Corporations Outline—Professor O’Kelley
Spring 2002: Jeffrey Kwastel
I.
Introduction
A)
What is a corporation?
1. A type of firm: mechanism for dealing with complexities of real world to maximize
value of those who chose to participate in the firm.
i.
Firms are producers that receive price signals and respond to the market.
ii.
Some central control or authority over productive activities (some
surrender of autotomy).
iii.
Every firm relies on agency law with respect to its employees (masterservant laws), with principal as residual claimant.
iv.
Simplist form is sole proprietership.
2. A corporation is an artificial legal entity that substitutes for a proprieter.
B)
i.
Shareholders don’t really own the corporation, should be saying that the
corporation owns the firm, like a sole prioprieter owns the sole
proprietership.
ii.
Corporate and business association law provide a framework where parties
can adjust their relationships over time (too complex to use discreet
contractural relationships).
Agency and fiduciary duty as it relates to non-owners (employees)
1. For firm’s non-owning employees, focus on:
i.
Employment relationship: default rule is at will (unless set by contract).
Employees only have what they brought with them (usually human
capital).
ii.
Agent has the right to act for principal to bind both parties according to
manifestations of consent. Look at restatement requirements (§§376, 381,
383, 385, 387, 393, 395). Ex: CCS, could be breaches of several duties,
including 381 and duties not to compete with principal (although could try
to make several arguments including Reily’s leaving didn’t affect his
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performance and that he initially told the church he couldn’t manage
them).
2. Want to chill agents from breaching fiduciary duties to principal.
i.
Ex: court in CCS seems to be trying hard to find that Reily violated his
fiduciary duty.
ii.
Agents will typically have fewer resources to litigate than will principals.
II.
Mechanics of setting up a corporation
A)
Classes of shares: Common v. Preferred
1. Stock created in the articles of incorporation (DL §102).
i.
§102.4 is the total amount of stock which the corporation shall have the
authority to issue and its par value (or lack thereof) of those shares.
ii.
Capital stock can be assigned a value ranging from 0 to the actual amount
paid for the stock.
2. One class: A corporation may chose to issue only one type of shares, giving each
shareholder an equal ownership right. These will probably be called “common shares.”
i.
If there is only one class of stock, then that class will have the voting
rights, and the rights to residuals if and when the corporation is
terminated.
ii.
Venturers Example: could be bad for investors. Ex: corporation dissolves
on day 2 after investors have invested $400,000. Each shareholder has
equal rights to residuals based on their shares, so the investors would only
get back half their investment. Also, giving stock to A,C, and D here
would be treated as a taxable event by the IRS (even before the stock has
real value).
3. Multiple classes: A corporation may create multiple classes of stock, or creates series
within a class, having varying rights.
i.
One or more classes together must have unlimited voting rights and one or
more classes together have a right to receive the corporation’s net assets
on dissolution.
ii.
Classes and series must be described in the articles: If there are going to be
multiple classes of shares, the articles of incorporation must 1) prescribe
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the number of shares of each class, 2) prescribe a distinguishing
designation for each class, and 3) either describe the rights, preferences,
and limitations of each class or provide that the rights, etc within each
series or class shall be determined by the board prior to issuance.
iii.
Venturers Example: Could create preferred stock for the investors with a
par value and a liquidation preference (so they would take before common
shareholders). Ex: Pop had a par value of $150,000 and a liquidation
preference of $150,000.
4. Could also create debt notes with interest payments.
B)
Balance Sheets
1. Surplus account: where profits are distributed from.
i.
Really an accounting fiction, legal means of telling you how much you
can distribute.
ii.
Example:
Assets
Liability
Cash
$1,000
Acct Py:
$100,000
Accts Rec.
$999,000
Surplus:
$500,000
Capital:
$400,000
If accounts payable were $800,000, surplus would be $200,000. It’s a fiction.
2. Capital account: originally set up so that outside creditors would know what was in
the corporation. Default is for funds to go there.
i.
C)
Venturers Example: $400,000 would go into capital account and 0 into
surplus. That would mean that $400,000 would be there for the protection
of investors, and to that extent distributions could not be made (it would
stay with corporation).
Par Value
1. Par value now protects preferred share holders against common shareholders.
Provides no protection for creditors.
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i.
Par stock: If the stock has “par value,” stated capital is equal to the
number of shares outstanding times the par value of each share.
ii.
“No-par”: If the stock is “no-par” stock, as is now permitted in most
states, stated capital is an arbitrary amount that directors decide to assign
to the stated capital account (this amount will be at most equal to what the
shareholders paid for their stock at the time of its original issue, but is
otherwise whatever the directors decide it should be a t the time the stock
is issued.)
iii.
The corporation may not sell the shares for less than their par value..
iv.
Ultimately if reach your capitalization goal will need a large number of
shares, so want them to be trading below $100.
2. Relation of par value of DL incorporation taxes: §391—taxes and fees that have to be
paid on registration. Really just charging for the par value you create.
D)
i.
No par stock costs less than low par stock.
ii.
§391(a) says, for stock with par value, to divide the total par value by 100,
and that gives the number of shares that have for these valuation purposes.
Then tax each of those shares 2 cents (x .02), Ex: $400,000 of capital
stock authorized, divide by 100=4000 shares, multiply by .02=$80.00.
iii.
Annual franchise tax that ranges from $30 to $150,000. Depends on the
number of shares that are authorized versus those that are used. Comes
into account when assets get large (how DL gets its money).
Someone has to be the incorporator.
1. Can be anyone, including the lawyer. Doesn’t have to be anyone who will be a
shareholder or an investor.
2. Once articles are filed, the incorporator operates the corporation unless the articles
have specified the names of the initial directors (in which case the powers of the
incorporator ceases as soon as the articles are filed).
3. Otherwise, incorporator continues to exercise powers until the organizational meeting
pursuant to §108.
i.
Business at the organizational meeting can be done by unianimous written
consent, depending on who has authority.
ii.
At that meeting adopt bylaws, decide directors.
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E)
Use of committees of directors
1. Some of the more significant responsibilities of the board should be perfomed by
subcommittees made up of outside directors.
i.
Ex: compensation and audit committees, recommended by NYSE and
Business Round Table (BRT).
III.
Market Theories
A)
Semi-Strong
1. According to this theory, analysts cannot beat the market.
2. Theory says that the market price at any given moment reflects investors educated
guess about the value of a stock, given currently available information about that given
company and that given security.
B)
i.
Any additional new information will be absorbed almost immediately, so
by the time the news gets to the papers, it’s too late.
ii.
Catch-22 then. Analysts can’t beat the market, but if we don’t pay the
analysts then the information won’t be there and the market won’t be as
efficient. The service they provide is a public good.
iii.
Enron indicates a semi-strong market hypothesis.
Strong-form hypothesis
1. When previously unknown, nonpublic information goes public, the market won’t react
at all because somehow it has already gotten the information.
C)
Efficient market theory
1. Market professionals prevail.
2. But what if informed traders can’t overwhelm irrational buyers—“noise traders”? In
that case, informed traders should ride the wave, hold the stock a little longer.
i.
Could be what happened with the internet bubble…no value, dawned on
enough people that it became a panic.
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IV.
Federal Securities Laws
A)
Registration with the SEC—1933 Securities Act.
1. If a company has at least 500 shareholders and total assets of at least $10 million, then
that company has to register with the SEC.
2. Focused on transformation of companies from small, non-publically traded outfits into
publically traded companies (requires detailed accountings).
3. In judging adequacy of disclosure, court will look to whether an investor needs the
protection of the act.
4. How to decide if there is a public offering under the act—further out you get more
likely it is to have been offered to someone who needs protection:
i.
Venturers example: if they had put out a message on the Princeton
internet, “first 5 people to reply get to invest.” Seems more like a public
offering and a greater chance of person not knowing things (and needing
protection).
ii.
Even if the person who needs protection does not accept, have still
destroyed the exemption.
iii.
If don’t register and should have, then every purchaser has a right to
rescind and get their money back.
iv.
Could be a tough question if company prepares a circular that gives all the
information that would have been received in registration (and free to
contact)—argument would then be why would they need the protection of
registration.
5. Rule 504 safe harbor provision for offers not exceeding $1,000,000.
i.
Not as broad as statute, so if in violation could still be okay.
ii.
