CORPORATIONS 2004
1) AGENCY –
a)
The fiduciary relationship that results when 1) the PRINCIPAL CONSENTS that someone 2) act for him as his agent,
subject to his CONTROL, and 3) the AGENT CONSENTS to so act. The principal is responsible for the acts of the
agent where the agent is acting within the scope of the agent’s authority. Once consent has been established, how does
fact pattern suggest control?
b) Test Approach: Argue both Actual & Apparent Authority on both sides
i)
Actual Authority p.16
(1) Cargill, Inc.: p. 12 Actual Authority Case. Cargill, Inc. financed Warren Seed, Inc. to sell grain to farmers.
Warren Seed defaulted on its Ks and the farmers sued Cargill, claiming that Cargill and Warren had surpassed the
basic debtor/creditor relationship and that Warren had become Cargill’s agent. Held- Agency requirements met.
(2) Actual Authority Factors – Agent/Principal or just a Debtor/Creditor?
(a) Principal’s Consent to Delegate Decision-making Authority
(i) Directing the “agent” to implement recommendations
(ii) Determination the “agent needs “strong paternal guidance”
(b) *****Principal’s Control*****
(i) day to day interference – checks and audits, constant recommendations and criticisms regarding finances,
salaries, and inventory,
(ii) veto power over mortgage entry, stock purchases, dividend payments
(iii) financing of all operations
(iv) power to discontinue financing
(v) providing forms for the “agent” with the principal’s letterhead
(c) Agent’s Consent to above
ii) Apparent Authority –
(1) Policy: to allow 3rd parties to rely on “reasonable perceptions of agency” without having to investigate the validity
of the agency before every transaction
(2) Butler v. McDonald’s Corp: p 22 Apparent Authority Case. Kid cut his hand when a glass door shattered at a
McDonald’s leased under a franchise agreement to Mr. Cooper. The parents sued McDonald’s claiming that Mr.
Cooper 1) had held himself out as McDonald’s agent and 2) P believed and relied on this. Held – Survived
summary judgment. (Hoffnagle found that corp. intrusion only applies to uniformity and standards) contra (Miller
holding that message sent to public creates link for agency).
(3) Apparent Authority Factors - Can a RP distinguish between corporate-owned and merely franchised?
(i) Franchiser’s “image of uniformity” led a RP to think that he or his employees were employees or agents of
the D “principal”: national-corporate advertising; common signs and uniforms; common menus; common
standards of maintenance, appearance, operation; national-corporate logos
(ii) P actually believed it
(iii) P relied to his detriment on “agents’” care and skill
2) PARTNERSHIPS
a)
1) An EXPRESS OR IMPLIED K 2) between two or more persons to carry on as CO-OWNERS 3) a business FOR
PROFIT. General partnerships may be created without a filing, limited partnerships cannot. Types of Problems: Has
someone gotten sucked into a partnership without intending to be in one? OR Has someone been kicked back to a
partnership because the corporate form was defective? Also, argue the creditor/debtor/partnership tension in light of limited
liability policy.
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b) Default Rules (p44-46) These rules may be overridden by a partnership agreement:
i) J&S Liability
ii) Profit Split regardless of Investment
iii) Equal voting Rights
c)
Factors in Finding a General Partnership where Denied - * Statements that no partnership is intended not being conclusive,
the court will consider:
i)
Written K Provisions – Provisions Properly Inserted to Protect Lenders (focus on the re-payment of the loan) or
Provisions Contemplating a Controlling interest in a Business for Profit (focus on making money)?
(1) Implying an close partnership association with the business: power to initiate transactions, power to bind the other
like a partner, option to buy into the business
(2) Just guarding an interest in re-payment: name used (trustees), keeping advised, inspecting books, vetoing highly
speculative/ injurious business, loaned securities kept separate, provisions in place to compensate for the rise and
fall of security’s value, cap on profit related to loan repayment
ii) Implied by a Sharing of Profits Alone – Method to Pay a Debt or Business for Profit?
(1) Paying profits in lieu of interest to repay the loan – debtor/creditor
(2) Making profits above those related to the loan – partnership
iii) Martin: p 27 Implied Partnership Case. Owner of KN&K formed a K to borrow money from three friends. To secure
the loan, KN&K agreed to hand over some securities. As payment for the loan (instead of interest) KN&K agreed to pay
the three friends 40% of its profits, not to exceed 500K, until the return was made. Held – No partnership b/c K
provisions deemed not to contemplate profits beyond those made on the loan itself (only related to interest, security,
and re-payment of the loan).
d) Fiduciary Obligations - Partners are held to “something stricter than the morals of the marketplace” and have fiduciary
responsibilities to one another while the partnership lasts
i)
Meinhard: p 31 Partner Fiduciary Obligations Case. Gerry leased her hotel to Mr. Salmon and his financer-partner Mr.
Meinhard. After 20 years as partners, while the partnership was still in force but was about to end b/c the lease was
about to run out, Salmon was approached in his capacity as the “sole” leaser with a business-deal involving a new lease
on the hotel. He accepted this deal for himself w/o telling Meinhard about the opportunity. Bullardism, “Must inform
your partner of the opportunity or it is a breach of your fiduciary duty.” Held – Salmon had a fiduciary duty to inform
his partner of the business deal and allow him to compete for the new lease b/c it had come to the partnership
ii) If he was approached after the lease expired he would be ok. If the property was separate from the lease (on other side of
town) then he would have been ok. If he had been approached because of his accomplishments of the lease then he
would be ok. Salmon only had to disclose and give notice what he was doing (and not breach the fiduciary duty) to
break away and go out on his own venture. If partnership has gone bad, find out why and see if it is fixable, then can
offer a deal, if they don’t accept then it is dissolved.
e)
Binding Authority – A partner is an agent of the partnership and has the authority to bind the partnership and copartners
when acting in the ordinary course of business. Partners have equal rights in the management of the partnership business and
disagreements are to be settled by a majority vote. See p 36
i)
Dooley: p. 36 Partner Action Deemed Outside the Ordinary Course of Business. When one of two partners became
unable to work, he decided to hire an employee to replace him over the other partner’s objections and then charged the
dissenting partner with the costs incurred as a result of his unilateral decision. The dissenting partner refused to pay.
Held – Dissenting partner not liable b/c he continuously objected and the expense was incurred for the benefit of
only one partner
ii) Stroud: p 38 Partner Action (buying bread) Deemed Inside the Ordinary Course of Business. One partner of Stroud
Food Center told a bread maker (3rd party) not to sell bread to his partner anymore. His partner entered into a K to buy
the bread anyway. The dissenting partner refused to pay the 3 rd party. Held – What either party does with a third
party is binding on the partnership when acting in the ordinary course of business
f)
Limited Partnership
i)
Essential Characteristics
(1) Created by statute
(2) Triggered by a written filing
(3) One or more general partners with unlimited liability
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(4) One or more passive partners with liability limited to what they have contributed to the partnership (they just invest
money)
(a) No ability to bind the partnership
(b) Limited partners who take an active role in controlling the business lose limited liability if: 1) the limited
partnership’s control of the business is “substantially the same” as that of a general partner or 2) people who
transact business with the limited partnership have actual knowledge of his participation in control. These are
questions of fact
(c) A.R.S. Safe Harbor Provisions – Control means more than just: Being a Contractor, Consults or advises the
Gen Partner with respect to business, Acting as surety (financial backer), Approving or disproving an
amendment to partnership agreement, Voting on dissolution of the partnership or sale, exchange, lease,
mortgage, pledge or other transfer of assets of partnership other than ordinary course of business, incurrence of
debt other than normal business, change in nature of business, removal of a Gen Partner
ii)
Gateway Potato: p 55 Suing the Limited Liability Partner. Gateway potato sued Sunworth (general partner) and GB
(limited partner) for money it had lent to the partnership, claiming that GB’s participation in control raised questions
of fact regarding GB’s possible loss of limited liability. Held – Survived summary judgment
g) Incorporated Partnerships - LLPs & LLCs
i)
Essential Characteristics
(1) LLP - You are not normally liable for contract breach or torts of the other partners. You are only liable for your
own wrongful conduct and for the people who are underneath you if you had direct control over them. Must file
with state (pass through tax treatment and limited liability). Popular with law firms, accountancy firms etc. (good
for separate vertical hierarchies w/n a law firm). Disadvantage: Hard to transfer ownership. See Rosenfeld p 61
(2) LLC – Members can actively participate in management or be passive w/o incurring unlimited liability.
Disadvantage: Transferability of ownership may be limited by operating agreement or securities laws. See Jaffari p
63
4) CORPORATE STRUCTURE
a)
Formation of the Corporation
i)
(p 83-86)
Preparatory steps and pre-incorporation shareholder agreement, name, office in the state of incorporation p 83-84
ii) Filing a simple Charter a.k.a. Articles of Incorporation w/ the Secretary of State in each state in which it does business. P
84
(1) Good idea to say “for any lawful business.”
(2) The Charter can only be amended by the board after majority approval by the shareholders and a new filing if the
shareholders would be adversely affected (ex; changes in stockholder dividend or voting rights).
iii) Should Conduct an Initial Organizational Meeting to Commence Operating: issue stock, appoint directors to appoint
officers, decide compensation, ratify Ks incurred on behalf of the corp. before its existence was formalized, approve
resolutions for opening bank accounts, leases, and Ks to start operations
iv) By-laws: Rules governing internal affairs (not filed).
(1) Rules governing internal affairs include: date and place of annual shareholder meetings, number of directors,
cumulative voting?, listing of officers and duties, what makes a quorum for director meetings etc.
