Stephanie Whitfield
Corporations
Professor Wachter, Spring 2000
Corporations
Agency
 Agency – law governs relationships b/w principals & agents
 Questions to explore
 Type & Scope – When does agent have authority? What is the scope?
 Liability to 3rd Parties – Who is liable when agent’s actions lead to damages to 3rd parties?
 Duty - Duty of loyalty owed to principal (agent’s)
 Types of Authority
 Actual Authority – implied & express – If Principals words or conduct lead a reasonable
person to believe that the agent has authority
 Implied – incidental authority; common type of implied actual authority. A is authorized
to do acts reasonably necessary to accomplish an authorized transaction or that usually
accompany it.
 Apparent Authority – power of position (i.e. CEO would have certain powers), words,
conduct of the principal.
 Restatement of Agency § 27 = apparent authority to do an act is created as to 3rd
parties by written or spoken words or any other conduct of the principal which
reasonably interpreted causes the 3rd party to believe the principal consents to have the
act done on his behalf by the person purporting to act for him. What matters are the
representations of principals!
 HYPO 1 – A is agent for D, an apartment owner. A says to family “we rent to
families with kids” when really D told A doesn’t rent to families w/ kids. Family not
off hook b/c it matters what representations D, the principal made to the family! If D
never represented that A had authority to make K.
 HYPO 2 – Family enters office of A where signs says “Manager.” Is apparent
authority created? Yes – power of position – it is normal for people to believe A has
power incidental to his position.
 HYPO 3 – If Family has reason to believe D won’t agree, then no apparent authority.
Power of position doesn’t trump actual knowledge.
 HYPO 4 – D is an undisclosed principal. Can there be apparent authority if D is
undisclosed? No. Apparent authority requires some act or representations of the
principal.
 Inherent Authority – Foreseeable action to be undertaken by agent that is incident to
authorized transaction.
 Types of principals
 Disclosed principal
 Partially disclosed principal
 Undisclosed principal – an undisclosed principal cannot hide behind the fact that he is
undisclosed to support fact that he hasn’t given authority. Inherent authority fills the gap!
Restatement § 194
 Inherent authority
 Restatement § 161 Unauthorized Acts of General Agent (disclosed and partially disclosed
principals) - a general agent for a disclosed or partially disclosed principal subjects his
principal to liability for acts done on his account which usually accompany or are identical
to transactions which the agent is authorized to conduct if, although they are forbidden by
the principal, the other party reasonably believes that the agent is authorized to do them
and has no notice that he is not so authorized.
 Restatement § 194 Acts of General Agents (Creation of Liability by Unauthorized Acts) –
a general agent for an undisclosed principal authorized to conduct transactions subjects his
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principal to liability for acts done on his account, if usual or necessary in such
transactions, although forbidden by the principal to do them.
 Difference b/w § 161 & § 194 is that a 3rd party can’t reasonably believe an Agent has
authority in 194 b/c principal is undisclosed.
Crosisant v. Watrud
 Facts – case of disclosed agent. P had bizness. Left town an asked Watrud to manage affairs
although he was only accountant. Watrud was responsible for paying for bills, etc. Watrud gave
$$ to P husband not authorized to do and also stole. Watrud did not have actual or apparent
authority. P sues Watrud’s accounting firm. Ds argue Watrud was acting as separate trustee, not
part of firm bizness.
 Court said even though Watrud was not doing work for P that was typical for accountants, P
reasonably believed it was the type done by accountants. Evidence = P paid the accounting
firm for the services performed by Watrud, not him individually!
 Court finds Inherent Authority – actions incidental to transactions that usually accompany a
position. Purpose = to protect 3rd parties for tortious acts.
 Why should the accounting firm be liable?
 Firm = beneficiary of the services performed, able to monitor agents better to make sure
they are not transgressing.
 Liability of Watrud – is Watrud liable to the accounting firm? In case where there is apparent
authority and A transgresses authority given by P, A is liable to P.
 Inherent Authority liability – unsettled point – comes out of torts.
 Difference b/w Apparent Authority & Inherent Authority
 Disclosed vs. Undisclosed Principal
 Inherent authority = when agent isn’t acting w/in scope of duties!
HYPO – A = broker, sells bonds to B in a fictious company. A has apparent authority b/c his acts are
associated w/ power of position = acting in manner consistent w/ position. See page 11 of casebook.
HYPO – P = agent, D = owner of W. Philly apts. UPHS asks P to write check for charity, P does, but
D wants check back. Should D get check back? Argument for = yes, b/c $$ to hospital doesn’t
advance bizness. Argument against = doing public service, good thing for community. Outcome
depends on facts!
Variant HYPO – D wants to sell bldg., says to P to sell apts. L bids for 3 million, T bids for 3.5
million with no improvements. Can P buy from L? Yes b/c was within his discretion! Now P no
longer working for D. Obligations of P to D are now limited. Issue of sale of bizness raises
questions.
HYPO cont’d – What if D says to P, get highest price for building? Highest price defined is
problematic b/c most deals financed by other securities as well as cash. What constitutes highest
price becomes controversial. Sale of bizness is different kind of transaction though.
HYPO – C is real estate agent, visits D’s office, sees P (manager). C wants to sell her building. P
says he will buy it. D asks that P’s deal be rescinded. P is using property of D to advance his own
interest.
Agent’s Duty of Loyalty
 Tarnowski v. Resop
 Facts – P bought jukeboxes based on his agent’s investigation. Turns out agent
misrepresented bizness to P and received a secret commission. P sues to get the commission
given to agent b/c the deal was bad and to rescind the deal. Court finds for P. When agent
acts for principal, has duty to maximize profits of principal & act solely for his benefit.
Agency = special obligation, not contractual!!
 Restatement § 387 Duty of Loyalty (General Principle)– unless otherwise agreed, an
agent is subject to a duty to his principal to act solely for the benefit of the principal in
all matters connected with his agency.
 Restatement § 388 Duty to Account for Profits Arising Out of Employment – 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
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Restatement § 393 – Competition as to Subject Matter of Agency – Unless otherwise
agreed, an agent is subject to a duty not to compete with the principal concerning the
subject matter of his agency.
Jensen & Meckling Article: Theory of the Firm: Management Behavior, Agency Costs and
Ownership Structure
 Introduced principal agent problem
 Costs of Agency
 Costs of monitoring – paid for by principal
 I.e. paying w/ stock options
 Bonding costs of agent – paid for by agent
 I.e. press release, annual & quarterly reports of bizness – managers of company mail
annual reports to shareholders
 Residual costs – remaining discrepancy resulting form agent not action on behalf of
principal.
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Partnership
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Partnership Formation – whether or not there is a partnership is a legal conclusion that fits in UPA
§ 6 or RUPA § 202, 101. 35 states use UPA, 15 states RUPA
 UPA § 6 Partnership Defined – a partnership is an association of two or more persons to carry
on as co-owners a business for profit.
 RUPA § 202 Formation of Partnership – except as otherwise provided … the association of
two or more persons to carry on as co-owners a business for profit forms a partnership, whether
or not the persons intend to form a partnership.
 Martin v. Peyton
 Facts – Peyton & friends loan securities to KN&K to be used as collateral so KN&K could
borrow $ from bank. Securities were to be returned in 2 years. P’s sue b/c say they want to
be declared partners.
 Court looks to whether Ps were 1) co-owners 2) for profit. Profit was involved. Ps were
to get 40% return on the loan. But, sharing profits is important, but not sufficient
evidence of partnership!
 Lenders (Ps) acted as trustees. Couldn’t initiate own actions, but could veto some
actions.
 Court says profit sharing wasn’t dispositive that there was a partnership.
 Lupien v. Malsbenden
 Facts – P arranged to buy a car from D’s friend who ran Motor Mart. Friend disappeared w/o
finishing car. D had bought P car to use. P sues D saying he was partner and liable when car
was not built. Court finds D was partner b/c he was heavily involved in bizness. By
definition – co-owners, for profit.
 D argued, just protecting the loan he gave to his friend. D became a co-owner for
protecting his loan by operating the bizness in friend’s absence & sharing profits.
 Did D have authority? Yes!
 What was P trying to get? Agency plus liability for car.
 UPA § 7(4) Rules for Determining Existence of Partnership – the receipt by a person
of a share of the profits of a business is prima facie evidence that he is a partner in the
bizness, but no such inference shall be drawn if such profits were received in payment….
 P needed to prove 1) D was agent w/ authority, 2) profit sharing and 3) D had some
control of bizness.
Partnership – requires positive action to say you aren’t a partnership! (Partnership is something one
can by default fall into.
 I.e. one of forms that limit liability
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Term – joint venture – often used, limited in scope for single, one shot activity, sole proprietorship, lender.
Entity Status of Partnership –
Aggregate
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UPA § 6
vs.
Entity
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RUPA § 201
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History
 Lewis – drafter of UPA, unfriendly to entity theory, Ames - friendly to entity theory.
 Aggregation Theory – aggregation of individuals can’t own property, but entities can, so under
RUPA, it is clearer on this point in thinking of a partnership.
Note – if there is no partnership agreement, UPA = default unless the parties contract around
terms. UPA = enabling statute, not mandatory terms, permissive terms that exist unless you
contract around
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Management of Partnership
 HYPO – A B C form partnership. A - $90k in capital and receives 90% of profits. All work full
time for company. A wants to move. B & C don’t want to move. Who wins? B & C win b/c
they have equal votes.
 UPA § 18h Rules Determining Rights and Duties of Partners – any difference arising as
to ordinary matters connected with the partnership bizness may be decided by a majority of
the partners; but no act in contravention of any agreement between the partners may be done
rightfully without consent of all the partners.
 Statute is pro-majority vote!
 Contribution to a partnership = start-up $$$, not loan, no termination date, no interest; if
partnership fails, creditor would get assets b/f return in capital. Equity investment in firm.
 Summers v. Dooley
 Facts – P sued D b/c he sought reimbursement from partnership for paying for an additional
employee who D explicitly did not authorize. P ran biz, while D put up $$. Court finds for D
b/c D explicitly disagreed with hiring.
 Summers could have argued that there was an implied agreement that he would run the
bizness since he was there on a regular basis. But, problem is that court would find
weakness in argument for implied agreement b/c 1) agreement was never written down
and 2) parties talked about issue.
 Implied agreements can be used to find equity, change statute!! Defense.
 UPA § 18 e – all partners have equal rights in the management and conduct of the
partnership bizness = this means equal voting rights on decisions. Rationale is that if
everybody has unlimited liability, everyone should have equal rights so if A B C
partnership, A & B can’t just blow off C.
 Authority
 HYPO – A & I are partners, no agreement. A asks D for supplies on credit. D gets paid plus
interest. I decides that they should no longer buy on credit, and tells A. A continues. Should
D get the interest?
 Agency argument = Rest. § 161, inherent authority
 RUPA § 301 – each partner is an agent of the partnership for the purpose of its business.
An act of a partner, including the execution of an instrument in the partnership name, for
apparently carrying on in the ordinary course the partnership business or business of the
kind carried on by the partnership binds the partnership unless the partner had no
authority to act for the partnership in the particular matter and the person with whom
the partner was dealing knew or had received a notification that the partner lacked
authority.
 Partnership embodies inherent authority form Restatement of Agency. Partners carry
inherent authority. D would get interest!
 Alternative argument = I couldn’t change b/c need majority vote to change usual carrying
on of bizness and it would be a deadlock, so go to default rule.
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Payment, Distribution, Remuneration, Indemnification & Contribution
Paid In Capital
15,000
15,000
20,000
0
Abe
Bill
Pamela
Morris
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Gain of $20,000
20,000
20,000
25,000
5,000
Loss of $20,000
10,000
10,000
15,000
-5,000
Under UPA § 18a – all partners share equally in the profits and surplus remaining after all
liabilities, including those to partners, are satisfied; and must contribute towards the losses,
whether of capital or otherwise, sustained by the partnership according to his share of the
profits.
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Partnership entitles you to profit sharing and if there is a separate agreement, to distribute
from draw – separate
Law firm partners – have to pay-in capital, usually make it as a loan to new partner which
carries interest and carries termination date!!
Partnership law assumes everybody = all working equally.
If not forming equal $$ partnership, i.e. services by one partner, capital by other, should put
arrangement in the partnership agreement!
Payment for Partnership
 Draw against partnership account. Partners agree whether to pay out or management committee.
 Partnership income – have to pay taxes on it.
 UPA § 18 – in partnership, all partners have right to participate in management. Section
envisions everyone working, so no salary, paid out in profits.
Unlimited Liability
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UPA § 15 Nature of Partner’s Liability – all partners are liable a) jointly & severally for
everything chargeable to the partnership under sections 13 & 14..b) jointly for all other debts and
obligations of the partnership but any partner may enter into a separate obligation to perform a
partnership contract.
 Joint liability – creditor has to join all partners and go after them.
 Several liability – creditor can go after one if all are missing.
RUPA § 306 Partner’s Liability – except as otherwise provided…all partners are liable jointly and
severally for all obligations of the partnership unless otherwise agreed by the claimant or provided
by law. Now creditor bears the burden??
RUPA § 307 Actions By And Against Partnership and Partners - Exhaustion rule, creditors have
to go after partnership’s assets in total first before going after a partner’s personal assets. Applies
when a judgment has not been totally recovered. 307© a 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’s assets unless there is also a judgment against the partner.
Note – it is difficult to collect individually from partners!
Note – can agree to something other than unlimited liability!
Once become partner, liable, when stop being a partner, liability ceases except for things that
occurred during partnership.
Partnership Interests & Property Rights
 Rapoport v. 55 Perry Co. - Ps assign a portion of their partnership shares to kids then sue to make
them partners in bizness. Court says no, kids not partners!
 UPA § 18(g) – no person can become a member of a partnership without the consent of all the
parties.
 But, partner can assign interest – share of distribution of profits to kids!
 Issues
 Parties had drafted issue in partnership agreement
 Disagreement as to meaning of partnership agreement
 Motion for summary judgment on both sides
 Court says can’t make kids partners. Partners have share in
management, and with unlimited liability, it matters who your partners
are and how deep are their pockets, who is on the hook w/ you. Structure
makes it impracticable to assign partnership status to kids!
Partner’s Duty of Loyalty & Dissolution
 Meinhard v. Salmon Facts – Lessor leased building to D for 20 yrs. P enters in arrangement
with D to construct a hotel on site as co-venturer. P was a banker. D did all the work.
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Arrangement was for 20 yrs. Near end of the lease, D strikes a bigger deal with Lessor for lease
of more property. D enters deal, doesn’t tell P. P sues to be co-venture in new deal.
 Fiduciary ties make disclosure more imperative in partnership
 Court orders co-venture to continue in new project  One can’t act in a way that is subterfuge while enterprise is still going on!!!
 Meinhard wasn’t just banker b/c he agreed to share in the losses!! D argued that
Meinhard just loaned money, wasn’t a partner. Court holds that profit sharing alone is
not enough to make something not a loan, but since Meinhard agreed to share in losses
was relevant.
 Dissent – D retained lease only. Lease should not have been a part of the venture. The
venture should have been considered for a limited purpose, since joint ventures are
traditionally limited in scope.
 Informational Advantage & Penalty Default – puts obligation on party with most
information or power to disclose information. Broad duty of loyalty definition – if you
find something out that would make your position better, have a duty to disclose to
weaker party.
 Penalty default – since it is a default, parties can contract around it.
 UPA §103(b)(3) – can’t contract around duty of loyalty in UPA, but can restrict,
define.
 RUPA § 404 Standard (General Standards of Partner’s Conduct) – under RUPA, D
could have contracted around duty to notify Meinhard.
 RUPA § 404(e) – A partner does not violate a duty or obligation under the Act or
under the partnership agreement merely because the partner’s conduct furthers
the partner’s own interest.
 RUPA § 404(f) – A partner may lend money to and transact other business with
the partnership, and as to each loan or transaction the rights and obligations of
the partner are the same as those of a person who is not a partner
 Dissolution – Dissolving of Partnership
 Principles – any partner has power to dissolve partnership at any time. BUT any partner
does not necessarily have the power to dissolve at any time.????
 Justification - Partners have unlimited liability, the way money is paid out requires ease
of dissolution.
 Page v. Page (pg. 83)—Page (P) sought a declaratory judgment that the partnership he had
with Page (D); both had put a lot of $ in the business, but an army base was coming to town,
so business would improve; P wants to dissolve, D said partnership had to continue until the
debt was all paid back and that P was acting in bad faith by trying to take advantage of the
military’s business on his own. Held: this was a partnership at will that P could dissolve
 No evidence showing an intention that the partnership would continue until in could pay
back the debt
 If P is acting on bad faith in the dissolution, D must sue P on that ground
 RULE: A partnership may be dissolved by the express will of any partner when no
definite term or particular undertaking is specified. If, however, it is proved that plaintiff
acted in bad faith and violated his fiduciary duty by attempting to appropriate to his own
use the new prosperity of the partnership without adequate compensation to his copartner,
the dissolution would be wrongful and the plaintiff would be liable
 Fiduciary duty of good faith dealing is not diminished by virtue of what is adopted by
UPA and RUPA; can’t take advantage of p-ship business for own profit.
 Essentially the business ops are the property of the partnership; the general fiduciary duty
that kicks in, you must compensate your partner for use of any such opportunity
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 Dreifurst v. Dreifurst Facts - Partners owned feed mills. Ps served notice of dissolution
and wind-up. D wanted assets sold so he could be cashed out. Ps didn’t want to provide cash
for cash out. Ps didn’t want cash out so asked the court to divide up the mills. Asked for inkind distribution = Court decides what is fair, instead of sale of biz to determine what the
value is.
 Standard Rules for Winding Up
 Biz liquefied to pay creditors and remaining $ goes to partners for cash-out.
 Assets are sold at judicial sale to pay creditors and pay out. Often, one of the
partners will buy biz and continuing running it.
 Dissolution
 Triggers winding up of biz, but not until after the winding up is the biz officially
terminated.
 Doesn’t mean biz has ended, just the partnership!
Dissolution cont’d
 Doesn’t end partnership. Termination only occurs after winding-up has occurred.
 UPA – partners always have power to dissolve partnership
 Dreifurst – argument was re: winding up. Default setting is a judicial sale, not in-kind
distribution because of issues of fairness.
 Page v. Page
 Facts – Issue before the court = Ps sought a declaratory judgment to determine and clarify
the rights of the partners. Issue was whether the partnership was for a term or at will.
 Court said the partnership was not for a definite term defined in the partnership K.
There was no K, so court said partnership was at will.
 The D argued that there was a term implied for the partnership, that the term would
be for when they would make a profit
 Fiduciary duty – once partnership is terminated, there is no fiduciary duty to
continue to bargain in good faith. But dissolution alone does not end fiduciary
obligation.
 Court didn’t enforce at will partnership because judge wanted to prevent a partner from
buying the biz on the cheap after dissolving the biz.
 UPA – even if partnership is at will, a partner can dissolve it but continuing fiduciary
duty of loyalty during winding up exists.
 RUPA §602(b) Partner’s Power to Dissociate: Wrongful Dissociation – it is much
easier to dissolve a biz under RUPA.
When Dissolution Is Wrongful
 HYPO – P1 P2 P3 P4 P5 are equal partners in a biz. P2 P3 P4 P5 want to grow the biz,
P1 wants to cash out to get a BMW. In fit of anger P1 wants to dissolve biz, partnership
has a term.
 Biz had $1million in equipment, $1million in contingent receivables and $1million
accounting receivables. If the biz was sold, it would be sold for $8million
 Good Will of Biz = difference b/w biz assets and what biz sold for
 What does P1 get, since P1 dissolved b/f the term of the partnership? P1 Wrongfully
dissolved biz that had value as a going concern
 When biz dissolves, only partnership ends, biz still running and can be sold to
outsiders or remaining partners as a going concern.
 RUPA §602©- P1 would only get part of the assets, he wouldn’t get good will (the
$8 million split) because he is liable to firm for the wrongful dissolution.
 Dreshner v. Sorenson
 Facts – In case of wrongful dissolution, partner responsible doesn’t get good will of
biz. Everyone wanted partnership dissolved, but person who spent time in bars
drinking, etc. had his dissolution action termed wrongful. Although it wasn’t so clear
that he dissolved wrongful. Incentive for other Ps to try and get other P to dissolve
wrongfully. This is case of partners acting opportunistically!!!
 Difference b/w RUPA & UPA
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RUPA § 602 – uses term dissociation. Leads to 1 of 2 results
 Remaining partners buy out disassociating partner
 Winding up of biz
UPA
RUPA – streamlined, don’t have to form a new partnership
Dissolution
Winding Up
Termination
Dissociation
Buyout or Winding Up & Termination
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RUPA – If good will damaged by wrongful dissolution, partner doesn’t get full
good will. Wrongful partner gets discounted good will, doesn’t lose it all.
RUPA §602 – states that depending on rules any party can act opportunistically
so we will nuance rules so there is balance among the parties (vulnerable & nonvulnerable can both act opportunistically) Encourages writing of a partnership K.
Courts will clearly enforce partnership rules and makes rules clearer.
RUPA has more complex rules for duty of loyalty, can’t overwrite it, but can define what
boundaries are.
Limited Partnerships – cross b/w corporation & general partnership
 Note – it is important to find out what kind of biz each of the forms is best suited for.
 Definition – under RUPA & UPA = association of 2 or more owners
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 Management: Uniform Limited Partnership Act § 403 (General Powers and Liabilities)
Default = general partner is essentially the one calling the shots, unless parties place
something different in the partnership K. A general partner of a limited partnership has the
rights and powers and is subject to the restrictions of a partner in a partnership w/o limited
partners.
 Uniform Limited Partnership Act § 405 Voting (General Partners) – The partnership
agreement may grant to all or certain identified general partners the right to vote separately or
with all or any class of the limited partners on any matter.
 Uniform Limited Partnership Act § 302 Voting (Limited Partners) – Partnership
agreement may grant to all or a specified group of the limited partners the right to vote on a
per capita or other basis on any matter.
 Can’t find you in a limited partnership. Requires filing a form
 Norm is limited partnerships usually have 1 general partner
 HYPO – D is front man, general partner, M is shy, limited partner. D represents to
public like he is the owner. The biz is not doing well. The Bank wants to collect from D
or M. Who can the bank collect from? Not M, b/c D was general partner!!
 Pitman v. Flanagan Lumber Co. – P was limited partner. Obtained credit on behalf of
biz. Exhibited control = liability to limited partnership. To prove unlimited liability of
limited partner, had to show the limited partner participated in control of biz and person
reasonably relied on his control(status) in transacting in biz.
 RULPA § 303(a) – now gives limited partner some protection b/c now person with
inside info can disclose he is limited partner when acting as a general partner. A
limited partner is not liable for the obligations of a limited partnership unless he is
also a general partner or in addition to the exercise of his rights and powers as a
limited partner, he participates in the control of the business. If the limited partner
participates in the control of the business, he is liable only to persons who transact
biz with the limited partner reasonably believing based on the limited partner’s
conduct, that the limited partner is a general partner.
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Tort Cases
 P could go after partnership assets. But limited partner only liable up to his interest
in the partnership. In HYPO, if limited partner stays in shadow, can’t be liable for
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tort claim b/c under § 303(a), victim must have thought that limited partner was
general partner. Victim would have to know of his existence!
Arguments for Limited Partnerships
 Enables limited liability to people?
 Banks don’t mind lending, probably better than corporation b/c someone is
unlimitedly liable – the general partner
Assignment & Dissolution
 ULPA § 702 Assignment of Partnership Interest – rule is that interest assigned
is only profits distributed, not unlimited liability. An assignment of a
partnership interest does not dissolve a limited partnership or entitle the
assignee to become or exercise rights of a partner. An assignment entitles the
assignee to receive only the distribution to which the assignor would be entitled.
Unless provided for in partnership agreement, a partner ceases to be a partner
upon assignment of all his partnership interest.
 ULPA § 801 Nonjudicial Dissolution – any individual limited partner cannot
cause dissolution of biz. A limited partnership is dissolved and its affairs shall be
wound up upon the happening of the first to occur of :
 § 803(3)– written consent of all partners
 § 801(4) – a general partner can dissolve if there is 1 other general partner to
agree to it.??? General partner can dissolve unless other gp agrees to continue
biz
 Have greater continuity than general partnerships.
Frigidaire Sales Corp. v. Union Properties Inc.
 Default rule = a corporation is not unlimitedly liable just because it is a general
partner. A corporation can be a general partner. A bank/plaintiff can’t get at
personal assets, only the corporation assets.
 Limited partnerships can look very different depending on the underpinnings of the
agreement
 Bank shouldn’t be worse off – tort claimant is worse off b/c doesn’t know who is
limited partner or if general partner is a corporation. Limited partners have to file
forms or be considered general partners.
 Limited partnerships usually found in real estate, venture capital since largely
financial assets and general partner puts up the capital. Limited partnership act
assumes you have a partnership agreement!!
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Corporation Law
 Corporate Form Key Features
 Free transferability of interests
 Limited liability for all officers
 Continuity of existence – entity status
 Centralized management
 HYPO – XYZ corp, xyz are shareholders, each owns 1/3 of network switches company
X – manager, Y – venture capitalist, Z-engineer
Note – in start-ups, venture capitalist will put up the money and others get paid in common
stock and salary.
XYZ = close corporation = corporation w/ few shareholders, shares don’t trade on stock
exchange & overlap b/w managers and shareholders
Q – doesn’t own shares but is in a related biz of routers, is expert and plays tennis w/Y
Problem = How to make product. They all disagree. XY team against Z.
 Under Delaware corporation law § 141(a) – the biz and affairs of every corp. shall
be run by the BOARD OF DIRECTORS.
 § 211(b)(a) – meetings of stockholders & annual meetings
 § 212(a) – each shareholder shall be entitled to one vote for each share of capital stock vs.
partnership one vote rule.
Xyz decide to have board of directors of 3 people.
X votes for XYQ
Y votes for XYQ
Z votes for Z & 2 others
XYQ get most votes. Q can be a director even if he doesn’t own stock!! Under § 141(b),
qualifications can be made in certificate of incorporation.
 Does Z have to be listened to? No b/c biz & affairs of corporation are run by the
board of directors, so if Z is not on board, doesn’t get to run the company, make
decisions. CORE OF CENTRALIZED MANAGEMENT
 Note in start-ups, venture capitalist will put up $$ and others get paid in common
stock & salary.
 Board of directors = centralized management
 Note – in start-ups, venture capitalist will put up the money and others get paid in
common stock and salary
 HYPO cont’d – Disagreement # 2 - XYZ corp., xyz are shareholders, each owns 1/3 of
network switches company. X – manager, Y – venture capitalist, Z-engineer.
Y wants $ out of the corporation to buy a Lexus.
Z wants $ out of corporation
2/3 votes of the vote essentially want out of the corporation.
How are distributions made? In partnership, each has a vote to decide.
In corporation, distributions = dividends = payout from corporate treasury, paid pro rata (per
share)
 §170 Dividends: Payment: Wasting Asset Corporations- directors get to decide on
distributions. In HYPO, 2/3 of voting shares want dividends. But only Bd. of Direcs get
to decide!!. Since Y has stock, some dividends are probably paid, plus salaries.
 Bd. of Direcs vote = majority rule = each direc gets 1 vote. Note, under 141(b), there can
be only 1 direc, also can decide qualifications of Bd. members.
 Q & X decided no dividends, so Y doesn’t get Lexus.
 Partners don’t get salaries, distributions are based on surplus.
 HYPO – Disagreement #3 – XYZ – close corporation. Y decides there is a depression,
wants out of the biz. Unless there are restrictions, during a depression, Y can sell stock, but
has to find a buyer. In public corp., sale is on NYSE. But this is close corp.!
 § 275 Dissolution Procedure = 2 step process
 Resolution §275(a): Directors have to initiate dissolution, if they don’t, that’s it.
Have to authorize a vote by adoption of a resolution.
11


