the amount
they
received)
Members
have limited
liability,
even if
managers
Everyone/Al
l partners
have limited
liability
(similar to
LLC)
Liability is
Limited to
investment
of
shareholder
Managers
(may be
members)
Transferability
May be restricted
by OA and
securities laws
Transferability
May be restricted
by PA and
securities laws
Separate
ownership
form control
Disadvanta
ge AND
advantage:
(minority
shareholder
can invest but
I have no
ability to tell
apple how to
make an
iphone)
Transferable
subject to SA and
securities law
can sell corps
readily
Unlike
partnershi
p - cant
sell
partnershi
p interest
unless
other
partners
agree
(+sole
proprietor
s same
problem)
cant sell it if
market is bad
17
It must comply with
expensive reporting
and registration
requirements under
federal securities
law.
If owner dies, it
continues on and
on for as long as
you apy taxes and
such
?? will do be liable for anything you or your employees do, but the passive investors will not be
“
Not-for profit:
not allowed to make loans to their officers
Governed by separate statutes as compared to corps
Partnerships agreement to share profits and losses equally
A partner's interest in a general partnershiprepresents his right to share in a
certain proportion of partnership profits, losses and distributions.
Under state law, an interest in a general partnership is
freely transferable unless a partnership agreement restricts transfers
of interest.
services do not add value to partnership acct. balance
Moe invests $1000 in BBP; Larry deeds Redacre worth $400 to BBP; and Curly works for
BBP without pay. Moe’s partnership account would be credited with $1000;
Larry’s partnership account would be credited at $400; and Curly’s partnership
account would still be at $0 as no partnership account credit would be given for services
contributed by Curly to the partnership.
Our concern as lawyers is the inadvertent formation of a partnership (biz that gets started in a
garage or dorm room)
The legal attributes of a partnership can be found primarily in the statutes of the state where the
partnership is located. Most state statutes are modeled after either the Uniform Partnership Act
(UPA) or the Revised Uniform Partnership Act (RUPA).
Uniform Partnership Act (UPA) Governs partnerships
UPA is commonly labeled as an “aggregate-based statute.”
RUPA is commonly referred to as an “entity-based statute.”
.
A. How is a Partnership formed?
1. Martin v. Peyton
For partnership to be formed: it must be intended that 2+ persons
agree to carry on as co-owners and share the profits from the business
*but they don’t have to intend to call relationship a partnership
Note: Sharing in profits creates a prima facia case of a partnership.
18
Note: Difference from Cargill? Here, lawyers created a record of EXACTLY
what they were trying to do record clearly shows that Ds only wanted to
protect their loans
Bottom Line Courts will look at agreement to see if you were carrying on a
business for profit with
someone else. If Yes partnership
1. Why Is a Partnership Considered an “Entity”?
A partnership is an “entity” to the extent that relevant state law treats it as a separate person.
People can sue or be sued in their own name.
Under both UPA and RUPA, a partnership can sue or be sued in its own name. 20 People can own
property. Under UPA and RUPA, a partnership can own property. A partner can only use partnership
property for partnership purposes, not for personal gain. People can incur debt. Under UPA or
RUPA, BBP can incur debt. And, if BBP does not pay its debts, BBP’s creditors can use the judicial
process to collect judgments from BBP’s property, such as Redacre.
2. Why Is a Partnership Considered an “Aggregate” and Not an “Entity”?
A partnership is an “aggregate” to the extent that the law treats it as merely an aggregate of its
owners rather than as a separate person. The most important example of a federal law treating
a partnership as an aggregate is the Internal Revenue Code. For example, BBP (partnership)
does not pay taxes. The income from BBP is “passed through” to its partners, Larry, Moe, and
Curly. The most important example of state law treating a partnership as an aggregate is the
statutory rule that partners are personally liable for the partnership’s debts. Under both UPA
and RUPA, BBP’s creditors can collect from BBP’s partners, if BBP’s creditors are unable to
satisfy their judgments in full from BBP’s property. The most important aggregate/entity
distinction between UPA and RUPA is the effect of a partner’s leaving the partnership. More
about that later.
I.
Definition – What is a Partnership?
If two or more people are co-owners of a for profit business that is not a corporation or a
limited liability company, that business is a partnership. Re-read that sentence. Four big
“take-aways.” First, a partnership requires two or more co-owners. No such thing as a one
person partnership. The co-owners of a partnership do not have to be flesh and blood
people. A legal entity such as a corporation or a limited liability company can be a partner.
For example, Acme, Inc. and Baker Corp. could form a partnership and be the only
partners in that partnership. Second, a partnership is the default form of
association/organization for a business with two or more owners. If such a business has not
met the requirements for being a corporation or limited liability company, then it is a
partnership. 22 Third, the most important requirement for the formation of a partnership
, the most important fact in
determining whether people are co-owners is
sharing profits. If Larry, Moe, and Curly are
sharing BBP’s profits, that creates a rebuttable
presumption that they are partners. That
presumption can be rebutted. For example, a creditor can share in
is co-ownership. And
a business’s profits without being deemed a co-owner and thus a partner. Co-ownership
also involves control over the business’s affairs. Martin v. Peyton, included in many
casebooks, concluded that a lender who was sharing in the profits was not a partner
because it “may not initiate any transactions as a partner may do.” Fourth, no formal act
19
is required to start a partnership. Nothing needs to be filed by the owners; nothing needs to
be recorded or done by the state. While no formal acts are required to create a
partnership, two formal acts are likely to appear appear on your exam: (1) partnership
agreements and (2) partners’ accounts.
3.
What Is the Importance of a Partnership Agreement?
A partnership agreement is an agreement among the partners and between the
partnership and the partners. If Gertrude Stein were to read that last sentence, she might
accuse me of plagiarism. Just as a “rose is a rose,” a “partnership agreement is an
agreement among the partners….” There are two important things for you to know about
partnership agreements: 23 First, a partnership agreement does not have to be in writing
or be based on words. A partnership can be based, in whole or in part, on conduct, RUPA
101(7).
Second, and more important, the partnership agreement can change much of the statutory
partnership law that would otherwise govern disputes among the partners and between the
partnership and the partners, RUPA 103(a).
If the exam question is about the relative rights and duties of partner Larry and
partnership BBP, or the rights and duties of partners Larry and Moe to each other, then
look first for information about what the partners have agreed to and second look to
RUPA 103. On the other hand, if the exam question is a dispute between the partnership or
one of more partners and some third party who is not a partner, then the provisions in the
partnership agreement are irrelevant.
3. What Are Partners’ Accounts? Partners’ accounts are relevant if the exam question
involves dissolution of a partnership. Partners’ accounts show the money and other
property that a partner has invested in the partnership, and the money or other
distributions that a partner has received from the partnership. If Moe invests 100 in BBP
and later receives 40 as his share of BBP’s profits, then Moe’s partner’s account would
show a positive balance of 60. Under partnership statutes, a partner’s account is credited
to show property that partner contributed to the partnership, as well as cash that partner
invested in the partnership, but not the value of services that partner contributed.
The following hypothetical illustrates the application of this rule.
Moe invests $1000 in BBP; Larry deeds Redacre worth $400 to BBP; and Curly works for
BBP without pay. Moe’s partnership account would be credited with $1000;
Larry’s partnership account would be credited at $400; and Curly’s partnership
account would still be at $0 as no partnership account credit would be given for services
contributed by Curly to the partnership. =So curly essentially worked for free. This seems
unfair. Many casebooks include the case of Kovacik v. Reed, in which Reed invested
$10,000 in a home remodeling partnership and Kovacik contributed his labor. The
California Supreme Court concluded that the partners, by their agreement to share profits
and losses equally, had in essence agreed that the labor contributed by Kovacik was to be
valued the same in the partnership accounts as the capital invested by Reed. The dispute in
Kovacik v. Reed arose at the dissolution of the partnership. When we study partnership
dissolution in Chapter 10, we will see that the amounts in BBP’s various partners’ accounts
is important when BBP dissolves and makes final distributions to its partners.
*Recall that most of the UPA and RUPA rules governing the relative rights of partners
and the partnership are “default rules”—rules that can be changed by agreement of
the parties. Accordingly, this “implied” (court-supplied?) agreement between Kovacik
and Reed could change the statutory rule that regarding partnership accounts.
By statute, each partner is an agent of the partnership.
RUPA 301 + remember: Agent is a fiduciary with duties
to principal:
20
(1) General rule: any partner has authority to enter into contract that is “ordinary course” for
that partnership’s business.
Thus if the only facts in the exam fact pattern are that BBP is in the business of
barbecuing brisket and partner Larry buys brisket on credit for the BBP barbecue
partnership from T that debt to T for brisket is a debt of the partnership. And, T
can collect the debt from BBP or from Larry and the other partners.
Second: Who Is Liable for a Partnership’s Debts to Third Parties?
A partnership can be held liable for its debts. If, for example T, a client of the BBP law
partnership, proves that lawyer partner Moe committed malpractice and obtains a
judgment of 150, then T can recover from the BBP partnership. And, all of the partners
are liable for the debts of a partnership. Under the facts in the prior paragraph, T can also
recover from the partners in BBP. All the partners. Not just the tortfeasor partner. T
could recover from partner Larry for partner Moe’s malpractice.
It will be less complicated procedurally for T to collect the debt from the partnership BBP
than from partner tortfeasor Larry.
Because Under RUPA, in order for a creditor of the BBP partnership such as T to collect
from a partner such as Larry T must have a J against everyone! + T must have
exhausted efforts to collect from the partnership T must have not only a judgment against
both the partnership, BBP, and a judgment against the partner, Larry, but also have
exhausted efforts to collect from BBP before being able to collect BBP’s debt from partner
Larry. And, if T collects BBP’s 150 debt from Larry, then Larry would have a right of
indemnity against BBP and a right of contribution from the other partners Moe and Curly.
To do the math, if BBP is not able to repay Larry, then Larry could compel Moe and Curly
to contribute 50 each to Larry.
Partnership agreements cannot eliminate or limit partners’ possible liability for the debts
of a partnership.
 A partnership agreement cannot “restrict the rights of third parties” 103(b)(10).
Fiduciary Duty of Partner in a Partnership
Requirements for Breach of fiduciary obligation for taking a new business opp
while the old business still exists (Cardozo’s opinion in Meinhard v Salmon)
(1) the “relation between the business conducted by the manager and the
opportunity brought to him as an incident of management” and =new opp
came to tortfeasor bcuz of old opp
(2) the “subject matter of the new lease was an extension and an enlargement of
the subject-matter of the old one.” =new opp similar to old opp?
= if the subject matter of the new opportunity is similar in subject matter to
the old one (eg joint venture) + the new opp was brought to the attention of the
tortfeasor as a direct result of the old opp  no breach of fiduciary duty by
taking a partnership opportunity.
**Ex. partner Salmon gets the opportunity because his daughter is on the
same soccer team as Gerry’s kid,  there is no breach of fiduciary duty by
21
taking a partnership opportunity. The opportunity was not “brought to him
as an incident of management.”
Or
**Ex. improving and operating a building (new opp) DISSIMILAR FROM
opening a Glatt Kosher Chinese restaurant
**Meinhard v Salmon: Ex of fiduciary breach by joint venture partner in a
partnership
Numerous law professors consider Meinhard v. Salmon to be the
most important business associations/organizations case ever.
Meinhard and Salmon formed what the court called a joint venture
to invest in, lease, and manage a building owned by Gerry.
Meinhard was the “behind the scenes money-man.”
Salmon was the manager or what the court repeatedly called the
“managing coadventurer.”
Shortly before the end of the lease, Gerry approached Salmon about
investing in, leasing, and managing a new, larger project involving a
replacement building and adjacent land.
Salmon took this opportunity for himself.
Meinhard sued for being cut out of the deal.
“manifestly unreasonable” std: You just need to know that a partnership
agreement’s limitations on a partner’s duty of loyalty are subject to a “not
manifestly unreasonable” limitation.
B. Fiduciary Obligation: must take care when performing your actions ; are very
flexible.
1. Meinhard v. Salmon Ex of fiduciary breach by joint venture partner in a
partnership
[Fiduciary duty exists between partners—can’t be waived]
1)
2)
UPA – Adopted by all states but Louisiana
RUPA – Adopted by 2/3 of states
22
a)
3)
4)
5)
6)
7)
8)
MARKHAM: GENERALLY
DISREGARD RUPA; LOOK TO
RUPA more for LPs
Partnership results from contract, express or implied (by actions).
a) Can be proved by circumstantial evidence
b) Denial of partnership is not conclusive
c) Sharing of profits important but not decisive
d) In the absence of a Partnership Agreement, terms of UPA or RUPA control partnership
obligations
A partnership is created if as a whole a contract contemplates “an association of two or
more persons to carry on as co-owners of a business for profit” UPA
>>> Sharing profits is prima facie evidence of partnership unless you can show that is a
compensation scheme
Lender may take exercise certain controls of Borrower actions protect its interest without
creating a partnership Martin v. Peyton
a) Lender should not have authority to bind borrower company or to initiate transactions
for borrower company
JOINT VENTURE: Ad-hoc partnership limited to specific undertaking or investment
(rather than an a continuing business enterprise)
Transferability:
a) Partner MAY NOT make a transferee a member (with rights to participate in
management)
b) Partner can ASSIGN his interest in the partnership
c) Unless all other partners agree, a partner can only sell or otherwise transfer her
own “transferable interest.”
What is a Partnership?
= an association of two or more persons to carry on as co-owners a
business for profit
*+Sharing of profits  rebuttable presumption of partnership
1.
2)
X Joint owners or tenancies
 – in some cases yes, if profits shared
2. X Lenders paid debt or interest (even if in form of profits)
3. X Landlords
4. X Employees
5. X Purchaser of business assets
Wife’s Actions (which indicated a Partnership w/ her husband in Peed case) She
acted like a co-owner.
 She made capital contributions
 She signed Promissory Notes to buy cows
 Cows registered in both their names
 Title to farm in both their names
 Tax Return said it was a Partnership
 TOTALITY OF CIRCUMSTANCES indicated a partnership.
 Fact that one partner provides capital and another services is not determinative
Lawyers must guard from these informal business relationships
a) Need to formalize it
b) We must advise never to be partnerships
c) If we must have a partnership, must have a Partnership Agreement
23
[Fiduciary duty exists between partners—can’t be waived]
[The Std for a fiduciary duty: Joint venturers owe a duty of finest loyalty to
one another while their enterprise continues]
[Very high standard!!! Unbending rule]
B.
d)
Managing partner have obligation to disclose to other partners business
opportunities incident to or arising from the partnership enterprise
e)
OPPOSITION BY CONTRACTUALISTS: Chicago??
 Fiduciary duty imposed by courts is an attempt to guess what partners would have
agreed if the situation had been considered
 Contract and not fiduciary duty should guide management because fiduciary duty
can only be determined by courts
 The Delaware Limited Partnership Act allows fiduciary duty to be modified or
eliminated by contract.
 HOWEVER, with contract view - there could be overreaching, lengthy agreements
 Applying contractualist view – there were no explicit rights of renewal that bound
the partners after the termination of the lease
f)
CARDOZO imposed high fiduciary duties in business law cases
Partner’s Authority / Governance
1) Partner is an agent of the partnership with apparent authority to bind the partnership
within the scope of such authority (in the usual course of business
2) Partnership NOT BOUND for acts of partner acting outside his authority with 3d party who
HAS KNOWLEDGE of his lack of authority
3) Ordinary Course Of Business
a) Partner is an agent of the partnership and each partner can bind the partnership when
acting in the ordinary course of business
 Partnership Agreement can vary default partnership rules regarding authority of
partners
b) RUPA 303 Only way to change liability to third party is to notify third party of limits
on partner’s apparent authority to act and bind the partnership on matters in the
ordinary course of business
4) DIFFERENCES REGARDING ORDINARY COURSE OF BUSINESS
a) Majority of Partners required
5) MATTER OUTSIDE THE ORDINARY COURSE OF BUSINESS – EXTRAORDINARY
CIRCUMSTANCES
a) Unanimous Consent of Partners required
 PARTNER LIABILITY: Other partners are not liable to partner or third
parties for actions of another partner acting outside the scope of his authority
6)
Martin v Peyton – 1927 NY SC (before the
1928 1stock market crash)
7)

Facts: Banking firm asked Ds for loans that the bank could use as collateral
to secure bank
advances. It was expressly denied that Ds become
1
24


partners of the firm. In exchange and
assurance debt was to be repaid,
firm agreed to give Ds speculative securities and 40% of firm’s profits until
repayment of loans. P sued Ds arguing that they were partners of the firm.
Issue: Whether Δ became partners in a firm?
Holding: No partnership. Agreement was for repayment of loans, not
for sharing of profits.
a)
b)
c)
d)
e)
ISSUE: Did terms of lender’s agreement with borrower to protect its interest as
lender, including its loan compensation in profit, create a partnership relationship
where they were co-owners of the business ? NO
PARTIES: Respondent: Lender Peyton
FACTS:
 Creditors in Peyton loaned $500K of Liberty bonds to KNK (company) to use as
collateral for a loan but it wasn't enough..

 Partnership offered but refused (this comp was in trouble so no way). Instead,
Peyton created 3 agreements with KNK.
 1. Peyton and others loaned KNK $2.5M of liquid securities they could pledge for
loans up to $2M. Thebanks would loan 2M and the 2.5M of liquid securities would
be used as collateral for that 2M loan. KNK in turn gave to the D nonliquid
securities. So the Lenders received KNK securities as collateral. Compensation
for investors loan was 40% of profits until loan paid ($100K-$500K) = sharing of
profits = prima facie case for partnership!! Lenders imposed certain restrictions
on KNK actions to protect lender interests.
 2. Indenture >> Agreement regarding loan
 3. Option Agreement for Partnership – D could either become shareholders if a
corp was formed OR they could become partners. Mr Hall jad to manage the firm,
the other partners could terminate Hall at anytime, the trustees could inspect the
biz at any time, no loans to partners was allowed, partner’s salaries were fixed,
etc. These are as restrictive and intrusive as the Cargill case!!!
RULES
 Partnership results from contract, express or implied.
 A partnership is created if as a whole a contract contemplates an association of two
or more persons to carry on as co-owners of a business for profit.
 In determining whether contract between parties creates partnership,
arrangement for sharing profits should be considered and given due weight,
but it is not decisive, since it may be merely method adopted to pay debt or
wages, interest on loan, or for other reasons.
1. Share of profits could be prima facie evidence of a partnership, UNLESS, as
here, it was characterized as a compensation schema (to protect the rights of
the creditors)
REASONING
 Court looked at instruments and circumstances surrounding their execution as
necessary to understand the instruments
 Lender could not initiate any transactions for KNK or bind KNK, as a
partner may do
 Lender’s actions to protect its interest were proper for lender
1. Highly speculative loan that allowed lender to take precautions and exercise
certain controls of KNK to protect its interest
2. Loan funds not to be commingled
3. Lender to receive all dividends and income from securities loaned
4. Collateral Assignment of Hall’s life insurance policy
5. Collateral assignment of securities of KNK
6. Veto power over speculative business
7. No loans to Partners
25




8)
8. Partners had to assign their interests to Lender
9. Partner resignations held in trust by Hall
Denial of partnership:
1. Interests in profits was to be compensation for loans not interest in company
2. Expressly stated that no partnership was being created
 This alone is not conclusive
3. Not liable for losses or to be treated as partners
4. Option to purchase partnership interests at stated price
Difference from Cargill
1. Lawyers drafted documents – clearly crafted, as opposed to no record
2. No active participation in operations
3. Could not initiate transactions or bind KNK
 (except veto power of speculative ventures)
4. Not propping business up like in Cargill
5. Limit in profits received as compensation very important
Could there have been a claim that Cargill was a partner of Warren?
1. Possibly
GOOD RESULTS OF GOOD DRAFTING
1. Investors get to keep the illiquid securities
2. Become general creditors who can share in balance of bankruptcy estate
Peed v. Peed – 1985 NC App
a)
INADVERTENT PARTNERSHIP?
 Informal business relations that may create partners
 Want profits – Want to share losses
 Courts less inclined to find partnership when you are trying to impose liability
[Inadvertent partnership—court looks at all circumstances-  you are coowners you share in profits and losses]
[This case: wife not an employee because it was never specified who was who!]
The fact that one person contributes services and other contributes services does
not deter the creation of a partnership
Facts: Husband got drunk and left the gate open to an enclosure of cows. Cows
escaped onto nearby road and into oncoming traffic. The injured drivers and
passengers sued them both. Former wife brought action against her former husband,
claiming a one-half interest in
sale proceeds of a dairy herd and other property
connected with farming and dairyoperation,
based on the theory of partnership.
 At the time of their marriage, both were employed off the
farm and used
their earnings to pay farm expenses.
 Plaintiff testified that she and the defendant
reached an agreement that they
would become partners in the dairy,
 that the cows would be registered in both their names, and that
 the title of the farm would be changed to contain both their names.
Issue: Where they partners?
b)
ISSUE: Can the contribution of capital and time to a company create a
partnership?
Holding: Yes—partners: jury could infer based on facts above. Even though D
(husband) solely owned the property, P (wife) performed certain services, contributed
$, and helped with management.
26

The court set out factors to consider in determining whether a partnership
exists.
-A joint tenancy, tenancy in common, or part ownership does not
itself establish a
partnership, whether such co-owners do or do not
share any profits made by the use of
property.

-The sharing of gross returns does not itself establish a partnership


-No partnership if such profits were received in payment as a debt,
as wages of an employee or rent to a landlord, as interest on a loan, or as the
consideration for the sale of a goodwill of a business or other property by
installments or otherwise.
PH: Appeal by Л Wife of directed verdict for Δ Husband that no partnership existed.
HOLDING: Court found reversible error and remanded because there was
sufficient evidence of a partnership to take to the jury.
e) FACTS: Wife claims partnership interest in dairy due to her capital contribution and
her time and effort in business, although she had a separate job. Husband transferred
cows and land into joint names but denied partnership because wife worked at another
company.
f)
RULES / REASONING:
 Partnership is an association of two or more persons to carry on as co-owners a
business for profit
1. X Joint owners or tenancies
 – in some cases yes, if profits shared
2. X Lenders paid debt or interest (even if in form of profits)
3. X Landlords
4. X Employees
5. X Purchaser of business assets
 Wife’s Actions as Partner
1. She made capital contributions
2. She signed Promissory Notes to buy cows
3. Cows registered in both their names
4. Title to farm in both their names
5. Tax Return said it was a Partnership
 Court draws inferences from analysis of circumstances attendant and creation
and operation of partnership.
 TOTALITY OF CIRCUMSTANCES indicate a partnership.
 Fact that one partner provides capital and another services is not determinative
9) Lawyers must guard from these informal business relationships
a) Need to formalize it
b) We must advise never to be partnerships
c) If we must have a partnership, must have a Partnership Agreement
Fiduciary Obligation
1) Partners / joint adventurers owe each other the duty of loyalty.
2) A manager or trustee is held to a higher standard than the morals of the market place.
3) The partner entrusted with management is all the more charged with the duty of disclosure
to the other partners, because only through disclosure could opportunity be equalized within
the partnership.
4) Meinhard v. Salmon – 1928 NY Cardozo READ
c)
d)
C.
2. Meinhard v. Salmon
27
[Fiduciary duty exists between partners—can’t be waived]
[The Std for a fiduciary duty: Joint venturers owe a duty of finest loyalty to
one another while their enterprise continues]
[Very high standard!!! Unbending rule]
Facts: A joint venture existed in which two partners pooled their money in
order to
lease a building for shops and offices. Δ partner was more
business savvy and, in an
effort to increase his wealth, entered into an
agreement with another business person to
lease surrounding
property while joint venture still existed. The specifics of this transaction
were not disclosed to Π partner, and he was sued after his partner
(Meinhard) found out he was going
behind his back.
Issue: Did D break his fiduciary obligation?
Held: Yes. D excluded his partner from any chance to compete/enjoy new
opportunity.
Opportunity had come to D as a result of joint venture.
a)
b)
c)
d)
ISSUE: Does managing partner have obligation to disclose to other partners
business opportunities incident to or arising from the partnership enterprise? YES
PH: Trial court gave Meinhard 25% interest in new enterprise; Appellate court affirmed
but increased Meinhard’s interest to 50%
FACTS:
 Δ Salmon leases Bristol Hotel from Landlord Gerry, constructs $200K buildings
with funds from Л Meinhard. Δ Salmon acts as manager but parties are partners in
Bristol Hotel business.
 Lease expires and Δ Salmon alone negotiates a 20-yr (80-yr max) lease to his
corporation for Bristol Hotel property and larger tracts with Landlord Gerry, with
obligation to construct $3M of buildings and personal lease guaranty.
 Meinhard demands an interest in the new lease and operations resulting therefrom
RULE / REASONING
 Fiduciary Duty of Loyalty
 Partners / joint adventurers owe each other the highest duty of loyalty. “the duty of
loyalty must be relentless and supreme”
1. Many conduct between parties in the marketplace is not permitted in a
fiduciary relationship
 Salmon, as managing partner has assumed a responsibility by which Meinhard
must rely on him to manage the partnership.
 Partner, especially managing partner, has obligation to not separate his
interest from that of his partners with respect to opportunities incident to or
arising from the partnership enterprise
1. Especially where there exists a nexus of relation between business of the
enterprise and the opportunity brought to him as incident of management of
enterprise
 Pre-emptive opportunities of the enterprise or otherwise related thereto
belong to the partnership, not to the partners separately
1. Here Salmon appropriated to himself in secrecy and silence an opportunity
arising from the enterprise between himself and Meinhard
 Fiduciary Duty of Loyalty requires that partner disclose opportunities to other
partners that arise from the partnership
28



D.
Salmon not guilty of Fraud – but you can violate a fiduciary duty without
committing fraud
QUESTIONS:
1. Why didn’t Meinhard question what was going on with the partnership, with
20-yr lease about to expire?
2. Did offer come to partner in his capacity as a partner in a partnership or
because of a personal relationship or other reason?
HOLDING: Affirmed lower court but gave Salmon 51% and Meinhard 49%.
Salmon, as the managing partner, owed Meinhard, as the investing partner, a
fiduciary duty, and that this included a duty to inform Meinhard of the new leasing
opportunity.
Salmon was an agent for the joint venture, and when Salmon agreed to the new
business opportunity—which was made available to Salmon only because he held
that position with relation to the joint venture—Salmon carried the joint venture
into the new lease with him.
This decision extended the duties of partnership far beyond duties under a
contract. It determined that in such a relationship, loyalty must be undivided and
unselfish, and that a breach of fiduciary duty can occur by something less than
fraud or intentional bad faith.
e)
OPPOSITION BY CONTRACTUALISTS: Chicago??
 Fiduciary duty imposed by courts is an attempt to guess what partners would have
agreed if the situation had been considered
 Contract and not fiduciary duty should guide management because fiduciary duty
can only be determined by courts
 The Delaware Limited Partnership Act allows fiduciary duty to be modified or
eliminated by contract.
 HOWEVER, with contract view - there could be overreaching, lengthy agreements
 Applying contractualist view – there were no explicit rights of renewal that bound
the partners after the termination of the lease
f)
CARDOZO imposed high fiduciary duties in business law cases
Partner’s Authority / Governance
1) Partner is an agent of the partnership with apparent authority to bind the partnership
within the scope of such authority (in the usual course of business
2) Partnership NOT BOUND for acts of partner acting outside his authority with 3d party who
HAS KNOWLEDGE of his lack of authority
3) Ordinary Course Of Business
a) Partner is an agent of the partnership and each partner can bind the partnership when
acting in the ordinary course of business
 Partnership Agreement can vary default partnership rules regarding authority of
partners
b) RUPA 303 Only way to change liability to third party is to notify third party of limits
on partner’s apparent authority to act and bind the partnership on matters in the
ordinary course of business
4) DIFFERENCES REGARDING ORDINARY COURSE OF BUSINESS
a) Majority of Partners required
5) MATTER OUTSIDE THE ORDINARY COURSE OF BUSINESS – EXTRAORDINARY
CIRCUMSTANCES
a) Unanimous Consent of Partners required
 PARTNER LIABILITY: Other partners are not liable to partner or third
parties for actions of another partner acting outside the scope of his authority
29
6)
Summers v. Dooley – 1971 Idaho SC
a) ISSUE: Can equal partner in two-man partnership take action in ordinary course
of business over objection of other partner? NO
b) FACTS: Partners Summers and Dooley in trash business. Both work on truck and when
one couldn’t pay, he paid the new employee out of pocket to take his role. Partner
Summers hired third employee over objection of Partner Dooley. Summers seeks
reimbursement of ½ of expenses of hiring from Dooley. Always
c) RULE:
 Business differences in the ordinary course of business must be decided by
majority of partners.
 PARTNER LIABILITY: Other partners are not liable to partner or third
parties for actions of another partner acting outside the scope of his authority
 Where there are only two partners – majority requires both partners.
d) REASONING:
 What was the ordinary course of business?
e) HOLDING: Affirmed lower court denial of reimbursement to partner taking action
objected to by other partner.
MAJORITY VOTE REQURD to INCREASE BUSINESS – add new employee
Natl Biscuit Co v. Stroud – 1959 NC S
a) ISSUE: Can a partner refuse liability for actions of another partner in ordinary
course of business? NO
b) FACTS: Partners have agreement to purchase groceries. Partner purchases bread from
third party in ordinary course of business. Another partner notifies bread supplier he
will not be liable for those debts. $171 claim taken to NC SC.
c) RULE:
 Partner is authorized to act within the ordinary course of business and another
partner cannot restrict his authority
 Partners can bind the partnership and other partners when acting in the
ordinary course of business.
 Partner activities within the ordinary course of business cannot be restricted
except by partnership agreement
 MAJORITY VOTE REQURD to DECREASE BUSINESS – eliminate
supplier/goods
 RUPA 303 Only way to change liability to third party is to notify third party of
limits on partner’s apparent authority to act and bind the partnership on matters in
the ordinary course of business
Entity v. Aggregate
7)
E.
II.
Debate Whether the partnership should be treated as a separate entity
from its partners vs. whether the partnership should be viewed as
having no separate existence, making it just an aggregate of its partners.
(corporate laws are based on an entity concept)
III.
Aggregate theory won
IV.
Today, LLP retains some of the entity notion.
V.
VI.
You can sue a partnership but if you win you only get the partnership’s
assets.
UPA revised UPA is more entity based became LLC statutes
A.
1)
Issue whether partnership should be seen as a separate entity or an aggregate of its
partners
30
a)
b)
c)
UPA adopted the aggregate view
 Separate partners must be sued separately
RUPA 201 adopted the entity view
 Can be sued
 Can own property
 >>> LLC came along and kind of stopped this trend
Many states require partnerships to file Fictitious Names
I.
II.
B.
A fictitious= or assumed, name does not create a business
entity, but helps the business get noticed by customers.
Depending on the state or local jurisdiction,
"Fictitious Business Names" (FBN) registrations are often
referred to as "Doing Business As" (DBA), "Assumed Names",
or "Trade Names."
Partnerships vs Limited Liability Partnerships
 Partnerships file Informational Returns but gains and losses passed to individual
partners
 LLPs are treated as entity and provided limited liability for conduct outside a
particular partner’s sphere (conduct of other partners)
X Arthur Anderson LLP indicted and charged for actions of a few
2) Suing a Partnership
a) May need to name (sue) the individual partners
 To get jurisdiction
 To be able to attach to the partners’ assets as well as the partnership assets
Partnership Liabilities and Duties
1) PARTNER LIABILITY
a) UPA 13 / 14
 Partners are jointly and severally liable - for wrongful acts of a partner
b) UPA 40(f) with right of contribution against co-partners
== When a specific partner was not sued, other partners can seek contribution from that
other partner
 Partners jointly liable for all other liability of partnership
c) RUPA 306(a) Partners are jointly and severally liable for all partnership
obligations
 including the wrongful acts of partner
 RUPA has Exhaustion Rule that must exhaust partnership’s liability before
attacking personal assets.
d) UPA 9 Partner are agents of partnership and can bind partnership
 X Except where 3rd party knows of partner’s lack of authority
e) UPA 20 Partners must render true and full information to other partners
2) PARTNER RIGHTS
a) UPA 18 – Default Rights and Duties of Partners
 All partners have equal management rights
 All partners must approve admission of new partners
 UPA 19 All partners may inspects books and records of partnership
 All partners have duty to render true and full
 Can be varied by the Partnership Agreement
1. Executive committees
2. Managing Partner
UPA – AGGREGATE VIEW (not a separate entity)
dissociation triggers dissolution
=if one partner dissociates  entire partnership dissolves
31
= Since UPA viewed BBP as no more than a combination of Larry, Moe, and Curly, BBP
could not continue to exist after Moe’s withdrawal. Without Moe, the aggregate of Larry,
Moe, and Curly no longer exists. Again, the UPA rule is that a partner’s withdrawal triggers
dissolution.
The RUPA rule that a partner’s withdrawal from a partnership does not trigger dissolution is subject to
two exceptions that might be important on your exam: First,
I.
in an at-will partnership  a partner who chooses to dissociate can compel dissolution.
II. in a partnership for a term or particular undertaking, a partner’s death or wrongful dissociation gives
half or more of the remaining partners the power to cause dissolution of the partnership.
After dissolution, the business of the partnership must be wound up, unless the partners agree to carry on
the business. In essence, winding up means that the partnership can finish up old business, but the
dissolving partnership cannot take in new business. After dissolution, partners retain actual authority only
to enter into transactions designed to terminate the business. And, winding up typically involves the sale
of partnership assets with the sale proceeds distributed first to creditors and then to partners.
‘
3. What Are the Effects of Partnership Dissolution on Creditors of the Partnership? Remember what a
balance sheet looks like? Debt above equity? In other words, on a balance sheet, debt comes before
equity. Similarly, on dissolution of a partnership, the partnerships’ creditors must be paid in full before
the partners recover any part of their investment. A person can be both a partner and a creditor. For
example, Moe might pay BBP 1000 to acquire a 1/3 partnership interest and later lend BBP 300. Moe
would thus be both a creditor and partner. 51 RUPA treats debts owed to partners no different from other
debts. UPA requires a dissolving partnership to pay its other creditors first. To illustrate, assume that BBP
owes 30,000, including the 300 owed to Moe. If the liquidation of BBP’s assets nets only 15,000, then
Moe would receive 150 (300 × 15,000/30,000) under RUPA and nothing under UPA. Not only can a
partner be a creditor of the partnership, but a partner can also (and more likely) be an additional debtor
for the partnership’s creditors. If the proceeds from the liquidation of the partnership’s assets are not
sufficient, then the partners are jointly and severally liable for any insufficiency.
4. What Are the Effects of Partnership Dissolution on the Partners? We have just seen two of the three
exam-important effects of partnership dissolution on the partners—first, limitation on partners’ actual
authority and, second, possible personal liability of partners to the partnership’s creditors. The third effect
of partnership dissolution on the partners—settlement of partnership accounts—is what is most likely to
be tested. Recall that each partner has a partnership account that shows how much that partner invested in
the partnership and how much that partner received from the partnership. In winding up a dissolving
partnership, the partnership accounts must be settled after the partnership’s creditors have been paid. The
easiest way to explain settlement of partnership accounts is through illustrations.
RUPA – ENTITY VIEW
RUPA Adopts entity view of partnership and abolishes concept of tenancy in
partnership
c) RUPA 501 Partner is NOT a co-owner of partnership property and has no
transferable right in partnership property (for voluntary or involuntary transfer)
d) PERSONAL CREDITORS LIEN: Personal creditor of a partner doesn’t have a
claim against partnership but can have a claim against a partner’s partnership
interest
 RUPA 504 Charging Order entitles creditor to diversion of partner withdrawals
and distributions to creditor
 Partner retains other partnership rights (voting, management, etc.)
Dissolution =end of partnership
Disassociation =end of partner’s life at partnership
a) UPA 29 change in the relation of partners caused when one partner ceases to be
associated with the partnership
b) does not mean the termination of the partnership
b)
C.
D.
32
c)
d)
e)
partnership continues either:
 LIQUIDATION until winding up of partnership affairs (liquidation) is completed
 CONTINUATION subject to a Continuation Agreement
 RECONSTITUTES reforms and continues business under new partnership
X Dissolution in Violation of Partnership Agreement
 Entitles non-breaching partners to continue the partnership
 Entitles non-breaching partners to damages
 Breaching partner will be given his interest in partnership LESS GOODWILL
3 Phases of UPA Termination:
 Dissolution change in legal status of partnership and partners
1. Disassociation: termination of partner’s status
2. Winding Up is the economic event of liquidation (settling partnerships’
accounts after paying off creditors)
3. Termination: end point of winding up
Winding up =
I.
the partnership continues while its operations are in the
process of being terminated. Assets are liquidated,
partnership debts satisfied and any remaining assets
distributed to the partners.
II.
In liquidation, partners receive back their initial contribution
and then share in the profits and surplus after all liabilities
have been paid off.
III.
Each partner is liable for the partnership losses to the extent
of his share of the profits.
GOODWILL
 Income company is able to generate – not just its assets
c) Partnership Termination:
 UPA
RIGHTFUL DISSOLUTION: Terminable at will unless for specified term
1. Partnership Agreement can override effect of partner withdrawal
2. Allowing continuation of partnership after withdrawal of partner
WRONGFUL DISSOLUTION: express will of a partner in contravention to
partnership agreement or court order
1. Partnership dissolved but remaining partners can continue business as new
partners if they pay breaching partner his interest minus dissolution damages
b) Causes of Dissolution - UPA 31
 termination of the definite term of the partnership
 express withdrawal of any partner when no definite term
 death or incapacity of a partner
 bankruptcy of a partner
 express will of a partner in contravention to partnership agreement
 court order
Effect of Dissolution
a) UPA 38
 Terminates authority of all partners to act for partnership except as necessary to
wind up affairs
1. Unless Partnership Agreement otherwise overrides effect of partner
withdrawal
2. Allowing continuation of partnership after withdrawal of partner
 Creates problem with 3rd party agreements
b)
2)
33
1.
3)
Leases, licenses, franchises must be transferred to new partnership--Problems
arise if these agreements are not transferrable
Page v. Page – 1961 Ca
+[A partnership may be dissolved by the express will of any partner when no
definite term or particular undertaking is specified—at will partnership]
Absent evidence that partners intended psp to be for a specific term, psp
is considered at will partnership.
(and thus, a partner does not breach by ending the partnership)
Solely because they agreed the partnership was to continue for “a reasonable time as
necessary to repay start-up costs of business” was not sufficient = A “common
hope” that partnership will be profitable is not sufficient to create a term
partnership.
(must specify term??)


At will partnership can be dissolved any time\
 a partner can terminate psp by giving an express
will to leave.
Term partnership damages if partner dissolves before term
ends
o Wrongful dissolution partner entitled to share of
profits minus damages
 **Partner not entitled to good will! (good
will = future value of the business)
In Page v. Page, a case with such facts that it is included in several casebooks, the
California Supreme Court stated: “A partner at will is not bound to remain in a
partnership, … A partner may not however, … ‘freeze out’=?? a co-partner and
appropriate the business to his own use. A partner may not dissolve a partnership to
gain the benefits of the partnership for himself, unless he fully compensates his copartner for his share of the prospective business opportunity.”
4)
Facts: Two partners entered into an oral partnership agreement. Each
partner to contribute equal $$ to partnership. Psp was unprofitable for 8
years and owed huge debt to a corp. After psp began to improve, one
partner decided to terminate psp.
a)
b)
c)
FACTS: Brothers were partners in business. One partner wanted to terminate
partnership (Л). Other partner (Δ) did not, as partnership business, which had been
operating at a loss, was starting to show profit. Л owned corporation that held $47K
note from partnership.
PH: J for Δ declaring the partnership for a term rather than at will, such that Л could not
dissolve partnership by withdrawal. Л appeals.
Issue: Whether this is a partnership at will or for a term?
Holding: Psp was at will.
Absent evidence that partners intended psp to be for an intended term, psp is
considered at will.
A “common hope” that psp will be profitable is not sufficient to create a term
partnership.

At will partnership can be dissolved any time\
34


a partner can terminate psp by giving an express will to
leave.
Term partnership damages if partner dissolves before term ends
o
d)
e)
f)
Wrongful dissolution partner entitled to share of profits minus
damages
 **Partner not entitled to good will! (good will =
future value of the business)
ARGUMENT: Δ claimed the partnership was for term and Л could not withdraw or
dissolve partnership. Л disagreed
RULE/ REASONING:
 Court found partnership was not for term
1. Solely because they agreed the partnership was to continue for “a reasonable
time as necessary to repay start-up costs of business” was not sufficient
2. There was no agreement as to what would occur if company saw no profits
3. Partner could withdraw
 However, Court found that despite no term, Л had a fiduciary duty to Δ to
withdraw only in good faith
1. Could not exercise the right to withdraw to defraud the other, freeze out copartner or appropriate business to his own use without fully compensating the
other partner for his share of prospective business opportunities
HOLDING: Judgment reversed – for plaintiff, but subject to whether Л acted in bad
faith when withdrawing
_____
Asdv.
Asdv
Sd
V
sv
B.
Disassociation Compared
1) RUPA v. UPA
a) Entity view v. Aggregate View
 UPA: aggregate view of partnerships
 Partner withdrawal causes DISSOLUTION, not termination
 Change in composition is a change in partnership
 RUPA: entity concept of partnerships
 Partner withdrawal causes DISASSOCIATION
 Partner can be bought out without dissolution
 There is still Continuity of existence of the partnership
b) RUPA allows greater stability than UPA for partnership
2) RUPA - Disassociation
a) Disassociation: Term used by RUPA for partner withdrawal, instead of dissolution
b) Disassociation allows buyout of the partner to avoid dissolution
c) Partnership can also voluntarily dissolve
3) RUPA 701 – Buyout
a) provides default rules for valuation and payout of withdrawing partner’s interest
4) RUPA 801 - Liquidation Required
a) identifies when liquidation must occur
5) Effect of Disassociation
a) Withdrawing partner has no further authority to act for the partnership
35
b)
c)
d)
Withdrawing partner is not restricted from competing with the partnership,
unless PA provides otherwise
Does not dissolve withdrawing partner from liability incurred prior to disassociation
Problem of lingering “Apparent Authority”
Need to notify parties previously doing business with withdrawing partner
CHAPTER 3 Limited Partnerships, LLPs and LLCs
I.
Limited Partnerships
 a general partner, who manages the business and has unlimited
personal liability for the debts and obligations of the Limited Partnership,
and a limited partner(s), who has limited liability but cannot participate in
management.

A limited partnership usually has only one general partner; a limited partnership usually has
multiple limited partners.

Unlike general partners, a limited partner does not have personal liability for the limited partnership's debts. The most a limited partner can lose from her investment in a limited partnership
is her investment

a limited partner in a limited partnership is like a shareholder in a corporation in that she is
essentially a passive investor in a business.
LP Requirements:
1. The LP must have at least one general partner;
2. this general partner is liable for the debts of the partnership (unlike the limited partners,); and
3. the name and the address of the general partner must be set out in the Certificate of Limited Partnership which is filed in
public records with the State
Certificate of Limited Partnership = limited partnerships do not come into existence until there has been a public filing, usually with the
secretary of state of the state of organization (unlike general partnerships (but like corporations))
The two exam-important requirements for certificates of limited partnership are (1) the name
of the business, which must include the term “limited partnership," or some abbreviation thereof?
egl, Horse Feathers, LP, and (2) the name and address of all general partners
Even if the Certificate of Limited Partnership meets the requirements of the state’s limited partnership law, that document alone will not meet the requirements of the business and its owners
limited partnership agreement
The more important document for limited partnerships is the limited partnership agreement
Although RULPA does not require that there be a written limited partnership agreement, almost
all limited partnerships have detailed written agreements,
These partnership agreements define the
relative roles of the limited partners and the general partner and largely supplant the limited part»
nership statute as the place to look for answers in resolving disputes between the limited partnership and partners and disputes among partners
What Can the Owners of an LLC Sell?
The most important limitation on an LLC member’s making money by selling her interest for
more than she paid for it is imposed by the market, not by the legislature, the courts, or even the op»
erating agreement It is usually difficult to find a buyer for a minority interest in a small business, or
36
even a minority interest in large business, that has relatively few owners,
Even if a member of a limited liability company is able to find a buyer for her interest, her ability
to sell may be limited by statute, or by the operating agreement, or by both, Recall what you learned
about a partner’s sale of her interest.
Unlike a shareholder, but like a partner, an LLC member is barred by statute from selling her full ownership interest to an
outsider.
Like partnership statutes and limited partnership statutes, LLC statutes provide that an LLC member can sell her financial rights
but not her management rights, Even in manager-managed LLCs,
How LLCs end:
Once you have paid all of your LLC's outstanding financial obligations, you can distribute any remaining assets to the LLC's members.
Just as you filed paperwork with the state to form your LLC, you must file articles of dissolution or a similar document
to dissolve the LLC.
-
Note: There is no corporate law equivalent of dissociation
I hope that you don’t recall a shareholder's power to compel the corporation to purchase her shares
by invoking the concept of dissociation, There is no corporate law equivalent of dissociation,
And, in some states, there is no limited liability equivalent of dissociation For example, the
Delaware LLC statute does not even use the term "dissociation" Instead, the Delaware LLC statute
provides that a member may not resign from an LLC prior to dissolution unless an LLC agreement
otherwise provides. In other states, a member’s dissociation does not obligate the LLC to buyout the
dissociating member’s intere stl
If LLCs Are So Important,Why Is the Part of the Book on LLCs So Short?
- First, the answers to most LLC questions turn on the interpretation of the provisions of the operating
agreement, not LLC statutes or case law.
-
Second, LLC statutes vary widely from state to state, Some borrow more from corporate laws; others borrow
more from partnership laws Third, the questions that arise in forming, operating, growing, and end.
Definition
1) Statutorily-created method of profit sharing by passive investors
2) Two classes of limited partners: general and limited
3) General partners manage partnership
a) Unlimited liability
b) General Partner may be a corporation (Frigidaire Sales v. Union Properties – 1977)
 thereby allowing for no personal liability!!!
4) Limited partners are passive in management
a) Limited liability for losses up to the amount of their investment, subject to limitations
on participation in LP management
b) NOT AGENTS of the LP  cannot bind it
c) Hold no title or property rights in assets of LP
C. Governing Law
1) ULPA Uniform Limited Partnership Act 1916 - Enacted by every state
2) RULPA Revised Uniform Limited Partnership Act 1976 - Adopted in most jurisdictions
LP Advantages
 OVER GENERAL PARTNERSHIPS
 Provides same advantages as general partnership (pass-through +)
 But allows passive investors to avoid unlimited liability for obligations of general partner
 Subject to limitations on activities of limited partners to participation and control of the LP
 OVER LLC AND LLPS
 Guarantee centralized management
 Effective means to limit influence of limited partners --- There is nothing more limited than a
limited partner. NY Yankees Limited Partner
 More suitable for public trading
D. Liability of Limited Partners
1) Generally
a) Limited liability for losses up to the amount of their investment
b) Subject to limitations on participation in partnership management (See Below)
B.

37
Subordinate to creditors if partnership insolvent or liquidated
Limited Partnership Liability and Participation in Management
a) MANAGEMENT PARTICIPATION
 A limited partners may become liable for the obligations of the LP when it (a)
is also a general partner, or (b) has taken part in control or management of
the corporation
 2 Different Tests – Based on 3d party knowledge or limited partner’s conduct
 SUBSTANTIALLY THE SAME TEST (Original ULPA):
 ULPA 303 (1976)
 Limited partner’s exercising all power of a GP could not escape liability by
avoiding contact with 3d parties
 If limited partner exercises control substantially the same as GP he is
liable to 3d partys
 IRRELEVANT of whether or not 3d party had ACTUAL
KNOWLEDGE of limited partner’s participation or whether limited
partner had DIRECT CONTACT with 3d party
 Some states still employ this test
 3D PARTY KNOWLEDGE- REASONABLE BELIEF TEST
 RULPA 303 (1985) 3d party must REASONABLY BELIEVE the limited
partner is a GP, based on the LIMITED PARTNER’S CONDUCT.
 Reluctance to impose liability on limited partner who had no direct
contact with 3d party
 Not sound public policy to hold a limited partner liable except to persons
who have done business with the limited partners reasonably believing
and relying on that he is a GP that can bind the LP
 Even if limited partner exercises control substantially the same as GP, ULPA
Substantially the Same Test does not apply
 Difficult to determine when “Control Line” has been overstepped
 Whether limited partner has exercised degree of control to expose him to liability is
a QUESTION OF FACT
c)
2)
LP PARTICIPATION AND
LIABILITY
OLD RULPA 303
Substantially the Same
Not Substantially the Same
NEW RULPA 303
Participates in control
3d Party Actual
Knowledge
Limited Partner’s Conduct Direct
Contact w/ 3d Party
Not Required
Required
Not Required
Required
Required
b)
3d Party
Reasonably
Believes
Required
SAFE HARBOR FOR LIMITED PARTNERS: CHECK ULPA AND RULPA
Under RULPA, for example, a limited partner is personally liable for the debts of the
limited partnership only if she "participate[s] in the control of the business but also her
conduct causes the creditor to believe she was a general partner"
Moreover, the statute sets out “safe harbors," i,e,, things that a limited partner can do
without participating “in the control of the business," such as:
- voting on the admission or removal of a general partner;
- voting on the limited partnership’s selling assets or incurring debt; and
- serving as a director or officer of the corporate general partner.
=
 The following are permissible control actions by LP:
 Acting as contractor, agent or employee of LP or GP
 Consulting with or advising GP
 Acting as surety for LP
 Approving or rejecting LPA amendment
38

3)
Voting on
 dissolution or winding up
 sale, lease, mortgage, pledge or other transfer of substantially all assets
other than in ordinary course of business
 incurrence of indebtedness not in ordinary course of business
 change in nature of business
 removal of GP
 Exercise of other powers does not necessarily constitute participation
c) CORPORATE GENERAL PARTNER
 POST-RULPA: Limited partners acting as Officers, Directors or Shareholders of a
Corporate General Partner
 Do not expose themselves to unlimited liability when participating in the LP in
such capacity
 Allows limited partners to participate in the business through the corporate
vehicle
 Must prove participation or control was in such capacity
 PRE-RULPA did not permit to evade liability
d) ANNUAL REPORTS – CONTINUING STATE AUTHORITY
 Failure to file Annual Reports and/or loss of rights to continue operating as an LP
can subject limited partners to unlimited liability
Gateway Potato Sales v. GB Investments
a) FACTS:
 Gateway sues to recover for payment of goods sold to Sunworth Packing LP.
Sought recovery from LP, GP and a limited partner, GB Investments. Gateway
claims it only sold to LP when Ellsworth, President of GP, told him GB
Investments was actively involved in LP. Gateway believed he was dealing with a
GP (Sunworth Packing Company), although he only dealt with Ellsworth and never
dealt with GB Investments until after sale.
 Disputed whether GB Investments ever provided any assurance of payment to
Gateway. GB says no, Ellsworth says GB’s employees controlled day to day
operations of LP and Ellsworth reported to them.
b) PH: Trial court granted Summary Judgment in favor of GB.
c) HOLDING: REVERSED.
 Whether LP exercised sufficient control of LP to open itself to liability to 3d
party was a QUESTION OF FACT and summary judgment was not
appropriate.
d) ARGUMENT: Gateway alleges that it believed, based on Ellwsorth’s reps, that it was
doing business with a general partnership of which GB Investments was partner. Relied
on that representation and belief in selling to the LP, would not have sold otherwise.
e) RULE: A limited partners may benome liable for the obligations of the LP when it
(a) is also a general partner, or (b) has taken part in control or management of the
corporation
f)
ISSUE: HOW MUCH CONTROL and KNOWLEDGE OR BELIEF OF 3D
PARTY
 Unless limited partner’s participation in control is not substantially the same
as that of the GP, in which case the limited partner is only liable to persons
who transaction business with the LP WITH ACTUAL KNOWLEDGE of its
participation.
 IMPLIED RULE: If LP’s participation the same as GP, he is liable to 3d
party even if that party does NOT HAVE ACTUAL KNOWLEDGE of
GP’s participation.
 ULPA 303 (1976) : ACTUAL KNOWLEDGE of limited partner’s
participation irrelevant
 Limited partner’s exercising all power of a GP could not escape liability
by avoiding contact with 3d parties
 Arizona follows this rule
39

E.
Arizona has NOT modified its statutes to reflect the revision to ULPA 303
(1985) that 3d party MUST REASONABLY BELIEVE limited partner is a
GP based on the limited partners conduct.
 SAFE HARBOR FOR LIMITED PARTNERS:
 Certain enumerated acts are permissible control actions by LP that do not
expose it to unlimited liability.
 Exercise of other powers not enumerated does not necessarily constitute
participation
g) REASONING:
 Arizona uses the “substantially the same test” under the OLD RULPA 303
 Substantially the same test does not require 3d party have actual knowledge or that
limited partner exercising control have direct contact with the limited partners
 Irrelevant that Gateway had not direct contact with GB Investments
Limited Partnership Rollup Reform Act of 1993
1) 1986 Tax Reform Act of 1986
a) Limited LP ‘s advantage to offset personal income with partnership losses.
b) Loss of this advantage increased the impact of the disadvantage of illiquidity.
 Investors trapped in investment until assets liquidated
 Restricted assignability of LIMITED PARTNERSHIP STATUS
 No ready market for limited partnership interests
2) Master Limited Partnerships (MLPs)
a) Publicly-traded limited partnership listing its interest in an exchange or OTC market
(NASDAQ)
b) Sells UNITS to circumvent restrictions on transferability of limited partnership status
c) Developed in 1980s to overcome problem of illiquidity of LP interests
d) Limited partnerships sold to the public are securities
e) Concerns of fraudulent sales practices in sales of limited partnership interests:
 Misleading profit claims
 Failure to disclose risk of investment
A limited partnership is subject to federal securities laws such as Rule 10b-5
and state securities laws, A limited partnership interest the name cleverly used to describe the
ownership interest is treated as a “security” by the federal and state securities laws, including Rule
10b-5. This makes sense because, as we will see repeatedly in this chapter, a limited partner in a lim»
ited partnership is like a shareholder in a corporation in that she is essentially a passive investor in a business.
The general partner of a limited partnership has the same duty of care and duty of loyalty as the general
partner of a partnership, and if she breaches that duty she is liable, except as provided below (2).
1.
under the Delaware limited partnership law, the limited partnership agreement caneliminate the
general partner’s duty of care and loyalty.
2.
There is a somewhat comparable provision in RULPA which permits modification but not
elimination of the general partner’s duties.
Dicta in In re USA Cafes, LP, Litigation, a Delaware trial court case, that the
director of a corporate general partner owes a duty of care and duty of loyalty not only to the corporate
general partner but also to the limited partnership.
It is understandable that a general partner in a limited partnership should be under the same
statutory constraints as a general partner in a partnership, A general partner in a limited partnership, like a general partner in a partnership, makes decisions that impact the other owners of the
busines st
If Groucho is the general partner of Horse Feathers Limited Partnership, he makes decisions that
impact the limited partners Chico and Harpo, General partner Groucho should not be able to sell
40
that decision making power to Zeppo, And so, limited partnership statutes impose the same transfer
constraints on the general partner in a limited partnership as RUPA imposes on the partners in a
partnership.
What is harder to understand is why limited partnership statutes impose the same sale con»
straint on the limited partners of a limited partnership Limited partners do not make decisions that
impact the other owners of the business
If limited partner Chico sells his interest in Horse Feathers, LP to Gummo, that would have no
possible effect on the other owners of Horse Feathers, LPA. Nonetheless, limited partnership statutes
place the same constraint on transfers by limited partners as on
transfers by general partners. Limited partners like Chico can only sell their "transferable interests",
i,e., their financial interests
II.
Limited Liability Partnerships
=An LLP is a special form of general partnership in which the general partners have no
liability
for the LLP’s debts (an LLP is not a limited partnership)
LLP requirements
- all partners are general partners and
- all the general partners are protected from liability to creditors of the limited liability
partnership
Governed by state partnership statutes
- LLPs were invented by the Texas legislature to protect accountants and lawyers in big firms
structured as general partnerships from personal liability for malpractice by their partners. Other
states followed Texas’ lead All states now have LLP statutory provisions.
= Original LLP statute in Texas sought to protect large law firms from being bankrupted as
the result of the misconduct of a single partner. Large Dallas firm held liable for actions of
one partner in the 1980’s S&L industry catastrophe.
A.
B.
Limited Liability of Partners of a Limited Liability Partnership
1) LLP Partners
a) liable only for obligations arising from their own conduct or activities
 Personally liable to the full extent of their wealth
b) have limited liability and are not liable for debts or liabilities (arising in tort or K) of the
partnership solely by reason of membership in the partnership
 Partners of an LLP are not liable for debts and fraud for the bad acts of one of the
partners.
 Liability of LLP partner ends with one’s own conduct and the employees they
personally supervise.
a) X Negligent or wrongful acts or misconduct committed by the actual partner or
any person under his direct supervision
b) X Some states extend limit liability to malpractice but not ordinary commercial debts.
 Distinction used in Enron against a large accounting firm).
2) Compare to the UNLIMITED LIABILITY OF PARTNERS OF GENERAL
PARTNERSHIPGP: Partners of a general partnership are subject to unlimited liability and
may held be liable for the acts of any other general partners, whether or not they participated
or knew.
3) Original LLP statute in Texas sought to protect large law firms from being bankrupted as
the result of the misconduct of a single partner. Large Dallas firm held liable for actions of
one partner in the 1980’s S&L industry catastrophe.
4) Usually used by large law firms
5) LLP statutes vary from state to state.
Lewis v. Rosenfeld
1) FACTS:
41
PARTIES
 RBT- LLP with 3 partners: Rosenfeld, Bernstein & Tannenhauser
 Tower Hill – GP formed by the 3 RBT partners – individually – and Fresne, Л
Lewis’ broker, to conduct certain business of the LLP in connection Mad Martha’s
Ice Cream.
 Л Lewis: Made a $650,000 loan to Mad Martha's in June 1995 but is not repaid
because Mad Martha's files for bankruptcy on February 1996.
b) Л Lewis claims Rosenfeld made fraudulent representations on which he materially
relied in making the loan. Rosenfeld is both the limited partner of the LLP and a partner
in the general partnership of Tower Hill
 Л sues the LLP (RBT) and R, B & T in their capacity as the individual partners of
the GP (Tower Hill) for fraudulent representations
c) Partners B and T allege no liability to Л for fraud because of R’s actions because they
were partners of an LLP (RBT).
d) Court finds that although B and T could not be found liable as members of the
LLP (no tortious conduct) they could be held liable as individual partners of the
general partnership, Tower Hill (no limited liability).
2) CLAIMS:
a) RBT and Rosenfeld, acting for himself, RBT and Tower Hill, knew of Fresne’s
fiduciary duties to Lewis but knowingly participated with Fresne to defraud Lewis and
breach his fiduciary duties.
b) RBT and Rosenfeld, acting for RBT and Tower Hill, committed common law fraud
because of misrepresentations and omissions.
c) Δs engaged in civil conspiracy to divert Plaint’s funds to themselves or their affiliates
d) Actions of Rosenfeld and RBT constitute negligent misrepresentation.
e) Seeks J against all Δs, individually, jointly and severally
3) RULE:
a) LIMITED LIABILITY OF PARTNERS OF A LIMITED LIABILITY
PARTNERSHIP:
 Partners of an LLP have limited liability and are not liable for debts or liabilities
(arising in tort or contract) of the partnership solely by reason of their membership
in the partnership
 X Negligent or wrongful acts or misconduct committed by the actual partner or any
person under his direct supervision
b) UNLIMITED LIABILITY OF PARTNERS OF GENERAL PARTNERSHIPGP:
Partners of a general partnership are subject to unlimited liability and may held be
liable for the acts of any other general partners, whether or not they participated or
knew
4) REASONING:
a) Л does not allege that Bernstein or Tannenhaus or anyone under their control
committed any tortious acts
 B and T Cannot be held liable as members of the LLP
b) Because Rosenfeld was acting on behalf of the Tower Hill (the GP) as well as the LLP,
B & T could be held liable for his actions as partners of the GP.
Limited Liability Companies: LLC’s
a)
II.
An LLC is in some respects like a partnership and in other respects like a corporation.
Like a limited partnership, an LLC offers its members both (i) protection from liability for the
business’s debts similar to the liability protection of shareholders of a corporation, and (ii) the same
pass-through income tax characteristics of a partnership.
What is most important about LLC statutes is how unimportant the statutes are In the main,
LLC problems are answered by contract provisions rather than the provisions of the LLC statute LLC
statutes set out primarily "default rules", i.e., rules that apply only if there is no agreement to the
contrary
42
“Operating Agreement" – how the LLC will operate + dispute resolution clause
A limited liability company’s most important document is the “Operating Agreement" The
operating agreement is not a public document, i,e., it is not filed State limited liability company
statutes do not even require that there be an operating agreement
As the term "operating agreement" suggests, an operating agreement governs how the limited
liability company operates In resolving disputes over the operation of a limited liability company,
courts look first to the operating agreement.
Most LLC statute provisions are “default rules," iiei, applicable only if the LLC’s operating
agreement does not otherwise provide.
In a member-managed company, the operating agreement will answer such questions as: (1)
how to determine how many votes each member has and (2) how to determine what matters require
more than majority vote In a manager-managed company, the operating agreement will answer
questions such as: (1) how members elect and remove managers and (2) what issues require a mem»
her vote.
A.
B.
C.
Generally
1) DEFINITION: A joint venture designed to permit persons or entities to join together in an
environment of private ordering to form and operate the enterprise under an LLC agreement
with tax benefits of a partnership (flow-through tax status) and limited liability of a
corporation
2) An entity by contract – Operating Agreement spells out rights and obligations
a) Chicago School Theory of Contracts
b) Everything must be in writing
c) Operating Agreement is key.
3) PURPOSE: To encourage investors in business by offering limited liability in exchange for
exclusive management.
4) Arthur Anderson’s collapse led to a ruling that LLC members are not liable for commercial
debt, but may be for other debts.
5) Many states have business courts (including FL) to deal with LLC , but all these courts seem
to do is apply DE decisions.
Advantages
1) Combines corporate-type limited liability
2) With partnership-type flexibility and tax advantages
3) IRS 1988 ruling that allowed LLC to be treated as a partnership for federal income tax
purposes allowed gains and losses to be passed through to LLC members
a) Allowed LLCs the same advantage of Sub-S corporation without the many restrictions
imposed on Sub-S
Governing Law
1) ULLCA Uniform Limited Liability Company Act (1994/1995-96)
a) Has not been widely popular
b) Only 7 jurisdictions had adopted as of 1999
c) Delaware LLC Act is a better prototype
2) Delaware LLC Act
a) First separate LLC statute – codifies LLC
b) A “flexible statute” that permits members to SUBSTANTIAL FREEDOM OF
CONTRACT to govern their relationship
c) X Cannot contravene or be inconsistent with certain mandatory statute provisions
 X Such mandatory provisions were likely those intended to protect third parties,
not the contracting members
d) Act provisions act as default provisions when Operating Agreement is silent
 You can extend the ceiling but you can’t lower the floor.
e) Gives maximum effect to freedom of contract principle
and to the enforceability of limited liability company agreements
f)
Also gives jurisdiction to special Chancery Court to hear cases
43
Delaware has Chancery judges that play a major role in corporate law cases and their
opinions are looked at by the entire country.
3) Limited Case Law
a) Precedential value of cases from other jurisdictions is questionable because of widely
divergent rules
b) Inhibits development of uniform case law
c) Case law will have little precedential value from state to state
Operating Agreements
1) Operating Agreements are agreements among the members establishing the conduct of LLC
business
2) Operating Agreements do not require the signature of the LLC to bind the LLC to its terms
3) Operating Agreement allows members substantial freedom of contract to govern their
relationship
a) Provided they are not inconsistent with mandatory provisions of governing statutes
b) May not modify fiduciary duties
4) Operating Agreements incorporate provisions of the statutes that govern LLCs, including
statutory fiduciary duties.
LLC as Securities
1) Because LLC interests are not represented by stock, member interests may be treated as
securities subject to regulation under the federal securities laws:
a) YES: Non-Member Managed LLCs:
 LLC will be treated as security if members are passive investors (like limited
partners) dependent on active managers
 In such case, member’s interest may become an investment interest
b) NO. Member-Managed LLCs
2) LLC will not be treated as a security if it is member-managed and members are active
managers (like in a general partnership).
Elf Atochem North America v. Jaffari
1) LLC bound to terms of Operating Agreement among members
2) I: Does LLC’s failure to file an Operating Agreement relieve it from an obligation to
be bound to the terms thereof (i.e. an Arbitration Clause)? NO
3) FACTS:
a) Elf Atochem (Penn) + Malek, Inc. (Jaffari) (California) = Malek, LLC joint venture
(Delaware)
 Malek Inc. is 70% GP (Rights in maskant) and Elf is 30% LP ($1M) – Both Cal.
corps
 Joint venture is to market environmentally-safe maskant used in aerospace
industry.
b) Malek LLC (Del): Members of LLC sign Operating Agreement- contains Arbitration
Clause & Forum Selection Clause. LLC itself does not sign OA.
 The Distribution Agreement entered into by Elf Atochem and Malek LLC, in
contrast, probably contained neither an arbitration nor a choice-of-forum provision
c) Elf Atochem uses derivatively on behalf of the Malek LLC against Jaffari (Malek, Inc.)
for breaching a fiduciary duty to Malek, LLC.
d) Elf Atoichem (for Malek LLC) claims the LLC is not bound to the arbitration
provision of the Operating Agreement because it was not a signatory to it – can
instead bring its claim in Chancery Court in Delaware, as permitted by the Delaware
LLC Act.
4) RULE:
a) Delaware LLC Act permits members to SUBSTANTIAL FREEDOM OF
CONTRACT to govern their relationship
b) X Cannot contravene certain mandatory statute provisions
c) Act provisions act as default provisions when Operating Agreement is silent
d) You can extend the ceiling but you can’t lower the floor.
5) REASONING:
a) The law defines an Operating Agreement as an agreement amongs its members.
b) Characterized the Agreement as a contract among its members.
g)
D.
E.
F.
44
It is the members of the LLC who are the real parties in interest … the LLC is
simply a joint business vehicle.
d) Probably viewed the arbitration provision as being in line with the state policy favoring
methods of alternative dispute resolution, then determined tha the purpose of
encouraging arbitration outweighed the Delaware LLC Act's purposes for vesting the
Court of Chancery with jurisdiction
6) HOLDING:
a) Affirmed the Court of Chancery’s dismissal of Elf Atochem’s Amended Compalint
for lack of subject matter jurisdiction.
b) Malek LLC’s failure to sign the Agreement does not affect its being bound to the terms
and provisions of the agreement among its members for the conduct of its business.
7) OTHER POSITION:
a) To the extent that an LLC exists as an entity apart from its members, it should not itself
be bound by an agreement among its members simply by virtue of their having signed
it.
b) Shows conflict between protecting the LLC as an independent entity and
preserving the principles of freedom of contract.
G.
Harbison v. Strickland
1) LLC subject to fiduciary duties in statute that empowers its existence
2) F: Harbison claims court erred in looking only at four corners of the LLC Operating
Agreement and not looking at the fiduciary duties imposed by statute.
3) REASONING:
a) LLCs, like corporations and LPs, are creatures of statute, subject to the statutes that
create and govern them
 Legislatures have imposed fiduciary duties on statute-created entities such as
LLCs, LPs and corps
 Parties cannot anticipate every aspect of their business and foresee every possible
situation so some fiduciary duties exist and always will.
b) Member and managers of LLC owe a duty of loyalty to the LLC
c) Articles of Organization or Operating Agreement of LLC may not modify fiduciary
duties:
 Duty of loyalty
 Unreasonably reduce duty of care
 Eliminate obligation of good faith and fair dealing
 Unreasonably restrict access to information or record
4) HOLDING: LLC
a) Remanded to determine if Strickland breached his fiduciary duties.
b) Operating Agreements incorporate provisions of the statutes that govern LLCs,
including fiduciary duties.
5) This is still an unsettled area as to how the fiduciary duties fit in to LLC. Court tends to find
inherent fiduciary duties and not allow provisions that would limit it.
III. Withdrawal and Expelling Members Member Withdrawal
1) May vary from state to state
2) Should address in Operating Agreement
a) Whether withdrawing member get only capital account balance and/or value of
enterprise
b) If withdrawing member gets value of enterprise where does the LLC get the money
c) If not specified, it could force dissolution of the LLC when the members want to
continue
3) Can company continue after member withdraws?
a) If Operating Agreement allows, pursuant to its terms
b) > If all remaining members consent
c) > Member may force dissolution if his capital contribution is not returned
d) Court may force dissolution if it is not “reasonably practicable” for LLC to continue
4) What does withdrawing member receive?
a) Usually return of his capital contribution if
 Operating Agreement does not restrict
c)
45
 Company can pay its liabilities
Sometimes return ON his capital contribution
 If company forced to dissolve
 If Operating Agreement requires
 If Operating Agreement allows buy-out
 If Court requires
5) Courts may force dissolution
Expelling a Member
1) Depends on whether Operating Agreement permits
2) What happens when they are expelled?
Lieberman v. Wyoming.com LLC
1) Return of goodwill of business to withdrawing member
2) ISSUE: Is a withdrawing member entitled to the return of his capital contribution and the
fair market value of his membership interest? NO
3) FACTS: Member withdraws and wants percentage of business. Operating Agreement silent
on whether a member is entitled to return of his capital contribution or fair market value of
his membership upon withdrawal. Court had to decide what withdrawing member was
entitled to.
4) REASONING / RULE:
a) WYOMING LLC ACT
b) Did withdrawal trigger dissolution? NO
 Statute permits remaining members to continue the business if all agree after
withdrawal of member or other event which terminates continued membership
 UNDER WYOMING LAW: Withdrawing member can only demand dissolution if
his request for return of his capital contribution was unsuccessful
c) Is withdrawing member entitled to return of capital contribution? MAYBE
 Can be restricted in the Operating Agreement (but it was not in the Operating
Agreement or the Articles of Organization in this case)
 If not restricted, member entitled to return of capital contribution if liabilities can
be paid without that contribution and all members consent to return
d) Is withdrawing member entitled to interest in company in excess of capital
contribution? MAYBE
 Distinction made by Court between withdrawal of capital contribution and
disassociation with the LLC
 Can withdrawing partner force dissolution
5) H: Withdrawing partner could do nothing until the business dissolved and then he would get
his fair share of the business not just his capital investment
b)
B.
C.
CHAPTER 4 Corporations – Formation
and Finances
Each state’s corporation statute is different from the corporation statutes in other states. This is
important because a business can choose to incorporate in any state, even a state in which it has no
business activities.
If, for example, Bubba’s Barbecue Corporation (BBC) incorporates in Delaware, Delaware law will
govern issues such as shareholders’ right to vote, the procedures by which the board of directors
act, and the duties of directors to the corporation. Again, this is true even though none of BBC’s
shareholders, directors, or barbecue has ever been in Delaware.
A foreign corp = a corp that is incorporated under the laws of another state
Domestic corp = incorporated in that state
46
Qualification usually includes (i) obtaining authorization from the appropriate state agency, (ii)
appointing a registered agent in that state, (iii) filing annual statements in that state, and (iv) paying
fees and franchise taxes to that state. A Texas-based business that choses to incorporate in Delaware
must pay fees to both Texas and Delaware. Most corporations transact business in a single state.
And, most corporations incorporate in that state to avoid the complications and costs of having to
qualify as a “foreign corporation.”
Why incorporate in Delaware? Delaware has more laws and is generally sympathetic to corps
I.
The Role of the Corporate Lawyer
A. Litigators v. Corporate Lawyers
1) Litigators get set of facts they must deal with
a) Advocate their client’s position based on those facts
2) Corporate lawyers create the facts, create the record (so that if there is a future dispute, the
litigator will have to use the corporate lawyer’s record).
a) Not advocates, but counselors
b) Advise our clients pros and cons
c) Create the record through correspondence, minutes, conferences
B. Relationship of Corporate Lawyer and Client
1) Not an adversarial relationship
2) Be careful with e-mails and instant messaging
a) Casual comments
b) Sense of urgency
3) Forget about attorney-client privilege, assume it does not exist in corporate law.
a) It will be breached (if corporation goes bankrupt, bankruptcy attorney may waive all a-c
privileges and all materials will come out)
b) Client will let it go eventually
4) Must know Securities Regulation
a) Easy to get screwed here
C. What Corporate Lawyers Do:
consigliore
1) Drafting documents
2) Avoid exposing client to
a) unnecessary legal risks
b) costly litigation and damage
3) Counsel clients
a) Choices
b) Risks
c) Avoiding Litigation
(go out with client, be their friend)
4) Create organizations
5) File with SEC
a) Initial Filings
b) Reports
c) Disclosures
6) Negotiate contracts and other agreements
7) You are the client intake for business into the law firm
a) Source for specialists: litigators, other law specialists
b) In-House Counsel
 Your Boss is Your Client
 Relationship w/ independent Outside Counsel
 In-House Counsel will often find problems to send to Outside Counsel (because in
house counsel won’t have as much time)
8) Lobbying
9) Know tax considerations
a) Highly specialized area
b) Most business decisions are structured for tax consequences
c) Need basic knowledge of taxes, not tax expertise
47
Everything you do will be driven by generating least amount of taxes
Know Delaware Law
a) Need to know for public corporations
Where Were the Lawyers?
1) Savings and Loan Association
a) Gov’t froze assets of NY law firm
b) Movement led to LLP’s for law firms
2) Enron / World-Com / Adelphia / Global Crossings
a) Massive accounting failures triggered new movement
b) Sarbanes-Oxley Act imposed obligations on public lawyers dealing with N-6. Pg 100
c) Lawyers should be gate keepers, policing conduct of their clients
d) Lawyers had to report to mangers and up the chain to Board of Directors
and thereafter withdraw if Board does not correct
e) If our clients disobeying federal securities law we have obligation to rat them up to the
Board
3) Conflicts of Interest
a) Who is my client?
b) Must make the distinction between who is the corporation and who is the individual
c) If representing the corporation, may need to have separate counsel for shareholder,
director, officer or employee unless they waive conflict of interest
d) If representing two individuals forming a company
Advantages of Corp
1) Limited liability
a) Has strategic value when corporations fail
b) Shareholders
 Limited to their capital contribution (=how much they paid for their stock)
c) Officers and Directors
 Agents not liable if acting within their scope of authority
d) X HOWEVER
 Wrongful acts will be considered personal acts.
 Corporations act through their employees
2) Transferability
a) Shares can be sold if there is a market
 Close corporations may restrict transferability
 Requires a market for the shares
b) LLC’s can be transferable (be careful with SEC)
c) Partnerships cannot be transferable
d) Federal Securities Laws
 Sale of stock to the public to raise capital requires SEC filing
 SEC requirements and limitations are tremendous
3) Continuing Existence
a) Corporations are perpetual in existence
4) Centralized Management
a) Ownership and Control separated
 Professional managers manage for passive investors
 Problem is to align interests of management and shareholders and keep
management from overreaching
 Stock options
 Didn’t work because management manipulated earnings
 Disclosure of compensation of operating executives
 Didn’t work because executives began comparing salaries and demanding
more
b) Corporate form is ideal form of efficient management of large-scale enterprise
 As companies grow, want to make decision-making more sophisticated
c) Board of Directors – Set policy
d) Officers – Carry out policy = CEO, COO, CFO, etc…
d)
10)
D.
E.
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F.
3 Disadvantages of Incorporation
1) Complexity and Costs
a) Must pay managers, outside advisors, etc.
b) Proxies, minutes
c) Management structures
2) Federal Securities Laws
3) Double Taxation
a) Tax both corporate net profit (40%) and shareholder dividends (15%)
b) Corporations often discouraged to distribute and instead retain for internal growth
c) Small companies can avoid double taxation by electing to be a Sub-S
G.
Liquidation / Bankruptcy Preferences
1) Creditors
2) Preferred Shareholders
3) Common Shareholders
Constituents of Company
1) Shareholders
2) Board of Directors
3) Officers / Managers
4) Employees
5) Customers
6) Outside Advisors
7) Creditors
8) Bond Holders
H.
II.
Forming the Corporation/Corporate Formation/Corp form
\-Promotersa person who contracts on behalf of a corporation that does not yet exist;
Ordinarily, a promoter is not relieved of liability under a preincorporation contract
simply by reason of ratification of that agreement by the corporation. The promoter
must see the agreement through!!
a) DURATION:
 Do not cease to be promoters upon incorporation
 Promoter liable until the entire promotion scheme carried through, including final
original stock transfers – ratification at earlier date does not terminate that liability
to subsequent original issue stockholders
b) FIDUCIARY DUTY TO CORPORATION AND SUBSCRIBERS:
 Promoter’s have fiduciary duty to the corporation, include good faith duty
 Promoter’s liability continues until his promotion scheme has been carried through
and all capitalization has been completed
 Ratification of wrongful act (non-disclosure to future subscribers) committed
prior to full capitalization under promotion scheme cannot absolve promoter of
liability
Promoter’s Liability
c)
Issues
 Liability of promoters
 Liability of corporation
 WHEN corporate liability attaches to promoter’s pre-incorporation actions
49
MBCA 2.04 All persons purporting to act as or on behalf of a corporation, knowing
there was no corporation, are jointly and severally liable for all liabilities while so
acting.
e) FLORIDA 607.0204 .--All persons purporting to act as or on behalf of a corporation,
having actual knowledge that there was no incorporation, are jointly and severally
liable for all liabilities created while so acting except for any liability to any person who
also had actual knowledge that there was no incorporation.
 >>> Some states may look at 3d party’s knowledge
Promoter’s generally personally liable for actions taken prior to incorporation
a) Generally-Owners cannot claim acting as agents of corporation b/c corp does not yet
exist
 No agency relationship can exist in the absence of a principal The corporation is
not liable on the contract until it ratifies the contract;
 Generally Promoter cannot bind a corporation that does not exist but
promoter may look to that corporation for ratification after the fact and
indemnification. O’Rorke v. Geary
d)
2)
Although there are cases to the contrary, the traditional common law view is that, prior to
the time a corporation is properly formed, the entity created by the proposed incorporators
exists as a partnership. Each partner is ordinarily jointly and severally liable for the
obligations of a partnership.
Siegels
3)
4)
3 Ways To Deal With Pre-Incorporation Contracts
a) TREAT AS OFFER. Create a contract binding on the corporation if he takes on its
behalf an offer which is accepted after formation of the corporation
 PROBLEM: No one to enforce contract against in interim; can’t perform under K
until corporation formed
b) RATIFICATION / INDEMNIFICATION; Bind himself and look to proposed company
for ratification and indemnification
 PROBLEM; Promoter remains liable and has to look to company for
indemnification
c) NOVATION; Make a contract binding himself but releasing him from and shifting
liability to corporation once formed
d) Existence of promotional relationship is not enough to establish the liability of a postcontract corporation
Theories Advanced for Corporate Liability for Promoter Contracts
a) Courts recently relying on Adoption/Ratification Theory
b) Ratification
 Corporation’s retroactive acceptance of act of its agent
 Problem is that principal must exist at time of K (for capacity) and does not
 Because it RELATES BACK to date of contract
c) Adoption
 Corporation’s assent to a contract made in contemplation of assumption by
corporation
 Takes promoter’s contract rights and makes them its own
 Binding as of DATE OF ADOPTION
 But nothing prevents adopting retroactively as of date of contract
 Like ratification, may be shown by
 knowingly accepting benefits
 performing obligations imposed on it
d) Acceptance (of a Continuing Offer)
 Explains how ADOPTION can occur:
 See contract as a CONTINUING PROPOSAL which corporation may accept when
it comes into existence
e) Formation of New Contract
 Adoption is the making of a new contract for new consideration
50
f)
Novation
 Contract contemplates adoption/acceptance it contemplates a novation
 Courts recently not relying on novation – but on adoption/ratification
 is a CONTINUING PROPOSAL which corporation may accept when it comes into
existence
O’Rorke v. Geary promoter case
g) ISSUE: Does promoter bind himself or the company be to be incorporated under preincorporation contracts?
h) FACTS: Geary contracts (for bridge company to be formed) with O’Rorke to build a
bridge. Geary thereafter claims no liability under K- claims corporation is liable.
i)
RULES:
 Promoter cannot bind/contract with a corporation that does not exist
 HOWEVER, promoter is allowed to :
1. Create a contract binding on the corporation if he takes on its behalf an offer
which is accepted after formation of the corporation
2. Make a contract binding himself but releasing him from and shifting liability
to corporation once formed
 =NOVATION
3. Bind himself (as the promoter) and stipulate in the K that the proposed
company will indemnify the promoter
 Court found Geary in this position
 Necessary conclusion of the applying traditional agency principles
j)
HOLDING. Court disagrees – makes Geary personally liable as promoter because
he could not act as agent for a corporation principal that did not yet exist and
would not likely exist by the time of completion of the K; can only look to
corporation for indemnification.
k) ROL: Where Δ entered into a contract for a bridge company, to be incorporated, and
signed the contract individually without seal and the contract provided for the
immediate commencement of the work before a company could be incorporated, Δ is
personally liable on the contract.
Old Dominion Copper Mining
Water stock came from a old practice, feed cattle a lot of water.
Property – bought it for 1 million and want to sell it for more.
Owners of property form a corp. and buy the property for 3 million, there are no other shareholders.
They know the property does not worth 3 million but the corp. subsequently sell stocks to public based on
valuation of 3 million.
Issue: is whether they defraud
Court said no. There is no fiduciary duty.
SEC is always concerned related party transaction.
This case is a good example what corporate lawyers do, figure out the scamp to the shareholders.
Shareholders can sue corporation, but not the promoters.
Old Dominion Copper Mining Co v. Lewison
l)
ISSUE:
 Issue is not the disclosure problems with the public sale
but the distinct nature of the corporate entity, distinct from its shareholders
 Whether the Corporation can take action against the promoters for actions it
approved or otherwise ratified with full disclosure when stock changed hands …
m) FACTS
 Corporation sought to rescind a sale to it under promoter’s scheme where
promoter sold property to corporation at inflated prices (watered stock=Par
51
n)
value stock issued for consideration with a value less than par)?why is this
here?
 Subsequent public subscribers thought assets properly valued
 Promoter did not disclose the profit scheme to public subscribers
 Corporation seeks to recover a secret profit made by promoters in breach of trust in
the sale of their own property to the corporation
 Sought to implicate promoters as liable to shareholders / corporation for
actions taken in forming and capitalizing the corporation
 Promoters for Syndicate purchased property from Baltimore Co and Keyser
worth $1M (paid in cash and notes by Promoters)
 Promoters for Syndicate transfer purchased property to NEWCO
 Baltimore Co / Syndicate then purchases property worth $1M for 100,000
shares of stock of NEWCO at $2.5M -- at a large profit– more than value of
Co
 Baltimore Co. / Syndicate purchases land worth $5K for 30,000 shares at
$750K (which went to Promoters Lewishon and Bigelow)
 NEWCO offers 20,000 shares of stock to public without disclosing profit
made
 $1M Co sold as $2.5M Co to public
 Public buys $500K of stock
REASONING/ RULES
 Corporation is a separate and distinct from its shareholders
 Change of stockholders / ownership of corporation does not alter the
corporate personality
 Corporation ratified the public sale with full disclosure
 All members involved in plan to buy for less and sell to corporation for
more
 Bigelow and Lewis got shares for the sale of the real estate but the
syndicate was paid for it, whoever received it was approved by the
syndicate
 Corporation “in full life” with 13/15ths of stock issued when it assented to
sale with full knowledge of facts
 Shareholder cannot complain in the name of the corporation for actions of
corporation or its promoters when shares change hand – it is still the same
corporation
 Change in stockholder composition / internal constitution of corporation does
not change the character of the corporation
 Corporation did not get a new right when new blood that did not know of
actions of old blood came in
 Corporation had ratified what it did – irrelevant that new members did not
know of those actions
 If facts gave them / shareholders no claim, they also gave none to the
corporation
Old Dominion Copper Mining Co v. Bigelow
o) ISSUE:
 Court found corporate right of action against promoters selling property to the
corporation at inflated prices
 Is promoter immune from liability for an act in breach of trust of subscribers if
promoter owned all issued stock at time of act, although additional issue to the
public contemplated by promotion scheme where there will not be full disclosure?
NO
 Ratification does not absolve promoter of liability
 Promoter remains liable to corporation until promotion scheme completed
52

p)
q)
r)
Whether the ratification of the breach of trust while promoters scheme still
intended an issuance to the public of a substantial portion of the stock absolves
promoter of liability? NO
FACTS:
 Corporation seeks to recover a secret profit made by promoters in breach of trust in
the sale of their own property to the corporation
 See Lewison above
Δ/Promoter’s Argument:
 Promoter may sell property to corporation if contract ratified by shareholders of
fully-formed corporation with full disclosure
 When promoter himself is the real subscriber of all shares
REASONING:
 Promoter cannot sell his own property to the corporation at an advance (on profit_
without full disclosure
 RULE: There is a liability of the promoter to the corporation when the original
subscribers to the capital stock contemplated in the promotion scheme came in
after the transaction
 Although property purchase ratified by all shareholders at that time, it was not all
proposed shareholders under the promotion scheme for the corporation
 RULE: Promoters are liable to the corporation until all prospective
original subscribers for stock have been completed
 Liability until his job is finished > i.e. capitalization
 Promoter still liable to corporation and its subscribers to make full disclosures
 Ratification invalid -- does not dissolve promoter of his fiduciary duty to
the corporation, when, as part of promotion scheme, uninformed
stockholders are to be brought in after the wrong perpetrated and its
ratification


VIEW OF PROMOTER LIABILITY - LEWISON
 It is not that no wrong has been committed – but there is no one to enforce the
remedy
 No man can be on both sides of the bargain
 Looks at corporation as indistinct from its shareholders so that
misinformed subsequent shareholders cannot object to corporation’s prior
ratifications of wrongdoing (i.e. breach of trust)
 Allows corporation to ratify act which absolves promoter of liability,
although promoter’s role not complete
VIEW OF PROMOTER LIABILITY – THIS CASE
 Promoters remain liable to the corporation – there is someone to enforce
remedy
 Promoters have fiduciary duty to subscribers and is liable to the
corporation until he has carried out his promotion scheme in totality
 Promotion scheme defines the boundaries of the promoter’s liability
 Cannot change hats/roles – promoter to director – to dissolve himself of
liability
 Its how you look at it
 If Corporation distinct from shareholders– corporation can be wronged by
its promoters
 If Corporation not distinct shareholders (not the case) – corporation
cannot be wronged when shareholders wronged by promoters
 Promoter remains liable to corporation until all original issue stock is
issued; ratification of wrongdoing at prior stage invalid to release
promoter of liability
Old Dominion Copper Mining & Smelting Co. v. Lewisohn
53
[Corporation is not affected by a change in its members—corp has separate existence]
[If corporation discloses everything—bars complaints from sh/s when shares change hands]
Facts: Promoters bought land for mining for $1M. The promoters then form a company. They sell it to
their company that they bought for $3M and paid back in share of the company. They go out and sell
the stock of the company, and collect $3M from the public. The promoters end up receiving $3M for
something they paid $1M for.
Issue: Did the promoters do anything wrong?
Holding: No. The corporation remained unchanged and unaffected in identity by a change in its
members (change occurred when promoters sold their stocks in the company). No breach, corporation
knew what was going on—its management was in fact the promoters.
Note supports conclusion that ratification by a corp upon full disclosure will bar any complaints
when the shares change hands
Old Dominion Copper Mining & Smelting Co. v. Bigelow
[Promoters must make full disclosure to corporation when making transactions w/ corp]
Facts: Π/corporation seeks to recover a secret profit made by promoters in the sale of their own
property to the corporation.

See Lewison above
Issue: Whether the promoter is immune from liability?
Holding: No—promoter must make full disclosure to corporation.