Need to look at 502(c) limitations on method of offer. Can’t have
advertisement, seminar, etc, also have limitations on resale.
iii.
504(b)(1) provisions. Could thus avoid limitations on resale in 502(d).
6. 3(a)(11) safe harbor provisions: Could still win under 3(a)(11): where offered and
sold to persons in one state (although still need to worry about state rules).
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7. Limitations on resale: those who try to sell might violate the securities act, and the
sale might destroy the exemption with regards to the entire transaction (prior to the
registration of those securities).
B)
i.
Normally can immedialty resell a security after buying it.
ii.
If there is an exemption, and quickly sell, SEC will say bougt with intent
to resell. Could cause transaction not to qualify to begin with.
iii.
§5(a): unless a registration statement is in affect for a security, it shall be
unlawful for any person…”
iv.
Look for exceptions under §4(1) or (2).
v.
Under 2(a)(11) could qualify as an underwriter (anyone who has
purchased from an issuer with a view to resale of such securities).
vi.
Accredited investor: net worth of $1 million, income of $200,000, with
spouse, so if have enough resources are deemed to be able to fend for
yourself for the purposes of safe harbor.
1934 Securities Exchange Act
1. Focused on trading of companies once they go public.
i.
Each year files a 10-K with extensive disclosure (make sure that things
like disclosure are being properly done).
ii.
Every quarter file a 10-Q going from 10-K to next annual report.
iii.
Must also file 8-Ks: periodic reports when a big thing happens that can’t
wait (like a plan to merge).
iv.
Analysts get a lot of their information from these forms.
2. Intended to provide fair and efficient exchanges on which stocks can be traded by the
investing public.
3. Act has rules that apply to brokers and dealers. Requires them not to engage in
activities that cause prices to be biased or unfair (ex: can’t engage in churning).
4. Gives the SEC the authority to regulate exchanges. Exchanges such as the NYSE do a
lot of self-regulation (SROs), as long as the SEC approves their rules. SRO rules could
be more stringent than what is required by the exchanges.
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V.
Corporate Form and Specialized Role of Shareholders
A)
Generally
1. §141(a) and (b): Norm is an annual election of directors, although statute allows that
to be varied in certain situations.
2. Want to have a board and an annual meeting:
i.
Unless you want the corporation dominated by one person, want directors
on a periodic basis to think reflect on the venture and their role in it.
ii.
B)
Trying to set up a framework so that individuals can respond to
contingencies that could not be planned for in advance.
Straight v. Cumulative
1. Straight, “normal” voting regime: each shareholder can cast their votes for each of the
candidates.
i.
Venturers example: 1000 shares, 3 posts, so won’t be able to cast more
than 1000 votes for any person. Thus if Charlotte only has 1/3 of the
votes, she can be kept from becoming a director.
2. Cumulative: entitles a shareholder to aggregate his votes in favor of fewer candidates
than there are slots available. Consequence is that a minority shareholder is far more
likely to be able to obtain at least one slot on the board.
i.
Venturers example: Charolette would put all 3,000 on herself is she thinks
she is out of favor. Then Angela and Davis could not keep her off the
board since together they could muster only 3000 votes. Could then get
into problem of what would happen if Angela and Davis just fired her
(might have provision requiring some type of stock buy back).
ii.
The maximum voting power of a given block of shares under cumulative
voting: SX/(D + 1).
S=total shares voting (need to predict ex ante)
D=total number of directors to be elected
X=number of directors looking to elect
iii.
Ex: Problem 3-5 (page 191)—Total of 5,500,000 shares. Cabal owns a
block of shares in Protein, Inc. Protein has 6,000,000 outstanding shares,
Cabal has 2,000,000 of these. 9 person board. Managmenet will have
enough votes to 6 get 6 candidates (3,300,000), the Cabal will get 3
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(1,650,000). If management decided to distribute its shares amongst 9
candidatese, Cabal could note for 5 candidates and get a majority of the
board (3,300,000/9=388,000 votes needed).
iv.
Problem 3-6 (192): Start-up company with 5,000,000 outstanding shares
held by 24 sophisticated investors. Newly hired CEO, Stark, has 1,000
shares. Investor, Door, will invest if he can get 3,000,000 shares and the
ability to elect 4/9 members of the board. Stark favors the deal but will
quit unless the board gives her one third of the voting power in the
election of the board majority.
Corporation probably issuing new stock, since they are trying to raise new
capital. Could give Stark 2,490,000 shares to give her the voting power
she is looking for. These new shares could be a class whose only right is
to vote, par value of .001 so if she has to sell it back it will only cost $250.
Could also have a special class for Door (probably convertible into
common at his preference, or having all the rights of common stock with
special voting rights).
v.
Problem 3-7. Issue of majority voting v. supermajority. Look to §141(b),
211, 212, 216. Need command of bylaws and articles for this particular
case.
3. Can use various combinations of staggered terms, classifications of shares, and
cumulative voting.
C)
Staggered Terms: Adaptability v. Stability
1. Can fix in the articles or the bylaws or both.
i.
§141(b) says need to fix the number of directors in the bylaws. .
ii.
§102: don’t have to put a lot of things in the articles. 102(a)(6) would say
have to put this in the articles if wanted to take these powers away from
the incorporator.
2. Altering Articles and Bylaws.
i.
Bylaws: Directors can usually change bylaws (if given that power in the
articles) and shareholders can intiate those changes.
ii.
Articles: Amending the articles requires the approval of both directors
and shareholders (although only directors can intiate amendments to the
articles).
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iii.
Ex: Centaur Partners v National Intergroup. Centuar needs to get control
of the company to make it a good investment, but National had provisions
to insulate them against this type of situation. They had set up staggered
terms so it would take 2 years to gain control of the board. So, if Centaur
needs to change the Articles to effectuate this change, they can’t do it.
They could if it were just a bylaw change.
3. Provision for staggering terms: Can insert such a term under §141(d).
4. Bylaws must be consistent with the Articles: (195) want to prevent contradiction and
nullification.
i.
Ex: Centuar. If what they want to do by way of amending the bylaws
doesn’t constitute an amendment or repeal, and its not inconsistent with
Article 8 (or any similar provision) then there’s no problem. Its also not
inconsistent with §16 of the bylaws.
5. Ultimately goes to who has residual power over a corporation. Result Delaware
Supreme Court reached in Centuar, that supermajority vote required by charter and so
Centuars efforts were null, could hve been a reaction to possible consequences of having
to otherwise decide thousands of contested bylaws in hostile takeovers.
D)
Removal of Directors and Other Midstream Private Ordering
1. Most modern statutes provide that directors may be removed by a majority vote of
shareholders either with or without cause.
i.
Ex: Dolgoff v. Projectavision. Corporation formed by 2 people, Dolgoff
and Maslaw, who later had a falling out. Became a contest. Wanted to get
rid of Dolgoff, but there was a staggered board, so he remained even after
he got fired. Company tried to convene a meeting in which to fire him,
but hadn’t been keeping up with meetings, and Dolgoff demanded a
chance to be heard.
2. However, these new norms are accompanied by statutory rules that limit or eliminate
shareholders’ removal power when the corporation has instituted cumulative voting,
staggered terms for directors, or class election of directors--§141(k).
i.
NYSE permits staggered boards, but doesn’t like them because it makes it
harder for shareholders to express their preferences.
ii.
Under DL law can’t remove a director from a classified board unless for
cause, per 141(k).
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iii.
If don’t want to remove for casue can amend by laws to declassify the
board, or override the default rule in §141(k) via a provision in the articles
to remove without cause.
iv.
Ex: Roven v. Cotter. Company has a staggered board, takes it away
because it wants to be able to remove Roven. Have to amend the bylaws
to do this per 141(k). May have been doing this to try and make it seem
like wre doing something in corporate best interests rather than just petty
dispute, maybe responding to concern of large instutional shareholders.
This case is an example of how provisions put into articles and bylaws
without much thought can become critical in a power struggle.
v.
Problem 3-8: Robbins fired as CEO in response to concern by large
institutional investor Biotech, and then re-elected as director on the same
day (proxies were already solicited and returned). 9 member board was
divided into 3 classes per §141(k). There is cumulative voting and the
board wants to remove him without declassifying. There could be cause
in Robbins did indeed lie to the board. He won’t have enough shares to
block his removal: S/(D+1), D=3 (since not whole board), so demoninator
is 4. If all 10 million voting he doesn’t have enough votes to block his
removal because that comes out to 2.5 million and he only has 2.
vi.