Shareholder Vote §275(b): Majority of outstanding stockholders have to vote and
approve dissolution resolution.
 If stockholders want to dissolve corp. but bd. doesn’t want to, can they?
 Dissolution w/o Direcs Initiation §275(c) - Alternative = all stockholders can
dissolve. Dissolution of a corp. may also be authorized w/o action of bd. of direcs if
all the stockholders entitled to vote shall consent in writing and a certificate of
dissolution shall be filled…
 Tells about greater continuity of existence – in partnership, every partner has power
to dissolve a partnership – if dissociate, can force company to buy back your stock.
But in corporations, looks like a partnership too, but can’t get $$$ out if try to
dissolve? Ask about this?
HYPO – Disagreement #4 – XYZ still is close corp. XY don’t like Z, decide to pass
provision that distributes $$ only to them. Says pay out $1 million to X & Y who are on the
bd. of direcs. Z is only a shareholder. Can they do it?
 § 144 Interested Directors: Quorum – Managers can’t run biz in an interested
fashion. Triggered by actions by bd. that enrich members of bd. or take actions
discriminatory toward shareholders.
 Note: just b/c direcs are interested doesn’t mean action bad!! Transaction is good if:
 §144(a)(1) – Material facts as to direcs or officer’s relationship or interest are
disclosed or known to bd. of direcs and bd. in good faith authorizes transaction
by votes of majority of disinterested direcs, even if less than a quorum
 §144(a)(2) - Material facts as to direcs or officer’s relationship or interest is
disclosed or known to shareholders entitled to vote, and they approve in good
faith
 §144(a)(3) – The contract or transaction is fair to corporation as of the time it
was authorized, approved or ratified by bd. of direcs, or shareholders
 §144(b) – Interested direcs may be counted in determining the presence of a
quorum at a meeting of bd. of direcs, which authorizes the transaction of K.
 X & Y can’t favor themselves over Z in distribution of surplus.
Difference b/w partnership
Centralized
Management
Continuity of
existence (entity
status)
Limited Liability
Free transferability
Partnership
Decentralized
management
Dissolves when 1
partner leaves (UPA)
RUPA = dissolve &
wind – up or partner
dissociate & no winding
– up
Unlimited for all
partners! Joint &
several – torts
Transfer share of profits.
Can’t transfer unlimited
liability or management
interest.
Limited partnership
In between, general
partner acts a bd. of
direcs.
Limited partners can’t
dissolve limited
partnership.
General partner can
dissociate or dissolve.
Corporation
Centralized
management
Limited partners –
have limited liability.
General partner –
unlimited liability,
unless general partner
= corporation.
Transferability greater
for limited partners.
Have limited liability
for everyone
Entity status,
indeterminate duration
Transfer right to vote
& right to pro-rata
distribution (not
management, only
board of direcs can do)
12



Where have unlimited liability, never have free transferability!! Because would
matter on wealth of buyer and seller. Only want wealthy to buy.
 Statutes are enabling rather mandatory (EXCEPT DUTY OF LOYALTY)
Why form a corporation to build high-tech, network switches?
 High risk, want limited liability
 Decision-making by committee = centralized management = ability to make
decisions quickly.
 Continuity of existence = in partnership, biz is vulnerable b/c a party can dissolve
easily so easy for parties to act opportunistically. In corporation, can’t do that.
People can threaten to get out if they don’t get their way, but there is difficulty in
dissolution, and ease in partnership.
 Z’s threat to cause trouble is credible in partnership, not credible in corporation!!
Q = is threat credible?
Limited Liability Co.
 Requires a lot of start-up
 Get ability to partition assets
 Carve up shareholder interests
 Easier to borrow money
 For creditors, it is better b/c know what you can collect on
Corporate Structure – Forming a Corporation
 Question – What state should you incorporate? Each state has its own laws, most popular
states = DE, CA and NY
 XYZ all live in CA, all plants in CA – don’t have to incorporate there though!
 Internal Affairs doctrine = internal affairs governed by law incorporate, not place of biz!
 State race to compete? Is it good or bad and for whom?
 Theories
 Race to the Bottom (Carey) – Bad for states to compete for biz to incorporate.
1930s, a lot of non-close corporations. Earle Means recognized manageralism =
corp. run for managers not shareholders. States wrote statutes favoring managers to
attack bizness b/c of tax, revenue benefits. Politicians also are about support – pass
pro-management legislation.
 Good for managers, bad for consumers & shareholders. Why? Agency Theory:
Maybe agents spend time monitoring & bonding, agency costs. (I.e. Armand
Hammer building a museum. Maximizing profits & being efficient not easy)
 Bad for society? We want firms to maximize profits – but at what costs?
 Alternative argument – good for society to have divergence b/w managers &
shareholders b/c managers will consider other interests besides profits.
 Race to Top – DE prevails, as choice place of incorporation b/c law is shareholder &
manager friendly. Law that benefits both. If a company is inefficient & state has
inefficient rules, will be reflected in stock price. As a result, someone will come along
and buy up company & then pocket the difference – become efficient.
 If product market - ??
 If a manager & there is a market for managers – push managers to maximize
profits b/c want to be known as a good manager.
 Having a state rich in case law = makes better corporation law. Others states
follow b/c more predictability.
 Evidence more supportive of race to top argument – i.e. when corps.
Reincorporate to DE stock prices go up.
 Note = PA has corp. law that says a company doesn’t have to maximize profits =
can take other constituents concerns in account.
 Stock options – narrow difference b/w shareholders & managers. Shareholders
don’t mind giving stock to bring 2 interests in align. Managers like stock option.
13
What matters is how stock increases wealth of the manager. Incentive for
managers to maximize profits so little shares could make a lot of $$$.
 Forming a Corporation – How to Do It
 If PA Company wants to incorporate in DE, forms a subsidiary in DE and have sub buy
Parent Company.
 Delaware Law, §102 Certificate of Incorporation – Contents = corporate constitution, all
corps must initially adopt when form a corp. Need info, name address, nature of biz.
 Mandatory Components for Certificate of Incorporation – need to form
corporation
 §102(4) = most important = tells what classes of stock can be issued and
rules governing as such.
 §102(2) = address, name
 §102(3) = nature of the biz or purposes to be conducted or promoted
 §102(6)(b)(6) = can impose personal liability for debts on shareholders,
changes rights and powers. Can’t be changed by by-law!
 Amending the Certificate of Incorporation (After Receipt of Payment for
Stock) §242 – 2 step procedure
 Resolution by Board: First need resolution by directors to authorize a vote
 Approval by Shareholders: Next need majority of stockholders to vote
 Note – if shareholders want something but bd. of direcs don’t, can’t get it
passed. MOVING PARTY IS BD. OF DIRECS!
 §109 By-Laws – can put anything in by-laws as long as not inconsistent with
laws or certificate of incorporation
 Changing by-laws by stockholders entitled to vote. Stockholders can
propose by-laws!!! Directors can change by-laws themselves if put in
Certificate of Incorporation, but can’t take away authority of shareholders,
i.e. pass a law taking away power of shareholders to amend by-laws. Direcs
only and shareholders can change by-laws. No resolution needed first.
BATTLEGROUND = intersection b/w §109 & 141. Direcs assert §141 as a defense!!!!

Limited Liability
 HYPO – Biotech Company has 2 projects A & B
$10 million (capital)
A 50% success chance if works, worth $100 million
$10 million in bank
A Expected value = .50 x 100 + 50 x ) = 50 (risky), but
if risk neutral , go for this b/c value = more
B 50% x 40 million
50% x 10 million
Expected value = 25 million
Society would prefer to do project A – take more risks
Variant
Project A 50% chance worth $100 million
If drug doesn’t work, people sue = -100 x 50%
Expected value = 0, .50% x 100 + -100 x .50 =0
Proj. B 50% chance worth 40 million, 50%, 10 million = 25mil
risky project, but society would prefer to do B over A
 By limiting liability, solve problem of risk adverseness. But Project A has a 50% payoff
x 100 + 50% x 0 = $50 million. With limited liability, it may still be stockholder’s interest to
do project A, and society takes all the risks.
 Question = does doctrine surrounding limited liability and ability to pierce corporate veil
solve the problem?
14
Piercing the Corporate Veil: Disregard of the Corporate Entity
 In some instances, even though corp. is has limited liability, the court will pierce the
corporate veil and hold individuals and shareholder’s personally liable.
 HYPO – PAL (Pill & Lose) is company that has drug for weight loss. Capitalization = $20
million.
 50% chance if pill sells - $100 million - .50 x 100
 20% x 0 – pill doesn’t work
 30% x –300 million = lose weight, but turns you green
 Expected value with unlimited liability - -40 million
 Limited liability + 50 – company will take risk. Encourages risk taking, put $$ in
company only lose what put in; Ps couldn’t go after anything else.
 Question is if 30% scenario materializes, PAL doesn’t have $$ to pay tort claim. Try to
go after Congress.
 What does PAL have to do to have limited liability – file limited liability forms, notes,
and mail to shareholders.
 Walkovsky v. Carlton – man injured by taxi-cab. Sues D who owns cabs, but each 2 cabs is
combined to form a corporation. P alleged fraud (misrepresentation of material fact which he
relied to his detriment). But there was no fraud! Main argument was there was under
capitalization. D only had the minimum amount of insurance for each cab so since they were
corps, P was limited in the amount of money he could get. Undercapitalization is not
dispositive!!!
 Court held for D. Suggested P should have argued that D’s companies were dummy
corps. for personal ends.
 Factors as evidence of shells
 Intermingling of assets
 Undercapitalization
 No regard for formalities
 Minton v. Cavaney - Seminole Hot Springs Corporation formed by 3 – leased swimming
pools. P’s kid drowned. Corp. had no assets. P sued D, who was not regular shareholder,
equity shareholder. Ps argued that D used corp. as alter ego for personal use. D was lawyer
of corp. and direc, secretary & treasurer.
 Alter ego doctrine – various situations such as where equitable owners of a
corporation are personally liable: 1) when they treat the assets of the corporation as
their own and add or w/draw capital from the corporation at will or hold themselves
out as being personally liable for the debts of the corporation or when they provide
inadequate capitalization and actively participate in the conduct of corporate
affairs.
 What matters in capitalization? What counts is the capitalization at the beginning,
original capitalization, not at the time the lawsuit was filed.
 Court held for P. Said it was dummy corp. – never had any capitalization.
 D didn’t have to pay b/c issue never was relitigated.
 Kinney Shoe – contract claim rather than tort claim. Dummy corporation claim. Seems like
a fraud case. Kinney subleased to Industrial, which had no assets. The D put all assets in
Polan Industries. Industrial subleases to Polan. Polan never pays Industrial. Kinney goes
after Polan. Court held D was liable for the lease to Industrial.
 3 Prong Test
 Unity of ownership & interest
 Equitable nature of result
 Assumption of risk – not mandatory, but important. If a company is
undercapitalized, there is an understanding among leaders to investigate. But if a
company is set-up to commit fraud, that will be dispositive.
 Court found that formalities were lacking and it was wrong (didn’t reach 3rd prong of
test). If company is set-up to engage in fraud, sufficient to pierce the corporate veil.
15







Industrial didn’t exist as an entity!!! Was a shell w/ no assets, no formalities, etc.
Narrow legal argument = why do formalities matter? If you are going to be a
corporate entity, be a corporation!
 Didn’t matter that the P could have found out about the undercapitalization or
should have known better.
Sea Land v. Pepper - P sued D for defaulting on shipment payment for spices. D never paid
the freight bill, owned several other entities. P goes after D Marchese, pierce corp. veil.
Court allowed P to pierce corporate veil. D manipulated funds so P didn’t get paid.
 Equity argument – person was unjustly enriched to make sure he won’t have to
pay bill. Court wanted a better argument than we can’t collect on a debt, (i.e.
evidence of lack of formalities, fraud).
 D had withdrawn a salary from an entity leaving it insolvent and unable to satisfy
liabilities of $450,000. Took shareholder “loans” from the corporations to pay
personal expenses, leaving them insolvent.
Looks like black letter law says if you keep up formalities, might be home free!
Domination – corp. isn’t really an entity separate from the person who dominates it – should
have its own purpose.
Fraudulent Conveyance Doctrine – Uniform Fraudulent Transfer Act §4 – overlaps what
law is & outcomes. Intent to avoid creditors. Need to go after each individual transaction
and see if the transaction is fraudulent. Issue is the fraudulent transfer. See 548 green.
Piercing cases = liberalized version of fraudulent conveyance. Can go after all assets, not just
ones fraudulently conveyed. Test = domination, formalities, fraud.
Corporate Structure
 Form – Certificate of Incorporation – if biz purpose is as broad as any activity, lawful under
DE law if put in “purposes & activities in aid”?? general purpose clause.
 Ultra Vires – refers to authorized powers of corps, not duties
 § 124 Lack of Corporate Capacity or Power: Effect: Ultra Vires – even if want to put
it in, can’t use it against creditors. Used strategically against people who made
transactions w/ corps. that corps. later backed out of. No act of a corporation and no
conveyance or transfer of real or personal property to or by a corporation shall be
invalid by reason of the fact that the corporation was without capacity or power to do
such act or to make such conveyance or transfer, but such lack of capacity or power may
be asserted:1) in a proceeding by a stockholder against the corp to enjoin the doing of
act or acts…2)in a proceeding by the corporation ..against an incumbent or former
officer or director for loss or damage due to …the unauthorized act 3) proceeding by
the Attorney General.
 Not a way for 3rd party to undo what was done. May have a claim if nothing had
happened yet.
 Objectives & Conduct of Corps
 HYPO: White Knight is another firm that will rescue firm from takeover. Ron Perelman
tried to buy Revlon at $65 share. White Knight offered $60 share. What can be done?
Revlon knows P will get company, it is interests of shareholders to prevent that.
 Dodge v. Ford – Ford decides to re-invest $$ in company rather than pay-out dividends.
Ford wanted to protect employees. Dodge bros wanted dividends to compete w/ Ford, start
new company. Ford was a close corp., so bros couldn’t sell stock on the exchange. Bros
sued.
 Ford’s mistake = argued wanted to re-invest for employees = expand by employing more
people so the wealth of their industrial sate could be shared by greater # of people
 Black Letter Case on shareholder supremacy. Company should be run for benefit of
shareholders.
 Ford should have said want to reinvest & expand Ford to gain more market share, but
Ford was under antitrust scrutiny at the time.
16

Smith v. Barlow – Company gives $$ to Princeton. New owner wanted to stop $ being given
to Princeton, argued giving $$ was ultra vires.
 Black Letter Case – Corps. can make charitable contributions, as long as reasonable.
Courts argument = don’t look at case unless contribution is outrageous, no judicial
micromanagement, let direcs & shareholders fight it out.
 Bd. of direcs can make case that’s it is in best interest of shareholders, corp. Court
doesn’t ask for a particularized showing.
 HYPO cont’d – Revlon question = what happens to shareholders? They get bought out!
Harder to make long-term benefit of firm argument when shareholders will be bought
out. Have to take best offer. What is boundary when bd. has taken best interest of
shareholders in account? There is a line you don’t cross. De Court said Revlon has to
entertain offer from Revlon. Corp. has to be managed for benefit of shareholders!
 § 122(9) – corp. can make charitable contribution. In old days it was argued that this
was ultra vires – outside the power of corps.
 ALI §201 – Objective and Conduct of the Corporation = “a corporation should
have as its objective the conduct of business activities with a view to enhancing
corporate profit and shareholder gain.”
 PA Const. § 1715 – “deems appropriate” – allows bd. to refuse to take high $ Revlon company case
 Give stock options to give incentive to take tender offer
17
Voting & Shareholders




Miscellaneous
Why do only shareholders vote? Only shareholders have an interest as residual
claimants on maximizing wealth of corp. & shareholders are only ones not protected by
K. I.e. banks can contract to protect loss. Impossible to make by contract, everything
that can happen & no time limit for ??
Company dissolves – creditors paid out – shareholders get pro- rata share of their interest
of corps.
Pure residual claimants – claimants after creditors have been paid - have interest in
making surplus as big as it can be
Project A
EV= $100 x .5 + $0 x .5 = 50
Project B
EV = $40 x .5 + $10 x .5 = 25
Banks will vote for project B. To minimize risks you take once lend $, make sure employees stay
 Corporate Structure – Chapter 4
 Inverted Pyramid Structure & Growth of Institutional Investor
Rational Apathy
Shareholders
Berle & Means – basic balance of power changed on this model
Example:
Rational Apathy = XYZ corp, have 1000 shares. If spend 100 hr
Thinking about problem, would save $100 million. 100 hrs at
$400 hr/rate = $40,000. 1 million shares = $1000. You would be
apathetic b/c it would cost you more than pro-rata return of stock
elect
Note: no real agency relationship b/w shareholders & direcs!
Directors
CEO – Chairman of Bd. (appoints Bd. of direcs)
Biz & affairs
Employees




Depends on whether Shareholders are Dispersed and Apathetic
 ERISA – gov’t regulation, required separate trustee for pension plans. Trustee’s
obligation is to maximize profits of pension plan (shareholder value).
 ⅓ market owned by pension plans
 Pension plans now have enough stock not to be rationally apathetic = power
 Now have large corps. w/ substantial insider ownership
Most voting takes place by proxy – most shareholders don’t attend annual meeting
Battles b/w corps & shareholders
HYPO – Calpers = votes shares of CA retirement system. Large shareholder! Takes
position that Corp. XYZ shouldn’t do biz in SF. Have 51% of vote. Write letter to bd. Does
bd. have to listen? No:
 Charlestown Boot & Shoe Co. – Bd. of direcs manage biz & affairs of corp. Centralized
management. Direcs don’t have to listen to shareholder’s recs on biz affairs.
 Manice v. Powell – if direcs were trad’l agents of shareholders, would have to listen to
them. But relationship b/w direcs & shareholders = trustee relationship.
18



HYPO – Calpers wants to call meeting to fire CEO – vote CEO out. Can they do it? YES!
 Auer v. Dressel – bd. canned pres. Shareholders led insurrection to fire bd. & re-instate
pres. Inherent power of shareholders to have meeting. Note = shareholders passed
resolution asking bd. to reinstate Auer, but didn’t tell bd. what to do!!! Can’t do under
§141. Shareholders don’t have power to hire or fire people.
 §141(k) = Any direc or the entire bd. of direcs may be removed, with or w/o cause, by
the holders of a majority of the shares then entitled to vote at an election of direcs…
 Classified bds. - §141(d) – each class of direcs (3 classes), means only can throw out
1/3 of bd. a year. (without cause). Organizes direcs.
 Alternative = arbitration, fired for cause
 When hostile bid – replace bd. by putting own people – not fired for cause!
 Can you have direc for 10 years? Have to have new class of stock? Classes of stock
doesn’t correspond to # of direcs.
HYPO Variant – Calpers (DE corp.) wants to have amend’t to certificate of incorporation.
Can they do it? 2 step process = reso by bd. of direcs or by-law by Calpers & vote
 §109 By-laws –by statute
 Corp. argues that they have a right to manage biz & affairs of corp. & shareholders
can’t change that by by-laws.
HYPO Variant –Calpers want to retire direcs. Can they pass by-laws saying 10 year terms?
Yes – under §141(b) – statute says can be put in by-laws.
BATTLEGROUND
§ 109
Ability of shareholders to amend by-laws



vs.
§ 141
Direcs argue by-law conflicts w/ corp biz, affairs
DE = caselaw is fact intensive. Need to know facts & know relationship to see if law applies
generally or in specific situation = no bright line rules!
Schnell v. Chris-Craft Industries Inc.
 HYPO Variant – Calpers wants to pass by-law to say direcs can’t do biz w/ corp.
(hostile bid) Bd. wanted to block hostile bid so advanced date of annual meeting &
issued a block of authorized stock to company to White Knight. Corp. Partners –
advice of Goldman Sachs. In statute, said can have meetings whenever.
 Court in case said purpose was to circumvent dissident shareholders = inequitable.
Inequitable action not permissible, just b/c it is legal to do.
 In HYPO, bd. had a proper purpose. In Schnell, purpose was entrenchment =
illegal.
Blasius Industries Inc. v. Atlas Corp. – Atlas had bad biz. Blasius intent was to takeover
corp.(not hostile) & change by-laws to increase bd. Bd. was classified so couldn’t throw
everybody out. Wanted to expand bd. to have control; also suggested who 8 new members
would be. Atlas in response calls meeting, telephone meeting (permissible by §141(i)) - # of
bd. members can be increased by certificate or by-laws. But if fixed # is in certificate of
incorporation, can’t change by by-laws under §141(b), only by amending the certificate of
amendment!
 Blasius had 60% of vote. Can they say they want to change by-laws, w/o meeting?
 § 228 Consent of Stockholders in Lieu of Meeting – Majority of
shareholders want to pass something, don’t have to wait until meeting.
Consent by writing of majority of stockholders.
 Atlas calls investment bankers – calls emergency meeting, votes to add 2 new bd.
members of Blasius.
 Workings of staggered board can slow down process of a hostile takeover of a
company. Therefore, have to take steps to increase board.
19



Form 13D, buy certain % of stock, have to say why bought stock. Companies go into
war mode.
 Blasius argues it has cause of action – like Schnell. Direcs hold powers, duty of
loyalty to pursue best interests of corp. Not to try and entrench themselves and
disenfranchise shareholders.
 Atlas argued = biz judgment rule, biz & affairs of corp.
 Court – Ps wanted per se rule like Schnell. Court says case-by-case.
 Court test = Board must have compelling justification for defensive action thwarting
action of shareholder. Testing for “scrupulous fairness.” Here, bd. merely tried to
prevent Blasius from being majority of bd.
 Big concern/issue in case = underpinning of what makes corp. law/governance work
= shareholders must have right to exercise vote & special standard need to protect
franchise (shareholder). Since all shareholder power is in voting to elect bd.
CONSTITUTIONAL GOVERNANCE POINT.
 Court = Bd. wasn’t face w/ a coercive action or rush for time. If he found Blasius
proposal coercive, may have been a compelling justification for act.
 Court held = voided Atlas expansion of the Bd., injunctive remedy.

Form 13D, buy certain % of stock, have to say why bought stock. Companies go
into war mode.
HYPO – Calpers want to limit qualifications of direcs to no one who has connections to the
firm. Concern by XYZ corp. that hostile takeover will occur, increased by fight w/ Calpers.
Stroud v. Grace – 1st decision of Crt. In evaluating what corp. can do. Standard to Apply,
Burden of Proof. Bd. of Direcs passed amend’ts on who can sit on board. Qualifications.
Little Stroud’s were unhappy b/c Milliken is close corp. and they can’t sell stock, can’t sit on
board of direcs under new amendments, thus don’t even have a say in corp. Were kids of
daughter (Stroud). Brothers were running company. Little Stroud’s didn’t agree w/
shareholder agreement which said if shareholders agree if sell stock, will give company 1st
refusal.
 Chancery Court – applied Blasius standard
 De Supreme Court says no, biz judgment rule applies. Blasius doesn’t apply b/c
shareholders had voted on amendments!!
 Blasius didn’t apply so Court scrutinized the shareholder vote. Issue = whether
shareholders were fully informed. Court did not look at substance of the Amendments.
Court says facially, amendments were unfair.
Blasius Standard:


Unilateral Board Action: Entrenchment Purpose: If board has acted for the primary
purpose of interfering with shareholders right to vote to matter that would have right to
vote on (i.e. bd. takeover attempt) AND

No Shareholder Vote: The stockholders have not, after being given reasonable
disclosure about the interference, approved the transaction.