Court found corporate right of action against promoters selling property to the corporation at inflated prices
The court found that


a)
Ratification does not absolve promoter of liability
Promoter remains liable to corporation until promotion scheme completed
REASONING:
 Promoter cannot sell his own property to the corporation at an advance (on profit_ without full disclosure
 RULE: There is a liability of the promoter to the corporation when the original subscribers to the capital stock
contemplated in the promotion scheme came in after the transaction
 Although property purchase ratified by all shareholders at that time, it was not all proposed shareholders under the
promotion scheme for the corporation
 RULE: Promoters are liable to the corporation until all prospective original subscribers for stock have
been completed
 Liability until his job is finished > i.e. capitalization
 Promoter still liable to corporation and its subscribers to make full disclosures
TAKEAWAY Fiduciary duties were there in other court, not there in state court!!
Fiduciary Duties of Promoter to Future Shareholders Fiduciary duties are flexible and different courts will interpret
differently
a) Lewison Court View – Holmes SC
 Corporation is a distinct entity from its shareholders
 Corporation (via shareholder) cannot file a complaint for actions of corporation or its promoters when shares
change hand – it is still the same corporation
54

b)
Corporation had ratified what it did with full disclosure– irrelevant that new members did not know of those
actions
Bigelow Case View – Ruggs SC
 Irrelevant that at time of act all shareholders ratified the act – if the promotion scheme contemplates and requires
additional original issues – promoter remains liable to subsequent original issue shareholders for full disclosure
 Even after the corporation is formed, the Promoter has liability until his work as promoter of the corporation is
done, and that includes completing required capitalization needs as per promotion scheme
 Promoter’s liability to corporation and its subscribers does not end when corporation formed
Why Corps must be registered with the state!:
If T contracts with Moe acting on behalf of BBP partnership, T does not need public notice that BBP is a
partnership. BBP’s status as a partnership does not affect T’s rights to enforce that contract against the owners of
the business. On the other hand, if T contracts with Moe acting on behalf of BBC corporation, T should have at least
public notice that BBC is a corporation. BBC’s status as a corporation affects T’s rights to enforce that contract
against the owners of the BBC/business. Thus, a filing is required to give public notice for the creation of a
corporation and no filing is required to give public notice of the creation of a partnership.
General “thing” 2: Ignore statements in other student guides about a shareholder’s “limited liability.” Such
statements are misleading at best. A shareholder does not have “limited liability” to a corporation’s creditors.
Instead, a shareholder has “limited loss exposure.” If you bought BBC stock for $100 and BBC closes owing
creditors hundreds of thousands of dollars, you do not owe BBC creditors anything—not even $100. You lose your
$100 investment. That is your limited loss exposure. 76 You do not owe BBC’s creditors $100 just because you paid
$100 for your stock. A shareholder’s does not have liability to the corporation’s creditors based on the amount she
paid for her stock. Limited loss exposure, not limited liability.
B.
Mechanics of Incorporation
1) Business Plan
a) Nature of Business
b) Capital / Debt Structure Loan or Stock
c) Ownership Interests
d) Majority Rule or Veto power
e) Control and Management ***
f)
Lease or purchases
g) Budget
h) NEED TO KNOW TO SELECT PROPER TYPE OF ENTITY
2) MBCA 4.01 / 4.02 Corporate Name
a) Can reserve name in advance (MBCA: 120 days)
 Varies by state
b) Secretary of State search
c) Federal copyright check
d) State and federal tradename or trademark name check
3) MBCA 6.20 Subscription Agreement
a) Agreement to purchase stock
b) Irrevocable for 6 months unless otherwise stated
or all subscribers agree to revocation
c) Default –Only Board has authority to offer stock
4) MBCA 7.32 Shareholder Agreement / Operating Agreeement
a) Addresses many aspects of Business Plan
 Stock transfer restrictions
 Buy-Outs
 Non-compete
55
b)
c)
d)
e)
 Dispute resolutions
Valid only for 10 years unless agreement otherwise provides
Must be signed by all shareholders and binds corporation and all subsequent
shareholders
Legend on stock certificates
Shall cease to be effective upon going public see 4 below
There are at least six things you need to take away from this excerpt of MBCA S 732:
(1) Agreements under MBCA S 732 are called “shareholder agreements"
(2) MBCA S 732 shareholder agreements must be agreed to by all the shareholders at
the time of the agreements
(3) In an MBCA S 732 agreement, all shareholders can agree to eliminate the board of
directors so that shareholders are running the corporation or instructing the
board as to what it can do or will do
(4) Public corporations do not have MBCA S 732 shareholder agreements,
Bcuz public comps can get huge # of shareholders! An MBCA 732 shareholder
agreement makes no sense for a public corporation like McDonald's. It is hard to
imagine all of the millions of shareholders of a public corporation like McDonald’s
agreeing to anythingfmuch less agreeing to eliminate the board of
directorsAccordingly, MBCA 7.32 expressly provides that any shareholder
management agreement "ceases to be effective when the corporation becomes a public
corporation,"
(5) MBCA S 732 shareholder agreements are different from the shareholder voting
agreements in that:
(a) MBCA S 732 -shareholder agreements affect how a corporation is
governed;
-shareholder voting agreements simply affect how the contracting
shareholders will vote their shares
(b) MBCA S 732 shareholder agreements are valid only if all shareholders at
the time of the agreement enter into the agreement;
-shareholder voting agreements require only that two or more shareholders
agree.
(6) If an MBCA S 732 shareholder agreement eliminates the board of directors so that
shareholders have the power of directors, those shareholders have the same "liability for acts or omissions imposed by law on directors."
5)
6)
Presence in State of Incorporation
a) Technical Office
b) Registered Agent
MBCA 6.20 Articles of Incorporation/Corporate Charter
a) REQUIRED:
 Name
 address
 $ of authorized shares of stock of the business
 CAUTION: Some states tax on number of shares (Delaware franchise tax)
 Registered Agent
 Special provisions governing the corp
 Incorporator
 Directors (Optional)
b) 101 – 102 DGCL
56
7)
8)
9)
 Also:
 Address
 Purpose
 Directors, if incorporator’s powers terminate
c) APPROPRIATE
 Shareholder Pre-Emptive Rights
 If shareholders adopt bylaws
d) Should be limited to statutory requirement to avoid limiting scope of business
e) Where to vest power to amend Articles or Bylaws – Check binding law
 MBCA 10.20 gives Board and shareholders the right to amend Bylaws unless
Articles state Board of Directors cannot
 Delaware Act gives only shareholders the right to amend the Bylaws unless
Articles give the Board the power/authority
 Decision can provide advantage to one side or the other in a battle for corporate
control yet may restrict flexibility of Board to respond to business situations
 Shareholder may want to control the Board from amending Bylaws without their
authority
f)
Defective filing (usually without knowledge) may allow for a de facto corporation with
limited liability for stockholders
g) See applicable statute on amendment of Articles
 May require Articles grant or restrict authority beyond statute
MBCA 2.06 Bylaws (like corporation’s statutes)
a) Governs management and operation of the corporation
b) If silent, defaults to statute rules
c) May be given to shareholders only, or shareholders and Board, depending on applicable
law
d) Power to adopt or amend bylaws usually limited by statute to shareholders, sometimes
also given to Board
 Check applicable law – may require Articles grant or restrict authority beyond
statute
Authorization to Do Business in Other States
a) Foreign corporations may not transact business in states where they have not been
authorized to do business
 MBCA 15.01 What is NOT doing business?
 Litigation
 Board meetings
 Bank accounts
 Selling through independent contractors (NOT EMPLOYEES)
 Loans, mortgages or security agreements
 Owning property
Organizational Meeting --going to specify:
a) Adopt bylaws
b) Corporate secretary (who will take minutes of meetings + certify that records of the
comp are records of the comp)
c) Elect officers and directors
 Same person cannot be President and Secretary
d) Compensation of officers
e) Ratify contracts and other obligations incurred by promoters
f)
Authorize bank account signatories / limits
g) Authorize leases and other needed contracts
h) Minutes or Unanimous Consent – creating the record
 Held after due notice or notice waived
 Special or Regular
 Dates and times of the meetings
 Who in attendance / quorum present
 Reference substance of any reports
57
C.
 Reference discussion
 Record Vote
 LESS IS BEST
10) Comply with Federal and State Securities Laws
11) Stock Issuance
a) Secure payment of consideration
b) Issue stock certificates
c) Default –Only Board has authority to offer stock
12) Tax ID #
13) Sub-S Election
a) 75 days from date of incorporation
14) Local Licenses
Law of Corporations
1) Statute
2) Articles of Incorporation
3) Bylaws
4) BOD Resolutions authorizing Management/Officers to act
Effects of Defective Incorporation de jure corporation +
de facto corporation + corp by estoppel
 In sum, a de facto corporation or corporation by estoppel, like a de jure
corporation (a corporation by law), protects a business’s owners from personal
liability on the business’s obligations.
 De facto corporation and corporation by estoppel are both terms that are used
by courts in most common law jurisdictions to describe circumstances in which
a business organization that has failed to become a de jure corporation (a
corporation by law) will nonetheless be treated as a corporation, thereby
shielding shareholders from liability. Wikipedia.
A De-facto corporation
= a de facto corp may be formed if there is a good faith effort to incorporate, and actual
exercise of corporate powers., and there is a law authorizing incorporation
 good faith effort to incorporate =attempted to file but something
happened: not “forgot to file” or “left on desk”, but lost in the
mailavoids liability
the people running the business (1) attempted to incorporate and (2) thought the
attempt was successful. did everything to form a corporation that we can
reasonably expect them to do
Corporation by Estoppel doctrine
= a person seeking to hold a corporate officer personally liable may not do so if he has dealt
with the association as if it were a legally-existing corporation. IBM dealt with the business as
if it were a legitimate corporation, and relied on its credit rather than that of Cranson,
personally. Thus, it is estopped to assert that the business was not incorporated.
= If P or D was dealing with a business as if it were a corporation or if they are deriving the
benefits of the alleged non-corporation, should an action arise out of these dealings, P or D will
be estopped/ prevented from declaring the company is not a corporation
Because dealing with a business as if it were a corporation = an admission that
the entity is a corporation  estoppel
the doctrine of estoppel may be applied for the benefit of a creditor to estop the corporation, its
members, or its stockholders thereof, from denying its corporate existence = the defective corp cant
exploit this loophole even if defective incorporation was a mistakecreditor can get the corp’s money.
By holding otherwise, parties might avail themselves of the powers and privileges of a corporation,
without in any manner subjecting themselves to its duties and obligations (and might set up their own
58
neglect of duty, of wilful omission to comply with the requirements of the statute) as means of
discharge from all their just obligations under the law. This is forbidden by every principle of law and
justice, and hence such a defense could never be tolerated."
D/Borrower/mortgagor/debtor cannot claim/will be estopped from claiming as a defense to avoid
paying his debt that(P/creditor’s or D’s corporation DNE
Remember: Borrower/mortgagor/debtor= a person or institution that owes a sum of money
Corporation by Estoppel Doctrine ARE CLAIMS OF CORPARATION’s
inexistence ESTOPPED by both parties? Yes
 P cant assert D or D’s shareholders are personally liable because of D’s defective
MBCA 2.04

incorporation (if P dealt with D as if it were a corp): The P/person doing business with
such an entity/D as if it were a limited liability entity or corporation may later
be estopped from arguing that D is not in fact a limited liability entity in an attempt to
reach the assets of the incorporators.
D can’t deny its own corporation’s existence to avoid liability if D dealt with P as if D
were a corp: For the same reason, defendants who had acted as a corporation will be
estopped from denying liability as a corporation when sued by a plaintiff who had relied
on the defendant's corporate form when dealing with the defendant.
Other important Background:
B.
C.
MBCA 2.04 (Rev) Personal Liability will be imposed only on persons who act on behalf of a corporation
knowing that the corporation does not yet exist = bad faith
1) Recognizes the DE FACTO CORPORATION doctrine
 OLD MBCA attempted to eliminate the doctrine – anything short of filing was
defective
 Important because if de facto corporation does not exist when and there is no de
jure corporation  the shareholders are open to unlimited liability
 NORTH CAROLINA does not accept the “knowing” requirement
Doctrines Providing Unlimited Liability to Officers in Defective Incorporation
MBCA 2.04 De Facto Corporation Doctrine
 If there has been a bona fide effort to comply with

b)
c)
d)
the law to create a
corporation and the company has functioned/acted like a corporation
company is a de facto corporation and its sh/s are protected from private
lawsuits
attempted to file but something happened: not “forgot to file” or “left on
desk”, but lost in the mailavoids liability
NARROW EXCEPTION =rarely exempts people from liability
May arise when Articles of Organization not filed but there was any of the following:
 Bona-fide good faith effort to charter
 Participant believed Articles filed but they were not
 Articles mailed to Secretary of State but delayed or returned
 Δ enters into a contract on behalf of the corporation and Л deals with the
corporation not the individual, even though its Articles not filed.
 Passive investor restricts use of funds until Articles filed but managers commence
operations prior
Requires Cranson v. IBM
 Law authorizing incorporation
 Good faith effort to incorporate / Believed there was incorporation?
59
 Actual use or exercise of corporate power
 Common law did not recognize this – not all states follow it
The terms “de facto corporation” and “corporation by estoppel” are used when (i)
there were problems with the formation of the corporation, and (ii) people starting
the business were unaware of the problems, and (iii) the business made a contract
or commits a tort. The owners of this business will be personally liable for this
contract or tort unless they can convince the court to apply either the de facto
corporation doctrine or the corporation by estoppel doctrine. The critical facts for
de facto corporation are that the people running the business (1) attempted to
incorporate and (2) thought the attempt was successful. For example, Larry, Moe,
and Curly hire attorney James M. McGill to prepare and file articles of
incorporation for BBC. They execute the articles and issue a check for the filing
fee. McGill slips up by not filing the articles. Not knowing about McGill’s slip,
Larry, Moe, and Curly start operating BBC and contract to sell barbecue to Acme
Nursing Home (Acme). They breach the contract with Acme. Larry, Moe, and
Curly might be able to avoid personal liability on the Acme contract by invoking
the de facto corporation doctrine. Some courts might conclude that Larry, Moe,
and Curly did everything to form a corporation that we can reasonably expect
them to do and so should be treated as if BBC was a de facto corporation.
-common law did not allow this defense
Delaware Act forbids defective incorporation as a defense to any claim =The Delaware Act
§329 provides that “the want of legal organization” may not be used as a defense
to any claim
Corporation by Estoppel = Promissory Estoppel (P/debtor relied on incorporation to his
detriment)
= P or D is prevented from declaring the company is not a corporation if they were dealing
with a business as if it were a corporation or if they are deriving the benefits of the alleged noncorporation should an action arise out of these dealings
 Because dealing with a business as if it were a corporation  an
admission that the entity is a corporation  they will be estopped to
deny its incorporation/prevented from alleging the corporation DNE/they will
be estopped from seeking to hold an officer of a defectively incorporated
corporation personally liable for that person’s wrong/ prevented from declaring
the company is not a corporation
D/Borrower/mortgagor/debtor cannot claim/will be estopped from claiming as a defense
to avoid paying his debt that(P/creditor’s or D’s corporation DNE
Borrower/mortgagor/debtor= a person or institution that owes a sum of money
ARE CLAIMS OF CORPARATION’s inexistence ESTOPPED by both parties? Yes
BBC was defectively incorporated unbenoun to Acme. Acme contracts with BBC. BBC breaks the
contract. Acme sues BBC. Larry, Moe, and Curly (of BBC) might avoid personal contract liability to
Acme by invoking corporation by estoppel.  The critical fact will be whether Acme believed that it
was contracting with a corporation. If Acme believed that BBC was corporation, then Acme was
willing to make a deal in which Larry, Moe, and Curly had no personal liability. If Acme was now
permitted to recover from the personal assets of Larry, Moe, and Curly, Acme would be getting legal
rights that it did not bargain for an unfair “windfall.”
60
II.
III.
P cant assert D or D’s shareholders are personally liable because of D’s defective incorporation (if P
dealt with D as if it were a corp): The P/person doing business with such an entity/D as if it were a
limited liability entity or corporation may later be estopped from arguing that D is not in fact a limited
liability entity in an attempt to reach the assets of the incorporators.
D can’t deny its own corporation’s existence to avoid liability if D dealt with P as if D were a corp: For
the same reason, defendants who had acted as a corporation will be estopped from denying liability as
a corporation when sued by a plaintiff who had relied on the defendant's corporate form when dealing
with the defendant.
1)
2)
3)
4)
Doctrine of Incorporation by Estoppel
a) (Cannot Deny Corporate Existence)
b) Person dealing with an association (even their own) in such a manner as to recognize
and admit existence of corporate entity is estopped from denying the corporate
assistance and seeking to hold an officer of a defectively incorporated corporation
personally liable for that person’s wrong
c) Even if the corporation is not a de facto corporation
d) Usually applied when value given, such that D/party receiving value cannot seek to
resist P’s recovery on the grounds it was not a legal corporation Pochahontas v.
Tarboro
e) Can we estop either party from claiming lack of incorporation? Yes.
 Creditor sues shareholder as partner because no bona-fide effort to incorporate,
 Although officer thought in good faith
 Court will says you dealt with them at corporation
Delaware Act forbids defective incorporation as a defense to any claim
Pocahontas Fuel Co. v. Tarboro Cotton Factory
a) ISSUE: Personal liability of shareholders of a company operating under a defective
charter
b) De Facto Corporation Doctrine not estoppel??
 Bona-fide effort to incorporate – Charter exists but not filed
 Persons have acted in reliance of incorporation
 Persons have exercise function of corporation
c) De facto corporation may exercise the powers assumed
d) Doctrine of Estoppel did not apply here
 Doctrine of estoppel usually applied when value was given to P, such that party
receiving value cannot seek to resist recovery on the grounds it was not a legal
corporation
Corportion by estoppel Usually enforced for creditor when debtor claims defense but not
vice versa
Cranson v. IBM – Estoppel
5)
[Changed common law rule now allows promissory estoppel as a defense]
a)

b)
c)
d)
CHANGE FROM COMMON LAW – Not all states adopted
Facts: The Cranson business of the new venture was conducted as if it were a
corporation. Cranson was
elected president and conducted transactions with
I.B.M. Due to an oversight, the certificate of incorporation for Cranson was signed but
not filed when Cranson purchased items from IBM. IBM argued that Cranson was a
partner (and thus personally liable) because Cranson’s corporation did not really exist.
ISSUE: Personal liability of Cranson officer of a company operating under a defective
charter that believes incorporation had occurred
IBM sues Cranson personally for the purchase for corporation of IBM typewriters.
Cranson thought Articles filed by lawyer but they were not. IBM sues for purchases
during period prior to incorporation
IBM is neither de jure or de facto corporation
61
e)
f)
g)
B.
Court finds that IBM is estopped from denying the corporate existence because IBM
did business with Cranson as Cranson was an officer of the corporation
 Relied on the corporation’s credit
Cranson not personally liable
See DGCL 329 Defective organization cannot be used as defense to any claim why is
this here?
Capital Formation – First Look
1) Forms of Capital
a) Financing / Creditors
 Third party or shareholder loans
 Secured or unsecured
 Recourse or non-recourse
 Bonds / Debentures
 Loans given by the public, evidenced by bonds issued by the company
 Secured or unsecured
 Certificate that contains a promise from the corporation to repay the lender the principal plus interest at some
future dates
 Bondholders have priority over shareholders in liquidation / bankruptcy
b) Equity / Stocks
 Certificates that reflect an ownership interest in the corporation
 Creditors have priority over Shareholders in liquidation / bankruptcy
2) Stock
a) Generally, all of the shares of stock issued by a corporation are the same. Each share carries one vote on
matters that shareholders vote on
b) Common Stock
 =aliquot ownership in the corporation
 Paid dividends
 May be divided into separate classes with different rights (voting, dividends)
c) Preferred Stock -paid first
 =Stock that gives preference over common stockholders in receipt of dividends and in liquidation after
dissolution
 To illustrate, Baker Corp has issued 100 shares of Class 1 and 200 shares of Class 2. Baker Corp’s articles
provide that Class 2 has a $5 liquidation preference. Baker Corp dissolves and has a $1,100 surplus.  Each
of the 200 shares of Class 2 would be paid $5 first—before anything is distributed to the Class 1 stock.
=Under these facts, a holder of a Class 2 stock would receive $5 for each share of Class 2 stock she owns,
while a holder of Class 1 stock would receive $1 a share for each share of Class 1 stock she owns because the
remainder is $100 from that $1100
 Usually given a specified dividend - % of liquidation value – before common shareholders
 Usually non-voting unless dividends are missed for some specified period of time (springing voting rights)
 May be cumulative or non-cumulative-meaning if the cumulative were not paid before, they need to be paid
for the time before and also this years dividends due
d) Par Value = minimum issuance price= the minimum value a stock may be issued by BOD (stated in the
AOI)
 Par value has no effect on the price for which a BBC shareholder later resells his shares.
 =it is an Artificial value designation
 watered stock=Par value stock issued for consideration with a value less than par)
 BOD has a duty to not issue watered stock, otherwise they will be liable for the difference ???relevant???
 MBCA does not require par value for stock
 MBCA tieds dividend restriction to solvency tests, not capital accounts
 Still have par value but only because Delaware doesn’t let go it
 Delaware Act also allows issuance of no-par stock but corporation must designate an amount for stated capital
 Tied to Delaware’s limitation on dividends from capital
62
 Cannot sell stock for more than par, can sell for less – SO KEEP IT LOW
Redemption and Conversion
 Redeemable / Callable - Bonds or Preferred Stock
 Board can call bonds or stock – pay it off / buy it back before expiration
 Usually with penalty
 Holder will want call protection – penalty for call
 If redeemable, Directors can call bonds or preferred stock when market rate better
 If paying preferred 8% and market interest rate is 6% will want to call
 Conversion Rights - Debt convertible to stock
 Provides incentive to lender to offer lower interest rate
f)
Stock Representations
 Duly authorized - Charter and Board authorized
 Fully Paid – Paid in full
 Non-Assessable – Fully paid
Dividends
a) Pro rata claim by the shareholder on the earnings of the corporation
b) Board of Directors must declare dividends before shareholders entitled to them
 No rights in dividends until declared
c) Preferred shareholder dividends may be cumulative or non-cumulative
 Cumulative – if preferred dividend is missed, common stockholders cannot receive a dividend until any
preferred dividends in arrears are paid
 Non-Cumulative – preferred dividends not declared are forfeited
Balance Sheet both sides “balance” out
a) Assets = Source of Assets
Assets
 Current/Short term (cash or assets convertible to cash)or fixed/long term (asset not converted to cash w/in a
year)
 Valuing Assets
 Book Value – purchase price
 Mark-to-Market – at current market value
 Accounts Receivable / Bad Accounts
 Intangible Assets (Patents and Goodwill)
 Amortized
 Tangible v Intangible
 Tangible
 Intangible: goodwill, patents
 Goodwill
 The value paid in excess of the tangible assets of a purchases business
 Assets + Goodwill = Purchase Price
 Usually the revenue flow and profits of the company
 Goodwill must be written off if the acquired business declines in value
 Patent
 Limited life and its value is intangible
 LIFO/FIFO-Last in First Out, or First In First Out, does not matter only a formula to determine the value of
the inventory
 Collection of accounts receivable
b) Liabilities
 Debts of the corporation
 Short-term or long-term
 Senior or junior –priority over payment in bankruptcy
e)
3)
4)
Remember that debt comes before/above equity in a balance sheetfilel, rights of creditors come
above/before rights of shareholders Creditors also come before shareholders in state corporation
statutes
Equity
63
=assets – debt/liabilities
=the difference between the value of the assets and the value of the liabilities of
something owned
Ex. Someone gives you a car worth $15k for free you now own $15k of equity in that car
Ex. how much you've paid off on a debt in something you own *take into account the new market price!
For example, if someone owns a car worth $15,000, but owes $5,000 on a loan against
that car, the car represents $10,000 of equity.
c)
Equity Capital
 Common Stock and Preferred Stock (liquidated preference)
 Stated Capital Account
 Reflects par value of common stock
 Some states prohibit payment of dividends out of Stated Capital
 Capital Surplus Account
 Reflects difference between par value and amount corporation received for stock
 Some states restrict payment of dividends out of Capital Surplus
 Retained Earnings
 Profits not paid out as dividends
 Usually the source of dividends
d) Liabilities + Equity = Corporation Funding
Aka
(debts + stated capital) = "Surplus”
 Borrowings
 Sale of Stock
 Retained Earnings
e) Period Covered
 Balance Sheet – As of Specific Date
 Income Statement – Period
5) Income Statement
a) Shows profit or loss for a particular accounting period
b) Shows expenses and revenue
c) Includes non-cash charges such as depreciation
d) Ratios:
 ROE - return on equity = Profit/Capital
 PE Ratio = Market Price of Stock / Earnings Per Share
e) Operating Income = Sales – CGS
6) Statement of Cash Flows
a) Similar to income statement except that depreciation and other non-cash charges
are added back in to determine cash in and out
b) EBITDA – earnings before interest, taxes, depreciation and amortization
7) Lending v. Equity Financing
a) Leverage
 Using Borrowing / OPM to increase the return on your investment
 Equity financing dilutes the ownership interest
 Borrowing may be preferred because it provides leverage and avoids dilution
 Stock dilution, also known as equity dilution, is the
decrease in existing shareholders' ownership of a company
as a result of the company issuing new equity.

More borrowing allows for more leverage, great when the market is going up,
but compounded badly when the market is going down
CHAPTER 5 Piercing the Corporate Veil and Ultra Vires
I.
Piercing the Corporate Veil
64



Rarely happens because protection of the corporation’s owners from liability for the
corporation’s debts is an essential legal attribute of corporations. **LLC ARE EASIER TO
PIERCE
Cases are highly fact driven
None of the piercing the corporate veil cases in casebooks involve a corporation with more
than ten shareholders. None of the cases mention that fact.

Factors considered important in deciding to pierce the corporate veil: gross
undercapitalization, nonobservance of corporate formalities, nonpayment of dividends,
insolvency of the corporations a the time of the litigated transaction, siphoning of corporate
funds by the dominant shareholders, nonfunctioning of officers and directors other than the
dominant shareholders, absence of corporate record, use of corporation as a façade for the
conduct of the shareholder’s business.
** LOOK @ P. 164 ELEMENTS CONSIDERED WHEN PIERCING THE CORPORATE
VEIL.
A.
Disregarding the Corporate Entity
1) Equitable Principle
a) Based on equitable principles: fairness and fiduciary standards
b) If duly organized, you generally do not have personal liability
2) LEGAL APPROACHES:
a) Piercing the Corporate Veil
 Abuse of corporate privilege
 Individual shareholders disregard corporate entity and act for personal benefit
 Parent corporations may be liable for acts of subsidiary corporations
 Fraud is NOT required
 X Lawyers incorporating corporations in practice of law
 X Adequate capitalization alone is not sufficient to pierce the corporate veil
 Doctrines
 Alter Ego Doctrine
 Instrumentality Doctrine
 Identity Doctrine
 Agency Theory
b) Equitable Subordination
 Fraudulent conveyances
 Federal bankruptcy law and state fraudulent conveyance law
 1984 Uniform Fraudulent Transfer Act
 Federal bankruptcy law allows preferential transfers to shareholders or
others be set aside or subordinated to creditor debts (equitable
subordination)
 Prohibits assets being transferred for amount less than their fair market
value
 Fraud is NOT required
 Designed to avoid corporate assets from being removed to the
disadvantage of creditors
 Deep Rock Doctrine
c) Continuation
 Fraudulent conveyance of assets to another successor corporation owned by
same parties to continue business debt-free
 Transferee / successor corporation held personally liable on theory of
fraudulent conveyances or continuation
 Fraud may be required ????
 Liability NOT restricted to value of assets received
 Injured party can collect against either or both corporations
65
Piercing the Corporate Veil - Definition
a) Privilege of limited liability is not without its limits
b) Abuse of the corporate privilege allows the courts to disregard the corporate entity
and “pierce the corporate veil”
c) Usually to prevent fraud or achieve equity
d) Equitable owners of a corporation are personally liable when they
 treat the assets of the corporation as their own
 use control of corporation to further personal interests rather than corporate
business
 If a shareholder does not treat the corporation as a separate
entity, why should she be able to escape liability by asserting
that the corporation’s creditors, unlike her, must treat the
corporation as a separate entity?
 Small corporations scrutinized more than large corporations when piercing
corporate veil
Jurisprudence Variants of Piercing the Corporate Veil
1) Instrumentality Doctrine
a) Complete control and domination (finances, policy, practices)
 Corporate entity has no separate will
b) Control used to commit fraud, wrong, dishonesty or unjust act
c) Control is proximate cause of Л’s injury or loss
d) Developers Mainly Use This-Viewed to be instrumentalities of the individual
construction company,
2) Alter Ego Doctrine
a) Corporation relegated to alter ego of the shareholder
b) Requires Лs show:
 such unity of interest and ownership that the separate personalities of the
corporation and the individual no longer exist
 if the acts are treated as those of the corporation alone, an inequitable result
will follow.
c) Alter Ego doctrine applies to tort claims as well as contractual debts against a
corporation
d) Undercapitalized sometime influential
 PROBLEM: What is adequate capital?
e) Voluntary creditor is going to have a harder time piercing the veil than an
involuntary creditor
 Voluntary creditor has a greater opportunity to investigate
3) Identity Doctrine
a) Unity of interest and ownership such that corporation ceased to exist such
b) Adherence to the corporate fiction would only defeat justice or equity
c) Same identity – we combine and collapse into one
d) Luckenbach
e) Single part of a mechanism we can’t really pull apart
4) OTHER APPROACHES:
a) Agency Theory
 Holding larger or other corporations liable in agency
 Usually under the principle of RESPONDEAT SUPERIOR – holding the
whole enterprise responsible for the acts of its agents
 Have to show agency existed under actual or formal authority
 Walzisky
b) Equitable Subordination
 EXAMPLE: Re-Characterizing shareholder loan derived from withdrawal of
capital from a creditor liability back to capital, thereby changing its priority –
subordinate to creditors
c) Continuation
 Transferee / successor corporation held personally liable on theory of
fraudulent conveyances or continuation
3)
B.
66

5)
6)
Fraudulent conveyance of assets to another successor corporation owned by
same parties to continue business debt-free
Factors Considered
a) Commingling funds
b) Diversion of corporate funds or assets to non-corporate uses
c) Failure to maintain corporate formalities
d) Using same office, employing same employees
Other Matters
a) Identity Rule – Can’t incorporate every pencil
b) No public company has ever had its corporate veil pierced = ** NO
PIERCING OF PUBLIC COMPANIES (THAT ARE
REGISTERED WITH THE SEC).
C.
D.
E.
F.
Policy Issues
1) POLICY VIOLATION / FAVORING PUBLIC INTEREST
a) Dissent in Walkovsky v. Carlton
b) Limited liability sought through incorporation may be qualified or denied.
c) State policy should not allow abuse of corporate limited liability privilege to be
abused
 I.E. Intentionally undercapitalized to avoid liability
d) Court has power to refuse to condone a promotional scheme which attempts to
circumvent or undermine a legislative policy
e) A scheme designed solely to abuse the corporate privilege at the expense of public
interest
2) ANOTHER POLICY VIEW – FAVORING CORPORATE IDENTITY
 Cannot ignore separation between subsidiary and parent
3) UNDERCAPITALIZATION
a) If corporation undercapitalized and unable to meet liabilities certain to arise in
course of business, shareholder may be held personally liable
Undercapitalization
1) GENERALLY: Failure to provide adequate capitalization alone is not sufficient to
pierce the corporate veil
2) However, POLICY / EQUITY: If corporation undercapitalized and unable to meet
liabilities certain to arise in course of business, shareholder may be held personally
liable Walkovsky v. Carlton (dissent)
3) Reasonable amount – business has a chance – as measured at outset of business
a) Subsequent withdrawals irrelevant – unless made in BAD FAITH
Parent Corporations and Subsidiaries
1) Difference between piercing the corporate veil and a claim under the agency principle
to impose liability on the parent company for the acts of its subsidiaries when the
subsidiaries are part of the parent enterprise
2) Agency Principle of Respondent Superior
3) Parent may be held liable for subsidiary obligations if parent operates the entire
enterprise for is own personal benefit
4) Under RULES OF AGENCY parent is principal and subsidiary is agent
5) Walzinsky
6) Л stated wrong cause of action (piercing the corporate veil) when the appropriate action
was to claim liability of shareholder of multiple corporations as principal of taxi cab
corporations under agency principle of Respondeat Superior
7) Luckenbach
a) For all practical puroses, two concerns are one
b) Unconscionable to allow owner of fleet of steamers worth millions to escape
liability because it split entity into smaller $10K corporations
Minton v. Cavaney
1) Lawyer Incorporating is Practicing Law
2) ISSUE: Is attorney in forming corporation acting as an alter ego of the corporation
such that he could become personally liable? NO – HE IS PRACTICING LAW
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FACTS:
a) Л’s daughter drowned in pool leased and operated by Seminole Hot Springs
Corporation.
b) Л holds Δ Cavaney, an equitable owner and director, personally liable for judgment
against Seminole.
 Caveney equitable owner – was to receive one third share of company
 Cavenay kept corporate records at his office
 Caveney appointed director and could not “divorce the statutory
responsibilities of that office claiming his position was solely an
accommodation
c) Л Relies On: ALTER EGO DOCTRINE
d) Δ argues alter ego doctrine does not apply
 Δ argues he cannot be liable without opportunity to relitigate judgment
(Minton enforcing judgment against Seminole)
4) RULE / REASONING:
a) Alter Ego doctrine requires Лs show
 such unity of interest and ownership that the separate personalities of the
corporation and the individual no longer exist
 that, if the acts are treated as those of the corporation alone, an inequitable
result will follow.
 Л DID NOT MEET BURDEN OF PROOF
 Ignore the Corporate Form, no board meetings, no board members, if funds
needed the owner provides it, the corporation is never treated as being a
coroporation
 -No separetness
 -Treat corporate assets as their own, hold themselves out as responsible for
activities, and inadequate capitalization
 -Where a corporation is inadequately capitalized it might be able to pierce the
corporate veil
 -Best advice is you say need enough to cover expenses and need insurance,
particularly term insurance as opposed to funding the corporation themselves,
need liability insurance
 Sometimes liabilities may be unknown, can’t be something small, needs to be
considerable amount of insurance

b) Judgment being enforced against Caveney not binding on him
 He was not a party
 Not given the opportunity to litigate or “control” the litigation
 Res Judicata unenforceable
c) Inadequate capitalization alone may be sufficient to allow piercing the corporate
veil
 Capitalization trifling considering risks of doing business
 HOWEVER no standard establishing what is SUFFIICENT
5) HOLDING
a) Judgment being enforced against Caveney not binding on him
b) If it had been, he would be liable because of his participation, control and
inadequate capitalization
c) Cavaney held liable for his duties, and his inadequate capitalization
6) DISSENT
a) Lawyer’s services in incorporation
 Are not acts of or carrying on the business of the corporation
 Not engaging in business of corporation – but practicing law
b) Lawyer’s task of creating a corporation ready to engage in business
is not an alter ego of the corporation
-Note what the Lawyer did here, served on the board of directors, can be held liable sometimes for
the actions of the corporation particularly if they did something wrong
-Court looking to see if they can hold Cavaney liable and pierce the corporate veil
3)
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-Inadvertent Creditor-more sympathetic to the plaintiff, because they might have got hit by the truck
and the courts will say the creditor did not have the opportunity to review financial statements, may
lead more to piercing the corporate veil
-Very far in terms of any court has gone, NO court has pierced the corporate veil of a Public
Corporation
-Capitalization is also viewed at the time the corporation was incorporated, as long as you had
adequate capitalization to begin with it will look better for the corporation
-We have a history in this country of having minimums capitalization requirements, but difficult to
apply because one size does not fit all depending on the size of the corporation
-Courts say we will pierce on equitable grounds, meaning they will have considerable creditors
G. Walkovsky v. Carlton
1) Piercing the Corporate Veil v. Agency Theory / Respondeat Superior
2) FACTS.
a) Δ Carlton employs a common practice in taxi industry to own a taxi fleet under
various corporations, limiting his liability. Carlton owns all 10 corporations that
make up the fleet. Although independent corporations, they are operated as a single
enterprise
b) Л struck by taxicab owned by one corporation, Seon Cab Corp
c) Injured Л has claim against Seon Cab Corporation
d) Л also wants to hold Carlton, as the stockholder of the 10 taxi corporations,
personally liable
e) Wants to pierce the corporate veil because of fraud in corporate structure
 Separate corporations undercapitalized
 Assets of separate corporation intermingled
 because the multiple corporate structure constitutes an unlawful attempt
'to defraud members of the general public' who might be injured by the
cabs
3) RULE
a) Abuse of the corporate privilege allows the courts to disregard the corporate entity
and “pierce the corporate veil”
b) Difference between
 Finding a corporation is a fragment of a larger corporate combination
 Whereby larger corporation would be held liable
 Finding a corporation is a dummy for its individual stockholders who in reality
are carrying on a business in their own personal capacities for purely personal
rather than corporate ends
 Whereby individual shareholders reached by piercing the corporate veil
4) REASONING/ HOLDING
a) See Rule
b) Л failed to state a valid cause of action – made the wrong claim
 PIERCING CORPORATE VEIL:
 Cannot substantiate a claim to pierce the corporate veil to reach Δ
personally
 Without facts supporting doing business in their individual capacity
 Facts do not support that Carlton “perverting the privilege of doing
business in a corporate form”
 No unlawful distribution (i.e. fraudulent conveyance)
 PRINCIPAL AND AGENT:
 Should instead seek to hold the larger corporate entity liable
 And must sustain that claim not in fraud but in agency under the
principle of RESPONDEAT SUPERIOR – holding the whole
enterprise responsible for the acts of its agents
 Had to show agency existed under actual or formal authority
c) Undercapitalization irrelevant, company meets statutory requirements
 Problem for legislature, not courts
5) DISSENT
a) Looked at equitable aspects and effects of undercapitalization
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POLICY VIOLATION / PUBLIC INTEREST
 State policy should not allow abuse of corporate limited liability privilege to
be abused
 Intentionally undercapitalized to avoid liability
 Cited Cardozo in Anderson v. Abbott: Limited liability sought through
incorporation may be qualified or denied.
 Court has power to refuse to condone a promotional scheme which attempts to
circumvent or undermine a legislative policy
 A scheme designed solely to abuse the corporate privilege at the expense of
public interest
c) UNDERCAPITALIZATION
 If corporation undercapitalized and unable to meet liabilities certain to arise in
course of business shareholder may be held personally liable
 USED TO REQUIRE MINIMUM CAPITALIZATION
 But no longer do that because business capitalization needs vary based on
nature of business
6) HOLDING Reversed Order, Certified Question answered NO, Leave to Amend
Complaint
-Notes-Carlton has 20 taxi cabs, and incorporates two each in 10 different corporations, either one
insurance policy for all, or only two per corporation and the minimum amount of liability on the two
each-this limits the liability to at most the two cabs under each insurance policy
-Can be liable as an AGENT-if this company is acting as an agent for Carlton, where Carlton has
control over it without recognition of the Corporate veil, and probably we are going to find that
Carlton is running the rest of the taxis even though they are considered separate corporations on
paper,
-Need to maintain the corporate veil, conduct the business as if it were a corporate business with
board minutes, separate accounting, and then it will be easier to maintain that the corporations are
separate and not an agency relationship
H. Luckenbach SS v. WR Grace
1) FACTS: Luckenbach owns two companies: Luckenbach Company – capitalized at
$800K – and Luckenbach Steamship Co – capitalized at $10K. Both have same
shareholders Co owns the steamships but leases them to Steamship. Court believed it
was a liability block.
2) HOLDING:
a) For all practical purposes, the two concerns are one
b) Unconscionable to allow owner of fleet to escape liability because it turned them
over for a year before to a $10K corporation which is simply another form of itself.
Notes from Luckenbach-Identity Doctrine, at some point the courts are going to say, we cannot let
you incorporate every steam ship, or every pencil, every piece of office furniture differently, another
stretching case
I.
Costello v. Fazio
1) Equitable subordination of converted shareholder loans
2) FACTS
a) Objection by bankruptcy trustee seeking to subordinate shareholder promissory
notes under scheme to re-characterize capital contribution as a corporate liability
b) Partners incorporated business and withdrew their varying capital to reduce capital
contribution to $2K per stockholders by taking notes from corporation for their
additional capital contributions ($41K and 4.5K) when the corporation was a
partnership.
c) 600 Shares issued at $2 per share / divided among three partners
d) Corporation filed for bankruptcy and shareholders made claims against the
corporation as creditors for their notes payable
3) REASONING
a) Shareholders withdrew 88% of initial capital contribution
 For personal benefit: to equalize capital contributions and reduce tax liability
 To detriment of corporation and its creditors
b) Shareholders sought to place themselves in the same class as unsecured creditors
b)
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There was more than undercapitalization
Fraud need not be present
 Transaction occurred prior to incorporation but in contemplation of
incorporation
4) HOLDING
a) Reversed
b) Conversion and re-characterization of capital contribution into shareholder loan
leaving company undercapitalized to detriment of corporation and its creditors, can
be subordinated to claims of general unsecured creditors under doctrine of
EQUITABLE SUBORDINATION.
Notes-This is not veil piercing we are in bankruptcy, Partnership-Balance Sheet
-200K of assets, borrowed 150K, and the partners contributed 50K with equal among the partners
-Lawyer then says, listen the liability extends personally because of the partnership, the lawyer
advise incorporation to protect personal assets, and wanted to protect initial capital investments from
the partners into shareholders equity-but in this case it was a promissory note to cover the original
partner investments
-Court here said the original partners claim was equitable servitude, so when the corporation declared
bankruptcy the original partners were placed behind other creditors because it is not equitable for the
partners to take out their capital when they incorporated
-This is an exceptional case, normally creditors need to protect themselves
-Equitable subordination doctrine-getting larger, because what is happening is the large banks
making big loans are trying to apply it to corporations
No court is going to pierce the veil of a publicly held company- public policy.
c)
d)
Ultra Vires See DGCL 124 No ultra vires
OLD VIEW: When specific purpose required, corporations only have those purposes
and others are ultra vires and void.= Corporations must confine their business to those
activities specified in their charter
Back in the old days, you had to specify in the company charter what the business was to
engage in.
I.
Any actions by the corporation that are contrary to the charter or in a clause in its Articles
of Association would be null and void.
II. void or voidable.
III. Ultra vires is only important if an exam fact pattern includes language from the articles of
incorporation that state a narrow purpose. If, as authorized by the Delaware General
Corporation Law, the articles provide that the corporation can engage in any lawful
activities, then there are no ultra vires issues. Similarly, under MBCA 3.01, a corporation
can engage in any lawful activity unless the corporation’s articles state a narrow purpose
and so no ultra vires issues.
If the articles provide that the corporation can engage in “any lawful
activities”= ALL-PURPOSE CLAUSE NO Ultra Vires issues
Corporate Purpose versus Corporate Powers + Ultra Vires:
a.Corporate Purpose clause: refers to a statement describing the
business the corporation
is to conduct.
d. Delaware still adheres to the more traditional approach that
requires an all-purpose clause be stated in the Articles of
Incorporation
b. Corporate Powers: refers to methods the corporation may use to
achieve its purpose.
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c. MBCA §3.01(a): Unless otherwise provided, a corporation
has the power to
conduct all lawful business.
i. in other words, there is no requirement that there be
a purpose clause as opposed
to the Delaware statute requirement above, and the
default is a so-called “all
purpose clause”
Ultra Vires: (a corporation acting outside the scope it will be void)
a. At common law, a corporation had the powers enumerated in its purpose clause as
well as the implied powers necessary to the
accomplishment of its purpose.
b. If a corporation engaged in conduct not authorized by its express implied powers, the
conduct was deemed ultra vires and void.
i. courts over time interpreted corporate power broadly.
ii. Legislatures also authorized a corporation’s articles to broadly enable the
corporation to engage
in “any lawful purpose” and by limiting the relief and
sanctions available for ultra vires acts.
iii. Ultra vires can be used as a cause of action by shareholder in a corporate
action
A.
Corporate Purpose
1)
Purpose v. Powers
a)
b)
2)
Traditionally corporations had to enumerate their specific purpose
Legislatures broadened and authorize “any lawful purpose”

MBCA 3.01 Default: ALL-PURPOSE CLAUSE - Unless narrow purposes are stated in Articles – all purposes

Delaware Requires purpose be stated in Articles
MBCA 3.04. Ultra Vires
1)
2)
Ultra vires in many respects is dead because of all-purpose clause, with some exceptions.
The validity of corporate action may not be challenged on the ground that the corporation lacks or lacked power to act.
a)
3)
4)
5)
C.
Powers – confers and limits methods that may be used to achieve purpose
Purpose
a)
b)
B.
Purpose – defines scope of business
X A corporation’s power to act may be challenged in a proceeding

by shareholder against corporation Wiswall

by corporation against a director, officer, employer or agent

directly, derivatively, or through a receiver, trustee, or other legal representative

by the attorney general under Section 14.30.
In a shareholder’s proceeding to enjoin an unauthorized corporate act, the court may
a)
enjoin or set aside the act, if equitable

if all affected persons are parties to the proceeding
b)
award damages for loss (other than anticipated profits) suffered by the corporation or another party because of enjoining the unauthorized act
DGCL 124: Similar to MBCA
Comments
a)
COMMON LAW VIEW:

Corporations have powers enumerated in the purpose clause of its charter
and the implied powers necessary to the accomplishment of that purpose

Purpose clauses were enumerated and pages long

Conduct outside authorized power is ultra vires and void

Wiswal v. Plank Road Company (1857)
b)
MODERN VIEW:

Courts now interpret corporate powers more broadly

Legislatures authorize “any lawful purpose”

MBCA 3.01 Default: ALL-PURPOSE CLAUSE *
Unless stated in Articles – all purposes

Delaware Requires purpose be stated in Articles, page 357 book ultra vires section 124
c)
CREATIVE USE:

Using ultra vires to void company policy not permitted by Articles or Bylaws

Cross v. Midtown Club (1976)
Wiswall v. The Greenville and Raleigh Plan Road Company (1857)
1)
2)
OLD VIEW: When specific purpose required, corporations only have those purposes and others are ultra vires and void.
3)
4)
RULE/ REASONING: Corporations must confine their business to those activities specified in their charter
FACTS: Shareholders sue officers and directors for acting outside scope of authority under charter. Charter authorized building and repairing plank road and collecting tolls.
Directors seek to purchase stages with toll revenue and enter into contract to deliver US mail.
HOLDING: Directors acting outside the scope of their authority.
-Notes-Ulta Vires-simply means the old view was that a corporation could do nothing outside the charter from the state
-Court pointed out the dangers of what could happen, if they did not abide by the charter
D.
Cross v. Midtown Club
1) Powers of corporation management must be NECESSARY OR CONVENIENT to the purpose of
the corporation – if not otherwise stated in Articles or Bylaws
Notes: This case shows ultra vires is alive and well.
a)
Usually an obnoxious practice
2)
FACTS: Female friend of Л member of luncheon club is denied membership and guest privileges at luncheon club corporation. Л claims the policy excluding females from membership and guest privileges is
ultra vires – exceed powers conferred on corporate management, thereby breaching Л’s rights as a member of the corporation.
3)
4)
ISSUE: Is it necessary or convenient to the purpose for which the corporation was organized for it to exclude women members?
RULE:
a)
5)
Corporation has those powers stated in the Articles, Bylaws and applicable law and those powers NECESSARY OR CONVENIENT to the purpose for which the corporation was organized.
HOLDING:
a)
Policy to exclude women from membership was not (a) granted in Articles or Bylaws and (b) necessary or convenient to the purpose of the corporation, and was therefore ultra vires and in derogation of
the rights of the Л as a member.

Especially because the club was a principal luncheon club for businessmen and professional and entry of women into business.
\
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Corporate Responsibility
A. Corporate Responsibility to the Public
1) Debate
a) Corporate viewpoint – to make money for their shareholders and obey the law
 Maximize their benefit to society by performing that role only Milton Friedman
 Efficient, more competitive, better cheaper product
 Critics call contributions CORPORATE WELFARE
b) Other Viewpoint – transfer of wealth to corporations requires that corporations be responsible to
society in addition to making money for their shareholders
 What is the role of the corporation in our society?
 What is the responsibility to the public? Are corporations citizens, or are they there to simply
make profits for its shareholders?
-Notes-Should corporations have the power to make charitable contributions? Should the corporations be able to make
contributions to political campaigns?
-Charitable Contributions-Often go to the CEO’s favorite charity in the big corporations, prestigious all at the cost of
the shareholders
-What about if you are making a contribution to something I don’t like? Abortion Clinics? Controversial
Contributions?
-Should we allow corporations to give millions of dollars away that would otherwise go to the shareholders?
-Corporate Waste-Need to make some care of making sure contributions are not a waste of assets, because that is
illegal.
B. Corporation Contributions
1) 4 Approaches to Authorization of Corporate Contributions
a) MBCA 3.02 (13) Corporations may make donations for the public welfare or for charitable,
scientific or educational purposes
 Need not necessarily further company interests
 X Prohibit contributions in federal elections
 Get around through PACS
b) Further Corporate Interest
 Corporations may make donations that further their own corporate interest
 Reasonable charitable gifts are proper
 Tax Code sets the guide for reasonableness
c) Sound Business Judgment Rule
 Court defers to management decisions
 Assumed to be reasonably arrived at by business rationale and judgment
 Courts will rarely second-guess management on business judgments:
 Prices at which you offer your products
 Management decisions on quality, etc.
 Dividends
d) Retroactive Legislation
 Reserved Powers Provision
 Trustees of Dartmouth v. Woodward allows reservation of rights to change corporate laws
 State cannot pass legislation that impairs contracts
 Curtails legislation that affects corporations already holding charters
 Justice Story’s concurrence suggested a reservation of power to modify would get around
restriction
C. AP Smith v. Barlow
1) Legislation can modify charter statute – impair contract
2) FACTS:
a) Shareholders objected to AP Smith donation of money to Princeton on grounds that:
 Articles do not authorize contribution
 Legislation allowing contributions could not retroactively alter their corporate charged
3) RULE/REASONING:
IV.
73
Looks at role of corporation in society – have corporate responsibility
HISTORICALLY
Most corporations initially for public purposes – university, turnpikes, water companies
Few commercial corporations
Over time commercial corporations dominated and their goal was to make money
Courts will usually uphold corporate donations because they can further corporate interests
Common law allows change when necessary – growth and development
4) HOLDING:
a) Legislation may modify charter of earlier-chartered corporations to empower to make corporate
contributions.
 Reserved Powers Provision: Every corporate charter hereafter granted shall be subject to
alterations, suspension and repeal in the discretion of the legislature.
b) Corporate contributions further the corporate interest
Adams v. Smith
1) Applies Business Judgment Rule to allow widow gifts
2) FACTS:
a) Unauthorized gifts to the widows of several high ranking officials of the corporation
b) Corporation authorized making gifts to widows of officers / management. Not within powers of
corporation to give gifts and that the gift was without equity.
c) Issue: 1) that the allegation that the payments to the widows are “ultra vires the powers of the
corporation”?
d) Issue: 2) The bill is without equity?
3) RULE/REASONING:
a) Cannot give away corporate property without consideration (in interest of corporation)
b) Business-Judgment Rule: Courts will usually defer to the business judgment rule
c) Unless there is in the character of the of the corporation a provision which confers on the majority
the power to give away the corporations’ money without consideration, Generally not allowed to
give away money.
d) Business Judgment Rule: Alleged payments may be made lawfully by the directors under their power
to manage the internal affairs of the corporation without interference by the courts, or, that if the
directors could not do so, then the majority of the stockholders could ratify the alleged acts of the
directors, who would not be liable after such ratification.
4) HOLDING:
a) Court applied Business Judgment Rule and deferred to management decision
b) Holding Issue 1: The instant bill does not contain a copy of the certificate of incorporation nor are the
charter powers otherwise stated in the bill. It follows, therefore, that the averment that the alleged
payments are ultra vires is not a proper pleading of facts and the grounds of demurrer taking that
point were due to be sustained.
c) Holding 2: Directors and Majority Stockholders have power to make bonus or retirement payments
to officers and employees of the corporation, and their widows or dependent, because such payments
can be and are for the benefit and furtherance of the business of the corporation. However, that is not
the case here because the payments to the widows were without consideration.
a)
b)
c)
d)
e)
f)
g)
D.
E.
Dodge v. Ford Motor Co. This is the outer limit.
F.
Court actually deemed that Henry Ford (BOD) exceeded his bounds of discretion by
essentially refusing to pay dividends (D's policy is now to pay only a regular dividend (60% on stated
capital) and reserve the remainder of the earnings for expansion and price reductions.)
Ordinarily, Courts will not require corps to pay out dividends. That is left to the
discretion (BJ?) of the board of directors. However, the court stated corporations are for
profitable purposes to return profits to the shareholders Therefore, Ford went too far and
turned the corporation into a non-for-profit.  court ordered the BOD to pay dividends
This is the outer limit of court interreference with BOD discretion
1)
2)
3)
Denied corporate responsibility (Exceptional Case)
The refusal of the Ford board of directors to issue a special dividend when holding large profits amounted
to a willful abuse of discretion BOD ordered to pay dividends
FACTS:
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4)
Balance sheet shows $52 million cash in hand in 1919. Liabilities – no debt, rest is in
surplus.
Dodge Bros. were major shareholders, and wished to get some money to open a competing business.
Dodge argued the corporation was giving away corporate funds.
b) Dodge sued to compel Ford’s board to declare a special dividend equal to one-half of its surplus.
The lower court awarded the dividend.
c) Ford had a surplus of almost $112 million. It declared a regular dividend of $1.2 million but refused
to declare a special dividend.
d) Ford said it was taking corporate responsibility in reducing prices, increasing quality and
seeking expansion and operating cushion.
e) Ford owned 58 Percent of the company still and said that his ambition was to grow the company as
that to do that he made the great share of the profits back into the business in order to purchase
several other areas of materials, raw and finished, to grow the business.
RULE/REASONING:
a) It is well recognized that the power to declare a dividend, and the amount of the dividend, is
exclusively within the discretion of the board of directors.
b) However, a board may be compelled to pay a dividend if the failure to do so would be a willful
abuse of their discretionary powers, or fraud, or breach of the fiduciary duty.
c) Here, the surplus is so large, that even if Ford were to immediately spend all of the money it planned
for expansion, there would still be an obscene surplus.
HOLDING:
a) Court says corporation’s purpose is to return profits to shareholder.
b) Clearly more than enough money to pay a dividend and require a distributions.
THIS CASE IS THE EXCEPTION – Court extremely reluctant to override management decision
a)
5)
6)
7)
Holding: Courts will not require corps to pay out dividends. That is left to the
discretion of the board of directors. The court found the company was forgoing huge
profits and the
shareholders claim that this is a charitable action by Ford. Ford
wanted to spread the wealth.
The court also said corporations are for profitable
purposes to return profits to the shareholders
and that we are not going to second
guess the business plan of the business people. Courts will
defer to the business
executive as long as they don’t breach their fiduciary duties. Court said
Ford
went too far and turned the corporation into a non-for-profit. The court held that the
accumulation of so large a surplus established that there was an arbitrary refusal to
distribute funds to stockholders as dividends and ordered that such dividends, plus
interest, should be
paid by defendant corporation.
CHAPTER 6 MANAGEMENT OF CORPORATIONS
I.
Corporate Structure
A. Articles and Bylaws
1) Articles or Bylaws can enlarge or restrict powers to officers (or Board) granted by statute
B. Stockholders and Management
1) Wall Street Rule:
a) Vote with your feet. If shareholders don’t like what management is doing you sell the stock
2) Powers granted to a corporation must be exercise through it directors, although chosen by the
shareholders, those shareholders cannot exercise those powers Charleston Boot & Shoe Co v. Dunsmore
C. Corporate Duties Outside Corporation
1) US
a) Management and Labor is an adversarial process – employee contracts
b) Management and labor relations must be separated by law
2) NON-US
a) Co-Determination (Germany and other companies) – joint management and labor committees
3) Constituency Statutes – permit directors to consider interests other than maximation of shareholder
wealth
II. The Board of Directors
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A.
B.
C.
Number and Term
1) # of Directors established in Articles or Bylaws
2) Term of office is one year (annual stockholder meeting) unless staggered
3) Staggered Terms
a) MBCA 8.06 Articles may provide for Staggered Terms
b) Maximum of 2-3 staggered terms of 2-3 years each
c) PURPOSE:
 Continuity of management
 Making unwanted shareholder takeover attempts more difficult
 Making directors that could run the company down
d) Criticized heavily because of it entrenches management
4) MBCA 8.05
5) Decrease in number of directors does not shorten term of incumbent
6) Term of successor director (filling a vacancy) ends at next annual stockholder meeting
7) Despite expiration, director serves until successor elected and qualified or decrease in #
Compensation of Directors
1) Board of Directors can set Director compensation
a) X Unless Articles or Bylaws provide otherwise
Director Appointment
1) Voting Requirements
a) Directors getting most votes will win
b) Cumulative Voting
 More minority stockholder representation on Board
 You get i.e. 5 votes (based on # of directors running for office) but can cumulate them all for one
director
2) Director Panel
a) Board select panel from which shareholder elects
b) Sometimes Nominating Committee has this task
3) Proxy of Shareholders
a) Shareholder gives authority to another individual to vote for him at shareholder’s meeting
b) Like an absentee ballot
c) The word “proxy” is used both to describe that authorization and to identify the person so authorized.
That person is also referred to as the proxy holder.
d) Proxy = Power granted by a shareholder to another person to exercise the shareholder’s voting rights
 The word “proxy” is used both to describe that authorization and to identify the person so
authorized. That person is also referred to as the proxy holder.
 There are four things that you need to know about the state law relating to proxies. First, a proxy
is effective for eleven months unless the proxy states otherwise. Second, a proxy is revocable by
the record shareholder even if the proxy states otherwise. Third, a proxy is irrevocable only if it
both states that it is irrevocable and is also “coupled with an interest.” Fourth, “coupled with an
interest” means that the proxy holder has some interest in the stock other than just voting the
shares.
e)
D.
Director Removal and Vacancies
1) MBCA 8.08 Shareholders can remove directors for cause or no cause
a) X Unless Articles limit to only for cause
b) COMMON LAW Stockholders empowered to elect Board have inherent power to remove them for
cause. Auer V. Dressel
c) Only voting group that elected Director can remove him
d) Only at shareholders at meeting called for that purpose + notice of meeting with that purpose
2) Due Process of Directors to be Removed for Cause
a) Notice of specific charges must be given to director
b) Opportunity to respond
 Proxy solicitation seeking authority to remove a director for cause must be accompanied by or
preceded by a statement from such director presenting his defense
3) Filling Vacancies
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“Vacancies” includes newly created directorships
MBCA 8.10: Shareholders or Board may fill vacancies
 X Unless Articles provide otherwise
 If remaining directors less than a quorum, majority of remaining directors may fill vacancies
Role of Board of Directors
1) Managing Body
a) MBCA 8.01
(commensurate with Del 141)
 Business of corporation is managed by or under the direction of the Board
 Corporations must have a Board of Directors
 X Unless Shareholder’s Agreement provides otherwise
a)
b)
E.
2. What Do Corporate Statutes Provide About the Role of an Individual
Director?
Note that the statutes refer to the "board of directors," not to directors. The statutes give
the authority to run the corporation to the board as a group. Directors can only act as a body An
individual director does not have the power to act on behalf of the corporation The
relationship between a director and the corporation is not an agency relationship
2)
Notice also, both the Delaware and MBCA provisions use the phrase "under the direction
of."
This phrase authorizes the board of directors to delegate managerial functions to
corporate oflicers
and other corporate employees. Both the Delaware statute and the MBCA contemplate
that the board
of directors will select and supervise the corporation’s officers, who will then hire
managers who will make the day to day operational decisions
BOD Functions
a) Hiring and Monitoring Management
b) Establishing Policy
c) Establishing Strategic Planning and Financial Objectives
d) Advice and counsel Management
e) Recommend Directors to Shareholders
f)
Implementing Internal Controls
=
FUNCTION OF THE BOD
-Authority to select managers, set policy, but the BOD does not control the corporation on a day to
day basis
-Strategies, financial goals, review the accounts of the company, advise directors on how the new
policies of the corporation should be invented
-Director Compensation-paid for the roles, cash compensation, broken down into the amount of
meetings you attend more money if you attend in person
-Typically give the directors some amount of stock, usually small amount,
Primary Legal Obligations of Directors to a Corporation (1) a duty of care and (2) a duty
of loyalty.
Neither the Delaware General Corporation Law nor the MBCA expressly creates a duty of
care or duty of loyalty,= duty of care and loyalty is based on case law, not statutory law
Nonetheless, cases and commentaries consistently discuss directors’ duty of care and
duty of loyalty, Thus, when you encounter an exam fact pattern with (1) a corporation that
has lost
money (or lost an opportunity to make more money), and (2) the corporation’s board of
directors
(or equally likely, a particular director) was arguably stupid, lazy or greedy, then you need
to decide
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whether the question involves a possible breach by directors of the duty of care or a
possible breach
by the directors of the duty or loyalty.
3)
Independent Body
a) Board’s powers are originals and undelegated
Legal Obligations of Directors to the Corporation?
-directors are not agents of the corporation.
agent has a fiduciary duty to its principal
partners are agents,
officers of a corporation are agents of the corporation,
-directors are fiduciaries of the corporation
fiduciary is someone who is acting in the interest of someone else
a trustee acts on behalf of a beneficiary of the trust  trustee owes a legal duty, (ie a
fiduciary duty), to the beneficiaries
Similarly, directors act on behalf of the corporation  directors are fiduciaries  owe a
fiduciary duty to the corporation
b) TRUSTEE  SHAREHOLDERS
 Board of Directors are NOT AGENTS of the shareholders – but trustees of the corp
 Independent body that exercises its own judgment
 Do not have to accept views of shareholders or officers
c) AGENCY  CORPORATION
 Corporation is the Principal of the Board
 Corporation is bound by the acts of its Board as agents
 Fiduciary Duty
 Directors must use ordinary care and diligence
 Although not agents of shareholders, they are agents of corporation and have a
fiduciary duty to it and its shareholders
d) Not employees of the company
4) Court Deference to Board Business Judgment
a) Directors are to act in their own best judgment and cannot be controlled except by Articles or Bylaws
b) Courts will generally not second guess the judgment of the Board
c) Director’s discretion unfettered except
 Waste
 Breach of fiduciary duty
 Articles, Bylaw or Shareholder’s Agreement limitation
5) Charleston Boot & Shoe Co v. Dunsmore
a) Powers granted to a corporation must be exercise through it directors, although chosen by the
shareholders those shareholders cannot exercise those powers
b) Only directors can manage the corporation
c) FACTS:
 Shareholders claim directors mismanaging the company
 Shareholders created a committee to act with the directors to close up its affairs and chose
Osgood to head the committee.
 Directors refused to act with Osgood.
d) RULES:
 Business of a dividend-paying corporation shall be managed by its directors
 Limited by Articles, Bylaws and votes
 Shareholders have no authority
e) HOLDING:
 Shareholders had no authority to appoint Osgood to act with the directors to close up the affairs
of the Л
-Case Notes for Charleston
-Directors have independent responsibility, and they are liable for their personal assets if they breach their fiduciary
duties
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-Shareholders cannot tell the directors how to vote on board meeting issues, shareholders can vote the directors out of
office and remove the director, but the director cannot be told how to vote
-Model for Corporate Governors- BOD will set the direction of the company
-Corporate bylaws may place restrictions on the BOD
-BOD are not under the control of the shareholders
6) Auer V. Dressel
a) Stockholders empowered to elect Board have inherent power to remove them for cause.
b) FACT:
 Majority stockholders (55% of vote) want to call a meeting of class A Stockholders, for a
particular purpose and President does not call the meeting.
 President did not have discretion to call the meeting, “The important right of stockholders to
have such meetings called will be of little practical value if corporate management can ignore
the requests, force the stockholders to commence legal proceedings, and then, by purely formal
denials, put the stockholdings which are peculiarly within the knowledge of the corporate
officers.
 Shareholders trying to i) hear charges against and remove directors for cause and ii) amend
Bylaws to raise director quorum requirement
 Trying to get rid of the 4 defectors and raise a quorum requirement on them.
c) RULE:
 Interpretation of Articles / Bylaws:
 If Articles allows Board to remove directors on charge it does not dissolve the shareholders
inherent power to do the same
 GENERALLY Permission to one party is not denial to another party
 If shareholders have power to elect directors, they have inherent power to remove them
 Its seems settled law that the stockholders who are empowered to elect directors have the
inherent power to remove them for cause.
 You can limit Board discretion by a Bylaw
d) HOLDING:
 Purpose of meeting proper and shareholders have inherent power to
 Remove the directors they have the express power to elect
 Amend the bylaws to allow their election of successors to removed directors
 Corporate officer has no discretion to not call a meeting when shareholders request
7) Campbell v. Loews
a) Issue: Plaintiff’s request for a preliminary injunction to restrain the holding of stockholders’ meeting
or alternatively to prevent the voting of certain proxies?
b) FACTS:
 Tomlinson faction versus the Vogel faction for control of Loews
 Shareholders faction between shareholders Vogel (Loews) and Tomlinson/Meyer over MGM’s
Board of Directors
 Each faction was to have 6 directors and jointly elect a 13 th member, two of the 6 Vogel
directors resigned and the 13th neutral member resigned, Qurom is 7
 July 29th day before one of the Tomlinson directors resigned, Left 5 Tomlinson and 4 Vogel
directors at the meeting
 July 29th Vogel sent out notice for director’s meeting for September 12 th, for several purposes
 Vogel, President called stockholder meeting and sent proxy
 To remove 2 directors (Tomlinson – who was causing trouble
 Amend bylaws to increase # of directors and quorum requirement (13 to 19)
 To fill director vacancies and new director positions, to remove Meyer and Tomlinson
 Neutral director and others resigned
 Tomlinson called Director Meeting
 4 Vogel directors avoided meeting on purpose
 Can a director avoid meeting to avoid quorum?
 Л argued
 authority of President to call stockholder meeting
 due process requirements of directors to be removed
 Bylaw allowed President to call meeting of shareholders for any purpose
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c)
d)
 Board is frozen and management is in control of the company
RULES / REASONING
First Issue: Whether the President Vogel was within his legal rights to call the stockholders meeting
for the stated purposes?- Short answer yes President had the power.
 AUTHORITY OF PRESIDENT TO CALL STOCKHOLDER’S MEETING +
 Bylaws can enlarge powers to officers (or Board) granted by statute
 Bylaws approved by shareholders gave President authority to call stockholder meeting
 President’s actions related to stockholder matters and did not violate Delaware statute by
impinging on director duties
 Allowed President to circumvent the Board of Directors
 Stockholders chose to give the President this unusually broad power
 Validity not wisdom of grant of power at issue
 Shareholders have the power to remove directors for cause
 Cumulative Voting: Not plurality, people are voted into office based on a certain number of
votes that needs to be obtained.
 Issue 2: President has no authority, without board approval, to propose an amendment of the
bylaws to enlarge the board of directors?
 AUTHORITY OF PRESIDENT
 President given authority by Bylaws to call the stockholder meeting simply from the wording of
the bylaws that authorizes such action.
Issue 3: Plaintiff next argues that the stockholders have no power between annual meetings to
elect directors to fill newly created directorships?-Short Answer yes stockholders do have the
right between annual meetings to elect directors to fill newly created directorships.
 STATUTORY INTERPRETATION
 Moon case- held that the stockholders had the inherent right between annual meetings to fill
newly created directorships. Controlling here because the statute has been amended to
provide that not only vacancies but newly created directorships unless the certificate of
incorporation or the bylaws specifically state otherwise.
 Statute allowing directors may fill newly created directorships as well as vacancies did not
make that power exclusive to directors - stockholders can fill also
 GENERALLY Permission to one party is not denial to another party
 Stockholders may elect directors to fill newly created directorships between annual
meetings
 Stockholders have the inherent power to fill newly created directorships
 Stockholders have the inherent power to remove directors for cause
even for cumulative cause
 Issue 4: Shareholders of a DE Corp have no power to remove directors from office even for
cause and thus the call for its purpose is invalid?-Short answer is yes the stockholders have the
power to remove a director for cause.
 Nothing in the statutory law providing for the removal of directors from stockholders,
Considering the damage that a director might be able to inflict upon his corporation, the benefit
of the doubt of the statutes should be in favor of allowing the removal of directors for cause, i.e.
disclosing trade secrets
 I need not and do not decide whether the stockholders can be appropriate charter or by-law
provision deprive themselves of this right.
 Issue 5: Procedural defects and irregularities in proxy selection by the Vogel group?
 PROCEDURAL DEFECTS
 Stockholders can vote to remove a director for cause only after such director has been given
adequate notice of charges of grave impropriety and afforded an opportunity to be heard?
 See the procedural defects on page 214 middle of the page, short answer is that the
accompanying letter was sufficient compliance with the notice requirement
 When shareholders attempt to remove a director for cause the director is entitled to specific
charges, adequate notice and full opportunity to be heard in meeting the accusation
 Issue 6: Charges against the two directors do not constitute “cause” as a matter of law?
 1) charges that the two directors failed to cooperate with Vogel in his announced program for
rebuilding the company, see top of the page on 215 …..I am convinced that a charge that the
directors desired to take over control of the corporation is not a reason for their ouster.
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
2) Charge is that these directors, in effect, engaged in calculated plan of harassment to the
detriment of the corporation, Conclusion is that the charge of a “planned scheme of harassment”
as detailed in the letter constitutes a justifiable legal basis for removing a director.
 Issue 7: Whether the directors sought to be removed have been given a reasonable opportunity
to be heard by the stockholders on the charges made?
 Vogel physically took control of the corporation and its facilities. By this action the corporation
through Vogel has deliberately refused to afford the directors in question adequate opportunity
to be heard by the stockholders on the charges made.
 Proxies are not good enough here: To require anything less than the foregoing is to deprive the
stockholders of the opportunity to consider the case made by both sides before voting and would
make a mockery of the requirement that a director sought to be removed for cause is entitled to
an opportunity to be heard before the stockholders vote.
 Procedural sequence here adopted for soliciting proxies seeking authority to vote on the removal
of the two directors is contrary to law. The result is that the proxy solicited by the Vogel group,
which is based upon unilateral presentation of the facts by those in control of the corporate
facilities, must be declared invalid insofar as they purport to give authority to vote for the
removal of the directors for cause.
 Proxies invalid; injcunction issued prohibiting corporation from recognizing any proxies
held by the Vogel group approving removal of directors
e) HOLDING:
 AUTHORITY OF PRESIDENT
 President given authority by Bylaws to call the stockholder meeting and by implication of those
powers to amend bylaws
 Stockholders can fill director vacancies and fill newly created directorships
 Stockholders can amend Bylaws vacancies, stockholders removing amendment to Bylaws
 PROCEDURAL DEFECTS
 Directors not given required due process:
 Directors DID receive adequate notice
 Director harassment / obstruction of business was deemed GOOD CAUSE for removal
 But Directors not given list of stockholders or ability to present defend their position with
respect to the proxies
 Proxy solicitation seeking authority to remove a director for cause was not accompanied by
a statement from such director presenting his defense
 Proxies invalid; injcunction issued prohibiting corporation from recognizing any proxies
held by the Vogel group approving removal of directors
-Divorce of Management and Control
-President Vogel did have power under the bylaws
-Notice of the Charges in Corporate Case, “you are not very helpful here and we think this justifies your removal” does
not have to be the same standard of the pleadings
-Expenses of the Proxies can be financed in a certain ways, President has control of the corporate treasury you can
mail them out and then charged it to the corporation,
-Corporate Campaigns are run very similar to Political Campaigns
-Vogel faction not compelled to attend the board meeting, huge because if they attended they would have lost control
of the corporation
-Bylaws here determined the outcome of this fight
FUNCTION OF THE BOARD OF DIRECTORS
-Authority to select managers, set policy, but the BOD does not control the corporation on a day to day basis
-Strategies, financial goals, review the accounts of the company, advise directors on how the new policies of the
corporation should be invented
-Director Compensation-paid for the roles, cash compensation, broken down into the amount of meetings you attend
more money if you attend in person
-Typically give the directors some amount of stock, usually small amount,
Primary Legal Obligations of Directors to a Corporation (1) a duty of care and (2) a duty
of loyalty.
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Neither the Delaware General Corporation Law nor the MBCA expressly creates a duty of
care or duty of loyalty,= duty of care and loyalty is based on case law, not statutory law
Nonetheless, cases and commentaries consistently discuss directors’ duty of care and
duty of loyalty, Thus, when you encounter an exam fact pattern with (1) a corporation that
has lost
money (or lost an opportunity to make more money), and (2) the corporation’s board of
directors
(or equally likely, a particular director) was arguably stupid, lazy or greedy, then you need
to decide
whether the question involves a possible breach by directors of the duty of care or a
possible breach
by the directors of the duty or loyalty.
-Class Notes Starting Around These Concepts 9/14/11
-Board of Directors Are Independent not as agents of the corporation that is delegated to the management
-Loew’s Case bylaws effecting the outcome of the corporation, bylaws made him able to call the meeting
-Managers control the corporation until they are removed
-House Keeping Requirements
-Qurom, Noitce, Voting, all important because they will determine the validity of the corporate actions
-Also play into the context of piercing the corporate veil, if you do a good job at the house keeping it is increasingly
difficult to pierce the corporate veil
-Courts are more forgiving for the lack of house keeping requirements for very small corporations, very large public
corporations will not get the same treatment
-DE 141(b) page 364 in rules, section (i)
-Model Business Corp Act, 8.20-8.24, pages 252-53
-BOD often acts through committees, BOD may be an unwieldy group, 9-15 directors usually for the large public corp
-Difficult to call a meeting, BOD probably meets once a month, in the interim we want to have BOD action take and
they do this through committees,
-SEC requires committees for public corporation, Executive Committee, Chairman CEO and anybody else they want,
and they will make the decisions in between of the BOD meetings
-Compensation Committee-What the compensation is for the directors, officers get huge salaries, trying to curb this
now
-Audit CommitteeF. Director Meetings
1) Breach of administrative technicalities may invalidate corporate action taken in violation thereof - i.e.
improperly conducted meeting
2) Meeting
a) Collegial decision of board required
 Won’t make massive mistakes but someone will think of what another won’t
b) Directors cannot vote by proxy
c) But physical presence not required - 2-Way Communication sufficient (video conference)
d) Exception for Close Corporations where action often informally
3) Notice of Meeting
a) Regular meetings require NO notice, typical rule no notice needed because there is notice in the
regularity
b) Special meetings requires 2-day notice-typically, can be shortened by the bylaws or the certificate of
incorporation
 Purpose generally not required, do NOT have to state the purpose
 Exception for Director removal – Due Process requirements
 Can be modified by Bylaws
4) Waiver of Notice
a) Director may waive notice by signed writing
b) Director presence at meeting is waiver unless
 Director objects at outset of meeting AND
 Abstains from voting or assenting to action taken at meeting
G. Director Action - Voting Requirements
1) Quorum
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=Majority of total number of authorized directors on the Board which must be present at the meeting
(not just those in office or present at a meeting)
 Articles or Bylaws may set a lower or higher number (supermajority or unanimity)
But never less than 1/3 of Board
 Supports the Doctrine of Collegial Decision
 EXAMPLE: 12 Authorized – 6 is quorum even if only 9 directors left
b) Affirmative vote of majority of directors present at meeting
when quorum present constitutes an act of the Board
c) Abstention acts as No Vote
d) General rule is that quorum requires majority of the board members authorized, meaning the board
members who are actually authorized to be in office
e) Can be varied by the certificate or bylaws, but no less that 1/3 requirement, can increase and not
uncommon for there to be a 100% requirement
f)
Board can act after quorum, board can act by a majority of those present
g) If a board member is attending by telephone, television, the party attending must be able to hear and
communicate
h) Notice requirements may be waived if everybody agrees to waiver of the notice for special meetings
2) Dissent or Abstention
a) Director deemed to have assented to action of Board
unless he records a Dissent or Abstention (No Vote)
3) Unanimous Consent of Board
a) Modern view recognizes informal but unanimous board action
 Don’t need collegial decision making
4) General Rule: 1) that collective action is necessary, in order that the act may be deliberately adopted, after
the second opportunity for discussion and an interchange of views; and 2) that directors are, for the
purpose of managing the affairs of the corporation, the agents of the stockholders, and given no power to
act otherwise.
H. Board Amendment Powers
1) Articles – Board must adopt; shareholders must approve
2) Bylaws – Board may amend
I.
Board Committees
1) Some statutes authorize Board to divide into committees with full power of Board
a) Executive committee – general business of corporation
b) SEC REQUIRES ALL COMMITTEES HAVE MAJORITY OF OUTSIDE DIRECTORS
c) Sarbanes-Oxley Act-passed in the wake of the Enron fiasco requires the audit committees of
publicly owned corporations to be composed of “independent” outside directors who are
neither employees of nor consultants to the corporation.
d) MUST BE ALL OUTSIDE DIRECTORS
 Compensation committee – compensation of officers, proven to be ineffective
 Audit committee –only outside directors now but proven to be ineffective
e) Nominating Committee-may or may not be all outside, select the candidates for the BOD, CEO
ensures that the candidates will be the one CEO wants
f)
Special Litigation Committee-someone is suing the corporation claiming an inside director or
manager has breach a fiduciary duty or did something else wrong, there will be a conflict of interest
 For shareholder derivative action
INSIDE Directors
-Inside directors have an inherent conflict of interest, they have no ownership interest only looking out for themselves
-Now said that outside directors are needed on the boards to curb this
-SEC sought at least 50% to be all outside directors, bottom line it does not matter how many outside directors you
have
-Management controls the information flows, and the information flows will dictate how much the outside director can
truly influence anyway
-Enron had a majority of outside directors on the board, chairman and CEO were split, same thing at WorldCom,
ultimately controlled by managers controlling the information
J. Board Reform
1) Outside Directors
a) Not major stockholders
a)
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Not involved in management
Usually business professionals or scholars
ADVANTAGES
 Independence – no personal gain conflict
 Offer different perspective
 Strategic Vision
 Offer business contacts
 Check on management
e) DISADVANTAGES
 Does not always mean business success
 Controlled by information flow from management
 Cannot direct full-time to these jobs
2) Split CEO/Chairman of the Board Role
a) Independent Chairman
b) Inside CEO
c) Studies show the split doesn’t help much
K. Director Informational Rights
1) Director is personally liable for the actions of the corporation, directors have a duty to inform themselves
and the courts will not cut short the director’s access, even though it might look like the director is
seeking the information for an improper purpose
2) Unlimited right to inspect books and records to keep themselves informed
3) How can director manage without that information?
4) Courts allow unlimited inspection or may restrict
a) Those allowing feel there are remedies available – fiduciary duty
b) Those restricting claim right ceases when motive improper – not related to his position as director
-Corporations only act through individuals, BOD selects the officers, officers select the managers, managers select the
employees
-Corporate lawyer does not like apparent authority
-Actual Authority is Expressed or Implied
-Does a title give apparent authority?-maybe, problem is over the years corporate titles tend to change and different
titles mean different things depending on the corporation
III. Officers and Sources of Power
A. Authority and Sources of Power
1) Actual Authority
a) Express grant of authority from the Board
b) Authority derives from Agency
c) Officers have no authority the Bylaws or Board have not given them
d) By placing a person in a corporate office or position a corporation it may give that officer inherent
authority
e) “A corporation is bound by contracts entered into by its officers and agents acting on behalf of the
corporation and for its benefits, provided they act within the scope of their powers”
2) Apparent Authority
a) Officers may be clothed with apparent authority
b) Essentially a question of fact, as a general rule the business of the corporation is to be managed by its
board of directors
c) Titles are very tricky with apparent authorityd) Secretary has little apparent authority- they are responsible for maintaining authority but not much
more
B. Officer Authority Generally
1) All corporate action must be legally traceable, directly or indirectly to the Board
2) ORDINARY COURSE OF BUSINESS. Corporate officers have certain inherent powers from their
position but those powers only extend to transactions within the usual and ordinary course of business
a) Authority for extraordinary transactions must be expressly granted by the Board
3) AGENT DELEGATION OF POWER LIMITED. Agent can delegate ministerial tasks to someone
else but those which requires the exercise of judgment or discretion unless he is expressly authorized to
do so.
b)
c)
d)
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THIRD PARTY. When a third party knows or has reason to know the agent with whom he is dealing is
in fact exceeding his authority
a) The third party’s right to rely on the agent’s authority is extinguished
Evanston Bank v. Conticommodity Services
1) Bank loses $1.2M in one year of trading commodities and pays $270K in commissions. Bank brings
action against Futures Merchant for unauthorized trading, fraudulent misrepresentations, fraudulent or
deceptive business practices and negligence. Bank claims it only wanted to hedge trade, not make
voluminous speculative trades. Bank gave CEO/Chairman Christianson authority to handle commodities
trades.
2) Conti claimed
a) it was granted both apparent and actual authority to make those trades by power of attorney from
Christianson (a CEO)
b) Bank was notified daily of trades and its silence was approval
4)
C.
IV.
Issue: Whether the actions by the CEO (Christianson) were outside the bounds of his
authority?
RULES / HOLDING
a) Christianson did not have authority to grant Power of Attorney
 So that Conti could not rely on that authority (conti had to take the hit)
Because this was a hedge account and these trades were not hedging, they were simply being
traded in a speculative manner
-CEO of the bank, there was no actual authority here because it could not be traced back to an action of the BOD, that
would destroy your actual authority claim
-Brokers have problem because when they open the account the CEO had BOD authority to trade the account, the CEO
gets tired of it and lets somebody else do it, and by the time it gets to the next person trading it, the paper work was not
in line with the person trading the account
-The kinds of transactions here were speculative trading, banks are only allowed to go in and trade on conservative
things like some kind of hedge funds
-Chairmen of the Corporation-Powerful position, but depends on what corporation and who they are to determine what
authority they really have
-Most corporations combine the position of CEO/Chairmen of the Board
-CFO does everything almost every day without resolutions, CFO has actual authority to carry out transactions
necessary to promote the company
-Want all the apparent authority you can get for large transactions, BOD resolution, Opinion of Counsel saying the
BOD took lawful action, and the validity of the action is good, or actual authority for better purposes
1)
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THE DUTY OF CARE XXXXXXX
Chapter 7
I.
The Standard of Care
A. Director Duty of Care
1) ATTENTION TO COMPANY
a) Duty to be attentive to company
2) INFORMED OF CONDUCT OF BUSINESS
a) Duty to be informed of company’s conduct of business
b) MBCA 8.30 RELIANCE ON CORPORATE RECORDS AND REPORTS =Directors may
reasonably rely on corporate reports from management and other experts unless there is reason to
believe otherwise -the question is what is reasonable?
MBCA 8.42(a) (Duty of officers)What Does the Delaware General Corporation Law and the Articles of
Incorporation of a Delaware Corporation Say About the Duty of Care
No Delaware statutory std of care for directors (CL instead) The Delaware General Corporation Law
does not the use the phrase "duty of care" and nowhere establishes a standard of care for directors
Under Delaware law, a director’s duty of care is based on case law, not statutory law.
Elimination of std of care by COI While the Delaware General Corporation Law does not create a
director's duty of care, the Dela-ware statute does provide for the possible elimination of a director’s
duty of care in the corporation’s certificate of incorporation. Under section 102(b)(7), added in 1986,
a corporation's certificate of incorporation can provide that directors have no personal liability for
breach of duty of care Such a provision is almost certain to be included in the certificate of
incorporation of corporations in the real world, and always possible to be included in the unreal
world of law school exam questions
Reasonable reliance Delaware also protects directors from liability for breach of duty of care in
section 141(e). Under
section 141(e) of the Delaware General Corporation Law, directors can escape liability for breach of
duty of care if their actions or inactions were based on reasonable reliance on the information and
advice of officers, employees, or outside experts In the event that you have a law school exam ques»
tion involving (1) a Delaware corporation, (2) without a section 102(b)(7) provision in its certificate
of incorporation, and (3) with facts that suggest the board or a director was dumb or lazy, then look
for facts about reliance on oflicers or outside experts.
What Does the MBCA and the Articles of Incorporation of a MBCA Corporation Say About
the Duty of Care
Reasonable reliance Like DGCL 141(e),, MBCA section 83 1(e) protects directors from possible
duty of care liability if their actions or inactions were based on reasonable reliance on the
information and advice of officers, employees, or outside experts,
86
Std of care for directors Unlike the Delaware General Corporation Law, the MBCA does expressly
set a standard of care for Directors. MBCA section 8.30 requires that in discharging their decisionmaking function and in discharging their oversight function, directors must "discharge their duties with the care that a person in
like position would reasonably believe appropriate under similar circumstances" This seems similar
to the duty of care commonly imposed under tort law.
MBCA and DGCL Statutory Release of Liability for Duty of Care
MBCA section 2.02(b)(4) permits a corporation in its articles of incorporation to eliminate the
personal liability of a director for breach of duty of care
 same as DGCL 102(b)(7) except DGCL has different exclusions including violation of duty
of loyalty.
MBCA §2.02(b)(4)  the articles may include a provision limiting the liability of the directors, except
for:
 financial benefit from self-dealing
 intentional infliction of harm on the corporation
 distribution of an illegal dividend
 intentional criminal acts
 must be in the articles (“opt-in”) approach
 only precludes monetary damages, not equitable relief.
 only protects the directors
In re caremark
The Delaware cases involved (i) large corporations and allegations that (ii) the board (not any
one particular director) has failed to (iii) implement or maintain systems to monitor operations Del»
aware cases regularly refer to the board’s oversight duties as "Caremark duties"
Caremark International, Inc, is in the health care business A substantial part of the revenues
generated by Caremark’s businesses is derived from Medicare and Medicaid reimbursement programs Caremark paid $250,000,000 in fines for its employees’ violations of Medicare and Medicaid
rules, A lawsuit was filed alleging that the Caremark board of directors should be held liable to the
corporation for the $2 5 0,000,000 because of the board of directors' oversight failures.
The Caremark board was not held liable, Instead, the case was settled
In upholding the settlement in which the members of the board of directors of Caremark paid
$0.00 to the corporation, the Delaware Supreme Court made the following statement about
director’s oversight duties: “a director’s obligation includes a duty to attempt in good faith to assure
that a corporate information and reporting system, which the board concludes is adequate, exists,
and that failure to do so under some circumstances may, in theory at least, render a director liable
for losses caused by non-compliance with applicable legal standards"
Did you catch the three “weasel words" in the above statement? First, the court used the permissive "may," instead of the mandatory "will," Second, the court inserted the qualifying phrase "in
theory," Third, the court added yet another qualifying phrase, "under some circumstances" What
are "some circumstances?"
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Frances v United jersey bank
Here, we have a director who didn't direct
Reinsurance company that would make loans to the family members of that business out of
the company’s profits = comingling
What would a reasonable person in that position have done? Familiarize themselves with
everything—
If she could not carry out those duties, she should have selected someone who could have
carried out those duties.
Proximate cause-did that failure to direct proximately cause the damage?
DGCL 141(E) Directors are fully protected in reasonably relying in good faith on such reports
Director is not required to interfere in management by officers
But it must keep himself informed in some detail of its affairs and the conduct of its business
Not just a FIGUREHEAD, relying on others
3) INTERNAL CONTROL SYSTEMS
a) Duty to put in place internal controls to confirm
 compliance with laws and regulations
 prevent mismanagement and fraud
 otherwise protect assets of the corporation
b) SEC and Sarbanes-Oxley Act 404 imposes even greater liability in this area than common law
 Management must report on those controls
 Has proved to be incredibly costly to public corporations
c) Cannot, as held in Graham v. Allis-Chambers, excuse directors and management from putting
internal controls systems in place because no wrong has yet been committed
d) Accountants / Auditors play critical role
 confirm that Financials prepared in accordance with GAAP
 do not necessarily confirm or opine that the Financials are accurate
 Arthur Anderson – shredded documents under “Document Retention Plan”
 Found guilty of obstruction of justice
 25,000 employees lost their job / 5000 at Enron
 Down to Final Four Accounting Firm
e) 4 Sets of Book
 SEC Books
 IRS Books
 Pro-Forma – SEC minus extraordinary events
 Manager
Officer’s Duty of Care
1) Because certain officers such as the President manage day-to-day affairs of company they may have a
higher duty of care than directors whose contact with company is more remote
a) Because their duty of care is higher – they are more apt to be liable for losses to the company
resulting from that breach
Business Judgment Rule (goes to the first part of duty of care) – we want managers to take risks
1) The business judgment rule is a rebuttable presumption that in making that decision the directors /
management acted on an informed basis and in good faith in the best interest of the company = director is
protected even if the J was wrong– we want managers to take risks
a) Management decision could be wrong (could have made more money otherwise)
 While decision wrong, question properly before directors and there was no fraud or
illegality Shlensky v. Wrigley
b) X HOWEVER failure to use reasonable diligence to make an informed decision exposes the directors
to liability for breach of the duty of care imposed on them by their position.
2) Business Judgment Rule makes it difficult to attack the duty of care
Liability for Breach of Duty of Care
1) ATTENTIVE AND INFORMED.
a) Director cannot be liable for collapse of company unless it is proven that some specific loss could
have been avoided if he had been reasonably diligent in performance of his duty. Barnes v. Andrew
c)
d)
e)
f)
B.
C.
D.
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2)
TORT LIABILITY / DAMAGES.
a) Tort liability requires proof of causation – that failure to perform a duty was the cause of loss or
injury. Barnes v. Andrew
Not only was there a breach of duty, but there is causation
INTERNAL CONTROLS.
a) Director or officers may be held liable for failing to put in place internal controls or to investigate
after warnings of fraud or other mismanagement surface Bates v. Dresser
E. Exculpatory Provisions - Statutory Release of Liability for Duty of Care
1) MBCA §2.02(b)(4) a) the articles may include a provision limiting the liability of the directors, except for:
 financial benefit from self-dealing
 intentional infliction of harm on the corporation
 distribution of an illegal dividend
 intentional criminal acts
b) must be in the articles (“opt-in”) approach
c) only precludes monetary damages, not equitable relief.
d) only protects the directors
2) DGCL 102(b)(7)
a) allows Delaware corporations, with approval of shareholders, to adopt charter amendments that
exculpate directors from personal liability for breaches of the duty of care
b) difference from MBCA 2.02(b)(4) = same, except it has different exclusions including violation of
duty of loyalty.
F. Attacking Director Duty Of Care
1) Cannot attack content of board or management decision
a) Problem is the Business Judgment Rule and its powerful presumption in favor of management
2) MUST ATTACK process – not content
a) Fully informed
b) No conflict of interest
c) Exceptional Case: Dodge v. Ford – Court upheld attack on content
G. Bad Faith
1) 3 Types of Bad Faith
a) Subjective Bad Faith – motivated by intent to do harm
 Intentional Misconduct
 Knowing violation of the law
b) IN THE MIDDLE >>> Fiduciary Misconduct
 Not disloyal but more culpable than gross negligence***
c) Gross Negligence - w/o bad intent
d) *** Defined by Ovitz/Disney court as “dereliction of duty, conscious disregard for responsibilities”
e) ISSUE: Whether middle-ground misconduct is non-exculpable and non-indemnifiable
f)
YES – Only gross negligence can be non-exculpable and non-indemnifiable
3)
. Section 102(b)(7)
1. Del. C. § 102(b)(7) was in response to Van Gorkom.
2. Under this statute: a corporation may include in its certificate of incorporation:
a. A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for
monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability
of a director:
i. for any breach of the director’s duty of loyalty to the corp. or the stockholders.
ii. for acts or omissions not in good faith or which involve intentional misconduct or a knowing
violation of law.
iii. under §174
iv. or for any transaction from which the director derived an improper personal benefit.
2)
Distinction between Gross Negligence and Good Faith
a) Gross Negligence and Good Faith are separate and distinct.
b) Delaware statutes confirm the distinctions and find no basis in policy or
otherwise to dismantle the distinction
89


DGCL 102(b)(7) Allows shareholders to exculpate directors from
liability for breach of their duty of care, but not for conduct in bad
faith
DGCL Indemnification Statute allows indemnification for liability
from violation of duty of care, but not for violation of duty to act in
good faith
Bates v. Dresser – Justice Holmes

MBCA 8.42(a) (Duty of officers)-

MBCA §8.30(e) allows directors in carrying out their duties to reasonably
rely on corporate records and on the reports of officers,(including presidents)
employees, and third parties such as lawyers and accountants.


