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Professor Dan Danielsen
Tuesday, May 27, 2003 (Class 1)
Logistical Details
Take home exam distributed on last day of class, due last day of exam period
(50% of evaluation).
3 very short papers (25% of evaluation).
Group participation (25% of evaluation).
Revised Modified Business Corporate Act and Delaware Law are only law we
will study; RMBCA is only one needed for exam.
Purposes of Corporation
Facilitate risk spreading
Collect capital
Limit liability
Separate ownership from day-to-day operations
Independent existence
Generate revenue
Enable state to regulate economic activities
Facilitate public ownership -- sale of stock coupled with limited liability
Common rules and expectations
Governance structure: designed to structure relationship between shareholders
and managers.
Maximizes shareholder value/returns
Can't do business with "corporation" per se; interact with managers, president,
employees, etc.. Constituency may have complex motivations and interests may
not be all aligned.
Corporation has no existence outside of legal structure.
Four primary characteristics of corporation:
o Separate entity with perpetual existence
o Limit investor liability to amount invested in business
o Centralized management (shareholders need not be involved in
Transferability of ownership interests; corporation continues regardless
of whether investors sell shares
William T. Allen, Our Schizophrenic Conception of the Business Corporation
[14 Cardozo L.Rev. 261] 1992
Property conception: only to make money
Social, institution conception: corporations control wealthy, structure
relationships, have impact on people's lives, and thus are social institutions, and
should be regulated in the public interest.
Much of corporate law is managing tension between property and social
institution conception.
History of corporate law
Early corporations were charities, churches, etc..
Charter needed to be signed by King
Could be revoked at any time
Business associations: originally took form of guilds (like ABA)
If you met requirements, you could practice in guild for yourself.
Quasi commercial corporations began to appear in early 17th century, focused
on foreign trade
License granted by King to carry out functions in foreign places, performed
many public functions
Evolved out of colonialism
United States corporations followed history; started as quasi-public entities,
including churches and charities, but also public-private partnerships: toll
roads, canals, transportation lines.
Corporations created on case-by-case basis by legislature.
Granted monopoly.
With railroads, corporations grew quickly, concern in state legislatures.
State legislatures started to include special regulations in charter.
Corruption between corporations and legislatures because of nature of
legislative grant of exclusive rights.
Populist rebellion: move from specific legislative grants to free incorporation
(right rather than privilege).
1888: New Jersey passed bare minimum comprehensive corporation law.
1916: Woodrow Wilson, worried about corporate power, repealed much of
New Jersey corporate law.
1899, amended after 1916: Delaware passed corporation law most 'open' to
Delaware became predictable place to run a corporations, attracted many
Most statutes have moved in direction of Delaware: allow general corporations.
Regulatory Goals
Tension between goal of maximizing shareholder value and providing
accountability between various constituencies and between corporation and
Some scholars argue that these goals are best achieved by minimizing
regulation entirely
How to regulate complicated socioeconomic, political, legal entity?
o Procedural or Structural (create the system and let things happen).
 Voting rights
 Separation of powers between shareholders and managers.
o Regulatory or punitive
 Criminal laws
 Torts
 Fiduciary duties
 Liability for securities violations
Exit vs. Voice (economist Herschman)
o Exit: If you are dissatisfied, you can leave--sell shares, which will punish
company and encourage it to change its ways
o Those who argue for deregulation say all you need is to be able to exit.
o Voice: Stay in institution and express yourself. Depends on likelihood
that someone will listen.
o Availability of exit decreases probability of using voice.
o Loyalty issue effects action as well.
Wednesday, May 28, 2003 (Class 2)
Hypothetical firm: "Omega"
Separate existence, perpetual life
Maximize total returns by maximizing efficiency, minimizing costs
What incentives would be needed to make actors behave properly? Proper level
of monitoring/accountability.
What about installing surveillance system of cameras?
If cost of surveillance system per month is $100, and loss to Omega from
employee theft was $50, then Omega still shouldn't put in system.
Corporate lawyer does not represent the shareholders, customers, employees,
employers, etc.; instead represents the abstract entity known as corporation, and
tries to advise on what is best for corporate entity.
Assumption of alignment of interests--that investors, managers, employees all
want to maximize long term value.
One person owns business ("O"), doesn't want to work, and other person will
work ("W").
o O's ability to metabolize risk/diversification
o What's at stake for each person
 Time horizon: long term or short term
 Obtaining returns
 Relationship between entities--sharing profits/sharing risks
(allocation of responsibility and risk)
 Stage of life
 Experience
o Product diversification
o Wealth
o Insurance
o Alternatives for O and W
o Risks: controllable vs. uncontrollable
Friday, May 30, 2003 (Class 3)
Tuesday: Groups 1-5 on, groups 11-15 client'
Wednesday: Groups 6-10 on, groups 1-5 client
Friday: Groups 11-15 on, groups 6-10 client
Theory of Firm
Analysis of motivations and risk tolerance of primary constituents of business
Rational individual: each person is expected to maximize happiness, etc., and
minimize loss
Economic theory tries to build analogy between individual and firm
Problem with theory: managers might not be able to tell what employees are
doing; board might send instructions to management that are disregarded
(versus analogy of individual--left hand, right hand, brain).
Contracts and business regulation, from business perspective, to monitor to
make sure all parts of business are acting together. Assumption is that parts
work together; so regulation and contracts manage at margin.
Even in simple case (wine grower and worker from last class) there are many
variables and gaps in knowledge.
In face of these uncertainties, economic model shifts from descriptive to
predictive: note that everyone fits the model, but that most people do.
Business and business law is about managing uncertainty left over from
Business lawyer: use skills to advise business person how to implement
When someone wants to do something that is illegal, business lawyer's job is
not just to tell them that it is illegal, but to find way to do it legally.
Questions to ask:
o What are client's business objectives?
o What are motivations for doing it?
o What are available strategies for achieving objectives?
o Which are legal?
o What are costs and benefits associated with each strategy?
Basic Concepts and Terms
Four main sources of corporate law:
o State corporation statutes
o Case law
o Articles of Incorporation/Charter?
o Bylaws
Client influeces articles and bylaws, but not statute or case law
o Number of shares
o If there is more than one class of stock, needs to be specified
o Special voting requirements
o Restrictions on power of board
o Can be more stringent than statute but not less (e.g., require 2/3 majority
for merger even if statute requires majority; but not vice-versa)
o Frequently harder to change than bylaws
o Procedural guidelines for governance of corporation
Board is given fair amount of discretion, within limits of statute, case law,
articles, and bylaws
Common stock: residual interest in corporation on liquidation after all other
creditors have been satisfied
Authorized stock: how much stock can be issued
Outstanding stock: actually issued
Debt securities: bonds, etc..
Sometimes difficult to tell difference between debt and equity
Fiduciary duties: generally arise from case law
Movement to include indemnification in statutes: if board is sued for breach of
fiduciary duties and board wins, then legal costs are covered.
Exculpation provision: need to be supernegligent to be held liable.
These statutory provisions control articles and bylaws
Duty of Care
Directors need to act is with same caution they would use in their own affairs.
Directors are not insurers.
Want to encourage risk-tasking.
Must take "reasonable care"; broad latitude. Liability is incurred closer to "no
care/self interest" on care spectrum.
Business judgment rule: presumption that law won't hold directors liable for
honest mistakes and good faith effort.
Duty of Loyalty
Director owes full and complete loyalty to corporation; prohibits "self-dealing"
Can't serve "two masters"
Usually when director perceives conflict of interest, will disclose that to board
and refrain from voting on matter
If shareholder can demonstrate actual conflict of interest, court will apply strict
scrutiny to board's actions.
Chesapeake Marine Hypothetical
Firm with one director ("Apple") who owns more than 1/3rd of shares, as well
as substantial stock of competitor, Lambert family owns remainder of stock,
but no one more than 200 shares.
Board wants to issue more shares to raise capital, Apple opposes.
We represent "corporation": directors and shareholders can both be indicative
of corporation's interest.
Business judgment rule: as long as directors have acted in good faith with due
diligence, unlikely to be fiduciary duty lawsuits.
No fiduciary duty of shareholder to corporation
Only duty is when majority shareholders abuse minority shareholders
Tuesday, June 3, 2003 (Class 4)
Two handouts
o Chart comparing corporate entities
o Problem for Friday on Financial Accounting (replacing problem in
Chesapeake Marine Services Part I Cont'd
As long as directors act in good faith and in the best interest of corporation, no
risk of liability for breach of fiduciary duty.
Reason for capping shares in Articles: protects shareholder control of company;
keeps investment units at reasonable amount.
Board has authority to sell authorized but unissued shares, thus diluting interest
of current shareholders.
Authority of corporation is vested in board; in certain extraordinary
circumstances shareholders vote. When statute conflicts with articles, usually
statute will control, but statute does not prevent more stringent requirements.
If Apple votes against issuing stock, there should be no liability, because
shareholders only vote their own self-interest. Exception: when majority abuses
minority shareholders. No shareholder fiduciary duty.
If Apple is acting in role of director, fiduciary duty would arise.
Corporations are made up of multiple constitutencies; they can have good faith
or bad faith motives; agendas can influence idea of what's in the best interest of
Business judgment rule: allows boards to move almost with impunity. Even if
they are completely wrong in their judgment, they're not liable.
Board behavior circumscribed by fiduciary duties: if they act fraudulently
against corporation (MCI-WorldCom?), or if they become too complacent
Since management doesn't bear risk of corporation, shareholders must bear
Doctrine requires parties acting in multiple roles to bifurcate their identity:
when acting as board members, should think only about what is best for
Equitable Limitations of Legal Possibilities
"Bookends" as to how creative you can be as a legal advisor
Schnell v. Chris-Craft Industries, Inc.
[285 A.2d 437] 1971 Delaware Superior Court (cb47)
Group of unhappy shareholders sought to initiate proxy contests to replace
board of directors
Board amends bylaws to schedule annual meeting on different day, and then
reschedule meeting a month earlier in difficult to access location.
Shareholders challenge director's actions on equitable grounds
No other business purpose for moving meeting other than to disrupt vote, thus
not permissible.
Bove v. Community Hotel Corporation. of Newport, R.I.
[<<105 R.I. 36249 A.2d 89] 1969 Rhode Island Supreme Court (cb49)
Preferred shareholders are due 24 years of unpaid dividends before corporation
could pay dividends on common stock.
Unanimity of preferred shareholders required to amend the charter.
Directors created new corporation, merged old corporation into new to get rid
of preferred stock.
Independent legal significance: each provision of the corporate statute stands
on its own. Just because something can be done under one section but not under
another does not make it illegal.
Schnell and Bove are "bookends" of permissible corporate active. In particular,
when directors act to interfere with shareholders' voting rights, court might act
equitably to prevent.