(2) If the Charter does not contain provisions about adopting or amending the by-laws state law gap fillers may govern
(a) DL law says the power to adopt or amend the by-laws rests solely with the shareholders
(b) Charters often allow the by-laws to be amended either by the shareholders or the board of directors
v) Must create and maintain minutes by statute p 85-86
(1) Date, time, place, specify before or after required notice, special or regular meeting
(2) Departures/returns of board members
(3) Summary of actions taken, discussions, and reports
(4) Usually brought for approval to next meeting to clear up ambiguities
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b) Capital Structure
i)
(p 90-96)
How the Corp. Raises Money and Financially Operates
Makes Loans p 90 – Corp must pay back money with interest, but avoids the dilution of control and sharing of future
profits that comes with issuing stock
(1) non-recourse loan
(2) guaranteed loan
(3) bonds – Corporation borrows money from the public by selling certificates that contain a promise from the corp. to
repay the lender the principal plus interest at a future date.
(4) Policy behind loan provisions – Corp. takes on more risk after they borrow money
ii) Issues Stocks p 90-91 – Certificates that reflect an ownership interest in the corp. Corp avoids having to pay back money
with interest but loses some control and must share future profits with new shareholders (diluting the ownership interest)
(1) Common Stock Ownership
(a) Usually entitled to vote to elect the board of directors and on other issues submitted to the shareholders for
approval (like adoption/ amendment of by-laws)
(b) Right to a proportional amount of any dividends (earnings) “declared” by the directors
(c) Charter may vary the rights of common stockholders by creating different classes of stocks with various rights
to vote/ get dividends
(2) Preferred Stock Ownership
(a) Usually not entitled to vote unless dividends are not declared for a specified period of time; then they may be
able to elect a specified number of directors
(b) Advantage over common stockholders in receiving dividends and in bankruptcy. After you got your dividend
preference, you participate equally with the common stockholders in dividends
(c) Cumulative Preferred Stock – When a dividend is declared, the common stockholder cannot get the dividend
until any dividends in arrears are paid to the preferred stockholders
(d) Non-Cumulative Preferred Stock – The preferred stockholder loses the right to any dividends if the board does
not declare them in any given year; no right to dividends missed in prior years
iii) Balance Sheet p 91-95 – Identifies corporate assets and the sources of the assets; assets must balance out with the
liabilities, equity investments and retained earnings (profits not paid out as dividends)
(1) Stated capital = “Par Value” is the stated value of a security as it appears on its certificate. A bond's par value is the
dollar amount on which interest is calculated and the amount paid to holders at maturity. Its face value or nominal
value
(2) Capital Surplus - All the money invested in the corporation in return for shares. Stockholder contributions that are
in excess of a stock's stated or par value. For example, if a firm issues stock with a par value of $1 per share but sells
the stock to investors at $10 per share, the firm's financial statements will show $1 in common stock and $9 in
additional paid-in capital for each share issued.
(3) In some states the ability to pay dividends is limited by shareholder equity related to capital surplus and stated
capital.
iv) Income Statement p 95-96 – Shows net income and income per share after expenses (gauges profitability)
v) Bankruptcy
(1) Debtors have priority over stockholders in bankruptcy and thus shareholders only share in assets left over after all of
the debts of the corporation have been paid
(2) Preferred stockholders get their stocks’ full liquidation value and then common stockholders share pro rata in
whatever is left
(3) Liquidation preferences – who goes first and why depends on the risk they have incurred.
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c)
Operation of the Corporation (p 153-166)
i)
Generally
(1) The shareholders elect a board of directors to run the company for them on a day-to-day basis. The board of
directors is not the shareholders’ agent.
(a) Dunsmore: The Corp. as a whole (shareholders) improperly elected a committee chairman to tell the board
to liquidate the co.
(b) BUT Courts are deferential to shareholder power to remove directors for cause.
(i) Dressel: Shareholders used by-laws to call a special meeting to endorse the old pres. and vote for the
removal of four directors. President refused to call the meeting, saying the Charter gave removal power to
the officers. Held - Just b/c the Charter gave the directors the power to remove directors doesn’t
mean that shareholders don’t have that power
(ii) Campbell: Two factions were fighting for control of Loew’s. There were 13 directors; a quorum was
seven. After several resignations, 5 of one faction and 4 of the other (including the President) were left on
the board. The other faction refused to come to the meeting so there could be no quorum. Therefore, Pres.
called a stockholder’s meeting to remove two directors for cause, increase the size of the board and quorum
to 19 and 10 respectively, and fill the vacancies. He sent out solicitations and a call for proxy votes (laying
out charges against the directors he wanted removed). Other faction claimed this was contra DL policy b/c
if the majority could increase the size of the board it could defeat the minority influence created by
cumulative voting.
(iii) Held – Shareholders implied power to remove directors for cause outweighs cumulative voting
policies where 1) there has been service of specific charges 2) adequate notice, and 3) a full
opportunity of meeting the accusation. Here, the solicitation was one sided and unfair (you have to give
the other side the opportunity defend themselves)
(2) Usually the whole board is elected once a year. Sometimes the by-laws call for staggered elections, making it
longer, harder, and more expensive for power to change hands; provides continuity. * Make sure by-laws allow for
removal of directors for cause (or even w/o cause) so your client shareholders don’t have to wait for the next
staggered election
(a) Staggered Board
(i) Ensures that take-overs are not fast nor easy because the directors are entrenched (which can also be bad).
Would take almost 2 years to change the composition of the board. (Hazen pg 152 n. 2)
(ii) Some states now provide for removal of directors by shareholders for cause unless the certificate of
incorporation or by-laws provide otherwise.
(3) The number of directors needed to take action as established in the by-laws controls the number of voting cycles
needed to take control; example a 10 votes out of 12 majority would entrench the bd. – 4yrs. But its harder to get
stuff done and they might turn against you (the shareholders)
ii) Board Functions and Compensation p 152-153
(1)
(2)
(3)
(4)
(5)
(6)
(7)
Often may fix their own salaries
Select, evaluate, pay, replace the CEO
Advise (shareholders) and/or approve strategy
Counsel executive officers
Select and recommend directors for shareholder elections
Monitor internal controls for money, regulations, and law
Must initiate mergers, selling substantially all assets, liquidation, or consolidation, subject to minority shareholder
right of appraisal – statutes generally force bd. to buy out minority shareholders if they vote against at least one of
these.
(8) Must initiate changes in charter/ articles of incorporation, or change of state of incorporation
iii) Board Committees p 159-163
(1) Powers delegable to committee - Executive, Compensation (direct), Audit (high oversight), Special litigation (often
outside counsel to gain neutrality in shareholder derivative suit), Nominating
(2) Powers not delegable to committee - Fill vacancies, Change by-laws
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iv) Officers and their Sources of Power p 163-165 – A corporation is bound by Ks entered into by its officers and agents
acting on behalf of the corporation and for its benefit (agency) provided that they act w/n the scope of their express or
implied powers
(1) Actual Authority to act from by-laws, board resolutions, or job descriptions from the board or a superior corporate
agent
(2) Apparent Authority to act
v) Housekeeping Requirements for Enforceable Board Meetings p153-155
(1) Board action must be taken at a duly convened meeting unless there is unanimous approval by the board of directors
– Policy: board action should follow a complete airing of views
(a) Directors cannot vote by proxy
(b) Directors may be present by electronic communication which guarantees two way communication which all
directors can hear
(2) Notice of meetings – May be waived in writing or by attendance (unless attendance to protest the meeting)
(a) Two days for special meeting
(b) None for routine meetings
(3) Quorum and Voting requirements p 155
(a) If a quorum is present, the affirmative vote of a majority of directors present (not just those voting) will
constitute an act of the board
(b) Ordinarily a quorum for directors meetings consists of a majority of the total number of directors on the board –
By statute, The Charter or By-laws can fix the number of directors that constitute a quorum as high as
unanimity and as low as 1/3 of the total number of directors
(4) If faulty process, ratify at next meeting; if challenged, ct. more differential to internal complainants (purpose of
rules)
(5) Record Date = Date where shareholders with power can vote on the issue. Shares will change hands once the issue
is presented (makes people who own the shares at the time of conflict vote and not those who shuffle their shares
around for tactical purposes).
5) CORPORATE ACTS
a)
Acts by a Yet to be Formed Corporation – Promoter Liability
i)
Promoter makes K in his own name, and Corp. is not named – Promoter is personally liable
ii) K Says the Corp. ‘Will be Formed’
(1) Corp. is never formed or not deemed to have adopted it – Promoter is personally liable
(2) Corp. expressly or impliedly adopts the K – Look to intent of the parties to see whether promoter is supposed to
escape liability. Possibilities:
(a) Promoter meant to take the risk and bind himself, and after formation seek indemnity if necessary *
(b) Promoter meant to bind himself under stipulation that once the company is formed it would step into his shoes
(c) Other party is made an offer to the non-existing corporation which results in a K if the corporation is formed
while the offer is still open.
(3) Geary Promoter acting for a company not yet formed, entered into a contract to build a bridge. Issue, did the guy
bind himself or the not yet formed company to the contract obligation? Held - No agency power vested to Geary
so he acted alone in entering into the contract (#1 above).
(4) Old Dominion A syndicate was formed to buy land and mining rights from another company. Profit was to be
divided based on how much pro rata individuals invested in the syndicate. After the purchase the syndicate created
a corporation and increased shares of stock to 150,000 at $25 per. Two directors then sold 100,000 shares and sell
the property for 30,000 shares, thus leaving 20,000 shares to be sold to the public. The two directors essentially sold
land and property worth $1,005,00 for $2,500,00. Thereby devaluing the 20,000 shares sold to the public. Ct. held
that no wrong was done to either side because each side had a say in the plan, except for the public which was
uninformed.