ISSUE: Liability of Directors –
o Whether they neglected their duty by accepting the
cashier's statement of liabilities and failing to inspect the
depositors' ledger? – they properly relied on Bank
President  Director care was sufficient NO
ISSUE 2: Liability of President for negligence ? YES
-President held liable here for not making an inquiry
breached his fiduciary duty of care not to investigate
Facts: Appellant bank president and directors and appellee bank receiver appealed the
lower court's judgment in favor of directors but against bank president on appellee's bill
in equity charging appellants with the loss of the bank's assets though a bank
employee's theft during their tenure.
Although there were warning signs that the thieving employee was taking advantage of the
situation and another employee raised the issue of possible theft, the theft was not ascertainable on
the face of the bank's ledgers and semi-annual audits revealed no fraud.
Issue: Whether the directors are liable and if they neglected their duty by accepting the cashier’s
statement of liabilities and failing to inspect the depositors’ ledger when they were so many red
flags.
Holding: The Supreme Court affirmed the lower court's judgment in favor of the directors since
there was no indication that they should have been on notice of the bank employee's theft; it also
affirmed the judgment upholding the bank president's liability since he assumed responsibility for
losses to the bank which were chargeable to his failure to act on the warning signs.
Notes: MBCA §8.30(e) allows directors in carrying out their duties to reasonably rely on corporate
records
and on the reports of officers, employees, and third parties such as lawyers and accountants.
3)
a)
FACTS
 Suit by Bates, receiver of the Massachusetts bank, against administrator of estate of Edwin
Dresser, deceased President of bank
 Bookkeeper/Teller Coleman committed fraud and stole over $300K from bank over the years via
a novel scheme
 Obvious warnings ignored by President
 Unexplained shortages
 Rapid decline in deposit accounts
 Suspicion of fired Teller that Coleman stealing
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
Information received that Coleman living beyond his means
Bank goes into receivership and receiver sues Directors and President for negligence in their
duty of care
b) ISSUE: Liability of Directors –
 Whether they neglected their duty by accepting the cashier's statement of liabilities and failing to
inspect the depositors' ledger? – they properly relied on Bank President  Director care was
sufficient NO
c) ISSUE 2: Liability of President for negligence ? YES
-President held liable here for not making an inquiry breached his fiduciary duty of care not to
investigate
 He had sufficient warnings to look into the possible fraud and did not
 As officer controlling day to day operations, he had access to information and ignored warnings
that should have induced scrutiny and spurned investigations
 President “put upon his guard”
 Is it fair to impose liability on an officer for fraud he did not commit?
-Court was tougher on the President here, various indicators Coleman was doing something bad,
-Fraud was very novel, bank examiners did not find anything, Bank manager was actually increasing the accounts,
president thought the declining amounts in
-RED FLAG ANALYSIS- claims will often be raised that during some kinds of fraud, there was some telling signs
that should have been caught by the outside directors, 20/20 hindsight is the easiest way to find fraud, however very
difficult to see in prospectively
-President held liable here for not making an inquiry breached his fiduciary duty of care not to investigate
4) Barnes v. Andrews – Justice Learned Hand (1924) duty of care to keep advised on corporate affairs
+proximate cause
a) Director has duty of care to be attentive to and informed of company’s conduct of business but
he cannot be held liable for company failure due to general mismanagement without proving a
causational relationship between the two.
b) FACTS:
 Liberty Starters Corporation formed in 1918 to manufacture starters for Ford motors and
airplanes.
 $500K was raised by sale of stock (public?)
 Δ Director Andrews was the largest stockholder and served as director for 8 months
 Company had problem because production delays due to mismanagement resulting in high
salaries and other costs bleeding the company dry.
 Л Barnes was appointed receiver – who found company funds depleted.
 Suit by receiver Barnes, against Andrews, a director for failure to give adequate attention to
company and to keep himself informed.
 Attended only one director meeting
 Informed only through communications with President
 Waste of company funds due to inter alia, high salaries being paid before production, excess
royalties being paid to engineer and fraudulent circulars inducing stock purchases
 Incompetent management and disagreements between officer
c) RULES / REASONING
 1 > DIRECTOR DUTY TO REMAIN INFORMED.
 Director is not required to interfere in management by officers
 But it must keep himself informed in some detail of its affairs and the conduct of its
business.
 Not just a FIGUREHEAD, relying on others
 We do have a breach of duty of care
 2> Л MUST PROVE CAUSATION
Breach of Duty of Care resulted in specific loss
 Action in Tort requires causation
 Л must show that omission of duty resulted in loss
– a loss that performance of duty would have avoided
Could have made it prosper or broken its fall
 But for causation
 And Л cannot show that

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

Different when there is theft or misappropriation
But not when general mismanagement causes problem
It is impossible to set a hypothetical standard of success
 3 > DIRECTORS HAVE NO LIABILITY FOR LACK OF BUSINESS KNOWLEDGE OR
EXPERIENCE
 Directors ”give no warranty of special fitness”
 Directors are not specialists but only general advisers of the business
 Corporation which has chosen director cannot charge him with general liability for
losses because of his lack of business knowledge or experience.
 Director has Duty of Care:
 A director cannot be held liable generally for collapse of the business of the corporation,
because of inattention to its affairs, but some specific loss must be shown, which would
have been avoided, if he had been reasonably diligent in performance of his duty
 Burden of proving same rests on a receiver, suing therefore.
d) HOLDING
 Director failed to keep himself informed
 Director not liable for failure of company due to general mismanagement because
 Л unable to show causation
 There is no evidence that Director’s neglect caused any losses to the company
 If there were losses, they cannot be determined.
-Got to be a causation requirement, here the company went down the tubes the director did not see what was going on
at the corporation
-Court said yeah there was a breach here, but did the breach actually cause the damage
-Court said we don’t know what the director could have done to correct the problems
-We have a a) find the breach, and then b) causation
The Business Judgment Rule
The courts wont review the merits of BOD decisions – judges are not experienced in making
corporate decisions+We want managers to take risks if they are going to be held personally liable for the risk
banks will not lend money
And, most important, the business judgment rule must appear in any exam answer
involving
litigation over the substantive merits of a board decision The business judgment rule
means that
a plaintiff alleging that directors breached their duty of care cannot prevail solely by
attacking the substantive merits of a board decision. Because of the business
judgment rule, a court will not rule as to whether aboard decision was a smart
decision or a stupid decision when there is no proof that the board acted in some
way badly.
Whether a judge or jury considering the matter after the fact, believes a decision
substantively
wrong, or degrees of wrong extending through "stupid" to “egregious” or "irrational",
provides no ground for director liability“ Thus, the business judgment rule is process
oriented and informed by a deep respect for all good faith board decisions,"
-If you exercise the business judgment and the judgment turns out to be a bad one, you will not be
held personally liable
-Exception to the rule is that you WILL be held liable if you breach the fiduciary duties in making
the decision
-If you inform yourself of all the pros and cons and then exercise business judgment you will be
protected by Business Judgment
92
Shlensky v. Wrigley
Facts: The stockholder filed a stockholders' derivative suit against the directors for
negligence and mismanagement. It is charged that the directors are acting for a reason or
reasons contrary and wholly unrelated to the business interest of the corporation; that such
arbitrary and capricious mismanagement and waste of corporate assets, and the directors
have been negligent in failing to exercise reasonable care and prudence in the management
of the corporate affairs. The stockholder sought damages and he prayed for an order that
required the corporate directors to install lights at the baseball field owned by the
corporation, and requested that they schedule night baseball games. The lower court held
that
The Informed Business Judgment Rule – PRESUMPTION REBUTTABLE
Judges have experience in making decisions, not experience in corporate decision
making. However, since courts of law has experience, if not expertise, in the decision
making process, courts will not invoke the business judgment to avoid reviewing
challenges to the decision making process of a BOD.
Rationale: The court said “the rule itself ‘is a presumption that in making a
business decision,
the directors of a corporation acted on an informed
basis, in good faith and in the honest belief that the action taken was in the
best interests of the company.’ ...Thus, the party attacking a
board
decision as uninformed must rebut the presumption that its business judgment
was an informed one.”.
Today, the basic lesson of Van Gorkom is that directors of a Delaware corporation face liability for breach of
their duty of care if they are grossly negligent in failing to adequately inform themselves regarding a decision
before them, unless that
Delaware corporation’s certificate of incorporation has eliminated liability for breach of duty of case
as permitted by section 102(b)(7),

 Directors will be liable to shareholders for breach of duty of care for Failure to make an
informed decision which will restrict the court from applying the business judgment rule.
Directors who approved a merger without properly informing themselves as to the value of
the business breached their duty of care. Shlensky
=Can the Board of Directors Breach Its Duty of Care by Carelessly Making
a Decision? Yes
Shlensky v. Wrigley VS Smith v. Van Gorkom
 Shlensky v. Wrigley, discussed above, is an example of not playing baseball games at night as an
allegedly flawed decision

Smith v. Van Gorkom, discussed below, is an example of approving a sale of the business in a single,
short meeting as an allegedly flawed decision-making process
The plaintiffs focused on the directors' decision-making process rather than the merits of the
At the time of the Delaware Supreme Court decision, the basic lesson of the Van
Gurkum case was
that directors of a Delaware corporation face liability for breach of a duty of care if
they are grossly
93
negligent in failing to adequately inform themselves. Shortly after the Smith v, Van
Gorkom decision, the Delaware legislature added section 102(b)(7) to the
Delaware General Corporation statute permitting a Delaware corporation to include
a provision in its certificate of incorporation that eliminates the duty of care. The
MBCA then authorized similar exculpatory provisions.
Smith v. Van Gorkom
e)
FACTS:
 CEO of Trans Union, a public company, privately negotiated, without informing directors, a
leveraged-buyout at $55 a share when market share was approximately $38 per share with
Pritzer.
 CEO requested director approval on 3-day notice
 5 outside – 5 inside directors and one was absent
 Management meeting held before director meeting
 Management opposed because they would probably lose their job
 Claimed not a good price to sell the stock
 Directors approved merger in 2 hours only after a 20-minute oral presentation from the CEO and
ad-hoc information from CFO and lawyer
 Without requesting a formal valuation of the business
 No Fairness Opinion
 Without reviewing the Merger Agreement
 Although the directors requested a 90-day Shop Window to take other offers, the Merger
Agreement did not include that provision.
 Lawyer advised if you don’t accept this offer you can get sued because it’s a good deal
they aren’t officers or agents?? Reasonable reliance does not count here??
 Standard is Gross Negligence

f)
g)
DUTY OF CARE OPT-OUT
 Delaaware responded to this case with DGCL 102(b)(7) which allows Delaware
corporations, with approval of shareholders, to adopt charter amendments that exculpate
directors from personal liability for breaches of the duty of care
 However, corp cannot adopt amendments that exculpate them from duty of loyalty
(INTENTIONAL MISCONDUCT OR VIOLATION OF LAW)
 90% of Delaware corporations opted out on duty of care
REACTION:
 Director liability insurance rose over 300%
 Legislation enacted allowing removing directors from duty of care
 Chicago school up in arms. How could directors be liable for approving a deal where
shareholders got a 50% premium over the market price of their stock? And what business did the
court have second-guessing the directors' judgment?
 Some called it worst decision in corporate history
 Delaware courts going nuts
 Decision Making Process – Court v. Business
 Court is telling business people to make decisions like lawyers and judges do
 Review tons of documents, deliberate
 Looking for process-oriented decision
 Business people don’t make decisions like that
 Must act quickly in business or you will not be profitable
 Lost opportunities
CURRENT LAW:
 DUTY OF CARE OPT-OUT
 Delaaware responded to this case with DGCL 102(b)(7) which allows Delaware
corporations, with approval of shareholders, to adopt charter amendments that exculpate
directors from personal liability for breaches of the duty of care
 However, corp cannot adopt amendments that exculpate them from duty of loyalty
(INTENTIONAL MISCONDUCT OR VIOLATION OF LAW)
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
90% of Delaware corporations opted out on duty of care
???BOD’s Duty to oversee = duty of loyalty?  DGCL 102(b)(7) duty of care exculpatory
provision will be irrelevant if duty of oversight is breached. Stone v Ritter (we did not go over this
case)
Second, notice that in Stone v. Ritter, the Delaware Supreme Court interpreted the Caremark duty
of oversight (which the Caremark case based on a duty of care) as a duty of loyalty, That is examimportant. Recall that Delaware General Corporation Statute section 107(b)(7) permits a Delaware
corporation to eliminate the directors’ liability for breach of a duty of care by so providing in the corpora»
tion’s certificate of incorporation. Section 102(b)(7) goes on to state that "such provision shall not
eliminate or limit the liability of a director for breach of the director's duty of loyalty," Thus, in an
exam fact pattern involving lack of oversight by the directors of a Delaware corporation that has an
exculpatory provision in its certificate, that exculpatory provision will be irrelevant

Van Gorkum Case Notes:
-Corporation called Trans-Union with a problem, Tax Credit you can deduct dollar for dollar a tax
credit, for every for tax credit I can put that against a dollar for dollar cash
-Problem is that Trans-Union is not generating enough cash to make that credit worthwhile, just like
watching money being burned and not being used
-BOD debate ad nauesium,
-President of the Company Van Gorkum, need to sell the company, $45 a share we would be happy
with that
-Priscet says he wants the tax credit, they sit down and negotiate a price BOD are not involved in the
negotiation between these two
-Triangular Merger, caused problems at the company
-Officers plan was to borrow money from the bank to buy the rest of the publicly traded stock, cut
expenses, use the money the corporation generates to pay off the loan, and then we will own the
company worth 100 million, called a LEVERAGED BUYOUT
-Managers told Van Gorkum that a leveraged buyout would bring about 50-60 dollars per share, Van
Gorkum pulled the figure of $55 out of the air, he did not research, an investment banker like
Morgan Stanley, how much the share was actually worth that is just what he wanted to sell it for to
retire
-Van Gorkum does the handshake deal with the other person, calls a BOD meeting the next day
without notice, meeting did not go through smoothly
-5 Outside and 5 Inside Directors, 20 min. presentation by Van Gorkum, no documents, not
investment banker there, no merger agreement between Van Gorkum and the other guy except for
handshake
-this was a Fight over whether the leveraged buyout was the best course of action,
-BOD approves the agreement unanimously, Van Gorkum signs the agreement never read it
-Management revolts after the deal is done, Solomon Brothers was the most aggressive investment
bankers in USA, sought dozens of companies and nobody wanted to buy the company
-Delaware Court is faced with the issue, did Van Gorkum breach the duty of care and the other BOD
members duty of care, did they fail to sufficiently inform themselves about the decision?
-Court was appalled that they only spent 20 minutes discussing this issue, Court is also angry that the
BOD never read the merger agreement
-What the Court was trying to do was to impose the kind of decision making process, with a very
structured decision making process, the court wants to see a process similar to the way law operates
so the record is clear and the duty of care gets satisfied
-Result Van Gorkum held liable, insurance paid most of the money, after this decision insurance
companies way overpriced the premiums on the BOD, and DE changed the law for the BOD to be
able to waive the duty of Care responsibility
-Court said standard of care is gross negligence,
-Business Judgment Rule-requires the director to be informed of the decision so as to not be held
personally liable for the poor decision
95
-Smith v. Van Gorkum-effort to define BJR, what degree of care must an executive take to be
protected, Court held that gross negligence was sufficient, merger agreement was not read all
happened too fast, found gross breach of duty of care for gross negligence
-Court says you must inform yourself be investigating the decision, facts look like the executive
discouraged the other potential buyers
-Court overreached the business operating procedures, business deals need to be done “while the iron
is hot”
-Court was trying to impose a ritualized decision process in the way that lawyers and courts make
decisions, business does not operate like that
-Result of the decision, DE legislature allowed corporations to opt out of the duty of care and most
DE corporations did, instead of imposing a higher standard, we got no standard
-DE General Corp. 102 (7)(b)- page 343 allowing corporation to opt out of the duty of care,
begging the question is there anything left
Issue: Does Π have a cause of action to interfere with the business practices
and judgment of the directors?
Holding: No; A court will not interfere with honest business judgment
of the directors of a corporation unless there is a showing of fraud, illegality or
conflict of interest. The court affirmed, maintaining that courts should not interfere
in a corporation's management unless fraud or a breach of faith existed. The
decision at issue was one properly before the corporation's directors, and the
motives alleged in the amended complaint showed no fraud, illegality, or conflict of
interest in their making of that decision. The allegations in the stockholder's
amended complaint were mere conclusions, which were insufficient to except the
directors from the business judgment rule.
Notes:
-Brought against directors by shareholders. Wrigley didn’t want to ad
lights.
-Very delicate balance – using standard of care – as long as don’t
breach your fiduciary
duty, not liable even if your decisions is a disastrous
one. Courts are not going to second
guess the business judgment and wants
to encourage risk taking. Once you breach your
fiduciary duty you lose
the protection of the business judgment rule.
5)
Shlensky v. Wrigley
a) CLASSIC Business Judgment Rule– we want managers to take risks
b) Management decision could be wrong (could have made more money
otherwise) – we want managers to take risks
c) Will look at corporate decision making to see if right or wrong to confirm they
used duty of care and duty of loyalty
d) FACTS:
 Stockholders of Wrigley Field bring derivate suit against directors
because directors have not put any lights to hold night games – and company
lost money because of that
 Directors made business decision that they felt appropriate
baseball is a day game and we don’t want night games, even if we lose money
e) ISSUE: Do stockholders have cause of action? Did directors breach their duty of
care?
f)
REASONING:
 Wheeler: Policy or business methods of a corporation
 Davis: Court deference to Business Judgment
 Shareholders did not properly allege a breach of duty of care
96


Cannot just allege that directors made a wrong or bad decision
Have to allege a breach of duty of care or duty of loyalty
 Not informed
 In bad faith
g) HOLDING:
 While decision wrong, question properly before directors and there was
no fraud or illegality
-Start analysis of fiduciary duties with the Business Judgment Rule
-We want managers to take risks if they are going to be held personally liable for the risk banks
will not lend money
-If you exercise the business judgment and the judgment turns out to be a bad one, you will not be
held personally liable
-Exception to the rule is that you WILL be held liable if you breach the fiduciary duties in making
the decision
-If you inform yourself of all the pros and cons and then exercise business judgment you will be
protected by Business Judgment
Shlensky v. Wrigley VS Smith v. Van Gorkom
 Shlensky v. Wrigley, discussed above, is an example of not playing baseball games at night
as an allegedly flawed decision

Smith v. Van Gorkom, discussed below, is an example of approving a sale of the business in
a single, short meeting as an allegedly flawed decision-making process
Can the Board of Directors Breach Its Duty of Care by Carelessly Making
a Decision? Yes
Smith v. Van Gorkom
Smith v. Van Gorkom is the case most commonly used to illustrate the proposition that a board of
directors breaches its duty of care by carelessly making a decision. In that case, the plaintiffs alleged
that the Trans Union board of directors’ decision to approve and recommend for approval by share»
holder a transaction merger in which Trans Union’s shareholders received $5 cash per share was a
breach of the board's duty of care
The plaintiffs focused on the directors' decision-making process rather than the merits of the
directors’ decision. The merger had been negotiated by Van Gorkom, Trans Union’s CEO (and director), without the knowledge of the rest of the Trans Union board.
The other board members did not know about the merger before the board of directors meeting, A meeting which lasted less than two hours A meeting at which, in the language of the court,
"the Board approved the cash-out merger based solely on Van Gorkom’s twenty-minute oral presentation about the merger proposal, and the Board failed to review any documents (or ask for a written
summary of the merger terms) before approving.” A meeting at which directors neither received nor
asked for any written documentation of the basis for the $55 per share price,
The trial court ruled for the defendant directors, finding that the directors' approval of the cash
merger fell within the protection of the business judgment rule
The Delaware Supreme Court over- ruled the trial court and ruled for the plaintiffs, reasoning:
- the business judgment rule protects only "informed decisions";
- gross negligence is the proper standard for determining whether a board decision is an
"informed decision";
- the decision-making process of the Trans Union board was grossly negligent,
At the time of the Delaware Supreme Court decision, the basic lesson of the Van Gurkum case was
97
that directors of a Delaware corporation face liability for breach of a duty of care if they are grossly
negligent in failing to adequately inform themselves. Shortly after the Smith v, Van Gorkom
decision,
the Delaware legislature added section 102(b)(7) to the Delaware General Corporation statute per»
mitting a Delaware corporation to include a provision in its certificate of incorporation that elimi»
nates the duty of care. The MBCA then authorized similar exculpatory provisions.
Today, the basic lesson of Van Gorkom is that directors of a Delaware corporation face liability for
breach of their duty of care if they are grossly negligent in failing to adequately inform themselves
regarding a decision before them, unless that
Delaware corporation’s certificate of incorporation has eliminated liability for breach of duty of case
as permitted by section 102(b)(7),
Smith v. Van Gorkom-As a result of Van Gorkem – Del legislature amended its laws
(102(b)(7))
Facts: The case involved a proposed leveraged buy-out merger of
TransUnion by Marmon
Group which was controlled by Jay
Pritzker. Defendant Jerome Van Gorkom, who was the
company's Chairman and CEO, chose a proposed price of $55
without consultation with
outside financial experts. He only
consulted with the company's CFO, and that consultation was
to
determine a per share price that would work for a leveraged buyout.
Van Gorkom and the CFO did not determine an actual total value of
the company. The court was highly critical of
this
decision,
writing that "the record is devoid of any competent evidence that $55
represented the per share intrinsic value of the Company."
The proposed merger was subject to Board approval. At the Board
meeting, a number of items were not disclosed, including the
problematic methodology that Van Gorkom used to arrive at
the proposed price. Also, previous objections by management
were not discussed. The Board
approved the proposal.
Leverage buyout-transunion would go and
borrow money from investment banks and
make an offer to the shareholders of the comp
to buy their stock. You use the money
generated by the corp to buy off the bank loan.
The officers and directors end up as owners.
Holding: The Court found that the directors, because they approved
the merger in minimal
time and without seeking any expert
advice, breached the duty of care they owed to the corporation and
could not seek protection of the business judgment rule.
Rule: Under the business judgment rule there is no protection for
directors who have made "an unintelligent or unadvised
judgment." A director's duty to inform himself in preparation
for a decision derives from the fiduciary capacity in which
he serves the corporation and its stockholders. Since a director
is vested with the responsibility for the management of the
affairs of the corporation, he must execute that duty with
the recognition that he acts on
behalf of others. Such
98
obligation does not tolerate faithlessness or self-dealing. But
fulfillment of the fiduciary function requires more than the
mere absence of bad faith or
fraud. Representation of the
financial interests of others imposes on a director an affirmative
duty to protect those interests and to proceed with a critical
eye in assessing information of
the type and under the
circumstances present here. Thus, a director's duty to exercise an
informed business judgment is in the nature of a duty of
care, as distinguished from a duty of
loyalty.
Rationale: The court said “the rule itself ‘is a presumption that in
making a business decision, the directors of a corporation acted on
an informed basis, in good faith and in the honest belief
that the
action taken was in the best interests of the company.’ ...Thus, the
party attacking a
board decision as uninformed must rebut the
presumption that its business judgment was an
informed one.”.
The decision also clarified the directors' duty of disclosure, stating that
corporate directors must
disclose all facts germane to a
transaction that is subject to a shareholder vote.
Notes:
-As a result of Van Gorkem – Del legislature amended its laws
(102(b)(7))
Cashout merger: Trans Union purchased for cash – all share for cash
– shareholder vote, if approved. All shareholders bought out - if you
don’t like the price you go to court and get more
or less.
Triangular merger: Pritzker (owned Marmon) wanted to buy,
subsidiary to buy tran union, two corporation merge and trans union
becomes subsidiary of Marmon.
Leveraged Buyout: Offering more than the market price and buyout
all of the shareholders.
Business Judgment Rule:
-Board must act in a deliberate and informed manner.
-It does not protect unintelligent and unadvised decisions
-Negligence standard.
6)
Smith v. Van Gorkom (Delaware, 1985) again
a) Director’s duty of care and the application of the business judgment rule
 The business judgment rule is a rebuttable presumption that in making
that decision the directors acted on an informed basis and in good faith in
the best interest of the company
b) FACTS:
 CEO of Trans Union, a public company, privately negotiated, without
informing directors, a leveraged-buyout at $55 a share when market share was
approximately $38 per share with Pritzer.
 CEO requested director approval on 3-day notice
 5 outside – 5 inside directors and one was absent
 Management meeting held before director meeting
 Management opposed because they would probably lose their job
99

c)
d)
e)
f)
 Claimed not a good price to sell the stock
Directors approved merger in 2 hours only after a 20-minute oral presentation
from the CEO and ad-hoc information from CFO and lawyer
 Without requesting a formal valuation of the business
 No Fairness Opinion
 Without reviewing the Merger Agreement
 Although the directors requested a 90-day Shop Window to take other
offers, the Merger Agreement did not include that provision.
 Lawyer advised if you don’t accept this offer you can get sued because
it’s a good deal
they aren’t officers or agents?? Reasonable reliance does not count
here??
 Standard is Gross Negligence
RULES
 Directors have a duty of care to be informed and make informed decisions
 Do not suggest Directors have to read every contract it approves
 The business judgment rule is a rebuttable presumption that in making
that decision the directors acted on an informed basis and in good faith in
the best interest of the company
 Failure to make an informed decision exposes the directors to liability for
breach of the duty of care imposed on them by their position.
 Standard is Gross Negligence
DEFENSES:
 We got good value over market
 Market was undervaluing the shares, does not reflect the value of control
 Did not look at value of cash flow
 We got Market Test when we asked Soloman to get offers and nothing bit
 You didn’t preserve it and you had lock-up provisions discouraging other
investors
 Your effort to cure did not cure
 Look at the quality of this Board of Directors – eminently qualified
HOLDING:
 Directors liable to shareholders for breach of duty of care.
 Failure to make an informed decision restricted the court from applying the
business judgment rule.
 Directors who approved a merger without properly informing themselves
as to the value of the business breached their duty of care. Because their
decision was not an informed decision the deference of the court to their
business judgment was not available.
 Reversed and remanded for valuation of the business to determine damages
due shareholders smith
 Settlement reached where shareholders received $23.5M: $10M from
director’s liability insurance and $13.5M paid by buyer (Pritzker) on condition
directors pay $1.35M to charity.
REACTION:
 Director liability insurance rose over 300%
 Legislation enacted allowing removing directors from duty of care
 Chicago school up in arms. How could directors be liable for approving a deal
where shareholders got a 50% premium over the market price of their stock?
And what business did the court have second-guessing the directors'
judgment?
 Some called it worst decision in corporate history
 Delaware courts going nuts
100

g)
Decision Making Process – Court v. Business
 Court is telling business people to make decisions like lawyers and judges
do
 Review tons of documents, deliberate
 Looking for process-oriented decision
 Business people don’t make decisions like that
 Must act quickly in business or you will not be profitable
 Lost opportunities
 Market tells you what value is – not investment bankers
 What am I getting?
CURRENT LAW:

DUTY OF CARE OPT-OUT
 Delaaware responded to this case with DGCL 102(b)(7) which allows
Delaware corporations, with approval of shareholders, to adopt charter
amendments that exculpate directors from personal liability for breaches
of the duty of care
 However, corp cannot adopt amendments that exculpate them
from duty of loyalty (INTENTIONAL MISCONDUCT OR
VIOLATION OF LAW)
 90% of Delaware corporations opted out on duty of care
Walt Disney Derivative Action (Ovitz) what is good faith? What levels of bad faith are there? Which levels can be waived?
the facts necessary to support a lack of good faith are facts that "suggest that the defendant directors consciously and
intentionally disregarded their responsibilities"



-Good faith is presumed Plaintiff must prove bad faith on the part of the directors.
In Delaware we have: duty of care, loyalty, and duty of good faith
You can waive a duty of care, you cant waive a duty of bad faith.
-The duty of care analysis was done for good faith [essentially].
h)



i)
NO BAD FAITH basically BJ rule
-Walt Disney hired Ovitz, Eisner was something of an executive who could do whatever, wanted to
hire Ovitz, carefully negotiated an employment contract with Ovitz, Ovitz had huge amount of
contacts and business in entertainment industry with protections
-Disney decides to terminate Ovitz, no basis of termination for cause, only basis is without cause,
BOD decide to fire Ovitz and under the contract Ovitz gets $130 million
-Was this bad faith? Court says BOD was silly to agree to this, however they were fully informed no
breach of GOOD FAITH
Shareholder derivative action brought against Ovitz and Disney directors, claiming the Ovitz
$140M severance package was a breach of fiduciary duty
In Disney they waived duty of care but [it was argued that the directors] did not act
in good faith because they did not make a serious effort in reviewing the contract
The claims were based on alleged knowing and deliberate indifference to a potential
risk of harm to the corporation.
j)



Compensation Committee and Directors failed to exercise due care in approving OEA
Court disagreed - Informed decisions protected by the business judgment rule
: The actions if the Disney board did not meet the ideal corporate practices, and
did not
rise to the level of a breach of fiduciary duties. The duty of care
analysis was done for good faith [essentially].
101
k)
FACTS
CEO Eisner seeks successor to him at Disney and approaches Creative Artists’ Ovitz. Ovitz enter
discussions with Eisner and Disney that leads to an Employment Agreement
 OEA required termination only for cause and in event of termination without cause it triggered
No-Fault Termination provisions that ensured Ovitz certain protections
 Ovitz required “downsize protection” to give up a 55% interest in CAA and $20-$25M
per year he made from CAA
 Given 3M Options guaranteed to have a value of $50M
 Compensation experts said it was an “extraordinary compensation package” but noted
that Ovitz was an “extraordinary corporate executive”
 Court recognized that Ovitz sacrificed “booked CAA commissions of $150M-$200M” and
properly demanded risk protection in the event his relationship with Disney did not work
out
 COMMITTEE INFORMATION. Directors on Compensation Committee reviews magnitude of
provisions, hires outside experts and otherwise applies several valuation methods of the options
and severance package
 Even though Committee members only given Term Sheet and not OEA
 Court said that although not Best Practices the Committee’s conduct met the due care
standard
 Committee properly informed of effect of NFT and approved it
 BOARD INFORMATION Eisner had continually discussed Ovitz and his qualifications with the
Board, informed of key terms of OEA and relied on Compensation Committee approval
 Announcement of his hiring alone increased stock price and increased market value of
company by $1B
 Directors properly exercised business judgment and acted in accordance with their fiduciary
duties when they elected Ovitz to the Presidency.
Holding: The actions if the Disney board did not meet the ideal corporate practices, and
did not
rise to the level of a breach of fiduciary duties. Fiduciaries are charged to act
faithfully and
honestly on behalf of those whose interests they represent are indeed
granted wide latitude in their efforts to maximize shareholder investment. The
decision makers entrusted by
shareholders must act out of loyalty to those
shareholders. They must in good faith act to make
informed decisions on behalf of
the shareholders, untainted by self-interest. Where they fail to do so, this Court stands
ready to remedy breaches of fiduciary duty.
The redress for failures that
arise from faithful management must come from the
markets, through the action of shareholders and the free flow of capital, and not from
the court.= (just sell the stock!!!)
BAD FAITH
Rittner (a case we did not go over) + Short and Happy Guide  Duty of Good faith is part of Duty of
Loyalty
 Disney case provides Judicial guidance for judicially uncharted area of corporate law of bad
faith
 Made distinction between gross negligence and good faith
 Disney Shareholders argued you cannot look at good faith unless you do not find due care,
as if one were part of the other
 The Disney Court argued that they were separate and distinct.Delaware statutes confirm the
distinctions and find no basis in policy or otherwise to dismantle the distinction
Cannot waive duty of good faith in Delaware
a) After section 102(b)(7) was added to the Delaware General Corporation Statute enabling a
Dela»
102
ware corporation to add a provision to its articles eliminating director liability for breach of
the duty
of care, the Walt Disney Company, like most Delaware corporations, added such an
exculpatory pro»
vision to its certificate.
Section 102(b)(7), however, does not permit a corporation to "eliminate or limit the liability
of a director for acts or omissions not in good faith"
b)
I: What is Good Faith? Neither the Delaware General Corporation Statute
nor the MBCA defines "good faith" Good faith has been said to require “honesty of
purpose” and a genuine care for the
fiduciary’s constituents, but at least in the corporate fiduciary
context, it is probably easier to define bad faith rather than good faith.
Bad faith: authorizing a transaction for some purpose other than a genuine attempt to advance
corporate welfare or [when the transaction] is known to constitute a violation of applicable positive
law. See below for 3 types of bad faith.
I: Does a breach of Good Faith require motive?
Defined by Disney court as “dereliction of duty, conscious disregard for responsibilities”=gross negligence = the std for breach of
It is unclear whether motive is a
necessary element for a successful claim that a director has acted
in bad faith, and if so, whether that motive must be shown
explicitly or whether it can be inferred from the directors’
conduct.
duty of care. (now it is the std for breach of duty of good faith?
3 Types of Bad Faith

Subjective Bad Faith – motivated by intent to do harm
 Intentional Misconduct
 Knowing violation of the law

IN THE MIDDLE >>> Fiduciary Misconduct
 Not disloyal but more culpable than gross negligence***
Motive?

Gross Negligence – NOT motivated by intent to do harm remember – this is the std for the
breach of BJ
(Lowest)




NOT equal to Bad faith (bad faith is somewhere higher)
*** Defined by court as “dereliction of duty, conscious disregard for responsibilities”
*Deliberate indifference and inaction in the face of a duty to act
a reckless indifference to or a deliberate disregard of the whole
stockholders’ or actions which are without the bound of reason.
body of
Only gross negligence can be non-exculpable and non-indemnifiabl
103
a)
a.
b.
b)
c)
Gross Negligence and Good Faith are separate and distinct. Delaware statutes confirm
the distinctions and find no basis in policy or otherwise to dismantle the distinction
Ignorance in and of itself probably does not belong on the list, but
ignorance attributable to any of the moral failings (hatred, lust, envy, revenge, shame, sloth, …)
constitute bad faith.
could
DGCL 102(b)(7) Allows shareholders to exculpate directors from liability for breach of their duty of care, but not
for conduct in bad faith
DGCL Indemnification Statute allows indemnification for liability from violation of duty of care, but not for
violation of duty to act in good faith
Section 102(b)(7)
1. Del. C. § 102(b)(7) was in response to Van Gorkom.
2. Under this statute: a corporation may include in its certificate of incorporation:
a. A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary
damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director:
i. for any breach of the director’s duty of loyalty to the corp. or the stockholders.
ii. for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.
iii. under §174
iv. or for any transaction from which the director derived an improper personal benefit.
1. Fiduciary Duty of Care: requires that directors [of a Delaware
Corporation] “use the amount
of care which ordinarily careful and
prudent men would use in similar circumstances,” and
“consider all
material information reasonably available” in making business decisions,
and that
deficiencies in the directors’ process are actionable only if the
directors’ actions are grossly negligent
OTHER – WASTE
 Л who fails to rebut the business judgment rule presumption is not entitled to any remedy unless
the transaction constitutes waste
 Л has to show exchange was “so one-sided no business person with sound judgment could
conclude that the corporation had received adequate consideration”
 Must be a squander or give-away of corporate assets
 Payment of a contractually –obligated amount cannot be waste
 Shareholders argued NFT provisions were waste because they gave Ovitz incentive to not
perform
Emerald Partners v. Berlin (Del. 2001)
a) Court is saying here reluctance to give up the duty of care
b) Court says you cannot come in and assert the Duty of Care waiver as a defense, until it is proved that
you breached the duty of Care
c) We say that because you have three duties 1) Duty of Care, 2) Duty of Good Faith, 3) Duty of
Loyalty
d)
2)
CASE NOTES:
-Duty of Loyalty has a particular meaning, however, hanging over everything is a general duty of
GOOD FAITH
-Walt Disney NOTES-claim here is that the directors acted in bad faith because they failed to inform
themselves of this contract provision that provided for such high compensation to Ovitz, plaintiffs
claimed a breach of the duty of good faith
-DE courts were extremely reluctant to read out of the statute a duty of good faith
-Walt Disney hired Ovitz, Eisner was something of an executive who could do whatever, wanted to
hire Ovitz, carefully negotiated an employment contract with Ovitz, Ovitz had huge amount of
contacts and business in entertainment industry with protections
-Disney decides to terminate Ovitz, no basis of termination for cause, only basis is without cause,
BOD decide to fire Ovitz and under the contract Ovitz gets $130 million
104
-Was this bad faith? Court says BOD was silly to agree to this, however they were fully informed no
breach of GOOD FAITH
-Leaves us with, where duty of care and duty of good faith, might overlap
-Markham gave a speech on this decision and said the Court could never act in a meaningful manner
to curb executive compensation, and the man in the front row was Justice Jacobs from DE who
authored this decision.
105
DUTY OF LOYALTY
CHAPTER 8
Breach of fiduciary duty of loyalty= a director uses her position as a director to gain some individual monetary gain or other personal
advantage.
BOD’s Duty of Loyalty to corp cannot be eliminated
=
A Delaware Corporation’s Certificate of Incorporation OR an MBCA
Act State Corporation’s Article of Incorporation CANNOT Eliminate a Director’s
Liability for
(l) Usurping a Corporate Opportunity,
(2) Entering into an Interested Director Transaction, or
(3) Competing with the Corporation
+ Breach of duty of good faith? Gross negligence Rittner + short aand happ yguide
BJ DNA when there is an interested director transaction (Conflict of interest) p 137 short and ahoppy guide
I.
Duty of Loyalty - Self-Dealing Transactions
A. Effect of Director’s Self-Interest
1) Conflicts of Interest
a) MBCA 8.60 Conflicting Interest
 When director or a related person has an financial or other interest, or holds a position with a
party to a proposed or effected transaction, that would influence his judgment were he called
upon to vote on the transaction
2) Voting on Interested Transactions
a) COMMON LAW:
 Any contract with a director of a corporation was voidable.
 1910 Not voidable if approved by a disinterested majority and not unfair
 1960 Could not void contract even if it involved majority of board as long as it was fair
 Could not count interested director to meet quorum requirement
b) MBCA 8.61: Allows interested directors may be counted to meet quorum requirements and
interested transactions are not automatically voidable IF
 Director provides Required Disclosure
 Full Disclosure
 Limited Disclosure where he has duty to other limiting disclosure (as long as he or a related
party are not a party to the proposed or effected transaction)
AND
 1 of 3 Other Conditions Must be Met:
 MBCA 8.61 Showing contract is FAIR to the corporation
 Delaware and most other courts require this always
 MBCA 8.62 AFTER FULL DISCLOSURE: Ratification by majority of independent/
qualified/disinterest directors of board or a committee OR
 MBCA 8.63 AFTER FULL DISCLOSURE Approval or ratification by shareholders
c) DGCL 144
 The same as MBCA
NOTE:
 Only applicable to directors
 Does not preclude further scrutiny
3) Contracts Voidable by Corporation
a) MODERN VIEW: Corporate transactions where a director or shareholder had self-interest
were automatically voidable by the corporation if
 Interested director did NOT comply with 8.62
 Interested shareholder comply with 8.63 OR
 Transaction is unfair to the corporation
 REASONING:
 Violation of the duty of loyalty
 Faith in interested director’s loyalty disarms suspicion of the rest of the Board
106

B.
If contract unfair and interested director did not warn those that relied on his loyalty of its
unfairness
 Trustee (director) has duty to seek no harsh advantage to the detriment of those that rely on
his loyalty
b) Exclupatory Provisions - Requirements to Validate Interested Transactions
 Required Disclosure
 MBCA 8.60(4) FULL DISCLOSURE
 Director has obligation to fully disclose
 Existence and nature of his conflict
 All material facts know to him that he is authorized to disclose
 Perils, value of property or services, amount of director’s profit from the transaction
 Failure of interested director to make full disclosure to an independent board is in
itself unfair to the corporation
 MBCA 8.62(b) LIMITED DISCLOSURE
 Permits limited disclosure where he has duty to other limiting disclosure
 Must disclose nature of his conflict and limitations imposed on him by that relationship
regarding disclosure
 Director or a related party cannot be a party to the proposed or effected transaction
 Director cannot play any part in deliberation or vote
 Fairness
 Where director does not or cannot disclose he must show contract is fair
 Unfair in price, terms or conditions
 Burden of proof on interested director
 Example where disclosure not possible (interested director controls majority of the board)
 Same rule applies for controlling shareholder
 MOST COURTS – DELAWARE AND OTHERS REQUIRE FAIRNESS NO MATTER
WHAT
 Delaware
Globe Woolen Co v. Utica Gas – Cardozo
1) Unfair corporate contract involving an interested director who did not fully disclose perils of contract is
voidable by the corporation
2) FACTS
a) Maynard is Director, President and majority stockholder of Л Globe Woolen mills. He is also a director of Δ
Utica Gas & Electric.
b) He negotiates an agreement for the mills solely with a superintendent / general manager of the electrical
company to provide electricity to his mills, replacing steam.
c) Maynard requires and is given a guaranty of savings. Maynard and the superintendent close the agreement and
it is later presented to the Board for ratification. Maynard chairs the Δ’s board meeting where ratification of
the contract is requested and abstains from voting because of his interest in the mills.
d) There is later a second contract for another mill with additional preferential provisions which Maynard does
not disclose
e) Shortly after the contracts are entered into, the mills change their operations so they dye more yarns (which
takes twice as much electricity). Despite increased use, the electrical company must under their contract with
the mills guarantee a savings. The corporation provides $60-$70K of electricity to mills, receiving no money
and in fact owing him $12K. It calculates if the contracts go to term the corporation will be providing
electricity to the mills at a loss of $300K.
f)
The electrical company rescinds the contract as a contract made under dominating influence of a common
director, with unfair terms and oppressive consequences.
3) RULES/ REASONING:
a) There must be candor and equity in the transaction
 Interested director’s refusal to vote is sufficient if all is equitable and fair
 But such abstention does not relieve him of the duty to warn and denounce possible inequities
4) HOLDING:
a) Contract is voidable at election of the Δ
 Maynard was a dominating influence
 Faith in his loyalty disarmed suspicion
 May betray a beneficiary by silence as well as by the spoken word
107

Maynard knew of or could have foreseen unfairness of contract and did not warn directors that relied
on his loyalty
 Changes in business that increased power costs permits the inference they were premeditated (in bad
faith)
b) Refusal to vote does not nullify an influence exerted without a vote
c) Trustee (director) has duty to seek no harsh advantage to the detriment of those that rely on his loyalty
d) Equity allows voiding a contract that results only from a breach of the duty of loyalty
5) MARKHAM ASKS:
a) What about other directors?
 Cardozo doesn’t mention but they may have had a duty of care to be informed, especially because
Maynard
 HOWEVER Directors can rely on experts though – report of engineer
-Utica Gas Case NOTES-Breach of the DUTY of LOYALTY in this case, what happened here conflicting loyalties
because Maynard stood on both sides of the transactions
-Maynard wanted a guarantee that he would be given a saving if Maynard switched over the power of the plant to
electricity
-Immediately the substantial costs of doing the business with electricity in the plant was grossly over consumed by the
amount of electricity that was required to run the plant
-Cardozo opinion here who is in favor of the breech of loyalty, Cardozo says you did not warn them of the danger of
the contract, and the overuse of electricity constituted a breach of the duty of loyalty
-Common law changed over time and so did the statute, Courts wanted to make sure that executives could not sit on
both sides of the transactions
-However, NOW courts do not strike down contracts where conflicts of interests exist, it needs to be a fair contract,
and a disinterested majority of the BOD approved the contract
-We need to make sure that if we have a contract with a director with an interest in the transaction, you need to comply
with the State statute concerning the conflict of interest
108
Duty of Loyalty -
Conflicts of Interest
Who is your client? The president (who retained us) or the corporation? The corporation and its shareholders is
our client, not the person that hired us Corporate lawyers will ALWAYS do what’s best for corporation  since
were representing the corporation, may need to have separate counsel for shareholder, director, officer or employee unless they waive
conflict of interest
An "interested director transaction" aka director’s conflicting interest transaction by MBCA
is a transaction between a corporation and one or more of its directors (or officers or controlling shareholders), or between the
corporation and an entity in which one or more of its directors has a material financial interest.
D’s sale of Redacre to the corporation for which she is a director
To review, a corporation’s transactions are typically made or reviewed by the board of directors
When a director of the corporation has a personal interest in a transaction with the corporation,
that transaction must be approved by disinterested people. The disinterested people can be either (i)
other members of the board of directors who are disinterested, (ii) other shareholders who are disin»
terested, or (iii) a judge. If (i) or (ii), then there must be disclosure, If (iii), then there is the "entire fair»
ness" standard review by a judge.
Note: the MBCA uses the term “qualified” instead of “disinterested”
Relevant statutes: Both are very similar
MBCA 8.60 to 8.63
DGCL 144
Even if a corporation enters into a transaction with one of its directors that transaction will not always be avoided, and that interested director will not always be
held liable If a director can prove "the entire fairness" of the interested director transaction to the corporation at the time
of the transaction, the director escapes judgement
+ if the director interested transaction is approved by a majority of the disinterested directors or by the disinterested holders of a majority of shares, the
director escapes judicial relief against her for the transaction
109
Under both the Delaware General Corporation Statute and the MBCA, an interested director transaction will not be subject to an entire fairness standard if the transaction was approved by a majority
of the disinterested directors or the disinterested holders of a majority of the shares.
Thisalso means that Director approval or shareholder approval will have this "cleansing" effect
only if there has been full disclosure of the conflicting interest.
To illustrate, D, one of the four directors of BBC, sells Redacre to BBC. If, after disclosure of D’s
ownership of Redacre, two of the other three BBC directors authorize the transaction, then D does
not have to prove the "entire fairness" of the transaction, Similarly, if D owns 100 shares of BBC stock, S owns 700 shares, and various other
shareholders own the other 200 outstanding shares, then D does not have to prove “entire fairness" if S approves the transaction
after disclosure
DGCL 144 (1967)
Makes an exception to the Per Se Rule by establishing how interested transactions could be validated –
shareholder approval, disinterested director approval
 Director can participate in a meeting and even vote
c) Section 144 HOWEVER is not exclusive vehicle for validating interested director transactions
d) Delaware and most courts also require Fairness
6) ONE VIEW:
a) Even if you comply with a statute exculpating interested transactions the court may still find you violate a
fiduciary duty PGA
b) Directors cannot vote on a matter in which they have a conflict of interest.
7) OTHER VIEW: ??????
Fairness (case law – “fairness” is nowhere in MBCA or DGCL)
1) Intrinsic Fairness Test
a) If a transaction advances the personal interests of the directors at the expense of the stockholders it is
UNFAIR  and voidable by the stockholders
b) Look at motives of Δ directors and effect of transaction on corporation
2) Two Tiered Analysis Fliegler
a) Application of Section 144 + an Intrinsic Fairness Test
 Necessary where shareholder control by interested directors precludes independent review
b) Where compliance with Section 144 is impossible under the circumstances, the Intrinsic Fairness Test can be
applied
3) Whether fairness and approval after disclosure are alternatives to validation of an interested director
transaction varies by jurisdiction -->= Some courts require both
a) Interested transaction may be set aside if unfair to the corporation, even it was approved after full disclosure
b)
Validity of interested transactions requires an analysis of compliance with validating statutes and an
intrinsic fairness test. Marciano v. Nakash
b)
C.
Marciano v. Nakash – Delaware 1987
Corp was split between two families,
one family lends the business money to keep it going,
Issue: was the loan voidable because it was an interested transaction because there were interested members of the board
1) ISSUE:
a) Whether the loan, although an interested transaction not approved by a disinterested majority of the
directors or shareholders, was nonetheless fair and therefore valid?
The loans were given to help the corp  fairnot grounds for invalid under the interested director
transaction  debt was valid !
4)
5)
6)
Validity of director interested transactions requires an analysis of compliance with validating statutes and
an intrinsic fairness test.
a) Лs argue DGCL 144 was the only basis for immunizing self-interested transactions and if that
failed, transaction must be voided. NOPE
PH:
a) The other family brought an action to have the debt declared void as interested transaction not
properly authorized by the Board.
RULE / REASONING:
110
Per Se Rule of Voidability
 Potter characterized transactions between corporations having common directors and officers as
constructively fraudulent absent shareholder ratification.
 Voidable because the vote of an interested director will not be counted towards the affirmative
vote of a majority
b) DGCL 144 (1967)
 Makes an exception to the Per Se Rule by establishing how interested transactions could be
validated – shareholder approval, disinterested director approval
 Section 144 is not exclusive vehicle for validating interested director transactions
 144 is safe harbor – if you comply you are good
 COMPARE TO PGA – Safe harbor if no other fiduciary concerns
c) Two Tiered Analysis Fliegler
 Application of Section 144 + an Intrinsic Fairness Test
 Necessary where shareholder control by interested directors precludes independent review
 Where compliance with Section 144 is impossible under the circumstances, the Intrinsic
Fairness Test can be applied
 INTRINSIC FAIRNESS TEST
 If a transaction advances the personal interests of the directors at the expense of the
stockholders it is UNFAIR and voidable by the stockholders
 Look at motives of Δ directors and effect of transaction on corporation
d) REASONING:
 Motive: Loans made with bona-fide intent to allow the company to stay in business
 Effect: Terms of the loan were comparable to those of unrelated lenders
 Not depriving the corporation of a business opportunity but instead providing a benefit otherwise
unavailable.
7) ISSUE:
a) Whether the loan, although an interested transaction not approved by a disinterested majority of the
directors or shareholders, was nonetheless fair and therefore valid?
8) HOLDING: Yes.
a) Chancery Court properly applied the Intrinsic Fairness Test to determine the validity of the interested
director transaction. Fairness finding supported by the record.
-Marciano Case NotesCorp was split between two families,
one family lends the business money to keep it going,
Issue: was the loan voidable because it was an interested transaction because there were interested members of the
board
-Safe Harbor- if you fit within these prongs you are okay, but they are not exclusive, if you try to show that court that
you fit within the prongs for some other reason you may be ok
-Here there was simply a fair decision with the transaction
a)
The loans were given to help the corp  fairnot grounds for invalid under the interested director
transaction  debt was valid !The court examined the motive of the defendant directors and the
effect of the transaction had on the corporation and its shareholders. The court said a finding of
fairness is particularly appropriate in this case because the evidence indicates that the loans were
made by the Nakashes with a bona fide intention of assisting Gasoline’s efforts to remain in
business. Directors who advance funds to a corporation in such circumstances do not forfeit their
claims as creditors merely because relationship. The interested directors were not depriving the
corporation of a business but providing a benefit which was unavailable elsewhere.
Gilder v. PGA Tour
9)
ex of COI and fairness test -this case is useless
MARKHAM TRIED THIS CASE
Even if you comply with a statute exculpating interested transactions the court may still find you violate a
fiduciary duty
a) Directors cannot vote on a matter in which they have a conflict of interest.
111
10)
11)
PGA bans U-shaped groove clubs.
Manufacturer Karsten and 8 professional golf players sue PGA, alleging antitrust and breach of fiduciary duty and
moved for injunction preventing PGA from banning the clubs.
12) They presented
evidence showing that plaintiff manufacturer would suffer harm to its reputation and plaintiff
players would lose endorsements and be disadvantaged on the tour by being required to use
new clubs.
FACTS
a) PGA Board Structure and Director Action:
 4 professional players, 3 PGA of America officers and 3 independents.
 May 88 -- PGA Board approves rule banning U-grooves.
 Feb 89 --PGA then attempts to obtain Board approval to further amendment of rule.
 7 directors abstain due to conflict of interest and 3 independents vote for approval on ban.
 BUT Bylaws requires approval of rule change by majority of directors present AND 3 of the 4
player directors = breach of bylaws
 Dec 89 -- Board obtains approval to change Bylaws to allow disinterested directors can bind corporation
when majority of directors could not vote because of conflict.
 All 10 directors voted unanimously to amend Bylaws.
 Board then resubmits rule change to Board and 3 disinterested directors vote for approval.
14) PH:
a) Trial Court granted Л Karsten’s temporary injunction, having met the burden of proof to grant the temporary
injunction.
15) HOLDING/RULE:
a) When directors voted on Bylaw amendment they were voting on a matter in which they had an interest
which may violate a fiduciary duty.
 Players knew result of the amendment would be what aresult and bhow thjey know?
 Even if you comply with statute …
 You can’t do anything because of a conflict of interest
b) Court held that trial court did not abuse its discretion in granting injunction but did not rule on the merits of
the case because the record was undeveloped.
c) Settlement was that grandfather U-groove clubs but in future only V-grooves
-Markham tried this case,
PGA Tour and Golfers used golf clubs and the quality of equipment is becoming more important to the game of golf
-Charge was the U grove clubs allowed the players more back spin, and more control, taking out of the penalty of hitting the
fairway on the drive as opposed to players who were in the rough and still were able to hit the green in regulation with the U
grove shaped clubs
-Concern with the lawyers, is any time you have a league, unless you are MLB, you have anti-trust issues
-General Rule is that you have to give a fair amount of DUE Process and have not discriminated over one manufacturer
-Independent tests were conducted to determine if the U grove shape club actually did the help
-Analysis conclude that there was a statistically significant advantage of the U grove, USGA did the same type of study
-concern of the lawyers was always anti-trust, we did not want to treat club manufacturers unfairly players all had conflicts of
interest
-USGA wanted to use outside directors to vote on this instead, to avoid the conflict of interest and satisfy anti-trust issues
-Only anti-trust lawyers did not read bylaws, on equipment issues, the player representatives need to be involved in the voting
-Markham wanted to amend the bylaws to get around this, it works about half the time, courts may say it’s a breach of
something to just change the rules like that specifically when someone has a legitimate claim against you for whatever reason
-USGA amended the bylaw, and the court said NO even though you complied with the statute there is a breach of fiduciary duty
here because the interested directors knew what the outcome of the decision would be so the interested transaction was
unfair?
-Even if you have a disinterested majority of directors, the contract needs to be fair
-USGA ended up grandfathering the rule, saying clubs with U no longer good, people can play with them until they break
-Even if you meet the statutory requirement for the interested director transaction courts will determine if the transaction is fair
13)
112
-Duty of Loyalty- has
1) conflict of interest, glob wolin case director sat on both sides of the transaction, breach of the loyalty and
2) Corporate Opportunity-fiduciary duty of loyalty, court looked at several items to determine if the officer actually breached
the duty, what hat was the director wearing, did the corporation previously negotiate for it, critical factor did the corporate
officer disclose the opportunity to the corporation so the corporation can take advantage of the opportunity, 99% protection if
you disclose the opportunity of the director to the corporation
Usurpation of a corporate opportunity  director’s breach of fiduciary duty of loyalty to corp
ALI – ALI States - hinges on disclosure + specific rules
Guth V Loft - Delaware - balancing test
Line of business test
B.
C.
Corporate Opportunity Doctrine
1) Definition
a) Fiduciary Duty Precludes Director From Usurping Corporate Opportunity
The duty of loyalty bars a director from taking for himself any advantage or business opportunity that
property belongs to the corporation
b) POLICY:
 Corporate officers and directors are not permitted to use their position of trust to further private interests.
 Cannot deprive the corporation of profit, advantage or opportunity
 Allowing director to usurp a corporate opportunity in general will discourage director from making his
best efforts to obtain the needed money for the corporation
Financial ability irrelevant unless the company is insolvent ???????
 Allowing director to usurp a corporate opportunity when he determines corporation financially unable
creates temptation for fiduciary to not diligently seek financing for the corporation

2) Corporation has the Right of First Refusal
a) Director must make full disclosure and offer to the corporation any such opportunity
b) Right of First Refusal – right to exercise the opportunity on the same terms offered to the director
3) Standard of Fairness
a) Whether unfair for the director to exploit the opportunity
Traditional Corporate Opportunity Doctrine Tests
1) Interest or Expectancy test
a) had the corporation undertaken to negotiate in the field
b) it does not have to be essential to its business or interest
2) Line of Business test
a) applied broadly to extend beyond current operations
113
narrower than Expectancy
Consider such factors as resources, facilities, equipment, experience, knowledge and ability to pursue a related
business opportunity
d) Latitude allowed for development and expansion
3) Fairness test
a) using fairness factors:
 was it presented to the corporation
 was the conflict disclosed to the corporation
 were the corporation’s assets or resources used
 was there good faith
4) Other Factors Determining Corporate Opportunity
a) Corporate Plans and Expectations
 Corporation has a present interest or tangible expectancy in the opportunity
 Specific need
 Resolved to acquire it
 Actively considered its acquisition
 X Useful not enough
b) Director’s Capacity in Dealing
 If discovered by the director in his capacity as director acting for the corporation it is a corporate
opportunity
 Was the offer made to the corporation or the individual?
 IF DIRECTOR INVOLVED IN MANY COMPANIES it may be easier to prove the deal was made to
him individually
c) Corporate Funds or Resources Used
 A breach of fiduciary duty will most likely be found where the director has used corporate funds or
resources in starting or acquiring a competing business.
d) Corporation’s Financial Ability Irrelevant
Financial ability irrelevant unless the company is insolvent ???????
 Allowing director to usurp a corporate opportunity when he determines corporation financially unable
creates temptation for fiduciary to not diligently seek financing for the corporation
Where Corporation Unable to Take Advantage of Corporate Opportunity
1) Corporation Unable
If after full disclosure, the corporation is unable to take advantage of the opportunity, the director may take advantage
of it.
 If corporation insolvent or financially unable
2) Ultra Vires Transaction
a) Some courts allow director to take opportunity if transaction is ultra vires
Avoiding the Corporate Opportunity Doctrine
KEY IN ALL THESE CASES IS DISCLOSURE
a) If after full disclosure, the corporation does not act, it allows director / officer to take the opportunity
b) Resolve the conflict before director invests funds into a new business only to have itself deprived of those profits later
b)
c)
D.
E.
F.
Remedy for Usurping Corporate Opportunity
a)
b)
c)
CONSTRUCTIVE TRUST.
 Interest held by director is deemed to be held in constructive trust for the corporation and all profits derived
therefrom are due to the corporation.
 Courts may declare director holds the opportunity as constructive trustee for the corporation, forcing a conveyance
of the business opportunity to the corporation at the cost to the direction and an accounting the corporation for any
profits, income or rent derived therefrom
DIVESTITURE.
 Divest/relinquish director of all profits and benefits of usurped opportunity
 Extinguishes all possibility of profit flowing from the breach of confidence
Rigid and uncompromising standard
 No consideration of damages
 Purpose of strict application is to remove all temptation of director to usurp such opportunity
 Irrelevant that director took failing company and turned it into profit
114


Because a corporate opportunity is determined as of the time it was presented, the corporation usually waits
until it is successful to bring an action (thus avoiding risks associated with developing the opportunity).
>>> Courts do not look at or consider these factors
Delaware on Corporate Opportunities
Guth v. Loft (Delaware) – balancing test
--leading case on usurpation of corporate opportunities
Remember: The corporate opportunity doctrine is the legal principle providing that directors, officers,
and controlling shareholders of a corporation must not take for themselves any
business opportunity that could benefit the corporation.  forfeit all profits

The corporate opportunity doctrine is one application of the fiduciary duty of loyalty.
-1) Was it in the “Line of Business” of the corporation?- does not have to be exactly the same
 =?=It does not have to be essential to its business or interest
-2) Was it an opportunity presented to the corporate director himself, or in his capacity of the BOD of
Loft?-Guth was wearing a Loft hat and it looked like he took it on Loft status
-3) Does Corporation have the resources to take advantage of the opportunity?-Most courts downplay
this because if it was a really great opportunity the corporation could borrow money against the opportunity
and their line of credit
-4) Did the Corporation ever negotiate for this kind of opportunity?
-5) Was the opportunity disclosed to the corporation before the officer took advantage of the
corporation?-Probably the most critical factor especially for “GOOD FAITH” purposes, 99% going to be
enough for the courts
-Odd part is that if Guth would have disclosed, he was really disclosing to himself
-6) Did the Corporate Officer use the funds or facilities to take advantage of the opportunity?
=
Delaware - Guth v Loft
"[I]f there is presented to a corporate officer or director a business opportunity which the
corporation is financially able to undertake, is, from its nature, in the line of the
corporation’s business and is of practical advantage to it, is one in which the corporation
has an interest or a reasonable expectancy, and, by embracing the opportunity, the selfinterest of the officer or director will be brought into conflict with that of his corporation,
the law will not permit him to seize the opportunity, (emphasis added)
Line of business test: A version of the corporate opportunity doctrine
under which a director may not usurp a business opportunity if the
corporation is financially able to take the opportunity, the opportunity is
in the corporation’s line of business, and a conflict of interest would
result between the corporation and the director if the director took the
opportunity.
“where a corporation is engaged in a certain business, and an opportunity is presented to it embracing an activity as to which it has fundamental knowledge, practical
experience and ability to pursue, which logically and naturally is adaptable to its business having regard for its financial position, and is one that is consonant with its
reasonable needs and aspirations for expansion, it may be properly said that the opportunity is inside the line of the corporation’s business.”
d)
FACTS:
115



1.
2.
3.
4.
5.
-Guth is running Loft, and one big expense item is soda fountain with Coca-Cola charging them a price for the
syrup, Coca-Cola wanted a price same as everybody else regardless of the amount LUFT was buying which was
huge
-Pepsi-Cola- said you want to take us over because we are pretty much bankrupt, Guth took over Pepsi-Cola and
all of the sugar produced by Pepsi-Cola was given to Loft
-Issue: Guth actually said he made a good decision because he got Loft cheaper sugar, Loft said Guth could
not take over Pepsi-Cola by himself?
Guth was Director and President of Loft retail candy business and had absolute freedom of action with respect to
the company.
Guth, in looking to replace Coca-Cola as the supplier of syrup for Loft, was offered to purchase Pepsico who was
in bankruptcy.
He took the opportunity personally rather than offering it to the company.
8 Years later(no SOL?) the corporation took action against Guth for usurping corporate opportunity
Court found Guth improperly took a corporate opportunityUsed corporate resources to fund and get it off the
ground Guth must forfeit all profits
Guth QUESTIONS / TESTS
 What if it didn’t come to him in his capacity as officer?
 Guth argued he had been approached by Pepsi before he was involved in Loft and this was continuation of
those negotiations
 COURT SAID NO: Opportunity came to him because he was looking for syrup for Loft
 What if it was outside its line of business = line of business test
 It does not have to be essential to its business or interest
 Although in the retail candy business it did buy and use syrup in its operations and may have benefited from
this opportunity for a related expansion/diversification into the food / beverage industry
 Loft facilities could easily accommodate the necessary production, it did have profitable wholesale sales and it
did manufacture syrups to supply its needs.
 Success of Loft increased with full utilization of plant facilities
 What if corporation didn’t have money to pay for it? DNM
 That alone is not determinative  it could borrow money.
 Here it is clear that Loft had the resources because Guth used Loft resources for Pepsi
 Were corporate resources used? yes
 He used Loft employees, facilities and other resources without putting at risk any of his own
 He thrust on Luft the hazard while he personally reaped the benefit
Competititon?
 Normally no unity between retailer and supplier
 Retailer free to change suppliers – under no compulsion or restraint
 Here because Guth was Loft and Guth was Pepsi
 Here there was unity whereby Guth as Pepsi could force prices and terms on Guth as Loft
 Guth gave Loft no contract for specified supply at set prices
 Put him in a competitive position with Loft for a commodity essential to it
 Guth assumed a dual personality and conflict of interest position his corporate duty did not allow him
to assume.
Line of Business Test
“where a corporation is engaged in a certain business, and an opportunity is presented to it embracing an
activity as to which it has fundamental knowledge, practical experience and ability to pursue, which
logically and naturally is adaptable to its business having regard for its financial position, and is one that is
consonant with its reasonable needs and aspirations for expansion, it may be properly said that the
opportunity is inside the line of the corporation’s business.”
=if it came to the person and not in the corporation, it is outside the line of business
-Guth v. Loft Case NOTES
-Corporate Opportunity: Did you breach your fiduciary duty of loyalty by taking advantage of the opportunity
that rightfully belonged to the corporation?
-Court found YES there was a breach here laid out certain factors to see if breach
-1) Was it in the “Line of Business” of the corporation?- does not have to be exactly the same
116
-2) Was it an opportunity presented to the corporate director himself, or in his capacity of the BOD of
Loft?-Guth was wearing a Loft hat and it looked like he took it on Loft status
-3) Does Corporation have the resources to take advantage of the opportunity?-Most courts downplay
this because if it was a really great opportunity the corporation could borrow money against the opportunity
and their line of credit
-4) Did the Corporation ever negotiate for this kind of opportunity?
-5) Was the opportunity disclosed to the corporation before the officer took advantage of the
corporation?-Probably the most critical factor especially for “GOOD FAITH” purposes, 99% going to be
enough for the courts
-Odd part is that if Guth would have disclosed, he was really disclosing to himself
-6) Did the Corporate Officer use the funds or facilities to take advantage of the opportunity?
ALI states on Corporate Opportunities
Northeast Harbor Golf Club, Inc. v. Harris
the Maine Supreme Court rejected Guth v. Loft, Inc. and applied the ALI
Harris was president of a Maine corporation which operated a golf club, She purchased two
parcels of land near the club, the Gilpin property and the Smallidge property, Harris was approached
about the Gilpin property because she was president of the corporation and the seller thought the
corporation would be interested in the purchase to maintain a buffer around the club and for devel»
opment. The Smallidge property came to Harris's attention when a person she played golf with told
her about it.
The trial court relied on Guth v, Loft, Inc, the Delaware case discussed above, and held that Harris had not usurped a corporate opportunity because
(1) the land was not in the corporation’s “line of business" and
(2) the corporation lacked the financial wherewithal to purchase the property, On
appeal, the Supreme Court of Maine reversed and remanded, rejecting the Guth approach and adopting the ALI Principles of Corporate Governance instead.
ALI
= The American Law Institute’s Approach to Duty of Loyalty to Director’s Usurpation of a
Corporate Opportunity:
-hinges on disclosure = if the officer or director presents the opp to the corp. and the corp declines
the opportunity, then the officer is blessed = 99% protection if you disclose the opportunity of the director to
the corporation
-most accepted std
-Remember: The American Law Institute's ("ALI") Principles of Corporate Governance are binding only to the extent
adopted by courts.
ALI v Delaware
= ALI (Northeast Harbor Golf Club, Inc. v. Harris) versus Guth v Loft approach to the Corporate
Opportunity Doctrine
ALI has specific rules for :
Delaware uses a balancing of factors to determine :
(1) what is a corporate opportunity and
(2) what a director or officer must do before she can take that opportunity for herself
Specifically:
ALI: if the business prospect is a corporate opportunitiy, it must be ofiered to P corporation and turned down
by P corporation before D Director can take the corporate opportunity
117
=DNM if the corporation was unable to take advantage of the opportunity, the director STILL must disclose it
(Unlike Delaware) If P corporation insolvent or financially unable to take advantage of the corporate
opportunity presented to D Direcotr, it is still a breach of fiduciary duty not to tell P corp about it
Delaware case law: whether the business prospects is a corporate opportunity and whether D must disclose these opportunities to P corporation is a factual question to be decided by
balancing test of reasonable inference from objective facts, including the financial ability of P to pursue these
business prospects
What Does the American Law Institute’s Principles of Corporate Governance Provisions on Corporate Opportunity add
to Meinhard v. Salmon?  The ALI Principles of Corporate Governance differs significantly from Guth and later Delaware
cases.
ALI takeaway
Corporate opp = a business prospect is a "corporate opportunity" if the director or corporate officer
learns of the opportunity because she is a director or officer or
a business prospect is a “corporate opportunity" if it is closely related to a business in which the corporation is now
engaged or expects to engage, regardless of how the director or officer learns of the opportunity
disclosure: offer and rejection a director or corporate ofiicer must always ofier a "corporate opportunity” to the
corporation and the corporation must reject it thereafter
financial ability irrelevant whether the corporation is financially able to pursue the business prospect is irrelevant to the questions of whether abusiness prospect is a "corporate opportunity”
or whether the director or corporate oflicer must offer the “corporate opportu»
nity" to the corporations
=DNM If the corporation was unable to take advantage of the opportunity, the director STILL
must disclose it. (Unlike Delaware)(this is not stated in the ALI??) If corporation insolvent or
financially unable to take advantage of the corporate opportunity presented to you, it is still a
breach of fiduciary duty not to tell them about it
ALI: sd;lf;sdlkg
a. A director or senior executive may not take advantage of a corporate opportunity
unless:
(1) He first offers the opportunity to the corporation and makes disclosure
concerning the conflict of interest and the corporate opportunity;
(2) Corporate opportunity is rejected by the corporation
(3) Either:
i. Rejection of opportunity is fair to the corporation;
ii. Opportunity is rejected in advance in a manner that satisfies the
business judgment rule; or
iii. Rejection is authorized in advance or ratified, following such
disclosure, by disinterested shareholders, and the rejection is not
equivalent to a waste of corporate
assets.
=
ALI - 5.05 – on Duty of Loyalty – Corporate Opportunties cont.
Taking of Corporate Opportunities by Directors or Senior Executives
a) General Rule. A director or senior executive may not take advantage of a corporate opportunity unless:
(1) The director or senior executive first offers the corporate opportunity to the corporation and makes disclosure concerning the conflict of interest and the corporate
opportunity;
(2) The corporate opportunity is rejected by the corporation; and
(3) Either:
(A) The rejection of the opportunity is fair to the corporation;
(B) The opportunity is rejected in advance, following such disclosure, by disinterested directors , or, in the case of a senior executive who is not a director,
by a disinterested superior, in a manner that satisfies the standards of the business judgment rule; or
(C) The rejection is authorized in advance or ratified, following such disclosure, by disinterested shareholders, and the rejection is not equivalent to a waste
of corporate assets.
118
(b) Corporate Opportunity. For purposes of this Section, a corporate opportunity means:
(1) Any opportunity to engage in a business activity of which a director or senior executive becomes aware, either:
a business prospect is a "corporate opportunity" if the director or corporate officer
learns of the opportunity because she is a director or officer or
=
(A) In connection with the performance of functions as a director or senior executive, or under circumstances that should reasonably lead the director or
senior executive to believe that the person offering the opportunity expects it to be offered to the corporation; or
(B) Through the use of corporate information or property, if the resulting opportunity is one that the director or senior executive should reasonably be
expected to believe would be of interest to the corporation; or
a business prospect is a “corporate opportunity" if it is closely related to a business in which the corporation is now engaged or expects to engage,
regardless of how the director or officer learns of the opportunity
=
(2) Any opportunity to engage in a business activity of which a senior executive becomes aware and knows is closely related to a business in which the
corporation is engaged or expects to engage
(c) Burden of Proof. A party who challenges the taking of a corporate opportunity has the burden of proof, except that if such party establishes that the requirements of Subsection
(a)(3)(B) or (C) are not met, the director or the senior executive has the burden of proving that the rejection and the taking of the opportunity were fair to the corporation.
(d) Ratification of Defective Disclosure. A good faith but defective disclosure of the facts concerning the corporate opportunity may be cured if at any time (but no later than a
reasonable time after suit is filed challenging the taking of the corporate opportunity) the original rejection of the corporate opportunity is ratified, following the required disclosure, by
the board, the shareholders, or the corporate decisionmaker who initially approved the rejection of the corporate opportunity, or such decisionmaker's successor.
(e) Special Rule Concerning Delayed Offering of Corporate Opportunities. Relief based solely on failure to first offer an opportunity to the corporation under Subsection (a)(1) is not
available if:
(1) such failure resulted from a good faith belief that the business activity did not constitute a corporate opportunity, and
(2) not later than a reasonable time after suit is filed challenging the taking of the corporate opportunity, the corporate opportunity is to the extent possible offered to the
corporation and rejected in a manner that satisfies the standards of Subsection (a).
Delaware on Corporate Opportunities
Northeast Harbor Golf Club, Inc. v. Harris
the Maine Supreme Court rejected Guth v. Loft, Inc. and applied the ALI
Harris was president of a Maine corporation which operated a golf club, She purchased two
parcels of land near the club, the Gilpin property and the Smallidge property, Harris was approached
about the Gilpin property because she was president of the corporation and the seller thought the
corporation would be interested in the purchase to maintain a buffer around the club and for devel»
opment. The Smallidge property came to Harris's attention when a person she played golf with told
her about it.
The trial court relied on Guth v, Loft, Inc, the Delaware case discussed above, and held that Harris had not usurped a corporate opportunity because
(1) the land was not in the corporation’s “line of business" and
(2) the corporation lacked the financial wherewithal to purchase the property, On
appeal, the Supreme Court of Maine reversed and remanded, rejecting the Guth approach and adopting the ALI Principles of Corporate Governance instead.
 The ALI Principles of Corporate Governance differs significantly from Guth and later Delaware cases.
Delaware cases use a balancing of factors to determine:
(1) what is a "corporate opportunity" and
(2) what a director or officer must do before she can take that opportunity for herself.
ALI Principles of Corporate Governance has specific rules as to
(1) what is a corporate opportunity and
(2) what a director or officer must do before she can take that opportunity for herself
II.
Duty of Loyalty - Competition
will be governed by the contract law covering covenants not to compete, and the tort law regarding trade secrets
A.
Competing Business
1) Although not a corporate opportunity, a director or officer who obtains a financial interest in a competing business
puts himself in a conflict of interest situation-even if the competing business is NOT a corporate opportunity.
2) May be held a breach of fiduciary duty where director or officer may be held liable for damages or enjoined from such
competition.
3) Distinction made between restriction on competing business and usurping corporate opportunity where company
had previously rejected the corporate opportunity Lincoln Stores
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Employee Competition
1) Employees are agents of a company
2) Employees have a duty of loyalty to their employers
a) Problem in Duane
 Employees strong-arming employer
 Not above board and not disclosing
b) Employees have a duty of loyalty to not compete with the business during their employment
 If you leave the company you can compete as long as you don’t use company assets (such as customer lists)
 There should also be disclosure to employer
c) Dalton v. Camp
 Courts recognize an employee’s duty of loyalty to an employee
 However a breach of that duty cannot serve as an independent claim
 It can only serve a justification for a Δ-employer in a wrongful termination action by an employee
 Only remedy for employee breach of a duty of loyalty is cause for dismissal.
3) In extreme cases where employees, as agents, through a competing business conspire to destroy the business of the
company for their benefit the Courts may find a breach of the fiduciary duty of loyalty. Duane Jones
4) As long as they do not breach a fidcuariy duty while employed (using firm resources) employees are free to compete with
the employer after their employment is terminated unless restricted by a non-compete agreement.
C. Cases
1) Lincoln Stores
a) FACTS
 Lincoln owns many stores. The store had previously rejected leasing or purchasing additional space in Norwich.
Offer to purchase stock of nearby furniture store came to Director Grant. He did not offer it to the corporation but
instead Grant, Director Martin and a previous buyer and they purchased the stock of the store individually. Grant
and Martin kept their purchase of a competing business from the company, stayed in the employ of Lincoln and
used corporate resources to set it up.
b) ARGUMENT:
 Lincoln got damages from them for using their position at the company for a competitive business but also wanted
shares put in constructive trust and close down that new store.
c) HOLDING
 Court found they were operating a competing business using corporate resources
 They had to pay back salaries, expenses, etc.
 But there was no usurping of a corporate opportunity warranting a constructive trust
 Company disclosed and chose not to exercise the corporate opportunity previously
 Company had to have an existing expectancy. No interest in acquiring that store.
-CASE NOTES- Officers used company funds to go out and acquire the opportunity, court found parent company did not express any
interest and actually past on the opportunity in previous instances
-Doctrine is limited to where the corporation has an expected interest in the opportunity, or a current interest in the opportunity to find
that the directors had breached their duty of loyalty in actually pursuing the opportunity
B.
They were allowed to leaves the corp and pursue the business opp but thye could not use the corps assets in doing so
2)
Duane Jones Co v. Burke 1954
a) Employees have fiduciary duty of loyalty to not compete with the business during their employment
 If you leave the company you can compete as long as you don’t use assets of the company
--these guys breached the duty not to compete by convincing the corp’s existing clients to move to the
competing corp
b) FACTS:
 Duane Jones Co, a very successful advertising agency, seeks damages from former employees the company
alleges conspired to deprive the company of its principal customers and key employees for their own benefit.
 Duane’s behavior became eradic (from substance abuse) and he had lost some contracts.
 Δs were account executives that managed the company accounts. After pre-selling the idea to Duane Jones
customers, they conspire, while still employed by Duane Jones, to force the sale of the company to them or they
would take several major accounts and form their own company. Duane Jones accepted the offer but only because
he felt he had a gun to his head. The sale however was never consummated.
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
After negotiation fell through, Δs resigned as employees but many stayed on temporarily for a few weeks,
continuing to provide services and receiving payments from the company. Δs thereafter form a new corporation,
lease a space and start business with 71 of 130 employees of Duane Jones.
c) HOLDING:
 Court holds that the employees’ actions fell below the standard of good faith and loyalty required of agents or
employees.
 Solicited the company’s accounts and employees while still employed by the company without disclosure to
the company
 Took more than 50% of the company’s employees when they left
 The Δ’s conduct resulted in a benefit to themselves through the destruction of the Л’s business in
violation of their fiduciary duties of good faith and fair dealing
 Opportunities gained by reason of their employment relationship
 Results of a pre-determined course of action
-CASE NOTES-Duane Jones has a successful advertising firms, Duan began to drink and was driving off the customers, employees saw
the company going south, customers were all at-will and so were the employees, Employees set up their own company and soliciting
clients previously from Duane Jones to the new company
-Duane sues saying a breach of fiduciary duty, and the court held the employees did because they breached their duty while they were
still employed at the Duane Jones company when they were moving the clients to the new company
3) Dalton v. Camp 2001 NC
a) Employee has no fiduciary duty to an employer because employer does not confide in employee and employee
does not dominate and influence employer.
Professor thinks this case is an outlier
 No tort recovery for breach of this fiduciary duty = this is not a tort in Supreme Court of NC
b) FACTS:
 Л Dalton produced an employee newspaper for Klaussner furniture under contract. Δ Camp was an employee of Л.
While Dalton was negotiating with Klaussner to renew the contract, Camp formed his own company and
negotiated with Klaussner for his new company to publish the employee newspaper. Camp then resigned.
c) HOLDING / REASONING:
 Court holds there was no fiduciary relationship between Dalton and Camp because there is no fiduciary
relationship between and employer and an employee.
 Fiduciary Duty requires:
 Confidence on one side and domination and influence on the other
 Relationship of employer and employee is not confidential
 Camp’s position as employee was not one of domination and influence
 Courts recognize an employee’s duty of loyalty to an employee
 However a breach of that duty cannot serve as an independent claim
 It can only serve a justification for a Δ-employer in a wrongful termination action by an employee
 Only remedy for employee breach of a duty of loyalty is cause for dismissal.
CASE NOTES- Taken a different approach from the previous case, court held the narrow relationship from the employer employee
relationship, and court held there was no tort for breach of fiduciary duty, EXTREME HERE, for the rest of the country we are resting
somewhere between Dalton and Duane
-Cases are important for lawyers because associates now move from one law firm to another, As a partner in a law firm even LLP
fiduciary duty, however lawyerdoom is a special relationship, attorney-client privilege, NOT allowed to use the funds of the partnership
to move the clients, and as long as you are a member of a partnership you have a duty of candor, you need to say yes I plan on moving
-Typically, Lawyer client relationship clients will move with the lawyer, but we also see same issue in brokerage firms, book of clients
up for bid, Employment contracts, NTC within a reasonable amount of time with the firm, cannot use firms assets and documents in
private endeavor, when the broker leaves the left firm will SUE no matter what, stole documents or information from the firm with the
clients, and since there is no attorney client privilege you may be in breach
-Courts do not like Non-Compete agreements, courts narrowly construe them to limited time and geographic area
-Remember overall review here
-BJR-Loyalty- can be 1) conflict of 2) corporate opportunity
Its not competition for lawyers to take clients from one firm to another-csome clients relate beterr to certain attorneys rather than the firm
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III.
Executive Compensation
A. Conflict of interest may arise with respect to compensation
1) Usually the conflict is raised by a minority shareholder in a derivative suit charging excessive compensation unfair and
waste to corporation
B. Authorization for Compensation
1) Board approval required without participation of interested director
2) Similar issues as interested transactions
3) MBCA 8.05 ______________________
C. Reasonableness of Compensation
1) Doctrine of Waste
a) If not reasonable, can be challenged as waste of corporate assets
2) Business Judgment Rule
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D.
may protect disinterested directors from liability for compensation
Courts hesitant to second guess the business decision on the value of an employee’s services
3) Courts will generally defer to judgment of shareholders on management compensation schemes unless there is fraud, breach
of fiduciary duty or other wrongdoing
Salary Limitations
1) Omnibus Revenue Reconciliation Bill of 1993
a) prohibited corporations from giving out more than $1M per executive for non-incentive based compensation without
shareholder approval
b) Made stock options more attractive because there was no cap on incentive-based compensation
E.
Incentive-Based Compensation
a)
b)
1)
2)
3)
4)
Phantom Stock
a) Give incentive for increase in stock price
Restricted Stock
a) Given stock that could not be sold for several years
 Incentive to stay with company and for long-term management
 Incentive to boost stock price
 Often used in start-up ventures
Stock Options
a) Definition
 A form of contingent or deferred compensation, like bonuses
 Option to purchase stock at a set price that serves as incentive to executives to increase stock price
 Goal is to align shareholder and management interests
b) SEC Chairman suggestions for decisions to grant stock options
 Approval by shareholders after full disclosure
 Approved by a committee of independent directors
 Should be granted only after sustained, long-term growth and success achieved, not simply granted for short-term
gains
c) Less tax on sale of stock than income
d) Not Expensed as Salary
 Allows management to report higher earning
 Although in reality the stock options substantially reduced true earnings
 Efforts to expense stock options have failed
e) Not the great reform vehicle we have hoped for
Golden Parachute
a) In the event company taken over, you get $X dollars to leave
b) Poison Pill - Disincentive for the raider to takeover because the corp leaders will leave leaving the raiders with no
leaders
c) Statutory restrictions now
**Golden parachute rationale: we don’t want the executive worried that if someone comes and takes over the company. --Congress then put an excise tax on this so the company has to pay taxes on that amount.
Compensation Disclosures
1) SEC requires 4 operating executives of public corporations to disclose their compensation packages, in an effort to share
them from overreaching and to alert shareholders
a) Meant to shame them but instead it has created competition resulting in increased compensations
G. Restriction on Loans to Officers and Directors
1) Sarbanes-Oxley Act
a) prohibits public corporations from making personal loans to officers or directors
b) restricted cashless-exercise of stock options: executives that were loaned funds to purchase their stock options that
would be repaid when they sold their stock for a profit
F.
+-SEC authorized by Dodd-Frank to hear compensation issues, previously excluded because impair the discretion of the BOD
+-“Say of Pay Proposal” not telling the BOD what they can do or how much they could get paid, simply showing the disapproval of the
shareholders, most of the proposals do not pass anyway and even if they did the BOD is not shamed and would usually take the large pay
options anyway
7.01 (pg 325)
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7.02
7.05 (who is the shareholder that needs the notice to attend meeting? Shareholder will not be the same from July 10 to July 25.)
NOTES- Executive Compensation: 1) Salary, 2) Bonus, and 3) Petition Component
-Stock Option may be the best way to combine the interest of the Management and Shareholders, Management will get compensated
with the rise of the stock price and so will stockholders, it DID NOT WORK OUT AT ALL
-Another idea, Executive Salary could be penalized by the government for excessive salary, however the bonuses and options could not
be controlled by the government and that became the way to go about it in America
-Unfortunately $1 million became the new minimum wage for executive salaries, not the maximum
-Stock : $10 per share, stockholders want money, we want to give the management an incentive to make the stock price go UP
-10 million options on the stock in the company, if you boost the price of the stock options for incentives on the price of the stock ratio
-Problem encountered is that the Management will pursue short term goals to raise the price of the stock that may not be in the best
interest of the company
-Public traded companies must meet estimates for stock every three months, business do not operate like that, long-range outlooks may
be tied to the type of business pursued
-This led to large firms falsifying the numbers on the books to meet the stock consensus prices, however if the economy starts to shrink
these things get exposed
-ENRON,WORLDCOM- all accounting gimmick, the complexity of what they did is mind boggling
-Chanel Stuffing-accounting standards, if I sell something I book that as revenue even if you do not pay me for another year,
-Decrease Expenses by Capitalizing-Depreciation values for equipment, instead of taking the immediate loss for the real amount of the
equipment, you could parse out the amount it depreciates over several years
-ENRON-Borrowed money from bank to show cash flow, they had a scheme with the bank where we would sell the bank oil, for
delivery a year later, but you are going to pay us up front, they treated that as a sale of oil on the books and not a loan from the bank
-Cash Accounting-this is what the real world does in their accounting, if I bill a client on Dec. 31 for $10,000, I do not treat this as
revenue until the client actually pays me I cannot put it on the books until I actually get paid, even though it will be in the next year
because our business was done on Dec. 31.
-Corporate Accounting-Accountants say this misleads clients because they want to make the books and records accurate when the
business gets done not when you actually get paid
-Accounting maneuvers were running rampant at ENRON
-OPTION CONTRACT- if the company pays me a salary as an executive they have to have that as an expense, the companies did not
have to deduct the expense for the options, corporations do not have to deduct anything, THIS IS ALL PRE-ENRON DIFFERENT
NOW
-Stock APPRECIATION RIGHTS-don’t worry executive, just pretend that you own 1 million shares of stock, we will look at what the
compensation will be with the stock price at the end of the year, and if the stock went you we will right you a check for the difference, an
the executive did not have to give us the cash to actually own 1 million shares of stock, one way street should the stock go down we do
not want money from the executive
-Laffer Curve-The more you raise the taxes the less revenue you get, the less you tax the more revenue you create, somewhere in
between is the ideal spot for taxation
-Methods to try to stop excessive Executive Compensation- 1) Taxation, 2) Fiduciary Duties, 3) SEC Full-Disclosure-disclose the
amount of the top four executives and it will shame them into taking less, this backfired, Executives then put themselves in competition
for the highest executive pay, they would hire compensation consultants to find unique and innovative ways to pour money into the
Executive compensation
-SEC Katie Couric Amendment-Entertainers, Broadcasters, Media Personnel
-PERKS-most large companies have corporate jets, cars and drivers, apartments in the city, Super Bowl tickets, and retirement still have
access to most of this stuff
-SEC is on a campaign to force disclosure of the perks, Courts typically don’t want to second guess these perks
H. Cases
1) Rogers v. Hill – 1933 US SC
a) FACTS:
 Shareholder of American Tobacco Company brings suit against President and 3 Vice-Presidents challenging the
corporation’s management compensation scheme.
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
2)
3)
Bylaws adopted by shareholder in 1912 allowed management to be pay sums in addition to their fixed salaries. Up
to 10 of profits over $8.M
2 ½ % of profits to President and 1 ½ of profits to 3 VPs.
 Because of huge increases in profits after 1921, the incentive-based compensation scheme had resulted in huge
bonuses to the management
 President: 1929: $450K - 1930: $850K
 VPs: 1929: $115K – 1930: $410K
b) HOLDING / REASONING:
 Although authorized by Bylaws with no indication of fraud or bad faith
 Payments so large as to warrant investigation in equity in the interest of the corporation
 Bylaw cannot, against the protest of a shareholder, justify payments so large that they may amount to waste of
corporate assets
 Did it as some point become so unreasonable?
 YES >>> Must be reasonable relation to services provided
 But court not qualified to make this determination
 Remanded for District Court to determine what portion of payments were waste
 Settlement reached
 Put floor and ceiling on amount of compensation
Heller v. Boylan 1941 NY
a) Deferred to judgment of shareholders on management compensation schemes
b) FACTS:
 Another 7 shareholders (out of 62,000 shareholders) of ATC again files derivative suit for corporate waste in
compensation scheme approved by shareholders via Bylaws and even later ratified by shareholders
 President Hill: $4.5M between 1926-1938
 VP Hill Jr: 1939: $230K
c) HOLDING / REASONING
 Court notes other large compensation packages in the business world
 Court notes the tax burden on those large payments and what management ends up with after taxes
 Court reasons it has no gauge or standard by which to determine what is excessive
 Hill’s tenure and leadership skills were certainly integral to company profits
 Hill Jr although young and new to the company does manage the $12M budget of the advertising department
 The shareholders are better qualified to assess compensation schemes and their reasonableness, especially because
it is their profit that is being forfeited to management
 If there is to be a change in the compensation scheme it is the shareholders who should be its architect, not the
courts
 Noted that Л did not show fraud, bad faith or breach of trust
 THIS CASE PRETTY MUCH ENDED FIDUCIARY DUTY TO CHALLENGE COMPENSATION CASES
UNTIL OVITZ CASE
Marx v. Akers - 1996
a) FACTS:
 Shareholder of IBM files derivative action objecting to the directors approval of their compensation increases and
that such increases (a) bore no relation to company profits or stock prices (which had been poor) or to the services
rendered by non-employee directors.
 From $20k + $500 p/meeting + retainer of $55K + 100 shares p/meeting over a 5-yr period
 NOT CLEAR IF THE DIRECTORS THEMSELVES INCREASED THEIR OWN SALARIES
b) RULES:
 Board of Directors has authority to fix director compensation unless the charter or bylaws limit or deny that
authority.
 Courts will not review fairness of salaries unless
 Wrongdoing
 Oppression
 Violation of fiduciary duty
c) HOLDING
 Case dismissed for failure to state a cause of action
 Л made only bare allegations that compensation increases bore no relationship to duties, profits or cost of living
increases
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-CASE NOTES- Shield Directors, Not just officers, Courts will not second guess the compensation of the directors, Directors are really
paid a nominal amount in relation to the Executives, based normally on the personal attendance of meetings, small amount of stock
-Large Public Corporation between 250-300 per year for the directors, BJR is going to shield directors too not just Executives
CHAPTER 9 – CORPORATE DEMOCRACY – STATE LAW
I.
Shareholder Suffrage / Voting Rights
A. Publicly traded corporations
1) Most shareholders vote in accordance with management recommendations
2) Some argue that dispersion of ownership and control by management of proxy machinery, management always prevails
a) Whereby stockholder voting is redundant and waste of time
b) Market can keep management in place
3) Reform for more stockholder power
B. 3 Types of Control
1) Majority Control
a) one shareholder owns large percent of stock and he controls
2) Management Control
a) no large block of stock owned by any one stockholder so management controls
3) Minority Control
a) stockholder doesn’t have majority but enough to create trouble – management often shared
4) HISTORICALLY – over half of all stock held by institutional investors holding large amounts of stock
C. Shareholder Voting Rights
1) Shareholders Voting Required
a) Election and removal of directors
b) Amendment of Articles and Bylaws
c) Major corporate action or fundamental changes (sale of assets, mergers, dissolutions)
2) Record date
a) Determines shareholders entitled to vote at meeting by establishing date on which stock ownership must exist
b) is usually date notice of meeting mailed out
c) Articles or Bylaws may designate another date
d) Sale of Shares after Record Date
 Buyer should get proxy at time of sale
3) Class Voting
a) MBCA 6.01(c) - the Articles may authorize different voting classes of stock, with each class having different voting
rights (i.e. electing certain directors, etc.)
b) Also see DGCL 141(d)
-Corporate Suffrage NOTES-9/21/11
-Courts have a tendency to view corporate suffrage the same as voters rights in the political system
-Today most stock is owned by institutions such as: Mutual Fund-whole group of people pool money for an investment, pool is owned by
retail shareholders but advised by a professional manager who in effect own a ton of stock, Insurance Companies, Pension Plans, Hedge
Funds
-These are all professional managers, our system was really designed for individuals to own the stocks individually
-Lot of stock is held in street name, brokerage firm holds the stock in the stockholders name, all of this for voting rights causes problems
as to who should vote and why
-Three Types of Control in Corporations 1) Management, 2) Majority, 3) Minority
-Management the Norm
-Minority Shareholder that owns maybe 30% of the stock, the management cannot override the minority but they usually end up working
together
-Majority-usually not found in most public companies,
-Most of what we are looking at is the management type of control, courts are particularly careful with their control of the shareholders
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Cumulative Voting: permits a shareholder to combine (or accumulate) all their votes and cast them for one or
more candidates.
 Exception to plurality voting
Plurality voting: the statutory word “plurality”-Both the Delaware and MBCA statutory provisions on election of
directors use the term “plurality.” The candidate who gets the highest number of shares voting for her is elected,
even if she does not get a majority
II.
Cumulative Voting
A. Definition
1) Shareholder votes as many shares as he has times the number of directors being elected, and cast the product among the
director candidates.
a) EXAMPLE: 100 Shares X 10 Directors = 1000 cumulative votes
b) Shareholder can combine (or accumulate) all his votes for one or more candidates
c) Allows a greater opportunity for representation of minority on board
2) Use of staggered terms can undermine effectiveness of cumulative voting
3) MBCA 8.08 requires reverse cumulative voting to remove directors
a) # of votes cast against removal < amount sufficient to elect him originally ???
B. Articles of Incorporation Must Authorize cumulative voting
1) MBCA 7.28 - all that is required is a simple statement in the Articles that “shareholders are entitled to cumulate their votes
for directors.”
2) DGCL 214 - cumulative voting must be provided for in the articles
3) OTHERWISE directors elected by a PLURALITY of the shareholders
4) A few states mandate cumulative voting
C. Cumulative Voting Formula
1) How many votes of ALL SH votes are sufficient to elect a specified number of directors?
X = a X b +1 X = # of Ds wanted X # of total shares
c+1
# of Ds being elected
1000 shares ; 2 Directors desires ; 5 positions open
2 X 1000 / 5 + 1 = 2000/6 = 333.33
2) How many directors can one shareholder elect with a given # of shares?
X = (n-1)(d+1)
X = (# of 1 owner shares -1) (# of Ds being elected + 1)
S
Total Shares – All Owners
401 shares; 1000 shares voting ; 4 directors
(401-1)(4+1) / 1000 = 400X5=2000/1000 = 2
601 shares; 1000 shares voting ; 4 directors
(601-1)(4+1) / 1000 = 600X5=3000/1000 = 3
-General rule is that corporations use plurality voting to fill the offices
-Wall-Street Rule-Vote with your feet, sell your stock, why spend the time fighting management, just sell the stock and that will
hurt the company in the worst possible place
-Now we are saying we need more qualitative measures for stockholders
-Cumulative Voting today is not mandatory but is permissible, protection has been given there by the courts, you cannot remove
a director put there through cumulative voting without cause
-STAGGERED Board of Directors
-Rational is that it assures an institutional memory and continuity in management (wont have complete turnover over 3 years or
so) - wont have corporate takeover - because we only remove at the most three directors at a time from our 9, it will take at
least three years to completely turn over the BOD
-Real reason is that management does not have to submit to some kind of hostile takeover, and they don’t look bad for taking
over the company because it takes a full three years
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In answering exam questions about the role of shareholders in running a corporation, you might also need to know about:
(1) shareholders’ right to inspect corporate records for a proper purpose; (2) annual meetings and special meetings; 90 (3)
quorums, majorities, and pluralities; (4) record owner on record date; (5) proxy; (6) straight and cumulative voting in
electing directors; (7) voting trusts and voting agreements.
What Is the “Record Owner as of the Record Date”?
. If you own McDonald’s stock, your McDonald’s shares are probably held in an account at a brokerage firm, bank, brokerdealer, or other similar organization. The organization holding your account is considered the shareholder of record for purposes
of voting at shareholder meetings. You have the right to instruct that organization on how to vote the shares held in your
account. People shown on the corporate records as owning stock are the “record owners.” “Record date” is a date set by the
board of directors in advance of the meeting that serves as a cutoff point. This gap period between the record date and the vote
gives the corporation time to determine who is entitled to vote and send proper notices to those entitled to vote.
Varying Shareholder Rights
A. Varying Voting Rights
1) Differing classes of stock with differing voting rights are permissible
2) Weighted Voting
a) One class has a multiple number of votes
b) Allows acquisition of control with fewer shares
3) Class Voting.
a) Voting by voting groups
b) Guarantees representation on board to each class of stock – certain directors chosen only by one class stock of stock
 Limit on removal of that director without approval of electing group
4) Contingent Voting
a) Gives voting rights to normally non-voting stock upon occurrence of certain events (contingency)
 i.e. preferred shareholders given contingent voting rights if dividends not declared in X periods
5) Disparate Voting
a) Disparate among classes of stock
b) Where one class of stock has no voting rights or has weighted vote (multiple votes per share)
c) Lacos Land Co
d) Non-voting stock permitted by securities laws
 Class B Stock may gives holder control if he forfeits higher dividends under Class A stock
 SEC tried to limit Class B disparate voting but found to be beyond scope of federal securities laws
 NYSE and NASD do not list non-voting stock – whether common or preferred
6) Why Give Up Dividend Stock?
a) Shareholders may give up dividends for control
7) Other Allocations of Voting Rights
a) Convertible securities, warrants, redemption rights, tracking stock
B. Treasury Shares
1) Shares repurchased by the corporation that issued them
2) Cannot vote or received dividends on TS
3) MBCA and most states: authorized but not issued
a) Authorized by Articles but distribution not approved by Board
b) Capital accounts must be reduced to reflect change in capitalization
-Shareholder NOTESC. Cases
III.
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1)
Lacos Land Co v. Arden Group
a) Disparate Voting Arrangements not necessarily valid, even if properly adopted by shareholders, if the vote is
obtained by threat.
b) FACTS Shareholders brought action attacking proposed recapitalization of corporation which would create supervoting common stock class, and sought preliminary injunction against issuance of super-voting stock.
c) New Class B stock brought before shareholders would have 10 votes per share and reduced dividends, and allow the
class to elect 75% of stockholders. Class A stock can be exchanged for Class B stock. It is anticipated only Briskin,
who owns 21% of Class A stock, will exchange his stock for Class B. Briskin is CEO and has improved company over
years. Motivation for new class of stock is to protect his control of co. Briskin threatened to vote against support future
transactions beneficial to company
d) HOLDING
 Not all disparate voting arrangements invalid but in this case … it was
 reasonable likelihood stockholder vote authorizing super-voting stock would be found to be fatally flawed by
implied and expressed threats that unless proposed amendments were authorized, shareholder-officer-director
would oppose transactions which board of directors might determine to be in best interests of all shareholders;
 proxy statement produced in connection with authorization vote presented substantial risk of misleading
shareholders on material point concerning shareholder-officer-director's status as "restricted person" under
certificate of incorporation article requiring affirmative vote of holders of 70% of outstanding shares to authorize
business combination with restricted person, and there was material likelihood that misleading conclusion would
be important to reasonable shareholder deciding how to vote on issuance of supervoting stock; and
 balance of equities favored injunction
-Case NOTES-Class A stock for the greater dividends, and only elect 25% share of the BOD, one time .30 cent
dividend plus future dividend
-Class B Shareholders, had 10 votes per share, and elected 75% of the BOD, no .30 cent dividend and would be
entitled to future dividend equal to 90% of the class A stock
-Briskin wants to make sure he had control of the company, wanted to make sure in the event of a hostile take over, a
company coming in and pitching directly to the shareholders to remove the BOD and other management
-If Briskin had control of the voting rights of the company the voters would obviously not go for that because he
controls the votes for the shareholders
-In asking the shareholders to take this .30 cent dividend he basically threatened them saying he would refuse to act in
the best interest of the company and the stock price would have gone down, the problem was the THREAT
-Briskin mad a mistake by actually threatening the shareholders, the voters would have went for it without the threat
any most likely
-Result was the shareholders won the court case, but the shareholders also lost their .30 cents and the proposal was no
longer good, from a business perspective the court decision was a bad deal and the offer by Briskin was the bad deal
-SEC also takes the perspective that shareholder voting should be viewed as a political model
-SEC passed a rule that said these types of shareholder arrangements would not be permissible, D.C. Circuit held SEC did not have such
power, however companies that had such arrangements were Grandfathered in
-CerverCO examples from Markham
-Had the class B and class A stock with the same rights and obligation for shareholders as in this case
-CerverCO then bought another company and did the same thing, essentially CerverCO held the voting rights in two separate companies,
just forshawdowing here
Treasury Shares: large companies will try to buy their stock back, which makes their stock value go up.
(they are held in the treasury of the corp )
-Treasury Shares-Authorized shares that have been issued, but the Company then bought back the shares, how do we treat those shares?
-We treat them really as unissued shares,
-1) the shares have to be authorized, 2) BOD has to approve the sale, 3) issued to whoever bought the stock
-If we buy them back its as if they are not issued, merely held in the treasury no voting rights, the company cannot use them in voting
-Usually this happens when management is trying to get their stock price up in the short term, for management stock options
Sadler v. NCR CORP (2nd Cir. 1991)
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NOBO Lists – non-objecting beneficial owners who have given consent to disclosures of their identities
 MBCA requires disclosure of NOBO lists but only if in existence - does NOT require they be compiled if not in
existence
 Sadler required disclosure of NOBO lists even if not in existence - required they be compiled because this was an
easy compilation
-CASE NOTES-Case concerning AT&T acting through NY resident stockholder of NCR to order a NOBO lists, judge found in the
interest of the stockholders being entitled to information from the corporation, List to compile NOBO was rightfully granted.
-NOBO list was not in existence at the time, this was one of the issues because the statute, if read narrowly, would only entitle the
shareholders Sadler to the documents that were in existence at the time
-The Court ruled as a public policy reason that the statute should be construed generally to allow for the access and the NOBO list was
really a mechanical obligation that would take no more than 10 days to compile
-shareholders raise a different issues, they have less access to the books of the company even though they own it, some of the
information is confidential, proprietary, secretive, and could be used against the corporation
-Need restrictions on shareholder access
-One area where the courts have given broader access is the list of shareholders, the reasons is that the list is how the shareholders can
communicate with one another
-Beneficial Ownership Concept-To Cut down on the previous paper work, an individual stockholder was the owner in name of the stock
but in order to meet the demands of the transfer agents of the stock, when the individual stockholder sells or buys, the stock broker firm
is the one who actually carries out the transaction
-Everyday instead of deal with hundreds of customers, were are dealing with several hundred stock brokers trading the stocks back and
forth, called holding the stock in STREET NAME
-No necessary, but stockholders always go for it, if it is held in Street Name the brokers get all of the correspondence from the company
-Markham held the stock in his kids names, got all the letters from Mattel, Coca-Coal, Disney, Marvel comics
-Proxy Voting-You can vote by mail, you don’t actually have to go to the stock holder meeting
-Also designed to prevent theft, the stock is in a vault not individual papers floating around at people’s houses
-This has not stopped all theft, now were are going to certificateless shares, no problems with transferring the shares
-Problem in this system, for efficiency it works great, but problem is what about shareholder voting rights since the stock is really in the
street name of Meryl Lynch or another large company
-Some of the safety nets put in place, the company is required to have a list of the actual names of the holders for the individual
-99.9% of the shareholders do NOT care about voting, nobody cares, and the brokerage firms know that, so Meryl Lynch says the stock
will be held in street name and we will vote your shares UNLESS you OBJECT
-SEC says ok, but Meryl Lynch you cannot vote on important matters, for example merger and acquisitions, liquidation of the company
-Previously the important votes were fairly limited, now the shareholders are getting more rights with the votes
-Another problem is Institutional Investors, such as a mutual fund holding a lot of shares of stock with the people putting their money
into the mutual fund pool
-Mutual fund says we don’t want to vote, we only want to manage money, if we don’t like the company we sell the stock, “voting with
you feet”
-SEC says, sorry mutual fund it is your duty to vote, and you need to tell the shareholders the voting practices
-Mutual funds usually vote for management no matter what, or they sell the stock SEC didn’t like that
-Mutual funds went to advisory firms and told them how to vote politically correct manner
-What about access of shareholders of these lists of shareholders? Street names most common, brokers can produce by proper person a
list of the Non-Objecting Beneficial Owners, NOBO
-Question is Can I force the corporation to produce NOBO?-No Good answer really
-Another issue some states restrict the right of shareholders to get the lists
-For a couple of reasons, 1) We don’t want a shareholder to buy one share of stock simply to get access to a shareholder list, we may
restrict you by requiring that you own a certain amount of stock and keep it for a certain period of time, the stock should be bought for a
legitimate purpose dealing with the shareholder interests
-Advertisers often wanted a list to advertise products to shareholders for example
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Class Notes Starting 9/26/11
-SEC tried to use full disclosure, top executives of the company to have compensation disclosed, failed to work, opposite encouraged
executives to compete for greater salaries depending upon competition
-Compensation of Directors, usually contingent upon the attendance of board meetings, also given stock, no where near the level of the
executives receive
-Corporate Suffrage-Shareholders right to vote, common stock one share one vote classic model, classically elected by plurality for the
business
-Cumulative Voting-Give minority a greater opportunity to have a representative on the board, five slots open and six directors running,
allows the minority voters to elect at least one director but no assurances depends on the math, formula is very complex
-Today cumulative voting is permissive, but NOT many corporations have it
-Corporations can allocate the voting any way they want to for the rights and obligations of the stockholders
-Courts often try to treat corporate shareholder votes in a way that is politically treated, does not work very well
IV.
Shareholder Meeting Formalities
A. Shareholder Meetings
1) Annual Meetings
a) MBCA 7.01 Requires annual meeting of SH
b) But failure to hold meeting does not affect validity of corporate action
c) Time and place of annual meeting set in Bylaws
d) NOTICE
 MBCA requires notice for annual meeting
 Some states do not require notice
 SEC requires a purpose of the annual meeting
2) Special Meetings
a) MBCA 7.02
 Can be called by Board or others authorized in Articles or Bylaws
 10% of shares entitled to vote on the issue can call a special meeting
b) NOTICE
 MBCA requires notice for annual meeting
 For special meeting not less than 10 days or more than 60 days before special meeting
 Must state purpose of meeting
 But State laws vary on min/max days of notice
 Some states require different notice requirements for mergers, amendment to Articles, etc.
3) Record Date
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Must be owners on record date to be able to vote or receive dividends
MBCA record date to be set in Bylaws or by directors if not in bylaws
Record date cannot be more than 70 days before meeting
Whoever is the holder of record on that date will be entitled to vote at the meeting
The person that the transfer agent recognizes as the individual owner of the stock
Quorum
a) MBCA 7.27 Permits a greater than majority stockholder quorum silent on less than majority quorum (not permissible)
b) Shareholder majority quorum required of those entitled to vote, unless otherwise stated by bylaws, default
c) DGCL 216 Shareholder quorum may be as low as 1/3 =limits it to 1/3
d) COMPARE TO MBCA 8.24 which does not permit a director quorum to be less than 1/3
e) If SHAREHOLDER leaves meeting – still a quorum
f)
If DIRECTOR leaves meeting before vote – NO quorum – must be present at time of vote
g) For Ordinary matters a quorum of those present will be enough to take action,
h) Certificate can require unanimous vote for the corp. to take action, but state default for quorom
i)
Abstention
 Shareholder - generally disenfranchises unless vote must be by majority entitled to vote (to approve a merger or
amend Articles in some Js) and abstention is NO VOTE
7.25 (pg 341) as long as we had sufficient quorum at the beginning of the meeting
a)
b)
c)
d)
e)
4)
Unanimous Written Consent
a) MBCA authorizes
b) Delaware allows for majority of shares entitled to vote
c) Most states require unanimity, DE does not
d) DE says if you have consent, Theory under DE law is that if you have enough votes the meeting is not relevant because
it is a waste of time, we know nobody has enough power to vote against the corporate action
Schnell v. Chris-Craft (DE 1971)
1) Management may not change annual meeting date from bylaws for unlawful purpose.
-Proxy Campaigns- Extremely like the political process, professional proxy firms to run the campaigns like a political operation
-Large Institutional Investors-Road Show, need to vote for management, entertainment, Need corporate jets, Major Money
-Anybody mounting a proxy campaign at a public company needs several million dollars to be successful
-Management-Can use corporate funds to carry out their own campaigns, controls access to the information, timing the meeting
in a way that will preclude them from conducting an effective campaign
-Court says no that is inappropriate, need to be fair
5)
B.
Shareholder Inspection Rights
proper purpose – for directors, it must be related to their interests as a director
proper purpose – for shareholders, it must be reasonably related to their interests as a shareholder
political purpose is NOT a proper purpose so the court denied access
Proper purpose: vote for shemp for director/ vote for trump for president
V.
Section 5: Shareholder Inspection Rights
1. Shareholders are the owners of the corporation and should have the rights to inspect its
books and records in order to determine the condition of their investment.
a. Such access should not, however, be used to harm the company or expose its
confidential information.
-Corporation cannot own itself, somebody has to be a shareholder
Shareholders don’t get to decide whether to amend the articles or merge or sell assets or dissolve. Rather,
when shareholders’ vote on amendments to the articles, mergers, sales of assets, or dissolution, they are
merely voting on whether to approve decisions made by the board of directors to amend, to merge, to sell
or to dissolve.
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A.
B.
Statutory Requirements
1) MBCA 7.20 – Shareholder List
a) Allows access to shareholder list to any shareholder
b) Must be available to shareholder two business days after notice of meeting
c) If corporation refuses, shareholder may file action with court
2) MBCA 16.01 Records Required / 16.02 Inspection Rights / 16.04
a) Records Required / Requirements to Inspect
 Articles, bylaws, resolutions creating classes of shares, director lists, 3-yrs of shareholder minutes, 3-yrs of
communications to shareholders, 3-yrs of financial statements
 Only need to make WRITTEN DEMAND on 5-day notice
 Other minutes of board meetings, board committee actions, accounting records (not included in inspection rights),
SHAREHOLDER LISTS
 Also need written demand on 5-day notice
 PLUS good faith and a proper purpose
 Directly related to that purpose
3) DGCL 220
a) Shareholder List - Written demand stating purpose
b) Other Corporate Documents: Written demand, proving a stockholder, proper purpose
c) Do not need proper purpose for shareholder list – only need to be a shareholder
4) Standard / Burden of Proof:
a) Preponderance of the Evidence Haywood
The Requirements
1) Reasonably related to the person’s Economic INTEREST as a stockholder Haywood
a) BONA-FIDE INVESTMENT INTEREST Honeywell
 Delaware Courts have not followed Honeywell
 MAJORITY RULE Social Responsibility Investment Strategies
 Conservative Caucus v. Chevron: Stockholder sought to warn other stockholders of economic and social concerns
of business in Angola – Court found proper purposeTo investigate possible mismanagement
---- PLUS ---b) To communicate with other shareholder (Some courts)
c) Breaches of fiduciary duty
d) Waste of corporate assets
e) Fraud
f)
ACTUAL WRONGDOING NEED NOT BE PROVED – BUT NEED CREDIBLE BASIS
g) Adverseness to management and to gain control for economic benefit
h) WHY: Power to Inspect is Power to Destroy
 Must have bona fide interest to enjoy that power
 Danger it could be used in a lawsuit
 Danger it could be exposed to media
i)
Not Proper Purpose
 No investment interests (Sometimes)
 Solely to further social or philosophical interests
 For purpose of maintaining a legal proceeding
2) Standing as Stockholder
a) QUALIFIIED SHAREHOLDERS Some statutes also require
 a min % of ownership (5%) or
 holding of stock for min time (6 months)
 Assures an investment interest
b) Few states may require purpose of investment must be related to economic benefits Honeywell
3) Facts Must Support a Proper Purpose
a) Mere statement of proper purpose is not sufficient
 Facts must support
b) <<< COMPARE RIGHTS OF DIRECTORS TO INSPECT RECORDS
 Broader approach than shareholders
 Must be reasonably related to his position as director
 Also includes other records that shareholders may not have access to
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Cases
1) Haywood v. Ambase
a) FACTS:
 Stockholders Haywood and Cronin seek corporate records of Ambase to investigate mismanagement which
President was denying them that access
 Ambase / Previously Carteret Bank - litigation with the US over the RTC S&L takeovers
 Dissatisfied with $1.8M discretionary bonuses granted the President and CEO Bianco by Personnel Committee of
company.
b) RULE:
 Sect 220 of DGCL:
 Stockholder must state a proper purpose for requested inspection of books and records
 Proper purpose: reasonably related to such person’s interest as a shareholder
 Investigation of mismanagement is a proper purpose
 Actual wrongdoing need not be proved
 BUT must demonstrate CREDIBLE BASIS to find probable wrongdoing
c) HOLDING:
 In view of the facts - Bianco’s compensation – Stockholder’s purpose was a proper purpose
 the purpose of investigating mismanagement is proper
 Standard of Review; Preponderance of the evidence
-CASE NOTES-Problem here, Unless you are public company and subject to SEC rules, compensation is considered a confidential
matter
-Couldn’t as a shareholder, even at large companies, see the other lower people on the rungs compensation, companies don’t want that
information out there
-Here the court saw enough concerns that executive was problematic, need some showing that access was appropriate,
-We don’t typically allow shareholder access in cases like this
C.
2)
Pillsbury v. Honeywell
proper purpose – for directors, it must be related to their interests as a director
proper purpose – for shareholders, it must be reasonably related to their interests as a shareholder
political purpose is NOT a proper purpose so the court denied access
Proper purpose: vote for shemp for director/ vote for trump for president
a)
b)
c)
d)
FACTS
 Л politically objects to the Vietnam War and Honeywell’s manufacture of ammunition for the war. P purchases
stock in Honeywell solely to further his political opposition to Honeywell’s involvement in the war. He seeks
corporate shareholder ledgers to contact shareholders to solicit proxies to get a voice on the board and change its
policy. He also seeks corporate records relating to weapons and ammunitions manufacturing.
 He admits in depositions that the purpose of his investment in Honeywell is solely political, not for investment
purposes. ISSUE: was that a proper purpose?
 He admits why he wants the records and lists arguing that a stockholder who disagrees with management has a
right to inspect records to solicit proxies to change corporate policy.
PH
 Writ of Mandamus denied - Improper and indefinite purpose
 Not entitled to relief as a matter of law
RULES
 DGCL 220: Shareholder must demonstrate a proper purpose germane to his interest as a shareholder to inspect
corporate records other than stockholder lists
ARGUMENTS / REASONING
 Improper Purpose
 Economic Investment Concerns
 P argues his solicitation of shareholder proxies to change corporate policy was a proper purpose
 Honeywell argues and Court agrees that a proper purpose contemplates concern with an economic
investment
 Standing as Stockholder Tenuous
 SEE Stock
 Purpose of investment not related to economic benefits
 For purpose of maintaining a legal proceeding
134

