The Corporate Form
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Corporations 2009 - Wachter
Table of Contents
Introduction ......................................................................................................................................................... 3
Agency ................................................................................................................................................................. 4
Introduction ..................................................................................................................................................... 4
Actual Authority .............................................................................................................................................. 4
Apparent Authority ......................................................................................................................................... 5
Agency by Estoppel ......................................................................................................................................... 5
Inherent Authority ........................................................................................................................................... 5
Ratification ...................................................................................................................................................... 6
Termination of Authority................................................................................................................................. 6
Liability of Principal & Agent ........................................................................................................................... 6
Agent’s Duty of Loyalty & Corporate Opportunity .......................................................................................... 7
Partnership .......................................................................................................................................................... 8
Introduction ..................................................................................................................................................... 8
Partnership Liability ......................................................................................................................................... 9
Partnership Formation .................................................................................................................................... 9
Legal Nature of Partnership (Entity v. Aggregate)......................................................................................... 10
Partnerships v. Joint Ventures....................................................................................................................... 10
Ongoing Operations of Partnerships ............................................................................................................. 10
Partnership Agreements................................................................................................................................ 12
The Internal Affairs of Partnerships – The Authority of a Partner ................................................................ 13
Partnership Liability ....................................................................................................................................... 15
Partnership Interest & Partnership Property ................................................................................................ 16
Partner’s Duty of Loyalty ............................................................................................................................... 16
Dissolution ..................................................................................................................................................... 17
Limited Partnerships.......................................................................................................................................... 21
Formation of a Limited Partnership .............................................................................................................. 21
Liability of Limited Partners........................................................................................................................... 22
Corporate General Partners & The Duty of Loyalty ...................................................................................... 23
Fiduciary Obligations ..................................................................................................................................... 24
Benefits of Alternative Corporate Forms ...................................................................................................... 24
The Corporate Form .......................................................................................................................................... 25
Introduction and Organization of a Corporation........................................................................................... 25
The Classical Ultra Vires Doctrine .................................................................................................................. 27
Legal Structure of Management.................................................................................................................... 28
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The Objectives & Conduct of the Corporation .............................................................................................. 30
The Nature of Corporate Law ........................................................................................................................ 31
Corporate Structure .......................................................................................................................................... 32
Shareholdership in Publicly Held Corporations ............................................................................................. 32
The Legal Structure of Management ............................................................................................................. 33
Allocation of Legal Power between Management and Shareholders ........................................................... 34
Limited Liability & Piercing the Corporate Veil ............................................................................................. 37
Equitable Subordination of Shareholder Claims ........................................................................................... 42
Fraudulent Transfers ..................................................................................................................................... 43
The Monitoring Board ................................................................................................................................... 43
Information Rights & Voting .............................................................................................................................. 44
Shareholder Information Rights Under State Law ........................................................................................ 44
Shareholders Informational Rights under Federal Law & Stock Exchange Rules .......................................... 46
Introduction to Proxy Rules ........................................................................................................................... 47
Proxy Rules .................................................................................................................................................... 48
Private Actions Under the Proxy Rules .......................................................................................................... 50
Shareholder Proposals and Proxy Rules ........................................................................................................ 52
Proxy Contests ............................................................................................................................................... 54
Duty of Care ....................................................................................................................................................... 55
Basic Standard of Care................................................................................................................................... 55
Duty to Ensure Corporation has Effective Internal Controls ......................................................................... 61
Liability Shields .............................................................................................................................................. 62
Duty to Act in Good Faith .................................................................................................................................. 63
Duty of Loyalty................................................................................................................................................... 65
Self-Interested Transactions.......................................................................................................................... 65
Statutory Approaches .................................................................................................................................... 67
Waste of Corporate Assets ............................................................................................................................ 69
Shifting Burden of Proof in an Interested Transaction .................................................................................. 69
Executive Compensation ............................................................................................................................... 71
Use of Corporate Assets & the Corporate Opportunity Doctrine ................................................................. 74
Duties of Controlling Shareholders ............................................................................................................... 78
Sale of Corporate Office/Control................................................................................................................... 83
Insider Trading & Material Misrepresentations ................................................................................................ 85
SEA §10(b) and Rule 10(b)-5 – Elements of Claims ....................................................................................... 86
The Scienter Requirement ............................................................................................................................. 87
The “In Connection With” Requirement ....................................................................................................... 87
Manipulative/Deceptive Device Requirement .............................................................................................. 88
Duty to Disclose – “Any Person” Unraveled .................................................................................................. 90
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Other Theories for Assigning 10(b) Duties .................................................................................................... 90
Materiality Requirement ............................................................................................................................... 93
Transaction Causation/Reliance Requirement .............................................................................................. 95
Loss Causation ............................................................................................................................................... 95
Limits on Liability ........................................................................................................................................... 99
Liability for Short-Swing Trading Under SEA §16(b) .................................................................................... 100
Regulation FD .............................................................................................................................................. 102
Shareholder Suits............................................................................................................................................. 103
Derivative Actions........................................................................................................................................ 103
Individual (Pro Rata) Recovery in Derivative Actions .................................................................................. 106
Contemporaneous Ownership Rule – who has standing? .......................................................................... 106
Demand on the Board & Termination of Derivative Actions On Recommendation of the Board or Committee
.............................................................................................................................................................. 108
Corporate Combinations ................................................................................................................................. 113
Sale of Substantially All Assets .................................................................................................................... 114
The Appraisal Remedy ................................................................................................................................. 115
Statutory Mergers ....................................................................................................................................... 117
Note on Tax Treatment of Corp Combinations—(pp1059-60)................................................................ 118
Triangular Mergers ...................................................................................................................................... 118
Freezeouts ................................................................................................................................................... 119
Cash-Out Mergers (Need Board Approval).............................................................................................. 119
Tender Offers (No Board Approval Needed) ........................................................................................... 120
Hostile Tender Offers & Defensive Measures ............................................................................................. 124
The Poison Pill: Shareholders’ Rights Plans ............................................................................................. 125
Conclusion ....................................................................................................................................................... 129
Introduction
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History of Corporate Law
o Big change in corporations began in 1900s, when separation began between ownership & control, but corporate
law didn’t start to take traction till 1920s
o Modern form of corporate law comes from 1970s-80s
Overarching Themes
o Why has the corporate form been so successful?
o Why do ppl invest in common stock w/o promise of return?
Because of the idea of the “faithful fiduciary” investors rely on reasonable enforcement of the duty of
loyalty
For the system to work, have to get the directors to be faithful fiduciaries (developing a set of incentives
to get there)
o Interplay btw state corporate law & federal securities law (in both statues & case law)
o Very few corporate cases go to trial on the merits – most settle or end on a motion to dismiss on the merits
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Agency
Introduction
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Agency = liability of principle to 3rd parties
o Restatement 3rd of Agency §1.01 Definition: Agency is the fiduciary relationship that arises when one
person (a “principal”) manifests assent to another person (an “agent”) that the agent shall act on the
principal’s behalf and subject to the principal’s control, and the agent manifests assent or otherwise
consents so to act.
Agent person who by mutual assent acts on behalf of another & subject to another’s control
Principal person for whom the agent acts
Sole Proprietorship
o When there’s no distinction btw the person & the company, no stock, and no statutory form
o They’re still businesses that may employ a lot of people, so the agency question comes up what is
the employee’s power/authority to make decisions on behalf of sole proprietorship?
Two types of agents
o General agent authorized to conduct a series of transactions involving continuity of service
o Special agent authorized to conduct on a single transaction, or only a series of transactions not
involving continuity of service
Three types of principals
o Disclosed principal when agent & 3rd party interact, 3rd party knows the agent is acting for a principal
& knows the principal’s ID
o Partially disclosed or unidentified principal when agent & 3rd party interact, 3rd party knows the
agent is acting for a principal but does NOT know the principal’s ID
o Undisclosed principal when agent & 3rd party interact, 3rd party has no notice agent is acting for a
principal
Actual Authority
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3rd Restatement §2.01 on Actual Authority:
o An agent acts w/ actual authority when, at the time of taking action that has legal consequences for the
principal, the agent reasonably believes, in accordance w/ the principal’s manifestations to the agent,
that the principals wishes the agent so to act.
Ex: you believe you have actual authority to close windows in room b/c you were instructed to
do so
3rd Restatement §3.01 – Creation of Actual Authority
o Actual authority is created by a principal’s manifestations to an agent that, as reasonably understood by
the agent, expresses the principal’s assent that the agent take action on the principal’s behalf.
Express actual authority
o When the principal actually tells the agent to do something
Implied actual authority
o 3rd Restatement §2.02 – Scope of Actual Authority governs implied authority
(1) An agent has actual authority to take action designated or implied in the principal’s
manifestations to the agent and acts necessary or incidental to achieving the principal’s
objectives, as the agent reasonably understands the principal’s manifestations and objectives
when the agent determines how to act.
(2) Agent’s interpretation is reasonable if it reflects any meaning known by the agent to be
ascribed by the principal and, in the absence of any meaning known to the agent, as a
reasonable person in the agent’s position would interpret the manifestations in light of the
context, including circumstances of which the agent has notice and the agent’s fiduciary duty to
the principal.
o Incidental authority a common form of implied actual authority
Defined as the authority to do incidental acts that are reasonably necessary to accomplish an
actually authorized transaction, or that usually accompany it
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Liability If A is acting w/ actual authority, then the P is bound and liable to a 3rd person even if the 3rd person
didn’t know the A had actual authority.
o P is liable to 3rd person as a result of act of transaction by the A on the principal’s behalf if A had actual,
apparent, or (traditionally) inherent authority to act on P’s behalf.
P is also liable if the A was an agent by estoppel, or if the P ratified the act or transaction
o 3rd Restatement’s approach to P’s vicarious liability for an A’s torts
An employee is an A whose P “controls or has the right to control the manner and means of the
agent’s performance or work”
§7.07(1) & (2):
An employer is subject to vicarious liability for a tort committed by its employee acting
w/in the scope of employment
An employee acts w/in the scope of employment when performing work assigned by
the employer, or a course of conduct subject to the employer’s control
Apparent Authority
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Restatement 3rd §2.03 – Definition: apparent authority is the power held by an agent or other actor to affect a
P’s legal relations w/ 3rd parties when a 3rd party reasonably believes that the actor has authority to act on
behalf of the principal and that belief is traceable to the P’s manifestations
To create apparent authority, it’s not the manifestations of the A that counts, it’s the manifestations of the P
that counts
Biggest way to create apparent authority power of position
o Creates apparent authority by appointing a person to a position (e.g. manager or treasurer), which
carries w/ it generally recognized duties; to those who know of the appointment there is apparent
authority to do the things ordinarily entrusted to one occupying such a position.
o Anyone dealing w/ such an A is justified in inferring that he has such authority, in the absence of reason
to know otherwise. (Restatement 2nd §27, Comment a and §49 comment c)
Agency by Estoppel
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Restatement 3rd §2.05 – Definition: A person who has not made a manifestation that an actor has authority as
an agent and who is not otherwise liable as party to a transaction purportedly done by the actor on that
person’s account is subject to liability to a 3rd party who justifiably is induced to make a detrimental change in
position b/c the transaction is believed to be on the person’s account, if:
o (1) the person intentionally or carelessly caused such belief; or
o (2) having notice of such belief that it might induce others to change their positions, the person did not
take reasonable steps to notify them of the facts.
Inherent Authority
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NOT a statutory authority in the 3rd Restatement, has been incorporates into broader definition of apparently
authority
o Gap filler for where there seems to be authority the authority can be inherent in the nature of the
relationship btw the P and A
o Still important for states that haven’t amended their statutes
o Can be used for claims in tort law (2nd Rest. analogizes inherent authority to doctrine of respondeat
superior)
Puts the burden on the P and A to disclose their relationship to a 3rd party
Can bind a P in certain cases even where the A had neither actual or apparent authority
Justifications for inherent authority
o If one appoints A to conduct series of transactions over a period of time, it’s fair he should bear losses
which are incurred when such an A, although w/o authority to do so, does something that’s usually
done in connection w/ the transactions he’s employed to conduct
Commercial convenience requires P to be responsible when there’s deviations from the usually
granted authority b/c 3rd parties shouldn’t have to look too much into As
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Based on P’s reasonable expectations, it should be foreseeable to a P that an A, acting in good faith for
the benefit of the P, is likely to deviate occasionally from instructions. The harm from that shouldn’t
fall on 3rd parties.
Ratification
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Definition – Ratification is the affirmance of a prior act done by another, whereby the act is given effect as if
done by an A acting w/ actual authority
A person ratifies an act by objective manifestations:
o Either manifesting assent that the act shall affect the person’s legal relations; or
o Engaging in conduct that justifies a reasonable assumption that the person so consents
Requirements for ratification
o Act must be ratifiable under §4.03
o Person ratifying has capacity under §4.04
o Ratification is timely as stated in §4.05, and
o Ratification encompasses the act in its entirely as stated in §4.07
Acquiescence – if the A performs a series of acts of similar nature, the failure of the P to object to them is an
indication that he consents to the performance of similar acts in the future under similar conditions
o For the A, this gives rise to actual authority
o For 3rd persons who knew of the acquiescence, it gives rise to apparent authority
Termination of Authority
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P can terminate A’s authority at any time, even if it violates contract
Exception to rule – applies to an agency (or power) coupled w/ an interest
o Such a contract will create liability damages for wrongful termination
Liability of Principal & Agent
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Disclosed principal- when 3rd party has notice A is acting for a P and has notice of P’s ID
o A’s liability where P is bound:
If P is bound by A’s act b/c A had actual, apparent, or inherent authority, or b/c the P ratified
the act general rule is that the A is NOT bound to the 3rd party (b/c 3rd didn’t expect A to be
bound, only the P to be bound)
Partially disclosed or unidentified principal – when 3rd party has notice A is acting for a P, but doesn’t know P’s
ID
o A’s liability where P is bound:
P & A are both bound to 3rd person (b/c 3rd person couldn’t investigate P’d credit or reliability
and probably expected A to be liable as sole or co-promisor or surety)
Undisclosed principal- when 3rd party has no notice A is acting for a P
o A’s liability where P is bound:
Generally the A is bound even though P is also bound (3rd person excepted A to be bound b/c
he knew nothing about P)
Majority rule: if 3rd person obtains judgment against P, A is discharged from liability and vice
versa
Minority rule: (favored by book) no discharge of liability
A’s liability where P is not bound
o If P isn’t bound b/c A didn’t have actual apparent or inherent authority agent is liable to 3rd person
based on theory that A made an implied warranty of authority to the 3rd person
Liability of contract theory: 3rd person will recover gains that would have derived under the K
(expectation damages)
Implied warranty theory: 3rd person will recover only losses he suffered by entering into
transaction (reliance damages)
The Restatements adopt implied warranty theory, but provides expectation measure damages
(2nd Rest. §329, 3rd Rest. §6.10)
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Liability of A to P
o If A had no actual authority but P is bound b/c A had apparent authority A is liable to P for any
resulting damages to P (2nd Rest. §328, 3rd Rest. §8.09)
Liability of P to A
o If A acted w/in his actual authority, P is under duty to indemnify the A for payments the A made that
were authorized or made necessary in executing the P’s affairs (list of what’s (list of what’s included on
p.19)
Morris Oil v. Rainbow Oilfield Trucking Inc. (undisclosed principal, agency by ratification)
o Facts: (New Mexico Ct/A) Δ Dawn is P, Rainbow is A, has contract where Rainbow is allowed to use
oilfield trucking business, Rainbow incurred $25,000 debt w/ П Morris
P had terminal agreement w/ A saying Rainbow is not an agent other “than in the ordinary
course of business”
P Dawn said it would pay Morris from escrow account
No expressed authority, b/c Dawn explicitly told Rainbow it can’t incur debt, may or may not be
implied authority based on reading of agreement
o Issue is there agency relationship btw Dawn & Rainbow?
o Rules:
undisclosed P is liable to 3rd party that didn’t know about limitations on the A or other
agreements btw the P & A
P also liable for unauthorized acts of A if the P later ratifies the transaction w/ knowledge of the
material facts
o Holding: Since P retained the benefits/proceeds of its business relationship w/ its A w/ knowledge of
material facts, the P is deemed to have ratified the methods employed by the A and is liable to П Morris
Agent’s Duty of Loyalty & Corporate Opportunity
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Tarnowski v. Resop (coin operated juke machines, P recovered A’s secret commission)
o Facts: (S/Ct of Minn.) П used Δ as agent to investigate & negotiate to buy route of coin-operated
machines, Δ didn’t research well & misrepresented info about route & profits
П sued seller & bock money back, then sued Δ to recover secret commission made by Δ & for
damages for losses incurred by Δ Agent’s wrong
o Rules:
All profits made by A in course of agency belongs to the P (even if Δ already recovered & was
made whole from a 3rd party)
2nd Rest. §407(1) if A has received a benefit as result of violating duty of loyalty, P is entitled to
recover from him what he received, its value, or its proceeds, & the amount of damages caused
thereby, except that if the violation consists of the wrongful disposal of P’s property, the P
cannot recover its value and also what the agent received in exchange therefor.
Under Bergquist v. Kreidler, P recovered attorney’s fees & disbursements which were expected
results of A’s misrepresentation
o Holding: П can recover secret commission from Δ as well as attorney’s fees & other expenses directly
traceable to harm caused by Δs wrongdoing
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3 Rest. §8.01 – General Fiduciary Principle
o A has fiduciary duty to act loyally for the P’s benefit in all matters connected w/ the agency relationship
3rd Rest. §8.02 – Material Benefit Arising out of Position
o A has duty not to acquire a material benefit from a 3rd party in connection w/ transactions conducted or
other actions taken on behalf of the principal or otherwise through the A’s use of the A’s position
o Comment to §8.02 comes down to why ppl are willing to invest in common stock, b/c they can rely
on reasonable enforcement of the duty of loyalty
o Any business opportunity that arises is supposed to be brought to P, A can’t keep it
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A can take business deals that are specifically directed to the A alone, NOT deals that are
directed to both the A & P
Theories for why benefits go to the P
o Expectation to receive benefit may stem from fact that when A acts w/ actual or apparent authority,
the P risks being bound by bad transactions
o Another risk is that A may believe no harm will befall the P from A taking the benefit, but the A isn’t in a
position to disinterested assess whether the P’s interests would be better served if the A did not take
the benefit from the 3rd party
Reading v. Attorney General (British army officer illegally transporting whisky, army gets $)
o Facts: A (sergeant) used position in working for P (Royal Army Med. Corp) to make money by illegally
transporting whiskey, the P is entitled to the $ he made
o Rule If a servant, in violation of his duty of honestly & good faith, take advantages of his service to
make a profit to himself, but the assets to which he has control, or the facilitates which he enjoys, or
the position he occupies are the real cause of his obtaining the money (they play a prominent role as
opposed to merely being a opportunity for getting it), then he’s accountable for it to the master
o Holding $ Agent made has to go to the British Government
Partnership
Introduction
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Martin v. Peyton – “partnership results from contract, express or implied. If denied it may be proved by the
production of some written instrument, by testimony as to some conversation; by circumstantial evidence. If
nothing else appear the receipt the Δ of a share of the profits of a business is enough”
Share in profits
o You can be a partner if you act like you’re in a partnership legal conclusion
o If you act like a partner, you can be held to be a partner even if there was no conscious intention to be
a partner (banks get into trouble w/ this when trying to recover from creditors)
A business relationship is a partnership when there are two people doing business for profit
RUPA v. UPA (some states still use UPA)
o Entity status (UPA uses aggregate theory, RUPA uses entity theory)
UPA §6(1) – does NOT define a partnership as an entity
UPA defines partnership as an association of 2+ persons to carry on as co-owners of a business
for profit
RUPA §202 – defines a partnership as an entity
Entity status simplifies many partnership rules, like those dealing w/ partnership
property & litigation
RUPA §101(6) – partnership means an association of 2+ persons to carry on as co-owners of a
business for profit formed under §202, predecessor law, or comparable law of another JX
o UPA §7(3) – Rules for determining existence of partnership
The sharing of gross returns is not enough to establish partnership, whether or not the persons
sharing them have a joint or common right or interest in any property from which the returns
are derived
The receipt of a person of a share of the profits of a business is prima facie evidence that he is
a partner in the business, but not if such profits were received in payment:
As a debt by installments or otherwise
As wages of an employee or rent to a landlord
As an annuity to a widow or representatives of a deceased partner
As interest on a loan, though the amount of payment varies w/ profits of business
As the consideration for the sale of a good-will of business or other property by
installments or otherwise
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RUPA §202 – Rules for determining partnership, has a lot more detail and more subsections in the
statute, makes it explicit no intention to form partnership is required
o To determine whether a partnership exists, first look to see if it’s in a UPA or RUPA state
But supposedly no substantive change in law btw UPA and RUPA
Corporations v. Partnerships
Corporations are defined by:
Partnerships are defined by:
Limited liability
Unlimited liability for partners
Free transferability of interests
Reduced transferability
Legal personality
Less of a legal personality
Centralized management
Less centralized managment
Partnership Liability
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Unlimited liability for partnerships
o UPA §15 – all partners are liable joint & severally for everything chargeable to the partnership under
§§13-14 and jointly for all other debts & obligations to the partnership, but any partner may enter into
a separate obligation to perform a partnership contract
o UPA §40(b) ranks liabilities in terms of priority
o RUPA §306 – all partners are liable jointly & severally for all obligations of the partnership
Partnership Formation
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Hilco Property Services v. U.S. (subjective intent doesn’t matter)
o To see whether there was partnership (factual question) look @ conduct of parties & the
circumstances surrounding their relationship & transactions
o The only necessary intent is an intent to do those things which constitute a partnership, the subjective
intent of the parties to form a partnership does not matter, it’s immaterial that the parties don’t call, or
believe, their relationship to be a partnership, esp where 3rd parties’ rights are concerned
Martin v. Peyton (look at control as part of factor to find partnership)
o Facts: (NY Ct/A 1927) П Martin is owned money, Δ part of a group of “trustees”, which borrowed $2.5
mil of liquid securities from П, trustees said they weren’t in a partnership
o Issue did the Δs become partners in the firm of KN&K so that they and it together carried on as coowners of a business for profit?
o Court looks at various business instruments, and arrangements for sharing of profits (thought it’s not
decisive)
Control was merely supervisory they couldn’t initiate anything on their own (Wachter’s idea
of controlling the accelerator v. break: if you have control, you’re partner)
They had no right to participate in management, or bid the partnership
o Holding there was no partnership, all factors together not enough to induce finding of partnership
Lupien v. Malsbenden (car maker ran off, his “banker” found to be partner )
o Facts: (S. Judicial Ct of Maine, 1984)
П and Cragin had agreement to build Bradley automobile & do business as York Motor Mart,
Cragin didn’t deliver car & disappeared
Δ had loaned money to Cragin for business & dealt w/ П in business & operated company after
Cragin disappeared, Δ has power to initiate/veto projects
T/Ct find that even though Δ was “only a banker” his total involvement was that of a partner
o Issue Were Δ & Cragin partners in pertinent part of York Motor Mark’s business?
o Relevant Law Maine uses UPA, determination of partnership an inference of law based on
established facts, can be based on evidence of express or implied agreement
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Holding there was a partnership as a matter of law
The Δ’s “loan” to Cragin carried no interest, not to be repaid in fixed amounts or times, Δ’s dayto-day participation in the business was unlike a banker
Joint control over the business & intent to share in profits amounted to partnership under 31
MRSA §286
Four Element Test (deviates from UPA & RUPA) (Montana & Texas)
o Sometimes said where there’s no express partnership agreement, a relationship will be considered a
partnership only if 4 elements are present:
(1) an agreement to share profits
(2) agreements to share losses
(3) mutual right of control or management of the business
(4) community of interest in the venture
o UPA §6(a) & RUPA §202 says nothing about control or loss-sharing
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Legal Nature of Partnership (Entity v. Aggregate)
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Aggregate Theory (UPA §6 and common law)
o UPA §6 and common law
o Partnership is an aggregation of individuals and can’t own property in its own name
The partnership itself isn’t a legal entity
o Wachter likes the aggregate theory, b/c partnership is NOT a corporation
Entity Theory (RUPA §201)
o RUPA §201(a) – “A partnership is an entity distinct from its partners”
Means partnership can sue in its own name
Ability of partnership to continue business if one partner drops off
o BUT RUPA allows certain areas for aggregate theory (liability for debts, duty of loyalty, etc)
o Problem w/ aggregate theory came when dissolving the partnership, if one of the partner died or
dropped out then the whole thing ended
Under RUPA, partnership lives on even though a partner drops off. End result partnerships
are not quite entities or aggregations, while corporations are clearly entities
Partnerships v. Joint Ventures
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Corporations will frequently join in “joint venture” to conduct business between the two of them
Main differences btw joint ventures & partnerships
o 3rd parties in joint venture can’t automatically assume one of them has authority and is agent
o Joint venture has greater room to protect & further your own interests
o Joint venture usually adjudicated under UPA or RUPA rules
o Some cts held that a services partner need not contribute towards a capital loss if the enterprise is a
“joint venture” rather than a partnership
RUPA §202 (comment) – “relationships that are called ‘joint ventures’ are partnerships if they otherwise fit the
definition of a partnership. An association is not classified as a partnership, however, simply b/c it is called a
‘joint venture””
Ongoing Operations of Partnerships
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Management & Decision-Making Power
o See UPA §18(a)(e)(h), §19, §20
UPA §18(h) – any difference arising as to ordinary matters connected w/ the partnership
business may be decided by a majority of the partners; but no act in contravention of any
agreement btw the partners may be done rightfully w/o the consent of all of the partners.
UPA §18 is a set of default rules if partnership agreement is contrary to §18 then the
agreement governs, but if it’s silent on an issue then §18 governs
o See RUPA §§401(f)(i)(j), 403
§401 includes all the things that can be changed by partnership agreement
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§103(b) are the nonwaivable provisions – says the partnership agreement may not:
(1) vary the rights & duties under §105 except for the duty to provide copies of
statements to all the partners
(2) unreasonably restrict the right of access to books & records
(3) eliminate the duty of loyalty
(4) unreasonably reduce the duty of care… etc etc
Making decisions regarding ordinary course of business and becoming a partner
In partnership all partners are counted equally (subject to partnership agreement), unlike a
corporation
UPA §18 – Rights & Duties of Partners (default rules subject to partnership agreement)
(e) all partners have equal rights in the management & conduct of business
(g) no person can become a member of partnership w/o consent of all the partners
(h) any difference arising as to ordinary matters connected w/ the partnership business
may be decided by a majority of the partners.
o BUT no act in contravention of any agreement btw the partners may be done
rightfully w/o the consent of all the partners.
RUPA §401 – Partner’s Rights & Duties
(f) each partner has equal rights in management & conduct of the business
(i) a person may become a partner only w/ the consent of all the partners
(j) a difference arising as to a matter in the ordinary course of business of a partnership
may be decided by a majority of the partners
o BUT there must be consent of all partners for:
An act outside the ordinary course of business of partnership; or
An amendment to the partnership agreement
NOTE these are default rules (comment says they’re still subject to any agreement
btw them, which is supported by §103 which says partnership agreement grumps)
RUPA §403 – Partner’s Rights & Duties wrt Information
A partnership shall provide
o Partners & their agents & attorneys access to its books & records
o Former partners and their agents & attorneys access to books & records
pertaining to the period during which they were partners
The right of access provides the opportunity to inspect and copy books & records
during ordinary business hours
(c) each partner & the partnership shall furnish to a partner:
o (1) without demand, any info concerning the partnership’s business & affairs
reasonably required for the proper exercise of the partner’s rights & duties
under the partnership agreement or this Act; and
o (2) on demand, any other info concerning the partnership’s business & affairs
o Except to the extent the demand or the info demanded Is unreasonable or
otherwise improper under the circumstances
Ordinary v. extraordinary
o Extraordinary changes the form of the business entity, or substantially alters
the rights of the parties
The RUPA provision tracks UPA fairly closely, except that under RUPA a partnership
agreement consists of the fragmentary implicit & explicit agreements made as the
partnership agreement evolves; therefore, unanimity is required not ONLY to depart
from the formal agreement, but ALSO the fragmentary ones
Summers v. Dooley (trash collectors - can’t have unilateral decision in 2 person partnership)
Facts: (S/Ct of Idaho, 1971) Two partners in garbage collecting business disagreed over hiring
3rd employee, П went ahead & hired employee w/ his own money, then sued Δ for his share of
the pay
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П argued he should be reimbursed for expenses & costs connected to employing extra
help by Δ, b/c by benefiting from the profits generated by the new employee Δ ratified
the unilateral decision by П
Issue does 1 partner in a 2 man partnership have the authority to hire a new employee
despite the other’s dissent & recover costs from the dissenting partner?
Rule L Idaho law says “any difference arising as to ordinary matters connected w/ the
partnership must be decided by a majority of the partners.
Holding T/Ct was right to find for the Δ b/c there wasn’t majority consent to hiring the 3rd
employee
There is equal rights in management of partnership; in a 2 person partnership one
partner can’t take action over the other’s objection
Can’t permit recovery of an expense which was incurred individually & not for the
benefit of the partnership, but rather for the benefit of one partner
NOTE under the default rules of partnership, all partners count EQUALLY despite how much
they contribute to the capital of the partnership, BUT these default rules can be changed by the
partnership agreement
Types of Rules under UPA and RUPA
They can be default
They can be mandatory rules – CANNOT be changed by agreement
They can be enabling rules – specifically direct the parties to write in language
Sanchez v. Saylor (need majority to agree, one partner can’t force the other by suing)
Facts: П and Δ were partners & tried to get a loan from 3rd party, who required Sanchez to
provide personal financial statements as condition of loan. Sanchez refused & Saylor sued,
arguing Sanchez’s refusal violated fiduciary obligations.
Rule Ct cites Covalt – absent an enforceable agreement covering circumstances of
disagreement, when both partners in 2-partner partnership disagree, the appropriate avenue
of relief is dissolution, not an action for breach of fiduciary duty.
Holding Held for Δ Sanchez, if 2 partners can’t agree and don’t want to continue partnership,
the remedy is dissolution
Since both partners have equal rights in management, one can’t impose his
will/decision concerning the operation of partnership on the other
The fact that a proposal benefits partnership doesn’t mean partner has to agree
Law governing internal affairs of partnerships
Choice of law determines what state’s law governs
For corps, LPs, and LLCs (formed by filing), general rule internal affairs are governed by state
of incorporation or organization (LPs and LLCs)
For general partnerships, UPA doesn’t have provision for choice of law wrt internal affairs, but
under RUPA §106 general partnership internal affairs are governed by the law of the state in
which the partnership has its chief executive office.
Indemnification and Contribution
Partner has a right to be indemnified by the partnership, partnership has a right to require
contribution from one or more partners
Indemnification – becomes a partnership obligation
Contribution – a partner’s obligation and NOT the partnership itself
Each partner is only liable for his share of partnership obligations
Partnership Agreements
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Distributions, Remuneration, and Capital Contributions
o Distributions – UPA §18(a), RUPA §401(a)(b)
o In partnership all partners share EQUALLY (subject to partnership agreement), which is unlike a
corporation
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UPA §18 (subject to any agreement btw them)
(a) each partner shall be:
Repaid his contributions (capital or property) and
Share equally in the profits and surplus remaining after all liabilities, including those to
partners, are satisfied; and
Must contribute towards the losses sustained by the partnership according to his share
in the profits
o RUPA §401
(a) Each partner is deemed to have an account that is:
(1) credited with an amount equal to the
o Money the partner contributes
o PLUS the value of any other property (NET of the amount of any liabilities) the
partner contributes to the partnership
o PLUS the partner’s share of the partnership profits; AND
(2) charged with an amount equal to the
o Money distributed by the partnership to the partner
o PLUS the value of any other property (NET of the amount of any liabilities)
distributed by the partnership to the partner
o PLUS the partner’s share of the partnership losses.
(b) Each partner is entitled to an equal share of the partnership profits and is chargeable w/ a
share of the partnership losses in proportion to the partner’s share of the profits
Capital Account & Draw
o How is profit split btw the partners?
o UPA §18(a) and RUPA §401 (a)(b) indicate that profits will be shared equally
UPA §18(f) indicates there’s no guarantee of remuneration from a partnership, only a right of a
draw (cash distribution to partners) but all partners must agree upon it under §18(h)
“draws” are subtracted from the firm’s total capital +/- the amount of profits/losses of
the firm
o If partners decide to sell, partnership worth more in reality than money in the bank due to good will
(positive relationships it has w/ customers & the public)
The paid-in-capital (PIC) put in by the partners isn’t relevant to a distribution of profits till the
partnership is dissolved, once that happens the PIC has to be repaid proportionally
No interest on the PIC
o Partners are individually liable to the partnership’s creditors for ALL partnership obligations
As between the partners, however, each is only liable for his share of the partnership
obligations
UPA §40(b) indicates that the liabilities of the partnership rank in the order of payments
distributed
The Internal Affairs of Partnerships – The Authority of a Partner
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Statutes
o UPA §9 Says every partner can carry on the business of the partnership “in the usual way of the
business of the partnership,” and can bind the partnership, unless he has no such authority the person
with which he is dealing “has knowledge of the fact that he has no such authority”
o RUPA §301 a partner’s actions bind the partnership as long as he is “apparently carrying on the
partnership business or business of the kind carried on by the partnership” unless the person with
whom the partner was dealing “knew or had received a notification that the partner lacked authority”
RUPA is more protective of 3rd parties by requiring notification that the partner lacked
authority to bind the partnership
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UPA had put a burden on 3rd parties to inquire about a partner’s authority in some cases
RUPA makes it so that 3rd parties has to have actual knowledge, they won’t be deemed to have
notice from facts & circumstances
RUPA makes it clear that a partnership is bound by an act of the partner for apparently carrying
on the partnership business in the usual way or business of the kind carried on by the
partnership
Authority of a Partner
o Apparent authority is often key in partnerships power of position is important
If someone has the position and title, he generally has that apparent authority to do what a
person in that position would do
o Example: H & W are partners; W had been buying goods on credit and regularly paying off credit. H
decides they no longer should buy on credit b/c it’s more expensive, W continues buying on credit from
A, can A recover any loss of interest?
Two scenarios: 1) A doesn’t know partners are deadlocked & doesn’t try to find out; 2) A is
notified that they’re deadlocked. Turn to UPA and RUPA
UPA §9
For there to be no authority, the partner has to have no authority & person has to have
knowledge that partner has no such authority
UPA §9(1) – a 3rd party had knowledge if he had actual knowledge OR when he has
knowledge of such other facts as in the circumstances shows bad faith
(implied/inquiry notice) Note: no duty of inquiry or deemed to have notice from facts
& circumstances under RUPA
RUPA §301
The 3rd party has to know or received a notification that the partner lacked authority
DIFFERENCE UPA allows constructive knowledge, RUPA requires actual knowledge
First question were partners carrying on partnership business in the usual way?
RUPA clarifies that apparent authority includes acts for carrying on in the ordinary
course “business of the kind carried on by the partnership,” not just the business of the
particular partnership
If yes, this ends the inquiry UNLESS:
Second question was it shown that the person w/ whom the partner is dealing actually knew
or received notification that the partner lacked authority?
RUPA protects partners by making notification of lack of authority to 3rd parties
effective upon receipt
o RUPA provides ways for partners to protect themselves against unauthorized actions:
Partnership may notify a 3rd party of partner’s lack of authority
Partnership may file a statement of partnership authority restricting a partner’s authority
o RNR Investments v. Peoples’ First Community Bank (need actual knowledge of restrictions on authority
under RUPA)
Facts: FL case. Partner @ RNR entered into construction loan agreement w/ People’s bank,
RNR defaulted on loan. RNR claim bank negligently failed to investigate and to realize the
general partner had no authority to execute notes (agreement approved financing amount of
$665K, not $990K).
Issue Did partner have authority to enter into loan?
Rule Under RUPA, bank can rely unless it had actual knowledge of restrictions of authority
(need cognitive awareness, constructive notice isn’t enough)
Holding no Q of fact as to whether RNR had actual knowledge, SJ for bank
o Northmon Investment Comp. v. Milford Plaza Assocs. (99 yr lease not ordinary, not binding)
Facts: NY S/Ct. Dispute btw partners concerning Δ’s authority to enter into 99 year lease of
real property constituting partnership’s only asset.
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Holding In favor of П, Δ lacked authority – the 99 yr lease is not ordinary and П can’t be
bound by it
Within a partnership, the fact that one partner has apparent authority doesn’t “affect the right
of partners as btw themselves to prevent contemplated transactions w/ 3rd parties, or
otherwise to assert their ‘equal rights in the management and conduct of the partnership
business’”
Partnership Liability
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Liability for Partnership Obligations
o Joint Liability partner only liable for his/her share of damages
o Joint & Several Liability higher degree of liability for partners… one partner could be held liable for
all the damages
Exhaustion Rule under joint & several liability you would exhaust all the partnership assets
before you can go after an individual’s assets. The partner who’s been sued jointly and
severally doesn’t have to seek indemnification or contribution b/c the exhaustion rule would
have that effect
o UPA §15 – partners are jointly & severally liable for everything chargeable to the partnership under §13
& 14 and jointly for all other debts and obligations of the partnership but any partner may enter into a
separate obligation to perform a partnership contract
o UPA §17 – new partners admitted into existing partnerships are liable for the obligations of the
partnership arising before his admission – but only out of partnership assets, not personal assets
o RUPA §306, 307
307(a) says judgment against a partnership is not by itself a judgment against a partner. A
judgment against a partnership may not be satisfied from a partner’ assets unless there is also a
judgment against the partner
Under RUPA you’re liable for the capital contribution you put in, but beyond that you’re not
personally liable
Under RUPA you have to name all the partners that you would have the right to collect against
RUPA lets a partnership be sued in the name of the partnership, even states w/o RUPA have
adopted “common name” statutes allowing partnerships be sued as a whole
o UPA v. RUPA on liability
RUPA has only J&S for everything
UPA has J&S only for some circumstances, but only J in others
o Tort Liability
UPA §15 makes all partners jointly & severally liable for torts and breaches of trust injuring 3 rd
parties, but only jointly liable on all partnership debts & contracts
RUPA §305 makes a partnership liable for loss caused to a person as a result of a wrongful act
or omission of a partner acting in the ordinary course of business of the partnership or w/ the
authority of the partnership
Indemnification v. Contribution
o Contribution means you have to pay if the partnership takes on new debts (a partner’s obligation)
o Indemnification is the right of the partner to be indemnified if they have been sued (a partnership’s
obligation)
o Davis v. Loftus (merely calling someone a P doesn’t make it so)
Facts: (Ill. App. 2002) П claim 2 lawyers at firm committed malpractice & sued all partners of
firm for damages, some partners are “income partners” as opposed to “equity partners” and
didn’t share in profits & had no decision making power, only put in capital w/o interest
Rule look @ substance, not form, check if provisions of partnership agreement make
someone a P w/in meaning of Act
Holding income partners were not partners under meaning of UPA, thus not liable
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Partnership Interest & Partnership Property
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Rapoport v. 55 Perry Co. (assignability of partnership interest)
o Facts: (NY S/Ct 1975) 2 families in partnership, each w/ 50% interest. П wanted to assign 10% of
partnership interest, Δ family refused arguing new partners can’t be added w/o consent of all existing
partners
o Rules:
UPA §18(g) – no person can become a member of a partnership w/o the consent of all partners
RUPA §502 – The only transferable interest of a partner in the partnership is the partner’s
share of the profits & losses of the partnership & the partner’s right to receive distribution. The
interest is personal property.
o Holding Consent of Δs required to add new partners, П can assign partnership interests (income &
profit share) but NOT management rights (b/c P agreement doesn’t say otherwise)
Bauer v. Bloomfield Co. (assignees ARE NOT partners and cannot interfere with management).
o Facts: (Alaska 1993) Holdens assign their interest in a partnership to Bauer. Profits are disbursed for a
while but then stop. Partnership had voted to pay one of the partners a fee which ran through the
profits. Bauer tries to sue for his share of the profits.
o Rules:
Alaska Law: assignees are not entitled to interfere with the management of the partnership.
o Holding The payment of the profits as a fee was a management decision and so Bauer cannot
complain. Assignees may not have the same interest in the continuance/health of the partnership and
therefore there really is not duty to protect their interests outside of their slice of the partnership.
o Dissent: The partners should owe a duty of good faith to assignees. Arguably cutting the assignee out
of the profits would violate that duty.
Cannot assign liability for losses (assignment of interest doesn’t change the liability of the assigner)
Can assign interest away in the partnership agreement (ex: when my kids become adults they become
partners)
o Can write it into the agreement b/c you have unanimous consent when you adopt the agreement.
However, still cannot contract away your unlimited liability through the agreement.
Assignee does NOT have right to inspect partnership books
o UPA §27 – assignment of interest does NOT dissolve the partnership, nor does it give the assignee
power to interfere in the management or administration of the partnership business or affairs, or to
require any information or account of partnership transactions
Dissolutions
o RUPA §601(4)(ii) – can dissolve by the partner’s expulsion by the unanimous vote of the other partners
if: there has been a transfer of all or substantially all of that partner’s transferable interest in the
partnership, other than a transfer for security purposes, or a court order
Creditors
o Under UPA §28 if a partner’s separate creditor obtains a judgment under UPA §28 he can get a
charging order on the partner’s partnership interests this gives the creditor the right to be paid the
partnership distributions to which the debtor partner would otherwise be entitled
o The creditor can foreclose on the partnership interest under UPA §28 and thereby cause its sale. In
which case, the buyer of the interest has the right to compel dissolution if:
(1) the term of the partnership has expired; OR
(2) the partnership is at will.
o Alternatively, the creditor can put the individual partner in bankruptcy, which will result in dissolution
of the partnership under UPA §31(5).
Partner’s Duty of Loyalty
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Partners have a fiduciary duty to share business opportunities
UPA §21 – Partner Accountable as Fiduciary
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Every partner must account to the partnership for any benefit and hold as trustee for it any profits
derived by him w/o the consent of the other partners from any transaction connected w/ the formation,
conduct, or liquidation of the partnership or from any use by him of its property
o This applies to the representation of a deceased partner engaged in the liquidation of the affairs of the
partnership as the personal representatives of the last surviving partner
RUPA §404 – General Standards of Partner’s Conduct
o Partners own a duty of care and a duty of loyalty to the partnership and one another (generally narrow
or limiting language rather than expansive language on loyalty, but covers duty of care, good faith, and
fair dealing)
o Duty of loyalty is limited to what’s listed:
Account & hold partnership’s property, profits, benefits derived
Refrain from dealing w/ partnership on behalf of a party having an interest adverse to the
partnership
Refrain from competing w/ the partnership in the conduct of business before the dissolution of
the partnership
Can you contract out of the duty of loyalty?
o RUPA §103(b) – says the partnership agreement may NOT eliminate the duty of loyalty, but the
agreement CAN indentify specific types of categories of activities that do not violate the duty of loyalty
(if not manifestly unreasonable)
RUPA §103(3)(ii) - Partners can authorize or ratify, after full disclosure of all material facts, a
specific act or transaction that otherwise would violate duty of loyalty
o Under UPA – you can’t get out of duty of loyalty? Look at §18
Meinhard v. Salmon (Cardozo opinion – opportunity that comes to individual as a P has to be shared)
o Facts: (NY Ct/A 1928) П & Δ co-adventurers in a joint-venture. Meinhart had $ & Salmon doing all the
work/operating in the business, been in long-term relationship. A deal comes in w/ adjacent property
next door, Δ thinks he should have a right to it & doesn’t give П a change and П isn’t included in deal.
o Issue whose opportunity was the new deal?
o Rule: Joint adventurers, like co-partners, owe to one another, while the enterprise continues, the duty
of finest loyalty. Many forms of conduct permissible in a workday world for those actions at an arm’s
length, are forbidden to those bound by fiduciary ties.
This includes an obligation not to usurp opportunities that are incidents of the venture
o Holding Δ Salmon was approached in the realm of being a P in a partnership & the partnership had
opportunity to make more money, gave ½ of entire lease to П’s interest
o Dissent this wasn’t a general partnership but joint venture entered into by Δ to obtain financing;
there was no expectancy of renewal of joint venture
Latta v. Kilbourne (US S/Ct – a P can’t directly or indirectly use partnership assets for his own benefit)
o P can’t take profit of partnership clandestinely for himself
o Can’t carry on the business of the partnership for his private advantage
o Can’t carry on another business in competition or rivalry w/ that of the partnership
o Can’t be permitted to secure for himself that which it is duty to obtain for the partnership
Dissolution
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Partnerships fairly easy to dissolve – just say you don’t want to be a P anymore
o If partnership doesn’t want to be dissolved when a P leaves, needs to write it into the partnership
agreement
Dissolution starts the winding up process winding up gives the partners a way to end the business in a way
that is most advantageous to them
Dissolution by Rightful Election
o UPA §29 – defines dissolution as the change in the relation of the partners caused by any partner
ceasing to be associated in the carrying on as distinguished from the winding up of the business
o UPA §30 – on dissolution, the partnership is NOT terminated, but continues until the winding up of
partnership affairs is completed
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Dissolution the event that triggers process, notification by one of the partners (change in
legal status of Ps and the partnership)
Winding up involves settling accounts, finishing projects, etc (economic event of liquidation)
Termination means the sale or distribution of assets
UPA §31 – Causes of dissolution:
Without violation of the agreement btw the parties: 1) by termination of the definite term of
particular undertaking specified in the agreement, 2) by the express will of any partner when
there is no definite term, 3) by the expulsion of any partner form the business
In contravention of the agreement btw the partners, where the circumstances don’t permit a
dissolution under any other provisions of this section, by the express will of any partner at any
time
By any event which makes it unlawful for the business to continue
By death of a partner
By bankruptcy of a partner
By decree of court under §42
UPA §38 – When a partnership is being dissolved the partnerships’ assets are pretty much dissolved
into cash
§38(1) – when dissolution happens the partnership property may be used to discharge
liabilities, and the surplus goes to pay the met amount owing to the respective partners; an
expelled P will receive only the net amount due to him from the partnership
§38(2)(b) – if a partner W wrongfully causes dissolution, the remaining Ps after dissolution can
continue the partnership’s business by:
(1) paying W value of his interest (NOT counting value of good will); OR
(2) putting up a bond to secure such a payment and indemnify W against present &
future partnership liabilities
UPA §40 – rules for distribution ; who gets paid first
§40(a) – assets of partnership = partnership property + contributions of the partners necessary
for the payments of all liabilities
§40(b) – Ranking of liabilities
(1) pay off creditors
(2) pay off Ps if they have contributed or loan anything to business
(3) Ps in respect to capital
(4) Ps in respect to profit
§40(d) – Ps shall contribute the amounts necessary to satisfy liabilities but if any but not all Ps
are insolvent, the others shall contribute their share of the liabilities
RUPA §601 – A partner is dissociated upon any of the following:
(1) the partnership having notice of a P’s express will to withdraw as a P
(2) an event agreed to in the partnership agreement as causing P’s dissociation
(3) the P’s expulsion as per the agreement
(4) the P’s expulsion by the unanimous vote of the other partners
(5) the P’s expulsion by judicial determination
RUPA §602 – A partner has the right to dissociate at any time, rightfully or wrongfully
Dissociation is wrongful if it breaches an express provision of the agreement or occurs before
the expiration of a definite term or particular undertaking
Wrongful dissociation makes the P liable for damages caused by the dissociation
RUPA §701 – if dissociation occurs without dissolution
The partnership can purchase the dissociate P’s interest for a buyout price (the amount
distributed to partners if the assets of the partnership were sold on the day of dissociation)
BUT the damages for wrongful dissociation are offset against the buyout price
RUPA §801 – Dissolution
A partnership is dissolved and business must be sound up ONLY:
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(1) where the partnership is at will, the occurrence of the partnerships’ having notice of
a partner’s express will to withdraw, other than a partner who was dissociated under
§601(2)-(10)
(2) where a partnership is for a limited term, the express will of at least ½ of the Ps; or
any event agreed to in the partnership agreement that would result in winding up; an
event that makes it unlawful to continue the partners
o Key differences btw UPA & RUPA (Dissolution v. Dissociation)
Under UPA, if partnership is dissolved b/c one P’s status is terminated, the remaining Ps might
continue the business as a new partnership
Dissolution winding up termination
Under RUPA, the agreement can provide that the dissociation of a partner doesn’t cause
dissolution at all
Still keeps terms above, but adds a new one: dissociation to describe the termination
of a person’s status as partner
Dissociation leads to a fork in road, partnership can:
o Can lead to a mandatory buyout under Article 7, which can be rightful or
wrongful
RUPA §602(b) distinguishes rightful from wrongful conduct in
dissociation P’s dissociation is wrongful ONLY IF: 1) It’s in breach of
an express provision of the agreement, or 2) it’s before the expiration
of the term or the completion of the undertaking of partnership
o Or can lead to winding up of the business under Article 6
Dissociation (Art. 6) Buyout (Art. 7) OR winding up (Art 8)
Language of §602(b) means that at will partnerships are NOT wrongfully dissolved if
one P wants to get out (Wachter thinks it overturns what judge in Page v. Page tried to
do)
Absolute right to end partnership changes when you move to RUPA b/c there is no longer an
absolute right to dissolution!