Might have trouble doing something like putting in a provision that
directors can always be removed without casue (so as to solve (k)(2)). Not
cast as a default rule, its an immutable protection so long as keep
cumulative voting in place. So will probably have to remove the whole
board and do something about classification.
vii.
Always want to think about these things in the articles or bylaws.
VI.
Mergers and Other “Friendly” Control Transactions: Protecting
Shareholders.
A)
Introduction:
1. Shareholders may get treated differently than expected: risk when merger occurs
2. Can view mergers as friendly acquisitions
i.
In order for a merger to occur, the management of both companies, and in
many cases shareholders as well, must consensually agree.
ii.
In many cases combining assets of 2 companies under common
management frequently takes place because of the need of a new
management team.
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iii.
If a merger is approved, then under §259 the effect of a merger once its
effective is that all the assets and liabilities of the disappearing company
become assets and liabilities of the surviving company
iv.
Can transfer liabilities during a merger as well, they can be still be left
behind (even if transfer assets).
v.
Would still have 2 separate entites with assets and liabilities although now
one set of managers could exercise dominance over subsidiary assets.
3. Exceptions to usual rule that shareholders of both corporations must approve the
transaction:
B)
i.
“Small-scale”: if a corporation will be merged into a much larger
corporation, the shareholders of the surviving corporation need not
approve the merger.
ii.
Short-form: If corporation P owns an overwhelming majority of the
shares of corporation S, so that they are basically in a parent-subsidiary
relationship, S may be merged into P without the approval of the
shareholders of either P or S. Both Delaware and RMBCA allow a shortform merger where P holds 90% or more of the stock in S.
Apprasial and voting rights
1. Reason for appraisal rights: If the approval of the target’s shareholders is not
unianimous, there are likely to be unhappy shareholders. Apprsial can provide a solution
to 2 principal problems:
i.
Fairness: Especially likely to be true where there is a single shareholder or
small tightly-knit group that controls a majority of the corporation’s stock.
This control group might engineer a sale or merger of the company on
terms that are very generous to the control group but unfair to the outside
minority holders.
ii.
Merger (strangers): If the transaction is a merger of one corporation into
another, even though the transaction may be “fair” in the strict economic
sense each stockholder, including those opposing the transaction, is being
forced to trade his investment for stock in a company that may be a
stranger to him, and that may have most of its operations in a completely
separate industry.
2. Nature of apprisal: Permits a shareholder in certain circumstances to disinvest at a fair
price.
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i.
Instead of being forced to trade his shares for shares in a different
company (as would otherwise happen in a merger or other share
exchange), and instead of being forced to receive cash consideration
determined in a not-arm’s-length manner, appraisal gives the dissatisfied
shareholder a way to be “cashed out” of his investment at a price
determined by a court to be fair.
ii.
Appraisal is therefore a sort of safety valve that protects a minority
shareholder against being forced to invest in an undesreiable enterprise,
and against other possible types of unfairness.
iii.
In MBCA surviving corporation shareholders get a right of appraisal too
(not in DL).
3. §262(b)(2) apprsial rights available if shareholder required to except anything other
than:
i.
Shares resulting from the merger (ex problem 7-1, Executive shares),
ii.
Stock of any corporation which will either be listed or designated as a
national market security or held by record by more than 2000 holders.
iii.
Cash in lieu of fractional shares (not going to trigger apprsial rights for
fractional parts).
3. Exceptions to appraisal and voting rights:
i.
§251(f): exceptions to when voting rights apply.
ii.
Publically traded exception: §262(b)(1). A number of states, including
Delaware, deny the appraisal remedy for publicly traded stock. If its
traded on the NYSE, don’t need appraisal because the market puts a value
on the stock. If only traded on NASDQ market exception would not
apply. However, there could be a lot of reasons why there wouldn’t be a
correspondance with market price.
iii.
§262(b)(1): if shareholders of surviving corporation are not required to
vote pursuant to §251(f) then there are no appraisal rights.
iv.
De minimus: Denies voting rights to shareholders of the surviving
corporation in a merger the terms of which shall not significantly affect
the pre-merger shareholder’s voting or equity rights, nor require a change
in the corporation’s articles of incorporation. If its under 20% its not that
much of a change so don’t need shareholder approval. Ex: page 681.
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Tuxedo has just 50 shareholders so won’t be publically traded. Might
have de minimus exception, but don’t have apprasail rights.
VII. Business Judgment Rule
A)
Overview
1. Structure of corporate law: believe in delegating day-to-day policymaking.
2. To the extent we want shareholder participation, we want it done by majority rule. If
we have a lawsuit filed by the minority, then it’s the minority that’s trying to take control
of the corporation via litigation.
3. Voluntariness/Diversity:
i.
There are some advantages in having directors take risks (as opposed to a
driver having 3 or 4 drinks)—we want entrepenurs.
ii.
The investor has chosen between a lot of different investment vehicles to
increase their return.
iii.
Managers who guess wrong in one area will be offset by managers who
guess right in another area.
iv.
Shareholders risk capital, but managers are disciplined by the risk to their
reputations.
B)
Business judgment rule: Makes the duty of care less burdensome than it would
otherwise be. It basically means that courts will not second-guess the wisdom of
director’ and officers’ business judgments, and will not impose liability even for stupid
business decisions so long as the director or officer. The requirements to impose the rule
are:
1. Had no conflict of interest when he made the decision.
i.
Director or officer will lose the protection of the business judgment rule if
he has an “interest” in the transaction. Thus if he is a party to the
transaction, or is related to a party, or otherwise has some financial stake
in the transaction’s outcome that is adverse to the corporation’s stake, the
business judgment rule will not apply.
ii.
Any taint of self-dealing by the director will be enough to deprive him of
the rule’s protection.
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iii.
Rationale: We want to protect honest, if mistaken, business judgment.
But if the director has engaged in self-dealing, he has not really engaged in
business judgment (in the sense of judgment on behalf of the corporation)
at all. He is instead pursuing his own objectives.
2. Gathered a reasonable amount of information before deciding (decision is
informed)—Smith v. Van Gorkom.
i.
Rule: As the Delaware Court put it, the directors must inform themselves
“prior to making a business decision, of all material information
reasonably available to them.”
ii.
???should this be here??? §141(e) Delaware Code: “A member of the
board of directors, or a member of any committee designated by the board
of directors, shall in the performance of such member’s duties, be fully
protected in relying in good faith upon the records of the corporation and
upon such information, opinions, reports or statements presented to the
corporation by any of the corporations’ officers or employees, or
committees of the board of directors, or by any other person as to matters
the member reasonably believes are within such person’s professional or
expert competence and who has been selected with reasonable care by or
on behalf of the corporation.”—didn’t see much for this defense in Van
Gorkom.
iii.
Facts: s were directors of Trans Union Corp., including its
chairman/CEO, Van Gorkom. Trans Union was publically-held, and Van
Gorkom held a sizeable, but minority, stake. Van Gorkom was near
retirement age, and apparently wished to sell his shares prior to retirement.
He had his chief financial officer compute the price at which a leveraged
buyout could be done: the CFO reported that at $50 per share, the
corporation’s cash flow would easily support a buyout, but that at $60 a
share the cash flow might not be sufficient. Van Gorkom then, without
consulting with anyone else in senior management, proposed to his friend
Pritzker (a well-known corporate acquirer) to sell him the company for
$55 per share. The company’s price on the NYSE had recently fluctuated
between $29 and $38, and in its history had never been higher than $39 ½.
Pritzker agreed to a $55 per share buyout price.
iv.
Board approval: Van Gorkom did not attempt to get any other offers for
the company. Nor did he never commission a formal study of the
company’s value. Instead, he went to his board of directors and asked
them to approve the sale to Pritzker at $55. He did not invite the
company’s investment bankers to the board meeting. He told the board
that Pritzker was demanding an answer within three days. Most members
of senior management opposed the deal on the grounds that the price was
too low. The board was not shown the proposed merger agreement, or any
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documents concerning the value of the company; it relied solely on Van
Gorkom’s oral presentation, the chief financial officer’s statement that the
price offered was in the “low” range of appropriate valuation, and an
outside lawyer’s advice that the board might be sued if they failed to
accept the offer. The board approved the buyout on this basis. The sale
went through at $55 per share.
v.