Facts Must Support a Proper Purpose
 Mere statement of proper purpose is not sufficient
e) HOLDING
 P’s purpose for inspecting corporate records was not a proper purpose germane to his economic interest
 Seeking to solicit proxies for a board seat to change policies to favor his social and political interests, absent
an economic interest, is insufficient to compel inspection
f)
MARKHAM
 Markham says all he had to say that munitions sales would have adverse effect on company and his and other
shareholder investments
-CASE NOTES-here plaintiff says I want records, I bought the share of the company in order to get access to the information, I want the
information to protest the Vietnam war
-DE statute requires you to have a proper purpose, NOT a proper purpose to stop the Vietnam war, it needs to be something linked to the
economic interests of the business
-Court cut off access here because the shareholder did not have a proper purpose, Directors have access to any information whenever
they want it
-Concern for directors is that they have to keep themselves informed
-Conservative Caucus Case-page 423, Markham Notes
-Court granted access
-Most courts, if you phrase your purpose in some economic terms, will grant you access to the books and records
-DE 220 does is divide corporate records and book into two groups
-1) Public Documents/Non-Problematic, shareholders list is the key to the determination
-2) Other books and records we are going to put the burden on the shareholder to show the proper purpose, even if you show a proper
purpose, courts will often not grant access to some sensitive information
-
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VI.
Proxy Contests
A. Proxy Contests
1)
Proxy = Power granted by a shareholder to another person to exercise the shareholder’s voting rights
a) The word “proxy” is used both to describe that authorization and to identify the person so authorized. That person is
also referred to as the proxy holder.
b) There are four things that you need to know about the state law relating to proxies. First, a proxy is effective for eleven
months unless the proxy states otherwise. Second, a proxy is revocable by the record shareholder even if the proxy
states otherwise. Third, a proxy is irrevocable only if it both states that it is irrevocable and is also “coupled with an
interest.” Fourth, “coupled with an interest” means that the proxy holder has some interest in the stock other than just
voting the shares.
2)
3)
4)
5)
 Must be in writing
 Revocable at any time
 Agency relationship
c) Only way shareholder or minority director can change policy is to make a proposal to shareholders
Purpose of Proxy Contests:
a) To effect a change in management or change in ownership (takeover, merger)
 Could be on any shareholder approval issue
 But usually over control
 Usually very important because it is very costly
Concerns:
a) Inspection of Shareholder List
b) Expenses of mailing proposal (mailing, etc.)
c) Expense of proxy solicitation
 Incumbent management has advantage of using corporate funds for its solicitation
 Insurgents must initially foot the bill – later can get shareholder approval for corporate reimbursement if
successful  opposer needs a deep pocket!!!
Corporate Expenses of Solicitation > Rosenfeld
a) May incumbent management look to corporate treasury for reasonable expenses of soliciting proxies in a
contest over policy?
 Majority – YES if directors acting in good faith with valid purpose (in interest of corporation (policy) v. personal
power))
 Directors must be able to freely answer challenges to policy at the expense of the corporation otherwise they
are at the mercy of challenges by those with ample funds to conduct a proxy contest
 Provided there is no challenge to reasonableness
b) Question is what is reasonable?
 Must be reasonably related to the purposes of the corporation
 BUT Л needs to challenge reasonableness
 Markham says no court has found any cost unreasonable
c) Successful insurgent in proxy battle OVER POLICY may, upon shareholder resolution, be paid for proper and
reasonable costs of proxy solicitation
 Insurgents have no right to corporate payment of solicitation, even if successful
 BUT Shareholders may agree to pay the costs of an insurgent,
whether or not they were successful
 Why pay an unsuccessful dissident? In assurance they will go away and not come back
Can you buy a vote?
a) MAJORITY RULE: NO you cannot buy vote
 POLICY OBJECTION: Part of corporate democracy that should be protected in the same way as votes in a
political campaign
 Common law did not allow vote buying
b) MINORITY RULE - YES – it is a financial transaction; would allow a large loan to be paid in exchange for a vote
Hewlett v. HP (Court refused to find coercion to buy a vote)
c) HOWEVER Shareholders vote with management 90% of the time
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B.
Campbell v. Loews
 Who has access to the corporate funds for solicitations in a proxy contest: corp. management because they
control the treasury (Vogel faction)
o Although there is a tiny exception in the SEC rules
o both factions should have equal opp to have access to the shareholder lists
FACTS
a) Louis B. Meyer case – Tolman Group (Majority Directors) v. Vogel Group (Management)
b) Proxy fight between management and majority directors.
c) Management is frozen. Lack of quorum, resignations. The President (Vogel group) called a special shareholders
meeting to fill director seats.
d) Tomlinson group claims Vogel group is usurping the authority of the Board by calling shareholders to act.
e) P seeks to
 Obtain shareholder lists to solicit proxies
 Temporarily enjoin Loew’s Vogel group
 From voting those proxies solicited
 from using corporate funds, employees and facilites for solication of proxies
2) REASONING / HOLDING
a) Obtain shareholder lists to solicit proxies
 Tomlinson directors have as much right to stockholder lists as those 4 Vogel directors in charge of management
that have such access
 Compels inspection of shareholder lists
b) Temporarily enjoin Loew’s Vogel group until the other group can get the list for their advantage
 voting those proxies solicited
 COURT MODIFIES not full nullification of all proxies
 Allow Tomlinson group to solicit proxies after it obtains stockholder list
 from using corporate funds
 COURT DENIES Vogel, as management, can use corporate funds to solicit proxies
 from using employees and facilities for solicitation of proxies
 COURT GRANTS would increase strife in a proxy fight
 Must outsource PR campaign
c) OPEN ISSUE: If Tomlinson faction prevailed, could they recover funds they expended?
-CASE NOTES-Big Issue is who gets to use the corporate funds to pay for the proxy campaign? Left the Vogel faction in charge of the
company and Vogel could use corporate funds to carry out the campaign, however, the Tomlinson faction was also entitled to use
corporate assets to pay for the proxy campaign
-Left Open the Question1)
3)
Rosenfeld v. Fairchild Engine & Airplane
a) Corporation Payment for Proxy Battle – Incumbent Management v. Successful Insurgents
b) FACTS
 Stockholder derivative action where attorney seeks return of $260K paid out of corporate funds to reimburse both
sides to a proxy battle based on a difference in management policies
 Incumbent Management paid for all solicitation expenses during its incumbency ($133K v. usual $7-$28K
costs of annual meetings) – authorized itself
 P contends excessive expenses and should have been submitted to management
 Insurgent paid expenses by resolution of majority shareholders (16 to 1) after they were successful in the
proxy battle
c) ISSUE – RULES – HOLDING
 May incumbent management look to corporate treasury for reasonable expenses of soliciting proxies in a
contest over policy ?
 Majority – Yes if directors acting in good faith with valid purpose (in interest of corporation (policy) v.
personal power))
 Directors must be able to freely answer challenges to policy at the expense of the corporation otherwise
they are at the mercy of challenges by those with ample funds to conduct a proxy contest
 Provided there is no challenge to reasonableness
 Question is what is reasonable ?
137




4)
Must be reasonably related to the purposes of the corporation
Does Л need to challenge reasonableness ?
 Majority – Yes otherwise not an issue (even if facts indicate unreasonable)
Successful insurgent in proxy battle OVER POLICY may, upon shareholder resolution, be paid for proper
and reasonable costs of proxy solicitation
Rule: p. 429 top, “ In a contest over policy, as compared to a purley personal power contest, corporate
directors have the right to make reasonable and proper expenditures, subject to the scrutiny for the courts
when duly challenged, from the corporate treasury for the purpose of persuading the stockholders of the
correctness of their position and soliciting their support for policies which the directors believe, in all good
faith, are in the best interests of the corporation.
Hewlett v. Hewlett-Packard
a) Can you buy a vote?
 MAJORITY RULE: YES – it is a financial transaction; would allow a large loan to be paid in exchange for a vote
b) HP Director claim that HP bought votes of shareholder Deutche Bank (coercion; threatening continuing
business relationships
c) FACTS
 Former Director Hewlett and his father’s trust challenge the shareholder approval of the merger of HP and
Compaq because it was coerced by pressure placed on a lender that was also a shareholder. HP Board unanimously
approved merger in Sept 2001. Hewlett voiced his objection and each side solicited votes in the proxy battle for
the 2002 shareholder meeting to approve the merger
 Duetche Bank’s had several relationships with the company: merger bank, participant in the HP revolving credit
facility and shareholder of 17M shares under its asset management division (DBAM). DBAM, through its PWG
voting decision committee, had initially agreed to vote Compaq stock for the merger and HP stock against the
merger. After a presentation by each side in the proxy contest to HP in a telephone conference call, DBAM
changed its HP vote for the merger. Hewlett contends HP coerced Deutche Bank into changing its vote in favor of
the merger by threatening continuing business relationships.
d) HOLDING
 Court holds that there was no evidence of coercion
 CEO’s statement to PWG that “it is of great importance to our ongoing relationship” was not sufficient evidence
of coercion
 HP argued for the merger on the merits, not via coercion
CHAPTER 10
CLOSELY HELD CORPORATIONS
Definition – small company, no outside market for shares. If you are minority shareholder, you are in the whim of
the majority. Closely corp. are mostly family affairs. How they protect family members and how ugly can it get.
-Closely held corporations – small companies without a few shareholders often managers and owners as well. No
market for the stock of this company.



closely held corporation or a private corporation is one that is owned by private individuals who do not trade or sell their shares of
ownership
More than 90 percent of all businesses in the United States are closely held.
Closely held firms are those in which a small group of shareholders control the operating and managerial policies of the firm
It is not as easy to see the reasons that people buy stock in a close corporation People do not buy
stock in close corporations in order to resell their shares at a profit People buy stock in close corpora»
tions for different reasons
The most common reason that a person buys stock in a close corporation is employment opportunities Assume for example, that Archie, Ken, and Wanda are unhappy with their jobs They decide
to get into the jewelry business as a new line of work. Archie, Ken, and Wanda form a corporation,
Goldfish, Inc. (GI)“ A They become both the shareholders and employees of GI, which owns and oper»
ates the jewelry business
A less common reason that a person buys stock in a close corporation is dividend opportunities
Otto may buy stock in GI because he believes that GI will be profitable and he wants to share in GI's
138
profits by receiving stock dividends
I: In a close corporation, a shareholder who does not herself own a majority of the stock may be in
a very precarious investment position The other shareholders might decide not to hire her or decide
to terminate her employment The other shareholders might decide to increase their salaries or expand the business, instead of paying dividends
A minority shareholder in a close corporation can be stuck with stock that brings her no return
on investment, As we will see in the next section, courtsfespecially courts in Massachusettsfhave
been increasingly willing to step in and create common law concepts to protect minority stockholders of close corporations from oppression,
Massachusetts’ courts have taken the lead in protecting minority shareholders of a close corporation. Massachusetts is to exam questions about closely held corporations, what Delaware is to
exam questions about publicly traded corporations.
I. Heightened Fiduciary Duties in Closely Held Corporations
1) Close Corporation – Common Law Definition
a) A small number of stockholders
b) Not ready market for stock
c) Usually shareholder control and participation of company
 Ownership and management in same hands
d) Very similar to a partnership
e) Partnership clothed in the benefits of a corporation
 Built usually on PERSONAL RELATIONSHIPS
 When break down, majority can use their position of control against the minority stockholder, denying him his
reasonable expectation from the close-corporation (employment, benefits, dividends, etc.)
2) Close Corporation – DGCL 342 Definition
a) Articles of Incorporation must state
 It is a close corporation under this section
 Establish limitations:
 No more than 30 stockholders
 Restrictions on transfer of stock
 No public stock offerings
b) Close corporation may eliminate board of directors but only in Articles
 Corporation would then be shareholder managed
 UNLIKE MBCA which allows by Shareholder Agreement signed by all
3) Close Corporation - Shareholder Interests
a) Rights to more than traditional shareholder rights
b) Personal relationships give rise to certain REASONABLE EXPECTATIONS
 Participation in management
 Employment
 Benefits
c) REASONABLE EXPECTIONS Meisleman
 Courts look at history of the participant’s relationship
 At inception, as altered over time
 Must be known to and concurred in by other shareholders
4) Fiduciary Duty
a) Stockholders in a close corporation are really a partnership clothed with the benefits of a corporation
b) Stockholder relationship in a close-corporation is different than in a larger corporation
c) Stockholders of close corporation, like partners, owe each other the fiduciary duty that partners owe to one
another
5) Freezing Out Minority
a) Closely held corporations afford opportunity for Majority stockholders to oppress Minority
b) Liquidity problems in closely-held corporations
 No ready market and minority shareholders locked in
 Majority may actually have a market for its shares because someone may buy their controlling shares but probably
would not also buy minority shares it does not need for control
c) Other devises to oppress Minority
 Denial of corporate offices and employment to Minority
139
 Courts will rarely interfere
 Failure to declare dividends
d) Earnings of close corporations are distributed in major part in salaries and bonuses
e) PURPOSE: To compel minority to sell stock at reduced price
f) If shareholder frozen out and there is no ready market for its shares HIS INVESTMENT IS LOCKED UP
 Cannot form dissolution of corporation unless he has majority stock
 BUT In partnership any partner can cause dissolution to reclaim his investment
 Courts will generally not interfere in management decisions (employment, dividends, etc.)
 Stockholder REMEDY-LESS so courts may force dissolution or create a remedy to protect a complaining
minority shareholder Meiselman
6) General Corporate Law Barriers to Oppressed Minority Shareholder Relief
a) 2 Barriers in Corporate Law to aggrieved minority shareholders in close corporations
 Principle of majority rule
 Business Judgment Rule
b) Stockholder freezed-out in close corporation is REMEDY-LESS
 Statutory equitable remedy created so courts may force dissolution or create a remedy to protect a complaining
minority shareholder
 Unlike in partnership where partner can cause dissolution or force buy-out or in public corporations where
shareholders have ready market for their shares
7) 4 SITUATIONS WHERE STATUTORY EQUITABLE DISSOLUTION / REMEDIES AVAILABLE TO OPPRESSED
MINORITY SHAREHOLDER Meiselmen
 Liquidation is reasonably necessary for protection of rights or interests of the complaining shareholder
 Directors deadlocked in management and shareholders cannot break deadlock
 Shareholders deadlocked and cannot fill director positions for 2 years
 Shareholder Agreement liquidation or dissolution at will or upon occurrence of special event that has occurred
 EQUITABLE DISSOLUTION
 Does not require fraud, mismanagement, waste or other wrong other than oppression
 A form of breach of fiduciary duty of shareholders or directors to other shareholders
8) MBCA 7.32 Shareholder Agreements
a) Can often avoid minority oppression through Shareholder Agreements
b) Can opt out of many provisions of statutes, articles or bylaws in Shareholder Agreements
 Eliminate Board of Directors
 Determine who will be Board or Officers
 Dispute Resolution
 Mechanisms to deal with deadlock
c) All shareholders at time of Agreement must sign
d) Only good for 10 Years unless the Agreement provides otherwise
B. Cases
1) Donahue v. Rodd Electrotype
a) Heightened fiduciary duty in closely-held corporations

**closely held corps are treated like a partnership  Requires much higher duty
of good faith than a corporations.  this why you might want an LLC instead of
a closely help corporation. Any lesser standard would put minority shareholders at the
mercy of the controlling shareholders.
b) Equal shareholder rights
The "equal access” rule is simple enough: controlling shareholders of a close corporation owe a
fiduciary duty to minority shareholders to accord them an equal opportunity to sell their stock to
the corporation.
The holding is limited to close corporations,
close corporations:
(1) a small number of shareholders;
(2) no ready market for its stock; and
(3) substantial majority share»
holder participation in management Because Rodd Electrotype Cor comes within this definition
of a
140
close corporation, the equal access rule applies.
Under the equal access rule, the corporation must ei»
ther buy Donahue’s stock at $800 per share or rescind the purchase of Harry's stock
c) FREEZE OUT case example


=Any tactic used by majority shareholders to deprive minority shareholders of governing control
of a corporation. It is used to pressure the minority shareholders to sell their stock in
the corporation, usually in the context of an acquisition.
=A technique used by majority shareholders in a close corporation to eliminate a minority
shareholder’s interest by refusing to declare dividends or removing the minority shareholder from
office or employment in the corporation, thereby forcing him to sell his interest often at less than
par value.
Freeze-out possibilities:
Refuse to declare dividends;
drain off the corporation’s earnings in the form of exorbitant salaries and bonuses to the majority shareholders-officers
and perhaps to their relatives, or in the form of high rent by the corporation for property leased from majority
shareholders;
deprive minority shareholders of corporate offices and of employment by the company;
they may cause the corporation to sell its assets at an inadequate price to the majority shareholders.
Donahue v. Rodd Electrotype Company of New England, Inc. ►
[Generally]
Facts. Donahue (P), a minority stockholder in Rodd Electrotype (D), brought suit against the corporation, its
directors, and Harry Rodd, a former director and officer who had been the company's controlling shareholder.
When Rodd retired, he sold some of his stock to the corporation at $800 per share. P and her husband offered
their shares to the corporation on the same terms. The corporation said it could not afford to pay so much for
the shares. It did make offers to buy them from P at prices ranging from $40 to $200 per share.
P brought this suit to rescind Rodd's sale of stock to the corporation and to compel him to repay the purchase
price. She alleged that the defendant-directors of the corporation violated their fiduciary duty to her when they
bought Rodd's stock, and that the purchase was actually an unlawful distribution of corporate assets to the
controlling stockholder.
The defendants countered that there was no shareholder right of equal opportunity to sell shares to the
treasury.
They argued that the proper measure of their duties as directors was good faith and inherent fairness and that
the stock purchase met these requirements.
The trial court dismissed P's bill on the merits. The appellate court affirmed. P appeals.
Issue. Did the defendants breach their fiduciary duty to P?
Held. Yes. Judgment reversed.
1) The defendants distributed corporate assets to Rodd in exchange for his shares and refused to do the same
for P. The court below may either rescind the sale and require Rodd to return the purchase price with interest
or order the corporation to buy from P the same number of shares it bought from Rodd at the same price it
paid him.
2) Shareholders in a close corporation are much like members of a partnership. Frequently, the controlling
shareholders are also managers and directors of the corporation. Therefore, they have a strict duty of good
faith to the minority shareholders. "Not honesty alone, but the punctilio of an honor the most sensitive is the
standard of behavior." Any lesser standard would put minority shareholders at the mercy of the controlling
shareholders.
3) The controlling stockholders of a close corporation who cause the corporation to purchase its own shares
must act with the utmost good faith and loyalty to the other stockholders. If the corporation is buying shares
from a member of the controlling group, each shareholder must be given an opportunity to sell a ratable
number of shares to the corporation at the same price.
141
Rule: Because of the fundamental resemblance of the close corporation to the partnership, the trust and confidence which are essential to this
scale and manner of enterprise, and the inherent danger to minority interests in the close corporation, Stockholders in the close corporation
owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another. The standard of duty
is “utmost good faith and loyalty.”
d)
RULES / HOLDING:
 FREEZE OUT Majority can oppress minority and thereby lock him up in his investment because there is no ready
market for his shares – forcing a sale at a lower price.




Imposition of a Duty of Loyalty more exacting than a duty owed by a director to his corporation or by a majority
stockholders to the minority in a public corporation because of facts particular to the close corporation in the cases.
CORPORATE STOCK BUY-BACK – EQUAL OPPORTUNITY. Allowed but in close corporations, if majority
or controlling stockholder given opportunity to sell stock to the corporation, all other stockholders must be given
opportunity to sell their ratable number of his shares at the same price.
 Otherwise, a violation of fiduciary duty and preferential distribution
 Cannot deny the other shareholders the liquidity / market for his shares that were offered to majority
stockholder
MARKHAM suggests that court decision made Donahue an equal partner to Rodd, which he was not. But most of
class does not agree – we argued equal shareholder rights. Markham contends court did not see it as creating equal
partners, only equal shareholder rights.
CASENOTE: Wilkes (386). Court looks to see if there is a legitimate purpose for disparate treatment of minority
shareholders, if not it may find it is a freeze out.
Analysis for claiming breach of duty--See Note 4 (Wilkes - freeze out transaction whereby the minority
shareholders are eliminated from further participation in the business): Analyze the action taken by the
controlling stockholders in the individual case
1. Whether the controlling group can demonstrate a legitimate business purpose for its action
1. The controlling group in a close corporation must have some room to maneuver in
establishing the business policy of the corporation
a. i.e. Must have a large measure of discretion in declaring or withholding dividends;
deciding whether to merge or consolidate; establishing the salaries of corporate
officers; dismissing directors with or without cause; and hiring and firing corporate
employees.

2) Meiselman v. Mieselman
a) FACTS: 2 Brothers hold stock in family enterprise valued at $11M.
 Michael seeks relief reasonably necessary for the protection of the rights or interests of the complaining
shareholder.
 Such rights or interests may be reasonable expectations (salary, participation in management, etc.), which in
close corporations, majority cannot frustrate
 Michael effectively seeking a buyout …. claims oppression that forces statutory equitable dissolution or other
remedy – i.e. resolution
b) RULES / REASONING
 PERSONAL RELATIONSHIPS
 Reasonable Expectations- the parties expectations that they will participate in the management of the
company or be employed.
 Majority Shareholder is in a position of power, because of his greater voting power, to terminate the minority
shareholder’s employment and to exclude him from participation in management decisions.
 Unfortunately American Courts are unwilling to interfere in the personal relationships of the closely held
corporation management, and because they are often family even less
 CORPORATE LAW
 Special approach needed for close corporations
 2 Barriers to aggrieved minority shareholders in close corporations
 Principle of majority rule
 Business Judgment Rule
 FREEZE OUT If shareholder frozen out and there is no ready market for its shares HIS INVESTMENT IS
LOCKED UP
142

Stockholder in close corporation is REMEDY-LESS so courts may force dissolution or create a remedy to
protect a complaining minority shareholder
6 corporate law concepts are applicable ONLY to close corporations
1. shareholder agreements apply to close corps oNLY but NOT public corps (because they can get super big and too many shareholders
with the abiity to make shareholder agreements could lead to chaos) –this is why MBCA 7.32 ability to enact shareholder agreements
DNextend to public corps
2. cumulative voting Under both the Delaware General Corporation Statute and
the MBCA, shareholders can use cumulative voting in voting for directors if the articles of incorpo»
ration expressly so provide. While neither the Delaware General Corporation Statute nor the MBCA
expressly so provides, the use of cumulative voting is limited to close corporations
. Why??
3. , pre-emptive rights Similarly, under both the Delaware General Corporation
statute and the MBCA, shareholders have a right to maintain their percentage of ownership by buying their proportionate interest on any new offerings, if the articles of incorporation expressly so provide. And, again, while neither the
Delaware General Corporation Statute nor the MBCA expressly so provides, the use of pre-emptive rights is Limited to close corporations.
4.
voting agreements
5.
voting agreements Both the Delaware General Corporation Statute and the MBCA expressly authorize shareholders to agree
about how their shares are to be voted by using either a voting trust or a voting agreement. And, yet again, while neither the
Delaware General Corporation Statute nor the MBCA expressly so provides, the use of voting trustsand voting agreements is
limited to close corporations.
6. piercing the corporate veil While generally shareholders are not liable for the
debts of their corporation, courts have created a common law exception generally referred to as
piercing the corporate veil. All of the reported piercing the corporate veil cases involve close corporations
143
II. Voting Agreements in Closely Held Corporations 9/24
A. Voting Rights Generally
1) Wide Liberty
a) Shareholders may exercise wide liberality of judgment in the matter of voting
b) Even if for personal profit
c) Only restriction is not to violate duty to other shareholders
2) Severance of Ownership from Voting Rights
a) Can by agreement sever ownership rights from voting rights (w/certain limitations)
 See Pooling Agreements and Voting Trusts below
 But must generally be coupled with an interest for the agreement to be specifically enforceable
b) Voting Trusts
 Sever ownership rights from voting rights
 Specifically enforceable because they are coupled with an interest
 Trustee holds title to stock
Voting Trust: commonly understood as a device whereby two or more persons owning stock
with voting power, divorce the voting rights thereof from the ownership, retaining to all
intents and purposes the voting rights and transferring the voting powers to trustees in whom the
voting rights of all the depositors in the trust are pooled. See Ringling.
A voting trusts means that you put stock into a voting stock which means trustee runs the stock
until the time is set for the trust to terminate. Usually these trusts were limited in time… so
instance your children are minors and want to leave them a business.
What Is a Voting Trust? The term "voting trust" is descriptive, if not self»exp1anatoryr. If
Shemp and Larry agree on a voting trust, they will:
(1) set up a trust;
(2) transfer their shares to the trust so that the trust is now the record owner of
their shares and they are the beneficial owners;
144
(3) designate a person to serve as trustee and vote the shares held by the trust;
and (iv) provide instructions in the trust agreement as to how the shares are to be
voted.
State corporation statutes authorize shareholder voting trusts, Typically, the statutes require
that the trust agreement be filed with the corporation
A voting trust is a legally effective way for shareholders to combine their voting power The
trustee has a fiduciary duty to vote the shares as instructed in the trust instrument If she does
not do so, a court will compel her.
a. Voting trusts may be used for several purposes beyond just preventing other shareholders to
acquire control:
i. Creditors might want voting control placed with trustees to protect the
company’s
assets from waste.
ii. A family corporation might need trustees where the founder has no successor in the
family that can take control and operate the business. The trustees can
appoint
professional managers and oversee the company’s business for the benefit of the
family.
iii. Voting trusts have also been used to divest control for antitrust or other purposes.
c) Pooling Agreements.
 Do not sever ownership rights from voting rights
 Specifically enforceable under MBCA
 But other statutes require it be COUPLED WITH AN INTEREST (stock ownership) ???
 Consider whether party can only break deadlock while parties otherwise retain their voting rights
 Or if party has absolutely deprived parties of their voting rights
 See Ringling Bros
 Joint voting agreements or pooling agreements appointing a designated arbitrator to vote in the event
there is no disagreement between shareholders are valid.
 Pooling Agreements are not voting trusts because shareholders retain legal and beneficial ownership interest;
arbitrator’s rights are limited to breaking deadlock
B. SPECIFICALLY ENFORCEABLE VOTING AGREEMENTS - THE RULE
1) Voting Trusts that comply with statute
a) DGCL §218(a) Otherwise unlawful
 Copy of voting trust must be filed and made available for inspection at corporation’s Delaware office
 Trustee must become shareholder of record
 Stock must legend the Voting Agreement
 Stock ledger must legend the Voting Agreement
 NO TIME LIMIT
b) MBCA 7.30(b)
 Copy of Voting Trust and List of shareholders (name, address, shares) must be filed with the corporation’s
principal office
 Trustee must become shareholder of record
 original stock must be surrendered and cancelled
 No requirement for legends on stock or stock ledger
 10 YEAR TIME LIMIT – Renewable
 Don’t want to have to renegotiate Agreement
c) TEST:
 the voting rights are separated from the beneficial ownership of the stock
 the voting rights are irrevocable for a stated period
 The principle purpose is to acquire voting control of the corporation.
145
2) Voting Trusts that don’t comply with Statute Oceanic Exploration
a) Most courts will invalidate Voting Trust that does not comply with statute formalities
 Abercrombie v. Davies “Secret Voting Trust” illegal
b) Other courts may nevertheless validate if policy of statute fulfilled
 Oceanic Exploration All shareholders had notice of the voting trust agreement even though it was not filed with
the corporation
 Statute not exclusive
 Other corporate actions may meet purpose of statute – to avoid secrecy
 Must be open and notorious – not secret
 Can look at is as a valid shareholder’s agreement, not a voting trust
c) NOT VALID – Secret Voting Trusts
d) Illegal because it falls in the legislative field of voting trusts in which case you must comply with statute
 If it falls outside the field (like a pooling agreement)
 If shareholders no longer hold voting rights in the stock
 Failure to transfer stock to trustee alone did not avoid that, there will still a separation of voting rights from
beneficial ownership
3) Pooling Agreements
 Specifically enforceable under MPC
 Under other statutes, must be
 Coupled with an interest Ambercrombie
 Can create a separate class of stock to give to person with DEADLOCK voting rights. Lehrman
 Where stockholder retains voting rights and other party holding different class of stock only breaks deadlock,
rights are not separated from the beneficial ownership - other classes still retain complete control of the voting
power of their own stock. Lehrman
C. Control Devices Relating to Shareholder Voting
1)
Shareholder Pooling/Voting Agreements
a) DEFINITION: Form of shareholder voting agreement establishing how usually non-minority stockholders will pool
and vote their shares to achieve a desired effect i.e. good management, continued participation by particular
shareholders or other individuals in management
 Shareholders may lawfully K amongst themselves so as to obtain advantages of concerted action
 Must be made for proper purpose (even to elect themselves as directors)
 Work no fraud on creditors or other stockholders
 CALIFORNIA: Limits pooling agreements to close corporations
 Arbitrator in such agreements should only be a deadlock-breaking measure
b) MBCA 7.31(b) Makes Voting Agreements specifically enforceable whether or not coupled w/an interest
 May not affect the powers of the board of directors, or it falls under MBCA 7.32
c) DGCL 218 (c) Make Pooling Agreements valid
 no time limit
 unknown whether it is specifically enforceable
d) REMEDY FOR BREACH:
 Usually specific performance; legal remedy inadequate]
 Some courts will not grant specific performance when all shareholders were not a party to the Agreement
(prejudicial to non-party)
2) Voting Trusts Restricted MBCA 7.30
a) Device whereby two or more shareholders divorce their voting rights from their ownership, retaining to all intents
and purposes the latter in themselves and transferring the former to trustees in whom the voting rights of all the
depositors in the trust are pooled.
 Shares transferred to Trustee (new certificates / cancellation of old)
 Voting rights transferred to Trustee
 Shareholder receives a Voting Trust Certificate evidencing beneficial ownership. giving it rights to dividends and
distributions
 Safe harbor but not that flexible – you may prefer a Voting / Shareholder’s Agreement
b) Rigid structure – parties may prefer other agreements
c) STATUTORY REQUIREMENTS
146

PURPOSE OF REQUIREMENTS:
 To avoid secret voting trusts
 ENFORCEMENT:
 Most courts will invalidate Voting Trust that does not comply with statute formalities
 Abercrombie v. Davies “Secret Voting Trust” illegal
 Other courts may nevertheless validate if policy of statute fulfilled
 Oceanic Exploration All shareholders had notice of the voting trust agreement even though it was not filed
with the corporation
d) DGCL §218(a) Otherwise unlawful
 Copy of voting trust must be filed and made available for inspection at corporation’s Delaware office
 Trustee must become shareholder of record
 Stock must legend the Voting Agreement
 Stock ledger must legend the Voting Agreement
 NO TIME LIMIT
e) MBCA 7.30(b)
 Copy of Voting Trust and List of shareholders (name, address, shares) must be filed with the corporation’s
principal office
 Trustee must become shareholder of record
 original stock must be surrendered and cancelled
 No requirement for legends on stock or stock ledger
 10 YEAR TIME LIMIT – Renewable
 Don’t want to have to renegotiate Agreement
Pooling Agreement
Voting Trust
Duration
Can be perpetual
10-Yr Max in most states
MBCA: 10 Yrs
DGCL: No Limit
Share Ownership
Shareholders retain both legal and
Legal ownership transferred to trustee,
beneficial ownership
shareholders retain beneficial
ownerships
3) Proxies
a) Proxy revocable unless it expressly states it is irrevocable AND coupled with an interest (in stock or corporation
generally)
 Otherwise generally revocable and VALID FOR ONLY 11 MONTHS unless expressly stated otherwise
 Useful when coupled with a pooling agreement to make the pooling agreement self-executing (don’t have to go to
court).
b) MBCA 7.22 / DGCL 212(e) Same rule
 212(a) Broad flexibility on voting rights
 212(c) How to grant a proxy
c) Examples of Proxies Coupled with an Interest
 A pledge (person to whom stock is pledged as security)
 A person who purchased or agreed to purchase stock
 Creditor of corporation who required proxy
 Employee of corporation who’s employment K requires proxy
 Party to a voting agreement
4) Deadlock Devices
a) Shareholders Agreement – Arbitration
 Expensive in Time and Cost
 No Appeal so not assured of correct decision
 But gets dispute resolved
D. CASES
Ringling v. Ringling Bros-Barnum & Bailey – Delaware
Chancery Court 9/24 voting trusts
147
** As a general rule VOTING AGREEMENTS ARE VALID. The courts will strike voting agreements if they are
based on a personal benefit. Proxy???
How Is a Voting Agreement Different from a Voting Trust?
The voting agreement case that you need to know for your exam is the case involving a circus
incorporated in Delaware, RinglingBros.-Barnum £1 Bailey Combined Shows v, Ringling, There, two shareholders,
Mrs. Ringling & Mrs. Haley, entered into agreement that they would both vote their shares for the same slate of
directors, Mrs. Ringling complied with the agreement Mrs. Haley breached. She voted for some, but not all, of the
agreed upon slate of director candidates. When Mrs. Ringling sued, Mrs. Haley contended that the agreement was
invalid. At the time of the litigation, Delaware had a statutory provision authorizing voting trusts but no statutory
provision regarding voting agreements.
= The shareholder and the stockholder executed an agreement that inter alia, sought to
pool their respective
shares. The shareholder sought to enforce the terms of the agreement.
I: Is Voting Agreement valid and if so, is it specifically enforceable?
Nonetheless, the court upheld the validity of the agreement.
Since then, the Delaware Corporate Code and the MBCA have expressly recognized voting agree»
ments More importantly, the MBCA provision, but not the Delaware provision, expressly provides
for specific performance, In other words, under the MBCA the court can compel the breaching party
to vote as she agreed to do
In the Delaware circus case, the court did not order specific performance Instead, it held that
the votes by Mrs, Haley that were in breach of the agreement should simply be disregarded As a re»
sult, one of the directors who would have been elected had Mrs. Haley not breached was not elected
Looking back, both voting trusts and voting agreements are legal and both can affect how
shareholders vote on all matters requiring a shareholder vote, not just the election of directors.
voting trust ( as compared to a voting agreement)
- a voting trust is a more formal, complicated arrangement requiring transfer of record ownership of the shares to
a trust
+a voting trust is always effective.
 Unless the corporation is incorporated in an MBCA state, the voting agreement might not be
efective might not be specifically enforceable.
-Here you have a valid agreement that wasn’t enforceable – the proxy provision was not
enforceable because it was not coupled with an interest.
-Most courts hold that a strike down a voting agreement if based on a private benefit.
-Court is split on valid agreement if not coupled with interest.
-Most states follow the Delaware rule – most voting agreements are valid.
NOTES:
-Shareholder agreement, ring ling brothers case, agreed to vote their shares in the same manner, and if they could not agree they would
settle with arbitration,
-Shareholders agreement was permissible but not specifically enforceable,
- issue will turn upon whether the interests in the proxy are covered in the agreement
148
-Was the agreement void because it violated the voting trust statute?-Allows parties to put their stock into a trust and the trustee is
allowed to vote for the person who owns the stock
-Those kinds of agreements are enforceable, has some limitations, agreement must be noted on the shares predominantly, sometimes
allow an extension
-However, problem, closely held company, it is going to be around for a long time and it is anticipated the family will own the same
stock for the desired length of time
-Ring-Ling- held agreement was enforceable, held voting trust statute was not intended to hold voter trust agreements
-Specifically enforceable-court held no because it was not coupled with an interest,
Agency Law-Contract is not enforceable, and the voter trust was a agency contract example
-We can have damages, problem is how to we determine them
-Contract law liquidated damages clause, we can specify that if the damages are not able to be determined or identified
-Couples with an interest-=has to be coupled with the stock itself, and the interest has to be in all the shares of the stock
-Terms of the agreements seem to allow for enforceable now
-Mr. Lewes assumed control of the circus because the parties could not agree, and within a few years
-Rule is-Shareholders agreement is enforceable, but under what conditions will it be actually enforceable

Here you have a valid agreement that wasn’t enforceable – the proxy provision
enforceable because it was not coupled with an interest.
was not
A suit over whether or not a voting agreement
between two shareholders was valid.
Between Ringling versus Hailey. The stockholders meeting, Ringling and Hailey could not decide
who to vote for, and Hailey had a proxy. Loos
was the arbitrator who was going to decide if
they couldn’t. Hailey’s proxy did not vote pursuant to arbitrators decision.
a) FACTS
Holding:

The

The agreement was not a voting
trust within the meaning of that term in the Delaware General
Corporation Law § 18 and as such was not invalid for failure to comply with the provisions
thereof. (=voting trust rules DNA).

The stock held under the
arbitrator to the parties or

The nature of the agreement did not preclude the granting of specific
specific performance would be tantamount to declaring the agreement

As the shareholder's rights were properly preserved at the stockholders' meeting, the
meeting
was a nullity to the extent that it failed to give effect to the provisions of the
agreement. It
was preferable to hold a new election rather than attempt to reconstruct the
contested
meeting.

The court found that the stock-pooling agreement was valid and
court concluded that the agreement was sufficiently definite in terms of the duties and
obligations imposed on the parties to be legally enforceable.
agreement should have been voted pursuant to the direction of the
their representatives.
performance. To deny
invalid.
enforceable.
Notes:
149

Ringling Shareholder Edith Ringling contests the validity of the election of directors and officers at the 1946
annual shareholder and director meetings.
 Edith and Δ Audrey Haley Ringling had, under written Voting Agreement, agreed to ROFT and to vote jointly
their respective 315 shares or otherwise allow designated Arbitrator Loos to vote for them under binding
arbitration
 To allow them to appoint 5 directors and not let North get control
 If they did not vote jointly, North could appoint 3 directors and gain control of corporation
 Audrey’s proxy did not vote in accordance with the Agreement.
 Edith and Audrey could not agree on who to elect as directors in 1946.
 The seven director seats were open and the shareholders had cumulative voting rights.
 Loos stepped in as arbitrator directing Edith and Audrey how to vote so that they would choose 5 directors.
 Audrey’s husband acting under Audrey’s proxy instead votes for Audrey and himself only (and not the 5 th
director). Edith claims this violated their Voting Agreement and invalidated the elections.
b) ΔS ARGUMENTS / HOLDING
 Voting Agreement is unenforceable
 I: CHOICE OF LAW. Delaware law applies because agreements affecting voting rights are tested by the law
of the state of incorporation – not where Agreement executed or otherwise.
 1) I: Agreement to Agree. NO, mutual restraints act as consideration and terms sufficiently definite such that
the Agreement is legally enforceable.
 2) I: Illegal Delegation of Irrevocable Control over Voting Rights
 A) I: In violation of Delaware Law on Voting Trust. NO, not a voting trust. Not a divorce of voting
rights from ownership. Arbitrator directs vote only in limited circumstances. Pooling agreement not a
voting trust
 Statute not exclusive – you can have other voting agreements that do not
 B) I: In violation of Public Policy. NO, arbitrator a person of confidence chosen by shareholders. Court
refuses to follow non-Delaware courts that do not allow agreements that sever voting control from
ownership. No Delaware precedent.
 3) I: Proxy Rules Govern / Revocable. NO. Not a proxy issue, Kual and not revocable.
 4) I: Arbitration Provision Unenforceable NO. Although Delaware courts will not enforce an arbitration
provision here the arbitrator is not given both sides of the conflict to resolve which would otherwise be decided by
a court, instead he makes a decision independently.
c) RULING
 Voting Agreement is specifically enforceable by specific performance.
 Election a nullity because of failure of shareholder to abide by valid Voting Agreement.
 Ordered a new meeting of the board of directors to again elect directors and to abide by the Voting Agreement in
voting therein.
d) PRACTICE TIP
 How do we give Loos an ownership interest in the stock so that Voting Agreement could be specifically enforced?
 Have him give a loan and give him security in stock
 Employment K tied to the stock
 Problem is we don’t want to give up ownership interest in valuable stock
2) Ringling Bros v. Ringling – Delaware Supreme Court
2 Ringling Bros.-Barnum & Bailey Combined Shows, Inc. v. Ringling
Facts: Appellants challenged a judgment of the Delaware Court of Chancery for New Castle
County,
which found in favor of appellee in her suit to enforce the terms of a shareholders'
agreement purported to
bind one appellant's voting rights. Appellee and individual appellant
entered into agreement regarding their
voting rights and duties with regard to shares in
corporate appellant. After a dispute at a corporate meeting
over an election of directors, appellee sued, arguing the agreement had required individual appellant to either vote
for an adjournment of the meeting or for a particular slate of directors. Individual appellant contended the
agreement was invalid.
Holding: The court first held that an arbitration provision within the agreement gave the appointed
arbitrator no substantive powers to enforce his decision. The court then followed the
rule that a shareholder
could enter into a binding agreement with respect to the voting rights of corporate shares. Thus, the court held
that the agreement was binding. However, the court refused to declare the election invalid in order to respect the
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voting rights of appellant shareholder who was not a party to the agreement, instead vacating one director's
position that had not received a majority vote.
The judgment was modified, as the agreement between the shareholding parties was binding; however, rights of a
shareholder not party to the agreement precluded invalidating the election.




Haley/Audrey breached the K
HOWEVER Voting trust that did not comply with statute
Election should not be declared invalid (as ruled by Chancery)
 North not a party to Voting Agreement, not equitable to grant specific performance
INSTEAD Disregard Haley’s votes and consider only those of Edith and North so that the 6 directors they voted
for are elected. The 7th Director seat is to be filled at the next annual meeting.
Notes:
3. Del. §218(b) and (c) now provide that voting agreements, as well as voting trusts, are valid, but
Delaware law continues to draw a distinction between irrevocable proxies and other voting
arrangements.
Del. §212(e) states that:
-A duly executed proxy shall be irrevocable if it states that it is irrevocable and if, and
only as long as, it is coupled with an interest sufficient in law to support an irrevocable
power. A
proxy may be irrevocable regardless of whether the interest with which it is
coupled is an interest in
the stock itself or an interest in the corporation generally.
** A proxy usually equal to an agent. But if a proxy is coupled with an interest it can be enforceable.
b) FACTS
 Appeal to Delaware Supreme Court of previous decision. Same facts as before with more detail. Apparently the
parties could not agree on the 5th director. Loos directed that stock of both ladies be voted to adjourn for 60 days so
agreement could be reached between both women. Edith moved for adjournment accordingly. Haley (under
Audrey’s proxy) and North voted against adjournment.
 Loos as Arbitrator then directed Edith and Haley how to vote under the cumulative voting scheme to ensure the
election of 5 directors by both shareholders; however Haley did not vote for the third director, Mr. Dunn, as
directed by Loos. Chairmen ruled directors elected as if Haley had voted as Loos directed – so that Mr.
Dunn was elected rather than Mr. Griffin. SO WHY DID EDITH WANT THIS ELECTION INVALIDATED?
If Haley’s voted had been considered, Griffin would have been elected instead of Dunn because of North’s votes
for Griffin. Both Dunn and Griffin, over objections from each side, attempted to vote as directors for officers.
c) RULE/ HOLDING
 Again, the court addresses Audrey’s argument that the Voting Agreement is unenforceable as an Illegal
Delegation of Irrevocable Control over Voting Rights
 Court found the rule Δ proposed (where P could not sever voting from ownership)
 was not supported by statute or common law
 would restrict acceptable means of shareholders conferring voting rights on others
 This was a lawful agreement between shareholders on how to vote their stock, not a statutory voting trust  the
voting trust requirements did not apply.
 Took no unlawful advantage of others shareholders
 Did not violate any rule of law or public policy
 BUT NOT SPECIFICALLY ENFORCEABLE (By specific performance)
 Out of agency law
 Even if you have an agreement with me, I can fire you anytime although you can still sue me for damages you
cannot specifically sue me for breach
 Proxy creates an agency relationship
 Not specifically enforceable unless it is coupled with an interest

Damages? In these kinds of cases you can put a liquidated damages provision. Be sure
to pout it in writing because you can’t measue the damages otherwise!.... Or couple it
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with an interest…such security in stock. Look at Delaware §7.22 and §218(392) and
Model Business Corporation Act §7.30 and 7.31 (241).u
Voting trust vs Voting agreement
Voting trust = a separation of voting rights from the other attributes of ownership.
Voting agreement = It you wanted to be a pooling agreement, you need a proxy coupled with an interest.
Abercrombie v. Davies
Class Notes:
 Here we have oil companies who wanted to maintain control through this pooling agreement. None of
the holders had more than majority.
 6 of them got together and gave them 54.5% and kept the voting power away from Phillips.
 The shares were given to trustees in a trust so they could find a way to make the decisions enforceable.
 Phillips wanted the agreement declared void because it violated state statute – Δ argue it was a pooling
agreement.
 Court held it was a voting trust and therefore had to comply with the statute – the key distinction
between pooling agreement in Ringling and here was that there was a separation of voting rights from
the other attributes of ownership. In Ringling they did not separate the voting rights. This was a secret
voting trust and therefore improper and invalid under Del stat.
 It you wanted to be a pooling agreement, you need a proxy coupled with an interest.
Voting trust vs Voting agreement
Voting trust = a separation of voting rights from the other attributes of ownership.
Voting agreement = It you wanted to be a pooling agreement, you need a proxy coupled with an interest.
d) Consortium comprised of individuals and various large oil companies form American Independent Oil Co to develop
oil concession in Kuwait-Saudi Arabia.
e) None of the stockholders have a majority but Phillips has 33% and can elect 4 directors. Shareholders have cumulative
voting rights. Articles allowed 15 directors.
f) Various shareholders (the Davies Group) holding a collective 54% interest enter into a Voting Trust Agreement to
achieve effective control of the Board – primarily to prevent Phillips from garnering control.
g) Agreement
 allows shareholders to elect directors who act as “Agents” with exclusive voting authority and to vote as a unit, if
not a neutral arbitrator would decide
 stock put in trust with blank proxy
 allows 7 of 8 shareholders to terminate Agreement and/or to create a Voting Trust (the form of which is attached)
 Tried to make a Ringling Voting Agreement but get around the problem in Ringling by giving the “Agents” an
interest so that it would be specifically enforceable
h) Two Ashland directors defect and vote with Phillips in violation of the Agreement
i) Davies Group argues this is a Pooling Agreement, not a voting trust
j) HOLDING
 Distinction from Ringling
 Shareholders still held voting rights
 Court looks at terms of Agreement and compares it to the form of Voting Trust attached.
 Notes that all terms the same except the Voting Trust terms which require the shareholders to transfer stock to
trustee
 Agreement was a secret voting trust
 Illegal because it falls in the legislative field in which case you must comply with statute
 If it falls outside the field (like a pooling agreement)
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



Voting Trust conversion provision only added mechanics that statute required
Attempt to create a “secret voting trust”
Shareholders no longer held voting rights in the stock
Key is separation of voting rights from other attributes of ownership for a specified period
 Failure to transfer stock to trustee alone did not avoid that
-Parties were trying to control their corporation by voting all of their interests in the same way, agreement provided all the shares to be
placed in escrow
-Lawyers here looked at the Ring Ling Brothers case and said how can we do that, we need to have a shareholders agreement to be
specifically enforceable
-Set up like a voting trust, and effectively place these shares in trust so that it will specifically enforceable
-Problem was DE SC did not think about the scope of the Ring Ling Decision-People here created effectively what turned out to be a
voting trust, which was determined by the statute
-Court held this violated the statute because it was not open and notorious
-Courts may also look at the purpose
-We still have the concern how do we control the situation, of how can we control the company with two owners of 50/50 ownership
3) Lehrman v. Cohen 9/24
a) To make a voting agreement specifically enforceable in Delaware, corporation created a third class of stock to
issue to agent/trustee (counsel) so that his voting right would be coupled with an interest. ENFORCEABLE
 Neither a voting trust or a pooling agreement.
b) FACTS: Giant Food had two classes of voting stock, equally divided among two families 50/50 Cohen (Class AC) Lehrman (Class AL) with cumulative voting rights
 To break deadlocks they created one share of a third class of voting stock, which had no right to dividends an only
$10 par, and issued it to their corporate counsel (Denansky). He could elect one director (elects himself) and can
break dispute.
 Denansky given an employment K, using his single share to approve it. He becomes President.
 Denansky thereafter proceeds to consistently vote against the wishes of one of the families. Could also sell out the
company >>>>>>>>>>
 The overtake of control the shareholders were initially trying to avoid nevertheless occurs – by their own agent.
c) PH: The minority family brought this action to declare the deadlock-breaking class of stock invalid as a voting
trust. The lower court found that the stock was valid.
d) ISSUE Whether the third class of voting stock created here was valid . YES
e) REASONING / HOLDING:
 1) CONTENTION 1: 3D CLASS OF STOCK IS ILLEGAL VOTING TRUST
(Not limited in years) - NO
 RULE: There are three tests that must be satisfied to establish that an arrangement is a voting trust:
 the voting rights are separated from the beneficial ownership of the stock
 the voting rights are irrevocable for a stated period
 The principle purpose is to acquire voting control of the corporation.
 APPLICATION: Here, the voting rights were not separated from the beneficial ownership. Although the
creation of the third class of stock diluted the voting power of the other two classes, the other two classes still
retained complete control of the voting power of their own stock.
 2) CONTENTION 2: AGAINST PUBLIC POLICY – NO
 Even non-voting stock is allowed by DGCL 151(a), it is not against public policy to separate voting rights
from beneficial stock ownership. =Leave it up to you how you want to classify your stock and what rights
your stock has
 RESULT: Lehrman family lost control of company.
CASE NOTES-Moral of the story is do not trust your lawyer
-Look at the ring ling brothers case again, Court
-Look at this case, how can we make the shareholders interest separate but make a provision for deadlock of holdings,
-Young associate said we can create a class of stock, to use that break
-Create three classes of stock ownership, two families get different stock to control half each, and then create a tie breaker which was
given to the attorney to make a good decision, and then they would be impartial because of the decision
-Problem with the stock is that there is no cognizable interests with the attorney’s stock, and there has to be an interest in play
-Sole purpose was to act as a tiebreaker, 1964 he defected to one of the two controlling families and he voted his share to approve this
arrangement, the attorney became president of the company, and appointed someone else to fill his place
-The other family now lost control of the corporation, they became minority shareholders
-Both parties claimed original actions are illegal because they created a voting trust and therefore it should be nullified, the Court held no
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-Here there was no separation of ownership and control and therefore not an invalid capitalization of the stock
-Problem is that the attorney’s stock was not limited in time, and the losing family could have lost forever, and took it away from what
they intended to accomplish
4) Oceanic Exploration v. Grynberg (DE. 1981)
a) Voting Trust statute not exclusive – other corporations action may meet the purpose of statute – to avoid
secrecy.
b) Valid as a shareholder’s agreement – not a valid voting trust.
c) Majority shareholders sued by their creditors. All stock in voting trust. Amended requiring founder to resign,
restrictions on sale or hypothecation of share.
d) We can break this agreement – it’s a voting trust and they didn’t renew before statutory expiration.
e) HOLDING
 Not Abercrombie
 Open and notorious – not secret
 Other equitable grounds
 Voting Trust statute not exclusive – other corporations action may meet the purpose of statute – to
avoid secrecy.
 Valid as a shareholder’s agreement – not a valid voting trust.
 Still need to come up with the interest required in Ambercrombie.
 Invalid violated extension restrictions of voting trust
 218(a+b) changed – more modern view
 Purpose and public policy valid
CASE NOTES-Sounds like it should be void under the Ambercrombie decision, Court said no because there are a lot of public policy
reasons as to why this is ok
-Use of shareholder agreements, courts have to decide whether those agreements are enforceable, problem is are we doing something to
change the structure of the corporation, a shareholder agreement can only go so far with Ring Ling, we looked at a pooling of voting,
other shareholder agreements might go further
-Ways in which we can control the corporation , we can have higher quorum requirements, we often see that in small business, we need a
100 percent vote in order to pass corporate action, that will ensure that no majority of the managers can bully others, seems like a good
idea
-However, not good because minority shareholders can often wield a type of veto power against the majority
III. Voting and Quorum Requirements for Control
1) Benintendi v. Kenton Hotel
 2 unequal shareholders. But want to run everything by unanimous action. Will bring in a third director to give us
guidance at board or shareholder level.
 All action had to be by unanimous vote. Could not even amend
 HOLDING: NO – Violates NY law – requires only plurality (quorum)
 No supermajority allowed
 Bylaw unworkable and unenforceable
 Common law only require quorum
 Does not violate public policy
 State has interest in confirming bylaws not inconsistent
 NOW: Hereafter (not at time of case) statutes allowed supermajority
 Statute amounts are default –

election of directors unless there is
2) Blount v. Taft
a) Close Corporation Ownership split between 3 groups
b) 1971 Board meeting: by unanimous vote, a bylaw was adopted –that bylaws could only be amended by unanimous
vote
 Each family would nominate one individual as member of employment committee
 So not all one group’s people are hired
 Could only be amended by unanimous vote
 Mrs. Blount coming to Board and could not attend. Bylaw amended to repeal prior bylaw and allowed them to hire
the Tafts without hiring Blounts.
 Blounts say WAIT this is a Shareholder’s Agreement (K) and should be enforceable, should not be able to repeal a
K(
154
c) ISSUE Whether Bylaw is valid?
d) Court saw purpose was to protect minority shareholder
 Problem with close corporations
 To protect their interests shareholders agreement are used to protect minority shareholders
 Restrictions on transfers
e) CONTENTION: Dispute whether a bylaw or a shareholder agreement
f) Court says it doesn’t matter
g) Purpose was not to have this unanimity rule
h) Shareholders able to protect their interest for a while but bylaw should be able to be amended by plurality
i) Shareholder’s Agreements recognized by most states
j) Bylaw can constitute a Shareholders Agreement
k) One way to adopt the Agreement.
l) Bylaws in their entirety are shareholder agreements
m) Looking at them in their entirety it was proper to amend the bylaws.
n) BYLAWS CAN BE USED AS SHAREHOLDER’S AGREEMENT BUT LACK AT THEM IN THEIR ENTIRETY.
o) Blounts – your fault - You’ve lost control of the corporation
p) Should have had a Shareholder’s Agreement
-CASE NOTES- Common provision is veto power over hiring, veto on dividends, conversely we might have an affirmative requirement
for provisions
-Procedures for resolving disputes
-Most States have provisions that now allow for shareholder agreements that will affect the power of the BOD, state legislatures are
going to allow it for a bona fide shareholder agreement in line with our statute
-This is only true for closely held corporations, statutes are specifically aimed at small corporations, this gives you a great amount of
flexibility but the better option is probably the LLC
-FL has a shareholder agreement limited to companies with less than 100 shareholders the last time Markham looked
1) MBCA 7.32 Shareholder Agreement / Operating Agreeement
a) Addresses many aspects of Business Plan
 Stock transfer restrictions
 Buy-Outs
 Non-compete
 Dispute resolutions
b) Valid only for 10 years unless agreement otherwise provides
c) Must be signed by all shareholders and binds corporation and all subsequent shareholders
d) Legend on stock certificates
e) Shall cease to be effective upon going public
2) Presence in State of Incorporation
a) Technical Office
b) Registered Agent
B. Gearing v. Kelly
1) Ownership: Meecham – 50% ; Kellys 50%
2) 4-member board – Kelly Dad, Kelly Son, Meacham, Lee
3) Lee resigned. Beecham did not attend Board to avoid required majority and frustrate corporate action (so they could not fill
the vacancy with their successor). --Issue: was this a valid election? There was not a valid quorum there.
4) COURT SAYS NO. although most courts say yes.
a) Will not allow director to avoid meeting to frustrate corporate action – election valid
b) Cannot use quorum requirements in this way
c) Conflicts with MGM case
5) MARKHAM: Case is extreme. MGM- Campbell v. Loews is majority
a) Prefer Shareholder’s Agreement then maneuvering Housekeeping Duties in Bylaws
6) DISSENT:
a) Court interfering
b) Court destroyed existing structure and reasonable expectations
c) Attendance would stripped of control on the board
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 No requirement you attend a meeting
7) NEW YORK STATUTE CHANGED AFTER THIS CASE
CASE NOTES-Effort to block corporation action by preventing a quorum
-Gearing-father that had control, daughter given 50% of the shares, Kelly family also had 50% of the shares, 4 members on the BOD,
Kelly senior and junior, Gearing-his daughter Beechem and Margaret Lee-Lee decides to resign, we now have three members to
constitute a qurom, if they have a BOD meeting they can vote to fulfill the slot with another person on their side in order to control the
company even though they only own 50% of the stock
-Beechem stays away, Court said no you stayed away only to block a quorum, that is bad faith
-Compare this with Loewe’s who held that staying away was fine
-This case is probably the outlier, most courts will not make you go to the meeting, better to have LLC spell out what the parties can and
cannot do
C. Managing Control
1) Shareholders Agreements
a) Pooling Agreement
b) Voting Trust
c) MUST COUPLE WITH AN INTEREST IN DELAWARE
 To be specifically enforceable
2) Voting and Quorum Requirements
a) Can set supermajority
 BUT if we can’t get supermajority we are deadlocked
3) Interplay between Corporate Law and K Law
a) If it fails under corporate law may be able to enforce under K law
b) Oral but enforceable
IV. Shareholder Agreements and Direction Discretion
A. Informal Restriction of Shareholder Agreements
1) Case Rules
a) WHERE SHAREHOLDER-DIRECTORS AGREE ON HOW TO VOTE FOR OFFICERS
b) McQuade v. Stoneham– TRADITIONAL STRICT VIEW – PUBLIC POLICY
 Stockholders cannot by agreement invade powers of directorate
c) Clark v. Dodge – HARM TEST
 Agreements by stockholders of close corporation that conflict to a slight extent with statutory director duties
are not illegal as long as no one (individuals or public) is harmed by the provision.
 Some states require ALL stockholders to be party to agreement – or quicker to uphold
 Not allowed for public corporations, usually only close corporations
d) Galler v. Galler – SLIGHT DEVIATIONS FROM STATUTES ALLOWED FOR CCs
 Shareholders of close corporations may enter into Agreements regarding management although slight
deviation from governing corporate statutes (serves same purpose)
 But not actions in direct contravention to statutes
 Court refused to invalidate a shareholder agreement because of duration, officer appointments, required dividends
or salary requirements.
 Close corporations like partnerships and allowed Kual flexibility
e) Somers v. AAA Temp –DIRECT CONTRAVENTIONS TO STATUTES NOT ALLOWED for CCs
 Shareholder amendment of articles unauthorized – not stated in Articles
 Allow slight deviations from statute, cannot allow a direct contravention to statute
2) MBCA 7.83 Shareholder Agreements
a) Shareholders of close corporations may eliminate board or restrict their power, govern distributions, establish officers
and directors
 Not public corporation
 Written Agreement by ALL shareholders or in Articles/Bylaws
 Legend on stock certificate
 Valid only for 10 years unless Agreement provides otherwise
3) DGCL 350 – Shareholder Agreements
a) only close corporations can have Shareholder Agreement
b) close corporation” as defined in DGCL §342 has:
 no more than 30 shareholders
 no public offering of stock
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c) only a majority of the stockholders approval is required
d) no time limit
4) Eliminating Board of Directors
a) DGCL 351 - shareholders in a close corporation may eliminate the board of directors only if in Articles
b) UNLIKE MBCA 7.83 where board can be eliminated by unanimous Shareholder Agreement
SHAREHOLDER
MBCA
DGCL
AGREEMENTS
Not public
No. of Shareholders
Time Limit
Other
Yes
Unanimous
10 Years unless otherwise stated
Legend on stock certificate
Eliminate Board
Yes
Majority approval
No time limit
Only close corporations
30 shareholders
No public offering of stock
Not by Shareholder Agreement
Must be in Articles
Yes by unanimous Shareholder
Agreement
5) Test for Valid Shareholders Agreement
a) Only allowed for close corporations
 Delaware – statutory compliance for close corporation designation in Articles
b) Courts liberal in enforcing statutory duties on close corporations when
 NO HARM OR DAMAGES – TO
 Public
 Other Shareholders (Complaining Minority Interest)
 Creditors
 NO CLEARLY PROHIBITIVE STATUTORY LANGUAGE
6)
McQuade v. Stoneham


Shareholder Agreements and Director Discretion
TRADITIONAL STRICT VIEW – PUBLIC POLICY
Why Is It Important to Determine Whether a Person Who Is Both a
Shareholder and a Director Is Acting in Her Role as Director or in Her Role as a
Shareholder?
The baseball case, McQuade v, Stoneham, is the case that most BA/BO casebooks use to make that
point McGraw, McQuade and Stoneharn, three of the shareholders of the National Exhibition Company, which owned the New York Giants, shareholder agreement stated they would "use their best
endeavors for the purpose of continuing as directors of said Company and as officers the following
(followed by their three names)"
As a result of Stoneham’s breach of this agreement, McQuade was voted out as treasurer when
McQuade sued,



he New York Court of Appeals concluded that the part of the shareholder voting agreement
concerning the appointment of officers was void The court reasoned that (i) directors, not
shareholders, appoint oflicers, (ii) when the three agreed to appoint each other as officers,
they were agreeing as to what they would do as directors,and (iii) directors, unlike
shareholders, are fiduciaries to the corporation and, as such, must exercise independent
judgment  Accordingly, any such agreement as to what they would do as directors violated
public policy

The court in M cQuade v. Stoneham also stated by way of dictum that the agreement about
electing each other to the board was valid. when McGraw, McQuade, and Stoneharn vote for
directors, they are acting as shareholders, not as directors  shareholders can enter into
voting agreements.
I: Whether the shareholder K was void because it restricted the rights of the directors. yes
Stockholders cannot by agreement invade powers of directorate
157





=Court held shareholders agreement may not divest the power of the BOD through the shareholder agreement.
agreement among directors void Director’s duty is to corporation  agreement compelling director to vote a particular officer violates director’s duty to corporation  illegal
=K among shareholders or directors to preclude Board from using their business judgment  illegal  void
Stockholders may unite voting power but only to elect director BUT cannot unite to limit power of directors to manage business or use their business judgment
-CASE NOTES:

Working backwards to the common law rule, BOD need to make decisions, the shareholders cannot make decisions and cannot tell the BOD what to do,
o
the shareholders power is only to vote for the people on the BOD

-Corporate decision making is intended to be collegial, but personalities often get involved, decision making is not helped by personal battles between parties

-All bets were off when the falling out occurred

-Common law rule, shareholders can combine to elect BOD members, but that limitation of the shareholders was election of BOD, BOD governs the corporation not the shareholders

-Common Law Rule-Ring Ling Brothers Ok- Not going to allow an agreement that will allow for the shareholders to interfere in the decision making capacity of the BOD members
a) Л seeks specific performance of agreement among shareholders/directors.
b) PH: Lower court gave McQuaid damages but would not specifically enforce the Agreement, voiding his firing.
c) HOLDING:
 REVERSED – Not an enforceable legal K
NO DAMAGES OR SPECIFIC PERFORMANCE
d) FACTS
 NY Giants baseball team. Stoneham owns majority but sells 70 shares each to McGraw and McQuaid.
Shareholder’s Agreement between 3 stockholders agreed to elect themselves as directors and Stoneham would
elect other directors. No corporate changes would be made unless all agreed.
 Good for 9 years until Stone and McQuaid had a fight. McQuaid thought he had a strong bargaining position
because he was needed for Stonehams majority. Stoneham and McGraw pooled their interest to get McQuaid out
after Stoneham and McQuade had a falling out.
e) PROCEDURAL POSTURE:
 Л McQuade contends agreement among directors to continue a man as officer is binding as long as such officer is
loyal. COURT DISAGREES
HOLDING:
 agreement among directors void
 Director’s duty is to corporation  agreement compelling director to vote a particular officer
violates director’s duty to corporation  illegal
=K among shareholders or directors to preclude Board from using their business judgment  illegal 
void

 Stockholders may unite voting power but only to elect directors
 BUT cannot unite to limit power of directors to manage business or use their business judgment
f) HOLDING
 Directors Stoneham and McGraw did not have fiduciary duties towards McQuade as an individual
-CASE NOTES-Working backwards to the common law rule, BOD need to make decisions, the shareholders cannot make decisions and
cannot tell the BOD what to do,
- the shareholders power is only to vote for the people on the BOD
-Corporate decision making is intended to be collegial, but personalities often get involved, decision making is not helped by personal
battles between parties
-All bets were off when the falling out occurred
-Common law rule, shareholders can combine to elect BOD members, but that limitation of the shareholders was election of BOD, BOD
governs the corporation not the shareholders
-Common Law Rule-Ring Ling Brothers Ok- Not going to allow an agreement that will allow for the shareholders to interfere in the
decision making capacity of the BOD members
7) Clark v. Dodge the mcquade attitude shifted in this case
a) Agreements by stockholders of close corporation that conflict to a slight extent with statutory director duties are
not illegal as long as no one (individuals or public) is harmed by the provision.
 Some states require ALL stockholders to be party to agreement – or quicker to uphold
 Not allowed for public corporations, usually only close corporations
b) FACTS: Clark (25%) and Dodge (75%) own 2 companies (Bell & Co and Holling-Smith). Clark runs companies and
knows secret formula. Dodge and Clark enter into agreement for Bell South whereby:
 Dodge agrees to:
 Vote Clark as director and officer (if faithful, efficient and competent)
 Clarke receives ¼ of net income
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No unreasonable salaries that would impair that ¼ right
Clark agrees to
 Disclose secret formula to Dodge’s son
 Bequeath his stock to Dodge’s family if he dies without issue
 Similar agreement as to net profits and salaries for Holling-Smith
 Dodge does not vote Clarke as director and general manager and Clark sues to specifically enforce Agreement
Issue: is the agreement enforceable?
c) COURT FINDS ALL TERMS REASONABLE AND ENFORCEABLE
 Where the directors are the stockholders there is no harm in their agreeing who to appoint as officers
 NEW STANDARD to test Shareholder Agreement: Harm
 Agreements by stockholders of close corporation that conflict to a slight extent with statutory director duties are
not illegal as long as no one (individuals or public) is harmed by the provision.
 Some states require ALL stockholders to be party to agreement – or quicker to uphold
 Not allowed for public corporations, usually only close corporations
CASE NOTES- consistency is not a part of corporate law, DE and NY courts do not achieve consistency
-Dodge 75%, and Clark 25%, selling the secret oil that was known only to Clark-he was supposed to be the one selling the medicine
-Dodge was supposed to be the passive investor, Dodge was all the other portions of the management
-Issue is whether the Contract is legal under the previous McQuade decision?
-Court said where the shareholders are the only shareholders of the corporation who is to be hurt here, all of the shareholders agree to it
so where is the injury going to occur here
-Doesn’t exactly overturn McQuade, but recognizes the small companies need protection, but different than that of the large public
corporations
-Hence the outcome of the LLC companies


8) Galler v. Galler
a) INFORMALITY FOR CLOSE CORPORATIONS
 Shareholders of close corporations may enter into Agreements regarding management although slight
deviation from governing corporate statutes.
 But not actions in direct contravention to statutes
 Court refused to invalidate a shareholder agreement because corporate actions slightly varies from statute
 duration, officer appointments, required dividends or salary requirements.
 Close corporations like partnerships and allowed Kual flexibility
b) FACTS: Courts Two brothers, Benjamin and Isadore, enter into Shareholder Agreement for their company, Galler
Drug Company. Each own 110 shares. They each sell 6 shares to employee Rosenberg, guaranteeing repurchase.
Benjamin and Isadore enter into a Shareholder’s Agreement
 Agreement was designed to ensure that both family’s interests were equal in the business even though one of the
founders had died.- both families would have equal control.
 =Purpose: financial protection of their families and equal control of the corporation after death of one of the
brothers

After Benjamin dies, Isadore denies Benjamin’s wife, Emma, access to the company and its management. Isadore
and his family refuse to honor the Shareholder Agreement. Isadore and his wife also purchase Rosenberg’s 12
shares, gaining majority control, without giving Emma the right to purchase.
 Emma sues in equity for an accounting to specifically enforce terms of the Shareholder’s Agreement. She also has
a claim in this action asserting an equitable right to 6 of the 12 Ronseberg shares.
c) PP: Δs contend the Agreement is void for reasons hereafter stated. Court disagrees
Issue: Was this an improper agreement that interfered with BOD power?
d) RULES / HOLDING
 CLOSE CORPORATIONS/ SHAREHOLDER AGREEMENTS
 Shareholder Agreements are necessary for shareholders in close corporations to protect their investment, for which
there is no ready market.
 As owners of corporation, they can choose to run that corporation however they want and to make agreements
amongst themselves as long as they don’t go too far
 Will not invalidate these Agreements on the basis of public policy
 TEST
 Court stresses that courts are liberal in enforcing statutory duties on close corporations when
 No harm or damages – to
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


Public
Other Shareholders (Complaining Minority Interest)
Creditors
 No clearly prohibitive statutory language
e) HOLDING: Agreement valid + not a violation of state law
 Indefinite time period irrelevant for straight voting agreements
 straight voting =Unless the articles otherwise provide, each shareholder will cast one
vote for each share he holds and will do so in each of election of a director.