Enhanced scrutiny: No biz judgment rule!

If conditions not met, shareholders voted, then biz judgment applies; burden shifts to
Plaintiff b/c court looks at whether vote is fair and shareholders were informed.
Stroud v. Grace, Williams v. Greier
Williams v. Greier – Cincinnati Milacron company-family owned majority of stock.
Proposed amendment to certificate of incorporation where there would be tenured voting.
Current stock owners would get 10 votes/share. If shareholders tried to transfer their stock or
20
were new stockholders, have to have stock for 3 years to get 10 votes. Tenured voting.
Majority of shareholder’s don’t hold stock long. (8 months). So Family could sell huge
chunks of stock & still maintain control of majority of shares. P argued purpose of
amendment was entrenchment
 Potential for coercion existed; if stock gets de-listed, stock is worthless AND said had
votes anyway.
 Issues raised = whether new plan was fair to the minority.
 Ds argued – Directors were independent, acting w/ fiduciary duty: if they weren’t, entire
fairness would have been triggered.
 Shareholder ratification: Vote was held – issue was whether majority of minority was
needed for vote to pass.
 Court said no requirement in DE Corp. Law for majority of minority to approve a
transaction, BUT in parent-sub cases maybe
 Stroud standard – biz judgment rule b/c there was a vote!
 Court doesn’t look at merits of proposal b/c shareholders voted. Only look at whether
vote was fair.
HYPO: Calpers (30% share) wants to make resolution that people who do biz w/ company can’t be
directors. XYZ moves date of meeting & issue stock in treasury that had been authorized.
 What standard of review? Heightened level of scrutiny, like Blasius.
 Could have argued, stock issued must be authorized by stockholder vote, so prior
ratification by shareholders to give bd. some discretion on when to issue it.
 Blasius & Schnell = took place in battle for corporate control. Differences b/w cases =
whether there is a hostile takeover attempt. It matters b/c court would evaluate whether
actors are trying to thwart a threat of stifle shareholder franchise.


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
Shareholder Democracy – minority shareholders don’t have much say. Majority of shares
run corporation. Note – if buy into close corporation run by family, family could change
stuff, no say, no market out.
Mechanics that enable CEO to run corp. Does machinery of corporate power centralized
through CEO?
 Directors
 Inside = work for CEO, who generally runs the show and appts. direcs
 Outside = generally high level people who have jobs elsewhere. Will never have
enough info to tell CEO what to do.
Responses to Reality of CEO really running corp.
 CEO running company – need professional managers to run corp. Rejected b/c
would result in dual governance slow structure. Once have centralized management,
difficult to switch, enables company to move quickly.
 Monitoring Device – directors should be monitoring committee. Have to proved
critical oversight. NYSE requires companies have disinterested direcs on board.
Control over nominating, audit compensating committees are invariably outside
direcs. Monitoring = independent, powerful outsiders who don’t run the board.
 High Tech Board Model = people w/ expertise in the industry. People who have
relationships w/ company. Board has some influence in company. Not insiders, but
powerful outsiders – more like allies of the firm.
 DE law doesn’t require outside directors.
Shareholder Power – how do they use it?
 HYPO – Gamble Bros are heirs to P & G biz, shareholders decide that P & G
shouldn’t be doing biz in El Salvador. Want amendment to by-laws not to do biz.
Want to contact other shareholders. What can they do?
 §219 List of Stockholders Entitled to Vote – at least 10 days b/f meeting corp.
has to provide list of stockholders entitled to vote at meeting; if purpose (for
21
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
seeing list) is germane to meeting stockholder can see list. Burden on corp. to
show shareholder has improper purpose, etc.
 §220 Inspection of Books & Records – can get shareholder list, but must have
proper purpose. Burden on P. If corp. refuses, can go to court for compulsion.
 HYPO variant – Suppose Gamble Bros. wants list of shareholders to vote out bd. of
direcs – can they get the list? YES! = proper purpose under §220.
 HYPO: Gamble Bros believe El Salvador is really a problem. Want Ks and info on
company’s who do biz w/ P & G
 Pillsbury v. Honeywell – shareholder was opposed to Vietnam war, asked for
shareholder ledger for records dealing with weapons and munitions manufacture.
Argued proper purpose. Court said no proper purpose! Argued for list & records.
 Proper purposes
 Misconduct
 Condition of Company
 Ascertain # of shares
 Improper purposes
 Instituting Nuisance Suits
 Scheme to bring pressure on 3rd company
 To sell list
 Fishing expedition to settle idle curiosity
Security First Corp. v. U.S. Die Casting & Development – against fishing expedition. P is
a 5% shareholder in D; merger agreement b/w D and another bank, had a termination
agreement; merger fell through, termination agreement kicked in, stock price of D fell
considerably; P gives a written request to see books and records related to merger and its
termination, but D refused to comply; P goes to Chancery to compel. Held: P hasn’t met
its burden of proof to receive all of what it wanted, too bread a scope.
 Federal and state discovery rules (rule 11) are MUCH broader than §220; don’t have to
show proper purpose, but do need a certain amount of evidence to get to R11; if you
don’t have that evidence, then use §220; R11 casts a wider net.
 This is what’s going on here, D is trying to halt P from gathering info
 Stockholders can get info under §220 by showing: by a preponderance of evidence,
that there exists a credible basis to find probable corp. wrongdoing; don’t have to
prove the wrongdoing itself in order to inspect … and must do so for each set of books
requested.
 1st Question = is request for a proper purpose?
 “Rifled Precision” vs. Fishing Expedition
 Can get shareholder list easily if just want to communicate w/ other
shareholders, but safeguard where threat is to company.
Note = every company has a Cede & Company (street name – broker) = depository for major
bizness. Safety b/c if want to sell stock, have to have the certificate w/in 3 days to complete
transaction. Proof of ownership. Clear a transaction is important. In NY, NOBO rule
requires disclosure of name, address, etc.
HYPO
S1
S2
S3
S4
25%
25%
25%
25%
On ski trip, S1 asks S2 & S3 for their vote in company election. S4, mad.
Has S1 violated any rule? No b/c not going to be traded!
22
Securities Exchange Act of 1934
 SEA § 12(a) Registration Requirements for Securities – if you want to trade a security,
have to be registered under the 1933 Act. Commission has rule-making power.
 SEA §13 Periodical and Other Reports– if you are registered security under §12, have to
file some info, determined by SEC
 §13(d)(1)(C) Reports by Persons Acquiring More Than 5%.. – if buy up 5%,
beneficial owner, required to file, including the purpose of the purchase if it is to acquire
biz. This is what triggered Blasius filing. Required whenever someone buys more than
55 of stock.
 §14 Proxies – (a) Solicitation of proxies = serious request. Proxy – person or written
statement w/ instructions, it can be unlawful to solicit unless follow certain steps, rules by
SEC. If you get viewed as soliciting someone’s proxy, have to file form.
 SEC Rules & Forms – if firm is going to trade, have to file. Coordinated filing system.
 10Ks – annual reports
 10Qs – quarterly reports
 Corps use 10K & 10Q to sell their stock – will go into details, safe harbor.
 8K – all info relating to merger (anytime anything happens that is material to a corp.),
must be filed in 8K.
 HYPO – Calpers want new CEO of Kodak. Take out ad in NY Times urging others to
w/hold their vote. Just say no. Does this act trigger a filing?
 Step 1 = is this a solicitation?
 Under Rules & Forms 14a-1(L)(iii) = definition = the furnishing of a form
of proxy or other communication to security holders under circumstances
reasonably calculated to result in the procurement, w/holding of a proxy.
 Seems like a solicitation, but can fall out of being considered a solicitation in a number of
cases. I.e., if just stated in public communication how you were going to vote, not
solicitation.
 Step 2 = If you are a solicitation – do you have to file a 14 a? Are you covered under
Rule 14a-2?
 ***??Exemptions: If you are company soliciting, don’t have to file. I.e. buying corp.
 Step 3 = don’t have to do anything, b/c in public media, no filing obligations.
 Rule 14a-9 False or Misleading Statements = prohibits misleading, false acts, omissions.
 HYPO – Calpers calls I5 institutional investors.
 Rule 14a-1(1) Step 1 = is it a solicitation? Yes!
 Step 2 – Must we file Proxy? 14a-2(b)
 Step 3 – 14a-6(g)(2) – oral communication, no filing
 HYPO – what if Calpers has private meeting instead of calling?
 Step 1 – is it a solicitation? Yes!
 Step 2 – Must we file a 14a-3 proxy filing?
 Step 3 – 14a-6(g) – no filing for oral communication
 HYPO – what if Calpers sends letter to15 investors?
 Step 1 – is it a solicitation? Yes!
 Step 2 – Must we file a 14a-2(b) proxy filing?
 Step 3 – You must file the letter with SEC & company 14a-6(g)(ii)
 HYPO – what if Calpers sends letter to 8 investors?
 Step 1 – is it a solicitation? Yes!
 Step 2 – Must we file a 14a-2(b)(2) – if more than 10 have to file, otherwise exempt
 Step 3 –14a-6(g) – only applies to 14a-2(b)(1)!
 HYPO – Response by the Company
 Step 1 – is it a solicitation? Yes!
 Step 2 – Must we file a 14a-2(b)(1) – officer of registrant must file.
23
 Does Calpers have any other worries? Filing requirements? Well 14a-9 applies
(false/misleading statements)
 Remember 13D triggered by 5%
 13D(3) – if Calpers and the group decided to act as a “group” they are deemed a “person”
w/ more to 55 and they would have to file a 13D
 Test for Materiality: If the info is important enough to influence the way the
shareholders would vote, its material.
 7th Cir. reversed on Causation – they said if there was a complete disclosure and result
would have stayed the same – because was fair price, the shareholders would have voted
for X and causation broken.
 Supreme Court: If its material and if that was an essential link in accomplishing the
transaction, then causation is established.
 P lawyer can establish liability, then he/she can collect fees. This creates a plaintiffs bar
that can itself police merger statements.
 A federal corporate fiduciary law was created in the 1934 Act to counter the “race to the
bottom.”
SEA 1934 The Implied Right of Action: Private Actions under the Proxy Rules
- J.I. Case Co. v. Borak (US 1964)
 Held: A shareholder can bring either a direct action or a derivative action for a violation of the
proxy rules, even though this right of action is not explicitly provided for in the Exchange Act or in
the Exchange Act Rules
 Materiality - the falsehood or omission in question must be material to give rise to a private
cause of action - the Supreme Court standard is objective: “an omitted fact is material is there is a
substantial likelihood that a reasonable shareholder would consider it important in deciding how to
vote.”  must show a substantial likelihood that, under all of the circumstances, the omitted fact
would have assumed actual significance in the deliberations of the reasonable shareholder (TSC
Industries)
 See Virginia Bankshares - undisclosed motivation, standing alone, is insufficient to satisfy the
element of fact that must be established under § 14a - P must show that the statement also expressly
or implicitly asserted something false or misleading about its subject matter.
 Failure to disclose that an I bank has a fee arrangement is material

HYPO – Pickins Inc. own 40% Acura. 100 Pickens. Merge the two. Acura bd. has Pickins
reps. Proxy statement didn’t have disclosure of overlapping boards. Need 50% of votes. He
will need vote of shareholders of both corps. He must get vote of Acura shareholders, file
proxy statement etc. Goes to Ibanker, who advises that $50 is fair prices. IB’s fee =
$250,000 if deal doesn’t go through and $1,000,000 if deal goes through. They doesn’t put
fee arrangement in proxy materials. A shareholder claims proxy is violative of 14a-9 b/c it is
false and misleading. Cause of action? Yes, even though no direct reference to private cause
of action.

Mills v. Electro Auto Lite (pg. 337) - Ps were shareholders of D; Mergenthaler Linotype Co.
already owned over 50% of the stock of Auto-Lite, was in control; D’s shareholders were
sent proxy materials asking for their approval of a merger of Auto-Lite into M. The materials
stated that the board of Auto-Lite had approved the merger, but did not disclose that these
directors were all M nominees (so that they would, arguably, approve a transaction desired by
M even if it wasn’t in the best interest of Auto-Lite’s non-M shareholders); Even though M
owned a majority of Auto-Lite stock, state merger rules required approval of Auto-Lite’s
minority shareholders.
 Invented cause of action under Borak. Ps alleged violation of § 14(a) of SEA of 1934.
Proxies – solicitation of proxies – can’t violate rules of SEC. Misleading statement made
and merger was approved by bd. Failed to disclose that bd. was also involved in new
company. Direcs. Of Electro Lite were also under Mergenthaler.
24
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
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


Conflict arises – origin of problem is the fiduciary duty owed to company. Direcs should
be forced disclose this. Bd. of direcs under state law owe duty of loyalty.
Investment banks give fairness opinion – said price paid = fair price, so direcs had done
right thing, but mere fact that there was a conflict required disclosure.
Supreme Court held = do have liability b/c of the non-disclosure
Issue over what standard to use in order to determine if Ps showed the omission was
material
Standard for materiality—that the defect was of such a character that it might have
been considered important by a reasonable shareholder who was in the process of
deciding how to vote
Standard for Causation: A shareholder has made a sufficient showing of a causal
relationship between the violation and the injury for which he seeks redress he proves
that the proxy solicitation itself, rather than the particular defect in the solicitation
materials, was an essential link in the accomplishment of the transaction
Dispersed shareholders = rational apathy – if it costs you $ won’t do it even if it
benefits you. Pro rata benefits w/ costs concentrated on party who bears it. The more
concentrated the ownership, the less rational apathy.
 Electro Auto Lite solves the problem, transfers cost to corporation to pay fees – Ps
attys got fees.
 Bounty hunter mentality = if there are high expenses to company or potential
disclosures – company may settle. So – even though it would cost a lot for Ps to sue
– even if don’t win atty fees, largely cases will settle
TSC Industries v. Northway: Materiality: an omitted fact is material if there is a substantial
likelihood that a reasonable shareholder would consider it important in deciding how to vote.
When the shareholder vote isn’t required:
 Virginia Bankshares, Inc. v. Sandberg (pg. 347)—After approval of a “freeze-out” merger
at a shareholders’ meeting, (shareholders get cash, not shares of new stock) minority
shareholder Sandberg (P) sought damages, alleging materially false and misleading
statements in the proxy solicitations. 14a-9 claim thrown out of court, fiduciary duty claim
was state, so no jurisdictional hook for it anymore. P loses. But narrow cause of action. Ps
didn’t have federal cause of action. §14a SEA is supposed to enforce the act. So no private
cause of action. Went to jury, cert. to Supremes on linkage to causality.
 Question = when beliefs & opinions become misrepresentations. Court says break in
chain means no cause of action. Supremes stopped creating new rights, Electro-Autolite
still good law though.
 Issue #1 = Ps argued direcs of bd. didn’t believe share price was really fair. IB’s fairness
opinion had qualifications, market thin, shares not actually traded.
 Distinction b/w thinking a price is fair & knowing a price isn’t fair. Bd. argued that
you can’t sue us on our beliefs.
 Supreme Court said have to show that they lied. That fair price wasn’t fair – have to
have hard facts to support allegation that direcs didn’t believe what they said.
 Ps got $18 share more? No. Supremes reversed b/c minority shareholders vote was not
needed to go through w/ merger so Ps didn’t have federal case.
 Held: FORM OF STATEMENT: false, misleading statements or omissions of reasons
may be actionable even though conclusory in form. Must show by objective evidence that
statement also expressly or impliedly asserted something false or misleading about its
subject matter.
 Court held that it was not going to create any new causes of action.
 Note: if you don’t need the shares, causal break in the linkage, no reliance to
detriment. We don’t want suits in federal courts, state law provides cause of action.
There is no private recovery for proxy misstatements if the board of directors could have
acted without the consent of the minority (e.g., when the majority holder controls the
25
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board and state law requires only majority rule for action). Plaintiffs must look for a state
remedy. At least the “minority votes were inadequate to ratify the merger under state law”
…
What do you need to show a Mills v. Electro-Autolite case?
 Misrepresentation – (scienter?) whether person did it knowingly, or negligently – not
required.
 Materiality
 Reliance to Detriment
 Damages
 Appraisal remedy in squeeze out mergers – if can prove would have gotten higher
price, can get difference.
 Can’t lie, cause still bound by duty of loyalty or when SEC is P, but in private action
in fed courts????
Shareholder Proposals
 HYPO – Bob Monks runs Lens fund. Bought into companies w/ bad management. Try to get
better management by harassing direcs & shareholders that if the co. didn’t turn around, would sell it.
BM owns 100,000 shares of XYZ corp. under DE. Wants by-law re: shareholder rights and by-law
prohibiting repricing of stock options to be included in proxy materials. Can he submit proposals?

He can only submit 1 at a time, limited to 500 words.

Rule 14a-8 – all relates to by-laws

Question 9 (Rules & Forms) = If I have complied w/ procedural requirements, on
what other bases may a company rely to exclude my proposal? –
 14a-8(1) Conflict w/ state law.
 14a-8(4) – personal grievance, special interest = special interest if distribution
wouldn’t be pro-rata.
 14a-9(5) Relevance – if proposal relates to less than 5% of biz total assets, not
significantly related to co. biz operations
 14a-8(6) – absence of power/authority – i.e. asking company to take steps to prevent
global warning
 14a-8(7) – management functions – if proposal deals w/ a matter relating to the
company’s ordinary biz operations
 14a-8(8) – relates to election – if proposal relates to election of bd.
 14a-8(9) Conflicts w/ company’s proposal

 14a-8(12) – resubmission possible w/ qualifications.
 Teamsters v. Fleming – Teamsters 1st made a non-binding resolution to have shareholder’s rights
bill re: poison pill. 2nd time, made binding resolution by attempting to amend the by-laws. Corp. bd.
refused to put on proxy ballot. Court allows reso to be placed in proxy materials b/c statute is silent
and certificate was silent.
 Auer v. Dressel revisited = conflict w/ §141 ends if non-binding reso to bd.
 General Data Com. – Corp. tried to prevent by-law re: repricing of stock options. DE Supreme
Court refused to decide, said case not ripe for review.
 HYPO – Can proposal to restrict biz in S.Africa get in?
 Yes = important policy decision = social policy argument, gets away from §141 biz & affairs
argument.
 No = 14a-9(5) Relevance

Process for 14a-8 Shareholder proposals = corp. asks SEC, issue no action letter, not
final, advisory, can be challenged in court.

No-action letter—issued by the SEC; if you don’t include this proposal, we are not
going to take action, we’ll leave it alone – for exclusion.
 Roosevelt v. E.I. Dupont de Nemours & Co. – P filed proposals to change date for
phasing out CFS and wanted reports of development of alternatives to using CFS. Since P’s
26
and management’s proposals differ by only one year, P’s proposal P wants DuPont (D) to
phase out all CFC production before the start of 1995. DuPont agrees that CFCs should be
phased out as soon as possible, but commits only to phase them out by the end of 1995; P
wants her proposal included in management’s proxy materials, but D says amounts to a
question of ordinary business operations and thus need not be included. Held: for D
 Issue = TIMING of phasing out – Court found this is an ordinary biz matter!
 Distinction from Philip Morris = whether to phase out tobacco completely cigs
 If P and D disagreed on whether to phase out CFCs, such a disagreement would rise to
the level of a significant policy disagreement, and P’s proposal would be includible
 Such a small disagreement is in effect a matter of implementing, not setting, policy
and therefore is an aspect of ordinary business operations
 If the proposal raises a major social, ethical, political or economic issue, the ordinary
business operations exclusion from Q9 does not apply even though the matter might
otherwise seem to fall within the corporation’s routine business
 NOTE: The SEC has held that proposals relating to senior executive compensation are not matters
relating to ordinary business operations of the company and that shareholder proposals on this topic
may no longer be excluded under (c)(7)
 AON Corp No action letter: purchase of tobacco equities will not be excluded under 8c5
because it is otherwise significantly related to registrant’s business. Even though it represent
less than 5%, such a proxy request cannot be excluded.
 Amalgamated v. Wal-Mart: P winning the right to have proxy request included in a proxy,
even when such request was defeated by vote, still has the right to attorney’s fees. (As
prevailing party, the other beneficiaries of which are easily identifiable, AND the benefit is
substantial, and where such cost may be proportionately spread.)
Proxy Fights

HYPO – Monk tries to get rid of board, owns 8% – can he get it on proxy? No!
 14a-8(8) – relates to election exclusion
 has to file 13D letter b/c owns 8%
 Monk would have to pay for proxy contest, if he wins can submit a proposal to shareholders
to get reimbursed. Can’t just get reimbursed b/c would be self-dealing.
 If old board wins contest, company pays b/c don’t want direcs getting voted out of office b/c
of corp. democracy would come to grinding halt. But if old bd. gets vote out, who pays?
27
Duty of Care = bd. decisions, omissions
Categories
Duty to Inquire
Duty to Monitor
Duty to Act Lawfully

Deals with fiduciary duty of direcs & how they manage biz & affairs of corp. What are the
behavioral standards bd. of direcs held to? = DUTY OF LOYALTY & DUTY OF CARE
 Francis v. United Jersey Bank (NJ case)– Wife, Mrs. Pritchard, when hubby died, b/came
major shareholder on bd w/ kids also.. Wife drank a lot, died, company went down hill.
Sued, but died b/f trial. Sons were taking $ from co., called it a loan, but really wasn’t,
approx $12million. Wife’s estates is sued b/c sons have no money. Creditors going after
son’s inheritance. Court said can’t argue gross incompetence as a defense to duty of care.
Wife did nothing!! Held for Ps. If on bd. of direcs, have to do something!!
 Directors are not required to conduct a detailed inspection of day-to-day activities, BUT
they must at least become familiar with the fundamentals of the business, and must keep
informed in a general way about the corporation’s activities
 Duty to monitor—directors should exercise reasonable supervision and control over
the policies and practice of the corp; specifically:
 Should acquire at least a rudimentary understanding of the business of the corp
 Continuing obligation to keep informed about the activities of the corp
 Monitor corp. affairs and policies; do NOT need to inspect day to day activities
 Should be familiar w/ financial status of the corp
 May have a duty to take reasonable steps to prevent illegal conduct by codirectors
 Under Federal Sentencing Guidelines, there is a clear duty/requirement to
set up an internal compliance program and enforce it
Director’s duty to monitor is NOT protected by the BJR
 Standards for Duty of Care
 ALI § 4.01(a) = direcs have duty to corp. to perform duties in good faith in a manner he
reasonably believes to be in best interests of corp. w/ care an ordinary prudent person
would reasonably be expected to exercise in a like position and circumstances.
 ALI §4.01(a)(1) – duty to make an inquiry when circumstances would alert a
reasonable direc; inquiry is to extent reasonably necessary (subjective)
 ALI §4.01(a)(2) – Direc is entitled to rely on materials or persons (i.e. experts)
 ALI §4.01(c) – biz judgment rule = a presumption that duty of care satisfied if
criteria met: “a direc or officer who makes a biz judgment in good faith fulfills the
duty of care if:
 Not interested = no self-dealing
 Is Informed w/ respect to subject of the biz judgment to extent dire or officer
reasonably believes is appropriate
 Rationally believes that the biz judgment = best interest of the corp.
 Note = gross negligence means something more than negligence!!!
 HYPO – HFC merges w/ Forbes CUC – new company from merger of equals. Sendent –
Silverman bought CVC which was fraudulently doing transaction so stock value failed. We
are shareholders who bought Sendent at 40/sh, now trading at 8/sh. What is the cause of
action.
 Direcs didn’t meet standard of care
 Probably would get off under § 4.01(c) – biz judgment rule
 Caremark – shareholders claimed direcs breached duty of care. Caremark had Ks with
doctors. Doctors were given kickbacks by Caremark employees, making payments to docs
28
who made referrals to Caremark. Suit involved claims that members of D’s board of directors
breached their fiduciary duty of care to corp in connection w/ alleged violations by
employees of federal and state laws and regulations applicable to healthcare providers. P and
D want to settle the suit; P doesn’t get much, but gets assurances that a better compliance
system will be put into place; court has to decide if the settlement is fair or not Held:
settlement approved
 Failure to Monitor Case
 Chancery = no findings, just stipulations by parties. No adversarial system involved.
Both sides wanted to settle even though it was a weak case.
 2 ways a breach of duty of care arises:
 Failure to act, nonfeasance
 Liability following from a bad decision that causes a loss b/c the board was ill
advised or negligent, misfeasance
 What P has to show to prove a director breached:
 Directors knew or should have known that there were violations of law occurring
 Factual Q, how many red flags were there
 Directors took no steps in good faith to prevent or remedy
 Such failure proximately caused the losses
*Kicker here is that the liability may occur after a compliance program is in place
 NOTE: case shows the importance of a corp having compliance guidelines
 People think this case is a complete dog, D had no chance … when they had a standard
system in place, difficult to say they took no steps
 Under DE law, monitoring system not required, but it is strongly suggested. Instructive as
to what you should do
 Depends on facts: Whether system is effective: Absent monitoring device
 *Will not be a per se violation not to have an effective compliance system in place,
but damn near close to it …
 Looking at importance of the Board, the need for constant monitoring info to fulfill
the Duty to Monitor (no other way), federal sentencing guidelines. Can’t in good faith
fulfill this duty without having such a system in place.
 Test for Liability: Determination of liability requires findings that there was a duty to the
clients that was breached and that the breach was the proximate cause of the losses
 Causation:
 Delaware has rejected the requirement of causation. Where there has been a breach of
duty of care, the burden of proof shifts to the directors to demonstrate that the duty was
entirely fair
 In other jurisdictions, there MUST be cause-in-fact and proximate causation to
establish liability
 Causation-in-fact—a finding that the D’s acts or omissions were a necessary
antecedent of the loss, i.e., that if the D had observed his or her duty of care,
the loss would not have occurred
 Defenses:
 Not having the ability or capacity to be a director is NOT a defense
 A director acting in good faith may rely on statements and reports by other
officers, directors, employees, and experts as to matters w/in their authority,
ALI §4.02
 Director can also rely on a committee of the Board, ALI §4.03
 Shareholder’s ratification is a defense
EXAM NOTE: If there is a violation of duty of care also look for a violation of 14a-9 (violation for
material misstatement or omission in a proxy statement), 10b-5 violation for material
misstatements or omissions, illegal activity, duty of loyalty violation


Business Judgment Rule for Duty of Care
BJR is the default rule in duty of care
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 A presumption that in making a business decision, the directors of the corp acted on an informed
basis, in good faith, and in the honest belief that the action taken was in the best interest of the corp
Designed to insulate directors against liability
 A director is NOT personally liable for errors in judgment. The P MUST show that the
decision was grossly negligent, while D need only show that his decision was “rational,” which is
an easy standard to meet
 Applies only to misfeasance cases
 Only applies where certain requirements are met—
 Delaware:
 Independent
 Acting in good faith, AND
 Have the honest belief that the action was taken in the best interest of the corp
If these 3 standards are not met, Del requires that entire fairness be used
 ALI:
 Acting in good faith
 NOT interested
 Informed
 Rational belief that the decision is in the best interests of the corp
 Good faith probably includes NOT (1) perpetrating a fraud and (2) engaging in illegal
activity or conflict of interest
 BJR matters: policy of mgmt, expediency of K or action, adequacy of consideration, lawful
appropriation of funds ….