Girard Bank v. Haley (partnership at-will can be terminated at any time w/o cause or justification)
o Facts: P in an at-will UPA partnership sent letter saying she’s terminating partnership
o Rule: UPA §31 says dissolution is caused by express will of any partner, the expression of that will
doesn’t need to be supported by any justification
P Agreement didn’t have duration term or particular undertaking (here the undertaking was
maintaining and leasing of real estate, no ascertainable finish date)
o Holding Δ P can dissolve partnership at will, not in contravention of agreement
At Will Partnerships
o Can be dissolved for almost any reasons
o Alternative is a partnership at term, if it’s dissolved before the term it results in a breach of contract &
Ps can sue for damages
Creel v. Lilly (no forced liquidation upon P’s death, dissolution must occur in good faith)
o Facts: (Maryland, 1999) Mr. Creel, pervious P w/ Lilly & Altizer, died. П wife argues she has right to
liquidate business & cause it to cease operations. П got cashed out, but claims that instead of winding
up business the Δs continued business under new name using assets of the partnership.
o Issue Can П demand liquidation upon P’s death where the partnership agreement doesn’t expressly
provide for continuation of partnership & where the estate doesn’t consent to continuation
o Rule where the surviving Ps have in good faith wound up the business and the deceased P’s estate is
provided w/ accurate accounting allowing for payment of a proportionate share of the business, then
forced sale of all partnership assets is unwarranted
Decided under UPA, but the outcome would’ve been the same under RUPA
Forced liquidation can be harmful to business, usually destroys value
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Holding New business “Good Ol Boys” is a successor partnership (Joe’s was wound up) and the
partnership CAN continue under same name or as a successor w/o all assets being liquidated
Page v. Page (dissolution must occur in good faith, can’t use adverse pressure to freeze out a copartner & use
business for oneself)
o Facts: (CA S/Ct 1961) П and Δ entered into oral partnership agreement in regards to linen business, lost
money for a while, once it started to make $ П sought to dissolve it, П is also creditor of partnership.
Δ says П just wants to dissolve the partnership so he can take it up himself & profit
o Rule P can’t use pressure to freeze out a co-partner
o Holding ct finds this to be at-will partnership, but the П’s dissolution is in bad faith violation of
loyalty П is at fault in the dissolution
o Problem w/ Holding:
Imposing this “good faith” standard is against the statute – RUPA §602(b)(1) overrules Traynor
(Δ) here, stating that a parte-at-will can dissolve the partnership for any reason
Excessive use of this “bad faith” in court rooms can discourage business activity
Wachter thinks Page is supposed to get the going concern value of the business, the
opportunity that came w/ the business.
Disotell v. Stiltner
o Holding relevant statute didn’t require liquidation of business assets & didn’t forbid buyout, so Δ
was permitted to buy out П’s partnership interest.
Leff v. Gunter (P can’t exploit information & opportunity of partnership & then just disassociate himself by
leaving partnership)
Rosenfield, Meyter & Susman v. Cohen (P can’t dissolve partnership at will in bad faith)
Farnsworth v. Deaver (settling of capital accounts)
o If partnership’s debts > assets, capital losses must be satisfied by the partners in direct proportion to
their share of the profits
o Ex: partners contributed $10,000, $5000, and $2000 to partnership and agreed to share in profits
equally
Partnership contributions are also considered debts so additional loss (to be taken into
consideration after other debts are sorted out) is $17,000
Upon dissolution only $5000 remained after paying creditors, so less $17,000 in partner credits
there is a negative balance of $12,000.
Divide $12,000 equally between 3 Ps (b/c they share equally in profits & losses) results in each
owing the partnership $4000, then offset it against initial contributions
P who paid $10,000 has balance of $6000, P w/ $5000 has balance of $1000, P paid $200 would
have negative Balance of $2000 and has to pay $2000 from partnership to remove his capital
account from negative position
Dissolution by Judicial Decree and Wrongful Dissolution
o McCormick v. Brevig
Holding when partnerships’ dissolution is court ordered pursuant to §35-10-624(5)
partnership assets necessarily must be reduced to cash in order to satisfy the obligations of the
partnership and distribute any net surplus in cash to the remaining Ps in accordance w/ their
respective interest
Wachter says: Unlike other cases liquidation was required here because of allegations of bad
faith. Remember we are in a court of equity.
o Drashner v. Sorenson (under UPA – wrongful dissolution = no good will value)
Facts: (S. Dakota, 1954) П & Δ co-owners in real estate, loan, & insurance business, П
demanded larger share of income of partnership than he was entitled & brought case to
dissolve & wind up partnership. Δ argue П mismanaged partnership (was a drunk) & is guilty of
wrongful dissolution
Issue did П cause dissolution wrongfully?
Rule under UPA §31(2) & §38(2) in a wrongful dissolution the ct doesn’t have to take good
will into account (however, if this was RUPA state, §602 says it’s not clear who’s the bad guy)
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Holding П willfully committed breach of agreement by demanding more than the agreed
amount & wrongfully caused the dissolution
Consequences of wrongful dissolution
Damages
Valuation of P’s interest that doesn’t reflect the real value fo the interest b/c goodwill isn’t
taken into account
Continuation of the business w/o him
Expulsion of a Partner
Expulsion of P w/o good cause is usually a wrongful violation of the partnership agreement
Under UPA §31(1)(d) & §32(1)(d) the wrongfully expelled P has right to have
partnership dissolved & liquidated
But partnership agreement may lawfully provide that a partner can be expelled w/o cause upon
a designated vote of the remaining partners (UPA §38(1)(d))
Lawlis – expelling Ps act in good faith regardless of the motivation IF “the expulsion does not
cause a wrongful withholding of money or property legally due the expelled P at the time he is
expelled”
Winston & Strawn v. Nosal - Nosal expelled from law firm after requesting partnership info he
had right to and threatened to sue if it wasn’t given to him raises inference that Nosal was
expelled solely b/c of request and this violates duty of good faith & fail dealing that Ps owe
each other
Levy v. Nassau Queens – While expulsion in bad faith may be actionable, there needs to be
some showing that the partnership acted out of a desire to gain business or property
advantage for the remaining partners
Policy disagreements don’t constitute bad faith
Crutcher v. Smith - $500 bad check insufficient to trigger dissolution (not every trivial departure
from duty or violation leads to dissolution)
o
o
Limited Partnerships
Formation of a Limited Partnership
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Key Features
o Cross btw a general partnership and a corporation
o Only way to form a limited partnership is by filing paper to make it a limited partnership can’t fall
into it like you can a general partnership (RULPA §201)
o Limited liability granted to limited partners
o Great degree of centralized management, general partner (GP) run the day to day affairs
o Transferability allows partnership to attract equity through passive investors
o Continuity or rules governing dissolution
Creation of statute
o RULPA §101(7) defines a “limited partnership” and “domestic limited partnership” as a partnership
formed by 2+ persons under the laws of this State and having one or more general partners and one or
more limited partners.
As such it IS a partnership w/in meaning of UPA §6 and RUPA §202
o MUST execute a certificate of limited partnership under RULPA §201, setting forth certain basic info
about the partnership
LP statutes contemplated that the parties will enter into a written agreement specifying terms
Separation of ownership and management functions
o RULPA §403 – General Power and Liabilities of a Limited Partnership
The general partner (GP) assumes management responsibilities and full personal liability for
the debts of the partnership
The GP has same rights/obligations of partners found under RUPA
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The limited partner (LP) makes a contribution of cash, property, or services to the partnership
and obtains an interest in the partnership in return – but NOT active in the management and
his liability is limited to the amount of his investment.
o Voting (see §405 & §302)
GP gets to vote; LP only gets to vote if the agreement says so (most agreement do not give this
right)
GP is designated in the agreement
Assignment and Dissolution
o Transferability is easy for the LP, but highly restrictive for the GP
o If a GP assigns his/her interests – the partnership would dissolve unless there is another GP
GP assigning interest is effectively a withdrawal
See RULPA §702 – Assignment of Partnership Interest
Since a GP is like a partner under UPA or RUPA, he can assign his interest but he can’t
assign his liability & he doesn’t stop being a partner
o An LP’s interest is the income he gets from the partnership, the assignee will not get more than the
income essentially a commodity you can exchange, very liquid
LP cannot force dissolution, limited partnerships have increased continuity (§801)
RULPA §704 – right of assignee to become LP
o RULPA §801 – Nonjudicial Dissolution of a limited partnership
A ltd partnership is dissolved and its affairs shall be wound up upon the happening of the first to
occur of the following:
1. At the time specified I the certificate of ltd partnership
2. Upon the happening of events specified in writing in the partnership agreement
3. Written consent of all partners
4. An event of withdraw of a general partner unless at the time there is at least one other
general partner and the written provisions of the partnership agreement permit the
business of the limited partnership to be carried on by the remaining general partner and
that partner does so, but the ltd partnership is not dissolved and is not required to be
wound up by reason of any event of withdrawal.
Liability of Limited Partners
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RULPA §303
o Old Rule:
(a) a LP is not usually liable to 3rd parties unless the LP also participates in control of the
business. But if the LP’s participation isn’t substantially the same as the GP’s exercise of
powers, then he’s only liable to persons who transact business w/ the limited partnership w/
actual knowledge of his participation in control.
(b) limits the definition of what can constitute control safe harbor
o New Rule:
Adds to section (a) – “However, if the LP participates in the control of the business, he/she is
liable only to persons who transact business w/ the limited partnership reasonably believing,
based upon the limited partner’s conduct, that the LP is a GP”
Need direct contact w/ the 3rd party, it’s the LP’s behavior that counts (not what GP says about
LP)
o Change was made b/c of difficulty of determining when the “control line” has been overstepped and
also b/c it’s not sound public policy to hold a LP who isn’t a GP liable for obligations of the partnership.
Gateway Potato Sales v. G.B. Investment Co. (LPs who assert control are personally liable for partnership
liabilities)
o Facts: (Arizona Ct/A 1991)
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П creditor sued Δ LP to recover partnership debts – П financed partnership b/c other Ps assured
him that Δ would provide the financing. П thought it was a general partnership, not a limited
one.
Δ claims he wasn’t involved in managing the business – but ct finds Δ approved spending of
funds & oversaw daily operations
o Rule: Ct does NOT follow new RULPA rule (requiring direct contact btw LP and 3rd party) AZ only
requires that the 3rd party had “actual knowledge” of the LP’s participation in management
In the absence of actual knowledge of the LP’s participation in control of business, there must
be evidence from which a trier of fact might find not only control, but control that is
“substantially the same as the exercise of powers of the GP”
If the “substantially the same as” test is not met, then direct contact is required
o Holding Overrules T/Ct finding there needs to be actual contact, and remanded.
Incentives created by this system (under Gateway Potato)
o Creditor has incentive to find out all he can about the partnership & LP
Especially strong incentives if the lender is a bank
o П lender should ask for certificate of limited partnership, the partnership agreement, and financial
statements
Corporate General Partners & The Duty of Loyalty
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RULPA §§303(b)(1) & 402(9) explicitly recognize that a corporation can be a GP in a limited partnership
agreement
o RULPA §303(b) – provides that “a LP does not participate in the control of the business… by… being an
officer, director, or SH of a GP that is a corporation”
o Although a director or officer of a corporate GP isn’t liable for the debts of a limited partnership, if he
participates in the control of the partnerships’ business in that capacity, he may become liable IF:
(a) if the corporate officers fail to maintain their corporate officer identify in conducting
partnership affairs; or
(b) if corporate assets are intermingled w/ partnership assets; or
(c) if the corporation is not sufficiently capitalized
In re USA Cafes, L.P. Litigation (a corporate GP’s officers owe a fiduciary duty to LPs)
o Facts: (Del. Chan. Ct. 1991) Officers of the GP are accused of having sold shares of limited partnership
back to the GP for a lesser value than they were worth for personal pay-offs; Пs (holders of limited
partnership units) assert a breach of loyalty by the GP’s directors.
o Rule Corporate directors are regarded as fiduciaries for corporate SHs; they owe the partnership and
its LPs a fiduciary duty of loyalty for dealings w/ the partnership.
Here, the LPs can go after the corporate officers directly, but only for breach of fiduciary duty
of loyalty
In 3rd party case, the relationship is contractual btw the corporate GP and the 3rd party – so 3rd
parties can’t go after the officers, only the corp GP
o Holding Corporate GP owes fiduciary duties directly to LPs, the complaint alleges claim upon which
relief can be granted. (directors Δs breached fiduciary obligations imposed upon them as directors of a
DE corporation or have participated in a breach of such duties by the GP)
Note on Taxation of Unincorporated Business Organizations
o Two basic patterns of business taxation under IRC:
(1) Firm taxation (i.e. double taxation) business firm is taxable on its income; if a firm makes
distributions to its owners out of after-tax income, the owners generally pay taxes on those
distributions
Historically applied to corporations
(2) Flow-through taxation a firm’s not subject to taxation; instead, all income, expenses,
gains, losses are taxable directly to the firms’ owners; distributions aren’t taxed
Historically applied to partnerships
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o
o
An “eligible entity” can elect either flow-through or firm taxation it’s any business entity other than:
A corporation
A business entity that is specifically made taxable under the IRC (e.g. a master limited
partnership – a ltd partnership whose interests are publicly traded)
Some corporations (S corps) may elect to be treated as partnerships for tax purposes, must:
Not have more than 100 SHs
Not have more than one class of stock
All SHs must be individuals or qualified estates of trusts; and
No SH may be a nonresident alien
Fiduciary Obligations
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Gotham Partners v. Hallwood (a ltd partnership agreement may provide for fiduciary duties that are the same
as those in corp law)
o Facts: (DE S/Ct 2002) П Gotham is LP and Δ is GP, GP did a reverse split and odd lot tender offer. Δ
didn’t inform audit committee as required by §7.10(a) to review or approve the odd lot offer and resale
and failed to perform a market check or obtain any reliable financial analysis indicating that the Odd Lot
Resale would be conducted on the same terms obtainable from a 3rd party.
o Rule A limited partnership may provide for fiduciary duties that are the same as those in corporate
law
After decision in Gotham, DE legislature amended the DRUPA to make explicit that in these 3
forms of organizations the governing agreement (partnership agreement, ltd partnership
agreement, or ltd liability company agreement) can eliminate, as well as expand or restrict,
fiduciary or other duties.
Amendments also made clear that the implied contractual covenant of good faith and fair
dealing cannot be eliminated by agreement.
o Holding GP breached its duty of loyalty by failing to comply w/ the contractually created entire
fairness standard during the Odd Lot resale, which resulted in the GP & its corp parent solidifying
control over the Partnership
Benefits of Alternative Corporate Forms
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Compare general partnerships, limited partnerships, and corporations against 4 features: limited liability,
transferability, continuity, and centralized management.
On limited liability both the investor & manager have shared interests
o Partnership gives no protection – all are liable
o Ltd partnership – provides protection for LPs as long as they don’t trip into being GPs
o The corporation provides limited liability to the investors AND the manager is protected by agency
On transferability and continuity
o Only the corporate form provides ease of transfer, same true for continuity
Allows corp to exist forever while investors can exit and enter at will
o In general partnerships, only the interest in the profits and losses can be assigned, and the partnership
dissolves at will by the Ps unless the partnership agreement specifies a term
o In ltd partnerships, there is imperfect ability to transfer shares by the limited partners. For continuity,
GPs can exist and other GPs can maintain continuity and the LPs can trigger dissolution only by majority
vote
Form:
Limited Liability
GP
No – all Ps are liable
LP (LPs/GPs)
Yes/No (only GPs liable)
Transferability
No – can only assign
interest
Continuity
No – ease of dissolution
Yes/No (LPs can assign
everything, GPs can only
assign interest)
Somewhat better – GP can
dissolve but LPs can’t (if
Corporation
Yes (directors & SHs not
liable)
Yes
Yes (unless shorter term in
cert. of incorp.)
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Legal Personality
Central Management
No (UPA)/Yes (RUPA)
No (all Ps have right to
participate)
GP is corp then can
continue forever)
Yes (GPs can be sued)
Mixed (yes if there’s only
1 GP)
Yes
Yes (board of directors has
control)
The Corporate Form
Introduction and Organization of a Corporation
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Characteristics of the Corporation
o Limited liability
o Free transferability of ownership interests
o Continuity of existence
o Centralized management
o Entity status
Selecting a State of Incorporation
o May incorporate in ANY state you want, states can’t discriminate (Commerce Clause)
Close corporations will almost always incorporate locally for tax reasons (states will impose a
doing-business tax for doing business there, and a franchise tax for incorporating in that state)
o Choice of law rules internal affairs doctrine corp. is governed by the state of incorporation, NOT
where it does business
o Two Theories (assuming managers’ & SHs’ interests are NOT aligned, and that managers make the
decision as to where to incorporate)
(1) Race to the bottom
Managers choose where to incorporate & they’re going to incorporate ein the state
that has the most hands off policies for managers – states that best allow
entrenchment to take place
Wachter thinks this is not the situation in corporate law; if it was it would reduce
incentive for ppl to invest & eventually undercut free market system
(2) Race to the top
Suggests SHs should be willing to pay more in states that don’t allow that type of
managerial discretion – market should correct that in the long term (if corp. is poorly
run it will go bankrupt in long-run)
Market for capital: involves the market for corp. control. The takeover market is
central to make sure these problems are not as serious as they otherwise might be.
If management were to choose a state whose laws were adverse to SHs, the value of
the corp’s stock would fall, making it an appealing takeover target, and thus
threatening management’s jobs
Wachter thinks this theory is correct
o VantagePoint Venture Partners 1996 v. Examen, Inc. (internal affairs doctrine, look to law of state of
incorporation)
Facts: (DE 2005) CA enacted statute requiring companies, who weren’t incorporated in CA, but
met certain criteria (x & of business transactions, etc) to file as quasi- CA corp which was then
subject to certain CA statutes
Issue: Corp was a Delaware corp – conflict of law b/t CA & DE statues
Rule internal affairs doctrine – only one state should have authority to regulate a
corporation’s internal affairs – state of incorporation
Holding cites 14th Amend. as justification for internal affairs doctrine, DE corp law governs
o Friese v. Superior Court (incurring debt or security NOT part of internal affairs!)
Facts: (CA 2005)
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Rule internal affairs doctrine recognizes only one State shold have authority to regulate
corp’s internal affairs (i.e. matters peculiar to the relationship btw or among the corp & its
current officers, directors, and SHs); BUT incurring debt/security is NOT part of internal affairs
of corp and CAN be regulated
Holding although the corp is incorporated in DE, the forum state is CA and CA can apply its
insider trading laws to the transaction
Organizing a Corporation
o STEP 1: (DGCL §101)
§101 says anyone may form a corporation by filing w/ the Secretary of State a certificate of
incorporation which shall be executed, acknowledged, and filed in accordance w/ §103
A corporation may be incorporated or organized under this chapter to conduct or promote any
lawful business or purpose, except as may otherwise be provided by the constitution or other
law of this State
o STEP 2: (DGCL §102 – Certificate of Incorp.) (sample on Supp. p. 1471)
§102(a) Sets forth the specific contents in the certification of incorporation, mandatory terms
include:
Name, address
Nature of the business to be conducted (or simply that it will engage in lawful activity)
Total number of shares of stock which the corporation will issue
Statement concerning the powers, rights, and limitations of any class of stock
§102(b) sets forth terms that can be put into the article of incorporation IF you want to include
them:
Provisions for management of the business & affairs of the corp
Providing for a vote of a larger portion of stock than required by the DGCL for a
corporate action
Imposing personal liability on the SHs
Eliminating/limiting personal liability of a director to the corp or its SHs for damages of
breach of fiduciary duty as a director; provided that such provision shall not eliminate
or limit the liability of a director for a breach of loyalty to the corp, for acts in bad faith,
or for transaction where an improper personal benefit was derived
§242 – Amendment of Certificate of Incorp. After receipt of Payment for Stock
Two step process
BoD are the only ones who can propose a change, but then need a approval by majority
of the SHs
o STEP 3: (DGCL§109 – Bylaws)
Unlike the cert. of incorporation, the by-laws may be fairly easily changed
§109(b) bylaws may contain ANY provision not inconsistent w/ the provisions of the
certificate of Incorp.
Bylaws can be adopted, amended, or repealed by the incorporators, by the initial directors
named in the cert. of incorp., or by its board of directors before a corp received any payment
for stock
Can be changed by a vote of the board of directors (BoD) or the SHs
# of members of the board can be in the bylaws, unless it’s in the certificate often
used by hostile bidders to encourage a SH vote to increase the size of a hostile board
DGCL §141(a) – CRITICAL SECTION
o The business and affairs of every corporation organized under this chapter shall be managed by or
under the direction of a board of directors…
Classes of Stock
o §151 – Classes & Series of Stock; Rights, etc.
Common stock is how corps obtain their capital
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o
But common stock has no fixed claim on corp – only residual interest (claim to what’s
left after all senior claimants have been satisfied)
Preferred stock – combines ownership element of common stock & senior nature of debt
No promise of repayment of the original investment, no legal obligation to pay a fixed
rate of return on investment
Preferred SH shall have “preference” or first claim in the event that the directors pay a
dividend or the event of liquidation of the business
Rights & obligations of SH – default is to have one vote/share, but common stock can be issued w/ no
voting rights (must be set forth in the cert of incorp)
The Classical Ultra Vires Doctrine
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Corporations were created as fictitious entities and given capacities only as provided in their charters,
transactions outside that sphere were characters by the courts as ultra vires (beyond the corp’s explicit or
implicit power) and therefore unenforceable – both against the corp and by the corp
o Doctrine has eroded as corp powers came to be deemed implied or incidental to the main business
purpose of the corporation, and as cert of incorp. (CoI) lost importance
o DGCL §101(b)- a corp can be created as long as it’s engaged in ANY “lawful business or purpose”
o DGCL §121 – corporations have all powers listed in §122, in the CoI, together with “any powers
incidental thereto, so far as such powers and privileges are necessary and convenient” to business
purposes
o DGCL §122 – Specific Powers: perpetual existence, the power to sue and be sued, acquire property,
adopt and amend by-laws, make donations, make contracts, dissolve itself
o DGCL §124 – Lack of Corporate Capacity or Power: no corporate act shall be invalid by reason of the
fact that the corporation was without capacity or power to do such act, but a SH can seek to enjoin
such acts, and a corp can seek damages against a director’s improper acts. Lists 3 exceptions:
In a proceeding by SH against the corp to enjoin the doing of any act or the transfer of real or
personal property by or to the corp
Can only “enjoin” can’t use this argument after the fact of the act
In a proceeding by the corp against an incumbent or former officer or director of the corp for
loss or damages due to such incumbent or former officer’s or director’s unauthorized act
In a proceeding by the Attorney General to dissolve the corp, or to enjoin the corp from the
transaction of unauthorized business
Takeaway the Ultra Vires doctrine is pretty much dead at this point
o Statutes indicated that corporations can engage in pretty much any kind of business
o SH can at best enjoin actions that haven’t already gone through, CAN’T rescind them
o Ultra Vires is NOT a defense to corporate tort or criminal liability
Ultra Vires as applied to executor contracts
o Majority view nonperforming party, having received a benefit under the contract, is estopped from
asserting ultra vires defense
o Minority view (the “federal rule”) past performance doesn’t have estoppel effect, on the theory that
ultra vires contract was prohibited by law & therefore void
Under American law, unanimous SH approval bars ultra vires defense unless creditors would be injured
Goodman v. Ladd Estate Co. (if SH knew about/participated in ultra vires, can’t claim it as defense)
o Facts: (Oregon S/Ct 1967)
П want to stop Δ corp from enforcing a guaranty agreement executed by Westover corp in
favor of Δ Ladd Estate (made at request of old directors of Westover, Δs defaulted & Ladd
Estate wanted $ from Δ)
П husband and wife bought all common shares of Westover, fully aware of guaranty agreement
given by Westover and Liles to Ladd Estate but argue guaranty agreement was ultra vires the
corporation
П argues loan was for old director Wheatley’s personal purposes, completely foreign to any
corporate purpose
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Rule Even before statute, corp might properly enter into guaranty agreement in the legitimate
furtherance of its business purposes – later statute DGCL §124 says the agreement is enforceable even
though ultra vires
o Holding Пs knew about note before buying stock; just b/c they guessed wrong doesn’t make it
equitable to give relief here; also wouldn’t be inequitable to enforce agreement b/c of purpose which
the guaranty was intended to serve
If a SH participates in the ultra vires act he can’t later attack it as such
Important not to hurt creditor’s interest
Inter-Continental Corp. v. Moody (ultra vires defense barred by §, but SH can intervene to enjoin ultra vires act)
o Facts: (Texas 1966) Prez of ICC guaranteed a note to Mody, but Prez lost control of ICC & ICC refuse dto
pay note; Moody should’ve known note was guaranteed for Prez’s personal benefit
o Rule Texas has statute comparable to DGCL §124
o Holding ultra vires defense by ICC barred under statute, even if the 3rd party had actual knowledge
that the corp lacked authority to enter into the transaction
However, a SH can intervene to enjoy an ultra vires act even if he’s been solicited (as here) to
do so by the corp, provided the SH isn’t the corp’s agent
711 Kings Highway Corp. v. F.I.M.’s Marine Repair Serv. Inc. (§124 applies both where ultra vires is raised as a
defense and when it’s invoked in support of cause of action)
o Facts: (NY 1966) Kings leased movie theatre for 15 yrs to Marine; Kings bought action for D.J. to
invalidate lease on ground it was void for ultra vires for Marine to conduct a move theatre business
o Rule NY statute (Bus Corp Law §103) was comparable to DGCL §124
o Holding held for Marine – case doesn’t fall w/in exceptions in §203, thus ultra vires may not be
invoked as a sword in support of a cause of action any more than it can be utilized as a defense
o
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Legal Structure of Management
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Architecture of Corporate Law
o 4 major modules of corporate law:
State statutory law
State judge-made law
Federal law (such as Sarbanes-Oxley Act & Securitites Act)
Private ordering or “soft law” (such as NYSE listing rules)
Directors’ Information Rights
o Cases are split on whether the director’s intent is relevant to the right to information concerning the
corporation
o NY cases deems the director’s intent irrelevant – director must have unqualified access to information if
he’s to perform his directorial duties
Cohen v. Cocoline Prods., Inc. (NY 1955)(ct says corporate directors have an absolute,
unqualified, right… to inspect their corporate books and records)
o Competing theory deems intent relevant – director’s right to information presupposes that he is not
hostile to the corporation
State v. Seiberling Rubber (Del. 1961) (if it can be established that the director’s motives are
improper, or that they’re in derogation to the interest of the corp, then his right to inspect
ceases to exist)
Traditional v. Modern Legal Model
o Traditional legal model has the board manage the corp’s business
The board was, and still is, conceived as an independent institution, not as an agent of the SHs
o In modern corporation, the management function is ordinarily located in the corp executives (officers)
w/ the central figure in the corp being the CEO
Directors are constrained from managing b/c they don’t usually meet often, info is filtered
through management, and they’re usually recruited by management
DGCL §142 – says every corporation shall have officers
o Emerging in DE & all over the idea of the monitoring board
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The board is established as primarily made up of outside directors (those not under the thumb
of the CEO of management)
They dominate the Audit and Compensation committees, and seeks to ensure the CEO & other
officers are doing their job
The Board of Directors
o DGCL §141
(a) The businesses and affairs of every corp organized under this chapter shall be managed by
or under the direction of a board of directors, except as otherwise may be provided in this
chapter or in its certificate of incorporation
(b) the bylaws can provide that a number less than the majority fo directors can constitute a
quorum; but it can be no less than 1/3 the total number of directors
# of directors fixed by either the CoI or by the by-laws
Corporations can’t be directors; must be a natural person
(c)(2) the board may appoint committees which may act in the Board’ stead the board can
delegate its powers to them
Indicative of the fact that in practice the Board doesn’t run the corp
(d) the election of the board may be staggered
(e) the board is allowed to rely on committees or representations by Officers in decisions
o DGCL §223 – vacancies resulting from an increase in the # of directors can be filled by the majority of
directors then in office, though less than a quorum
o Election of the Board – DGCL §211 Meeting of Stockholders
(a) annual meetings will be held
(b) SHs vote
DGCL §212(a) – one vote/share of capital stock
DGCL §151 – there can be different voting rights across different classes of stock
o w/in each class, the rights are pro rata – each have the same rights
o voting power and preferences have to be set in the CoI
SHs can vote by proxy
Dividends
o DGCL §170 on Dividends: though not defined by statute, a dividend is a payment made by the
corporation to its SHs
They’re made on a pro rata basis, such that each share is entitled to the same amount
§170(a) indicates that directors can decide to pay dividends
Dissolution
o DGCL §275 – requires the action of both the SHs and the board to dissolve the corp
If a majority of the Board approves resolution to dissolve, it will happen ONLY once a majority
of the SHs agree
If ALL SHs approve dissolution, then it will happen
o But the corp isn’t required to buy back any shares from a SH who wishes to get out (unlike in
partnerships)
Shareholder Voting
o SHs usually get to vote on fundamental changes in the corp (ex: merger or sale of corp, sale of assets)
o Voting by proxy
Proxy is either a person the SH has authorized to vote for them or a piece of paper they’ve
indicated they will vote on
o DGCL §242 – SHs get to vote on amendments to the CoI
o DGCL §220 – SHs have the right to access books of the corporation if their purpose is proper
o DGCL §228 – Consent of SHs in Lieu of Meeting
If consents in writing, setting forth the action so taken, shall be signed by the holders of the
outstanding stock having not less than the minimum of votes that would be necessary to
authorize or take such action at a meeting, the actual meeting is not required
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The Objectives & Conduct of the Corporation
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Dodge v. Ford Motor Co (powers of directors are to be employed primarily for the profit of the SHs)
o Facts: (Mich. 1919) Ford owned 58% of stock & controlled board, Dodge bros owned 10% in closed
corporation. Henry Ford declared it’s now the company policy not to pay any special dividends in the
future, but to put back into the business for the future of all earnings of the company new goal is to
help make cars cheaper & more affordable for public
Dodge bros brought suit to try & compel dividend equal to 75% of the accumulated cash
surplus
o Issue can the corporation take on social responsibility at expense of SHs?
o Rule Board can’t shape policy to benefit others w/ only mere incidental benefits to SH, the business
corporation is organized & carried on primarily for the profit of the SHs
o Holding It’s not lawful for directors to harm the SHs for the primary purpose of benefiting others,
upheld T/Ct order of $19.3 mil dividend
A.P. Smith Mfg. v. Barlow (corps can make charitable contributions w/ in “reasonable limits”)
o Facts: (NJ S/Ct 1953) BoD of Smith Mfg. wanted to donated $ to Princeton b/c it benefits corp by
increasing good will of company, & donation is expected by public. Пs brought D.J. action to declare
donation intra vires.
o Rule Common law rule: those who manage the corp can’t disburse any corporate funds for
philanthropic or other worthy public cause unless the expenditure would benefit the corp (cts have
taken a broad view as to what “benefits” the corp)
There is NJ statute allowing & encouraging corporate charitable donations w/ certain
limitations.
o Holding The corp has right to reasonably contribute to academic institutions, the donation is valid &
lawful exercise of the corp’s implied & incidental powers under common-law principles & came in w/
express authority of the NJ statute
Ct uses a “reasonable limits” standard of review
o DGCL §122(9) put in place after this case gives corps the power to “make donations for the public
welfare or for charitable, scientific or educational purposes, and in time of war or other national
emergency in aid thereof”
Reasonableness is implied (though not explicit)
ALI Principles of Corporate Governance
o §2.01(a) – subject to the provision of subsection (b)… a corp should have as its objective … to enhancing
corporate profit and SH gain
o §2.01(b) – says even if corporate profit and SH gain are not thereby enhanced, the corporation in the
conduct of its business:
is obliged, to the same extent of a natural person, to act w/in the boundaries set by law
may take into account ethical considerations that are reasonably regarded as appropriate to
the responsible conduct of business; and
may devote a reasonable amount of resources to public welfare, humanitarian, education,
and philanthropic purposes.
“Other Constituencies” under Delaware Law
o DE doesn’t have an other-constituency statute like the other state statutes
o Unocal has 2 paragraphs that go in somewhat opposite directions
In determining the board’s exercise of corp power to forestall a takeover bid our analysis begins
w/ the basic principle that corp directors have a fiduciary duty to act in the best interests of the
corp’s SHs
But then in introducing the Unocal standard, the ct refers to “danger to corporate policy”
Does this “corporate policy” have a meaning independent of the “best interests of the
corp’s SHs?”
In describing the impact on the “corporate enterprise” they mention the impact on the
“constituencies” other than SHs
30
o
o
o
o
o
o
Revlon says when concern for various corporate constituencies is/isn’t proper:
While concern for various corporate constituencies is proper when address a takeover threat,
that principle is limited by the requirement that there be some rationally related benefit
accruing to the SHs
However, such concerns for non-SH interest is inappropriate when an auction among active
bidders is in progress, and the object no longer is to protect o maintain the corporate
enterprise but to sell it to the highest bidder
Time v. Paramount
BoD has duty to manage business and affairs of corporation under §141(a) – the question of
“long term” v. “short term” values is largely irrelevant b/c directors, generally, are obligated to
chart a course for a corporation which is in its best interests w/o regard to a fixed investment
horizon
Absent limited set of circumstances as defined under Revlon, a BoD, while always
required to act in an informed manner, is not under any per se duty to maximize SH
value in the short term, even in the context of a takeover
Fiduciary duty to manage a corporate enterprise includes the selection of a time frame for
achievement of corporate goals – that duty may not be delegated to the SHs
Directors don’t have to abandon a deliberately conceived corporate plan for a shortterm SH profit unless there is clearly no basis to sustain the corporate strategy
Katz v. Oak Indus. Inc. (maximizing long-run interest of SHs at expense of others isn’t enough for a
breach of duty, directors have NO fiduciary duty to bond holders)
(Del. Ch. 1986)
Says it’s the obligation of Δs to attempt, w/in the law, to maximize the long-run interests of the
corp’s SHs. That they may do so sometimes at the expense of others… does not for that reason
alone constitute a breach of duty. (ex: corp restructuring to max SH values may require
bondholders to bear greater risk of loss & transfers econ value from bondholders to SHs)
Credit Lyonnais Bank Nederland v. Pathe Communs. Corp (in zone of insolvency, BoD is not merely the
agent of the SHs, but owes its duty to the corporate enterprise)
(Del. Ch. 1991)
When a corp is in the zone of insolvency, the fiduciary duty shifts not only to the SHs, but to the
creditors as well
Unclear when a company is in the “zone of insolvency” – but where the corp is operating in the
vicinity of insolvency, the board’s duty to the corp enterprise means it (wants the corp entity to
exist and do well, not merely get SHs the most $ upon liquidation of the assets)
Banks are NOT allowed to vote in corporate decision-making, though they might have lent corp a lot of
money
As lenders, they can negotiate terms to insure they get a return, which SHs have no guarantee
of
Their interests will not necessarily align w/ those of the corp (to max value); SHs as residual
claimants will seek to do just that
Employees are also not allowed to vote for the same reason
If employee voted, they wouldn’t seek to maximize the corp’s value but would rather
emphasize the security of their jobs
The Nature of Corporate Law
-
Separation of ownership & control
o Problems that emerge when there’s separation:
Managers may take less risk
Diversion mangers may decide to increase their own wealth instead of SH wealth
Entrenchment-shirking may tell yourself you’re better off if you take long vacations w/ CEOs
of other companies
31
o
o
o
o
When KKR takes over a company & gives the directors amazing stock options,
companies suddenly become uber productive and cut costs
Why don’t SHs guard against this, assuming they’re aware of this behavior?
SHs are rationally apathetic, don’t have the power to take them on.
Ex: With the amount of share one owns in a company, it’s usually a better use of time not to try
and figure out if there was a problem w/ the company when looking at one’s hourly rate
With separation of ownership and control you get all the costs but very little of the benefit
Solution to this problem?
Give the directors stock options
Paradox of corporate law
Managers and directors know more about the company than anyone else; however, when they
tell us what they know we can’t always believe them b/c of fears of diversion & entrenchment
Key question why are we willing to put all our $ into corporate stock? Problem of corporate law is to
solve this problem
Corporate Structure
Shareholdership in Publicly Held Corporations
-
-
-
Board of directors “run the corp” but in fact SHs “control” the corporation
o SHs are owners b/c they get to vote the directors, but they don’t get to “mess w/” the company
Reason why SHs get a vote
o Their alignment of interests are with the company b/c they ARE the residual claims
o Bondholders don’t get to vote b/c they have a fixed claim and no residual claim, and as long as the
company is solvent, the bondholders won’t want them to make investments
They’d just vote for the company to use the cash flow & buy US treasury bills to pay off their
loans
o The employees also don’t have an alignment w/ corporate interests – all they care about is their jobs
The rise of institutional investors (pension funds, mutual funds) works against the early view of corporate
power allocation where diversified holdings lead to rational apathy
o With institutional SHs no longer rationally apathetic
Pension plans (public & private) and mutual funds hold such large quantities of stock that
they’re necessarily interested in the operations of their holdings
The ERISA requirements that pension managers act to maximize the pension holdings, making
them fiduciaries, inspired the activism of institutional SHs
o There’s been an increase in activist SHs in general
SHs buy into corps b/c they think they’re undervalued b/c of ineptitude of managers and seek
to change the management’s personnel and/or methods
o The biggest ones making a difference is private equity and hedge funds – large pools of money not
rationally apathetic & may have better monitoring of managers & reduced agency costs
Dark Side? they’re there to maximize their own investment (presumably is everyone’s
interest – but possibility of legal side deals is still an open question)
What do SHs get to decide?
o Electing directors (DGCL §212(b))
o Amend bylaws
o Vote on amendments to the certificate of incorporation (DGCL §242)
o Dissolution (need majority vote of SHs as well as majority of the shares outstanding)
o Some mergers
o Extraordinary transactions
Ex: Vote on sale of substantially all of the assets (DGCL §271)
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The Legal Structure of Management
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-
-
-
-
-
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Modern corporate practice in public held corps locates management function w/ the executives, not the BoD
o The central figure in management is the CEO
o The limited role of the BoD in managing the corp is the result of several critical restraints imposed by
modern BoD practice:
Constraints of time directors spend very little time fulfilling board service responsibilities –
short of time that would be required to actually manage the corp
Constraints of info Asymmetrical distribution of information – the officers of corp usually
have more info than the Board, & control flow of into to the Board
Constraints of composition Typical BoD includes a # of directors who are economically or
psychologically tied to corp executives (esp CEO); shown in #of seats of BoD usually held by
insider directors (executives)
Monitoring Model over last 25 yrs there’s a shift from managing to monitoring function for BoD
o BoD mostly monitors, management is mostly in hands of senior execs
o This is almost universally accepted & required of corps listed on the NYSE or NASDAQ!
DE won the race to the top/bottom and holds a kind of monopoly position
o DE has a special incentive NOT to lead in the adoption of innovative suboptimal rules
o Incentive is to avoid massive federal intervention into corporate law (e.g. Sarbanes-Oxley)
Statutory Structure
o Board of directors
o Managers
o Shareholders
o Employees, suppliers, customers, the community
Formalities Required for Action by Board
o Validity of an action by the BoD involves rules concerning requirements of a meeting, notice, quorum,
and voting.
o Rules on 2 levels: (see pp.207-210)
(1) The governing rules on formalities for board action
(2) The rules concerning the consequences of noncompliance
o These rules usually applicable to committees as well
o See DGCL §141(c) and Model Bus. Corp. Act §8.25
Formalities Required for Shareholder Action
o See pp. 215-17
o DGCL §211, 214, 216, 222, 228 rules for SH meeting, quorum, voting on ordinary matters &
fundamental changes & election of directors.
Authority of Corporate Actors
o President has apparent authority to bind corp to Ks in the usual and regular course of business, but
not Ks of an extraordinary nature
NJ reads prez authority expansively – includes actual circumstances where executives do most
management
Declaration of dividends must be decided by BOARD; as required by statute
In deciding whether something is extraordinary – look to economic magnitude of action in
relation to corp asset & earnings, cost of reversing the action, theextent of the risk involved,
and the time span of the action’s effect
In generally, decisions that makes a significant change in the structure of the business
enterprise or control over the enterprise = extraordinary corp actions & normally
outside the prez’s apparent authority
o CEO, VPs, Chairman of the Board not much CL on this (p.213)
o Secretary has apparent authority to certify the records of corp, including resolutions of the board
o Treasurer apparent authority is close to nothing (p.214)
o Ratification - even if an officer lacks both actual & apparent authority, corp may be bound by the act in
entering into a K or other transaction on its behalf if the board later ratifies the officer’s act
33
o
Ratification can occur where a corp, knowing all the facts, accepts and uses the proceeds of an
unauthorized K executed on its behalf
Schoonejongen v. Curtis Wright Corp (3d Cir. 1998) (officers’ powers are both express & implied)
Express authority – usually manifested through statute, CoI, bylaws, or the BoD or SH action
Implied actual authority – may be found through evidence as to the manner in which the
business has operated in the past, the facts of transaction in question, circumstantial ev of
board declarations surrounding the given transaction, or the habitual usage of course of dealing
common to the company
Authority will be implied when it’s reasonably necessary & proper to effectuate the purpose of
the office or the main authority conferred
Allocation of Legal Power between Management and Shareholders
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-
-
“inequitable action does not become permissible simply b/c it is legally possible”
DGCL §141(a)- provides the business & affairs of a corp shall be managed by or under the direction of the board
o But §141(k) provides that a director, or the entire board, may be removed, w/ or w/o cause, by the
majority of SHs, unless the CoI provides otherwise
Delaware Case Law
o Complicated & fact intensive; std of review equally fact intensive
o Rule: known ex ante – clearly known by everyone before the fact
o Standard: known ex post – known after the fact, developed b/c of holding
o SEC has a lot of bright line rules, DE does not
Chan Ct in DE is the T/Ct – 5 chancellors, don’t sit on panel. Once handles each case.
Four Basic Standards of Review
o 1) Business Judgment Rule
Default rule for all business decisions made by board presumption is that it applies (if it does,
highly differential)
П has burden of rebutting this presumption
As the court entertains the case it presumes that the corp’s directors have acted:
On an informed basis
In good faith, and
In the honest belief that the action taken was in the best interests of the corporation
Absent an abuse of discretion, the director’s business judgment will be respected
o 2) Entire Fairness
Highly intrusive – if you’re outside counsel for corp you want to make sure whatever steps the
board takes for making a decision satisfies the BJR presumption
CEOs do not want the standard of entire fairness requires intensive fact finding
o 3) Unocal standard
Applies to contest control transactions. In a tender offer, a hostile bidder bypasses the board
by having the target’s SHs directly sell to the bidder
Often the takeover battle involves SH vote, hence involving Blasius standard of review
Enhanced business judgment rule or intermediate standard of review (btw BJR and duty of
loyalty)
Board must FIRST show that:
It has reasonable grounds for believing that the tender offer presented a danger to
corporate policy & effectiveness
Board must then satisfy a proportionality test the defensive action must be
reasonable in relation to the threat posed
o Under Unitrin – ct must first determine whether the board’s defensive action
was “draconian” by being either “preclusive or coercive”
o If not preclusive or coercive, must be “within a range of reasonable responses
to the threat” posed by the tender offer
If board can satisfy 2 part test above, then BJR attaches
34
o
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-
-
-
-
-
4) Blasius
In cases involving interference w/ the SH franchise, there is an intrusive standard
Directors must demonstrate a compelling justification for their actions
Standard applies to cases involving the exercise of the SH franchise where the directors have
taken unilateral action for the purpose of interfering w/ the franchise
Charlestown Boot & Shoe Co. v. Dunsmore (limitations to director control must be in bylaws)
o Facts: (NH S/Ct 1990) SH ordered Directors to close up shop & chose Osgood to direct the closing.
Directors refused to work w/ him, kept the business running at a loss; didn’t takeout insurance on
property which turned down in fire
o Rule directors don’t have to do what the SHs tell them to, their fiduciary duty is to do what they
think is best for the corporation
o Holding Δ directors found NOT liable b/c business of corp is under their control – any limits must be
in the bylaws and any usurpation of this power contrary to the bylaws will be void
People Ex Rel., Manice v. Powell (SHs can’t manage corp, can’t control directors)
o Facts: (NY 1911)
o Directors aren’t private agents or mere employees of corp, they’re executive agents of the corp; SHs
can’t act in relation to the ordinary business of the corp and can’t control the directors in the exercise
of Judgment vested in them by virtue of the office.
o Directors possess & act as if they own the property of the corp (even though it’s actually SH property) standard agency relationship is not in effect here
Removal of Directors
o By SH generally need cause (except in CA which doesn’t require cause & NY which permits SH to
remove a director w/o cause if the CoI or bylaws so provide)
o By Board in the absence of statute, the board can’t remove a director, w/ or w/o cause
o By Court cases are split as to whether ct can remove directors for cause
Schnell v. Chris-Craft Indus., Inc. (directors can’t use corp machinery to entrench themselves)
o Facts: (DE S/Ct 1971) SHs want to stop directors from moving up date of SH’s meeting by >1months;
denied by Chan. Ct.
o Holding Ct’s factual analysis showed the board had motives of entrenchment, “management had
attempted to utilize the corp. machinery and the DE law for the purpose of perpetuating itself in office”
Even though board can legally change the date of SH meeting, it’s not equitable just b/c it’s
legal per se
Narrow holding – if board can show they’re not acting for purpose of entrenchment, then such
a move may be allowed
Berle & Means – The Modern Corporation & Private Property
o All powers granted to a corporation or to the management of a corp, or to any group within the corp,
whether derived from statute or charter or both, are necessarily and at all times exercisable only for
the ratable benefit of all the SHs as their interest appears
o The use of the power is subject to equitable limitation when the power has been exercised to the
detriment of their interest, however absolute the grant of power may be in terms, and however correct
the technical exercise of it may have been.