Chesapeake Marine Services Part II
Financial aspects
o Value of Shipyard = fair market value of shipyard divison plus cash
from stock sale = $150/share
Lamberts purchased shares at $100/share
Chesapeake price is $187.50/share
Under Bove, wouldn't matter if directors have bad motives. As long as
corporation is statutorily authorized to take action, then independent legal
significance doctrine would allow them to do indirectly what they couldn't do
But from fiduciary duty perspective, motive would be examined: does it make
sense for Chesapeake to pay nearly twice as much as Lamberts pay?
If there is a conflict of interest, court will apply strict scrutiny, hard to justify
difference in stock price.
Wednesday, June 4, 2003 (Class 5)
Chesapeake Marine Services Part II Continued
Lamberts purchased stocks at nearly half the price as charged to Chesapeake,
depending on how assets are valued. Using Fair Market Value for shipyard
assets, Chesapeake pays $187.50 per share, while Lambert and investors pay
$100 per share. If book value is used, then cost per share would be equal.
Assessment of share prices is, itself, a business judgment.
Business judgment rule protects decisions unless there is self-dealing.
Advice to client: if you want to avoid litigation, need to restructure transaction:
o Increase number of shares given to Chesapeake, or decrease number of
shares given to Lambert, to equalize numbers
o Bolster business judgment by showing value is less
o Offer shares to Apple at $100 per share--makes self dealing go away.
o Don't offer shares to Lambert or Apple, just sell shares to third party
Used to be that shareholders had preemptive right to purchase new shares, rule
is no longer in place.
"Fairness" is relative--if Apple had opportunity, then all shareholders would be
treated equally, even if price is "too low."
Choice of Organizational Form
Need snapshot of present moment and idea of where business might go to pick
organizational form.
Example: want to start law firm. Major input is human capital. Unlikely to have
future need for capital. General participation in management by partners may
be desirable. Partners taxed on earnings whether distributed or not. Partnership
is typical form.
Manufacturing concern: needs regular and continuous investment in business.
Ability to sell stock or debt securities could be important. Centralized
management may be important. If company keeps earnings rather than
distributing, no tax consequences to shareholders. Corporation form.
Corporations generally cheaper to form because they can take "off the shelf"
When stock in corporation is transferred, both ownership interest and
voting/control rights are transferred.
With other forms, economic interest can be separated from control interest.
If all profits are given out (e.g., law firm), corporation would require "double
taxation", thus partnership would be preferable.
If law firm partners want to do additional real estate business, however,
partnership would be bad because partners would be taxed on income when it
came into partnership even if they don't actually get the money.
S-Corporation: small, closely held corporation. Maximum of 35 shareholders,
must be individuals. Only has one class of stock. Limited liability, but treated
as partnership for tax purposes. Could convert to regular corporation later,
unlike LLC.
Precision Tools Problem
Business will operate at a loss early on
Will need capital to expand business, probably from outside sources
Bernie is retiring, probably wants limited liability.
None of the investors can absorb large risk.
Might want to be able to retain earnings to business without tax consequences
to themselves. (but also see early losses).
Friday, June 6, 2003 (Class 6)
Continuation of Precision Tools: Which form to use?
If company requires ongoing reinvestment of profits, some perform
corporation, because earnings have no tax implications for shareholders.
Limited Partnership (with corporation as general partner (Jessica and Michael
as shareholders), and Bernie as limited partner)
o Pros:
 Limited liability
Bernie liimted participation in management
Flow through tax treatment--Bernie can take corporation losses
against his income (does not necessarily benefit Jessica and
Bernie can't make management decisions, or he will turn into a
General Partner
 Partnership ends when general partner withdraws
 Bernie can transfer economic interest, but not control interest
Limited Liability Corporation
o Pros:
 Flexibility in governance structure
 Continued Existence
 Choice of tax treatment
o Cons:
 More expensive to set up
o If you elect corporate tax setup, usually chosing LLC for other reasons
than tax.
o If you chose patnership tax setup, might be doing this for tax reasons...
o Can be harder to find investors for LLC.
o Pros:
 Limited liability
 Bernie on board
 Transferability
 Easier to raise funds
 Quick and easy to set up
 Unlimited life
 Familiar form of doing business
o Cons:
 No flow through tax treatment
Simplest form would be corporation; if Jessica and Michael want flow through
treatment temporarily, they could form S corporation.
LLC's: "Check the Box" tax treatment--whether you want tax flow through or
Introduction to Financial Accounting
Although financial accounting seem to be all about numbers, in fact is much
more art than science.
Can't value things like Coca-Cola Trademark, so balance sheet often doesn't
give information that you would otherwise want to know.
Cable companies: appears to be just debt (to finance laying cable), but you
don't see on balance sheet exclusive right to reach certain customers.
Two fundamental ideas
o Balance sheet (snapshot at particular time)
o Income statement (finances over time, between balance sheets)
Developed by management, audited by accountants
Based on books of corporation that record every transaction
Must comply with Generally Accepted Acounting Principles (GAAP).
Building must depreciate over time, land remains at price purchased
o Financial recording as accurate as possible
o Reasonably reliable
o Prepare financial statements at a reasonable cost
Record things at purchase price, and record depreciation, even if this doesn't
accurately reflect situation.
Balance sheet--fundamental equation: assets = liabilities + equity
Equity is what business starts out with.
Next Week
o Tuesday: do accounting problem, finish discussion of accounting, groups
11-15 continue to be on, 6-10 client.
o Wednesday: go back to old schedule. 6-10 on, 1-5 client.
Tuesday, June 10, 2003 (Class 7)
Relationship of Balance Sheet to Income Statement
Balance sheet as snapshot
o Income statement as motion over time--transaction that happened
between one balance sheet and the next
Many believe income statement is more reliable than balance sheet in
predicting future profits
Many options within GAAP that manager has to make picture of company look
o Might keep income in one year, and push expenses into the next
Accrual accounting -- to avoid manipulation of times
Realization Principle: income is generated in the period in which it was
o Matching Principle: always have to match costs of generating income
in same period
Accrual accounting is supposed to be less manipulable
Still subject to manipulation
Question: when is item sold for manufacturer?
o When order is made
o When items are manufactured and shipped
o When items are received and accepted
Changing accounting practices requires board approval
Cash Flows: Need to track cash as well as income because some payments
may not be received.
Balance sheet terms
o Assets: Everything, including fixed assets, cash, etc..
o Current assets: can be converted into cash within one year--cash,
accounts receivable, marketable securities.
o Accounts receivable: moneys owed to the company for the sale of
services or goods. Should reflect a reserve for bad debt--some
percentage will not be collected. When accounts receivable increases, it
might mean more sales, or it might mean harder time collecting on debt.
o Inventory: could use average cost method for item that remains fairly
constant over time. For items like computers or fashion-related,
inventory should be valued otherwise. First In First Out, Last In First
Out, Average Cost methods, depending on practices for particular
o Prepaid expenses: e.g., car insurance for year, if paid up front. Show up
as assets.
o Deferred charges: e.g., advertisements.
o Goodwill: if you buy a company and pay more than fair market value,
goodwill is difference between price you pay and fair market value.
Depreciates over 40 years. Lots of planning goes into avoiding
transactions that generate goodwill.
Precision Tools Problem
Good signs: net income is up, debt to equity ratio decreasing
Potential trouble: accounts receivable are growing
Liquidity Analysis
o If ratio is not good, might be harder to get more money.
Current ratio: current assets divided by current liabilities. Assets that
could be realized within one year idividied by liabilities that need to be
paid within one year. 1996: 1.57, 1997: 1.64. People like to see 2:1 ratio.
Could be lower if it's easy to collect on account receivables and
inventory can easily be turned into cash.
o Liquidity ratio: quick assets divided by current liabilities. 0.87 for 1996
and 1997. High debt to available assets to pay. Should be at least 1:1.
Debt-Equity Ratios
o Divide long-term debt by balance sheet equity; should be at most 1:1.
o 2.102 in 1996, 1.32 in 1997.
Interest coverage ratio
o Net income divided by interest expense.
o 0.67 in 1996, 1.22 in 1997. Have more interest expense than profit in
1996, but better in 1997.
Operating Margins
o Operating income divided by net sales--how much income generated off
of sales.
o Increasing every year, partially because of decrease in R & D. Need to
show that increase in sales is greater than increase in operating expenses.
Return on Equity
o Last year's equity divided by this year's icome.
o 35% from 1996 to 1997. Looks like good return, but doesn't take into
account the leveraging. Business has borrowed a lot of money to make
For tomorrow: what valuation methods would you apply, derived from Apple
Tree example?
Start Class 7--determining capital structure, groups 6-10 will be 'on'.
Wednesday, June 11, 2003 (Class 8)
Valuation of Company
Price/earnings ratio--capitalization of earnings
o Compare return on investment versus less risky investments--e.g., bonds.
o If you want 30% return, divide 100 by desired return = 3.33:1. Use past
earnings to determine likely return.
Fair Market Value--what people are willing to pay
What other similar businesses have sold for (substitute for Fair Market Value)
Book Value--just value of assets--lowest possible value
Discount cash flow--how much would I be willing to pay now for x earnings
over time?
o Problem: over time, earnings become risky.
Precision Tools Problem
o Working with historical data suggests low asking price, useful for
bargaining with sellers
o Buyers expect market will take off, however, so they may be willing to
pay much more
o Resulting price likely to be some medium between company valuation
and hopes of buyers
Capital Structure
Financer is looking for three things
o Receive money from current operations
 Stockholder receiving dividends
 Debtholder receiving interests
o Share in proceeds if firm becomes insolvent, dissolves, or is sold
o Ability to monitor investment
 Controllable risks
 Uncontrollable risks
 Could be voting on certain transactions, special rights to
dividends, etc..
All these results come from security itself.
Debt vs. Equity
o Ownership interest in company.
o Residual interest after everyone else is paid off.
o No fixed rate of return.
o Generally investment for unlimited period of time, no right to get money
o Three way of getting money out:
 Dividends
 Business is sold
 Sell stock--usually to third party rather than company
o Highest risk investment
o Biggest chance of reward--everything which is left after everyone else is
paid off.
o Risk is compensated by increased input into management
No ownership stake
No residual interest
Fixed return--negotiated interest rate
Fixed length of time
Get paid before any equity holder
Less risk, lower returns
Less or no input into decisionmaking of business
Common Stock
 Default type
 Comes with voting rights
 Last to receive payment
 Elects board
 Benefit from Board's fiduciary duties
Preferred Stock (possible meanings--varies by stock--might be any of
 Right to dividends before common stock
 Special rights to dividend--e.g., fixed at 5% per year on amount
 Cumulative rights: dividends accrue with interest regardless of
whether they're paid
 Participating preferred: get preferred dividend, and also common
shareholder dividends
 Liquidation preference: preferred gets paid first. Often equal to
price paid for shares plus any unpaid dividends.
 Redemption rights: rights to have company repurchase shares at
some date in future. Usually equal to liquidation preference.