Holding: The Delaware Supreme Court, by a three-two vote, held that the
directors had been grossly negligent in failing to inform themselves
adequately about the transaction that they were approving. The majority
seemed especially influenced by the fact that: 1) it was Van Gorkom, not
Pritzker, who promoted the deal and named the eventual sale price, and
the board never ascertained this; 2) the board had made no real attempts to
learn the “intrinsic value” of the company; 3) the board had no written
documentation before it and relied completely on oral statements, mostly
by Van Gorkom; and 4) the board made its entire decision in a two hour
period with no advance notice that a buyout would be the subject of the
meeting, and in circumstances where there was no real crisis or
emergency.
vi.
Dissent: The two dissenters argued that the directors’ decision to approve
the merger should have been protected by the business judgment rule.
One of them pointed out that the directors were highly sophisticated
businessmen who were very well informed about the company’s affairs.
vii.
Significance: The Van Gorkom case seems most significant for the
proposition that process is exceptionally important in obtaining the
benefits of the business judgment rule. Had the board members reviewed
the proposed merger agreement, and obtained an investment banker’s
opinion that $55 was a “fair” price, the court would probably have found
that decision was an “informed” one, and was therefore protected by the
business judgment rule. Thus, the actual merits of the decision, whether
$55 was an appropriate price, wasn’t really what made the difference.
3. Did not act wholly irrationally.
C)
Pleading the Business Judgment Rule
1. Will have motion to dismiss at the pleadings, after opening, then after presentation of
evidence.
2. Would say a claim has not been stated, or there are no facts in evidence, to show that
the presumption has been pierced.
16
3. Can have candor violations where presumptions of business judgment rule are still in
place.
i.
Want managers to conduct valuation studies. Might be a good idea if done
by outside experts (maybe an I-banker).
ii.
Tell the next Van Gorkom not to be such a “lone ranger.”
4. Burdens
D)
i.
 initially has the burden to show that the directors did not act in good
faith, the best interest of the corporation, or ???
ii.
Burden would then shift to the s. Page 307: “A breach of either the duty
of loyalty of the duty of care rebuts the presumption that the directors have
acted in the best interests of the shareholders, and requires the directors to
prove the transaction was entirely fair. Court will be presented with
evidence of fair dealing and price and will make a determination over
whether the transaction was entirely fair. Directors must also show that
they fulfilled the shareholders their fiduciary duty to “disclose all facts
germane to the transaction at issue in an atmosphere of complete candor.”
(302-303).
Modern Statutory Modifications To The Rules Of Director Liability
1. Reasons for statutory modifications: As the number of suits successfully holding
directors liable for breach of the duty of care has multiplied, many states have tried to
counteract this trend by modifying their statutes. In general, these states appear to feel
that increasing directors’ and officers’ risk of personal liability does not improve the
economic efficiency of business as a whole, and certainly does not improve a state’s
ability to induce corporations to choose that state as their domicile.
2. Delaware §102(b)(7): allow shareholders to amend the corporate charter.
i.
§102(b)(7) allows the shareholders to amend the corporate charter to
eliminate or reduce directors’ personal liability for violations of the duty
of due care. It allows the corporation to modify the corporate charter to
eliminate money damages for breach of the duty of due care, so long as
the director has acted in good faith without knowingly violating the law
and without obtaining any improper personal benefit.
ii.
Contractural decision made by stockholders of the company not to impose
liability on directors. May not then extend to directors of non-profits.
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VIII. Fiduciary duties of directors: Due care, loyalty, and good faith.
(Getting past the business judgment rule, must show breach of at least one of these)
A)
The Fiduciary Duty of Care
1. Statement of the duty of care: A director or officer must, in handling the corporation’s
affairs, behave with the level of care that a reasonable person in similar circumstances
would use.
2. No duty to detect wrongdoing: The directors certainly do not have any explicit duty to
in fact detect wrongdoing. That is, most courts would probably hold that the board
members need not be suspicious sorts who go out of their way searching for evidence of
embezzlement, bribery, self-dealing, or other misconduct by operating level managers or
employees.
i.
Ex: Graham v. Allis-Chalmers. Allis-Chamlmers Corp was a large
manufacturing company. The corporation and four of its employees pled
guilty to price-fixing and other antitrust charges. s sue the corporation’s
directors, alleging they violated their duty of due care by not learning
about and prevening these antitrust violations. The s point out that some
20 years ago, Allis-Chalmers had entered into various FTC consent
decrees regarding price-fixing (as did nine other companies in the same
industries). The Court held that the directors did not violate their duty of
due care. Directors “are entitled to rely on the honesty and integrity of
their subordinates until something occurs to put them on suspicion that
something is wrong…[A]bsent 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 to reason to suspect exists. The
20-year old consent decrees didn’t out the board on notice of the real
possibility of future price-fixing.
ii.
Updated by Justice Allen of the Chancery Court in Caremark. Board
reacted right away (unlike Allis) and were trying to fundamentally change
how the corporation worked. Allen feels that as long as the process is
done in good faith (information from inside management and audit
committee) it is almost inconceivable that directors would be subject to
liability.
3. Actual grounds for suspicion: However, if the directors are on notice of facts that
would make a reasonable person suspicious that wrongdoing is taking place, they must
act.
i.
Ex: if Allis-Chambers had many sexual harrasment suits from 1985
onwards that were settled but cost the firm a lot. Then could say had a
violation of the duty of care and that there was actual knowledge of the
problems.
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4. 102(b)(7): If corporation has adopted this provision a suit that only allegdes breach of
duty of care can be dismissed pretrial. Would have been able to dismiss Smith v. Van
Gorkom on those grounds.
i.
B)
Ex: Emerald Partners v. Berlin: Court looks to see that complaint
alledges something other than just breach of duty of care. Here, the Court
says that Hall was on both sides of the transaction, and owned a lot of the
stock so that was enough to look at entire fairness.
The Fiduciary Duty of Loyalty
1. Introduction: The requirement that a director favor the corporation’s interests over his
own whenever those interests conflict.
i.
Candor: As with the duty of care, there is a duty of candor aspect to the
duty of loyalty.
ii.
Courts will scrutinize whether a director has unfairly favored his personal
interest in that transaction and whether he has been completely candid
with the corporation and its shareholders.
2. Corporate opportunity doctrine: Has the person taken something that belongs, or
ought to belong to the corporation? If so, it is per se wrongful and the corporation may
recover.
i.
4 part test in DL from Broz: 1) Can the corporation undertake the
opportunity, 2) Is it within the line of business, 3) Is there an interest or
expectancy, and 4) By taking the opportunity is the person in conflict with
the corporation.
ii.
Corollary from Guth which states that a director or officer may take a
corporate opportunity if: (348). 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 the officer
has not wrongfully employed the resources of the corporation in pursuing
or exploiting the opportunity.
iii.
Ex: Northeast Harbor Gold Club v. Harris. The opportunity was the
chance to purchase real estate near the golf course. The interest or
expectancy was whether the corporation had an interest since the purchase
of the real estate could have contributed to preserving the golf course, so
they might have an expectancy in what happens to that property. So here,
may not have 1, maybe 2, could have 3 and 4.
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iv.
ALI test (505(b)(1)(A)): 1) Must be a corporate opportunity, and 2) Must
have disclosure. In Northeast Harbor there might be several possible
opportunities which definitely were not offered to the board (therefore
Harris did not satisfy the test).
v.
ALI rule more efficient, but DL rule gives more opportunity for tailored
relief.
vi.
Problem 4-6 (357-358)
a
1) Might be financially able
2) Broadly within line of business, but not narrowly.
3) Might have an interest or expectancy since were going to expand into
airline charter business.
4) Could be conflicts of interest.
B
5) Might be financially able.
6) Broadly within the line of business, but not narrowly.
7) Might have an interest or expectancy since were going to expand into
airline charter business.
8) Could be conflicts of interest.
c
Would cut in favor of opportunity not being wrongfully taken.
