Corporations Tests

Corporations Tests
- State law
o Fiduciary duties
- Federal law
o Mandatory disclosures
o Accountants and auditors
- How shareholders are protected
o Laws against fraud and unfairness
o Ability to sell their shares in a stock market
o Holding stock in portfolios
- How management is disciplined
o Competitive markets
o Capital markets
o Stock price
Limited Liability
Is it a limited corporation?
o How is it formed?
 File articles of incorporation w/ Sec of State
 Filing fees
o Who is liable?
 Limited to the value of shares of each investor
o Who has control?
 Board, elected by shareholders (but can modify by K to resemble
Did corporation effectively incorporate under DGCL?
o Did corp file certificate of incorporation w/ Sec of State, w/
 Name of corp
 Name and address of registered agent
 Nature of biz (any lawful activity)
 Description of corp’s stock and relations among stockholders
 Name and address of incorporator
 Optional provisions
 Limits on directors or shareholders
 Supermajority vote of shareholders, or quorums
o Unanimity recommended if only 4 shareholders
 Limits on duration
 Provisions imposing personal liability
 Preemptive rights
 Provision allowing corp to opt out of monetary damages for
duty of care
o Were bylaws properly amended?
 By director vote
o If incorporation is defective,
 Is it a de facto corporation? Cranson
 Is there a law authorizing the corp?
 Is there a good faith effort to comply w/ the law?
o Hiring atty who makes mistakes not enough
 Is there an actual exercise of corporate powers?
 Is it a corp by estoppel? Cranson
 Envelope from IBM addressed to corp is enough b/c shows
that IBM assumed it was dealing w/ a corp.
 Of no use in torts claims; does apply in contracts claims
Corporate formalities
o DGCL §211b: directors are elected at an annual meeting
o DGCL §211d: board may call special meeting
o DGCL §212a: one vote per share unless cert of incorp says otherwise
o DGCL §216: majority quorum unless cert of incorp says otherwise
o DGCL §212b: in a large publicly traded corp, most votes are by proxy. In
DE, proxies are good for 3 years.
Who has control?
o DGCL §141(a): “The business and affairs of every corporation organized
under this chapter shall be managed by or under the direction of a board of
 §141(c)(2): board can delegate to committees, but CANNOT
 anything that requires stockholder action
 amendment of certificate of incorporation
 recommendation to stockholders to sell, lease, or exchange
all or substantially all of corp’s property and assets
 recommendation to stockholders of a dissolution of the
 adoption, amendment, or repeal of bylaws
Did the board act in good faith? DGCL §141(e)
o Board is fully protected in relying in good faith on the records of the corp,
and on info, opinions, reports or statements presented to the board by any
officer or employee, board committee, or any other person as to matters
the member reasonably believes are within such other person’s
professional or expert competence and who has been selected w/
reasonable care by or on behalf of the corporation (accountant, atty, etc).
Can the privileges of limited liability be taken away (piercing the veil)?
o  Shareholders can be held personally liable for the corp’s debts
o Does the alter ego or instrumentality rule apply?
 Was the sole owner of a corp alleged to have treated corp’s assets
as his own; not w/ appropriate dignity? If ∆ directly treats corp as
personal property, or forms parent or subsidiaries and fails to treat
them separately, then veil can be pierced.
 PUT Laya v Erin
o Is there inadequate capitalization?
 Minton: Can pierce if there is inadequate capitalization, even if
there is no fraud/wrongdoing
 There is no statutory minimum of capital required to form
corporation, but can pierce the corporate veil when capital
is trifling compared to the actual needs of the corporation.
Look to the standards of the industry, or the state insurance
requirement if there is one.
 Walkowsky: insufficient $ alone is not enough to pierce; also need
failure to follow corporate formalities.
o Is there fraud?
 If you represent as the sole owner of the corp, and figures of
assets/liability are false (too high or too low), can pierce the
corporate veil, IF misrepresentation is MATERIAL.
Corporate Purposes
Corporate purpose is primarily for the benefit of shareholders
o Dodge v Ford: Henry Ford can’t decide to reduce price of cars instead of
increasing corporate profits
If want part of the purpose to be for charity,:
o 1) must be reasonable in amount
o 2) must be an indirect benefit for the corporation
 Ex (Smith v Barlow): supporting the free enterprise system
PUT Dodge v Ford and Smith v Barlow
Constituency statutes
o Unocal: in takeover defense, it was suggested that board didn’t take into
account creditors, employees, etc
o Revlon: limited Unocal constituency holding to situations when
dissolution is inevitable.
Duty of Care
Duty to perform w/ that diligence, care and skill which ordinarily prudent persons
would exercise in similar circumstances.
o Л has burden of persuasion
o 1) Bates v Dresser: Duty to supervise: one bite rule
 1) was there a red flag/was director placed on notice that
something was amiss? Yes 
 2) did director inquire?
 Here, bank director liable when employee bookkeeper stole $,
director had warning that $ was missing and an employee was
likely at fault, employee had low income but many stocks and a
new car, yet director accepted book reports w/o investigation.
o 2) Barnes v Andrews: standard amplified
 Duty to perform w/ skill of person in like position
 Minimum level of competence, understanding business
 Duty to keep one’s self informed
Director only went to one board meeting and thus did not
learn of production delays
 Must show causation:
 1) show violation of duty
 2) show violation was proximate cause: the only or primary
o 3) Francis v United Jersey Bank: standard amplified
 Must be competent, understand the rudiments of the business
and financial statements, habitually attend meetings (absence
is considered concurrence), habitually review financial
statements (lack of knowledge is not a defense), and comply
with laws, and if something is wrong and don’t know how to fix
it, duty to consult outsiders or atty.
 Proximate cause modified:
 Violation of duty does not have to be only cause; only
needs to be a substantial factor.
o Mrs Pritchard’s failure to review financial
statements or consult an atty were a substantial
factor. It does not matter that her sons’ fraud also
contributed to the injury.
o 4) Caremark:
 Director has a duty to attempt in good faith to ensure that an
adequate corporation information and reporting system
(compliance system) operates, to make sure the company is
complying with laws.
 It is not enough to respond when suspicion presents
o Did director know or should have known facts
which would prompt an ordinarily prudent
person to investigate or change corporate
o Here: Directors not held liable b/c did not lack good
faith in monitoring or conscientiously permit known
violations of anti-referral law to occur. When
Caremark was investigated, it increased its
o Miscellaneous
 NOTE: Duty of care suits are hard to win b/c:
 Л has BOP
 In DE, gross negligence standard applies
 §102(b)(7) opt out provision
 business judgment rule defense
o directors can rely on the reports of officers,
committees, and outsiders
 Does the business judgment rule defense apply to the ∆ corp? SEE
Standard is higher for insider or bigger corp
 Most states: negligence
 Delaware: gross negligence
BUSINESS JUDGMENT RULE DEFENSE: a defense to duty of care
violation claims
o Standard in DE: gross negligence
o Smith v Van Gorkom:
 A director or officer will not be held liable if a business
judgment is:
 (1) disinterested (no conflict of interest),
o If there is a conflict of interest, duty of loyalty
 (2) reasonably informed (did a reasonable investigation,
did not make a decision until had all material info
available to them), and
o 141(e) “directors are fully protected in relying in
good faith on reports made by officers”
 does not include oral comments
o Here: Directors approved leveraged buyout
agreement after only 2 hours’ consideration, no
written terms were presented, most people weren’t
aware of the merger proposal until 1 hour before the
o Here: A premium is not adequate basis to decide the
fairness of an offering price b/c only shows the
value of one share, w/o considering cashflow, etc. If
no adequate reports from people that are informed
about corp’s assets, must do a valuation. Should
have found out if this was the best price they could
get (in the best interests of the shareholders)
o Here: Directors based their decision on
representations by one person, Romans, which did
not constitute a report they could reasonably rely on
under DGCL §141(e).
o Here: Shareholder vote did not cure the merger b/c
shareholders were not fully informed of all facts
material to their vote on the merger.
o See also Walt Disney, Aronson(2) for reasonably
 (3) the director or officer reasonably believes that the
business judgment is in the best interests of the corp
o (decision, at the time it was made, cannot be
viewed as entirely irrational)
o Presumption that directors acted on an informed basis, in good faith and in
the honest belief that the action was taken in the best interests of the corp.