NO REAL BLACK LETTER LAW TO DETERMINE DUTY OF CARE - every case is highly fact
specific - simply a conception of what violates law
 Graham v. Allis-Chambers Co.) - P suing directors for violation of duty of care resulting from the
conduct that was the cause of prior criminal indictments of some of co’s employees. Price-fixing
case. Direcs exercised duty of care. Argument made that can’t expect direcs to know everything.
Held: for the directors
 Big company, no red flags; not possible for directors to be policeman of every employer
 Court doesn’t even consider requiring a compliance program
 Chancellor Allen says since sentencing guidelines change, indicate that reduction in liability for
preventive programs = monitoring process lower penalties, don’t put in place, would be much
higher. Rational direcs would put programs in place.
 HYPO – put rich & famous person on board. Can direcs use it as a defense if person doesn’t know
anything (i.e, just put on board b/c famous?) No, all direcs have to be informed.
 Difference b/w Caremark shareholders & Silverman HYPO = Are the employees of Caremark
acting in best interest of company? Yes, maximizing value of company, even though there actions
are illegal (kickbacks). But, direcs are not allowed to encourage maximization of wealth at the
expense of law!
 If direcs not maximizing wealth, then must be a taint of self-interest involved and not afforded the
biz judgment rule.
 What made Caremark case hard = if the direcs were working on behalf of corp., biz judgment
rule should apply, only if decision rational…
 Self dealing ≠ BJR
 To go after direcs, have to argue they weren’t informed!
 Failure to monitor the breaking of the law vs. making stupid biz decision where lost $
 Under the cases
 Under Francis v. U.S. Jersey Bank – can’t do nothing as direc
 Caremark – have to monitor & implicitly monitor so company not breaking the law.
Also, derivative suit doesn’t work.
 Test = does § 4.01 ALI standards apply? If D meets tests, wins case, if not settle.
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Duty to Make Inquiry - BJR
 HYPO – Bank in Cambridge, Mass. Coleman works for bank. Is hot shot. Works under Earl
who is honest. Bank audits, $$ is going down. Rumors that Coleman is living well. Stole $$
from bank. If Earl had looked closer, would have seen the stealing. Creditors came after bank
direcs just like Mrs. Pritchard b/c company went under. See Bates v. Dresser.
 Under ALI §4.01(a)(1) – obligation to make or cause to be made an inquiry when the
circumstances would alert a reasonable direc…the extent of such inquiry shall be such as
the direc reasonably believes is necessary.
 Bates v. Dresser (pg. 587) - D, the president and director of a bank, believes that his bookkeeper
is honest, but there are a number of clues to the contrary that D ignores—another employee
accuses the bookkeeper of being dishonest; several small thefts are reported that might have been
committed by the bookkeeper or by someone else; the bookkeeper appears to be living beyond his
means; no compliance standards; Issue: under Caremark, is this a situation where the directors
knew or should have known? Held: president/direcs liable. He was in there day to day.
 Duty to Make Inquiry case
 Principle that directors may rely on statements by officers or experts if the circumstances
make the reliance reasonable
 The swindling was done in a way never been seen before, so how could directors be on
the look out, none of the usual red flags; not expected to do the day-to-day
 Kamin v. American Express (pg. 592)- Amex buys DLJ shares; paid $30m, now worth $4m; $25
million loss. Issue = what to do with the loss. Options = sell on open market (would get $4m in
cash, plus 7.5% tax credit, but earnings would go down; payout in dividends, distributing to
shareholders, no tax credit, and shareholders would get distribution in kin and get taxed on it. AE
decided to distribute the shares as a dividend to the stockholders but not a rational decision, P
wants AE to sell the stock and recognize the loss and get taxed on it. Held: for D, P is merely
claiming that another decision would have been more advantageous.
 Court said since no fraud, self-dealing, bad judgment so won’t interfere.
 NY Bus. Corp. Law §720(1)(A) – Actions Against Direcs ..for Misconduct
 Court said neglect in statute refers to nonfeasance, not misjudgment
 A complaint alleging merely that some other decision would have been wiser does not
state a cause of action, because of the BJR. For D to be found liable under the BJR, more
than imprudence of mistaken judgment must be shown
 Note, under ALI 4.01(c)(1) – requires rationality, but not necessarily economic
rationality = triggers duty of loyalty. Firms lose duty of loyalty cases. Also lose duty of
care when there is a duty of loyalty issue.
 The only hint of self-interest, which is raised, is that 4 of 20 directors were officers and
employees of AmEx and members of Exec Incentive Comp Plan.
 RULE: the Court will NOT interfere unless a clear case is made out of bad faith or
dishonest purpose
 Efficient Market Hypothesis – different forms
 Strong forms – market prices w/ all info, published and unpublished reflected in stock.
 Semi-strong- stock price accurately reflects all published info
 Weak form –stock reflects old info.
 Aronson v. Lewis (pg. 596) – BJR = legal conclusion, rather than a rule. If you do XYZ,
afforded protection of BJR. Always good faith requirement as rebuttal to company satisfying ALI
§4.01 (1-3)The BJR is a presumption that in making business decisions, the directors of a corporation
acted (funky presumption, as P has burden):
 On an informed basis,
 In good faith and
 In honest belief that the action taken was in the best interest of the company….
 Absent an abuse of discretion, the courts will respect that judgment. The burden is on the
party challenging the decision to establish facts rebutting the presumption.
 Joy v. North (pg. 600) – Corp. gave real estate developers money and then continued to poor
good money after bad. Biz judgment rule is rational.
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 Its NOT just bad decisions that give rise to bad faith, it’s REALLY bad decisions
 Some actions are so unjustifiable that they are evidence of bad faith
 Shareholders take risk of bad judgment
 Litigation is imperfect way to evaluate biz decisions – 2nd guessing
 Important for law not to chill corporate decisions – pay direcs to run corp & get into new
markets to take risks. Don’t want your directors to be risk adverse, shareholders want them to
choose the project w/ the highest return
 Standard of Review v. Standard of Conduct:
 BJR = standard very high
 BJR as rule = low
 In corp law, duty of care literally is a higher standard than is imposed in court by the BJR
Generally a rationality standard is imposed … which (1) looks for some basis in reason; (2)
evaluates the quality of the decision.
 Reckless: Gross negligence is occasionally applied in those cases where the BJR does not
apply ... ie duty to monitor, duty of inquiry, duty to employ reasonable decision-making process.
It is possible that some judges will go so low as ordinary negligence.
 HYPO – Friend wants buy company $75, what do you have to do? Can you sell? Need an
Ibanker? Test the market? BJR case? Never been about $40-$75.
 Smith v. Van Gorkom (1985) (pg. 605) – Co. involved in leasing market. Accumulated tax loss
that they could use as a tax credit, but didn’t have enough income. VG knew company could be sold
to company w/ more $ to get a higher price than company sold for. Had financial guy run#s for
leveraged buy-out. Buy $50 share easy, $60 hard to do. Pritzker agrees to $55/share. Ds were the
directors of Trans Union Corp., including its chairman/CEO, VG. VG was near retirement age, and
wished to sell his shares prior to retirement. He had the chief financial officer compute the price at
which leveraged buyout could be done; the CFO reported that at $50/share, the corporation’s cash
flow might not be sufficient.
 VG then, without consulting with anyone else in senior management, proposed to his friend
Pritzker (a well known corporate raider) to sell him the company for $55/sharePritzker agreed
VG did not attempt to get any other offers for the company, nor did he ever commission a
formal study of the company’s value. Instead, he went to his Board and asked them to
approve the sale.
 2nd meeting – key officers threatened to resign – so Pritzker agrees to amendments – allow
company to solicit other offers. Pritzker was given authorized, un-issued shares – no
shareholder ratification necessary.
 Original bidder has high transaction costs – initial due diligence. So asks to buy stock at
market price to initiate the process – lock-up provisions.
 2 offers were made to corp. – GE & KKR – no offer made higher than $55/sh, GE wanted
w/drawl of original merger.
 He never invited I-Bankers and said that Pritzker wanted the answer in three days. Most
Board members opposed the sale b/c the price was too low. Board never looked at merger
document or other papers - simply took Van Gorkom’s oral presentation on its word and, a
lawyer’s advice that the board may be sued if it rejected the offer. Board approved sale at
$55/share.
 Went to a shareholder vote – ratification gets biz judgment rule BUT if ratification defective,
shareholder’s not fully informed.
 Held: 2-3 Del SC decision (very rare for Del.) that the directors had been grossly
negligent in failing to inform themselves adequately about the transaction that they were
approving; a finding of action w/o due care
 The majority seemed especially influenced that (1) it was VG, not Pritzker, who promoted
the deal and named the sale price, (2) the Board had made no real attempts to learn the
intrinsic value of the co, (3) the board had no written documentation before it and relied
completely on oral statements by VG, (4) the board made its entire decision in a two hour
period, with nor advance notice that a buyout would be the subject of the meeting, and in
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circumstances where there was no real crisis or emergency, (5) VG signed the documents at
the opera
 In Delaware, the standard is gross negligence for determining whether the BJ reached
by a board of directors was an informed one
 Generally, the CEO’s incentives are aligned w/ the shareholders in wanting to get as much $
as possible
 Note – VG could have been out for shareholders – could argue that he wanted highest price
b/c held a lot of shares and no incentive to get low price – unlike managers who may be
afraid to be fired by new boss Pritzker. BUT here, also the possibility that VG just wants to
get out & would take a lower price
Significance of Case: Supports the proposition that process is exceptionally important in
obtaining the benefits of the BJR. The key to the BJR is that the decision made must be an
informed one
 The most controversial case in Delaware history—resulted in DE Corp. Law §102(b)(7),
which is a provision that limits personal liability by allowing directors to opt out of liability
for breach of duty’s of care except when not in good faith.
 Under Del. Gen. Corp. L. §141, if duty of care b/came intrusive, would undermine
centralized management.
 Does Aronson test: good faith, informed basis, honest belief in best interest (rational)
 Informed: whether the directors have informed themselves prior to making a business
decision of all material information reasonably available; gross negligence is the standard
for determining whether informed or not … here in context of §251 merger, see (615)
 Fulfilling fiduciary duty requires more than not fraud, not bad faith
 This was in the context of a cash-out merger, end game, no more shareholder value, they
are done and done … has to be a heightened sensitivity at work here
 Need to do a value study of the stock and/or have a “market test” in the merger
agreement that allows for market valuation post-agreement but pre-sale; a stockholder
ratification won’t cure, because shareholders were not fairly informed due to board
deficiency of action.
 Difference b/w Smith & Kamin – Smith = end game case, selling the company, more
likely to have duty of loyalty problems involved b/c direcs don’t continue to be direcs.
So may be looking to get something out of company. Continuing direcs, different.
 Now, since Smith, corps. always have Ibanker, market tests. Cede – make sure conflicts
of interests are disclosed.
*voluntary clause to put in cert of inc., if already in, could vote it out; doesn’t eliminate the duty of care,
but it can eliminate personal liability for duty of care
 Cede & Cede v. Technicolor:- (628) Sale of Technicolor to MAF (R.Perelman). 1 director had
vested interest in transaction – never divulged to board. Personally benefited and board was not
told. Board was out of the loop, then approved based on what they were “told.” Not informed.
Lower court held for Ds, applied BJR as standard of review. DE Supreme reversed, direcs
breached duty of care (overcomes BJR) therefore burden on D to show entire fairness.
 Substance of the decision doesn’t matter, its all about PROCESS
 Problems = agreement was not preceded by a prudent search of alternatives; direcs had no
knowledge of sale of biz terms, side Ks until they arrived at meeting; bd. not fully informed.
 Standard of review = not fully informed & interested direc = triggers entire fairness
burden on D to show (transaction fair) fair dealing + fair price
 Court found price was fair – so biz judgment
 DE Supreme Crt = if no fully informed, no biz judgment, EF
 At trial court level, Chancery believed SOR = BJR which places burden on P to show
price wasn’t fair. Ps didn’t do this. DE Supreme Court says law, SOR = if decision was not
fully informed, then P has rebutted presumption of BJR. Therefore, SOR changes to EF and
burden shifts from Ps to Ds.
 Outcome = Ds showed price was fair.
 IF YOU LOSE ON DUTY OF CARE PRESUMPTION, MUST COME WITH AN
ENTIRE FAIRNESS ARGUMENT.
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 If you lose on entire fairness, then you pay in damages the difference between fair
value and what price you gave the shareholders.
Duty to Act Lawfully – is it a violation when company violates law?
 Depends on if there is a law prohibiting such behavior
 Miller v. AT&T (CTA-3 1974) Ps alleges Ds didn’t collect on campaign services debt. Alleged
used debt as a contribution. Shareholders were suing direcs, derivate suit on behalf of corp. against
direcs. AT&T did not collect $1.5 million debt from the Democratic National Committee. The
plaintiffs alleged that not collecting from the DNC violated the duty of diligence in handling the
affairs of the corporation, given that it gave preference to the DNC collections. Ps sought an
injunction to collect the debt from the DNC.
 Difference w/ Caremark – CM had sentencing guidelines, which gave them incentives to put
compliance program in place b/c sentencing guidelines made it actionable against direcs.
 Derivative suit was actionable b/c use of corp funds was illegal for that purpose
 Acts were passed to protect shareholders & should be able to bring suit
 Duty upon direcs to ensure corp. acts lawfully – social responsibility
 Why are direcs liable for corp. acting unlawfully? §141 biz & affairs of corp. run by direcs.
In close corps. direcs really run corp. Ultimately direcs really run corp. Bd. can’t hide
behind argument that they provide oversight-monitoring function.
 With institutional investors, no rational apathy, shareholder activism putting pressure on.
 Held: Underlying the BJR is an assumption that the BOD used reasonable diligence in
reaching the decision which it justified. If the reason that the corporation relied on in
coming to a decision is illegal, BJR does not insulate the corporation’s actions. Acting
illegally is exception to BJR - even if the action taken by the corporation is for the
shareholders’ benefit if the action is illegal there may be a breach of a fiduciary duty to act
lawfully.
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Duty of Loyalty
(Ps have good chance of winning)
Categories
Basic Self-dealing
Corporate Opportunity/Competition
Executive Compensation/Waste
Duties of Controlling Shareholders
Sale of Control (includes Sale of Office)

Initial question = why not leave duty of loyalty to market?
 If corp. badly managed, price of shares go down, raider will go in and takeover, run corp.
efficiently.
 Product market
 Labor market for direcs – in self interest of direcs to act w/ care
 In duty of loyalty – can get risk by stealing. Can retire outside of sanctions
 Self dealing not necessarily fraud
Self-dealing Transactions – when direc dealing on both side of transaction. Historically transactions
were either void or voidable by corp. – automatically
 HYPO – XYZ corp. CEO = Amelia, $1000, $2000 sold to XYZ, $3000 now worth. If K is void,
can’t get profits, if voidable, can get profits from sale = $3000
 Requires directors to act in good faith and in the best interest of the corp. Direcs may not,
therefore, place themselves in a position where their personal interests would prevent them from
acting in the best interests of the corp and shareholders
 Market checks do not help control breaches of the duty of loyalty as much as they do for the duty
of care.
 The benefits derived from breaching the duty of loyalty are far greater than those that accrue
through violation under the duty of care.
 It is easier to cover up issues such as self-dealing (much harder to do so under negligence).
 Furthermore, because breaches of the duty of loyalty are often clandestine there is no
necessary reflection (i.e., reduction) in stock price to act as a weeding-out mechanism.
The use of an independent regulatory structure shifts the burden to the challenging party to
show the transaction is not entirely fair; good faith is the key
 Types of duty of loyalty cases:
 Self-dealing: fiduciary on both sides of the transaction (personal deal w/ corp)
 Executive compensation: selling self to firm
 Corp opportunity: not purely a trans with the corp, opportunity that did not come to the
officer/director in their individual capacity
Self-interested Transactions Theory
 With duty of care, much of what made it handleable by non-legal sanction was that it aligns the
interests of the agents and principals and maj/min shareholders; their share in the gain (pro-rata
distribution, dividend) and criminal sanctions. Legal sanction MUST be involved in self-dealing
where there is the potential for a non-pro rata distribution of corporate monies.
 Three conditions most concerned with (when Director is self-interested):
 The key player and the corporation are on opposite sides of transaction
 The key player has helped influence the corporation’s decision to enter the transaction
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

The key player’s personal financial interests are at least potentially in conflict with the
financial interests of the corporation, to such a degree that there is reason to doubt whether
the key player is necessarily motivated to act in the corporation’s best interests.
Plaintiff has the burden of showing that the director was self-interested
NOTE: not all self-dealing is bad and hurts the corp; certain self-dealing transactions are fair
and increase the value of the corp
 The big issue is disclosure by the self-dealer
 Cure any problems of self-dealing by having arms-length transactions by means of
disinterested directors
Self-Interested/Dealing Transactions Standard
Absent a conflict of interests, courts will apply the BJR when examining a transaction. Where the
requirements of the BJR are not met, then the transaction will be approved if it is entirely fair to the
corporation
Entire Fairness—requires (1) fair dealing & (2) fair price
This standard of review does not look solely at procedure, but also examines the terms of the
transaction. Looks to see if the transaction was substantively fair. One way to do this is to ask if a
willing buyer and seller would think the arrangement was fair=market fairness
 Directors must prove that the transaction was fair and reasonable to the corp.
Entire Fairness Standard
 Initial burden of establishing entire fairness rests upon the party who stands on both sides of
the transaction.
 An approval of the transaction by an independent committee of directors or a majority of
minority shareholders shifts the burden of proof on the issue of fairness from the controlling or
dominating shareholder to the challenging shareholder plaintiff.
Ps almost always lose under BJR, sometimes win under Entire Fairness



Default setting under duty of loyalty = entire fairness
Default setting under duty of care = BJR
Lewis v. S.L. & E., Inc. (CTA-2 1980) Three of the father’s six children owned stock in LGT
(tire dealership), while all six of them owned stock in SL&E (owned the land) (the three were on
the BOD of both companies). When they received the stock, they signed an agreement that any
shareholders of SL&E on 6/1/72 who didn’t own any LGT on the same date had to sell out to the
LGT shareholders. Plaintiff sues, claiming that the SL&E stock was undervalued because the
LGT shareholders caused SL&E to undercharge LGT for rent for the past 6 years.
 Held: The LGT shareholders, because of the conflict of interest existing between the two
companies, could not make use of the BJR, and had the burden of proof of showing that the
rental amounts charged were fair and reasonable. They failed to do so.
 Burden on Richard (son) b/c he approved the transaction, should have to prove justification &
force all information into the open.
 When have 2 corps not owned equally by same shareholders, transactions can amount to
unjust enrichment.
 This case represents the current status of the law - absent a conflict of interest, the court
will apply the BJR; where a conflict of interest exists, the court will examine the
transaction for “fairness,” and the burden of proof is on the BOD.
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
Talbot v. James (pg. 665)—Mrs. T has some land, James is the developer; create a corp to build
apartments, she contributes land in exchange for stock, he contributes plant and know how.
Talbot contended that James violated his fiduciary relationship to the corporation and to Talbot as
a stockholder thereof, by diverting specific funds to himself by being the building contractor. D
never disclosed (a) his conflict of interest (b) monetary benefit he received (profit). Held: for P, D
entered into a K w/ himself. Close corp., Talbot (P) had been fired by James, so wasn’t an
employee anymore; couldn’t get his $$ out b/c company wasn’t paying dividends = had dead $ in
corp. & sued.
 Shareholder ratification will be effective only if it comes after there has been full disclosure
to the shareholders of both the conflict and the material facts of the transaction itself
 The officers and directors of the corporation stand in a fiduciary relationship to the individual
stockholders and in every instance must make a full disclosure of all relevant facts when
entering into a contract with said corporation.
 Majority said self-dealing. No disclosure. Transaction wasn’t fair. James was adequately
paid. Double-dipping.
 Dissent – believes James agreed to be the developer, difference from general contractor.
 Note – self-dealing doesn’t mean acting in bad faith.
Self dealing-transactions that are not pro-rata. Talbot protected b/c if James tries to sell, entitled to
pro-rata distribution. Restrictions on self-dealing are essential to protect the sanctity of pro-rata
distribution of shareholders.


It this case it came off as an absolute, voidable regardless of fairness based on lack of disclosure of
the position of the parties. No per se restriction not to deal, just under terms that clearly as
possible replicate arms lengths transaction, eliminates fiduciaries unequal bargain position by
virtue of information.
Consider also that not merely the terms of the agreement need by fair, but that the deal in general
is in the corporation’s best interest (could be fair terms, just totally unreasonable to do)
Election Compensation – Defense- who pays?




Rosenfeld – insurgent section won election & got the bd. to compensate for expenses. Sought
approval by shareholder’s and that sanitized the transaction.
Relevant Factors in Self-Dealing Transactions
 Ratification
 Controlling Shareholder
 Interested direcs
HYPO – Gerry sets up Fitness Ranch as sub of Trans Union (he owns). Fitness Ranch reasonably
profitably. Gerry wants to sell FR to himself. He sets up sub LHIW Inc. and makes bid to Fitness
Ranch. Doesn’t disclose info. Bids $50 million.
 ALI §5.02
 §5.02(a)(1) – disclosure
 §5.02(a)(2) – transaction fair, authorized in advance, ratified
 §144(a) Del. Gen. Corp. L – puts a stake in ground. Says transaction not automatically
voidable b/c of self-dealing.
 §144(a)(1)(3) – not voidable if:
 Material facts disclosed in good faith and majority vote by disinterested direcs or
 Material facts disclosed to shareholder, ratification (informed vote) or
 The contract is fair to the corp.
HYPO cont’d – 2yrs later Jerry sells land around Ranch for $100million. Shareholders want to
sue. Direcs wants to argue BJR, shareholders informed; direcs are protected b/c rationally believe
was in corp. interest – BJR protection. Shareholders counterargument = direcs grossly negligent.
But if no disclosure, found at later, don’t get in under §144 – transaction is void or voidable.
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


Doesn’t automatically end if no disclosure, if transaction found to be fair on substance or
procedure.
 Void transaction = ultra vires
 Voidable transaction = can be fixed by parties who created defect. Option of injured party to
void transaction in shareholder derivative suit.
Most direcs are interested in some way. Be careful not to throw out whole bd. I.e. squash player,
former dean of biz school. If interested direcs tell everything at bd. meeting, will be able to win If
representing Bd., Bd. should appoint a special committee to look into the transaction, made up of
disinterested direcs.
Under Delaware law, if an independent committee was set up to negotiate the sale for the
corporation; the court probably would apply the BJ standard of review - even if the CEO didn’t
reveal her subjective evaluation of the assets. The court views a truly independent committee as
removing the “taint of self-interest/self dealing.”
 Special committee should get outside counsel, Ibanker
 Standard for special committee – arms length, don’t necessarily need outside offer, but
should. Also don’t have to disclose reservation price unless have some duty to disclose it if it
is based on objective information.
 What if Ibanker on Bd. – handles all transactions of Trans Union. He would be interested.
So would the general counsel. No inside direcs can really be disinterested direcs. Case law
says direcs fee wouldn’t make you an interested director. Direcs aren’t employees of
company – fee rather than salary.
 Interested direcs ALI Principles of Corp. Gov. §1.23(a), 1-4
 If direc is party to transaction
 Direc has biz, financial or familial relationship w/ party in transaction
 Direc has a material pecuniary interest in transaction
 Direc is subject to controlling interest
In Stroud v. Grace – bros. had controlling influence, controlling shareholder – someone who has
the votes acting in concert or w/ group of people?
Self-Dealing & Controlling Shareholders Preview (section latter)
 Cookies Food Products v. Lakes Warehouse (Iowa 1988) - L.D. Cook incorporated Cookies BBQ
Co. It improved the local market, but the business didn’t do well. Cookies told “Speed” Herrig that he
could buy Cookies sauce for 20% less and distribute it to his customers. So Speed (who owned LW)
entered into an exclusive distribution agreement with Cookies. Under Speed, sales went up. Cookies
gave Speed 2% of gross sales to cover freight costs. Speed offered the rest of the stockholders $10.00
for their stock and became Cookies’ majority shareholder. He began to take a higher royalty. He was
given salary increases, etc.
 Note = Herrig was Controlling Shareholder on both sides of transaction! Shareholders Ps were
upset b/c the corp. wasn’t paying dividends, were direcs, got fired when Herrig b/c controlling
shareholder. Question = was transaction Herrig did w/ himself fair.
 Speed’s conduct must be evaluated only after he assumed responsibility (which is after he became
a manager). The limit of this rule is that there must be disclosure to directors, the relationship must
be disclosed, OR the transaction must be fair. The burden of proof is on Speed to prove that one of
these conditions was present.
 Court says transaction was fair to corp. Decision on substance, not process, wins on substantive
fairness b/c Speed had made so much money for Cookies, the court held that the increased royalties
were fair to the corporation.
 Cooke v. Oolie (p115 supp)—2 directors of a corp. made loans to the corp., disinterested directors
approved; Ps instituted a shareholder derivative suit, self-dealing, loan unfair. No controlling
shareholder or stockholder ratification! Test = entire fairness & burden on D, even if it is not alleged
Ds were interested.
38


Falling w/in Del. §144 does NOT entitle the bd. to the BJR, just shifts the burden to P to
demonstrate that the transaction was unfair … having met §144(a)(1) it still must meet the
standard for entire fairness
Khan v. Lynch – initial burden on party on both sides of transaction, if not shifts to P.
The Effect of Shareholder Ratification

HYPO – VG doesn’t own controlling shares. Direcs decide to sell FR to sub. VG after put up for
shareholder ratification. Is transaction good?

