MODULE 1: INTRODUCTION
Corporation is a separate legal entity.
● Can sue
● Can be sued on its own in its own name
● Can serve as a partner in a partnership
● Can enter into a contract
● Can incur debt
Consequences of being a separate legal entity:
● Limited liability: when a corporation breaches a contract, or incurs a debt, or commits a
tort, who is liable for that?
○ The corporation, not it’s owners or the people who run it
● Limited liability
○ Means that a shareholder might lose her investment, but you are not liable for the
debts of that corporation.
● Taxation (disadvantage):
○ Double taxation: In general, a corporation must pay income tax on its profits. In
addition, if the corp. Pays dividends to shareholders, the shareholders pay taxes
on those dividends
■ Way around this: can qualify as an “S” corporation: if qualify for this
status, then the entity is not taxed as the entity level. We simply pay
individual tax.
○ But if taxed under “C” as in C corporation: both taxes.
Partnership
● Each partner is liable for the partnership’s debt
● If one is harmed by a partnership, may sue the individual partners for that claim
● Flow through taxation. Partnership is not taxed on its profits… credit each
● We assume that the owners have equal rights.
3 sets of players
1. shareholders/stockholders: they own the corporation. The corp issues shares of stock.
Shares of stock are units of ownership. If you own shares, you are a share owner. They
do a lot of things.
a. In a general corporate model, the shareholders do not manage the corporation.
They own it, but they do not run it. Instead, the shareholders elect people who
will manage the corporation: the board of directors.
b. Shareholder power is measured by the number of shares the shareholder owns.
50 shares vs. 10 shares → 5 times the ownership stake, 5 times the votes in
shareholder voting, and for every dollar in dividends 5 dollars.
2. The board of directors: run and manage the corporation
a. Set the corporate policy
b. Make the big business decisions to guide the corporation
c. They act as a group. An individual director has no authority to do anything to bind
the corporation.
d. Individual directors are not agents of the corporation
3. Officers:
a. Appointed by the board and monitored by the board to carry out the board’s
policy.
b. Board sets out policy, and hires officers to execute the policy
c. They act not as groups, but as individuals.
d. Ex. CEO, President, Tresasurer, Secretary
e. Officers are agents of the corporation
i.
Officers can bind the corporation to contract as long as they have agency
authority
** even though there are 3 sets of actors here, one person can serve as all 3 at the same time.
So make sure you keep track of what hat that person is wearing at the time he acts.
●
There can be corporations with one shareholder one director and one officer, all the
same person. That one person won’t be liable.
Law sees the corporation as 2 categories
1. Closely held corporation
a. Many exceptions arise to the corporate model here
b. Vast majority are closely held
c. Sometimes family businesses
d. Can do away with the board of directors and allow the shareholders to run it
e. Shareholders can sometimes be held liable for business debts
f. Few shareholders and no public market for the stock… there are still gigantic
businesses that are closely held.
2. Public corporation
a. Enormous businesses
b. Stock is traded on the public stock exchange
c. Ex. coca cola, ford motor, microsoft…
d. Have thousands of shareholders
The law:
● By which we form and operate corporations
○ All state law, no federal law for forming a corporation
■ There are some federally chartered corporations
Formation of a corporation
● Corporation can be formed only by satisfying the requirements set forth by the state
statute
● Everytime we have limited liability: We must deliver to the appropriate state officer
(usually the secretary of state), a document (usually the articles of incorporation)... the
article of corporation must be accepted for filing by that appropriate state officer.
Until that happens, we do not have a corporation.
○ Must have the states imprimatur
Partnership:
● Doesn’t require filing by the state. Just require co-owners running a business for profit.
Financing
● Most businesses financed by the proprietors
● But the corporation can raise capital in 2 ways
○ 1. Loans (debt financing)
○ 2. Selling ownership interests (equity financing)
One heavily debated question
● Whether a for-profit corporation can engage in any other activity than trying to make
money…
○ Corporation that makes widgets, can that business make things like charitable
donations or support a philanthropy
■ Many say no, must maximize the profit for the owners
○ Conflict: the board of directors are not the owners, so when they decide to give
away 100k to a college donation, whose money are they given away? The
shareholders. But the board of directors call the shots.
● Today, law recognizes that corporations are members of the community, so businesses
can support charities.
Benefit Corporation
● For profit corporation which says we are here to make money, but are also expressly
committed to benefit society by certain causes.
○ Ex. a B-corporation that manufactures widgets in foreign countries can say we
want to pay foreign workers the same amount of money they would make in the
United States. That is going to hurt the corporation’s bottom line, but in a benefit
corporation, they can do that and because that cause is expressly stated and the
board can’t get sued for wasting other people’s money in that way.
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MODULE 2: FORMATION AND RELATED TOPICS
Topic 1: formation and organization of a corporation
● 3 requirements:
○ 1. A person (incorporatior)
○ 2. A paper (AOI)
○ 3. Acts:
■ Deliver those articles to the appropriate state agency for filing (secretary
of state)
1. The person involved in the process of forming (incorporator
● Can have more than one incorporator.
● Usually a human, but can be an entity. A corporation can serve as an incorporator for
another corporation.
● What he needs to do:
○ 1. Execute the articles
○ 2. Arrange to have the articles delivered to the appropriate state officers
2. The Paper (usually AOI)
a. Forms the corporation
b. Under modern statues:
i.
Requirements of what must be in the articles: Section 2.02(a) of
model act.
1. Name of the corporation
a. Must have one of the 4 magic words in the corporate
names
i.
Corporation, company, incorporated, limited
2. Name and address of each incorporator
3. Give name of our registered agent and the address of the
registered office.
a. Address of registered office must be in the state of
incorporation
b. Registered agent is the official legal representative of the
corporation
i.
E.g. she can receive service of process, or tax docs
from the state
4. Information about our stock
a. The corp issues stock, and the articles must tell the state
the number of shares that the corporation will be
authorized to sell / issue.
b. In most states if you’re going to have different classes of
stock, must give info about those stocks
c. Might have par stock or no par stock, dividend stock…
ii.
What may be included (optional provisions): MBCA 2.02(b)
iii.
iv.
1. Exculpation provision
2. Names of initial directors
Other states:
a. Might need the purpose for forming the corporation. Make
a general statement of purpose – this corporation is formed
to conduct any lawful business. (not required under the
model act)
Other things that may be in the articles
1. If we are going to have an exculpation provision
2. Name the initial directors
3. The acts that must be taken
a. Incorporator must sign and notarize the article, and the articles must be delivered
to the secretary of state
b. Fee must be paid for forming the corporation
c. If the corporation checks out, the secretary of state will file the corporation
i.
Once this happens, the corporation is formed (de jure corporation - legal
corporation in the eyes of the law)
4. Organizing
a. If the the initial directors were named in the articles, those directors will get
together and hold the organizational meeting
i.
The board of directors will select officers, adopt the initial bylaws for the
corporation, and the board can do other appropriate business
1. Ex. authorize the issuance of stock
b. If the initial directors were not named in the articles
i.
The incorporators will hold the organizational meeting (can happen by
written consent)
ii.
The incorporator will select the initial board of directors
iii.
In most states, the incorporators could also appoint the officers and adopt
the initial bylaws, or simply let those initial directors do that.
Adoption of initial bylaws & bylaws v. articles
● Do not confuse articles with the bylaws
● Articles are much more important than the bylaws (articles actually form the corporation.)
the articles are public documents filed with the state
● Bylaws are not filed with the state and are completely internal (not available to the
public)
● Bylaws are more detailed
○ Lay out the internal rules running our corporation.
○ E.g.
■ How we give notice to directors of directors meetings, etc.
● Amending the articles is difficult, a fundamental corporate change
● The bylaws are much easier to amend.
●
○ In most states the shareholder can simply act to amend the bylaws
○ In some states, the shareholder or board of directors can do it.
Bylaws and articles should never contradict each other
○
But when the bylaws and articles conflict → the articles will win
TOPIC 2: Internal Affairs Rule and Foreign Corporations
Ex. we form our corporation in state A, but we want to do business in state B.
● Do not need to incorporate in state B.
● Incorporate in State A and then must qualify to do business in state B as a foreign
corporation
○ Foreign v domestic
■ If we incorporate in State A, we are a domestic corporation in State A and
a foreign corporation in every other state.
● (the type of business conducted matters)
○ Not just doing occasional business or sporadic, we do not have to qualify to do
that business in State B.
○ We are doing business if we are engaged in the regular course of intrastate
business activity in state B, we must qualify to do business in State B.
●
●
How to qualify to do business in another state
○ Go to the appropriate state agency in State B
○ Apply for a certificate of authority
■ To get this, must show the secretary of state
● 1. What’s in the articles
● 2. Must prove that the corporation is in good standing in State A
(state of incorporation)
■ Must also appoint a registered agent in state B (so that if the corp is sued
in state B, there is someone there that can receive service of process on
behalf of the corporation.
■ Need to also pay fees to state B
If we do business in State B and failed to qualify in the above ways, what’s going to
happen:
○ Subject to a civil fine
○ Cannot assert a claim in State B (can’t sue anyone in state B)
○ Essentially, in order to sue someone in state B, must be qualified
What Law is going to govern how we run this corporation (what law is going to govern our
internal affairs?)
● The internal affairs rule
○ The internal affairs of a State A corporation are governed by State A law.
Wherever you are incorporated, that state’s law will govern your internal
affairs.
●
What are internal affairs?
○ Roles, relationships, duties of the directors, officers and shareholders
TOPIC 3: PRE-INCORPORATION CONTRACTS
A contract before we have a corporation
● Ex. corporation is planned to form… but land is available for lease now and we want the
corporation to get that land / lease. If we wait until we form the corporation to get that
land, that land will get scooped up.
○ Somebody steps up on behalf of the corporation that’s not yet formed and enters
a contract on behalf of a corporation not yet formed
○ PROMOTER: The person acting on behalf of the corporation that’s not yet
formed and enters a contract on behalf of a corporation not yet formed
Who is liable on the contract on pre-incorporation contracts?
● Hypo: Paula is a promoter for a corporation not yet formed. Paula is planned to form
Paula Inc. but there is land available for lease now… so paula signs the lease on behalf
of Paula Inc. (not yet formed). Everyone knows the corp is not yet formed. The lease
gets entered, and a week later, the corp gets formed.
● Is the corporation liable on that lease?
○ No, merely by coming into existence that corporation is not automatically liable
on these pre-incorporation contracts.
○ Rule: The corporation is not liable on pre-incorporation contracts until it
adopts the contract. The corporation must do something to adopt the
contract. Adoption can be expressed or implied
■ Express adoption: ex. The board of directors has a meeting and agrees
that the corporation will adopt the contract. From that moment on the
corporation is a party to the contract and is liable
■ Implied adoption: if the corporation accepts a benefit under that
contract.
● Ex. corporation is formed and moves into those premises. At that
moment, there is an implied adoption of the contract, and the
corporation is liable on the contract.
● Promoter’s liability
○ Promoter is personally liable on the lease. She entered a contract on behalf of a
non-existent corporation. Thus, she acted on behalf of a non-existent principal,
which means she is a party to the contract. She is personally liable on the
contract.
■ That is true even if the corporation is never formed.
○ If the corporation gets formed and adopts the contract: The promoter is still
liable under pre-incorporation contracts until there is a novation.
■
Novation: an agreement between the promoter, the corporation, and the
lessee (or other party to the contract) that the corporation replaces the
promoter under the contract.
TOPIC 4: DEFECTIVE INCORPORATION
Situation in which people think the corporation has already been formed, but there is in fact no
corporation because of a defect in formation.
● HYPO. two individuals intend to form a corporation. Their lawyer tells them that the
articles will be filed and there will be a corporation de jure by Tuesday. The two sign a
contract with a third party on Tuesday. However, lawyer neglected to have the articles
formed, so no de jure corporation existed at the time of the contract.
○ However, those two individuals still formed a business structure: a partnership.
Partnership is formed by conduct. Partners are personally liable for the business
debts. Thus they are personally liable on the contract.
●
2 common law doctrines that help avoid liability for defective incorporation &
liability attaching to individuals: under these doctrines, the business is treated as
a corporation. That means that the two individuals would not be liable for
business debt.
○ 1. De facto corporation (3 requirements): Court treats the corporation as if
there was a corporation. APPLIES IN CONTRACT AND IN TORT.
■ (1a) Anyone asserting either de facto corporation or CBE must be
unaware of the failure to form a de jure corporation.
■ 1. There is a relevant incorporation statute (pretty much
automatically met)
■ 2. Must show that the parties made a good faith colorable attempt to
comply with the relevant incorporation statute.
● Coming VERY CLOSE to complying with the requirements for
a de jure corporation
■ 3. Must show that there has been some exercise of corporate
privileges
● This means that the parties are acting as though there is a
corporation there
■
→ Exception: the only party that can hassle for failing to form a de jure
corporation is the State. But in terms of the relationships with third parties,
de facto is the same as being corporation de jure.
○
2. Corporation by estoppel (CBE): (REQUIREMENTS): If i treat a business
as a corporation, and act as though its a corporation, if it turns out there is
no corporation, i may be estopped to deny this corpration
■ (1a) Anyone asserting either de facto corporation or CBE must be
unaware of the failure to form a de jure corporation.
■
(1) Can only be raised in contract cases, not in tort.
■
Hypo: One does business with another business. That person thinks its a
corporation. The proprietors think its a corporation. The person writes
checks to it, treats it like a corporation… Turns out there is no corporation
and all there is is a partnership. The person then tries to sue the
individuals… → those individuals can raise the defense of CBE and if
successful, the court will estop them from denying that it is a corporation
●
→ not all states recognize both.
●
2.04 of model act: people who act on behalf of a corporation knowing that it does
not exist they are personally liable
○ Some people believe that implies that de facto corporation and CBE are
abolished
○ Others believe that that statute implies that if you’re acting on behalf of a
corporation not knowing that it was not properly formed, then they should be able
to use de facto corporation and CBE
MODULE 3: FINANCE, ACCOUNTING, AND DISTRIBUTIONS
TOPIC 1: DEBT AND EQUITY FINANCING
●
Debt and equity and financing: every business needs money.
2 ways that a corporation can raise money. Most business raise capital using a combination
of debt and equity financing. To use either one, the corporation will issue securities (issue = sell)
(securities = investments)
1. Borrow money (debt financing)
a. Need to repay along with interest
b. Person who lends money to the corporation is the creditor of the corporation, not
an owner of the corporation
c. Riskier for the corporation because they have to repay it
d. The corporation can issue debt securities (in which case they give an IOU to
the lender who is now a creditor.
i.
Usually called bonds (debt financing)
e. Debenture: just a loan to the corporation, the repayment of which is not secured
by corporate assets. (debt financing)
2. Sell / Allow investors to buy ownership interest in the business (equity financing)
a. Equity = ownership
b. Riskier for investors because they could lose their investment.
c. If equity financing → issues stock (ownership interests in the corporation)
Hypo:
● I form Corporation. Corporation needs 20k to get started. I invest 10k of my own and get
stock. But i still need another 10k, so i go to someone else. That person has a choice:
○ they can lend the 10k to the corporation (debt financing) - that needs to be paid
back. If the corporation lost money, that person still gets paid. The corp makes
money, the lender still only gets the 10k plus interest, so doesn’t get to share in
the upside.
○ They can invest 10k in the corporation as a stockholder. They get 50 percent of
ownership in the corporation. This is equity financing. Here, he is an owner and
not a creditor. One year later, the business loses lots of money, what does he
get? Nothing because he is an owner not a creditor. If the business does very
well and makes a million, what does he get? Half a million dollars because he is
a 50 percent owner.
TOPIC 2: ISSUANCE OF STOCK
●
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Issuance of stock = corporation is selling its own stock
Authorized stock = the maximum number of shares the corporation may sell.
○ Always set in the articles. It is a cap / ceiling.
●
●
●
○ Cannot go above this unless the articles are amended.
Issued stock: the number of shares the corporation actually does sell
○ Do not have to issue all of the authorized stock
Outstanding: Shares that the corporation has sold and has not reacquired
○ After a corp sells stock, the corporation is free to go out to the stockholders and
buy the stock back. And shares that the corporation buys back are no longer
outstanding.
Note: shareholder rights:
○ Ex. rights to get dividends and rights to vote depend on the number of shares
outstanding
Issuance Rules
● Issuance = corporation is selling its own stock
● 2 things to look at when a corporation is selling its own stock:
○ 1. Must be for a proper form of consideration
■ Historically, corporations could not issue stock for promissory notes or
promise of future services. All a corp could do is issue stock for money,
property, or services that had already been formed. This is the very
minority of states that still have this.
■ Modern view (6.01 modern act): the buyer may pay for an issuance
with ANY tangible or intangible property or benefit to the
corporation.
● Includes promissory notes, future services, money, property, past
services, etc. anything that is consideration that can benefit the
corporation is OK.
○ 2. Must be for a proper amount of consideration
■ PAR = minimum issuance price
● If the corporation is selling its own stock, it’s got to get at least the
par value.
● Par stock is not required. If we have it, it will be set up in the
articles so everyone will know it.
● E.g. Corporation issues 10k shares of 3 dollar par = corporation
must receive at least 30k from that issuance. But they can sell it
for more.
■ NO PAR STOCK = no minimum issuance price
● Board can set whatever price it wants for the issuance of that
stock.
● All of this, including different classes of stock will be set up in the
articles.
■
Note: if we are selling 10k shares of par stock of 10 dollars for land → only
good if the land is worth 100k. The board of directors has the job of
figuring out whether that land is worth 100k. If the board of directors
decides in good faith that it is worth that, that’s going to be fine. A good
○
○
issuance.
Par value is completely arbitrary. No necessary correlation with the actual value
of the stock. It is aimed at providing some security for creditors of the
corporation.
■ Note: what we are talking about with the form of consideration and the
amount of consideration, these are issuance rules. So they apply only
when there is an issuance. And an issuance only happens when a
corporation is selling its own stock. So they do not apply when
normal shareholders are buying and selling stock.
● So if a shareholder wants to sell stock to another for less than par
value, that’s okay.
What happens if the corporation issues par stock for less than par value?
■ We then have watered stock
■ Hypo: our corporation issues 10,000 shares of $3 par to X for $22,000. It
should have gotten $30,000. That’s $8,000 short ($8,000 of “water”). The
corporation is going to sue to get the $8,000 back. Who is liable?
● 1. The directors who approved the issuance
● 2. X is liable for the “water.” X is the one who bought the watered
stock from the corp. If you buy watered stock from the corporation,
you are liable for the water. X is charged with notice of the par
value, so there is no defense for the buyer there.
■ What happens if the buyer “X” turns around and transfers that stock to a
third party?
● The third party is not liable if she did not know about the water.
● The buyer is still liable
● And the directors who approved this issuance are liable.
TOPIC 3: DISTRIBUTIONS TO SHAREHOLDERS
Distribution: corporation is paying shareholders because of their status as shareholders
Distributions come up in 3 ways
1. Dividend: corporation is paying the shareholders. Corporation is doing well and making
money. They could use that money to expand the business, or it could choose to give a
dividend to the shareholders.
2. Repurchase of stock: if the corporation comes to shareholders and pays the
shareholder to buy back their stock, that is a distribution because the corporation is
paying the shareholder.
3. Redemption: (rare): must be said in the articles. Says that the corporation has a class of
stock that the corporation can force the shareholder to sell back at a set price. The set
price will be in the articles.
Distributions
●
●
●
Distributions of every type are made in the discretion of the board of directors. Up to the
board whether to do it
If you try to sue to enforce the board of directors to make distributions, likely going to
lose.
Shareholders have no right to a distribution until the board declares it
Dividends:
● When it happens it is paid pro rata to each outstanding share, unless the articles say
something different
● Ex. board of directors decides to declare a distribution dividend of $40,000 (the pool).
Only stock in our shares is 10,000 shares of common stock. You just divide it out. Each
share gets $4.
● But, ex. 10,000 shares of common stock and 2,000 shares of preferred stock with a $2
dividend preference (the articles will tell us what the preference is, here the preference
10,000 shares with a $2 dividend preference).
○ Preferred means pay first
○ Take the 2,000 shares multiplied by $2 preference = $4,000. The first $4k out of
the $40k pool goes to the preferred stock holders. That leaves $36k. The
common share gets this = $3.60 per share.
TOPIC 4: PROPRIETY OF DISTRIBUTIONS
●
Law imposes restrictions on when a corporation can make a distribution of any of the 3
types
2 approaches to this law (or rules for proper and improper distributions)
● Historical approach (not many use it)
○ We must know about 3 types of funds (3 pots of money in the life of the
corporation)
■ Type of fund #1 = earned surplus: the corporation earned this by doing
well in the market (selling a lot of widgets) (more money that it spends)
● This is a proper source for distributions
■ Type of fund #2: Stated Capital: Corporation raises money by issuing
stock. Stated capital is the par value of a par issuance.
● Everytime the corporation the earns from issuing stock, every
penny must be allocated between stated capital and capital
surplus.
● Stated capital is a fund to protect creditors.
● Stated capital may never be used for a distribution
■ Type of fund #3: Capital surplus: Capital surplus is the excess over par
value
● Can be a source for distribution
● Capital surplus is the excess over par value
○
Ex. corporation issues 10k shares of $2 par and issues it for $50,000.
■
Out of that $50k, how much must go into stated capital? → 20k because
that’s the par value. Cannot pay a distribution from that
■
The other $30k → excess over par goes into capital surplus and can be
used for distribution
○
In a no par issuance → board must allocate how much goes into stated capital
and how much goes into capital surplus.
●
Modern approach
○ The corporation can make a distribution unless the corporation is insolvent or the
distribution will render it insolvent
■ The company will be insolvent if either of these 2 definitions are met. And
if it is insolvent that means it was an improper distribution
● MBCA 6.40 (C)(1)&(2)
○ Test 1: the corporation is insolvent if it is unable to pay its
debts as they come due
■ Ex. if the corporation makes a distribution and the
next day they cannot pay for stuff, then that was an
improper distribution because it rendered the
corporation unable to pay its debts as it came due
and was thus insolvent.
○ Test 2: the company is insolvent if the corporation’s assets
are less than its liabilities
■ Professor will have to tell us the assets and
liabilities
■ Liabilities include preferential liquidation rights
● Stock with a liquidation preference (works
exactly like a divided preference but instead
of coming up at dividend time, it comes up
when the company dissolves.)
○ When the company dissolves and
the company liquidates, any money
that is left over for shareholders, is
going to be distributed first to
shareholders with liquidation
preferences.
● Ex. corporation with assets of $5k. And has
liabilities of $4k. But the corporation has 1k
shares of stock with a liquidation preference
of $2 per share. 1k shares multiplied by
their $2 liquidation preference = $2k
○
●
Corporation has to include the $2k in
the liabilities. Now we have assets of
$5k and assets of $4k.
Liabilities for improper distribution
○ If we have an improper distribution, directors who approved the
distribution are usually liable to the extent that the distribution was
improper.
■ In some states it is strict liability. In other states, must show that they
breached the duty of care. But directors are usually going to be on the
hook for that to the extent that the distribution was improper.
○ Shareholders are liable for an improper distribution only if they knew the
distribution was improper at the moment they received it.
MODULE 4: BOARD OF DIRECTORS AND OFFICERS
TOPIC 1: BACKGROUND ON DIRECTORS
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The initial directors of the corporation are either named in the articles or elected by the
incorporators. After that the directors are elected by the shareholders. This is done every
year at the annual meeting of the shareholders.
Traditionally
○ Corporations were required to have at least 3 directors (not true anymore)
Where is the number of directors set?
○ In some states, must be in the articles
○ Other states, must be in the bylaws
○ Under MBCA: the number of directors can bet either in the articles or the bylaws
Directors must be human beings. An entity cannot be a director.
○ An entity can be an incorporator, but not a director.
Individual directors are not agents of the corporation. An individual director has
no authority to bind the corporation to the contract. Thus, directors must act as a
group.
○ Officers are agents of the corporation, but directors are not
The board is ultimately responsible for the direction and management of the corporation.
○ In small corporations, the board actually does the day-to-day decision making
■ Might even be one person who is the sole director, sole officer and sole
shareholder
○ In large publicly traded corporations, the board of directors doesn’t get engaged
in the nitty gritty day-to-day stuff. Instead, it oversees the management and the
management is actually undertaken by the senior officers.
Board of directors sets the management policy
Large corporations
● Common to have both inside and outside directors in large corporations
○ Inside director: someone who is not only a director but is employed full time by
the corporation. Day job is with the corporation.
■ Will always be an officer. So if you have a director who is also an
officer, that is an inside director
○ Outside director: an outside director is one whose day job is not with the
corporation. It is simply a directorship.
Separation of ownership and management
● The locus of decision making and authority is the board of directors. The board calls the
shots. NOT the shareholders.
● The shareholders elect the board of directors
● Thus we have separated ownership and management.
○
Shareholders are owners but don’t run the corporation. They elect the board and
the board runs
ELECTION AND REMOVAL OF DIRECTORS
Annual Meeting of shareholders
● The initial directors of the corporation are either named in the articles or elected by the
incorporators. After that the directors are elected by the shareholders. This is done every
year at the annual meeting of the shareholders.
● Meeting is required because that’s where we elect directors
● If we are late with the meeting, the directors will be holdover directors:
○ Holdover directors keep that office until we elect a successor
Usually the entire board is up for election each year (meaning they serve one year terms)
● However, Staggered Board (classified board): divided into halves or thirds and one
half or one third of the directors are elected each year.
○ Ex. board of directors with 9 directors. Ordinarily all 9 are elected each year and
serve one year terms. But, if we have a staggered board divided into thirds, so
there would be three groups of 3 directors. 3 would be elected this year, a
different 3 the next year, and they would serve three year terms
○ Staggered boards tends to ensure continuity of management or alternatively then
entrench the management of the corporation (make it much more difficult to elect
no management because it would take 3 years to replace all of the management)
How the shareholders vote at the annual meeting (hiring and firing of directors)
● The shareholders not only hire the directors each year at the annual meeting
● but the shareholders can also fire directors as well. Shareholders can remove a director
before her term expires. And in almost every state, the shareholder can do this with or
without cause
○ Nuance:
■ in some states: If staggered board: then shareholders can remove a
director only for cause
What happens if there is a vacancy in the board? (director resigns before her term is up or is
removed by shareholders)
● Who appoints a new director to fill out the rest of that term?
○ States vary, but common answer is that the remaining directors or the
shareholders appoint the new director
○ Nuance:
■ In many states if the shareholders created the vacancy by removing a
director, then the shareholders should elect the replacement
TOPIC 3: HOW DOES THE BOARD TAKE AN ACTION?
2 ways the board can take an action
1. Unanimous written agreement
a. If all the directors agree in writing that they want to take an action, that is okay.