 Good faith means not knowingly unlawful
o Л must prove
 Duty of care was violated
 Causation
 damages
o Policy: want directors to take risks
 Bigger risks → greater likelihood of greater rewards for
 Rational shareholders can diversify away firm-specific risk
through a portfolio
o Safe harbor: DGCL §102(b)(7) adopted after Van Gorkom
 the shareholders may modify the corporation’s charger to
eliminate money damages for breach of the duty of care, so
long as the director has acted in good faith w/o knowingly
violating the law and w/o obtaining any improper personal
 Cannot eliminate monetary damages for duty of loyalty
WASTE DOCTRINE: executive compensation
o Payment can’t be so large as in substance and effect to amount to
spoliation or waste of corporate property.
o Rogers v Hill: Л has burden to prove that a bonus payment has no
relation to value of services for which it was given and is in reality a
 Otherwise, the majority stockholders have no power to give away
corporate property against the protest of the minority.
 Bylaw authorizing payments to pres and VP of American
Tobacco Company on top of their salaries, 10% of excess
profits, is enough for a jury question on waste.
o NOTE: cts are split on whether someone who voted
against the bylaw can bring a suit.
o Walt Disney: ∆s can be held personally liable to the corporation for
directors knowing or intentional lack of due care regarding an
executive’s employment contract and termination agreement.
 Director violated fiduciary duty by failing to negotiate in an
adversarial and arms-length manner: Ovitz violated fiduciary duty
to Disney by not negotiating honestly and in good faith so as not to
advantage himself at the expense of his shareholders.
 Ovitz should have negotiated w/ compensation committee, instead
of w/ a personal friend.
 To do this right: Ovitz should have negotiated w/ a disinterested
board, made sure special counsel for the transaction was
disinterested, and told Ovitz there is a choice w/ risks: follow the
right procedures so cannot be liable, or do it your way w/ Eisner
and get a huge bonus.
o Stock options for executives
 State corporate law applies
Dilution danger: if company sells stock worth $75 to execs for
only $50, can no longer sell to the public for $75
Consultant manipulation: There are ways for compensation
consultants, such as Graef Crystal) to justify pay raises for execs
by using comparative studies, etc, when a pay raise might actually
be waste.
Motivation argument: overpayment can motivate execs to work
harder making money for the company
 Counterarg: marginal productivity theory applies. This arg
is easy to assert but difficult to prove.
Superior executive trap: If executive is the best around,
comparative studies of appropriate salary don’t really apply. Also,
what if the exec threatens to quit if his bonus is cut, but the
company fears shareholders will sue if bonus is not reduced?
Duty of Loyalty
3 kinds
o 2 corps w/ one director person on each side (board interlock)
o individual director engages in a transaction w/ his own corp
o parent-subsidiary: parent owns a controlling interest less than 100% and
engages in a transaction w/ its subsidiary
Modern view (by 1960s): no transaction of a corp w/ any or all of its directors
is automatically voidable by shareholder suit, whether there was a
disinterested majority of the board or not; courts review the K under rigid
and careful scrutiny, and invalidate it if it is found to be unfair to the corp.
∆ has burden of persuasion except in the case of safe harbor statutes (more
demanding than duty of care)
o Safe harbor: DE 144
 1) were material facts about director’s interest and about the
transaction disclosed to the board?
 2) was the transaction approved by a disinterested majority of
 Then: BOP shifts to Л to prove that an interested transaction
was unfair
 If P shows a conflict, D can still validate K if show that the
transaction was fair under Gries.
 PUT Marciano v Nakash
Globe Woolen: someone can violate duty of loyalty even if they don’t vote. If
you have a conflict of interest, you should recuse yourself from discussion
and approval.
o Board interlock case: 2 corps w/ a common director engage in a
transaction (Director person is on both sides)
 Here: Maynard was on the Boards of Globe (mills) and Utica
(power), and held stock in Globe but not Utica. Maynard
negotiated K whereby Utica had a losing K, due to miscalculation
by Utica and undisclosed expected increase in power usage by
Globe. At approval meeting, Maynard remained silent.
 Maynard violated duty of loyalty owed Utica. Refusing to
vote creates assumption of fairness and approval; it does
not create a disinterests vote. Director can only remain
silent if all is equitable and fair.
Gries Sports v Cleveland Browns: arms-length transaction required
o Board interlock
 Modell owned 53% of Browns; Gries owned 43% of Browns.
Modell formed CSC,and owned 80% of it. Browns brought CSC,
no arms-length negotiation, Gries claims Modell overvalued the
 When the parties controlling the transaction are on both sides,
presumption of deference to sound business judgment drops
 (1) Was transaction approved by a majority of
disinterested shareholders and independent directors?
o No:
 Browns directors received a financial benefit
from the transaction (they were shareholders
of both Browns and CSC and CSC minority
stock was redeemed).
 Berick not independent b/c was dominated
by Modell and would get fired if did not do
what Modell said.
 (2) Was the transaction intrinsically unfair to the corp
and its minority shareholders? Strict scrutiny applies.
o Yes:
 Price was not based on valuations, etc; price
was decided b/c it was beneficial to
eliminate directors’ personal debts
 Should have had a range of prices, if
Policy: don’t want a transaction to favor one of the contracting parties; want it to
be fair, like b/tw 2 strangers.
o 1880: any K b/tw a director and his corp was voidable by the corp or its
shareholders (one shareholder alone enough), w/o regard to its fairness.
 This was overinclusive and unworkable and did not allow conflicts
of interest that might actually benefit the corp
o 1910, more relaxed: was K approved by a disinterested majority of
 Yes: valid as long as, if challenged, ct does not find it unfair or
 No, by an interested board of directors: K voidable by corp or its
shareholders w/o regard to its fairness.
3 types
o Did individual director engage in a transaction w/ his own corp?
o Board interlock: Did 2 corps w/ a common director engage in a
transaction (Director person is on both sides)?
 Prohibited by §8 of the Clayton Act if either firm has $1m in assets
or profits
o Parent-subsidiary: Did parent corp engage in a transaction w/ a
subsidiary, w/ parent owning a controlling interest but less than 100%?
o DE elements:
 (1) Is the opportunity in the same line of business as the
corporation, or a line in which the corporation has an interest or
 (2) Was the opportunity presented to a corporate officer in a
corporate rather than individual capacity?