Blasius Indus. V. Atlas Corp (board action interfering w/ SH vote in contest of control is subject to enhanced
scrutiny under compelling justification standard)
o Facts: (DE Chan. 1988)
П Blasius is 9% SH of Atlas, presented board w/ a consent solicitation to increase Atlas’ board to
15 – w/ 8 of the new directors nominated by Blasius
At board meeting, Δ Atlas added 2 new members to Atlas’ 7 member board – in response to
notice by П that w/ SH approval the board would be increased to 15 w/ 8 of new directors
nominated by П
o Issue whether board acted w/in fiduciary duty when it acts (in good faith & w/ appropriate care), for
the primary purpose of preventing or impeding an unaffiliated majority of SHs from expanding the
board and electing a new majority
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Rule When there is a contest of control – deferential business judgment doesn’t apply to board acts
taken for the primary purpose of interfering w/ a SH vote, even if taken advisedly and in good faith a
more stringent standard of compelling justification is applied.
Examples of compelling justification not having enough time to inform SH about negative
effects of what would happen; or if action board’s faced w/ is coercive
o Holding Even though action was taken in good faith – it constitute an unintended violation of the
duty of loyalty that the board owned to SHs
BJR doesn’t apply here b/c it’s not a business judgment, it’s a decision that affects the SH
franchise
SH’s vote is very important b/c it’s one of the only ways for SHs to protect themselves, here
there’s no justification for board’s action except that it “knows better” than the SHs what’s in
the corp’s best interest (ct didn’t like the undue speed the board took)
Condec Corp. v. Lunkenheimer Co. (board can’t issue stock to retain control & deprive SH of voting control)
o Facts: (DE Chan. 1967) П Condec wanted to merger w/ Δ but Δ refused, П made 2nd tender offer which
would have given П half of Δ’s shares; Δ’s board caused Δ to swap shares of its stock for shares of
wholly owned subsidiary stock of US Industs., which would dilute П’s interest into minority interest.
o Rule board can’t use issuance of shares to get voting control from the SHs – it’s breach of fiduciary
duty to deal fairly & justly (Yasik v. wachtel)
o Holding Held for П b/c SH w/ a contractual right to assert voting control is being deprived of such
control by what is “virtually a corporate legerdemain.” “Manipulation of this type is not permissible”
Look @ whether objective behind the board’s action is to get control – when the objective
behind issuing stock is not merely the pursual of a business purpose but ALSO to retain control
– it’s been held to be a “mockery to suggest that the control effect is merely incidental to its
primary business objective”
Note on Takeovers
o When board wants to take defensive actions against takeover- has to satisfy an enhanced BJR or
intermediate standard of review the Unocal/Unitrin standard
1) BoD must show it had reasonable grounds for believing that the tender offer presented a
threat to corp policy & effectiveness
Burden is met by showing good faith & reasonable investigation
2) BoD must satisfy proportionality test – defensive action must be reasonable in relation to the
threat posed
Defensive action can’t be preclusive or coercive, and must be “w/in a range of
reasonable responses to the threat” posed by the tender offer
Note on Weighted Voting in Publicly Held Corps
o Voting rights can be conferred on preferred stock or bonds
o Corp can have 2+ classes of common stock each w/ different votings rights
Usually one class has voting power out of proportion to equity interests
Known as dual-class common, super voting stock, or weighted voting
These structures allow members of control group to maintain power by giving out “supervoting stock” w/o a lot of investment
o Stroh v. Blackhawk Holding Corp (Ill. 1971) – Illinois corp statute allows diving stock into classes w/
different power here the cheaper stock carrying the same voting power/share was NOT permitted to
share at all in the dividends or assets of the corp, but was not invalidated.
o Providence & Worcester Co. v. Baker (Del. 1977) – It’s okay to limit the voting power of stock w/ cert.
of incorp.
Int’l Brotherhood of Teamsteres v. Fleming Comp. Inc. (SHs can propose bylaws restricting board
implementation of SH rights plans, assuming the CoI doesn’t provide otherwise)
o Facts: (OK S/Ct 1999) ΔCorp has anti-takeover mechanism (SH Rights Plan – aka poison pill) triggered
by single SH’s amassment of certain % of stock; poison pills usually resulting in entrenching
management, making takeover less likely
o
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-
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-
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Issue who has power to create & implement SH Rights Plans? Just the board or can the SHs propose
resolution require that SH Rights plans by submitted to a SH vote?
o Rule OK statute says every “corporation” may create and issue … rights or options. Ct finds that
“corporations” ≠ board of directors
o Holding Board doesn’t have exclusive authority to implement SH Rights plans, SHs can also propose
enactment of by-laws restricting board implementation of SHs Rights plans
Ct equates Rights Plan to stock option plan – which can be subject to SH approval
Holding does mean ALL SH Rights Plans are required to submit to SH approval, ratification, or
review.
o Note Wachter thinks this case would’ve come out other way if it was in DE b/c it would violated
§141(a) using bylaws to limit is in violation, using CoI wouldn’t violate.
MM Companies. Inc. v. Liquid Audio, Inc. (expanding BoD to keep control of corp & impeding SH vote triggers
Blasius & compelling justification standard)
o Facts: (DE S/Ct 2003)
MM part of group holding 7% of Δ’s stock. П tried on 2 occaions to take over control of Δ, also
offered 2 different prices for Δ’s stock (both rejected)
Δ’s bylaws provided for staggered BoD, П announced its intention to nominate its own
candidates for 2 seats on Δ’s board – then sent notice of intention to bring to the annual
meeting a proposal increasing size of board by 4 directors (filled by П’s nominees)
Δ decides to increase the size of the board from 5-7 members & amended bylaws to do so –
argues they did it b/c w/ П’s ppl on the board there would be bad blood & one of the 3Δ
directors might resign & thus they’d lose control of board
П sued, alleging expansion of Δ’s board, its timing, and the appointment of 2 new directors
violated the principles of Blasius & Unocal
Chan. Ct. held for Δ – finds their action wasn’t preclusive & it only diminished the influence of
any nominees of MM that were in elected, at least in numerical terms
o Rule Blasius applies b/c same action & purpose – compelling justification standard Δ board has
burden of demonstrating compelling justification for that action to w/stand judicial scrutiny w/in the
Unocal standard of reasonability and proportionality
o Holding S/Ct reverses – Δ admits what they’re doing is to preclude the П from taking control of the
company by impeding an effective vote of the SHs & to minimize impact of MM’s nominees to board
SH’s power to vote in election of directors is important for proper balance btw SH and BoD
The compelling justification for board’s action under Blasius is a condition precedent to any
judicial consideration of reasonableness & proportionality
o Takeaway this case applies Blasius more freely – used even when facts aren’t exactly the same
o
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Limited Liability & Piercing the Corporate Veil
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-
SHs ordinarily has NO liability for corporate obligations – their risk is limited to their investment
o DGCL §102(b)(6) – SHs are not liable unless the CoI explicitly says otherwise
Corporate managers, as well as corp SHs, are ordinarily not liable for corp obligations
o They’re not liable on straightforward agency principles
Advantages of limited liability
o Encourages entrepreneurial risk-taking
o It’s argued that if you desire free transferability in capital markets, limited liability is necessary;
otherwise, the richest SH would be pursued by all the creditors, and the riches would therefore get out
of market
o Makes it easy to partition corporate assets when necessary for creditors to recover
Limited liability essentially means “no liability”
Traditionally SHs are not liable b/c corps are separate legal entities (also not liable by statute)
Managers are not liable b/c agency principles
Problems with limited liability
37
SHs don’t bear the full risk of a project, though they can receive unlimited gains they may choose
projects that society wouldn’t choose
o Corps may take excessive risks on projects that will only be valuable if they succeed, and will harm only
the creditor if they fail
o When close to bankruptcy or having inadequate capitalization, corps will be particularly prone to taking
actions that have a negative expected value – but they won’t suffer losses due to LL
Resolving issues with limited liability
o Banks are often seen as resolving some of the issues w/ LL
They protect the involuntary creditors by investigation the company prior to investment & only
financing certain projects or insisting on other protections for risky endeavors
Corp managers will often be risk-averse in ways that SH will not be, as their interest in keeping
their position will diverge from that of SHs
o When directors are held personally liable called “piercing the corporate veil”
On these rare occasions, when it’s deemed that one has used the control of the corp to further
his own business, the corporate veil will be pierced to prevent fraud
o How big is the “dark side” of LL?
Excessive risk taking in that zone of insolvency given that no other cts have started to enforce
the zone
What are controls that can be used?
Investigatory powers of the credit worthiness of the borrower
Amount of leverage the firm has
Managers may be risk averse in zone of insolvency
The corporate veil can be pierced where the Corp and the SH operated as a single economic entity and there
was an overall element of unfairness present
Limited Liability & Directors
o Risk aversion on the part of individuals or management directors’ wish to entrench themselves
works out here b/c they don’t want the company to go bankrupt
o HYPO – Risk aversion on part of owners/managers
K has $10 mil invested in Kims, Inc – has two possible projects A & B
If K invests in A, pay off is $100 mil 50% of the time, but $0 50% of the time
Expected Value = Payoff – Project Cost
Project A: Expected Value (EV) = ($100-$10)*0.5+($10-$10)*0.5=$45mil
Project B: EV = ($30-$10)*.5+($20-$10)*.5=$15mil
Kim may choose B b/c he’s risk averse & doesn’t want to lose all his money
Society prefers investors maximize wealth – there’s lots of individuals w/ lots of projects – so
society can diversify and expect to earn the sum of the EV of the different projects
o Credit Lyonnais (previous case – zone of insolvency)
When a company is in the zone of insolvency the fiduciary duty shifts not only to the SHs, but
to the creditors as well
No case where the directors have been liable for violating zone of insolvency
o Implication of LL in bankruptcy or zone of insolvency
If only see upside of project it may look profitable – if company is close to bankruptcy then the
creditors would take loss, not SHs
Board might decide to make investment when the downside is huge & upside small
When a LLC is close to bankruptcy – you don’t see the downside, only upside
PIERCING THE CORPORATE VEIL
o Fletcher v. Atex (DE law on piercing corp veil in alter ego claim – need operation as “single economic
entity” and “overall element of injustice/unfairness”
Facts: (2d Cir. 1995) Пs filed suit against Δ Atex & parent company (Eastman Kodak) – Atex is
wholly-owned subsidiary of Kodak. Atex ended being sold & lost most of its assets, Пs trying to
place liability on Eastman Kodak
o
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-
-
38
o
Пs argue Atex was Kodak’s alter ego – Atex was Kodak’s agent in the manufacture &
marketing of keyboards; that Kodak was the “apparent manufacturer” of the Atex
keyboards & Kodak acted in tortuous concert w/ Atex in manufacturing & marketing
allegedly defective keyboards
D/Ct held Δs not liable b/c it observed all corporate formalities and maintained
separate corporate existences
Rule DE law permits a court to pierce the corporate veil “where there is fraud or where it is
in fact a mere instrumentality or alter ego of its owner.” To prevail on an alter ego claim
under DE law, a П must show:
1) that the parent & subsidiary “operated as a single economic entity” and
2) that an “overall element of injustice or unfairness is present”
3) under an alter ego theory there is no requirement of a showing of fraud
Factors to be considered for a “single economic entity”
o Whether the corp was adequately capitalized
o Whether corp was solvent
o Whether dividends were paid
o Whether corp records were kept
o Whether other corp formalities were performed; and
o Whether, in general the corp simply functioned as a façade for the dominate
SH
Holding Atex & Kodak were separate entities even though:
Atex participated in Kodak’s cash management system
Kodak required Atex to get approval for real estate leases, major capital expenditures
(normal in parent/sub relationship)
Presence of Kodak employees at periodic meetings w/ Atex’s CFO and comptroller was
found to be “entirely appropriate”
Presence of Kodak’s logo in Atex’s promotional literature
Overlapping of boards of directors
Ct also found the П didn’t satisfy 2nd prong of alter-ego analysis b/c П failed to present ev of
“overall element of injustice of unfairness”
Takeaway the law observes its own formalities, if a corp acts as an independent agent the
law will treat it as such
Walkovsky v. Carlton (NY taxi case – to pierce veil П needs to show corp boundaries weren’t being
followed)
Facts: (NY Ct/A 1966) П is run down by a cab, cab owned by corp owned by Δ; Δ owns
numerous corps which operate single cabs, maintained w/ minimal level of insurance on each
(Taxi that ran over П Walkovsky is owned by company that Carlton owns)
П wants to hold all SHs of 10 corps liable b/c they “operated as a single entity, unit, &
enterprise”
Mangan v. Terminal Transp. Sys. (NY taxi case) П injured as result of negligent operation of
cab owned & operated by 1 of 4 corps affiliated w/ Δ – ct pierced veil & held Δ liable even
though Δ wasn’t SH of any of the operating companies b/c Δ’s name was displayed on side of all
taxies used in enterprise & Δ serviced, inspected, repaired & dispatched them
Rule To win, П must argue that Δ Carlton was:
Conducting business in his individual capacity, AND
Was not actually using the corporate form
o Didn’t have books or records
o Corp were undercapitalized
o Shuttling personal funds in and out
o Corp had no other purpose but to limit liability
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Holding ct finds the veil should likely be pierced, as the cabs were undercapitalized, BUT the
П here did NOT assert the right argument
Tells П to amend his argument to assert that corporate boundaries weren’t being
followed; that Δ was operating corps for his personal benefit; that there was no
formalities observed by the corp П must show the corp had no other purpose than
to limit liability
Ct says to look for: lack of meetings, shuttling money in and out of company (moving
funds freely btw corps demonstrates no regard for the corp as an entity), taking all
$ out of corp as soon as it had any profit, not treating the corp as an entity that was
economically viable
Takeaway the corp veil will be pierced where the corp is a dummy for its SHs
Limited Liability Against Tort Claimants (pp.234-39)
LL easy to justify against contract creditors, not so easy for tort creditors
Legislative trend now is not only to preserve but to extend limited liability
In publicly held corps, policy reasons for limited SH liability is b/c management is not
vested in the SHs, thus the control predicate of vicarious liability is missing
Legislature more willing to make firms bear risks they weren’t at fault for creating than
to require individuals to bear such risks.
Piercing the corporate veil allows cts to impose liability on SHs in appropriate cases
Although in practice it’s only applied to close corps and subsidiaries
Wachter knows of NO public corps when there’s been piercing of corp veil
Minton v. Cavaney (pool drowning – THE case that everyone follows – comes close to saying that
undercapitalization is enough for piercing)
Facts: (CA S/Ct 1961) П’s daughter drowned in a pool owned by Seminole corp, which was
partly owned by Δ (also director/secretary/treasurer); b/c Seminole was broke, П sued Δ
Cavaney
Rule equitable owners of a corp are personally liable when they treat the assets of the corp
as their own & add/withdraw capital from the corp at will; when they hold themselves out as
being personally liable for the debts of the corp; or when they provide inadequate
capitalization & actively participate in the conduct of corp affairs
For undercapitalization, what matters is NOT capitalization @ time of accident, but if
there was ever was adequate capitalization
Holding Ct find the “business” was undercapitalized from the beginning compared to
business to be done & risks of loss, therefore the Δ as an owner CAN be held liable, BUT Δ can’t
be held liable for debts of Seminole w/o an opportunity to re-litigate these issues
П can’t just rely on judgment against Seminole, needs to re-litigate issues of Seminole’s
negligence & amount of damages sustained by Пs
Arnold v. Browne (CA 1972) (evidence f inadequate capital NOT sufficient alone to pierce the corp veil,
merely a factor to be considered by the T/Ct, doesn’t require piercing)
Slottow Fidelity Bank v. Am. Casualty (9th Cir. 1993) (corp was undercapitalized, ct says under CA law –
inadequate capitalization of a subsidiary may alone be a basis for holding the parent corp liable for the
acts of the subsidiary)
Truckweld Equipment v. Olson (WA 1980) (Olson acquired Aztec when financially troubled, ct says
though corp may be so thinly capitalized as to manifest a fraudulent intent, NO rule of law requires a
corp’s SH to commit additional private funds to an already faltering corp)
Radaszewski v. Telecom Corp (8th Cir. 1992) (adequate insurance properly capitalized)
Collet Test (from Montana case): in order to pierce corp veil, a П must show that the Δ’s
control of a subsidiary has:
been used by the Δ to commit fraud or wrong
to perpetuate the violation of a statutory or other positive legal duty, or dishonest &
unjust act in contravention of П’s legal rights
o
o
o
o
o
o
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Holding the purpose of asking whether a subsidiary is properly capitalized is to determine its
financial responsibility – if the subsidiary is financially responsible (whether by insurance or
otherwise ) – the policy behind the Collet test is met
Insurance meets this policy just as well, perhaps even better, than a healthy balance
sheet
o Sea-Land Services, Inc. v. Pepper Source (Illinois 2 prong piercing test – unity of interest & unjust
circumstances )
Facts: (7th Cir. 1993) П shipping company shipped peppers for Δ, Δ stiffed П on large freight bill.
Δ then dissolved for failure to pay state franchise tax, apparently had no assets. П brought suit
against Marchese & 5 businesses he owns
Rule: Ct applies Illinois law & test for corporate veil-piercing in Van Dorn Co. v. Future
Chemical & Oil Corp two prong test for piercing corporate veil:
1) must be such unity of interest & ownership that the separate personalities of the
corp and the individual (or other corp) no longer exist. Illinois cases looks at 4 factors
for this determination:
o Failure to maintain adequate records or to comply w/ corporate formalities
o The commingling of funds or assets
o Undercapitalization
o One corp treating the assets of another corp as its own (Van Dorn)
2) circumstances must be such that adherence to the fiction of separate corporate
existence would sanction a fraud or promote injustice
Holding PS was one of a handful of companies owned by Δ Marchese – ct held that PS was
but one of Marchese’s playthings, Marchese was the “dominant force” behind all the corps
ct pierced the corp veil
PS never had a single corporate meeting, never passed bylaws, etc
Marchese runs all 4 companies out of same single office, same phone lines, same
expense accounts
His corps borrow money from each other
He didn’t even have a personal bank account
Second prong is met b/c Δ intentionally manipulated & diverted corp funds away from
creditors
o Berkey v. Third Ave. Ry. Co. (NY 1926, Cardozo) (principle/agent relationship)
Dominion may be so complete, interference so obtrusive, that by eth general rules of agency
the parent will be a principal and the subsidiary an agent
Even when there isn’t clear control for “proper” agency – look to see if it the attempted
separation btw parent & subsidiary will work a fraud upon the law
o Carte Blanche (Singapore) v. Diners Club Int’l Inc. (2d Cir. 1993)
Issue whether the policy behind presumption of corporate independence & limited SH
liability(encouraging business development) is outweighed by policy justifying disregarding the
corporate form (need to protect those who deal w/ corp)
Direct Liability
o U.S. v. Bestfoods (parent can be held liable WITHOUT piercing the corp veil on the ground that the
parent is DIRECTLY liable for wrongs committed in directing sub’s operations)
Facts: (US S/Ct 1998) Ott Chemical manufactured chemicals at plant & significantly polluted soil
& ground water by intentionally & unintentionally dumping hazardous materials over time. Ott
was wholly owned subsidiary of CPC Int’l – US sued CPC under CERCLA
Rule Generally, parent corp not liable for subsidiaries by exercising stockowner control. BUT,
a parent corporation can be directly liable for its own actions in operating a facility owned by
its subsidiary
If parent directly controls operations of facility liable
o To “operate” means to exercise direction over the facility’s activities
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Employees of parent corp on board of sub. Isn’t enough alone to holding parent liable
need to show that they were acting as CPC officers
There is evidence that an agent of CPC actively participated in and exerted control over
variety of Ott environmental matters
o Kinney Shoe Corp. v. Polan (permissive 3rd prong – if there’s a contract you assume the risk if you don’t
investigate credit of the corp first)
Facts: (4th Cir. 1991) П subleased portion of building to Indus. Corp, owned entirely by Δ;
Industrial had no assets, no income, observed no corp formalities, no stock, kept no minutes. П
filed suit against Δ when Industrial didn’t pay the rent
Rule Ct adopted the standard two prong test, examined the viability of 3rd prong for contract
creditors they will be expected to have investigated the assets of the corp and assumed the
risk when they contract w/ them
Holding Ct finds the 3rd prong permissive – asserts that here, Δ established that corp entirely
as a shell and thus he is liable.
Summary of Requirements for Piercing the Corporate Veil
o
o
Mere undercapitalization is not sufficient to establish that the veil should be pierced, it’s only one of
several factors to be considered
If the corporation was completely dominated, such that it had no existence of its own, it’s a likely case
for piercing; this will be shown by:
1) absence of formalities of corp existence
2) personal use of corp funds through commingling of funds/assets
3) one corp treating the assets of another as its own
4) inadequate capitalization
Equitable Subordination of Shareholder Claims
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Doctrine of Equitable Subordination
o When a corp is in bankruptcy, debt claims that a controlling SH has against the corp may be
subordinated to the claims of other persons, including the claims of preferred SHs, on various equitable
grounds
Taylor v. Standard Gas & Elec. (US S/Ct 1939) Ct subordinated the parent’s claim, as a creditor of the
subsidiary, to the claims of other creditors & preferred SHs of the subsidiary because:
o Parents’ improper management of the subsidiary for the parents’ benefit
o The subsidiary had been inadequately capitalized
Gannett Co. v. Larry (when П’s “disastrous experiment” goes bad, his claim can be subordinated to claims of
other creditors who wouldn’t be benefited by the experiment)
o Facts: (2d Cir. 1955) П purchased all stock of Berwin Paper & converted it from publisher to newsprint
supplier – Berwin became insolvent & trustee in bankruptcy was appointed
o Holding ct subordinated П’s claim for sums it had loaned to Berwin to the claims of other creditors
b/c П lent money not to make Berwin profitable, but to change it entirely (for П’s use) – so it would be
inequitable to pay П first since the change didn’t benefit creditors
Didn’t require proof of fraud or illegality
Undercapitalization is important here – just as in piercing corp veil cases
o Equitable remedy for subordination is much less drastic
o It’s easier to get subordination of a controlling person’s claim based on a lesser evidence of misuse of
corp form than what’s required to pierce corp veil (impose affirmative personal liability for all corp
obligations)
o Arnold v. Phillips (importance of undercapitalization in equitable subordination)
Facts: (5th Cir. 1941) П A formed brewery company & lent brewery $75K, business had large
losses, П advanced large additional $, brewery went bankruptcy.
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Holding Mortgage held by П to secure loans held invalid on ground of inadequate
capitalization for $ he loaned the brewery to build & equip plant, but valid as to subsequent
advances made after brewery became going concern.
What П contributed to plant was actually intended to be capital
Benjamin v. Diamond (5th Cir. 1977) (3 conditions required for equitable subordination)
o Three Conditions must be satisfied before exercising power of eq subordination:
1) claimant (who may be owner, director, or officer of bankrupt corp) must have engaged in
some type of inequitable conduct
2) the misconduct must have resulted in injury to the creditors of the bankrupt corp OR
conferred an unfair advantage on the claimant; and
3) eq subordination of the claim must NOT be inconsistent w/ the provisions of the Bankruptcy
Act
o In determining whether these conditions are met, should look to 3 principles:
1) ineq conduct directed against the bankrupt corp or its creditors may be sufficient to warrant
subordination of a claim irrespective of whether it was related to the acquisition or assertion of
that claim;
2) A claim or claims should be subordinated only to the extent necessary to offset the harm
which the bankrupt and its creditors suffered on account of the ineq conduct;
3) An objection resting on eq grounds must contain some substantial factual basis to support
its allegation of impropriety
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Fraudulent Transfers
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Legal rule that is closely related to piercing based on under-capitalization
Transfers made by a corp w/o an equivalent exchange
o Under Bankruptcy Code, a transfer by corp to its SHs w/o an equivalent exchange (such as a dividend)
can be recovered on the corp’s behalf if the transfer left the corp w/ unreasonably small capital to
engage in business
Counts both business the corp was already engaged in or was about to engage in
Uniform Fraudulent Transfer Act §4 – Transfers Fraudulent as to Present & Future Creditors
o (a) a transfer made or obligation incurred by a debtor is fraudulent as to a creditor, whether the
creditor’s claim arose before or after the transfer was made or the obligation was incurred, if the
debtor made the transfer or incurred the obligation:
(1) with actual intent to hinder, delay, or defraud any creditor of the debtor; or
(2) without receiving a reasonably equivalent value in exchange for the transfer or obligation,
and the debtor:
(ix) was engaged or was about to engage in a business or a transaction for which the
remaining assets of the debtor were unreasonably small in relation to the business or
transaction; or
o (ii) intended to incur, or believed or reasonably should have believed that he or
she would incur, debts beyond his ability to pay as they became due
o So a transfer is fraudulent when:
There’s intent to deceive or defraud creditor
Or if there’s exchange, doesn’t have reasonably equivalent value
If you’re П’s lawyer, you’d prefer piercing over fraudulent conveyance
o b/c for fraudulent transfer, you have to go after EACH transaction
The Monitoring Board
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Purpose of board controls managers b/c the insiders have an interest to divert resources to their own use &
SHs are dispersed & “rationally apathetic”
o Board manages & directs the business & affairs of corp
o Directors appoint the exec officers who run the corp on a day-to-day basis; they “own” the firm in
terms of controlling its assets
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The SHs can:
Elect directors & amend bylaws
Vote on certain extraordinary decisions
Mount derivative suits on behalf of the corporation
o In reality – the board does NOT control the corp
Having full time professionals doesn’t help b/c they will be either under the CEO’s thumb or are
rivals to the CEO
Instead, the Monitoring Board has developed
o The Board will no longer be a mere figurehead, but will have real power, but power separate & distinct
from that of the CEO
o The board will necessarily be made up significantly of outside directors
o It will have an oversight function
ALI’s Principles of Corporate Governance supports this movement
o Unlike DE law, which doesn’t have statute delineating what constitutes an outside or independent
directors, the ALI comes up w/ the idea of the “independent director”
o ALI §3.01 – says board should be made up of a majority of independent directors
o ALI §3.02(b) – gives the Board to initiated corporate plans, adopt changes in accounting principles,
make recommendations to SHs, and to create committees
ALI supports different committees:
Independent nominating committee
Audit committee (§38.04)
Compensation committee
o ALI §3.04 – establishes independent directors who are not themselves experts, but can independently
hire their own outside counsel & outside experts
Even if there’s a CEO on the board, an indep director can hire outside expertise
Has become effectively the way corporate governance works today in the US (NYSE now
requires some independent directors)
o But important to understand that many corporate practices are NOT mandated, but accepted as good
forms of corporate governance
Good corp governance is important to the multiples that Wall Street will attach to the corp
Important to follow “best corporate practices”
The ALI is principle NOT law
o Most of the ALI provision were adopted by the NYSE as part of their rules
o The Sarbanes-Oxley Act took the ALI model & took if further:
SEC requires a corp to have independent directors if it wants to be listed on the national stock
exchange
Audit committee must be made up of independent directors, at least one has to be an expert in
finances; and the outside auditors now reports directly to the Committee (not to the CEO)
Information Rights & Voting
Shareholder Information Rights Under State Law
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Inspection of Books & Records
o DGCL §219 gives SH right to see the stockholder list. You can get it 10 days before a SH meeting and it
has to be for the purpose of that meeting
the list of SH really just comes out to about 4 SH – the depositories (b/c today most stock is
held in “street name” – the bank’s name or the broker’s name)
voting mechanism is complex b/c of question of who actually owns the stock
If you get the SH list – it’s the NOBO list (non-objecting beneficial owners)
R.B. Assocs. Of NJ v. Gilette Co. (DE Chan. 1988) (corp can’t be forced by SH to create a
NOBO list which it didn’t already have)
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o
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DGCL §220 must more helpful – gives the SH the right to get books & records
Can’t get just ANY records, must establish any proper purpose
Can get the corp’s stock ledger, list of SHs, books & records, a subsidiary’s boos & records w/in
certain limitations
§220 suits are key to derivative suits by SHs. Initiate a 220 suit in order to get the actual info
that can be used as the basis of the derivative suit itself
Pillsbury v. Honeywell (SH purpose only proper if the reason behind a SH’s desire to communicate is proper)
REPUDIATED by Credit Bureau
o Facts: (Minn 1971) П Pillsbury bought into Δ stock, he opposed Vietnam War & asked for all corp
records dealing w/ weapons manufacture – П admitted his only purpose was to try & persuade
Honeywell to stop manufacturing weapons, but argued the desire to communicate w/ other SHs was a
proper purpose
o Rule a mere desire to communicate w/ other SHs is not a proper purpose per se –SH needs to have a
proper purpose for such communication
Minn. Ct. used DE law b/c Δ was DE corp, but assumed DE law was no different than Minn. law
o Holding ct held for Δ Honeywell, b/c П’s only purpose was to assert ownership privileges in an effort
to get Δ to stop producing weapons.
Both DE law and ALI §2.01 would seem to conflict w/ the Pillsbury’s view of proper cause
o Pillsbury was repudiated by DE S/Ct in Credit Bureau Reports, Inc. v. Credit Bureau of St. Paul in so
far as it’s related to requests for SH lists
says “any further or secondary” purpose ancillary to the main purpose of soliciting proxies for a
slate of directors in opposition to management (which purpose is necessarily a legitimate SH
interest) is irrelevant
As long as there’s some proper purpose behind request for SH list, possessing other improper
purposes doesn’t matter
Improper v. Proper purpose
o Proper purposes include:
Determining financial situation of corp to evaluate the value of SH’s shares
Determining if there had been mismanagement
What constitutes mismanagement will have broader possibilities under ALI than under
DGCL (ALI allows ethical considerations even though a corp should operate w/ a view to
enhancing profits)
o Improper purposes include:
Annoying & harassing the directors
Fishing expeditions (can’t just “find out what’s going on”)
Mere curiosity as to the operation of the corp
Selling the list to another party
Anything where the SH is acting in bad faith
Seinfield v. Verizon Communs. (“credible basis” standard – need to prove by preponderance of evidence that
there’s credible basis in П’s allegation of proper purpose)
o Facts: (DE S/Ct 2006) П brought §220 suit to compel П to produce books & records related to
compensation of Δ’s 3 highest corp officers from 2000-02, П claim their compensation was excessive &
wasteful
o Rule DE law requires П to present some ev that establishes a credible basis from which the ct could
infer there were legitimate issues of possible waste, mismanagement or wrong doing that warranted
further investigation
o Holding П didn’t show proper purpose
Turns down П’s argument of “insurmountable barrier for the minority SH” (requiring evidence
to get to the books & records “evidence” is too hard on SHs)
П’s disagreement w/ BoD’s BJ is not sufficient evidence, SH needs some evidence of
mismanagement or that BoD is being wasteful
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§220 and the “proper purpose” requirement are the result of ct’s attempt to balance the rights
of SH to info against interest of corp not to be messed with.
Saito v. McKesson HBOC, Inc. (if related to proper purpose, SH can get info & records under §220 from period
before П became SH)
o Facts: (DE S/Ct 2002) McKesson then merged w/ HBOC (HBOC became sub); Δ then announced series
of financial restatements & reduced revenues due to accounting irregularities. П bought stock in Δ corp
after the merger
П first brought suit in Ash alleging mismanagement of the merger involving breach of director’s
duty suit dismissed by Chan. Ct b/c П didn’t use right basis to bring suit, suggest using §220
П brought case under §220 – seeking docs including those relating to the pre-merger review &
verification of financial info; communs. btw i-bankers & accountants; and reports made by
outside financial directors
Chan Ct. found П stated proper purpose for §220 request, but ONLY as to those subsequent to
his purchase of stock
o Rule If activities occurring before purchase date are “reasonably related” to the SH’s interest in a
proper purpose, then SH should be given access to records necessary to understand those activities (no
automatic cut-off date in §220 action)
To bring a SH derivate suit under §327, you have to be SH during period of wrongdoing;
however, you don’t have to be SH during period you’re seeking info from if that info is relevant
to the suit.
o Holding П can get info prior to period when he was a SH if it was related to the proper purpose
(advisors’ reports & correspondence, except for anything created by advisors (working papers), and
HBOC docs were all relevant)
Steps of a §220 suit analysis
o Filing purely technical
o Look to whether there is a proper purpose
o Look to whether the П can show, by a preponderance of the evidence, that the claim (such as
mismanagement) indeed must be true
Doesn’t have to prove it, just raise by preponderance
o П bears burden of proving that each category of books & records is essential to the accomplishment
of the SH’s articulated purpose of inspection
o “a section 220 proceeding should result in an order circumscribed w/ rifled precision” – Norm Veasey
Shareholders Informational Rights under Federal Law & Stock Exchange Rules
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Overview of Stock Markets
o Primary Markets: original sale of securities by governments and corporations
Corps engage in two type of primary market transaction – public offers & private placements
Public offers of debt & equity MUST be registered w/ the SEC
Private placements do NOT have to be registered
o Secondary Markets: Those in which these securities are bought and sold after the original sale
Investors more likely to buy securities in a primary market when they now they can be resold if
desired
Two kinds of secondary markets – dealer & auction markets
Dealers buy for themselves @ their own risk
Auction markets have a physical location – primary purpose is to match those who wish
to sell w/ those who wish to buy
Overview of the SEC and the Securities Exchange Act (SEA)
o ’34 Act – created the SEC & the rules promulgated there under
IDs and prohibits certain types of conduct in the markets & provides the Commission w/
disciplinary powers over regulated entities and person associated /w them
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Empowers the SEC to require period reporting of info by companies w/ publicly traded
securities
o ’33 Act – deals more w/ selling of securities
Both passed after the 1929 stock market crash
o See ’34 Act §12(a), (b), (g); rule 12g-1
o §13(a) – reports by issuer of security
o §13(d) – reports by persons acquiring more than 5% of certain classes of securities
§13(d)(3) says when 2+ persons act as a partnership or other group for the purpose of acquiring
securities, such syndicate or group shall be deemed a “person” for purposes of this subsection
Periodic Disclosure Under the SEA
o SEA §13 – Periodical and other Reports
§13(a) – the contents of reports by issuer of security, must file w/ the SEC. Also says what form
the report has to be in.
o SEA §10(k) – Annual Reports
Contains the company’s earnings & the risks to business plan, IDs competitors, specifies what
bad things may happen, whether there’s outstanding litigation
Annual reports governed by R.14a-3
o SEA §10(q) – Quarterly Reports
Include quarterly financial data, management report, disclosures concerning legal proceedings,
defaults on senior securitites
o SEA §8(k) – Reports that have be filed w/in 4 business days after the occurrence of certain events:
Change in control of the corp
Acquisition or disposition of a significant amount of assets
A change in accountants
Termination of a material definitive agreement
Departure of a director or principal officer
Amendments to by-laws or articles or code of ethics
Transactional Reporting
o Proxy Rules require full disclosure in connection w/ transactions that SHs are being asked to approve –
e.g. mergers, certificate amendments, or election of directors
Introduction to Proxy Rules
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Definitions
o Proxy holder person authorized to vote shares on a SH’s behalf
o Proxy, form of proxy, & proxy form the written instrument in which such an authorization is
embodied
o Proxy solicitation the process by which SHs are asked to give their proxies
o Proxy statement a written statement sent to SHs as a means of proxy solicitation
o Proxy materials the proxy statement and form of proxy
Purpose of proxy rules require full disclosure in connection w/ transactions that SHs are being asked to
approve
o NOTE: different from rule 10(b)(5) – which governs general non-proxy statements and where you need
to show scienter
Solicitation Rules
o Rule 14a-3 provides no solicitation of proxies that is subject to the Proxy Rules shall be made
UNLESS the person being solicited “is currently furnished or has previously been furnished w/ a written
proxy statement containing the info specified in Schedule 14A”
Schedule 14A lists in detail info that must be furnished when specified types of transactions are
to be acted upon by SHs
o Rule 14a-9 backs up 14a-3 and Schedule 14A by providing that no solicitation subject to the Proxy
Rules shall contain any statement that is false or misleading with respect to any material fact or omits a
material fact
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Gives an implied private right of action for breach of §14(a)
Broad in scope
Covers more than just proxy solicitations – even ads in the paper
§14(a) – Solicitation of Proxies in Violation of Rules & Regulations
o It shall be unlawful for any person… in contravention of such rules & regulations as the Commission
may prescribe as necessary … to solicit tor to permit the use of his name to solicit any proxy or consent
or authorization in respect of any security … registered pursuant to §12 of this title
§14(e) – Untrue statement of material fact or omission of fact with respect to tender offer
o It shall be unlawful for any person to make any untrue statement of a material fact or omit to state any
material fact necessary in order to make the statements made … not misleading… in connection with
any tender offer or request or invitation for tenders or any solicitation of any security holders in
opposition to or in favor of any such offer, request, or invitation. THE commission shall… define &
prescribe means reasonably designed to prevent, such acts and practices as are fraudulent, deceptive
or manipulative
Definitions in relation to §14
o §14a-1(f) the term “proxy” includes every proxy, consent or authorization w/in the meaning of §14(a)
of the act. THE consent or authorization may take the form of failure to object or to dissent
o Coverage: §14a-2 provides that Proxy rules “apply to every solicitation of a proxy w/ respect to
securities registered pursuant to §12 of the Act”
o What constitutes a solicitation of a proxy?
§14a-1(l) the term “solicitation” includes: (i) any request for a proxy… (ii) any request to
execute or not to execute or to revoke a proxy
Studebaker Corp. v. Gittlin (ct held a letter which didn’t request the giving of any authorization
was subject to the Proxy rules if it was part of “a continuous plan” intended to end in
solicitation and to prepare the way for success)
o Required to file: Rule 14a-3 – Information to be Furnished to Security Holders
Persons solicited have to contemporaneously provide them w/ a proxy containing the info
provided in Schedule 14A
HUGE filing requirements
Proxy Rules
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Proxies are the written instrument in which an authorization to vote on a SH’s behalf is embodied
o Proxy voting dominant mode of SH decision-making in public-held corporations; b/c the SHs are so
dispersed, it’s logically unfeasible for all of them to physically attend the meetings
o Proxy solicitation process by which SHs are contacted and urged to execute and return proxy forms
Regulation 14A – Solicitation of Proxies
o Rule 14a-1
14a-1(a)(l)(1): “solicitation;” {if there is no solicitation, then the proxy rules don’t apply}
solicitation can mean
(i) any request for a proxy whether or not accompanied by or included in a form of
proxy
(ii) any request to execute, not execute, or revoke, a proxy
(iii) the furnishing of a form of proxy or other communication to security holders under
circumstances reasonably calculated to result in the procurement, withholding, or
revocation of a proxy
14a-1(a)(l)(2): a solicitation is not such things as (i) giving a shareholder a proxy upon their own
request, (ii) performing acts required by Rule 14a-7, (iii) performing ministerial acts for
someone who’s actually soliciting a proxy, or,
(iv) a communication by a shareholder who does not otherwise engage in proxy
solicitation stating how he is going to vote that is:
o (A) made by way of public forum, media, etc;
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(B) that is directed to persons to who whom he has a fiduciary duty in
connection with the voting of securities of a registrant held by the security
holder, or
o (C) that is made in response to unsolicited requests for additional information
with respect to a prior communication by the security holder made pursuant to
this paragraph (l)(2)(iv)
o Rule 14a-2: Solicitations to Which Rule 14a-3 -- 14a-15 Apply: they apply to every solicitation not
exempted in this rule; such exempted solicitations are:
14a-2(a) Rules 14a-3 to 14-a15 do not apply to; companies transmitting forms from the corps.
to the actual shareholders
14a-2(b): Rules 14a-3 to 14a-6 (other than Rules 14a-6(g), 14a-8, and 14a-10 to 14a-15) do not
apply to the following:
(1): if you are soliciting but not looking for the power to act as the shareholder’s proxy,
provided that the exemption does not apply to (i) the corporation, (ii) officers of the
corporation, (iv) nominees for director, (v) any person soliciting in opposition to a
merger, extraordinary transaction, etc.
o 14a-2(b)(1)(ix) the exemption does not apply to any person who has a
substantial interest in the solicitation
(2) if it is a solicitation made to less than 10 shareholders that is not done on behalf of
the corporation
(3) if you are furnishing proxy voting advice to any person with whom you have a
business relationship, if the advice is rendered in the ordinary course of business and
no special commission is received
o Rule 14a-3. Information to Be Furnished to Security Holders; persons solicited have to
contemporaneously provided with a proxy containing the information provided in Schedule 14A
Schedule 14A [p. 1868] Information Required in Proxy Statement the “Big One”
requires a massive amount of detail to be revealed; the place and time of the meeting
Item 4: the identities of the solicitor of the proxy must be revealed
Item 5: the interests of the solicitors must be revealed
o Rule 14a-6. Filing Requirements [p. 1854]
14a-6(g); Solicitations subject to 14a-2(b)(1): any person who engages in solicitation and owns
shares with a value of over $5 million shall file a Form of Notice of Exempt Solicitation; no
submission need be made with respect to oral solicitations or those appearing or published in a
media outlet
Three Step Approach to Filing Requirements Under the Proxy Rules
o (1) Is it a solicitation? See 14a-1(l)(1), esp subdivision (III), which provides that a solicitation includes
any communication reasonably calculated to result in getting a proxy
Any request for a proxy
Any request to execute or not to execute or revoke a proxy;
Furnishing of the form of proxy or other communication which under circumstances reasonably
calculated to result in the procurement, withholding or revoking of proxy.
it is NOT a solicitation if it only says how the person requesting the proxy is going to vote,
without telling people how they should vote; or that is made in a public forum without actually
otherwise soliciting proxies
o (2) If a solicitation, do they have a file a proxy under Schedule 14A – or is it exempt? 14a-3 triggers a
need to file 14A (the Big One). See 14a-2 for solicitations to which 14a-3 and 14a-4 do NOT apply:
14a-2(b)(1) is the big exception here
14a-2(b)(2) – you do NOT have to file 14A if the solicitation is to fewer than 10 SHs
14a-6(g) applies to solicitation of a class w/ MV>$5mil
14a-7 registrant must provide a SH list if requested
14a-9 false/misleading statements are prohibited
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o
(3) If exempt from filing 14A, are there still filing requirements? See 14-a-2(b)(2) & 14a-6(g), 14a-7, &
14a-9
14a-6(g) states that it’s triggered ONLY by solicitations subject to 14a-2(b)(1) & where the
applicant owns more than $5mil in stock; such individuals provide the information in Notice of
Exempt Solicitation
Exceptions include a solicitation by public media & an oral solicitation
Oral solicitations thus have no filing requirements!
14a-7 provides the obligation of a registrant (person who registered shares under the SEA)
14a-9 covers false & misleading statements
Under 13(d)(1) & 13D, there is a filing requirement if the person has 5% of the stock. Must
file b/c 13(d)(3) states that a person can become a group for purposes of solicitations
Private Actions Under the Proxy Rules
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There is a right to provide action, but what kind of right?
o After Wyandotte, the ct decides that it’s under tort law
o For a tort claim, needs to show there is a duty to disclose, and that the Δ breached that duty, which
resulted in a harm when the П relied on that to her detriment.
There is NO need for intent
But, there are causation issues
Suits filed under §14a-9 – False or misleading statements
o Wachter sees these rights of private action as good b/c private law enforcement is one of the primary
solutions to the problem of corp directors/officers not being faithful fiduciaries
o SEC doesn’t have funding to prosecute all misleading statements, so Congress allows these suits by SHs
o As law current stands – to recover under 14a-9 suit you don’t need to show intent to deceive, you only
need to show negligence.
o SH only needs to prove materiality to establish causation – Mills v. Elec. Auto-Lite
J.I. Case Co. v. Borak (SH can bring either direct or derivative action for violation of proxy rules)
o Facts: (US S/Ct 1964) П SH sued for rescission or damages when a merger was consummated as
authorized by proxies solicited by proxy statement that П claims contained false statements
o Rule To have a private right of action for suit under a 14a-9 violation, there MUST be:
(1) misrepresentation of a material fact
(2) reliance
(3) evidence that the reliance caused harm
o Holding SH has a private of action against a Δ corp for issuing material false proxy statement right
is implied under the ’34 Act
Congressional purpose is present, but not the right to enforce it – so the ct creates the right
Cort v. Ash (4 factors to determine whether private remedy is implicit in statute)
o (US S/Ct 1975) – 4 factors to see if private remedy is implicit in statute:
(1) Is the П one of the class for whose especial benefit the statute was enacted? (does the
statute create a federal right in favor of the П?)
(2) is there any indication of leg intent, explicit or implicit, either to create such a remedy or to
deny one?
(3) is it consistent w/ the underlying purpose of the legislative scheme to imply such a remedy
for the П?
(4) is the cause of action one traditionally relegated to state law, in an area basically of State
concern, so that it would be inappropriate to infer a cause of action based solely on fed law?
Mills v. Electric Auti-Lite Co. (SH have right to informed vote, fairness of merger isn’t relevant if there was
material representation that was a necessary link to SH’s vote)
o Facts: (US S/Ct 1970) П is minority SH of Δ corp which is merging w/ ML. П claims the proxy statement
from EAL included misleading statement – specifically that it neglected to mention that the BoD at EAL
were also board members at ML & owned 50% of stock.
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Rule if the statement or omission is material, that’s enough for a cause of action, do NOT need to
show the SHs relied upon it, merely that it was a necessary link
o Holding Overturns Ct/A’s upholding of material omission and refusal of damages b/c the merger was
fair – S/Ct says that fairness is NOT relevant – as long as there’s omission/misrepresentation that’s
enough
Also says SH can collect attorney’s fees even if there aren’t damages – fees are necessary b/c
need to create incentive for private actions
Fairness of merger terms ARE relevant to determination of damages
TSC Indus. V. Norway (US S/Ct test for materiality as applied to 14a-9)
o An omitted fact is material if there is a substantial likelihood that a reasonable SH would consider it
important in deciding how to vote
o Don’t require proof of a substantial likelihood that disclosure of the omitted fact would have CAUSED
the reasonable e investor to change his vote just that it would have assumed actual significance in
the deliberations of the reasonable SH
If there’s materiality, don’t need to separately show causality
Virginia Bankshares v. Sandberg (putting a break on implied private right of action – if there’s state remedy no
federal remedy is needed)
o Facts: (US S/Ct 1991) First Am. Bankshares (FABI) owned 85% of First American Bank of VA shares,
began a “freeze-out” merger to get the other 15%. Corps entered into merger agreement, Bank would
become wholly subsidiary of FABI.
FABI’s i-bank said $42/share would be “high price” and a proxy was sent out to the minority SHs
stating this (even though VA law didn’t require proxies) – but in reality $42/share was in the
low range of the stock value
Merger approved, but П minority SH in FABI claimed it wasn’t fair
Δ argue a statement of belief can’t be actionable as a misstatement of fact
o Rule statement couched in conclusory or qualitative terms purporting to explain directors’ reasons
for recommending corp action CAN be material misleading – but it can’t be shown in this case by
member of class of minority SHs whose votes are not required by law to authorize the corp action
o Holding Statement of belief by Δ directors can affect a reasonable SH’s vote – and thus CAN be
misleading (only if it’s a misstatement of what the speaker actually believes)
Here it was shown that the directors issued statement believing it not to be true AND that the
price wasn’t in fact fair but nevertheless no recovery b/c there was no causation (the board
wasn’t required to submit merger proposal for SH vote)
Ct very reluctant to extend a cause of action – remedy should have been found on state level
(right to appraisal or action based on defective vote)
Wilson v. Great American Indus., Inc. (П action not barred if false misstatements deprived them of state
remedy)
o Facts: (2d Cir. 1992) П minority SHs alleged material misstatements in proxy statement caused them to
exchange shares of Chenango stock for new preferred Great Am. Stock
o Holding П’s action is NOT barred under Virginia Bankshares if, as a result of false statements in the
proxy statements, the Пs have lost their appraisal right or some other state remedy
Cowin v. Bresler (D.C. Cir. 1984) (even SH who did NOT grant proxy in reliance on proxy statement has standing
to sue)
o Because the damage suffered results on the deceit practice on the SHs as a group, not the individual SH
alone
Gerstle v. Gamble (negligence is enough to establish liability under 14a-9, scienter not an element)
o (2d Cir. 1973) When П represent the class asked to approve the merger, they’re not required to
establish any evil motive or even reckless disregard of facts.
o US S/Ct has several times explicitly taken note of the position taken here – that scienter is not an
element of liability under 14(a), but declined to address issue
Adams v. Standard Knitting Mills (6th Cir. 1980) (says scienter should be an element of liability in private suits
under proxy provisionas they apply to outside accountants)
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Shidler v. All American Life & Financial Corp (8th Cir. 1985) (no liability w/o fault under §14(a))
Shareholder Proposals and Proxy Rules
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Two mechanisms under 14a for effective SH access to the proxy solicitation process:
o Rule 14a-7: Obligations…to Provide a List of…Security Holders requires a corporation that is itself
soliciting shareholders in conjunction with an annual or special meeting to provide specified proxy
solicitation assistance to requesting shareholders.