Email works.
2. At a meeting
Meetings of the Board of directors (2 kinds)
● Regular meeting
○ Corporation is not required to give notice to the directors
○ Usually set up in the bylaws
● Special board meeting
○ Corporation must give notice to the directors
■ Notice must state the time and place of the meeting
■ Notice does not need to state the purpose of the meeting
○ MBCA 8.22(b) requires that notice of special meeting be given at least 2 days
before the special meeting
■ Statutes rarely give guidance as to how notice must be given. Usually this
is set out in the bylaws
○ If the corporation has a special meeting and fails to give notice to one of the
directors
■ Failure means that any action taken by the board at the meeting is
voidable unless those who are not given notice waive the notice defect.
● They may do this in writing anytime, or by attending the meeting
without objecting at the outset of the meeting.
How do meetings work?
● Every decision the board makes will come before the board as a resolution and the
question is whether the resolution will pass
● The first question is do we have a quorum
○ Cannot take an act if there is no quorum
○ Quorum: unless the articles say otherwise, a quorum is a majority of all
directors.
■ If 9 directors on the board, at least 5 of them must attend the meeting or
the board cannot act.
● If you have a quorum
○ Passing a resolution requires the yes vote of the majority of those who are
present.
○ So we must have an affirmative vote by a majority of those who are present
○ Ex. 9 directors, 5 show up. 3 have to affirmatively vote to pass the resolution
○ Ex. 9 directors, 5 show up, but one director leaves the meeting.
■ The quorum has been broken and the board cannot act.
● The test is whether they can hear each other live
○
Telephone meetings are fine
Shareholder voting
● Shareholders can vote by proxy and can enter voting agreements and they can enter
voting agreement on how they’re going to vote as shareholders
○ But directors owe nondelegable fiduciary duties to the corporation. That
means that proxies for director voting and agreements on how directors
will vote are against public policy. CANNOT HAVE THEM
● One person may different roles in the corporation
○ The same person may be a director and may be a shareholder. If they are going
to a shareholder meeting to vote as a shareholder, proxies and agreements are
fine. But if acting in a directorial role, no proxies and no agreements.
● Every director present at the meeting is presumed to concur with whatever action
the board took. You are presumed to have concurred with whatever the board did
unless the director’s dissent or abstention is noted in writing. AN ORAL dissent or
abstention doesn’t work.
○ Must be in writing (3 ways)
■ 1. Must be in the minutes (make sure that the corporate secretary gets
the dissent in the minute)
■ 2. Or, delivered in writing to the presiding officer
■ 3. File written dissent with the corporation immediately after the meeting.
TOPIC 4: COMMITTEES OF THE BOARD
committees
● The board of directors can delegate various tasks or functions to a committee
○ Committee = subset of the board
■ Need only have one member
● Statutes limit the the tasks that can be performed by a committee
○ Board cannot delegate all of its tasks to a committee
○ What the committee cannot do depends on what the statute says (statutes vary)
■ In many states a committee cannot declare a distribution to shareholders
■ In many states a committee cannot set director compensation
○ Even though a committee cannot do those things, it is okay to have the
committee recommend such things to the board.
● In large public corporations, there are many committees
○ Some are standing committees: they exist all the time
○ Some are ad hoc committees: put together for certain tasks along the way
● Sarbanes-Oxley act: Public corporations must have an audit committee
○ Law requires that the people on that committee have expertise in financial
matters
TOPIC 5: OFFICERS
●
●
●
●
●
Individual directors are not agents of the corporation, so no authority to bind
But officers are agents of the corporation, so we apply agency law
The corporation is the principal, the officer is the agent
The question on whether agent (officer) can bind the principal (corporation) depends on
whether the officer has authority
○ Could be
■ actual authority
■ Apparent authority
■ Inherent authority: the power to bind the corporation that exists simply
by virtue of the office
● Ex. corporate president: in many states the president of the
corporation has inherent authority to bind the corporation to
contracts in the ordinary course of business.
Basic statutes allow us to have any officers we want to set up
○ Always will have a corporate secretary responsible for keeping the records and
the minutes
○ Today, one person can hold multiple officers simultaneously
Where do officers come from
● Officers are hired and fired by the board of directors
● Board also sets officer compensation
● One very important function of the board is to monitor the performance of officers
○ The board should fire officers who are not doing their job.
● Shareholders do not hire and fire officers
○ Shareholders hire and fire directors, but it is the board of directors that hires and
fires directors.
Quorum rules
● When it comes to officers we do not need to go through voting rules and quorum rules
because they do not make group decisions
● Each officer has their own responsibility and act in accordance with that responsibility
TOPIC 6: FIDUCIARY DUTIES
●
●
Directors and officers are fiduciaries of the corporation and owe fiduciary duties to the
corporation
○ Fiduciary: someone acting for the benefit of someone else (in this case the
corporation)
Some cases say that the directors and officers owe fiduciary duties to the shareholders
(this is referring to shareholders in the collective sense)
●
That means if the officers or directors breach these duties, the corporation is hurt
and the corporation will have a claim against the breaching fiduciary.
○
Usually the corporation doesn’t bring that suit, but the shareholder will →
shareholder derivative suit
Fiduciary duties
1. Duty of good faith
a. Courts in Delaware say that the duty of good faith is not a duty, but is an
obligation which is part of the duty of loyalty.
b. A fiduciary (director or officer) must act in good faith. Whatever she does for that
corporation must be done in good faith.
c. Disney case & Stone v. Ritter: say that lack of good faith includes a
conscious disregard of one’s obligation
d. Stone v Ritter: it would be a breach of the obligation of good faith if the board of
directors failed to establish and police a monitoring system
i.
Monitoring system: aimed at ensuring the board of directors gets notice
of what’s going on at lower levels in the corporation
1. Would have people way down reporting to their superiors, who
report to their superiors and so on so that the board has an
reporting of what is going on in the corporation
a. Not everything, but so that the board is aware of problems
that may be percolating at lower levels in the organization
2. Ex. a lower level employee is engaging in medicaid fraud that
exposes the corporation to a quarter billion dollars of liability… are
the directors liable because they failed to act in good faith in
ferreting that out? → they do not breach their obligation of
goodfaith if they set up their monitoring system and actively
police it (don’t ignore the reports that come to them.)
ii.
So, it would be a breach of good faith if the board failed to set up a
monitoring system, or if the board set one up and paid no attention to it →
that is conscious disregard of one’s obligation.
2. Duty of care
a. Officers owe the same duties as directors
b. MBCA 8.30(a)&(b): talk about the duties owed by directors
i.
MBCA 8.30(b): codifies the basic duty of care: a director must act in
a way that a person in like position would reasonably consider
appropriate
1. In many states, statute says the director must act in a way that a
prudent person would do
c. Dut of care is implicated in 2 ways:
i.
Nonfeasance: the director is lazy.
1. nonfeasance cases are sually brought against individual directors,
not the entire board.
2. Basically, the individual employer doesn’t do anything. Doesn’t go
to meetings, doesn’t do homework, not engaged at all
3. Barnes v. Andrews: a director not doing anything is not
enough for liability. Under Barnes and in most states the
plaintiff must also show causation. It is not enough just to
show breach of the duty of care, they must also show
causation.
a. Must show that the corporation lost money because
this particular director didn’t do anything.
i.
Often the corporation would have lost money
anyways.
ii.
Under Barnes, they said that the corporation had
other problems that he couldn’t fix.
4. How can a plaintiff show causation in a nonfeasance case?
a. If a director has special expertise
i.
Ex. director who is an antitrust expert who
breaches the duty of care by doing nothing. In his
absence the board approved a contract that
violated the antitrust laws which exposed the
corporation to enormous liability. Is that director
liable? → yes, there is a breach because he wasn’t
doing what a reasonable prudent person would do.
And here, there is causation, if he was engaged,
given his expertise in antitrust, he could have
stopped the board from doing something.
ii.
Misfeasance
1. Misfeasance claims are usually against the whole board of
directors who approved a particular act that hurt the corporation /
corporation lost money.
2. In these cases, causation is clear because the corporation did
something. So causation is not an issue here
3. In misfeasance cases, directors are protected by the
business judgment rule
4. BUSINESS JUDGMENT RULE: presumption that when a
board does something, it acts in good faith and did
appropriate homework (acted like a reasonable and prudent
person would). This is true even if what the board did lost
money.
5. Shlensky v Wrigley
a. Board of directors of the Cubs decided that the Cubs
would play no night baseball games. It was very clear that
this decision cost the corporation money. Nonetheless, the
BJR shielded what the directors did. And the plaintiff failed
to overcome the BJR (presumption) that the board in
making these decisions acted in good faith and was
reasonable or prudent.
b. Directors are not guarantors of success
6. How can a business overcome the BJR? (3 ways)
a. (1) plaintiff shows conflict of interest: if the directors
were in a conflict of interest situation, the BJR does
not apply
i.
Actually, when a director is in a conflict of
interest situation, that’s not the duty of care at
all, that’s the duty of loyalty. Either way, the
BJR does not apply
b. (2) some decisions by the board are so stupid that
they lose the protection of the BJR.
i.
Joy v. North: board of directors of a bank approved
ongoing loans, loan after loan, to a borrower who
clearly was not going to repay. Had not repaid
anything and was not going to repay anything. That
is such a no-win situation that the board is not
protected by the business judgment rule.
c. (3) plaintiff shows that the board failed to do
appropriate homework before taking this action. The
directors were not adequately informed.
i.
Smith v. Van Gorkum: board of directors of
Transunion approved a merger that would end the
existence of Transunion. It would be merged into
another corporation. That is a big important
decision, yet the board made that decision on the
basis of one 2-hour meeting at which basically
none of the directors had a written report of what
was going to happen. There was very little
presentation about how the decision was made
(that the merger should be made at this price or
another price), and there was nothing but a very
hurried up estimate by an investment bank about
what would be a fair price
1. Court said that the directors were not
protected by the BJR because they did not
do appropriate homework
2. How this makes sense: the duty of care
means that a director what a reasonable or
prudent person would do. And a reasonable
or prudent person would do their homework
for a massive decision like this.
3. Doesn’t mean that they have to take years
to make a decision, but on the facts of the
case, they did appropriate homework. The
looked, they analyzed, asked appropriate
question… etc.
7. If the plaintiff cannot show one of these three things (conflict of
interest, stupid decision, or board failed to do homework) → the
defendants are protected by the BJR
d. MBCA 8.42(a): makes it clear that officers owe the same duties
3. Duty of loyalty
a. MBCA 8.30(a)(2): the statutory standard: a director must act with the
reasonable belief that what she does is in the company’s best interest
i.
Easy to spot because they are conflicts of interest. Tempted to put her
own interest above that of the corporation. As soon as she is in that
situation, we know 2 things:
1. (1) Duty of loyalty is implicated, not duty of care and
2. (2) the BJR does not apply. And that means burden is on the
defendant. We start with the proposition that the defendant is
going to be liable unless the defendant can show that they
should not be held liable.
b. Easy examples of breaches: directors and officers stealing money
c. 3 example patterns where the duty of loyalty is breached
i.
(1) Interested director transaction (or self-dealing): there is a deal /
transaction between the corporation and on the other side of the
deal is one of its directors or officers, or in most states, a close
relative or other business of the director or officer. It’s a conflict of
interest because the director is on both sides as a fiduciary for the
corporation and as a party on the other side or affected on the other
side. THE BJR DOES NOT APPLY. BURDEN IS ON THE FIDUCIARY.
1. Generally: the defendant is going to be liable unless the
defendant shows one of three things:
a. (1) Defendant must show that the deal was fair to the
corporation, or
b. (2) defendant shows that the deal was disclosed and
approved by the disinterested directors, or
i.
MBCA 8.60 through 8.63 talks about qualified
directors (same thing as disinterested)
ii.
iii.
c. (3) defendant shows that the deal was disclosed and
approved by the disinterested shareholders.
2. (applies to officers as well)
(2) competing ventures: a fiduciary can have other business
interests, but there is a problem if you have an interest in a
corporation that competes head to head with your corporation
1. Duane Jones: corporation ran an advertising agency and some of
the officers and directors decided they were going to set up a
competing advertising agency. If they had resigned from Duane
Jones and decided to do that, that would be okay, but they did not
do that. Instead, they set up the competing business and stole
clients and stole employees while they were still fiduciaries for
Duane Jones. That is an obvious breach of the duty of loyalty. It
was not in the best interests of the corporation. Do not steal stuff
from your corporation when you’re setting it up.
(3) Usurpation of corporate opportunities
1. Ex. corporation that develops condo projects and is in a constant
need for land. One director learns of some land that’s just been
zoned for condos which would be great for the corporation. But
without telling the company, the director buys the land for himself.
That puts the director in a conflict of interest situation. He is
tempted to put his own interests above that of the corporation
2. Steps to take in these cases:
a. (1) determine whether whatever the director took was a
corporate opportunity:
i.
Factors:
1. It’s a corporate opportunity if it’s in the
corporate’s line of business
a. In the example: it is. Land is in the
business line of a condo developing
country
2. It’s a corporate opportunity if the
company has an interest or expectancy
in the property
a. Not clear how interested it would
have to be
3. It’s a corporate opportunity if it was
found on company time or with company
resources.
4. Overall fairness: is it fair that this
director took it?
5. Other factors
b. (2) if it is an opportunity, what happens?
i.
ii.
iii.
iv.
v.
vi.
Some courts: say that the fiduciary breaches
her duty of loyalty if she did not offer it first to
the corporation and wait for the corporation to
turn it down (ALI 5.05 principles of corporate
governance)
Thus there is an absolute duty to take it to the
corporation and wait for the corporation to turn
it down before acting yourself.
Other courts: do not require the defendant to
present the opportunity to the corporation first.
Courts also disagree about:
1. Whether the corporation’s financial
ability to pay for the opportunity is
relevant (defense)
a. Delaware states that something is
not a corporate opportunity or there
is no liability if the corporation could
not have paid for it.
b. Other courts disagree
These are not hermetically sealed:
Ex: we have director of the corporation who buys
land for himself and doesn’t tell the corporation
about it. Then he sells the land to the corporation.
This engages 2 fact patterns:
1. (1) usurpation of corporate opportunity, and
the (2)nd, when he sold it to the corporation
was self-dealing and interested director
transaction.
TOPIC 7: EXCULPATION AND INDEMNIFICATION OF DIRECTORS AND OFFICERS
●
When someone is sued for breach of a duty, one possible defense to look for is that she
relied on good faith on what employees or professionals told her.
○ This is a valid defense in every state, as long as the reliance was in good
faith.
○ Ex. improper distributions case. Board declares an improper distribution. A
director may say “i relied on good faith on what the financial people told me.”
○ Smith v. Van Gorkum
■ Said in approving the merger they relied on what the CEO told them. But
the court said it was not good faith reliance. Because if they had pushed
and asked any questions they would have known that the CEO did not
know what he was talking about.
After the decision of Smtih v Van Gorkum, every state passed things called EXCULPATION
STATUTES
●
●
Allow the corporation to have a provision in the articles, that says directors (and in some
states officers), cannot be held liable to the corporation or shareholders for damages.
Every exculpation statute has exceptions (Cannot exculpate for certain things:)
○ Typically cannot exculpate for acts not in good faith and cannot exculpate
for breach of the duty of loyalty. So really only for breach of the duty of
care.
Indemnification statutes
● A fiduciary (director and in most states an officer) has been sued for breach of duty, and
when she got sued, she incurred expenses and attorneys fees (had to pay a lot of
money in the defense of that case) Then she goes to the corporation and says,
reimburse me for all these litigation expenses.
● Statutes vary but mainly provide for 3 categories of cases
○ (1) where the corporation is required to reimburse her.
■ Happens If when she was sued, she won a judgment. (MBCA 8.52)
○ (2) where the corporation is prohibited from reimbursing her expenses)
■ In some states: Happens if the person was adjudged liable to the
corporation. When she got sued there was an actual adjudication
that she was liable to the corporation
■ MBCA 8.51(d)(2): reimbursement is prohibited only if she was held
liable because she received an improper financial benefit
○ (3) permitted reimbursement or permitted indemnification:
■ Every other case other than the ones above.
■ She may ask for reimbursement, and the corporation may reimburse
her, but she will have to make a showing to be qualified for this.
MUST show that she acted in good faith AND that she acted with the
reasonable belief that her acts were in the company’s best interest.
MBCA 8.51(1)(a)(1)
●
→ this second part is essentially the duty of loyalty. She has to
show she acted in good faith and in accordance with the duty of
loyalty to ask for permissive indemnification
MODULE 5: SHAREHOLDERS
TOPIC #1: HOW DO SHAREHOLDERS TAKE AN ACT?
●
●
What do shareholders do?
○ They hire and fire directors
○ Approve fundamental corporate changes
○ Amend bylaws
○ Disinterested shareholders may approve an interested director transaction
When the shareholders act, they act as a group
Shareholders can act as a group in one of two ways (same as directors):
1. Unanimous written consent
a. Includes email
2. Act at a meeting
Shareholder Actions at Meetings
A. Who votes?
●
●
●
●
●
Unless the articles say otherwise, each outstanding share gets one vote
To be eligible to vote, must be a record shareholder as of the record date
○ Record shareholder: must be a shareholder shown in the public record
○ Record date: voter eligibility cutoff
■ Normally set between 10 and 60 days before the meeting.
So you must have owned the stock on the record date to be eligible to vote
Even if they sell the stock after the record date and before the meeting, still that record
shareholder votes.
Proxies: a writing signed by the record shareholder directed to the secretary of
the corporation authorizing someone else to vote their shares. A proxy is an
agency.
○ Can be used to vote
○ In shareholder voting, can use proxies
○ Includes email (as long as we can identify the sender)
○ Proxies generally good for 11 months unless they say otherwise
○ Revoking proxies:
■ Can do it in writing
■ Can do it by showing up at the meeting and voting.
■ Proxies can be revoked even if they say they are irrevocable.
■ Only one way to have a truly irrevocable proxy
● Proxy coupled with an interest: needs to be a proxy that says
irrevocable and the proxy holder (person appointed to be the
proxy) must have some interest in that stock b beyond the interest
simply in voting
○ Ex. shareholder gives someone an option to buy his stock,
in addition also gives that person a proxy to vote for him at
an upcoming meeting. That proxy says it is irrevocable.
That proxy is irrevocable.
Pooling voting power (often in small corporations shareholders will try to combine their voting
power)
●
2 ways to think about pooling voting power
○ (1) Voting trust: shareholders agree to pool their power, but want to make it
official so they can’t back out of the deal. With a voting trust, there is a true trust,
a separation of legal and equitable title. Court will enforce this.
■ Both shareholders have a written trust agreement
■ Requires the shareholders to transfer the legal title of the stock to a third
party called a voting trustee
■ Written agreement gives the voting trustee instructions on how the stock
should be voted.
■ Both shareholders get trust certificates (meaning they retain all other
shareholder rights, such as the right to inspect books and records, or the
right to bring derivative suits
■ Voting trust is cumbersome.
■ In most states, voting trusts must be filed with the corporation, so they
aren’t a secret.
○ (2) the voting agreement: a written agreement between two shareholders in
which they agree how they will vote their stock
■ In many states including Delaware, courts will not give specific
performance for this.
■ In some states and MBCA 7.31(b): makes voting agreements specifically
enforceable
B. WHERE DO THE SHAREHOLDERS VOTE?
2 kinds of meetings for shareholders
1. Annual meeting
2. Special meeting
Annual meeting
● Where shareholders elect directors
● Annual meeting is required
● If it hasn’t been held annually, a shareholder can get a court order that the corporation
hold the annual meeting
●
Until new directors are elected and qualified, the old directors will stay in
Special Meeting
● Basically everything else is done here
● Who can call a special meeting of shareholders?
○ Board of directors can always call this meeting
○ And in most states, a specified percentage of the shares can also call the
meeting
■ Usually 10 percent of the outstanding share
● Hypo: In a state where 10 percent of the outstanding shares can call a special meeting.
10 percent of the shares do so. And the purpose of that meeting is to fire the
corporation’s president.
○ NO not okay, even though we have satisfied the requirements to call the
meeting, this is not for a proper shareholder purpose.
○ The president is an officer.
○ Shareholders do not hire and fire officers
○ However, the shareholders could hold a meeting to fire a director at one of these
meetings
●
If meeting → the corporation must give written notice to every shareholder who is entitled
to vote
○
●
In most states that notice must be delivered between 10 and 60 days before the
meeting
○ Requirements for the notice:
■ Must always state the date, time and place of the meeting.
■ Notice of a special meeting must state the purpose of the meeting
● Limits what the shareholders can do at this meeting
○ If notice says we are going to vote on removing a director,
we cannot vote to approve a merger.
What happens if the corporation fails to give the required notice to all
shareholders entitled to vote (in special or annual meeting)?
○ Everything that happened at the meeting is voidable unless the
shareholders who were not notified waive the notice defect.
○ May waive the notice defect in writing at any time, or by attending the
meeting without objecting at the outset of the meeting.
C. HOW DO THE SHAREHOLDERS VOTE?
●
●
The first thing in any meeting of any group is to determine: do we have a quorum
○ True for board of directors meetings, true for shareholders meetings, true for any
group
Determination of a quorum in shareholder voting focuses on the number of shares
at the meeting, not the number of shareholders
●
●
●
●
○ Look at # of shares represented at the meeting, can be by proxy
The general rule is that a quorum requires a majority of the outstanding shares
○ Ex. if there are 10k outstanding shares, at least 5,001 shares must be
represented at that meeting. If not, the shareholders cannot act.
Once we have a quorum, that quorum is not lost if people leave the meeting.
○ Different from board of directors meeting.
Once we have a quorum:
○ Then the shareholders will vote on whatever is on the agenda.
○ What vote is required Depends on what we are voting on
■ (1) to elect directors, all that is needed is a plurality not a majority
● If we are voting for who is going to sit in seat number 1, the
person who gets the most votes for seat #1 will be elected to seat
#1 even if it a majority of the votes cast.
■ (2) if we are voting to remove a director:
● Traditional view followed by DE, we need a majority of the
shares entitled to vote.
○ NOT a majority of the shares present at the meeting or a
majority of shares who actually do vote.
● Modern trend: (MBCA): a majority of the shares which
actually do vote at the meeting.
■ (3) Fundamental corporate changes
■ (4) shareholders may vote to approve an interested director
transaction
■ (5) voting on anything else
● Amending bylaws, etc.
● Traditional view followed in DE: Need a majority of the shares
present at the meeting
● Modern view (MBCA): majority of the shares that actually vote
on that issue
Cumulative voting
○ Used when the shareholders vote to elect directors (that’s the only time). When
the shareholders elect directors: we either use straight voting or cumulative
voting
○ Hypo: 2 shareholders, A holds 101, B holds 100. At a shareholder meeting, they
are electing 3 directors to the board.
■ Straight voting: three separate elections at that meeting. For seat #1 on
the board, there is a separate election on that. A gets 101 votes, B holds
100 votes. A will win 101 to 100. On seat 2: same result. On seat 3, same
result.
■ Cumulative voting: do not have 3 separate elections, just one. The three
top finishers are elected to the board. Multiply the number of shares X the
number of directors to be elected. So A has 303 votes. B has 300 votes.
Can take three seats worth of voting onto just one person if they want.
●
■
Helps smaller shareholders to get some representation on the
board
In most states, cumulative voting is only a thing if it is in the articles. If the
articles are silent, we don’t use them.
TOPIC 2: SHAREHOLDER MANAGEMENT OF THE CORPORATION
●
●
●
●
●
●
Generally, shareholders don’t have management authority
However, shareholders can manage the corporation directly in a close corporation
Closely held corporation: one that has few shareholders and the stock is not publicly
traded. No public market for the stock
○ Can run it just like other corporations, or can run it differently:
In the close corporation, can set up management in a far more informal way by entering
a shareholder management agreement
○ Shareholder management agreement: the shareholders can take over
management of the corporation. They can even do away with the board.
○ Provisions vary: but
■ MBCA 7.32: requires that shareholder management agreements
must be in writing.
● In some states they must be in the articles. And even if they
are in the articles, they must also be approved in writing by
all shareholders.
■ MBCA 7.32: OR you can set up a shareholder management
agreement even if it’s not in the articles as long as we have
unanimous shareholder written agreement
Under a shareholder management agreement: can abolish the board of directors
and allow the shareholders to run the corporation, or can hire a third party
manager to run the corporation.
NOTE: the people who actually do manage the corporation under the shareholder
management agreement owe the fiduciary duties to the corporation. They owe the
same duties, duty of good faith, duty of loyalty, duty of care, that fiduciaries owe
in any business.
TOPIC 3: DUTIES OF CONTROLLING SHAREHOLDERS
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Shareholders can take over management and if they do, they owe the fiduciary duties to
the corporation
But this is a different duty
This is a duty owed by controlling shareholders to the minority shareholders.
○ Breach of this duty gives rise to a direct action for harm to those other
shareholders.
Almost always comes up in a close corporation, but can arise in a public corporation
Duty of utmost good faith
●
○ Comes from partnership law Ex. three shareholders, A, B, and C. Each owns ⅓ of the stock, each has a job with the
corporation. There is a falling out. A and B don’t like C anymore. A and B vote to fire C
from his job so C no longer has employment with the corporation. They refuse to have
the corporation to give dividends, so C is not getting dividends. And A and B also refuse
to have the corporation buy C’s stock. So C is stuck with this stock. In a public
corporation, could just sell the stock publicly.
○ In these situations, many courts will allow C to sue A and B for shareholder
oppression
■ Where C has been frozen out with no voice, no job, no return on
investment. A and B have oppressed C. and this is a breach of the duty
of utmost good faith.
○ Donahue and Wilkes
■ They let C sue A and B because they “thwarted C’s legitimate interests
for investing in the corporation.”
○ This is the case in MA, but not all states recognize a cause of action.
○ In some of those states, the oppressed minority shareholder may be able to
seek involuntary dissolution
TOPIC 4: LIABILITY OF THE SHAREHOLDER FOR CORPORATE DEBT
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In the corporation there is limited liability so shareholders aren’t liable for corporate debt
●
HOWEVER: there are circumstances where a court will allow a third party to sue the
shareholders for the corporate debt → piercing the corporate veil
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Piercing the corporate veil occurs ONLY IN CLOSELY HELD CORPORATIONS.
Policy: if you want the benefits of having the corporation (limited liability), you must take
the corporation seriously. That means you must capitalize it sufficiently.
○ At the outset, the shareholders must invest enough money to cover
prospective liabilities (enough capitalization).