 (3) Was the corporation financially able to undertake the
o Interest or expectancy test: An opp is corporate if
the corp has a “beachhead” in the sense of a legal or
equitable interest or expectancy growing out of a
preexisting right or relationship.
o * Line of business test: An opp is corporate if a managing officer
becomes involved in an activity intimately or closely associated w/ the
existing or prospective activities of the corp: Guth v Loft, DE 1939
 Director can seize the opportunity if:
 1) Offer is made ton director as an individual and not as an
 2) Corporation is not able to financially undertake the
 3) Opportunity is not in the interest or expectancy of the
o Is the opp in the line of the corp’s biz and of
practical advantage to it?
 Hardware opp not in line of candy co’s biz
 If interests of corp are betrayed, constructive trust imposed
on dir (Guth) for benefit of corp.
o Here: Pres of candy co that bought syrup from
Coke. Pres had Pepsi shares. Pres dominated candy
co through board control, and controlled Pepsi, and
caused candy co to become chief customer of Pepsi.
 Harris, ME 1995 narrowed the Guth test, and did not look at
interest or expectancy: The test really asks whether the opportunity
was so closely associated w/ the existing biz activities as to bring
the transaction w/in the class of cases where the acquisition of the
property would throw the corporate officer purchasing it into
competition w/ his company.
Harris says the corp’s ability to pay for the opportunity is
not outcome determinative.
 Broz, DE 1996: applied Guth line of business test
 To be a corporate opportunity, must:
o come via the corp, not to an individual
o corp must be able to finance the opp
o corp must have an interest or expectancy in the opp
o must be a conflict b/tw fiduciary’s duties to the corp
and the self-interest of the director as actualized by
the exploitation of the opportunity.
 Also from Guth: If dir believes, based on one of the Guth
factors, that corp is not entitled to the opp, dir may take it
for himself.
o Presenting to board creates a safe harbor for
director, but it is not required.
 Here: Broz owned RFB and was on board of financially
unstable CIS, which was about to be bought out by unstable
PriCellular. Broz bought a phone line for RFB w/o offering
it to CIS. Broz, dir of CIS (target of an acquisition), did not
have a fiduciary duty to present the opp to CIS, b/c
opportunity failed the line of business test: opp came to
Broz individually; CIS and PriCellular could not pay for it;
no envidence that CIS had an interest or expectancy (no tie
b/tw line and nature of CIS); Broz’ interest in phone line
created no duties that were inimicable to his obligations to
o Fairness test: Apply ethical standards of what is fair and equitable under
the circs. Durfee.
 Harris criticizes this test: provides no guidance to the director
seeking to measure her obligations. Totally depends on the facts of
each case
o Line of business and fairness combined: Miller v Miller.
 (1) is the opp w/in the corp’s line of business?
 (2) evaluate the equitable considerations
 Harris criticizes this test: combines the vagueness of each test
o * ALI §5.05 test: Harris, ME 1995. Must disclose the opportunity to the
 Goal of ALI test is to avoid litigation
 Is there a corporate opportunity?
 Any opp to engage in a biz activity of which a director
becomes aware, either
o In connection w/ the performance of functions as a
director, or under circs that should reasonably lead
the director to believe that the person offering the
opp expects it to be offered to the corp, or
o Through the use of corp info or property, if the
resulting opp is one that the director should
reasonably be expected to believe would be of
interest to the corp, or
 Any opp to engage in a biz activity of which a senior exec
becomes aware and knows is closely related to a biz in
which the corp is engaged or expects to engage
 A director or senior exec may NOT take advantage of a corp opp
 The director or senior exec first offers the corp opp to the
corp and makes disclosure concerning the conflict of
interest and the corp opp;
 The corp opp is rejected by the corp, and
 Either
o The rejection of the opp is fair to the corp
o The opp is rejected in advance, following such
disclosure, by disinterested directors, or, in the case
of a senior exec who is not a director, by a
disinterested superior, in a manner that satisfies the
standards of the biz judgment rule, or
o The rejection is authorized in advance or ratified,
following such disclosure, by disinterested
shareholders, and the rejection is not equivalent to a
waste of corp assets.
 In Harris: Nancy Harris, Golf Club pres, bought land adjacent to
club and used it to build a subdivision in her children’s name. Club
must show: This was a corporate opportunity; Harris did not offer
the opportunity to the club, OR the Club did not reject the offer
properly (Harris can defend on the basis that taking the opportunity
was fair to the corporation)
CLOSE CORPORATIONS: Heightened Fiduciary Duties
o Accountability mechanisms (diff from corp managers)
 Heightened fiduciary duties
 Shareholder voting as an accountability mechanism is often
nullified by a voting arrangement
 No mandatory disclosure obligations under federal securities
law—but fraud enforcement under Securities Exchange Act Rule
o  Compare to accountability mechanisms for corp managers:
 Fiduciary duties
 Shareholder voting
 Mandatory disclosure system and fraud litigation
o Danger: minority stockholders are vulnerable to oppression (freezeout)
from the majority stockholders.
o Is it a close corporation?
341(a): parties must elect to be a close corporation
342 eligibility requirements:
o 1. Fewer than 30 shareholders
o 2. All of these shareholders’ stock must be subject
to 1+ restrictions under section 202
 a) A restriction must be noted conspicuously
 c) A restriction on the transfer of securities
of a corp is permitted if:
 1) the holder of the restricted
securities must offer to the corp or
any other holders a prior opp to buy
the restricted securities
 2) the corp or holder is obligated to
buy securities which are the subject
of an agreement to buy
 3) corp or other holders are required
to consent to the transfer
 4) transfers to designated persons or
classes of persons are prohibited if
designation is not unreasonable
o 3. No public offering of stock
 How do you define the value of shares NOW to be
transferred at a future time? Ways to do this:
o Original price: this will probably be worth less than
the value of a successful close corp’s stock
o Book value: based on original cost and may be
considerably less than current fair market value.
o Earnings value, or capitalization of earnings: must
use an appraiser
 Donahue, MA 1975
 Small # of stockholders
 no ready market for the corporate stock
 substantial majority stockholder participation in the
management, direction and operations of the corp.
o Donahue: Did stockholders violate fiduciary duty of good faith and
loyalty owed other stockholders in the operation of the enterprise?
 Must not act self-interested or w/ avarice or expediency
 if a corp makes an offer to majority stockholders, it must also
offer all other stockholders (including minority stockholders
an equal opportunity to sell shares to the corp at the same price.
 Policy:
o all stockholders should have equal access to
benefits of stock purchases
o majority stockholders should not be allowed to use
their control to establish an exclusive market in
previously unmarketable shares from which
minority stockholders are excluded.
 Here: Rodd corp had 6 shareholders. Rodd bought shares from
majority stockholder Harry Rodd at a high price, but refused to buy
a similar portion of plaintiff-minority stockholder’s shares for the
same price, leaving plaintiff with an unmarketable share.
o Wilkes, MA 1976: Applied Donahue duty w/ a 2-part test:
 (Facts): 4 stockholders shared ownership and management
of the corp. Relations b/tw plaintiff Wilkes and the other 3
turned sour, and the other 3 terminated Wilkes’ salary and
caused him to leave the board.