14a-7(a)(1)(ii): it must provide the number of shareholders of record, the number of beneficial
shareholders, or any more limited group of such holders, an estimate of the solicitation cost,
and copies of any proxy statement
the company is required to mail one copy of the shareholder’s proxy statement to
security holders
i.e. the corporation, or a shareholder, can opt to contact less than the whole body of
voting shareholders
this does not preempt laws such as DGCL §220, which have a “proper purpose” requirement for
shareholders to gain access to certain information
14a-7(c)(2)(i) also indicates that the mailing list can only be used for purposes relevant
to that of the shareholder meeting
further, the shareholder must be entitled to vote on the matter
he must defray the costs of mailing the proxy solicitation out
14a-7 is a benefit for shareholders; but it is less generous than state law, which allows access to
shareholders’ list on demand not only for use in connection with a proxy solicitation, but for
other “proper purposes”
o Rule 14a-8: Shareholder Proposals A “qualifying shareholder” may require her corporation to
include a “shareholder proposal” and an accompanying supporting statement.
(b)(1) any beneficial owner of 1% or $2000 of stock who has the stock for at least a year can
present a proposal for action in a proxy statement
(c) only one proposal per shareholder per meeting
(d) can only be 500 words or less
(f) company can exclude your proposal after notifying you if you have failed to follow the
procedural requirements
(g) company has the burden of proving that the proposal can be excluded
American Federation of State, County & Municipal Employees v. American Int’l Group, Inc. (if SEC changes
interpretation of rule, needs to offer sufficient reason)
o Facts: (2d Cir. 2006) П SH (public service employee union, had lots of corp’s stock through pension plan)
submitted SH proposal for inclusion in a proxy statement that would amend corp’s bylaws to require
publishing the name of SH-nominated director candidates along w/ board-nominees.
Corp excluded proposal from proxy statement, П filed suit
D/Ct held for Δ corp, found it properly excluded b/c it was related to an election (relied on SEC
interpretation of this rule)
o Issue whether a SH proposal requiring a corp to include certain SH-nominated candidates for the
BoD can be excluded from the proxy materials on the basis that the proposal is “related to an election”
under SEC R. 14a-8(i)(8)
o Rule agency’s interpretation of ambiguous regulation made @ time regulation was
implemented/revised should control UNLESS the agency offered sufficient reason for its changed
interpretation
o Holding SH proposal does NOT relate to an election w/in the meaning of 14a-8(i)(8) and therefore
can’t be excluded from corp proxy materials
Because language of rule was ambiguous & SEC ascribed two different interpretations to this
rule (1 when rule was published, another 16 yrs later) but since SEC didn’t offer sufficient
reasons for change interpretation – the 1st interpretation is the controlling one
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Original interpretation election exclusion limited to SH proposals used to oppose
solicitations dealing w/ an indentified BoD seat in upcoming election rejects broader
interpretation that the exclusion applies to SH proposals instituting procedures making such
election contests more likely
Reasons for Corp to EXCLUDE an otherwise eligible proposal from the proxy
o improper under state law (i.e. would be binding on the corporation; most recommendations or
requests are proper)
A by-law would be binding, a resolution would not be
o violation of law
o violation of proxy rules (including Rule14a-9)
o personal grievance; special interest; redress of personal grievance; benefit to one shareholder and not
shareholders at large
o relevance: if relates to operations which account for <5% of company’s total assets or net earnings and
gross sales and is not otherwise significantly related to the company’s business
SEC’s No-Action letter to Aon Corp (1997) proposal that board initiate policy mandating no
further purchases of tobacco found to be “otherwise significantly related’ to the corp’s business
& corp can’t rely on 14a-8(i)(7) to omit proposal
o absence of power/authority (Ø be able to implement it)
o management functions (deals w/ a matter relating to the company’s ordinary business operations)
SEC staff bulletin (2002): traditionally equity compensation plans have been considered
“ordinary business ops” b/c related to general employee compensation
Exception to “ordinary business” matters that focus on “sufficiently significant social policy
issues that “transcend the day-to-day business matters.”
Presence of widespread public debate may be indication of significant social policy issues.
SEC determined that in 2002 equity compensation plans for senior executive officers (not other
employees) was a social policy issue and that companies could not rely on 14a-8(i)(7) to omit
these proposals
Determined that “employment-related proposals that raise sufficiently significant social policy
issues” will be a significant policy issue (Crackel Barrel case)
o relates to election (election for membership on the company’s BoD)
o conflicts with company’s proposal (if conflicts in substance to one of the company’s own proposals it is
submitting at the same meeting)
o substantially implemented—company has already substantially implemented the proposal
o duplication—substantially duplicates another proposal previously submitted to the company by
another proponent that will be included in the company’s proxy materials for the same meeting
o resubmissions—deals w/ substantially the same subject matter as another proposal that has been
included in the company’s proxy material w/ in the preceding 5 years, a company max exclude it from
its proxy for any meeting held within 3 calendar years of the last time it was included if the proposal
received certain vote percentages in time frames.
If company intends to exclude the proposal it must: (14a-8(j)(1))
o file its reasons w/ the SEC no later than 80 days before it files its definitive proxy statement and form of
proxy
o must provide a shareholder with a copy of its submission
o company must (j)(2) file six paper copies of the following:
the proposal
an explanation fo why the company believes it may exclude the proposal
supporting opinion of counsel when such reasons are based on matters of state or foreign law
If the SEC agrees with management’s statement, it sends management a “no-action letter” stating that if the
shareholder proposal is omitted, no action will be taken by the SEC.
o If the SEC disagrees—it sends management a letter stating why the proposal should be included. If
management decides not to include it, there is an implicit threat of legal action.
AT&T (1994)
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At administrative hearing, SEC determined that even though SH proposal was related to less than 5% of
company’s assets – it WAS otherwisely significantly related to the comps business
o 14A-8(i)(5) permits the omission of a proposal if it relates to operations which account for <5% of
registrant’s total assets & is NOT otherwise significantly related to the registrant’s business
See p.306 for 14a-8(i)(7) exclusions
Roosevelt v. E.I. Du Pont de Nemours & Co. (П SHs can’t propose that the corp implement policies in a specific
manner)
o Facts: (D.C. Cir. 1992) П wanted Δ corp to phase out its production of chlorofluorocarbons in quick
manner than it was already doing. Δ sought to exclude proposal from proxy & SEC issued no-action
letter as it judged the letter to relate to ordinary business operations, П filed suit to have it included
anyway
o Holding there IS a private right of action under §14(a) to enforce company’s obligations to include
SH proposal in proxy materials
However, here the П had no right to include proposal in materials. Beyond the fact that Δ corp
has already sped up reduction of CFCs, the proposal is a matter related to ordinary business
operations – properly excluded under 14a-8(i)(7).
International Brotherhood of Teamsters v. Fleming (DE ct hasn’t decided this issue, but would probably go
AGAINST this decision b/c of DGCL §141(a))
o Facts: (OK 1999) Directors of Fleming had poison pill plan that could potentially harm SH’s interests. Пs
Teamsters proposed bylaws requiring any SH rights plan be subject to SH majority vote – Δ refused to
put this in proxy statement, asserts SHs can’t restrict directors’ ability to pass such plans by going
through the bylaws
o Holding OK S/Ct determined the right to pass such poison-pill/SH rights plans is NOT restricted only
to the directors; but that SHs may pass them
General Datacomm Indus. V. Wisconsin Invest. Board (not in fall 2007 reading)
o Facts: П corp seeks declaratory relief from Δs (institutional SH)’s attempt to include a proposal in the
proxy statement about allowing SH control over stock-option repricing
o Holding Chan Ct refused to rule on this matter till a vote had been taken by the SHs on it; it was not
yet ripe for adjudication
Computer Associates, Inc. v. AFSCME Pension Plan (Shareholders may propose bylaws that dictate the process
through which board decisions are made but not the decisions themselves per 141. Shareholders may not
propose bylaws that would cause the BoD to violate the triad of duties.)
o Facts: AFSCME, an institutional shareholder of Computer Assoc. (CA) wants to propose a bylaw that
requires reimbursement of proxy expenses related to BoD elections. CA decides this is not a proper
subject matter for a shareholder proposed bylaw amendment and requests an SEC “no-action” letter.
o Procedure: DE ct. gets involved when SEC is faced with two arguments (it is proper/it isn’t).
o Holding Big deal here is first: Can AFSCME suggest something that limits the power of the board?
Yes. So long as the bylaw only suggests limits on process of decision making and not decision making
itself (109(a) gives the SH the power to suggest bylaws but that is limited by 141). Here it is especially
OK because it has to do with shareholder voting. Second: So if you can suggest something that limits
the BoDs power what else is required? Cannot violate state law. Here comes the triad of duties. If a
BoD is required to reimburse all proxy expenses related to elections, what if said reimbursement violate
the fiduciary duty the BoD owes the shareholders? Pretty likely hypo so DE Ct. says it’s a no go.
o End result: Proper subject matter but would violate state law so AFSCME can’t do it.
Proxy Contests
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Classical proxy fight in 1960s – run a slate of Directors in opposition to that slate offered by management – “the
pure proxy fight”
o They are different today due to the SH’s rights plans
o The 3rd sort of fight is over the SH proposals, though the SHs usually lose the vote
A proxy contest = any competition btw two competing factors to obtain SH votes on a proposal
o Built in advantages for management:
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SHs tend to vote for management
Management can use corporate funds to pay for its arguments
Management knows who the SHs are and how much each owns so that they can plan a strategy
accordingly
Insurgents have to litigate to get those lists
Rosenfeld v. Fairchild Engine & Airplane Corp (who pays expenses of proxy battle?)
o Facts: (NY 1955) П is SH of Δ corp w/ 25 out of 2.3mil shares, want to compel return of $261,422 paid
out of the corp treasury to reimburse both sides’ expenses in a proxy contest
o Rule black letter law is that in proxy contests, both groups are held to standard of reasonable &
proper expenses:
For incumbent directors acting in good faith in soliciting proxies & defending their corporate
policies AND/OR
For successful insurgent groups, where after gaining power, such groups can receive
ratification by SHs for reimbursement
Corporate funds CAN’T be used for proxy fights over personal difference; must be trying to take
over the company for policy reasons
o Holding here the П doesn’t argue the sums paid by corp were unfair or unreasonable, П’s action
denied.
Reimbursement permissible as long as the contest involved permissible policy dispute, rather
than personal attempt to entrench, as long as SH approve plan
o NOTE both sides usually get reimbursed, b/c the old board has corp pay expenses before they leave.
The losing insurgents can get expenses if SHs approve.
Duty of Care
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Basic Standard of Care
o Duty of care is a negligence standard!
o Duty of care is NOT in the DGCL – first time the duty of care analysis appears is in Aronson v. Lewis
o Duty of care is a jurisdictional boundary more than a standard of review ct says it will not mess
w/ business judgments UNLESS those BJs are procedurally problematic
Thus most of duty of care is not substantive review, almost entirely procedural
Basic Standard of Care
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Francis v. United Jersey Bank (poor Mrs. Pritchett, you can’t do nothing as a director & turn a blind eye)
o Facts: (NJ S/Ct 1981) Have a family held reinsurance brokerage firm. Pritchett senior had founded and
ran the corporation. Two sons also "ran" the firm. The wife, Lillian Pritchard, became the "director" of
the firm. Ms. Pritchard didn't do anything as director--- she didn't even look at the financial statements.
Sons ultimately misappropriated trust funds.
o Court decided that her "nonfeasance" was actionable and that the estate was liable for paying back
money to shareholders. Held that she was personally liable for negligence in failing to prevent the
misappropriation.
o Court applied a standard of ordinary care. Insisted that directors should acquire at least a rudimentary
understanding of the business of the corporation.
o Have to show that she:
had a duty to her clients
breached that duty
her breach was proximate cause of their losses
o “if she would have read the financial statements she would have known that her sons were converting
trust funds.”
No Note that in DE there is a zone of insolvency; where a company is close to bankruptcy, the
fiduciary duties of the Directors switch from protecting the shareholders to the creditors; they
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can no longer take a big risk that will injure the creditors, though it may help the shareholders
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Nonfeasance is more difficult for causation—determination of the reasonable steps a director should
have taken and whether that course of action would have averted the loss.
Is this really a duty of care case? What's going on here? Why are they going after poor Mrs. Pritchard?
They are going after her estate--- really a fraudulent conveyance, piercing the corporate veil
case parading around as a duty of care case.
As a director, you can't do nothing.
Was there much of Learned Hand's standard in this case?
If she had done something, and the fraud had continued, would they have been able to go after her
personal fortune? We don't know… don't learn this in this case.
Rev. Model Bus. Corp. Act § 8.30 Standards of Conduct for Directors
(a) …members of board shall act 1) in good faith 2) in a manner the director reasonably believes to be in
the best interests of the corporation.
(b) …shall discharge their duties with the care that a person in a like position would reasonably believe
appropriate under similar circumstances.
(c) …director shall disclose to other directors... information not already known by them but known by the
director to be material to the discharge of their decision-making or oversight functions…unless would
violate a legal duty
(d) Discharging duties may rely on the performance…to whom the board may have delegated… the
authority or duty to perform (under (f)) one or more of the board’s functions that are delegable under
applicable law.
(e) …discharging duties… a director…is entitled to rely on information, opinions, reports or
statements…prepared by any persons specified in subsection (f).
(f) Director is entitled to rely, in accordance with (d) or (e) on:
(1) one or more officers or employees… whom the director believes is reliable and competent in
the functions performed or… reports provided.
(2) Legal counsel, public accountants…other persons retained containing skills or expertise that the
directors reasonably believe are matters (i) within the particular person’s professional or expert
competence or (ii) as to which the particular person merits confidence; or
(3) A committee of the BoD of which the director is not a member if the director reasonably
believes the committee merits confidence.
Rev. Model Bus. Corp. Act § 8.31 Standards of Liability for Directors
(a) a director is not liable for any decision or non-action UNLESS the party challenging proves that:
(1) The challenge conduct consisted of or was a result of:
(i) action not in good faith; or
(ii) a decision
A. which the director did not reasonably believe to be in the best interest of the
corporation, or
B. the director was not informed to an extent reasonably appropriate
(iii) lack of objectivity due to familial, financial, or business relationship OR a lack of
independence due to director’s domination or control by, another person having a
material interest in the challenged conduct.
(iv) a sustained failure of the director to devote attention to ongoing oversight of the
business affairs of the corporation…
(b) party seeking to hold the director liable:
(1) for money damages, shall also have the burden of establishing that:
(i) harm to the corporation or its shareholders has been suffered, and
(ii) the harm suffered was proximately caused by the director’s challenged conduct….
ALI § 4.01 Duty of Care of Directors and Officers; the Business Judgment Rule
(Essentially the same as Rev. Model Bus. Corp. Act 8.30.)
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(c) A director or officer who makes a business judgment in good faith fulfills the duty under this section if
the director or officer:
(1) is not interested [§ 1.23] in the subject of the business judgment
(2) is informed with respect to the subject of the business judgment to the extent the director or
officer reasonably believes to be appropriate under the circumstances
(3) rationally believes that the business judgment is in the best interests of the corporation
The Business Judgment Rule
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Aronson v. Lewis (DE 1984) (BJR – director liability predicated on concepts of gross negligence)
o Directors have a duty to inform themselves, prior to making a business decision, of all material info
reasonably available to them; having so informed themselves, they must then act with requisite care in
the discharge of their duties.
Business Judgment Rule: There is a presumption in Delaware that in making a business decision, directors act
on an informed basis, in good faith, and in honest belief that action taken was in best interest of the
corporation
o Can only be claimed by disinterested directors – directors can’t appear on both sides of a transaction
or derive personal financial benefit (self-dealing), the benefit must devolve upon the corporation or all
the SHs generally
o To claim BJR, directors have a duty to be informed, prior to making a business decision, of all material
info reasonably available to them after being informed, they must act w/ requisite care
o BJR fails when applied only for gross negligence (never)
2-prong BJR Test
o To rebut, P must allege particularized facts that raise a reasonable doubt that:
Directors are disinterested or independent
Challenged transaction was otherwise result of valid business judgment
(Must analyze whether directors exercised procedural and substantive due care)
o If P rebuts presumption of business judgment rule, then case is reviewed under entire fairness
Purpose of BJR
o To protect directors from the hindsight bias, which would lead to unfair liability, provides directors w/ a
large zone of protection when their decisions are attacked
o Fact finders (courts) usually are bad ad distinguishing btw good and bad business decisions
Causation Issues
o Barnes v. Andrew: (S.D.N.Y. 1924) ct held that P had to prove that the corp’s losses would not have
occurred if D had properly performed his duties, and that no such showing had been made. Need to
show D didn’t perform duties, but ALSO that it was cause of loss.
o Trans Union
“…on the threshold duty of care issue, the standard should be ‘reasonable care under the
circumstances’ as some argued all along.”
o Cede & Co. v. Technicolor (DE 1993)
DE S/Ct held П doesn’t have burden of proving injury – if a П establishes there was a breach of
duty of care, that showing overcomes presumption of BJR & establishes prima facie case of
liability even w/o showing of injury
In Re Emerging Communications, Inc. (when D has personal expertise, can’t rely on “expert opinon” when he
knows better)
o Facts: (2004) In this case the director voted to approve the merger at $10.25 claiming that it was a fair
price. He said he relied on the opinion of the expert. The director, however, because of his expert
financial knowledge was not entitled to rely on this expert’s opinion when he believed the stock was
worth more (up to $20)…”[the director’s] expertise in this industry was equivalent, if not superior to
that of Houlihan… that expertise gave the director far less reason to defer to Houlihan’s valuation…”
o Holding Muoio liable for his conduct as director b/c he voted to approve transaction even though he
knew merger price was unfair
Elements of The Business Judgment Rule
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o Make an affirmative business decision (is this the std?)
o Informed, due inquiry
o Good faith—very important; semantics whether or not it’s a separate duty
o honest belief that it is good for the corporation
o no financial interest- disinterested, Ø interest other than the interest of owning the stock
How is the presumption rebutted?
o You file a § 220 suit to get the facts to rebut the presumption; ask for books and records. Remember:
need 1) proper purpose with 2) preponderance of evidence of some elements of wrong doing
o Where get info for the § 220 suit? From reports of the companies (10K, 10Q, 8K, proxy statements
and other things [’34 Act gives us these]).
If rebut presumption, what happens next?
o Hasn’t won, just survived the motion to dismiss for failure to state a claim
o Standard of review is based on entire fairness and reasonability
o Burden on directors to show:
Process was fair
Substance of the transaction was fair
If BJR is not rebutted, and attaches instead:
o Lower standard of review:
Acting in good faith
Decision must be rational or have a rational basis
o Case is usually over
Substance over Process in Duty of Care cases
o BJR gives wide latitude to a substantive decision of a Director if the process element of the duty of care
are satisfied
o Process includes: preparing to make a decision, general monitoring, following up suspicious
circumstances
o If the process by which a decision was made satisfies the reasonability standard, the substantive
decision itself will be reviewed only under the much looser standard of rationality
Kamin v. American Express Co. (BoD allowed to make dumb decisions, protected by BJR as long as there’s no
bad faith or failure to be informed)
o Facts: (NY 1976) Πs, minority SHs of AmEx, moved to stop a dividend, or alternately for monetary
damages. The company had bought another which had been worth $30 million and is now worth only
$4 million; ∆s, Directors, now want to distribute the shares to its own shareholders. Πs insist that a sale
of these shares would result in a loss of $25 million which could be a tax write-off. Another derivative
suit.
o Holding the court finds for the Directors here due to the business judgment rule.
More than imprudence or mistake judgment must be shown.
The Board could make a dumb decision and not get sued for it because Πs’ objections and
alternate plan was carefully considered and rejected; and ∆s have expressed good reason to go
with their plan; the financials would look bad and the stock would have decreased. There was
no bad faith.
o Tells us that the duty of care as a standard of review is almost entirely procedural (with a slight
exception in the ALI).
ALI on Duty of Care & BJR §4.01
o Says director or officer has duty to corp to:
Perform functions in good faith
In a manner reasonably believed to be in the best interests of the corp
Rationality test – almost never gets into court
And w/ care that an ordinarily prudent person would reasonably be expected to exercise in a
like position
o §4.01(a)(2) – says director/officer is entitled to rely on materials & persons in accordance w/ §4.02 &
§4.03
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§4.01(b) says director entitled to rely on presentations by the CFO or outside experts to make himself
fully informed
o §4.01(c) is statement of the BJR
Says it can ONLY be claimed by disinterested directors
Alignment of director interest & SH interest
o Pretty much directly aligned, because:
Directors also have stock options
Bad directors lead to the comp losing market shares
o Job of courts is to make sure directors are faithful, not that they’re smart it’s the job of the market
to correct the problem of not so smart directors
Cede v. Technicolor (DE 1993)
o Where Π has established that there was a breach of the duty of care, the presumption of the BJR is
overcome and there is a prima facie case of liability; the burden shifts to ∆s to show that the
transaction was “entirely fair.”
Selheimer v. Manganese Corp. of Am. (D’s decision FAILS rationality standard b/c it cannot be coherently
explained)
o Facts: (PA 1966) Corp's managers poured almost all of the corporation's funds into the development of
a single plant even though they knew that the plant could not operate profitably for a number of
reasons.
o Holding managers were liable in that the decision "defied explanation."
Only one other case where the court has held “what could they have been thinking?!”
Smith v. Van Gorkem (DE 1985) (court looks at process, not substance of deal, Ds must be informed)
o Facts: (DE 1985) Π SHs sue in a class action the Directors after a merger of their company into another.
Van Gorkom, CEO, about to retire, decided to look into getting bought out. He shared the idea with
senior management and a very small amount of research was done; CFO saw $50/share as a good price.
He determined a price of $55/share while talking only with one officer and consulting with one outside
advisor.
o Issues 1) whether the application of BJR to 9/20 board meeting (where management approved
proposed Merger Agreement w/o looking @ proposed agreement) is appropriate; and 2) whether the
later “market test” is enough to make the 9/20 decision reasonable
o Holdings
9/20 meeting not subject to BJR – directors uninformed & were grossly negligent in approving
sale, no informed BJ as to the fairness of $55/share
Board never looked at the actual value of the company—no study was done to
determine what value the shares could reach
Didn't get an I banker to tell them what the company was worth.
The board conducts the affairs of a Delaware corporation; can't let the Chairman and
CEO call all the shots. VG is about to retire, wants to cash out- does the deal himself
and brings it to the board for ratification. Court doesn't like this.
Failed to fully incorporate the clause that they could solicit other agreements; didn't do
a thorough market test. Instead, took it to Pritzker then they did a market test with
conditions attached to the side deal.
Senior management entirely opposed the deal. A deal was signed on this basis, and no
other firm offers came up.
The Board approved it after a two hour meeting, without seeing the specifics of the
deal and relying entirely on Van Gorkum’s oral presentation.
No market test of the stock was done.
Van Gorkum was a pal with Pritzker, the individual who was in charge of the purchasing
company
Ct also finds the “market test” not enough to make the 9/20 decision reasonable; there’s no
rational basis to conclude that the offer was condition on a market test & the right to withdraw
wasn’t there
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The DE Sup Ct finds that there was no fraud or bad faith on the part of the Board, but that it
was grossly negligent in failing to inform themselves as to the transaction they were approving
if Van Gorkum had done a market test and had presented sound evidence to the Board,
his opinion as to the deal could be relied upon (to determine whether a business
judgment reached by a BoD is an informed one, we determine whether the directors
were grossly negligent—as used in Moran v. Household)
The uninformed state of the Directors means that the BJR does not apply here
the problem here was not that the price was bad; it was that the decision-making
process was defective
although there was a shareholder vote here, it does not operate as effective ratification
because it was itself defective
on remand, the fair value of the company had to be assessed so as to determine
damages
with this finding of the duty of care, Chancery on remand had to determine whether there were
damages; it did this under entire fairness scrutiny
Case settled for $23.5 mil, Pritzker, the buyer, ended up paying $13.5 mil that wasn’t covered
by liability insurance
o But if the case had actually gone to Chan Ct there probably wouldn’t have been
damages b/c the price was fair!
Aftermath of Smith v. VanGorkem
o DGCL § 251 (d). Fiduciary-out; put in the statute after Smith v. VG.
o What is its import?
If you have the fiduciary-out what does it say about the board's discretion if another bid occurs.
141(a) managed by the BOD—in this context, this means that having signed a deal, selling the
company, does not abrogate the duties of the directors.
This fiduciary out says that if they get a better offer, even if shareholders have already approved it,
they can take the better offer.
May incur penalties that have clauses which make it costly to take a higher offer.
Penalties cannot be draconian—can have lock up provisions, but can't be at a level to prevent
another deal from going forward. Can compensate the other buyer for costs in time in pursuing the
original deal.
o Today, do you have to have an investment banker by law?
No. But you will have an investment banker.
Not only that, is the deal done by Van Gorkom? Who in fact runs the deal if VG said he was
going to sell the company? Do you have the inside directors run it?
- No, have the outside directors run the company.
- Look at Harrah's entertainment-- the day they received the unsolicited offer, the directors
met, established a committee with the outside directors to conduct negotiations on behalf
of the company.
Outside directors will hire an investment banker who will not only give them a fairness opinion,
but will solicit other offers through a market test.
o This decision threatened the very fabric of corporate law; Directors like to think that if they make a
decision in good faith, the courts will not reverse it
Directors began having trouble getting insurance to cover themselves
DE stepped in and enacted § 102(b)(7), effectively overruling this decision.
DGCL §102(b)(7) noted that the certificate of incorporation could include:
o a provision eliminating or limiting the personal liability of a director to the corporation or its
stockholders for monetary damages for breach of fiduciary duty as a director except for the
breach of loyalty, good faith, or for any improperly-derived personal benefit
o this removes duty of care liability
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a Π would now have to claim that the Director acted in bad faith or with an intent to
harm the corporation, and not just stupidly or sloppily
o and though shareholder approval is required to amend the certificate of incorporation, virtually
all corporations have done this
o Can have a finding of fault without harm. Finding that the presumption of the BJR has been
rebutted only means that you have acted to violate your duty of care.
o If Smith v. VG was raised today it would be dismissed as soon as directors raise the shield of
102(b)(7).
Importance of SH Ratification
o Doesn’t come up in Smith v. VanGorkom, but if SH are informed then their ratification by vote
can clean up & exonerate a lot of procedural problems
Duty to Ensure Corporation has Effective Internal Controls
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In re Caremark Intl Inc. Derivative Litigation (actually duty of care case, but Пs had to show breach of good
faith b/c §102(b)(7) doesn’t allow recovery on violation of duty of care monitoring board very important!)
Facts: (DE Chan 1996) Caremark is a healthcare provider. The US initiated an investigation into
Caremark’s predecessor on suspicion of it having paid physicians to induce referral of patients.
Caremark reached settlement w/ DIG & DOJ.
o SHs in this derivative suit allege that the Directors breached their fiduciary duty of care by
failing to adequately supervise or actively monitor the conduct of Caremark employees, or
institute corrective measures, thereby exposing them to fines and causing the stock to
plummet.
Relevant Case History:
o Graham v. Allis-Chalmers (when there’s no grounds for suspicions, the board doesn’t have to
look into all conduct that may lead to corp liability)
o Best Foods (piercing case, direct liability case – pp. who were engaged in wrongdoing has no
protection)
court states here that a Director’s obligation includes a duty to attempt in good faith to assure that a
corporate information and reporting system exists, which the Board concludes is adequate, and that
failure to do may in some cases render a director liable for losses caused with non-compliance with the
law
to show that the Directors breached their duty of care by failing to control the employees, Пs would
have to show: (1) that the Directors knew or (2) should have known of illegality, (3) that they took no
steps in good faith effort to remedy the situation, and (4) that the illegality resulted in the losses
o only a systematic, sustained failure to exercise oversight will establish the lack of good faith
required for liability
o the new standard is sustained inattention
Πs here had to allege a breach of good faith b/c you can’t collect under §102(b)(7) for violation of
duty of care.
o this case doesn’t try to eviscerate §102(b)(7); it just shifts the old duty of care requirements
over to the duty of good faith
there is no requirement of a monitoring system expounded here; but the suggestion is that if you have
one in place, you will be able to get a case such as this one dismissed
o corps will pay less in fines for breaking the law if there’s a monitoring sys in place
o establishing a monitoring board is safety measure to insure the presumption of the BJR isn’t
rebutted
o Here Caremark DID have a monitoring network in place
Holding Given the weakness of П’s claims & fact that the proposed settlement appears to be an
adequate reasonable and beneficial outcome, the proposed settlement is approved.
o Very low probability that the BoD of Caremark breached any duty to appropriately monitor &
supervise the corp
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o
Caremark had internal audit plan designed to assure compliance w/ business & ethics policies &
also outside auditors
o Absent grounds to suspect deception, BoD and senior officers can’t be charged w/ wrongdoing
just for assuming the integrity of employees & the honestly of their dealings on the company’s
behalf
Two situations where plaintiff may hope to win:
o Potential liability for directorial decision when board decision was ill devised or negligent –
unconsidered failure of the board to act in circumstances in which due attention would have
likely prevented the loss
o Liability for failure to montir loss eventuates not from the decision, but from unconsidered
action
Takeaway
o A director's obligation includes a duty to attempt in good faith to assure that a corporate
information and reporting system exists, and that failure to do so, in some circumstances, may
render a director liable for losses caused by non-compliance with applicable legal standards.
o Only a sustained or systematic failure of the board to exercise oversight will establish the lack
of good faith.
Liability Shields
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Using §102(b)(7) as an affirmative defense
o Must be in the articles of incorporations, SHs have to approve it
o Has been approved in almost every case w/ overwhelming SH vote
3 elements may serve to reduce or eliminate civil liability for breach of director’s duties:
o Direct limits of liability
o Insurance
o Indemnification
Emerald Partners v. Berlin (if both duty of loyalty & duty of care claims, they’re linked; person seeking liability
shield under 102(b)(7) has burden to demonstrate good faith)
o (DE 1999) – if the Пs only allege a violation of the duty of care, the case can be dismissed on a motion
to dismiss simply for failure to state a claim
o Demonstrating good faith is burden of the party seeking protection of §102(b)(7)
o If a case alleges BOTH a duty of loyalty AND a duty of care claim, and the duty of loyalty claim survives
the motion to dismiss not only does the duty of loyalty claim go to trial, but the duty of care is also
NOT terminated (even w/ §102(b)(7))
b/c duty of care claim is so “inextricably linked” to duty of loyalty claim
This increases settlement value b/c directors don’t like to be found grossly negligent – looks
bad for company
o What do directors do as soon as suit is filed?
File a motion to dismiss under a duty of care claim
Malpiede v. Townson (DE 2001) (Frederick’s of Hollywood case – need to adequately allege breach of duty of
loyalty to get around §102(b)(7) defense in corp charter)
o Facts: Merger w/ Fredericks of Hollywood and Knightsbridge Capital. F agreed not to solicit other
bidders, but more emerged. Ulitmately, Veritas had the highest bid at $9, but the board went with K at
$7.75 claiming that K’s “no talk” provision would have allowed K to vote against 3rd party shares.
Board hired outside –ibanker
П’s claim that board was grossly negligent and thus, breached its duty of care in failing to
implement a routine defensive strategy to enable the board to negotiate for a higher price.
This is a Revlon case – nature of bidding process controlled by Revlon duties
o Issue whether §102(b)(7) applies. Does the complaint only include a due care claim?
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Holding the complaint fails to allege a breach of BoD’s duty of loyalty or its disclosure duty and the
§102(b)(7) clause in Frederick’s charter bars claims for money damages for alleged breach of duty of
care
Here the claim is ONLY unambiguously a duty of care claim, so clause bars suit
Court holds that the complaint fails to invoke loyalty and bad faith claims
the clause operates as an affirmative defense; and on this motion to dismiss, ∆s do not have to
prove the elements
Cash out sale (Revlon Land)
o When a company is being put for sale in a cash sale—outside directors have to hold an auction and sell
at the highest price they can get for the company.
o If cash, high price is cash price. If it is stock and bonds, BoD can use their judgment with what it
believes to be the best offer.
Shareholder Ratification as a Liability Shield
o Not usually effective when directors want it to be
o If SH’s ratification didn’t have all the information available, then the vote is defective and ratification is
NOT sufficient to insulate directors
o If SH ratification is effective it can sometimes be used to extinguish claims or allow Δs to win on
motion to dismiss
Importance of Duty of Care
o Less important than duty of loyalty or good faith
o In most cases, it’s the BJR anyway and directors’ interests are usually aligned w/ the corporation (this
isn’t the case in duty of loyalty)
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Duty to Act in Good Faith
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In re The Walt Disney Company Derivative Litigation (sets forth potential definitions of bad faith)
o Facts: (DE S/Ct 2006): Disney hired Ovitz as new CEO, he has huge compensation package if he’s
terminated. П sue after Ovitz’s termination, claiming directors violated their fiduciary duty by agreeing
to it
derivative claim—demand must be made on board or demand must be shown to be futile
Πs here allege that the directors of Disney breached their fiduciary duties with their blind
approval of an employment agreement with Ovitz and then ignored Eisner’s dealings with Ovitz
over the no-fault termination (Eisner & Ovitz were friends & wanted Ovitz to takeover, even
though he didn’t have exp in this corp)
Пs know that a case won’t be dismissed just because there is a ί102(b)(7) clause, have tried to
mount a case based on breach of the duty of good faith negligence; that the directors failed to
act honestly and in good faith. They also assert a breach of duty of loyalty claim against Eisner
and Ovitz.
The analysis in this case doesn’t focus on the substance of the agreement—it focuses on the
process of reaching it. The S/Ct doesn’t want to judge business decisions, but it is good at
procedure.
The board hires an outside executive compensation expert—this is key to management’s
victory. Court is more comfortable with outside experts because they are less likely to be
biased and less likely to be influenced by what the CEO wants.
o Issue ct looks at good faith – even though they found the BJR wasn’t rebutted
No violation of duty of care
No violation of duty of loyalty
How can there be a violation of good faith?
o Three definitions of good faith:
(1) Bad faith is when a director consciously and intentionally disregards their responsibilities.
(2) Intermediate category: intentional dereliction of duty, a constant disregard for one’s duties.
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(3) Lack of due care—legislature has said the std here is gross negligence, Ø the same as bad
faith. (NOT bad faith)
o Difference btw good faith & due care Kamin says more than imprudence or mistaken judgment must
be shown Disney implies you have to allege fraud, dishonesty, or malfeasance. Close to duty of
care standard.
o Holding Held for Δs. Compensation committee were sufficiently informed about severance package
($150-200 mil) & BoD acted in good faith when approving OEA & electing Ovitz as prez.
Eisner & Litvack didn’t violate fiduciary duty in terminating Ovitz & remaining directors entitled
to rely on Eisner’s & Litvack’s advice that Ovitz couldn’t be terminated for cause
Gross negligence alone is not enough to constitute breach of duty of good faith- sharp
difference btw duty of care & duty of good faith (§102(b)(7) carves out several exceptions –
including “acts or omissions not in good faith”)
Пs did NOT establish corporate waste by rebut BJR
o Wachter thinks this case might actually give us some idea of what “good faith” is
Miller v. AT&T (directors have important duty to act lawfully)
o Facts: (3d Cir. 1974) AT&T provided service to the democratic national convention; never collected for
the millions due from the service. П SHs brought a derivative suit claiming that didn't follow duty of
loyalty. Don't get BJR protection.
o Rule If AT&T decides not to collect from someone, AT&T get BJR protection, except when the
decision not to collect is b/c they are interested, or if the decision violates the law.
BJR can’t be used to protect directors if they did something illegal
o Holding Пs did state claim for breach of fiduciary duty arising from the alleged violation of 18 USC
§610
if they had alleged only that this was a failure to pursue a corporate claim, that would’ve run up
against the BJR and been dismissed; but their allegations are of illegal acts
one of the very purposes of the statute was to prevent donations by corporations to political
organizations that the shareholders don’t support
Пs still must prove the elements of the statutory violation; i.e. that it was actually a
contribution to influence the election and therefore illegal
o Entire fairness?
Not in this case. But interested directors can approve an interested transaction & escape claim
of breach of fiduciary duty IF the transaction is found to be entirely fair to the corp
Duty of loyalty is really where the action is, deals with:
o Basic self dealing
o Executive compensation
o Diversion of corporate opportunity
o Special obligations and sale of control
Stone v. Ritter (says no separate duty of good faith – it’s just an element of duty of loyalty)
o Facts: (DE S/Ct 2006) Bank gets in trouble for having inadequate mechanisms in place to file SARs, has
to pay fines & penalties. Issue before the court is the derivative case brought shareholders. П SHs
allege violation of directors’ duty of good faith regarding banking law violations
o Rule uses Caremark conditions for assessing director oversight liability.
You will have violated the standard if you intentionally act not in the best interest of the corp
pulls in the duty to act lawfully in to the duty of loyalty, then puts in Caremark systematic
failure of the board to exercise oversight
Where directors fail to act in the face of a known duty to act, thereby demonstrating a
conscious disregard for their responsibilities – they breach their duty of loyalty BY failing to
discharge that fiduciary obligation in good faith
o Holding Affirms Chan Ct’s decision to vacate claim based on Caremark analysis.
o Takeaway gets rid of triage of duties – says duty of loyalty includes more than just conflicts of
interest and rolls up violations of duty of good faith
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To violate duty of loyalty, you don’t have to have self-dealing. If you act in bad faith you
can’t be acting loyally
Ct clearly intended that the standard requires intent (not like gross negligence)
Criminal Liabilities of Directors & Officers
o 1st type of statute makes corp managers criminally liable for unlawful corporate acts if the managers
themselves performed or caused the performance of the act
People v. Film Recovery Sys., Inc. (Ill. 1985) (worker died from inhaling cyanide gas; poor
ventilation & workers who couldn’t read English couldn’t read warnings) ct finds president,
plant manager, and foreman guilty of murder & sentenced to 25 yrs
o 2nd type of statute makes managers criminally liable for the unlawful acts of employees over whom
they had the power of control, even if that power was not exercised
Responsible-corporate-officer doctrine
U.S. v. Park (US S/Ct 1975) (although employees were responsible for sanitation (rats getting
into food), the prez was also held liable although he didn’t authorize violations & statute didn’t
expressly impose liability on managers based on acts of others). Ct. relied on:
US v. Dotterweich: PP from this case taken in support; “in the interest of the larger
good it puts the burden of acting at hazard upon a person otherwise innocent but
standing in responsible relation to a public danger.”
Meyer v. Holley: (US S/Ct 2003) limited the sweep of this type of statute’s “responsible
corporate officer doctrine;” ct pointed out that under traditional agency rules, one person is
not vicariously liable for the actions of another person, unless the other person was NOT ONLY
under or subject to the firsts’ control, but ALSO acted for and on his behalf.
Directors’ & Officers’ Liability Insurance
o Often claims against D’s are covered by insurance (see p.603-05)
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Duty of Loyalty
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Duty of loyalty v. duty of care
o Duty of loyalty is markedly different from duty of care.
o With a duty of care analysis, the underlying facts are slightly different—with duty of care the director’s
and the corporations interests are still aligned; under a duty of loyalty claim the alignment of interests
has become skewed.
o The directors are charged with walking away with the corporate treasury; they have found a way of
exploiting the corporate form for their own benefit.
Concept of loyalty
o The concept of loyalty has changed over the years.
o In 1880, it would have been said that any contract between a director and his corporation was voidable
by the corporation or the shareholders without regard to the fairness of the transaction; the concept of
disinterested directors did not matter.
o Thirty years later this principle changed to a policy that allowed such a contract with approval by a
disinterested majority of the board if the contract was not found to be unfair or fraudulent by the
court if challenged.
A contract where the majority of the board was interested was voidable, even if the contract
was fair.
o By 1960 – generally rule was that no transaction of a corporation with any or all of its directors was
automatically voidable at the suit of a shareholder, whether there was a disinterested majority of the
board or not; but that the courts would review such a contract and subject it to rigid and careful
scrutiny, and would invalidate the contract if it was found to be unfair to the corporation.”
Self-Interested Transactions
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Four Basic Types of Self-Dealing (The “4 boxes”)
o (1) basic self-dealing where one party is on both sides of the transaction
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(2) executive compensation can become problematic when directors decide their own
compensation
o (3) diversion of corporate opportunity where the director has taken business that is rightfully the
corporation’s
o (4) controlling shareholders special obligations result where controlling shareholders are selling
stock
Lewis v. S.L.&E. Inc. (directors making self-interested transactions will not have protection of BJR; what makes
transaction wrongful isn’t that it’s conflict – it’s b/c it’s not fair & reasonable)
o Facts: (2d Cir. 1980) (closed corporation) Father had six children; three of them owned stock in LGT
(Lewis General Tires); Richard, Allen, Leon. All of them, those three plus Donald and his daughters,
owned stock in SLE. Π Donald alleged that ∆s, the three who owned LGT, wasted the corporate assets
of SLE by renting the property it owned to LGT at below-market value prices, and thereby treating it as
existing purely for the benefit of SLE.
o Rule Where the D’s have a conflict of interest in regard to transactions entered into by the
corporation, the BJR is rebutted they therefore have the burden of proof to show that the
transaction was entirely fair and reasonable to the corporation
because the BJR is rebutted, the court examines the substance of the deal with great detail;
and ∆s had to prove that the rental price was a fair one; they failed to carry that burden
o Holding Δ directors had burden to prove there was no waste & price paid for rent of the SLE
property was fair & reasonable. On remand – ct must determine the fair rental price & then give the
$ to П, then find out what the SLE shares are worth & order specific performance of the SH’s agreement
for the Δ to buy П’s stock
Remedies
o Traditional remedies for violations of the duty of loyalty are restitutionary attempt to put the
corporation back where it was before the duty of loyalty was violated (accounting for the difference
between the contract price and the fair price), or rescissionary (either before the deal goes through or
sometimes after the transaction has taken place)
damages in interested transaction case restitution damages, unless time allows for
injunction
o the remedies are much less severe than sanctions for duty of care, where the director must pay
damages even if he has made no gain from the wrongful action
o note that these remedies are not as effective as they could be: that is, if optimal deterrence theory was
followed, the fine would be the gain divided by the probability of detection, such that if detection of
the breach happened only half the time, the fine would be double the gain
o where fraud is present, courts have occasionally awarded punitive damages against directors or
officers who have breached their duty of loyalty
DE does not allow this, as Chancery is a court of equity
ALI §7.18(d) – director/officer who violates duty of fair dealing should normally be required to
pay the counsel fees & other expenses incurred by the corp in establishing the violation
Talbot v. James (It is generally a good idea to disclose when making a self-interested transaction)
o Facts: (SC S/Ct 1972) Πs, Talbots, agreed with ∆ to form a corporation to construct and operate an
apartment complex; Пs don’t do a good job of managing company, losing money, so Δ takes over &
does a good job.
П gets upset b/c of a fee Δ received in a contracting job for the corp - ∆ was on both sides of the
transaction (director of corp & owner of the constructing comp).
Πs argue that ∆ diverted funds to himself, while ∆ asserts that he only received the funds that
he was supposed for building the apartments ($25K fee)
Пs demanded to examine corp records & Δ refused – raises inference he didn’t want Пs to see
how funds were dispersed & that Δ got a benefit out of it
o Rule where a party is interested, it is their burden to make a full disclosure of all relevant facts
when entering into a contract with the corporation.
o
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There’s no strict rule against self-dealing b/c it can be good for corp and SHs – BUT there must
be rules to govern both the process & substance of such transactions
o Holding finds ∆ breached his fiduciary duty by examining the process of the transaction because Δ
entered into contract w/ himself w/o making full disclosure of his interest to the other officers and SHs
of corp.
o Dissent argues that ∆ received only a fair price for his trouble, and that Πs knew very well that ∆ was
the builder
o NOTE How would Delaware come out on this case? It seems like the Supreme Court of South
Carolina says that disclosure is a necessary element to a legitimate transaction; however, they also say
that the transaction was not entirely fair. In Delaware, if the transaction was fair the directors probably
wouldn’t be liable as long as the transaction was entirely fair and reasonable.
Sanitizing a self-interested transaction
o In Rosenfield context, u can do so by getting SH ratification b/c there was no disinterested directors on
board
2 Aspects of Fairness in the Duty of Loyalty
o In corporate context, terms of a self-interest transaction must be fair; AND
o In entering into the transaction, even on fair terms, must be in the corp’s interest
o Fill Buildings v. Alexander Hamilton Life Ins. Co. of Am. (Mich. 1976) the burden to establish
fairness rests on Δ, requires not only a showing of “fair price” but also a showing of the fairness of the
bargain to the interests of the corp
Note on associates of directors and senior executives
o What if a corporation deals not with a director or senior executive, but with an enterprise or individual
with whom a director or senior executive has a significant relationship?
o Such an enterprise or individual may be referred to as an “associate” of the director or senior executive.
ALI Principles of Corp Governance § 1.03
Statutory Approaches
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DGCL §144. Interested Directors; Quorum
o (a) No contract or transaction between a corporation and one or more of its directors…shall be void or
voidable solely for this reason, or solely because the director is present at or participates in the meeting
of the board or committee thereof which authorizes the contract or transaction, or solely because any
such director’s votes are counted for such purpose, if:
(1) the material facts of the director’s relationship are disclosed or are known to the BoD, and
the BoD in good faith authorizes the contract… by the affirmative votes of a majority of the
disinterested directors even though the disinterested directors be less than a quorum; or
(2) material facts…are known to the shareholders…and the shareholders approve the
transaction by a vote in good faith; or
(3) the contract is fair to the corporation…
o (b) Common or interested directors may be counted in determining the presence of a quorum at a
meeting of the board of directors which authorizes the contract or transaction.
o Note on §144: it was written to change the common law away from “void and voidable.” Historically,
self dealing was automatically void or voidable even if entirely fair. The DGCL changed this in 1967.
The statute provides guidance for making a conflicted transaction rightful. Case law provides the
details on how the board can avoid entire fairness scrutiny.
ALI § 5.02 Transaction with the Corporation
o (a) A director (§ 1.13) or senior executive (§ 1.33) who enters into a transaction with the
corporation…fulfills the duty of fair dealing with respect to the transaction if:
(1) disclosure concerning the conflict of interest (§1.14(a)) and the transaction (§ 1.14(b)) is
made to the corporate decision maker (§ 1.11) who authorizes in advance or ratifies the
transaction and
(2) either:
(A) the transaction is fair to the corporation when entered into;
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(B) the transaction is authorized in advance, following disclosure concerning the
conflict of interest and the transaction, by disinterested directors (§ 1.15)…who could
reasonably have concluded that the transaction was fair to the corporation at the time
of such authorization;
(C) transaction is ratified, following such disclosure, by disinterested directors (§ 1.23)
who could reasonably have concluded that the transaction was fair to the corporation
at the time ti was entered into..