In re Wheelabrator Tech (supp) – Waste had interest in Wheelabrator. P are shareholders in
WTI; Waste corp. owned 20%, was minority but had substantial interest having put bd. members on
WTI board and wanted to become majority shareholder, so merger proposal; WTI’s independent
directors decided that the merger should go through, then had to be approved by a majority of minority
shareholders; under §144, full disclosure was given. No controlling shareholder, but shareholder
ratification. Special meeting, but not special committee – disinterested members voted, consulted w/
Ibanker.
 The merger = stock transaction –WTI shareholders get stock! vs. Sale of Fitness Ranch=
cash transaction – if FR did well, VG would make a lot of $$$
 Even though shareholders continue in Wheelabrator, issue remains as to what the exchange
rate is – how much Waste stock do you get? I.e. Waste stock is $70, WTI $35
 If no premium, for every 1 WTI share = ½ share of Waste; if premium, could get even
exchange; here there was a 10% premium – if stock was $35, now would get 38.5%
 What’s the nature of shareholder ratification? What’s burden on D = always have to show
shareholder’s fully informed!!
 No –lock-up provisions – meant to raise the bar for any other new bidder to come in to breakup merger, becomes more difficult for new corp. to come in.
 What are legitimate lock-ups, vs. what is entrenchment to prevent X – current issue of DE
law. Purpose of lock-up provisions = protect reliance expenditures of parties – damage
clause. Look at proportionality of lock-up to expenditures – see if it is fair – that’s why some
restrictions.
 Court held: Ps didn’t present any facts refuting duty of disclosure – no defective process as
in Smith VG to defeat shareholder vote – there was adequate disclosure for vote – claim
dismissed.
BASIC SELF-DEALING
Transaction Involves
Interested Director
Nothing
Non-controlling
fiduciary (no
shareholder had more
than 50% of vote or
controlled bd.)
Controlling Shareholder
(never get BJR b/c there
are extra obligations
that attach to protect
minority shareholders
Entire Fairness
Burden on D

Entire Fairness
Burden on D
Special Committee
(shifts burden to P if
special committee
exists)
Cooke v. Oolie
D burden to show arms
length transaction
Ps burden to show entire
fairness
Khan v. Lynch
Burden on D to show
arms length transaction
P entire fairness
Ratification by
Disinterested
Stockholders
Wheelabrator
BJR
Burden on P
Standard shifts to BJR
P burden to show entire
fairness
Shareholder ratification extinguishes duty of care claim (failure of board to make
informed choice);
39
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


Fully informed shareholder ratification does not extinguish a duty of loyalty claim, but it
serves to make the BJR the applicable review standard with the burden of proof resting on the
plaintiff shareholder.
BJR is the standard of review b/c the it was a fully informed shareholder ratification
B/c there was no one controlling shareholder, which would have prompted entire fairness
scrutiny (regardless of the full disclosure); potential for process manipulation is high, justify
heightened scrutiny … generally occurs in the parent-subsidiary merger context
Interested transactions – sanctions of market don’t matter b/c person can get rich at one
transaction.
 §144 Factors that make K not automatically void
 In case of non-controlling shareholder, corp. will set up a process where disinterested direcs
pass on transaction – independent direcs vote only. Burden on P to show EF. Most direcs
don’t like EF standard, very intrusive, but once process is in place, hard for court to strike
down a transaction. Burden shifting important to outcome in cases.
 Ratification by disinterested shareholders = BJR
 Standard for most interested transactions = entire fairness – when transaction hasn’t been
ratified by disinterested shareholders.
 Entire fairness = fair dealing (process) + fair price (substantive fairness).
 Fair Dealing = Direcs who negotiated arms length – shareholders don’t’ expect to be a
part of the process. Not sufficient alone. But it is proxy for substantive fairness!
 Fair price – necessary and sufficient condition! Shareholders are interested in whether
direcs maximize shareholder wealth.
 Key factors to show arms length = looking for alternatives or that price = market price.
Executive Compensation & Waste


Executive Compensation – sub box in duty of loyalty, along w/ self-dealing
 CEO is effectively on both sides b/c it picks bd., committee to fix compensation.
 Del. Corp. Law §141(h) – not in §144, Bd. of direcs will set the salaries – goals are to align
direcs, incentives to those of the shareholders.
 CEO compensation = Salary, Bonus, Stock Options
 HYPO – Silverman CEO & Chair of Cendent Corp. $40/sh. Disclosure of acct’g problems –
stock fell to $9/sh. Silverman repriced stock options at $10/sh.
 Reprice Options – Options = strike price – price at which option is worth o, when stock is at
that price. $30/sh, if price of stock goes up to $31, the value of the option would be $1.
Value of the stock option = current price – strike price. Maturity = if option not used,
becomes 0.
 Key Features of options
 They have no downside – doesn’t require you buy stock at certain price, only the
option to.
 Have tremendous leverage - $30 - $40 = +10/30. The option has no value at $30,
every move = $1 more.
 When option is still open = no stock
 When option is exercised, corp. will issue authorized but unissued stock – usually
corp. buys back stock w/ cash flow if don’t want stock base to increase.
 Vesting = when stock 1st becomes exercised. Note, CEO can hold the stock or sell it.
Don’t have to put up capital, don’t get stock for free – that’s why execs sell it once
exercised. Makes direcs to want the stock prices to go up! Incentive is to make $
from exercising options. What corp. does = give option to execs to buy the stock, if
they want to keep stock have to pay for it. Not taxed on option until exercised.
American Tobacco – CEO set up system so new companies would give execs 10% of company.
Direcs got it as form of compensation. Was it in articles of incorporation or by-laws? Supremes
standard = waste of corp. resources. Struck down as waste.
40


Zupnick v. Goizueta - Waste standard. Court analogized to bonus. Coca-cola stock option plan
approved by a majority of the independent directors and the shareholders; plan granted options at
market price as of the date of the grant, but could not be exercised for 1 yr., after that, available for 3
years, options are exercisable immediately if the optionee dies, disabled, retires or if there is a
change in control of the co. P arguing that directors committed corp. waste by granting options to
CEO Goizueta who was eligible to retire at the time. Held: motion to dismiss granted
 Applies Del. §157 Rights and Options Respecting Stock: “in absence of fraud,
…judgment of direcs shall be conclusive” in the absence of fraud, the sufficiency/excess of
executive compensation is a matter of business judgment for the directors
 P claiming no consideration for the options b/c CEO already obligated to perform tasks for
the co by virtue of his position
 Under the §157, any type of consideration will be ok absent fraud
 Options may be given as a bonus
 Court using a standard that is very deferential to the corp.
 In Zupnick, had both disinterested director AND shareholder approval. In that case the
burden will shift, and significantly harsher burden of unfairness will lie on P.
 Standard creates burden of proof on P that is impossible to meet – disinterested direcs
making non-fraudulent deals – Ps almost will never survive – public corps, BUT win in close
corps. b/c no disinterested direcs, courts will give closer scrutiny (see Cookies), b/c no
dividends can’t sell stock and overlap b/w managers & shareholders.
 Proper consideration can be: any fair compensation for future services (salary); any
reasonable amount as incentive bonus; as payment for past services (if great performance);
where an implied K is shown.
What makes Del. Corp. law work – shareholders are entitled to distributions pro-rata distributions;
can not be non-pro-rata distributions not in shareholders interest. If executive compensation rises
to certain level – will be struck down as violating pro-rata distribution.
Executive Compensation Mechanics
 Owners in corps. taxed 2xs = after tax distribution to shareholders taxed as personal income + corps
income is taxed.
 In close corps, mangers & shareholders are same – managers avoid double taxation by trying to take
out as much as executive compensation – corp. profits would be negligible and nothing left to tax.
 Problem = salaries paid to managers don’t reflect pro-rata distribution to shareholders and when
managers & shareholders are different
 Remedies = derivative suit, court would use substantive test to see if amount meets market fairness.
 Law has to protect pro-rata distribution to shareholders.
 Dividends = what’s left over after corp. tax paid, taxed as income
Ps Argument for Executive Compensation as Waste
Executive Compensation = excessive & wasted corp. resources so that there is nothing left of profits
to be distributed.
Claim of waste: no person of ordinary sound business judgment would say that the consideration
received for the options was a fair exchange for the options granted. P must allege facts that what the
corporation has received is so inadequate in value that none would think it adequate. (An extreme test,
never satisfied.)
A P challenging a corp. payment has the burden of demonstrating that no reasonable businessman
could find that adequate consideration had been supplied for the payment
 BUT even disinterested directors do NOT have the power to waste corp assets, absent
unanimous shareholder approval
41
 Compensation for past services is NOT allowed
 Reasonable bonuses are ok if approved by the majority of the shareholders
There MUST be some reasonable relationship between the amount paid by the corp and the value
of the services rendered (not hard to satisfy for public corps)
Doctrine of Waste
Standard Waste Argument: whatever transaction is being proposed (e.g., executive compensation),
the P will argue that the performing party is already under a duty to perform and therefore any
further payment will be a waste of assets. In essence, this is a contract claim that hinges on lack of
consideration coming from the performing party.
Counter Argument: Simply condition the expenditure on some future act by the performing party,
and you’ll get around the lack of consideration problem. No matter how sophisticated you get,
there is not a legal issue, nor is there a satisfactory legal solution. If, for instance, you condition
executive compensation packages too much, the top executives will leave



Interested parties in executive compensation
 Minority shareholders who aren’t managers or managers w/low pay
 IRS §162(m) – performance pay is not capped. Close & publicly traded corp. SEC operates
as a control.
 SEC Form SK, Item 402 – Executive Compensation, Filing requirements.
 Publishing salaries – embarrassing factor, set off institutional investors and used by
executive compensation committee
American CEO’s get paid most b/c CEO position seen as a winner of tournament, gets huge prize
disproportionately. Gets 2nd tier jump, incentives to reach CEO.
CEO has enormous role in critical issue to shareholders [CEO is chair of bd. of direcs] – if person
comes with offer to buy company, CEO gets a lot of $$ by having an incentive to sell company b/c
will get very rich by virtue of stock options. U.S. system compensates CEOs highly = efficient in
mind of shareholders. Greed is factor. Stock options are responsible for big booms.
Use of Corporate Assets; Competition with the Corp; Corporate Opportunity Doctrine
Note: Entire Fairness is not implicated as standard in corp. oppty. cases! Why not?

Corporate Opportunity Doctrine – look at as a property issue

HYPO: SH Hospital moved to new land. Land around it undeveloped. RE agent goes to Jack,
offered to sell it to him. Jack is chair of bd. of SH. Jack buys it not on behalf of hospital, but for
himself. Tells other direcs who say its okay. Battle on bd., Jack is ousted by Joan. Joan says it
was corp. opportunity. Is she right?

Gulf v. Luft - P was CEO of Luft, didn’t like biz arrangement w/ Coke. Bought up Pepsi b/c was
valuable. P claimed he mentioned the opportunity to the corp. Borrowed the facilities (used
coke $ to start own company).
 Court says it matters who opportunity was brought to – Gulf was president of corp.
 Whether opportunity was “in line of bizness” (same as corp.)
 By buying company = would the biz be in competition w/ the corp.
 DE standard
 Was the opportunity brought personally or in capacity as officer?
 Is opportunity in line of biz
 Did person disclose fact that opportunity came along.
42
If person w/ opportunity fully discloses it & the potential conflict , steps aside – has fulfilled
fiduciary duty! (Like DE law test for self-dealing)

ALI § 5.05 Standard
 §5.05(b) Defines corp. opportunity = the opportunity to engage in any business
activity of which the director or executive became aware
 How did you learn about it
 In connection with performance of function as a director or exec, if the
person offering would reasonably believe that the offer would be relayed to
the corp
 Did you use corp. property
 Through the use of corp info or property, if the resulting opp is one that
would reasonably be of interest to the corp
 Is the biz closely related to corp. biz
 Any opp to engage in a business opportunity closely related to a business in
which the corp is engaged in or expects to engage in
 ALI does NOT allow any rationalization that the corp couldn’t take advantage
of the opp for financial reasons, so its not really a corp opp
 §5.05(a) Execs have to make opportunity available to corp. disclose! Test =
fiduciary obligation of person on bd. 3rd party could take the opportunity. If corp.
rejects:
 The rejection of the opportunity is fair to the corp
 The opportunity is rejected in advance, following such disclosure, by
disinterested directors
 Ratified by disinterested direcs – no waste - the rejection is authorized in
advance, following such disclosure, by disinterested shareholders
 Fiduciary duties = bd. of direcs and executive officers have duties – doesn’t really
apply to low level employees. Note – shareholder wouldn’t have cause of action
against lower level employee. Fiduciary obligation to shareholder doesn’t extend far
down to lower level employees
 HYPO cont’d – Did Joan have a case? Yes b/c opportunity only presented informally. No full
rejections by direcs – too casual. In context, SH bd. didn’t have opportunity.
 HYPO – lawyer goes to hospital bd. w/ corp. oppty. Hospital doesn’t have funds to develop. Bd.
gives approval for lawyer to do it. Is it okay for him to buy?
ALI Test
Rejected by maj.
Disinterested direcs?


Bd. rejection of oppty
is fair to corp?
Ratified by disinterested shareholders?
Question arises when officer in good faith takes corporate opportunity when
corp. couldn’t afford it and there was rush to take it?
In close corps, have shareholder contracts, that define better what corp. oppty.
Is – case where direc says I’ll be chairman but don’t stand in way of RE
endeavors. DE & ALI approach = law for public corps, close corps different.
Four Tests - four different tests are used (depending on the court) to determine whether an
opportunity is a corporate opportunity
 Line of business - Delaware—If the opportunity is closely related to the corporation’s
existing or prospective activities. Elements: (1) the activity presented is one about which the
43
corp has fundamental knowledge and practical experience, (2) corp has the ability to pursue,
(3) the activity is adaptable to the corp.’s business having regard for its financial position,
(4) the activity is consonant w/ the corp.’s reasonable needs and aspirations for expansion
 Fairness test—the court measures the overall unfairness, on the particular facts, that would
result if the insider took the opportunity for himself. Test tells you nothing until you define
what fairness means
 Combination—some courts adopt a two-step test, under which they combine the line of
business and fairness tests - requiring satisfaction of both tests for a corporate opportunity
 Other factors - regardless of which test is used, here are some factors that courts find
important in determining whether an opportunity was a corporate one.
 Whether the opportunity was offered to the insider as an individual or as a corporate
manager
 Whether the insider learned of the opportunity while acting in his role as the
corporation’s agent
 Whether the insider used corporate resources to take advantage of the opportunity
 Whether the opportunity was essential to the corporation’s well being
 Whether the parties had a reasonable expectation that such opportunities would be
regarded as corporate ones
 Whether the corporation is closely or publicly held (the case for finding a corporate
opportunity is stronger in the case of a publicly held corporation).
 Whether the person taking the opportunity is an outside director of a full-time executive
(more likely to be a corporate opportunity in the case of a full time executive)
 Whether the corporation had the ability to take advantage of the opportunity (but not all
courts will use this factor)
 Damages—2 ways to measure:
 Damages should be measured by how much the corp was harmed
 BUT if the corp couldn’t afford the opp in the first place, then no real harm
 Restitution remedy; constructive trust—the corp now is given the chance to take over the
opportunity
Northeast Harbor Golf Club, Inc. v. Harris (supp pg. 105)—Harris (D) president of (P),
personally bought and developed adjoining property without advising the remaining board
members
 Corporate officers and directors must disclose all relevant information prior to taking
personal advantage of any potentially corporate opportunity.
 Court held that Club had to show that the land was corp. oppty, and that Harris didn’t
offer it to the club, or that club didn’t reject it properly. If Club shows that it did not
reject the oppty properly by vote of disinterested direcs after full disclosure, Harris had to
show that taking of oppty was fair to corp.

Competition w/ Corporation, Use of Corporate Assets


Use of Corporate Assets—
 A key player may not use corporate assets if this use either (1) harms the corporation or (2)
gives the key player a financial benefit.
 Corporate assets include not only tangible goods, but also intangibles like information.
 ALI §5.04—Use of corporate assets will not violate duty of loyalty if:
 It is approved by disinterested directors (after full disclosure)
 It is ratified by shareholders (after full disclosure)
 The key player pays the fair market value for any benefit he has received=§5.02
 The use constitutes compensation=§5.03
A violation will most likely be found where a director uses corp assets in starting up or
acquiring a competing business
Competition with Corporation - ALI §5.06
44





HYPO – oppty comes up 5 mi away. Chairman of bd. of SH develops surgical outpatient
center. Since biz would be competing w/ corp., have a duty to disclose.
ALI approach not a bright line rule. Often direcs have right to compete w/ corp. by K.
 A director or senior executive may NOT compete with the corporation, where this
competition is likely to harm the corp
 Conduct that would otherwise be prohibited as disloyal competition MAY be validated
by being approved by disinterested directors OR by being ratified by the shareholders.
The key player must first make full disclosure about the conflict and the competition that he
proposes to engage in.
Usually, courts find that a key player has violated his duty of loyalty even if he just prepares
to compete (rather than actually competing) while still in the corporation’s employ.
The court often will order the insider to return all salary he earned during the period. BUT if
the executive first leaves the corp, and only then begins preparations or actual competition,
this does NOT constitute a violation of the duty of loyalty.
Duties of Controlling Shareholders



Duties of Controlling Shareholders
 Almost no courts have held that a controlling shareholder owes any kind of general fiduciary
duty to the minority shareholders.
 The controlling shareholder is NOT held to the same level of fiduciary duties as directors and
managers. Nonetheless, the controlling shareholder MUST make full disclosures to their
fellow shareholders when they propose a transaction with those shareholders.
 GENERAL RULE: a shareholder owes a fiduciary duty if it owns a majority interest in or
exercises control over the business affairs of the corp. Such a shareholder MUST refrain
from using his control in order to obtain a special advantage, or cause the corp to take action
that unfairly prejudices the minority shareholders
 Duty of Complete disclosure owed to non-controlling shareholders w/ respect to a
transaction, as a matter of state common law.
 Parent/Subsidiary relations—when the controlling shareholder is another corporation (the
parent/subsidiary context), essentially the same rules apply.
 ALI §5.10—Transactions by a controlling shareholder w/ the corp
 ALI §5.11—Use by controlling shareholder of corp prop material, non-pub. corp info or corp
position
 ALI §5.12—Taking of corp opp by a controlling shareholder
HYPO - Barbie owns 85% of close corp. Guy & Doll (DG) which distributes toys. Hasboro wants
to sell name Barbie back, B wants to buy back & sell toys over internet w/ new company Barbie
Doll, not D& G. Ken complains. If Ken brings a suit? Who wins?
Zahn v. Transamerica Corporation (CTA-3 1947) Corporation had two classes of stock - class A,
which was publicly held and had a redemption price of $60, and class B, which was almost all
owned by T. Class B was the primary voting stock, but under certain circumstances, class A
retained voting rights. If the company liquidated, class A received twice as much as class B, and
class A had the right to convert into class B shares. T realized that the corporation’s inventory had
become more valuable than the books indicated, and decided to liquidate AFTER redeeming all of
the class A stock, so that T would get all of the gains in liquidation (because the liquidation value of
class A stock was greater than $60). (This was the tobacco case, where tobacco price went up
unbeknownst to minority shareholders, corp. had owned tobacco, rose in price).
 Held: under the broad language of fiduciary duty, good faith and fairness, plaintiff (and
class all A shareholders) wins. T legally had the right to call in stock by law & redemption
provision. But had to disclose that tobacco price would go up & conversion of shares.
 Rationale: The wrong wasn’t that the class B shareholders preferred their own interests to
those of class A, the wrong was their failure to disclose that the inventory was so valuable
and that liquidation was expected - because then, the class A shareholders could have
converted to class B and shared in the profits.
45



If ownership is same – no self-dealing, but if own different %s of stocks = self-dealing.
Significance: Does NOT stand for the proposition that the majority shareholder must always
subordinate their interests to those of fellow shareholders, only that the controlling
shareholder must make full disclosure to their fellow shareholders when they propose a
transaction with those shareholders.
Sinclair Oil Corporation v. Levien (pg. 748)- Sinclair owns 97% of the stock of Sinven &
Sinclair controls the board of directors of Sinven; Sinclair causes Sinven to pay out extremely
high dividends (in fact, dividends in excess of Sinven’s earnings). The Ps (who are among the
3% minority stockholders in Sinven) sue Sinclair, arguing that this dividend policy violates
Sinclair’s fiduciary duty to Sinven. Held: for D, Ps got their share of all dividends paid out, so Ds
received nothing from Sinven that Ps didn’t also get (being paid pro rata)
 3 Issues Presented
 Dividends – used dividends paid out by Sinven – minority claimed excess dividends paid
out for benefit of Sinclair and prevented Sinven from taking new opportunities.
 Corporate Opportunity – oppty’s wouldn’t be available to Sinven b/c company only put
subs in localized area.
 K Violation b/w Sinven & Sinclair – self-dealing by Sinclair by late payments that
benefited Sinclair at expense of Sinven, not equal ownership. Standard =EF
 B/c no self-dealing in paying out dividends, the BJR should have been applied
 Since the Ps cannot show that the dividends resulted from “improper motives and amounted
to waste” the BJR is satisfied and the dividend policy must be upheld.
 Self-dealing- Sinclair was on both sides of the transaction! But, it did not self-deal in this
instance w/ pro-rata distribution. Self-dealing occurs when the parent, by virtue of its
domination of the sub, causes the sub to act in such a way that the parent receives something
from the sub to the exclusion of, and detriment to, the minority stockholders of the sub.
 Such a self-dealing contract will only be upheld if the parent satisfies the intrinsic fairness
standard.
 Del §170 Dividends Payment - directors of every corporation may declare and pay
dividends, NO shareholder input or vote. Unless in certificate of corp. up to discretion of bd.
can pay it out as surplus.
 This is creditors protection device b/c creditors are the ones who worry about how much is
being paid out
 RULE: if a dividend is, in essence, self-dealing by the parent, then the intrinsic fairness
standard is the proper standard. If no self-dealing, BJR.
Controlling Shareholder








Different b/c raises question of responsibilities of individual not direcs who have fiduciary
duty to corp.
When dealing with controlling shareholder – analysis is for basic-self dealing. In close corp,
controlling shareholder = direc, so fiduciary duty.
Standard is always EF never BJR, but who has burden is question.
Court concerned that controlling shareholder has so much power that will control others.
Question = to what extent are we looking at separate fiduciary obligation?
HYPO – DG, distributor of toys, Barbie wants to form Barbie Inc., sell toys on Internet. VC
asks for consideration from Barbie – puts up her stock in D&G as capital. Can she do it?
Greene v. Dunhill – Dunhill owns Spalding. Buys company that Spalding minority
shareholders believe should have belonged to Spalding. Really corp. oppty. Case.
Kahn v. Tremont Corp (supp) - Kahn (minority) owns shares in Tremont; Simmons is the
controlling guy, he owns 90% of Valhi, Vahli owns 44% of Tremont and 55% of NL, selling
15% of NL to Tremont in order to get tax benefits and deconsolidate NL on tax statements; P
is worried about the price, that Tremont paid too much to Valhi = classic self-dealing.
Simmons wants the price to be high b/c he gets 90% of 55% rather than of 44% Held: entire
fairness standard applies
46