 (1) Can the controlling group (majority stockholders)
demonstrate a legitimate business purpose for its
o majority is allowed some room to maneuver in
establishing the business policy of the corporation
o Here: majority has not shown a legitimate business
purpose for severing Wilkes from the payroll and
refusing to reelect him; it was a freezeout.
 (2) If yes, can the minority shareholders show that the
same legitimate business objective could have been
achieved through an alternative course of action less
harmful to the minority’s interest?
o Deadlock Avoidance and Dissolution
 DGCL 350
 Stockholders of a close corp who own a majority of the
voting stock can enter a written judgment to supplant the
board in part or whole in management of the corp
 DGCL 351
 Certificate of incorp can say that corp shall be managed by
stockholders rather than a board
 DGCL 354
 Close corp stockholders can make agreements to treat a
close corp like a partnership
 Special remedies:
 352: custodian
 353: provisional director
 355: dissolution, see below
 Dissolution
 DGCL 355: Shareholders can dissolve corp
 Kemp, NY 1984: NY Biz Corp Law 1104a allows
dissolution when a corp’s majority is doing “oppressive
action” toward the complaining stockholders, if
stockholders have 20% or more. Test or oppressive
o Did the majority conduct substantially defeat
expectations of the minority that, objectively
viewed, were both reasonable under the circs
and central to plaintiff’s decision to join the
 Here, Plaintiff had a reasonable expectation
that he would be paid dividends in the form
of extra compensation bonuses, per Kemp’s
long-standing policy.
 Ex: oppressive to job, dividends, etc
Interested Mergers
o When directors of a corp are on both sides of a transaction, they must
demonstrate their utmost good faith and the most scrupulous inherent
fairness of the bargain.
 Fairness has 2 parts (examine as a whole, but unfair price can
outweigh fair dealing):
 Duty of loyalty requires Fair dealing
o Factors: how transaction was timed, structured,
initiated, negotiated, disclosed to the directors; how
director and stockholder approval were obtained
o Includes a duty of candor: one w/ superior
knowledge may not mislead any stockholder
o Here:
 Signal, majority owner of UOP, bought out
UOP. 4 UOP directors were also Signal
directors. Weinberger was former
shareholder of UOP, suing b/c merger
eliminated UOP minority shareholders and
gave them an inferior price for their shares
 decision took only 4 days; no arms-length
negotiations b/c Crawford just said $20-21 is
a fair price; lack of disclosure of $24
suggested price to minority stockholders;
lack of disclosure of cursory preparation of
Lehman fairness opinion.
o Should have done: had an independent committee
negotiate the transaction.
 Duty of loyalty requires Fair price
o Factors: assets, market value, earnings, future
prospects, other elements that effect value of co’s
o How price should be proven:
 DE’s block method of valuation is
Broadened the appraisal remedy: By any
valuation techniques or methods which
are generally considered acceptable in the
financial community
o Here: feasibility study named $24, not $21
o Appraisal remedy is not the only remedy available when there is
fraud, misrepresentation, self-dealing, deliberate waste of corporate
assets: shareholder can also seek injunctive relief, so can negotiate new
o Weinberger also held that the business purpose requirement is no longer in
force in DE b/c does not protect minority shareholders.
 Biz purpose test said that even if insiders pay a fair price, they
can’t make a transaction whose sole purpose is to eliminate the
minority stockholders; there must be another valid corporate
 Some states still apply this test.
Is a party on both sides of the transaction?
o Ct will examine the transaction more rigorously.
Litigation strategy: challenge the merger before it occurs or after the fact?
o More evidence might be available after the fact
o But then it is harder to unscramble.
Burden of persuasion rules: Weinberger
o Same for all duty of loyalty cases:
o Plaintiff must show conflict. If successful,
o Has the transaction been approved by an informed vote of a majority of
the disinterested stockholders?
 Yes: Plaintiff must prove unfairness
 No: Defendant must prove fairness.
Derivative Claims
o A wrongful act that is separate and distinct from any corporate injury,
such as an act that denies or interferes w/ the rightful incidents of share
o Can’t be estopped by corp or board
o Ex: claim that corp defrauded a shareholder when it sold him stock
o Note: if material misreps or omissions can be alleged, must use direct
litigation instead of derivative.
o Shareholder’s right to sue derives from corp’s right to protect its assets
o A wrongful act that depletes corp assets and injures shareholders only
indirectly, by reason to the prior injury to the corp.
o Note: if material misreps or omissions can be alleged, must use direct
litigation instead of derivative.
o Policy:
compensate shareholders for losses suffered as a result of officer or
director violations of duties of care or loyalty or the waste doctrine
 avoids multiple lawsuits
 better protects creditors
 ensures equal treatment of shareholders w/in each class
 The director demand requirement is consistent w/ the notion that
directors are the shareholders’ representatives to manage the
Advantages of derivative litigation:
 Deters some corporate greed
 Deters corps from wasting assets
 Accumulates some of the winnings of the litigation to the corp for
the equitable protection of creditors and shareholders
 If shareholder wins, Л is entitled to reimbursement of expenses and
atty's fees from the corp (RIGHT?)
Consequences (procedural) of derivative litigation:
 Shareholder must meet standing requirements
 Such as contemporaneous ownership
 Shareholder must satisfy demand requirements
 May have to demand that the board bring the action on
behalf of the corp
 Shareholder must post a security bond in some jurisdictions to
cover ∆’s litigation expenses
In the 1970s, special litigation committees arose as an alternative to
derivative litigation.
 Demand required: Most states require that before a derivative suit
can be brought, Л must make a demand on the board, asking the
corporation to take over the suit. If board declines, the ct will often
dismiss the suit.
 Demand excused: Many states excuse the demand on the board in
certain circs, such as where demand is likely to be futile (e.g. the
entire board is accused of wrongdoing, or of being under the
wrongdoer’s thumb).
 3 Court approaches to demand:
 Auerbach, NY 1979
o Ct will defer to business judgment of Special
Litigation Committee and not examine its
recommendation to dismiss the derivative claim if:
 (1) its members were disinterested, and
 (2) it used adequate and appropriate
investigative procedures and methodologies
 Miller, IA 1983
o Directors who are being sued in a derivative action
may not appoint an independent committee (SLC)
for the purpose or recommending dismissal of the
derivative suit, b/c the board is biased.
 Zapata, DE 1981 (see below)
 “Disinterested person” approach:
o Disinterested person = not a party, or is a party but
corp shows that claim is frivolous
o If 1+ disinterested persons appointed by the ct has
made a determination in good faith after conducting
a reasonable investigation and concluded that the
derivative proceeding is not in the best interests of
the corp, ct shall dismiss the derivative proceeding.
Is demand excused? Use Zapata and Oracle.
 Zapata, DE 1981
o Demand on the board is required except when
demand would be futile, or there otherwise is a
wrongful decision not to sue.
 Futile: a majority of the board has a
conflict of interest
o When demand is futile, board may delegate
authority to seek termination of a derivative suit
to a disinterested minority of the board.
o When an independent committee dismisses a
derivative suit, ct should decide if dismissal was
proper using this 2-part test:
 (1) Did committee act independently and
in good faith?