○ Must treat the corporation with some respect (go through all the motions of
running the corporation by the book). If you do not, a court may say that
you are treating that corporation as your alter ego (that you’re not
respecting the corporate form)
■ Appoint officers,
■ Shareholders meetings
■ Directors meetings
■ Minutes of the meetings
■ Records
Piercing the corporate veil: court ignores the corporate form and imposes liability
on the shareholders who are responsible for it.
○ Courts tend to think that being sloppy with corporate formalities is not
enough.
●
Hypo: shareholders set up a corporation that is involved in a dangerous activity (bungie
jumping). But the shareholders invest very little money, only capitalize it with $1k, and
fail to buy insurance. Then they fail to run the business with the corporate formalities. No
meetings, no books, no officers, no records. Plaintiff is injured bungie jumping with this
corporation. The plaintiff wants to sue the corporation, but the corp has no money. So he
wants to go after the responsible shareholders, the ones responsible for not capitalizing
and not using corporate formalities.
○ There is a strong argument for piercing. The shareholders have been acting as
though there’s no corporation there, they’ve been running the business in
essentially their individual capacity.
TOPIC 5: SHAREHOLDER DERIVATIVE ACTIONS
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Everytime a shareholder sues (when a shareholder is acting a plaintiff), question #1 is
always: whether this is a direct suit or a derivative suit.
If direct suit: that plaintiff shareholder is suing to vindicate her rights as a
shareholder
○ Its just regular litigation, no special prerequisites
If derivative suit: she (shareholder) is suing to vindicate the corporation’s rights
○ Many procedural hoops to jump through
To determine whether direct suit or derivative suit:
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ASK: COULD THE CORPORATION HAVE BROUGHT THIS SUIT?
○ If the corporation could have brought this suit: it is a derivative suit
because we are vindicating the corporation’s claims
○ If the corporation could not have brought this suit: it is a direct suit
Hypo: plaintiff shareholder sues to force the corporation to declare dividends
○
Could the corporation have brought this suit? → NO, this is personal to the
shareholder, so it is a direct suit. The shareholder is trying to get dividends into
her own pocket. She is not vindicating any claim by the corporation.
●
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Hypo: plaintiff shareholder is suing because the corporation has failed to recognize her
preemptive rights, so she sues to enforce preemptive rights
○ This is a direct suit.
Hypo: plaintiff shareholder sues the board of directors for breaching duty of good faith,
duty of care, or duty of loyalty
○ these^ are always derivative cases. Because the corporation could bring
this suit because those duties are owed to the corporation, not to the
shareholders. So breach of those duties harms the corporation.
Procedural rules for derivative rules
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(1) Standing: to have standing, the plaintiff must have owned stock when the
claim arose, OR she must have gotten it by operation of law from someone who
did know it then.
○ Operation of law:
■ Ex. inheritance
(2) Plaintiff must also show that she will adequately represent the corporation’s
interest in the suit.
○ Probably means that she should own stock all the way through the case
○ Will have to demonstrate that she and her lawyer will be able to handle this
litigation
(3) the shareholder must make a written demand on the directors that the
corporation bring suit.
○ Whether to have the corporation sue is a management decision and
management is normally before the board. So plaintiff must go to the managers,
make a written demand that they sue on behalf of the corporation
○ Under MBCA: the shareholder must ALWAYS make this demand on
directors.
○ Under MBCA: generally plaintiff cannot sue until 90 days after making this
demand on the directors.
■ Could do it earlier if the demand is rejected in the meantime, or if waiting
will cause irreparable harm to the corporation
○ Under non model states and DE: shareholder need not make the demand if
it would be futile to do so.
■ Often it will be futile to make the demand because often this case will be
against those very directors.
(4) We cannot settle or voluntarily dismiss a derivative suit without court approval.
The court must give the okay.
If the shareholder brings a shareholder derivative suit and wins:
○ The corporation gets the judgment, not the shareholder
○ The shareholders usually recovers her litigation costs from the defendant,
and recovers her attorneys fees from the corporation.
If the shareholder brings a derivative suit and loses:
○ The shareholder will bear her own costs and attorneys’ fees.
○ The court may order the shareholder to cover the defendant’s attorney’s fees if
the suit was brought without reasonable purpose
○ Once this suit has been brought and lost, no other shareholders can sue on
behalf of the corporation for that claim (claim precluded)
After a shareholder files a derivative suit, the corporation will likely move to dismiss:
● Most times on the basis that the suit is not in the corporation’s best interests
(perhaps that the cost will exceed the benefits, or it has a low chance of winning)
○ That conclusion must be made by independent directors, and they must
undertake a reasonable investigation. (often called a special litigation
committee)
● UNDER MBCA: all the court will look at on this motion to dismiss for the case not
being in the corporation’s best interests: is whether (1) the people who
investigated were independent directors, and (2) whether they made a reasonable
investigation
○ Under MBCA: If there are no independent directors, the court can appoint a
panel of independent people
● In some states (DE):
○ The court looks at (1) the people who investigated were independent
directors, and (2) whether they made a reasonable investigation AND (3)
will then make its own independent determination of weather the suit is in
the corporation’s best interests. Zapata.
TOPIC 6: INSPECTION RIGHTS
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Shareholders have a right to inspect and copy corporate records
Model Act: bifurcates the kind of records into categories
○ (1) for routine things (shareholders minutes, bylaws, list of officers
directors…):
■ any shareholder can inspect those things. She must make a written
demand at least 5 business days in advance. Does not have to state
a purpose.
○ (2) More sensitive documents (financial records, minutes from the board of
directors meeting, list of shareholders):
■ Any shareholder makes a written demand at least 5 business days in
advance, but the demand MUST state a proper purpose.
● PROPER PURPOSE: a purpose that’s reasonably related to
your interest as a shareholder.
○ Ex. wanting to look at the books and records to ferret out
wrongdoing by directors and officers so the shareholder
can bring a derivative suit.
○ Ex. shareholder in a closed corporation wants to know
what her stock is with, so she wants to get access to
financial records
Note: directors are managers and thus have access to the books and records
TOPIC 7: PREEMPTIVE RIGHTS
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Hypo: shareholder in a corporations worries about dilution of their ownership. That
shareholder owns 25 percent of the stock in a closed corporation. Now the board
decides that the corporation will issue new stock. If that is issued to someone else, that
shareholder’s interest in the corporation is diluted: the shareholder’s voting power and
percentage of financial stake go down.
○ How to protect himself from dilution: Preemptive right:
Preemptive right: the right to maintain your percentage of ownership by buying
stock when there’s a new issuance of stock for money. (and the articles must say
so)
○ Hypo above: shareholder owns 25 percent of the stock. The company is now
issuing 1,000 more shares. If the shareholder has preemptive rights, then that
shareholder has the right to buy 250 of those 1,000 shares. It is a right to
maintain that percentage by buying that percentage.
In most states:
○ You get preemptive rights only if the issuance of stock is for money
■ Ex. say the corporation is issuing shares of stock in exchange for real
property: shareholder won’t get preemptive rights.
○ Also, in most states, you get preemptive rights only if the articles say so.
TOPIC 8: STOCK TRANSFER RESTRICTIONS
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Comes up more in the close corporation
Note: in a partnership, generally can’t add new partners unless all the partners agree.
In a corporation:
○ If the person owns stock, they can sell it to someone else. But sometimes the
corporation wants to keep outsiders out – how to do this? Stock transfer
restriction
Stock transfer restriction:
○ Set up in the articles OR can be an agreement between the corporation and
the shareholder, OR just an agreement among the shareholders
○ Essentially imposes restrictions on the transfer of stock
■ Main example: Right of first refusal:
Right of first refusal: before the shareholder can transfer their stock to a third
party, they must offer it first to the corporation
RULE:
○ Stock transfer restrictions are okay if they are reasonable
■ Reasonable = not an undue restraint on alienation
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Right of first refusal is reasonable because it is not an undue
restraint, because the corporation isn’t telling the shareholders that
they can’t tell their stock, or that they must sell it for a penny.
If there is a stock transfer restriction and a shareholder transfers stock in violation
of the restriction:
○ Can we sue the third party transferee to have that transfer set aside?
■ The stock transfer restriction is enforceable against a third party
only if the restriction is noted conspicuously on the stock
certificates OR if that third party had actual knowledge of the
restriction.
MODULE 6: FUNDAMENTAL CORPORATE CHANGES
TOPIC 1: BACKGROUND
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Most decisions in the life of the corporation are made by the board of directors, not the
shareholders.
However, some changes (fundamental corporate changes) to the corporation that are so
fundamental and organic that they cannot be done by the board alone. They require
shareholder votes as well. (require approval by the board and the shareholders)
5 Fundamental Corporate Changes
1. Amending the articles:
2. Selling off substantially all assets
3. Merging into another corporation
a. If merged, it is gone
4. Converting to another business form
a. Corp can convert into a partnership or limited liability company
5. Dissolution
TOPIC 2: PROCEDURE FOR FUNDAMENTAL CHANGES
‘In general, any of the four fundamental changes requires four steps
1. Board of directors adopts a resolution of fundamental change
2. The board submits a proposal to the shareholders with written notice of the
change
3. Board calls a special meeting of the shareholders who must approve the changes
4. The corporation must file a document with the appropriate state agency
a. Usually the secretary of state
Step 3: Board calls a special meeting of the shareholders who must approve the changes
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Everytime we have a meeting of any group, there must be a quorum.
○ For shareholders: must have a majority of the outstanding shares
What vote is required / what level of approval is required? (3 approaches)
○ (1): Traditional approach: the change must be approved by 2 / 3 of the
shares entitled to vote (not 2 / 3 of shares who did vote) (TX, MA)
○ (2) Delaware approach: the change must be approved by a majority of the
shares entitled to vote
○ (3) Modern approach (MBCA 7.25(c): it must be approved by a majority of
the shares that actually vote
●
Hypo: corporation has 9k outstanding shares. At the meeting to consider the
fundamental corporate shares, 7k attend. That gives us a quorum (would need 4,501).
What vote is required?
○ Under traditional approach, at least 6k shares should need to vote yes.
○ Delaware approach: at least 4,501 must vote yes
○ Under model act approach: say that there at 7k shares present at the meeting,
but only 6k vote on them, would only need 3,001
TOPIC 3: RIGHT OF APPRAISAL
If we have a shareholder that does not like this fundamental change.
● Statutes in every state provide a remedy called the right of appraisal
● Right of appraisal: the right to force the corporation to buy your stock for fair
value
○ The right of appraisal applies ONLY in CLOSE corporations, not in publicly
traded corporations
■ In public corporations, can just sell your stock on the public market
○ Only some fundamental changes will trigger the right of appraisal:
■ (1) right is triggered if the corporation is merging into another
company
■ (2) right is triggered if the corporation is selling off substantially all
its assets
■ (3) having its stock acquired in a stock exchange
■ (4) if it’s converting into another form of business
■ States differ on whether an amendment of the articles triggers the
right of appraisal:
● States that do allow the amendment of the article to trigger
the right of appraisal allow it only if the amendment hurts you
○ Ex. the amendment takes away your dividend preference.
Assuming the corporation is doing one of the things that triggers the right of appraisal: How
does the shareholder perfect it? (3 steps)
● 1. Before the shareholders vote, you file with the corporation a written objection
and notice of your intent to demand payment
● 2. Shareholder must abstain or vote against the proposed change
● 3. After the vote (after it was approved by shareholders): you make a written
demand to be bought out and deposit your stock with the corporation
What happens after?
● The corporation either pays you your demand OR the corporation and the shareholder
disagree (on price)
○
If the corporation and shareholder disagree → litigation of what is the fair value of
the stock (most time brought by the corporation).
○
■ Court can appoint an appraiser
Is the right of appraisal the sole remedy for a shareholder if he is against
the fundamental corporate change?
■ YES, unless you can show fraud
TOPIC 4: WALK THROUGH FUNDAMENTAL CHANGES
Note: for every one of these, we are going to have to go through procedure in step 2.
A. Fundamental Corporate change 1: Amending the Articles
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(1) go through the procedure in step 2 above.
(2) if it is approved, we deliver amended articles to the secretary of state
○ Make sure you know if the state offers a right of appraisal for amending the
articles
B. Fundamental Corporate Change 2: Mergers
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In a merger, 2 or more corporations combine and usually one of them will survive the
merger.
Merger is always a fundamental corporate change for the company that
disappears.
○ So if company A disappears, that company must go through the procedures in
section 2.
○ In some states in very rare circumstances, it can be a fundamental corporate
change for the survivor
○ That means the disappearing company must go through all the steps in section
(2), and if it is approved, the surviving corporation will deliver articles of merger to
the secretary of state
■ If its a close corp, the shareholders of the disappearing corporation will
have the right of appraisal.
Consolidation: 2 corporations go into it and both disappear into a third company
which is now created.
○ That would be a fundamental corporate change for both companies
What is the effect of a consolidation or merger?
● Successor liability: The surviving corporation succeeds to all rights and liabilities
of the disappearing corporation
○
A corporation is gone and has disappeared. If you are a creditor of the
disappearing corporation, you are now a creditor of the surviving corporation.
C. TRANSFER OF SUBSTANTIALLY ALL THE ASSETS
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Rule of thumb is that “substantially all the assets” means a company is selling off
at least 75 percent of its assets
○ Does not have to be a sale: can be a transfer… but transfer normally means
sale. If only leasing them, that’s probably not a fundamental corporate change.
This sale of substantially all your assets must be NOT in the ORDINARY Course of
BUSINESS
○ Very few companies are actually in the business of selling off all their business
■ Exception: real estate companies selling off all their assets … that is not
going to be a fundamental corporate change.
Transfer of substantially all the assets is a fundamental corporate change for
ONLY the corporation selling off all of its assets. It is not a fundamental change
for the buyer.
○ The selling corporation must go through the procedure in section (2) of this
module. The buying corporation does not.
The sale of assets generally, no filing is required with the state.
○ If it is a close corporation the sale of substantially all assets will trigger the
right of appraisal for the shareholders of the SELLING corporation, not for
the buying corporation. (because it’s not a fundamental corporate change)
In the sale of assets, WE DO NOT EXPECT SUCCESSOR LIABILITY. (different from
the merger)
○ In the merger, the surviving company the surviving does get the liabilities of the
company that disappeared. But in the sale of assets, the company that buys up
assets does NOT get the liabilities of the selling company. Because the selling
company has not disappeared and is flush with cash. The creditor can just sue
that company
Share exchange: not clear that these are used much. They work exactly like the
sale of substantially all the assets. Except here, the company is buying up the
stock of the selling corporation, not the assets.
○ This is a fundamental change only for the company that’s selling off all its
stock.
○ The selling corporation must go through the steps in section 2.
○ The acquiring company will file articles of exchange with the secretary of state
D. CONVERSION INTO A NEW CORPORATE FORM
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Historically, you could not do this in one step. You had to dissolve the corporation, and
then the proprietors had to start a new business in the new form
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NOW MBCA 9.50 through 8.56: corporation can simply convert (ENTITY
CONVERSION)
This is a fundamental corporate change, so the company must go through the
procedure in section 2. And if it is a close corporation, the shareholders have the
right of appraisal
○ The new business delivers articles of conversion to the secretary of state
for filing.
TOPIC 5: DISSOLUTION AND LIQUIDATION
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Dissolution hand liquidation is the ultimate fundamental corporate change. The
company is going out of business.
There will be an event that triggers that dissolution.
○ NOTE: dissolution is a process, not an event.
Because this dissolution will end the corporate existence and the shareholders
will get a distribution of any assets left over after paying off creditors, there is NO
right of appraisal here.
Ways to dissolve
1. Administrative dissolution: allows a state official (maybe secretary of state)
simply to declare that the corporation is dissolved
a. Usually because the corporation is not paying its taxes to the state
2. Voluntary dissolution
3. Involuntary dissolution
Voluntary dissolution:
● Done exactly the same as every other fundamental corporate change above, so
must go through the process in section 2 of this module
● If it is approved, the corporation delivers a document called notice of intent to
dissolve to the secretary of state for filing AND the corporation will also notify its
creditors so they can make claims.
○ That does not end the corporate existence. It merely triggers the
dissolution and the liquidation process.
Involuntary dissolution
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Involuntary dissolution: Judicial dissolution. Someone goes into court and asks
the court to enter an order ending this corporation.
Who can ask? (states vary)
○ Most states allow creditors to ask for involuntary dissolution IF (1) they
have a corporation that is insolvent and (2) the creditor has a judgment
against the corporation
When can a shareholder ask for involuntary dissolution:
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Almost always: the shareholder petition is going to be in a close
corporation.
○ MBCA 14.30: The shareholder petition is available only in the close
corporation.
Why would a shareholder petition for this?
○ In most statutes, shareholders of a corporation can ask for involuntary
judicial dissolution IF (1) the directors are engaged in illegal, fraudulent or
oppressive behavior
■ When it does, a shareholder may be able to ask. The decision of whether
to do this is up to the court.
■ Sometimes, when there is a petition such as this by one of the
shareholders, the court will say, instead of ordering dissolution,
going to order the corporation to buy out the complaining
shareholder
● Good in close corporations
Whether voluntary or involuntary dissolution, the corporation must liquidate, (wind up)
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voluntary dissolution: board oversees the wind up process.
Involuntary dissolution: the court will probably appoint a receiver to oversee the
process
Process of winding up:
1. Gather all assets (everything of the corporation)
2. Convert all assets into cash
3. Pay creditors
4. Distribute any remaining funds to the shareholders.
So creditors are paid before shareholders.
●
The money that go to shareholders after paying off creditors (if any) is called a
LIQUIDATING DISTRIBUTION
●
Ex. $10k left after paying off creditors, 1k shares of common stock → each share gets
$10 per share.
○
BUT, might have a class of stock set up in the articles that have a liquidation
preference:
■ Hypo $10k left over after paying creditors and 1k shares with a liquidation
preference with $2 per share, the first $2k goes to them. The rest then
goes to the common shares
When winding up is wrapped up
● Going to file articles of dissolution with the state, deliver those to the state. That
terminates the existence of the corporation.
SLIDES
Assignment 1
What State Law Governs?
Internal affairs doctrine:
Internal Affairs = law of the state of incorporated governs (no matter where sued)
● Voting Rights
● Officer Rights/Liabilities
● Director Rights/Liabilities
● Shareholder Rights/Liabilities
● Distributions
● Indemnifications
● Mergers
● Power Limitations
● Derivative Litigation
External Affairs = law of the state where sued governs
● Taxes
● Antitrust
● Employment
● Environmental
● Securities
● Intellectual Property
● Consumer Protection
● Contracts / Torts
● All Else
Organization Documents:
Articles / certificate of incorporation
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Content dictated by applicable statute
○ MBCA §2.02: (a) specifies what must be included (mandatory provisions); (b)
specifies what may be included (optional provisions)
○ DGCL §102: (a) specifies mandatory provisions; (b) specifies optional provisions
Requirements of what must be in the articles: Section 2.02(a) of model act.
○ Name of the corporation
■ Must have one of the 4 magic words in the corporate names
● Corporation, company, incorporated, limited
○ Name and address of each incorporator
○ Give name of our registered agent and the address of the registered office.
■ Address of registered office must be in the state of incorporation
■ Registered agent is the official legal representative of the corporation
● E.g. she can receive service of process, or tax docs from the state
○ Information about our stock
■ The corp issues stock, and the articles must tell the state the number of
shares that the corporation will be authorized to sell / issue.
■ In most states if you’re going to have different classes of stock, must give
info about those stocks
■ Might have par stock or no par stock, dividend stock…
What may be included (optional provisions): MBCA 2.02(b)
○ Exculpation provision
○ Names of initial directors
Other things needed to Begin
● FIRST: Naming directors (unless the directors are named in the articles)
○ How? Named in Articles or elected by incorporators
● Directors then:
○ Elect officers (handle day to day affairs and report back to directors)
○ Adopt bylaws
■ Corporate governance stuff! Typically govern things like conduct of
shareholder meetings, the powers of various officers and so on
■ Easier to amend than articles
○ Authorize sale of shares
■ Ch 15
○ Designate a corporate bank account
Default Organizational Structure:
3 levels of control:
1. Shareholders (“sh” or “s/h”)
2. Board of Directors (“BoD” or “board” or “directors”)
a. Can have as many or as little as it chooses
3. Officers
a. and can have as many or as little as it chooses
Pre-Incorporation Contracts
● Promoter: Person(s) who get the business up and running
● Before there is a corp, someone typically takes actions to set it up
○ Hire people, enter leases, buy equipment, ect.
○ Who is responsible for these obligations?
● Incorporator vs. promoter
When is the corporation liable on Promoters’ Contracts?
● McArthur v. Times Printing Co.,
○ Why? Adoption (does not relate back) vs. ratification (relates back)
Who is liable on the contract on pre-incorporation contracts?
● Hypo: Paula is a promoter for a corporation not yet formed. Paula is planned to form
Paula Inc. but there is land available for lease now… so paula signs the lease on behalf
of Paula Inc. (not yet formed). Everyone knows the corp is not yet formed. The lease
gets entered, and a week later, the corp gets formed.
● Is the corporation liable on that lease?
○ No, merely by coming into existence that corporation is not automatically liable
on these pre-incorporation contracts.
○ Rule: The corporation is not liable on pre-incorporation contracts until it
adopts the contract. The corporation must do something to adopt the
contract. Adoption can be expressed or implied
■ Express adoption: ex. The board of directors has a meeting and agrees
that the corporation will adopt the contract. From that moment on the
corporation is a party to the contract and is liable
■ Implied adoption: if the corporation accepts a benefit under that
contract.
● Ex. corporation is formed and moves into those premises. At that
moment, there is an implied adoption of the contract, and the
corporation is liable on the contract.
●
Promoter’s liability
○ Promoter is personally liable on the lease. She entered a contract on behalf of a
non-existent corporation. Thus, she acted on behalf of a non-existent principal,
which means she is a party to the contract. She is personally liable on the
contract.
■ That is true even if the corporation is never formed.
○ If the corporation gets formed and adopts the contract: The promoter is still
liable under pre-incorporation contracts until there is a novation.
■ Novation: an agreement between the promoter, the corporation, and the
lessee (or other party to the contract) that the corporation replaces the
promoter under the contract.
When is a Principal Bound?
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A principal is bound to a contract made by an agent on its behalf if the agent acted with:
○ actual authority, or
○ apparent authority.
A party may be bound to a contract made on its behalf under the doctrine of
○ estoppel,
○ inherent agency power, or
○ ratification.
When Is a Promoter Liable
● Restatement (Third) of Agency § 6.04 pg. 404 Principal Does Not Exist or Lacks
Capacity
○ Unless the third party agrees otherwise, a person who makes a contract with a
third party purportedly as an agent on behalf of a principal becomes a party to
the contract if the purported agent knows or has reason to know that the
purported principal does not exist or lacks capacity to be a party to a contract.
● MBCA §2.04 (later) LIABILITY FOR PREINCORPORATION TRANSACTIONS
○ All persons purporting to act as or on behalf of a corporation, knowing there was
no incorporation under this Act, are jointly and severally liable for all liabilities
created while so acting
● Does this apply even if the other parties know no corporation exists yet?
Corporation Liability on Pre-Incorporation Contracts
● General rule: Corporation is not liable unless it adopts (or ratifies) the contract
● Unless the third party agrees, in advance, to the contrary, the promoter will normally be
liable on a contract entered into prior to the formation of the corporation, even if she
purports only to act for the corporation, and will remain personally liable unless there is a
novation.
○ Novation: an agreement in which two parties to a contract agree that some third
person will take over responsibility for one of the original 2 and release that party
from liability
○ In practice: once Corp formed, Corp can adopt the contract and enter novation
agreement releasing promoter
● Promoter remains liable unless the other party to the contract agrees to discharge the
promoter
Defective Incorporation
● Defective Incorporation: a business that thinks it has incorporated but has not
● General rule:
○ Signer of contract on behalf of defective corporation is personally liable on the
contract per agency law
○ Owners of the business are personally liable on the contract per partnership law
● Exceptions:
○ De facto corporation
○ Corporation by estoppel
Liabilities resulting from Defective Incorporation
MBCA § 2.03 INCORPORATION
● (a) Unless a delayed effective date is specified, the corporate existence begins when the
articles of incorporation are filed.
● (b) The secretary of state’s filing of the articles of incorporation is conclusive proof that
the incorporators satisfied all conditions precedent to incorporation except in a
proceeding by the state to cancel or revoke the incorporation or involuntarily dissolve the
corporation. – what is the effect?
MBCA § 2.04 . LIABILITY FOR PREINCORPORATION TRANSACTIONS
● All persons purporting to act as or on behalf of a corporation, knowing there was no
incorporation under this Act, are jointly and severally liable for all liabilities created while
so acting.– what is the effect?
Liabilities Resulting from Defective Incorporation
● Robertson v. Levy
● Timberline Equipment Co, v. Davenport
● MBCA 2.04
●
→ Plaintiff knows corporation not formed; defendant knows corporation not
formed – is the promoter liable?
○ YES, because of the rule that an agent for a non-existent principal is liable
unless there is an agreement to the contrary
●
→ Plaintiff does NOT know corporation is formed; Defendant KNOWS corporation NOT
formed. Is promoter liable?
○
●
Yes, because of §2.04.
→ Plaintiff KNOWS corporation is not formed defendant does not know corporation not
formed. Is Promoter Liable?
○
●
NO, because of §2.04
→ Plaintiff does not know corporation not formed; defendant does not know corporation
not formed. Is the promoter liable?
○
NO, because of §2.04
De Facto Incorporation
1. There is a law under which a corporation with the power assumed might be
incorporated;
2. There has been a bona fide attempt to organize a corporation in the manner prescribed
by the statute; and
3. There has been an actual exercise of corporate powers.
Corporation by Estoppel
●
●
If a party contracts and deals with an entity as a corporation, estopped to deny its
incorporation
Manifests parties’ intent
Court really saying: It would be unfair for a person to do business with a company as if it were a
corp. and then try to act like its not in later litigation
What is “corporation by estoppel” really? Think back to 1st year contracts…
ASSIGNMENT 2:
CH. 14: PURPOSE
Purpose, Power, and the Doctrine of Ultra Vires
● Terminology
○ “Charters”: Articles of Incorporation - document needed to become a corporation
■ Charters closely circumscribed both corporate purpose and the powers
that corporations could exercise in achieving them
● Ultra Vires: Acts outside the power of the corporation – which are legally unenforceable
because they have no legal power to do so.
○ So, a power exercised outside the allowed powers in the charter
A.P. Smith MFG Co. v. Barlow
● Facts
○ Manufacturing corporation gave charitable donation to Princeton. Some
shareholders claimed this was ultra vires, outside the scope of the corporation's
power.
● Issue:
○ was the donation ultra vires?