Special Committee set up of Stein, Boushka, Stafford: Chancery court found committee was
adequate, burden shifted to P, who didn’t meet standard.
DE crt. said special committee = adequate
 Adequacy of special committee = Have to e a disinterested committee not under control
of controlling shareholder AND has to go through arms length transaction w/ controlling
shareholder.
Court is telling directors – establish norms of behavior for direcs. If you don’t do job, can’t
escape liability.
What constitutes an arms length transaction?
 When Simmons wanted to sell NL stock, went to Saoloman which said that shares would
be hard to sell, so would need illiquidity discount of 20% (i.e. couldn’t sell at $10, would
be $8). Why? B/c people don’t want to buy minority share of stock. Market sanction
requires that nobody will buy the stock, requires the discount b/f anyone will buy.
 Not duty of Simmons to disclose it, but duty of special committee to discover it! (Duty of
care issue)
 If can’t show arms length, will have difficulty showing fair price & vice versa. Difficult
to prove price = unfair, depends on who has burden.
*If the majority shareholder is on both sides of the transaction:
 EF, burden to D (default)
 EF, burden to P, if vote by majority or the minority (disinterested shareholders)
 Under Weinberger,
 The EF test is: (a) fair price: economic and financial consideration relied upon (market,
intrinsic value, …)
 Fair dealing: conduct of corp fiduciaries in effecting the transaction (timing,
disclosure, structure, negotiated, how approvals obtained…)
 Must disclose to the minority all material facts (only whether relevant, not
whether it would have changed his decision, only that it change the total mix of
information)
Jones v. H.F. Ahmanson & Co. (pg. 766) - California case - Dealing w/ a closed corp; Large
group of shareholders breaks off and forms United Financial, in which they use Association
stock as an asset in new corp. Association had 2 different groups of common stock; 1 group,
UF, which owned the 85%, was a control group consisting of a very successful financier and
his small circle of friends and associates. UF created a holding co and went public creating
liquidity for their shares, the minority owners of the 15% could not sell their shares – could
sell but not buyers, only left to sell to Association. Controlling shareholder fiduciary. Sued.
 Inherent fairness test—burden is on the director or maj shareholder not only to prove
the good faith of the transaction, BUT also to show its inherent fairness from the
viewpoint of the corp and those interested therein
 Equal opportunity w/ respect to liquidity = when controlling shareholder is providing
liquidity for itself, must provide for minority shareholders even if they are not being
harmed. LAW IN CA ONLY!
For when you think of the opportunity as property
 Case seems to expand the duties of majority shareholder when transacting w/ the firm to
make sure the transaction meets the intrinsic fairness test
 RULE: Majority cannot use their power to control the corporation for the purpose of
promoting a marketing scheme that benefits themselves alone to the detriment of the
minority. Any use to which they put the corporation or their power to control the
corporation must benefit all shareholders proportionately and must not conflict with the
proper conduct of the corporation’s business.
NOTE:
DOES NOT REPRESENT LAW IN EVERY STATE
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Sale of Control

HYPO: Barbie decides to retire instead of putting shares in new corp. Wants to sell DG stock to
Cut & Run corp. who wants to buy entire company for $70/sh. Barbie says no, wants no less
than $80. But CR wants controlling share only. Can she do it and leave Ken remaining as
minority shareholder?
 Basic rule = Zetlin v. Hanson – a controlling shareholder can sell stock at premium price. D
owned 44% of X’s stock, and sold its shares at a premium over the per share market price
because 44% represented effective control of X. P claims that he’s entitled to a share of the
premium. Held: A controlling shareholder is free to sell his shares at a premium so long as
there’s no fraud or bad faith. To require that all minority shareholders automatically share in
every opportunity for premiums would make every bid for control be a full tender offer.
 Note: may get better controller for sale of control. Who can sell stock – new controller
liquidates for better price beneficial to shareholders.
Exceptions to Basic Rule
 Gerdes v. Reynolds – Reynolds = close end fund, assets = stock in other companies. Ps sued
direcs (who were controlling shareholders) b/c sold company to new direcs who looted company.
Ps argued, sale was illegal transaction and bad faith by direcs. D sold their shares to a group for a
substantial premium, and immediately after the sale, D resigned from the BOD and the buyers
replaced them. Buyers looted the corporation, and it filed for bankruptcy. Plaintiff sued,
claiming breach of the duty of loyalty in the sale.
 Held: Duty to inquire: Because the price for D’s shares was so high relative to any
reasonable valuation, D should have been on notice of the potential fraudulent intent of the
purchasers (and they didn’t really perform any due diligence with respect to the buyers’
background). Part of the purchase price was attributable to a buy-off (compensation for the
BOD to resign), so the sellers were liable for the amount allocable to the “bribe”. If you
know buyer is paying a lot more for company than its worth and buyer knows this, then
should know plan is to loot company.
 Standard = shareholders knew or ought to have known.
 Notes: certain factors should have put the sellers on notice of the likely fraud:
 Price was much higher than the fair value of the assets
 The corporation’s assets were very liquid - holding company for securities, so how could
the buyers expect to profit.
 the buyers were known corporate raiders
 Perlman v. Feldmann (CTA-2 1955) F sold his controlling interest in a steel production corp.
to an end user of steel during the Korean War when steel was in short supply because of the
government’s price freeze. The purchaser wanted the company so that it could secure contracts
for the supply of steel. D established Feldman plan to get around gov’t price controls, charged
higher price by breaking in 2, direct price regulated by gov’t, interest free loan, used for
improvement. Wilmot wanted to buy more steel, but once b/comes controlling shareholder don’t
have to pay the interest loan so value of Newport goes down, value of Wilmot goes up &
minority shareholders were hurt by less $ coming in from loans.
 Issue = do minority shareholders have right to profits to Feldman Plan? Yes in this case.
 Held: Value of control = corp. asset D got more of a premium. Feldmann = selling out
an opportunity to minority shareholders – selling out for higher price b/c he was taking
something, monetizing to his own value of the Feldmann Plan. Different kind of looting.
The mere possibility of corporate gain creates a breach of duty / an entitlement to
recovery. Rock says that this case reflects the times, because the court saw D profiting
from the war - it was quick to find a violation, because the opportunity to control the steel
supply belonged to the producer corporation. Held: Ps are entitled to the bonus/premium
D got when he sold his shares.
 If the corporation has an unusual business opportunity that it is not completely taken
advantage of, this opportunity may not be appropriated by the controlling shareholder in
the form of a premium for the sale of control. The power to control steel was an asset
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held in trust for the company; not something, the depletion of which would go along with
control .. you can deliver control with a sale, but you can’t deliver the assets

Equal opportunity doctrine – Andrews – if equal oppty rule, Ken would get what Barbie gets.
Pros & Cons
 Cons
 Discourages purchasers who would have to buy 90% instead of 30%. But new
controlling shareholder is better controller than other one. Hence pays the premium,
therefore advantageous to minority shareholder to have new controlling shareholder..
higher prices down the road.
 Also might make creditors worse off b/c presumably c/s have to put up more $$, borrow
to get company.
 Why have equal oppty doctrine? Worried that new buyer will engage in self-dealing that
would hurt the minority. In US have better controls against self-dealing than Europe so
more comfortable not having equal oppty. Rule. We have sufficient controls over selfdealing.
Sale of Office
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Caplan v. Lionel Corp. – D wanted to buy control of corp. but not own the stock. Intent was to
steal. Held: Where there is a transfer of a controlling/majority interest, a change of directors by
resignations and filling vacancies is appropriate, but here, the transferred interest was not a
controlling one - it was only 3%, so the court affirmed the injunction.
 Stands for the proposition that you can NOT sell corporate office absent selling
controlling control
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Essex Universal Corp. v. Yates (CTA-2 1962) Essex wanted to buy Republic Pictures (Yates
was its chairman). Essex and Yates signed K that if Essex so desired, a majority of the BOD
would resign, to be replaced by Essex’s nominees. Yates backed out at the last minute, and Essex
sought damages. Yates claimed that the contract was illegal and per se void because of the
requirement for transfer of control of the BOD (motion for SJ).
 Issue = whether in K can say I want majority of direcs even though I’m not owning 50% of
stock.
 Held: If Essex would have achieved majority share control through the transfer, then the
legality of the contract needs more analysis. It is legal to give/receive payment for the
immediate transfer of control to someone who has received majority control. The case was
remanded to determine whether 28.3% was majority control.
 Court = sometimes sale of office = good for shareholders. I.e. if company had staggered
bd. purchaser might be unwilling if it would take 3 years to take control of bd.
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Close Corporations
 Generally defined
 Has few shareholders – less than 30
 No public market for shares
 Substantial overlap b/w managers & shareholders – parties are together a lot. Suppliers of
labor & capital = same.
 May not have dividends, salaries instead..
 Types of close corps.
 Mom & Pop family biz, family =shareholders & managers
 Pre-IPO – high tech, biotech corp – corps recently formed, intend to have IPO
 If form under sub chapter XIV under Del. Corp. L. = close corp.
 Factors for deciding to be a public corp. v. cc
 Access to additional capital
 Ability to attract managers
 Market for shares - liquidity
 What protections available in cc for parties locked in? Shares can’t easily get out
 Distinction of Corporate Form for Public & CC
 Direcs are elected by majority of shares – biz & affairs means if want centralized
management, cc corp form will do it. Avoids frequent deadlock in partnerships
 Dissolution requires reso by bd. of direcs and vote of shareholders (maj.)
 Individual shareholders don’t have automatic right to sell to firm – can assign rights – can
find someone else to buy shares – no forced buy back. Gives lock-in of shareholders in cc b/c
can’t force corp. to buy stock, result = no drain on liquidity of corp. by selling of shares by
shareholders.
 All distributions have to be pro-rata
 Minority Oppression by Majority Shareholders - Types
 Falling out – b/w Maj. & Min. Maj. Can do whatever he wants, fires minority – no job,
capital locked in. Min. can’t force buy back.
 Maj. Plus group – allows buy back of majority’s stock, but not minorities. Controlling
shareholders can b/c hold vote & buyback stock. Donahue & Nixon cases.
 Majority Shareholder sells controlling stock to 3rd party and doesn’t make same oppty. to
minority. Feldman case.
 Issues that arise
 Minority Oppression
 Ability of shareholders to adopt shareholders agreements outside of certificate of
incorporation, that are enforceable. Voting block shareholder agreement.
 Del. Gen. Corp. L. §203 – enabling, invite parties to enter into agreement
 §351, 352 Provisions, Few cc use chapter 14
 Trend by corp. to grant minority shareholders rights they wouldn’t have in public corp.
 Protections
 No pro rata distributions
 Fiduciary duty of loyalty, prevents excessive salaries
 Illiquidity remains – legislatures have made it easier for minority shareholders. Court
also provides protections.
 Wilkes v. Springside Nursing Home Inc.(Mass. Case) – Majority stockholder, breached fiduciary
duties to P who was minority shareholder of Springside. Direcs had K that $ would be paid to
officers & direcs. Didn’t elect P when he had dispute w/ Quinn. He worked for corp. P stopped
getting $. Sued. Wilkes got damages, his salary.
 Court held: Direcs had no biz purpose for action = Freeze out, liable to P. If fire a minority
shareholder in cc, majority has to show legit biz purpose. If P can show alternative to
achieving the result, majority had to use the alternative.
 Quinn behaved opportunistically.
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Case overturns employment at will doctrine. Pushes standard in direction unless persons acts
inappropriately, can’t be discharged.
 2 Part Test
 No legit purpose by D (D burden to show legit biz purpose)
 P – alternative could have been done to achieve objective
 Wilkes fiduciary duty implied that minority shareholders had right to be employees of corp.
unless legit biz purpose achieved by no other means.
 CC frequently don’t have profits!
Donahue v. Rodd (CA case) – Retiring owner wants to buy back his stock. P wants buyback of
his shares also. Fiduciary duty: to allow equal opportunity for liquidity of all shareholders if
majority giving right to majority block. Court argues: CC is like partnership, “punctilio of
honor”.
 Held: either transaction was void or have to buy back minority shares
 Can offer price to shareholders that is not entirely fair, but can’t force them to accept price.
 No claim here that transaction was entirely fair.
 In Mass., equal oppty rule – have to allow sales back to corp. by min. shareholders.
 New fiduciary duty = argument is about liquidity, can’t apply liquidity discriminatorily!
Nixon v. Blackwell – 2 classes of stock, class A & B=employees, non-employees. Ps are
minority owners who aren’t employees. Majority shareholders are employees of corp.
Preference for liquidity for employees. In Mass., P would win.
 In DE, Court says Ps could have contracted around this. No other obligations under DE law.
We don’t imply any new fiduciary rights.
 Standard = entire fairness, D burden: Procedural part – legit biz purpose, longstanding biz
arrangement, no discrimination. Price fair, valuations fair.
 Transaction of this sort where no clear biz justification, there is conclusive presumption
that transaction ≠ fair, so unless presumption overturned, transaction can be overturned
by offering equal opportunity (b/c of self-dealing, buy back of Daddy Rodd)
 EF works will in public corp. setting, but in close corp. no notion of what a fair price is.
 Test in DE = EF, not equal opportunity.
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Insider Trading
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Rule 10b-5 of SEA 1934 – general restrictions on misrepresentations or fraud in purchase of
securities. Gives rise to all kinds of issues.
Tension exists b/c 10b-5 = federal law, state corp. law = duties of loyalty, care, etc.
Misrepresentations where Ps relied to their detriment
Questions
 Is 10b-5 an extension of fiduciary duty of state law?
 Functioning of capital markets – society has interest in market working fairly to encourage
investment.
Issues
 Is it more like state fid. Law/ capital market fairness
 Kinds of cases
 Insider Trading
 Firm misrepresentation (or omission of material fact) that p relied to detriment when
bought stock (non insider trading cases)
Insider Trading Cases
 Goodwin v. Agassiz (1933) D insider bought options on land based on geologist theory
about minerals. Ps owned shares, Ds bought Ps shares through intermediary. Shareholder
brought suit against director, seeking rescission of an agreement that he had made to sell his
stock to the director. He argued that the director had material knowledge about the value of
stock that remained undisclosed. Namely, director knew of a geologist’s theory that there
were copper deposits under the land around the area that the corp. owned, and thus that the
stock was grossly undervalued. (not on exam)
 Court says in general, there is obligation to disclose but in this case, facts weren’t
MATERIAL!!! Fiduciary law = obligation of direcs to corp.! But not shareholders.
Corp. wasn’t harmed here. No violation of fiduciary duty.
 Exception = when you target a person for their stocks, face to face misreps. Under
certain circumstances, a transaction between a shareholder and a director may need to be
set aside - but the court should closely scrutinize such transactions where the director
seeks out a shareholder and buys or sells shares without making a disclosure of material
nonpublic information.
 But, have to be concerned about obligation of direcs to shareholders – fairness of
markets.
 Held: The knowledge that D had amounted to an unproved theory at best, and
accordingly, the non-disclosure didn’t harm the corporation (disclosure would have hurt
the corporation). P was an experienced investor, and the shares were purchased and sold
on an impersonal market - all these lead to NO wrongdoing by the director.
 §10 of SEA – covers all transactions and close corps. Any security. Insider Trading,
Fraud, Misrepresentation.
 §10b – Untrue statements of material facts.
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
Cady Roberts – Person not insider, has correlative duties to person giving him information.
Rule = disclose or abstain rule. 10b-5 requires only: 1) existence of a relationship of access
to information; 2) inherent unfairness involved where a party takes advantage of such
information knowing it is unavailable.
SEC v. TX Gulf Sulphur (pg. 822) - TGS (D) made a significantly large discovery of
mineral deposits. While concealing the magnitude of the find, certain corporate employees
purchased large amounts of TGS stock. Ds didn’t tell direcs, b/c had to buy land – had
corporate purpose for keeping it secret. A misleading press release was issued to suppress
the effect of rumors of the large discovery. Some non-employees bought TGS stock just
prior to public release of the discovery based on their advance knowledge of the release
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Claim based on fiduciary duty – no claim if no insider traded. Claim is fiduciary
obligation & we need fair markets. This kind of trading harms the market. People won’t
invest if not fair market. The P = SEC, arguing violation of 1934 Act.
Anyone in possession of material inside information must either disclose it to the
investing public, or, MUST abstain from trading in or recommending the securities
concerned while such inside information remains undisclosed
Case was easy, but problems arose as to what parties actually did wrong. Person who
collects is limited to gains made by the offending party. SEA 1934 §20A = gives private
cause of action, but most cases brought by FTC.
Note: Potential suit by landowners precluded b/c no fiduciary duty owed to them.
A corporation that issues public statements relating to material information concerning a
matter which could affect the corporation’s securities in the marketplace must fully and
fairly state facts upon which investors can reasonably rely
Any departure from that std subjects the corp to liability for violation of 10b-5
Arises only in those situations which are essentially extraordinary in nature and which are
reasonably certain to have a substantial effect on the market price of the security if
disclosed.
NOT required to release guesses and predictions. Only facts, so that outsiders may make
their own assumptions upon which to trade or not. These are the material facts … the
facts to which a reasonable man would attach importance.
Materiality thus may depend on: indicated % the event will occur; and the magnitude of
the event in light of the totality of the company activity.
PUBLIC POLICY: all investors should have equal access to the rewards of participation
in securities transactions ... ; subject to identical market risks … creates trust and security
of a level playing field with respect to the market
Disclosure must occur in a fashion sufficient to insure its availability to the investing
public
The TGS rule - mere possession of material nonpublic information is subject to Rule 10b-5

Arguments Pro & Con for Insider Trading
 Pro – in the end, shareholders would get more $$
 Con – insider trading by direcs who have fiduciary duty may harm the firm. Officers &
direcs should manipulate info in a way that generates variance (movement in price of
stock)
 Arguments for Regulation
 Fairness
 Integrity of the Market
 Misappropriation Theory – it’s costly for firms to generate info properly. Anyone
that steals property has misappropriated it and shouldn’t be allowed to trade on it.
Materiality Standard
Elements of Fraud
Affirmative misrepresentation or omission where there is duty to disclose
Material
Done to deceive – purpose (scienter)
 Basic Inc. v. Levinson (US 1988) Starting in 1976, Combustion Engineering discussed a
possible merger with Basic. In 1977 and 1978, Basic publicly denied any merger talks since no
agreement in principle reached, not definite, stating that they had no explanation for the drastic
rise in the company’s stock. Reason for silence is fear of price going up & may have agreed on 1
53
stock price and shares may go up and scare off merger. On 12/18/78, Basic informed the NYSE
that it had been “approached by another company concerning a merger,” and on 12/19/78, the
BOD approved the merger. Plaintiffs are former stockholders who sold after the 1977 merger
denial, but before the actual announcement. They are the only people who could have realized
an injury by virtue of the misstatement.
 Held: Basic affirmatively denied something that was TRUE.
 Reliance – Court says market price is what people notice, people buy & sell stock b/c
price reflects info out in market, integrity of market
 Efficiency of market theories.
 Weak form = all past price info is in current price of stock: underlies premise
that stock prices move randomly. No sophisticated equation that gives info about
what happens next. Technological analysis doesn’t work.
 Semi-strong – all material published info is in price of stock. Markets respond
to public info. Can’t engage in any kind of analysis to beat this.
 Strong form – even non-published info in market. (not widely held). All prices
would be right all the time.
 B/c price had a lot of info in it & people buy & sell based on it (the wrong price),
material representation is something they relied upon even if didn’t know.
 Rebuttable Presumption of Reliance : Trading at market price has a presumption
that you relied on price having correct material info in it. In class action, can poll Ps
to see if really relied.
 The question of materiality is heavily fact-specific, balancing the probability
of a merger (or any other event) occurring and the magnitude of such an
event. The “fraud on the market” theory (price of a stock is determined by
all available information, misleading statements will defraud purchasers)
creates a rebuttable presumption of reliance. The defendants may rebut
this by showing that something breaks the causal connection (absent this
presumption, it would be hard to establish a cause of action). Once the
statement was made denying the presence of merger discussions, it is a 10b-5
misstatement - however, the court has to determine whether that
misstatement is of a material fact.
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Basically means that by virtue of relying on the market price, you relied on the misleading
facts
NOTE, NOONE HERE WAS INSIDER TRADING, PURELY A MATTER OF DISCLOSURE
(OR LACK THEREOF)
How to Rebutt: show that the misrepresentation in fact did not lead to a distortion of price or that an
individual P traded or would have traded despite his knowing that statements were false. That “severs the
link.” 1. If the market makers knew that the talk was bullshit (i.e. the market price was correct); 2. If the
correct information was in the market and was prevalent; 3. Knew the truth and sold anyway; or would
have sold regardless of the news.
10b-5 Claim
Rock: 10b-5 plays two roles: a. rule that regulates trading by insiders on material non-public
information; b. disclosure regulation by corps
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SEC §10(b) and Rule 10b-5
 The principle proscription against insider trading is SEC’s Rule 10b-5
 §10(b)—employment of manipulative and deceptive devices—it shall be unlawful for
any person, directly or indirectly, to use or employ, in connection w/ the purchase or sale
of any security registered on a nat’l 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 (see 10b-5)
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Any person who makes a misrepresentation (including an omission) or employs anything
to defraud, in connection w/ a purchase or sale of stock may be liable, insider or not
 An action for fraud requires:
 A material misrepresentation or omission (when there is a duty to disclose)
 Made with scienter=intention to deceive
No liability for negligence, but there is for recklessness; gross negligence is probably enough,
but subject to a factual inquiry
 Upon which there was reliance
 In connection w/ a purchase or sale
 W/ damages
Also a federal jurisdictional requirement, which will be readily met in the case of any policy
traded security, but may not be met in a face-to-face sale
Elements of a 10b-5 Action – 10b = Rule!!!
 The general elements of a 10b-5 action that plaintiff must prove are as follows:
 Defendant made a material misstatement or omission where there was a duty to disclose (see
TGS and Santa Fe)
 Plaintiff purchased/sold the security (see Blue Chip Stamps)’
 -or is it enough that it prevented you from doing so
 Scienter by D (intention to deceive - see Ernst)
 Reliance on the misrepresentation or nondisclosure (see Basic) - transaction causation
 Plaintiff incurred damages - loss causation
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10b-5 makes it unlawful to (if they occur in connection with the purchase or sale of ANY
security—registered or not, public or closely held):
 Employ any device, scheme, or artifice to defraud
 Make any untrue statement of a material fact or to omit to state a material fact
 Engage in any act, practice, or course of business which operates or would
operate as a fraud or deceit upon any person
 The insider does NOT have an affirmative obligation to disclose the material, non-public
information; he MUST choose between disclosure and abstaining from trading.
 If an insider makes an affirmative misrepresentation, he can be liable under 10b5 even if he does not buy or sell the stock himself
 Cady-Roberts Rule: insiders must disclose facts which are known to them by
virtue of their position but which are not known to persons with whom they deal
and which, if known, would affect their investment judgment
 the possession of the info creates the duty to disclose or abstain
This is the disclose or abstain rule
 If the claim is based on insider trading, D MUST be shown to have had a special
relationship with the issuer, based on some kind of fiduciary duty
 Fiduciary relationships absolutely create a duty to disclose or abstain
 Terms—
 Material Fact—A fact is material if there is a substantial likelihood that a
reasonable shareholder would consider it important in deciding whether to buy,
hold, or sell the stock. The fact that a company is engaged in a merge is no
necessarily material. Further, a fact need not be outcome determinative to be
material.
 Materiality Test—whether a reasonable man would attach importance … in
determining his choice of action in the transaction in question; balancing of both
the indicated probability of the event occurring and the anticipated magnitude of
the event in light of the totality of the company activity.
 Insider—one who obtains information by virtue of his employment with the
company whose stock he trades in.
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Tippees—person who is NOT the insider, but receives the info from the insider.
The liability is derivative from the insider’s liability. If a person knows that the
source of his tip has violated a fiduciary obligation to the issuer. If the tippee
does not know this, the tippee is not liable.
 Misappropriator—one who takes information from anyone, especially from a
person who is not the issuer, in violation of an express or implied obligation of
confidentiality
 Scienter—intent to deceive, manipulate or defraud.
 A knowing falsehood
 Absence of belief as to the truth of the statement
 False statement of knowledge
 Recklessness
This is not an exclusive list
 Who can sue under 10b-5?
 SEC
 Private parties
 MUST be someone who actually purchased or sold the securities b/c of
the material misstatement or omission
 Private remedies under 10b-5:
 Out-of-pocket measure—P recovers the price paid that he was induced to pay as
a result of the misstatement
 Loss of bargain measure—P is put in economic position where he would have
been had the misrepresentation been true
 Recissionary: not available generally for public corps
 Restitution—return the purchase price and get back property
 Civil penalties§21(a), criminal penalties §32(a)
 §20A—Liability to Contemporaneous Traders for Insider Trading
 private cause of action (for misappropriation AND for breach)
 Liability for purchasing or selling a security while in possession of material,
nonpublic information
 Liable to contemporaneous traders who purchased or sold securities of the same
class
 20A(b)—limits on liability:
 Limited to the profit gained or loss avoided
B/c of the limits, very few cases are brought as private claims, instead, they are brought
by the SEC under 10b-5
§21: allows SEC to bring a civil action
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ALI §5.04—a director or senior executive may NOT use corp property or material nonpublic information info unless:
 Value is given for the use—§5.02
 Constitutes compensation—§5.03
 The corp info is not in connection w/ trading corp securities
 Authorized in advanced, ratified
§5.02, §5.03
There are two causation issues inherent in a 10b-5 claim:
 Transaction causation (the misrepresentation caused the plaintiff to buy/sell the stock),
and
 Loss causation (the failure to disclose the inside information caused the stock to be
improperly valued, which hurt the plaintiff)
 The efficient market Hypothesis asserts that the market fully incorporates all information
into stock prices - Rock says that this speaks to loss causation requirement, but it doesn’t
address the transaction causation problem.
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White’s dissent in Basic reflects this weakness. He says that people rarely rely on market
price as a reason to buy the stock - people assume that the stock is undervalued in the
market and then they buy it.
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Buyer/Seller Requirement - normally this precludes the corporation from bringing a
10b-5 claim (but they still have the duty of loyalty claim).
HYPO – Headwaiter at good restaurant. He assigns tables based n your power. CEO sits at
pricey table and is overheard saying will do the XYZ deal by tomorrow. A stock broker tips
waiter to sit near table & overhears as well as does headwaiter. They both trade on the
information. The headwaiter regularly does this so his stockbroker also buys. 5 people trade
on the information.
Chiarella v. U.S. – p 884 - D was a printer at a financial printing company. D deduced the
identity of some targets of takeovers by Shark Inc., purchase of Target and secretly used the
information to buy share of the targets. SEC brought suit, violation of 10b-5, abstain disclose
rule applies to everyone, including non-insiders. Held: No 10b-5 violation b/c under NO
duty to disclose or abstain
 Supreme Court : 10b-5 requires fraud or deceit. Can be in silence with regards to
trading securities, but only where fiduciary duty exists! The duty to disclose or abstain
only applied where there was a relationship of trust and confidence between parties to
a transaction.
 Here D had no direct fiduciary relationship with the target companies whose shares he
traded in. Therefore, the mere fact that he traded while in possession of material nonpublic information was not enough to make him a violator of 10b-5.
 RULE: A person who trades on material non-public information is not liable unless
he is an insider or tippee and has a duty to disclose
 Thus, one way to read this case is a rejection of the Cady-Roberts rule
 Significance of Chiarella—led to the enactment of §14e-3 of SEA. 14e-3, in case of
tender offers, prevents trading by person who gets info he knows is from an insider.
Derivative liability based on derivative fiduciary duty directly or indirectly from an
insider. As long as you knew or had reason to know that you attained the info this way..
 In HYPO, headwaiter & Chiarella would be caught. Also the stockbroker who overhears
(although for x it is harder to draw fiduciary duty to him). Rule 14e-3, creates 10b-5
violations.
 Mere trading on non-public, material information does not in itself violate 10b-5 and
there can be a 10b-5 violation only when the person has violated, or knowingly benefited
from another’s violation of a fiduciary duty.
 Today, D could be convicted of wire fraud or mail fraud for having misappropriated the
information entrusted by the acquirers to Printer and thence to him. (Carpenter)
 The Supreme Court has finally accepted the misappropriation theory urged by the dissent
in Chiarella. (in O’Hagan)
 The only situation in which the non-liability rule of Chiarella clearly applies is where the
trader has learned the information without any breach of fiduciary responsibility to
anyone
 SEC was pissed after Chiarella. So they promulgated Rule §14e(3)
 §14e-3—applies only to tender offer information (NOT all public information)
 If any person has taken substantial steps to commence a tender offer, it shall constitute a
fraudulent, deceptive, or manipulative act or practice for any other person who possesses
material information relating to such tender offer which he knows or has reason to know
is nonpublic, to purchase, sell, or cause to be purchased or sold any of such securities
unless w/in a reasonable time, the info and its source are publicly disclosed
 This makes Chiarella guilty
 Reflects the SEC’s theory that you have a duty to disclose to the market
 Why Chiarella? Because we want to protect research, market analysis
57