Enables preferred to get capital back when there is no market for
 Debtholders often have affirmative and restrictive covenants
preventing company from paying dividends if they are behind on
 Special voting rights: sometimes preferred stock permits election
of board member, or majority of board; vote on fundamental
changes; prevent company from taking on certain debt without
 Can be converted into common stock.
Rights to preferred shareholders will depend on how difficult it is for
company to get money.
o Debentures
 Unsecured
o Notes
 Either secured or unsecured
o No fiduciary duties
o Have to pay interest and principal regardless of whether you have
o Debtholders usually have right to accelerate payment if payment is
missed. E.g., if you miss mortgage payment, bank has right to make you
pay the full amount immediately.
o Often "callable" by company itself--they can pay it in advance.
o Can have ability to convert debt to stock--allows debtholder to get some
of benefit of equity without risk of equity.
o Sometimes if debtholders get too involved in governance, court will
strike down priority for lender repayment. Looks too much like equity.
Tension between debtholders and equity holders
o Increased risk doesn't benefit debtholders, even if produces lots of
rewards for company
From investors profile, choice between debt and equity will depend on
individual situation/investment profile.
From company's profile, depends on leverage.
o If company can borrow money and get returns higher than interest
payment. If stockholders were added instead, then profit needs to be
shared among more people.
o Borrowing increases shareholder risk because there is no discretion in
paying and debtholders get paid first.
o When tax is considered, borrowing becomes even more attractive for
company: interest payments are tax deductible.
o See example cb230-231 to see difference in borrowing and equity.
o If profit expectations turn out to be wrong, however, company is in
trouble because it has to pay interest regardless.
o Other risks: recharacterization. You thought it was debt, but turns out to
be equity.
Friday, June 13, 2003 (Class 9)
Precision Tools Part V
All rights to Bernie, Jessica, Michael, Stern, and Starr are contractual--need to
be specified.
If company gives up a lot of rights at the beginning, it may be hard to give up
fewer rights in later rounds of financing, unless company is doing so well that
everyone wants to invest.
Preemptive rights often have exemptions: e.g., employee stock plans.
Legal Capital
Still the law in Delaware and other jurisdictions
19th and early 20th century: par value and legal capital
Par value: originally, price paid when stock issue stock
Legal Capital: money from par value stocks--prohibited from being out. All
dividends needed to come from subsequent profits.
o Par value has no relation to worth of company.
o Regulators did not allow companies to sell share for less than par value,
thus companies set par value very low.
Difference between market value and par value is par surplus.
On Balance Sheet
o Paid-In Capital
o Legal Capital: par value times shares sold
o Surplus: difference between number of shares sold and price for shares
Solutions used: Dividends can only be paid out of earned surplus, and if there
are earned profits.
RMBCA, two practical tests to see if dividend can be paid
o Equity insolvency test: board must look at financials as a whole,
including debts, cash, when debt is due, and make determination that
payment of dividend will not render company unable to pay debts when
due. (more of a judgment call). Protected by business judgment rule.
o Balance sheet test: if dividend payment would make assets drop below
liabilities, plus money owed to preferred shares (accrued but unpaid
dividends), then no payment. (more of a mechanical test).
Tuesday, June 17, 2003 (Class 10)
Three short papers assignment
Legal Capital, Par Value, and Dividends
Par Value: Attempt to create protections for shareholders and creditors.
Par Value = Share Price--amount company wanted to raise divided by number
of shares it intended to issue
If X company wants to raise $1000 selling 10 shares, par value and share price
would be $100 per share.
Corporate regulators made two rules:
o No shares can be sold for less than par value
 Avoids "watered stock"
 Promoters might present shares for $100 per share, and some
people would purchase with property, etc., worth less than $100.
o Can't pay dividends if amount paid would diminish capital
 Capital: par value times shares sold
 Doesn't say anything about creditworthiness of business, however.
 Really "legal fiction"--capital can be used for
anything except dividends.
Par Value doesn't really have relationship to what shares are worth--market
might value them for more or less.
In response, companies set par value very low--a few cents.
Capital calculated then becomes very low, no check on dividends.
Regulatory response
o Delaware: Calculates surplus differently--assets minus liabilities, then
subtract legal capital, anything left is surplus.
o Some other states: Only allow dividends paid out of earned surplus -roughly equivalent to retained earnings.
o RMBCA §6.40--rejects both approaches, adopts pragmatic approach
 Does not require par value, irrelevant to dividends question
 Equity insolvency test: Board reviews financial statements,
would payment of dividends make it difficult to pay debts of
corporation when due? Usually, look at current assets and current
liabilities (due in next year). Judgment call, protected
by business judgment rule.
 Balance Sheet Test: can't pay dividend if total assets is less than
total liabilities plus all amounts due to preferred shareholders.
 Don't need to use GAAP financials
From standpoint of creditor, whether company pays dividend or repurchases
share, same effect. Assets are being paid out to shareholders, diminishing
available assets for repayment of liabilities. Corporation statutes treat them the
If shareholders who received dividends or repurchase knew that payment was
improper, Board can sue shareholders for contribution.
Decisions to pay or not to pay dividends is protected by business judgment rule,
thus usually fraud, self-dealing, or bad faith are needed to overcome business
judgment rule. In small closely held companies, sometimes courts will
intervene in equity.
Precisions Tools Problem Part VII
Can PT pay $2000,000 dividend?
o In Delaware with $100 par value, subtract liabilities for assets, then
subtract par value. Get $100,000. $200,000 not possible.
o For $1 par value, however, surplus is $595,000, thus $200,000 dividend
is possible.
o Under Equity Insolvency Test: Current assets minus current liabilities,
leaves $685,000.
o Balance Sheet Test: Total assets minus total liabilities, minus preferred
shareholders. Seems okay here.
Can shareholders buy back Bernie's shares to get rid of Bill Gould? Cost would
be $500,000.
o Same treatment as dividend; not allowed in Delaware if par value is
$100. Yes, at $1 par value.
o Under equity insolvency test, comes down to business judgment.
For purpose of balance and equity insolvency test, assume debt is due all at
once, thus it might make difference if money is borrowed to pay dividend or
buy back shares.
As long as Michael and Jessica are not acting in bad faith, it's unlikely that
Bernie could force them to pay dividend.
Wednesday, June 18, 2003 (Class 11)
Securities Regulation
Thus far, almost all regulation has been from state law, with exception of
certain areas which supplement state law.
Securities regulations, however, preempt state laws.
Reasons to regulate Securities at federal law:
o Need safe, stable securities market to have markets at all
o Buyers can't inspect securities directly like real goods, need information
to make purchases
o Given all information, buyers will make rational investment decision,
capital will go to most deserving companies.
Without information, people will make bad investment decisions, messes
up market efficiency.
Dubious as to whether securities market actually work in the way the securities
laws assume (rationally).
Focus is on disclosure. Laws make no assessments as to quality of product,
etc., only degree and accuracy of disclosure.
Default rule: all securities must be registered with SEC unless covered
by exemption.
Required documents: prospetus and supplement
Examples of failure to comply
o Fail to register shares because you think it is not required
o Including false, misleading, or inaccurate information
If company fails to comply, investors can demand money back.
Precision Tools Problem Part VIII
Michael, Jessica, and Bernie decide they need to raise more capital, want $3
Company is already highly leveraged.
First needs to decide whether things being issued are "securities".
Would be difficult in this situation to establish that offering is not security.
Reasons not to want to disclose
o Expensive
o May reveal negative information
o Might be subject to liability for error in disclosure documents
o Time consuming
Why not negotiate with venture capital?
o Might be less funds available
o May have to give up more control
Options for avoiding registration
o Could do intrastate offering
o Regulation D: safe habour for smaller offerings. Sell to accredited
investors and up to 35 non-accredited.
o Can't advertise
Other exceptions
o §4(1): applies to shareholders selling shares to other shareholders--can't
apply here
o §4(2): private offering. Doran case gives guidance for how to determine
if it is a public offering or not. Depends on number of purchasers,
number of units sold. Need to make available information that people
would have had in registration statement.
Suggest §4(2) or Rule 506. Rule 506 has no dollar limit, but can only be sold to
accredited investors.
Rule 506 is absolute safe harbour, versus §4(2) which has to meet Doran test.
Regulation A also allows company to "test the waters"; otherwise strict contact
rules apply.
Still subject to fraud requirements of securities laws, even if not required to
Friday, June 20, 2003 (Class 12)
Outline of first journal entry assignment
Limits on Limited Liability
When we looked at dividends, saw that corporate law tries to protect, to some
extent, creditors of corporation.
Equitable rules with respect to piercing the corporate veil: another way the
law tries to protect entities other than the corporation.
Issue arises when corporation has insufficient resources to satisfy claims,
whether tort or contract.
Scenarios--different factual proof requirements:
o One, or few, entities owning corporation. Creditor is trying to pierce
through corporate form to shareholder.
o Creditor seeking assets of sister corporations, where same shareholder(s)
own several corporations.
o Creditor seeking assets of parent corporation, where same shareholder(s)
own parent corporation (which might also have several subidiaries).
Economics question: who has deepest pocket to satisfy judgment?
Terms of art when seeking to collect from shareholder: "Mere instrumentality",
"alter ego", "dummy". No distinguishing shareholder from corporation.
Three standard tests for shareholder liability (from Walkovszky)
o Corporate formalities
 Important, particularly in closely held corporations, to have board
meetings, record minutes, keep books, etc., even if there is only
one shareholder.
o Legitimate reason for setting up corporation or just to shield assets?
o Is business undercapitalized, where shareholder knew capital would be
insufficient to meet potential liabilities?
Equitable remedy--court made.
When looking at sister companies, did one often pay debts of other, etc.; are
there things to suggest corporate boundaries were not real? Separate
meetings, insurance policies, bank accounts.
Is all money in subsidiary immediately paid to parent?
Is it abuse of corporate form to take advantage of key element--limited
Walkovskzy v. Carlton
[223 N.E.2d 6] 1966 New York Superior Court (cb311)
Radaszewski v. Telecom Corp.
[981 F.3d 305] 1992 8th Circuit Court of Appeals (cb317)
Relationship between insurance and undercapitalization--is insurance
reasonable substitute for capital?
Where does society want to place risk? If we want taxi drivers, can limit
liability, shift costs to society as a whole, through insurance, government
program, etc..
Discourse today in piercing corporate veil is dominated by economics, shifting
burden, placing risk, etc..
Precision Tools Problem Part IX
PTC has long term customer, Higgins, which has business trouble, PTC extends
credit, works with company to try to support it, ultimately company fails.
Michael, Jessica, and Bernie purchase Higgins in proportion to stock
ownership, set up new company, "New Higgins."
$25,000 capital from MJB, $75,000 from bank, guaranteed by MJB. $50,000
loan to New Higgins as working capital. Market rate loans. New Higgins thus
has $150,000 assets, of which $125,000 is debt.