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(a) Bullardism = If a corporation ratifies/endorses an activity, you can’t legally go after the directors that benefited
from it.
iii) K says the Corp. Exists and Will Honor the K
(1) Promoter is aware no Corp., and other party doesn’t know this – Promoter is personally liable on a misrepresentation
theory (unless Corp. adopts)
(2) Promoter honestly believes there is a Corp. - Use Defective Corp. Analysis
iv) Note: Promoter has a fiduciary obligation to the to-be-formed corp. (see corporate opportunity doctrine)
b) Acts by a Yet to be Formed Corporation – Liability of the Corporation Once Formed
i)
Must adopt to be liable
ii) Types of adoption
(1) Express – by resolution
(2) Implied – by acts or failure to act: example, corp. receives K benefits w/o objection; acquiescence
c)
Defective Corporation
i)
De Facto Corporation – Charter Filed Wrong - If a “colorable” attempt at incorporation was made, the corp. is not a
corp. in the eyes of a state but the promoter and his passive shareholders can enjoy limited liability ‘quasi-incorporation’
status with regard to their creditors
(1) Especially where the 3rd party thought it was dealing with a corporation
(2) Unless the promoters knew the incorporation was defective
(3) Pocahontas p 86 Attempt at compliance was enough to meet de facto corporation, although the mere fact that a
creditor has dealt with the D as a corporation is not alone sufficient
(4) Five Times when De Facto Corporations Arise
(a) Participant honestly & reasonably believes the certificate of incorporation has been filed by an attorney when it
hasn’t been.
(b) When the articles or incorporation have been mailed to the Sec. of State but they were delayed or returned
because of an error.
(c) A 3rd party agrees to enter into a contract with a company in its corporate name even though 3rd party knows
company has not filed its charter yet.
(d) Party enters into a contract on behalf of a company even though its charter has not been filed yet, and the other
party dealt with the defective corporation and not the individual.
(e) A passive investor provides funds with the instruction not to engage in business until the articles of
incorporation are filed but the business commenced anyway before the incorporation.
ii) Corporation by Estoppel – Charter Not Filed at all or Severe Defect
(1) Creditor dealt with business as a corporation
(2) The shareholder asserting the defense did not know the corporation was defective (especially used when there was
GF reliance on a third party to incorporate who doesn’t do it)
(3) Even usable where defect in incorporation is too severe to allow a de facto corp.
(4) Cranson p 87 D is advised by his lawyer that his business is incorporated. He orders typewriters from IBM in the
Co. name and IBM relies on the Co. credit when shipping the typewriters. Unknown to him, incorporation does not
take place until after the order. Held – No personal liability. In relying on the Co. credit, IBM dealt with the
GF D as a corporation and was estopped from denying its existence
d) Piercing of the Corporate Veil
i)
(p 107 Factors p 108)
Theoretical Doctrines to Pierce
(1) Instrumentality doctrine,
(2) Alter Ego doctrine,
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(3) Identity Doctrine (same basically)
ii) Majority Rule actually looks at Inadequate Capital + one other (esp. corp. procedures)
(1) Inadequate Capitalization* for reasonably foreseeable business needs (including damages)
(a) Zero capitalization provides no protection; corp. empty shell
(b) For close corp., inadequate capitalization reflection of leaders’ failure; since they have more incentive to
undercapitalize it goes to intentional misconduct; not true of public corp., so never pierced
(c) Amount of insurance considered in total capitalization
(d) Initial capitalization usually what’s considered; no duty to add new capital to a business dying b/c of mkt.
concerns, but if business grows, could argue needed to add more
(2) Tort (more likely) vs. K claim when co. can’t pay damages
(a) Voluntary creditors could have bargained for a personal guarantee but didn’t (fair result)
(b) Involuntary creditors (like tort victims) couldn’t bargain to offset co. transferring defective products’ risk to
them
(3) Fraud made it so co. can’t pay damages
(a) Policy – Even K creditors couldn’t offset their risks if lied to
(b) Esp. where managers have siphoned out funds
(4) Failure to follow Corp. Formalities made co. unable to pay damages (shares not formally issued, meetings not held,
minutes not maintained)
(5) No Real Separation btwn Shareholder and Corp (No proper distinction btwn shareholder property and corp.
property, Sole/ single family ownership, Diversion of funds to non-corp. uses, Same office, employees)
(6) Making the corp. to cover personal debts: Fraudulent conveyance – corporate pocket to avoid creditors: recovery
limited to the transaction
iii) Cases to illustrate these tests:
(1) Minton: A lawyer and two friends started a corporation which owned a pool. That corporation never had any assets
or money and was not allowed to trade stocks. A girl drowned at the pool but that corporation couldn’t pay the
judgment. Family tried to go after the partner with money and make him pay based on “Alter Ego” that the guy had
unity of interest. Held - No unity of interest, b/c he didn’t 1) treat the assets as his own and withdraw or add
capital from the corporation as if it were his own, 2) hold himself out as personally liable or 3) provide
inadequate capitalization, 4) actively participate in the day to day affairs
(2) Walovsky: Taxi cab service set it up so that many corporations existed, each owning one taxi cab and then one
central corporation dispatched them all thereby limiting the need for liability insurance required by law for fleets.
Guy had ten corporations, each with two cabs, one which hit a bystander. Ct held generally that you can pierce the
veil to prevent fraud or inequity. People using the corporate structure to further their own business, rather than the
corporations, will be liable for the corporation’s acts. Held – No piercing b/c complied with all laws and
requirements, even though he deliberately split them up to avoid paying more insurance that was an issue for
the legislature to deal with not the courts. Dissent said that this is an example of intentional under capitalization
and thus should pierce the veil. He suggested that in Minton, their failure to capitalize in the advent of a negligent
drowning, should have pierced the veil and it should have done here
(3) Costello: A partnership was created by three guys investing money. Once the partnership was formed, two of the
three partners withdrew all their money leaving each partner having invested 2K. The business suffered losses and
owed money so they incorporated it thus trying to shield themselves from the debts. To run the company basically
the ct held they needed 50K on hand (just to restock shelves and pay expenses - normally you should be able to
restock your shelves 7-8 times) but they only had $66. Held - Inadequately capitalized and thus the banks could
pierce the veil. Moreover, when the two partners withdrew the money they did it for their own benefit and to
the detriment of the corporation. Minority rule: A finding of under capitalization by itself is sufficient to pierce
the veil. The higher your merchandise turn-over-rate the lower the capital you need (because you are constantly
making money for each sale), however here it was too low.
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(4) Luckenbach: A parent company can not start a child company and then under capitalize it. Here a big company
started a subsidiary steamship company and then put 10k into it when it needed 800K. Held - Pierce the veil of the
subsidiary to the parent company because the identity is one and the same.
e)
Ultra Vires – Protecting Shareholders from Un-contemplated Risks
i)
Traditional Doctrine:
(1) No business acts not contemplated by the charter
(2) Wiswall: Hot craze of the 1800s to make plank roads. Company had a K to make a road, but didn’t make it even
though they kept charging tolls. Shareholders wanted the profits but D&Os wanted to expand the business to
include stagecoaches and mail delivery. Held – Charter didn’t allow these new types of endeavors. The new
rule and views about business would allow this but in this era it didn’t.
ii) Modern Courts Largely Abolished Ultra Vires Doctrine
(1) Statutes mostly allow Corp. to engage in “any lawful business” unless the Charter says different
(2) Most states also abolished 3rd party claims of ultra vires to rescind a K; stopped chilling corp. K
(3) Policy – Today, shareholders invest more in the managers than in the co. specific projects
(4) Cross: A private member’s club would only allow members inside but they would not accept women as members.
A woman wanted in so she brought suit using ultra vires. The corporate charter did not specify who could be a
member and thus didn’t preclude women b/c it was created to include business people before women were part of
the business world. Held: If you wanted to exclude business people, you have to say that in the charter.
f)
Corporate Responsibility
i)
Bullard: Is the general corporate purpose to engage in public altruism (helping society) or is it just simply to make
money? Barlow policy analysis: Wealth used to be in the hands of individuals, who made charitable donations. Now
wealth has shifted to corporations and individuals are heavily taxed, so it is good public policy to allow corporations
leeway to give money to charity under a liberal construction of “corporate benefit.”
ii) Charitable contributions must be tied to the corporation’s bottom line, but charitable acts will never be held as ultra vires
in the real world because you can almost always relate public image and good will to bottom line
(1) Barlow: Corporation wanted to donate money to Princeton. Shareholders didn’t like it. Directors argue
contributing to school gives better education (hiring), and community goodwill (mkt. base).
(a) Held – Closely enough tied to bottom line
(2) Adams: Corporation gave money to officers’ widows w/o consideration. Shareholders claimed ultra vires gift of
corporate property. Corp. claimed giving bonus/ pension benefits to officers and their widows and dependants was a
benefit to the co. and should be shielded by BJR.
(a) Held – Not valid b/c no valid consideration and no K
(3) Only win injunction if “smoking gun” that the director knew it would be bad in the short and long term – then use
fiduciary duty analysis. Dodge: Ford had surplus cash, which he invested into other businesses to “spread
industrialization.” He also lowered the cost of the cars w/o increasing the volume. Ford only gave a small dividend
and shareholders, who got mad and sued Ford for corporate irresponsibility (GMC & Dodge wanted to use the extra
money to set up their own business that would compete).
(a) Held – Stipulating that you are spending corporate funds solely for the public good while you are also
reducing profits is a breach of fiduciary duties.
6) DERIVATIVE CLAIMS
a)
A corporate COA permitting shareholders to call directors, officers, and 3 rd parties into account for harm to the corp. when
the managers refuse to do so
b) Derivative or Personal Claim? P 775-776
c)
Standing Requirements p776-777
i)
P was a SH at the time of the transaction (harm)
(a) Unless stock acquired by operation of law
ii) Not collusive to confer improper jurisdiction
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iii) P fairly and adequate represents the interests of the SH
(a) Look out for personal vendettas/ motivated by personal litigation
iv) Other rules – Merger destroys SH standing, Creditors don’t have standing
d) Demand Requirement p 777
i)
Complaint must state the efforts made by P to obtain relief from the directors and that:
(1) They failed
(2) OR Demand would have been futile b/c directors are the same ones you sued (everyone is conflicted – if only some
are, recuse or vote out of presence of conflicted ones)
ii) Alford p778 Shareholders made demand on directors b/c of their fraud and self-dealing. Directors appointed a special
litigation committee, which found no problems. Shareholders filed the suit.