● Holding:
○ No. Donation was within the common law powers and purpose of a corporation
○ Why: no suggestion it was made indiscriminately or in furtherance of personal
rather than corporate ends. Reasonable belief that the contribution would
advance the interest of the private corporation and the community in which it
operates. Additionally- within the expressed authority of state legislation
Purpose, Power, and Ultra Vires per the MBCA
3.01 Purpose
● (a) Every corporation incorporated under this Act has the purpose of engaging in any
lawful business unless a more limited purpose is set forth in the articles of incorporation.
3.02 General Powers
● Unless its articles of incorporation provide otherwise, every corporation has perpetual
duration and succession in its corporate name and has the same powers as an
individual to do all things necessary or convenient to carry out its business and affairs. . .
[goes on to enumerate a number of examples, including power to make donations for the
public welfare or for charitable, scientific, or educational purposes.] GO SEE
3.04 Ultra Vires
● (a) Except as provided in subsection (b), the validity of corporate action may not be
challenged on the ground that the corporation lacks or lacked power to act.
● (b) A corporation’s power to act may be challenged:
○ 1. in a proceeding by a shareholder against the corporation to enjoin the act;
○ 2. in a proceeding by the corporation, directly, derivatively, or through a receiver,
trustee, or other legal representative, against an incumbent or former director,
officer, employee, or agent of the corporation; or
●
○ 3. in a proceeding by the attorney general under section 14.30.
(c) In a shareholder’s proceeding under subsection (b)(1) to enjoin an unauthorized
corporate act, the court may enjoin or set aside the act, if equitable and if all affected
persons are parties to the proceeding, and may award damages for loss (other than
anticipated profits) suffered by the corporation or another party because of enjoining the
unauthorized act.
Questions and answers:
1. Could a corporation formed in an MBCA jurisdiction give away all of its assets?
ANSWER: Presumably not, as that would hardly be “necessary or convenient to carry out its
business and affairs,” as required as required §3.02, and in any event the act would require
shareholder approval under §12.02(a), which would seem not likely forthcoming.
2. Could a corporation formed in an MBCA jurisdiction enter into a contract to pay an
employee less than the legal minimum wage?
ANSWER: The corporation has “power” to do the act despite its illegality, just as do individuals,
who are capable of committing crimes and acting illegally. The wage would still be illegal and
subject to redress.
3. Suppose Glenda has invested in Monstro, Inc., a corporation formed in a state following
the MBCA. Glenda discovers Monstro has given a very large gift to Princeton University.
Assume, further, that a majority of the directors, as well as many of their children, are
graduates of Princeton. Does Glenda have any legal complaint?
ANSWER: Not really. The A.P. Smith Mfg. Co. case has explained that charity donations are
within the Board’s discretion and cannot be challenged based on ultra vires. However, here,
Glenda may argue that because the majority of the directors are Princeton graduates, there may
be some conflicts of interest. But, because the Board has broad discretion on charity donations,
this argument may not work.
ASSIGNMENT 3: CORPORATE POWER AND PURPOSE CONTINUED
Corporate Purpose
● Sufficient MBCA 3.01 Purpose
○ Every corporation incorporated under this Act has the purpose of engaging in any
lawful business unless a more limited purpose is set forth in the articles of
incorporation
The common law of corporate purpose
● What it means for a corporation's fiduciaries to make decisions “in the best interest of the
corporation”
● Corporation must make decisions on behalf of the company in the best interest of the
company
Dodge v. Ford
Questions
What does this have to do with the statutes providing that corporations can be formed for any
lawful purpose?
● The common law of corporate purpose puts an important constraint on corporate
behavior, even if the charter puts no limits on the corporation’s purpose. For whatever
purpose the corporation is engaged, its management must nevertheless act in the best
interests of the corporation, which generally means roughly in the long-term financial
best interests of the shareholders.
How does this work with corporate powers and their ability to give to charities?
Corporate Purpose
● MCBA § 2.02. Articles of Incorporation:
○ (b) The articles of incorporation may set forth:
■ (1) the names and addresses of the individuals who are to serve as the
initial directors;
■ (2) provisions not inconsistent with law regarding:
● (i) the purpose or purposes for which the corporation is
organized;
● MCBA§3.01. Purpose
○ Every corporation incorporated under this Act has the purpose of engaging in
any lawful business unless a more limited purpose is set forth in the
articles of incorporation.
Burwell v. Hobby Lobby Stores, Inc.
ASSIGNMENT 4: SHARES, SHAREHOLDERS, AND CORPORATE DEBT
Raising External Funding
2 major ways to raise money for a corporation:
1. Issuance of stock– Equity= ownership
2. Issuing Debt – borrowing/liability
** “security” is a corporate stock – stock is always a security. However, not all securities are
stock. There are other types of “securities” – ex: debt securities- which we will discuss
Issuance of Stock - §6.21 Issuance of Shares
● Closely held
○ Sells shares upon its formation to s small group
■ Simple contractual sale- shares of stock are issued in exchange for
immediately delivered consideration (cash, promissory note, tangible or
intangible property, agreement for service)
● Publicly traded
○ Public offering – sells shares to the public at large
○ Triggers ongoing obligations under federal securities law
○ IPO- initial public offering – requires “underwriter” – investment bank, advises the
issuing corporation how to structure and price and aids in distribution
Types of Shares
● If there is more than one class of stock, the articles must authorize each class and
define their terms. §6.01
● There are several possible types, but 2 main types:
○ 1. Common stock:
○ 2. Preferred stock
Types of Shares:
● Common Stock:
○ with voting rights and a right to receive residual proceeds upon dissolution and
liquidation; no entitlement to dividends unless declared
○ Dividends at the discretion of the board of directors
● Preferred Stock
○ Usually without voting rights
○ Dividend preference of a fixed amount each year if the Board declares dividends
at all
■ “Preference” is the preferred stockholder’s dividend/distribution
■ Dividend preferences must be satisfied before common shareholders
receive distributions
■ Dividend preferences can be either cumulative or non-cumulative
●
○
○
Cumulative: each year the corporation fails to pay preference, it
will be added to the next year’s
● Non-cumulative: if dividend is not declared in a given year, lose
right to receive it
Liquidation preference: preferred stock will receive a fixed sum per share after
paying off creditors and before common stockholders receive any share
Resembles a “debt”- often issued for a term of years and the company can or
must redeem y corporation
Shareholder Rights & Obligations
● Distributions are ordinarily discretionary, and shareholders cannot force corporations to
pay them, but shareholders enjoy certain other enforceable rights
● However:
○ Distributions: shareholders cannot force the Board to make distributions unless
the Board acted in bad faith in withholding them
○ Preemptive rights: A right to acquire a proportional number of shares out of any
subsequent offering of the same class.
■ MBCA Default: Need to opt in in the Charter
○ Dilution: A right against unfair dilution
■ Dilution occurs when the value of a holder’s shares are reduced by the
sale of new shares for some lesser value
“Par Value”
● Par value: the minimum value for which shares can be sold by the corporation
○ Specified by the charter
○ No longer an issue in MBCA jurisdictions
○ May influence franchise tax in some jurisdictions
Limited Liability and Exceptions
● § 6.22. LIABILITY OF SHAREHOLDERS
○ Shareholders in a corporation enjoy limited liability. Unlike a sol proprietorship or
partners in a GP, shareholders cannot be required to contribute their own
personal assets for obligations of the corporation that the business itself cannot
cover.
● 2 situations where courts have held shareholders liable for the company debts:
○ Piercing the Corporate Veil: next assignment – but when the court decides for
equitable reasons to disregard the corporate entity
○ “Watered stock” liability: If shareholders paid less than the par value for the
shares, they are responsible for the difference
Hanewald v. Bryan’s Inc.
● Holding: Keither and Joan are personally liable for the company’s unpaid debts up to the
value of their promised but unpaid consideration. This amount is popularly known as
●
“watered stock” liability. They never paid for their stock which (50 shares each at $1k par
value)
While a corporation may legitimately be organized to avoid personal liability, it is the
shareholders’ initial investment in the corporation that protects their personal assets from
future liability, not the mere act of forming a corporation or fixing the amount of its capital
stock. Under the Model Business Corporation Act (MBCA) (1969) § 25, in effect when
Bryan’s Inc. was incorporated, shareholders are required to pay for their shares
before their personal liability will be limited.
Gashwiler v. Willis
● Shareholders cannot make decisions relating to corporate management- even
unanimously- unless specifically authorized in a statute (or in articles of
incorporation)
● The statute authorizing the creation of mining corporations vests the corporation’s
powers in a Board of Trustees made up of shareholders. A majority of the Board must be
present, and a majority of those present must vote in favor of an act in order for the
corporation to take action. This is the procedure that must be followed in order for the
corporation to sell its property. The statute does not give shareholders the right to
authorize the sale of corporate property. In this case, the property belonged to Rawhide,
an entity created by statute. The stockholders had no right to sell the property, and the
fact that they acted collectively does not change that. Rawhide was only permitted to act
through the Board of Trustees. It is irrelevant that the trustees were present and voted in
the stockholders’ meeting, because the trustees were acting in their individual capacities
as corporate stockholders. Only when meeting and acting as a Board of Trustees did the
trustees have the statutory authority to cause the corporation to act.
Shareholder’s right to sue
● First thing to understand: Whether the corporation should bring a lawsuit is
ordinarily left to the discretion of the officers and directors.
● Direct claims
○ Shareholder directly harmed. If a shareholder is looking to assert a claim that the
corporation violated its duty to that shareholder, then he or she would file a direct
claim. The purpose of the claim is to seek damages for harm that occurred to the
shareholder as a result of the corporation’s violation of their duty.
● Derivative Suit
○ Corporation directly harmed. These are claims that belong to the corporation, but
are brought by a shareholder on behalf of the corporation because the
corporation’s management is either unwilling or unable to do so. It is an effective
method of taking action when a shareholder believes management should or
shouldn’t have done something.
Corporate Debt - Issuing Debt
● Issuing debt: company sells bonds to external investors.
○
●
●
●
A bond functions as a loan between an investor and a corporation. The investor
agrees to give the corporation a certain amount of money for a specific period of
time. In exchange, the investor receives periodic interest payments. When the
bond reaches its maturity date, the company repays the investor.
Private debt
○ From banks, private third-party lenders, or the Small Business Administration
Public issuance of debt – “debt securities”
○ Most common- Bonds: company sells bonds to external investors. A bond
functions as a loan between an investor and a corporation. The investor agrees
to give the corporation a certain amount of money for a specific period of time. In
exchange, the investor receives periodic interest payments. When the bond
reaches its maturity date, the company repays the investor.
Interest rates and the price of debt
Equity vs. Debt
● Debt: usually must be repaid, holders usually entitled to ongoing compensation, known
as “interest,” until the principle is fully paid. Interest paid is deductible for tax purposes.
○ One reason preferred stock resembles debt is because it is often issued for a
term of years and the company can or must redeem.
● Equity: usually not subject to repayment, sharing of profits is discretionary (BOD
decides), payments made to equity holders (such as dividends or other distributions) are
not tax deductible
Equity vs Debt
●
●
●
Basic strategy for capital structure
Distinction between equity and debt:
○ Equity: Riskier to investors than debt, but potentially more profitable
■ Think of the stock market
○ Debt: Less risky and return frequently is fixed
The concept of leverage
○ A company can earn returns that exceed the interest owed on debt
2nd corporations – Shares, Shareholders, and Corporate debt - Class 2
Equity Securities
● Equity Securities: an investment that represents ownership- we call these shares.
○ When a company is formed, it decides on the maximum number of shares it
would like to offer. These shares are referred to as authorized stock.
○ Authorized stock is the maximum number of shares that a corporation is legally
permitted to issue, as specified in its articles of incorporation
○
○
○
Private companies that want to raise capital may choose to sell shares to
investors through an initial public offering (IPO). As the name implies, an IPO
is the first time a company offers shares to the public. These are new securities
that are sold to investors on the primary market. The public can then sell it to
another investor on the secondary market (stock exchange for example)
Companies are not required to issue all of their authorized shares, in fact, most
do not. Rather, they issue some of their authorized shares. The number of
authorized shares the corporation has actually issued that are held by the public
are called outstanding shares.
By keeping some of the authorized shares, the company can offer and sell more
shares in the future (called a secondary offering) if it needs to raise additional
funds. The corporation can use the proceeds to fund its day-to-day operations,
make acquisitions, finance debt, or for other purposes.
Equity Securities (Cont.)
● For example, if a company has 1 million authorized shares, it might only sell 500,000 of
the shares during its initial public offering (IPO). The company might reserve 50,000 of
authorized stock as stock options to attract and retain employees. It might sell 150,000
more in a secondary offering to raise more money in the future.
●
● Real Example: On August 18, 2004, Alphabet's Google (GOOG) offered 14,142,135
shares of common stock at its initial public offering (IPO) price of $85.00 per share,
raising more than $1.168 billion for the company. One year later, on September 14,
2005, Google Inc. issued a follow-on public offering of 14,159,265 shares of common
stock at a price of $295.00 per share for an approximate total of $4.17 billion.
Debt Securities
● Debt Securities: an investment that involves a debt rather than ownership in a company.
●
● A debt security is a financial instrument issued by an entity and sold to an investor.
●
● A debt security represents a loan from the buyer to the issuer (the company) and it
represents an obligation for the investor to be paid back the face value plus interest
income as the instrument matures. A common example is when a corporation issues a
bond and sells it to investors.
●
● Essentially, the company sells a bond to an investor for X amount. The company
receives the full amount of X at the time of purchase. The bond will include an interest
rate and a certain date (maturity date) the company must pay back the X amount. In the
meantime, the company may pay periodic interest payments to the investor.
●
● The holder of the bond can simply collect the interest payments while waiting for the
bond to reach maturity
●
●
Unlike stocks, bonds issued by companies do not give ownership rights. The holder of a
bond does not necessarily benefit from the company's growth, but they are not impacted
when the company isn't doing as well, either—as long as it still has the resources to stay
current on its loans.
Hybrid securities – Preferred Stock
● Hybrid Securities: representing ownership in a company (like equity) but having fixed
payments (like bonds). Most common is preferred stock.
●
● Preferred stock offers consistent and regular payments in the form of dividends, which
resemble bond interest payments. However, unlike bonds, preferred stock is not debt
that must be repaid. Preferred stock also provides equity ownership. Thus, if the
company does well, there is a potential for the value of the preferred shares to increase.
Equity or Debt Securities
● Debt and equity capital both provide businesses with the money they need to maintain
their day-to-day operations. Equity capital tends to be more expensive for companies
and does not have a favorable tax treatment. Too much debt financing, however, can
lead to creditworthiness issues and increase the risk of default or bankruptcy.
Equity or Debt Securities?
● Why would a company use equity over debt?
○ Less burdensome- no loan to repay, no interest payments (especially important if
they have little profit), no collateral (company’s assets), No additional financial
burden on the company, investors typically are more interested in helping you
succeed than lenders are because the rewards can be substantial
● Why would a company use debt over equity?
○ Doesn’t provide ownership stake, does not dilute owner’s equity of control, don’t
need to share in profits. The interest rate that companies pay bond investors is
usually less than the interest rate available from banks, interest payments tax
deductible, once the debt is repaid it’s gone
Shareholder’s right to sue (intro)
● First thing to understand: Whether the corporation should bring a lawsuit is ordinarily left
to the discretion of the officers and directors.
●
● Direct claims
○ Shareholder directly harmed. If a shareholder is looking to assert a claim that the
corporation violated its duty to that shareholder, then he or she would file a direct
claim. The purpose of the claim is to seek damages for harm that occurred to the
shareholder as a result of the corporation’s violation of their duty.
●
●
Derivative Suit
○ Corporation directly harmed. These are claims that belong to the corporation, but
are brought by a shareholder on behalf of the corporation because the
corporation’s management is either unwilling or unable to do so. It is an effective
method of taking action when a shareholder believes management should or
shouldn’t have done something.
ASSIGNMENT 5: PIERCING THE VEIL (DAY 1)
The Corporate Veil
● The corporate veil is a legal concept that separates the personality of a corporation from
the personalities of its shareholders, and protects them from being personally liable for
the company’s debts and other obligations.
●
● Essentially, the corporate veil is the liability protection that owners, corporate officers,
and corporate shareholders receive when they form a limited liability company* or
corporation.
Piercing the corporate veil
● Doctrine used to “prevent fraud or to achieve equity”
●
● When the corporate veil is pierced, the owners (shareholders) of a corporation lose their
limited liability status that having a corporation provides them.
●
● When this happens, the owners/shareholders’ personal assets can be used to satisfy
business debts and liabilities.
●
● While we call it piercing the corporate veil, this doctrine is used in any case involving any
limited liability formed entity (i.e., LLC, LLP and all those other entities that have filed
with the state for limited liability protected)
Piercing the corporate veil
● Piercing the veil is appropriate where:
○ 1. defendant uses the corporation as a “mere instrumentality,”
○ 2. does so “to commit a fraud or other wrongdoing,” and
○ 3. the fraud results in “unjust loss or injury to plaintiff.”
Terms
● “Mere instrumentality”- we will take a look at this through the cases
●
● “Alter Ego”: when an individual treats a corporation as an instrumentality through which
he is conducting his personal business. When a corporation lacks a separate identity
from an individual or corporate shareholder.
●
● Undercapitalization: when a company does not have enough capital to conduct ordinary
business operations.
●
● Judgement proof: person who does not have enough assets for a creditor to seize when
a court order requires debt repayment. It likely means that they have no assets and no
job.
Baatz v. Arrow Bar (dram shop)
● 1. Individual Liability as Employees- Respondent Superior
○ Respondeat superior is unavailable because the only employees who served
drinks were employees of the incorporated bar, and while one of the named
defendants was herself the manager of the bar, the employee that served the
drinks was only her co-agent. piercing the veil is not available for lack of relevant
evidence.
● 2. Individual Liability by Piercing the Corporate Veil
○ A corporation shall be considered a separate legal entity until there is sufficient
reason to the contrary
○ When continued recognition of corporation would produce “injustices and
inequitable consequences” the court has sufficient reason to pierce the corporate
veil
● Factors that indicate “injustice and inequitable consequences:
○ Fraudulent representation by corporate directors
○ Undercapitalization
○ Failure to observe corporate formalities
○ Absence of corporate records
○ Payment by the corporation of individual obligations OR
○ Use of corporation to promote fraud, injustice, or illegalities
Baatz
a personal loan guarantee is a contract and does not affect tort liability. In addition,
personally guaranteeing a corporate obligation is the opposite of factor (5) listed above,
and as such supports recognition of the corporate entity. Finally, Baatz argues that the
corporate veil should be pierced because the corporation failed to observe corporate formalities,
noting that Arrow Bar’s signs and advertising did not indicate that it was a corporation. To the
contrary, the corporation has complied with statutory requirements. Even if it had failed to do so,
however, the occasional failure to follow all the required forms for conducting corporate
activities does not justify disregarding the corporate entity, especially where the claimed
defect and the resulting harm are unrelated. There is no evidence that the Neuroths
personally served McBride on the day of the accident, or any evidence that the Neuroths’
treatment of the corporation would produce the injustices and inequitable consequences
required to pierce the corporate veil
Walkovsky v. Carlton (taxi cab 10 corporations 2 cars each, plaintiff was injured by a cab)
If a corporation functions merely as an agent of its shareholder, courts will hold the principal
vicariously liable for the corporation’s conduct on the theory of respondeat superior. Rather, the
plaintiff must show that a shareholder used the corporation as his agent to conduct business in
an individual capacity. In this case, Seon Cab Company was undercapitalized and carried only
the bare minimum amount of insurance required by law. This is relevant, but it is not enough to
allow a plaintiff to pierce the veil. Instead, there must be some evidence that the owners
themselves were merely using the company as a shell.
PIERCING THE VEIL DAY 2
Piercing the Corporate Veil - Who can be held liable?
● Shareholders
● And others?
Freeman v. Complex Computing Co.
To pierce the corporate veil under New York law, one must prove that shareholder
dominated and controlled the corporation and that the control was used to commit a
fraud or other wrong. New York has recognized the equitable ownership doctrine for veilpiercing purposes. Under this doctrine, a non-shareholder defendant who exercises
sufficient control over a corporation may be deemed an "equitable owner" of the
corporation. However, domination and control alone are not sufficient to pierce the
corporate veil. New York law only allows veil-piercing when the control was used to
commit a fraud or other wrong. Here, although Glazier was not C3's shareholder, he is
properly deemed C3's equitable owner for veil-piercing purposes, because Glazier "exercised
considerable authority" over C3, completely disregarded the corporate form, and acted like C3's
assets were his own. Further, the record shows sufficient examples of Glazier's control over C3.
Nevertheless, there was no finding by the district court of any fraudulent or wrongful act toward
Freeman
Liability: Direct vs. Derivative:
● General Rule: A parent company is NOT liable for the acts of its subsidiaries
○ Shareholder “control” will not create liability beyond the assets of the subsidiary
●
But there are times the parent company will be found liable for acts of subsidiaries
●
In our context:
○ Direct liability: refers to a situation in which a parent company becomes liable for
subsidiary’s wrongs on the basis of their own act or omission.
○ Derivative liability: refers to a parent company being held accountable for the
acts of subsidiary when the subsidiary’s corporate form would otherwise be
misused to accomplish certain wrongful acts on shareholder’s (parent
company’s) behalf
United States v. Bestfoods
● Facts
○ From 1965 to 1972, CPC, owned a chemical manufacturing plant in Michigan.
The Michigan operation was organized as a wholly owned subsidiary of CPC,
and is referred to in the opinion as Ott II. During the course of its ownership of Ott
II, CPC appointed Ott II’s board and many of its officers, and also directed one of
its own officials, G.R.D. Williams, to play a role in shaping Ott II’s environmental
compliance policy. A few years later, following the bankruptcy of Ott II’s
subsequent owner, state and federal environmental regulators discovered illegal
pollution at the site, and now sue CPC and other entities to recover the costs of
clean-up.
●
●
●
Issue:
○ Can CPC, the parent company of Ott II, be held liable?
Holding:
○ CPC may be held liable as an “operating” but not as the owner of Ott II
Why:
○ There was no factual demonstration sufficient to permit piercing Ott II’s
corporate veil, to hold CPC liable. Same reasoning of why we can’t hold
shareholders (owners) liable for the corporation’s liabilities. Here, CPC corp was
the owner (sole shareholder) of Ott II corp.
○ Lower Court’s application of this direct liability analysis—which the Court
characterizes as an “actual control” test—was mistaken because it would
permit liability based on mere exercise of shareholders’ ordinary rights as
to their corporation, like electing directors and causing them to appoint
officers. As the Court observes: “The question is not whether the parent
operates the subsidiary, but rather whether it operates the facility, and that
operation is evidenced by participation in the activities of the facility, not the
subsidiary.”
○ Thus, the only alternative for CPC liability, therefore, would be if CPC could be
shown actually to have undertaken the illegal conduct itself, through its own
agents. This is the ”operator” liability, which is provided for in CERCLA
What Actions Could Pierce the Veil?
Each state has different legal standards, but courts tend to look at a few common factors when
determining whether the corporate veil has, in fact, been pierced:
● The confused intermingling of business activities, assets, or management with personal
activities and accounts
● Thin capitalization, which is a reference to the debt-to-equity ratio (If a company carries
a lot of debt and very little capital, this could pierce the corporate veil)
● Nonobservance of corporate formalities, including the ones mentioned above like not
hosting shareholder meetings
● Absence of corporate records, including things like bylaws and operating agreements
● Insolvency at the time of the disputed transaction, which means that the company
entered into a deal knowing that it would not be able to repay the debts owed
● Siphoning away of corporate assets by the dominant shareholders
● Officers and directors who don’t fulfill their obligations and duties as outlined in
governing documents like the bylaws
● Use of the corporation in promoting fraud
ASSIGNMENT 7: BASICS OF CORPORATE GOVERNANCE
Corporate Law Foundation
● Review: Gashwiler v. Willis and Corporate Law
○ Shareholders cannot make decisions relating to corporate management- even
unanimously- unless specifically authorized in a statute (or in articles of
incorporation)
○ This general rule is the heart of corporate law and the fundamental justification of
the Business Judgment Rule (nxt ch)
●
●
MBCA §8.01(b)
“… all corporate powers shall be exercised by or under the authority of the board of
directors, and the business and affairs of the corporation shall be managed by or under
the direction, and subject to the oversight, of the board of directors.”
McQuade v. Stoneham
● Majority: shareholder agreements that include provisions beyond shareholders’ power
are void because they constitute a threat to directors’ independent business judgment
and therefore are against public policy. Here, because shareholders do not have the
power to appoint officers, the agreement between the parties is void.
●
Concurring: the inquiry about a shareholder agreement should be fact based and
consider the practical influence on directors’ independence in decision making.
Action by Shareholders
1. Meetings
● Types of meetings
● Notice and record dates
● Record and beneficial owners
● Quorum Requirements
● Proxies
● Waivers
● Voting requirements: other than election of directors
● Voting requirements: election of directors
● Cumulative vs. straight voting
2. Action without Meetings
● Written consent
● Electronic consent
Action by Shareholders – Types of Meetings
Annual Meeting
○ MBCA §7.01(b): a corporation shall hold a meeting of shareholders annually at a
time stated in or fixed in accordance with the bylaws at which directors shall be
elected.
● Purpose: elect directors – but can also include other things, but need notice of topic
○ (c) The failure to hold an annual meeting at the time stated in or fixed in
accordance with a corporation’s bylaws does not affect the validity of any
corporate action.
●
Special Meetings
○ MBCA §7.02: called by the BOD, anyone authorized in the bylaws or articles to
call a meeting, or at the request of some % of the votes entitled to be cast on the
issue to come before the meeting (usually 10%- by statute and allowed to
change in articles or bylaws)
Action by Shareholders – Meetings Requirements
● Notice and Record Dates: The Board sets the record date as of which the corporation’s
records will be consulted to identify the shareholders entitled to notice
● Record and Beneficial Owners: record holder/owner vs. beneficial holder/owner
● Quorum Requirements:
○ The minimum number of shares that must be represented for action to be valid.
○ Default is simple majority but can be changed in Articles
■ There is a change to the MBCA that is not yet reflected in the text.
● Citing to MBCA §7.27, book states a quorum requirement can be
adjusted up but not down by the Articles of Incorporation.
● MBCA § 7.27 now permits shareholder quora to be decreased, as
well as increased.
○
Quorum assumed to continue once formed
Action by Shareholders – Meetings
● Proxy: MBCA § 7.22
○ Proxy voting is when a voting member delegates their voting power to a
representative who can vote in their absence.