In third year, NH starts being profitable. In fourth year, MJB get dividend.
Tort action: customer of New Higgins suffers fire, people are killed, customer
sues New Higgins, MJB, and PTC.
Contract action: same defendants, past due invoice.
Should MJB settle claims with contract or tort plaintiffs?
Tuesday, June 24, 2003 (Class 13)
Subsidiary company: owned by another company, in part or in whole. If parent
company has controlling stake, usually have to consolidate accounting
Focus in liability cases: actual control/domination of subsidiary.
Issue arises when subsidiary have insufficient assets to satisfy creditors.
Usually claimant is seeking assets of parent company, rather than shareholders
of parent company.
Test: totality of the circumstances, focus on:
o Whether parent exercised such complete and
absolute domination and control of subsidiary so as to treat it, for
liability purposes, as not a separate entity. No distinction between parent
and subsidiary vis-a-vis third parties.
o Whether parent deployed subsidiary in such a way as to mislead
creditors--abuse of corporate form.
Domination and control
o Corporate formalities very important--was subsidiary treated as separate
o Sometimes involvement in subsidiary management is a good thing-Atex case. When company buys other company, it's usually to create
synergies, manage it better, etc..
o Issue: how to tell whether involvement is good vs. absolute
domination/alter egos?
o Some states, (e.g., Delaware), require only a showing of absolute
o Courts usually look for bad consequences or wrongdoing to decide if
there is absolute domination.
Fletcher v. Atex, Inc.
[68 F.3d 1451] 1995 2d Circuit Court of Appeals (cb339)
Defendants propose complete domination/control because:
o Company used cash management system
 Not enough to show domination or control in Delaware, might be
o Parent company exercised control over sale of large asests, etc..
 But this is true of shareholders generally.
o Dominating presence on board of directors
 Not sufficient either--quite common for coordinating business
o Subsidiary held itself out as branch of parent company
 Again, not enough, no attempt to mislead the market
In re Silicone Gel Breast Implants Products Liability Litigation
[887 F.Supp. 1447] 1995 North District Alabama (cb333)
Court seems to focus on Bristol-Meyers (parent company) holding itself out to
assure safety of MEC's products. Unlike Atex, here consumers may have relied
on parent company name in making decision.
Just when liability starts to hit, Bristol-Meyers take all assets other than breast
implants out of MEC, then buys MEC's assets for a note.
Although wrongdoing is never required, court again looks for wrongdoing and
finds it and thus refuses to grant summary judgment to defendants on corporate
veil issue.
Precision Tools Part IX
Two companies--PTC and New Higgins--with same shareholders, but not
Tort and contract plaintifss trying to pierce veil both up to shareholders and
sister company.
Tort claim to shareholders
o Argument for piercing corporate veil
 Owners did not abide by all corporate formalities; made decisions
not within formal board meetings. But then afterwards went back
and ratified decisions in board meetings.
 Possibly violated dividend rules
 Many loans to start company; maybe company was
For contract claim, how well could have creditor protected themselves in
To go after PTC's funds, would have to view PTC and New Higgins as parentsubsidiary relationship.
Separate boards, individual loans, would go against parent-subsidiary idea.
Wednesday, June 25, 2003 (Class 14)
Next up: Legal mechanisms for allocating authority within corporation itself
RMBCA and State Corporate Statutes impose same requirements
o Business must be run by a Board of Directors
 Board doesn't have to make every day-to-day decision; though.
Usually delegate responsibilities to staff.
Treasurer and secretary roles
Any set of officers is permissible--could be multiple CEO's, etc..--need
to determine authority of officers.
Certain responsibilities can't be delegated to board:
 Statutory responsibility to be finally responsible for management
of business
Principles of agency
o Principal and agent: agent is authorized to take certain functions and act
on behalf of principal; agent can bind principal within scope of agent's
o Agent has duty to follow principal's instructions: fiduciary relationship.
o Issue of when person is acting to bind corporation. Since all corporate
action needs to be through agent; thus this area of law is dedicated to
principles of agencies.
Bases for authority
o Actual authority
 Express: words, written or spoken, by principal, to agent, as to
what principal is entitled to do
 Implied: doesn't come directly from words of principal, but from
deeds, circumstances, course of dealing, that give rise to
reasonable belief on part of agent.
o Apparent Authority: when third parties are informed of authority, but
agent isn't necessarily informed. Principal can't sue third parties but
could possibly sue agent.
 Express: principal could suggest to third person directly that
agent has authority.
 Implied: position of agent in company, course of dealing.
Lee v. Jenkins Brothers
[268 F.2d 357] 2d Circuit Court of Appeals (cb355)
Lee is senior vice-president, promised lifetime pension if he stayed at company.
Company claims president had no authority to enter into contract for pension.
No question of actual authority, because no board vote that directly authorized
president to make promise.
President has authority to do things in usual and ordinary course of business,
but not contracts of an extraordinary nature.
Court finds distinction between e.g., lifetime employment contract, and future
pension contract, where the former would be extraordinary, while the latter
would not be.
Gets more complicated when there are multiple levels of authority.
First Interstate Bank of Texas v. First National Bak of Jefferson
[928 F.2d 153] 1991 5th Circuit Court of Appeals (cb359)
Another example where company is trying to get out of deal signed by agent, in
this case Senior Vice President.
Bond purchase agreement included provision for company to be forced to buy
back bonds, company claims VP didn't have authority to sign agreement.
Court looks to see if there were actions by president that authorized VP to enter
into deal; would have first had to establish that president had authority as well.
Court says third party can rely on apparent authority of agent, thus company
must buy back bonds. Unless there is some red flag to indicate person does not
have authority, then you can assume he does.
Usually, as you move down the chain, away from the president, courts tend to
require more diligence from third parties (not so in this case).
Problem: Agency Relations -- Part I
1. Express actual authority.
2. Implied actual authority. Apparent authority as well.
3. No actual authority. Factual inquiry for apparent authority, but usually foreman
has no authority to enter into contract, so probably no apparent authority.
4. Ratification authority, and possibly apparent authority.
Problem: Agency Relations -- Part II
Standard order: look for actual, then apparent, then ratification authority.
Factual inquiry for latter two.
Friday, June 27, 2003 (Class 15)
Board Formalities
Can't give proxy for vote.
Board must meet formally; or must have unanimity.
Quorum can be adjusted, normally 50%, could be as low as 1/3rd, but not
Could have executive committee, reserve only major decisions to full board.
Sarbaines-Oxley Act: Majority of outside directors (not management) and audit
committee now required for publicly owned companies.
Limitations on committees
o Can't delegate more power than board itself has
o Can't delegate powers that statute or bylaws require full board to decide
Various exceptions to requirements:
o Could meet by conference call if everyone can speak and be heard
o Could communicate notice electronically
Consider who is likely to complain if board formality is not met.
Problem -- Widget Corporation
Fiduciary Duty
Arises out of agency relationship
Over time, high trustee-like standard has been watered down to be "less than
Two main kinds of fiduciary duties
o Duty of care
 Board is required to exercise reasonable care in supervising
operation of corporation, and with respect to particular corporate
o Duty of loyalty
 Must place best interests of corporation above own personal
Also, duty of disclosure -- linked to other duties. Must disclose certain material
information to other directors or shareholders.
Board Functions
o Monitoring
 Oversight of day-to-day operations of business
 Compliance with legal requirements
 Financial soundness, reporting
o Decisions
 Requirement of exercising due care in making important decisions
RMBCA 8.30(a): due care requirement.
o Covers manner in which director makes decisions, not outcome.
o Looks at objective reasonableness.
o Contextualized to circumstances.
Standard of behavior of ordinarily prudent person--not highly skilled,
Relationship of business judgment rule and other standards
Discrete decisions: business judgment rule applies
o E.g., decide to make one product rather than another. Presumed to have
been made in good faith and in the best interest of the corporation.
Monitoring: measured by reasonableness standard; did directors exercise
reasonable care?
o E.g., failure to read financial statement is not a business judgment.
Next time: start with problem, with cases as examples.
Tuesday, July 1, 2003 (Class 16)
Francis v. United Jersey Bank
[432 A.2d 814] 1981 New Jersey Supreme Court (cb661)
Mother director did nothing while sons made "shareholder loans" to
themselves, taking away assets of corporation.
Court hold mother's estate liable, even though she had no expert knowledge.
Graham v. Allis-Chalmers Manufacturing Co.
[188 A.2d 125] 1963 Delaware Chancery (cb667)
Issue: how far does responsibility of Board run down chain of command to
identify wrongdoing?
Very large company, decentralized management.
Company never admitted any wrongdoing in antitrust, but entered consent
decree to avoid litigation.
Court reject argument that responsibility runs all the way up to the board, if
there was no knowledge or constructive knowledge of antitrust violations.
Red flag test--unless there is a red flag, no duty to set up surveillance, etc..
In re Caremark International Inc. Derivative Litigation
[698 A.2d 959] 1996 Delaware Chancery (cb672)
Can't identify a red flag unless there are sufficient monitoring and reporting
systems so that Board could discover.
Plaintiff needs to show that directors
o knew or should have known that misconduct was occurring
o should have known--need to show that failure to monitor isn't protected
by business judgment rule
o failure resulted in losses
If Board knowingly engages in bad acts, generally no protection for Board.
Fashion, Inc. Problem Part I
Peters, fashion designer, asked to be on board of corporation she sold her
company to.
Two inside directors on board, also includes many prominent people.
Peters wants to know what her duties are.
Duty of care, duty of loyalty.
Would need to know generally about regulatory, etc., rules, and know what
monitoring is in place.
Fashion, Inc. Problem Part II
Peters has joined Board, receives notice from CEO of emergency meeting to be
held tomorrow.
Emergency meeting to discuss acquisition of United Stores.
Newspaper says United is in serious financial trouble, needs $500M new
capital to avoid bankruptcy. Also knows CEO of United is good friend of CEO
of Fashion.
Worried that friendship might be interfering with decision to acquire United.
Will see
o Report by CEO
o Financials prepared by acquisition target
o Analysis by Fashion's CFO
Needs to decide immediately in order to get shareholder approval in time.
o Should review everything with critical eye
o Investigate how deal started--how does it relate to relationship of CEO's?
o Should see if there's a way to make the decision less quickly
Need rational basis to believe that information was reliable
Might want outside audit of financials unless financials were prepared for SEC.
Decision to buy United would be protected by business judgment rule;
plaintiffs would need to overcome presumption.
If Peters determined that purchase was in best interest of corporation and it
cannot be shown that there was a duty to inquiry along the lines of Van
Should reflect any engaged discussion in minutes of meeting.
Fact that shareholders ratified Board decision in Van Gorkom does not
exculpate Directors; need to disclose all information to make informed decision
Wednesday, July 2, 2003 (Class 17)
Fall-out from Van Gorkom and Caremark: looks like courts are dramatically
expanding liability for fiduciary duties of directors.