(1) Issue: Special litigation committee shielded by BJR? Three Approaches 1) Apply BJR (safe unless uninformed/BF)
2) Conflicted directors can’t participate 3) If futile, ct. applies Substantive Scrutiny: Corp must show informed/GF,
then court decides whether derivative action should be dismissed.
(2) Held – Trial Ct. should have used # 3, not # 1 under NC law.
iii) Miller p783 AT&T directors refused to recover 1.5 million debt from DNC for 4 yrs. Directors say BJR shields them.
Shareholders claimed this equated to campaign spending (outlawed by statute), and the breach of the statue avoids the
BJR problem.
(1) Issue: Is this claim subject to a derivative suit? Held – Normally, not collecting a debt would be covered by the
BJR, but where not collecting a debt is itself alleged to be an illegal act, and the statute was enacted in part to
protect stockholders from corporate funding of campaigns without their approval, 1) stockholders have
standing and 2) can bring a derivative claim based on the illegality of the act
7) DUTIES OF CARE AND BUSINESS JUDGMENT
a)
Duty of Care – Cases Board failed to stop Fraud/ Theft/ Malfeasance
i)
Issue: Should something the Board failed to do make them liable for damages?
(1) Board should monitor for agency costs, especially the officers
(2) Oversight or micromanagement?
(3) Red Flag facts ignored? * Many cases turn on this failure to trigger of micro-review
ii) Duty to act in 1) Good Faith 2) With a rational belief they’ve acted in best interests of the co. (ordinary prudent person
eliminated by BBA b/c encouraged managers to be too conservative)
iii) Tension: other than decisions whether to stop fraud, theft or malfeasance, which are clearly always bad for the co., Board
decisions are generally evaluated under the business judgment rule below b/c courts realize Bd. must be free to make
business decisions in GF.
iv) In cases of theft or malfeasance, the Board may be held liable for not no micro-reviewing
(1) Bates: High living bookkeeper steals all the money from the bank over a period of years. Bullardism, “Were the
procedures in place to protect against theft were they adequate at the time or is this a completely new type of theft
which the directors could not have reasonably protected themselves against, or at the time did the directors have
reasonable procedures in place, should they have done more.” Here, obvious risk, lots of red flags, few employees,
board had duty to monitor president; President liable but directors escape b/c court view of red flags went toward
directors - properly relied on president, new scam, not paid salary; inconceivable not liable today
(2) Barnes: Factory output lagging; tire co. failed. Bullardism, “You have not failed the duty of care just because the
business has failed. There has to be some causal connection between the breach of duty and the failure. You need a
rule like this to protect directors or none them would take chances or take the job. Don’t want punishment for
failure to meet your businesses goals ” Complete absence of information about the co. will lead to liability, but here,
they did not show directors responsible for co. collapse. Informed prong anticipates Business Judgment Rule by
considering risk taking.
(3) Emerald: Derivative suit challenged a merger b/c the controlling shareholder had an interest in both the parties to
the merger. DL had passed a statute granting immunity from duty of care claims. Held - Case dismissed because
of the failure to assert a duty of loyalty claim in addition to a duty of care claim. Bullardism, “You always
want to be arguing a duty of loyalty claim as well as duty of care.” [This would only come up if he gave us a statute
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saying director liability is limited under duty of care] Then you need to respond listing the factors showing a duty of
care as well as a duty of loyalty claim and tell how they can be used for both ways
b) Business Judgment Rule – Presumption that Business Decisions not allowing fraud/ theft are Protected from Scrutiny
i)
Presumption Bd. decision is o.k. if 1) Informed 2) GF and 3) Rational belief in co. best interest
(a) Usually turns on “Informed” b/c self dealing is outside of BJR anyway and easy to show belief in co. best
interest (see Wrigley below)
ii) Application of Business Judgment Rule
(1) Wrigley: No lights = No night games which = Less profits. Rational belief in co. best interest? Yes, b/c no data co.
would make more money and even if you showed that, directors could argue lights pissed off neighbors and
made neighborhood go downhill. Thus decision rationally in co. long-term best interest. Note that charitable
purpose can always be linked to co. bottom line
(2) Eisner: Disney CEO hired a new President and let him go after problems thereby giving him a huge contract
default payout of stocks. Board sued for failing to inform itself about the employment agreement’s severance
package. Board claimed reliance on an expert was enough to meet BJR “informed” prong. Held – A board of
directors is “uninformed” only where grossly negligent. It’ GF reliance on a qualified expert may meet the
“informed” prong of the BJR: SEE P 219 FACTORS. Bullardism, “Expert testimony, and a DL statute that
protected the board of directors if they relied upon expert opinion (lawyer). When would reliance on an expert in
this set of facts or is this opinion so transparently incorrect that they should have been on notice, or was this an error
that you should be able to reasonably able to rely upon an experts to NOT get wrong.
(3) Van Gorkom: Retiring CEO wants to sell co. for $55/ share and merge w/ another co. Bd. drives the deal through
biased proxies. The stock was trading at $38/ share but shareholders sued claiming CEO and directors should have
gotten more for co. value b/c calculating the stock sale price back from the amount needed to pay interest [cash flow
+ dividends] on huge LBO debt was a dumb way to calc. co. value (mkt. might not value income tax credits/ control
premiums - CEO conserv. b/c wanted to retire and cash out on sure thing while “shark” saw great deal in splitting up
and selling off co. for huge profit).
(a) Bullardism, “Key issue is: What should we expect the Directors to do as a matter of law to inform themselves
so they can get the presumption that they are protected under the BJR? They failed to be fully informed. What
we want them to do as a matter of law is different from what we would like them to do as a matter of best
practice. Discuss policy of higher standard of best practice and why we allow the lower standard of matter of
law.”
(b) Issue: Bd. shielded by Bus. J. Rule Presumption? No, b/c Bd. not informed. Directors must make
reasonable efforts to be informed 1) Bf. deal closed, relied on CEO evaluation w/o asking him to explain it
(need honest in/outside eval. of co. value) 2) Exp. Bd. should have known co. eval. could have been based on
LBO; still did not seek outside expertise [DISSENT- Bd. exp. enough for “informed”] 3) Relied on legal advice
“you don’t need outside opinion” as meaning “you don’t need to evaluate the price at all”; obviously
incomplete; legal opinions must be written, detailed, reasonable, complete and well-balanced to be relied on 4)
Three days to consider deal [shark pushing hard] 5) Did not solicit other buyers during mkt. test period - too
passive seeking higher price, even discouraging in press releases (made deal look final) 6) Did not cure
“uninformed” until after they were sued and caught in the K.
(c) Tension: State cts. must resolve issue of lying about the merits of deal or Feds may reluctantly step in
(d) Perfect Storm for Liability b/c 1) Endgame, price all that matters on sale; narrow, unambiguous issue like
theft/malfeasance above 2) Directors dared ct. to find them all guilty together thinking ct. would not fault
relatively innocent directors 3) represented by the same attorney under investigation for giving them bad
counsel – so he didn’t testify about what he actually told directors about not needing an outside opinion;
attorney drafted merger agreement disappeared (could have shown “informed” by true market test)
(e) Normally, BJR allows capitalism to punish co. that make bad bus. decisions by being eaten up by “sharks” that
put capital to a “higher” use
8) DUTY OF LOYALTY
a)
Look at pg 246 & 248 for Exam hypos and facts!
Self Dealing Transactions: Director 1) on opposite sides of a deal with his co. 2) helped to influence the co. decision to take
the deal 3) his personal financial interests are potentially in conflict with the co. best interests. Ex: Director influences his
own co. to buy real estate from him.
i)
If totally one-sided (waste/ fraud) almost always voidable
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ii) If deal one-sided but not to the level of waste or fraud, director can insulate from future recession by
(1) Bd. Directors Approval
(i) Ratified by a majority of disinterested directors (Majority of a committee is enough)
(ii) A Director w/o a conflicting interest or under the influence of the key player are disinterested
(iii) Majority Rule: Not enough disinterested directors for a quorum: if a majority of disinterested directors
approve the deal, counts as a quorum. Not true in Gilder
(iv) Gilder – Not enough disinterested directors (ties w/ other golf clubs) to make their vote banning U-shaped
clubs valid, so interested Bd. amended by-laws to give disinterested directors binding authority; the
amendment left directors open to breach of loyalty action b/c interested directors made amendments
knowing disinterested ones were going to change their minds after the co. was sued (too costly to litigate);
Bullardism, “How do you avoid being in a situation like the PGA was in here? Be on the look out for times
when you CAN amend the bylaws but the time and reason for doing it is self dealing in nature. The
problem was that the amendment was related to a specific issue/problem/transaction, so by changing it they
got around the problem, thus self dealing.” Held - the time between the vote and the amendment was
too close and it was found to be a self dealing transaction.
(v) After Full Disclosure
(vi) Say why there’s a conflict (if not obvious)
(vii) Tell underlying facts you know likely to make the deal turn out badly for your co. - “reasonably material
facts”
(viii)
Woolen – Elec. Co. sued for rescinding losing K with yarn maker. Elec. Co. argued that the K
was voidable b/c the key player breached his fiduciary duty to them during formation by failing to fully
disclose conflict/transaction. Held - Abstaining from voting was not enough of a disclosure when he
remained silent at the bd. meeting. You have to proactively bring it to the attention of the board and if it
was bad for the company you HAD to say so.
(2) Shareholder ratification: 1) need full disclosure as above 2) cts. split on whether majority means majority of
disinterested shareholders or whether they all can vote
(3) Showing it was fair when made – BOP on the key player so bad to rely on this
(i) Marciano: One co. lent the other money in a self-dealing transaction, which was not ratified by one the
boards. Bd. of liquidating co. was split 50/50. Held – Liquidating co. could not have approved the K
b/c of the split anyway, and the K was fair so upheld. P 226-20
(ii) Bullardism, “The issue was whether it could have been possible to satisfy the standards usually applied in
BJR. The split was ok because even though it was not approved by the other board it was substantively
fair.”
b) Usurping Corporate Opportunities: (p 249 & §505)
i)
An employee, director, or controlling shareholder takes over an opportunity for himself that belonged to the corporation.