(D) the transaction is authorized in advance or ratified following such disclosure, by
disinterested shareholders (§ 1.16) and does not constitute a waste of corporate assets
(§ 1.42) at the time of the shareholder action.
o (b) Party challenging transaction has the burden of proof unless that party can establish that none of
subsections (a)(2)(B), (C), or (D) is satisfied.
o The ALI has a disclosure requirement which the DGCL does not; §5.02(a)(1) makes disclosure an
absolutely mandatory part of any interested transaction disclosure as a threshold condition
note also the burden shifting of the ALI in §5.02(b)
Cookies Food Products v. Lakes Warehouse (Δ director has burden to show he acted in good faith – sets forth 3
conditions where self-interested transaction isn’t void or voidable)
o Facts: (Iowa S/Ct 1988) Herrig, ∆, had acquired a majority of Cookies shares (BBQ sauce company)
when the founder sold out. ∆ had been one of the original investors, and had operated another
corporation which served, under exclusive agreements to distribute, market, and transport the sauce
(Speed’s Auto). When he became majority SH & CEO of Cookies, the agreements with his corp. were
extended, and he received higher salaries as increased sales required increased management.
П minority SHs of Cookies accused ∆ of self-dealing, in that he had negotiated agreements with
the corp. without disclosing his interest; their real complaint is that they have not yet received
a dividend/any profit.
o Rule There are 3 circumstances under which a director can deal w/ the comp & not violate his duty
of loyalty, the burden of proof is on the director to establish these factors:
(1) where the interest is disclosed to the board, and majority of disinterested directors approve
it,
(2) where the interest is disclosed to the SHs, and they approve it, or
(3) if the transaction is fair and reasonable to the corporation
Also requires directors to establish additional element that they acted in good faith, honesty, &
fairness (Iowa fair & reasonable test comes close to the entire-fairness DE standard)
o Holding the transaction is NOT automatically void just b/c he was self-dealing; that a director can
contract with the corporation so long as it is with the strictest good faith, full disclosure, and consent of
all concerned
Here, ∆ satisfied the burden of proof in that he established that the other directors were wellaware of his interest in the transactions before they approved them
Majority also sees Δ as done wonders for the corp
o Dissent the majority places too much faith in the appearance of a profit; that just because the
transactions resulted in profits doesn’t meant they were fair; ∆ should have been made to show that
the FMV of his services were in fact what he was paid (where he was in reality overcompensated)
When is a director “disinterested”?
o ALI § 1.23 – Interested
(a) a director (§1.13) or officer (§ 1.27) is “interested” in a transaction or conduct if either:
(1) the director or officer, or an associate (§1.03) of the director or officer, is a party to
the transaction or conduct;
(2) the director or officer has a business, financial, or familial relationship with a
party…that relationship would reasonably be expected to affect the director’s or
officer’s judgment…in a manner adverse to the corporation;
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(3) the director…or an associate of the officer…with a business, familial or financial
relationship…has a material pecuniary interest in the transaction or conduct… and that
interest would reasonably be expected to affect the director’s or… in a judgment
adverse to the corporation.
o ’34 Act: § 10A(m)(3)
(A) Each member of audit committee shall be independent
(B) In order to be considered independent… a member of the audit committee may not, other
than in their capacity as a member of the audit committee
(i) accept any consulting, advisory, or other compensatory fee from the issuer; or
(ii) be an affiliated person of the issuer or any subsidiary thereof.
(C) Commission may exempt the requirements of (B) if deemed appropriate.
o For our purposes, DE law defines “interested” in a similar manner to ALI
However, the ALI does NOT distinguish between those corporations that have a controlling
shareholder and those that do not; while DGCL §144 also does not so distinguish, DE case law
does.
Practical advice to a CEO in making an interested transaction (i.e. a management buyout):
o (1) make full disclosure to the board
o (2) create a committee of outside and disinterested directors to study your proposal and to hire an
outside investment bank and attorneys
o (3) do not try to sell the deal to the board
o (4) do not vote on the deal; only disinterested individuals should vote
TAKEAWAY Earlier case law seems to suggest approval by disinterested directors reinstates BJR (in the
sense that the П doesn’t ask the ct to decide whether the transaction was fair to the corp)
o In Marciano v. Nakash (1987) the Delaware S/Ct stated that “approval by fully-informed disinterested
directors under §144(a)(1), or disinterested stockholders under section (2), permits invocation of the
BJR and limits judicial review to issues of gift or waste with the burden of proof on the party attacking
the transaction.”
o By going through a disinterested committee you have effectively made the approval process
disinterested. Without case law we have no way of knowing what 144 means.
o How do we know if dealing is at arm’s length?
Do a market test
Waste of Corporate Assets
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Standard: waste entails an exchange of corporate assets for consideration so disproportionately small as to lie
beyond the range at which any reasonable person might be willing to trade.
o A board that commits waste would normally also violate the BJR. The issue of waste therefore overlaps
with the effect of shareholder ratification of a conflict of interest transaction.
o SHs may NOT ratify a waste except by a unanimous vote (Saxe v. Brady (DE 1962))
Four possible effects of shareholder ratification (Chancellor Allen in Vogelstein):
o (1) Complete defense to any charge of breach of duty
o (2) Shift the substantive test on judicial review of the act from one of fairness that would otherwise be
obtained to one of waste
o (3) Shifts the burden of proof of unfairness to plaintiff, but leaves that shareholder protective test in
place.
o (4) No assurance of assent of a character that deserves judicial recognition.
Shifting Burden of Proof in an Interested Transaction
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Analysis of the Shifting Burden of Proof in an Interested Transaction:
o (1) Whether there is a controlling shareholder or not, the initial burden on Π is always to rebut the
presumption of the BJR, which is the presumption that the directors were informed (not grossly
negligent), were disinterested and/or independent, and that they rationally believed that the
transaction was in the best interests of the corporation (that they acted in good faith)
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(2) If Πs overcome the BJR presumption by showing that the transaction was interested, then ∆s will
bear the burden of showing that the transaction was entirely fair to the corporation
(3) ∆s can attempt to satisfy entire fairness scrutiny in the following ways:
(a) they may do so by showing there was a truly independent, disinterested committee that
negotiated at arm’s length and approved the interested transaction: if they do so, and there is
not a controlling shareholder, the BJR will reattach; Πs will then have the burden of rebutting
this presumption of the BJR by showing that either:
(i) the disinterested committee was not truly disinterested
(ii) the disinterested committee was not informed, or
(iii) the disinterested committee could not have rationally believed that the transaction
was in the corporation’s best interests
(b) ∆s may also satisfy entire fairness scrutiny by showing that there was a fully informed, uncoerced vote of the disinterested shareholders; and, if there is no controlling shareholder, the
burden will shift to Πs to either:
(i) prove that the vote was in some way defective, or
(ii) prove that the transaction amounted to waste
(c) ∆s may further satisfy entire fairness scrutiny at any time by proving that the deal was
actually fair; that is, by showing BOTH fair dealing and a fair price
Addendum for Controlling Shareholders:
(I) entire fairness scrutiny may also be met in the case of a controlling shareholder and a
disinterested committee, but only insofar as the burden will shift to Πs to prove that the deal
was not entirely fair, and not to rebut the BJR presumption
(II) entire fairness scrutiny may be met in the case of a controlling shareholder and a valid
shareholder vote, and then the burden will shift to Πs to prove that the transaction was unfair
Пs need to plead w/ particularity to prevent case from getting dismissed
But at Trial stage, the Δ can STILL claim the BJR
b/c at motion to dismiss stage, П have shown there’s cause of action, but there are disputed
facts which means the BJR can still apply
@ initial stage of trial, Пs still have burden of overcoming the BJR
The steps of analyzing the Burden of Proof in interested transactions, in stupid chart form:
Transaction approved by Full Board
No controlling
SH
П rebuts BJR by showing transaction was
interested
Standard becomes entire fairness
Δ must establish fair dealing & fair price
NO BJR presumption permissible
Controlling SH
Entire fairness – Δs must establish the
transaction had fair dealing & fair price
NO BJR presumption permissible (i.e.
Cookies v. Lakes Warehouse)
Transaction approved by Disinterested
Committee
П needs to rebut BJR, then standard
becomes entire fairness
Δs can establish entire fairness by showing
transaction was approved by disinterested
committee (cts can infer fair process from
substantive fairness) BJR reattaches
Many statutes (such as DE) require approval
by disinterested directors be in good faith
П can then attempt to rebut by showing the
committee was not truly disinterested,
informed, or its decision lacked a rational
basis
Once П rebuts BJR, standard becomes
entire fairness
Δs can establish entire fairness by showing
transaction was approved by disinterested
committee BJR does NOT reattach b/c of
existence of the controlling SH
П can then establish that the transaction
was not entirely fair
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Executive Compensation
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Statutory Guidance:
o DGCL §141(h)
Unless otherwise restricted by the certificate of incorporation or by-laws, the BoD shall have
the authority to fix the compensation of directors.
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DGCL § 157 Rights and Options Respecting Stock
(a) subject to any provision in the CoI, every corporation may create and issue, whether or not
in connection with the issue and sale of any shares of stock or other securities of the
corporation, rights or options entitling the holders thereof to acquire from the corporation
any shares of its capital stock of any class or classes, such rights or options…as shall be
approved by the board of directors.
(b) The terms, including the time or times… and the consideration for which such shares may be
acquired from the corp upon the exercise of any such right or option, shall be stated in the CoI
or in a resolution…in the absence of actual fraud in the transaction, the judgment of the
directors as to the consideration for the issuance of such rights or options and the sufficiency
thereof shall be conclusive.
Constructive fraud doesn’t count
o SEC Regulation S-K, Item 402 - Executive Compensation
Requires a lot of public disclosure; as soon as you have requirement of disclosure, inaccurate or
misleading disclosure are then in violation of the Securities act and can lead to civil or criminal
penalties.
Persons covered: CEO, the registrant’s four most highly compensated executive officers other
than the CEO who were serving as executive officers at the end of the last completed fiscal year;
and; up to two additional individuals for whom disclosure would have been required except for
they were not serving as an executive officer of the registrant at the end of the last completed
fiscal year.
o IRS Code § 162(m) Trade or Business Expenses
(1) indicates that there is no deduction allowed for paying executives over $1 million hence
corporations will not tend to pay more than that in salary
(4) indicates that you can pay them more if you do so through performance-based
compensation; i.e. stock options or bonuses; but in order to do so, you must have shareholder
approval
These IRS rules work in tandem with the SEC rules requiring disclosure of executive pay
for proxy statements are usually required to include any changes in executive
compensation
Theories of Executive Compensation
o Tournaments theory: all along the way you have to encourage workers to work hard or they will slack.
As you get up the pyramid, there is only ONE CEO position. You need to make the CEO position as
attractive as possible to keep people working hard.
o Market: as long as the stock market is doing well do you really want to fix something that might not be
broken?
Shareholders may really care about compensation affecting performance—they care about if
the CEO will work harder if they are paid for it.
Phantom of private equity supports this argument:
Highly levered—if stock market does well, you do better than the stock market
Strategy invented by KKR and Blackstone—take managers who were not highly
incentivized and give them the possibility of making $30 million, not $5 million. They
started making decisions and improved the performance of the company.
is there a point of diminishing returns? What is excessive?
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Option driven nature of Executive Compensation:
o Section 162(m) of the IRS code limits what you can pay as straight pay and still be able to deduct it as
an expense. Leads to options compensation.
Options help align the interests of the CEO and the shareholders.
o IRS regulations requires SH approval for compensation proposed by managers:
§ 1.162-27 Material forms of performance goals must be disclosed and subsequently approved
by the shareholders of the publicly held corporation (to get IRS tax incentive).
Shareholders are then informed through Regulation SK.
o Options granted as part of executive compensation are treated differently depending if they are in the
money or not. In the money options have to be expensed, out of the money options do not have to be
expensed.
o Issues with back dating. The exercise price is when the stock options are initially fixed. Say it was fixed
in November at $20. If you back date the option you say you really gave it in July when it was selling for
$10. The problem is that under regulation S-K this all has to be voted on (and thus, disclosed) and it will
then violate IRS rules. Absent rule SK there would be no disclosure problem, but if you disclose
incorrectly and knowingly it is fraud.
backdating will almost always violate disclosure requirements (also, fraud if done intentionally
and not reported)
runs into problems with the IRS because can violate their income reporting if stock options
are in the money they have to be expensed immediately and they have a different value than if
they are at FMV.
Executive compensation and closed corporations:
o Court deals w/ exec compensation in closed corporations very differently than it does with publicly
traded corps. In part, this is because of IRS rules. From a corporate law perspective, in closed
corporations managers have two benefits if they pay themselves a lot:
(1) Not much income that gets doubly taxed
(2) No approval needed by disinterested directors or SHs
o If there are minority SHs not working for the corp – they’re harmed by the working directors’ excessive
compensation special need to protect minority SHs
o Delaware’s solutions to this “conflict:”
Market solution—a corporation that pays too much in executive compensation may have too
high of costs and suffer in the product market. Market will adjust for abuse of compensation.
Fiduciary law remedies—doesn’t work well. Easy for plaintiffs to rebut presumption of BJR, but
because executive compensation is invariably ratified by shareholders (and assuming it is
effective) then the remedy that remains, is only the test of waste—which is hard to show on a
case on the merits.
Federal securities law—Reg SK. As soon as you have requirement of disclosure, inaccurate or
misleading disclosure are then violations of the Securities Act and can lead to civil or criminal
penalties.
Tax laws—162(m) and the rules coming out of it (E(4)), requirements for a stock option plan or
a performance based plan to be ratified by the shareholders to meet IRS requirements that it is
performance based [IRS ceiling on how much you can have if not performance based].
Disclosure and required voting places two hurdles in the way of wrongdoing.
§ 1.162-27 (e)(2)(vi)(A): compensation attributable to a stock option or a stock
appreciation right is deemed to satisfy requirements of (e)(2) if…the amount of
compensation the employee could receive is based solely on an increase in the value of
the stock after the date of the grant or award.
Conversely, if the amount of compensation the employee will receive under the grant
or award is not based solely on an increase in the value of the stock after the date of
grant or award (e.g., …in the case of an option that is granted with an exercise price
that is less than the fair market value of the stock as of the date of grant), none of the
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compensation attributable to the grant or award is qualified performance-based
compensation because it does not satisfy the requirement of this paragraph (e)(2(vi)(A).
§ 1.162-27(e)(4) Shareholder approval requirement The material terms of the
performance goal under which the compensation is to be paid must be disclosed to and
subsequently approved by the shareholder of the publicly held corporation before the
compensation is paid….the material terms include the employees eligible to receive
compensation… business criteria (p. 1290) on which performance is based…
Wilderman v. Wilderman (factors for whether exec compensation is excessive)
o Facts: (DE Chan 1974) Involved claim of excessive compensation in a close corp, in which compensation
had not been approved by disinterested directors or SHs
o Holding ct said should look to what other execs similarly situated received as compensation and the
ability of the exec. Other judicial recognized factors are:
Whether the IRS has allowed the corp to deduct the amount of salary alleged to be
unreasonable
Whether the salary bears a reasonable relation to the success of the corp
The amount previously received as salary
Whether increases in salary are geared to increases in value of services rendered
Amount of the challenged salary compared to other salaries paid by employer
Executive compensation in close corporation without approval or ratification might still be okay
In Re Tyson Foods, Inc. (spring-loaded options violates duty of loyalty – even though directors were
independent, BJR didn’t attach)
o Facts: (DE Chan 2007) Δ Corp Tyson makes meat, 2 classes of stock: A SH may cast one vote per share,
B SH can cast ten votes per share; Tyson Limited Partnership (TLP), ltd partnership owns 99.9% of the
class B stock and thus controls over 80% of corp's voting power; ΔnDon Tyson controls 99% of TLP; Δ
John Tyson (Don’s son) is chairman of board & Tyson’s CEO
SH brought derivative suit claim, that the Δs used "spring loading" to give the board stock
options before the prices went up to get around the plan which required the price of the option
to be no lower than the fair market value of the company's stock on the day of the grant
"spring loading" when the company has info that will make the price of the stock go up, they
grant the options and then give the info and then the price goes up and the directors get
money from the increase in value of their options
o Issue whether “spring loading” constitutes bad faith; and whether demand is excused
o Rule Look at R.23.1 to see standard for demand excusal – 2 prongs: Пs must show theirs is reason to
doubt either:
1) that directors be independent & disinterested (in 99% of cases this is enough)
2) that directors rationally believed it was in the best interest of the corp (possibility the
transaction was an exercise of BJ)
o Rule For bad faith in “spring loading” look at whether it's intentionally enriching employees and
avoiding SH imposed requirement:
o Holding Since board had material insider info & there’s SH approved stock option plan – the ct
concludes that the П has alleged adequately that the compensation committee violated fiduciary duty
by acting disloyally & in bad faith w/ regard to the grant of options
this couldn’t have been good faith on part of the board – indirect deception on director’s part
b/c SHs that approved incentive option plan probably didn’t expect spring-loaded options
Δs used inside material non-public info w/ intent to circumvent SH approved plan
o П must alleged that the options were issued according to SH approved plan & Δs who approved springloaded options:
(a) had material nonpublic info (in this case, that shares were actually worth more than
exercise price) soon to be released that would impact the company’s share price, and
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(b) issued those options with the intent to circumvent otherwise valid SH-approved restrictions
upon the exercise price of the options (wanted to enrich EE’s beyond what SH’s approved).
Ryan v. Gifford (backdating is egregious on its face & board approval can’t meet BJ test, also case on when
failure to make demand is excused)
o Facts: (DE Chan. 2007) П SH, filed a derivative action against D’s, the corp bd and compensation
committee members, for an alleged breach of their duties of due care and loyalty in approving or
accepting backdated options in violation of a stock option plan and stock incentive plan. The members
moved to stay the action in favor of earlier filed federal actions in CA; alternatively, they moved to
dismiss the action on its merits.
П argue grants of stock options were backdated b/c they were too fortuitously timed to be
explained as coincidence (price went up shortly after grant)
o Holding ct denied Δ’s stay request b/c DE had an overwhelming interest in resolving questions of
first impression under DE law and the doctrine of forum non conveniens did not require the stay.
SH provided sufficient particularity in the pleading to survive a motion to dismiss for failure to
make demand under Del. Ch. Ct. R. 23.1.
Even if compensation committee’s decision wasn’t imputable to the entire BoD to implicate
Aroson rule – demand is also futile under Rales test (where board hasn’t made a decision,
demand is excused when complaint contains particularized facts creating a reason to doubt
that a majority of the directors would have been independent & disinterested when
considering demand)
There were sufficient allegations to raise a reasonable doubt re: the disinterestedness of the
BoD complaint alleges bad faith & thus breach of duty of loyalty sufficient to rebut BJR &
survive motion
П SH lacks standing to bring claims under DGCL §327 before 3/11/2001 b/c he didn’t own stock
before then
Director who approves backdating of options faces substantial likelihood of liability hard
to conceive of a context in which a D may simultaneously lie to his SH’s (re: his violations of a
SH approved plan) and yet satisfy his duty of loyalty.
Review – Gantler
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Gantler v. Stephens (DE 2009) ()
o Facts: Bank in Ohio (First Nile) has a board of interested people. They are considering whether to sell or
go private. Decide to do the latter, which requires reclassifying stock. To do this they need a
shareholder vote. See SEA Rule 13e-3. In the final version of the proxy letter they explain the different
options, state the savings from going private and also admit that they are all interested. The BoD did
hire outside counsel and also a financial advisor when reviewing the options.
o Rule BJR
First look to Aronson v. Lewis: BJR is “a presumption that in making a business decision the
directors of corporation acted on an informed basis, in good faith, and in the honest belief that
the action taken was in the best interests of the company.”
Second go to Unocal v. Mesa: plaintiffs can rebut that presumption by showing a breach of the
duty of loyalty or the duty of care. Outside of that the board’s decision will stand since “a
court will not substitute it’s judgement for that of the board if the … decision can be ‘attributed
to any rational business purpose.’”
Duty of Loyalty claim: Did the board exercise good faith in pursuit of a legit corporate
interest? Did they do so advisedly?
o Holding Loyalty Claim: Boards voting on mergers/sales, etc. will always be interested so you must
allege something more. Here they did. The directors were all interested in other ways (mostly because
a reclassification can be structed in a way to benefit them more) and Stephens, by failing to furnish due
diligence requests to the two bidders breached his duty of loyalty.
Duty to Disclose & Ratification: You cannot ratify an interested board decision while voting on
something else. Has to be a separate proxy.
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Ratification: Cleansing of a conflicted board action by a fully informed shareholder vote. This
decision restricts it to cleansing those decisions which do not independently need a
shareholder vote. And even then, only restores the application of BJR not disallows claims.
The ratification doctrine does not apply to those situations which statutorily require a
shareholder vote.
Use of Corporate Assets & the Corporate Opportunity Doctrine
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Hawaiian Intl Finance v. Pablo (interested director can’t keep secret commission from land deal)
o Facts: (Hawaii S/Ct 1971) Δ Pablo ran a realty brokerage and were also part of the directorship of
Hawaiian Itnl. Δ arranged a land deal in California. As a result of the deal, Pablo got some commission.
The problem is that he was approached as a director of Hawaiian Intl Finances. He did not disclose his
interest in the deal until the board approached him about it.
o Rule been widely held that a director while engaged in a transaction for his corp cannot retain an
undisclosed profit
o Holding Pablo breached his fiduciary duty to Hawaiian Intl. Doesn’t matter that the corp wouldn’t
have gotten a commission, the corp opportunity is governed by the punctilio of honor
Hawaiian Intl Finances would have been interested in getting the land at a price less the
commission.
The money belongs to the corporation, part of your fiduciary duty towards it.
Forkin v. Cole (using corp asset for personal benefit = misappropriation even when there’s no harm)
o Facts: (Ill. 1989) Δ controlled HPDI corp, mortgaged HPDI property to bank to secure personal loan
made to Cole by the bank
o Holding Doesn’t matter there was no actual harm to corp, Δ used corp asset for his personal benefit
so there was a misappropriation of corporate asset
ALI § 5.04 Use by a Director…of Corporate Property, Material Non-public Corporate Information, or
Corporate Position
o (a) General rule. A director or senior executive may not use corporate property, material non-public
corporate information, or corporate position to secure a pecuniary benefit, unless either:
(1) Value is given for the use and the transaction meets the standards of § 5.02
(2) The use constitutes compensation and meets the standards of § 5.03
(3) The use is solely of corporate information, and is not in connection with trading of the
corporation’s securities, is not a use of proprietary information of the corporation, and does
not harm the corporation
(4) Use is subject neither to § 5.02 nor § 5.03 but is authorized in advance or ratified by
disinterested directors or disinterested shareholders, and meets the requirements and
standards of disclosure and review set forth in § 5.02 as if that section were applicable to the
use; or
(5) The benefit is received as a shareholder and is made proportionately available to all other
similarly situated shareholders, and the use is not otherwise unlawful.
o (b) A party who challenges the conduct of a director or senior executive under subsection (a) has the
burden of proof…except that if value was given for the benefit, the burden of proving whether value
was fair should be allocated as provided in § 5.02 in the case of transactions w/ the corporation.
Restatement 2nd of Agency § 388. Duty to Account for Profits Arising Out of Employment
o Unless otherwise agreed, an agent who makes a profit in connection with transactions conducted by
him on behalf of the principal is under a duty to give such profit to the principal.
ALI rule v. DE rule
o ALI very clear if you don’t disclose you’re in trouble
Doesn’t go into whether something is a corp opportunity has broader interpretation of
what’s a corp opp.
Pushes disclosure b/c they think the BoD should decide if something’s a corp opp.
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DE rule look at whether something was a corp opportunity under 4 factor test: (similar to ALI
§5.05(b))
1) whether the corp have the financial ability to make use of the opp
2) whether it’s in the corp’s line of business
3) whether the corp has an interest or expectancy in the opp
4) whether there would be other conflicts of duties for the exec to take the opp
Northeast Harbor Golf Club, Inc. v. Harris (using ALI test for corp opp)
o Facts: (Maine 1995) Δ was director and president of the golf club. The club had been struggling
financially and had considered the possibility of building homes around the golf course but the idea had
always been rejected. On two occasions, Nancy, the director had the opportunity to buy some of the
land surrounding the course. After she buys the land, she tells the club that she bought it. She now
wants to develop it and the board sues her for breach of fiduciary duty.
o Rule In determining the corporate opportunity doctrine of Maine, the court evaluates existing
doctrine:
1) Line of business test: (DE test)
Opportunity which the corporation is financially able to undertake and is, from its
nature, in the line of the corporation’s business.
Look @ whether the opportunity “was so closely associated with the existing business
activities…as to bring the transaction within that class of cases where the acquisition of
the property would throw the corporate officer purchasing it into competition with his
company.” Guth v. Loft (De 1939)
Weaknesses: whether a particular activity is within a corporation’s line of business is
conceptually difficult to answer. Also, the Guth test includes as an element the
financial ability of the corporation to take advantage of the opportunity.
2) Fairness test: (MA test)
Also known as the Durfee test (Mass. 1948). The “true basis of governing doctrine rests
on the unfairness in the particular circumstances of a director, whose relation to the
corporation is fiduciary, taking advantage of an opportunity [for her personal profit]
when the interest of the corporation justly calls for protection.”
Weaknesses: lack of principled content.
3) Combination of the two: (Minn . test in Miller v. Miller)
Uses a 2 step analysis: look @ whether opp was w/in corp’s line of business, then look
at equitable considerations
Court notes that this test just piles the uncertainty of the second on the first.
The court decides to explicitly adopt the ALI test in § 5.05—Taking of Corporate Opportunities
by Directors or Senior Executives
(a) General rule. A director…may not take advantage of a corporate opportunity unless:
o (1) the director of senior executive first offers the corporate opportunity to the
corporation and makes disclosure concerning the conflict of interest and the
corporate opportunity
o (2) the corporate opportunity is rejected by the corporation and
o (3) either:
(A) the rejection of the opportunity is fair to the corporation;
(B) The opportunity is rejected in advance, following such disclosure,
by disinterested directors…in a manner that satisfies the standards of
the BJR.
(C) Rejection in advance… and the rejection is NOT equivalent to a
waste of corporate assets.
(b) Definition of a Corporate Opportunity.
o (1) any opportunity to engage in a business activity of which a director or
senior executive becomes aware, either:
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(A) in connection with the performance of functions as a director…or
under circumstances that should reasonably lead the director or senior
executive to believe that the person offering the opportunity expects it
to be offered to the corporation; or
(B) through the use of corporate information or property, if the
resulting opportunity is one that the director or senior executive should
reasonably be expected to believe would be an interest of the
corporation.
o (2) any opportunity to engage in a business activity… that is closely related to a
business in which the corporation is engaged or expects to engage.
(e) special rule concerning delay offering of corp opportunities
The central feature of the ALI test is the strict requirement of full disclosure prior to
taking advantage of any corporate opportunity.
Burden of proof party challenging taking of opportunity has initial burden but if party can
show §(a)(3)(B) or (C) aren’t met director has burden of proving the rejection and the taking
of the opp were fair to the corp
Employees don’t own fiduciary duty to corp, but for an employee to take advantage of a corp
opp they have to get permission from directors/supervisors
o Holding ALI test explicitly adopted, disclosure is of paramount importance – remanded.
o Outcome Maine S/Ct held for П board, properties were corp opps. Corp & BoD gets to decide if
something is a corp opp & doubts regarding if something’s a corp opp gets resolved in favor of the corp.
Broz. V. Cellular Information Systems, Inc. (DE ct looks at if something IS a corp opp first before requiring
disclosure – nondisclosure doesn’t necessarily mean liability)
o Facts: (DE 1996) Δ Broz is on the board of CIS and owns RFB. Provider goes to Broz to sell the Michigan
2 license. Doesn’t go to CIS b/c they don’t think they can afford it. Broz doesn’t talk to the board of CIS,
but the board says that if he would have they would have told him to go ahead with the investment for
RFB. PriCellular buys CIS and goes after Broz for exploiting a corporate opportunity for CIS.
o Rule DE puts question of corp opportunity first, not disclosure. 1st see if there’s a corp opportunity
(Δ can rely on situation as it exists @ time opp is presented):
is corp financially capable of exploiting it?
Is it in the corp’s line of business? only matters what the board thinks is in their lines of
business, doesn’t matter what Δ thinks
Is there interest or expectancy?
If director takes interest for his own, will fiduciary be placed in a position contrary to his duty
for the corp?
o Holding DE S/Ct finds for Broz and says that he did not need to present it the CIS board b/c Broz did
not misappropriate a corp opportunity. CIS was not financially capable, nor was it clear that CIS had an
interest or expectancy. No one factor is dispositive. All the factors must be considered.
o Note that just because ∆ here approached the directors of CIS doesn’t mean he has obtained “safe
harbor” for the court will still examine the board’s approval of an arguably interested transaction to
determine if the directors were interested
Guth v. Loft (DE 1939) (articulates line-of-business test for corp opportunity)
o Note: by contract can broaden or narrow what is a corporate opportunity But, can’t have open
language that says the only thing that constitutes a conflict of interest is X
ALI § 5.06 Competition with the Corporation
o (a) directors and senior executives may not advance their pecuniary interests by engaging in
competition with the corporation unless either:
(1) any reasonably foreseeable harm to the corporation from such competition is outweighed
by the benefit that the corporation may reasonably be expected to derive from allowing the
competition to take place, or there is no reasonably foreseeable harm to the corporation from
such competition;
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(2) The competition is authorized in advance or ratified, following disclosure concerning the
conflict of interest and the competition, by disinterested directors…in a matter that satisfies
the standards of the BJR.
In Re: eBay, Inc. Shareholders Litigation (DE ct against ALI, address 1st if there’s a corp opp – directors are
interested where they get “reward” by doing business w/ Goldman Sachs)
o Facts: (DE Chan 2004) EBay SHs in this derivative suit allege that the directors took opportunities that
rightfully belonged to the corporation. Goldman Sachs had done eBay’s IPO, and rewarded the
directors with the opportunity to buy shares in other IPOs. ∆s argue that these were “collateral
business opportunities” not within eBay’s line of business.
o Holdings:
motion to dismiss for failure to made demand denied – ct finds that the “independent”
directors were not in fact so independent due to the vast amount of stock options they
received working for eBay
directors are also not independent b/c they would’ve have been fired if they had complained
of the stock options the insider directors received from Goldman Sachs
Finds that there was a corporate opportunity not only was eBay able to exploit the
opportunities in question, it frequently invested in securities
∆s here obtained the opportunity to invest due to their connections with the
corporation
Since directors were interested, they have burden of proof @ trial to show the transactions
were entirely fair to corp
Duties of Controlling Shareholders
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Statutory Sections
o ALI § 5.10 - Transactions by a Controlling Shareholder With the Corporation
(a) A controlling shareholder who enters into a transaction with the corporation fulfills the
duty of fair dealing to the corporation with respect to the transaction if:
(1) the transaction is fair to the corporation when entered into; OR
(2) the transaction is authorized in advance or ratified by disinterested shareholders,
following disclosure concerning the conflict of interest and the transaction, and does
not constitute a waste of corporate assets at the time of shareholders action.
(b) If the transaction was authorized in advance by disinterested directors… the party
challenging the transaction has the burden of proof. Also, the party challenging has the
burden of proof if the transaction was ratified by disinterested directors and the failure to
obtain advance authorization did not adversely affect the interests of the corporation in a
significant way. If the transaction was not so authorized…the controlling shareholder has the
burden of proof.
(c) If the transaction… was in the ordinary course of business…the party challenging the
transaction has the burden of coming forward with evidence the transaction was unfair…
whether or not the transaction was authorized in advance or ratified…
o ALI § 5.11 - Use by a Controlling Shareholder of Corporate Property, Material Non-public Corporate
Information, or Corporate Position
(a) A controlling shareholder may not use corporate property, its controlling position, or (when
trading in the corporation’s securities) material non-public corporate information to secure a
pecuniary benefit, unless:
(1) Value is given for the use and the transaction meets the standards of § 5.10, or
(2) Any resulting benefit to the controlling shareholder either is made proportionally
available to the other similarly situated shareholders or is derived only from the use of
controlling position and is not unfair to the other shareholders.
(b) The party challenging the conduct in (A) has the burden of proof—except that if value was
given for benefit, the burden of proving whether the value was fair should be determined as
provided in § 5.10 in the case of a transaction w/ the corp.
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(c) A controlling shareholder is subject to liability under this section only to the extent of any
improper benefit received and retained, except to the extent that any foreseeable harm
caused by the shareholder’s conduct exceeds the value of the benefit received, and multiple
liability based on receipt of the same benefit is not to be imposed.
o ALI § 5.12 - Taking of Corporate Opportunities by a Controlling Shareholder
(a) A controlling shareholder may not take advantage of corporate opportunity unless:
(1) the taking…was fair to the corporation; or
(2) the taking…was authorized in advance…following disclosure of the conflict of
interest and the taking is not equivalent to a waste of corporate assets.
(b) A corporate opportunity means any opportunity to engage in a business activity that:
(1) is developed or received by the corporation, or comes to the controlling
shareholder primarily by virtue of its relationship to the corporation; or
(2) held out to shareholders of the corp by the controlling shareholder…as being a type
of business activity that will be within the scope of the business in which the
corporation is engaged or expects to engage [and will not be within the scope of the
controlling shareholders business.] why do we care about this?
(c) The person challenging has the burden of proof unless the taking was not authorized in
advance or ratified by disinterested directors or shareholders—then the controlling
shareholder has the burden of proving the taking was fair to the corporation
Zahn v. Transamerica Corporation (majority controlling SH has same fiduciary duty as directors –owe duty of
complete disclosure to minority SHs)
o Facts: (3rd Cir. 1947) П Zahn held class A stock of Axton-Fisher Tobacco (Kentucky corp), Δ Transamerica
(DE corp) was majority SH of Axton & controlled board. Class A = preferred stock (gets annual
cumulative dividend, get liquidation preference (2X as much assets/share as class B), no voting rights).
Class B = common stock (less annual dividend, less $ upon liquidation).
Before company was liquidated {for an extremely good price because the market value of
tobacco was very high at this point}, the A shareholders are converted to B shareholders; the
former A shareholders protest that they should have been able to participate in the liquidation
of the company and not just the redemption.
o Rule 3rd Cir. here determines that a majority shareholder may not use its control of the board to
gain at the expense of the minority shareholders; it may vote according to its interests, but it has a
fiduciary duty to the corporation and the minority shareholders just as directors do
the burden will be on the controlling shareholder to show that the transaction was in good
faith and was entirely fair
o Choice of law Use law of state of incorp to determine the extent & nature of relationship btw
corporation & SH (Kentucky law), use law of the place of wrong (final act establishing liability) to find
the quantum of breach of duty (DE law)
o Holding If П can prove his allegations, then he can recover on both causes of action b/c BoD in
recalling A stock were influenced by Δ SH – no reason to redeem A stock except to enable B stock to
profit @ expense of A stock.
The CoI gave directors power to convert A to B stock @ anytime, therefore such an act could
have been legally consummated by a disinterested board, but since the directors here were
under the control of Transamerica, the action is voidable in equity
a controlling shareholder need not always subordinate his interests to the minority, but it must
make full disclosure to the fellow shareholders when proposing a transaction
o Outcome call of A stock found to be rightful, even though it benefited B stock & hurt A
o Note BoD’s fiduciary duty to SH w/ voting rights ≠ duty to SH w/o voting rights
SH w/ voting rights full disclosure (duty of complete candor only when SHs are asked to vote
on an issue where they HAVE voting rights)
SH w/o voting rights maximizing SH value
Duty of Disclosure by Controlling SHs under DE Law
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DE courts have been very rigorous in requiring full disclosure by controlling shareholders when they
deal with the minority
o Lynch v. Vickers Energy Corp. (1977), the court asserted that the controlling shareholders owed
“complete candor” in disclosing fully “all the facts and circumstances surrounding” the tender offer
they made for the 46% publicly-owned stock (all germane facts, not just “adequate” facts)
o Rosenblatt v. Getty (1985): all the “material” facts must be disclosedtaking a page from TSC
Industries v. Northway (where the USSC said the test of materiality was whether a reasonable man
would attach importance to the fact misrepresented or omitted in determining his course of action)
o Shell Petroleum v. Smith (1992): majority SH has burden of showing “complete disclosure of all
material facts relevant to a minority SH’s decision “ test for materiality = “whether there’s a
substantial likelihood that the omitted fact would have been viewed by the reasonable investor as
having significantly altered the ‘total mix’ of information made available”
Doesn’t matter if the info wouldn’t have changed a reasonable SH’s mind, just if it was relevant
to SH.
Sinclair Oil Corp. v. Levien (parent corp engaging in self-dealing w/ its subsidiary has burden of proof – test of
“intrinsic fairness” used in self-dealing btw parent & sub “intrinsic fairness” no longer a DE term, but used in
other JXs to mean entire fairness)
o Facts: (DE S/Ct 1971) ∆, Sinclair Oil, owned 97% of Sinven (an oil corp. it had started in Venezuela). All
Sinven’s directors were nominated by ∆. Π alleges Sinven paid out excess dividends for ∆’s cash needs,
and therefore neglected a corporate opportunity to expand in Venezuela; and further that there was a
breach of contract because ∆ had agreed to buy oil from Sinven which it did not do. ∆ argues that the
BJR should apply to all transactions between it and Sinven.
o Rule proper standard is “test of intrinsic fairness” in situation w/ parent & subsidiary where the
parent is controlling the transaction (self-dealing). Intrinsic fairness ≠ entire fairness. Intrinsic fairness
test requires:
1) fiduciary duty btw parent & subsidiary
2) self-dealing where the parent benefits @ expense of subsidiary
o Holdings:
Regarding dividends DGCL §170 gives the board the power to declare dividends; and since
the minority shareholders received their pro rata share, there was no self-dealing; therefore
the BJR was the proper standard as to the dividend complaint
Regarding corp opp claim Π could not prove that there were any opportunities which
Sinclair usurped from Sinven no self-dealing & BJR applies
Regarding breach of contract claim there WAS a case of basic self-dealing, as ∆ was on both
sides of the transaction; therefore, the intrinsic fairness test applies ∆ had to prove that
causing Sinven not to honor the contract was intrinsically fair to the minority Sinven
shareholders; ∆ couldn’t do that
Greene v. Dunhill International (controlling SH can’t divert/misappropriate corporate opportunity)
o Facts: (DE Chan 1968) ∆, Dunhill, owned 80% of Spalding which made baseballs and toys. The minority
shareholders of Spalding protested when Dunhill, not itself making any toys, bought Child Guidance
Toys for itself, argued Δ misappropriated corporate opportunity
o Rule controlling shareholders have a duty not to divert corporate opportunities
o Holding there was showing of a corporate opportunity which Δ SH misappropriated
Kahn v. Lynch Communications, Inc. (VERY IMP! board in interested transaction w/ controlling SH must be
truly independent, or else no burden shifting – need real arm’s length bargaining)
o Facts: (DE S/Ct 1994) Π had sought to stop the acquisition of Lynch by Alcatel. Alcatel owned 44% of
Lynch, and was effectively its controlling shareholder as it dominated the board. Lynch had sought to a
buy a fiber-optics company, TelCo; but Alcatel instead wanted it to purchase Celwave (owned by
Alcatel’s own parent, CGE). The independent committee created by Lynch to examine the Celwave deal
did not approve the purchase. Alcatel then moved to buy the other 56% of Lynch at $14 a share, and
the independent committee was ordered to look into such a deal. It approved the deal, but ONLY b/c it
knew Alcatel would instead move in with a hostile takeover if this wasn’t approved.
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П argues no arm’s length bargaining
П argues Alcatel’s offer to purchase was false & misleading b/c they didn’t disclose threats
made to the independent committee
П argues merger price was unfair
o Issues:
1) Whether Alcatel had control over Lynch
2) Who has burden of proving entire fairness of merger transaction?
o Shift of Burdens:
Generally the controlling SH has burden to show entire fairness
But when transaction’s done by independent committee bargaining @ arm’s length OR if
there’s approval by informed majority of the minority SHs burden shifts to the П minority SH
test is still entire fairness
2 part test to see if burden should shift in interested merger transaction:
1) The majority SH must NOT dictate the terms of the merger
2) The special committee must have real bargaining power that it can exercise w/ the
majority SH on an arm’s length basis
o Holdings:
Affirms Chan Ct’s finding that Alcatel WAS a controlling SH of Lynch even though only owned
44% of stock (veto power makes Alcatel the controlling SH)
The controlling SH (Alcatel) has burden of proving entire fairness
BJR doesn’t apply b/c it’s an interested merger transaction
Burden never shifted back to П b/c there was NO independent committee bargaining @
arms’ length committee quickly capitulated to Alcatel’s terms – not truly
independent (running dogs of capitalism)
Δ’s ability to threaten means extra scrutiny by court
o Court uses great condemnatory language for members of the “independent” committee who were
really conflicted & did the master’s bidding:
It is clear that Boushka and Stafford abdicated their responsibility as committee members . . . [p.
721 last paragraph]
Stafford’s absence from all meetings . . . rendered him ill suited as a defender of the interests of
minority shareholders.
From its inception, the Special Committee failed to operate in a manner which would create the
appearance of objectivity in Tremont’s decision to purchase NL stock. [P. 722 2nd full paragraph]
The record is replete with examples of how the lack of the Special Committee’s independence
fostered an atmosphere in which the directors were permitted to default on their obligation to
remain fully informed. [P. 722 last paragraph.]
o Takeaways:
Note that courts do not like doing entire fairness scrutiny that much; they will therefore often
take evidence of an arm’s length transaction as an equivalent demonstration of a fair price
having been achieved
If corp had independent committee, did market price to see if price was adequate, had
indep. Counsel & financial advisors & negotiated hard court is likely to find that it
was an arm’s length transaction
Note also that if the price and the process stink badly enough, though DE is an equity court and
does not award punitive damages, it may well award rescissory damages (above the actual
proper market price; are very similar to punitive damages) because the deal was so bad
o Outcome upon remand Chan Ct found merger was entirely fair to minority SHs
What does Arm’s Length Bargaining mean?
o Alcatel didn’t have to tell SHs their bottom line price.
o “Defendant need not disclose information which might be adverse to its interest because the normal
standards of arms-length bargaining do not mandate a disclosure of weakness.”
Chart revisited - analyzing the burden of proof in interested transactions
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No Controlling
SH
Decision made by
Full Board
Decision made by an
“Independent Committee”
Decision ratified by
Disinterested SHs
(1) BJR presumption
(1) BJR presumption; (2) П
rebuts and the standard
becomes entire fairness; (3) ∆s
show independent committee
approval and the BJR
reattaches; (4) П can return the
standard to EF by showing the
committee was not
independent, not informed, or
that it’s decision lacked a
rational basis (Cooke)
(1) BJR presumption; (2) П
rebuts and the standard
becomes EF; (3) ∆s show
that there was informed
SH ratification; (4) П can
attempt to rebut the
informed nature of the
ratification, but if he can’t,
then the transaction may
be reviewed on the basis
of waste (waste standard =
have to show there was no
consideration at all)
(1) BJR presumption: (2) П
rebuts and the standard
becomes EF; (3) ∆ can show that
an independent committee
ratified the decision but the
BJR does not reattach &
standard stays at EF; (4) П can
show the transaction was not EF
(1) BJR presumption; (2) П
rebuts and the standard
becomes EF; (3) ∆s can
show there’s disinterested
SH approval; but this will
satisfy a court only to the
point of (3) shifting the
burden to П to prove the
transaction was not
entirely fair; for SHs may
well be intimidated by the
controlling shareholder
(2) П can rebut
(3) Δ can prove
transaction was
entirely fair
Controlling SH
(1) BJR presumption
(2) П can rebut
(3) Δ can establish
entire fairness
(Kahn v. Lynch)
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Levco Alternative Fund v. The Reader’s Digest Ass’n (when there’s conflicting interest btw different SH classes,
directors must do fairness analysis for each class individually)
o Facts: (DE S/Ct 2002) RDA had two classes of stock, A which voted, and B which didn’t. There was (as
in Zahn) a recapitalization plan proposed that would make it so that there was only one class of voting
stock. Πs allege that the independent committee which approved the deal did not in fact adequately
consider A class’ interests, in that they would gain voting rights but lose stock value & B class are
favored over them.
o Burdens of Proof:
the initial burden lies on the interested party to prove the fairness of the transaction;
here the independent committee was not function property on both process & price
therefore the burden never shifted to Π the committee’s fairness analysis was for company
as a whole, but NOT done individually for each SH class
what’s fair for entire corp isn’t’ always fair to SH class
o this case is different from Kahn b/c here the corp did NOT have a contractual right to repurchase the
stock; it was trying to change those rights; and if you are going to change contractual rights, you have
an obligation to each and every shareholder to maximize their interests
o Holding Factors for preliminary injunction in favor of Пs, since there were conflicting interests of the
SH classes – the transaction as NOT entirely fair to class A SHs
Since directors didn’t secure sufficient info concerning effect of recapitalization on Class A SHs,
raises serious question concerning the duty of care
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Jones v. H.F. Ahmanson & Co. (CA case – Traynor’s broad notion of good faith – only case to deal w/ the equal
opportunity principle)
o Facts: (CA S/Ct 1969) П is minority SH of a savings and loan (close corp) brought an action against ∆s,
87% SHs of the company. ∆s had transferred their shares in the S&L into a holding company, and
created a public market for the shares of the holding company. ∆s shares were selling above book
value & kept on making offers to buy S&L stock at lower prices, while Πs could not access the public
market and Πs’ dividends were declining.
o Rule CA rule of “inherent fairness” from the viewpoint of the corp and those interested therein
majority shareholders have a fiduciary duty to minority shareholders and can’t use their power
to benefit themselves at the expense of the minority
here the majority SH denied the minority any market for their stock
majority also created caused “inextricably wedded conflict of interest” btw the minority SH of
each corp
o Holding crazy CA court ruled here that Πs have a cause of action for breach of fiduciary duty by ∆s;
as the minority should have gotten a chance to participate in the deal
Traynor here seems to think that the minority shareholders should get an equal opportunity
with that of the majority shareholders; Wachter is certain he is crazy, and even more certain
that the law doesn’t work that way
Traynor asserts a broad duty of fair dealing – Δ had opp to make S&L more attractive or help
the minority SH in some way, but didn’t do so
o In states OTHER than DE, employment & corp law are combined in an uneasy way; employees with
shares have more rights than they would otherwise
DE does not do this because it does not want to create a separate set of law for big and small
corporations;
it does have a separate section of the DGCL for close corporations; if parties wish to, they can
incorporate under that, and write in extra protections for employees who are also shareholders
Sale of Corporate Office/Control
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Minority shareholders are entitled to protection against abuse by controlling shareholders but are NOT entitled
to inhibit the legitimate interests of other
o There’s usually premium on controlling shares b/c that’s the additional amount the investor is willing to
pay for privilege of directly influencing the corp’s affairs
o EXCEPTIONS:
You can’t sell control for premium when you have reason to believe premium is being paid to
you in order to steal corporate assets (Gerdes)
You can’t sell control for premium when premium is in consideration for sale of a corporate
opportunity (Feldmann)
You can’t use assets from one corporation to help second corporation b/c you still have
fiduciary duty to the first (Omundson?)
Zetlin v. Hanson Holdings (SH’s right to sell controlling interest @ premium w/ certain exceptions)
o Facts: (NY Ct/A 1979) Δs sold their shares of Gable Industries to Flinkote Co. for a premium price of
$15/share, enough shares to give Finkote effective control of corp. Market price was $7.38/share.
o Rule Absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts
of bad faith, a controlling stockholder is free to sell, and a purchaser is free to buy, that controlling
interest at a premium price.
Minority shareholders are NOT entitled to share equally in the premium.