Concern that no one would want to serve on corporate boards any more
Result: exculpation and indemnification
Exculpation: forward looking--future conduct, you won't be liable if...
Indemnification: company's agreement to cover cost of liability
Amend corporate by-laws for indemnification.
Some states changed standard to require higher degree of fault.
Virginia: absolute cap on damages; ALI: floor on damages.
Delaware: 102(b)7: company can amend charter to create exculpation for
breaches of due care, except:
o Negligence or conflicts of interest
o Bad faith acts or omissions
RMBCA: directors can be exculpated, even for breaches of duty of loyalty.
o Improperly received financial benefits
o Intentional infliction of harm
ALI: should not absolve for breaches of fiduciary duty, but should not be liable
to full extent.
Argument that company and shareholders are better riskholders than directors-shareholders can diversify their holdings.
May have to pay directors more in face of liability.
Delaware indemnification statute 145:
o 145(a) Third party suits against directors. Indemnify directors for
expenses, including attorney's fees, damages, or amounts paid in
145(b) Suits on behalf of corporation (shareholder derivative actions):
only expenses, but not damages or settlement amounts (because then
company would be paying itself).
145(c) if director wins: director is entitled to indemnification for
RMBCA 8.51: indemnify if conductor acted in good faith, no reasonable cause
to believe conduct was unlawful.
Delaware regime: advances on legal fees are permissible, but not required.
RMBCA: 8.53 requires advances if two conditions are met:
o Director must affirm in writing that she acted in good faith, and met
relevant standards for indemnification under rule
o Majority vote of disinterested directors or independent legal counsel or
shareholders needed for indemnification--finding of entitlement.
Used to be requirement in Delaware to post bond for legal fees.
RMBCA: no requirement of security or other protection.
Can't indemnify someone who acted in bad faith.
By and large, indemnification agreements have to conform to statutes, but some
latitude allowed.
o Both Delaware and RMBCA authorize "directors & officers liability
o Both statutes permit insurance to be significantly broader than what
company could do through indemnification or exculpation.
Fashion, Inc. Problem -- Part III
8.53(c): Disinterested directors on board can vote to indemnify. Directors need
to sign affirmation of good faith behavior.
Directors must agree to pay back company if affirmation was wrong.
Tuesday, July 8, 2003 (Class 18)
Duty of Loyalty
What happens when director brings transaction to board in which he or she has
financial stake?
Some interested transactions are good for company, however, so can't be
blanket prohibition.
Why doesn't the business judgment rule apply here as in other contexts?
o Business judgment rule requires indepedent decisionmaking on part of
o Thus, self-interested director's decision is never protected by business
judgment rule.
What about when decision is approved by disinterested directors?
Should fairness be measured vis-a-vis "arm's length transaction"?
Common Law
Common law viewed interested transactions as always voidable by
complaining shareholder, absolute right.
Later, rule adopted that interested transactions would not be voidable if it were
approved by disinterested directors or shareholders, and transaction was fair.
Later, transaction only needed to be fair to corporation.
Procedural and substantive
Shlensky v. South Parkway Building Corp.
[166 N.E.2d 793] 1960 Illinois Supreme Court (cb756)
Common law interpretation of procedural fairness. Courts often see statutory
standard as codifying common law.
Company spent $100,000 to purchase fixtures of tenant of building ("the
Store"). Chairman of Building Corp. owned the Store.
Under no circumstances can directors engage in transactions for personal gain;
in case of apparent gain, court will examine with strict scrutiny for utmost
Procedural mechanisms: disinterested vote of directors, shareholders
Substantive mechanisms: was it fair to corporation, business value
Doesn't require company to get better deal than market, needs only to be fair as
arms-length market transaction.
Fact that transaction is between two corporations does not absolve director of
Plaintiff must present prima facie case that there is conflict (personal gain on
part of directors), then burden shifts to defendants to demonstrate utmost
Court asks was there any business purpose to purchasing fixtures?
Court also asks if there was any reason to give rent decrease? Defendants argue
that they needed anchor tenant, court finds, however, that it would have been
easy to rent space to another party at a significantly higher price.
Many directors were also directors of the Store; court finds that none of the
directors were disinterested.
Director owned majority of stock of both companies, thus must be selfinterested even with shareholder approval.
Procedural fairness is not substitute for substantive fairness, just changes
burden of proof.
Statutory Approach
Delaware § 144, RMBCA § 8.31.
Allows interested transactions when there is full disclosure and disinterested
shareholder or director approval.
Remillard Brick Co. v. Remillard-Dandini Co.
[241 P.2d 66] 1952 Califorina Court of Appeals (cb761)
Need to show that disinterested shareholders approved.
Delaware § 144 as interpretted by courts:
o Plaintiff has burden of prima facie case of conflict
o Defendant then has opportunity to show procedural fairness
 Disinterested approval by directors or shareholders
o Then plaintiff has burden to show deal was unfair to company
o Otherwise burden remains on board to show that deal was fair to
Underlying issue: was deal fair to business?
Starcrest Corporation -- Part I
Need to see if other inside directors are dominated by Adams.
Procedural fairness
o Committee vote--two outside directors--one voted for, one voted against,
and general counsel voted for, so question is whether general counsel is
o Board vote--three inside people voting for transaction, one outside
voting for transaction, and one dissent. Only one to one if insiders are
Question of whether showing procedural fairness just shifts burden, or invokes
business judgment rule.
Shareholder vote: if Elizabeth's shares are removed, vote becomes closer; if
family shares are removed, then it becomes 14% in favor and 22% against.
Wednesday, July 9, 2003 (Class 19)
Executive Compensation
Special category of duty of loyalty
Need to find 'optimum' balance--enough so that directors will do their best, but
not so much that it constitutes waste.
Main idea behind stock options: align director's intersts with shareholders.
Accounting standards board determined that Board does not need to account for
option grant until option is exercised, thus from accounting perspective, grant
of options was "free".
Option only has value if stock goes up; theoretically gives incentive to help
grow company.
In reality, directors have short term interest to maximize difference between
market price and strike price, but not necessarily long term.
Same requirements as other duty of loyalty cases for executive compensation-approve by outside/disinterested in committee, at board, and by shareholders.
If procedural requirements have been met, then plaintiff would have to
demonstrate waste (not fairness, as in other duty of loyalty cases).
Corporate Opportunity
Directors and officers can't take opportunities from corporation, difficult to
determine which opportunities are barred.
o If corporation has interest or reasonable expectancy in opportunity
 Was opportunity something corporation was relying on...?
o Opportunity is corporation's line of business
 More general... was corporation in business, did it have ability to
be in business, was it expanding in that direction....
o Opportunity which corporation has financial wearwithal to undertake
 More controversial, hard to determine.
 Often arises as a defense.
o Opportunity is advantageous to corporation
If board rejects opportunity, director is then free to pursue, corporation will be
estopped from asserting claim.
Friday, July 11, 2003 (Class 20)
Starcrest Corporation Problem -- Part II
Four Factors
o Interest or Expectancy
 Starcrest is already in Hotel Business, expressed interest in casino,
 But was Starcrest considering expanding beyond the United
 Expectations of White as director: did the recruit him because of
his real estate connections, would expect him to bring in
opportunities; alternatively, company may have known he would
have outside transactions and not expect him to bring in
opportunities that came to him.
o Line of Business
 Casino is often connected to restaurant and hotel
 Did White know what scope of Starcrest's business was? Maybe
casino did not fit into Starcrest's business strategy.
o Advantageous to company
o Financial ability to invest
 Could Starcrest get money in time to make investment?
 Could arise as defense, or as requirement of proof.
o (General Fairness)
ALI Rule--§5.05
o Focuses on disclosure
o Question: did opportunity come to director because of role with
corporation? (b)(1)(A)
o More restrictive standard than other laws, easier to understand, but only
adopted in two states
Rights of Shareholders
Fact that shareholder can sue for breach of fiduciary duty is monitoring device
Veto and exit rights--other alternatives.
Shareholders can vote ("veto rights"):
o Charter Amendments -- including increasing authorized stock
Sale of all assets
Dissolution of company
At Common Law, idea was that shareholders were investing in specific thing;
required unanimity to change.
Criticized as "tyranny of the minority," also failed to address changing dynamic
Legislature shifted requirements from unanimity to majority, or sometimes
super-majority. In compensation, shareholders got "appraisal/dissenter's" rights.
Can't block transaction, but instead, can cash out on investment.
Appraisal rights vary across jurisdictions, also only available in very limited
situations, always specified in statute.
Always give right to exchange shares for cash at fair market value.
Most frequently arises in merger context.
Depends strongly on form of transaction, even if results are nearly identical.
Forms of merger
o Statutory merger
 All of assets of T are combined with P, result is single corporation
P+T, shareholders of P and T are shareholders of new company
o Triangular Merger
 S becomes wholly owned subsidiary of P; S gets consideration for
purchasing T; then merger of S and T (or vice-versa for reverse
triangular merger). Reverse merger is not considered to be transfer
of assets for tax purposes. Parent company is shielded from
o Share Exchange
 P gives stock to T, T gives stock to P, result is the same as
statutory merger
o Asset sale
 P purchases all of T's assets with stock, taxable transaction,
usually then T gives dividends of P stock to B and dissolves.
Tuesday, July 15, 2003 (Class 21)
After effect of share exchange: T is wholly owned subsidiary of P, same as
triangular merger.
Tender Offer
o All other forms of merger, both companies agree to transaction, but not
so in tender offer.
o Can be unsolicited.
o P offers to purchase shares from T's shareholders, either for cash or
o Usually conditioned on purchasing at least 90% of shares.
o By purchasing 90% of shares, company can then merge without approval
of minority shareholders (RMBCA §11.05).
o Can force remaining 10% to sell their share. They would have appraisal
rights, but no veto rights.
o Also doesn't require approval of shareholders of purchasing company,
unless new shares need to be authorized.
o Thus, result can be same as statutory merger, but no appraisal or veto
Chart with appraisal/veto rights--cb378.
De Facto Merger Doctrine: very small exception--only really adopted in
Pennsylvania--if result is same as statutory merger, then might be treated as
merger for veto/appraisal rights.
Appraisal rights most important when large minority shareholder could block
transaction by threatening to exercise appraisal rights--if shareholder cashes
out, not enough money would be left to consummate transaction.
Problem: LaFrance? Cosmetics -- Part I
Four shareholders:
o Mimi 400,000
o Pierre 100,000
o Margaret 100,000
o Bank 400,000
Mimi and Pierre want to purchase fragrance company, Margaret wants to sell
company, Bank is on the fence.
1,000,000 authorized but unissued shares
400,000 proposed consideration to purchase fragrance company
Can we limit shareholder vote, because if Bank votes with Margaret, then
transaction won't go through; and how to deal with appraisal rights, because if
Bank or Margaret objects, there won't be enough cash to do transaction.