The corp. may get damages for the lost deal. Bullardism, “If they ask, how should you have dealt with this corporate
opportunity? Say, insulate yourself by getting board approval.”
ii) Was the Opportunity a Corporate Opportunity? – Use either test:
(1) Is the opportunity closely related to the business’ existing or prospective activities; even if different industries
[WAS IT INTEGRALLY LINKED TO WHAT THE CO. WAS ALREADY DOING]
(i) co. special expertise
(ii) functional relationship w/ prospective activity
(iii) Guth v. Loft: Guth was the power behind Loft, but he was a powerful businessman himself. Loft owned a
lot of candy companies and Coke was screwing Loft and Guth over so Guth was looking for a new product
for Loft. Pepsi offers to sell the corporation to Guth, and Guth buys it buy financing the purchase through
Pepsi. Question is how the Pepsi offer came to him. **Pepsi came to Guth, BECAUSE Guth was a
director of Loft and Loft had the ability to make Pepsi big. Loft was in the position and known for selling
candy and cola so it was in their line of business to take on Pepsi. If the original corporation was not in the
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business and not an opportunity they would take, just because it was brought to you as a director doesn’t
mean you have to present it to the company.
(2) Did the corp. have an interest (K right) or expectancy (reasonable anticipation e.g., prior negotiations) of getting
the opportunity [WAS IT COMPLIMENTARY TO WHAT CO WAS DOING ALREADY]
iii) Other Factors - Fairness
(1) Deal offered to the individual, or as manager to convey to corp.? Individual capacity is not a defense by itself if test
1) or 2) is met, only one factor in fairness analysis
(2) How learned of deal?
(3) Use of corp. resources?
(4) How bad will the injury to the corp. be (how essential)?
(5) Public corp.? More likely to find opportunity belonged to corp. b/c harder to monitor than close corp.
(6) Corp. inability to take advantage (defense generally only allowed after full disclosure)
(7) These all go to GF on the director’s part
iv) Key Player must offer “Corporate Opportunities” to the corp. and the corp. must reject it for Key Player to escape
liability;
(1) Full disclosure then
(2) Majority vote of disinterested managers/ shareholders rejecting the opportunity
(3) Some cts. allow after the fact ratification; some don’t b/c really too late for corp. to take advantage of it
(4) Johnson: You owe a duty to offer a “corporate opportunity” to all corps to whom you are loyal; if they all pass, you
can claim the opportunity
c)
Breach by Competition with the Corp. - The Key Player (director, senior executive) competes w/ his corp. in a way likely to
HARM it
i)
No general duty to not compete with your current employer. But if you compete there is a high likelihood you will harm
them and THAT is wrong.
ii) Duane Jones: Ad executives wanted to go out on their own because CEO/President was a jerk and so they rented space,
bought supplies and then started stealing clients. Bullardism, “There was clearly a harm to the old business because the
employees were already soliciting the clients before they left the business. You can create stationary, incorporate, rent
space with the intent to leave, they just can’t talk to or contact those clients until you have left your old position.”
iii) Not barred from competing AFTER employment unless:
(1) Use of Corp. info (see Lincoln Stores)
(2) Under a reasonable (time, area, scope) non-competition agreement
d) Breach by Use of Corporate Assets/ Information - Key Player uses corp. assets/ information to 1) harm corp. OR 2) get
financial benefit
i)
Lincoln Stores: Several guys working for a retail store wanted to open their own retail store, so they learned how to run
the business. Then they left the business, bought a spot next to the store, and opened it for business. Held - Their use of
business information (gained while working for the old company) itself is fine, but the use of confidential
information (inventory and business strategies) was illegal. Corporate opportunity was not an issue because Lincoln
had said they were not interested in getting another store so they were not obligated to bring up the opportunity b/c the
board had pretty much said they didn’t want it. Bullardism, “This is a good case because it helps you to distinguish
when there is a violation of your duty to the corporation. Simply leasing the new store, buying supplies, renting space is
not a breach.
9) CORPORATE DEMOCRACY
a)
Cumulative Voting
i)
Basic Equation
(1) To determine how many spots you can get with your votes:
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(a) X = ((n-1) x (d+1)) / s [n = total # of minority shares, d = # of directors up for election, s = total # of votes from
both majority and minority]
(2) To determine how many votes is enough to win those seats from above:
(a) X = ((a x b) / (c + 1 )) + 1 [a = # of directors spots you want, b = total # of shares, c = total # of director spots
up for election, X = number of shares needed to win]
ii) Hypothetical
(1) There is a board of 9 directors, one faction controls 80% of the shares. And they are all up for election, how do you
tell your client to vote. What is the minimum number of directors you can get and why?
(2) Diffuse Ownership versus Cumulative Voting
(a) When there are millions of shares and thousands of shareholders ownership is diffused and cumulative voting is
NOT as important.
(b) Closely held companies it is very important because large blocks are owned and those blocks can make a big
difference in voting.
(c) The expenses involved will also be reflexive of size.
(3) Staggered versus Cumulative
(a) If all the directors are being elected at once, versus only a few directors per year, the cumulative voter (minority
shareholders) can get more directors on the board if ALL the directors are up for election at once.
(b) With staggered voting, the minority shareholder will NOT be able to get as many directors on the board.
(c) Refer to PP slides for Cumulative voting questions.
(d) If you are doing a staggered cumulative vote every year for ONLY one director, it is the same as straight line
voting because the minority can’t over come their numbers.
(4) Example Answers
(a) Zero, because straight line voting will prohibit the minority group from getting any directors.
(b) Three, assuming a three year cycle of this answer, each year the minority winning one director based on this
yearly scenario. If three slots are available, (Maj 180, Min 120) the majority must play 90 votes in two slots
(dir1 & dir2) the minority must beat 90 votes (eg 91 or more) to win a slot. That leaves the minority with only
29 votes, so they can only win their one director cumulative voting will allow.
(i) If it is a staggered board with a 80% / 20% split the minority can never get a director on because using all
of their votes combined will not give them enough votes.
(c) 9 member board, all up for election with a 80/20 split. For Bullard (unlike reality) start and allocate the
minority votes (ask yourself if the majority can beat them - not tie)? If the answer is no, then that is the number
the minority wins.
(5) Reverse Cumulative Voting = Any director(s) can be removed with/without cause, by the majority shareholders
who are then entitled to vote. So after the election you could have another election to remove the minority’s director
by the majority. This way the majority could kick out any minority director that won.
(a) First calculate the minimum number of shareholder votes needed to elect him in the first place. Then, if that
number of shareholders votes AGAINST removal, he stays. So if one less voter that voted for him, he is gone.
iii) Example problem (c) 60/40 staggered 3 per year, (Maj goes 90, 90, 90 & Min goes 91 [min amount needed to elect] and
89) so for reverse 91 guy would need 91 votes again to stay or else he is gone. (S*N/D+1) + 1 [S = total # of votes][N =
# of Directors being removed][D = Director positions that were open]. Must use formula here!
b) Formalities and Mechanics of proxy process
i)
Record Date: Date where people who “owned stock” will be allowed to vote on an issue and receive a dividend
(because stocks are constantly being bought/sold and it would be a mess if they didn’t set a date). This date can’t be
more than 70 days before the board meeting where the new issues will be voted on.
14
ii) SEC Requirements
(1) Must file your proxy solicitation with the SEC before being sent to shareholders.
(2) Every solicitation must include or be preceded by a written “proxy statement” which discloses any conflicts of
interest, compensation given to five highest-paid officers and details of any major changes being voted on.
(3) Proxy rules require an annual report be sent to all shareholders.
(4) Any false or misleading statements or omissions are banned by SEC rules
(5) The proxy card must have a signature signed and be returned by the shareholder.
(6) The proxy must vote the way the shareholder noted in their proxy card. (Proxies can always revoke their vote even
if the card said irrevocable).
iii) Lacos
(1) Dual classes of shares issues, where if the directors said if you don’t create these types of shares that vest all
authority with management, as opposed to equitable ownership, I am going to do harm to the corporation.
(2) Bullardism, “I’m going to do harm to the corporation, since I am a shareholder to, am I allowed to vote a way to
harm the corporation? His role as a shareholder conflicted with his role as a director. To do this, you must say I am
representing myself, not the company in this vote.”
iv) Types of Stocks & Voter Rights (See Manthos Outline)
(1) Preferred Stock
(a) Cumulative
(b) Non Cumulative
(2) Common Stock
(3) Varying Shareholder Rights (pg 270-71)
(a) Weighted Voting = one vote may have multiple votes as prescribed by charter and state law.
(b) Class Voting = Different classes have different voting rights, may only allow common stock holders to vote as a
class for new directors or preclude preferred stock holders from voting on certain issues. Some classes of stock
exist to only vote directors on or only to remove directors.
(c) Contingent Voting = For example, preferred shareholders ONLY get to vote if they are denied dividends for a
year, thus allowing re-election of the board.
(d) Disparate Voting = At the common law all stocks had to have voting powers but today you can have non-voting
stock. Unless the charter says different, all stocks are voting stocks.
v)
Schnell
(1) Board moved back the date of a vote to stop the minority from getting a proxy vote together.
vi) Honeywell
(1) Right to obtain the shareholder list. You don’t need the answer because it depends on the state.
(2) Bullardism, “You must know the importance of the C-List and the Nobo List. No Objecting shareholder list
(otherwise you won’t know if a broker is mailing the list to the right people or not) Brokers have the list of
shareholders and you have to have access to the list and check what they are doing?
vii) Campbell
(1) Two factions are fighting for control of the corp. (MGM) by changing composite of the board. Pres. sent out
solicitations and call for proxy votes (laying out charges against the directors he wants removed). By-laws gave
Pres. ability to call meeting where he could remove directors (a lot of power). The solicitation was one sided and ct
held this unfair (you have to give the other side the opportunity defend themselves). Cross apply this to corporate
structure section.