We do NOT have an equal opportunity rule because the fiduciary duties exist to maximize the
value of the corporation, not to keep any individual’s job
Arguments for and against equal opportunity in sale of controlling shares
o Andrews, SHs Right to Eq Opportunity in the Sale of Shares—(pp 720-22)
o Contra above, Javaras, Eq Opportunity in the Sale of Controlling Shares: A Reply to Andrews—(pp722-24)
Gerdes v. Reynolds (you can’t sell controlling shares when there’s corp looting by the buyers)
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Facts: (NY 1941) ∆s, the board of Reynolds Company, were selling off the company, a closed-down
mutual fund which owned only stocks in publicly-listed companies. The buyers they found were willing
to pay more than the fair price – but only because they were planning on stealing the company’s assets.
∆s immediately resigned upon the sale, and the buyers shredded Reynolds to pieces; Π is the trustee in
bankruptcy.
o Rule While controlling shareholders may normally sell their shares without any fiduciary duty to the
corporation or minority shareholders, it is in fact a breach of fiduciary duty to do so where the officers
and directors decide to sell to person they should have known would loot the company, and then
immediately resign after the sale
Director’s right to resign, although sometimes stated with seeming absoluteness, is qualified by
their fiduciary obligations to others.
Directors must be reasonably vigilant in assessing the circumstances of the sale. Duty to
reasonably perceive risk, fully investigate, disclose resignation plans in connection with sale
to shareholders.
o Holding Officers & directors violated their fiduciary duty, should have seen the red flag – the
egregious price paid WAY above value of shares. Δs must account to the corporation… for the sum of
$1,318,750, and for all damages naturally resulting from their official misconduct.
Perlman v. Feldmann (Controlling SH can’t sell @ a premium when that premium is due to sale of a corp
opportunity/asset)
o Facts: (2d Cir. 1955) Derivative action by minority SHs, Πs sue Feldman, the former President and
Chairman of the Board of Newport Steel, and dominant shareholder. Пs assert ∆ violated his fiduciary
duty to the corp and the shareholders by selling control along with a corporate asset. That asset was
the “Feldman Plan,” a method of obtaining high returns on steel sales when the prices were controlled
by the government. For ∆ sold to Newport’s customers who immediately did away with the plan.
o Issue Can Δ take advantage of the tight steel market & sell his controlling shares at premium?
o Rule controlling SH can sell corp advantage at a premium, BUT he can’t take it for himself @ expense
of corp the minority SHs have to get their share of that advantage
Δ would have burden of proof to show there would’ve been no corp advantage under the
circumstances of the transaction
o Holding The Feldman plan was deemed to be a corporate asset here; and because ∆ received a
premium for the sale of his shares and control, he violated his fiduciary duties, not only as a director
and President, but as a controlling shareholder
There was no fraud or the like – just profit to which ∆ was not entitled, Пs can recover their %
of the premium the Δ profited from his sale of the “asset”
Broad interpretation - suggest that fiduciary duties take into account a variety of things, one of
which is in the sale of the company in a particular environment whereby you are losing out on a
large source of revenue for the company through the sale.
o Dissent it’s important to know nature of conflict in a transaction, if the conflict is the sale of control
the only time a П wins is when it falls w/in the list of exceptions – argues against creating a bigger set of
obligations for the dominant SH in selling controlling shares.
Under DE law – you can’t just sell the corporate office by itself!
o DE case law also says you can’t sell control if u think the buyer is going to harm the corp
o
Brecher v. Gregg (NY- illegal to sell corp office or control w/o sufficient shares of voting stock)
o Facts: (NY 1975) Transaction between Δ Gregg, largest beneficial owner of LIN and a member of the
board of directors and the Saturday Evening Post Company (SEPCO) in which SEPCO bought Gregg’s
82,000 shares and paid an amount $1.26mil more than the market price on the sale date. Пs argue that
SEPCO paid Gregg a premium for his promise to resign immediately as CEO and president of LIN… in
order to bring about the election of a majority of SEPCO’s nominees.
o Rule It’s illegal to sell corporate office or management control by itself (accompanied by no stock
or insufficient stock to carry voting control)
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Holding The agreement insofar as it provided for a premium in exchange for a promise of control
with only 4% of the outstanding shares actually being transferred, was contrary to public policy and
illegal.
Illegal profit belongs to the corporation (any amount over and above that which would be
realized in an arm’s length transaction, over the counter.
Essex Universal Corp v. Yates (NY – okay to sell @ premium for immediate transfer of control where the buyer
has received enough stock for majority control)
o Facts: (2d Cir. 1962) П corp sued a controlling SH from whom it had agreed to purchase a 28% share
and immediate control of the board, Δ backed out of sale & argued the agreement was illegal as a
defense
o Issue Is contract for sale of 28.3% of stock w/ clause giving purchase option to require a majority of
the existing directors to replace themselves invalid under NY law?
o Rule general rule is that a bargain for the sale of a majority of stock isn’t made illegal by a plan for
immediate transfer of management control. It is legal to give/receive payment for the immediate
transfer of control to someone who has received majority control.
Although under NY law, illegal to sell corp office or management control by itself
o Holding Provision not invalid on its face, inseparable from sale of shares & 28.3% usually constitutes
a majority so Δ Yates has burden to show otherwise for contract to be illegal.
NOTE: Shareholders have an interest as residual claimants. If not going to get elected, and are going to get
appointed by outgoing directors. Needs to be a big enough chunk of stock so the new directors will have the
same incentives as the outgoing directors. This issue has become very hot lately.
o In the last couple years hedge funds have bought stock to influence an election, sold options on that
stock, essentially hedging that position (so they don't have real risk/ownership in performance), then
vote their shares in a way that may protect some other investment that they have.
o EX: Hedge fund has stock in A. A & B merge. Hedge fund thinks merger will be bad for A. Try to
influence an election w/o having any ownership interest in one of the companies by buy stock and
hedging position with options. Remember: Rule F 14(1) 2056, filing requirements when change of
control.
SEC Rule 14(f)(1) Change in Majority of Directors
o If pursuant to any arrangement or understanding with a person… acquiring securities in a transaction
subject to 13(d) or 14(d) of the Act, any persons are to be elected or designated as directors of the
issuer, otherwise than at a meeting of security holders… and the persons elected will constitute a
majority of the directors of the issuer…then not less than ten days prior to the date such person take
office as director….the issuer shall file with the Commission and submit to all shareholders…information
which would be required by items 6(a)(d)(e), 7,8, of schedule and regulation 14A…
ALI § 5.16 Disposition of Voting Equity Securities by a Controlling Shareholder to Third Parties
o A controlling shareholder has the same right to dispose of voting equity securities as any other
shareholder, including the right to dispose of those securities for a price that is not made proportionally
available to other shareholders, but the controlling shareholder does not satisfy the duty of fair dealing
to the other shareholders if:
(a) the controlling shareholder does not make disclosure concerning the transaction to other
shareholders with whom the controlling shareholder deals in connection with the transaction;
or
(b) it is apparent from the circumstances that the purchaser is likely to violate the duty of fair
dealing under Part V in such a way as to obtain a significant financial benefit for the purchaser
or an associate.
o
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Insider Trading & Material Misrepresentations
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SEA §10(b) and Rule 10(b)-5 – Elements of Claims
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Securities Exchange Act § 10(b) and Rule § 10(b)-5
o § 10(b) Manipulative and Deceptive Devices:
It shall be unlawful for any person, directly or indirectly, by the use of any means or
instrumentality of interstate commerce or of the mails, or of any facility of any national
securities exchange—
(b) to use or employ, in connection with the purchase or sale of any security registered on a
national securities exchange or any security not so registered, …any manipulative or deceptive
device or contrivance in contravention of such rules and regulations as the commission may
prescribe as necessary or appropriate in the public interest or for the protection of investors…
o Rule 10b-5 Employment of Manipulative and Deceptive Devices
It shall be unlawful for any person, directly or indirectly, by the use of any means or
instrumentality of interstate commerce, or of the mails or of any facility of any national
securities exchange,
(a) to employ any device, scheme, or artifice to defraud,
(b) to make any untrue statement of a material fact or to omit to state a material fact
necessary in order to make the statements made, in the light of the circumstances
under which they were made, not misleading, or
(c) to engage in any act, practice, or course of business which operates or would
operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security.
Introduction
o In some ways, a continuation of duty of loyalty a lot of the analysis hinges on the duty of loyalty on
the part of corporate executives, insiders, or other who have inside information. Two views:
1) Continuation of fiduciary duties. In some respects, it should be handled under state law in
terms of the use of corporate property—viewed this way it’s an extension of what we already
did.
2) Arises from need to protect market. Another view is that as ’34 Act trumps state law, for a
free enterprise system to work with the separation of ownership and control necessary for a
modern corporation, there is a need for well-functioning securities markets leads to the idea
that the securities market itself has to be protected for the corporate form to succeed.
Importance of well-functioning securities market we are so willing to invest our
money in stocks because the duty of loyalty can be controlled at the state level &
directors are not going to walk off with the treasury and the residual claimants get a
return. An essential part of this is the ability to buy and sell those shares.
o Why don’t you want insiders trading stock?
in essence, they are stealing from the corporation
the corporation doesn’t want to disclose because they want to get the best position out of the
situation as possible (don’t want insider trading to move the market)
On the other hand—could argue that insider trading serves a good purpose because it gets the
price right and that anything that gets the price right (by getting information into the market)
has merit to it—but the problem is the duty of loyalty problem and that it can hurt the
company.
Two very different claims under §10(b) and Rule 10b-5:
o Traditional “insider trading” insider trading by individuals who have material non-public information
when they have a duty to disclose
cases on this basis are brought by the SEC itself
o Corporations/individuals who put out misleading statements. Defective disclosure by the corporation
in the context of §13; for, whereas proxy statement disclosure is regulated by Rule 14a-9, all other
disclosures are regulated by §10(b)
Пs in these cases will be SHs, Δs will be corps
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note that Rule 14a-9 is based on negligence, whereas a Π in a §10(b) case will have to prove
fraud.
o Elements of a Claim for 1) individuals who have material non-public info w/ duty to disclose
(1) the “in connection with” requirement
(2) inside information: material, non-public
(3) duty to “disclose or abstain”
SEC will usually bring claim does NOT have to show causation/damages.
o Elements of a Claim for 2) corporations/individuals who put out misleading statements
(1) defendant made material misrepresentation or omission (i.e. the “manipulative or
deceptive device”)
(2) with the intent to misrepresent or omit=scienter
(3) made in connection with the purchase or sale of a security
Broad definition of “sale” – Rubin v. U.S. (pledge of securities constitutes an offer or
sale)
(4) upon which there was reliance
(5) which caused (economic loss/transaction causation)
(6) damage (loss causation)
Pleading Requirement – SEA §21D(b)
o §21D(b)(1) – requires the П to plead w/ particularity
Feds moving towards heightened pleading standard that DE law has
o §21D(b)(2) – П who alleges securities fraud must “state w/ particularity facts giving rise to a strong
inference that the Δ acted w/ the required state of mind”
Scienter requirement
The Scienter Requirement
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Ernst & Ernst v. Hochelder (US S/Ct 1976) – held no private action for damages under 10b-5 in the absence of
allegation of scienter (defined as an “intent to deceive, manipulate, or defraud”) on the Δ’s part
o Doesn’t address whether recklessness can be scienter subsequent decision have held that
recklessness = scienter
o Compare to proxy statements where only negligence was required, not scienter
Sundstrand Corp v. Sun Chemical Corp (7th Cir. 1977) – defines recklessness as an extreme departure from the
standards of ordinary care, which presents a danger of misleading buyers/sellers that’s known to the Δ or so
obvious the Δ must have known of it
o Merely simple, or even inexcusable negligence is NOT enough
Sanders v. John Nuveen & Co. Inc. (7th Cir. 1977) – differentiates recklessness for scienter from negligence
(more than merely a greater degree of ordinary negligence) – not just a difference in degree, but in kind
Aaron v. SEC (US S/Ct 1980) – showing of scienter is requirement for injunctive action under 10b-5
For allegedly fraudulent forward-looking statements you need actual knowledge, recklessness is not enough
(PSLRA)
o Private Security Litigation Reform Act
Supposed to take care of some of the abuses in the П’s side in securities litigation
§21E(a)(2) says that the П can’t purchase the stock just to be a plaintiff, (v) IDs professional Пs,
(vi) says П can’t accept payment
The “In Connection With” Requirement
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The “in connection with requirement”
o Requirement limits standing to those who purchased or sold stock
o Very expansive definition of what constitutes a “sale” (Zandford)
o Includes options or other rights to purchase or sell securities (Blue Chip)
o Includes oral contracts to purchase or sell securities (Wharf)
The Wharf (Holdings) Limited v. United International Holdings (not honoring sale of stock options violates
§10(b), stock options count as securities)
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Facts: (US S/Ct 2001) Δ Wharf, a Hong Kong company, sought United’s help in assembling their
proposal for a cable contract in Hong Kong. United bargained for an option for 10% of Wharf’s
securities, had oral agreement & П raised $ to finance 10% share. Wharf later refused to hand over the
10%, had docs suggesting Δ never intended to fulfill promise.
o Issue whether selling an option w/o intent to actually honor it violates §10(b) & 10(b)-5
o Holding YES, secretly not intending to honor sale of stock options violates §10(b)
this seems like a contract dispute; but the USSC here expanded the ’34 Act, allowing a private
suit to be brought under §10(b); oral agreements to buy or sell stock options fall under the SEA
umbrella
the “security” at issue is not the cable system stock, but the option to purchase that stock.
since the agreement did relate to the value of the security, the option was in fact worthless (if
they never planned on handing over stock)
Blue Chip Stamps v. Manor Drugs Stores (only those who bought/sold stock can bring action)
o Facts: (US S/Ct 1975)
o Holding under the “in connect with” clause, only a person who had actually purchased/sold stock
had standing to bring private action under 10b-5
continuing investors who neither bought nor sold shares around the time of misrepresentation
has only a state law remedy this halted the federalization of corporate law by placing limits
on Rule 10b-5 suits
holding affects ppl who claim they “would have sold” stock had they not been induced to retain
stock by misrepresentations
Semerenko v. Cendant Corp (3rd Cir. 2000)
o Where the fraud alleged involves the public dissemination of info in a medium upon which an investor
would presumably rely, the “in connection w/” requirement can be met by showing materiality of
misrepresentation and the means of its dissemination.
o Under this standard, it is irrelevant that the misrepresentations weren’t made for the purpose or the
object of influencing the investment decisions of market participants.
SEC v. Zandford (shows breadth of ’34 Act – fraudulent scheme to defraud falls under §10(b))
o Facts: (US S/Ct 2002) Δ stockbroker would sell his customer’s securities and use the proceeds for his
own benefit w/o the customer’s knowledge or consent. Δ argue the sale of the securities were
incidental to fraud & more akin to stealing than manipulation of security
o Issue whether this conduct was “in connect w/ the purchase or sale of any security” w/in meaning of
§10(b) and 10b-5
o Holding The court determined that this was “in connection with the purchase or sale of any
security” within the meaning of the statute and the rule.
SC reiterates that “[the ’34 Act] should be ‘construed not technically and restrictively, but
flexibly to effectuate its remedial purposes.’”
“Neither the SEC nor this Court has ever held that there must be a misrepresentation about the
value of a particular security in order to run afoul of the Act.”
Court analyzed these events as a “scheme to defraud” noting that it is not “a case in which a
thief simply invested the proceeds of a routine conversion in the stock market. Rather,
respondent’s fraud coincided with the sales themselves.”
Merrill Lynch v. Dabit (US S/Ct 2006) (very expansive reading of “in connection with” – П doesn’t have to be the
buyer/seller)
o Holding it’s enough that the fraud alleged “coincide” with a securities transaction – whether by the
П or by someone else
o Only requires showing of “deception in connection w/ purchase or sale of any security,” don’t need
deception of an identifiable purchaser or seller
Manipulative/Deceptive Device Requirement
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What constitutes a manipulative/deceptive device:
o Misstatement
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o
o
o
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Omission, if (and only if) you have a duty to disclose
There has been some actual deception – claim is about fraud not enough that it was unfair
The fact that you need a “material representation” keeps many traditional state-law claims out of fed
court (see Meridor)
Organ v. Laidlaw (when there’s no duty to disclose, parties can’t make misleading statements)
o Facts: First insider trading case, arising during the War of 1812. Organ and Laidlaw both sold tobacco.
One day Organ bought a lot of tobacco—Laidlaw inquired as to why by Organ equivocated. Transaction
occurs. In fact, the war is already over and Organ knew it—also knew that tobacco prices would take
off as soon as the embargo was lifted.
o Holding Justice Marshall says there is no duty to disclose, but the parties can’t say anything to
mislead. Took a while for the SEC to get what Marshall got.
Santa Fe Industries, Inc. v. Green (10b-5 actions on the basis of breach of fiduciary duty due to corporate
mismanagement are improper where there is a state remedy)
o Facts: (US S/Ct 1977) Santa Fe had acquired 95% of Kirby Lumber and sought to use the DE short-form
merger to acquire the other 5%. Πs, minority shareholders, objected to the merger terms (they got $25
over the book value, but think with a calculation of assets their shares are worth $600 more than that)
and are trying to take this §10b-5 action on the basis that ∆ had used a “fraudulent appraisal” of the
value of the shares, therefore being an artifice to defraud.
Δ satisfied all filing requirements under DGCL §253
Δ got independent i-bank to appraise value of stock
o Issue whether §10(b) applies when a majority SH uses a short-form merger to eliminate minority
interest in a corp
o Holding the US S/Ct denies this 10b-5 action thoroughly and completely, on three grounds:
(1) there was no intent to deceive; for Santa Fe here had actually given Πs here the
ammunition by disclosing their rationale for the price
(2) Πs here could have used the state law remedy of appraisal
federal law does not provide a remedy for breach of fiduciary duty of officers in
connection with the sale of the corporation
(3) unnecessary litigation can be vexatious and a waste of money
o Takeaway For 10b-5 case, П needs evidence of some sort of nondisclosure or a misleading
representation; not just evidence of internal corporate mismanagement
This case, in conjunction with Blue Chip Stamps, marked the turning away from federalization
of US Securities law
Goldberg v. Meridor (allows 10b-5 action for unfair transaction btw corp & controlling SH – rejected by 7th Cir –
no S/Ct decision on this yet)
o Facts: (2d Cir. 1977) UGO corp controlled by Maritimecor, in turn controlled by Maritime fruid. П UGO
SH alleges that ∆, a large SH in UGO caused UGO to acquire Maritimecor’s assets in exchange for UGO
stock w/ inadequate compensation. Press releases describing agreement failed to disclose certain
material facts concerning assets’ value.
o Rule a derivative action can be brought under 10b-5 on the basis of an unfair transaction between a
corporation and a controlling shareholder if:
(1) the transaction involved stock; and
(2) material facts concerning the transaction had not been disclosed to shareholders
o Holding The 2nd Cir. allowed this to be a 10b-5 violation, but Π needs to show that this state act
would likely have succeeded
Ct says that Schoenbaum survived Santa Fe
This is actually a duty of care case – a version of Sinclair
o NOTE: in Isquith v. Caremark Int’l the 7th Cir. rejected Goldberg as too much an extension of federal
securities law which would allow every complaint about corporations to come under the ’34 Act
o This case has been widely followed; generally, to succeed under the principles of this case, the plaintiff
must show:
(1) a misrepresentation or nondisclosure that caused a loss to the shareholders
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(2) if the controlling SH did not need approval by the minority shareholders to effectuate the
relevant transaction, then to show causation the plaintiff must normally establish that as a
result of the lack of full disclosure, a state remedy, was foregone.
most commonly, the plaintiff attempts to satisfy this by arguing that if full disclosure
had been made, the shareholders could have sought injunctive relief against the
proposed transaction under state law.
Wachter points out that “non-disclosure” raised in such cases is just a hook to try to get this under the ’34
Act
o really, at bottom these are state law cases; for they are about the duty of loyalty
o the ’34 Act does not have the rules on burden shifting and the like which DE does
o Under DE law, there is a duty of complete candor when shareholder action is required
Duty to Disclose – “Any Person” Unraveled
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Greenfield v. Heublein (3d Cir. 1984) - Although a corp may be under no duty to disclose…if a corp voluntarily
makes a public statement that is correct when issues, the corp has a duty to update the statement if it becomes
materially misleading in light of subsequent events.
Backman v. Polaroid Corp. (duty to correct can also apply to a certain narrow set of forward-looking
statements)
o But the scope of duty to update has been brought into question by safe harbor provisions in SEA
§21(E)(d) – says no duty to update forward-looking statement as defined in 21E.
Who is “any person”
o Obvious insiders officers, directors, controlling SHs
o Obligation to “disclose or abstain” Cady Roberts
o Narrowed (or mooted?) by Chiarella
In re Cady, Roberts & Co (1961) (1st case law statement - definition of “any person”)
o Rule There is a disclosure requirement for corporate insiders in dealing w/ investors, they must
either disclose non-public material info or abstain from acting on that info
This applies to “any person” who has inside info – not just restricted to officers, directors, &
controlling SHs.
To see who has this obligations, look at 2 elements:
(1) the existence of a relationship giving access, directly or indirectly to information
intended to be available only for a corporate purpose and not for the personal benefit
of anyone, (“regularly available”) and
(2) the inherent unfairness involved where a party takes advantage of such
information knowing it is unavailable to those with whom he is dealing.
o The SEC tried to push the “any person” part of the rule, but later lost a lot of cases
Rule 10b-5(2)(b) [p. 1924]: Duties of Trust or Confidence in Misappropriation Insider Trading Cases:
o a duty of trust or confidence exists where:
(1) you agree to maintain the information in confidence
(2) where you and the person who gave you the information have a history of sharing such
information in confidence
(3) whenever you receive such information from a spouse, parent, child or sibling (unless you
demonstrate their was explicit recognition there was no duty of confidence)
Other Theories for Assigning 10(b) Duties
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Fiduciary Relationship
o Duty to disclose comes out of your fiduciary relationship (Chiarella)
o Duty inherited from another if you knew or should have known of the other’s duty (Dirks)
Chiarella v. United States (Cady Roberts no longer good law – the “disclose or abstain” rule does NOT apply to
“any person” – only those w/ duty to disclose)
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Facts: (US S/Ct 1980) Chiarella was a mark-up man at a printing company. They were printing
disclosure statements of “ABC company” and Chiarella decoded the actual name of the company. Once
he figured it out he bought stock and made $30,000.
o Issue This case surrounds the “any person” part of 10b. This guy is not trading in his own company’s
stock, he is not a fiduciary of ABC nor his company. Did he employ a “manipulative or deceptive
device?”
o Rule Elements of a 10b-5 violation:
(1) the existence of a fiduciary relationship affording access to insider information intended to
be available only for a corporate purpose, and
(2) the unfairness of allowing a corporate insider to take advantage of that information by
trading without disclosure.
o Holding The standard is NOT “any person” – It is any person who has a duty to disclose but doesn’t
disclose. Here Chiarella didn’t have a duty so his silence was lawful!
“First, not every instance of financial unfairness constitutes fraudulent activity under § 10(b).
Second, the element required to make silence fraudulent—a duty to disclose—is absent in this
case.”
“Application of the duty to disclose prior to trading guarantees that corporate insiders, who
have an obligation to place the shareholder’s welfare before their own, will not benefit
personally through fraudulent use of material, nonpublic information.”
§ 1483 – Part of Williams act incorporated into the 34 Act regulating tender offers
o Says any person who makes any untrue statement of a material fact or to engaged in any fraudulent,
deceptive, or manipulated acts regarding a tender offer is liable
o In response to Chiarella - the SEC passed Rule 14e-3 which says that if ANY PERSON gets any
information regarding a tender offer, he can’t trade on that information
Doesn’t matter if he got the info directly or indirectly
Also illegal to communicate info regarding tender offer to another person if it can be
reasonably anticipated that the info would induce the other person to violate the section
o Effect of 14e-3
Covers Chestman & gets him in trouble
Also reverses Chiarella in a way, b/c he’d be guilty under 14e-3
Misappropriation Theory
o Test is whether the insider benefited, either directly or indirectly, from the disclosure (Dirks)
o Theory is used to fill the gap when fiduciary link breaks
o Liability b/c of fiduciary turned trader’s deception of those who entrusted him with confidential info
Dirks v. SEC (tipper/tipee case: if a tipper has fiduciary duty not to disclose & discloses to tipee then the tipee
inherits that duty as well a derivative fiduciary duty)
o Facts: (US S/Ct 1983) Dirks was an officer at a New York based broker-dealer firm. He gets tipped off
by Secrest that Equity Funding of America has been engaging in fraudulent corporate practices,
overstating their profits. Dirks flies to LA and conducts his own investigation. He talks to a lot of people
and he thinks he’s onto something. Tries to get the WSJ to publish something, but they won’t do it. He
starts telling people about it (clients & investors who then sold a lot of stock)—Δ & his firm didn’t own
any stock in the corp & didn’t trade on the info.
o Issue Δ isn’t trading himself, but who can he tell?
o Rule S/Ct has two theories:
(1) If Secrest has a fiduciary duty, and he tells Dirks, then Dirks inherits the fiduciary duty (if
Dirks knows or should know). Is there a fiduciary?
Initial inquiry whether there’s been breach of duty by the insider – requires ct to
focus on objective criteria
(2) Test is whether the insider himself will benefit, either directly or indirectly, from the
disclosure. Did he benefit?
Pecuniary gain or reputation benefit that will translate into future earnings
Existence of a quid pro quo relationship will satisfy this
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OR if tipper is giving the info as a “gift” to a relative/friend (p.832)
o Holding No violation by Dirks under tipping rules, inside tippers didn’t violate their fiduciary duty &
thus no derivative breach by Dirks, Dirks had no duty to abstain from use of the inside info
SEC v. Yun (11th Cir. 2003) (benefit to tipper doesn’t have to be pecuniary, can be future earnings)
o In cases involving tippee liability, the SEC must establish that the tippers intended to benefit from their
disclosure of confidential info
“benefit” defined broadly under Dirk not only does an actual pecuniary gain (e.g., a kickback
or expectation of a reciprocal tip in the future) suffice to create a ‘benefit’, but also cases
where the tipper sought to enhance his reputation (translates into future earnings)
o HERE, SEC presented evidence that tipper and tippee were ‘friendly’ and worked together for several
years during which they split RE commissions
From this, jury may reasonably conclude that tippee got benefit from maintaining relationship
with friend and frequent partner in RE deals.
United States v. O’Hagan (adopting misappropriation theory to fill gap – Δ didn’t deal in stock of company he
owned fiduciary duty to – BUT he’s feigning loyalty to the law firm & gaining access to material nonpublic info
which he then used for his own purposes)
o Facts: (US S/Ct 1997) ∆ worked for a MN law firm which was helping to negotiate a tender offer for a
corp – Grand Met. Δ didn’t work on the case, firm withdrew from representing Grant Met, which
announce tender offer 1 month later, Δ bought stock in the target company (while firm still
representing Grand Met) and sold it at a profit when the merger was announced.
o Issue whether there is a deceptive or manipulative device.
o Holdings: S/Ct finds that:
(1) that a person who trades in securities for personal profit, using confidential information he
misappropriated in breach of a fiduciary duty owed to the source is guilty of violating 10b-5,
and
(2) the SEC did not exceed its power by adopting 14e-3(a) (proscribing trading in the tender
offer setting, even absent a duty to disclose)
o Ct approves the SEC’s misappropriation theory under 10b-5 a person commits fraud in connection
with a securities transaction when he misappropriates confidential information for securities trading
purposes in breach of a duty owed to the source of the information
this theory satisfies §10(b)’s requirement that chargeable conduct include a “deceptive device”
used “in connection with” trading in securities
the SEC has authority to promulgate this rule under 10(b) which says the SEC may prohibit
fraudulent acts.
o Rule 14e-3 is proper because the SEC may prohibit acts that aren’t themselves fraudulent if that
prohibition is reasonably designed to prevent acts that are fraudulent
Per se prohibition on using material, non-public info for trading in tender offers – Rule 14e-3(a)
o No fiduciary relationship or misappropriation in tender offer context needed
o Rule 14e-3 Transactions in Securities on the Basis of Material, Nonpublic Information in the Context
of Tender Offers
(a) If any person has taken a substantial step or steps to commence, or has commenced, a
tender offer, it shall constitute a fraudulent, deceptive or manipulative act or practice within
the meaning of section 14(e) of the Act for any other person who is in possession of material
information relating to such tender offer which information he knows or has reason to know is
nonpublic and which he knows or has reason to know has been acquired directly or indirectly
from:
(1) The offering person,
(2) The issuer of the securities sought or to be sought by such tender offer, or
(3) Any officer, director, partner or employee or any other person acting on behalf of
the offering person or such issuer,
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to purchase or sell or cause to be purchased or sold any of such securities or any securities
convertible into or exchangeable for any such securities or any option or right to obtain or to
dispose of any of the foregoing securities, unless within a reasonable time prior to any
purchase or sale such information and its source are publicly disclosed by press release or
otherwise.
Rule 10b-5-1
Not a defense to claim u knew the info but didn’t use it when u traded. If you knew the
information, you used the information
General rule under 10b-5-1 purchase/sale of a security violates Rule 10b-5 if the
purchaser/seller was aware of material nonpublic info about the security or issuer at the time
of purchase/sale
An affirmative defense if you can prove that the contract of sale was already in place before
any such inside info was known
Materiality Requirement
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Omission is material if a reasonable investor would have attached importance in determining his choice of
action (TSC)
o When does an event (like merger) become material enough to disclose? balance two factors:
Probability the event will occur
Magnitude if it does occur
o Once Пs have shown materiality, burden shifts to Δ to show П would have made the investment even if
the disclosure had been made
o You don’t have to disclose material information, but if you don’t disclose, you have to abstain (Casy,
TGS)
If the SEC calls and asks if anything is going on in 1976 do you have to tell them? NO. Do
not have a duty to disclose, but you DO have a duty not to misrepresent. Just say that “you
have nothing to say, and that you don’t comment on market rumors.”
US v. Chestman (2d Cir. 1991)
o Rule 14e-3: cannot use material nonpublic information in connection with a tender offer
o Problem w/ insider trading:
“Where the profit from an activity is likely to be diverted, investment in that activity will
decline” and
It “increases the risk that confidential information acquired at a cost may be disclosed.” (info as
corp property)
SEC v. Texas Gulf Supher Co. (TGS) (Directors can’t act on material non-public info – need to disclose or abstain)
o Facts: (2d Cir. 1968) Case grew out of an important discovery by TGS. The four person exploration team
made a discovery of k-55-1; found an anomaly of copper, zinc, and silver. Sent it off for more tests in
October. By November 8th, insiders start buying. Stories start circulating in the public about this new
drill site, but the directors put out a press release saying they don’t know anything about it this is
where the misrepresentation occurs. Ultimately, the company confirmed a 10 million ton ore strike
and sent out a press release which was published on April 16th.
o Timeline for case:
11/63 before drilling: $17 when K-55-1 was completed
12/63 after assay: $23
3/64 after drilling resumed $26
4/12 after 1st release $31 rumors spread
4/16 after 2nd release $37 correct press release
5/15 $57
o Holding Court held that all transaction in TGS stock or calls by individuals apprised of the drilling
results of K-55-1 were made in violation of Rule 10b-5.
Δs who bought after official announce may still be in trouble b/c they didn’t wait a sufficient
amount of time after announcement
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Δ directors who accepted stock options there was a duty to disclose material info before
accepting stock options, Δ Kline didn’t, so his options are subject to rescission
o Analysis of 10(b):
Materiality: the basic test of materiality is whether a reasonable man would attach
importance…in determining his choice of action in the transaction in question.
material facts include not only info disclosing the earnings and distributions of a
company but also those facts which affect the probable future of the company and
those which may affect the desire of investors to buy, sell, or hold the company’s
securities
Whether a fact is material will depend upon a balancing of both the indicated
probability that the event will occur and the anticipated magnitude of the event in
light of the totality of the company activity.
When may insiders act?
Such information must have been effectively disclosed in a manner sufficient to insure
its availability to the investing public—all insider activity must await dissemination of
the promised official announcement.
o Takeaway directors/officers can’t trade b/c it may be harming comp by disclosing material inside
info that the company wants to keep confidential
o Also fits well as a duty of loyalty case – b/c ALI §504 says corp officers can’t use corp info for personal
gain in trading (slight extension of duty of loyalty)
Basic Inc. v. Levinson (materiality requirement of §10(b) in context of prelim corp merger discussion)
o Facts: (US S/Ct 1988) Combustion began talking w/ options and directors of Basic in September of 1976.
Trading was suspended in 1978 when the merger is going to be announced. In 1977 Basic made a
public announcement denying that there were any talks of merger. Then later Basic stated it was
consider merger & accepted tender offer.
П are former Basic SH who sold their stock after Basic’s public statement that they weren’t
going to merger & before disclosing the tender offer
Пs (class action) argue they were injured by selling Basic shares @ artificially depressed price in
market due to Δ’s misleading statements
o Issue whether person who traded a corporation’s shares on a securities exchange after the issuance
of a materially misleading statement by the corporation may invoke a rebuttable presumption that, in
trading, he relied on the integrity of the price set by the market.
o Holding b/c most publicly available info is reflected in market price, П’s reliance on public material
misrepresentations can be presumed for purposes of a 10b-5 action
o Materiality Requirement: (Ct uses TGS probability/magnitude approach)
Whether merger discussions are material will depend on the facts. Generally, in order to assess
the probability that the event will occur, a fact finder will need to look to indicia of interest in
the transaction at the highest corporate levels.
Fact finder will consider such facts as the size of the two corporate entities and of the potential
premiums over market value.
Materiality depends on the significance the reasonable investor would place on the withheld or
misrepresented information.
o Misrepresentation & Scienter Requirement:
There was scienter in this case—news release is clearly intentional misrepresentation the
company was afraid it would create a problem in their negotiations.
o Fraud on the Market Theory:
Theory argues that persons who had traded Basic shares had done so in reliance on the
integrity of the price set by the market, but because of petitioner’s material misrepresentation
that the price had been fraudulently depressed.
Because most publicly available info is reflected in market price, by relying on market price
(which has been affected by the misstatement), the П who purchased the stock is relying on the
misstatement
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Rebutting the Presumption of Reliance in Fraud on the Market Theory:
The presumption does NOT require reliance from each member of the proposed П class
Δ can rebut proof of the elements giving rise to the presumption, or show the
misrepresentation did NOT lead to a distortion of price, or that an individual П traded or would
have traded despite his knowing the statement was false.
Any showing that severs the link between the alleged misrepresentation and either the price
received by the plaintiff or his decision to trade at a fair market price will be sufficient to rebut
the presumption of reliance.
Transaction Causation/Reliance Requirement
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Transactional causality—news comes out, misinformation causes the loss
Loss causality—difference between stock prices. Suppose stock selling at $40, say “not in merger discussion”
and it goes to $35. Do we have loss causation? YES. Company intentionally lies and market opens 5 points
lower. We know exactly what the effect of the lie is on the market place.
Fraud-on-the-market theory—if the market for the security if efficient, there’s a presumption of reliance
because the market incorporated the fraud into the price, and the investor then relied on the market price
(Basic, Verifone)
o Defendant can rebut the the presumption by showing that the investor did not rely on the market price
o “Truth-on-the-market principle”—if the market knows about the misrepresentation and therefore isn’t
affected by it, the fraud on the market theory can’t show reliance
o Fraud on the market will only work when there is a well developed market for the security. If there
isn’t, you’ll have to show reliance just as you would in traditional face-to-face transaction.
Lentell v. Merrill Lynch (reliance based on fraud on the market theory)
o Facts (2d Cir. 2005) This case takes into account Dura. People were buying stock based on Merrill
Lynch reports. Merrill was pumping up their stock to get their clients to buy them. This was a problem.
o Holding Even if the clients didn’t read the reports, there was still reliance based on fraud on the
market.
o Was there loss causation?
Ct refers to the PSLRA and says there is proximate cause b/c the loss suffered was foreseeable.
Have to isolate the impact of the misrepresentation of the stock.
In Re Verifone Securities Litigation (9th Cir. 1993)
o Fraud on the market theory shifts the inquiry from whether an individual investor was fooled to
whether the market as a whole was fooled (if market already had the correct information from other
sources could be no causation and no damages).
Loss Causation
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Must how a causal nexus between the misrepresentation and the actual loss suffered (Dura)
o Have to isolate the period where the misrepresentation was in effect and see what part of the actual
loss depended on it
o 10b isn’t there to provide insurance against market losses that would have happened anyway
AUSA Life Ins. Co. v. Ernst & Young (2000) (cited in supp case) (loss causation – the damages u supper have to
be actually from the misrepresentation)
o Facts: Πs, insurance companies, invested through bonds in a corp. JWP who had leveraged itself up
shit’s creek. ∆s, here, Ersnt & Young, did JWP’s books, but, alas, the statements were not accurate or in
accordance with accounting principles. JWP went under after acquiring Businessland, and ∆s sue the
accountants for recovery of their bonds.
D/Ct found that Πs could not recover here because the causation requirement was not met.
JWP went down b/c of business risk of acquisition, NOT b/c of misrepresentations in their
financials
o Holding 2nd Cir. remanded; it determined firstly that transaction causation was obviously established,
as Πs only bought the shares because of ∆’s accounting reports
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as to loss causation, it is a problem of proximate cause; for if there had been misrepresentation
but JWP was going to go under anyway, then Πs have no suit;
the idea here is that even if an investment is induced by a violation of Rule 10b-5, the investor’s
loss may have been the result of an investment risk independent of the violation
o Dissent asserts that loss causation was already proved, in that Πs would never have bought into JWP
if ∆ had blown the whistle
o Takeaway courts will take the problem of loss causation seriously; you have to prove that you
actually suffered damages from the misrepresentation
In regard to damages: you should be able to collect for the value of what the company was
actually worth as opposed to what you paid for it
Dura Pharmaceuticals v. Broudo (alleging wrong/inflated price isn’t enough for loss causation – need to show
causal nexus)
o Facts: (US S/Ct 2005) Dura makes asthmatic inhalers. Dura made false statements about the inhaler’s
profits (overstated) & regarding FDA approval. П bought stock in Dura, to prove economic loss – П only
says he relied on integrity of market & paid artificially inflated prices @ time of purchase.
o Issue What do u need to show to prove loss causation?
o Holding:
Ct/A said just showing price is wrong @ time of purchase is enough for loss causation
S/Ct REVERSES – says the inflated purchase isn’t enough need to allege actual causation
between the material representation and the loss suffered—must show a causal nexus running
from the misrepresentation to the loss.
o Takeaway we’re not sure where loss causation stands now, but need to ID carefully how much of the
loss in price was a result of misrepresentation
o Goes to what the purpose of the ’34 Act is:
Some say should come down hard against any potential misrepresentations.
The SC says no, we want to prevent fraud, not provide insurance against market losses.
In terms of Dura, it means that the stock price went down b/c the product didn’t catch
on, not because of the misrepresentation if there had been no misrepresentation the
stock price would have been where it was with the misrepresentation.
Stoneridge Investent Partners, LLC v. Scientific-Atlanta, Inc. (aiding and abetting will not meet reliance prong,
you must establish direct reliance)
o Facts: (US S/Ct 2008) Charter Communications is a cable company who inflated their books with the
help of some funky transactions with Scientific-Atlanta and Motorola (over charging for products and
then pushing money back in though advertising sales). P tries to bring a 10b claim against SA for aiding
and abetting in Charter’s fraud.
o Holding:
There is a private right of action in 10b but it is limited to situations where all prongs of test in
Dura are met, even for those who aid and abet: (material misrepresentation or omission,
scienter, connection between misrep/omission and purchase or sale of a security, reliance
upon m or o, economic loss, and loss causation). Big deal here: RELIANCE
Conduct itself can be deceptive but the question is did Stoneridge rely on anything SA or
Motorola did? Not really, yes, as it was reflected in the books of Charter but not directly
enough for a cause of action. Court won’t stretch it that far.
Rebuttable presumption of reliance is undisturbed BUT only applies in 2 scenarios: (not here)
If there was an omission of a material fact by one with a duty to disclose
If there was a mis-statement in public papers (fraud on the market).
o Policy
w/o causal connection vexatious litigation which is esp. harmful to corps can run rampant
(leading to extortion, echoed in Blue Chips)
would tie up market-place, everyone would fear becoming an aider and abettor.
10b is not anti-fraud, it is very specific re: what it covers. (see Santa Fe)
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Don’t extend rights of action that Congress has not authorized, also PLRSA goes against
extending here.
o Dissent: this is letting them off on a technicality.
SEC v. Rocklage—(W’s preexisting scheme w/ brother is a manipulative/deceptive device – may be held liable
under misappropriation theory)
Facts: (1st Cir. 2006) П, SEC, filed a civil complaint against D’s, a wife, the wife's brother, and the brother's
friend, alleging insider trading under § 10(b) & 10b-5 based on misappropriation. D Ct denied defendants'
motion to dismiss. Defendants appealed.
o Δ husband (H) was CEO of publicly traded biotech company, told W info about company in
confidence. W tells H she’s going to tell her brother (they had previous agreement where W tells B
if something bad was happening w/ comp), H tells her not to but W does it anyway. Brother B tells
his friend David Jones, they both trade on info & make lots of money
o Δs argued that the wife's pre-tip disclosure to her husband, telling him that she intended to tip-off
her brother, completely negated any liability under the misappropriation theory.
Holding the wife's acquisition of info WAS deceptive and her deceptive acquisition of material inside
information was "in connection with" a securities transaction since she deceptively obtained the
information as part of a preexisting scheme to assist her brother in the sale of securities
o W's post-acquisition disclosure of her intention to tip did not rendered her acquisition of
information non-deceptive since her overall scheme is the manipulative/deceptive device
Rule Under the classical theory, §10(b) and R. 10(b)-5 are violated when an insider trades (w/o
disclosure) in a corp’s securities based on material nonpublic info that he has acquired.
o So long as that insider owes a fiduciary duty to the corp’s SHs, the Sup Ct has deemed such trades
to be deceptive b/c they constitute a breach of that duty.
o HOWEVER, when the person trading doesn’t owe a fiduciary duty to the SHs, and he has not
obtained the info from one who has breached his duty, there can be no insider trading liability
under the classical theory.
BUT, there may be liability under a misappropriation theory, based on deception of the
source of the info, rather than deception of the SHs
HERE, to establish liability under the misapp. theory, the SEC would have to show that Wife
communicated material nonpublic info (undisputed), with scienter (undisputed), in
violation of a fiduciary duty to her Husband (undisputed); so case depends on whether
SEC’s complaint has stated a claim that Wife engaged in any “manipulative or deceptive
device” that was “in connection with the purchase of sale of any security.”
Deceptive devices knew Husband expected info to be kept confidential and didn’t tell
him she would tell others before he told her about the failed clinical trials (the govt can
satisfy the “in connection with” requirement when a tipper misappropriates info that his
tippees later trade on, US v. Carpenter)
Ct says that her preexisting understanding w/ bro re: tipping him off, is a “scheme” or
“practice”
Ct also says that although she disclosed to her H that she was going to tip her bro, this may
or may not render her “mechanism for distributing” non-deceptive; but either way, the way
she acquired the info was deceptive (fooled H into thinking would be confidant and never
corrected) and that was her device.
Loss causation and JWP hypo:
o Damages depend critically on the treatment of lost causality.
o JWP is a company that is expanding rapidly. Not doing great, but expanding rapidly. Want to buy
Business Land Computer. As part of that, in terms of the in connection with requirement—involves the
private placement of notes that JWP sold to AUSA insurance to help fund the expansion of JWP's
business. Evidence that JWP misstates its results. Evidence that Ernst & Ernst helped in the
misstatement.
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AUSA said relied on the Ernst certification of results, arguing that they were misled. If the stock
price was originally $50 at the time they put out the news that was intentionally incorrect and
then the stock goes to $0, is loss causality $50? Or is it less?
Did the misrepresentation cause the stock to go to zero? Can you show the nexus?
o Have to isolate the effect of misrepresentation on the stock price which in this case essentially
increased the value of the stock by giving better news than existed.
But if the business model was bank, and the business was going bust anyway, the
misrepresentation did not result in all the losses.
o Compare to ENRON:
Business didn’t go bankrupt b/c of a misrepresentation; most of the misrepresentations
occurred after the business started to go bad.
Enron lost causation; you do these event studies, figure out when the misrepresentation
occurred, and figure out how much that shot up the stock price:
Suppose the market itself went up during that period by 1%. In that case, the market, on its
own probably would have dragged the stock up from $50 to $51. You would take that factor,
subtract it from $55 and therefore the loss causation would be $4.
o What helps is the assumption that markets are efficient and that all publicly held information gets
quickly incorporated into stock prices.
3 Forms of Efficient Markets:
o Price changes are completely independent of one another. The market, from one day to the next, does
not know what it is going to do. The market is not affected by how it did the day before. Three forms
of market efficiency:
o 1) Weak form. Can't predict future prices based on current prices. Also, prices reflect the information
contained in the record of past prices. It is impossible to make consistently superior profits by studying
past returns.
Prices follow a random walk
o 2) Semi-strong form. All publicly available information is currently imbedded in market prices. If there
is news overnight, when the market opens-- the news is in the stock price.
Prices will adjust immediate to public info
o 3) Strong form. Prices reflect all the information that can be acquired by painstaking analysis of the
company. Includes all private and public knowledge. Strong form holds if enough illegal insider trading
to move the stock price. This form implies that there are not any restriction to insider trading. The
strong form does not hold.
6 lessons of market efficiency:
o Trust market prices; in an efficient market one can trust these prices because they contain all available
information about the value of each security; there is no way for most investors to achieve consistently
higher levels of return.
o Markets have no memory; the sequence of past prices is irrelevant to future changes
o Read the entrails-- security prices tell us a lot.
o There are no financial illusions; investors are concerned strictly with cash flow and profit.
o Do-it-yourself alternative: don't pay for others to do what you can do.
o Seen one stock, seen them all; investors don’t buy stock for its unique qualities, but because it offers
the prospect of a fair return for the risk.
Specific Requirements for Class Actions (Private Securities Litigation Act)
o ’34 Act § 21D imposes specific requirements for class actions
o § 21D(a)(2) has requirements about not accepting payment for being a named plaintiff, not being a
professional plaintiff, etc.
o § 21D(d) says the complaint must allege with particularity why the statement is misleading and all the
facts on which that belief is formed
o Greatly enhanced pleading requirement in securities fraud cases
Federal or State Court?
o § 10b allows a lot of traditional state law claims into federal court
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You do have to have a misrepresentation—that puts the brakes on it somewhat
Reasons you might not want to use the federal claim instead of the state claim:
Forward-looking statement protection (§ 21E)
Heightened pleading requirement (§21D)
Malone v. Brincat (constant compass language – directors knowingly disseminating false info resulting in harm
violate their fiduciary duty to corp)
o Facts: (DE S/Ct 1998) 2 directors sold stock (56,500 shares) before public news that would make stock
price decrease was released. Complaint alleges that Directors breached fiduciary duty of disclosure.
Also alleged that KPMG aided and abetted BoD to breach fiduciary duty. Said that BoD overstated
financial condition throughout 4 year period in disclosures to SHs; said that SEC filings were knowingly
and materially false and as a direct result of the false disclosures, the company has lost virtually all of its
value. Shareholders brought a direct suit claiming that the wrongdoings hurt the corporation.
o Possible Causes of Action:
Federal: Could’ve sued under 14a-9 for a violation of the proxy rules; this is also like Basic
where there was issuer misrepresentation
State: Breach of Fiduciary duty
The Пs had the elements of a 10b case, but chose to file under state law
o HOLDING Suit was properly dismissed, but should’ve been dismissed w/o prejudice.
Directors who knowingly disseminate false information that results in corporate injury or
damage to an individual stockholder violate their fiduciary duty, and may be held accountable
in a manner appropriate to the circumstances.
This case was properly dismissed because it should have been brought as a derivative not a
direct suit since the injury happened to the corporation. If Пs plead properly they could allege
injury to themselves if they want this to be a direct suit.