Triangular merger: need only approval of fragrance company, no problem here.
Only difference in Delaware: no stock exchange transaction; no dissenters
rights for asset sale.
Transaction Size
Shareholders have rights when board wants to sell all or substantially all assets
of company
Gimbel v. Signal Companies, Inc.
[316 A.2d 599] 1974 Delaware Chancery (cb388)
Signal started out as oil/gas exploration company, now diversified.
Company wants to sell oil company because it is not generating much revenue
To give shareholder rights, must go to "fundamental root cause" of business-doesn't occur here.
Needs not only to be unusual transaction, but sale of assets must be
quatitatively vital to the operation of the corporation.
In this case, assets are less than half of corporation's assets, thus not "all or
substantially all".
RMBCA: sets out transactions where there is no shareholder vote (nonfundamental transactions). Tries to get rid of some ambiguity. Also sets out
safe harbor--75% of assets and 25% of income or revenues.
Problem: LaFrance? Cosmetics -- Part II
Transaction to purchase LaFrance? went ahead, has been disaster.
LaFrance? accounts for a lot of revenue, but little profit.
Margaret wants whole business to be sold, not just fragrance. Bank agrees.
Wednesday, July 16, 2003 (Class 22)
RMBCA Standard
o Sets safe harbor with quantitative levels. If you haven't sold 75% of
assets and 25% of income/revenue, then no investigation into qualitative
nature of transaction.
o Possible to sell more than 75% of assets an still not meet requirement for
shareholder vote.
o Qualitative investigation occurs between 75% and 100%.
Problem: LaFrance? Cosmetics -- Part II Continued
Sweet Violet accounts for 2/3 of assets of LaFrance?, thus less than 75% of
assets, safe under RMBCA.
Under Delaware law (Gimbel analysis):
o Not ordinary transaction, thus might need approval
o Was substantially all of assets?
o Can determine clearly on quantitive level, must look at qualitative levels.
Requirement for call to be issued for shareholder meeting.
Special meetings must be initiated, determined by statute.
Most statutes allow board members to call meeting, as board, acting as a whole,
or shareholders holding more than 10% of shares, or other persons as described
in by-laws (usually president or chairman can call meeting in company bylaws).
Delaware statute does not have 10% shareholder right to call meeting.
Possibility of waiver of notice of meeting at meeting itself.
Powers not explicitly granted to shareholders are reserved to the board.
Primary remedy for shareholders to reject management activities is to sell
shares or vote out board.
Auer v. Dressel
[118 N.E.2d 590] 1954 New York Superior Court (cb395)
Class A shareholders ask President of company to hold special meeting to vote
on resolution endorsing prior President; to provide for vacancies to be filled by
vote of shareholders; to remove Class A directors and elect successors; to
reduce quorum requirement.
President refused to call meeting, shareholders sue.
While shareholders can't vote out President, they can put board on notice.
Campbell v. Loew's, Inc.
[134 A.2d 852] 1957 Delaware Chancery Court (cb398)
Divided board in balance between dissident factions; some directors resign;
majority remaining tries to replace vacancies with people on their side.
Court holds action invalid because of lack of quorum.
President tries to gain control by calling special shareholders meeting to
increase board members, increase quorum, remove certain directors, and fill
Court strongly affirms inherent power of shareholders to remove directors for
cause and fill vacancies.
Possible valid causes for removing directors
o Systematic plan to harrass corporation--valid reason.
o Embezzlement.
Seeking to take over is not sufficient cause for removal.
Holdings: shareholders can remove directors for cause; requires only
disclosure, not full judicial process. Illegally removed directors can challenge
removal in court.
President could use corporate funds in attempt to oust rival through proxy; he
was representing "status quo." Significant tilt in favor of incumbent
RMBCA permits removal without cause; Delaware requires cause unless
otherwise specified in by-laws.
Blasius Industries, Inc. v. Atlas Corp.
[564 A.2d 651] 1988 Delaware Chancery Court (cb403)
Blasius wanted Atlas to borrow money for restructuring, acquired 9.1% of
Sent Atlas Board written consent requesting:
o Precatory resolution to restructure
o Amend by-laws to expand board from 7 to 15
o Electing 8 named persons to fill directorships (thus would take over
Board responded by increasing board to 9 and filling vacancies, so as to prevent
dissident shareholders from filling board.
In this case, doesn't matter what motive was, still not permissible--cannot
substitute judgment for shareholders judgment.
Could have expended corporate funds convincing shareholders as to why
Blasius proposal was bad.
Right of Inspection
At Common Law, shareholders had right to access accounting books and
shareholder list as part of ownership.
Must have proper purpose, however.
Interest must be articulated in economic terms.
State Ex Rel. Pillsbury v. Honeywell, Inc.
[191 N.W.2d 406] 1971 Minnesota Supreme Court (cb410)
Court holds that wanted to access books to get company to stop making bombs
was not proper purpose.
Shareholder with bona fide investment interest, however, could have brought
LaFrance? Cosmetics Problem -- Part III
How can dissident shareholder disrupt transaction without being able to vote on
transaction itself?
Can shareholders demand special meeting compelling board to abandon sale of
Sweet Violet? Adopting resolution to recommend?
o Probably can't compel board, but can adopt resolution.
o Unless in by-laws or statute, can't force special meeting
o Board might ignore resolution
Can shareholders act at other than properly called meeting?
o If there is unanimous written consent, yes. But two directors want
transaction to go through, so they probably won't consent.
Can shareholders remove directors who support sale and replace them?
o RMBCA says they can be removed without cause, thus if they can get
special meeting, then yes.
Friday, July 18, 2003 (Class 23)
LaFrance? Cosmetics Problem -- Part III Continued
What can board do to prevent shareholders from calling meeting to amend
o Board cannot interfere with franchise, but can use company funds to
campaign for their interest.
o Could set meeting date very soon, to give dissidents little time to rally
people to their position
o Could set meeting date after closing date for Sweet Violet transaction-but may be equitable limitation on this. Schnell case says boards can't
interfere with franchise by moving meeting date; but on the other hand,
shareholders are not entitled to vote on transaction, just on board, so
perhaps wouldn't be a problem.
o Could also manipulate record date (date when shareholders who own
stock on that day are counted for vote).
Proxy is when shareholder is authorizing someone to vote on their behalf at
Normally, agent is directed by principle to do something; in this case, agent is
directing principle to vote.
Subsequent proxies always supercede earlier ones, except in rare situation of
irrevocable proxy.
Window into complex reliationship between state and fedeal law.
o Substantive rules are generally state law.
o Need to understand federal securities and federal fraud laws.
Self Regulatory Organizations (SRO): New York Stock Exchange,
NASDAQ, etc..
Federal law has disclosure requirements.
Description of agenda (what will be decided), etc., all put together in draft
proxy statement.
Draft proxy is filed with SEC.
Technical possible for alternative candidates to be considered at meeting, but
almost always the case that election of directors is determined before meeting
Possibility of really doing somethig at meeting requires that alternative group
also do a proxy solicitation.
Federal requirement is accuracy and completeness.
Proxy can't force shareholders to accept all directors as block, or all decisions
as block; shareholders need to be able to vote on each matter separately.
Overall process in cumbersome, time consuming, and expensive.
§14(a) of Exchange Act regulates all solicitations of proxies.
§14(a)(1) solicitation can be:
o any request for proxy whether or not accompanied by form of proxy
(e.g., phone request can be solicitation)
o any request to execute, not execute, or revoke proxy
o furnishing of form or other communication to shareholders reasonably
 e.g., letter to shareholders, advertisement in newspaper
Never supposed to try to get shareholder to vote on something, or influence
them to vote, without giving them full information
At one point, SEC wanted everything to be categorized as solicitation.
Low point: shareholder who hadn't held stock for 6 months as required
by New York law to vote, went to get shareholder list, was considered
by court to be a solicitation.
Since then, courts have cut back on what will be considered solicitation.
Tension in SEC between wanting adequate disclosure through proxy process
and wanting companies to tell shareholders about important things as soon as
Collective Action Problem
Robert Clark: it might be in all shareholders interest to act in a certain way, but
no individual shareholder has sufficient incentive to organize. "Rational
SEC prohibited companies from being listed on public exchanges if the
company limited shareholder voting through proxy, ultimately struck down by
court. Business Roundtable v. Securities and Exchange Commission. Voting
was province of State Law.
Ultimately, exchanges made agreement that they would not list companies that
diminished voting power of existing shares.
Thus, new companies could enter with multiple classes of stock, but existing
companies could not reduce voting power of existing shares.
Tuesday, July 22, 2003 (Class 24)
Universal Netware, Inc. -- Part I
Company wants to reprice stock options at current price, as options granted to
employees are worthless due to drop in stock price.
Collective action problem/free riding--unless issue is brought to the forefront,
and there isn't a diversity of opinion on it, probably will be approved.
Issuance of press release--would this violate proxy rules?
Does communication actively solicit proxy votes? If so, would be in violation
of SEC rules.
"Reasonably calculated to result in the procurement of a proxy or to influence
shareholder's vote."
What about reasonably calculated? Does this mean board had to intend to
impact shareholder's votes? Or be reasonably likely to impact shareholder's
"Facts and circumstances" test--
How soon is annual meeting? If it is soon, then it is more likely to count as
Dissident shareholder: can go ahead and publicize his views, say which way he
will vote. Does not own $5M of stock, thus no notice requirement. As long as
there is no personal benefit (not common to all shareholders), then no
solicitation requirements.
General rule: shareholders can put proposals on proxy statement that would
proper for meeting
Transamerica: proper subject for meeting is what would be proper in state of
incorporation, federal mechanism to enforce state rights
o Proposal to have shareholder election of independent public auditors
o Proposal to amend bylaws with respect to procedure for bylaw
o Proposal to require report of annual meeting to shareholders
Federal anti-fraud provision requires all matters that come up at meeting to be
in proxy; this is basis of rule requiring company to include these proposals in
Originally, shareholder proposals were about corporate democracy; in 1970s,
increasingly involved social issues.
More recently, shareholder proposals generally involve anti-takeover measures,
executive compensation.
If proposal does not meet one of the exclusions in regulations, it must be
Company decides not to include shareholder proposals, sends it to SEC, SEC
staff decide whether or not to issue "no action" letter.
No official status for "no action" letter, could be reversed by Commission, thus
cannot sue on basis of "no action" letter.
Three possible conclusions:
o SEC could say proposal is not excludable, and thus must be included
o SEC could say change in form is required (i.e., binding command vs.
precatory resolution)
o "No action" letter--company can probably exclude proposal
Private right of action under SEC rules to sue company for excluding proposal
SEC can also bring action to injoin company to include proposal
Substantive exclusions
o 14a-8(i)(1): improper under state law
o (i)(5): does not meet minimum economic test and is not otherwise
significantly related to business
(i)(7): ordinary business exclusion; shouldn't be decided by shareholders
Frequently not a lot of state law on issue; thus decided on something like
"federal common law."