Dirks v. SEC (pg. 896) - Dirks was a securities analyst who specialized in insurance stocks,
received a call from Secrist, claiming that Equity Funding’s (EF) engaged in fraudulent
accounting, assets overstated. Dirks investigated officers and employees, tried to get the
WSJ to publish fraud, but they said no. Although Dirks and his firm did not trade on stock
but told investor customers about fraud, who sold their stock. Stock price collapsed, trading
was halted and the fraud was exposed. The SEC charged Dirks with a violation of 10b-5 on
the theory that the fraud allegations were inside information that Dirks gave to his clients for
the purpose of permitted them to trade in Equity Funding stock. SEC felt Dirks should have
disclosed or abstained. Held: no 10b-5 violation, Dirks was clearly a tippee, not an
insider any liability for misusing the inside information must derive from the liability of
his tipper (in this case Secrist).
 Supremes: Tippee’s duty derives from the insiders duty and because Secrist did not seek
personal gain, but was motivated by a desire to expose the fraud. So Dirks goes free!
Cady-Roberts Rule rejected by SC
 Based on the job of the analyst to piece together information. Analysts are the reason
that markets are informationally efficient
 Chiarella was buying Target not Shark stock. He had duty to printer – Shark docs.
 Dirks purchase & sale goes to company that he has duty. (Insider trading on company
where info came from_
 Dirks had no independent fiduciary duty to EFA & did not acquire a duty through
Secrist’s leak – which was no violation. Dirks’s fiduciary duty was to his customers!
 What may have made Dirk’s Liable?
 If Secrist had a profit motive (derivative), personal gain test
 Or if he acquired a derivative fiduciary duty himself by taking trust of EF people X
he got info from? Ask tim.
Dirks Rule—tippee assumes a fiduciary duty only when:
 The insider (tipper) has breached his fiduciary duty to the shareholder by disclosing the
information to the tippee
 The tippee knows or should know that there has been a breach AND
 The tipper will benefit, directly or indirectly, from his disclosure




So absent personal gain by the insider, no breach, absent insider’s breach, no
derivative breach
 Liability of Tipper: No liability unless tipper personally benefits, directly or indirectly
from his disclosure. A gift to a friend of inside information will result in liability. Here,
disclosure motivated only by desire to disclose fraud, no personal benefit realized by the
officers of the corp.
Chiarella and Dirks—
 Chiarella - says w/o fiduciary duty of the insider, you don’t have to abstain
 Note - could have been a breach of fiduciary duty if Dirks had had a confidentiality
agreement with his sources for the article.
 Dirks—extends this to tippees
 In HYPO, is the headwaiter a tippee?
US v. Chestman p. 923 - Mr. & Mrs. Waubaum want to sell their stock. Ms. W calls
daughter to drive her to safe to get stock certificates. Daughter drives her to bank. Another
daughter calls daughter 1 & finds out what went on; Daughter 2 tells husband who trades on
info through his stockbroker.
Misappropriation Theory
US. V. Carpenter – Winans works for WSJ. Writes the “Heard” column about stocks and
provided C, a broker, with advance copies, began to trade on information he was privy to
before it was published. The paper had a policy of confidentiality that employees were
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supposed to follow. SEC puts forth misappropriation theory – if it is no your secret to tell,
you can’t tell it. Maybe WSJ could trade on it, buy you can’t misappropriate it and trade
o Court held: Anyone who receives information through stealing, misappropriation, or any
other “bad” means and uses it in connection with the sale or purchase of securities can be
reached by 10b-5. Since the employee breached his duty to the paper by stealing the
information from the paper, C is guilty of a 10b-5 violation.
MISAPPROPRIATION: filling that ugly gap where fiduciary links leave you high and dry

Carpenter s very different from Chiarella, which looked for some preexisting fiduciary
relationship upon which to pin a duty, and finding none, held there was no violation (the
Chiarella court never reached the misappropriation question because that theory wasn’t
presented to it). In Carpenter, both courts said that it was enough that Carpenter
breached a duty arising out of his employment relationship - his relationship with a third
party (the paper) produced a duty to abstain or disclose.
 Under § 20A, the seller of the stock can bring a cause of action - “any person who
violates 10b-5 … shall be liable to any person who contemporaneously bought/sold…” see how § 20A doesn’t refer to what the violation entails; if courts define the
misappropriation as a violation, then a buyer/seller has a cause of action, if not, then no
cause of action.
Missappropriation
 US v. O’Hagan (supp) - While tender offer plan was still a secret, D went out and made
open-market purchases of shares and call options, made $4.3m by the time plan was
announced. Hagen was working for law firm who reps GrandMet who wanted to buy
Pillsbury.
 Question 1 = Does Hagen have derivative duty to Pillsbury? No
 Hagen has derivative duty to Grand Met. If you misappropriate information of firm
involved in other side of transaction – violate 10b.
 Fiduciary duty owed to 1 firm, trades on other firm = stealing information from 1st firm
to trade on other firm. Can’t for any firm engaged in purchase or sale of securities.
 Supremes – Misappropriation theory is based on
 Fraud or deceit
 Purchase of sale of securities
 Since gap b/w the 2, filled gap w/ misappropriation
 Rule 14e(3) – goes to when hear from officer about non-published info. Doesn’t
exceed SEC rulemaking authority. SEC trying to protect financial markets. Settles as a
matter of black letter law that SEC has the authority to make 14e-3
 O’Hagen differs from Chiarella b/c Hagen was an attorney – Chiarella was purchasing
stock of Target, when duty would have been to Shark: In Dirks, he was tipping off
clients ( purchase and sale goes to fiduciary).
 Consistent w/ Chiarella & the Misappropriation theory is accepted—anyone who
misappropriates confidential info from anyone can be liable for trading on that info
 If you have breached a duty in getting that info, then you are in violation of 10b-5
if you then trade on it
 Business property theory—information belongs to the corp and the employees
are stealing it; taking business property for personal use w/o permission
 Problem w/ the business property theory is that it would support optional rules
against insider trading b/c there may be an optimal level for insider trading vs. TGS
disclose or abstain rule, which is mandatory
59
Misappropriation theory:
Outlaws trading on the basis of nonpublic information by a corporate “outsider”
in breach of a duty owed not to a trading party, but to the source of the
information (although lawyers can have fiduciary duty to corps) Just like
embezzlement. The manipulation and deception is of the source of the
information.
Attempts by
the SEC to
limit
expansion of
private
action under
10b-5





HYPO - High yield bonds – bonds that have substantial credit risk, junk bonds. CEO of
Reliance insurance says in restaurant that he has line $ up to continue to pay. Can anybody
trade on the information?
10b-5 is really about deceit & fraud and misrepresentation. SEA has expanded powers of
SEC w/ respect to insider trading (i.e SEC suing individuals) vs. SCT private causes of action
against corps. (court has narrowed jurisdiction of SEC).
HYPO – T owns 1000 shares of XYZ corp. Was going to sell, company says it will get
better. Does T have a cause of action that he would have sold if XYZ stock still falls? No –
can’t bring private cause of action saying you would have sold – 10b is about sale or
purchase of security. Only actual purchase or sale gives private cause of action under 10b
Buyer/Seller Requirement - normally this precludes the corporation from bringing a 10b-5
claim (but they still have the duty of loyalty claim).
 Blue Chip Stamps v. Manor Drug Stores (US 1975) Plaintiff in a 10b-5 action must
have purchased or sold stock. the statute doesn’t actually mandate that plaintiff has to be
a buyer or seller - you could interpret the “in connection with a purchase or sale”
language broadly, but the court declined to do so.
Scienter - the intent to deceive by not disclosing material nonpublic information D
 Ernst & Ernst v. Hochfelder (US 1976) - held that a 10b-5 action requires an allegation
of scienter, an “intent to deceive, manipulate, or defraud.” No private action in absence
of scienter. Need it b/c it is fraud, not an accidental misrepresentation.
 Under state law, do you need to prove intended to deceive? No – punctilio of honor –
duty owed of a high order. Some courts have held that recklessness suffices for a 10b-5
claim. See page 876 for definitions of recklessness.
Fraud/Misrepresentation

Santa Fe Industries, Inc. v. Green (US 1977) Santa Fe owned 95% of Kirby Corporation
(Delaware) and wanted to perform a “short-form” merger (Under Delaware § 253, because
Santa Fe owned more than 90% of Kirby, it could merge with Kirby without minority
shareholder approval - only requirement is notice to the minority shareholder and a fair price
for his shares). Green sued for 10b-5 violations saying stock was worth more and claiming
that there was a material lack of disclosure.
 Held: Santa Fe disclosed everything that they were required to the minority shareholders
before the merger. Because there was no fraud or misrepresentation about the buyout,
there can be no 10b-5 action. Full disclosure made it impossible for the plaintiffs to have
a cause of action.
 Court said shareholders were informed of §253(d) rights.
 No cause of action b/c SEA is not about internal management of corporations – since
have remedy under state law. Stands for premise that you can lie, if you don’t need votes
(see Virginia Bankshares).
 Ps had remedy = appraisal rights under state law where there is no requirement of
proof of fraud. Really have to have fraud or deceit for federal suit 10b-5 claim. Fed
courts pushing private Ps to state law – put halt on expansion of federal fiduciary
common law. Shareholder democracy doesn’t mean running corp. Well managed corps.,
60



don’t expect suits. Derivative suits on behalf of corp. are good for corp. though.
Balancing act – what maximizes shareholder wealth. Encourage suits vs. invalid suits.
If want to merger under §253 Del. Gen. Corp. L., have to file form unless own a lot.
Santa Fe stands for the fact that you have to have some sort of nondisclosure or a
misleading representation to maintain a 10b-claim.
The minority shareholders might have been able to bring a duty of loyalty claim, because
the majority shareholders froze out the minority, but that also is a state claim.
Disclosure

Malone v. Brincat – Ps allege directors of Mercury issued a continuing line of false and
misleading statements to keep stock prices up and which took the value of the company down to
nothing. Every filing made over a several year period was false regarding the financial
statements. Financials said corp. was doing well. Held: Ps have no cause of action!
 Chancery Court held: no duty to disclose absent request for shareholder action. Mercury
wasn’t asking for shareholder action. Generally the duty of disclosure only comes when the
corporation is asking for shareholder action of some kind. Otherwise, there is no separate
fiduciary duty with respect to disclosure. Federal law governs timely releases of info, and the
accuracy of such.
 Hold here that 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 circs.
 DE SCT - duty = care, loyalty & good faith & fair dealing. Cause of action = for direcs
being dishonest in public disclosure. When do disclose, have to give accurate information.
 Response to cases out of Santa Fe – Fed courts moving out of proving protection to
shareholders where corps. misstate information.
 Note = too much disclosure can harm – operating biz, may be short term but stock could go
down. Disclosure requirements are federal 33 & 34 Acts.
 Duty if you do disclose, and that disclosure is incorrect, may have cause of action in state
court (not based on fraud, but duty of due care & loyalty). If no federal cause of disclosure,
state will not make one.
61
Short Swing Trading

§16- Liability for Short Swing Trading under SEA
 §16(a) – if you have 10% or more of security, have to file. Beneficial owners buying over
10% of stock in a corp. AND directors, officers, CEO of a corp. MUST file a report w/ SEC
w/in 10 days of purchase.
 §16(b) SEA persons under §16(a) must give up any profits made in connection to a purchase
and sale (or sale and purchase) of any equity security made w/in 6 months = short swing
trading
 HYPO – Director A 3/99 $23/sh bought 10,000 shares 16(d) filing requirement – yes b/c
he is direc. 4/99 discloses, 11/00 sells for $53/sh – no violation, if sold in 8/99 = violation.
Corp. has 60 days to sue.
 Most have 4.5% of 9.9% of stock b/c 10% makes you and insider. If own 5% under § 13
have to file, but you are not necessarily and insider. Become insider under §16 if own 10%
of stock. If want to buy corp., under 5% - no duty. If 5% + have to disclose under §13.
 Exception for good faith in connection w/ a debt previously contracted
 Shareholders bringing derivative suits – corp. gets $, shareholders get benefit by pro rata
distribution. Corps have as a matter of general policy – have to tell General Counsel when
want to buy/sell stock.
 Purpose of §16(b): Have a troublesome situation of insiders having access to all this inside
information, this takes a small segment of dealings and says that it’s illegal To place a check on
beneficial owners who by virtue of owning so much stock can throw their weight around and get
insider info
 Why bring a case under 10b-5 instead of §16(b)?
 10b-5 covers more—just a purchase is enough for a violation whereas 16(b) requires a
purchase and a sale
 Corp gets the $ under 16(b), under 10b-5, the shareholders get it; so if a shareholder class
action, have to use 10b-5
 If you want to send a person to jail, have to use 10b-5, which has the possibility of
criminal ramifications
 When is a shareholder a beneficial shareholder >10%?
 Only subject to 16(b) at the point you own more than 10%
 If you purchased incrementally, only liable from the point you went from 9.9% to
10%
 If you jump from 7.3% to 13.6% all in one transaction, then NOT liable for
anything as a beneficial owner b/c never purchased stock as a beneficial owner
 Exchange of shares for cash is categorized as a sale
 Options: If they are non-discretionary, they don’t count under 16b-3a; but if it is a discretionary
grant of an option, then the date of receipt OF THE OPTION is the date of “purchase” for purpose of
16b-6.
 What is a sale for § 16(b) - usually, this is an easy question, because most stock transactions are
the exchange of shares for cash or the exchange of cash for shares; however, some unorthodox
transactions provide problems, and unfortunately, most of these occur in a merger.
 HYPO – Boon Pickens (MESA) wanted to buy Unocal. Acquired 9.7% through market
transaction. Started buying stock until 13% then bought MESA at $54/sh = 51% of company =
tender offer. Had to file §13 = interest in buying company. Unocal ahs self-tender = we buy a
certain amount of stock at $72/sh. Half leverage buyout. Says Pickens can’t participate. Pickens
share wouldn’t be worth anything. So they let him self-tender, then sued under 16b. Pickens would
lose b/c unlike Kerns, he wasn’t buying all of company, no exemption.
 Kern County Land Co. v. Occidental Petroleum Corp. (US 1973) Oxy Petroleum purchased
shares in Old Kern pursuant to a tender offer. By the time that the offer expired on June 8, OP
owned more than 10% of Old Kern’s shares. Then, Old Kern’s management tried to frustrate OP’s
takeover by initiating a defensive merger with Tenneco, whereby all of the Old Kern shareholders
would receive Tenneco stock in exchange for their stock. Therefore, there would be no more Old
62
Kern stock. OP didn’t want to be locked into a minority position in Tenneco, so just before the
expiration of its own tender offer, it sold Tenneco a $9 million option to buy back all of the Tenneco
shares that OP would receive on the merger for a stated price. Tenneco was not allowed to exercise
the option until six months after the OP tender offer expired. On August 30, OP became entitled to
receive Tenneco shares, and after the six month waiting period, Tenneco exercised its option and
bought back its shares from OP.

Issue: New Kern, the company that Tenneco formed to carry on Old Kern’s business after
the merger sued OP, arguing that granting an option to Tenneco was a sale, and that the
closing of the merger between Old Kern and Tenneco effected a sale of stock by OP for
purposes of § 16(b) (because OP traded Old Kern stock for Tenneco stock).

Crt held: Option is irrelevant. When tendered their Old Kern stock = sale. Once tendered
stock = purchase & sale w/in 6 month period. Effective the date of merger.

No violation b/c they had no choice! – gave them no ability to hold onto stock. OP never an
insider b/c never had material non-public information. Exempt from

Held: The court held for OP - neither the option grant or the transfer of stock pursuant to
the merger was a sale within the meaning of § 16(b). The court focused on two criteria - (1)
OP clearly had no access to inside information on Old Kern and the potential merger; and
(2) the exchange was essentially involuntary (the exchange of shares for stock in the
surviving company was automatic under state law - this does not mean that economic
coercion is involuntary).

Notes:

The Kern two-part test must be met before an unorthodox transaction will escape § 16(b)
liability (the test doesn’t apply to a “garden variety” transaction).
 Notice that in a usual situation; where a takeover target arranges a defensive merger, and
the unsuccessful bidder surrenders his shares as part of the merger, the bidder normally will
not have § 16(b) liability, even if the surrender occurs less than six months after the bidder’s
initial purchase.
 However, if the bidder tries to unload his stocks in the open market (once it becomes
clear that he’s lost and the defensive merger will take place), he probably won’t be able to
claim that the sale was “involuntary” (economic coercion is not a good reason), and he can
face § 16(b) liability.
 Even if OP had sold its Tenneco stock back to Tenneco within six months, there would
not have been a § 16(b) violation, because it would have been the sale of a different stock
than he purchased (purchased Old Kern stock, sold Tenneco stock).
 Argue that (1) with respect to receiving the options it was not a voluntary event, thus not
a sale; and on (2) the sale of the Tenneco shares was not a sale of the same shares that they
purchased …
 Company standard plan: accumulate slowly up to 4.9% (don’t have to declare under
13D): then rush to grab 9.9%, period before the disclosure duty kicks in; and should it go
bust you have no 16b problem about short swing.
63
Shareholder Suits

You can bring either Direct or Derivative Suits.
 Direct Suit = shareholder acts on their won behalf – can become a class action (aggregation of
individual harms)
 Derivative suit – You are suing on behalf of the corporation
 Individuals do invest in a corp. and are assuming the risk of bad management. The competitive
markets (product, control, X) police much of this XX? See tim notes
 Shareholder suits also police management. Each shareholder is a “arm” of the corporation.
 In Derivative suits, the corporation recovers the $$. The shareholders who bring the suit will
get attorney’s fees & expenses.
 There is a valuable detriment effect of derivative suits – keeps direcs in line!
 Concern is w/ Strike suits which reduces of corporation.
 Where managers & direcs find suit to be a nuisance and settle to get case out of their hair
– even if they did nothing wrong.
 Ps settle instead of seeing suit through (not helping the corporation in any way) P
attorneys want to take as little risk as possible.
 §21(d) of SEA 1934 has complicated pleading requirements in class action
 Very often, derivative suits are not heard on the merits. The P makes a demand on corp. to
investigate or suggests that such demand would be futile & files suit. This level comes b/f
consideration of the suit.
 The requirement of making demand or no is often substantive in regards to the actual merits
of the case.
 Choice 1 – Do you have a state or federal case? Direct or Derivative?
 HYPO – P& G dabble in derivatives to reduce risks. They lost much $ in these derivatives
b/c they had increased their risk, stock plummets. What cause of action do you bring?
 Fiduciary Duty of Care? – Managers failed to fully investigate, etc.
 Federal Securities case? Misrepresentation, failure to disclose? Misrepresentation or
omission w/ regards to info about hedging on the derivatives.
 P has burden of showing D should not get BJR (absent gross negligence). Read 947-952
 The Fiduciary duty of care is owed to corporation – so it would have to be a derivative
suit. If all shareholders suffer pro-rata, the suit is derivative.
 In Malone v. Brincat – supp. 202 – This was a class action suit (the corporation was not
harmed). The duty to disclose, if it exists, runs to the shareholders. The court doesn’t know
whether it should be a direct or derivative case. Court dismissed the case!
 Blasius – the classic direct suit – shareholder franchise was effected – where shareholder
voting / franchise is infringed, it is an individual shareholder’s right – direct suit.
 Diversion Of Corporate Opportunity = Derivative
 Self-Interest Transactions – can go either way (it duty of loyalty case then it is derivative –
Duty of Loyalty owed to the corporation). Non-pro-rata transaction would lead to a direct
suit.
 You would prefer to have a direct suit because you would not have to make demand on the
corporation. Also, you would like to collect damages. Also have to make security deposits
for derivative suits.
 Once you frame the cause of action you know which way you are going.
Federal Cases
 Largely direct – the class of buyers or sellers are injured
 Some derivative (rule 23.1, p 950) Goldberg v. Meridor is derivative (see Garrett
outline)
 Why are Ps not compensated, but corp. is?
 Glenn v. Hotelran Systems – p. 1016. 2 shareholders in close corp. A diverts corp.
assets to another corp. B sues for diversion of corporate opportunity. Court rules that
64