Even though there was no SH vote, only SEC filings there is still a fiduciary duty under state
law the “triparte fiduciary duty does not operate intermittently but is the constant compass
by which all director actions for the corp & interactions w/ its SHs must be guided”
o Note This case was brought to avoid the requirements of the PSLRA
If you plead this properly you can avoid removal Federal passed law that said – SEA § 28(f) –
no covered class action based on the statutory or common law of any state may be maintained
in any federal court by any party alleging a misrepresentation of material fact in connection
with the purchase or sale of a covered security; or that the defendant used or employed any
manipulative or deceptive device or contrivance in connection with the purchase or sale of a
covered security
DE has a carve out where SHs can bring suit for violations of fiduciary duty wrt dissemination of
incorrect info when SH action isn’t really allowed
Limits on Liability
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Forward-Looking Statements and the “Bespeaks Caution” Doctrine
o Companies will seek to legitimately inject info to the market through giving projections to financial
analysts
o SEA §21E: Application of Safe Harbor for Forward-Looking Statements (applies to forward looking
statements made by an issuer, except those included in a financial statement, or having to do w/ a
tender offer or IPO)
(c)(1): a person shall not be liable for any forward-looking statement, whether written or oral,
if
(A) the forward-looking statement is identified as such an is accompanied by
meaningful cautionary statements identifying factors that could cause actual results to
differ from those in the statement, or it is immaterial, or
(B) if Π fails to prove that the statement was made with actual knowledge that it was
false or misleading
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(c)(2) an oral statement falls within the safe harbor if it is accompanied by a cautionary
statement and points to documents that support it
(d) there is no duty to update
(i) a “forward-looking statement” is (A) a statement containing a projection of
revenues, income, earnings, or other financial items, (B) a statement of plans and
objectives of management for future operations, (C) a statement of future economic
performance
o PSLRA gets rid of the recklessness as scienter for forward-looking statements
o This allows companies to make such statements without concerns of liability:
Companies say “this is a forward looking statement” or “sales may not materialize” etc.
If they put this cautionary language in, the plaintiff has the burden to prove that the forwardlooking statement was made with actual knowledge by the person that the statement was false
or misleading.
Central Bank of Denver v. First Interstate Bank of Denver (US S/Ct 1994): held that liability can’t be imposed on
a person under R. 10b—5 solely because that person aided and abetted a violation of the Rule.
o In the aftermath of this case, 2 standards have emerged:
“substantial participation” test substantial participation or intricate involvement will make
the conduct of a secondary actor into a primary actor (lower cts are left to create line).
bright line test in order for the conduct of a secondary actor to rise to the level of a primary
violation, the secondary actor must not only make a material misstatement or omission, but
the “misrepresentation must be attributed to the specific actor at the time of public
dissemination.”
o In In re Enron Corp. Securities, Derivatives & ERISA Litigation (S.D. Tex. 2002) – ct adopts the SEC’s
proposed test for primary liability of a secondary party under §10(b) a person can be a primary
violator if he acts “with the requisite scienter” (e.g. if a person writes misrepresentations for inclusion
in a doc to be given for investors, even if those ideas came from someone else)
Liability for Short-Swing Trading Under SEA §16(b)
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SEA §16 Directors, Officers, and Principal Stockholders [p. 1874]
o (a) Disclosures required: if you are a director, officer, or owner of more than 10% of the stock, then
you must file a statement with the SEC of the amount of all shares which you own, and any changes in
the status of that ownership
o (b) Profits from purchase and sale within six months: any profit realized by one of the above folks from
the purchase or sale and sale and purchase of any shares of such issuer within six months must be
turned over to the corporation, regardless of the intent of the actor
suit to recover such profit may be instituted by the issuer or any holder of the stock if the issuer
refuses to do so within 60 days
o (c) Conditions for sale of security by beneficial owner, director, or officer: it shall be unlawful for any
beneficial owner, director, or officer to sell any security if the person selling the security or his principal
does not own the security sold you can’t sell what you don’t own (you can’t short sell!!!)
Understand then, that if you acquire over 10% of a corporation and then decide you don’t want
it, you can’t sell it again within six months
this prevents short-term trading on a stock
want to make sure interests are aligned
Rule 16b-6, Derivative Securities:[p. 2069]
o (a) establishment or increase in a call equivalent position or liquidation of a decrease in a put
equivalent position shall be deemed a purchase of the underlying security for purposes of § 16(b)…and
the establishment of or increase in a put equivalent position or liquidation of or decrease in a call
equivalent position shall be deemed a sale of the underlying securities.
(indicates that for options, the establishment of the call position (i.e. the date on which you are
first given the option) determines the purchase date; a holder of options needs to hold the
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option for six months, but once that has passed, they can exercise the option and sell the stock
immediately)
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NOTE on § 16:
o § 16(a) is widely used by Wall Street to determine how well the company is doing and if anyone inside
the company is making a move. Under this section you have to report whether a big outside investor is
buying or selling the stock. (even if Ø trade on inside info, seem to have a bias to selling and buying at
the right time)
o CANNOT trade on INSIDE INFO=bright line rule. CANNOT short swing trade. Why?
to remove temptation to cause fluctuations in the stock price in order to create profitable
trading opportunities
using inside info, should not be able to profit unfairly
no temptation to manipulate the market
o Under §16 – there’s prohibition of certain kinds of insider trading where no possession of material
nonpublic info is required
Unlike §10(b) there’s no requirement for manipulative or deceptive device
No requirement for material nonpublic info
o definition of “officer” for 16(b):
SEC’s definition of “officer” is more function based and more limited than its old rule. The new
rule, 16a-1(f) makes clear that a person’s functions and not simply title will determine the
applicability of Section 16.
Enforcement of §16
o §16(b) is enforced by shareholders or the corporation; plaintiff attorneys specialize in examining who
has been doing such swing-trading and finding shareholders to reclaim the profits made
The security holder (SH) can bring suit on behalf of the issuer (corp) if the issuer fails or refuses
to bring the suit w/in 60 days after the request or fails to diligently prosecute the suit
But if no suit can be brought >2yrs after date the profit was realized
Gollust v. Mendell (US S/Ct 1991) П can sue under §10(b) for “any security” – including stock,
notes, warrants, bonds, debentures, puts, calls… only exclusions are “currency or any note,
draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance of
not exceeding 9 months”
o §16(a), the filing requirement, is enforced by the SEC
Gratz v. Claughton (since Δ’s wrongful actions lead to uncertainty, use upper limit on damages when
calculating his profit from wrong)
o Facts: (2d Cir. 1951) Δ appeals from judgment against him under §16(b), argues the venue, rule for
calculating profits, & const’l of statute were all wrong.
o Holdings:
venue was proper b/c the wrong occurred in JX
T/Ct used proper rule to calculate Δ’s damages – using any given sale to match against any
purchase to increase Δ possible profits to the maximum (upper limit) instead of trying to match
up exact shares bought/sold
Uses “lowest purchase price, highest sale price”
Smolowe v. Delendo Corp. (2d Cir. 1943) (also uses ‘”lowest purchase price, highest sale price” rule)
Arrow Distributing Corp. v. Baumgartner (2nd Cir. 1986) (the liberal approach of §16(b) is restricted to
“unorthodox transactions”, otherwise it’s narrow objective test)
o “Section 16(b) is a strict liability rule. Enacted precisely because of the difficulty of establishing
whether an insider did indeed benefit from the information available to him in his strategic position. It
adopts a purely objective test: if a sale and a purchase or a purchase and a sale result in a net gain,
the gain is recoverable.”
Kern County Land Co. v. Occidental Petroleum Corp. (2 part test for when unorthodox transactions are exempt
from §16(b) liability – insider info & voluntariness)
o Facts: (US S/Ct 1973) Δ tried to merge w/ П Old Kern, failed, Δ then issued a tender offer for 500K Old
Kern shares; it acquired more than 10% of the total (became a statutory insider). Old Kern’s directors
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sought to have Tenneco buy all the corp.’s assets, such that “New Kern” would be a subsidiary of
Tenneco (it was also willing to pay $105, $20 more than Occidental). Occidental failed to stop the
merger, so it initiated a deal with Tenneco where Tenneco would be able to buy all its Kern shares
(giving Occidental a nice profit of $21/share) that couldn’t be used until six months and a day had
passed. The merger went through before six months past, and the option became viable at that date.
When six months passed, Occidental exercised its option (with $20 million profit), and New Kern filed a
§16(b) suit.
П argue the execution of the option (not the exercise) and the exchange of stock were all
“sales” which took place w/in 6 months of date on which Δ acquired >10% of Old Kern Stock
o Issues:
Whether there was a “sale” when Δ became irrevocably bound to exchange its Old Kern shares
for shares of Tenneco (New Kern)
Whether there was a “sale” when Δ gave an option to Tenneco to purchase from Δ the Tenneco
shares that were exchange for Old Kern Shares
o Holdings Since this is an unorthodox transaction, ct looks at whether the border-line transaction will
give rise to speculative abuse. Finds that the option was not a §16(b) sale; because :
(1) ∆ had no access to inside information on Old Kern and the potential merger, and
(2) the exchange was essentially involuntary as the exchange of shares for stock in the
surviving company operated automatically as a matter of state law
o Rule 2 part test to be met before an unorthodox transaction will be exempt from §16(b) liability:
Did Δ have access to insider information?
Was the unorthodox transaction voluntary?
In usually situation where takeover target arranges a defensive merger, the failed bidder will
normally not have §16(b) liability; UNLESS it tries to unload its stocks in the open market
Colan v. Mesa Petroleum (involuntariness factor to unorthodox transaction exception VERY important)
o Facts: (9th Cir. 1991) Mesa acquired 13.6% of Unocal shares at an average of $45. It made its tender
offer at $54 per share. Unocal initiates its exclusionary self-tender at $72. Eventually, a deal is struck
allowing Mesa to participate in the self-tender. A Unocal SH brought this §16(b) action seeking to
recover the short-swing profit Mesa made.
o Holding Ct held for П - the exchange of Unocal stock for Unocal negotiable debt securities pursuant
to the self-tender WAS a sale – the “unorthodox transaction” exception didn’t apply.
Δ’s participation in the offer was voluntary, thus liable under §16(b) no state law forced Δ to
give up his Unocal shares, it was a tender offer, not a statutory merger
Insider status only at one end of a swing
o §16(b) has exemption for >10% beneficial owner who didn’t have 10% both at the time of the purchase
& the sale
o Foremost-McKesson v. Provident securities Co. (US S/Ct 1976) in the case of a purchase-sale
sequence, a >10% beneficial owner is NOT labile unless he was such before the purchase in question
o Feder v. Martin Marietta Corp (US S/Ct 1970) director can’t escape liability by resigning & then
selling w/in 6 months
Regulation FD
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The SEC promulgated rule FD in response to:
o concern over the “potential for corporate management to treat material information as a commodity
to be sued to gain or maintain favor with particular analysts or investors…
o in the absence of prohibition on selective disclosure, analysts may feel pressured to report favorably
about a company or otherwise slant their analysis in order to have continued access to selectively
disclosed information….concerned… with reports that analysts who publish negative views of an issuer
are sometimes excluded by that issuer from calls and meetings to which other analysts are invited…
o Finally, … technological developments have made it much easier for issuers to disseminate information
broadly…regulation FD targets the practice by establishing new requirements for full and fair disclosure
by public companies…” SEC Release No. 33-7881 (2000)
102
o
Regulation FD- rule 100 - Under this rule, whenever:
(1)an issuer, or person acting on its behalf,
(2) discloses material nonpublic information,
(3) to certain enumerated persons (in general, securities market professionals or holders of the
issuer’s securities who may well trade on the basis of the information)
(4) the issuer must make public disclosure of that same information:
(a) simultaneously (for intentional disclosures) or
(b) promptly (for non-intentional disclosures)
As a whole, the regulation requires that when an issuer makes an intentional disclosure of
material nonpublic information to a person covered by the regulation, it must do so in a
manner that provides general public disclosure, rather than through a selective disclosure. For
a non-intentional selective disclosure, the issuer must publicly disclose the information
promptly after it knows (or reckless in not knowing) that the information selectively disclosed
was both material and nonpublic…
Shareholder Suits
Derivative Actions
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Characteristics of the Derivative Suit
o The law permits shareholders to sue for breach of fiduciary duty on the corporation’s behalf.
o Preconditions for claims (Ross v. Bernahard):
(1) valid claim on which the corporation could have sued
(2) corporation itself had refused to proceed after suitable demand (unless excused by
extraordinary circumstances)
o Looked at the dual nature of the action: 1) the stockholder’s right to sue and 2) the merits of the
corporation’s claim itself
o A shareholder with a tiny investment can force an expenditure by the corporation of a large amount of
funds and executive time
o Corporation is an indispensable party and must be joined in the suit
o Lawyer would prefer a direct suit b/c many procedural rules apply to derivative suits
o Rationale: (from pp 915) the economic rationale for R 23(b)(3) class action stands in sharp contrast to
the rationale for the SHs derivative suit.
(1) SH’s derivative suits aren’t premised on collective action probs in litigation, but instead
presuppose the existence of a corp form that is organized to overcome such collective action
probs.
(2) The problem, rather, is with collective action WITHIN the corp form.
(3) Corp managers generally have only a small ownership stake in their firms, so their interests
diverge from those of SH’s in that managers may prefer to consume excessive
Direct or Derivative? (The Tooley Test)
o (1) Nature of the injury Who suffered the alleged harm (the corporation or the suing stockholders,
individually); and
a suit alleging breach of fiduciary duty will generally be considered to allege an injury to the
corporation
o Who recoversWho would receive the benefit of the remedy (the corporation or the stockholders,
individually)?
Derivative suits are good in that they protect not only the shareholders, but the creditors and
the employees of the corporation.
Who can Bring a Derivative Action?
o Plaintiff must be a shareholder when the action begins and must remain a shareholder during the
pendency of the action (contemporaneous SH rule) when a company merges with another, the suit
drops out b/c the plaintiff is no longer a shareholder of the constituent company
103
o
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EXCEPTIONS:
(1) where merger is subject to claim that it was perpetrated merely to deprive stockholders of
right to bring derivative action;
(2) where merger is in reality a reorganization that doesn’t affect the plaintiff’s ownership of
the biz enterprise
o Creditors – ordinarily has no right to bring a derivative action. Sometimes they can if they have debt
that is convertible into stock.
o Directors – Occasionally statute gives officer or director right to bring derivative action. Ex. NY law.
When can a shareholder not bring a derivative suit?
o Shareholder is barred from bringing a derivative action if either:
(1) she participated in the alleged wrong
(2) consented to the wrong or explicitly ratified it
(3) guilty of laches?
(4) Acquiesced in the wrong or failed to object theory of these rules is that in such a case the
plaintiff lacks “clean hands.”
o “Tainted share rule” if the person who owned the stock can’t bring suit for one of the above reasons,
then the person who the stock is sold to/transferred to can’t bring suit either
Cases likely to be direct suit:
o Issuance of stock for the wrongful purpose of perpetuating or shifting control
o Almost anything that turns on voting is going to be a direct case
o In Smith v. VG, shareholders were mad b/c Ø get highest price for their stock; would be a direct harm (?)
Right to Trial By Jury In Derivative Actions
o under 7th amendment a derivative action brought in federal court the parties have right to a jury where
the action would be triable to a jury if it had been brought by the corporation itself
o 7th amendment only applies to federal actions, state-court decision vary:
In Alabama, Alaska, New Mexico, & NY allow parties to derivative actions right to trial by jury
if the underlying corp claim asserted by the П on the corp’s behalf would have entitled the corp
to jury trial
In Arkansas, CA, FL, Iowa, MA, and probably DE form of action is dispositive – NO right to
jury trial in derivative suit b/c of the equitable nature of the suit
Tooley v. Donaldason, Lufkin & Jenrette (sets forth test for whether suit is direct or derivative, get rid of special
injury requirement for direct suit)
o Facts: (DE S/Ct 2004) Minority stockholders in DLJ (the corp) brought a direct suit against the former
directors of DLJ, arguing that when Credit Suisse had acquired DLJ, the directors allowed Credit Suisse
to postpone the actual merger twice, thereby harming the minority shareholders due to the time value
of money.
Chan Ct dismissed suit for being actually derivative under the “special injury” standard
o Rule Look at the nature of the wrong & who the relief should go to, questions are:
1) who suffered the alleged harm (corp or SHs individually)
2) who would receive the benefit of the remedy or recovery
o Holding The DE Supreme Court rejected that test and substituted the two-prong analysis described
above. In this case, the Court found that it would have been a direct claim, except that the plaintiffs
didn’t actual have any of their rights violated, so they have no direct claim.
Ct gets rid of: Bokat rule (if all SHs are equally harmed, then suit must be derivative) with the 2
question rule above.
Ct gets rid of: Lipton’s “special injury” the wrong was separate and distinct from that
suffered by other SHs, or involved a right that exists independent of a right of the corp.
For a direct claim, the П SH’s claimed direct injury must be independent of any alleged injury to
the corp. The SH must demonstrate that the duty breached was owed to the SH and that he or
she can prevail without showing an injury t to the corp.”
Barth v. Barth (ALI permits direct suit in closed corp – NOT DE law!)
104
o
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Facts: (Ind. S/Ct 1995) П is suing president of Barth Electric (who is his brother). This is a close
corporation. Alleging that Δ paid himself excessive salaries and diverted corporate funds to himself. П
alleges that this is a direct suit b/c the nature of the corporation is closed; with a derivative suit, all the
money would just go back to the offender—the corporation.
o Rule The SC of Indiana adopts the ALI rule 7.01(d) which allows a П to directly sue under a breach of
fiduciary duty claim when the corporation is a close one.
Under this rule, a court, in its discretion, may treat an act raising derivative claims as a direct
action if it finds it will NOT:
unfairly expose the corporation or Ds to a multiplicity of actions
materially prejudice the creditors of the corporation
interfere with a fair distribution of the recovery among all interested parties
DELAWARE does NOT follow the ALI rule!!!!!!! in DE, for a direct suit, a П must state a claim for:
o (1) an injury that is separate and distinct from that suffered by other shareholders; or
o (2) a wrong involving a contractual right of a shareholder that exists independent of any right of the
corporation
o DE courts will therefore examine:
(1) the nature of the injury; if it is pro rata, it will be a derivative suit
Breach of fiduciary duty derivative suit (generally) b/c these duties are owed the
corporation first, and the shareholders only receive them derivatively through it
(2) who recovers; usually if the corporation does, it’s derivative
Bagdon v. Bridgestone/Firestone: (DE says claim is derivative if injury is mediate through corp – require
derivate suit in close-held corporations)
o (7th Cir. 1991) OH, like a few other states, has expanded the “special injury” doctrine into a general
exception for closely held corporations, treating them as if they were partnerships. ALI recommends
this.
o However, DE follows the rule that a claim is derivative if the injury is mediated through the corp. [Why
hasn’t DE done this? b/c DE deals with SO MANY cases that it needs practical rules that can be easily
used and applied (administrative efficiency); also isn’t so fact-specific, so gives predictability of
outcomes, so ppl know what to expect when making the deal.]
Derivative v. Direct Actions
o 2 reasons advanced for distinguishing b/w derivative and direct action:
The theoretical reason since a corp is a legal person separate from its SHs, an injury to the
corp is not an injury to its SHs; this is strange, since every injury to a corp, must have impact on
SHs;
The pragmatic reason (i) to avoid a multiplicity of suits by each injured SH, (ii) and to protect
the corporate creditors, (iii) and to protect all the SHs since a corp recovery benefits all equally
while a direct action will not.
o Easy Cases: (at one end of the spectrum) a wrongful act that depletes corporate assets, and affects the
SH only by reducing the value of his stock, gives rise only to an action on the corp’s behalf, and (at the
other end of the spectrum) a wrongful act that does not deplete a corporate assets, and interferes with
rights that are traditionally viewed as either incident to the ownership of stock or inhering in the shares
themselves (such as voting or pre-emptive rights) gives rise only to a direct action by the injured SHs.
o Harder Cases: Its relatively clear that a direct action will lie based on the issuance of stock for the
wrongful purpose or perpetuating or shifting control; a rule permitting a direct action seems to be
emerging in suits based on wrongs by controlling against noncontrolling SHs/ [Suits to enjoin
improperly authorized corporate actions are also commonly treated as direct actions, either implicitly
(without discussion of the issue), or explicitly, but the authorities are in conflict on this type of case.
o Cases that can be characterized as either direct or derivative: sometimes wrongful acts both deplete
corporate assets AND interferes with rights traditionally viewed as inhering in shares; a direct action is
not precluded simply b/c the same facts could also give rise to a derivative action (ex. Bennett v.
Breuil Petroleum Corp in which P claimed that the controlling SH had caused the corp to issue stock for
an improper purpose—impairing his interest and forcing him out on managements’ terms—at a grossly
105
inadequate consideration. Ct held that the 1st claim stated a direct and second a derivative cause of
action.) (also, proxy-rule violation cases can be either direct or derivative, since these violations
interferes with the individual SHs voting rights (direct) and involves a breach of managements fiduciary
duties (derivative).
Individual (Pro Rata) Recovery in Derivative Actions
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Glenn v. Hoteltron Systems, Inc. (where П & Δ both owners in corp – Δ as SH of corp gets part of the recovery –
no special exception in NY)
o Facts: (NY Ct/A 1989) Π and ∆ were each 50% owners and officers in Ketek Corp. Π’s derivative suit
was successful, and he argued that he, rather than the corporation, should get compensated, because it
would allow ∆ to share in the benefit to the corporation when he caused the harm.
o Rule Black-letter law: corps recover in derivative suits to protect the corporation and its creditors;
and also the interests of the unaware shareholders and the desire to maintain the limited liability status
of shareholders
Where there is individual recovery, the shareholder who sued recovers a percentage of the
total damage that was done to the corporation corresponding to his percentage ownership in
the corp.
EX: If Π owns 20% of the corporation, ∆ owns 80%, and the court determines that ∆ harmed
the corporation to the extent of $1,000,000 then in pro rata recovery, Π would get $200,000,
∆ and the corporation would get nothing
o Holding NY ct here asserts that b/c a SH’s derivative suit seeks to vindicate a wrong done to the
corporation, any recovery obtained is for the benefit of the injured corporation NO special exception
to general rule in this case
Note on Pro Rata Recovery & When It’s Allowed (pp.933-35)
Perlman v. Feldmann—(allowing individual recovery in derivative suit when the corp has been taken over &
new SHs weren’t owners of injured corp)
o Facts: (2d Cir. 1955) This was the above case regarding the steel company whose controlling
shareholder essentially sold the corporate asset (the unique business plan) to another company when
he sold control to that company.
o Holding Though it was a derivative suit, the court allowed individual recovery.
The key thing here is that the injured corporation was no longer in existence, and it wouldn’t
be fair to allow the new corporation’s shareholders, many of whom weren’t owners of the
injured corporation, to recover (the subsequent purchasers would otherwise share in the
recovery)
When individual recovery is ordered it is often when the company has been taken over and
new owner was involved and has done harm to the corporation
Relief
o Unlike class actions, in which the relief is given to the plaintiff class members, any relief recovered in a
derivative action (net of expenses including attorneys’ fees) is returned to the corporation
o But in pro-rata recovery cases that involve derivative cases, the remedy goes directly to the SHs.
Contemporaneous Ownership Rule – who has standing?
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Policies in favor of the contemporaneous ownership rule:
o preventing unjust enrichment of shareholders who purchased w/ knowledge of circumstances
o discouraging litigation by individuals who purchase one share just to bring suit no purchasing the
cause of action
DGCL § 327 Stockholder’s Derivative Action; Allegation of Stock Ownership
o In any derivative suit instituted by a stockholder of a corporation, it shall be averred in the complaint
that the plaintiff was a stockholder of the corporation at the time of the transaction of which such
stockholder complains or that such stockholder’s stock thereafter devolved upon such stockholder by
operation of the law.
ALI §7.02: Standing to Commence and Maintain a Derivative Action
106
o
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(a) a holder of an equity security has standing to commence and maintain a derivative action if the
holder
(1) acquired the security (A) before the material facts relating to the alleged wrong were
publicly disclosed or known to the holder, or (B) by devolution of law from a prior holder who
satisfies (A); [and]
(2) continues to hold the security until the time of judgment, unless the failure to do so is the
result of corp. action to which to holder did not acquiesce, and either (A) the derivative action
was commenced prior to the corp. action terminating the holder’s status, or (B) the court finds
the holder is better able to represent the interests of the shareholders than any other holder
who has brought suit
NY Bus. Corp. Law. §626 Shareholder’s Derivative Action . . . (NY law captures DE law, though DE law isn’t
written out in its statute)
o (a) indicates that an action may be brought
o (b) Π must show that he is such a holder at the time of bringing the action and that he was such a
holder at the time of the transaction of which he complains, or that his shares or his interest therein
devolved upon him by operation of law
o (c) Π must set forth with particularity his efforts to secure the initiation of such action by the board or
the reasons for not making such effort demand must be made
o (d) such action shall not be discontinued, compromised, or settled without the approval of the court
o (e) Π can receive attorney’s fees
Bangor Punta Operations v. Bangor & Aroostook (contemporaneous ownership rule – wrong to corp reflected
in price @ time П bought stock)
o Facts: (US S/Ct 1974) Bangor & Aroostook sold the 98% of the BAR stock it owned to Bangor Punta.
Bangor Punta held onto to BAR for five years than sold it to Amoskeag. Amoskeag, owning 99% of BAR,
caused BAR to bring suit, alleging corporate waste and conversion during the period when B&A and
Punta owned BAR.
o Rule contemporaneous ownership rule П has to be SH @ time of wrong, and under Forbes v.
Wells Beach Casino – no stand for SH to bring derivative suit if he/his vendor participated or acquiesced
in the wrong that he complains of
o Holding Holds for Δs b/c Пs were not contemporaneous owners; a shareholder may not complain of
acts of corporate wrongdoing if he acquired his shares from those who participated in the wrongful
action
The price at which Пs bought was entirely fair, the discounted price reflected the damage done
to the corporation already П had negotiated for the price, and would be unjustly enriched if
they received more money than they paid
though this is technically a derivative suit brought by BAR’s controlling shareholder, the Court
disregards the fiction and considers this a direct suit by Amoskeag
Rifkin v. Steele Platt (contemporaneous ownership rule rebutted where sale price didn’t reflect wrongs)
o Facts: (Colorado Ct/A 1991) Πs, the present principal shareholders, purchased a controlling interest in a
restaurant from ∆. Πs, following the purchase, discovered that ∆s had misappropriated funds, made
misrepresentations, and looted the corporation. Πs filed suit alleging breach of contract, breach of
good faith, breach of fiduciary duty, and unjust enrichment.
o Rule rebutting the contemporaneous ownership rule:
the contemporaneous ownership rule can be rebutted if it is established that the share price at
the time you bought it did not reflect the damage done to the corporation
o Holding as the parties here dispute whether the sale price reflected the wrongdoings, the case is
remanded to the trial court for determining if it did or did not
Exceptions to the Contemporaneous Ownership Rule:
o A SH may NOT be barred from bringing a derivative action if he did not hold his shares when the harm
occurred, if one of the following things existed:
Π received his shares by devolution of operation of law (i.e. a merger or inheritance) from one
who was a shareholder at the time of the alleged wrong
107
The continuing wrong theory: a Π can bring an action to challenge a wrong that began before
he acquired his shares but continues thereafter
SEA §16(b) claims: a non-contemporaneous shareholder can bring a derivative action for shortswing trading under §16(b); the statute states that an owner of securities may bring suit – with
no qualification put upon it
potential Bangor Punta exception in that case, no contemporaneous shareholders owned a
significant amount of BAR stock; if there had been significant portions owned by a
contemporaneous shareholder, a court could arguably impose liability on the wrongdoer but
grant pro rata relief to the contemporaneous shareholders
Demand on the Board & Termination of Derivative Actions On Recommendation of the
Board or Committee
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Demand Requirement
o Shareholders have to bring the claim to the attention of the board and ask them to rectify it
Otherwise, it will be dismissed for failure to make demand.
Attempts to balance the fact that shareholders are bringing suits on behalf of the corporation
and 141(a)
More efficient to let corporation handle it before it gets to court
If shareholder Ø hear back from company, has claim for wrongful refusal.
o Demand excusable when it is futile.
directors were interested, or
directors were uninformed or irrational (Aronson v. Lewis)
П must plead with particularity the facts beyond a reasonable doubt (NY is stricter, Ø use
reasonable doubt)
Pleading requirement for demand futility is basically the pleading requirement for
rebutting the BJR Delaware has collapsed the BJR inquiry into the demand
requirement.
o If you make demand and lose, your case is basically over because making demand means you didn’t
have enough facts to rebut the BJR. Rarely, do groups make demand—the pleading time is the time to
show the court what you have.
o If demand is futile, board can either:
Settle
go to trial on the merits
Board can appoint its own Special Litigation Committee
Board can try to cleanse the transaction by appointing a committee to evaluate the
claim and recommend settlement or dismissal
Ind. committee is made up of directors who are not even on the board at the time of
the transaction. Power to delegate to them is § 141(c)
NOT a safe harbor Board still has to prove the committee was independent and
rationally informed.
Committee has to act rationally and has burden to show that it did.
Two-part test for analysis of the decision:
o (1) Procedurally fair
o (2) Substantive evaluation of the decision from the court’s perspective that
considers even public policy concerns (rarely triggered)
o Demand rule exists because whether or not to pursue litigation for the corporation is supposedly a
business decision like any other—and directors will be in the best position to determine what’s in the
best interests of the corporation. (Might not be the case when the action is against the directors
themselves).
o Most of the time a case dismissed for failure to make demand will also be dismissed for failure to state
a claim. (Except: director compensation claim in Marx and a 102(b)(7) claim, where demand will be
futile but there’s no claim b/c no remedy).
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Demand is basically the BJR Rule
o If you can’t rebut BJR – then demand is required
o If you CAN rebut the BJR, but don’t make demand – then when case goes to ct it will look @ whether
the demand was excused
Demand made & board says NOT in
best interest to litigate litigation
dies
(can only attack based on procedure)
1)
2)
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Is majority of board
self-interested?
Is underlying cause of
action so egregious it
couldn’t have been
made by disinterested
party?
If NO to both:
Demand is necessary
Demand made & board says YES to
pursue litigation litigation
controlled by board
If YES to at least one:
Demand is NOT necessary
Proceed w/ litigation, nothing else
special required
Marx v. Akers (NY uses 3 part test for demand futility – NOT same as DE & ALI)
o Facts: (NY Ct/A 1996) Π SHs of IBM allege that the outside directors and certain senior executives were
paid too much (waste of corp assets). Πs did not make a demand on the corporation, and the App. Div.
dismissed the suit for failure to make demand.
o Rule Ct examines DE approach & the universal demand approach, rejects both.
in DE, a Π can be excused from making demand if he casts a reasonable doubt on the idea that
(1) the directors were disinterested, and (2) the transaction was a valid exercise of the BJR
[comes down that demand will be excused if you can rebut the presumption]
See Chan Ct. R.23.1
More SH friendly rule than NY – reasonable doubt standard b/c you’re at early stage of
suit w/o discovery
the universal demand approach expressed in ALI §7.03 establishes a bright-line rule that would
always require demand to be made on the corporation (unless Π shows that irreparable
damage would otherwise done to the corp.); if the corp. rejects the suit, then that decision
would be closely examined
Ct adopts NY test - that demand is futile if:
(1) a majority of the directors are interested or not independent, or
(2) that that the directors didn’t fully inform themselves, or
(3) the challenged transaction was so egregious on its face that it could not have been
the product of sound BJ.
o Holding Case survives motion to dismiss for failure to make demand, BUT dismissed b/c П failed to
make showing of corp waste necessary to establish cause of action (didn’t allege particularized & 141(h)
permits directors to set their own compensation)
here, only three directors were alleged to have benefited from the executive compensation,
and Π failed to allege that a majority of the board was interested and failed to establish that
the Board didn’t make an informed business decision, failure to make a demand was fatal to
the portion of the complain challenging that transaction
109
as to the increased pay for outside directors, such business decisions are always interested
demand excused & Δ’s motion to dismiss for failure to make demand turned down (but case
dismissed anyway)
Barr v. Wackman (NY case)(Demand excused where there’s self-dealing or self-interest of directors in
challenged transaction)
o Even disinterested outside directors are excused from demand b/c of their breach of due care &
diligence
o BUT, it’s NOT enough simply to name a majority of directors as parties Δ w/ “conclusory allegations of
wrongdoing or control by wrongdoers” requires complain stating w/ particularity why demand
wasn’t made
Purposes of requiring demand are to:
o Relieve courts from deciding matters of internal corp governance by providing corp directors w/
opportunities to correct alleged abuses;
Derivate suit strikes @ heart of §141(a)
o Provide corp boards w/ reasonable protection from harassment by litigation on matters clearly w/i the
discretion of directors; and
o Discourage “strike suits” commenced by SHs for personal gain rather than for the benefit of the corp
o Note: demand is generally there to weed out unnecessary or illegitimate SH suits since demand is
excused when you can rebut the BJR presumption; so when you make demand – you’re basically telling
the BoD u think there’s a business judgment
Aronson v. Lewis (DE 1984) (original DE 2 part test - the form of the Aronson test was later changed to “or” –
disjunctive 2 prong test we have now)
o DE Rule for determining demand futility: the ct must decide whether under the particularized facts
alleged, a reasonable doubt is created that:
(1) the D’s are disinterested and independent and
(2) the challenged transaction was otherwise the product of a valid exercise of business
judgment (substantive nature of transaction)
o If directors are interested or engaged in self-dealing BJR doesn’t apply & demand is futile
the mere threat of personal liability for approving a questioned transaction, standing alone, is
insufficient to challenged either the independence or disinterestedness of D’s, although in rare
cases a transaction may be so egregious on its face that bd approval cannot meet the test of
business judgment, and a substantial likelihood of D liability therefore exists
o The alleged wrong is substantively reviewed against the factual background alleged in the complaint
Grobow v. Perot (Del. 1998) (no standard for finding reasonable doubt ; need case-by-case determination)
o It would be neither practicable nor wise to attempt to form a criterion of general application for
determining reasonable doubt under Aronson.
o “We think it sufficiently simple to say that the Ct must weigh the presumption of the BJR that attaches
to bd decision against the well-pleaded facts alleged in a P’s demand-futility complaint.”
DE Approach to Demand Requirement – Chan Ct R.23.1
o Complaint must allege w/ particularity the efforts, if any, made by the П to obtain the action the П
desires & the reasons for the П’s failure to obtain the action or not making the effort
o 2 prong test for determining demand futility. П must allege particularized facts which case a
reasonable doubt that:
(1) the directors are disinterested & independent, OR
(2) the challenged transaction was otherwise the product of a valid exercise of business
judgment
o The test is disjunctive if it can be shown there was direct interest – then BJR is inapplicable &
demand can be excused w/o further inquiry
ALI §7.03 – Universal Demand Requirement
o Bright line rule for ALWAYS requiring demand unless the corp would suffer irreparable injury
o Requires П to serve written demand on corporation
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110
o
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-
-
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Board’s decision is subjected to elaborate set of standards that calibrates the difference afforded to the
decision of the directors to the character of the claim being asserted
o NOTE PA has adopted the ALI approach to making demand on the corporation, such that a universal
demand is required, though the corporation’s decision not to have a suit will be closely examined
Cuker v. Mikalauskas (PA adopts ALI §7.02-7.10, 7.13 universal demand requirement)
o Facts: (Pa. 1997) PECO Energy filed motion for SJ seeking to dismiss minority SH derivative action, Δ
had report of special litigation committee that proceeding w/ action is not in corp’s best interests
o Rule Adopts ALI’s Universal Demand Requirement look @ BJR factors to see if board’s decision to
terminate was valid (if committee members were disinterested, independent, assisted by counsel,
prepared written report, conducted adequate investigation, acted in good faith…)
Used ALI b/c DE law permit cts to apply its own “business judgment” which the PA ct doesn’t
like
Auerbach v. Bennett (establishing disinterested special committee gives BoD chance to correct mistake –
analysis starts @ whether committee was interested, informed, or irrational in its decision)
o Facts: (NY Ct/A 1979) The directors of General Telephone and Electric, feared that their employees had
been bribing foreign officials and initiated a self-investigation. When the committee discovered that
such bribes had indeed been made and announced them publicly, a group of SHs filed a derivative suit
alleging that the directors were liable for a breach of fiduciary duty. The board established a Special
Litigation Committee, made up of 3 outside directors who had joined after the bribes were paid. It
concluded that the suit was not in the best interests of the corporation.
o Rule normally a shareholder must make a demand on the corporation to bring suit before bringing
his own derivative suit, and if they refuse on the basis of a good faith business judgment, then the court
will dismiss the suit
BJR applies even when some directors are charged w/ wrongdoing, so long as the remaining
directors making decision are disinterested & independent
o Holding Π here failed to establish that the Committee’s decision-making procedures were in any way
lacking
Special Committee’s substantive decision that a continuation of the suit would not be in the
best interests of the corporation is protected by the BJR
the court can only investigate the committee’s disinterestedness and its procedures of coming
to its decision
Zapata Corp. v. Maldonado (Del. 1981) (2 step test to judge committee’s decision not to pursue suit – corp has
burden of proof)
o Facts: (DE S/Ct 1981) Derivative suit against the board, plaintiffs did not make demand b/c it would
have been futile, but board decided to form a litigation committee to evaluate the claim, which decided
it’s in the best interest of corp not to go forth w/ suit.
o Holding The court determined that even if the entire board had been implicated in the purported
wrongful action, it still had authority under 141(a) to delegate its decision on whether to pursue the
suit to a Special Litigation Committee of disinterested directors.
o Rule The standard of review for the committee’s decision is NOT BJR corp has burden of proof to:
(1) establish members of special committee are: independent, acting in good faith, conducted
reasonable investigation (like hiring outside counsel, i-bankers, etc) (step 1 procedural –
entire fairness)
(2) Then the court can evaluate the decision using its own business judgment, including
considerations of public policy (step 2 substance - BJR)
NOTE usually if the procedural stuff goes through the ct normally won’t judge the
committee’s decision
In Re PSE&G SH Litigation (NJ 2000) (NJ’s modified BJR standard of review)
o Rule NJ standard of review: a modified BJR that imposes an initial burden on a corp to demonstrate
that in deciding to reject or terminate a SH’s suit the members of the board:
(1) were independent and disinterestedness,
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(2) acted in good faith and with due care in their investigation of the SH’s allegations, and that
(3) the bd’s decision was reasonable [all three elements must be satisfied]
Beam v. Martha Stewart (disinterested nature of board when there’s friendship w/ interested director)
o Facts: (DE 2004) Martha Stewart was director & 94% owner of MSO. Beam was minority SH, brought
derivative action alleging Δ breached her fiduciary duties of loyalty & care to MSO by insider trading in
another comp & mishandling media attention that followed
o Issue Was board really disinterested when some directors are friends w/ Martha?
o Holding Complaint failed to raise reasonable doubt that MSO’s board was disinterested &
independent (even though Martha is on board & thus interested) – but S/Ct said in an appropriate case
strong ties of personal friendship or other nonfinancial relationship could lead to a conclusion that a
director lacked independence
Mere personal friendship not enough to raise reasonable doubt
Nature of relationship must make director more willing to risk reputation
In re Oracle Corp. Derivative Litigation (Stanford profs on SLC might not be disinterested b/c Δs had important
ties to Stanford)
o Facts: (DE Chan 2003) Derivate action brought alleging illegal insider trading, 2 person litigation
committee (SLC) moved to dismiss action. Δ had connections to Stanford Uni.; П argue members of
committee were NOT independent b/c they were both Standard profs.
o Holding there was reasonable doubt about impartiality of the SLC
Possibility of extraneous considerations biasing the inquiry of the SLC is too substantial for the
court to ignore
In Re Tyson Foods (even w/ independent directors, BJR doesn’t attach if the transaction is in bad faith and
couldn’t have been valid exercise of BJ)
Facts: (DE Chan 2007) Δ Corp Tyson makes meat, 2 classes of stock: A SH may cast one vote per share, B SH
can cast ten votes per share; Tyson Limited Partnership (TLP), limited partnership owns 99.9% of the class B
stock and thus controls over 80% of corp's voting power; Don Tyson controls 99% of TLP. Δ John Tyson
(son of Don Tyson) is chairman of board and Tyson's CEO
o SH brought derivative suit claim, that the Δs used "spring loading" to give the board stock options
before the prices went up to get around the plan which required the price of the option to be no
lower than the fair market value of the company's stock on the day of the grant
Look to R.23.1 for standard for demand excusal:
o П must show there's reason to doubt either:
(1) the disinterestedness and independence of the majority of the board; or
(2) the possibility that the transaction would have been an exercise of business judgment
o b/c of BJR presumption, П needs to show bad faith
Issue is there bad faith in "spring-loading
o Look at whether it's intentionally enriching employees and avoiding SH imposed requirement
Holding Since the board had material insider information, there is a SH approved stock option plan (the
goal is incentive based which is undermined by the spring loading of options), the ct reaches a conclusion
that the П has alleged adequately that the compensation committee violated a fiduciary duty by acting
disloyally and in bad faith w/ regard to the grant of options
o Get to the 2nd prong this couldn't have been a good faith on the part of the board board
couldn’t rationally believed spring-loading options was in the best interest of corp
o BJR is rebutted
What Пs must allege:
o that options were issues according to a SH-approved EE compensation plan
o and that the D’s who approved spring-loaded options:
(a) had material nonpublic info (in this case, that shares were actually worth more than
exercise price) soon to be released that would impact the company’s share price, and
(b) issued those options with the intent to circumvent otherwise valid SH-approved
restrictions upon the exercise price of the options (wanted to enrich EE’s beyond what SH’s
approved).
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Note This is an unusual case, since normally when we see D’s were independent, then BJR attaches and
the case is over. But here, EVEN THOUGH ct found that D’s were independent, BJR DIDN’T attach.
Ryan v. Gifford (demand found futile under both Aronson 2 part test & Rales test)
Facts: (DE Chan 2007) П SH, filed a derivative action against D’s, the corp bd and compensation committee
members, for an alleged breach of their duties of due care and loyalty in approving or accepting backdated
options in violation of a stock option plan and stock incentive plan. The members moved to stay the action
in favor of earlier filed federal actions in CA; alternatively, they moved to dismiss the action on its merits.
o П SH alleged that grants of stock options to the founder of the corporation were backdated, as the
grants were too fortuitously timed to be explained as coincidence
o The compensation committee which approved the transactions was composed of 3 of 6 corp D’s
2 prong test for demand futility: (disinterestedness & independence or question of validity of exercise of BJ)
o Compensation committee that approved challenged option grants (comprised ½ of board) – where
½ or more of board is in place at time the complaint was filed approved the challenging transaction
the approval can be imputed to the entire board this triggers 2 part Aronson test
Facts of case provides sufficient particularity in the pleading to survive motion to dismiss
for failure to make demand – raises reason to doubt valid BJ
Unusual facts raise a reason to doubt the challenged transaction resulted from valid
exercise of BJ
Demand also futile under Rales Test
o Even if decision of compensation committee is not imputable to entire board for purpose of
Aronson, demand futile under Rales b/c:
o Where the board has not yet made a decision, demand is excused when the complaint contains
particularized facts creating a reason to doubt that a majority of the directors would have been
independent & disinterested when considering the demand
Directors who are sued have a disabling interest when there’s a substantial likelihood of
liability
Backdating is wrong on its face – board approval can’t meet BJ test – thus a substantial
likelihood of director liability exists
Holdings:
o There were sufficient allegations to raise a reasonable doubt re: the disinterestedness of the bd
if ½ or more of board is interested – they CAN’T make a valid BJ
o Intentional violation of SH approved stock option plan coupled w/ fraudulent disclosures regarding
purported compliance w/ that plan conduct that’s disloyal to corp and thus bad faith
allegation of such conduct rebuts BJR & survives motion to dismiss
Also a uncommon case in that the board made a decision that cannot be valid exercise of BJR
Corporate Combinations
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Terminology:
o Raider or bidder: person/corporation that makes a tender offer
o White Knight: when management knows it’s going to be taken over solicits competing tender offers
from other corporations. The more friendly corporations are “white knights.”
o Lock-up: device used to protect one bidder (usually the white knight) against competition by other
bidders. The favored bidder is given an option to acquire selected assets, or a given number of shares
of the target at a favorable price under certain conditions—these conditions usually involve the defeat
of the favored bidder’s attempt to acquire the company or the occurrence of events that would make
such defeat likely.
o Crown jewels: to defeat or discourage a takeover bid, a target may give the white knight a lock-up
option that covers the target’s most desirable business or the business most coveted by the disfavored
bidder.
o Fair price provision: requires that a super-majority (usually 80%) of the voting power of a corporation
must approve any merger or similar combination with an acquirer who owns a specified interest in the
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corporation—usually 20% of the voting power. This supermajority vote is not required in some
conditions—most notably, if the transaction is approved by a majority of those directors who are not
affiliated with the acquirer and who were directors at the time the acquirer reached the specified level
of ownership of the company, or if certain minimum price criteria and procedural requirements are
satisfied.
Fair price provision discourages purchasers whose objective is to seek control of a corporation
at a relatively cheap price and discourages accumulations of large blocks b/c it reduces the
options that an acquirer has once it reaches specified level of shares.
o Management buyout (MBO): acquisition in cash or securities by a newly organized corporation in
which members of the former management of the public corporation will have a significant equity
interest, pursuant to a merger or the like.
o Leveraged buyout: an MBO that is highly levered, acquiring a huge amount of debt in relation to its
equity.
o Poison pill: plan under which the board of directors creates rights that are distributable to
shareholders. Under the rights, upon the occurrence of certain events shareholders (other than a
tender offer bidder or prospective bidder) have the right to purchase stock in the corporation (or maybe
the acquirer) at a deep discount.
Because the potential exercise of these rights would dramatically dilute the value of the target
stock that the bidder proposes to acquire, the mere potential that the rights will be exercised
may serve as a deterrent to making a bid in the first place.
the “flip-over” provision, triggered after the acquirer seeks to institute a merger, allows the
target company’s shareholders to buy the acquirer’s stock at half price
DE law provides 3 types of corporations transactions where 2 companies can combine:
o Sales of assets
o Merger
o Tender offer
Sale of Substantially All Assets
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DGCL §271 – Sale, Lease or Exchange of Assets; Consideration; Procedure
o (a) Says in a sale of all or substantially all of a corporation’s assets the corp has to be authorized by a
resolution adopted by the holders of a majority of the outstanding stock of the corp entitled to vote
thereon (majority outstanding SH vote)
o (b) BoD can abandon the proposed sale… w/o further action by SHs, subject to rights, if any, of third
parties under any contract relating thereto
o (c) The property & assets of the corp include the property and assets of any subsidiary of the corp…
Notwithstanding subsection (a) of this section, except to the extent the CoI otherwise provides, no
resolution of SHs or members shall be required for a sale, lease or exchange or property & assets of
the corp to a subsidiary
Assets can be sold for any type of consideration cash, debt, stock, etc…
First question: is there a vote? What constitutes all or substantially all the assets?
o Gimble standard: whether a transaction involves the sale of:
(1) assets quantitatively vita to the operation of the corporation
(2) is out of the ordinary and substantially affects the existence and purpose of the corporation
Second question: who gets to vote?
o Only the company that is selling all or substantially all assets – their SHs get to vote
Third question: is there an appraisal right?