○ A proxy is revocable unless the appointment form conspicuously says it is
irrevocable and the appointment is coupled with an interest
● Waiver
○ if notice is not sent to every voting shareholder or is defective, the meeting
cannot take place without waiver
○ Attendance to the meeting without objection usually constitutes a waiver
Action by Shareholders – Voting Requirements
● Voting Requirements: Other than election of directors
○ MBCA § 7.25(c): A majority of votes cast unless
■ Articles can create increase the voting requirement
● Voting Requirements: Election of Directors is by Plurality
○ Plurality of votes rather than majority
■ If someone doesn’t get the majority of the votes, but gets the most, they
get the position
● Cumulative v. Straight Voting
Action by Shareholders – Voting Requirements: Cumulative v. Straight Voting
● Straight: default in most jurisdictions. One share gets one vote for each open position.
○ Meaning: a majority shareholder, or group of shareholders acting together to
create a majority, can elected every member of the board
●
Cumulative: one share gets one vote for each opening position, but votes can be
cumulated and cast for fewer than all openings.
Action by Shareholders – Without a Meeting
● MBCA § 7.04
○ Written Consent: By all shareholders entitled to vote, with the date of signature,
description of the action taken, all shareholders’ signatures, and delivered to the
corporation for inclusion in records
■ Alternatively, if Articles so provide, signed by holders of outstanding
shares having no less than the minimum number of votes that would be
required to authorize the action
Action by Board of Directors
Planned action by the Board
● Action at a Meeting
○ Physical
○ Conference call
● Action without a meeting
○ Unanimous written consent
● Unplanned Action by the Board
○ Creating apparent authority through inaction
Action by Board of Directors - Planned
● Action at a Meeting: Physical
○ Majority quorum subject to changes in the articles or bylaws
○ No notice required for regularly scheduled meetings; two-day notice for special
meetings
○ No mechanism for voting by proxy
○ Conference calls are allowed
● Action at a Meeting: Committee Action
○ the Board may delegate certain functions to committees
○ In the case of companies with registered securities, audit committees are
“outside”/”independent” directors
○ Certain functions cannot be delegated to committees (will discuss later)
● Action Without a Meeting: Unanimous written consent
Action by Board of Directors – Unplanned
Unplanned Action by the Board
● May be the consequence of creating an officer’s authority
○ Unplanned action by the board may also result in creating an officer's authority. If
the board, through its inaction or informal conduct, allows an officer to act on
behalf of the corporation without proper authorization or approval, the officer may
be viewed as having apparent authority to take certain actions, even if such
actions were not explicitly authorized. This can be problematic for the corporation
if the officer's actions end up causing harm or liability
● Creating apparent authority through inaction
○
○
○
○
○
Unplanned action by the board refers to situations where the board takes
action that is outside of its usual course of business, without having
previously considered or planned for the action. In these situations, the
board may not have the express authority to take the action, but their
inaction or failure to object may create the appearance of authority to
others.
This can relate to creating apparent authority through inaction because
when the board takes unplanned action, it may not have taken the
necessary steps to limit the authority of individual board members or
managers, or to ensure that their actions are consistent with the company's
policies and procedures. As a result, third parties may assume that the
board has authorized the action, and the board may be held liable for the
actions of its agents or employees.
For example, if a board member takes an action on behalf of the company
without prior authorization or approval, but the board fails to object or take
corrective action, third parties may assume that the action was authorized by the
board. This could create the appearance of authority, and the board could be
held liable for any damages resulting from the unauthorized action.
○
Action by Officers
● Action by the board creates authority for actions of the officers
○ Thus, officers are agents of a corporation
● The president: the ordinary/extraordinary distinction
○ President has authority in ordinary but not in extraordinary corporate affairs
● The secretary: attests to authority of other officers
(Under the MBCA, the ordinary business operations of a corporation are generally
managed by the corporation's officers, including the president. This includes day-to-day
operations such as hiring and firing employees, managing finances, and entering into contracts
in the normal course of business.
Extraordinary actions, on the other hand, generally require approval from the board of
directors and/or shareholders. Examples of extraordinary actions might include entering into
a merger or acquisition, selling a significant portion of the corporation's assets, or taking on
significant debt.
The distinction between ordinary and extraordinary actions is important because it determines
who has the authority to take certain actions on behalf of the corporation. If an officer, such as
the president, takes an action that is considered extraordinary without the proper approval, it
may be challenged as unauthorized and potentially invalidated. On the other hand, if the
president takes actions within the scope of ordinary business operations, they are generally
considered authorized and binding on the corporation.)
Lee v. Jenkins Bros.
● Rule: A corporation’s president has authority to bind the company by acts that arise in
the usual course of business, but not for contracts that are extraordinary in nature.
○ Here, Yardley, the president offered Lee a paid pension upon reaching the age fo
60 of about $1500 a year, even if he were no longer working for Jenkins at that
time.
● A corporation’s president has the authority to bind the company to an oral
pension agreement with an employee, if it is not extraordinary. In general, a
corporation’s president has authority to bind the company by acts that arise in the
usual course of business, but not for contracts that are extraordinary in nature.
● In the context of employment contracts, a corporation’s president, as part of the
regular course of business, may hire and fire employees and fix their
compensation, and may choose to hire an employee for a specific, reasonable
number of years. However, employment contracts for life are usually considered
to be extraordinary and beyond a president’s authority. Such contracts impede
shareholders’ and future directors’ power regarding management policies, subject
the corporation to substantial liability, and run for long, indefinite periods of time.
● BUT
○ The pension contract in this case was not unreasonable, and was in fact
beneficial and necessary for the corporation. Whether apparent authority
exists is a question of fact that depends on many factors, including the
officer negotiating the contract, the corporation’s usual manner of
conducting business, the corporation’s size and its number of
stockholders, the circumstances surrounding the contract, its
reasonableness, the amounts involved, and the contracting third party.
Here, Yardley was not only president, but chairman of the board, a substantial
stockholder, and trustee and son-in-law of the major stockholder’s estate. The
contract was made in the presence of the vice president, for a reasonable
amount of time, to secure badly needed personnel, and limited the corporation’s
liability under such a pension to $1,500 per year. In this case, reasonable men
could differ as to whether Yardley had apparent authority to make the contract
with Lee.
In Re Drive in Development Corp
● Statements made by an officer in the course of a transaction in which the
corporation is engaged and which are within the scope of the officer’s authority
are binding upon the corporation. Generally, a secretary’s duties include
maintaining the corporation’s records, including records of resolutions of the
board of directors. In this case, the district court erred in finding that Drive In was not
bound by the purported guaranty to the bank. Dick was the Secretary of Drive In. As
an officer, Dick’s statements in the course of Drive In transactions are binding
upon Drive In if they are within the scope of his authority. As part of his secretarial
duties, Dick made a record of board resolutions. An attestation and provision of a
certified copy of a board resolution are thus within the scope of Dick’s authority. Dick
attested to the board’s execution of the guaranty and provided to the bank a certified
copy of the board’s resolution. These statements by Dick bound Drive In and estopped
Drive In from claiming that Maranz did not have the authority to bind the corporation
ASSIGNMENT 8: FIDUCIARY DUTIES IN THE CORPORATE CONTEXT: THE DUTY OF
CARE
Overall theme
● Officers and Directors owe the corporation fiduciary duties- the two main fiduciary duties
are the duty of care and the duty of loyalty
● Whatever this duty is that is owed by the officers and directors, is sometimes modified by
the business judgment rule (BJR).
Fiduciary Duty and Introduction to Duty of Care
● Fiduciary: person that acts on behalf of another, putting the other’s interest ahead of
their own
● Fiduciaries are obliged to act on behalf of another, who is known as the beneficiary
● There is a traditional division between the duties of care and loyalty
● In general, duties are owed to the corporation rather than its individual shareholders
● An action based on breach of the duty of care is akin to an action for negligence
Duty of Care and the Failure to Act
● Failure to act is actionable when there is a duty to act
● Directors must exercise the degree of diligence, care and skill which an ordinarily
prudent person would exercise under similar circumstances in like positions
○ Directors should acquire at least a rudimentary knowledge of the business
● Directors are under a continuing duty to stay informed and cannot close their eyes to
misconduct by other corporate actors
○ Directors are under a continuing obligation to keep informed about the activities
of the business, including its financial status
● However, the Business Judgment Rule applies: The courts will not interfere with the
directors’ honest business judgment unless there is a showing of fraud, illegality or
conflict of interest – burden on Plaintiff
● – The presumption that a directors’ business judgment is fully informed, made in good
faith and in the corporation’s best interests can be rebutted by the plaintiff’s showing of
gross negligence.
● – Traditional Approach: The courts will not interfere with the directors’ honest business
● judgment unless there is a showing of fraud, illegality or conflict of interest
Duty of Care & Satisfying the BJR
An officer or director is entitled to the protection of the business judgment rule and
satisfies the duty of care if he or she makes a business judgment in good faith and is:
● (1)not self-interested (conflict of interest- duty of loyalty);
● (2)informed to the extent reasonably believed appropriate (oversight/monitor);
AND
●
(3)rationally believes the business judgment is in the best interests of the
corporation.
→ Notes: (2) requires a duty to monitor/oversight
Francis v. United Jersey Bank
● Analysis based on negligence involves determining whether:
○ The Defendant bore a duty of care;
○ The Defendant breached that duty;
○ The Plaintiff suffered an injury; and
○ The Defendant’s breach was the actual and proximate cause of the Plaintiff’s
injury
●
Duty of Care
● Directors owe a duty of care to the corporation to act honestly and in good faith
● The nature and extent of reasonable care required depends on the type of corporation,
its size, and financial resources
○ A bank director is held to a stricter standard than the director of an ordinary
business
● Proximate cause: To determine if there was a negligent omission that caused the harm,
analyze the reasonable steps a director should have taken and whether that course of
action would have averted the loss
Duty of Care, Decisions that Turn Out Badly, and The Business Judgment Rule
● A Traditional Approach: The courts will not interfere with the directors’ honest business
judgment unless there is a showing of fraud, illegality or conflict of interest
○ Process-based complaints: Plaintiff complains that the decision-making process
of the directors was inadequate
○ Substance-based complaints: Plaintiff complains that the directors’ decision
eventually resulted in harm to the corporation
The Business Judgment Rule
● Who does it protect?
○ Boards and Officers
Shlensky v. Wrigley (not playing night games at Wrigley field)
A corporation’s president and board have authority to determine what course of action is
best for the business. While the president and board must have a valid business purpose
behind their actions, a decision motivated by a valid business purpose will be given
great deference. In this case, while Shlensky may disagree with the board’s course of action,
Wrigley could have reached the legitimate business conclusion that the Cubs were better off not
playing night games. Wrigley and the board may be concerned about maintaining goodwill in the
community from which the Cubs draw their fans; or they may be concerned about the costs of
operating the lights. Wrigley and the board may have determined that night games would not
have brought in additional revenue.
Duty of Care, Decisions that Turn Out Badly, and The Business Judgment Rule
● The Business Judgment Rule (BJR) and its Limits
○ It is not always clear whether the BJR is a rule of abstention for judges or a
standard of conduct for corporate fiduciaries
●
○ There is a limit on the BJR for illegal acts
■ Miller v. AT&T: If a fiduciary’s crime results in significant harm to the
corporation, then the fiduciary will be called to account personally
○ However, while a fiduciary may breach the duty of care by any knowingly
wrongful or criminal act that causes the corporation injury, the fiduciary
will not be liable to the corporation in money damages if the injury was a
net profit.
● Failure to act is actionable when there is a duty to act
○ – Directors must exercise the degree of diligence, care and skill which an
ordinarily prudent person would exercise under similar circumstances in like
positions
● – Directors are under a continuing duty to stay informed and cannot close their eyes
to misconduct by other corporate actors
●
● A lack of informed process has consequences
○ Smith van Gorkom:
■ 1. Directors were liable because they made their business decision
to sell shares too quickly and without adequate information
■ 2. The court said that there is no protection under the BJR for
directors who made an unintelligent or unadvised decision
SUMMARY (AND FRANCIS)
● The cause of action for breach of fiduciary duty looks just like the common law
cause of action for negligence: A plaintiff would have to show: the duty exists and
is owed to plaintiff, the duty was breached, plaintiff suffered injury and the injury
was caused by defendant’s breach.
● Francis made clear that, at a minimum, gross inattention will constitute a breach
of a director’s duty of care.
SUMMARY:
● The practical impact of the BJR is that so long as a business choice is:
○ Based on reasonable information,
○ Not self-interested, and
○ Not inherently illegal
● Corporate decision-makers have virtually nothing to fear.
VAN GORKOM
The Business Judgment Rule under Van Gorkom
Nature of Mergers
● Smith v. Van Gorkom involves a merger, namely, a cash-out merger of the Trans Union
corporation into the Marmon Group
● The way this works is that first, under the corporation statutes of most states, the Board
of Directors must first receive and consider a merger proposal and then recommend it to
the shareholders.
● Can’t make dishonest statements to the shareholders and they must make all
disclosures that would be important to shareholders in making their decision.
● In the Van Gorkom case we have what was called a cash-out merger. A cash-out
merger is a way to squeeze out minority shareholders.
The Business Judgment Rule under Van Gorkom
LBOs
● The Van Gorkom court tells us that the merger that Pritzker proposed and the Trans
Union Board approved was a kind of deal called a leveraged buyout or an “LBO.” All this
means is that a private group of investors will buy up all the shares of a company and
finance the purchase with debt.
○ if you buy a company with debt, you have to be able to pay back the interest, and
usually these purchases involve huge amounts of debt.
● Pritzker proposed to buy the company with about $500M in debt and only $200M in
cash, so they would need a huge amount of cash. The reason that Trans Union turned
out to be a good candidate for an LBO was that it had huge cash flow
The Business Judgment Rule under Van Gorkom
Control Premium
● Note that the $55 price that Pritzker ultimately paid for Trans Union was quite a bit
higher than the going stock price at any time within several years prior to the merger. So
why should the shareholders have a right to complain?
● Because the price of an individual share of stock doesn’t reflect the value of control of
the company. Control of the whole company has value in itself
● Thus, the person taking control will need to pay more than market price for the stockthe excess over the market prices is called the ”control premium.”
Legislative Responses to Officer and Director Liability
● state legislatures enacted laws that decreased directors’ liability risks: These are often
called “exculpation” or “raincoat” provisions
● Two main ways:
○
○
Allow individual corporations, through shareholder action, to include in
their articles a provision limiting their directors’ monetary liability for
various types of wrongdoing not involving lack of loyalty, lack of good
faith, or illegality (where have we seen this?)
Alters the standards of fiduciary duties imposed on all corporate directors,
typically lowering the standard of conduct for duty of care
Oversight, Monitoring and the Duty of Care
● Most of the time, board will have done something to comply with their fiduciary
obligations, and the question become – whether they did enough.
Oversight, Monitoring and the Duty of Care
● In re Caremark Intl. Inc. Derivative Litigation (Lower employees were messing with
medicare and medicaid benefits. Derivative suit brought on the basis of breach of duty of
care.)
○ The duty of care owed by corporate directors may be breached either by
active decisions which are negligent, or by negligent failure to act.
Generally, a director’s inattention must be egregious for liability to attach.
Directors are not expected to oversee all actions of all employees
○ directors must make good-faith efforts to ensure that reporting and
informational systems exist. The business judgment rule protects
directors’ discretion in determining the extent of such systems. Total
failure to exercise reasonable oversight, however, may subject directors to
liability.
○ Here: they made at least minimal efforts. Made good-faith attempts to keep
abreast of the law and to adjust Caremark’s practices when they strayed from
legal requirements.
● Why?
○ Graham v. Allis Chalmers
■ Generally a corporation’s directors and officers have a right to
reasonably rely on the honesty and integrity of company employees.
Reliance is no longer reasonable if the directors and officers are put
on notice that wrongdoing may be happening. Director and officer
liability may be imposed if, after such notice, nothing is done to find
and prevent misconduct. Nevertheless, directors and officers are not
under a duty to “install and operate a corporate system of espionage to
ferret out wrongdoing which they have no reason to suspect exists.” The
question of when a director has breached the common law duty of
supervising and managing the business is dependent on the
surrounding circumstances. Liability is proper if a director
recklessly trusts an employee who is clearly untrustworthy,
seriously neglects her duties, or willfully or negligently ignores
“obvious danger signs of employee wrongdoing.”
●
Here: the corporation was huge. It was impossible for the directors
to personally know and supervise all of the company’s employees.
Also, the board acted immediately when it learned of the
wrongdoing.
Oversight, Monitoring and the Duty of Care
● “absent cause for suspicion there is no duty upon the directors to install and operate a
corporate system of espionage to ferret out wrongdoing which they have no reason to
suspect exists.”
● However, relevant and timely information is essential to discharge the board’s
supervisory and monitoring role.
● Duty to monitor: “[A] director’s obligation includes a duty to attempt in good faith to
assure that a corporate information and reporting system, which the board concludes is
adequate, exists.”
● prove breach of the duty?
○ (1) that the directors knew or should have known that violations of law
were occurring and, in either event, (2) that the directors took no steps in a
good faith effort to prevent or remedy that situation, and (3) that such
failure proximately resulted in the losses complained of.]
● How can we tell if directors should they have known?
○ Only if there was “a sustained or systematic failure of the board to exercise
oversight – such as an utter failure to attempt to assure a reasonable
information and reporting system exists – will establish the lack of good
faith that is a necessary condition to liability.”
Oversight, Monitoring and the Duty of Care
● As a result of Caremark, the board, among its other fiduciary obligations, must undertake
a duty of oversight to make a good faith effort to put into place a reasonable boardlevel system of monitoring and reporting.
ASSIGNMENT 10 & 11: DUTY OF LOYALTY AND CONFLICTS OF INTEREST: SELFDEALING TRANSACTIONS AND CORPORATE OPPORTUNITY
Duty of Loyalty
● Triggered only when a fiduciary acts under a “conflict of interest”
● There are two broad categories of conflicted conduct:
○ 1. Interested transactions: If an officer or director engages in a transaction
involving a conflict of interest, the director or officer bears the burden of proving
that the transaction was fair and reasonable
■ The general idea is that a conflict exists where a corporate fiduciary is on
both sides of a transaction.
■ Test: intrinsic or entire fairness test: Fiduciary bears the burden of
proving that the transaction was fair and reasonable (both a
substantive and procedural aspect)
● If the fiduciary can show the transaction was intrinsically fairno breach of loyalty
○ 2. Corporate opportunity transactions
■ 1. Corp. financially able to exploit the opportunity;
■ 2. Within corp.'s line of of business;
■ 3. Corp. interest or expectancy; AND
■ 4. Fiduciary taking opp will place their interest above Corp
● BJR does not apply to breaches of loyalty cases
The Duty of Loyalty: Interested transactions
● “Interested” transactions:
○ Cases in which the fiduciary has some direct pecuniary interest in a transaction
that involves the corporation
○ Cases in which the fiduciary is related to or closely associated with a person who
has a direct personal stake in a transaction involving the corporation
○ Cases in which a fiduciary owes duties both to the corporation and to another
person involved in a transaction with the corporation
○ Conflict arises in classic self-dealing situations, dealings between corporations
with common directors and dealings with the officer or director’s family
● **judged pursuant to the “entire fairness” or “intrinsic fairness” standard
● The usual remedy = voiding the tainted transaction
What is “self-dealing”
● Self-dealings: When parent causes subsidiary to act in such a way that results in a
benefit for the parent to the exclusion or detriment of the minority stockholders of the
subsidiary
●
The intrinsic fairness standard is applied in situations when the parent owes a fiduciary
duty to the subsidiary and is engaged in “self-dealing”
Intrinsic Fairness:
● A high degree of fairness and a shift in the burden of proof from the Plaintiff to the
Defendant
● Under this test, the Defendant must prove both substantive and procedural fairness
Summary of Common Law Test: Intrinsic Fairness Test
● If an officer or director engages in a transaction involving a conflict of interest, the
director or officer bears the burden of proving that the transaction was fair and
reasonable. This is a fact intensive test, keep in mind:
○ The common law test has both a substantive and procedural aspect
○ The corporation’s need for the transaction can cut both ways. If the deal is
especially valuable to the corporation, it might be fair to pay more than the
market value; if the deal in fact is not valuable to the corporation, even paying fair
market value might not be fair. The interested fiduciary could be just dumping an
asset.
■ Substantive: defendant shows terms of the transaction are fair
■ Procedural: defendant shows either their beneficiaries or a disinterested
decision maker was made fully aware of the transaction at issue and the
nature of the conflict, and no decision-making procedures were skipped
○ Remember: not all corporate transactions involving a conflict of interest violates
the duty of loyalty – those that satisfy the “intrinsic fairness” test do not
● Conflict arises in classic self-dealing situations, dealings between corporations with
common directors and dealings with the officer or director’s family.
● The general idea is that a conflict exists where a corporate fiduciary is on both sides of a
transaction.
Ratification
● Not all corporate transactions involving a conflict of interest violates the duty of loyalty
and ratification reduces the chance of a violation being found.
● Ways to ratify:
○ A principal’s approval “after the fact” of an action carried out by his agent
■ Agency law- agent had no authority, but principal likes deal and wants to
keep it
○ A second approval that is legally required to complete a process
■ Ex: Board approves (1st approval) merger and the shareholder then
approve (2nd approval)
● An approval that is not required for the act to be effective but plays a role in insulating
the act from a later challenge
○ Ex: corp fiduciary loans money to company , likely no need to for anyone to do
anything, but ratification may be sought
The Duty of Loyalty: Interested Transactions: Ratification
● Most states have adopted what we call safe harbor statutes to protect officers and
directors from liability. These statutes reflect common law evolution and basically set up
procedures under which either a disinterested majority of the Board of Directors or
the shareholders can ratify a self-interested transaction - like § 144. Interested
directors; quorum:
○ 1. Fully disclosed/known and majority of disinterested directors approve (BJR
burden on plaintiff);
○ 2. Fully disclosed/known and shareholders approve (BJR burden on plaintiff); or
○ 3. The transaction is entirely fair and approved by directors (or committees), or
shareholders (intrinsic fairness burden on director).
● If none of these exists, still not per se void. Next step: apply Intrinsic Fairness Test
● Note: approval by fully-informed disinterested directors (§144(a)(1)) or disinterested
shareholders (§144(a)(2)) invokes BJR.
● *** This all applies to general interested transactions- NOT controlling shareholder
transactions
The Duty of Loyalty: Interested Transactions: Ratification
● According to §144(a)(2), an informed and disinterested shareholder approval of a
general “interested transaction” invokes the business judgment rule
○ – The party attacking (the plaintiff) has the burden of proof
●
In duty of loyalty cases involving controlling shareholder (think parent-subsidiary) do
not fall under §144, the standard of review of the transaction is intrinsic fairness:
○ – And the defendant directors have the burden of proof
○ – Unless a “majority of the minority” shareholders approved (ratified) the
transaction, in which case, the Plaintiff has the burden of proof
§ 144. Interested directors; quorum. - simplified
● (a) A transaction involving self interest will not be void or voidable simply because it
involves a conflict of interest, IF
○ (1) The material facts of the interest transaction are disclosed or are known and
the board or committee in good faith authorizes the transaction by the affirmative
votes of a majority of the disinterested directors; or
○ (2) The material facts of the interest transaction are disclosed or are known to the
stockholders entitled to vote, and transaction is specifically approved in good
faith by vote of the stockholders; or
○ (3) The transaction is fair as to the corporation as of the time it is authorized,
approved or ratified, by the board of directors, a committee or the stockholders.
● (b) Common or interested directors may be counted in determining the presence of a
quorum at a meeting of the board of directors or of a committee which authorizes the
contract or transaction.
ESSENTIALLY: The Duty of Loyalty: Interested Transactions: Ratification
●
●
●
●
●
●
Most states have adopted what we call safe harbor statutes to protect officers and
directors from liability. These statutes reflect common law evolution and basically set up
procedures under which either a disinterested majority of the Board of Directors or the
shareholders can ratify a self-interested transaction - like § 144. Interested directors;
quorum:
○ 1. Fully disclosed/known and majority of disinterested directors approve (BRJ
burden on plaintiff);
○ 2. Fully disclosed/known and shareholders approve (BRJ burden on plaintiff); or
○ 3. The transaction is entirely fair and approved by directors (or committees), or
shareholders (intrinsic fairness burden on director).
If none of these exists, still not per se void. Next step: apply Intrinsic Fairness Test
Note: approval by fully-informed disinterested directors (§144(a)(1)) or disinterested
shareholders (§144(a)(2)) invokes BJR.
*** This all applies to general interested transactions- NOT controlling shareholder
transactions
According to §144(a)(2), an informed and disinterested shareholder approval of a
general “interested transaction” invokes the business judgment rule
○ Burden of proof lies on the party attacking the transaction
○ Shareholder ratification of voidable director acts will extinguish claims in only the
following two circumstances
■ When the directors act in good faith but exceed the board’s de jure
authority
■ When the directors fail to reach an informed business judgment in
approving a transaction
In duty of loyalty cases involving controlling shareholder (think parent-subsidiary) do not
fall under§144 the standard of review of the transaction is intrinsic fairness:
○ And the defendant directors have the burden of proof
○ Unless a “majority of the minority” shareholders approved the transaction, in
which case, the Plaintiff has the burden of proof
Lewis v. S.L. & E., Inc.
● Directors can’t rely on the Business Judgment Rule to protect them in situations of
conflicts of interest
● The burden of proof rests on the defendant directors to show that the transactions were
fair and reasonable at the time that they were made
Sinclair Oil Corp. v. Levien
Duty of Loyalty: Corporate Opportunity Transactions
●
The duty of loyalty requires the directors to place the interests of the company and the
shareholders before any of their personal interests. The directors' actions such as
diverting corporate assets, opportunities, or information for personal gain can certainly
violate their duty of loyalty.
●
Thus the duty of loyalty Prohibits an officer or director of a corporation from diverting a
business opportunity presented to, or otherwise rightfully belonging to, the corporation to
himself or any of his affiliates.