Opportunity is also not essential to the corporation. Might depend on how
she represents herself to the NFL. It would be an intensely factual
decision.
d
Might have had an impact under NY law if just a director v. CEO.
Under ALI test:
Bright line rule could still tend to be fairly fact intensive. Seems like have
a corporate opportunity, but if she was on vacation, the or part would
come into play. If she’s in Chicago and acting on her own behalf she
could still be captured by (b)(1)(B).
Under Guth v Loft it’s a corporate opportunity.
3. Self-Dealing:
i.
To have self dealing, have 1) Parent on both sides of the deal, 2) Parent
dominated in order to receive/take something to the detriment of the
minority shareholder.
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ii.
Pleading: Must establish that the majority shareholder has used his power
to control the board: the  must be able to plead something that can be
construed as self-dealing.
iii.
If proven, automatically get past the business judgment rule presumptions,
then go to intrinsic fairness test. Burden shifts to .
iv.
Ex: Thorpe v. CERBCO.  shareholder sues in derivative suit, alledging
that s (directors and controlling shareholders of CERBCO) usurped a
corporate opportunity that belonged to the corporation (regarding the
purchase of stock to acquire a subsidiary). The transaction wasn’t self
dealing to the extent that the Ericksons didn’t sell their shares, since they
have the right to control their shares. It was self-dealing to the extent that
the Ericksons were using corporate assets to prepare these deals. The
Delaware Court holds that what might not have been legitimate was for s
to use their board positions to block the transactions: once they knew of
the interest from the outside party, they had a fiduciary obligation of
candor to tell the other directors. After that they could stand aside and
compete with the corporation. Ericksons are made to reimburse
corporation for expenses in this matter.
v.
Voiding conflicting-interest transactions: A process where common law
results can be voided. Transactions will not be voidable solely because of
the existence of a conflict. Delaware §144 (although the courts frequently
use their own rubric and don’t refer to this section). No such thing as
automatic voidability.
vi.
Vote by a disinterested board or shareholder ratification could lead to
reimposition of business judgment rule.
vii.
Minority shareholder situation won’t allow bop to shift back because
we’re worried about the minority shareholder being dominated and not
able to freely exercise their will. Ex: Emerald Partners v. Berlin.
Transactions between May Petroleum and corporations owned entirely by
May’s chairman, Hall. Court says fact that Hall on both sides of
transaction is enough to invoke entire fairness. There’s a conflicting
interest transaction, as encompassed by §144, before or after Hall reduces
his interest in May from 52% to 25%. However, the transaction was later
ratified by disinterested board members, and by the shareholders. Here,
don’t allow burden of proof to shift back because it’s a minority
shareholder and we’re concerned about them being dominated and not
able to exercise their will freely.
4. Entire Fairness: Most courts will uphold clearly fair transactions, clearly-abusive ones
(eg waste or fraud) are struck down, and only if the transaction’s fairness is ambiguous
21
will the fact of disinterested director approval or shareholder ratification make a
difference.
i.
DL §144(a)(3), used to examine transaction if it’s a conflict transaction
and there is neither the approval of shareholders or disinterested directors.
Burden would then shift to  to prove its fair, in which case burden would
shift back again.
ii.
Fairness is comprised of fair dealing and fair price. Not bifurcated, look at
the same time
iii.
Ex: Kahn v. Tremont. Transaction between Valhi and Tremont. V owns
stock in Tremont and NL. The transaction was selling NL stock from V to
T. Lots of overlapping relationships. Chancellor Allen looks at the timing
of the deal. Transaction seems to be done by Valhi to deconsolidate
income tax earnings. Could say Tremont did all they could, or that they
weren’t disinterested since a disinterested director worked for their
financial advisor and they wound up paying a lot for a falling stock in a
falling market. Allen placed emphais on possibility of wide range of fair
prices, although Court seems like they’re disagreeing with that. Court in a
3-2 decision says there wasn’t an arms length transaction here.
iv.
???conflict between DL SC and Chancery in Emerald Partners about
whether have to go through entire fairness analysis pretrial???
5. Stock option plans (corps may use these to get senior executives to think like owners
and act in company’s best long term interests). ???Plan by a disinterested board will
probably get the protection of the business judgment rule???:
i.
DL has a 2-pronged test for determining if there is self-dealing in the
awarding of stock options (court won’t dismiss if the complaint alledges
that the decision made by the directors will not pass this test):
1) Can the corporation may expect to receive the contemplated benefit
from the grant of options: Burden on  per business judgment rule. To
the extent that the business judgment rule isn’t in place, it would be the
burden of the directors to prove this prong isn’t satisfied.
2) Must be a reasonable relationship between the value of the benefits and
the value of the options that are being granted to the optionee. There is a
conflict between DL law (which says no fraud no problem) and the Court
(which is concerned with not having waste, that the value is proportional).
Court will want to see adequate consideration given for the benefits
received.
ii.
If self-dealing is found than will use entire fairness standard.
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iii.
Shifting burden of proof: If disinterested directors or shareholders have
approved the scheme, a much greater showing of unfairness will be
needed to strike the plan, and the burden of proof shifts from the executive
to the person attacking the plan.
C)
The fiduciary duty of good faith
D)
Distinguishing derivative from direct suits:
1. General rule: The most general distinction is based on who has been directly injured.
i.
If the injury is to the corporation the suit to redress it is a derivative action.
ii.
If the injury is to some or all the shareholders, the suit is a direct one.
iii.
Direct action is usually preferred because the rules imposed in derivative
suits are generally tougher for  than in a direct suit.
iv.
Ex: Suit against directors because they sold property and shareholders are
disappointed to find out that property that was sold for $1 million is now
worth $20 million. Would probably be a derivative suit.
2. Derivative suits exception to normal corporate operations: Derivative suits are an
intrusion on the director’s job of running a corporation.
i.
Derivative suit develops because directors who have done wrong are
unlikely to sue themselves. But it’s still an exception to the normal rule.
ii.
Shareholders are seeking to individually enforce rights that belong to the
corporation.
3. Demand requirement in derivative suits: Proceedure may give stability to DL
corporations, and precedent guides a lot of the decisions. Submitting demand takes time
and effectively concedes prong 1. Demand on the board is excused where it would be
“futile.” Typically, that happens if the board is accused of having participated in the
wrongdoing. In Delaware, a  will have to make a demand on the board unless he carries
the burden of showing a reasonable doubt, by pleading facts with particularity, that, as
held in Aronson v. Lewis:
i.
Directors are disinterested and independent: Through personal
relationships, directors are beholden, that they had a personal interest in
the matter. Not enough to plead control, have to plead facts that create
23
reasonable doubt about the person’s independence.  will need to go the
substance of the transaction to show these things.
ii.
E)
The Challenged transaction was otherwise the product of a valid exercise
of business judgment. Would be challenged as a waste or a gift—
something so far outside the norm that no rational director could have
thought this was a fair or reasonable transaction for the corporation to
enter into.
Brehm v. Eisner
1.  appeals on 2 claims:
i.
Whether or not the negoaition and approval of Ovitz contract is subject to
appeal on some basis (board’s approval).
ii.
Whether the decision to grant no fault termination met the Aronson test for
further discovery and proof at trial.
2. Must plead particularized facts, but  is entitled to reasonable inferences that flow
from those facts.
i.
Pleading question about whether reliance on expert affords full protection
under the business judgment rule (§141(d)).
3. §220: Might want to think of things that can get through §220, to get access to books
and records, rather than litigation discovery.
i.
With §220 need to describe what you’re looking for with precision. Here,
the Court said in the first complaint they should have used this tools at
hand.
ii.
Court seems to expressing a preference for good lawyering; this would
seem to concentrates these suits into just a few firms with the resources to
do this.
4. Breaches claimed by :
i.
Giving Ovtiz no-fault rather than firing for cause cost the corporation
hundreds of millions of dollars that could have been avoided. This would
be a violation of the duty of care and would be waste (disincentivized him
to stay).
ii.
Could be a violation of the duty of loyalty since Ovitz was looking for a
new job when this all happened.
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iii.
No-Fault termination could be considered a conflicting interest transaction
since Ovtiz was still a director when he obtained this agreement, and it
was in his best interest to do so. Easier to see Eisner as interested since he
had obvious conflicts, but the Court says  has lost that claim.
iv.