(2) The two directors charged refused to go to the meeting which mean they couldn’t be removed. Some courts hold
that purposely skipping meeting is a breach of fiduciary duty, but here it was not. Ct. said you have to be able to
remove directors for cause b/c if director is doing horrible stuff you must be able to remove them. Shareholders
must have ability to get rid of bad apples.
15
viii) Rosenfeld
(1) Should the new board pay for the old board’s solicitation costs.
(2) Bullardism, “Discuss pros and cons. Should the losing board get paid? They were formally acting in the best
interest of the shareholders. Why don’t you pay losing challengers, because they were only ever previously
shareholders. We have no formal requirement for them to act in the best interest of the corporation (maybe by
challenging they were not so there is no per se duty to pay losing challengers). If they win, then you can assume the
shareholders chose them because they WERE acting in the best interest of the company.” Prevailing View: You
can pay losing directors the cost of their Proxy defenses.
(3) Good Romano Policy arguments for why one is good and the other is bad.
ix) Sadler
(1) Merger between AT&T and NCR. NCR board was against it so AT&T tried to hold a special shareholder meeting
to out the board. AT&T buys shares and finds shareholder representative (AT&T couldn’t under law) but the
representative did not have the shares for six months. NCR also didn’t have a NOBO list and they felt the law
should force them to compile one to give to a company trying to take them over. Circuits were split whether a
corporation should have to compile a NOBO list if one didn’t exist, NY found that a corporation did have to compile
one if they didn’t have one on hand.
(2) Statute Provided: NY residents who for six months had owned shares of foreign corporation doing business in NY
to obtain a list of all its shareholders and their addresses, number of shares and their types and when they became
owners.
(3) Bullardism, “Issues was not whether Sadler was a six month shareholder but rather if AT&T could piggy back on
the Sadler’s ownership of shares. Could AT&T use the Sadler’s right to get the NOBO shareholder list to oust the
board? Yes, nothing in the statute prohibits this unless it were used in bad faith.”
(a) NOBO list = Non-objecting beneficial owners lists play a central roll in a proxy contest because they effectively
vote “no” on changing the board (if you get the list), thus “voting with the management.”
(i) These list can help put shareholders on equal footing with the management in obtaining access to other
shareholders.
(b) C-List = Usually provided to shareholders or their representative and Directors engaged in a proxy vote that
includes: membership list, list of those entitled to receive notice about meetings, members who are entitled to
vote, financial statements, list of current and past directors, list of officers etc.
x) L.I. Lighting
(1) SEC requires proxy solicitations to be fair. This guy mounts a political campaign to stop a nuclear reactor (board of
his company wanted a reactor, but the shareholder was opposed to it). Guy starting lying about reasons why board
was bad to influence shareholders (not true stuff). SEC proxy regulations apply, ct found that SEC could stop the
guy from lying. Dissent said guy has a first amendment right to be misleading in political campaigns!
10) INSIDER TRADING
a) Section 16
i)
“Short Swing Profits”
Must consider both § 16 with the common law applications.
ii) Filing Requirements
(1) Purchase and sale if you are a D&O or a 10% shareholder
(a) If you are only 9.9%, then § 16 doesn’t apply and you can get away with short-swing profits.
(2) Violator has to be an officer or director. (Crotty)
(3) Violator had to be a shareholder at the time of the suit.
(4) Contemporaneous shareholder rule does NOT apply if you are filing the allegation.
(a) You must continue to have an interest through out the trial (pendency).
(b) You have to be around to collect.
(c) You can buy a share, bring the suit and be a qualified plaintiff. NOT so in insider trading.
(5) If you sell-buy after 6 months and 1 day you can’t be charged with short-swing.
(a) Two year statute of limitation.
(b) Two day filing deadline has effectively required pre-approval of buy-sell.
16
(6) Unless Borg doctrine you MUST make demand on corporation and give them 60 days to respond.
(7) Simply complying with regulations does NOT insulate you from suit.
b) Steps to Analyze Insider Trading
i)
Determine who had the fiduciary duty link (relationship)?
ii) Was there another way to access the information? Society should promote diligence and hard work to research this
because it helps the market. (Who’s job is it to promote it)
iii) Even if you have no duty (called a Tippee) [and you receive information from a person who did have a duty to someone
else] you can’t act upon it.
c)
How to Work a Short Swing Profits Problem
i)
Look at lowest purchase price, subtracted from the highest price sold at, then multiple that value time the number of
shares. [Dummer pg 18, Hazen pg 568]
d) Details and Cases
i)
Private Cause of Action
(1) Crotty
(a) Guy held honorary VP of United Artists but his actual duties were not that of an officer. He did NOT have
access to any insider trading information. Your duties must reflect title and you must have access to insider
information or you are NOT automatically an officer.
(b) Ct said he wasn’t, because he did not have access to inside information and you have to have the real
obligations and powers.
(2) Feder
(a) Deputized director, he was clearly under § 16 definitions, but about the company he works for, what that person
deemed to be a director. Need to look this up!
(b) Bullardism, “If a company deputizes a person (as an agent?) is that person con
(3) Kern County
(a) Company was granted an option and the court said that because the option, isn’t necessarily going to be
exercised by the other party, it didn’t qualify as a sale under § 16. Also looked at whether the guy had access
(like Crotty)?
(b) Bullardism, “Issue, Should section 16 apply? An option to buy does not qualify as a sale. They found the
person did NOT have access, although they were a majority shareholder, they were an outsider who was trying
to take over the company.
(4) Standard
(a) After a transaction the Δ received convertible shares in the new company and then they sold them. What that a
“sale?”
(b) Bullardism, “Look at how involuntary was the sale.”
(5) Winston Case
(a) A retiring CEO sold stock five days after quitting. Ct. held that even though he was out of loop he has the
burden to show he did NOT have any inside information. The effective date of retirement, there is the
presumption that you have information until that date expires. He should have waited for 6 months and 1 day
after (effective date) of leaving the company before selling his stocks. Even though he had the presumption
you can rebut it with evidence that you were out of loop (playing golf).
(6) Smolowe
(a) When you are looking at lots of buys and sells you go with the lowest buy and highest sale for short swing sales
to determine what the gain was and thus how much they have to give back. (see Stephen Notes pg 18).
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e)
Derivative Claims
i)
Diamond
(1) MAI was sourcing out their repair services to IBM because they knew costs of repairs were going to go up and their
profit would go down so they sold before their own stock fell. They didn’t make profit, but they didn’t lose as much
as much as they would have. Avoidance of loss is the same as profit. Ct. held directors should NOT be able to
keep the profits (amount they didn’t lose).
(2) It is the company’s assets that suffer the harm to their reputation. You must allow someone to have the cause of
action. Otherwise there won’t be anyone who will be able to recover for this abuse of access to this information.
The impact of this trading affects the price of shares, so the trading had a direct affect on the value of the company.
(a) Brophy case: Public policy will not permit an employee in a position of trust to abuse that relation to his own
profit even if his employer doesn’t suffer any loss.
(3) Driving up the price and then selling is a real harm.
ii) Freeman
(1) Rejects the generalized harm to corporation argument found in Diamond.
(2) Bullardism, “Don’t just say these are two different ways to view it. Say this guy went in and traded and drove up
the price and that is a real harm to the corporation. This is beyond the reputational cost because his acts are directly
hurting/cheating shareholders and the market.
f)
Other Claims
i)
Disclose or Abstain
ii) General Theory of Misappropriation:
(1) It is designed to protect the integrity of the market against abuses by outsiders to a corporation who have access to
confidential information that will affect the corporation’s price when revealed, who owe no fiduciary duty to the
corporation’s shareholders.
iii) Cases
(1) O’Hagan
(a) Use O’Hagan only, not traditional cases.
(b) Guy was a lawyer at firm that was handling a merger (he was not in on the work) but he used his information to
buy stocks. His conviction broadly expanded the misappropriate theory and changed the court back to Cady
Roberts from Chiarella. If you steal information (non-public) or used it to your advantage it is unfair and
illegal.
(c) Two Factors to Look at:
(i) One area of law arises from SEC (desires to protect the market and increase confidence in their trading).
(ii) Another area is from Congress is state law or Corporate law (punish people criminally for breaching duty to
buyers and sellers).
iv) Tippees
(1) Dirks
(a) An analyst got information that a company was defrauding its shareholders so he started investigating and
telling people about it. Lots of them dumped their stocks. He found they were committing fraud but the SEC
charged him for violating his duty to the market place. Dirks was a tippee but ct held he was not liable because
he didn’t meet the factors.
(b) Factors
(i) There had to have been a breach of duty of the tipper.
(ii) Tippee has to know there was a breach of duty.
(iii) Tippee’s guilt is derivative from the tippers breach of duty.
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v) Nature of Duty
(1) Kim
(a) CEO was member of “Young Presidents Club” and he told one of them about a business deal and that member,
against club policy, acted on it and bought stocks. Did the club rules create a fiduciary duty between its
members? Not at that time but 10b5-2 was amended to create one. Technically the tipper breached his duty but
the SEC chose to go after Tippee instead but it could have gone the other way.
(2) Key Points of New 10b5-2
(pg 605 Duty of Trust Factors)
(a) If a person makes an agreement to maintain confidences
(b) History or practice or pattern of sharing confidences
(i) Need to know the current law (but not the case names)
(ii) You can try to show duty by illustrating history, pattern etc.
(c) Familial relationship (spouse, child etc)
(i) If this rule would have existed before Kim, it would have come out differently.
(ii) If you give inside information to your family and they use it, you are liable.
(iii) This is a debatable issue because the term family is vague.
(3) 10b5-2 Overview
(a) This creates a presumption that a relationship exists and you have to prove it doesn’t!