THE DUTY OF LOYALTY: CORPORATE OPPORTUNITY TRANSACTION:
● The corporate opportunity doctrine (Guth test) states that a director/officer may not take
a business for her own if:
○ 1. The corporation is financially able to exploit the opportunity;
○ 2. The opportunity is within the corporation’s line of of business;
○ 3. The corporation has an interest or expectancy in the opportunity; AND
○ 4. By taking the opportunity herself, the fiduciary will be placed in a position
unamicable to her duties to the corporation
● Unless it is waived in charter or by board, or if the transaction is entirely fair
● If the transaction passes the corporate opportunity test, the BJR applies
●
The “line of business” test requires a two-step analysis:
○ 1. Determine whether a particular opportunity was within the corporation’s line of
business
○ 2. Scrutinize the equitable considerations existing before, during, and after the
director’s acquisition
● The “fairness test”:
○ Calls on the application of fair and equitable standards when determining
whether a director took personal advantage of an opportunity against the
interests of the corporations
Main features of ALI § 5.05:
● Strict requirement of full disclosure prior to a director taking advantage of any corporate
opportunity
● Broad definition of corporate opportunity including:
○ Opportunities closely related to a business in which the corporation is engaged
■ Any opportunities that accrue to the fiduciary as a result of her position
Guth Test
● The corporate opportunity doctrine states that a director may not take a business for her
own if:
○ 1. The corporation is financially able to exploit the opportunity;
○ 2. The opportunity is within the corporation’s line of of business;
○ 3. The corporation has an interest or expectancy in the opportunity; AND
○ 4. By taking the opportunity herself, the fiduciary will be placed in a position
unamicable to her duties to the corporation
Guth Test
● The corporate opportunity doctrine states that a director may take a business for her
own if:
○ 1. The opportunity presented to the officer or director in her individual capacity;
○ 2. The opportunity is not essential to the corporation;
○ 3. The corporation has no interest or expectancy in the opportunity; AND
○ 4. The office or director has not wrongfully employed the corporation’s resources
The Duty of Loyalty: Corporate opportunity transactions
● “Usurpation of corporate opportunity” transactions:
○ Cases in which the fiduciary has taken something that belongs to the corporation
and used it for the fiduciary’s benefit
●
Essential, the investment should have been left to the corporation to make not the
individual
●
●
** judged state by state and varies
The usual remedy= impose a constructive trust: fiduciary holds the opportunity int rust
for the corporation and must account for all profits
Marciano v. Nakash
● Two-tired analysis to determine if the act is voidable:
○ Application of D.G.C.L. § 144
○ Application of the intrinsic fairness test
●
In other words, firs we apply the safe harbor statute (Delaware General Corporation Law
§ 144) and if the interested party can show any one of the (a)(1)-(3) -or the safe harbor
statute doesn’t apply (deadlock and no ratification could happen), the transaction is not
void per se BUT THEN we apply the intrinsic fairness test (to see if it is voidable).
In re Wheelabrator Technologies, Inc. Shareholder Litigation
● Shareholder ratification of voidable director acts will extinguish claims in only the
following two circumstances:
○ 1. When the directors act in good faith but exceed the board’s de jure authority
○ 2. When the directors fail to reach an informed business judgment in approving a
transaction
● According to § 144(a)(2), an informed and disinterested shareholder approval of an
“interested transaction” invokes the business judgment rule
●
○ Burden of proof lies on the party attacking the transaction
In duty of loyalty cases involving parent-subsidiary mergers the standard of review of the
transaction is intrinsic fairness:
○ And the defendant directors have the burden of proof
○ Unless a “majority of the minority” shareholders approved the merger, in which
case, the Plaintiff has the burden of proof
Broz v. Cellular Information Systems, Inc.
○
Northeast Harbor Golf Club, Inc. v. Harris
● The “line of business” test requires a two-step analysis:
○ 1. Determine whether a particular opportunity was within the corporation’s line of
business
○ 2. Scrutinize the equitable considerations existing before, during, and after the
director’s acquisition
● The “fairness test”:
○ Calls on the application of fair and equitable standards when determining
whether a director took personal advantage of an opportunity against the
interests of the corporations
Main features of ALI § 5.05:
● Strict requirement of full disclosure prior to a director taking advantage of any corporate
opportunity
● Broad definition of corporate opportunity including:
○ Opportunities closely related to a business in which the corporation is engaged
■ Any opportunities that accrue to the fiduciary as a result of her position
Bottom Line
● A corporate fiduciary should not serve both corporate and personal interests at the same
time
ASSIGNMENT 12: DUTY OF LOYALTY: GOOD FAITH AND DISCLOSURE EXECUTIVE PAY
Review: Exculpatory Clauses aka Raincoat Provisions
● Clauses limiting director and officer liability (exculpatory= to clear from liability)
○ “No director shall be personally liable to the Corporation or its stockholders for
monetary damages for any breach of fiduciary duty by such director as a director.
Notwithstanding the foregoing sentence, a director shall be liable to the extent
provided by applicable law, (i) for breach of the director’s duty of loyalty to the
Corporation or its stockholders, (ii) for acts or omissions not in good faith or
which involve intentional misconduct or a knowing violation of the law, (iii)
pursuant to Section 174 of the Delaware General Corporation Law or (iv) for any
transaction from which the director derived an improper personal benefit[.]”
●
●
State exculpates directors only for gross negligence – does not exculpate for acts not in
good faith
○ “Acts or omissions not in good faith”
Does not exculpate for acts of intentional misconduct or knowingly violating the law
General Idea of Delaware Law
● Start with the idea that something is a business judgment (thus, BJR applies)
● It will not be questioned unless:
○ there has been gross negligence (breach of duty of care), breach of duty of
loyalty, or lack of good faith
■ If one of those, then the fiduciary is called upon to justify the decision
Good Faith: A Staple of the Common Law
● In re The Walt Disney Co. Derivative Litigation:
○ Standards for bad faith corporate fiduciary conduct:
■ Intentional dereliction of duty: a conscious disregard for one’s
responsibilities is a legally appropriate standard
■ Subjective bad faith: Fiduciary conduct motivated by intent to do harm
● Exculpatory clause permits exculpation for gross negligence but not for:
○ Intentional misconduct, knowing violation of law, or lack of good faith
■ Thus, lack of good faith means something other than gross negligence
● = gross negligence alone is not lack of good faith
Good Faith: A Pre-Condition to Satisfy the Duty of Loyalty
● Stone v. Ritter
○ Failure to act in good faith does not automatically impose fiduciary liability
○
○
○
Failure to act in good faith may result in liability because it is a subsidiary
element of the duty of loyalty
The obligation to act in good faith is not an independent duty such as the duty of
loyalty and duty of care
Caremark test for determining the director’s oversight liability:
■ The director utterly failed to implement any reporting or information
system controls, or
■ Having implemented such system or controls, consciously failed to
oversee or monitor their operations
Disclosure
● A fiduciary is required to make full disclosure to the beneficiary about all matters related
to the beneficiary’s business (MBCA)
● Corporate fiduciaries sometimes owe a state corporate law duty of disclosure to the
corporation’s shareholders and prospective shareholders
● In Delaware, only deliberate (and possibly reckless) non-disclosure is a breach of the
duty of loyalty
Improper Benefit
● Diamond v. Oreamuno
○ – A director may not rely on valuable information available to him because of his
position to obtain trading profits for himself in the stock of his corporation,
regardless of whether he causes injury to the corporation or not
○ – A director may assume the same risks and obtain the same benefits as other
● shareholders, but he may not use his privileged position to obtain an advantage
● over other shareholders
EXCULPATION, INDEMNIFICATION, AND INSURANCE
Exculpation, Indemnification, and Insurance
● Exculpation: Statutes allow corporation to exempt their officers and directors from duty
of care liability
○ – These provisions MUST in a corporation's charter (articles of incorporating)
● Indemnification: compensate/reimburse/cover expense for a loss- The power to
indemnify is usually within a state statute.
● – These statutes may list when a corporation MUST indemnify, when they MAY
indemnify, and when they CANNOT indemnify
● Insurance: statutes create D&O insurance which covers costs that cannot (or the
corporation will not) indemnify
○ – However, there are exclusions: most common are fraud and intentional noncompliant acts
● The underwriting process - cost (premium) affected by the insurer’s assessment of a
corporation’s governance structure and corporate culture
Ex:
○ A corporation shall have power to indemnify any person who was or is a party or
is threatened to be made a party to any threatened… (other than an action by or
in the right of the corporation) by reason of the fact that the person is or was a
director, officer, employee or agent of the corporation . . . against expenses
(including attorneys’ fees), judgments, fines and amounts paid in settlement
actually and reasonably incurred by the person in connection with such action,
suit or proceeding if the person acted in good faith and in a manner the person
reasonably believed to be in or not opposed to the best interests of the
corporation, and, with respect to any criminal action or proceeding, had no
reasonable cause to believe the person’s conduct was unlawful.
Insurance – D&O Insurance
● Corporations may purchase liability insurance to indemnify directors or officers for
actions against them
○ – However, there are exclusions: most common are fraud and intentional noncompliant acts
Indemnification
● Indemnification = compensate person for a loss
● The power to indemnify is usually within a state statute.
○ Unless limited by the articles, a corporation must indemnify reasonable
expenses a director or officer incurs if they prevail in defending an action against
them
● A corporation may indemnify director or officer when:
○ – Directors acted in good faith
○
●
– In the best interest of the corporation (conduct at issue within director’s official
capacity OR not opposed to the best interest of the corporation (when conduct
was not within the director’s official capacity) or
○ – Was not unlawful
Corporation may not indemnify a director who is unsuccessful in defending: (1) a direct
or derivative action when the director is found liable to the corporation or (2) an action
charging the director received an improper benefit.
Exculpation – Raincoat Provisions Revisited
● MBCA 2.02(b)(4) and (6)
● Arnold v. Society for Savings Bancorp
○ Proxy Statement: A document sent to shareholders letting them know when and
where a shareholders' meeting is taking place and detailing the matters to be
voted upon at the meeting
○ – When a corporation’s charter exculpates directors from personal liability in
accordance with D.G.C.L section 102(b)(7), a corporation’s directors may not be
held liable for violations of fiduciary disclosure requirements
○ – 102(b)(7) permits exculpation from liability for breach of fiduciary duty
○ – 102(b)(7) creates exceptions prohibiting exculpation of directors who breach
the duty of loyalty or act in bad faith
○ – 102(b)(7) applies to disclosure claims because it provides protection for breach
of fiduciary duty- meaning it it protects directors
○ – The duty of loyalty was not implicated under the exceptions in Section
102(b)(7)(i) & (ii) because the Plaintiff’s claims were conclusory
Waltuch v. Conticommodity Services
What is the meaning of “success”
● Waltuch v. Conticommodity Services
○ No Delaware court had applied §145(c) in the context of indemnification
stemming from the settlement of civil litigation
○ According to criminal case Merritt-Chapman & Scott Corp. v. Wolfson
■ Dismissals are considered both a “success” in the context of §145(c) and
a “vindication;” there is no need to delve into the reasons why the case
was dismissed
■
→ For purposes of indemnification, a defendant is “successful” in defense
of the claim against him if he assumes no liability and does not have to
pay the settlement because his employer paid the whole settlement
payment. A court will not go “behind the result” and inquire as to why a
defendant assumes no liability or payment in a claim against him. The
fact that the defendant is dismissed from the case, even if his employer
paid the settlement, is sufficient to warrant indemnification of his legal
expenses because he is “successful on the merits or otherwise.
Indemnification
● What is the meaning of “by reason of”?
○ §145(a) “a corporation may indemnify any person who was or is a party to any
[suit] by reason of the fact that he is or was a director . . . ”
●
Heffernan v. Pacific Dunlap GNB Corp.
○ Indemnification is not limited to only those suits that are brought against a
director for breaching a duty of his directorship or for acting wrongfully
○ Heffernan was not trading securities for his own account but participating in a
structured sale of control of the corporation
■ Therefore, he was sued “by reason of the fact” that he was a director
Exculpation – Raincoat Provisions Revisited
● Recall, Smith v. Van Gorkom, where the Del. SC decision found directors of a publicly
held company to have been grossly negligent in approving the sale of the company.
● Also recall, following the decision, many states created statutes and ways to limit
directors and officers.
○ One type of exculpation involves limiting monetary damages
○ Another type redefines duty
WLR Foods v. Tyson Foods
Exculpation – Raincoat Provisions Revisited
● WLR Foods v. Tyson Foods
○ Virginia Business Judgment Statute, Va. Code Ann. §13.1-690 (“§690”), allows
an inquiry only into the processes employed by corporate directors in making
their decisions regarding a takeover, and not into the substance of those
decisions
○ The director’s decision is not to be analyzed in comparison with whether a
“reasonable man” would have acted similarly
DERIVATIVE LITIGATION
Overview
● Directors and officers of a public corporation owe fiduciary duties to their company- duty
of care and duty of loyalty.
● When corporate boards or officers have breached their duties and the company is
harmed by that breach, a shareholder can bring a derivative suit naming its board
and officers as defendants.
● Derivative suits permit an individual shareholder to bring suit to “enforce a
corporate cause of action against officers, directors, and third parties.”
○ The suit is “derivative” because the shareholder is not bringing the suit directly for
their personal benefit, but rather, on behalf of the company.
● Therefore, any monetary damages awarded to the shareholder plaintiff are paid to
the corporation, not the individual shareholder.
●
●
●
Derivative suits are a matter of state corporate law- most states have specific
prerequisites and high pleading standards for derivative suits:
○ The most important pre-filing requirement is that the shareholder plaintiff made
a “demand” on the board or officers, and if they did not, the shareholder
plaintiff must demonstrate the demand would be “futile.”
The derivative complaint therefore requires a shareholder plaintiff to demonstrate
with specificity: (1) the shareholder plaintiff made a pre-suit demand on the board,
which the board wrongfully refused;
○ If a demand is made: the board’s refusal of the demand is “subject only to
the deferential ‘business judgment rule’s standard of review” and is
presumed valid, unless the shareholder plaintiff can rebut the presumption.
OR (2) the reason for not making a demand or not making the effort.
○ If a demand is not made: the shareholder plaintiff must allege with
particularity that demand would be futile is that a “reasonable doubt”
exists that the board is capable of making an independent decision to
assert the claim if demand were made
Delaware Derivative Requirements
Delaware Chancery Court Rule 23.1 sets out typical procedural requirements
● Derivative litigation is to enforce a right of a corporation that the corporation is not
pursuing itself
● Derivative litigation may only be brought by a plaintiff who was a shareholder at the time
of the complained about event
● A prospective plaintiff must ask the directors to pursue the matter or explain why the
request was not made
● The pleading of demand and futility must be done with particularity
● Once derivative litigation has started it cannot be withdrawn or settled without court
approval
Demand and Futility
● Courts and legislatures consider the corporation’s decision to sue to be a business
matter ordinarily reserved to the entity’s usual decision makers.
● And so, in most cases, a disgruntled shareholder cannot simply go to court on the
company’s behalf.
○ reflects perhaps corporation law’s most fundamental policy, the requirement that
ultimate decision-making authority be left in the board of directors.
● However, such a system may seem to make less sense where the members of the
board are called upon to decide whether to sue themselves (or their close relatives,
friends, etc.).
○ “Demand” in that case might seem pointless, and indeed Delaware and some
other states will excuse demand where circumstances strongly indicate that we
cannot trust a company’s sitting management to make decisions in its best
interests.
●
●
A shareholder must make a written demand and wait 90 days before filing suit unless the
demand is rejected earlier
If the demand is rejected the shareholder is free to file the suit
Direct v. Derivative Suits
● Most cases are clear; infrequently cases arise that are quite difficult
● Some facts give rise to both derivative and direct claims
○ Derivative claims: Claims where a shareholder plaintiff seeks to enforce
rights on behalf of the corporation
○ Direct claims: Claims where a shareholder plaintiff seeks to enforce rights
in his or her personal capacity
● Possible clues
○ Does the claim relate to exceeding power or to breach of duty?
○ To whom was a breached duty owed?
○ What remedy is sought?
Direct vs. Derivative
● “… a court should look to the nature of the wrong and to whom the relief should go.
The stockholder’s claimed direct injury must be independent of any alleged injury to
the corporation. The stockholder must demonstrate that the duty breached was owed
to the stockholder and that he or she can prevail without showing an injury to the
corporation. This means that shareholders seeking to bring direct claims are going to
have to establish that the defendants owed duties directly to them, as well as (or
instead of) to the corporation
Demand Requirement- When Demand is NOT Made (Aronson v. Lewis)
● If a demand is not made, plaintiffs must plead futility:
● Plaintiff must plead facts with particularity creating “a reasonable doubt . . . that:
○ (1) the directors are disinterested and independent and
○ (2) the challenged transaction was otherwise the product of a valid exercise
of business judgment.
Demand Requirement- When Demand is Made (Grimes v. Donald)
● If demand is made, and board rejects demand, the board is entitled to the
presumption of the business judgment rule unless the presumption of that rule can be
rebutted.
○ This may be rebutted only by pleading with particularity why the Board’s refusal
to act on the derivative claims was wrongful.
○ If there is reason to doubt that the board acted independently or with due care in
responding to the demand, the stockholder then has the right* to bring an
underlying action.
■ Same right as if the demand is excused as futile
Directors’ Authority to Dismiss Derivative Litigation
● Essentially: shareholder will believe that an officer or director has breached a fiduciary
duty and make a demand. The Board will then appoint a special committee of outside
directors to decide whether or not to sue. If they choose to sue, no derivative suit is
necessary and shareholder plaintiff’s case will be dismissed if he tries to proceed.
●
●
●
●
●
Special Litigation Committee: A committee of independent directors generally has the
power to dismiss derivative litigation, subject to the satisfaction of a jurisdiction’s relevant
test
○ Pretty much always be comprised solely of outside directors, that is appointed to
decide whether or not to accept the invitation of a shareholder to cause a
corporation to file a lawsuit.
The Business judgment rule applies where some directors are charged with
wrongdoing
So long as there is a majority of the Board that is not involved in the challenged conduct,
the Board can simply move to dismiss a lawsuit.
Some tests are deferential and some are not
a derivative suit can be brought by a shareholder to force the company to sue a
third party, like another company that owes the company money.
Directors’ authority to dismiss derivative litigation
MBCA
● Majority of disinterested directors found in good faith after reasonable inquiry that
the suit is not in the best interested of the corporation, the suit may be dismissed.
●
Burden of proof:
○ To avoid dismissal, shareholder has burden of proving to the court that the
decision was not made in good faith after reasonable inquiry
○ If majority of directors had a personal interest, corporation will have the
burden of showing the decision was made in good faith after reasonable
inquiry
Zapata Corp. Maldonado (or you can use the MBCA)
● There is a two-step test to determine whether the Independent Committee created
by the board should be allowed dismiss the pending suit:
○ Step 1: Defendant has the burden of proving that the Committee is truly
independent and is carrying out the investigation reasonably and in good faith
○ Step 2: Court applies its own business judgment on whether the motion to
dismiss the suit should be granted
Eisenberg v. Flying Tiger Line
● Direct suit: injury complained of was done to shareholder not to the corporation
● The corporation had no right of action here
Grimes v. Donald
● The court noted that the same facts can give rise to both direct and derivative claims.
● A direct claim requires an injury suffered by a shareholder that is not suffered by the
corporation.
● One of the factors taken into account is the remedy sought.
● As Grimes’ sought injunctive relief, which would lead to no recovery by the
corporation, the court characterized the cause of action as direct.
Auerbach v. Bennett
● The business judgment rule applies where some directors are charged with wrongdoing,
so long as the remaining directors making the decision are disinterested and
independent
●
● However, the courts can examine the methodologies and procedures best suited to the
conduct of the investigation and determination of legal liability
Directors’ Authority to Dismiss Derivative Litigation (example)
● The Board refuses to initiate litigation but tries to take internal corrective action that the
plaintiff thinks is inadequate.
○ The question would be whether the plaintiff could still preserve some sort of
lawsuit.
●
●
●
●
●
●
●
Ex: Take the Grimes case.
Again, that case involved an employment contract with a CEO that abdicated the
Board’s authority. Let’s say that the plaintiff had attempted to make a demand by writing
a letter to the Board complaining about the contract, saying it was legally void as a
breach of fiduciary duty, and threatening litigation if the Board took no action.
Let’s say that the Board and the CEO meet, and in order to avoid litigation they agree to
rewrite the K so that the BoD doesn’t abdicate so much of its power.
But let’s say as well that the plaintiff is still not satisfied and thinks there is a fiduciary
breach.
Now if the plaintiff then brings a derivative lawsuit, the Board will probably direct the
company to seek dismissal.
The question in this case would still just be the Auerbach inquiry, or whatever other test
the particular jurisdiction uses to test the effect of a Board’s effort to terminate derivative
litigation.
The question would simply be whether the Board’s decision to dismiss the suit was an
independent decision and that it otherwise would satisfy the business judgment rule.
Alford V. Shaw
● Note this is in North Carolina
● Court rejects the Auerbach approach because it relies too heavily on the business
judgment rule, choosing instead to rely on the Business Corporation Act
● Court applies a modified Zapata rule by extending its application to all derivative suits,
even where directors are not charged with fraud or self-dealing
●
● Model Business Corporations Act §7.44: follow the blueprint
CORPORATE CONTROL TRANSACTIONS
Overview of Corporate Acquisitions
● Major types of transactions:
○ Purchase of assets (ch 12)
○ Share exchange (ch 11)
○ Merger (ch 11)
○ Consolidation (Ch 11)
○ Tender Offer
○ Private purchases of control shares
Purchase of Assets
● One company acquires another simply by buying up all of the target’s assets and
goodwill
●
Result: seller corporation will remain in existence but it will no longer have any hard
assets (besides the cash or the acquiring corporation’s shares- depending on what the
buyer corp used to buy assets)
●
Unless AOI say otherwise, no shareholder approval is required to sell or otherwise
dispose of all a corporation’s assets in the usual and regular course of business
UNLESS
It will leave the corporation without a significant continuing business activity
●
●
Share Exchange
● A corporation or person buys all the shared of another corporation through a ”share
exchange”
● The consideration given for the shares acquired can be cash, stock or other securities
●
●
●
●
●
MBCA Chapter 11
Procedure:
○ Buyer proposes a ”plan of share exchange” to the BOD of target corp
○ Board recommends the plan to shareholders
Shareholders approve by majority vote (appraisal rights)
Result: target corp continues to exists as a separate entity, but all its shares will be held
by the acquiror
Merger
● MBCA Chapter 11
● Procedure:
○ The board of a company to be merged must proposed a plan to merger to its
shareholders
○
○
Shareholders approve by majority vote (appraisal rights)
Shareholder of the company to be merged will exchange their shares for shares
of the newly merged entity
●
Result: one of both of the previously existing corporations will cease to exists
●
●
●
2 important things:
TAX FREE
Survivor corp will take on all liabilities of the merger partner
Merger
● Two ways mergers can be structured:
● 1. Merger
○ True merger, corp A merges into corp B. Corp B still exists but corp A no longer
●
2. Consolidation
○ Both of the original companies cease to exist and together they form a new
corporation
Tender Offer
● An open market offer to purchase some or all of the outstanding shares
● Procedure:
○ Does not require approval of board
○ “hostile takeover”- next chapter
Private Purchase of Control Shares
● Purchaser may negotiate privately with the owner(s) of shares sufficient to transfer
control of a corporation
Statutory Framework
● Model Business Corporations Act Chapters 11 and 12 cover the methods of
accomplishing the following:
○ Mergers
○ Share exchanges
○ Sales of substantially all the assets
● Importantly:
○ Lay out what is required procedurally
○ Appraisal rights: dissenting shareholders of the target company can seek to
convince a court that the consideration they were offered was inadequate
De Factor Merger
● Sometimes, corporations structure a merger as something else. Why? When
corporations are avoiding:
○
○
○
●
the rights of shareholder to vote on the transaction
appraisal rights if it is approved
Taking on the preexisting liability of target corporation
The doctrine deals with the rights of shareholders in cases where transactions are
structured to avoid the rights of shareholders to vote on the transaction and obtain
appraisal of their shares
Farris v. Glen Alden Corp
● Court held that the plan was a de facto merger because it looked at the consequences of
the transaction as opposed to the nature of the transaction:
● Plaintiff ended up owning shares in a very different corporation
● The board of the corporation had changed
● Plaintiff’s share of outstanding stock, along with its value, had decreased
De Facto Merger
● The doctrine also applies to protect creditors’ rights
● Although the general rule is that a corporate purchaser of corporate property does not
take on the liabilities of the selling corporation, there are exceptions to this rule
● These exceptions are an important part of mergers and acquisitions planning
Hariton v. Arco Electronics, Inc
● Arco complied with Delaware’s asset sale statute
● Corporation does not need to also comply with the merger statute
● The merger and asset sale statutes are independent of each other
Freeze-Out Merger
● A freeze-out merger, also called a cash-out merger, is considered a kind of hostile
merger, where minority shareholders in a company are deliberately prevented from
expressing their opinion on whether a merger should take place.
● Duties of the Majority to the minority shareholders
○ In the case of a cash-out merger, the majority shareholder owes a fiduciary
duty to minority shareholders to disclose all relevant information regarding
the merger
○ Weinberger v. UOP, Inc. Court found that there was a lack of fair-dealing by the
majority shareholder because:
■ When corporate action has been approved by an informed vote of a
majority of the minority, burden is on Plaintiff to show unfair
● Plaintiff in a suit challenging a cash-out merger must allege
specific acts of fraud, misrepresentation, or other items of
misconduct to demonstrate the unfairness of the merger terms to
the minority
Appraisal Rights
When statutes provides for appraisal rights:
● The dissenting shareholders have the right to receive “fair value” for their shares.
○ Reasoning: the shareholder in the target company is forced to accept an
outcome he does not want
Weinberger v. UOP, Inc.
● In the case of a cash-out merger, the majority shareholder owes a fiduciary duty to
minority shareholders to disclose all relevant information regarding the merger
● Court found that there was a lack of fair-dealing by the majority shareholder because:
○ Majority shareholder did not provide the details of the Arledge-Chitiea study (did
not disclose relevant information)
○ Minority shareholders only received a hurried fairness report from a potentially
partial party
● When corporate action has been approved by an informed vote of a majority of the
minority, burden is on Plaintiff to show unfair
● Plaintiff in a suit challenging a cash-out merger must allege specific acts of fraud,
misrepresentation, or other items of misconduct to demonstrate the unfairness of the
merger terms to the minority
● Minority shareholders can challenge a cash out merger. If they prove fraud or
misrepresentation, the burden shifts to the majority shareholders to prove that a merger
involved both fair dealing and a fair price.
○ If minority shareholders prove their vote on the merger wasn’t sufficiently
informed of the relevant facts as the result of fraud or misrepresentation, the
burden shifts to the majority shareholders to prove that the merger was fair.
○ Fairness = fair dealing and fair price
■ Fair dealing: looks at not only how the merger was initiated, structured,
negotiated and disclosed to the directors, but also how the approvals of
the directors and shareholders were obtained.
■ Fair price: looks at the merger’s economic and financial considerations,
including assets, market value, earnings, future prospects, and any other
elements that affect the intrinsic or inherent value of the stock being
bought.
■ Here, failure of 2 UOP directors who also served on Signal’s board to
disclose to UOP’s board they they had opined to Signal’s board the $24
would have been a good investment share (instead of $21 per share)
Kahn v. M&F Worldwide Corp
● Facts:
○ A controlling shareholder seeking to merge with its controlled subsidiary
conditioned its ability to accomplish the merger on the dual procedural
protections of negotiation of terms by an independent committee of the
subsidiary’s directors and approval by a fully informed, non-coerced vote by the
subsidiary’s minority shareholders. The merger was approved, but was
challenged by Kahn, a dissenting minority shareholder.