“Straight voting” is the term commonly used to describe shareholders’ voting for
directors where the articles do not provide for cumulative voting.
 only Voting Trusts are limited and yet renewable)
 Appointment of officers
 Allowed where shareholders are also directors
 Dividends
 No harm by such agreement (they agreed to it in the first place)
 Salaries
-CASE NOTES-Family corporation, two brothers own it, successful, what happens when one of them dies, and what happens to their
families,
-Enter into an agreement, providing for health of the families and wealth of the families
-One family member dies
-Should the other side get 50%? Or does the company now need the total 100% of the value of the company?
-Agreement that they entered into
9) Somers v. AAA Temporary
a) Can shareholders amend the bylaws if such power not reserved in Articles?
 Delaware defaults to shareholders – So in Delaware YES
 MBCA defaults to Board or shareholder – So in MBCA States…
b) FACTS
 Action brought by a director (not a shareholder) to invalidate action by sole shareholders amending bylaws to
reduce number of directors from 2 to 3 and thus removing him
 Raimer and Kay, shareholders, waive notice of annual meeting then hold meeting amending Bylaws to reduce
directors from 3 to 2 and appoint themselves as directors (eliminating Л Somers). Then hold director meeting.
c) RULE
 ILLINOIS: Power to amend Bylaws vested to Board unless Articles reserve to shareholders
 Shareholders did not reserve power in Articles
 Action a nullity
 Upholds lower court
 Δ’s relies on Galler v. Galler to argue that the action should be allowed as a deviation from statute permitted for
close corporations in Galler
 Court says NO – taking that too far (any action changing the bylaws would have to be approved by the BOD)
 Galler allows slight deviations from statute – not actions in direct contravention to statute
V.
LOOK TO THE STATE STATUTE! Some statutes say the shareholders (unless otherwise provided in AOI),
other statutes say the BOD (unless otherwise prvided in AOI)
Restrictions on Transfers
A. Rules
1) Purpose:
a) So shareholders may control entry into corporation like a partnership
b) To broaden, not limit circumstances in which such restrictions would be enforced
c) STOCKS ARE PERSONAL PROPERTY
d) Must broadly define transfer “to include transfers by operation of law” otherwise courts may not enforce in such cases
because of “restraints on alienation”
2) MBCA 6.27 Restriction on Transfers of Shares and Other Securities
a) Restriction can be in Articles, Bylaws or Shareholder Agreement
b) Enforceable if:
 Reasonable restraint on alienation
 Even consent restraints ok if reasonable
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
Prohibits transfers to designated persons or classes of persons
3) DGCL 202 Restrictions on Transfer and Ownership of Shares
a) Enforceable if:
 Restriction on stock certificate
or in Information Statement given with uncertificated shares
If shareholders will take action on a matter but management is not soliciting proxies, the company must provide shareholders with an information statement that is
similar to a proxy statement.
B. Types of Restrictions
1) Right of First Refusal (popular)
a) Holder is not forced to sell but if he decides to sell, he must give ROFR to purchase to the option holder
b) Courts generally UPHOLD
c) MOST POPULAR
d) Price: Matches Market Price
2) Option
a) Irrevocable right granted to another to purchase, sometimes conditioned on certain events occurring: death, termination
of employment, etc.
b) Corporation or each shareholder has right to purchase other shareholder’s stock before 3d party sale or upon
occurrence of some event
c) Courts usually UPHOLD
d) Price: PROBLEM Not matching an offer; How to value? Book (less than market) Market (hard to measure for CC)
3) Consent Restraints
a) Requires approval of other stockholders before shares can be sold
b) DISFAVORED by courts
 MBCA allows if not manifestly unreasonable
4) REASONABLE
a) All must be reasonable restraints on alienation of stock
b) All must be exercised within a reasonable time
C. Buy-Sell Agreements (popular)
 Buy-Sell Agreements: (Permissible restrictions) if one partner dies or leaves, the other party has the
right to buy or sell, but the corporation could also buy or sell. An arrangement whereby (1) how do we
fund the buyout? (2) at what price to we buy them out at? If we set the price at the beginning worth, its
probably worth nothing – 20 years later it’s probably worth a lot. Two problems:
o Value (price)
o Funding
1) As seller, how do you set the price
2) As buyer, how do you fund the purchased --where does the money come from?
3) POISON PILL – Unanimity required in all decisions
a) Person already in can keep operating in ordinary course of business
D. Funding Issues
50% owner dies, the other 50% owner agrees to buy them out... where does the money come from?
1) Death- can fund through insurance (but who pays insurance)
2) Redemption – corporation purchases stock
a) Problem is funding for corporation to purchase stock
E. Pricing Issues
1) Book value does not reflect market value
a) Shows depreciated value of a building that has actually appreciated
b) Ignores market appreciation
c) Ignores good will
2) Need Pricing Formula
a) Appraiser
 Comparables
 Reconstruct Costs
 Capitalization
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F. Cases
St. Louis Union Trust v. Merrill Lynch
a) FACTS
 Action by estate of deceased shareholder questioning the validity and enforceability of an option held by MerrillLynch to repurchase its stock from a deceased shareholder
 1959: Merrill Lynch incorporated (formerly a partnership) The charter restricts stock transfers, grants an option to
the corporation to purchase stock at adjusted net book value upon death of shareholder, among other events.
Transfer restriction is noted on stock legend.
 Book Value ≠ Market Value
 Book Value =
 1962 Shareholder Biting retires and exchanges his voting stock for cash and non-voting stock. Dies 8 years later
1970 and Merrill Lynch exercise its repurchase option as to the Biting’s non-voting stock. Widow given and
accepts opportunity to purchase 10,000 non-voting shares
 1971 Merrill Lynch goes public – starting at $28 per share (after 3 for 1 stock split)-3x what merrell paid the
decedents estate under the repurchase agreement.
 Splits stock to lower price and make them more appealing to public
b) ISSUE: Whether the stock restriction enforceable in 1970?
+Was this repurchase agreement fair?
c) RULE / HOLDING: YES, under DGCL 202(c)(1) it was an agreed to price!
 DGCL 202 Restrictions on transfers permitted by this section may be enforced against the holder of the security
and his successors (both voluntary and involuntary).
 Validates both options to purchase and rights of first refusal
Before 1970s, stockbrokers were not allowed to incorporate because the courts wanted them to be personally liable
(like partners in a law firm)
Class Notes Starting 10/10/11
-Still looking at fiduciary duties
-Issue of whether you could sell controlling interest in corporation?-Yes you can sell control for a premium, exceptions you cannot sell to
a looter, you cannot sell to someone who will loot the company, you can also not sell a company office, not permitted to sell it you can
transfer but not sell
-51% easy, 48% still a controlling interest, around 35% even though less than a majority may be controlling in the corporation
CHAPTER 11 DUTIES OF CONTROLLING SHAREHOLDERS
I. Fiduciary Duties of Controlling Shareholders
A. Restrictions on Self-Dealing by Controlling Shareholders
1) If Self-Dealing: INTRINSIC FAIRNESS TEST APPLIED
a) When parent, by virtue of its domination of the subsidiary caused the subsidiary to act in a way that the parent receives
a benefit to the detriment and exclusion
 Conflict of Interest
 If all shareholders do not benefit equally (not fair to corporation) you should suspect self-dealing
2) If no Self-Dealing BUSINESS JUDGMENT RULE APPLIED
a) Wide discretion
B. Fiduciary Duties Controlling Shareholders
1) Controlling shareholders owe a duty to minority shareholders when they exercise their control
a) in management of corporation
2) Shareholders, however, have no fiduciary duty in sale of their stock except
a) __________________
b) Directors may be liable for negligent turnover of control of large qtys of liquid assets without full purchase price paid
c) ________________
C. Case Rules
1) Sinclar v. Levien
a) INTRINSIC FAIRNESS TEST –for SELF-DEALING (applies only in self dealing cases) (=where the parent
company receives something to the exclusion of the minority shareholders)
 In self-dealing transactions between parent and its subsidiary
 burden is on Δ to prove intrinsic fairness to minority shareholders –"the minority got their aliquot as well”
b) BUSINESS JUDGMENT RULE TEST – NO SELF-DEALING
 If there is no self-dealing, the business judgment rule is applied, where courts defer to judgement of directors
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
Court did not consider preferential tax treatment and tax savings to Sinclair, who under consolidated tax return
with parent would not be taxed on dividends although minority shareholders were taxed
Zahn v. Transamerica How this fiduciary duty comes up in another instance
c) Majority has the right to control but when it does it has a fiduciary duty to the minority as much as to the corporation
itself. = ** CONTROLLING SHAREHOLDERS HAVE A FIDUCIARY DUTY to the minority
shareholders.
If Directors act in the interest of majority stockholders that appoint them for the purpose of profiting for that majority,
at the detriment of the minority, such action is voidable in equity.
Class Notes:
 3 classes of stock and each has different rights and preferences (see note on p. 588 for details of
breakdown)
1. class A = shares that refer to a classification of common stock that is accompanied by
more voting rights than Class B shares, usually given to a company's management team. For
example, one Class A share may be accompanied by five voting rights, while one Class B
share may be accompanied by only one right to vote.
2. Class B - less voting shares than A but more than C
3. Class C - common stock no voting rights
*Option of Conversion - pg. 479 -480 (for disinterested board of directors)
Convert to Class B shares on a 1:1 basis --but the redemption was provided with notice to late to exercise the conversion right
Facts. Zahn (P) owned class A common stock; there were two other classes (class B common and preferred stock). Upon liquidation, the
preferred received a set amount; then class A got $2 for each $1 paid to class B (the voting stock). The class A stock (convertible on a
one-to-one basis into class B stock) was callable by the board for $60 per share plus any accrued dividends. Transamerica (D) bought
both class A and B stock; it then converted its A stock into B
Not D owned almost all of the B stock. It thus controlled the company; it also controlled the board.
The inventory of the corporation was listed with a book value of $6 million but actually had a market value of $20 million (due to a
recent rapid rise in the value of tobacco, which was the inventory). This was unknown to the shareholders. D called the class A shares.
Then it liquidated the assets, paid off the preferred shares and paid itself (since it controlled almost all of the class B stock) the
remainder.
P claimed (in a class action of class A shareholders) that, had he been included in the liquidation, he would have received $240 per share
rather than the $80 per share paid pursuant to the call ($60 plus accrued dividends). P's action was to recover this difference. The lower
court found for D. P appeals.
Issue. May the majority shareholder use its control of the board of directors to gain at the expense of the minority shareholders in a
transaction where each step is performed in accordance with state law?
Held. No. Judgment reversed.
a) A majority shareholder may vote according to its own interests.
b) But a majority shareholder also has a fiduciary duty to the corporation and the minority shareholders the same as the directors. Actions
taken by the majority must, therefore, meet the standards of good faith and fairness.
c) Disinterested directors could have called the class A stock. But here, the directors were controlled by the majority shareholder.
Directors owe the duty of acting in the best interests of all of the shareholders; these directors acted only in the best interests of the
majority shareholder.
d) There was no business purpose for the call of class A stock and then liquidation, except to benefit the class B shareholders (D) at the
expense of the class A shareholders.
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D also failed to notify the class A shareholders of the liquidation plans and that class A would get a big
profit. A could have converted to class B shareholders!!!! That info should been given to the class A
shareholders).
- Cumulative Preferred Stock a stock whose unpaid dividends accumulates
until they are paid
- Nnoncumulative “straight” preferred stock does not accumulate unpaid dividends, but its
dividends are paid ahead of common stock
If financial problems beset a company, causing it to lose money, it can't pay its
dividend obligations to its preferred and common stockholders. For holders of
cumulative preferred stock, the dividends owed continue to accumulate until they are
paid.
All dividends owed to holders of cumulative preferred shares must be paid before
holders of straight, or noncumulative, preferred and common stock can receive
dividends.
The MBCA uses the term "distribution," not cash dividend
The MBCA definition of "distribution" includes cash dividends.
Under the MBCA, cash dividends are one form of distribution.
Another form of an MBCA “distribution" is a corporation’s repurchase of its shares from its shareholders
Stock dividends do we need to know the regualtions on cash dividends?
payment made in the form of additional sharesrather than a cash payout.
advantage - companies may decide to distribute this type of dividend to shareholders of
record if the company's availability of liquid cash is in short supply.
advantage - Stock dividends are not dsitributionsv- Under the MBCA, stock dividends are
not subject to the same restrictions as cash dividends and other distributions.
A stock dividend is not even really a dividend. Think about the financial consequences of Acme’s
board of directors declaring a stock dividend. Issuing an additional 200 shares as a stock
dividend. The existence of additional 200 outstanding shares would have no effect on Acme’s
balance sheet and no effect on Acme’s creditors.
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D. Various Types of Stocks and Rights Therein XPS
1) Convertible Securities
a) Certain securities convertible into other forms of securities (bonds to stock, preferred to common, etc.)
b) Usually for limited time
c) Conversion feature makes security more valuable and more attractive
 But usually provides lower return than market before conversion because of the added benefit of the conversion
feature
d) When conversion exercised, new stock issued
 Don’t have to have authorized and holding, can just issue new
 But stock value will be diluted by new issue
e) Convertible Bonds
 Have set interest, although lower
 Priority in bankruptcy
 Yet have opportunity to buy stock when it increases
f) Warrants
g) Option to purchase stock
h) Lender could be given warrant
i) Lender takes lower interest rate for benefit of warrant
j) Warrant is detachable – can be sold separately
 Unlike a convertible security, don’t have to give up the bond or loan – to sell the warrant
 First in line for bankruptcy as bondholder, can keep interest income on your bond, AND can take capital
appreciation by selling your warrant when stock price goes up
2) Redemption and Call
a) Usually on bonds
b) Want the right to call a bond when interest rates decrease
 Can call bond
 But must pay Call Protection
 guarantee of a certain return
 assurance company will not redeem unless interest rate spread justifies paying spread
3) Tracking Stock
a) Stock interest in one aspect of the company’s business (divisions or subsidiaries)
 How do you value?
 Conflict of interest?
b) Large companies may have core businesses you don’t like, but have other side businesses you do like
c) Ok, we’ll sell you interest (tracking stock) in those businesses you like
E. Cases
1) Sinclair Oil v. Levien
a) INTRINSIC FAIRNESS TEST V. BUSINESS JUDGMENT RULE
 In transactions between parent and subsidiary, if there is no self-dealing the courts apply the Business
Judgment rule but if there is self-dealing, the courts apply the Intrinsic Fairness Test and shift the burden
on the Δ to prove the intrinsic fairness of the transaction to minority shareholders
b) Sinclair owns 97% of subsidiary Sinclair Venezuelan Oil Co (Sinven) and 3% publicly held.
c) Public shareholder of Sinven files derivative action requiring parent (Sinclair Oil Corp) to account for damages to
subsidiary
 Excessive dividends paid (in excess of retained earnings so from other earnings, almost like in liquidation)
 Denial of business opportunities
 Breach of K between another subsidiary
d) ISSUE: What standard to apply to transactions between controlling parent and subsidiary
e) RULE
 Depends on whether or not there is self-dealing
 Self-Dealing: When parent, by virtue of its domination of the subsidiary caused the subsidiary to act in a way that
the parent receives a benefit to the detriment and exclusion
 INTRINSIC FAIRNESS TEST – SELF-DEALING
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In self-dealing transactions between parent and its subsidiary burden is on Δ to prove intrinsic fairness to
minority shareholders
 BUSINESS JUDGMENT RULE TEST – NO SELF-DEALING
 If there is no self-dealing, the business judgment rule is applied, where courts defer to judgment of directors
f) HOLDING
 Dividends
 Not unfair because ALL shareholders benefited from excessive dividends
 Even though it could be deemed in essence a liquidation
 KEY HERE- A proportionate share of the money received was provided to the minority shareholders of
Sinven also. Sinclair received nothing from Sinven to the exclusion of its minority stockholders, as such these
dividends were not self-dealing.
 No self-dealing - Applied Business Judgment Rule
 Do not second guess management on dividends unless waste or spoilage
 Henry Ford – waste
 Denial of business opportunities
 Л did not prove Sinclair usurped business opportunities of Sinven
 Breach of K
 International (sub of Sinclair) breached Agreement with Sinven
 Violated payment and quantity terms
 Conflict of Interest
 Found self-dealing, because International benefited at expense of Sinven
 Applied Intrinsic Fairness Test
 MARKHAM: THROWING THEM A BONE
2) Zahn v. Transamerica
a) FACTS
 New majority stockholders of Class B voting stock in control of the corporation through managements scheme to
take advantage of increased value of tobacco inventory to the detriment of Class A stockholders. Instead of
allowing Class A to benefit from huge sale and later liquidation, they call and redeem the Class A stock and keep
the profit for themselves.
 Zahn, a Class A stockholder, claims that Transamerica called the Class A stock at $80 per share and thereafter
liquidated the company and kept the profits for itself. And that if the Class A stockholders had been allowed to
participate in the liquidation they would have received $240 per share.
b) RULES/ REASONING: Majority has the right to control but when it does it has a fiduciary duty to the minority as
much as to the corporation itself.
c) HOLDING
 USE OF CONTROL TO AVOID EQUITABLE DISTRIBUTION OF CORPORATE ASSETS
 Although the stock was callable, in so doing Transamerica acted not for the Axton-Fisher, but for its true principal,
Transamerica itself, at the expense of the other stockholders of Axton-Fisher.
 Had the call on the Class A stock been taken by disinterested directors and not followed by the liquidation it would
have been valid. But disinterested directors would have advised the Class A stockholders of the liquidation would
have afforded those stockholders the right to convert their stock to Class B stock to share in the benefits.
 But because of how this went down and because the directors of Axton-Fisher appointed by Transamerica were
solely instruments of Transamerica, acting in its own self-interest, such act is VOIDABLE IN EQUITY because of
a dereliction of fiduciary duty.
 It is obvious that the Class A stock was called only to thereafter liquidate the company for the benefit of
Transamerica.
3) Jones v. H.F. Ahmanson
a) Л’S ARGUMENT: S&L: United Savings and Loan Association ; Holding Co: United Financial Corporation of
America
b) Minority shareholder of S&L files this action against majority stockholders as United Financial and as officers and
directors of the S&L for
 BREACH OF FIDUCIARY DUTY by using their control of the Association for their own advantage to the
detriment of the Association.
 Did not offer minority stockholders the opportunity to participate in an initial exchange of shares in a
company they later successfully took public

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
II.
When they did offer minority stockholders the opportunity to participate in the exchane of shares in the now
public company, they did so on unfavorable terms that were not comparable to those offered to the majority
shareholders
 ANTI-TRUST RESTRAINT ON TRADE
c) Δ’S DEFENSE
 No fiduciary duty as shareholders to other shareholders
 What they do with their own shares is their own business
d) FACTS
 In order to take advantage in increased market price for s&l stocks, the s&L’s majority stockholders, owning 87%
of the stock of the S&L, deviced a scheme to profit from that increased market, but not by making the Association
shares more valuable or more marketable.
 Shares in s&L don’t trade because their price is too high - $1000s per share
 Instead of doing a stock split to make the S&L shares directly more attractive
 The majority shareholders form a new holding company; transfer shares to holding company 250 to 1. They did
not offer the share exchange to the minority stockholders of the S&L.
 The holding company then had a huge public offering, where the majority stockholders made Millions. Via this
schema they created a ready market for the Holding company shares but rendered the Association shares
unmarketable except to the Holding Company.
 They then further depleted the value of the S&L shares by reducing their dividend from $75-57 per share to $4 per
share. Only at this point did they offer to minority shareholders of the Association the opportunity to exchange
Association shares for Holding Shares, but on unfavorable terms and not on the same basis as that offered the
majority stockholders. ???
e) Holding: Reverses. Holds for Л. COURT REVERSES MOTION TO DISMISS P’S COMPLAINT.
f) Reasoning:
 FIDUCIARY DUTY.
 Majority shareholders may not use their power to control corporate activities to benefit themselves alone
or in a manner detrimental to the minority. Cannot serve two masters. Any use to which they put the
corporation must benefit the shareholders proportionally.
 RULE OF INHERENT FAIRNESS
 Good faith and inherent fairness to the minority is required in any transaction involving control of the
corporation by the majority shareholders (not just officers and directors)
 Transactions resulting by action or direction of majority shareholders must meet the fairness standards of an
arms-length transaction and failing that will be set aside in equity.
 The majority shareholders could have accomplished the same result by
 (a) effecting a stock split of the S&L to make its stock more marketable
 (b) offering shares to all shareholders in a holding company before offering shares to the public – the minority
would have a market to sell their shares if majority took control
g) MARKHAM does not believe there was a breach of a legal fiduciary duty but that court only found an inequity.
 Should have included Class A stockholders in first opportunity
 Should not have offered to purchase the stock
Premiums for Sale of Control Transactions
A. Theories
1) Varying approaches to sale of corporate control and the appropriate treatment of the resulting premium above market price
a) Premium for sale of controlling stock is corporate asset
 Rarely applied and highly criticized
 Premium for corporate power must be shared with other shareholders
 But see Perlman
b) Premium for sale of controlling stock is NOT a corporate asset
 That premium is part of the value of the stock and should belong to the majority stockholder (control of
management runs with stock, not part of corporate assets)
 Controlling stockholder may act in his own best interest in selling his stock, no fiduciary duty, absent fraud or
looting
B. Stockholder Right to Sell Stock
1) Shares of corporate stock are stockholders' property
2) They may sell them when and to whom they please
a) Controlling shareholder may sell his controlling interest at a premium price
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b) Premium is not a corporate opportunity that must be shared equally with other shareholders
3) No fiduciary duty to other shareholders in this respect.
C. The Rule on Premiums for Controlling Shares
There are three important exceptions to the rule that a minority shareholder may retain a premium received in the
sale of control shares. Those are:
i. sales to a looter
ii. Sales of a corporate office, and
iii. Sales of corporate assets.
1) Premium paid for controlling stock will belong to the selling shareholder
2) Exceptions to Allowing Shareholder to Retain Premium
a) Sales to looters - Subsequent Looting Gerdes v. Reynolds
 Fiduciary duty of majority as directors to minority stockholders to not allow an opportunity to loot the corporate
treasury by turning over control to new stockholders
 Especially if stock not fully paid for
 Or if assets to which stockholders have control have more value than money received
 Shareholders, officers and directors may jointly and severally liable for return of premium if their participation
was in a breach of fiduciary duty, even if they did not receive premium
 What level of knowledge is required? Various opinions
 Actual knowledge, knew or should have known
 Can assume integrity unless put on notice of lack of integrity
b) Sale of Management / Corporate Office Essex Universal
 Sale=Resignation of directorship and election of purchasers
 Usually must be accompanied by a sale of majority controlling stock or at least working control (i.e. in
public company, where majority is usually not 50%)
 Sale of minority stock cannot be accompanied by sale of corporate office
 Lionel / Roy Cohn – sale of 3% stock with resignation of 7 or 10 directors
 Cannot sell management control apart from actual stock control
c) Sale of Corporate Assets Perlman
 If what you are selling was not control but a corporate asset
 I.e. The right to decide to whom to sell its product in a time of shortage
 Is Buyer an interested customer for the corporation’s product who will usurp this product?
 Does the market create other corporate opportunities that are being denied because of such usurping of
corporate assets?
 Did seller of majority control receive a large profit for what results in a large corporate sacrifice?
 Denying corporate opportunity to corporation Perlman Thorpe
 Siphoning off for personal gain corporate advantages derived from a favorable market situation
 Denial or usurping of corporate opportunities by sale
 Corporate opportunities need not be a certainty
 Premium from sale of controlling stock during market shortage to a company that allows that company to
diverts corporate assets to its benefit denying other corporate opportunities
D. Cases
1) Zetlin v. Hanson
a) Controlling shareholder may sell his controlling interest at a premium price
b) Premium is not a corporate opportunity that must be shared equally with other shareholders
 Absent fraud or looting
2) Gerdes v, Reynolds
Can’t sell to looters.
 D’s had no actual knowledge of fraud, but they were fiduciaries and had a duty to find out if this
were a legitimate transaction.
a) Sale of control to looters or incompetents
b) Action by John Gerdes and individual shareholders and others to hold Δs accountable for assets of the company
allegedly wasted and improperly applied and to recover money illegally taken from the treasury of the corporation
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c) Majority Stockholders sold controlling shares in corporation at premium price ($2 for .06 shares) under
agreement that seller effect replacement of management with new purchaser
 Thereafter the purchaser’s proceeded to liquidate and loot the corporation to detriment of other
shareholders.
 Assets of corporation were liquid securities
d) On date of sale of majority of common stock of corporate investment trust, stock had an asset value of less than 6 cents
per share and that price of $2,110,000 paid for 1,055,000 shares of stock was so grossly in excess of value of stock that
it carried on its face a plain indication that price was paid not for stock alone but partly for immediate en masse
resignations of officers and directors and immediate election of purchasers' nominees as their successors
e) $1,318,750 of $2,110,000 paid for common stock of corporate investment trust was paid for resignations of officers
and directors and their election of purchasers' nominees as their successors, and officers and directors
f) RULES
 ALTHOUGH
 Shares of corporate stock are stockholders' property, and they may sell them when and to whom they please.
No fiduciary duty to other shareholders in this respect.
 evidence showed that none of the sellers of the stock had any knowledge that purchasers or any one acting for
them had any intention to loot the corporation or to pay any part of the purchase price out of corporation's own
assets
 EVIDENCE SHOWS
 Although none of the selling shareholders knew purchaser would loot the corporation, the overpayment for
stock and demand for control should have aroused suspicion.
 CANNOT RESIGN FOR MONEY – SELL CORPORATE OFFICE
 Overpayment clearly indicates officers and directors paid to resign and elect new directors in violation of their
fiduciary duty to trust and its creditors and other stockholders. Cannot be paid by others for your director or
officer action
 NATURE OF ASSETS
 Where assets are land and buildings, concern of looting not high
 But resignation and turn over of control of highly valuable convertible securities that exceed purchase price, a
purchase price not fully paid shareholders/directors have obligation to be more cautious
 IF PAID FOR RESIGNATIONS OR NEGLIGENTLY TURNED OVER CONTROL - LIABLE
 Evidence showed that $1,318,750 of $2,110,000 paid for common stock of corporate investment trust was
paid for resignations of officers and directors and their election of purchasers' nominees
 even though much of that sum never passed into or through their hands,
 Shareholders, officers and directors jointly and severally liable for return of premium because of
their participation in a breach of fiduciary duty
 Even without actual knowledge of fraud
 Gross excess of price should have raised suspicion
3) Essex Universal v. Yates
a) The agreement to transfer corporate offices to purchaser of majority stock is not illegal.
 Unless party claiming illegality of transfer of office in conjunction with sale meets the burden of proving the
new purchaser would not otherwise be able to obtain that control otherwise
b) FACTS
 Yates, majority stockholder, Ked to sell his 500-600K shares in Republic Pictures (a public corporation to Essex
Universal. K included agreement to resign 8 or 1 director positions and elect new purchaser to board. At closing,
Essex tendered 1.7M in payment of 37.5% of purchase price but then Yates gets greedy and chooses to not close
on sale.
 Essex files this action, claiming damages of $2.7M, the increase in the value of the stock since day of closing.
 Yates argues the K is illegal because of the provision requiring the immediate transfer of control of the
board because the stock represented only 28.3% of the total stock.
c) ISSUE:
 Can the purchaser of less than 50% majority stock legally require transfer of control of the board? In
public corporation, MAYBE
 Burden on seller to show the shares sold would have control of management
d) HOLDING:
 Trial court reverses summary judgment and holds that the trial court should regard the K as legal and proceed on
the merits of the case.
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
Court suggests that 28% of the stock of a public corporation may represent a majority, factual issue to be
determined on remand.
 But burden of proof will be on Yates to prove some foreseeable reason why Essex would not have obtained the
control of the board it required – other organized minority blocks, etc.
4) Perlman v. Feldman
a) In a time of a market shortage, where the power to allocate a corporation’s product commands an unusually
large premium, a fiduciary may not appropriate to himself the value of that premium
 Premium from sale of controlling stock during market shortage to a company that allows that company to diverts
corporate assets to its benefit
b) CANNOT APPROPRIATE PREMIUM FOR SALE OF A CORPORATE ASSET
 What you were selling was not control but a corporate asset – here being the right to decide to whom to sell
its product
c) FACTS
 Feldman turns down a merger offer that all shareholders could benefit from.
 Newport Steel is a mid-sized steel company trying to expand its market during the steel shortages of the Korean
war. Feldman is the chairman and controlling stockholder of Newport. Feldman sold his controlling interest in
Newport for $20 per share to a customer company, Wilport, who needed to secure a stable source of steel during
the shortage. This enabled Wilport to allocate more steel to itself by placing several people on Newport’s board.
The book value of the stock was $17 per share and the market value was $12 per share.
d) Procedural Posture:
 A derivative action brought by minority shareholders against Feldman for an accounting and restitution of the
profits that Feldman personally realized from the sale of his controlling interest. The trial judge found that the $20
per share price was fair and was not the sale of a corporate asset.
e) Issue: Whether the sale of control under these facts was the sale of a corporate asset which would entitle the
corporation to the profit realized by Feldman. YES
f) Reasoning: CANNOT APPROPRIATE PREMIUM FOR SALE OF A CORPORATE ASSET
 What you were selling was not control but a corporate asset – here being the right to decide to whom to sell
its product
 A fiduciary has the responsibility to dedicate his uncorrupted business judgment for the sole benefit of the
corporation in any dealings which may adversely affect it.
 The possibility that the corporation would have benefited is all that is required, not a showing of absolute
certainty.
 Feldman’s actions prevented the corporation from obtaining interest-free advances from prospective
purchasers, to expand production building up its customer base.
 The Feldman Plan
g) SHIFT OF BURDEN:
 The Δ must show that there was no possibility of any gain by the corporation and he has not met that burden of
proof.
-CASE NOTES-Whether plainitffs are entitled to a share of the premium? Yes, Feldmand was not just a shareholder but also a
controlling member-Court acknowledged it was not a large breach of the fiduciary duty- higher than normally would be held, because the
court noted
-Shortage of steel and defendant took advantage of the market-fiduciaries also had a duty of fairness
-Exceptions 1) can’t sell to looter, 2) can’t sell corporate office, and 3) can’t sell corporate asset
-Government set controls of prices for steel at the time due to the Korean War, could sell all the steel they could produce at the
government set price
-President owned the controlling interest and sold that controlling interest to another person or president
-Court asked what was the premium for? Court held he was selling the right to control where the steel went to and the court held it was a
corporate asset and it was not his to sell!
-Fact that corporation could not take advantage of the sale was not a defense
-Court says in the unique circumstances it was improper for him to sell the steel at the premium
5) Thorpe v. Cerbco XPP
a) Company wants to buy a profitable subsidiary of Cerbco through purchase of Majority Shareholder’s B shares. Public
owns A shares. Cerbco forms a special committee of independent directors but they act as controlling shareholder
desires.
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b) Shareholder brought derivative action against controlling shareholders who were also directors of corporation, alleging
that controlling shareholders usurped corporate opportunity by not informing corporation of another
corporation's interest in purchasing corporation's subsidiary.
 Court says should have brought corporate opportunity to Cerbco board to approve and they did not.
 OPPORTUNITY FOR CERBCO TO SELL SUB- NOT CONTROLLING SHAREHOLDER
c) PH: Court held that controlling shareholders usurped corporate opportunity, but that corporation sustained no damage.
Shareholder appealed.
d) HOLDING: The Supreme Court of Delaware held that:
 (1) controlling shareholders usurped corporate opportunity and breached their duty of loyalty to
corporation
 (2) corporation could not recover transactional damages for controlling shareholders' breach of duty of loyalty
 Corporation could not have sold subsidiary even if controlling shareholders had not usurped opportunity,
since controlling shareholders had power to veto sale under statute which requires vote of holders of majority
of corporation's stock to approve sale of substantially all of corporation's assets.
 (3) BUT controlling shareholders were liable to corporation for expenses corporation incurred in connection with
negotiations for controlling shareholders' proposed sale of their interest in corporation to other corporation.
 Affirmed in part, reversed in part, and remanded.
e) RULES
 BOARD DISCLOSURE OF CORPORATE OPPORTUNITY
 Disclosure to and informed approval by board of directors may insulate director from liability where corporate
opportunity doctrine otherwise applies
 Director who opts not to inform board of corporate opportunity acts at his peril unless he is ultimately able to
demonstrate post hoc that corporation was not deprived of opportunity in which it had interest in or capability
of engaging.
 SALE OF ALL ASSETS REQUIRES SHAREHOLDER APPROVAL.
 Potential sale of corporation's stock in its subsidiary would have constituted sale of "substantially all of
corporation's assets" and, thus, controlling shareholders would have had right to block potential sale under
statute which requires vote of holders of majority of corporation's stock to approve sale of substantially all of
corporation's assets
 Where corporation's stock in subsidiary accounted for 68% of corporation's assets and subsidiary was
corporation's primary income generating asset
-CASE NOTES- Markham’s Client Again
-Erickson’s had a duty of loyalty in their directors capacities
-Erickson’s owned control of the voting stock of Cerbco-bought a company called insitufor???- company who lines the sewer pipes
before construction of the buildings above
-Had an offering to the sharehodlers A for voting, B for non-voting with dividends, and the public took the non-voting with dividends
-Erickson’s had control of Cerbco and Cerbo had control of Insituform
-Instead the company made an offer of the Erickson’s for control of the stock in Cerbco and therefore insitufor
-Shareholders said wait a minute you are selling a corporate asset and you should not be able to do that
-Court looked at the issue- held breach of fiduciary duty here, because Erickson’s gave to the bidder confidential information of
Insituform and that was the breach of fiduciary duty
-Court noted Erickson’s had control of Cerbco, and if this issue was submitted to a vote the Erickson’s would have prevailed, and under
DE law they don’t even need the meeting because they had controlling stock
-The way they went about it was wrong
-Court really does not want to broaden Pearlman v. Feldman-Cannot do something in you capacity that would breach your fiduciary duty
as a shareholder such as supplying confidential information
-A) we can sell control, excpetions 1) no looters, 2) no corporate asset, and 3) don’t give away confidential information of company
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33 Act
the Securities Act, the Truth in Securities Act, the Federal Securities Act
-purpose: Prohibits Fraud, provides for lawsuits, regulations on what the company can do during the offering process, cannot take orders
The Securities Act of 1933 required that investors receive financial information from securities being offered for public sale. ... The other main point of the
Securities Act of 1933 was to prohibit deceit and misrepresentations. The act aimed to eliminate fraud that happens during the sales of securities.
established as a result of the stock market crash of 1929. The legislation had two main goals: to ensure more transparency in financial statements so investors
can make informed decisions about investments; and to establish laws against misrepresentation and fraudulent activities in the securities markets.
the first major legislation regarding the sale of securities. Prior to this legislation, the sales of securities were primarily governed by state laws. The legislation
addressed the need for better disclosure by requiring companies to register with the Securities and Exchange Commission. Registration ensures companies
provide the SEC and potential investors with all relevant information by means of the prospectus and registration statement
the 3 3 Act's registration requirements only apply to a corporation’s issuance
of stock to the public "public offering.”
-1933-first of federal securities, applies to initial offerings to the public
-Require you to make a filing, registration statement, cannot sell to public until registration declared effective under SEC
-Must disclose every verifiable fact of the company, accounts,
-After that stock will be traded in the public market
33 Act and its exemptions from its registration requirements
Before attempting to understand the registration requirements, understand that the exemptions are so
pervasive that comparatively few issuances of stock are subject to the 3 3 Act's registration requirements
In essence, registration is required only for public offerings and most stock issuances are not public
offerings and so are exempt from the 3 3 Act's registration requirements
Again, most corporations' issuances of stock
come within the 3 3 Act's exemptions from these registration requirements. The most im»
portant factors in determining whether a corporation’s issuance of stock is exempt from
the 33 Act’s registration requirements are (1) the number of people to whom the stock is
being offered and (2) whether the issuer uses general advertising or otherwise engages in
mass solicitation of offers
These registration requirements are in essence disclosure requirements. The 3 3
Act contemplates that a corporation issuing securities in a public offering will first file a
detailed and extensive “registration statement" with the SEC. Then, the SEC reviews the
adequacy of the information provided in the registration statement. Typically, the SEC will
request changes.
After the issuing corporation has changed the registration statement as requested by
the SEC, the issuing corporation provides a copy of the main part of the registration statement called the "prospectus" to all people to whom the corporation offers the securities.
Offering stock to the public requires this extensive and expensive disclosure process.
The Securities Act of 1933 is governed by the Securities and Exchange Commission, which was created a
year later by the Securities Act of 1934.
Several amendments to the Securities Act of 1933 have passed since its creation.
-File updated financial reports every quarter on form 10-Q, annually 10-K, proxy statements, and special statements such special events
occur in between the quarter forms
-Clients think there is a pot of gold in going public
-Problem is it has only begun severe costs with going public-serious financial reports in time and expense process to be able to handle the
costs of going public
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Public Companies
-Ones owned by public shareholders-generally unsophisticated and not wealthy
-SEC laws- and exemptions
-Talking about NYSE companies, NASDAQ
-Subject to SEC laws, and regulate every aspect of the operations
-Highly Cautious Here-clients want to raise money from all areas, and cause registration problems
1933 act
-1933-first of federal securities, applies to initial offerings to the public
-Require you to make a filing, registration statement, cannot sell to public until registration declared effective under SEC
-Must disclose every verifiable fact of the company, accounts,
-Prohibits Fraud provides for lawsuits, regulations on what the company can do during the offering process, cannot take orders,
-Once sold or go public 33 act is done
-After that stock will be traded in the public market
1934 act
-1934 takes over, governs the trading of the stock in the secondary market, imposes all kinds of regulation, all aspects of the secondary
market-created SEC Commission-independent federal agency run by 5 commissioners appointed by the President with the advice and
consent of the President, no more than 3 from either party supposed to be bipartisan
-Staff is in charge commissioners do not really do anything, and the people who serve only do public aspects
-SEC staff is divided into various divisions-staff is the most crucial because they are the people still there for the commission
-SEC jurisdiction has been expanded
1934 ACT picks up where the 33 act left off
-File updated financial reports every quarter on form 10-Q, annually 10-K, proxy statements, and special statements such special events
occur in between the quarter forms
-Clients think there is a pot of gold in going public
-Problem is it has only begun severe costs with going public-serious financial reports in time and expense process to be able to handle the
costs of going public
-Investment Company ACT of 1940-most complex statute devised by anyone every
-Govern every aspect of the mutual funds
-Investment ACT of 1940-advising more than 15 people subject to registration under the ACT
-Legislation was passed in 1930s after the crash of 1929
-Previously no securities markets in the United States,
-Buttonwood agreement-became the basis for the NYSE some years later, also one in Philadelphia-Traded in rotation or call market, twice daily the president of the exchange would call off the names of the stock- and they could buy or
sell, not all stocks were listed on the NYSE and some traders did not want to trade or were not allowed to trade on the NYSE
-Curb Market-traders standing on the curb- just buying and selling with each other outside-NYSE still supreme done on Rotation-Not a big affair until the civil war-change trading in stocks and commodities significantly
-NYSE emerged as the primary exchange now called the over the counter market-Gradually the call or rotation system broke down because of the changes in the flow and speed of information-Certain traders became specialists in particular stocks-this made the stocks more liquid
-Liquidity is everything in the stock market-Meaning the ability to get cash for a stock-Key feature of any market is the spread-at any given time in a liquid market people are buying and selling, always try to buy low sell
high
-Costs of liquidity is the reason the specialists will always by and sell the stock because he always makes money on the transactions,
narrow spread tells us the market is liquid
-Pretty soon specialists would handle every stock- buy or sell based on the specialists spread, and gradually got down to oone person per
stock to be the specialists
-Specialists would keep a book of liquid orders-meaning I want to buy an 11 stock is selling at 12 and I say leave the order there till it
goes down to 11 and then you can execute my order
-Major Stock Early on was in the railroads because they required such a high degree of capital to complete the projects
-Investment Bankers then appeared
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-Professional bankers and brokers who went in and tried to regularize these corporate finances so they would be real business-not so
fraudulent
-Back then no state or Federal regulation, other than the issuance of charters, NOT STOCK
-SEC did not exists
-1907 Stock Market Panic-JP Morgan and private bankers stepped in and saved the panic over 25 million dollars
-Federal Reserve Board was supposed to prevent those things from happening in the future
-“MONEY TRUSTS”- there was a money trust, JP Morgan and a small group of bankers controlled all the major corporations of
America with interlocking corporate directors
-Still no federal regulation of stock trades
-1911-states created statutes for stock controlled within their borders of the state-varied and no real power
-1914 WWI-huge stock exchange interest in people
-1920s speculation became rampant-1928 shooting upward, everybody who had a nickel was investing in the stock market and buying on
“margin”-IBM selling for $10, I only have $2, broker would buy the stock for you, and the broker would use the loan to leverage the
holding against the person originally buying the stock
-NY banks would normally loan the stock brokers in the money, and the country banks would get it from the NY banks, all with interests
rates and everybody making out of the transaction
-Fall Harvest Time- we need all the money back so
we can Harvest-All Stock Market Crashes Occur in
October
-Another problem, if the stock drops in value- the broker would ask for more money called a margin call to cover the diminishment of
the stock-problem was nobody had any- sell the stock the prices goes down- cascade effect for everybody involved
-As long as the stock market went up don’t have to worry about it, 1928 it was going WAY UP
-Government got worried about the stock market having a bubble effect- debate for years what actually caused the
market to crash????
-We will never know
-Market Crashed though and United States had a great depression
-Over the long run, if you compare all asset classes-the perform better and return the most are STOCKS
-In the Long Run we are all going to be dead, 1929 high till 1954 is a long run of bad stocks
-Government Regulationpeople involved 1) specialists, 2) floor brokers, and 3) floor traders- individuals on the floor who were trading for their own account
-SEC said we don’t like people trading on their own account-you can react more quickly than anybody else outside the
exchange, meaning the other passive stock holders
-SEC said floor traders are OUTTA here-SEC said specialists are different in providing the benefit of liquidity in the market-Obligations you must maintain a continuous two sided market to be fair and orderly-when the market is going down you must
buy, and when the market is going down you must sell to stabilize the market and that is the price you pay for being able to stay
on the floor and receive that spread, and the time and place advantage of being on the floor
Over the Counter Market were the ones NOT listed on the NYSE
-something called the pink sheets-list all the brokers and all of the stock in the over counter market that was being traded and the brokers
that could buy and sell the stock for you
-Over the Counter Brokers did not have any continuous obligation like the floor specialists
-Pretty much an inefficient market
-Fairly inefficient until the computer came along
-SEC also concerned with short sales-Means you are selling something you do not own
-Day 1 I sell the stock, I don’t have to deliver the stock for 5 days, so what I could do was sell the stock and not own it because I don’t
have to deliver it for 5 days
-5 days later the price might have went up or down, and I could but the stock at the lower price
-Problem is not owning the stock- the broker would allow you to borrow the stock, and the borrowing fee was less than what was paid to
the person in the amount the stock was actually worth because you only borrowed
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-Short sale is a covered short-but the concern was the naked short-meaning I never borrowed a stock and the stock went up in price I
would not pay, and if the price went down I would collect
-SEC did not like short sales-Called tick—test to combat that-meaning you cannot sell short unless there is an uptick-to make sure the
person would make money on the stock
-Idea was we are not going to let you keep selling short to push the market down-we did not want brokers to force the short sales with the
prices going down
-Over the Counter Market-1960s- computer was coming on to the scene
-Pink Sheets were then computerized-created an electronic market which is Now NASDAQ
-Substitute for the Pink Sheets- you could see who the brokers were and the prices they were quoting- competitive market, “market
makers” who were like floor specialists but they actually competed against each other,
-NASDAQ market- has all competing market makers-had what we call national best bidder offer-SEC said you have to make a
continuous market meaning you just had to buy and sell according to the market
-Market developed a small order execution system
-Somebody figured out, these brokers are busy-let’s watch the particular stock and if the change in the stock is there we want to get the
orders in before the Market Markers will change the quote of the stock
-Market Markers responded by not paying out, widened the bids to have a bigger profit, and the margins would not be so big on the slight
change in the stock
-Block Traders-Specialists can take control of the orders that are so large, specialists were not allowed to intervene and make a
commission on each transaction for the particular sale of stock
-Then SEC said we are going to do away with fixed commissions of the specialists-huge blow to wall street, but
-Large Brokerage firms told the small firms-we will charge you the same commissions you were paying before, and the small firms were
then
-Created a smaller discount investor trader-with no advice allowed to charged a smaller commission
-Discount brokers v. Full-Service Brokers
-Institutions started saying you know we don’t understand why we are going through the NYSE
-Instutions a big enough to trade amongst ourselves
-Wanted to eliminate the specialists, led to the electronic trading systems, the orders are matched with people who want to buy and sell
-Pretty soon volume started going into the electronic execution systems
10/12/11
CHAPTER 12 PUBLICLY TRADED STOCKS – SEC REGULATION
II. Overview of Federal Securities Laws
A. Federal Laws (created laws about stocks)
1) Securities Act of 1933 (the first of these)
a) Regulates PUBLIC OFFERINGS of securities (ONLY regulates the initial issuance of stock to the public)
 Contents of Prospectus and Registration Statement
 Registration Statement requires financial information and all material matters (to keep public informed)
 Financial Statements
 Officers and Directors
b) Prohibits offers and sales of securities not registered with SEC
c) PURPOSE: To bring FULL DISCLOSURE to securities sales as a way of exposing and deterring abuses
2) Securities Exchange Act of 1934 (congress said we need something more than 1933 act)
a) Regulates trading in securities already issued to public
 Takeover bids, tender offers, treasury share purchases
 Restricts insider trading of their own company stock for short-term profits
b) Regulates Broker-Dealers
c) Requires periodic REPORTING
d) Applies to stocks after IPO
e) PURPOSE/ GOAL
 To protect individual investors engaged in stock transactions
 To assure broad public confidence in the integrity of the stock market
 Level playing field – FULL DISCLOSURE
3) Trust Indenture Act of 1939
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a)
b)
c)
d)
Regulates public issue of DEBT SECURITIES OVER $1M (corporate bonds)
Establishes duties of trustees (bank that collects P+I from companies and then forward to bondholders)
Fairly
Trust Indentures: Master Agreements that govern the terms and conditions of general obligation corporate bonds
(debentures) that are offered to the public under the Securities Act
4) Investment Company Act of 1940 (most complex statute ever written by mankind”) prof
a) Grants SEC regulatory authority over investment companies (including mutual funds)
 Regulates management, capital structure and changes in investment policy
 “The most intrusive financial legislation known to man”
b) Mutual Funds: Investment of a pool of money from multiple investors like you in various securities
 Continuously offering its shares to the public
 Has professional advisors who decide which stocks to invest in
 Mutual funds vary by multiple strategies - Could be diversified, could be in stocks rather than bonds, etc.
 Close out at the end of the day
c) OTHERS
 Closed-In Corporation
 Will not redeem your funds – have to sell your stock
 ETFs – Exchange Traded Funds
 Can close out any time (unlike mutual funds whichbclose at end of the day)
5) Investment Advisers Act of 1940 (regulates anybody providing advice)
a) Requires the registration and regulation of investment advisers (after SEC study found abuses)
 Prohibits fraud by investment advisors
 Registration and disclosure requirements
 Otherwise self-regulating
 Restricts profit-based performance fees for investment advisors
 Heads I win – Tails you lose
B. Securities and Exchange Commission
1) DEFINITION:
a) Independent federal agency responsible for enforcement and administration of federal securities laws
b) 5-members appt for 5-yr staggered terms
 Chairman Christopher Cox – Former Majority Leader of the U.S. House of Reps
c) Appointed by President and approved by Senate
d) Not more than 3 from same political party
e) PURPOSE: To restore investor confidence in capital markets after 1930s crash and run on banks
by providing structure and government oversight
 Disclosure on public sales
 Brokers and dealers must treat investors fairly
2) Structure and Divisions
a) See CHART
b) Broad powers
c) Can issue subpoenas
d) Can fine
e) Can bar an individual from acting as officer or director (Martha Stewart
f) Have their own
3) NASD National Association of Securities Dealers
a) Under supervision of SEC
Class Notes Starting 10/17/11
-First point of Markham’s lecture
-Underwriting the IPO
-Securities bought from the issuer of the securities and then resold to the public
-Not anti-competitive, the underwriters were legal in selling the securities to the public
-Then went immediately into the Billing case on page 618
III. Underwriting the IPO (Initial Public Offering)
A. History of Investment Banking - US v. Morgan
1) First Investment Banking Firms
176
a)
b)
c)
d)
Goldman Sachs
Lehman Brothers
Started buying company’s short-term promissory notes they later sold to bank and other investors
Had novel idea to incorporate private businesses and sell stock to raise capital
 United Cigar Manufacturers, Sears Roebuck, BF Goodrich, Woolworth
2) The Traditional IPO – Investment Bank Process
a) Originating Banker / House of Issue Investment Banker purchased entire issue from Company
b) Syndicates formed to pool underwriting resources for larger and larger corporate issues
 Originating Banker >> Purchase Syndicate >>> Banking Syndicate >>> Selling Syndicate
c) Selling Syndicates >>> Public
 Unlimited or Limited Liability to prior syndicate or corporation ?
 Liable or not liable for unsold shares
 Members are principals of managers in distributing securities to the public
 Purchase Price and Stabilizing
 Syndicate Agreement set sale price
 Manager traded in market to stabilize sale price
 Repurchase penalties on new issue if manager had to re-buy security (serial #s)
d) Banks could be deposit banks AND investment banks
 Private banking houses had not duty to disclose like national banks
 Era of mystery
e) Abuses led to Federal Securities Regulations
 Banking Act / Securities Act required banks to choose between being deposit bank or investment bank, could not
be both
 Caused the withdrawal from investment banking of capital funds of the commercial banks
 Adopted Justice Brandeis theory:
3) The Modern IPO – Investment Bank Process
a) Agreements
 Underwriting Agreement (Issuer and Manager)
 Between Issuer (Corporation) and Manager representing underwriters
 Manager negotiates with issues and supervises underwriting and distribution process
 Underwriters Agreements (among Underwriters)
b) Full Services of Investment Banker
 Design and set-up of issue
 Timing critical (most important service of top investment banker)
 Organization of group to underwriter risk
 Selection and participation of underwriters
 Issuer has final say on underwriters
 List of dealers for selling group
 Preparation of Prospectus and Registration Statement
 Work with executive and financial advisers of Issuer
 Study the business
 Plan of distribution
 Road show
 Pricing of Issue
 Often a problem area between Issuer and Investment Banker
 Offering Price, spread and price paid to Issuer
 Spread must cover compensation of all participants
 Spread higher with stock and lower with bonds (tied to risk)
c) Trends
 Spreads smaller
 Decrease in use of Selling Syndicates
 Maximum life of syndicates shorter (15-30 days)
 Price restrictions removed earlier
 Private placement grew – to avoid SEC regulations
 Variations in use of full-services of Investment Banker
 Issuer negotiates for services of investment banker
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 Very competitive
4) Underwriter Agreements
a) Firm Commitments: Underwriter agrees that Issuer will receive fixed amount on a fixed date for its issue
 Removes uncertainty to issuer
 Transfers risk of unsold issue to underwriter
5) Stabilization and Manipulation of Stock – Billing v. Credit Suisse
a) CASE ALLEGATIONS
 Underwriters entered into illegal Ks with purchasers in IPS whereby they manipulate and grossly inflate price after
IPO in the aftermarket.
 Firms capitalized at inflated prices at expense of investing public
b) HOLDING
 Securities laws do not preclude anti-trust claims
 Lower court reversed
c) THE IPO PROCESS
 Syndicates
 Emerged to manage risk inherent in underwriting
 Buying Syndicates bought entire new issue from Issuer at fixed price and reoffered to public at increased
offering or issue price
 Sold to public by both underwriters and Selling Groups
 IPO Book-Building Process / Road Show
 Begins with filing Registration Statement with estimated price range
 Underwriter then conducts road show to market the offering to potential investors
 Allows underwriters to collect information on interest in IP and potential investor’s view on value of
proposed security
 Based on this information, issuer and underwriters will agree on the size and pricing of the offering
d) MANIPULATION OF STOCK
 IPO / Book-Building Process can become a locus of price manipulation by syndicate members
 IPO
 Incentive to manipulate IPO process to facilitate sale of all stock in issue
 Underwriters associated with successful IPOs attract future issuers
 Direct interest and risk in firm commitments
 IPO-Aftermarket
 Same incentives as during IPO
 Control over allocation of securities
 If HOT ISSUE – those receiving preferred allocations can make quick-profits
 Not all Underwriter Manipulations Prohibited
 Certain manipulations are STABILIZING and permitted
 Limited to those attempts to maintaining price levels or avoid declines
 Must be restricted to minimize manipulative impact
 STABLIZATION: placing of any bide or the effecting of any purchase for the purpose or preventing or
retarding a decline in the open market price
 Prohibited Manipulations of Stocks
 Tie-In Agreements Prohibited: Req’s consideration in addition to stated IPO offering price in order to
obtain allocation of offered shares
 Quid-Pro-Quo arrangements
 We will give you HOT ISSUE but you have to also buy cold offerings
 Pre-Selling the Aftermarket Must also buy after-market stock in IPO
 Laddering
 FRAUDULENT and MANIPULATIVE
-CASE NOTES FOR THE BILLING CASE ON PAGE 618 starting
-Court found securities law does not preclude all anti-trust claims
-Issuers come to the underwriters and we have to register with the SEC prior to doing anything
-Prior to filing with SEC you are not supposed to be talking about what the IPO will be
-During that period with the SEC considering with the IPO is ok, in the middle you are allowed to do certain things
-Preliminary prospective to be sent out to a few investors, we want to limit a lot of other writings
-People can call and say we have something pending before the SEC and ask would you be interested and how muc, allows them to presell the market?
178
-Road Shows: Large investors about the company and pre-sell the issue before it becomes public, once it is declared effective by the
SEC then you can buy orders
-All of this is very delicate
-Hot or cold issue: offering price may be under or over the demand for the stock, if we underprice the stock it could go up very rapidly
we can resell it and make a nice profit
-Hot offering is a very valuable product, all depends on the best customers with the most amount of money to spend, the CEOs can buy
large amounts of stock make a quick profit and then the broker gets the business of the CEO and the company on future ventures
-Cold Issue: price of the stock is usually overvalued or the stock will not sell because of lack of interest in the company or product
-Brokers play the game between cold and hot because people only want hot, but the brokers need to sell both, so they often require
people to buy some cold issues in order to get the business with the hot issues
-All of these practices are on the line between legal and illegal
-Brokers can Stabilize the market buying some of these things, in order to make sure the market does not go down
-“Seasoned” Company-shelf-registration, SEC we do not need to sell stock right now, but we might need to sell some stock later without
going through the registration statement
-SEC says fine you can do that because you are putting out periodic financial information, so we will not require you to give us all that
paperwork with the initial registration, ability to pull the stock off the shelf and just start selling it
-Mortgage back securities-bottom of the financial crisis
-MBS: simply like a mutual fund, going to buy a bunch of mortgages maybe thousands, and put a bunch of them into a pool, and then we
sell the interest in the pool, so we can buy a MBS and that will give an interest in pool
-As an investor I own the mortgage-means the mortgage will continue to pay mortgage every month and the payments will go into the
pool and the payments will be distributed to the investors in the pool accordingly every month, as the people pay off mortgage the
investment will disappear
-Problem back in the 1930s small banks and small communities only lending to local banks-small banks had to hold on to the mortgages
until they were paid off
-This created the MBS to allow more liquid market for the mortgages
-We had to do a lot between then, 30 year mortgages, all the same terms and obligations, roughly the same interest rates for regions of
the country and time
-Still problem-what if the folks default?-Government said, Government will guarantee the mortgages-we will take away that concern and
that will allow people to buy into these MBS pools
-Fannie Mae, Freddy Mac-both turned into private enterprises but they are government there, Jennie Mae-100%governement
-Implicit guarantee that the mortgages were guaranteed by the government
-People loved these for the retirement portfolio
-Problems:
-1. Jenny Mae- said we will guarantee these things-EXPLICIT, very popular,
-30 year mortgages-but not everybody keeps the mortgage for 30 years people move and buy houses, and other people might re-finance
their mortgages for whatever reason, half life of the mortgage for 12 years, roughly 9% return on the investment
-Problem was that the interest rates went lower, and the money that they re-finance with will go back into the pool, and the investors are
getting their money back but at the lower interest rates of previously 9% now roughly 6% of the mortgage rate, cuts the return
-Problem was the re-financing risk-Wall street says ok, we will divide you up in trenches, the lower people will take the risk of the
buyers not re-financing in order to have the money still coming in, and the others will basically buy more protection for the same trickle
of money on the investment
-Further problem-What happens when the interest rates go UP?- because the interests rates have increased, the model of the half life then
becomes 15 years because people will no longer re-finance at the higher interest rates
-1994 Government jacked rates up, this problem went the other way
-Government solution-we want to factor into the pool the amount of people that might default in order to make the investment more
sound
-SUB-Prime Mortgages: either someone who has bad credit, someone who has no credit, or someone who has credit but can’t afford to
borrow any more money
-Way to deal with the risk securitize the SUB-Prime
-Put all the Sub-Primes into the pool, and enough that they will cover the projected defaults, the people who are in the lower trenches
again will take the risk of the default but be entitled to the highest return
-Hedge-Fund people still took it for the higher risk and the greater return
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-So safe at the top of the trench though that it received AAA rating and AIG even said they are so safe we will insure those AAA subprime mortgages at the top of the trenches
-SUB-Prime Mortgage Crises happens-No longer triple AAA rated, price of those bonds dropped from 100 cents on the dollar to roughly
21 cents on the dollar
-400 Billion total across the country on this, stocks plunged, and the MBS was to blame for it all
-Little flaw in the crisis-at the end of the first quarter 2009 17% of Sub-Prime Mortgages were going to default, we had already modeled
in about 4% default from the start, 13% difference
-When the mortgage defaults there is collateral behind it, Schiller Housing Index something around 20% meaning the value of the house
was going to deline 20%, very low down payments on the house, going to roughly recover 80% of the 13% remaining
-Markham was saying if we forclosed on these and recovered all the collateral on the houses we would have had a roughly 94% return on
the housing markets
-WHY? Something about how the SEC told them they had to put the houses on their books and they declared it all at once, meaning the
stock just plummeted and that effected the market so much more in the long term.
-
-Page 625 NASDAQ-Competing Market Markers
-Market Makers were not quite as agile from the specialist on the NYSE, if you have knowledge and you can move fast, you may be able
to move faster than the market maker and make a profit before he has an opportunity to change the market spread
-NASDAQ marker makers resorted to self-help, the market makers would trade amongst themselves to make sure than nobody got hurt
really bad by people moving faster than the market-makers
-The market-makers also widened out the spread, meaning the profits would only come when the market was really moving and by that
time the marker makers could shift their bids
-Market-Makers were colluding with one another, NASDAQ was reprimanded forced to change the system, and paid extensive amounts
to put in monitoring controls
-System is like a shotgun-(“SEC”)- wanted the NASDAQ to police their own members, and only bring in the shotgun when necessary
-FINRA-enforce all SEC rules and their own rules-Silver v. NYSE (SCTOUS, 1963)-page 634
-Issue: whether the NYSE is to be held liable to a nonmember broker-dealer under the anti-trust laws or regarded as impliedly immune
therefrom when, pursuant to the rules of the Exchange has adopted under the SEC Act of 1934?
-The crux was that it members removed private direct telephone wire connections previously in operation between their offices and those
of non-members notice, assigning him any reason for the action, or affording him an opportunity to be heard.
-MARKHAM NOTES
-NYSE is an anti-trust of manipulation of the stocks when it gets down to it, Congress said the thing is too valuable, the exhcnage act
must work to provide for the self-policing of the NYSE, we are going to find an implicit repeal of the anti-trust laws to make sure the
NYSE works
-Seems to be that the courts focus on whether the SEC is regulating the area in question to a certain extent and not proper for the courts
-Liquidity is critical-you will be stuck with the stock if you cannot sell it
IV. AFTER THE IPO – MARKETS
A. Markets Generally
1) Purpose: Creates two-sided market and creates a liquidity market
2) Types of Markets
a) NYSE
 Not a Dealer Market ; Specialists
 Emerged as the preferred exchange for large corporations
b) NASDAQ - OTC (over the counter)
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
Dealer Market: Competing Market-Makers
 Broker-dealers competing for your order
 Must create market by quoting both bid price and ask price
 Electronic interdealer quotation system
 Owned and operated by NASD
c) ECN Electronic Communication Networks
 Electronic trading system that matches orders - buyers and sellers
 Not exchanges regulated by SEC
d) Options Market (Chicago Options Market)
 Market for sale of options on stock
 If it goes to 20$, I have the right to buy at $10
 You pay a premium to purchase that option/right
 Right will exist for a certain amount of time
 “Call” in the case of a put option
 “Sell” in the case of ???? option
 Value varies by volatility of the stock
e) Derivatives Market
3) Broker-Dealers
a) Underwriters in pre-IPO and IPO
b) Broker-dealer in the aftermarket
 Broker – Buys or sells for you as agent
 Makes commission on the sale
 Dealer – Buys or sells stock to you it has purchased for its own account
 Chares mark-up ; Nasdaq limits to less than 5% of transaction price
c) Registered with SEC
 Cannot recommend stocks not suitable to you
 Books and record keeping requirements
B. NYSE
1) Not a Dealer Market ; Specialists
a) No competition but Duty to Maintain Market for that Stock
b) Almost a license to print money
 Book of limit orders, can react before anyone else can
 Can buy and sell stock with profit
 Makes money on the spread, buying first on good news
c) In order for you to maintain this monopoly you must maintain a fair and orderly market
 Must be willing to buy and sell
 Affirmative obligation to buyer
 __________ obligation to sell
2) Emerged as the preferred exchange for large corporations
C. NASDAQ – OTC (over the counter) (call around on the phone to people to buy stocks)
1) Dealer Market: Competing Market-Makers
a) Broker-dealers competing for your order
b) Trade via broker-dealers
c) Must create market by quoting both bid price and ask price
 Inside bid – Highest buy price
 Inside ask – Lowest sell price
 Spread: Difference between inside bid and inside ask
 More liquid or competitive the stock – the narrower the spread
d) REGULATIONS PROHIBIT
 Arrangements with other dealers to create false or misleading prices
 Coordinate entry of bid and/or ask quotations by market makers – artificial pricing
 Failing to provide the best execution of customer orders
 Firm Quote Rule: Market maker is required to execute any order presented to it at a price at least as
favorable to buyer or seller as the market maker’s published bid or offer
 Favoring market maker’s own interest over interests of customers
 Delaying reporting of significant trades
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2) Electronic inter-dealer quotation system
a) Owned and operated by NASD
D. ECN Electronic Communication Networks
1) Electronic trading system that matches orders - buyers and sellers -through electronic trading platforms
2) Not exchanges regulated by SEC
3) NYSE merged with Archipelago and went public
4) Nasdaq bought ___________
-CLASS NOTES FROM MARKHAM 10/17/11
-ECN said we look at the volume of the markets and the institutions are the ones doing the great bulk of the trading, and they want to
have their own big market
-ECN networks developed to match orders all automatically-didn’t have to worry about market-markers or floor specialists
-Traders liked this because they did not have to pay others the commissions, and very efficient in electronically matching and the speed
of trading
-Huge Debate right now of good or bad thing?
-Speed is everything, placing there servers right next to the exchange to execute the orders in nano-seconds faster
E. No More Fixed Commissions – Discount Dealers Emerge
1) Prohibition of fixed commissions created market for Discount Dealers
2) Discount dealers offer no advice – only an execution tool
3) NYSE abandoned rule that no member cannot trade stock except through the exchange
F. Self-Regulation
1) SEC keeps shotgun behind the door in case
a) SEC and NASD set policy
b) Exchanges also set policies for their members
c) NYSE; Nasdaq
2) Enforcement / Supervisory Requirement
a) Broker/Dealer level – lowest level
b) NASD or NYSE
c) SEC
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Where to put?
Section 6: Derivatives Trading
Intro: Derivative markets indirectly supplies liquidity and risk protection to the securities
markets.
1. United States and Investments Regulation Handbook:
a. Concepts:
- Spot transactions (cash/actual) – go into a firm and buy a commodity and leave with
it.
Its an immediate purchase. It’s a cash or actual transaction.
- Forward transaction – buy commodity but defer delivery to a later point.
-Option contract – gives you the right, not the obligation to buy a number of shares
over a period of time.
- Futures Contract – acts as a price protection device.
Where to put?
V. Derivatives Trading (derivatives of cash transactions)
A. Future/ Options Markets
1) Types
a) Options Ks
 Call option gives you the option to buy a stock at a certain price for a time
b) Commodity Futures Ks
c) Future Options
d) Stock Security Options
e) Stock Index Futures
2) Markets
a) Most sold on Ks markets
b) Governed and licensed by CFTC Commodity Futures Trading Commission
c) Exchanges: Chicago Board of Trade / CBOE Chicago Boards Options Exchange
B. Options Ks
1) =Gives purchaser the right but not the obligation to purchase or sell
a) Differs from futures in that purchaser not required to buy or sell unless option exercised
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2)
3)
4)
5)
6)
Call Option: BUY Option to buy at stated price
Put Option: SELL Option to sell at stated price
American Options: Exercisable at any time
Price paid is premium – not purchase price
Determining how to price options
a) Volatility of stock and time value of option
7) Advantages:
a) Only pay for option – not full cost of stock
b) Liability limited to the premium paid for the option
8) EXCHANGE: CBOE Chicago Board Options Exchange
a) For Stock Options
b) Other Options ???
c) The Pit: Market-maker obligations ; book of customer limit orders
C. Commodity Futures Ks
1) Futures K: Bilateral obligation seller (short) agrees to sell and buyer (long) agree to sell/buy a set amount of commodity at
a specified price at a specified date in the future
 I agree to purchase your grain at sometime in the future
b) Delivery is an option
c) Fungible – traders can close out their position without delivery
d) Like a forward K but with standardized terms
 Wide range of standardized delivery dates
 Only price is negotiated
2) Use clearinghouse as interceder/intermediary that takes title
3) Sold on Margin – only percent of total price due
a) Initial Margin – buyer and seller post initial margin (deposit)
b) Variation/Maintenance Margin – after initial margin, gain or loss daily (as futures marked-to-market) determines
whether you get credit on your margin (if gain) or need to put additional deposit (on loss)
c) If you don’t meet your margin call – they will close you out
4) It was a Free-For-All >>> No book of limit orders – Nor market makers
5) EXCHANGE: Chicago Board of Trade (“CBT”) -standardized these Ks
6) HISTORICALLY
a) Futures market started out in agriculture
b) Forward Delivery K >> bring a sample to CBT and we’ll look at it and enter into K to buy your grain for future or
deferred delivery
 I agree to purchase your grain at sometime in the future
 Preferred before the civil war
 Farmers then needed to store grain – created grain elevators
 Grain no longer rotting in the street—instead, farmers were told to bring sample to the city at a certain time and
now no rotting grain and up and down swinging prices
c) Spot / Actual K >>> bought for immediate delivery
d) Chicago Board of Trade considered applying same concept to instrument
 Became speculative
 Created futures Ks >> like forward Ks but with standardized terms
7)
Hedge agriculutural device in the 60s
a) Hedging – Price insurance; method to guarantee a desired return
 Take 2 opposite positions so that however market goes, you maintain a certain profit
 Grow beans >>> long ; sell a futures K >>>> short
b) Farmer: “Its spring time, I gotta know what to plant”
c) Farmer looks at prices of soybeans in newspaper
d) If farmer thinks he will grow however many bushels of soybeans, he sells futures K selling that soybean in october
e) Selling of those futures Ks tells the marketplace that the supply for those soybeans is increasing
f) Its getting close to October.... the farmer offsets those futures contracts
????
g) Futures K show soybeans will be $12 in November
h) Farmer has broker sell futures K on the crop I will grow (soybean) for $10
i) Come October I sell my soybeans to local grain elevator for $8 per bushel
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D.
E.
F.
G.
H.
j) Then I go to Chicago Board of Trade and close out my futures K for $10
k) I get the $2 difference I wanted that I did not get from my crop from my futures K
l) Preferable to hedge with futures (only pay margin, which gets applied to price) rather than premium on options
(where you pay premium + cost upon purchase)
m) Hedging is a great thing if prices go down. Bad thing if goes up (the farmers get the agreed upon price)
n) No hedging means tha farmers are gambling (they don't know what is going to happen to the price)
o) Can Hedge anything that has a price risk
Future Options
1) Option on futures K
2) Only pay premium
3) Have to pay margin on futures when option exercised
Stock Security Options
1) Option on an equity security or other form of security (US Treasury Bills)
2) Licensed by SEC and NOT within jurisdiction of CFTC
Innovative Form of OTC Derivative
1) Swap payment flows
2) Cap, Floor or Collar– For paid fee we will cap or floor your loan interest rate
a) Is that futures? Is that insurance?
Regulation
1) Originally, commodities futures
2) When futures became speculative, SEC given regulation control of futures
3) 1974 created Commodity Futures Trading Commission (CFTC) and given exclusive jurisdiction on any commodities
futures
4) SEC did not like when CFTC was regulating futures and options authorizing securities
5) CFTC and SEC decided to dived
a) SEC
 exclusive jurisdiction on stock options
 CBOE governed by SEC
b) CFTC
 exclusive jurisdiction on commodity futures and options on futures
 Option or future on currency traded on a board of trade or OTC
 Even single stock futures (shared with SEC)
 Chicago Board of Trade governed by CFTC
Margins (put up a small % of the K= enough to protect against loss)
Deisgned so that if market price became adverse to stock trader, then the margin payment
At the end of the day: “Hey you've got a loss, put up more margin”
If it goes down, farmer agreed to buy something fo $10 for something now worth $9.
Farmer has in theory made a theoretical; prfit of $9. Cleartinghouse pays him that dollar.
Sloshes back and forth to protect those gains and losses.
1) Margins in stock
a) FRB sets margin on stock >>> Currently 50%
b) Don’t like stock margins
c) Less leverage than futures
2) Margins in futures industry
a) Exchanges set margins on futures >>> Currently 5%
 To make sure you are performing
 Make sure our clearing house gets paid - less than 5%
b) Love futures speculators
3) High leverage
RECAP OF DERIVATIVES
CBOE - OPTIONS
Competing Market-makers – trade on your own account on the floor / pit
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Nasdaq – except they are all together in a pit and can execute immediately
Problem when market makers not on the floor – lunch, etc.
Hard to supervise they are always in the pit
FUTURES
Standardized K – only price negotiated ; choose delivery dates
Hybrid of Forward Delivery Ks i(ndividually negotiated – actual delivery)
Uses Clearinghouse to intercede
Floor Brokers executing customer orders
Time and place advantage over any other trader
Quoting a spread by buying and selling
No obligation to maintain a fair and orderly market
-CASE NOTES ON DERIVATIVES 10/3/11
-Basic Building Blocks need to be understood first
-1. Cash/Actual Transaction- think about going to the store paying for shoes in cash and taking them (the shoes) away
-2. Forward/Deferred-Buy the commodity but don’t take the order immediately I want to buy plants and you can deliver them to my
house in the next 2 weeks
-3. Option Contracts-Think about an option on land-I want the right to buy your property over the next two months, I want to pay you
something to keep that option contract open.
-4. Futures Contract-Critical stage-1800s Chicago became great trading market, at harvest ship the grain to Chicago-when a large supply
the price goes down, because we had so much grain in Chicago
-Merchants on the Chicago Board of Trade said, don’t bring your grain to market, only bring a sample and we will negotiate the price
and entered into a contract for forward delivery-don’t bring the grain till market until January-Help regularize the market place
-Merchants on the Chicago Board of Trade learned sometimes people needed grain badly and the merchant would sell the grain they
bought previously at a lower price for the deferred orders and the merchants realized they could make a profit here
-Problem: contracts were all individual, hard to buy and sell because of so much difference
-Solution: standardized the contracts with everything except for the PRICE, was the only variable
-Allowed merchants to buy and sell more easily
-Crops: soybeans at $12, wheat at $10, and cotton at $8
-Because we could change these contracts, couple of things we could do with them 1) Hedge
Hedge
-1)
-hedge the positions meaning make a future contract at the current price, and make sure that the system won’t hurt the
farmers and the people will also have the needed demand for the market and work it down the same way through the totality of the crops
Delivery is rarely made on hedging!!! There is almost always a cash settlement--Trading on the prices-not the underlying commodity
=-If the price goes up for the farmer you can deliver on the contract, or enter into a off-setting contract that will settle the price
differences
-Instead of taking the soy beans to Chicago, whichever way the prices go the farmer is hedging the price to make sure that he gets the
$12 he initially wanted even if the prices went up to $20 or down to $8.
-Provides liquidity to the farmer-need those speculators to buy those contracts to provide that liquidity, and provide information
-Futures Industry-If you have insider information, you bring it to the market place and make it more efficient, meaning it is not a crime
to trade on insider information, Futures Industry encourages insider trading because it brings the proper supply and demand price to the
market
-FCMs-Future Commission Merchants-member of the exchange, here in this case Chicago Board of Exchange,-the order would go from
my broker down to a trading pit-buying and selling contracts-no market making obligations-competitive open outcry auction market
-People buying for their own account or representing another customer-buyer and seller
-The orders once executed in the pit, go up to the clearing house-critical to the functioning of the market place-responsible for meeting
the obligations of both traders –Clearing House will make sure that the buyers and sellers will perform on their contracts
-Rare event when the commodity actually gets delivered, the people are trading on the price differences, the idea is market efficiency
Class Notes Starting 10/19/11
-Still looking at Market structure, Specialist in the NYSE-quoting a market on both sides, ECNs largely did away with this with matching
large orders
-NASDAQ-competing market makers-orders also being matched but still market markers operating in the system
-Bond Market-Buyers and Sellers for bonds, bonds react to market events interest rates go up, value of bonds go down and vice versa
-MBS-securitization, asset goes into pool and the ownership sold to investors, 1,000 mortgages and then sell interest in the pool of the
mortgages, investors receive the principal and interests of the people paying off their mortgages
-Loan Originators, have very complex system for how this actually gets done in terms of going into the pool
186
-Principle and interest coming in every month, can divide payments schemes into the different types of investors depending on the risk
incurred by the investors, higher the risk greater the return
-Designed to allow investors to avoid, delay, the re-finance risks of the people and their mortgages
-Previously with securities when interest rates drop-people would re-finance and the lesser rate would mean people who invested in the
mortgage pool would see lesser return on the investment
-You could buy basically insurance of being in the higher trench, to avoid the moves of interest rates, because of the lesser return lesser
risk
-We can put anything into these pools does not have to be MBS, anything that has a payment stream we can put into that pool and allows
the owner of the payment stream to make money off of it
-Secondary market created by the loan originations
Mortgage pool
A mortgage pool is a group of mortgages held in trust as collateral for the issuance of a mortgagebacked security. Some mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie
Mae are known as "pools" themselves.
-Derivatives-Need Building Blocks-Remember
-Cash or actual transaction-cash for the good or service
-Forward Contract-Agree to buy the item, may pay now or later, but take delivery on the item at some date in the future, individually
negotiated and always have delivery except in the case of some unusual commercial circumstance
-Forward Contract-Originally Developed to stabilize the grain markets in Chicago for the best sale price and the best way to distribute
the grain for everyone
-Traders learned that they could sell these contracts to different buyers, difficult to trade in because forward contracts previously did not
have standardized terms
-Board of Trade in Chicago-Standardized the terms, all except for the price of the particular crop or good-this standardization made it
possible for traders to sell these negotiated contracts
-Allowed contracts to be traded much more easily
-Opened the door to a lot of things but most particularly it allowed 1) Hedging and 2) speculation
-Futures industry used to like speculators
-Hedgers-going out to try to protect themselves against a commercial risk
-Hedger would look at the prices on the Board of Trade-look at cost, my land is more productive for wheat-bring in price for $12 a
bushel and all costs would be accounted for and for good profit, problem every other farmer sees the same price, and price may drop
because all other farmers would plant wheat too
-Solution-Call up broker, tell him how much of the crop will be produced, sell that wheat at $12 a bushel right now, effects=signal to the
rest of the world supply is increasing, meaning prices will go down, next farmer looking at changed board of trade will plant different
crop because the price will go down, further effect farmers will make the crops that will be the most profitable regularizes
supply/demand
-Provides an insurance, if for whatever reason wheat drops to zero, does not matter that farmer is protected because he hedge and sold at
$12 before the harvest-no matter what if he delivers on the contract he will receive the $12 per bushel, if the price goes up or down he
will not be effected
-Whether the price went up or down the farmer will receive $12
-If the farmer does not hedge, the farmer is gambling
-Hedging concept was though whether it would apply to securities
-Chicago Board of Trade asked whether commodities future trade principles could be applied to securities.-Previously only applied to
agricultural transactions due to the perishable nature of the harvest
-YES short answer.
-Speculators-Out there to make money off of people who have made sometimes bad decisions, trying to take advantage of the markets
-Used to be good in futures contracts-provided liquidity for all the hedgers-may be easier for the people who are stuck with a shorter
return on the hedge
-Speculators are basically saying we think the price is going to go up, farmer would lose the opportunity to capture any increase in price
the hedger would not be entitled to that, speculator absorbs the risk of the price going down
-Another addition of the speculator is about the price discover-Insider Information-In the futures markets you are a hero-because you are
bringing information to the market place to tell us what the commodities are actually worth-crop information that will effect the price of
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the market, something like a serious drought, an outbreak of some kind of defect in the crops, speculators provided a valuable function in
the futures markets
-Trading Process: Examples of Two Gold Speculators-think the price of gold is going to go UP
-1) could go out and buy gold himself or for the client
-2) My client wants to buy Gold-Pure open auction market-whoevers orders go in there will be matched first come first served
-Clearing House for the Exchange is brought into play-buyer of the gold who thinks going up
-CFTC-given a lot of power of futures contracts-had to be traded on a “contract market” if you were not a contract market you could not
trade these things
-This meant that you could not trade future contracts over the counter like stocks
-Some things came along that were sort of futures or sort of not, difficult to determine
-OPTIONS
-had a long history in the futures industry bad reputation-basically they were bets, they would just trade in differences
-If the price went up I would make the difference from the broker, if the price went down I would have to pay the broker the difference
-Viewed as gambling
-Court in a famous case-said enforcement of this kind of contract was not legal because it was merely gambling
-1974 CFTC-Congress said we change our minds CFTC has exclusive jurisdiction on options on comoddites but not stocks
-SEC then had the authority to enforce, but nobody traded them
-Chicago Board of Trade 1972-futures principles for securities?-Simplification is the Call-Option-Buyer Option
-1) Call Options-Give you the right to buy 100 shares of stock at an agreed open price-you can exercise that option at any time during the
life of the contract and you will pay a premium for that contract to remain open-Similar to option contract in Contracts.
-I am going to buy the right to buy these stocks at any time over the next three months for $100 dollars a share-paid you $150 to keep
that right open over the next three months, if the stock goes up I’ll buy because of the profit, if goes down then I probably won’t buy
-The seller made out too-If the seller thinks stock will not go anywhere for the next three months, sell the right for the premium, and the
buyer probably won’t buy anything because the stock did not move, seller liked it because of the premium
-Became very popular very quick-people were happy to buy on speculation
-Variations-The longer the period of time that the option contract exists the higher the premium, if the stock is volatile-meaning moving
up and down a lot-the higher the premium, if you can figure this out you get a Nobel Prize
-2) Put Option-I have the option to put the option to you at a specific price-This is from the seller-Seller-Option
-What would you charge me to sell you the stock for $100 over the next three months?-Buyer would charge premium, and if the stock
goes down, now the seller makes out because he would get the $100 for the stock and if the stock went down to $50 he would make the
profit
-Extremely Popular Products, same variations apply for the more volatile stocks and the length of the contracts for the premium
-Commodity Options
-Commodities used to be just wheat, corn, specified agricultural enumerated commodities
-Huge Scandal in the 1970s that banned this, but now more relaxed can trade but more restrictions
-Foreign Currency Transactions-nothing really amounted out of this discussion
-Swap Transaction-Plain Vanilla Interest Rate Swap easiest way to understand
-I have a loan for $100 million variable rate of 5% currently
-Another party $100 million at fixed 6% rate
-Parties are worried about rates going up or down paying more than currently paying
-Swap dealer says okay every month you will swap payments, you will not write a check for each other’s loan, you just write a
check for the difference, were just swapping the interest payments, handles the risk of the rate moving either way
-Enormously Popular-Governments are doing this on a big level
-US company trading on the $, with British subsidiary of pound sterling
-British Company Trading on Pound Sterling, with US subsidiary on the $
-We can do the same thing with oil
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-Airline Example-Jet Fuel is my biggest cost, if oil prices go up after I sold all those holiday tickets I am stuck paying more for the fuel,
and not put the price difference on the customers
-Oil company and airline can protect each other from the shifts in the price of oil
Jet fuel needs to be bought constantly-prices are constantly fluctuating
This guy wants a fixed price for the jet fuel
Goes to trading firm and pays monthly to maintain a fixed amount of money on the jet fuel.
Swap: commodities
Customer with a fixed interest rate loan
Customer with an adjustable rate loan
Both customers want to swap these rates on loan
Broker would organize the swap???
Swap Credit default swap
“whether Lehman bros gets bankrupt ornot, I pay you 1 mill per month”
Risky home mortgages swap
Package thousands of mortgages in one entity =mortgage backed securities
-RECAP of Derivatives
-Cash-We do not really regulate
-Forward-Contract-not really regulates, Futures Contracts-DO regulate standardized
-Options-SEC has stock option, CFTC-has commodity options
-CTFC-regulates commodities based swap, SEC-has swap options of stocks and securities
++Regulates-commodity pools (hedge funds essentially), swaps transactions,
CFTC REGULATION-essential purpose present an attack of commodities market from manipulation by traders
-in the 37 year history they have only won one manipulation case,
-ENRON massively manipulated the CA electricity market
-CFTC regulatory scheme mirrors SEC in some ways other ways not so much, SEC brokers cannot make a recommendation to another
person unless it is reasonably in the persons circumstances
-CFTC regulation said, we will give people one page warning in bold print says you may lose initial amount, and everything because
futures trading in commodities is SO risky
-Futures and derivatives markets are dominated by economic products, derivative lawyers do a ton of financial securities work
A no-action letter is a letter written by the staff members of a government agency, requested by an
entity subject to regulation by that agency, indicating that the staff will not recommend that the agency
take legal action against the entity, should the entity engage in a course of action proposed by the
entity ...
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Further Discussion after Markets of 10/3/11
VI. Financial Reporting
A. Different Reports
1) 10-K Annual Audited
a) Compensation of top four officers and CEO (+ all perks)
b) Adequacy of financial controls
c) Footnotes – where bodies are buried
2) 10-Q Quarterly Non-Audited
3) 8-K Material Effects Report
a) Change in control of registrant
b) Resignation of Directors
c) Change in accountants
ADDED BY SARBANES-OXLEY ACT
d) Termination of material agreements
e) Appointments and resignations of officers and directors
f) Changes to Bylaws
4) Sarbanes-Oxley Act requires
a) real-time disclosure
b) Section 404 requires management to ensure its
c) PCAOB Public Company Accounting Oversight Board (Peekaboo)
 Public body appointed by SEC
 Paid by the industry
Financial Reporting Notes
-make sure that customers are kept appraised of current financial information in the company
-SEC regulates the proxy filings, annual report,
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-Huge cost attached- financial statements-Corporate Officers are liable for these statements now, CEO and CFO are guaranteed life in
prison if something goes wrong
-4 Big accounting firms to go to only and they ain’t cheap, and they will take months to compile this financial information
-SEC will sue you if you do not put these statements out being a publicly traded company, and big time SEC judgments
-Tremendous incentive for stock price to go up for executives, and tremendous incentive to manipulate data to make stock go UP
-SEC regulations and State law regulations for proxy materials are both in jurisdiction
-SEC series of regulations under section 14(a) -9 and 14(a)8 on pages 568 on the supplement book
VII.
SEC Proxy Regulations