damages go to corporation, not B even though A would get some proceeds. Why? To
protect corporate entity & creditors of the corp., it is a corp. asset that was diverted.
 S
HYPO – 2 shareholders B&G. B owns 60%, G 40%. $100 is diverted to B’s bucket. B is
now ahead $40 because he stole G’s $40. G could sue to have $100 given to G – but ujust
enrichment. G could sue to have $100 returned to corp. of which his is entitled to 40% of
$40. You could conceivably give G the $40. But his cuts creditors out of the picture! Takes
$ from corporation. Also, you would fear that of $ put back in corp. that B would simply
divert again. In theory, corp. could be dissolved – that doesn’t happen often! If B had just
diverted G’s shares, there would be a direct suit! (can arise in the close corporation settings)
Perlmann v. Feldman – p.787 – Newport steel was purchased by Wilmot. A derivative suit
would allow Wilmot to recover! Wilmot was the wrongdoers so the minority shareholders of
Newport recover.
Contemporaneous Ownership Rule see Tim’s notes
Bangor Punta Operations, Inc. v. Bangor & Aroostook R.R. (pg. 1021) - Bangor Punta had
once held 98% of the stock in Bangor & Aroostook, which new owner claimed that Bangor
Punta had engaged in acts of mismanagement, misappropriation, and waste in controlling the
affairs of Bangor & Aroostook. BP sold BAR to AR in 1964 1969. A filed suit in 1971.
 This is a direct suit—suit by corp. against a former fiduciary
 Equitable principles preclude use of the corporate fiction to evade the contemporaneous
ownership rule which provides that the complaining shareholder in a derivative action
must have been a shareholder at the time of the wrong of which he complains
 Illustrates the potential for a windfall that would happen if you allow parties that buy
shares after to then bring suit
 New owner of shares already compensated for BP’s wrongs in their purchase price and if
they could sue, they would be compensated twice
§ 21D of Securities Exchange Act of 1934 Private Class Actions
 Most federal suits are class actions – break w/ Fed.R..C.P. Rules are more burdensome on
Ps. Special rule governing class actions.
 §21D(a)(2)(A) – Certificates have to be filed by representative Ps
 §21D(a)(2)(A)(ii) – flushes out whether you are a professional P
 §21D(a)(2)(iv) –
 §21D(a)(2)(vi) – can’t accept payment other than pro rata share
 §21D(3)(iii) – Rebuttable presumption – stops race to courthouse. Effectively makes party
w/ largest financial interest the lead P if they want to be – that P is not likely to settle when
they shouldn’t. That person is a material shareholder. [The race now is to sign up an
institutional investor shareholder as lead P] – P might be more willing to be too cushy w/
bizness though or have interests of shareholders. Lead P basically runs the show.
 §21D(b) – Requirements for Securities Fraud Actions (for private suits)
 §21D(b)(1) – Misleading statements and Omissions – P must state w/ particularity
what was misrepresented.
 §21D(b)(2) – State of mind – P must state w/ particularity any state of mind. Required to
prevent fishing expedition. Why? B/c Ps have access to info of publicly traded
corporation. P is insider/owner/shareholder – assumption is that you can plead w/
particularity.
 §21D(f) – Proportionate Liability – no joint & several liability. Unless there is a
determination that there was a knowing violation of securities laws. In class actions,
favorable to force Ds to settle.
 §21E(c) – Application of safe harbor for forward looking statements. Can make projections
on how biz will be, even if later wrong.
 §21E – Waiver of liability. Allowed to do this under the Act. ??
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State law cases
 HYPO – Taking derivatives, positions that hurt the company. Must demand be made?
Demand = request board to investigate & pursue a suit for some shareholders – not
necessarily futile. ALI = Universal Demand Requirement.
 Demand Requirement – have to write to the board. Please remedy the problems. Have
to make demand. Must allege in complaint why it is futile. Corp. will argue more for
dismissal for failure to make demand.
 HYPO – Corp. argues K with ad firm. The ads were terrible. Corp. paid firm anyway. A
shareholder wants to force corp. not to pay the ad firm. Must demand be made? Yes!
The direcs are not interested – so it is a BJR case. You might claim that this was an
uninformed decision, or that there were interested parties.
 Blasius – Must demand be made? No it is a direct suit! Demand must be made only in
derivative suits!
 When do you have to argue demand?
 Most of the time, corp. does something dumb = BJR.
Derivative Suit
Make Demand
You admit demand is not futile:
So it will fall w/in ambit of BJR –
so you’ll lose on Summary Judgment!
Don’t make demand! = lose case
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Claim Futility
Motion to dismiss for failure to make demand
HYPO = CEO is embezzling $ from corp. b/c he’s taking drugs. Corp. finds out. P doesn’t
make demand.
 In NY §626 (p. 874) – have to state w/ particularity demand or reasons why not.
 When you state w/ particularity that )p223 supp. 1-3
 Majority of direcs are interested
 Direcs failed to inform themselves
 Direcs failed to exercise BJ in approving transaction
In order to succeed in NY under Akers, Ps have to show sufficient particularity.
Demand requirement gets at earliest stage of outline of the case. Largely tied to if going to
have a good case on the merits. Most derivate suits are based largely on whether or not had
to make demand.
 If court says P had to make demand: P loses
 If Chancellor says demand would be futile, corp. will suffer.
Once Court says demand would be futile, etc. you put together a special litigation committee
by appointing new direcs – disinterested that will at in a totally independent way.
In Auerbach v. Bennett p. 1042 – if court decides special committee was disinterested, P
loses, BJR = standard.
 2 Tier – Kickbacks & Bribes paid to foreign gov’ts & Litigation committee was tainted
b/c it was appointed by original board.
 Court held = would decide whether they are independent, but direcs can appoint
independent persons.
 Special committee enables you to cleanse previous actions – it is as if when suit was 1st
filed, the direcs were these people, b/came fully informed, etc.= BJR protection. Special
Committee enables you to re-run this when original direcs not qualified, gives a second
chance.
 Corp. would ask for stay while litigation committee did its work.
When corp. decides to settle suit – is like P & D direcs on behalf of corp may have harmed to
corp.
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If Court decides that special committee was disinterested, that it followed proper procedures,
then that decision is governed by BJR.
Corp is the P = try and decided whether or not to pursue the claim.
So special committee can cure interested direcs & re-run BJR.
 Virtually always the Committee recommends the suit should be dismissed = if a corp.
looks like it will be nailed, it does not constitute a special committee & will settle.
These committees are expensive & time consuming. New corps. often settle if it can do so
cheaper. When corp. settles, it is P & D. Corp. pays the settlement. Do direcs have to pay if
found liable = so there is a huge incentive to settle! Pay off Ps lawyers
Typical settlement: corrective steps, payment of fees. This is why the pleading requirements
are so important. Most of our decisions are based on granting of summary judgment. Rarely
are cases tried on merits.
NY Process
Bad rejection: Sh goes ahead w/ suit,
corp forms special committee
Required & Rejected
Good rejection: No suit
Demand
Suit litigated
Excused
Board of Dirs or Special Committee
recommends dismissal (BJR scrutiny)
P bringing derivative suit:
Norm Veasey Lecture: Demand, Derivative Litigation, Direct, Class Action
 BJR – in takeover context, wasn’t working. Too much deference to board of direcs.
 In 1985 – Smith v. VG – violation of duty of care. Bd. has to be aware of all material facts
reasonably available to be informed to be protected by BJR.
 1984 – Aronson v. Lewis – to carry out duty of care, bd. has to be aware of all material facts
reasonably available.
 Unocal – when bd. of direcs conflicting – have to see a threat to corp. and they can take
counter measure as long as proportionately related to threat – proportionality requirement.
 Mirand v. Household – poison pill okay. Option to buy at lower price of stock in threat of
takeover.
 Revlon – bd. of direcs can defend corp. bastion until they decided to sell, then have to seek
best price. But up until that point, a lot of deference.
 Direct action – if something being done that affects you directly as an individual
stockholder, [injunction, relief] – usually class action. (i.e. fraud, misrepresentation]
 Derivative suit – have to plead more than conclusions!! When arguing demand was futile –
facts must be plead w/ particularity.
 §220 DE – stockholder can get books and papers of corp. as related to the demand. Stock
list (§219).
 Can’t ask for just anything – “RIFLED PRECISION” –
 Tactical Issue - Person who files 1st will get fees
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
Zapata v. Maldonado – demand was determined to be excused. If corp. bd. special
committee decides that litigation not good, get BJR, shareholder has to show bd. decision was
not independent.
Delaware Process:
 Same as NY, EXCEPT for when P follows the demand excused route and you get to the
second step of BJR scrutiny of the independent committee
Delaware’s means of assessing the indep committee under demand excused:
First, courts inquire into the independence and good faith of the committee
This is the
If NOT independent, then the suit proceeds
Zapata 2 part
If NOT reasonable pursuit of info., then the suit proceeds
test for
If NOT a good faith decision …
Delaware:
Second,
the
court applies its own business judgment to decide if the motion to dismiss
(p. 1061)
should be granted. This is the court’s own independent judgment.
Have to determine whether suit is Direct or Derivative:
 Direct Suit:
 Voting Rights Affecting Shareholders directly
 Derivative Suit:
 Hurts to corp., stockholder indirectly
 Have to ask bd. FIRST! – BJR
 Its’ the corps’s claim – have to ask for demand or ask court: original judgment is outside
BJR or Direcs not independent.
 Aronson – discretion of Chancery Court to decide on cases. Levine is not barrier. If bd.
is conflicted, all you have to raise is a reasonable doubt direcs are independent or
transaction violated BJR. Court can exercise discretion to determine whether reasonable
doubt established.
 Brehm v. Ovitz – Disney case. In derivative action, don’t go outside the 4 corners of the
complaint to see/ determine excusal of demand.
 Wrongful Demand Refusal – waive right to question independence of direcs if make
demand. Can’t make alternate claims. Once make demand, admitting direcs aren’t
independent.
 Zapata – seldom used. Most wars fought on whether demand is excused.
 Special litigation committee has to be above approach & act independent. Most of the
cases settle in derivative litigation.
 §220 Action – Ps should use it more to sharpen issues and get more settlement.
 Duty of Care vs. Duty of Loyalty = DOC will never result in pecuniary liability on direcs.
See § 102(b)(7), why exemption in certificate of incorp.
 Derivative Suit – whether demand is excused is issue decided 1str b/f summary judgment, etc.
 ALI (p. 1028) §7.01 - §7.03
 §7.01 = Direct & Derivative Actions Distinguished
 §7.03 – Demand is universally required. Futility isn’t enough. If make demand under
ALI, no futility excuse. Not harmed by that fact. But in DE, when make demand,
showing that demand is not futile. Under ALI, demand is excused if P shows irreparable
harm under §7.03(b).
 ALI §7.06 – Court authority to stay a derivative suit
 ALI §7.07 – Substantive standard on role of court in dismissing derivative suit on rec of
bd. or committee.
 §7.07(a)(2)
 §7.10 – Standard of judicial review – will lose on a motion dismiss b/c Flash would
have retained a benefit. Drug hypo. Look for how get through demand procedural
requirements.
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Combinations and Tender Offers – Mergers & Acquisitions
 Physical and Intangible Capital
 What makes corps. successful, when merged or buy assets – numerous transactions. Giving
liquidity to new owners as consideration – once go public can use stock as cash.
 HYPO - Time Warner Merger – Time & Warner decided to merge to form media giant.
 Wanted to avoid taking on too much debt. Didn’t want to be taken over by another corp.
– hostile takeover.
 Didn’t want tax liability.
 Levin (Time) wanted to continue to run corp. How did he do it?
 Merger vs. Asset Sale
 Difference b/w Merger & Asset Sales
 Mergers usually combination of 2 to form a better one company
 Asset – best done for piece meal, surviving company integrates assets into its operations
 Merger - Combined company has all liabilities of both companies and their assets. All
biz continue.
 Asset Sale – If buying piece of company (not whole) for flexibility. Strategic
advantages. Liabilities don’t necessarily become part of surviving company.
Determined contractually. Liability succeeded contractually. But if continue
operations in tact, looks like merger – may be held liable.
 Cash – If Time gives cash as merger consideration. Time buys studios, assets w/
cash. What happens to Warner stockholder? All Warner assets = now cash, so
usually will dissolve & distribute cash. Since this is cash deal and Time is the buying
corp.(doesn’t need shareholder approval), Time shareholders don’t get to vote.
 DE §271 – Sale of Assets – bd. can put assets up. Warner bd. is selling, so shareholders
of selling corp. vote – change is material enough so shareholders get vote.
 Appraisal - §262, a §271 transaction doesn’t trigger appraisal rights.
 Suppose Warner selling 57% of assets does that give shareholders right to vote? 51% is
enough to trigger rights under §271 = substantial amount of assets.
 What actions does the bd. have to take?
 Do shareholders get right to vote?
 Do shareholders get right of appraisal?
 Stock – Time offers stock – no cash have to put up. “Debt burden” – has advantages
over cash. Looks like a merger. But? No! Merger = one of 2 companies survive.
Here: Warner would own controlling interest in Time if issued Time stock to
Warner. Time would have made itself a sub of Warner b/c Warner bd. of direcs have
majority of stock. In merger, Warner bd. does not exist per se.
 Who gets to vote – both boards have to approve action. Warner shareholders get
right to vote automatically under? (I think §271). Time shareholders don’t vote
under §271 unless not enough stock and company have to authorize new stock
and to do so have to amend certificate of incorporation or under §312.03(c)(1) =
Issuance of certain 20% of stock require vote of shareholders – but only if
company listed under NYSE.
 Do issuance of bonds trigger right to vote? No! But stock yes b/c have to amend
certificate.
 §242 Amendment of Certificate of Incorporation – bd. passes action by
both parties & shareholders vote
 § 251 Merger – each will convert shares into either a combined company or one company.
Usually large company (or higher valuation). Who gets vote? – everyone votes, bd. &
shareholders.
 De Facto Merger Doctrine Guidelines – doing a merger as asset acquisition, so shareholders
don’t vote (acquiring company) – Some court use doctrine, DE DOESN’T.
 Argument for DM: don’t put form over substance
 DE law – puts form over substance. DE puts fiduciary duty into rule.
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Corp. law – gives them a menu of choices to maximize wealth.
Times into close corps., partnerships, etc.
Appraisal remedy - §262, very few get appraisal rights. If listed company, publicly
traded, don’t get appraisal but in §262(b) (2) – doesn’t give it , market out exceptions – if
there is a market for stock, doesn’t get appraisal.
Triangular Mergers
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Triangular Mergers – variant on merger theme - §251 merger
Warner
Time
T Sub
Time forms a sub, wholly owned and T sub merges
Biz rationale: if sub, no intermingling can protect T shareholders from unanticipated liabilities from
Warner.
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Time sets up T sub – gives it Time stock. In return, T sub gives Time stock to Warner?.
Merger is b/w Warner & T sub. As long as T sub is wholly owned!!! Critical feature is where
there is different ownership in various subs.
Who gets to vote
 Warner shareholders get to vote
 T Sub shareholders get to vote
 Time shareholders don’t vote
Who has appraisal rights?
 Warner shareholders don’t get appraisal – publicly traded corp. market out exception –
since public corp., they can sell shares on open market!!
 T sub – don’t get appraisal rights ?? b/c stock transaction
 Time appraisal – no appraisal rights
Any substantial change, beyond power of corp. & shareholders should be able to vote
DE rule, §251(c) merger votes – need majority of outstanding stock (not held by treasury) –
higher voting requirement.
Provisions for doing deals – 1 requires voting, 1 doesn’t
 §271
 §251 Mergers – no votes of shareholders of surviving corp. required
Explanation for disjoined voting for acquiring & non-acquiring corps. in mergers. No
problems – do we need to worry about protecting Time shareholders? No, disincentives –
Time shareholders protected by fiduciary duty laws. Plus Time is continuing company –
protected by duty of care/loyalty. Market constraints will be in effect also.
Appraisal remedy – emerged when states moved from unanimity principle
§262(a) DE – Vote no, and can ask for appraisal
§262(b) – when appraisal rights apply
§262(b)(1) – market out exception. If publicly traded company, don’t get appraisal. B/c you
can always sell stock to get out transaction. Still problem b/c if bad merger, stock price will
drop.
If stock sells down (loses value when announced), means merger is bad and may not be
approved.
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 Problems – bad deal – trigger duty problems/inquiry
 Market discipline – if deal bad, institutional shareholders will vote against deal(threat of
election also) won’t be a problem w/ shareholders b/c they most likely own stock in both
companies (portfolio diversified investors).
 Appraisal Proceedings §262(1) – close corps., no market out.
 Public corps - §262(b)(1) – market out = no appraisal.
§262(b)(2) DE – Market out exception isn’t always applicable to publicly traded corps.
 If stock is merger consideration – no appraisal
 If cash is merger consideration, Warner gets appraisal. Why? Time & Warner
shareholders don’t continue to own stock, cashed out.
 Cash in lieu of stock – if conversion ratio comes to less than a share don’t get appraisal
for that.
§262(b)(3) – Freeze out Merger – where controlling shareholder does merger w/out holding a
vote. Appraisal entitled. If it is a publicly traded sub & minorities shareholders being frozen out,
get appraisal even though public corp.
§262(d) – Appraisal is individual remedy (no class action or derivative) – have to separately ask
for it.
§262(h) – how to value assets – market protection vs. fiduciary duties. Too much disagreement
over valuation in appraisal remedy.
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Tender Offers
 HYPO cont’d – Time decides to buy Warner stock. Time will buy space in NY Times saying we
are offering to buy W stock, at $60/sh so send in form. Rights included, right to refuse to buy if
no majority. Condition also = poison pill. Time won’t buy on market b/c market will react and
price will go up. Usually buy 4.9% then tender offer.
 Voting – Warner shareholders don’t vote b/c no combined or concert of action. Time going
outside W bd. and appealing directly to shareholders.
 Market transaction, not corporate governance
 1934 SEA issue
 Time buys stock owns less than 100%. If got 90%, do a §253 merger. W shareholders wouldn’t
have no right to vote, but can get appraisal. If less than 90%, §203 merger.
 If Time bought W stock, 60%(for example), it is an interested stockholder, and can’t do anything
for 3 years.
 Exceptions
 Forces Time to go to W bd.
 If Time got 85% of stock, can do the deal regardless
 2/3 of disinterested shareholders in favor, can do transaction.
 HYPO - Sinven revisited – corporate opportunity case. Suppose Sinclair wants to buy out
Sinven. It has the power to buy, but does it have the right? Can shareholders go to court to and
ask not to be forced out? Does Sinclair need biz justification to do the merger? Under §262
Freeze-out, cash out merger – Sinclair cash for stock sale, so no market out exception. But
shareholders would get right to appraisal.
 Weinberger v. UOP – Why might market price of stock be adequate? B/c sub usually sell for less
and break out value may be more. Therefore appraisal shows the true value. Shareholders asking
for more than appraisal, felt it wasn’t enough. EF wasn’t issue, Appraisal remedy was. Court
was concerned that there was bad process will lead to bad price! Also bad process could affect
appraisal remedy b/c it did arms length transaction.
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Remedy = Quasi recissionary damages – puts P in position had there been no deal. Since
court is in equity, no punitive damages. In this case, Chancery Court added $1 to share as
damages.
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Weinberger standard on Quasi appraisal applies – appraisal remedy will include it as an
element. Are the remedies adequate? Signal probably thought it was doing a good thing by
UOP shareholders.
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Ps suit after deal is done – Smith v. VG & Weinberger
 Most cases involve BJR – have to make demand – if not, most likely to get dismissed on failure
to make a demand. Better to sue for wrongful refusal.
 If self-dealing, you will give it away by making demand??? Violation of duty of loyalty
 Grimes = tells corps how to avoid wrongful refusal.
 Williams Act – deals w/ tender offer. Shareholder protection legislation.
 §13D – 5% requirement of SEA that you own it
 §14D – provides SEC w/ broad rulemaking authority in tender offers
 §14 E
 Unocal v. MESA– Pickens owns controlling interest in publicly traded corp. MESA. Pickens
offered MESA $54/sh for 34% of Unocal, had 13% on open market. Was 2 stage deal: 2nd stage,
for $54 /sh of highly leveraged shares that would probably sell fore very little (well below $54)
In response: Unocal would buy 51% of own shares at $72/sh. Unocal was worth $60. What
would co. be worth afterwards? $47.50, .51 x 72 + .49x = $60???? Idea is to dilute ownership of
Pickens so he would lose $.
 Court there is fear of entrenchment – announces Unocal standard.
 Intermediate standard b/w BJR & EF
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Unocal 2 Step : Remember = Measures in Board Response to Takeover!!!
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Look at whether there is a threat (coercive 2-tier tender offer, inadequate price?)
Is response of incumbent bd. proportional to the threat
If yes, then BJR
Gross Negligence?
 Concern in terms of Unocal b/c of benefits of entrenchment. Mesa was terrible investment.
No case against Pickens b/c he is protected by BJR. No concern that MESA is being
necessarily hurt by Picken’s decisions. BJ – fully informed and b/c he wasn’t cashing out, no
self-interest.
 Nature of threat = 2 tier offer was coercive b/c if bonds not worth $54/sh, you would rather
sell tender stock, than get 2nd stage (i.e. didn’t tender could get $40)
 Board’s response was proportional, so could fashion a deal that would not allow him to tender
his stock. Unocal standard survives, but specific reaction prohibited by:
 Rule 14D-10 of SEA p. 1442 – (1)Equal Treatment of Security Holders – No bidder shall
make a tender offer unless: the tender offer is open to all security holders of the class subject
to the tender offer… And (2) the consideration paid to any security holder is the highest
consideration paid to any other security holder during tender…
 HYPO – which is really later case… Time & Warner want to merge. In middle of merger,
Paramount offers $125/sh. Time selling less than $100/sh. What are the responsibilities of Time
board?
 Miran v. Household – Poison Pill Defensive Measure B/f Tender Offer Occurred!
HH wasn’t up for sale no bids pending, but corp. adopted PP to prevent anyone from buying up
corp.
 Lock-up provision – permissible under Unocal. Poison Pill Case.
 2 steps
 Flip-End: If someone makes tender offer to HH – triggers creation of rights that can
be exercised in terms of redeemable preferred stock.
 Flip Over: If tender succeeds – the holder of right can convert and buy bidder’s
stock for $.50 on dollar. HH was concerned about DKM would want to buy HH
down the road. Poison Pill would enable HH shareholders to exercise rights to
preferred stocks in HH to flip over to buy stock in DKM at $.50 on dollar.
 Theory –Flip In/Flip Over causes massive dilution in stock of bidder company.
Rights Plan under which target company could buy shares at discount in bidder
company shares. Tender would be implicit acceptance of poison pill. HH – DKM
doesn’t have to go for tender offer. PP = contractual term of the merger.
 Chancery Court – PP is not violative of DE law. B/c no takeover offer was on table
so doesn’t trigger Unocal. It’s proportional response to hypothetical takeover. But
not always? Acquiring corp. doesn’t have to trigger PP – if does, viewed as
ratification/acceptance of terms.
 There are ways to structure transactions to make PP less onerous. (i.e. set up shell
corp.)
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DE Law & PP acceptance
 Smith v. VG – was decided long ago – any new case would be decided in favor of
management. HH, 1st major case after VG
 PP puts direcs & CC back into play. Critical issue = when you can use it, when do you
have to pull it in?
 Tender offer = federal issues! Outside of state law!
 Quickturn case – PP puts in conflict of §141 Now bidder company has to ask for PP to be
pulled. If don’t end up in Chancery Court.
 HH – PP could be set up- but not decided could it be used!!
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Revlon v. MacAndrews & Forbes – Perleman wanted to buy corp. up w/ cash – used junk bonds.
Needed credible financing. Cash only offer. Pantry Pride/Ron Pearlman wants to buy. Revlon
doesn’t want Pearlman to buy, responds with a Poison Pill that includes an exchange offer. Revlon
then finds Forstmann to acquire Revlon in a friendly leveraged buyout. Pearlman keeps making his
price higher. Holding: Revlon was acting in good faith up to the point when it put the pill into
place, BUT once PP raised its offer and it became apparent that Revlon was going to be sold, the
board’s responsibility was to get the highest price, so deal w/ Forstmann was inappropriate

Bergerac of Revlon mounts defenses:
 Finds White Knight – Forstmann – variant of management buyout
 DE says – takeover context, therefore heightened scrutiny = Unocal 2 step = threat,
proportional response, BJR unless gross negligence
 Court finds there was a threat, self- tender was response.
Revlon Duties
Triggered
When a corp. initiates an active bidding process seeking to sell itself
When in response to a bidder’s offer, a target abandons its long-term strategy and seeks
an alternative transaction also involving the breakup of the corp.
Distinguishing long-term plan from up for sale
After this case, as long as you have a long-term plan, you can say no to a tender
Factors
Cash out? or Stockholders continue?
Initiation of Bidding Process?
Solicitation of White Knight?
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Revlon ended the bidding – WRONG- viewed as not proportional threat.
In cash out merger, corp. has to got to highest bidder.
Court says can make constituent argument, but shareholders are first!
Revlon duties – how do we know when duties attach ?? IN REVLON, BERGERAC WENT
TO CORP., SOLICITED BIDS TO BUY CORP. TO CASH OUT!
CASH OUT – makes everything clear b/c not continuing shareholders.
Key Ingredients in case – Going to white knight, cash deal!
Paramount v. Time – Levin wanted synergy of multi-media empire. Goes after Warner. Time
wants to control corp. Structured as merger of equals. Would allow Time to pay smaller
premium. Paramount says wants to buy Time.
 Time was $80/sh – went up to $100+, Paramount offers $175/sh – Time believes price
inadequate – Time worth $250.
 Triangular merger – Time sub & Warner. T shareholders don’t vote, but Warner’s does.
 Time makes its deal w/ Warner – all out cash merger b/d required a vote under NYSE & DE
if tried to issue stock to pay for deal. Decides to take on dept to finance junk bonds so T
won’t vote.
 Time said no to Paramount – we don’t want to merge!
 §203 DE law – Paramount needs approval that not covered
 Cause of action – P trying to enjoin Time from going through merger w/ Warner.
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Court held: only preliminary injunction if reasonable chance that would win on merits.
In this case NO!
 Unocal duties:
 Threat = Paramount plan wasn’t coercive, but inadequate price! Also Time integrity,
Fear that shareholders would jump at Paramount bid
 Reasonable response = Time said go away after meeting, some defense measures, but
not prevented.
 Additional – Paramount wanted to wait until after mailing of proxy materials = coercive,
be trying to rush through.
 Revlon duties = if company up for sale, have to take highest bidder!!!
 No Revlon duties: Why?
 No cash out, stockholders continue
 Time didn’t call up white knight
 Time didn’t initiate a bidding process or solicit other bids
Cases: involve injunctive relief – equity – duty of care – move b/f enjoin.
VG – deal was done, here not coming too late.
Parmount v. QVC – Paramount wants to merge w/ Viacom. QVC came in too late (CC thought).
QVC wants to make a better tender offer, Paramount put in place defensive measures to thwart
QVC and arguing that they have a long-term plan. Held: for QVC

DE SCT held Paramount had to allow equal bidding.
 Change in control – Sumner Redstone was controlling shareholder in Viacom and would be
in new corp.
 DE – Paramount had duty to activity to act in good faith in regards to shareholders. Mistake
was Paramount didn’t talk to QVC, made up mind.
 Del ct’s saying: “as long as board acts in good faith and due care, it can just say no”
 Just having a long-term plan in place isn’t enough
 Board will never know if a counteroffer is better if they don’t look at the offer, so the target
has to look at the offer before saying no
 So if Paramount had just sat down w/ QVC, they would have had a much better chance of
winning in Chancery Court
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