If  established a breach of fiduciary duty, then it becomes  duty to show
entire fairness. However, if instead  establishes waste, then have show
the transaction wasn’t fair and have gotten into showing breach of
business judgment rule.
v.
However…the prices for option As being the same as for option Bs could
give him an incentive to work harder because the more valuable he makes
the company the more valuable are his options. In addition, Ovitz’s
reputation suffers a blow when he pulls out after 14 months. Could say
that Ovtiz just bargained for something along the lines of contract
insurance.
5. Standard of review: Split on whether on appeal from dismissal on the pleadings it is
de novo or clearly erroneous. Could be a deterrant to let  have 2 bites, or it could be that
Court has lost confidence in Chancery.
6. Dumps distinction between substantive due care and procedural due care. But that
wasn’t a big deal in the first place.
VIX: Mergers and other unfriendly transactions
A)
The intersection between the Appraisal Remedy and Fiduciary-Duty-Based
Judicial Review—Weinberger v. UOP.
1. Used to modernize the appraisal remedy and reshape the rules governing fiduciary
duty-based review of cash-out mergers:
i.
Cash-out mergers: minority shareholder given cash or short term notes,
not stock, thus “cashing them out” of the corporation.
ii.
Previously DL encouraged distisfied shareholders to challenge cash-out
mergers via a cost spreading class action suit rather than pursue an
individual appraisal action.
iii.
Created in the 1970s when poor market conditions caused many
companies to take the opportunity to start buying back stock, which was
good for the controlling shareholder. Encouraged federal legislative
activity, since the perception was that state law was inadequate.
25
2. Can’t have a merger whose sole purpose is to freeze out minority.
i.
Business purpose test adopted in Lynch: Grafted on top of entire fariness
review. Decreased value of appraisal remedy. Drove up value of
litigating in DL, and of settlement for . By merely claiming that the
transactions lacks business purpose,  will at least get to discovery. Court
says not same rules as disclosure violation, once established that duty of
candor has been breached, going to require Chancery to award recissory
damages. Thus, if the value of acquired assets taken into the corporation
goes way up, s are going to get the benefit of that gain.
ii.
Court gets rid of business purpose test in Weinberger v UOP because it
says there will never be a place for it in an arm’s length transaction. Thus,
establishing a breach of fiduciary duty no longer automatically entitles a 
to recissionary damages. Business purpose only comes into play as a part
of the mix. In Weinberger, Signal tried to structure the transaction so it
wouldn’t look to the courts like it was using its controlling power over
UOP (Signal had nominated a majority of UOP’s directors and could
control them).
iii.
 now has the first burden for invoking fairness obligation: Will trigger an
entire fairness review.  must be able to allege that ultimately the
transaction was monetarily unfair to the shareholders because there was
some misuse of controlling shareholder’s power. If this were a derivative
suit, as opposed to shareholder right, would have to plead like Aronson
with more particularity.
iv.
From now on expect appraisal to be remedy in cash out merger:  would
sue for apprisal. Chancery court, using valuation experts, would provide
such a valuation.
v.
If  choses a fiduciary duty suit after Weinberger and the court says case
doesn’t fit into one of the narrow exceptions, that is the suit boils down to
nothing more than a dispute over value of shares,  will have lost the
chance to get judicial scrutiny over the value of those shares.
vi.
Will now see much more independent committees made up of independent
directors (so will have no information to share and there will be no misuse
of power via conflicted positions). Still a lot of uncertainty and unclarity
about these matters.
X.
Federal Securities Laws Affecting Corporate Transactions
A)
Implied private causes of action:
26
1. §14(a) of the 1934 Exchange Act. Court implied a private right of action in Rule 14a9 (from §14(a)—Solicitation of Proxies in Violation of Rules and Regulations) in Case v.
Borak.
i.
Said it was a necessary supplement to the SEC since their resources are
limited. However, there is nothing that specifically speaks to that right of
action. Spillover activism from the Court in the commercial area from
broader federal activism (ex Mills v. Electric Auto-Lite).
ii.
§14(a) is concerned with “Soliciation of Proxies in violation of Rules and
Regulations.” Ex: Case v. Borak. Harm done with the false and
misleading proxy in Case, was judged to have harmed the totality of the
shareholders.
iii.
Causation: Breach of disclosure on a material issue provides coa under
14(a). In Case,  claims the merger would not have been approved
without the use of these false and misleading proxies. Question over
whether  has to show direct harm to the . Court says this breach is what
gives a §14(a) cause of action. Court says we want to make sure there is
adequate disclosure.???
iv.
In contrast, if it were state law claim we would look at misuse of power
resulting in harm to shareholders which would trigger an entire fairness
review.
2. Regulation of Insider Trading under §16(a) and (b) of the Securities Exchange Act of
1934 (Gollust v. Mendell, CBI Industries v. Horton, and Feder v. Martin Marietta):
Present strict liability rules, for private parties only, to regulate insider-trading.
i.
§16(a) requires registration of everyone who directly or indirectly in the
beneficial owner of more than 10% of any class of any equity registered
pursuant to §12.
ii.
§16(b) holds that once you become a 10% owner, can’t make a subsequent
transaction within a 6 month period, other than at the exact same price at
which the previous transaction was made. Anything acquired before you
became a 10% owner isn’t subject to this provision (even when sold). If
you are only covered because you are a director, must resign first and then
make the sale or purchase that would have otherwise given rise to the
§16(b) claim. ???so if bought 50 shares before and then 50 shares and
sell 100 shares, does the take back only apply to 50 shares???
iii.
Recovery is found by taking the 6 month period, looking for the highest
possible gain, then using each transaction to match up the maximum
gain/loss avoided. Ex: page 1199, problem 11-8. Lowest price was on
Oct. 15, at $10, and highest price was on May 1 for $15. The difference
27
was $5 per share, were 100 shares, so liability is $500. But, if he became
a director on May 1 by buying 100 shares at $15, and then on Oct. 15 he
sells those shares at $20 making him no longer a 10% owner, as soon as he
went from beneficial to nonbeneficial owner he wasn’t within §16(b). If
on May 1 he buys 100 shares which makes him a just more than 10%
owner. Then on May 2 buys 150 additional shares at $15 which makes
him 20% owner. Sells all 250 shares on Oct 15. As to May 1 acquisition
he was not a beneficial owner at that time. May 2 he was so those profits
need to be given back.
iv.
Who is an insider will always be a question: CBI Industries v. Horton.
People will always try to take advantage of inside information by having
someone else make the acquisition, but be the ones to really benefit.
Posner’s view in CBI is that there should be a direct pecuniary benefit;
opposes looking at direct v indirect benefit because it would make it too
hard for an insider to benefit (which would exceed what Congress had in
mind). View of other circuits isn’t as favorable to insiders.
v.
Deputization: Feder v. Martin Marietta. Just as a person or eneity may be
the “beneficial” or “indirect” owner of stock even though he is not the
elgal owner, so a person or entity may be treated as being effeictvely a
“director” of the company if he or it has deputized another person to serve
as a board member. Ex: ABC owns a substantial interest in XYZ, and thus
designates its employee E to sit on the XYZ board as ABC’s representivie,
then ABC will be found to have “deputized” E to be a director, and ABC
will be treated as being functionally a director and thus covered by 16(b)
This case is a road map about how to deal with interlocking directorships
(which is the dominant trend, with about 85-90% of American directors in
the position of being directors for multiple companies). Usually taken
care of in employment contracts. If not, and nothing in minutes to clarify,
could be a reasonable inference that the board wants them to serve on
boards in of companies in which they’ve invested. Always comes up in
relatively ill advised start ups that have just gone public, and aren’t
squared away, can’t afford adequate representation.
3. Corporate opportunity: minority shareholder rights to enforce in Perlman v. Feldman.
i.
Facts: Feldman was the president and dominant shareholder of Newport
Steel Corp. During the Korean War, the steel industry voluntarily
refrained from increasing its prices. Wilport was a syndicate of steel endusers who wanted to obtain more steel than they had been able to get.