I.
A reporting company must comply with the SEC's proxy rules whenever its management submits proposals to shareholders that will
be subject to a shareholder vote, usually at a shareholders’ meeting.
The proxy rules require the company to provide certain disclosures in a proxy statement to its shareholders,
Persons Subject to Section 16 – Insiders Defined
A. Applies only to Reporting Companies under Section 12 of the 34 Act
1) 500 shareholders / $10M Assets
2) Trading on national securities exchange
=
Some, but not all, corporations that have made public offerings of their stock are
also "registered corporations" Section 1 2 of the 34 Act requires corporations with shares
traded on a national exchange, such as the New York Stock Exchange, or which have over
$10,000,000 in assets and at least 500 shareholders who are not accredited investors to register with SEC
These corporations are called "registered" or "34 Act companies.” And, these corporations are subject to the proxy rules of section 14 of the 34 Act and the "short-swing trading" rules of section 16 ofthe 34 Act see elsewhere
How Much Do you Have to Know About the Federal Proxy Rules?
Hopefully, nothing.
About 1/2 of the casebooks do not cover the federal proxy rules And at least 1/2 of the professors who use casebooks
If your professor did cover the federal proxy rules, you need to know when you do
state proxy law and when you do the federal proxy rule.
State Proxy rules: The only likely exam question on state proxy laws will be a question about revocability of a proxy
For example: If S grants a proxy to P and the proxy expressly states that it is irrevoca»
ble, can S still revoke the proxy?  S can still revoke unless
there are other facts that show that this was a “proxy coupled with an interest."
Federal Proxy Rules For any question on the federal proxy rules, you also need to know five things about
the federal proxy rules:
(1) registered corporations regularly solicit shareholder proxies to ensure that
shareholder meeting quorum requirements are satisfied;
(2) these solicitations must be accompanied by a "proxy statement" which
satisfies the requirements of the federal proxy rules;
(3) one such rule prohibits fraud in connection with the solicitation of a
proxy;
(4) violation of this rule gives rise to a private right of action for damages; and
(5) a "qualified shareholder" can submit proposals for inclusion in the corporation's proxy solicitation materials
background:
A proxy statement is a statement required of a firm when soliciting shareholder votes.
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This statement is filed in advance of the annual meeting. The firm needs to file
a proxy statement, otherwise known as a Form DEF 14A (Definitive Proxy Statement),
with the SEC.
Proxy rules get their name from the common practice of management asking shareholders to
provide them with a document called a “proxy card” granting authority to vote the shareholders’
shares at the meeting. The proxy rules require the company to provide certain disclosures in a
proxy statement to its shareholders, together with a proxy card in a specified format, when
soliciting authority to vote the shareholders’ shares. Proxy statements describe matters up for
shareholder vote, and include management and executive compensation information if the
shareholders are voting for the election of directors.
The proxy rules also require the company to send an annual report to shareholders if the
shareholders are voting for directors.
The proxy rules also govern when your company must provide shareholder lists to investors and
when it must include a proposal from a shareholder in its proxy statement or information
statement.
Class Notes Starting 10/24/11
-Derivatives go to the types of the transactions, cash-forward contracts, future contracts-rarely made delivery
in the future we settle the differences in the contracts allows for hedging and speculation, Options-Call-gives
the right to purchase something, Put-Option the right to sell something
-Swap contracts-swap of usually a variable payment for a fixed payment, but can swap anything, currencies,
oil markets,
-SEC-Securities, swaps that involve securities
-CFTC-commodities, and swaps that involve commodities
-Financial Reports that Companies Must make when they go public
-SEC section 14-regulates proxies, public companies are subject to their State proxy provisions, and SEC
14(a)-8-shareholder proposals
-SEC requires companies to present the proposals of shareholders
-SEC 14(a)-8 difficult rule to apply
-SEC is regulating speech within the First Amendment, want full disclosure because we want people to be
able to make informed decisions about what securities they want to invest in
-1st Amendment-want free speech, even if false, even if misleading, however there are exceptions and the test
has been refined
-SEC regulates the Speech-Commercial Speech-Not really valuable speech, therefore we can regulate it, not
entitled to the same protection that we give to other forms of speech-allows SEC regulation and particularly
fraud
-Here people mounting a political campaign against LILCO-Court had to address that issue, they kind of
avoided answering the issue, however courts will look to see if the speech is political or not to inquire into
First Amendment because they do not want to get into that
A. Proxy Requirements rule 14(a)(4)
1) Corporation required to provide a proxy statement and proxy to shareholders before each shareholder meeting
2) BENEFICIAL OWNERS Must inquire into beneficial owners of securities held by brokers and provide them with
sufficient proxies to distribute to all beneficial owners
a) CEDE List – brokerage firms and other record owners who bought shares in street name for their customers
b) NOBO Lists – non-objecting beneficial owners who have given consent to disclosures of their identities
 MBCA requires disclosure of NOBO lists but only if in existence does NOT require they be compiled if not in
existence
3) SEC FILING Requirements
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B.
C.
D.
E.
F.
4) PROXY CONTEST. Additional SEC filing requirements when there is a contest with respect to election or removal of
directors
Four Aspects of Proxy Regulation under Securities Exchange Act
1) Full and fair DISCLOSURE of all material facts
2) Material misstatements, omissions and fraud prohibited
3) Management required to not only put their proposals in their proxy statements but also
a) shareholder proposals
b) must allow proponents to explain their position in face of management opposition
4) Full disclosure in non-management proxy materials
Federal v State Proxy Regulations
1) Supplements state corporate law proxy regulations
2) Focus of federal-state tensions
3) STATE LAW: basic corporate governance rules
4) FEDERAL SECURITIES LAWS: impose disclosure requirements
Disclosures Required Beyond Proxy Solicitations
1) Management must disclose to shareholders when majority of board replaced by action of directors in connection with
transfer of controlling stock
2) CEDE List
a) brokerage firms and other record owners who bought shares in street name for their customers
b) Shares in custody of depository firms, such as Depository Trust Co, reflected in the corporation’s records under the
name of the nominee used by such depository firms
c) Depository Trust Co uses CEDE & Co as nominee - main depository for most broker-dealer stocks
3) NOBO Lists
a) non-objecting beneficial owners who have given consent to disclosures of their identities
 SEC requires that brokers compile NOBO list upon request of corporation
b) MBCA 16.03 does not require that corporations compile NOBOs, only need to disclose
Broker-Dealers and Transfer Agents
1) Broker-Dealer Voting
a) Broker-Dealers vote on routine matters and vote in favor of management unless you authorize otherwise
 SEC just announced is going to change its rules and not allow Broker-Dealers to vote on routine matters
2) Broker Dealers Insurance
a) Securities Investor Protection Act of 1970 insures broker-dealer customer accounts for $500K per customer from
losses caused by bankruptcy of broker-dealers holding their stock as nominee
 Protects against shortage of assets in bankruptcy
3) SEC Regulation of Transfer Agents
a) SEC now has regulatory authority over transfer agents that record changes in stock ownership
b) T+3 Securities transactions must be cleared and settled within three days
c) Delaware now allows certificate-less corporations
d) SEC requires broker-dealers holding stock in street names to deliver proxies to beneficial owners
4) Proxy Solicitation Firms
a) Broker-Dealers and Banks have to forward proxy solicitations to their clients
b) Many broker-dealers have OUTSOURCED proxy delivery obligation to specialty firms
 Firms assist in development of strategies to influence shareholder voting
 Keep count of votes
 Visit and solicit large institutional investors
 Contested solicitation may resembles a political campaign – with polls, etc.
Proxy Statement Requirements – SEC Rule 14a
1) SEC must approve form of Proxy
a) Cannot have a speech
b) Only a ballot
c) Can say that management supports it
2) Documents Included:
a) Form of Proxy for next annual meeting
b) Annual Report (with or prior to proxy solicitations for Annual Meeting)
c) 2 Years of Audited Financial Statements
3) Information Included:
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a)
b)
c)
d)
e)
f)
g)
h)
4)
5)
6)
7)
8)
Deadline for shareholder proposals
If revocable and how
Person making solicitation – if Management
Source of costs of solicitation
List voting securities and principal holders thereof
Record date
Explain cumulative voting rights
As to Nominee Directors:
 Relationship to affiliated companies and interest in the issuer’s activities
 Leave room for write-in candidates
i) Compensation of Directors and Officers
j) Disclosure by insurgents
SEC Filings
a) Preliminary copies with SEC at least 10 days before mailing (5 copies)
 X Unless annual meeting only for director election or shareholder proposals
b) Definitive copies after mailing (8 copies)
 PLUS (3 copies) with each national securities exchange listing the stock
c) Additional solicitation materials at least 2 days before mailing (5 copies)
No misleading statements allowed in Proxy Statements
What is a Proxy Solicitation?
a) SEC has not defined – have to look at case law
What is Not a Proxy Solicitation Long Island Lighting
a) SEC amended it proxy rules after the Long Island holding to narrow the definition of proxy solicitations
b) Statements by someone who does not engage in proxy solicitations made in a public forum or press releases,
publications or advertisements are NOT proxy solicitations
c) Allows for political advocacy
SEE SEC Proxy Rules in Statute Books
a) Rule 14(a)(3) Can’t solicit a proxy without a proxy statement (which must be filed w/SEC)
b) Disputes with SEC over proxies usually worked out by negotiation
c) Rule 14(a)(9) Anti-fraud provision – no omissions, affirmative misstatements
d) Rule 14(a)(6) Filing requirements
e) Corporate Finance Division of SEC reviews proxies
14(a)(8)-if you meet the threshold requirement (which is very little) you can send your opiion ot the corporate higher up
Who is eligible to submit a proposal (p 789)
G. CASES
1) Sadler v. NCR-NOT IN THIS CASE BOOK, starting the next case is on page 662
a) AT&T purchases 100 shares of NCR. They then make a tender offer for all the common stock of NCR, which was
mailed by NCR to all stockholders but the Board rejects the offer. AT&T wants to solicit NCR shareholders to call a
meeting to replace directors so AT&T’s offer can be accepted. AS part of that , they need stockholder information.
They approach Sadlers, owners of 6000 shares of NCR, to seek the corporate shareholder list from NCR, including
CEDE lists and NOBO lists, for themselves and AT&T.
 CEDE List – brokerage firms and other record owners who bought shares in street name for their customers
 NOBO Lists – non-objecting beneficial owners who have given consent to disclosures of their identities
 SEC requires that brokers compile NOBO list upon request of corporation
b) NCR refuses to produce
 Sadler making request as agent of AT&T and not for itself
 NOBO list not producible because it did not exist but had to be compiled and Section 1315 NY Bus Corp Law
does not require it
c) Court says NCR must produce NOBO, even if they have to compile it
 DC: Although law not clear (contrasting decisions/interpretations), inequitable not to allow AT&T to
communicate with shareholders and to have access to NOBO list
 Court found no improper purpose although AT&T using Sadlers as their stocking horse
 This Court: Statute is to be liberally construed
 NOBO list compilation is a simple task
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
Purpose of statute requiring shareholder information be available to shareholders is to give shareholders the
same opportunity to communicate with shareholders as managers have
d) HOLDING CONTRARY TO MBCA >>> MBCA does not require that NOBO lists be compiled if not in existence
2) Long Island Lighting v. Barbash
How far can SEC regulate speech?
a) Л is a utility company whose stock is publicly held. The Utility Company (Long Island Lighting Co) is involved in a
public controversy over the construction of a nuclear power plant. Δs are parties that oppose the nuclear power plant –
one a stockholder and the other a Citizen’s Committees. Δ Matthews was a candidate for local office who purchased
stock in Lillco to oppose it politically. Δs, prior to a stockholder meeting to elect a new Board, advertise in newspaper
and on radio, criticizing LILLCO and urging LILLCO be replaced with state-run company. The utility company takes
action against them – claiming the false advertisements violated SEC Rule 14 governing proxy solicitations. Seeks to
enjoin Δs from further solicitation of shareholders.
b) PH: Trial Court grants Δ’s 12(b)(6) motion and treats it as a Summary Judgment dismissing complaint.
 Proxy rules did not apply to the advertisements
c) LILLCO ARGUES:
 Communications to shareholders through general and indirect publications could be solicitations under the proxy
rules
 Objects to court’s reasoning that the construction of proxy rules employed by the Court was required by First
Amendment
 This is commercial speech and cannot make false statements
d) COURT HOLDING / RULES
 Remand
 Lower Court erred in what constitutes a proxy and in relationship between proxy rules and First Amendment
 PROXY SOLICITATIONS
 SEC Rules apply to direct requests for votes and media requests
 WHAT IS A SOLICITATION?
 Any communication to security holders under circumstances reasonably calculated to result in
procurement or withholding of a proxy
 Any communication that accompanies a direct request for proxy, or that is a step in the chain of
communications designed to ultimately procure or withhold a proxy
 TEST: Whether the challenged communication in the totality of the circumstances is reasonably
calculated to influence the shareholders
 X Exception now made for media by
 Does not need to be targeted directly at shareholders
 Denies any connection between the First Amendment and proxy rules
 DISSENT disagrees
 Believes the advertisement by the Citizens Committee was sheer political advocacy by a party disinterested in
the investment of the shareholders – and as such is protected by the First Amendment and not subject to
federal proxy solicitation rules
 I am concerned we will become censors – even if a proxy solicitation, it has political context
 OTHER US-SC CASE
 Whether an investment newsletter is a proxy solicitation?
 Claimed first amendment right to lie – protected speech SEC cannot regulate
 US-SC – can’t regulate newsletters
CASE NOTES for LONG Island Lighting CO. on page 662
-Famous for High Energy Prices in this particular Long Island CO.
-it became a community Effort of the proxy contest to throw management out (by putting ads in news publications seeking that
kind of relief)
-Lilco sued these people by alleging this was a violation of SEC regulation-by saying this was a proxy solicitation –this was a
question of freedom of speech
---does SEC preemp the first amendment?
Commercial speech can be regulated!
-SEC rules regulate everything that must go into the proxy materials
-First Amendment concern here on the very border of commercial versus private speech.
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VIII.
Shareholder Proxy Proposals
A. Management’s Obligation
1) If properly notified, Management must include shareholder proxy proposal in its proxy statement
a) Proposal + 500 Word max
2) So many exclusions its hard for shareholders to get on the ballot
B. SEC Shareholder Proxy Requirements
1) MATERIAL / RELEVANT
a) Objectively / Financially Material. What you are proposing has to account for more than 5% of issuer’s total assets
and 5% of is net earnings and gross sales
 Can use this standard if issue over money and no social or political
b) Subjectively / Policy Material Lovenhiem
 If of little economic significance, may be sufficient if it has ethical or social significance – policy questions
significantly related to the company’s business
 Also used against the Ordinary Business Operations exception
2) SHAREHOLDER INTEREST
a) Shareholder must own at least $2K of stock or 1% of securities entitled to vote
b) Must hold stock for 1 Year
3) PROPER SUBJECT FOR SHAREHOLDER ACTION
a) That which stockholders may properly be interested and under which they have the authority to act
b) Bylaws, information, fiduciary relationship with directors
c) Recommendations to Board more likely to pass than mandates to Board
C. SEC Exceptions Allowing Rejection SEC Rule 14-a(8)
1) Not Material / Relevant
a) Objectively – Financially
b) Subjectively – Policy
2) No Shareholder Interest
3) Not proper subject for shareholder action
4) Ordinary Business Operations (Management functions)
a) Shareholders cannot tell management what to do (Charleston Boot)
b) Day-to-day management v. general policy issues
c) DISCRIMINATION ISSUES
 Proposals of significant social policy issues transcend day to day business matters and reasise policy issues
so significant that it would be appropriate for shareholder vote
5) Personal grievance or special interest
6) Illegal
7) Relating to elections (Recent case does not allow exclusion on this basis)
8) Contrary to SEC Proxy Rules
a) Vague or misleading
9) Beyond the company’s power to effectuate
a) Social concerns management by itself cannot remedy
10) Contradicts management proposal
11) Moot
12) Duplicative
13) Dividends
14) Resubmissions
a) Cannot resubmit for 3-5 years, depending on vote obtained
D. SEC No-Action Letter
1) Management can get a No-Action letter and we will recommend no enforcement action against management if you refuse
the shareholder proposal
2) No-Action letters issued by SEC staff
3) Not commission action – so may not be reviewable
E. Purpose
1) Used by proponents of shareholder democracy (changes in management)
2) Used by proponents of corporate social responsibility (war protests, environmentalists)
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3) Allows shareholders to participate at company’s expense
4) CORPORATE GADFLIES
a) Individuals buying small amounts of stock to make stockholder proposals that serve their purpose: against
management, anti-war, other social or political causes
F. SEC resists but often change their positions
1) EXAMPLES
a) Medical Committee Case – shareholders wanted company not to make napalm
b) Declared moot because company allowed it to be included in the proxy proposal
2) Don’t know quite what review standard or even if reviewable
a) SEC allowed Mobil to refuse proposal that Mobil not make cigarette packages
b) Originally SEC allowed exclusion of executive compensation / shareholder proposals
 _________ said if golden parachute excess compensation, excess tax and not deductible so vulnerable
 SEC NOW ALLOWS
c) Equal Employment Issues
 SEC flip-flopped twice – now allowed to INCLUDE Cracker Barrel
d) Current battle is on election proposals
G. Is SEC No-Action process reviewable?
1) What is remedy for shareholder if wrong?
2) They keep changing
3) Medical Committee case – not quite sure what result
a) 2nd Circuit Case: What is rule making or interpretive? Court says interpretive and non-binding and not reviewable.
4) But STILL UP IN THE AIR IF REVIEWABLE
5) COURT DEFERRENCE TO NO-ACTIONS
6) No-Action Letters are not really agency action
a) Staff responses to private requests
 we will not recommend to the commission
 staff interpretations – not formal commission action
b) Accordingly limited in whether court must defer to them
c) But courts often do if consistent
H. Cases
1) Lovenheim v. Iroquois Brands
Have to disclose all material facts! So what is material? This calse comes closest to defining materiality
Nonmaterial=you do not have to include certain provisions because they do not involve the matter of roughly 5% of the
business (ex. gross net sales).
Here, the company was permitted to exclude
a) Owner of 200 shares of Iroquois want to bring proxy proposal to study possibly cruel methods used to make pate and if
cruel to stop purchase of pate. Iroquois argued 14(a)(8) required the proposal have a minimum economic effect to be
material. Lovenheim argued the rule’s language in 14(a)(8) which states that “and is not otherwise significantly
related to the issuer’s business.”
b) HOLDING
 Court found rule ambiguous and reviewed history for interpretation
 Found SEC did not intend Rule 14(a)(8) to limit permitted shareholder proposals solely based on economic
relativity
 Materiality requirement not limited to economic significance
 Policy questions (social or political) may create materiality as well
c) RULING: Remanded, Court granted P’s motion for preliminary injunction because it was able to prove it could
succeed on the merits in its action.
-CASE NOTES-proposal the shareholder is requesting to be put into the proxy provisions, however, SEC does not have to include
certain provisions because they do not involve the matter of roughly 5% of the business, among others I think 13 total
-Important language was “and if not otherwise significantly related to the issuer’s business.”
-State law says you cannot tell the BOD what to do, so if the proxy materials say the shareholders are telling the BOD not to pay such
high salaries to the executives, that is illegal and SEC says you do not have to include any materials that are illegal in the proxy materials
Facts: After Iroquois Brands (D-Delaware corporation) refused to include Lovenheim’s (P) proposed
resolution (on the force-feeding of geese to produce pate) in the proxy materials being sent to
shareholders prior to the annual meeting, Lovenheim (P) sought to compel the inclusion of his
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resolution in the proxy materials. Less than 0.05% of Iroquois’ assets were involved in the importation
of pate.
Issue: May an issuer omit a security holder’s proposal for action if it relates to operations accounting
for less than 5% of the (business) issuer’s total assets and its net earnings and gross sales and is not
otherwise significantly related to the issuer’s business?
Holding: Yes. However, the meaning of “significantly related” is not limited to economic significance.
Since P’s proposal raises substantial ethical and social issues, and these issues are tied to significant
business activity by D (even though economically insignificant), D must include P’s proposal in its
proxy materials.
Rule: If proposal is significant because of the social or ethical issues that it raises, and there are related
to the corporation’s business, the proposal will not be automatically excluded because it does not
satisfy the 5% test.
2) SEC v. Transamerica-NOT IN THE CASE BOOK page 673
a) Gilbert owns only 17 shares of Transamerica (corporate gadfly). Requests shareholder proposal for (a) independent
auditors of the books elected by SH; (b) amend bylaw to eliminate notice of bylaw change, and (3) requiring report to
stockholders of proceedings of annual meeting
b) Transamerica refused to include Gilbert’s proposal c
c) TRANS ARGUMENT:
 These actions are management and management is the management’s business
 Not proper subject for action by shareholders
d) What is a proper subject for shareholder action?
 That which stockholders may properly be interested and under which they have the authority to act
e) HOLDING : Court accepts SEC position
 Gilbert’s Proposals found proper subject for shareholder action
 Independent auditors: Proper review of trust relationship between SH and BOD
 Annual Meeting Report: Proper to meet SH need for Accurate Information
 Corporate bylaw cannot frustrate legislative intent
 Transamerica using bylaw provision to circumvent intent of Congress to require fair opportunity for operation
of corporate suffrage
CA, Inc. v. AFSCME Employees Pension Plan (Del. Supreme Court, 2008)-page 673
Facts:
AFSCME is a group of employees seeking to amend the bylaws of CA to include a provision that would allow the CA BOD
elections to be reimbursed for candidates that run against the BOD members who were elected annually in CA. Meaning the AFSCME
wanted the CA to include in its proxy materials a shareholder vote for the amending of the bylaws that would make CA reimburse people
who ran against the BOD for election even if they lost with a certain amount of restrictions, something about the elections had to be in
question meaning not a landslide.
Procedural History:
Some kind of special review seems to be called a certified question for the DE Supreme Court to determine the extent of the
SEC rules with this under DE law?
Issus:
1.
2.
Is the AFSCME proposal a proper subject for action by shareholders as a matter of DE law?
Would the AFSCME proposal, if adopted, cause CA to violate any DE law to which it is subject?
Rules:
Indeed, it is well-established that stockholders of a corporation subject to the DGCL may not directly manage the business and
affairs of the corporation, at least without specific authorization in either the statute or the certificate of incorporation. Therefore, the
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shareholders’ statutory power to amend, adopt, or repeal bylaws is not coextensive with the board’s concurrent power and is limited by
the board’s management prerogatives, under section 141 (a).
Rationale:
Under at least one such hypothetical, the BOD would breach their fiduciary duties if the complied with the Bylaw.
Accordingly, we conclude that the Bylaw, as drafted, would violate the prohibition, which our decisions have derived from section
141(a), against contractual arrangements that commit the BOD to a course of action that would preclude them from fully discharging
their fiduciary duties to the corporation and its shareholders.
Holding:
The BOD has the ultimate responsibility for managing the business and affairs of a corporation.
-CASE NOTES-Process-Company receives a proposal, they usually don’t want to include it, look to SEC rules to see if they can exclude
it, if close they ask SEC for NO ACTION LETTER
-It is our opinion that we need not include the proxy materials for the following reasons, if the SEC agrees with the company, then we
will not recommend to the commission that they will not sue your company because you failed to include the materials in the company
reports-this have never happened when the SEC has went against the recommendation
-Serious issues over whether the SEC staff decision is reviewable-usually not courts reluctant to do that, battle is really fought before the
division of corporate finance at the SEC
-Overtime SEC has changed its position on hot issues over several years-Proposal in this case- was to require the Company to reimburse shareholders who run a campaign for a candidate to run for the BOD,
even if they lose, by changing the bylaw
-SEC staff looked at the proposal, said under DE law we are not sure, we want to certify the question to DE state court and get a
definitive answer to determine whether SEC would violate DE law
-Court concluded the proposal would violate BOD discretion- and shareholders cannot tell the BOD what to do
-Unions are broadly involved in these securities laws decisions, pension plans for the unions and the institutions are usually lead
plaintiffs in the class actions because they are so largely invested in these securities for the corporations
AFSCME, Pension Plan v. American International Group, Inc. (2 nd Cir. 2006)-page 679
Facts:
Issue:
Whether a shareholder proposal requiring a company to include certain shareholder-nominated candidates for the BOD on the
corporate ballot can be excluded from the corporate proxy materials on the basis that the proposal “relates to an election” under SEC
Rule 14a-8(i)(8)? –What does “relates to an election” mean under the rule?
Rules:
The 1976 SEC Statement of interpretation of the “relates to an election” meant that shareholder proposals can be excluded
under the election exclusion if they would result in an immediate election contest.
Holding:
We believe that an agency’s interpretation of an ambiguous regulation made at the time the regulation was implemented or
revised should control unless that agency has offered sufficient reasons for its changed interpretation. Accordingly, we hold that the
shareholder proposal that seeks to amend the corporate bylaws to establish a procedure by which shareholder-nominated candidates may
be included on the corporate ballot does not relate to an election within the meaning of the rule and therefore cannot be excluded from
corporate proxy materials under that regulation.
Order:
-1976 SEC statement said this is not the kind of thing we are trying to exclude
-We can legally at least advise the BOD or ask the BOD for something, without telling them what to do.
-Court said it is merely process here, and not telling the BOD what to do exactly
-Another area of concern is the pay of the management of the company
-A lot of concern, criticism, and anger when the economy was doing very poorly
-SEC authorized by Dodd-Frank to hear compensation issues, previously excluded because impair the discretion of the BOD
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-“Say of Pay Proposal” not telling the BOD what they can do or how much they could get paid, simply showing the disapproval of the
shareholders, most of the proposals do not pass anyway and even if they did the BOD is not shamed and would usually take the large pay
options anyway
-Issue that comes up is whether the rulings by the SEC are reviewable in Court?-Very difficult to get that review
-Once the proposal is excluded, the company can exclude the proposal for a specified number of years depending on how many votes the
proposal received
CHAPTER 13 FRAUD CLAIMS UNDER FEDERAL SECURITIES LAW
I.
10B-5
SEC Anti-Fraud Rule
It can be difficult to prove that an insider who is buying or selling her corporation’s stock is wrongly benefitting from material inside
information=diflicu1t to prove all of the elements of a Rule 10b-5 cause of action
 administrative regulation
 promulgated by the Securities and Exchange Commission (“SEC") pursuant to section 10(b) of the 34 Act.
Rule l0b—5 prohibits making a false or misleading statement of material facts in connection with the purchase or sale of
securities
Very similar to/ Can be brought with the common law contracts and tort concepts of misrepresentation, fraud, and deceit
Most of what you need to know from 10b-5 comes, not from the language of the 34 Act or of Rule 10b-5 itself, but from
Supreme Court case law.
For example, Rule 10b-5 simply states "It shall be unlawful to make an untrue
statement of material fact in connection with the purchase or sale of any security"
These words suggest that the plaintiff in a Rule 10b-5 action must be the United States (either the Department of Justice or the SEC) and that all the United States has to prove is that:
(i) the defendant made a statement in connection with the purchase or sale of stock; (ii) the
statement was false; and (iii) the false statement was material.
Case law adds the following additional important information about possible plaintiffs.
 Not only the United States can sue under 10b-5, but also the private party who bought or sold the stock
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
In addition to proving the falsity and materiality of the D’s statement as per 10b-5, case law dictates that P will
also have to prove reliance and scienter.
10b-5 issues that your prof will be looking for you to address are (1) materiality, (2) reliance, and (3) scienter,
Most of what you need to know about Rule 10B-5 is how it applies to
(1) a sale of a corporation’s stock in which either the buyer or the seller relied on a false or misleading
statement of material fact about the corporation and
(2) a sale of a corporation’s stock in which either the buyer or the seller relied on material nonpublic information
about the corporation
A. Section 10B of Securities Exchange Act -broad application of power to the SEC
1) Prohibits, in connection with the purchase or sale of any security,
2) use of manipulative or deceptive devises
3) or in contradiction to rules set by Commission
4) in the public interest or for the protection of investors
B. Rule 10B-5 (1943)
1) Rule implements 10B of SEA
2) Unlawful in connection with the purchase or sale of any security to
a) Employ any devise or scheme to defraud
b) Make any untrue statement of material fact
c) Omits to state a necessary material fact
d) Any practice or course of business that is a fraud or deceit upon any person
e) by use of mail, interstate commerce or any securities exchange
3) No exceptions – applies to all securities
a) Whether securities registered or unregistered
b) Whether public or closely-held corporation
4) No MATERIAL MISREPRESENTATIONS OR OMISSIONS
5) Rule 14(a)(9) – Proxy solicitation anti-fraud counterpart to 10(b)(5) (for purchases and sales)
C. Elements of Rule 10B-5 what do you have ti show for a violation of 10(b)(5)
1) Deceit-Must be some kind of fraud as in Santa Fe Case???
2) MATERIALITY Basic
Substantial likelihood that a reasonable shareholder would consider it important in making decision to buy or
sell the stock
a) Would significantly alter the total mix of information TSR Basic v. Levinson
b) Example: Knowledge of a possibility
c) Need not be decisive but must be something that they would like to consider in the total mix of info
3) IN CONNECTION WITH PURCHASE OR SALE OF SECURITY Birnbaum + Blue Chips Stamp Case
a) In connection with the purchase or sale of a security
b) Do NOT have to be a buyer or seller of the stock?
c) Old Birnham Rule replaced by Zandford decision allowing a broad interpretation of in connection with - fraud
involves sale or purchase of security
d) Need not always be a buyer or seller to have private right of action
e) Fraud need not come directly from purchase or sale of securities, which may be legal of itself
4) SCIENTER (Intent / Recklessness) Ernst & Ernst
a) Mens Rea
b) Intent to Deceive/Mislead or Recklessness or above required
c) Negligence or less not sufficient
d) There must be fraud Santa Fe
5) ECONOMIC LOSS – Private Л
6) CAUSATION
a) Reliance / Transaction Causation But for causation Basic: Fraud caused the Л to enter into the transaction
b) Loss Causation Proximate cause: The transaction caused the loss to the Л
D. Defenses to Rule 10-B 5
1) Lack of Scienter
2) Lack of Causation
3) Lack of Reliance
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4) Lack of Due Diligence
5) In Pari Delicto
-10b-5 Notes-Huge Rule-gives the authority for the SEC to pass rules against Fraud
-Probably the Most Important Rule for the Securities Law
-BLUE Chips v. Manor Drug Stores (SCOTUS, 1975)-page 695 casual adoption of the rule by the commission
-Makes the Rule 10b-5 apply to both buying and selling the stock-previously only spoke of selling the stock
-Applies even if it is exempted from registration
-Basic rule against fraud
-Courts look very carefully at the language of 10b-5 in hearing a claim of fraud or deceit
-Greatest expansion of the
II. Private Right of Action for Securities Fraud
A. Case History
III.
1) Courts have implied a PRIVATE RIGHT OF ACTION under 10(b)(5) (not express ROA)
a) The problem with implied is we have to make up the standards for what we do in court
2) 1946 Kardon
a) Court created a private right of action under 10B-5 where one could obtain damages for violations – opened the
door to private rights of action
b) Based on common law principles:
c) Violation of a legislative enactment makes the actor liable for invasion of those the legislation intended to
protect
d) Disregard of the command of statute is a wrongful act and tort
3) 1964 Borak
a) Court implied a private right of action under the anti-fraud provision of Rule 14a-9 (proxy solicitation)
b) Shareholder injury from management fraud or deception flows from damages to corporation and not stockholder
individually
c) Derivative as well as direct actions
d) Duty of court to provide remedies necessary to make effective congressional intent and purposes
e) US Code grants District Courts “jurisdiction of all suits in equity and at law brouh to enforce any liability of duty
created by this title”
f) SCOTUS basically said it is too late to close the front door, because so many courts applied the private right of action
under 10b-5, we continue to have a private right of action
g) However, Congress and the SCOTUS have very narrowly refined the scope of this private right of action under 10b-5
4) 1979 Cannon
a) Discredited and rejected the Kardon rationale for a right of private action under 10B-5 b) Supreme Court limited what was a private right of action but too late – horse out of the barn door
B. Cort Test – Parameters of a Private Right of Action-page 700 note 2
1) P must be one of the class for whose benefit statute enacted
2) Must be indication of legislative intent to create remedy (or deny one)
3) Implying a remedy is consistent with purpose of legislation
4) NOT traditionally relegated to state law
a) inappropriate to infer a cause of action based solely on federal law
b) This Rejects the Previous Kardon standard above and says that the rationale underlying the decision was flawed noting
that “the Court has been especially reluctant to imply causes of action under statutes that create duites on the part of
persons for the benefit of the public at large.
Materiality
A. Standard of Materiality
1) OBJECTIVE STANDARD (Reasonable Person)
a) Substantial likelihood reasonable shareholder would consider it important in making decision
b) Would significantly alter the total mix of information TSR Basic v. Levinson
c) Mixed question of law and fact
d) Example: Knowledge of a possibility
2) Even Knowledge of Possibilities
a) Any fact which in reasonable contemplation might affect the value of the stock
b) SEC v. Texas Gulf Sulphur. Failure to disclose preliminary drilling results of a large filed was material
c) Based on balance of Probability >> Magnitude of Event
3) Quantitative Standard
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a) Usually quantitative
b) So that issues that reflect on quality – bad management practices (small legal bribes) may not be deemed material
4) Merger Negotiations
a) Problems with disclosure is that stock price of company being acquired will increase
b) Basic: Materiality of merger depends on the CIRCUMSTANCES in each case
 Look to INDICIA OF INTEREST in the transaction at the highest corporate levels
 No particular factor or event is necessary to render merger discussions material
c) Basic REJECTS Agreement in Principle Test and Material Lie Theory
5) Market Value Statements
a) SEC prohibited market value stimates as misleading – required book value or original cost
b) But may have revisited that position
 Failure to disclose market property values when offer for shares made may be misleading
B. Cases
1) TSC Industries v. Northway(1976)-Defining Materiality under 14a-9, and 10b-5
a) Rule 14A-9 (anti-fraud in proxy solicitations) (read in tandem w/ 10B-5 – applies same standard)
b) Rule 14a-9: No proxy statement should be false or misleading---states a materiality requiremenet not what is
material
c) National Industries buys interest in TSC Industries from Schmidt. Board thereafter proposes liquidation of TSC and
sale to Natl by proxy statement to each of their shareholders. Shareholders approve and sale is completed.
d) Northway claimed proxy statement omitted material fact that purchase of Schmidt stock by Natl gave Natl control of
TSC
e) SC MATERIALITY STANDARD : material if:
 a reasonable shareholder would have considered the misstatement or omission in making his decision
 Mixed question of law and fact (raises concerns when you go for summary judgement)
 Claimed to be objective
 “An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it
important in deciding how to vote.”
 There must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the
reasonable investor as having significantly altered the “total mix” of information made available-page 705
 It need not be shown that but for the material omission, the vote would have gone the other way
f) HOLDING
 Proxy showed through information provided that Natl controlling TSC (34% interest; 5 of 10 directors)
 Here – omitted but information in other filings (10-K)
 Courts all over whether info in other filings enough
2) Lockheed
a) Bribing – small, not quantitative
b) Not material – and NOT self-dealing (would show deceit shareholder would want to put into their mix of information)
c) SEC started suing cos for these bribes – law prohibits bribing US officials,
not foreign officials (not bribes but questionable payments)
d) NOW not allowed to bribe foreign officials
Basic Inc v Levinson
- sliding scale test for materiality applies if the misstatement is about
contingent facts (like a potential merger in this case)
"contingent facts", i.el, something that may (but not necessarily will) happen
Remember: a fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important.
-Do not have to disclose information concerning merger negotiations, but if the information is material, they you cannot make a
misleading statement about it
the Basic test for materiality only becomes important when the false statement relates to "contingent facts,"
=when the relevant facts are "contingent facts", i.el, something that may (but not necessarily will) happen. Apply Basic test of materiality
The Supreme Court in Basic adopted a sliding scale test for determining the materiality of
contingent facts, that considers
(1) the magnitude/impact of the possible event and (the moreimpactful, the more material)
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(2) the probability that the event will occur. (the less likely, the more material)
=In other words, the greater the impact of the event, the less certain its occurrence must
be in order for investors to find the information important and, thus, material

-10b-5  also have to show fraud or deceit, or manipulation + 1) materiality, 2) in connection with 3) reliance
- MATERIALITY-first pleading burden that we have to
meet


Court says NO Lying does not make it material – you can lie about non-material things
MARKHAM: Silence is not a violation – absence of duty to disclose, All they have to say is “NO COMMENT,” Can’t lie and
say NO we are not negotiating then a merger happens

-CASE NOTES-If an issue is small is it material, quantity-concerns economic materiality to the company but so small in terms
of the economic terms, and qualitative- terms it might still be important to shareholders for other reasons other than
economically
Reliance = In the case of a securities market, the dissemination or withholding of information by the issuer affects the price of
the stock in the market, and investors rely on the market price as a reflection of the stock's value.


provides a causal connection between a defendant's misrepresentation and a plaintiff's injury.
this causal connection can be proved in a number of ways.
Instead of requiring any direct proof of reliance, the Court in Basic adopted what is called the "fraud on the market”
theory.

The fraud-on-the-market theory is the idea that stock prices are a function of all material information about the company
and its business.

Basic’s fraud on the market theory essentially eliminates a need to prove reliance when a public statement is
made about a stock traded on a developed securities market such as the New York Stock Exchange,
Basic Inc v Levinson
e)
f)
g)
h)
i)
j)
k)
l)
Issue: whether statements were material
–should there be dsiclosures about meetings that might discuss mergers
Interprets materiality standard for SEC 10B-5
Some company wants to buy Basic.
Rumor gets out of merger(and stock goes up) but Basic publically denies there will be a merger several times.
Shareholders sell stock relying on these misleading statements.
The merger happens
Merger stock of acquired cmpany shoots up
 This is why would they mislead about merger- they would want to keep it secret so price of stock does not go up
m) Class action for persons selling after first press release(denial) and when merger was announced
n) The plaintiffs alleged that they received a lower price for their Basic, Incl stock than they would have received if Basic,
Incl had not made false statements,
o) HOLDING
 Takes MATERIALITY STANDARD from TSC-ADOPTED MATERIALITY FROM TSC
 Requirement: Significantly alters total mix of information (is it something the investor wants to know before they
sell the stock?)



Materiality of Merger depends on the CIRCUMSTANCES in each case
 Look to INDICIA OF INTEREST in the transaction at the highest corporate levels
Information concerning merger discussions is material to stockholders
Materiality depends on the significance the reasonable investor would place on the withheld or misrepresented
information. Page 713 Middle, A fact-finder will need to consider such facts as the size of the two corporate
entities and of the potential premiums over market value. No particular event or factor short of closing the
204
transaction need to be either necessary or sufficient by itself to render merger discussions material. Page
713 above previous standard.
Supreme Court rejects 2 Merger Standards Tests
 AGREEMENT IN PRINCIPLE TEST
 3rd Circuit: Brite Line – No need to disclose until there is an agreement in principle as to price and structure
 Otherwise confidentiality of negotiations would be violated and might prejudice negotiations
 ALL LIES are MATERIAL
 The immaterial becomes material by virtue of he statement denying its existence
 The lie makes it material because it now deceives
 Court says NO Lying does not make it material – you can lie about non-material things
 MARKHAM: Silence is not a violation – absence of duty to disclose, All they have to say is “NO COMMENT,”
Can’t lie and say NO we are not negotiating then a merger happens
p) d) Concurrence and dissent (White, O'Connor, JJ.).

1] The fraud-on-the-market theory should not be applied in this case.

2] The fraud-on-the-market theory is an economic doctrine, not a doctrine based on traditional legal fraud
principles. If rule 10b-5 is to be changed, Congress should do it.

3] It is not clear that investors rely on the "integrity" of the markets (i.e., on the price of a stock reflecting its
value).

4] In rejecting the original version of section 18 of the Securities Exchange Act, Congress rejected a liability
provision that allowed an investor recovery based solely on the fact that the price of the security bought or sold
was affected by a misrepresentation. Congress altered section 18 to include a specific reliance requirement.

5] The fraud-on-the-market theory is in opposition to the fundamental policy of disclosure, which is based on the
idea of investors looking out for themselves by reading and relying on publicly disclosed information.

6] This is a bad case in which to apply the fraud-on-the-market theory. Ps' sales occurred over a 14-month period.
At the time the period began, Basic's stock sold for $20 per share; when it ended, the stock sold for $30 per share,
so all Ps made money. Also, Basic did not withhold information to defraud anyone. And no one connected with
Basic was trading in its securities. Finally, some Ps bought stock after Ds' first false statement in 1977,
disbelieving the statement. They then made a profit, and can still recover under the fraud-on-the-market theory.
These Ps are speculators. Their judgment comes from other, innocent shareholders who held the stock.
-CASE NOTES-If an issue is small is it material, quantity-concerns economic materiality to the company but so small in terms of the
economic terms, and qualitative- terms it might still be important to shareholders for other reasons other than economically
-Problem with this case is that executives always talk about merger, at What point do these discussions become material?
-Company in this case denied that they three times had merger negotiations, and the plaintiffs said they would not have sold if they knew
about the merger so they were harmed.
-Do not have to disclose information concerning merger negotiations, but if the information is material, they you cannot make a
misleading statement about it
-In order to resolve the problem, if somebody asks you the company can say NO COMMENT
-If you chose to answer the question about merger negotiations you must answer truthfully
-If it is NOT MATERIAL you CAN lie about it because we do not care at all
-10b-5, have to show fraud or deceit, or manipulation
-Have to show elements such as MATERIALITY-first pleading burden that we have to meet
-1) materiality, 2) in connection with
IV. In Connection With Purchase or Sale of Security
A. Historical Analysis
1) OLD Birnbaum Rule
a) Л class in Rule 10b-5 action is limited to actual purchasers and sellers of securities
b) 1975 Acknowledged by Supreme Court Blue Chips
 No right of private action if refrained from purchasing or exercising an option
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
No right of private action in refrained from selling
 In either case due to misrepresentations or fraud
c) PSLRA
 Now PSLRA Private Securities Litigation Reform Act of 1995 curbs abuses in securities litigation cases
brought for frivolous reasons only to coerce settlements
 Requires higher standard of “Deliberate Recklessness”
2) Small v. Fritz Rule (California)
a) Fraud gives rise to tort action of deceit
b) Tort of negligent misrepresentation does not
c) Court allowed 10B-5 action by party who RETAINED STOCK – instead of buying or selling – in reliance on false
representations
 Denies a blanket rule on nonliability (Birnham Rule)
 Analyzes as a tort fraud claim
 Forebearance = Reliance
 Fraud doer liable to those he intends to mislead
 Induced forbearance can be the basis for tort liability
d) Forbearance – the decision not to exercise a right or power -- is sufficient consideration to support a K AND to
sufficient to fulfill the element of reliance necessary to retain an action for fraud
e) One who commits fraud is subject to liability to the persons or class of person whom he intends to or expects to act or
refrain from action in reliance upon the misrepresentation
f) Notes Enron where stockholders induced to hold corporate stock by rosy but false financial reports while those in the
know exercised options or sold stock at inflated prices
three classes of plaintiffs (without actual monetary damage) that can sue
1) potential plaintiffs/purchasers dissuaded from purchases from poor news, 2) discouraged from selling for
good news, 3) shareholders who do not buy or sell but the stock price moved due to the violative activities
--the last two can be state claims
SEC v. Zandford – SC
3) Zandford Rule
a) Interpret “in connection with” requirement broadly
b) Fraud does not have to result directly from sale or purchase of securities
c) Sufficient that the fraud involves sale or purchase of securities
 Even in sale or purchases of securities themselves legal, if the fraudulent scheme involves sale or purchases of
security, that is sufficient to be in connection with
 Allows 10-B-5 action under enforceable options – even if option not exercised
The stockbroker's fraud coincided with the sales themselves, and each sale was made to further
respondent's fraudulent scheme
ISSUE: Again raised the issue of whether you’re a purchaser or seller
d) Fraud- he stole the money (the proceeds were stolen)
e) Zanford persuaded Wood to allow him to make investments for him and his granddaughter. Zanford promised to invest
Wood’s $500K conservatively but spent all the money/personal use of the proceeds(=Zandford stole it by SELLING
IT=made in connection )
f) He argued the sale was lawful
g) COURT HELD Zanford engaged in fraudulent conduct in connection with a purchase or sale of security, even though
Zanford had not actually purchased or sold securities
the Woods were injured as investors through respondent's deceptions, which deprived them of any
compensation for the sale of their valuable securities. They were duped into believing respondent would
"conservatively invest" their assets in the stock market and that any transactions made
on [****17] their behalf
Key Question is do we have a purchaser or seller?-->P/Woods did not sell but D did  Court said close enough
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Blue Chip Stamps v. Manor Drug Store – SC (Markham’s case)
Confirmed the Birnbaum Rule
OVERRULED the case law that allowed in plaintiffs that are excluded by the Birnbaum Rule (where, even if here was no
purchase or sale by P, P coulds still sue and if they facts alleged are truethen there was clearly fraud under 16(b))
NOW:
Purchaser/Seller Doctrine P MUST be a buyer or seller of the stock to fit the “in
connection with a security” requirement  to be actionable under 16(b)
REASONING
POLICY ARGUMENT
 Limit on litigation `Not limiting Л class to buyers or sellers would permit non-meritorious “strike” suits designed
to coerce settlements = Frivolous lawsuits still have settlement value to Лs  excess lawsuits would frustrate
business activity
strike suit is a lawsuit brought with the purpose of gaining a private settlement before going to court that would be less than
the cost of the D’s legal costs
h)
i)
j)
k)
l)
Birnbaum Rule confirmed by SC (these people were not buyers or sellers, but they were damaged anyway)
Do you have to be a buyer or seller of the stock? Yes
Л class in Rule 10b-5 action is limited to actual purchasers and sellers of securities
FACTS: Л taking action not because of a sale or purchase but because he REFRAINED FROM PURCHASING –
did not exercise an option or accept an offer – because of materially misleading negative statements about the
company in its offering materials
REASONING
POLICY ARGUMENT
 Limit on litigation `Not limiting Л class to buyers or sellers would permit non-meritorious “strike” suits designed
to coerce settlements = Frivolous lawsuits still have settlement value to Лs  excess lawsuits would frustrate
business activity
strike suit is a lawsuit brought with the purpose of gaining a private settlement before going to court that would be less than
the cost of the D’s legal costs
m) DISSENT
 Feels Birnbaum is an arbitrary principle of standing
 Majority exhibits a preternatural solicitousness for corporate well-being at the expense of the investing public
-CASE NOTES-Purchaser/Seller Doctrine-you have to be a purchaser or seller before you would have a right of
action under the rule
-SEC for many years tried to have the Birnbaum rule overturned without any success
-OVERRULED the Birnbaum Rule-where, even if here was no purchase or sale, if they facts alleged are
truethen there was clearly fraud under 16(b)
-Must be a purchaser or seller of securities-NOT enough to be discouraged from buying or selling the securities
-Change to Scienter Requirement-For Fraud Very Difficult
-Probably the hardest one to prosecute and the most important for the defense, all kinds of levels of intent here so need to make sure what
the substantive law calls for and the way in which the intent coincides with the scienter requirement
-Toughest Standard of All-Specific Intent-Person intended to commit fraud, willfulness-some statutes require that the conduct be
willful which contains all kinds of connotations
-Particularly in the area of Federal Securities Laws, Intent is going to be critical
-Most of the actors in these cases are secondary actors-they are usually not trying to steal money directly
V.
Scienter Requirement

A 10b-5 plaintiff must prove “scienter,” a showing that the defendant acted with an intent to “deceive,
manipulate or defraud"
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
This precludes any Rule 10b-5 liability for any defendant who negligently mislead the buyer of her stocks While the
Supreme Court made clear that thereis no liability for mere negligence, it left open the question of whether the
plaintifi’s proving that the defendant acted recklessly supports a Rule 10b-5 claim
A. Scienter – Definition
1) Scienter = 1) intent to deceive or mislead or 2) Careless/Recklessness as to truth (reckless is sufficient-even tho the
SC has not specifically adopted that)
a) Without fault or merely Negligent ≠ Scienter
b) Reckless = Scienter
c) Recklessness as to truth
d) 10B-5 clearly connotes intentional misconduct
e) Negligence=person texting and pass through the stop sign=negligence
f) Gross negligence=Person closes their eyes and stomp on gas through a stop sign =“haha look at me Im breaking the
law” even though you don't really mean it
Gross negligence "a conscious, voluntary act or omission in reckless disregard of a legal duty and of the
consequences to another party."
2) Recklessness
a) =Reasonable person would have known it was not true or misleading
b) Aka Highly unreasonable
c) Extreme departure from ordinary care
3) Private v. Govt Suit
a) Recklessness – Private Suit Standard
b) Negligence - Government Suit (SEC) – Many courts
4) PSLRA Private Securities Litigation Reform Act of 1995
a) Curbs abuses in securities litigation cases brought for frivolous reasons only to coerce settlements
b) Requires higher standard of “deliberate recklessness”
B. Cases
1) Ernst & Ernst v. Hochfelder
a) First Securities President Nay defrauded some private customers and stole their moneys. Nay commits suicide when he
bankrupts First Securities. Customers sue Ernst & Ernst accountants under 10B-5 for not auditing controls and finding
fraud.
b) Issue: had they eben negligent in not looking at the procedure for the brokerage firm—rule:-all incoming mail is
inspected before going to the brokers and all outgoing mail is inspected to prevent brokers from frauding customers
c) They had not been doing this
 Issue: Rule 10b-5 authorize this action or did it have to be something more?
d) COURT DENIES CLAIM
e) Ernst & Ernst did not have SCIENTER required for 10B-5 (mere negligence is insuffient)
f) Did not have knowledge of fraud or reckless in not knowing
g) Negligence not enough
Reklessness would be sufficient scienter for an action under 10b-5 not negligence
-CASE NOTES-SCOTUS basically said that the standard under 10b-5 is requirement of intent to deceive, manipulate, or defraud.
-The scheme here was not with the requisite intent because the accounting firm,
-This is the PONZI scheme-President said nobody open my mail, I am the supervisor, person operating on the side of the accounts,
people who gave the money were told that the money was invested in some other kind of transaction and nobody knew about it because
the president’s mail was not subject to scrutiny because he told people not to open his mail
-The investors in this case sued the company alleging that they had committed the fraud because they were negligent in the accounting
practice here because they did not provide any scrutiny of the accounts of the president
-Here Ernst and Ernst has not considered the effects of the rule imposed by the president requiring that his mail not be examined, the
accounting practice was negligent and in violation of 10b-5
-Negligence-MEANS that you did not use due care, they had no intention to defraud the investors or that they intended to help the
president in defrauding, very low standard because easy for someone to say they should have done that
-Court said language of 10b-5 requires intentional knowing conduct, way above the level of negligence, not allow an action here that
would allow negligence to be the standard
-Court said you are going to have to show scienter to establish a violation of 10b-5,
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-Problems: There are different types of scienter and the court did not decide what the standard would be?
-Negligent-Driving down the road and run a stop sign causing the accident, I did not use due care I am negligent
-Another driver sees the stop sign, closes his eyes, and speeds through, person was Reckless
-Next driver sees the stop and someone in the intersection and tries to hit the car specifically-Intentional Conduct
-All Federal Courts except the one that Counts, SCOTUS, have held reckless enough for 10b-5 violation
-Only begins the discussion because there are varying degrees of reckless behavior
-Page 730-731 Sundstrand v. Sun Chemical Language Generally accepted definition of reckless conduct
-SCOTUS-said scienter in the actions under section 10b-5 for violation
-Page 732 17(a) page 512 of the supplement concerns the differences in the specifics of the transactions
-17(a)- applies to the offer and sale of the securities meaning only originally covered the sale,
-10b-5 given for the sale also in terms of committing a fraud
-PSLRA 1995- a lot of other requirements for section 10b-5 because we want to stop the abuse of 10b-5 claims
2) Tellabs, Inc. v. Makor Issues & Rights, Ltd. (SCOTUS 2007)
a) As a check against abusive litigation by private parties, Congress enacted the Private Securities Litigation Reform Act
of 1995 (PSLRA).
b) Exacting pleading requirements are among the control measures Congress enacted in the PLSRA.
c) Pleading requirements: The Act requires plaintiff to state with particularity both the facts constituting the alleged
violation, and the facts evidencing scienter, i.e. the defendant’s intention to “deceive, manipulate, or defraud.
d) Issue: What does it mean to say that did this pleading fulfill the requirement that “plaintiffs must state with
particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” 15 U.S.C.
78u-4(b)2.
e) Issue: Whether and to what extent, a court must consider competing inferences in determining whether a securities
fraud complaint gives rise to a “strong inference” of scienter?-page 735 middle
f) Rule: To qualify as a “strong” within the itendment of 21 D(b)(2), we hold, an inference of scienter must be more than
merely plausible or reasonable-it must be cogent and at least as compelling as any opposing inference of nonfradulent
intent.
g) Holding: When the allegations are taken as true and taken collectively, would a reasonable person deem the inference
of scienter at least as strong as any opposing inference?
-CASE NOTES-Discovery was enormously expensive and large corporations usually settled because they did not want to engage in the discovery
process and the corporations were not inclined to go before the jury
-Actual plaintiffs in the case very rarely saw anything in the way of cash because the attorneys most likely took all of the fees
-Congress said this is an abuse
-1) No longer going to have the lead plaintiff be selected by first in time, rather it will be the investor with the largest stake in the matter
-Most cases going to be a union pension plans-they usually just hired the most experienced attorneys anyway
-Most attorneys engaged in some misconduct, they would have people on file who owned some stock in every major company and once
the serious matters would take place the lawyers would just slap that person’s name on the complaint, the lawyers usually paid the person
under the table and expert witness on a contingency basis which was held to be improper
-2) Once a complaint was filed 12b(6) meant discovery would not commence until decided 12b6
-3) statute said Fraud-Needed to be pled with particularity-PLSRA wanted a much more heightened pleading standard was to describe
the scienter
-What has happened is the complaints now look like a book, 200-300 pages long with all kinds of information not particularly relevant
-In the Tellabs Case-classic accounting scheme-revenues declined and the accounting and executives engaged in channel stuffing
meaning buy our products, we will buy them back and then we will be able to list them as profits now and probably not render them as
expenses later
-The pleading for fraud-must be greater than any equally logical inference of non-fraudulent behavior.
-1) Materiality, 2) In Connection with Purchase and Sale, and 3) Scienter
VI. Deception Requirement
A. Mismanagement Alone Insufficient
1) Fraud under 10B-5 must involve some deception or concealment of material information
2) Not just mismanagement or unfairness
3) Breach of fiduciary duty absent fraud is insufficient Sante Fe Industries
B. Delaware Short-Form Merger / Going Private
1) Allows stockholder corporation owning 90% or more of public company to merge sub with parent with
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a) approval of board
b) SEC: filing of information re:merger with SEC
c) SEC: 20-day notice to stockholders
C. State Right of Appraisal
1) If shareholder not pleased with offer to purchase
2) Can seek appraisal under State law instead of 10B-5
3) Could turn out better under appraisal
D. Cases
1) Santa Fe Industries (markham’s client) v. Green SCOTUS (1977)-page 737-Can’t be just a mere breach of state law
(breach of fiduciary duty in this case) , must be deception/fraud!
a) Majority stockholders used Delaware short-form merger law to merge parent with sub
 Delaware Short Form Merger: Allows shareholders owning more than 90% of a corporation to merge it with
parent without minority shareholder consent, notice of the merger must be given within 10 days of its effective
date
 Remedy wanted-injunction and revent the merger?
b) Shareholders claimed although merger legal under the Delaware short-form merger act, the action was breach of
fiduciary duty that violated 10-B5
c) Shareholders had choice
 Could sue for fraud under state law
 Or could take 10B5 action
d) Ernst-from the case above makes it clear-The claim of fraud and fiduciary duty breach in the complaints states a cause
of action under any part of Rule 10b-5, ONLY if the conduct alleged can be fairly viewed as “manipulative or
deceptive” within the meaning of the statute.
e) COURT HELD-“It is our judgment that the transaction, if carried out as alleged in the complaint, was neither deceptive
nor manipulative and therefore did not violate either 10b of the Act or Rule 10b-5. Basically that breach of fiduciary
duty was not a violation under 10B-5-page 741 middle.
f) Statutory interpretation, as in Ernst & Ernst (scienter standard), indicates that only manipulation and deception are
violations under 10B-5
g) Transaction was neither manipulative or deceptive
h) Cannot federalize portion of corporate law where state policies of corporate regulation would govern
-CASE NOTES-A lot easier to proceed under 10b-5, discovery would have been open, and the rule at the time would have been given an opportunity for
expansive attorneys fees
-morgan Stanley assessed the stock at $120
-company offered it for $150
-Some shareholders did not accept the offer and sued under 10b5 claiming this offer was a scheme to defraud (falsely stating the stock
was worth $120 even though its worth a lot more in this case went to DE (state?) court and appraisal came out to be $254 per share
rather than the $150 that was offered
-court held that state law remedy was adequate
-As it turned out the shareholders were out because there are strict procedural provisions (SOL for suing for an appraisal had passed)
Goldberg
Claim under 10b5
OP says there was no fraudulent intent and thus no COA under 10b5
Under shoembaum, disclosure was mandatory,
Under pumpkin,
They could refile
VII.
Causation Requirement
A. Two Types of Causation in financial cases
1) Transaction Causation / Reliance
a) BUT FOR CAUSATION / RELIANCE
b) =Fraudulently induced/caused the Л to enter into the transaction
2) Loss Causation
 PROXIMATE CAUSE
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 The transaction caused the loss to the Л
 Common Law Fraud Rule >> MUST PROVE DAMAGES / LOSS
3) Burden of Proof
a) Л has the burden of proof
b) By Preponderance of the Evidence
 Allows both parties to share risk of error
 More likely than not
c) Not Clear and Convincing Evidence
 A higher standard that prefers one side’s interest
 Interests of Лs in such cases significant
 Interests of Δs do not differ from other similar violations
Transaction Causation
But For / Reliance
Fraud caused > P to enter Trans
Loss Causation
Proximate Cause
Trans caused > Loss to P
B. Proving Causation
1) Where Minority Votes Needed Mills
a) Causation can be proved merely by a showing of materiality

Because
 the votes of the minority were necessary and indispensable to vote in the merger
 Defect, because it is material, has a propensity to affect the voting process
 CAUSAL RELATIONSHIP WAS SHOWN
 The proxy solicitation itself rather than the particular defect was an essential link in the accomplishment of the
transaction
b) Where Minority Votes NOT Needed Virginia Bankshares
 Theory is that false statements in proxy statement could not have caused the loss to the minority, because the
transaction would have been approved even without their minority vote
 NO BUT / TRANSACTIONAL FOR CAUSATION
 X Exception where shareholder induced by misleading proxy statement to FORFEIT A STATE RIGHT /
REMEDY (forfeiting right to appraisal or deterred from obtaining an injunction against a damaging action)
NOTES-Conduct must have caused some harm, divided into two pongs, economic loss
C. Cases
1) Mills v. Electric Auto-Lite Co
a) Causation can be proved merely by a showing of materiality
 Shareholder who seeks to set aside or enjoin a transaction because shareholder approval was solicited by a proxy
statement in violation of 14(a)(9) (analogous to 10b5) shareholder need only prove materiality to prove causation
b) LIMIT: Where minority shareholder vote (should we merge: yes, no, undecided?) is necessary and indispensable to
the approval sought in the proxy
c) ISSUE: What causal relationship must be shown between a misleading statement and the merger
d) FACTS
 3 companies were going to merge
 Companies through proxy solicitation sought the 2/3 supermajority approval of shareholders required
 Shareholder asserts corporate merger effected by a materially false or misleading proxy statement (as in Borak)
 Shareholders of AutoLite brought suit on the date before the SH meeting to approve the merger of Electric AutoLite into Mergenthaler. Claimed proxies did not state that AutoLite directors controlled by Mergenthaler.
Sought injunction against AutoLite voting proxies but did not seek a temporary restraining order and the merger
was approved.
 14A-9 action
e) PH
 DISTRICT COURT found omission was material and held hearing on the causal connection.
 Determined that YES because minority vote required
 COA: Reversed on causal relationship because injunction had not been sought,
 Employed the common law fraud test – whether the injured party relied on the representation (reliance and
transactional causation)
 Issue was to be determined by proof of the fairness of the terms of the merger: NO
f) HOLDING
 Transactional Causation: Where misstatement or omission is material, it follows the defect was of such a
character that it might have induced the stockholder to vote a particular way
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 Defect, because it is material, has a propensity to affect the voting process
Where misstatement or omission is material, causal relationship between the violation and the injury if he proves
the proxy solicitation itself rather than the particular defect was an essential link in the accomplishment of the
transaction
 Shareholders entitled to vote were necessary and indispensable to achieve the vote
 If misstatement or omission is material it follows the necessary minority relied on the statement to grant
proxies
 Assumed that the proxy given in accordance with the tenor of the solicitation (in reliance thereon / but for the
proxy they may not have…)
 Proxy solicitation is an essential link in the accomplishment of the transaction
g) BUT WHAT DO YOU DO? Merger has already occurred?
 Give monetary relief only if damage was shown
 Back down to 7th Circuit: Found merger fair – no damages

Section 7: The Causation Requirement
1. Mills v. Electric Auto-Lite Company
Facts: Petitioners, minority shareholders of respondent Electric Auto-Lite Co., brought this action
derivatively and on behalf of minority shareholders as a class to set aside a merger of Auto-Lite and the
Mergenthaler Linotype Co. (which, before the merger, owned over half of Auto-Lite's stock). Petitioners
charged that the proxy solicitation for the merger by Auto-Lite's management was materially misleading,
and
violated § 14(a) and Rule 14a-9 thereunder in that the merger was recommended to Auto-Lite's
shareholders
by that company's directors without their disclosing that they were all nominees of and controlled
by
Mergenthaler. The District Court ruled that the defect in the proxy statement was a material omission,
and,
after a hearing, concluded that, without the votes of minority stockholders, approval of the merger could
not
have been achieved, and that a causal relationship had thus been shown between the finding of a §
14(a) violation and the alleged injury to petitioners. The court referred the case to a master to consider
appropriate
relief. The Court of Appeals affirmed the conclusion, but held that the granting of summary
judgment with respect to causation was erroneous, and that it was necessary to resolve at trial whether there
was a causal
relationship between the deficiency in the proxy statement and the merger. Finding that
causation could not
be directly established because of the impracticalities of determining how many votes
were affected, the court ruled that the issue was to be determined by proof of fairness of the merger, and, if the
respondents could
prove fairness, it could be concluded that a sufficient number of shareholders would
have approved the
merger regardless of the misrepresentation.
§
the
Holding: 1. Fairness of the merger terms does not constitute a defense to a private action for violation of
14(a) of the Act complaining of materially misleading solicitation of proxies that authorized a corporate
merger.
(a) Permitting liability to be foreclosed on the basis of a finding that the merger was fair would contravene
purpose of § 14(a) by bypassing the stockholders.
(b) Imposing on small shareholders the burden of rebutting the corporation's evidence of fairness would
discourage them from the private enforcement of proxy rules that "provides a necessary supplement to
Commission action."
(c) Where, as here, there was proof that the misstatement or omission in the proxy statement was
material,
this showing that the defect might have been considered important in shaping the shareholders'
vote is sufficient without proof, which the Court of Appeals erroneously held was necessary, that its effect was
decisive.
the
the
2. In devising retrospective relief for violation of the proxy rules, the federal courts should be guided by
principles of equity.
(a) The fairness of the merger may be a relevant consideration in determining the appropriate relief, and
merger should be set aside only if a court of equity concludes from all the circumstances that it would be
equitable to do so.
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(b) Damages should be recoverable here only to the extent that they can be proved.
are
3. Petitioners, who have established a violation of the securities laws by their corporation and its officials,
entitled to an interim award of litigation expenses and reasonable attorneys' fees incurred in proving the
violation, since the expenses petitioners incurred were for the benefit of the corporation and the other
stockholders. The Court does not decide the further question of reimbursement for litigation expenses
incurred in any ensuing proceedings.
2) Virginia Bankshares v. Sandberg 10/10/18
a) Transaction Causation
b) Can a member of a shareholder class that is not required to approve a transaction prove the necessary causation?
c) Can a shareholder who is not necessary and indispensable to achieve a vote to authorize corporate action have a
private right of action for 14a9 violation?
d) False or misleading statements in a proxy solicitation will not necessarily give rise to liability in a private action by
minority shareholders
 Theory is that false statements in proxy statement could not have caused the loss to the minority, because the
transaction would have been approved even without their minority vote
 NO BUT FOR CAUSATION
e) FACTS: Unlike Mills, here the minority shareholder vote was not necessary to approve a merger, and in Mills the
Court called the proxy solicitation an “essential link in the accomplishment of the transaction.”
f) P ARGUES: In attempt to establish a causal connection
 Proxy Solicitation was nevertheless an essential link to accomplish the transaction because
 1) VBI and FABI would not have merged if they did not have minority shareholder approval – to avoid bad
shareholder or public relations – for cosmetic purposes
 Causal Connection would turn on whether-Desire to avoid ill will of minority
 Shame Facts(here it was shame facts) if they were required to disclose the facts, they would be ambarrassed
and ashamed and would not go through with that merger and could not offer the vote for that prive
 2) In the Alternative, proxy solicitation was an essential link-because it was a means to satisfy a state statutory
requirement of minority shareholder approval, to save the merger from the later attack because of a conflict of
interest on the part of one of the Bank’s directors, who voted in favor of the merger while he was also the director
of FABI.
 To bar minority shareholders from commencing proceedings to declare the merger void
 To bar them from a state remedy
RULE-in the wake of Borak and Mills-recognition of any private right of action for violating a federal statute must ultimately rest on
congressional intent to provide a private remedy.
g) HOLDING/ REASONING
 As to Ill Will Avoidance / Shame Facts Argument
 Cannot for policy reasons allow recovery on hypothetical evidence
 Would lead to speculative claims, causation based on inferences of what directors would have thought and
done
 There would be little reliable evidence
 As to State Remedy Argument
 LEFT OPEN whether it would be the same if the minority shareholders had lost a state remedy (probably
would) under 14A9
 But here there was no forfeit of a state remedy
 Under Virginia law, if the proxy was misleading, the favorable minority vote does not render the merger
invulnerable to later attack on the ground of conflict
 Forfeit of state right remedy may not be applicable to 10B 5
-CASE NOTES-Majority said they did not have to find a violation because they vote was irrelevant, the minority shareholders could
have voted and the merger would have still be approved
-Must be some causation that effects the shareholders, here there was no cause
3) Dura Pharmaceutical v. Broudo
a) Loss Causation
b) Court REJECTED 9th Circuit’s rule that loss causation is established if price on date of purchase was inflated
because of the misrepresentation
213
c) PH: District Court dismissed the complaint – failed to allege loss causation, COA reversed – finding loss causation
because price on date of purchase was inflated because of the misrepresentation
d) RULES / REASONING:
 Private right of action under securities fraud statutes and rules SIMILAR BUT NOT IDENTICAL TO COMMONLAW TORT
 Elements of Private Right of Action for Securities Fraud
 MATERIALITY Basic
 IN CONNECTION WITH PURCHASE OR SALE OF SECURITY ________
 SCIENTER (Intent / Recklessness)
 ECONOMIC LOSS
 CAUSATION
 Reliance / Transaction Causation But for causation Basic
 Loss Causation Proximate cause
e) HOLDING: 9th Circuit’s rule that loss causation is established if price on date of purchase was inflated because of the
misrepresentation IS WRONG
 NO PROXIMATE CAUSE
An inflated purchase price will not itself proximately cause relevant economic loss (we need to weed out
everything untilall were left with is misrepresentation as the proximate cause + the D caused the loss)
 Drop in price of stock could be the result of various factors, not limited to the earlier representations
 Change in economic circumstances
 Changes in investor expectations
 AND the greater the time between purchase and sale – the more likely other factors caused the loss
 As in common-law tort, losses do not afford any basis for recovery where brought about by business
conditions or other factors
 Anti-fraud securities statutes are not broad insurance against market losses
 Must establish traditional elements of loss and causation
 PSLRA Private Securities Litigation Reform Act requires explicit facts in securities fraud complaints
 Specify each misleading statement
 Facts on which belief of fraud formed
 Facts that support the mens rea of deceit
-CASE NOTES
-Causation Must be for Economic Loss and Proximately Cause
-Here the claim was made was that the price was artificially inflated, but the only relevant inquiry was whether the loss was actually
caused by what the defendant did?
-Incredibly complex standard of proof to show that the people caused the loss, meaning actually loss and the loss was caused by the
defendant
-SCOTUS said no to this type of analysis, first get through all of the elements and then see if you are going to have any kind of economic
loss, once you show a loss, you are going to have to show that the wrongful conduct was the actual cause of the LOSS.
VIII.
Reliance Requirements
A. Presumption of Reliance
1) Must show reliance on misrepresentations or omissions for Transaction Causation
2) Basic v Levinson (materiality case) allows presumption of reliance based on the Fraud on the Market Theory
a) Presumptions allowed where firm evidence would be difficult to obtain
b) How do you prove you relied? Did or did not read prospectus? Did or did not know of misrepresentation?
3) Fraud on the Market Theory Basic
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a) Chicago School of Law Theory – Market reflects information in the market
 Market is efficient and will discipline or reward you
 Don’t need fiduciary duty – market will take care of you
b) Market translates a misrepresentation from voice to price
c) THE THEORY: Where securities sold in a well-developed market, all purchasers or sellers of stock rely on the
integrity of the market and that the market price reflects true value of stock
 Where materially misleading statements have been disseminated into the market the reliance of individuals on the
integrity of the market price may be presumed
 Л may establish reliance on the integrity of the market
 May be defrauded even if they do not directly rely on the information
4) How to Rebut Presumption of Reliance based on Fraud on the Market
a) SEVER THE LINK between misrepresentation and price
 Market makers knew truth and adjusted price
 News of truth had disseminated into the market and price adjusted
5) Eckstein / Shores – Fraud Creates the Market
a) Fraud on the market assumes here is a market to defraud
b) What if securities are not publicly traded?
c) Ecksteins argue
 Company’s offering contingent on its ability to raise $35M
 MINIMUM SALES REQUIREMENT serves 2 functions
 Ensuring the Co has needed capital to function
 Vicarious protection to ignorant investors – who assume that if that condition met a significant number
of informed buyers think it is a good investment – ignorant rely on that
 If Co had been truthful it would not have been able to raise the required capital and they would have gotten their
money back
 Their fraud created the market
 6th and 7th Circuits reject this theory
d) 5th Circuit in Shores and 10th and 11th circuits accept similar theories
 If the fraud permits the securities to exist in the market and the investors relied on their existence Shores
B. Omission v. Misrepresentation (or Commission)
1) Omission – presumption of direct reliance
a) But not based on Fraud on the Market Theory b) Presumption can be rebutted by showing Л did not directly rely on the omission
c) Omissions by corporate insiders are NOT rendered immaterial by dissemination of the truth into the market
place
d) If P actually and directly relied on the omission – it does no mater hat the market is aware of the truth
2) Misrepresentation – presumption of indirect reliance based on Fraud on the Market Theory
a) D’s failure to disclose information is excused where the truth has made its way into the market by other reliable
sources so that the price is adjusted
b) At that point, P’s reliance on the market has not hurt him because the market reflects the truth or full facts
c) Press must be intense and credibly sufficient to counterbalance any misleading statements made by corporate insiders –
not if only brief mention in poorly-circulated publications
-Class Notes Starting 10/31/11
-
C. Cases
1) Basic v. Levinson
a) Basic allows presumption of reliance based on the Fraud on the Market Theory/ fraud-on-the-market theory
 Where materially misleading statements have been disseminated into the market the reliance of individuals on the
integrity of the market price may be presumed
 D can rebut this presumption by showing the shareholder disbelieved it (we thought they were lying)
215

In essence, an alternative to reliance to prove causation to support recovery by investors who never read the
deceitful statement
b) FACTS: Shareholders claim Basic’s denial of merger negotiations was a 10B5 misrepresentation. Court here looks at
the reliance element for transactional causation
c) RULES/REASONING
 More than one way to demonstrate reliance – does not always have to be direct
 The Court relies on the Fraud on the Market Theory to find a presumption of reliance
 Where securities sold in a well-developed market, ALL purchasers or sellers of stock rely on the integrity of
the market and that the market price reflects true value of stock
 Who would roll the dice in a crooked craps game?
 PRESUMPTIONS created by courts where direct evidence would be difficult to obtain
 How do you prove you relied? Did or did not read prospectus? Did or did not know of misrepresentation?
 Unlike common-law fraud – often face to face – the modern securities markets differs and 10B5 reliance
requirements must encompass these differences
d) HOLDING:
 Based on the Fraud on the Market Theory, Л may establish reliance on the integrity of the market
 May be defrauded even if they do not directly rely on the information
e) DISSENT
 FOTMT is just a theory
 Majority accepts the FOTMT with confidence usually reserved for mature, established legal doctrines – dissent
rejects
 Not the job of the courts to employ recent economic theories to better fit new realities of financial markets – that is
better left to legislatures
 Does not believe all buyers and sellers of securities rely on the integrity of the market to reflect true price of stock
 Much stock investment and trading is based on belief or hope that price inaccurately reflects the corporation’s
worth
 Majority’s rule may create an investor insurance scheme
 Also had problem with the lengthy class period (Лs sold stock over a 14-month period)
f) None of the officers or directors bought stock – insider trading – so what are we suing them for?
-CASE NOTES-Reliance 1) have to be concerned with omissions and commissions
-When the fraud is an omission-the RELIANCE would be presumed because it is like proving a negative (prove that each of those
shareholders relied on that misrep. (eg they read the newspaper) And that would end cclass actions)
-Court in Basic found economic theory that markets are efficient and the prices will reflect all available public information
-If you put in bad information the market will reflect it including the fraud
-Will be rebuttable presumption for the people in the market, controversial theory and for the SCOTUS to rely on the theory is unique
-Market will discipline everyone basically, anybody putting flase information in there will be punished by the market
-SCOTUS had a unique interpretation saying since the information was put in the market, we can presume people rely on the overall
information of the market
-Court will presume reliance on Omissions and Affirmative Misrepresentations-Rebuttable Presumption
-Presumption of Reliance-for Omissions and Affirmative Misrepresentations-presume you would not have acted in a way if you knew
the information, shifts the burden on the defendant to prove that you did not actually rely on the omissions or the affirmative
representations of the corporations
-Justice White’s Dissent-Not appropriate to base a rule of law on a untested economic theory
-Basic v. Levison is the oddity or the outlier because Chicago School of Economics does not really provide for this theory
-Rare intrusions where the school of thought is that the markets will take care of the efficiency of everything, not to be judicially
imposed as is the norm
2) Apple Computer
a) Omission v. Misrepresentation
b) FACTS
 Лs allege, based on fraud on the market theory, that they relied on and where misled by the statements of Apples’
officers and directors about the future success of Lisa and its disk-drive sysem Twiggy. Lisa was a computer
marketed for commercial use that employed new input technologies: the mouse and the graphic interface.
Although the company made many positive statements about the success of Lisa, Lisa was highly scrutinized by
the press and there were a least 20 highly-publicized reports about the risks and underlying problems with Lisa.
c) PH:
 Δ’s MSJs granted.
 Disclosures of risks by the press rendered the omissions immaterial
216

Ps contend the trial court misapplied the standard for materiality in a FOTM case
 Notwithstanding the press – omissions material because a reasonable investor would place greater weight on
insider opinions NO
d) REASONING
 Claim-we should just rescind the contract
 Court syas this is an imprecise measure-we need to lok at out of pocket losses-what did you pay for it and what did
you get for it?
 Court distinguishes between omission and misrepresentations and the effect of news on P’s reliance
 Omission – presumption of direct reliance
 But not based on Fraud on the Market Theory
 Presumption can be rebutted by showing Л did not directly rely on the omission
 Omissions by corporate insiders are NOT rendered immaterial by dissemination of the truth into the
market place
 If P actually and directly relied on the omission – it does no mater hat the market is aware of the truth
 Misrepresentation – presumption of indirect reliance based on Fraud on the Market Theory
 D’s failure to disclose information is excused where the truth has made its way into the market by other
reliable sources so that the price is adjusted
 At that point, P’s reliance on the market has not hurt him because the market reflects the truth or full facts
 LIMIT ON EXCEPTION: Press must be intense and credibly sufficient to counterbalance any misleading
statements made by corporate insiders – not if only brief mention in poorly-circulated publications
 Here 20 reports, including reports in Business Week and the Wall Street Journal disclosed the risks
e) HOLDING
 As to Twiggy
 Insiders knew disk drives were slow and unreliable and did not disclose
 These problems were not disclosed by the press or otherwise
 Triable issue – Reversed MSJ and remanded
 As to Lisa
 Intense press corrected market price so there could be no reliance based on the fraud on the market theory
 Affirmed MSJ
f) REMAND : Although jury found two officers liable under 10B5, Judge entered JNOV because the officers lacked
scienter
-CASE NOTES-Reliance interplays with causation, if you did not rely on the statement it is very difficult to prove that the statements
caused the economic loss if the plaintiffs can even show that loss
-
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IX. Litigation Reform Act
A. PSLRA Private Securities Litigation Reform Act designed to prevent abuses in classa ctions under 10b5
1) Purpose
a) enacted to cut down on fraud strike suits
b) to deter opportunistic private Лs from filing abusive securities fraud claims
c) Tried to make losing party pay prevailing party’s attorneys fees but this did no fly
2) Heightened 10B5 Fraud Pleading Specificity
a) Requires fraud be pled with specificity – explicit facts in securities fraud complaints
 Specify each misleading statement
 Facts on which belief of fraud formed
 Facts that support the mens rea of deceit
 Strong circumstantial evidence of DELIBERATE RECKLESSNESS or CONSCIOUS MISCONDUCT
3) Lead Л
a) Lead Л must be largest shareholder
b) Problem because this put institutional investors in charge of case
 Most institutions had little interest in pursuing this litigation
 But state and union pension funds did and became professional Лs
 Have used this power to pursue their political agendas
-MARKHAM NOTES FOR THIS PSLRA
-1) Heightened pleading requirements, plead with particularity the facts alleging the fraud, plead with particularity scienter, race to the
court house over because the lead plaintiff or lead attorney was given to the shareholders with the greatest share
-Plaintiffs tried to go over to state court instead to avoid all of this Congress acted again to bring the claims back into Federal Court if
they involved a publicly traded company
-Largely ineffective, particularity has become a 300 page complaint, settlements still largely given to the lawyers for legal fees and the
investors who were defrauded did not get much of anything
-Big part of litigation in Federal Courts still
B. SLUSA Securities Litigation Uniform Standards Act
1) Лs were filing securities fraud actions against public companies under state law in state courts to avoid the PLSRA
heightened pleading standards
2) To avoid this circumvention, SLUSA enacted
3) No class action against a covered security for omission or misrepresentation may be brought in state court – must be
brought in federal court under federal law.
4) Pre-empts state court action
5) X Exceptions:
a) Class actions with 50 or fewer members
b) Shareholder derivative actions
c) Delaware Carve-Out: actions based on law of state where issuer incorporated
d) Actions brought by a state
C. Cases
1) Silicon Graphics 9th Circuit
a) Interpreting PLSRA
b) ISSUE: What must P allege/prove to satisfy the PLSRA pleading requirement that he state facts giving rise to a
strong inference of the required state of mind?
 Strong circumstantial evidence of DELIBERATE RECKLESSNESS OR CONSCIOUS MISCONDUCT
 Must be intentional and knowing, not just showing motive and opportunity
 Believe recklessness is intentional and not just negligent
 Relies on Ernst & Ernst v. Hochfelder (10B5 requires recklessness, not just negligence)
-CASE NOTES-Requires specific facts that plaintiffs to plead particular facts giving rise to a strong inference of deliberate recklessness
-Pleading state of mind is the hardest thing to do for a lawyer
-PSLRA-puts its almost into intentional conduct, we need specific evidence to show that someone was intending to commit fraud
-VBI v. Sandberg (SCOTUS, 1991)-Starting on page 791
-What is an opinion worth? Are opinions actionable fraud? Is that the kind of thing people rely on and constitutes fraud and deceit?
-BOD said it is our opinion shareholders is that the stock value is a good value for the interest
-SCOTUS asked are the statements MATERIAL? Maybe, opinions can be actionable because a reasonable shareholder would rely
-Still have materiality and an actionable statement even though the statement is couched in terms of an opinion
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Deliberate Recklessness - More towards specific intent rather than mere negligence
Plaintiff appealed an order of the United States District Court, dismissing securities fraud class action against
defendant corporation for failure to state a claim, and for failure to plead as required by the Private
Securities Litigation Reform Act of 1995, 15 U.S.C.S. § 78u-4(b)(2).
OVERVIEW: Plaintiff brought a securities fraud class action suit against defendant corporation and officers,
alleging that defendant's officers made misleading statements to inflate stock value and then engaged in
insider trading in violation of the Securities Exchange Act of 1934 §§ 10(b) and 20A, 15 U.S.C.S. §§ 78(b)
and 78t-1, and 10b-5. The district court dismissed for failure to state a claim and entered summary
judgment in favor of defendant's officers. On appeal, the court affirmed. A private securities plaintiff
proceeding under the Private Securities Litigation Reform Act of 1995, 15 U.S.C.S. § 78u-4(b)(2) must plead
specific and extensive facts amounting to strong circumstantial evidence of deliberately reckless or
conscious misconduct. The district court did not err in finding that plaintiff's contentions in the complaint did
not establish a "strong inference of deliberate recklessness"; they were insufficiently specific and particular
to support such an inference. The court affirmed the dismissal of the action; plaintiff failed to adhere to
pleading requirements because allegations were not specific and did not demonstrate a "strong inference of
deliberate recklessness"; the court affirmed the grant of summary judgment to defendant officers.
X. Projections – predicting the future of your company
A. Generally
1) What happens when projections wrong?
a) Want management and analysts to make projections
b) But if wrong, management gets sued
c) SEC and Courts say – we need that information w/o worrying about getting sued
2) BeSpeaks Caution Doctrine Trump
a) Safe Harbor for Projections: a company can make projections without liability if they bespeak caution –“we could be
wrong, this is our best judemenent, so take this with caution” When an offering documents’ projections are
accompanied by cautionary statements such projections cannot form the basis for a securities fraud claim
b) CAUTIONARY LANGUAGE renders the omission or misrepresentations immaterial
 Negates any potentially misleading effect and statement LACKS MATERIALITY
c) It must be tailored precisely to the projections P challenges – not blanket/boilerplate
d) X Unless those statements affect the total mix of information
e) Codified in PSLRA
3) Reasonable Basis for Forward Looking Statements
a) If projections or forecasts are founded on a reasonable basis they will NOT violate 10B5
4) Duty to correct v. Duty to Update Stransky cases are all over the lot
a) Duty to correct >>> Historical Statements YES Backman v. Polaroid
 Historical statement that at the time the company believes is true but later discovered information proves false
 Misleading when made >>> but party did not know then
 Company must correct statement if statement still alive and not stale (still material)
 COURTS NOT CONSISTENT – on whether you have to correct if a subsequent event changes
 Other courts may require duty to update projections – as we are moving towards continuous disclosures
b) Duty to update >>> Future Projections > NO
 Projections (forward-looking statements) that become untrue because of subsequent events
 Not misleading when made >>> subsequent events change it
 Company does NOT need to correct
5) Statements of reasons, opinions, or beliefs are/may be ACTIONABLE
a) They are statements with respect to material facts that can be proved by objective evidence outside Л’s control
 Matters of corporate record subject to documentation that can be supported or attacked by evidence of historical
fact outside a Л’s control
 If there are no such facts supporting -- they are misleading
 HOWEVER Mere disbelief or undisclosed motivation -- because it CANNOT be proved by objective evidence
-- will NOT suffice for liability under 14A9
 If statement was not true and directors knew it – liability
 If value was not high but directors believed otherwise – no liability
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-CASE NOTES FOR PROJECTIONS:
-“I say as CEO I project a good fourth quarter because of X, and I project that we will make 4 cents a share”
-We do not want this to be actionable because we want the CEO to be able to say that to generate business
-Safe Harbor on these statements-Have to may the bespeaks caution language specific to the statements, not boilerplate
B. Cases
1) Stransky v. Cummins Engine
a) FACTS
 Cummins made optimistic projections or statements about future performance that turned out to be otherwise.
Stransky claims Cummins received information after the projections that made those statements untrue and failed
in its duty to update/correct its projections
 Cummins, who make diesel engines, was forced due to EPA emission standards, to redesign its engines. Because
of this rush there were design problems and warranty costs (to repair or replace defective engines under warranty)
were higher than normal. Stransky alleges Cummins failed to update its projections accordingly.
b) PH:
 District Court dismissed Stransky’s claim of what it labeled “a duty to supplement” because it felt the warranty
costs did not render the statements false (because they were not within the scope of the statements made).
 District Court also held Stransky had forfeited his alternative legal argument that the statements were fraudulent.
c) HOLDING:
 Court of Appeals focuses here on the duty to correct – distinguishing it from the duty to update
 Some courts had recognized, as other methods to demonstrate 10b5 fraud claims – 1) a duty to correct and 2) a
duty to update
 But because of current state of law, they are confused or otherwise not distinguished – and should be
 Duty to correct >>> Historical Statements YES Backman v. Polaroid
 Historical statement that at the time the company believes is true but later discovered information proves
false
 Company must correct statement
 Duty to update >>> Projections > NO
 Projections (forward-looking statements) that become untrue because of subsequent events – we told
everybody it was a projection subject to future events
 Court reversed, Held that, although Stransky or Court may have mislabeled his allegation -- as a duty to update a
projection, rather than as a duty to correct a historical statement
 Cummins could have a duty to correct historical statements and Stransky therefore had a valid cause of action
on which to proceed
 Court also held that Stransky did not forfeit his alternative legal arguments and could proceed on those as
well.
2) Donald J. Trump
In re Donald Trump Trumpo said allegedly misleading things tried to get people to invest in Taj Majal casino
Facts: Plaintiffs appealed the orders of the United States District Court for the District of
New Jersey dismissing
plaintiffs' complaints under the Securities Act of 1933 and the
Securities Exchange Act of 1934 for affirmatively and
materially making misleading
statements and omissions in a prospectus accompanying the issuance of bonds. Plaintiff
investors filed an action against defendant developers and accountant for violations of the
federal securities laws and
state law for fraud, misleading statements, and omissions in a
prospectus for the issuance of bonds. The court dismissed
the securities claims, holding
that sufficient cautionary statements were included in the prospectus. On appeal, the court
affirmed, holding that the district court had authority pursuant to the Judicial Panel on
Multidistrict Litigation, 28
U.S.C. S. § 1407, to issue dispositive orders. The doctrine of "bespeaks caution" allowed dismissal as a matter of law because the
prospectus contained abundant and meaningful cautionary language that negated any material misrepresentations. Nor did
the prospectus omit facts that were material. The prospectus went to great lengths to alert plaintiffs, as reasonable investors, to
specific risks and the magnitude of the project. The securities laws did not create liability for breaches of fiduciary duty or
mismanagement.
Holding: The court affirmed the dismissal of the securities claims, holding that abundant
and meaningful cautionary
language contained in the prospectus negated any misleading
statements or omissions to a reasonable investor.
Notes:
-Fixed Caution Doctrine if there is specific text that forecasts predictions, these statements
should not be relied upon.
-junk bond with a lot of cautionary language (don't know how much we will make with the casino, but these are our projections). Court says if you've been
warned in that manner then there is no causation – can't rely on statements you've been told not to rely upon. Court also
cautions that you can't get away with a
boilerplate saying you can't rely on this – you must tailor the statement to something more specific.
c. If the SEC requires an issuer to make qualitative or evaluative statements, the question arises,
whether, and under what circumstances, a
statement of opinion can be considered a materially misleading statement of fact.
a) No details or facts
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b) Claim is for securities fraud, for a misrepresentation or omission in its prospectus regarding its ability to repay bonds
(Revenue from Taj Mahal Casino will cover debts)
c) Court applies the bespeaks caution doctrine to dismiss the claim
 Bespeaks Caution Doctrine : When an offering documents’ projections are accompanied by cautionary
statements such projections cannot form the basis for a securities fraud claim
 Cautionary language renders the omission or misrepresentations immaterial
 Negates any potentially misleading effect
 X Unless those statements affect the total mix of information
 It must be tailored precisely to the projections P challenges – not blanket/boilerplate
d) HERE cautionary language was abundant and meaningfully directed to the projection challenged regarding repayment
of the bonds. And V – negated misleading effect.
-CASE NOTES
-Court held not fraudulent even though wrong, because there was enough language in there to warn the investors
-You do not have to be accurate in predicting the future, as long as you tell people that is what you are doing trying to predict the future
3) Virginia Bankshares v. Sandberg
a) Parent bank wants to merge into one of its banking subsidiaries a bank it controls with 85% interest. It hires an
investment banking firm to price the stock and the stock price for the merger is set at $42 per share. The proxy
solicitation for the proposed merger stated the minority shareholders would achieve a “high” value and that the merger
terms were “fair”.
b) Л Sandburg did not give the requested proxy and after approval of the merger filed a 14a9 securities fraud action
seeking damages
c) HOLDING
 1) Statements of reasons, opinions, or beliefs are MATERIAL
 Shareholders will think it important to know what directors think or believe
 “substantial likelihood a reasonable shareholder would consider it important in deciding how to vote:
 2) Statements of reasons, opinions, or beliefs are may be ACTIONABLE under 14A9
 A) They are statements with respect to material facts
 Can be proved by objective evidence outside Л’s control
 Matters of corporate record subject to documentation that can be supported or attacked by evidence of
historical fact outside a Л’s control
 B) Fact that no specific dollar value was stated does not matter
 The conclusory terms “high” and “fair” are nevertheless understood to have a factual basis that makes
them accurate
 If there are no such facts supporting -- they are misleading
 Л has a cause of action he should be allowed to prove
 Court distinguishes
 HOWEVER Mere disbelief or undisclosed motivation -- because it CANNOT be proved by objective evidence
-- will NOT suffice for liability under 14A9
 DISSENT summarizes majority rule
 If value was not high and directors knew it – liability
 If value was not high but directors believed otherwise – no liability
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XI. SELECTIVE DISCLOSURE
A. Selective Disclosure to Financial Analysts
1)
2)
3)
4)
At least one financial analyst following big company and will tell clients whether or not to buy or sell the stock
Will come up with CONSENSUS ESTIMATES
Always like to get a leg up, visit company and get SOFT INFORMATION (trying to predict information)
Financial analysts would Walk around the plant and Talk to the employees and If everybody happy – good ; talk to
employees ; get context to #s
a) SEC objected to this process – they felt these guys were given special treatment—they were given entitled info when
other investors were not
B. SEC Regulation FAIR DISCLOSURE -prohibits soft information disclosure
1) If comp wants to disclose info to financial analysts, It must do so to all analysts—give equal access to information—
no investor should have info not available to all (how to do this: comp should host an internet conference for anyone
to join)
2) When you make an announcement you have to make it publicly not selectively
a) To public, not just to the one analyst
b) SEC says you are making SELECTIVE DISCLOSURE when you give that financial analyst this information
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c)
d)
e)
f)
Information is the lifeblood of the securities markets
Management now has to do teleconferences
SEC theory used in insider trading actions
Financial analysts now have less of an edge >they cant pick up info on their own > became investment bankers through
their financial reports
3) Applies to communications
a) by senior management, its investor relation professionals and security holders
b) to market professionals and the company’s securities holders
 X press, rating agencies and ordinary business with customers and suppliers
c) where foreseeable security holders will trade on the basis of the information
 Material
 Non-Public
4) Other Aspects of Rule
a) Only a disclosure rule - Does not create civil liability for fraud
b) No Private Right of Action - Only SEC can enforce
c) Requires Intentional or Reckless Conduct
d) X Does not apply to:
 Original issues
 Foreign issuers
C. Separation of Research /Analysts from Investment Banking (Offerings)
1) World Com and AT&T – Jack Grubman of A
-SELECTIVE DISCLOSURE NOTES
-Soft Information largely at issue here, just a feel, are people busy at the company, is there a change in management, etc.
-Financial Analyst give you a feel for the company, but the SEC did not like that, they want everybody to have the same information
-Particularly concerned with financial analyst, the executives at the company would tell the analysts that they were friends with, the
analyst would then tell their investors and it looks all too close to the insider trading schemes
-Regulation FD prohibits companies from providing information to analysts without providing same information to everyone, it's a JOKE
according to Markham
-Created a problem for financial analysts, nothing to contribute to the process anymore, instead of becoming investigative reporters they
then became more interested in obtaining more information outside of their official capacity, and basically advising their clients on their
own feel and notions of the companies, leads to easy manipulation of the market because the people actually investing were largely
taking their word for it
-
XII.
SECONDARY LIABILITY
A. Aiding and abetting
1) SCOTUS Private party has no private right of action for aiding and abetting under 10B5 (no action for banks,
accoutnants, lawyers)
2) Congress ALLOWS ONLY SEC to bring action for aiding and abetting
B. Cases
1) Central Bank v. First Interstate Bank SCOTUS
a) FACTS: Л claims respondent liable under 10B5 for aiding and abetting in the violation.
b) HOLDING / REASONING
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
The Supreme Court held that private Л may not bring Rule 10b-5 suit against Δ for aiding and abetting
 Statutory text controls the definition of prohibited conduct –
 No cause of action for acts not prohibited by text of § 10b
 Rule’s inclusion of fraudulent conduct committed "directly or indirectly" within scope of prohibited conduct,
§ 10(b) does not cover aiding and abetting liability.
 If Congress assumed to impose liability for aiding and abetting under 10b5 it would have stated so
 Survey of express causes of action in the securities act reveals that each specifies the conduct for which Δs
may be held liable – none of which impose liability for aiding and abetting
 Congress enacted 18 USC 2 imposing liability for general Aiding and Abetting in Criminal Offenses and
Restatement of Torts recognizes liability for aiding and abetting under tort law
BUT Congress has not enacted a general civil aiding and abetting either for government or private suits
 FINALLY policy considerations do not follow the objectives of the statutes so they are better served.
 That Congress has chosen to impose some forms of secondary liability, but not others, in securities laws indicated
deliberate congressional choice with which courts should not interfere
 Joint and several liability is a problem under this statute as well
-SECONDARY LIABILITY NOTES
-Most secondary actors are not going to have the requisite intent to commit whatever kind of fraud is involved
-Lawyers, accountants, bankers, all who may be involved in the transactions but did not perform the transactions
-Think about aider and abettor as the wheel man for the other bank robbers, you did not actually rob the bank but aided by driving away
when the others robbed the bank in criminal law that is enough
-10b-5 private actions, you did not make the fraudulent statement yourself but you aided and abetted the person who did put the
statement
-They could not have done the fraud without the lawyers, bankers, and accountants
-Private Party cannot maintain a suit for damages, SEC can only bring the suit not private litigants
-Push back from secondary liability in going after deep pockets
-Aiding and Abetting is not going to be sufficient to include these people in secondary liability
-Not going to get to the deep pockets in aiding and abetting liability, need to show direct participation in the fraud
-Lawyers said ok, instead of aiding and abetting, we will charge you as a “participant in the scheme”, making you liable in 10b-5
-Called Scheme Liability Defined on page 819 at the bottom
-Very successful particularly for the banks that were involved in ENRON, then question finally made it to SCOTUS in next case
Stoneridge Invetsment v. Scientific Atlanta (SCOTUS, 2008)-page 816
-They knew what they were doing was dressing or cooking the books in order to mislead their investors
-Problem was the company had not duty to disclose to the investors, meaning the lawyers, accountants, or bankers had no duty to the
investors whatsoever
-If there is no duty to disclose there is NO violation which is pretty much the standard that is not controlling in SCOTUS
-Important because it cuts off access to the deep pockets-cuts off liability to the “aiders and abettors” not able to use scheme liability
because they had no duty to disclose
-Big Hurdle in bringing a 10b-5 case
XIII.
PROFESSIONAL RESPONSIBILITY
A. Actions Against Lawyers for Fraudulent Filings
1) ____________________________
2) Attorneys say we are only advisors, we cannot tell our client what to do
3) SEC says no if your client is doing something wrong, you have to disclose
a) ABA and attorney concern over confidentiality
b) SEC says no confidentiality for past crimes but for future crimes
224
4) Brownwood
a) Action against 2 respected lawyers
b) SEC punted – this is a mess, we don’t know what to do with this and are going to leave it alone
c) We are not going to police attorneys anymore UNTIL
5) Then came Enron and World Com widespread problems in this accounting statements
a) Assets were being inflated, employees lost their pension funds, bankruptcty, etc.
b) Where were the lawyers? The accountants?  They didn’t stop this – they facilitated this
c) No BAR has sanctioned any of these lawyers for Enron
d) 40 Professors did round-robin letter to Congress to ask Congress to change laws requiring lawyers to report
violations of securities laws
e) SEC given authority to create these rules requiring lawyers to report client violations of securities laws
 Lawyer has duty to be report securities wrong – starting at supervisor … to board
 If board will do nothing must make a NOISY WITHDRAWAL – SEC filing LATER DROPPED
 But do not have to disclose what the violation is …
 LAWYERS have duty to POLICE CLIENTS but unknown standard
 Very difficult to comply with
-SEC says it can bar lawyers from practicing before it if they engage in misconduct
-SEC did not really every enforce that rule until the 1970s
-Lawyers and Accountants considered to be the “Gatekeepers”-meaning we should protect the public when a OUR client might defraud
them
-Preferred role for the lawyers is we give advice to the client and they can chose to follow the advice or not
-SEC says no you need to do more than that
-Lawyers fought back and finally SEC let go because too difficult to convict lawyers of anything, they fight that to the death
-Then came ENRON-to date no ENRON lawyer has been convicted of anything, few outside lawyers settled for peanuts, no proof of any
misconduct on the lawyers, but the perception was there
-Under the Sarbanes-Oxley Act of 2002-the attorneys were required to report violations to a board committee composed entirely of
outside directors if the companies own people will not take it seriously or take no action.
-SEC loves to sue lawyers, amazing how many are out there
XIV.
STATUTE OF LIMITATIONS
A. Congress 10B Statutes of Limitation 2/5
1) 2 Year from date of discovery
2) 5 Years from date of repose (from date of second transaction) SCOTUS Says this is for the SEC-SEC cant impose sanctions
5 yrs past discovery of these violations
B. Insider Trading Limitation 20a -trading on info that is not publically available
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1) 5 years
C. Cases
1) Lampf v. Gilbertson
a) Which statute of limitation is applicable to private suit under 10B5?
b) RULES
 When Congress has failed to provide a statute of limitations for a federal cause of action, the court “borrows” the
local time limitation most analogous to the case – STATE-BORROWING DOCTRINE
 X When state limitations period frustrate policies of federal statute instead look to federal law if it is a
better fit
 States had looked at state fraud laws – so they were not uniform
c) REASONING
 Look at federal statute – how did Congress limit similar and related protections?
 Securities Exchange Act generally adopted for express causes of action
 1 Year from date of discovery
 3 Years from date of repose
 Eliminates disparities in state-law based limitations
 Rejected-Doctrine of Equitable Tolling was Rejected
 SEC’s desire for a 5-yr statute of limitations (same as for insider trading)
 Doctrine of Equitable Tolling – bar of the statute does not begin to run until the fraud is discovered
 Doctrine of Equitable Tolling-does not apply to 10b because it frustrates the purpose, equitable tolling says
that the party injured by the fraud does not begin the statute time until he discovers the fraud, the Court
rejected that idea to say that it is inconsistent with the 1 year 3 year provision they decided today.
 Holding: Litigation under 10b MUST be commenced within 1 year of discovery of the facts that
constitutes the violation, and within 3 years after the violation actually occurred.
-NOTES
-Incredibly Short Period of Time, about a year before the fraud gets to the office, and about a year to figure out what the hell the fraud
was?
-Congress has amended the statute to 2-5 Year Limitation still very short
-RECAP
-Private Action Under Rule 10b-5
-1) Deceit
-2) Materiality
3) Scienter
4) Purchase or sale of a security-“in connection with”
5) Causation –economic loss and proximate cause
5) Reliance-reliance presumed under efficient market, omission
6) Last one
-Plus we have the PSLRA in terms of the heightened pleading requirements
-And a very short Period of Statute of Limitations
CLASS NOTES starting 11/2/11
-Insider Trading 1) Common Law Rules, 2) Section 16-designed to deal with inside trading, 3) SEC effort to expand under 10b-5 for
insider trading
CHAPTER 14 INSIDER TRADING AT COMMON LAW
I.
XXXXXX
Basic Problem
A. Possibility that insider has an UNFAIR ADVANTAGE
1) Because he knows facts about corporation that are not known to others with whom he deals
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And he knows these facts only because of his fiduciary duty
Officer or director who purchase or sell stock based on information withheld from others
Common Law Rules
A. Early Cases
1) Laidlaw v. Organ 1817-common law:
2)
3)
II.
Facts: Organ purchased 111 hogsheads of tobacco (111,000 pounds) from Laidlaw Co. on February
18, 1815. The purchase was made between 8 and 9am on the same day that news
broke that a
peace treaty had been accepted between America and Britain lifting a naval embargo that drastically
affected the price of tobacco by 30 to 50 percent (Treaty of Ghent).
Organ was aware of the lifting
of the embargo while Laidlaw was not. During the discussion of
the contract Organ was asked
he was aware of any reasons for the price to be higher. Organ stayed silent over the news of the
embargo lifting. Two days later, on the 20th, Laidlaw & Co. repossessed the tobacco by force from
Organ. Organ filed suit for breach of contract to regain the tobacco or be awarded damages.
Guy did not tell him there was a settlement.
corporate insider did not ordinarily violate his fiduciary duty by insider info dealing
a) Purchaser under no obligation to disclose facts unknown to seller that may affect value of property
b) No duty to disclose info about commodities youre buying or selling!!!
c) But you cannot deceive/mislead/lie to someone. If asked you must be truthful.
d) Economic theory of rewarding those who bring information to the market
e) FACTS: Purchaser agrees to by tobacco at certain price. Purchaser knew but Seller did not know about peace treaty
that would raise price of tobacco (it would skyrocket). Buyer rushed the purchase through.
f)
HOLDING: Justice Marshal says; No duty to disclose ; No fraud liability for "mere silence"
-CASE NOTES-Cannot misrepresent, but there is NO affirmative duty to disclose
-Insider Trading-Commodity Markets-there is no insider trading restriction, in fact we urge you to find outside information and make a huge profit, we
want to do that because the information brought to the market is to provide price efficiency, and the more information we provide to the
market the better the price and for all consumers-Congress has adopted a provision into the commodity exchange act which adopted the
laidlaw rule for commodities trading markets (no misleading, don't need to disclose nonpublic info) to allow for such activity
-Buying and Selling Property-Historically no duty to disclose, cannot misrepresent or lie then
-Securities-Over the years there is a duty to disclose non-public information about a corporation before you buy or sell a stock
-Debate-Unfair to allow insiders to profit off a stock, moral claim, receiving a benefit that they are not due
2)
-Insider Trading only makes the markets more efficient, and are markets are truly
only semi-efficient, because the market does not reflect all inside or private
information, would make it more efficient
how?
-Inside positions-there are always people in different positions
-When we steal information, we are going to distinguish that, that is not the same thing as allowing people to trade on inside information
3) Goodwin v.Aggasiz (Massachusetts SC, 1933) notice-1933-the same year as 1933 act and 1 year before the securities act
-Same Year the Securities Act of 1933 and one year before the 1934 Act which included section 10b-5, and Section 16
Mining company stockholder filed suit for losses
suffered in selling stock shares to the
defendants who were directors of the corporation,
alleging that defendants' purchase of stocks
without first disclosing to him the existence and results of the geological survey.
Issue: Was this a fraud or breach of fiduciary duty? NO duty to disclose. Not a fact to face transaction. the seller
did not know who he was selling to and the buyer vice versa.
a) Common Law Fraud: Officer / Director has duty to corporation, no fiduciary duty to individual shareholders
b) Therefore, there is no harm done to the company by use of inside information in sale of securities, so no problem
 Mere possibilities are not material facts in common law fraud
 Court justified the information was an unproved theory – a hope or expectation in its nebulous stage
c) Rejected extending insider trading restrictions to those impersonal trades.
d) Absence of duty of participants in open market
 X May be “special facts exception” in face-to-face trading
e) FACTS: Directors had knowledge from a geologist that there may be copper deposits
227
Special Facts Doctrine provides a CL right to sue for not disclosing info
non-face to face transactions no duty to disclose
face to face transactions + the nonpublic info pertains to an event is so
big it will have a dramatic effect on the company
(increase in stock 10x in value)duty to disclose (maybe)
there is a strong basis for this holding—agency theory: agent cannot profit from info gleaned from the course of employment
under the principal (must return profit to Principal)
Diamond v. Oreamuno NY 1969-The New Approach Issue:
whether defendant corporate
officers
could be held accountable to their corporation for gains realized by them from transactions in
the company's stock as a result of their use of material inside information