(b) Purchase is made on basis of non-public information and person was aware of that information (did they
possess it) you are deemed to used it to make the trade.
(c) Codified “knowing possession (material non-public)” of Dirks
(d) If you have a preplanned sale structure that can insulate you from insider trading claims. (Easier to meet filing
time periods to SEC).
(e) It was not intended to be a band aid for insider trading, nor a cause of action for the SEC but it has become one.
vi) Possession v. Use
(1) Adler
(a) Mere possession doesn’t mean you used the information. If you “had” planned on buying prior to getting the
information then this would be a good defense if you can prove it through a pre-buy order or notation to buy at
x time or price before receiving the information.
(2) Bullardism, “Focus on what is needed, don’t just try and include all factors, don’t mix all these up.”
(3) 10b5-1 Overview
(a) Codifies the knowing possession test
(b) Safe Harbors:
(i) Preexisting investing plan (purchase or sales) [can’t change these at last moment--pretty much set in stone
after you write, otherwise fishy]
(ii) Decision by blind trustee [not safe because they can go behind scenes and tip off trustee]
11) MANAGERIAL BEHAVIOR, AGENCY COSTS AND OWNERSHIP STRUCTURE: THEORY OF THE FIRM
i)
Agency costs are the sum of:
(1) The monitoring expenditures by the principal.
(2) The bonding expenditures by the agent.
(3) The residual loss.
ii) The optimal mix (not including taxing schemes) of pecuniary/nonpecuniary benefits is achieved when each dollar spent
stops another dollar from being wasted.
(1) If a company spends too much money on monitoring they are throwing profits away.
(2) Methods of monitoring are auditing, formal control systems, budget restrictions and incentives systems.
(3) Pareto optimality = If you make one person better off, you are naturally making another worse off. Here it is a
struggle between shareholders and D&Os.
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iii) As an owners ownership interest falls, he will be encouraged to spend more of the corporation’s money because he will
be gaining a larger share of benefit and less personal cost. This is why monitoring is important to curb (see ii above).
iv) The more a company reduces its benefits (illegal or not) the more they must pay in salary or else D&Os won’t want to
work there if there are no perks compared to the risks they expose themselves to.
v) Owners have little incentive to completely invest in a single firm because diversification distributes the risk of loss and
they can get more benefit with less cost.
12) COSTS OF OWNERSHIP OF THE FIRM: THEORY
a)
Monitoring Costs Include:
i)
Informing yourself of the firms ongoing operations
ii) Communicating among yourselves to exchange information and making decisions
iii) Bringing your decisions to bear on the firm’s management.
b) Collective Decision Making
i)
With many differing opinions and classes of people involved a system must be developed to allow the system to not get
bogged down.
ii) A voting mechanism must be employed which weighs votes based on volume of patronage and class of shareholder.
Methods must be employed to aggregate groups of patrons (proxy voting) and provide incentives (payment of costs) for
groups challenging the majority opinions because for a corporation to maximize its business multiple viewpoints must be
debated.
c)
Risk Bearing
i)
Some patrons will be in a better position to bear the risk (usually those with more money) so more risk should be
assigned to them. They, in turn, will try to insure less risk taking and a closer control over the system so they are not
exposed to too much risk. They can’t be exposed to too much risk or else it is not worth it to them.
d) Bounded Rationality, Opportunism and Transaction Considerations
i)
Bullardism, “We have necessarily incomplete contracts because we can not anticipate everything - that is why contracts
are bounded = bounded rationality.” Thus we have more complete contracts, and people are going to try and take
advantages of gaps in the contracts “opportunism.”
ii) Bullard will test this by transaction specific assets fact scenarios to show how people take advantage of this.
(Leverage analysis)
(1) Bauxite mine examples, Node A (general item, highly mobile, no need for protections), Node B (highly specialized,
locked in and economically dependent, has no protections), Node C (highly specialized, locked in and economically
dependent, has contractual protections).
iii) Policies Behind Limited Liability – Easterbrook - Risks v. Social Benefit Should = Net Positive
(1) Upside: Limited Liability Decreases Shareholder Monitoring Costs
(a) Monitoring Other Shareholders: w/o LL, the richest shareholders would worry about being sued the most and
would try to stop people from getting less shares than them; to do this, they would need to spend a lot to
monitor
(b) Impact on Stock Sales (transferability): Less buying b/c more risky – must monitor co. for lawsuits; value of all
shares go down b/c possibility of lawsuits; Woodward: also, in case of class action, big stock owners would sell
off stocks incurring inefficient transaction costs; no problem w/ LL b/c they can’t be sued anyway
(c) Impact on Mkt. Price: w/o LL would need to investigate mkt. price based on the owners net worth to get
accurate value – Wealthy owners, value down (more to lose), poor owners value up (less to lose); meaning of
mkt. value would not be uniform so more monitoring
(d) Diversification: w/o LL, less incentive to diversify b/c more co., more chance sued and lose everything; LL
encourages diversification, which reduces risk in long run b/c back-up co. in case one fails
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(2) Downside of Limited Liability
(a) * Co. acts riskier b/c LL caps recovery, allowing it to externalize costs (pollute and not pay for damage);
creditors now bear all the risk of behavior. Voluntary creditors can K, but w/ LL tort victims can’t contract for
terms offsetting the co. risky behavior = windfall for corp.
(b) Mkt. does not often reflect the net cost to society so can’t control risk taking; e.g., defective cars not always
cheaper so shareholders might risk harm to society for profit
(c) * But must have rules for piercing veil that don’t chill investment b/c shareholders liable for every tort!
Remember, Corp. main wealth creating mechanism
(d) Insurance needed where monitoring isn’t sufficient to stop co. from externalizing costs (like for torts); whether
insurance stops risky behavior is unclear, but allows recovery
iv) Conflicts between debt-holders and the Corp. - Corp. Takes More Risks after it Borrows
(1) Shareholder pressure to pay dividends forces Co. to beat debtholder interest rate by taking more risks; debt holders
prefer risk=interest rate
(2) Psychology of Leverage (borrowing)- Chance for profit w/ other people’s money make Corp. careless
(a) Limited Liability makes Corp. act riskier b/c people running it can only lose the money they borrowed. Once
lose initial investment, nothing left to lose by risky investments
(b) Done over 100 corp. they are willing to role the dice
v) Provisions, Rules, Agency Costs Combating This - Bullardism, “Conflict between a company and its creditors, why
when you borrow money, your risk characteristics change. Indenture provisions act as monitoring because they can’t do
it any other way.”
(1) Default Rules- Courts enforce Ks, Bankruptcy priority, Disclosure of Co. assets, Mainly- increased interest rates
(2) Private Restrictions Controlling Risky Behavior
(a) Can’t invest in other businesses-Why? Could invest in riskier businesses than debtholder planned for; bond
value goes down b/c chance getting paid goes down
(b) Restricted Risks w/n Co.- Hard to monitor; often too expensive
(c) Merger Restriction- Why? If managers change, risk could increase
(3) Private Restrictions Securing Money for Bankruptcy
(a) Securing Debt- Up to 120% of debt; can’t sell asset or substitute a riskier one
(b) Restrictions on Dividend Payments- Why? Ensuring a buffer
(c) Restrictions on Debt Priority- No new debt, or new debt triggers same priority as you, or secure assets triggered
by new debt; this all discourages new debtors from being interested b/c their chance of recovering these assets
reduced or at least like yours; both controls risky behavior (debt) and secures assets in case
(4) LBOs: New Provisions to Protect Debt holders from
(a) During the ‘80s, co. 1 would borrow huge sums (w/ little security) at very high interest to buy co. 2. Once co. 2
was owned by co. 1, all of co. 2 bonds fell by half b/c co. 1 so risky previous lenders likely to never be paid
back. High interest compounded problem b/c forced co. 1 to be super risky to clear huge interest rates. Debt
holders sued but ct. held co. 1 had no fiduciary duty to debt holders; governed by K, and no covenants in place
to stop it. Corp. eventually reacted:
(b) Right to Convert Bonds to Stocks- Why? Escape and sell out big
(c) Par Value Sell = During LBOs if there is not a provision the new company will try to buy the bond at the
principle rate thereby hurting the income the lender would have gotten if they company had continued to pay
the interest on it.
(d) Bond coupon rate adjusted as risk increases- Why? Reflects new increased risk
(e) Poison Put = Covenants that kills or poisons the LBO because bond holders demand immediate payment of all
their bonds in the advent of a LBO. This reduces value of corp. because it forces possible stagnation and an
incoming debt. The value of corp. is very dependant then on interest rates and how that affects your par value.
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(f) Sinking Funds- Payments structured to gradually reduce principal, covering assets by reducing amount co.
needs to pay you back
(i) Scholars once argued that debt holders would monitor LBO co. more closely and therefore make
bankruptcy less likely b/c debt so high, co. value would only have to decrease a little bf. debt holders
panicked seeing asset buffer gone; this was wrong
e)
Policy Underlying Corp. Democracy Laws (Easterbrook) – Gap fillers save money b/c you don’t need to K for these
i)
Only Those with Greatest Residual interest Should be Allowed to Vote – Usually common shareholders
(1) They usually have the greatest residual interest
(a) Residual Interest = (profits after employees, debt holders etc. get paid)
(2) So they have the best incentive: most profitable decisions will be made by those who stand to get those profits (debt
holders usually want behavior which is too conservative but can K for voting rights)
(3) Plus if non-SH groups voted, different views of risk might make the resulting bd. split and inefficient, allowing
management to step in and seize more power
(4) However, voting rights should flow to whatever single group holds the residual claim at the time – preferred
stockholders when firm refuses them dividends, creditors when co. changes its risk profile, bondholders when
ii) One share one vote: Match residual interest to voting power. Otherwise the co. would incur needless management
agency costs b/c those with disproportionate voting power will not make the best decisions since they do not get
proportional residual benefits:
iii) Presumption against Cumulative Voting: Gives disproportionate power to minority shares (see b) above) and thus
creates agency costs; also, supermajority type provisions stop residual claimants from changing the board easily and
support management against residual claimants. (Bullard: bd. majority will win anyway, really just minority ‘spy’, and
public co. really don’t need cum. Voting b/c SH so dispersed need small % to control)
iv) No buying of a Vote w/o Buying the Stock: Residual interests would not be aligned with voting power and this would
create agency costs (Bullard: this explanation works better when outside buyer w/o equity wants to buy vote power;
another SH would only sell b/c he thinks his residual interest is being replaced)
v) Proxy Campaign Reimbursal: Winners and losing incumbents should be reimbursed b/c they were chosen by the
shareholders to represent their residual interests. Losing challengers should not be reimbursed b/c they were never
chosen by the shareholders to represent their residual interests; also the threat of frivolous challenges or LILCO type
incentives (to cover 1st amendment rights not to win) make paying losing challengers bad policy.
f)
Governance Structure
i)
Board Representation of Different Constituencies
(1) Bullardism, “The role the board plays while representing labor versus management concerns is a balancing act for
node B & C type employees. Node A employees can easily be replaced so no future planning really needs done.