 Was the biz judgment rule satisfied?
o Was there a reasonable
 Burden on committee
 (2) If no, ct applies its own independent
business judgment to decide if the case
should be dismissed.
 Is the suit in the corp’s best
o Ct compares out of pocket
costs of litigating to benefit
in proceeding w/ the
o Jay v North, 2d Cir, 1982:
 Moving party must
show that the action is
more likely than not
to be against the
interests of the corp
Not in best interests
of corp: if likely
recoverable damages
discounted by
probability of a
finding of liability are
less than the costs to
the corp in continuing
the action
o SLC wins unless COI or
SLC’s decision was
o Problem w/ Zapata:
 Creates a way for the board, pretrial, to
estop a claim against a majority of directors.
This counters the demand requirement’s
purpose: to ensure board autonomy in
managing the corp by providing a
channeling mechanism to ensure that the
board can review all litigation decisions the
board does not have a conflict with.
 Did not say when demand is required.
When is demand excused? Aronson, DE 1984
 Л must allege particularized facts that show:
o Aronson facts not particular enough:
 Director Fink owns 47% of stock
 Л should have shown facts that show,
through relationships, that the
directors are under Fink’s control
 Director Fink personally selected each
 Л should have shown facts about
care and sense of responsibility; not
the method of election
 A reasonable doubt is created that
o Note: standard raised from reasonable inference to
reasonable doubt
o (1) the directors are disinterested and
independent, and
 to be independent, director’s decision must
be based on the corporate merits of the
subject rather than extraneous considerations
or influences
 Disinterested if transaction was approved by
a majority of disinterested directors. If not,
then don’t go to step (2); reasonable doubt is
o (2) the challenged transaction was otherwise the
product of a valid exercise of business judgment
 must look at factual background
 Walt Disney, DE 2003
 Aronson (2): Board should not
approve a K whose terms they don’t
understand; Board should perform a
reasonable investigation rather than
rely on what management tells them.
Verbal description not enough; make
sure you see docs, a valuation study.
Board’s approval of Ovitz’s employment
K was not a valid biz judgment under
Arsonson (2):
 Old Board: meeting barely discussed
Ovitz, no presentations on the
agreement, Board passed off details
to Ovitz & Eisner, did not question
Eisner’s grant of a non-fault
 New Board: did not meet to discuss
non-fault termination, even though
Board approval was required, never
tried to negotiate w/ Ovitz before he
left, blindly allowed Eisner to give
$38m in cash and $3m in stock
options to friend Ovitz
 Directors consciously and
intentionally disregarded their
responsibilities, making decisions
w/o adequate info, w/o caring about
the injury to the corp and its
 Board should have: not approved a K
whose terms they didn’t understand,
performed a reasonable investigation
rather than relying on what
management tells them. Verbal
description not enough; make sure
you see docs, a valuation study.
SO: if directors are independent, demand is required
o Policy: make sure a shareholder exhausts his
intracorporate remedies; provide a safeguard against
strike suits, recognize that directors, not
shareholders, manage the biz and affairs of corps.
 Note: this case made it harder for a Л to win
Oracle, DE 2003
 How to tell if a board member is independent:
o SLC has burden to prove that there is no
material issue calling into doubt its
 Applied Zapata, and added this independence test:
o Is the director, for any substantial reason,
incapable of making a decision w/ only the best
interests of the corp in mind?
 Is director impartial and objective: is the
director beholden to an interested person,
via personal or other relationships?
 Love, friendship, & collegiality are
influences, in addition to
domination/control by other board
 But social relationships, such as
country club membership, do not
threaten independence
 Here: issue of material fact b/c undisclosed
significant ties b/tw corp (Oracle), and
Stanford, which employs 2 SLC members.
When an SLC moves to terminate a derivative action, SLC has
burden of persuasion, to show that there is no material issue of fact
calling its independence into question.
Shareholder Voting Rights
Type of voting (varies by state statute)
o see theories (notes p37-8)
Proxy Expenses
- Will corporation reimburse proxy contest expenses in a vote contest?
Rosenfeld v Fairchild Engine, NY 1955: LOOK UP CASEBRIEF
o A corporation can pay the proxy expenses of its own directors if:
 (1) contest must involve a conflict over policy, and not just a
personal power contest
 (2) expenses must be reasonable in amount
 What does this include?
 Note: opens the door for a waste claim.
o If outsider loses, not entitled to reimbursement.
o If outsider wins, can be reimbursed but might need a shareholder vote.
- SEA 14a-8: communicating w/ other shareholders to solicit proxies for
shareholder proposal, or against management proposal
o Applies to corps covered by §12 and 12g-1 of the SEA: w/ securities listed
on a national exchange, or traded in the over-the-counter market w/ 500 or
more holders of a class of stock, and $10m in assets.
o A shareholder can circulate a proposal for action on issues other than
director nominations if the shareholder satisfied the eligibility
requirements of 14a-8(b), number and length requirements of 14-8(c)-(d)
and is not excluded under 14a-8(i): improper under state law, personal
grievance, relevance, and ordinary business operations. This means that
the corp pays to distribute the proposal to all the shareholders.
Dual class voting, DGCL §151
o State law permits dual classes of stock under DGCL §151. Very
occasionally dual class patterns have been held to violate equity
limitations on directors or their corporations:
 Lacos Land Co, DE 1986
 Director’s duty of loyalty to shareholders was violated
when director tried to reorganize voting rights to increase
his % by threatening to vote against transactions in the
corp’s best interests unless his voting position was secured.
 This case said there are very few restrictions to dual class
 Zahn v Transamerica Corp, 3d Cir 1947
 Duty of loyalty violated when parent corp tried to increase
the value of its shares in liquidation by causing the
redemption of a separate class of stock before liquidation,
w/ no persuasive reason for doing so.
o The key point is that usually Delaware and other states will allow
corporations broad latitude to design any capital structure they choose,
subject to equitable limitations.
o 19th Century: Jacksonian hostility toward big entities.
 Mergers required supermajority votes (2/3 of shareholders)
 Appraisal remedy protected dissenters: disapproving shareholders
could terminate their membership in the corp and receive the value
of their shares
o 20th Century:
 Corporate law no longer has size constraints or discourages
 Appraisal remedy is not as available
 High voting requirements are eliminated
 Shareholders in public corps are instead protected by their ability
to sell shares in a stock market.
o DE Merger Law
 DGCL 251b: Merger must be approved by majority vote by
shareholders in both firms
DGCL 262: shareholders are entitled to the fair value of their
shares (appraisal rights)
 Exceptions to 251b or 262 (situations when these rights aren’t
 Surviving corporations: 251f: No vote of stockholders in a
corp surviving a merger is required if:
o A) the merger agreement does not amend the
certificate of incorporation
o B) after the merger, shares of stock remain identical
to before the merger.
o C) No more than 20% of common stock employed.
No appraisal right often for survivor’s shareholders.
DGCL 262b1: acquired corp’s shareholders will
vote and may be entitled to appraisal rights.
 Parent-subsidiary or short-form mergers, 253:
 If parent owns at least 90% of subsidiary,
o no vote for surviving parent or subsidiary
o no appraisal rights for parent
 Stock market exception: 262b1: No appraisal rights for
shareholders whose stock was either:
 In a firm listed on a national exchange, or
 Held by 2000+ shareholders
 De Facto Mergers, 271: In DE, a de facto merger does not require
an appraisal remedy. If there is a sale or lease of all or substantially
all assets, there is a vote, but no appraisal.