Hollinger v. Hollinger (Gimbel 2 part quantitative/qualitative test for what IS “substantially all”)
o Facts: (DE Chan 2004) The subsidiary is suing the parent company b/c the parent is trying to sell the
Telegraph subsidiary without a §271 vote. П SHs argue that is “substantially all” of the corporations
assets.
o Rule the Gimbel test: (contextual approach)
SH vote under §271 is required if:
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(1) the assets to be sold “are quantitatively vital to the operation of the corporation, and –
quantitative test
(2) substantially effect the existence and purpose of the corporation – qualitative test
Vital to the Operation Indicators:
bids (Telegraph was worth 56-57% of International’s asset value and the Chicago Group
was 43-44%; ct says this isn’t the “substantially all” set forth by statute and the
remaining asset is a quantitatively vital asset itself)
revenue (Telegraph accounts for less than half of International’s revenue for the past 3
years)
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) (here
shows rough parity b/w 2 groups)
Substantially Effect:
Aesthetic quality of company doesn’t matter, focus on economic quality
Whatever social importance of the Telegraph in the UK, the economic value of that
importance to International is what matters under the Gimbel test, not “how cool it
would be to be the Telegraph’s publisher.”
Holding under quantitative prong: neither Telegraph Group nor Chicago group were quantitatively
vital to meet Gimbel test. Under qualitative test, Telegraph also fails.
Sale of Telegraph doesn’t amount to a sale of “substantially all” of Δ corps’ assets no SH vote.
Strine says “substantially all” means “essentially everything.”
The Appraisal Remedy
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DGCL § 262 –gives stockholders the right to ask the Chan Ct to determine whether or not they received “fair
value.” (fair value gets defined in case law)
o The “fair value” doesn’t include the effects of the merger (says so in statute)
o §262(a) says SH of a corp that bought the shares before the merger & holds the shares till the day of
the merger and didn’t vote in favor of the merger CAN get an appraisal
When do you NOT have appraisal rights?
o If you are not a continuing shareholder § 262(d) tells us how to perfect appraisal rights (hold shares
continuously, non-consenting, obligation on company to inform you that you have appraisal rights)
o If you voted “yes”you have to be a dissenting shareholder
o Asset sales do not generate appraisal rights § 271
o When the stock is traded on a public exchange (privately held corporations get appraisal rights)
(rationale seems to be that the public markets will price stock well)
o Exceptions:
Cash out merger §262(b)(2) says that if it’s a cash-out merger you get appraisal rights. Why
don’t you get this in a stock deal?; when cash is a consideration, you get appraisal;
Short form merger §253 where the parent owns 90%+ of the sub then it’s a 253 merger (this
isn’t on the school-closing list, so effect is that you get your appraisal and you aren’t covered by
the market out exception)
CoI § 262(c) can put it in the CoI, but to Wachter’s knowledge this has never been done
o §262(b)(1) takes away a lot of the broad grant of appraisal rights
o Market out exception: if you’re located on a national exchange, then there is a wash out of appraisal
rights (ex. If you trade on NASDAQ, so this sweeps appraisal rights for all the big guys)
Reason for this is that judge’s don’t want to make appraisals when they think the market will do
a better job, since judges aren’t very good at it (point (i))
Possible EXAM question: do you expand appraisal rights or retract them and not even give them to cash out
mergers?
o How is appraisal calculated?
§ 262(h) is the substantive section, tells you that you get fair value exclusive of any value of
appraisal arising from synergies of the company (that is, from the merger). Get going concern
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value (as it is understood by DE). Calculated by a discounted cash flow analysis of the value of
the free cash flows discounted to their present value.
You don’t get the value of merger b/c the statute says you get fair value – value created by the
merger; you are voting against it, presumably because you don’t think it’s a good move—so you
shouldn’t be upset that you don’t get added merger value
o When do you get appraisal? 3 cases:
Closed corporations
Cash mergers - §262(b)(2)
§ 253 short form mergers (Ø get to vote, but get appraisal)
o If you don’t get appraisal, can argue for violation of fiduciary duty, unfair price/deal and way to get into
a kind of appraisal.
o §262(d)(1) has to be done individually; [normally done that all SHs that demand appraisal will
combine into a group and it will be done once; but this means that if you are an individual SH is that if
you ask for appraisal, you have to pay for it; so basically this only happens with large SHs that have
enough to make it worthwhile]
Piemonte v. New Boston Garden Corp—(DE Block Method of Valuation – can’t just use market value of stock if
there’s no established market for the stock)
o Facts: (MA 1979) Пs were SHs in a MA corp whose SHs voted to merge w/ Δ, Пs were entitled to
demand payment for their stock and an appraisal in accordance with Mass. Gen. Laws ch. 156B, § 85. P
commenced action under Mass. Gen. Laws ch. 156B, § 90, seeking a judicial determination of the "fair
value" of plaintiffs' shares under Mass. Gen. Laws ch. 156B, § 92. Each party appealed from a judgment
determining the fair value of P’s stock.
o Holding Ct concluded T/Ct followed acceptable procedures in valuing plaintiffs' stock; that his
determinations were generally within the range of discretion accorded a fact finder; but that the
judge's treatment of the evidence was, or may have been, in error on three points:
remanded the determination for clarification and further consideration on the record of three
matters: (1) the trial court's valuation of the sports arena, (2) the professional sports franchise,
and (3) the concession operation.
o Market value can be a significant factor, but when there is no established market for a particular stock,
actual market value cannot be used (here the stock was traded on the Boston Stock Exchange, but
rarely--~90% was held by controlling shares and not traded)
Looking at volume of trading is okay
Selecting a multiplier of 10 based on popularity & success of team, high attendance, etc was
“with reason”
For net asset value, judge not bound to accept expert’s valuations
Judge weighted the three valuations as such:
Market value – 10%
Earnings Value – 40%
Net Asset Value – 50%
o DE law on computing value based on corp earnings:
start by computing avg earnings of corp for past 5 yrs (extraordinary gains/losses excluded)
then select a multiplier which reflects the prospective financial conditions of the corp and the
risk factor inherent in the corp and the industry (choice here will be upheld if “within reason”)
o Note DE Block Method not the ONLY valuation method used now
Weinberger v. UOP (DE S/Ct 1983) (DE Block Method can’t exclude other generally accepted valuation
techniques – ct takes more liberal approach allowing any technique/method generally considered acceptable in
the financial community)
o Rule §262 now mandates the determination of “fair” value based upon “all relevant factors”
Leader v. Hycor, Inc—(MA 1985) (DE Block Method is not the ONLY method for valuation, but a valid one)
o Holding do NOT think that the DE block method for valuing closely held stock from Piemonte is
outmoded
П argued that DE sup ct rejected this method in Weinberger.
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Ct’s response That ct only said that the method was outmoded “to the extent it excludes
other generally accepted techniques used in the financial community and the cts’ and that it
would no longer ‘exclusively control such proceedings.”
Charland v. County View Golf Club, Inc. (RI and DE ct do NOT apply minority discounts in appraisal valuation,
but NY will apply a “marketability discount” in certain cases)
o Facts: (Rhode Island) П appeals from Superior Ct of RI, which entered judgment on P’s complaint to
dissolve the corp under R.I. Gen. Laws section 7-1.1-90 discounting P’s shares b/c of their minority
status and lack of marketability; D, corp, moved under same statute to purchase P’s shares; lower ct
entered judgment discounting P’s shares; P appealed.
o Holding RI S/Ct reversed, held П’s shares should NOT be discounted based on minority status b/c
minority SHs should not receive less than FMV for their shares if, instead of fighting the dissolution
action, the majority decides to seek appraisal of minority shares in order to buy out the minority
A lack of marketability discount was inapposite when a corp elected to buy out a SH that filed
for dissolution of a corp (the minority status doesn’t matter b/c they’re not sold on the open
market)
o Minority discount: after a minority SH’s stock is initially discounted for the minority percentage owned,
the pro rata value is determined; then an additional discount is taken since minority SHs lack decision
making power (this second discount is the minority discount). rejected by ct
o Marketability discount: ct decides against it for same reasons as for minority discount
NY, however, applied a lack of marketability discount to shares in closely held corps when the
corp elects to buy out a minority SH in order to avoid dissolution (b/c shares of a closely held
corp can’t readily be sold on the public market)
o NOTE DE ct does NOT apply minority discounts in valuation – the dissenter gets “fair value” not
“market value”
MT Properties v. CMC Real Estate Corp—(pp 1053) (Minn. doesn’t apply minority discount in FV valuations)
o (Minn. 1992) - “The issue of minority discounts involves highly conflicting policy considerations. Either
resolution of the issue risks unduly enlarging the value of some shares, either those of the remaining
SH’s or those of the dissenter. However, b/c the leg has enacted the statute w/ the evident aim to
protect the dissenting SH, we must prohibit application of minority discounts when determining ‘fair
value’ in accord with the approach of the majority of states which have addressed this issue.”
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Statutory Mergers
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Often requires shareholder approval (when new stock issued)
o In order for a company to issue new stock, which is often the consideration in a merger, DGCL §
242(a)(3) requires that any changes to the number of issued shares by approved by a majority of
shareholders.
o NOTE SH approval is not required to change the amount of authorized stock, just the amount of
stock in existence at all (b/c will dilute current shareholders)
DGCL § 251 Merger or Consolidation of Domestic Corporations (classical merger)
o (b) board must adopt a resolution
Need approval of BOTH corp’s boards
o (c) agreement must be submitted to shareholders and a majority of the outstanding stock must
approve it before it will go into effect.
SHs of both corps get to vote
o (d) directors can decide to terminate the merger at any point
o (f) NO shareholder approval required when: (the pipsqueak merger)
The agreement in no way amends the certificate of incorporation
Each share of stock of the surviving corporation is to be identical to what it is before the merger
and:
no new shares are to be issued or
the authorized unissued shares will not amount to more than 20% of the stock
outstanding before the merger.
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See also Rule 312.03
DGCL §253 – Short Form Merger
o Mergers b/t parents and their less than 100%-owned subsidiary, typically if a parent owns 90% or more
of a company it can buy out the remaining minority shareholders without stockholder approval.
Tax Treatment of Corporate Combinations (see p. 1059-60)
o “tax free combination” – means the taxes on the transferor’s gain will be postponed & the transferor’s
bassis in the stock/property received will remaind unchanged from the transferee’s basis & past
operating losses of both companies can generally be carried over to apply against future earnings (IRC
§§354(a)(1), 358, 361(a), 381, 382)
o 3 routes for tax-free combinations (ABC):
Type A reorganization statutory merger or consolidation
Survivor can use consideration other than voting stock
“continuity of interest” doctrine transferor’s SHs must receive a significant equity
interest in the survivor if the merger is to qualify as tax-free
Type B reorganization stock-for-stock combinations
Consideration given by acquiring corp must consist SOLELY of voting stock
Type C reorganization stock for assets combination
Consideration given must consist PRIMARILY of voting stock
Note on Tax Treatment of Corp Combinations—(pp1059-60)
Triangular Mergers
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DGCL §251(b)(5)
Advantages of triangular merger:
o Gives the management the best of both types of “mergers” – the form of a merge but w/o assuming
liabilities of the disappearing corporations and w/o voting or appraisal rights for the survivor’s SHs
o One of the most widely used mechanisms
How it works
o S & T want to merge. S will be the survivor and T shareholders will end up with 100k shares of S.
In a normal merger, this would happen by S issuing 100k of its own stock to T shareholders.
o In a triangular merger, S instead begins by creating a new subsidiary, S/sub. It then transfers 100k
shares of its own stock to S/sub in exchange for all of S/sub’s stock.
o S/sub and T then engage in a statutory merger, but instead of issuing its own stock to T, S/sub issues
100k shares of S stock.
b/c statutory merger allows any kind of consideration, doesn’t have to be your own stock
§251(b)(4)
o T’s business is now owned by S’s wholly owned subsidiary and T’s shareholders now own 100k shares of
S stock.
o S can now insulate itself from direct responsibility of T’s liabilities.
o Important problem caused by triangular mergers is that they may allow subversion of shareholder
voting and appraisal rights.
Terry v. Penn Central Corp—(PA case, in forward triangular merger – no right for acquirer’s SHs)
o Facts: (3rd Cir. 1981) Terry is SH in Penn, Penn sets up Holdings in order to merge with Colt & gives
Holdings shares of Penn for one share of Holdings & Colt and Penn agree to merger. Holdings gives
Penn stock to Colt shareholders, Colt would give shares to Holdings
П is not party to the merger since it’s btw Holdings & Colt
But П wants to enjoy merger & enforce voting & dissenter’s rights
o Issue Is Penn a party to the merger and can П get relief?
o Rule PA Corp Law §1908 and §1311 does not cover this transaction b/c the parties to a merger are
described as those entities that are “actually” combined into a single corp. Δ Penn not a party under
§1907’s language.
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Holding NO de facto merger doctrine (b/c PA legislature explicitly goes against that) so Penn SHs (П)
have no rights regarding this merger
NOTE reverse triangular merger
In a forward, the sub buys target (A own sub who owns Target)
In a reverse, Target buys S and remains (A owns Target)
Freezeouts
Cash-Out Mergers (Need Board Approval)
- Corporate transaction whose principal purpose is to reconstitute the corporation’s ownership by involuntarily
eliminating the equity interest of the minority shareholders.
- Weinberger v. UOP, Inc (in cash-out merger the minority vote needs to be informed, or else entire fairness
standard applies says appraisal is exclusive remedy, but only exclusive for §253 mergers arms’ length
bargaining VERY important overturns “business purpose requirement”)
o Facts: (DE S/Ct 1983) Right around time of VanGorkum & Unocal – Signal (public corp) had excess $,
acquired 50% interest in UOP, wanted to buy out rest of UOP in cash-out merger. 2 of UOP directors
also Signal directors, did a “feasibility study” of a total acquisition of UOP by Signal, and determined
that a price up to $24 would be good for Signal. In discussions with the CEO of UOP, a former Signal
executive, they told him nothing about the $24 study – and he told them only that $21 would be a fair
price, and that the employees needed assurances. The UOP CEO then hired Lehman Brothers to study
whether $21 would be a fair price; they came to an affirmative decision after 4 days. The disinterested
directors of UOP approved a deal at $21 – having no knowledge of the feasibility study. After an
affirmative shareholder vote as per §251, –П SH brought direct class action suit.
No market for corp control b/c Signal is already controlling SH, no one to pay premium for
UOP’s shares
Chan Ct found terms of merger fair to П & other minority SHs, standard is entire fairness & П
had to allege specific acts of fraud or misrepresentation.
o Rule where the corporate action is approved by an informed vote of the minority shareholders, the
burden of proof entirely shifts to П to show the transaction was unfair to the minority; however, ∆s
have the burden of establishing that the minority shareholders were informed in their voting
if the vote was not informed, then the burden of proof remains with ∆s to show that the deal
itself was entirely fair
o Two aspects of “entire fairness” – court examines both fair dealing & fair price
clearly, there was no fair dealing here
as to fair price, a quasi-appraisal method will be used; that is, not just the standard DE “block”
evaluation of appraisal, but one including rescissory damages if the Chancellor deems them
relevant, e.g. especially if fraud is present (here the Chan judge ended up adding $1 b/c he had
no idea what rescissory damages are)
NOTE – if the procedural part of merger is fair, ct will usually conclude the price is fair, but
finding fair price doesn’t necessarily mean the ct will find the procedure fair as well
o Holding S/Ct affirms in part and reverses in part even though the ultimate burden of proof to
show a transaction is fair is on the majority SH, a minority SH П must first show some basis for invoking
the fairness test
No informed minority vote b/c Δ w/held material information – no shift of burden to П
Here there is NO arm’s length bargaining – so the burden of proof is on Signal to show the
transaction was entire fair
$24 price has to be disclosed b/c there’s no arm’s length bargaining (Arledge & Chitiea
on both boards are supposed to be UOP’s faithful fiduciaries)
Since this is cash-out merger appraisal is a remedy
Overturns “business purpose requirement” from Singer v. Magnavox – no longer DE law
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Takeaway Ct tried to say here that appraisal following this case would be the “exclusive” remedy,
but in fact, what it meant to say was what it said in Glassman v. Unocal Exploration: that that appraisal
is the exclusive remedy only in §253 (short-form) and not in mergers pursuant to other statutes
Later, in Rabkin v. Philip A. Hunt Chem. Corp ct held appraisal is NOT exclusive remedy in a
claim for breach of fiduciary duty of entire fairness in long-form merger
o Importance of arm’s length bargaining: (if you use correct procedure – ct will conclude substantive
price is fair too)
If there’s arm’s length bargaining a lot more likely ct will find terms of merger to be fair
If no arm’s length bargaining ct will conclude the transaction was conflicted, look at fairness
of merger in term of adequacy of price paid for minority shares
o from here on out, the fair price you receive in appraisal is equivalent to the fair price in a fiduciary
duty suit
Kahn v. Lynch Communications, Inc. (Case from before, reiterating importance of real arm’s length bargaining
for burden shifting where controlling SH is buying out rest of corp’s shares)
Glassman v. Unocal Exploration (appraisal is the exclusive remedy in short-form mergers absent actual fraud or
illegality, SH can’t bring other fiduciary duty claims)
o Facts: (DE S/Ct 2001) §253 short-form merger btw Unocal & Unocal Exploration (sub). Пs are minority
SH of subsidiary, filed a class action against Δs - the parent corp and its directors, alleging that the Δs
breached their fiduciary duties of entire fairness and full disclosure. Ct of chancery (DE) held that the
minority SH’s exclusive remedy was appraisal and the SHs appealed.
Unocal owned 96% of UXC, wanted to get rid of minority interest to cut costs; both boards
appointed a special committee to study possible merger. Subsidiary corp’s committee
consisted of 3 D’s who weren’t officers/EEs of the parent company; subsidiary retained
financial and legal advisors to assist it during the review process and its D’s agreed to the
merger at an exchange ratio of .54 shares of the parent corp’s stock for each share of the sub’s
stock.
o Issue what are a parent corp’s duties to its subsidiary’s minority SHs in a short form merger?
o Holding in a §253 short-form merger, no need to show entire fairness – absent fraud or illegality,
appraisal is the exclusive remedy for minority SHs dissatisfied w/ the merger.
But there’s still duty of full disclosure in the context of request for SH action
Resolves confusion from Weinberger & Rabkin
No need to prove business purpose b/c that test is eliminated
Stauffer – ct held appraisal is NOT exclusive remedy in short-form merger w/ fraud or illegality
(fits w/ legislative intent b/c equitable claim would conflict w/ statute)
o Takeaway minority SH can’t allege breach of fiduciary duty in §253 merger UNLESS it’s for actual
fraud (not structural fraud) or illegality
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Tender Offers (No Board Approval Needed)
- Tender Offers v. Mergers
o Tender offers are NOT covered in the DGCL
Can be friendly or unfriendly
o In a merger, the bidder’s board would negotiate w/ the board w/ the target
o In a tender offer, the bidder targets the SHs of the target directly & bypasses the board
After Williams Act target board has obligation to advice its SHs as to whether it believes the
tender offer is in the best interest of the corp (but they’re not part of negotiation)
o Not entirely settled what constitutes a tender offer, see below test
- 8 factor test for determining when there’s a tender offer:
o (1) whether the purchasers engage in active and widespread solicitations of public shareholders
o (2) whether the solicitation is made for a substantial percentage of the issuer’s stock
o (3) whether the offer to purchase is made at a premium over the prevailing market price
o (4) whether the terms of the offer are firm rather than negotiable
o (5) whether the offer is contingent on the tender of a fixed number of shares
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(6) whether the offer is open only for a limited period of time
(7) whether the offerees are under pressure to sell their stock
(7) whether public announcements of a purchasing program preceded or accompanied a rapid
accumulation of large amounts of the target’s securities
o Note 2d Cir rejects the 8 factor test – Hanson Trust PLC v. SCM (test for tender offer under Williams
Act turns on whether there’s a likelihood that w/o following the Act, there is a risk that unsolicited SHs
will lack info needed to make carefully considered appraisal of the offer)
How a tender offer usually works – 2 stage process:
o 1) send a message out to the public – put an ad in the paper like the WSJ or NYT announcing the tender
offer: (needs approval by bidder’s BoA)
Usually conditioned that unless they get a certain percentage (enough for control) they won’t
buy any of the shares
Bidder will hire a proxy solicitation firm to figure out who the SHs are who are the “warm
bodies”
Bidder sends out a letter to the SHs in the mail
Almost all tender offers are @ a premium price, unless the bidder is already a controller
Target’s BoA will make a recommendation to its SHs, but has no final say
Bidder will never get 100% of stock, will go for either 51% or 90% (short-form merger)
o 2) get the remaining outstanding shares
If tender offer is successful, the bidder is now the controlling SH and can put its own ppl on the
target’s BoA (amend the by-laws? Call SH meeting under 141(k)?)
Under Williams Act – 2nd stage has to be at the same price as the 1st stage
2nd stage known as a “squeeze out merger”
If bidder has >50%, can do a §251 cash-out merger
If bidder has >90%, can do a §253 short-form merger
See DGCL §203 on restrictions
Staggered Boards may serve as a defense to a succinct takeover, as with a staggered board, the directors
can’t be quickly replaced so as to do the bidder-controlling shareholder’s bidding
o generally accepted view is that a staggered board is only effective in such circumstances if it has been
established by the certificate of incorporation, and is not so effective if it is in the bylaws for then
the board would simply be able to institute a staggered board to prevent a hostile takeover
Appraisals pursuant to tender offers only once an actual merger has been effected:
o when there is a hostile tender offer followed by a squeeze-out merger, as the merger is done following
the bidding process, the corporation may be more valuable now that the bidder has control of the
company and may have established a set plan
o therefore, it is critical to a profitable tender offer merger to effect the merger immediately by written
consent following the closing of the successful tender offer
Solomon v. Pathe (tender offers are voluntary, SH doesn’t have right to a “fair” price & can’t bring fiduciary suit
unless there’s coercion or disclosure violations)
o Facts: (DE S/Ct 1996) CLBN owned 89% of Pathe, made tender offer for rest of it, Δ Pathe had special
committee to review proposal w/ its own legal & financial advisors. П Pathe SH argues that the tender
offer was unfair to all SHs – coercive & amounted to breach of loyalty by CLBN as controlling SH of
Pathe. Complaint attempts to assert a breach of duty of fair dealing by the directors b/c they did not
oppose the tender offer.
o Holding If this was a merger case, П could have brought fiduciary claim. BUT a tender offer is
voluntary. You don’t have to sell your stock if you don’t want to. Case dismissed for failure to state a
claim.
In tender offers, the SH doesn’t have a right to receive a particular price
o Rule A tender offer is not voluntary when:
coercion is present, or
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there are “materially false or misleading disclosures made to shareholders in connection with
the offer.”
Pure Resources Inc. (no entire fairness in tender offers by controlling SH, BUT offer is non-coercive ONLY under
3 conditions)
o Facts: (DE Chan 2002) Unocal owned 65% of Pure, made tender offer for remaining 35% conditioned
on majority of shares being tendered. П SHs argue entire fairness standard applies.
o Issue what standard of fiduciary conduct applies when controlling SH seeks to acquire rest of
company’s shares?
o Holding entire fairness does NOT apply in tender offers by controlling SH – but such an offer should
be deemed non-coercive only when it’s subject to condition that a majority of the minority accept the
tender
o Two strands of cases:
(1) controlling shareholders negotiate a merger agreement with a target board to buy out the
minority gets entire fairness (Kahn v. Lynch), appraisal rights
(2) controlling stockholders seeks to acquire the rest of the company’s shares through a tender
offer followed by a short-form mergerSH doesn’t have to sell stock (look to see if sale was
involuntary)
Prisoner’s dilemma: if you don’t tender your shares you may be stock with a lower
price in a short form merger or you might lose liquidity b/c will be so few minority
shares structural coercion
o Tender Offers by Controlling SH only non-coercive when:
(1) it is subject to the condition that a majority of the minority accept the tender;
(2) the controlling shareholder promises to consummate a prompt short-form merger at the
same price if as a result of the tender it acquires ends up owning more than 90% of the
controlled corporation’s shares; AND
(3) controlling SH has made no threats of retribution if tender offer fails.
o Majority SH & independent directors’ duties in tender offer:
Majority SH owes duty to permit the independent directors on target board both free rein &
adequate time to react to tender offer & made recommendation
Independent directors have duty to undertake these tasks in good faith & diligently, and to
pursue the best interests of the minority
o Holding ct finds offer in its present is coercive b/c its definition of “minority” includes SHs who are
affiliated w/ Unocal as directors & officers & management of Pure (may have skewed incentives)
prob can be fixed by amending offer
o Takeaway This provision goes a long way toward establishing entire fairness standard in tender offer
context!
Hostile Tender Offers
o Regulation of the 2nd stage of a tender offer
o This then has an effect on how the first stage of the tender offer takes place
Coggins v. New England Patriots Football Club (MA ct still applies business-purpose test to cash freeze-out
mergers, Δ’s compliance w/ statutory provisions isn’t enough)
o Facts: (MA 1986) П representing minority SHs in a class action appealed from a dismissal of П’s claim
for waste of corporate assets and a decision MA Superior Ct that a freeze-out merger should not be
undone.
o Business Purpose Test
Ct feels it’s an additional useful means for examining transaction where a controlling SH
eliminates the minority interest in a corp justifies it w/ past holdings that wrt close corps the
statute doesn’t divest the cts of their equitable jurisdiction to assure that the conduct of
controlling SH doesn’t violate the fiduciary principles governing the relationship btw majority &
minority SHs
Duty of corp director is to further legit goals of corp – so corp directors has to show allowing a
freeze-out merger is furthering legitimate goals
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Holding Ct feels there’s a danger of self dealing, so need to look to controlling SH’s motives – finds
the freeze-out was designed for the majority SH’s own personal benefit to eliminate the interests of the
minority SH’s and did not further the interests of the corp.
The merger was a violation of fiduciary duty to minority SH’s, and therefore impermissible.
Although rescission is the normal remedy, the court determined it would be inequitable and
remanded for a determination of the present value of the nonvoting stock, as though the
merger were rescinded. Those Пs who did not turn in their shares and did not perfect their
appraisal rights were entitled to receive damages in the amount their stock would be currently
worth, plus interest at the statutory rate.
o Two requirements for freeze-out merger to go through:
(1) satisfy the business purpose test – need to show it’s advancing a legit corp purpose
(2) ct proceeds to determine the transaction was fair by examining the totality of the
circumstances
Alpert v. 28 Williams St Corp—(NY 1984) (NY also requires advancement of general corp interest/benefit for
freeze-out merger)
o In the context of freezeout merger, variant treatment of the minority SH—i.e. causing their removal will
be justified when related to the advancement of a general corp interest. The benefit need not be
great, but it must be for the corp.
o EX: if removal of minority SHs furthers objective of conferring some general gain upon the corp, then
it’s okay even though this may ultimately have the effect of increasing individual wealth of the
remaining SHs.
o An independent corp purpose for the action taken by the majority will not be defeated merely by the
fact that the corp objective could have been accomplished another way, or by the fact that the action
chosen was not the best way to achieve the bona fide business objective.
Freeze-outs by Reverse Stock Splits
o Reverse stock split = a consolidation of outstanding stock – resulting in some SHs becoming entitled to
only fractional shares
Some statutes allow corp to compel SHs to accept cash in lieu of fractional shares
o Teschner v. Chicago Title & Trust Co. (Ill. 1974)– reverse-split freezeout allowed by ct b/c no fraud or
deceptive conduct was found – ct analogized transaction to short-form merger statutes
o Clark v. Pattern Analysis & Recognition Corp. (NY 1976) – ct issued temp injunction against reversesplit freezeout plan says minority SH should be able to contest freezeout when there’s allegation of
fraud, illegality or bad faith, coupled w/ tenuous showing of legitimate corp business purpose. But
where a strong & compelling business purpose is shown, cts shouldn’t interfere.
Going Private
o Converting a corporation that’s publicly held into one that’s privately held (p. 1114-15)
The Williams Act
Passed in 1968 & amended in the 1970s, this is SH protection legislation; it added §13(d),
§13(e), Schedule 13D, §14(d) and §14(f), and Schedule 14D to the SEA
o §13(d) – indicates that any individual who has acquired more than 5% of a class of stock registered
under the Act must, as per Rule 13d, file a Schedule 13D [p. 1829], which will include the purchaser’s
background and identity, and the sources of the funds and the purpose of the purchase
note that the Hart-Scott-Rodino law effectively lowers the threshold by requiring disclosure if
the acquisitions will result in the acquirer’s owning voting stock in the corporation in excess of
$15 million: most corporations that are targets of tender offers have values where $15 million
will be far less than 5% of the stock
o Rule 13d-2 - requires updating to the Schedule 13D for any changes
o §13(e) - Purchase of Securities by Issuer [p. 1711]: indicates that corporations that tender for their own
stock are subject to regulations similar to those imposed on outside bidders under Rule 14d and 14e
o §14(d) & Rule 14d apply to tender offers for more than 5% of any class of security:
Rule 14d-8: proration: a bidder making a partial tender offer and more securities are tendered
than it sought to buy will have to accept up to the percentage on a pro rata basis
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Rule 14d-10: all holder’s rule: the tender offer must be open to all shareholders this
overrules the Unocal holding which allowed a discriminatory merger
Rule 14d-10: also has the best price rule: the price paid to any security holder must equal the
highest price the bidder paid to any security holder during the tender offer
o Rule 14e-1: the minimum duration: an offer must be open for at least 20 days
o §14(e) [p. 1718] and Rule 14e [p. 1901] are fraud provisions applying to any tender offer; no untrue
statements or omissions of material fact in relation to tender offers
note however that this is a scienter provision, requiring that – establish an intention to defraud
and not merely a negligent misstatement or omission
Rule 14e-2 establishes an obligation of the target corp.’s management to respond to a hostile
tender offer; to tell the shareholders whether they approve, disapprove, have no comment
upon, or are unable to make a comment on the offer
State law during the 1908s, when hostile takeovers received a great deal of publicity, DE passed its own antihostile takeover provision (closest thing we get to DE takeover law)
DGCL §203 [p. 573]: Business Combinations with Interested Stockholders
o this provision is triggered by a tender offer, and basically indicates that once you become a majority
shareholder, you can’t effect the back end of the tender offer merger (the actual merger bit) unless
either the board approved the merger before you became a majority shareholder, or else three years
have passed
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Hostile Tender Offers & Defensive Measures
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Unocal v. Mesa Petroleum (establishes the intermediate standard of review – if Δ satisfies 2 prong test for
defensive measure (reasonable threat & proportionality) then BJR attaches)
o Facts: (DE S/Ct 1985) Pickins, head of Mesa, made a two-tiered tender offer for Unocal: he already
owned 13% and made an offer of $54 in cash for 37%. The second stage of the offer would give the
other 50% of shareholders papers supposedly equivalent to $54, but not until maturity. The board
rightly perceives it as a coercive offer, and decided to initiate an exclusionary self-tender offer; that is,
they will buy back 49% of the stock at $72 and hold it in its treasury. Mesa’s % of stock would then be
worth very little.
Mesa challenged exclusion in exchange offer & filed suit – Unocal’s i-bank & legal counsel told
them they should waive the condition as to 50mil shares & under DE law Mesa could only be
excluded for a valid corp purpose here the objective was adequately compensated SHs at the
“bank-end” of Mesa’s proposal
o Issue Did the Unocal board have the power & duty to oppose a takeover threat it reasonably
perceived to be harmful to the corp & if so, is it action entitled to the protection of the BJR?
o Holdings:
Board has power under §141(a) to defend against hostile takeovers & under §160(a) to make a
self-tender (broad authority to deal in its own stock)
The BJR is applicable in corp takeovers – the board has duty to determine whether the offer is
in the best interest of the corp & its SHs
Recall that ALI says board should make decisions “w/ a view to enhancing” the value of
the corp, while DGCL §141(a) lets directors decide simply what’s best for the corp
Here the board acted in good faith & after reasonable investigation, found offer was
inadequate & coercive. The defensive measure was reasonable in relation to the threat b/c
Mesa’s participation in offer would have thwarted its purpose
o Two-Prong Test for Determining Whether Defensive Measure is Proper:
(1) directors must demonstrate they have a reasonable basis for believing that a threat to
corporate policy and effectiveness exists; they satisfy this by showing good faith and
reasonable investigation in their determination process
The proof is materially enhanced when there’s approval by a board comprised of
majority of outside directors
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They will NOT satisfy it if there is a showing they were trying to entrench themselves
(2) they must further demonstrate that their defensive action was a reasonable response to
the threat at hand
Look at whether the defensive was proportional to threat
IF the directors meet both prongs of this test the BJR applies
Takeaway Even though Unocal’s discriminatory self-tender is no longer allowed under Williams Act,
BUT Unocal standard is still good law
The Poison Pill: Shareholders’ Rights Plans
- The board issues Rights; one Right per share
o these Rights enable the corp. to effect a self-dilutive provision: if a certain amount of stock (perhaps
15%) is acquired by any individual, the market will be flooded with new stock of the target
o a holder of a Right can, once the “flip-in” provision is triggered, buy stock of the target company at halfprice
o the “flip-over” provision, triggered after the acquirer seeks to institute a merger, allows the target
company’s shareholders to buy the acquirer’s stock at half price
- Unitrin, Inc. v. American General Corp (puts a “gloss” on Unocal – defines “proportional” as not draconian, i.e.
preclusive or coercive)
o Facts: (DE 1995) defensive measures taken by Unitrin including a poison pill & repurchase program
o Ct looks at 3 types of threats to a corp:
Opportunity loss
Structural coercion
Substantive coercion found substantive coercion here(low ball purchase)
o Standard for applying proportionality review of defensive measure: (2nd prong of Unocal)
For a defense to be proportional, it cannot be draconian can’t be coercive or preclusive
Defensive measures which are preclusive or coercive are not proportional and violate
second prong of Unocal
As long as SHs have the proxy, defensive measure are not preclusive
A poison pill that absolutely stops tender offer not preclusive if the bidder can still
succeed in a proxy contest
If defense NOT draconian – judicial scrutiny shifts to if defense was “within the range of
reasonableness”
To look at range of reasonableness, ct takes into account whether: 1) it’s a statutorily
authorized form of business decision; 2) it was limited & corresponded in degree or
magnitude to that of the threat; 3) whether board properly recognized that all SHs are
not like & allowed immediate liquidity to SHs who wanted it
o Takeaway Unitrin puts a gloss on Unocal, what the DE S/Ct is really saying is that even though the
repurchasing of the stock is giving the board veto power, it’s NOT a violation b/c they already had
majority control
Unocal made management discretion the rule of the land
- MM v. Liquid Audio (2nd prong of Unocal has 2 parts – Blasius triggered if the target’s defensive measures
interferes w/ voter franchise)
o Unocal Second Prong:
(1) defensive actions can’t be preclusive or coercive
as long as you can get to a shareholder vote, it is not preclusive or coercive
(2) defensive action must be w/ in reasonable range
if target attempts to interfere with the franchise Blasius says that this is no longer
reasonable
- Unocal/Unitrin Test
o (1) is there a threat to the corporation?
Board needs to show good faith & reasonable investigation (helps if had independent directors
making decision)
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(2) are the defensive measures reasonable and proportional?
(a) are defensive measures preclusive or coercive?
as long as you get a shareholder vote, it is not:
preclusive (i.e., force a management-sponsored alternative upon shareholders); OR
coercive (i.e., make it impossible for the shareholders to vote in favor of the hostile
proposal)
(b) do defensive measure attempt to interfere with the shareholder franchise under Blasius?
If so, then directors need compelling justification, which never happens
Moran v. Household Intl, Inc. (poison pill allowed as defensive measure – but directors’ actions will be
evaluated @ time of response)
o Facts: (DE 1985) П Moran is Δ corp’s director & chairman of EKM (corporate SH that’s considered a
leveraged buyout of Δ corp), Δ Household has 16 directors on board, adopted Rights Plan as defensive
measure (w/ 20% & 30% triggers) with “flip-over” provision where Rights holder can purchase common
stock of the tender offeror for ½ price (Wachtell’s idea)
o Issue should BJR be standard by which Rights Plan (esp flip-over prov) is reviewed?
o Holding the poison pill w/ flip over provision is OKAY as a defensive measure – not per se illegal.
Board has authority to issue such rights under §151 (preferred stock) and §157. Analogizes rights plan
as “anti-destruction” or “anti-dilution” plans customary in corp securities.
Says the poison pill will NOT hinder having a proxy contest b/c a proxy doesn’t make the holder
a “beneficial owner” and doesn’t trigger the Rights @ 20%. Also, u don’t need 20% to
successfully wage a proxy contest (can do 19.9%)
Poison pill doesn’t erode fundamental SH rights b/c BoD doesn’t have unfettered discretion to
reject a hostile offer or to refuse to redeem the pill
Says ultimate response to an actual takeover bid must be judge by the director’s response @
the time, nothing will relieve them of their basic fundamental duties to the corp & its SHs
o Standard for Burden Shifting:
Directors have initial burden to demonstrate their defensive measure is okay under Unocal test
(reasonable belief of threat & proportionality)
Then BJR attaches & burden shifts back to Пs to demonstrate directors breached their fiduciary
duties
Under BJR, the board just has to be informed (not grossly negligent)
o Takeaway Puts the state ct & the BoD back in the game of tender offers, makes §203 less relevant
b/c now u do have to deal w/ the board – forces takeover battle out of the tender offer context & puts
it in proxy contest
Carmody v. Toll Brothers, Inc. (dead hand poison pill invalid under Blasius, §141(a), & Unocal/Unitrin)
o Facts: (DE Chan 1998)
o Issue is a “dead hand” poison pill (one that can’t be redeemed except by the incumbent directors
who adopted plan or their designated successors) legal?
o Holding the dead hand pill is invalid because:
It impermissibly creates voting-power distinctions among directors without authorization in the
certificate of incorporation, and by interfering with the directors’ statutory power to manage
the business and affairs of the corporation.
unlawful under Blasius because it purposefully interferes with the shareholder voting franchise
without any compelling justification
it is “disproportionate” defensive measure under Unocal/Unitrin because it either precludes or
materially abridges the shareholder’s rights to receive tender offers and to wage a proxy
contest to replace the board.
It’s draconian - board can’t preclude proxy context altogether!
Quickturn Design Systems, Inc. v. Shapiro (DRP invalid under §141(a) for interfering w/ BoD power)
o Facts: (DE 1998) П is acquiring comp & SH of Δ Corp, Mentor made hostile bid to acquire Δ (long patent
litigation btw Mentor & Quickturn), Δ BoD initiated 2 defensive measures:
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Amended shareholder’s rights plan by adopting a “no hand” feature of limited duration
“delayed redemption provision” court held invalid
No newly elected board could redeem the Rights Plan for six months after taking office,
if the purpose or effect would be to facilitate a transaction with an “interested person”
Board amended the by-laws to delay the holding of any special stockholders meeting requested
by stockholders for 90 to 100 days after the validity of the request is determined. ct held
valid under Unocal
Effect would be to delay shareholder’s meeting for at least three months
o Holding the DRP is invalid as matter of law for violating §141(a)
The DRP would prevent a newly elected board from completely discharging its fundamental
management duties to the corporation & its SHs for 6 months.
The DRP violates the “unremitting constant compass” of fiduciary duty
Revlon v. MacAndrews & Forbes Holding, Inc. (when corp puts itself up for sale, it’s in Revlon Land and its
position becomes that of an auctioneer – duty is to get highest price for SHs)
o Facts: (DE S/Ct 1985) Ron (CEO of Pantry Pride) wanted to acquire Revlon w/ tender offer, Revlon thinks
price too low. Revlon board (most were interested & not truly outside independent directors).
Revlon BoA adopts 2 defensive measures suggested by Lipton (@ this point NOT a violation of
fiduciary duty)
Revlon repurchases up to 5 mil of its 30 mil outstanding shares
Revlon adopts a Note Purchase Rights Plan
The bidding process:
PP keeps increasing its offer price. Revlon gets White Knight – Forstmann (private
equity company) for a leveraged buyout.
Forstmann had inside Revlon financial info not available to PP, & its offer had several
conditions (lock-up option, no-shop provision, $25 mil cancellation fee, no Revlon
management participation in merger)
Revlon BoD approves Forstmann proposal: says it’s higher price than PP, protects SH, &
Forstmann’s financing firmly in place
o Holding The defensive measures are NOT allowed, they were okay before BoD went to Forstmann.
Once they got Forstmann at this point it becomes clear that the company is up for sale. Now,
Revlon is going to sell itself on its own, “voluntarily.” At the point of the MBO they are initiating the
sale of the company and there will be a cash-out of Revlon shareholders.
o Rules of “Revlon Land”
At this point, BoD is in “Revlon land.” He has agreed to sell the company and the only question
is—what is the price going to be and who is going to be the buyer?
Once in “Revlon Land” – the directors’ duty is to be the auctioneer and get the highest price
for the SHs can’t look to long term goals anymore
When in Revlon land, you’re subject to higher standard than Unocal/Unitrin & can’t take into
account other constituencies b/c it conflicts w/ the wealth creation of SHs
o Takeaway Case subject to heightened standard because:
1) the corp put itself up for sale by approaching White Knight
2) it’s an all-cash deal (if it was partly stock then indep board has more room to argue for long
term goals of corp)
3) because Revlon board NOT truly independent – “we cannot conclude that this board is
entitled to certain presumptions that generally attach to the decisions of a board whose
majority consists of truly outside independent directors”
o Note ALI § 2.01 (b)(2) might give us a different answer: even if corporate profit and shareholder
gain are not thereby enhanced, the corporation, in the conduct of business:…may take into account
ethical considerations that are reasonably regarded as appropriate to the responsible conduct of
business; and…(3) may devote a reasonable amount of resources to public welfare, humanitarian,
educational, and philanthropic purposes.
Barkan v. Amsted Industries (Del. Supr. 1989) (when you don’t have to conduct an “active market survey”)
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Rules for Running an Auction in “Revlon Land”:
1) no single blueprint for selling off a comp that the board has to follow when fulfilling its
duties
2) directors can’t use defensive measures to destroy the auctioning process
once it’s clear the auction will result in change of corp control, BoD has to act in neutral
manner to encourage highest price for SHs
3) where there’s multiple bidders – can’t use defensive mechanisms to favor one bidder over
another
4) where there’s a single offer w/o reliable groups upon which to judge its adequacy
Board must conduct a canvas of the market to determine if higher bids can be elicited
Advice of i-banker is frequently a pale substitute for the dependable info that a canvas
of market can provide (no single method required though)
5) However, the BoD does NOT have a conduct an active survey of the market if they “possess
a body of reliable evidence w/ which to evaluate the fairness of a transaction”:
They are fully informed
No single method a board must use to acquire the “reliable evidence”
When they’re not cashing out all the SHs
o Takeaway still in Revlon Land & still have to be neutral at all times in the auctioning process, but you
don’t always have to run a formal auction. You can canvass the market, if no one else is out there and
it’s a good deal, you can go for it.
Paramount v. Time Inc. (when there’s NO change of control, Revlon duties do NOT attach & Unocal standard is
applied – threat to corp can include threat to corp policy)
o Facts: (DE S/Ct 1989) Time and Warner decide they want to have a “merger of equals.” Paramount
decides it wants in on the action. Paramount goes after Time. Time enacts defensive measures.
T also says P offer is inadequate and that their proposed deal with Warner creates more value
for the company looking at synergies, firm cultures, etc; they make a very specific statement
that they believe the Warner deal is better for the stockholders than the Paramount deal.
they can say this b/c we are not dealing with a cash out merger, but a merger of equals…it’s
not cash, but the value of companies when merged. TW creates more value than TP.
In response to P’s tender offer, T made all-cash offer for 51% of W’s stock
Definitely an informed board., there was arms length negotiation
Clearly the market thinks the P deal is better (price rises when market thinks it may go through)
o Ct refuses to apply Revlon Not in Revlon Land b/c Time made it clear they weren’t on sale, made
public announcements, really wanted to preserve the “Time culture”
There is NO change of control!
Before merger agreement, the control of the corp existed in a fluid aggregation of publicly
held shares and this would be the case AFTER the merger as well.
“Did Times board…come under a fiduciary duty to jettison its plan and put the corps future in
the hands of its SHs?”—No
No Revlon duties b/c BoD is taking defensive measures w/o abandoning corporate existence
o Time’s Duties under Unocal:
The threat here is that the SHs don’t recognize or understand (that the D’s do) that they will
make more money in the long term w/ Warner than with Paramount.
Generally, this threat is that SHs will think they are getting a better deal, when in reality
they would get a better deal in the long term going the other way.
This is important because it gives the BoD more power, unlike in Revlon land.
The company can chart a course for the company’s best interest, but not obliged to
abandon a deliberately conceived corporate plan for a short term corporate profit
unless there is clearly no basis to sustain the corporate strategy.
Ct finds the defensive measure was reasonable/proportionate despite incurring large amount
of debt
BJR attaches!
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The fact that the market thinks the paramount deal is better Ø matter; the SC of
Delaware will not second guess the BoD.
All factors have to be taken into consideration, not just price
Takeaway:
This cases broadens what is included under the “threat.” This is when a threat to corporate
policy becomes cognizable.
Stands for the proposition that a corporation can “just say no,” but to say no, they have to be
informed. Have to hear them out, negotiate, bring in investment bankers.
Paramount v. QVC Network—(you can’t “just say no” – have to go through best practices & have independent
board decide. Sale of control gets you into Revlon Land)
o Facts: (DE S/Ct 1994) Paramount found its marriage partner in Viacom. QVC tries to make its own offer
– and Paramount refuses to even chat with them b/c of “defensive measures,” which were: poison pill
exemption for Viacom, no shop clause, no stock lock-up, and termination fee of $100M.
o Revlon Duties Attached! (even though Paramount didn’t “put themselves up for sale”)
Ct looks at if there was a change of control
Yes, there was a change of control here. Here they adopt the language above…where if it goes
from fluid aggregation of SHs to a controlling SH [this is because voting is very important and
when you go from fractioned and fluid voting to having a controller], you lose the benefits of
voting—you can only sell yourself once for premium, so now if Paramount is selling to Viacom,
it is selling corporate control.
Now Δ BoD has duty to secure the best premium for the SH’s stock b/c of sale of control (after
merger Viacom would be in charge)
o the DE SC here asserts that Revlon duties are instituted once a corporation initiates a reorganization of
itself or its break-up; or, when an active bidding process is initiated, such that in response to a bidder’s
offer, the long-term plans of the company are abandoned
importance of the change of control: “When a majority of a corporation’s voting shares are
acquired by a single person . . . there is a significant diminution in voting power of those who
thereby become minority shareholders.”
whereas, when a company is owned by a “fluid aggregation of shareholders” following the
transaction, shareholder rights are preserved
o Directors’ Obligations when Selling Control:
Directors have burden to show they reasonably sought the transaction offering the best value
reasonably available to SHs
Board just be diligent & well informed
Duty of care & loyalty applies
Role of outside, independent directors become really important when selling control
o Holding here the directors actions doesn’t survive the higher level of scrutiny for the duty of care
and loyalty; ∆s violated their Revlon duties by favoring the Viacom deal over the QVC one for no
sufficient reason
Arnold v. Society for Savings Bancorp (DE 1994) (3 ways of getting into Revlon land)
o 3 ways to get into Revlon Land:
(1) when a corp initiates an active bidding process seeking to sell itself or to effect a business
reorganization involving a clear break-up of the company
(2) when in response to a bidder, the target abandons its long term strategy and seeks an
alternative transaction involving the break-up of the company
(3) when approval of a transaction results in a “sale or change of control”
There is NO sale/change in control when control of both companies remain in a large,
fluid, changeable & changing market
o
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Conclusion
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Why are corps so great and why do we invest our $ in stock? Wachter has given us answers:
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o
o
o
the market works: the management is properly controlled by the market (duty of care)
directors don’t have to be smart, the market will keep them smart
state law works: the law on the duty of loyalty are effective
law keeps directors faithful
SEC’s role: securities regulation makes the stock market fair
SEC creates a fair, transparent, & disclosed trading space.
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