Node B & C will demand higher wages if their interests are not protected through contract provisions which offset
their risk, however long term contract provisions can hurt one side in the long run if they are not properly informed
by locking them into a deal that goes bad. Wage rates must be set in accordance with risk-over-time-projections and
this can be done by including labor on the board.”
(2) Labor on the board will want more benefits and pay, but having them on the board will also allow them to exert
pressure on the board which will ultimately hurt profitability of the company.
ii) Logic of Limited Liability
(1) Easterbrook, “Closed corporations are more easily pierced, why? Why do we pierce the veil for subsidiaries to
attack the parent company? Why would you pierce a company with only a few individuals behind it and not one
with thousands?”
(2) Woodward says, “Limited liability promotes the transferability of shares. By creating limited liability it allows
shareholders to buy-sell-trade stocks upon a whim to reflect their own risk taking approaches and allows
management to do pretty much what they want in return for a shareholder freedom. If you lock a shareholder in and
tell them they are liable, they will want more control regarding what the D&Os do since they would ultimately be
responsible.”
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(3) Hanseman says, A well crafted rule of unlimited liability would neither impair nor impose marketability or
collection costs. But such as rule doesn’t exist, and it is not reasonable to harness shareholders with liability when
they don’t have a say in how a corporation does something. If you saddle shareholders with liability you have to
give them more control in the company or else they will not invest without huge returns for their risk (doing this
would hurt profitability). Unlimited liability would make share prices reflect possible tort costs rather than value of
the company.
iii) Shareholder Voting
(1) Easterbrook, Why does it make sense to have one vote for one share? (Manthos Theory Section, voting section)
(2) Gorden, Most shareholders are not informed as to voting issues, nor do they even read the prospectus or charter
provisions, so it makes sense to limit some of their voting power or convert it with proxy voting to those who are
informed and have an interest in the vote outcome. Since security laws demand all shareholders treated the same,
some shareholders get a free ride on the backs of sophisticated investors. Underwriters then take profits away from
sophisticated investors by selling that profitability to the regular shareholder. Having dual classes of shares rewards
those who are involved and sophisticated while still providing a pro rata (for their effort) benefit to common stock
holders (just not as much). Often times it doesn’t work out this way because an uninformed can buy preferred stock
and still cause the same problem.
(3) Rowe, The public does NOT want Wall Street and big corporations to own other corporations or else the public
loses control of their own fate. (eg. banks can’t own stock, mutual funds or insurance companies can’t ever own a
controlling amount). However, that is not to say that they still don’t own huge shares of corporate America, abet
spread out, they just don’t control the boards per se. Large corporations are the dominant form b/c they are better
able to disperse control, liability and funding to conform to the public’s wishes for control AND cover all the
monitoring costs to do it.
(4) Black, Everyone needs oversight or else they can run rampant and if you allow institutional ownership, no one
would have the power to oust them from doing wrongs. Thus we have prohibited them from getting too much
power through regulation. However, since they are so big they still need a voice (thus the small ownership levels).
Institutional voice is different from institutional control. Corporate managers can then watch the largest institutional
investor (pension funds) while the public watches the managers, so somebody is always watching someone else.
Risks of institutional ownership.
g) Theories of Insider Trading
i)
Scott, Rule 10b-5 is designed to serve the ends of fairness and equity from when a party takes inside information and
profits from it. It also facilitates the free flow of information which makes the market function better. They also
shouldn’t be able to hurt the corporation with their actions.
(1) “Fair play concept” = says insiders shouldn’t be able to profit from their knowledge nor hurt the market or the
corporation with it. If the market knows that insiders are playing with loaded dice they will want a market price
adjustment to compensate for their disadvantage or else people just won’t play.
(2) Information going to market argument = 10b-5 forces the free flow information and makes the market a more
accurate representation of itself thus allowing the public to trade based on a better understanding of a company’s
true value and not a false value created by lack of information. This doesn’t explain a justification for why a
company would want to put out bad news because it would only hurt them whereas good new would help their
company. No incentive for bad news.
(3) Business property argument = Inside information is the corporation’s property and you should NOT be able to use it
without the company’s permission. The company has invested money to get this information and by taking it you
have reduced their investment to acquire the information in the first place. You have gotten without giving.
(4) Insider information as a Form of compensation = Others argue that insider trading is a “compensation and benefit”
for those working inside [the public has found this justification unpersuasive]. There are many other forms of
compensation and benefits which will not hurt the market.
ii) Cox’s Economic Arguments Against Insider Trading
(1) It is important to understand executive compensation (and be able to put them in line with shareholder goals)
(2) It is more difficult to assess stewardship if that person is allowed to engage in insider trading.
(3) It diverts attention away from increasing shareholder wealth, because you are trying to make more money for
yourself and not the shareholders.
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13) D&O COVERAGE
a)
Pressure to Settle Securities Class Actions – Stock drops following claim of failure to inform market of problems “artificially
inflated stock price”; shareholders bring derivative suit
i)
D & O don’t want to try cases
(1) Risk of gigantic mismanagement awards that might blow through insurance coverage
(2) Settle, and insurance will pay anyway
(3) Attorney/ discovery fees after motion to dismiss huge
(4) Stock may drop if class action pending
ii) Hits D & O Insurance – Keeps qualified people on Publicly Traded Co. Boards
(1) Covers personal assets (life and death) of D & O for wrongful acts if corp. doesn’t indemnify them (bankruptcy,
settlement in shareholder derivative suit b/c money would circle back) ; insures corporate balance sheet
(2) Covers indemnified loss
(3) Poor regulation of D & O behavior b/c once covered less careful, and competitive mkt. keeps D & O from enforcing
“best practice” provisions
(4) Can rescind if lied in application process; also exclusions for fraud, dishonesty, illegality, personal profit (trigger for
exclusion usually more than alleging it, usually “if fraud occurred in fact’)
(5) Less need for Private co. but could still be sued by your own shareholders
b) PSLRA Provisions & Unintended Consequences
i)
Lead Plaintiff Provision – Lead plaintiffs have to be the shareholder w/ the most damages to prevent P attorneys from
driving the litigation for their own benefit. Consequence: Did not effect number of class actions just tightened the
number of firms who had relationships w/ big investors; also the P wants money himself so attorneys are just as
aggressive; average settlements have stayed the same.
ii) Proportional Liability - J/S liability for D & O used to provide incentive to settle early as % you could get stuck with
“ratcheted up” as more Ds settled. Now, proportional liability provides a reverse incentive to settle early, esp. for high
fault Ds, b/c don’t want court to “cap” the damages of the other Ds by reference to your early settlement; Consequence:
Insurance co. money often used up to defend corp. when they would rather pay P and settle; P won’t settle early so
invests more in case, settlement price goes up right up to court date, then co. forced to settle big to avoid trial
c)
Size of Settlements Exploding
(1) Since 1999 the size of settlements has sky rocketed, with some in excess of 200 million. Smaller cases now settle
for more than 30-50% more than they would have in 1999.
(2) Plaintiff leverage, even after the reform acts, has forced higher settlement because defendants fear going to a jury in
case the jury comes back with some huge number. This is now partly because the claims arise from allegations of
fraud which juries hate.
(3) There is no “safe” industry anymore, simple drop in stock price can trigger a suit and as a result premiums have
risen while the contract provisions now limit more than they did too. One important provision creates incentives for
defendants to negotiate settlement, otherwise the corporation will just say, ah whatever, we have insurance and lose
big.
(4) Exclusionary Terms are important because policies now may exclude exemplary, punitive, treble damages as well as
amounts which D&O’s are not liable for (non-recourse settlements) or costs to comply with injunctions or other
non-monetary relief.
(5) Insured v. Insured Exclusion, this is when a company will sue its own D&Os as a way to cash in their policy as a
money making scheme. Most policies now prohibit this, but look out for it to see if they go too far.
(6) The hammer; provisions which say if an insured was asked to settle and they didn’t and then the plaintiffs got more,
then the company has to pay post settlement costs and any additional amount above the settlement amount. This can
encourage high settlement to (take what ever the plaintiff offers) for fear of the insurance not paying more.
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ii) D&O, is it time to quit?
(1) D&O are at more risk than they ever have been in the past. This means that boards may spend more time planning
and trying to avoid suits than in making money for the corporations. This additional planning may inadvertently
lead to MORE suits rather than decreasing their risk by making them look guilty.
(2) All this has the unfortunate side effect of discouraging desirable directors from serving.
(3) Corporations can reduce their risk with three things.
(a) Adopt governance best practice policies: Board member evaluations, meetings to discuss these issues, structure
board (possibly adding a governance committee), review board director (ensure they challenge management
when they don’t like something), educate D&O about their risk, create CEO succession plan to prevent chaos
from occurring and stocks dropping, hire only D&O of great integrity.
(b) Compensation reform, pay more, use less stock options.
(4) Get Insurance Coverage!
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