 Note: most other states allow an appraisal for sales of
assets, and allow the de facto merger doctrine.
 Triangular mergers: DE statute says
 Target stockholders have a right to vote on the merger.
 Parent corp (sole stockholder) has a right to vote on the
 But parent corp stockholders do not have the right to vote
on the merger and do not have appraisal rights.
 Tender offers
 If acquiring corp buys stock interest in a target through a
tender offer, there is no voting right or appraisal right for
either the acquiring corp’s or the target cor’s shareholders.
o Appraisal Remedy
 DE block approach
 Purpose: to give stockholders the value of the stock at the
moment of the merger (the “going concern” value.
 Factors that could come up:
o Market value
 Has never been given more than 50% weight
in appraisal
o Asset value
 Based on a current appraisal, rather than
book value
o Dividends
 Only significant if unpaid
o Earnings value
 Average last 5 years, multiply by a
o Any other facts which throw light on future
prospects of the firm that was merged.
o Note: using all of these factors avoids undue
reliance on market value, and recognizes that each
factor alone can be speculative.
o Highly subjective
o Shows a hostility to market value in appraisals yet
creates a stock market exception
o Appraisal costs are uncertain; ct has discretion
Tender Offers
2 ways to take over an unwilling target co:
o Proxy contests
o Tender offers
 Cheaper
 Offer can be limited to a fixed period of time
 If offer fails, offeror might be able to get rid of some of its stock
w/o loss to the target co or a larger aggregate
 Can be made by cash, securities, or both
 2 ways
 Friendly: part of a merger
 Hostile: unsolicited, and heavily litigated
o How it works: bidder makes an offer to each of the
individual stockholders of the target corp, to buy
their shares. If a majority tender (sell) to the bidder,
the bidder has control of the target.
Why do hostile takeovers occur? Hypotheses:
o Disciplinary hypothesis: tender offers replace inefficient managers w/
more efficient managers.
o Synergy hypothesis: b/c of unique characteristics of the bidder, a target
may be worth more to it than to the market generally
o Empire building hypothesis:
 takeovers are not motivated by the best interests of the offeror’s
shareholders, but by the desire of its managers to get higher
compensation or prestige b/c of its bigger size or visibility of the
new consolidated firm, or to reduce bidder’s risk of takeover.
o Exploitation hypothesis:
bidders attempt to exploit the “prisoner’s dilemma” or collective
action problems experienced by dispersed target shareholders
through the offering of unsatisfactorily low prices with the
knowledge that the target shareholders may accept them, even if
they regard them as low, b/c of concerns about lower future stock
market prices
Is a merger subject to enhanced judicial scrutiny?
o Unocal: when a board adopts defensive measures in response to a hostile
takeover proposal that the board reasonably determines is a threat to
corporate policy and effectiveness. This also applies to the adoption of a
stockholder’s rights plan, even in the absence of an immediate threat.
o Revlon: when the board enters into a merger transaction that will cause a
change in corporate control; when the board initiates an active bidding
process seeking to sell the corp; when the board makes a break up of the
corporate entity inevitable; etc.
Defensive measures: Unocal, DE 1985: When a target tries to repulse hostile
bidder via share repurchases (offering a higher price for its own shares than the
bidder is offering, in order to make the target’s shareholders less likely to tender
to the bidder), the target MAY exclude the bidder from participating in the share
repurchase program, IF:
o (1) Cheff: Threat must pose a danger to the corp’s welfare (not just to
the directors and management’s interest in staying in office)
 ∆ has burden to show threat to corp; biz judgment rule is not
proper analysis
 Policy: ensure best interests of corp and its shareholders are at
 Here:
 Mesa’s offer posed a threat to the corp’s welfare b/c was
coercive: offer price ($54) was substantially lower than
value ($72)
 Securities to be offered to minority shareholders were junk
bonds worth much less than $54
 Designed to stampede shareholders into tendering at the 1st
tier, even for an inadequate price, out of fear of what they
would receive as remaining minority holders (junk bonds)
 Omnicare adds:
 Board must show good faith and reasonable investigation in
order to satisfy its burden of proof
 Proof is materially enhanced if it is approved by a board
comprised of a majority of outside directors or an
independent committee
o (2) (added by Unocal): Defensive measures (such as exclusion of
acquiring corp from share repurchase program) must be reasonable
in relation (proportional) to the threat posed.
 Factors:
 Inadequacy of price offered
Nature and timing of offer
Questions of illegality
Impact on constituencies other than shareholders (creditors,
customers, employees, suppliers & distributors, the
community generally)
 Risk of nonconsummation
 Quality of securities being offered in the exchange
 Basic stockholder interests at stake
Here: reasonable in relation to threat b/c is consistent w/ the
fairness principle that minority holder should receive substantial
equivalent in value to what he had before.
Omnicare, DE 2003 changes Unocal’s proportionality analysis to
a 2-part test (see 2a and 2b):
 Note: 3-2 decision
 Analyzed under Unocal, NOT Revlon, b/c Revlon is
being strictly construed.
 Facts:
o Genesis and Omnicare were offering competing
bids for NCS.
o Omnicare made an offer.
o Then Genesis made better offer, so long as no one
else could bid (exclusivity agreement, so G could
not be outbid by O); agreement also said holders
must vote even if board didn’t recommend the
transaction; no fiduciary out clause for NCS. G also
locked up transaction w/ a voting agreement w/ 2
NCS stockholders (Shaw and Outcalt) who
combined owned a majority of NCS.
o Board recommended G offer to holders.
o O made a better offer and NCS withdrew its reco
o NCS stockholders sued to enjoin NCS-G
 [Unocal (1): Here, there is a threat: the possibility of
losing the Genesis offer and being left w/ no comparable
alternative transaction
 2a) : board must show that the merger deal protection
devices adopted in response to the threat were not
coercive OR preclusive
o Coercive: aimed at forcing upon stockholders a
management-sponsored alternative to a hostile
 Did the board or another party take actions
which have the effect of causing the
stockholders to vote in favor of the
transaction for some reason other than the
merits of the transaction?
Here: coercive b/c stockholder vote would
not be effective b/c of the coercion that
predetermined the outcome of the merger:
the voting agreements, the lack of a
fiduciary out clause—made it impossible for
the Genesis proposal to not be approved or
any other proposal to be considered.
o Preclusive: deprives stockholders of the right to
receive all tender offers or precludes a bidder from
seeking control by fundamentally restricting proxy
o Here: agreement of board to present merger
agreement to shareholders for a vote under DE
§251(c), even if board no longer recommended the
merger, coupled w/ agreement of majority
stockholders to vote in favor of the merger, in the
absence of an effective fiduciary out clause, was
both preclusive and coercive and therefore
 MUST have a fiduciary out clause!
2b) If not coercive or preclusive, was the defense
o Board must show that their response was within a
range of reasonable responses to the threat
o Defensive devices must be proportionate to the
perceived threat to the corp and its stockholders if
the merger transaction is not consummated
Defensive measures also unenforceable b/c of lack of
fiduciary out clause.
o NCS-G agreement left out fiduciary duty clause;
NCS thus did not owe a duty to its shareholders to
sell to a higher bidder. A board cannot limit its
fiduciary duties, by trying to leave the vote entirely
to the shareholders, when a majority has already
agreed to vote for the merger.
o This was unfair b/c:
 Minority holders are powerless b/c Shaw
and Outcalt have a majority and have agreed
to vote for the transaction.