Wilport bought Feldman’s controlling interest in Newport for a price of
$20 per share (at a time when the publicily-traded shares of Newport were
selling for $12 a share, and its book value was $17). Once Wilport gained
control, it apparently caused Newport to sell substantial amounts of steel
to Wilport’s memberts though such sales were always made at the same
28
prices Newport charged its other customers. Non-controlling shareholders
of Newport sued Feldman, arguing that the control premium Feldman had
received for his shares was directly due to the premium buyers were
willing to pay for steel in a time of shortage ant that this premium was
therefore essentially a corporate asset that should belong to all
shareholders pro rata.
ii.
B)
Holding: Court seemed to be saying that if the corporation has an unusual
business opportunity that it is not completely taking advantage of, this
opportunity may not be appropriated by the controlling shareholder in the
form of a premium for the sale of control. Appeals agreed with  that
Feldman had violated his fiducuariy duty to the other shareholders.
Ordered that recovery (amount of the premium) be paid directly to the
minority shareholders.
Rule 10b-5 as a Regulator of Insider Trading
1. “Classic” Insider Trading As Fraud: SEC v. Texas Gulf Sulphur
i.
Facts: Texas Gulf Sulphur (TGS) had been looking for minerals in eastern
Canada for a number of years. In early November 1963, it drilled a test
hole, the test core from which showed a higher percentage of minerals
than TGS’s geologists had seen before. From November until February
1964, TGS stopped drilling to keep its find confidential (and so it could
obtain leases on additional nearby acerage). During the non-drilling
period, various employees bought lots of TGS stock and calls, and the
company issued options to high level employees. Drilling resumed in late
March 1964 and produced favorable results. To defuse rumors about this
find, the company offered a press release on April 12 that said reports
were exaggerated and couldn’t reach conclusions (whereas they had
already identified a sizeable value of materials). Price went up from $17
to $36 on the day TGS announced the results. The SEC subsequently sued
the employees who had knowledge of the probable strike between
November 8 and April 16 to disgorge their profits. It also sued TGS itself
on the theory that by issuing the misleading April 12 press release it
induced outsiders to sell at prices lower than they would have gotten had
that misleading press release not been issued.
ii.
Court adopts “disclose or abstain” rule urged by the SEC: Under this rule
an insider with material non-public information must choose between
disclosing it to the public or abstain from trading in the stock.
iii.
Press release: Press release (1142) where tried to hide that there was
anything good about the drillings. Could say that statement was an artifice
to defraud. Its generality, when there were more specific findings
29
available, was itself enough to make the report misleading (even though
the company didn’t trade its own stock).
2. Standing in connection with a purchase or sale:
i.
Birnbaum rule from Birnbaum v. Newport Steel Corp. In private
securities litigation, only a purchaser or seller will have standing (not a
fiduciary).
ii.
Court agrees there is an implied private right of action under 10b-5 in
Superintendent of Insurance v. Banker’s Life & Casualty (ultimate failure
to deliver consider to Manhattan that creates the loss). Typical of non-DL
cases in that it cites from a lot of different sources.
iii.
Transaction must be a purchase or sale of a security—Blue Chip Stamps v.
Manor Drug Stores. s weren’t able to sue since they hadn’t actually
traded the shares yet, and the propspectus was overly pessimistic (usually
problems are with prospectuses that are too optomisitc).
3. Requirement of scienter: A  will be liable under 10b-5 only if he acted with scienter,
that is, with an intent to deceive , manipulative or defraud (Ernst and Ernst).
i.
Facts: s were a big 8 accounting firm that had audited the books of First
Securities Co., a small brokerage firm. First Securities’ president had
been carrying on a massive fraud for years, converting customers’
accounts to his own use. The accouting firm missed a number of clues to
the fraud (eg the fact that the president insistend on being the only one to
open certain kinds of mail), yet there was no suggestion that the
accounting firm ever intended to defraud or mislead those who relied on
its audit.
ii.
Holding: A majority of the Court held that a showing of sicenter is
necessary in any 10b-5 action (at least any private action for damages).
The court relied heavily on the use of the word “manipulative,” device,”
and “contrivance” in §10(b) of the ’34 Act.
iii.
Limits aiding and abetting of charges of 10b-5 violations for professional
firms unless  can show that the firm’s conduct amounted to something
worse than negligence (won’t be liable). Consequence of freeing
accountants from potential liability is that will lower their insurance
premiums and ensure that less care is taken.
4. Meaning of scienter: Court in Ernst v. Ernst held that its means an intent to “deceive,
manipulate, or defraud.” But this could amount to several things [not from class]:
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i.
Knowing falsehood: If  misstates a material fact knowing that the
statement is false, and with the intent that the listener rely on the
misstatement, scienter is present.
ii.
Absence of belief: If the representation is made without any belief as to
whether it is true or not, this almost certainly constitutes scienter as well.
iii.
False statement of knowledge: Similarly, if  states that he knows a fact
to be true, when in fact  knows that he does not really know whether the
fact is true or not, this is almost certainly scienter as well.
iv.
Recklessness: Court hasn’t addressed this question, but virtually all courts
post-Hochfelder have concluded that if the  makes a misstatement
recklessly he has scienter. More clear when it is an affirmative
misstatement than when it is an omission.
5. Breach of fiduciary duty without misrepresentation won’t be a 10b-5 violation—Santa
Fe v. Green.
i.
Facts: , Santa Fe, owned 95% of the stock of Kirby Lumber. DL law
allowed a parent corporation that owns more than 90% of the stock of a
subsidiary corporation to effect a “short-form” merger, whereby they may
cash-out the minority by buying their shares whether or not they consent.
 put through a merger whereby the minority shareholders in Kirby were
offered $150 per share. s were minority shareholders who were unhappy
with this price, and wanted to use federal securities law rather than statelaw apprisial rights. Claimed that by putting through the merger at an
unfairly low price,  was engaging in a kind of fraud or decit upon the
minority. Appeals court cites concerns, including SEC Commissioner
Sommers, that upholding an action like this will make individual
shareholders more hostile since its not something investors could have
anticipated (know will be able to do this again by taking the corporation
public again shortly thereafter).
ii.
Holding: Court held that  did not state any 10b-5 claim because there
was no omission or misstatement in the information given by s to s.
10b-5 doesn’t apply where “the essence of the complaint is that
shareholders were treated unfairly by a fiduciary.”
ii.
Court did not want to federalize state fiduciary law: Traditionally, the
rules governing fiduciaries, especially corporate insiders, have been the
subject of state, not federal regulation. This case does show there is an
overlap that can’t be eliminated (Medina says there is a market in which
federal and state courts and legislatures compete and present alternative
remedies).
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iii.
Possibilities for overlap: Ex: Weinberger v. UOP will be brought as state
law; could bring it under federal law as well but that probably won’t be the
best venue. Reject 2nd circuit argument that the merger was the fraud. But
in Schoenbaum appeals court talks about purchasing securities with inside
info that wasn’t disclosed to the public. In that case there would be
nondisclosure was well as classic self-dealing under state law.
6. Misrepresentation or omission of a material fact: In Basic Inc. v. Levinson the Court
holds that the misrepresentation or omission must be of a “material” fact.
i.
Materiality: In a 10b-5 suit a fact is material “if there is a substantial
likelihood that a reasonable shareholder would consider it important” in
deciding whether to buy, hold, or sell the stock. The Court rephrases this
a bit, in the context of proxy materials, in TSC when they hold that a fact
is “material” if there is a “substantial likelihood that the
disclosure…would have been viewed by the reasonable investor as having
significantly altered the ‘total mix’ of information made available.”
(changed so it wouldn’t be too easy for  to get to discovery and summary
judgment). Footnote 17: must be misleading to be actionable and silence
is not misleading.
ii.
Balancing test for mergers: Mere fact that an insider  had material nonpublic information and failed to disclose it is never, by itself, enough to
expose him to a 10b-5 action (disclose or abstain rule from Texas Gulf
Sulpher). In a merger negotiation, the materiality of the fact that secret
merger negotiations are under way, and major terms are not yet agreed
upon is determined by “a balancing of both the indicated probability that
the even will occur and the anticipated magnitude of the event in light of
the totality of the company activity.” (Basic, quoting from Texas Gulf
Sulphur). This probability/magnitude test increases the ability of a litigant
to get to discovery.
iii.
Covering up something that is otherwise immaterial can make the fact
material. The underlying facts could be material, and the integrity of
management is material.
iv.