Wednesday, July 23, 2003 (Class 25)
Universal Netware, Inc. Part II
Students want to make shareholder proposal, have purchased 100 shares at $32
per share over a year ago.
Rule 14a-8: no problem with being qualified shareholder, own more than $2000
for 1 year.
Possible objections from Universal Netware:
o Less than 5% of overall revenue, potentially excludable under 14a8(i)(5).
o (i)(7) management functions, ordinary business
o (i)(1) barred under state law
Student group responses:
o General public policy
Resolution can't be mandatory, must be precatory.
Can't interfere with board's ordinary decision making.
Requirement that corporation furnish impact statements: may be too extensive
under Wal-mart.
Duty of Disclosure
Potentially a new fiduciary duty, in addition to duty of loyalty and duty of care.
Need to understand proxy process first.
Disclosure is at core of other duties--e.g., need to disclose to shareholders to
approve self-interested transaction.
False or misleading proxy statement is violation of §14(a) of SEC Act.
Federal government is supposed to scrutinize only disclosure, not fairness of
underlying transactions.
Direct actions vs. derivative actions
o Action for proxy violation--difficult to tell whether action is derivative
or direct
o Injury from transaction going forward on false or misleading information
harms corporation directly, harms shareholders indirectly, since they get
burdens of bad deal.
Shareholders are not harmed as individuals, but harmed as a proportion
of their ownership of business--thus from this perspective proxy
violation is derivative action.
o However, since each shareholder is impacted individually by being
provided bad information; could argue that franchise has been harmed.
From this perspective, §14(a) action should be direct action.
o If action is derivative action, plaintiff needs to put up bond for
defendants' expenses, acts as jurisdictional block.
o No procedural hurdle to direct action, however.
o Also, scope of remedies: derivative actions usually produce relief and
benefits to corporation.
Prior to Borak, only prospective injunctive relief was available under Federal
Securities laws--could only get injunction for full disclosure.
But Federal Courts have exclusive jurisdiction for claims under proxy rules,
thus you had to give up possibility of damages, could not litigate fiduciary duty
claims. If you brought fiduciary duty claim, however, would bring it in state
court, and could not litigate proxy claims.
J.I. Case Co. v. Borak
[377 U.S. 426] 1964 United States Supreme Court (cb831)
Actions initiated under §14(a) are both derivative and direct.
Right to bring proxy suit is federal right, thus federal procedure applies, no
requirement to post bond.
Implied private right of action is derived from broad purposes of Act.
Even though State Law issues are effected, §14(a) is essentially Federal Right,
Federal Courts have full range of discretion to craft remedy.
Left several questions unanswered
o How do we know hen false or misleading statement is sufficient to give
rise to remedy under §14a?
 Would shareholder have had to change vote based on information
to be material?
o How to assess causation?
 How does shareholder show result would have been different with
TSC Industries, Inc. v. Northway, Inc.
[426 U.S. 438] 1976 United States Supreme Court (cb838)
Trying to resolve split in circuit on materiality questions
"All facts a reasonable shareholder might consider important"
"fact would have significant propensity to affect the voting process"
Standard will be objective.
Court doesn't want to overwhelm shareholders with information--wants board
to select out important information.
Omitted fact is material if reasonable shareholder would consider it important
in deciding how to vote.
Do not need to show that shareholder would have changed her mind, only that
she would have considered it when deciding how to vote.
Finally, is it ever appropriate to grant summary judgment in this area?
o Normally, materiality is factual inquiry.
o In certain circumstances, it is possible that omission would be so critical
and important that summary judgment could be granted.
Friday, July 25, 2003 (Class 26)
Relationship between Federal and State Law in securities regulations
Reluctance at Federal level to scrutinize underlying fairness--should be done at
state level
TSC: Court is trying to encourage optimal level of disclosure, rather than
avalanche of information.
Mills v. Electric Auto-Lite Co.
[396 U.S. 375] 1970 United States Supreme Court (cb846)
TSC dealt with materiality, Mills deals with question of what needs to be
shown to prove causation.
District Court: first determine whether misrepresentation was material, next
hold hearing to see on causation.
District Court: don't need to show that material misrepresentation was
outcome-determinative, instead show that people whose vote was needed to
approve transaction would have cared about misrepresentation, then causation
is proved.
Appeals Court: looked at underlying fairness; if transaction was not fair,
assume shareholders would not have approved transaction.
Supreme Court: Federal Securities regulation is not about the underlying
Might be cases where misrepresentation has nothing to do with fairness of
underlying transaction. E.g., might have failed to disclose that Director had
committed fraud in the past, has nothing to do with fairness of transaction.
Causation rule
o First, look for material misrepresentation
o Did you need votes of shareholders who cared about material
misrepresentation? If so, then causation is established.
Fairness analysis only enters in at level of remedies
Many reasons why plaintiffs might want to go to Federal Court, even if their
concern is fairness of underlying transaction
Federal Courts have exclusive jurisdiction over securities claim; may be issue
and claim preclusion in Federal Court after litigating state court claims
Footnote in Mills: left open question where directors hold majority of shares; or
where misrepresentation is unrelated to proxy at all
Underlying question is whether rules 10a or 14a will ultimately capture most
fiduciary duty claims
Santa Fe Industries, Inc. v. Green
[430 U.S. 462] 1977 United States Supreme Court (cb855)
Rule 10b-5 case
Short-form merger--defendant parent owned 95% of stuck of Kirby Lumber
Company, wanted to acquire remaining 5%
§253 Delaware law provided that parent could complete merger without
consent of minority shareholders
Minority shareholders were entitled to appraisal rights
Morgan Stanley determined that Kirby Lumber was worth $125 per share;
Santa Fe offered $150 per share.
Santa Fe notified shareholders that they were entitled to appraisal rights, sent
them Morgan Stanley valuation, and assets appraisal.
At assets appraisal, however, stock was worth $640 per share.
Instead of objecting and demanding appraisal rights, minority shareholders
brought suit in Federal Court, alleging per se violation of 10b-5 which regulates
fraud in securities.
Plaintiffs claim that there was no business purpose other than to take advantage
of minority shareholders, and that this constitutes fraud.
Supreme Court dismisses both of plaintiff's claims
Wasn't sufficient to show deception in information provided under Rule 10(b)5.
Defendants had provided asset values and other information.
If you give shareholders all information they need to do analysis, do not need to
say "this transaction is unfair."
Idea of making things clear for shareholders: plain English rule, etc., but if
facts are presented, unlikely to be held liable for misrepresentation.
Virginia Bankshares, Inc. v. Sandberg
[501 U.S. 1083] 1991 United States Supreme Court (cb862)
Question of causation when you don't need vote of minority shareholders
Plaintiffs claimed merger would not have gone through if information had been
disclosed, even though they could not have changed vote.
o Possibly could have exercise appraisal rights, might have blocked
o Bad press, other issues
o Could have made claim of breach of fiduciary duty
Court holds that it was too speculative and uncertain to determine whether
board would have gone through with transaction if minority group had
Possible voidability for conflict of interest that could have been insulated by
minority approval; Court holds that ratification vote wouldn't count if minority
shareholders were misinformed, thus they could have made state claim for
breach of duty of loyalty/fiduciary duty.
Directors said consideration had "high value" for transaction; Court holds that
claim could be made iif Board knew claim was untrue. Unnecessary holding,
because Court had already held there was no causation.
Scalia dissent: difference between statement of opinion and assertion of truth.
Wouldn't be actionable if claim was opinion.
Question remains: what if shareholder has lost right to state remedy?
Wilson v. Great American Industries, Inc.
[979 F.2d 924] 1992 2d Circuit Court of Appeals (cb878)
If shareholders have relied on proxy statement that misrepresented facts, and
have lost appraisal rights, then misrepresentation is actionable under federal
securities law, because shareholders have lost appraisal rights as a result of bad
Governing precedent, hasn't reached Supreme Court.
No requirement to show ability to effect outcome of underlying transaction
Precisely situation where minority shareholder can't change outcome is when
they are most likely to be abused, thus should be protected.
14a claim can't be brought if proxy solicitation couldn't effect the outcome of
underlying transaction (Virginia Bankshares), unless you've lost a state remedy
Directors and majority shareholders don't need to disclose that transaction is
unfair or dubious (Santa Fe), but must disclose sufficient information for
shareholder to conclude transaction is unfair.
If directors put forward views about fairness and value, must be demonstrably
true, can't know it to be false.
Tuesday, July 29, 2003 (Class 27)
National Metal Products Problem
Delaware corporation, listed on NYSE.
Proxy contained all information required by SEC about merger and candidates.
Statements included
o "Board recommends approval of merger. Based upon review of
management's report and recommendations and financial statements of
IPC. It is board's judgment...that merger is in best interests of company
and shareholders."
National's board meeting in approving merger was very brief. Board only had
financial statements for 2 days. Discussion time was 30 minutes.
Merger was unanimously approved.
Acquisition problematic as result of price fixing scheme with IPC. No mention
in proxy.
National entered into settlement with environmental agencies regarding
violations of rules. Fined $500,000. Board knew about risks but did not
disclose risks.
Rogers owns 1000 shares of common stuck, believes proxy was materially false
and misleading in violation of Rule 14a-9.
Possible state law claims
o Breach of fiduciary duty
 Breach of due care: directors didn't give proper consideration to
potential merger
 Breach of due care for failing to monitor for price fixing after
If there was evidence of personal benefit for CEOs, maybe duty of
o Environmental issue: if directors knew it was illegal, could be liable; if
not, might be protecting by business judgment rule.
Assuming violation of 14a-9, can Rogers bring suit for relief?
o Borak private right of action to sue for proxy violations, both derivative
and direct claims.
o Can possibly get both prospective relief and damages
 Recission of merger
 Determination of damages--difference of value had disclosure
been made
o Materiality
 Is it likely that shareholder would have wanted to know?
 Statement can be material misrepresentation if board knows at the
time that claim is false.
 Board used same review process three times in the past.
 Omission of prior bad acts of IPC with respect to price fixing:
only CEO knew about price fixing.
 Sanford (National CEO) might not have elected to new board
o Mills: need to show that proxy was essential link in merger
 State law requires shareholder approval for merger
 Presume that management does not hold controlling share
 Might have exercised appraisal rights had shareholders known-but don't need to get to loss of state remedy unless you can't prove
that vote was required link to approve merger
o Environmental issue: might be able to focus on election of director, if
shareholder had known about environmental violation.
No 10b-5 violation; there was no material misstatement, thus no violation of
securities law (under 10b-5 or 14a-9).