 Minority’s only protection is the fiduciary
duty owed them by the directors.
Should have done:
o Don’t put anything in writing. Then you can’t be
No one is saying there is a fiduciary duty
when shareholders acting as shareholders;
there is only a fiduciary duty when
shareholders are also acting as directors. So
don’t write up a contract that omits a
fiduciary out clause. Avoid the whole
situation by not writing anything up. Right?
 Majority thought that Shaw and Outcalt
were directors, and therefore the deal
protection device violated fiduciary duty
 Dissent said Shaw and Outcalt are
shareholders, and so they do not have a
fiduciary duty to sell to the highest bidder,
and so they can sell to any bidder they want,
and fiduciary duty was not violated, and this
transaction should have been forced
o Veasey dissent: given the facts of this case, the
better rule is that the biz judgment rule should apply
but even under Unocal the proportionality inquiry
should take into account that the contractual
measure protecting this merger agreement were
necessary to obtain this deal.
 NOTE: The SEC later reversed Unocal for companies subject to
the SEA. (SEE 1206, n 4)
REVLON: Does board have a duty to get best price for shareholders; instead
of using defensive measures?
 1) Is firm breakup inevitable?
 2) Is there a change in control?
 3) Did the board put the corporation up for auction?
o Yes  Board has a duty to get best price for shareholders.
 Must run an auction
 Must treat all bidders equally.
 Defensive measures no longer available.
 Lockups (advantages given to one bidder over others that make it
more likely that that bidder will win, and discourage other bidders)
only OK if don’t end auction; must be used to expand the
competition by inspiring other competitors to make bids; cannot
destroy competition by precluding other bidders b/c violates duty
to get highest bid for holders.
 Here:
o Pantry Pride made hostile takeover bids to Revlon;
bids rejected. Revlon used defensive measures:
repurchase, and not purchase (poison pill).
o Then, R created lockup w/ white knight Forstmann:
R offered 2 subsidiaries at a low price to F only, and
said no one else can bid.
o B/c F was already a bidder, the lockup ended the
auction rather than enhancing it. R violated duty by
accepting F bid before PP made its final bid.
o Lockup unenforceable.
Federal Proxy Fraud
Rule 14a-9
o No solicitation ... shall be made by means of any proxy statement ...
containing any statement which, at the time and in the light of the
circumstances under which it is made, is false or misleading with
respect to any material fact, or which omits to state any material fact
necessary in order to make the statements therein not false or
misleading or necessary to correct any statement in any earlier
communication with respect to the solicitation of a proxy for the same
meeting or subject matter which has become false or misleading.
 So, ask:
 (1) Is a particular statement or omission false and
 (2) Is the statement or omission material?
o A material fact does not have to be expressed in
certain words.
 These things could be misleading:
 Predictions as to specific future market values
 Material which directly or indirectly impugns character,
integrity or personal reputation, or directly or indirectly
makes charges concerning improper, illegal or immoral
conduct or associations, without factual foundation.
 Failure to so identify a proxy statement, form of proxy and
other soliciting material as to clearly distinguish it from the
soliciting material of any other person or persons soliciting
for the same meeting or subject matter.
 Claims made prior to a meeting regarding the results of a
 Policy: Want to promote the free exercise of the voting rights of
stockholders by ensuring that proxies are solicited w/ explanation
to the stockholder of the real nature of the questions for which
authority to cast his vote is sought.
Borak: a private cause of action is implied under 14a-9
o Applies to direct AND derivative claims
o Here: Л-shareholder sued ∆-corp to enjoin a merger, alleging deprivation
of preemptive rights of shareholders by a merger. Л claimed merger was
effected through a circulation of a false and misleading proxy statement by
those proposing the merger.
Mills: No causation required: Л only must show:
o 1) there was a material misrepresentation.
o 2) the proxy solicitation itself, rather than the particular defect in the
solicitation materials, was an essential link in the accomplishment of the
 Do NOT have to prove that the proxy solicitation actually had a
decisive effect on the voting.
o Here: Л-shareholders sued ∆-co Autolite, which merged into
Mergenthaler, claiming the merger was accomplished through the use of a
proxy statement that was materially false or misleading.
 Лs claim proxy statment was misleading b/c of an omission of a
COI: 11 of Autolite's directors were nominees of Mergenthaler and
under the domination and control of Mergenthaler.
TSC v Northway: Basic materiality standard
o An omitted fact (or misrepresentation) is material if there is a
substantial likelihood that a reasonable shareholder would consider it
important in deciding how to vote.
 Do not have to give voters an enormous amount of trivial or
cumulative info.
 Here: Л, TSC shareholder, sued TSC and its acquirer, National,
claiming that their joint proxy statement was incomplete and
materially misleading b/c failed to state that the transfer of
Schmidt’s interest in TSC to National gave National control of
 These facts were not material:
o Dual allegiances of TSC and National directors
o Both co’s had reported in SEC filings that TSC
could be called a subsidiary of National
o Facts that indicate the unfavorability of the terms to
TSC shareholder,
 Because proxy statement reported that 5 directors were
from National, and National owned 34% of TSC.
Additional omitted facts not so obviously important that
reasonable minds could differ on their materiality.
Basic v Levinson: TSC materiality standard applies to forward-looking
statements, too.
o If information has bearing on a 5% price move on the shareholder’s stock,
it is material, and you can be held liable for a misrepresentation made in
pre-merger negotiations.
 How to tell if there is a 5% move:
 Probability of event occurring, x magnitude for the specific
o * 5% doesn’t come from this case, it comes from Staff Accounting
Bulletin (SAB) No. 99
o Here: Basic was negotiating a merger. NYSE asked Basic if it was
negotiating a merger and it said no this counts as a misrepresentation, even
though there was not an agreement yet, and negotiations were only
tentative. Basic should have said (1) don’t want the info to go public, or
(2) it can’t make a material misrepresentation.
VA Bankshares: statements of reasons, opinions, or beliefs can be both
misrepresented and material.
o If they are knowingly false and misleading
 This includes
 (i) Statements that misstate the speaker’s reasons
o Ex: here, where directors did not believe $42 was in
shareholders best interests, but they told
shareholders it was in their best interests so they
would vote for the merger, b/c directors wanted to
stay on the board
 (ii) Statements that mislead the stated subject matter
o Here, that $42 was a fair price, when really $60 was
 Policy: Statements of reasons, opinion or belief are material b/c
shareholders know that directors have superior knowledge and
expertness, and b/c of the common knowledge that state law
obliges directors to act in the shareholders’ interest
o Here: FABI owned 85% of Bank, wanted to get rid of the 15% minority
shareholders, so FABI and Bank entered a merger agreement, whereby
Bank merged into subsidiary of FABI. FABI hired investment banking
firm to give opinion on value of minority shares; said $42. Proxy
solicitation said price was “fair” and gave shareholders a “high value.”
Did not disclose that shares were worth $60.