Reg. FD: Rule 102 explicitly overrides 10b-5. If an improper disclosure
is made, and/or something is leaked to analyst, corrective disclosure needs
to be made. However, not creating a new cause of action.
v.
8-K: From Rule 13a-11 requirement to file quarterly reports. Need to file
one of these reports if something major happens in the interim. Amongst
the events that require disclosure (by filing an 8-K) are a change in control
of the registrant, change in certifying accountant, resignation of director
and if director and if directors sets out reasons in letter and asks them to be
disclosed, and anything else you want to. Disclosure in 8-K doesn’t
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conceed that a matter is material, so as to not chill people from making
disclosure for fear of giving away part of a litigant’s case.
7. Reliance and Causation:
i.
Normal requirements of proximate cause don’t seem to apply in 10b-5
actions.  need not show that he traded directly with ; mere fact that 
bought at the market price, and this market price would have been
different had  discharged his duty to disclose before trading, will be
enough to show proximate cause (case cites???). Don’t need to show a
state corporate law claim as a link between a private  and the fraudulent
action. The main requirement is that the case involves the purchase or sale
of a security (otherwise it encounters the problem of being too far
removed from the securities laws, ie Blue Chip Stamps).
ii.
Must show a link for action under §14(a): In Mills v. Electric Auto Lite
the Court held that the “shareholder has made a sufficient showing of
causal relationship between the violation and the in jury for which he
seeks redress, if, as here, he proves that the proxy soliciation itself, rather
than the particular defect in the solicitation materials, was an essential link
in the accomplishment of the transaction.” However, in Virginia
Bankshares v. Sandberg, the Court held that proxy statements under14(a)
had to form a link between the shareholders and the damage causing
corporate actions. In the case of a minority shareholder, the only way for
a private  to establish this link is to show that the misleading proxy
statement caused the shareholder to forgo a state corporate law claim that
would have been otherwise available (eg getting an injunction. However,
the Court has declined to address what showing would be needed of what
would have had to have happened under the applicable state law. This
changes
8. Tightening of requirements for private securities law actions: Private Securities
Litigation Reform Act of 1995.
i.
Want to avoid wrongdoing but also prevent strike suits. Ex: Time Warner.
Time had to go into debt to finance the merger (previous to which it was
debt free). Quickly became obvious that TW couldn’t carry that much
debt. Shortly after the merger, the price fell from $200 per share to $94
per share. There was shareholder disappointment at not having been able
to cash in at $200 per share. 2nd Circuit holds that there were no
affirmative misrepresentations, that there were no problems with
nondisclosure of issues in the strategic alliance negotiations, but that there
may be an unfulfilled obligation here to disclose alternate approaches to
reaching the stated goal while these approaches are still under
consideration.
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ii.
§21(e) added to the 1934 Act by the 1995 Private Securities Reform Act.
Made it harder for s to survive dismissal at pleading stage (thus more
likely that fraudulent activity would occur). Addresses to what extent
companies should be protected for forward looking statements. §21(e)
could be seen as a codification of the “bespeaks caution” doctrine that
allows safe harbor for forward looking statements if there is sufficient
cautionary language (such that a reasonably sophisticated investor would
understand that information was subject to change). Ex: problem 9-5. Not
a slam dunk to just point out any discrepancy, doesn’t mean its material.
iii.
Incorporation by reference doctrine—§21(E)(e): ???  gets to include
publically filed documents in which they say they have made appropriate
cautionary statements to insulate themselves from liability at dismissal
stage. The statements are treated as a summary judgment matter, rather
than letting it be a matter for discovery. Thus,  can attack elements of 
case, and try to get safe harbor.
iv.
Scienter: Made §21(E)(c) safe harbor actual knowledge. Therefore, the
implication is that it left recklessness in place everywhere else. However,
it is possible that the Court could take a case and require actual fraudulent
intent for 10b-5 action.
v.
Pleading requirements, §21D: deals with heightened pleading
requirements. 2nd circuit says Congress adopted their view that must plead
facts with particularity so as to give rise to strong inference of the required
state of mind. Congress wanted to undue the ability of s to use the 9th
circuit as a place to extort settlements from companies. Every circuit will
say its pleading burden is something less than actual intent. 2nd circuit
holds that Congress adopted its pleading standard of motive and
opportunity (although it says the 11th misapplies, that this requires
something unique to that corporate insider)—Novak v. Kaskas.
vi.
Must now state with particularity all facts on which “information and
belief” are formed. Only comes into play when pleading facts based on
“information and belief.”; federal law requires them to have knowledge of
facts that would support accusations, or state reasons why they believe
those facts to be true. Ex: Novak v. Kaskas. DC dismissed complaint
under this standard because  didn’t reveal the name of its source on Ann
Taylors “box up” policy. Appeals disagreed, although could have
situation where court will require naming the source.
vii.
Preempting state law claims: Congress wanted to preempt state law
securities fraud actions. Only left Delaware carve out, which specifically
does not preempt those disclosure related lawsuits that have been
traditionally handled by state courts (transactional and other fiduciary
related lawsuits).
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viii.
C)
DL Court holds that fraud on the market is a totally federal matter—
Malone v. McNally. Only when insiders speak directly to shareholders, in
a context other than asking them to do something, do we see an extension
of DL law to a breach of fiduciary duty. Here,  seeks damages against
company for fraudulently overestimating how well the company is doing,
and want to hold the accountants liable for aiding and abetting (can’t do
that under federal law anymore). Claim is that they held onto their shares
as a result of inaccurate information. DL could extend a coa since there’s
no federal 10b-5 action available since s aren’t purchasers or sellers; they
decline to do this and tell s they can replead the case as a derivative suit.
s might try to fashion a coa for individual harm, but it would be hard to
establish reliance and causation.
Extensions of theories of insider-trading
1. Tippee Liability and Constructive Insiders: A duty to “disclose or abstain” only
applies to “insiders,” “tippees,” or “misappropriators.” A person who is none of these
simply has no duty to disclose or abstain (Chiarella, cited in Dirks v. SEC).
i.
Liability of Tippee: Under 10b-5 liability is derivative from the liability
of the tipper—unless the insider/tipper has consciously violated his
fiduciary responsibility to the company for personal gain, the tippee has no
liability even if he trades on the information for his own gain (a tippee is
someone who receives inside information from an insider). Dirks v. SEC
(1983). “[A] tippee assumes a fiduciary duty to the shareholders of a
corporation not to trade on material nonpublic information only when the
insider has breached his fiduciary duty to the shareholders by disclosing
the information to the tippee and the tippee knows or should know that
there has been a breach.” Blackum in dissent holds that the insider still
loses no matter what the motive is; that 10b-5 is addressed to actions and
consequences to shareholders, not to motives.
ii.
Possession of information on tender offers imposes an obligation not to
trade under 14e-3. Williams act passed to deal with the Chiarella
situation, it contains a number of provisions to protect shareholders. Says
if you have information about a pending tender offer, that should have
known is nonpublic and had a source that is one of the parties to the tender
offer, then can’t trade.
iii.
Problem 11-1: The executive talking to the spouse could be a breach of
care and/or loyalty. Under the classic theory there is no problem with the
coach because he is not an insider. Would have to find that there was
some fiduciary duty, or some confidential duty akin to a fiduciary
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relationship. Might be in violation of 14e-3 though if the information was
about a tender offer.
2. Misappropriation: Under this theory the basis for liability is that the person in
possession of inside information breaches a fiduciary responsibility to someone else, not
the issuer or the issuer’s shareholders. Formally adopted by Supreme Court in 1997 with
United States v. O’Hagan (discussed on 1173, and in O’Hagan).
i.
A person can violate 10b-5 even if the material non-public information
comes from a source that has nothing to do with the company. US v.
O’Hagan holds that a is liable under 10b-5 if he has misappropriated the
information by breaching a fiduciary relationship with the source of the
information.
ii.
Problem 11-7: Doesn’t look like Sid violated 10b-5 by virtue of recipt,
has no scienter. Doesn’t look like he tried to help Jonathan so Jonathan
isn’t liable under the classic insider theory. Would have to be based on
misappropriation of inside information. Chessman susgests that a
confidential relationship might be created (eg they were in the habit of
discussing business affairs could day there was a relationship of trust and
confidence). But here, that’s beginning to become a tough claim.
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