● “… In controller buyouts, the business judgment standard of review will be applied
if and only if: (i) the controller conditions the procession of the transaction on the
approval of a Special Committee and a majority of the minority stockholders; (ii)
the Special Committee is independent; (iii) the Special Committee is empowered
to freely select its own advisors and to say no definitively; (iv) the Special
Committee meets its duty of care in negotiating a fair price; (v) the vote of the
minority is informed; and (vi) there is no coercion of the minority.”
●
● In other words: The Business Judgment Rule applies when there are dual
procedural protections – the transaction is conditioned on approval by both (1) an
independent negotiation committee and (2) a majority of minority shareholders
(fully informed).
Sale of Control
● When a shareholder wishes to sell her controlling interest in a corporation, she will
typically be able to sell that block of shares for more money per share than a
shareholder who owns a mere minority. This is because the purchaser is not only
receiving the value of the shares but the value of control. (This is generally known as a
“control premium”)
● Duties of Care and Loyalty also apply to “controlling shareholders”
● Here, the controlling shareholder is not seeking a merger, but to sell out to the highest
bidder
● Perlman v. Feldman
○ Traditional approach regarding whether a controlling shareholder may sell a
controlling stake in the company and keep whatever “control premium” was
received
○ Held: A controlling shareholder owes the minority shareholders a fiduciary duty
and must pay them their share of the control premium
● Modern Approach: (Zetlin v. Hanson Holdings, Inc.)
● A controlling shareholder does owe minority shareholders a fiduciary duty
● However, absent bad faith, this duty does not extend to an obligation to pay the
minority shareholders a “control premium”
What you need to know
● Generally, SH are free to act for their own benefit
○
Exception: Controlling SH must refrain from using control to obtain special
advantages or to cause corp to take action that unfairly prejudices minority SH
[this invokes the duties that majority shareholder owes to a minority shareholder]
■ Therefore, controlling SH must disclose material info to minority SH
Corporate Control Transactions,
Part II : Tender Offers, Tender Offer Defenses, and Special Fiduciary Duties in Hostile
Takeover Situations
Intro
●
●
●
The tender offer and other hostile acquisitions of control
○ Offers for cash or shares
○ Two-tier tender offers
Federal regulatory scheme
○ Williams Act in 1968 amended the Securities Act of 1934
○ Disclosure
○ Anti-fraud
○ Regulation of terms
Hostile Acquisition Structuring Options
Hostile Takeover Defenses
Tender Offer- Inherent Conflicts of Interest
● Inherent conflicts of interest
○ Between directors’ job security and their fiduciary duty to the corporation
○ Between shareholders’ pecuniary interest and the directors’ interests
Cheff v. Mathes (1964) [too old]
● In employing defensive tactics, directors bear the burden of showing that they had
reasonable grounds for believing that the threatened takeover posed a threat to
corporate policy and effectiveness.
○ This can be established by showing good faith and reasonable investigation.
● Here:
○ One company was buying up all the stock of Cheff’s company and evidence
pointed to the company wanting to take over and liquidate. So they bought all
their shares back and were able to prove that the threatened takeover posed a
threat to corporate policy and effectiveness (especially because the company
expressed a dislike of the business practice of selling its furnaces by directly
hired retail salesmen)
Modern Developments: Background
● The business, social and legal landscape has changed significantly since the 1950s
Cheff decision when hostile takeovers were uncommon and thought of badly
●
There has been a rise in a new kind of investment banks that specialize in corporate
acquisition transactions along with a rise in law firms specializing in mergers and
acquisitions
●
Modern Developments: New Fiduciary Duties: Unocal and Revlon
DEFENSIVE MEASURES:
Unocal Corop v. Mesa Petroleum : repurchasing stock from its stockholders selectively to the
exclusion of a company that wants control (Mesa submitted an offer that was grossly
inadequate)
● In the context of adopting a defensive measure…
● The board gets the benefit of the BJR only when and if the board first sustains its
own burden of satisfying a 2-prong test:
○ (1) a reasonableness test that the directors had reasonable grounds to
believe that a danger to corporate policy and effectiveness existed
AND
○ (2) a proportionality test that the board’s responses were reasonable in
relation to the threat posed.
Unocal Corop v. Mesa Petroleum (1985) -- TEST
● Was the action within the power or authority of the board?
○ (1) does the statute authorize this defense; and
○ (2) if it is okay under the statute, does the firm’s charter impose any restrictions
on the use of this defense?
●
The board had reasonable grounds for believing that a danger to corporate policy and
effectiveness existed.
○ The directors satisfy this burden by showing good faith and reasonable
investigation.
●
●
The defense was reasonable in relation to the threat posed.
The standards for this has been fleshed out in further case law.
Post- Unocal Standards of Review
● Traditional BJR,
● Traditional duty of loyalty
● The new conditional BJR set out by Unocal
● Unocal left two critical questions:
○ 1. Which decisions get reviewed under which standard?
○ 2. What content should we give the applicable standard in a given situation?
TAKEOVER UNAVOIDABLE:
Revlon v. MacAndrews & Forbes Holdings
● Revlon’s directors owed a fiduciary duty to act in the best interests of the corporation,
but once it became evident that a takeover was unavoidable, Revlon’s directors owed a
duty to the shareholders to get the best price possible
●
Revlon’s agreement with Frostmann prevented an auction between Pantry Pride and
others, which was not in the best interest of the shareholders
When does Revlon apply?
● Revlon duties triggered when corporation initiates an active bidding process to sell itself
or effect a reorganization involving the break up of the company, and when in response
to a bidder’s offer the target abandon’s its long term strategy and seeks an alternative
transaction involving the breakup of the company.
○ Note that this rule says the Revlon duties are triggered when a company
undertakes a transaction that will cause a change in corporate control OR a
break-up of the entity – not necessarily BOTH
● A pure stock-for-stock transaction may not trigger Revlon duties (would not amount to a
change of control because of shareholder investment opportunity would remain),
● But in a mixed consideration transaction, it is likely that the DE SC would apply Revlon
duties to a transaction with a near-equal split of cash and stock because there would be
“no tomorrow” for half of the shareholders’ investment.
Combining Unocal and Revlon
● Decision to buy/sell: Business judgment rule
○ Unless:
○ conflict of interest, then entire fairness, or
○ change of control/break-up, then Revlon (see below)
●
Decision to implement defensive measure or deal protection device: Board must show
that it reasonably perceived a threat to corporate policy and effectiveness and its
responsive actions were reasonable in relation to that threat
●
Decision to undertake a transaction which will cause a change in corporate control, or a
break-up: Board must seek best price reasonably available to the stockholders
Paramount Communications, Inc. v. Time, Inc.
● Court applied a revised Unocal/Revlon test:
○ Determine if the corporation is putting itself up for sale or a takeover is imminent
○ If yes, then the directors owe a duty to shareholders to maximize the price of the
shares
○ If not, then the Unocal standard of reasonableness applies
INTRO TO SEC AND PROXY REGULATIONS
Securities and Exchange Commission - SEC
● Securities Act of 1933 and Securities Exchange Act of 1934 have 3 purposes:
○ 1. Require disclosure of meaningful information about a security and its issuer to
allow investors to make intelligent investment decisions
○ 2. Impose liability on those who make inadequate and erroneous disclosures of
information
○ 3. Regulate insiders, professional sellers of securities, securities exchanges, and
other self-regulatory securities organizations
Proxy
● Prior to each shareholders’ meeting, a public company solicits a proxy from each of its
shareholders by providing a proxy statement and a proxy card (or voting instructions).
● A proxy is a power of attorney allowing the company’s management (or another
designee) to vote the shares owned by a shareholder as directed by the shareholder or
at the designee’s discretion.
● The proxy solicitation process allows shareholders to exercise their voting rights without
being physically present at the shareholders’ meeting.
● The proxy statement informs shareholders about the items of business to be voted on at
a shareholders’ meeting, provides certain other SEC-required disclosures and solicits a
proxy from each shareholder entitled to vote at the meeting.
Proxies revisited
● A proxy may be thought of as a grant of authority by a shareholder that allows some
other person to vote the shareholder’s shares
● MBCA: proxy must be in writing, expire after 11 months unless otherwise provided, and
are revocable unless otherwise provided.
● To be irrevocable- must be “coupled with an interest”- consideration! (pp. 515-517)
●
● The federal government effectively has preempted the field
● Federal law deals with certain matters connected with shareholder voting that state law
covered inadequately
Exchange Act § 14 and the Proxy Rules
● 1. Exchange Act § 14(a)
○ Gives the SEC power to pass rules that have the force of law
○ These apply broadly to solicitations of proxies, consents, and authorizations
relating to shares that are registered under the ‘34 Act
●
● 2. How the Proxy System Works
○ Rule 14a-101 details the disclosure requirements
●
●
●
○ Rule 14a-6 is a filing requirement
○ Proxy rules apply to everyone, not just management
○ Exclusions and exemptions from coverage exist in some circumstances
○ Section 14A requires advisory votes on compensation
3. Proposals of Security Holders
○ Under Rule 14A-7, shareholders may choose to handle their own solicitations, in
which case management must (at its election) provide a list of holders or mail the
shareholders’ materials at the solicitors’ expense
○ Under Rule 14-8, shareholders meeting certain requirements may have their
proposals included in the management’s solicitation materials
4. False or Misleading Statements
○ Rule 14a-9, which prohibits false or misleading statements in a solicitation
subject to regulation, may be enforced by the SEC, the DoJ (if the violation is
willful), and by private parties under a long – recognized implied right
Private Right for Materially Misleading Communications
● An implied private right exists
● The plaintiff bears the burden with respect to several elements:
○ 1. Material facts
○ 2. Causation/ essential link
○ 3. Degree of fault required
Private Right – 1. Material Fact
● TSC Industries v. Northway
○ “An omitted fact is material if there is a substantial likelihood that a
reasonable shareholder would consider it important in deciding how to
vote.”
Private Right – 2. Causation/Essential Link
● How to prove causation/essential link?
○ Mills v. Electric Auto-Lite:
■ Where a misstatement or omission in a proxy statement has been
shown to be material, that determination itself can lead to the
conclusion that there is causation
■ There is no need for proof of whether the defect actually had an
effect on the voting, provided that the vote itself was an essential
link to the injury complained of
○ Virginia Bankshares v. Sandberg
■
■
A federal claim cannot be brought on the basis of a proxy statement
if the votes being solicited by the proxy statement could not affect
the outcome of the vote,
An opinion misstatement misleads when it is not honestly held and
misleads as to underlying subject matter
Private Right – 3. Degree of Fault Required
● Fradkin v Ernst
○ Negligence standard applies to the defendant corporation issuing a proxy
statement
10-b-5
Rule 10b-5
● Rule 10b-5 is a regulation created under the Securities and Exchange Act of 1934 that
targets securities fraud.
● This rule makes it illegal for anybody to directly or indirectly use any measure to
defraud, make false statements, omit relevant information, or otherwise conduct
business operations that would deceive another person in the process of
conducting transactions involving stock and other securities
Rule 10b-5
● "Rule 10b-5: Employment of Manipulative and Deceptive Practices":
● It shall be unlawful for any person, directly or indirectly, by the use of any means
or instrumentality of interstate commerce, or of the mails or of any facility of any
national securities exchange,
○ a)To employ any device, scheme, or artifice to defraud,
○ b) To make any untrue statement of a material fact or to omit to state a
material fact necessary in order to make the statements made, in the light
of the circumstances under which they were made, not misleading, or
○ c) To engage in any act, practice, or course of business which operates or
would operate as a fraud or deceit upon any person,
● in connection with the purchase or sale of any security.
SEC v. Texas Gulf Sulphur Co.
● Rule: if any individual has material non-public information, she must either
disclose that information or abstain from trading.
●
● This case underscored the “equal access to information” policy as the bedrock principle
for investor protection and market integrity.
●
● The Second Circuit agreed with the SEC that Rule 10b-5 was intended to assure that “all
investors trading on impersonal exchanges have relatively equal access to material
information,” and that “all members of the investing public should be subject to identical
market risks”
Persons subject to trading constraints
● Everyone has a duty to refrain from making material affirmative misrepresentations in
connection with the purchase or sale of a security
●
Not everyone has a duty to disclose material information before making a purchase or
sale
●
Which means, not everyone can violate 10b-5 through omission
Chiarella v. United States
● Rule: A duty to disclose information arises if there is a relationship of trust and
confidence between parties to the transaction.
●
● Chiarella had no such duty:
○ He was not a corporate insider in the acquiring corporation and he did not
receive confidential information from the target company
○ He had no fiduciary relationship with the shareholders of the target company:
■ he was not their agent;
■ they placed no trust or confidence in him;
■ they had no prior dealings with him.
● A duty to disclose under Section 10(b) does not arise from the mere possession of
nonpublic market information.
Rule 10b-5 and Classical Theory
● The rule: “silence in connection with the purchase or sale of securities may operate as a
fraud actionable under § 10(b) … such liability is premised upon a duty to disclose
arising from a relationship of trust and confidence between parties to a
transaction.”
10-b-5 and tipping
Misappropriation Theory
● Under the misappropriation theory, the duty arises out of an agreement, relationship or
course of conduct between the source of the information and the recipient that requires
the recipient to keep the information confidential.
Rule 10b5-2
● A duty of trust or confidence arises, in addition to other circumstances, whenever:
○ a person agrees to maintain information in confidence;
○ persons sharing confidence have a history, pattern, or practice of sharing
confidences such that the recipient of material non-public information knows or
reasonably should know that the person communicating the information expects
that the recipient will maintain its confidentiality; or
○ a person receives or obtains material non-public information from a spouse,
parent, child, or sibling, unless the recipient can demonstrate that, under the
facts and circumstances of that family relationship, no duty of trust or confidence
existed.
● Tipper-tippee cases, whether or not the crime of insider trading has occurred is
dependent upon the relational distance between the tipper and tippee. In other words, a
tipper who is related to, or a close friend of, the tippee has committed insider trading,
whereas a tip to a stranger does not meet the elements of the crime,
Here's how I would go about it.
Distinguish between duty of loyalty and duty of care.
a. Duty of loyalty – self-dealing, corporate opportunities, obligation of good faith
i. Self-dealing – director on both sides of transaction. Include any corporation owned or
controlled by director, any partnership that director is partner in, director’s close relative, etc.
ii. Corporate opportunities – director appropriated business opportunity that belonged to
corporation – apply four factor balancing test
iii. Obligation of good faith – subjective bad faith or intentional dereliction of duty, not gross
negligence
b. Duty of care – duty to act as a reasonable director would
2. Duty of care
a. If no business judgment (misfeasance), then was director reasonable in not acting and was
that a proximate cause of the harm?
b. If business judgment, the business judgment rule applies. BJR is rebutted when
i. Uninformed decision -> show gross negligence on the part of the directors in arriving at the
decision
ii. Self-dealing -> duty of loyalty
iii. Bad faith -> duty of loyalty
Fraud -> bad faith -> duty of loyalty
Illegality -> bad faith -> duty of loyalty
c. If BJR rebutted, then burden shifts to defendants to prove entire fairness
d. If not, plaintiff can prove waste (so one-sided such that corporation wasted or gifted its assets
away) -> very rare
e. If ratification in good faith by majority of disinterested directors or shareholders -> no liability
f. If corporation has DGCL 102(b)(7) provision, then directors not personally liable for monetary
damages. 102(b)(7) protects against duty of claim, but not duty of loyalty claims. That is, duty of
care claim is largely impossible with the exculpation provision.
3. Duty of loyalty
a. For self-dealing and corporate opportunity, ratification in good faith by majority of fully
informed disinterested directors or shareholders -> BJR -> no liability unless waste
b. If no ratification, burden shifts to defendant to prove entire fairness
c. If defendant proves -> no liability. If not, liable and transaction is voidable and defendant has
to account for his profit
d. For claims against controlling shareholder, ratification by either directors or shareholders
shifts burden to plaintiff to prove transaction was unfair
e. Ratification by both -> BJR -> no liability unless waste
f. Bad faith -> liability
Fiduciary duties
when you encounter an exam fact pattern with (1) a corporation that has lost money (or lost an
opportunity to make more money), and (2) the corporation’s board of directors (or, equally likely,
a particular director) was arguably stupid, lazy or greedy, then you need to decide whether the
question involves a possible breach by directors of the duty of care or a possible breach by the
directors of the duty or loyalty
Duty of care:
In essence, a board of directors makes decisions and supervises the decisions of others.
If an exam fact pattern raises the possibility that:
●
the board made a dumb decision, the board made a decision without appropriate study
and preparation, or the board did not spend enough time and effort in supervising others,
→ directors duty of care
Delaware also protects directors from liability for breach of duty of care in section 141(e).
Under section 141(e) of the Delaware General Corporation Law, directors can escape
liability for breach of duty of care if their actions or inactions were based on reasonable
reliance on the information and advice of officers, employees, or outside experts. In the
event that you have a law school exam question involving (1) a Delaware corporation, (2)
without a section 102(b)(7) provision in its certificate of incorporation, and (3) with facts that
suggest the board or a director was dumb or lazy, then look for facts about reliance on officers
or outside experts
MBCA duty of care
●
●
●
MBCA section 8.31(e) protects directors from possible duty of care liability if their actions
or inactions were based on reasonable reliance on the information and advice of officers,
employees, or outside experts.
MBCA section 2.02(b)(4) permits a corporation in its articles of incorporation to eliminate
the personal liability of a director for breach of duty of care.
MBCA section 8.30 requires that in discharging their decision-making function
and in discharging their oversight function, directors must “discharge their duties
with the care that a person in like position would reasonably believe appropriate
under similar circumstances.”
What Is the Business Judgment Rule and How Should the Business Judgment Rule Be Used in
Answering Exam Questions About the Merits of a Board of Directors’ Decision?
●
the business judgment rule must appear in any exam answer involving litigation over the
substantive merits of a board decision.
●
The business judgment rule means that a plaintiff alleging that directors breached
their duty of care cannot prevail solely by attacking the substantive merits of a
board decision. Because of the business judgment rule, a court will not rule as to
whether a board decision was a smart decision or a stupid decision when there is
no proof that the members of the board have in some way acted badly
●
under the business judgment rule a court will not review the merits of board
action when there is no proof that the members of the board have acted badly, i.e.,
“fraud, illegality or conflict of interest.”
8. Can the Board of Directors Breach Its Duty of Care by Carelessly Making a Decision?
●
Smith v. Van Gorkom is the case most commonly used to illustrate the proposition that a
board of directors breaches its duty of care by carelessly making a decision. In that
case, the plaintiffs alleged that the Trans Union board of directors’ decision to approve
and recommend for approval by shareholder a merger transaction in which Trans
Union’s shareholders received $55 cash per share was a breach of the board’s duty of
care
●
The trial court ruled for the defendant directors, finding that the directors’ approval of the
cash merger fell within the protection of the business judgment rule. The Delaware
Supreme Court overruled the trial court and ruled for the plaintiffs, reasoning: the
business judgment rule protects only “informed decisions”; gross negligence is
the proper standard for determining whether a board decision is an “informed
decision”; the decision-making process of the Trans Union board was grossly
negligent.
Today, the basic lesson of Van Gorkom is that 120 directors of a Delaware corporation
face liability for breach of their duty of care if they are grossly negligent in failing to
adequately inform themselves regarding a decision before them, unless that Delaware
corporation’s certificate of incorporation has eliminated liability for breach of duty of
case as permitted by section 102(b)(7)
Recall that Delaware General Corporation Statute section 107(b)(7) permits a Delaware
corporation to eliminate the directors’ liability for breach of a duty of care by so providing in the
corporation’s certificate of incorporation. Section 102(b)(7) goes on to state that “such provision
shall not eliminate or limit the liability of a director . . . for breach of the director’s duty of loyalty.”
Thus, in an exam fact pattern involving lack of oversight by the directors of a Delaware
corporation that has an exculpatory provision in its certificate, that exculpatory provision will be
irrelevant under Stone v. Ritter. 10.
What Facts Suggest That a Director Has Breached Her Duty of Loyalty to the Corporation?
Look for a fact pattern in which a director uses her position as a director to gain some
individual monetary gain or other personal advantage. More specifically, watch for either
(1) the director’s 126 usurping a “corporate opportunity” [e.g., BBC, a corporation, owns
and operates a restaurant that needs to expand. S, the owner of land adjacent to the
restaurant, contacts D because D is a director of BBC and offers to sell BBC the land that
is adjacent to BBC’s restaurant. D buys the land for D’s own real estate development
company, D Realty Inc., without ever mentioning the opportunity to BBC’s other
directors] or (2) the corporation’s entering into an “interested director transaction” [e.g.,
BBC corporation buys land from D Realty, Inc., a corporation owned by one of its
directors at an above market price] or (3) (much less likely) a director’s competing with the
corporation [e.g., D, a director of the BBC corporation, opens D’s own restaurant in the same
neighborhood as BBC’s restaurant].
11. Can a Delaware Corporation’s Certificate of Incorporation or an MBCA Act State
Corporation’s Article of Incorporation Eliminate a Director’s Liability for (1) Usurping a Corporate
Opportunity, (2) Entering into an Interested Director Transaction, or (3) Competing with the
Corporation?
The Delaware General Corporation Statute and the MBCA use different words to state the
same general rule: a corporation cannot in its certificate or articles eliminate a director’s
liability for (1) usurping a corporate opportunity, (2) entering into an interested director
transaction, or (3) competing with the corporation.
12. What Does Delaware Corporate Law on Usurping a “Corporate Opportunity”
if the corporation in your exam fact pattern is a Delaware corporation, then you should also
mention Guth v. Loft, Inc., the leading Delaware case on usurping a corporate opportunity.
Guth was the President and a director of Loft Inc., a corporation that manufactured and sold
candies, syrups, food and beverages, including Coca-Cola (but not Pepsi-Cola). Guth took for
himself the opportunity to purchase the Pepsi-Cola formula and trademark. In finding that Guth
violated the “rule of corporate opportunity,”
Guth Test: “[I]f there is presented to a corporate officer or director a business
opportunity which the corporation is financially able to undertake, is, from its nature, in
the line of the corporation’s business and is of practical advantage to it, is one in which
the corporation has an interest or a reasonable expectancy, and, by embracing the
opportunity, the self-interest of the officer or director will be brought into conflict with
that of his corporation, the law will not permit him to seize the opportunity.”
GUTH TEST:
The corporate opportunity doctrine, as delineated by Guth and its progeny, holds that a
corporate officer or director may not take a business opportunity for his own if: (1) the
corporation is financially able to exploit the opportunity; (2) the opportunity is within the
corporation's line of business; (3) the corporation has an interest or expectancy in the
opportunity; and (4) by taking the opportunity for his own, the corporate fiduciary will thereby be
placed in a position inimicable to his duties to the corporation.
→ The Court in Guth also derived a corollary which states that a director or officer may take a
corporate opportunity if: (1) the opportunity is presented to the director or officer in his
individual and not his corporate capacity; (2) the opportunity is not essential to the
corporation; (3) the corporation holds no interest or expectancy in the opportunity; and
(4) the director or officer has not wrongfully employed the resources of the corporation
in pursuing or exploiting the opportunity.
OR Rejection of Guth Test in Northeast Harbor Golf Club (instead use ALI principles for
corporate opportunity doctrine):
The four such ALI rules that were most important in Northeast Harbor Golf Club, Inc. v.
Harris, (and most likely to be important on your exam) are: (1) a business prospect is a
“corporate opportunity” if the director or corporate officer learns of the opportunity
because she is a director or officer—even if the opportunity is not in the corporation’s
line of business, and (2) similarly, a business prospect is a “corporate opportunity” if it is
closely related to a business in which the corporation is now engaged or expects to 130
engage, regardless of how the director or officer learns of the opportunity, and (3) a
director or corporate officer must always offer a “corporate opportunity” to the
corporation and the corporation must reject it before taking it for herself, and (4) whether
the corporation is financially able to pursue the business prospect is irrelevant to the
questions of whether a business prospect is a “corporate opportunity” or whether the
director or corporate officer must offer the “corporate opportunity” to the corporation.
What Are “Interested Director Transactions” and How Do the MBCA and the Delaware General
Corporation Statute Deal with “Interested Director Transactions”?
An “interested director transaction” is a transaction between a corporation and one or
more of its directors (or officers or controlling shareholders), or between the corporation
and an entity in which one or more of its directors has a material financial interest. For
example, D is a member of the board of directors of BBC corporation. D’s sale of Redacre to
BBC would be an “interested director transaction.” Or, to use the language of the MBCA, D’s
sale of Redacre to the corporation for which D is a director would be a “director’s conflicting
interest transaction.
While the language of the relevant MBCA provisions (FOR INTERESTED TRANSACTIONS)—
sections 8.60 to 8.63—is different from the language of the relevant Delaware provision—
section 144, the basic approach of the two statutes is similar in at least THREE respects:
(1) Even if a corporation enters into a transaction with one of its directors that
transaction will not always be avoided, and that interested director will not always be
held liable.
● Some interested directors transactions are good for the corporation. For example, a
director might be willing to sell to the corporation at a discount or make a loan to a
corporation even though the corporation’s credit rating makes it impossible to obtain a
loan from a financial institution.
(2) If a transaction is an interested director transaction, the director escapes judicial
relief against her or the 132 transaction by proving “the entire fairness” of the
transaction to the corporation at the time of the transaction.
● Notice that the defendant has the burden of proving fairness at the time of transaction.
● Under the entire fairness standard, the defendant directors have the burden of
proving both (1) procedural fairness, i.e., that the agreement process was fair
(sometimes referred to as “fair dealing”) and (2) substantive fairness, i.e., that the
price was fair.
○ While your answer should treat “fair dealing” and “fair price” as separate
components, a court’s concern about the deal process often affects its
conclusion about the fairness of the deal’s substance.
○ “fair price” requires more than proof that the price was reasonable. Instead, the
entire fairness defense to a suit challenging an interested director transaction
requires that the defendant prove that the price would not have been better if the
deal process had not been flawed????
(Third factor, and HOW CAN an interested director transaction be structured so that there is no
judicial relief against the director or the transaction without meeting the burden of proving “the
entire fairness” of the transaction to the corporation at the time of the transaction?::::
(3) If a transaction is an interested director transaction, the director escapes judicial
relief against her or the transaction if the transaction is approved by a majority of the
disinterested directors or by the disinterested holders of a majority of shares after full
disclosure.