Only three states have passed proxy disclosure laws
o Two states have no private right of action
o Other state has not generated any litigation
Common law duty to disclose, prominent in Delaware, is broader than proxy
disclosure requirements.
o Generally duty to fiduciaries, not duty to public
o Tracks federal law on questions of materiality and causation
o Standard of liability is strict; what to disclose is not protected by
business judgment rule
o Can't make business judgment to "mislead"
Interesting question: how does this impact issue of availability of state remedy
at federal level?
o Does it matter if you lost right to state appraisal rights, if there is a cause
of action for disclosure at state level?
Insider Trading
Presupposition of securities market: if price reflected all information (both
public and private) and that price represented best possible estimate of present
value of security, three consequences
o Insider trading wouldn't be profitable
o Publication of false or misleading information about company would
cause no harm
o Attemption to outperform market would be futile--every security would
have its actual value
Not true; however. Clearly this is some information that insiders have that is
not public.
Securities market react extremely quickly to information once it is disclosed
Persons other than insiders with information cannot capitalize once information
is public
If you want to beat market, need to discover facts which people aren't taking
into account
Advantages should not include information that everyone cannot get
Wednesday, July 30, 2003 (Class 28)
Insider Trading
Different theories of insider trading have different ideas of who is the harmed
Possible Victims
o Investors
 Would have traded at different price if they had known what
insider knows
 But whether you trade or not won't change if insider's trading is
 Maybe disclosure is issue, not insider trading
o Market
 Insiders will delay disclosure in order to take advantage of their
insider status
Window of time between disclosure and action is very small,
information is reflected in market almost immediately
 But there is no incentive to delay good news disclosure, and if
there is bad news, insider sale will convey that information, which
would not otherwise be disclosed.
o Corporation
 Increases cost of capital
 Investors can't tell who is going to engage in inside trading, thus
need to discount all stock prices but expectation that there will be
insider trading
 Depends on other theories of harm, however
 Could be fixed by companies themselves; could enact bylaws
prohibiting insider trading if they wanted to, in order to attract
Might be helpful to investors--encourage better management
Might also stabilize stock prices, as information leaks out through insider
In re Cady, Roberts & Co.
[40 S.E.C. 907] 1961 Securities Exchange Commission (cb928)
First SEC insider trading case
Investor discovered that company was about to cut dividend because he was on
board of company, sold stock short and sold stock for children.
Corporate insider who possessed material nonpublic information obtained for
corporate purposes could be held for trading on information prior to its
If you get information just for corporate purposes and not for personal benefit,
can't act on it or must disclose it.
Held to be unfair.
Normally, in a fraud case, there needs to be a one-to-one relationship between
perpetrator and victim; SEC acknowledged that 10b-5 was more protective than
common law fraud.
10b-5 must cover stock market, according to SEC, because most securities
transaction are on stock market.
10b-5 had been on books since 1942, first time it was used.
10b-5: illegal to use manipulative or otherwise deceitful practice in sale of
Securities and Exchange Commission v. Texas Gulf Sulphur Co.
[401 F.2d 833] 1969 2d Circuit Court of Appeals (cb930)
SEC prosecuted officers, directors, and employees; one question is "who is
Texas Gulf Sulphur was mining company, was looking for geological features
in Canada indicating precious metals
Company decides to engage in land acquisition, tries to keep discovery secret
so property price doesn't go up.
Several defendants purchased stocks or calls.
Next year, board issued stock options to managers, but board was unaware of
property discovery.
Rumours started leaking out about possible discovery
Defendant read about rumours in press, called up other defendants and decided
to issue press release that understates discovery.
Stock price then dips.
Various trades between first press release and second press release announcing
District Court found no 10b-5 violation for most defendants; information about
mine did not become material until 4/12 press release.
o Defendant who traded between 4/12 press release and 4/16 press
conference was found to be insider trader
o Defendant who traded after 4/16 conference was not, because
information had been disclosed
Court of Appeals decides that key question is materiality: when does
information become sufficient material to constitute material insider
information for the purposes of insider trading?
Involves likelihood of truth of information and magnitude or importance of
Was this the sort of information that it would effect investors decision to trade?
o Obviously it was, because everyone was buying up stock when they
knew information.
Court did not hold that information needed to be disclosed, but only that it
couldn't be traded on until it was disclosed.
Issue is not just when disclosure was made, but whether there was sufficient
time for information to reach market.
Thus, both defendants who traded before and after press conference were liable
for 10b-5 violations.
Insider is not only one who is liable; also people who find out from insiders.
On remand, District Court found all defendants liable.
Damages were equal to price after press conference--difference between how
much insider paid and post-press conference price.
Chiarella: only people with fiduciary relationship has duty not to disclose
Dirks: could be "temporary" insider as lawyer, accountant, etc., without direct
fiduciary relationship to shareholders
Need to also know, as "tippee", that information is privileged, to be liable.
O'Hagan: misappropriation theory. Lawyer in law firm representing acquirer in
merger, told someone to buy stock in company to be acquired. Lawyer has no
fiduciary relationship to company to be acquired. If you misappropriate
material nonpublic information and use it for personal gain, then
misappropriation is violation.
For Friday: remedies.
Friday, August 1, 2003 (Class 29)
Insider Trading Conclusion
Private right of action against insiders or constructive insiders (lawyers,
accountants), tippers, tippees, controlling persons.
Liability for private actions under 20(a) is limited to actual profits--difference
between what price of stock would have been had information been disclosed
and price insider got.
Rule 21a
§32(a): Criminal penalties for insider trading.
Derivative Actions
Designed by Judges to give shareholders mechanism for challenging
management abuse when management itself is unlikely to challenge its own
Emerged from equitable doctrine
As equitable remedy, intended for extraordinary situations.
Seeks to balance board discretionary decisionmaking ability with shareholders'
Rationales for derivative suit
o Problems with shareholder's suits--collective action problem--fixed by
derivative suit
o Private enforcement of fiduciary duties discourage government
Ability to obtain costs and attorneys fees permits single shareholder to engage
in efficient monitoring
o Derivative actions may be bad surrogate; because ownership for shares
changes all the time, shareholder at time of alleged bad act may not be
shareholder at time of recovery
o Response: corporation has independent existence, why should it matter
who recovers?
o Given that share of benefit for shareholder is so small, are incentives
really proper?
Usually, counsel chooses plaintiff for derivative suit.
o Counsel gets fees if case goes to settlement and it is deemed to be in best
interest of corporation.
o Thus, Counsel may have incentive to settle earlier, while shareholder
might want maximum recovery because portion of benefits is so small.
Defendant is usually indemnified, and damages are covered by insurance. Thus,
risk averse defendants are incentived to settle without admitting wrongdoing, in
order to get costs covered.
Bangor Punta Operations, Inc. v. Bangor & Aroostook Railroad Co.
[417 U.S. 703] 1974 United States Supreme Court (cb1028)
Claim involves harm to subsidiary (BAR) from parent corporation (BPO)
which is subsidiary of BP.
Amoskeag buys 99% of BAR after alleged harms.
Issue is whether shareholder who did not own stock at time of injury has
standing to sue.
Derivative action by Amoskeag on behalf of BAR.
Court holds that FRCP 23.1 requires contemparaneous ownership in order to
have standing to bring derivative action
Dissent: case could have been brought by 1% minority shareholder. Benefit is
going to corporation, not to Amoskeag.
Depends on whether you see issue as deterrence or compensation.
Some suggestion that contemparaneous ownership rules are loosening up, in
context of injuries to corporation which have a "continuing legal effect".
Creditor standing: conceptual difference between debt and equity. General
rule is that creditors have no standing to bring derivative actions on behalf of
Demand requirement: derives from nature of derivative suit remedy. Claim is
based on idea of direct injury to corporation, indirect injury to shareholders.
Shareholders must make demand on corporation that they take up and correct
aggrieving matter first.
o Exception to demand requirement: Futility exception.
Rational board or not guilty board might actually sue, or could decide it's not
worth it. Business judgment whether or not to bring derivative action.
Wednesday, August 6, 2003 (Class 30)
State law claims
o Breach of fiduciary duty: duty of loyalty, duty of care
 Duty of care: consulting agreement with outgoing board members
and chairman; increased compensation for incoming board; stock
options granted to new members. Failed to talk to consultants, do
study, to see industry standards. Presumption of business
judgment rule and good faith.
 Duty of loyalty: New board members; would need to find some
sort of conflict of interest.
 What was benefit to company of granting options that could be
exercised immediately?
 Why did Willy, Jr. get 10x what his father got? Why does he
father continue to get paid what he was paid when he was
working? What is consideration for consulting agreements? Looks
like self dealing.
 Doesn't consideration for Willy, Sr. look like compensation for
past services, in which case it would be corporate waste?
 By granting immediately exercisable option, might look more like
a transfer.
 May be a business purpose for consulting agreements.
 Procedural and substantive fairness.
o If plaintiffs can show self-dealing, defendants can rebut by
demonstrating procedural fairness.
o "Common enterprise" idea -- board members agree to approve each
other's compensation
o Could be approved by disinterested shareholders; board members own
%47, Wentworth Charitable Foundation owns 5%. Question: was board
member who heads up Wentworth Charitable Foundation able to
influence vote of Foundation?
o If board shows procedural fairness, then plaintiff needs to demonstarte
substantive unfairness
o Might be duty of disclosure under state law issue
Federal claims
o Proxy statement problems
 Did board disclose sufficient information for a reasonable
shareholder to piece together the fairness of the deal?
 Should board have disclosed comparative historical data?
 "Substantial likelihood that shareholder would have considered it
important in voting."
 If board makes statement, it is weighed heavily; can't make
statements they know to be false when they make them.
 "Compensation until consulting agreement is fair and reasonable."
"Great value; significant access" etc.. Is this sufficient to show
that board knew it to be false at time?
 Need to demonstrate materiality.
 Causation: was this something shareholders were entitled to vote
on? No, not compensation; was their vote necessary for approval?
 Loss of state right?
 Injury: who was hurt by misrepresentations? After
misrepresentation, stock value increased. Does stock value have
to decrease again before injury can be proved? Or were people
who bought stock at higher price injured?
 Press release as part of proxy solicitation--might be understood to
be solicitation. Unlikely to prevail.
 Maybe 10b5 claim with respect to press release-misrepresentation in connection with purchase or sale of
securities... who was harmed?
Procedural hurdles
o Demand requirement: do we have obligation to make demand on board
with respect to breach of fiduciary duty claims?
 Need to make demand unless it would be futile; look
to Aronson test.
o Don't need to make demand requirement with respect to duty of loyalty
o Problem: board that made decisions is different from sitting board
now. Rails v. Blasband: if there has been a change of board, then look to
see whether you could plead sufficient facts to demonstrate that the
board was unlikely to be disinterested.
Is Willy, Jr. disinterested or dominated by Willy, Sr.?
Did new board members get any personal financial benefit from deal?
(doesn't appear to be).
o If not, then new board members could make determination as to whether
or not to bring suit, demand futility would fail.
Use old Rule 8.31 for conflict of interest, not subchapter F from supplement.