 Л, minority shareholder, sued for soliciting proxies in violation of
14a-9 b/c directors didn't beliefe offered price was high or merger
terms were fair, but they recommended the merger b/c it was the
only way they could remain on the board.
SAB No. 99: Both quantitative and qualitative measures of materiality can be
used. There are numerous circs in which misstatements below 5% could be
material if qualitatively material.
o Ex of qualitatively material:
 If director violates law and goes to jail
 If misstatement arises from an item capable of precise
measurement or from and estimate, and, if so, the degree of
imprecision inherent in the estimate
 If misstatement makes a change in earnings or other trends
 If misstatement hides a failure to meet analysts’ consensus
expectations for the enterprise
 If the misstatement changes a loss into income or vice versa
 If the misstatement concerns a segment or other portion of the
registrant’s biz that has been identified as playing a significant role
in the registrant’s operations or profitability
 If the misstatement affects the registrant’s compliance w/
regulatory requirements
If the misstatement affects the registrant’s compliance w/ loan
covenant or other contractual requirements
 If the misstatement has the effect of increasing management’s
compensation—for example, by satisfying requirements for the
award of bonuses or other forms of incentive compensation
 If the misstatement involves concealment of an unlawful
Bespeaks Caution Doctrine:
o A false statement is not considered material if it is accompanied by
cautionary language in the relevant corporate document.
o Ex: “exploring the possibility” is possibility and can’t be considered
o 2 limitations on the doctrines (Donald Trump case):
 only applies to forward looking statements
 vague or blanket disclosures, which merely warn that the
investment has risks, do not count.
o Note: cts will not apply the bespeaks caution doctrine if ∆s were aware or
should have been aware of a misrep or omission and chose not to disclose
Rule 10b-5
o 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,
 (1) to employ any device, scheme, or artifice to defraud,
 (2) 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
 imposes a duty to correct and a duty to update previous
material disclosures. These duties are limited to statements
attributable to the firm.
 (3) 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 w/ the purchase or sale of any security.
2 basic types of cases:
- Insider trading
o Usually omission cases
 Omission or misrepresentation must be MATERIAL
o Also: trading while in possession of material nonpublic info
- False corporate statements
- Standing
o Blue Chip Stamps:
In a private lawsuit, Л must be an actual purchaser or seller
(Birmbaum rule)
 Can be purchaser or seller of an option
 Offeree in consent settlement of a lawsuit does NOT have standing
Scienter (culpability)
o Historical: use Ernst &Ernst
 You can always bring a 10b-5 case if can show actual intent
(knowledge) to defraud or deceit
 Can never bring 10b-5 on basis of negligence
 FN 12: recklessness left unanswered, but every circuit has since
said recklessness is allowed
o Forward looking: use SEA §21E
 Standard is now limited to actual knowledge
A fraud: misrepresentation or omission
o Materiality
 see above
o Misrep: reliance is an element
o Omission: reliance is NOT an element
o Basic v Levinson
 Fraud on the market presumption:
 Л can normally presume reliance if a false statement is
made and stock price moves as a result; Л does not have to
prove actual reliance (that actually read the statement; only
show that Л paid the stock price).
o Policy: if had to prove reliance, would have to show
that each Л read or were somehow aware of the
statement, each Л would have to be subject to cross,
and would have to show how became aware of the
statement. It would be very difficult to form a class.
 Presumption is rebuttable in 2 ways:
o 1: If person relying on stock price knew there was
fraud, person cannot claim reliance
o 2: Presumption is limited to active trading on
securities market. ∆ can show this is not the kind of
market Basic was referring to, so Л must prove
Duty to disclose: omission cases
o Can only bring suit for an omission if there is a duty to disclose.
o Chiarella
 “any person” = any person w/ a duty to disclose
 Any employee is an agent and subject to the duty, just like
 1) There must be a duty.
 If disclose  Can trade
 If don’t disclose  can’t trade until disclose
2) duty to employer reserved
 stephens’ concurrence adopted in modified form in
3) misappropriation duty reserved
 Burger: adopted in modified form in O’Hagan
o Dirks
 Duty element reaffirmed but not only applies to insiders, but also
constructive insiders (FN 14): outsiders doing certain work: attys,
accountants, etc provided w/ info for a corporate purpose w/ an
expectation of confidentiality
 Not insiders, but become insiders b/c an insider consciously
gave him inside info
 Tipper/Tippee:
 Tipper: tip must be provided consistent w/ culpability
standards, violating fiduciary duty. Judge says could
involve selling info. Look at Dirks facts for typical case:
trying to end a fraud and to trade ahead of the end of the
fraud. SEC and subsequent courts were horrified by the
decision b/c Dirks was able to take advantage of insider
o O’Hagan
 Did ∆ misappropriate info by breaching a fiduciary relationship w/
the source of the info?
 Affirms 14b3: SEC not required to prove fiduciary duty
 Adopted Burger’s misappropriation theory from Chiarella, in
criminal cases
 wrongful taking of info simultaneously involving
 deception on the source of the info
o must not inform person what you are going to do
 Theory: protect integrity of securities markets from abuses
by outsiders. Looked at underlying purpose of the act, not
just plain language, to justify a very aggressive
interpretation of 10b-5.
o After O’Hagan
 10b-5-2(a)(3): If one family member provides info to another
family member, must look at all family members together to see if
there is misappropriation or wrongful tipping.
o Texas Gulf
 Insiders may accept stock options w/o disclosing material info to
the issuer IF the insider is NOT a member of top management
 Disclosure not required all the time; there may be business
judgment reasons not to disclose sometimes.
Fraud must be “in connection” w/ securities trade
o Texas Gulf Sulphur
Corporation didn’t have to buy or sell stock to be ∆, just had to
make statement roughly contemporaneously w/ the buy or sell
 Did it cause investors to rely on it and in connection
therewith cause them to purchase or sell a corp’s securities?
(Is it probably that this info will move the price by more
than 5%?)
o O’Hagan
 When ∆ w/ potential fiduciary duty to law firm or corporate bidder
employed by law firm deceives them and trades  WHAT
 Tipper/tippee theory wasn’t working very well. RULING?
Regulation FD
- Does not give rise to a private cause of action
- Prohibition on selective disclosure of material information to (1) a broker-dealer;
(2) an investment adviser; (3) an investment company; or (4) a holder of issuer’s
o So, if you make this disclosure, you have an obligation to disclose the
same info
 Simultaneously if intentional disclosure (streaming webcasts)
 w/in 24 hours (“promptly”) if not done intentionally
- Exceptions: Public disclosure not required (do not have to satisfy FD) if info is
disclosed to:
o A person who owes a duty of trust or confidence (Dirks FN 14) (are a
FN14 insider)
o A person who agrees to maintain info in confidence (signed a
confidentiality agreement)
o Credit rating agency
o In connection w/ the public offering under 1933 Securities Act
- Policy: strengthen SEC’s ability to prosecute tipper/tippee when no
This led to adoption of 10b-5-1
- PUT text
- 10b-5-1(b): person making purchase or sale must be aware of presence of
nonpublic info (was a memo circulated? Were they informed by someone?)
- 10b-5-1(b)(1): a defense
o you are allowed to trade on basis of material nonpublic info if you have
earlier entered a contract in writing w/ broker that says anytime stock
reaches price of X, I want it sold. This is a perfect defense to a 10b-5
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