Harm is NOT necessary element for breach of fiduciary duty (as with fraud)
 The harm is assumed  undermines corp’s reputation, + corporation has an interest in honest
executives
 Corporation can recover profits from breach of duty
-Court hit on something here, that they duty of the agent-cannot profit from the information you learn from the
duties in the company, similar to first part of the semester with the sanitation worker finding gold on his trash
route really supposed to turn the gold into the company because you found it within the duties as an agent of the
company
CASE NOTES-At least in non-face to face transactions, transactions made on the exchange, no duty to disclose this information to the
market place
 There may be a duty to disclose in face to face transactions
o exception-Special facts doctrine-in some very special circumstances there may be a duty to disclose, where
the event is so big it will have a dramatic effect on the company (increase in stock 10x in value),
o -----very few cases where the doctrine was actually imposed
2)
Diamond v. Oreamuno NY 1969-The New Approach there is a CL right to sue for not disclosing info(been somewhat
criticized but there is a strong basis for this holding—agency theory: agent cannot profit from info gleaned from the course
of employment under the principal (must return profit to Principal)
a) Insider Trading constitutes a breach of fiduciary duty to the corporation breach of duty not to use corporate
assets for other than corporate purposes (for personal benefits)
b) Issue: whether defendant corporate
officers could be held accountable to their corporation
for gains realized by them from
material inside information
c)
d)
e)
f)
transactions in the company's stock as a result of their use of
Facts: Alleged that Oreamuno and Gonzalez, the company’s chairman of the BOD and president, had used insider
information, acquired by them solely of their position in order to reap large personal profits from the sale of MAI
shares and that these profits rightfully belong to the corporation.
Even though the Executives may not have directly caused harm to the Corp, the executives were able to profit from
the sale of the stock solely because of the positions they had and had a fiduciary duty to protect the interest of
shareholders.
Harm is NOT necessary element for breach of fiduciary duty (as with fraud)
 The harm is assumed – undermines corp’s reputation, + corporation has an interest in honest executives
Corporation can recover profits from breach of duty
II.
228
III.
Holding: The court held that a person who acquired special knowledge by virtue of a fiduciary
relationship with another was not free to exploit that knowledge for his own personal benefit
but had
to account to his principal for any profits derived therefrom. Further, the court held that
an allegation of
corporate damages was not required. In view of the practical difficulties
inherent in an action under
federal law, the desirability of creating an effective common-law
remedy through the medium of the
derivative action brought in the name of the corporation was manifest. The court affirmed the judgment of
the lower court.
a)
-CASE NOTES-Start of the different approach, common law actions are not quite as important, insider trading has two sides, might
trade on favorable information, buying in advance to make a profit, or hear bad news and sell the stock before it is made public
-Court hit on something here, that they duty of the agent-cannot profit from the information you learn from the duties in the company,
similar to first part of the semester with the sanitation worker finding gold on his trash route really supposed to turn the gold into the
company because you found it within the duties as an agent of the company
-Almost every merger, there is trading within the stock of the company, before almost every bad event there is significant trading on the
stock, to keep that information contained is almost impossible
Freeman v Decio, (7th Cir. 1978)
a) Did not accept Diamond but SCOTUS let Florida SC interpretation-Would not follow the court in Diamond because
the harm needed to be proved not inferred, and the innovative ruling was an attempt to create a judicial remedy for
insider trading on the part of the shareholders, but ultimately quite unworkable formula.
 Securities regulations now takes care of insider trading well. Diamond Court was legislating
 Adopts Florida’s refusal to accept Diamond
 Split on state law but not that important that you don’t have common law uniformity,
10B-5 should take care of the problem
 If there is a state action: NY  yes you have an action. FL no.
 Most cases would be brought under 10b5
 Diamond, goodman, laidlaw v organ– CL action
-CASE NOTESIV. General Concepts / Definitions
A. Generally
1) Insider Trading – someone with information about company not known to company used to trade
2) Market v. Inside Information
a) SEC doesn’t care about market information that anyone can acquire through the market
b) Inside Information is not disseminated to the public that is only accessible to those inside the corporation
3) Economist Theory
a) Buyers buy because of Asymmetry of Information
b) No obligation for buyer to disclose this information
4) DEBATE: Why must we protect it?
a) Why wouldn’t we encourage release of information into public market
5) STOCK WATCH UNITS
a) SEC, NYSE, etc. watch stock activity
b) Monitor blips followed by announcements
c) Then go to these purchasers to see how they knew to buy
-INSIDER TRADING NOTES
-We have information that is not available to the public only because of our position in the company and we profit from it
-Classic Model was Caveat Emptor-You did not have to disclose, but you could not mislead meaning lie if you were asked
-Prohibited Insider Trading in a very narrow manner under Section 16-only officers, directors, and beneficial shareholders for at least
10% total of the amount of the common stock
2)
CHAPTER 15-Section 16 of Securities Exchange Act
II. Section 16 – Insider Trading Statute
A. PURPOSE:
1) To prevent principals of corporation from using inside information to make a personal profit on the trading of the stock
229
Prevents short-swing trading (within 6 months)*
Applies only to officers, directors, and shareholders with more than 10% of the common stock
Enormous class of people, people who receive a tip, ordinary employees
The 3 Parts of Section 16
1) SEC 16(a) Reporting Requirement
a) If Insider buys or sells stock must report to SEC your position in that stock and any changes in that position and
those reports are made public
b) Applies to companies registered under Section 12 of 34 act
c) -premised on the theory that corporate higherups have acces to special info – hard or soft info
 Hard info- info that will clearly hurt or help the stock (no one else knows it-super important info) that
allowed me to trade ahead
 Soft info – the feel of the company -cant point to any one single thing that allowed me to trade ahead
 Form 3
Acquisition of Title/Interest
10 Days
 Form 4
Change in Interest (Buy/Sell)
2 Days
 Form 5
Annual Report
45 Days
d) REMEDY:
 SEC can enforce
 Criminal liability
 But NO PRIVATE RIGHT OF ACTION under this section part
2)
3)
4)
B.
SEC 16(b) of 34 act
discourage insider trading fairness to outside traders + Efficient Market
Make sure the question provides BOTH a sale and a purchase within 6 months
Director, officer, or “10% shareholder” “profits” from “short swing trades”  disgorge
profits to shareholders
the purpose of section 16(b) is to deter insiders from speculating in their corporations stock – 16(b) is a
"prophylactic” rule
speculation
is the practice of engaging in risky financial transactions in an attempt to profit from short
term fluctuations in the market value of a tradable financial instrument—rather than
attempting to profit from the underlying financial attributes embodied in the instrument
such as capital gains, dividends, or interest.
Capital gains - a profit from the sale of property or of an investment.
short swing trade rule restricts officers and insiders of a company from making short-term
profits at the expense of the firm. It is part of United States federal securities law, and is a
prophylactic measure intended to guard against so-called insider trading.
Insider trading is the trading of a public company's stock or other securities (such as bonds or stock options)
by individuals with access to nonpublic information about the company. In various countries, some kinds of
trading based on insider information is illegal.
Unfairness to outside traders: This is because it is seen as unfair to other investors who do not have
access to the information, as the investor with insider information could potentially make larger profits
than a typical investor could make.

Efficient Market theory is a theory in financial economics that states that asset prices
fully reflect all available information
230
o No insider trading  accurate pricing  consumer confidence efficient market
theory
o One argument against insider trading is that it robs the investors who do not have
nonpublic information of receiving the full value for their securities.
o =If nonpublic information became widely known before an insider trading situation
took place, the markets would integrate that information and the securities in
question would become more accurately priced as a result
The 34 Act imposes additional disclosure requirements not only on registered corporations but also on the directors, oflicers, and 10% shareholders of
registered corporations
10% shareholderMust have been a 10% shareholder before she purchased AND before she sold
Officer Must have been an Officer EITHER before she purchased or before she sold
DirectorMust have been an Director EITHER before she purchased or before she sold

Under section 16(a) of the 34 Act, such persons must report to the SEC all of
their purchases and sales of the corporation’s stock within two business days of their occurrence,
 Under section 16(b) any "profit" earned on purchases and sales
within a six month period must be disgorged to the corporation
It can be difficult to prove that an insider who is buying or selling her corporation’s stock is wrongly benefitting from material inside
information=diflicu1t to prove all of the elements of a Rule 10b-5 cause of action
By comparison, the elements of a cause of action under section 16(b) are easy to
prove
"section 16(b) profits"
ANY profit on ANY trade of that corp’s stock within a 6 month period by off,
dir, or 10% must be forfeited tothe corporation.
Section 16(b) provides a bright line rule to discourage insiders from both buying and selling, or selling and
buying, their corporation's stock within a six-month period.
Issues:
First: when do you apply section 16(b)?
Second: How do you apply section 16(b) to determine whether there is a profit as determined by section 16(b)?
Third: How is section 16(b) different from Rule 10b-5?
First: When do you apply section 16 (b)?
Section 16(b) only applies when the stock being bought and sold is the stock of a registered corporation under the 34 Act.
The same person must both buy stock of the corporation and sell stock of that corporation within a single six-month period.
It does notmatter which came first: buy then sell or sell then buy.
The person buying and selling must be a 10% shareholder, or an officer or director
231
10% shareholder Must have been a 10% shareholder before she purchased and before she sold
Officer Must have been an Officer EITHER before she purchased or before she sold
DirectorMust have been an Director EITHER before she purchased or before she sold
=
The oflicer/director requirement is satisfied if the person was an officer and/or director both at the time of her purchase and of her sale of stock, or at the time of either her
purchase or her sale of stock
Second: how do you apply section 16(b) ?
Under section 16(b), you ignore the order in which the transactions occurred:
Section 16(b) profit: occurs where the purchase is followed by a sale at higher price
Section 16(b) profit: occurs if a sale is followed by a purchase at a lower price
Profit from ANY stock transaction
Profit from all DNM You need to understand that whether a director actually profited from all of his “short-swing" trading is irrelevant.
Makes no sense, That is why your professor is likely to test section 1 6(b)
Makes no sense unless you remember that the purpose of section 16(b) is to deter insiders
from speculating in their corporation’s stock – 16(b) is a "prophylactic” rule
Third: how does section 16 b differ from Rule 10B-5?
Recoveree:

Rule 10b—5 recovery goes to the injured buying or selling shareholders .

A section 16(b) recovery goes to the corporation whose stock was bought and sold in the six- month period,
Transaction

Section 16(b) only applies if the stock transactions involved stock in a public company registered under the 34 Act.

Rule 10B-5 applies to sale of securities of any company
is the general antifraud provision of the federal securities laws. The Rule covers fraud in the purchase or sale of securities as well as insider
trading in securities.
Who it applies to:

Third, section 16(b) only applies if the person engaged in the stock transactions is an oflicer, director, or 10% shareholder of that
public corporation

Rule 10B-5 only applies to defendants who do tacky things - make false statement or buy or sell stock relying on material inside
information
+Section 16(b) imposes strict liability on people need to prove that defendant did something wrong
Insider trading by a company's directors can be legal as long as they disclose their buying or selling activity
to the Securities and Exchange Commission (SEC) and that information subsequently becomes public.
2)
3)
4)
5)
Insiders must return short-term profits to corporation (disgorge) -prohibits exdcutives from
speculating/swing trading/buying or selling the stock on a short term basis within 6 months
Cannot make a profit on your stock within 6 months
if you’re an insider you must give up any stock within any 6mon period ;
applies to insiders (=senior officers etc , directors and to any 10% shareholder)
10% shareholder rule: must be na insider on both sides of the trade!
232
a)
Later sold At 9.9% and you were not an insider NOT 10% shareholde
Disgorges profits from short-swing trades (buy and sell within 6 months)
 Purchase and Sale or Sale and Purchase in any six-month block
 Court matches highest purchase with highest sale
 Can find profit when there is none
EXCEPTIONS:
 X Previously Ked debt
 X Insider on both transactions (when you were not working for the company)
c) PURPOSE: Reduces possibility that inside information would give you unfair advantage in that length of time
d) REMEDY:
 SEC NOT authorized to enforce
 Federal Cause of Action
 Private Right of Action
 Corporation may sue
 Shareholder may sue on behalf of corporation after 60 day notice to SEC
with no action by SEC
 BUT only corporation has right to recover profits
 No criminal liability
 Corporation or any shareholder can sue ; SEC not authorized to enforce
-NOTES-if you(one of the class of people reach by the statute) make a profit within 6 months, there is a presumption that you are trading
on inside information, don’t have to prove that the person actually did trade on the profits, then the person has to forfeit the profit
-Problem, the person can wait until 6 months and one day to either buy or sell and continue to make the profit
-What the courts do is that they pick and choose, if they can show that you make the profit within 6 months they will be held liable and
have to forfeit the profit,
-Additionally, you have to be an officer on both sides of the transaction, meaning if you were not an officer you would be under no duty,
problem could be I was an officer and then I resigned in order to sell and make the profit and not be subject to section 16
6) SEC 16(c) prohibits uncovered short stock sales
a) Cannot sell stock you don’t own
b) Uncovered Short sale – don’t own stock, borrow it, sell it, market goes down, buy it cheaper and give it back to him
(short the stock)
c) Anti-Wiggin Amendment: Insiders should not be taking advantage of downturns in company’s stock through short
sales
NOTES-prohibits short sales of the company’s stock,
b)
III.
16(a) Reporting
SEC Enforcement
YES – criminal liability
Private Right of Action
NO
16(b) Trading
NO – No criminal liability
Corporation
Shareholder on behalf of Corporation
60 days after demand on corporation
Persons Subject to Section 16 – Insiders Defined
A. Applies only to Reporting Companies under Section 12 of the 34 Act
1) 500 shareholders / $10M Assets
2) Trading on national securities exchange
=
Some, but not all, corporations that have made public offerings of their stock are
also "registered corporations" Section 1 2 of the 34 Act requires corporations with shares
traded on a national exchange, such as the New York Stock Exchange, or which have over
$10,000,000 in assets and at least 500 shareholders who are not accredited investors to register with SEC
These corporations are called "registered" or "34 Act companies.” And, these corporations are subject to the proxy rules of section 14 of the 34 Act and the "short-swing trading" rules of section 16 ofthe 34 Act see elsewhere
233
B.
What is an Insider? =Somene who has access to inside info of comp-CRA Realty.
1) SEC Definition
a)
Directors, President, Vice-President, Secretary, Treasurer, CFO, Comptroller or Accountants and More-than-10%
shareholders
b) Bondholders (of more than 10%?) do NOT control corporation such as to be Insiders
2) Colby Theory
a) Title may be irrelevant – question is whether you have ACCESS to information
 Functional approach
 Duties of employee rather than his corporate title determine whether he is an insider
 Foregoing title does no restrict Section 16 liability
b) CODIFIED INTO Section 16
c) If an insider under 16B – don’t have to show you had insider information ONLY access to inside information
d) If NOT an INSIDER – then 10B-5 applies – where you have to show insider information <<<
3) Beneficial Ownership
a) For purposes of Determining if More Than 10% Ownership
 Based on direct or indirect CONTROL OF STOCK by either
 Voting Power – power to vote the security OR
 Investment Power – power to dispose of the security
b) For purpose of Reporting and Liability
 Based on direct or indirect PECUNIARY INTEREST
 Pecuniary Interest: Opportunity to profit or share in any profit derived from a securities transaction
 So that the trades of the record owner are imputed to an insider
 MORE THAN 10% SHAREHOLDERS
 Beneficial Ownership based on criteria for reporting if more than 5% shareholders under Section 13
 Nonvoting securities excluded from 10% computation
 Phantom stock, derivatives and swaps included
 Moving Target – Shareholder must have notice he has reached 10% threshold
 FAMILY MEMBERS
 Rebuttable Presumption that Insider has indirect pecuniary interest (attribution) in stock/securities of
members of his immediate family sharing the same residence
 Grandparent, Parent, Spouse, Child, steps, adopts, in-laws
 PARTNERSHIPS
 Insider that is general partner of partnership has pecuniary interest in partnership stock transactions
 CORPORATIONS
 Insider has pecuniary interest in corporate shareholder transactions if:
 Controlling shareholder AND
 Investment control of corporate shareholder’s portfolio
4) Attribution Theory (See Beneficial Ownership)
a) Rule 16(a)-1 a-2-a
b) Should we attribute the sales of x to an insider because of their relationship, through which information might be
shared?
 Court looks for interrelated financial circumstances
c) FAMILY MEMBERS
 If the family member shares benefits from the other’s ownership of the company’s stock he is deemed to
have beneficial ownership of stock such that stock trades of family are seen as one
 Family members of Insiders also required to report sales and purchases
5) Deputization officer, director, or 10% shareholder under 16(b)?
a) Fact Determinative
b) A director is also someone who has been “deputized” by another to act as director for him
c) Whereby person deputizing (Corporation - Shareholder) is also a “director” of the company
 Corporate stockholder is liable for short-swing trade profits made while its deputy is sitting on the Board as
director
 Deputy represents the corporate shareholder’s interest
 Deputy passes inside information to corporate shareholder
 Deputy may be principal of corporate shareholder, with power to use inside information for corporate shareholder
Feder v. Martin
234

6)
C.
EXCEPTION: Blau v. Lehman Director of Corp X is also partner of Oil Co – but NOT deputized.
 Director did not discuss Corp X with members of Oil Co
 Oil Co did not trade Corp X stock based on inside info from Director
d) NOT CODIFIED. Case law on deputization not codified in SEC Acts
Relevance of Insider Period to 16B
a) OFFICERS AND DIRECTORS
 Must be officer at beginning of swing – not at end of swing – to be subject to 16B
 Stock sale or purchase AFTER LEAVING office still subject to 16B if within 6-months period
 Stock sale or purchase BEFORE OBTAINING office is NOT subject to 16B
b) 10% SHAREHOLDERS (anything but an open and shut rule)
 Must be 10% shareholder at BOTH beginning and end of swing (sale and purchase)
 Must be 10% shareholder BEFORE the purchase
 A 16b sale cannot be the sale that made him a 10% shareholder
Cases|
1) CRA Realty (officer=)
2)
insider=someone who has access to inside info
Whether Crotty is an officer ? NOT an officer  not subject to 16b – his title (VP) was honorary – he had no
access to inside information (how the comp was doing, etc.)  he’s not an insider  he did not have to return
the profit.
b) COLBY RULE Corporate employee who did not hold the title of a corporate officer, nevertheless could be an officer
within the meaning of 16(b), if “he performed important executive duties of such character that he would be likely, in
discharging these duties, to obtain confidential information about the company’s affairs that would aid him if he
engaged in personal market transactions.” page 869 middle
 You don’t have to have inside information
 You have to have access to information
 Don’t need to prove you actually HAD inside information
c) HERE vice-versa >>> someone with title without access is not subject to 16(b) trading limitation
 What do you really do?
 Holding: It is the duties of an employee, especially his potential access to inside information, rather than his
corporate title which determine whether he is an officer subject to short-swing trading restrictions of 16(b). Page
870 top
d) Look at Rule 3-b-2 – Page 520
-CASE NOTES-Apparent authority-if you go into a bank everybody in the place is a vice president doesn’t really mean anything, and
that is what the court is saying here
-Just because you have a name title does not necessarily mean you will be subject to 16(b)
-Section 16(b)-is concerned that insiders had a feel of what was going on at the company and Congress wanted to restrict that
-Whether you had access to inside information, not necessarily if you did use the information to trade on
-We are going to presume that if you had access to inside information
-Counter to the argument-even a student-employee has knowledge of what is going on at the company depending on the normal
comings and goings that take place at his branch of whatever the company is
-SEC has broadly defined the term officer, but they have identified people they think would be included, Senior Officers, Executives, and
Accountants
-CASE REALLY DEFINES WHO IS A DIRECTOR-someone who would have access to the inside information, NOT use it
a)
3)
Whiting v. Dow Chemical
4)
Facts: Spouse sells the stock, one month later her husband who is an insider exercises an
and buys the stock at 21 or 24 dollars and gets a short sale transaction.
a)
b)
c)
option
Company sues shareholders for violation of 16B – alleging husband was beneficial owner of wife’s stock. Wife she
sold at $55 …. Husband borrows from wife to buy stock at a lower price =considered to be a short sale profit trade –
sold high and bought lower later you will be liable for the difference
Same financial advisor …
ATTRIBUTION – Should we attribute the sales of x to an insider because of their relationship (as here, to the
wife), through which information might be shared?
 Court looks for interrelated financial circumstances
235
 He borrowed money from her, they had the same financial advisor
 Since you treat it singly we will treat it singly
 Court found husband’s purchase attributable to insider wife-Director was liable for wife’s transactions
 Rule 16-a-1 a-2-a Rebuttable Presumption of attribution if members of immediate family sharing the same
residence
-CASE NOTES-Attribution theory for persons who could be liable even though they are not insiders/officers --Did the person have a
relationship with the insider so that the transactions should be attributed to the insider person
-Court viewed that the dangers sought to be prevented by 16(b) were present here, and we are concerned that if we didn’t do it here there
would be abuses
a)
Feder v. Martin -- deputization maybe (Factual issue whether deputized)
2)
Court found he was a deputy in this case due to his language in his resignation letter Leeter of Resignation to General
on the Board on behalf of Martin
Marietta”this was damning he was DEUPTIZED as a DIRECTOR
McArthur – “thank you for letting me sit
both the deputy and the original director are subject to Section 16 ?
a)
b)
c)
d)
Is principal of Corporation X shareholder sitting on Board of Corporation Y (owned by Corp X)
deputized by the corporate shareholder so that both are subject to Section 16 ? MAYBE
Martin Marietta (Corporation) buys and sells Sperry stock. Bunker is Pres/CEO of Martin-Marrieta and director of
Sperry.
Issue: Deputy of martin marieta or was he individual capacity representing lehman’s interest on the board?
 Marietta in complete control of Martin Marieta
 In a position where he could use Sperry insider information for benefit of Martin Marrietta
Issue: Is President deputy of Martin-Marietta? Was President sitting on his own behalf or on behalf of Martin-Marieta.
Leeter of Resignation to General McArthur – “thank you for letting me sit
on the Board on behalf
of Martin Marietta”this was damning
HOLDING Martin was sitting on behalf of Martin-Marietta (not individually) - Martin-Marietta deputized him
deputized ??? -- Must disgorge
f)
Factual issue whether deputized
-CASE NOTES-Deputization Theory –
-Lower court dismissed the action finding the officer was not a deputy of the company
-Issue: Was this person on the BOD acting as a individual in his own capacity, or is he there as an agent or deputy of another company?
-Court held that if you are a deputy, then your activities will be represented to the actions of the company
-Issue: Was this person on the BOD acting as a individual in his own capacity, or is he there as an agent or deputy of another company?
-he was DEUPTIZED as a DIRECTOR Court found he was a deputy in this case due to his language in his resignation letter
e)
3)
4)
5)
6)
Shareholder 16B Private Right of Action
a) Shareholder can sue 60 days after making demand on corporation (directors)-officers, directors, beneficial owners of
more than 10%
 Unless excused as futile – director self-interest
b) Shareholder sues on behalf of and for corporation (not himself)
Shareholder Standing
a) Need NOT be shareholder at time of Insider violation *(which occurs at the 2nd transactionwhen profit was made)
b) MUST be shareholder at time of suit
c) Must have CONTINUING INTEREST in corporation (or its assets)during entire suit
 If he is cashed out in merger no continuing interest
Attorneys Fees-KEY MOTIVATION OF THE LAWSUITS, courts still say we don’t care why you a bringing suit
a) Paid from recovery funds
b) Not added to Δ liability
c) Because corporation benefits from attorneys services even if shareholder brings action
Computing Matching Sales and Purchases
236
a)
b)
=Lowest Price In, Highest Price Out=Can find profit when there is none
Even if he had a net loss on total trading in 6-month period!!
Damages receoverable = (e.g., the lowest purchase and highest sale prices within the six-month period are matched,
then the second lowest purchase and sale prices are matched).
Date Transaction Sales by Director
price
1/1 Buys 500 shares of Zeta common stock $7
4/5 Buys 200 shares of Zeta common stock $6
5/5 Sells 600 shares of Zeta common stock $8
Take the the amount transacted at the lowest price and then multyiply that same number of shares to highest price
(highest match)
Because the greatest disparity is between the 200 shares of stock purchased at $6 per share and the stock sold at $8 per
share, this calculation is done first (200 shares times $2 (=$8-$6) per share equals $400)
(subtract the remaining sares bought from the remaining shares that were sold—(because not all shares bought were
sold ultimately)
Next, the remaining 400 shares sold on May 5 are matched against those purchased at $7 per share, resulting in another
$400 difference.
\16B Purchases and Sales
1) Garden-Variety Transactions
a) Sale or purchase of stock for cash
2) Unorthodox Transactions
a) Other than garden-variety which MAY BE purchase or sale under 16B
b) EXAMPLES:
 Mergers
 Stock options
 Conversions or redemptions
c) SEC has adopted complex rules that exempt certain unorthodox transactions that meet certain conditions
3) 2 Theories of Interpretation:- Unorthodox Transactions
a) Where Rules do not apply courts have used various theories of interpretation
b) OBJECTIVE Theory
 Apply 16B broadly – to all it can reachregardless of purpose of 16B Smolowe
c) SUBJECTIVE / PRAGMATIC Theory
 Apply only to those unorthodox transactions that give rise to a potential for abuse 16B seeks to prevent
 Usually only applied to INVOLUNTARY transactions
 EX: here merger and resulting share conversion or exchange is involuntarily thrust upon a 10% shareholder by
an antagonistic corporation, no real potential for speculative abuse by shareholder of the kind 16B seeks to prevent
Kern County v. Occidental (Pragmatic Approach
4) Options and Other Sales
a) Options – sale on date option created
 SALES: Acquisition/creation of option, convertible security or other derivative security
 NOT SALES: Exercise of option or conversion rights
b) Sale after Mergers
 If merger involuntary not a sale See KERN
Smolowe v. Delendo Corp. (2nd Cir. 1943)-page 883
Issue: to determine if there was 6 month profit from multiple trades over 6 months -- should we trace the stock? Or is should profit over 6
months be determined by first in to first out ? tracing/ matching up all the transaction to find out if ANY profit occurred (even if there
was an overall loss!!!!)
-Court saying here that we do not care if you actually had a realized profit
-Meaning the 6 month time frame is the bigger issue here that needs to be taken into account, anything that the person who is subject to
section 16 does within a 6 month window concerning a buy or a sell, might constitute a profit depending on the price of the securities
B.
237
-Under Section 16(b) shareholder made a demand to the Executives of the Company, and if not the shareholder can go directly under 16
(b) largely stirred up by lawyers to
Section 4: Purchase or Sale under 16(b)
5) Bershad v. McDonough
a) Director’s option agreement deemed a sale in violation of 16(b)-Option agreement was a “purchase or sale”
b) Director granted option but also obtained/granted
 14% deposit
 Stock in escrow endorsed in blank
 Irrevocable proxy
 Resigned directorship ; appointed optionee director
c) No question sale occurred – question was WHEN
 Court held sale occurred on date of option, not date of exercise of option
d) RULE: Look at commercial substance of transaction – not form
 Should not be able to speculate by varying the paper form of the transaction
 Options, conversion and similar devices lend themselves to abuse (avoiding “sales”), So often SEC characterizes
them as sales
 “Any K to sell or dispose of security”
-CASE NOTES-intention was to curtail the insider trading, substance more important that form,
-Options and Derivatives present a problem here under 16(b) because we don’t actually know when the purchase or sale will occur with
the option
-Statute says you have to be an insider on both sides of the transactions,
-With respect to the insider meaning you owned 10% of the stock, we need to look at that in terms of the section 16(b)
-for 10% shareholders, we are going to look to see if you were an insider on both sides of the transaction and we will take a look at the
functionality of 16b
INSIDER TRADING AS FRAUD
CHAPTER 16
I.
10B-5 V. 16
10B-5 Liability
16 Liabilty
Purpose
Avoid ____________________
Avoid insider unfair advantage in trading due to
access to insider information
Type of Action
Fraud
Criminal Liability
Private right of action
but NOT under 3d party
Misappropriation Theory
Irrelevant whether insider traded or not
ISSUE IS WHAT IS SAID OR NOT
SAID
_____________
Federal Cause of Action
RECKLESSNESS +
Fraud
STRICT LIABILITY
Qualified Inside
Access to insider info
Profit from Sale/ Purchase w/in 6 Months
No wrongdoing need be shown
NARROW CLASS OF ΔS
Shareholder Derivative
Shareholder need NOT own stock
at time of violation
BROADER CLASS OF ЛS
Shareholder must own stock at time of suit AND
continuing interest during suit
Court
Findings Required
Shareholder
Standing
Shareholder Derivative
Shareholder must own stock
at time of fraud
Irrelevant whether insider committed fraud
ISSUE IS THAT HE TRADED SHORT-TERM
Federal Court
238
Remedy
Not Compensatory Remedy
No criminal liability under 16(b)
2 Yrs – 5 Yrs
Statute of
Limitations
II. History - Using 10B5 to Control Insider Trading
A. HISTORY:
1) “The history of SEC efforts to regulate insider trading is a story of …Created the modern system of insider trading
enforcement despite the absence of a specific legal definition of the practice."”
B. EARLY ISSUES:
1) If the basis for insider trading liability was common law fraud founded in state common law and corporate law principles,
could there be liability for insider trading unless the trader had a specific duty to disclose the information to the other party?
2)
Could there be such a duty to a person with whom the insider had no common law fiduciary relationship, such as sellers of
stock on large, impersonal stock exchanges?
3) Why should fraudulent transactions in securities law be inherently different from ordinary K law?
a) Because well-functioning capital markets were an essential component of an advanced economy. For policy reasons,
securities regulation required more extensive disclosure than that which was required under common law.
C. STEP IN SEC CHAIRMAN WILLIAM CARY 1960:
1) Cary was convinced that the states were not effective regulators of insider trading abuses in the national markets
2) Began to use Section 10(b) of the 1934 Securities Exchange Act to enforce insider trading sanctions after SC refused to
broaden Section 16
3) Faced obstacle of using Section 16 as an effective enforcement tool, and with the problems of relying on the common law
of fraud to regulate insider trading
4) “Disclose or Abstain Rule," whereby an insider in possession of material nonpublic information must disclose such
information before trading, or if disclosure be impossible or improper, must abstain from trading in that company's stock
5) CADY ROBERTS
a) Cary wrote an administrative opinion in Cady, Roberts & Company that rejected the majority state approach and
expanded Rule 10b-5 as a basis for insider trading causes of action.
6) SEC V. TEXAS GULF SULPHUR:
a) Building on a line of reasoning that expanded the application of the common law rules of fraud to include stock trading
in an impersonal market, the SEC argued the Disclose or Abstain Rule
b) Expanded the liability of insiders to include liability to members of the general public who sold stock if the insider who
used the inside information breached a duty to the source of the inside information
 Created a duty of anyone with insider information to the market Whereas 10B5 previously based on
fiduciary duty of insiders to corporation
D. STEP IN SC JUSTICE POWELL 1972:
1) Powell believed that the SEC had overstepped its power under the Securities Acts.
a) Favored state common law of fraud as major enforcement theory for corporate and securities law.
b) Rule 10b-5 part of federal common law, whereby Court obligated to examine any underlying policy considerations
(challenged SEC policy approach)
c) Favored narrow application federal securities law.
2) Chiarella
3) Dirks
-INITIAL NOTES ON CHAPTER 16
-Section 16(b) is a targeted prohibition,
-Does not matter what your intent was in buying and selling, if you sold within 6 months too bad
-Leaves a huge gap-between state law that was still following common law, and 16(b) was applied very narrowly
-What about other instances?-Say a director bought the stock 2 years ago at $10, now the officer sells for $100 16(b) can’t do anything?
-That is bad director still abused position to use insider information, only limited remedies to bring for insider information
-Turned to section 10b-5, however 10b-5 is really designed as a anti-fraud statute
-Insider Trading was a more attractive case for the SEC
III. SEC Chairman Cary Expands SEC 10-B5 Powers
A. Disclose or Abstain Rule – SEC Chairman Cary Expands 10B5
1) Cady Roberts
a) Cady established SEC's expansive extension of Congressional intent as the basis for Rule 10b-5 liability – not
limited to common law of fraud.
b) Disclose or Abstain Rule Cady
239

Must DISCLOSE material non-public INFORMATION before trading
OR if disclosure impossible or improper, must ABSTAIN FROM TRADING
 Runs not only to insiders but to non-shareholder purchasers
c) Extended insider trading sanctions to anyone privy to confidential corporate data.
 SEC Chairman Cary believed the information belonged to the corporation and
ANY use of it by any individual for personal profit fell within prohibitions of Rule 10b-5
 Created a DUTY TO THE MARKET of anyone using insider information for personal profit
 Whereas 10B5 previously limited to and based on fiduciary DUTY TO CORPORATION only of
insiders
d) “Insider” Expanded
 Antifraud provisions aimed not only at insiders but at any person:
 Having a relationship giving access to undisclosed material information (recvd from director)
 That personally benefits unfairly from that undisclosed company information
 Basis for Duty
 Fairness to the Market
 Fairness to the Corporation
2) SEC v. Texas Gulf Sulphur
a) Insiders that knew and did not disclose huge mineral find and whose directors personally profited from stock trades
based on that information violates 10B5.
b) FOR INSIDER - TRADE NOT NECESSARY.
 Mere fact that insider did not trade in 10B5 irrelevant – non-trading person may still be liable under 10B5
c) INSIDER NOT NECESSARY
 Insider trading is not limited to insiders but also extends to outsiders such as tippees.
 DUTY TO THE MARKET?
B. Cases
1) Cady Roberts SEC Decision – Cary (1961, first glimmer that 10b-5 could be used against insider trading?)
a) Disclose or Abstain Rule:
 Must disclose or abstain material non-public information before trading OR if disclosure impossible or
improper, must abstain from trading
 Runs not only to insiders but to non-shareholder purchasers
 Actually expands the definition of an insider to a person
b) F: Director gave his partner in stock broker firm (Cady) inside information on dividend cut which partner relied to sell
the partnership clients’ stock and sell short
c) H: Partner and Partnership violated 10B5 by purchasing stock and selling short based on information not yet disclosed
 SCOPE OF 10B5 Antifraud provisions aimed not only at insiders but at any person
 Having a relationship giving access to undisclosed material information (recvd from director)
 Unfairness when where party personally benefits from that undisclosed information
 COMMON LAW FRAUD NOT REQUIRED. 10B5 aims at reaching misleading or deceptive practices- whether
or no they can sustain common law action fraud
d) IMPORTANCE:
 Cady established SEC's expansive extension of Congressional intent as the basis for Rule 10b-5 liability –
not limited to common law of fraud.
 Disclose or Abstain Rule
e) CLASSIC “TIPPEE” CASE
 Possessor of the inside knowledge himself earned no profits from the information. But the person whom had been
"tipped" to the information did.
 Critics of insider trading prohibitions argued that, unlike cases of direct fraud, there was no harm to anyone
 SEC Chairman Cary believed the information belonged to the corporation and ANY use of it by any
individual for personal profit fell within prohibitions of Rule 10b-5
 adopted the Disclose or Abstain Rule proposed by the SEC/ Mere fact that insider did not trade in 10B5 irrelevant
f)
Extended insider trading sanctions to anyone privy to confidential corporate data.
-CASE NOTES-Purpose of these SEC divisions, is that the SEC is making up all of these provisions out of whole cloth, and they are not
subject to judicial review, because of Chevron doctrine the Court defers to the interpretation of the statutes by the SEC and the SEC
makes so much law out of these things that the courts will have no choice but to adhere to whatever the SEC says because there is so
much law to go through
-According to the SEC, equal access doctrine with an abstain or disclose requirement, if you have access to information that the public
does not have you could be subject to liability
240
-HUGE PROBLEMS-information asymmetry is widely recognized in the markets, people have all different kinds of information, and
secondly HOW do we keep something a secret, even if only two people know something that does not make it a secret
-Persuasive Impact not binding on anyone
2) SEC v. Texas Gulf Sulphur 2nd Circuit
a) Insiders that knew and did not disclose huge mineral find and whose directors personally profited from stock
trades based on that information violates 10B5.
b) Mere fact that insider did not trade in 10B5 irrelevant – non-trading person may still be liable under 10B5 for
misrepresentations
3) 5] Specific intent to defraud need not be shown. Negligent insider conduct is sufficient for liability. Hence, the claim that
the news was public when the officer phoned his order the night before the company news conference is not a reasonable
belief, and the officer is liable for negligent violation of the Act.
\Geologists acting for the Texas Gulf Sulphur Col (TGS) found evidence of ore deposits
on land TGS had optioned TGS kept this information confidentialfnot even all of the
members of the TGS board of directors knew of the mineral discoveryfso that TGS could
buy surrounding land cheaply
Some TGS oflicers and directors, however, not only knew of the mineral findings but
also (1) took advantage of this "material inside information" to buy TGS stock before the information became
public and the price of
TGS stock increased, and (2) "tipped,” i.e., told others so that they could buy TGS stock be»
fore the information became public.fl
The SEC filed a Rule lob—5 action against (i) the oflicers and directors who bought
TGS stock, (ii) the officers and directors who told others to buy TGS stock (now known as
"tippers"), and (iii) non»insiders who were given this inside information (now known as
"tippees"),
a) FACTS:
 Insiders knew exploratory drilling that promised a huge mineral strike. In the months before the formal
announcement, numerous TGS insiders bought stock or stock options in the company. Others tipped off outsiders
who also bought stock in the company. Price went from $20 to $58.
 SEC sued TGS and thirteen of its officers, directors and employees under Rule 10b-5 to recover the profits from
the insiders. Named in the suit was TGS director Thomas S. Lamont, a director and former vice chairman of
Morgan Guaranty Trust, who was alleged to have tipped others to the knowledge, but not to have personally
profited from the insider trades.
 SEC argued that the company's press releases about the discovery were "materially false and misleading" and
known to be so by TGS officer and employees.
 TGS contended that the SEC's position requiring disclosure before trading would "not have been in the best
interest of the public, the company and its stockholders" because disclosing the find prematurely would have made
it impossible to secure the mineral rights
 RULE: “anyone in possession of material inside information must either disclose it to the investing public,
 or, if he is disabled from disclosing it in order to protect a corporate confidence, or
 or, if he chooses not to do so, must abstain from trading in or recommending the securities concerned while such
inside information remains undisclosed.”
b) HOLDING: Second Circuit adopted the Disclose or Abstain Rule proposed by the SEC/
 Material even though possible that thorough exploration would find a non-minable body of ore
 Although no affirmative duty of the company to prematurely disclose the ore find until after the mineral rights
had been acquired
c) EFFECT / IMPORTANCE
 Extended insider trading sanctions to anyone privy to confidential corporate data.
 Would stand for the next decade as the pre-eminent insider trading rule.
 LIABILITY OF NON-TRADING PERSON FOR MISREPRESENTATION
-CASE NOTES FOR TEXAS GULF-Court essentially adopts the SEC theory from the Cady Roberts, Geological reports of anomalies might be a big find here for the
minerals, no certainty to it
241
-However, the insiders certainly thought there was something, they were buying stock in large amounts and stock options, back then very
small market, but a lot of bang for the buck to pay a small premium on the stock, and when the stock goes up they can execute the
transaction and make profit
-News was leaking about this, company came out with a press release, page 905-fight over whether the inside information was material?
-Rule 10b-5 has the expectation that all traders are trading on the same access to material information
-Court basically bought the SEC rule, must disclose or abstain,
-This came as a great shock to corporate America
-As far as the disclosure, there must be effective disclosure meaning broadly disseminated to the public,
-Opened up a whole pandora’s box of questions, who can sue for damages, what are the damages, what was the effect of the market,
when did the information actually leak out there, when did the people trade on the information
-At this stage, this got widespread attention and adopted by several lower courts, bad news a bunch of people were caught in insider
trading, GOD watching here because the executives plane went down when this news broke also
Rule 10b-5 has the expectation that all traders are trading on the same access to material information
There is very broad dicta about insider trading in the Second Circuit’s Texas Gulf Sulphur decision:
"The essence of the Rule is that anyone who, trading for his own account in the
securities of a corporation, has ‘access, directly or indirectly, to information
intended to be available only for a corporate purpose and not for the personal
benefit of anyone' may not take ‘advantage of such information knowing it is
unavailable to those with whom he is dealing,’ ie, the investing public"
 RULE: “anyone in possession of material inside information must either disclose it to the investing public,
 or, if he is disabled from disclosing it in order to protect a corporate confidence, or
 or, if he chooses not to do so, must abstain from trading in or recommending the securities concerned while such
inside information remains undisclosed.”
=non-trading person may still be liable
=ANYONE in possession of material inside information about a corporation who bought or
sold that corporation's stock violated Rule 10b5
the Supreme Court in Chiarella and Dirks narrowed the impact of Rule 1ob75 on trading
with inside information. -Cady Roberts, created a new doctrine under 10b-5, SEC adopted or created an equal access, must either
disclose or abstain, not yet been excepted by the courts
 After Chiarella, the SEC adopted Rule 14e—3 which bars
everyone - not just directors and oflicers - from buying or selling
stock on the basis of material, nonpublic information about tender
offers.
14e-3– applies to any persons - NO ONE CAN USE INSIDE INFORMATION ON MERGER
3 Theories – classical, misappropriation, tippees.
Classic theory : if you are insider, you have fiduciary duty to the
company and
shareholders.
242
 Scotus adopted
Misappropriation theory - ?
Tipees IV.
SEC Curbed – SC Returns to Common Law Breach of Duty
A. 3 Theories of Liability under 10B5
1) Insider Trading
a) Must be an insider
b) Breach of duty between insider and corporation
c) SC refused the expansive SEC approach of DUTY TO MARKET
2) Misappropriation Theory
a) Corporate outsider
b) Breach of duty between owner of confidential information and individual entrusted with that information
c) O’Hagan adopted this theory
3) Tippee Liability
a) No duty on tippee unless 1) you knew tippor breaching a fiduciary duty 2) from which tipper would derive financial or
reputational benefit Dirks (does not have to be a substantial benefit)
 Tippee’s duty derivative from insider’s
b) But benefit broadly interpreted (sister who tells brother, wife who is not careful and co-worker overhears her)
c) Tippe liability the same whether information comes from insider or outsider
Other Case Rules
a) Rebuttal presumption that you used confidential information in trade, rebuttable with plan that shows you were
planning that trade before SEC v. Adler
 Use v. Possession – SEC strict liability rejected
b) If given confidential information under agreement to keep it confidential that creates a duty that can serve as a
basis for 10B5 liability SEC after-effect to ______
Misappropriation Theory-O’Hagan page 922
1) Fraud and 10B5 liability exists where someone
a) misappropriates confidential information
b) for securities trading purposes
c) in breach of fiduciary duty or other trust relationship
 “owed to source of information”
d) BROADER than traditional insider traditional
e) Traditional Theory of Insider Trading v. Misappropriation Theory
 Traditional: Duty of Insider to Corporation
 Misappropriation: Duty of Outsider to Source of Information Not to Corporation
SC Position - Fiduciary Relationship Required
1) SC Rejects Broad Duty to Market Chiarella (Printer)
a) Requires liability be related to a “duty to corporation”, which only an insider can have
 Rejects expanding 10B5 liability and insider definition to include non-insiders because of a “duty to the
market”
 No general duty between all participants in market transactions
 Must be a relationship between the party trading/benefiting and the corporation that gives rise to a duty
b) Silence especially is only fraudulent if there is a duty to disclose
2) SC accepts Misappropriation Theory as basis for 10B5 liability of outsiders O’Hagan
3) SC Again Requires a Breach of Duty for 10B5 Violation
a) – defines a relationship of trust and confidence Kim
b) UNLIKE SANTA FE – where breach of duty was not basis for 10B5 liability
c) Now breach of duty must exist for 10B5 liability
 After Kim, SEC created a duty if under confidentiality agreement
d) Must be a fiduciary relationship or relationship of trust and confidence that creates a breach of duty for 10B5
liability
4)
B.
C.
243

e)
Relationship of trust and confidence exists
 where confidential information obtained because of their position with the corporation
 functional equivalent of a fiduciary relationship Kim
 That relationship gives rise to the duty to disclose or abstain from trading stock of that corporation - to prevent
an unfair advantage
SEC Rule - Confidentiality Agreement: If given confidential information under agreement to keep it confidential as
a legal obligation (rather than ethical or moral obligation Kim) that creates a duty that can serve as a basis for 10B5
liability
Chiarella SC Powell 1980 not guilty
-Information he was trading on here was actually “outside” information, because he figured this out for himself by deducing
what the companies were that were eventually going to merge
Directors and officers owe a fiduciary duty. Chiarella was an employee of an unrelated printed company, not a director
or officer of the corporation’s whose stock he purchased.  Chiarella did not breach a fiduciary duty  did not violate
Rule 10b5
=Printer had no duty to company or market that would create 10B5 liability for failing to disclose insider
information before trade
 Rejects expanding 10B5 liability and insider definition to include non-insiders because of a “duty to the
market rejects SEC's aggressive interpretation because extending the applicability of Rule 10b-5 to these kinds
of situations would injure the efficiency of the markets. “A purchaser of stock who has no duty to a prospective
seller because he is neither an insider nor a fiduciary has been held to have NO obligation to reveal material facts.

 =the “traditional" or “classical theory" of insider trading.
In Chiarella v, United States, the person trading with the benefit of inside information
was not an insider of the corporation whose stock he was purchasing, Instead, Chiarella
worked for the printing company that was preparing tender ofier documentsl He was able
to figure out the identity of the target corporation, bought its stock, and sold that stock for
a profit after announcement of the tender offer
Chiarella was convicted of violating Rule 10b5 but
The Supreme Court reversed the conviction because the jury instruction was wrong,
The jury instruction was consistent with the above dicta from Texas GuLfSuthur,
The jury was told that all that they needed to find in order to convict Chiarella was that he
benefitted from material, non»public information in buying the stock, The Supreme Court
held that the jury instruction was wrongfmerely proving possession of material nonpublic information by a buyer of stock is not enough to establish a violation of Rule 10b75 .
f)
g)
In explaining this holding, the Court in Chiarella developed what has come to be
known as the “traditional" or “classical theory" of insider trading. Under this theory, section 10(b) of the 34 Act and Rule 10b75 are violated when a corporate insider with material nonpublic
information buys or sells her corporation's stock. The violation arises from a breach of fiduciary duty
Directors and oflicers owe a fiduciary duty Chiarella was an employee of an unrelated
printed company, not a director or officer of the corporation’s whose stock he purchased.
FACTS: Chiarella worked for printer that printed disclosure materials for tender offers and he traded shares of the
companies he knew were involved, even though the names of the securities were blanked out. SEC, brought 10B-5
charges against Chiarella and he was convicted of violating
REASONING / HOLDING
 Expansion of state common law because Chiarella had no fiduciary relationship with any party to his stock
transactions.
244

h)
Justice Powell struck down SEC's aggressive interpretation because extending the applicability of Rule 10b-5 to
these kinds of situations would injure the efficiency of the markets. “A purchaser of stock who has no duty to a
prospective seller because he is neither an insider nor a fiduciary has been held to have NO obligation to reveal
material facts.
 Powell also challenged the institutional capacity of the SEC as an administrative agency to expand the rules
beyond that which Congress had intended.
Powell succeeded in establishing the common law of fraud, rather than the SEC's expansive extension of
Congressional intent, as the basis for Rule 10b-5 liability.
-CASE NOTES
-Back in the old days for this case, printing company still in business, through typewriters
-SEC caught this guy, entered into a settlement with them, returned the profits, he thinks the case is over, however, he was indicted by
the criminal courts even though he already settled with SEC
-Charged with violation of 10b-5, based on Texas GULF AND CADY ROBERTS rule that anyone who has material information must
disclose or abstain from trading on it
-Information he was trading on here was actually “outside” information, because he figured this out for himself by deducing what the
companies were that were eventually going to merge
-Court said NO open ended duty to disclose-SEC said it does not matter to the court because we have a clear case of fraud because he
misappropriated the information given to him as a printer
-SCOTUS, cannot present new information on appeal, stands no showing of any duty to disclose, conviction was thrown out,
-Sharply curbed the SEC approached that previously held anyone who has material inside or outside information must disclose, there is
no open ended duty to disclose the material information if there was no duty to disclose because the person was an insider in some way
-LOOK AT NOTE 5 On PAGE 920, US v. Carpenter, Markham spoke about this case at length
the Supreme Court in Chiarella and Dirks narrowed the impact of Rule 1ob75 on trading
with inside information. -Cady Roberts, created a new doctrine under 10b-5, SEC adopted or created an equal access, must either
disclose or abstain, not yet been excepted by the courts
 After Chiarella, the SEC adopted Rule 14e—3 which bars
everyone - not just directors and oflicers - from buying or selling
stock on the basis of material, nonpublic information about tender
offers.
14e-3– applies to any persons - NO ONE CAN USE INSIDE INFORMATION ON MERGER
In Carpenter v. U.S.,
-LOOK AT NOTE 5 On PAGE 920, US v. Carpenter, Markham spoke about this case at length

misappropriation theor(=D stole info  guilty for mail and wire fraud  SCOTUS undecided
about 10b
SCOTUS. in Carpenter was split regarding the misappropriation theory
however, It was unanimous that such conduct violated mail and wire fraud (financial fraud involving
the use of telecommunications or information technology)







D reporter stole info
Carpenter – reporter tipped friends in advance.
Reporter was charged criminally for violating 10b-5.
SEC sued him for insider trading criminally.
SEC brought another case based on the misappropriation theory against him
2d Circuit said he had violated 10b 5.
appealed to SCOTUS
245

Supreme Court confirmed his mail fraud charge but his conviction of Rule 10b-5 was affirmed due
to a 4-4 vote without opinion. Supreme Ct. was evenly divided so decision of the 2d Circuit was let
stand. However, the opinion was therefore not authoritative.
This issue went up again to Scotus in the O’Hagan case.
Ginsburg wrote the opinion
UNITED STATES V. O’HAGAN Accepts Misappropriation Theory guilty of 10b
duty to the source of the information factually similar to Dirks
(d) We therefore find that the misappropriation theory can provide the basis for a section 10(b) violation. To hold otherwise
would frustrate the congressional purposes of the Act. If such conduct were not held to be a vio- lation, it could have the effect
of inhibiting participation in the market.
O’Hagan “Misappropriation Theory” Expand the Insider Trading Application of Rule 10b-5?
How? the Court focused on whether the defendant owed a fiduciary duty to the source of the non-public
information  Ohagan was not working for the target corp whose stock he bought.
In both Chiarella and Dirks, the Supreme Court focused on whether the defendant owed a fiduciary
duty to the corporation whose stock was being bought or sold (that’s why they were not guilty)
Misappropriation theory = a person commits fraud in connection with the securities transaction and
thereby violates section 10(b) and 10(b)-5, when he misappropriates confidential information for securities
trading purposes, in breach of a duty owed to the source of the information.
 =a person who trades in securities for personal profit, using confidential information stolen (misappropriation
theory) is in breach of a fiduciary duty to the source of the information  is guilty of violating section 10b-5 and
10(b)

the trader's duty is not owed to another trader, but to the source of the information.
OHAGAN FACTS:
 Company A is taking over Pillsbury.
 Lawyer of A traded.
  guilty
 Lawyer has no relationship with Pillsbury But Lawyer abused his duty/fiduciary relationship with
his law firm and its clients
o – need to have a fiduciary duty to the owner of the info.
o The misappropriation theory is design to protect the integrity of the securities markets against
abuses by “outsiders” to a corporation who have access to confidential information that will affect
the corp’s security price when revealed, but who owe no fiduciary or other duty to that corp’s
shareholders.
Exam hints:
246
(1) The Supreme Court in O’Hagan expressly limits its use of the "misapprcr
priation theory" to criminal actions
(2) Footnote 14 from Dirks is not directly relevant to the O'Hagan facts.
Supreme Court’s O'Hagan decision expands classical or traditional insider trading to lawyers working for the corporations whose stock they
buy using material nonpublic information.
O’Hagan was not working for the target corporation whose stock he bought,
++The other federal securities laws that might have been covered in your basic business
associations/organizations course apply only to public corporations Public corporations
are, of course, corporations that have issued stock publicly. And, of course, a corporation’s
offering of its stock to the public is called a public offering.
O'Hagan was a lawyer with a large firm. He learned of atender offer that others in his
firm were working on and bought stock in the target company, the Pillsbury Company.
In a criminal proceeding, O'Hagan was convicted of violating section 10b of the 34 Act and Rule
10b-5.
The Supreme Court affirmed the conviction.
"The misappropriation was properly made the subject
of a section 10(b) charge because it meets the statutory requirement that there be 'deceptive' conduct 'in connection with’ securities transactions."
O'Hagan was not a Pillsbury officer or director, nor did he receive material nonpublic
information from a Pillsbury insider. Neither O’Hagan, nor his law firm was the attorney
for Pillsbury, Accordingly, O'Hagan did not come within the classical or traditional theory
of insider trading developed in Chiarella and Dirks.
The Court in O’Hagan did not rely on the classic theory of insider trading developed
in Chiarella and Dirks.
Instead, the O’Hagan case relied on the "misappropriation theory" of
insider trading, which looks to the relationship between the defendant and the source of
the nonpublic information.
The Court’s reasoning was that O'Hagan was in a fiduciary relationship with his law
firm and its clients. By buying stock of the target corporation, O’Hagan misappropriated
information belonging to the law firm and its clients, This was abreach of his fiduciary
duty, or, in the Court’s language: "The misappropriation was properly made the subject
of a section 10(b) charge because it meets the statutory requirement that there be 'deceptive' conduct 'in connection with’ securities transactions."
Issue: Does a person who trade in securities for personal profit, using confidential information
misappropriated in breach of a fiduciary duty to the source of the information, violating 10(b) and 10b5? (Yes, using misappropriation theory).
Under traditional insider liability, §10b-5 is violated when a corp insider trades in the securities of his corp
on the basis of material, nonpublic information because a relationship of trust and confidence exists
247


between the shareholders of a corporation and those insiders who have obtained confidential information
by reason of their position with that corp. That relationship gives rise to a duty to disclose because of the
necessity of preventing a corp insider from taking unfair advantage of uninformed stockholders. The
classical theory applies to insiders and temporary insiders.
Rule:
Misappropriation theory = a person commits fraud in connection with the securities transaction and
thereby violates section 10(b) and 10(b)-5, when he misappropriates confidential information for securities
trading purposes, in breach of a duty owed to the source of the information.
o – need to have a fiduciary duty to the owner of the info.
o The misappropriation theory is design to protect the integrity of the securities markets against
abuses by “outsiders” to a corporation who have access to confidential information that will affect
the corp’s security price when revealed, but who owe no fiduciary or other duty to that corp’s
shareholders.
Outside does not escape liability simply because he was associated with, and gained nonpublic information
from, the bidder, rather than the target.
Ct. in Carpenter was split regarding the misappropriation theory.
1. It was unanimous that such conduct violated mail and wire fraud (financial fraud involving the use of
telecommunications or information technology), even though you can escape the 10b-5.
Court changed and adopted the misappropriation theory this time.
Theories – classical, misappropriation, tippees.
Classic theory : if you are insider, you have fiduciary duty to the company and
shareholders.
 Scotus adopted
Misappropriation theory – permission may have some influence on legality.
Company A is taking over Pillsbury.
Lawyer of A traded.
 guilty
Lawyer has no relationship with Pillsbury But Lawyer abused his duty and stole info from Company A. 10b-5
applies when the information is misappropriated.
Raised question if Wall Street Journal give the permission for Carpenter to trade, theoretical there is no liability.
Football coach overheard tip –not guilty. When are you stealing?
Psychiatrist - guilty



Court found he was liable for 10B5 violation while representing the bidder
Would not have found 10B5 violation if he represented the target of the bidder
Classic Fiduciary Relationship
-CASE NOTES-Holds that the misappropriation theory does constitute, a violation of 10b-5
-Depends on some improper taking of the information and using that information for their own personal gain, must be when the person is
given the information in some kind of confidence from the source of the information
248
SEC following the Chiarella enacts rule 14(e) page 591 of the
rule supplement book
-
-Look at the notes of following Case on page 926, Markhamd liked these see if they are exam questions
Notes p. 925
Note 1. The misappropriation theory is consistent with the agency principles. But it results in
some very uneven applications.
Reporter of newspaper guilty,
football coach who overheard boosters not guilty,
psychiatrist guilty.
Note 2. What if the reporter’s company give permission to reporter or the company making tender
offer proposes to pay the law firm by letting them trade with inside information in lieu of legal
fees? Is there any other legal basis for imposing liability for this use of nonpublic information? –
Tipper, tippee?
US v. Kim SC Breyer 2002
a) Δ Kim, a CEO, traded in stock of Meridian based on confidential information of merger of Meridian that he obtained
as a member of the Young President’s Organization YPO.
b) ISSUE Whether relationship between Δ and members of YPO give rise to a legal duty of confidentiality which can
serve as a basis for 10B5 liability under the misappropriation theory?
 Here, not classic fiduciary relationship
 What is a relationship of trust and confidence?
 Case analyzes fiduciary relationship as a means of determining what a relationship of trust and confidence
c) Fiduciary Relationship
 Reliance + Superiority / Influence
 Attorney, Doctor, etc. – Superior knowledge
 Employer-Employee
 Relied heavily on Chestman
 “The heart of the fiduciary relationship lies reliance, and de facto control and dominance. The fiduciary
relation exists when confidence is reposed on one side and there is resulting superiority and influence on the
other.” Page 929
d) HOLDING: Court refused to find a relationship of trust and confidence between Kim and YPO member
e) SEC AFTER-EFFECT
 NEW RULE: If given confidential information under agreement to keep it confidential that creates a duty
that can serve as a basis for 10B5 liability
-CASE NOTES
-Did he misappropriate the information?-Court said this is not the relationship where we can find misappropriation, can’t find a duty to
keep the information in confidence, no duty to keep the information confidential and no violation of 10b-5
-10b-5-2 rule added after Chestman,
3) Chestman
a) Broker-dealer finds out from a prospective client down the pipeline that the company – Waldbaum was being taken
over. He trades on that information. Broker argues no duty to Waldbaum so not liable
b) 2nd Circuit Court says
 No 10B5 LIABILITY
 Misappropriation Theory did not apply because there was no fiduciary relationship
 No evidence that Chestman knew the tipper was breaching a confidential relationship
 14e-3 violated – applies to any persons - NO ONE CAN USE INSIDE INFORMATION ON MERGER
 Broker did violate 14-e-3
-CASE NOTES
-Did uphold Chestman conviction on 14e-3, mail and wire fraud convictions
2)
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-Now 10b-5-2 designed to close the Chestman gap, if somebody gives you information where you agree or confidentiality should be
reasonably expected you will be subject to 10b-5
14e-3 violated – applies to any persons - NO ONE CAN USE INSIDE INFORMATION ON MERGER
“Tippee” Liability
Dirks v. SEC
the Supreme Court limited the application of Rule ions with
respect to tipping Secrist, a former insider of Equity Funding Corporation (EFC), was con»
cerned about fraud at EFC.
Secrist tipped off Dirks, an investment analyst, to the EFC fraud in the hope that Dirks would expose the
scheme. Dirks told his brokerage firm's clients about the EFC fraud and they sold their EFC stock before
the fraud became public knowledge, avoiding significant losses.
The SEC censured Dirks for violating Rule IDES,
Supreme Court reversed
In so ruling, the Court in Dirks provides three tipping rules:
(1) insider = A person is a tipper for purposes of Rule lob—5 only if she (i) is an insider of
a corporation who (ii) passes along nonpublic information about the corporation (iii) in
breach of a fiduciary duty to the corporation and (iv) receives some benefit for it. So Secrist
was not a tipper. He received no benefit by revealing the information of the EFC fraud.
(2) There cannot be a tippee for purposes of Rule 10b-5 without a tipper.
Since Secrist was not a tipper, Dirks is not a tippee,
(3) A tippee assumes the fiduciary duty of his tipper, and so violates Rule ___ by tipping
others. Again, this does not apply to Dirks. Since Secrist violated no duty to EFC when he
gave the information to Dirks, then Dirks did not violate Rule IOIFS when he gave the
same information to his firm’s customers.
In footnote 14, Dirks suggests that accountants, attorneys, consultants, or underwriters
who in the course of their work for a corporation receive non»public information should be
viewed as temporary insiders with all the fiduciary obligations of an insider. Accordingly,
such a person violates Rule lob—5 by buying or selling stock of the corporation that she is
working for, or by tipping others who buy or sell that stock
4)
Dirks v. SEC (SCOTUS 1983)
250
No duty on tippee UNLESS 1) you knew tipper breaching a fiduciary duty 2) from which tipper would derive
financial or reputational benefit
b) FACTS:
 SEC had censured Dirks, a securities analyst, for tipping The Wall Street Journal and some of his customers about
a growing fraud scandal that he had uncovered at Equity Fundings
 Principal of company tells Dirks the company had overstated its assets
 Dirks tells his clients, tells Wall Street Journal and tells SEC
 He was TRYING to disclose
c) REASONING
 What is the duty and responsibility of a tippee?
 No general duty to disclose
 That duty arises from a fiduciary relationship
 You do not automatically inherit the duty from an insider
 HOWEVER anyone who knowingly participates with an insider with the breach of their Fid duty
 Must show you knew of the fiduciary duty
 Was the information given to you because the insider would benefit personally - Financially or
Reputationally?
 Dirk was outside analyst – no benefit to Tippee
d) HOLDING: SC reversed SEC censure, rejected the SEC's interpretation of Rule 10b-5 coverage for tippee liability
 Powell asks SEC how far the chain of liability went
 Relying on common law of fraud
 Required a breach of a specific fiduciary duty and Dirks's sources clearly violated no duty
 Limits tippee insider trading liability to breaches of duty that closely resembled traditional fraud actions in state
corporate law.
 The Court rejected the SEC's view that anyone who received non-public information from a corporate insider
"inherited" the insider's legal obligation to either make the information public or abstain from trading.
e) EFFECT / IMPORTANCE
 Finding of insider trading liability turns on the motive of the insider, whether the "insider personally
benefited, directly or indirectly, from his disclosure."
 The very definition of insider trading the SEC had long hoped to avoid.
-“TIPPEE” Liability Notes
-When the insider tipped another person, the tippee is not an “insider”, the “tippee” will tip along the way till it goes down the whole
“pipeline” because when the information is out the people will trade on it and make money because they know the stock will go up
-Question that we have is whether the insider is guilty? Certainly guilty if they trade on own account, but what about the “tippee”?
-Is the “tippee” liable under 10b-5?
-MARKHAM CASE DIRKS
-Dirks was an investment analyst, this is before regulation FD-Full Disclosure, Dirks befriended an employee and saw that the company
Equity Funding of America was committing fraud
-Dirks told his clients to dump their stock in Equity Funding, and saved his clients a boat load of money, Dirks did not trade on the stock
himself, Dirks tried to tell the SEC and the Wall Street Journal but nobody listened to him
-SEC went after Dirks, Dirks was censured only because the SEC was tipped by Dirks
-Dirks was charged with using the inside information, he was a “TIPPEE” according to SEC
SCOTUS said NO, tippee has not duty to disclose information, ONLY if the Tipee know the source of the information committed a
breach of the fiduciary duty and the Tipper would derive financial or reputational benefit
a)
SEC v. Yun 11th Circuit (2003)
a) Broad interpretation of benefit to tipper
b) Husband tells wife about company problem. Co-worker overhears wife telling her divorce lawyer and the co-worker
traded on the information.
c) SEC wants to find wife liable for 10B5 liability under Misappropriation Theory
 Wife had relationship with husband that creates a fiduciary relationship – you are insider
 You tipped your co-worker by letting him overhear your conversation
 Because you had a business relationship with co-worker (shared commissions etc) she was deemed to have
derived a benefit
 Broad interpretation of benefit to tipper
-CASE NOTES5)
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-Classic Theory-Insider, officer or director of the company
-Misappropriation, O’Hagan Case, accepted the misappropriation liability through duty to source of information
-Analysis is the same for “tippee” liability
-How do these insider traders get caught?
-1) SEC and NYSE, and NASDAQ, all follow the stock market, sole job is to follow the market every day, and if there is a large
announcement, there is a large movement in the stock of whatever stock
-Investigation will take place of any of the people who traded on the stock before the announcement
-People often lie, problem is that many of these cases could be settled administratively, have to pay back 3x the earnings
-However, people lie and then SEC brings criminal charges for lying to the government
-2) SEC gets wind of suspicious activity and then they start the plea bargains to get the big fish
-Dennis Lavine, broker in NY, big story, ring of informants, young lawyers, often tipped about pending deals at the law firms
-Lawyers sat dwn with Lavine, and said you have difficult choices here, big charges, insider trading etc.
-Lavine looks to “rat” other people out, only rat up you cannot rat down, according to SEC
-Ivan Bosky??-“greed is good” line from Wall Street the movie actually
-Now Bosky has the same problem, who can he rat out?
-Michael Milken-Junk Bond King, 550 million deal, wasn’t anybody bigger than him, he got 10 years
-SEC will also subpoena all the phone records, e-mails, instant messages, bank accounts, and find out if there is any connection to
anyone connected with the company
-Modern life, every minute of our lives are now pretty much documented, very easy to find out everything
-Other issues are foreign accounts, we will use foreign accounts to hid the transactions, now the SEC has memorandum and
understandings with most foreign governments around the world, SEC will be able to get the information-regardless of country bank
laws, including Switzerland the ultimate in secrecy
-Foreign bank accounts are a real bad idea, 1) SEC loves to jump on airplanes, travel, and look for information-income tax return force
you to disclose that you have a foreign account, need to pay taxes on that account, and problems with the government finding out
something foreign=something illegal going on
Bahamian bank
– ebvery trade made money for their client
Dennis levine ratted out ivan bosqui (the guy who told the world of “greed is good” – the two were engaged with insider trading
Ratted out Mike Milkin – made 600 million a year
One got 3 yra jIL TIME AND FINED 600 MILLION-that's how these cases go
Martha Stewart
(sold on the basis of insider trading)- SEC sued her
Martha Stewart had a convo with Merril lynch – she sold her Enclone stock (saved her $58,000)
Lots of officials and lawyers sat in on a hearing for her story -she should have taken the 5th amendment
Charged and convicted with false statements to the govt – ink expert came in and said
She would have had to pay 3 X 58,000
Instead, her company lost hundreds of millions of dollars + vacation in West Virgina
FBI finds out everything!
-MARTHA STEWART CASE XXX
-Martha Stewart and Broxal, same broker at Meryl Lynch,-Both invested in a drug thought to due well had hiccups, and the other guy
Broxal sold all of his stock because he freaked out
-Same broker at Meryl Lynch had told Martha Stewart that the other guy was selling
-What she said happened was she went into the broker and the broker told her if the stock in the drug falls I would put a stop order in the
stock at $59 and sell automatically
-She told the same story to the investigators from SEC and everybody else who was trying to get involved in it
-She did not take the 5th, she decided to tell the story of automatically selling stock at $59
252
-Problem was somebody ratted out the boss the broker, and the broker told the underling to tell Martha Stewart to sell the stock, Stewart
is on phone connection
-She was convicted of giving false information to the government, NOT insider trading
Spoofing- people would spoof emails with fake addresses (from an insider of the company) with fake information (why the stock will go
up) and therefore, the people would try to get off this way
Pump and dump - people pump info about stocks and get everyone to buy it then the people would dump the stock
Use v. Possession of Insider Information
A. Rebuttal Presumption
1) that you used confidential information in trade, rebuttable with plan that shows you were planning that trade before
2) SEC v. Adler 11th Circuit
a) Use v. Possession of Confidential Information as basis of 10B5 liability
b) He had a pre-existing plan to sell the stock – he did not trade BECAUSE of inside information he had
c) TESTS:
 SEC PROPOSES: Knowledge and Possession – Strict Liability
 Hard to prove you used info for trade so we will make strict liability
 COURT SAYS: Rebuttal presumption that you used confidential information in trade,
rebuttable with plan that shows you were planning that trade before
d) SEC Codified Rule: If you have a plan you can sell your stock, but must have a plan
-CLASS NOTES Starting 11/9/11
-misappropriation-could be an outsider who misappropriates or stills the information could violate the statute
-What is the liability to someone who is tipped? Well, maybe, in those instances where the insider is profiting either financially or by
reputation the person may be liable
-Whether the tipper would receive a benefit is the test.
-Looking at the concept of use versus possession
-Chestman Case-Who constitutes an INSIDER?-If you gave the information to someone with the expectation to be kept confidential, or
if the relationship by its normal course would be understood to maintain the information confidential, like that of a spouse
-CASE NOTES SEC v. ADLER
-Issue is USE versus POSSESSION?
-SEC does not give a definition of insider trading because they think that if they give a definition of the insider trading business people
and lawyers will find a way to get around it
II.
III.
Civil Liability For Insider Trading-starting on page 958
A. Expanding Civil Liability
1) Originally - No Civil Liability under Misappropriation Theory
a) Private right of action only under classical insider trading
2) Rules 21A and 20A change this
a) Expand civil liability of trader
b) SEC sought and Congress enacted ITSA and ITSFEA
c) Anyone trading while in possession of material nonpublic information
 Rule 21A Can be penalized up to 3X profit by SEC
 10% to whistleblowers
 Rule 20A Trader liable to others trading on other side
B. SEC Rule 21A
1) ITSA and ITSFEA
a) ITSA Insider Trading Sanctions Act and ITSFEA Insider Trading and Securities Fraud Enforcement Act
b) Stiffer sanctions for insider trading
2) SEC can seek civil penalty of 3Xs the profit
a) $1M penalty maximum
b) Reduced by disgorgement
3) Up to 10% of civil penalty paid to whistleblower
C. SEC Rule 20A
253
Civil Liability Liable to any person contemporaneously trading he same security on the other side of the market
No Double Jeopardy for Civil Disgorgement
1) Civil liability of disgorgement does not bar criminal prosecution, or vice-versa
1)
D.
-
MERGERS + Acquisitions (start here)
Generally, the shareholders of the disappearing corporation give up their stock in the disappearing corporation and get stock in the surviving corporation
+ cash out merger “cash for stock merger” = the shareholders of the disappearing corporation receive cash instead (no longer
own the stock) affects their voting rights in the surviving company watch out for freeze out mergers!
The plan of merger must be approved by the BOD and the requisite majorities of the shareholders of
BOTH the disappearing and the surviving corporation – also required by both the MBCA and DGCS
Merger Dissenting shareholder’s rights
First, you know that shareholders who are unhappy with the merger can vote against it
Second, you know that mergers also require decisions by the board of directors, a
shareholder who is unhappy with a decision of the board of directors can claim that the directors
who approved the merger breached their Duty of care or Duty of loyalty (if the facts support such a claim)
Ex. if it was a freeze out merger sue for fairness
"freeze out merger" = Watch for a merger in which (i) the shareholders of the disappearing corporation receive cash
and (ii) the majority shareholder of the disappearing corporation is also the owner of the
surviving corporation. Such a merger is called a "freeze out merger" because the minority share»
holder is forced out, ie"frozen out," when you see such a fact pattern in an exam question you are
seeing an interested director transaction and your professor needs to see your application of the Entire Fairness Doctrine
Whether the terms of a proposed merger was fair to the minority shareholders
Procedure:

Л must allege specific acts of fraud, misrepresentation or other misconduct to demonstrate unfairness of merger to minority – and a basis for invoking the fairness obligation.