● Director approval or shareholder approval will have this “cleansing” effect only if there
has been full disclosure of the conflicting interest
●
EXAMPLE:
○ To illustrate, Larry, one of the four directors of BBC, sells Redacre to BBC. If,
after disclosure of D’s ownership of Redacre, two of the other three BBC
directors authorize the transaction, then D does not have to prove the “entire
fairness” of the transaction. Similarly, if Larry owns 100 shares of BBC stock and
Moe, Curly and Shemp own the other 1200 outstanding shares, then D does not
have to prove “entire fairness” if a majority of the shares owned by shareholders
other than Larry approve the transaction after disclosure
Essentially:
● a corporation’s transactions are typically made or reviewed by the board of directors.
When a director of the corporation has a personal interest in a transaction with the
corporation, that transaction must be approved by disinterested people. The
disinterested people can be either (i) other members of the board of directors who are
disinterested, (ii) other shareholders who are disinterested, or (iii) a judge. If (i) or (ii),
then 136 there must be disclosure. If (iii), then there is the “entire fairness” standard
review by a judge.
Good Faith:
In re The Walt Disney Company Derivative Litigation
● case involved a challenge to the Walt Disney Company’s board of directors’ approval of
$140 million of termination pay to outgoing president Michael Ovitz. Challenged on bad
faith
○ Walt Disney Company, like most Delaware corporations, added such an
exculpatory provision to its certificate. Section 102(b)(7), however, does not
permit a corporation to “eliminate or limit the liability of a director . . . for acts or
omissions not in good faith.” but 102(b)(7), however, does not permit a
corporation to “eliminate or limit the liability of a director . . . for acts or omissions
not in good faith.”
● court indicated that the facts necessary to support a lack of good faith are facts that
“suggest that the defendant directors consciously and intentionally disregarded their
responsibilities
and Stone v. Ritter
●
●
the duty to act in good faith is a part of the duty of loyalty.
Traditionally, the duty of loyalty has been limited to situations in which a director realizes
a personal financial gain at the expense of the corporation—taking an opportunity from
the corporation, profiting from a transaction with the corporation, competing with the
corporation
●
After Stone v. Ritter, there is a lack of good faith and thus breach of a duty of
loyalty whenever a director knowingly, for any reason, does not act in the
corporation’s best interest. The important word is “knowingly.”
3 categories of indemnification categories
Category (1) Mandatory Indemnification
A corporation must indemnify a director who was “wholly successful” in the litigation. If
the court rules for the defendant director, then the corporation must reimburse the director for
the litigation expenses she incurred.
● Wholly successful”, a phrase used both by the MBCA and the Delaware General
Corporation Statute, means a judgment in the director’s favor, regardless of the reason
for the judgment. Winning on a motion to dismiss because the plaintiff lacked standing to
bring a derivative action or on a motion for summary judgment because the statute of
limitations has run is just as “wholly successful” as a jury verdict on the merits. “Wholly.”
The win must be a total win. No mandatory indemnification for the director defendant
who was sued by a plaintiff seeking $1,000,000 and receiving only a judgment of $1.
Category (2) Prohibited Indemnification
Prohibited indemnification fact patterns involve shareholder derivative actions. If the
plaintiff is the corporation or a shareholder bringing a derivative suit on behalf of the
corporation, the corporation is prohibited from indemnifying the director for any
judgment or amount paid in settlement where the payment goes to the corporation.
●
●
EXAMPLE: To illustrate, P, an Acme Corp. shareholder, brings a shareholder derivative
suit against D, a director of Acme Corp., alleging D’s breach of their fiduciary duty
caused Acme Corp. to lose $200,000. D settles for $99,000. If D paid the $99,000
settlement to Acme Corp. and Acme Corp. was able to indemnify D by reimbursing D for
the $99,000 that D paid to Acme Corp., then the litigation and the settlement would have
been pointless.
“for any judgment or amount paid in settlement:” The absolute prohibition on
indemnification is limited to the judgment or amount in settlement. The prohibition on
indemnification does not include reimbursement of the defendant director’s attorneys’
fees or other litigation-related expenses unless (i) the defendant director was “adjudged
liable” and (ii) received an “improper financial benefit.” MBCA 8.51(d)(2)
Category (3) Permissive Indemnification
Residual category
●
●
Above shareholder derivative hypo - attorney’s fees and other litigation expenses are
permissive.
Direct suit hypo: S, a shareholder, sues the board of directors of Baker Corp. alleging
that they had been wrongfully denied access to Baker Corp’s books and records. Baker
Corp’s board 155 of directors pays $100,000 to S to settle the direct suit and incurs
attorneys’ fees of $20,000. Both the $100,000 settlement payment and the $20,000
expenses come within category 3 permissive indemnification
NOTE:
● As to direct actions, judgments and amounts paid in settlements, as well as expenses,
come within the category of permissible indemnification.
● As to derivative actions, only expenses come within the category of permissible
indemnification and then only if (i) there was not a judgment for the plaintiff and (ii) no
“financial benefit” to the director.
NOTE: indemnification statutes further limit indemnification for category three
permissive indemnification to directors who can show that they (1) acted in good faith
and (2) with the reasonable belief that they acted in the best interests of the corporation
SHAREHOLDER DERIVATIVE SUITS
Keep in mind:
● a corporation is owned by its shareholders;
● even though a corporation is owned by its shareholders, a corporation is governed by its
board of directors—a corporation’s decisions are made by its board of directors;
● the business judgment rule generally precludes judicial review of the merits of a decision
by the board of directors;
● among the many decisions made by a corporation’s board of directors is the decision
whether to sue someone;
● the business judgment rule generally precludes judicial review of merits of a decision by
a corporation’s board of directors not to sue;
● the business judgment rule, however, does not apply to all decisions by a board of
directors. The business judgment rule applies only when directors make a decision
without a conflict of interest.
Four important things about shareholder derivative action
●
●
●
●
(1) Whether a suit initiated by a shareholder should be treated as a shareholder
derivative suit
(2) Who “wins” in a shareholder derivative action
(3) What the special procedural requirements for a shareholder derivative action are
(4) What the role of a special litigation committee is
1. What Factors Determine Whether a Lawsuit Initiated by Shareholders Should Be Treated as
a Shareholder Derivative Action or a Direct Action?
●
courts generally ask two closely related questions: (1) who sustained a direct harm and
(2) who should receive relief
Difficult case in determining direct or derivative (Flying Tiger):
●
Court looked at the impact of the merger on the shareholder and rights of the 143
shareholder, not the impact of the merger on the corporation – said it was a direct action
→ “where a shareholder sues on behalf of himself and all others similarly situated to * * * enjoin
a proposed merger or consolidation * * * he is not enforcing a derivative right; he is, by an
appropriate type of class suit enforcing a right common to all the shareholders which runs
against the corporation. . . . [Plaintiff’s] position is even stronger than it would be in the ordinary
merger case. In routine merger circumstances the stockholders retain a voice in the operation of
the company, albeit a corporation other than their original choice. Here, however, the
reorganization deprived him and other minority stockholders of any voice in the affairs of their
previously existing operating company.”
Easier examples:
● Suits by shareholders alleging denial of voting rights or nonpayment of declared
dividends are easier examples of direct suits
● suits alleging directors’ breach of duty of care or duty of loyalty are easy examples of
derivative suits. Directors owe fiduciary duties to the corporation.
2. Who Wins in a Shareholder Derivative Action?
●
The corporation is supposed to be the winner in a shareholder derivative action. As
stated above, in a derivative action, the plaintiff shareholder(s) is asserting the
corporation’s claim and so if the plaintiff shareholder(s) prevails in a shareholder
derivative action, any damages should be paid to the corporation and not the plaintiff
shareholder(s)
Caremark
● The court can order the corporation to pay the fees of the attorney for the plaintiff if the
case resulted in a substantial benefit to the corporation.
3. What Are the Special Procedural Requirements for Commencing and Ending a Shareholder
Derivative Lawsuit?
●
“contemporaneous ownership” requirement for shareholder derivative action:
○ The plaintiff in a shareholder derivative suit must be a shareholder at the time the
shareholder derivative suit was brought and, subject to limited exceptions, must
also have owned the stock when the claim arose
●
the shareholder bringing the derivative action must show that she will adequately
represent the interest of the corporation.
●
Similarly, statutes and rules governing shareholder derivative actions, like statutes and
rules governing class actions, require that the suit cannot be dismissed or settled without
the court’s approval.
●
the procedural requirement in all states that the shareholder make a demand on the
board of directors of the corporation that it bring the suit prior to the
shareholder’s filing a derivative suit would seem to make sense.
○
●
●
●
The demand is essentially a letter from the shareholder to the board of directors,
explaining the grounds for the corporation’s suing and asking the board of
directors to bring the suit. At first blush, requiring a demand does not seem like a
big deal. The shareholder just needs to (i) send the demand letter, (ii) wait for
147 the board of directors to reject the demand, and (iii) then bring the suit
herself as a shareholder derivative suit
The problem with a shareholder’s pursuing the demand alternative is that Delaware
courts treat the shareholder’s making a demand as a concession by the shareholder that
the board of directors is free from conflict.
○ Whether to initiate litigation to pursue the claims in a stockholder’s demand is
then left to the board’s business judgment. And, when the board of directors
refuses the shareholder’s demand that the corporation initiate litigation, a
shareholder wishing to pursue the litigation must somehow first rebut the
business judgment rule presumptions given to the board’s decision
To come within the excuse of futile demand alternative, the plaintiff shareholder
must then provide specific factual allegations (not just general statements) that
raise a reasonable doubt that either (1) the board of directors was disinterested, or
(2) the challenged act is so egregious on its face that it could not have resulted
from the exercise of sound business judgment. (Delaware)
MBCA:
● MBCA requires that a pre-suit demand must be made in every shareholder derivative
case
● under the MBCA, a board’s rejection of plaintiff’s demand will not be entitled to the
judicial deference of the business judgment rule
4. What Is the Role of a Special Litigation Committee?
●
●
●
Under the Delaware General Corporation Statute and the MBCA, the board of directors
can delegate governance over a particular decision to a subcommittee of some of the
directors. An SLC is such a subcommittee of independent directors—often new directors
brought on to the board specifically to serve on the SLC—that conducts its own,
independent review of the complaint to recommend whether the litigation is in the best
interest of the corporation
RAISES 2 questions for the court:
○ 1. Was the SLC truly independent and acting in good fatih? (corp has burden of
showing independence and good faith of the SLC)
○ 2. What deference should the court give to a truly independent SLC’s
recommendation that the shareholder derivative action be dismissed
■
MBCA: the court “shall dismiss a derivative proceeding on motion of the
corporation if [an SLC] . . . determines in good faith after conducting a
reasonable inquiry upon which its conclusions are based that the
maintenance of the derivative proceeding is not in the best interest of the
corporation. . . .” This seems consistent with the business judgment
rule—the court deferring to the business judgment of the board (or
subcommittee of the board) rather than interjecting its own business
judgment
■
Delaware: Zapata: (2 step process)
● The Court should apply a two-step test to the motion.
● First, the Court should inquire into the independence and
good faith of the committee and the bases supporting its
conclusions. . . . The second step, [t]he Court should
determine, applying its own independent business judgment,
whether the motion should be granted. This means, of
course, that instances could arise where a committee can
establish its independence and sound bases for its good faith
decisions and still have the corporation’s motion denied
■
Mergers & Acquisitions
2. What are the legal effects of a merger
MBCA section 11.07(a)(2) is typical of corporate codes in providing that “[w]hen a merger
becomes effective . . . the separate existence of every corporation . . . that is merged into the
survivor cease(s).
It is not only the disappearing corporation’s “existence” that is merged into the survivor, but also
the disappearing corporation’s assets and liabilities.
● When Acme Corp. merges into Baker Corp., all assets of Acme Corp. and all assets of
Baker Corp. become assets of Baker Corp. And, all creditors of Acme Corp. and all
creditors of Baker Corp. become creditors of Baker Corp.
Shareholders of A become shareholders of B. Shareholders of B remain shareholders of B…
OR the the shareholders of the disappearing corporation receive cash instead of stock. In such
a cash for stock merger (a/k/a a “cash out merger”), the shareholders of the disappearing Acme
Corp. receive cash
3. Who Has to Approve a Merger?
First, executives of the two corporations negotiate a merger agreement.
Then, the boards of directors of both of the merging companies must approve the merger.
● If Acme Corp. is merging into Baker Corp., the Acme Corp. board of directors and
the Baker Corp. board of directors both must agree on a plan of merger.
● Generally, the plan of merger must also be approved by the requisite majorities of
the shareholders of both the disappearing and the surviving corporation.
● Under both the Delaware General Corporation Statute and the MBCA, an
affirmative vote of the shareholders of the surviving corporation is not required if
the number of outstanding voting shares of the surviving corporation after the
combination is not increased by more than 20% from the number of outstanding
voting shares before the combination
4. What if a Shareholder Is Unhappy with the Proposed Plan of Merger?
●
First, you know that shareholders who are unhappy with the proposed merger can sell
their shares.
●
Second, you know that shareholders who are unhappy with the proposed merger can
vote against it. 202
●
Third, you know that (i) mergers also require decisions by the board of directors, and (ii)
a shareholder who is unhappy with a decision of the board of directors can claim that the
directors approving the merger breached their duty of care or duty of loyalty, if the facts
support such a claim.
●
Fourth: appraisal rights: a shareholder who properly assert their dissenting shareholder’s
right of appraisal can compel the corporation to pay them in cash the fair value of their
shares as determined by a judicial appraisal process.
○ Ex: S is a 10% shareholder of Acme Corp., which merges into Baker Corp. The
effect of the merger, of course, is that Acme Corp. and its shares both cease to
exist. Assume that the merger agreement values Acme Corp. at $3,000,000 and
so provides that Acme Corp. shareholders will receive consideration that has a
value of $3,000,000. This consideration can be Baker Corp. stock or other
property or cash. As a 10% shareholder of Acme Corp., S would receive 10% of
that consideration, i.e. consideration with a value of $300,000
○
Ex. Assume next that S instead properly asserts their dissenting shareholder’s
right of appraisal, and the court decides that the fair value of Acme Corp. is
$5,000,000, and not $3,000,000. S, as a dissenting shareholder who owns 10%
of the outstanding stock of Acme Corp. and seeks appraisal, has a right to
$500,000 (10% of $5,000,000) in cash not $300,000 (10% of the $3,000,000 of
total consideration actually received by Acme Corp).
○
Procedure: Shareholder must send notice to the corporation of their intent to
exercise appraisal rights before the shareholder vote. Then, of course, the
shareholder must later abstain or vote against the merger. Finally, if the merger
is approved, the shareholder must timely tender their stock to the corporation and
make a written demand for appraisal
○
Watch for a merger agreement in which (i) the shareholders of the disappearing
corporation receive cash and (ii) the majority shareholder of the disappearing
corporation is also the owner of the surviving corporation. Such a merger is called a
“freeze out merger” because the minority shareholder is forced out, i.e., “frozen out.”
When you see such a fact pattern in an exam question you are seeing an interested
director transaction and your professor needs to see your application of the entire
fairness doctrine discussed supra at page 131 et seq
5. How Does a Corporation’s Selling All (or substantially all) of its assets to another corporation
differ from that corporation’s merging into another corporation)
●
Similarities: The two transactions are similar in that an end result of both is that Baker
Corp. still exists. And, another end result of both is that Baker Corp. will own all assets
that formerly belonged to Acme Corp. Finally, Acme Corp.’s sale of all of its assets to
Baker Corp., like Acme Corp’s merger into Baker Corp., would have to be approved by
the board of directors of both corporations.
●
Differences:
○ Acme Corp.’s sale of all of its assets to Baker Corp. does not end Acme Corp.’s
existence. Instead, Acme Corp.’s sale of all of its assets to Baker Corp. simply
changes Acme Corp.’s assets from what it once owned, but has now sold to
Baker Corp., to the proceeds from that sale
○
○
○
After Acme Corp.’s merger into Baker Corp., Acme Corp.’s creditors become
creditors of Baker Corp. After Acme Corp.’s sale of its assets to Baker Corp.,
Acme Corp.’s creditors remain creditors of Acme Corp.
In a merger, the shareholders of the disappearing corporation and the
shareholders of surviving corporation have the same rights. Both have the right
to vote on the merger; both have the same appraisal rights. In a sale of assets,
the shareholders of the selling corporation have a right to vote on the transaction
and have appraisal rights. The shareholders of the buying corporation, however,
have neither the right to vote on the transaction nor appraisal rights.
■ To review, Acme Corp.’s sale of all of its assets to Baker Corp. would
have to be approved by (1) the board of directors of both Acme Corp. and
Baker Corp. and (2) the shareholders of Acme Corp. The shareholders of
Acme Corp. would have appraisal rights. The 206 shareholders of Baker
Corp., would not have a right to vote on Baker Corp.’s purchase of Acme
Corp.’s assets and would not have appraisal rights unless the Baker
Corp. shareholders are able to convince the court to apply the “de facto
merger doctrine
6. What is de facto merger concept?
In some states, shareholders of a corporation that has bought all of the assets of another
corporation have successfully invoked the de facto merger doctrine to gain appraisal
rights
●
Ex. Baker Corp. buys all of the assets of Acme Corp. As a result of the deal structure,
Baker Corp.’s shareholders will not be entitled to vote and will not have appraisal rights.
Unhappy Baker Corp. shareholders argue that the sale of assets is a de facto merger. If
the court agrees, then the court will ignore the form of the transaction and grant Baker
Corp. shareholders the right to vote and to appraisal
Hariton
●
rejected a shareholder’s efforts to re-characterize a sale of assets as a de facto merger.
7. How is a Tender Offer Different from a Merger or Asset Sale?
The tender offer is a form of acquisition that does not require the approval of the board
of directors of the acquired corporation (a/k/a the “target corporation”). A tender offer is
an offer made by the bidder directly to the shareholders of the target corporation to
purchase their shares.
● The usual purpose of a tender offer is to acquire a sufficient number of shares of the
target corporation to replace the target’s present board of directors with directors more
acceptable to the bidder.
A typical tender offer has the following characteristics:
● the target company is a public corporation that is a registered corporation;
● the offer is made at a fixed price which is at a premium above the prevailing market
price;
● the offer is open for a limited period of time;
● the offer is contingent on shareholders’ tendering some minimum number and/or
maximum number of shares that the bidder will buy;
● the offer is communicated to all shareholders of the target corporation by means of
newspaper advertisements and a general mailing.
If the tender offer is opposed by the board of directors of the target corporation, then the
tender offer is referred to as a “hostile takeover.”
● Actions taken by the board of directors of a target corporation to prevent a hostile
takeover have such colorful names as “Pac Man,” “poison pill,” and “shark repellent” and
are covered in a Merger and Acquisition course
Securities
How Does Rule 10b–5 Come into Play When a Person Makes a False or Misleading Statement
in Connection with a Stock Transaction?
Rule 10b–5 prohibits making a false or misleading statement of material facts in connection with
the purchase or sale of securities. 10b5 applies to all sales of stock, regardless of who the seller
and buyer are and regardless of whether the stock is stock of a public corporation like
McDonald’s or stock of a close corporation like CGS
●
Ex. Ehrlich, one of three shareholders of California Gulf Sulfur, Inc. (CGS) who is neither
an officer nor director of CGS induces Dinesh to buy his CGS stock by making false
statements about mineral deposits on land owned by CGS, then Ehrlich has possibly
violated Rule 10b–5
the plaintiff in a Rule 10b–5 action must be the United States (either the Department of Justice
or the SEC) and that all the United States has to prove is that: (i) the defendant made a
statement in connection with the purchase or sale of stock; (ii) the statement was false; and (iii)
the false statement was material.
→ must also prove reliance and scienter
(1) Materiality
● (1) the general test for materiality: whether there is a substantial likelihood that a
reasonable investor would consider the information important in deciding whether
to buy or sell the stock
● (2) Basic, Inc. v. Levinson test to determine materiality when the relevant facts are
“contingent facts”, i.e., something that may (but not necessarily will) happen.
○ Materiality of contingent facts: considers (1) the magnitude of the possible event
and (2) the probability that the event will occur. In other words, the greater the
impact of the event, the less certain its occurrence must be in order for investors
to find the information important and, thus, material
(2) Reliance
● Plaintiff has the burden of proving reliance.
(3) Scienter
● a Rule 10b–5 plaintiff must prove “scienter,” which the Court then described as showing
that the defendant acted with an intent to (tendency to deceive) “deceive, manipulate or
defraud.”
● has to be more than mere negligence.
● Reckless may be enough
●
The plaintiff in a Rule 10b–5 case can be not only the United States but also the private
party who bought or sold the stock.2 Therefore, Dinesh can be a Rule 10b–5 plaintiff.
○ if Dinesh is the plaintiff in a Rule 10b–5 action, it will be a direct, not derivative,
action. The claim belongs to Dinesh—he was the victim of Ehrlich’s false
statement
2. How Did the Texas Gulf Sulphur Case Expand the Application of Rule 10b–5 to “Insider
Trading”?
●
We know that saying stuff that is false (e.g., “Acme Corp. has been profitable every
quarter” when Acme Corp. has not been profitable every quarter) or misleading (e.g.,
“Acme Corp. has been profitable every quarter” when the speaker knows that Acme will
not be profitable this quarter) can be the basis for a Rule 10b–5 action by the
government, or by the buyer, or seller of stock who relied on the false or misleading
statement
●
SEC v. Texas Gulf Sulphur Co. was the first circuit court decision holding that the failure
to say something, i.e., nondisclosure, can be the basis for a Rule 10b–5 action
Facts:
Geologists acting for the Texas Gulf Sulphur Co. (TGS) found evidence of ore deposits on land
TGS had optioned. TGS kept this information confidential—not even all of the members of the
TGS board of directors knew of the mineral discovery—so that TGS could buy surrounding land
cheaply.
Some TGS officers and directors, however, not only knew of the mineral findings but also (1)
took advantage of this “material inside information” to buy TGS stock before the information
became public and the price of TGS stock increased, and (2) “tipped,” i.e., told others so that
they could buy TGS stock before the information became public.
The SEC filed a Rule 10b–5 action against (i) the officers and directors who bought TGS stock,
(ii) the officers and directors who told others to buy TGS stock (now known as “tippers”), and (iii)
non-insiders who were given this inside information (now known as “tippees”).
The Second Circuit referred to the TGS officers and directors as “insiders” and held that these
insiders violated Rule 10b–5 by “insider trading,” i.e., buying TGS stock when they had material
“inside information” (i.e., information unavailable to those with whom they were dealing). The
Second Circuit also held that non-insiders, such as the people who had been told by insiders
about the mineral find, violated Rule 10b–5 by buying TGS stock—“all transactions in TGS stock
. . . by individuals apprised of the drilling results . . . were in violation of Rule 10b–5.”
RULE:
●
“The essence of the Rule is that anyone who, trading for his own account in the
securities of a corporation, has ‘access, directly or indirectly, to information intended
to be available only for a corporate purpose and not for the personal benefit of anyone’
may not take ‘advantage of such information knowing it is unavailable to those with
whom he is dealing,’ i.e., the investing public.”
How Did Post-Texas Gulf Sulphur Supreme Court Decisions in Chiarella and Dirks Narrow the
Impact of Rule 10b–5 on Trading with Inside Information?
Chiarella
In Chiarella v. United States, the person trading with the benefit of inside information was not an
insider of the corporation whose stock he was purchasing. Instead, Chiarella worked for the
printing company that was preparing tender offer documents. He was able to figure out the
identity of the target corporation, bought its stock, and sold that stock for a profit after
announcement of the tender offer.
Chiarella was convicted of violating Rule 10b–5. The Supreme Court reversed the conviction
because the jury instruction was wrong
The jury instruction was consistent with the above dicta from Texas Gulf Sulphur. The jury was
told that all that they needed to find in order to convict Chiarella was that he benefitted from
material, non-public information in buying the stock. The Supreme Court held that the jury
instruction was wrong—merely proving possession of material nonpublic information by
a buyer of stock is not enough to establish a violation of Rule 10b–5
Under this theory, section 10(b) of the 34 Act and Rule 10b–5 are violated when a
corporate insider with material nonpublic information buys or sells her corporation’s
stock. The violation arises from a breach of fiduciary duty. Directors and officers owe a
fiduciary duty. Chiarella was an employee of an unrelated printed company, not a director or
officer of the corporation’s whose stock he purchased. Chiarella did not breach a fiduciary duty
and so did not violate Rule 10b–5.5
Proxy laws
The most likely exam question on federal proxy laws will involve a registered corporation’s
soliciting proxies from all of its shareholders to ensure that there will be a quorum and the
necessary majority shareholder vote for the merger proposed by the board of directors.8 A
shareholder contends that the corporation’s proxy statement was fraudulent
●
Rule 14a–9 is a broad anti-fraud rule, covering both false statements of material facts
and omissions of material facts;
●
●
●
●
The test for materiality is “substantial likelihood that a reasonable shareholder would
consider it important in deciding how to vote”;9
The Supreme Court has recognized an implied private right of action for violation of Rule
14a–9;
In any such private right of action, shareholder reliance on the misstatement or omission
in the proxy statement is presumed.10
1. Election of officers; hiring or dismissal of executive employees
2. Setting compensation of principal employees
3. Establishment of pension, profit-sharing, and insurance plans
4. Selection of directors to fill vacancies on the Board or a committee
5. Purchase, sale, or lease of major or long-term assets
6. Borrowing funds, entering into credit agreements, and establishing or changing bank
accounts
7. Lending money, except in the case of companies whose business it is to do so
8. Offering new services or opening a branch office
9. Changing the location of the principal office
10. Instituting or settling litigation
11. Issuing shares of stock
12. Investing corporate funds (other than short-term cash management)
13. Adopting or changing share certificates or the corporate seal
14. Declaration of dividends or distributions
15. Establishing or changing dates of regular meetings of stockholders and directors
16. Establishing a fiscal year
Actions Requiring Board & Stockholder Approval
1. Amendments to the Certificate of Incorporation
2. Adopting or amending bylaws
3. Establishing a subsidiary or entering into any merger, acquisition, or other reorganization,
recapitalization, or change in stockholders’ rights
4. Sale, lease, exchange, or other disposition of all or substantially all of the corporation’s assets
5. Dissolution of the corporation
6. In certain instances, indemnification of directors, officers, and employees
7. Approval of certain transactions between the directors/officers and the corporation, including,
in some cases, loans to or guarantees of the debts of such persons
8. Adoption of stock option plans and employee benefits plans involving directors and officers
Actions Typically Requiring Stockholder Approval
1. Election and removal of directors
If a corporation proposes to take any action on exceptional business dealings, such as any of
those above mentioned matters, the Secretary should plan either to obtain the proper written
consent of the directors and/or stockholders on the matter, or at least add it to the agenda for
the next corporate meeting