 D - Burden then shifts to controlling shareholders to prove transaction was fair and all material information was disclosed
=The controlling shareholders must carry the burden of proving the merger was fair and that all material information was disclosed. Weinberger v. UOP

ENTIRE FAIRNESS COMPONENTS

Fair Dealing

Transaction structure, negotiations and how approved

Fair Price

Economic and financial considerations of proposed merger

But fairness considered as a whole, not a bifurcated test

Where one stands on both sides of a transaction, he has burden of establishing entire fairness (fairness in dealing and price).
Appraiser right Third, and most important, dissenting shareholder can asserts her right of appraisal can compel the corporation to pay her
in cash the fair value of her shares as determined by a judicial appraisal process.
The phrase "appraisal rights" is incomplete and maybe even misleading A shareholder who opposes
a merger and complies with the detailed statutory requirements in Delaware General Corporation
Statute section 262 (or MBCA Chapter 13 or whatever the relevant state corporation statute is) has
more than the right to have her shares appraised or valued. Rather, a shareholder who properly asserts her dissenting shareholder’s right of appraisal can compel the corporation to pay her in cash
the fair value of her shares as determined by a judicial appraisal process.
Merger agreement values Acme Corp. at $3,000,000 and so provides that Acme Corpl shareholders will
receive consideration that has a value of $3,000,000 This consideration can be Baker Corp. stock or
other property or cash As a 10% shareholder of Acrne Corpl, S would receive 10% of that consider-
254
ation, i.e. consideration with a value of $300,000 S instead properly asserts her dissenting shareholder's right of appraisal. The court decides that the fair value of Acme Corp. is $5,000,000, and not
$3,000,000 S, as a dissenting shareholder who owns 10% ofthe outstanding stock ofAcme Corp,
and seeks appraisal, has a right to $500,000 (10% of $5,000,000) in cash not $300,000 (10% of the
$3,000,000 of total consideration actually received by Acme Corp).
Not all mergers trigger appraisal rights
If corp is listed national securities exchange(public) or corp has > 2,000 record shareholders  no shareholder appraisal rights
Because these comps have a market the shareholder can sell
DGCS 262(b)  appraisal rights are not available for shareholders of corporations whose stock is listed on a national
securities exchange or which has more than 2,000 record shareholders
 The MBCA and most states have similar provisions
This statutory exclusion of appraisal rights makes sense. If a corporation’s stock is publicly
traded or if the corporation has a large number of shareholders, a shareholder unhappy with a plan
of merger has a market for her shares. She does not need an appraisal remedy, she can sell her shares.
State corporate statutes further limit the availability of appraisal.
1. The shareholder must send notice to her corporation of her intent to exercise appraisal rights before the shareholder vote.
2. of course, the shareholder must later abstain or vote against the merger.
3. Finally, if the merger is approved, the shareholder must timely tender her stock to the corporation and make a written
demand for appraisal.
Then the court must determine the fair value of her shares.
 Corporate statutes provide little guidance as to how courts should determine fair value.  According to Weinberger v.
UOP, a leading Delaware decision, courts can use any valuation technique considered acceptable in the financial
community.
When the dissapearing company continues to exist after merger
Acme Corp,’s sale of all of its assets to Baker
Corpl does not end Acme Corp.’s existence. Instead, Acme Corp.’s sale of all of its assets to Baker Corp.
simply changes Acme Corp,’s assets from what it once owned (now owned by Baker) to the
proceeds from that sale to Baker.
The existence of a corporation that sells all of its assets commonly ends shortly after that sale.
The selling corporation often follows up the sale of all of its assets with dissolution
(legal process of ending the corporation’s existence) and liquidation (distribution of the sale proceeds first to the corporation’s creditors and then to its shareholders),
creditors of disappearing comp remain creditors of that disappearing comp even
after the sale of all its assets to
survivor comp
This should make sensefin theory, After the sale of its assets to Baker Corp, Acme Corp, has the
sale proceeds, In theory, those sale proceeds should have the same market value as the Acme Corpl
assets that have been sold, Thus, in theory, Acme Corp,’s creditors have not been adversely affected
by Acme Corpl's sale of all of its assets
Acme Corp,’s sale of all of its assets to Baker Corp, would have to be approved by
(1)Both Acme Corp’s BOD. and Baker Corp’s BOD. and
(2) the shareholders of Acme Corp (not Buyer corp’s shareholders)
rights of either parties in a transaction of the disappearing comp’s assets
o The shareholders of the selling corporation have a right to vote on the sale and have appraisal rights.
o The shareholders of the buying corporation have neither the right to vote on the purchase nor appraisal rights
unless the Baker Corps shareholders are able to convince the court to apply the "de facto
 merger doctrines” see chapter 18
255
MERGERS AND ACQUISITIONS (start above)
CHAPTER 17
I.
M&A Issues
A. Types of M&As (how mergers occur)
1) Merger
2) Consolidation
3) Stock Purchases (makes target company a subsidiary)
4) Asset Purchases
B. Consideration
1) Cash
2) Stock
C. Some Concerns
1) Valuation of Target Company-How much is the BUYER willing to pay?
a) Investment bankers issue Fairness Opinion
b) Look at Price to Earning Ratio, Return on Equity, and EBITA (earning before interest, taxes, and depreciation)
2) Liabilities of Target Company
a) Make target subsidiary rather than merging to isolate liabilities and protect parent stock
D. Due Diligence
1) Background investigation conducted before purchase to identify potential impediments to merger
a) Governmental Consents
 FTC Anti-Trust Approval
 Hart-Scott-Rodino Anti-trust Act
 If more than $50M Purchase Price
 30-day waiting period
 Other regulatory agency approvals
 If foreign country there may be restrictions, filings (especially if defense-related)
b) 3d Party Consents
 Depends on structure of acquisition
 Asset Purchase requires assignment of K by consent of K parties
 Mergers and Stock Purchases usually do not require 3d party consents
 Unless K has change of control provision triggering consent
 Ks may contain assignment restrictions or change of control provisions
 Depends on Articles or Bylaws
 Shareholder consent may be required for target or buyer company
 Depends on State Laws
 Supermajority shareholder consent of target may be required for merger
2) Types of Due Diligence
a) Organizational Status
 Structure of the Acquisition will have an impact on how important the Buyer investigates some areas.
 Asset Purchase v. Stock Purchase or Merger
 Buyer may spend less time on organizational tax, and employee benefit matters because it is not acquiring the
legal entity that was the previous corporation,
b) Material Contracts
 Acquisition and Financing Agreements
 Unexpected Liabilities
 Non-Compete
 Indemnification
 Options, ROFR, Reservations
 Change of control or assignment restrictions/prohibitions
 Pricing Provisions
c) Labor Matters
 Key Employees subject to non-compete and confidentiality
 Union Ks
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 Grievance Logs
 Employee benefits that will accelerate
 Whether any special payments will be triggered as a result of the acquisition, and if so, who pays?
d) Litigation Investigation
 Audit Response Letters
 Any outstanding or threatened litigation and other claims against the target company
 Judgment searches
e) Environmental and Safety Issues
 Compliance and clean-up issues
 Compliance- 1) has obtained appropriate environmental permits for its facilities and operations, 2) complies with
the terms of those permits, and 3) has appropriate safeguards concerning warnings, and programs in place for
employees in the workplace with respects to potentially dangerous chemicals and conditions.
 Environmental Permits
 Programs in place
f)
Intellectual Property
 Good title to all different types of IP, with copyright, domain name, US Patent and Trademark Office
 Infringements-whether the target company has infringed on another party’s IP rights, or another party on the target
 License Agreement provisions
g) Real Estate Due Diligence
h) Federal Securities Laws
E. Structure of Acquisitions
1) Structure often based on avoidance of certain factors
a) Tax liability
b) Other liabilities
c) 3d party consents
d) Shareholder approval
-MERGER AND ACQUISITIONS NOTES
-Groups involved, potential litigation
-No merger with some company that has a huge liability on its books, contracts, labor, real estate, once we merge checking is over, so we
have to check everything to determine any kind of liabilities
-Tax liabilities, Anti-Trust Concerns, Federal Trade Commission to know we are contemplating a merger, may require us to get rid of
some divisions
-Form of the Combination-Merger-means two companies are going to merge into one company, surviving entity will take over both
assets and liabilities of the previous target company
-Instead of Merger, Acquire the Company and Treat it as a subsidiary-to decrease the possibility of liabilities with litigation to the
company
-Usually all of this is on a very fast track, day and night trying to lay out those concerns
-State law issues, under most states law, the shareholders of both companies must agree to the merger of the two companies
-Costly-SEC filings, possible charges, violation of 10b-5 fraud for several firms just alleging that
-Appraisal Rights- In a merger shareholders may be given the right of appraisal in the buyout by the court
-Assets-here is cash leave all the liabilities concerns, we have to prove that we gave fair value for those assets
-Federal Securities Law-Williams Act, Tax Considerations, Accounting Issues
-Complex issues concerning goodwill of the company we acquired
-Resolution-You can put the goodwill on your balance sheet, but you have to write it off if you think the asset is not worth what you
think it was
-Accountants are going to be vital to this process-If you don’t want to merge in terms of liabilities, A can simply acquire B and treat it as a subsidiary
-Or Buy the assets of B, and simply give cash to B for the assets, B can liquidate it or just carry on without the assets of B
-Triangular Merger-creating a subsidiary that merges with the target company
-A creates a new subsidiary,
-Could be reverse triangular merger
-Whatever the entity is, the A shareholders will not get a vote, because A is simply requiring an Asset, if we were merging the A
shareholders would have to get a vote
-Mergers with a corporation and a LLC, we can do it bottom line, but we may have to jump through some hoops
-Typically, if you have an LLC, and are going to turn it Corporate, mechanical but we can do it and it needs to be done right
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II.
Forms of Combination
A. Factors Considered in Structure of Acquisitions
1) Statutory Procedure conveniences sought-Either 1) Merger, 2) Consolidation, 3) Sale of Assets
a) Statutory Combinations and Requirements
b) Shareholder Voting
 State laws
 Appraisal Rights
 Not in Ordinary Course of Business
c) Minority or Dissenting Shareholders
 Treatment of Minority Shareholders
 Fairness
 Appraisal Rights
2) Federal Securities Laws
a) Except if cash for assets
b) Extensive disclosures required for Public Offerings under Securities Act
c) Section 14 Proxy requirements of if shareholder voting
d) Section ___ Tender offers of
3) Tax Considerations (Tax Laws)
a) Some mergers tax free
b) IRC 368
 Type A: Mergers and Consolidations-May be entitled to tax deferred
 Type B: Exchange of Shares
 Type C: Purchase of Assets
 Type D: Spin-Offs, Split-Offs and Split-Ups
 Reorganizations
4) Anti-Trust and Regulatory Concerns
5) Liability Exposure
a) Product Liability
b) Superfund
c) See Ks, Acquisition Docs and Financing Docs
B. Need to look at the subsidiari’s voting rights What the Voting Rights and Appraisal Rights
1) Mergers – Yes
2) Share exchange – Yes
3) Sale of all assets - Yes
4) Buying
C. Statutory Forms of Combination
1) Merger: Target merges and disappears (“disappearing corp”) into Buyer corp who survives
2) Consolidation: Two corporations combine into a third surviving company
3) Triangular Mergers
a) Purchaser funds NewCo with its stock, stock that will be used for share exchange upon merger
b) T shares converted to P shares
c) Straight Triangular Merger: Purchaser >> NewCo (Survives) <<< Target
 Merger of Target into NewCo – Newco Survives
d) Reverse Triangular Merger: Purchaser >>> NewCo (Phantom) >>> Target (Survives) name of subisidiary becomes
B company because we want to keepthe value of the ???
 Merger of Newco into Target – Target survives
 If name of Target has value
D. Benefits of Triangular Mergers
1) OVER 2-PARTY MERGER
a) Avoids automatic assumption of subsidiary’s liabilities of P
b) Avoids voting and appraisal rights of P shareholders
 Critics argue it is an impermissible run-around shareholder approval
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Subsidiary can be kept in existence to avoid other problems-such as 1) new labor contracts, 2) impairments of
management and employee morale, 3) pension plan problems, 4) impairment of customer relations
2) OVER PURCHASE OF ASSETS
a) Greater flexibility in the types of consideration, P may pay for assets without jeopardizing tax-free status
b) T Merger avoids transfer of title
c) Reverse T Merger allows T to remain in existence to avoid termination of K, license or other rights
d) Eliminates the extra step of liquidating T corp, that would be otherwise involved
e) Avoid the need for P shareholder vote in very few states that require shareholders vote when assets are purchased
3) Other Benefits
a) Tax benefits available
b) MBCA 11.01 and 11.03 allows
Corporate Divisions
1) Spin-Offs
a) Shares of Sub distributed to shareholders of parent AS DIVIDEND
b) Like a Property Dividend
c) TAX PROBLEM: IRC 355
 Spin-offs of assets owned less than 5 years are taxable
2) Split-Offs
a) Some shareholders of parent EXCHANGE their parent stock for sub stock
 After split-off – some shareholders own sub, others own parent
b) Like a Redemption
3) Split-Ups
a) Parent’s assets divided between two subs and parent liquidated
b) Like a Dissolution
Sale of Assets
1) Sale of all or substantially all assets of corporation
a) Shareholder approval required
b) Question is: What is all or substantially all ?
 Look at quantitative and qualitative value of assets being sold within business as a whole
 Not by size of sale alone but by its qualitative effect upon the corporation
 Not always a set percentage (80% tax rule)
 Radical Departure Test – radically departs from prior business
2) Not in Ordinary Course of Business
a) Shareholder approval and appraisal rights may be triggered if NOT in ordinary course of business
b) BUT Not all transactions not in ordinary course of business require shareholder approval
3) “Tender Offer”
 = a general solicitation to all target company shareholders that they sell their shares to the acquirer.
 Share acquisitions can be based either on a cash purchase or on an exchange of shares
 = an offer to purchase some or all of shareholders' shares in a corporation. The price offered
c)
E.
F.
is usually at a premium to the market price.

4)
-does not require approval of the target corporation’s BOD
-purpose of a tender offer is to acquire a sufficient number of shares of the target corporation to replace the target’s
present board of directors with directors more acceptable to the bidders
Gimbel v. Signal Companies
When there is a merger of A and B-there is a liquidation of that company.
When we purchase the assets of B, is that a merger of B? basically, yes
a) What is sale of all or substantially all assets of corporation that would require shareholder approval?
b) Signal is parent of Signal Oil. Board of Signal approves sale of Signal Oil sub. Shareholders contest sale without
shareholder approval and seek injunction
c) P argues sale requires shareholder approval under DGCA which requires shareholder approval for sale of all or
substantially all assets
 Not all transactions not in ordinary course of business require shareholder approval
d) ISSUES: 1) Does the sale require authorization by a majority of the outstanding stock of Signal pursuant to DE statute?
And 2) Was the action by Signal’s BOD in approving the 480 million dollar sale price reckless as to justify the entry of
a preliminary injunction prohibiting the consummation of the sale?-page 984 top
e) Here, Signal had diversified its business operations (truck manufacturing, aerospace and industrial)
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f)
 Court looked at financials – Signal Oil had low rate of return
 Other business operations more prominent and profitable
 Signal now a conglomerate – not an oil company
 200M of Signal Oil assets sold in past 5 years
HOLDING:
 Sale was not a sale of all or substantially all assets that required shareholder approval
 However, preliminary injunction granted because of the disparity between fair market value of assets and purchase
price value of sale there is possibility P will succeed on the merits with respect to the purchase price
 Difficult to undo the transaction
-CASE NOTES-Section 271(a) of the DE General Corporate Law
-Holistic Approach-Only Question is really what does ALL of substantially ALL mean for purposes of the sale and does it require a
shareholder vote?
III.
De Facto Mergers  Successor Liability (=buyer comp will get disappearing corp’s liability)
A de facto merger occurs when a transaction (which is not structured as a merger in form) is in
substance a merger of the seller and buyer. The de facto merger doctrine is meant to detect these
transactions (usually an asset sale) to prevent companies from avoiding the assumption of seller's
liabilities while enjoying all the benefits of a merger.
Shareholder of buyer comp will attempt to characterize a sale of disappearing comp’s assets to his own corp as a de facto merger in
order to gain voting rights on thaat purchase and appraisal rights
For example, that Baker Corp, buys all of the assets of Acme Corp. As a result of the deal
structure, Baker Corpr’s shareholders will not be entitled to vote and will not have appraisal rights
Unhappy Baker Corp. shareholders argue that the sale of assets is a de facto merger.
 the court will ignore the form of the transaction (=elevate substance over form) and grant Baker Corp shareholders the right to
vote and to appraisal
WHY?
To review:
Disappearing Acme Corp,’s sale of all of its assets to Buyer Baker Corp, would have to be approved by
(1)Both Acme Corp’s BOD. and Baker Corp’s BOD. and
(2) the shareholders of Acme Corp (not Buyer corp’s shareholders)
rights of either parties in a transaction of the disappearing comp’s assets
o
The shareholders of the selling corporation have a right to vote on the sale and have appraisal rights.
o
The shareholders of the buying corporation have neither the right to vote on the purchase nor appraisal rights
unless the Baker Corps shareholders are able to convince the court to apply the "de facto

merger doctrines” see chapter 18
A.
B.
Sale of Assets as De Facto Merger
1) Where a corporation purchases most assets of a corporation the Courts may nevertheless find a De Facto Merger
a) Subject to Successor Liability (buyer corp acquires disappearing corp’s liabilities)
Successor Liability Exists – Shane / Rockwell
1) Express assumption of liability under K
2) Merger or Consolidation
3) Continuation (of selling corporation)
4) Fraudulent transaction to avoid liabilities
5) BUT ALSO DE FACTO MERGER
Knapp v. North American Rockwell
a) De Facto Merger (where the assetsa re purchased and they continue on as they did before) and Successor
Liability
b) TMW substantially sold all its assets to Rockwell in exchange for Rockwell stock. Rockwell dissolved 18 months later
but was prohibited after sale from active operations.
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Л was injured one year after the sale to Rockwell by a defective machine manufactured by TMW, sought to make
Rockwell liable for its injuries as a successor of TMW, subject to successor liability under the theory of de facto
merger
d) RULE: Court relies on Shane for the rule on successor liability
e) HOLDING: Court finds the transaction, although a sale of assets was a de facto merger  Rockwell could be liable for
TMW’s defective product liability, it was a continuation of the prior business
 Rockwell actually continued operations of TMW
 Assets, officers, employees and customer and supplier relationships
 TMW to dissolve as soon as possible
 TMW existed but had no true substance
 TMW could not conduct its active business operations
f)
POLICY dictates Knapp not be left without a remedy, Rockwell able to spread burden of loss, could have assumed
TMW’s insurance and did not
-CASE NOTES
-Asset Purchase we think we are leaving the liabilities behind
-Here not so, it was a continuation of the prior business, TMW still held liable
-Asset purchase may not be the clean and simple way to acquire another company, liabilities may still come with us
-Triangular Merger-Favored approach because the set up corporation by the companies will take care of the liabilities for a
shortened period of time
c)
Sun chemical case
Arguing the de facto merger doctrine
Were the selling shareholders entitled to be trateted as a merger with appraisal and voting rights?
As soon as the transaction ended, the one corp would dissolve.
The seller shareholder might be able to claim these rights but not .... thts what the delaware statute said.
transX was tainted with self interest
Hariton v. Aero Electronics(Del emphasized importance of form of transaction made De Facto less likely)
The Delaware Supreme Court in Hariton v. Aero Electronics, rejected a shareholder's efiorts to recharacterize a sale of assets as a de facto mergers.Hariton elevated form over substance because that
is what the Delaware legislature had done by providing different ways of accomplishing an acquisition with different consequences.
Unaninmous vote
You can argue either statute!
Herriton and archo challenged the sale
The court held the statutes have “equal dignitity” (you can pursue rights under either doctrine) - you can pursue legal action
under either statute for asset purchase OR statute for de facto merger
 Stock Split: corps. split stock 2 for 1 or some other formula so that for each share you own, you are
given another share. In theory, that doesn’t do anything and shouldn’t make any difference, but in fact
when a company announces this the value goes up. Done because: if stock price gets too high, people
won’t buy as large an amount.
.Appraisl process
3 kinds of appraisal valuations
 Market value
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o
o


Comparable properties: Find and select a neighborhood with comparable sales
Problem: appraiser may select a neighborhood with super high sales
For fairness, appraiser will adjust for things like extra bathroom and roof on that
house in that neighborhood
Can be very speculative!!!!! You can challenge these assumptions!
Replacement value
o They value your house based on how much it cost to replace it (including construction costs to bulldoze and replace
that property)
o Courts generally do not like this approach because were not replacing your house and market value is a more reliable
process
Income value
o If its used for rental, that renatl income and leases can bea good measure of income value
Look at what similar corporations have sold for
Problem: adjustments—very speculative
Replacement costs are not very useful
CHAPTER 18 FAIRNESS: APPRAISAL RIGHTS AND JUDICIAL CONTROL
II. Appraisal Rights
A. Appraisal Rights – Generally
1) DEFINITION
a) Rights of dissenting shareholders to demand payment of the fair value of their shares, available in the case of
certain fundamental changes (merger, consolidation, sale of all assets)
 X DGCA 262(b) Market-Out Exception for publicly traded corporations with 2000 or more shareholders
 X MBCA 13.02(b)(1) on NYSE, ASE or NASD market OR not so listed but has 2000 shareholders and share
class has $20M market value
 Efficient market available for disposal of shares at market
b) Best protection for minority shareholders in acquisitions involving controlling shareholder conflicts of interest
2) PURPOSE
a) Impetus: Remove doubt about constitutionality of statutes authorizing fundamental changes o existing corporations and
K rights of shareholders
b) In Theory: Allows dissenting shareholders both liquidity and an exit (safety valve to vent unhappiness)
c) In Reality: Protects the majority by allowing acquisition to continue uninterrupted by dissenting minority
 Change takes place subject to a collateral proceeding to value the shares
d) Existence of appraisal remedy provides incentive for Board to offer a fair price to avoid cost of appraisal actions
B. Statutory Requirements
1) Generally
a) Must attend meeting in person or by proxy to avail oneself of appraisal rights
b) In some situations must abstain from voting, in others must vote against
2) MBCA 13.21-13.26
a) 13.21 Must give written notice of intent to dissent prior to vote
b) Must refrain from voting in favor
c) Corporation must give notice to shareholders of procedure to be followed (no time limit)
d) 13.26 Shareholder must then demand payment of fair value within at least 30 days
e) Shareholder loses all rights as shareholder – except to payment
f)
Corporation must within 60 days of demand – initiate the proceeding
3) DGCA 262
a) Corporation must give notice to shareholders of procedure to be followed 10 days after the vote
b) Shareholder must make written demand for payment of fair value within 20 days
-APPRAISAL RIGHTS NOTES
-Contain attorneys fees, lawyers love it
-Trial here is economics, what is the value of the corporation?
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-Plaintiff will bring in appraisal experts that will express an opinion through a very thick report, sounds like science
-But then the defendant comes in with an equally thick report, and say it is worth considerably less
-Lawyers job is to attack the report of the other appraiser, KEY TO IT ALL ARE THE ASSUMPTIONS
-Think in terms of Real Estate to simplify first-1)Reconstructed Value-what would it cost to replace the house on the property
and what is the cost of the actual land, that is typically not accepted as a good appraisal because only outside of the property , 2)
Comparison Method-Similar Properties in the neighborhood, and we will see what they sold for and account for the comparable
amenities
-ALL apparaisers opinions based/TURNS ON ASSUMPTIONS
Appraisal opinions for corporations:
-For Corporations we may use something called 1) Income and 2) Capitalization
-Corporations we are really talking about income, NIKE STORE-we have only $10,000 worth of shoes at any one given time in the store
but the overall value of the NIKE store is significantly more because the NIKE store generates $100,000 worth in sales over the given
month
-Key to the process is-What is the value of a business that generates $100,000 a month? What would I pay for that business? Incredibly
complex formula really
-First, remove risk from the table, how much money would it take to generate $100,000 per month risk free?-US Government Bonds
only, take considerable amount more probably like 10 million dollars worth of bonds to get risk free $100,000 per month roughly
-Second, NOT RISK FREE, we don’t know what will happen to the NIKE store, assess the risk of competition, how long can we expect
the business to keep generating the same amount of income, I think it will roughly remain the same for the next 10 years, I am think
about 5 million for it, because of all of the risk involved as opposed to the 10 million that will have no risk, OR the business could just be
getting started and if I run it, it will go up to $500,000 per month, we somehow have to make these determinations
-ALL in the assumptions, experts who want to increase the value will say something, the other experts will say it goes down, lead us to
the DE BLOCK APPROACH BELOW
C.
Fair Value Determinations appraisals cont.
1) Delaware Block Approach to Fair Value
a) Determine 3 Values
 Market Share
 Of little value if there is no market for shares
 If no established market, cannot use market value
 Net Earnings Value
 =Reflects what people today would pay for the right to receive a stream of earning in the future. =how much would I pay to
get those earnings?
 Earnings over a 5-year period X multiplier
 Multiplier is usually based on comparable companies
 Prospective financial condition
 Risk factor inherent
 Do not need to consider dividends
 Dividends reflect same factors as earnings
 Net Asset Value
 Not on liquidation value if company not being liquidated
b) Then each valuation element given percentage weight based on the specific circumstances
c) KEY: Get appraiser assumptions
d) However, other valuation methods may be used
2) Challenging Minority Freeze Out merger / Cash-Out Mergers
a) BURDEN OF PROOF
 Л must allege specific acts of fraud, misrepresentation or other misconduct to demonstrate unfairness of merger to
minority – and a basis for invoking the fairness obligation.
  D - Burden then shifts to controlling shareholders to prove transaction fair and all material information
disclosed
b) APPRAISAL RIGHTS NOT EXCLUSIVE REMEDY.
 Under Entire Fairness minority shareholders can use a class action suit rather than the appraisal method with its
stringent notice requirement if there is evidence of fraud or misrepresentation.
3) Entire Fairness
a) ENTIRE FAIRNESS TEST.
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
Overruled the Singer rule allowing solely legitimate business purpose for the merger as no longer sufficient when
minority shareholders challenge a freeze out merger.
 Where one stands on both sides of a transaction, he has burden of establishing entire fairness.
b) ENTIRE FAIRNESS COMPONENTS
 Fair Dealing
 Transaction structure, negotiations and how approved
 FIDUCIARY DUTY OF COMPLETE CANDOR
 Fair Price
 Economic and financial considerations of proposed merger
 But fairness considered as a whole, not a bifurcated test
4) Fairness Opinions
a) Issued by investment bankers or analysts as to fair value of offer price
b) Based on review of financial statements, 10Ks, 10Qs, historical market prices, terms of offers to purchase
c) Smith v. Van Gorkham. Court found absence of fairness opinion one of the failures of the Trans Union board’s
evaluation of the Pritzker’s offer.
d) Weinberger. Court not impressed by the fairness opinion
5) Piemont v. New Boston Garden Corp
a) Court employed the Delaware block approach.
-CASE NOTES
-DE BLOCK APPROACH=Market Value, The Earning Value, Net Asset Value
De block procedure= assign a value to each one of these, then assign a percentage of the total appraisal, then add them up together
-Pick and choose the three elements of the corporations value, because one may be more significant than the other
-if its publicaly traded stock or actively traded, that ends it-that gives you the value. But if its not, use this approach
-market value-for publicly traded corporation that is the end of the determination there, only if the stock is not public, or the closely held
corporation has no liquid market for their shares of the stock we need a different value of the stock
-Earnings are going to be the biggest fight, experts will argue over this till kingdom come
-net asset value -?
-Problems with the block approach: if we change the weight that we give to the numbers of the three different elements, the final
numbers will change dramatically, it will be up to the judge to make the determinations
-Santa Fe v. Green-went for appraisal in DE Court, the court made a determination-about a hundred dollars above the appraisals offered
by the companies, so don’t blow off the appraisal process because companies always undervalue the amount of the stock in order to
avoid what they are paying.
Section 2. Fair Value
1. Piemonte v. New Boston Garden Corp.
Facts: Plaintiffs filed an action against defendant under Mass. § 90, for a judicial
determination
of the "fair value" of plaintiffs' shares, and each party appealed from the
trial court's determination of
the shares' fair value. Plaintiffs were stockholders in a
Massachusetts corporation (Boston Garden Arena
Corp) whose stockholders voted to merge with defendant. Plaintiffs were entitled to demand payment for
their stock and an
appraisal in accordance with Mass. § 85, as amended by § 22. Plaintiffs commenced
action under Mass. § 90, seeking a judicial determination of the "fair value" of plaintiffs' shares
under
Mass. § 92, inserted by § 1. Each party appealed from a judgment determining the fair value of plaintiffs'
stock.
Holding: The court on appeal, concluded that the trial judge followed acceptable
procedures in
valuing plaintiffs' stock; that his determinations were generally within the
range of discretion accorded a
fact finder; but that the judge's treatment of the evidence
was, or may have been, in error on three
points. The court concluded that the judge's
method of valuing plaintiff's stock was essentially correct,
but remanded the determination
for clarification and further consideration on the record of three matters:
the trial court's
valuation of the sports arena, the professional sports franchise, and the concession
operation.
Casenotes
-3 different approaches were used and determine which approach is more effective.
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- A judicial proceeding where a faction of SH ask for a judicial determination of a stock's value. -Here,
group of SH forced out of Boston Garden Corp. and requested valuation of the shares
being bought out.
-Three types of value:
 • Market value --> auction price that will reflect value because info is available and analyzed instantly by
buyers. Last sales price in large public market will be the market value. But sales price in thinly traded
market may not reflect market value. Factors may depress market, control block may depress price by
paying low dividends. it does not account for intangibles, doesn't account for SH loss of control and
doesn't account for inefficient market. Boston Garden Corp. Stock was not very liquid, i.e. not widely
traded.
 •Earning Valuation --> Attempt to predict future earnings & rate at which they are
capitalized. Reflects what people today would pay for the right to receive a stream of
earning in the future. A control block can affect earnings by deciding disbursement,
investments, financing, etc.
 • Net Asset value --> value if you liquidates all the assets = Total assets of corp. less total liabilities of
corp. divided by total number of shares
• Weighting --> Assign a percentage weight to each value depending on the corporation and add values
THIS IS what us lawyers have to worry about
Weinberger – fairness to escape J from an interested director ttransaction (Conflict of interest)
Many casebooks also include Weinberger v, UOP, Inc., a less obvious example of an "interested
director" transaction
"interested director" transaction of a merger of a partially owned subsidiary into a parent, There, Signal
owned 50.5% of the outstanding stock of UOP and wanted to acquire the other 49,50/0 in a cash out mergeri
Two of the Signal directors were also UOP directors, More important, Signal, as majority shareholder of UOP, controlled the election of all of the UOP directors,
Not surprisingly, when the Signal board offered a merger price of $2 1 a share (i,e,, UOP would
merge into Signal, UOP would thus cease to exist, and the shareholders of UOP would receive $21 a
share), the UOP board accepted the offer. Not surprisingly, Weinberger brought a class action on be»
half of all of the minority shareholders of UOP claiming breach of a fiduciary duty
The Delaware Supreme Court held for the plaintiffs applying the entire fairness standard and
stating:
"where directors of a Delaware corporation are on both sides of a transaction, they are
required to demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargainw The concept of fairness has two basic aspects: fair dealing and fair
price. However, the test for fairness is not a bifurcated one as between fair dealing and price
All aspects of the issue must be examined as a whole since the question is one of entire
fairnes 5."
Think about the costs of litigating the "entire fairness" of a complicated transaction such as the
265
merger of UOP into Signal. The transaction occurred early in 1978. The lawsuit was filed shortly
thereafter The trial concluded late in 1980, Extensive and expensive expert testimony on disputed
issues of valuation of UOP as of the time of the merger were needed.
Thus the (hopefully) obvious question, how can an interested director transaction be structured
so that there is no judicial relief against the director or the transaction without meeting the burden
of proving "the entire fairness" of the transaction to the corporation at the time of the transaction?
Weinberger v. UOP 1983-page 1071
a) FACTS
b) COURT HOLDING:
 BURDEN TO PROVE FAIR Upheld Chancery Court’s rule that in minority shareholder actions challenging
freeze out mergers as unfair, Л must first allege specific acts of fraud, misrepresentation or other misconduct to
demonstrate unfairness of merger to minority – and a basis for invoking the fairness obligation.
 Thereafter, the controlling shareholders carry the burden of proving the merger was fair and that all material
information was disclosed.
 ENTIRE FAIRNESS COMPONENTS
 Fair Dealing
 Transaction structure, negotiations and how approved
 Fair Price
 Economic and financial considerations of proposed merger
 But fairness considered as a whole, not a bifurcated test
 Where one stands on both sides of a transaction, he has burden of establishing entire fairness
(fairness in dealing and price).
 FAIRNESS NOT PROVED Because Signal had directors sitting on both boards and did not disclosing all material
information in their possession it failed to meet that burden and in fact had breached their fiduciary duty.
 BUSINESS PURPOSE OVERRULED. Overruled the Singer rule allowing solely legitimate business purpose for
the merger as no longer sufficient when minority shareholders challenge a freeze out merger
 “basic concept of value under the appraisal statute is that the stockholder is entitled to what has been taken from
him, vis-sa-vis, his Proportionate Interest in a Going Concern. In determining what figure represents this true or
intrinsic value, the appraiser and the courts must take into consideration all factors and elements which reasonably
might enter into fixing of value.” Page 1010 middle
 Discounted cash flow method applied
-CASE NOTES
-Company bought the other company’s stock in two separate purchases, meaning it was an acquisition, and the put a whole bunch of
directors on the BOD
-BOD then decided they had enough cash to buy the rest of the company UOP
-Fairness Opinion-whatever price you are offering is a fair one, the investment banker has never given an opinion that the company is not
fair
-Court slams the Lehman Brothers for only conducting a fairness opinion in 4 days before returning it to Signal
-Duty of Openness and Candor here, the court wanted the BOD to disclose this fairness opinion
-Court here suggest the problems could have been avoided, if the BOD would have appointed considerable number of independent
directors
-If they appoint a special committee of independent directors
-Stupid ultimately, MARKHAM says if we appoint more independent directors there is no way it would change anything they have no
bargaining power to sell the minority interest in a company because who wants to buy a minority interest in a company that I own 50.1
ownership in so that I ultimately have all decision-making power
-Point to take away here is that you can save yourself a lot of trouble if you just disclose the fairness opinion to the stockholders and
make sure that they have access to it, because ultimately what stockholder is actually going to read the fairness opinion anyway
6)
-CASE NOTES STARTING 11/14/11
-DE Block Approach
-Basically trying to determine the value of the cash flow
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-Net Asset Value- Court may give it some weight, it might be different though because the assets are often a poor representation of the
value of the company if you are seeking appraisal
-Determination of each of the three categories will be different depending on the expert testimony, and the court can give greater weight
to any of the three value determinations, depending on the type of enterprise involved
McLoon Oil Co. Stock Valuation 1976 Case Notes-page 1007
Delaware block method is not the only method we can use. We can look at the present value as well
Looking at the valutation that should be applied:
-Application of the DE Block Method
-Issue: Whether the Stock Price should be reduced by what they call a “minority discount”?
-Total value of the company, but the minority shareholders interests here should be discounted because they are only the minority
-Court said no, we are going to determine the entire value of the company and distribute it according to the interest of the shareholders
-DE Block Approach is still going to be the starting point, but you can add in a discounted cash flow factor, and
In re Valuation of Common Stock of McLoon Oil Co.
1. The relevant inquiry is the highest price a reasonable buyer would pay
2. However, if corporations are essentially contractual, why shouldn't the
majority be permitted to buy out the minority?
3. Question of institutional competence?
CaseNotes:
Sterling v. Mayflower Hotel Corp. (DE 1952)- page 1050
--Issue: Was the merger between the two fair?=Whether the terms of a proposed merger of Mayflower Hotel
Corporation into its parent corporation, Hilton Hotels Corporation, are fair to the minority shareholders? (Hilton stock would be
exchanged for mayflower stock)
-Court is looking at a stock for stock exchange, problem is that the stocks are moving targets every day and the two stocks may not trade
evenly during the period when they are actually converted
-DE courts do NOT give much value to the liquidation value of the company, MARKHAM says that is wrong
-Court says no: we value the company at the value of the company now, not what it would go for if the company was liquidated
The price was reviewed to be fair and thus, no breach of fiduciary duty
Casenotes:
-Hilton acquired majority of stock and merged. When you merge and make an offer, you
have an investment banker to make a fairness opinion to determine the fairness of the
offer.
Mills v. Electric Auto-Lite Co also above
2. Mills v. Electric Auto-Lite Co.
Facts: Defendant controlling shareholder appealed from a judgment of the District Court
that
terms of a merger between defendant and plaintiff minority shareholders' corporation
was unfair, and
awarded damages and attorneys' fees to plaintiffs. Plaintiffs also appealed
claiming that the amount of
damages was too low, and the attorneys' fees should have
been paid by defendant rather than from the
award. Plaintiff minority shareholders
challenged the fairness of a merger between the corporation in
which they owned shares
and defendant controlling shareholder of that corporation. In prior proceedings
plaintiffs
obtained a decision of the US Supreme Court that defendant had used a proxy statement
that violated the Securities Exchange Act of 1934, § 78(n), and that plaintiffs were entitled to
attorneys' fees and damages if the merger terms were unfair. Defendant appealed from
the trial court
judgment on remand that the merger terms were unfair and that plaintiffs
were entitled to damages and
attorneys' fees. Plaintiffs appealed claiming that the
damages awarded were too low, and attorneys'
fees should be paid by defendant, not from
the damages.
Couldn't unscamrble the merger, it already happened so the oucrt looked to see if it was “fair” to the
shareholders
267
Appealed for Fairness
Holding: The court reversed. The merger terms were fair, and plaintiffs were not
damaged
because the shares they received in the merger had a higher market value than
they were worth (they
made a profit from the resulting merger!). Plaintiffs failed to demonstrate that their attorneys produced any
benefit
after the Supreme Court decision. Accordingly, plaintiffs were only entitled to attorneys'
fees, to be paid by defendant, for work done through the Supreme Court decision. The
judgment that the merger between defendant controlling shareholder and plaintiff minority
shareholders' corporation was unfair and the award of damages and attorneys' fees to
plaintiffs
were reversed. The terms of the merger were fair, plaintiffs were not entitled to
damages, and plaintiffs
were only entitled to attorneys' fees for earlier proceedings that
culminated in a favorable decision by
the United States Supreme Court.
Casenotes:
-The courts will take a broad range of approaches.
About as far as we get with fairness analysis of valuations
Rabkin v. Philip A. Hunt Chemical Corp –page 1089
-CASE NOTES
-In a non-fraudulent transaction the price was everything in Weinberger, NOW THE COURT IS SAYING THE OPPOSITE
-Seller imposed requirement
-Concern that they didn’t want other shareholders to come in and complain that everybody should have gotten the same deal
-DE has a crazy holding here, no reason why they should have to look out for any stockholders interest
Annuities
An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily
used as an income stream for retirees.
How does annuity work: an annuity is a long term investment that is issued by an insurance company
designed to help protect you from the risk of outliving your income. Through annuitization, your
purchase payments (what you contribute) are converted into periodic payments that can last for life.
 You do have the option of naming a beneficiary on your annuity, and with certain types of
payout options that beneficially could receive the money in your annuity when you die.
 Other options just pay out during your lifetime, and the payments stop when you die.
If you get a fixed annuity, there is something called inflation. Big problem.
Mattison v ziebert?? 1952
Shareholder is blocking that action and he is trying to extort money from the majority shareholder.
To get rid of the shareholder, they proposed a merger with Snowy. Preferred shares that were callable.
3. Weinberger v. UOP, Inc.
Facts: Plaintiff appealed from decision of the Court of Chancery of the State of Delaware in and for
New Castle County awarding judgment in favor of defendants in action brought by
plaintiff that challenged
the elimination of defendant's minority shareholders by cash-out
merger between defendant and its
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majority owner. Action was brought by plaintiff class
challenging the elimination of defendant
corporation's minority shareholders by a cash-out
merger between defendant corporation and its
majority owner. The lower court held that the terms of the merger were fair to plaintiff and the other
minority shareholders of
defendant corporation.
Holding: On appeal, the court held that the record did not establish that the transaction
satisfied
any reasonable concept of fair dealing, as the matter of disclosure to the
defendant's directors was
wholly flawed by conflicts of interest raised in feasibility study, and the minority shareholders were denied
critical information; thus, the vote of the minority shareholders was not an informed one.
The court further held that the standard "Delaware block" or weighted average method of valuation, should
not control. Rather, the
court endorsed a more liberal approach requiring consideration of all relevant
factors
pursuant to Del. § 262(h).
The court reversed the judgment and remanded the matter for further proceedings.
Classnotes:
-Signal companies sold subsidiary; they started negotiating to purchase UOP. It
was an
arms length negotiation- they agreed to sell for $21 per share. Signal is
buying control. They
bought 50.5% through a tender offer (asking shareholders
to sell for $21 per share). 6 of
the 13 directors were selected by Signal. The old UOP president retires and Signal becomes
president so they have majority. Later,
they bought the rest of UOP. So they did a study to
see what the price would be.
Directors said that any price up to $24 would be a good
investment. UOP said $2021 per share. At the time the UOP stock was selling at $14 per
share so the shareholders was going to get a premium above the market price. Signal did a
fairness
opinion about whether the price offered for the stock is fairthe opinion does not
offer the best price, its not the worse price, its simply a fair price)– and there was a “fishy”
scheme about what numbers came up-the fairness opinion was constructed in a sketchy way.
The
investment banking company thought $50 above was fair but with no analysis to back it up
($20-21 was fair). UOP chairman said it would be fair (20-21). Both boards met to consider offer,
they had shareholders approve it. The board had plenty of info and carefully considered it. The
court said they did not disclose to the UOP shareholders that 24 would be a fair price. Court
found that disclosure was required.
Signal did an internal study (informally) that it could go up
to $24; which should
have been disclosed. Signal did not vote in the meeting to approve the
merger.
Court said you have to look at if you met your fiduciary duty. How should they
treat the shareholders? The majority of board was appointed by Signal. In this
circumstances – Signal has a duty of complete candor to the minority shareholders in
failing to disclose the $24 study (this
was made up by the court). The court said they
breached this duty of candor by
not telling the shareholders of this study.
Looking at fairness:
-The structure of the deal
-The timing of the deal
-negotiations vs ??
-The duty of candor was met?
`
-(disclosure to directors)
-The valuation of the deal
2nd element: fair price determination---llok at all the things we look for in the appraisal
Markham doesn't understand why the court is making this an arms length transaction. The courts are just not business people. They
simply ccould have pourchased it for less price.
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CHAPTER 19 DEFENSIVE MEASURE TO BOARD CONTROL CHALLENGES
Section 1. Defensive Measures
Intro: Defenses to takeover must be reasonable to actions posed.
Friendly takeover-both parties agree ot the merger (will recommend to the shareholders that they approve the deal- Delaware
law states that the shareholder smust either approve it, disapprove it, or take no vote at all)
I.
Control Transactions
A. 3 Types of Control Transactions
1) REQUIRE SHAREHOLDER APPROVAL
a) Purchase assets
b) Merge
2) DO NOT REQUIRE SHAREHOLDER APPROVAL
a) Purchase controlling blocks of shares
b) Most often used for that reason
c) Then a second-step merger implemented
B. Goal of Corporate Law in Acquisitions
1) To create decision rules that provide reasonable assurance that good transactions will be approved and bad transactions
rejected
a) Good transactions – will increase shareholder value
C. Tender Offers and Hostile Takeovers
1) Issues
a) If board rejects an offer, what can it do when offeror seeks to purchase controlling blocks of stock from shareholders?
b) May boards bargain on behalf of widely dispersed shareholders?
c) Should courts police that self-interest?
2) Tender Offers
a) Conditional public offer to purchase stock for a limited period usually at a price above market
b) 1968 Williams Act added Sections 13 and 14 of SEA, limiting tender offers
3) Hostile Transactions
a) Hostile transactions create a conflict of interest for board and officers.
b) Once rejected suitor makes a hostile tender offer, what role should target’s management play?
-DEFENSIVE MEASURES MARKHAM NOTES
-What is the role of management at the target company when they are facing a hostile takeover?
-Should they be quiet, should they make a recommendation to shareholders, or should they take defensive measures
-What is the proper role of management and what can it legally do?
-Hostile takeovers became extremely popular
-Under DE statute, BOD does have duties when it comes to things like mergers
-BOD shall provide shareholders with their opinion on the merger, A) we favor the merger, B) we disfavor, C) No Comment
-Really the only three options with the opinion
-CASE NOTES
-Whether the company could enact such a defensive measure to prevent takeover?
-Defensive Measure must be in reasonably related to the threat posed,
-Subject to the Business Judgement Rule
-This Court’s decision is now excluded under the Williams Act under Federal Law, allowed here because it was State law
-Two tiered takeover scheme, Idea was to stamped into the management and control the shareholders by offering them premiums above
the current stock price in order to give up their voting rights and allow Mesa to take control
-$54 per share was way below the $60 that was supposed to be the bottom under the fairness opinion from Goldman Sachs.
-Mesa is offering 54 per share, the company is saying we will give you 72 dollars per share, if we don’t have at least 64 million shares
sold the $54 share would not be invoked
-Unocal Duties-the BOD are allowed to take defensive measures, but because of the conflict and concern of entrenchment, the court will
look to see if the defensive measures are reasonable in relation to the actions of the corporate raider’s tactics
-Court held it was a reasonable response in relation to the threat posed
-The company’s directors can take defensive measures, including a poison pill, as long as they are reasonable related to the threat posed
-9) Break Up Fees-Massive really, supposed to cover the cost of the White Knight, actually designed to raid the corporate treasury and
make it unattractive to the corporate treasury (if the merger doesn't go through, youll pay me X million dollars to ocver my expenses)
270
-10) Litigation-whenever a “Tender Offer’ is made, there is almost a guarantee of litigation
-Speculative opportunity-hostile takeover, the shareholders do not get the money of the Tender Offer unless the takeover is actually
consummated
-Investment banks will buy the shareholders for a premium for a guarantee on the money and then the investment bank gets the money of
the stock if the merger falls through
-Can be a huge amount of gain or hit depending if the corporate takeover goes through
-Cheff v. Mathes (DE. 1964) whether it is appropriate at all to use defensive measures yes you can take defensive measures (they did not
hold which takeover methods are appropriate)
-CASE NOTES
-Management does not have to be neutral, management can be assertive and defensive in measures to save the company
-Court held there are appropriate grounds
-“Green Mail”-extorting a company to buy that premium in order to avoid a hostile takeover -widespread practice, where a liquidator
would show up buy a lot of stock, and then would be paid back by the company at a later date with interest so that the stock price goes up
and the corporate raider seeking to have a hostile takeover will go away
-Claim that is made is that management has a conflict of interest, however courts usually hold that is not a breach of a fiduciary duty
-Number of defensive measures traditionally employed in these cases
-1) white knight??? Target does not want to be taken over by the Raider, so they will go out and get their White Knight to save
them and merge with that company to escape the Raider
-2) Porcupine measures-makes it harder to be taken over, and negotiating room
-3) Poison Pill-So drastic that the corporate raider will not be able to take over the company
-4) Crown Jewels-Sell off the best assets to another company for lesser price if someone steps on and makes a better offer and
we deny, youll sel me your assets (crown jewels)  wioll discourage a takeover from another company
-5) Golden Parachute-If the company gets taken over, invoke golden parachute and then the company will pay you millions of
dollars, this is a porcupine provision (designed to prevent them)-a) pull money out of the treasury, and b) the management is
gone there is nothing left to steal from the corp. for the raider
-Still encouraged Golden Parachutes after Congressional Legislation-since Congress taxed it heavily the company just
upped the amount that it would pay out to the BOD
-6) Pacman-A tries to takeover B, B responds by trying to take over A ---they eat themselves - A tries to buy up B, B tries to buy up A
-7) Staggered board BOD-only electing about 3 a year out of a possible 12, numbers can differ, don’t want to pay a lot of money for a
company when I am not going to be able to take control of the company immediately
If I takeover, I want to takeover all 9 BOD sdoooo????????
-8) If all else fails go to the state legislature and ask for a law to block the action
II.
Defensive Measures must be in reasonabkle in relation to thethreat imposed
A. Various Defensive Measures see other outline!!! XXXX
1) Share Repurchase Agreements
a) Target repurchases its own shares
 Self-tender offer
 Street Sweep: raider will Buy as much stock as possible in open market (upheld) (purpose: to get as much cheap
stock as possible)
b) Purpose: To drive target company’s stock higher than aggressor’s offer and prices aggressor out of the market 
percentage of ownership will be that much harder to obtain
2) Poison Pills requiring a supermajority of shareholders to approve merger
a) Makes target difficult, if not lethal, to swallow
b) -CAN BE WAIVED----maybe disappearing comp likes you!!!! They will waive the poison pills
c) The Original Pill. Board creates preferred stock it offers to common stockholders as a dividend. Stock is convertible
to common stock but only if acquirer were to purchase more than specified percentage of target stock.
d) Adaptations
 Fair Price Provision – Flip In
 Adds fair price provision to redemption formula at price equal to bidder’s highest price paid
 Additional triggering events
 Share Purchase Rights Plan – Flip Over
 Issue warrants to shareholder that conditionally entitles all but bidder to purchase stock
271
 If target acquired by tender offer or major stock acquisition warrant is exercisable
Note Purchase Rights Plan
 Holder of rights may compel target to exchange stock for a valuable securities package (usually senior debt
securities subject to financial covenants hat interfere with bidder’s financing)
White Knight Transactions
a) Arrange acquisition with a more compatible corporation = merge with someone who’s more friendly
ASSET CHANGES
a) Sale of Crown Jewels -make them less appealing
b) Acquisition of Assets
 Purchase unwanted assets
 Purchase regulated industry (to require industry approval) – radio, television
 Scorched Earth: Destroying the company as it previously existed
c) Lock-Up and Lock-Out Arrangements
 LOCK-UP
 Target ties up assets suitor seeking by K to sell or transfer control of assets to third parties Revlon
 LOCK-OUT
 Merger non-termination clause keeps target unavailable.
 Disapproved in First Union v. SunTrust
Diluting Shares / ESOPs –
a) Issuing additional shares to diluting suitor’s control under already acquired shares
b) Often done through ESOP Employee Stock Ownership Plan with new shares in control of managers that will support
incumbent Board
Greenmail – you pay me a premium over those shares in order to make me go away
a) Paying off the aggressor to walk away
 Target’s board purchases potential bidder’s stock in target company for above-market price
b) Premium is greenmail – justified as required to avoid disruption of operations by bidder’s continued acquisition of
stock
c) Most courts allow under business judgment rule
 Studies show target purchaser stock value declines – suggesting entrenchment motives when used because
stockholders not benefited
 But Pennsylvania requires profits be disgorged
 IRS taxes at 50%
Golden Parachutes – promising executives a golden parachute if merger happens –if the new comp wants to keep them,
too bad, they will be gone
a) High severance payments to top management to avoid takeovers
b) IRS taxes and limits their deductibility of excessive GP payments
Restructuring Defenses
a) Target management offers shareholders a package of cash or securities with a greater value than bidder’s package
b) Usually requires increased use of debt borrowing to pay shareholders or sale or spin-off of assets
c) LBO – leveraged buy-out
 Target management forms new corporation who offers to buy target stock with proceeds of loan that will be
secured by target’s assets
 Usually starts a bidding war with bidder
d) Recapitalization
 Board offers public shareholders cash and debt securities while offers management additions shares or options to
purchase them
 BENEFIT OVER LBO
 Management left with more equity without requiring personal borrowing
 Shareholder vote not required
 Does not price the company and start a bidding war
 Hostile bidder may back off if highly-leveraged capital structure reduces liquidation value that originally
attracted bidder
BYLAW PROVISIONS
a) Supermajority Provisions
 Requires more than majority shareholder approval
 Discourages partial bids

3)
4)
5)
6)
7)
8)
9)
272

B.
A.
MBCA requires specified supermajority to adopt a supermajority provision
 Most other corporate statutes require a simple majority vote
b) Fair Price Provisions
 Require second-step merger price (after block stock purchase) to be at fair price
 Highest price paid by bidder for shares
 Higher market price during some period
 May yield higher second step price and make discourage original tender offer
c) Staggered Board Provisions
 Deters control of board if target’s directors remain on board after hostile takeover of majority of stock
d) Shark Repellant Bylaws
 Require advance notice to board to bring action before shareholders or nominate directors
 Grant board, not shareholders, , power to fill newly created board positions. Constrain shareholder action through
written consent
10) Effect on shareholder wealth
a) Successful management resistance may hurt shareholders have no impact and or may help, depending on the defensive
tactic used
Validity of Defensive Measures
1) Unocal v Mesa – Poison Pill Permitted
a) BOARD MAY TAKE DEFENSIVE HAS POWER TO OPPOSE TENDER OFFER
 Duty to protect corporation and its stockholders, irrespective of source of harm
b) BOARD MAY SELF-TENDER
 Decision to self-tender will be upheld as a proper exercise of business judgment if
 Directors Acted In Good Faith
 In concern for corporation and shareholders
 Disinterested
 Business Judgment Rule
 Presumption that director resolution adopted
 in good faith
 on an informed basis
 in honest belief action in best interest of shareholders
c) In acquisition of its own shares, board may deal selectively with its stockholders
 X Except where Board acting solely to entrench itself
 THREAT EXISTS Must show reasonable grounds for believing a danger to corporate policy and effectiveness
existed because of another’s ownership of company stock
 Good faith concern for welfare of corporation
 DEFENSIVE MEASURE REASONABLY RELATED TO THREAT TAKEOVER
 Was the price fair?
 Was the green mail method appropriate?
Cases
1) Unocal v. Mesa Petroleum
a) FACTS
 Mesa made a tender offer of $54 per share that Unocal’s board rejected as inadequate.
 Board decided to take a defensive measure against the Mesa hostile takeover by creating a stock exchange plan
 Board would make a conditional self-tender offer, where corporation would exchange common stock for
company debt securities equal to $72 per share.
 But that offer would be triggered only when Mesa purchased 51% of Unocal stock and excluded Mesa
from the exchange offer
= Shareholders will not be getting a fair price, they should be getting at least $60, not $54. One
option was self tender- that would add about $6 billion dollars and would certainly make the
company less appealing. The board met and approved a self tender at $72/share. The tender
offer would only be effective if Mesa purchased 51% of Unocal stock, and excluded Mesa from the
exchange offer.

Mesa brought suit challenging its exclusion from Unocal’s exchange offer.
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The Unocal board then met with investment bankers and counsel, who provided the board with the opinion
that the Mesa offer was inadequate. As a defensive measure, it was suggested that Unocal pursue a selftender, which excluded Mesa, to provide shareholders with a fairly priced alternative to the Mesa proposal. Mesa
challenged the legality of its exclusion from Unocal's
self-tender.
Holding: The Court held that a board of directors may only try to prevent a take-over where it can be
shown that there was a threat to corporate policy and the tactic used was proportional
and reasonable given
the nature of the threat. When evaluating defensive measures a board
has undertaken in response to a
hostile takeover, the directors must satisfy a two-pronged threshold for their actions to fall within the ambit of
the business judgment rule: (1) that they had reasonable grounds for believing that a danger to corporate
policy and effectiveness
existed because of another person's stock ownership; and (2) that the defensive
measure was reasonable in relation to the threat posed. In this case, the court found that the Unocal board
satisfied both elements.
PH: Trial Court held target’s management could oppose hostile takeover but had to show valid corporate purpose
and fairness
 Here -- Although in good faith, business judgment rule could not apply to a selective stock exchange offer
(the poison pill)
c) HOLDING/ REASONING
 BOARD HAS POWER TO TAKE DEFENSIVE MEASURE TO OPPOSE TENDER OFFER
 Duty to protect corporation and its stockholders, irrespective of source of harm
 BOARD MAY SELF-TENDER
 Decision to self-tender will be upheld as a proper exercise of business judgment if
 Directors Acted In Good Faith
 In concern for corporation and shareholders
 Disinterested
 BURDEN TO PROVE NOT FOR PURPOSE OF ENTRENCHMENT
 Independent Directors very helpful in this respect
 With Due Care
 Reasonable Investigation
 Business Judgment Rule
 Presumption that director resolution adopted
 in good faith
 on an informed basis
 in honest belief action in best interest of shareholders
 BOARD MAY DEAL SELECTIVELY WITH SHAREHOLDERS
 In acquisition of its own shares, board may deal selectively with its stockholders
 X Except where Board acting solely to entrench itself Cheff v. Mathes
 THREAT EXISTS Must show reasonable grounds for believing a danger to corporate policy and
effectiveness existed because of another’s ownership of company stock
 Here – inadequacy of price offer was threat
 Mesa was a corporate raider
 Can also consider effects on community (creditors, customers, employees, etc.
 DEFENSIVE MEASURE REASONABLY RELATED TO THREAT POSED
 Here offering $72 to current shareholders would either defeat Mesa’s inadequate offer or if Mesa
succeeded, would provide $72 of superior debt to remaining stockholders who would otherwise
receive junk bonds
 Including Mesa defeats Purpose of Board Defensive Action
 Mesa’s participation in Unocal exchange offer thwarts the corporate purpose of the action and would
in fact subsidize the very purchase by Mesa that Unocal is trying to avoid
 Mesa not within class of stockholders the stock exchange is seeking to protect and could therefore be
excluded from the offer
CLASS NOTES Starting 11/16/11
-MUST put on your Unocal hat, and that means that any defensive measures must be reasonably related to the threat posed, meaning you
cannot entrench into the positions for management just based on any posed threat, must have a reasonable relation to the threat
b)
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Revlon v. Forbes –Delaware - Poison Pill -undesirable, uneconomic takeover—
Issue: Did BOD breach their duty to prevent it-unfair to shareholdersa) FACTS
 Pantry Pride – Perlman - tries to buy Revlon, but Revlon refuses. Revlon’s president dislike Perlman personally,
irrespective of $45 price offer, tells Board price inadequate.

 CEO did not eantything to do with Pearlman and rejected the offer on hand
 Hostile company tender offer for $45 offer
 Revlon had an investment banker agree that the sale was worth 60 to 70$ a share so this tender offer was grossly
unfair
 Buy up 5mmillion
 Defensive Measure:
 Revlon adopted a Note Purchase Exchange
 Posion pill=Note Purchase Plan – each shareholder (except Perlman) up to 5 million shares would receive
this right
 Condition: acquired 20% of Revlon stock at a right less than $65 9then these rights would be issued to all
shareholders) which would exclude Pearlman of that offer
 Right: Stock for Note: right to exchange one share of stock for Note $65 + pay one year worth of interest
at 12% interest within year
 Anyone who did not accept Pearlman offer would get this note
 To avoid default Revlon promises
 Pantry Pride tenders for $40 per share if it gets more than 90% of shares X numbers, and will pay more
shares if the exchange offer terminated. Pantry Pride continues to up its offer
 Revlon rejected
 Pantry made a 10 million self tender
 Finds a white knight in Forstmann Little and proposes a Leveraged Buyout at $56 per share
 Had to waive note negative covenants under Note Exchange Plan
 Would allow management to exercise their Golden Parachutes (entrenched management)
 Forstmann Little (investment banking firm) $57– countering Pantry Pride’s counter
 If two divisions locked-up - sold to Forstmann at bargain price - so Pantry Pride would not get these two
valuable divisions
 $25M cancellation price
 Pantry pride responded by offering more - Price up to $58
 Said their leverage buyout proposal would be higher this time too
 No shop provision – Revlon would shop to no one else (Delaware courts hate this)
 Break up fee if the transaction did not go through
 “well support the value of the notes you gave” so those folks wont lose any money
 Revlon Board finally says – not based on price – we want to do deal with Forstmann – even with poison pills
 Revlon shareholders sue
II. ISSUE: Price went from 45 to 57.5$!!!!! negotiations led to this!
a) COURT SAYS
 Stock for notes exchange – acceptable defensive measure
 Unocal Test no longer applies once the bidding war began (now the only issue is price)
  now the Revlon rule  youre an auctioneer now (duty to keep the price low)
 Defensive measures became moot
 Once it is clear company will be changed role changes from preserving company to get highest price for the
shareholders --- Markham thinks that's harsh (it was all apart of the continuum of going back and forth
fiduciary duties are owed to shareholders not bond holdres)
 Take off your Unocal hat and put on your Revlon hat
 You should have held an auction
 No shop clause and lock-up agreements NOT VALID BOARD ACTION AT THAT POINT
 Fiduciary to shareholders NOT creditors
 Lock-up can be used to increase price not to decrease price
We can always seek an appraisal if we don't like the price.
2)
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RULES AND NOTES
-The ultimate responsibility for managing the business and affairs of a corporation falls on its BOD, and in discharging this function they
owe a duty of care and loyalty to the corporation and its shareholders. These principles apply with equal force when a board approves a
corporate merger; and of course they are the bedrock of our law regarding corporate takeover issues. Page 1128 bottom
-If the business judgment rule applies, “there is a presumption that in making a business decision the directors of a corporation acted on
an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Page 1128
bottom
-When facing corporate takeover measures, the BOD may employ certain defensive measures, but they may also be acting only in the
interest of maintaining their positions within the company, rather than the interest of the corporation and shareholders. This places a
upon the BOD a burden of proving that they had reasonable grounds for believing there was a danger to corporate policy and
effectiveness, a burden satisfied by showing of good faith and reasonable investigation. Page 1128 bottom
-In addition the BOD must analyze the takeover threats and show that the defensive measures employed, is “reasonable in relation to the
threat posed”. Page 1129 top
-CASE NOTES
-Start with Unocal hat-take defensive measures, BUT our responsibilities may shift to REVLON hat here to maximize corporate
stock value
-CEO of Revlon did not want to be taken over by this particular corporate raider, so Revlon found a white knight
-Also, poison pill-Note Purchase Right-One right when anybody would receive 20% of the stock, swapping one share of the
stock for 60 bucks a piece, meaning if the raider bought at least 20% of the company’s stock the shareholders could sell back
their stock to a large amount of the already in place BOD and the BOD would buy back the stock and maintain their position on
the BOD, while not allowing the raider to obtain more than 20% of the overall company’s stock
-This all came up to a bidding WAR, they wanted their White Knight to win the bidding war as opposed to the raider
-DE Court has to sort this whole thing out to whether Revlon acted properly in the BOD’s duty to protect the company from the
raider?
-1) Company Note Right ok because the raider was threatening a tender offer so that was ok, BUT then the role starting shifting
-After the White Knight appeared it was clear the company was going to be sold off to somebody who had the deepest pockets,
and the Court then said the duty of the BOD is to become an auctioneer to get the highest price possible for the stockholders
best interest in getting the best price for the maximization of the shareholders price of stock
-Court held, LOCKUP was improper, designed to discourage a higher price because they favored the White Knight
-Court said NO, No obligation to creditors (bond holders?), only duty you owed them was in the credit agreement,
-Fiduciary Duties stop with shareholders-they do not apply to creditors, duty stops to the creditors
-Problem with the opinion is that the Court is overlooking what we have to do in business, there will be give and take
in the negotiation and if you look at the Revlon negotiation, they maximized the price 12 dollars more than the original
price that was the tender offer by the raider
-Court over steeping the bounds here looks like a referee too much, not the way business is really done and too vague
to tell when the duties changed,
-This decision instituted the Revlon duties-first announced in this case, the lawyers in this case didn’t know about these duties
-No Good way to conduct an auction for the Corporation, Not sure how the Court wants us to conduct this auction because that
is what they are telling the lawyers to do in this case ( you could try “sealed bids” )
-MARKHAM said this was an excellent auction process, even though they probably weren’t trying to conduct an auction, no
way to tell how we can advise our client’s concerning the corporate duties
Sealed bids----2 rounds - whoever gets the highest bid gets a premium
Second round has to get 10% higher than first round of bid
2)
Paramount v. Time Inc.
Issue: what hat do you wear? Revlon or unocal?
a) FACTS: Reverse Triangular Merger: Time Inc. would create Sub >> Warner would merge with Sub
 New company becomes: Time Warner Inc.
 Once deal restructured Time shareholders had no right to vote
 Time buying Warner - Done deal:
 Tied up big banks
 No shop clause
 Special committee set up to prevent any COIs
 Told the president our merger isnot controversial – this one involes no increased debt
 Originally all stock exchange – restructured as a finance of $10 Billion
276

b)
c)
d)
e)
Until Paramount comes in and make an all-cash all-share offer for $175 per share for Time Inc. stock, well above
market price. Offer fully negotiable
 Conditions to drop some stuff with Warner
 Time Inc. rejects offer and you conflict with our Time Inc. culture of much value to company
 Paramount raises to $200 per share which time again rejects
ISSUE: Where they supposed to be wearing a Revlon hat or a Unocal hat?
 Was a sale certain?
HOLDING
 We’re not going to favor one or the other deal
 Just because two companies are bidding you do not have to abandon long-term strategic goals – you can apply
and we will defer to the business judgment rule
 Different from Revlon – where they had no long term strategic goals
 See this as a Unocal case – where you can use defensive measures to maintain long-term strategic goals
MARKHAM
 What suddenly made culture so important; Why didn’t we let shareholder decide
AFTEREFFECT
 Time Inc. culture was not preserved
 Stock value plummeted and never nowhere near
-CASE NOTES
-Time Inc. fabled news magazine business is no collapsing due to the decline in print media, they need to change business model they
wanted to merge with Warner, but maintain the Time Culture of the corporation
-They wanted to preserve the Time culture or they would not merge
-Finally Time people felt like they could merge with Warner and preserve the Time culture, so they agreed to a merger
-DEAL was Done
-Then Paramount came in and drops a bomb of an all cash offer, of $175 initially and then raised offer to $200 cash, with everything
culture wise being open for negotiation (they wanted to preserve the comp)
--Time Rejected offer again (reasoning - a threat to time cuktures)
Time sued based on revlon
Paramount brought suit on unocal
-Question was: Whether Time violated fiduciary duties by looking at Unocal and Revlon duties? They should have oput revlon on,
auctioned, and gotten $200 oferr!! It would have made more valuable company
-Court said NO -business jdgement - we do not have to just authorize our Revlon duties, Corporation’s can take a longer-term
view, it was better for shareholders to merge with Warner in the long term it would bring in more money to the shareholders of
Time and only that needs to be taken into account for the Unocal Duties
-Court said you did not even get to the Revlon duties, because corporations are not bound to except short-term versus long-term goals
this was business jdgement of the direcotrs -these strategic interest would keep Revlon happy instrad of unocal
-DE Court is crazy here, Time people lost all of their “culture” and the stock went down very quickly to shareholders receiving just about
$35 per share
-SO instead of getting $200 per share from Paramount, Time ended up getting around $35 business decision by the court was
horrible
-Important to set your record, need to establish that to make sure that all of your decision will fit within the Business Judgment Rule whil
you are wearing your Unocal Duties
-This case can best be called the “Time Inc. Exception to the Revlon Duties”-Because general Revlon duties do exist but they were not
applied in this case
Paramount v. QVC
a) Paramount now decides to merge with Viacom and got into fight with QVC
b) Strategic alliance with Viacom – following logic of prior case
c) COURT SAYS NO: You have to put on your Revlon hat on.
-CASE NOTES
-QVC drops the bomb here with the cash offer Paramount reacts using the Unocal hat-trying to fight off the QVC offer
-They adopt various poison pills trying to use the “Time Inc. Analysis”-saying were pursuing future goals
-COURT SAYS NO, the company was definitely going to be sold
-So you need to put on your Revlon hat and get the best price possible for you shareholders
3)
277
-RULE 1) Defensive Measures-Are permissible-in threat to takeover
-2) If you do use defensive measures they must be reasonably related to the threats posed, Court will measure whatever you did in
response to the particular threat, and they Courts will defer to management on this even if the shareholders get stuck
-Things that courts do not like are measures that would discourage competitive bids, we need to be careful to not offer NO SHOP
CLAUSES, DO not sell the crown jewels at a bargain price be very careful
-3) Once it appears that the company will be bought no matter what, then duties SHIFT to REVLON duties and the corporation BOD had
the duty to be an auctioneer and get the maximum value for the shareholders
-REVLON duties will NOT apply if there is a strategic reason-by management that it will be in the company’s best interest to pursue
long-term goals to bring more value to the company than the short-term goal of the largest amount of money by the company’s
competing, The Court says that is fine under the Business Judgment Rule even if a bad decision-Under Time Inc. Case
-4) QVC case-if you know the company is going to be taken over no matter what, and you cannot point to the long-term business plan
strategy, then you must put back on the REVLON hat and become an auctioneer and get the best price
-This is very unclear on how the lawyers make this decision in the moment, but for our purposes just be aware of the structure of the
standards that the courts will apply concerning this
First Union v. SunTrust Banks, Inc. (North Carolina Business Court, 2001)-page 1216
CASE NOTES
-Court notes that DE changed its statute to control the duties of the BOD when these kinds of hostile takeovers are present
-So what the hell are the normal fiduciary duties that must be adhered too???
-MARKHAM-not good way to describe what happens or what structure to follow just look to the unocal, Revlon, and Time cases
Omnicare, Inc. v. NCS Healthcare, Inc.
There was no provision for them to withdraw – if a better offer came along, there was no way for them to
reject the current offer??
Court ahd to determine whether this deal protection device wasn't a fiduciary u\duty by not giving an out for the BOD
Coercive-consittuted a lockup (all the things Delaware court hates- breach of fiduciary duty
The problem is negotiations between business people
Disappearing company was debt, so new company was going to save them. when a better offer came along, the disappearing suffered
So now we have ---Strategic duties + duties + duties
Procedural Posture
Plaintiff suitor sued for a preliminary injunction to stop the merger between defendant target and defendant
acquirer corporations. The Court of Chancery, New Castle County, Delaware, denied the injunction. The suitor's
appeal was consolidated with plaintiff target's shareholders' appeal of the Court of Chancery's denial of their
action to enjoin the merger in their class action against defendants target, its directors, and acquirer.
Overview
The target was financially recovering after it received the suitor's first offer. The target accepted the acquirer's
better offer but entered into two defensive measures the acquirer requested: (1) to include a voting trust in
which the two major shareholders agreed to vote for the merger, and (2) to omit a "fiduciary out" clause: the
board agreed not to consider other merger offers, to put the merger to a shareholder vote, and to allow minority
shareholders to have appraisal rights. The acquirer then declined the suitor's second, better offer because of the
defensive measures. The case addressed tests of the extent to which the board was to exercise, not abrogate,
its continuing fiduciary duties. The board combined two otherwise valid actions (stockholder voting agreements
and the authority of directors to insert a Del. Code Ann. tit. 8, § 251(c) provision) in the merger agreement and
caused them to operate in concert as an absolute lock up. The board should have contracted for an
effective fiduciary out clause. The acquirer's contract expectations had to yield to the supervening responsibility
of the directors to discharge their fiduciary duties on a continuing basis.
278
Outcome
The supreme court of Delaware (1) reversed the judgment denying the suitor's application for a temporary
injunction and issued an immediate mandate for a temporary injunction to prevent the merger, (2) reversed a
decision to the extent it permitted the implementation of a voting agreement contrary to the supreme court's
ruling on fiduciary duty claims, and (3) declared moot a holding that the suitor lacked standing to assert
certain fiduciary claims.
Stock price will go up as a result of offer but not up to $100 because a lot of things happen
Risk arbitrager would ascertain whether the merger would go through and would act accordingly
if the stock value is 70, and the predicted price after merger is 100, risk arbitrager try to buy the stock above 70 but under 100 –as low as
possible based on the risk that the merger would go through. RISKY
The key in the battle is who is going to be the CEO?
never works)
Sometimes there will be joint CEOs (CEOs from both companies join forces
Williams act
Mendmenet to act of 1934 governed tender offers for merger acquisitions of public companies.
These controversies in 1970s were highly controversies. 1000s of employees would be laid off,
and ther were lots of concerns that economy would be disrupted. This act was supposed to be
enatural to target comp and acquirer. Designed to protect shareholders to allow them tmie and
procedures to let them make informed decisions. Also contained a fraud provision.
Provisions;
Offeror is required to file with sec (made public) disclosing who they are, info about the offeror,
source of funds, purposes of purchase (is it to liquidate something else?) and holdings have to be
disclosed.
-Same price to everyone!
Legislation that governs take over on state and federal level:
Federal level
-Williams Act: intended to make it hard to do these type of take-overs. It imposes
authority on SEC to adopt regulations in mergers. First, requires offeror to file 13D statement with
SEC when they acquire more than 5% in the company . That
schedule (13D) says who you are,
how many share you bought, where you got
financing, and what are you plans with the
company. This prevented a corporate
raider from acquiring the stock quietly; then they would
go out hitting up the
institutions so they get the 40-50% of the company for a takeover. People
would
try to go around this rule by buying 4.9999% of the company. SEC came back and
said you are evading our requirement. The SEC was also authorized to have
procedural rules; so that the company would have adequate time to consider the
offers.
Another rule was added - if more shares are tendered, proration is
required. Same price
all shares rule was also added.
279
Note:
-Schedule 13D – must be filed within 10days of acquiring shares.
-signals to management youre in trouble-someone out there is buying a hug allows them to form
defense plans. The twenty days is sued to fightit.--> actually favors target companies (even though it was
designed to be neutral)
-Another rule prevents the Mesa exclusion (which said you cannot exclude
people from offer)
-tender Offer must be left open for 20 days – any change must add on 10 days from
that change. (min of 20 days open offer altogether)
-shareholders can withdraw their tender anytime before the conclsion of the offer
-Target company must state a recommendation to the shareholders (take
the offer, don’t take it, or have no opinion).
CAPTER 20 – TAKEOVER AND TENDER OFFER LAWS
6)
Tender Offer”
 = a general solicitation to all target company shareholders that they sell their shares to the acquirer.
 Share acquisitions can be based either on a cash purchase or on an exchange of shares
 = an offer to purchase some or all of shareholders' shares in a corporation. The price offered
is usually at a premium to the market price.

-does not require approval of the target corporation’s BOD
-purpose of a tender offer is to acquire a sufficient number of shares of the target corporation to replace the target’s
present board of directors with directors more acceptable to the bidders
“hostile takeover” = If, as is usually the case, the tender offer is opposed by the board of directors of the target
corp
Defensive measures=Actions taken by the board of directors of a target corporation to prevent a hostile
takeover have such colorful names as "Pac Man," "poison pill,” and "shark repellent"
If the target corporation in a tender offer is a registered corporation, then the tender offer is regulated by the 34 Act
Section 5. State Regulation of Tender Offers
The constitutional issues are whether the Williams Act preempts the field and whether the state statues impose an
impermissible burden on interstate commerce.
Summary of Supreme Court cases is that the state legislation is permissible so long as it does not (1) alter the
Williams Act’s basic neutrality between tender offerors and target management or (2) impose burdens that
conflict with the Williams Act regulations.
State Legislation (3 generations adopted) –
1. First Generation: Edgar v. Mite – Illinois adopted 20 day waiting period on any tender offer and provided
for a hearing to determine the fairness of the offer. Scotus held that this is an excessive burden.
2. Second Generation:
a.
280
b. Control Share Acquisition Acts- limit a control person’s voting rights. As a bidder come across
different control thresholds, the bidder cannot vote the shares it has acquired unless there has been
a favorable vote by a majority of the disinterested shares. Disinterested shares exclude shares
controlled by the people seeking control, and the shares controlled by the target company’s
management. CTS Corp. v. Dynamics
c. Fair price statutes – any person acquiring a covered corporation must pay to all shareholders the
“best price” paid to any shareholder.
3. Third Generation: cannot merge until after three years. If you take over the company, you cannot do
anything for three years. Amanda Acquisition Corp. v. Universal. This stopped leverage buyout in
Wisconsin. You can work around it in Delaware.
Williams Act and SEC Prohibitions
A. 1968 Williams Act
1) Passed legislation to assure shareholders when confronted with a hostile takeover
a) can make informed decisions
b) fair to shareholders
2) Supposed to be neutral but was actually against hostile takeovers
a) Doctrine of well-intended consequences alive in corporate America – had
B. Added Sections 13 and 14 of SEA, limiting tender offers
1) SEC Rules 13(e)(4)-f and 14(d)(10) prohibits discriminatory tender offers (whether self-tender or not)
a) Prohibited selective ____________ of _________
2) Pre-empts the defensive tactic of selective self-tender employed in Unocal
C. Tender Offer Requirements – Schedule 13d
1) When more than 5% of company stock – Schedule 13(d)
2) Schedule 13D must be filed within 10 days of acquisition of stock
3) Required make statement to SEC
a) Describing yourself
b) Source and amount of funds available
c) Purpose, including plans to restructure or liquidate company
 Investors doing Street Sweep to get all they can first on street
 Move swiftly before target knows what is going on
 Schedule 13D prevented that
D. Procedural Requirements
1) Allows shareholders who tendered to withdraw acceptance during specified period
a) Change of mind or better offer
2) SAME PRICE TO EVERYONE
a) Have to pay the same price to all sellers for the same tender offers
b) If oversubscribed, I have to pro-rata for everyone (no more Mesa exclusions)
3) Offer must be held open for at least 20 days
4) BOARD RECOMMENDATION
a) Board must either recommend, decline or no opinion on tender offer
5) SEC 14-e-3 Anti-Fraud rule prohibits trading on tender offer on unpublished information no matter who you are
a) 1968 Williams Act
E. Wellman – What is a Tender Offer???
-Markham’s WILLIAMS ACT NOTES
-Creative destruction-it is good unless you are being destroyed
-Congress responded in a “neutral” way, aide shareholders and make this process more transparent, ACTUALLY it was intended to favor
the shareholders, but through doctrine of unintended consequences it ended up favoring the raiders because this legitimized the business
of the raiders and allowed for large level financing to be obtained by the raiders to raid even more
-WILLIAMS ACT
-1) Anyone acquiring 5% or more of the stock of the company has to file a schedule 13d with the SEC, who you are, where did you get
the financing, and what are your future goals for your interest in this company, basically giving fair warning to the BOD and
management, to let them know what was going on
I.
281
-Various procedural rules, 1) anyone who tenders into a tender offer-you can withdraw the shares if you want, if more shares are
tendered rather than offered than you have to pro rata them equally amongst the shareholders
-Mesa Exclusion is ruled out because all shareholders must get the same thing
-If you increase your offering price before the end of the 20 day period, you have to give the shareholders a larger amount of time to
consider the sale of the stock
-File within 10 days of the purchase of 5% or more of the company’s stock
-Problems: people buy 4.99% stock and ask their buddy to buy the rest, “park stock”, if people are operating in unison the SEC usually
seeks those people out to pool their mutual interest
-20 business days the offer must be kept open, if we increase or decrease our tender offer price, you have to extend the tender offer for
another 10 days for the shareholders to decide
-Management must either a) say we think you should accept, b) don’t accept, or c) No Comment
-Comply with the DE duties and the Williams Act to make sure we meet these requirements-both run together
Cases
1) SEC v. Carter Hawley Hale Stores
a) Company doing a Street Sweep –(= buying stock on the market)
 Companies often repurchase their stock to raise prices or fend off a takeover
 Street Sweep takes time though – and
b) ISSUE: Is a share repurchase offer a tender offer?
 Tender offer not defined in the rules
c) RULES / REASONING
 Courts looked at Wellman for characteristics of a tender offer
 If most Wellman factors fit we will find a tender offer, otherwise not
CASE NOTES
-Williams Act does not define what a Tender Offer is so the courts have come up with their own definition. Tender Offer-defined by the
Wellman test, Offers can be by the purchaser of the stock or someone trying to propose a hostile takeover
-“Street Sweep” buy anything that comes onto the market to continue to bid the price up, I will go to large shareholders to pay over
market and give a position in the company and file with the SEC-game changer because I am going to have to state in there that I will
plan to take over the company’s stock
-At what point do I make a Tender Offer???-Street Sweep, Big Shareholders Offer??
-Courts are saying not defined in Williams Act
-Individually negotiated purchasers-NOT Tender Offers
-Tender Offer-Seeking Broad Base Offer trying to Buy substantial percentage of the stock, 8 factor test to determine whether you made a
Tender Offer that is Subject to the Williams ACT
F.
Hanson Trust PLC v. SCM Corp. (Second Cir. 1985)-page 1234
Facts: barely went over in class
Hanson Trust PLC v SCM Corp
SUMMARY: Issuing corporation applied for restraining order barring certain corporate purchasers from acquiring more of issuer's stock
for 24 hours. Temporary restraining order was extended by consent pending decision on issuer's application for preliminary injunction.
The District Court for the Southern District of New York, 617 F.Supp. 832, Shirley Wohl Kram, J., granted a preliminary injunction
barring purchasers, their officers, agents, and employees from acquiring any shares of corporation and from exercising any voting rights
with respect to shares already acquired by them. Purchasers appealed. The Court of Appeals, Mansfield, Circuit Judge, held that: (1)
negotiation of five private stock purchases in one open market purchase totaling 25% of issuer's outstanding stock did not constitute
"tender offer" within meaning of Williams Act, and (2) private purchases were not "de facto" continuation of earlier tender offer
and thus issuance of preliminary injunction was abuse of discretion. Reversed; preliminary injunction vacated; remanded.
OVERVIEW: The parties were involved in a bidding contest for control of appellee, a large public corporation. Appellant made a public
announcement to make a cash tender offer pursuant to the Williams Act, 15 U.S.C.S. § 78n(d)(1). Appellee entered into a leveraged buyout agreement to stop appellant from gaining control. Appellant announced that it terminated its cash offer. Appellant then decided to
make a cash purchase in the open market or through privately negotiated transactions. Appellee alleged that this purchase of stocks
violated the Williams Act, 15 U.S.C.S. § 78n(d)(1). The court held that the district court erred when it held that appellee's post-tender
offer private purchases of stock constituted a de facto tender offer. The court vacated the preliminary injunction against appellant
and remanded for further proceedings.
OUTCOME: The court reversed and vacated the order of the district court that restricted appellant from acquiring any shares of appellee
and remanded for further proceedings, holding that appellant's post-tender offer private purchases of appellee's stock did not constitute a
de facto tender offer.
282
Hanson appealed an order of the Southern District of New York that granted SCM's motion for a preliminary
injunction and barred Hanson from acquiring any SCM shares on the ground that Hanson’s Sept 11 acquisition of
the SCM stock through five private and one open market purchases amounted to a “tender offer” for more than
5% of SCM’s outstanding shares, which violated §§14(d)(1) and (6) of the Williams Act.
The parties were involved in a bidding contest for control of SCM, a large public corporation. Hanson made a
public announcement to make a cash tender offer pursuant to the Williams Act. SCM entered into a leveraged
buy-out agreement with Merrill to stop Hanson from gaining control. Hanson announced that it terminated its cash
offer. Hanson then decided to make a cash purchase through privately negotiated transactions and in the open
market. SCM alleged that this purchase of stocks violated the Williams Act.
Rule: Since the purpose of § 14(d) is to protect the ill-informed solicitee, the question of whether a solicitation
constitutes a tender offer within the meaning of 14(d) turns on whether, viewing the transaction in the light of the
totality of circumstances, there appears to be a likelihood that unless the pre-acquisition filing strictures of that
statute are followed there will be a substantial risk that solicities will lack information needed to make a carefully
considered appraisal of the proposal put before them.
Reasoning:
1. In a market of 22,800 SCM shareholders, the number of SCM sellers was miniscule compared with the
numbers involved in public solicitations of the type against which the Act was directed.
2. At least 5 of the sellers were highly sophisticated professionals, knowledgeable in the market place and
well aware do the essential facts needed to exercise their professional skills and to appraise Hanson’s
offer.
3. The sellers were not pressured to sell their shares by any conduct that the Williams Act was designed to
alleviate, but by the forces of the market place. The $73.50 price was not fixed in advance by Hanson. It
was negotiated. The sellers remained free to accept the $74 per share tender offer made by the SCMMerrill group.
4. There was no active or widespread advance publicity or public solicitation, which is one of the earmarks of
a conventional tender offer.
5. The price received by the 6 sellers, $73.50 per share, can scarcely be dignified with the label premium. It
did not meet SCE’s proposed definition of a premium, which is $2.00 per share or 5% above market price,
whichever is greater.
6. Unlike most tender offers, the purchases were not made contingent upon Hanson’s acquiring a fixed
minimum number or percentage of SCM’s outstanding shares.
7. Unlike most tender offers, there was no general time limit within which Hanson would make purchases of
SCM stock.
Holding: The court held that the district court erred when it held that SCM 's post-tender offer private
purchases of stock constituted a de facto tender offer. The court vacated the preliminary injunction against
Hanson and remanded for further proceedings.
Issue: Are the five private transactions and the one public purchase a tender offer ?The intent of the act is to
protect unsophisticated solicitee
Risk arbitrage?? – one who is betting on whether the tender offer will take place.
e.g. share at $50, tender offer at $75. Stock may drop if tender offer fell through.
The risk arbitrar is offering something lower than the tender offer price. Risk Art. makes money if tender offer
goes through.
Ct. said these people don’t need protection.
p. 1243, outline restriction of the Williams Act.
State also intervened to adopt rules on tender offer.
283
Scotus addressed restriction to see whether they are preempt by Williams Act or violated the Commerce Clause
Edgar v. Mite
Takeover statute was invalid-it conflicted with Williams act – there the offer was subject to several
requirements that were in conflict with the willimas. (ex. it contained requirements restricting the closing of the
offer, etc.)therefore the statute was unconstitutional. HOWEVER thisw as a split decision so it is of little
precedential value.
One tier
CASE NOTES
-Risk Arbitrager-People gambling on whether the takeover/merger will go through or not, they buy a little over the premium of the
present amount of the stock, say if the stock was currently trading at 40, I will give you 50, if you don’t take my offer and it goes through
you will probably get less, if the merger goes through you may be able to get 80.
-SO the decision is do you the current stock holder want 10 right now, or do you want to bear the risk that it does not go through and you
will lose out on the possible 80.
-Hugely profitable business if you get it right
-Parties in the case went to the Risk Arbitragers that had already bought the stock-and said listen we will buy it from you because we are
looking to get 1/3 interest of the stock here with the intent to take over the company entirely
-Court here says we are going to look at the 8 factor test, we are going to treat it as a non-tender offer because it is a private negotiation
and purchase of the people who had the interest in the stock
-It was not public it was more private transactions on a larger scale but each individual transaction was
-Rule 14e-3-tricy situation in there-have to analyze these things, misappropriation no, classic probably not, rule 14e-3, and section 16 are
we going to run a foul to that as an insider
-If we have a Tender Offer-then all of the Williams Acts Procedural provisions will kick in
humana
Competing tender offerors had No Standing to sue eachother because there were no damages but injunctive relief was available
Schreiber v
You have to have fraud
14 e fraud
40 million offers accepted resulting the creation of share price. Nondisclosure is an essential elementof 14b.
Scope of the antifraud provision. (remember scienter requirement of 10b-5) same determination in 14e but focused more on tender
offers/
Nondiclsocure or misrepresentation is required.
No Fairness be considered in whether a violation occurs? No, were only going to look at fraud.
Polaroid
Extends schreibre
CTS Corp. v. Dynamics Corp. of America, Scotus 1987.
Premepiton doctrine -federal statute - 3 basis—
1. State law doesn't apply
2. ??
3. Whether the tatute occupies the field
Facts: Indiana has a Control Share Acquisition Chapter (Indiana Act) which provides that an entity acquiring to
or above any of three threshold: 20% (they will not be able to vote those shares unless disinterred shareholders
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approve-disinterested shareholders are people who are not in management, did not tender offer) so this puts a
lot of pressure to make a friendly transaction and approve it by management., 33 1/3, or 50% does not necessary
acquire voting rights. Those rights are gained the majority vote of all disinterested shareholders holding each
class of stock for passage of such a resolution. The shareholders will vote at the next regularly scheduled
meeting, or a special meeting, or the acquirer can require management of the corporation to hold such a special
meeting within 50 days if it files an acquiring person statement and pay for the meeting.
Issues:
1. Whether William Act preempt the Indiana Control Share Statute? No
2. Whether the Indiana statute violated Commerce Clause? No
Reasoning:
o Mite is a plurality opinion. The Indiana Act protects independent shareholders against both management
and tender offeror. So the Act furthers a basic purpose of the Williams Act- placing investors on an equal
footing with the takeover bidder.
o By allowing shareholders voting as a group, the Act protects them from the coercive aspects of some
tender offer. Example, shareholders may think the tender offer is not for the corporation’s best interest, but
they vote yes because they believe that a successful tender offer will be followed by a purchase of nontendering shares at a depressed price.
o Therefore this Act furthers the federal policy of investor protection.
o The Act does not give management or offeror an advantage in communicating the shareholders about the
impending offer and it does not impose an indefinite delay on tender offers.
o The 50 day delay is within the 60-day maximum period Congress established for tender offers.—so you
can work around this
Holding: Williams Act does not preempt the Indiana Act.
o Mite is plurality. This statute is consistent with Williams Act.
o Once a party gained controlling shares, the person would not be able vote those shares until the
disinterested shareholders restored the voting to those shares.
o This is a very good poison pill for the company who is being attacked. Encourage the takeover person to
negotiate with the target company.
Notes, p. 1263
Note 1. Not many states followed Indiana.
Note 2. Section 203 of the Delaware General Corporation Law prohibits a business combination with an
“interested stockholder” owner of 15% or more of the company’s shares for a period of three years unless either
(a) the combination was approved by the board before the acquisition, (b) the interested stockholder acquired at
least 85% of the target’s voting stock (excluding directors and certain types of employee stock plans) at the time it
became an interested shareholder, or (c) the transaction is approved by the directors and by the holders of at least
2/3 of the outstanding stock not owned by the interested stockholder.
G.
State Anti-Takeover Statutes
1) Tender offers restricted to avoid hostile takeovers
 Unless target management agrees to it
2) 3 GENERATIONS
a) Illinois
 Supreme Court struck Illinois statute as pre-empted by Williams Act
 Required 20 days pre-commencement (Conflict with Williams time limits)
 Approval by Illinois Securities Administrator
 Hearing with no deadline
 SCOTUS held that did not pass Constitutional Muster, largely because Conflicted with the Williams Act
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Indiana Statute
 Controlled shares – 20% of your stock
 Could not vote those shares unless majority of disinterested shareholders approved (excluded management
from approval requirements)
 If not sure we can get that disinterested vote, because management would still have proxy control, would deter
hostile takeover
 Would need management approval
 Supreme Court approved / not a conflict with Williams Act
c) Best price to be paid by controlling shareholder to all shareholders
d) Others had a delay provision – if I purchased can’t merge for 5 years
e) Past Constitutional Muster
f)
Delaware __________ TAKEOVER STATUTE - 203?
 90-day shareholder vote to approve a merger with a controlled person
 Or in lieu thereof approval by the target’s board or 3-year delay before you can take control of company that can
be waived by 2/3 vote of shareholders
 Before I can take control
 Approval of board OR (management sometimes caves)
 Get 90% vote of a;; shareholders OR
 Wait 3 years, which can be waived
 Also past Constitutional Muster
Private Equity Takeovers
1) Private companies taking over Public Companies
a) poison pill – defensive measure to keep raider out.
2) Merger
a) Corporations combine and become one corporation
b) Types of Merger
 Cash Out Merger
 Will buy all stock at X dollars
 Short-Form Merger
 Holders of 90% or more
Exchange Stock for Stock
c) Board must recommend, not recommend or give no opinion
b)
H.
3)
DILUTION
a) No longer have to give right of first refusal to shareholders for new issue
 Need to add to Articles or Bylaws to enforceable
4)
DUTIES OF PARTIES
a) Partner duty to Other Partner: Very high fiduciary duty
b) Shareholder duties to other Shareholders:
c) Director duties/relationship to Shareholders:
d) Director duties/relationship to Corporation
-NOTES ON WILLIAMS
-State Law Concerns-Unocal, Revlon, Time
-Williams ACT-for Federal Procedural Requirements, Tactically it will probably allow defensive measures to be
imposed against us
-State Take Over Provisions
-Restrict the Abilities of Raiders-Designed to allow the companies to block the raiders
Amanda Acquisition Corp. v. Universal Foods Corp. 7th Cir, 1989
FACTS: Wisconsin has a third-generation takeover statute that postpones the transaction usually that follows
tender offers. Unless the target board agrees to the transaction in advance, the bidder must wait three years after
buying the shares to merge with the target or acquire more than 5% of the assets. Amanda is a shell with a single
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purpose to acquire Universal Foods Corp. Amanda’s financing for the tender offer is contingent on a prompt
merger with Universal if the offer succeeds so the offer is conditional on a judicial declaration that the law is
invalid.
Issue: Whether the Wisconsin statue is consistent with the Williams Act and Commerce Clause.
Reasoning:
o That state law is unwise. But that's for the legislature. Not judicial. The prospect of monitoring by wouldbe bidders, and an occasional bid at a premium, induces managers to run corporations more efficiently and
replaces them if they will not.
o But skepticism about the wisdom of a state law does not lead to the conclusion that the law is beyond the
state’s powers.
o The Williams Act regulates the process of tender offers: timing, disclosure, proration , best-price rules.
Delay in completing a second-stage merger may make the target less attractive but if does not alter any of
the procedures governed by federal regulation.
o Only if the Williams Act gives investors a right to be the beneficiary of offers could Wisconsin’s law run
afoul of the federal rule. Williams Act gives no such entitlement.
o Amanda sues as bidder rather than as investor seeking to sell, the Williams Act does not create a right to
profit from the business of making tender offers.
o Amanda argued that the Wisconsin law is fatal because it does not offer the option available in Delaware.
The Delaware statute allows merger to proceed if the bidder obtains 85% of the shares other than those
held by management and employee stock plans.
o Ct. said even in Wisconsin, options remain. Because every bidder ahs the same drawback, the firm
placing the highest value on the target still should win.
o It does not matter whether bidder’s countermeasures are enough. The Commerce Clause does not demand
that states leave bidders a “meaningful opportunity for success.
Holding: The Wisconsin law may well be a folly, but it is constitutional.-did not clash with the Williams act. The
Appeal Court affirmed the lower court decision that the statute is constitutional and not preempted by Williams
Act.  permissible - third tier
Addressing the Delaware statute as well
Court said this may be an unwise statute, shareholders cannot get premium price for their shares. But court said
even it is unwise, it is not unconstitutional.
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-Derivative Lawsuits
-state statutes allow shareholders to bring “derivative lawsuits”-on behalf of the corporation to make the
corporation take some action that the corporation is not taking
Must keep stock until end of litigation
There must be some duty owed to the corp
-Largely pushed by lawyers because they are guaranteed the attorney’s fees for the case
-1) before you bring the lawsuit, you must make a demand on the management (and ask it to sue—then if it
refuses to sue, then I can sue on its behalf)
Futility-if the corp BOD leaders made the wrong you don't have to demand -Demand may be excused if
the Directors would breach their fiduciary duty
-Derivative Lawyers will try to show that management may have a conflict of interest with the fiduciary duties so
that they could not invoke the business judgment rule
-Corporations love to defend by created a special committee (to prevent COI) to pursue these things so that-they
could not invoke the breach of fiduciary duty –good ay to get back into the BJ rule because –this was a corporate
decision
Courts go back and forth with ruling on this
-All companies then created all kinds of special committees, Courts saw these and did not like it because made it
too hard to see if the management had the demand imposed on them
-Insurance
(most corp has them)insurance comp that pays for the cost of these litigations
BOD FREE TO USE THEIR JUDGEMENT WITHOUT BEING frear of getting sued
-May allow insurance for BOD members who breach their fiduciary duties??
-Results in companies having D and O Insurance-Director and Officer Insurance of Liability for the breach of the
fiduciary duties
-Companies are required under DE law to indemnify their directors and officers in litigation
-Created problems with criminal liability-because the insurance companies have the best lawyers willing to drag
out all cases
- nolo contender don't count as a conviction, has to be a conviction
Cash accounting
accrual accounting
Accrual Accounting. Definition: Accountingmethod that records revenues and expenses when
they are incurred, regardless of when cash is exchanged. The term "accrual" refers to any
individual entry recording revenue or expense in the absence of a cash transaction.
Well attribute the check to December even though we did not get I t
Causes problems like depreciation
All this is discretionary and can be manipulated
We can treat things like expenses
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